Lessons Learned from Corporate Failures: How Can Audit Committees Be More Attuned to the Early Warning Signs of Distress

1. Lessons Learned from Corporate Failures: How Can Audit Committees Be More Attuned to the Early Warning Signs of Distress in an Organization Michael Barrack Thornton Grout Finnigan

2. Changing Role of the Audit Committee • If insolvency is suspected, the role of the Audit Committee becomes much more challenging. • The information sought by the Committee will change from normal times. • The sources of that information may change. • New players may emerge, both internal and external.

3. Definitions of Insolvency • Inability to pay debts as they come due • Value of the assets is less than the obligations of the business. • Definitions vary slightly under different statutes. • Companies’ Creditors Arrangement Act takes a pragmatic approach by defining insolvency as including a pending liquidity crisis.

4. Audit Committee’s Obligations • The impact of these definitions of insolvency is that the Audit Committee is obliged to assess the financial health of the corporation. • It should be familiar with these definitions and ask the right questions when there is any suggestion of pending financial difficulty.

5. Anticipating Insolvency • Courts have accepted that a business needs a period, prior to running out of cash, to move through the steps involved in a restructuring. • The Audit Committee needs to carefully monitor the business to know when events are anticipated that make a restructuring either inevitable or desirable.

6. Conducting Proper Inquires • Management should be questioned closely regarding future limits on liquidity. • Financial information should be considered closely in the context of historical results for same month, quarter or other reporting period. • Significant changes in pricing or input costs should be assessed.

7. Significant Items to Monitor • Maturity of long-term debt • Payments in respect of pension liabilities - funding deficits or solvency payments • Contingent liabilities, including matters which are subject of current or potential litigation

8. Assessing Consolidated Corporations • For each of the entities within the corporate family determine: • where the cash is located in the corporate chain and how available it is to service the obligations of the other entities. • the effect of guarantees, cross default provisions, or other inter-relationships. • the functional business dependency of each entity on the other.

9. The Steps in a Restructuring • Arranging debtor in possession financing • Identifying stakeholders and their interests • Conducting meaningful communication with stakeholders • Dealing with immediate relationship issues • Sharing information about the need to restructure • Developing restructuring alternatives • Building consensus around a plan

10. Getting the Appropriate Internal Help • Identify the members of management with the knowledge and skill set. • Consider the need for additional management with particular skills which assist the restructuring. • Be sensitive to the fact that management may be reacting to increased scrutiny and the introduction of outsiders.

11. Getting the Appropriate External Help • Determine the need for outside advisors: • Chief Restructuring Officer • Financial Advisor/Accountants who may become Monitor • Lawyers • Investment Bankers • Industry Experts • HR and Pension Specialists

12. Identifying Stakeholder Interests • Identify the stakeholders and their interests as a possible source of tipping the corporation into a crisis that will require response: • Lenders • Employees and Retirees • Suppliers • Landlords • Customers • Governments/Pension Regulators

13. Stakeholder Reaction to Communication • Consider the needs of the business from each stakeholder group. • Consider the possible actions that each of those groups may take when learning of pending insolvency. • Consider the effect on each group of the failure to make timely disclosure of a pending insolvency.

14. Stakeholder Reaction to Communication • Stakeholder reactions may have a significant impact on the ability of the corporation to carry on its business if customers, suppliers and/or creditors lose confidence and refuse to continue to do business. • The Audit Committee may be put in the position of confirming or countering speculation in the press which is affecting stakeholders.

15. Directors’ Duties • Audit Committee and all Directors retain a fiduciary duty to do what is in the best interest of the company. • Generally, assumes that the goal is a continuing corporate entity. • The fiduciary duty is owed to the corporation only and not to individual stakeholders or stakeholder groups.

16. Stakeholder Expectations Directors are required to be mindful of stakeholders’ interests and legitimate expectations based upon: • general commercial practice • the nature of the corporation • the relationship between the parties • past practice • ability of stakeholders to take steps to protect themselves • contracts and agreements • representations

17. Fair Treatment Among Stakeholders • Very little sophisticated judicial guidance on the balancing of interests. • The Audit Committee has special functions. • Not required to make decisions which may favor one group of stakeholders over another. • Charged with the responsibility to ensure that information is shared equally, or at least ratably, between the stakeholder groups.

18. Protection of Directors • Ensure that the company has made the payments which would otherwise expose the directors to personal liability. • Source deductions for unremitted taxes, withholding for CPP and EI • Wage liabilities such as under the Wage Earner Protection Act • Ensure proper insurance in place.

19. The Personal Decision to Continue • An insolvency may impact the willingness of Committee Members to continue to serve: • the number of meetings will increase • insolvency expertise or specialized business expertise will be required • Committee Members will be under intense scrutiny • director resignations may alter the perception of the business