“The thoroughness of the board’s understanding of the company” is viewed by directors as one of the misfeasances by board that contributed to the current Great Recession, according to a paper written by Jay Lorsch that was based upon a survey of directors conducted in 2009 by the Harvard Business School as part of its Corporate Governance Initiative.  

One director is quoted as saying, “I don’t think independence is anywhere near as important as we thought it was.”  

Congress reacted to the dot.com burst by enacting Sarbanes-Oxley and requiring greater independence of members of audit committees. Quasi-government organizations such as the New York Stock Exchange and Nasdaq expanded the independence requirements from audit committees to other oversight committees, such as compensation and nominating, and to the board itself. Regulators such as the SEC, IRS and the Treasury, as well as banking and insurance regulators, expanded the independence requirements from publicly-held companies to tax-exempt organizations and financial institutions.  

The result has been that management members of the board who understood the business model and strategic direction of their organizations are being replaced with independent members not having such understanding. This loss of understanding is now being realized by the independent directors.

The trend toward independence probably should not be reversed. Independent directors, especially those who are selected on the basis of the expertise, experience and knowledge they contribute to the board as a whole, add value to the board and the organization.

However, if the loss cited by the directors surveyed by Harvard is true, then this loss should be mitigated by inviting key management in addition to the CEO to serve as resources to the board at board meetings.

In any event, a good practice is for boards and their oversight committees to meet regularly with key management. Benefits of regular meetings with key management are that:

• It opens communication channels between the board and key management;
• Doing so regularly usually does not offend CEO;
• It facilitates the board’s federal and state obligations not to impede whistle blowing by encouraging communication both from employees to the board, hopefully without anonymity, and
• Board and management will each learn from the other.

Generally, familiarity of management with the board and vice versa will not breed contempt, but will foster trust and eliminate contempt.

Read January's issue of Acredula which contains an article on Ten Considerations for Making You a Better Board Member. Also included is an article by Kevin Kinross on the governance checklist recently released by the IRS for its agents audits of tax-exempt entities entitled IRS Continues Focus on Corporate Governance.

COMMENTARY

Governing boards should heed recent actions of the Obama administration apparently calling for a new era of director-centric governance for at least publicly-held companies, financial institutions and, perhaps eventually, tax-exempt entities.

Director-centric governance is in contrast to the strong-CEO paradigm described by Alan Greenspan before New York University’s Stern School of Business on March 26, 2002 and advocated by John and Miriam Carver in their “policy form of governance.” Director-centric governance is the underlying principle of Sarbanes-Oxley: The best defense against mismanagement, fraud and greed is oversight by independent directors with counsel of independent advisers and holding management accountable for providing necessary information.

The Obama administration appears to be taking director-centric governance to the next level: That the best line of “good governance” is governance by independent directors having the expertise necessary to oversee business decisions of management.

Evidence of this new era is Treasury Secretary Timothy Geithner’s March 26, 2009 statement before the Committee on Financial Services of the US House. Geithner states that “[i]nnovation and complexity overwhelmed the checks and balances of the system,” which must include the check and balance to have been provided by the boards of these institutions; “[c]ompensation practices rewarded short-term profits over long-term return,” which indicts these boards’ oversight of the executive compensation of these institutions; and “firms encouraged people to take unwise risks on complicated products . . . [that] outmatched the risk-management capabilities of even the most sophisticated financial institutions,” which second-guesses the these boards’ expertise to oversee the products and their related risks.

Further evidence of the new era includes statements buried beneath the headlines “White House ousts GM chief Rick Wagoner” (March 31, 2009, Los Angeles Times), “U.S. Plays Key Role in Naming GM Board” (April 1, 2009, Washington Post), and “GM Will Replace at Least Six Others on Board” (April 1, 2009, Wall Street Journal). While the media has focused on the removal of Wagoner as CEO, the more substantive change is apparently Wagoner’s removal as Chairperson of the board and the appointment of Kent Kresa, a current GM board member and former CEO of Northrop Grumman Corporation. This had to require approval of GM’s board because the Vice Chairperson who would have otherwise succeeded Mr. Wagoner was Frederick A. Henderson, who instead became CEO.

Despite the conspiracy theories to the contrary, Obama apparently means what he said on March 30, 2009 that his administration has "no intention" of running GM. Instead, the administration wants a better GM board.

According to the Wall Street Journal, at least six, or a majority, of the board is to change. GM’s board has been criticized as a “pedigree” board: Members selected for “who they are” rather than for their experience, skills, and expertise. Most telling is the statement in the Washington Post by new GM Chairman, Kent Kresa, that the GM board needs “new directors with additional skills and experience.”

