Responding to the Challenges
to Corporate Governance

Murray Weidenbaum

1. Murray Weidenbaum is the Mallinckrodt Distinguished University Professor at Washington University in St. Louis, where he also is honorary chairman of the Weidenbaum Center on the Economy, Government, and Public Policy. This speech was a presentation to "Focus 2002-Conversations on Public Policy" sponsored by the Weidenbaum Center on the Economy, Government, and Public Policy, Osterville, MA, June 21, 2002.

Corporate governance in the United States is facing an unprecedented variety of pressures for change. Although some of the shortcomings are of long standing, the trigger for the current wave of concern was several dramatic bankruptcies, most notably Enron. As a result, we may be in the early stages of the most important changes in corporate governance since the New Deal days of the 1930s.

Let us examine the key issues that have been raised in the national media as well as in a flurry of congressional investigations. The following appear to be the most troubling questions:

1. Have the accounting firms lost their independence and integrity in the effort to expand the scope of their operations and their profits?

2. Are lawyers failing to alert their corporate clients to the perils of using clever ways of cutting corners in meeting the requirements of law and regulation?

3. Have the boards of directors of corporations been unable to keep up with the intricacies of business finance and thus have they not adequately performed their critical role of overseers of management?

4. More specifically, have the audit committees failed in their function of serving as the fiscal conscience of the corporation?

5. Has the effort to get top management to think like shareholders-especially by using options as a major portion of compensation-backfired?

These are loaded questions that the typical honest American business manager must resent having to hear, much less answer. Surely, that was my personal response as a corporate director. Nevertheless, these questions-and many others in the same vein- reflect the growing public dissatisfaction with the state of corporate governance in the United States. The underlying resentments are not new, but they were submerged when the stock market was booming. The less favorable stockholder experiences of more recent times-such as Tyco and Worldcom-have brought these long simmering concerns to the surface. Unless these concerns are seriously addressed-in the public sector or the private sector-the present sour attitude of investors is likely to linger.

Some Lessons from the Past

The widespread damage done to employees and investors by the Enron bankruptcy and several other similar episodes may well produce a new wave of government regulation of business. The sheer magnitude of the disaster-as well as the reported shenanigans on the part of highly paid professionals who should have known better-almost guarantees that Congress will respond with some new statutory requirements.

Under the circumstances, attention is warranted to ways that will help policymakers writing constructive laws and regulations. Some lessons from past efforts to regulate business would seem to be a useful starting point. For example, despite all the talk about "deregulation," the fact is that the great variety, as well as complexity, of the existing array of regulation of business is awesome.

Anyone who has any doubts on that score should examine the many volumes of the Code of Federal Regulations. Better yet, just try to read one of the daily issues of the Federal Register. It is an eyeopener just to see the number and variety of governmental regulations that are issued in a single day. It is not merely a matter of diminishing returns (i.e., very modest benefits) from this process.

The most relevant "lesson" is that so often regulatory power is exercised in a manner that generates unexpected-and frequently counterproductive-results. A cogent case in point is the rise of the 401(k) "retirement" plans that are receiving much attention. In the case of Enron, many culprits were involved, not the least of which was the well-intended ERISA (the Employees Retirement Income Security Act).

Congress enacted ERISA in 1974 after hearing dramatic cases of workers losing their pensions after many years of service. As would be expected, Congress responded by enacting a host of statutory "protections." Why make a point of that? Because, back in 1974, most company-sponsored pensions were of the "defined benefit" variety, where the employers were on the hook to pay specified pension benefits to their retiring workers.

In retrospect, the ERISA experience exemplifies the old notion that "the best is the enemy of the good." ERISA imposed so many paperwork and other costly burdens on employers that thousands of pension plans were quickly terminated (about 10 percent of existing plans). More importantly, over the years that followed, companies and other employers learned the advantages, at least to them, of getting out from under the burdens of ERISA by shifting to "defined contribution" arrangements such as 401(k) plans. Under this approach, the employer may set up a retirement plan but it does not necessarily have to make a financial contribution (or that contribution can be in the form of company stock). Under the "defined contribution" plans, employers are not responsible for the payment of any specific level of retirement benefits. The basic risk in retirement financing shifts from the employers to the employees. Most company retirement plans are now of the "defined contribution" type and not subject to the rigors of ERISA. Enron was a typical, not an unusual, example of such arrangements.

