Background Paper Prepared for a Program Sponsored by
Northwest Chapter
National Association of Corporate Directors
on
“The Government is Watching: Changes in the Political Landscape
and Implications for Business Governance”
by
Dick Thornburgh
Counsel, K&L Gates LLP
Former Attorney General of the United States
and Governor of Pennsylvania
Wednesday, March 31, 2010
Multnomah Athletic Club
Portland, Oregon
“Boards today are operating in what may be one of the most challenging business
environments any generation of directors has ever known.”
National Association of Corporate Directors, Blue Ribbon Commission on Risk
Governance: Balancing Risk and Rewards (October 2009).
Today’s times are indeed challenging ones for boards of directors. The recent financial
crisis has focused significant attention upon corporate conduct and its role in the worldwide
economy. Proposed legislative and regulatory changes threaten to alter the legal landscape in
which boards function. Increased concern has been evident over questions of corporate integrity,
the quality of corporate governance and compliance programs, and the effect of a supposed
“culture of greed” in the worldwide business community, especially in the compensation area.
Shareholders, government regulators and the broader public are looking to boards to reform
corporate culture where necessary and also to prevent companies from falling prey to excessive
greed and risk. Boards that ignore red flags or rubber stamp ill-advised management schemes
will be at an even greater risk of being held accountable when companies do fail.
I am somewhat of a hybrid in my calling, having begun my legal career over 50 years ago
in the corporate Legal Department of ALCOA in my home town of Pittsburgh, Pennsylvania.
With K&L Gates in my early career I represented a variety of corporate clients in an equal
variety of matters. I then later served as a prosecutor of white collar crime and public corruption
cases with the U.S. Department of Justice. Since 1994 I have been once again with K&L Gates,
serving as a “trouble shooter” for corporate clients, focusing on internal investigations and on
corporate governance and compliance issues. During that time I also served as an independent
board member of a number of publicly-held companies and consulted with international
organizations such as the United Nations, the World Bank and the Inter-American Development
Bank on anti-corruption and integrity issues.
In the earlier part of this decade, the failures of Enron and WorldCom attracted particular
attention as they became, in effect the “poster children” of corporate malfeasance in our country.
Following the bankruptcy filing of WorldCom, then the largest in our history, I was appointed as
the Examiner in those proceedings by our Department of Justice in August, 2002, with a broad
mandate to investigate any allegations of fraud, wrongdoing, mismanagement or incompetence
which caused the corporation to fail and to report our findings to the Bankruptcy Judge.
You may recall that WorldCom as the world’s second largest telecommunications
company that had a meteoric rise and an equally swift fall when some $11 billion in accounting
irregularities were identified in mid-2002.
We conducted an 18-month investigation and uncovered a number of problematic issues
quite apart from the accounting issues. For example we found
•
A rubber stamp Board of Directors dominated by CEO Bernard Ebbers which
failed to observe its fiduciary responsibilities to company shareholders.
•
A minimum amount of oversight and insufficient risk assessments and
transactional due diligence in the flurry of acquisitions that created the
conglomerate that was to become WorldCom.
•
Audit shortcomings among both internal auditors (which were diverted into cost
saving efforts) and external auditors who identified the company as a “high risk”
client but failed to drill down into the numbers in a manner reflecting that
designation (perhaps for fear of jeopardizing lucrative non-audit services which
they provided to WorldCom).
•
A compensation committee and board of directors which authorized some $400
million in loans to CEO Ebbers without sufficient collateral, none of which,
needless to say, was ever repaid.
•
Investment bankers which handled the multitude of acquisitions undertaken by
WorldCom during its growth period and literally “bought their way” into the
business by extending “sweetheart” deals on new stock issues to CEO Ebbers,
netting him some $11 million in personal gain, a practice perilously close to
commercial bribery.
•
All of this was compounded by gatekeepers consistently “asleep at the switch”
while much of this activity was going on.
