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Best Business Books 2004: Governance

Next Steps for Boardroom Reform

(originally published by Booz & Company)

The start of the 21st century was not a good time for chief executives. In less than a year, from 2001 to 2002, more than a quarter of the largest American corporations experienced downturns in current or projected revenues, which prompted their stock prices to drop from the $50 range to $1 or less. In the last quarter of 2001, Enron, until then America's fifth-largest corporation, lost 99 percent of its value. All too often, managers tried to stave off disaster with misleading or even fraudulent financial reports.

Small wonder that CEOs came to rank in public opinion only a notch above used-car salesmen. Many CEOs are now more self-conscious about the public's distrust of them. The vogue of the 1990s, the hero-boss, has given way to a fashion of chief executive officers who exhibit humility and straight dealing.

But how to ensure that there are no more Enrons, WorldComs, or Tycos? In the past year or so, several books have appeared with advice to offer, from people with a broad range of experience. They agree, for the most part, that the responsibility for corporate rectitude rests with boards of directors. And collectively, they suggest that the conduct of corporations depends, ultimately, more on character and teamwork than on regulation and legislation. But each offers a different viewpoint on the most contentious question in the current U.S. debate on boardroom governance: Whether the role of chairman and CEO must be split between two individuals.

Two of the books are by people who have run sizable businesses, one on either side of the Atlantic. Bill George, the former CEO of Medtronic Inc., having made a success of this big medical technology company (and acquired the splendidly titled role of Executive in Residence at Yale University), has written Authentic Leadership: Rediscovering the Secrets to Creating Lasting Value (Jossey-Bass, 2003). Sir Adrian Cadbury, author of Corporate Governance and Chairmanship: A Personal View (Oxford University Press, 2002), also made a success of his time at the family confectionery firm. One of his retirement jobs was chairing a committee on corporate governance whose code of best practices, published in 1992, has been the basis for corporate governance reforms in Britain over the past decade.

Two other books are by specialists in corporate governance who have spent their careers moving in and out of boardrooms as advisors or as independent directors. Back to the Drawing Board: Designing Corporate Boards for a Complex World (Harvard Business School Press, 2004) -- s+b's choice for the best book in this category -- is by Colin B. Carter, a management consultant, and Jay W. Lorsch, a professor at Harvard Business School; The Recurrent Crisis in Corporate Governance (Palgrave Macmillan, 2004) is by Paul W. MacAvoy, a professor at the Yale School of Management, and Ira M. Millstein, a corporate lawyer.

Is "Buff" Enough?
The fifth book in this selection approaches governance from a different angle. In The Naked Corporation: How the Age of Transparency Will Revolutionize Business (Free Press, 2003), Canadian consultants Don Tapscott and David Ticoll attempt to unravel the impacts of information technology on society, the economy, and business. Their starting point is that "the crisis of 2002 was a crisis of disclosure and transparency" -- the worst on Wall Street since the crash of 1929. Their antidote: lots more transparency. "If you're going to be naked," they counsel, in a sentence that clearly delighted their publishers, "you'd better be buff!"

To describe the collapse of the dot-com bubble as a crisis of disclosure seems rather odd. True, there was dishonesty in some big companies (but in only a small minority: not at GE, say, or GM or Procter & Gamble or a host of other household names). And true, many investment bankers hyped shares of e-companies excessively, persuading the gullible and greedy that pewter was silver and brass was gold. But the stampede into dot-com shares was the sort of mass mania that happens once every two or three generations, with tulips or railways or radio, and would probably have occurred even if every dot-com company had been "buff."

And what about the "be buff" injunction? Tapscott and Ticoll describe all sorts of areas in corporate life in which, they argue, it is easier for the outside world to see what companies are doing, whether or not the exposure is desirable. Their basic theme -- not surprisingly, given their past interest in things digital (their previous collaboration was Digital Capital: Harnessing the Power of Business Webs, from Harvard Business School Press in 2000) -- is that the Internet has turned the spotlight on corporate performance to an unprecedented extent. From that, they move swiftly to arguing that proactive communication and disclosure is a good thing, in all sorts of ways, and then to urging companies to do more of it. Companies should, for instance, come clean with nongovernmental groups; executives should avoid keeping secrets from employees; they should not be nasty to whistle-blowers.

