An Open Letter to the Board of Directors

An Open Letter to the Board of Directors

Last week, I gave a keynote talk at the CRIM Crystal Ball Conference in Montreal, and the speech seemed to be really well received. I had decided ahead of time that the best way to talk about today’s problems was to have a frank conversation about how the world really worked – not how it was supposed to work, nor how we all thought it worked a few years ago, but how it really was working during the already-infamous Bush era.

 This was an era in which many systems were broken, and whole sectors were coming apart, driven by the failures of key players. The media have already blamed the regulators (or lack of regulations), greedy CEOs, off-balance sheet banking practices, unethical hedge fund operators, removal of the uptick rule, general short-selling in wolf packs, the repeal of the Glass-Steagall Act, program trading, physicists coming to Wall St., the ethical collapse of the rating agencies, the fall of Fed power, the global liquidity bubble, speculation-driven oil pricing, oil price manipulation by oil providers, and bad luck.

 There is a simpler way to describe what happened: intellectual honesty, and real honesty, went by the boards.

 The people involved in all these things generally knew they wouldn’t work for long, knew they were unethical, knew they were skirting the legal (or were illegal), and knew they were lying to themselves, their families, and their colleagues about the long-term effects of what they were doing.

 I had dinner last week in Washington, D.C., with a top lobbyist, who told me proudly that she had led the charge in repealing the Glass-Steagall Act. (This allowed banks to get involved with non-bank, high-risk activities.) I had heard that the bankers spent $1B to get rid of this iconic piece of learning from the Great Depression; she confirmed it. Ten years later she is 38, and she laughingly told me over hors d’oeuvres that she now recognizes it was a huge mistake, adding that she no longer represents the banks.

 Oops. I guess that’s how you destroy empires.

 Which leaves the obvious unfortunate impression: the banks themselves must have known what a mistake this would be.

 Yesterday, in a lunch discussion with serial entrepreneur Al Davis, we covered all this ground in about an hour, and then he said, “You know, this all comes down to the board of directors.” And that brings us to today’s subject.

 We can blame the regulators who really came from industry, we can blame the bankers and CEOs and their lobbyists, we can blame the politicians who pretended that no regulation was good regulation, we can blame co-presidents George Bush and Dick Cheney. But, with the exception of the last two, there is another layer of governance that should take most, if not all, of the responsibility: the board of directors.

 Too much is made of the symptoms of bad management, and much too little is made of those really responsible for the quality of this management.

 At different times, I’ve written open letters to specific boards, but today I wanted to write an open letter to all boards. If you are a corporate board member, please read this carefully; I’m betting that, after reading it, you’ll agree: you were probably not doing your job.

 Let me start by breaking the neck of the good-old-boy scheme: most board members are friends (or even relatives) of the CEO, or work for him or her. Those who are not – even the most independent “outside” directors – tend to be selected on a rank of the CEO’s ability to direct, manipulate, or intimidate them; OR because they are guaranteed not to look too closely at the company.

 This formation step is the first place where things go wrong.

 A good board of directors should number 9 to 11, and have the following composition:

 The Chairman, often  the past CEO, and certainly NOT the current CEO.

The CEO.

The CFO. This will surprise most readers.

At least half the directors should be “outside” directors.

There may be a rotating spot for one or more employees (the German model).

The General Counsel.

The CTO or CIO should also be considered, since most strategic decisions involve technology inputs that others may miss entirely.

 Outside directors should be just that; not just golf cronies or the targets of interlocking board favors. Rather, they should bring strengths from areas of current or planned company operations.

 In the old model of governance, it was generally agreed that the primary job of the board was to hire and fire the CEO: he/she was its primary, and often its only, point of contact with the company.

 There are some things we can now say about this Old Model:

1. It did little or nothing to prevent corporate fraud and misbehavior.

2. Despite words to the contrary, it did nothing to protect shareholders, and much to protect the CEO.

3. It delivered any pay scheme the CEO wanted, via the Exec or Compensation Committee.

4. It did not prevent the current collapse of today’s many broken systems and companies, but rather encouraged this tragedy; i.e., it didn’t work.

 Let me give a few examples of what I mean by “it didn’t work.”

 AIG wrote insurance in amounts far greater than its total book value, or the value of all its reserves, creating liabilities infinitely beyond its ability to pay. Today, the now-defrocked longtime CEO Hank Greenberg continues to “protest too much” on TV: that he is the good guy, the government got it all wrong, if only he were still in charge all would be fine, the government wrecked his company, and so on.

 How did Hank and his short-term successor, Milton Sullivan, get away with it all? It would appear, among other things, that they used the usual tricks: find famous, busy people who make you look good and have no time to dig deeply into company affairs; and make sure your board is too large, so that nothing ever really happens at board level. In AIG’s case, that number was 17, or about eight more than are really useful.

 Over-large boards are the first sign of an errant CEO.

 How, exactly, did the board let this most egregious set of affairs take place? Obviously, they could not rely solely on their CEO; he’s lost it. But THAT’S WHY THEY ARE THERE: to hire and fire the CEO. This whole board should be named, shamed, and pictured somewhere, so that no one ever hires them again for any but the most menial types of yard work. (We have saved you the trouble. See our “TakeOut Window” below.)

