Corporate Governance in the Global Economy: Roles and Responsibilities of Corporate Directors

Date July 26, 2006
Speaker Roger RABER(President and CEO, National Association of Corporate Directors)
Moderator KOBAYASHI Keiichiro(Fellow, RIETI)


I am from the National Association of Corporate Directors (NACD) of the United States. We are the only organization focused exclusively on directors, and so I am going to speak from a director's perspective. People ask me, "What is corporate governance?" It means accountability; that the board of directors is accountable to shareholders and investors, and not only the institutional investors. Look at Enron: when Enron failed, the investors lost money, the employees lost their jobs and nonprofit organizations funded by Enron collapsed. The board's accountability is to those stakeholders.

Twenty years ago, when I got on a board, a director said, "If a problem is there, it is management's problem!" No. The accountability of the board is to hold management accountable, but the board itself is also accountable to stakeholders, shareholders and constituents. As a result, management is empowered. Management manages, boards govern. For years, many directors did not understand their responsibility. The responsibility of the board is what we call a fiduciary responsibility, not a management one.

What are fiduciaries? Fiduciaries make sure that the corporate auditors, internal auditors and management are doing the right thing. Fiduciary means to be faithful, faithful to the public. In many of the problems, such as those that happened at WorldCom and Enron, the public did not look at management; they looked at the board. But where was the board? More often than not they say, "The board probably had a conflict. The board could have been looking at its own particular interests," or "The board did not know what it was doing," or "It was asleep at the switch," or "It did not anticipate this." That is the result of corporate governance and fiduciary responsibility. Directors now understand what they do, and management understands what it does. As a director, when you transition from a management position to a board position, you are now a fiduciary, and the fiduciary again monitors those people.

Under U.S. law, boards have what they call duty of good faith, the duty to do the best that you can. Board members need to have a duty of care; you need directors who will really understand the company's problems. Probably the most important duty for a director is loyalty, which means that you look at the best interests of the corporation and the investors, not your own. Many class action lawsuits have to do with directors who were looking after their own interests, not the corporation's. For example, 25% of lawsuits involving duty of loyalty are around mergers and acquisitions. In these lawsuits, shareholders say a board makes a decision not in their best interests. If directors follow these two duties, they may be protected by a legal principle, which is not a legal rule, called the "business judgment rule." It means that if a businessperson does the best he can, but somehow it goes wrong and he is sued, the courts will uphold the fact that he did the best he could. These duties and protections are fairly general and practical; if they did not exist, no one would go on a board. Even though board members are compensated, you are never compensated enough if you have significant liability.

What do directors do? We at NACD feel strongly that the most important thing that a board can do is to get the right CEO and make sure they have the right board.

Let us talk about the right directors. I am talking about two basic kinds of directors: outside directors and inside directors. Outside directors are ideally independent. Some, though, are not really independent, because for example they may have worked for the company or have other ties. The other kind of directors are inside directors (company executives who are directors), but I do not want to focus too much on that. In the U.S., to list on the major exchanges, the majority of your directors have to be independent directors. But having inside directors is still permitted and in many cases can be optimal.

So what makes the right directors? First, you want board members who understand the company and the industry. They do not need to manage the company, but they need to know how it impacts with industry, economics, regulations, risks, etc. Part of the problem in the U.S. was that we had directors who had high celebrity status but were not good directors. Second, you cannot be a director unless you understand finance. According to rules passed Sarbanes-Oxley, each board must have an "audit committee financial expert." Twenty years ago, we did not see particularly high financial acuity or competency on boards, but now I cannot imagine someone going onto a board without understanding the industry, the company and having an understanding of finance and accounting. Third, you must be there as a fiduciary, not to come in and tell management how to run the company. That said, you also want a director who can add value. If a company needs someone with a certain background, you do bring in a person who would add that value, but you are simply providing additional information; it is still management that is going to make the decisions.

What about the CEO? You must make sure that a CEO candidate who meets with a nominating committee has done some research on the company where that person is being considered. The person has to challenge the board as far as what the company is all about and where the company is going. Strategy discussions come when a CEO is hired, not after the CEO is there for several years. There must be a connection between the CEO and where the company is going, short-term and long-term. Sometimes when CEOs are hired, it is because they did a great job at another company, but that does not mean the CEO is going to be good at every company.

