Executive compensation is discussed throughout President Obama’s Financial Regulatory Reform issued by the Department of Treasury on June 17, 2009 (the “Regulatory Reform Proposal” or the “Proposal”). The theme throughout is that executive compensation must refocus on the correct fundamentals: Long-term value rather than short-term profits; financial stability, and management of risks.

The theme begins on the first page of the Regulatory Reform Proposal with a finding that that “Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value.” The theme is then developed further by proposing that federal regulators of financial institutions should issue standards and guidelines to better align compensation practices with the correct fundamentals through “five principles”:

1. Compensation plans should properly measure and reward performance;
2. Compensation should be structured to account for the time horizon of risks;
3. Compensation practices should be aligned with sound risk management;
4. Golden parachutes and supplemental retirement packages should be reexamined to determine whether they align the interests of executives and shareholders; and
5. Transparency and accountability should be promoted in the process of setting compensation.

These principles are then expanded to include more than U.S. financial firms: Loan brokers and lenders; investment banking firms securitizing investments; publicly-held companies; and international companies subject to governance by G-20 countries

The regulation of executive compensation included in the June 2009 Regulatory Reform Proposal is more tempered than the regulation imposed in February, 2009 on companies receiving TARP funds (see Corporate Governance Blog posted February 4, 2009 on “U.S. Department of Treasury Guidelines for President Obama’s Executive Pay Limits”). For example, the TARP limitations on the dollar amount of total annual compensation other than restricted stock are not included.

Instead, the Regulatory Reform Proposal includes the more traditional “say-on-pay” empowerment of shareholders. The Proposal says the Obama Administration will work with Congress to pass legislation that will require all public companies to offer an annual non-binding vote on compensation packages for senior executive officers. The Proposal states that such votes “provide a strong message to management and boards and serve to support a culture of performance, transparency, and accountability in executive compensation. Shareholders are often concerned about large corporate bonus plans in situations in which they, as the company's owners, have experienced losses. Currently, these decisions are often not directly reviewed by shareholders – leaving shareholders with limited rights to voice their concerns about compensation through an advisory vote.”

Additionally, the Proposal recognizes the underlying principle of Sarbanes-Oxley: That the first and best line of defense against mismanagement and fraud is oversight by independent directors with advice of independent advisors (see Corporate Governance Blog posted March 30, 2009 with commentary on “A wishful alternative to Geithner’s proposed regulation”). The Proposal would give the SEC the power to require that compensation committees are more independent; compensation committees would have the responsibility and the resources to hire their own independent compensation consultants and outside counsel; and the SEC will create standards for ensuring the independence of compensation consultants, providing shareholders with the confidence that the compensation committee is receiving objective, expert advice.

Although the Proposal does not expressly include the TARP clawback bonuses to executives engaging in deceptive practices, the Sarbanes-Oxley clawback applicable to bonuses of executives of publicly-held companies remains available.

Finally, the Proposal criticizes the commissioned-based compensation of security brokers, originators, sponsors, underwriters, and others being compensated by those subject to the regulatory reform being proposed. The Proposal call for changing such commission based compensation to provide appropriate incentives for participants to best serve the interests of their clients, the borrowers and investor, linked to the longer-term performance rather than only to the production, creation or inception of products.

See Corporate Governance Blog posted on February 26, 2009 on “Cure for the Meltdown Requires Changing Focus” for further information on principle-based compensation similar to that discussed by the Proposal.

The Supreme Court agreed on Monday to rule on the constitutionality of the Sarbanes-Oxley Act passed in 2002 to create a new government agency to regulate firms that audit the books of publicly traded companies. The key question in the case is whether the Act violated the separation-of-powers doctrine by the mode of selection and removal of members of the Public Company Accounting Oversight Board. The case is Free Enterprise Fund v. PCAOB (08-861). The case questions the limits on the authority of the president to remove officials in the executive branch. Under it current structure, members of the PCAOB can only be removed for cause by the SEC. 

