Can your audit committee withstand the market's scrutiny of independence? (Audit Committees).

Two professors summarize the recent rules about audit committees coming from Sarbanes-Oxley and the stock exchanges--and offer advice about what to do and what not to do.

In the wake of Global Crossing's bankruptcy filing, the potentially conflicting interests of its audit committee members are being carefully examined. Particularly troubling is the fact that executives of firms with substantial holdings in the company's stock served on the committee.

For nearly a year, William Conway, a managing director of the Carlyle Group, sat on Global Crossing's audit committee while his company held 2.2 million Global Crossing shares. In addition, Eric Hippeau, managing director of a unit of Softbank Corp., served during a time when his unit controlled nearly 16 percent of the stock of a Global Crossing subsidiary.

Both audit committee members would have gained information about Global Crossing's deteriorating financial condition, which begs an obvious question: Did they act on this information objectively, or to benefit themselves?

Investors are scrutinizing audit committee members and the job they do protecting the integrity of financial reporting more closely than ever. During much of the past year, stock prices were falling and borrowing costs were rising in response to what some have deemed aggressive accounting practices at Cisco Systems Inc., IBM Corp., Tyco International and Quest Communications, to name just a few.

Of course, concern over the effectiveness of audit committees and the independence of their members isn't new. It surfaced in September 1998 with former Securities and Exchange Commission (SEC) Chairman Arthur Levitt's call for improvement. In response, the exchanges adopted new rules. While many had hoped that these new rules would lead to effective audit committees, the recent governance and accounting scandals suggest otherwise.

Responding to growing pressure, former SEC Chairman Harvey Pitt asked the exchanges to reexamine their requirements for audit committees. Both the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) announced recommendations in June to strengthen independence rules. Then, in July, Congress passed the Sarbanes-Oxley Act of 2002, further tightening the restrictions on audit committee independence. The NYSE and NASD quickly modified their recommendations to meet standards found in the new law, and SEC approval is expected.

Federal Reserve Chairman Alan Greenspan recently observed, "Corporate reputation is fortunately reemerging out of the ashes of the Enron debacle as a significant economic value. Markets are evidently beginning to put a price-earnings premium on reported earnings that appear free of spin." With the markets disciplining aggressive financial reporting and with audit committees increasingly being held responsible, thoughtful corporate executives and directors will not delay or be limited by exchange rules in changing their own committees to preserve lower capital costs.

Independence

While the U.S. corporate governance system depends on the competence and activities of audit committee members, their pursuit of shareholders' best interests hinges ultimately on independence. Former SEC Chairman Roderick Hills insists that independence is a prerequisite for audit committee effectiveness. The Sarbanes-Oxley Act and the recommendations from the exchanges only reinforce that idea.

Both independence "in fact" and "appearance" are crucial to investors. Independence "in fact" requires that audit committee members' judgments are not tainted by their interests in management or in the auditor. Independence "in appearance" demands that a reasonable person with knowledge of the interests of the audit committee member would conclude that the member is objective.

If corporations are intent on providing high-quality financial reporting, directors need to aggressively pursue the independence "in fact" of audit committee members. If corporations want to preserve lower capital costs, they need to effectively communicate the independence of audit committee members to investors.

Committee Composition

The Sarbanes-Oxley Act requires that all audit committee members be independent unless they are specifically exempted by the SEC. The NYSE takes the restrictions a step further, requiring a minimum of three independent members on the audit committee and providing for no exceptions to its own independence rules.

The NYSE and NASD rules also require at least three independent members. However, the NASD proposes that under exceptional circumstances, a director who is not independent under each of the NASD rules but meets the independence rules of Sarbanes-Oxley may serve on an audit committee for two years.

Under these conditions, the board of directors of a Nasdaq-listed company must determine that this exception is in the best interests of the shareholders, disclose the situation in the next proxy statement and prevent the member from chairing the audit committee. Vigilant boards will not exercise independence exceptions. The potential benefits will rarely outweigh the tremendous risk of discounting earnings by investors due to a perceived erosion of audit committee effectiveness.