Boards of organizations that are regulated through federal securities and tax laws, such as publicly-held companies and tax-exempt entities, and boards of major banks, investment banks, insurance companies, and other financial institutions that are likely to become subject to Geithner’s proposed regulatory system, should heed the new direction toward director-centric governance apparently being advocated by the administration:

• The best line of good governance is governance by independent directors having the expertise necessary to oversee business decisions of management; and
• Boards should review their composition in terms of experience, skills, and other expertise, and add new directors where needed experience, skill or other expertise is missing.

COMMENTARY

On March 26, 2009, Treasury Secretary, Timothy Geithner, released a statement that our financial system “require[s] comprehensive reform. Not modest repairs at the margin, but new rules of the game.”

Geithner’s statement contains two very telling positions: 

• The first is that “[f]inancial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take.” His premise is that past regulation has not been sufficient.
      
• The second is that “oversight” was insufficient to constrain dangerous levels of risk-taking [by financial institutions] throughout the financial system.” His premise is that the first line of oversight of the these financial institutions, their governing boards, is not sufficient to supervise these risks.

History of past regulation

Historically, major adverse economic events have resulted in legislation by Congress addressing its perception of mismanagement or fraud:

• The stock market crash of 1929 resulted in the Securities Act of 1933 requiring greater disclosure of information by companies before offering their securities in public markets and the Securities Act of 1934 to require continued dissemination of information as long as those securities remained publicly held;
    
• Reporting under-the-table payments to foreign officials as deductible for tax purposes and as legitimate for GAAP purposes resulted in the Foreign Corrupt Practices Act of 1977 requiring the maintenance of books and records and reconciliation of financial statements to those books and records that eventually became known as internal controls;
     
• The failure of illegal acts and third-party transactions to be detected during the audit process resulted in the Private Securities Litigation Reform Act of 1995 requiring audit of public companies to contain audit procedures designed to detect illegal acts, material related party transactions and continuation as a going concern; and
    
• The failure of the audit process to result in adequate disclosure of liabilities incurred by Enron, WorldCom, and others in the late 1990s and early 2000s resulted in the Sarbanes-Oxley Act of 2002 requiring oversight of the financial preparation and audit process of public companies by independent directors.

The focus of these regulations is disclosure with the underlying assumption being that knowledge of the facts will prevent mismanagement and fraud. Opponents of regulation argue that the cost of complying with these disclosure requirements has outweighed any benefit, resulting in public companies going private or changing their domicile to off-shore in order to avoid such costs. Proponents of regulation argue that these regulations have not gone far enough: instead of requiring disclosure, the regulations should regulate the substantive fairness of the operations of business and their transactions.

Mr. Geithner apparently falls within the class of proponents of regulation. His statement proposes regulation of the capital requirements, compensation incentives, and even the size of financial institutions, but also of the products offered by these institutions.

Responsibility for oversight

In the American corporate model, the responsibility for oversight has been traditionally vested in each organization’s governing board. The basic premise of Sarbanes-Oxley is that the best defense against corporate mismanagement is independent oversight of management by independent directors with counsel of independent advisers and holding management accountable for the information provided.

Opponents of regulatory oversight argue that independent directors know more about, and are closer to, the businesses of their organizations, and can take corrective action more quickly and knowledgeably, than any government official or agency. Proponents of regulation argue boards have become a social clubs of the CEO’s best friends and as a result few directors see their interests as separate from those of the CEO and management.

A wish for the future

Although regulation having the breadth of that proposed by Mr. Geithner as with past expansive regulation will directly benefit every lawyer and similar professional, I wish the focus would be on fixing, rather than changing, oversight in the American corporate model.

This focus should be the expertise either present among, or available to, the members of the board not only to provide direction of the organization, but also to oversee risks to the organization’s stakeholders. To me, a better regulatory paradigm is to require disclosure of:

• Whether and, if so, how frequently boards evaluate the collective skills, experience and other expertise of each of their members;
    
• What expertise each board member is believed to contribute to the collective expertise of the board; and
    
• What actions are being taken to enhance the collective expertise of the board through education, recruitment of other members, or access to expert advisers.

Requiring disclosure by each organization of the collective expertise, and steps being taken to enhance that expertise, of those responsible for direction and oversight will empower shareholders and other stakeholders of the organization to protect themselves by making intelligent decisions whether to continue being invested in, employed by, or otherwise relying upon soundness of the organization.