Chapter 11

Harry J. Bruce How the Board of Directors Holds a Corporations Management CEO Illinois Central Railroad Accountable to Its Shareholders
Quis custodiet ipsos custodes? (Who will guard the guardians themselves?) Juvenal, Satires 2.6, c. 116 A.D.

Corporate Governance

I N T R O D U C T I O N TO C O R P O R AT E G O V E R N A N C E Issues of Management, Power, and Accountability Who owns todays business corporations? What does it mean to be the owner of a shareor of a million sharesof a corporations stock? Who really runs todays corporations? Management? The board of directors? The shareholders? The large institutional investors? How does personal ownership of shares influence management decisions? To whom are corporations accountable in their conduct and performance? The board of directors? The shareholders? The law? The employees? The customers? Government? What institutions, agencies, or individuals have a right to demand a particular level of performance from corporations? How can corporations be held accountable to those who exercise such rights? How do those making demands on corporations bring about the responses they seek? How much should the chief executive officer and top managers of corporations be paid? Should excellent managers be paid more than mediocre ones? Who decides what constitutes excellent performance by a CEO? What kind of compensation package is most likely to stimulate effective performance? The proper term for the subject of all these questions is corporate governance the distribution of power and accountability within the modern business corporation. In particular, corporate governance is concerned with the enormous power exercised by the management of the

modern corporation. The purpose of this chapter is to describe key issues in corporate governanceissues of management, power, and accountabilityby looking at the history of American corporations; the relationship among shareholders, top management, and the board of directors; the boards fiduciary duties and legal powers; and the way the board actually does its job (both outside and inside the boardroom). The better one understands such key issues in corporate governance, the better chance one has to control them (or not fall victim to them). The modern corporation has the power to change the lives of millions of people for good or for bad. The largest Fortune 500 companies have revenues that exceed the annual budgets of many national governments: Mitsubishi is bigger than Indonesia; Ford is bigger than Turkey; Wal-Marts resources exceed the gross domestic product of Poland.1 The dollars these companies pay to their employees and their suppliers, along with the taxes they pay to various governments, produce enormous economic impact. So do the products and services corporations bring to the world marketplace. So does the growth in shareholder wealth that occurs when a corporation is successful. For these reasons, the top executives of modern business corporations are among the most powerful people ever to appear on the stage of history. Such power can be dangerous unless those who wield it are part of a wider system that holds them accountable. Just ask any Enron employee who was forced to stay vested in the companys stock just as the firm was suddenly to go bankrupt. New York corporate lawyers Arthur Fleischer, Jr., Geoffrey C. Hazard, Jr., and Miriam Z. Klipper state the problem this way:
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http://www.marketplace-simulation.com

BEST-USE CORRELATIONS
In Marketplace, your firms board of directors begins to take on a leading role in Q5. To prepare you for this new dimension in simulation play, Chapter 11 provides an in-depth review of corporate governance practices and obligations. Who Will Be on Your Teams Board? In Q5, teams sell part of their companies to venture capitalists in return for an infusion of investment funds. A board can be very helpful to a young company. Directors can provide experience and connections that the executive team does not have. Does your team lack financial, marketing, or technical expertise? Does it need connections to banks, other investors, key suppliers, or important customers? Think strategically. Who should join your board? Who Decides Who Sits on Your Board? In Marketplace, you will know your investors very well and they will insist, rather forcefully, on knowing you equally as well. As the condition of their investment, they will want representation on your board, probably a majority position. Chapter 11 will prepare you to deal with the demands of outsiders who want a voice in management decisions. You Can Be Replaced The most important decision a board makes involves the selection and retention of the chief executive officer. In Marketplace, Q5 and beyond, a board may exercise its power to remove a teams CEO (and, potentially, other top managers) if it concludes that management is floundering.

To be secure, power has to be legitimate, and for power to be legitimate, whether public or private, it has to be accountable. The modern business corporation is accountable according to its constitutional law, just as the government is accountable according to constitutional law. The constitutional law of the business corporation is called the law of corporate governance, which defines the accountability of directors to shareholders and of officers to directors. Corporate-governance law is important law because ultimately it affects every shareholder and the entire economy.2

Senior corporate managers (officers, as Fleischer, Hazard, and Klipper call them) thus must be held accountable. But to whom? And for what? How is corporate governance supposed to work? How well does it work? To understand that, we need to understand how corporations originated, how they developed over time, and how finding a balance between accountability and initiative within corporate governance has evolved into a persisting contemporary dilemma. Historical Evolution of Boards and Corporations The corporate form of business organization is relatively new. Until about the mid-18th century, when the Industrial Revolution in England brought about the first mass production of goods in mechanized factories, virtually all private business was conducted by sole proprietors, families, or partnerships. Small workshops and cottage industries, selling hand-crafted products direct to a small and mostly local consumer market, had little need for the large amounts of capital and division of labor coordinated by a professional management that corporations provide. Perpetual Existence Although private business corporations did not exist until the mid-1800s, other types of corporations had been around for centuries: City governments, universities, monastic religious orders, charitable organizations, hospitals, and even the Roman Catholic Church were organized according to a corporate model. Incorporation enabled them to enjoy what lawyers term perpetual existence. Todays business corporations also enjoy this potential for perpetual existence; they are legal entities distinct from either their members or their leaders.

Another similarity between todays business corporations and earlier institutions built on the corporate model is that they can hold property in their own name another way the corporation perpetuates itself. This property belongs to the corporation, not to its members or its officers. The officers control the use of the property, but only so long as they hold office. The power really belongs to the corporation, which delegates it to the officer. The origin of the word corporation helps make this clear. It comes from the Latin word corpus, meaning body. A corporation is a group of people organized in such a way that they can act as if they were literally one body. Because corporations enjoy many of the same legal rights and privileges as a living individual, lawyers often call a corporation a person on paper. Joint-Stock Companies and Limited Liability The first demands for the application of this corporate model to profit-making business came with the great voyages of exploration and the establishment of overseas colonies in the 15th and 16th centuries. These ventures required more capital than any single individual or a few partners could raise, and they threatened to overtax government treasuries as well. So the sovereigns of the exploring nations, chiefly Great Britain and the Netherlands, issued royal charters authorizing the creation of joint stock companies to pool the resources of dozens, perhaps even hundreds, of individuals willing to risk some of their capital for the chance of long-term gain. To attract as much capital as possible, the charters establishing these early corporations promised investors not only a share of the profits but also limited liability: If the corporation ran up debts that exceeded its earnings, the investors would not be personally liable for making good the losses. An investor might lose all of his original stake, but he could not be dunned for more. The creditors, not the investors, would bear any residual risk. To this day, British corporations still carry the name Limited to indicate that their shareholders enjoy the protection of this limited liability. Mergers and Boards of Directors In addition to large amounts of capital, a colonizing expedition required a more complex organization than the typical

The Enron Collapse: The Biggest Corporate Governance Failure of All Time
The December 2, 2001, collapse of Enron Corporation, the largest corporate bankruptcy in history, seemingly took the business world by surprise. Investment analysts, business-school professors, economists and high-profile business journalists pronounced themselves shocked and puzzled that billions of dollars in shareholder value could implode almost overnight. Less than two months earlier investors were valuing Enron at $28 billion, and a few months before that three McKinsey & Company consultants, Ed Michaels, Helen Handfield-Jones and Beth Axelrod, praised the Houston-based energy trading giant in lavish terms: Few companies will be able to achieve the excitement extravaganza that Enron has in its remarkable business transformation, they wrote, but many could apply some of the principles.1 Fortune magazine voted Enron The most innovative company of the year for 2000. How were so many experts able to fool themselves for so long about Enron? Possibly because they failed to take a searching look at the companys governance structure and its board of directors. Had anyone with a basic understanding of corporate governance taken the trouble to examine Enrons board in the months preceding the scandal, he or she quickly would have picked up danger signals of the type described in this chapter. Lets look at the more benign danger signals first. Board size? In the year prior to the collapse, the Enron board had 15 members, including Chairman/CEO Kenneth Lay. The author considers this about twice the number required for an effective board. Once the number of directors goes beyond seven or eight, communication becomes difficult and the board tends to break down into an inner group of relatively active members and a lessinvolved outer group of go-along types. Board composition? Enrons directors included some names with strong corporatemanagement credentials, such as Norman Blake, Jr., Chairman, President and CEO of Comdisco and former CEO and secretary general of the U.S. Olympic Committee; and Herbert Winokur Jr., Chairman and CEO of Capricorn Holdings and former senior executive vice president of Penn Central Corp. But it also included Charles Lemaistre, M.D., president emeritus of the M.D. Anderson Cancer Center at the University of Texas, as well as John Mendelsohn, M.D., the Anderson Centers current president. Placing a medical doctor from a highprofile research and teaching hospital on a corporate board may lend the board some prestige, but its not clear whether such a move brings any serious breadth of experience or policy judgment to a corporation dealing in highly complex and abstract financial instruments such as Enrons futures contracts. Putting two M.D.s from the same institution on the board only compounds the error. Board activism and participation? Enron director Ronnie Chan, CEO of Hong Kongbased real estate firm Hang Lung Group, missed 75 percent of the Enron boards meetings. William Patterson, director of the AFL-CIOs office of investment, noted that Chan also sits on the board of Motorola, Inc., and Standard Chartered plc. Chan is a classic example of a director who sits on too many boards, Patterson said.2 But the attendance records and professional qualifications of the Enron board members were small change compared to the compromising relationships into which roughly half of the directors allowed themselves to be drawn by the companys management. Technically, all of the board members except Chairman Lay were outside directors, supposedly independent because they did not serve as part of the companys management. But six of them had effectively renounced their independence and become management insiders by accepting company favors.3 Director William Powers Jr., dean of the University of Texas School of Law, sat on the Enron board at the same time that Enron management donated $250,000 to his law school and $3 million to the university at large. In addition, Enrons law firm, Vinson & Elkins, endowed a chair at the law school. Director Robert Belfer, CEO of Belfer Management, established a company called Belco Oil & Gas Corp., which became one of Enrons customers. It was all out in the open. Since 1996 Enrons proxy statements have included the disclaimer that Belco Oil & Gas Corp. has entered into natural gas and crude oil commodity swap agreements and option agreements with Enron Capital & Trade Resources Corp. In 2000, Enron earned $33 million in connection with the Belco agreements. Director Herbert Winokur, Jr., who joined the Enron board in 1985, is affiliated with the National Tank Co., a vendor of oil-industry supplies which in 2000 received $370,294 in orders from Enron. This information was disclosed in Enrons most recent proxy. Director Lord John Wakeham, a former minister of energy in the British cabinet, received $70,000 in consulting fees from Enron while sitting on the board. Wendy Gramm, wife of U.S. Senator Phil Gramm (R-Tex.), received a seat on the Enron board in 1993, only a few weeks after the federal agency she headed, the Commodity Futures Trading Commission, ended restrictions on the types of energy trades in which Enron management planned to engage (she left the CFTC before joining Enron). Former Enron Director John Urquehart received consulting fees from the company while he sat on the board. In 2000 he received $493,000 in such fees on top of his $50,000 annual directors fee and an additional $10,000 received for sitting on a committee. Amazingly, all of these relationships were disclosed in Enrons proxy statements and thus available for securities analysts and portfolio managers to evaluate. Virtually all of these investment professionals either chose to ignore the danger signals or simply failed to recognize that board members cozy relationships with management were likely to compromise their capacity for evaluating managements performance objectively on behalf of the shareholders. Not revealed in any proxy statement, but perhaps more damaging to Enrons corporate governance, was a statement made in 1989 by board member Robert Jaedicke, dean of the Graduate School of Business at Stanford University, an accountant and head of the Enron boards audit committee. According to Vanity Fair writerat-large Marie Brenner, Jaedicke visited with Enrons internal-audit staff in March 1989 and was asked, How do you view your role as an independent director? Im here to support management, Brenner says he replied. Im here to support Ken Lay. Brenner concluded: The two auditors took this remark as an indication of where Jaedickes loyalties lay.4 Jaedickes remark is astonishingand discouraging. If the dean of the number-oneranked U.S. business school5 can misconstrue the duty of a corporate director by 180 degrees viewing himself as responsible not to the shareholders but to the chief executive officer then shareholder capitalism may be in bigger trouble than anyone has imagined. The deans remark suggests that tomorrows business leaders are emerging from one of the worlds most prestigious institutions of higher learning unaware of their true legal and ethical responsibilities, unprepared to distinguish between the interests of the shareholders and the interests of management, and unable to act correctly when a conflict between the two arises. Indeed, they may not even be able to discern the very existence of such a conflict. The ultimate impact of the Enron collapse on the corporate system and economic growth remains to be seen. Already, one great American auditing firm, Arthur Andersen & Company, appears headed for extinction in the wake of its alleged collaboration with Enron management in a scheme to mask losses and confect bogus profits. While the Enron collapse is unlikely to lead directly to the demise of other firms, the public cynicism it generated may be acting like a lowlevel pollutant, repelling potential investors from committing their wealth to the care of corporate managers and retarding the global economic growth on which the welfare of billions depends. That consequence may best be summarized in a remark made to the author by Dr. Tony Maingot, director of Caribbean ResearchYale University:6
Without trust in leaders of institutions, both private and public, there is growth in cynicism. Without trust there is no growth.
1 Why honesty is the best policy, The Economist, March 9, 2002, p. 9 (Back to Basics supplementary insert). 2 Ron Orol, Critics: Time to overhaul corporate boards, The Deal.com, Feb. 6, 2002 3 Robert Manor, Stephen J. Hedges and Melita Maria Garza, Critics: Enron probe pretty soft on board, Chicago Tribune, Feb. 5, 2002, Sec. 3, p. 4. 4 Marie Brenner, The Enron Wars, Vanity Fair, April 2002, p. 206. 5 The Best Graduate Schools for 2003, special publication by U.S. News & World Report, 2002. 6 Tony Maingot, Ph.D., personal interview, Rio de Janeiro, April 2002.

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proprietorship or family enterprise of the period. Many individuals with different skills were needed, plus a cadre of especially skilled and motivated people to coordinate and direct their workmanagers. To make the colonizing ventures successful, these managers had to be given broad power and authority over the companys employees, property, and funds. The shareholders in the new joint stock companies gave their managers this power but under a condition: The managers had to be accountable to the shareholders for what they did with the wealth and power entrusted to them. Because the managers were going overseas and could not be observed or supervised directly by the people putting up the capital, a mechanism of accountability was needed. This board of directors consisted of men not involved in the day-to-day management of the enterprise. Their responsibility was to periodically examine and evaluate the managers performance, report their findings back to the shareholders, and replace the managers if their performance was deemed inadequate. The first two private corporations that colonized America for the British, the Virginia Company of London and the Virginia Company of Plymouth, both had boards of directors specified in the royal charters that established them. In fact, they each had two boardsa local council in the New World and a supervisory board in England. Monopolies The first joint stock companies chartered by the British and Dutch crowns (as well as the earliest American corporations) were basically monopolies, chartered by government to private entrepreneurs to accomplish some acknowledged public purpose, public work, or internal improvement that government could not finance by itself: construction and operation of canals, ports and harbors, toll bridges, turnpikes, plank roads, and other public infrastructure; colonial settlements; and overseas trading corporations that shipped spices back to England and Holland. Each corporation was awarded a royal monopoly to engage in a particular activity or to dominate a particular geographic area. Government let private investors keep the profits in return for assuming financial risk and undertaking management of the venture. At this stage of development, corporations were actually an extension of the power of the Crown.

