Behind Every Failed Firm, A Bad Board?

By<a Href="">peter Dizikes</a>

N E W &nbsp; Y O R K, July 9, 2002 -- Corporate boards are supposed to be watchdogs in the business world. But they haven't been barking very often lately.

That's why, given the wave of scandals that has swept over the U.S. business world in 2002, the role of those boards is becoming an increasingly central issue for the would-be reformers of corporate America.

To be sure, high-profile former executives — like Enron's Kenneth Lay and Jeffrey Skilling or WorldCom's Bernard Ebbers — have borne much of the public blame so far for the collapses of their companies. But now, Congress and other regulators are beginning to take aim at boards, which are supposed to monitor executives and look out for the interests of shareholders.

For instance, the U.S. Senate Permanent Subcommittee on Investigations, in a report about the failed energy firm Enron that was released on Sunday, pointed a finger at the company's directors, concluding, "Much that was wrong with Enron was known to the board."

In a New York Times editorial on Monday, Sen. John McCain, R-Ariz., called for boards to be composed of directors who "have no material relationship with the company or personal relationship with its management."

And the New York Stock Exchange's recent proposal for better corporate governance, released in June, calls for at least half of the directors on any corporate board to be from outside the company — the better to sound the alarm when they think things are going awry.

The Problems? Too Little Time …

While boards may be under fire at the moment, some observers of corporate ethics say the current scandals have merely brought new attention to a longstanding issue.

"The problem of the passive board is an old one," says Charles Elson, director of the Center for Corporate Governance at the University of Delaware.

Still, the accounting and managing problems revealed by Fortune 500 companies have been of historic proportions. Enron filed the biggest bankruptcy claim in U.S. history last November, while WorldCom announced in June it had misrepresented more than $4 billion in expenses.

Others think modern financial tools — like the off-the-books partnerships Enron used to hide debt — have become too sophisticated for a board to fully keep track of its firm's finances. In tough economic times, that can lead executives to try to fudge the numbers.

"Companies have just become so much more complicated and complex," says Don Hambrick, a professor at Penn State University's Smeal College of Business in State College, Pa. "Boards have never been terrifically vigilant … but in the last 18 months, the combination of increased complexity, plus the shortfall in performance has caused managers to do screwy and unethical things."

On one level, the problem of effective oversight is a matter of time. Directors, while often earning hundreds of thousands of dollars for sitting on a corporate board, typically spend about two weeks' worth of work per year on the company in question. And directors are frequently high-flying executives from other realms of business who serve on multiple boards and may not have the time or attention to fully scrutinize a firm's affairs.

… And Too Much CEO Power …

But then there are the cases of simple transactions approved by the board, like huge loans to executives, which have blown holes in the finances of some companies. For instance, WorldCom announced its former chief executive officer, Bernard Ebbers, owed the firm more than $400 million in board-approved loans. Troubled cable company Adelphia Communications loaned $2.3 billion to the family of CEO John J. Rigas, a transaction that has helped put the firm in dire straits.

Many business ethicists think the boards in question should have nixed both deals — but say boards have frequently become watered down with directors essentially chosen by the CEO himself. And that, say some, is the result of a business culture too heavily focused on top-of-the-heap executives.

"Over the past few years, we've watched the emergence of the CEO as superstar," says Harold Star, a professor of management at the University of Buffalo.

As a result, claims, Hambrick, "These independent directors are almost always selected with the heavy input … of the CEO himself. Even if it's an outside nominating committee, the CEO gets to say whether he likes their ideas or not. They can be long-term buddies or cronies."

What Is to Be Done?

While critics of the current corporate culture tend to agree about the problems with boards, they also have varying ideas about what should be done.

Many people think separating the roles of CEO and Chairman of the Board — which is mandated in some countries, including Canada and Great Britain — would increase the board's authority and power to act.

"It's very commonplace for the CEO to be the chairman of the board," notes Star. "But when you let the CEO be chairman of the board, you let the fox into the henhouse. The fox is in fact running the henhouse."

The NYSE's recommendation would give firms a two-year transition period to make at least half their board members independent of ties to the firm. The NYSE also wants all the members of three important executive committees — the auditing, nominating and compensation committees — to be entirely composed of independent directors, and calls for the definition of "independent" to include a "five-year cooling-off period" for former company employees.

Hambrick, for one, recommends that board members should take an equity stake in a company rather than accept cash compensation, thus further aligning their interests with those of the shareholders.

"It should be restricted stock that they can't sell until they leave," argues Hambrick, which he says would cut down on "short-termism and opportunism."

Market Power

Still, Hambrick is unsure if even the current calls for corporate reform will turn into concrete changes in the way firms must do business.

The most certain route to change, he says, "has to occur through the pressure of institutional investors, and possibly the action of the SEC or NYSE or other regulatory bodies."

Others think that well-connected public companies with plenty of lobbying muscle will be able to resist or limit any government regulations dictating the way boards are set up. Instead, suggests Star, the most effective impetus for change could come from the marketplace itself.

"There are tens of thousands of firms that are playing it straight," says Star. "If you're a CEO and you want to make it clear you're straight, what's the one thing you can do? You can say, 'We have a really independent board.' It's in the self-interest of a really good CEO to say the board is independent."

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