QUESTIONS FOR THE BOARD

Carolyn Brancato is director of the Global Corporate Governance Research Center with the Conference Board in New York, NY.

Facing increased, liabilities, companies and their boards must shore up their compliance practices. Here's what they have to think about.

The cases almost always come as a surprise. Sunbeam. Cendant. Waste Management. Enron. When the facts finally emerge, it seems like the abuses were taking place in a corporate culture devoid of certain legal, ethical, or moral rules. The litany of problems invariably gets longer: Accounting fraud, insider dealing, side compensation packages benefiting a few top executives, economic activities far afield of the core business sector, and joint ventures and transactions with off-balance sheet and income statement implications. The first response is to blame the accountants. But accountants don't act in isolation. It takes a board, management, legal counsel, and a host of others to create some of these spectacular failures of corporate governance—as well as to successfully manage a company.

The Enron effect has not only reduced public confidence in the corporate sector generally but also led to stock price erosion in some leading blue-chip companies. The failure of investor confidence poses a significant threat, especially to companies with complex corporate accounting and in certain sectors such as the energy industry where deregulation and changing markets have produced a series of relatively new corporate arrangements. To avoid being tarred by the Enron brush, companies must start thinking of their corporate governance not just as a set of things to do in order to avoid shareholder criticism, but also as a risk management tool. And, if companies establish better governance practices, they can benefit not only by satisfying shareholders and inspiring investor confidence, they can also institute processes that will lead to greater internal corporate efficiencies.

There is a new environment for corporate governance. Developing case law has stripped corporate directors of the wide protections they once enjoyed and now requires them to be increasingly proactive to ensure that corporate compliance programs are in place. (See the sidebar, "The Legal Rationale.") Directors are compelled to question management if red flags arise. They also must know when and if they, as directors, should reasonably be expected to realize that such flags could lead to deeper problems.

Now more than ever, boards should re-examine how they manage board oversight processes to minimize corporate risk and prevent destruction of shareholder value. And CEOs and management need to work with the board to set up the right kind of processes and communications to ensure that the company is running effectively and in accordance with the board's fiduciary oversight requirements—that is, that the board is keeping its eye on the company shareholder interests. Moreover, it is management's responsibility to inform the directors of the things they should focus on to ensure they meet their increasingly stringent fiduciary responsibilities. These days, management and those in the boardroom need to ask themselves and each other a lot of questions.

Demanding Accountability
Many classic corporate disasters have occurred at companies where the trappings of good corporate governance seemed to be in place. They had outside "independent" directors and directors who owned stock and therefore had their interests "aligned" with those of shareholders. They had audit committees that met the recommendations of the Blue Ribbon Committee (established by the New York Stock Exchange and National Association of Securities Dealers Automated Quotations) and the subsequent NYSE and NASDAQ changes in listing requirements covering audit committee independence and competence. Weren't these initiatives enough? What went wrong?

While it can be difficult to uncover premeditated and outright management fraud, boards can and should be more proactive in demanding accountability; and management should be more proactive in bringing things to the attention of the board. Management must not let complacent board directors put the company at risk by not having sufficient compliance systems in place. Boards should treat the current focus on Enron as an opportunity to review with management these systems. But they should do this not merely to enact quick fixes; rather, they should engage in an overall and comprehensive review of their board management system to ensure that they have the most effective short-and long-term approaches to carrying out their fiduciary responsibilities.

A Long List
Several short-term issues should be on the minds of directors, CEOs, and a company's senior executives.

• In light of the board's fiduciary duty of care and loyalty, what quality controls should the board institute to ensure that it understands and effectively performs its oversight role? What role should management play in assisting the board to fulfill its fiduciary duties and properly monitor the corporation?
• How do the various committees, such as audit and compensation committees, function to provide oversight? How can a board member know when things aren't right?
• Are these board management systems adequately designed to uncover red flags, which might warn the board of impending disasters in areas such as accounting and regulatory compliance?
• What checks and balances exist between the board's committees and outside experts such as accountants and consultants? And there are several long-term issues.
• What role should management play to assist the board in overseeing the strategic direction of the company?
• Has the board, together with management, developed a system of key performance measurements so the board can keep track of strategic issues without micromanaging the company?
• Have the board and management agreed on a set of things to track (such as quality improvements, environmental compliance, etc.) which are strategic issues? While the board should not get involved in operational issues, sometimes those issues can become strategic issues—as when quality is so low that the company's long-term viability is endangered. This may have happened in the Firestone tire situation.
• Does the board assess its own overall performance? The contributions of individual members?

A Three-Step Process
Any good board management system will address three principal issues:

• Does our board follow prudent and "best practices" in key areas such as auditing, disclosure of related party transactions, and reporting for special transactions?
• Do we have a board that will get us where we want to go? Do we have a process for measuring the board's performance?
• Do we have the right mix of skills on the board? Are we satisfied with individual member contributions?

The answers to these questions should clarify the role and responsibilities of the board and help it identify its strengths and weaknesses. This will ensure that it is meeting "best practices" in the compliance area. It will also focus the board's agenda on strategic planning and improve its efficiency and time management. Finally, going through a process to address these questions will improve communications and relations among directors, management, and shareholders.

The first part of the process is a short-term compliance review, the central focus of which is the company's auditing policies, processes, and procedures, and the board's oversight role. What are the red flags, when should directors know about them, and how do they identify them? The Enron case will likely add to case law by addressing when the directors should have known that red flags were present and whether they should have pursued them to uncover deeper problems.

