Corporate Governance

The Acton Institute affirms the responsibility of the corporation to its shareholders, recognizing that it is sometimes in a company’s best interest to sacrifice short-term profit for long-term gain. Profit is the first, essential moral obligation of a company in providing jobs and opportunities for individuals, thereby allowing employees and customers to meet their own responsibilities to their families.

FEATURED ARTICLE:
“Enron, Board Governance and Moral Failings”
by Gerald Zandstra

Introduction

The stock of publicly held companies rises and falls on the leadership of its executives and its board of directors. President Bush recently developed a plan to address key issues involved in corporate responsibility. His plan, however, fails to take into account one of the most important weaknesses in the corporate governance: the board of directors. Ultimately the public and especially the shareholders have to trust that the board charged with company oversight will act in the best interest of the company. The board is the recipient of the public and shareholder trust and, in addition to portraying confidence to investors, it is responsible to see that wise decisions are made and that the law is being followed.

What role did the board of directors play in the collapse of Enron and how will President Bush’s solutions address the situation?

Presidential solutions

On March 7, 2002, President George Bush outlined his plan to improve corporate responsibility and protect America’s shareholders. The plan has three core principles. The first is focused on information. It insists that investors have quarterly access to information that will allow them to gain a firm sense of the corporation’s financial situation as well as immediate access to critical information.

The second broad principle pertains to chief executive officers (CEOs) and other executives and their accountability to investors. The CEO must personally vouch for the truth, timeliness, and fairness of information sent to investors and cannot benefit from financial statements, which provide false or misleading information. Instead of the lag time currently in the system, the President proposes that executives who buy or sell stock be required to more quickly inform the public. Those who are found to be in violation would lose their right to serve in a position of corporate leadership.

The third principle addresses audits. In the President’s plan, it would be expected that investors would be able to have complete confidence in financial audits and that those doing the audits be held to the highest ethical and professional standards.

Unfortunately, none of these principles addresses the role of the board of directors. While executive behavior and information and auditing are certainly important matters that must be considered, it is important to look carefully at the makeup, expertise, and responsibility of the board to determine if part of the blame for Enron’s collapse belongs to the board.

The Enron board of directors

One look around the Enron board room in 2000 would instill confidence in any investor who could be assured that the company was in the hands of legal, ethical, political, and economic leaders. Surely they would be sufficient gate­keepers. In addition to Kenneth Lay and Jeffrey Skilling, there were 15 external directors whose resumes were impeccable. These were people with a combined total of several hundred years worth of board oversight.

The expertise in the room is astounding. There are people who have served as CEOs in several companies, as bank executives, as capital management leaders, and several who are familiar with the gas and oil business.

There are several law degrees and one person who served as the dean of a law school. There are two physicians. One current university president sits next to one who is now emeritus. Multiple Harvard MBAs can discuss their alma mater with one of its current professors in government. One director has written multiple articles for the Journal of Law and Economics.

The board has political experience with one member who has served in the British Parliament, one member who is an expert in anti-regulatory legislation, and several who have served in one political capacity or another. They were international, with people from or with expertise in Asia, Europe, South America, Africa, and the Middle East. One was an elder at his Presbyterian Church and almost all had served or were serving on at least one non-profit board of directors. Taken together, these 15 external directors had served on at least 130 boards of directors of both for-profit and non-profit organizations.

Companies are about leadership and the board of Enron certainly had it in 2000. They had the expertise to know what to do. They also had the incentive as many of them had extensive Enron holdings in addition to their $300,000 annual compensation for their board service.

Who could doubt the viability of Enron? The company’s business was complicated to be sure. But with Lay and Skilling driving the ship and this talented board of directors charting the course, no one would doubt that Enron would remain a world business leader for a very long time.

So what happened? Where was Enron’s board of directors? How could this group of world-class business, political, and legal leaders allow such a catastrophe to occur on their watch? Enron has exposed one of the issues which modern corporations and all stockholders must face: the role of the board of directors in today’s companies. Another Enron will not be prevented by a new series of regulations or laws or accounting practices. Creative accountants and savvy executives will always find ways around such attempts to control them. Adding laws to the legal code does not necessarily solve the problem of crime.

The development and function of the board of director system

Samuel Gregg (2001, p. 11) makes the argument that the roots of the corporation can be found in the Middle Ages. Stanley Vance (1983, p. 3) tells the story of Alexander Hamilton’s corporation, ‘The Society for Establishing Useful Manufactures” as an example of an early American corporation and it is interesting to note that the company failed “because the absentee outside directors failed to involve themselves in the affairs of the enterprise.” Despite similar failures, the corporate concept quickly spread so that “by 1800, the US had more business corporations than all of Europe combined” (Gregg, 2001, p. 12).