What should Congress do? Before it starts to write new statutes, Congress should make sure that the existing laws are being fully enforced. Judging from widespread media reporting, at least some of the people involved in the Enron fiasco broke the law. To the extent that any of them violated statutes or regulations, the extensive law enforcement and judicial powers of the federal government should be fully utilized to "throw the book at them." Heavy fines and long jail sentences, when the law calls for them, are a strong signal to the rest of us that the highly criticized conduct is not acceptable to the society.

Subsequently, after making sure that the country needs some new laws, the Congress should-without the theatrics of recent hearings-sit down in quiet committee sessions and go about the serious business of writing new legislation. Contrary to the standard treatment in the civics books, the actual process of writing the laws does not get as much congressional attention as it deserves or as the public thinks. Without the TV cameras and press coverage, many committee members are off doing something else-especially if the alternative to the difficult chore of legislative drafting is participating in another publicized hearing. The result, more often than not, is a hastily drawn law that passes the buck to a regulatory agency. If that sounds too harsh, consider how frequently new laws written under great pressure are followed a year or two later with a "corrections" bill trying to fix the mistakes in the earlier bill.

Governmental decision makers also need to take into account the important changes that corporations and auditing firms are now making voluntarily so that they will not have to endure an Enron-like experience. My personal forecast is that-whether or not Congress passes a law on the subject-fewer and fewer companies will repeat the Enron blunder of hiring the same accounting firm to do both the internal audit and the external audit. Moreover, a great many companies are limiting their accounting firm to performing the traditional audit function or at least severely restricting the amount of consulting work that they can do for the company.

As for the popular proposal to require corporate boards of directors to contain a majority of "outside" (i.e., non-management) directors, that has been standard procedure at the larger companies for many years. However, the distinction between a non-management director and an independent director is another matter. As we will see, that distinction needs to be developed.

What Changes Should Be Made?

It likely is an exercise in wishful thinking to expect that, before it acts, Congress will carefully survey the true condition of corporate governance in the United States. As someone who has served on a number of corporate boards of directors for over a quarter of a century, I personally am struck by the variety of circumstances that exist.

Surely, many companies are well managed. Their senior executives, boards, and outside legal and accounting firms all do the conscientious and honest job that is expected of them. Yet, as recent events have made clear, such a benign situation is hardly a universal experience. How should the interests of the public be protected in an environment dominated neither by sinners nor saints? And how can that protection be provided so that minimum damage is done to the efficiency of the private enterprise system that generates such great magnitudes of goods and services, employment, income, wealth, innovation, and progress?

Achieving those multiple objectives is, to put it mildly, a tall order. It surely requires some modesty in recommending specific courses of action. The sensible place to begin may be the questions that were posed earlier. Let us see how responding to each of these questions may generate a useful agenda for reforming corporate governance in the United States. However, unlike the media and congressional coverage of these matters, it seems more appropriate to start at the top of the corporate hierarchy rather than in the middle or the bottom.

1. The role of the CEO must be reconsidered and revised.

In theory, the shareholders elect the members of the corporation's board of directors who, in turn, select the chief executive to carry out the policies of the board. That legalistic description of corporate governance is so sterile as to be laughable.

In practice, the CEO, as the leader of the corporation, is the focal point of the governing power of the corporation. He runs the day-to-day operations of the company and controls the resources to support his ideas. In 90 percent of the cases, the CEO chairs the board of directors, conducting the meeting according to an agenda that he or she sets. The CEO often suggests the candidates for the board and frequently contacts potential directors. It is the rarest of board nominating committees that will recommend a new director that the CEO opposes. It is equally rare for the shareholders to reject the nominations that are contained in the annual proxy statement.

