EXECUTIVE SUMMARY
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Section 407 of SOX
requires public company
disclosure of “financial expert”
participation on an audit committee but
stops short of requiring one. Reasons for
not including one must be disclosed. CPAs
have become prime candidates to serve in
this capacity because they generally meet
the definition of a financial expert.
Typical corporate
director duties include managing a
company on behalf of, and in
the best interests of, the shareholders in
an oversight and advisory role. The audit
committee of a board has additional
responsibilities, and for public companies
these responsibilities must be carried out
in accordance with SEC, SOX, and stock
exchange requirements.
Directors are
expected to perform their duties
according to certain standards of
conduct. State and federal guidance on
director liability provides that directors
acting in good faith and performing duties
with due care, loyalty, and diligence
should be protected from liability in
conjunction with board service.
Out-of-court
settlements in high-profile cases
such as Enron and Worldcom may
have heightened concerns about the
personal liability of directors, but do
not create a legal precedent.
Recent litigation
cases involving director liability
suggest that board members will
be insulated from liability as long as
they did not breach their fiduciary duty
by engaging in self-dealing and were not
personally aware of wrongdoing on the part
of the corporation or its officers.
Being designated an
expert means that directors are
expected to use that expertise when
carrying out duties, and this will be
considered when determining whether those
duties were performed with due diligence
and in good faith.
Deborah Archambeault,
CPA, Ph.D., is assistant
professor of accounting at the University
of Tennessee at Chattanooga. John
Friedl is a professor in the
Department of Accounting and Department of
Political Science, Public Administration,
and Nonprofit Management at the University
of Tennessee at Chattanooga. Their e-mail
addresses, respectively, are
Debbie-Archambeault@utc.edu and John-Friedl@utc.edu. |
Financial scandals routinely highlight the
need for improved corporate governance and the
reliability of financial reporting. Lawsuits
associated with these scandals have focused
attention on the individuals involved, management
and directors alike, and the personal liability
that may result. The profession is at an
interesting crossroads—CPAs are needed to fill the
roles of conscientious, diligent watchdogs on
corporate boards and audit committees. However,
personal liability concerns may deter excellent
candidates from agreeing to serve. This article
summarizes some relevant legal issues and provides
suggestions for accountants who are considering
whether to serve on a board.
ADDITIONAL DEMAND The
Sarbanes-Oxley Act contains requirements intended
to improve the accuracy and reliability of
corporate disclosures. Section 407 of SOX requires
public companies to disclose whether the audit
committee of the board of directors includes at
least one “financial expert.” Final rules issued
pursuant to section 407 (SEC Rel. No. 33-8177)
define an audit committee financial expert
as a person who has an understanding of GAAP
and financial statements; an ability to assess the
application of accounting principles; experience
in the preparation, audit, analysis or evaluation
of financial statements; experience in accounting
internal controls; and an understanding of audit
committee functions. (For a complete SEC
definition of an audit committee financial expert,
see page 46.) Section 407 stops short of
requiring the presence of a financial expert on
the audit committee, but it does require companies
lacking a financial expert to disclose their
reasons for failing to include one. It seems
companies should prefer including a financial
expert on the audit committee rather than
explaining the absence of one. A director does not
have to be a CPA or an accountant to qualify as a
financial expert, but CPAs are prime candidates
for the position because they generally meet the
qualifications.
