December 14, 2003

A Boss for the Boss

THE collapse of Enron and WorldCom, the fall from grace of Martha Stewart and Richard Grasso and the humbling of Wall Street in general have spawned new legislation, regulatory reforms, criminal prosecutions, lawsuits, books, articles and -need we add? -- stock-market losses. It has also spawned a revolution.

Revolutions are about power; they are also about ideas. This one is approximately seven decades overdue, but it is nonetheless transformative. As the scandals continue to spread, most recently to mutual funds, people have begun to realize that mere laws, mere new regulations and even the threat of prison sentences will never do the trick.

''People being human, there will always be someone cutting corners and acting in their own self-interest,'' observes Ira Millstein, the lawyer most active in the suddenly trendy field of corporate governance. And so, regulators, investors, academics and even corporate directors are coming round to the idea that Millstein has been championing for two decades: a better way must be found to govern the corporation from within.

This intellectual ferment has upended life in that formerly cozy preserve known as the corporate boardroom. A transfer of accountability has occurred, a reapportionment of turf. ''People used to say problems were management's concern,'' Millstein says. ''When it comes to the scandals of the 90's, they are blaming the passivity of boards.'' These scandals are making plain the futility of merely blaming C.E.O.'s or even ''greedy C.E.O.'s.'' C.E.O.'s are greedy, often obscenely so. Presumably, they will be that way in 100 years. The question is not how to enlighten them, but how, and who, to restrain them.

It may seem curious that no one, until recently, thought that it was a matter for directors or fretted if a chief executive stacked his board with friends. The Disney board once included Michael Eisner's lawyer, his architect and the principal of his kids' school. With this type of oversight, C.E.O.'s could do no wrong. Consider Tyco, whose chief executive, L. Dennis Kozlowski, is now on trial for stealing from his shareholders. In 2001, shortly before his supposed crimes came to light, Kozlowski demanded a contract that guaranteed his severance, even if he committed a felony. The directors might have reasonably asked if Kozlowski were plotting a little arson or, perhaps, a discreet murder. Instead, they met his terms.

Nell Minow, a shareholder activist, says no board would grant such a blank check today, and not only because the rules for directors have changed. The culture is also changing. ''It used to be considered rude to ask a question,'' she says. ''Now they are all vying to ask the toughest question.''

Optimism must be tempered by the experience of two prior periods of activism, neither of which solved the governance riddle. There is a metaphysical sense in which the problem is irresolvable. Plato argued for a society run by perfect guardians; Juvenal is said to have replied, ''And who will guard the guardians?'' That has always been the dilemma.

IN the United States, the issue dates to the Constitutional era. James Madison argued that the federal government should be authorized to charter corporations. But federal charters smacked of royal perquisites, like those enjoyed by the East India Company. No one wanted another tea party. Therefore, it was left to the states to write the rules. Delaware, through its utter permissiveness, became the corporate residence of choice, much as the Cayman Islands is a paper domicile for secrecy-minded bankers. To this day, more than half of America's largest companies are incorporated in its second-smallest state. Delaware laws are so lax they don't even require publishing an annual report.

The absolute passivity of boards did not matter when companies were family-owned. If the DuPont family wanted to fritter away the assets of DuPont -- well, it was their company. But by the 1920's, many corporate families had issued stock to the public and hired managers. The first to recognize the sweeping significance of the transformation was a Columbia Law School professor named Adolf Berle. The titans of industry had been replaced, Berle saw, by millions of essentially powerless shareholders. A new class of managers -- who didn't own assets but nonetheless controlled them -- had assumed command and answered to no one. ''The location of decision-making in the economic world has shifted,'' Berle wrote, with the assistance of Gardiner Means, in a 1932 book, ''The Modern Corporation and Private Property.''

The book appeared at the depths of the Depression, a time of great corporate crisis. Amid scandals not dissimilar from today's, the New Deal created the Securities and Exchange Commission, which forced companies to disclose more. But almost everything else -- for example, what directors should do and how they should be chosen -- was left to the states. The New York Stock Exchange did adopt modest governance requirements for listed companies. Unions also imposed some restraints, as did antitrust cops. But managers continued to do pretty much what they pleased, and directors didn't challenge or even usually scrutinize them. And so it was for decades.

Until, in 1970, Penn Central, the country's sixth-biggest company, collapsed, touching off a tempest. The board, like Enron's later, hadn't had a clue. Harvey Goldschmid, then a young law professor and today an S.E.C. commissioner, offered a proposal to make boards stronger. But the federal government was reluctant. The S.E.C.'s mandate had always been about disclosure. Governance was for the states, remember? Other proposals were circulated, including one from Ralph Nader that called for companies to be federally chartered. But these reform efforts mostly failed.

