scandals have put corporate governance in the spotlight, accenting
the leadership role directors should play to ensure ethical
oversight and economic viability. Kellogg School experts assess
the governance landscape, and tell what must change to regain
of the last decade it seemed that Wall Street investors expected
the financial markets to ascend forever like some miraculous
balloon. Few cared to dwell on inconvenient lessons about
gravity. Curmudgeons who did suggest that old economic laws
remained in effect despite the New Economy’s advent
were considered to be acting in bad form — or were perhaps
simply confused about the entrepreneurial dynamics that were
supposedly changing the rules for good.
crash, and especially events of the past 12 months, have shown
that the rules were not so much changed as they were twisted
into pretzels by the business community’s less scrupulous
citizens. But the often dodgy accounting and compensation
rules themselves bear some of the blame, as do novice investors
eager to believe the hype surrounding surreal earnings, when
any sober assessment of the data might have urged caution.
those investors lament the loss of value in their retirement
portfolios. They’re angry too, wondering where all the
cash went. (For those keeping score, Global Crossing’s
Gary Winnick pocketed $512 million, Enron’s Ken Lay
another $246 million and the senior executives and directors
of the 25 biggest business collapses — dubbed the “barons
of bankruptcy” by the Financial Times — nabbed
some $3.3 billion in salary, bonuses and stock, even as their
corporate ships went down, taking almost 100,000 jobs with
critics have rushed to blame the scandals on lackadaisical
accountants, content to forego scrutiny of the numbers put
up by management, thereby ensuring an uninterrupted flow of
lucrative consulting deals with their clients (see
related story). Management itself, of course, deserves
a large share of responsibility, as do banks that lent firms
money, then helped conceal the debt. And the corporate boards
— such as that at Enron, which apparently waived portions
of the firm’s ethics code to help hide debt —
are hardly blameless. These governance structures were designed
to moderate the excesses of executives bent on personal gain
at the expense of shareholders, but failed to stop the malfeasance.
the infamous list of apparent governance oversights, it would
be easy to suspect a widespread leadership crisis in corporate
governance today. Kellogg School experts disagree, though,
contending that the notorious examples are the exceptions
to the rule.
Dean Dipak C. Jain and Dean Emeritus Donald P. Jacobs insist
that most boards have been and continue to work effectively
within the law. Jacobs, a longtime governance guru at the
Kellogg School, was instrumental in creating an important
annual conference on the subject
and putting Kellogg in the vanguard of schools who took governance
seriously when few of its peers did. Now in its 12th year,
the Corporate Governance Conference brings leading thinkers
together to discuss challenges facing boards and institutional
believes that Enron represents a “watershed occurrence”
that is changing the laws surrounding corporate governance
in the United States, and that these changes will have lasting,
significant effects. He points to the Sarbanes-Oxley Act,
reforms passed by Congress on July 25 this year, as an example
of how the governance landscape is changing in the scandals’
institution of the independent auditor seems to have had some
problems, as has the practice of self-regulation,” Jacobs
says. “These areas demonstrate the need for some correctives,
and the SEC is going to descend to make those corrections.”
Jain, accountability is the most important outcome of the
scandals. Accountability stretches far and wide to encompass
a number of players, he notes, but among them are board directors
who should themselves be governed by two principal tenets:
duty of care and duty of loyalty — governance-speak
which means that directors should exercise due diligence and
refrain from self-dealing.
scandals have highlighted the rules and responsibilities of
the board. Their role is not just to sit around and have a
nice dinner together. The rules and responsibilities were
always there, but now the issue of accountability comes clearly
into focus,” Jain says.
is the new leadership mantra,” he adds.
watchers among the Kellogg faculty also say boards will grow
more independent, especially on their audit and compensation
committees, and that governance decisions will assume much
more transparency. Legislation will force some of these moves,
while others will be adopted by companies eager to regain
investor confidence. For example, Coca-Cola Co. is one firm
now treating stock options as expenses, a reform most businesses
have historically resisted for reasons to do with how options
impact earnings reports.
issue of CEO compensation — and the board’s role
in setting this compensation— that lies near the heart
of the scandals will also likely undergo review to address
flaws in incentive structures that have contributed to what
Paul Volcker, former chairman of the Federal Reserve Board,
called a “deeply troubled…systemic problem”
in his remarks
made at a June 2002 conference on credible financial disclosures
hosted by the Kellogg School.
