The Message From Congress:
Boards Should Retake The Reins

John P. Beavers
Bricker & Eckler LLP
September 2002

First, Enron captured the headlines. Then, the U.S. House of Representatives passed a bill directing the SEC to determine how to increase accountability. And before the U.S. Senate could consider the House’s version of the bill, Adelphia, Dynegy, ImClone, Qwest, Tyco, and WorldCom captured the headlines. The Senate and eventually all of Congress responded beginning with the Sarbanes-Oxley Act of 2002. The Congressional message is clear: American businesses need to do a better job of governing themselves.

The American Corporate Model

Until Enron, the American corporate model was the envy of the world. Stockholders as owners do not directly manage, but elect governing boards to direct management. A governing board's function is to give direction by decision-making, oversight, and mentoring.

Boards function by delegating. They delegate to management the authority and responsibility for executing and managing the corporation's everyday affairs. In the American corporate model, management is headed by a CEO, who typically has the power to hire, fire, and compensate every other member of management.

With Sarbanes-Oxley, Congress is regulating the delegation of authority and responsibility by the board. Congress believes that too much authority has been given to, or usurped by, management without sufficient accountability to the board and stockholders. Sarbanes-Oxley is Congress' first step to restore authority to the board and increase the accountability of management.

Restoring the Board’s Authority

The Congressional view of board authority is clearly evident in Sarbanes-Oxley’s audit committee provisions. Congress is forcing management to return control of the audit process to the board.

In the Congressional view, the audit process is, itself, an oversight function that is to be directed by the board. It defines “audit” in oversight language as “an examination of the financial statements . . . for the purpose of expressing an opinion on such statements” as to their compliance with generally accepted accounting principles and federal securities laws1.

Accordingly, Congress requires that independent board members and not management are to:

• Hire, fire, and compensate the auditors, subject to shareholder approval;

• Oversee the auditor’s work and resolve any disagreements between management and the auditor;

• Establish procedure for and receive complaints, including anonymous submissions by employees;

• Engage independent counsel and other advisers, the fees for which must be provided by the issuer;

• Determine the scope of the auditor's engagement, subject to disclosure to investors;

• Receive reports from the auditor on policies used and alternative treatments discussed with management, as well as those considered preferred; and

• Receive and determine remedial action to take regarding any illegal act brought to its attention by the auditor2.

Although much of what Congress has done is consistent with the recommendations in the 1999 Report of the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees, Congress has gone beyond the Blue Ribbon Committee’s recommendations. The importance to Congress of returning authority from management to independent directors is evident by the mandate summarized above that (i) at least the audit committee must have the authority to engage legal counsel and other advisers independent of legal counsel and advisers to the business, as the committee determines necessary to carry out its duties, and (ii) the business must provide for appropriate funding, as determined by the audit committee, for payment of the fees of such counsel or advisers3.

Congress has even gone a step farther by directing the SEC to prescribe rules making it unlawful for any officer to fraudulently influence the performance of an audit and by changing the criminal code to make it a crime not to retain audit workpapers and other documents that form the basis of an audit4.

In addition, Congress made the audit committee, or otherwise independent directors, the designated recipients of any illegal conduct coming to the attention of outside auditors in the course of an audit; any significant deficiencies in internal accounting controls and any fraud, whether or not material, involving management having roles with internal accounting controls coming to the attention of the CEO or CFO; and any evidence of material violations of securities laws or breaches of fiduciary duty coming to the attention of legal counsel that are not appropriately responded to by the CEO or chief legal officer.

Increasing Management’s Accountability

An under-emphasized part of Sarbanes-Oxley is the requirement for businesses to disclose whether they have adopted a code of ethics for their senior financial officers5. Congress is apparently frustrated by the fact that senior financial officers who are not subject to professional codes of ethics are not as accountable as general counsel who are subject to a Code or Model Rules of Professional Responsibility. There is little doubt that the shareholders could bring a derivative action on behalf of the business to hold general counsel responsible for breach of duties of competency and loyalty. Until a code of ethics is imposed contractually by a business, financial officers are not subject to similar fiduciary duties as those imposed on lawyers by their Codes or Model Rules.

Congress has gone even farther in increasing the accountability of CEOs and CFOs by requiring them to certify that:

• Subject to criminal penalties, the financial statement filed with any Form 10-K, 10-Q, or 8-K report with the SEC complies with SEC requirements and fairly presents, in all material respects, the financial condition and results of operations;

• They have read each annual and quarterly report filed with or submitted to the SEC and, based upon the officer’s knowledge, the report does not contain any material misstatement or omission and fairly presents in all material respects the financial condition and results of operations;

• They are responsible for establishing and maintaining internal controls; they have designed internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers; they have evaluated the effectiveness of those internal controls at least 90 days prior to the report; and they have presented in the report their conclusions about the effectiveness of their internal controls; and

• They have disclosed to the auditor and the audit committee all significant deficiencies in the design or operation of internal controls and any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer's internal controls6.

As a means of self-enforcement of these provisions, Congress is requiring each business to force CEOs and CFOs to reimburse the business for all incentive-based or equity based compensation and for profits realized from the sale of the business’ securities during the 12-month period after the issuance or filing with the SEC of any financial statement that is required to be restated due to failure to abide by any of the forgoing certifications or other misconduct7.

What Congress Did Not Do

Although Congress is restoring authority for oversight to the board, it did not increase the accountability of boards as it did the accountability of CEOs and CFOs. Congress was apparently cognizant of fear that increasing board accountability will make it more difficult to attract independent and competent board members. It did not require boards to review, certify, or become signatories to Form 8-K, Form 10-Q, or Form 10-K reports filed with the SEC or proxy or other materials furnished to security holders. It did not require boards to assume responsibility for implementing or supervising internal accounting controls. It did not require boards to forfeit compensation if financial statements need to be restated for reasons of noncompliance. Although Congress required the board and its audit committee to be recipients of reports from the outside auditor, Congress did not require boards to have dialog with the outside or internal auditors.

Is There a Change in Standard of Conduct for Boards?

Although Congress may not have intended to increase the accountability of boards, by expressly making the board the authority for oversight of the audit process, Congress has likely raised the bar on the standard of conduct for boards.

Under most corporate statutes, a corporation’s board is responsible for the direction of the corporation's management8. Congress has now added to that direction express responsibility for hiring, firing, compensating, and overseeing the work of the auditors and the other matters described under “Restoring the Board’s Authority.”

Under most corporate statutes, a board typically performs its responsibilities by delegating to others, including management, board committees, and professionals such as accountants and legal counsel9. Although Congress has allowed the independent members of a board to rely upon an audit committee that is composed of independent members, it can be argued that the board must assume,10 or assure itself that its audit committee assumes, responsibility for hiring, firing, compensating, and overseeing the work of the auditors and the other matters described under “Restoring the Board’s Authority.”