Corporate Governance and Client Investing

Selecting top-notch money managers is key in a post-Sarbanes-Oxley world.

AS CORPORATE GOVERNANCE ISSUES TAKE ON INCREASED importance in the value of a stock, CPAs should take the opportunity to get ahead of the curve and help clients monitor such issues. There is general agreement that the quality of corporate governance and the effectiveness of a board of directors are critical to a company’s success.

CPAs SEARCHING FOR STOCKS OF COMPANIES WITH GOOD governance practices to recommend to clients can focus on factors such as an absence of accounting problems, employee stock option and executive compensation plans that are in the best interests of shareholders, a board of directors that isn’t dominated by shareholders with large blocks of stock and ensuring that management is pursuing a sound business strategy.

UNTIL INFORMATION ON CORPORATE GOVERNANCE practices of companies becomes more easily available, CPAs will rely on individual and mutual fund managers to monitor these issues only after carefully screening the managers themselves. To help do this CPAs should select only managers who have established reputations for integrity and ethical practices.

SOME CPAs ARE SKEPTICAL ABOUT THE INFORMATION provided by corporate governance rating services such as Moody’s or Governance Metrics International. To be effective, rating systems have to know what investors absolutely can’t live without—full disclosure, director independence and a sound business strategy.

MAUREEN NEVIN DUFFY is a freelance business writer in New Jersey. She is the editor and publisher of the Corporate Governance Fund Report, , and the newly launched CG Rate Monitor. Her e-mail address is .

ith the debris of bad corporate governance still falling from the sky—more than a year after the first major blasts erupted—it would be reasonable to expect questions about related guidelines and policies to be forming on every investor’s lips. But that’s not what CPA investment advisers are finding in the field. Most clients haven’t started to ask yet. In the meantime reactionary trends are taking hold that practitioners need to consider and apply in their work.

This article explains how some advisers have begun to work corporate governance issues into investment decisions. And with others expected to follow the trend as clients begin to understand these complicated issues better, company ethics will become a more important criterion in choosing investments than ever before. Here’s how CPAs can be ahead of the curve on a developing trend and keep themselves and their clients well informed.

If investors and the CPAs who advise them learned anything from Enron, WorldCom and other companies whose problems came to light during the past few years, it’s that the quality of corporate governance and the effectiveness of the board of directors are critical to an organization’s success. Yet most of those who agree good corporate governance is important to a company’s success probably are not yet using it as an investment-screening tool. With the ink on the Sarbanes-Oxley Act of 2002, and related SEC rules to implement it, just beginning to dry, most investment advisers are beginning to give substantive thought to the consequences of good or bad corporate governance on a stock’s investment prospects.

Sheryl Rowling, CPA/PFS, of Rowling Dold & Associates in San Diego and a member of the AICPA PFP executive committee, says right now her clients are “more concerned about the overall integrity of the market than they are with an individual company’s financial statements. The interest in corporate governance behavior hasn’t yet filtered down to my investors,” who are, Rowling says, mostly affluent professionals. She believes this attitude will change, “as more companies are charged with fraudulent practices.”

Investor Research
CPAs and their clients might have difficulty finding details of companies’ corporate governance policies. In an April 2003 survey, only 33% of the companies questioned said they had met the New York Stock Exchange requirement that they include this information on their Web sites.

Source: Blunn & Co., “Standards of Online Corporate Governance,” .

Rowling says last fall’s mutual fund scandal was of particular concern to her clients because most of their portfolios included mutual funds as opposed to individual stocks. She emphasizes that “corporate governance and the integrity of financial information are critical considerations when making investment decisions. A good investment adviser will look at these issues when selecting mutual funds as well as when analyzing fund managers’ strategies.” This process, Rowling says, is “of utmost importance to protect client interests, whether or not they themselves express this concern.”

