An endemic problem with U.S. corporate boards

Rarely does a week go by without another media report of misdirection, lack of control or malfeasance in an American corporation ”“ at board and top management levels. In the majority of cases it is the shareholders who end up paying the price.

Take the case of Goldman Sachs. The U.S. Securities and Exchange Commission last year charged the investment banking firm with possible failure to inform several client groups about its “duplicitous” role in organizing and selling packaged mortgages. Some of us thought the case flimsy as the SEC laws do not deal specifically with “errors of omission.” However, Goldman was glad to settle with a fine of some $500 million to hopefully stem the sales of its shares and eliminate client concern over the publicity.

The billions of dollars in losses to UBS due to inadequate internal controls over a “renegade” trader resulted in the CEO”™s resignation but it will not replace the loss in share values for the Swiss bank”™s shareholders.

Hewlett-Packard is another case where internal squabbles at the board level have again resulted in a huge golden parachute for the CEO, a new generous contract for his successor and, of course, a rapid decline in share values.

These aren”™t rare occasions, but rather evidence of failures in governance throughout U.S. financial institutions, manufacturing and service sectors, public sectors, states, cities, towns, and educational and charitable organizations.

It is time we face up to reality. Most boards of directors in every sector are overwhelmed with the increasing complexity of carrying out their fiduciary and trustee duties. We thought Sarbanes-Oxley would eliminate most of the irregularities by threatening severe penalties for board members not doing their job. Recall that two members of the Enron board, one a leading business school dean, paid huge fines for their lack of due-diligence in overseeing management.

However, the regulations, not to mention what is on the horizon with Dodd-Frank, actually complicate the role of effective board oversight.

The globalization of business, growth in rapid capital flows, new competitors shaking up existing industries and the lack of internal (non-regulatory) controls have made our laws of incorporation and board of directors”™ structures grossly inadequate to the challenges. The issues are far too great and complicated for part-time board members.

The situation is exacerbated by the dual role of chairman of the board and CEO. The often incestuous situations, “you serve on my board, I”™ll serve on yours,” do not lend themselves to objective standards for selecting board members with real industry know-how, indepth knowledge of competition and, especially for audit committee members, a thorough understanding of regulations.

We should give serious consideration to the German corporate governance model. Companies of significant size must separate the responsibilities and the functions of the two-board structure ”“ supervisor and management boards. The supervisory board comprises outsiders, non-executive members. The laws also frown on board members with close ties to the company as lenders, suppliers or customers.

I don”™t recommend we adopt the German laws that all companies with 2,001 or more employees must seat union leaders in half the board seats (chairman has two votes in ties). However, the legal functions of the German supervisory board are clear and concise:

• Approve the strategy and strategic plans;
• Approve all financial documents for both external and internal controls, including new provisions that all board members select the external auditors and sign the audit; and
• Hire and fire all members of the management board who serve under contracts of definite duration and are extended only with board approval.

Members of the management board are elected by the supervisory board. The management board”™s functions are focused on operational measures. However, it is responsible for putting forth recommendations on strategy and risk-management and for carrying out its assigned responsibilities.

We do not require all these German innovations to become more effective. However, some of these practices could be a major step forward.

John Alan James, a management consultant, is a professor of management and corporate governance at the Lubin School of Business at Pace University. Reach him at jjames@pace.edu.