Setting a new route for corporate governance. (Cover Story).

Corporate governance has been shaken to the roots by revelations following the collapse of Enron. While a host of issues is involved, auditor independence and audit committee performance have drawn particular attention.

These days, Einstein's famous theorem, E=[MC.sup.(2)], could be rewritten with a more current formulation: Enron = management culpability squared.

Whatever becomes of the corporate assets of Enron Corp. and its fallen executives, the company's collapse will be forever remembered for its horrific object lesson on ethics and corporate governance. In its wake, critics of corporate policy-making have gotten a new soapbox, a revered accounting firm has been rudely dismantled and corporate icons like IBM Corp. and General Electric Co. have had their accounting practices put under an unprecedented public microscope.

The tangled threads of the Enron story, which include auditor independence, corporate ethics and accounting obfuscation, are continuing to play out. After voicing its collective outrage, Congress is weighing in with reform legislation -- two dozen bills of various kinds have been introduced, and at least one has passed the House - and the Securities and Exchange Commission and the major stock exchanges are being compelled to offer reforms of their own. The SEC has proposed rules calling on companies to go beyond boilerplate descriptions of their accounting to explain their financial condition in plain English.

Where all of this will end, no one knows. But it seems clear that, at least for the near term, there will be heightened sensitivity to corporate governance issues, especially as they touch on internal, and especially external, auditors. Shareholder activists and other critics of unresponsive corporate management have found traction with a public startled by the revelations of the accounting shenanigans at Enron and the fate of thousands of its employees whose life savings have been all but vaporized.

"Enron has been like a lightning bolt, shooting through corporate America," says Charles King, managing director of Korn/Ferry International's Global Board Services Practice.

"It's changed the whole world of corporate governance. It's caused directors to examine their roles and responsibilities and dedicate more time and energy to their fiduciary responsibilities."

Few companies will experience the Icarus-like fall of Enron. Yet the recent travails of IBM, GE and Xerox Corp. -- the latter already reeling from earlier accounting charges -- argue that no one is safe from a market scalding and a bruising, if temporary, fall in stock price. Public companies, especially, are being forced to do some real soul-searching, and are bending over backwards to show that they are improving disclosure and revisiting independence and other key governance policies.

"It's evident in press releases describing enhanced disclosure and statements better outlining accounting practices that corporate America is beginning to respond," says Elizabeth Saunders, chairman of Ashton Partners, a Chicago financial communications consultancy. "By the time the SEC reforms and other regulatory proposals are debated and voted upon, market efficiencies may already have begun to solve the problem."

That may well be. Professional organizations like FBI have pushed for revisiting corporate ethics, arguing that management sets the tone for corporate governance -- and that top officers, like CFOs, should sign a code of ethics committing themselves to appropriate conduct (see page 7). Others have looked to root causes, arguing that the incestuous relationship between Arthur Andersen and Enron was a key element in the latter's downfall -- and that auditors must have more distance from their clients.

Companies are facing a newly energized shareholder community -- especially big pension funds, foundations and social activists, who often had trouble getting themselves heard in the go-go 1990s. "Enron has raised concerns of corporate governance to a level that is almost unimaginable," says Robert A.G. Monks, a prominent shareholder activist and founder of Institutional Shareholders Services in the 1980s and later Lens Inc., an investment fund. Monks also helped found the Corporate Library, a research organization dedicated to corporate governance.

"There have been periods before where we had significant movement toward reform, and concern for governance and social values," Monks adds. "Some came in the late '70s. The real question one has to ask is: Has the enormity of this disaster created sustainable political energy for real reform? If it is anything like the 1930s, there could be a careful and measured legislative response. But if it is like the savings and loan scandal, where [the government] socialized the debt -- after all, it was just a half-billion dollars -- and hung a couple of people and then went on to other things, it would be a shame." (For more of Monks' insights, see "From Inside and Outside, He Sees Need for Reforms, " page 35.)

