Document Type

Article

Publication Date

3-24-2004

Abstract

Audit committees of corporate boards of directors are central to corporate governance for many corporations. Their effectiveness in supervising financial managers and overseeing the financial reporting process is important to promote reliable financial statements. This centrality suggests that it is likewise important for investors and others to have a basis for justifiable confidence in audit committee effectiveness. At present, there is no such mechanism. This Article explains why, considers a way states can provide it and assesses as low the likelihood that states will do so. In the swirling corporate governance reforms led by SOX, the SEC, SROs and PCAOB, states are playing minor roles at best. State absence leaves missing a potentially critical link in the evolving US corporate governance circle. The circle is drawn as follows: state corporation law charges boards of directors with managing corporations and authorizes board committees; SOX charges audit committees with certain tasks, including supervising external auditors; the SEC and SROs require audit committee characteristics like independence and compel disclosure; and PCAOB now requires external auditors to evaluate audit committee effectiveness. This last step could close the circle except that auditors performing this evaluation generate conflicts with state corporation law, conflicts between auditors and audit committees and face other limitations. These conflicts and limitations can be neutralized in an audit committee evaluation exercise conducted by newly-created state agencies staffed with experts in state corporation law such as retired lawyers and judges or academics. These newly-created state agencies could thus square the newly-forming corporate governance circle. The paper presents and evaluates this concept. It reviews the central role audit committees play in corporate governance; considers existing mechanisms that promote committee effectiveness—state fiduciary duties, SEC-SRO disclosure rules, and traditional auditing—noting the limits of each. It considers PCAOB’s new auditing standards requiring auditors to evaluate audit committee effectiveness, showing both the perceived need for such an evaluation and inherent limits on auditor capabilities to render this evaluation effectively. This review leads to state agencies as possible providers of this evaluation and certification. The paper sketches the outlines for creating and running such state agencies. The paper then assesses the likelihood that this concept would be accepted by various corporate constituents. Likely supporters include users and producers of financial information and the auditing and legal professions. More uncertain is SEC support, given a new model of corporate-governance production in which the SEC uses various instrumentalities, like SROs and PCAOB, to federalize corporate governance. State receptivity depends in part upon and is evaluated according to rival corporation law production models (a race to the top or bottom; interest group; or state versus federal). The paper concludes by lamenting that in the evolving corporate-governance production model, missing links like this one are unlikely to be corrected by state or federal law—unless private-sector agents likely to support such concepts lobby for them.