The American Corporation: Less Public Purpose, More Private Profit After the Revolutionary War, Americans continued to use the British model of corporate organization but with two important differences. The first American innovation was that the charter authorizing private individuals to form a corporation came not from the king but from the legislature of each state. American corporations also differed from the British model in that they gradually shed their original public character and migrated into what we today call the private sector. It took several generations of evolution in public consciousness before investors, lawyers, and the public could accept the idea of placing a powerful wealth-multiplying mechanism such as the corporation in the hands of businesspeople solely interested in making a private profit while competing with others for the same business. Even after Adam Smiths Wealth of Nations was published in 1776, there was a lag of several decades before the public at large accepted Smiths notion that private profit brought public benefits. As J.M. Juran and J. Keith Louden write:
There were fears (amply justified) that the charter rights would be abused. There were apprehensions about breathing life into immortal creatures. There was downright disgust about the idea of limited liability, which was widely regarded as welshing on ones honorable debts. The opponents of corporations saw trouble ahead if the way were opened to a new breed of immortal monsters, each unlimited to growth, yet limited as to liability.3

1. Hamilton had to appeal directly to the legislature for a special act granting SUM a corporate charter. Chartering a corporation today is a routine administrative procedure that any entrepreneur may undertake simply by filing a special form and paying a registration fee. This change was made to eliminate the oncecommon practice of bribing legislators to obtain a charter. Today, each state has a General Corporation Law setting forth the rules for incorporation of any type of business. This one-size-fits-all set of guidelines makes further legislation superfluous and enables virtually anyone to establish a corporation. 2. Corporate charters no longer specify that a corporation confine itself to a certain type of business, to a specific territory, or to the production of certain products, such as making shoes, milling flour, or running a railroad between Point A and Point B. Today, a corporation may engage in any lawful activity, and a charter obtained in one state authorizes the company to engage in business in any of the others. 3. Finally, corporate charters no longer grant monopolies. Corporate businesses are expected to compete in free markets. Differences between Corporations and Other Businesses All businesses need management. Why do corporations require not just management, but governance? Governance is required primarily because a corporation differs very substantially from the other two common formats for organizing a businessthe sole proprietorship and the partnership. In proprietorships and partnerships, the same people who own the business also manage it. They are financially responsible only to themselves, and if they manage poorly, they usually lose. But in a business organized as a corporation, ownership and management are divorced. All the owners do is invest their money in the business; professional managers run the business for them. If the managers fail, they do not automatically lose wealth, but the investors do. In fact, corporate managers can do a poor job for extended periods of timeyears, even decadesand still keep their well-paid jobs while shareholders watch the value of their investment drop. Because the interests of managers can conflict with those of shareholders, the law

Adam Smiths belief in the public benefits of private profit and competition got a much better reception in the new American republic than in its country of origin, Great Britain. In this country, many advocates of independence envisioned a healthy private corporate sector as a strong counterweight to the kind of powerful centralized government the colonies had just rejected. One of these advocates was the new nations first treasury secretary, Alexander Hamilton. In November 1791, Hamilton obtained a charter from the New Jersey legislature authorizing him to form a corporation known as the Society for Establishing Useful Manufactures (SUM), which was to produce a series of products ranging from sailcloth to womens shoes.4 Hamiltons SUM was different from todays corporations in three respects:

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requires that corporations have a governance structure to make sure the activities of the managers are carried out for the benefit of the owners. If this is not done, there is a danger managers will exceed their legal authority and begin operating the corporation for their own benefit rather than for the shareholders. For example, they may decide to increase their salaries even though profits are not growing, or they may award some of the corporations business to outside firms they control. Or they may engage in ill-advised acquisitions or mergers that increase managerial power and salaries without necessarily raising shareholder value or long-term corporate viability. The Upside of Corporations: Fast, Strong Growth Separating ownership and management according to the corporate model increases the practical benefits to a business, particularly a business requiring large amounts of capital. Having a multitude of owners each contributing a small amount of money enables a business to raise far more capital than it could attract from a few individual owner/managers using their own funds. Keeping the management function separate from the ownership function also leaves the professional managers with more freedom to take risks and to act aggressively than if they were funded solely with their own money or with borrowed funds that must be paid back with specified interest on a definite schedule. The combination of strong capitalization and professional management can have a powerful liberating effect on managerial effortand on results. If corporations are powerful, it is because the corporate system of separating management from investment unleashes the maximum potential of each component. Downside of Corporations: Disenfranchised Owners and Unaccountable Managers But the economic advantages of the corporate form of business organization come at a price: The owners of a business corporation are radically disenfranchised, while the managers are supplied with vast discretionary power. Although separation of ownership and management raises economic performance, it also leaves every corporation with a problem of accountability: When managerial power is concentrated

in the hands of a small number of skilled professionals while ownership is dispersed among a vast number of uninvolved, nonmanaging owners, what assurance is there that the powerful managers will use their power for the benefit of the powerless shareholders? History and Mechanisms of Shareholder Disenfranchisement The potential for shareholder disenfranchisement is always present in any corporate business. But it apparently was not a major problem until the post-Civil War era, when the development of the telegraph and the ticker tape enabled investors all over the United States to trade shares on the New York Stock Exchange. Prior to that time, most corporations were small, local businesses with a few dozenor perhaps a hundredlarge shareholders, all living in or near the city where the corporation was headquartered. If these shareholders became concerned about the conduct of the business, they could communicate directly with the board of directors. Most held their shares for long periodseven for life. Dumping their stock was not the option it is today; lack of a nationwide stock-trading system made it hard for sellers to find buyers. For these early shareholders, communicating their dissatisfaction to the company (exercising their voice) was a comparatively strong option, while choosing to sell their stock (choosing exit) was a comparatively weak one. Students of business history say many of these early corporations actually behaved more like large partnerships than like todays true corporations. William T. Allen, Chancellor of the Delaware Court of Chancery, says that up until about the mid19th century, corporate shareholders had a sense, but only a weak sense, of a distinctive artificial corporate entity.5 Another source views the corporations of that period as little more than limited partnerships, every member exercising through his vote an immediate control over the interests of the whole body.6 All this changed in the huge outburst of post-Civil War business expansion that knitted the United States together into a single, nationwide, industrial economy. Legally, corporate shareholders were still entitled to accountability from management. Practically, however, the increasing numbers and geographic dispersion of

shareholders, along with the ease of liquidity made possible by a national stock market, isolated shareholders from management and made accountability difficult to enforce. Today, three factors keep shareholders, the owners of a corporation, from enjoying the powers of proprietors and partners who own other kinds of businesses. Together, these factors add up to what students of organizational behavior call the collectiveaction problem (i.e., the inherent difficulty of organizing large numbers of dissimilar people into an effective operational group). The first factor in the shareholders collective-action problem is sheer numbers. A typical large corporation will have hundreds of thousands of shareholders. Some will be individuals holding a few hundred to several thousand shares each, while others will be institutional investors: mutual funds or pension funds holding millions of shares on behalf of hundreds of thousands of individual plan members who are the beneficial, though not legal, owners of the shares. Some of the shareholders will even be other corporations. Most of these shareholders will be unknown to one another, since only the management of their company holds a complete list of all its investors. Unable to communicate with one another, the shareholders cannot act as a group to defend their interests. The second factor in shareholder disenfranchisement is geography. While the top management of a corporation normally is found all in one placecorporate headquartersshareholders are spread across the nation and the world. This geographic dispersion makes it even more difficult to organize a multitude of shareholders into an effective group. Even with todays most advanced telecommunications technologies, loose ownership cannot easily obtain information controlled by a tightly coordinated management. The third factor is liquidity, the ease with which corporate shares can be bought and sold on a modern stock exchange. Because today people can trade stock almost as easily as they can hold it, a shareholder who is dissatisfied with the financial performance of his stock is more likely to sell it and reinvest the proceeds in another stock than to exhaust himself in a futile attempt to reach out to management and get it to do a better job. When traders dump a stock that has not met their expectations, they call it walking the Wall Street
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walk. The disgruntled investor votes with his feet by walking away from the underperforming corporation rather than trying to stimulate it to do better. If the investor were for some reason unable to sell the stock, he would be more strongly motivated to communicate with the board of directors and seek some sort of managerial reform, to exercise voice. Today, for all but the largest investors, voice is impossible to achieve. Because the shareholder is voiceless, it is easier just to exit. B O A R D O F D I R E C TO R S Total Accountability to Disenfranchised Shareholders; Limited Authority over Powerful Managers In one respect, Alexander Hamiltons SUM corporation of two centuries ago was strikingly similar to todays Fortune 500 companies: Its prospectus said, The affairs of the company [are] to be under the management of thirteen directors. The current General Corporation Law of the State of Delaware, where more than 50 percent of the nations publicly traded corporations are incorporated, reads, The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.7 The incorporation laws of the other 49 states employ almost identical language. Note the expression managed by or under the direction of. Managing is a fulltime job. A board of directors, which normally meets no more than five to eight times a year, cannot actually manage a corporation. The courts have held, however, that the expression under the direction of gives the board the right to delegate its management authority to professional managers. This means managers are legally accountable to the board for their actions because it is from the board that they receive their authority and powers. It also means the board in turn is accountable to the shareholders for the performance of the managers because it is from the shareholders that the corporation receives its capital. The courts have found that it is really the boards own managerial authority that the managers are exercising. This authority, in turn, comes from the shareholders, whose equity provides the managers with the financial means to carry out their work. Thus, in the corporate system, it is ultimately the shareholder investment that legitimizes management power.
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(Mythical) Model of Corporate Governance Corporate governance involves three elements: the shareholders, who own the corporation but have no voice; the managers, who operate the company and have virtually total voice; and the board of directors, who supervise the managers on behalf of the shareholders and supply at least a token of the voice the shareholders have relinquished. The central element is the board, ideally a strong, independent-minded panel of experienced businesspeople who meet periodically to evaluate managements performance, appraise managements proposals for the forward movement of the enterprise, approve recommended gain-sharing (dividends) from time to time, and determine whether management is doing an adequate job of multiplying the shareholders wealth in compliance with the law. Should the directors determine that managements performance has been inadequate, they may exercise one of their most important powers by discharging the chief executive officer and retaining a new one. The board is supposed to serve as the voice for the voiceless shareholders, representing them and making sure management acts in their interest. Under the law of corporate governance, shareholders relinquish the right to manage their property, but they do not relinquish their right to retain effective management. Proper management of the shareholders property is the managers obligation, and the board of directors is there to make sure that management carries out its side of the bargain. More Realistic Model Unfortunately, the model described above contains more myth than reality. The way boards of directors work is very different from what the public imagines. It is even different from what most business managers imagine. Neither the shareholders nor the board is at the top of a chain of command. For reasons already discussed, the shareholders are largely powerless. And except in a few areas (such as discharging the chief executive officer and retaining a new one), the board, too, is largely powerless. The way a corporation really works is that virtually all power to initiate action is vested in management. All of the companys goals, plans, and strategies for growth are developed at the management level. So are all of the programs, including the bud-

get, that enable the managers to implement those plans and realize their goals. The board can at best only periodically monitor and review the way those plans and strategies are being implemented and determine whether the goals are being reached. Wakeup Call to U.S. Boards: The Global Economy In order to work, managements accountability to shareholders must have a mechanism: corporate governance centered in a strong and relatively independent board of directors. But by the early 1970s, it began to be apparent that is not the model which Americas growing new industrial economy got. The first signs that something might be amiss with corporate governance in the United States came in the 1970s, when several large corporations were caught breaking the law. Lockheed Aircraft Corp. admitted paying bribes to Japanese government officials to obtain contracts in that country; Gulf Oil was found guilty of making illegal political contributions;8 and ITT used corporate funds to support CIA activities against Chile when that nations new Marxist government threatened to nationalize the companys telecommunications properties.9 A few media critics chastised the boards of these companies for ignoring managements excesses, but the business community saw little reason to question the governance mechanism. Profits had not suffered, so why get upset?10 Attention focused on boards again in the late 1970s when civil-rights advocates noted that virtually every boardroom was totally male and totally white. To mollify the critics, many companies named a token female, black, Hispanic, or labor-union official to their boards, a cosmetic change that fooled no one and left the existing corporate-governance format intact. The new directors accepted their places in the system without challenging its fundamental assumptions about governance. Starting in 1981, however, corporate governance at last began to come under real scrutiny and real demands for change. This time the challenge to corporate America was not legal or racial but economic: For the first time, U.S. corporations were facing serious competition, and some of them were losing the battle. Throughout the 1980s and into the early 1990s, millions of investors learned for the first time that

holding a blue chip stock no longer meant safe, steady growth and uninterrupted dividends. Household names such as Weirton Steel, Pan American World Airways, Chrysler Corporation, International Harvestereven venerable public utilities such as Chicagos Commonwealth Edison found themselves struggling with unforeseen challenges. As the decade of the 80s progressed, some of those household names did the unthinkable: They disappeared through liquidation. Pan Am and Eastern no longer are around. Neither are some of the steelmakers. Gone, too, is a whole laundry list of less-than-truckload motor carriers whose managers proved unable to adjust to free-market competition after Congress deregulated their industry in 1981. Spector, Dohrn, Red Ball, Time-DC, Campbell Express, Wilson, PIE, and a host of smaller truck lines simply went out of business. By the mid-80s, even companies once considered untouchablecompanies such as IBM and General Motorswere in deep, deep trouble, watching helplessly as their market share dribbled away to upstarts at home and abroad. Yet their boards appeared to be sleepwalking, leaving the same CEO and management team in place for years. As these businesses unraveled, critics began to ask, Why doesnt the board do something?
Todays corporate managers and directors operate in a changed environment and therefore experience their roles differently. Management performance is being judged by world competitive standards. Most large American business corporations directly confront, in their own backyards, competition from businesses in every other part of the world businesses that are run by relentless competitors who have their own sources of manpower, innovation, and capital and often the overt or covert support of their governments. Even business competition within the United States has become far more dynamic as a result of greater technical innovation and product change, to mention only two factors. Hence, every business is much more vulnerable than in the past to the adverse consequences of ineffective management. An investor can no longer invest in a good sound company and simply relax. That good sound company might turn out to be a Republic Steel or Swift & Company. Neither can management assume that they have it made when they have made it. We

have to earn our wings every day, as Frank Borman, then CEO of Eastern Airlines, said before he lost his.11

