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Weil, Gotshal & Manges LLP
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Trouble - A Factor in Selecting Directors
Millstein, Ira M.
(June 2000, Directors Monthly)
By Ira Millstein
The point of this note is to urge directors, as they consider candidates
for the board, and shareholders, as they exercise their voting responsibilities,
to include consciously their respective decision-making processes the potential
for the director-candidate to deal credibly with "trouble" of
the kind where management appears to be directly or indirectly involved.
No company has made it from here to there without, at least once, running
into life-threatening or near life-threatening trouble. Trouble of one
kind or another is inevitable for many reasons. Corporations are not composed
of perfectly programmed cyborgs, but of fallible human beings -- who may
not always bring appropriate ethical grounding to their business lives,
or who may not always recognize that their leadership is failing or that
their corporate strategy needs severe correction. To paraphrase Philip
Roth, human beings live there.
Companies, under pressure to meet the high expectations of investors and
Wall Street, may at times favor questionable tactics which help the financial
outlook in the short term. Or they may skirt legal requirements, or even
step over the line. Moreover, well-thought-out strategies may stall in
the face of changing circumstances for which the company is unprepared.
And a leader may have stayed the course too long, or simply lost the confidence
of the organization.
The potential sources of "trouble" are endless. Whether a company
is able to both avoid these and other troubles -- or to deal with them
effectively when they occur -- can often define the long-term success or
failure of the enterprise.
Effective governance by an independent and active board of directors is
the means by which both the incidence and impact of trouble is minimized.
The board can be an effective agent in managing crises when trouble occurs
and in preventing trouble -- through oversight of compliance measures,
oversight of financial reporting, and close monitoring of management's
performance.
Dealing with Trouble: The Board’s Role In Crisis Management
Effective corporate governance may preserve the enterprise when trouble
does occur, as it inevitably does. Who else, besides the board, is there
to protect and preserve whatever shareholder value is protectable and preservable
when management appears to have been either the direct or indirect cause
of the problems that led to the trouble -- and government has other interests
to protect?
There are many decisions facing managers in which managers' interests may
not be consistent, for personal reasons, with those of shareholders. Examples
include: determining where the buck stops for legal infractions; deciding
whether and when to abandon a failed strategy that a manager appears to
have ego or other personal interest reasons for supporting; addressing
the underperformance -- or worse -- of an executive with whom a manager
has a personal relationship; or even recognizing that the organization
has lost confidence in the CEO. Even though the vast majority of top managers
are sufficiently enlightened to avoid acting in a self-interested manner
in these situations, good corporate governance can assure shareholders
that a distinct and objective body is truly watching and acting when necessary.
Obviously government does not provide the solution to a crisis. Many of
the biggest forms of “trouble” are related to government action that
is not aimed at protecting and preserving shareholder value, but rather
is aimed at forwarding other important policies (e.g., antitrust and securities).
While government agencies can provide external pressure by requiring managers
to comply with various rules and regulations, the key decisions about a
company’s direction while dealing with infractions or performance problems
must be made by management and the board of directors as surrogates for
the owners.
Shareholders do not provide the solution either. Just as every decision
of national policy cannot be decided by a voter referendum, every important
corporate decision cannot be put to a shareholder vote. Business decisions
must be made quickly, decisively, and in an organized fashion, and the
shareholder body lacks detailed information and is too fragmented and disorganized
to provide the immediate and sensitive responses that are necessary when
trouble occurs.
Obviously then, by a process of elimination -- if not strict law -- the
duty of protecting shareholder value in times of crisis falls to the board
of directors when management either appears to be involved, or appears
to have a self interest. Even when management can be relied upon to execute
solutions, the directors are there to assure shareholders that management
is doing so.
Since “trouble” is an investor’s worst nightmare, the capacity of directors
to deal with it should be a crucial factor in investors’ decisions about
where to invest. We all know three of the key qualities expected of a board
member: "independence" from management, the capacity for objective
"judgment," and commitment of "attention." Now consider
these qualities in light of the inevitability of “trouble”: Is the director
being considered so independent of management, in mind and spirit, and
so capable of objective judgment as to make the hard decisions required
when real trouble occurs? Especially since trouble of the kind here discussed
in all likelihood means dealing with management, often top management,
and often the top management the director may have chosen. This can be
trauma for all concerned.
