It has been said that Casey Stengel, the first (1962-1965) manager of the New York Mets, was so confounded by the team’s ineptitude during its inaugural season that he demanded, “Can’t anybody here play this game?”
The same might be inquired of corporate directors, in the context of the nebulous concept, and the even more vague (and underinclusive) requirement, of their “financial literacy.”
In September 1998, the NYSE and NASDAQ exchanges established a Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Five months later, the ten recommendations of the Committee’s final report included the establishment of a financial literacy requirement for all directors serving on audit committees.
The Committee explained that “a director’s ability to ask and intelligently evaluate the answers to [‘probing questions about the corporation’s financial risks and accounting’] may not require ‘expertise’ but rather hinges on intelligence, diligence, a probing mind, and a certain basic ‘financial literacy.” It added, “Directors who have limited familiarity with finance can achieve such ‘literacy’ through company-sponsored training programs.” Report and Recommendations of the Blue Ribbon Committee, 54 Bus. Law. 1067, 1081-1082 (1999).
Effective January 31, 2000, the SEC approved the exchanges’ revised listing standards, which adopted the Committee’s definition of financial literacy: the ability “to read and understand fundamental financial statements, including a Company’s balance sheet, income statement, and cash flow statement.” Id. at 1081; Commentary to NYSE Listed Company Manual Section 303A.07(a); NASDAQ Listing Rule 5605(c)(2)(A).
However, this requirement is not so simple as it seems.
First, “financial literacy” is far from a precise term, and it has not been addressed or interpreted by caselaw.
For instance, what other documents, besides those specified, should a member of the audit committee be able to “read and understand”? And, to what degree or level must such a director “understand” these often-complex and usually-footnoted documents?
(Both sets of listing standards additionally, though still somewhat murkily, require that at least one member of an audit committee have a deeper background in accounting: for NYSE, “accounting or related financial management expertise, as the listed company’s board interprets such qualification in its business judgment”; and for NASDAQ, “past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.”)
Compounding this confusion and cloudiness, the audit committee charters of some companies find it necessary to add that directors on the committee should have “a working familiarity with basic financial and accounting practices” or a “general knowledge of key business and financial risks and related controls or control processes.”
Second, boards should clarify how a current or potential director’s financial literacy is to be determined, rather than leaving it to, as many corporate governance guidelines (and the NYSE’s Commentary) permit, “the board’s business judgment.”
At least one company’s corporate governance guidelines call for each member of the audit committee “to complete an appropriate questionnaire.”
The most specific approach may be that of Proctor & Gamble’s governance guidelines, whose Appendix C provides a two-part definition of “financial literacy” and lists seven non-exclusive ways to satisfy this qualification, including “Financial training provided as part of new Committee member onboarding”; “Accounting or other financial education”; and various forms of professional experience.
(One simple but effective approach might be for a board to retain an independent third party, such as a business school professor, to furnish a set of (real or mock) financial statements to any candidate, along with a series of questions to be answered in the examiner’s (physical or virtual) presence over the next ninety minutes.)
Third, the NYSE Commentary and many audit committee charters indicate that if a director is not already financially literate when she joins the audit committee, she must become so “within a reasonable period of time thereafter.” What is a “reasonable period of time” for a skill this fundamental to the directors’ monitoring role?
According to New Jersey lore, in patronage-pervaded Hudson County, a newly-appointed director of the state’s Office of Weights and Measures, asked by a reporter at his swearing-in ceremony, “How many ounces are in a pound?”, replied, “Give me a break—I just got this job!”
Fourth, shouldn’t financial literacy—however that might be defined—be required of all corporate directors, as of the time they join the board, rather than just those on the audit committees of NYSE- and NASDAQ-listed companies, “within a reasonable period of time” after joining the committee?
In fact, some companies’ governance guidelines (which, both by their own titles and terms and by common understanding, do not legally bind the board) indicate that financial literacy is a factor to be considered in assessing potential candidates for directorships.