DIRECTOR RESPONSIBILITIES
The corporate director’s role is to manage
the company in the best interests of the
shareholders. Directors generally delegate
authority and responsibility for daily operations
to the CEO and senior management, while taking on
an oversight and advisory role. Typical director
responsibilities are described in Corporate
Governance Best Practices: A Blueprint for the
Post-Enron Era , a 2003 report by The
Conference Board, and in Principles of
Corporate Governance , a 2005 report by the
Business Roundtable. Many of these
responsibilities, summarized in Exhibit 1 , focus on
business strategy, risk assessment and corporate
objectives. The Conference Board noted that in the
wake of recent corporate scandals, boards face the
challenge of increasing their focus on oversight
to actively monitor management. In
addition to these typical director
responsibilities, which apply to directors of
public and private companies, directors of
publicly traded companies are required to carry
out other duties on the company’s behalf. Section
10A of the Securities Exchange Act of 1934 places
specific requirements on the board’s audit
committee (see “Eight Habits of Highly Effective
Audit Committees,” page 46). In addition to
preapproving all audit and non-audit services
provided by the company’s registered public
accounting firm, the audit committee is required
to appoint and compensate the public accounting
firm and oversee its work. The audit committee
must establish procedures for handling accounting
or auditing complaints, and handling confidential
anonymous concerns from employees on accounting or
auditing matters. Item 407 of Regulation
S-K requires the audit committee to disclose its
activities, which include review and discussion of
the financial statements with management and
required communication with the external auditor.
Directors of public companies may be subject to
additional responsibilities under the corporate
governance standards that stock exchanges impose
on registrants. For example, the corporate
governance standards for New York Stock Exchange
registrants (Standard 303A.07) require audit
committee members to be involved in and familiar
with the company’s risk assessment and risk
management processes.
Exhibit 1 | Responsibilities of
Corporate Directors |
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DIRECTOR LIABILITY
Directors are expected to adhere to certain
standards of conduct. While statutes vary by
state, most states have adopted the provisions of
the Model Business Corporation Act (MBCA), which
requires directors to act in good faith, in a
manner he or she reasonably believes is in the
corporation’s best interests, and with the care
that a person in a like position would reasonably
believe appropriate. Additionally, a director is
entitled to rely on the performance or opinions of
others, as long as the director “does not have
knowledge that makes this reliance unwarranted”
(MBCA § 8.30). The common law business
judgment rule , the main provisions of
which have been incorporated into the MBCA,
protects directors involved in shareholder
lawsuits. Under this safe harbor, a director is
not liable for breaching a fiduciary duty as long
as he or she acts in good faith, believes the
decisions are in the corporation’s best interest,
makes an informed decision, and does not act with
self-interest. If any of these criteria are not
met, the director loses the protection of the
business judgment rule and may be held liable for
damages caused by the breach of duty. A
slightly different standard is used to assess
whether a director of a public company has
breached fiduciary duties at the federal level.
Under section 11 of the Securities Act of 1933,
directors of an issuer may be liable to any person
acquiring a security pursuant to a registration
statement that contains a material omission or
misstatement. A director is expected to undertake
a reasonable investigation and have reasonable
grounds to believe that the statements contained
within the registration statement are true and do
not omit any material fact. In determining what
constitutes reasonable behavior in such cases, the
statute uses a prudent person standard.
This test says the director is expected to act
with the standard of reasonableness “required of a
prudent man in the management of his own
property.” Directors who can show that
they exercised such due diligence, either through
their own investigation or through their
reasonable reliance on the work of experts, can
avoid liability. Hence, a director of a publicly
traded company is expected to thoroughly review
the information contained in (or omitted from) the
registration statement. This requires making a
reasonable investigation, using the assistance of
experts if needed, to ensure that the registration
statement does not contain any material omissions
or misstatements. Because the work of
experts is explicitly addressed in the civil
liability provisions of Section 11, there was some
concern that directors identified as experts might
be held to a higher standard of performance than
other directors. Section 11 does not specifically
address this issue. Responding to concerns that
being designated as an audit committee financial
expert might create additional liability, however,
the SEC created a safe harbor in 2003. Under this
provision (adopted in SEC Rel. No. 33-8177),
designating a director as an audit committee
financial expert will not cause the director to be
deemed an “expert” under Section 11, nor “impose
on such person any duties, obligations, or
liability that are greater than the duties,
obligations, and liability” that the person would
have absent this expert designation. As long as a
director who is an audit committee financial
expert can demonstrate the requisite due
diligence, as described above, he or she should
not fear additional liability under federal
statutes. Moreover, while this safe harbor, by its
terms, applies only in cases arising under the
federal securities laws, the SEC has opined that a
director’s designation as a financial expert
similarly should not alter his or her fiduciary
duties or liabilities under state law.
