Advising boards to be a "check and balance" of senior management is going to an extreme

February 2000

As a result of today’s litigious society, have corporate counsel gone too far in advising boards to serve as a "check and balance" of management? I believe we corporate counsel have gone too far if the result is creation of an adversarial relationship between the board and senior management except in the rare occasions when a level of due diligence greater than oversight is necessary.

A litigious society has driven legal advice to an extreme

Society is more litigious today. We corporate counsel read cases of billion dollar jury awards against directors of the parent corporation of U-Haul and news articles about billion dollar settlements agreed to by directors of an investment banking firm. More recently we have read about criminal liability with FBI agents invading the corporate offices of Archer-Daniels-Midland, corporate officers of a pharmaceutical company being arraigned in handcuffs for alleged violation of federal drug laws, and directors and officers of hospitals being restrained from the premises of a hospital for alleged health care fraud.

As a result, we corporate counsel have responded by recommending increased "oversight" by boards of senior management. Accordingly, we have advised:

  • increasing the number of independent directors of the board so that substantially more than a majority would consist of independent directors;

  • defining "independence" as excluding anyone who is or has been a member of senior management or who has a close family or similar relationship with such a member;

  • separating the chair of the board and chief executive officer of the organization in different persons;

  • having a "lead" or "contact" outside director designated as the primary representative of, focal point for, outside directors for boards where the chair is affiliated with senior management;

  • eliminating senior management (sometimes with the exception of the chief executive officer) for consideration as board members; and

  • annual or other periodic evaluations by the board of the chief executive officer and sometimes of others in senior management.

All of these are valuable unless taken to an extreme.

Reacting to the Congressional drive to criminalize certain fraudulent business conduct by organizations, we corporate counsel have advised establishing corporate compliance programs modeled on guidelines of the United States Sentencing Commission as a precautionary measure in case an organization is found guilty of criminal felonies and certain misdemeanors under federal law.1  These programs by definition are to be "designed, implemented, and enforced" to "detect" and "prevent" "criminal conduct."2  The tone of these words is prosecutorial. Whether or not intended, the language appears to call for a "check" on senior management’s conduct even when criminal or fraudulent conduct is not suspected.

Too often the tone of compliance programs is prosecutorial and the effect, whether or not intended, is an expansion of the board’s role from that of "oversight" to that of a "check and balance." In fact, some of us are now advising that boards go beyond "oversight" and in fact serve as a "check" of senior management. In arguing the issue, they purportedly rely upon corporate law. However, a "check and balance" government is not a concept found in corporate statutes; it is not emphasized in corporate policies and guidelines of institutional investors and business or professional associations with experience or expertise in corporate governance; and under most circumstances it is not productive for a business enterprise.

The scheme of corporate law does not include "check and balance" governance

Although under most states’ corporate statutes, all of a corporation’s power and authority are vested in its board of directors, almost every state’s corporate statute recognizes that a board does not directly exercise that power and authority; power and authority are exercised "under the direction" of the board.3   In reality, a board exercises that power and authority under its direction by delegating to others, principally to officers and senior management. In fact, almost every state’s corporate statute requires a corporation to have officers to whom the board delegates.4  Most states’ corporate statutes reflect this reality by entitling the board as well as individual directors to rely upon information, opinions, reports, or statements, including financial statements and other financial data, that are prepared or presented by officers or senior management.5   In fact, these statutes encourage such delegation because boards are "fully protected" when properly delegating and then relying upon such delegation,6' and this is broader protection than boards are entitled for their own acts under the business judgment rule.

Neither the term nor concept "check and balance" appears in any corporate statute.

Corporate governance guidelines do not emphasize check and balance concepts

A number of institutional investors and business or professional associations with experience or expertise in corporate governance have issued polices or guidelines for board responsibilities. These include:

  • American Law Institute with its Principals of Corporate Governance: Analysis and Recommendations (1994);

  • American Society of Corporate Secretaries, Inc. with its Current Board Practices – Second Study (March, 1998);

  • The Business Roundtable with its Statement on Corporate Governance (September, 1997);

  • California Public Employees’ Retirement System with its Corporate Governance Core Principles and Guidelines (April, 1998);

  • The Council of Institution Investors with its Core Policies, General Principles and Positions (March, 1998);

  • National Associate of Corporate Directors with The NACD Board Guidelines (1998); and

  • Teachers Insurance and Annuity Associates – College Retirement Equities Fund with its TIAA-CREFF Policy Statement on Corporation Governance (October, 1993).

These policies and guidelines promote the same increasing of the number of independent directors, defining of "independence," and establishing of annual or other periodic evaluations of the chief executive officer as are advised by corporate counsel. They also promote the concepts of boards serving as a "sounding board" for ideas of senior management; "providing advice and counsel to management"7; making available to senior management diversity "in geographic origin, gender, ethnic background and professional experience" to senior management; and "acting as a resource for management . . . through advice, mentoring and introductions".8

Neither the term nor concept "check and balance" appears in any of these guidelines or otherwise as a criteria for rating management for institutional investors.

