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The SEC's Colossal Failure of Oversight-- Isn't This a Violation of the Business Judgment Rule?

The damning New York Times headline, "SEC CONCEDES OVERSIGHT FLAWS FUELED COLLAPSE," from a September 26th article by Stephen Labaton, will hopefully end up as more than a footnote in the long list of misdeeds by the 'stewards' of the American economy that have brought American capitalism to the precipice of systemic financial collapse. According to the article, a report by the inspector general of the SEC asserts that "voluntary regulation does not work" and that the SEC's oversight program for the investment banks "was fundamentally flawed from the beginning."

The article goes on to state:

The report found that the S.E.C. division that oversees trading and markets had failed to update the rules of the program and was “not fulfilling its obligations.” It said that nearly one-third of the firms under supervision had failed to file the required documents. And it found that the division had not adequately reviewed many of the filings made by other firms. The division’s “failure to carry out the purpose and goals of the broker-dealer risk assessment program hinders the commission’s ability to foresee or respond to weaknesses in the financial markets,” the report said.

We should not gloss over the importance and the far reaching nature of this indictment of the SEC by the SEC's inspector general. The most fundamental fiduciary duty in business is the Duty of Oversight. Oversight is a theme which binds together the more commonly referred to fiduciary Duties of Care, Loyalty, Confidentiality, and Disclosure. Violators of the fiduciary duties listed above often seek refuge in the Business Judgment Rule and try to to hide behind 'squishy' judgment call concepts like "good faith" and "honest belief". But the Business Judgment Rule stands on oversight, and the SEC clearly failed in its duty of oversight of the investment banks. In my view, in addition to the bankers, the regulators themselves should also be held responsible for this crime against America.

Below is a definition of the rule, taken from the white paper, "A Simple Guide to the Basic Responsibilities of VC-Backed Company Directors", written by the Working Group on Director Accountability and Board Effectiveness:

Business Judgment Rule
Creates a presumption that in making a business decision, the directors of a company acted on an informed
basis, in good faith and in the honest belief that the action taken was in the best interests of the company.
The business judgment rule helps protect a director from personal liability for allegedly bad business
decisions by essentially shifting the burden of proof to a plaintiff alleging that the director did not satisfy
its fiduciary duties. This presumption and the protections afforded by the business judgment rule are lost if the directors involved in the decision are not disinterested, do not make appropriate inquiry prior to
making their decisions, or fail to establish adequate oversight mechanisims.

All corporate directors and persons in positions of accountable oversight responsibility need to commit these rules to memory-- and, more importantly, to act on them in the daily course of business.

Missing the Point-- WSJ Reports on Splitting the Chairman and CEO Roles in Public Companies

The Wall Street Journal's January 14th article "When Chairman and CEO Roles Get A Divorce" explores the increasing trend toward separating the Chairman and CEO titles.  Unfortunately, it fails to raise a critically important question-- is it advisable for former CEO's to remain on their own boards as independent directors, much less as chairmen? 

The article points out that "36% of Standard & Poor's-500 companies have separate chairmen and CEO's, up from 22% in 2002, according to the Corporate Library, a research group in Portland, Maine."  The article does not note that the S&P 500 lags significantly behind all public corporations in this regard, as 49% of all U.S. public companies have inside chairmen vs. 51% that do not, according to the Corporate Board Member / PricewaterhouseCoopers Survey, What Directors Think 2007.

The Journal writes in the context of James Cayne's resignation as the CEO of Bear Stearns last week, noting that Cayne remains board chairman.  Reporting from London, the WSJ reporter, Joann S. Lublin, observes the following:

"As at Bear Stearns, splits in the top posts at American businesses are often the result of a leadership transition or financial trouble.  In numerous cases, the chairman is a concern's retired CEO.  Yet the gradual emergence of non-CEO chairmen in the U.S. raises a sticky question: How do you perform a role that rarely existed until recently?"

While the article goes on to discuss the dynamics of groups that have been formed to provide peer support for independent board chairmen, I would like to pose a different, and perhaps more difficult, question.

Why doesn't Jimmy Cayne make a clean break from Bear Stearns and become the chairman of another board?

