After the Storm

March / April 2009 BY JOHN BUCHANAN

How will today’s economic crisis impact tomorrow’s corporate governance?

JOHN BUCHANAN is a journalist, author, and screenwriter. He lives in Cocoa Beach, Fla. His last article for the magazine was “Last Year in Vegas; This Year in New Orleans?” in the March/April 2008 issue.

There’s no shortage of villains to blame for the mess we’re in: anti-regulation lawmakers, CEOs who asked no questions, predatory lenders who took the money and ran, Fed chairmen who allowed the free market free rein, homeowners who used their houses as ATMs, watchdogs asleep at the switch.

And corporate directors are due for their share.

Indeed, the economic tsunami sweeping the globe is set to overhaul the entire concept of corporate governance. “We are in the middle of the biggest revolution in corporate governance since the 1930s, when we brought in the current regime of fair reporting and fair disclosure of material risks,” says Richard Cellini, senior VP of business and legal affairs at Waltham, Mass.-based Integrity Interactive Corp., which advises Fortune 1,000 boards and C-suite executives. “What we found in the fall of 2008 is that that was not enough. Our economy and much of the economy of the Western world went into near collapse.”

Outsized risks propelled enormous short-term revenues that fed top-executive compensation packages based on such near-term performance. As a result, boards and top management are racing to determine whether a humble and serious display of self-regulation can stave off a rush of momentum for new congressional oversight—oversight that opponents fear might cripple the free-enterprise business model.

The call for change in governance practices and increased regulation is nothing new, of course, especially given the parade of corporate scandals throughout this decade. But today the issue is not illegal actions by a few executives—rather, critics are blaming an entire system of corporate governance for wrecking the whole economy. Eventually, the crisis will pass. Here’s what to expect after the storm.

Blaming Boards
Whatever problems were caused by legislation and consumer choices and CEO negligence, many observers fault boards—the most important line of defense against corporate breakdown—for a fundamental failure of oversight.“Boards should have been applying more scrutiny all along,” says Mat Allen of Stamford, Conn.-based global consultancy Marsh Inc. “By definition, the role of a board is to ensure that the senior leadership has engaged in the appropriate level of due diligence regarding decisions they make. And that includes the fundamental question, ‘What risks are we exposed to as a result of these decisions?’”

The failure of boards to assess and manage risk responsibly lies at the center of the economic crisis, many critics argue, and the consequences of that failure will now require new levels of oversight from boards. The challenge, says Steve Wagner, managing partner at the Deloitte Center for Corporate Governance in Boston, is that “boards are only able to act effectively on the information they have available. And one of the lessons we are learning now, as a result of all the problems in the marketplace today—and especially those related to risk—is that boards, in general, do not believe they are getting enough of the right kinds of information in order for them to effectively execute their responsibility of risk oversight.”

Bart Friedman, a partner at New York law firm Cahill Gordon, advises boards, audit committees, and C-suite executives—and agrees that risk assessment and management will drive the post-crisis transformation of corporate governance. Board members will have to assess management’s ability to reduce risk. “They will have to ask themselves whether they need separate and distinct resources, like lawyers or consultants, to assist them in determining whether or not management is thinking broadly and carefully enough about risk,” Friedman says.

Indeed, he has noted a sharp uptick in boards retaining their own legal counsel and other consultants to help them properly measure management’s ability to gauge risk and deal with its downside. “An important issue that board members are facing now,” Friedman says, “is the question of whether they want to be involved with a company if they don’t have someone they can turn to for objective advice.”

A practical consequence of the brighter spotlight on management and business fundamentals will be an increase in the amount of time demanded of directors. “It’s going to make it even more time-consuming for people to serve on boards,” Wag­ner points out, “which will make it more difficult for the best and brightest of our people to assume those roles.”

“We are moving quickly toward a more European mode of board engagement,” Cellini adds. “The frequency and length of board meetings have probably tripled or quadrupled recently. And that shows no sign of easing up. European boards have always met much more frequently, at much greater length, and focused on much more detail than their North American counterparts have.”

