Keeping Boards Informed

By the time Edward D. Breen Jr. took over as CEO and chairman of Tyco International in July 2002, the company was in the midst of what threatened to become a death spiral. Its stock price had tanked, it was deep in debt, its once-stellar reputation was sullied by scandal, employee morale was in tatters and the company’s strategic momentum had stalled. The previous CEO and chairman, L. Dennis Kozlowski, had become the latest poster boy for executive excess, accused of raiding the company treasury to pad an increasingly lavish lifestyle — including a $2 million 40th birthday party in Sardinia for his wife and a $6,000 shower curtain for Tyco’s New York City apartment. Almost overnight, Kozlowski went from being touted on magazine covers as “the next Jack Welch” to being investigated for fraud.

Although Kozlowski was widely considered the prime culprit in Tyco’s reversal of fortune, the company’s passive and disengaged board of directors, which appeared to function mainly as a rubber stamp, ran a close second. According to Breen, the Tyco board had let risk get out of control during the company’s years of explosive growth.

“We had $32 billion in debt, and $13 billion was owed in my first year,” said Breen. “We didn’t have the money, and we had an $8 stock price.”

Kozlowski had powered Tyco’s growth through a frenzy of acquisitions, earning himself the nickname “Deal-a-Day Dennis.” On his watch, Tyco bought almost 600 companies between 1997 and 2002, including nearly $20 billion worth of acquisitions in 2001 alone. According to Breen, the deal-making velocity left too little time to thoroughly evaluate and integrate all those new properties.

Over time, the profusion of acquisitions — some of poor or unknown quality — gave the company a bad case of indigestion that brought it to the brink of bankruptcy, said Breen. He became convinced that the board of directors that hired him to replace Kozlowski also needed replacing since it had failed to prevent, or even recognize, the perils that nearly destroyed Tyco. Central to the board’s dysfunction was its passivity. It failed to pursue information that might have awakened it to the risks the company faced and it failed to question the wisdom of management’s deal-making pace, said Breen.

“Just imagine if the board had spent two or three meetings talking about the balance sheet,” and playing the whatif game, said Breen. “ ‘What if the stock market takes a downturn? What if the financial markets tighten up? What if we can’t raise money for a little bit of time?’ Very basic questions that might have caused a smart board member to get really nervous.”

Breen’s search for new directors ushered in a range of reforms aimed at ensuring that no future Tyco board would allow a similar crisis to develop on its watch. In revising board practices, Breen and the new board tackled many of the key challenges commonly confronted by corporate directors.

Data Mining

The difficulty boards encounter in obtaining critical information has long been seen as a challenge to good corporate governance. Management invariably knows more about the company than do the directors, shareholders or regulators. So the mission of every board is, in part, to close the gap as much as possible. It is more a problem of quality than of quantity. Clearly, the board does not need to know everything management knows — just the really important things.

Boards usually have no shortage of information. Management customarily deluges boards with analysts’ reports, compliance filings and memos on strategy, risk and financial performance. And that deluge has been steadily growing in recent years. In fact, the volume of information with which boards need to concern themselves has gone from a trickle to a flood in the last 25 years.

In the mid-1980s, “if there was something of significance on the [meeting agenda], you might have 10 to 15 pages of reading and not much more,” said James I. Cash Jr., an emeritus professor of business administration at Harvard Business School who has served on the boards of public companies since 1984. Cash saw the volume of information boards received rise steadily throughout the 1990s — nudged along by globalization and the occasional lurid business debacle — and then spike sharply with the passage of the Sarbanes-Oxley Act in 2002. That legislation demanded numerous new disclosures that multiplied the information directors needed to review.

But the flood of information can serve as much to obfuscate and even misinform as to enlighten. Boards can be so overwhelmed with information that they are unable to zero in on what is critical. And management may sometimes be motivated to take advantage of voluminous information to divert directors’ attention from vital facts.

