The Role of the Board, Administration, Audit Committee, and Legal Counsel in Light of Post-Enron Culture and Sarbanes-Oxley Governance Standards

By Edgar H. Bittle and Martin Semple

Edgar H. Bittle is an attorney with the Des Moines, Iowa, firm of Ahlers & Cooney, P.C.

Martin Semple is a member of the Denver, Colorado, firm of Semple, Miller, Mooney & Farrington, P.C.

The purpose of this article is to identify issues. It does not purport to be exhaustive or to render legal advice. Readers should consult with qualified counsel or other professionals in developing responses to specific situations.

The article orignially appeared in the December 2005 issue of Inquiry and Analysis, published by the National Association of School Boards, Council of School Attorneys. Reprinted with permission.

In the wake of financial scandals involving Enron, Arthur Anderson, Global Crossings, and others, Congress made sweeping changes in governing and managing companies that are regulated by federal securities laws. It adopted the American Competitiveness and Corporate Accountability Act of 2002, otherwise referred to as the Sarbanes-Oxley Act.1 While this law only applies to publicly traded companies regulated by federal securities laws, there has been a great deal of discussion of the extent of application of certain provisions to nonprofit corporations and public bodies, including public school districts. Sarbanes-Oxley clearly does not directly apply to public school districts (with two exceptions relating to the destruction of documents and whistleblower protection, discussed below), but the obligations that it imposes on regulated corporations to disclose and certify to a true and accurate financial condition, to increase financial transparency and accountability, and to design internal financial controls may suggest some practices that school board members and administrators need to understand.2

The effect of the Sarbanes-Oxley Act has been to redefine corporate responsibility, generally. Even though it does not technically apply to public school corporations in most instances, school administrators, school business officials, school officers, and board members need to understand this climate for increased corporate responsibility with respect to the exercise of their statutory financial oversight obligations. 3

Put another way, the Sarbanes-Oxley Act did not impose any new legal responsibilities on school board members, but the public’s expectations may have changed. Financial advisors, auditors, attorneys, insurers providing directors and officers liability insurance, bond rating agencies, or board members who serve on corporate boards of directors may expect that the practices imposed by Sarbanes-Oxley should be applied to oversight of public school district financial operations.4 In addition, it can be anticipated that when courts are asked to review the exercise of statutory responsibilities of a public school corporation board member or officer, they may look to this redefined corporate responsibility to help define a board member’s duty of care.

Several recent cases have provided case studies that invite a review of school board financial oversight practices.

In the Saint Vrain, Colorado, School District, the school district auditor at a December 12, 2001, meeting told the school board that she did not recommend that it (the board) continue approving budgets in which the district spent more than it brought in. She said (as recorded on videotape): “Your fund balance from the general fund dropped fairly significantly this year. . . . It was your budget, so it was something that probably wasn’t a surprise to you guys, but it gets to be a concern when that fund balance continues to drop.” On January 9, 2003, the Denver Post reported on this auditor’s report: “The district, by the time of the videotaped meeting, had budgeted expenses for fiscal 2002—a year that had not yet been audited—to overrun revenue by $9.8 million. Part of the problem was that the 2002 budget was drafted to erroneously show that the district would start the year with a balance of $15.1 million.”5 When this crisis first surfaced, one board member was quoted as saying it was not the board member’s responsibility to double check the district’s finances, but the board ultimately recognized that the responsibility rested with them; one board member stated: “I think we blame ourselves. We all think we could have done a better job.”6

In the Elizabeth, Colorado, School District, a $2.25 million shortfall in a $30 million budget was discovered in the 2002–03 school year. The CFO used school bond money to cover cash flow problems and violated school budget statutes. The superintendent altered his contract in three separate school years. At a public meeting, he stated his salary was $123,000; the actual salary he drew was $177,000. The chief financial officer (CFO) altered her contract to get an extra $6,000 to $13,000 per year. The superintendent and CFO were found guilty of fraud, embezzlement, and each received six-year jail sentences. The district judge was quoted: “The Defendants have suggested that there is plenty of blame to go round. They are correct. When a school board says ‘We may be stupid but we are not liars’ something is terribly wrong.”7

In the Sauk Village, Illinois, School District, the Chicago Tribune reported that the superintendent was charged with stealing more than $100,000 and was charged with bribery, intimidation, harassment of a witness, obstruction of justice, and official misconduct. The former school board president was charged with theft, misapplication of funds, and official misconduct.8

In the Roslyn, New York, School District, the New York Times reported that the superintendent pleaded guilty to stealing $2 million from the school system over the past six years. All together, he, with other top administrators, stole approximately $11 million from the school district.9

Orientation—Board Members Duty of Care

These cases suggest that school board financial oversight and the scope of audits need to be carefully reviewed. As a matter of prudence, principles of auditor independence and corporate responsibility for financial statements and other practices found in Sarbanes-Oxley provide lessons for school boards to consider. One best practice could be to establish an orientation for board members and administrators, covering their duty of care and statutory financial oversight responsibilities. School boards also may wish to consider establishment of an audit committee, a code of ethics for administrators and financial officers, a document management system, and whistleblower protection as a matter of good practice.

