...and Where Were the Directors

How is it that publicly held companies with boards of directors that are composed of intelligent, influential

individuals can end up on the brink of disaster? Why is it that, according to <i>Fortune Magazine,</i> companies such as

IBM, General Motors and Sears—which ranked numbers 1, 4 and 6 in a 1972 list of the world's 20 largest

companies by stock market price—were no longer represented in that same list in 1992? (In fact, these three

companies lost a total of $32.4 billion in 1992, and each was in some form of crisis.) Why is it that so many

well-known names such as Woodward &amp; Lothrop, Eastern Airlines and Allis Chalmers no longer exist?

</p><p>These scenarios have been repeated numerous times over the last two decades. While it may be true that boards

of directors are becoming much less passive, impotent and ceremonial, the move to becoming more effective

monitors of corporate performance is, in my opinion, more of a slow drift rather than a rush to activism.

</p><p>I have observed that the boards of directors of troubled companies often have a common set of limitations:

</p><ol>

<li>A singular focus on short term and immediate earnings per share (EPS) growth;

</li><li>A lack of true independence among the directors, perhaps not as legally defined, but in the real and practical

sense; and

</li><li>A lack of resolution and dedication on the part of the directors to make the necessary commitment of time and

energy.</li></ol>

<h3>What Did the Share Price Do Today?</h3>

<p>As stated in the <i>Report of the National Association of Corporate Directors Blue Ribbon Report on Director

Professionalism,</i> "The objective of the corporation (and therefore of its management and board of directors) is to

conduct business activities so as to enhance corporate profit and shareholder gain. In pursuing this corporate

objective, the board's role is to assume accountability for the success of the enterprise by taking responsibility for

the management, in both success and failure." In other words, good corporate governance dictates the accountability

of management to the board of directors and the accountability of the directors to the shareholders.

</p><p>Directors have long understood that their job is to grow shareholder wealth. However, the problem in many of

the troubled companies with which I have been involved is that the directors focused the majority of their time and

decisions on improving short-term EPS, rather than becoming active decision-makers in ensuring the overall

long-term success and viability of the company. Very often these same directors have allowed mediocrity at the key

management levels, and this mediocrity has followed to the board level. In these cases, there are typically no

clear-cut lines of responsibility, authority and accountability established. The directors have never benchmarked

themselves or the key executives of the corporation against well-defined, well-considered metrics for success. These

metrics go beyond the current share price to measure success as defined by the maintenance of corporate value and

financial returns over the long run. In addition to its obligation to increase stock value, the board has responsibilities

to the corporation's

employees, customers, creditors, vendors and the communities where it operates. It also has the responsibility for

developing strategic direction and foresight concerning the corporation's resources, future needs and contingencies.

This does not imply that it is the board's job to operate the company; that must be left to the CEO and his/her

management team. However, as has been stated by Ira M. Millstein of Weil, Gotshal &amp; Manges LLP, "The focal

point of corporate governance is the board, which at the first level is charged with making sure that management

does not work against the interest of the shareholders. The board is also charged with monitoring management

performance and enhancing long-term shareholder value—and to ensure society's expectations are met as well." In

troubled companies, this expanded view of the board's role is seldom acknowledged.

</p><p>If long-term, sustainable value is not the board's focus, it will not, by definition, be the focus of management.

Certainly over the last five or six years we have too often seen that capital and other resources of companies that

have found themselves in a crisis have been spent on growth for the sake of raising share prices. Thought is seldom

given to the infrastructure and integration requirements that must accompany this growth in order to insure long-term

preservation of value. This has been especially true in industries where companies have traded predominantly off

multiples of revenue, rather than EBITDA or free cash flow. It has also been particularly true in industries

undergoing furious consolidation such as telecommunications and health care, where "bigger is better" is the mantra

of the day. This pursuit of growth often has resulted in a lack of sound strategic and operational planning, as well as

a lack of sound capital investment. A short-term viewpoint can strain the company's resources beyond its limits,

eventually leading to an operational and financial crisis if not corrected.

</p><h3>...but the CEO Is My Golf Partner</h3>

<p>Most boards of publicly traded companies are currently composed of a majority of independent directors, at least

under the legal definition of "independent." However, an independent director from a more practical perspective is,

simply put, an outside director who will make impartial judgments. When I look at the boards of publicly held

troubled companies (large and small), their composition very often includes a majority of directors who are the

CEO's friend or directors who were responsible for placing an inadequate CEO into office; an outside counsel or

investment banker who has been involved with the company for an extended period of time and who is only too

aware that it could lose a profitable client if it does not follow the party line; an officer of a corporation thatis a m

ajor vendor or customer of the company; a former company executive or individual who has long-term ties with

management; and an overwhelming number of members of an investment group who hold a large stake in the

company and who have difficulty segregating their own interest from the interest of the shareholder group at large.

