'Boards can work!.' (role of corporate boards in replacing ineffective management)

Governance has measurably improved, and the focus now should be on a process that will provide directors with more leverage on ineffective management.

In the recent past fund managers, and pension fund managers in particular, have been increasingly outspoken in their criticism of poorly performing corporations. IBM, Sears, Eastman Kodak -- Dow Jones stalwarts all -- are just three of the many objects of the managers' fury. Typically, the funds, often acting in concert, seek the replacement of the chief executive officer, the divestment of underperforming or non-core units, and, on occasion, the sale of the company.

An inexorable fact is that every year an increasing percentage of the equity of our largest corporations will be held by funds with managers willing to criticize the manner in which these corporations are managed. Some welcome this trend as a return to the times when owners were joined in the quest for corporate performance. Professor Michael Jensen of the Harvard Business School went so far in 1990 as to predict the "eclipse" of the public corporation. The premise of his predictions is undoubtedly correct: Fund managers are having far more impact on professional managers, a circumstance that has been a rude shock for those managers who prefer stockholders to sell rather than to scold.

Arguably, any action that makes corporate management more accountable should be applauded. However, those who see investment managers as the savior of the American corporation ignore the obvious fact that the skills of successful investors will rarely incorporate those of a skilled corporate manager. The danger, as I see it, is the temptation to use the proxy season rather than the board of directors to cure perceived mismanagement.

The theme of this article is to urge fund mangers to use their clout to improve performance of corporate boards rather than to choose the managers or the strategies of corporations.

For decades, directors have been derided as the golf-playing buddies of chief executive officers; men (almost always) who would prefer to quietly resign their post than engage in a public spat with their pal. No doubt this was too often an accurate depiction of many boards 20 or 30 years ago and no doubt there are contemporary examples of such behavior. However, one can scarcely ignore the dramatic shift that has been occurring for at least 20 years. The objective evidence that boards have acted effectively to change both managers and strategies should be a compelling argument to look at further ways to improve their performance rather than to bypass them.

I offer my own, entirely accidental, experiences as the director of 10 publicly traded companies over the past 24 years as a testament to the fact that boards can work! Consider:

* In 1970 we replaced management of Beck Industries that had acquired 20 companies without care to cash flow.

* From 1971 to 1975 we replaced two sets of management of Republic Corp.: one that gobbled up over 100 companies and one that attempted to cure the resultant indigestion without concern for the stockholders.

* From 1982 to 1986 our audit committee, which uncovered a massive fraud by the officers of an acquired company, battled our honest but baffled managers who were indecisive in dealing with it.

* Twice in the 1980s, along with my fellow directors, I had to deal with the consequences of a highly respected fellow director who was jailed for acquiring stock when our corporation was about to either sell our own company or purchase another.

* In 1984 I joined the directors of Oak Industries who had just fired a management that presided over the destruction of a once high-flying technology company, but five years later I found it necessary to lead a successful proxy fight against those same directors who were content with an honest but ineffective leader. That new management that we installed has provided substantial rewards for those stockholders who supported our fight.

* In 1989 I became a member of the court-required Oversight Committee (and thus a director) of Drexel Burnham Lambert. As tragic as the Drexel experience was for so many corporations that spun out of control as Drexel failed, our Oversight Committee saw a number of corporate boards grab hold of the reins of their corporations and install successful new management teams.

* In 1991 the creditors of Sunbeam-Oster caused me to be a director to oversee the company's emergence from bankruptcy, led by a team of brilliant investors who took control while the company was still in the bankruptcy proceeding. Yet, in less than two years I had to join other directors to replace them with a team better able to grow this consumer products company.

During this same 24 years I had the enormous satisfaction of working with directors of five superbly managed companies that have consistently given their shareholders great value, companies managed by teams that have replaced themselves with little assistance from us.

