In-house counsel’s crucial responsibility for governance counseling

Alan S. Gutterman, Founder & Executive Director, Business Counselor Institute

The unprecedented turbulence in the business and financial markets during the early 2000s led to substantial scrutiny of corporate management and the professionals, including in-house attorneys and lawyers from outside law firms, who routinely provide advice and guidance to the chief executive and financial officers of public companies. Scandals and substantial losses by ordinary and institutional investors led to tremendous changes in the regulatory environment for corporations. As a result, the traditional corporate governance scheme that had existed for years was thrust into a state of transition. Congress and the Executive Branch, through sweeping legislation such as the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), the Securities and Exchange Commission (“SEC”) and the major securities exchanges developed new rules that expanded the rights of, and protections for, shareholders while imposing substantial obligations on directors, officers, outside auditors, attorneys, and investment bankers.

Some of the notable consequences of these regulatory changes in the area of corporate governance included the following:

• The fiduciary obligations of the directors and officers, as well as of the professional advisors for the corporation, to the shareholders were enhanced and focused through the imposition of additional duties on directors to oversee the flow of information made available to investors;
• Directors, particularly those serving as members of audit committees of public companies, were given unprecedented authority to participate directly in day-to-day management of the corporation, at least in relation to supervision of the auditing and reporting process;
• The traditional powers of senior management in relation to directors was substantially reduced, as the board was empowered to act independently with respect to selection of directors and auditors;
• New duties were imposed on professional advisors to public companies, including serious reporting obligations on attorneys practicing on behalf of an issuer before the SEC and on the independent auditors of public companies;
• The framework relating to disclosure and accounting requirements was significantly altered by the creation of a new oversight body for accounting firms involved in the audit of public companies and the adoption of new rules regarding the use and explanation of accounting methods that diverge from generally accepted accounting principles;
• New rules for director and executive compensation were designed to increase the independence of directors in the course of their oversight responsibilities and reduce the incentives for executives to use nontraditional accounting and reporting strategies;
• Increased scrutiny of internal controls established by public companies, as well as the degree of auditor independence; and
• Requirements that public companies establish a “hotline” to allow employees to report to the audit committee, on a confidential and anonymous basis, alleged problems relating to the company’s accounting practices, internal accounting controls, or auditing matters.

It is obvious that the changes summarized above were far-reaching and impacted directors and officers, accountants and attorneys. The overriding purpose of the changing corporate governance scheme was to establish the shareholders as the principal beneficiaries of the fiduciary duties and management responsibilities imposed on the board of directors and the officers and managers of the corporation. The notion that the fiduciary duties of directors and officers of a corporation run to the shareholders was not new. However, the Sarbanes-Oxley Act, as well as other substantial changes recently made to SEC rules and procedures, was intended to enhance the level of information and protection for investors in public companies. For example, corporate responsibility for the preparation and overall accuracy of financial reports was substantially increased by requirements for certification of periodic reports (i.e., Forms 10-K and 10-Q) and the establishment of disclosure controls and procedures.

In addition, the breadth and scope of the information that must be included in periodic reports was enhanced by requiring mandatory disclosure of material correcting adjustments to financial statements that had been identified by the company’s auditors; off-balance-sheet transactions; reconciliation of pro-forma financial statements with GAAP; management’s assessment of the company’s internal controls; the existence of a code of ethics for the senior officers of the company; and the composition of the audit committee of the board, including participation by any person(s) qualifying as “financial experts.” Enhanced information flow to shareholders was supplemented by expanded corporate democracy in areas where directors and executive officers had sometimes engaged in excessive activities. Most notably, shareholders of listed companies must, subject to certain limited exceptions, be permitted to vote on and approve all stock-option and other equity-compensation plans (and material modifications thereto).