“Very often, they’ll bury them in data, but it’s not the right data,” said Nell Minow, co-founder of The Corporate Library (www.thecorporatelibrary.com), an independent corporate governance research firm.

The motivation to misinform can arise from the inherent conflict of interest that is at the core of the relationship between boards and management teams. Robert A.G. Monks and Minow described that essential conflict in their 1995 book, “Corporate Governance.” It is the board’s job to hire, and sometimes fire, top management; thus management reports to the board, which oversees its performance, the authors observed. And yet “in the overwhelming majority of cases, directors are beholden to management for nomination, compensation and information,” they wrote.

The job of boards then is to avoid being drowned in information, to pull out the information they need and to get the information they cannot obtain from management by other means.

Taking Control of Information

One of the principal ways that boards can regain control of the information they receive is by setting the agenda for board meetings.

“I can’t emphasize enough that the board itself needs to control the agenda for board meetings,” said Minow. “The board has to say to the CEO, assuming the CEO is chairman, ‘If you’ve got good news, send it to us in an e-mail. We’re happy to have it, and we’ll stand up and applaud. But the board meeting, when we’re all in the room together, is about the bad news. It’s about the toughest problems and the hardest questions. That’s why we’re here. So we start with that, and if there’s time left over, we get to the good news.’ And that’s why the board has to control the agenda. Because if they do, they will also control the information they receive.”

At Tyco International, the board now routinely proposes topics for discussion, said Breen. He also is careful to leave plenty of time in meetings for discussion; there are no long presentations or slide decks.

“If you ask for an open dialogue at the board meeting, hundreds of questions usually get at all the issues,” he said. ”Versus a board that just sits there and lets management present, and maybe once an hour there’s a question.”

Another innovation at Tyco is the institution of regular teleconferences in the months between the board’s six formal meetings. There are a small number of agenda items for each of these calls, but the bulk of the time is left for open discussion. Breen finds that often questions raised by the teleconferences surface at the next formal meeting.

Field Work

Boards can also exert control over the information they acquire by conducting firsthand research themselves. Minow thinks field trips are a must.

The Home Depot, for example, has required its directors to make three store visits a month, said Minow. Home Depot’s directors “would hang out in the parking lot for a while and ask people coming out of the store if they’d gotten everything they needed” and whether the shopping experience was acceptable, Minow said. “Then they’d go inside and look around. And then there’d be an announcement on the PA saying, ‘One of our board members is here today. If any employee or customer wants to talk to him, here’s where you’ll find him.’ ”

The Tyco board has become as intent upon doing its own research as its predecessor was complacent about it. The board has launched a range of risk-mitigation activities across the business, including trips to foreign facilities, said Dennis Carey, a senior client partner in Korn/Ferry International’s CEO and Board Services Practice. Carey believes that few boards take risk assessment seriously enough.

“Many boards still have not gotten to the point where I would feel comfortable saying that they have very effective risk-mitigation discussions at the board level,” he said.

Risk-assessment visits to worldwide business units are now a staple of Tyco directors’ work, said Breen. Directors spend a large part of one day meeting with the presidents of local business units and their direct reports. Board members ask the local managers what they think are the two or three worst things that could happen to them at any moment. Directors also tour the facilities and meet with employees to answer their questions. Breen and other top executives deliberately do not attend.

“We let the board team go do it and have a freely flowing dialogue,” he said.

Boards can also take what amount to virtual field trips. The growing number of social networks and online communities — many of which are largely populated by a particular company’s customers or employees — are full of diverse viewpoints on corporate performance. Increasingly, companies actively monitor what is said about them on Twitter, Facebook and the Web sites of specialized advocacy communities that coalesce around various consumer interests and sectors. Boards should just as actively seek out those perspectives.

Minow also recommends that boards visit Yahoo and The Motley Fool message boards, where they are apt to find valuable information from unhappy employees as well as investors. Boards can only get a comprehensive picture of a company by gleaning information from as wide a variety of sources as possible, she said.

