The Sarbanes-Oxley Act, passed by the US Congress last year to deter corporate fraud in financial reporting with the threat of stiffer penalties, now dominates discussion of corporate governance in the US.
And the legislation could prove especially worrisome for oil and gas companies.
The act requires principal executive and financial officers to certify corporate financial and other information in quarterly and annual reports to the Securities and Exchange Commission. It also dictates how a company's management should assess internal controls and auditing standards.
Sarbanes-Oxley is deemed the legislative equivalent of "looking for [business] 'weapons of mass destruction,'" said Arthur S. Berner, a partner and corporate governance specialist with Haynes & Boone LLP, Houston.
"I think it's going to hit the oil and gas business worse than others because there are so many relatively small public companies in this industry," he said. "There has been some discussion about somehow changing some of the rules to [differentiate between] smaller and larger companies. But my guess is that will never happen, or if it does, it won't be significant."
Corporate changes under way
US companies in various industries are beginning to change board structures, practices, and compensation in response to the Sarbanes-Oxley Act, said officials at Buck Consultants, a New York subsidiary of Mellon Financial Corp.
Based on a recent survey of board practices at more than 160 companies representing a cross-section of industries, Edward Speidel, a principal in Buck's compensation consulting practice, reported that initial response among firms "is a cautious one, indicating that companies are focusing on compliance with the new act's legal requirements. Results also show relatively small-scale adjustments to board structure, practices, and compensation rather than more contentious issues, such as the use of lead directors or formal CEO evaluations."
Only three oil and gas producers were included in the survey—ExxonMobil Corp., Occidental Petroleum Corp., and Remington Oil & Gas Corp., Dallas.
The most important change indicated by the survey "is the presence of change itself," said Buck Consultants. "Boards clearly heard the message that they need to examine their practices and respond constructively to shareholder concerns about corporate governance," said Speidel.
Among the companies surveyed, the consulting firm reported:
- 56% are seeking new board members with specific expertise.
- 54% are realigning the membership of board committees.
- 49% are hiring outside or independent consultants.
- 46% are increasing the frequency of committee meetings.
- 43% are holding board meetings without company management present.
- 32% are providing director education.
Virtually all the surveyed companies now have both audit and compensation committees, and the median annual number of audit committee meetings has increased to six (from five in 2002), the consultants reported. They also found that only 10% of the respondents have interlocking boards—a special area of concern because of the potential for conflict of interest regarding director compensation.
However, the survey revealed less movement toward adoption of more-challenging reforms. Only 21% of the companies require their directors to own stock in the firm, and only 17% formally evaluate board members' performance.
"In reviewing survey results, we noticed that no single organization or industry group is taking the lead on issues like board performance reviews," said Speidel. "While boards are more closely scrutinizing the link between executive pay and company and individual performance goals, the idea of similar links for board members appears to have not yet reached their radar screens. This may be a more difficult psychological hurdle, since it requires board members to set their own performance standards and conduct self or peer assessments."
So far, most of the change in corporate governance has been among the "larger, more visible companies" with "more than $1 billion in annual revenue," with medium-sized and small companies lagging in their introduction of reforms, said Buck Consultants.
"Our survey shows that change is going to be evolutionary and seems likely to gather momentum over the next few months as additional companies comply with Sarbanes-Oxley," Speidel said.
Berner also sees "a significant difference between what the big companies are doing and what the small and middle-sized companies are doing. Sarbanes-Oxley is clearly a big-company legislation. When it was adopted, they had in mind Enron [Corp., Houston,] and WorldCom [Inc., Ashburn, Va.]. They really didn't realize how much of a problem it was going to be for smaller companies."
Like many in business, he claims Sarbanes-Oxley legislation is too broad and pervasive. "There were a few bad apples [among corporate executives], but they would have been bad apples under Sarbanes-Oxley. This legislation doesn't stop you from committing fraud," he said. "There are a lot of good things in Sarbanes-Oxley, but there is a lot stuff that, in my opinion, is too costly, too time-consuming, and not clear that it gets at what they're trying to get at."