Ancillary Compensation

Independence in fact and appearance requires the absence of significant potential conflicts between the markets' interests and those of audit committee members. Any link between the economic well-being of members and their financial reporting decisions can corrode committee effectiveness. Particularly troubling under prior rules was compensation permitted for consulting and other ancillary services.

Lord Wakeham, a member of Enron's audit committee, received $72,000 per year in consulting fees, in addition to director fees of $50,000. At what level of ancillary compensation might Lord Wakeham choose not to ask tough questions of Enron's management? Because apprehension over losing future cash inflows can corrupt decision-making, the Sarbanes-Oxley Act permits payments to audit committee members solely for their service on the audit committee.

Managers and directors concerned with the capital markets' perceptions should weigh carefully the potential for market penalties, while contracting with directors for their audit committee service.

Looking beyond the rules, boards should examine whether their director fees are excessive for the duties required, potentially creating the appearance of a "bribe." For example, if an audit committee member receives $150,000 for four one-hour meetings each year, investors might question the propriety of the payment. On the other hand, if only a nominal fee for audit committee service is paid, investors might justifiably question the quality of the audit committee's oversight.

Stock Ownership

Conflicts between responsible corporate governance and the economic interests of audit committee members can arise from their stock holdings, as well as compensation. One glaring shortcoming in previous exchange rules was the unrestricted ownership of shares in the company by audit committee members. Three members of Enron's audit committee collectively owned $7.5 million in Enron shares. Did this subvert their oversight responsibilities on Enron's financial reporting? Sarbanes-Oxley and current exchange rules do little to address this problem.

Auditor independence rules prohibit those participating in or overseeing an audit from owning shares of the client's stock. Yet, while oversight responsibilities extend to the audit committee, prohibitions against stock ownership by committee members do not.

The Sarbanes-Oxley Act restricts audit committee membership to persons unaffiliated with the company or its subsidiaries, but the Act fails to define "affiliated person." Boards must look to the exchanges for guidance on unacceptable stock holdings. The NYSE proposes that boards of directors affirmatively determine that an audit committee member has no material relationship with the company. Boards should consider materiality not only from the stand-point of the audit committee member, but also from the organizations with which that member has an affiliation.

Finally, boards must disclose the standards with which they measure independence. The NYSE has specifically stated that it does not view the ownership of even a significant amount of stock, by itself, as a violation of independence. The NASD has taken a more direct approach by specifically defining ownership of 20 percent or more of the corporation's stock as a violation of independence.

It appears that corporations and their boards will be provided much leeway in defining standards for audit committee members' independence. However, companies genuinely interested in encouraging investor confidence will set strict standards limiting stock ownership that focus on the net worth of the individual audit committee member rather than the company's outstanding stock. At issue is the impact of a potential decline in audit committee member wealth on an audit committee member's decision-making.

While the potential loss of $7.5 million by Enron's audit committee members was a pittance relative to Enron's peak capitalization, it probably represented a substantial portion of the wealth of those individual committee members. Diligent and astute boards will seek to distinguish themselves by imposing stricter standards for independence and disclosing those standards to investors.

Significant Relationships

With financial management experience a prerequisite for audit committees, many audit committee members manage and direct other organizations. Independence can be impaired when the two organizations conduct business for each other. An audit committee member's demand for more credible reporting by one organization can provoke lost sales for the other organization and diminished bonuses or job loss for himself/herself. Further, related organizations often own shares of the corporation on whose audit committee the individual serves. Conway, the Carlyle Group executive, sat on Global Crossing's audit committee while the Carlyle Group held 2.2 million shares of Global Crossing. Any push by Conway for improved reporting might have led to substantial investment losses by his employer.

This problem is addressed by the Sarbanes-Oxley Act through its restriction on audit committee membership to unaffiliated persons. Again, because the Act does not define "affiliated persons," the exchanges provide the better guidance. The NYSE, for example, permits individual boards to determine what is significant enough to preclude independence.

