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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.

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