is your brain on stock options
the system that Volcker cites won’t happen overnight,
or without a fight. (Witness former SEC Chairman Harvey Pitt’s
waffling on plans to appoint a strong, independent person
to lead a new accounting oversight board.) Increased vigilance
in the boardroom is one way to minimize malfeasance, but board
directors, while an important part of the reform puzzle, remain
only part of a complex system.
has mitigated some of the conflicts of interest between auditors
and the firms for which they work, but already there has been
lobbying to weaken the reform. In addition, dozens of quoted
U.S. companies are considering going private, after learning
the New York Stock Exchange intends to require listed firms
to have a majority of independent directors on their boards,
and staff their compensation, audit and nominating committees
entirely with independent directors.
option reform remains central to the discussion as well. To
gain some perspective, consider that the most recent figures
for CEO compensation, as produced by the Institute for Policy
Studies and United for a Fair Economy, reveal that top corporate
executives in the United States now earn 411 times more than
the average worker in their firms — an increase of nearly
10 times the salary earned by execs 20 years ago.
these executives are paid is as important as how much they
are paid, say Kellogg accounting faculty. In 1980 fewer than
one-third of CEOs of public companies were granted stock options.
That figure rose to 92 percent in 1997, according to executive-compensation
consulting firm Pearl Meyer & Partners.
of financial incentives have made companies eager to pay management
in options, rather than cash. Why? Because federal guidelines
have not required firms to treat these options as expenses.
As a result, companies could manage (read, artificially inflate)
their stock prices in ways they would find difficult to achieve
were they forced to pay CEOs in cash. Over time, stock prices
soared, and the dynamics partially driving the phenomenon
led to more shares being distributed, only exacerbating the
problem of inflated value.
compensation committees on boards making decisions about executive
salaries, governance will clearly be part of the solution
if corporate America hopes to lure investors back to Wall
Street in earnest.
executive compensation went through the roof, in part because
of board decisions, but also because of the unexpected rewards
generated by the stock market,” says Professor Wally
Scott, co-founder and director of the Kellogg
Center for Executive Women and a governance expert who
believes the scandals will tend to correct themselves. “There’s
no doubt that to some degree these scandals were importantly
triggered by the stock market. There was a lot of money slopping
around out there.”
resists embracing government legislation as the total solution,
though he agrees it’s generally a good idea to tighten
requirements for serving on a firm’s audit committee
and assuring independence on boards. He says companies will
have to realize that establishing transparency and independence
in their governance structures — regardless of any federal
oversight — will be important, because doing so will
be in the firms’ best interests if they want to attract
both investors and customers who value ethical behavior.
Kraus, president and CEO of APCO Worldwide, and a Kellogg
Dean’s Advisory Board member, agrees. Companies will
no longer merely have to post a profit, she says; they will
also have to demonstrate the highest ethical standards.
performance will be one measure of value for companies, but
not the only one,” insists Kraus. “We’ve
seen what happens when we drive everything by financial performance
alone: we get behaviors that, in the long run, bring down
the financial performance of the firm, not enhance it.”
moral of the story?
Some of that fiscal “slop” that Scott mentions
showed up in the bank accounts of less-than-scrupulous executives,
prompting cries of ethical lapses. To be sure, the evidence
reveals that ethics, or their lack, did play a part in some
instances. To help address that aspect of the governance problem,
and make students aware of the broader context in which companies
operate, Kellogg has launched a comprehensive new major called
Business and its Social Environment, or BASE (see
of rampant ethics violations may ultimately be something of
a red herring, a distraction from a stickier problem; namely,
those incentives built into an imperfect economic system that
rewards those who are, at the end of the day, playing by the
rules — more or less.
made this point in his address at Kellogg, saying: “Some
of the best mathematical minds…turned to the sophisticated
new profession of financial engineering, designing ever more
complicated financial instruments. The rationale was risk
management and exploiting market imperfections.”
accounting professors Ronald Dye, Lawrence
Revsine and Thomas Lys echo this concern about how the rules
governing financial reporting have allowed considerable interpretive
latitude — and incentive— to manipulate earnings.
one holds politicians, industry lobby groups or corporate
leaders responsible for the way the rule book is written —
say, in the case of how options are typically granted at a
“strike price” rather than indexed to the Dow
Jones or NASDAQ, resulting in situations where executives
can be generously compensated even when their companies underperform
— doesn’t mean anyone has broken the law. It may
just mean the law is absurd.
director who has been honored for his exemplary service, and
who believes the ethics of most executives remain as strong
as ever, is Michael Miles, former
CEO of Philip Morris, who has also been the chairman of the
Kellogg Dean’s Advisory Board for the past six years.