While hardly a new issue, auditor independence has vaulted into public consciousness. It's no secret that in recent years, major accounting firms have increasingly zeroed in on selling consulting services, with audit as a proverbial loss leader. Seventy-two percent of major companies' fees to auditors were for non-audit services in 2001, according to one study of major corporations; a study of the 30 companies in the Dow Jones Industrials index by The Wall Street Journal came up with an almost identical 73 percent -- though the Journal noted that the percentage was 77 percent in 2000, the first year in which disclosures were required under new rules for proxy statements. Those new rules were approved by the SEC as part of its efforts to promote auditor independence.

Getting approval for an outside auditor has been one of the most routine votes of any proxy season. But with Arthur Andersen in disrepute, that has changed. "Enron has reminded us all that formerly ordinary votes, like the selection of the auditors, are filled with importance. Voting shares is a significant and important act," says Timothy H. Smith, president of the Social Investment Forum.

Asked if that might translate into a surge of "no" votes against auditors, Smith said, "There may be a kind of knee-jerk outrage, 'we're voting against them.' On a more thoughtful approach, folks might see that other auditors were acting quite similarly to Andersen in their approach. There may be an anger vote that might materialize."

The issue of mandatory auditor rotation -- requiring companies to change auditors every five or seven years, say, to foster more independence -- has been raised with more volume than in the past. Most corporations don't want that any more than auditors do, citing the disruptions that result and the need to bring the new audit firm up to speed. But the idea has some staunch advocates.

"Clearly, had Enron been required to rotate its auditors every five to seven years, it is unlikely that misleading financial statements would have continued, or that members of the board's audit committee would have been kept in the dark, as they claim they were," says John H. Biggs, chairman and CEO of pension provider TIAA-CREF. Calpers, another huge pension fund, says it will consistently vote against auditors who have been on an account for more than five years.

"We need, at minimum, mandatory auditor rotation, principles-based accounting standards and shareholders who will demand that management keeps its hands off the audit committee," Thomas Selling, professor at the American Graduate School of International Management and a former SEC academic fellow, told a conference audience recently. "We have placed undue reliance on the ideal of auditor independence to protect investors, when in fact, auditors are like every other species -- fiercely loyal to the ones who feed them well."

Just as FEI has offered a series of recommendations for improving disclosure and corporate governance -- they are posted on the Web site, www.fei.org/download/ReformRecommendations.pdf -- groups like the Institute of Internal Auditors are making themselves heard, too. The 75,000-member IIA has called for the active involvement of the SEC and the major stock exchanges in promoting governance improvements.

"We started with the exchanges because we think they can move more quickly than anyone else," said William G. Bishop 3rd, president of the IIA, in an interview. "When we were all pushing for audit committee rules, the SEC seemed to stay away, and exchanges were the ones that actually did [put in rules]. I see this as going the same way -- the SEC would encourage some of these steps, but stop short" of implementing them.

This spring, Bishop noted, the New York Stock Exchange had a second round of meetings to discuss this subject, and the Nasdaq has recommitted to assuring best practices in corporate governance for its listed companies, according to a letter to SEC Chairman Harvey Pitt from Nasdaq Chairman and CEO Hardwick Simmons. Says Bishop: "They are in the game. We see that as a positive movement in the right direction."

In his letter, Simmons noted that the Nasdaq Listing and Hearing Review Council "believes that as a best practice, the audit committee... should recommend the selection or replacement of the independent auditor." This action, he wrote, should be coupled with the recent SEC rule requiring a company to disclose in its annual report whether or not the board disagreed with any recommendations of the audit committee regarding selection or replacement of the independent auditor.

The IIA is looking for increased disclosure or explanation. Bishop notes that in the United Kingdom and South Africa, rules in place require boards to offer disclosures about their internal controls. While there is some precedent for that in the U.S., most commentary is confined to the management discussion and analysis (MD&A) portion of the annual report, and companies don't provide actual evidence about those controls. "Typically, they're talking about accounting processes," he adds. "We want a more comprehensive statement predicated on identifying the risk that the organization faces."

Stepped-up efforts are underway to transform what is largely an informal, best-practices approach to one in which firm rules are set. Legislation being pushed in the Senate by Sen. Carl Levin (D-Mich.), for instance, would direct the SEC to issue and enforce tougher rules on corporate governance. His bill would require the audit committee of any public company's board to oversee the company's accounting practices -- something that hasn't yet been codified into law and concerns more than a few observers, since it would effectively federalize the oversight process.