Redefined Roles
As boards increase their vigilance, a more robust dynamic between boards and management will redefine the roles of CEOs and other C-suite executives. “Top management will spend more of their time as stewards of risk,” says Mark Goodburn, vice chairman at KPMG in New York. In addition, senior executives will have to articulate, both internally and externally, the implications of such risks in order to satisfy an increased demand for transparency and the need to benchmark against other companies.

C-suite executives, traditionally tasked with big-picture evaluations, will have to understand the details of their business more than they did in the past. “They’re going to have to look further down into the organization,” says Jack Dolmat-Connell, a Waltham, Mass.-based executive-compensation consultant. “But therein lies the problem: C-suite executives have generally played strategic roles and left the operational stuff to lower-level executives.”

Wagner suggests that a more difficult evolution for CEOs and CFOs will be challenging their own assumptions and decisions in ways they never have during the era of the imperial CEO, cast in the Jack Welch mold. “Top executives will need to consider the fact that their assumptions could be completely wrong,” Wagner says. Although it is difficult to change a company’s culture, particularly at the top, he believes that it’s important to cultivate an environment in which it is readily accepted that challenging assumptions is appropriate and welcome. He adds that “healthy skepticism and asking tough questions, for the long-term betterment of the corporation, are what’s important.”

Betsy Atkins, who sits on four public boards and is former CEO of several successful companies, believes the anticipated changes in the thinking of top management may negatively impact C-suite focus and efficiency. “We’re already seeing that CEOs are now spending a big chunk of their time having to think about the downside, whereas ten years ago they just thought about how to grow the business,” she says. That, combined with what Atkins calls “a hostile press and a Congress that wants to punish CEOs,” means that chief executives will have less time to do what they should be doing: gaining market share in a protracted economic slowdown.

Also expect increasing bifurcation of the roles of CEO and chairman, predicts Clarke Murphy, a managing director at global executive-search firm Russell Reynolds Associates. Surprisingly, he thinks that’s something a lot of CEOs will embrace. “I think you’re going to see them agree that there should be a non-executive chairman in order to help bolster the board’s work. It helps a CEO focus,” Murphy says. “We’re already seeing more separation of the roles. And it’s not necessarily a pen­alty for the CEO to be taken out of the chairman’s role. A CEO can get a lot of support from a good non-executive chairman.”

CEOs will also have less time to sit on the boards of other companies. Managing companies in tough economic times re­quires a lot more time and attention from CEOs, leaving them with less time to serve on boards. “This may be unhealthy for the corporate community and CEOs,” Wagner says. “There is a very, very valuable kind of experience that CEOs get by serving on the boards of other companies. Without that kind of experience, they lose one set of comparison and benchmarking tools and the ability to engage in dialogue about critical business issues, which can enhance their ability to run their own companies.”

“It Will Be a Revolution”
The shifting balance of power between the boardroom and the C-suite will also provoke a broad reassessment of executive compensation. “Management is going to have to understand that times have changed and it will no longer be business as usual with respect to compensation,” says Dolmat-Connell. “Compensation committees are going to scrutinize and question everything. They are not going to approve anything that deviates very far from the norm.”

Boards will get much tougher on pay-for-performance metrics and measurement—and offer no pay for nonperformance, Dolmat-Connell predicts. Management will have to swallow other adjustments: scaled-back severance, more carefully constructed bonus plans, and upside compensation potential tempered by downside financial risk.

Former GE general counsel Ben W. Heineman Jr. agrees wholeheartedly with those who say that CEOs who underperform—or perform recklessly—should be hit hard in the wallet. “The point of what we have just seen in 2008 is that you shouldn’t get paid for generating paper,” Heineman says. “You shouldn’t get outsized bonuses based on revenues. We need to have compensation that is based on creating economic value over time—like deferring compensation so that it is based on results of more than one quarter in one year.”

For example, stock options should be deferred for fully a decade, he suggests. “That means you have to create value over the long term, because you can’t cash in your options for ten years,” he says. “And you shouldn’t get them at all if you jump ship.”

In the meantime, one major compensation change is already under way. Increasingly, companies have introduced contractual provisions that allow clawbacks of executive compensation in the event of the types of failures we’ve seen in the financial markets. Senior executives will more likely be held liable not just for corporate-governance or compliance failures in which they were personally involved but for any failures that occur on their watch. “It will be a revolution,” Cellini remarks.

