Responsibilities of the Board of Directors

The Center for Corporate Change
Second Annual Changing the Game Forum
June 10 - 12, 2004
Beaver Creek, Colorado

The Center for Corporate Change, a component of the Vail Leadership Institute, is devoted to substantially raising the standards of ethical conduct of American business. One important medium for accomplishing this goal is the Center's Annual Changing the Game Forum. At this Forum the Center invites leaders from the business and academic communities to identify, discuss and debate key issues affecting the ethical conduct of business and its leaders.

The Forum discussions are based on a list of seven "Root Causes" of corporate malfeasance as identified by the Center founders in 2002:

• Corporate Valuation
• Board Governance
• Leadership and Corporate Culture
• Compensation
• Competitive Practices
• Accountancy
• Regulation

A team of nationally recognized researchers from the Daniels College of Business of the University of Denver presented an update of the base line research they did in 2003 regarding the seven root causes of corporate malfeasance as identified by the Center for Corporate Change. In 2003, the research team gave the general business / regulatory community a grade of D for their performance on these issues. For 2004, while the research team identified some progress especially in the area of regulation, they also saw some deterioration in terms of Leadership and Culture. In sum, however, there was not enough improvement from 2003 to 2004 to move the needle from the D grade of last year.

The 2003 Forum identified three issues to be researched and debated at the 2004 Forum: The separation of the CEO and Chairperson positions; the roles and responsibilities of boards of directors for corporate culture; and multiple stakeholder valuation.

Each of these topics was assigned to an independent organization for study and presentation to the Forum. A panel of experts was assembled at the Forum to provide alternative perspectives on the issue. Finally, the Forum audience of another 80 participants was invited to discuss and debate the issue further. The Center's intent was to provide a well rounded examination of the topic and from this examination to form a perspective which reflects the recommendations of the Center and its constituencies and the best interests of the American social / economic system. This paper reflects the summary of the position paper and debate on the second of these issues: the roles and responsibilities of the board of directors for corporate culture.

The Position Paper

Mr. Rand Garbacz presented the position paper prepared for the Forum by ATKearney, a leading strategic management consulting practice headquartered in San Francisco. Mr. Garbacz first reported on a series of research statistics demonstrating a strong and positive link between quality governance and company performance and shareholder value. Specifically, he noted that firms that had very high GMI (Governance Metrics International) scores tended also to show very high total shareholder returns. These included firms such as Coventry Health, Sunoco, ITT, 3-M and Harley Davidson. On the other hand, companies that demonstrated very low GMI scores also tended to show quite low total shareholder returns. These corporations included such firms as Lucent, Qwest, Xerox and Williams.

Linking good governance with corporate culture, Mr. Garbacz noted that "culture impacts the interests of all other stakeholders, and thus derivatively has a direct, measurable impact on shareholder wealth". Therefore, he said, culture, as a governance role is neither optional nor tangential. He than stated that corporate culture starts with the board and identified a number of board issues that significantly influence corporate culture:

• Independence: Objectivity
• Committee structure: Agenda
• Nominating process: who selects / what criteria
• Time dedicated: Time really available?
• Compensation: cash or stock
• Philosophy: CEO "rules" or CEO the hired hand

The culture set at the board level then gives cues to executive management in such issues as:

• Accountability: To whom? What basis? What metrics?
• Transparency: clear or opaque?
• EPS or cash flow: "hit" targets or create value
• Executive style: participative or autocratic?
• Promotion path: dictatorial or meritocracy?
• Succession: hold the course or fresh ideas?
• Reality of conduct and ethics: as preached or as practiced?

Mr. Garbacz reported on the results of a survey of over 410 directors of public companies regarding a wide variety of corporate governance issues. Several of the questions dealt directly with the question of the responsibilities of the board for corporate culture. Some 42% of the directors queried said that culture is an important concern for the board and ought to be monitored by the board independently of the CEO. Here are some more of the key statistics:

• Culture is an important concern for the board: 70%
• Culture should be independently monitored by the board: 60%
• Culture should be monitored through:
  
  • Existing committee structure 70%
  • Other means 30%
• What should be monitored?
  
  • Employee indicators 70%
  • Market/customer indicators 60%
  • Incident indicators 100%
  • Financial indicators 100%

ATKearney takes the position that boards need to take action in five critical areas of governance:

• Monitor corporate performance with forward-looking and non financial business indicators
• Strengthen business strategy through diverse perspectives and ongoing attention
• Improve risk monitoring and mitigation
• Shift from succession policy to successor readiness
• Foster a constructively challenging culture, engaging as owners vs. as reviewers.