In this new and more dangerous competitive environment, the board of directors takes on fresh importance. Under the laws of corporate governance, only the board has the authority to replace the chief executive officer when management appears to be losing the battle for corporate viability and growth. If the board fails to act in time, shareholder choices quickly dwindle. A proxy fight staged by a disgruntled investor may lead to ousting of the incumbent board and its management, but only a large shareholder with deep pockets can afford such a campaign. Stanford Law School Professor and former Securities and Exchange Commissioner Joseph Grundfest notes that the costs of a 1992 proxy contest at Jefferson-Pilot Corp. [a North Carolina-based insurance and broadcasting conglomerate] exceeded $5 million.12 Or a takeover company may offer the shareholders a premium for their shares, but this is likely to happen only if the acquirer perceives the target company to have considerable value left. Takeover artists look for underperforming companies, not dying companies. In any case, proxy fights and takeovers only beg the question of how the target company came to be a chronic underperformer in the first place. Here the finger points back at the board. The absolute minimum duty incumbent upon a board of directors is that of safeguarding the shareholders capital, taking care to see that their investment is not diminished. Beyond that, the boards duty is to see that management multiplies that capital to the greatest extent practicable. If growth fails to occur or losses begin to accumulate, the board is the shareholders first and to a large extent only line of defense. The boards most important duty is to evaluate managements performance and to act promptly and appropriately if it finds that performance inadequate. At this point the question becomes: Does the board have what it takes to hire the right CEO, track his performance, and replace him if he fails to protect and multiply the shareholders assets? Myth of the All-Powerful Board When Lee Iacocca was brought in to rescue the technically bankrupt Chrysler Motor Corporation in 1980, he knew the compa-

nys sleepy management had been ignoring innovation and giving away market share to vigorous Japanese competitors for more than a decade. What he could not understand was why Chryslers board had never seriously questioned what management was doing.
I often wondered: where was the board while all this was going on? . . . When I became chairman, I moved in on the board members very gradually. I wasnt crazy enough to point my finger at a group that had just hired me and tell them: Its all your fault. But once or twice I did ask the board, as politely as I could: How did management ever get their plans past such a distinguished group of businessmen? Didnt you guys get any information?13

Iacoccas question was rhetorical. As a veteran of the Ford Motor Company under its quixotic chairman Henry Ford II, Iacocca knew perfectly well that few boards of directors actually perform all of the oversight functions assigned to them by the law and entrusted to them by the shareholders. And he probably knew why: Although directors are legally obligated to defend the interests of the shareholders, most boards are mere appendages of management. The failure of the public to grasp this reality has led to the growth of a whole board-ofdirectors mythology that differs radically from the facts. The following myth/fact inventory suggests why boards usually rubber-stamp management when they are supposed to question and challenge it. Corporate Governance Myth-Fact Inventory Myth No. 1: The board of directors is the supreme power in the corporation. The board appoints the chief executive officer. The CEO and senior management answer to the board and can be replaced if management performance does not meet the boards standards. Fact: Most U.S. boards are de facto subordinate to management, not superior to it. The directors are selected by the head of the management teamthe CEOand owe their prestigious positions and their many privileges to him. As for the chairperson of the board, in more than 75 percent of U.S. corporations the CEO and the chairperson are the same person, and the CEO persona prevails. In effect, management runs the board, not vice versa. Myth No. 2: Shareholders own the company. Fact: Ownership of shares in
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a business corporation does not bring with it the same rights and privileges as ownership of other types of property. Legally, the holder of corporate shares is considered an investor rather than a proprietor. He has no access to what he owns and no say in how it is used or managed. All he has is a right to a share of the profits and a right to an accounting by management of the companys performance. Myth No. 3: The board manages the company. Fact: The board cannot manage the company. The board meets only five to eight times a year for approximately four hours per session and maintains no ongoing communication with the many specialized departments and functions essential to a modern corporation. It delegates the management function to professional managers who work fulltime in their specialized areas. Only these managers have the expertise to plan, organize, coordinate, and control the day-to-day functions of the enterprise. Myth No. 4: The board represents the shareholders and makes sure management acts in their interest. Fact: See Myth No. 1. Boards do a better job of representing managementor representing themselvesthan representing shareholders. Myth No. 5: The board takes the long view, grasps the big picture that management misses due to its need to focus on the details. Fact: The board is in the dark because management controls all essential information about the firm. The head of the management team, the CEO/chairperson sets the agenda for board meetings. The chairperson thus controls the amount and kinds of information the directors receive. Myth No. 6: While quiescent in normal times, the board becomes active during periods of trouble. It probes, investigates, interrogates management, gets to the bottom of the problem. Fact: See Myth No. 1. Directors are reluctant to challenge the CEO because in most cases he was the one who gave them their directorships. A collegial, old-boy culture discourages confrontation in the boardroom while encouraging an ethos of to get along, go along. Even when they suspect problems are developing, directors are slow to react until pressure from major shareholders, lenders, the news media, or a tender offer forces a response.
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Myth No. 7: If shareholders feel certain directors are delinquent in holding management accountable for corporate performance, they can vote such directors out of office at the annual meeting. Fact: The annual election of corporate directors in the United States closely resembles the elections of delegates to the Central Committee of the Communist Party of North Korea.14 There is only one slate of candidates, and it is picked by management. Shareholders can either vote for the entire slate or abstain. Most corporate bylaws offer shareholders little more than the chance to ratify measures on which management already has decided. Contesting a board election usually involves a proxy contest likely to cost an insurgent shareholder at least $500,000much of it for legal fees, the rest for advertising and direct mail appeals to other shareholders. As a forum in which management can be challenged, much less changed, the annual meeting is almost useless. The notion that shareholder meetings are hollow rituals is hardly new, writes Joseph Grundfest, citing Adolph A. Berles remark in 1957 that the annual meeting is a kind of ancient, meaningless ritual like some of the ceremonies that go on with the mace in the House of Lords.15 Origins of the Board Myth How did the myths of corporate governance come to be so widely believed? Governance guru Nell Minow says it happened because management wanted it that way. Managements perpetuate those myths to lull the shareholders, Minow says. Shareholders feel more secure if they believe a wise board of directors is watching and correcting management.16 Managements do not need an expensive or carefully orchestrated propaganda campaign to get the corporate-governance myths into circulation. All that is required is a typical corporate public relations department with a professional grasp of press-release language. For example: The Board of Directors of XYZ Corporation today declared a dividend of 12 cents per share of common stock to shareholders of record as of May 15, reads the opening line of a typical release. Reading this kind of language, even veteran investors cannot help visualizing a dozen silver-haired wise men of industry grouped around a mahogany table to address the solemn issue

of how much of the companys current earnings should be distributed to the shareholders. The reality is that the CEO and the chief financial officer decided how large the dividend should be, and the directors routinely ratified their decision. Another release might read, The Board of Directors of Intercontinental-Universal Incorporated today elected Daniel C. Smith as Chairman and Chief Executive Officer, effective October 1. Mr. Smith will succeed Thomas M. Jones, who is retiring. Like the release announcing the dividend, the disclosure that the board elected a new CEO conceals a baser reality: The CEO picked his own successor, and the board accepted that choice. In the real world, most boards accept with only token dissent almost everything management proposes. Most board resolutions, in fact, are adopted unanimously. Boards vote with management because board members are appointed by management and paid by management; they owe their perks and privileges to management. Under the law, boards work for the shareholders; they are not employees of the corporation and hence not subordinate to its management. In the boardroom, however, corporate directors find themselves enmeshed in a powerful web of other obligations and relationships that can be very difficult to evade. Methods and Motives for Keeping Boards Loyal to Management Rather Than to Shareholders Between the fees, the perks, and the prestigeall controlled by the powerful chairperson/CEOit is not surprising that boards frequently fail to perform the governance duties that the shareholders and the law expect of them. If the CEO is of the imperial variety, unscrupulous dispensing of perks can draw the board deeper and deeper into the orbit of management, detaching the board further and further from the interests and perspective of the shareholdersand even the customers. For example, during the mid-1980s, when General Motors management stood virtually helpless as Japanese competitors ate deeply into GMs historic market dominance, the corporations directors were totally in the dark about the widening quality gap between GMs cars and those of its popular Japanese competitors. GM cars had become legendary for falling apart after 10,000 miles or rusting out after one bad

winter. Yet GMs directors remained ignorant of the companys quality problems. Why? Because GMs Chairman/CEO Roger B. Smith made sure that each director got a brand-new GM car for personal use every 90 days. The cars were replaced before any director had a chance to experience personally the infuriating manufacturing errors that were turning GM from a legend into a laughingstock.17 Dilemma of Corporate Governance: Initiative vs. Accountability The extraordinary amount of power and freedom that senior executives are given to use other peoples money in pursuit of economic growth is one of the important keys to the great economic productivity of the corporate form of business organization. If this managerial initiative were to be seriously curtailed, the corporations potential for multiplying shareholder value could be crippled. Thus, any restriction on management power must be applied with extreme care and discretion, and by law that discretion belongs to the board of directors. The board must keep the managers law abiding and loyal to the stockholders, but it must do so without exerting a chilling effect on managerial initiative or effort. How much freedom should corporate managers be allowed? Total power is not advisable. Power corrupts, and absolute power corrupts absolutely, wrote British historian Lord Acton (18341902). But governance that involves too much monitoring, too many restrictions and guidelines and rules can err in the other direction, stifling the creativity and extra effort that build high performance. A business corporation is a wealth-generating machine. Its only reason for existence is to create customers and produce profits. Fettered, frustrated managers working in a militarystyle chain-of-command structure cannot generate the profits investors seek when they put their capital at risk. Corporate governance, then, is not just a problem or a task. It is a dynamic dilemma, a perpetual effort to maintain a balance between excessive freedom and excessive monitoring. An effective board of directors is continually trying to balance the managements need for initiative and freedom against the shareholders entitlement to an accounting of managements performance. Unfortunately, many boards find that balancing act too demanding. Instead of mediating between the managements need

for power and the shareholders entitlement to accountability, they identify with and embrace management. And with good reason: Management has more to offer. How CEOs Can Seduce Their Boards Serving on a corporate board of directors is rewarding in many respects. At the typical Fortune 500 company, such positions offer $25,000$50,000 per year for between five and eight four-hour meetings (banks are an exception; by law their boards must meet monthly). About two-thirds of the total represents a retainer, or flat annual rate, while the balance represents fees of $1,500 to $2,000 for each meeting the director attends. A director who serves on a board committee receives additional compensation for each committee meeting attended. The sums cited may seem small compared to the seven- or eight-figure salaryplus-bonus packages of top CEOs, but directors work part-time while CEOs work full-time and then some. In addition, retainers and meeting fees may be only the tip of a much bigger financial iceberg for some directors. These are directors of corporations in which the CEO bonds with the board by routing his corporations business to firms owned or managed by his directors. That might mean lucrative contracts for a directors consulting company, legal business for a directors law firm, loan business or deposits for a directors bank, corporate contracts for a directors insurance company, or charitable donations from the corporation to a directors alma mater or favorite charity. In a 1993 article in New York magazine, reporter Christopher Byron explained how James Robinson, the embattled chairman of American Express Corporation, kept board members loyal to him even after the company suffered a decade-long string of business reverses. Among his directors were former Secretary of State Henry Kissinger and former President Gerald Ford. Each received Amex consulting contracts. In 1991 alone Kissingers foreign-affairs consulting firm received $500,000; Ford received $100,000.18 Because a board seat brings both income and prestige, most directors are careful not to engage in behavior that might endanger their eligibility for continuing board membership. That basically means getting along well with the chairperson/CEO and the other directors, which means not being too independent and not leading a fight to

upend the CEOs plans and programs. The old rule prevails: To get along, go along. In companies ruled by an imperial chairperson/CEO, a dissenting director is unlikely to be renominated at the end of her term. In effect, she is fired. Once she is let go, the intercorporate grapevine may label the dissident as not a team player. She could be dropped quietly from consideration for membership on other boards. Disenfranchised Owners, Powerful Managers The combination of disenfranchised shareholders and boards of directors too beholden to management opens the door to many kinds of abuse. Such abuse of managerial power and authority is not just a potential but a reality. In recent years the media have carried a growing number of stories detailing managerial conduct that was in conflict with the interests of the shareholders. Some typical examples: Managers award themselves salary increases and bonuses even though the company is failing to earn profits. Managers (or directors) use corporate (i.e., shareholder-owned) assets for their personal leisure or that of their families and friends. Managers (or directors) use corporate bank accounts to grant themselves lowinterest loans, interest-free loans, or loans so open-ended that they need never be repaid. Managers award corporate business to a company in which they or a family member holds a financial interest (so-called sweetheart deals), often bypassing other vendors offering better products or services at lower prices. Managers act on inside information to trade profitably in their companys stock before outsiders have had a chance to learn the state of the companys performance (insider trading). Managers acquire other companies and engage in empire-building in order to raise their power, status, and salaries, even though the acquisitions mesh poorly with the core corporation and contribute little or nothing to long-term growth or financial viability. Managers break the law, subjecting the corporation to large fines or legal settlements that are paid not out of the managers personal wealth but out of shareholder equity.
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Arguably the most common form of managerial abuse is plain old mediocre performance: The managers run the company just well enough to generate good salaries for themselves but not well enough to build value for the shareholders. During the 1980s, takeover specialists made it their business to identify such underachieving corporations, and they found hundreds of them. Many of these companies were successfully acquired when takeover companies convinced shareholders that the value of their stock would never grow as long as the company was being run by its incumbent management. To take control of the company, the raiders offered the shareholders a premium over the market price for their stock. In many cases, the shareholders willingly sold out, and the takeover firm then installed a new board and executive team. Abuse of power by managers is dangerous because it can erode the long-term economic viability on which shareholder value depends. Shareholders invest their capital in a corporation for one reason: to multiply their wealth. When corporate assets or corporate power and authority are converted to serve the private interests of managers, shareholder wealth is diminished and investor confidence is eroded. So is the companys fundamental economic strengthits ability to develop good products that will generate profits and jobs. What makes managerial abuse really problematic, however, is that it is hard for shareholders to identify it and document it, much less stop it. Thus, to a large extent, corporate shareholders are without power. They need a governance system to keep managers accountable because without such a system there is almost nothing they can do to affect the performance of the company in which their money is invested. Without strong and responsible governance, a corporation is a faceless, self-governing, nonaccountableand extremely powerfulentity that cannot be controlled through the historic mechanisms of reward and punishment that society uses to control its individual members. This potential for nonaccountability is why the French call a corporation a socit anonyme and the Spanish call it a sociedad annima, an anonymous society. It is also why the British Lord Chancellor Edward, Baron Thurlow (17311806) complained: Did you ever expect a corporation to have a conscience, when it has no soul to be damned and no body to be kicked?19
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C O R P O R AT E G O V E R N A N C E AND THE LAW The Boards Fiduciary Duties and Legal Powers What Good Boards Are Supposed to Do Robert Kirk Mueller, former chairman of Arthur D. Little, Inc., and author of seven books on boards of directors, writes that governance is understood as the continuous exercise of authority and decision over, and the performance of, political functions of policymaking and resource allocation. Thats fancy language for overseeing and monitoring a companys conduct, i.e., bugging the management to get with it.20 In recent years, corporate-governance analysts have begun focusing more sharply on just what governance is and why it is essential to strong corporate performance.
The single major challenge addressed by corporate governance is how to grant managers enormous discretionary power over the conduct of the business while holding them accountable for the use of that power. Shareholders cannot possibly oversee the managers they hire. . . . In theory, at least, the law imposes on the board a strict and absolute fiduciary duty to ensure that a company is run in the long-term interests of the owners, the shareholders.21

not place herself in a conflict of interesta situation in which she uses her corporate powers to serve her own interest at the expense of the interests of the shareholders. (Managers are under the same obligation when they exercise their corporate powers and use the corporate resources the shareholders have placed at their disposal.) Monks and Minow elaborate:
Duty of loyalty means that a director must demonstrate unyielding loyalty to the companys shareholders. Thus, if a director sat on the boards of two companies with conflicting interests (both trying to buy a third business, for example), he would be forced to resign from one board because clearly he could not demonstrate loyalty to the shareholders of both companies at the same time.22 The basic principle of loyalty is not complicated. Stealing from the company is disloyalty in its extreme form. Yet even mild forms of disloyalty can have very destructive effects, because disloyalty necessarily diminishes profits to shareholders and almost inevitably demoralizes the organization. This happened at Chrysler in the 1950s, when top management stole from the company by setting up sweetheart contracts with supplier companies that they controlled. Receiving unjustified compensation is stealing from the company. But what level of compensation is unjustified?23