Similarly, Barbara Raasch, a CPA/PFS with Ernst & Young in New York City, who also is a member of the PFP executive committee, says none of her clients has yet asked about corporate governance screens for money managers or what processes managers are using to gauge ethics or corporate governance criteria. However, if clients start asking for such screening, Raasch says, “I definitely see it taking hold.”

One indication of the growing trend toward corporate governance’s becoming a permanent focus for investors is the launch of a new mutual fund: The Watchdog Fund, an open-ended fund, will invest in companies to reward good governance practices. It also will take positions in public companies that need to improve their behavior. According to its prospectus, the fund may also “sell short” the shares of companies that don’t appear capable of acting on the fund’s advice for improved governance.

Howard Horowitz, chairman and CEO of H Team Capital LLC, the fund’s investment adviser, says, “CPAs need to see corporate governance as a major issue. If they hadn’t focused on it before, they need to do so now.” Horowitz cautions that the emphasis on governance and accounting issues is going to increase. In this business climate, Horowitz believes both investors and companies will be receptive to such a fund.

Exhibit 1 : Red Flags of Poor Corporate Governance
The existence of an insider-dominated board of directors.

The presence of a “celebrity” CEO.

Questionable board composition, including members with inadequate business experience or those who appear to be members due to political or other influence.

Risky pay schemes for top executives that could encourage short-term actions harmful to the company’s creditors.

The absence of an independent committee to nominate directors.

Accounting restatements or indications the company is unusually aggressive in its accounting assumptions, indicating a lack of proper controls or effective director oversight.

Evidence the company’s audit committee is not firmly in charge of the relationship with the external auditor.

High director absenteeism or lack of attendance at key meetings,
particularly the audit committee.

Lack of reasonable director turnover, which may indicate the absence of a fresh perspective on the board.

An excessive number of takeover defenses indicating an entrenched management and desire to protect the status quo.

No respect of shareholder views by rejecting shareholder proxy requests.

An incoherent ethics policy or one without a clear implementation plan.

Source: Moody’s Investors Service, rating methodology, .

For CPAs searching for stocks of companies with good governance practices to recommend to their clients, Horowitz suggest they focus on factors such as

An absence of accounting problems.
Employee stock option plans that are aligned with the best interests of shareholders.
Executive compensation plans that don’t divert value from shareholders.
Boards of directors that aren’t dominated by shareholders who own large blocks of stock.
Ensuring that management is pursuing a sound overall business strategy.

In what some may see as a contrarian strategy, Horowitz says his fund also will look to invest in companies that do not have these characteristics with the idea that share prices will rise when the company reforms its practices. For a list of red flags that indicate potentially poor corporate governance, see exhibit 1 , above.

Most of the CPAs we interviewed say they use mutual funds or separate account managers, who in turn pick the individual stocks. (Good governance, however, goes beyond stocks. See “ Corporate Governance Isn’t Just for Equities ” for more details.) That’s why the careful screening of money managers is where some CPAs say they are beginning to use corporate governance criteria.

Beth Gamel, a CPA/PFS, says her firm, Pillar Financial Advisors, in Waltham, Massachusetts, recently added five specific questions on corporate governance issues to the 48-point questionnaire it uses to select money managers (see exhibit 2 ). For example, the form asks what role matters of corporate governance and accounting policies play in a manager’s investment analysis.”

To vet the list, Pillar conferred with Boston College professor Larry Cunningham, a specialist in corporate governance issues. Pillar brought Cunningham in because the firm was concerned it wasn’t asking prospective managers enough questions about corporate governance. “We didn’t want our managers picking the next Enron,” says Gamel, whose clients are mostly high-net-worth individuals with at least $5 million to invest. She thinks the new questions have “helped us do a better job of selecting managers.” Gamel says managers have been “impressed with the questions and our enhanced due diligence. Some have strengthened their analysis due to the corporate scandals and are eager to tell us about it.”

Pillar explains to its clients its new money-manager-screening questions, using them to open a discussion about the risks inherent in investing. Gamel says the questions also allow Pillar to “show clients the level of research we do on money managers.”