Taking off from the last of these items, Mr. Garbacz suggested several steps that a board can implement in order to foster such a corporate culture:

• Set the agenda
• Challenge assumptions and monitor progress
• Ensure all voices are heard - formal and informal exchanges
• Take advantage of today's technology for effective communication
• Alternate self-reviews and independent reviews

The Panel Discussion

The panel for the discussion of this position paper consisted of Mr. Ed McVaney, former CEO of J. D. Edwards; Mr. David Nadler, Chairman of Mercer-Delta, Mr. James Sprayregen, partner with Kirkland and Ellis; and Bethany McLean, Senior Writer with Fortune magazine. The Moderator of the session was Ms. Ellen Heffes, managing Editor of Financial Executives magazine.

Ms. Heffes led the session with some opening remarks noting that while it is obvious that not all boards of directors have neglected their responsibilities, the general business press has included boards among today's culprits in the spate of corporate malfeasance. As moderator of the panel, she indicated that this panel will look into the board's role and responsibilities for shaping corporate culture. Ms. Heffes said that it's not perfectly clear that the board has or even should have a role in shaping the culture of the corporation. A critical question she posed in this regard was: What was the culture and ethical behavior like at companies like Enron, Worldcom, Healthsouth and Adelphia that allowed the malfeasance or misguided judgments to happen — and, where were the boards?

Mr. Sprayregen said that in his experience board culture and activity, or inactivity is a major driver of company performance. In its most malignant form, such a culture can lead a company through three levels of poor performance: (1) A long process of decline caused not by malfeasance but by non-feasance; (2) denial of a problem associated with the rejection of unpleasant corrective action recommendations; and (3) crisis management requiring extreme measures. Throughout this process he said that people in the role of independent and responsible directors make an enormous difference and that governance processes are an important and powerful tool for the board. Further, the addition of effective board processes add even more value to the company's governance.

Mr. McVaney, relying on his many years as a very effective CEO of a very successful company, said quite emphatically that corporate culture is the responsibility of the CEO, and not a responsibility for the board of directors. Bringing the issue to a sharp point, he said, "any board that tries (to manage corporate culture) will find itself and the CEO frustrated". Mr. McVaney said that "…your corporate culture runs your business 90% of the time - especially when you're not there" and is therefore a very important ingredient to the company's performance. It is important to the company "way before the board ever gets there". To a point, Mr. McVaney said the culture of a company is essentially the demonstration of the company's work environment and that is certainly the CEO's job. He also noted that changing the corporate culture is very difficult and time consuming and therefore not an appropriate job for the board.

David Nadler also took the position that while board culture is critical, corporate culture is not the responsibility of the board. He noted that a great deal of data shows that corporate culture is a very profound driver of a business. Agreeing with Mr. McVaney, Mr. Nadler also stressed the difficulty of changing corporate culture. He noted also that the largest influence on corporate culture is the company's leadership, both institutional leadership and day-to-day leadership. He indicated that the board should not try to shape the culture of the company, but it should be very concerned about it. Culture should be addressed as any other key issue on the board's agenda such as financial performance or risk assessment. Therefore, he said, the board should gather information about the company's culture and review the firm's strategy and execution as it impacts the culture of the organization.

Ms. McLean, relying on her extensive knowledge as a reporter and author studying and writing on the rise and the fall of Enron, observed that the corporate culture of Enron was one of the most important factors in the company's apparent success and dramatic demise. She said that rather than the board shaping the Enron culture, the executive management of the company shaped the board's culture. The Enron board became too much a part of the Enron culture and therefore lost its ability to provide any independent oversight. Ms McLean noted that the board of directors should stand apart from the corporation's culture so as to not loose its ability to observe and judge management's behavior objectively; that is, they must resist being seduced by the company, its power and its success.

The Audience Discussion

This very active panel discussion spurred a very energetic debate among the audience participants and the panel. Doug Sims clearly agreed that the CEO should set the corporate culture but that the board has a responsibility to monitor its effects. They must assess the actual culture as it is exhibited in the behavior of the organization compared to what has been written on paper. In order to do this, the board, according to Mr. Nadler, must get information that goes beyond what management presents to them including formal outside assessments, internal data and informal contacts with non-executive personnel. Also, the board must look at the processes that are in place to effect the expression of the corporate culture.