That leads to performance metrics. When a CEO comes in, there must be clear indications of what is expected. New products, new technology, a merger and acquisition, a collaboration; whatever it may be, the financial implications have to be spelled out. Executive compensation metrics must start when a person comes in, and a person must be evaluated and critiqued on a regular basis, so that there is no disconnect between strategy, performance metrics, and where the company is going. If you have the right board and the right CEO, you are likely to have a good company, because 90% of it is about good governance. We now have a dysfunctional executive compensation environment. We have people who are paid for non-performance, because in order to get a CEO to come to a company, you have to offer a big financial package with severance. That is a major challenge for boards.

Strategy is probably the most important thing after getting the right CEO and board. We ask board members every year to talk about strategy and what it means. It is not the responsibility of the board, although some people think it is. The CEO develops the strategy of an organization. In the past, CEOs would bring a big book and say, "Here is the strategy for 2007." They would show it at the annual meeting, and then the board would bless it and then walk away. Now the CEO brings a strategy to the board, and the board critiques it, challenges it, and maybe forces a change. A director has got to be constructively engaged in interacting with the CEO insofar as strategy is concerned. I see companies in many industries in which they have not had a deep enough strategy discussion, which could somehow improve what is going to happen in the future. Strategy is not an event; it is an ongoing process. Every enlightened board has discussions on where we are going, not just waiting until the pension fund has bankrupt the company or competition has run all over it. These things must be anticipated beforehand. At the end of the day, investors are not going to tell the CEO that (s)he is doing a poor job; they are going to go to the board and say, "What happened? You had the responsibility of hiring that person, to have clear expectations for performance. Where were you?"

I will now summarize some additional governance duties and current trends.

Reviewing corporate performance
I still see companies - Enron was a good example - with special purpose entities and third-party transactions. At Enron, it took a relatively junior investment officer to say "That is a shell. That is not really an organization." Directors have to look at and judge on performance. Besides having finance and accounting, they have to dig into that.

Engaging in ethical behavior
All those things I talked about before - being a good fiduciary, adding value - bringing all those things together, you have to behave appropriately. A few years ago there was a survey of a number of companies that had codes of ethics. The most highly evaluated company was Enron. What that tells you is that not only having, but also actually following, a code of ethics is an issue.

Directors evaluate the CEO, their internal and external auditors, and outside council members, and at the end of the day, they have to evaluate themselves. Whether they are independent directors, outside directors, or executives of the organization, accountability is tantamount. Especially in banking, people often feel when they get on a board that they have ownership. These days they have what they call no-fault resignations. For instance, if a company changes or grows to an extent that a director is no longer able to fulfill his duties, or if he misses board meetings, or is not engaged in discussion and not adding value, he will be asked or forced to step down. Many directors are indignant about it, but everyone must be evaluated.

As a result of corporate reforms such as Sarbanes-Oxley, auditors, like the directors, have to be independent. The public, who may be small investors, do not make distinctions between public, private, and nonprofits; companies cannot just say "We are a private company," or "We are a nonprofit company." I run a nonprofit, and I have to certify financial statements. Of course, for public companies (under Sarbanes-Oxley), the stakes are high. Now you not only have to certify, but if you certify a statement that turns out to be false, they could put you in prison. This shows the importance of disclosure and transparency: no matter how good a board is, they need to know what is going on. The board and management should not be the last to know.

I am tired of hearing "I did not get this far in my life that I have to be educated." That is a red flag. Anyone who says to you that they do not need any more education has to get off the board. They are accountable. How a board operates, the environment, the industry, the structure you are in - you have to have education. There is no such thing as enough. New York Stock Exchange listing rules require disclosures pertaining to education.

We have issues now about internal control. Public companies are required to assess their internal controls, under Sarbanes-Oxley. But every company, public, private and nonprofit, should have internal controls over financial reporting for the whole company. The public has no understanding of companies that do not anticipate risk; you have to anticipate the worst thing that could happen. Many nominating committees look for directors with a crisis-management background. Anybody can be a great director when things are going well, but when things are not going well you need a good director, and that requires education.

People in the U.S. keep saying that we need to have a majority of independent directors. Independent director means a director not affiliated with a company, someone who has no conflict. In the U.S., stock exchanges require a majority. In other countries you may have a majority of executive directors, i.e., the executives of the company are directors. You have people who have retired who come back as directors, and then you have independent directors.

At the end of the day I am not going to make prescriptions. There is a lot of flexibility in governance in Japan, the culture, issues regarding behavior, integrity, and courage. I have seen more of that in Japan than in the U.S. You seldom hear people questioning the meaning of being candid, open-minded, or deliberative in conversations. All of these are behavioral conduct and personal attributes. I am delighted to say that I found this richness of integrity in the Japanese environment more than in the U.S.

Global corporate governance is here to stay. It is not a fixed way of doing things. If you have any comments or ways to enlighten me to say how we can do a better job as directors and work with investors, I am anxious to hear them.

