That was then ... this is now: what progress has been made in corporate governance over the past three decades? To find out, we asked several Directors & Boards authors to revisit their classic articles.

Improvement, yes, but dangers lurk

Ed. Note: Roderick M. Hills was chairman of the Securities and Exchange Commission when DIRECTORS & BOARDS was founded in 1976. He has been a leading advocate of effective corporate governance throughout a distinguished career in the public and private sectors. By 1994, when he authored "Boards Can Work!" for the journal, he had served as a director of 10 publicly traded companies, several of which were imperiled by financial and leadership crises. The article was a powerful summation of the state of governance, drawing upon his quarter century of board service both before and after his tenure at the SEC. Today he continues to serve on boards and has founded the Hills Program on Governance, an initiative of the Washington, D.C.-based Center for Strategic and International Studies that is a resource for executives, academics, and government officials seeking information on sound governance practices, particularly in emerging markets (www.hillsgovernance.org).

IN MY 1994 ARTICLE I asked:

* What can directors do that they are not doing?

* How can we get directors to do what they should?

* Are there enough independent directors?

* Who is to say whether they are or are not independent?

I opined: "There has been an enormous improvement in the staffing and operation of corporate boards in the 17 years since independent audit committees were required by the New York Stock Exchange." And I warned: "The danger, as I see it, is the temptation to use the proxy season rather than the board of directors to cure perceived mismanagement."

In place of proposals that would guarantee more proxy fights, I argued that "We could use ... a better process for putting and keeping directors in place [that] are sufficiently independent of management to protect the long-term interests of shareholders," and added that "Directors must be certain that the board's selection process is designed to provide that [needed] quality of independence.

"The remaining question," I noted, is "who is to say whether they are or are not independent" and that "a form of automatic monitoring is needed."

I am satisfied, even pleased, with what I said then. The Enron-era cases notwithstanding, I continue to believe that there has been a constant improvement in the governance of our publicly traded companies. I certainly believe that the there was then as there is now a need for a better process for putting and keeping directors in place that are sufficiently independent of management along with a better standard to decide whether the requisite independence exists. I also continue to believe that there is danger in the fact that well-meaning reformers are determined to make far more use of the proxy season to cure corporate mismanagement.

The enduring paradox

The paradox with which corporate America has lived is that, conceptually, shareholders are supposed to choose directors who then choose corporate managers. But until recently the nearly universal practice was for management to choose the directors, and all too often to discard those directors who seemed obstreperous.

The experience of the last 12 years has caused me to conclude that the only effective solution to the paradox is to substantially reduce the role of management in choosing directors and subordinate that role to the authority of committees of directors that at least appear to be completely independent of management.

I am not happy with that conclusion. Most excellent managers should excel at selecting directors, just as they must have excelled in selecting their management teams. Warren Buffett, for example, has a board staffed with many of his friends, but who can doubt the integrity or success of Berkshire Hathaway--and anyone who knows those directors knows very well that they are prepared to challenge his conduct when appropriate.

The problem, of course, is that there are not enough CEOs with the ability and willingness to choose such directors. So, as the lesser of evils, nominating committees of independent directors must take charge of the director selection process.

The proxy season will remain as the course of last resort to dispose of a board that refuses to deal with management failures. The claim that a proxy fight today is too expensive to be an effective tool ignores the fact that huge fund managers own substantial blocks of publicly traded stock. Most have the capacity to wage an effective contest if the cause is just.

A critical fact to be understood is that far too often shareholders with a significant holding seek control of corporations for reasons that are not in the best interests of all shareholders. This point is discussed in Private Enterprise, Public Trust, a recent publication of a subcommittee that I chaired of the Committee for Economic Development.

What did I miss?

While I urged audit committees to play a strong role in both the external and internal process, I really did not then appreciate the degree to which so many audit committees yielded their authority to whatever the external auditors and management might agree. More recently, both before and after the passage of Sarbanes-Oxley, I along with many others have stressed the absolute need for audit committees to take charge of the audit process, the selection of the external auditor and its engagement partner, the internal auditor, and of the scope of the audit.

My big miss was a failure to appreciate the degree to which the external audit has become a commodity of little intrinsic value to management, and the fact that the standard financial statement has become obsolete.

It is not extreme to say that years of pressure on audit firms to reduce the cost of the external audit and the diversion of accountants to more lucrative consulting assignments have turned much of the external audit into a commodity--a "compliance tax" that has substantially reduced its value as a management tool. It is incumbent both on the Public Company Accounting Oversight Board (PCAOB), a creation of Sarbanes-Oxley, and on corporate financial management to redesign the audit. Such redesign is under way at a number of companies.

Amid all the complaints made about the cost of the 404 process (also required by Sarbanes-Oxley), a number of large companies have, to a great extent, made it into the management tool that the external audit is not. Many companies are merging the two exercises into a single process that they believe can create more value out of the combined effort.

That our financial statement has become obsolete cannot be doubted. It was constructed in the "bricks and mortar" days when most assets were tangible. Auditors confirmed the original cost and, for the most part, merely confirmed management's arithmetic by deducting a percentage of that original cost based on the expected life of the asset.

Today we are largely an information-based society where a far greater percentage of corporate assets are intangible and where there is great pressure to value even tangible assets at current value rather than using original cost. Management has been given enormous discretion in setting the value of corporate assets and, as a result, enormous discretion in fixing earnings per share. External auditors cannot easily challenge the assumptions and estimates chosen by management to make such valuations.

Sarbanes-Oxley has to some degree alleviated the problem of our obsolete financial statement, but more is needed. It is essential for the SEC and the Financial Accounting Standards Board to begin the process of substantially redesigning it. Its essential ambiguity must be displayed either by showing alternative numbers or by expressing some values in ranges. It is just as important to put significant non-financial indicators of value into financial statements. Information such as trends in hotel occupancy rates can be far more important in judging the future value of a leisure company's stock than current numbers.

It also must be made clear that the auditor has little capacity to attest to the precision of such numbers as earnings per share. It is far more important that auditors develop a strong capacity to attest to the process used by management to produce those numbers.

What more needs to be done?

There are other reform ideas. There are, in fact, an almost endless number of them. Reformers seem never to accept the notion that we ought to see how well new reforms will work before seeking new ones. Two proposed reforms seem to me to be premature if not foolish:

* A mandatory rotation of the external auditor every five or so years.

* The mandatory separation of the chair's job from that of the CEO.

Even if we still had eight big accounting firms instead of four, the idea of mandatory rotation would be wrong-headed. Moving a few thousand companies around a ring of eight firms would at least be possible, whereas to do it with four is seemingly impossible.

Also, Sarbanes-Oxley has placed responsibility for the audit squarely on the audit committee. That responsibility, together with the detailed examinations required by Section 404 along with the unique and comprehensive oversight of the PCAOB, should surely dissuade those who wish to play musical chairs with the audit, which already costs millions of dollars each year for even some of the smaller firms.

More important, even a shallow analysis should reveal that mandatory rotation would make the newly empowered audit committees toothless. Audit firms that come and go in military precision have no need to respond to audit committees or to anyone else. They would be ruthlessly obstinate in their judgments. It is unlikely that such obstinacy would cause them to be fired. Management would not wish to speed up the costly rotation process.

The expense of retraining whole cadres of accountants and the obvious gap in understanding between the departure of the old firm and the time it will take a new firm to grasp the complexities of a new client...