The Boss On The Sidelines
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If anybody needed proof that the new balance of power in Corporate America has shifted, Maurice R. "Hank" Greenberg provided it on Sunday, Mar. 13. While the imperious chairman and CEO of American International Group Inc. (AIG ) was holed up aboard his yacht on the Florida coast, his company's independent directors were packed into a conference room in their lawyer's Manhattan office. The board members faced an urgent crisis: a growing accounting scandal that seemed to lead straight to the CEO. As directors debated whether to cut Greenberg loose, the 79-year-old titan lashed out at them by telephone. "This board is being run by a bunch of lawyers who can't spell the word 'insurance,"' he shouted. "If you get rid of me, you will destroy this company!" It was the kind of intimidation that had helped Greenberg consolidate unprecedented power in his four decades at the helm of the insurer. But this time, the bullying didn't work. Within a day, Greenberg, once the most powerful man in the industry, was out as CEO. Two weeks later, as the scandal widened, he was forced to resign the chairmanship, too.
Greenberg failed to appreciate the first rule of this new era: that directors, auditors, and lawyers are more powerful than ever. That shift has fundamentally altered relations between CEOs and the advisers they depend on. At their best, these supposed guardians of shareholder value, chosen for their ability to complement the CEO and provide specific areas of expertise, were trusted advisers. At their worst, they were little more than bag carriers and sycophants. Either way, these advisers -- who were always supposed to work for the shareholders, not the CEO -- usually exercised their power as watchdogs only in moments of genuine crisis. But now the chumminess and banter have given way to a more adversarial attitude. This new cop-on-the-beat mentality has helped to topple Fannie Mae (FNM ) CEO Franklin D. Raines, Boeing (BA ) CEO Harry C. Stonecipher, Walt Disney (DIS ) CEO Michael D. Eisner, and Hewlett-Packard (HPQ ) CEO Carleton S. Fiorina, among others.
The new rebelliousness is also spreading quietly, behind closed doors, to companies large and small that aren't making headlines. Auditor complaints led the initially reluctant board of Molex Inc. (MOLX ), a $2.2 billion electronics manufacturer headquartered near Chicago, to oust its CEO in December. Similarly, accounting problems led independent directors at Delphi Corp. (DPH ) to force out the chief financial officer in March. Dozens of similar dramas are playing out in office towers across the country. Even CEOs who don't lose their jobs are finding that their ability to impose their will, whether it's in setting strategy or hiring a successor, has been severely curtailed.
The reason for the new defiance among directors, auditors, and lawyers is no great mystery: The watchdogs are finally facing genuine liability for their failures. The Big Five in the accounting world became the Big Four after prosecutors effectively put Arthur Andersen out of business for its role in the Enron debacle. Meanwhile, directors at the bankrupt Houston energy giant and WorldCom are paying off fraud claims from their own pockets. That's almost unheard of. In a forthcoming research paper, a trio of professors from Stanford University, the University of Texas, and Cambridge University report that they were able to find only three prior cases since 1968 in which board members faced financial liability that was not fully covered by insurance. And the Sarbanes-Oxley Act has imposed tough new whistleblowing requirements on everybody -- including, for the first time, corporate attorneys.
The upshot of all this is a climate of fear. Directors, auditors, and lawyers are worried, first and foremost, about protecting their hides. The old attitude of informal cooperation with the CEO has been replaced by a new spirit of legalistic, often antagonistic, check-the-boxes formality. When red flags arise, directors are quicker than ever to hire outside attorneys to investigate potential wrongdoing. And the lawyers conducting these probes have been transformed from trusted counselors, who in the past were all too willing to lend their credibility to whitewashes, into inquisitorial cops.
That often leads to an elaborate game of shift the blame. The rallying cry of the moment: "Put it in writing." Some auditors are afraid even to talk to CEOs and CFOs about the appropriate accounting treatment for complex transactions, reports Philip Livingston, a former CFO at World Wrestling Entertainment Inc. (WWE ) who is audit committee chairman at Insurance Auto Auctions Inc. (IAAI ) and Cott Corp. (COT ) "The documentation and paperwork that is being paid for is off the charts," says Livingston.