The ABA Section of Business Law’s Corporate Director’s Guidebook (4th ed.) suggests some principles that could be considered for orientation of administrators and board members with respect to their duty of care and statutory financial oversight responsibilities. Orientation of board members should include financial literacy training. During orientation, board members should consider their decision-making duties, including how they formulate district policy and strategic goals with the administration and how they take actions with respect to specific matters, including those required legally. They should consider how they exercise oversight duties, including ongoing monitoring of the district’s business and affairs, business performance, plans and strategies, risk assessment, risk management, compliance with legal obligations and policies, financial reports, and any matters suggesting a need for inquiry or investigation.10

As part of this orientation, board members should consider how best to carry out their responsibility to promote the best interests of the school corporation and its stakeholders in directing the corporation’s business and affairs. A board member should exercise independent judgment for the overall benefit of the school corporation and all its stakeholders. A board member must discharge his or her duties in good faith, with care, diligently, and reasonably as an ordinarily prudent person in a like position under similar circumstances in a manner he or she reasonably believes is in the best interests of the school corporation. This includes: regular attendance at meetings; timely receipt of information and of agendas reasonably in advance of meetings; studying agendas and information; keeping informed of the efforts of those on whom the board relies, including legal counsel, accountants, or others who are acting within their professional or expert competence; and evaluation of employees and others upon whom the board relies in exercising its corporate responsibilities.11

On January 24, 1996, the Securities and Exchange Commission (SEC) issued a cease-and-desist order against individual members of the Board of Supervisors of Orange County, California, and released its report of an investigation that asserted inadequate disclosure in connection with the offer and sale of municipal securities issued by the county.12 In that report, the SEC stated:

Public entities that issue securities are primarily liable for the content of their disclosure documents. . . . In addition to the governmental entity issuing municipal securities, public officials of the issuer who have ultimate authority to approve the issuance of securities and related disclosure documents have responsibilities under the federal securities laws as well. In authorizing the issuance of securities and related disclosure documents, a public official may not authorize disclosure that the official knows to be false; nor may the public official authorize disclosure while recklessly disregarding facts that indicate that there is a risk that the disclosure may be misleading.13

The SEC Order and Report illustrate the duty and standard of conduct that will be expected of board members when working with the officers, employees, legal counsel, auditors, financial advisors, and other professionals employed by the school board for bond or other debt issues. The Order and Report suggest a duty of care for a prudent school board member exercising his or her financial oversight responsibilities. A board member cannot shed these responsibilities by simply engaging legal counsel and other professionals, and if he or she waits until the time comes to make disclosure in a bond or other debt offering, it may be too late, as illustrated by the St. Vrain case.14

Audit Committee

Sarbanes-Oxley mandates publicly traded companies to set up an independent audit committee; no “inside” directors, namely employees of the company, can be members of the audit committee, and the audit committee must appoint, set compensation, and oversee work of the independent auditor.15

Creation of an audit committee of the school board may be appropriate in certain circumstances, assuming that creation of such a committee is consistent with applicable state law.16 Subject to state statutory provisions, a school board audit committee would be made up of board members and could include a member or members from the community who could be considered a financial expert. Under Sarbanes-Oxley, a “financial expert” is defined as someone who, through education or experience, has knowledge of generally accepted accounting principles (GAAP) and financial statements, experience in the preparation or application of audit statements, experience with internal accounting controls, and an understanding of audit committee functions.17

The primary function of an audit committee would be to recommend the appointment of the auditor to the board, recommend the terms of engagement set forth in an engagement letter, including compensation, and to oversee the work of the independent auditor. The superintendent and business manager could be required to certify that they have reviewed the audit report, that it does not contain any untrue statement of a material fact, or omit a material fact that makes the statements misleading. The audit committee would also work with the administration and the board to establish internal controls.18

As a result of the St. Vrain and Elizabeth School District experiences, the Colorado legislature amended a number of its school budgetary and financial reporting statutes. The superintendent and chief financial officer are now required to certify to the state treasurer any amount requested under the state’s interest free loan program,19 the school board must adopt a specific resolution to authorize the use of a portion of the beginning fund balance, and the school board must be provided a quarterly review of the fund balance budgeted and actually spent.20 Other states have considered or may in the future be considering regulation of school board financial oversight responsibilities.21

