Some boards of directors may be facing some of their biggest challenges
of the last 20 years. While it’s too soon to predict what, if any, litigation or
increased oversight will be brought into
boardrooms in the wake of the recent
turbulence, it is clear that boards must
move forward with an elevated sense of
responsibility.
“So far, there has been relatively little
focus on the role that boards may or not
have played in the financial crisis,” says
James Tompkins, Ph.D., director of
Board Advisory Services, Corporate
Governance Center, Coles College of
Business at Kennesaw State University.
“However, the fire is still burning fiercely, and once the dust settles, it is likely
that board processes or activities will be
heavily scrutinized.”
Smart Business recently learned more
from Tompkins about the dangers of subsidizing risk, the benefits of skepticism,
and why self-assessments will keep
boards operating in the best interests of
the company and its shareholders.
What dangers should be considered when
subsidizing risk?
Consider the following scenario:
Suppose I tell my 12-year-old daughter
that I will contribute half the cost of her
iPod if she ever damages it. With such a
subsidy, she might choose to take her
iPod to the pool and risk getting it wet.
Conversely, if she bore the whole cost,
she may prudently decide to leave her
iPod at home whenever she swims.
Similarly, if a corporation bears risk to
reap the expected returns, it will more
likely make prudent decisions. However,
if the government subsidizes the risk
in any way, this can alter the decision-making of corporations in a perverse
direction.
In my view, as we move forward with
the financial crisis, a key principle of government regulation should be to ask the
question: Does this regulation in any way
subsidize risk? If the answer is yes, the
next question should be: Is subsidizing
this risk in the best interests of the taxpayers as a whole?
How can boards best manage their purpose
of protecting stockholder interests and their
responsibility of monitoring risk?
The purpose of a board is not just to protect but also to promote stockholder
interests. Shareholders finance corporations to take risks in their areas of expertise. Hence, management promotes shareholder interests by engaging in such risks
on behalf of shareholders. However, part
of prudent risk-taking means that the
board should have a big-picture understanding of the risk being taken and processes in place to both measure and monitor such risks. Such processes are consistent with protecting shareholder interests.
An analogy might be when a shipping
company sends a ship to sail from A to B
because engaging in this risk is expected
to reap returns to the shareholder; management promotes stockholder interests
when it risks this voyage. However, shareholder interests are protected when there
is radar on board and an instrument to
receive weather maps so the captain can
change course to avoid dangerous storms.
Why is ‘healthy skepticism’ a key trait for
today’s directors?
I would argue that a key reason in which
the board of Enron played a role in its collapse was because it did not employ
‘healthy skepticism’ in meeting its responsibilities. I recently served as a corporate governance expert witness for an Enron lawsuit, and my observation was that, as individuals, the directors of Enron were all
highly successful, intelligent and talented
people. However, they were also on the
board at a time when the executive management at Enron — Lay, Schilling, Fastow
— were being lauded for their leadership
and accomplishments at Enron. This can
make it very tempting for board members
to fall asleep at the wheel and become complacent with their responsibilities. In other
words, I believe they became too trusting of
management and did not provide rigorous
oversight and monitoring. A board that
does not employ ‘healthy skepticism’ in
meeting its responsibilities is not providing
the constructive and rigorous oversight and
monitoring required to achieve its purpose.
Can directors use self-assessments to gauge
their performance around interaction, independence and integrity?
Yes, it is a best governance practice to
have procedures in place to evaluate the
board as a whole, the committees and even
individual directors. In partnership with
other governance centers, our center
recently released ‘21st Century Governance
Principles for U.S. Public Companies’ that
addresses all these questions, including: Is
the board’s interaction effective? Does its
interaction result in communications that
promotes good decisions? Are the vast
majority of directors not only independent,
but also independent-minded? Do directors
have unblemished records of integrity?
These are all questions that will promote
and protect shareholder interests. A prudent board will conduct such evaluations
with the goal of serving in an environment
of continuous improvement.
DR. JAMES TOMPKINS is director of Board Advisory Services, Corporate Governance Center, Coles College of Business, Kennesaw
State University. Reach him at (770) 499-3326 or [email protected].