Corporate boards can work and have worked. In attempting to deal with a universal desire to improve corporate management, I suggest that greater emphasis be placed on boards and that steps be taken to make them even more responsive to the legitimate concerns of their stockholders who now have the capacity to bypass them.

Change in Behavior

The behavior of a relatively small number of investment bankers and managers in the 1980s caused enforcement activity and media coverage that has dulled our collective memory of the hundreds of cases of questionable payments made by corporations prior to 1975, and uncovered and dealt with by the Securities and Exchange Commission in 1975 and 1976. Known as the Lockheed era, the Commission's actions, taken in reaction to its discoveries, accelerated, perhaps caused, a very material change in the composition and behavior of corporate boards. We then suggested (with some emphasis) that three steps be taken:

* We asked the New York Stock Exchange to require an independent audit committee on each listed company.

* We insisted that the accounting profession change its auditing standards to require that "suspicious matters" be disclosed to persons entirely independent of the suspicion.

* We told Congress and the investing public that a material weakness in the internal controls of a publicly traded company would be grounds for action under our Rule 10b(5) if it was not carefully sought and corrected and disclosed when found.

By these actions we effectively told management that they must pay far more attention to internal controls; told auditors that they had to look for material weaknesses in those controls and report any funny business to independent directors; and told audit committees that they were the court of last resort that would have to take effective action if management did not. Few would deny that the results of these actions have substantially improved corporate government.

Today the focus is less on corrupt management and more on a process that will provide more leverage on ineffective management. I respond to that legitimate concern by suggesting that the questions that deserve attention are:

* What can directors do that they are not doing?

* How can we get directors to do what they should?

Allow me to offer some notions that I have about corporate boards and about the pressures -- ethical, economic, and ethereal -- that seek to change corporate behavior.

There are after all some serious problems with how directors conduct their business. There is a diversity of views about how directors ought to act but there is very little talk about what is meant by the term "independent." Too many directors resign rather than quarrel with their old friend, the chairman. Too many others are dropped from management slates because they do not fit in. And we still see far too many instances in which the directors fail to oust management teams for poor performance. Many directors believe that their job is only to keep the company honest and offer advice to management. If they become disenchanted, even disgusted, with management, they just quit.

Far More Is Required

On each occasion that I have witnessed or participated in the unexpected termination of a CEO, I have been astonished by how the auditors and lawyers have been of the view, after the fact, that the management should have been changed much earlier -- but they did not have confidence that we, as outside directors, would take them seriously if they approached us and would protect them from the wrath of the CEO.

Surely it should be apparent by now to anyone familiar with the workings of a modern board that far more is required of all parties. Directors are as responsible for the quality of management as they are for the integrity of management. Directors are equally responsible for the quality of the board itself. All of us should ask ourselves: "Is the board capable of monitoring this company?" An important element of this capability is whether the board has a sufficiently independent quality to deal with those issues that require independent judgment. Directors must be certain that the board's selection process is designed to produce that quality of independence.

But more than independence is needed. Every company must have a business plan that passes the laugh test, and surely a director is negligent if he or she is not able to accept the plan and conclude that the projected returns are sufficient to justify keeping control of the business in the hands of the management.

Above all, a board must open and maintain communication to people other than the CEO in a way that does not undermine the authority of the CEO. The general counsel, chief financial officer, and the internal auditor must feel free to talk to board members, and the board members should make it a point to find out how these people feel about the company. Outside auditors, as well as outside counsel, bear some of the responsibility for the shortcomings of boards. They, too, should be frank with board members about operations or management problems that fall short of illegality.

Let me emphasize that these observations are not a complaint about the basic structure of corporate governance in this country. There has been an enormous improvement in the staffing and operation of corporate boards in the 17 years since independent audit committees were required by the New York Stock Exchange. More corporate chiefs have been replaced. More takeover offers opposed by management have been accepted, and more accounting issues have been resolved over the objections of management.

