Executive officer transitions arise under a variety of circumstances. According to a report from recruitment firm Spencer Stuart, 69 percent of CEO departures in the US last year were the result of retirements or resignations. This is consistent with the expectation that most CEO appointments have historically been made through some form of succession planning.
But Spencer Stuart also reports that 22 percent of CEOs resigned under some form of pressure, and when a CEO unexpectedly resigns under pressure for any of a variety of reasons, a company is more likely to hire an outside successor than promote from within the organization.
Regardless of whether a transition is part of a planned succession or an abrupt departure and whether a well-groomed internal candidate or an outsider with a fresh perspective is appointed, there will inevitably be an impact within the organization as well as on the outside world. For public companies in particular, executive officer successions trigger a number of important and time-sensitive obligations, from following internal procedures and obtaining board and other approvals to making timely and complete public disclosures, such as filing 8K reports to announce appointments and departures.
Simultaneously, a new CEO or CFO appointed from the outside must acclimate to the organization’s culture and its long and short-term business objectives, all while likely eager to implement his or her own initiatives. Companies increasingly are recognizing the growing importance of developing a detailed and dynamic succession plan that is designed to optimize continuous performance while minimizing business disruption.
In fact, although regulatory rules do not explicitly require public disclosure about succession planning, institutional investors are more regularly looking to companies to provide meaningful disclosure about aspects of their succession strategies.
There are several immediate-term public disclosure requirements, such as 8K reports and initial Section 16 filings, all of which can be reduced to a checklist. There are also one-off and limited-duration disclosures to consider, such as determining which of the current and former executive officers’ compensation to report in the next several years’ proxy statements and preparing narrative disclosure about transition-related compensation arrangements.
In addition to those requirements, which are primarily obligations of the company, new CEOs and CFOs must also quickly get up to speed on the company’s systems of internal controls so they can certify the annual and quarterly reports.
In making these required certifications, CEOs and CFOs assume individual responsibility for the fairness, accuracy and completeness of public disclosures regarding the financial condition and the results of operations of the company that are contained in the reports, as well as for the effectiveness of the company’s disclosure controls and procedures – that is, the company’s system for developing accurate and complete reports. False certifications may give rise to civil and criminal liability, monetary fines and, in egregious circumstances, imprisonment.
Although developing a deep understanding of and familiarity with a company’s internal controls and reporting procedures is challenging for any new arrival, it is a particular challenge when the outgoing executive has left under pressure or in the wake of a scandal. Doing so may be an even greater challenge when there has been financial mismanagement and restatements of prior-period financial reports are being contemplated.
It is valuable to have a thoughtful and detailed process in place to ensure a new CEO or CFO can complete the necessary diligence to certify the annual and quarterly reports, make representations to the auditor and complete similar tasks. Specifically, it is useful to begin by establishing a company’s objectives with respect to internal controls, which are largely led by regulatory requirements, and evaluating the company’s current mechanism for generating and communicating information, including the current involvement of the CEO and CFO throughout the process.
Based on these, the company should develop and integrate with its succession plan a comprehensive set of controls and procedures to allow incoming CEOs and CFOs to make necessary certifications truthfully and confidently. With a new person in learning mode, this process is likely to require a far deeper dive into the controls and certification back-up process than any existing standard quarterly process requires.
SOX 404
Public companies must comply with Section 404 of the Sarbanes-Oxley Act (SOX 44). This requires management of a public company to annually assess the effectiveness of its internal control over financial reporting and, with certain exceptions for smaller companies and those that are newly public, requires that the auditor report on and attest to management’s assessment of internal control over financial reporting.
Due to the involvement of auditors, a significant body of guidance has developed regarding best practices for public companies to conduct these assessments. In addition to the SOX 404 assessments, federal securities laws also require periodic certifications from CEOs and CFOs of, and for inclusion in, the company’s annual and quarterly reports.
Although much has been made over the years of the legal risks presented to CEOs and CFOs regarding these certifications, the SEC has provided little in the way of guidance regarding what is required of a CEO and a CFO in making them. Over time, many CEOs, CFOs and public companies have developed and implemented ‘sub-certification’ policies, procedures and practices to link the company’s internal control obligations and processes to the CEO and CFO certifications. These certification practices should be tailored to a specific company’s business model and structure.
The process and procedures will necessarily be complex and have more inputs for companies with multiple business lines, subsidiaries, affiliates and operating departments than for smaller companies with more streamlined structures. Companies would be well served to analyze their certification and sub-certification practices and to work through them with a new CEO or CFO early in the orientation process rather than waiting for the standard financial reporting timeline.
Although the guidance for sub-certifications is limited, we encourage the following:
- Selection of sub-certifiers – Care should be taken to select the appropriate individuals who report directly to the CEO and CFO as sub-certifiers, down to their direct reports, and thereafter down to the appropriate level of the particular business model to act as a sub-certifier
- Sub-certification documentation – The sub-certification documentation should provide appropriate and reasonable assurances regarding the contents of the financial statements and assurances regarding the sufficiency and effectiveness of internal control and absence of fraud
- Training – A sub-certifier should receive training about the certification process and purpose upon assuming that role. Thereafter, all sub-certifiers should receive training on at least an annual basis in a timeframe that is in reasonable proximity to the start of the work related to the annual reporting
- Officer review process – At a minimum, the CEO and CFO should review the sub-certifications and any supporting documentation from their direct reports. Depending on the size and the complexity of the organization, they may want to review all of the sub-certifications. The CEO and CFO should be empowered and encouraged to ask for any supporting documentation and to meet with or interview any sub-certifiers
- Documentation – The diligence efforts of the CEO and CFO should be documented in an appropriate and reasonable manner. To the extent that any efforts throughout this process result in any potential for regulatory or litigation exposure, in-house or outside counsel should be engaged to establish and preserve privilege.
Audit firms have also increased their demands with respect to the representation letter delivered by management, and the diligence required for a CEO or CFO to sign the letter has increased accordingly.
These regular sub-certification diligence practices can be transitioned to developing a documented process for a new CEO or CFO to conduct the necessary level of diligence to deliver the ‘rep letter.’ Similarly, under the rare and high-risk circumstances when a new CEO or CFO arrives on the eve or in the middle of a restatement, a more intense process tailored to the restated issues and existing internal control weaknesses can be developed to allow the CEO and CFO to certify the restated financial statements.
Regardless of the reasons for a CEO or CFO transition, companies and their boards of directors would be well served to have in place succession and transition plans for their senior officers, as well as detailed and documented sub-certification policies, procedures and practices, and to continue to test and refine them based on the evolution of the business over time. Taking this approach should help facilitate smooth transitions and should lead to process improvements in the ordinary course of business.
Elizabeth Diffley and James Lundy are partners with Drinker Biddle & Reath in Philadelphia and Chicago, respectively. Associate Sujata Wiese assisted in the preparation of this article
