Back to the drawing board

The options backdating scandal at UnitedHealth Group is the latest corporate offense to focus attention on the perils of a weak board. Like many scandals, it has resulted in some unexpected consequences, including a creative change to the company’s governance and independence structure.

Shareholder suits, federal and state investigations, an earnings restatement and the disappearance of billions in market value followed reports showing that CEO William McGuire and other top managers at the Minnesota-based health insurer improperly backdated hundreds of millions of dollars worth of stock options.

Record-keeping at UnitedHealth on its stock-options grant program was so poor that it is unclear whether the board knew much about what McGuire was doing or was fully in his sway. What is obvious is that the board failed to function in the most basic ways in analyzing possible adverse consequences of inappropriate executive actions.

An investigation by WilmerHale, the firm’s outside counsel, uncovered a list of governance problems: conflicts of interest, inadequate internal controls and poor disclosure. Even before the conclusion of the slew of investigations, UnitedHealth has undertaken a self-correction. Its reforms include ousting McGuire, bringing in five new board members, reducing compensation and repricing options.

One change of particular interest is UnitedHealth’s creation of the position of board secretary separate from its general counsel/corporate secretary office – a move that corporate governance analysts think could catch on. UnitedHealth says the new post’s ‘sole responsibility will be to support the activities of the board and its committees, including ensuring that the board’s activities and record-keeping are in line with corporate best practices.’ The new secretary, who at press time had not yet been hired, will be selected by the board and report directly to it.

While outside directors have grown in their jobs in recent years and are asking tougher questions, there is still the concern that they don’t have the support to meet heightened expectations. ‘The position provides direct support to the board at a time when there are huge demands on this board as well as other boards,’ says Don Nathan, a spokesman for UnitedHealth. ‘It also enhances the independence of the board.’

Mark Watson, managing director of the corporate governance specialist team at Moody’s Investors Service, welcomes the idea and explains that in interviews with directors, he has found that boards continue to struggle from a lack of direct staff support. Indeed, poor board response in crises could have its roots in such ‘prosaic’ factors.

Moody’s envisions a secretary with direct and sole accountability to the board. The board would independently hire, fire and compensate the person in that function. One or several professionals could be devoted to board support, depending on company size and perceived need. The unit would be charged with ensuring that the board and its committees are sufficiently resourced and have access to unvarnished information on the company.

While a board secretary is particularly useful in situations where management has been called into question, Watson says the structure might benefit companies with no significant governance failures.

Removing conflicts of interest
The existing corporate structure has limitations. Boards typically get assistance from corporate secretaries housed within the legal department or mid-level executives in charge of specific corporate functions such as human resources. People in these positions may naturally feel more allegiance to the CEO or other top executives whom they work with regularly. ‘Are people supporting boards somewhat conflicted?’ Watson asks. ‘Can boards be supported when executives have other day jobs?’

There has long been debate over whether a corporate secretary’s ties to management interfere with his or her board relationships. It has led to discussion about whether it is time to split the roles of corporate secretary and board secretary as has been done commonly with the CEO and chairman positions. ‘There has to be some merit to that point,’ says Deepak Nanda, a partner with Foley & Lardner.

Ira Millstein, a senior partner with Weil, Gotshal & Manges who counsels numerous boards, agrees but isn’t too concerned. ‘Corporate secretaries get paid by management and hired and fired by management and that’s a powerful motivator, but they understand their obligation is to the corporation [as a whole].

‘I’ve seen them improving a lot,’ Millstein adds. ‘I think corporate secretaries are much more sophisticated than they were a few years ago.’

Roger Raber, recently retired president and CEO of the National Association of Corporate Directors (NACD), doesn’t think corporate secretaries have confused loyalties. ‘It’s quite clear that for general counsels and/or corporate secretaries, their allegiance is to the board. It’s as simple as that.’

There may have been problems with corporate secretaries ‘way back when,’ Raber adds. ‘Frankly, in the wake of the corporate scandals, the corporate secretary has been empowered … and has a line straight to the board.’

Still, Millstein has considered the potential benefit of a dedicated board secretary. ‘It’s something I’ve always thought about,’ he says. ‘Boards are dealing with a great deal of information. It would be useful for someone to sort it all out.’

Early efforts
UnitedHealth is not alone in the appointment of an independent board secretary. AIG also has made a move in this direction. As part of its governance reforms following major accounting irregularities, the insurer created the post of secretary to the board. A lawyer holds the position and reports directly to the board on governance issues, although he provides counsel to the company in general corporate, finance and securities law areas. Meanwhile, a separate employee serves as the corporate secretary. Watson notes that the AIG position doesn’t go as far as the role at UnitedHealth, since the board secretary has some management responsibilities.

It is not just scandal-hit companies that are adopting the structure. Although far from being at the forefront of the activist investor community’s collective mind, some select shareholder groups have been supporting the idea for some time. The New York City pension funds, for example, have been pushing the idea in shareholder proposals since 2003.

Ken Sylvester, the city’s asset management assistant comptroller, says the proposals to establish an Office of the Board of Directors have had ‘limited success in terms of very high votes’ at the companies they’ve targeted. Yet the funds will pursue the idea as a way to strengthen the board.

‘Communication, unfettered by management screening or interference, is important to establish director accountability to the shareholders and to improve director knowledge,’ Sylvester explains.

