Economic Downturn Week, Part I – Mapping of Your Internal Compliance Controls

This week I will present a series on steps that you can take in your compliance program if you find yourself, your company or your industry in an economic downturn. All of the recommendations I will make are ideas that have been put into action by companies currently facing these issues. They are ideas that you can use if you have scarce or lessened economic resources for your compliance function. Today I will take my cue from the recent Securities and Exchange Commission (SEC) enforcement action against BHP Billiton (BHP) as a key indicator of where greater and more rigorous SEC enforcement is heading. That is in the area of the enforcement of internal controls and steps that you can take right now, even with reduced head count and budgetary resources, to improve your Foreign Corrupt Practices Act (FCPA), UK Bribery Act or other anti-corruption compliance program.

However, before we get to that subject, I want to remember Marques Haynes, who died last week. Haynes was a basket baller extraordinaire who played with the Harlem Globetrotters off and on for 40 years. As was set out in his New York Times (NYT) obituary last week, Haynes “whose dazzling ball-handling skills, exhibited for more than 40 years as a member of the Harlem Globetrotters and other barnstorming black basketball teams, earned him a place in the Naismith Basketball Hall of Fame and an international reputation as the world’s greatest dribbler”. He was the first Globetrotter inducted into the Naismith Memorial Basketball Hall of Fame. I saw Haynes play in the later stages of his career with the Globetrotters; both on ABC’s Wide World of Sports and through their non-stop touring when they came to even my Podunk hometown. So here’s to you Marques and I am sure you have called ‘Next’ for that great pickup game in the sky several times now.

As they made clear with several FCPA enforcement actions from last fall, the SEC has placed a renewed interest in the accounting provisions of the FCPA, specifically the internal controls provisions. The BHP enforcement continued this trend, where there was no evidence that bribes were paid or offered in violation of the FCPA, tet the poor internal compliance controls at BHP led to a $25MM fine. Indeed Kara Brockmeyer, the Chief, FCPA Unit; Division of Enforcement of the SEC, who spoke at the recently concluded Compliance Week 2015, in a session entitled “A New Look at FCPA Enforcement”, reiterated that the SEC was committed to protecting investors in US public companies and those which list other securities in the US, through enforcement of the accounting provisions, including internal controls provisions of the FCPA. It would seem that the reason is straightforward; a company with rigorous internal compliance controls is better able to prevent, detect and remedy any FCPA violations that may occur.

So, in the midst of an economic downturn, what can you do around the FCPA’s requirements for internal controls and current SEC emphasis? I would suggest that you begin with an exercise where you map the internal controls your company has in place to the indicia of the Ten Hallmarks of an Effective Compliance Program, as set out in the FCPA Guidance. While most compliance practitioners are familiar with the Ten Hallmarks, you may not be as familiar with standards for internal controls. I would suggest that you begin with the COSO 2013 Framework as your starting point.

As a lawyer or compliance practitioner you may not be familiar with all the internal controls that you have in place. This exercise would give you a good opportunity to meet with the heads of Internal Audit, Finance and Accounting (F&A), Treasury or any other function in your company that deals with financial controls. Talk with them about the financial controls you may already have in place. An easy example is employee expense reports. Every company I have ever worked at or even heard about requires expenses for reimbursement to be presented, in documented form on some type of expense reimbursement form. This is mandatory for IRS reporting; so all entities perform this action. See how many controls are in place. Is the employee who submits the expense reimbursement required to sign it? Does his/her immediate supervisor review, approve and sign it? Does any party in the employee’s direct reporting chain review, approve and sign? Does anyone from accounts payable review and approve, both for accuracy and to make sure that all referenced expenses are properly receipted? Is there any other review in accounts payable? Is there any aggregate review of expense reports? Is there a monetary limit over which additional reviews and approvals occur?

Now if an employee has submitted expenses for activities that occurred outside the US are there are any foreign government officials involved? Were those employees identified on the expense reimbursement form? Was the business purpose of the meal, gift or other hospitality recorded? Can you aggregate the monies spent on any one foreign official or by a single employee in your expense reporting system? All of these are internal controls that can be mapped to the appropriate prong of the Ten Hallmarks or other indicia of your compliance program.

You can take this exercise through each of the five objectives under the COSO 2013 Framework and its attendant 17 Principles. From this mapping you can then perform a gap analysis to determine where you might need to implement internal compliance controls into your anti-corruption compliance program. This can lead to remedial steps that you can take. For example you can recommend procedures be written for all key compliance areas in which there are currently no procedures and your existing procedures can be updated to include compliance issues and clear definition how controls are to be evidenced. Through this you can move from having detect controls in place, to having prevent controls, whenever possible.

As a Chief Compliance Officer (CCO) or compliance practitioner, this is an exercise that you can engage in at no cost. You simply investigate and note what internal controls you have in place and how they may be a part of your anti-corruption efforts going forward. As I said last week, compliance is a straightforward exercise. This does not mean that it is easy; you do have to work at it so that you will simply not have a paper, “check the box”, program. But using the excuse that you have limited resources is simply an excuse and a rather poor one at that. While the clear lesson from the BHP enforcement action is that you are required to have effective internal controls in place, by engaging in this mapping exercise you can then figure out what you have and, more importantly, what internal compliance controls that you do not have and need to institute.

Finally, if you do have resources and need some help, you can reach me at the email below.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Is Strict Liability Coming to FCPA Enforcement?

I think that a strict liability standard is coming to Foreign Corrupt Practices Act (FCPA) enforcement. A number of factors have caused me to come to this conclusion. While there may well be wide disagreement as to whether such a standard is warranted under the FCPA, I think it is coming and it is something every Chief Compliance Officer (CCO) and compliance practitioner needs to be ready to address if and when the day comes that your company is under the shadow of a FCPA investigation.

I do not think this strict liability standard is coming for criminal enforcement of the FCPA by the Department of Justice (DOJ) because there is still a requirement of intent under the Act. Intent can be inferred by conscious indifference but I still do not think that day of reckoning is near for DOJ enforcement. However I do think that a confluence of events, FCPA enforcement actions by the Securities and Exchange Commission (SEC) and statements by the SEC representatives, all point towards a new enforcement angle to the FCPA. I think that the SEC is moving towards a strict liability standard for internal controls under the FCPA. That means if your compliance internal control regime is investigated, you will have to demonstrate that it meets some minimum standard that satisfies the SEC. If not, there will be a SEC administrative complaint filed against your company, alleging failure to maintain appropriate internal controls as required by the FCPA and your company will bear the burden of proof to demonstrate that you have designed and implemented an effective system of compliance internal controls.

The FCPA says that internal controls requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that—

(i) transactions are executed in accordance with man­agement’s general or specific authorization;

(ii) transactions are recorded as necessary (I) to per­mit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (II) to maintain accountability for assets;

(iii) access to assets is permitted only in accordance with management’s general or specific authorization; and

(iv) the recorded accountability for assets is com­pared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences. 

