Who will lead?
Business 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 investor confidence

By Matt Golosinski

For much 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.

The market 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.

© Nathan Mandell James H. Lowry, featured in "Diversity in Action."

Today, 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 them.)

Some 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.

Given 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.

Kellogg 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 investors.

Jacobs 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’ wake.

“The 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.”

For Dean 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.

“The 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.

“Governance is the new leadership mantra,” he adds.

	© 2002 James Kegley Photography Margery Kraus, featured in "Reform demands won't discourage veteran board member from service."

Governance 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.

The contentious 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.

This is your brain on stock options
Reforming 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.

Sarbanes-Oxley 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.

Stock 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.

And how 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.

A host 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.

With 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.

“Certainly 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.”

Scott 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.

Margery 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.

“Financial 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.”

The 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 related story).

But claims 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.

Volcker 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.”

© Nathan Mandell Michael Miles, featured in the article "Helping companies see the forest for the trees."

Kellogg 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.

Whether 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.

One corporate 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.

“Clearly, 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.

“We shouldn’t overreact on the basis of 10 train wrecks and conclude that governance needs to be fixed,” he insists.

Signs 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.

“We 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.

What Zajac 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 values.”

One of 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.

The “ceremonial 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 governance structure.

“A 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.

So will the current governance reforms do much to effect real change?

	© Nathan Mandell "Kellogg has long history as governance leader."

Zajac 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 function.

For example, 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.

Furthermore, 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.

One conclusion he and Westphal suggest to improve boards includes increasing their diversity across professional background, age, education, ethnicity and gender.

Women, 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.

Traditionally 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.

“I 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 positions.”

Medvec 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.

“It’s 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 qualified.’”

Kraus 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.

Scott shares her concerns and perspective. He also worries about excessive regulatory constraints on business today.

“Congress 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.”

Perhaps 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.

James 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.”

In addition 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.

“The 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.”

Is there any empirical evidence that board diversity makes a difference?

Well, 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.