RJR Nabisco. CEO Tylee Wilson spent $68 million developing an ultimately disastrous
“smokeless” cigarette without telling the board. As chronicled in Barbarians at the Gate, even in an epic of corporate excess, Wilson’s directors were livid that he had far exceeded his spending limits without board approval.
“ “Why didn’t you tell us about this sooner?” Juanita Krepps demanded. “You trust hundreds of company people working on this project; you trust dozens of people at
an ad agency you’re working with; you trust outside suppliers and scientists – but you don’t trust us,” she said. “I, for one, absolutely resent that.”47
”
Wilson’s successor, F. Ross Johnson, behaved similarly. He handled his board with a combination of lavish perquisites and meager information. He arranged for his directors to rub shoulders with celebrities, use corporate planes and apartments, and he even endowed chairs at their alma maters with corporate funds. All this made it hard for directors to push him on tough questions.
Two Wall Street Journal reporters described the life of an RJR Nabisco board mem- ber: “A seat on RJR Nabisco’s board was almost like Easy Street: lucrative directors’ fees, fat consulting contracts and the constant loving care of the company’s president and chief executive offi cer, F. Ross Johnson. ‘I sometimes feel like the director of transporta- tion’ he once remarked, after ordering up a corporate jet for a board member. ‘But if I’m there for them, they’ll be there for me.’”48 While he was dazzling his handpicked directors, who could expect them to complain about his jets and country clubs?
Lone Star Industries. The Lone Star board ordered a special inquiry into the expenses of CEO James Stewart, following a Business Week article that criticized his lifestyle at a time of company cutbacks. The inquiry alleged that Stewart billed the company $1.1 million for
“purely personal expenses,” including taking his personal music teacher on Lone Star trips to three continents. The nine-man board, including such luminaries as Robert L. Strauss, later Ambassador to Russia, never scrutinized Stewart’s expenses. “You make an assump- tion that the CEO is honest and prudent,” said David Wallace, an outsider who succeeded Mr. Stewart. “We didn’t know what he was doing.” In 1990, Lone Star fi led for bankruptcy protection.49
Tambrands Inc. On June 1, 1993, Martin F. C. Emmett was fi red as the CEO of Tambrands Inc., the manufacturer of feminine hygiene products. Seemingly, his ouster was a rou- tine affair, given the increasingly troubled operations of the company. Market share for Tampax, the company’s leading product, had dropped 8 percent since mid-1992, and share value had declined by a third in less than six months. The board apparently fi red Emmett after he failed to outline a satisfactory recovery strategy.
Ten weeks after the fi ring, the Wall Street Journal reported that Emmett’s depar- ture had opened a walk-in closet full of skeletons. The story demonstrates the extent to which an executive can keep his board in the dark. The Wall Street Journal com- mented that the story raises “murky ethical issues hinged on friendships, business rela- tionships, and ultimately a board’s role in policing corporate operations.”50 The scandal was based on Emmett’s unusually close relationship with two principals in a consulting fi rm called Personnel Corp. of North America (PCA) – the fi rm that had originally landed Emmett his job at Tambrands. Immediately after Emmett’s departure, Tambrands ended
most of its contacts with PCA. PCA’s two principals were long-time friends of Emmett’s.
During his tenure, he steered contracts worth $2 million to PCA, including compensa- tion, pension administration, and outplacement. Not only did he retain the fi rm, but the two principals were placed on individual retainers that exceeded the salaries of most of Tambrands’ offi cers.
Emmett’s relationship with the PCA executives dated back to the mid-1970s, when PCA principals David R. Meredith and Jack L. Lederer conducted a compensation study for Standard Brands Inc., where Emmett was then an executive. When Standard Brands merged with Nabisco in 1981, Emmett referred PCA to Nabisco, and PCA was awarded a contract. When Emmett left Nabisco to chair the investment banking subsidiary of Security Pacifi c in New York, PCA followed also.