As further explained in the FCPA Guidance, “the Act defines “reasonable assurances” as “such level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs.” The Act does not specify a particular set of controls that companies are required to implement. Rather, the internal controls provision gives companies the flexibility to develop and maintain a system of controls that is appropriate to their particular needs and circumstances.””

My evolution of thinking on this issue began last fall with the Smith & Wesson (S&W) FCPA enforcement action. There was nothing in the reported settlement documents that tied the failure of S&W internal controls to the payment (or offer to pay) of a bribe or the obtaining of any benefit. The claims made against S&W were basically along the lines of this language laid out in the Order Instituting Cease-and-Desist Proceedings, “Despite making it a high priority to grow sales in new and high risk markets overseas, the company failed to design and implement a system of internal controls or an appropriate FCPA compliance program reasonably designed to address the increased risks of its new business model.” It should be noted that S&W did not ‘admit or deny’ any of the allegations made against it, the company simply consented to the entry of the Order.

In its Administrative Order, the SEC stated, “Smith & Wesson failed to devise and maintain sufficient internal controls with respect to its international sales operations. While the company had a basic corporate policy prohibiting the payment of bribes, it failed to implement a reasonable system of controls to effectuate that policy.” Additionally, the company did not “devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are executed in accordance with management’s general or specific authorization; transactions are recorded as necessary to maintain accountability for assets, and that access to assets is permitted only in accordance with management’s general or specific authorization.”

All of this was laid out in the face of no evidence of the payment of bribes by S&W to obtain or retain business. This means it was as close to strict liability as it can be without using those words. Kara Brockmeyer, chief of the SEC Enforcement Division’s FCPA Unit, was quoted in a SEC Press Release on the matter that ““This is a wake-up call for small and medium-size businesses that want to enter into high-risk markets and expand their international sales.” When a company makes the strategic decision to sell its products overseas, it must ensure that the right internal controls are in place and operating.””

The second factor that informs my thinking on this issue is the updated COSO 2013 Framework that became effective in December 2014. Larry Rittenberg, in his book COSO Internal Control-Integrated Framework, said that the original COSO framework from 1992 has stood the test of time “because it was built as conceptual framework that could accommodate changes in (a) the environment, (b) globalization, (c) organizational relationship and dependencies, and (d) information processing and analysis.” Moreover, the updated 2013 Framework was based upon four general principles which include the following: (1) the updated Framework should be conceptual which allows for updating as internal controls (and compliance programs) evolve; (2) internal controls are a process which is designed to help businesses achieve their business goals; (3) internal controls applies to more than simply accounting controls, it applies to compliance controls and operational controls; and (4) while it all starts with Tone at the Top, compliance is the responsibility for the implementation of effective internal controls resides with everyone in the organization.”

For the compliance practitioner, this final statement is of significant importance because it directly speaks to the need for the compliance practitioner to be involved in the design and implementation of internal controls for compliance and not to simply rely upon a company’s accounting, finance or internal audit function to do so.

The updated Framework also gives a precise model for the SEC to use to inquire from companies about their compliance internal controls. How many companies could not only present evidence of implementation of compliance internal controls along the lines of the updated Framework but also evidence of their effectiveness? Unfortunately the answer is not many.

There is one other factor that informs my evolution of thinking regarding a strict liability standard under the FCPA. Under Sarbanes-Oxley (SOX), Section 404, public companies are required to report on the adequacy of the company’s internal control on financial reporting. The report must affirm the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. The report must also contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. External auditors must also assess and make such a report. To do so, most companies, and their external auditors were using the prior COSO Framework.

Now imagine a situation where your external auditors have made their report and your company has made such report public, under its SOX 404 reporting obligation. What if the SEC took that report, reviewed it and made an initial assessment that your compliance internal controls around bribery and corruption were not sufficient, as required under the FCPA? What if the SEC sent you a letter asking for evidence of development and implementation of compliance internal controls, also asking for your audited evidence of effectiveness? What if you respond in due course and you receive another letter from SEC, which opines that your compliance internal controls are insufficient under the FCPA giving your proposed fine. You protest that there is no evidence of bribery or corruption regarding this insufficiency of your compliance internal controls. What if your company is then invited to contest this issue through the SEC Administrative process?

Does that sound far-fetched? Maybe it is but, from where I sit, that is the direction I see the issue of internal controls going in FCPA enforcement. I think a strict liability regime is coming under SEC enforcement of the FCPA. As a CCO or compliance practitioner in a public company, you need to be ready to defend your compliance internal controls.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Farewell to Mr. Spock and Risk Assessment Under COSO

Leonard Nimoy died last Friday. He will be forever associated with the role of Mr. Spock in the original Star Trek television show which premiered in 1966. The original series ran for only three years but had a full life in syndication up through this day. He also reprised the role in six movies featuring the crew of the original series and in the recent reboot.

Mr. Spock was about a personal character for me as I ever saw on television. For a boy going through the insanity of adolescence and the early teen years, I found Mr. Spock and his focus on logic as a way to think about things. He pursued this path while dealing with his half human side, which compelled emotions. This focus also led me to explore Mediations by Marcus Aurelius. But more than simply logic and being a tortured soul, Mr. Spock and his way looking at things and Star Trek with its reach for the stars ethos inspired me when it came out and still does to this day.

Mr. Spock and his pursuit of logic inform today’s blog post. Every compliance practitioner is aware of the need for a risk assessment in any best practices compliance program; whether that program is based on the US Foreign Corrupt Practices Act (FCPA), UK Bribery Act or some other compliance law or regime. While the category of risk assessment is listed as Number 3 in the Ten Hallmarks of an Effective Compliance Program in the FCPA Guidance, both the Department of Justice (DOJ) and Securities and Exchange Commission (SEC) intone that your compliance journey begins with a risk assessment for two basic reasons. The first is that you must know the corruption risks your company faces and second, a risk assessment is your road map going forward to manage those risks.

Interestingly Risk Assessment is the second objective in the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Cube. In its volume entitled “Internal Control – Integrated Framework”, herein ‘the Framework Volume’, it recognizes that “every entity faces a variety of risks from external and internal sources.” This objective is designed to provide a company with a “dynamic and iterative process for identifying and assessing risks.” For the compliance practitioner none of this will sound new or even insightful, however the COSO Framework requires a component of management input and oversight that was perhaps not as well understood. The Framework Volume says that “Management specifies objectives within the category relating to operations, reporting and compliance with such clarity to be able to identify and analyze risks to those objectives.” But management’s role continues throughout the process as it must consider both internal and external changes which can effect or change risk “that may render internal controls ineffective.” This final requirement is also important for any anti-corruption compliance internal control. Changes are coming quite quickly in the realm of anti-corruption laws and their enforcement. Management needs to be cognizant of these changes and changes that its business model may make in the delivery of goods or services which could increase risk of running afoul of these laws.

The objective of Risk Assessment consists of four principles. They are:

Principle 6 – “The organization specifies objectives with sufficient clarity to enable the identification and assessment of risks relating to the objectives.”

Principle 7 – “The organization identifies risks to the achievement of its objectives across the entity and analyzes risks as a basis for determining how the risks should be managed.”

