Published on June 1, 2010
Originally Posted in the Harvard Business School Alumni Bulletin
by John Gillespie and David Zweig
In a company as large, complex, and prestigious as Lehman Brothers, one would expect to have found seasoned, astute, well-informed directors to oversee the managers and the risks the firm undertook with shareholders’ money. Yet when Lehman collapsed into bankruptcy in September 2008, just one of its ten non-executive directors had any recent banking experience. He had joined the board five months before Lehman went bust.
The backgrounds of Lehman’s independent directors were hardly suited to overseeing a complicated financial entity. Directors included a retired art-auction company executive; the former CEO of a Spanish-language television company; a retired rear admiral who had headed the Girl Scouts and served on the board of Weight Watchers International; a theatrical producer; and, until two years before Lehman’s downfall, the 83-year-old actress and socialite Dina Merrill, who sat on the board for eighteen years and served on the compensation committee that approved CEO Richard Fuld’s $484 million in salary, stock options, and bonuses from 2000 to 2007.
John Helyar, coauthor of Barbarians at the Gate and now a Bloomberg reporter who studied the Lehman leadership, told us, “The few people on the Lehman board who actually had relevant experience were kind of like an all-star team from the 1980s back for an old-timers game in which they weren’t even up on the new rules and equipment. Fuld selected them because he didn’t want to be challenged by anyone. Most of the top executives didn’t understand the risks they were taking, so can you imagine a septuagenarian sitting in the boardroom getting a PowerPoint presentation on synthetic CDOs and credit default swaps?”
In a conference call announcing Lehman’s 2008 third-quarter loss of $3.9 billion, Fuld told analysts, “I must say the board’s been wonderfully supportive.” The next day the board approved $100 million in payouts to five executives. Four days later the 159-year-old company declared the largest bankruptcy in U.S. history. Lehman’s shareholders, represented by the board, lost over $45 billion.
Says a former senior investment banker who now serves as a director for several S&P 500 companies: “The Lehman board was a joke and a disgrace. Asleep at the switch doesn’t begin to describe it.”
Inherent Conflicts of Interest
The Lehman disaster was not an isolated instance of hubris, incompetence, and negligence by a corporate board. The board at Merrill Lynch was so disconnected from the company that when shareholders met in December 2008 to approve the company’s sale to Bank of America — after five straight quarterly losses totaling $24 billion — not a single one of the nine non-executive Merrill directors even attended the meeting.
Stories of boards and CEOs failing to do their jobs on behalf of shareholders can also be told about AIG, Bank of America, Bear Stearns, Citigroup, Countrywide, Fannie Mae, Sovereign Bank, Wachovia, Washington Mutual, and many other companies directly involved in the recent financial meltdown, as well as many firms outside of finance whose governance-related troubles came home to roost in the recession.
On behalf of shareholders, boards’ specific duties are to choose and, when necessary, replace the chief executive officer of the company; evaluate the performance of senior managers; set executive compensation; approve key strategic and financial decisions; nominate candidates for shareholders to elect as directors; and ensure the company’s integrity, sustainability, and compliance with laws and regulations as it tries to grow.
Ideally, a board of directors is informed, active, and offers sound advice while maintaining a collegial but challenging relationship with the company’s CEO. In reality, some 61 percent of CEOs at our largest companies also serve as board chairman — an inherent conflict of interest that leaves board members dependent on the person they’re supposed to supervise for compensation, information, perks, committee assignments, and, often, their very presence at the table.
More Regulations Not the Answer
America’s most successful investor, Warren Buffett, has long been a critic of public company boards. His 2002 letter to Berkshire Hathaway shareholders, for example, asked, “Why have intelligent and decent directors failed so miserably?” No doubt he had the spectacular collapses at Enron and WorldCom in mind.
After every scandal there tends to be a call for board reform, followed by cleanup efforts that focus on the perceived cause of the most recent crash. These efforts have ignored the enduring cultural problems of CEO-board collusive relationships and the lack of shareholder power. The result is the imposition of ineffective, costly, or counter-productive legal and structural requirements that boards and executives quickly find ways around, with the assistance of lawyers, accountants, lobbyists, and bankers. Billions of shareholders’ dollars are spent to forestall or circumvent more effective reforms. Even worse, people are lulled into a false sense of security that the problem has been addressed, investors return to the markets, and the cycle continues. In light of this poor regulatory track record, we believe government-mandated reforms and more regulation alone cannot solve the current crisis of corporate leadership.
Bill George, the former CEO and chairman of Medtronic, now a Professor of Management Practice at HBS who serves on the boards of ExxonMobil and Goldman Sachs, told a forum of directors in 2008, “Serving on a board is about one thing: It’s about responsibility for the preservation and growth of the enterprise. If you can’t pass that test, you can’t blame it on the CEO; you can’t blame it on your fellow directors. You have to look at yourself in the mirror.”
Teflon Corporate Boards
Ironically, in the reckoning after the most recent financial crisis, boards of directors have largely escaped blame — because to blame them, investors would have to know who they are. Their names appear on the generic, straight-to-the-wastebasket proxy forms that shareholders receive. But despite recent improvements that have increased shareholders’ voices in governance, a levelheaded observer like former SEC chairman William Donaldson (MBA ’58) has compared the current system of choosing directors to “the old Soviet-style elections” in which shareholders’ real choice is to vote for anointed nominees, abstain, or sell the stock. Of all the nominees put forward by boards, 99.7 percent win election.