Joel H. Framson, CPA, of the Allied Consulting Group in Los Angeles says CPAs and their clients “shouldn’t reward unethical companies with their investment capital.” His current approach to corporate governance investing is to “have confidence in money managers rather than inspecting their individual criteria” for choosing stocks. The key, he says, is for CPAs to “select managers who have established reputations for integrity and ethical practices.” These professionals, Framson notes, have tools at their disposal to make the right decisions about corporate governance investing. For example, he says, managers can learn a great deal about a company by “going to corporate headquarters and meeting the CEO.” These opportunities typically aren’t available to individual CPAs.

Exhibit 2 : Five Questions for Money Managers
1. What role do matters of corporate governance and accounting policies play in your analysis [of a company]?

2. How long have these matters played such a role?

3. Do you follow general guidance concerning best practices such as those publicized by CalPERS [the California state employees retirement fund], or do you have your own best-practices template?

4. As to corporate governance, what bearing, if any, do such features as the following have on your analysis (please mention others you rank as more relevant): (a) splitting the identity of the board chairman and the CEO; (b) adopting a code of ethics; and (c) the depth of financial expertise on the board’s audit committee (or other audit committee characteristics)?

5. As to accounting policies, what bearing, if any, do these practices have on your analysis (please mention others you rank as more relevant): (a) the use of pro forma accounting presentation in the ordinary course of reporting in public disclosures, including press releases; (b) the extent the company uses off-balance-sheet-financing structures, including asset securitizations; (c) the extent and manner of accounting for financial derivative instruments; and (d) the extent and manner of accounting for stock options?

Source: Pillar Financial Advisors, .

While Framson acknowledges that it’s hard to do all the due diligence necessary to select a manager, he says “as CPAs we are in a profession committed to helping protect the public.” Framson is the 2003 AICPA PFP division’s distinguished service award winner and a contributor to the just published Prudent Investment Practices, a handbook for investment fiduciaries (for more information, see “ Improve the Quality of Investment Advice ”). According to Framson this group—trustees of private trusts, corporate pension plans, 401(k) plans and the like—must pay particular attention to corporate governance issues because of the potential for personal liability. “The courts are now permitting lawsuits against individuals who neglect their fiduciary duties.” Framson says in this post-Enron environment, monitoring companies that have been identified as being complicit in self-dealing or fraud will be a key function for investment professionals.

CPAs concerned about the difficulty of selecting a money manager will find some software companies provide programs that screen them. However, Prima Capital, which in 1999 came out with PrimaGuide, a Web-based application that provides objective research, due diligence and recommendations on private money managers for high-net-worth investors, says it does not screen for corporate governance. Their major clients haven’t asked for the screen, explains David Eral, director of business development with Denver-based Prima. “We pride ourselves on enhancing our products to meet the growing needs of our clients. If we receive requests we will certainly add a corporate governance screen to PrimaGuide.”

Framson sees current efforts among educators to merge accounting data using technology as key to more transparency for investors. He says the work of Rutgers University “accounting guru” Dean Miklos Voserelli in bringing database technology to bear on corporate governance holds great promise for improved corporate research. Also the advent of XBRL, a system for standardizing financial reports and comparing specific numbers across documents and across companies, will become the new “gold rush” for those seeking to compare companies. Currently, says Framson, analysts cover only about one-third of public companies. XBRL—a global effort with 220 companies involved—has a “DVD-like format that makes it possible to see the information you want without reading the entire report.” This could make it easier for CPAs doing research to find the information they are seeking about a company without having to read stacks of annual reports.
Corporate Governance Rating Services

The Corporate Library, .

Institutional Shareholder Services, .

GovernanceMetrics International, .

Moody’s Investors Service, .