A copy of the Wall Street Journal Article on the grant of cert can be seen here

The Securities and Exchange Commission, according to its officials, will propose new rules today that will pave the way for a company’s shareholders to elect a limited number of independent directors. 

If adopted, the proposal would open the door to a significant change in the role played by investors in governing publicly traded companies.

The proposal would permit large shareholders — typically institutional investors like pension funds or hedge funds — or alliances of shareholders to nominate as many as one-quarter of the directors. For the 700 largest public companies, the proposal would require approval by 1 percent of the shareholders for a dissident slate to be nominated. For smaller companies, it would be either 3 percent or 5 percent, depending on the size of the business.

On Tuesday, Senators Schumer (N.Y.) and Cantwell (Wash.) announced that they had introduced legislation to give shareholders the right to hold advisory votes on executive pay. The legislation also instructs the commission to issue rules that would permit shareholders to propose their own directors.

The N.Y. Times article on the proposed rule can be read here

Treasury Secretary Timothy Geithner has proposed sweeping reforms of the financial regulatory system. 

Under the Obama administration’s proposal, the federal government would for the first time have oversight of many complex and previously unregulated financial derivatives, including securities like credit default swaps. 

Geithner also recommended that a single federal agency be granted wide authority to monitor risk across all financial markets.

“To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game,” Geithner said in his opening remarks to the House Financial Services Committee. “The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the structure of our financial system.”

The Treasury Secretary added: “Let me be clear. The days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers must end.”

The proposals address four broad themes: containing systemic risk, protecting consumers and investors, eliminating gaps in the regulatory structure and fostering international coordination.

In his testimony Thursday, Geithner stressed the importance of containing systemic risk and said the new proposals offer six methods for addressing the issue:

1. A single independent regulator to watch over systemically important firms and the critical payment and settlement systems used by those firms.
2. Higher standards on capital and risk management for systemically important firms.
3. Registration of all hedge fund advisers with assets under management above a moderate threshold.
4. A comprehensive framework of oversight, protections and disclosure for the over-the-counter derivatives market.
5. New requirements for money market funds to reduce the risk of rapid withdrawals.
6. A stronger resolution authority to protect against the failure of complex institutions.

Another important aspect of the proposal would allow the federal government to seize control of nonbank institutions when they teeter toward collapse, as AIG did last September.

Treasury Secretary Geithner’s entire testimony can be seen here.

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.

Today, the Treasury Department is issuing a new set of guidelines on executive pay for financial institutions that are receiving government assistance to address our current financial crisis. These measures are designed to ensure that public funds are directed only toward the public interest in strengthening our economy by stabilizing our financial system and not toward inappropriate private gain. The measures announced today are designed to ensure that the compensation of top executives in the financial community is closely aligned not only with the interests of shareholders and financial institutions, but with the taxpayers providing assistance to those companies.

The Treasury guidelines on executive pay seek to strike the correct balance between the need for strict monitoring and accountability on executive pay and the need for financial institutions to fully function and attract the talent pool that will maximize the chances of financial recovery and taxpayers being paid back on their investments. The proposals below, such as emphasizing restricted stock that vests as the government is repaid with interest, seek to strike exactly that balance.

The guidelines distinguish between banks participating in any new generally available capital access program and banks needing "exceptional assistance." Generally available programs have the same terms for all recipients, with limits on the amount each institution may receive and specified returns for taxpayers. The goal of these programs is to help ensure the financial system as a whole can provide the credit necessary for recovery, including providing capital to smaller community banks that play a critical role in lending to small businesses, families and others. The previously announced Capital Purchase Program is an example of a generally available capital access program.

If a firm needs more assistance than is allowed under a widely available standard program, then that is exceptional assistance. Banks falling under the "exceptional assistance" standard have bank-specific negotiated agreements with Treasury. Examples include AIG, and the Bank of America and Citi transactions under the Targeted Investment Program.