On the surface, this sounds like the structure for an efficient-shall we say businesslike-operation. In fact, this model often works quite well. Many dedicated CEOs truly attempt to build an effective, profitable organization producing goods and services that meet the public's needs and to do so in an ethical manner. Many CEOs have spent a lifetime with the company while directors, at best, are part-timers and shareholders mere transients.

However, the centralization of power in the CEO, not surprisingly, has led to a variety of abuses. The skyrocketing of CEO compensation is a symptom-albeit a dramatic one-of the shortcomings of the status quo in corporate governance. An effective response must go beyond dealing with such technical, although important, questions as the accounting treatment of stock options or the adequacy of controls in the company being charged for the personal expenses of the CEO. It is folly to expect subordinates to limit the financial appetite of a determined, greedy, and ethically insensitive CEO.

The answer to this basic problem of corporate governance must start in the boardroom. Many American companies may find it appropriate to adopt the British tradition of appointing an outside director to chair the board and thus to conduct board meetings. The chairman is usually a prestigious and very experienced person who is at the stage of life where he is not viewed as a challenger to management. Although usually occupied with his own professional matters, the chairman devotes sufficient time and effort to the position so that he or she is no mere figurehead.

Of course, few U.S. CEOs can be expected to welcome with enthusiasm such a dilution of their customary authority. However, even in the United States the outside chairman is not an unknown phenomenon. Major investors at times serve as board chairs of new enterprises. During periods of transition, outside directors have been designated as the board chairman, at least for a limited period of time. In the non-profit sector, an outside member typically chairs the board of trustees. Many non-profit organizations-hospitals, museums, and universities-rival business enterprises in terms of number of employees and annual revenues.

On the positive side, an effective enterprise requires strong leadership. No committee-and that is the organizational form of any board-can or should try to run a business. Every director should understand that the CEO is the day-to-day leader of the enterprise and provides its public face. However, that does not require a weak or passive board. Let us now turn to the changing role of the board of directors.

2. The Board of Directors must be strengthened.

As a long-time corporate director, I note with great sadness the many instances where boards of directors seem to be asleep at the switch. At a time when public criticism of business is rising, the truly independent members of corporate boards have a more vital role than ever in assuring shareholders and the society as a whole that the business is being responsibly managed. In my personal experience, most directors take their responsibility very seriously. However, it is the lapses from good practice that attract public attention and that give business in general a "black eye."

When the CEO also serves as the chairman of the board of directors, it is difficult for the individual director to seriously question the major decisions of the management. Yet, when we consider the disgrace that has been heaped upon some of the Enron directors-and earlier on Archer Daniels Midland's board-it seems clear that exercising independent judgment is not just a prerogative of an outside director. The attitude of independence is a basic way of protecting the individual director's integrity, as well as that of the enterprise.

In that regard, several director selection practices should be frowned upon-such as "celebrity" directors who do not understand the basics of corporate governance, overly committed directors who serve on 8, 10, or more boards while holding down a "regular" job, personal friends of the CEO, and directors who simultaneously serve as high-priced consultants or suppliers to the corporation.

The limitations of any board must be kept in mind. Despite its latent power derived from the shareholders (owners) of the business, the board cannot run the corporation or provide the leadership. The successful board members operate in the middle, avoiding the extremes of becoming either sycophants or rivals to the management. The board's basic task is oversight-advising and questioning the management rather than trying to second-guess it. No legislation can mandate such wisdom on the part of directors, but more public attention to the conduct of boards is encouraging a greater dedication to the task.

In terms of the specifics of corporate governance, the key committees of the board need to be bolstered. Attention quite properly is focused on the audit committee; its watchdog functions should be enhanced (this is a topic we will cover soon). Yet if CEO compensation has at times become obscene, that is an indictment of the compensation committee, which also deserves more notice. Also, the role of the relatively recent phenomenon of the governance committee (which replaces the nominating committee) needs to be developed. Governance committees now regularly review the performance of the CEO and of the board itself.