Clawbacks based on actual performance—rather than simply stock price or impressive quarterly numbers—are healthy, Atkins says, as long as they are self-imposed and not mandated by Congress. “But one way or the other, I think we’re going to see more of them,” she says.

Cellini agrees: “If we ever have the kinds of failures again that we’ve just seen, top executives who get fired are not going to walk away with $40 million, $80 million, $120 million. We’re going to see clawback provisions that will allow us to get back some or all of that compensation.” Already, New York State Attorney General Andrew Cuomo has thrown down the gauntlet over golden parachutes that land failed executives on Easy Street while reducing the assets of working stiffs in the company and individual shareholders to rubble.

Uncle Sam’s Heavy Hand
Even proponents of a revolution in corporate governance worry about the timing of a new, empowered Congress and presidential administration that could opt to ride a populist, anti-business wave of public sentiment by tying the hands of American business—to everyone’s detriment—for years to come.

“The government is not just the biggest regulator of the financial-services industry,” Cellini points out. “It is now the biggest shareholder in some of these companies, like AIG. And members of Congress, like Barney Frank, are not even acting like regulators. They’re asking the kind of questions that inves­tors ask, like, ‘Who’s getting a bonus this year, and how much?’”

As a lieutenant to Jack Welch during a period when the mythologized modern icon of the infallible, omnipotent CEO was born, Heineman feels little sympathy for beleaguered executives who have had any hand in the current economic meltdown. “The real dilemma for capitalism is that the leaders of the financial sector have lost all trust because they failed so badly,” he says. “The line between corporate self-determination and public regulation is clearly going to move in the direction of public regulation. That is obvious. We are going to have a whole range of reforms that will impinge on corporate self-determination.”

Atkins also believes that business will go through a profound and sometimes painful transformation that, despite decent intentions, will not always be in the best interest of corporate sovereignty. “We have never had the government opine on what the compensation of C-suite executives should be, or how to apply the concept of meritocracy,” she says. “Having government meddle in the free market is a very frightening idea. And the likelihood of that resulting in positive change is very slim.”

As an example, she cites the fierce scrutiny of Detroit’s Big Three by Congress, think tanks, and the general public. “If you have Congress telling automakers what cars to make, the free market is being destroyed,” she says. “And it’s being destroyed by people who have never made a product or met a payroll in their lives. But the larger issue, for me, is that if you start to limit and control compensation and you whip up a furor against CEOs, who are the engines of capitalism, you start to destroy the concept of meritocracy, which is what this country has always run on. If that happens, the best people are going to go elsewhere, like to nonprofit foundations.”

Still, Dolmat-Connell believes that aggressive self-regulation will short-circuit any political drive for Washington to weigh in. “I’ve been to twenty board meetings in the last month,” he said last November. “There is an intensely different climate out there these days. I truly believe that top executives and boards get the message now and that you’re going to see companies make changes voluntarily. You’re not going to need government intervention.”

A Paradigm Shift
Like all dark clouds, the current economic crisis could ultimately reveal a silver lining, at least to the most optimistic observers. There is hope that the obsession over quarterly numbers during the last decade could give way to a more meaningful measurement focusing on market viability, long-term sustainability, and consistent profitability.

“I believe the pressure for quarterly performance has had an unhealthy influence,” Atkins says, “because you’re not looking at a long enough period of time to try to make the appropriate tradeoffs between short-term and long-term investments. As a result of that realization, we now see more companies getting away from giving quarterly guidance, and I think that is a healthy thing.”

“Going forward, there can’t be such a focus anymore on immediate and aggressive growth,” Mat Allen adds. The broader investing public—everybody on Wall Street, the analysts, the banks, the shareholders—will have to change their way of measuring companies by nothing other than material growth, quarter over quarter. Indeed, the addiction to ever-better quarterly reporting fed the appetite for excessive risk that pushed the global economy to a dangerous precipice, says Wagner, who adds that “driving short-term earnings based on greater risk-taking is not consistent with long-term shareholder value.”

“If top executives have the luxury to worry about things on a three-to-five-year basis,” Murphy says, “it would alter the way they make decisions.”
And that would be a good thing for business.