While each corporation is governed by state statute and no state has legal requirements to be eligible for board of director membership, each board of directors has at least the following three functions. First of all, the board of directors is responsible for lending an air of legitimacy to the corporation. While this is a passive function, it is important that the company have a board made up of people with some prestige attached to their name. They ought to be people with expertise and experience in business. Their involvement ought to lend a level of confidence to the enterprise and those who purchase stock in it. But it is vital to remember that this is not where board responsibility ends.

The second function is focused on auditing and legal requirements. The board is entrusted with the duty of ensuring that any information given to stockholders, the public, and the government is accurate. Auditing oversight is usually completed by an auditing committee, which is a subset of the board. The entire board is responsible to ensure that every legal requirement is met. Neither of these is a simple task. Both require a high level of specialization in finance and law. Those on the auditing committee certainly must be able to read a financial report with the eye of an expert who is able to discern the location and depth of trouble spots, which threaten the vitality of the company.

The third is more of a directorial role. The corporate board of directors is expected to determine, modify, and approve a business plan. Obviously, corporate executives are responsible for entering into dialogue with the board, framing the discussion, giving input and implementing board decisions. This may be one of the more difficult aspects of being a board member in a corporation with thousands of employees, projects that extend around the world, and a level of complexity that few can master. The difficulty is one of knowledge. It is far more difficult work now than it was for those who made up the board of Alexander Hamilton’s corporation. But the primary legal responsibility for the direction of the company remains in the hands of the board of directors.

These three functions are aimed at preserving the stockholder’s equity and the stock’s value. They are also aimed at providing the best service possible for the customer, a matter upon which the survival of the

corporation depends. Failure to take seriously these three functions leads to collapses similar to that of Enron and, in the end, are moral failures on the part of those who serve in the board of directors.

The moral obligations of directors

The representative nature of a board

The real issue of Enron’s and every other corporate board is a moral one. Those who accept public responsibility for oversight must be diligent in their tasks no matter if they are paid or volunteer. This is certainly not unique to a board of directors in a corporation. The public is reliant on a variety of people in whom they have placed their trust. All sorts of organizations represent the citizens and do for them what they are not able or willing to do for themselves. Police, fire fighters, politicians, teachers, housing inspectors and a host of other government and non-government groups take upon themselves certain public responsibilities. And they are expected to take their duties seriously. Failure to do so can cause significant physical harm, loss of property, and in some cases, loss of life.

A board of directors is no different. It is supposed to act on behalf of shareholders. Directors are also aware that their actions, or their failure to act, can have serious consequences beyond merely the shareholders, to whom they are primarily responsible. In Enron’s case, the collateral employees have lost their jobs and retired employees have lost the funds on which they depend. Mutual fund investors have also felt the impact of a serious drop in value of Enron stock. Beyond that, Enron’s accounting irregularities have caused other companies to fall under a shadow of suspicion that has hindered the stock market for several months.

When boards fall In their moral obligations

In his book, Servant Leadership, Robert Greenleaf (1991, p. 101) writes that if directors:

... satisfy legal requirements and give the cover of legitimacy but little more, is not this arrangement neglect by trustees? Who is being deceived? At whose expense is this carried on? One is inclined to answer All of those who are served by or depend on the institution,” which, if it is a major one, can be a large number of people.

Some sense of the true number of people affected when a board of directors fails in its moral obligations is brought into view when it is remembered “publicly-listed corporations constitute barely 1 percent of all business organizations. Yet in 1997, they produced more than half of the United States’ economic output” (Gregg, 2001, p. 10).

None of this is to argue that being a board member is a simple matter. Louis Cabot once described his experience of serving on the board of Penn Central Railroad as it struggled through the 1970s and 1980s. He said:

We were treated like a rubber stamp. Board meetings would last only a half an hour. We’d start with the waiving of the minutes of the prior meeting, and then we’d have only a summary of those. Then we’d hundreds of different locations you never heard of... .Then we’d turn to the financial reports. They weren’t in any form I’d ever seen. They were summaries. They didn’t show all the facts that later turned out to be crucially important (Waldo, 1985. p. 4).

Sins of commission and omission

Enron did not fail because it was not a viable business. It did not collapse because it failed to make a profit. Ultimately, it failed because of its deceptions. There is no doubt that some of Enron’s business decisions showed poor prudential judgment. But every organization makes bad business choices and most of them survive. Enron failed because its board failed. Either they knew what was happening with the secret partnerships, conflicts of interest, and the cooking of the books, in which case they are culpable for a sin of commission. Or they were inept, slothful or simply did not understand their role as members of the board of directors at Enron, in which case they are culpable for a sin of omission.

Perhaps there is one further option: they should be exonerated and the blame should be laid at the feet of the executives. But before anyone rushes to this conclusion, it is important to hear the words of Enron’s own board on its actions. Three members of Enron’s board were given the task of performing an investigation of the company and its business practices in light of its implosion. The assignment was given in late October of 2001, following the disclosure of hidden debt and exaggerated profits. The report was made public on February 1, 2002. Those issuing the report claim that the board “cannot be faulted for the various instances in which it was apparently denied important information” (Powers et at., 2002, p. 23). This statement would defend them against the charge that the board committed an act of commission. In other words, the committee does not believe that the board had all the facts that were required to know the true state of affairs of its own company.