Some guidelines do state that all directors “should know how to read and understand fundamental financial statements and understand the use of financial ratios and information in evaluating the financial performance of the Company,” or “should know how to read a balance sheet, income statement, and cash flow statement, and understand the use of financial ratios and other indices for evaluating company performance.”
A universal requirement of financial literacy would simplify, for listed companies, the question of quickly filling a vacancy on the audit committee, since all directors would already satisfy this qualification.
Indeed, this basic but essential capability—and responsibility— appears among those identified forty years ago by the New Jersey Supreme Court, in its interpretation of the requirement (under N.J.S.A. 14A:6-14) that directors of companies incorporated in New Jersey “discharge their duties in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions.”
In Francis v. United Jersey Bank, 432 A.2d 814, 821-823 (N.J. 1981), the Court held that, “As a general rule, a director should acquire at least a rudimentary understanding of the business of the corporation. Accordingly, a director should become familiar with the fundamentals of the business in which the corporation is engaged.”
“Directors are under a continuing obligation to keep informed about the activities of the corporation. . . . Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect.”
“Directorial management does not require a detailed inspection of day-to-day activities, but rather a general monitoring of corporate affairs and policies. . . . Accordingly, a director is well advised to attend board meetings regularly. . . . Regular attendance does not mean that directors must attend every meeting, but that directors should attend meetings as a matter of practice.”
“While directors are not required to audit corporate books, they should maintain familiarity with the financial status of the corporation by a regular review of financial statements. . . . In some circumstances, directors may be charged with assuring that bookkeeping methods conform to industry custom and usage. . . . Adequate financial review normally would be more informal in a private corporation than in a publicly held corporation.”
“The review of financial statements, however, may give rise to a duty to inquire further into matters revealed by those statements. . . . Upon discovery of an illegal course of action, a director has a duty to object and, if the corporation does not correct the conduct, to resign. . . . Sometimes a director may be required to seek the advice of counsel.” [emphasis added]
Fifth, and finally, might not both the level at which a director should “understand” key financial documents, and the “reasonable time” in which she should attain this capability, be determined at least in part by the nature of her particular company’s business?
The Francis Court found that “the most striking circumstances” surrounding a director’s failure to detect and stop embezzlement by her sons included “the character of the reinsurance industry [, in which insurance companies distribute among themselves the risk that a particular insured will have a particularly large claim to be paid] and the nature of the misappropriated funds. . . The hallmark of the reinsurance industry has been the unqualified trust and confidence reposed by ceding companies and reinsurers in reinsurance brokers. Those companies entrust money to reinsurance intermediaries with the justifiable expectation that the funds will be transmitted to the appropriate parties. . . .
“[The company] received annually as a fiduciary millions of dollars of clients’ money which it was under a duty to segregate. To this extent, it resembled a bank rather than a small family business. Accordingly, [the director’s] relationship to the clientele of [the company] was akin to that of a director of a bank to its depositors. All parties agree that [the company] held the misappropriated funds in an implied trust. That trust relationship gave rise to a fiduciary duty to guard the funds with fidelity and good faith.” 432 A.2d at 825.
The New Jersey Supreme Court declared, “A director is not an ornament, but an essential component of corporate governance. Consequently, a director cannot protect himself behind a paper shield bearing the motto, ‘dummy director.’” Id. at 823.
Boards might thus be well-advised to provide, in their “on-boarding” process for all incoming directors, not only educational material—from the most introductory to more specialized and complex treatments—but also training, on “financial literacy.”
If not a perfect solution, that might be (with apologies to Mr. Stengel), a pretty good baseline for keeping directors in-bounds.
[Those interested in the dynamics of the New Jersey Supreme Court during a key portion (1985-1994) of the (1979-1996) term of Chief Justice Robert N. Wilentz might find of professional and personal interest the insights of former Associate Justice Daniel J. O’Hern (for whom I had the great privilege of clerking) in What Makes a Court Supreme (posthumously published in 2020).]