September 03, 2002
Really Scary

It's hard to know if this is a fair picture of what went on--and of how ignorant the typical large-corporation board member is. But if it is a fair picture, it's really scary.

Back to School, but This One Is for Top Corporate Officials

September 3, 2002


CHICAGO The class was not faring well. On its accounting exam the average score was 32 percent. The teacher was particularly exasperated that so many students had missed a multiple-choice question on the meaning of retained earnings.

"Don't tell me that you're on the audit committee and can't tell me what retained earnings are," Roman L. Weil, an accounting professor at the University of Chicago Graduate School of Business, said to the class.

These were no first-year M.B.A. students. They were top executives and board members of some of the nation's largest corporations, at a novel post- Enron boot camp.

About 80 officers and directors from companies including Pfizer, McDonald's, Motorola and Dow Chemical sat through three days of lectures to understand how to do their jobs at a time when far more people are watching them.

Many students came away daunted and frustrated by the overwhelming message in almost every lecture: that the legal landscape is constantly shifting and the liabilities for directors are greater than ever.

"We've got so many unknowns; there are no answers," James Boyd, chairman of Arch Coal Inc., lamented on the last day of class. "And the risk has changed. They are going to hold us to a much higher standard."

The program the Directors' Consortium was developed by the Wharton School at the University of Pennsylvania, Stanford Law School and the University of Chicago Graduate School of Business. It focuses on everything from whether notes should be destroyed after board meetings (the answer: usually, but not always), to who qualifies as a financial expert on a board's audit committee under the strict new legislation approved by Congress. (The class members decided that most of them would not qualify, but happily determined that Warren E. Buffett would not either.)

"As I look around the room I'm not sure if this is an executive education program or a support group," said Joseph A. Grundfest, a professor of law at Stanford University who is a former commissioner of the Securities and Exchange Commission and is on the board of the Oracle Corporation. "I feel your pain."

A class on directors' fiduciary duties and legal liabilities focused on the very basic question of whether board members' main responsibility is to shareholders, to all stakeholders or to the chief executive. "To whom do you owe the duty?" asked Richard A. Epstein, a law professor at the University of Chicago. (The class was divided on the answer.)

He told the class to always think about the answer this way: "Who can sue whom for what?"

"The board is like an insurance policy," Mr. Epstein said. "When things are good, you take your money and go to the beach. When there's a crisis, you're working overtime and massively underpaid."

With executives now constantly in the firing line, in front of judges and Congress, part of one class explored how to prepare for a deposition.

"You don't want to volunteer anything," Mr. Epstein said. "You have to have a personality vasectomy." Mr. Grundfest added: "Think slowly. Don't pull a Bill Clinton and ask what the definition of is is."

Henry J. McKinnell Jr., chairman and chief executive of Pfizer, told the class at lunch that at a deposition recently he was asked whether the board minutes, which were purposely kept vague, were accurate. "I had to tell them the truth," he said. "I said, `No. The minutes are not a complete reflection of what went on there.' Our lawyer was going crazy."

At one point, the conversation turned to how to pick an outside lawyer. "The real risk is that if you hire a criminal lawyer, you look guilty," Mr. Grundfest said.

Most of the lectures were about why it is so important to avoid a lawsuit in the first place. Of Arthur Andersen, Mr. Grundfest said: "As soon as it was indicted it lost. They were de facto dead."

Board members were advised to create clear corporate governance policies and always to make decisions collectively to avoid serious liability. "If you want to get in real trouble, make a decision by yourself," Mr. Epstein said. "This kind of misery loves company."

And the professors stressed over and over again to tell the truth.

"If there are ways people in this room go to jail, it's probably through crimes of upholstery the cover-up will kill you," Mr. Grundfest told the class. He brought up the case in which Martha Stewart is being investigated for insider trading. "She might go to jail because she lied even though she might not have committed insider trading."

Given the greater liability now faced and the greater time commitment required of board members, some students who are members of several boards while also serving as officials at their own companies said they expected that they might have to resign from one or two boards. Mr. McKinnell of Pfizer said board members at his company put in about 200 hours of work a year.

David F. Larcker, a professor at Wharton, began his lecture on compensation committees by acknowledging: "Once the public gets finished pointing fingers at the audit committee, the compensation committee is next. This kind of stuff is a public relations nightmare."

He discussed how boards should arrange compensation packages among salary, stock options, restricted stock, benefits and perquisites and other items like severance agreements. Despite dozens of seemingly outlandish compensation arrangements for chief executives, which he displayed on a slide, Mr. Larcker told the class that compensation in corporate America is "nowhere near how out of whack as it is made out to be."

Still, he reminded the class that when interviewing job candidates: "If the first question they ask is `How many country club memberships do I get,' that's probably not the best candidate."

