The agency that bills itself as “the investor’s advocate” needs to go well beyond asking boards to chime in on what’s behind their structure. It needs to focus on the bigger picture of the role of the board in the worst financial crisis since the 1930s and the persistent folly of directors who do not direct. That, in our view, is the real definition of systemic risk.
There is a common factor in nearly every major corporate governance failure and virtually all of the enforcement actions taken by the Securities and Exchange Commission since the 1960s. In almost every instance, including the bankruptcy of Penn Central Railroad, the bribery scandals of the 1970s involving Gulf Oil, Lockheed and many others, the criminal misconduct at Enron, WorldCom, Tyco, Qwest, Livent, and Hollinger, and, more recently, the stock options backdating scandal at Research In Motion, these companies preferred to vest the powers of the board chair in the hands of the CEO. In all these situations, there was a troubling degree of boardroom deference to the CEO while improprieties were occurring.
So it is that the announcement by the SEC’s new chair, Mary L. Shapiro, that the agency is thinking of requiring listed firms to disclose their reasons for adopting their particular leadership structure, and whether that structure includes an independent chair, struck us as somewhat anticlimactic and underwhelming.
The case for separating the roles of CEO and board head, with the board chair being filled by an outside director, has been supported by a formidable consensus of independent corporate governance experts since the 1940s. It was a prominent part of the groundbreaking research by the late Myles L. Mace of Harvard in the 1970s and has continued to be embraced by leading authorities since that time. The rationale for separating these positions is simple: it defies both human nature and precepts of modern organization for a CEO to be held properly accountable to a board which he or she heads and leads. To instill a true culture of accountability, a CEO needs to see an independent counterpoint to his power sitting at the other end of the boardroom table, and not just a mirror image of himself.
I made that case in 1994 when I was invited to testify before Canada’s Senate banking committee (and in several subsequent appearances), as well as in submissions to committees of the U.S. House and Senate during hearings leading to the passage of the Sarbanes-Oxley Act of 2002. An argument can be made, as I did, that separating these top positions is as important to the effective running of a major publicly traded company as the requirement to have an audit committee composed of independent directors.
Given the undeniable weight of history in tow on this subject, the SEC should be doing more than trying to send up a trial balloon and looking rather feeble in the process. What is required is for the agency to be far more aggressive about fostering a climate of accountability in American boardrooms. That it has taken this long to recognize a reality that has stood the test of time for decades, and that it is only now thinking about asking boards where they stand on the issue, illustrates how far behind the curve the SEC is when it comes to modern corporate governance practices.
The agency that bills itself as “the investor’s advocate” needs to go well beyond asking boards to chime in on what’s behind their structure. It needs to set out principles of sound corporate governance in language as hard as cannonballs, to borrow from Emerson. And it should insist on narrative from boards that is extensive and sets out in clear language in circumstances where a company has departed from those practices, including the appointment of an independent board chair. Naturally, separating the top positions and requiring an independent director as chair of the board is no guarantee of success. Having a ball team of nine players is no winning formula either, as any Mets or Cubs fan will admit. But not having the right number means that you don’t even get to play the game. Boardrooms have also reached the point where some basic structural rules are too important to overlook.
It was as a result of the financial excesses and failures of the 1930s that the SEC was born. There has been nothing even remotely approaching that level of reform coming out of the SEC in what has been the worst financial crisis since that time.
Here’s something else the SEC is missing: What exactly was the role of boards of directors in the credit and financial meltdowns of the past 18 months, and to what extent did a failure of structure or culture among directors contribute to a global crisis affecting hundreds of millions of individuals, costing trillions of dollars and eventually leading to the collapse of banks around the world? We have already pointed out on these pages the colossal shortcomings of the boards of Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup and Countrywide Financial, to name a few. All of these troubled institutions, by the way, followed the unified CEO/board chair model, although at Bear Stearns, James Cayne gave up the CEO slot and became an executive board chair a few months before the company’s collapse.
What boards did and did not do, and how they were organized, in recent years and months when calamity has been such a frequent guest are lessons that are too important to ignore. We suspect that what will be found is a weak and compliant boardroom culture where the most taxing job for most directors was lifting the rubber stamp marked “yes.” That, in our view, is the real definition of systemic risk.
During a disaster of a much more limited scale -the collapse of Penn Central Railroad- the SEC ordered its staff to conduct a through review of what the directors knew and when they knew it. Staff also examined the structure and culture of the board and its interactions with management. The result was illuminating and became a template for the disengaged board. As the staff report concluded:
Directors of Penn Central were accustomed to a generally inactive role in the affairs of the company. They never changed their view of their role.
The SEC has no trouble spending what seem like endless time and resources looking at the uptick rule and the allegedly detrimental role of short-selling, for instance. A case can be made that it is focusing too much on the individual trees and not on the health of the boardroom forest. Much more has been lost by shareholders, and by society more recently, as a result of boards that simply did not direct, did not hold management sufficiently accountable for its actions and were not adequately engaged with the affairs of the company in order to monitor risk and foresee the disasters that were looming on the horizon. The corporate board, with all the power and responsibility it entails, is an institution that requires considerably more focus on its limitations, its deficiencies and on its need for reform if it is to play its necessary role as a steward of investors’ interests and a guardian of the integrity of capitalism itself.
We will have more discussion about the past and future role of boards, and where they fit into the post-subprime recession era, in the days ahead.