NOVEMBER 2007

Inside:

Behind the Headlines: Lessons Learned From Corporate Scandals

A Word from the President - The Society's David W. Smith takes a look at Society membership from a different angle.

Events - The Society is hosting Issues Update in New York City this month and the Essentials Seminar in Orlando, Florida in January 2008.

Behind the Headlines:
Lessons Learned From Corporate Scandals

By Katherine K. Combs

In the five years since WorldCom, Enron and Sarbanes-Oxley, the President's Corporate Fraud Task Force has obtained more than 1,200 criminal convictions, involving over 400 corporate executives, and some of the largest civil penalties in United States history.¹Although much has been written about these "corporate scandals," the media have focused more on the sensational aspects of the criminal trials, and less on the corporate governance lapses that failed to prevent or detect the misconduct, or the empirical research that bears on whether Sarbanes-Oxley and the other reforms adopted in their wake will be effective.²

The 61st National Conference of the Society of Corporate Secretaries and Governance Professionals, June 28, 2007, brought together the prosecutors of some of the most significant criminal trials and a number of academic and governance experts to look "behind the headlines" for the lessons corporate secretaries and governance professionals can learn from the criminal investigations and from recent empirical research on the underlying causes of the scandals and the efficacy of the reforms.

What the Prosecutors Found

What role did corporate governance practices play in the causes of the scandals and the degree of harm that resulted? After interviewing directors, auditors, and executives, and reviewing countless minutes, corporate records and compliance program details, the prosecutors of the HealthSouth, Enron and options backdating cases found significant evidence of poor governance practices, including directors, auditors, attorneys and others who failed to inquire or challenge management when they should have, or to insist on good governance practices that would have exposed the wrongdoing before it could do so much harm.

Alice H. Martin, U.S. Attorney, N.D. Alabama, who led the prosecution team in the trial of Richard Scrushy, HealthSouth's founder and former CEO, found the HealthSouth board too trusting of management, never questioning

1. the accounting practices that evolved from "aggressive accounting" into pure fabrication,
2. the repeated resignations of the CFO — 5 changes in 6 years,
3. the infrequency of the board's meetings with the internal auditor, which allowed management to intimidate the auditor into giving advance notice of audits, and enabled management to avoid detection of the fraudulent accounting, or
4. the grossly inadequate staffing of the ethics and compliance function.

Several members of the HealthSouth board had significant undisclosed personal contracts with the company and some failed to disclose to the rest of the board the fraud when they became aware of it. Directors who questioned management were marginalized or squeezed out, creating a chilling effect on those who remained. Meeting minutes were drafted so late (9-12 months after the meeting) that directors often could not remember what had occurred, and did not notice that fictitious minutes of a compensation committee meeting that never took place were presented for their approval.

Doing the Perp Walk: Jeffrey Skilling and Ken Lay in handcuffs.

Sean M. Berkowitz, currently a partner at Latham & Watkins, served as head of the Enron Task Force and lead prosecutor in the Enron trial against Kenneth Lay and Jeffrey Skilling. He told the conference that up until its fall, Enron was considered one of the world's most-respected and most-innovative companies. All of the Enron directors were "independent" as defined by the standard criteria and the board's governance practices were considered best practices at the time. So, what happened to turn such a well-respected company into one whose name is now synonymous with corporate fraud? Mr. Berkowitz believes that the Enron story was not about greed, but about a self-confident, aggressive culture, that was convinced its survival depended on meeting Wall Street's earnings expectations and took advantage of ambiguous accounting rules, and ultimately phantom transactions to ensure that they did. Moreover, Enron did not tolerate dissent, and moved people to the side whom it considered "incapable of making aggressive accounting decisions" necessary to achieve the earnings targets. Although Enron's governance practices and compliance plan looked good on paper, they were illusory, because management didn't follow them and reported concerns were not treated seriously. And up until the end, Enron was so confident that it had the talent and ability to turn things around, that it didn't consider its conduct illegal or fraudulent, but means to an appropriate end.

Douglas Sprague, is Chief of the Oakland Branch of the United States Attorney's Office for the Northern District of California and serves on the Stock Options Backdating Task Force. At the time of the conference, there had been more than 150 internal investigations of potential options backdating practices, resulting in financial restatements totaling billions and the termination of scores of corporate executives across the country; the first case to come to trial, Brocade Communications, Inc, was about to begin.³ Backdating refers to the practice of selecting a date in the past when a company's stock is low and retroactively pegging stock option grants to those past dates. The result is an option that is "in the money," or already has value on the date it is granted (in contrast to the normal grant, which has no value on the date of the grant). The goal of backdating is to boost the recipient's potential windfall, and undercapitalized companies frequently used backdated options as free cash to attract and retain top talent.

