Thanks...I Needed That!
from
January/February 2006
by Chalres Burck
The
board meeting takes on a glow of satisfaction. The CEO exults that
business is up and that Sarbanes-Oxley compliance is all nailed down.
Laughs, witty compliments, and confident projections for the
future—what a lovefest.
Stop! It’s time for a reality check.
All
too often board members are blindsided by the misbehavior of executives
or, more commonly, by failures of strategy or execution that they could
have spotted if they’d been paying closer attention. They overlook a
warning flag or misread a signal, and before anyone realizes what’s
happening, management has led the company into deep trouble. After the
train wreck, everybody asks, “Where were the directors? What were they
thinking?”
The risk of losing sight of reality is never
greater than when a company’s on a roll. “Managements can get away with
murder when things are going well,” says Larry Bossidy, former chairman
and CEO of Honeywell International and a director of Berkshire Hills
Bancorp, JPMorgan Chase, and Merck. “The boards tend to get too relaxed
and comfortable. They stop being vigilant.” Board members can also
become intellectual captives of the people they’re supposed to oversee,
adds Robert E. Mittelstaedt Jr., dean of the W.P. Carey School of
Business at Arizona State University and a director of Laboratory Corp.
of America Holdings and Innovative Solutions & Support Inc., an
aerospace electronics company. “They can fall into the same mind-set as
management; they can get hubristic, even arrogant.” Or they may be
cowed by the kind of CEO that Bossidy calls “a self-anointed deity.”
Are directors at code orange when, say, a Maurice “Hank” Greenberg is
showing earnings growth year after year at AIG, or a Carly Fiorina is
unveiling a grand strategy that will make Hewlett-Packard the dominant
player in its industry? One or two may have doubts, but nobody really
wants to speak up without probable cause.
Even great
CEOs can ignore good advice. When GE’s Jack Welch set his heart on
acquiring the Kidder Peabody brokerage firm in 1986, at least three of
his directors argued against the deal. Welch admitted in his
autobiography: “Frankly, I was just full of myself. . . . I thought I
could make anything work.” He couldn’t, and Kidder, a disaster for GE,
was sold to PaineWebber in 1994.
Paradoxically, at some
companies Sarbanes-Oxley may have contributed to the distancing of
board members from reality. “The law forced directors to be more
actively engaged in compliance issues,” says author and management
adviser Ram Charan. “If the board digs endlessly into minutiae, it
emasculates management. It must be sure it’s asking the incisive
questions that focus management on the critical issues.”
Incisive
questioning is the essence of a reality check, and it doesn’t require
calling in consultants or holding a special meeting. Stripped to its
essentials, such a check comes down to three basic questions that board
members should ask themselves:
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Do I understand how the company makes its money?
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Do I understand the strategy, in the context of both the company’s external environment and its ability to execute?
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If management is off track, is the board prepared to act decisively?
Directors
don’t have the time to ride herd on management’s every move, of
course—nor should they. And if the board and the CEO work well
together, with plenty of clear and candid dialogue in their meetings,
any nascent problems are likely to turn up early. But in the
less-than-ideal world, directors need to be the ultimate realists. As
Bossidy puts it, “A board member has the responsibility to be sure that
the company is on the right track; that management has assessed the
environment properly, performed well against the competition, or know
why they haven’t; and that they have a realistic plan to improve the
fortunes of the company.” Directors aren’t going to meet this
responsibility if they’ve grown complacent because of success or timid
about speaking up. Says Mittelstaedt: “Management teams on their way to
disaster tend to deny obvious signals. In some cases, the board is the
last hope.”
Do you understand how the company makes its money?
This
is neither an insult nor a gratuitous jibe. The board of every big
company that fails or goes spectacularly astray, from AT&T, Lucent
Technologies, and Conseco to Enron, KPMG, and (fill in the latest
hapless headline-maker), is populated by high-powered, seasoned
executives who presumably did not understand where the company’s
profits came from. Roman L. Weil, a professor of accounting at the
University of Chicago Graduate School of Business, goes so far as to
call most directors financially illiterate. He defines financial
literacy as a board member’s ability to understand the important
accounting judgments that managers of the company make, why they make
those judgments, and how they can use them to manipulate financial
statements.