Improving board function is more than a passing interest to directors, since their missteps can take a serious personal toll. For example, eleven former directors at WorldCom agreed to pay $18 million of their own money to settle claims in the company’s $11 billion accounting scandal. Similarly, ten former Enron directors agreed to dole out $13 million from their own funds to help cover losses resulting from that company’s collapse.

Insurers providing director and officer (D&O) liability coverage do consider whether boards have adequate support, but it’s not a huge part of their calculations. ‘Board support is obviously important to us,’ says a spokesperson from a leading D&O coverage provider. ‘But the underwriting process has a lot less to do with the board and board makeup than it does the actual company itself. We are asking, Has the company had problems in the past? Is it embarking on a new strategy? Is it going from public to private?’

Too much work, not enough time
Conflicts of interest aren’t the only problem an independent board secretary might solve. They can help directors get answers to questions they feel might be too much of a burden on management, Watson says. ‘In our experience, directors are well aware of these limitations and limit the degree to which they call upon executives,’ he explains.

Directors have a great deal of responsibility and are calling for more information than ever before. In order to perform their duties effectively, they need constant updates. Often the corporate secretariat or general counsel teams are neck deep in other business (for example, ensuring the company is compliant with increasingly burdensome regulatory and filing requirements) and are unable to service the board as they might like.

Yet Millstein reminds that whatever structure is in place, boards have the right and responsibility to be demanding. ‘Maybe boards don’t ask enough questions, but boards should never feel awkward,’ he says. ‘If they have questions, they should ask them.’

There are problems moving to a model that provides direct board staffing. ‘The central one is whether by instituting an office like this, or any secondary layer, we are creating a process where the board is overstepping its bounds into management,’ Nanda says.

Watson agrees that this is a potential negative, but says ‘most directors of large companies are fully aware that they must chart a course that balances active need for engagement ... without becoming micromanagers in part to preserve their independence.’ He also notes that board-support professionals with no ties to the management side could be so isolated from the day-to-day activities of the firm that their roles would be difficult and unproductive.

Alternate ideas
It is clear that there is wide support for finding ways to enhance board independence. Frederick Lipman, a partner at Blank Rome, likes the board secretary model but doesn’t think it goes far enough, particularly as envisioned by UnitedHealth. ‘Will that person be taking into account the broader information the board needs?’ he asks.

In his 2006 book Corporate Governance: Best Practices, Lipman lays out a chapter on the idea of using an internal auditor as staff support for the board. ‘I think you need someone with a financial background to act as the eyes and ears of the board,’ he says. ‘That person can also operate as a secretary to the board.’

The auditor should be hired and compensated by the board and report exclusively to directors. ‘The board needs its own sources of information,’ Lipman says. ‘I don’t think boards are waking up to this. It’s beginning to happen, but it’s very early in the story.’

It’s not only corporate governance consultants who have been rethinking corporate structure. General counsels also have been asking how they can help balance the distribution of power. After the Enron and WorldCom scandals, the cries of ‘where were all the lawyers?’ prompted the New York City Bar Association to look for ways to enhance the performance of in-house and outside lawyers.

‘Lawyers did not cause any of these recent scandals,’ says Thomas Moreland, who chaired a task force on the subject. ‘But it does appear that at least some of these scandals might have been avoided had lawyers been more assertive in questioning management and more willing to bring their concerns to boards of directors.’

Moreland’s group proposes that New York amend its ethical rules for lawyers to permit them to disclose to regulatory authorities, such as the SEC, criminal or fraudulent conduct by a client company’s management. Currently, lawyers are required by SEC rules and the Sarbanes-Oxley Act to ‘report up’ to the board any wrongdoing by corporate managers. An ethics rule change would allow them to ‘report out’ the misconduct to authorities if they are unable to persuade the board to act, says Moreland, a partner at Kramer Levin Naftalis & Frankel.

It’s a radical idea borrowed from the American Bar Association’s model rules, which the state’s bar association doesn’t like since it could chill attorney-client communication. Moreland says the topic will be a big issue later this year as an element of New York’s proposed wholesale revision of its Rules of Professional Conduct.

Along with the ‘reporting out’ concept, the city bar is advancing a new series of best practices for general counsels advising public companies. One idea is to make boards solely responsible for hiring general counsels and setting their compensation. ‘As it stands, some boards might have a say, some not,’ Moreland says. ‘Unless you expressly give power to the board, it tends to be the CEO who selects the general counsel and controls their tenure.’

General counsel should also have ultimate authority with respect to the selection of outside lawyers. ‘I think
it’s becoming increasingly frequent,’ Moreland says. ‘It’s becoming the norm, as we think it should be.’

As the city bar effort shows, there are ways to work with and tweak the structures that companies already have. In thinking back to the board secretary proposal, Nanda believes it is unnecessary and could interpose too much distance. ‘You want there to be a connection between the CEO and the board, but you don’t want it to rise to the level of cronyism,’ Nanda explains. ‘At the same time, you want there to be a professional camaraderie where they trust each other’s judgment.’

A board secretary may get companies closer to ‘the greater good,’ he says, but the costs could be greater than the benefits. The most basic and important thing for general counsels and corporate secretaries to do to prevent failure is to keep information to the board open, free-flowing and timely.

‘I don’t think we need to go to [the board secretary] mode,’ Nanda says. ‘One thing to keep in mind is that process and structure have a place, but they can’t be a substitute for honesty and transparency. Although some high-profile failures have come to light, in practice most people want to do their job properly.’