Is It Financial Expertise or New Blood That’s Improving Boards?

—–Original Message—–From: Roman Weil [mailto:roman.weil@chicagogsb.edu] Sent: Friday, April 15, 2005 12:27 AM
To: Ms. X
Cc: dcoates@gsb.uchicago.eduSubject:

Doug: This is Ms. X, (the commenter from last night), who had that clever insight about its being independence, not literacy, driving our results. She wants to be in touch with us.

Ms. X: You are terrific. many thanks. roman

Professor Roman L. Weil is the Duane Rath Professor of Accounting at the University of Chicago’s Graduate School of Business. I heard him speak in the Spring of 2005 at Gleacher Center, the downtown Chicago campus of the University of Chicago GSB. He spoke about the preliminary results of a paper he and some others were writing regarding Audit Committee financial literacy requirements.

SEC Final Rule Requires Disclosure of Audit Committee Financial Experts In accordance with Section 407 of the Sarbanes-Oxley Act of 2002, on January 23, 2003 the SEC issued a final rule 1 whereby a company is required to disclose whether its board of directors has determined that the company either:
1. has at least one audit committee financial expert on its audit committee;
or 2. does not have an audit committee expert serving on its audit committee.
If the committee does have such an expert, the company must disclose his or her name and whether such person is independent of management. If it does not, the company must disclose why it does not have such an expert. Such disclosure will be required in all annual reports filed after July 15, 2003.

Professor Weil had spoken many times before on this topic in various media, in particular about a financial literacy quiz which had been taken voluntarily the prior fall by 1,000-plus board members attending three-day financial workshops for corporate directors. Weil developed a set of standards for what he feels financial literacy means and found that most audit committee members fall short of these criteria. For example, he said that 69% of the respondents did not fully understand retained earnings. Students who take one course (Business 3000) in the MBA program did better than most audit committee members at that time, said Weil.

The conclusions of his paper, which have been finalized since then, also describe a correlation between audit committee financial literacy and the financial results of the company. Professor Weil, or Roman as he prefers everyone to call him, is a very engaging, interesting, blunt and opinionated guy. I like that in a guy who wears a bow tie. He feels strongly about these issues and is not afraid to call a spade a spade. This is evidenced for example by his letter to the SEC when commenting on the proposed rules in December of 2002.

Roman Weil writes:
“…Financial Literacy. In the months since the passage of SOX and the weeks since the proposed regulations issued, I’ve been listening to and talking with CEOs, CFOs, Boards, and their lawyers. … My own research of the past year or so persuades me that corporate boards are financially illiterate even by modest standards… I now use a working definition of Financial Literacy, having discarded one that current CEOs, CFOs, and Board Chairmen have told me is too tough. I first proposed that a Financially Literate audit committee member will understand, in his or her own head, the material transactions of a firm and the accounting issues with respect to those issues. I get push back on this: “That’s too much to expect.” I think it’s not too much to expect. …
Let’s define Financial Literacy for the Audit Committee member Board as the ability to understand, in his or her own head, the transactions underlying the critical accounting judgments and the accounting issues for these transactions. By ‘understand, in his or her own head,’ I mean to exclude the oft-heard excuse, “Well, I don’t fully comprehend that, but we have retained outside experts who do and trust them when they tell us everything is OK.” For example, the audit committee member of some financial institutions needs to understand the transactions derivatives attempt to hedge, how to tell a hedging derivative from a speculative one and the accounting controversies for the various sorts of derivatives. …
I am disheartened by the number of board members who think Reserves are things with debit balances, so confuse Reserves with liquid assets available to pay for various outcomes. Any audit committee member should understand the issues of revenue recognition when uncertainties exist about after-sale returns, warranties, and technical support. … If you want to hear more on these subjects, just ask.”

