For more than a decade, investors in the US, UK and other markets have been searching for the outward features of governance that promise good decisions within the boardroom. What public foundations are required for unbiased, thoughtful, hard-hitting and timely decisions when boards convene behind closed doors?
The outward signs are important, since directors rarely reveal anything about decisions taken inside the boardroom. Shareholders learn the directors’ identities from annual reports but virtually nothing about what they have done. In the absence of direct data, outward appearances have come to serve as useful proxy - if the board includes respected directors, independent committees and performance-based compensation, then it is more likely, so the argument goes, to make good and timely decisions.
We define governance decisions as those moments when directors face a relatively discrete opportunity to commit company resources to one course of action or another. Inaction in the face of such an opportunity should also be seen as a decision. Taken well, such decisions can drive a company’s growth; taken poorly, they can cause the opposite. To see this, we begin with a comparison of director decisions at two troubled US companies.
When governance decisions fail
The consequence of sub-optimal board decisions is strikingly evident in the 2001 bankruptcy of Enron. We have learned more about its governance decisions than at virtually any other US company following the US Senate subpoenas for director testimony and records, as well as the investigation by Enron’s post-bankruptcy board into decisions made prior to bankruptcy.
The governing board of Enron met many of the contemporary standards for good governance. Its 13 directors included just two company executives; the size was small enough to keep directors engaged; the board chair had been separated from the chief executive; the non-executive directors were largely independent; and the directors had adopted a strong code of conduct.
Yet the outward signs of good governance did not correlate with good decisions inside the boardroom. Despite appearances, the Enron directors took a range of decisions that directly contributed to the company’s demise.
In mid-1999, Andrew Fastow, Enron’s chief financial officer, sought board endorsement of a partnership called LJM. This created a governance problem, since the board’s code of conduct stipulated that “even the appearance of an improper transaction must be avoided,” and that no employee could receive “financial gain separately derived” from service with the company. Yet the special purpose entity that Mr Fastow proposed would result in those conditions, and thus he asked the board to suspend its code.
The board’s audit committee, which was best positioned to make an informed decision on Mr Fastow’s request, did not vet the request before it went to the full board for approval and neither did the finance committee review the financial implications. The directors received the proposal just three days before a special board meeting that was to be held by teleconference on June 28 1999. The agenda for that meeting was also filled with other weighty matters: authorisation of a stock split; placement of shares in a compensation plan; purchase of a corporate jet and investment in a power plant in the Middle East. The board completed its review in just an hour and among its decisions was the suspension of the conduct code to permit the special partnership. It would later approve additional partnerships and suspensions in a similar fashion.
Since Mr Fastow would now sit on both sides of the table in negotiating transactions between the partnerships and Enron, the board asked for controls to prevent conflicts of interest in the wake of the code’s repeated suspension. The directors required that executives review and sign “Deal Approval Sheets” before executing one of the conflicted transactions. But for many of the deals, the board did not enforce its oversight, allowing executives to either not prepare or not sign the approval sheets.
When Mr Fastow secretly enjoyed a $30m windfall from his partnerships in 1999-2000, Enron directors became suspicious, and the board’s finance committee requested that its compensation committee investigate. The chair of the compensation committee in turn asked Enron’s top human resources officer for data on Mr Fastow’s earnings, but the officer did not provide the data. When the committee chair asked for it again but failed to receive it a second time, he dropped the matter.
Members of the Enron board entered meetings ill-prepared to make educated choices. They deliberated so briefly that informed decisions were unlikely, approved management’s illicit partnerships hastily and exercised faulty oversight of the conflicted decisions that followed. When Enron directors became concerned about illicit executive compensation, they decided not to heed the warning signs.
When governance decisions succeed
The Enron board still might have averted bankruptcy had it decided to remove top management once it became aware of how the partnerships were being misused for executive gain. A decade earlier, that was how the Salomon Brothers board saved its company from damage brought about by a rogue trader and a chief executive who failed to take timely action.
On February 21 1991, Salomon bond trader Paul Mozer made an illegal $3.2bn bid for US treasury securities. His superior, John Meriwether, reported the transaction to top management on April 28, but CEO John Gutfreund did not take the infraction seriously and failed to report it for more than three months.
