It has been said that a little paranoia is good for a Board. To that I would add, so too may be healthy doses of skepticism and curiosity. I attended a director’s roundtable recently and heard about a new world of corporate governance under the Dodd-Frank Wall Street Reform and Consumer Protection Act. You may think this law, passed last year in the wake of the financial collapse of 2008–2009, applies only to financial institutions. It goes much further, and touches most public companies with new disclosures and mandates and, if history is any lesson in the wake of Sarbanes-Oxley and similar laws of the last decade, could leave fingerprints on non-profit entities as well – a form of governance “creep”.
At the roundtable, presenters described renewed enforcement focus at the SEC, which now houses new investigative units for market abuse, asset management and the Foreign Corrupt Practices Act, and now armed with new “offensive strategies” that include criminal enforcement, non-criminal “cooperation initiatives”, and risk-based investigative programs. Remedies are wide-ranging, including disgorgement of financial gains for companies and clawbacks with a 3-year lookback for executive officers – both current and former. Whistleblower provisions provide huge incentives to individuals – between 10% and 30% of monetary sanctions – for information leading to successful enforcement actions under securities laws, and that arguably encourage whistleblowers to bypass company internal compliance systems. At the same time, say-on-pay and on golden parachutes, and proxy access, are here to stay with even more detailed proxy disclosure requirements.
It seems the ongoing march toward greater Board governance accountability is accelerating. The pressure on Boards and directors is intensifying, and it shows this last year, during which:
• The SEC sued three former outside directors of DHB Industries on grounds they were “willfully blind” to the company’s fraudulent accounting practices.
• In SEC v. Raval an audit committee chair was sued for failing to sufficiently investigate red flags surrounding expenses of a former CEO.
• In SEC v. Krantz an outside director and audit committee members were accused of being willfully blind to red flags of company’s accounting fraud.
In short, the SEC is not shy about targeting directors for what it sees as dereliction of duty.
The pressure on directors – and particularly outside directors – is mounting. Where does this leave our boards, and the willingness or propensity of directors to take on the new challenges? Perhaps directors should be more knowledgeable, spend more time on the job, be paid more for it, and stay for so long as they are still contributing. Maybe not. The debate is ongoing.
At a recent meeting of the National Association of Corporate Directors I had the opportunity to have a discussion with Robert C. Pozen, a nationally acclaimed expert on the Wall Street financial collapse and corporate governance, about the role of directors in a changing governance environment. A summary of that discussion appears here. Mr. Pozen is Chairman Emeritus of MFS Investment Management, and a senior lecturer at the Harvard Business School and a Senior Research Fellow at the Brookings Institution. He is an outside director of Medtronic, Inc, and Nielsen, Inc., and is the author of various books on financial mangagement and governance.
The discussion went like this. The Sarbanes-Oxley Act of 2002 (“SOX”) focused on the need for more independent directors on boards, audit procedures and internal controls, all intended to make governance more effective. Ten years later, the Dodd-Frank Act is another lengthy piece of legislation that in effect is an indictment of the failures of SOX. SOX did not protect Lehman Bros, ALG or other institutions from failure, each of which did have SOX protections in place. The key to good corporate governance is in the culture of the Board, and the way it functions in its oversight responsibility. One key to effective performance is the use of board executive sessions, without management present. Only in executive session where board members may freely debate issues of concern about the institution can effective decision-making begin. It is best to have such session before the full board meeting, for the purpose of helping establish the agenda and course of the board meeting.
There are three additional major issues boards need to address:
1. Size of the board. Less than 10 outside directors, with no more than one CEO insider is preferred. It is easier to reach consensus with a smaller board, and easier to avoid inattention by any one board member.
2. Experience. The majority of board members should have deep experience in the industry represented by the institution. The number of generalists on the board should be limited, while recognizing the need for financial experts, who likely will be retired members of audit firms. Otherwise, the pool of experienced director should come from among retired executives of competitors of the institution, who know the business thoroughly. Former Federal cabinet officials, and by implication public office holders, are not good recruits for boards. Reputation in government circles is not enough to bring business acumen or expertise to a board. Sitting CEO’s are not to be favored either, because they are too busy in their own business and not steeped in the business of the institution being governed.
3. Time. The amount of time a director spends on an institution’s governance reflects directly on how much a director knows. Those who cannot spend the time on the business do not have the ability to know the business. They are too reliant on the information provided by management, and tend to receive only the information that management wants the board to know.
Arguments against addressing these major issues:
1. Do retirees make good board members? They may not be up to date on current business issues. This is not necessarily so; many if not most sitting board members today are retired, and have no problem staying up to date.
2. Would directors pay will have to be increased to capture more of their time and attention? Raising director compensation is all right provided payment is primarily equity based, aligning directors’ interest with those of shareowners.
3. Would a more professional board tend to micro-manage the business? This can be overcome by carefully focusing directors’ attentions on issues appropriate for board consideration, and on informing the board of any management issue found by the auditors to be debatable “close calls”, as well as alternatives to management decision-making that were considered or that could have been considered. Audit committee members should feel free, and driven, to “walk around” and talk to people in mid- and line-management.
Ultimately, executive compensation is one of the most important issues of governance. Work done in the wake of SOX on bonuses and clawbacks is good. But, the measurement periods should be re-examined. A performance measurement period for bonus awards should be 3 years, not 1 year. Restricted shares don’t work, since their value depends on factors unrelated to performance. Options can better reflect performance-based measures and assure continued strong alignment with shareowner interests. Directors should be awarded performance-based stock options, and they should be required to hold exercised options for extended periods of time.
Advisory say-on-pay votes by shareowners are fine, but not largely effective in the long run. Compensation formulae and performance-based criteria are too complex for most shareowners to digest in voting the proxy. However, say-on-pay has been helpful in prompting boards to roll back excessive pay and truly underserved pay. For the more detailed compensation packages, the board should have the final decision.
Boards should be prepared to accept information brought to them by management, but also be prepared to seek out from among company managers information that may reinforce or contradict what management has offered. Boards should weigh management presentations, but also focus on weak points such as risk, plan execution, alternatives and operations.
Term limits and mandatory retirement should not be favored. Such arbitrary deadlines to not take appropriate account of knowledge, ability or understanding of the business. There are other ways to address ineffective or inattentive directors, through performance reviews.
Interesting food for thought, considering that up to 90% or more of the capital assets of the United States are within the management authority of our corporate and nonprofit boards of directors. Wit this thought in mind, look for future comments concerning mandatory education for directors.