Clearly, the major stock exchanges have come under increasing pressure to stiffen standards for listing companies in areas such as director independence, and a number of companies have been de-listed, for this and other reasons. But NYSE Chairman Richard Grasso has publicly stated his strong opposition to the exchanges being responsible for assigning independent auditors for public companies. He adds that any setting of national standards and guidelines should be left to the SEC and not to the stock exchanges.

In the meantime, the almost-daily parade of headlines about auditing problems has put audit committees under the gun. "The primary changes now are that audit committees are spending a lot more time meeting, and are driven by digging down a lot deeper and asking far more detailed questions than they used to," Korn/Ferry's King says. "Also, they are exercising the right to hire independent outside counsel to assist the committee in preparing them to do the job fully.

Is Risk Worth the Rewards?

"People who have served on audit committees recognize the responsibility, and understand that the function is under a lot more scrutiny these days. If they've done it before, say for three to five years, and they feel as if they know what they're doing, I think that a number of folks are comfortable with the risk issue." Still, he expects some turnover in those ranks. "Some [directors] are reevaluating whether the risk is worth the reward. The result will be seen in this proxy cycle. I expect that a group will decide that the reward is not worth the risk, and won't stand for reelection."

King is convinced that "in general, corporate governance has improved by leaps and bounds in the past 10 to 12 years." Still, the increasing tendency for investors sensing a whiff of trouble is to shoot first and ask questions later. That's as true of once-hallowed names like Xerox as it is of the shot-down high-fliers like Global Crossing Ltd., the telecom firm that declared bankruptcy this past winter.

Michael Holland, manager of the New York-based Holland Balanced Fund, told CBSMarketwatch recently that a company's pedigree matters more than ever in the wake of Enron. "Fund managers will recognize that a company's size doesn't presume the quality of its character or its earnings," Holland said. However, "Generally, the big, high-quality companies will be the ones unsullied by the scandal."

Then again, "big" and "high quality" are probably adjectives most experts would have used only a year ago to describe Enron.

RELATED ARTICLE: Reactions to Enron... A Partial List

* More extensive financial disclosures

* Some companies have eliminated consulting by auditors

* More attention to shareholder-brought resolutions

* New SEC rules on accounting disclosure (proposed)

* Strong shareholder challenges to executive pay policies

* Shareholder calls to tighten company auditor independence rules

* Calls for Congress to oversee accounting industry

Have Expertise, Will Serve

Not many FEI members have served on a corporate audit committee. Frank J. Borelli has been audit committee chairman of three New York Stock Exchange-listed companies over the years, and still chairs the audit panel at Interpublic Group, the big advertising firm, and Express Scripts, a Nasdaq-listed pharmacy benefits management company.

Borelli, who was national chairman of FEI in 1996-97 and is a retired CFO of Marsh & McLenan Cos., first did duty on an audit committee more than 20 years ago and can attest to the way things have changed. He joined the audit committee of United Water Co. in 1980 and became chairman a few years later. ""t was a different area," he recalled in a recent interview. "We met less frequently, and we didn't get involved in quarterly reporting. It was really more about the annual report though there was a fair amount of discussion about internal auditing."

A few years ago, long before the Enron collapse--in fact while the Houston energy firm was still ascending the corporate are firmament -- the Blue Ribbon Panel on audit committees had put new focus on the panels and their responsibilities. With that, many audit committees became a lot more active.

"Now, there are more meetings," Borelli says. "The average number of meetings in the '80s was probably two a year; today, most boards have six or so, and some meet eight or none times. I am pushing the educational process side, where the audit committee members get to meet the financial people at the corporation, and the operating people."

He says that audit committees have a heavy focus on revenue recognition, and that many stress educational sessions involving major departments like treasury and tax. "Internal audit is really an adjunct," Borelli says. In both boards he now serves on, he says, the internal audit staff has considerable strength in both numbers and quality. "It's important that the internal audit group keep up with the size of the company," he says.

