Directors will be expected to provide greater scrutiny to assertions made by executives.
The Satyam scandal has dragged an otherwise anonymous group — corporate directors — into the spotlight. In its wake, a complete overhaul is being contemplated and market regulator Securities & Exchange Board of India (Sebi) is drafting a concept note on revamping Clause 49 of the corporate listing agreement.
This is good. New rules focusing on more timely and transparent financial disclosure; greater accountability for financial reporting; increased oversight and independence of the audit function; enhanced Sebi review of financial statements and enforcement of regulation; and broader remedies for violations are all necessary to convince the investing audience that lessons from l’affaire Satyam have been learnt and acted upon.
Not surprisingly, the new regime will create potential additional personal liability for directors. In the past, directors had to focus their attention only on ensuring the company’s compliance with procedural rules. If a company followed the letter of the rules, board members could serve in relative safety. They could lay all but the most egregious failures at the feet of others such as promoters, managers, bankers, consultants and auditors.
Merely complying with rules won’t pass muster anymore. Directors will now be expected to provide greater scrutiny to assertions made by executives and take greater pains to convince themselves that such contentions accurately and comprehensively represent the business situation. The question is: what is needed for boards to be able to do this?
We believe that this will need boards to change fundamentally their approach to the job at hand. Wise CEOs and promoters will want boards to do so, not only to soothe restive institutional shareholders and regulators, but also to reduce the probability of future problems in their companies.
The first step
We must begin by redefining the decision rights and role of the board. Many years ago, economist Eugene Fama and our colleague Michael Jensen suggested a compelling framework for understanding the proper role of the board (based on an understanding of the inherent nature of agency costs — the costs which arise anytime human beings attempt to engage in cooperative effort, as in the modern corporation). When people (including managers) make decisions for which they do not personally bear the full costs or benefits, the organisation and society are at risk. That risk arises less from the prospect of malfeasance or fraud and more from self-interest and the human tendency to avoid blame.
When control is effective in an organisation, management rights for a decision are separated from control rights for that decision. The board must hold top-level control rights in the organisation, including rights to initiate and implement certain decisions such as the right to hire, evaluate, compensate, and fire top management teams, board members, and the company’s auditor. The board must also hold the right to ratify and monitor other major decisions such as those pertaining to changes in fundamental strategic direction. This implies that the chairman of the board cannot be the chief executive officer because a chairman’s main job is to set the agenda of the board and oversee the hiring, firing, and evaluation of the top management team — and no CEO can effectively run the process that evaluates himself. The attractiveness of this approach stems not only from the hope that non-executive chairmen will interdict the cycles of managerial self-delusion, hubris and, (as in Satyam, outright fraud) that destroys value, but also from pure workload considerations.
Second, it is important to reform the structural, social, psychological and power environment of the board. For all intents and purposes, directors at most companies are employees of the CEO. The CEO does most of the recruiting for the board. Except in unusual cases, board members serve at the pleasure of the CEO. It is rare that the board meets outside of the CEO’s presence or without his explicit permission. Finally, virtually all information board members receive from the company originates from the CEO, except in highly-controlled or unusual circumstances. A change in these practices will require a change in the power relationship between the board and the CEO, and companies can implement several practical steps immediately to infuse more balance into the board’s deliberations.
As is already the case at some leading boards such as Infosys’, the board should have (and utilise) its own budget for purchasing advice from outside experts — consultants, lawyers, financial and other experts. The audit and compensation committees must become the true clients of auditors and compensation consultants. That suggests locating decision rights for choices previously made by management, and associated budget authority, to boards. Similarly, the carefully choreographed and often perfunctory board “grand performances” must be replaced by selective, but nonetheless substantial, dialogue — regular, planned meetings with the entire top management team and frequent opportunities to interact privately with managers on key elements of strategy. For instance, while a few Satyam directors raised questions about the Maytas transaction at the December 16 board meeting, reports suggest that the dialogue lacked depth — not just about the advisability of this specific transaction but even in relation to the general issue of takeover defence.
The board, in its duty to evaluate the CEO and other top managers, can productively implement principles of 360-degree evaluation, and this should not happen by accident or through back channel conversations. The board must take firm control over not only its own processes, but also its own composition. That requires constituting a nominating committee where the CEO becomes a participant in a board-sponsored process of recruitment, rather than acting as the chief recruiter.
The philosophy
Beyond this structural and cultural shift, philosophical shifts are necessary. The mindsets of boards must move from one of careful review to one of insatiable curiosity — an attitude of informed inquisitiveness, questioning assumptions and probing anomalies. If the company’s expectations lie outside those that experts generally view as plausible for the firm’s industry in terms of growth, profit margin, or return on assets, its board must investigate the assumptions underlying such projections. Directors must answer a fundamental question about such a company — what observable sources of competitive advantage allow it to outperform its market so consistently and not be content to conclude that growth rates arising from “stretch” goals designed to stimulate the organisation to excellent performance will lead ineluctably to outstanding performance. Boards should take responsibility for understanding how traditional budget processes and stretch goals frequently inculcate a lack of integrity in an organisation and destroy value and play a role in reforming these systems.
Directors must move beyond a single-minded, legalistic focus on compliance and focus on clarity. This represents more than getting the footnotes right or engaging the right auditors. Boards need to overhaul the process by which they get substantive information about corporate performance from one controlled by the CEO to one in which the board has ready access to relevant information from unimpeachable sources. Board members must understand the key strategic dimensions that determine the company’s competitive position, the factors that drive the logic of value creation, review progress against those drivers regularly and audit the company’s performance against relevant measurements across those dimensions from year to year.
Finally, no combination of rules, punishments, and threats can substitute for men and women of integrity who bring principles to the boardroom and apply them. Honesty and integrity constitute matters of human behaviour and human choice. If companies are to behave with more integrity than the Satyam case illustrates, the people in them from the board of directors on down must come to better understand the nature of these choices. Boards must take seriously their responsibility to ensure the integrity of the organisation in all matters. Even more importantly, board members must be willing to incur costs to do so.
Everyone espouses allegiance to principles such as honesty and integrity. Yet evidence from human behaviour indicates that when it really matters, people very often choose to abandon the very standards they espouse — including both who clearly transgress what is legal (as is the case in Satyam) and others who make a habit of sailing close to the wind. It is now time for corporate directors to think carefully about how to restore integrity in corporate governance. This is not an easy task. It will only come when men and women of principle not only confront substantive, difficult business questions honestly, but also change inbred behaviours which encourage many of them to avoid painful confrontations and difficult trade-offs. Using the Satyam example makes this transition possible, as consequences of unethical or illegal behaviour, including ruined reputations, ruined companies, and criminal prosecutions for once-feted executives are unambiguous to even the most timid or insouciant directors.
In the end, legislatures will pass new laws, regulators will promulgate new rules, and the climate of capital markets will change. But restoring integrity to the system will occur one step, one director, one audit committee, one board, and one organisation at a time. It will require men and women of courage and conviction on boards and in management teams to incur costs in the short run in order to preserve their reputations and fulfill their duty — the preservation of the value of the organisations they serve.
Indeed, it is our belief and our great hope that ruined reputations, corporate value destruction, and new laws will do more than force directors to do the job they have long been employed to do. Rather, they will encourage them to do that job more confidently and competently, as well as cause management to support them unreservedly in that work.
Joe Fuller is senior partner at Monitor Group, where Nikhil Prasad Ojha is managing partner for India. Monitor Group is a global strategy consulting firm founded by professor Michael Porter.
