Managing systemic risk, ethics and integrity

Some board members who were supposed to prevent their companies imploding in the 
credit crisis seem to have emerged unscathed and found profitable new perches, according to a report by Gretchen Morgenson of the New York Times.

Citing examples of directors from Washington Mutual and Fannie Mae (among others) who have found new boards to sit on, the article highlights a growing feeling on the part of many stakeholders that there is little accountability for being asleep at the switch and failing to prevent disasters that in some cases were foreseeable. It has been argued that while managers took titanic risks (some involving dubious ethics) that tore at the core of companies, the ultimate losers were the stakeholders.

The New York Times report cites Frederick Rowe, president of shareholder advocacy group Investors for Director Accountability, who said, ‘Here’s a conversation you’ll never hear: Yes, I get paid $475,000 a year. I play golf with the CEO; he’s a personal friend. I go to interesting places for board meetings, I am around interesting people, and I would never say one word that would jeopardize my position on the board.’

Some argue that if closed networks on boards (even where the directors are nominally independent) and resistance to majority voting produce little fear of real oversight by boards over managers, then the core fiduciary duties of directors are more at risk than we care to think about. The counter-argument one could make, however, is that shareholders often get the board and senior managers they deserve. Many investors demand returns that encourage excessive risk taking but then condemn management when those risks materialize and damage shareholder value.

Introducing behavioral governance

The position boards should take is to be engaged in oversight behavior that is constructively skeptical of the risks both senior managers and shareholders demand.

In the present economic and regulatory environment, attention has to turn to what can be called ‘the imperative of behavioral governance of corporate boards’. Corporate governance watchers should note how behavioral finance or economics is coming to the fore in demonstrating the weaknesses of Chicago School free market economic theories, on which Nobel Prize-winning economist Paul Krugman lays much of the blame for creating the conditions for the global economic collapse. In a similar fashion, behavioral governance is the key to addressing the cultural changes needed to ensure that directors achieve effective oversight.

Some of the suggested changes are well known. These include having term limits to combat the 
endurance of closed networks, and separating the board chair and CEO. Perhaps the most important thing in this new era, however, is for directors – or at least a substantial number of them – to understand what forms of behavioral governance produce recurrent crises. These include dangerous risk management strategies that result in excessive, enterprise-endangering leverage, cutting safety and health corners to meet quarterly goals, and careless acceptance of toxic assets.

Other key benchmarks that should be the indicators of good behavioral governance include:
 

• A focus on the behavioral governance conduct of the CEO. This requires boards to insist that the most important role of the CEO is to achieve a balance between managing economic performance, financial management and risk while protecting the company against reputational and political risks that can cause sustained damage.
• Holding the CEO to high standards of integrity, including rigorous adherence to compliance 
standards. The CEO must ensure all employees and partners buy into the stated ethical standards and values of the company. This is meant not only to reinforce compliance, which is a minimal standard, but also to provide protection against ethical, reputational and political risks.
• The oversight and monitoring function of boards must focus on key behavioral governance 
indicators along a short, middle and long-term spectrum in order to ensure the sustainability of the corporation. What has endangered some of the world’s formerly most successful companies is the curse of short-termism, which focuses on quarterly guidance targets at the expense of the entire corporation – and, more recently, of the global financial system itself.

Role of the secretary in behavioral governance

One of the key roles of a corporate secretary is to ensure boards obtain all necessary and relevant information. There are some who allege that corporate secretaries have divided loyalties that ebb and flow between the most senior ranks of management and the board. Those divided loyalties may sometimes lead to insufficient critical information reaching even the most active and efficient board.

The critical role of the corporate secretary in the behavioral governance framework can be achieved by establishing close relationships with the chairs of the most important board committees in order to assist those chairs in establishing the appropriate integrity and risk agenda and information requirements.

For example, the corporate secretary could work with the chair of the finance or audit committees to ensure information relating to the ‘real’ economic performance of the company is brought to the full board in order to prevent stock price or balance sheet manipulation. The short-termism that sometimes pressures management into practices that can result in disaster should be monitored by all relevant board committees, assisted by the corporate secretary.

Dealing with risk information at board level may be a more daunting task than first imagined. The blow-out at the BP Deepwater Horizon oil rig may have been a low-probability risk, but it was a high-cost one. According to Robert Stavins, an environmental economist at Harvard, these types of risks are very hard for managers to assess and take the right actions to 
prevent. He says when an event is difficult to imagine, we tend to underestimate the likelihood of it occurring.

Finally, corporate secretaries should be assisting the compensation committee in finding effective methods to match the new behavioral governance indicators to the pay of the CEO and senior managers. Risk management and integrity performance must be integrated with assessment of economic or financial performance.

Compensation consultants used by the board could be examined by the corporate secretary to 
determine how they intend to deal with the behavioral governance indicators mentioned above when assessing compensation levels. Compensation should not depend solely on industry or commercial pay trends, but should instead focus on sustainable growth and long-term value creation that provides durable returns to shareholders and other stakeholders.

While boards must be the main players in determining what reforms are needed, corporate secretaries should be playing a vital role in these discussions and debates. It must be emphasized that corporate secretaries should not be expected to be surrogate board members. Their role in the areas discussed above should be strictly 
limited to being filters for the information the key board committees and the full board need to fulfill their present and evolving fiduciary duties.