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Corporate governance: Hard facts, soft behavior

Experts at Strategy + Business explain why the conventional wisdom about how to prevent future corporate scandals still comes up short of what's really needed to fix the mess.

Here's a test for corporate America--and corporate Europe and the corporate Pacific Rim, for that matter.

• In the wake of the accounting, leadership and governance scandals at large companies such as Enron, Tyco and WorldCom, the provision in the Sarbanes-Oxley Act of 2002 that CEOs and CFOs personally certify the accuracy of their financial statements will restore investor confidence. True or false?

• All the problems with corporate governance boil down to one thing: Boards of directors aren't independent enough. True or false?

• Holding chief executive officers to stricter performance standards will cause corporate performance to improve. True or false?

Conventional wisdom increasingly is answering "true" to these questions. Companies are falling over themselves to institute visible and verifiable changes in board composition and structure: requiring that a certain proportion of directors be outsiders; appointing a lead director; requiring "outsider only" membership on board audit and nominating committees; and so on. And boards have CEOs on the run--a Booz Allen Hamilton study found that turnover of CEOs at the world's 2,500 largest publicly traded companies increased by 53 percent between 1995 and 2001.

Are these changes in the structure of business necessary? Probably. Are they sufficient? Certainly not.

Current attempts to embed irreproachable business behavior in the composition and structure of corporate boards are, we believe, doomed to fail.

The fixes many firms are rushing to institutionalize may even be naively counterproductive. The drive to more tightly regulate the membership and functions of corporate boards is already encouraging companies to view governance as a legal challenge rather than a way to improve performance. Moreover, evidence exists that such externally imposed governance requirements may compromise long-term performance.

"Hard" solutions, in short, will not resolve the challenges companies face in simultaneously serving the interests of shareholders and other stakeholders. By reducing the critically important issue of corporate governance to what amounts to a box-checking exercise, corporate directors and senior executives are addressing the symptoms, not the root cause, of the governance crisis.

Our experience in advising boards and CEOs in the United States, Europe, Australia and Asia; our primary research in these markets, including interviews with hundreds of directors and corporate officers about board effectiveness; and a review of contemporary best practices leads to one universal conclusion: Governance begins at home--inside the boardroom, among the directors. It is embedded in how, when, and why they gather, interact and work with one another and with management?in other words, the "soft" stuff. But qualitative reforms to the behaviors, relationships and objectives of the directors and the CEO are meaningless unless they are subjected to the "hard" mechanisms of performance criteria, processes and measurements.

This combination of soft and hard solutions can turn governance from a vague concept into a means to deliver organizational resilience, robustness and continuously improved corporate performance.

Qualitative reform
It was, perhaps, inevitable that the bubble economy of the late 1990s would be followed by both decline and introspection, but the degree of soul-searching today is striking nonetheless. Forty-six percent of the corporate executives surveyed by Kennedy Information, publisher of Shareholder Value magazine, said the recent wave of corporate scandals had harmed the way investors viewed their companies, and 43 percent were committed to changing the way they did business.

The problem is, in too few cases is this reflection prompting companies to change, a situation that almost begs governments to attempt regulatory solutions--which will not, by themselves, create conditions for better governance and improved performance.

Too often, firms assume that "soft" reforms cannot be assessed, or even implemented, rigorously.

What distinguishes superior performance among boards is the "qualitative" reforms that companies put in place between the structural boxes and the lines of legislative mandate. With tens of thousands of publicly traded companies around the world, the recipe for reforming the soft side of governance will need to be adjusted to the specific circumstances of an individual company. Still, although governance regulations and management culture differ from firm to firm, our experience persuades us that the following best practices can--and should--cross borders.

Too often, firms assume that "soft" reforms cannot be assessed, or even implemented, rigorously. But if a company aims to better serve shareholders' interests--and adapt to the rigors of an increasingly competitive global economy--it must address board culture and behavior through a systematic and solution-oriented approach.

The first imperative, naturally, is choosing the right directors, with the right skills, expertise and personalities. An impulse in the current crisis environment will be to try to satisfy regulators simply by changing the insider-outsider mix on the board. But board balance alone is an insufficient guarantor of effectiveness. Boards need to possess, collectively, the diverse array of skills and knowledge needed to perform effectively in their advisory and oversight capacities. The central test for a director should be: Does he or she add value?

Sometimes the skills needed--and absent--are painfully obvious. Frank Cahouet, retired chairman of the Mellon Bank Corporation, recalls recruiting Ira J. Gumberg when, in the late 1980s, Mellon was burdened with bad real estate loans. Gumberg, a developer and still a Mellon director, worked directly with the company's real estate department to give managers hands-on advice on how to extricate the bank from its loan-portfolio mess. "Directors all have strong suits," says Cahouet, now a director at executive recruiting firm Korn/Ferry International and Allegheny Technologies. "What you do is pull on their special knowledge."

Possessed of such business acumen and technical know-how, directors also need charm and the chutzpah to engage in debate. Again and again, when asked to describe the key activities and characteristics of a well-run board, directors we've interviewed say the same thing: debate, dissent, active engagement. "What you're looking for is an open, rigorous discussion, with people challenging each other, challenging the CEO," says Marc Epstein, a business professor and governance expert at Rice University in Houston.

