Corporate governance on the frontline

Dec. 1, 2006
Every responsible corporate executive I have spoken to is eager to comply with the highest standards of financial compliance and corporate ethics.
In the aftermath of the Enron debacle, American corporations have been burdened with a heavy load of new rules, regulations, and competing bureaucracies. If the intent was to create greater financial transparency, the outcome has been regulatory opacity.

Jim Trippon, CPA - Trippon Wealth Management, Houston

Every responsible corporate executive I have spoken to is eager to comply with the highest standards of financial compliance and corporate ethics. Unfortunately that’s not always easy in today’s regulatory environment. Sometimes new rules and bureaucracies compete and conflict in ways that don’t always serve the best interests of corporations or their shareholders.

The Securities and Exchange Commission (SEC) has tried to improve the guidance it offers companies, investors, and auditors. Sarbanes-Oxley, or SOX, is one of the relatively new regulatory structures intended to further improve the reliability of financial statements and to protect investors. SOX is designed to prevent a replay of the Enron disaster but it is widely recognized as a complex and burdensome regulatory tool.

Most recently, the SEC issued a series of actions it intends to take to improve the implementation of the Section 404 internal control requirements of the Sarbanes-Oxley Act of 2002.

Under the SOX Act, a non-profit corporation called the PCAOB, or the Public Company Accounting Oversight Board, was created to oversee the auditors of public companies and to ensure the protection of investors’ interests. They do this by examining the practices of CPA firms that audit public companies.

The board’s operating budget is funded by “accounting support fees” collected from public companies. These fees are mandatory, and failure to pay them is a violation of the Securities Exchange Act of 1934.

I found it odd that out of several thousand companies registered with the PCAOB, not one of them managed to get a clean bill. Could this be because of a lack of competence among the auditors? Or is the list of policies that companies are required to comply with too vague? I believe it’s the latter. A source I spoke to at the PCAOB perhaps put it best when he said, “The SEC is breathing down our necks.”

The Institutional Shareholder Services (ISS) is another flawed branch of corporate governance that no one can seem to do anything about. This organization, which wields tremendous power over public companies and their ratings, seems to be pushing its own political agenda through the ratings companies are marked with.

Over the past few years, ISS has transformed itself into a powerhouse in providing corporate governance ratings to its institutional investor clients. Their product “governance analytics” is a widely used reference source for evaluating governance at public companies. ISS uses its power in this area to push its own social and political agendas, most recently through its new “environmental governance ratings.”

I recently sat down to speak with several prominent industry professionals to hear their thoughts about SOX and the complex regulatory environment as a whole. Here’s what they had to say:

Table 1: Largest companies’ governance rankingsOil and gas Company34.8 ScoreBP90Royal Dutch79Statoil72Total62Chevron57Anadarko39Sunoco39Amerada Hess35ConocoPhillips35ExxonMobil35Marathon26Occidental25Valero24Apache22Tesoro15Burlington13Devon Energy11El Paso9Murphy Oil6Williams3Note: Companies were evaluated according to a Climate Change Governance Checklist. The checklist consists of governance steps that companies can take to proactively address climate change. For this report, the checklist ranks companies on a 100-point scale. Each of the five governance categories carries a different number of maximum points to reflect the number of actions available and their relative importance to the overall score. The average scores for oil and gas is 34.8. Individual scores are listed by company.
Source: ISS

Question: From your perspective, how is today’s financial regulatory environment impacting the energy industry?

Click here to enlarge image

Gary Prasher, Systems & Process Assurance partner, Pricewaterhouse-Coopers LLP: Well, from a 404 perspective, obviously there’s been a lot of growth over the last 3 years. However, I think that the larger energy companies that I deal with view 404 as more of a positive than a negative. I think it allows the financial people in these organizations to drive the changes that they wanted to drive but weren’t doing it for cost reasons. Many companies are really using it to drive change to improve processes.