Certification
The portion of the Sarbanes-Oxley Act that has attracted the most public and corporate attention is the requirement that chief executive officers and chief financial officers certify periodic corporate reports containing financial information, subject to potential criminal penalties.
"It's a criminal statute that [the US Department of Justice is] charged with enforcing," said Paul Maco, a former SEC senior staffer who now chairs the corporate-governance practice at the Houston law firm of Vinson & Elkins LLP. "Unlike the SEC, the Justice Department isn't set up to have this whole rule-making interpretation and exemptive process." Certification requirements under two sections of the Sarbanes-Oxley Act "have already been put to use in SEC and Department of Justice proceedings, with tough consequences," Maco said.
In complying with that law, CEOs and CFOs "are signing [certifications] in their personal capacity. So depending upon the size of the organization, there can be quite a bit of background work that one must do before one is comfortable putting one's signature on it," Maco said. "It [means] having the backup [to ascertain] that everything is working well and that the numbers being reported are presented properly.
"This is one of the key themes of the Sarbanes-Oxley Act—it is highly personal in the responsibility and liability it creates for senior management and, under a separate provision, for lawyers," he said.
Large oil and gas companies generally have complicated organizations and remote operations that increase the risks for those officers who certify financial reports. "Along with that, there has been a dramatic change in the reporting requirements, the timing of reporting, and in the internal procedures and governance issues, all of which have been required to be digested and implemented in a relatively short period of time," said Maco. "Some of it is still pending."
In addition to federal regulators, bankers and insurance underwriters now put "enormous emphasis" on corporate compliance with Sarbanes-Oxley regulations, especially those rules dealing with financial audits and documentation of internal controls. Some attorneys said they wouldn't rule out the possibility that such emphasis might even extend to the common industry practice of restating oil and gas reserves as a result of commodity prices and other industry-wide factors.
"There are always going to be restatements of financial information for a lot of reasons. And you know someone is going to find some lawyer who is going to bring a lawsuit," Berner said.
"A lot of issues are going to come out of Sarbanes-Oxley that we still have not fully understood," he said. "The provisions, for example, that deal with what outside lawyers and in-house lawyers have to do if they sense that there might be something wrong are totally new. And again, you have civil and criminal penalties if they do it wrong. There will be a lot of teeth-gnashing for the next 1-5 years."
Reducing management's control
Even before the recent wave of scandals, voluntary business reform was being driven by "a global consensus" that capital markets, investor confidence, and good corporate governance are clearly linked, say reform proponents.
The scandals and financial failures at Enron and other corporations illustrate the key issues of whether boards of directors, representing the investors, are getting full information from management executives who run the company and if board members are confronting the correct issues, advocates contend.
Those proponents were advocating a greater role for independent directors prior to passage of Sarbanes-Oxley. They still call for directors to meet in executive sessions without management in attendance and other methods of reducing management's control while increasing shareholder input into corporate operations.
"Public companies are going to have to get away from management control," said Berner. "Up until now, you've had boards of directors who to a great extent would follow management's recommendations until management really screwed up. No question, Sarbanes-Oxley is requiring the board to spend a lot more time in understanding the company, and general control of the company—not day-to-day operation—is being shifted from management to the outside board members."
There is now increased pressure on board members to look behind the information that management gives them. "Board members can't just rely on what management tells them," said Berner.
However, he said, acquiring the necessary information about a company's operations "takes time, and it requires you to get someone to help you. Who could figure out what Enron was doing?"
Berner observed, "If you're an Enron board member and management tells you, 'We ran this by our accountants and our outside counsel, and they both said it was okay, and we're going to save the company a lot of money if we do this,' I'm not sure what more the board was supposed to do. I don't know that they weren't fulfilling their fiduciary duty."
Even after passage of Sarbanes-Oxley, there remains "a number of areas of potential disconnect," said Charles Harrell, a partner and corporate management specialist in the Houston office of Weil, Gotshal & Manges LLP. For example, he said, "A board's independent audit committee still doesn't have clear access to financial data prior to its being cleared by management. The independent committee is still getting the refined version."
