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How should a board oversee ethics?

I recently moderated a keynote address by Andrew Fastow, the former CFO of Enron, and followed up by delivering a keynote on the role of the board in ethics, tying in aspects of Mr. Fastow’s speech. What follows is based on my speech; incorporates not only my interactions with Mr. Fastow, but also Messrs. Conrad Black and Arthur Porter; and draws on my work with boards that have succeeded and failed in their ethics oversight.

Here are ten ways a board can oversee ethics:

  1. Ask the right questions.

Good questions for boards, when faced with an ethically problematic action, are: (i) How will this action impact our reputation? (ii) How will this action impact us over the long-term? (iii) What are the aggregate effects of this action? (iv) What will the view of this action be by objective parties, especially if current circumstances change? (v) Even if this action is technically correct or permitted, does it meet the principle or spirit of applicable guidelines and rules? and (vi) Are we doing the right thing?

Management should have detailed answers to these questions. And they should leave the room so only independent directors can discuss.

  1. Have a line of sight over ethics, integrity, reputation and culture.

Many behavioural and integrity controls fail in their design and implementation, and because they do not go far enough or are subject to management override. These controls should be independently audited. Good companies are measuring and assuring reputation, integrity and risk culture for boards. It is important that this assurance reach the board un-funneled by reporting management. Good Audit and Quality Committees are reaching deep into organizations to view culture, quality and “tone in the middle.” Toxic culture or wrongdoing can bring enormous and rapid harm to brand and reputation. Bad news needs to rise, without delay, and good boards do not want surprises. The days of boards overseeing just the CEO and other senior management are gone. Management needs to accept more activist boards. This does not mean boards are running companies, but they are overseeing conduct.

  1. Use executive sessions, questions and information as your leverage touch-points.

Have the authority in your board and committee charters to obtain any information, to interview any personnel, and to obtain any outside assistance that you need to in order to fulfill your duties. If management blocks access, you now work for them. Obtain disconfirming information from the outside as well. Meet directly with auditors, consultants, the risk function, and the compliance function, including without any manager in the room. Meet also with major long-term shareholders without any manager present. Only then will you hear what others hear. Boards can live in an echo chamber otherwise. You do not want to be the last to know.

  1. Make sure your lawyer is independent.

The person drafting the above charters, including your clawback clause (see 6. below), should not be the general counsel or the external counsel who works for management, or colleagues of lawyers at the law firm. None of these parties is independent. Just like auditors and compensation consultants must be independent, so should the board’s counsel. Independent assurance on related party transactions, conflicts of interest, the code of conduct, investigations, integrity risks, and whistle-blowing cannot occur by management or their advisors. Only independent advisors will be free to recommend action that corrects and directs (and when necessary, terminates) reporting management.

  1. Address whistle-blowing defects.

Once the Ontario Securities Commission enacts a whistle-blowing reward regime like has been done by the Securities and Exchange Commission in the U.S., there will be a changeover from defective regimes currently in place. If the point of contact for a whistle-blowing program is any manager, the policy is defective. The point of contact must be an independent person or party who reports directly to the Audit Committee. Only then will anonymity be preserved and the channel be used fully. Bad news needs to rise, and investigations need to occur when warranted, and neither happens if it is management investigating management.

  1. Pay for conduct and performance.

Pay drives behavior, including ethics. Many pay committees under-utilize their executive pay toolbox and control over management.

Because pay practices can incent risk-taking and unethical conduct, good regulators and pay committees require ethical conduct to be tied to executive pay. If risk management or the Code of Conduct is breached, executive pay should not vest and be clawed back if it has vested. Conduct and risks should be evaluated every pay period before the pay committee allows equity to vest or a bonus to be received. And ethics and morals clauses should be in every executive and employee contract. And directors need to lead by example, with ethics clauses drafted into their terms of service. A good board insists on resignation in advance if an ethics clause is breached.