A very active discussion developed around the often-unanticipated cultural consequences of incentive compensation plans. The old saw that "you must reward what you expect because you have to expect what you reward" was cited as a reflection of the causes of a lot of the executive malfeasance of the past several years.

Bob Vanourek offered an impassioned perspective regarding the ultimate responsibility of the board for the behavior and therefore the culture of the organization. He said that if 95% of what happens in a company is a function of the company's culture, the board must be directly concerned about that culture. Mr. Vanourek said that the board is responsible for the purpose or mission, the values, vision and goals of the corporation and it is up to management to execute against these ideals. Further, said Mr. Vanourek, the board is responsible for protecting the culture beyond and across various CEO's that may come and go.

Mr. Nadler took equally impassioned exception to this position. He said that the CEO, not the board was responsible for formulating the corporation's purpose or mission, values, vision and goals and that if the board does not like the positions taken on these issues by management, they need to "take out the management".

Mr. Nadler noted also that the board needs better performance measures, especially for corporate culture than lagging financial indicators.

Hal Logan noted also that the board should carefully assess the company's culture in light of the particular strategy the company is pursuing.

The Center for Corporate Change Perspective

The Center for Corporate Change believes that corporate culture, indeed, has a profound impact on the performance of any corporation. Expert opinion from many experienced business leaders attests to the impact of corporate culture on company performance. As the old adage goes, "It's not what they do when you are here that counts; it's what they do when you're not here." And "what they do when you're not here" is driven, very often, by the organization's culture.

This impact of culture on company performance has not yet been statistically proven, nor has the impact of good Board governance on company performance been directly linked to corporate culture. But the Center for Corporate Change believes there is a very strong indirect link at least between culture and company performance.

Therefore, the Board of any progressive company will want to take a keen interest in the culture of that company. This interest by the Board is not to usurp or interfere with the proper role of management in the area of corporate culture, but it is to ensure that the proper culture is set and implemented.

However, for the Board to assume some role for setting corporate culture is new territory. This responsibility has not been delineated before. What specifically should a Board do vis-a-vis management in the area of corporate culture? And how can the proper roles of the Board and management be protected in this fuzzy area?

If a company's culture can be defined as "how we do things here," then culture evolves over time from a very complex set of drivers. These include the company's defined purpose for being, its explicit or implicit values, the specific goals it strives to achieve, the key metrics to which it pays attention, its strategy and tactical action plans, its economic, industry, and competitive environments, and, most of all, its people related aspects----the organization structure, the type of people at the firm, especially the leadership philosophy of the CEO, the amount of collaboration or teamwork encouraged, the leadership styles valued and utilized, and the reward and punishment systems to name just some of the drivers. Culture results, generally over long periods of time, from the impacts of all of these complex and interrelated factors. Culture is not easily changed and can clearly have a powerful impact on what people do.

No Board can or should get involved in managing the details of how things are done in a company. That is management's responsibility under the leadership of the CEO. And management's actions will clearly have a huge impact on the culture of the company. Management defines the strategy of the company and the detailed action plans; management hires and terminates certain kinds of people, writes the policies, and sets (either consciously or unconsciously) the leadership styles used in the company; management decides who to reward and punish; and management is responsible for many other culture setting aspects of the firm.

So then, does a progressive Board just say "We can't get involved in this corporate culture stuff; we don't have the time, nor the mandate to do so; we have to leave that to management"? The Center for Corporate Change believes that position will become increasingly untenable for a progressive Board wishing to be successful in the 21st century. Witness the Enron Board with impeccable credentials in most areas, but woefully unaware of what was really happening on the trading floors and in the company operations. That Board presided over one of the most massive corporate implosions in history. Will any responsible director now assert that we have to leave those issues exclusively to management?

Most directors probably serve much longer tenures than the average CEO. Most CEO tenures are probably 4-6 years, and culture change in larger companies can really take hold and be sustainable over longer periods.
For a Board to leave culture to the CEO exclusively is to abdicate a key responsibility.

The Center for Corporate Change believes effective Boards, progressive Boards, the leading Boards of the 21st century can have a profound impact on corporate culture in several critical ways. None of these are completely effective in and of themselves. Rather, they interact to set and sustain a corporate culture. These critical influencing factors are:

• Setting the "tone at the top" for the culture of the Board itself.
• More broadly defining the Purpose of the company, i.e., whom it serves.
• Defining the desired Values by which the company should operate.
• Setting the strategic Goals to be achieved.
• Carefully considering the Values and corporate culture beliefs of the CEO to be hired.
• Monitoring the activities inside the company to ensure the results are being achieved in accordance with the defined Purpose and Values.

