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THE BOARD SEAT
BECOMES A HOT SEAT:
NEW LIABILITY RISKS FOR CORPORATE DIRECTORS
By Philip
Mattera
As members of
the world’s corporate elite descended on the
Swiss village of Davos this winter for their
annual retreat, the conversation was not
only about trade policy, energy prices and
the growing power of China. According to the
Wall Street Journal, top executives
at the event were also voicing concerns
about the seemingly mundane matter of
whether they should agree to serve as
directors of other companies.
At issue is
not simply time management. The once common
practice of CEOs to sit on the boards of a
few other companies—for reasons of prestige
and networking—is now viewed with
trepidation. Top executives and others in
the director class worry that the financial
and professional rewards of board
memberships are being overwhelmed by the
increasing potential liability of those
positions.
What put board
members particularly on edge were recently
announced settlements in lawsuits brought by
former investors in two firms that went from
being Wall Street darlings to symbols of
corporate corruption: Enron Corp. and
WorldCom Inc.
In the
WorldCom case, ten former directors of the
firm agreed to pay $18 million out of their
own pockets as part of a $54 million
settlement with class-action plaintiffs led
by the New York State Common Retirement
Fund. From the beginning of the case,
investors in the now bankrupt telecom
company sought to hold the directors
personally responsible for failing to
prevent the massive accounting fraud that
took place during their watch. The $18
million figure represented about 20 percent
of the aggregate personal net worth (apart
from primary residences and retirement
accounts) of the board members involved.
Insurance carriers were to pay the balance
of the settlement.
Two days after
the WorldCom announcement, a group of ten
former directors of Enron agreed to pay $13
million of their own funds as part of a $168
million settlement of a suit brought by
investors who lost billions of dollars when
the company collapsed in the wake of
revelations about widespread bogus
transactions and insider self-dealing.
The rarity of
these settlements was underscored by Michael
Klausner, a law professor at Stanford
University, who told the New York Times
that his research on director liability had
found only four cases from 1968 to 2003 in
which board members contributed their own
money to settle a shareholder lawsuit.
Directors are now worrying that the WorldCom
and Enron cases could signal a turning point
in the treatment of personal liability. “My
life savings could be at jeopardy,” a
director at tobacco company Reynolds
American Inc. told a reporter. “It’s very
scary.”
AN “IMPOTENT CEREMONIAL AND LEGAL FICTION”
In the early
20th Century there had been
concern that directors who sat on various
boards (a practice known as interlocking
directorates) helped to solidify the ties
among large companies and created the
potential for anti-competitive collusion.
Yet in the postwar period, power came to be
concentrated in the hands of the chief
executive officer. Those chosen to serve as
board members were often friends of the CEO
who were happy to rubber-stamp his decisions
and approve generous increases in his
compensation package. The fact that the
board was, on paper, the ultimate
policymaking body of the corporation meant
little in practice. Management guru Peter
Drucker once called the power of boards an
“impotent ceremonial and legal fiction.”
As noted in
Corporate Research E-Letter No. 3,
passive boards often came under attack
during the 1980s, when corporate raiders
sought to shake up stodgy companies. Yet
directors tended to stay loyal to
management. This bond weakened in the early
1990s, when many large U.S. companies began
to feel the effects of heightened
international competition. As losses
mounted, some boards felt compelled to act.
In 1991 the outside directors of Goodyear
Tire & Rubber forced out the chief
executive. Even more significant was the
move the following year by the board of
General Motors, the country’s largest
corporation, to force the resignation of CEO
Robert Stempel because of the automaker’s
poor performance.
The New
York Times wrote at the time that “many
predict that the awakening of the once
sleepy GM board will redefine the cozy
relationship that often exists between the
nation's top executives and the hand-picked
members of their boards.” It's true that in
the following years the boards of other
large companies such as Eastman Kodak
engaged in similar coups.
Overall,
however, the board revolution never
materialized. The zeal of outside directors
was quenched in no small part by the fact
that board service had become an
increasingly lucrative activity. By the
mid-1990s, some large companies were paying
directors annual fees of $50,000 plus stock
options and other perks. For directors who
served on multiple boards it was now
possible to earn well into six figures from
a bunch of rather undemanding part-time
jobs—very part-time, given that they were
usually required to attend only a few
meetings a year.