Some CPAs do advise clients about corporate governance on an ongoing basis. Jim Luffman, with Chas P Smith & Associates, in Lakeland, Florida, says his clients ask about the new rules regularly. But he says they haven’t yet begun to ask about the corporate governance rankings that ratings services such as Moody’s or Governance Metrics International have begun to assign to companies (see “ Corporate Governance Rating Services ”). Luffman acknowledges that corporate governance is a critical issue for investors. “Eventually bad governance is going to hurt shareholders and the price of stocks. So CPAs have got to stay on top of it. Otherwise, clients are going to lose money.”

Until it becomes easier to track corporate governance issues, Luffman says he is following CEO and CFO self-dealing more in the press than in ratings reports. “I hope the quality and availability of ratings get better. At some point they will become something I will pay more attention to.” In the meantime Luffman is advising his clients to “stay away from companies where the directors have been cited for self-dealing to the detriment of shareholders” (as with the recent mutual fund scandals). He emphasizes that investors are “looking for companies that keep their names out of the paper.”

“Ratings are something we discuss with portfolio managers to be sure they’re aware of them,” says Randi Grant, CPA/PFS, with Berkowitz Dick Pollack & Grant in Miami and a member of the AICPA PFP executive and PFS credential committees. Although the opinions of rating services vary widely, Grant believes most do good research on the composition and activities of corporate boards in assigning their corporate governance ratings. Grant says money managers who aren’t paying attention to these ratings “should be.”


Add appropriate new questions on corporate governance issues to any questionnaire the firm uses to evaluate investment products or services of mutual fund or separate account managers.

Until corporate governance issues become easier to track and research, concentrate on companies that have no accounting problems and that have stock option and executive compensation plans that are in the best interests of shareholders and boards of directors that aren’t dominated by shareholders who own large blocks of stock.

When selecting money managers, concentrate on people, process and performance. Who are the major players in the company? What process do they use to select the companies they invest in? What’s their track record?

Right now Grant says she also is concerned about proxy voting and the potential conflict when an officer or director influences a portfolio manager who holds proxy votes for a large block of shares. She says more clients are allowing managers to vote the proxies on stocks the client owns instead of voting themselves. “Someone should monitor how these managers vote to be sure there are no conflicts of interest,” Grant says. “I rely on the portfolio managers to make sure they have proper policies in place on how they vote proxies.” Her concern: “Not adhering to policies could create an undisclosed liability.” Grant recommends CPAs “monitor corporate governance and proxy voting lest an external auditor’s breach have an impact on financial statements” and ultimately on stock prices.

Deena Katz, a financial planner with Evansky Brown & Katz in Coral Gables, Florida, also relies on money managers to walk the straight and narrow. “I have to be sure the people I’m using are up-to-date on accounting rules and how boards operate. After all, they’re taking my clients’ money. My criteria for selecting managers are people, process and performance. Who are the major players in the firm? What process do they use to select the companies they invest in?” Katz says, “I don’t want to be blindsided by people of questionable character and bad ethics.”

One big problem, Katz says, is that “we have yet to figure out what we should be thinking about corporate governance.” As a result, she doesn’t think CPAs and other investment advisers “should depend on some rating” to make investment decisions. “To be effective,” she says, “rating systems have to know what we absolutely can’t live without—full disclosure, director independence, a sound business strategy.” Katz says ratings also need to monitor what companies are actually doing, not just what they say they’ll do. In the final analysis, she says “good corporate governance is subjective because ethics, which are essential, are themselves very subjective.


AICPA Sarbanes-Oxley Act/PCAOB Implementation Central,
, includes a variety of educational resources related to the act and its implementation including background documents, a summary of the act and links to the PCAOB and the SEC.

Members also can call the AICPA Sarbanes-Oxley hot line at 866-265-1977.

In early 2004 CPAs and other investment professionals are ready to admit that, when it comes to corporate governance, they don’t have all the answers yet. In some instances, they say, they don’t even know what all the questions are. As the implementation of Sarbanes-Oxley proceeds and good corporate governance becomes a characteristic of a sound company with solid investment prospects, more investors will look to buy stock in companies they know they can trust. That means the CPAs who advise them will have to know how to research such issues before recommending an individual stock purchase, mutual fund or portfolio manager.

