BUSINESS: The Ultimate Resource January 2007 Upgrade 52

BEST PRACTICE VIEWPOINT

Whats a Director to Do?
by Michael Jensen and Joe Fuller

Executive Summary
Every wave of corporate turmoil or malfeasance inevitably leads to a discussion about the role of the board of directors. Indeed, in the wake of the latest scandals, a barrage of new legislation has rolled over corporate directors. These new requirements, including the recently passed U.S. Sarbanes-Oxley bill, all attempts to address corporate abuses and boost confidence in securities markets. The new rules focus on more timely and transparent financial disclosure; greater accountability for financial reporting; increased oversight and independence of the audit function; enhanced SEC review of financial statements and enforcement of regulation, and broader remedies for violations. Not surprisingly, these new regulations create potential additional personal liability for directors. In fact, the new legislation requires senior managers to certify that they have implemented procedures to gather all material information about the business. Moreover, management must ensure that either the audit committee or the independent members of the board validates that attestation. The legislation also stipulates that every board should have at least one financial expert who has: an understanding of generally accepted accounting principles and financial statements experience in (i) the preparation or auditing of financial statements of generally comparable companies, and (ii) the application of such principles in connection with the accounting for estimates, accruals, and reserves experience with internal accounting controls an understanding of audit committee functions Clearly, the legislators intend to render mute any future defense predicated on a boards lack of oversight responsibility or technical skill. In addition, the legislation calls for new processes to collect and disseminate information on corporate performance, new faster reporting cycles, and a clear obligation to certify that financial reports fairly present in all material respects the financial condition and results of operations of the issuer. Yet, it is fair to say that few, if any, boards can satisfy these conditions as currently constituted. How can boards fulfill these new mandates? They should focus on the following areas:

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Be Clear About the Decision Rights and Role of the Board

When people (including managers) make decisions for which they do not personally bear the full costs or benefits, the organization and society is at risk. That risk arises less from the prospect of malfeasance or fraud, but rather from self-interest and the human tendency to avoid blame. We can deconstruct any major decision into a sequence of sub-decisions in the decision process. They are: the right to initiate recommendations for resource allocations or contracts the right to ratify those initiatives the right to implement the ratified initiatives the right to monitor those decisions Monitoring rights includes not only the right to measure and evaluate, but also the right to reward and punish performance. We generally assign the initiation and implementation rights to the same party, and, hence, we call these the management rights, while simultaneously assigning to a separate party the ratification and monitoring rights, the control rights, essential to disciplining managerial behavior. When control is effective in an organization, the management rights for a decision are separated from the control rights for that decision. We must separate the management rights from the control rights at all levels in the organization to reduce aberrant behavior. This is especially true at the board level. Doing so will bring a new level of stability and oversight to corporate governance. This proposition thus generalizes to the governance structure the long-standing separation principle of controllership: that one should not allow a person receiving cash to be the same person who records its receipt. Applying this formula to the board would yield the following decision-making model. The board must hold the top-level control rights in the organization, and these include: the rights to initiate and implement certain decisions, such as the right to hire, evaluate, compensate, and fire the top management team, board members, and the companys auditor. The board must also hold the right to ratify and monitor other major decisions, such as those pertaining to changes in fundamental strategic direction. This implies that the chairman of the board cannot be the CEO, because a chairmans main job is to set the agenda of the board and to oversee the hiring, firing, and evaluation of the top management teamand no CEO can effectively run the process that evaluates himself. The annual election of directors by shareholders accomplishes the same principal of separation for the board of directors.

FocusF OnF ChangingF theF Structural,F Social,F Psychological,F andF PowerF EnvironmentF ofF theF BoardF
To all intents and purposes, the directors at most companies are employees of the CEO. The CEO does most of the recruiting for the board and extends the offer to join the board. And, except in unusual cases, board members serve at the pleasure of the CEO. Moreover, it is rare that the board meets outside of the CEOs presence or without his explicit permission. Finally, virtually all information board members

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receive from the company originates from the CEO, except in highly controlled or unusual circumstances. A change in these practices will require a major change in the power relationship between the board and the CEO, perhaps going as far as a structural separation between the chairmans and CEOs positions. Companies can implement several practical steps immediately to infuse more balance into the boards deliberations. They include: The board should have its own budget for purchasing advice from outside experts of various sortsconsultants, lawyers, financial, and other experts. The Audit and Compensation Committees must become the true clients of the auditors and compensation consultants. The board should have regular, planned meetings with the entire top management team and frequent opportunities to interact privately with key managers. Boards must create opportunities to come to know, on a personal basis, the individuals on whose abilities and judgment the shareholders rely. The board, in its duty to evaluate the CEO and other top managers, can productively implement the principle of 360-degree evaluation, and it should not happen by accident through back-channel conversations. The board must take firm control over not only its own processes but also its own composition. That requires employing the newly required Nominating Committee as a vehicle for building the boards ability to exercise its expanding role effectively. The CEO should become a participant in a boardsponsored process of recruitment, rather than serving as the chief recruiter.