A partner at Haskins and Sells for many years before joining Marsh, Borelli notes that most audit committee members are operating executives, and only one fellow Interpublic board member -- Michael Roth, CEO of the MONY Group and another former "Big Eight" partner -- is "pretty close" in terms of comparable experience. At Express Scripts, Borelli was made audit committee chair immediately on joining the board.

Does he think more CFOs will be recruited for audit committees? Yes, but he says the final rules issued after the Blue Ribbon panel report was finished ending up watering down the qualification, which "dampened the rush on recruiting CFOs." He expects a gradual move to bring in more finance chiefs, but it may take "new legislation or new rules" to really push the process.

High-level board recruiter Charles King of Korn/Ferry International disagrees, saying, "We find a huge demand for seasoned financial talent in boardrooms -- it means that we are finding a lot clients interested in bringing on CFOs for their audit committees. We're working on number of searches right now." He says the firm recently placed a couple of high-profile CFOs -- whom he says he can't name for confidentiality reasons -- on big company boards.

Borelli believes that committees start with a proper procedural framework. "The key thing is the quality of the meeting and the agenda-setting -- that should be set by the committee," he says. "The optimal situation is that the agenda is determined with the chairman of the audit committee and the CEO, with support from internal and external audit."

From Inside and Outside, He Sees Need for Reforms

Shareholder activists have a bad reputation in many corporate circles. Executives tend to see them as gadflies or long-winded idealists whose ideas don't make much sense in the real world.

But Robert A.G. Monks is an activist who understands the corporate world; he's been in it, and he doesn't think shareholders have any business running a company. "There really isn't yet a definition of the legitimate scope of involvement by shareholders [in corporate affairs]. We're far apart from where we should be," he said in a lengthy interview. "The way in which shareholders should exercise their authority is in the selection of directors, and directors should the run the company." However, he says that societal issues like global warming -- where he is very active -- are different, and that shareholders "should instruct managers, especially on issues that can't be resolved under the law."

Monks, who is the publisher of ragm.com -- a Web site focused on gathering and disseminating information and opinion about global corporate governance -- believes governance can, and must, improve. He brings the perspective of service on a dozen boards of public companies, among them one much in the news -- Tyco International (see story on page 20).

It was at Tyco, he says, that he found just how hard it can be to get a company to change auditors. "I'd as sooner have separated my Siamese children," he recalls with a rueful chuckle. "The cross-fertilization of auditors and companies is very pronounced. That really is quite a critical problem."

He adds, "The inappropriate evolution of auditors to consultants was made desperately clear by Enron. A lot of [positive] momentum has continued -- when attention is called to it in shareholder resolutions, smart people see the need for change...What I hope for is sustained and respectful look at audit committees."

Monks is skeptical of the audit committee changes sponsored by the SEC, such as the idea that the audit panel should have sole authority to decide which outside auditor to recommend, and to have control over hiring and firing that firm.

"That's operating under the presumption that you could get the audit function accomplished with the same allocation of resources you have now. I don't think that's true," he says. "You can't just make rules and eliminate the need for the work to be done. It should be a work-oriented approach. How much expert time is necessary?"

"I've been a director of a dozen New York Stock Exchange companies in my lifetime, but I knew only one audit committee chairman who was first-rate," Monks adds. "That's not to say the others were poor, but it's unreal what we're asking them to do. They don't have access to company resources... You need professionals and time, and that may mean hiring professional staff on their own" -- something that is not being done now.

He's no more than cautiously optimistic about the flurry of activity that surrounds current stabs at reform. "The last time we really had a sustained, responsible effort to deal with shortcomings in the financial system was in the '30s -- and that pattern proved very durable," Monks says. "The pattern was that the SEC was a good super-agency, and [it] would create a variety of sub-agencies that could be self-regulating. That's a better pattern than something that works directly from Congress.

"We don't know if Enron is the beginning or the end," he sighs. "Recent history, like the savings and loan mess, [shows that] there is a great capacity to have massive executions, then change nothing. I have to think that is the default setting. But a lot of things are happening to suggest that perhaps this [reform] has legs."