Also, thanks to the Delaware courts’ generous interpretation of the business judgment rule, directors must have “knowingly and completely failed to undertake their responsibilities” or had “an actual intent to do harm” — a standard that has let thousands of failed boards off the hook over the years.
While there’s no downside for bad directors, the system also makes it difficult for good directors to excel. Post-Enron reforms such as the Sarbanes-Oxley Act, and new stock exchange requirements that call for more independent directors and periodic board sessions without the CEO, have brought unintended consequences. Too often, well-intentioned boards are now compelled to focus on protective legal processes and box-checking exercises rather than on formulating company strategy, identifying risks, and evaluating executive performance.
The increasing time commitment required of board members, the complexity of contemporary business problems, the inherent conflicts between monitoring and advisory responsibilities, and the frustration of serving in a role under intense scrutiny in a brutal economic environment have made the job unattractive to many capable people and difficult for anyone to discharge effectively. Speaking at Directorship magazine’s annual conference in December 2008, Massachusetts Congressman Barney Frank, chairman of the House Financial Services Committee, told several hundred prominent board members that he couldn’t conceive of how they might do their jobs successfully: “I get very nervous about being held responsible for things that I don’t have complete control of. The notion that there would be very intelligent people doing very complicated things six and a half days a week, and I would come in on a periodic basis and tell them how to do it better, I don’t understand how you do that.”
Our anachronistic board structure, dating back to the 18th century, is not up to 21st-century demands, for investors or for directors themselves.
Ideas for Fundamental Reforms
Boards are not going to disappear. Nor, despite their many flaws, should they. They remain the only practical way for shareholders to be represented within companies. With developments such as the recent Supreme Court decision allowing companies to spend more freely on political campaigns, the importance of corporate governance is likely to grow. Many boards are effective, and even on flawed boards exclusivity is a form of opportunity. With such a small group around the table, a single talented and committed director can turn an entire company on its axis.
Still, the system is in need of fundamental change. Shareholders have a part to play. They must shed their apathy and ignorance and demand higher standards of performance from the CEOs, boards, gatekeepers, and financial institutions they pay to grow their investments. Public outrage over scandals or excessive executive compensation is ephemeral. It must be channeled to demand a transformation in how our companies are governed.
Congress can help, too, by mandating the long-overdue split between the roles of chairman and CEO. The CEO works for the board, not the other way around; but the continuation of combined roles creates an insurmountable imbalance of power. Lead directors have served as a half-step toward a solution, but often the CEO dominates the lead director appointment, the board’s agenda, and the flow of information. Proposals to separate the chairman and CEO posts only when a new CEO takes office have not worked because as long as other CEOs remain chairmen, there is the appearance of a demotion and loss of face. The change should be mandated by law.
Ultimately, though, you can’t regulate your way to strong leadership or good character any more than you can legislate morality. Companies and their shareholders have to want to change their boards — and to help make board members perform better.
Formal certification of all directors is an unworkable idea, but because the boardroom environment is more challenging than ever, the learning needs of directors have grown. There currently exists a hodgepodge of optional director training programs at universities, associations, and for-profits, but they are not consistent or sufficiently rigorous.
A consortium of the major business schools should create a formal and permanent directors’ institute with East and West Coast campuses. Its purpose would be to ensure that directors are intensively trained for initial board service and then remain current on business, strategic, legal, financial, regulatory, and accounting developments, as well as techniques for improving group process — like a Six Sigma Black Belt for directors. A fee of one one-hundredth of one cent per share on the current volume of the U.S. stock exchanges would yield about $50 million annually — more than enough to fund such directors’ training.
All the postmortems of the current collapse show people making unconscious or malfeasant choices. At the MBA level, it’s encouraging that HBS and other leading business schools are reexamining their curricula and placing a new emphasis on corporate responsibility. They should more deeply integrate technical and behavioral finance, organizational behavior, and ethics to better prepare future leaders — and also focus more cases on the proper role of boards.
Once directors are properly trained, it is crucial that they perform active service, but not for too long. Numerous countries, including the United Kingdom, force turnover of their independent directors after nine years. That’s a policy that should be adopted here. The loss of experience would be outweighed by reduced cronyism. If a director were truly indispensable, he or she could remain on the board but would no longer be considered independent and thus would be ineligible to serve on key committees.
Finally, companies must only nominate directors willing to put skin in the game. Shareholders deserve directors who think like owners and not like reactive defenders of management. Exchange rules should set up minimum requirements for equity ownership by directors, and bylaws should require them. The “play money” distributed in the form of stock options and gifts of restricted stock should not be included. Directors should have a meaningful percentage of their net worth invested in companies they serve, something along the lines of 3 to 6 percent, depending on the number of directorships they hold. And they should have holding period requirements that extend beyond their tenure on the board.
Imagine if, in the years before the financial crisis, boards had asked tough questions; second-guessed shortsighted strategies; and aligned risk, compensation, and performance. What if they had been true stewards of other people’s money? Surely, they would have reduced the incalculable financial devastation and human suffering that has followed.
We still don’t truly know how far we have moved from that disaster and whether it may soon be repeated on a more catastrophic scale. If we are ever going to make it to safety, it’s well past time for corporate boards to remember whom they truly serve and to step up and do their jobs.