Computer Associates and the Board's Determination of Independence

Another interesting piece of information in the SLC report for Computer Associates concerned the role of the audit committee in uncovering the fraud and the independence of the chair.  We have been writing about how the rules of the self regulatory organizations leave the determination of independence to the board.  Moreover, while the exchanges contain general definitions (the NYSE excludes from the definition directors who have a "material relationship with the listed company" see NYSE Guide 303A.02), it is not at all clear that the boards apply them in a rigorous fashion.  In part as a result, Item 407(a)(3) of Regulation S-K requires companies to disclose any arrangements or transactions involving independent directors that "were considered by the board."  In other words, the Commission wants to force the board to publicly disclose the types of relationships that it found did not impair independence.  This is another example of the Commission trying to use disclosure to force on the board a more rigorous process. 

What does all of this have to do with Computer Associates?  According to the SLC report, a New York Times Article in 2001 disclosed possible “accounting tricks,” including the use of the 35 day month (the behavior that was apparently at the heart of the fraud).  As the report noted:

• "Mr. Berenson’s article, which was featured prominently in the Sunday edition of the paper, accused CA of using several 'accounting tricks,' including the 35-Day Month, to inflate its revenue and earnings, and remarked that CA stood for 'creative accounting.' Specifically, the article stated, in its fifth paragraph, that '[t]he practices were so widespread that employees joked that C.A. stood for ‘Creative Accounting,’ and that March, June, September and December, when fiscal quarters end, had 35 days, giving the company extra time to close sales and book revenue.'”

When the article came out, the audit committee looked into the allegations. The chair of the committee was Dr. Kenny. According to the report, Dr. Kenny met with management and the outside auditors for 45 minutes and, apparently, concluded in conjunction with the other two members of the committee that nothing further needed to be done.

The report, however, noted issues with Kenny's independence.  Appointed as chair of the committee in June 2000, Dr. Kenny served as the the president of the State University of New York at Stony Brook. In 1996, Mr. Wang (the founder of Computer Associates) agreed to fund the construction of the Center for Asian and Asian American Culture at Stony Brook at a cost of more than $52 million. The project was only completed in 2002.

Despite the size of the gift and its ongoing nature, the Board determined that Dr. Kenny was  independent within the meaning of the rules of the New York Stock Exchange in place at that time.  The board, however, did not appear to have undertaken an in depth review of the relationship.  As the report noted:   

• "However, the SLC was troubled by the fact that the Board does not appear to have considered at length, either at the time Dr. Kenny joined the Board in 1994 or at the time she was appointed head of the Audit Committee, whether this relationship, which was publicly known and discussed at the Board level, impaired her independence. In the end, based upon the SLC’s interviews of Dr. Kenny and others, the SLC found no evidence that Dr. Kenny’s relationship with Mr. Wang impaired her ability to independently evaluate the allegations made in the article, adversely impacted or affected the analysis that she performed, or ultimately colored her conclusions. That said, it is far from a best practice to have the head of the Audit Committee have such an important and meaningful relationship to the CEO (which Mr. Wang was in June 2000 when she was appointed), and would likely not be permissible under today’s independence rules."

The rules of the exchanges did get tougher in the aftermath of SOX, including stricter definitions of independence.  But in the end, it all comes down to the application of the definition by the board and the degree of enforcement by the exchange.  At least with respect to the latter, there is no reason to believe anything has changed in a post-SOX environment.