Mr. Sprague explained that backdating is not illegal, provided it is disclosed and properly accounted for, by recording it as a compensation expense. Brocade's CEO was convicted for securities fraud for failing to record the compensation expense, and for lying to investors and auditors in order to falsely boost Brocade's profitability. And the former CFO of Comverse Technology, Inc. pleaded guilty to fraud charges arising from the backdating, the granting of options to fictitious employees and the falsification of records to cover up the practice. Mr. Sprague stated that the fraud was undetected for some time because the Comverse board's compensation committee⁴ approved option grants by unanimous written consent, rather than in a formal meeting, allowing the grant date to be filled out without its knowledge, and enabling the alteration of dates without the knowledge of the board.

Lessons Learned for Corporate Secretaries and Governance Professionals

The prosecutors offered numerous lessons for corporate secretaries based on what they found in their investigations:

1. Provide Detailed Minutes. Provide sufficient detail of the significant issues discussed at board and committee meetings so that directors (who also sit on other boards) can recall what happened, often years later. Each of the prosecutors stated that inadequate detail in the minutes, coupled with the directors' failure to recall independently, made prosecution of their cases more difficult.
   
   
2. Follow Routine Processes and Establish Good Internal Controls on Minutes. The prosecutors agreed that if the corporate secretaries had established and routinely followed processes under which board and committee meeting minutes had been routinely prepared reviewed and approved by the board a reasonable time after each meeting, it would have been much harder for the alternations, or misconduct to have taken place, or continue so long undetected (e.g., HealthSouth's chronic lag of 9 months between meeting date and minute review). In addition, they advised that strong internal controls must be established to ensure the authenticity of approved minutes, or unanimous written consents, and to ensure that unauthorized changes are not made to the approved minutes. They advised against the practice used by the Monster compensation committee, of having directors sign unanimous written consents that do not have the date of the grant filled in, to be inserted by an officer at a later date. They also recommend using a computer to create and store approved copies of minutes to reduce the opportunity to alter the authorized version, and to generate meta data, which enables others to determine who accessed the document, when and by whom any changes were made. They also recommend that the corporate secretary record the chain of custody of approved minutes, certify hard copies to the outside auditor and burn the final copy to a read-only CD that can not be altered.
   
   
3. Ask How The Board Wishes to Document Decisions Made Outside of Meetings. While notice and quorum requirements generally require that decisions be made in meetings, occasionally decisions will be made outside of formal meetings; informal decisions should be documented like any other. The prosecutors recommend that corporate secretaries establish a process for documenting, reviewing and reporting informal decisions and follow it consistently.
   
   
4. Insulate Compliance Plans From Management Influence. Even a model compliance program will be ineffective if it is not followed, if reported concerns are not taken seriously and thoroughly investigated and violations are not consistently enforced. The prosecutors recommended that the person taking "hotline" calls have direct access to the audit committee, which oversees the process under post-SOX listing standards, and the courage to resist any management attempt to limit or control the outcomes of investigations.
   
   
5. Avoid Placing Too Much Control in a Few. Douglas Sprague stated his opinion that alterations of minutes and undisclosed backdating were facilitated by the delegation of too much authority to a small options committee (comprised of one member in Brocade and three members in McAfee, Inc.), which could act by majority written vote. Instead, he recommended that options grants be treated like any other board action, and that the grant process have adequate internal controls.
   
   
6. Encourage Directors to ask the Right, Tough Questions and Follow-up. Alice Martin said that the HealthSouth audit committee members either failed to ask the follow-up questions that would have alerted them to the existence of a fraud, or were intimidated by the CEO who berated or ridiculed legitimate inquiry. She advised corporate secretaries and governance professionals to be alert for board mailings that contain only good news, or only positive analyst reports. "Ensure that directors get a balanced view of the company and the challenges it faces," she said.
   
   
7. Speak Up If You See Something Fishy. Sean Berkowitz urged everyone to "ask questions." He said, "Don't be dissuaded if someone says they don't want to discuss it — insist on an answer. Don't think you are not bright enough to understand the rationale for conduct you find disturbing. Don't assume that someone else will report the misconduct — if you don't, no one else will. And don't think you are powerless to prevent someone with criminal intent from doing harm. You are, and sometimes you must."
   
   
8. Don't Think it Can't Happen Here, or to Me. All agreed that complacency and inertia are dangerous in these situations. "Never underestimate the creativity of the criminal mind," Berkowitz cautioned.
   
   
9. Culture Influences Behavior. Berkowitz concluded by saying "Enron teaches us that where the culture won't tolerate dissent and is focused on hitting short-term earnings targets, good people will 'cross the line' and engage in illegal conduct. If you find yourself in such a culture, and you can't change it, your best option may be to resign."