The new environment is making everything about running a company more arduous for CEOs. The watchdogs are playing a bigger role in fundamental management decisions about strategy, acquisitions, succession planning, crisis response, and what can be booked as earnings. "Life is going to be much tougher for the Imperial CEO," says Robert S. Miller Jr., a turnaround specialist who stepped aside as the interim CEO of Federal-Mogul (FDMLQ ) in February and serves on the boards of United Airlines (UALAQ ), Reynolds American (RAI ), Waste Management (WMI ), and three other companies. "It is what shareholders want," he says. "It is going to be much more difficult today for anyone to pull off the gross accounting scandals of four or five years ago."
CEOs, to put it another way, are now being managed with sticks. This is a fundamentally different corporate-governance philosophy than the one that prevailed during the bubble years, when bosses were primarily motivated with carrots -- otherwise known as stock options. CEOs still make boatloads of money, but these days the upside has been limited and the booty is much more likely to come with strings attached.) Both of these approaches were driven by the business crises that defined earlier decades: the competitive failure of corporate leaders in the 1980s, whose pay was not linked to performance, and the greed of CEOs in the late '90s and early '00s, whose pay was too closely linked to stock prices.
The new vigilance will almost certainly provide some desperately needed clarity in corporate governance and cut down on the old abuses. But as is often the case, the new rules may initially go too far and create their own distinctive set of problems. Directors, auditors, and lawyers are all going to command higher fees in the future. And the quality of their advice may well decline. Why? When really tough issues arise -- involving risky deals, aggressive regulators, or gray-area accounting -- CEOs have always been able to turn to board members and professionals for advice. Now piety reigns supreme, and candid conversations are virtually taboo.
Micromanagement is an equally important danger. CEOs who are always second-guessed by their boards can soon become risk-averse, opting to pursue strategies that are "safe" but ultimately unwise rather than risk confrontations with boards over bolder, but smarter, moves. At a conference last year, Kenneth G. Langone, the Home Depot Inc. (HD )co-founder and a central figure in the controversy over Richard A. Grasso's pay at the New York Stock Exchange, warned of the danger that America would have "the best-governed, worst-managed" corporations in the world. "I don't think an adversarial process between management and the board works," says George David, chairman and CEO of United Technologies Corp. "Directors are only able to judge a company at a very high level. The idea that a board will operate 24/7 just isn't realistic."
In a remarkably short period of time, Corporate America has moved from the age of the celebrity CEO to the age of the downsized CEO. With corporate scandals still playing out, there's little chance of CEOs regaining their old clout anytime soon. Here's a closer look at how the balance of power in corporate boardrooms has shifted away from the chief executive:
The big question in the wake of the AIG, Disney, and Hewlett-Packard (HPQ ) dramas is how far will boards go in exercising their vast latent power. Under the law, they have the ultimate authority over key policy decisions -- whether the CEO embraces their views or not. In the past the issue rarely arose. The CEO set the agenda, and while the board may have questioned the boss's decisions, it rarely countermanded them.
It's already clear that directors are getting together more frequently, holding longer meetings, and taking their once-ceremonial duties far more seriously. At E*Trade Group Inc., which revamped its board in 2003 after criticism of then-CEO Christos M. Cotsakos' $80 million pay package, directors meet four times a year for what it calls "deep dives" -- intense discussions lasting up to four hours that give them a chance to interrogate managers about a single topic, such as the one last year that allowed directors to bore into the company's plans for international expansion. "It has been a significant shift," says CEO Mitchell H. Caplan. "When I think about our board today, I think of people who are genuinely concerned about the success of our company."
Even more important, directors at many companies are now required, under recently updated NYSE governance rules, to meet routinely without management present. That is a big threat to the old order. The idea is to allow board members to raise delicate issues -- from executive pay and manage- ment style to lackluster performance -- that they would find difficult to confront with the chief executive in the room. At one of the five boards she serves on, including Dow Chemical Co. (DOW ) and Aetna Inc. (AET ), former Commerce Secretary Barbara Hackman Franklin recalls that concerns about administrative expenses raised in executive session were relayed to management -- and the costs were reined in. "That's the kind of thing that can happen in those sessions," says Franklin.
