A self-correcting course for governance.

• Author: Millstein, Ira M.
• Position: Board Leadership

Directors, fix your boards. Figure out an information-gathering process and a board leadership structure that ensures that the board meets what may be a change in the standard of conduct by which it is judged.

WHEN A SYSTEM breaks down, a common way to fix it is to look at the different machines which comprise the system to see what went wrong with each machine and then adjust each part accordingly. But to do that, we ought to know what the system should look like after we adjust all the machines.

In other words, we must know what we are adjusting the machines to do. What's the model we should have in mind as we make the necessary adjustments? Remember, the corporation is the premier organizational vehicle to assemble human and financial capital. At its heart are the concepts of limited liability and perpetual life, and it needs to work better if our system is to continue.

Originally the model of governance was simple. The shareholder who provided the capital, the manager who ran the corporation, and the board of directors required by law were all virtually the same person, or at least in the same family. There were no conflicts among managers, boards, and shareholders because their interests were clearly aligned -- indeed, they were actually identical.

Over time, it was growth, expansion, and the need for outside capital that led to dispersed shareholder ownership in companies, and boards and managers became strangers to the shareholders as well as to each other. Recognizing the agency principle, the interests of shareholders and managers often diverged -- and boards were caught in the middle. Ever since, we have been endeavoring by law and practice to recreate the model of the family corporation by bringing about a convergence in, and an alignment of, interests, so that no one group takes advantage of another. The major effort on this front has been the corporate governance system of checks and balances.

Protecting other people's money

The essence of the system is the notion that when we talk about corporate governance, we are talking about monitoring the use by managers of other people's money. That money, invested by the shareholders, is to be protected: The board checks the managers, shareholders check the board, and lawyers and accountants have a professional responsibility to the corporation and its shareholders, not to management.

While we have strived for a model in which boards and managers are aligned with shareholders, as if they were members of the same family, the recent scandals are evidence that although boards got better at checking managers in the '80s and '90s, they didn't get all the way there, and maybe they never will.

I think managers and boards became too caught up in the euphoria of the stock market bubble (see sidebar, "Machine Components in Disrepair and Disrepute"), and I've tried to figure out why. Perhaps some of it was that the very means boards used to harmonize manager and shareholder interests -- i.e., stock options for managers -- got wildly out of control as the market soared. Managers tried to make numbers that maximized their options without regard for the effects. Lawyers, accountants, and analysts, who profited along with management, helped or looked the other way. And shareholders, too, stopped looking at the footnotes, as they reaped short-term profits (at least on paper). I can't prove it empirically, but I do believe everyone's greed simply overcame good sense.

But that was only a part of it. The rest was the board's inattention in many cases, its lack of leadership, and, most important, the lack of information about the corporation's business and the risks it faces. I believe that in many of the recent highly public corporate governance failures, a more active, engaged, and informed board of directors might have uncovered, prevented, or at least mitigated the crises that caused many of these companies to collapse.

This is not to indict those particular boards because, looking backward with 20/20 hindsight, passivity by boards seems to have been more prevalent than many believed. The failure of boards to be activist and more vigilant has been, in my experience over the last three decades, a result of one of two things: (1) Boards are often not helped by management to obtain needed information, and in some cases may be prevented by management from obtaining information, or (2) The board never tries to get that information. I'll focus on these issues, because today boards must face them, or face potential liability.

Adjusting: Back to basics

So how do we fix this lack of information? Back to basics. State law provides that the corporation is managed by, or under the direction of, the board. State courts have developed the concept of fiduciary duty for directors -- that is, a duty to represent, and be accountable to, the interests of the shareholders, to monitor and supervise -- checking the managers in such a way that the managers' and shareholders' interests and motivations are intelligently aligned. Somehow, we have to reinforce the board's duty to check management and remind the board of its accountability to shareholders.

The flurry of legislative and regulatory action that followed the recent governance scandals -- namely the Sarbanes-Oxley Act, with its accompanying implementing rules, and the proposed amendments to the listing requirements by the NYSE and Nasdaq -- have greatly reinforced these checks and balances (see sidebar, "The New Rules of the Road"). Moreover, courts in Delaware and elsewhere have indicated that these reforms may raise the standard of conduct to which directors are held. All of this means that, now as never before, boards must figure out how to get the information necessary to carry out the new burdens that the reforms and the public's expectations have...