We must acknowledge the painful truth on CEO compensation. The effort to get top management to think like shareholders has not only failed-it has backfired. Many corporate executives have learned how to use arcane financial methods-which may (or may not) meet the minimum requirements of existing laws and regulations-to manipulate corporate reporting and in the process generate unprecedented rewards for themselves.

Simultaneously, compensation committees have recommended and boards of directors have blithely approved extremely generous stock option plans that often bear little relation to the contribution of the senior management to the returns to shareholders. As we have learned in the case of governmental accounting, activities that are off-budget are more likely to spiral out of control. Putting option awards into the company's financial statements will help. But there is no substitute for the compensation committee and the full board being more cautious in awarding large numbers of options to any individual executive.

The basic shortcoming is not with the theory of options, but in the practice of granting them. In that spirit, a few companies have revised their option plans so that the executive only benefits when the price of the company's stock increases at least as rapidly as the average of its peer group.

Like the audit committees, the compensation committees of boards of directors would benefit from a greater degree of independence. The compensation committee also should consist entirely of truly independent directors (as it often does). Moreover, the selection and pay of the outside compensation advisers should be determined by the committee and not by the management that is to be rewarded. Here is another example of the inability of corporate legal advisers to detect and blow the whistle on what, at least to a layman, appears to be a blatant conflict of interest: management selecting the folks who draw up its compensation plans and who advise the board on those same compensation matters.

As a firm advocate of incentive compensation, I am dismayed, however, by the numerous examples of generous payments for poor performance. For example, there is little justification for the all-too-common practice of rewarding management for below average increases in stock prices. Perhaps broadening the composition of compensation committees would help. At present, they tend to be dominated by directors who are senior executives of other companies and inherently sympathetic to the desires of the management.

3. Wake up the Audit Committee.

A recent analysis by investigative reporters of the Chicago Tribune revealed the extent to which these financial watchdogs did not bark. Of the 207 publicly traded companies that filed for bankruptcy in 2001, many lacked an audit committee or had current or recently departed company executives on the committee. In a dozen cases, the audit committee did not even meet during the year prior to the bankruptcy. Another 28 only met once.

The New York Stock Exchange has rules prohibiting most of these practices. For example, it requires each listed company to establish an audit committee consisting entirely of outside directors. Nevertheless, it seems quite clear that the effectiveness of audit committees is, to say the least, uneven. Enron's audit committee met all of the formal NYSE and SEC requirements. Yet it failed to blow the whistle on the outrageous financial practices that were perpetrated on unsuspecting shareholders.

In a world of increasingly sophisticated financial techniques, the company's audit committee-as well as the entire Enron board-seem to have violated one of the most elementary rules of management: if you don't understand something, don't approve it. Audit committee members need to show a spirit of inquiring independence. An arms length relationship between the audit committee and the company management is essential in establishing and maintaining that independence. That means no former executives of the company on the audit committee, nor any consultants to the company, nor employees of companies that sell goods and services to the company.

A reasonable extension of the power of the audit committee is to vest in it the sole authority to hire and set the fees for the outside auditing firm. At present, management tends to do that, only subject to the approval of the committee. Such a seemingly technical and operational shift would help both bolster the authority of the audit committee and strengthen the independence of the external auditors.

4. Refocus the role of the accounting firms.

Former SEC chairman Roderick Hills recently told the Senate Banking Committee,

. . . it is increasingly clear that the accounting profession is not able consistently to resist management pressures to permit incomplete or misleading financial statements.

Hills's concerns have been voiced by other knowledgeable observers. A fundamental response is required on the part of the accounting profession and its clients.

As a practical manner, the practice whereby a company uses the firm that conducts its outside audit to perform a variety of other services has fallen out of fashion. Whether or not as a matter of formal policy, a great many companies-perhaps the majority-are phasing out the non-audit functions of their external auditors. In some cases, these ancillary functions were not substantial or are now much smaller than was the case a few years ago.