Even in those days, Emmett enjoyed the trappings of executive privilege. Emmett’s boss in the Standard Brands’ days was the same F. Ross Johnson described above, who went on from Standard Brands to be CEO of both Nabisco and, following the merger with R.J. Reynolds, RJR Nabisco. Barbarians at the Gate describes Emmett’s career at Standard Brands: “Johnson lavished gifts on Emmett, including a luxurious corporate apartment and an unlimited expense account.” When Emmett was being hunted to head Tambrands, at least one executive search fi rm report commented on Emmett’s apparent taste for the high life.
Lynn Salvage, a director who left the board in 1991, told the Wall Street Journal that once PCA had been retained, the two partners “did everything in their power to get [Emmett] the most lucrative compensation scheme they could.”51 Pearl Meyer, a compensation consultant with her own fi rm, described the PCA consultants as “very capable and energetic advocates on [Emmett’s] behalf.”52 Mr. Emmett’s stock options and benefi ts were more appropriate for a company twice Tambrands’ size. He received options to buy nearly 600,000 Tambrands shares over the years: in December of 1992 he exercised options for 150,000 shares, which he sold at a profi t of over $5 million.53 PCA also argued that the board was underpaid. Following this advice, the board voted to increase its annual retainer from $13,000 to $20,000, and to award themselves options on 1,100 shares annually.
After his ouster, Emmett still had ten years to exercise his remaining 450,000 stock options – a severance package negotiated by PCA in 1992. Following his departure, he continued to work in an offi ce provided by PCA in their Connecticut headquarters.
Warnaco. “Hard-driving corporate leader Linda Wachner is an example of what hap- pens when lack of self-discipline and arrogance converge in a leader. Rising quickly from department store buyer to be CEO of clothing manufacturer Warnaco, she led a lever- aged buyout of the company in 1986. Like Alexander she proved she could put together an empire but couldn’t make it last.”54 In 1992, Warnaco’s Linda Wachner was the only woman CEO in the Fortune 500. Once the lingerie company’s fi rst female vice president,
she became CEO by working with a group of investors on a hostile takeover in 1986.
She took the company public and led it to $1.95 billion in sales in 1998. She was one of the country’s highest-paid CEOs, receiving some $158 million from 1993 to 1999, but she made a number of mistakes. She was also distracted by serving as CEO of a second company. The compliant Warnaco board not only allowed her to spin it off but paid her the investment banking fee for brokering the transaction when they bought it back.
The company went into bankruptcy in 2000 and Wachner went to court to insist on her
$25 million severance package.
Hollinger. Former SEC Chairman Richard Breeden coined the term “corporate kleptocracy” in his report on the failures of oversight at Hollinger. He said,
“ [T]his story is about how Hollinger was systematically manipulated and used by its controlling shareholders for their sole benefi t, and in a manner that violated every concept of fi duciary duty. Not once or twice, but on dozens of occasions, Hollinger was victimized by its controlling shareholders as they transferred to themselves and their affi liates more than $400 million in the last seven years. The aggregate cash taken by Hollinger’s former CEO Conrad M. Black and its former COO F. David Radler and their associates represented 95.2 percent of Hollinger’s entire adjusted net income during 1997–2003 . . . . Hollinger went from being an expanding business to becoming a company whose sole preoccupation was generating current cash for the controlling shareholders, with no concern for building future enterprise value or wealth for all shareholders. Behind a constant stream of bombast regarding their accomplishments as self-described ‘proprietors,’ Black and Radler made it their busi- ness to line their pockets at the expense of Hollinger almost every day, in almost every way they could devise. The Special Committee knows of few parallels to Black and Radler’s brand of self-righteous and aggressive looting of Hollinger to the exclu- sion of all other concerns or interests, and irrespective of whether their actions were remotely fair to shareholders.