  1. Oversee the oversight functions.

Your eyes and ears in the company are internal audit, risk and compliance. These functions must now have reporting channels right into the boardroom and committees. Does your board directly oversee these functions? Does your company have these functions? I have recommended to numerous boards the hiring of these functions and doing so can greatly improve toxic culture, flawed risk management, and unethical conduct. Just as in the early 2000s when the audit committee began to hire, fire and pay the external auditor, now the audit and other committees and the board hire, fire and pay risk, compliance and internal audit.

  1. Speak up and recruit a board challenger.

When directors and chairs are chosen on the basis of preexisting relationships, which many or most are, this means directors are beholden to each other, or worse yet, to management. These directors will not speak up or ask tough questions, as they are owned by their extra-boardroom relationships. The board becomes accountable to management rather than the other way around. Boards where fraud has occurred often met governance guidelines, including Enron. Andy Fastow said that the Enron board not only approved but encouraged his actions (in the words of one director): “Fastow you are a —- genius!” Recruit directors who have no pre-existing relationship to any other director or manager. This includes female directors.

  1. Recruit independent, competent directors with courage.

Independence of mind is not formal independence. Smart managers can capture directors through relationships, perks and incentives. There are directors on boards are well out of their depth. They are there because of relationships, profile and glow, but know little about the actual business and cannot or will not challenge because they are captured. Seeing them ask perfunctory questions is akin to a fork trying to hold water. Only when a director is truly independent and competent, can that director then challenge. Often directors are docile because they simply do not know what to do.

  1. Set tone at the top.

Lastly, and most importantly, set the ethical tone. The actions and behaviour you observe as a director is the tone that you have just accepted. Good tone at the top is unambiguous, applies to everybody, and is consequential. And it is exercised. It is the board, not just management, that sets tone. I recall the story of the audit committee chair who saw the CFO go through customs at an airport and not declare a bottle of wine. The next morning, the CFO was fired.

Management is fond of explaining unethical conduct away by saying it was a “rogue” employee. Boards are fond of explaining unethical conduct by saying “we missed it.” If boards and management teams are truly honest, they know they should not have missed it and that it was not a rogue employee. It was an employee operating within the culture that was accepted.

In all of my interviews of directors over the years, including during ethical failure, when I ask about directors’ greatest regret, the answer is consistently, “I should have spoken up when I had the chance.” Speaking up is incredibly important when it comes to tone at the top. If you are uncomfortable, “speak up” is the best advice I could give a director. Chances are, several of your colleagues are thinking the exact same thing.

Why integrity is good for business, and the role that boards play

“We didn’t know.” “We missed it.” “It was a rogue employee.” There is not an excuse I have not heard for ethical failure. But when I investigate a company after allegations of fraud, corruption or workplace wrongdoing, almost always there is a complacent, captured or entrenched board that did not take corrective action. In a few cases, boards actually encouraged the wrongdoing.

The first myth is that the board is a “good” board. There is no relationship between the “glow” or profile of directors and whether the board is “good.” Often times, there is an inverse relationship, as trophy or legacy directors typically lack industry and risk expertise in recognizing fraud or understanding what proper compliance looks like, are not really independent, are coasting and not prepared to put in the work, or they themselves may not possess integrity.

How important is integrity? Extremely. Three factors make for a good director or manager: competence, commitment and integrity, with integrity ranking first. Otherwise, you have the first two working against you.

Integrity needs to be defined, recruited for, and enforced. “Does your colleague possess integrity?” “Yes” is an answer to this perfunctory question. Full marks. But when I define integrity to include avoiding conflicts of interest, consistency between what is said and done, ethical conduct, and trustworthiness – and guarantee anonymity, I get a spread of performance scores. Those who do not possess integrity in the eyes of their colleagues are poison and should are extracted from any board or a senior management team. They never should have been elected or hired in the first place, which is a recruitment failure.