Mr Gutfreund was so discredited by the delay when it became public that he appreciated that his career with Salomon was finished. He called upon Salomon outside director Warren Buffett to step in to resurrect the company and its shattered credibility.
Two days later, Mr Buffett took the reigns of Salomon with the board’s vigorous backing. He forced out the old management team and installed his own. Instead of shredding evidence, he turned it over to investigators. Rather than delegating enforcement to others, he named himself the chief compliance officer. Instead of suspending the code of conduct, he insisted that any violation of ethical standards, federal regulation or public statute be brought immediately to his personal attention.
Although Salomon paid dearly for its rogue trader - customers fled, shares dropped and fines topped $290m - the firm survived, prospered and was later sold to Travelers Group for $9bn. Had Mr Buffett not cleaned house with the board’s support, 9,000 Salomon employees would almost certainly have lost their jobs and thousands of investors their equity.
By contrast, no Enron director decided to step forward when the scale of the improper partnerships became known. Nor had the directors taken earlier decisions that might have stopped the malfeasance in the first place when the early warning signs were reaching the boardroom.
The primary function of a board is to protect investors’ equity - and to pick quality managers to husband and expand that equity. The Enron directors, however, approved a chief financial officer who hid critical information from them, appointed a chief executive who failed to supervise the CFO, and accepted flawed partnerships that they did not fully understand. When it unravelled, none stepped forward to spearhead a process of housecleaning and restoration.
Building composition and policies for board decisions
Taken together, these examples point to the importance of preparing boards for making good decisions. Composing the board well and setting the right policies are essential pre-conditions for that.
The oversight team brought in to resurrect Enron took the view that the failure of its directors to protect the company was partly a product of the shortcomings of those that met in the boardroom, and it replaced all board members. So too did WorldCom and Tyco in the wake of the decisions by their boards that permitted executives to mismanage their companies.
Consistent with what academic research would recommend, new directors for all three companies were more independent of management and brought stronger governance and management backgrounds to their boardrooms. The new boards were also smaller than those that they replaced, and that too was consonant with what research studies confirm: namely that smaller teams (and smaller boards in particular) generally make better decisions. As a foundation for governance decisions, board composition matters.
Had they been in place in 2001, new policy provisions from the New York Stock Exchange and Securities and Exchange Commission might have prevented the lapses in governance at Enron. For example, the NYSE’s new rules for listed companies require that:
Non-executive directors must regularly meet without management. Had Enron’s outside directors met without the CEO from time to time, their private misgivings about the partnerships and the CFO’s personal gains might well have congealed into a board decision to retract them.
Companies must have audit, compensation, and nominations/governance committees that are comprised of independent directors. If Enron’s audit committee had not included two directors who were not entirely independent, it might have earlier questioned the purpose of the company’s increasingly questionable special purpose entities, and it may have recommended to the full board that it reject management’s request for approval.
Companies must adopt a code of conduct and disclose any waiver of the code for directors and officers. If Enron had been required to disclose publicly that it had waived its conduct code to allow its CFO to sit on both sides of its partnership transactions, it might well have pulled back from its decision to do so.
While the US has spearheaded reforms for better decision-making in the boardroom, comparable initiatives have recently emerged elsewhere. Companies in the UK, for example, have been subject to several waves of reform, beginning with a 1992 commission headed by Adrian Cadbury, to more recent ones urging greater director independencce and stronger audit committees. Similar recommendations have been issued by organisations in Brazil, Canada, France, Germany, Spain and the European Union. India and China are also moving in the same direction.
Building the process and culture for board decisions
Good governance decisions depend upon a proactive board process and a prescriptive governance culture. These should be viewed as necessary additions to a board’s composition and policies. They help to ensure that the directors are asked to make the major decisions but, at the same time, that they do not inadvertently slide into management of the company.
Many companies are adopting issue calendars and decision protocols as part of a proactive process. The issue calendar usefully requires that the board address all major decision areas on an annual cycle. The directors of one major US company, for example, evaluate the strategic plan in January, the annual budget in March, past performance in May, the operating plan in June, executive compensation in September and succession planning in November.