Principle 8 – “The organization considers the potential for fraud in assessment risks to the achievement of objectives.”

Principle 9 – “The organization identifies and assesses changes that could significantly impact the system of internal control.”

Principle 6 – Suitable Objectives 

Your risk analysis should always relate to stated objectives. As noted in the Framework Volume, it is management who is responsible for setting the objectives. Rittenberg explained, “Too often, an organization starts with a list of risks instead of considering what objectives are threatened by the risk, and then what control activities or other actions it needs to take.” In other words your objectives should form the basis on which your risk assessments are approached.

Principle 7 – Identifies and Analyzes Risk 

Risk identification should be an ongoing process. While it should begin at senior management, Rittenberg believes that even though a risk assessment may originate at the top of an organization or even in an operating function, “the key is that an overall process exists to determine how risks are identified and managed across the entity.” You need to avoid siloed risks at all costs. The Framework Volume cautions that “Risk identification must be comprehensive.”

Principle 8 – Fraud Risk 

Every compliance practitioner should understand that fraud exists in every organization. Moreover, the monies that must be generated to pay bribes can come from what may be characterized as traditional fraud schemes, such as employee expense account fraud, fraudulent third party contracting and payments and even fraudulent over-charging and pocketing of the differences in sales price. This means that is should be considered as an important risk analysis. It is important that any company follow the flow of money and if the Fraud Triangle is present, management be placed around such risk.

Principle 9 – Identifies and Analyzes Significant Change

It really is true that if there is one constant in business, it is that there will always be change. The Framework Volume states, “every entity will require a process to identify and assess those internal and external factors that significantly affect its ability to achieve its objectives. Rittenberg intones that companies “should have a formal process to identify significant changes, both internal and external, and assess the risks and approaches to mitigate the risk” in a timely manner.

Today’s blog post is a tribute to Mr. Spock as he, Star Trek and its characters continue to teach us lessons which we can apply in business going forward. It is the process of compliance which informs your program going forward. A risk assessment is recognized by sources as diverse as the DOJ, SEC and COSO as a necessary step. Just as Mr. Spock, the Science Officer onboard the Enterprise, was required to assess the risk to the ship and crew from a scientific perspective, a risk assessment can give you the tools to not only assess the corruption compliance risk to your company but a road map to managing that risk. So farewell to my long time friend Mr. Spock, you gave to me more than I ever gave back to you. I can think of no more fitting tribute to Spock than to say Live Long and Prosper.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Assessing Internal Controls, Part III

In this blog post I conclude my exploration of how you should assess your compliance internal controls using the Committee of Sponsoring Organization of the Treadway Organization (COSO), publication “Internal Controls – Integrated Framework, Illustrative Tools for Assessing Effectiveness of a System of Internal Controls”, (herein ‘the Illustrative Guide’) as a starting point and basis for discussion. You will recall from my series on compliance internal controls under the COSO 2013 Framework there are five objectives: (1) Control Environment; (2) Risk Assessment; (3) Control Activities; (4) Information and Communication; and (5) Monitoring Activities. Today I will review issues around compliance internal control assessments on Control Activities and Information and Communication.

One of the things the Illustrated Guide makes clear is the inter-related nature of internal controls. Simply because there may be a deficiency in one specific Principle or even if controls are not present around such a Principle, a company can consider its overall internal controls to effect the principles. For the compliance practitioner I think this is significant because you may have one Principle present and function in the context of another Principle. An example from the Illustrated Guide is the situation where Principle 8, Assessing Fraud Risk is not present yet if other Principles such as Principle 3 Establishing Structure, Authority and Responsibility and Principle 5, Enforcing Accountability adequately address the issue from a control perspective then a deficiency is handled. At the end of the day, unless a major deficiency is noted, it is up to senior management to assess the “severity of an internal control deficiency or combination of deficiencies, in determining whether components and relevant principles are present and functioning, and the components are operating together, and ultimately in determining the effectiveness of the entity’s system of internal control.” So this would also be true from the compliance internal control perspective.

I.     Control Activity

Under the objective of Control Activity there are three principles which you will need to assess. The three principles are:

Principle 10 states that “The organization selects and develops control activities that contribute to the mitigation of risks to the achievement of objectives to acceptable levels.” Your entity must demonstrate that it integrates its compliance function around its risk assessment. You must demonstrate more than simply an ‘out of the box’ compliance solution but that your company has considered specific factors to it, including its relevant business processes, an evaluation of a mix of control activity types and consideration of at what level such compliance controls are applied. Finally there must be evidence that your company has addressed segregation of duties from the compliance perspective.

Principle 11 states that “The organization selects and develops general control activities over technology to support the achievement of the objectives.” Here a company must determine the dependency between the use of technology in business process and technology general controls. Then there must be evidence that it has established relevant technology acquisition, development, and maintenance process control activities over this technology. There must be evidence of the establishment of relevant technology infrastructure control activities and relevant security management process control activities.

Principle 12 states that “The organization deploys control activities through policies that establish what is expected and procedures to put policies into action.” This Principle management to put sufficient compliance policies and procedures in place to support the company’s anti-corruption compliance mandates and requires training of employees on these compliance policies and procedures with testing to determine the adequacy of such compliance training. It also requires evidence that sufficient incentives have been put in place for employees to follow the compliance regime with timely discipline administered for those employees who failed to do so. Finally it requires evidence of period re-assessments of the policies and procedures.

II.    Information and Communication 

This objective has three Principles that require assessment. They are (numbers follow the COSO Framework):

Principle 13 states that “The organization obtains (or generates) and uses relevant, quality information to support the functioning of internal control.” This means that from the compliance perspective you must identify information requirements for your compliance program and then capture that data via internal and external sources. If you cannot do so you must explain why you cannot do so. You must process the information and use it in your compliance function going forward and document that use.

Principle 14 states that “The organization internally communicates information, including objectives and responsibilities for internal control, necessary to support the functioning of internal control.” Under this Principle you must be able to demonstrate that your company communicates compliance internal control information with not only senior management but also appropriate employees and your board of directors. It re-emphasizes the need for separate lines of communications and there is documented consideration to show the reason for selection of the relevant method of communication.

Principle 15 states that “The organization communicates with external parties regarding matters affecting the functioning of internal control.” This Principle relates to your communications to third parties so you will need to demonstrate internal controls around your compliance communications with parties external to your company. You will also be required to show compliance internal controls inbound to your organization from third parties.

III.   Monitoring Activities

The Monitoring Activities objective consists of two principles that require assessment. They are (numbers follow the COSO Framework):

Principle 16 states that an “organization selects, develops and performs ongoing and/or separate evaluations to ascertain whether the components of internal control are present and functioning.” This requires you to have employees knowledgeable in your business processes who can review it on an ongoing basis. You must show that there is a compliance internal controls which, in an objective manner evaluates rates of compliance changes, with an understanding of the baseline and projected business changes. All of this must be integrated with business processes with appropriate adjustments in scope and frequency.

