Financial scandals routinely highlight the need for improved corporate governance and the reliability of financial reporting. Lawsuits associated with these scandals have focused attention on the individuals involved — management and directors alike — and the personal liability that may result. The profession is at an interesting crossroads — CPAs are needed to fill the roles of conscientious, diligent watchdogs on corporate boards and audit committees. However, personal liability concerns may deter excellent candidates from agreeing to serve. This article summarizes some relevant legal issues and provides suggestions for accountants who are considering whether to serve on a board.

Additional Demand

The Sarbanes-Oxley Act contains requirements intended to improve the accuracy and reliability of corporate disclosures. Section 407 of SOX requires public companies to disclose whether the audit committee of the board of directors includes at least one “financial expert.” Final rules issued pursuant to section 407 (SEC Rel. No. 33-8177) define an audit committee financial expert as a person who has an understanding of GAAP and financial statements; an ability to assess the application of accounting principles; experience in the preparation, audit, analysis or evaluation of financial statements; experience in accounting internal controls; and an understanding of audit committee functions.

Section 407 stops short of requiring the presence of a financial expert on the audit committee, but it does require companies lacking a financial expert to disclose their reasons for failing to include one. It seems companies should prefer including a financial expert on the audit committee rather than explaining the absence of one. A director does not have to be a CPA or an accountant to qualify as a financial expert, but CPAs are prime candidates for the position because they generally meet the qualifications.

Director Responsibilities

The corporate director’s role is to manage the company in the best interests of the shareholders. Directors generally delegate authority and responsibility for daily operations to the CEO and senior management, while taking on an oversight and advisory role. Typical director responsibilities are described in Corporate Governance Best Practices: A Blueprint for the Post-Enron Era, a 2003 report by The Conference Board, and in Principles of Corporate Governance, a 2005 report by the Business Roundtable. Many of these responsibilities focus on business strategy, risk assessment and corporate objectives. The Conference Board noted that in the wake of recent corporate scandals, boards face the challenge of increasing their focus on oversight to actively monitor management.

In addition to these typical director responsibilities, which apply to directors of public and private companies, directors of publicly traded companies are required to carry out other duties on the company’s behalf. Section 10A of the Securities Exchange Act of 1934 places specific requirements on the board’s audit committee. In addition to preapproving all audit and non-audit services provided by the company’s registered public accounting firm, the audit committee is required to appoint and compensate the public accounting firm and oversee its work. The audit committee must establish procedures for handling accounting or auditing complaints, and handling confidential anonymous concerns from employees on accounting or auditing matters.

Item 407 of Regulation S-K requires the audit committee to disclose its activities, which include review and discussion of the financial statements with management and required communication with the external auditor. Directors of public companies may be subject to additional responsibilities under the corporate governance standards that stock exchanges impose on registrants. For example, the corporate governance standards for New York Stock Exchange registrants (Standard 303A.07) require audit committee members to be involved in and familiar with the company’s risk assessment and risk management processes.

Director Liability

Directors are expected to adhere to certain standards of conduct. While statutes vary by state, most states have adopted the provisions of the Model Business Corporation Act (MBCA), which requires directors to act in good faith, in a manner he or she reasonably believes is in the corporation’s best interests, and with the care that a person in a like position would reasonably believe appropriate. Additionally, a director is entitled to rely on the performance or opinions of others, as long as the director “does not have knowledge that makes this reliance unwarranted” (MBCA § 8.30).

The common law business judgment rule, the main provisions of which have been incorporated into the MBCA, protects directors involved in shareholder lawsuits. Under this safe harbor, a director is not liable for breaching a fiduciary duty as long as he or she acts in good faith, believes the decisions are in the corporation’s best interest, makes an informed decision, and does not act with self-interest. If any of these criteria are not met, the director loses the protection of the business judgment rule and may be held liable for damages caused by the breach of duty. A slightly different standard is used to assess whether a director of a public company has breached fiduciary duties at the federal level. Under section 11 of the Securities Act of 1933, directors of an issuer may be liable to any person acquiring a security pursuant to a registration statement that contains a material omission or misstatement. A director is expected to undertake a reasonable investigation and have reasonable grounds to believe that the statements contained within the registration statement are true and do not omit any material fact. In determining what constitutes reasonable behavior in such cases, the statute uses a prudent person standard. This test says the director is expected to act with the standard of reasonableness “required of a prudent man in the management of his own property.”

[READER NOTE: This article has been excerpted from the Journal of Accountancy. Read the full article here.]

Directors who can show that they exercised such due diligence, either through their own investigation or through their reasonable reliance on the work of experts, can avoid liability. Hence, a director of a publicly traded company is expected to thoroughly review the information contained in (or omitted from) the registration statement. This requires making a reasonable investigation, using the assistance of experts if needed, to ensure that the registration statement does not contain any material omissions or misstatements.

Because the work of experts is explicitly addressed in the civil liability provisions of Section 11, there was some concern that directors identified as experts might be held to a higher standard of performance than other directors. Section 11 does not specifically address this issue. Responding to concerns that being designated as an audit committee financial expert might create additional liability, however, the SEC created a safe harbor in 2003. Under this provision (adopted in SEC Rel. No. 33-8177), designating a director as an audit committee financial expert will not cause the director to be deemed an “expert” under Section 11, nor “impose on such person any duties, obligations, or liability that are greater than the duties, obligations, and liability” that the person would have absent this expert designation. As long as a director who is an audit committee financial expert can demonstrate the requisite due diligence, as described above, he or she should not fear additional liability under federal statutes. Moreover, while this safe harbor, by its terms, applies only in cases arising under the federal securities laws, the SEC has opined that a director’s designation as a financial expert similarly should not alter his or her fiduciary duties or liabilities under state law.

Conclusion

Recent court decisions affirm that the business judgment rule (with its component duties of good faith, loyalty and due care) is still the standard for assessing director liability for breach of fiduciary duty. Although out-of-court settlements may have heightened public awareness of director liability, directors who act with good faith, loyalty and due care should continue to be protected from personal liability.

Deborah Archambeault, CPA, Ph.D., is assistant professor of accounting at the University of Tennessee at Chattanooga. John Friedl is a professor in the Department of Accounting and Department of Political Science, Public Administration, and Nonprofit Management at the University of Tennessee at Chattanooga. Archambeault and Friedl are contributing writers of the Journal of Accountancy. Their views as expressed in this article do not necessarily reflect the views of the AICPA or the Journal of Accountancy.