Internal Controls and the Changing Role of Directors and Officers

Posted by Nancy Johnson on July 18, 2011

Two lawsuits -- one coming to a close in Australia, the other just beginning in Cincinnati, Ohio -- remind us that public company Directors and Officers (D&Os) are facing greater scrutiny and liability than ever before. They also reinforce how the presence or absence of a company's internal controls -- over financial reporting as well as compensation decisions -- can be used to protect or vilify D&Os in court.

In the the Australia case, a judge ruled that harm was caused to Centro Inc. and its shareholders when the company's D&Os signed off on financial reports that failed to disclose billions of dollars of short-term debt. Apparently, a junior-level staff member at Centro's audit firm, PWC, found the errors, and the information was escalated at a "high level" to the Audit Committee by a Centro accounting manager; PWC's senior partner on the audit, meanwhile, stayed silent on the matter. As reported at the, "[c]hanges to Centro's final accounts, which were proposed by PwC and Centro staff after directors had signed the final version, were not incorporated into the published accounts."

The other case involves telecom Cincinnati Bell, and a lawsuit brought by major shareholder NECA-IBEW Pension Fund over what the Fund claims is an excessive compensation package offered to Cincinnati Bell's executives. The lawsuit claims that proposed raises to executive compensation were as high as 80 percent - despite the fact that the company's net income declined more than 68 percent. the Cincinnati Business Courier reports, "The pay plan was approved by Bell’s board and unanimously recommended for shareholder approval by the directors." But shareholders disagreed, rejecting the proposal and filing the suit.  

Certainly, stronger internal controls around how debt is reported could have spared the Centro's D&Os (and PWC) from having to deal with the material error in the first place. But clearly the company's entity-level controls, which dictate policies and procedures around ethics and the company's committment to financial integrity, failed as well. The Audit Committee knew about the errors -- late in the game, to be sure -- but chose not to report them. This suggests a tone-at-the-top that valued expedience and tolerance for financial missatements, rather than a steadfast commitment to financial integrity. 

The Cincinnati Bell case also touches on entity-level controls. Here, the tone-at-the-top is clearly out of sync with shareholder values. It would be wise for the company's D&Os to review all their entity-level controls, including those related to compensation, to ensure that the policies and procedures that dictate company behavior are in alignment with the shareholders' #1 goal: that is, to increase the value of the company, not simply line the pockets of its executives.

Download Top 5 Risks for Directors and Officers to learn more about the changing landscape for Directors and Officers. 

Tags: Internal Controls, Entity Level Controls