There are serious difficulties facing a client pursuing a policy of eliminating its reliance on its customary auditor to perform other advisory functions. For example, there is a very considerable overlap in the knowledge needed to audit a given firm and the ability to assist in the preparation of its tax returns. Where should the line be drawn? Numerous instances have been brought to light where the non-audit work dominated the agenda (and earnings) of the audit firm. Given the tendency for the non-audit work to be more profitable, the expected incentive has been for the auditors to consider the actual audit work to be a "loss leader" and to move its best people into the non-audit functions.

Without the benefit of new laws or regulations, the era of non-audit dominance appears to be ending-although the threat of potential new statutes or rules surely has been present. In any event, this situation may be an example of the information alternative to regulation. The widespread understanding of the potential conflict of interest is, by itself, resulting in an improvement of the situation.

Yet there are other troubling aspects of the role of the accounting firms that are still with us. For example, it is not unusual for the "outside" auditor also to perform all or a large part of the internal audit function. Apparently this was the situation at Enron. Despite talk about "Chinese" walls separating the two functions, I find this practice highly undesirable. Lawyers may not consider such an arrangement to be a conflict of interest, but it surely is open to that kind of challenge. Having employees of the same firms do the internal audit and then perform the outside review reduces the effectiveness of the formal checks and balances that are designed to protect the financial integrity of the enterprise. The SEC should revoke its shameful ruling that the outside auditor can perform up to 40 percent of the internal audit. In this regard, the accounting profession is ahead of the regulators. The association of CPAs (the AICPA) has recommended eliminating this practice altogether.

More fundamentally, experiences at a number of companies (Global Crossing comes to mind) raise the uneasy feeling that the auditing firms at times have been reluctant to contest the questionable practices of a major client. Compounding the concern is the rising belief that the auditors did not always have an adequate understanding of the financial transactions that they were examining (Enron, again).

A major response to the need for bolstering the independence of the outside auditors is the proposal to establish, under the auspices of the Securities and Exchange Commission, an independent organization consisting primarily of public members. The new organization would regularly review the practices of the auditors of public companies. It would be empowered to maintain quality control by disciplining those who failed to maintain adequate controls and by publicizing the results of its investigations. All that should provide sufficient backbone to accounting firms faced with overly aggressive financial actions by the senior managements of their client companies.

5. Don't let the legal profession wiggle out of its share of the responsibility for the shortcomings in corporate governance.

It is fascinating to see how successful lawyers have been in ensuring that so much of the liability for the current problems of corporate governance falls on the accounting profession and so little on the members of the bar. To add the proverbial insult to injury, at the same time that attorneys are so actively urging accounting firms to rid themselves of their non-audit functions, they are campaigning vigorously to expand and strengthen the "multidisciplinary practices" of their own firms.

It is poor form for so many members of the bar to look down from Olympian heights and to castigate those other mere mortals for their shortcomings. The concern with maintaining high levels of legal ethics surely should extend to the advice that lawyers are providing to the corporate decision makers who have done such a great disservice to investors, employees, and the public generally.

The concern extends beyond the age-old notion that what is sauce for the CPA goose should also be administered to the LLB gander. Rather the point is far more fundamental: so many of the highly criticized financial activities actions by managements and auditors alike had been blessed in advance by their house counsels, outside law firms or both. To state the matter mildly, there is enough criticism to go around and the onus for bad performance needs to be shared fairly and more widely.

Conclusion

Corporate governance in the United States is being challenged for good reason. If American business wants to minimize the likelihood of another round of burdensome (and likely inefficient if not ineffective) regulation, top managements-boards and the most senior officers-must take the lead in cleaning house. Another incentive for such action may be even more basic-to maintain the confidence of the investing public.

At its best, America's system of private enterprise delivers an unparalleled combination of rising living standards, attractive employment opportunities, and technological innovation. It would be most unfortunate for the nation's future if the powerful benefits of the business system were obscured by uncorrected shortcomings.

The test of a strong management is the ability to respond to serious problems promptly; any management can react to the crises that inaction permits to develop. The challenge to American business now is to respond promptly and constructively to the severe challenges to corporate governance that face them-before the investors and the public generally lose confidence in the private enterprise system.