As shareholder activists demand more independent financial scrutiny in the wake of the Enron fiasco, a Tribune analysis shows that many of the Chicago area’s biggest public companies are still reporting possible conflicts of interest in their auditing practices.
Most of the area’s top companies award rich consulting contracts to their independent audit firms, the analysis shows, and some hire former employees of their auditors for top finance jobs that involve overseeing the audits. In addition, corporate directors responsible for supervising audits are sometimes ex-auditors themselves, or former financial executives from inside the company.
Those practices raise concerns that public companies are tolerating potential conflicts of interest that could undermine their ability to independently assess the quality of audit work. The issue has taken on new urgency with the collapse of Houston energy giant Enron Corp., which has inspired a wave of investor skepticism about the trustworthiness of corporate financial results.
In a review of proxy statements and other regulatory documents from the Chicago area’s largest 100 firms by market capitalization, the Tribune found that 1 in 5 had audit committees that included contractors hired by the company, or former company insiders or audit firm employees, including Telephone & Data Systems and First Health Group.
More than 1 in 10 disclosed that former employees of their independent auditors were high-ranking executives–among them the chief financial officer of Sara Lee Corp. and the chairman of Bally Total Fitness Holding Corp. The actual number could be far greater, but Securities and Exchange Commission rules require companies to disclose the executives’ employment histories for only the previous five years.
In addition, Chicago’s top 100 paid their auditors more than three times as much for other corporate work than for the core auditing services–although, companies point out, the category of other fees sometimes contains substantial “audit-related” expenses.
Overall, more than $331 million went to consulting and the like–enough to buy George Foreman grill marketer Salton Inc., at Friday’s market cap–while just under $106 million went to audits. Motorola Inc. had the biggest spread, spending 16 times more money on non-audit matters in 2000.
In fact, all 97 of the companies that disclosed fees paid at least some money to the auditors for other services, and more than two-thirds of the companies paid more for those services than for their audits–including 26 that paid more than 75 percent of their total bill in “other” charges.
Watchdogs worry
Shareholder watchdogs warn that such contracts could put pressure on public accountants to relax their standards for the less-lucrative audit work.
These practices persist despite years of progressive tightening of listing standards at the major U.S. stock exchanges, including rules governing the independence of audit committee members and requiring disclosure of potential conflicts. But all are coming under increasing scrutiny because of Enron.
Some Chicago-area companies say they are reviewing potential conflicts, though others say they are content to stand pat–a troubling notion to the watchdogs.
“These are serious issues,” said Ken Bertsch, director of corporate governance for giant teachers retirement fund and money manager TIAA-CREF. “For example, accounting firms have always said you could never prove conflicts of interest based on these fee ratios, but it’s common sense if a firm does a huge amount of other work for a company.”
Other shareholder advocates say the more subtle board and auditor ties still elude scrutiny.
“Most big companies are smart enough to clean up their proxies and comply with the current standards, but the required disclosure may not give all the information we really need to know,” said Ed Durkin, special programs director for the United Brotherhood of Carpenters, one of several shareholder activists with proxy proposals in the works for the coming annual meeting season.
The Council of Institutional Investors says shareholder activists, including labor groups such as the carpenters union, are preparing more than 50 proxy recommendations for corporate annual meetings this year.
They include shareholder proposals on auditor conflicts, audit committee makeup and independence, and overall board of director independence. Among them are resolutions for change at such bellwether companies as General Electric and General Motors.
Union to seek change
The carpenters union is preparing a shareholder resolution for Schaumburg-based Motorola’s proxy, citing the company’s $62.3 million paid to auditors for “other” work, compared with $3.9 million paid for its most recently disclosed audit. The proposal would prohibit Motorola from paying its auditor for non-audit services.
A Motorola spokesman noted that auditors KPMG affirmed that, in their judgment, the fees did not affect their independence, and said much of the “other” fees were one-time items, including development and deployment of a new cash management system.
Among companies that could face scrutiny for audit-committee independence is First Health Group. The Downers Grove-based managed-care company, which filed its proxy last year, a few weeks before the newest listing standards took effect regarding independent directors, has a former general counsel and corporate secretary as chairman of the audit committee.
Ronald H. Galowich retired from the company, but serves as chairman and chief executive of Madison Information Technologies, a service company that was paid $115,400 by First Health in 2000.
Another committee member, Michael J. Boskin, received money and stock options as a consultant too. And a third committee member, David E. Simon, is chief executive of a firm that is a First Health customer.
“Like every company in America, we are reviewing our practices in light of what went on at Enron,” First Health Chief Executive Edward Wristen said in an interview. Wristen emphasized that the company has been in compliance with Nasdaq listing standards, but acknowledged the board of directors will be considering the audit committee relationships before issuing this year’s proxy, expected to be published in April.
Telephone & Data Systems officials, meanwhile, say they are satisfied that a similar situation involving their audit committee poses no threat to corporate integrity.