The NASD identifies "significant" as payments between the organizations exceeding the greater of $200,000 or 5 percent of revenues. Clearly, investors are shunning corporations with vague disclosures. To build confidence, responsible directors and executives should develop and communicate to investors explicit guidelines governing significant relationships.

Cooling-Off Periods

Cooling-off periods are designed to prevent audit committee members from overseeing financial reporting processes they have influenced. Conflicts of interest can arise when evaluating one's own applications of critical accounting principles. While the Sarbanes-Oxley Act remains silent on this issue, the NYSE prohibits audit committee service if members have been employed by the corporation or its auditors during the past five years.

Moreover, directors who, in the past five years, have been part of an interlocking directorate--in which an executive officer of the listed company serves on the compensation committee of a company that employs the director--are prohibited from audit committee service.

Further, directors with immediate family members in these circumstances are similarly subject to the five-year cooling-off period. The NASD restriction regarding family members is less stringent and its cooling-off period shorter, extending only three years.

Prudent boards must consider carefully the employment histories of directors and their families before nominating audit committee members. Interlocking directorates can be incredibly complex, with relationships open to questions due simply to appearance. Audit committee membership should be restricted to individuals who are and appear able to constructively criticize the company's financial reporting.

Increasingly, capital markets demand that audit committees wield their power to improve corporate governance and financial reporting quality. The key to building a successful audit committee is attracting members courageous enough to ask tough questions and stand up to management, members whose interests are clearly independent of management.

The markets depend on effective audit committees to ensure the integrity of published financial statements. With audit committee performance so difficult to assess, investors are likely to focus on what they know about members' capabilities and independence. Moreover, investors will apply their own standards in evaluating audit committee members, rather than be limited to the independence mandates adopted by the exchanges.

Prudent managers and boards will aggressively review the independence qualifications of audit committee members from an investor perspective to avoid market penalties. The greatest rewards will go to those companies that adopt and publicly communicate standards that transcend the exchanges' minimum requirements.

Audit Committee Independence Rules

              Sarbanes - Oxley   NYSE

COMPOSITION   All members        At least three
              must be            members camposed
              independent        of entirely
              unless exempted    independent
              by the SEC.        directors.
                                 No exceptions.


ANCILLARY     No ancillary       Same as
              compensation       Sarbanes-Oxley.
              permitted.

STOCK         Restricts          Board must
OWNERSHIP     membership         affirmatively
              to persons         determine that
              unaffiliated       members have no
              with the           material
              company and        relationship with
              its subsidiaries.  the company.

SIGNIFICANT   Restricts          Board should
RELATIONSHIP  membership         consider the
              to persons         materiality
              unaffiliated       (significance) from
              with the           the standpoint
              company            of the member
              and its            and organizations
              subsidiaries.      with which
                                 the member is
                                 affiliated.







COOLING-OFF   Sarbanes-Oxley     Members and
PERIOD        does not           family are
              address.           prohibited, from
                                 employment by
                                 the corporation,
                                 its auditors or
                                 any company
                                 with compensation
                                 committee
                                 interlocks during
                                 the past five
                                 years.

              NASD

COMPOSITION   Same as NYSE,
              but allows an
              exception if
              the member
              still meets the
              Sarbanes-Oxley
              rules.

ANCILLARY     Same as
              Sarbanes-Oxley.


STOCK         Must own
OWNERSHIP     less than 20
              percent of the
              corporation's
              stock.



SIGNIFICANT   Cannot be a
RELATIONSHIP  partner or
              officer of a
              for-profit business
              for which the
              company made or
              received payments
              that
              exceed 5 percent
              of the recipient's
              consolidated
              revenues or
              $200,000,
              whichever is
              more, in the past
              three years.

COOLING-OFF   Similar to
PERIOD        NYSE, with
              less stringent
              family member
              restriction and
              a three-year
              period.

Robert C. Richardson is an Assistant Professor of Accounting and Charles R Baril is a Professor of Accounting and Frank & Company Faculty Fellow at James Madison University in Harrisonburg, Va. They can be reached at 540.568.6005.