But sins of commission are not the end of moral and ethical issues. There are also sins of omission in which a person fails to do what they agreed to do. What others are depending on them to do. What is good and right? Sins of omission are those which, by inaction, do what is hurtful and wrong. The investigative committee believes that Enron’s board failed:

... it can and should be faulted for failing to demand more information, and for failing to probe and understand the information that did come to it (Powers et al., 2002, p. 23).

A description of moral board behavior

Samuel Gregg provides a solid overview of the moral responsibilities of the board:

Directors must be able to identify the key issues facing the corporation. They must be able to ask the questions necessary to safeguard the owners’ interest and obtain, evaluate, and act on the answers. Their responsibilities are to ensure that the corporation remains loyal to its corporate purpose, to exercise prudential judgment, and to demonstrate moral courage in carrying out these

In short, the board of directors in every corporation must provide moral leadership in which the truth is sought vigorously and told completely. In which responsibilities are taken seriously. In which integrity matters. They must demand accurate, relevant, and up-to-date information.

Transparency is vital to the free market and one of its foundational principles. Without transparency at all levels, the market system will not function to its fullest potential and corruption will be systemic. And transparency, for the corporate world, begins in the boardroom. The temptation to artificially drive up stock prices, to invent profits and to hide losses is too great for those whose jobs depend on results. Without the board insisting on and guaranteeing transparency, the checks and balance system of the corporate market system will fall.

Perhaps in the short term, board members are content to do little. Greenleaf writes that “nominal trustees customarily accept, somewhat uncritically, data supplied by internal officers and take no steps to equip themselves to be critical. They restrict themselves to affirming the goals that are set by the administrators and staffs” (Greenleaf, 1991, p. 99).

Those who ask hard questions and demand truthful answers may not be voted in again. Holding an executive accountable might cause public jitters and a drop in the price of the stock. While this might be temporarily true, it is a failure to see beyond the agenda of the day. Enron is a fine example of what happens when the board of directors does not exercise its authority, ask questions, and demand accountability from its executive leadership. It shows the result of short-term omissions that cause long-term devastation.

Assuming that Enron’s board was unaware of the true state of the company because of misleading information from Kenneth Lay and Jeffrey Skilling, it is appropriate to ask whether or not they could have discovered such information with more effort. It is instructive to note that the special internal investigative committee of the board was able to produce a 203-page report within three months of being commissioned with the task.

It is also important to remember the depth and variety of knowledge and experience on Enron’s board. They are bright, competent and seasoned business leaders. They know the law and they know accounting. They know how to read a financial report and they know what questions to ask to ascertain the truth. And yet they claim to have failed to see the collapse coming off in the distance. It is this fact that led Rep. Chris John, R-LA to declare to members of Enron’s board appearing before his committee:

The board has a responsibility. You can only say “They didn’t tell us” ....You were paid $300,000 a year and you didn’t know? That’s just amazing (Beltran, 2002, p. 1).

Conclusions

Board membership is a serious matter. It is not about padding a resume or receiving high fees for little work because of one’s reputation. It is not about filling the boardroom with people who will be pliable tools in the hands of executives. It is about courageous moral leadership that asks tough questions, insists on complete answers, and takes its role in the company and in society seriously. As Enron demonstrates, the impact of such failures is wide and deep. The stock market continues to struggle as it wonders if there are other time bombs ticking away. Thousands of people have lost their retirement funds. At last count, there were no fewer than nine congressional committees investigating.

Could a properly functioning board have prevented the collapse? Yes, if its members were willing to take their responsibility seriously. Those who are unwilling to shoulder the ethical responsibilities to shareholders and the public should not allow themselves to be nominated to any board of directors. The potential for significant damage to the nation, the economy, and individual lives is too great to have anything less than serious leaders in board of director positions.

References

• Beltran, L (2002)’ “Enron: fathow takes fifth”, (accessed 2 February). Available at: http://money.cnn.com/2002/02/07.news/enron_hearing/
• Greanleaf, R. (1991), Servant Leadership: A Journey into the Nature of Legitimate Power and Greatness, Paulist Press, New York, NY.
• Gregg, S. (2001), Corporations and Corporate Governance: A Return to First Principles. The Centre for Independent Studies. Sidney.
• Powers, W., Troubh, R. and Winokur, H. (2002), Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. Enron Corporation, Houston, TX.
• Vance, S. (1983), Corporate Leadership: Boards, Directors, and Strategy, McGraw-Hill, New York, NY.
• Waldo, C. (1985), Boards of Directors: Their Changing Roles, Structure, and Information Needs, Quorum Books, Westport, CT.

This article originally appeared in Corporate Governance 2,2 2002, pp. 16-19. Adapted and reprinted with permission.