Corporate Governance from an Auditing Perspective
Stuart H. Deming
Partner
Inman Deming L.L.P.
It is very much a pleasure on my part to have an opportunity to participate in this conference on corporate governance being sponsored by the Pacific Basin Economic Council (PBEC). In thinking about corporate governance issues from an auditing perspective, I could not help but be drawn back to my experiences serving in various capacities with the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice. In this regard, as the only former prosecutor among the speakers, I thought it might be useful to initially focus on a few of my experiences in that capacity.
One of things that any prosecutor learns quickly is that there is a pattern that typically accompanies almost any illegal or questionable conduct. Seldom is an illegal act an isolated event. In almost every instance, it represents a pattern of activity. For this reason, from an investigative point of view, an investigator almost always believes that a little bit of digging will uncover more evidence.
For example, many of you may know that one of the most notorious gangsters in the United States, Al Capone, was ultimately convicted of tax evasion, not murder or many of the other offenses for which he was alleged to have been involved. This goes on today. If a regulator gets wind of questionable conduct, he will not be inclined to stop digging until he or she is satisfied that an appropriate resolution has been reached.
But similarly, from a corporate governance point of view, reports of illegal or questionable conduct should be taken very seriously. A single report is often very likely a signal of a pattern of questionable activity if not a systemic problem. As will be noted later, with the onset of ever-increasing reporting and disclosure requirements on corporate management and their auditors, one isolated report of questionable conduct can have significant implications.
Another perspective I have from my experience with the SEC is the vital role a truly independent board of directors and audit committee can play in protecting the interests of shareholders as well as the corporation as a whole. The particular instance that comes to mind relates to an investigation of a Fortune 500 company. The SEC was initially drawn into the investigation by allegations that the chairman of the company was engaged in misappropriating assets for himself.
As we began to dig, we learned that not only were substantial assets misappropriated, we found that the senior level of management had been engaged in a massive accounting fraud. Improper reserve accounts had been used to manage earnings. In other words, the company had set up "rainy day" accounts to be used for showing earnings growth when earnings were not growing as projected. This, of course, was improper since financial statements are supposed to be a "snapshot" of the financial status of a company at a given point in time.
This particular case represents an example of how cutting legal corners in one aspect of how a company does business can ultimately permeate the entire company. But it is also an example of what can take place when there is not a truly independent board of directors or audit committee. Had either been in place, the company would probably not have been run into the ground. We knew this because the one member of the board who asked the tough questions was effectively marginalized by the chairman of the board.
What occurred was the chairman of the board became preoccupied with other things in his life. As a result, the company's key product went to market well before it had been properly tested. The lack of quality control led to a reject rate of up to 70 percent. The practical effect of what took place was that the company went from a Fortune 500 company to a company that lost most of its talented engineers, its major contracts as well as its reputation for quality. Had there been an independent board, an effective audit committee, or, quite simply, effective corporate governance, many of the problems would have been caught early before the company was permanently damaged.
One of the generally-held impressions of the regulation of the U.S. capital markets is that the SEC is chiefly responsible for what is generally viewed as a well-regulated market. The SEC does do a good job. But what I learned at that SEC was that the SEC's role is only a small part of a much larger regulatory scheme. The active enforcement of professional standards for accountants, the ready availability of information and an effective legal system are among the many other components of an effective regulatory scheme.
In my view, by far the most effective mechanism to policing the U.S. securities markets is the private right of action. This is a means by which shareholders or others who are victims of a violation of U.S. securities laws can take action on their own through the U.S. legal system to enforce the U.S. securities laws. These private rights of actions often fall into the category of class actions which are a source of much criticism by many U.S. corporations.
While I can appreciate the criticism of business people, few realize the dramatic role that litigation or the prospect of litigation plays in policing the capital markets in the United States. At the SEC, I found that almost every major case in which we were involved was almost always preceded by a private lawsuit. The private bar moves more quickly than the SEC does. It is also able to address problems often overlooked by the SEC because of inadequate resources. Indeed, in the case that I have discussed, the private lawsuit was filed almost a full year before the SEC opened its inquiry.
The last position I held was that of a special prosecutor at the Department of Justice looking into a major scandal involving the Congress of the United States relating to the use of a banking facility at the U.S. House of Representatives. One of the most fascinating aspects of that investigation was the impact of disclosure laws.