Subject to applicable state law and the school board’s review and approval, the audit committee could be primarily responsible for oversight of the financial reporting process of the board. Oversight functions may include prevention, deterrence, investigation, and detection of fraud; monitoring the financial reporting process; overseeing the audit function; overseeing the internal control system; and reporting findings to the board.22

Under Sarbanes-Oxley, public accounting firms are prohibited from performing non-audit services to clients they audit and the audit committee must pre-approve all services provided by the auditor.23 The board may want to include in its policy or code of ethics, a statement that it is unlawful for a board member, administrator, or employee to exert influence or to mislead an auditor. The policy could require periodic rotation of the lead audit partner and the audit review partner and require the auditor to report to the audit committee and the board, not to the administration. In addition, if a school district hires someone formerly employed by the auditor, that person may have restricted responsibilities with respect to the audit.24

Two Provisions of Sarbanes-Oxley Apply to School Districts

While most of the provisions of Sarbanes-Oxley apply only to publicly traded companies regulated by federal securities laws, two specific provisions are applicable to school districts; both involve amendments to the federal criminal code, one dealing with document destruction and the other dealing with one of the sections on whistleblower protection.

School districts need to adopt a document management policy. The provisions of Sarbanes-Oxley relating to document destruction clearly apply to K-12 schools and anyone else dealing with the federal government. Sarbanes-Oxley makes it a crime to knowingly destroy a document with the intent to obstruct or influence “the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States . . . or in relation to or contemplation of any such matter or case.”25

Sarbanes-Oxley also makes it a crime for anyone, with intent to retaliate, to take any action harmful to anyone for providing to a law enforcement officer any truthful information relating to the commission of any federal offense. This is in addition to any responsibilities that may exist under state whistleblower and state and federal employment and civil rights statutes.26

Attorney’s Ethical Responsibilities

In addition to reviewing and establishing internal controls, a school board would be wise to adopt a code of ethics—general statements that describe the intended high standards of ethical conduct. Specific topics may include: conflicts of interest; gifts; travel and expense reporting; use of consultants, agents, and lobbyists; use of district-owned equipment; political contributions and activities; and public utterances on behalf of the district. In that regard, the board might look to the Association of School Business Officials International, Government Finance Officers’ Association, and National Association of College and University Business Officials (NACUBO) Codes of Ethics.

Board members should be aware of the ethical responsibilities of the professionals upon whom they rely. Sarbanes-Oxley defines new duties for attorneys, in effect making them “gatekeepers” for corporate conduct.27 Any attorney representing a corporation regulated by the SEC is required “to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the chief executive officer of the company (or the equivalent thereof). Attorneys have an obligation to accomplish a “noisy withdrawal” under certain circumstances.28 SEC rules to implement section 307 of the Sarbanes-Oxley Act require withdrawal and notification to the SEC when the attorney reasonably believes that a material violation is ongoing, is about to occur, or has occurred and is likely to result in substantial injury to the financial interest or property of the issuer or investors.29

These principles are now reflected in the Model Rules of Professional Conduct that govern the conduct of school attorneys. Rule 1.13(a) provides that: “A lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents.”30 Rule 1.13(b) provides that:

(b) If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law that reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization.31

The Rule continues:

Unless the lawyer reasonably believes that it is not necessary in the best interest of the organization to do so, the lawyer shall refer the matter to higher authority in the organization, including, if warranted by the circumstances to the highest authority that can act on behalf of the organization as determined by applicable law.32

Rule 1.13(c) provides that:

(c) if (1) despite the lawyer’s efforts in accordance with paragraph (b) the highest authority that can act on behalf of the organization insists upon or fails to address in a timely and appropriate manner an action, or a refusal to act, that is clearly a violation of law, and

(2) the lawyer reasonably believes that the violation is reasonably certain to result in substantial injury to the organization, then the lawyer may reveal information relating to the representation whether or not Rule 1.6 permits such disclosure, but only if and to the extent the lawyer reasonably believes necessary to prevent substantial injury to the organization.33

A lawyer who reasonably believes that he or she has been discharged because of the lawyer’s actions taken pursuant to paragraphs (b) or (c), or who withdraws under circumstances that require or permit the lawyer to take action under either of those paragraphs, can proceed as the lawyer reasonably believes necessary to assure that the organization’s highest authority is informed of the lawyer’s discharge or withdrawal.34

“In representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client’s situation.”35 The comment to this rule states:

In general, a lawyer is not expected to give advice until asked by the client. However, when a lawyer knows that a client proposes a course of action that is likely to result in substantial adverse legal consequences to the client, the lawyer’s duty to the client under Rule 1.4 may require that the lawyer offer advice if the client’s course of action is related to the representation.36

