Can your audit committee withstand the market's scrutiny of independence?

• Author: Richardson, Robert C.
• Position: Audit Committees - Audit committee regulations in US

Two professors summarize the recent rules about audit committees coming from Sarbanes-Oxley and the stock exchanges--and offer advice about what to do and what not to do.

In the wake of Global Crossing's bankruptcy filing, the potentially conflicting interests of its audit committee members are being carefully examined. Particularly troubling is the fact that executives of firms with substantial holdings in the company's stock served on the committee.

For nearly a year, William Conway, a managing director of the Carlyle Group, sat on Global Crossing's audit committee while his company held 2.2 million Global Crossing shares. In addition, Eric Hippeau, managing director of a unit of Softbank Corp., served during a time when his unit controlled nearly 16 percent of the stock of a Global Crossing subsidiary.

Both audit committee members would have gained information about Global Crossing's deteriorating financial condition, which begs an obvious question: Did they act on this information objectively, or to benefit themselves?

Investors are scrutinizing audit committee members and the job they do protecting the integrity of financial reporting more closely than ever. During much of the past year, stock prices were falling and borrowing costs were rising in response to what some have deemed aggressive accounting practices at Cisco Systems Inc., IBM Corp., Tyco International and Quest Communications, to name just a few.

Of course, concern over the effectiveness of audit committees and the independence of their members isn't new. It surfaced in September 1998 with former Securities and Exchange Commission (SEC) Chairman Arthur Levitt's call for improvement. In response, the exchanges adopted new rules. While many had hoped that these new rules would lead to effective audit committees, the recent governance and accounting scandals suggest otherwise.

Responding to growing pressure, former SEC Chairman Harvey Pitt asked the exchanges to reexamine their requirements for audit committees. Both the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) announced recommendations in June to strengthen independence rules. Then, in July, Congress passed the Sarbanes-Oxley Act of 2002, further tightening the restrictions on audit committee independence. The NYSE and NASD quickly modified their recommendations to meet standards found in the new law, and SEC approval is expected.

Federal Reserve Chairman Alan Greenspan recently observed, "Corporate reputation is fortunately reemerging out of the ashes of the Enron debacle as a significant economic value. Markets are evidently beginning to put a price-earnings premium on reported earnings that appear free of spin." With the markets disciplining aggressive financial reporting and with audit committees increasingly being held responsible, thoughtful corporate executives and directors will not delay or be limited by exchange rules in changing their own committees to preserve lower capital costs.

Independence

While the U.S. corporate governance system depends on the competence and activities of audit committee members, their pursuit of shareholders' best interests hinges ultimately on independence. Former SEC...