Keeping former CEO's on the board of your company is generally contra-indicated for several obvious reasons:

*First, most former CEO's have strongly held continuing views and core beliefs as to how the company should continue to be run;

*Second, it is emotionally very difficult for former CEO's to let go of such strongly held convictions; and

*Third, people have a natural tendency to second-guess other people.

These emotionally charged issues are only compounded when a CEO moves to the chairman's role under a cloud of some sort, as Ms. Lublin observes above. 

I wrote an extensive article on this topic in the Spring 1999 issue of Directors & Boards magazine, "The Problem of Emotion in the Board Room", in the context of the challenges faced by public and private companies.  A strong case can be made that former CEO's should normally not remain on the board of their former company, as chairman or otherwise.  They can be great directors and great chairmen, but they should accept these roles at new companies where they can perform in leadership positions without the emotional baggage they carry in the transition from the incumbent CEO role. 

I concluded the Directors & Boards article with the following:

"Walter Wriston, who retired as CEO and as a director of Citicorp in 1984, observed in a 1993 article in Directors & Boards that 'In short, there are a myriad of reasons for the retiring CEO to leave the board, and few if any arguments for the other course... the human desire to stay on with a company that has been home for many years is stong and understandable, but the world is so full of so many other interesting things to do that the desire to stay should be resisted doe one's own sake and for that of the company.' "

Top Reasons Why Public Company Directors Should be Removed

According to What Directors Think 2007, nearly one-quarter (23%) of the over 1,000 respondents to the sixth annual U.S. public company directors survey feel that a member of their board should be replaced.

Why:

*  The director does not have the skill set needed... 36%

*  The director is not engaged..................................  31%

*  The director comes to meetings unprepared........ 18%

*  The director has been on the board too long.......  17%

The first three categories above should resonate equally with private company directors and certainly with venture capitalist directors.  I have maintained for many years in my corporate governance writings that the most common problems faced by boards cut across issues of revenue size and company maturity.

At their core, these are issues that relate to the mutual accountability of individuals who belong to small groups and the need to avoid systemic dysfunction in order to maximize the opportunity for positive corporate outcomes.

In fact, many of these issues are only exacerbated in VC-backed companies because emerging companies are resource-constrained and under severe pressure to execute over a shorter time frame than larger corporations which have greater resources at their disposal.

Most Public Company Boards Conduct Full-Board Evaluations and Find Them Effective

PriceWaterhouse Coopers and Corporate Board Member recently released their sixth annual survey of directors of public companies, which aggregates responses from over 1,000 corporate directors on a variety of important issues. 

First, some interesting statistics from What Directors Think 2007:

How many people actually serve on public company boards of directors?  At the end of 2007, directors on U.S. corporate boards totaled 48,950 from 5,772 public companies. 

Of this total,  66% hold only one board seat-- a result which certainly surprised me and is unheard of among the multiple-board seat VC  community.

Women occupy 4,544 board seats, or 9.3% of the total.  Out of a total of 5.341 board chairmen, 49% are insider chairmen and 51% are outside chairmen-- a ratio that holds across revenue size categories.

The survey also revealed some very useful information on Corporate Governance--

Respondents rated the following Top Five hallmarks of good governance, in order of priority:

(1) The board holds regular executive sessions without the CEO;

(2) The board is composed mostly of independent directors;

(3) The board or a committee conducts regular, formal CEO performance reviews;

(4) The company has a formal management succession process in place;

(5) The board evaluates both whole-board and director performance.

As a VC, I feel strongly that numbers (1), (3), and (5) above are entirely applicable to VC-backed companies and should be high priorities for VC directors.

In 2007, 88% of public boards conducted a full-board performance evaluation on a regular basis, up from 33% in 2002-- 78% of respondent companies listed on NASDAQ do so even though this is not a NASDAQ requirement.

Only 57% of directors characteriz their board's evaluation process  as effective or very effective-- leaving 38% saying it is somewhat effective and 5% saying it is ineffective.  The authors conclude that "these results show many boards are not maximizing the usefulness of this process which, among other things, directors have told us can improve board communication, provide focus for board and management recruitment efforts, and identify ways to streamline board processes to make the best use of directors' time."