Trust, but Verify

In addition to independently gathering intelligence, boards must cast a skeptical eye over the information they do receive from management.

“You can’t do better than to quote Ronald Reagan, ‘Trust, but verify,’ ” said Minow. While she believes it is important for boards to build good relationships with management, she sees the job of verification as a perennial board challenge. (See sidebar, page 65, “To Ensure Candor at the Top, Begin at the Beginning.”)

Minow recalled a conversation with a director of one of the largest companies that imploded in the financial crisis to illustrate the pitfalls of directors taking what they are told at face value. She said the director told her, “I used to ask the CEO to get back to me on some things, and he wouldn’t do it. And I thought, oh well, he’s busy, I don’t want to bother him. But now I realize he was just hiding stuff.”

“Directors have to be immensely alert to discontinuities and inconsistencies — to things that just don’t seem right,” said Jay W. Lorsch, a professor of human relations at Harvard Business School. “If you smell smoke, you better go see if there’s a big fire.

But boards must tread a fine line in questioning management because maintaining a close relationship with management is crucial to the performance of a board’s responsibilities, according to Lorsch and other observers of corporate governance. The paramount goal of a board is to build a trusting relationship with the management team, these observers believe. That relationship is presumed to lubricate a candid, productive give and take, which in turn helps directors develop insight into management’s thinking and overall performance.

Boards “can’t start to look like watchdogs,” said Lorsch. “Even the audit committee, if it gets too aggressive, can create tensions.” So checking up on the management team “has got to be done carefully and with a fair degree of what I would call delicacy,” he said. That can be a tall order, he admitted.

Even when there is not a deliberate effort to conceal information, there is the danger that management is not in control of its operations. Lorsch believes that management’s failure to comprehend the risks that their companies were exposed to, rather than deliberate wrongdoing, caused many of the recent corporate crises. To protect against this, boards must be able to unravel what management cannot.

Building a board composed of experts in key disciplines — finance, risk, compensation and talent management — can therefore be critical. Likewise, directors with specific industry knowledge or track records of executive leadership in companies of comparable structure, scale and reach bring a significant advantage in their ability to understand what they see and hear from management. Carey, of Korn/Ferry International, said that most audit committees he has worked with have at least two financial experts.

“There’s a plethora now of CFOs and former CFOs on board audit committees — many, many more than were on boards before Sarbox,” said Carey, referring to the Sarbanes- Oxley Act. This is preferable to having professors of accounting serve on boards because CFOs know better what can be done to shade data, and they know what questions to ask of a company’s CFO, he said.

Carey, who recruited Breen and then Tyco’s new board, said he looked for “a world-class independent director who was a high-octane, high-energy person but also someone of great integrity.” Carey found Jack Krol, the former CEO of E.I. du Pont de Nemours, and the two of them assembled the rest of the new board.

“Because Tyco had had an investor crisis of confidence, we wanted to find people who were highly respected by the investor community,” said Carey. “We recruited a couple of people who were in the mold of no-holds-barred, shareholder- activist-supported directors. I wouldn’t do that in every case, but in this case it made sense.” Carey also looked for strong executive experience and hired two CEOs, William S. Stavropoulos of Dow Chemical and Rajiv L. Gupta of Rohm and Haas.

“These are big, global, complex companies that would not compete against Tyco but faced some of the same issues that Tyco would have to deal with,” said Carey. 

Courage Above All

While it is crucial for boards to independently collect information and have the expertise to understand financial statements and accounting rules, it is most important of all that they have “intellectual courage and curiosity,” said Minow.

In January 2001, Kozlowski presented the Tyco board with a new CEO employment contract stipulating “that a felony conviction would not be grounds for termination,” said Minow.

“And they signed it,” she said. “Now, don’t you think maybe that was a red flag, and someone should have raised his hand and asked, ‘Is there something you want to tell us?’ That’s not an issue of information — they had the information right in front of them.”