518 Making Key Strategic Decisions financing proposals. The board ensures that these proposals are consistent with the adopted strategy. If they are not, the company can drift off course and may get into serious trouble. DEALING WITH MAJOR CRISES In addition to its regular activities, a board occasionally must deal with crises. These usually arise unexpectedly and require special board meetings. We de- scribe two of these: terminating the CEO and dealing with takeover attempts. Terminating the CEO There are times when a board must replace the CEO. Failure to act in time is a major criticism of some boards. Although such criticism may be justified one should recognize that it is much easier for an outside observer to criticize than to be in the shoes of the directors who are faced with this decision. The decision to replace a CEO is subjective and usually emotional. Some- times there are compelling reasons for taking action—for example, when the CEO is becoming an alcoholic or when his or her corporate performance has dramatically deteriorated. In most instances, however, the case is not so clear. Earnings may not have kept pace with industry leaders because the board dis- couraged management from assuming additional debt that would have enabled the company to expand. Or perhaps the board supported a major acquisition that did not work out. In such instances, it is not obvious that the CEO is pri- marily at fault. There are, however, several important signals that can alert a board to question the CEO’s capabilities: • Loss of confidence in the CEO. If a significant number of directors have lost confidence in, or no longer trust, the CEO, the individual should be replaced. • Continuing deterioration in corporate results. Earnings may be signifi- cantly below industry norms or below the budget without an adequate ex- planation. The board must act before it is too late. • Organizational instability. A CEO who consistently has problems retain- ing qualified senior executives probably should be replaced. These problems are especially serious in the many new companies spring- ing up in information technology industries. In these industries, change is rapid, competition is severe, there are no track records on which to base judg- ment, and stock prices may change by huge percentages in a few days, reflect- ing changes in investors’ opinions about the company’s outlook. It is one thing for board members to begin to doubt the CEO’s capabili- ties, but it is quite another thing for them to demonstrate the courage and The Board of Directors 519 con sensus needed to take action. The CEO and the directors usually have worked together for some time; they are good, perhaps close, friends. For the CEO, dismissal is a catastrophic event. Taking action that will probably destroy the career of a business associate is a difficult decision. Replacing the CEO precipitates a crisis, not only for the board but also for the entire organization. When it happens, the board must be prepared to an- nounce a successor and to deal with the problems inherent in the transfer of ex- ecutive authority. Such action puts a major burden on the outside directors. Nevertheless, this is their responsibility to the shareholders and to the other constituencies of the corporation. For example, in early 2000, Jill E. Barad, CEO of Mattel Inc. the world’s largest toy manufacturer “resigned.” Ms. Barad built one of Mattel’s flagship products, the Barbie doll, from $250 million in annual sales in the mid-1980s to $1.7 billion in 1999. In the late 1980s, Barbie’s growth slowed, and Ms. Barad turned to acquisitions. Unfortunately, several acquisitions failed to live up to expectations. A loss of $82 million was recorded for 1999, and Mattel’s stock price dropped from a high of $45 in 1998 to a low of $11 in early 2000. The board acted, and Ms. Barad “resigned.” Apparently the board decided that there was no suitable successor within the company. They selected Robert Eckel, formerly CEO of Kraft Foods to be the new CEO. The turnover of CEOs of major corporations seems to be accelerating in the twenty-first century. Mr. William Rollinick, a Mattel board member and for- mer acting chairman, observed that when a chief executive stumbles, “there’s zero forgiveness. You screw up and you’re dead.” The investing community puts boards under considerable pressure to act when things appear to be going wrong. Sarah Telsik, executive director of the Council of Institutional Investors, which represents 110 pension funds with more than $1.5 trillion in assets, believes that underperforming CEOs were not losing their jobs fast enough. Too fast or too slow? A board should decide what is in the long-term best interests of the company and its stockholders. In some instances, immediate pressures should be resisted in favor of long-term considerations. In other cases, the board should “bite the bullet.” The decision is not easy. Unfriendly Takeover Attempts Another crisis event is the hostile, or unfriendly, takeover attempt. Board deci- sions vital to the company’s future—even its continued existence—must be made in circumstances in which emotions are high, vested interests are at stake, and advice is often conflicting. The business press reports daily the dra- matic developments of offers and counteroffers, tactics, and strategies as each side in the struggle seeks to gain an advantage. Boards and management spend much time preparing offensive and defensive plans. One of the problems in takeover situations is that the board, which repre- sents the shareholders, may have interests that differ from those of manage- ment. In most successful