Giving Toothless Boards Some Bite
Most directors are stuck in a system that makes it tough for them to protect shareholder interests. The author offers two solutions.
The possibility of directors paying out of their own pockets for corporate misconduct occurring under their watch has been raised by three recent cases. On January, 18 Enron directors agreed to pay $168 million -- 10 of them spent $13 million of their own money -- to settle their portions of securities class-action suits. In February, a deal fell apart that would have had 10 former WorldCom directors settling shareholder lawsuits by paying a total of $54 million -- $18 million from their own pockets, representing 20% of their net worth. And Walt Disney (DIS) shareholders are suing the company's former directors -- demanding they repay a $140 million severance package awarded to Michael Ovitz, who spent an unsuccessful 14 months as the entertainment giant's president. If Disney shareholders win this suit, the outcome could give new momentum in the move toward director accountability.
NOT WORTH IT? The trend is making it less profitable to serve on corporate boards. It's no longer enough to show up at quarterly meetings, enjoy the CEO's hospitality, and collect checks and stock grants. Corporate directors are under more scrutiny arising from the Sarbanes-Oxley law's requirements for greater disclosure, prompting an increase in the risks -- and potential legal fees -- that directors face.
Many directors will conclude that the potential costs exceed the benefits. This could make it increasingly difficult to recruit directors with the skills needed to serve effectively -- further weakening an already imperfect corporate-governance system.
Why do corporations have directors in the first place? They exist to safeguard shareholders' interests. Since investors can't run the business themselves, they "hire" boards of experts who recruit an agent, the CEO, to run the business on their behalf.
To learn more, click here
MAJORITY SHARE BENEFITS. Over time, abuses have crept into the system, leading to "agency costs," such as $15,000 umbrella stands, $4.7 million Renoirs, or $2 million Sardinian birthday celebrations. The directors' job is to minimize these costs. In theory, directors are there to ensure that a company's managers increase the value of the business -- or, at the very least, protect its value from being reduced.
In practice, directors fall into two broad categories: Majority Share, who generally walk the talk, and Minority Share, who usually don't.
Majority Share directors control a majority of the equity of the outfits on whose boards they serve. Usually, directors who are general partners in private-equity firms are Majority Share directors. Such firms have done a better job of aligning the incentives of owners and managers to minimize agency costs. According to the National Venture Capital Assn., buyout firms generated annual average returns of 12.3% from 1982 to 2002 -- outpacing the 9.6% returns of the benchmark Standard & Poor's 500-stock index.
LIMITED CONTROL. The general partners of such firms are paid to find private companies whose cash flows can be increased through attentive management. These directors choose and pay the CEO with a mix of stock and cash, and monitor the efforts to increase the company's value. When it comes time to sell, these directors -- and their fellow shareholders -- usually profit because the price is keyed to the business' increased cash-generating potential.
Unfortunately, most boards are filled with Minority Share directors, who hold very small stakes in the companies on whose boards they serve. The CEO invites most Minority Share directors to the board -- providing them with an incentive to preserve that CEO's position. More importantly, most Minority Share directors with valuable business experience are too busy with their main jobs to contribute meaningfully to key business decisions. As a result, boards often fail to evaluate rigorously resource-allocation decisions.
Minority Share directors are caught in a system that makes it difficult for many of them to protect shareholder interests. Such directors generally owe the bulk of their net worth to sources other than their positions on corporate boards. They join boards for the prestige, the perks, and to a lesser extent, the pay. With insurance covering less of their potential costs, directors bear a larger personal responsibility for a company's failure to act in the shareholders' best interests, while exercising limited control over the outfit's conduct.
CEO AGENTS IN PRACTICE. Moreover, it's considered out of line for a Minority Share director to oppose a CEO in a board meeting. A Minority Share director usually lacks the information required to challenge the financial results as the CEO presents them. If the company is doing well and the financial results accurately reflect that, the CEO may be able to take most of the credit -- and the board very little. If the company is doing poorly but the CEO cooks the books, the board will be hard-pressed to discover the problem.
Simply put, in many cases, Minority Share directors are themselves an agency cost -- they add limited value when the company is performing well, and they're in a weak position to uncover and solve problems, particularly when the CEO hides them under the rug. Often, Minority Share directors are ineffective because they act as shareholder agents in theory but as CEO agents in practice.
There are no ideal solutions to this problem. The Majority Share director approach works well, but it can only be applied to a limited number of companies.
A REAL STAKE. This leaves two imperfect solutions. One alternative might be to replace the notion of "directors as shareholder agents" with "shareholders as directors who represent their own interests." Under this scheme, directors would be selected based on two criteria:
1. They are among the company's largest shareholders.
2. These big shareholders are investing a large percentage of their wealth (or their funds under management) in the company.
These directors would serve for a period of years, during which they would retain their stake in the company. An independent body would grade them on their ability to generate and execute ideas to increase cash flow. Due to their big shareholdings, they would have the clout and the incentive to dig deep and push hard to create value. And those with the best reputations would be sought out by investors and, ultimately, shareholding CEOs.
CHANGE IS OVERDUE. Another alternative might be to create a class of professional directors with business knowledge and experience to offer useful advice. Such professional directors would serve full-time on a small enough number of boards that they could invest the time to challenge in a meaningful way the corporation's actions.
Furthermore, they would be paid out of a shareholder insurance fund created by a pool of shareholders -- rather than by the corporation. Independent representatives of the investor pool would choose and grade these professional directors -- paying out incentives based on the long-term shareholder value created or destroyed by the companies on whose boards they served.
Recent events are making it clear to corporate directors that whichever solution ultimately emerges, it's time for a change.
Purchase Peter's book: "Value Leadership" http://www.amazon.com/exec/obidos/tg/detail/-/0787966045/qid=1053090532/sr=8-1/ref=sr_8_1/103-6128061-2165430?v=glance&s=books&n=507846
How to Raise Millions for Any Company - Online Video Course
Bob Norton is a long-time Serial Entrepreneur and CEO with four exits that returned over $1 billion to investors. He has trained, coached and advised over 1,000 CEOs since 2002. And is Founder of The CEO Boot Camp™ and Entrepreneurship University™. Mr. Norton works with companies to triple their chances of success in launching new companies and products. And helps established companies scale faster using the six AirTight Management™ systems. And helps companies successfully raise capital.
Call (619) SCALE06 or email info@AirTightMgt.com for a complementary strategic consultation.