Twelve Lessons For Corporate Directors From Recent Governance Failures
By: JOHN H. STOUT
As published in the Star Tribune, September 29, 2002
It’s been a challenging year for governance – from the Board rooms of some very high profile public companies to the Catholic Church, we’ve had almost daily headlines reflecting governance failures. What can be learned from these failures?
1. Integrity is everything. It is the root of stakeholder and public confidence in an organization and its public pronouncements, financial statements, etc. Directors are responsible for the company’s integrity and must view its integrity as intertwined with their own. Organizational integrity starts at the top, i.e., the Board of Directors and senior management.
2. Boards must take more responsibility for compensation, perks and incentives. The media and several institutional shareholders have flogged this subject for years. And it’s critical that Boards do a better job. Recent disclosures of compensation levels and perks paid to senior management of troubled companies have incensed the public and their political representatives. Even in relatively successful companies like GE, Jack Welch-style perks are offensive. Compensation plans for senior executives and other managers must be reviewed to assure improper behavior is not incentified. Boards must realize that excessive director and executive compensation reflects poorly on their independence, integrity and judgment. Finally, some business groups may be addressing the problem; see the September 17, 2002, Conference Board Blue Ribbon Commission report on executive compensation.
3. Carefully assess actual and perceived conflicts of interest. Conflicts of interest in general, but particularly involving directors, senior management and key advisors, must be carefully assessed, and independent advice sought where necessary. This was a major problem with several of the Enron special purpose entities. Like the compensation issues, unresolved or poorly resolved conflicts of interest reflect badly on Boards’ independence, integrity and judgment.
4. Pay close attention to directors’ duties: care, loyalty, compliance and oversight.
- Care in every decision. Be informed. Directors shouldn’t approve matters they don’t understand. Real or perceived pressures shouldn’t overshadow the duty to make an informed judgment.
- Loyalty. The interests of the company always come first. Directors shouldn’t use their position or the confidential information they gain for their or others’ benefit. Boards must avoid being compromised by compensation or benefits which could actually, or be perceived in hindsight to, compromise their judgment.
- Compliance. Pay attention to the company’s governing documents, policies and agreements, and the laws and regulations to which the company is subject. It is difficult to enforce a company’s code of conduct and standards of legal compliance if the Board and management don’t conduct themselves accordingly.
- Oversight. A Board’s job isn’t to manage; it’s to vigorously oversee and evaluate management. The CEO reports to the Board, not the other way around. An adversarial relationship with management is counterproductive. Collaboration is essential. But personal relationships and compensation can’t be allowed to obscure the need for vigilant oversight.
5. Strive to understand risks. Every business has internal and external risks. Policies and procedures for assessing and monitoring risks are essential, and directors must assure that they are in place and functioning well. Allow risk managers direct access to the Board. Always consider the company’s disclosure obligations relative to risks.
6. Pay attention to warnings. A number of Enron employees expressed concerns about the company’s financial practices and condition. The initial reaction to Sherron Watkins’ warning letter was inadequate. The investigation of her concerns was very limited in scope. Warnings need to be heeded and promptly investigated. Investigation means a thorough effort to obtain all relevant information, using independent resources where necessary to assure objectivity.
7. Confront problems promptly and forthrightly. History provides ample lessons of the disastrous consequences of cover-ups. The U.S. Sentencing Guidelines offer incentives for effective discovery of, and dealing with, problems. As the Arthur Andersen prosecution and the Sarbanes-Oxley Act have underscored, be extremely careful about altering or destroying information if governmental investigations or litigation may reasonably be foreseen.
8. Transparency is good; obscuring reality is bad. Don’t engage in transactions, schemes or practices which make it difficult for those who rely on the company’s financial information to clearly understand that information. If third parties’ decisions are made based on potentially misleading omissions or information litigation and government investigations may ensue.
9. Targets are good; quarterly earnings obsessions are bad. Agreed that plans, targets and accountability are good. But not when the targets are unrealistic or the pressures or incentives to achieve them so great as to result in deliberate distortions, or the use of “cutting edge” accounting or business practices. A recent survey by CFO Magazine found that 17% of CFOs, many from the nation’s largest companies, had been pressured by CEOs one or more times in the last five years to misrepresent financial results. Directors need to be aggressive about investigating and ending that pressure.
10. Monitor corporate disclosures. Be aware of the company’s responsibility for accurate, complete disclosure to banks, creditors, insurance companies, government tax and regulatory authorities and others who rely on or require the company’s business and financial information. Be aware of the many ways in which the company provides information, e.g., public comments by management, management conduct, media interviews, analyst updates, press releases, websites, broadcast or directed email, regulatory agency filings and a multitude of forms and applications for other third parties.
11. Reputations take years to build; moments to lose. For most companies their reputations and goodwill are among their most valuable assets. Boards and senior management must be alert to individual and corporate conduct which compromises a company’s reputation for integrity and trustworthiness with employees, suppliers, customers, lenders and stockholders. As we’ve seen the consequences of a breach of trust can be brutal.
12. Good governance practices. Good governance in actuality, not just in appearance. The Boards of many companies now in the news are populated with individuals who have excellent credentials. Usually the appropriate Board committees are in place. Good governance is about organization, process and EXECUTION. And finally EVALUATION -- evaluation of management, principally the CEO, evaluation of the Board, and evaluation of directors. And even then for directors of complex, far-flung business organizations it may sometimes be a “but for the grace of God” world…