”
Enron. The Powers Report on Enron was produced under the direction of William Powers, Jr., Dean of the University of Texas Law School, who took a leave of absence to join the Enron board and, with the help of the SEC, uncover what went wrong:
“ Beyond the fi nancial statement consequences, the Chewco transaction raises sub- stantial corporate governance and management oversight issues. Under Enron’s Code of Conduct of Business Affairs, Kopper was prohibited from having a fi nancial or managerial role in Chewco unless the Chairman and CEO determined that his participation ‘does not adversely affect the best interests of the Company.’ Not- withstanding this requirement, we have seen no evidence that his participation was ever disclosed to, or approved by, either Kenneth Lay (who was Chairman and CEO) or the Board of Directors . . . .
Of course, not many executives try to push the limits as far as the CEOs of RJR Nabisco, Lone Star, Tambrands, Warnaco, Hollinger, or Enron. There are few examples of managers actively try- ing to mislead the board, and not many boards allow themselves to be kept in the dark for so long.
However, it is inevitable that executives will be more fully informed than the board, so there is inevitably an obvious problem deciding what information should be shared. For instance, see the Polaroid case study in chapter 7. In that case, the board was unaware that employee groups opposed swapping various compensation benefi ts for an enlarged employee stock ownership plan (ESOP).
Though a court ultimately determined that this information was immaterial, the example shows the kinds of confl icts of interest present in management–board relationships. (See also the Occidental Petroleum, WorldCom, and Adelphia case studies.)
The Board approved Fastow’s participation in the LJM partnerships with full knowledge and discussion of the obvious confl ict of interest that would result. The Board apparently believed that the confl ict, and the substantial risks associated with it, could be mitigated through certain controls (involving oversight by both the Board and Senior Management) to ensure that transactions were done on terms fair to Enron. In taking this step, the Board thought that the LJM partnerships would offer business benefi ts to Enron that would outweigh the potential costs. The prin- cipal reason advanced by Management in favor of the relationship, in the case of LJM1, was that it would permit Enron to accomplish a particular transaction it could not otherwise accomplish. In the case of LJM2, Management advocated that it would provide Enron with an additional potential buyer of assets that Enron wanted to sell, and that Fastow’s familiarity with the Company and the assets to be sold would per- mit Enron to move more quickly and incur fewer transaction costs . . . .
These controls as designed were not rigorous enough, and their implementa- tion and oversight was inadequate at both the Management and Board levels. No one in Management accepted primary responsibility for oversight; the controls were not executed properly; and there were structural defects in those controls that be- came apparent over time. For instance, while neither the Chief Accounting Offi cer, Causey, nor the Chief Risk Offi cer, Buy, ignored his responsibilities, they interpreted their roles very narrowly and did not give the transactions the degree of review the Board believed was occurring. Skilling appears to have been almost entirely un- involved in the process, notwithstanding representations made to the Board that he had undertaken a signifi cant role. No one in Management stepped forward to address the issues as they arose, or to bring the apparent problems to the Board’s attention.
”
Note also that the Enron board had a number of consulting fees and other related transactions involving directors, including charitable and political donations. Herbert S. Winokur, Jr., who was on the committee that approved the special purpose entities, was chairman of a water company set up with a $3 billion investment by Enron and whose board was made up of Enron directors. After it went public, Enron bought back the shares at more than double the market price. Furthermore, he was also a director of another company that did over $370,000 in business with Enron in 2000.
Technology has made additional sources of information more accessible than ever before. On- line discussions like Motley Fool, Yahoo Finance, have candid discussions about corporations and investments that provide a different perspective than the business press, analysts, and insiders.
Director Lucy P. Marcus recommends that boards take advantage of social networking online and check Twitter for updates on corporate governance.
