Financial experts on audit committees -- an overdue implementation. (President's Page).

The SEC has issued proposed implementation rules for Section 407 of the Sarbanes-Oxley Act of 2002

("The Act"). That section was initiated and authored by FEI pursuant to Recommendation 9 of our March 2002 initiative, "FEI Observations and Recommendations -- Improving Financial Management, Financial Reporting and Corporate Governance."

The title of Recommendation 9 bluntly states both the purpose and background of the recommendation: "Effective Implementation of the 1999 Blue Ribbon Panel Recommendations Re: Audit Committee Financial Experts." In 1999, the Blue Ribbon Panel on Audit Committee Effectiveness called for all audit committee members to be financially literate and for each committee to have at least one financial expert.

The formation of the important 1999 panel reflected the importance of reforming audit committee effectiveness. It correctly anticipated the failures at Enron, WorldCom and Tyco. The Blue Ribbon Panel was sponsored by the SEC, NYSE and Nasdaq and was loaded with luminaries from corporations, distinguished lawyers and securities industry leaders. Its recommendations were numerous and thoughtful.

But post-Enron, it was apparent that the goal of improving audit committee effectiveness was unmet. For too many years, audit committees perceived their job as getting a report on the annual audit and trying to lower audit fees. Audit committee meetings were overly form-driven, perfunctory and painful for directors.

The Blue Ribbon Panel sought to solve part of the problem by getting at least one true financial expert on every audit committee, and by requiring all audit committee members be financially literate. But the definitions of "financial expert" were weak and broad. The NYSE left it to the company to define. Thus, little real reform happened in the two years leading up to Enron's collapse, and few companies actually changed the composition of their audit committees.

Hence, the FEI recommendation and Section 407 of the Act requiring disclosure as to the existence of an audit committee member having financial management and financial reporting experience and expertise. More checklists are not the answer; audit committee reform demands additional skill sets and resources.

None of this implies that existing audit committee members can't be terrific contributors. Experienced general managers, investment bankers, academics and venture capitalists can ask tough questions and assess risks as well as anyone. But financial reporting and business practices have become so complicated that audit committees need experienced talent capable of identifying trouble or opaque reporting without having to rely on the auditors or management. Sometimes I suggest that the term "financial expert" be changed to "financial reporting expert" to more accurately reflect boardroom needs.

Regardless of Section 407 or the SEC's proposed rules, the marketplace (always the most efficient reformer) is moving. Audit committee members who know they are not up to the task are asking to be removed from the committee. More importantly, boards and their nominating committees are actively searching for and placing CFOs and auditors on their boards. Some of the nonsense of those now entrenched (that there are very few people available to meet the definition, or that the result will be dummying down the board) is disheartening, given the major audit committee failures we've witnessed. There are plenty of candidates out there, and the addition of a resource does not reduce the quality; no audit committee member is excluded from participation except by lack of independence.

A major alteration of the Blue Ribbon Panel's intent has been to allow someone that had supervised the finance function, but had no personal experience in the area, to satisfy the requirement. This was akin to a CFO claiming to be a legal expert, since the law department had reported to him or her. Section 407 intends for the financial expert to have personal experience in financial management, not supervisory experience.

Further, FEI consciously wrote section 407 as a disclosure standard, not an absolute requirement. Good companies can choose not to add such a person and disclose their reasoning. The market will accept that from a quality company. A high-risk, on-the-edge company will be forced to make real changes.

With all that in mind, the FEI Committee on Corporate Reporting (CCR) recently filed its comment letter on the SEC's proposed rules implementing the financial expert disclosure requirement.

While well-intentioned, the SEC took a tough new requirement and made it too tough, frankly. CCR correctly pointed out that the SEC unnecessarily implies that comparable industry experience is needed. FEI intended for the financial expert to have experience in a similarly complex company, but that can come from any industry. Similarly, public company experience is not needed. Audit committees need help in practical financial management and reporting, not SEC compliance. Further, the SEC specified 10 factors that a company should consider in identifying its financial expert. Too many will interpret those "considerations" as requirements and unduly narrow the field of candidates. Those 10 considerations should be eliminated.

The new financial expert definition is a major step toward achieving true audit committee reform and effectiveness. Real change is tough, but in this case clearly needed and overdue.

RELATED ARTICLE: FEI Task Force Recommendation 9

Effective Implementation of the 1999 Blue Ribbon Panel Recommendations Re: Audit Committee Financial Experts

FEI recommends that the NYSE and the NASDAQ set higher standards for audit committee "financial experts." These criteria should call for explicit experience requirements in the credentials of such experts. A financial expert should possess:

* An understanding of Generally Accepted Accounting Principles (GAAP) and audits of financial statements prepared under those principles. Such understanding may have been obtained either through education or experience. We believe it is important for someone on the audit committee to have a working knowledge of those principles and standards.

* Experience in the preparation and/or the auditing of financial statements of a company of similar size, scope and complexity as the company on whose board the committee member serves. The experience would generally be as a chief financial officer, chief accounting officer, controller or auditor of a similar entity. This background will provide a necessary understanding of the transactional and operational environment that produces the issuer's financial statements. It will also bring an understanding of what is involved in appropriate accounting estimates, accruals, reserve provisions, etc., and an appreciation of what is necessary to maintain a good internal control environment.

* Experience in the internal governance and procedure of audit committees, obtained either as an audit committee member, a senior corporate manager responsible for answering to the audit committee or an external auditor responsible for reporting on the execution and results of annual audits.

FEI strongly recommends that Congress and the SEC enact regulations that call for stock exchanges and markets to implement this recommendation through listing agreements.