unfriendly takeovers, the senior managers of the 520 Making Key Strategic Decisions target company lose their jobs. A common accusation, therefore, is that man- agement resists takeovers in order to entrench itself, even though the deal would result in a handsome gain for the shareholders. In these situations, directors must exercise great care in making a deci- sion that is in the shareholders’ interests. This is not always easy to determine. What is the intrinsic value of the corporation? What is the real value of the “junk bonds” being offered to the shareholders? What consideration, if any, should the directors give to the interests of other parties—employees, commu- nities, suppliers, and customers? In an unfriendly takeover attempt, the directors of the target company must rely on legal advice since takeovers inevitably lead to lawsuits. The board also depends on expert advice from investment banks about the value of the company and the true value of offers to acquire it. In practice, when a hostile takeover is initiated, the target company’s lawyers, investment bankers, accountants, and other advisers, together with the board and management, become involved in a hectic struggle that can last for weeks or months. It is a sixteen-hour-day, seven-day-week effort; nearly everything else yields to the intense preoccupation with survival or striking the best possible deal. BOARD COMMITTEES Much of the board’s work is done in committees. They meet before board meetings, hear reports, and prepare summaries and recommendations for full board action. In this section, we describe the activities of the three commit- tees—compensation, audit, and finance—that deal with finance and account- ing matters. COMPENSATION COMMITTEE The board determines the compensation of the CEO and the other principal corporate officers. In many boards, a compensation committee, composed of outside board members, analyzes what compensation should be and makes its recommendations to the full board. The SEC requires that a section of the proxy statement, issued prior to the annual meeting of shareholders, must describe the work of the compensa- tion committee, the decisions on compensating senior executives, reasons for the decision, their compensation for the past three years, and comparisons with other companies in the industry. CEO Compensation When the board sets the CEO’s compensation, it is establishing a compensation standard for managers throughout the company. Their compensation is inte grally The Board of Directors 521 related to the CEO’s and this, therefore, is the single most important compen- sation decision the board must make. In most instances this decision is not easy. Most CEOs are ambitious and competitive, and compensation is their report card. Since proxy statements dis- close the compensation of all CEOs of public companies, each CEO is able to see just where he or she stands in relation to others. Virtually every CEO would like to stand higher on that list. Compensation committees consider three principal factors. The CEO’s compensation should: (1) be related to performance, (2) be competitive, and (3) provide motivation. Compensation includes not only salary but also perquisites and, in most companies, long-term incentive arrangements, such as stock options or performance-share plans. These plans, however, are far from perfect, and compensation committees constantly struggle to find new arrangements or formulas in an effort to relate compensation more closely to performance. Performance The CEO’s compensation should be related to performance. Superior perfor- mance should be rewarded with high compensation, while poor performance, if it does not warrant dismissal, should at least result in decreases or minimal increases in compensation. There is justification for the claim that in some companies top-executive compensation continues to climb without regard to performance. The problem is complex. In theory, the CEO should be rewarded for increasing the share- owner’s wealth over the long term. Although this is a splendid generalization, the criterion is hard to measure, especially on a year-to-year basis. Competitive Range Compensation committees look at the CEO’s compensation relative to that of competitors. They can be sure that their CEO has this information and is likely to be unhappy if the compensation is perceived as unfair or not competitive. There are many sources for salary information. They include proxy state- ments from similar organizations and published surveys. Some consulting orga- nizations specialize in executive compensation; they provide data and advice on these matters. In the end and with all of the information at hand, the com- mittee makes its judgment as to where in the competitive spectrum they want the CEO’s compensation to fall. Motivation Compensation committees ask themselves, How can we structure a compensa- tion package that motivates the CEO to do what the board expects? If the company has a plan to move aggressively and take unusual risks in the near term, with the possibility of significant long-term payoff, the committee can 522 Making Key Strategic Decisions structure a compensation plan for the CEO that will reward that kind of be- havior. For example, the CEO might have a multiyear contract that provides as- surance of employment during the high-risk phase, as well as a long-term stock option plan. At the other extreme, a mature company might be interested in moderate growth but steady dividends. The compensation committee might then structure a plan weighted heavily toward a fixed salary, reviewed annu- ally, with only modest incentive