Miles was recently honored by trade publication Director’s
Alert as one of nine “Outstanding Directors for 2002”
in corporate America.
when the good times are rolling, there’s a risk that
some people will get careless and complacent, and start saying
that even the wildest things that happened to the market are
all part of the new economy, the new paradigm,” says
Miles, who contends that the best directors don’t see
themselves as “store managers” involved in the
day-to-day operations of a firm, but rather as big-picture
strategists. While Miles agrees that even a good system can
be improved, he says that lately too many people have lost
sight of the fact that 99 percent of publicly held companies
in America have had, and continue to have, good governance.
shouldn’t overreact on the basis of 10 train wrecks
and conclude that governance needs to be fixed,” he
and symbols of the times
Another Kellogg School governance expert, Edward Zajac, tends
to agree, though his research illustrates how subtle and complex
governance dynamics can be.
don’t have to paint corporations and their boards as
corrupt to suggest that intense pressures from a variety of
sources, including the financial investment community, have
led some people to figure out how to cut corners in ways that
are unlikely to be noticed,” says Zajac, the James F.
Beré Distinguished Professor of Management and Organizations,
whose many corporate governance publications include large-scale
empirical studies of board-CEO interactions. In that research,
Zajac, and occasional co-author James Westphal PhD ’96,
now on the management faculty at the University of Texas at
Austin, have made some interesting claims regarding the social
construction of the financial markets, constructions that
help establish estimates of value.
calls “symbolic management” represents an important
part of the governance equation. In one of their articles,
Zajac and Westphal contend that managers have “successfully
defended themselves against shareholder power…[through]
the use of symbolic actions to respond to societal norms and
these actions, the authors note, includes the institution
of long-term incentive plans (LTIPs) that are theoretically
intended to align management with shareholders and their interests.
In practice, however, Zajac found that the announcement of
a LTIP is sometimes “decoupled” from actual compensation
arrangements. The result is a “symbolic substitution
effect” that enables CEOs, through symbolic action,
to manage shareholders as well as manipulate board dynamics
by decreasing the likelihood of real alterations in governance
that would threaten management’s agenda.
adoption” of LTIPs as a reaction to investor demand,
write Zajac and Westphal, can convey powerful signals that
create impressions about management being confronted by the
same financial pressures as their subordinates. Adoption of
LTIPs also suggests drama and conflict between the board and
management, which may result in reinforcing “rationalistic
conceptions of corporate governance” that help perpetuate,
rather than force legitimate change, within a firm’s
lot of the governance debate is trying to get at real material
facts to change behaviors,” Zajac says. “But in
many cases a firm is more concerned about appearing to look
right.” The appearance of action, Zajac is quick to
point out, may well have a similar affect to “real”
reform, and can have significant and lasting impacts, especially
if a company’s artificially boosted stock can later
be used to acquire a company that has hard and real assets.
the current governance reforms do much to effect real change?
gives a mixed review to the reforms currently floated to add
more independence to boards. Self-dealing has proven a big
problem for governance, he says, but solving that issue requires
a degree of sophistication he finds lacking in much of the
discussion surrounding governance. His work seeks to move
the governance dialogue away from simple analyses of legal
requirements and incentives alignment to incorporate data
from the behavior sciences that offer insights into how boards
while the current governance debate tends to concentrate on
improving board independence, Zajac says that independence
can mean detachment from the organization, and detachment
may be good or not so good. “We want independent boards
in the sense that we want to curtail conflicts of interest,
but on the other hand, you can argue that a detached board
has limitations that may make it a great monitor, but not
a good sounding board,” he says.