Principle 17 – “The organization evaluates and communicates internal control deficiencies timely to those parties responsible for taking corrective action, including senior management and the board of directors, as appropriate.” Under this Principle you must be able to demonstrate that from the compliance perspective your results were assessed, any deficiencies were communicated to the appropriate parties and finally there was corrective action which was appropriately monitored.

I regularly say that the three most important about FCPA compliance is Document Document Document. I believe the COSO 2013 Framework puts that point into practice, particularly with the auditing requirement. As Ron Kral noted in his article, “Implementing COSO’s 2013 Framework: 10 Questions that Need to be Answered” you must “Verify the adequacy of your documentation and alignment of controls to the 17 principles with the external auditors at key junctions and decision points. Also, consider involving your internal audit function in answering this question. Not only do you want assurance that your documentation of control design is adequately aligned, but also that the controls are operating effectively.”

The auditing process should also work to determine not only if your compliance internal controls are are properly designed, operating effectively but also that the five components are operating together. Kral believes that “This is the essence of any sound internal control evaluation. It’s not merely a matter of satisfying documentation and compliance requirements, but rather a matter of protecting the interests of shareholders.” To which I agree. By going through the auditing exercise, you will have created a framework to operate, assess and update your compliance internal controls to meet the ever-evolving nature of FCPA and other anti-corruption compliance programs.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Assessing Internal Compliance Controls – Part II

In this blog post I continue my exploration of how you should assess your compliance internal controls using the Committee of Sponsoring Organization of the Treadway Organization (COSO), publication “Internal Controls – Integrated Framework, Illustrative Tools for Assessing Effectiveness of a System of Internal Controls” (herein ‘the Illustrative Guide’), as a starting point and basis for discussion. You will recall from my series on compliance internal controls under the COSO 2013 Framework there are five objectives: (1) Control Environment; (2) Risk Assessment; (3) Control Activities; (4) Information and Communication; and (5) Monitoring Activities. Today I will review issues around compliance internal control assessments on Control Environment and Risk Assessments.

First are some general definitions that you need to consider in your evaluation. A compliance internal control must be both present and functioning. A control is present if the “components and relevant principles exist in the design and implementation of the system of [compliance] internal control to achieve the specified objective.” A compliance internal control is functioning if the “components and relevant principles continue to exist in the conduct of the system of [compliance] internal controls to achieve specified objectives.”

I. Control Environment

Under the objective of Control Environment there are five principles which you will need to assess. The five principles are:

1. The organization demonstrates a commitment to integrity and ethical values. Here you can look to see if there is a training program to help make employees cognizant of the importance of doing business ethically and in compliance with the standard’s of your company’s Code of Conduct. Also is there specific training on the Foreign Corrupt Practices Act (FCPA), UK Bribery Act or other relevant anti-corruption/anti-bribery legislation which may govern your organization? Next does your company have in place any process to evaluate “individuals against published integrity and ethics policy”? Finally, do you have in place any process to “identify and address deviations in the organization”?
2. The board of directors demonstrates independence from management and exercises oversight of the development and performance of internal control. Under this Principle you must DOCUMENT the active involvement of your company’s Board of Directors. So not only must risk assessments be performed and evaluated by senior management, they must also be evaluated by the Board, separate and apart from senior management. A Board must also document its review of any remediation plans and monitoring activities.
3. Management establishes, with board oversight, structures, reporting lines and appropriate authorities and responsibility in pursuit of the objectives. This Principle deals primarily with reporting lines and structures so you will need to consider not only the structure of your business but also whether or not both clear and sufficient reporting lines have been established throughout the company. The next analysis is to move down the chain to see if there definitions and assignments for your compliance function. Lastly you need to assess whether there are sufficient parameters around the responsibilities of the compliance function and if there are limitations which should be addressed.
4. The organization demonstrates a commitment to attract, develop and retain competent individuals in alignment with the objectives. Under this Principle you will need to review the policies and procedures to make sure you have the minimum required under a best practices compliance program and then evaluate and address any shortcomings. This Principle also has a more personnel focus by requiring you to consider whether your organization attracts, develops and retains sufficient compliance personnel and is there an appropriate succession plan in place if someone ‘wins the lottery’ on the way to work.
5. The organization holds individuals accountable for their internal control responsibilities in the pursuit of the objective. Under this Principle review is required to determine whether the Board established and communicated the mechanisms to hold employees accountable for your compliance internal controls. As suggested in the FCPA Guidance, there should be both a carrot and stick approach, so for the carrot is there some type of Board, senior management or employee compensation based on whether they did their assignments in compliance with your Code of Conduct or are bonuses based strictly on a sales formulation? For the stick, have any employees ever been disciplined under your compliance regimes?

II. Risk Assessment

This objective has four Principles that require assessment. They are (numbers follow the COSO Framework):

6. The organization specifies objectives with sufficient clarity to enable the identification and assessment of risks relating to objectives which include Operations Objectives, External Financial Reporting Objectives, External Non-Financial Reporting Objectives, Internal Reporting Objectives and Compliance Objectives. Here I think the key is the documentation of several different topics and issues relating to your company and how it operations. This means you will need to assess such diverse concepts as what are your senior management’s choices for business and compliance? You will need to consider and assess tolerances for risk as demonstrated by such issues as operations and financial performance goals. Finally, it can be used as a basis for committing of compliance resources going forward.
7. The organization identifies risks to the achievement of its objectives across the entity and analyzes risks as a basis for determining how the risks should be managed. This Principle requires you to take a look at not only your compliance organization but also your business structure including entity, subsidiary, division, operating unit, and functional levels. You should assess the involvement of your compliance function at each point identified and the appropriate levels of management therein. Finally, from the compliance perspective, you should attempt to estimate not only the significance of compliance risks identified in the risk assessment but also determine how to respond to such identified compliance risks.
8. The organization considers the potential for fraud in assessing risks to the achievement of objectives. Bribery and corruption can be categorized as forms of fraud. Rather than being fraud against the company to obtain personal benefits it can be fraud in the form of bribery and corruption of foreign government officials. For the compliance internal control assessment around this Principle I would urge you to ‘follow the money’ in your organization and consider the mechanisms by which employees can generate the funds sufficient to pay bribes. Many of these are simply fraud schemes so you should consider this within the compliance context and assess incentive and pressures on employees to make their numbers or be fired. You should also assess your employees’ attitudes and rationalizations regarding same.
9. The organization identifies and assesses changes that could significantly impact the system of internal control. This Principle speaks to the need of your organization to maintain personnel competent to use the risk assessment going forward. But it also requires you to assesses changes in the external environment, assess changes in the business model or other significant business changes and, finally, to consider any changes in compliance leadership and how that would impact this Principle.

I often say that good compliance is simply good business. These COSO objectives are not only important from the compliance perspective but they also speak to the issue of overall process in your organization. The more you can burn these activities into the DNA of your company, the better run your organization will be going forward. Auditing against the COSO standards will provide your management with greater information on the health of your organization and satisfy your legal requirements under the FCPA.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Assessing Compliance Internal Controls – Part I

I have recently detailed the COSO 2013 Framework in the context of a best practices compliance regime. However there is one additional step you will need to take after you design and implement your internal controls. That step is that you will need to assess against your internal controls to determine if they are working.