To Serve or Not to Serve?
Consider the following before
deciding to serve on a board or an audit
committee, whether as a director or an
audit committee financial expert:
1.
It takes time. Service
as a director is a significant time
commitment due to the recent increased
focus on corporate governance. This is
especially true for audit committee
members whose duties require them to
address a variety of accounting, technical
and risk-related issues. Exhibit 1
presents a listing of director
responsibilities. 2.
Do some research before
deciding. The decision to
join a board is similar to the auditor’s
“client acceptance” decision and should be
accompanied by a similar due diligence
process. Recent SEC filings, background
information on current directors and
executives, and communication with the
company’s auditor and outside counsel are
all good sources to aid in making an
informed decision. 3.
Understand the
business. A thorough
understanding of the company’s business,
risks and the industry in which it
operates is important for directors—and
essential for audit committee financial
experts. 4.
Know your
responsibilities. Read and
understand the corporate charter, the
audit committee charter, and (for public
companies) the corporate governance
standards of the company’s stock exchange,
particularly as they relate to the duties
and expectations of directors and audit
committee members. Familiarity with your
duties is an important first step in
carrying them out. 5.
Expert duty of
care. Designated financial
experts will be expected to use their
expertise. That will likely be scrutinized
when evaluating whether a director
discharged his duties with due care and
diligence. 6.
Research insurance
protection. Familiarize
yourself with the insurance coverage that
is available to you. The recent trend in
settlement cases requiring directors to
make some payment out of personal assets
does not diminish the importance of
D&O insurance as a form of protection.
Additionally, CPAs whose firms already
provide approved non-audit services to a
company should ascertain whether their
malpractice insurance coverage will be
affected by their dual roles of director
and public accountant. In situations where
there is uncertainty about the capacity in
which the CPA is acting (director or
accountant), it is possible that the two
insurance companies may try to disclaim
coverage, arguing that the other insurance
company should be responsible. 7.
Be diligent. Once
the commitment to serve as a director has
been made, the director must be diligent
and act in good faith. The best defense
against liability is to diligently carry
out fiduciary duties.
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HIGH-PROFILE SETTLEMENTS
Recent out-of-court settlements
in a few high-profile cases have cast a light on
directors’ susceptibility to personal liability.
In the Enron and WorldCom cases, non-management
directors were accused of breach of fiduciary duty
for failing to oversee the company properly.
Settlement agreements in both cases required the
non-management directors to pay a portion of the
damages from their personal assets, even if
directors’ and officers’ (D&O) insurance would
cover the damages. In the Enron case,
payments from directors’ personal assets
represented disgorgement of a portion of the
profits that these directors received from the
sale of Enron stock prior to the company’s
collapse. In the WorldCom case, payments from
personal assets were determined strictly as a
percentage of each director’s personal net worth
and did not represent a disgorgement of profits.
This trend of punishing directors through the loss
of personal assets for failure to carry out their
fiduciary duties has emerged in SEC settlements.
These settlements also prohibit the settling party
from seeking reimbursement or indemnification from
D&O policies for amounts paid out of personal
assets. Since the Enron and WorldCom cases did not
go to trial, the settlements do not stand as legal
precedents. The next section examines cases
recently decided in the courts.
RECENT CASE LAW ON DIRECTOR
LIABILITY
Recent decisions in shareholder
derivative litigation suggest that audit committee
board members are insulated from liability as long
as they do not engage in self-dealing and are not
personally aware of wrongdoing by the corporation
or its officers. In the 2006 case of Yemin Ji
v. Kits van Heyningen (U.S. District Court
for the District of Rhode Island, 2006 U.S. Dist.
LEXIS 65926), shareholders sued personally members
of the board’s audit committee. The case alleged
the members breached financial oversight duties by
allowing the issuance of improper financials and
public disclosures. The court rejected this
standard of liability, requiring instead that the
plaintiffs show that members of the committee had
actual knowledge of improprieties. Similarly, in
the 2006 case of Conagra Foods Inc .