Then, in the 80's, a takeover frenzy reignited the issue. Academics reckoned that takeovers were a perfect fix. If a company wasn't well managed, T. Boone Pickens or somebody would gobble up the stock. This motivated managers to keep the stock price high. Theoretically, the market would provide all the governance you needed. But it didn't work that way. Managers with too much riding on the stock, especially in the short term, violated every sound business practice in the book. Big institutional investors did perk up, though; they wondered why some stocks soared and others went nowhere, year after year. Also, many of the big state pension funds had adopted indexing, meaning that even if a company was poorly managed, they were committed to holding it. The California Public Employees Retirement System, or Calpers, figured that if it couldn't sell a bad stock, it had to get involved.

By the late 80's, a group of corporate executives and big investors, including Calpers, was meeting to hash out governance proposals. The investors had some radical notions, like one that said boards should be run by an independent chairman. It was radical only because American companies were so tilted toward the C.E.O. -- what some were calling the imperial C.E.O. Logically, it makes no sense to think that Jack Welch or Ken Lay can supervise himself. Teachers need principals who need chancellors who need school boards; this is the way it works. Only C.E.O.'s were guardians of themselves. The executives did not favor any increased role for directors. The first meeting ended in a shouting match.

The investors focused on a company that clearly was not well run: General Motors. At the suggestion of Millstein (who was counsel to G.M.'s board), Richard Koppes, general counsel of Calpers, asked for a meeting with G.M. brass. Roger Smith, the C.E.O. and chairman of G.M., brushed him off. ''If you don't like the stock,'' he said, ''sell it.'' That would have worked once, but no longer. Prodded by Millstein, G.M.'s directors sacked management and named an independent chairman -- and in so doing, reinvented their jobs. In the mid-90's, a cottage industry of watchdog types routinely raised the governance issue with underperforming companies. Some, like Disney, did not respond at first. But several high-profile boards, including that of American Express, heeded the call and sacked their C.E.O.'s.

One of the few people who did not seem alarmed was Richard Grasso. He repeatedly exclaimed, ''For every Enron, there are 1,000 Exxons.'' In fact, hundreds of other companies have had to admit to reporting bogus earnings. Few of them could have gotten away with it had their boards' audit committees taken their role seriously.

Now, at long last, regulators seem to grasp the centrality of the board's role. The S.E.C. forced the stock exchange (and Grasso) to seriously beef up standards for directors. Matters like the C.E.O.'s compensation and nominations for the board will be decided entirely by independent directors. Also, the independent directors will have to meet regularly without anyone from management to review the C.E.O.'s performance. This change reflects an important truism of boardroom culture: directors speak more freely in confidence. Charles Elson, who teaches corporate governance at the University of Delaware, calls the reforms ''farsighted.'' It is an oddity of Grasso's career, of course, that he did not reform his own institution. He was forced to resign not so much because the board overpaid him but because the directors who did so were those he regulated.

The Sarbanes-Oxley Act, passed by Congress in 2002, steps up standards for directors even more. Significantly, independent directors will be responsible for the quality, and also the probity, of audits, the area in which directors' past passivity was most glaring. Perhaps the most radical change, just proposed (over heated protests from the lobbying arm of the C.E.O.'s, the Business Roundtable), is that proxy elections will be democratized, so that investors will have a genuine chance of proposing and electing a minority of directors.

Though no one seems to have noticed, Delaware has reverted to its proper position in the cosmos: a small state with an attractive shoreline and one with less influence over corporate affairs. By pushing directors to center stage, regulators federalized what had historically been Delaware's role.

Though the reforms, so far, exist only on paper, the climate in boardrooms is chastened. Serving on an audit committee is now considered work for Boy Scouts. (In fact, a new problem has emerged: where to find directors who understand accounting?)

The week Grasso was shown the door, Koppes, now in private practice, was speaking to a board of, as it happened, a well-known consumer company. As the directors nervously shifted, the C.E.O. suddenly interrupted him and declared: ''I'm no imperial C.E.O. I'm not paid like that. These'' -- he gestured at the directors -- ''are my bosses!''

It is too soon to say whether the imperial C.E.O. is really dead, but it is certain that no C.E.O. would have disdained such an image in the 90's. This reflects an idea both old and new: directors must be responsible. Whether it will endure into the next boom period cannot be known, but it is hard to imagine that directors will be quite so passive again.

Roger Lowenstein is the author of the coming "Origins of the Crash: The Great Bubble and Its Undoing."

Copyright 2003 The New York Times Company

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