Fraud, toxic workplaces, bullying, harassment and pressure do not occur in a vacuum. Many people in the company know. The issue will not go away, will only get worse, and is a latent legal, financial and reputation risk.

For bad news to rise, boards need to ensure that protected channels exist and are used – including for a director or executive to speak up in confidence, and for an independent consequential investigation to occur.

Ethical reporting also needs to assure anonymity to the fullest possible extent to receive reliable information. If a whistle-blowing program has any manager as the point of contact, it is not effective. Whistle blowing, culture surveys, and ethics audits should be conducted independently and reported directly to the board without management interference.

Frequently, I find ethical design and implementation failure are the culprits, with codes of conduct, conflict of interest policies, whistle-blowing procedures, culture and workplace audits, and education and communication being perfunctory at best, overridden by management at worst, and not taken seriously by employees or key suppliers, with minimal assurance and oversight by the board.

Complacent boards and executives are the last to know and deny any wrongdoing, having creating the conditions for fraud to flourish. Shockingly, lacking any pride, in full denial, and further reinforcing their entitled self-serving mindset, they refuse to resign.

After ethical failure happens, executives argue that it is a lone rogue employee or an isolated incident. Nothing could be further from the truth. It is an employee who reflects the true and actual culture, internal control environment, and practices of the organization, and who is attracted to and flourishes within them. There is no such thing as a rogue employee. It is a board that approved the conditions that management proposed within which employees operate. The board’s leverage of approval, documentation and questions went unused and unasserted. They are the very people who should not be overseeing subsequent reforms, as they are assessing their own shoddy work.

This lax control environment, where self-interest is pursued and where pressure is applied, is the heart of ethical failure.

There is a shocking lack of internal controls over employee and agent behavior that I have found in corrupt jurisdictions in which Western firms do business. This means, not only is the potential for fraud rampant, but also that costs of compliance are being borne by companies who do not bribe and have proper controls. They are penalized for doing things right.

Furthermore, there are corrupt jurisdictions whose companies and government officials offer and receive bribes and advantage themselves over Western counterparts, including in Russia, China, India and MENA. The most recent example is bribery allegations at FIFA. This unequal playing field puts Western companies – in the US, UK, Canada and elsewhere – at a disadvantage, when competing for business, opportunities and contracts.

This is why Western governments are seeking to put their countries and companies in the most competitive position possible. They are enforcing anti-corruption laws using long arms of justice to prosecute bribery. They are also debarring companies from government contracts who commit ethical breaches. This debarment is a powerful motivator to spur investment to internalize the costs of internal controls over integrity.

Western industry will mistakenly argue that integrity laws will disadvantage them or cost their industry jobs, but the reality is the opposite. Tough integrity laws will prevent substandard competitors from offering bribes, will disincent recipients from receiving bribes, and will strengthen Western companies who compete on the basis of price, quality and service.

When does it become unethical for a director to continue to serve?

I spoke to corporate and not-for-profit directors in Dallas, Texas, today, about board dynamics and board renewal. The subject of the length of board service and director retirement arose. I said there was a recent study that the optimal service for a director was nine years, beyond which firm value was adversely affected. Many directors serve beyond nine years. The most excessive example of long service occurred once when a director of a community bank board said, “Richard we have four directors who have been on our board for over 50 years.” I mistakenly thought that this was 50 years in total, among the four directors. But I was wrong. There were four directors who had been on the board for over 50 years, each.

Many directors hang on to directorships for far too long. I counted several directors who have been on corporate boards for 10, 15, 20 and 25 years. This blocks board renewal, up-skilling, and diversification. Incumbent directors offer reasons for staying: how they know the company, enjoy serving, etc., and are skillful at wiggling, raising the retirement age to 71, 72 and now 75 (from 69 and 70).