features. There are many types of compensation arrangements: base salary re- viewed annually, base salary plus annual discretionary bonus, base salary with bonus based on a formula, stock option plans, performance share plans, and multiyear incentive plans. Benefits play an important part in CEO com- pensation arrangements, especially retirement programs. Each plan has its own motivational features, and the compensation committee attempts to structure a plan that provides the motivation for the CEO that the board wants to generate. Compensation Reviews In addition to deciding the CEO’s compensation, the committee also deter- mines compensation for the other senior executives—that is, corporate officers and others whose salary is above a stated level. The review process usually takes place at a meeting that brings together the compensation committee, the CEO, and the staff officer concerned with compensation and personnel policies. At this meeting the CEO describes the compensation history of, and makes a recommendation for, each executive. Usually, a few of the recommen- dations are discussed, and a few changes may be made. For the most part, how- ever, the committee accepts the CEO’s recommendations. Nevertheless, the review process is important. It enables the compensation committee to be sure that the CEO is following sensible guidelines and consistent policies and is not playing favorites. It also serves to remind the CEO that recommendations to the committee must be justified. Board Remuneration The compensation committee also recommends compensation arrangements for the board members. Obviously, this is a delicate matter because the board is disbursing company funds (actually shareholder funds) to its members. Directors’ compensation is disclosed on the annual proxy statement. Most companies would like to see their directors “respectably” compensated and, while compensation usually is not the compelling reason for holding a director- ship, directors want to feel that they are being compensated on a competitive basis. On the other hand, most directors want to feel that their compensation is not excessive and that they will never be criticized for compensating them- selves improperly. The Board of Directors 523 Much survey information is available on board retainer fees, board meet- ing fees, and compensation for committee chairs to help reach a balanced level of compensation. AUDIT COMMITTEE The audit committee is responsible for ensuring that the company’s published financial statements are presented fairly in conformance with generally ac- cepted accounting principles (GAAP), and that the company’s internal control system is effective. Furthermore, the audit committee deals with important cases of alleged misconduct by employees, including violations of the company’s code of ethics. It also ratifies the selection of the company’s external auditor. All companies listed on major stock exchanges are required to have audit committees, and most other corporations have them. The SEC requires at least three members of the audit committee to be “financial literate or to become fi- nancial literate within a reasonable period of time.” 2 Responsibility Although the full board can delegate certain functions to the audit committee, this delegation does not relieve individual board members of their responsibil- ity for governance. In its 1967 decision in the BarChris case, the federal court emphasized this fact: 3 Section 11 [of the Securities Act of 1933] imposes liability in the first instance upon a director, no matter how new he is He is presumed to know his re- sponsibility when he became a director. He can escape liability only by using that reasonable care to investigate the facts which a prudent man would employ in the management of his own property. Directors have directors’ and officers’ (D&O) insurance, but this only partially protects them against loss from lawsuits claiming that they acted im- properly. Recent decisions suggest that courts are increasingly willing to exam- ine directors’ decisions. For example, the shareholders of Oxford Health Care sued the company for misleading financial statements. Oxford’s stock price thereupon fell by 50%, a $14 billion drop in market value. The company re- portedly agreed to settle the case for $2.83 billion. In the 1990s, there were more than 100 fraud actions annually against SEC firms and many more against smaller firms. Audit committee members walk a tightrope. On one hand, they want to support the CEO—the person whom the board itself selected. On the other hand, they have a clear responsibility to uncover and act on management in- adequacies. If they do not, the entire board of directors is subject to criti- cism at the very least and imprisonment at worst. Their task is neither easy nor pleasant. 