If the duty of a board is so clear, why do so many boards fail to do their duty? A clue can be found in the somewhat evasive qualifying phrase, In theory, at least. Under the law of corporations, which is virtually identical in every state and relies on a British precedent more than 250 years old, corporate directors are held to be fiduciaries of the stockholders. A fiduciaryfrom the Latin fides, faith, fidere, to trust, and fiducia, a thing held in trustmeans someone who can be trusted to be faithful to anothers interest, to care for anothers property as if it were his own. The law expects corporate directors to exercise what it calls fiduciary responsibility toward the shareholders property. In theory, the law would appear to hold corporate directors to a very high standard of behavior. In fact, the law goes even further, breaking the general concept of fiduciary responsibility down into two specific duties, the duty of loyalty and the duty of care. The duty of loyalty means that in all official conduct, a director is to act solely on behalf of the shareholders, never on behalf of another party or herself. She may

The other duty, the duty of care, means directors must be careful when exercising judgment and making decisions. They must take care by giving appropriate consideration to the issues they are called upon to decide. They must pay attention to what they are doing by asking appropriate questions so that they do not act out of ignorance or negligence. They must display what the courts have called reasonable diligence before coming to a conclusion. They must consider all the alternatives before coming to a decision. Business-Judgment Rule: Escape Hatch for Directors Fiduciary responsibility, with its charge that directors must treat shareholder interests with loyalty and care, would seem to be an ironclad guarantee that directors will always act in the best interests of owners. If they do not, they can end up on the wrong end of a shareholder lawsuit. But that threat exists more in theory than in reality. In reality the number of successful lawsuits against corporate directors is

relatively small because the courts have evolved another rule that to a great extent cancels out much of the doctrine of fiduciary responsibility. It is called the businessjudgment rule, and it means that the courts will not try to second-guess a directors business decisions unless there is evidence that the director benefited personally at the expense of the corporation or engaged in extreme neglect of his responsibility. The business-judgment rule evolved because the courts recognized that when corporate directors make a business decision they must act in real time, without knowing all of the facts that might become known later during a court trial.
The business-judgment rule protects a director who acts in good faith, who is adequately informed, and who has no personal interest in the transaction. In such circumstances a director is not liable for consequences of his decision unless the decision lacks any rational basis. The rule is known as a safe harbor, providing a director broad discretion to act without fear of second-guessing.24

years later against a background of perfect knowledge.26

In essence, the business-judgment rule provides that if any rational purpose exists for the directors or officers decisions, they are not liable for errors in judgment, even when the decisions turn out to be wrong.27 Despite the apparently strong language of the fiduciary standard, the businessjudgment rule allows directors loyalty to the shareholders to be diluted by loyalty to management. And, as we shall see, there are other factors that enhance this tendency, including boardroom culture, the CEOs ego, the directors egos, the power of the CEO to seduce the board with retainers, fees, and glamorous privilegesand the makeup of the board itself. Makeup of Todays Boards: Trends and Issues The following findings on the composition and conduct of contemporary boards represent a digest of several studies conducted during the 1990s, along with analysis and comment from the author and some 30 current and retired CEOs. Board Size Boards are getting smaller. In a 1993 study, the consulting firm SpencerStuart found that half of the corporate boards it surveyed had 13 or fewer directors. The same firms 1988 survey had shown half the firms to have 15 or fewer directors.28 Proponents of strong and responsible corporate governance tend to prefer a smaller board. A smaller board has more potential to restrain an imperial CEO because it can act more quickly and decisively than a large one. Large boards take more time to share information and arrive at a consensus. They are more easily subjected to an imperial CEOs divide-and-conquer strategy. If the board members are not only numerous but geographically scattered as well, vital time may be lost in convening them to handle an emergency. The idea that small is beautiful when it comes to boards is receiving an increasing amount of official sanction. A survey of 653 CEOs conducted in 1992 by the National Association of Corporate Directors found an overwhelming majority in favor of small, proactive, informed and truly independent boards.29 Corporate-governance specialist John E. Balkcom, of the Chicago management-consulting firm Sibson &

Company, says even large corporations now seem to be moving toward a standard board size of fewer than 10 directors.30 Insiders vs. Outsiders A very definite trend is under way toward fewer inside directors and more outside directors. The 1993 SpencerStuart study of the boards of the 100 largest U.S. corporations showed the median ratio of outsiders to insidersdirectors unaffiliated with the company vs. directors employed by the companyat 3:1. More than a quarter of the companies surveyed had an outside/inside ratio of 5:1 or better. In the five years leading up to the 1993 survey there was a net loss of 91 inside directorships and a net gain of two outside directorships, suggesting that elimination of inside directors may be fueling the board-shrinkage trend. Only seven of the boards in the survey had a majority of inside directors, while 14 had only one insider, the CEO. SpencerStuart says the drop in inside directorships has been going on steadily for at least a decade. In 1980 only 20 out of 100 boards had an outside/inside ratio of 3:1 or better. By 1990, 51 boards had reached that level.31 Also on the decrease is the class known as affiliated outsiders (i.e., directors not employed by the corporation but receiving some sort of benefit from it that could place a director in a conflict of interest). In 1980, for example, 32 percent of the boards included a director who also served as the companys outside legal counsel. By 1990, however, this figure had dropped to 21 percent. SpencerStuart concluded in its 1991 Index: Since 1980 . . . the combined total number of inside directors for all the SSBI companies has fallen from 584 to 410. Thats a decline of 30%.32 Corporate-governance advocates welcome the trend toward outside directors because outsiders are viewed as more likely to act independently in the event that managements performance falls and the CEO needs to be replaced. Outsiders are perceived as less obligated to the CEO than corporate managers who owe their jobs directly to a CEO appointment and serve on the management team. Nevertheless, the encouraging trend toward outsiders needs to be tinctured with a dose of realism. Although outside directors technically are not employees of the corporation and are putatively elected by the shareholders, they are really appointed
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Directors are allowed this wide latitude because it is nearly always impossible, and hence unfair, for a court to substitute its after-the-fact judgment for what business decisionmakers had to decide under pressure.
Two strikingly different realities can operate when a business transaction is being put together: the reality perceived by businesspeople and the reality perceived by lawyers. The businesspeople are living in real time, plagued by uncertainties that often must be resolved immediately. They must decide one way or another, on the basis of reasoning they have not time to expound. . . . The business persons focus is the bottom linewhat to do, not why it is being done.25

Because of the business-judgment rule, the courts will not find against a director or officer simply because shareholders experienced a negative outcome. Businessmen and businesswomen are allowed to fumble, to make errors of judgment, to make bad guesses. They are allowed to be human and fallible as long as they are not demonstrably negligent, careless, or fraudulent.
All [that] even the strictest fiduciary standard asks is that decisions be undertaken with care, good faith, disinterestedness, and without abuse of discretion. As one court has said, The entrepreneurs function is to encounter risks and to confront uncertainty, and a reasoned decision at the time may seem a wild hunch viewed

by the CEO and naturally feel an obligation, making them something like brevet insiders even if not formal members of the organization. Juran and Louden acknowledged that outsiders can be insiders when they wrote in 1966:
When we examine why in the world a nonemployee is called an insider, it turns out that for important investors the word inside is used in a sense totally different from employment. The word is used in the sense of being in the inner circle, having an inside track, being part of the inner power structure (like political ins versus outs). Some writers have used the term proprietary director for such cases. The Securities and Exchange Commission (SEC), in particular, makes use of the term corporate insiders to describe officers, directors, and controlling stockholders. In the dialect of the SEC, the word inside includes a strong connotation of possessing inside information, thereby having the potentiality to take advantage of those who are not in a special relationship with a company and privy to its internal affairs.33

other category of director to have the experience, judgment, and organizational skills necessary for monitoring managements performance. They understand what the CEO is trying to accomplish, and they understand the difficulties he is likely to encounter in accomplishing it. But this very familiarity with the CEO mentality can make a CEO director overly sympathetic to a CEO who is doing poorly and needs to be replaced. Along with the retainer, meeting fees, and perquisites the CEO has bestowed on him, an emotional bond with the CEO can interfere with the objectivity required for effective representation of stockholder interests. Seniors Dominate Despite many misconceptions about directors and their work, one popular myth turns out to be true: Most corporate directors are mature, if not actually elderly. A demographic analysis of SpencerStuarts 1994 study showed that of 1,003 outside directors representing 100 major corporations, only one percent were under 45 and only six percent were under 50. By contrast, 30% of the 1,003 directors were 66 years old or older and an astounding 58% were 61 or older, the report noted. This situation is unlikely to change, since CEOs normally cannot spare their young and busy subordinates for work on another companys board. Juran and Louden found that only 17 percent of CEOs they interviewed encouraged younger subordinates to sit on the boards of other companies. The remainder either actively or tacitly discouraged such board membership. The Boardaholic The 1992 Korn/Ferry survey revealed that 65 percent of the directors they surveyed served as outside directors on the boards of more than two companies. Over 20 percent of those surveyed served on four or more boards, with the most active respondent serving on 11 boards.34 In 1993 the Washington Post reported that former Reagan Administration Defense Secretary Frank Carlucci, at that time a full-time consultant, was serving on 20 corporate boards as well as 12 boards of nonprofit organizations. Reporter Kathleen Day told Post readers that in 1992 Carlucci had a board meeting every business day of the year and even attended one meeting by

Perhaps more important, however, outside directors objectivity remains under intense CEO pressure because most outsiders share a secret bond with the CEO: They are CEOs too. Board of Directors or CEOs Club? What kinds of people do CEOs like to have on their boards? One answer has remained consistent over the decades: other CEOs. Data collected by SpencerStuart and published quarterly in the Directors Roster section of Directors & Boards magazine show that CEOs remain the most popular category from which to recruit new directors. In the Spring 1995 issue, for example, the Directors Roster reported 297 new U.S. corporate board appointments for the preceding quarter. Of those, 32.2 percent came from the Chairman/CEO category, making this group the largest bloc in the roster. Not surprisingly, the second-largest bloc, 21 percent of the total, came from Senior Officers of business corporations (i.e., those most likely to become CEOs in the future). Together, these two corporate-officer categories made up the overwhelming majority of the new directorships53 percent. There are good reasons to have current or former CEOs onor even dominatinga corporate board. Successful, seasoned business executives are more likely than any
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telephone conference call from his physicians office.35 Juran and Louden, writing in 1966, referred to these virtually full-time board members as professional directors36 and seemed to feel they had much to offer, especially if they were retired CEOs. In the opinion of this author and his CEO colleagues, however, anyone expecting to do an effective job as director of more than four or possibly five corporations in the severely challenging business environment of the twenty-first century is kidding himself. A person taking on more than four or five directorships should probably be called a boardaholic rather than a professional director. The job is simply too taxing to be performed repeatedly and effectively. A 1995 study by Business Week of 120 underperforming corporations targeted by either the California Public Employees Retirement System or the Council of Institutional Investors documented statistically what many observers had long suspected intuitively: There is a numerical correlation between poor corporate performance and the presence of boardaholics among the directors. Boardaholic No. 1, Lilyan Affinito, turned up on the boards of Kmart Corp., Tambrands, Chrysler, Jostens, Lillian Vernon, and Caterpillar, three of which had been cited two years or more in a row for underperformance. The magazine said Ms. Affinito was collecting an aggregate $300,000 per year in meeting fees and retainers for her service on the six boards. Confirming what the Washington Post had suggested in 1993, Business Week named Frank Carlucci boardaholic No. 2 for sitting on the boards of troubled companies such as Westinghouse, General Dynamics, Northern Telecom, and Upjohn, two of which had been cited by investor watchdog groups as troubled for more than two years running. To a remarkable degree, the magazine wrote, the countrys most troubled companies share an overlapping cast of directors.37 Ideal Board: Small Is Beautiful; Outsiders Are In Over the years the 30 active and retired CEOs contributing to this text have headed a wide variety of corporations large and small. Industries represented include footwear, pharmaceuticals, defense technologies, consumer electronics, banking, transportation, adhesives, insurance, invest-

ment funds, refractory brick, and office supplies, to name just a few. Company size ranged from $30 million to more than $10 billion in annual revenues. Some of the CEOs devoted their entire professional careers to one firm; others climbed the corporate ladder by moving from firm to firm and even from industry to industry. Despite the wide disparities in their business backgrounds, however, all of these CEOs agreed that the governance of todays corporations would improve substantially if four fundamental changes were to occur in the composition of corporate boards: Boards must be (1) smaller, (2) more independent of management, (3) more professionally competent, and (4) more frequently renewed through mandatory retirement of older directors. What disturbed the CEO panel was that most boards today are too large, have too many inside directors, are too closely interlocked with the boards of other companies, and are too old (i.e., they keep the same directors for so long that the entire boards median age is in the geriatric end of the spectrum). While boards are often large in size, too many of them are thin in competence due to an excess of elderly directors, celebrities, boardaholics, or other directors lacking in professional competence relevant to the corporations needs. On December 8, 1995, the new board model that emerged from the deliberations of this CEO panel was aired before 60 members of the International Academy of Management when they held their annual meeting at the Harvard Business School.38 The mixed audience of business executives and professors of management greeted the proposals almost with a sense of relief. On January 29, 1996, Chicago Tribune reporter David Young printed the proposals in his Biz Tips column in the Monday business section.39 The proposals for the ideal board are few and simple, starting with the principle of Small is Beautiful: The board should consist of no more than seven directors, including the chairperson. All directors except the chairperson should be outsiders (i.e., neither current nor former employees of the company or its affiliates). No director should be a personal friend or relative of the chairperson/CEO, but all should be known to him by business reputation.

