The Enron collapse and subsequent statements and rule proposals released by the Securities and Exchange Commission (SEC) have increased interest in the internal workings of corporate governance and, in particular, the functions of the audit committee of a company’s board of directors. In general, the role of the audit committee is to review the financial operations and statements of a company and to affirm the integrity and accuracy of the preparation and dissemination of that information.

The increased focus on the functions of the audit committee and resulting concerns of increased liabilities with respect to serving as audit committee members necessitate action be taken that will protect committee members from the risks associated with carrying out their responsibilities. There are several steps companies can take to reduce this liability.

Initially, audit committees should establish compliance processes designed to, among other things, identify, investigate and evaluate issues relevant to their obligations. These processes should include proactive measures to enable the committee to establish a good faith effort to be reasonably informed of the company’s activities. Included in these procedures should be a comprehensive committee charter that clearly identifies the responsibilities of the committee, thereby reducing unreasonable expectations. The committee chair should also, in consultation with counsel and, as necessary, the company’s outside auditors, establish meeting agendas to identify the critical issues to be considered by committee members, both at the meeting and in advance.

Removing Doubt

In order to reduce the prospect that actions taken by the audit committee will be called into question, the committee should seek competent legal advice in carrying out its functions. Because a substantial part of an audit committee’s responsibilities is ensuring compliance with rules and regulations, the advice of counsel is critical.

Audit committees have relatively easy access to a company’s in-house counsel and the company’s regular outside counsel. In light of the revelations stemming from the Enron collapse, audit committees should also periodically seek the advice of independent, third-party counsel. Particularly in connection with its annual evaluation of whether the company’s financial statements comply with applicable rules and regulations and, if the company is public, with the disclosure obligations under federal securities laws.

In-house counsel and the company’s regular outside counsel will frequently have conflicts with respect to evaluating the procedures employed by management in the preparation and presentation of the financial information. Those conflicts could compromise, or taint, the reliability of the review provided by either of those two counsel.

Reasons for Counsel

Regardless of which counsel the audit committee chooses to employ, it should periodically seek advice on a number of matters, many of which will be dictated by the circumstances of the particular company. In particular, legal advice should be sought as to the following:

• the legal obligations of the audit committee and its members (in particular, advice should be sought on the manner in which the committee should comply with its due diligence and other fiduciary duty obligations);
• the legal obligations of the company (this will vary depending upon the public or private nature of the company, but any rules and regulations applicable to the preparation of the financial statements or the financial operations of the company should be explored and explained);
• the status of litigation involving the company and/or its officers and directors (in particular, advice should be sought as to how any existing litigation could have an impact on the companies financial statements); and
• the legal obligations of the audit committee with respect to any special investigations which the audit committee is undertaking into the company’s affairs (in particular, advice should be sought as to the scope and procedures of a particular investigation).

Indemnification

Nearly all states have adopted corporate statutes which permit companies to indemnify directors for defending actions arising out of initiatives they take as directors of the company or its subsidiaries, irrespective of whether such director is ultimately successful on the merits. In addition, these statutes permit companies to enter into contractual relationships with the directors, providing for specific procedures and remedies with respect to the company’s indemnification obligations.

It is important to note, however, that indemnification is only authorized if certain statutory standards have been met. Additionally, indemnification is not always available despite the existence of either the statute or a contractual relationship. Courts have held, for example, that indemnification against violations of the federal securities laws is against public policy. This position has also been adopted by the SEC.

Companies frequently buy insurance to provide financial protection from liabilities the company may have to directors and officers (D&O) as a result of indemnification provisions and to directly provide financial support for directors and officers in the undertaking of their corporate responsibilities. This D&O insurance will provide both benefits for the company to reimburse it for payments made under indemnification relationships with officers and directors and direct coverage for directors personally against liabilities and expenses that are not otherwise indemnified by the company.

As with all insurance policies, there are a number of actions that are excluded from coverage. It is advisable that the D&O insurance policy be reviewed at least annually to ensure that the coverage provided is appropriate for the circumstances of the company. In particular, a company intending to engage in a public offering will have different needs under its insurance policies than private companies.

Editor’s Note: For an overview of internal audit committees, their role and how they can best be utilized, see the “Accounting” column in the March/April 2002 Portfolio, www.nareit.com/portfoliomag/02marapr/accounting.shtml