Rule 1.16 governs Terminating Representation:

[A] lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if: (1) the representation will result in violation of the rules of professional conduct or other law; (2) the lawyer’s physical or mental condition materially impairs the lawyer’s ability to represent the client; or (3) the lawyer is discharged.37

Conclusion

While most of Sarbanes-Oxley is not legally applicable to public school districts, the practices that it establishes for ensuring accurate financial reporting, increased accountability, and internal financial controls may serve as a model for good business practices to be considered for voluntary adoption by any school district and its board of directors. The ultimate responsibility for the school district’s financial accountability rests with the board of directors. Those practices may provide both guidelines and protection for the administrators and employees reporting to the board, the state agencies, and particularly, to the public.

Endnotes

1. Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, 29 U.S.C.A.)

2. See Carl Oxholm III, Sarbanes-Oxley in Higher Education: Bringing Corporate America’s “Best Practices” to Academia, 31 J. C. & U. L. 351, 354–57 (2005).

3. Alexander E. Dreier, Sarbanes-Oxley and College Accountability, Chron. of Higher Ed., July 8, 2005, at B10.

4. Id.

5. Chris Frates, St. Vrain Was Warned in ‘01, Denver Post, Jan. 9, 2003; Daily Times Call, Jan. 17, 2003.

6. Daily Times Call, Jan. 19, 2003.

7. Denver Post, June 13, 2004.

8. Tom Rybarczyk, Sauk Superintendent Accused of Fraud, Bribery, Obstruction, Chi. Trib., Aug. 24, 2005.

9. Paul Vitello, Ex-Schools Chief Pleads Guilty to Huge Theft, N.Y. Times, Sept. 27, 2005.

10. ABA Committee on Corporate Laws, Corporate Director’s Guidebook 5–23 (4th ed. 2004).

11. Id.

12. Orange County, Securities Act of 1934, Release No. 36761, 1996 SEC LEXIS 132 (Jan. 24, 1996) (Report); Orange County, Securities Act of 1933, Release No. 7260, Securities Exchange Act of 1934, Release No. 36760, 1996 SEC LEXIS 213 (Jan. 24 1996) (Order).

13. In the Matter of County of Orange, et al., Admin. Proc. File No. 3-8937, Securities and Exchange Commission, 1996 SEC LEXIS 213 (the “Order”), 1996 SEC LEXIS 132 (the “Report”) (emphasis added).

14. See supra note 5.

15. See supra note 1.

16. See AICPA Audit Committee Toolkit, available at www.aicpa.org/acec (including checklists, matrices, questionnaires, and other materials). See also National Association of College and University Business Officers, The Sarbanes-Oxley Act of 2002: Recommendations for Higher Education, Adv. Rep. 2003-3 (Nov. 20, 2003); State of Iowa Board of Regents, Audit and Compliance Committee Memorandum, available at http://www2.state.ia.us/regents/Meetings/Committees/ AUDMemos/Nov04/1104_AUD0.pdf (May 10, 2004).

17. See supra note 1.

18. See supra note 16.

19. Colo. Rev. Stat. § 22-54-110.

20. Colo. Rev. Stat. §§ 22-44-105 and 22-45-102.

21. See supra note 2, at 351–52.

22. Presentation to Iowa Ass’n of School Bus. Officials, Oct. 6, 2004, by David A. Vaudt, Treasurer, State of Iowa.

23. 15 U.S.C.A. § 17j-l.

24. Independent Study Presentation, EdAdm 607, Iowa State University, 2004 by Vicki Lowe, Superintendent, Glidden-Ralston CSD and Galen Howsare, Associate Superintendent, West Des Moines CSD. See supra note 2, at 366.

25. 18 U.S.C.A. § 1519.

26. 18 U.S.C.A. § 1513(e). It should be noted that a much broader whistleblower protection provision in Sarbanes-Oxley applies only to employees of publicly traded companies, 18 U.S.C. § 1514A. This provision does not apply to public school districts.

27. 17 C.F.R. § 205 (2003).

28. Sarbanes-Oxley Act, § 307(1), 15 U.S.C.A. § 7245.

29. 17 C.F.R. § 205 (2003).

30. Model Rules of Prof’l Conduct R. 1.13(a) (2005).

31. Model Rules of Prof’l Conduct R. 1.13(b) .

32. Id.

33. Model Rules of Prof’l Conduct R. 1.13(c) .

34. Model Rules of Prof’l Conduct R. 1.13(e) .

35. Model Rules of Prof’l Conduct R. 2.1 (2005).

36. Model Rules of Prof’l Conduct R. 2.1, cmt. 5.

37. Model Rules of Prof’l Conduct R. 1.16 (2005).