What the SEC Could Do

In fact, the success to date should be a caution to Congress and to fund managers that would tinker with a system that "works." We can, however, make minor course corrections. Here is how the SEC could enhance the role of the independent director:

* Management should be required to disclose why any director leaves the board before a normal retirement age. If management chooses not to keep a director, the shareholders should be told in that director's own words what the causes of the departure may be. Management must explain why they change auditing firms. The standards should be no less for a change of directors.

* Directors who resign (even when the resignation is not requested) should be required to elaborate on the reasons for the resignation and perhaps they should be required to express a view of the capacity of the management.

* The SEC should require a greater explanation of how independent directors on audit committees keep open channels of communication to outside auditors and counsel, as well as to certain officers of the company, e.g., the CFO, general counsel, and internal auditor. Proper disclosure of these lines of communication will cause real communication rather than the perfunctory executive sessions that often take place in a few minutes just after a regular board meeting ends.

* Independent directors also can be given more authority in a proxy contest. For example, a director who has served for more than three years should be able to make a judgment about management. If he or she is not satisfied with the quality of management and wants to fight management, why not let him or her have equal access to the shareholders to offer an alternative slate of directors?

With such rules in place, a fund manager dissatisfied with management performance need only find a veteran director who shares those concerns and select, with that dissident director, an alternate slate to govern the subject company. It seems apparent to me that such an approach is far preferable to one that relies on outside shareholders to choose policies or directors through an unaided proxy process.

Question of Independence

The remaining question, of course, is whether there are enough "independent" directors and who is to say whether they are or are not independent?

We could in fact use a better process for putting and keeping directors in place and in informing them of their responsibilities. There is an understandable, general apprehension about whether board decisions -- to fight takeovers, grant golden parachutes, endure management LBOs, oppose proxy initiatives, approve acquisitions -- are made by persons sufficiently independent of management to protect the long-range interests of shareholders.

A form of automatic monitoring is needed -- a monitoring that will not guarantee the presence of the desired independence but one that will greatly enhance the process of selection and the sensitivity of all board members to the fact that the subject is important.

A simple way to provide that kind of monitoring would be to accept the point of view that the lack of an independent audit committee constitutes a material weakness in corporate control. Such a rule would require outside auditors to look into the question of whether an independent audit committee does exist. The auditors would not, by any stretch of the imagination, be required to guarantee such independence but they would have to make an effort to collect certain standard information about the composition, selection, and operation of the audit committee. The very process of securing such information would greatly increase the awareness of management and of directors to the need for, and the responsibilities of, the independent director.

A Material Weakness

Unless there is a truly independent group of directors, the outside auditors must be very careful of voicing suspicion. If they can't "prove" their suspicions, they may lose their client because of an overly protective boss. It really is not much of a stretch, therefore, to say the absence of a sufficient independent quality on a board is a material weakness.

My accounting friends will say, "Don't try to make us do something we can't do." How can we not be sympathetic to that point. For at least 25 years we have blamed the accountants for not finding something before stock prices plummet. And every time they fail (in the eyes of Congress, at least) to perform their task, we give them more tasks to perform.

So, I'm sympathetic, but there may be no alternative that would not put a far heavier burden on that profession. And let me emphasize again that we do not require auditors to give guarantees that these are not material weaknesses. We ask only that they look for them and report them when found.

Let's welcome the revolt of the fund managers, but let's make certain that there is a channel for their ire that will result in a better corporate governance than we could expect from those financial analysts who have decided that they bet on wrong management in the first place. Seventeen years of improvement in the corporate governance provided by directors deserves support.

Roderick M. Hills was Chairman of the Securities and Exchange Commission from 1975 to 1977. He is currently a Director of Federal-Mogul Corp., Sunbeam-Oster, Oak Industries (of which he is Vice Chairman), and the Mayflower Group. He is Counselor to Hills & Company, a consulting firm run by his wife, Carla Anderson Hills.