Conversely, said Harrell, "Many companies functioned well and ran smoothly when their boards of directors were 'packed' with friends of the chairmen. The key is still the quality of directors." Moreover, he said, "The size of the company and the nature of its operations have a lot to do with who is or should be on the board."
Risk aversion
The new system under the Sarbanes-Oxley Act that mandates an independent audit committee, with outside accountants and outside council, increases the possibility of conflict between corporate management and outside directors, especially if directors and their outside advisors "are very conservative and don't want to take any risks," said Berner.
"It's always easy to turn down a deal. If you don't want to take a risk, just turn it down. But that doesn't mean it's in the best interest of the shareholders to just keep turning deals down," he said.
Rep. Michael G. Oxley (R-Ohio), one of the sponsors of the Sarbanes-Oxley Act, has expressed concern that the legislation has made companies more cautious and averse to risks for fear of violating provisions of the law. He said that unintentional consequence could damage the economy.
However, the other sponsor, Sen. Paul Sarbanes (D-Maryland), claims there are not as many unintended consequences as some feared.
The review process for corporate decisions almost certainly will be longer and more complex now, which means that some public companies will not be able to move as quickly on some deals. "There is no question the process is going to be more costly, more time-consuming, more difficult to satisfy regulators," Berner said.
Recruitment sources closed
"In smaller companies, all of your accounting people, your CFO, your comptroller, your treasurer, [had] come out of the accounting firm that you dealt with. They knew your company, and after a few years of dealing with them, management often would say, 'Come over with us,' Now those people can't come in anymore," Berner said.
The same principle applies to in-house corporate attorneys who previously were usually recruited from the outside law firm that had worked with a particular company for years. Because of independence requirements under Sarbanes-Oxley, Berner said, companies can no longer recruit from among those people who know their business best.
"One of the corporate governance issues is mandatory retirement age. For some reason, someone arrived at the magical age of 72, which in our industry is absolutely hilarious," said an energy service company attorney who spoke to OGJ on condition of anonymity.
The shakeup of boards and corporate executives through Sarbanes-Oxley "is even worse, I think, in oil and gas, because historically this is a family-oriented business, where grandfather started the company, father is chairman of the board, and the son is now president. That violates several corporate ordinance guidelines right there," said the service company attorney. "At the end of the day, you have to go through the process of replacing [an experienced director or executive] with someone who is new to the business, doesn't have the relationships he has, doesn't have the history of executing on behalf of his clients the way that he does. All of a sudden they have to bring in a qualified candidate who, from what I've seen, are mostly people in their thirties and forties who want to pad their resumés with a directorship."
The service company attorney said, "I think that's where Congress is going to have to step in. With all due respect to the people coming on boards, in my opinion, we're dumbing down the gene pool, because the people who have been conscientious over the years and who have built up retirement and estates are getting off boards in droves because they can't afford to put their families' net worth at risk to serve on something that, while it may be very beneficial to the corporation, it certainly is not worth the [personal] financial risk."
Interlocking boards
The service company attorney conceded, "There are some very positive things that I'm all for, especially as regards compensation interlock—whether someone serving on your board can derive benefit from your company. This would be the classic [example of] an energy services [employee serving] on an E&P company board and getting contracts from that company. Before Sarbanes-Oxley, that was legal; now, they say, 'No, you cannot pay his company and have him then sit on your board and pass judgment on the propriety of what you're doing.' I'm all for the compensation interlocks, because that is a problem.
"But where it's really going to get interesting is where we have charities that are being contributed to by companies, and then someone who is associated with that charity is on the board," said the service company attorney. "We have at least an open issue, as far as I understand, as to whether or not those charitable contributions are going to trigger an interlock problem. That is a bigger issue because you can have several people sitting on philanthropic boards, and suddenly those people are precluded from serving on the boards of any contributors."
The same issue apparently would apply to universities, including many in the major producing states that have benefited from donations by people and companies in the oil and gas industry. People with direct or indirect connections with some of those schools also sit on the boards of their corporate benefactors. Many educational and cultural institutions in Houston and other energy-dependent areas "couldn't run" without financial support from "some legacy oil and gas names, and yet arguably you could have some issues if anybody decided to endow a chair or donate a scholarship or build a building" for some public institution, said the service company attorney.
