Corporate Governance: Time for a Check Up

The board of Community First Bankshares has always prided itself on being proactive, something attributable to the experience level of its directors. Several have done stints as top executives with other financial services companies; most have served on other boards. So when two directors suggested last fall that the Fargo, North Dakota-based company’s board conduct a formal corporate governance review, CEO Mark Anderson was all for it. “You’ve got new exchange rules, Sarbanes-Oxley, the SEC, and then the whole bank regulatory framework,” he explains. “We concluded there were so many pieces here that we needed to understand what was happening and make sure we were conforming.”

Anderson is far from alone. The recent flood of attention paid to governance issues in the wake of Enron and other corporate scandals has, by all accounts, made bankersu00e2u20ac”and their boardsu00e2u20ac”more thoughtful about their own governance standards. Kip Weissman, a Washington, D.C. securities partner with Jenkens & Gilchrist, estimates that before the rash of corporate failures, only about 5% of his firm’s clients were really interested in upgrading governance. “Now, the vast majority of banks are at least considering it,” he says.

And why not? Bank directors, as individuals, face potentially enormous liabilities. They could find themselves subject to civil money penalties and other enforcement actions from regulators, and other they face possible shareholder suits if stock prices stumbleu00e2u20ac”be it due to a stagnant economy, a breakdown in financial reporting, or poor management decisions. Marry those personal risks with the fact that the company foots the bill for a governance review, and it looks like a no-brainer.

Weissman offers the example of two banks faced with similarly serious loan-loss problems that spark investor and regulator suits. “If one has cutting-edge governance procedures and the other just has adequate procedures, the first will be in a much better position regarding litigation,” he says. In other words, a governance review can not only head off potential trouble before it hits, it can also act as a sort of company-paid “insurance policy” for directors who, in a worst-case situation, could cite such a review as evidence that they were handling their oversight duties diligently and with care.

For all that, most bankers have yet to take the review plunge. Many bankers are inherently suspicious of lawyers and their motives. And the fact that the fine print has yet to be written for many of the new rules and regulations makes it easy for directors and managers, who are only human, to leave the preventive medicine for another time.
“With the new laws and rules boards need to distill, there’s probably room for some type of review,” says David Bochnowski, chairman and CEO of NorthWest Indiana Bancorp, a $500 million thrift in Munster, Indiana, who nonetheless has opted against hiring a law firm for the task.

This approach can look penny-wise and pound-foolish. “We’ve got an old saying in Texas: Once their ox is in the ditch, people will pay you a fortune to help get it out, but they don’t want to spend any money to keep the ox from going into the ditch in the first place,” says Robert Clarke, a senior partner with Bracewell & Patterson in Houston.

But the need for a formal review varies by situation. Steve Johnson, a partner with Lindquist & Vennum in Minneapolis, notes that the managements of most small, closely held banks handle everything from lending to compliance, leaving them overwhelmed. “If your exam ratings and asset quality are good, you don’t have anything to panic about, and it would be premature to do a Sarbanes-Oxley-type audit at this point,” he says. Better, Johnson adds, to wait until bank regulators come out with firmer guidance about their expectations.

Size and ownership are key factors. Laws such as FDICIA, passed in the early 1990s following the thrift crisis, set governance requirements for banks and thrifts with assets of more than $500 million that exceed those expected of most other industries. Those rules appear to have paid off during the past few years, as banks emerged relatively unscathed amid a wave of corporate scandals. Indeed, FDICIA’s demands for CEOs and boards to certify financial reports and audits are now being mirrored in other industries.

And while Sarbanes-Oxley and new exchange requirements obviously apply to publicly traded banking companies, a joint letter issued in May by the Comptroller’s office, the Federal Reserve, and the Office of Thrift Supervision said that the agencies “encourage all non-public banking organizations to periodically review their [governance] policies and procedures,” … although they “do not expect to … apply the board composition, director independence, audit committee, auditor independence, and other corporate governance requirements” of the new laws and rules to private banks.

