Spotlight On The Audit Committee

Tuesday, June 1, 2004 - 00:00

Editor: Mr. Backman, you spent your entire career at Weil Gotshal. In this day and age, that is very unusual. Will you tell us about your career?

Backman:
I was the firm's first summer associate in 1961 after my second year of law school at Harvard. When I joined the firm in 1962 I was its 26th lawyer. Today, of course, it exceeds 1100. In the early days I was a corporate generalist - we did not have specialties - and with the passage of time I began to do more and more securities work and mergers and acquisitions. I have also had an increasing interest and involvement in corporate governance over the years.

Editor: How has your corporate governance practice changed over this time?

Backman:
I think the major change in the corporate governance area today - a change which began to gather momentum in the late 1980s - is the increasing importance placed on good governance by corporate America. Prior to that, there was an ideal of good corporate governance - something to be aspired to - which was regarded as unattainable. The principles of good governance have not changed very much, but today there is a real recognition of the benefits that flow from those principles. Most companies, I believe, are trying to implement them. Needless to say, the recent corporate scandals have forced corporate America to focus on the issues of good governance and have served to accelerate this development.

Editor: You have also been a prolific writer, combining a very active practice with a scholarly career. Please tell us how this has evolved.

Backman:
I have long looked upon teaching and writing as a way in which to make a contribution to the profession. I was very involved in Securities Act reform at a certain point, and that led me into analyzing the theoretical underpinnings of this statutory regime and, hence, into teaching and writing. I have been teaching at Fordham Law School for the past three years and, more recently, at Miami Law School in the spring. In addition, the recent attempts by Congress to use the securities laws as a means to impose corporate governance standards on corporate America have joined together the two major themes of my career. That has provided me with a very exciting opportunity to both teach and write.

Editor: The second edition of your book on corporate audit committees, written with Anne Marie Salan, was published recently. For starters, would you tell us about the first edition?

Backman:
The first edition was published in 2000 in response to the initial rules adopted by the SEC concerning audit committees. This derived from former SEC Chairman Arthur Levitt's focus on the importance of audit committees in monitoring a variety of accounting issues. The action of the SEC, together with the adoption of new listing standards - many dealing with the role of audit committees - by the New York Stock Exchange and other self-regulatory organizations, meant that there was a need for a new book on the subject.

Editor: Would you give us some background on the second edition? What are the things that have occurred to make a second edition necessary?

Backman:
The moving force was the adoption of the Sarbanes-Oxley Act of 2002. The major difference between the SEC's initial audit committee rules and the Sarbanes-Oxley model was that, for the first time, Congress and the SEC went beyond disclosure as the basis of regulation. Both the Securities Act of 1933, concerning the issuance of securities, and the Securities Exchange Act of 1934, concerning the trading of securities, were focussed on disclosure. Sarbanes-Oxley now prescribes normative conduct for many aspects of the corporate governance system, and there is a particular focus on the audit committee and its oversight responsibilities with respect to accounting and finance. This is a sea change. Various activities involving the internal functioning of corporations - something heretofore left to the individual states - are now the province of Congress, the SEC and the securities exchanges. That and the magnitude of the new rules mandated the issuance of a new edition.

Editor: Can you summarize those changes?

Backman:
The audit committee is now required to monitor and oversee the work of the outside accountants to a much greater degree than in the past. This monitoring and oversight responsibility extends to all accounting matters affecting the corporation. This includes authority to hire and fire a variety of advisors, to fund audits and to retain and release outside accountants, as well as determine their compensation. The audit committee is now required to receive reports from a variety of sources, and, of course, a failure to take appropriate action on such reports carries grave consequences.

Editor: Congress, the SEC and the securities exchanges have all weighed in on the role of the audit committee. To what extent do their rules differ? Are they focussed on different things?

Backman:
Neither Congress nor the SEC has tried to dictate everything an audit committee should do. Rather, they have focussed on audit related matters. Congress and the SEC have left it to the securities exchanges to determine most of the qualifications and responsibilities of the committee. As a result, each of the NYSE, NASDAQ and the American Stock Exchange has its own listing requirements. All three are substantially similar in concept, and they are consistent in their requirements - not identical, but very close. The most comprehensive, I think, are those of the NYSE, in that they have the most expansive list of items that ought to be included in an audit committee charter and identify the various powers, duties and responsibilities of the committee.