"You begin to lose qualified candidates for board members when you say they can't sit on any philanthropic board, can't sit on any charitable board, can't sit on any university board. I'm not sure you can be the head of the athletic foundation any more without it being considered an interlock if you end up voting on behalf of the board because that company has built you a stadium or something. It creates some very weird situations," the service company attorney said.
This comes at a time when many major international integrated oil companies have been reaching beyond the usual corporate confines to connect with academic, environmental, labor, cultural, and other community organizations. Several have endeavored to bring educators, labor, environmentalists, and others into the corporate decision-making process, including board memberships.
Foreign firms impacted
Foreign-based companies that obtain financing through US capital markets also are subject to US regulation under the Sarbanes-Oxley Act. "To many of those foreign entities, it is a surprise and a frustration that they need to deal with [these issues]," said Maco.
"One interesting shoe out there waiting to drop is the audit issue—foreign audit firms and foreign affiliates of US audit firms performing audit work for foreign companies covered by the Sarbanes-Oxley Act will have to register with the Public Company Accounting Oversight Board," he said. "At the moment, whether that will be an onerous process or purely ministerial is not at all clear. What is clear is the registration requirement has a lot of noses out of joint."
One item "that particularly hit home with foreign companies is this whole issue of certification," Maco said. He cited "renewed uncertainty" whether Sarbanes-Oxley certification requirements apply to the 6K form that foreign-based companies file with the SEC, which includes "interim information, other than annual information, produced in accordance with the laws with the home jurisdiction."
Application of Sarbanes-Oxley regulations to foreign-based companies operating in the US is "creating a lot of havoc," said Berner. "There are differences in law in foreign countries. For example, there is the [Sarbanes-Oxley] requirement that all directors on certain committees be independent; in a lot of countries where they have requirements that employees be represented on the board, they wouldn't be independent. You run into just a whole lot of conflicts like that, and the SEC is trying to deal with that."
Meanwhile, the Wall Street Journal reported that the amount of capital raised by non-US companies through American Depositary Receipts from US sale of their stock earlier this year was "on pace to be the lowest in more than a decade, despite a pickup in activity recently." Analysts and corporate executives blamed Sarbanes-Oxley for slowing and complicating foreign company listings.
Segment reporting of business
"One area that is getting some attention in the energy sector is the new emphasis on segment reporting," said Harrell. The objective of that financial reporting standard is to break down corporate financial information by segment, according to a company's different products and services or geographical areas in which it operates, if that segment represents 10% or more of a company's total revenue, profits, losses or assets, he said.
According to the Council on Corporate Disclosure and Governance, "Many enterprises provide groups of products and services or operate in geographical areas that are subject to differing rates of profitability, opportunities for growth, future prospects, and risks. Information about an enterprise's different types of products and services and its operations in different geographical areas—often called segment information—is relevant to assessing the risks and returns of a diversified or multinational enterprise but may not be determinable from the aggregated data. Therefore, segment information is widely regarded as necessary to meeting the needs of users of financial statements."
"Segment reporting is not peculiar to energy companies, but it is something they will have to take a close look at," said Harrell. "A lot of smaller and midmarket companies may not have previously gathered historical information in enough detail to provide the required information. This could come as an unpleasant surprise to them."
He said potential problems "could show up in segments that are not properly disclosed."
Corporate loans and insurance
Another touchy area of corporate governance involves loans to corporate officers, which now can "create huge issues" if those loans are forgiven or even not repaid on time, said industry sources.
"Outright loans are obvious. But things like life insurance, when the company pays insurance premiums for corporate officers—especially in a family situation where the company still pays the founder's life insurance premiums after he retires—are not considered a loan," said an insurance expert. "There are some fairly large [founders'] estates where the life insurance is paid for by the company because there is so much corporate stock in the estate that company officials want to make sure escrow taxes are paid. So historically they have had this life insurance policy sitting there to take care of all the expenses when the founder dies and the stock has to be distributed.