Even more importantly, does he or she have a reputation for taking responsibilities
seriously -- so that one can safely assume that he or she will devote the
time and energy required to know enough about the corporation to deal with
“trouble” when it arrives? Independence, judgment, and attention could
spell the difference between simple trouble and complete disaster.
The next time you nominate or elect a director, at least think about whether
these qualities are present in that person sufficient to assure the ability
to act in the most unpleasant circumstances.
Preventing Trouble: The Board’s Role
As the surrogate for shareholders, the board of directors seeks to avoid
the types of trouble that can result in significant loss of shareholder
value. The decisions referred to above are not easy to make, and the board
will be at its best when it doesn’t have to face such decisions. To this
end, boards should insist that internal systems exist to ensure that companies
are in legal compliance -- and that compliance failures are quickly detected
and dealt with. Boards should also insist that internal systems are designed
to ensure that financial reporting is credible, and that the board is provided
with the information necessary to monitor performance. Such "insistence"
by the board certainly makes sense on a personal level because these systems
help avoid the necessity of making the very wrenching decisions necessary
when trouble strikes. More importantly, however, interpretations of fiduciary
duties and other governance-related rules seem to be headed more and more
to making this "insistence" a requirement.
For example, in the Caremark In Re Caremark International Inc.
Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). case, the Delaware
court reminded directors that they have a duty not only to monitor the
business and affairs of the corporation, but also “to assure that appropriate
information and reporting systems are established by management.” While
the Delaware court recognized that the level of detail appropriate for
such systems is a question of business judgment, it emphasized the role
of boards in overseeing compliance with laws and regulations, by ensuringthat compliance systems exist and are functioning. While the board cannot
be expected to act as “big brother” by watching over every move the company’s
managers make, it can take an active role in insisting that systems and
processes designed to keep the company out of trouble -- and detect trouble
early -- are in place.
The responsibilities of boards in the financial reporting process have
been the subject of new rules by the Securities and Exchange Commission
and the leading stock exchanges.Order Adopting Rules Regarding Disclosure
By Audit Committees, Including Discussions With Auditors Regarding Financial
Statements, SEC Release Number 34-42266; Order Approving NYSE Proposed
Rule Change, SEC Release No. NYSE-34-42233; Order Approving AMEX Proposed
Rule Change, SEC Release No. AMEX-34-42232; Order Approving NASDAQ Proposed
Rule Change, SEC Release No.NASDAQ-34-42331.
During the past year, beginning with the report of a Blue Ribbon Committee
created by the Exchanges, there has been increased focus on the role of
board audit committees in the financial reporting process, resulting in
a series of rules designed to strengthen audit committee functions. For
example, the new rules require that a company adopt and disclose the audit
committee’s charter, and that the charter specify that the outside auditor
report to the board (not the managers) through the audit committee. In
addition, the company’s annual proxy statement must include a written
report by the audit committee and a disclosure regarding the independence
of the committee members. The NYSE, AMEX and NASD rules all address the
composition and duties of audit committees, including standards of independence
and financial expertise for audit committee members.
The trend toward more responsible and engaged audit committees recognizes
that good corporate governance may prevent less than adequate -- or even
fraudulent -- financial reporting. The new rules’ focus on the independence
of audit committee members again heightens awareness of a key factor in
the board’s ability to help avoid trouble -- independence from management.
While overseeing compliance systems and the financial reporting process
brings the board of directors into a better position to prevent and detect
trouble, the board can take this oversight one step further. Overseeing
management's performance implies that the board understand management's
strategy and business plan, as well as the underlying assumptions upon
which they are based. It also implies that the board monitor strategy and
the business plan from inception to implementation. Only with an understanding
of the financial, economic and competitive assumptions underlying strategies
and business plans can a board of directors truly monitor the continuing
efficacy of the strategy and business plan -- and management's performance.
But so equipped a board is more likely to deal with strategy and performance
failure earlier and with less trauma.
Again, for emphasis, the next time you select or elect a director, consider
whether he or she has the independence, judgment and commitment to act
without equivocation in the situations here described, which are hardly
a complete list of potential trouble.
Reprinted with permission from the June 2000 edition of Directors Monthly.
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