As part of President Obama's efforts to promote systemic regulatory reform, the standards today mark the beginning of a long-term effort to examine both the degree that executive compensation structures at financial institutions contributed to our current financial crisis and how corporate governance and compensation rules can be reformed to better promote long-term value and growth for shareholders, companies, workers and the economy at large and to prevent such financial crises from occurring again.

I. COMPLIANCE AND CERTIFICATION:

All Companies Receiving Government Assistance Must Ensure Compliance with Executive Compensation Provisions: The chief executive officers of all companies that have to this point received or do receive any form of government assistance must provide certification that the companies have strictly complied with statutory, Treasury, and contractual executive compensation restrictions. Chief executive officers must re-certify compliance with these restrictions on an annual basis. In addition, the compensation committees of all companies receiving government assistance must provide an explanation of how their senior executive compensation arrangements do not encourage excessive and unnecessary risk-taking.

II. ENHANCED CONDITIONS ON EXECUTIVE COMPENSATION GOING FORWARD:

A. Companies Receiving Exceptional Financial Recovery Assistance:

• Limit Senior Executives to $500,000 in Total Annual Compensation Other than Restricted Stock: Current programs providing exceptional assistance to financial institutions forbid recipients of government funds from taking a tax deduction for senior executive compensation above $500,000. Today's guidance takes this restriction further by limiting the total amount of compensation to no more than $500,000 for these senior executives except for restricted stock awards.
    
• Any Additional Pay for Senior Executives Must Be in Restricted Stock that Vests When the Government Has Been Repaid with Interest: Any pay to a senior executive of a company receiving exceptional assistance beyond $500,000 must be made in restricted stock or other similar long-term incentive arrangements. The senior executive receiving such restricted stock will only be able to cash in either after the government has been repaid – including the contractual dividend payments that ensure taxpayers are compensated for the time value of their money – or after a specified period according to conditions that consider among other factors the degree a company has satisfied repayment obligations, protected taxpayer interests or met lending and stability standards. Such a restricted stock strategy will help assure that senior executives of companies receiving exceptional assistance have incentives aligned with both the long-term interests of shareholders as well as minimizing the costs to taxpayers.
    
• Executive Compensation Structure and Strategy Must be Fully Disclosed and Subject to a "Say on Pay" Shareholder Resolution: The senior executive compensation structure and the rationale for how compensation is tied to sound risk management must be submitted to a non-binding shareholder resolution. There are no "Say on Pay" provisions in the existing programs.
    
• Require Provisions to Clawback Bonuses for Top Executives Engaging in Deceptive Practices: Under the existing programs providing exceptional assistance, only the top five senior executives were subject to a clawback provision. Going forward, a company receiving exceptional assistance must have in place provisions to claw back bonuses and incentive compensation from any of the next twenty senior executives if they are found to have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay.
    
• Increase Ban on Golden Parachutes for Senior Executives: The existing programs providing exceptional assistance to financial institutions prohibited the top five senior executives from receiving any golden parachute payment upon severance from employment, a ban that will be expanded to include the top ten senior executives. In addition, and at a minimum, the next twenty-five executives will be prohibited from receiving any golden parachute payment greater than one year's compensation upon severance from employment.
    
• Require Board of Directors' Adoption of Company Policy Relating to Approval of Luxury Expenditures: The boards of directors of companies receiving exceptional assistance from the government must adopt a company-wide policy on any expenditures related to aviation services, office and facility renovations, entertainment and holiday parties, and conferences and events. This policy is not intended to cover reasonable expenditures for sales conferences, staff development, reasonable performance incentives and other measures tied to a company's normal business operations. These new rules go beyond current guidelines, and would require certification by chief executive officers for expenditures that could be viewed as excessive or luxury items. Companies should also now post the text of the expenditures policy on their web sites.

B. Financial Institutions Participating in Generally Available Capital Access Programs:

The Treasury intends to issue proposed guidance subject to public comment on the following executive compensation requirements relating to future generally available capital access programs.