In its Illustrative Guide, the Committee of Sponsoring Organization of the Treadway Organization (COSO), entitled “Internal Controls – Integrated Framework, Illustrative Tools for Assessing Effectiveness of a System of Internal Controls” (herein ‘the Illustrative Guide’), laid out its views on “how to assess the effectiveness of its internal controls”. It went on to note, “An effective system of internal controls provides reasonable assurance of achievement of the entity’s objectives, relating to operations, reporting and compliance.” Moreover, there are two over-arching requirements which can only be met through such a structured post. First, each of the five components are present and function. Second, are the five components “operating together in an integrated approach”? Over the next couple of posts I will lay out what COSO itself says about assessing the effectiveness of your internal controls and tie it to your compliance related internal controls.

As the COSO Framework is designed to apply to a wider variety of corporate entities, your audit should be designed to test your internal controls. This means that if you have a multi-country or business unit organization, you need to determine how your compliance internal controls are inter-related up and down the organization. The Illustrative Guide also realizes that smaller companies may have less formal structures in place throughout the organization. Your auditing can and should reflect this business reality. Finally, if your company relies heavily on technology for your compliance function, you can leverage that technology to “support the ongoing assessment and evaluation” program going forward.

The Illustrative Guide suggests using a four-pronged approach in your assessment. (1) Make an overall assessment of your company’s system of internal controls. This should include an analysis of “whether each of the components and relevant principles is present and functioning and the components are operating together in an integrated manner.” (2) There should be a component evaluation. Here you need to more deeply evaluate any deficiencies which you may turn up and whether or not there are any compensating internal controls. (3) Assess whether each principle is present and functioning. As the COSO Framework does not prescribe “specific controls that must be selected, developed and deployed” your task here is to look at the main characteristics of each principle, as further defined in the points of focus, and then determine if a deficiency exists and it so what is the severity of the deficiency. (4) Finally, you should summarize all your internal control deficiencies in a log so they are addressed on a structured basis.

Another way to think through the approach could be along the following lines. A Principle Evaluation should consider “the controls to effect the principle” and would allow internal control deficiencies to be “identified along with an initial severity determination.” A Component Evaluation would “roll up the results of the component’s principle evaluations” and would allow a re-evaluation of the severity of any deficiency in the context of compensating controls. Lastly, an overall Effectiveness Assessment which would look at whether the controls were “operating together in an integrated manner by evaluating any internal control deficiencies aggregate to a major deficiency.” This type of process would then lend itself to an ongoing evaluation so that if business models, laws, regulations or other situations changed, you could assess if your internal controls were up to the new situations or needed adjustment.

The Illustrative Guide spent a fair amount of time discussing deficiencies. Initially it defined ‘internal control deficiency’ as a “shortcoming in a component or components and relevant principle(s) that reduces the likelihood of an entity achieving its objectives.” It went onto define ‘major deficiency’ as an “internal control deficiency or combination of deficiencies that severely reduces the likelihood that an entity can achieve its objectives.” Having a major deficiency is a significant issue because “When a major deficiency exists, the organization cannot conclude that it has met the requirements for an effective system of internal control.” Moreover, unlike deficiencies, “a major deficiency in one component cannot be mitigated to an acceptable level by the presence and functioning of another component.”

Under a compliance regime, you may be faced with known or relevant criteria to classify any deficiency. For example, if written policies do not have at a minimum the categories of policies laid out in the FCPA Guidance Ten Hallmarks of an Effective Compliance Program, which states “the nature and extent of transactions with foreign governments, including payments to foreign officials; use of third parties; gifts, travel, and entertainment expenses; charitable and political donations; and facilitating and expediting payments”, also formulated in the Illustrative Guide, such a finding would preclude management from “concluding that the entity has met the requirements for effective internal controls in accordance with the Framework.”

However, if there are no objective criteria, as laid out in the FCPA Guidance, to evaluate your company’s compliance internal controls, what steps should you take? The Illustrative Guide says that a business’ senior management, with appropriate board oversight, “may establish objective criteria for evaluating internal control deficiencies and for how deficiencies should be reported to those responsible for achieving those objectives.” Together with appropriate auditing boundaries set by either established law, regulation or standard, or through management exercising its judgment, you can then make a full determination of “whether each of the components and relevant principles is present and functioning and components are operating together, and ultimately in concluding on the effectiveness of the entity’s system of internal control.”

The Illustrative Guide has a useful set of templates that can serve as the basis for your reporting results. They are specifically designed to “support an assessment of the effectiveness of a system of internal control and help document such an assessment.” The Document, Document, and Document feature is critical in any best practices anti-corruption or anti-bribery compliance program whether based upon the Foreign Corrupt Practices Act (FCPA), UK Bribery Act or some other regulation. With the Illustrative Guide of these Illustrative Tools, COSO has given the compliance practitioner a very useful road map to begin an analysis into your company’s internal compliance controls. When the Securities and Exchange Commission (SEC) comes knocking this is precisely the type of evidence they will be looking for to evaluate if your company has met its obligations under the FCPA’s internal controls provisions. In subsequent blog posts I will take a look at how you might audit your compliance internal controls.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

Economic Downturns and Increased Compliance Risk

Oil is hovering around $50 per barrel. For most of the US economy this drop in oil price has provided a much-needed economic boost. One piece on the NPR website, entitled “Oil Price Dip, Global Slowdown Create Crosscurrents For U.S.”, said “economists have suggested the big drop in oil prices is a gift to consumers that will propel the economy.” Liz Ann Sonders, who is the chief investment strategist at Charles Schwab, was quoted as saying “The U.S. economy is 68 percent consumer spending, so right there you know that falling oil prices is a benefit.” Another economist said the positive effects could be “worth $400 billion” for the US economy as a whole.

But in the energy space, particularly in the city of Houston, Texas, this plunge has been devastating. It is so bad that in this past week’s issue of the Houston Business Journal (HBJ), it provided a ‘Box Score’ for energy company lay-offs. And that was before Halliburton announced a 10%-15% reduction and Hercules Offshore announced that it had laid off some 30% of its work force since last October. Nationally, for the energy industry, it will be just as bad. In the NPR piece, David R. Kotok, of Cumberland Advisors, said, “cuts in production and energy company payrolls will cost the U.S. economy up to $150 billion.” The Houston Chronicle headlined it was a “Bloodbath”.

I thought about what this plunge in the price of oil could mean for the compliance function in energy and energy related companies going forward. Many Chief Compliance Officers (CCOs) and compliance practitioners struggle with metrics to demonstrate revenue generation. Most of the time, such functions are simply viewed as non-revenue generating cost drags on business. This may lead to compliance functions being severely reduced in this downturn. However I believe such cuts would be far from short-sighted; they would actually cost energy companies far more in the short and long term.