Editor: The independent director has long been a staple of the audit committee. Is there an easily comprehensible definition of the independent director?

Backman:
The concept of independence from management is at the heart of all of the definitions of the independent director. There are a number of ways of looking at independence, however. Independence as it relates to the composition of the board is one way; independence as it relates to the audit committee - with an additional set of requirements - is another. There is no single, straightforward and all-encompassing definition at this point.

Editor: Please tell us about the audit committee charter. What should be in the charter?

Backman:
The NYSE and NASDAQ have very comparable requirements of what the charter should cover. With respect to purposes, for example, the charter must recite a dedication to the integrity of the financial statements, to compliance with law, to adherence to the qualifications of independent auditors and to certain performance standards for the internal audit function. The duties and responsibilities of the audit committee are spelled out with some particularity. It is important, I think, for the charter to include, in addition to those things that are mandated, a statement of what the governing board expects of the committee. The audit committee has received a great deal of attention lately, but it is not an autonomous, free-standing entity, but rather an integral part of the corporate governance structure.

Editor: What about proxy statement disclosure concerning the audit committee?

Backman:
Most of the SEC disclosure requirements have been carried over from the old rules. The really dramatic changes have to do with the listing requirements of the securities exchanges. Those changes go to the qualifications of committee members and to the duties and responsibilities of the committee. This represents a decision to mandate what the committee is to do, in contrast to disclosing what it has done or is expected to do.

Editor: Can you tell us about the particular risks that audit committee members face? Are they exposed to greater risk as a result of what has happened?

Backman:
I think they are. I would not have said that in 2000, but I think Sarbanes-Oxley has resulted in significant changes in this regard. Today, a state court considering the obligations of an audit committee member will, in all probability, find applicable a standard of care - at least in the accounting and financial oversight area -- that is higher than that applicable to the directors who are not members of the committee. Membership equates with financial literacy today, and that equates, I believe, to an increase in potential liability.

Editor: Are there red flags, things that might alert a committee member to an exposure to risk?

Backman:
There is a very good publication by the National Association of Corporate Directors of a Blue Ribbon Commission's Report on Audit Committees. This includes an appendix which lists key risk factors and financial reporting red flags. Your readers might find this very valuable.

Editor: If you are counseling a client thinking about joining the audit committee of a major corporation, what are the things you try to cover?

Backman:
The most important thing to discuss, of course, is the risks, the exposure to liability. Then there is the time commitment. Audit committee members today are required to devote substantial time to monitoring the affairs of the corporation. As a consequence of both of these things, the level of compensation for an audit committee member should be greater than that of a director who is not a member of the committee. That, too, is something to be covered with the client. I would certainly counsel the client to avoid being on too many audit committees.

Editor: Corporate America's need for independent directors has never been greater. Nor, it appears, has the reluctance of people qualified to fill that role to take it on. Is there any answer here?

Backman:
The recent focus on the audit committee may have opened up opportunities for retired accountants. Accounting is a profession that tends to retire people at a relatively young age, and there is a pool of such people. As a general proposition, I think that most audit committee members do not believe that, so long as they are attentive to their duties, there is an undue exposure to liability.

Editor: Is the importance of Sarbanes-Oxley going to fade with time? Or is it legislation that will rank with the securities laws of the 1930's in its impact on American corporate life?

Backman:
It is too early to tell what the long-term impact of Sarbanes-Oxley is going to be, but my sense is that it will not rank with 1933 and 1934 Acts because its focus is so much more limited. What it has accomplished, of course, is to bring to the corporate governance arena the influence of the federal securities laws, and that represents a very significant change from the past. At this point Sarbanes-Oxley appears to cast a very long shadow, but it is going to be some time before all the results are in.

Editor: Is there anything you would like to add?

Backman:
The spotlight that has been turned on the audit committee is part of an attempt to achieve a balance in the ways in which corporate America functions. The emphasis has been, and continues to be, on performance, and performance is measured by material success. But, performance must be within the rules. We are coming out of a period during which that very simple concept was ignored. A great many people have suffered grievously as a result. If any good is to be derived from the corporate scandals, it lies in the fact that we now have a very vivid set of examples to avoid.

Please email the interviewee at gerald.backman@weil.com with questions about this interview.