524 Making Key Strategic Decisions Published Financial Statements The audit committee does not conduct audits; it relies on two other groups to do this. One is the outside auditor, a firm of certified public accountants. All listed companies are required to have their financial statements examined by an outside auditor, and most other corporations do so in order to satisfy the re- quirements of banks and other lenders. The other group is the company’s in- ternal audit staff, a group of employees whose head reports to a senior officer, usually the CEO or chief financial officer (CFO). Selection of Auditors Ordinarily, management recommends that the current auditing firm be ap- pointed for another year and that its proposed audit scope and fee schedule be adopted. After some questioning, the audit committee usually recommends ap- proval. The recommendation is submitted to shareholders in the annual meet- ing. Occasionally, the audit committee gives more than routine consideration to this topic. There may be advantages to changing auditors, even when the relationship between the audit firm and the company has been satisfactory for several years. One advantage is that the process of requesting bids from other firms may cause the current firm to think carefully about its proposed fees. How- ever, the public may perceive that a change in outside auditors indicates that the superseded firm would not go along with a practice that the company wanted. The SEC requires that when a new auditing firm is appointed, the rea- son for making the change must be reported on its Form 8-K. Also, because a new firm’s initial task of learning about the company requires management time, management may be reluctant to recommend a change. Public accounting firms often perform various types of consulting en- gagements for the company: developing new accounting and control systems, analyzing proposed pension plans, and analyzing proposed acquisitions. Fees for this work may exceed the fees for audit work. The SEC and the stock ex- changes have strict rules that prohibit a public accounting firm from conduct- ing an audit if it has consulting engagements with the corporation that might affect the objectivity of the audit. Some auditing firms have responded to these rules by setting up a separate firm to conduct these engagements. The Audit Opinion In its opinion letter, the public accounting firm emphasizes the fact that man- agement, not the auditor, is responsible for the financial statements. Almost all companies receive a “clean opinion”; that is, the auditor states that the finan- cial statements “present fairly, in all material respects” the financial status and performance of the company in accordance with GAAP. Note that this state- ment says neither that the statements are 100% accurate nor whether different The Board of Directors 525 numbers would have been more fair. 4 The audit committee’s task is to decide whether the directors should concur with the outside auditor’s opinion and, oc- casionally, to resolve differences when auditors are unwilling to give a clean opinion on the numbers that management proposes. Management has some latitude in deciding the amounts to be reported, especially the amount of earnings. Since managers are human beings, it is reasonable to expect them to report performance in a favorable light. Examples of this tendency, discussed next, are: (1) accelerating revenue, (2) smoothing earnings, (3) reporting unfavorable developments, and (4) the “big bath.” Much of the discussion of these topics is complicated by differences in the meaning of “materiality.” The SEC has tried to lessen the reliance on material- ity by publishing detailed descriptions of what the term means. Accelerating Revenue A company may go to great lengths to count revenues actually earned in future periods as revenues in the current period, even though this decreases the next period’s revenues. The following example illustrates: The SEC sued two executives of Sirena Apparel Group for misleading revenue estimates for the quarter ended March 31, 1999. They instructed employees daily to set back the computer clock that entered the dates on invoices until a satisfactory revenue amount was recorded. Invoices dated from April 12, 1999, were set back. 5 Not all attempts to accelerate revenue recognition are improper. There are documented stories of managers who personally worked around the clock at year-end, packing goods in containers for shipment. This enabled them to count the value of the packed goods as revenue in the year that was about to end. Counting goods that actually were shipped as revenue is legitimate. Smoothing Earnings There is a widespread belief (not necessarily supported by the facts) that ideal performance is a steady growth in earnings, certainly from year to year, and desirably from quarter to quarter. Within the latitude permitted by GAAP, therefore, management may wish to smooth reported earnings—that is, to move reported income from what otherwise would be a highly profitable pe- riod to a less profitable period. The principal techniques for doing this are to vary the adjustments for inventory amounts and bad debts, and estimated re- turns, allowances, and warranties. The audit committee, therefore, pays considerable attention to the way these adjustments and allowances are calculated and to the resulting accounts receivable, inventory, and accrued liability amounts. Changes in the reserve percentages from one year to the next are suspect. The audit committee toler- ates a certain amount of smoothing, within limits. Indeed, it may not be aware 526 Making Key Strategic Decisions that smoothing has occurred. Outside these limits, however, the committee is obligated to make sure that the reserves and accrual calculations are reasonable. Management may also recommend terminology that does not affect net income but does affect income from operating activities. Examples are earn- ings before marketing costs, cash earnings per share, earnings before losses on new products, and pro forma earnings. None of these terms is permitted in GAAP; they appear in press releases and speeches. Reporting Unfavorable Developments The Securities and Exchange Commission requires that its Form 8-K report be filed promptly whenever an unusual material event that affects the financial statements becomes known. The principal concern is with the bottom line, the amount of reported earnings. Management, understandably, may be inclined