The academic evidence however does not support excessively long-serving directors, or directors who are serving on multiple boards (known as “over-tenured” and “over-boarded” directors, respectively). Firm value is adversely affected for over tenured directors (inverted U shape in relation to firm value); and oversight and long term performance are compromised by “consistent and convincing results” (according to Stanford researchers) for busy boards composed of over-boarded directors.

Often the most vocal directors are those who are the least relevant or most affected by renewal. When you do a proper board review, it is apparent who is performing and who is not. There is resistance to an expert third party board evaluation by underperforming directors for fear of being found out. Directors know who the non-performers are. I said to the audience this morning that every board has one (or more) underperforming or dysfunctional directors, and if you don’t know who it is on your board, then it is you.

If boards do not solve their lack of renewal, regulators will do it for them. It is already starting. Regulators in the UK, Australia, India, Hong Kong, Singapore and other countries are imposing term limits on directors of between 9 and 10 years, beyond which independence is questioned. Regulators are imposing diversity requirements on boards. In the UK, even auditors are subject to tendering every five years. Regulators read the press reports of directors serving 40 years, auditors even serving up to 100, and communicate with academics on what the empirical research findings are.

The fact of the matter is that boards, as self-policing bodies, may be incapable of solving the renewal issue on their own because of entrenchment and self-interest. And herein lies the ethical question, posed to me by a director today: “When does hanging on or digging in breach a fiduciary duty by the director to act in the company’s best interest, rather than the director’s?” When should doing what is right; putting oneself at risk; having proper succession planning; mentoring, coaching and developing the next generation of directors; and letting go gracefully and honorably, matter?

This is an integrity issue. If – or perhaps when – a director becomes irrelevant, or is destroying value, is it ethical for that director to continue? Is it ethical for the board to allow that director to continue? The problem is doing what is ethical vs. acting out of self-interest can get commingled in an under performing director’s mind, or even a founder’s mind, or even other directors’ minds (who have been captured by the entrenched director colleague), without an objective measurement. This is neither person-proofing governance, nor in the interests of the company and its shareholders.

Aggrandizing long service, referring to “god fathers,” compounds this renewal problem and wearing as a badge of honor how many boards one has served on, or does serve on. As one “godfather” recently remarked in open session at a corporate governance conference, “We did virtually no research.” Well, maybe research should be looked to more when policy is developed. Firm value and the oversight of shareholder investment are at stake.

Eventually, a director fights redundancy and relevance. A tipping point is reached if there is indefinite service. It is inevitable. No one wants to be irrelevant. If there is no policy or, better yet, no measurement of actual performance and follow up accordingly, self-interest is perpetuated and complacency is allowed to continue, by the very people who should be leading by example. Directors need to know when it is time to go. And if they do not, regulators will.


What boards and individual directors can learn from Toronto Mayor Rob Ford and managing conflicts of interest

What is the lesson here for boards of directors and individual directors and officers? Avoid conflicts of interest at all times, but if and when they do occur, the test is perception and process. Every board should have a conflict of interest statement that applies to officers and directors, and to a control person or significant shareholder if applicable. It should cover identification and resolving of the conflict. If you are in doubt as to whether you have a conflict, you must disclose and cannot influence or take part in a decision, transaction, arrangement or otherwise in which you: can be perceived to have an interest, direct or indirect; cannot be seen to be impartial from an outsider point of view; or receive a benefit not shared by other shareholders. If you do take part in the decision, or do not disclose the potential conflict, or attempt to influence the vote, you risk detailed legal scrutiny after the fact to show your conduct was improper and did not conform to best practice. Records of the matter should be kept, a special committee may need to be formed composed only of directors who are seen to be independent in all ways from the matter and the director or officer or shareholder with the conflict, and expert independent advice should be sought. These best practices will protect the board as well as yourself and your reputation that you acted prudently, exercised your duty of care, were transparent, and acted only in the best interest of the company and all shareholders.

Regulators turning up anti-bribery heat on corporate boards: But will practices change?

