During the financial crisis, many boards of directors showed that they did not fully understand the risks that their institutions were taking. Did this failure of board oversight occur because the directors did not comply with the governance provisions of the Sarbanes-Oxley Act?

No.

Although the financial crisis spawned numerous lawsuits, none alleged any significant SOX compliance failures by boards of directors or their audit committees.

As required by SOX and related Securities and Exchange Commission rules, most of the directors of these institutions were independent. Management regularly assessed their internal controls, and these assessments were attested to by their external auditors. In 2007, none of the major institutions that later came to the brink of insolvency reported material weaknesses in internal controls.

Their audit committees were composed entirely of independent directors, who made sure that their external auditors were truly independent. The committees regularly received a list of significant accounting policies from the external auditors. Committee members also met in executive session with the company's external and internal auditors.

So, what did we learn about corporate governance from the financial crisis?

In my view, the procedures mandated by SOX for audit committees are not focused on the key items, and the traditional model of a board of directors is not effective for a large, complex corporation. In both areas, we need a new approach.

 

AUDIT COMMITTEES

The members of audit committees are deluged with massive amounts of complex information - financial statements, technical notes to these statements and lengthy SEC filings including these statements. No matter how intelligent audit committee members are, they cannot easily pick out from this mass of data the key judgments made by management and the external auditors in preparing all these documents. To be blunt, most audit committee members know what they are told by management about the company's financial situation. To paraphrase Donald Rumsfeld, the outside directors do not know what they do not know.

To become more effective, audit committee members should insist on receiving three specific pieces of information from the company's external auditors. First, the external auditors should highlight any set of transactions, such as sale-leasebacks or tax-motivated deals, that occur repeatedly at the end of quarters or financial years. Although it is reasonable to engage in one specially designed transaction in response to a particular set of problems, it is more suspicious if similar transactions occur frequently near the end of a reporting period.

Second, the auditors should identify any material item where the accounting literature allows management to choose between alternative methods of presentation (e.g., the direct versus indirect method of presenting operating cash flows on the statement of cash flows, or the option to measure certain financial assets and liabilities at fair value). The company should supply the audit committee members with a clear explanation of why it chose the alternative it did.

Third, and perhaps most important, the auditors each year should provide the audit committee with a comparison of the company and its four or five main competitors with respect to significant accounting policies - those with material financial effects and involving significant matters of judgment.

This comparative analysis should cover, for example, revenue recognition, warranty obligations, retirement plan obligations, tax reserves, and valuation of goodwill or other intangibles. It has been my experience that some of the differences among companies are due to differences in how they run their businesses, but others represent accounting judgments that the audit committee members should fully understand.

All these pieces of information should be sent to the audit committee at least one week before the committee meets. During that week, the chairman of the audit committee should informally discuss with the external auditor and the company's chief financial officer any specific issues raised by this information, as well as other "close calls" embodied in the company's financial reports.

If these suggestions are followed, the members of the audit committee will be less likely to be overwhelmed by the documents sent to them. Instead, they will be focused on the key issues in reviewing whether the company's financial reports provide investors with a materially accurate and complete picture of its financial situation.

 

CORPORATE BOARDS

More fundamentally, we need to change the experience, commitment and size of corporate boards of large, complex companies. Many boards have directors without much experience in the actual line of business of the company. For example, of the 16 directors of Citigroup in 2006, only one had ever worked for a financial services company. While every board needs a few generalists, together with an audit expert, the bulk of board members should have worked in the same industry as the company. This is the best way to make sure that directors can truly comprehend the operations and challenges of a multinational company.

As a practical matter, directors from the same industry are going to be retired executives. At that stage in their career, they no longer have the conflicts of interest that would inevitably arise with sitting executives from competitor companies. They would also have the ability to spend more time on board matters. There is a large pool of retired executives, as life expectancy rises. For many retired executives, board service would be a welcome addition to their daily routines.

Many board members do not spend enough time on their role as directors. They read the board materials in advance and attend meetings religiously. But then they are receiving information about the company mainly from management - usually from a handful of the company's top executives. Even if one board meeting a year is held at a field site, the outside directors rarely hear anything from company employees that has not been rehearsed.

Between board meetings, directors need to be active in gathering information from a broad range of sources within and outside the company. When I served on the audit committee of a large foreign company, the committee chairman started to visit the company's offices a day or two each month to chat with the middle-level employees. While he informed management in advance of these visits, he was not accompanied by a top executive. Within a matter of months, he had identified a few new issues that were brought to the audit committee for discussion and resolution.

Finally, most boards are too large. Many boards have 10 to 12 outside directors plus the chief executive. At that size, outside directors may not take enough personal responsibility for board actions or inactions. This is what social psychologists call "social loafing."

Large boards also have a difficult time in make quick decisions when needed, since boards tend to operate by consensus.

The research from social psychologists strongly suggests that a board of six outside directors plus the CEO would be optimal. This is a good size for real participation and prompt decision-making, though there are enough members to have significant differences in perspectives. Three of the outside directors would serve as chairmen of the three key committees - audit, compensation and governance. The other three outside directors would each serve on two of these committees, so each committee would have three members.

Of course, some CEOs would feel threatened by a small board of very experienced directors who spent more time on company business. But other CEOs would welcome the change; they know we need a different approach to boards, rather than more governance requirements like those in SOX.

 

Robert C. Pozen is chairman emeritus of MFS Investment Management, and also serves as a senior lecturer at the Harvard Business School and a senior research fellow at the Brookings Institution. He served on President Bush’s Commission to Strengthen Social Security and was secretary of economic affairs for Massachusetts Governor Mitt Romney.

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