not to report events that might (or might not) have an unfavorable impact on earnings. These include the probable bankruptcy of an important customer, an important inventory shortage, a reported cash shortage that might (or might not) turn out to be a bookkeeping error, a possibly defective product that could lead to huge returns or to product liability suits, possible safety or environ- mental violations, an allegation of misdeeds by a corporate officer, the depar- ture of a senior manager, or a lawsuit that might (or might not) be well founded. It is human nature to hope that borderline situations will not actually have a material impact on the company’s earnings. Furthermore, publicizing some of these situations may harm the company unnecessarily. Disclosing a significant legal filing against the company is nec- essary, but disclosing the amount that the company thinks it might lose in such litigation, in a report that the plaintiff can read, would be foolish. In any event, the audit committee should be kept fully informed about all events that might eventually require filing a Form 8-K. One might think that the CEO would welcome the opportunity to inform the board of these events because this shifts the responsibility for disclosure to the board. But managers, like most human beings, prefer not to talk about bad news if there are reason- able grounds for waiting a while. Occasionally, a manager may attempt to “cook the books,” that is, to pro- duce favorable accounting results by making entries that are not in accordance with GAAP. The audit committee must rely on the auditors (or occasionally on a whistle-blower) to detect these situations. The Big Bath A new CEO may “take a big bath”; that is, the accounting department may be re- quired to write off or write down assets in the year he or she takes over, thereby reducing the amount of costs that remain to be charged off in future periods. This increases the reported earnings in the periods for which the new manage- ment is responsible. Since the situation that led to the replacement of the former The Board of Directors 527 manager may justify some charge-offs, and since the directors don’t want to dis- agree with the new chief executive officer during the honeymoon period, this tactic is sometimes tolerated. If the inflated earnings lead to extraordinarily high bonuses in future years, the board may regret its failure to act. Audit Committee Activities In probing for the possible existence of any of the situations described above, the audit committee takes two approaches. First, it asks probing questions of management: Why has the receivables-reserve percentage changed? What is the rationale for a large write-off of assets? Then, and much more important, the committee asks similar questions of the outside auditors. The audit committee usually meets privately with the outside auditors and tells them, in effect, “If you have any doubts about the numbers, or if you have reason to believe that management has withheld mate- rial information, let us know. If you don’t inform us, the facts will almost cer- tainly come to light later on. When they do, you will be fired.” A more polite way of probing is to ask the following: “Is there anything more you should tell us? What were your largest areas of concern? What were the most important matters, if any, on which you and management differed? Did the accounting treatment of certain events differ from general practice in the industry? If so, what was the rationale for the difference? How do you rate the professional competence of the finance and accounting staff?” Usually, these questions are raised orally. Because the auditors know from past experience what to expect, they come prepared to answer them. Some audit committees provide their questions in writing prior to the meeting. Although cases of improper disclosure make headlines, they occur in only a tiny fraction of 1% of listed companies. Most such incidents reflect poorly on the work of the board of directors and its audit committee. Increasingly, the courts penalize such boards for their laxity. Directors are aware of the fact that when serious misdeeds surface, the CEO often leaves the company, but the directors must stay with the ship, enduring public criticism and the blot on their professional reputation. Their lives will be much more pleasant in the long run if they act promptly. Quarterly Reports In addition to the annual financial statements, the SEC requires companies to file a quarterly summary of key financial data on Form 10-Q. Because the timing of the release of this report usually does not coincide with an audit committee meeting, most audit committees do not review it. Instead, they ask the CEO to inform the committee chair if there is an unusual situation that affects the quar- terly numbers. The chair then decides either to permit the report to be published as proposed or, if the topic seems sufficiently important, to have the committee meet in a telephone conference call or an e-mail exchange to discuss it. . the shareholders? What consideration, if any, should the directors give to the interests of other parties—employees, commu- nities, suppliers, and customers? In an unfriendly takeover attempt, the. option plans, performance share plans, and multiyear incentive plans. Benefits play an important part in CEO com- pensation arrangements, especially retirement programs. Each plan has its own motivational. Usually, a few of the recommen- dations are discussed, and a few changes may be made. For the most part, how- ever, the committee accepts the CEO’s recommendations. Nevertheless, the review process