COMMENT: Hidden flaws in corporate governance

By Michael S. Olympios, Chief Consultant, Allied Business Consultants

 

After more than three centuries, the theory of corporate governance first addressed by Adam Smith in his renowned “Wealth of Nations” is well developed and widely disseminated across the globe. Pioneering work by academics and professionals has established a rich literature on good governance. But most directors have received little if any training in its principles.

Despite the success of financial markets in rebounding from the excesses of the late 1990’s, the corporate world remains littered with examples of bad governance. Why? What makes companies fail their investors when so much regulation and know-how is out there to guide them?

Flawed analysis of governance, arrogance, excessive ambition, greed and other corporate vices are possible causes in most cases, but this article doesn’t attempt to explore all of them. Rather, it looks at one contributing factor that affects every company, whether listed or not, in one way or another: power.

Richard Breeden, the court-appointed corporate monitor in the case of WorldCom, began his executive summary in his report “Restoring Trust” with a quote from Lord Acton: “Power tends to corrupt, and absolute power corrupts absolutely.”

The various investigations that were undertaken in some of the most infamous corporate scandals of recent history such as Adelphia Communications, Enron, Globalsoft, WorldCom, Parmalat and many more reveal one striking similarity – their chairmen where holding the position of the CEO (with the exception of Enron) yet all of them were arrogant, greedy and ambitious.

Dominant board leaders, in order to avoid creative friction, ensure that devices are in place to neutralize independent directors’ effectiveness by filtering information, limiting their ability to challenge them or simply buying their loyalty. Most of these leaders undermine mechanisms of prompt disclosure in order to hide crucial information that could reveal conflict of interest or other suspicious activities which could result in a major conflict and potentially communicated to investors thus jeopardizing their own position and prestige.

Appointing loyal “independent” directors then became their priority.

This brings us to the next interesting question. Who appoints the independent directors?

The answer is as simple as tricky. The board of directors at the recommendation of the nomination committee and followed by shareholders’ approval at the annual general meeting. Right? Well, not so in practice.

Powerful chairmen, who often hold the job of CEO get the nomination committee’s approval without many formalities. After all, who picked them in the first place?

Tackling independence in depth is a tedious business. Those so-called “independent directors” in many cases have compromised their independence with the company long before they were appointed.

How many times has anyone heard that a candidate director failed the independence test? None. And how many times a nomination committee made a recommendation to the board contrary to the wishes of the chairman? Again… none.

Most experts agree that being willing to challenge company management or the chairman may be the most crucial qualification for a board seat. It’s a qualification that in fact all chairmen desire in theory but despise in practice.

Chairmen who don’t really want strangers bothering them with real questions just go for the “yes directors” to fulfill the independence requirements. In reality however, they create a board that is sound in appearance but not in fact. And that’s the greatest hidden flaw in governance.

A consensus is starting to emerge, and it involves directors being more informed, more skeptical and more active. But how can directors get all the information they need if their ties with executives prevent them from doing so? And how can they review a company’s financial performance and assess strategy without taking on the jobs executives?

No one has thought enough about how doable this is, especially for directors who have friendly or other ties with those they are suppose to watch. Although active institutional investors have often made the difference, CEO resistance and lack of director motivation and training are the biggest impediments to changes in the boardroom.