Stricter Guidelines Put Boardrooms on Notice

Directors in some San Diego boardrooms complain that recent compliance regulations are taking precious time and money that could be used to stoke their bottom lines. Still others contend that those rules are a "necessary evil."

Either way, all boards of directors - and high-level executives

On April 8, the U.S. Sentencing Commission voted unanimously to amend the existing guidelines for compliance and ethics programs, influenced, in part, by the Sarbanes-Oxley Act of 2002, created to monitor corporate accounting practices after a series of financial scandals.

The amended guidelines, originally issued by the commission in 1991, now place greater responsibility on boards of directors and executives-rather than management - for the oversight and management of its company's compliance programs.

Michael P. McCloskey, a partner at Foley & Lardner, is active in the securities litigation, enforcement and regulation, white-collar defense and corporate compliance practice groups. He said his clients view the increasing compliance rules more as a "necessary evil."

"No one wants to spend more time than they have to that doesn't go to the bottom line," he said. "They're out there to sell goods and services. To that extent, there is frustration. But my clients on boards of directors are very sophisticated businessmen and are very concerned with corporate culture and governance."

It can get very expensive, with new auditing requirements adding from $50,000 to $ 150,000 to a small firm's annual expenses; $300,000 to $500,000 for midsized companies; and into the millions for large firms, said McCloskey, who recently wrote an article for D&O Advisor magazine on the rising cost of compliance. Add to that the expense of additional training and directors' and officers' liability insurance.

"It takes away from profitability," McCloskey said. "The publicly traded companies have to answer to the shareholders and you have a trickle-down effect. The shareholders (complain) that they've spent too much money on auditing fees. But if the company doesn't and it opens the door to fraud, then the shareholders turn around and sue them for fraud."

The amendments represent the first time the "organizational" sentencing guidelines have been modified in their history, according to the commission. By organizational, the commission means corporations - public or private - partnerships, associations, joint stock companies, unions, trusts, pension funds, unincorporated organizations, governments and nonprofits.

Under the new rules, if companies seek reduced criminal fines, they must demonstrate that they have identified areas of risk where criminal violations may occur; trained high-level officials, as well as employees, about applicable rules and regulations; and given their compliance officers sufficient authority and resources to carry out their responsibilities. But beyond that, the commission said, they also must promote a culture that encourages ethical conduct.

Su Lian Lu, a corporate attorney with Sheppard Mullin Richter & Hampton LLP, had just finished writing up a client advisory on the new sentencing guidelines.

"A lot of companies are realizing that it's very important to have good corporate governance policies in place," she said. "It's not just about reducing sentences if they were to be charged. It demonstrates good corporate citizenship and reduces the chances that offenses will occur in the first place."

Changing Roles

Boards of directors are increasingly finding that their corporate roles are extending beyond the bottom line.

"Two or three years ago, boards were more focused on the performance of the CEO and how the business was growing," said Scott Stanton, a partner at the San Diego office of Morrison & Foerster LLP. "Board members used to fulfill what was expected of them by going to quarterly meetings. It's not that way anymore. They have to get involved in accounting and disclosure and compliance activities."

Raising the bar on ethical conduct - while generally lauded - also comes with a lot of compliance baggage that is both time-consuming and expensive, Stanton said.

"None of them is really thrilled by the additional procedures," he said of his clients, most of whom are technology companies. "There is a lot of bureaucracy. A lot of people wonder if these procedures are driving shareholder values."

At one board meeting, Stanton said a member complained, "I have a certain amount of time to devote as a director, setting the operations and markets for the company, and I'm spending too much time on regulations.

"A lot of heads were nodding," Stanton said.

That meeting devoted two of its eight hours to compliance issues, he added, "Two hours that, frankly, the board members could have used formulating the company's strategy or dealing with business."

And there is the matter of the added expense, which is about twice as much as anyone had expected, he said.

"It's an investment no one had anticipated, in time and money, especially for smaller companies that are strapped for resources," said Stanton.

But he sees value in the compliance programs - up to a point.

"They're using a pretty blunt instrument to attack a delicate program," he said. "If the intent of the amendments is to tell people they need to take their policies off the shelf and really work with them, I mostly think it's good to remind people of their obligation to be good corporate citizens. But the good ones are going to be good, and the bad ones are going to be bad despite these programs."

Sean Prosser, a partner with the San Diego office of Fish and Richardson, and a specialist in business and, securities litigation, thinks the shift to holding boards more responsible is a good way to ensure more transparency and ethical conduct. But, he added, finding qualified independent directors has become a challenge for many companies that want their boards to be less insulated.

"If you only have in-house people on the board, it's tougher for them to be critical," Prosser said. "If they are truly from outside with no allegiance, it's easier to change and criticize things. But there's been a shortage of independent directors because of the increased liability and the increased focus on financial backgrounds. I know clients who have been looking for independent directors and they are frustrated. It's easier said than done."

Prosser said he has clients who have created disclosure committees, which also include managers and the financial staff, not only the highest echelon.

"Having mid-level managers involved will give the directors more of an insight into the company that they might not get by going to board meetings or reading reports," he said.

Otto E. Sorensen, a partner with Luce Forward, said that the amended sentencing guidelines, as well as other Sarbanes-Oxley-style rules, actually are returning boards of directors to their historical roots.

"Corporate law goes back a long time," said Sorensen. "Boards of directors were intended to be a governing board responsible in a fiduciary way to the stockholders, and California law makes that clear.

"In larger public companies, in many cases, boards had abdicated their responsibility in some ways to management and didn't provide the kind of oversight that was required. Sarbanes-Oxley has changed that. The board is now more cognizant of their responsibilities."

Partnoy's Stand

Frank Partnoy, a professor at the University of San Diego School of Law specializing in corporate law and financial markets, believes there's a need for good ethics and compliance programs because, "There is a significant percentage of companies subject to criminal investigations every year."

While he sympathizes with the added burden compliance rules place on companies, Partnoy said, "Good governance doesn't come cheap."

The amended guidelines by the commission should send a message to businesses, he said.

"Having an ethics program is fine, but there is a need to take the level of oversight up several notches and for the board to be much more involved and have a greater understanding of business than in the past."

Partnoy is the author of "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets," a book that "tries to connect the dots" of recent corporate scandals, and "Fiasco," another dissection of corporate life.

"The world is so much more complex that, once you dip your toe into the markets, you are immediately subject to so many financial variables, to what will the investors say about your numbers, bow do you account for stock options - the level of expectations of what happens at board levels has gone up," he said. "There is a need to know how someone can screw you deep within the company. You have to have a program in place designed to catch this kind of problem."

Janice A. Kassebaum, the executive vice president of client services for Legacy Bank in La Jolla, also serves on the executive committee of the Corporate Directors Forum in San Diego. The group's mission statement: Better boards make better companies.

Kassebaum said successful companies don't necessarily need mandates to behave honestly, because, "They're already doing it." But, she added, "You can't have your hands in every department. You want to hope that every executive reflects what the company's ethics are. Essentially, it's the responsibility of all of us to monitor this, from the chairman to the executive team and their managers. It's another regulatory responsibility. Add it to the list, I guess."