Character in corporate governance

The View From Taft, Business World

November 14, 2002 (with edits and some updates)

What is to be done about today’s crisis of confidence in business caused by the global slowdown and the string of high-profile corporate scandals filling the headlines? One approach is the tightening of laws on corporate transparency and accountability. Another solution being pursued by government and the private sector is the strengthening of corporate governance.

Corporate governance is commonly defined as the system by which various stakeholders ensure the prudent management, increased value, and competitiveness of a company. The main mechanism meant to achieve these goals is the oversight of the company’s management team by a board of directors.

While its value is obvious in theory, good corporate governance is easier said than done. For one thing, boards of directors are predominantly composed of managers themselves, and so objective oversight over management is nearly impossible to do. Secondly, boards mainly try to influence management through a few meetings in a year. Because of the infrequency and shortness of such meetings, even the hardest-working directors have difficulty making a dent on the moral tone of a corporation. Thus, boards tend to simply ratify what management wants to do.

Given these structural difficulties, it seems unfair to expect so much from board directors. And yet, such expectations are a given. The SEC’s Code of Corporate Governance states: “A director’s office is one of trust and confidence. He should act in the best interest of the corporation in a manner characterized by transparency, accountability, and fairness. He should exercise leadership, prudence, and integrity in directing the corporation towards sustained progress over the long term.” In short, directors are the “conscience” of the company.

To better understand the board’s “conscience” role, we need to appreciate a fundamental feature of business in a democratic society. This feature, called the “social contract,” embodies the deal between business and society. A business commits to behave in a trustworthy manner towards all its stakeholders: giving fair and attractive returns for investors, repaying creditors, providing valuable products and services to customers, caring for the needs of employees, and otherwise being a good corporate citizen. In return, society, through government, grants a business the license to operate.

Although not a legal contract, the social contract has implicit expectations that test a company’s commitment – and character – to do right by its stakeholders. In fact, the power of the social contract to prove a company’s character rests on the fact that it is not compulsory by law. When one evaluates the character of a person, one looks for the person’s commitment to the values underlying a rule rather than mere compliance to its letter.

For example, according to published reports, Enron had a thick code of ethics, which, unfortunately, the board ignored when conflicts of interest arose. As explained by philosophy professor Alasdair MacIntyre of the University of Notre Dame, no code of ethics can work without a culture of ethics. And a culture of ethics is what the board needs to establish within the company. Only when such a culture exists can the company be considered truly trustworthy. And only when enough businesses are seen by the public as trustworthy will business confidence return once again.

But how does a director begin to influence and shape the core values that comprise the company’s culture? Social scientists have extensively studied cultural values leadership in business organizations. Their findings suggest some strategies that directors can put to good use in shaping the values of the company over the long run. These strategies can be summarized using the verbs ATTEND, ASK, REACT, and REWARD.

ATTEND. This refers to how directors spend their time and what they pay attention to. Being present in board meetings and intently listening to all presentations are two of the most potent values-shaping tools of the director. This also includes being around and interested during important events such as strategic planning sessions, where the long-term direction of the company is mapped. This sends the message: “Be careful about what you present to me. I am paying very close attention.” Conversely, a director who is often absent or pays little attention during meetings sends the strong message that what management is doing is not worth his time and, by default, management can do as it pleases.

ASK. This refers to the questions directors ask during meetings. A director sends a strong value message by consistently asking questions that verify management’s attention to ethical concerns and other cherished values of the company. To be sure, the pressure to conform and not to rock the boat can be very high in a board. Even among the most competent and intelligent groups, the phenomenon of groupthink has been noticed by behavioral scientists. Groupthink is the tendency of members of decision-making groups to think alike and interpret information and events in similar ways while ignoring negative information and suppressing conflict. This leads to faulty decision-making. This tendency is especially common in groups where members have a high need to please each other. In the case of board directors, this may very well be happening when a director’s appointment is strongly influenced by management itself. The director has a strong incentive to stay in the good graces of management. Also, a director who raises uncomfortable questions can prolong meetings and risk the ire of fellow directors. But rubberstamp boards won’t do if the intention is to build a culture of ethics. The director must be, in the words of the SEC, assiduous. In the vernacular, it’s simply being makulit. “Why do we have this much debt?” “What risks are we facing with this expansion?” “How are we meeting our safety obligations to our customers with this new product?”

REACT. This refers to how directors react to critical incidents. Whether faced with good or bad news, a director is expected to exercise independent judgment and to take a position that promotes the interest of the company and its stakeholders. For example, if revenue targets are being met through possible revenue manipulation, a director must react clearly to show that such a practice is unacceptable. Edmund Burke once said, “All it takes for evil to continue is for good men to do nothing.” Clearly, directors must break free of groupthink. The idea of an independent director is premised on this. Even executive directors must be capable of independent judgment and take positions that may be unpopular. But it isn’t enough to be independent-minded and be mistaken for an obstructionist. A director must advocate the core values of the company in pursuit of its duties to its stakeholders.

REWARD. Many of the poor decisions of companies have been due to shady accounting practices meant to manipulate financial performance reports. Because their financial rewards are based on these reports, managers have a powerful temptation to misrepresent performance. A board has a huge influence in this area. First, it approves, through the compensation committee, the financial incentives in the first place. Second, it approves the appointments of all top managers. Used properly, such powers can counterbalance the temptations to misrepresent performance. Of course, understanding the real performance picture on which to base rewards will mean a lot of homework for directors. But this is the price of moral leadership. Third, directors should not forget their power to reward managers who walk away from questionable business. An encouraging remark or even a commendation on the record goes a long way in strengthening the ethical culture.

It is a sobering thought that during these times of powerful transnational corporations, globalization, and lightning-speed communications, our ability to get out of the hole we are in rests greatly on the strength of character of a few selected men and women. But only character based on sound values, and not laws alone, will restore confidence in business. To paraphrase French sociologist Emile Durkheim: when values are sufficient, laws are unnecessary; when values are insufficient, laws are unenforceable.