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Don’t Leave Independent Seats Vacant for Long

The board of Pulaski Financial Corp. in St. Louis hasn’t done much wrong over the past decade. The once-sleepy mutual thrift had four branches and $168 million in assets when it went public in 1998. Today, $806 million Pulaski has nine branches and is regarded as one of the top-performing thrifts in the nation, with a 2005 return on equity of 16.55%. The company’s emphasis on a handful of consumer products, including mortgages and home equity lines of credit, has fueled compounded annual earnings growth rate of 25% since the IPO. “It’s been a nice success story,” says Chairman and CEO William Donius.

But as Pulaski’s recent experience illustrates, even the smartest of boards can sometimes stub their toes amid the constant swirl of new rules and regulatory pronouncements in the post-Enron world.

On March 6, Pulaski announced that Robert Ebel, audit committee chairman and a director since 1979, was retiring for health reasons. A few days later, Donius got a phone call from NASDAQ officials, notifying him that Ebel’s retirement had triggered a violation of the exchange’s Marketplace Rule 4350(d)(2), and that Pulaski would be receiving a public letter stating that its listing was in jeopardy if the problem wasn’t fixed.

Enacted in 2004, Marketplace Rule 4350(d)(2) requires that a NASDAQ-listed company’s audit committee be composed of three independent directors, including at least one with experience as an accountant or financial expert. Ebel’s retirement, coupled with the stepping down earlier in the year of director E. Douglas Britt, who hit the board’s mandatory retirement age of 75, left the committee with just two qualified outsiders.

The NASDAQ notice required Pulaski to file a Form 8-K with the SEC, and left Donius feeling miffedu00e2u20ac”and a bit embarrassedu00e2u20ac”at what he portrays as an avoidable oversight that left Pulaski’s board with a bit of egg on its face, but had little real impact on the company’s performance or operations. “It’s an obtuse NASDAQ rule. Unfortunately, we weren’t aware of it, and our SEC counsel wasn’t either,” he says. “We care about corporate governance, so shame on us for not knowing about it.”

Less than a week after the filing, Pulaski’s board appointed not just one, but three new independent directorsu00e2u20ac”all of them St. Louis-area business heavyweightsu00e2u20ac”quickly bringing the board back into compliance.

Those new board members include Michael Hogan, chief financial officer of chemical maker Sigma-Aldrich Corp., Steven Roberts, co-founder of Roberts & Associates, a St. Louis construction management firm, and Stanley Bradshaw, former CEO of Roosevelt Financial Group, a $9 billion thrift that was acquired in 1997 by the old Mercantile Bancorp. (Mercantile was later bought by Firstar Corp. and is now part of US Bancorp.)

The issue’s quick resolution only highlights Donius’s frustration. Pulaski’s nominating and governance committee already had those nominees ready to bring to the whole board, he says. Had directors been aware of the rule, they either could have asked Ebel to hold off on announcing his decision until the board’s scheduled March 15 board meeting or until they had a special vote and announced a replacement concurrent with Ebel’s resignation. “We erred,” Donius says. “The good news is, the infraction was extremely minor, and the board reacted very well.”

Beyond “maybe a dozen phone calls” Donius says he received from analysts, reporters, and shareholders wondering what to make of the 8-K filing, the market’s reaction was pretty much muted. Pulaski’s share price didn’t suffer as a result of the announcement, and analysts appeared to greet news of the violation with a yawn. “It didn’t cause me too much concern,” says Daniel Cardenas, an analyst with Howe Barnes Investments in Chicago.

Chris Cole, regulatory counsel with the Independent Community Bankers of America, says he has not heard of any other bank boards running afoul of the new rule. But he’s not surprised that it’s happened and views it as a cautionary tale for other public companies in the post-Sarbanes-Oxley age.

“There are so many new rules out there, that it becomes easy to get confused about them,” he says. For smaller banking companies, the rules on independence can be especially vexing, Cole adds, because so many potential directors have some sort of relationship with the company. Bank boards “really need to consult with their SEC counsel every time they have a vacancyu00e2u20ac”or potential vacancyu00e2u20ac”to make sure you’re living up to the letter of the law,” he says.