As directors
slipped back into their submissive and
lethargic ways, they came under increasing
criticism from activist institutional
investors such as large labor unions. In
1996 the Teamsters published a report called
America’s Least Valuable Directors
that scrutinized board members based on
their attendance record at meetings,
potential conflicts of interest and other
indicators of poor performance. That same
year, Business Week published the
first of what would be a series of features
on the country’s best and worst boards.
These
pressures helped bring about some
reforms—such as demands by companies that
outside directors limit the number of board
seats they held—but it eventually became
clear that something sinister was happening
at a number of large companies, and their
directors were doing nothing about it.
“A BOARD THAT RUNS DEEP”
In October
2000 Chief Executive published its
own assessment of board performance. The
magazine singled out for praise the
directors of then high-flying Enron, calling
them “a board that runs deep” and adding:
“we are heartened by the overall corporate
governance structure and by its governance
guidelines.”
Fourteen
months later, Enron filed for bankruptcy,
putting thousands of employees out of work
and erasing billions of dollars in the value
of its stock. In the wake of that debacle
came a series of revelations about other
companies whose executives were alleged to
have engaged in accounting frauds to enrich
themselves while giving the impression that
the firm was thriving.
In case after
case, it was clear that board members had
either failed to notice the irregularities
or had somehow approved illegitimate
practices. As for Enron, the evidence
suggested complicity rather than
obliviousness. An investigation conducted by
an outside law firm found evidence that
directors were well aware that executives
were creating numerous off-balance-sheet
partnerships. The board, in fact, had gone
so far as to suspend Enron’s code of ethics
in order to allow the company’s chief
financial officer to participate in some of
the partnerships for his personal benefit.
A 2003 inquiry
into the WorldCom scandal by former U.S.
Attorney General Dick Thornburgh found that
the board had approved large mergers after
being given only minimal information and had
allowed CEO Bernard Ebbers to borrow huge
sums from the company without considering
whether he could repay those amounts.
Board
oversight of questionable transactions (or
lack thereof) has been at the center of
another high-profile corporate corruption
case: the prosecution of L. Dennis Kozlowski
and Mark H. Swartz, two former executives of
Tyco International, on charges of illegally
awarding themselves hundreds of millions of
dollars in bonuses and loans that were
allegedly concealed from the company’s
board. At the original trial of the two men
last year (which ended in a mistrial) and
the current retrial, the defense argued that
the board knew of the lavish perks and thus
no crime was committed.
Jurors will
once again have to decide whether what
happened at Tyco was, in effect, a case of
executive larceny or board negligence.
Whichever way the case goes, it will
probably be of little help to the company in
defending itself against the wave of civil
lawsuits that have been brought by investors
and former employees.
AN END TO CRONYISM?
So what do
these cases mean for the future of corporate
governance? The succession of business
scandals that began in late 2001 brought
about some changes. The Sarbanes-Oxley Act
of 2002, for example, required that members
of board audit committees be independent
directors rather than company insiders. The
New York Stock Exchange and NASDAQ now have
rules that require a majority of board
members at listed companies to be
independent, though there is debate on how
rigorously that term is being applied.
These modest
reforms hardly seem adequate to address the
degree of board incompetence that has come
to light. The recent instances of personal
liability are of greater help, but what will
make a real difference is a fundamental
change in the way in which board members are
chosen. Only when there is an end to the
cronyism that characterizes the director
selection process will board independence
become meaningful.
To its credit,
the staff of the Securities and Exchange
Commission floated a proposal in 2003 that
would reform the selection process to make
it easier for shareholders to nominate
candidates, thus reducing the near-absolute
control now held by management and incumbent
directors. Unfortunately, the proposal has
remained bogged down at the Commission in
the face of vigorous opposition from
corporate advocacy groups such as the
Business Roundtable and the U.S. Chamber of
Commerce.
Despite the
embarrassment of scandals such as Enron and
WorldCom, Corporate America appears to be
doing everything in its power to keep true
democracy and accountability out of the
boardroom.
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