The Role of the Bar and the Audit in Shareholder-Director Relationships

I want to thank Jim Cheek for inviting me to Vanderbilt today, and all the people here at the law school who have made this event possible.

Let me begin by stating that the views I express today are my own and should not be attributed to the PCAOB as a whole or any other members or staff.

I am especially honored to be here among so many of the great lawyers who have helped shape the modern board room.

So many of you have, over the course of your careers, counseled boards out of crisis, defended them, and helped them build lasting trust with long-term shareholders.

It is wonderful to see old friends. Nevertheless, this is a bittersweet time because last week we lost too soon another champion of corporate governance and a friend – Ralph Whitworth.

Ralph has been called the lone ranger of board-room battles and a gentleman activist. I daresay many of you have some war stories that I hope you will tell, in Ralph's memory, as we move through the day.

While you may have been on the opposite side of some of these battles, Ralph was a fellow traveler as we navigated significant changes in corporate governance and deliberated on the nature of relationships between shareholders and directors. His constructive tone contributed to many lasting improvements in corporate governance, and benefits for the investing public and capital formation.

I. The Role of the Bar in the Evolution of Corporate Governance

Ralph and activist shareholders were motivated by their perception of economic dysfunction in the way some boards operated. The activists' technique was to press for changes in corporate governance. But these changes were effected by law, through the work of the lawyers and investment bankers on both sides of the battles and the policy debates.

That is, for good or ill – and that question is still debated – we lawyers were not only witnesses, but we laid the pathways and infrastructure for these changes. And there have been significant changes.

In the course of our careers, some of the changes have been sudden and dramatic. Other changes have been evolutionary, nearly indiscernibly gradual but, as with continental drift over time, significant nonetheless.

Entering practice, I grew up in the merger and acquisition boom of the 1970s and the advent of the tender offer.

There was no consensus that the tender offer would lead to any improvements in corporate governance or shareholder value. A lot of people viewed the tender offer as a disastrous exploitation of a loophole in the Williams Act (that amended the Securities Exchange Act), allowing self-interested raiders to leverage and bust up corporate America at a time of both economic and political weakness.

There was an immediate reaction in the form of new mechanisms developed by board counsel – poison pills, anti-takeover provisions. But something else happened: Investment bankers, investor relations professionals, lawyers in various roles, all began to change the way boards and management engaged with shareholders, especially the long-term, passive, institutional investors who heretofore generally sat on the sidelines.

When T. Boone Pickens took on Big Oil, he not only changed the shape of the industry, but he also allowed people to see that it was possible to question stale business strategies, even at the largest companies.

Shareholders need not accept unimaginative or distracted chief executive officers, and they could expect the boards that oversaw them to demand skilled management and good business strategies.

Boards came to understand that if they did not do their jobs well, activists would ensure that others would.

This was the era when the political theorist and legal scholar, Ronald Dworkin, wrote on the legitimacy of political power. Shareholder groups, too, began to ask, When is corporate power legitimate? It was the perceived arrogance of management that sustained and enabled the tender offer. But it also motivated boards to open a constructive dialogue with long-term investors.

This was a uniquely American phenomenon. There was no vehicle to merge two companies across borders in Europe. The impediments to tender offers were legion in Europe.

But, during the next decade, both here and in Europe, people began to talk about and institute independent committees and independent boards. These fresh boards competed with activists to mobilize funds and other previously passive institutions.

The American Law Institute (ALI) played an important role, by developing and advancing new model principles and bylaws, beginning in the 1970s all the way through the mid-1990s. The exchanges modified their listing standards.

These were the seeds of developments in corporate governance that are now institutionalized, and that young lawyers may take for granted today. Such has been the evolution of corporate law, from generation to generation, each starting from a new point and growing the law to address the challenges and demands that arise.

We are now well beyond the original principle motivating corporate governance reforms – that directors should attend the meetings, read the materials and ask questions about how management used the corporation's resources, and be attentive to weaknesses in management's strategies.

Directors can't just ratify unexamined actions. They must have a satisfactory reason for their decisions to maintain shareholder support. They cannot be perceived as simply the enabler of management.

Nor can their counsel. The Gutfreund case (In re John Gutfreund, 1992), and the Securities and Exchange Commission's rule 102(e) process contributed to the evolution of the role of corporation counsel vis-a-vis management.