The first step in the compliance area is to determine, as a matter of corporate policy, how "aggressive" the accounting practices should be, especially for innovative procedures such as off-balance-sheet accounting and accounting for various special-purpose entities. Boards and managements will want to address issues such as how long the principal auditor has performed the company's audit and whether the company should consider changing auditors every five to seven years, as some have proposed. What are the relationships between the audit partner and the company? The board should also determine if and when a peer review or audit of the auditor was performed by another accounting firm and whether just having such a peer review is enough to ensure credibility of its own company's financials.

The board should also ask itself not only whether its audit committee is sufficiently independent, but also whether it has enough expertise to delve into a report comprehensively. Is it chaired by someone who can get at the tough questions? Does the committee have input beyond that of the CEO and the chief financial officer, and the opportunity to question these executives independently to satisfy its own fiduciary responsibility?

Boards need to be particularly aware of areas of real or perceived conflicts of interest. Does the board have specific policies for permitting, disclosing, and accounting for related party transactions? What are the board's ethics policies? What are its compliance mechanisms to ensure these policies are carried out?

As a matter of company policy, the board's compensation committee, with the approval of the full board, should engage in an overall review of executive compensation. Again, this is prudent risk management, in that the issues on which the board focuses are those receiving the most attention in headlines about Enron: the equity of compensation to executives, the extent and terms of stock options, and the fairness of windows for selling stock held by executives versus stock held by general employees in 401(k) plans.

Overall Board Assessment
Every board needs to approach its own work not just in a collegial manner, but in a professional management context. Just as corporate management is responsible for devising a tracking system to measure its success, boards should devise ways to track and measure their own successes and challenges. Boards should begin to adopt and apply to their own processes some of these management tools that measure overall performance goals and assessments, with this key question in mind: Does our board have the strengths needed to help the company achieve its goals?

Boards first need to agree on their role versus that of management. While fiduciary law dictates much of the board's functioning, boards still have considerable latitude to define the extent of their oversight and to specify their mission and goals.

To track their success, managements often use a "dashboard" of performance measures. These are a few key indicators, like those found on the dashboard of a car, that show that a company is likely to reach its destination. Measures can be financial (such as profit margins and return on equity), as well as nonfinancial (such as customer satisfaction, quality control, and environmental compliance).

Each measure has a "target" and "actual" indexed amount, which focuses management's attention on which areas are performing and which need attention. Management can also use the dashboard to signal dangers in the company operations—a red light on the dashboard means that an area used to construct that measure is not meeting performance expectations or is out of compliance.

Companies are increasingly tracking nonfinancial performance measures to assess their strategic direction. These nonfinancial objectives—for example, new product and service development, information technology, the company's ability to attract and retain motivated talented people, or its expansion into new markets—are chosen because they will ultimately affect the company's profitability, although perhaps over a longer period than the more immediate quarterly and/or annual financial objectives.

The board should then construct its own dashboard measures to track those areas under its control, such as

• approval of long-term strategic plans;
• oversight of strategic plan implementation;
• CEO succession;
• executive compensation;
• information flow;
• compliance and risk assessment;
• board structure;
• meeting effectiveness; and
• the nomination process.

An agreement to track four or five key indicators will produce valuable dialogue as boards clarify their role, decide on their expectations of success, and measure their own performance against these expectations.

After addressing goals, the overall assessment should deal with basic structural issues. The board should ask whether it has the appropriate overall structure to meet the company's needs. Is it the right size? Does it have the right kinds of committees?

The board should then determine what the qualifications and expectations for director service should be. Are age or term limits appropriate? How are independent directors defined? What is the proportion of independent versus related directors? It is also important to look at what expertise resides on the board. Does it have the right mix and strengths to be of maximum effectiveness in performing its oversight role in connection with the company's strategic plan? Does the board need additional expertise? Should it obtain this expertise by appointing new board members or perhaps by adding an advisory board?

Other areas are critical to the functioning of the board. What is the relation of the board to the CEO in terms of setting board meeting agendas, information flow, its ability to meet outside the CEO's presence, setting CEO compensation, and establishing CEO succession? What inputs do outside auditors, compensation consultants, and legal counsel have? Are these auditors, consultants, and attorneys properly accountable to not only management, but also the board?

Individual Board Member Assessment
Once a board has performed its overall assessment and determined that it has professional processes in place to track and improve its performance, it can turn its attention to individual member assessment. Is the director performing the role expected of him or her as defined by the full board? Or is that director falling short of agreed-upon expectations and if so, is it more graceful to wait until that director's term has expired rather than ask him or her to leave mid-term? Relatively few boards proceed from overall board to individual director assessments for fear of disturbing the collegial balance. There are, however, a number of approaches that can minimize this concern.

Board members can conduct individual assessments by filling out questionnaires rating the board and individual members. One board member (perhaps the chair of the nominating/corporate governance committee) can compile the data and give the results to the board members privately and anonymously. Sometimes an external facilitator can perform the same function. The goal is to uncover strengths and weaknesses so the board is put in a better position to provide the required expertise and oversight.

Just as Important as Management
Even without the specter of Enron, solid corporate governance practices and processes are now a necessity for any company managing risk in the marketplace. To shore up the liabilities board members have, boards will probably become more active than they have been—it's just smart business. At the very least, they need to make sure that their compliance mechanisms can withstand scrutiny.

Before a crisis occurs and before the plaintiffs' bar and the courts step in, management should work with and inform the board of its evolving responsibilities. Good management systems should be brought to bear not just on the operational side of the company but in the area of corporate governance and the board-management relationship. Every company should make sure its board is run as professionally and effectively as its management.

© 2008 Edison Electric Institute