“ Reading newspapers, the trade press, and getting reports from the accounting fi rms and law fi rms all have a role to play, but over the past several months I found that Twitter offers an equally if not more effective way to do this in real time. Following people on Twitter who have similar interests and mind sets about corporate governance literally feeds me the information that is on the cutting edge – the issues that are on people’s minds about anything that impacts our roles, and what other non-exec board directors make of them, ensuring I am better equipped for the challenges that all of us have to deal with on a regular basis.55
P R AC T I C A L L I M I T S : T I M E A N D M O N E Y ”
Directors’ ability to oversee management is further undermined by the fact that many directors are unable to devote suffi cient time or resources to the job. The following comment was made by two of America’s most astute observers of corporate boardrooms, Martin Lipton of Wachtell, Lipton, Rosen
& Katz in New York and Jay Lorsch, Senior Associate Dean of the Harvard Business School:
“ Based on our experience, the most widely shared problem directors have is a lack of time to carry out their duties. The typical board meets less than eight times annually. Even with committee meetings and informal gatherings before or after the formal board meet- ing, directors rarely spend as much as a working day together in and around each meet- ing. Further, in many boardrooms too much of this limited time is occupied with reports from management and various formalities. In essence, the limited time outside directors have together is not used in a meaning ful exchange of ideas among themselves or with management/inside directors.56
”
Lipton and Lorsch said that for a director to do his job properly, he/she needs to devote at least 100 hours annually on the job. More recent analyses suggest that directors must be able to devote at least 250 hours a year to each board of a company that has no signifi cant problems. When there is a crisis, that number can quickly increase to full time. However, because so many directors serve on more than one board, in addition to a full-time job, their time and attention are limited.
In the post-Enron era, even the busiest directors are now serving on fewer boards. In 2002, former Congressman William Gray held nine directorships at S&P 500 companies. By 2010 he held only four, with the maximum number of S&P 500 directorships held by any single director being six. Yet, in 2010, 11 directors on boards of S&P 500 companies still served on six boards.57
Aside from the issue of time commitments, many directors are unable or unwilling to commit money and buy stock. If directors are to be the representatives of shareholders then it is not too
much to demand that they be shareholders. Yet all too often, outside directors hold, at best, only small proportions of their net worth, and merely token holdings at worst. Even those with signifi cant holdings seldom make the same commitment shareholders do; most director stock is provided by the company as a part of their fees. According to the Board Analyst director database at Govern- anceMetrics International, about one-sixth of public company directors have no stock at all in the companies on whose boards they serve.58
Is this a suffi cient contribution – of time or money – for a director to make? Who is in the best position to determine what a suffi cient contribution is, and how can that determination be made effective?
In cases like these, despite concerns about reputation and personal pride, directors may not have enough incentive to be aggressive in evaluating and overseeing management. A 1989 polling of Fortune 1000 directors found that 69 percent of respondents agreed that “directors are likely to have the same commitment to representing shareholders’ interests regardless of their equity holdings.”59 In some other countries, holding stock is considered a confl ict of interest. However, evidence of a strong connection between signifi cant (relative to net worth) director investment and better board and company performance60 and shareholder pressure has resulted in changes. Now it is widely, if not universally, considered inappropriate in the United States for a director not to hold stock. Equilar found that 84 percent of Fortune 250 companies have stock ownership guidelines for directors, often based on a multiple of the retainer.
T H E Y E A R S O F CO R P O R AT E SC A N DA L S – B OA R DS B EG I N TO A SK F O R M O R E
Behind each of the corporate scandals of 2002 and thereafter and each of the companies involved in the sub-prime and derivative-fueled fi nancial meltdown of 2008 was a board that complained that they had not been told what was going on. The outside directors of Adelphia and Tyco said that they had no idea that the executives were using corporate funds for personal expenses. The outside directors of Enron said they did not know that the special purpose entities created to hide losses were based on fraudulent information. The directors of the Wall Street companies said that they thought the derivatives were calculated to remove risk, not to increase it.
If directors have a duty of care and a duty of loyalty, how do they meet the duty of care in making sure that they get the information they need? When, if ever, is an “I didn’t know” defense suffi cient for a director?
“ Who has the ultimate responsibility for the corporation? Who is genuinely responsible for a company? And who should have control – management or the board? Legally, the answer is clear; in the fi nal analysis the board has the responsibility for the company and is, therefore, the ultimate fountain of power. It is in practice, not in law, that the problems arise. Management has the expertise, infrastructure, and time to run and control the company. Given this degree of management domination, how can a board still exercise its responsibility? Can an entrepreneurial, energetic management run the