NACD Insight & Analysis for December 10, 2010

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In response to the recent financial crisis, the European Commission (EC) released a Green Paper titled “Audit Policy: Lessons from the Crisis.” The Green Paper proposes multiple changes to promote auditor independence and competition in the European Union. Key proposals include:

  • Requiring companies to periodically rotate external audit firms
  • Requiring companies to hire more than one audit firm to conduct the audit
  • Requiring a third party, not the board of directors, to appoint the auditor.

The EC is seeking commentary to help improve new policies slated to begin in 2011. This week, NACD submitted a comment letter voicing our opinion on the undesirable consequences that may result from removing roles that are typically the responsibility of audit committees. While auditor independence is crucial for every organization, such governance mandates run the risk of undermining corporate governance.

To read our comment letter to the European Commission, click here.

Scrutinizing Financial Statements: The Board’s Role and Understanding Potential Impacts

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Listening to Dr. Robert A. Howell at NACD’s Director Professionalism® course here in Tampa reminds me of a video of Warren Buffett during a Berkshire Hathaway annual meeting – high energy, insightful, and focused on results. The key takeaway for the 85 directors and corporate governance professionals in attendance during this session, and for me as well, is that one does not need to be a financial expert to understand the board’s role in defining, monitoring and driving value for shareholders.

Dr. Howell’s remarks were grounded in one key theme: Free cash flow is king. All other performance metrics are secondary when understanding how much value an enterprise has created (or destroyed). As Dr. Howell states, “What other metric can you take to the bank? Do you walk up to the bank teller and say, ‘I’d like to deposit 25 earnings per share (EPS) or 50 returns on equity (ROE)?’ No. You go to the bank and deposit cash. All other metrics are based on accounting techniques and can be engineered. You load up cash and take it to the bank.”

From a background perspective, it’s important to realize that Dr. Howell is a distinguished professor at Dartmouth College’s Tuck School of Business. He has been the CFO of two very large publicly traded companies, and he’s been involved in practicing and teaching finance for over 50 years. Dr. Howell is an icon of finance, and all directors focused on demonstrating exemplary board leadership will benefit from Bob’s guidance and insights. As one attendee stated, “That session was worth the price of admission. I have been a director on public company boards for over 10 years, and I have never heard finance positioned in such a simple manner. All directors should come to NACD’s Director Professionalism program.”

The session started with a brief discussion of how much time directors and corporate governance executives spend, or should allocate, on various phases of the business:

  1. Monitoring the firm’s performance
  2. Challenging results and practices
  3. Assessing projected performance
  4. Driving sound economic decisions, and
  5. Increasing firm value

Attendees’ perspectives on time allocation across these five phases varied. While most admitted that they wished the majority of time was on numbers three to five (the future), many were challenged to really determine the most effective way to quickly define numbers one and two (the past) and allocate more time to overseeing strategy and future efforts to unleash potential shareholder value.

During the two-hour interactive discussion, Dr. Howell emphasized the importance of selecting the right performance metrics and focusing the board’s role on the financial objective of the firm:  driving long-term shareholder value. Specifically, through the future stream of cash flows, management’s mission is to generate more cash, preferably sooner than later, and at a lower discount rate. Many performance metrics were discussed, and Professor Howell stated that “Traditional metrics are lousy descriptors of value. Good ones are grounded in cash flow. ROIC (return on invested capital) and ROEmarket (return on equity, based on market value) are probably the two best. Read NACD’s new Report of the NACD Blue Ribbon Commission on Performance Metrics: Understanding the Board’s Role to get a good understanding of how to identify, prioritize and measure performance of management and your company.”

Through the right combination of compensation, metrics and value creation, the board can efficiently scrutinize financial statements and add valuable oversight for management. These efforts enable directors to disaggregate the component parts of the business and determine which are creating (or destroying) value.

Thanks, Bob, for a fantastic session, and we look forward to seeing you in 2011. The directors and board leaders of Corporate America, the guardians of capitalism, are dependent upon your insights, tutelage and guidance.

Learning to Lead at Board Level: Tom Presby speaks at NACD Director Professionalism

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Eighty-five directors spending two days at NACD’s Director Professionalism® course in a chilly Florida this week benefited from a thoughtful talk from experienced audit chair Tom Presby. Tom leads the audit committee for Tiffany and Co. and American Eagle Outfitters, and serves four other boards, as well.

“If you are invited to join a board, do the due diligence you would do if you were actually buying the company,” he said. “Get to know the other directors and assess the culture of the board and the company. Your board colleagues and the management they oversee will, in effect, be holding your wallet in their hands.”

Tom believes that there is often a connection between company culture, risk management and company performance. “Are people afraid of the boss?” he asked. “Is it ‘make plan or die’? These are potential symptoms of a dangerous culture.” Other red flags to look-out for, he said, are a tolerance for sloppiness, short-term people making long-term decisions (“If they won’t be charged with delivering it, don’t let them decide upon it”) and lack of follow-through on strategy.

Once you accept your board seat, Tom urges, make time to visit operations to take the pulse of the company, and do your best to attend all the committee meetings of the board, supplementing your industry knowledge and particular expertise with a solid grounding in all the issues bubbling at board level.

Protect your independence fiercely, Tom advises, and don’t be afraid to reject the advice of the general counsel, or even make the CEO impatient. When in doubt, ask the second question. “It’s what you’re there for,” he said. “It’s good to be collegial and supportive, but don’t make friends who’ll be offended when you do the job you’re there to do.”

Above all, Tom said to take time to educate yourself on boardroom issues, for you can never know enough. He walks his own talk. He is spending this afternoon at a finance session for board members. Not leading it, but sitting at the back of the room, taking careful notes. If you would like to know more about NACD’s Board Leadership Fellowships, educating directors to be exemplary board members, please contact fellowships@NACDonline.org and check out upcoming Director education courses here.