• Limit Senior Executives to $500,000 in Total Annual Compensation Plus Restricted Stock Unless Waived with Full Public Disclosure and Shareholder Vote: Companies that participate in generally available capital access programs may waive the $500,000 plus restricted stock rule only by disclosure of their compensation and, if requested, a non-binding "say on pay" shareholder resolution. All firms participating in a future capital access program must review and disclose the reasons that compensation arrangements of both the senior executives and other employees do not encourage excessive and unnecessary risk taking. Under the current Capital Purchase Program, the companies were only required to review and certify that the top five executives' compensation arrangements did not encourage excessive and unnecessary risk-taking.
    
• Require Provisions to Clawback Bonuses for Top Executives Engaging in Deceptive Practices: The same clawback provision that applies to companies receiving exceptional assistance will apply to those in generally available capital access programs. Thus, in addition to the clawback provision applicable to the top five executives as under the Capital Purchase Program, a company receiving assistance must have in place provisions to claw back bonuses and incentive compensation from any of the next twenty senior executives if they are found to have knowingly engaged in providing inaccurate information relating to financial statements or performance metrics used to calculate their own incentive pay.
    
• Increase Ban on Golden Parachutes for Senior Executives: Even under generally available capital access programs, the golden parachute ban will be strengthened: Upon a severance from employment, the top five senior executives will not be allowed a golden parachute payment greater than one year's compensation, as opposed to three years under the current Capital Purchase Program.
    
• Require Board of Directors' Adoption of Company Policy Relating to Approval of Luxury Expenditures: This policy will be the same for companies accessing generally available capital programs as it is for those receiving exceptional assistance. There are no guidelines on luxury expenditures under the current Capital Purchase Program.

[These new standards will not apply retroactively to existing investments or to programs already announced such as the Capital Purchase Program and the Term Asset-Backed Securities Loan Facility.]

III. LONG-TERM REGULATORY REFORM: COMPENSATION STRATEGIES ALIGNED WITH PROPER RISK MANAGEMENT AND LONG-TERM VALUE AND GROWTH:

Even as we work to recover from current market events, it is not too early to begin a serious effort to both examine how company-wide compensation strategies at financial institutions – not just those related to top executives – may have encouraged excessive risk-taking that contributed to current market events and to begin developing model compensation policies for the future. Such steps should include:

• Requiring all Compensation Committees of Public Financial Institutions to Review and Disclose Strategies for Aligning Compensation with Sound Risk-Management: The Secretary of the Treasury and the Chairman of the Securities and Exchange Commission should work together to require compensation committees of all public financial institutions – not just those receiving government assistance – to review and disclose executive and certain employee compensation arrangements and explain how these compensation arrangements are consistent with promoting sound risk management and long-term value creation for their companies and their shareholders.
    
• Compensation of Top Executives Should Include Incentives That Encourage a Long-Term Perspective: Over the last decade there has been an emerging consensus that top executives should receive compensation that encourages more of a long-term perspective on creating economic value for their shareholders and the economy at large. One idea worthy of serious consideration is requiring top executives at financial institutions to hold stock for several years after it is awarded before it can be cashed-out as this would encourage a more long-term focus on the economic interests of the firm.
    
• Pass Say on Pay Shareholder Resolutions on Executive Compensation: Even beyond companies receiving financial recovery assistance, owners of financial institutions – the shareholders – should have a non-binding resolution on both the levels of executive compensation as well as how the structure of compensation incentives help promote risk management and long-term value creation for the firm and the economy as a whole.
    
• White House -Treasury Conference on Long-Term Executive Pay Reform: The Secretary of the Treasury will host a conference with shareholder advocates, major public pension and institutional investor leaders, policy-makers, executives, academics, and others on executive pay reform at financial institutions. Treasury will seek testimony, comment, and white papers on model executive pay initiatives in the cause of establishing best practices and guidelines on executive compensation arrangements for financial institutions.