Still, good information may be available but ignored. A study of the Enron message boards on the Yahoo Finance Web page, quoted by the authors, found enormous numbers of anonymous notes describing the company's problems. When the dot-com boom was at its height, few investors wanted to listen to voices of caution. Quite a few companies see no benefit in subjecting themselves to the scrutiny that being publicly traded now imposes on them. In August, for example, the public but family-controlled Cox Communications announced plans to go private. Still, most large companies have no choice but to remain public; smaller and medium-sized ones may increasingly choose to remain private.

In Authentic Leadership (also reviewed in "Leadership" ), Bill George has hardly anything to say about transparency as he describes what makes a good leader and examines the relationship between good leadership and good governance. He does, however, have much to say about ethics and authenticity, two key qualities he believes successful leaders must have. Companies that are led by people who are consistently authentic and ethical, one suspects, don't need to worry much about installing elaborate machinery for corporate governance.

George worries anyway. Like other authors reviewed in this essay, he sees the structure and behavior of the corporate board as the key to good governance. He therefore wants to "restore the power of boards of directors to govern corporations," and has some sensible, practical suggestions on how to do so.

The board's job, he says, is oversight of executives who are subject to external pressures that could lead even the most moral among them astray. Indeed, the most striking passage in George's book is not in his own words, but in those of Daniel Vasella, CEO of Novartis. "Once you get under the domination of making the quarter," he says, "you start to compromise in the gray areas of your business…. The culprit that drives this cycle isn't the fear of failure so much as the craving for success…. You are idealized by the outside world, and there is a natural tendency to believe that what is written is true." If such temptations assail such an honorable and capable chief executive as Daniel Vasella, how much greater is the threat to those with a lesser sense of honor?

To govern well, says George, the board needs a set of governance principles and a governance committee made up of independent directors who nominate new directors, assess the performance of the board and its members, and handle succession planning. There should also be, he believes, a senior independent director (usually referred to as a lead director in the U.S.) who has a good working relationship and shares mutual respect with the CEO. Above all, the independent directors should meet regularly without the presence of the CEO -- something George sees as "essential to good governance." These conditions, he thinks, are of more importance than whether boards should combine the roles of chairman and CEO (as is normal in the United States) or separate them (as in Europe).

Perverse Incentives
More ruthlessly analytical than either the scattergun approach of The Naked Corporation or the genial semiautobiographical approach of Authentic Leadership is MacAvoy and Millstein's The Recurrent Crisis in Corporate Governance. Their admirably terse and lucid work has two particularly interesting dimensions. First, they put the evolution of better corporate governance into a historical context. Second, they pay close attention to the evidence that better governance leads to better financial performance.

On the historical front, the authors point out that this is not the first time American corporate governance has been under the microscope. In the 1960s and 1970s, aggressive acquisitive managers seized power from the board and built overstaffed, overdiversified empires through a process of excessive acquisition. The problem, the authors argue perceptively, was the reverse of that of the late 1990s: Then, managers used shareholder returns to overbuild the company and depress share prices; in the recent crisis, the problem was the overinflation of share prices. Then, corporate America paid its most important leaders like bureaucrats, as argued in 1990 by Michael Jensen, a Harvard finance professor, and Kevin Murphy (now at the University of Southern California); in response to such criticisms, corporate America now gives leaders too high a stake in the performance of their corporation's stock.

Before the Internet bubble, MacAvoy and Millstein confess, they thought that governance had reached "an enviable pinnacle of excellence." Now, they doubt whether the extensive reforms in the Sarbanes-Oxley Act of 2002 and the new rules introduced by the Securities and Exchange Commission and the New York Stock Exchange have done enough to make boards undertake their duties properly.

Why, though, does it matter whether companies are well governed or not? Obviously, it is important that companies not break the law, and shareholders prefer not to lose money. But MacAvoy and Millstein have a chapter titled "The Ambivalent Results of Extant Research on the Impact of Strong Corporate Governance." In a fine survey of the literature, they conclude that the best proof of the efficacy of good governance is the clear undesirability of the alternative: Few would argue that companies would perform better if they were once again governed by their management, with mere rubber-stamping by the board.

To reinforce this view, the authors have done a couple of studies of their own, one in 1997 and one recently. Their latest finding is that stronger corporate governance practices have delivered better performance in those large corporations that adopted them. It would be nice to believe that their finding is true. But it is at least possible that good governance and good management merely go hand in hand.

Like Bill George, Paul MacAvoy and Ira Millstein focus on the independence of the board of directors. "Where Was the Board?" they ask, in the scandals of the late 1990s. The key problem, they argue, was that the most troubled companies did not have adequately independent boards. But unlike George, they see the separation of the roles of chairman and chief executive as crucial to board independence. They also want the board to satisfy itself that the company's management information systems are good enough to ensure that public financial statements are accurate, and they want sophisticated evaluation of management performance, used to monitor effectiveness and to set compensation.

