The Battle for Business Ethics
The Answer is an SEC Mini-Me

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By TParadiso
April 4, 2003

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The Answer is an SEC Mini-Me

In speaking out on the abysmal state of corporate ethics and the general lack of governance, invariably the question is raised as to what can be done. To be honest, I've been unable to give what I considered a satisfactory answer. This is in part due to my focus on the root causes and long-term solution. The ultimate solution requires a dramatic change in corporate culture and the associated selection criteria for our business leaders.

Progress in these areas will occur in small steps and take many years and does nothing to address the issues in the short term. There has been some progress made by the government and regulators. Last year's Sarbanes-Oxley act addressed accounting conflicts of interest and lengthened sentences for those convicted of white-collar crimes. The Securities and Exchange Commission has proposed and passed numerous new regulations and seen its budget significantly increased.

Nonetheless, it is foolhardy to expect the government or regulators to do any more than help at the margins. The dangers on relying on these entities are many. There is a fine line between enacting necessary regulations and excessive government involvement that stymies corporate efficiencies. The complexity of corporate fraud cases combined with the high threshold of proof is contrary to effective government oversight. And from a purely practical standpoint, regulators will always be outnumbered and unable to audit more than a handful of companies at any given time.

Then it dawned on me that this was a case of not seeing the forest for the trees. A short-term solution capable of preempting corporate misconduct exists and can be found in an existing body that has long been chartered to serve that very role: the board of directors.

It's so simple. The sole purpose of the board of directors is to oversee management and ensure they are operating in the best interests of the stockholders. Boards have financial audit committees, set compensation policies, and review and determine the merits of major strategic decisions. In short, the board is the boss of management. If functioning as designed, a board of directors would constitute a mini-SEC for each and every public company.

Unfortunately, we have allowed corporate leaders to usurp the power of the board. The flaws in the current structure of boards of directors are so obvious it is absurd. Former SEC Chairman Arthur Levitt has been outspoken on this subject. He recently compared boards to fraternities and insisted there be "an atmosphere of constructive skepticism."

One notable statement made by Levitt included the following: There's no room for a director "whose only qualification is that he sends his children to the same private schools as the CEO..."

Amen brother. Levitt has hit the nail on the head. Boards have become nothing more than fraternities with members more concerned with cultivating mutually beneficial relationships with management than keeping management honest.

In reality, the members of the board are virtually handpicked by management. Even worse, the CEOs of many companies also hold the title of chairman of the board. This is the equivalent of a subordinate not only choosing their superior but also having authority over that superior. Makes perfect sense if your goal is to have free reign to do whatever you want. Somehow I think senior management might object if their subordinates sought similar authority.

Then there is the continuous debate over the definition of what constitutes an independent director. This is as ridiculous as debating the definition of the word "is." The definition of independence was settled centuries ago. It is only the self-serving individuals and entities intent on stacking the deck in favor of senior management that believe otherwise.

The New York Stock Exchange is one such entity having a bit of a problem making up their minds on the matter of independence. Rather than simply looking up the definition in Webster's, they choose to follow the example of former President Clinton and parse it into submission. One can only conclude this frivolous debate is intended to present the aura of addressing the problem without actually making any substantial change to the status quo.

In conjunction with the SEC, the NYSE is establishing limits on the amount of money that can flow between companies where board members are involved. In their mind, independence means no more than 2% of gross revenues or $1 million, whichever is greater.

They are also proposing a limit of $100,000 on fees for outside directors. Worried this may be overly restrictive they give existing boards more flexibility to decide whether someone collecting those fees should be considered independent. Say what? So when is someone who collects fees greater than $100,000 considered independent? Answer: whenever a company wants. That's some powerful corporate governance.

It gets worse. Previously the NYSE had proposed that any senior officer at a company couldn't serve on its board until five years after leaving the position. They've since decided that's no longer necessary.

In its place independence is dependent upon whether someone is paid more than $100,000, or not. The new proposal states directors would not be considered independent only if they or their family were paid $100,000 a year above ordinary board fees within the prior five years. In the same breath they again give existing boards the authority to override this standard if they consider the "compensatory relationship is not material." That makes sense. Set a regulation then give those being regulated the authority to override it.

Get the picture? This is exactly how Wall Street works and the management game is played: confusing and convoluted rules with enough loopholes to drive a truck through. The question I have is if these people are so bright why do they find it so difficult to solve such a straightforward problem? There are two possible answers: they ain't so bright or they don't truly want to solve the problem.

Here's a proposal offered to initiate debate on how to effectively revise the board of directors environment:

1. Mandate the chairman of the board not be a member of the company's management team.

2. Mandate that all outside directors be independent and that at least three-quarters of the board be comprised of outside directors.

3. Mandate no board member serve on more than four boards.

4. Mandate boards formally meet at least once per quarter and informally meet at least once every month. In conjunction with this, management should be required to submit monthly status reports to the board summarizing all key corporate issues.

5. Develop an unambiguous definition of independence. That definition should include never having been an employee of the company. Not having any business dealings with the company for at least the previous five years and a restriction on doing business for five years after leaving the board. Never having worked with a member of the management team at any previous company or on any other board of directors.

6. Take the authority to nominate board members away from the management team and allow the stockholders to nominate directors. Given the board is there to ensure the interest of the stockholders is being met, there is no logical reason to do it any other way.

7. To facilitate the election of board members, potential directors should be permitted to submit their desire to become a member of the board in the same fashion as elected officials do. The company would be responsible to ensure each candidate meets the definition of independence. Each candidate's qualifications should be included in the appropriate company documentation and stockholder filings.

8. Consideration should be given to dramatically altering the role of directors. Perhaps it is time to change the role from being a prestigious hobby to being a true profession. To that end, regulators should set board fees including the fees for special audit committees on a sliding scale based upon a company's revenue. Under this scenario directors would be paid like employees and would begin to act as such.

No doubt there are those who will argue against many if not all of these ideas. Alternative viewpoints are welcome as long as they are accompanied with the reasons why these ideas are not feasible. I do not profess to have all the answers. Nor do I claim to have examined all the ramifications of these proposals. It may very well turn out some are impractical. However, I suspect many are not. I also suspect that they are much closer to actually solving the problem than anything currently proposed by regulators.

The best hope we have of avoiding widespread corporate scandals in the future is to ensure the body that already exists within every public company is structured and empowered to perform its defined role.

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