Today, nonprofit corporations are saddled with a changing governance environment that brings with it a need to examine current board practices and consider new ones. These changes in expectations for nonprofit boards have been prompted, in part, by the new Form 990 but also by the economic crisis fueled by the host of for-profit meltdowns of AIG, Lehman Brothers, Freddie Mac, Fannie Mae and others this past year. 

While the economic crisis was not driven by nonprofit companies, it will impact corporate governance of all organizations. This crisis has generated discussion and rumored regulation, and it requires nonprofit boards to adopt new practices. The evolving changes in today's governance best practices - and the way nonprofits should respond - are critical to the health and sustainability of the organization. 

Wall Street has shattered the public trust and confidence in the for-profit world, and retaining the public trust and confidence in charitable organizations and nonprofits is critical to accomplishing their missions. However, without shareholders, nonprofits are missing the built-in accountability of the for-profit world, which means that the boards and executive directors of nonprofits must play the role of watchdog to ensure that the public trust and confidence is maintained and to do their part to resurrect corporate America without increased regulation. 

To do so, it is incumbent on all boards to take a step back, take a critical look and assess their structure, composition, committee charters and past performance and determine whether they are prepared for the current challenges and risks to the organizations. 

As we embark on what will certainly be an uncertain year, nonprofit boards should consider taking the following steps to maintain the public's trust and confidence in their organizations and to act before the government can react: 

• Board Education. Boards should begin with educating their members to be better directors, to become more familiar with the risks to their organizations, to be more aware of the strengths and weaknesses of the members of management and to learn how to hold management accountable for information being provided.

• Assess Current Board Experience and Add Directors with Needed Experience, Skills and Expertise. Boards should assess and create a database inventorying the experience, skills and expertise of their current members. That database expertise should be reviewed periodically to evaluate whether the correct mix is represented by the current members of the board. The goal of the organization should be to create an "expertised board" composed of persons each having particular experience, skills or expertise needed for the board to have as a whole.

• Access to Independent Advisors Who Can Provide Necessary Counsel. Because it takes time to constitute a board composed of the appropriate mix of experience, skills and expertise, a board should require that it be given access to independent advisors having the experience, skills and expertise to counsel the board. This requires a board to first have access to a database of such advisors and then to have the resources to retain those advisors to counsel the board. This is important because it is likely that boards will be judged by state attorney generals, regulators, donors and eventually courts by the least experienced, least skilled or least knowledgeable of its members unless such members have access to such counsel. 

• Coaching on Asking Questions. Boards should periodically receive coaching or training on how to ask questions, including: the purposes for which they should be asking questions; the extent to which they should ask questions; when they should accept answers and stop asking questions; and when they need to explore more deeply. This should be considered on a matter-by-matter basis for issues a director identifies that may need the help of an independent advisor. It also should be considered periodically as part of the board's continuing education process. 

• Authorize a Standing Committee to Oversee Enterprise Risks. Boards should delegate to a standing committee, or constitute a new standing committee with authority on behalf of the board to investigate, assess and take appropriate action with respect to risks of the organization's enterprise. To facilitate the exercise of this authority, a board should require the organization's management, including each of its executive officers, to report such risks to this oversight committee and to meet at least annually with the committee in executive session.

• Annual Review of the Roles and Responsibilities of Board Committees and Committee Charters. All organizations need to review their committee charters to ensure that such committees have the requisite authority necessary to complete its delegated tasks and additionally to ensure that such committees do not have authority greater than what the full board desires to grant Committee charters are often the most ignored governing document for any organization. The charter of any committee should be discussed, if not negotiated, between the directors who are on the committee and the remaining directors who will rely on the committee on an annual basis. A charter not only protects non-committee members from liability, but also imposes that liability on the committee members. For directors, state law allows them to rely upon a committee of directors of which they are not members. However, a director may rely upon a committee only for matters within the committee's designated authority and the committee has a legal duty of care to carry out that authority as an ordinarily prudent person in a like position would do under similar circumstances and a legal duty of loyalty to do so only in, or not opposed to, the best interest of the organization. Thus, it is imperative that the authority of a specific committee is properly and clearly designated in its charter. 