Surveys conducted by Korn/Ferry support this contention. Nine out of 10 directors polled by the firm cite "willingness to challenge management" as either the most important criterion or among the most important criteria in selecting new directors.

Train the watchdogs
Serving as a corporate director is not an honorary commitment. A director requires a thorough understanding of the company's past, present and potential performance to ask intelligent questions. The New York Stock Exchange recognized this when it mandated, as part of its new listing requirements, that governance principles address "director orientation and continuing education." Yet most companies have failed to furnish that training. A survey of 300 public companies conducted by the Financial Executives Institute in 2002 found that 86 percent of the respondents did not provide a continuing program for educating board members.

In fact, a surprisingly large number of company directors have little or no background in the businesses they are monitoring. As one Australian executive director we interviewed put it, "Most of our directors have little or no real understanding of our various businesses." Today, not all directors can even work their way through financial statements. One CEO recently asked Professor Epstein to join his board because the chief needed help figuring out his own financial statements. If the CEO isn't fully financially literate, Epstein wondered, how can the directors be expected to be? He declined the invitation.

Companies should develop training regimens for directors, and nominating committees should gain potential board members' commitment to engage in such schooling as a prerequisite for election. Other stock exchanges should follow the New York Stock Exchange's lead and institute training requirements.

Inform and empower
"Management writes the board agenda. We tend to look only where they shine the light," complained one director we surveyed. It's true. Most of the information reviewed by boards of directors is provided by management, generally a week to 10 days before the board meets. It is too little, too late.

A steady supply of credible and comprehensive information is the foundation of an effective board's power to govern competently. To gauge the adequacy of a board's information sources, Paul Lapides, director of the Corporate Governance Center at Kennesaw State University in Kennesaw, Ga., suggests directors ask themselves, "Can we have a conversation about this company without someone from management being there?"

Good corporate governance transcends ethics.

The frequency, format, sources, channels and content of that information all influence whether directors develop the knowledge needed to do their jobs. Edward Lawler III, professor of management at the University of Southern California and coauthor of "Corporate Boards: New Strategies for Adding Value at the Top" (Jossey-Bass, 2001), argues that this knowledge base should encompass more than financial results. "Simply looking at accounting data is inadequate," he says. "Directors need to develop a better mix of indicators of how the corporation is performing."

Professor Lawler suggests nonfinancial as well as financial indicators, leading indicators and lagging indicators, and indicators that include customer and employee satisfaction, quality, cycle times, and so forth. According to his research, companies that provide their boards a range of indicators enjoy significantly greater stock and investment returns than firms that do not.

Few issues are more hot--or more contentious--right now than the relationship between the CEO and the board of directors. "Independent" boards--that is, boards with few inside directors--have become the trend du jour. But as the Enron and Tyco sagas illustrate, even companies that comply with the recommended ratios of outsiders to insiders can stumble badly.

Our experience persuades us that companies benefit when the roles of CEO and chairman are split. The 1992 publication of the Cadbury Commission report on corporate governance in the U.K. ushered in a sweeping change in governance practices in Britain. Today, only a few major U.K. companies have a single chairman/CEO; the increased transparency resulting from better-balanced governing mechanisms prepared British companies for the era of increased shareholder activism, as Financial Times columnist John Plender remarked recently.

But there are other, less obvious reasons to recommend this separation of powers. One of the most prevalent private complaints of chief executives is that they have no one with whom they can talk deeply and seriously about the difficulties, some of them intensely personal, of running a complex enterprise. The avidity with which hundreds of CEOs flock to the annual meeting of the World Economic Forum in Davos, Switzerland, attests to their thirst for contact. A nonexecutive chairman can become the confidant and coach that so many chief executives crave, especially if (as is often the case in the U.K. and Australia, which also adopted Cadbury-like governance mechanisms in the past decade) the chairman is a retired CEO of another company who is clearly not in competition with the company's chief.

Evidence indicates that U.S. companies will be slow to adopt this approach; in January, for example, AOL Time Warner appointed CEO Richard Parsons to the additional role of chairman. So, short of role-splitting, there are other measures companies can and should take to ensure an appropriate power balance between CEOs and directors. Former Securities and Exchange Commission Chairman Roderick Hills recommends that the board nominating committee, not the CEO, recruit and hire directors. That change has become increasingly accepted; Korn/Ferry Managing Director Charles King says that nominating committees today initiate about 70 percent of the director searches he conducts, versus about 10 percent eight years ago. To reinforce its independence, a CEO/chairman should not be a member of the nominating committee. But because CEO-board chemistry is vitally important to corporate governance and operations, the chief should be able to vet and veto nominees with whom she or he is not comfortable.

Hills also says that audit committees, in particular, must have the ability to structure their operations to create their own power base. Audit committee directors should determine for themselves what they want to see--not simply accept what management hands them. He also urges that independent directors choose the company's external auditors, negotiate the auditing fee, and establish the reporting line from auditor to board. As Hills, who currently chairs the audit committees at Chiquita Brands International and ICN Pharmaceuticals, puts it, "You need to confer independence on the outside auditors."

