Over the past three years, corporate governance and boards of directors have been front and center in the media as we hopefully close the era on the litigation against corporate wrong-doers. Several executives are behind bars, fodder for the press, and many more are in the pipeline. A high level of scrutiny remains a theme of business life.
One point is clear. The vast majority of companies are led and governed by individuals who are honest and honorable. These boards and their management are resolute about creating value without cutting corners. Admittedly though, greed does make for strange bedfellows.
Since the passage of the Sarbanes-Oxley reforms in 2002, public companies have expended great effort and expense to comply. This legislation has yielded five principal consequences.
One of the primary consequences is the cost of compliance.
Many public companies, for example, have seen their audit fees skyrocket. Their fees reflect carrying out financial assurance under pressure to be fully diligent. In addition, compliance by public companies requires a full review and, if deemed necessary, strengthening of internal controls is now required. Extensive documentation of internal controls (known as “404”) is also required. These “404” reviews are carried out by independent accounting firms other than the audit firm that is conducting the annual company audit. For larger companies, the cost of these two activities alone has increased their total accounting fees, on average, as much as four times over the fees paid prior to 2002. I have heard that for some Fortune 500 companies this translates into professional fees which exceed $100 million. Obviously, as internal controls are documented and tightened in these enterprises, these fee levels will abate. In addition, to comply, companies have incurred additional legal and consulting fees.
Secondly, resources are precious for all growth-oriented mid-cap public companies.
These companies can least afford to spend large amounts for compliance, as most are under extraordinary market pressure for efficient use of capital. As much as the CEO’s and boards of these companies would like to expend their resources elsewhere, they must earmark the necessary funds to comply, whatever the cost. For example, there is a $100 million public company in Atlanta whose professional fees for audit and internal controls will exceed $2 million this year. Clearly, this has implications for our economy.
A third but positive consequence is that because of this scrutiny, corporate board members are hard at work.
Depending on specific company circumstances, a board member is very likely to expend between 200-300 hours annually on board/committee meetings, which is up from less than 100 hours in the pre-Sarbanes-Oxley era. If a “special matter” should arise such as an SEC Investigation, a whistle-blowing incident, or the replacement of the CEO and members of his/her team, additional hours of gathering and evaluating facts and of deliberation are very likely. So, being a board member today is time-consuming and taxing and requires consummate judgment and diligence. The number of individuals who are qualified and willing (and/or are willing to be re-nominated) to serve on corporate boards and who have the inclination and appropriate competencies and experience has dwindled. Given these circumstances, chief executive officers are being asked by their own boards, for the reasons cited above, to limit their outside board activities to one other board, at most. Today, about 50% of the Fortune 100 chief executive officers do not sit on another company board. By comparison, five years ago, CEOs of the Fortune 100 companies sat on at least one other board and, in many cases, two or more. Today, as a result, many observers believe we are facing an experience drain from America’s corporate boards.
A fourth consequence is that compliance comes with a flip side, liability.
Every board member today is concerned about financial liability of their companies as well as their personal liability and reputation. For companies, the cost of directors and officers insurance, which is paid by the company, has continued to spiral upward. Obviously, in this era of government inquiries and shareholder suits, every director has heightened awareness about personal liability and the challenges of maintaining ones’ personal reputation. In increasing numbers, corporate directors are seeking additional personal and portable liability coverage. Board members now realize, though, that when compliance is breached or, for example, fraud is detected, no amount of insurance will provide sufficient liability coverage. Clearly, our current litigation-oriented climate doesn’t help in attracting and retaining the necessary “gray hair” and talent in America’s corporate boardrooms.
Lastly, on a positive note, compliance necessitates observance of director independence guidelines.
To be a member of the board’s audit or compensation committees now requires experience in the matters governed by these committees. Being knowledgeable and in a position to ask insightful questions and provide guidance to management is essential. Independence is fundamental to corporate governance and perhaps to value creation. In fact, a recent study demonstrated a direct correlation between the quality and independence of company board members to share price.
With all of the above consequences, positive or not, compliance and its associated costs are still a “given”. Boards and their companies will comply…..or “face the music”.
Most boards of companies with whom Morgan Howard consults are now turning their attention to enterprise risk, which means that board members must have, or must seek out, a thorough understanding of the company’s business platforms, strategy and its key drivers to value, including challenges and opportunities. This also means a comprehensive knowledge of the company’s CEO and its executive talent…..depth, bench-strength and commitment to develop the current and next generation of key leaders.
In many respects, understanding an enterprise from a board perspective is more difficult than the prescriptives of compliance. Compliance is defined by guidelines and regulations but strategy, its implications, and leadership are not so clearly defined and are subject to controllable and non-controllable changes driven by the customer value equation, technology, competition and perhaps by key management additions and departures. To comprehend these matters and their implications requires true diligence by every board member.
For the foreseeable future, these consequences will play out. We will never be able to regulate away greed. If boards succumb to praying to the gods of compliance over the mantra of value creation and risk-balancing, then we face more difficulties than dealing with the wrong-doers of the past decade.