Almost any energy company of any size has gone through a Foreign Corrupt Practices Act (FCPA) investigation, whether internal or formal by the Department of Justice (DOJ) or Securities and Exchange Commission (SEC). Many had gone through enforcement actions. The risk profiles of these companies did not change because of the drop in oil prices. Extractive resources are still located largely in countries with a high perception of corruption. In others, the inherent compliance risks that currently exist for energy companies will certainly not lessen. Unfortunately they may well increase.

At this point I see two increasing compliance risks for energy companies. The first is that companies will attempt to reduce their costs by cutting their compliance personnel. A tangent but equally important component of this will be that companies that do not invest the monies needed to beef up their oversight through monitoring or other mechanisms are setting themselves up for serious compliance failures.

Moreover, what will be the pressure on the business folks of such companies to ‘get the deal done’ with this slashing of oil prices? Further, if there is a 10% to 30% overall employee reduction, what additional pressures will be on those employees remaining to make their numbers or face the same consequences as their former co-workers?

I think both of these scenarios are fraught with increased compliance risks. For companies to engage in behaviors as I have outlined above would certainly bring them into conflict with the Ten Hallmarks of an effective compliance program as set out in the FCPA Guidance. For instance on resources, the FCPA Guidance does not say in a time of less income, when your compliance risk remains the same or increases, you should cut your compliance function or the resources to support it. Indeed it intones the opposite, when stating, “Those individuals must have appropriate authority within the organization, adequate autonomy from management, and sufficient resources to ensure that the company’s compliance program is implemented effectively.” Moreover, the FCPA Guidance adds, “Moreover, the amount of resources devoted to compliance will depend on the company’s size, complex­ity, industry, geographical reach, and risks associated with the business. In assessing whether a company has reasonable internal controls, DOJ and SEC typically consider whether the company devoted adequate staffing and resources to the compliance program given the size, structure, and risk pro­file of the business.” So the resource issues is stated in reference to the risk profile of the business and not the current or fleeting economic issues of the day.

Also note that the FCPA Guidance speaks to an analysis from the DOJ side, which would presumably be a criminal side review. For instance, if a company cuts its compliance staff while its risk profile has not decreased, does this provide the required intent to commit a criminal act under the FCPA? Moreover, who would be the guilty party under such an analysis? Would it be the Chief Executive Officer (CEO) who ultimately decides we need a fixed percentage cut of employees or simply a raw number to be laid off? How about the department head (as in the CCO) who is told to cut your staff 10% or we will make the cuts for you? Or is it a company’s Human Resources (HR) department who delivers the dreaded knock on a compliance practitioner’s door (I’m from HR and could you come with me). What if a company’s decision-making authority is so decentralized that there is no one person who can be held accountable?

You should also note the SEC role in FCPA enforcement, as alluded to in the quote from the FCPA Guidance. There will be an assessment of internal controls. Now that the COSO 2013 Framework has become effective, will companies delay plans to implement the new Framework and to begin to audit against it? If so, would that be a per se FCPA violation?

But there is a second reason that I believe that energy companies risk profiles will increase in this industry-specific downturn. Unfortunately it will come from those employees who survive the lay offs. They will be under increased pressure to do the jobs of the laid-off folks so there will be a greater chance that something could slip through the cracks. If you are already working full time at one job and one, two or three other employees in your department are laid-off, which job is going to get priority? Will you only be able to put out fires or will you be able to accomplish what most business folks think is an administrative task?

But more than the extra work the survivors will have laid upon them will be the implicit message that some companies senior management may well lay down, that being Get the Deal Done. If economic times are tough, senior management will be looking even more closely at the sales numbers of employees. The sales incentives could very well move from a question of what will my bonus be if I close this transaction to one of will I be fired if I do not close this transaction. If senior management makes clear that it is bring in more business or the highway, employees will get that message.

Once again, where would the DOJ look for to find intent? Would it be the person out in the field who believed he was told that he or she either brought in twice as much work since there were half as many employees left after lay-offs? Would it be the middle manager who is more closely reviewing the sales numbers and sending out email reminders that if sales do not increase, there may well have to be more cuts? What about the CEO who simply raises one eyebrow and says we need to hunker down and get the job done?

What might be the DOJ or SEC reaction to the downsizing of compliance in the face of such increased compliance risk? The energy industry has not gone through this type of economic downsizing in the new age of FCPA prosecutions, largely since 2004, so there is no relevant time frame of FCPA enforcement to reflect from. However, the financial industry did go through such a contraction in the 2007-2010 time frame. We have seen the DOJ and other financial industry regulators draw huge penalties for a series of anti-money laundering (AML) and LIBOR scandals. My guess is that the DOJ and SEC will not allow companies to use economic arguments in the face of known and recognized increase in compliance risks. Indeed they may focus on some of these points as reasons for increased compliance vigilance in an energy company’s compliance function going forward.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

COSO and Internal Controls – Part V

This post concludes my exploration of internal controls and how companies can demonstrate compliance with the internal controls requirement under the Foreign Corrupt Practices Act (FCPA) by adhering to the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 2013 Framework. Today I want to look at the fifth component, Monitoring Activities. In its Executive Summary of the 2013 Framework, COSO said, “Ongoing evaluations, separate evaluations, or some combination of the two are used to ascertain whether each of the five components of internal control, including controls to effect the principles within each component, is present and functioning. Ongoing evaluations, built into business processes at different levels of the entity, provide timely information. Separate evaluations, conducted periodically, will vary in scope and fre­quency depending on assessment of risks, effectiveness of ongoing evaluations, and other management considerations. Findings are evaluated against criteria established by regulators, recognized standard-setting bodies or management and the board of directors, and deficiencies are communicated to management and the board of direc­tors as appropriate.”

However, as with the other components of the COSO Cube, Monitoring Activities are part of an inter-related whole and cannot be taken in singularly. Larry Rittenberg, in his book COSO Internal Control-Integrated Framework, said this objective “applies to all five components of internal control, and the nature of monitoring should fit the organization, its dependence on IT, and the effectiveness of monitoring providing relevant feedback on the other components, including the effectiveness of control activities.” I heartily agree with the author when he says that he believes monitoring will take on increased importance. For the Chief Compliance Officer (CCO) or compliance practitioner, Monitoring Activities has been growing in importance over the past few years and will continue to do so in the future. In their Five Principles of an Effective Compliance Program, developed by Paul McNulty and Stephen Martin at the law firm of Baker and McKenzie, they listed oversight as Principle 5, including ongoing monitoring and this is reinforced in the 2013 COSO Framework.

In an article in Corporate Compliance Insights, entitled “Implementing COSO’s 2013 Framework: 10 Questions that Need to be Answered”, Ron Kral explained that it is important to “ensure that adequate controls are ‘present’ in support of all relevant principles and the components before launching into efforts to prove that the controls are “functioning.” Remember that all relevant principles must be present and functioning in order for a company to safely conclude that their ICFR is effective. Aligning the design of controls to the 17 principles in order to see any gaps early in the implementation process will help ensure adequate time to remediate and test for operating effectiveness.” The same is equally, if not more so, true for your company’s compliance function.