(U.S. District Court for the District of Nebraska,
2006 U.S. Dist. LEXIS 70787), allegations that
audit committee members should have known about
accounting irregularities were insufficient. The
plaintiffs were required to provide particularized
allegations that members of the committee had
actual knowledge of the accounting errors.
The court in In re Cray Inc .
derivative litigation (U.S. District Court for the
Western District of Washington, 2006 U.S. Dist.
LEXIS 27182) ruled in 2006 that audit committee
members were not “interested parties” who stood to
gain by failing to take action with respect to
remedying the company’s internal controls. The
court said “[t]he relevant case law does not hold
that a director is interested merely by virtue of
sitting on an Audit Committee while the
corporation faces accounting and audit
irregularities.” No appeal is on record in any of
the three preceding cases, so reversal of these
decisions is not anticipated in the foreseeable
future. A 2006 Delaware Chancery Court
decision, in which no appeal has been filed, has
caused some concern about the liability of expert
directors. The Emerging Communications Inc
. shareholder suit (Court of Chancery of
Delaware, New Castle, 2006 Del. Ch. LEXIS 25) is
based on a merger negotiation in which the board
of directors, relying on the expertise of an
outside financial expert, approved a share price
that significantly undervalued the company.
Salvatore Muoio, a director who was a securities
analyst and mergers and acquisitions expert, was
found liable for approving this transaction that
undervalued the company’s stock. Other directors
without expertise in this area were not found
liable. The decision created significant
concern that audit committee financial experts
could face increased liability if they are
designated as experts. However, the findings in
the Emerging Communications case do not
support that conclusion. The court’s ruling did
not state, per se, that Muoio was subject to a
higher standard of due care. It limited the higher
standard to the specific area in which Muoio was
expert. The court found that “Muoio’s expertise in
this industry was equivalent, if not superior, to
that of Houlihan, the Special Committee’s
financial adviser. That expertise gave Muoio far
less reason to defer to Houlihan’s valuation.” The
court explored plausible explanations as to why
Muoio disregarded his own expert knowledge and
approved an unfair merger price. The court found
two possibilities— either a desire to further his
own interests, or an intentional disregard for his
responsibility to the shareholders—demonstrated
that Muoio had breached his duties of good faith
and/or loyalty. The “expert” director in this case
was found liable because his expertise was such
that he could not have relied on the outside
expert’s opinion in good faith. The main lesson
from this court’s finding is that a director who
possesses expertise is expected to use it in
carrying out fiduciary duties. Failure to do so
will be seen as a breach. The Delaware
Chancery Court decision in In re Walt Disney
Company (Court of Chancery of Delaware, New
Castle, 2005 Del. Ch. LEXIS 113), which was
affirmed by the Supreme Court of Delaware in 2006,
suggests that the business judgment rule is still
the standard for assessing director liability. In
this case, Disney’s board of directors, led by CEO
and Chairman Michael Eisner, approved a
compensation package to hire Michael Ovitz as
president. The deal provided for a large payout in
the event of his termination. When Ovitz was
terminated a year later, the severance package,
which included cash and the immediate vesting of
stock options, was valued at approximately $140
million. Stockholders sued the directors, alleging
they had breached their fiduciary duties by
approving the compensation package and allowing
the termination that resulted in the large payout.
The court found that Eisner and the other
directors acted in good faith and with the belief
that their actions were in the company’s best
interests. Hence, they did not violate their
fiduciary duties. The court criticized the
directors for not acting in accordance with
corporate governance “best practices,” but that
behavior did not amount to a breach of fiduciary
duty. The court noted that although corporate
governance best practices may change over time,
the duties of a fiduciary do not. Failure to
comply with the “aspirational ideal of best
practices” is not grounds for holding a fiduciary
liable, as long as the duties of loyalty, due care
and good faith are fulfilled.
CONCLUSIONS
Recent court decisions affirm that the
business judgment rule (with its component duties
of good faith, loyalty and due care) is still the
standard for assessing director liability for
breach of fiduciary duty. Although out-of-court
settlements may have heightened public awareness
of director liability, directors who act with good
faith, loyalty and due care should continue to be
protected from personal liability |