What We Now Know About the Causes of the Scandals and the Efficacy of the Reforms

The panel of academic and governance experts provided a range of opinions on the causes of the scandals, whether Sarbanes-Oxley and the related reforms are effective, and whether their costs outweigh the benefits.

Charles M. Elson, who is the Chair in Corporate Governance and Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, moderated the panel. Professor Elson believes that Enron's failure was caused, in part, by ineffective oversight by its board, which was not independent from management and lacked a long-term equity stake in the company. Had the board been independent, in spirit and fact, he stated, "perhaps it would have recognized the numerous warning signals before it and reacted in time to prevent the scandal and bankruptcy."⁵ To the extent that the legal and regulatory reforms focused on strengthening director independence, especially the new listing requirements, he believes they will help solve the governance problems that surfaced at Enron. But more is needed, in his view: "long-term equity ownership by directors is necessary . . . to create the incentive for objective directors to act ultimately in shareholder interest."⁶

James D. Cox is the Brainerd Currie Professor of Law at Duke University School of Law, where he specializes in corporate and securities law. Professor Cox believes that Sarbanes-Oxley made a number of positive changes, it:

1. created an independent, publicly funded accounting standards board, with the ability to make decisions,
2. strengthened the independence requirement for outside auditors,
3. anchored the retention and compensation of the outside auditor in the board audit committee, and
4. made progress towards requiring "real time" reporting of information that investors need.

Although no one anticipated the significant costs of compliance with Section 404⁷, he said, "at the end of the day, everyone will benefit from the improvement in internal controls."

Roberta Romano is the Oscar M. Ruehausen Professor of Law and Director of the Yale Law School Center for the Study of Corporate Law, as well as a research associate at the National Bureau for Economic Research. Professor Romano reported that there has been a "sea change in the perception of the efficacy of [SOX] that would have not been expected even a few years ago." Empirical research shows that since Sarbanes Oxley became law, capital markets in the United States have declined, as indicated by:

1. decreases in new foreign listings,
2. decreases in initial public offerings,
3. increases in going private transactions,
4. increases in director costs and audit fees (which have caused the overall cost of being a public company to double), and
5. an adverse impact on cross-listed firms.

Professor Romano discussed four studies (one by the SEC Advisory Committee on Smaller Public companies) commissioned between 2005 and 2007 that were sharply critical of SOX because of its adverse impact on small business and market competitiveness, and that recommended material revisions to Section 404, and in some cases, exemption of small firms from its requirements.⁸ Although the SEC rejected the proposal to exempt small firms, it has adopted new interpretive guidance on implementation and delayed the effective date for small and foreign issuers. She discussed the bills introduced in Congress in 2007 to alter Section 404, and media coverage of the criticism of SOX. She predicted that small firm relief from SOX will probably be approved in time, as the scandals fade from public memory, but that it could take a number of years, because of the difficulties of changing the status quo.

Peter Wallison is the Arthur F. Burns chair in Financial Market Studies at American Enterprises Institute and co-director of AEI's programs on financial market regulation. He believes that SOX and the SEC went too far, by mandating changes in listing standards, and without a notice and comment period through which we could have anticipated and avoided the adverse consequences to the U.S. economy:

1. companies moving overseas and out of the public sector markets,
2. a decline in investment in U.S. equity markets,
3. a reduction in U.S. start-ups and small companies, and
4. a decline in U.S. IPOs (which may indicate a decline in U.S. innovation).

In addition, he believes SOX may be causing intangible costs, such as a reduction of corporate risk-taking due to the fear of litigation or exposure to the new criminal provisions of SOX and a preoccupation with compliance on the part of boards, instead of strategy. He doubts that SOX has achieved the increase in investor confidence that its proponents sought. Rather, he interprets the decline in the Dow Jones Index following the enactment of SOX as an expression of "lack of confidence in the political class to fix the problems." He cautioned: "the markets are telling us that things are out of balance and we should do something about it."

William B. Chandler III is Chancellor of the Delaware Court of Chancery, and former President Judge of the Delaware Superior Court. Chancellor Chandler stated that the post-Enron reforms were a "plainly aggressive move by the SEC and the New York Stock Exchange into an area which has traditionally been the province of state law," and that a certain amount of creative friction has resulted. For example, by establishing bright-line independence criteria and requiring that the board be comprised of a majority of independent directors, he believes that the reforms have made it more difficult for plaintiffs in derivative litigation to plead structural bias on the part of the board, and must instead plead bias as a result of social ties -- which is a more difficult task. He also believes that the independent majority requirement should accelerate the trend towards fewer management directors, reducing the ability to hold key officers accountable for breaches of fiduciary duties. To ensure continuation of personal jurisdiction over the officers despite this change, the Delaware corporate law was changed to require key executives to consent to service of process in Delaware.

