Sarbanes-Oxley and the altered state of corporate governance

Paul Gilbert, Waller Lansden Dortch & Davis

On July 30, 2002, the Sarbanes-Oxley Act of 2002 (more commonly known as Sarbanes-Oxley or SOX) was signed into law. Enacted in response to a wave of corporate disclosure and accounting scandals that created a lack of investor confidence and a sense of distrust in corporate leadership and accounting practices, it is now beyond debate that SOX has dramatically altered the governance and disclosure landscape of investor-owned utilities.

Given the huge number of utilities that are not investor-owned, however, the more interesting question is what if anything SOX means for the officers and directors of utilities that are not directly subject to SOX. For example, will higher standards of care be applied to the actions of these officers and directors? Will the broad adoption of SOX-compliant governance standards, policies and procedures establish a new expectation of governance and financial transparency? Finally, will utilities that fail to adopt enhanced procedures have access to capital? We think the answers to these questions are yes, yes and perhaps.

Generally speaking, Sarbanes-Oxley, and the rules adopted thereunder, obligate investor-owned companies to maintain audited financial statements personally certified by their CEOs and CFOs, create independent audit committees with at least one financial expert, adopt a code of ethics for financial officers and their CEO (unless the company discloses otherwise), ensure auditor independence and refrain from loans to directors and officers. SOX also imposes on all companies new obligations with respect to document retention policies, whistleblower protections and possible obstruction of justice charges.

For those utilities not expressly subject to Sarbanes-Oxley, state law still defines and governs the fiduciary duties of directors. Under state law, directors of nonprofit corporations, like their investor-owned brethren, must provide oversight in a manner consistent with their fiduciary duties of care and loyalty. The duty often at issue, the duty of care, generally requires that directors act in good faith, in a manner reasonably believed to be in the best interests of the corporation, and with the care that an ordinarily prudent person would exercise in similar circumstances. If a board meets these duties, the decisions made by the board-whether good or very bad-should not be subject to judicial review.

Notwithstanding this fact, a number of public and not-for-profit companies have voluntarily revised their corporate governance standards, policies and procedures to be consistent with certain SOX requirements for public companies. Many seem to have done so after concluding that such standards represent governance “best practices” that should not be ignored. Others likely have adopted enhanced standards after witnessing corporate scandals such as those at Enron and WorldCom and the increased public and political pressure to demonstrate that public assets are being safeguarded and that financial results are being correctly (and transparently) reported.

Whatever the reason, it seems clear that many boards, especially those in highly regulated industries, have determined to meet and exceed the highest governance standards. As a result, we believe that the standard of care that must be met by directors and officers has been enhanced and that an “ordinarily prudent person in similar circumstances” would likely demand and do more when making a corporate decision in the post-SOX world. In the face of such a heightened standard, the acts and omissions of directors and officers will likely be more closely examined than in the past-especially if the act or omission that arguably led to or allowed the adoption of grossly inaccurate financial statements, a self-dealing transaction or other similar failure is judged with the benefit of “20-20 hindsight.” Put simply, the public (and probably the courts) expect more and will likely judge governance failures more harshly in the post-SOX world. This is especially true, we believe, if the failure could have been prevented by the adoption of enhanced governance policies and procedures.

A more persuasive argument that enhanced governance standards should be considered was recently made by Fitch Ratings, one of the three leading rating agencies that rate issuers’ credit quality and determine, to some extent, access to capital. In a May 4, 2004 conference call and companion report, Evaluating Corporate Governance: the Bondholders’ Perspective, Fitch explained how it evaluates and incorporates a review of the quality of an issuer’s corporate governance practices within the larger credit ratings process. Fitch stressed that its evaluation process is not static and that it will refine its approach “to reflect key trends and drivers affecting governance quality as the field evolves.” To evaluate corporate governance, Fitch currently employs publicly-available information and targeted research to determine if the interests of bondholders are protected. In this regard, Fitch believes the following principles are the most important to credit investors: (1) the independence and effectiveness of the board of directors; (2) the oversight of related party transactions; (3) the integrity of the audit process; and (4) the structure of management compensation. Fitch indicated that the quality and frequency of disclosure is another key factor in evaluating organizations who wish to access the capital markets.

In light of these evolving standards and the possibility that access to capital may be determined, at least in part, by the issuers’ governance practices and procedures, concerned boards might start by considering the following questions:

“- Is the board active and engaged or is it controlled by or beholden to management or some other official? If the board is not active and engaged, significant governance issues likely exist or may develop.

“- Is the size and expertise of the board appropriate given the complexity of the business at issue?

“- Does the board have an audit committee and, if so, are its members “independent” and “financially literate?” What is its relationship with outside auditors?

“- What mechanisms are in place to allow the expression of employee concerns?

“- Have all conflicts of interests been fully disclosed to the board? Does the utility make loans or advance funds to any person?

“- Are the company’s code of ethics and document retention policies current?

The answers to these questions may identify some red flag areas that interested boards need to consider to ensure both proper governance and compliance with applicable laws. Public utilities have long been among the leaders in their commitment to corporate governance and transparency. Now it seems that Sarbanes-Oxley should be added to the total mix of information that nonprofit boards consider when evaluating their effectiveness.

Gilbert is a member of Waller Lansden Dortch & Davis and serves on the firm’s board of directors. Gilbert practices in the areas of mergers and acquisitions and securities law.

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