Sarbanes-Oxley 404: Two Years After

Sarbanes-Oxley Section 404 compliance cost less to corporate America in year two of adoption than in year one, according to a survey by Financial Executives International (FEI). FEI polled 274 public companies, of which 238 are “accelerated filers” according to SEC definitions and have average revenues of $6 billion, to gauge experiences in complying with Sarbanes-Oxley’s Section 404.

According to the survey, the accelerated filers’ total average cost for Section 404 compliance was $3.8 million during fiscal year 2005u00e2u20ac”down 16.3% from 2004. The data shows that many of these reductions can be attributed to decreased levels of staff and consultant time and reduced auditor fees.

Increased efficiencies have reduced the number of internal staff hours needed to comply with Section 404 in 2005. Companies said that they had required an average of 22,786 people hours internally to comply with Section 404 in 2005. This average was 11.8% less than these companies required during 2004.

In addition, year two of Section 404 required less of an investment in external resources, such as software, consultants, and other vendors, according to the survey. In fact, respondents’ external costs averaged $1.3 million in 2005, representing an average of 22.7% from 2004.

Despite these decreases in overall costs, 85% of companies still do not believe that the benefits of compliance with Section 404 have exceeded the costs, although larger companies view it more favorably than smaller companies.

“Based on the feedback from our members, it is clear that the degree of documentation is the number-one issue,” said FEI President and CEO Colleen Cunningham.

Smaller banks, in particular, have felt the burden of complying with Section 404 according to the Independent Community Bankers of America, which, along with nearly 200 community bankers, are urging the Securities and Exchange Commission to adopt the recommendations made by an SEC Advisory Committee to fully or partially exempt smaller public companies from Section 404.

“The intensity of responses by community banks indicates strong support for the committee recommendations,” said Chris Cole, ICBA regulatory counsel. “Adopting the recommendations would greatly enable community banks to further support economic development and job creation in their local communities.”

In addition, ICBA says this proposed relief would benefit publicly held community banks and holding companies that are struggling with the costs of complying with SOX. Community bankers also support a study to consider whether the 500 shareholder threshold for registration should be updated and how to reduce duplicative regulatory reporting, according to the ICBA.

When given the opportunity to suggest how Section 404 could be made more efficient or effective, over half of the companies in the FEI study identified the following recommendations:

– Reduce the degree of documentation

– Permit greater reliance on internal audit data and resources

– Clarify the definition of “key controls”

– Permit roll-forward procedures

– Allow cumulative reliance on year one testing and documentation

Despite the need for improvement, the survey highlights at least one silver lining. A common theme across responding companies was an increase in investor confidence, with 56% agreeing that compliance with Section 404 has now resulted in greater investor confidence in financial reports.

Global Engines of Growth

As financial services firms look toward the future, they see an industry that is familiar, yet different from the one they currently know. According to Deloitte Touche Tohmatsu’s “Global Industry Outlook: Shaping Your Strategy for a Changing World,” the industry will need to address a number of key transformative issues over the next three to five years, including globalization, service and technology innovation, regulation, risk management and aging populations.

The study explored the top trends, challenges, and opportunities facing global financial services providers and identified five engines of growth, including:

– Penetrate emerging markets with low cost business models. The most successful players will pursue global expansion through cross-border consolidation, offshoring, and investment in compelling overseas markets, such as China.

– Capture customer relationships through service and technology innovation. Personalization will become increasingly important as firms use technology to deepen retail relationships.

– Use transparency and compliance as opportunities to improve performance. Competitive financial institutions will invest in compliance infrastructure but manage costs more effectively.

– Address risk with an extended view of the enterprise. Enterprise risk management will be the standard framework for integrating a view of all risks and relating them to business objectives.

– Move aggressively to capture opportunities in the retirement market. As Baby Boomers retire over the next 20 years, firms will need to offer products and advice focused on asset allocation and wealth transfer rather than asset accumulation.