Definition of corporate finance

FORMER ENRON CFO Andrew Fastow is by all accounts a persuasive personality but that doesn't explain why Enron's board of directors failed to raise even the smallest red flag. Not once did it voice an objection to any of management's accounting practices, according to a Senate subcommittee investigation, despite repeated warnings from Arthur Andersen auditors that those practices were "high risk." Shockingly, the board even waived its own conflict-of-interest guidelines to allow Fastow to set up off-balance-sheet partnerships that profited at the expense of Enron's shareholders.

In short, corporate governance failed abysmally at Enron, just as it failed at a number of other scandal-plagued companies in recent years, from Tyco International to WorldCom to Adelphia. As a result, the confidence of investors in the capital markets has been badly battered--along with their wallets--and reformers on Wall Street and Capitol Hill are trying to do something about it, by enacting the most sweeping agenda of corporate-governance reforms in 70 years.

The reforms--as embodied in the Sarbanes-Oxley Act of 2002, and in proposed guidelines from NASD--aim to make corporate boards more independent and knowledgeable, and thus a stronger check on corporate management. Indeed, by giving boards and audit committees greater responsibility for monitoring the actions of senior executives, the reforms may signal a radical rebalancing of corporate power.

"We're moving away from the imperial CEO model," comments William Allen, director of New York University's Center for Law and Business. "In the past, we have had powerful CEOs and passive boards of directors. If the CEO is good and honest, it's probably the most productive business model. If he's not, you can have a disaster."

But some observers question whether the new corporate-governance rules can prevent managerial shenanigans and the disasters they have caused. After all, in terms of knowledge and independence, Enron had an exemplary board of directors in the summer of 2001--at least on paper. Its members included CEOs, lawyers, academics, and former regulators. The chairman of the audit committee was the former dean of the Stanford Graduate School of Business. And only 2 of the 17 members, Enron's then-chairman Kenneth Lay and then-CEO Jeffrey Skilling, were insiders.

At the same time, the new rules may make it harder for companies to recruit effective board members, say critics. In the worst case, newly empowered boards may subject management to crippling second-guessing. "If you start to gut management's ability to make decisions and bet on the future, they can't compete," warns Harold Bradley, president of Kansas City, Missouri-based American Century Ventures, a unit of investment-management firm American Century Investments.

UNBINDING THE TIES

Independence is the main theme of the NYSE and NASD rules, which have yet to be approved by the Securities and Exchange Commission. They mandate that all listed companies have a majority of independent directors on their boards. The rules also considerably tighten the definition of independence. An independent director can have no material relationship with the listed company other than in his or her role as director, and companies must disclose how they arrived at that determination in proxy filings. The requirement means no commercial or industrial relationships; no family ties to management; no professional-services contracts to perform banking, consulting, accounting, or legal work for the company. The rules also require a five-year "cooling-off period" before former employees or auditors of the company can be designated independent directors.

Furthermore, under the new listing requirements, independence is required of all the directors on the committees overseeing auditing, compensation, and board nominations--arguably a board's three most important spheres of responsibility. "These changes alter the whole dynamic of the board," says Charles Elson, director of the Center for Corporate Governance at the University of Delaware. "There's now less threat of being replaced if you don't follow the CEO." As for directors' own compensation, the NYSE'S rules advise companies to "be aware that questions as to directors' independence may be raised when directors' fees and emoluments exceed what is customary."

Viewed from the perspective of the new rules, Enron's board wasn't as disinterested as it seemed. Directors were compensated handsomely for their trouble, receiving some $300,000-plus annually, and a number had financial ties to Enron. By contrast, according to a recent survey by CEO magazine of senior finance executives at 81 public companies, most directors are paid no more than $50,000 a year (see survey, page 36).

Of course, demands for greater board independence aren't new. The Walt Disney Co., for one, has been criticized for years for having too many board members with ties to CEO Michael Eisner, whose stratospheric compensation in the past six years or so has belied the disappointing performance of Disney's stock. What's more, many of the new board proposals were issued as recommendations by an SEC-convened blue-ribbon panel on audit-committee effectiveness four years ago. In fact, many companies were recruiting more independent directors for board positions long before the Enron debacle. "There's been a lot of attention paid to this in the last couple of years," says Dennis Beresford, a former chairman of the Financial Accounting Standards Board who now teaches at the University of Georgia.

"We don't need to change our board in terms of its independence," says R. Foster Duncan, CFO of Cinergy Corp., a Cincinnati-based diversified energy company. Eight of Cinergy's nine board members would currently meet the heightened standard for independence as proposed by the exchanges. Likewise, National Semiconductor has an eight-member board, with CEO Brian Halla being the only nonindependent director.

Even so, the CEO survey indicates that more than a few companies would have a long way to go to meet the new independence requirements. The survey found that more than 20 percent of the respondents had less than a majority of independent directors on their boards, and that more than a third lacked totally independent audit committees.

The issue of independence is clearly gaining currency among investors. HealthSouth and IDT recently joined Disney as objects of scrutiny because of their lack of it, and the list is likely to lengthen. "Some boards are well ahead of others on this, and won't have a lot to do. Others will have to change dramatically," says Beresford, who was elected to the WorldCom board in July and sits on two other public-company audit committees.

The changes may eventually raise the issue of whether the roles of CEO and chairman of the board should be kept separate, as is typically the case in Europe. "The NYSE rules don't mandate it, but the independent directors will be meeting on their own more frequently, and it's natural that a leader will emerge," says NYU's Allen. And that leader could provide a counterbalance to the CEO, though studies that attempt to analyze the effect of having separate board chairmen and CEOs in the United States and Europe have so far been inconclusive (see "Transatlantic Answers," October).

IN SEARCH OF NUMBER CRUNCHERS

Corporate directors will not only have to be more independent in the future, they will also have to be smarter-particularly those serving on the audit committee. Previously, exchange rules regarding "financial literacy" were broad enough that virtually anyone with a little business experience could qualify. Sarbanes-Oxley, however, recommends that at least one financial expert now sit on the audit committee and that such an expert have experience either preparing or auditing financial statements. If the committee does not have such a director, the company has to explain why in its proxy statement.

In the past, audit committees have often leaned on one person with deeper knowledge of financial statements to shoulder much of the oversight role, says Olivia Kirtley, a retired CEO who chairs the audit committees of one Amex-listed company, Lancer Corp., and two Nasdaq-listed companies, ResCare and Alderwoods Group. But while 8 in 10 of the CFO survey's respondents say the level of financial expertise on their audit committees is "good" or "excellent," almost half report that their committees need even more expertise.