The conclusions of Roman Weils’s paper as of November of 2006, are as follows:

“We find that (financial literacy) scores did not change between 1996 and 2000, but have improved significantly since. Still, the audit committees have room for improved financial literacy in the sense that we define. We also find evidence of superior stock market returns to companies who have improved the potential for financial literacy, as we measure it, of their audit committees over the last four years. The improvers in our sample enjoyed annualized abnormal, excess returns of 4.6 percent per year more than those which did not improve.”

My comment to Roman, that night and today, is that there was another major change that affected Boards of Directors, and in particular Audit Committees, as a result of Sarbanes-Oxley:

Independence requirements

SEC Proposes Rules to Implement Sarbanes-Oxley’s Audit Committee Independence Requirements, January 18, 2003
Last week, the SEC released proposed rules to implement the audit committee independence and whistleblower provisions of Section 301 of the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley (Sec. 301) requires the SEC to adopt final rules by April 26, 2003, directing all national securities exchanges and national securities associations (“SROs”), including NYSE and Nasdaq, to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements set out in Section 301.

These requirements forced many companies, most companies, to totally reconfigure their Boards of Directors, in particular their Audit Committees. During the period late 2002 (after Sarbanes-Oxley was passed) to the end of 2004, there were a significant number of changes made to Boards of Directors to meet the independence, financial literacy, size of the Board/Audit Committee and other legal, regulatory and corporate governance best practices requirements. We saw companies develop and publish charters for their Board committees, biographies of board members, charts of committee memberships and chairmanships, and policies and procedures for key topics such as ethics, whistleblower or communication with Board members.

Before 2002, it was difficult to find a company with a “Corporate Governance” section on its website. Many companies had to “retire” some prominent and longstanding Board members due to conflicts and over commitment. The idea of a sitting CEO of a public company or a recently retired CEO also sitting on a dozen other corporate Boards is now pretty much obsolete. Companies reviewed qualifications, commitments and independence of existing Board members and were much more diligent in looking at such criteria for new Board members. So we are seeing some fresh faces on Boards, including women, minorities and non-CEOs in the search for more options than the old baker’s dozen that seemed to all serve on every Fortune 500 board in one combination or another. There are exceptions, but in general, much of the cronyism that existed and was so blatantly self-serving in the past has had to disappear or go under the radar due to independence requirements and the scrutiny that came with greater transparency.

In particular, the SEC and exchange requirements for a fully independent Audit Committee, and one that has at least three members, including a financial expert, means that Audit Committees especially have very different members than in the past and are hopefully behaving very differently. Who is being selected as a financial expert in many cases? A retired Big 4 Audit partner. Are they from the company’s current auditor? Is there a rule about this?

Michael E. Lavin Elected to SPSS Board of Directors

CHICAGO — SPSS Inc. (NASDAQ:SPSS), a leading worldwide provider of predictive analytics software, today announced that Michael E. Lavin has been elected to the SPSS Board of Directors, effective immediately. The Board has decided, in accordance with its Bylaws, to increase its size from eight to nine members, appointing Mr. Lavin to fill the new position. Mr. Lavin will also serve as a member of the Company’s Audit Committee. Mr. Lavin, 59, brings a wealth of financial and business experience and insight to this new position. He currently serves as a member of the Board of Directors of Peoples Energy Corporation, Tellabs, Inc. and Education Corporation of America, Inc. He also serves as Chairman of the Audit Committee of each of these three companies. From 1993 to 2003, Mr. Lavin was the Midwest Area Managing Partner of KPMG LLP. Mr. Lavin retired from KPMG in January 2003, having been with the firm since 1967.

I encourage further academic and other studies that examine the positive impact of the overall reconfiguration of Audit Committees and Boards of Directors in general from 2003-2005. It would be interesting to see if companies that made corporate governance changes early and well, that complied with the spirit as well as the letter of the law and that promoted the active engagement ands scrutiny of the Audit Committee, including the active participation of the company’s internal audit function, have had less restatements, less material weaknesses and significant deficiencies and better overall financial results than those that have resisted these changes.