No director should sit on the board of another directors corporation or nonprofit institution. The company at which a director is employed in management must not accept business from a company he serves as a director. Each director should have a core competence in a specialty important to the corporation she directs, be it law, engineering, computer science, marketing, finance, logistics, or R&D. Directors should serve under some sort of term limits, such as mandatory retirement at age 70 or after two successive threeyear terms. What Todays Boards Cannot and Must Not Do Lets assume that a certain corporation has a board that exemplifies all the ideals agreed upon by the most serious students of governance reform. What exactly can this ideal board do to advance the interests of the shareholders it represents? Actually, very little. So little, in fact, that before discussing the relatively few things a board can and must do, it is more important to understand the many things a board cannot do: A board is not a super-management. It does not second-guess management by critiquing managements plans, suggesting alternatives, or reserving unto itself certain big decisions deemed too challenging for managements capabilities. A board is not a representative body like a legislature. It is not expected to represent or balance the interests of a variety of contending constituencies, such as the companys employees, customers, vendors, or lenders, nor does the board represent any outside critics impacted by the companys operations, such as environmentalists, the government, or consumer activists. No director is elected to serve as the representative of a specific constituency. All directors serve at large, and all serve only one constituency, the shareholders. Nor is any director elected by any specific group of shareholders, such as pension-fund members, mutualfund members, or individual investors. Each director is obligated to all of the common shareholders as a single body. (Note: This provision does not apply in certain European countries, some of which mandate that boards include a representative from organized labor, the

corporations major banks, its largest vendors, or, in some cases, the national government itself.) The board does not normally exercise initiative or leadership (i.e., it does not go first). Management makes the first move. The board can do no more than review the results of managements initiatives. The board is not a court of last resort or a corporate ombudsman. The board is not a place to which whistleblowers or disgruntled employees and customers can run with reports of trouble that management has ignored or overlooked. Troubleshooting is both a management prerogative and a management responsibility. If management is not spotting and treating problems effectively, a properly functioning board will become aware of such dereliction during the normal course of reviewing performance. If it finds such dereliction and is convinced that the current management is unlikely to restore effective performance, the boards appropriate response is to replace the CEO. Violating the One-Chain-of-Command Principle Boards historically have been restricted from engaging in managerial activities out of respect for a fundamental reality of organizational behavior: There can be only one chain of command. Accountability works only when lines of authority are clear and unambiguous, and when each subordinate reports to one superior. If a board were to intrude into managerial prerogatives, top managers would become confused about whether to take orders from a director, from all of the directors acting collectively as the board, or from the CEO. The CEO would bristlerightlyat this dilution of his authority. Organizational effectiveness would erode. No corporate management wants or expects to answer a question from a director outside the formal structure of a board meeting, and no serious or experienced director wants to become involved in management by doing an end run around the CEO. If a director feels he or she is not getting adequate answers from management within the classic board-meeting structure of formal reports followed by Q&A, the proper course is to resign. Becoming a one-man or one-woman factfinding committee is tantamount to establishing a second chain of command.
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Clear lines of reporting between top management and the board are sometimes compromised in another waywhen a CEO retires but remains on the board. This can leave the former CEOs subordinates confused as to whether their ex-boss really has relinquished his powers and authority or whether he actually plans to continue exercising them informally by managing from his seat on the board. The strain can be particularly hard on the new CEO. Just when he needs to take firm command of the organization, he finds himself glancing back over his shoulder to find out whether his predecessor is quietly second-guessing his decisions. Howard D. Sherman, author of the Institutional Shareholders Services 1991 report, felt that retention of former CEOs on corporate boards has the potential to weaken the boards effectiveness as a monitor and check on management.
They could dominate the board agenda and decisions. . . . [M]any, if not all, inside directors may owe their jobs to the retiring CEO, and would be reluctant to contradict his views out of a sense of loyalty and/or fear: CEOs often continue to exercise enormous power even after their retirement. The same combination of fear and loyalty can appear to the nonexecutive [outside] directors recruited by the retiring CEO.40

if they are also saddled with a legislativetype duty to represent a variety of constituencies or stakeholders, such as employees, communities where the company has plants or offices, or demographic minorities. The boards effectiveness is crippled by the need to report to so many different superiors. Dilution of responsibility can be just as corrosive as dilution of authority. If you are accountable to everyone, you are accountable to no one. What Todays Boards Can and Must Do Although boards cannot and must not manage, the law nevertheless insists that they govern. It gives them very few powers to do so, but these powers carry considerable authority and can prove to be very strong when applied at the critical time and in the appropriate sequence: The board has the sole authority to elect the corporations chief executive officer. The board has the sole authority to review the performance of the CEO and determine if it has been satisfactory (shareholder value has grown at an acceptable rate). It has the sole authority to set the CEOs salary and bonus in such a way as to reward him for performance. The board has the sole authority to determine whether managerial performance has been in compliance with the law. If the board deems that the performance of the CEO and his management team has not been successful, through either failure to grow the shareholders investment or failure to comply with the law, it has both a fiduciary obligation to the shareholders and the sole legal authority to discharge the CEO and replace him. These four functions are the core of the boards legally mandated mission. If we look at them closely, however, we realize they really add up to one function: Make sure the chief executive officer is working for the shareholders. This is virtually the definition of corporate governance. Boards also have exclusive authority over another critical corporate function, but one that tends to occur only at random intervals: change of ownership. Only the board can authorize the sale or merger of the company, the issuance of additional shares of stock or new classes of stock, the buying back of stock, the splitting of stock, or the conversion of one form of stock into another. Even here, however, the board does not normally initiate the action. A proposal to

merge, acquire, be acquired, or divest, or to issue, buy back, split, or convert stock typically will come fromor throughthe CEO. The board will merely ratify his proposal. The decision to declare a dividend bears the same stamp: Management proposes; the board disposes. So too when management asks the board to approve certain large expenditures and to review and approve major programs for the future growth of the company. In many corporations the bylaws mandate that the board approve all corporate expenditures above a stated sum. On paper, at least, such a bylaw would appear to give the board ultimate control of much of the CEOs spending and investing authority. But here, too, the reality is otherwise, for it is the CEO who initiates the budget request, while the board merely ratifies it. Should a director question the size of the proposed expenditure, the CEO almost invariably will prevail because the CEOs information on the companys day-to-day operations is vastly superior to that of even the best-informed director. When Harvard Business School Professor Myles L. Mace compiled his 1971 monograph, Directors: Myth and Reality (reprinted in 1986, from which this citation is taken), one of the CEOs he interviewed told him:
In the seventeen years Ive been with this company, and my previous associations, I havent been turned down by the board yet, that I can consciously remember. If I was, it was on some inconsequential thing, nothing important. The board is not in a particularly good position to say no to management. They dont know the industry. My operations people do. And if they come in and say we ought to expand a particular plant from 2000 tons to 5000 tons a month, how can any outside director say no? Nine hundred and ninety-nine times out of a thousand, the board goes along with management, and our batting average on making the right decisions is not that good.42

Although the retired CEO possesses considerable experience that may be useful to a successor, most corporate-governance authorities today recommend that if the new management or the board feel in need of her advice, she should dispense it from a position as outside consultantpaid or unpaidrather than from a seat on the board. Walter Wriston, the former CEO of Citicorp, came to a similar conclusion:
One reason for mandatory retirement is to assure the corporation of fresh leadership to meet changing conditions. If the new leadership wants to consult the old, no corporate structure is necessary; if consultation is not desired no corporate arrangement will assure it. On the other hand, if the new CEO wants to get moving with his or her agenda, a board seat occupied by the retired CEO may be seen as an impediment to getting on with the job, particularly if new management feels that radical measures are called for.41

Finally, a third kind of violation of the one-chain-of-command principle makes it difficult if not impossible for boards to discharge their accountability to shareholders
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The real source of the boards power, thereforethe one critical area where it can act on its own initiative and at its own discretionis its exclusive authority to hire, reward, penalize, and, if necessary, fire the chief executive officer, the one individual whose performance as a leader is the single biggest key to corporate success or failure. The relationship between the board and the CEO is the central theme of the ongoing drama of corporate governance and the reason that governance came under such intense

critical scrutiny during the late 1980s and early 1990s. This is the period when many proud U.S. companies went into a prolonged performance slump that should have led to decisive intervention by the board, ending in the selection of a new CEO. Why did so few boards actually take this step while they still had time to do so? While the answer is not entirely clear, there is at least some evidence that many directors do not actually understand the nature of governance. As the 1991 Institutional Shareholders Services study and the 1994 Boardroom Consultants studies indicated, something like 30 percent of the nations corporate boards apparently do not fully grasp the difference between governance and managementand prove it by permitting the retiring CEO to remain on the board. Meanwhile, anecdotal evidence collected by the author from active and retired chairmen/CEOs suggests that many corporate directors are unclear about what their governance duties actually are and how they are to be carried out. Granted that a board cant manage, these directors seem to be saying, but if it cant manage, what exactly does it do? What is the governance process, and how is it supposed to interact with the management process? Governance in Essence: Oversee. Review. Monitor. If we examine governance literature, including more than two centuries of court decisions in Britain and North America, three verbs recur in descriptions of the corporate boards activities: oversee, review, and monitor. This choice of verbs reflects an enduring sense on the part of scholars, jurists, and practical businesspeople alike that it is not the responsibility of the board to take the initiative. The first move belongs with management; the board waits for management to act and then reviews managements performance. The boards reviewing, monitoring, and oversight of management are largely confined to two distinct periods in the governance process. The first period of board activity comes when management proposes a business initiative and the board reviews the proposal prior to approving it; the second period of board activity takes place after management has implemented an initiative and a sufficient time has passed for the resultsespecially financial resultsto be evaluated.

Reviewing Managements Plans A major opportunity for the board to review managements plans and proposals comes once a year when management presents its annual budget to the board for approval. In essence, approval of a budget means approval of the activities which the budget is designed to support. Thus, the boards decision to accept and authorize the budget effectively tells management it has the boards authority to proceed with implementation of the corporate plan. Typically, the board will approve managements plan and budget unanimously. If anything less than unanimous approval is forthcoming, the meaning is unmistakable: The chief executive officer does not have the full confidence of the board, and the unhappy director either will resign soon or will not be asked to serve again when the term expires. If, however, a larger number of directors begin to withhold approval of managements plan or budget, it is the CEO who is likely to resign or be replaced. What is not likely, however, is that the board will become involved in changing or fixing the plan. The board does not engage in planningeven strategic planning because planning is a management responsibility. Approval of a plan and budget means the board has authorized management to use a number of valuable resources belonging to the shareholders, including the corporations capital, credit, facilities, and employee skills. In approving managements plan and budget, however, the board has tacitly granted management another valuable resourcetime. Only over time will corporate management be able to grow the shareholders investment sufficiently to earn an acceptable profit. How much time? Since no two industries are alike, no two corporations are alike, no two corporate managements are alike, and no two business situations are alike, it is up to the board, with its combination of varied business experience, to determine whether a CEOs program is progressing at the proper rate and showing acceptable financial results within a reasonable amount of time. This decision is when the distinction between corporate governance and corporate management becomes critical. Once the board has authorized management to proceed with a program, it stands back and leaves management alone, delegating to

management a vast amount of discretionary authority to organize personnel, spend money, acquire equipment and supplies, perform operations, enter into contracts with other businesses, and commit the company in dozens of other areas too detailed to be observed by the board. Management must be allowed to get on with its work and must be granted a so-called decent interval in which to carry out at least a portion of the tasks it has set for itself before undergoing review by the board. In the words of Robert K. Mueller, the appropriate behavior for the board during this period is Nose In, Fingers Out (NIFO), meaning the board keeps its nose in the business by evaluating the management reports presented at board meetings, but it keeps its hands off the actual tasks required to manage the business. The board watches, but it does not touch anything. Muellers advice to boards is, Concentrate on overseeing and monitoring managements performance, and then get out of the way.43 In addition to its annual approval of the budget and the strategic plan underlying it, the board may be called upon at other times during the year to review and approve certain types of management proposals. Under most corporate bylaws, the board must approve any management initiative that affects the capitalization of the company, such as the decision to declare a dividend, to split the stock, to issue additional shares or create a new class of stock, to make a major capital investment, to sell a subsidiary or spin it off as a dividend to the shareholders, to acquire another company, or to offer a stock option to employees, officers, or directors. In addition, the board must review and approve changes in employee benefits and health coverage. Reviewing Managements Performance and Results The boards second period of entry into the corporate governance process comes after managements programs have been under way for a sufficient time to have produced measurable results. At its regularly scheduled meetings, the board reviews the quarterly financial statements prepared by the chief financial officer. On the basis of these reports, as well as additional information supplied by other corporate officers, the board tries to determine whether the companys results are meetingor are likely
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to meetthe shareholders expectations for investment growth. If we examine the behavior of boards with regard to management, we find that boards are reactive rather than proactive. This quality is the reason that board meetings are infrequent and usually last no more than half a day. Boards actually do not have much to do. Governance is by definition a minimalist activity. The board listens to managements accounts of its plans and its performance, but it does not tell management what to do. Although a board may suggest ways for management to improve its performance, it is not obligated to do so. It is obligated only to review management plans and performance so that it can assure the shareholders it is holding management to the highest practicable and legal level of performance. We have already learned who makes up the typical board and how the directors get appointed to their jobs. Now lets examine how they do their work of monitoring the CEOs performance and rewarding or penalizing it appropriately. The theater in which this work occurs is the regular board meeting.

INSIDE AND OUTSIDE T H E B O A R D R O OM How Informal Director Dialogues and Formal Board Meetings Add Up to Good Governance Informal Governance: Outside the Boardroom Some of the most important work that directors perform on behalf of the shareholders takes place outside the boardroom as well as outside of the formal governance structure. What exactly makes up this important work that never appears in the minutes of board meetings? Nothing more or less than advice and counsel to the CEO on critical matters of management. True, boards do not manage, but these advice-and-counsel activities are not conducted by the board acting collectively or formally but by individual directors acting informally, usually outside the boardroom. Juran and Louden noted this informal background activity when they identified two separate components of directors work. The boards legally mandated fiduciary duty to oversee management on behalf of the shareholders they defined as the trustee250 Part 3: Expanding the Business

ship role; the nonbinding, informal component they identified as the advisory role. The latter, they pointed out, is strictly optional and off the record.44 Advising and counseling the CEO thus has no legal standing and is not understood to be part of a directors fiduciary obligations. If we look closely, we see that the two rolesadvising the CEO informally while monitoring the CEOs performance formallyinteract in ways that can very strongly affect the outcome of the governance process. We also see that the interaction can have both positive and negative aspects. Ideally, a proper adviceand-counsel relationship between a CEO and the board can help the CEO do a better job. This happens when the CEO is a fundamentally secure individual who can recognize the need for advice and can use it effectively without becoming overly dependent on it. She knows her job, but she also knows her limitations, and she has a reliable panel of advisors to whom she can turn when she senses that her own abilities need to be supplemented by others. The negative side of advising and counseling surfaces when a CEO becomes overly dependent on board input. Harvard Business School Professor Jay W. Lorsch said the directors he interviewed split 50/50 on this question, with half of his subjects expressing apprehension that the CEOs reliance on outside contact could be interpreted as a sign of inexperience. The advisory role of the board can develop another negative aspect: If the board members become too vested in advising the CEO, if his decisions become their decisions, they risk losing some of the critical distance essential to an objective review of the CEOs performance, the core of the boards legally binding fiduciary duty to the shareholders. Being solicited by the CEO for input can be flattering to a directors ego; if used to excess, however, it can draw the directors and the CEO into a relationship so chummy that the directors will instinctively avert their eyes from any evidence that the CEOs leadership may be faltering. To put it another way, by contributing too many of their own views to the CEOs decisionmaking, the directors effectively sneak back into management through the back door, which effectively robs them of the ability to perform their governance role. Fortunately, this tendency to cross the line into management can be offset if, in

addition to their informal relationship with the CEO, the outside directors also enjoy good relationships with one another. By discussing company affairs from time to timeinformally, off the record, in groups of two or threewithout the CEO present, the outside directors are more likely to form a cohesive unit capable of acting as a counterbalance to any excesses or neglect on the part of management. Informal though they be, these off-site, informal discussions are essential to good governance because they help cement the outside directors into a proshareholder body capable of ousting the CEO if his performance falters. Only in these informal contacts can directors establish the kind of relationship that will make it possible for them to ask one another: Is the CEO doing an effective job, and if not, how do we go about replacing him? Before we look at the critical issue of evaluating the CEOs performance and deciding to replace the CEOthe issue which is the acid test for any boardlet us first examine the structure of the normal board meeting. Preparing for the Regular Board Meeting Most corporate boards hold between five and eight regular board meetings per year. This figure does vary, however. Professor Graef S. Crystal of the Haas School of Business at the University of California at Berkeley found that in 1990 the board of grocery wholesaler Wetterau held only four meetings, while the board of Chemical Bank met 17 times (in most states, corporate charters issued to banks mandate monthly board meetings).45 Regardless of the number of regular meetings, however, additional meetings can be held at the discretion of the chairperson to handle extraordinary business, and multiple meetings are a must when the board is faced with the decision to accept or reject a tender offer. Emergency meetings to respond to a takeover attempt, however, are clearly atypical. Most regular board meetings start at 9 A.M. and last less than a day. Many conclude with lunch. Governance critics down through the years have remarked that the format of the typical regular board meeting is so routine as to be a stale ritual. To a large extent these comments remain true. The dates of meetings usually are set a year in advance, and in many corporations the regular meeting times are specified in the bylaws (e.g., the fourth Tuesday of each