Corporate Governance Isn’t Just for Equities

W ith the high-profile securities cases dealing mostly with stock manipulation, it’s easy for CPAs to overlook the effects of similar tactics on bond investors. However, the very maneuvers that inflated share values and hiked executive option packages also attacked bond values. CPA clients who opted for the more conservative fixed-income-weighted portfolios have just as much to lose from bad corporate governance as the more adventuresome equities holders.

A major change occurred when stock options started heating up. Management began treating bondholders very differently from shareholders. With options dangling in front of them, executives became myopic about increasing shareholder value. As David Baldt, executive vice-president of Schroder Investment Management in Philadelphia, points out: “You never heard anyone say, ‘I’m going to increase bondholder value.’ The quickest way to get your stock price up was to increase return on equity, which you could do by leveraging your balance sheet and taking down more debt,” in effect selling more bonds.

Experts at first considered executive stock options good for investors because they appeared to put management on the same footing as shareholders—they both stood to gain when share prices went up. But that wasn’t the real motive, says Baldt. “They did it for their own enrichment.” And, he says, “they were destroying bondholder credit quality” at the same time. Not only that, Baldt continues, “they were putting the corporation’s future at risk by having too large a bond component in their capital structure.”

Baldt says he and his colleagues became “pretty annoyed, to put it mildly,” at this shift in strategy that was going to beggar the bondholder to enrich the shareholder. “In our minds this lack of corporate governance was very irresponsible.”

S ome company management applied the same faulty logic when funding capital expenditures. Take this example: A company capitalized at $100 million with 100 million shares outstanding has earnings of $1 a share. If its management chooses to build a new factory to increase production, with the potential to increase company earnings to $150 million a year, it could elect to issue an additional 50 million shares of stock. With $150 million in earnings and 150 million shares outstanding, the company wouldn’t be increasing earnings per share and the stock price wouldn’t go up. Earnings would still be $1 a share.

But if the company took the riskier route of borrowing the $50 million in bonds, the $150 million in earnings would be divided only by the 100 million outstanding shares. And it would show an earnings increase to $1.50 per share.

“So that’s what management began to do” says Baldt, “expand their companies, but not proportionately (using some bonds and some equities).” Financing everything with bonds makes it look as if you’re earning more in the short term, he says. The short term was all many executives cared about since most would cash out their options and move to a new company within a few years. But when the economy slows down, it becomes difficult to pay off the bonds. That’s what happened to many highly leveraged companies.

Baldt sees some relief now that companies are required to expense stock options. Expensing cuts earnings, reducing the value of the options and forcing CEOs and board chairmen to stay on longer to collect their rewards. However, considerable damage already has been done. In August 2003 only 21% of corporate bonds were rated A or better; 79% were rated BBB or lower. “That’s not a healthy situation,” says Baldt. “If we have a recession, a lot of companies won’t make it.”

Of course, corporate governance always has been a large part of the bond analysis process, he says. “All along we’ve been asking how management’s actions help to preserve the company’s credit quality. Corporate governance, however, is becoming a more widespread concern for bond managers since the corporate abuses have been publicized.”

W ill corporate governance ratings help in selecting bonds? “A clever fraud can’t be detected at the time it happens,” says Baldt. “Merrill Lynch just discovered another $3 million fraud. I can’t blame the rating agencies for missing fraud and I think the analytical measures they use are good.” He feels Moody’s Investors Service’s new corporate governance initiative and other efforts “will help us do our jobs better by bringing even more focus on that area.” In August 2003 Moody’s announced it would begin publishing corporate governance assessments on selected major North American debt issuers. Its goal is to help investors assess credit risk by focusing on a company’s governance attributes and practices and their potential impact on credit quality.

As with stocks, CPAs can use this information themselves to evaluate bond issuers. Or they can make sure bond managers and bond mutual funds are taking such information into account in structuring bond portfolios for client accounts.

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