Check and Balance Attitude Is Not Productive

"Check and balance" is a Constitutional government concept and not a business one. And look how well it is operating today in government, with recurring conflicts between the President and Congress nationally and among the Governor, the State Assembly, and the Supreme Court in various states.

Unless there is reason to believe that authority is being exceeded or transactions are not being properly recorded, my experience is that a "check and balance" attitude is unproductive for business in that:

  • It requires an internal focus to resolve the check and balance rather than an external focus. Most businesses have enough competition externally without creating competition internally.

  • It fosters an adversarial relationship between the board and the chief executive officer or senior management. A "partnering" relationship is more productive than an adversarial one.

  • It tends to focus attention on the "expense" side of operations and the liability side of financial condition. Growth in revenue and net assets cures most ills.

  • It results in a competitive disadvantage because decisions are debated rather than timely made. In today’s competitive environment, businesses must be able to timely respond.

  • It tends to deny access to resources and reject new ideas. The role of management should be getting the various segments or operations of the business the resources they need rather than denying them.

  • It tends to focus negatively on "what you can’t do" rather than positively on "doing what you can do best."

Conclusion

Notwithstanding today’s litigious society, what businesses need is leadership and not checks and balances. We need to focus on positives, such as "what each of us does best" and not "what you can’t do without my permission." We need to promote, rather than deny, "availability resources" to those segments or operations of the business that offer the best return. We need timely decisions to remain competitive with a changing marketplace and environment and not debates. We need to remember that focusing on revenue growth to make the pie bigger cures most ills that may require checks and balances. We need to foster partnerships and team work rather than adversarial relationships. We need an external focus because we have enough competition with the outside world.

footnotes:

1.    In the Sentencing Reform Act of 1984 (which is Title II of the Comprehensive Crime Control Act of 1984), Congress directed the United States Sentencing Commission to review and adopt guidelines for federal judges in sentencing persons, expressly including organizations, convicted of almost any criminal felony and certain misdemeanors under federal law. The Commission adopted such guidelines which are set forth in the United States Sentencing Commission Guidelines Manual (1998), referred to as the USSG. Chapter 8 of the USSG deals with sentencing of organizations and provides for a reduction in sentence if an organization had in place at the time of the violation an "effective program to prevent and detect violations of law." Notes to the USSG define the seven steps that it considers requisite to an "effective program." These programs are generally known as "corporate compliance programs."

2.    See Note 3(f) to USSG §8A1.2 which states that "An ‘effective program to prevent and detect violations of law’ means a program that has been reasonably designed, implemented, and enforced so that it generally will be effective in preventing and detecting criminal conduct. Failure to prevent or detect the instant offense, by itself, does not mean that the program was not effective. The hallmark of an effective program to prevent and detect violations of law is that the organization exercised due diligence in seeking to prevent and detect criminal conduct by its employees and other agents."

3.     See 8 Delaware Laws Annotated §141(a) which provides that "The business and affairs of every corporation... shall be managed by or under the direction of a board of directors." (Emphasis added.) See Ohio Revised Code §1701.59(A) which provides that "the authority of a corporation shall be exercised by or under the direction of its directors." (Emphasis added.)

4.    See 8 Delaware Laws Annotated §142(a) which provides that a corporation "shall have such officers with such titles and duties as shall be stated in the bylaws or in a resolution of the board of directors which is not inconsistent with the bylaws." See also, Ohio Revised Code §1701.64 which requires each Ohio corporation to have "officers" consisting of at least a president, secretary, and treasurer having, respectively, "such authority and perform such duties as are determined by the directors…."

5.    See 8 Delaware Laws Annotated §142(e) which provides that "A member of the board... or a member of any committee... shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports, or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation." See also, Ohio Revised Code §1701.59(B) which provides "In performing his duties, a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, that are prepared or presented by:

(1) One or more directors, officers, or employees of the corporation who the director reasonably believes are reliable and competent in the matters prepared or presented;

(2) Counsel, public accountants, or other persons as to matters that the director reasonably believes are within the person's professional or expert competence;

(3) A committee of the directors upon which he does not serve, duly established in accordance with a provision of the articles or the regulations, as to matters within its designated authority, which committee the director reasonably believes to merit confidence."

6.    See, for example, 8 Del C A §142(e) which provides that "A member of the board... or a member of any committee... shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation." (Emphasis added.)

7.    See "II. Functions of the Board, Advising Management" of the Business Roundtable Statement on Corporate Governnance (September 1997)

8. See "The CEO and Other Senior Managers" of The NACD Board Guidelines (1998).

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