"It creates an issue where the company can't pay those premiums anymore without dropping a footnote and explaining why. The disclosure is good, but what's bad is the often knee-jerk reaction to the transaction without recognizing there are very valuable reasons why it is in the company's interest to pay for that life insurance, when controlling interest in the company is tied up in that estate."
SEC actions
Also in the offing are a spate of new SEC actions on shareholder rights related to or inspired by Sarbanes-Oxley.
"A lot of the regulations are dependent upon the SEC approving [actions by] the New York Stock Exchange and NASDAQ [the National Association of Securities Dealers Automated Quotation]," said Berner. "Everyone thought that was going to happen more than 8 months ago, and it still hasn't fully happened. So a lot of things still have not been implemented. I think we're going to see a lot changes in the next year or so as all of these things finally get adopted."
He acknowledged, "The SEC has been extremely busy. They have probably issued more rules this year than probably any year in their history, all because of Sarbanes-Oxley."
In July, the SEC staff drew up a list of recommendations regarding shareholder selection and nomination of representatives to corporate boards, with the aim of increasing shareholder rights and access to corporate proxies.
Members of the Social Investment Forum—a national trade association of financial planners, banks, mutual fund companies, research companies, foundations, and community investing institutions—endorsed that move as underscoring "what an increasing number of investors have come to recognize: that the current rules for board elections do not work and do not result in boards that are accountable to and represent the interests of shareholders."
The SEC staff report on the proxy process outlined five alternatives for increasing shareholder involvement in the nomination and election of corporate directors, including:
- Requiring companies to include shareholder nominees in company proxy materials.
- Requiring companies to deliver nominating-shareholders' proxy cards with company proxy materials.
- Requiring more disclosure by nominating committees.
- Requiring further disclosures regarding shareholder communications with the board.
- Revising Exchange Act Rule 14a-8 to allow shareholder proposals related to the company's nomination process.
The staff recommended that commissioners proceed with rulemaking based on three major components and cleanup amendments as necessary, including:
- Enhanced disclosure of the nomination process.
- Documentation of the criteria used by corporate committees to nominate directors. It would also address the disposition of nominations from shareholders who have owned a specified amount of stock for a minimum specified period. One of the more interesting provisions, said proponents, would be disclosure of "whether each member of the nominating committee believes that it [is] in the company's best interest not to nominate the [shareholder] candidate."
- Enhanced disclosure of shareholder communications with board members. Corporations would be required to specify how shareholders could communicate with specific board members or intermediaries. The staff also recommended a requirement that companies disclose how many times each director met with shareholders and "any action taken by the board as a result of the communications."
Corporate law expert Thomas W. Joo of the University of California at Davis, said that "unlike the rank-and-file and grassroots activists, those big players [who can meet proposed SEC thresholds of percentage of ownership] already have informal pull with boards, and they failed to exercise that pull to rein in the risky [or] illegal conduct of Enron, WorldCom, and others.
"Furthermore, because failure to respond to shareholder proposals will be one factor in granting access to the proxy, the proposal may trigger greater management resistance to proposals—both by exclusion from the corporate proxy under 14a-8 and by opposition to proposals on the proxy or independently submitted."
However, he also noted "in light of the political pressure the SEC faces from the business community, and in comparison [with] the unimpressive Sarbanes-Oxley Act, the proposals are encouraging. The political reality is that incremental reform is the best we can hope for."
The SEC staff report "is still being evaluated and considered," said Harrell. "No one expects all of the recommendations to be implemented. The general view is that one or more may be implemented in one form or another."
Requiring companies to deliver proxy cards for an opposing slate of directors nominated by shareholders certainly would reduce the cost to those shareholders pushing for a change. However, Harrell said the SEC previously "has been reluctant to change the current process."
'Disincentive' to go public
Under the circumstances, some say it might make economic sense for smaller public companies to go private to escape the more onerous aspects of the Sarbanes-Oxley Act.
"Well, you hear that," Berner acknowledged. "But the reason for being public is access to public money. My guess is that, even with all of this stuff, anyone that has any thought about access to public markets for getting capital will stay a public company."
However, he said, "I think that there are a bunch of companies that would have gone public that will not do it, if they can somehow access capital in other ways. I think this will be a clear disincentive to become a public company."