The Monitoring Activities objective consists of two principles. They are:

(1) Principle 16 – “The organization selects, develops and performs ongoing and/or separate evaluations to ascertain whether the components of internal control are present and functioning.”

(2) Principle 17 – “The organization evaluates and communicates internal control deficiencies timely to those parties responsible for taking corrective action, including senior management and the board of directors, as appropriate.”

Principle 16 – Ongoing evaluation

Rittenberg stresses that this Principle requires that “Monitoring should include ongoing or ‘continuous monitoring’ whenever such monitoring is reliable, timely and cost-effective.” This clearly incorporates McNulty and Martin’s dictate that Principle No. 5 consists of not only auditing but ongoing monitoring as well. The reason is simple; they are complementary tools to test the effectiveness of your compliance regime. The same is true of internal controls. But this Principle clearly expects your organization to engage in both types of oversight, monitoring and auditing.

For the CCO or compliance practitioner, there are several different areas and concepts you will need to consider going forward. A current risk assessment or other evaluation of business changes should be considered based upon some type of baseline understanding of your underlying compliance risk. Whatever you select it will need to be integrated with your ongoing business processes, adjusted as appropriate through ongoing risk assessments and objectively evaluated. 

Principle 17 – Communication of internal control deficiencies

This final Principle speaks to deficiencies and their correction. Rittenberg notes it requires a determination of what might constitute a deficiency in your internal control, who in your company is responsible for “taking corrective action and whether there is evidence that the corrective action was taken”. If that does not sound like McNulty Maxim No. 3 What did you do when you found out about it? I do not know what does.

Therefore, under this Principle the CCO will need to take timely and determined action to correct any deficiencies which might appear in your compliance regime. It will require you to assess results, communicate the deficiencies up the chain to the board or Audit Committee, correct and then monitor the corrective action going forward. Adapting Kral, I would urge that every key internal compliance control in support of the 17 Principles should “conclude upon by management in terms of their adequacy of design and operating efficiency.”

Monitoring Activities should bring together your entire compliance program and give you a sense of whether it is running properly. Both ongoing monitoring and auditing are tools the CCO and compliance practitioner should use in support of this objective. Near the end of his section on this objective, Rittenberg states, “Monitoring is a key component of the internal control framework because effective monitoring (a) recognizes the dynamics of change within an organization, and (b) provides the basis for corrective action on a timely basis.” I would add that it allows you to evaluate the effectiveness of that corrective action as well.

This concludes my exploration of COSO and internal compliance controls. While I have cited directly to the language of the COSO 2013 Framework, I hope that you now have a sense of how these concepts directly relate to your company’s compliance program. With the Securities and Exchange Commission’s (SEC) invigorated interest in internal controls, I believe that through adherence to these five objectives and 17 Principles will allow you to not only withstand such government scrutiny but also have a better run organization.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

COSO and Internal Controls – Part III

This post continues my exploration of internal controls and how companies can demonstrate compliance with the internal controls requirement under the Foreign Corrupt Practices Act (FCPA) by adhering to the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) 2013 Framework. To help introduce today’s topic, I cannot think of a much more appropriate person to honor than Dean Smith, who died yesterday. Smith coached the North Carolina Tar Heels basketball team for 36 years. He retired with 879 victories, a winning percentage of 77.6% and two NCAA championships. He was one of the true giants of college coaching and the game of basketball itself. He will be missed but certainly never forgotten. If there was ever a coach that epitomized internal controls and frameworks, it was Dean Smith.

I restart my discussion of the COSO 2013 Framework with a look at the third component, Control Activities. In its Executive Summary of the 2013 Framework, COSO said these “are the actions established through policies and procedures that help ensure that management’s directives to mitigate risks to the achievement of objectives are carried out. Control activities are performed at all levels of the entity, at various stages within business processes, and over the technology environment. They may be preventive or detective in nature and may encompass a range of manual and automated activities such as authorizations and approvals, verifications, reconciliations, and busi­ness performance reviews. Segregation of duties is typically built into the selection and development of control activities. Where segregation of duties is not practical, manage­ment selects and develops alternative control activities.”

However, as with the other components of the COSO Cube, Control Activities are not to be taken in a vacuum. Larry Rittenberg, in his book COSO Internal Control-Integrated Framework, said the Control Activities “have traditionally received the most attention of the component” but noted that the real-world experience since the initial implementation of the COSO Framework back in 1992 has demonstrated that “the effectiveness of control activities must be evaluated with the context of the other five components.” Moreover, he believes that these conditions are aided by a company’s policies and procedures, which should help to lessen and manage risk going forward. Finally, Control Activities should be performed at all levels in the business process cycle within an organization.

The objective of Control Activity consists of three principles. They are:

(1) Principle 10 – “The organization selects and develops control activities that contribute to the mitigation of risks to the achievement of objectives to acceptable levels.”

(2) Principle 11 – “The organization selects and develops general control activities over technology to support the achievement of the objectives.”

(3) Principle 12 – “The organization deploys control activities through policies that establish what is expected and procedures to put policies into action.”

A White Paper, entitled “The Updated COSO Internal Control Framework”, emphasized the inter-related nature of the five objectives when it noted “The risk assessment driven by the company’s management provides a context for designing the Control Activities necessary to reduce risks to an acceptable level (Principles 10, 11 and 12). Note that Principle 10 deals with the selection and development of control activities that mitigate risk to the achievement of compliance objectives, and Principle 12 deals with the development of control activities through established policies and procedures. Principle 11 addresses the impact of controls over general technology to the extent they impact the achievement of control activities.”

Principle 10 – Control Activities to mitigate risk

Rittenberg noted that there is no “silver bullet” in selecting the right internal controls. Yet when combined with your risk assessment, this Principle would point to an integration of your policies, procedures and overall corporate responsibilities, which should be chosen “sufficiently to reduce the risk of not achieving the objectives to an acceptable level.” You should consider your relevant business processes, evaluate your mix of control activities and then consider at what levels within your organization they are applied. But Rittenberg cautions that you should not “begin an analysis of control activities with a list of controls and check off whether they are present or not present. Rather, controls should be assessed in relationship to the risk being mitigated.” 

Principle 11 – Control Activities over general technology

Last week I had a series of guest posts from Joe Oringel of Visual Risk IQ regarding the use of data analytics in your compliance program. The use of technology will be greater and more important going forward. I would certainly expect the Securities and Exchange Commission (SEC) to focus on a company’s use of technology in any evaluation of its overall compliance program.

Therefore, under this Principle you will need to determine not only the use of technology in your compliance related internal controls but also the use of such technology in your overall company business process. To do so, you will need to consider your technology infrastructure, around compliance internal controls, security management of the same and then use this information to move forward to obtain and implement the most appropriate technology around your compliance internal controls.