The layman's currently jaundiced view of corporate governance--defensive CEO packs board with cronies and weaklings, then manages the information they get so they can't do him harm, in the process so enfeebling the board that they can never add value--is leading many to propose a more "modern" governance model: Enlightened, open CEO enlists extremely talented, opinionated, and strong-willed board members, gives them free access to whatever information they need, and then uses them as a strategic forum for formulating strategy, answering really difficult questions.

Although it's important to empower directors with information and arm them with the authority to make tough decisions, boards should not get into the habit of openly vying with the CEO. An atmosphere of antagonism and divisiveness serves no one's interests, least of all the shareholders'. CEOs must be able to treat directors "as a valued asset rather than a pain in the rear," says Richard Koppes, formerly with California Public Employees' Retirement System (CalPERS) and now a partner at the law firm Jones, Day, Reavis & Pogue and a director of Apria Healthcare and ICN Pharmaceuticals.

That's a stretch for many firms. As one company secretary we surveyed noted, "It's pretty easy to manipulate the board's role by the agenda and the papers we give them." Koppes agrees. "A fair number of CEOs," he says, "try to make the board nonperforming assets."

Watch the time
In today's increasingly complex and global business environment, the demands placed on board members are unprecedented. As industries deregulate, new markets emerge, mergers are made, and subsidiaries implode, board directors are increasingly pulled in multiple directions. These special circumstances are added to all the normal demands of board membership--meetings, training, and evaluations. It's little wonder that companies are having a difficult time fielding qualified candidates to fill their board seats. A lot more people are saying no.

To participate constructively in strategic and other board discussions, directors we've spoken to report that they spend time not only attending meetings, but also studying the issues beforehand, participating in site visits and informal gatherings, and conferring privately with the CEO and other executives. Korn/Ferry's Charles King estimates that audit committee members will spend as much as 300 hours per year per company fulfilling their board obligations. Other board members will commit between one and two days per month, roughly 100 to 200 hours per year, barring a crisis.

Although boards may shy away from setting strict numerical limits on members' other directorships, they should establish participation benchmarks for directors. Continued membership should be contingent on the faithful fulfillment of obligations.

A board's scrutiny should apply not only to the company's performance, but to its own performance. On this point, perhaps surprisingly, most directors concur. For example, in a Booz Allen survey of directors of Australia's 100 largest companies, 77 percent believed that substantial scope exists for improving the practices of boards. When asked about individual director contribution to board effectiveness, 89 percent said it varied significantly; 66 percent believed boards required better processes for self-assessment and evaluation; and 83 percent felt boards should have policies to replace nonperforming directors in an orderly fashion. A Booz Allen European survey revealed a similar consensus.

Yet very few companies have in place mechanisms for defining or measuring the performance of the board either as a unit or at the individual director level. In research with the Conference Board, we could identify only 13 incidents of directors' being removed for performance reasons, among 546 companies studied.

Of course, the measure of success in making boards accountable is not the removal of underperforming directors. Ideally, boards should put in place performance measures and evaluations that provide the group and individual directors the opportunity to correct course before real damage is done.

Nearly all governance experts urge directors to conduct board evaluations. Directors at best-practice companies like Target and Medtronic have done so for years.

When it comes to assessing individual directors, however, the subject of board self-evaluation becomes more controversial. Purdue's Professor Beering says the five boards he sits on have rejected the idea, believing it "pejorative and insulting." Yet the research by Professor Lawler of USC shows that directors rate board effectiveness significantly more positively on boards where individuals are evaluated. Perhaps that explains why studies by Korn/Ferry show that 71 percent of directors think individual evaluations are a good idea (although only 18 percent actually participate in them).

This is a sensitive area, but the increased need for improved board fitness demands progress on the issue of board (and probably individual director) evaluation. A healthy first step is for the chairman, in collaboration with the CEO, to draft a set of evaluation criteria relevant to the organization and its situation and circulate it among the directors for comment and discussion. This "Chairman's Checkup" should begin with a rigorous exploration of the firm's earnings drivers, and lead toward an analysis of the risks the company faces in those areas. Because boards are essential risk management mechanisms, the earnings and risk analysis can help guide the company toward the specific types of knowledge and skills its directors should have, the practices in which the board should engage, and the information directors require to perform their duties. Understanding the board's composition, information, and process requirements will in turn help define the metrics needed to ensure continuously high performance.

A shared understanding of ethical behavior is one of the critical elements that bind a society together. But good corporate governance transcends ethics: It is a crucial operating system for companies in complex, competitive, fast-moving industries, and thus an important component of economic stability and growth.

Legislation can stiffen penalties for directors, executives and firms straying from the path of good governance, and exchanges can tighten listing requirements, but only the chief executive officer, the chairman and their board of directors can choose to govern well. To do that, they must master the soft art of balancing power, nurturing a collegial culture, promoting continuous improvement, and educating and informing each other. Although these behaviors have always been noble goals, they are now a shareholder requirement in a newly chastened marketplace.

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Reprinted with permission from strategy+business, a quarterly management magazine published by Booz Allen Hamilton.