Click here to enlarge image

James D. Eggers, partner, Houston office of KPMG LLP: I think that the impact on the energy industry is similar to the impact on other industries, frankly. Clearly, with the pace of business we are seeing in the energy industry these days, it does present some unique circumstances, but the regulations are the regulations and everyone’s doing their very best to try and comply.

Click here to enlarge image

Mike McElwrath, CEO and president of Far East Energy: Perhaps the greatest impact has been upon the cost benefits analysis of whether companies should acquire capital by virtue of being publicly traded or privately held. Our observation is that there’s a very clear trend now for companies to veer towards going private or remaining private, as opposed to access to the public markets. That’s obviously related to the cost of compliance with Sarbanes-Oxley.

I would be willing to go so far as saying that Far East would probably have been better off on balance had it been a private company as opposed to a public one. The cost of complying with the financial regulatory environment is significant. The environment that we are currently operating in has created greater competition for resources, resulting in higher costs to comply.

Click here to enlarge image

Peggy Heeg, partner, Fulbright & Jaworski LLP: Energy companies are becoming much more focused, and rightfully so, on controls, processes, and compliance. For energy companies, I have seen an increasing concern with potential allegations of market manipulation. Allegations of market manipulation are a huge concern for energy companies because the concept of market manipulation and price gouging isn’t defined, the laws are extremely vague. When prices go up, it’s really easy for regulators and plaintiff’s lawyers to accuse companies of market manipulation.

Energy companies are concerned about the penalties, damages and reputational harm associated with such allegations. Most energy companies want to comply with the law, but some of these laws are so vague and politically motivated it’s difficult establishing effective programs. When you don’t know what the law is and you’ve got vague standards, it’s a very scary environment.

Q: What significant changes do you see occurring in the areas of corporate governance and financial regulation in regards to the energy industry today?

Eggers: I think there have been a lot of changes that have occurred and you can expect change to continue. The passage of the Sarbanes-Oxley Act, of which SOX 404 is only a part, has impacted virtually every aspect of corporate governance in the life of a public company. It’s obviously impacted how an audit is performed but it’s also had a very profound impact on how companies conduct themselves. Recent rules on executive compensation are just another example of the ongoing nature of regulations over corporate governance.

Q: What types of challenges do these changes create for management?

Eggers: The challenges that managements have today are quite different than those they were facing 2 or 3 years ago when these rules were first coming out. I think a big challenge that management has today is in creating a sustainable approach to compliance. In the initial year of adoption, the focus was very much on just trying to understand the rules and then getting through it. You had a lot of companies that formed what amounted to project teams whose task was to simply execute on SOX 404. These project teams may have been staffed with internal resources but many relied on outside contractors.

Members of the project team would document processes and controls across the company, which would later be subject to extensive testing. That was fine then, but that model really isn’t sustainable.

Going forward, the big challenge for management is to create a model that’s sustainable by moving from the project approach to a more embedded approach - just part of the day-to-day flow of business. I think this is something that’s really important and I think the best companies are clearly moving toward that.

The other challenge is to capture benefits beyond simple compliance with the rules. You hear a lot of talk out there about how costly this is and how the benefits aren’t that great. I suppose if the only benefit you see is mere compliance, then that may be a fair comment. But I think that the best companies are going beyond compliance and looking into their organizations to how they can change processes and controls to be more efficient and effective in what they do.

Information technology has also been a huge challenge. I think part of that is because a lot of the legacy systems companies were using were not that well understood, especially outside of the IT organization. All of a sudden you have this big, bright spotlight called SOX 404 that’s cast on IT, and it becomes a big challenge to comply with all that was demanded by the rules.

Another thing that makes this area a challenge is that companies are getting to a point in their IT lifecycles where they’re beginning to change systems. When you change a system in the middle of the year, it basically creates a whole new point of compliance for documenting and testing processes and controls that needs to happen along with the system change.