• Best Practices Audit. Most organizations have their financial statements audited on a yearly basis. However, very few conduct an audit, either formal or informal, of its corporate governance practices. A yearly audit of governance practices goes a long way in creating a productive board and ensuring your board is operating effectively. 

• Board Evaluations/Individual Director Evaluations. Boards must strive for commitment to excellence in corporate governance and not just adhering to minimum standards prescribed by law. This is especially true in today's environment and requires a goal of continuous improvement. Similar to evaluating the organization's chief executive officer, executive director and management for the organization's performance, the board must evaluate itself to constantly improve. A yearly board evaluation will allow an organization to: 

• Check progress against mission and goals Give directors a meaningful measure of accountability 
• Allow for a check of strengths and weaknesses 
• Emphasize the accomplishments of the board 
• Provide a yardstick with which the goals of the coming year can be measured; 
• Encourage teamwork approach to decision making; and 
• Give a feeling of accomplishment 

• Board Composition/Succession Planning. Succession is critical to the life of any organization. As such, one of a board's most important responsibilities is succession of management and the board. A good succession plan helps to prevent staleness on the board. Preventing staleness or "institutionalization" of thought on the board is in the best interests of the organization and its mission. However, adding directors with fresh or non-institutional thoughts comes with a price, whether accomplished through traditional approaches such as term limits or age restrictions or by involving the board in making itself an "expertise" board. Getting your board to buy into a succession plan helps create a multi-generational board that is future oriented and prepared for emergency absences. 

• Update your Organization's Conflict of Interest Policy and Disclosure Process. All nonprofit organizations need to have a well defined conflict of interest policy and disclosure process. A failure in an organization's conflict of interest policy will have an immediate impact on public confidence of any organization in addition to exposing the board to potential liability. 

• Review Executive Compensation. Review and, where appropriate, revise executive incentive compensation arrangements to ensure that they do not encourage executives and others in management to take unnecessary and excessive risks that threaten the value and mission of their organizations. 

What's Next?

Regardless of the cause, the melt down of the for-profit world will directly impact how directors of nonprofit organizations must think, evaluate and make decisions. Whether viewed as an overdue wake-up call or an unfair impugning of the nonprofit director's integrity as a result of the actions of the for-profits, it is important that all directors of nonprofit organizations understand the increased scrutiny on boards and the need for the boards to understand the risks of the organization. This includes understanding and recognizing the state of the environment the organization is operating. The economic crisis is going to have an effect on many organizations that are not interested in making a profit for private inurement. Nonprofits rely on corporate and private donations and interest income from their endowments for programs, operational support and long term sustainability, To maintain and to continue to receive this financial support in these challenging times, organizations need to strive to maintain the public trust and confidence in their operations, financial risk management and direction. 

Directors need to become risk smarter. They need to broaden their view of risk and not limit discussions or analysis only to specific areas of risk This will require directors to evaluate the role of the boards overseeing that there is adequate risk assessment and make changes where appropriate. As the watchdogs for the organization, directors must realize not only that they remain the first and best line of defense against mismanagement and fraud but also that they can be the best line of offense for good management and best practices.

As the new year begins the United States and the world remain saddled with an economic crisis that has not been witnessed in decades. 

A new administration in Washington takes over today, and there still exists uncertainty in how this administration, or Congress, will act to address this crisis in what commentators, and politicians, scream was a failure at the board level to understand and assess the risks of the organization and the boards failure to independently assess management of the organizations. Rumors abound speak of the Democratic Senate considering a bill to federalize fiduciary duties and impose a standard to act with the care that a prudent person acting in a like capacity and familiar with such matters would use -similar to the ERISA standard- as opposed to the state law ordinarily prudent person in a like position would use under similar circumstances. Yet to date we wait to see what the formal response will be.