Questions and Answers

Q: My concern is that in the majority of publicly traded companies in the U.S. and Japan, the chairman of the board and the CEO are the same person. In the European Union, on the other hand, the majority of big companies have a separate CEO and chairperson. Which do you think is better for purposes of corporate governance? Why, in the U.S., are the chairperson and CEO so often the same person?

A: You are absolutely right. That trend has declined, but it is still prevalent. In regions like the United Kingdom, you often have a non-executive chair. The NACD strongly encourages the separation of CEO and chairman. That has happened slowly, however, especially with large public companies. That said, board leadership in a company has to come from the independent directors. If a company has a joint chairperson and CEO, it must have a lead director elected by the independent directors. In the case that the board wants to fire the CEO, for example, it is the lead director who decides whether the CEO stays or not. At the end of the day, the chairman is not the leader of the board; he may develop the agenda, but the lead director has the right and privilege to change that particular agenda, and that has to be approved by the independent directors.

We are also finding fewer executives on boards in the U.S.; seldom do you see more than two directors who are executives on one board. We also have what we call "executive sessions," where the independent directors excuse the CEO and chair and meet privately among themselves on issues that relate to governance and performance of the company. You might think that large public companies would be upset about this, but they say they like that it gives them the ability to keep the chairman/CEO position. Ultimately, the independent directors are the fiduciaries; they hold the CEO and chair accountable, and they can fire them. The average tenure of a serving CEO is five years today, down from 10 years a few years ago, and many of those people did not leave of their own volition.

Q: What do you say to the emerging international standardization of management and the possible emerging of certification businesses?

A: I do not know that much about ISO certification; but I do know a lot about social responsibility. I am also on the Malcolm Baldrige board of overseers, which talks about ISO. I think we have a long way to go. For example, we developed a curriculum for boards. Somebody wanted us to "certify" them as a director, but we would not do that. When we talk about director education, we are talking about issues of evaluation, recruiting, holding directors accountable and participation in strategy. All of those are key but do not get at the issues related to integrity, open-mindedness, the courage to ask tough questions, being unbiased, deliberative, and being engaged, not passive. These are issues that would enhance governance and lend value to a corporate director's certificate, but I cannot mandate those behaviors. That said, I cannot imagine a company coming out to say that its exclusive responsibility as a board is shareholder value, and who cares about the rest of them. As a director, accountability is not only to the institutional investor, but also to small investors, employees, vendors, customers and local communities. Corporations should provide fiduciary responsibility. I think we will see more in that area, insofar as directors who have a social responsibility and personal attributes that add value to the companies, stakeholders and constituencies that they work with.

We have a long way to go. Although we have criteria that we can approximate, we are not there. We need more socially responsible investors telling us that good corporate governance is more than just financial performance. That is my assessment.

Q: I would like to push you on the definition of corporate governance. At the beginning you said that it is accountability of the board to the shareholders. You quickly expanded that to vendors, employees, customers, and local communities, but the interests of all of these constituencies are often in conflict. Can you give a definition that delineates the most important interests that a board needs to take into account?

A: Well said. It is clear that the accountability that a board has is mainly to the investors, but as I indicated, more enlightened boards also recognize that if you are going to add value, the board needs to look at its relationship with the employees, customers, vendors, and local communities. I do not believe that you can have good investor relations and performance unless you take into consideration the constituents that add value to your corporation. The key word I use is "mainly," but from an individual perspective, I would emphasize the constituents more, in light of the fact that there is already a great deal of focus on the investors. I would also say that there is an obligation for the public, whether or not they are investors, to speak candidly and not wait for some other group to comment on problems.

C: I ask because as boards become more accountable, they are being sued more often by investors. Everyone wants to behave in a friendly and appropriate manner, but at the end of the day there has to be a delineation at which point the board takes responsibility and someone can take action against the board.

A: As an educator, I encourage the boards and investors to recognize the importance of the constituencies that I talked about: employees, customers, and local communities. You can learn a lot from nonprofits; they have to work with a lot of stakeholders, and it raises a challenge, raises the issue that board members not only have to interact with shareholders, but also with employees. It is important that directors see what it is like to walk around one of the company's stores or factories. Perhaps I am too much focused on social responsibility issues, but I think this helps. May it lead to some sort of litigation? I suspect so.

For some boards, communicating with investors is like learning to walk - they should have been doing that all along. We are doing a report right now with the Council of Institutional Investors (CII) on how to deal with executive compensation, internal controls, and majority voting (versus plurality voting), three major issues to discuss with the investors. This would have been unheard of six, seven, or eight years ago. We bring up the same issues of shareholders and how they are defined; that is brought up with the investors as well. They may not be in complete synch, but they recognize the importance of working together with investors.