Heeg: In an attempt to deter non-compliant behavior, the government is focusing on individual accountability even more so than corporate accountability. This is a frightening environment for senior executives and board members. There have been some very recent SEC cases where the government is going after individuals, not for intentional violations of the law, but for failing to have adequate controls in place that arguably could prevent violations of the law.

Q: Have people in the industry generally been successful in addressing these challenges?

McElwrath: Yes, I think so. Generally, we have been successful and so have most of our counterparts. Success does come at a price, but the increased attention to matters that should be disclosed has been good. The companies I am most familiar with have achieved what they consider to be complete compliance with SOX. Getting prepared for full compliance has been tough and costly, but none of us that are wise are going to shirk away from whatever cost is necessary to achieve compliance.

Q: What is the hottest topic of discussion in the areas of corporate governance or SOX today?

Prasher: What I see is different than what you hear or read about. Clearly, from a regulatory standpoint and even what you’re starting to sense from the SEC, is that they are looking for a way to improve 404 that translates to lower cost. I am not going to say that we are 100% efficient, but I think we are clearly headed in the right direction. And if you look at all the problems that existed pre 404, I think 404 is starting to address some of those issues. There has got to be a compromise. We are getting more efficient, but I would hate to see that we revert to where we were. Maybe 404 went a little too far, but I would hate to see us go in another direction - that this thing gets so watered down that what we do just doesn’t make sense.

McElwrath: In my opinion, the hot topic is executive compensation, especially incentive compensation, and specifically the award of options. For a small company, the utilization of options in compensation packages can be important in the attraction and retention of talent. Historically, options allowed smaller, start-up companies to compete with their larger competitors for talent, but there is certainly a possibility that we will now see a trend away from options and that’s going to make things more difficult for smaller companies.

The energy industry does not appear to be caught up in the stock option issues reported in the financial press; however, the overall compensation issue will be an industry issue requiring greater explanation and education than in prior years. I think the great majority of companies have acted responsibly in their award of options. They don’t make the headlines.

Heeg: The hottest topic is probably the impact of hedge funds and the amount of control they’re starting to show in corporations and with boards. They’re basically pushing their agendas in the name of corporate governance and it’s a pretty big concern of boards.

Q: What significant governance and regulatory challenges do you expect to see occurring in the energy industry in the future over the next three to five years?

McElwrath: Over the next few years, I don’t see any big changes on the horizon. Maybe what will happen is that we will all get a little bit more proficient at controlling and managing the cost associated with SOX compliance and also the business in general. The regulatory authorities are looking at this question of balance. The pendulum has naturally swung a little bit towards the regulatory side in the wake of the Enron scandal. We are optimistic about where this will all end up and, hopefully in the long run, the shareholder will have been well served.

Q: What is the most frequent complaint about corporate governance or SOX that you hear from management?

Heeg: I hear complaints about the power some organizations have, like the Institutional Shareholder Services, ISS. They’ve got governance formulas that dictate their recommendations on how to vote for board members. I often hear complaints that these organizations have way too much power and their positions are not aligned with shareholder value. I think some of the stuff coming out in the name of corporate governance is not good for the industry. I hate to see organizations pushing their own agenda and people blindly following it.

Q: Are there any revisions or additions to the SOX Act that you think are necessary or would like to see happen?

McElwrath: I think that currently there is a disproportionately high amount of cost for smaller companies, and I trust that over the next few years the advocacy groups, as well as the regulatory agencies, will be taking a good hard look at that. It is difficult to achieve balance the first time around. I think a good-faith attempt was made and further attempts will be made. As the system is fine tuned, hopefully smaller companies won’t feel as though this is hurting them more than it should.

Heeg: I would reexamine and give more thought to the role of the PCAOB. I am concerned that with the PCAOB’s broad powers, we’ve created an environment where outside auditors are so afraid of liability that everything they do is in a defensive mode and I’m not so sure that’s good for the industry.