Private company directors should follow this increasing trend toward board and director performance evaluation in far greater numbers-- for more on how VC companies should apply best practices to approach these issues, go to www.levp.com/news/whitepapers.shtml to review material prepared by the Working Group on Director Accountability and Board Effectiveness.

Are Sentencing Guidelines for White Collar Criminals Too Severe?

The January/February 2008 issue of Corporate Board Member magazine features a picture of Dennis Kozlowski on its cover and asserts in its cover story tag line: "Why giving convicted executives decades in prison makes no sense."

The story itself mentions over a dozen recently convicted executives serving long sentences for fraud, including Bernie Ebbers, former CEO of WorldCom, 66 years old (25 years in Oakdale Federal prison in Louisiana); Walter Forbes, former Chairman of Cendant, 65 years old (12 years in Allenwood federal prison in Pennsylvania); Sanjay Kumar, former chairman and CEO of Computer Associates, 45 years old (12 years in the federal correctional facility at Fairton, New Jersey); John Rigas, 83 years old, former chairman and CEO of Adelphia Communications (15 years at the Butner federal facility in North Carolina; Jeffrey Skilling, former Enron CEO, 54 years old (24 years at the Federal correctional institution in Waseca, Minnesota; and Kozlowski-sidekick Mark Swartz, former CFO of Tyco, 46 years old (up to 25 years in state prison in Rome, New York). Swartz, like Kozlowski, is eligible for parole in 2013, and they are both two years into serving their 25 year sentences.

One of the main points of this interesting article follows:

"The overarching problem with multi-decade sentences for nonviolent crimes like fraud and drug possession is that they seem disproportionate to the goals prison sentences are supposed to achieve: penitence, deterrence, restitution, and retribution.  Does life without parole for a white-collar offender-- or 25 years for a single drug offense-- really accomplish these things any more effectively than, say, three-to-five-year sentences?  Perhaps in some specific cases, but surely not in all."

As I read the article, written by Rob Norton, I felt that it made many good points but that considering drug offenses and finanical fraud in the same construct detracted from some of the more powerful arguments for reform. 

In my view, the punishment meted out to individuals guilty of massive corporate fraud should be considered in a class of its own.  Where I think that the author falls short in this article is in failing to consider the fact that with great power comes great responsibility.  Corporate CEOs and other senior managers hold the financial futures of many thousands of people in their hands-- they are the stewards of the retirement plans for the generations of employees that may have preceded them, as well as of the financial security of the company's current employees and the investing public.  Many CEOs are responsible for corporations that have higher incomes than the GDP's of most countries in the world.

The fact is that too many CEOs have approached their responsibilities in a cavalier manner and ignored their roles as stewards of the public trust.  Should this be treated any differently than the commission of a violent crime against an individual? Yes.  But the magnitude of corporate fraud may impact thousands of families and ripple through many lives in ways that never come to light during trial.

Dennis Kozlowski states in this article: "I'm serving a worse sentence than many murderers, rapists, and child molesters.  Another thing, I was convicted of stealing my bonus.  Well, I never got it.  It's still in Tyco as deferred compensation I never collected.  It's like finding somebody guilty of bank robbery when the money is still in the bank."

I believe that Dennis Kozlowski's deferred comp may have recently left Tyco headquarters as part of the $3 billion class action lawsuit settlement agreed to be paid by the company last month.  I also doubt that he plans to try collecting it in 2013 if he makes parole.  More importantly, most rapists and murderers aren't sufficiently achievement oriented or psychologically stable enough to be afforded the kind of power and public trust that Dennis Kozlowski received in the first place.

I do agree with the underlying premises of the article-- that there is plenty wrong with our prison system, that it is overpopulated, and that rigid sentencing guidelines should be revised to give judges greater latitude in individual cases.  But I also feel strongly that senior corporate officers must be given powerful reasons to think long and hard before making the choice to cross the line into white collar crime.  Perhaps the headline-grabbing examples of these recent harsh sentences will help future CEOs and other senior executives consider the privilege of their positions and their stewardship obligations as corporate titans more seriously before they choose to pursue misguided visions of entitlement to the excess riches that attend powerful executive positions.