Directors are taking a more businesslike approach to everything they do. Compensation committees, for instance, used to base the chief executive's pay in large part on studies provided by consultants hired by management -- people who often reported to the very chief executives they were evaluating. These days board members are more likely to hire their own experts. When that happens, the whole process changes. The outside advisers are usually invited to reevaluate every element of the CEO's pay -- from bonuses to pensions to deferred compensation to perks, an exercise that makes it more likely that they'll find redundancy. They're also frequently asked to set realistic benchmarks for gauging the chief executive's performance -- as opposed to the easily attainable targets that characterized the boom years. "You don't have the free lunch like you had," says New York pay consultant James F. Reda.
Similarly, CEOs are losing the power to anoint their successors, a practice that sometimes allowed insecure leaders to make sure they were never threatened by a high-performing No. 2. Nor can CEOs easily stack their boards with cronies and yes-men. These days nominating committees are hiring their own search firms -- and even sometimes rejecting the CEO's choice to fill vacancies on the board of directors. At Chiquita Brands International Inc. (CQB ), the nominating committee is interviewing six board candidates -- none of them chosen by CEO Fernando Aguirre. Says committee member Roderick M. Hills: "You'll never get the degree of independence [boards need] unless you get directors who are chosen by someone else."
The committee that is undergoing the most change, though, is the all-important audit committee. Members now meet 8 to 12 times a year instead of just 4. And thanks to Sarbanes-Oxley, they now have the power to spend company money on their own lawyers, accountants, and forensic investigators. The law also makes it clear that the audit committee -- not the CEO or the CFO -- supervises the auditors. When Chiquita came out of bankruptcy a year and a half ago, Hills, who now heads the audit committee, took quick action to assert control over the auditors. "I called the chairman of Ernst & Young and said, 'We want the résumés of six new engagement partners.' I wanted to make sure that whoever comes -- that he knows very well he works for us." The audit-committee chairman says he now gets called in advance if any issues pop up, from accounting questions to consulting agreements. "Historically, that's not what happened," says Hills.
With so much power shifting to audit committees, companies have started hunting for professionals with close ties to the Big Four firms to sit on those committees. The idea is to find advocates who can help resolve disputes between management and auditors. J. Michael Cook, former CEO of Deloitte & Touche, serves on the audit committees of Eli Lilly (DOW ), Comcast (CMCSA ), and International Flavors & Fragrances. If a tough issue arises that requires consultation with an audit firm's national office, Cook says: "I know how to find my way around the halls there. I know the senior partners. I know who to call and who to engage when need be."
Empowered boards have a watchdog mentality that can serve shareholders well -- but only if they have top-notch directors serving on them. At a time when boards are being given more power than ever, the top-level management experience of directors has never been lower. A decade ago, sitting CEOs were the first choice to fill board vacancies, and they typically sat on two or three. Today many boards discourage such extracurricular activities, and nearly half of all CEOs sit on no boards besides their own. "You look at boards now, and you wonder who these people are," says James J. Drury, a Chicago headhunter who specializes in director searches. "I am concerned that boards will be weakened. The best directors will say, 'I don't need this."'
And in addition to all of the virtues of independence, shifting power away from the CEO does have some downsides. It makes it harder for them to put together boards that can compensate for their weaknesses. And while boards need to exercise oversight, chief executives, with their deeper understanding of their company's strengths and weaknesses, are often in a better position to make critical strategic decisions. Consider the issue of succession. Many of history's great CEOs, from General Electric (GE ) Co.'s Jack Welch to Coca-Cola Co.'s (KO ) Roberto Goizueta, were handpicked by the leaders they replaced. "There is an increasing desire for boards to take these newfound responsibilities and move into areas where they don't belong," says Welch.