In almost every instance, reports of members of Congress that were subject to some from of public scrutiny were largely free of any impropriety. The vast majority of members of the U.S. Congress came through the investigation without even a taint of questionable conduct. The few members who were charged were found to have problems that arose from their bank accounts, which were not subject to disclosure. Their filings with the Federal Election Commission, which were subject to public scrutiny, were almost entirely free from problems.
Now turning to the role of auditors in corporate governance, it must be kept in mind that financial statements are supposed to be like a photograph. They should reflect the true state of the financial condition of a company at any given point in time. An accountant'' role is to assemble the necessary information to provide an accurate picture of a company's financial condition. While the assembling of the information is the accountant's role that is most familiar to all of us, a critical aspect of preparing financial statements is determining whether, in a larger sense, the financial statements truly represent a company's financial condition.
For example, a company like Honda, Motorola or Samsung may be worth far more than the actual sum of its parts. A company's name and reputation may be worth far more than the bricks and mortar of its buildings. We can all agree that having a restaurant as part of a McDonald'' franchise would be worth more valuable than a restaurant that simply sells hamburgers. On the other hand, the value of a pharmaceutical company with its key patents expected to expire shortly may be worth far less than what simple math might suggest.
An accountant's role is to help investors, creditors and corporate officials get an accurate handle on the real financial condition of a company. This is a much more complex and difficult process than is often given credit. As a result of the Asian crisis, we are all far more appreciative of the role that accountants can and should play.
Moreover, as evidenced by the comments of a number of speakers in the course of our meetings this week, there is a growing recognition of the need for international accounting and auditing standards. The more that we are all operating off the same page in terms of accounting and auditing standards and, in turn, comparing apples to apples and oranges to oranges in making business decisions, trade and investment can only be enhanced throughout the Pacific Rim.
While an accountant's role relates to providing an assessment of a company's financial condition, in his capacity as an auditor he takes steps to provide reasonable assurance that the financial statements of a company fairly and accurately report the true nature of a company's financial condition. An accountant does not start from scratch in preparing financial statements. Instead, he largely relies upon the information provided to him in preparing the financial statements.
However, it is his role as an auditor to take reasonable steps to assure that the information being provided is accurate and reflects the true nature of a company's financial condition. This means that a variety of steps are taken. Bu what is important to understand is that auditors are increasingly being required to address issues relating in one form or another to corporate governance issues as part of their audit process.
These obligations are becoming increasingly pronounced for accountants that are audition companies subject to U.S. securities laws. This is not to suggest that what is done in the United States is necessarily superior to what takes place elsewhere. But because U.S. capital markets play such an important role in facilitating trade and investment today, it is essential for any major firm engaged in international business to be sensitive to these obligations.
In virtually all situations in which a foreign company enters U.S. capital markets, it is through what are called American Depository Receipts or, in another words, ADRs. A foreign company raising capital through ADRs therefore becomes what is called an "issuer" under U.S. law and subject to the U.S. securities laws, including the Foreign Corrupt Practices Act.
The premise that underlines U.S. securities laws is the concept of disclosure. Quite frankly, a company can do almost anything it wants under U.S. securities laws as long as it is properly disclosed. Seldom does the SEC become involved in ruling on what a company can or cannot do. On the other hand, no one likes to disclose what might be adverse or embarrassing. This is the self-policing mechanism that lies at the core of U.S. securities laws. If a problem later arises and there was no disclosure suggesting that the problem could arise, a violation of U.S. securities is triggered. A SEC investigation or surely a lawsuit can be expected to follow.
Historically, disclosure under U. S. securities laws focused on what was believed to be material in a quantitative sense to the bottom line of a company. This past year, in what is called Staff Accounting Bulletin N. 99, the SEC took the position that qualitative materiality should also be taken into consideration. It emphasized that the "evaluation of materiality requires a registrant and its auditor to consider all the relevant circumstances." It also reported that "there are numerous circumstances in which misstatements below 5% could well be material." Among the examples cited were misstatements involving concealment of an unlawful transaction.
A related and potentially more dramatic development relates to what is commonly referred to as "Section 10A." As part of the Private Securities Litigation Reform Act of 1995, issuers were required to institute procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts. Unless clearly inconsequential, Section 10A requires the auditor to inform the appropriate level of management of an illegal act and assure that the registrant's audit committee is "adequately informed" with respect to the illegal act.