   

   

Fred Amoroso and Carol Bartz on Director Accountability and the Value of Annual Board Assessment

SpencerStuart recently published the 2007 Silicon Valley Board Index, which updates useful statistics on Silicon Valley public boards, ranging from average annual board retainers for directors ($35,600 in 2007 up from $25,000 in 2003) to the continuing lagging percentage of female directors serving on Silicon Valley public boards (48% in 2007, up from 44% in 2003 but well below 91% for the S&P 500).

This year's report also includes a Roundtable Discussion featuring Carol Bartz, Executive Chairman of the board of Autodesk (formerly also President and CEO) and a Cisco director; and Fred Amoroso, President and Chief Executive Officer of Macrovision and Chairman of the board of Foundry Networks.

Co-authors Nayla Rizk and John Ware of SpencerStuart pose the following question, which is of particular relevance to VC-backed private company boards:

"Clearly, the way boards see their role has changed.  One way more boards are using to continually define their role and hold themselves accountable is the annual board assessment.  How do your boards handle evaluations?  Do you conduct individual evaluations?"

AMOROSO:  We've actually spoken a lot about whether we should do formal evaluations and, to be honest, it's a sensitive topic.  Not everyone likes to go through that level of scrutiny.  We've offered a kind of self- awareness approach.  A few of our board members have actually gone out and participated in director training in different areas, so they are more aware of some of these things. . . . Board training is going to be one of the things we'll see more of over time.

BARTZ: We do have board evaluations. . . . We've actually found it quite useful to collect information from each member and then tally it.  Then we can talk about it-- such as, "We've all given ourselves a low score here, what do we want to do about it?" . . . It's very important to be self-aware.  Even though we don't evaluate directors person by person, the board evaluation process makes everyone self-aware.  We include questions such as "Does everybody participate?"  "Is everyone adequately prepared?"  And if you are sitting around the room and we collectively got a low score on "Is eveyone prepared?", then you have to do a little self-evaluation.  You know, "Gee, maybe they are talking about me."  I think it is very effective.

As I read through these answers, I was struck by the fact that these observations are equally true for private companies.  As we have written in "A Simple Guide to the Basic Responsibilities of VC-Backed Company Directors", avoiding scrutiny of their own actions is a natural inclination for company directors because the CEO reports to the board. 

But shouldn't the board be held accountable to an absolute minimum standard of acceptable performance? Yes!  It is a critical legal requirement, through the exercise of the director's duty of oversight, to scrutinize company management.  At the same time, directors cannot be exempt from scrutiny themselves--  lest we forget what has occurred at the Adelphia's, Tyco's, and Enrons of the world...

As Bartz, points out, generating self-awareness is the key-- to the extent that asking questions about elements of the board's collective performance generates a "Gee, maybe I..." moment, that is a positive accomplishment.  These are basic best practices for large and small companies, whether they are public or private. 

Dennis Kozlowski, Mark Swartz, and "the Niceties of Corporate Governance"

 

Floyd Norris posted a story in his blog in today's New York Times, "Unhappy Birthday, Dennis", citing the New York State appellate court's unanimous ruling upholding the criminal convictions of Dennis Kozlowski and Mark Swartz for "grand larceny in the first degree (12 counts), conspiracy in the fourth degree, violation of General Business Law § 352-c(5) and falsifying business records in the first degree (8 counts)", otherwise known as stealing millions of dollars from Tyco and Tyco's shareholders.

In his blog post, Norris walks down memory lane and notes how he wrote a column in 1999 questioning the integrity of the Tyco juggernaut, whose astronomical growth throughout the 1990's was often compared to that of General Electric under the stewardship of Jack Welch.  Bringing us forward to the present day, Norris reflects:

"An investor who bought when I wrote back in 1999 could have gotten out with a nice profit a few months later. But if he held on, he would have since lost a third of his investment.  In that 1999 column, I quoted Mr. Kozlowski as saying there was “no risk that investors will wake up one day and find out there’s something wrong.” Perhaps the operative part of that forecast was “wake up.”

