Hedge Fund Guys Say Funny Things…

Back in the beginning of the year, I wrote a post about the competitive marketplace for senior internal audit executives at public companies. I lamented the fact that while the skills and experience of such a person are valued highly by the professional services firms, it doesn’t seem that most public companies had caught up to that idea. In most companies, you can’t find the name of the Chief Audit Executive in the annual report or on the website. They still fall under the spell and sometimes the undue influence of the CFO rather than the Audit Committee of the Board. And the Audit Committee of the Board still pays too much attention to the wishes and opinions of the CFO when choosing and working with the external auditor and in their interactions with the internal auditor. It has something to do with the fact that we’re seeing neither true independence nor true financial expertise on many of these audit committees.

One of the sessions at Compliance Week 2007 was called, The New Capitalists , focusing on the increasingly vocal power of institutional investors. The moderator was book author and Compliance Week columnist Stephen Davis.

One of the panelists was Roy Katzovicz, the General Counsel of Pershing Square Capital Management. Mr. Katzovicz had some interesting comments about McDonald’s and how they erroneously undervalued their franchise locations (or overvalued their company-owned outlets) by not including some costs in the company outlets when analyzing their returns.

Then he went on to talk about a company they had sued and unfortunately lost their case against, Ceridian. A light bulb went on in my head and I realized that this was the activist investor firm that had been seeking to nominate eight persons for election to the Board of Directors of Ceridian at the 2007 annual meeting of stockholders. Pershing Square had the backing of fellow activist investor, Relational Investors LLC.

The issue of their lawsuit was a sticky one. They were seeking to force the company to release two letters sent by senior executives of the company to the board of directors. Pershing Square believed that the letters included, “discussions of the senior executives’ concerns about the management of the Company, including concerns about the board of directors’ oversight responsibilities and/or the performance of the prior chief executive officer.”

When I came into contact with Ceridian last summer, they had been without a Chief Internal Audit Executive for almost a year. I asked Mr. Katzovicz if he was aware of that and why no one, not investors, analysts or their auditor, KPMG, had ever cited that fact. Being without a Chief Audit Executive was a major internal control weakness. NYSE rules state that all public companies must have an internal audit function. The problems with the company, including SEC investigations and restatements, were a sign that there was no oversight or monitoring of executives by internal audit or a strong Board, including an independent audit committee.

Mr. Katzovicz told me that he had never thought about this! I suspect many other investors, analysts, proxy advisors and surely auditors and regulators are not making enough of this point either. A strong internal audit function (and I don’t mean outsourced to another Big 4!) and a strong Chief Internal Audit Executive, one that can stand equal to the CFO and engage as a strategic partner with the audit committee and other outside parties such as the external auditors, is a huge governance advantage.

How many companies that have reported restatements, material weaknesses in the internal controls over financial reporting and/or significant deficiencies have also included a material weakness or a significant deficiency citing a non-existent or ineffective internal audit function? Not many… I suspect it is because companies’ management and their external auditors have never considered most internal audit functions as a significant control within the companies internal control structure. In fact, I know of at least one auditor and its client that discounted an ineffective internal audit function as a cause of its problems because the function was doing more operational auditing and consulting to management rather than participating in financial audits and acting as a monitor of the financial function and the external audit activities. If you’re not at the table, you’re not going to be counted. Internal audit should be, it must be a player per law and NYSE regulation. But if it isn’t, external auditors and regulators will look elsewhere.

It turns out that Pershing Square Capital Management is still fighting their battles at Ceridian. And the executives that sent the letters to the Board that were ignored are gone. One of them, the CFO Doug Neve, was someone I had met and liked very much. I realize now, he is one of the good guys and has suffered for it.