The panel engaged in a spirited debate about the wisdom of mandating that firms have a majority of independent directors on their board as a condition of listing. Chancellor Chandler referred to the long tradition under Delaware law of giving boards great flexibility and freedom to determine their own composition, and while state law emphasizes the importance of independence, it has never defined what it means in a categorical way. He expressed concern that the bright-line test now embodied in the listing standards may not be right for all boards. Professor Romano stated that the academic research overwhelmingly shows no correlation between director independence and firm performance. Mr. Wallison also considers the independence requirement a mistake, since by definition, independent directors know little about the company, and they are unlikely to be able to detect a fraud.

With regard to whether pressure to meet or beat Wall Street expectations contributed to the causes of the scandals (often referred to as "short-termism"), Professor Romano stated that the academic literature shows that when firms fail to meet earnings targets the price of their stock declines. So, managements' focus on meeting expectations is pragmatic. This problem could be mitigated, she suggested, by eliminating quarterly earnings guidance but she doubted that institutional investors would find that solution satisfactory.

At the conclusion of the panel discussions, we were reminded that the Chairman of the President's Corporate Fraud Task Force said: "the vast majority of American business leaders are responsible, honest, men and women. A few bad actors have tainted the reputations of many honest business people and companies. . . . I applaud the efforts of many in corporate America to set the highest ethical standards and foster healthy corporate cultures, where the investing public and the law are respected."⁹

Katherine K. Combs is Senior Vice President, Governance, Deputy General Counsel and Corporate Secretary of Exelon Corporation. She is a member of the Society's board of directors and served as the 2007 National Conference Chair.

A Word from the Society's President:

A Great Story to Tell . . .

By David W. Smith

As I begin my seventeenth year as president of the Society, I am pleased with our reputation as the premier networking organization for corporate governance executives, our important role and voice with our primary regulator, the breadth and scope of our activities, and the loyalty and dedication of our members. We have a great story to tell about the Society's venerable past, its serious engagement in current issues and its prospects for the future.

Still, I am not content. Our membership must grow, and I hope you will help. You are our best, and perhaps only, sales force.

There is a large group of corporate governance executives who would benefit from being part of the Society's network — and we would benefit from their joining us and bringing their knowledge and experience with them.

We want to grow our ranks of not-for-profit executives — our recently published monograph Governance for Nonprofits: From Little Leagues to Big Universities demonstrates that nonprofits have as many governance challenges and liabilities as for-profits. How could they not benefit from joining us?

We want to grow our numbers of lawyers in private practice who focus on governance issues. Our current members in private practice are among our most active members, helping us with writing and researching monographs and presenting at conferences and seminars. Their expertise — especially regarding litigation — is invaluable, and yet they are not corporate secretaries. Given that, they benefit from the expertise of the majority of our members who are.

And we want to grow our traditional base of corporate secretaries and governance professionals from companies and organizations of all sizes and in all industries. As we all know, the current regulatory environment has made the corporate secretary's job more difficult than ever — especially for smaller companies with limited resources. Having this group of executives plug into our network of professionals and use our online member library is a highly productive way of increasing their resources.

Just think of what the Society represents: a persuasive, responsible, and always timely voice and advocate for its members and their companies. Other organizations publicize the magnitude of the dollars they represent, but we have been reticent in this regard. If we added up our representation in dollars, it would dwarf most others. It is important to remember this influence as you encourage others to join the Society.

As I have recently asked you, please make a personal commitment to recruit at least one new member during this year's Membership Campaign, which will conclude on March 31, 2008.

Thank you.

Society Events

Issues Update 2007

Thursday, November 29, 2007
Grand Hyatt New York
New York

Program Highlights:

• The Proxy Process - New Concepts, New Mechanics
• Managing Shareholders - New Challenges
• Executive Compensation Disclosure - Practical Advice for 2008
• Plus - A Society Tradition - Benchmarking with your Peers

Essentials Seminar

The Basics of Corporate Governance and Beyond

Wednesday, January 30 - Friday, February 1, 2008
Disney's BoardWalk Inn
Orlando, Florida

Program Highlights:

The Corporate Secretary & Governance Professional is published through the year as a service to members of the Society of Corporate Secretaries and Governance Professionals. Articles or statements appearing herein do not constitute legal opinion, advice or judgment, and should not be relied upon as such. Inquiries regarding this newsletter's content should be directed to: Geoff Loftus - (212) 681-2004 gloftus@governanceprofessionals.org Other inquiries and orders should be addressed to: Membership: Deborah Fox - (212) 681-2014 dfox@governanceprofessionals.org Publications: Raul Matos - (212) 681-2007 rmatos@governanceprofessionals.org