Internal controls more important than ever

Executives manage the corporation. Directors, as the shareholders’ fiduciaries, ensure the corporation’s long-term success by selecting a competent chief executive officer, monitoring and evaluating executive performance, reviewing corporate policies and strategies, and recommending nominees for election to the board.

However, the financial scandals at Enron, WorldCom, Global Crossing, Tyco and other corporations revealed passive boards subservient to powerful CEOs.

CEOs dominate boards by handpicking members and by controlling the information flow, resulting in passive directors that rubber stamp executive proposals.

For example, as Enron, WorldCom, Global Crossing and other prominent businesses failed, the directors of the doomed companies awarded executives over $3 billion in salary, bonuses, and money from stock sales.

The seemingly endless corporate scandals cost the U.S. economy an estimated $7 trillion. The business failings caused widespread suffering as people lost their jobs, retirement savings and investments. In response to public outrage, and to restore public confidence, Congress quickly passed the Sarbanes-Oxley Act of 2002, or SOX.

Business commentators have focused on the new filing and accounting duties mandated by SOX, but SOX has broader implications for directors. They must now prove their control over the company’s internal business affairs.

Directors are responsible for fostering an ethical corporate atmosphere that makes legal compliance a company expectation.

Directors must impose internal procedures that ensure the board is advised of illegal acts and violations of corporate standards, especially about financial wrongdoing.

SOX’s requirement of greater director involvement in corporate governance has influenced institutional investors and insurers.

Major institutional investors, such as TIAA-CREF, have established new corporate governance guidelines to evaluate director performance (see TIAA-CREF’s detailed policy statement on corporate governance, www.tiaa-cref.org/governance).

Insurance companies have increased directors-and-officers policy premiums by as much as 500 percent. Underwriters demand details on internal corporate controls and director oversight, directors’ biographies, company ethics and compliance programs, and details on how knowledgeable directors are about the programs.

Insurers have changed directors-and-officers policies to eliminate the “severability” clause. Previously, one director’s wrongdoing would not affect coverage for innocent directors. With the severability clause’s elimination, the misdeeds of one director void D&O coverage for all directors.

Directors must adjust to this more demanding environment. SOX’s message is clear: Passive directors are now passé!

John D. Copeland, J.D., LL.M., Ed.D., is an executive in residence at the Donald G. Soderquist Center for Business Leadership and Ethics and Professor of Business at John Brown University in Arkansas.