Steven N. Kaplan, a finance and management professor at the University of Chicago School of Business and a board member of Morningstar, and Steven Koch, a vice chairman at Credit Suisse First Boston who conceived the program, taught a class on finance using Enron's balance sheet as a study of bad oversight.

"Look at this," Mr. Kaplan said, pointing to a line on Enron's cash flow statement showing that "changes in components of working capital" shifted from negative $1 billion to positive $1.7 billion in a year. "If you're a board member, there has to be a disconnect."

Mr. Koch also warned the group of tricks bankers use to justify bad deals. "When someone walks in the room and starts yakking about strategic value, you have to ask, `What the heck does that mean?' " Mr. Koch said. "This is a frequent repository for games."

For some students, the three-day program was more than enough. But others, like Terry L. Savage, a board member of McDonald's and Pennzoil, wanted even more. At the end of the accounting class, she raced up to Mr. Weil, the professor, and asked whether she could take his accounting class on Monday evenings to brush up. "After 11 years on the compensation committee and now going on the audit committee, I decided to make it a major project to become informed about the issues and the mathematics," she said.

Perhaps some other students should have shown her enthusiasm. While the average score for the accounting test was 32 percent, that question on retained earnings undistributed earnings that have not been paid out to stockholders or transferred to a surplus account was answered correctly by fewer than 20 percent.

Posted by DeLong at September 03, 2002 01:54 PM | Trackback

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After 2 years of business school, I suppose I should not be amazed that despite the fact that the purpose of a business is to make money and the purpose of a board of directors is to oversee the making of said money, that the members of the board are in fact singularly uninterested in exactly how the company figures out whether it has succeeded in achieving its goal.

But then again, we are living in a country governed by its first MBA-certified president, who campaigned on his intention to outsource his policy-making decisions.

So why then shouldn't a corporate board outsource its brains? Frankly, considering how much these directors and honchos are getting paid, I'm surporised nobody has suggested outsourcing the lot of them to some less expensive "3rd World" country.

Posted by: tigger0035 on September 3, 2002 04:42 PM

My wife is an certified accountant in one of the Fat 4 and she's been telling me that the accounting industry's dream is to obtain that at least 1 board member be knowledgeable about accounting practices and principles... I don't think their wish has been granted yet. Or have I missed an episode?

Posted by: Jean-Philippe Stijns on September 3, 2002 06:07 PM

I've spent two years doing Accounts Receivable, and I read the first chapter of an accounting textbook. Am I qualified to be on a board? The textbook defined retained earnings in that first chapter, even.

Posted by: J. Michael Neal on September 3, 2002 06:16 PM

J. Michael:

Are you qualified? Depends -- are you rich? Do you have rich friends? Do you have resources for quid pro quo, ie access to government funds?

Posted by: Adam on September 4, 2002 08:56 AM

Imagine, more than 80% of such directors not being able to guess "what are retained earnings." Astonishing.

Posted by: on September 4, 2002 10:01 AM

Flip through the back of any annual report, and you'll see the photos/names/bios of the firm's board members.

Many/most are on a particular board for their business connections, political access/pull, diversity symbolism, legal know-how, etc.

Yes, the notion that many of these folks don't know basic accounting is frightening, but that field was not the reason they were chosen to be on a given board. It is a good bet that will change going forward.

Also, as the LTCM debacle made clear, mathematical brilliance and the ability to parse a spreadsheet are no guarantee of financial success.

Posted by: George Zachar on September 4, 2002 10:24 AM

>> But if it is a fair picture, it's really scary. <<

If you want to be scared, *really* scared, look at the boards of not-for-profit organizations. They aren't accountable to anybody for anything. They have no shareholder/owners to answer to, the IRS never audits them, and they get next to no scrutiny from the media -- there's no 'not-for-profit press' as there is a 'business press'. So there's a real entitlement mentality among them: "Since we are not-for-profit the law doesn't apply to us and we can do whatever we want." They don't even bother to learn what laws they are breaking.

I've served on a number of these, and it's been illuminating. The first one I was asked to join in a turn-around effort after the organization, which had an endowment in valuable Manhattan real estate, had run itself into financial ruin.

At my first board meeting I found there were half a dozen more board members than allowed by law, because everybody had cronied his buddies onto the board. And of course the reason why the organization was broke was because its real estate had been all rented out at below market rates to friends and associates.

By the second meeting I'd learned that one of the board members was going through the mail delivered to the endowment property and was stealing Social Security and retirement checks sent to tenants. When this fact was presented to the other board members their reaction was "Yes, but we can't do anything about it because if we accuse him of it he could sue us for libel."

I could go on, but I'm saving it for a book. This was a fairly reputable and known organization soliciting deductible contributions from the public. So my advice is: never trust a not-for-profit. Or get in on the gravy train by starting your own.

Posted by: Jim Glass on September 5, 2002 07:54 AM
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