Zajac argues that just because a board is “independent”
does not automatically mean its outside directors will always
act like outside directors. He cites behavioral science research
that indicates outsiders may still prove surprisingly sympathetic
to CEOs, even when those CEOs are not overtly working to enhance
directors’ impressions of management’s performance.
“Attribution biases,” or errors in the perception
of why events occur, can seriously impact a board’s
ability to monitor management, notes Zajac.
he and Westphal suggest to improve boards includes increasing
their diversity across professional background, age, education,
ethnicity and gender.
minorities step into the governance circle
In fact, the Kellogg School has worked to provide the kind
of executive training that Zajac suggests can help build better
boards. Kellogg is now home to the Center for Executive Women
(CEW), a research, resource and education think tank established
in June 2001 whose mission is to provide leadership training
for women seeking governance roles. Among its initiatives,
the center hosts a two-day director development program for
women, the first of which ran in August with another session
in November. Both events received an enthusiastic response.
CEW also organizes symposia and speaker series whose subjects
are of particular importance to women executives.
kept out of the boardroom, women and minorities may now enjoy
more opportunities to serve in corporate governance, in part
due to new regulations that will restrict the number of boards
directors may serve on. In addition, governance will likely
remain under scrutiny, meaning that board service will demand
more time and attention from board members.
think the governance responsibilities will increase and expand,
and so board members are going to want to think very closely
about how many boards they serve on,” says Victoria
Medvec, the Adeline Barry Davee Professor of Organization
Behavior and executive director for CEW. “It’s
an opportune time for a new group of people to occupy governance
says that CEW helps prepare this new pool of female governance
experts by giving them the governance insights and financial
acumen to enable them to enter the boardroom with confidence.
She herself is confident that women have the talent to occupy
governance positions, though Medvec says that women currently
occupy only 11 percent of board seats at the top 1,000 U.S.
firms. The reason for this paucity, she suggests, is that
firms seeking to fill board positions are more likely to tap
those people who already serve on other boards. Men are more
likely to get their board seats through word-of-mouth, while
women often must rely on search firms.
difficult to get on boards. It’s difficult to get into
the system,” Medvec explains. “There are women
who have incredible skills, but are not serving on boards
now. We want to get rid of the excuse, ‘I want to have
women on my board, but I just don’t know any who are
is one such executive who serves on a number of boards, and
who works with Medvec and Professor Wally Scott as part of
the steering committee for CEW. Kraus says that she understands
how the huge impact that the “aggressiveness of a few”
has had on the economy warrants caution and oversight, but
she worries that too much regulation may discourage qualified
people from seeking board service.
shares her concerns and perspective. He also worries about
excessive regulatory constraints on business today.
does two things well: overreact and nothing,” he quips.
“There is magic in the free enterprise system. From
time to time it needs correction,” Scott adds. “Certainly
some CEOs have been allowed to run without any intervention.
But business is the only mechanism to raise wealth and create
jobs in this society, and we need to preserve those capabilities.”
one of the best ways to ensure the vitality of this system
is to enhance board diversity, so long as this diversity includes
some truly independent directors. Even in a climate that risks
extending reforms too far, Scott, Medvec and Kraus still believe
that women and minorities will enjoy increased opportunities
in governance positions as reforms take effect.
Lowry, vice president at the Chicago office of The Boston
Consulting Group and longtime member of the Kellogg Dean’s
Advisory Board, hopes so. He holds board members accountable
for much of the corporate scandals, saying that in some cases
they abdicated their fiduciary responsibilities and failed
shareholders by not being “bold enough to ask management
the tough questions.”
to more commitment from board members, Lowry says today’s
global marketplace increasingly demands diversity in the boardroom,
although at present he is not seeing enough of a governance
shift in this direction. When a business considers expanding
into diverse markets, there is a lot of value added by seeking
diverse opinions, he states.
world is smaller now than it was 30 years ago. Our growth
in terms of market share is really international,” Lowry
says. “You need to understand other cultures and how
other people make decisions, whether these decisions involve
investments or purchases, at the macro- or micro-levels.”
any empirical evidence that board diversity makes a difference?
notes Lowry, it’s worth remembering that it was women
who blew the whistles in the most high-profile accounting
scandals of the last year.