Tyco, Enron, WorldCom—these names, even a decade or more after they were front page news, still evoke memories and emotions, almost all of them negative, about corporate America and its “business” citizens. Each of these companies committed fraud and damaged their shareholders, the reputations of their employees and their directors along with the image of corporate America. As a result of these corporate crimes, the Sarbanes-Oxley Act (SOX) was the legislated antidote to cure the ethical diseases of corporations and to ensure transparency in financial accounting and reporting to shareholders, and the rest of the investing world. And, for all of the complaining that followed the enactment of SOX, it seems pretty clear that the increased transparency of financial reporting has worked just fine and employees, investors and directors have all benefited from this change.
However, although SOX increased disclosure and improved transparency for investors, no legislation or foresight prevented the behavior that led up to the “Black Swan,” the financial meltdown in the U.S. and around the world in 2008. And although I make no attempt to analyze the causes of this crisis or to assign blame, I do believe there is a meaningful correlation between the corporate climate that preceded the 2008 crisis and the evolution of the role of directors in the corporate boardroom. As a result of this evolution, I believe we are at a tipping point in the world of corporate governance. That is, the increasing fear that has invaded the boardroom in the aftermath of the financial crisis presents the danger that, without the courage that is necessary to make decisions in the face, and in spite of, uncertainty and vulnerability, directors risk defaulting to the easy and safe decision that may not be in the best interest of the shareholders. In the extreme, the inability of directors to make the decisions that are right for the company, even if this exposes them to criticism and reputational risk, can result in a breach of the directors critical duties to the company and its shareholders.
Stasia Kelly is a partner in DLA Piper’s White Collar, Corporate Crime and Investigations practice, based in Washington, D.C. This article is based on a presentation she gave earlier this year at a conference cosponsored by the NACD and the Center for America.
This is a cautionary tale and requires a look back at the roles of boards and directors over the last twenty years. Of course, all boards do not operate in the same way and many directors at the best managed companies have exercised their fiduciary duties wisely and well over the years. But, unfortunately, this is not true of some companies and these are the companies that I describe. Let’s start just twenty years ago, before Enron, Tyco and WorldCom but in the years leading up to these corporate meltdowns. These were the days of the most imperial CEOs. Directors were handpicked by the CEO, who most often was also the board chair. Most directors were CEOs themselves and the board as a whole was made up of like-minded and similarly situated business executives with similar backgrounds and ways of perceiving the world. A nod to diversity was most often accomplished by adding one, or at the most two, academic or nonprofit executives who were minority or female but who were not expected to add substance to the composition of the board.
In these days, CEOs tightly managed the board process—more often than not, the CEO had the only direct relationship with the directors, discouraging or closely monitoring communications between the senior management team and the directors. With the exception of the increased communication between the chair of the audit committee and the CFO that grew largely out of Sarbanes-Oxley, most other C-suite executives did not develop independent relationships with directors. In addition, the agendas for the board meetings were developed by the CEO which effectively controlled not only the subjects and issues of the meetings but also the materials directors received and discussed. Unless a director had a deep understanding of the business of the company, the controlled discussions and agendas made it difficult or impossible for a director to question or even spot an issue that the CEO did not want to be spotted.
Again, although the vast majority of CEOs were not trying to limit the information and access to directors in order to commit fraud or make inappropriate decisions, the result of the this practice in many companies was that the CEO’s strategy was seldom questioned, the numbers were not subject to close scrutiny and the importance of board involvement in corporate risk management oversight was not well recognized. In addition, I believe that compliance with SOX, which was expensive and complex, lulled many companies into a feeling that as long as the company was living by the new and often draconian requirements of the law and regulations, it was safe.
Of course, we all now know that SOX did not and could not have regulated the many forces that led to the 2008 financial crisis. It is clear that blame can be placed in many areas from regulatory lapses, Congressional misdirection, corporate greed and Wall Street hubris, to uncontrolled and undisciplined access to capital for both businesses and consumers. Whatever the causes, it is also clear that the reputation of corporations in America, along with their executives and directors, has been severely and perhaps irreparably damaged. Recall the vicious and personal threats against executives of AIG and other financial institutions that were rescued by the Federal Reserve and the American taxpayer. This “pitchfork” mentality produced real fear across corporate America and I believe deeply impacted executives, directors and employees across the board. The reaction of Congress and other government leaders, in continuing to vilify business executives to this day adds an air of authority and credibility to this negative mindset. Add to that the legislation and regulation that is being enacted and promulgated, from Dodd-Frank to new consumer protections, which has as much an air of “punishment” as it does remediation.
Although many of these reforms are reasonable and appropriate, I believe the negative regard in which executives and directors are viewed have combined with the increase in the threat of litigation and regulatory retaliation, to create a climate of fear and anxiety that has found its way to the C-suite and the boardroom. Every day the Wall Street Journal is full of reports of criminal actions against directors and executives, some of them the very bluest of the blue chips. This only adds to the feeling that corporate corruption is pervasive and universal. And, although the vast majority of corporate directors and executives work hard and long to do the best possible job for the shareholders and take the exercise of their fiduciary duty very seriously, this corrosive environment is a very real threat to the ability of willingness of directors and executives to make decisions and take actions that may expose them to potential liability or reputational damage even if those decisions are in the best interests of the shareholders.
And this is where I see the tipping point and the danger. Directors often face making tough decisions, whether it is a change in management at the top, or a controversial decision regarding business strategy. And more often than not, these decisions are public and subject to scrutiny and criticism. Companies are also more and more vulnerable to the corporate “crisis” which can come from many different directions and different causes. A company and its board’s reaction to a crisis can generate real liability and reputational damage that a reasonable director would understandably want to avoid. In these days of increased regulatory scrutiny and enforcement actions, there can also be a real threat to the directors and executives of civil and criminal exposure. It is not surprising then, that faced with difficult decisions that can expose them to liability and criticism, that many directors will choose to make a different or “easier” decision that will not be as risky. Even more understandable but of great concern is the possibility that such decisions either expose executives or other employees unnecessarily (for example, disciplining or terminating an executive because it is easier to do so to avoid criticism, even if the facts do not necessarily justify the action).
The most dangerous result of fear in the boardroom is that a director’s decision could breach his fiduciary duty to do what is in the best interests of the shareholders in order to protect himself from liability, criticism or reputational damage. It is critical that this danger not only be understood but discussed by directors and senior executives. Only by understanding this danger and doing what is required to make the right decisions for the shareholders will require real courage in the boardroom. The sooner that directors and CEOs recognize this and discuss this in their decision making the more likely it is that decisions will be made in the best interests of the shareholders even in the face of the very challenging environment.
Stasia Kelly is a partner in DLA Piper’s White Collar, Corporate Crime and Investigations practice, based in Washington, D.C. She also is a member of DLA Piper’s Corporate and Finance and Public Company and Corporate Governance practices. She is the former EVP and general counsel at AIG, MCI/Worldcom, Fannie Mae and Sears Roebuck. A video on this topic by Hugh Hewitt of Stasia Kelly is available at Tipping Points at www.centerforamerica.org.