Risky business Featured

7:00pm EDT November 25, 2008

Some boards of directors may be facing some of their biggest challenges of the last 20 years. While it’s too soon to predict what, if any, litigation or increased oversight will be brought into boardrooms in the wake of the recent turbulence, it is clear that boards must move forward with an elevated sense of responsibility.

“So far, there has been relatively little focus on the role that boards may or not have played in the financial crisis,” says James Tompkins, Ph.D., director of Board Advisory Services, Corporate Governance Center, Coles College of Business at Kennesaw State University. “However, the fire is still burning fiercely, and once the dust settles, it is likely that board processes or activities will be heavily scrutinized.”

Smart Business recently learned more from Tompkins about the dangers of subsidizing risk, the benefits of skepticism, and why self-assessments will keep boards operating in the best interests of the company and its shareholders.

What dangers should be considered when subsidizing risk?

Consider the following scenario: Suppose I tell my 12-year-old daughter that I will contribute half the cost of her iPod if she ever damages it. With such a subsidy, she might choose to take her iPod to the pool and risk getting it wet. Conversely, if she bore the whole cost, she may prudently decide to leave her iPod at home whenever she swims.

Similarly, if a corporation bears risk to reap the expected returns, it will more likely make prudent decisions. However, if the government subsidizes the risk in any way, this can alter the decision-making of corporations in a perverse direction.

In my view, as we move forward with the financial crisis, a key principle of government regulation should be to ask the question: Does this regulation in any way subsidize risk? If the answer is yes, the next question should be: Is subsidizing this risk in the best interests of the taxpayers as a whole?

How can boards best manage their purpose of protecting stockholder interests and their responsibility of monitoring risk?

The purpose of a board is not just to protect but also to promote stockholder interests. Shareholders finance corporations to take risks in their areas of expertise. Hence, management promotes shareholder interests by engaging in such risks on behalf of shareholders. However, part of prudent risk-taking means that the board should have a big-picture understanding of the risk being taken and processes in place to both measure and monitor such risks. Such processes are consistent with protecting shareholder interests. An analogy might be when a shipping company sends a ship to sail from A to B because engaging in this risk is expected to reap returns to the shareholder; management promotes stockholder interests when it risks this voyage. However, shareholder interests are protected when there is radar on board and an instrument to receive weather maps so the captain can change course to avoid dangerous storms.

Why is ‘healthy skepticism’ a key trait for today’s directors?

I would argue that a key reason in which the board of Enron played a role in its collapse was because it did not employ ‘healthy skepticism’ in meeting its responsibilities. I recently served as a corporate governance expert witness for an Enron lawsuit, and my observation was that, as individuals, the directors of Enron were all highly successful, intelligent and talented people. However, they were also on the board at a time when the executive management at Enron — Lay, Schilling, Fastow — were being lauded for their leadership and accomplishments at Enron. This can make it very tempting for board members to fall asleep at the wheel and become complacent with their responsibilities. In other words, I believe they became too trusting of management and did not provide rigorous oversight and monitoring. A board that does not employ ‘healthy skepticism’ in meeting its responsibilities is not providing the constructive and rigorous oversight and monitoring required to achieve its purpose.

Can directors use self-assessments to gauge their performance around interaction, independence and integrity?

Yes, it is a best governance practice to have procedures in place to evaluate the board as a whole, the committees and even individual directors. In partnership with other governance centers, our center recently released ‘21st Century Governance Principles for U.S. Public Companies’ that addresses all these questions, including: Is the board’s interaction effective? Does its interaction result in communications that promotes good decisions? Are the vast majority of directors not only independent, but also independent-minded? Do directors have unblemished records of integrity? These are all questions that will promote and protect shareholder interests. A prudent board will conduct such evaluations with the goal of serving in an environment of continuous improvement.

DR. JAMES TOMPKINS is director of Board Advisory Services, Corporate Governance Center, Coles College of Business, Kennesaw State University. Reach him at (770) 499-3326 or jtompkin@kennesaw.edu.