Enron and the Sarbanes-Oxley Act also intervened. The Act took up the legal themes of the ALI project on corporate governance and enshrined them into law. It refined and imposed new obligations for oversight of financial reporting.

There are new expectations that boards consider the implications of social, economic and environmental phenomena that go well beyond those prescribed by the securities laws. In this, Europe has taken the lead.

But through best practices and familiarity, the role of the U.S. board has also expanded to encompass new stakeholders whose actions, well-being or opinion could bear on shareholder value.

Earlier this week, we learned that the Paris climate agreement will now go into effect. That will undoubtedly have an impact on corporate responsibility and reporting. The Sustainability Accounting Standards Board is promoting new metrics and voluntary reporting on a wide range of nonfinancial topics found through its process to be important to investors and other stakeholders.

Whether or not all of these changes result in better, more efficient, corporations, we've got to face the fact that they didn't happen just because of government policies or the Congress. Heads of pension funds certainly had a roll; but we, the lawyers, informed and facilitated all these changes, and helped bring them about.

II. The Role of Audit in Board-Shareholder Relationship

The audit, too, contributes both to corporate governance and, ultimately, to shareholder value. But, in this case, boards and the bar could have done more to spur reforms to maintain the audit's usefulness to investors. I believe this is an idea whose time has come.

After all the changes in the field of corporate governance, it is anomalous that the audit has changed so little.

It's changed little since the 1970s when I started practicing and, up to that point, it had changed little since the Securities Act of 1933 made it mandatory. The late Sandy Burton noted just this point in 1980.

As Chief Accountant of the SEC during the 1970s, and then later, Dean of Columbia Business School, he challenged auditors to do more for the public interest. But he lamented that, instead, auditors devoted a "great deal of effort … to limiting responsibility rather than enlarging it."^[1]

To be sure, audit firms have expanded their offerings of non-audit services. But, other than Sarbanes-Oxley's Section 404 requirement that companies obtain an audit of internal control, the scope of the auditor's work, and the opinion, have barely changed.

New audit procedures have been devised and implemented, either in reaction to risks or developments in technology. But those procedures result in the same opinion that auditors have given since the 1930s, notwithstanding significant changes in corporate reporting, both in and outside of the financial statements; and, as I've described, the significant changes in board relationships and engagement with shareholders.

What I've seen, both in practice and at the Public Company Accounting Oversight Board (PCAOB), is that some companies mistake what the audit is about. Its value doesn't come from the compliance aspect alone – filing audited financial statements as is required by law. It comes from the confidence in the information that the audit provides, and the relevance of that information.

Auditors dig into corporate records, they go to far-flung subsidiaries, and they review the top-side journal entries at headquarters. They ask for and see anything they think they need in order to assure themselves that there are no material misstatements and, when applicable, that there is effective control over financial reporting.

Boards don't do that, but they and their shareholders sure can benefit from knowing what the auditor has learned, and from the discipline that the audit provides. If used well, the audit is a tool to communicate to shareholders about the reliability of the information that shareholders see as relevant to judge management's results.

Reliable reporting can't keep activists from questioning strategies that aren't working; but unreliable results give well-prepared adversaries an opening just when boards most need shareholder trust.

The '33 Act was enacted for just this reason – to bolster investor trust. It promoted capital formation and economic growth principally by coaxing people back into our securities markets. It did this by regulating the offer and sale of securities to ensure that buyers of securities receive complete and accurate financial information from the company, including financial statements audited by an independent accountant.

The audit is the linchpin to give shareholders confidence that they can rely on published financial statements to decide whether and in which companies to invest, and at what price.

Auditors were intended to be the eyes through which both directors and investors look for the truth. Over the years, public opinion has reinforced the continued importance of the auditor's independent view.

In corporate governance, most changes were driven by reform inside the board room, through the push and pull of activism and counseling. But, in auditing, changes to shore up public opinion of the audit were almost exclusively imposed from outside the board room, primarily by the Congress and the SEC.

There have been three key moments of reform.

First: In the late 1970s, there was the collapse of Equity Funding Corporation of America and the scandals over foreign payments that, while not necessarily quantitatively material, nevertheless had a dramatic effect on public trust.

The scandals resulted in broad congressional investigations of the accounting establishment, both in the House and Senate. The Moss and Metcalf investigations (Rep. John Moss and Sen. Lee Metcalf), had highly critical findings about the profession's standards and independence from management, and proposed a wide range of reforms, even foreshadowing independent oversight.