In response to this and other serious shortcomings unearthed in the course of various
investigations, Congress enacted the Sarbanes-Oxley Act of 2002 (SOX). This act and
accompanying regulations issued by the SEC, the New York Stock Exchange and the NASD
significantly altered the ground rules for corporate governance. Among other things, SOX
undertook to compel corporate CEOs and CFOs to certify as to the accuracy of financial
statements filed with the SEC; required listed companies to adopt corporate governance
guidelines or codes of ethics addressing the conduct of directors and officers; forbid corporations
to extend credit to their directors or officers; provided for forfeiture of bonuses and profits from
the sale of company stock if restatements had to be made as a result of “misconduct” in financial
reporting; required all members of audit, compensation and nominating or governance
committees be “independent” and that at least one member of the audit committee have
accounting expertise; and imposed stricter supervision over outside auditors. The New York
Stock Exchange (as does the NASD) now explicitly requires that a majority of board members of
listed companies be “independent;” that CEOs certify annually that the company has not violated
the Exchange’s corporate governance listing standards; and that shareholder approval is required
for all equity compensation plans. Many of these requirements, incidentally, were anticipated by
earlier recommendations made by Blue Ribbon Commissions of the National Association of
Corporate Directors (NACD).
More recently, we have had to deal with the worldwide credit crisis. And while the
last chapter has yet to be written in this unfortunate episode, we have seen familiar breakdowns
in the roles of gatekeepers there:
•
Boards that do not understand, or manage, risk on an enterprise-wide or any other
credible basis.
•
Management that took undue risks because of the great financial returns they
stood to personally reap.
•
An almost blind following of what others in particular industries were doing.
These most recent business and financial crises have also focused a lot more attention
upon the role of corporate conduct in the worldwide economy. Increased concern has been
evident over questions of corporate integrity, the quality of corporate governance and
compliance programs, and the fallout from a supposed “culture of greed” in the worldwide
business community.
Certain themes have evolved from these concerns that can teach us several important
lessons:
•
In particular, we have been reminded anew that our global economy has become
truly global and that, like a set of dominoes, a push at one end has the capacity to
send the whole set tumbling in the same direction.
•
We have seen that risk taking without strong controls can result in a course
susceptible to enormous failure, with no safety net to catch those who cannot bear
that risk. Institutions that were deemed “too big to fail” have, in fact, failed
taking many smaller institutions and individuals with them.
•
In the past two years we have also witnessed failures that have occurred when
management and company gatekeepers have not properly assessed risks nor taken
action to check runaway risk-taking, as in the U.S. cases involving major
financial houses and a string of Ponzi scheme disasters, such as those involving
Bernard Madoff and Allen Stanford.
•
Finally, regulators have particularly noticed the role that gatekeepers should play
and the compliance mechanisms with which they are involved. These inevitably
are in the crosshairs of regulatory action when failures occur.
What is to be done? Boards in 2010 must embark on a proactive course to reassess their
role – and management’s role – in steering their companies through the hoped-for economic
recovery. In particular, I suggest the following significant issues that many boards will need to
confront in the year ahead:
The Role of the Board and Its Committees. Now more than ever, boards must be
active and vigilant. Boards should be involved in assessing and shaping the long-term strategic
planning for the company and can serve as an important check on excessive focus on short-term
performance. Boards should remain informed regarding relevant business, legal, accounting, and
regulatory developments in order to be well-equipped to assess complex transactions and
strategies.
Seamless Web of Audit Capability. Late last year the Director of the SEC’s Division of
Enforcement warned that audit committees needed to take careful and proactive steps to ensure
that red flags are not missed. To accomplish this objective, the committee must work closely
with financial management, internal audit and outside auditors to establish a seamless web of
audit capability and promote clear and frequent communication so that together they can identify
and address issues even before they become red flags.
Risk Management. The economic crisis showed how excessive risk taking without
strong controls can cause even the largest institution to fail. In such cases, both management and
company gatekeepers frequently failed to assess risks properly or take effective action to check
runaway risk-taking. While a company’s board is not responsible for managing day-to-day risk,
it is responsible for oversight of risk management functions and for helping to ensure that the
company’s risk culture is clearly defined. Boards will want to reassess their role in overseeing
risk management to ensure that the board members with the most appropriate backgrounds are in
a position to evaluate management’s performance in particular areas. In addition, boards need to
be clear as to what the company’s risk profile – or risk culture – is and whether it is in line with
the company’s financial status, the competitive landscape and the broader economic climate.