Based on my own direct experience with Kozlowski and Swartz in the context of Tyco's AMP acquistion in 1998-1999, in 2002 I wrote an extensive expose of the Tyco fiasco in Directors & Boards Magazine titled "Tyco's Betrayal of Corporate Governance".  This story followed my Spring 1999 story, also featured in Directors & Boards, titled "The Problem of Emotion in the Boardroom", which dissected the topic of emotional dysfunction in both the public and prviate boardroom, using the example of the board dynamics at AMP, which was Tyco's last major acquisition ($11 billion).  In this case, in October 1998 Tyco interceded as a "white knight" to Allied Signal's hostile takeover bid for AMP in August 1998.

In reading the appellate court's decision (click here for the full text of the decision), I found it particularly galling that Mark Swartz and Dennis Kozlowski have persisted in claiming that they were legitimately entitled to the egregious compensation that they awarded to themselves.  Happily, the appellate court blasts this claim:

" More significantly, though, the entitlement claim was flatly refuted by Mark Foley, the Tyco executive who was responsible for the calculation of the year-end figures on which the annual bonuses were based. In fact, Foley's testimony unequivocally established that defendants received everything they were entitled to under the end-of-the-year formula. Thus, defendants' claims only succeeded in pitting their credibility against that of the committee members and Foley and various other members of their own staff. Defendants even contradicted each other on a number of points. The jury's resolution of this factual issue is amply supported by the weight of the evidence since defendants' self-serving testimony was illogical, internally inconsistent, refuted by Tyco's records and shown to be false by all other witnesses."

But I find the implications of Swartz and Kozlowski's assertions that corporate governance process is irrelevant even more disturbing:

"Most notably, Tyco's annual proxy statements, prepared under defendants' supervision, failed to indicate even the most oblique reference to their multimillion-dollar midyear bonuses. This documentary void revealed more than a few isolated "procedural irregularities," as Swartz maintains, or a "fail[ure] to adhere meticulously to all of the niceties of corporate governance," as Kozlowski would have it. Rather this consistent pattern of documentary omission over a period of years constituted powerful evidence of defendants' intentional hiding of these payments from the directors and led inexorably to the jury's conclusion that defendants took these bonuses without permission or authority. The absence of any reference to these transactions in the chain of documentation available to the committee clearly demonstrates defendants' coverup of their thievery."

Happily, the court soundly rejects these notions, yet I am deeply troubled that anyone, even a desperate person such as Kozlowski, would consider the approach that portraying corporate governance requirements as a "nicety" might carry weight with a panel of judges.

The requirements of corporate governance are not niceties.  They represent necessary processes with a fundamental purpose-- to protect investors and to safeguard the duties of responsible stewardship and oversight that define core director responsibilities.

Kozlowski and Swartz amply deserve to serve their full jail time, and it is cold comfort for investors who lost billions of dollars to see this small measure of justice strongly reaffirmed by the appellate court of the State of New York.

I wonder if Dennis was able to stick a small birthday candle in one of his delicious jailhouse vending machine Payday candy bars today to celebrate his 61st birthday?

      

   

What's New in the Expanded "A Simple Guide to the Basic Responsibilities of VC-Backed Company Directors"?

Today the Working Group on Director Accountability and Board Effectiveness released an expanded version of "A Simple Guide...".  The new material covers three main areas--

Details on how to conduct a board peer review; a process outline for conducting an annual CEO review; and how and why you need to consider internal controls (particularly as an audit committe) at the same time that you are considering governance process implementation.

We also expanded the section on the importance of having aligned interests around the board table-- both economic and strategic, outlining some of the key questions that need to be discussed to get to the bottom of these thorny issues. 

If you've read the paper before, the bulk of the new material is on the following pages:

How to Achieve an Aligned and Effective Board-- page 4

Development Stage, Governance Process, and Internal Controls-- pages 6 -9

How to Evaluate Your Own Participation on the Board-- page 19

How to Conduct an Annual CEO Performance Review-- page 20

How to Conduct an Annual Board Peer Review-- page 21

Comfortably Numb? Death by Board Meeting

When I was a child I caught a fleeting glimpse,
Out of the corner of my eye.
I turned to look but it was gone.
I cannot put my finger on it now.
The child is grown, the dream is gone.
I have become comfortably numb.

