Speech by SEC Staff:
Keeping up with the Smartest Guys in the Room: Raising the Bar for Corporate Boards
Linda Chatman Thomsen
Director, Division of Enforcement
U.S. Securities and Exchange Commission
Los Angeles, California
May 12, 2008
Thank you Al [Osborne] for that kind and generous introduction. I am delighted to be here today to address such an important topic: how can today's boards keep up with "the smartest guys in the room?" I want to congratulate all of you for attending this program. Attendance alone is a sign of the seriousness with which you take your role and, having looked at the agenda, you will leave here with all kinds of valuable learning.
Before I start, I need to make a few disclaimers — first is my required disclaimer — my views are my own and do not necessarily reflect the views of the Securities and Exchange Commission or any other member of the Commission staff.1 Second, and this one is not required, but fairness suggests I let you know that my views are affected by my view. And my view is not from inside a functioning board room, but from the outside. And because I am in enforcement, when I look in there or into any other company or business usually something has gone profoundly wrong. So let's dig in.
"Smartest guys in the room." Think about that phrase for just a second. Does it conjure up positive or negative connotations? Negative I expect. For me two things come to mind. First, smartest guy in the room syndrome — an affliction that is chronic for some. While I don't know whether anyone in this room is one of those chronic sufferers, I suspect not, as I just said your attendance at this program suggests a level of self-awareness that should inoculate your from the syndrome. But I bet every one of us has had a bout or two with the disease. Second, the phrase conjures up the book of the same title that examines the exploits of the bright minds behind the company that once was Enron — Kenneth Lay, Jeffrey Skilling and Andrew Fastow.2
Speaking of Messrs. Lay, Skilling and Fastow, who were the people charged with keeping an eye on those smart guys? A former chair of an independent agency of the federal government, the president of a world renowned cancer center, an air force veteran who went on to found a major public company, a navy veteran who became the general counsel and later president of an energy company. There were multiple CEOs of businesses ranging from finance to energy. Among them they served on dozens of boards of other public companies.
They also were trustees, deans, presidents and professors at prestigious educational institutions and served and supported major philanthropic enterprises. Obviously, they were pretty smart guys — I use that in its gender neutral form — themselves.
And yet things didn't go so well at Enron. To be sure the majority of the blame for that justifiably falls on the shoulders of Messrs. Lay, Skilling, Fastow and others who managed the company. But what about the board?
The U.S. Senate Permanent Subcommittee on Investigations found the Enron board breached its fiduciary duties, was embroiled in clear conflicts of interest, regularly approved excessive compensation for company executives and failed to monitor the effect of such on the company, and lacked independence due to financial ties between the company and several board members.3 The Subcommittee also found that the board knowingly allowed Enron to enter into billions of dollars of undisclosed, off-the-books transactions to make its financial condition appear better than it was.4
Another view of the board can be found on the civil litigation front. Ten former directors of Enron Corporation agreed to personally pay $13 million of a $168 million settlement to resolve claims against them for their alleged role in Enron's fraudulent accounting practices that resulted in the second largest bankruptcy in U.S. history.5 The Enron directors' out of pocket portion of the settlement represented 10% of their personal pretax profit from their Enron stock sales.6 The remaining settlement was covered by director and officer liability insurance. In addition to forfeiting personal gains, the sued former Enron directors lost their board positions. The damage to their respective reputations is unquantifiable, but surely not insignificant.
This is a particularly ignominious distinction because it is rare for outside directors to face this kind of liability and exceedingly rare for an outside director to ever personally pay any monies from his or her own resources.
I don't mean to understate the responsibility you have taken on. Indeed from a public policy perspective, I want you to feel every ounce of that burden. Outside directors of public companies face an array of legal obligations. Under federal securities law, directors are potentially liable whenever a company makes a materially misleading public statement or omission. Directors of Investment Advisor Firms and Mutual Funds have additional affirmative obligations under the Investment Company Act. Similarly, directors of pension funds have unique statutory obligations. Under corporate law, directors can be liable to the company and/or its shareholders for failure to adequately oversee management.
Delaware law — which of course governs the lion's share of US corporations — established long ago that the directors of a corporation must exercise three basic duties: the duty of care or prudence; the duty of loyalty; and the duty of good faith. Officers and directors are shielded from liability for good faith mistakes by the Business Judgment Rule. In fact, The Business Judgment Rule served as a virtual citadel against personal liability for officers and directors for more than a century, until 1985, when the Delaware Supreme Court handed down its famous decision in Smith v. Van Gorkom7.