Such a list of objectives places huge demands on board members. Wise Sir Adrian Cadbury, in his modest but persuasive Corporate Governance and Chairmanship, is more gentle toward the board. He praises the Anglo-Saxon unitary board over the German two-tier model, but he sees significant differences in the way American and British boards operate. There is little doubt which he thinks is more effective. On American boards, he says, the CEO is normally in charge, supported by the board. In Britain, the board is unquestionably in charge. "It is essentially a collegiate body reaching its decisions by consensus, and the CEO reports to it," he writes.

Do the Split
Sir Adrian's account of how a well-run board should operate is the best there is. He writes mainly for boards structured British-style, with a mix of senior executives and outsiders and with an independent and usually part-time chairman. The author has a tip for solving every quandary, whether it is what to do when the chairman disagrees with the finance director about a proposal coming to the board, or how to get rid of a chairman who is no longer up to the job. Like MacAvoy and Millstein, Sir Adrian believes in the advantages of splitting the top job; he also argues that there are signs that the practices in America and Britain may converge, if American boards grow more collegiate, and as a lead or presiding director becomes the norm. But ultimately, as he emphasizes more than any other author, what matters is behavior. Structures matter; getting human relationships right matters more.

Of the past year's crop of books on governance issues, though, none beats Back to the Drawing Board. Carter and Lorsch have an ideal combination of consultancy, real-world, and academic experience. They are prescriptive but not rigid, realizing that different solutions fit different companies. They both have long memories that allow them to describe what worked in the past, as well as what failed. Unlike MacAvoy and Millstein, let alone Tapscott and Ticoll, these experts remind executives about the international differences in approaches to governance. Ideas of what is appropriate board structure differ widely from one country to another. In Britain, for example, a company that combines the roles of chairman and chief executive is regarded with suspicion by regulators and shareholders alike. In America, the single "Chairman and CEO" is the norm.

Carter and Lorsch's primary concern, however, is that by focusing on the external pressures for change, boards will ignore the basic actions they must take internally to become more effective. Boards must go "back to the drawing board" -- closely examining their role by looking at the obstacles to doing their job properly and at the forces within the corporation that need oversight.

The authors debunk large tracts of accepted wisdom. They argue that the external appearance of boards -- the proportion of outside directors, or the frequency of board meetings -- bears no relationship to shareholders' results. What really counts in meeting the oversight, decision-making, and advisory challenges of the 21st century is "the dedication, energy, time commitment, and skills of the directors," together with a constructive, results-oriented atmosphere around the boardroom table. To that end, Carter and Lorsch preach the gospel of pragmatic eclecticism: "Today's conventional wisdom suggests that all boards undertake very similar roles, but we believe that boards have considerable leeway in deciding what activities they wish to undertake and that they must address this choice explicitly."

The pursuit of independent directors also comes at a price. Carter and Lorsch point out the impossible burden of responsibility that modern regulators have placed on independent board members. They note how little time board members have to give to a job in which they are supposed to set the course of great corporations. They worry that the increase in board power and responsibility has harmed relationships between chief executives and their boards.

Furthermore, "senior executives and CEOs tell us repeatedly that they question their outside directors' real understanding of their business," the authors report. No wonder. The definition of independence on boards "rules out just about anybody who has firsthand knowledge of the company and its industry," and it takes several years to get to know a company properly. "The ironic truth is that the more independent directors are on the board, the more reliant it is on management for information," the authors write.

Behind all these books lurks an even more ironic truth. Nearly always, nobody truly owns a public company. The institutional shareholders, at least in Anglo-Saxon countries, own small proportions of shares -- perhaps 5 to 6 percent at most. These institutions may own the shares on behalf of a future retiree, who may be quite unaware of a financial relationship with the company. If a single benign owner had control of the company (as is sometimes the case in Europe), and if all minority shareholders were treated as well as big ones, then the problem of governance would probably vanish.

Author profile:

Frances Cairncross (, rector of Exeter College at Oxford University, was formerly the management editor at The Economist. Her most recent books include The Death of Distance: How the Communications Revolution Is Changing Our Lives (Harvard Business School Press, 2001) and The Company of the Future: How the Communications Revolution Is Changing Management (Harvard Business School Press, 2002).

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