The decision protocol, sometimes termed the company’s “delegation of authority”, outlines decisions that the board must take or delegate to management. One large company, for example, has adopted a decision protocol that requires directors to decide upon the following issues: the annual business plan; capital structure and indebtedness limits; officer hiring and compensation; financial risk management; company insurance policy; transactions exceeding a specified dollar threshold in the areas of acquisitions and divestitures, capital expenditures, litigation settlements, tax resolutions, fines and penalties, contingent liabilities, pension contributions, restructurings, and changes in accounting policies that impact revenue or pre-tax income.
HBOS, one of the UK’s largest financial services companies, is one of the few companies that has made its decision protocol public. The protocol itemises dozens of “matters specifically reserved to [the board] for decision,” including the company’s financial results, executive remuneration, transactions exceeding £50m, significant changes in internal controls and any new business that would represent more than 1 per cent of the group’s gross income or expenses.
The issue calendar and decision protocol create a clearer line between the decisions that should be taken by the board and those that should remain with management. Of course, additional boardworthy issues inevitably arise throughout the year, ranging from competitor challenges to regulatory reviews, and here a pre-established consensus among directors and executives is essential for defining responsibilities.
The emerging norm for governance at many companies is to focus on the “materiality” of an issue in deciding whether it should go to the board for resolution. Materiality is defined by an issue’s potential for substantial gains or losses for the company; whether the matter is beyond the company’s normal business; and whether it is likely to have an impact on the company’s strategy and reputation. If the issue is material by any of those criteria, it must go to the board for review and decision.
To build an appropriate prescriptive culture, directors and executives are increasingly making a habit of openly reviewing issues about which the directors indicate they want to decide. An executive at a US manufacturing enterprise spoke for many in saying: “We are continually going back to the board and asking: ‘What do you want to know more about?’”
The difference good governance decisions make
To illustrate the difference that governance decisions can make, let us turn to the moment 52 years ago when Sir Edmund Hillary and Tenzing Norgay summited Mount Everest. Behind that accomplishment was an earlier board decision that was to prove critical.
The UK’s Himalayan Committee originally chose Eric Shipton to lead the assault on the summit. Shipton’s lightly equipped and nimble climbs had shown creative flair. But he was known to be inattentive to detail and planning, and the governing body worried that his style might not be up to the competition. A year earlier, a Swiss team had come within a few hundred feet of the summit; should the British fail this time, there were German and French expeditions ready to make attempts soon afterwards.
Fearful of another failure and believing that logistics would make the difference, The Himalayan Committee fired Shipton just six weeks after choosing him. In the resulting uproar, one climber resigned. Others protested about Shipton’s replacement, a career military man, called John Hunt, who was known for his management savvy but barely known to mountaineering.
In replacing its expedition CEO, the board had changed its strategy. As expedition leader, John Hunt indeed focused on logistics. His approach called for an array of climbers and Sherpas who would methodically move up the mountain, placing supplies at ever-higher camps. The goal was to deliver just two climbers to the summit, although ten mountaineers were in the running. The final choice, Hunt declared, would depend on who was climbing well and who was in high camp when the weather cleared. On May 28 1953, Hunt selected two men for immortality and, at 11.30am the next day, Edmund Hillary snapped the iconic photo of Tenzing Norgay atop the summit.
The unsung hero of this heroic achievement was The Himalayan Committee. It had decided that Everest’s conquest would require a well-organised team to succeed, and decided on a new executive for its new strategy. Whatever its composition and policies, the board had taken two history-making decisions that reflected governance decision-making at its best.
Conclusion
Under the attentive glare of investors and regulators, directors of companies ranging from Barclays to Disney and Toyota have been working hard in recent years to create boards that meet contemporary composition and policy standards. At the same time, boards are also working to ensure that they make the right decisions and, for that purpose, they are adopting issue calendars, decision protocols and other governance norms. The result of this should be greater director vigilance, not only for guarding against company malfeasance but also ensuring that management has the right strategy and chief executive for reaching its summit.
Michael Useem is professor and director of the Center for Leadership Change at the Wharton School of the University of Pennsylvania. His research has focused on governance and leadership, and he is the author of “The Inner Circle”, “Investor Capitalism”, “The Leadership Moment”, and “Leading Up”.