Looking back, there was an opportunity for boards to address auditor independence from management at the same time they strengthened their own independence. Instead, boards left that to the government.

Thus, Burton and then-SEC Chair Harold Williams personally negotiated changes in the profession's self-regulatory programs that at least made those programs more formal. They warned that, if self-regulation proved insufficient to sustain public confidence, an independent regulatory structure would follow.

Second: In the 80s, in response to the savings and loan crisis, the SEC, members of Congress, and then-Comptroller General Charles Bowsher pressed for improved auditing standards to address the "expectations gap" between what shareholders expected of the audit and what auditors professed to deliver.

Most notably, the resulting standards required auditors to enhance their procedures to detect fraud and other illegal acts, and to report when there is uncertainty about a company's ability to continue as a going concern, even if management has not warned investors.

These developments changed corporate governance. They clarified that, while the auditor does not speak for management, the auditor is supposed to speak. They provided boards and audit committees more information from the audit. But they came about through government efforts on behalf of investors – not by boards that, in other respects, were at the very same time looking for ways to open dialogue with investors and gain their trust.

Finally, 25 years after Burton and Williams gave the profession's self-regulatory institutions one last chance, following the accounting scandals at Enron, WorldCom and so many other companies, Congress stepped in with the Sarbanes-Oxley Act — which garnered overwhelming support in both the House and Senate.

Many of you played important roles in counseling boards of companies in distress in those days. And, I daresay, those boards came to appreciate the importance of a good audit. But, to this day, we have still not seen boards take a lead in strengthening and modernizing the audit for their own use or as a mechanism for communicating and engaging with their shareholders.

III. Sarbanes-Oxley Reforms Have Improved Audit Quality, but Boards Should Get into the Action

The Sarbanes-Oxley Act has nevertheless had a profound, positive effect on the quality of the audit.

In particular, independent oversight of auditors has proven to be a vital resource protecting investors and fostering economic resilience by advancing reliable, informative and independent audits.

The PCAOB promotes audit quality through its inspection and enforcement programs, its standard setting, coordination with other regulators, domestic and foreign, and with the important investment in economic analysis that we have made in recent years.

The PCAOB also benefits from extensive outreach to investors, preparers and audit committee members, academics, auditors and others.

In the PCAOB's 14 years, our inspectors have examined many thousands of audits and found numerous examples of high quality auditing, including evidence of auditors requiring companies to change their accounting or improve their internal controls over the production of financial reports. These auditors are the unsung heroes who avert the scandals that don't happen.

But our inspectors have also found and reported numerous instances in which firms' audit reports should not have been issued. These instances include audits of some of the largest companies in the world, as well as mid-size and smaller companies.

I understand that boards negotiate with their auditors some sort of arrangement to be notified if the PCAOB selects their audit for review. And when an auditor becomes aware of certain weaknesses in an audit, current standards may require additional audit work, which may come to the attention of a board.

We don't have much of a window into how boards react to the need to shore up an audit. What we hear is anecdotal and, for the most part, it's focused on the cost of additional procedures or better procedures in the next year's audit.

We don't hear about boards using the audit to obtain more insight into fraud risk or management integrity. The costs of audit enhancement are easier to quantify than the benefits, but that does not make them greater.

With that, let me tell you about what the PCAOB is doing to improve audit quality and promote investor protection. I hope that you will go back to your board clients and persuade them to think about what the audit can do for them and the company. Independent oversight is changing the landscape, but to reap the full benefit of these changes, boards should engage.

• PCAOB inspections have improved audits, and changed firms' attitudes and execution. Emerging research on our inspections indicates that when we find deficient audits, the engagement teams raise their game – without a commensurate increase in fees but with a statistically significant reduction in restatements.

• Issuance of regular PCAOB inspection reports provides meaningful information that didn't exist before, and that helps all parties, including investors, audit committees, and companies, make better decisions. You can help boards interpret this information for their specific use.

• PCAOB enforcement has helped root out bad apples, and fosters trust in the financial system. Boards can use our published cases to gravitate to better auditors and better audit practices.

• The PCAOB has issued better and clearer audit standards, and has made progress in improving the relevance and transparency of audits. Markets will soon have useful information to differentiate auditors on the basis of track records for quality.