The decision, also commonly known as the Trans Union case, set alarm bells off in Board rooms across the country by imposing personal liability on a group of directors that essentially rubber-stamped a proposed leveraged buy-out merger of Trans Union. Without any consultation with outside financial experts, the company's Chairman and CEO and the CFO chose a proposed price. They never calculated an actual total value of the company.8 The board approved the proposal and committed to selling the company after meeting for just two hours, without prior notice of the nature of the meeting or prior dissemination of relevant materials.9
The court found that the directors were grossly negligent in approving the merger without substantial inquiry or any expert advice and violated the duty of care which they owed to the shareholders.10 In rejecting the directors' Business Judgment Rule defense, the court found the rule was a rebuttable presumption that the directors acted on "an informed basis." Since the directors had no basis for the approval of the merger, they were not entitled to the protection of the Business Judgment Rule.11 The director defendants ultimately agreed to pay $23.5 million to settle the case.12
After Trans Union, the highly anticipated onslaught of decisions imposing liability on directors never came. Instead, many companies increased D&O insurance policies and adopted bylaws intended to exculpate directors and officers from personal liability.13 In the nearly twenty years between Trans Union and the massive accounting frauds at Enron and WorldCom, only a handful of outside directors were found liable for securities fraud and had to forfeit personal gains.
For our part, the Commission rarely sues directors solely in their capacity as directors. In fact in the last three years, during which we brought more than 1800 enforcement actions involving more than 3,000 defendants and respondents, the Commission has sued less than a dozen outside directors. Let's look at two recent examples.
In November 2006, the Commission filed settled charges against three former directors, two of whom were outside directors, of retail catalogue giant Spiegel in connection with the company's overstatement of the performance of its credit card receivables portfolio.14 The Commission's complaint alleged that after Spiegel's independent auditor advised the company that it would have to consider a "going concern" modification to its audit report, the director defendants actively participated in repeated decisions to withhold Commission filings in order to avoid the issuance of the "going concern" opinion.15 The complaint further alleges that the directors did so against the specific advice of both inside and outside counsel.16 After nearly a full year, Spiegel finally made its delinquent filings, and within weeks the company filed for Chapter 11 bankruptcy.17
This past summer, we sued an outside director of Engineered Support Systems, Inc. (ESSI), as well as the company's CEO, for their alleged participation in a stock option backdating scheme.18 The Commission's complaint alleges that ESSI's former CEO, Michael Shanahan, Sr. and his son, Michael Shanahan, Jr., an outside director and a member of the compensation committee, directly participated in backdating approximately $20 million worth of options to themselves and others at ESSI.19
The Complaint further alleges that Mr. Shanahan Jr. assumed a leading role in making recommendations regarding the award of stock options and on one occasion when he was asked whether ESSI had a Compensation Committee he replied "you're looking at it."20 As CEO, Mr. Shanahan Sr. was ultimately responsible for authorizing all of ESSI's stock options.21 The Complaint alleges that on at least ten separate dates during a five-year period the Shanahans approved the issuance of backdated stock options that coincided with historically low closing prices of ESSI's stock.22 According to the complaint, on at least two of these occasions, Mr. Shanahan Sr. approved cancellation and re-issuance of previously backdated ESSI stock options that had fallen out-of-the-money with new backdated grant dates and exercise options. Mr. Shanahan Sr. personally profited by nearly $9 million and outside directors profited in excess of $6 million from the allegedly unauthorized and undisclosed compensation as a result of the alleged backdating scheme.23
Now let me say again findings of director liability to the Commission, or plaintiffs, or others is, relatively speaking, rare. But, the risk is out there — and today's program is addressing it as the last item on the agenda — I hope because of its relative importance, but perhaps to keep you here until the end. But let's turn to something better. I am confident, or at least I sincerely hope, that you aspire to something more than barely escaping personal liability. So let's focus on some higher aspirations.
I'm going to start with a digression — but it has a point, I promise. In three days I will have been at this job three years. It was only a month or so after starting that I gave my first address as division director, and it was to a group of directors. I was a bit nervous and spent the hours before pacing and practicing — more pacing than practicing I suspect. I never managed to read the papers that day. And I should have. On the front page of the Wall Street Journal was a piece about anesthesiologists. About two decades ago they, like other doctors, were very concerned about the cost of malpractice insurance.24 While many groups of doctors at the time chose to blame increased malpractice costs on greedy plaintiffs' lawyers and capricious juries and focused on legislation and liability caps, the anesthesiologists took a different approach. They focused on patient safety. They launched a patient safety foundation that analyzed closed malpractice claims to determine the causes of patient deaths and based on the results instituted significant improvements in procedures and technologies. The result — after twenty years patient deaths dropped from one in every 5,000 cases to, conservatively speaking, one in every 200,000 cases.25 And guess what, malpractice rates fell, the number of suits fell and the size of payments fell. They had accomplished their objective, but more than that, they had become better doctors.