Q: Do you think there is any optimal board size?

A: Yes. With nonprofits, there tend to be 40 or 50 members. We at NACD say the optimum is between 8 and 11. Corporate governance is not a science; in many ways, it is just about what seems to work better. With fewer than eight, if some people are missing you can end up with two or three people making a decision. Especially when some of the startup tech companies have three or four board members, I get concerned about that. You have to have a majority of people present to have a quorum, and so on. On the other end, I would not go much above 11 or 12, because once you get up to 14 or 15, directors can get through board meetings without interacting. For many years we had dominant CEOs and passive directors, but you want directors who are not passive. Size does make a difference.

Q: Are you interested in the Chinese style of corporate governance? Do you see any difference between Chinese corporate governance and the Japanese or U.S. styles?

A: I see convergence, but I do not see one-size-fits-all. I think we can learn from each other. This is my second time coming to Japan. I have learned a great deal in my two days here, just as I do when I go to the UK and the Philippines. It is not an exact science, but about what works. One thing we do not talk about enough is culture. Culture is a big issue. I do not know enough about China's governance. As you know, the Organisation for Economic Co-operation and Development (OECD) is trying to bring together the 30 countries on corporate governance. No one wants to prescribe, but we are going in a direction of learning from each other. I consider this a cottage industry.

Q: Some Japanese people say that U.S. companies tend to maximize the interests of investors in the short run, and Japanese companies tend to maximize the long-term interests. Do you feel any conflicts between the interests of investors in the short run and the long term? Some Western people say that Japanese companies tend to sacrifice the interests of investors to the interests of employees. Do you share this opinion?

A: I do not have the empirical data on that for Japan, but it goes back to social responsibility. I would like to think that I am a good fiduciary. I communicate with investors, and we keep them up to date; they are a part of the communication process. You cannot have good performance unless you have good employees and customers. I know that investors are willing to pay a premium of up to 18% of stock value for U.S. companies that have good corporate governance. There is a correlation from an investor's perspective, but there is no proof that there is a correlation between good corporate governance and good corporate performance. If there were, I would have 10 times as many members as I do now in the NACD.

Investors are willing to pay more, because I think they look beyond just the ratings. It gets back to the fungible areas of behavior and conduct that we are not always good at. As you indicate, in Japan there is much more of a focus on employees and related people than on investors, although I have neither anecdotal nor empirical data on that.

Q: First, in Japan, the role of auditors is very important, but in your picture, U.S. auditors do not seem to play much of a role. How would you evaluate the role of auditors in Japan in comparison with the U.S.?

Second, are directors born as they are, or should they be trained in order to discharge their fiduciary responsibility? Or should they be nominated from another world, such as lawyers or ex-government officials?

A: I am going to say something contradictory: Internal auditors are what I would call independent insiders. They work with management for the board. It is up to the board to hire and fire the outside auditor. It is up to management to interact with the outside auditor on any and all issues. This gets back to checks and balances, because the auditor should have no conflict in providing these services. You do not want the auditor doing consulting, compensation or taxes. At the end of the day, it is the board that the internal auditor works for. I find that very valuable.

Let me talk about human resources (HR) training. At board meetings, the CEO, the CFO and the general council are always there, but where is the HR person? If you look at the major issues I talked about, these would be, again, educating the board. The New York Stock Exchange and NASDAQ do not require, but "expect," that companies will have annual education, and some corporate ratings services rate companies on education. Directors have to be trained just like anyone else, although we call it "professional development." HR executives are also trained in compensation and in selecting the right directors. However, HR organizations in the U.S. do not have the same impact as the Association of Corporate Counsel. I would challenge them to be in the boardroom, especially when you are talking about employee issues, training and governance.

Q: How many companies' boards do you think you can be on at the same time?

A: At NACD, our guidelines state that if you are a professional director, and directing is all that you do, that you do not serve on any more than five or six boards. You have to be cautious, because sometimes they will serve on five public company boards, three privately held companies, and four nonprofits, and many governance nominating committees will only look at one category. But best practice is no more than five; we track the number of hours per board membership, and it is well over 200 hours per board. If you are an executive, it could be two or three, depending on how much time and effort you have, and what you are doing. We do say quite clearly that if you are a serving CEO of a public company, the maximum would be one or two boards including your own. Overall, the tendency to serve on multiple boards has decreased.

*This summary was compiled by RIETI Editorial staff.