When an auditor concludes that an illegal act may have a material effect on the financial statements and that senior management has not taken remedial action, the auditor must report to the board of directors that the failure to take remedial action is reasonably expected to warrant departure from a standard report of the auditor or warrant resignation from the audit engagement. The board of directors must inform the SEC by notice not later than one business day after receipt of such a report.
It should be noted in this regard that in December the SEC's Chief Accountant disclosed in a letter t the American Institute of Certified Public Accountant's Director of Audit and Attest Standard that a relatively small number of reports have been submitted to the SEC pursuant to Section 10. For this reason, the SEC is likely to be looking for situations to make an example of a company or its auditors, or both, for failing to make a disclosure under Section 10A.
The obligations under Section 10A become particularly complex when the obligations under Rule 13b2-2 under the Exchange Act are taken into account. Rule 13b2-2 prohibits may officer or director from making materially false or misleading statements or omitting to state any officer or director from making materially false or misleading statements or omitting to state any material facts in the preparation of filings required by the Exchange Act. Though it applies only to officers and directors of a publicly-held company, Rule 13b2-2 is broad in terms of its coverage. It extends to internal auditors as well as to outside auditors. It also extends to "causing another person to make a material misstatement or make or cause to be made a materially false or misleading statement." Not only are misrepresentations covered, but a failure to clarify a statement can constitute a violation of Rule 13b2-2.
The combination of management's obligations under Rule 13b2-2 and an auditor's obligations under Section 10A therefore may effectively eviscerate the protections of the attorney-client privilege as well as any inclination to withhold unfavorable information. If auditors are carrying out their responsibilities under Section 10A, audits must now be designed to detect illegal conduct. As a result, questions should be asked as to whether management has knowledge of illegal acts or where illegal conduct is most likely to occur.
Even though management may have become aware of or suspect questionable conduct through its attorneys, management controls the attorney-client privilege and therefore is presented with the dilemma of disclosure along with the possible consequences or face a potential criminal charges for violating Rule 13b2-2 for failure to disclose. In short, the consequence of the increasing obligations to detect illegal conduct combined with the increasing obligations to disclose illegal conduct is that questionable conduct can no longer be ignored or remain concealed.
A company and, in particular, a publicly-held company is increasingly putting itself at great risk by not taking steps to insure that it has an effective system of corporate governance. While it is impractical in the course of a relatively brief presentation to lay out in any detail all the considerations that should go into developing good corporate governance program, there are three general principles that, in my opinion, should be kept in mind.
First of all, corporate governance programs should be clear, concise and be understood by people working at all levels within a company, including agents and independent contractors acting on behalf of a company. The latter category is especially important and is often overlooked. Everyone must understand the corporate policy and what is expected if they are to work for or on behalf of the company.
Secondly, the importance of compliance with corporate governance policies mush be demonstrated by top management not only by words but also by deeds. It must come from the top and be actively implemented and enforced, even at great cost or embarrassment to senior corporate officials. What is put on paper is not enough. Nor is the disciplining of low-level employees adequate. The right signal needs to be sent from senior management to set the tone for the entire company.
Lastly, corporate governance issues must be a collaborate effort. The more that corporations can establish means by which potential problems can be addressed at an early stage, the less likely are problems likely to fester and to turn into more serious problems. For example, often overlooked are the problems faced y people in the field. They are working in unfamiliar settings and under great pressure. Unwittingly, all of us could end up entering into an agreement where, after a night's reflection, we realize that we may have made a mistake.
The key is for the people in the field to have adequate confidence and ability to communicate with senior people, including company compliance officials. They should be able to call and ask whether they may have made a mistake and, as opposed to suffering retribution or covering up the problem, the company should work with him or her and, if necessary, extricate itself from the potentially damaging situation.
To me, a constructive approach in what we should be working towards in developing and implementing corporate governance programs. Problems will inevitably arise. They goal of corporate governance should be to ensure that problems will be surfaced at a time and in a way that they can be dealt with so that the damage to a company, its shareholders and to its reputation are minimized.
In concluding, let me acknowledge that corporate governance issues may pose headaches for corporate executive and take time from seemingly more important matters. But when I was asked to speak at this conference, the first thought that came to me was the reaction of a senior executive at a major investment firm after I had taken his testimony as part of an investigation with the SEC. He thanked me. He said if it were not for the SEC and other regulators, auditors and lawyers doing their job, an honest businessman like him could not do his job. This is the perspective that we must all keep in mind.