month except in July, August, and December). Although an effective chairperson/ CEO will do her best to keep the meeting interesting, a certain irreducible minimum of meeting time must nevertheless be spent on legally mandated procedure, such as approving the minutes of the previous meeting, hearing committee reports and approving committee resolutions, and reviewing financial reports. Before the regular board meeting convenes, however, two other formalities distribution of the advance briefing package and committee meetingsnormally precede it. Advance Briefing Package A week or more before the regularly scheduled board meeting, each outside director receives by mail or courier a briefing package containing informational materials on matters to be discussed at the upcoming meeting. This package usually will contain a copy of the agenda as prepared by the chairperson/CEO. This agenda will contain the schedule of business matters to be brought before the board (i.e., matters requiring a vote), but in most corporations today it will also list certain non-business items, such as informational presentations by members of management, which do not require a board response. For example, if the CEO has scheduled the vice president of international marketing to tell the board about the companys plans to launch a special line of products in Eastern Europe, the board will receive notice of his presentation in its advance briefing package even though such a presentation is not part of the formal Roberts Rules of Order agenda to be voted on and recorded in the minutes. The advance briefing package is a practical tool at a number of levels. First, it expedites the handling of business at the meeting. The board meeting can then be used more as a discussion and decisionmaking forum rather than as a slow-paced information bureau, write Juran and Louden. A meeting devoted to discussion and decision-making is a far more rewarding experience than one devoted to digging out information.46 Juran and Louden point out that the advance briefing package also acts as an important social lubricant. The decorum of board operation, no less than the need for effective conduct of board business, requires that there be no surprises, they note. Matters of importance [emphasis in original]

should not be brought up for decision without adequate notice and preparation.47 Perhaps most important, the briefing package can protect directors against the possibility of a shareholder lawsuit charging negligence. Since at least 1642, when the House of Lordsat that time the British equivalent of today's U.S. Supreme Court ruled in a case called Charitable Corporation v. Sutton, the law has held that under their duty of care directors can be held liable if they fail to inform themselves adequately about the issues facing the company. This obligation got a resounding reaffirmation 343 years later when the Delaware Supreme Court issued its 1985 ruling against the directors of Chicago-based Trans Union Corporation in the now legendary case known as Smith v. Van Gorkom. The court found that the Trans Union directors had been grossly negligent in approving a 1980 merger between Trans Union and the Marmon Corporation because they acted without having seen the merger agreement itself, which had been negotiated privately between Trans Union Chairman Jerome Van Gorkom and Marmon Chairman Jay Pritzker. As Fleischer et al. point out, the court did not attempt to second-guess whether the $55-per-share price that Pritzker agreed to pay for Trans Union was adequate.48 The court was interested only in whether the directors had acted on sound information as to how the two CEOs had arrived at a price. The court concluded the directors had never obtained such information. The 1985 Smith v. Van Gorkom decision had a profound effect on board meetings. Advance briefing packages for even the most routine board meetings became larger and more detailedto the point where many directors began to complain about the additional hours of preparation required for effective performance at meetings. The greater size and complexity of post-1985 briefing packages is a major reason that so many governance specialists now warn boardaholics to limit their intake to three or four directorships at most. Reading and understanding a briefing package may require a day or more of study and perhaps some phone calls to clarify obscure technical or legal points. These activities can seriously cut into the time a director has set aside for his own business or retirement activities. The Van Gorkom ruling had an even stronger impact on special board meetings

called in response to merger offers. To make sure directors are adequately informed about whether to accept or reject an offer, board chairpersons now invite the companys investment bankers to attend emergency board meetings and advise the directors as to whether a buyout or merger proposal represents real value for the shareholders. Outside legal counsel is present as well to brief the board on both its obligations and its options in the face of an offer for the companys shares. Although few directors can absorb the mass of intricate financial and legal detail laid down by the consultants appearing at these sessions, management nevertheless pays top dollar for such guest lecturers because their presence in the boardroom serves as a kind of insurance policy against shareholder lawsuits later. By showing that the board availed itself of the best legal and financial advice, the directors and management can take shelter under the business-judgment rule, which protects them from a potential shareholder lawsuit as long as they can demonstrate that they deliberated appropriately and took all reasonable measures to inform themselves prior to acting. Committee Meetings Before the members of a corporate board convene at their regularly scheduled 9 A.M. meeting, they often participate in a series of smaller committee meetings usually lasting an hour. Virtually all boards are divided into standing committees, of two to five directors each, to handle specialized duties. During their meeting these committee members will approve a report that their committee chairperson later will deliver to the full board meeting. Reviewing the Audit The most important of the committees is the audit committee. Its duty is to oversee and review the work of both the corporate accounting department and its outside auditing consultants to determine whether their picture of the corporations financial performance is accurate. Because corporate governance is primarily concerned with holding management accountable for preservation and enhancement of the shareholders capital investment, the work of the audit committee is absolutely fundamental to the boards performance; it is the shareholders only way of learning whether their investment is earning an adequate return. The audit committee also is important
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from a legal standpoint. If management has been engaged in any kind of financial misconduct, this committee should be the first component in the governance system to become aware of it. The audit committee is the last stop before the board accepts managements account of the companys financial condition and discloses that account to the shareholders and the public. Invariably, the full board will accept the audit committees findings. Whatever the audit committee determines thus will become the companys official report of its condition to the shareholders, the SEC, the IRS, and the investment community. The audit committee makes this determination in a more or less ritualized fashion. An hour before the start of the full board meeting, the audit committee meets with the companys outside auditors. Usually this meeting also will include the companys chief financial officer, the controller, and perhaps others from the companys financial staff. The members of the audit committee review the quarterly or monthly financial report that management plans to present to the board and discuss it with the lead outside auditor. At this point the chairperson of the audit committee asks the outside auditor, Do you have anything to tell us? Usually the answer is no. If the auditors had detected any discrepancies in the financial report, they would have mentioned them earlier. The audit committee adjourns, and its members then join the rest of the directors in the full board meeting, which will almost certainly feature a report by the chief financial officer. Setting Executive Pay While the audit committee is meeting, so are the other committees, the most common of which are the compensation committee (sometimes known as the compensation and organization committee) and the nominating committee. The compensation committee has the responsibility to advise the board on the salaries to be paid, as well as any bonuses or stock options to be awarded, to the CEO and other senior executives. The board has the sole legal authority to set the CEOs compensation (and that of all top management). Hence, any decision by the board to increase the CEOs salary, bonus, or perks is an implicit endorsement of current leadership. The work of the compensation committee therefore is critical to good gov252 Part 3: Expanding the Business

ernance. Giving the CEO more money is the boards way of saying, We think youre doing a good job of running this company and we want you to keep doing it. Since hiring, evaluating, rewarding, and replacing the CEO are really the only formal tools the board has for safeguarding the shareholders investment, bestowing or withholding rewards is one of the few ways a board has of grading the CEOs exam. During the 1980s, when many large U.S. firms began to lose market share and profitability in the face of intensified competition, corporate-governance critics homed in on executive-compensation practices as a major culprit. In company after company, the board was routinely authorizing an annual salary increase and even a bonus for the CEO despite falling market share, dwindling return on investment, and a stagnant or even falling stock price. This practice is indefensible. Recruiting Directors Most companies also have a nominating committee to identify and evaluate candidates for current or soon-to-be vacant positions on the board. At its best such a committee can act as an informal, internal head-hunting firm, listing three or four possibles for each vacant seat and letting the board make its choice. It may even make its own determination and submit the candidates name for ratification by the full board. As Lorsch points out, however, it is in the nature of the selection process that the nominating committee normally will not enjoy the same level of autonomy as the audit or compensation committees because director selection historically has been a prerogative of the CEO. In Lorschs 1988 survey, 55% of the directors reported that the CEO was the major source of new ideas for new candidates, while only one-third considered the nominating committee the most important source. Moreover, Lorsch notes, 42% of the directors reported that the CEOs candidates rarely were rejected by the nominating committee. Although nominating committees are becoming more common, with 84 percent of directors interviewed saying their boards had such a committee, Lorsch concludes that, Nevertheless, in many companies, these committees still have limited influence compared to that of the CEO. He even reports that many CEOs still are heard using the expression my board, or my directors.49

Regular Board Meetings Regular board meetings (as opposed to emergency board meetings called to deal with a crisis) are a paradox: Theyre all alike, yet each one is different. Regular meetings are all alike because to be legitimate they must follow the routine laid down in Roberts Rules of Order. Each session begins with a formal call to order by the chairperson, approval of the minutes of the previous meeting (usually without a reading), and a succession of business items requiring a vote by the board. A vote to adjourn brings the meeting to an end. What makes each board meeting different is the precise nature of the business to be voted on. These items might include approval of a proposal for the company to increase its indebtedness; declaration of a cash or stock dividend; a decision to split the stock or convert one class of stock into another; a decision to proceed with a major investment in new plant or technology; or approval of some major change in the companys holdings, such as acquisition of another company or divestiture or spin-off of a major division or subsidiary. There could be a vote to approve the appointment of a new director or to accept the resignation of an incumbent one. Based on the recommendation of the compensation committee, the board might vote to approve a salary increase, a bonus, or a stock option for the CEO and his senior executives. Almost invariably, the formal business handled by a board at one of its regular meetings will amount to a ratification of actions already decided upon by the CEO and the top managers. This does not necessarily mean that the CEO owns the board, or is acting in an imperial fashion, or that the directors are nothing but ink pads for the chairpersons rubber stamp. It simply reflects the reality discussed earlier: Proper corporate functioning requires management to take the initiative in all matters and the board to stick to the job of reviewing management performance. Unless the directors have become seriously apprehensive about the way the company is being managed, they are not likely to confront the CEO during a regular board meeting with initiatives of their own. They may subject the CEO to some serious but civil questioning about plans and programs before they vote, but when the Q&A period comes to an end, a unanimous ratification of managements proposals is the norm.

Not everything that happens at a typical regular board meeting comes under the formal heading of business (i.e., matters requiring a vote). Much of what happens is simply informational. After formally calling the meeting to order, the chairperson normally will make some opening remarks. This is not called for by Roberts Rules of Order or the bylaws; it is simply a courtesy to help the directors reorient themselves to a company with which they have had little contact since the previous meeting. After the minutes of the previous meeting are read and approved, another informational presentationthe chairpersons report or management reportis delivered. The chairperson, who in most U.S. companies is also the CEO, will update the directors on the progress of the companys programs, alert them to any unforeseen problems that have arisen, and discuss managements plans and expectations for the futurethe next quarter, perhaps the next year. At many corporations, one meeting each year is set aside for briefing the board on the companys three-year strategic plan. Like most reports delivered at todays board meetings, the management report is likely to be accompanied by slides, particularly when graphs and charts are required to clarify complex numerical material. Lorsch says:
Directors consider the Report of the CEO the most important event of a normal meeting. Its also the most timeconsuming, with the CEO informing the directors about what is going on at the company and describing his plans for the future. This report often includes assessments of the firms financial performance, results of various divisions, changes in management, and an update of events since the previous meeting. Specific management proposals are next in importance and are given ample discussion time. Top managers, who report to the CEO, generally present the proposals, then its the directors turn to ask questions and offer suggestions.50

One presentation that is never skipped, however, is the financial report, usually delivered by the chief financial officer. This is the basic information that enables the directors to learn how well the company has performed its core mission of increasing shareholder value. Some chairpersons/ CEOs see the financial report as so fundamental that they treat it as a de facto CEOs report, with the CEO simply delegating the reporting function to the CFO. There is nothing wrong with this. Since a corporation is basically a machine for generating wealth, financial performance and corporate performance are essentially the same thing.
Reviewing past financial results is the third most important and time-consuming activity, giving directors an opportunity to scrutinize the companys overall performance, as well as its various businesses. This report generally includes budget forecasts, which enable directors to consider probable future financial results. On many boards, the presentation, distinct from the CEOs report, is given by the chief financial officer and the controller and contains more financial detail than the CEOs overview.51

Depending on the chairpersons agenda, an additional management report might be made by operations, marketing, strategic planning, engineering, legal, or almost any other management department headed by a senior vice president, or by the president of a subsidiary. Normally, time will permit only one such report in any given meeting. Each committee chairperson will make a report, and a report from the general counsel is virtually obligatory if the company is involved in any major litigation.

A characteristic typical of the CFOs report is that if the company is doing well, the report will be short, while if the company is doing poorly, the report will be longer due to managements greater need to explain poor results (i.e., attribute them to factors outside of managements control). This is the part of the board meeting where directors must be particularly alert for signs of trouble, as well as for signs that management might be concealing something unpleasant. Following the informational reports, the CEO may introduce a report on something management is planning or asking authorization to do, such as investing money in a large new capital project. The presentation typically will include slides showing what the new facility or equipment will look like, and some of the slides will use graphics and tables to display the CFOs projection of the anticipated payback from the investment. The presentation will be followed by a Q&A during which one or more directors will ask how the payback schedule was determined. This is where it pays to have a director or two with a core competency in finance and engineering. As a rule, the board will authorize the expenditure unanimously after discussion.