These types of "outsider-insider" relationships have been described as a "corruption of obligation by friendships or

self-motivation."

</p><p>An effective board requires directors who are clearly and truly independent of management in order to be able to

impartially challenge and, when necessary, oppose management. Creating the correct balance of power and authority

is the single most important factor in insuring appropriate governance. As stated by Jay A. Conger, David Finegold

and Edward E. Lawler III in their article entitled "Appraising Boardroom Performance,"<i> Harvard Business Review,</i> Jan.-Feb. 1998, "An effective board needs authority [and] power to see that senior management is acceptable and

implements its (the board's) decisions." They go on to state that the irony of this principle is that today fully 97

percent of those chairing boards at public companies are either the current or former CEO of the company. This

statistic is probably even higher for troubled corporations. One may logically ask, how can the chairman/CEO ever

effectively insure that the board appropriately discharges its duties when the board is chaired by the very person

whom the directors have been charged with holding accountable?

</p><p>The CEO as chairman is especially problematic with passive boards where there is a lack of true independence

and where it has become typical of the directors to take all their direction from management. It is also problematic

where the CEO, as is true in most cases, is compensated through attaining annual financial measures and short-term

stock performance goals rather than long-term value.

</p><p>Because of the lack of independence often inherent when the CEO is the chairman, many well-managed boards

are moving to appoint a lead director who usually represents the outside directors. This individual often becomes

responsible for such things as setting agendas, insuring good corporate governance through the workings of the

appropriate established or special committees and proper evaluation of the CEO. The lead director is also often

designated to take over the board in the case of a crisis. Some boards have even established triggers to define when

this transition should occur.

</p><p>I believe that the lack of true independence of the directors is the single largest problem with troubled company

boards. Because of friendships and decisions made with self-interest at their center, the board becomes an ineffective

governance tool.

</p><h3>Asleep at the Switch?</h3>

<p>As cited in a speech given by Holly J. Gregory of Weil, Gotshal &amp; Manges LLP, titled "Improving How The

Board Works," on Feb. 27, 1998, Robert Townsend, when he was CEO of Avis, offered the following advice to

CEOs about the proper running of a board meeting: "Be sure to serve cocktails and a heavy lunch before the board

meeting. At least one of the older directors will fall asleep (literally) and the consequent embarrassment will make

everyone eager to get the mess over as soon as possible." While perhaps a slight exaggeration of today's boards, I

believe that most (although not all) of the boards of severely troubled companies have been asleep at the switch.

</p><p>It is certainly true that a passive and ceremonial board does not foster the concept of holding management

responsible. With passive boards, meetings tend to be dominated by management presentations with little challenge

or in-depth questions arising from the directors. Often the directors are ill-prepared and lack the specific knowledge or

information to make sound decisions.

</p><p>I recently had the pleasure of sitting on a panel of five very distinguished directors hosted by <i>Director's Alert.</i> The panel included Ken Roman, who sits on the boards of Compaq Computers, Brunswick and IBJ Schroeder. When

Roman discusses board responsibility, he expands beyond the traditional requirements of choosing the right CEO and

assuring that corporate strategy is being followed, to add such responsibilities as: (1) monitoring corporate

performance and reviewing results against corporate philosophy, the strategic plan and other long-term objectives; (2)

understanding the competition, the changes in technology and the business plan; (3) reviewing and approving the

corporation's financial standards, policies and plans, as well as all material transactions; (4) ensuring the soundness

of financial controls and systems; and (5) monitoring and evaluating management. Roman also states that every

corporation eventually will find itself in some kind of a crisis. The test of the strength of the board is whether it

faces up to the fact that the crisis exists and how quickly and accurately it responds to and handles the crisis.

</p><p>Note, Mr. Roman does not describe a passive board, but rather one that is proactive; it monitors, it evaluates, it

approves and it ensures. In order to be proactive, the board must be well-informed, not just about the corporation

itself and its existing resources, but also about the industry, the competition and the direction for the future. To

accomplish this mandate, the board must establish its information requirements accordingly. And it requires that the

directors regularly attend board meetings and actively contribute to those meetings through reviewing, monitoring

and challenging management's plans. It is through this active prepared participation on the part of the directors that

the board fulfills its responsibility of accountability not only to the shareholders, but to its other constituents as

well. It comes as no surprise, therefore, that passive boards, combined with mediocre or unqualified CEOs, constitute

a formula for a crisis.

</p><h3>...and What Happened to the Directors? </h3>

<p>To maintain or create a successful company, directors, individually and collectively, must concentrate on

increasing long-term shareholder value, insist on maintaining real independence from management and commit the

necessary time and energy to a continuing review of corporate performance and strategy. Otherwise, they may be

forced by their creditors, lenders or shareholders to call in an outsider for restructuring advice or as a crisis

manager—a call that no board of directors wants to make.

</p>