Culture of Compliance. A well-functioning corporate compliance system is not merely
a “check-the-box” exercise, but requires an enterprise-wide commitment, management
accountability and active audit committee oversight (consider, e.g., Enron had a 64-page ethics
manual and a secure “hot line” to report ethical lapses at the time of its collapse). Boards and
their audit committees must set the appropriate tone at the top and imbue in company
management and employees the importance of compliance. Among other things, this includes
ensuring that management is tasked with designing policies and procedures that are
understandable, practical, known, enforced and re-evaluated on a regular basis. Audit
committees should also evaluate the efficacy of the company’s whistleblower procedures to
ensure that they function as intended and remind company counsel of their up-the-ladder
reporting obligations to the board in the event of suspicions of serious wrongdoing or fraud.
Executive Compensation. Compensation committees have never before been under
such intense scrutiny in setting executive compensation. At a time when the rules of the road are
constantly changing, it is critical that committees have the appropriate resources at their disposal
– such as compensation consultants, comparative data and advice of counsel as necessary – in
order to make timely, well-reasoned and carefully documented decisions regarding
compensation. Compensation committees also need to be fully apprised of regulatory
developments and appreciate the political climate in which the compensation decisions are made.
Crisis Management. In the current environment, it is important for companies to be
prepared to respond to a significant event, such as an insider complaint, a government
investigation or a shareholder allegation of fraud. An ill-informed and piecemeal approach to a
crisis can lead to disastrous consequences. Depending on the nature of the allegations, it may not
be appropriate for management to be involved in handling the crisis. Boards need to have a plan
in place to establish leadership, determine a course of action, which may include an independent
investigation, coordinate media responses and control leaks. If an independent investigation by
outside professionals is warranted, the mandate of the investigation should be clearly identified.
Managing Conflicts of Interest. Concerns regarding related party transactions are not
new, but difficult economic times and performance pressures unfortunately often breed
motivation to cut corners. To the extent that boards are requested to approve related party
transactions, they must ensure that they are adequately – and independently – advised regarding
the nature of the conflicts, the risks and benefits to the company and the company’s disclosure
obligations.
The cure for many of the ills already identified, in this as in previous eras of corporate
wrongdoing is, in my view, a strong dose of leadership which emphasizes honesty, integrity,
character and transparency in the conduct of corporate affairs. I agree with what one observer
earlier in this decade noted:
“The tragedy which has befallen millions of shareholders of public corporations both within
and without the United States might have been avoided had the independent board members
remained independent and exercised the fiduciary duties imposed upon them by federal and
state laws.”
Such duties clearly require that individual directors each
1.
Insist on a relationship of transparency between management and the board, i.e.
adequate information presented in understandable form with sufficient time before
meetings for meaningful review. Management should know that the board will take
a dim view of surprises – whether related to business or to regulatory matters.
2.
Insist on adequate meeting time for critical deliberation of important issues.
Management should expect and prepare for a healthy dose of professional
skepticism from the board.
3.
Not hesitate to seek and utilize independent expertise and assistance concerning,
e.g., financial and technical evaluation, compensation and legal, regulatory and
other significant matters In some cases, regular retention of accounting or legal
experts to attend board or committee meetings may even be appropriate.
4.
Most important of all, independent directors, not management, should have the
final say on the selection of new or successor directors when vacancies occur so
that cronyism and “old boy networks” are not perpetuated.
Prior to my appointment as the WorldCom Examiner, I made an instructional film for
distribution to corporate America, dealing with legal and ethical challenges. Its message was a
simple one: “Do the right thing.” At bottom, when all is said and done, perhaps this is the basic
lesson taught by recently disclosed shortcomings in corporate governance. And it is a message
that must be taken to heart within America’s business and financial communities if they are to
continue to prosper and maintain the confidence of the investing and taxpaying public.