When the CEO Has to Go: How the Board Arrives at a Consensus The development of a board consensus that the CEOs performance is faltering is not the kind of formal, Roberts Rules of Order business likely to be placed on the agenda for discussion and a vote at a regular board meeting. The CEO, who in 80 percent of U.S. corporations is also board chairperson, sets the meeting agenda. He is not likely to arrange for his own execution. Nor is it likely that a director who has lost confidence in the CEO will bring up such concerns under New Business. To do so without some sort of preliminary discussion with the other directors would violate the unspoken no-surprises rule of boardroom etiquette and would sabotage the collegial atmosphere essential to the conduct of effective board meetings. For these reasons, much of the work the board performs in evaluating the CEO is virtually forced into the informal arena of casual private conversations outside the boardroom. First one outside director, then another, begins to worry about the companys performance under the incumbent CEO. Concerned Director A invites Potentially Concerned Director B to a friendly game of golf or a business lunch and, at first guardedly, then with greater concern and candor, begins to air his doubts about the CEOs performance. If Director B agrees with Director As suspicion that there is a problem, and if both view the problem with roughly the same sense of urgency, each of the directors will arrange to reach out to one or more other outside directors they believe might share their concerns. Again, the process remains informal and off-the-record, with the consensus gradually building in a series of private one-on-one conversations. At this point events can diverge in either of two directions: If the concerned directors meet resistance from directors who continue to believe the CEOs performance is adequate, and if the pro-CEO faction appears larger and more determined than the anti-CEO faction, the latter will most likely dropor at least relaxtheir campaign. Often the ringleader will quietly resign, her effectiveness as a director having been chilled by her aborted attempt at an anti-CEO initiative. In the other alternative, the anti-CEO faction succeeds in convincing a majority of the outside directors that the CEO has been underperforming, that improvement is not likely, and that protection and
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enhancement of the shareholders investment requires that the CEO be ousted by the board and replaced by someone with greater potential. Even at this dramatic juncture, however, nothing occurs in a formal board meeting. The fateful decision is made entirely in the informal arena as one outside director after another falls in with the insurgents calling for the CEOs ouster. Is the process somewhat conspiratorial? Yes, but not necessarily sinister, especially if the directors see themselves as the law sees them: duty-bound to protect billions of dollars worth of endangered shareholder equity that the disenfranchised owners of the company cannot protect by their own efforts. How is the actual termination performed? Softly. One of the outside directors will be designated to invite the CEO to a quiet, private meeting at an off-site location. After a few moments of chit-chat, the director selected to deliver the bad news will say something like, You know, several members of the board have become concerned about the direction the companys been taking lately. Weve come to the conclusion that maybe it would be a good thing for all concerned if you were to step asidemaybe take early retirement so we can bring in somebody with some fresh ideas. Usually the CEO will get it. He will submit a letter of resignation, which the board will accept unanimously, often in a conference-call phone meeting. If the CEO goes into denial, however, the bearer of bad tidings usually can bring him back to reality by explaining that the outside directors already have been polled and that the CEO has lost the support of the majority of the board. The corporate news release announcing the resignation will be kind. It will say something very much like this:
The board of directors of Intercontinental-Universal Incorporated announced today that it has accepted the resignation of Chairman and Chief Executive Officer J.T. Smith, effective Sept. 1. In a statement to the board, Ms. Smith, who has held the post for three years, said, I have contemplated this change for some time because of the need to spend more time with my family. I feel I have essentially completed the work I set out to do and can now safely entrust the next phase of the companys growth to fresh, new leadership.

comment, few veteran readers will be fooled by the careful language. They will understand that the boardpossibly under pressure from unhappy investorsgave up on the CEO and asked her to step down. The little charade has its uses. A messy boardroom battle has been avoided. The departing CEO is portrayed as leaving at her own initiative, with most of her dignity intact. The board is portrayed merely as having rubber-stamped her decision. The hunt for a successorprobably under way informally for several weekscan now be conducted openly. Corporate life goes on. Tough Job of Reviewing CEO Performance What is important in such situations, however, is not so much the mechanism the directors use to remove the CEO as the process by which they arrive at a consensus that he has failed and that they must summon the collective will to remove him. Deciding to discharge the CEO is the single most difficult and sensitive job a director ever will face. Some of the most useful thinking on the problem of CEO evaluation and removal by the board came during the late 1960s, when Harvard Business School Professor Myles L. Mace was collecting material for his 200-page 1971 monograph titled Directors: Myth and Reality. Using data from hundreds of interviews, Mace found that at least some boards removed their CEOs for underperformance during the largely prosperous 1960s, but many others that needed to do so were reluctant to face their responsibilities. Maces valuableand still very applicableconclusion is reproduced here in full (please note that Maces 40-year-old language uses president instead of todays chief executive officer).
It was found that boards of directors of most companies do not do an effective job in evaluating, appraising, and measuring the company president until the financial and other results are so dismal that some remedial action is forced upon the board. Any board has a difficult job in measuring the performance of a president. Criteria are rarely defined for his evaluation. The presidents instinct is to attribute poor results to factors over which he has no control. The inclination of friendly directors is to go along with these apparently plausible explanations. Control of the data made available to the board which provides a basis for evaluation of the president is in the presidents

own hands, and board members rarely have sufficient interest and time to really understand the critical elements in the operations of the company. Only when the companys results deteriorate almost to a fatal point does the board step in and face the unpleasant task of asking the president to resign.52

The 30 CEOs and directors who contributed to this section on corporate governance agree thoroughly with Mace on this point. Everyone who has served on a corporate board knows that the most difficult part of the job is not the actual removal of an underperforming CEO, which is only the final act in the boardroom drama, but the painful preliminary process of facing the CEOs performance problem and admitting it will be ended only with his resignation and replacement. Six Painful Obstacles to Facing CEO Underperformance There are six reasons that this process takes so long, involves so much agony, and is so frequently avoided: Personal loyalty of directors to the CEO. Disinclination to believe bad news. Disinclination to undertake something unfamiliar and possibly dangerous. Difficulty detecting gradual deterioration in conditions. Difficulty getting accurate information about the business. Unwillingness to disrupt boardroom cordiality and fellowship. All of the reasons support one another, creating a fierce wall of resistance to taking action.

Personal Loyalty to the CEO

Directors feel loyal to their CEO, and with good reason. They usually owe their prestigious positions to her. She probably reached out to them personally and invited them to join her board. Most of the directors are current or former CEOs themselves. They know what the CEO is going through and sympathize with her situation. Nor is it simply a matter of the CEO having reached out and brought the directors onto her board. The reverse may be just as true: The directors may have sought out the new CEO and unanimously elected her to head the company. If she turns out to be wrong for the company, that means the directors must have been wrong to name her its chief executive.

Even if the business pages reprint the news release without further coverage or
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While directors owe a legal duty of loyalty to the shareholders rather than to the CEO, the problem is that the shareholders are largely an abstraction, while the CEO is a living, breathing human being with whom the directors have shared values, duties, and responsibilities. Little wonder, then, that the tug of loyalty to one familiar CEO is stronger than the gravitational field exerted by hundreds of thousands of faceless, distant owners.

Disinclination to Believe Bad News

None of us likes to hear bad news, especially when the news carries strong implications that we must respond with some kind of disagreeable action. Psychologists tell us that it is virtually instinctive for people receiving bad news to react initially by exclaiming, Oh, no!as if the utterance could somehow command the facts to reverse themselves. Denial is a natural human reaction, and business executives, including corporate directors, are human. They do not like dealing with bad news any better than the rest of us. This natural tendency only enhances the difficulty of dealing with poor CEO performance.

nearly imperceptible drift in corporate performance, especially when it is unclear whether the reasons are external (negative industrywide trends) or internal (poor leadership from the CEO). Detecting the change is particularly difficult if the gradual deterioration follows a prolonged period of strong performance. In this situation, directors may be so lulled into taking performance for granted that they lose the capacity to detect a deviation. When evidence of deterioration does surface, it becomes easy to rationalize each successive event as insignificant and unique rather than as part of a developing pattern. If the CEO is glib in explaining away underperformance, or if the company is well known and prestigious, as IBM and General Motors were during their prolonged slippage through the 1980s, the directors may dwell in a dream world for years without facing the fact that even a legendary flagship of industry can drift off course and become stranded on a shoal.

scenes from classical antiquity decorate the walls. The atmosphere straddles the border between businesslike and clublike, between prudent sobriety and cordial comfort:
Like nearly everything else at PepsiCo, Inc., the rooms stately power and elegance made you stand a little straighter. A large abstract painting by Jackson Pollocks widow, Lee Krasner, dominated the far wall. Custom-designed carpeting in earth-toned colors cushioned the floor. The bronze-plated ceiling, perhaps more appropriate for a church, reflected burnished mahogany-paneled walls. High-backed beige leather chairs, so imposing they could have carried corporate titles of their own, surrounded the boardroom table.53

Difficulty Getting Accurate Information about the Business

In business as in life, decisions are supposed to be based on information, not guesswork. But for a corporate board, sound information on corporate performance is not as easy to come by as many people might think. The CEO controls the information the board gets, and he releases and discusses it only intermittentlyat the regular board meetings. Outside directors are by definition veterans of other businesses and industries, not the one they monitor as board members. Indices of corporate dysfunction do not always mean the same thing from one industry to another or one business to another. It is hard to know how much time to allow management to come to grips with a situation.

Disinclination to Undertake Something Unfamiliar and Possibly Dangerous

Calling for the resignation of a CEO is a venture into unknown territory for most boards. It is done so seldom that no one ever acquires a skill in itor a taste for it. Hence, even the most experienced board feels a little shaky approaching this particular moment of truth. There is no self-help manual on how and when to remove a CEO; each CEO is different, and so is each companys situation. There is no telephone hot line or late-night radio call-in show to dispense advice. A bungled attempt to oust the CEO can embarrass the board and damage the personal reputations of the directors, possibly barring them from service on other boards in the future. With so little outside support to rely on and so much at stake, prudence and caution can easily slide into timidity.

Unwillingness to Disrupt Boardroom Cordiality and Fellowship

The mystique of the corporate boardroom exerts a powerful effect on the directors who conduct their meetings there. The usual setting created by the decorators is one of tasteful, understated elegancenot glitter, but a great deal of wood paneling, leather cushions, and earth-toned fabrics set off by just enough brass or steel trim to create some contrast. More often than not, English sporting prints or lithographs of

The boardroom, in other words, is an excellent place in which to deliberate, ponder, and vote, but a poor place in which to have a confrontation. In the tacit understandings which make up corporate etiquette, arguing, disputing, disagreeing, and confronting are associated with management, not governance. The directors, most of whom have had their share of arguing and confrontation as members of management, expect the boardroom to be something of a refuge above the fray. Hence the disagreeable duty of firing the CEO is brought up in a less sensitive setting off-site. It simply does not fit in the boardroom. Nevertheless, the mystique of the boardroom continues to exert its comforting effect even when the directors are not physically present there, making it difficult for them to contemplateeven in the safety of their own homesthe disagreeable job of firing the person who brought them together in those comfortable and dignified surroundings. Whatever the CEOs failings, and whatever their effects, the hours spent in the boardroom are valued ones to most directors. Even when discussing difficult matters, most boards maintain a cordiality and collegiality rarely experienced by people who have not faced great challenges and dangerous moments together. To consider discharging the leader of the boardroom tends to violate that spirit and to rupture valued bonds of good fellowship and mutual self-esteem. CONCLUSION Boards That Faced the Heat and Replaced the CEO The failure of corporate boards to replace underperforming CEOs became a major
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Difficulty Detecting Gradual Deterioration in Conditions

Although boards tend to respond well to a sudden crisis, such as the unexpected death of the CEO, they are notoriously slow to take action as the result of a gradual slip or a

topic in the business news media during the late 1980s and early 1990s. When the rate of growth of a corporations stock persistently lags the Standard & Poors 500 index, or when the share price actually sinks over a prolonged period while the same top management remains in place, the media run extensive investigative pieces and exposs that conclude with the inevitable question, Why isnt the board doing something? In the cases of General Motors and IBM, not just news stories but entire books were written and published before the respective boards finally removed the CEO. Billions of dollars in shareholder value eroded as directors vacillated. Nevertheless, the prominence of such episodes should not be allowed to obscure the more positive side of the story: Almost every day, virtually unnoticed, other corporate boards do their duty and replace the chief executive officer without a prolonged bout of boardroom denial or endless months of negative media coverage. Here are three typical examples: Dial Corporation, 1996; Centennial Technologies, Inc., 1997; and Abbott Laboratories, 19891990. Case 1: Dial Corporation, 1996 On Monday, July 15, 1996, the board of directors of The Dial Corporation held a special meeting in Chicago. Late the next day Dials corporate headquarters in Phoenix issued a news release under the headline: John W. Teets, Chairman and CEO of The Dial Corp., says he plans to retire early next year.54 Members of the Phoenix business community were stunned. Teets, 62, had been serving as chairman/CEO of Dial for 15 years and had been a Sunbelt star well before that. His contract at Dial was not due to expire until Jan. 1, 1999. Now he had announced he would leave two years early. Did he jump, or was he pushed? A week later the storyor at least a good deal of itemerged in the Arizona Republic. Although Teets had led Dial through more than two decades of growth since forming the company in the 1970s out of the old intercity bus and meatpacking conglomerate known as Greyhound Corp., Dials more recent financial results had begun to slip as the company placed excessive emphasis on short-term cost cutting. Sales and profits fell sharply last year after years of consecutive, double-digit increases, demanded by bottom-line baron
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Teets, the newspaper reported. Much of the trouble was blamed on a standard inventory-reduction program, but the problems went much deeper, employees and industry analysts say. Years of shortterm focus hurt Dials key brands, and the company was losing market share in such key brands as Dial soap, they say.55 An executive who had left the company the year before told Republic reporters Dawn Gilbertson and Charles Kelly that Teetss intense focus on short-term cost cutting had come at the expense of long-range market development and brand management. Once the most serious excess costs had been identified and trimmed, the company appeared to have no more tricks in its kit with which to build market share and brand loyalty. There was almost more of a focus on how to please management than how to please the consumer, the ex-manager said.56 Disgruntled consumer-product marketing professionals began to flee, with some departments experiencing turnover as high as 50%. An employee newsletter in the fall of 1995 admitted that costs associated with employee turnover and relocations have cut into profits, and were having problems with inventories, customer-service levels, brand equity and lower-than-expected sales of some of our core brands.57 As if the numbers alone were not bad enough, one of the disgruntled former employees had circulated an anonymous letter implicating Teets in more than poor management. The letter said that Dials former VP-Human Resources Joan Potter Ingalls, 46, who had taken early retirement in the summer of 1996 amid rumors of scandal, had had a sexual relationship with Teets and had received a multimillion-dollar settlement paid by the company. The letter-writer also complained that Dials financial reverses, which included closure of six factories and severing of 700 workers, had not led Teets to crimp his luxurious lifestyle. The company still was paying $10$12 million per year to keep two Gulfstream IV corporate jets, still held partial ownership in professional sports teams and resort properties, and still kept corporate apartments in Manhattan and other locations that Teets and his wife had used for personal rather than business purposes. Allegations of scandal alone rarely torpedo a corporate chieftain, nor do charges of lavish lifestylesas long as the shareholders are making money. But after beating the

market for the previous five years, Dials shareholder value had stalled, stealing the luster from Teetss style. When things are going good, no one cares about those things, an anonymous Dial executive told the Republic. But when austerity came, people started asking, Why do we own the Phoenix Suns? Why do we need to own the building? Why do we need two jets?58 The unidentified executive was not the only one who asked those questions. So did Wall Street money manager Michael Price, whose Heine Securities held nearly 10 percent of Dials stock in its Mutual Series family of mutual funds. In the June 24, 1996, edition of Barrons, Price charged that a plan by Teets to spin off part of Dial would saddle the shareholders with excessive debt. He even said the name of the new entity, Viad, was Greek for screwing the shareholders.59 When business resumed after the 1996 Fourth of July weekend, Price asked the Securities and Exchange Commission to delay the spinoff and urged Dial to unload its airplanes, corporate apartments, and office building. Both in his public pronouncements and behind the scenes, Price also urged Dials board to act. The results were not long in coming. Only a week elapsed between Prices SEC filing and the special Dial board meeting in Chicago that brought an end to Teetss reign. Something happened, an anonymous observer told the Republic. Did those guys (Price and company) say, Were going to continue the pressure on this end? Did the board itself finally say, Enough is enough? Did John finally say, I fought this thing too long? I dont know. It was probably some combination of all of the above.60 Best of all, it did not take long. Dials shareholders, unlike those at GM and Kmart, did not have to wait years for board action. The board moved less than a year after viewing the first poor financial results and less than a week after the first public complaints by a major shareholder. In the corporate world, that is speed. Case 2: Centennial Technologies Inc., 1997 The February 12, 1997, edition of The Wall Street Journal carried a news story by reporter Jon G. Auerbach detailing the unexpected firing of a CEO:
Centennial Technologies Inc. fired its chairman and chief executive officer, removed its chief financial officer, and

announced it had launched an inquiry into the accuracy of its most recently reported earnings and prior financial statements. The surprise news from the maker of computer memory cardsa company recently touted by widely read investment newsletterscomes after days of swirling rumors about the 1996 stock-market high-flier, whose share price has dropped about 70% since the start of this year.61

A steep and sudden drop in the price of a companys stock is the biggest danger investors face. Such reverses seldom are recouped; the sheer size of the sell-off means investors have suddenly realized that their earlier perception of value in the corporation was misplaced. Such misperceptions can represent an honest mistake, particularly in the high-tech industry, where scientists and engineers sometimes generate breakthroughs faster than businesspersons can figure out how to commercialize them and yesterdays hot new technology turns out to be todays has-been. But sometimes the mistake is not an honest one. Sometimes investor expectations rise because a corporate management has misstatedperhaps deliberatelythe companys near-term potential. Something like this apparently happened at Centennial, because the Journal did not extend Centennials departed CEO its customary courtesy of saying he had resigned, and neither had the board. According to Auerbach:
Centennial said it fired Emanuel Pinez, its 58-year-old chairman and chief executive, and relieved its chief financial officer, James M. Murphy, 45, of his duties. . . . Centennial said the board had met and agreed early yesterday to remove Mr. Pinez after an internal investigation revealed certain preliminary information that led it to question the companys reported earnings for the fiscal second quarter ended Dec. 31. [Treasurer and Corporate Counsel Donald Peck] said Centennial had contacted the Securities and Exchange Commission and was actively working to get a full understanding of what happened.62

Under the laws of corporate governance, corporations must comply with the law, and the board of directors is responsible for reviewing managements conduct and determining whether it has been lawful. If the board finds that management has broken the law, its powers are the same as when it finds management has broken its obligation to the shareholders: The board replaces the chief executive officer.