Principle 12 – Control Activities established through policies and procedures

This Principle should be the most familiar one to the compliance practitioner as it points to the establishment of policies and procedures to support deployment of your compliance regime. It also sets out the responsibility and accountability for executing policies and procedures, specifies and assures corrective action as required and mandates periodic reassessment. Interestingly it also directs that there be competent personnel in place to do so. Rittenberg noted, “Responsibilities for control activities should be identified through policies and various procedures. Processes should be in place to ensure that all aspects are implemented and working.”

While the objective of Control Activities should be the most familiar to the Chief Compliance Officer (CCO) or compliance practitioner, you may well think of it in a way that basketball fans thought of Dean Smith’s Four Corners offense; in other words boring. However, just as Smith’s innovation was based on crisp focus and outstanding teamwork, this objective demonstrates the inter-relatedness of all the five COSO objectives. It is your Control Environment and then Risk Assessment that should lead you to this point. It is the Control Activities objective that lays the groundwork for a living, breathing compliance program going forward.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015

COSO and Internal Controls, Part II

This post continues my exploration of internal controls and how companies can demonstrate compliance with the internal controls requirement under the Foreign Corrupt Practices Act (FCPA) by adherence to the COSO 2013 Framework. Today I will begin a discussion of the updated COSO Framework. Brian Christensen, in an article in Corporate Compliance Insights, entitled “The Updated COSO Framework: Time for a Fresh Look at Internal Control”, said that the updated Framework retained the core definition of internal controls; those being control environment, risk assessment, control activities, information and communication, and monitoring activities. Further, these five operational concepts are still visually represented in the well-known three-dimensional “COSO Cube”. In addition, the criteria used to assess the effectiveness of an internal control system remain largely unchanged. The effectiveness of internal control is assessed relative to the five components of internal controls and the underlying principles supporting the components. However, it is the emphasis on the principles, which is new to the 2013 Framework.

Christensen believes that “COSO has chosen to formalize more explicitly the principles embedded in the 1992 version of the framework that facilitate development of effective internal control and assessment of its effectiveness. While the 1992 version implicitly reflected the core principles of internal control, the 2013 version explicitly states them in the form of 17 principles, each of which is mapped to one of the five components. The 17 principles represent fundamental concepts associated with the five components of internal control. There isn’t any new ground broken by these principles as they reflect widely known tenets of sound internal control that have been around for a long time.” The principles remain broadly stated as they are intended to apply to for-profit companies, not-for-profit entities, government bodies and other organizations. Moreover, “supporting each principle are points of focus, representing characteristics associated with the principles and providing guidance for their application. Together, the components and principles constitute the criteria and the points of focus provide the guidance that will assist management in assess­ing whether the components of internal control are present, functioning and operating together within the organization.”

 

The first of the five objectives is ‘control environment’. Larry Rittenberg, in his book COSO Internal Control-Integrated Framework, said the control environment “sets the tome for the implantation and operation of all other components of internal control. It starts with the ethical commitment of senior management, oversight by those in governance, and a commitment to competent employees.” The five principles of the control environment object are as follows:

1. The organization demonstrates a commitment to integrity and ethical values.
2. The board of directors demonstrates independence from management and exercises oversight of the development and performance of internal control.
3. Management establishes with board oversight, structures, reporting lines and appropriate authorizes and responsibility in pursuit of the objectives.
4. The organization demonstrates a commitment to attract, develop and retain competent individuals in alignment with the objectives.
5. The organization holds individuals accountable for their internal control responsibilities in the pursuit of the objective.

Commitment to integrity and ethical values

What are the characteristics of this principle? First, and foremost, is that an entity must have the appropriate tone at the top for a commitment to ethics and doing business in compliance. It also means that an organization establishes standards of conduct through the creation of a Code of Conduct or other baseline document. The next step is to demonstrate adherence to this standard of conduct by individual employees and throughout the organization. Finally, if there are any deviations, they would be addressed by the company in a timely manner. From the auditing perspective, I think that this principle requires an auditor to be able to assess if a company has the met its requirements to ethics and compliance and whether that commitment can be effectively measured and assessed.

 Board independence and oversight

 

This principle requires that a company’s Board of Directors establish oversight of a compliance function, separate and apart from the company’s senior management so that it operates independently in the compliance arena. Next there should be compliance expertise at the Board level which allows it actively manage its function. Finally, and perhaps most importantly, a Board must actively provide oversight on all compliance control activities, risk assessments, compliance control activities, information, compliance communications and compliance monitoring activities. Here, internal auditors must interact with a Board’s Compliance Committee (or other relevant committee such as the Audit Committee) to determine independence. There must also be documented evidence that the Board’s Compliance Committee provides sufficient oversight of the company’s compliance function.

 

Structures, reporting lines, authority and responsibility

 

This may not seem as obvious but it is critical that a compliance reporting line go up through and to the Board. Under this principle, you will need to consider all of the structures of your organization and then move to define the appropriate roles of compliance responsibility. Finally this principle requires establishment of the appropriate authority within the compliance function. Here your auditors must be able to assess whether compliance responsibilities are appropriately assigned to establish accountability.

 

Attracting, developing and retaining competent individuals

 

This principle gets into the nuts and bolts of doing compliance. It requires that a company establish compliance policies and procedures. Next there must be an evaluation of the effectiveness of those compliance policies and procedures and that any demonstrated shortcomings be addressed. This principle next turns the human component of a compliance program. A company must attract, develop and retain competent employees in the compliance function. Lastly, a company should have a demonstrable compliance succession plan in place. An auditor must be able to demonstrate, through its compliance policies and equally importantly its actions, that it has a commitment to attracting, developing and retaining competent persons in the compliance function and more generally employees who accept the company’s general principle of doing business ethically and in compliance.

 

Individuals held accountable

 

This is the ‘stick’ principle. A company must show that it enforces compliance accountability through its compliance structures, authorizes and responsibilities. A company must establish appropriate compliance performance metrics, incentives to do business ethically and in compliance and finally clearly reward such persons through the promotion process in an organization. Such reward is through an evaluation of appropriate compliance measures and incentives. Interestingly a company must consider pressures that it sends through off-messaging. Finally, each employee must be evaluated in his or her compliance performance; coupled with both rewards and discipline for employee actions around compliance. This principle requires evidence that can demonstrate to an auditor there are processes in place to hold employees accountable to their compliance objectives. Conversely, if an employee does not fulfill the compliance objectives there must be identifiable consequences. Lastly, if this accountability is not effective, the internal controls should be able to identify and manage the compliance risks that are not effectively mitigated.

 

I will take a short break from my explorations of COSO and Internal Controls next week, but do not worry the subject will return the week of February 9. Next week I will have a series of guest posts from Joe Oringel, Principle at Visual RiskIQ on data analytics.

This publication contains general information only and is based on the experiences and research of the author. The author is not, by means of this publication, rendering business, legal advice, or other professional advice or services. This publication is not a substitute for such legal advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified legal advisor. The author, his affiliates, and related entities shall not be responsible for any loss sustained by any person or entity that relies on this publication. The Author gives his permission to link, post, distribute, or reference this article for any lawful purpose, provided attribution is made to the author. The author can be reached at tfox@tfoxlaw.com.

© Thomas R. Fox, 2015