As a result of the economic crisis, boards of directors will need to respond to unknown challenges and pressures. Boards need to review their past actions in monitoring performance, compliance and risk management—and understand the role they must play going forward. The risk oversight role of the board has never been more critical and challenging than it is today.

In reviewing their role in overseeing risk to the organization, boards need to understand the changes that are likely coming, either through the courts applying new standards or interpreting existing ones, that will directly impact how these boards perform their functions and fulfill their fiduciary duties and likely increase board responsibility for risk management. While the current standard for director liability, established in Delaware by the Caremark case, requires that directors act as reasonably prudent person in a like or similar situation and provides the protection of the business judgment rule, if rumors are true there is real possibility that, as a result of the current economic crisis, boards will need to change how they act. Boards’ decisions will be in the crosshairs and will provide courts with repeated occasions to second-guess board decisions. 

The only certainty going forward is uncertainty. Uncertainty as to the when the recession will end, when the liquidity markets will thaw, when things will return to “normal”—whatever that is. 

One thing that we can be certain of is that there will be some kind of regulatory response to the economic crisis: just as the federal government reacted to the market crash of 1929 with the 33’ and 34’ Acts, just as the federal government reacted to expansion of United States businesses into foreign countries with the Foreign Corrupt Practices Act, and just as the federal government reacted to the Enron and WorldCom scandals with the Sarbanes-Oxley Act. Yes- there will be a regulatory response. But again there is uncertainty as to what the end product will look like. Boards need to be proactive in addressing new risks and new challenges this year will bring. By doing so Boards will be well prepared to handle and adjust to whatever regulatory response comes out of Washington.

AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Bros. et al. are the result of a fundamental flaw in governance of corporate America: Failure to provide independent oversight of management in the governance of these organizations. Management failed to assess, and boards failed to understand, the enterprise risks to these organizations in the debt and investment decisions made by management.

The likely reaction of the President and Congress after this November’s election will be to provide oversight through government regulation. To avert such regulation, corporate America needs to act quickly in correcting its governance.

The best defense against corporate mismanagement remains (1) independent oversight of management by independent directors (2) with counsel of independent advisers and (3) holding management accountable for the information provided:

(1) 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.

(2) However, these directors need counsel of independent advisers who have not participated with or advised management. Part of the governance failure of AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Bros. et al. is that their boards did not have an understandable assessment by independent advisers of the debt and investment risks being incurred by management and their advisers. The company counsel and other advisers to AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Bros. et al. could not, because of their participation, provide independent counsel needed by the boards.

(3) A board is only entitled to rely upon management for matters that the board reasonably believes management is reliable and competent. Determining reliability and competence requires a board to ask questions. Not just once, but repeatedly and of different constituencies of management, sometime separately with each in executive session. Management must be held accountable for their answers because without reliable and complete information, governance will fail.

A likely reaction to the failure in governance will be a federal codification to increase the duty of each director from that of an ordinarily prudent person which is the standard under most states’ corporation laws to that of a prudent expert with knowledge of the enterprise which is the standard under ERISA. Doing so will likely have adverse impact on governance because it will discourage knowledgeable independent people from assuming the resulting increased risk of being independent directors.

The solution is for boards to act before the government can react. In so acting, boards should begin with educating their members to be better directors, to become more familiar with the risks to the enterprise of their organizations, to be more aware of the strengths and weaknesses of the members of management, and to learn how to hold management accountable for the information being provided. Boards should do so with counsel of independent advisers who have not participated in advising management. And boards should hold management accountable for the reliability and completeness of the information being provided.

Only then will investors regain faith in corporate America. Only then can corporate America avert oversight by government regulation.

After weeks of historic events in the financial sector, Congress passed, and President Bush signed into law, the "Emergency Economic Stabilization Act of 2008" (the "Act"). An overview of the Act prepared by our Financial Services Industry Group can be reviewed here.