Among the laws that corporations must obey are SEC rules that prohibit corporations from issuing misleading claims about their future profit growth in order to hype the price of their stock. Auerbachs article noted that on the same day Mr. Pinez was fired, a shareholder lawsuit in Massachusetts alleged that Centennial and certain of its officers made false statements that caused the stock to be artificially inflated.63 The Wall Street Journal article said further that several investor newsletters had been told that Centennial was anticipating a $10 million order from AT&T Corp. for its Nomad telecommunications gear and a $60 million license fee for a satellite-linked truck communications system. The same assurances had been made to at least one individual investor, according to the Journal, while a portfolio manager for a Californiabased investment fund said he had acquired Centennial stock in May 1996 after the company told him it expected that a contract with AT&T would bring about $100 million in added revenue in 1997 and 1998. AT&T said it had no contract with Centennial and declined to say whether it was negotiating with the company. A graph appearing with the Journal article showed that Centennials stock price more than quadrupled during calendar 1996, beginning the year at around $10 and peaking at $58.25 in early January. Then, in a little over a month, it plunged nearly all the way back to its starting point, finishing at $16.50 the day the board fired Mr. Pinez and notified the SEC of its actions. Trading in the companys shares was halted. Considering that only a month passed between the first retreat in Centennials share price and the firing of the CEO, the boards action would seem to have been extraordinarily swift. For those who held the stock, however, the boards pace was tortoiselike. Centennials board was faced with a much bigger problem than a gradual slump in earnings. What it really faced was the sudden discovery that the company had experienced almost no earnings at all. Case 3: Abbott Laboratories, 19891990 Most corporations that replace a chief executive officer do so because financial performance has lagged. Profitability is flat or dropping, causing investors to walk the Wall Street walk by dumping the compa-

nys stock. Facing their fiduciary duty, the directors seek new leadership for the company. But sometimes a board of directors replaces a CEO while growth is impressive and the companys affairs appearto outsiders at leastto be going forward in a normal fashion. This is what happened in December 1989 when the directors of one of the worlds largest and most successful manufacturers of pharmaceuticals, Abbott Laboratories, of North Chicago, Illinois, removed chairman/CEO Robert Schoellhorn from his position as chief executive officer and elected Chief Financial Officer Duane L. Burnham to replace him on January 1, 1990. Schoellhorn, who was 61 and not scheduled to retire until he reached 65, retained his post as chairman. But on March 9 the other shoe dropped. The board took Schoellhorns chairmanship position away and awarded it as well to Burnham. Schoellhorn had been CEO of Abbott since 1979 and chairman since 1981, a period during which, according to the Chicago Tribune, the company has exhibited a consistently dazzling financial performance.64 Why, then, did the board remove him? Under the rules of corporate governance, directors are accountable to shareholders not simply for current performance but also for the long-term viability of the corporation as a wealth-generating mechanism. Although many shareholders invest for the short term, making their money in quick trades, the vast majority, including those whose shares are held by pension funds, expect to stay invested for consistent growth over the long term. Directors are expected to look after the interests of these investors by making sure the company is managed for steady longterm growth. Media accounts at the time of Schoellhorns ouster suggest that Abbotts directors, while acknowledging Schoellhorns past performance, were nervous that his leadership skills may have been faltering to a degree that endangered the companys future. They were particularly concerned about Schoellhorns attitude toward succession. As you learned in Chapter 1, a distinguishing mark of true leaders is an ongoing concern with identifying and developing future leaders. During his most recent years in office, however, Schoellhorn appeared to be doing just the opposite. Three times in a row, a second-in-command had left the company after a series of
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disagreements with the CEO. Two of these departed stars went on to join biotechnology companies that competed with Abbott. The Abbott board rightly wondered whether Schoellhorn, rather than seeking and welcoming fresh talent, was systematically driving it out of the company and into the more congenial arms of competitors. Wall Street Journal reporter James P. Miller acknowledged that Schoellhorn had delivered outstanding profits to the companys shareholders. Mr. Schoellhorn, however, developed a reputation as an authoritarian manager who could not bear the appearance of a possible contender for the job, he wrote.65 In March 1990, Schoellhorn sued the outside directors who made up the succession committee on the Abbott board, charging they had violated the by-laws in stripping him of his job. The lawsuit may have been an ill-advised move, however, because when Abbotts lawyers went to court in April to try to have the suit dismissed, they introduced additional material that might have stayed confidential had Schoellhorn chosen to leave quietly. Wrote Miller:
Earlier in the week, Abbott alleged for the first time that Mr. Schoellhorn violated his fiduciary obligations and repeatedly defrauded the company during his lengthy tenure. . . . Last week, Abbott said in court documents it had discovered, through an investigation which began a month ago, that during much of the past decade Schoellhorn has repeatedly misappropriated Abbott corporate assets for his personal use and committed fraudulent acts. The documents contain, among other things, allegations that Mr. Schoellhorn had on a number of occasions used the companys corporate aircraft for purely personal purposes and then ordered subordinates to make false entries to conceal the wrongdoing. It also claims he submitted false expense reports and was reimbursed by the company.66

One of the other things mentioned in the document was a charge that a gift presented to Abbott by a Japanese company and intended for the company had been appropriated by Schoellhorn as his personal property and was on display in his home. Perhaps more interesting than the charges against Schoellhorn was his response. According to Wall Street Journal reporter Jeff Bailey, Schoellhorn tried to shift the blame for his actions to his succes258 Part 3: Expanding the Business

sor, Duane Burnham, claiming that as the companys chief financial officer during the period named in the documents, Burnham should have made sure the companys assets were not misused. It was Mr. Burnhams job to question and rectify anything he thought was improper regarding use of company aircraft or other assets by company executives, Schoellhorn said.67 Here too it is useful to refer to Chapter 1, where Louis Lundberg reminds us that a real leader takes responsibility not only for his own actions but also for those of his subordinates. Lundbergs remarks suggest the Abbott board made the right decision. In the fall of 1990 the court ruled that the Abbott board had acted legally in removing Schoellhorn as chairman and CEO. However, it also ordered the board to award Schoellhorn $5.5 million in stock to which he was entitled by virtue of the companys financial results under his leadership. The companys profits in the six years following Schoellhorns ouster also suggest the board had made the right decision. No one is indispensable. Despite the loss of its star CEO, Abbott continued to be a star investment as it brought out a series of successful new drugs to treat acute and chronic illnesses: $100 invested in Abbott stock at the start of 1991 would have been worth about $170 at the close of 1996. Robert Schoellhorn had left Abbott a $6.2 billion company. Six years later under Duane Burnham it was an $11 billion company. Earnings per share in the last year of Schoellhorns leadership were 96 cents. Under his successor they reached $2.41. Abbott, moreover, had managed to achieve those results while remaining independent. Its competitors in the pharmaceutical industry had been able to survive only by merging into giant global companies. The Abbott boards decision to replace Schoellhorn with Burnham may have come just in the nick of time. This chapter has examined a number of key issues involved in the topic of corporate governance and the distribution of power and accountability within the modern corporation. The modern-day disenfranchisement of shareholders, coupled with the enormous power of todays CEOs, places the responsibility for enforcing managers accountability to shareholders squarely on the board of directors. Yet contrary to popular myth, the boardroom is not the seat of great power, which actually belongs to management. The directors, as

we have seen, are without power most of the time. The one occasion when they are supremely powerful is when they choose to replace the chief executive officer. If they do not enter upon their directorships prepared to take that step, they do not belong on a corporate board in the first place.

Chapter 11End Notes

1. R.C. Longworth, Corporate Giants Dwarf Many Nations, Chicago Tribune, October 11, 1996, pp. 1, 28. 2. Arthur Fleischer, Jr., Geoffrey C. Hazard, Jr., and Miriam Z. Klipper, Board Games: The Changing Shape of Corporate Power (Boston, MA: Little, Brown & Co., 1988): 3. 3. J.M. Juran and J. Keith Louden, The Corporate Director (New York: American Management Association, 1966): 337. 4. Robert A.G. Monks and Nell Minow, Corporate Governance (Cambridge, MA: Blackwell Business, 1995): 180. 5. William T. Allen, address to the Samuel and Ronnie Heyman Centre of Corporate Governance, Benjamin N. Cardozo School of Law, Yeshiva University, April 13, 1992. 6. Joseph K. Angell and Samuel Ames, A Treatise on the Law of Private Corporations, 6th ed. (Boston: Little, Brown and Co., 1858). 7. Delaware General Corporation Law Annotated Franchise Tax Law Uniform Limited Partnership Act, amended as of February 2, 1988. 8. Fleischer et al., Board Games, 11. 9. Robert Sobel, ITT: The Management of Opportunity (New York: Truman Talley Books, 1982): 302335. 10. Fleischer et al., Board Games, 12. 11. Ibid., 5. 12. Joseph A. Grundfest, Just Vote No: A Minimalist Strategy for Dealing with Barbarians inside the Gates, Stanford Law Review (April 1993): 952 n. 13. Lee Iacocca, with William Novak, Iacocca (New York: Bantam Books, 1984): 155. 14. Edward J. Epstein, Who Owns the Corporation? A Twentieth Century Fund Paper (New York: Priority Press, 1986): 13. 15. Grundfest, Just Vote No, 866. 16. Telephone conversation, September 22, 1995. 17. Doron P. Levin, Groping Giant: In a HighTech Drive, GM Falls Below Rivals in Auto Profit Margins, The Wall Street Journal, July 1986, p. A1. 18. Christopher Byron, House of Cards, New York, February 15, 1993. 19. The American Bar Association on Corporate Laws, Other Constituency Statutes: Potential for Confusion, The Business Lawyer (August 4, 1990): 26. 20. Robert Kirk Mueller, Behind the Boardroom Door (New York: Crown Publishers, Inc., 1984): 76. 21. Monks and Minow, Governance, 179180. 22. Ibid., 182. 23. Ibid., 6465. 24. Fleischer et al., Board Games, 33. 25. Ibid., 34. 26. Joy v. North., 692 F.2d 880, 886 (1982). 27. Monks and Minow, Governance, 86. 28. SpencerStuart Board Index, 1993. 29. National Association of Corporate Directors, NACD 1992 Corporate Governance Survey (Washington, DC: NACD, 1992): 1. 30. John E. Balkcom, The New Board: Redrawing the Lines, Directors & Boards (Spring 1994): 27. 31. Monks and Minow, Governance, 181. 32. Ibid., 203204. 33. Juran and Louden, Corporate Director, 169. 34. Korn/Ferry International, Board of Directors Twentieth Annual Study, 1993, 5. 35. Kathleen Day, Frank Carlucci and the Corporate Whirl, The Washington Post, February 7, 1993, p. H1. 36. Juran and Louden, Corporate Director, 333. 37. Business Week, November 13, 1995, 78. 38. Harry J. Bruce, A Corporate Director Looks at Governance Reform, International Academy of Management, Panels on Corporate Governance (Harvard Business School, Boston, December 8, 1995). 39. David Young, Boring Board: A Call for Fresh Blood, Chicago Tribune, January 1996, Business section, 3. 40. Howard D. Sherman, Catch 22: The Retired CEO as Company Director, Institutional Shareholder Services, July 15, 1991. 41. Monks and Minow, Governance, 192. 42. Myles L. Mace, Directors: Myth and Reality, Harvard Classics ed. (Boston, MA: Harvard Business School Press, 1986): 4647. 43. Robert K. Mueller, Oxenstiernas Law: The Issues of Corporate Governance, International Academy of Management, Panel on Corporate Governance (Boston, MA: Harvard Business School, December 8, 1995): 5. 44. Juran and Louden, Corporate Director, 113114. 45. Graef S. Crystal, Do Directors Earn Their Keep? Fortune, May 6, 1991, 78. Chemical Bank spokesman John Steffens said the five additional meetings held by that banks board in 1990 may have been associated with plans for Chemicals merger with Manufacturers Hanover Bank, consummated the following year (telephone interview, June 26, 1996). 46. Juran and Louden, Corporate Director, 259. 47. Ibid., 273. 48. Fleischer et al., Board Games, 3031. 49. Jay W. Lorsch, with Elizabeth MacIver, Pawns or Potentates: the Reality of Americas Corporate Boards (Boston, MA: Harvard Business School Press, 1989): 20. 50. Ibid., 6162. 51. Ibid., 62. 52. Mace, Directors, 41. 53. John Sculley, with John A. Byrne, Odyssey (New York: Harper & Row, 1987): 1. 54. Dawn Gilbertson and Charles Kelly, Dial CEOs departure puzzling, Arizona Republic, July 21, 1996, p. A15. 55. Ibid., A15. 56. Ibid., A15. 57. Ibid., A15. 58. Ibid., A15. 59. Ibid., A15. 60. Ibid., A15. 61. Jon G. Auerbach, Centennial Technologies Fires Chairman, The Wall Street Journal, February 12, 1997, p. A4. 62. Ibid., A4. 63. Ibid., A4. 64. Steven Morris, Fired, Schoellhorn Sues Abbott, Chicago Tribune, March 10, 1990, Business section, 1. 65. James P. Miller, Abbott Ousts Schoellhorn as Chairman, Drawing Lawsuit by Embattled Official, The Wall Street Journal, March 12, 1990, B6. 66. James P. Miller, Abbott Labs Derides Lawsuit by Former Chairman, Seeks Dismissal, The Wall Street Journal, April 9, 1990, p. B2. 67. Jeff Bailey, Ousted Chairman of Abbott Accuses Company in Filing, The Wall Street Journal, June 6, 1990, p. A6.

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