• Awareness of the PCAOB's role and mission is now firmly established, and emerging research suggests this is helping build public confidence in investing.

• The PCAOB has helped foster global recognition of the importance of cooperation. We have tailored a successful model for carrying out joint inspections with our counterparts around the world. By sewing up the gaps in auditor oversight, we enhance the overall reliability of multi-national audits, allowing boards and shareholders more confidence in the auditor as their eyes and ears around the world.

• The PCAOB has established a Center for Economic Analysis to further incorporate meaningful economic analysis in all aspects of our work. The published research papers give boards deeper insights into the role of the audit in establishing shareholder trust and the levers affecting audit quality.

I firmly believe that by improving audit quality, the PCAOB has played a part in helping companies maintain investor trust and avoid financial reporting failures and, in turn, helping our economy and capital markets be resilient and grow.

But, as a society, we must also continue to evolve the audit. The audit of the future will need to take advantage of "big data" to provide boards even more tools to guide companies with reliable information and insights.

The audit is also a tool to communicate with investors and other stakeholders. The current pass-fail audit report, in the case of the large firms, which is authored anonymously by one of potentially thousands of engagement partners, is an important albeit fairly rudimentary signal.

It can be fashioned into a more useful tool. Importantly, the statutory mission of the PCAOB is "to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports."

We are doing just that with a transparency initiative. Beginning in the first quarter of 2017, audit firms will report the names of the engagement partner and the other firms involved in the preparation of a company's audit report. Over time, this database will provide boards, investors and other stakeholders key information about partners' and firms' history of experience and propensity for quality.

We know from the research that markets that already have such information factor it into the cost of capital. For example, companies that choose engagement partners who are known to be lenient in issuing going concern qualifications signal poorer quality reporting to investors and pay for it. Conversely, those that reach for quality are rewarded with lower capital costs.

The PCAOB is also nearing completion of a project to make the auditor's report more useful and informative to investors and other financial statement users.

Through PCAOB's outreach, investors have confirmed the importance of retaining the binary, pass-fail opinion. But in today's complex economy, and particularly in light of lessons learned after the recent financial crisis, investors want a better understanding of the judgments that go into an opinion – not a recitation of the standard procedures that apply to any audit, but the specific judgments that were most critical to the auditor in arriving at the opinion.

While there has been promising experimentation abroad, beginning several years ago in the U.K., describing those judgments in a way that is appropriate and most useful for dispersed shareholders is new to the United States. We've proposed a framework for auditors to report such "critical audit matters," as we've termed and defined them.

As an experienced U.K. investor said earlier this year at a meeting of the Council of Institutional Investors in Washington, investors in U.K. companies finally have "an audit report worth reading."

When we asked the head of audit at KPMG U.K. to testify at a PCAOB hearing on our project about auditor experiences with expanded audit reporting, he said that in "20-odd years of auditing" he had never seen so much "interest from investors" in what he was doing. The change, he said, was "a real positive."

Those are strong testimonials. It is a welcome change to see the profession purposefully tilting toward investors. I am hopeful that these new tools will also help U.S. boards step into the action by supporting and improving the audit to meet their needs and those of their shareholders today.

In conclusion, the past few decades of evolution in the relationship between directors and shareholders have not led us to a resting place, but rather a frontier. Through the efforts of many in this room, after decades of fighting activist threats and managing dissidents, many corporate boards have developed and institutionalized strong mechanisms for engaging with shareholders and maintaining their trust.

But a rapidly changing landscape – with demands for new forms of corporate data – will require boards to develop even better tools to communicate trustworthy information, whether it's to stave off predatory raids from a new generation of activists, reassure diverse stakeholders on a range of new information, or simply an old-fashioned interest in enabling a company to benefit from the lowest available cost of capital from investors and lenders.

Going back to where this journey began, the advice of Sandy Burton rings true: The "concept of audit" has to be expanded. As with corporate governance, the audit must evolve to best serve stakeholders. The PCAOB has embarked on the path to do so, in the public interest, but boards should be catalysts as well.

People will continue to debate the benefits or harm of shareholder activism. But as we've seen over the last four decades, improvements in corporate governance have been decidedly good for companies, good for investors, and good for society. If cultivated, the audit is a tool that should further advance these benefits. I hope you will help boards find ways to do so.