RememberF ThatF BeyondF ThisF StructuralF andF CulturalF Shift,F TwoF ImportantF PhilosophicalF ShiftsF AreF NecessaryF
First, the mindsets of boards must move from one of careful review to one of insatiable curiosity. The duty to care has long stood as the principal legal hurdle for directors. We must now add to that a new dutyone of informed inquisitiveness. Question assumptions. Make note of and probe anomalies. If the companys expectations lie outside those that experts generally view as plausible for the firms industry in terms of growth, profit margin, or return on assets, its board must investigate the assumptions underlying such projections. Directors must answer a fundamental question about such a companywhat observable sources of competitive advantage allow it to perform at a high level consistently? Directors must not be content to conclude that growth rates arising from stretch goals designed to stimulate the organization to excellent performance will lead ineluctably to outstanding performance. Second, directors must move beyond a single-minded, legalistic focus on compliance and focus on clarity. This represents more than getting the footnotes right or engaging the right auditors. Instead, the current situation requires setting forth a truly accurate picture of the company and communicating that picture to shareholders. Rarely do board members have the kind of information they need to assess accurately the progress of the corporation; getting that information requires boards to overhaul the process by which they get substantive information about corporate performance from one controlled by the CEO to one in which the board has ready access to relevant

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information from unimpeachable sources. Board members must understand the key strategic dimensions that determine the companys competitive position, the factors that drive the logic of value creation, review progress against those drivers regularly, and audit the companys performance against relevant measurements across those dimensions from year to year.

HonestyF andF Integrity: F EasyF toF Assert,F DifficultF toF ImplementF

Honesty and integrity constitute matters of human behavior and human choice. No combination of rules, punishments, and threats can substitute for men and women of integrity who bring principles to the boardroom and apply them. Laws and regulations can help establish an environment that encourages honest behavior and punishes violations. But human choice and allegiance to these principles are critical attributes of any system of governance and, ultimately, for the principled and productive society that they enable. If companies are to behave with more integrity than we are currently observing, the people in them (from the board of directors on down) must come to better understand the nature of these choices. Boards must take seriously their responsibility to ensure the integrity of the organization in all matters. Even more importantly, board members must be willing to incur costs to do so. Everyone espouses allegiance to principles such as honesty and integrity. Yet, evidence from human behavior indicates that when it really matters, people often choose to abandon the very standards they espouse. This includes not only CEOs and directors, but also government and religious officials. It is now time for corporate directors to think carefully about how to restore integrity in corporate governance. This is not an easy task. It will only come when men and women of principle not only confront substantive, difficult business questions honestly, but also change inbred behaviors that encourage many of them to avoid painful confrontations and difficult trade-offs. The current tragic circumstances make this transition easier, as the consequences of unethical or illegal behavior, including ruined reputations, ruined companies, and criminal prosecutions for once-feted executives, are unambiguous to even the most cavalier and insouciant directors. Honesty and integrity in our actions and words are most valuable to others when it costs us something to adhere to them. When it costs us nothing, it generally follows that the associated actions are worth little or nothing to those who depend on us. In the end, legislators will pass new laws, regulators will promulgate new rules, and the climate of capital markets will change. But restoring integrity to the system will, ultimately, occur one step, one director, one audit committee, one board, and one organization at a time. It will require men and women of courage and conviction on boards and in management teams to incur costs in the short run in order to preserve their reputations and fulfill their dutythe preservation of the value of the organizations they serve.

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TheF BestF SourcesF ofF HelpF

Carter, Colin B., and Jay W. Lorsch. Back to the Drawing Board: Designing Corporate Boards for a Complex World. Boston: Harvard Business School Press, 2003. Institute of Directors. Standards for the Board: Improving the Effectiveness of Your Board. London: Kogan Page, 2002. Nadler, David A., Beverly Behan, Mark Nadler (editors). Building Better Boards: Treating the Board as a High-Performance Team. San Francisco: Pfeiffer Wiley, 2005.

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