The Worst Things a BOD Can Do
Most written board governance material focuses on “best practice” and “how-to” type articles. This essay will focus on what board directors should avoid. There are numerous public company examples to draw from, including the infamous 2001 implosion of Enron, which drove a significant change in Federal legislation with the Sarbanes Oxley Act. Worldcom in 2002 and more recently Boeing provide additional examples of what a board of directors should not do.
Board directors may think such extreme examples are not relevant because, in hindsight, the egregious events would never have been allowed to occur at “their” company. Yet, for the most part, the impeccable board director credentials of the companies in question suggest otherwise. Moreover, several factors happened over an extended period that fostered a weakened oversight environment. For this reason, there are lessons to be learned here.
Enron was the seventh-largest publicly-traded company in the US with $74 billion in assets when it declared bankruptcy in 2001. Then, only a few months later, the 89-year-old Arthur Andersen accounting firm, one of the most prestigious accounting firms in the world, collapsed. The outcome was thousands of people out of work, pensions lost, material stock market losses and years spent sorting out the remaining mess.
The board failed in its fiduciary duties, including care, loyalty, and confidentiality. It failed to safeguard Enron shareholders by allowing management to engage in high-risk accounting and management practices. As a result, explicit, unprecedented conflicts of interest existed. For example, the CFO operated LJM private equity fund, which profited at Enron’s expense. The board directors failed to protect shareholders from unfair dealings. Enron overstated results because of billions of dollars in off-the-book activities, and the board directors failed to ensure adequate public disclosure. The board directors lacked independence compromised by financial ties between the company and certain board members, including the outside auditor. Arthur Andersen provided internal audit and consulting services while serving as an external auditor.
The simple cure is for board directors to take their fiduciary duties seriously. Board oversight is paramount. The board must always look for management activities that promote high-risk practices, create potential conflicts, or motivate off-the-book activity. The board must also bar any financial ties between the company and directors except for direct board compensation. The board can ensure greater oversight by creating independent compensation and audit committees to oversee executive compensation and financial reporting. Independent committees begin with well-written committee charters that clearly define the scope of responsibility. Specific compensation designs promote undesirable behavior. Remember the adage, “You get what you pay for.” Audit committees need to ensure that the auditors are genuinely independent and free from conflicting financial ties. Audit committees need to be staffed with good accounting, finance, and risk management expertise to understand the subject material. Insufficient committee expertise contributed to the Enron failure. Audit committees must also have the hire/fire authority over the outside auditors.
WorldCom was the #2 long-distance company with 20 million residential customers when it filed for bankruptcy in 2002. With $104 billion in assets, WorldCom was the largest bankruptcy in history and followed right after Enron. The company was built by 75 acquisitions and amassed $32 billion in debt. The debt load drove the management team to pursue aggressive accounting practices. The board of directors allowed WorldCom to provide $408 million in personal loans to the CEO, Bernie Ebbers. At the time, WorldCom was “too big to fail,” a term we all heard again during the 2008-2010 great recession. Arthur Andersen was WorldCom’s outside auditor. Not surprisingly, there is a pattern here.
Weak audit and compensation committee oversight created an environment where the WorldCom CEO and CFO did whatever they wanted. The audit and compensation committees lacked the needed expertise to understand the accounting, financial, and risk factors. The board of directors failed to hold closed-door sessions without management present. The board failed to understand and monitor the business strategy. It failed to ensure proper criteria were in place to evaluate, finance, and run the acquisitions post-closing. There were no pre or post-action acquisition reviews to assess the target against the stated strategy or compare actual outcomes to plan and hold management accountable for the results.
Boeing had two 737 Max airplane crashes five months apart, costing 346 passengers and crew lives. The board of directors was filled with luminaries but limited in aeronautical engineering expertise. Boeing executive incentive plans focused on profits and the all-consuming “shareholder value” mantra to the exclusion of other KPI’s like testing, safety, and quality. As a result, the CEO demanded price concessions from suppliers and heaped cost demands on engineers while cutting the workforce by 7% and increasing output. In addition, the CEO mandated that employees limit the training and testing required to commercialize a plane. Boeing engineer annual reviews focused on design costs. At one point, the sales force sold planes four years out at prices the company couldn’t yet hit from an engineering standpoint. Another essential point, Boeing had “sweetheart” arrangements with FAA regulators. Former FAA employees worked for Boeing, and the board directors had a few well-connected politicians setting up the conflict of interest.
The board failed to react after the first crash or even immediately after the second crash. An engaged board knows when it is in a crisis. In these situations, the board directors need to be more proactive. The formation of an aerospace safety committee did not occur until one year after the crashes. It suggests financial statements and shareholder value were the scope of the board, and not safety, quality, and other KPI’s critical for the successful operation of a highly-engineered product company. The board of directors put explicit pressure on the CEO to reduce economic risk and bolster profits. The board set policies and created incentives for executive compensation that led to the disaster. Boeing has 13 board members, and at least seven of them were in place when the tragedy occurred. Board compensation totals over $345,000 annually, so attracting broad expertise is not a factor. Yet today, a surfeit of board directors with finance backgrounds and few directors able to evaluate more than financial statement metrics still exist.
Eight of 13 Boeing board directors hold multiple directorships, two serving on four boards each. Board director roles with complex companies like Boeing are full-time jobs. Though corporate governance standards suggest an upper limit of four boards, it is an indulgent standard. Duty of care requires the board director and Nom/Gov committee to evaluate the complexity of the other board obligations to avoid a dilution of attention.
Groupthink may have been a concern on the Boeing board. Three former Boeing board directors served together on the Caterpillar board. The Boeing compensation committee listed Caterpillar as a “peer company” for compensation comparisons. A former Boeing CEO, McNerney, and two other board directors sitting on the compensation committee were all former GE executives, and GE was also a peer company. Using a board skills matrix for recruiting and conducting professionally-managed board searches through the Nom/Gov committee will minimize groupthink. Avoid asking other board members to refer “friends and family” when conducting board searches.
Epic board failures come with a high cost. However, productive board directors following the duty of care, loyalty, and confidentiality can minimize the occurrence. Board directors must remain vigilant and independent to fulfill their role and avoid groupthink. Nom/Gov committees need disciplined recruiting processes and avoid the temptation of an informal search without clearly defined criteria. Competent board director candidates protect themselves by sizing up the existing board governance “tone at the top” when asked to join a fiduciary board. A “club-like” environment with limited or no policies or standing committees should be considered warning signs. Family business owners are better off formalizing their board processes, especially as the business increases in complexity and multiple generations join the business.
Mark Richards is the retired Chairman and CEO of Appvion, Inc., headquartered in Appleton, WI.
Mark is now President of Meade Street Advisors, LLC, board governance, executive coaching, and strategic planning consulting business headquartered in Fort Lauderdale, FL.