Accounting firms are still haunted by the ghost of Arthur Andersen. The remaining Big Four firms all face major securities-fraud lawsuits stemming from the corporate crime wave. An even more important legacy of that era is the Public Company Accounting Oversight Board (PCAOB ), which has been enforcing tough new standards on auditors. If auditors believe that CEOs and directors are not acting promptly to remedy a material error in the company's financial statements, for example, they must notify the SEC within 24 hours.
The net effect of all this tumult, ironically, has been to make auditing firms more profitable -- and powerful -- than ever. The buyer's market for auditors -- in which accounting firms cross-sold consulting services and pandered to clients -- has been transformed into a seller's market. Accounting firms have become much more choosy about which companies they choose to audit, dropping those they deem not worth the time or the risk. Big Four firms resigned from 210 public-company clients in 2004, three times as many as in 2001, according to AuditAnalytics.com.
This newfound assertiveness can lead to some bloody showdowns with CEOs -- with the boss sometimes losing. Consider recent events at Molex, the Chicago-area electronics maker. The company's auditor, Deloitte & Touche, complained that CEO J. Joseph King and his chief financial officer had not disclosed that they allowed a bookkeeping error worth 1% of net income into the audited results. When the auditor demanded on Nov. 13 that King be removed from office, the board initially stood behind the CEO with a unanimous vote.
Then Deloitte did something unexpected: It quit. Two weeks later the firm wrote a blistering and detailed account of the affair for public disclosure at the SEC. That virtually assured that no auditor would work for Molex again as long as King was in charge. Within 10 days, the directors had eaten crow: They ousted King, promised to hire a new director with financial expertise for their audit committee, and agreed to take training classes in proper financial reporting. The parties involved declined to comment for this article.
In most cases auditors can get their way without such fireworks. Accounting-firm partners say it is much easier now to get companies to make accounting estimates and judgments that are safely right down the middle of ranges, neither too aggressive nor too conservative. When the firms find fault with old accounting practices at one company, CEOs elsewhere in the same or similar industries are apt to get caught in fast-moving waves of financial restatements. In just five months after auditor KPMG changed its mind in November about a decades-old accounting practice followed by fast-food outfit CKE Restaurants Inc. (CKR ), more than 235 companies announced restatements or potential adjustments for lease expenses, according to Jack Ciesielski, an independent accounting analyst. The auditors essentially found that companies were understating lease expenses or accelerating credits, both of which inflate earnings.
The risk is that accounting firms will apply rules so strictly that financial reports become less useful to investors. Audit partners are pushing companies to restate financial reports for smaller amounts, sometimes over debatable issues. At Countrywide Financial Corp. (CFC ), auditor KPMG pushed the company to restate earnings because the company still held 0.1% to 2.2% stakes in assets it said it had booked as sold. Restatements such as those become a distraction for investors. At the same time, companies are loading up reports to the SEC with more informational text than most anyone can read. The average annual 10-K report from companies in the Dow Jones industrial average is 198 pages long, nearly double what it was six years ago, according to David Zion, an accounting analyst at Credit Suisse First Boston (CSK ). Some companies have disclosed, even when not required, that they had weaknesses in their bookkeeping that had only a remote chance of affecting their financial statements. This type of excessive caution is far more highly valued by the Big Four's legal counsel than by investors.
Law firms haven't suffered as seriously as accounting firms in the wake of Enron, WorldCom, and the other major corporate scandals. No attorneys have gone to jail for the advice they offered to the major rogue CEOs, no law firms have been driven out of business for assisting fraudsters, and private litigation has not proven to be a huge threat to business counselors.
But that doesn't mean things are unchanged in the legal world. Attorneys are no longer treating CEOs and general counsel as their most important patrons. Like accountants, attorneys are now more likely to be hired by directors -- and more important, to behave as if their true clients are shareholders. This new attitude is most visible in the way lawyers conduct "independent internal investigations" -- such as the ones that played big roles in the downfalls of AIG's Greenberg, ex-Computer Associates International (CA ) CEO Sanjay Kumar, and many others.