I certainly agree with and understand independence, but many times the accounting rules are not clear. It’s healthy for companies to be able to sit down with their auditors and discuss issues and make sure they come up with the best answer. The auditors are just so afraid of the liability that they are doing everything possible to be viewed as independent to protect themselves.

Q: What, if anything, do you see management or board members doing to shelter themselves personally from financial liability under SOX?

Eggers: The best shelter is to get it right. As everyone knows the Sarbanes-Oxley Act has really increased the penalties for those that might not get it right, so the stakes are definitely higher. That said, I don’t believe the Act requires perfection but it does require a good-faith effort by people exercising due diligence in the process to comply.

Since we are dealing with people here, we know that some mistakes are going to be made along the way - that’s just the way it is. But I believe that the best companies are focused on doing everything they can within the capacity of human accomplishment to make a true good-faith effort to comply. I think that’s really the best shelter. You’re not going to be perfect, but that good-faith effort will go a long way, and we’ve heard that a number of time from the regulators.

I think one other thing is that you have to be realistic about what you can do. For example, when the rules came out requiring audit committees to develop and disclose their charters, there were some companies that got very ambitious in terms of what they said they were going to be doing in the area of corporate governance. That’s certainly to their credit, but once you say you’re going to do something you had better do it.

Now I see some audit committees rethinking just how much they can do and where the boundaries of their authority and responsibility really exist. It’s important to strike a good balance in the audit committee charter between doing what is necessary to comply with the rules and changing the world of corporate governance. I want to see every company and audit committee raise the bar on corporate governance, but I don’t want to see them in a position where they have over-promised and under-delivered.

McElwrath: The main thing that any company can do, management or board member, is to be truly knowledgeable. Some of the things that happened in the late ‘90s and then in 2001 probably would not have happened had board members and senior management been properly informed and insisted on having the knowledge that they needed. I can speak without question for our board and management because we are all hands-on. I think that anybody that steps into a board chair or a senior executive management position these days had best be hands on. If they aren’t, they are crazy.

Heeg: Management and board members are all paying close attention to their policies and making sure they really understand them. Management wants clear policies so that employees understand what the limits are, what the expectations are and what the exceptions are. What you see regularly is just more activism by the boards to make sure that their companies have comprehensive ethics and compliance programs. In addition to being good business, comprehensive ethics and compliance programs with board oversight provides protection to board members, that they’ve asked questions and that the processes are in place to prevent and detect unethical behavior.

Q: Do you have a sense whether there is an adequate supply of experienced professionals for the current regulatory needs of the industry? What are companies doing to address this situation?

Prasher: I would say in some energy companies there is a deterioration of mechanics - both from a numbers standpoint and quality standpoint. Couple that with 404, I think for a lot of companies there was really a struggle to get the work done.

One client I recently dealt with got acquired and many of their people moved on afterwards. My understanding is from those people that moved on, the accounting, SOX and IT people got snapped up pretty quickly, and I think there’s still a demand for good people. Coupled with the fact that SOX has resulted in more IT work, there clearly weren’t and there’s still aren’t enough people in the IT arena that companies could use, so that in ‘04 and even in ‘05 a lot of the internal 404 testing was outsourced to various firms. To a great extent, that still goes on.

McElwrath: In my opinion, the increased regulatory requirements have created a new industry. There is an incredibly high demand for professionals with a strong grasp of SOX compliance and/or executive compensation. That creates a challenge for big companies but an even tougher challenge for small ones.

The competition for this compliance savvy talent is a classic example of a situation where smaller companies would like to level the playing field by the utilization of options. For smaller companies, given the cost of competing for top notch talent, if they don’t utilize options then they will have to resort to using independent contractors and that can be much more costly.

The author

Click here to enlarge image

Jim Trippon [[email protected]] is CEO of a financial advisory firm that helps energy executives optimize their personal finances. He is a recognized expert on stock option exercise strategy and managing employer stock concentration risk. Trippon has 23 years’ energy industry experience, including a stint with PricewaterhouseCoopers, where he ran the audits of Exxon and its pension plans.