Last year, the company disclosed it was replacing Walter Carlson, who had been audit committee chairman, because he is the son of company founder LeRoy Carlson and brother to CEO LeRoy Carlson Jr. Yet the person named to replace him doesn’t meet independence criteria outlined in exchange listing rules, either.
Donald Nebergall received $228,600 from TDS in 2000 working as a consultant to the firm. The company proxy states that no other board members were willing to serve in this capacity, and that Nebergall agreed to reduce his consulting work in 2001 to meet American Stock Exchange rules. That will qualify him as independent this year.
“We feel strongly that Mr. Nebergall is an independent director and his past relationship with the company will not affect his judgment,” a company spokesman said.
Critics say more conflicts lie beyond what’s spelled out in current listing standards, including the relatively common practice of companies hiring their auditors’ former employees, which, the critics believe, establishes a career path that makes auditors reluctant to rock the boat.
Recruiters defend hiring
But local executive recruiters defend the practice, saying it can be a net gain for shareholders.
“They know the business already, inside and out. There’s no learning curve,” notes John Rothschild of recruiter TMP Worldwide. “Of course if there is an audit partner who has committed fraud and he’s being brought over to keep his silence, that’s another story. But those cases are extremely rare.”
Cary McMillan joined Sara Lee as chief financial officer in 1999 after serving as managing partner of Andersen’s Chicago office. Andersen is Sara Lee’s auditor, and last year the company disclosed it paid the firm $31.3 million in other fees in addition to $6.6 million in audit fees. A spokeswoman says McMillan was hired for his overall leadership skills and points out he now runs an operating unit.
Three top executives at Bally Total Fitness came from company auditor Ernst & Young, according to SEC filings.
Chairman Lee S. Hillman joined Bally in 1991 as chief financial officer after leaving the accounting firm, where he was a partner. The next year John W. Dwyer, also an Ernst & Young partner, joined the company as controller. The year after that, Senior Vice President William G. Fanelli joined the company after nine years with the accounting firm.
Bally Total Fitness officials declined to comment.
Panel brought some reform
Since at least 1998, the SEC has urged Corporate America to pay more attention to potential conflicts in their audit committees, an effort inspired by high-profile accounting scandals preceding Enron. In that year, former SEC Chairman Arthur Levitt formed a “Blue Ribbon Committee on Improving Effectiveness of Corporate Audit Committees” that led to reworked listing requirements at the major U.S. stock exchanges.
But the standards that were eventually written–less stringent than what shareholder advocates had proposed–didn’t even take effect until last June, well after most company proxies had already been filed.
Although standards vary by stock exchange, to ensure independence audit committee members generally cannot have worked for the company in the past three years, cannot be related to a company executive or receive substantial payment from the company for activity not related to their board duties. Still, no company has faced the primary penalty that exchanges can impose for violating the audit committee rules–delisting.
And even as written, the rules contain loopholes. The Nasdaq stock market, for example, allows one audit committee member who is not independent if he or she is not a current employee or an employee’s immediate family member and the board determines the person is not conflicted. And directors who also head companies that are contractors are allowed if the contractors are paid less than 5 percent of the company’s gross revenues.
Firms disclaim liability
In addition, many companies write a wide-ranging liability disclaimer at the end of their audit committee charters found in proxy materials, saying they cannot assure that the audit complies with generally accepted accounting principles or that the company’s auditors are truly independent.
Without these disclaimers, some experts say, finding board members willing to sit on committees would be nearly impossible because of liability concerns.
Even so, the scrutiny engendered by Enron–and propelled further by the questions raised about companies ranging from Global Crossing and Computer Associates to GE–could be leading Corporate America to more rigorous standards, some say.
“We’ve now entered a world I liken to Caesar’s wife: You have to be above suspicion or the market will penalize you,” said professor John Coffee, a securities expert at Columbia University in New York.
“But the skepticism won’t last,” he predicted. “We’ll still need tighter rules.”
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Non-audit fees stack up for Chicago firms
Among the 100 largest companies in the Chicago area, these paid their independent auditors the most money for non-audit services, according to their most recent proxy statements. All paid less than one-third of their total bills for audit services. Overall, the 97 companies disclosing fees paid $105.7 million for audit services and $331.6 million in other fees.
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FEES IN MILLIONS
COMPANY AUDIT FEES OTHER FEES OTHER AS PCT. OF TOTAL
Motorola $3.9 $62.3 94.1%
Sara Lee 6.6 31.3 82.6%
Baxter Internation 3.1 28.3 90.1%
Boeing 10.5 24.3 69.8%
Bank One 4.0 24.0* 85.7%
CNA Financial 4.6 10.2 68.9%
Aon 2.6 9.8 79.0%
Illinois Tool Work 3.6 8.5 70.0%
Exelon 1.3 7.9 85.7%
*Includes fees paid to Andersen Consulting before its split from Andersen
in August 2000
Chicago Tribune
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