In the past these internal probes often turned out to be little more than whitewashes. Directors commissioned them in large part because In Re Caremark, a key 1996 Delaware Chancery Court decision, obligated them to investigate allegations of misconduct. But it was often easy for CEOs and other high-ranking managers to manipulate the supposedly neutral process by turning to friendly attorneys "who would develop a strategy to cut off the problem at the lowest level that could be sold to the outside world," says Edwin H. Steir, a former federal prosecutor who is the author of Corporate Internal Investigations: Independence and Credibility.
The big problem was that lawyers are not trained to be objective investigators. Their natural instinct is to serve as advocates for the people paying their bills. Even after the Caremark decision, lawyer-investigators sometimes agreed to conditions that undercut their effectiveness, such as allowing corporate executives to edit the prober's reports or sit in on witness interviews -- a strong disincentive to whistleblowing. Taking advantage of the attorney-client privilege, lawyers also generally kept all of their underlying research under wraps and offered regulators only a written summary of their conclusions.
Public disenchantment with corporate crime has certainly generated pressure to tighten standards for internal investigations. But another, comparatively unheralded factor has turned out to have a much greater impact: the renewed interest of the U.S. Justice Dept. in bringing criminal charges against companies, as opposed to individuals exclusively. This was articulated in a little-noticed January, 2003, policy memo written by then-Deputy Attorney General Larry D. Thompson entitled Principles of Federal Prosecution of Business Organizations.
The memo immediately caught the attention of corporate defense lawyers. Merely being charged with a crime amounts to a death sentence for some corporations -- especially those businesses that are built on public trust or that have to meet tough government vendor requirements. "If you are a financial-services company, if you are a defense company, if you are a drug company, or if you are in a whole host of other industries, the consequences of an indictment are so serious that you won't even make it to trial," says William McLucas, a Washington lawyer who conducted the internal investigations for directors in the aftermath of the Enron and WorldCom debacles.
The good news for Corporate America, though, was that the Thompson memo showed directors exactly how to avoid this awful fate. One way was to show a "willingness to cooperate in the investigation" of corporate employees. Another was to waive the attorney-client privilege that would ordinarily cover internal corporate investigations. These same general guidelines have also been followed by other federal agencies and the states.
The Thompson memo -- along with the broader enthusiasm state and federal prosecutors have displayed for corporate criminal charges -- has essentially killed the old whitewash machine. When companies face charges of serious wrongdoing, the first thing directors generally do is instruct employees to cooperate with regulators. The second thing that happens is that the board agrees to waive the attorney-client privilege for any damaging material uncovered by lawyer-investigators. This means regulators get to see every witness transcript, scrawled note, and smoking-gun e-mail that the company sees.
The upshot: CEOs and other executives can no longer regard the lawyers conducting internal probes as advocates in disguise. These days the investigators function much more like cops. Any doubt about the issue was eliminated last year when CA's Kumar was indicted on obstruction-of-justice charges for the alleged crime of lying -- not to regulators, but to internal investigators.
Now everybody up and down the management hierarchy needs to retain their own counsel when a probe is launched. That adds to the already massive troop deployments that characterize contemporary internal investigations. Consider superlawyer David Boies's investigation of Tyco International Ltd. (TYC ) He assigned 25 attorneys and 100 accountants to the job. Then forensic SWAT teams circled the globe, digging through file cabinets and hard drives and interviewing employees at 45 operating units in 13 countries. In all, more than 15,000 lawyer hours and 50,000 accountant hours were billed to the probe. Once such a large investigation is set in motion, "the CEO is no longer in charge," observes corporate lawyer Michael R. Young, of Willkie Farr & Gallagher in New York.
By and large, of course, chief executives are still in charge, but their power is much more limited. The downsizing of the CEO has led, to a certain extent, to the supersizing of the advisers. That's not necessarily a cure for everything that ails Corporate America. It is a clue that successful CEOs will have to be consensus builders in the future. And should be a warning to CEOs everywhere: The age of the absolute corporate monarch, such as AIG's Greenberg, is over.
By David Henry, Mike France, and Louis Lavelle
With Diane Brady in New York, Joseph Weber in Chicago, and bureau reports