So how can you become better board members? You certainly have the raw material — brains and experience. Let's start at the micro level.
Think about those things where the board may be not only the last check, but where it may the only real check — related party transactions and executive compensation are two examples that come to mind. Think about the things the Subcommittee on Investigations found wrong at Enron: conflicts; a lack of independence; and unusual transactions.
On a macro level there are perhaps no more important issues than corporate culture and the selection and oversight of the senior executives.
There is no one perfect culture. What works for one company, may be a disaster to another. Similarly, no culture is perfect. Every culture has strengths and weaknesses; understanding both is important so you can exploit the strengths and minimize the weaknesses. It is especially important to understand how the culture treats bad news. A dramatic reaction to bad news may be very effective in avoiding repeat behavior and may be necessary in some circumstances, but it may not encourage reporting of bad news, especially of smaller issues. Conversely, a company that encourages early reporting of all bad news and is focused on what to do going forward may be slow to recognize the circumstances when taking immediate dramatic action is needed.
Think about how compliance, legal and internal audit departments and personnel are treated. These are cost centers to be sure, but it is important that they function well.
As to that senior executive, of course you have to trust her. But in the words of a great Californian, you need to trust but verify. Engage, interact. Look out for changes. How does she treat you? Was the time they asked you to serve on the board the last time they asked you anything?
Let's go back to where we started — the smartest guys in the room. I must say I find it a little discouraging that the great gift of intellect is thought of negatively. But of course it is not the gift that is disparaged by the phrase, but the recipient of the gift. I was reminded of this when I flipped though this week's Time Magazine, which is devoted to the 100 most influential people in the world. One of the 100 is Oscar Pistorius, a world class sprinter, who has been a double leg amputee since the age of one.26 He is currently appealing a ruling that he cannot compete in the Beijing Olympics because, according to the deciding officials, his prosthetics give him an unfair advantage. The author of the essay on the sprinter, himself an amazing athlete and the only blind person to summit Mount Everest, wrote:
"It was only recently that living with prosthetic legs was seen as a huge impediment, but [Pistorius] has turned this perception upside down. He's on the cusp of a paradigm shift in which disability becomes ability, disadvantage becomes advantage. Yet we mustn't lose sight of what makes an athlete great. It's too easy to credit Pistorius' success to technology. Through birth or circumstance, some are given certain gifts, but it's what one does with those gifts, the hours devoted to training, the desire to be the best, that is at the true heart of a champion."27
What are we going to do with our gifts? What are we going to encourage others to do with theirs? Use them. As the saying goes, "dare to be great." But aspire to be good too.
As I wind up here, let's take a quick look at one of our great founding fathers, Ben Franklin. He was born in Massachusetts, the 15th child of a Boston candle maker. Not only was he a writer, scientist, inventor and statesman, he was a great entrepreneur. Over the course of his life he amassed a fortune. He had brains, ambition, a limitless capacity for work — he had, in short, everything a new country needed and everything we still value. Were he alive today, Franklin might have been one of our most highly compensated CEOs or perhaps a highly sought after board member.
At some point he articulated a list of thirteen virtues to which his descendants should aspire: Temperance, Silence, Order, Resolution, Frugality, Industry, Sincerity, Justice, Moderation, Cleanliness, Tranquility, Chastity and Humility. Franklin explained that he added Humility to the list when an honest friend informed him that he "was generally thought proud; [his] pride showed itself frequently in conversation; [and he] was not content with being in the right when discussing any point, but was overbearing, and rather insolent." Franklin was also candid about his own attempts to conquer his pride. "In reality, there is, perhaps, no one of our natural passions so hard to subdue as pride. Disguise it, struggle with it, beat it down, stifle it, mortify it as much as one pleases, it is still alive, and will every now and then peep out and show itself — even if I could conceive that I have completely overcome it, I should probably be proud of my humility." 28
I'm not sure I'm completely devoted to the entirety of his list — but certainly it's hard to argue with that late addition, especially for those who have been blessed with so many gifts. Leaders of great companies probably are the smartest guys in the room, but that isn't the end of a great story; rather, it is a great beginning.