Boards of directors aren’t supposed to second-guess routine management decisions, but they do have a mandate to step in when a company’s survival is at stake. Corporate governance experts say that oversight broke down with the implosion of Wall Street. As the traditional investment banking business model collapsed — Merrill Lynch & Co. was sold to Bank of America Corp., Bear Stearns Cos. was taken over by JPMorgan Chase & Co., Lehman Brothers Holdings went bankrupt, and Goldman Sachs Group and Morgan Stanley converted into bank holding companies — “the right questions weren’t being asked in the boardroom,” says Richard Bennett, chief executive of the Corporate Library, a Portland, Maine–based independent governance watchdog. “You have enterprises that took on inordinate amounts of risk, with [board] compensation packages that favored those actions.”
The need for better board oversight is clear. It’s only part of a series of reforms that will be necessary in the wake of the credit crisis. But the boardroom is a good place to start. Corporate directors have firsthand knowledge of executives and financials. They also have relatively more resources than do overworked and underpaid government regulators. Directors earn an average of $205,000 for eight meetings a year, according to New York–based executive search firm Spencer Stuart. That ought to be enough to attract good talent.
The crucial issue is making sure that directors take an objective view of management. In theory, board members work in the interests of shareholders. But they are nominated by management — some, of course, are management — and investors rubber-stamp those choices far too often. In practice, many directors can be too close to the people that they are supposed to govern.
Experts say that directors would be more effective if they received a greater percentage of their compensation in stock, as an incentive to take a longer-term view. Goldman, which has come through the credit crisis better than most, pays 92 percent of directors’ compensation, which averaged $640,846 last year, in stock and options. Other companies have been moving in that direction, albeit incrementally. Spencer Stuart says that stock as a percentage of average director compensation increased from 39 percent in 2006 to 41 percent in 2007.
Companies are adopting pay scales too. “Ten years ago every director [at a company] got the same pay, more or less,” says Paula Todd, a managing principal in the executive compensation group at Stamford, Connecticut–based consulting firm Towers Perrin. The chairs of audit and risk committees are now often paid more than other directors.
Companies need to make sure that the incentives built into stock- and options-based compensation plans aren’t negated by hedging strategies that are designed to offset share price declines, warns Gian Luca Clementi, an assistant professor of economics at New York University’s Stern School of Business. He believes that companies should be required to disclose such hedging activities on the part of directors. “These variables are of paramount importance and are not emphasized enough,” he warns. “If the hedging strategies are successful, then all the issues of incentives are thrown out the window.”
Directors of complex financial institutions would benefit from more professional support; they can hire their own lawyers, investment bankers and other advisers. A group of academics, former executives and former board members could help establish financial guidelines the way that the Group of Thirty offers economic advice, giving directors a rationale for overruling management. Phil Phan, a professor at the Johns Hopkins Carey School of Business in Baltimore, advocates “more scrutiny around agents of the boards, such as consultants, audit firms, law firms and outside banks.”
The ultimate responsibility for governance, though, lies with shareholders. It’s up to them to hold directors to account.