Board Culture
The progressive Board needs to start with its own Boardroom culture. Frequently this is done through a proactive Governance or Executive Committee. Are communications open and respectful? Is proper independence being honored? Are periodic evaluations of Board and individual directors being conducted? Are independent advisors available? Is access being provided to key stakeholders? Are agenda topics collaboratively set? Is sufficient preparation time and information provided for meaningful discussion? Are directors willing to be a "voice of one" when in disagreement? A good Board culture will evolve from these and other progressive governance practices. That good Board culture will then cascade down the whole company.

Purpose
Directors at the progressive Board should consider and define the company's reason for being. Whom does the company serve? The summary choices are (1) to serve the shareholders by maximizing their value over the long run, or (2) to create value for all stakeholders. The former way treats other stakeholders as "means" to the "end" of shareholder value. (Immanuel Kant would frown at that approach.) The latter way acknowledges the legal, moral, and fiduciary responsibility the company has to all stakeholders, as does the famous Johnson & Johnson Credo, attached. J&J has enjoyed over 100 years of double digit sales and earnings growth with this Credo and the philosophy that came even before the Credo was written.

The Center for Corporate Change endorses this stakeholder model and feels its acknowledgment by the progressive Board in the company's Purpose will help set the culture of the company.

Values
By defining the Values by which the company should operate in collaboration with management, the progressive Board will greatly influence the corporate culture. The Values embody the principles by which people will treat each other both inside and outside the company. Explicitly stated and scrupulously paid attention to, these Values will influence who gets hired, promoted, recognized, and separated from the company. No one will be perfect all the time, but by empowering the organization to put peer
pressure on its members to operate by the defined Values, the Board can have a profound impact on how results are achieved in the company.

Goals
The Board must clearly set the intermediate key Goals that it wishes the management of the company to achieve. Management cannot set its own goals. By picking the few key Goals which are to be achieved and which, presumably, would be rewarded, the Board "puts its money where its mouth is." If the Purpose and Values speak to lofty ideals involving customers, and community, and employee associates, but the Goals (and associated incentives) focus only on the year's earnings, then the culture will drive toward an exclusively financial focus. So, Goals for shareholders (i.e, earnings) and for other stakeholders need to be set to properly influence the corporate culture.

CEO Selection
One of the greatest influences a Board can have on the culture of a company is through the CEO selection. This is true because the CEO's leadership style and decisions on a day-to-day basis will have a large impact on what people do. Over time, this collective action of what people do will drive the culture. A progressive Board in the 21st century will pay as much attention to the demonstrated and documented Values by which an executive operates and the culture which he or she seeks to foster as to the results which they have achieved in their prior positions. It is one thing to achieve excellent results; it is wholly another thing to achieve them in ways that cut ethical corners, foster undesirable practices, or which model unacceptable behavior.

For these reasons progressive companies are more and more requiring that a company's internal performance and leadership review systems incorporate some measures of an executive's practices in this area of Values and management practices. When noble Values are espoused and codified on the wall, but shabby executive behavior is condoned or overlooked, the message sent to the firm's employees is unmistakable.

Monitoring
Finally, the progressive Board can greatly influence corporate culture by monitoring how things are being done in the company. Access to senior executives, other employees, key business partners, important shareholders, and other stakeholders needs to be openly provided . The literature is scarce on how progressive companies are doing this today without undermining, second guessing, or micro-managing the CEO and the management team. The Center for Corporate Change is researching this subject and will be providing suggestions to our associates about how to build this capability into a progressive Board.

Summary
Corporate culture is a strong driver of company performance. The Center for Corporate Change believes that a progressive Board ignores culture only at its own peril. Clear separation between the management role and the Board role in setting corporate culture is needed.

The Board's role is to define the culture desired with management's collaboration. Then the Board's role as steward is then to hire a CEO who will implement that culture and to monitor selected activities to ensure that the desired culture is being implemented by management.

Management's role is to offer collaborative input to the Board on culture and then to implement that culture as defined by the Board.

The Center for Corporate Changes welcomes thoughtful input from interested parties on all aspects of our work to progressively reform American business.