Serving the Shareholders

With billions of dollars in losses racked up on Wall Street casting new light on how boards of directors operate, the time may be right to re-examine the nation’s corporate governance laws

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On Sept. 15, 2008, when the 158-year-old investment bank Lehman Brothers filed the largest bankruptcy in U.S. history (with assets of $691 billion), its 11-member board of directors included nine retirees, five men over the age of 74, and, apart from Lehman’s chairman and CEO, only two people with any direct experience in the financial-services industry.

By most accounts, Lehman’s collapse set in motion the improbable crumbling of a handful of other venerable institutions and the global economic avalanche that followed. The resulting financial turbulence greatly affected Michigan and Detroit, as traditional lending sources dried up and consumers began monitoring nearly every outward expense in juxtaposition to their falling 401(k) balances and other market investments.

While few Michigan-based corporations have been immune to the global financial meltdown — whether it’s the Big Three automakers, Masco Corp., Penske Automotive Group, Pulte Homes, or Borders Group — the state’s 29 public companies that are part of the Fortune 1000 list of the largest American companies have been generally well-managed. Still, as General Motors and Chrysler (and initially Ford Motor Co.) were grilled by members of Congress last fall for flying to Washington in corporate jets to ask for loans to shore up their balance sheets, it became clear that corporations and their boards are now operating in an arena of increased scrutiny (even private companies are under greater review, as is the case with Chrysler).

The ensuing examination about why certain corporate actions or policies were pursued on Wall Street and why various complex financial instruments were permitted has tended to focus on the senior management of now-failed or troubled institutions. But those entrusted to oversee senior management’s strategies and police the interests of shareholders, whether in Michigan or elsewhere, have largely escaped closer examination.

“There are so many contributing factors leading to the situation we’re in today,” says Stephen Wagner, a managing partner at Deloitte, which operates a large public accounting office at Detroit’s Renaissance Center. “But for corporate boards to assert that they’ve had no culpability in this process is impossible.”

Indeed, the widespread trouble afflicting so many U.S. companies has raised some burning questions about whether the current corporate governance structure is working, and whether the overseers of shareholders’ capital — the boards of directors — are functioning effectively.

Since the advent of the modern U.S. corporate structure, shareholders have relied on the board and executive management to carry out company business, but have also relied on governmental agencies and other gatekeepers.  At an elementary level, board members are elected by shareholders as guardians of shareholder investments.  But shareholders rely on external corporate gatekeepers as well, such as auditors, government regulators, accountants, and lawyers, who offer opinions or make decisions that (at least for publicly traded companies) can be reviewed and evaluated by a shareholder, or potential investor.

Though it would be difficult to pin the sinking of Lehman Brothers, Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, and AIG on a single cause, most observers agree that senior management failed to assess, and boards failed to understand, the enterprise risks in the debt and investment decisions that were being pursued. The combined lack of information proved devastating.

What’s more, the resulting credit market collapse that vaporized nearly $11.2 trillion in U.S. household net worth last year — representing an 18 percent drop from 2007, the largest annual decline since the federal government began taking quarterly records in 1952 — and the trillion dollars and counting in bailout funds provided by taxpayers has many people looking for someone, or something, to blame.

Harvard Business School professor Jay W. Lorsch believes some of the blame should be directed toward the performance of corporate boards. Lorsch, co-author of the recent book Back to the Drawing Board: Designing Boards for a Complex World, believes boards are being pressed to perform unrealistic duties, given their traditional structure and time constraints of members. “It’s clear, in many cases, that boards have to do a better job of understanding what’s going on in their companies,” Lorsch says. “And we need to begin thinking about how else boards can gather necessary information.”

Commonly, boards obtain information and knowledge about company matters from management and auditors; however, if those
sources of information are inadequate, it will inevitably have consequences for boards. “If management didn’t know exactly what was going on, then how was the board expected to know?” adds Lorsch, who has advised and served on several corporate boards in diverse industries.

The notion that boards need greater access to company data is largely supported by the findings of an April 2007 corporate governance survey of 825 public company directors and more than 1,800 managers and executives. About seven of 10 directors indicated they were satisfied with their access to the financial information of the companies they serve, according to the McKinsey & Co. study. But satisfaction levels drop noticeably when access to strategic and operational information was considered. Only 50 percent of directors say they were satisfied with their access to information in these two respective areas. Not surprisingly, inside directors — executives serving on their own companies’ boards — expressed higher levels of satisfaction than independent directors (defined, in general, as someone who has not been an officer or employee or had any material relationship with a company for a three-year period prior to nomination to a board). The results of this study, conducted before the credit crisis, would likely have yielded different results if performed in the fall of 2008.

One problem (or, perhaps, advantage) faced by corporate boards is that they’re largely an afterthought to the media and the public. Usually, the media highlights a board’s activities only when addressing a possible scandal emanating from the boardroom — which isn’t too common. Yet boards — like Lehman Brothers’ — are often viewed as a group of mostly retired executives, bankers, lawyers, academics, and politicians who are well-compensated for their limited work and who gather periodically around a conference-room table to view PowerPoint slides and provide their stamp of approval for initiatives advanced by the CEO. But this is not entirely true.

Aside from hiring (and firing) the CEO, the function of boards of directors includes monitoring management and its strategy, while acting as an advocate for shareholders. Recently, more corporate directors have begun to acknowledge that they must oversee business risk as part of their overall strategy-setting role. A 2002 survey by McKinsey & Co., involving 200 directors representing 500 boards, revealed significant concerns about companies’ abilities to manage and assess enterprise risk. Of the participants surveyed, 36 percent said they had only a partial understanding of the major risks facing their respective organizations. In contrast, the 2006 survey revealed that nearly 90 percent of directors understood the major company risks. While it was a marked improvement, some would suggest that is still surprising.

For some time, the impact of boards has been questioned, as directors were often viewed as too beholden to CEOs, rarely asking tough questions or challenging the directives advanced by senior management. In a November 2008 interview with The Wall Street Journal, billionaire investor and longtime shareholder activist Carl Icahn cited a lack of accountability as a fundamental problem leading to the financial crisis. “You had very few real, functioning boards to control what happened on Wall Street,” said Icahn, who recently launched United Shareholders of America, a campaign to make companies and CEOs more accountable. According to Icahn, the crux of the problem is that CEOs often “put their friends and cronies on the board, and these guys aren’t going to throw him out.”

But, according to Wagner, that notion may be a thing of the past. “Composition of boards 20 years ago [was] much different than it is today,” he says. “In the past, CEOs tended to select people for their boards who they knew, trusted, and felt comfortable with, and those they were confident would support them.”

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