Russia is one of the most corrupt nations in the world (see a recent anti-corruption story on Russia by the New York Times). It ranks 143rd of all 182 countries on Transparency International’s corruption perception index, with a score of 2.4. Canada ranks the 10th least corrupt country in the world with a score of 8.7. New Zealand is the least corrupt country globally, ranking first with an overall score of 9.5. The US ranks 24th and the UK 16th, with scores of 7.1 and 7.8 respectively. See the “Full Table and Rankings,” where countries can be searched via the table. Lower rankings and higher scores mean the country is perceived as being less corrupt.

Prime Minister Harper visited China, India and Brazil to enhance trade with these countries, which are also some of the most corrupt nations in the world, ranking in at 95th, 75th and 73rd respectively. Libya, which involved the alleged Montreal-based SNC Lavalin bribes of some $56 million, comes in at 168. Within these countries, the governments themselves are the net beneficiaries of much of the corruption, so these politicians are far from motivated to impose reform.

Is it realistic to expect that Anglo-American nations, such as the US, UK and Canada, can impose “Western” will on the very way business is done, and has been done, in some countries for centuries? And if things will not or perhaps cannot change, should home country boards of directors be held responsible for systemic local corruption that may be beyond their control?

Regulators are taking corruption and the role of boards and senior management very seriously. The Securities and Exchange Commission and Department of Justice recently released 130 pages of guidance (see the PDF and other coverage here and here) on the Foreign Corrupt Practices Act (“FCPA”). The US has had the FCPA since 1977. Enforcement and penalties have gone up dramatically in recent years. The UK Bribery Act, from 2010, has some of the most stringent bribery laws in the world. In Canada, we have The Corruption of Foreign Officials Act (since 1999) and the recent guideline from the OSC for issuers operating in emerging markets (see the PDF).

Emerging economies are future markets for Canadian companies. The Prime Minister has a vision for Canada to be an energy supplier superpower. For this to happen, Canada will shift its trade to markets with 100s of millions or billions of consumers and much higher growth rates than our current major trade partner, the US, which could be coping with austerity due to its debt for years to come. Harper was in India last week to boost trade.

What is clear is that there is an enormous disconnect between the home country regulations now being imposed, and host country actual practices on the ground.

What should boards that have operations in emerging market jurisdictions do? Six things. First, if you are doing business in such a market, you need a director with extensive on-the-ground experience at the board table, who can tell you and management what the hotspots are. You should move a board meeting to the jurisdiction once a year so directors can get a first hand look. Second, boards must make it crystal clear to management that if the company is not going to bribe, management must walk away from certain business. And the board must support this and not have incentives that promote bribery. Third, the internal controls over financial reporting must be as strong in the emerging market as it is in the home market. Investment and resource commitments need to be made. Fourth, boards must have their own experts to scrutinize off-balance sheet and related-party transactions and complex structures; validate and assure internal controls; and provide foreign language document translation. Fifth, local auditors should have the same oversight, scrutiny, and as necessary direct contact with the audit committee that the home auditors have. Lastly, there needs to be zero tolerance by the board communicated to each employee and supplier. The UK is even banning facilitating payments, which are regarded as a “tip,” as these may be bribes in disguise.

Companies and politicians are feeling the pain, including on Canadian shores. The Wal-Mart bribery probe has widened beyond Mexico to include China, Brazil and India. The RCMP is investigating the SNC Lavalin bribery allegations, on which I advised a law firm suing the company. I blogged about Sino-Forest, a case of alleged Chinese fraud by a Canadian-listed company. In Quebec, the corruption inquiry has cost the Mayors of Montreal and Laval their jobs and this is only the beginning. There are allegations of kickbacks in cash that may reach other more senior politicians. And Ontario is not immune either. A senior Canadian director remarked that Ontario has a reputation for being “the best place to carry out a stock fraud in the industrialized world.”

Clearly, more work needs to be done. Canada’s corruption ranking on Transparency International may go down in 2012 instead of up.

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