Pink Floyd, Comfortably Numb, The Wall, 1979

In VentureBeat today, Nick Sturiale of Sevin Rosen writes an important editorial on ineffective board meetings.

"Death by Board Meeting" makes several important points about how to optimize board meetings-- the core link between all of them is the need for thoughtful process to be in place in order to make the board meeting valuable for all participants.

Defaulting to board meetings that emphasize form over substance-- allowing directors to  arrive unprepared and CEOs to emphasize operational reports as opposed to engaging in strategic discussions-- points to a deeper problem of failed communication.

If your board meeting turns into a waste of time, it is incumbent on both the management and the VCs to proactively change this dynamic.  Unfortunately the substance of this excellent editorial is unlikely to be a surprise to many VC company boards that are driven by inertia.  The question is, will they notice and do something about it?

VCs Need to Focus on How the Jockey Rides the Horse

Last week in PE Hub Dan Primack reported on a recent white paper, “Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies”.  In this paper, Professors Steven N. Kaplan (University of Chicago), Berk A. Sensoy (USC), and Per Stromberg (Stockholm Institute of Financial Research) survey 50 VC-backed companies that completed IPO’s in 2004.  They conclude the following:

“The results call into question the claim that “a great management team can find a good opportunity even if they have to make a huge leap from the market they currently occupy. . . . firms that go public rarely change or make a huge leap from their initial business idea or line of business.  An initial strong business, therefore, may not be sufficient, but appears to be almost necessary for a company to succeed.  On the other hand, it is common for firms to replace their founders and initial managers with new ones and still be able to go public, suggesting that VCs are regularly able to find management replacements or improvements for good businesses.  We interpret our results as indicating that, on the margin, VCs should spend more time on due diligence of the business rather than management.”

The authors wisely note the limitations of their small sample size and that 44% of the companies in their survey were life sciences companies.  They also point out that they are unable to access data on companies that experienced exits through acquisition (the vast majority of VC-backed companies) because this data is unavailable.  It is unfortunate that the value of much of the academic research conducted on our field is severely limited by the lack of access to relevant data.  This is clearly the case when one reflects on the conclusions of this report.  In my view, debating this aspect of the Horse vs. Jockey argument isn’t particularly useful to VCs or to entrepreneurs.

A more interesting line of related questions could begin with “Why do so few VC-backed firms succeed, period?”  "Is it endemic to venture capital investing that roughly 10% of investments will account for the vast majority of returns?"  "Can VCs do something to improve these statistics and therefore increase the return profile of the entire industry?" 

As the authors point out, VCs do, indeed, know how to replace management teams, and this occurs quite regularly.  More importantly, the human capital side of founder and management transitions is by no means optimized in our industry. In my opinion, the absence of consistent processes in many VC-company management transitions is the Achilles heel that spells failure for many companies—and this suggests that dysfunctional personal dynamics between VCs and founders may actually lead companies with solid business models to fail.

Start-ups experience accelerating rates of change, both internally and externally, as they develop.  The convergence of changing markets, evolving product lines, and frequent employee hires and replacements in a resource-constrained environment leads to extraordinary and stress inducing rapid rates of change in fledgling companies.

Through collaborative work on identifying governance best practices, the group of VCs and other industry professionals who have formed the Working Group on Director Accountability and Board Effectiveness conclude that having process and internal controls in place allows investors and the senior management team to better identify and calibrate problems, to determine the next course of action, and to reposition the company for success.  The outcome may involve changes to the team, to the business model, or both.

Process and controls form an important framework for management self-help in decision making.  Without process, it’s much easier to flounder and get caught in sub-optimal decisionmaking.

While VCs should certainly avoid investing in weak business models, in contrast to Professors Kaplan, Sensoy, and Stromberg, I would suggest that, at the margin, we should spend more time identifying and applying best practices and processes to our companies to improve our set of potential outcomes.  Assuming that we can identify strong business models, we should focus on maximizing the potential for our management teams to succeed in order to boost the VC industry’s collective returns for our investors.