A second major change was the expanded role of “outside directors” in monitoring the business of the corporation and the actions of senior executives. The Sarbanes-Oxley Act, as well as the revised listing requirements of the major securities exchanges, relies heavily on “independence” requirements designed to ensure that the director group includes experienced managers who can evaluate the activities and performance of the management team without actual or apparent conflicts of interest. Outside directors have been taking on greater responsibilities through their service as members of various board committees, particularly the audit committee. In addition to the rules that relate specifically to the board of directors and its committees, directors also became subject to many of the rules and regulations that apply to senior managers of public companies.

The enhanced role of outside directors was accompanied by a number of new rules and regulations adopted to curb incentives for the senior officers of a corporation, notably the president, chief executive officer (“CEO”), and chief financial officer (“CFO”), to engage in activities that might be harmful to investors. Examples include prohibitions on officers exerting, or attempting to exert, improper influence on the conduct of an audit, including any attempt to fraudulently influence, coerce, manipulate or mislead any public or certified accountant engaged in the audit, and requirements that the CEO and CFO forfeit certain bonuses and profits in the event their company is required to restate its accounting results due to material noncompliance by the company, as a result of misconduct, with any financial reporting requirement imposed under the securities laws. Also, personal loans to officers of reporting companies have essentially been prohibited.

The Sarbanes-Oxley Act also created criminal sanctions, and enhanced white-collar crime penalties, that apply to violations of the securities laws. Among other things, these provisions dealt with alteration, destruction, or concealment of corporate or audit records, including requirements relating to the maintenance of work papers by accountants; prohibitions on the ability of a debtor to use bankruptcy proceedings as a way to avoid, through discharge, liabilities incurred as a result of a violation of the securities laws; extension of the statute of limitations for private causes of action under the securities laws; evaluation and amendment of the United States Federal Sentencing Guidelines relating to crimes that involve the obstruction of justice; creating protection for “whistleblowers” in the form of civil and criminal sanctions against anyone that retaliates against persons who report potential violations of the securities laws or any other federal law that is intended to protect shareholders from fraud; and enhancement of criminal penalties under existing statutes as well as creation of new criminal statutes directed at activities that defraud the shareholders of public companies.

Clearly, all of the changes described above have dramatically expanded the role of attorneys that counsel public companies on corporate governance matters. At a minimum, the attorney’s role as a governance counselor to public companies should now include regularly working with directors and officers on all or most of the following issues and activities:

• Board and committee structure, composition and processes;
• Identification and compliance with fiduciary duties;
• Development and implementation of board committee charters, corporate governance guidelines, codes of conduct and other compliance policies and procedures;
• Interpreting “auditor independence” requirements;
• Structuring and conducting board and committee self-evaluations;
• Compliance with specific corporate governance listing requirements of the applicable securities exchange;
• Management assessments of internal controls;
• Executive officer and director compensation;
• Structuring and conducting internal investigations;
• Indemnification, insurance, and other liability protections for directors and officers; and
• Responding to shareholder activism and securities litigation.

In addition, in-house counsel should be prepared to counsel the senior executives and directors on a few fairly sensitive matters, including identification and compliance with fiduciary duties, board and board committee self-evaluations, performance assessments of the senior executives of the company, internal investigations, responding to shareholder activism and securities litigation, and liability protections for directors and officers.

All of this means that in-house counsel must be prepared to provide governance counseling to the leaders within their organizations. The stakes are high and the issues are difficult. While experts at outside law firms can and should be brought in to handle thorny questions, in-house attorneys must be able to give a solid first assessment to directors and officers and be knowledgeable enough about the issues to oversee the work of outside law firms in the governance area.

About the author

Alan S. Gutterman is a regular contributor to Corporate Counsel Connect and is the Founding Director of the Business Counselor Institute and the International Center for Growth-Oriented Sustainable Entrepreneurship. Mr. Gutterman has served as the general counsel for several companies during his career, including a large distributor of consumer electronics with operations in several foreign countries and a venture capital-backed startup. Additional commentary and practice tools that a general counsel can use in guiding his or her company can be found in Mr. Gutterman’s Westlaw database, Business Transactions Solution.

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