Still, he said, "Even for private companies and private deals, investment bankers are kind of requiring them to satisfy a lot of the corporate-governance rules of Sarbanes-Oxley—not all of them, but some."
Moving corporate headquarters and activity out of the US is another alternative, although Berner said, "I think there are reasons for staying here. But certainly alternatives that you might not have thought about before, you'll now give more thought to, and it's possible."
High cost of compliance
Virtually every oil and gas industry source questioned by OGJ claimed that the regulations imposed by the Sarbanes-Oxley Act do more harm than good.
Compliance is "just an incredibly expensive process for the smaller companies to go through for really what is, in my opinion, very little benefit," said one industry executive. "If you have a midsize E&P company, which would be less than $1 billion in market [capitalization], go down, it is a tragedy, but it's maybe 1,300 people [affected]. You have to ask yourself, on a cost-benefit analysis, first of all, are we going to keep them from going down with Sarbanes-Oxley? I'm not sure we are. And then you think about all the costs associated with what all the people have to comply with to keep that one company from going down."
Another executive agreed that some unscrupulous people are likely to skirt any rules "just because they can." Meanwhile, he said, the US government is imposing "an enormous burden" upon the majority of "very straight" operating firms.
"When you really look at the past, the companies that were committing fraud were very few, very far between, and none of this [regulation] would have made any difference, in my opinion," said Berner. "Thousands and thousands of companies were doing it right before [Sarbanes-Oxley]. Now they're just doing it differently or trying to figure out how to do it."
There have been estimates that compliance with Sarbanes-Oxley will cost the average public company $5 million the first year and $1-3 million/year thereafter. "That sounds to me to be very high," said Berner. "But when you look at outside legal costs and independent counsels, audit committees, they may be right."
Sarbanes-Oxley now requires audit committees "to do things they never did before, and they are getting their own legal counsel and their own consultants. Some audit committees are hiring people to work full time, so that the committee can better understand what's going on in the company and can do its work. You can run up a lot of money very quickly, and in the bigger companies, that is what is going on."
Whistle-blowers' 'dark side'
"I've always thought that, over time, the whistle-blower provision [of Sarbanes-Oxley] will be the most difficult for corporations to deal with," Berner said. "It's very, very broad," leaving open to question "what is whistle-blowing and what [corporate management] can and can't do if someone is a whistle-blower."
As it now stands, he said, a person in danger of being fired for legitimate reasons can obtain job security by calling "an anonymous hotline" and claiming knowledge of some corporate wrongdoing and then charging that he or she is being fired because of that action.
That leaves a company without recourse in dealing with "somebody who says, 'This guy's a crook, and this guy's a crook, and this guy's a crook,'" making "crazy claims against everybody and being disruptive to the company. But you can't fire him, because he'll say he was a whistle-blower. Because the penalties are so great if you do something against a whistle-blower, you have to keep this guy."
Therefore, companies may have to toughen their hiring practices and evaluations of future employees to try to weed out disruptive personnel. On this and other issues, Sarbanes-Oxley "will have ripple effects for many years," Berner said.
Shareholder proposals increase
Meanwhile, shareholder proposals hit a new high this year. The Investor Responsibility Research Center in Washington, DC, reported shareholders filed some 775 proposals as of mid-August, a sizeable increase over the 529 filed in all of 2002.
"A full 41% of the proposals we have looked at have dealt with executive pay, by far the most we have ever seen," said Carol Bowie, IRRC director of corporate-governance services. Unions have been the primary force in pushing corporate-governance resolutions related to executive compensation, IRRC officials said.
Proposals to address "poison pill" protections against takeovers were second at 23%. Proposals calling for companies to expense stock options were largely responsible for the rise in pay proposals, accounting for 15% of total proposals, said IRRC officials. Only five proposals called for the abolition of stock options altogether.
IRRC earlier reported more than 1,040 resolutions have been filed at corporations, a 20% increase over last year's total of 802. Proponents see this as evidence that shareowners are increasingly exercising their right to influence corporate practices and policies by filing and voting on shareowner resolutions.