The FDIC has also issued its own lengthier set of guidelinesu00e2u20ac”one each for institutions with assets greater than and less than $500 millionu00e2u20ac”that echoes the primary regulators’ recommendations. Those guidelines can be found on the FDIC’s website (www.fdic.gov).

Given all the guidance from regulatory agenciesu00e2u20ac”not to mention the new lawsu00e2u20ac”this isn’t exactly rocket science. In addition to law firms, accounting firms, board consultants, and regulators are offering group or individualized help on the governance issue. Bochnowski recently took eight board members to Indianapolis for a day-long FDIC governance seminaru00e2u20ac”a lower-cost option that he says was done well.

For larger banksu00e2u20ac”or those with specific governance issuesu00e2u20ac”a formal review by a law firm might be in order. The question is, who should you choose? The recent governance frenzy has fostered a fast-growing cottage industry of law firms offering to review governance structures and policies, for a fee. Bankers report being deluged over the past year with solicitations from law firms peddling such services.

Naturally, firms play up their strengths. Clarke, a former comptroller of the currency, suggests looking for partners that have regulatory experience. Weissman, whose firm has offered governance reviews for 12 years, says a track record is important. Meanwhile, some firms, including New York heavyweights like Weil Gotschal & Manges and Sullivan & Cromwell, have earned strong reputations for their governance prowess.

Many banks, such as Community First, simply turn to their regular outside firm for a review. “We figured it would be an ongoing process,” Anderson says. “So why not work with someone we already had a relationship with?” Those lacking that option can get recommendations from neighboring banks or their local trade associations.

A governance review can run the gamut from superficial to intensive, depending on the bank’s history and board structure. A basic review for a well-run bank could eat up as little as 20 billable hours, or around $5,000. For those needing a bigger governance overhaul, expect something more around 200 billable hours, or as much as $50,000.

Clarke often starts the process over the phone by walking through the mechanisms and structures in place with a bank’s CEO or legal counsel. Occasionally, he’s able to offer assurance that a bank is living up to the law’s intent. But it’s usually more complicated than that. Weissman focuses on the audit committee structure, how that committee interacts with management, and the financial reporting mechanisms. “The key is to ensure that the processes around your financial reports are correct, because that’s what you get sued on,” he says.

At $5.7 billion Community First, the timing of a review dovetailed nicely with some internal issues. Longtime Chairman Donald Mengedoth was retiring at the end of 2002, and directors had already been kicking around the idea of a nonexecutive chairman. Given the environment, board members concluded that a full review was in order.

Last October, CEO Anderson huddled with his chief financial officer and Jonathan Levy, a Lindquist & Vennum partner and former SEC staffer, to devise a “grid” that addressed the standards of various regulators and exchanges. “We touched on auditor independence, auditor and accounting independence, all the board and committee processes,” Anderson recalls. That framework was then brought to the board for feedback. It was confusing. In some cases, bank regulations seemed stricter than those required by Sarbanes-Oxley; in others, such as loans to insiders, the reverse was true.

From there, individual directors’ qualifications and independence were scrutinized. Some surprises quickly emerged.

One director’s company, for instance, did business with Community First in 2001 and could not be considered independent for three years under proposed NASDAQ rules. She had to be removed from committee work. Another, former South Dakota Gov. Harvey Wollman, a director since 1987, didn’t really qualify as a “financial expert,” even though he had previously served well on the audit committee. “When you put a director through the test relative to the standards, and you check ‘no’ in a category, it’s a little uncomfortable,” Anderson says.

Before the six-month process was finished, Community First’s board had rewritten every committee charter, established new reporting guidelines on areas like stock options, hired a new internal auditor, and built in new mechanisms to periodically assess director independence and update processes to meet any new standards that might emerge. “It was important to make it dynamic, because things will emerge that haven’t been proposed or implemented yet,” Anderson says. “It took a lot of work, money, and time. But it was worth it, because it’s given the board some peace of mind.”