CHAPTER ONE
Nominate Independent Directors
A WELL-RECRUITED AUDIT COMMITTEE provides a brain trust of backgrounds, experience, perceptions, intellect, and specific skills that facilitate cross-fertilization and exposure to new ideas. The audit committee is typically responsible for monitoring all internal and external audit functions of a company, overseeing the financial reporting process, and ensuring regulatory compliance. For publicly traded companies listed on a stock exchange, at least three independent directors are required to sit on the audit committee, with a requirement to disclose whether they have at least one financial expert.
Selecting members with an eye toward nurturing a culture that is collegial yet critical promotes the atmosphere of accountability necessary to ask hard questions of the chief financial officer, the external auditor, and even the chairman of the board and the organizationās chief executive officer. This chapter presents considerations for the nominating committee and for audit committee candidates.
Nominating Committee Perspective
Audit committee success starts with the nomination process. Therefore, audit committee success ultimately rests on the shoulders of the full board of directors because the appointment of directors, including audit committee members, is a full board responsibility. The re cruitment and selection of new directors and the evaluation of in cumbent directors typically rests with the boardās nominating committee, if one exists; otherwise the entire committee may take on the task of finding new members. The nominating committee is sometimes referred to as the corporate governance committee.
In considering candidates for open audit committee positions, nominating committees consider a candidateās independence, the need for a financial expert, diversity of skill sets, and demographic diversity.
Independence
The presence of independent oversight of management is directly linked to a lower perceived risk for the organization. An organization that lacks independent oversight is typically associated with a higher cost of capital because a potential shareholder or creditor demands a higher rate of return to compensate for the additional risk. So nominating committees strive to impanel an audit committee of which all members, or at least a majority, meet the organizationās definition of independence. For public companies listed on stock exchanges, all members of the audit committee must be independent per the listing requirements of the exchanges in order to comply with Section 301 of the Sarbanes-Oxley Act of 2002 (SOX), which requires that all members of an audit committee be independent for public companies that are listed on a national securities exchange.
Director independence is a vastly deeper, wider, and more complex topic than can be described by strictly adhering to specific definitions, because of the informal nature of many social connections that could impair independence. Regulators have been challenged to articulate a definition of independence that goes beyond direct relationships to address the deep web of personal connections formed through neighborhoods, schools, fraternities, social clubs, gyms, industry associations, former board members, and the like.
Regulators and funding sources have provided a slew of definitions of independence in an attempt to promote an audit committee culture immune from conflict-of-interest risks. In the case of audit committees, it is especially important that directors are independent from those in management and from the external auditor over whom they watch. Letās take a look at the definition of related parties per U.S. generally accepted accounting principles (GAAP), legal definitions of independence, and practical definition considerations for nonpublic companies.
Related Parties per U.S. GAAP
Directors and audit committee members are forbidden from involving themselves in related-party transactions unless properly disclosed in the financial statements, as such events might give rise to conflicts of interest and inhibit the appearance of independence required for boards and committees.
U.S. GAAP, the collection of generally accepted accounting standards by the Financial Accounting Standards Board, offers a definition for related parties that includes affiliates, control, immediate family, management, principal owners, and other related parties. Although the technical definition for related parties is quite long, it boils down to a relationship that offers the potential for transactions that are conducted at less than armās-length distance, that offer favorable treatment, or that provide an ability to influence the outcome of events differently from what might result in the absence of that relationship. U.S. GAAP goes on to stipulate that related-party transactions are not necessarily illegal, but material related-party transactions must be disclosed to the readers of the financial statements. Creditors of private companies and funding sources of nonprofit organizations require similar disclosures of related-party transactions, with the key objective of these disclosures being improved transparency of the relationships between the board, its audit committee, and management.1
Legal Definitions of Independence
As mentioned, Section 301 of SOX requires that for public companies listed on a national securities exchange, all members of an audit committee be independent. In order to be considered independent for purposes of SOX, audit committee members may not, other than in their capacity as directors, ā(i) accept any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof.ā
The SEC is tasked with crafting rules and regulations to effectively implement SEC. In doing so, the SEC directs companies to use the definition of independence from the national securities exchange or interdealer quotation system applicable to them.
All national securities exchanges and interdealer quotation systems in the United States have definitions of independence. For example, the New York Stock Exchange (NYSE) requires boards to affirmatively qualify directors as independent by determining that each director has no material relationship with the listed company. It further specifies that a director is not independent if the director:
Is or has been within the past three years an employee of the listed company.
Has an immediate family member who is or has been with in the past three years an executive officer of the listed company.
Accepts more than $120,000 in direct compensation (other than director fees) from the listed company.
Is a current partner or employee of a firm that is the listed companyās internal or external auditor.
Has been within the past three years employed as an executive officer of another...