 What about the board of Lehman Brothers? Or Bear Stearns? Who exactly  authorized 30/1 leverage on contracts that no one could understand, in numbers beyond count? Some board members, from the Old Model, would say: Well, that’s a level of detail beyond what we were asked to look at.

 Of course! Because, like Bernie Madoff’s accountant, they wanted you to stand up and sign off on something that was illegal, unethical, or just plain stupid. We can blame the hedge jackal packs, unrestrained by the uptick rule or anyone at home in the SEC, but let’s put the real blame where it belongs: on the board that got the companies into these messes.

 In the New Model, a board member would take the initiative to get answers for him or herself. In the New Model, the CEO looks to the board for real guidance and assistance. In the New Model, the CFO has twin allegiances, to the CEO and to the board. In the New Model, we substitute the charismatic, closed dictator for the engaging, transparent leader.

 In this vein, I’d like to suggest a checklist of questions for new board members:

 1. Are you going to be a good director, or a bad director? Define this now, so you can read it later when you’re under pressure.

 2. What kind of ethical leadership will you bring to the board, and to the company?

 3. How will you know if the company is meeting its Mission, and how will you assist in this?

 4. Who do you answer to? Who else?

 5. Are you willing to be fired or replaced if the company appears headed in the wrong direction? If not, please resign now; you’ll be saving yourself big legal bills later.

 6. Do you accept responsibility for corporate impacts beyond those on shareholders? Impacts on employees? Impacts on customers? Impacts on the planet?

 7. Are you going to miss some meetings, sit quietly, and collect your checks, or will you ask tough questions, make all meetings, and delve into areas needing more explanation?

 8. Are you emotionally prepared to fire the CEO? If circumstances required it, would you be prepared tonight?

 Let me give you a couple of surprising examples of failed boards and failed CEOs, in my opinion.

 Let’s take the two most famous, hero-worshipped idols of the modern corporate age:

   Lou Gerstner, IBM

   Jack Welch, GE

 What if it turned out that Lou smoothed earnings throughout his time as CEO of IBM in order to look great to the Street and to max out his personal compensation plan by keeping stock prices up? What if this smoothing was done illegally or unethically, by ransacking the company’s pension program, violating mandates for funding his own employees’ futures, and taking the money instead to buffer earnings shortfalls?

If that were true, you’d probably say he should go to jail, rather than be a hero. AND you’d say that his board of directors should have known about this transgression all along, and stopped it! Right?

What if it turned out that Jack smoothed earnings throughout his time as CEO of GE in order to look great to the Street and to max out his personal compensation plan by keeping stock prices up? What if this smoothing was done illegally or unethically, by ransacking the company’s insurance reserves, violating government mandates for funding the risk taken by his own insurance firms, and taking the money instead to buffer earnings shortfalls?

If that were true, you’d probably say he should go to jail, rather than be a hero. AND you’d say that his board of directors should have known about this transgression all along, and stopped it! Right?

 This brings us to quarterly earnings reports. Some modern-day CEOs have claimed that the combination of quarterly reporting and Wall Street’s savage punishment of any company not beating pre-set expectations by at least a penny – well, it’s impossible for a CEO, under today’s stock-heavy compensation plan, to stay above the law.

 Remember when SNS broke the story on Microsoft smoothing its earnings, back while Billg was CEO? And then, a bit later, the company’s internal auditor apparently sued the company over this very issue, settled in court, got his payoff, and all the papers were sealed by the court forever?

 See, it really isn’t hard to find these things.

 So maybe the board of directors has another problem to solve: how to pay CEOs.

 Today, it’s all about the stock price: cash for stock prices, bonuses for same, stock grants and stock options for the same thing; often tens of millions in compensation, all keying off the stock price.

 I would like to suggest that all F500 boards, worldwide, instruct their Executive Compensation Committees to immediately restructure the CEO compensation package, in this way:

1. Reduce dependency on quarterly performance, and reward longer-term goals and timeframes.

2. Expand the parameters beyond stock price, to include customer satisfaction, employee engagement, and sustainability. Define these to your own satisfaction.

3. Offer bonuses for attracting and retaining especially important talent, one of the CEO’s most important tasks.

4. When appropriate, also offer incentives for “real” innovation, in everything from processes to products. At the top, make these grants large and rare. At the bottom, make them small and common.

 Great companies don’t fail because of one madman; they fail because of one too-timid board. And great civilizations don’t fail because of one company gone awry; they fail because core beliefs and values fall away, which we’ve seen in the U.S. recently.

 When Rome collapsed, it wasn’t because the city burned. It was because the dream that once was Rome, of a great and civilized empire, stopped burning in the heart of every Roman.

 This is the task of being a board member: to bring that fire to the enterprise, insist that it spread throughout, and make sure it survives through intellectual, and real, honesty.

 Keep in mind: the CEO needs you. If she doesn’t, either fire her or resign.

 Your comments are always welcome.