Over the past several years, Weil and his
colleagues have tested more than 1,400 directors for their overall
financial literacy. “The median score on this quiz is about eight
correct answers out of 25 questions,” he says, “and fewer than 30% of
the respondents were right on six items you could answer from a
first-term M.B.A. textbook.” (See the print version on page 57.)
While
it’s unrealistic to expect board members to possess sophisticated
knowledge of accounting, there’s still much a reasonably astute
director can do to check on whether management is paying attention to
the things that matter. In Charan’s view, one of the board’s more
critical contributions is to focus on whether liquidity will be
adequate if conditions sour. “Adverse situations will come, whether
because of externalities like a recession or unexpected competition, or
from internal disappointments such as a big acquisition that doesn’t
work out,” he says. “Boards can suggest that management consider what
will happen to cash if things don’t go as planned, particularly if
several factors turn negative simultaneously.”
For
example, is management aware of potentially disruptive changes such as
emerging low-cost competition? Can it demonstrate that the business has
what’s needed—enough financial resources, the right people and
organizational structure—to execute its strategy? Are financial targets
like operating margins and revenue growth grounded in reality?
Make
sure you’re looking at the right numbers, advises Charan: “Too many
boards use too much time comparing recent performance against past
years or the strategic plan, when they should be evaluating forces that
drive future performance.” First among these is operating cash
flow—“the dye in the artery,” as Charan calls it—which shows “where the
cash is coming from, where it’s going, which businesses are consuming
it, which ones are generating it, whether the balance is good. The
basic purpose of this reality check is to ensure that future cash
obligations match with cash generation, stress-tested against various
adverse conditions and considering the realism, timing, and pattern of
inflows and outflows.”
If you’re not sure about the
numbers you’re getting from the CEO, go around him. “Ask him to put you
with the finance people and, when appropriate, with operating people,”
says Charan. “You will learn more this way, and in more depth. That’s
how I learn—through questioning, one-on-one tutorials, not through
presentations.”
For an example of what happens when
directors don’t check the dye in the arteries, consider the problems
that overtook Electronic Data Systems, a Plano, Texas-based
information-technology-services company. At the end of the 1990s,
chairman and CEO Dick Brown led a turnaround of the company, which had
languished with an obsolete business model and an ingrown culture.
Restructured and fired up to chase growth opportunities, EDS won scores
of big new contracts, and by 2002 its future looked bright.
The
contracts required large cash outlays up front, so the company borrowed
to finance the growth. Profit margins were rich enough that EDS stood
to make a lot of money over time.
But the contracts
also allowed customers to renegotiate prices each year, and as new
competition drove market prices down, margins and revenue began to
shrink. Delays in servicing a couple of big contracts hit revenues
another blow. When its customers’ IT spending collapsed, EDS’s
liquidity was seriously threatened. More customers defected, profits
evaporated, and the share price plunged from almost $70 early in 2002
to about $18 by year’s end. Brown left in March 2003, and his successor
saved EDS only through brutal cost-cutting.
Had the
board members been doing reality checks, they would have seen clear
warning signals in the shrinking margins and mounting competition. The
very nature of the contracts guaranteed that EDS would be vulnerable to
any marketplace disappointments. Yet there’s no evidence that the board
ever challenged management’s optimistic gamble; if any members did,
their judgments were overridden.
Do you really understand the strategy?
Strategic
plans too often rely on forecasts based on assumptions that aren’t
subject to enough critical scrutiny. Managements tend to get caught up
in wishful thinking and unfounded hopes. They don’t look objectively at
the external environment, they don’t realistically assess their
organizations’ ability to execute a plan, or they don’t look rigorously
enough at how the strategy will actually make money.
Directors
feel that too many managements launch strategies without much input
from their boards. The 2005 Corporate Board
Member/PricewaterhouseCoopers director survey found that 59% of the
respondents wanted more involvement in strategy discussions. “Most
boards discuss strategy piecemeal over a series of meetings, often at
the end,” Charan says. Even in longer meetings devoted to strategy,
including retreats, too many of the discussions are one-way. PowerPoint
presentations by management offer the board members little opportunity
to raise questions. When discussion finally does open up, says Charan,
“there’s often no clear train of thought, and seldom any closure.”
Running a reality check on strategy requires you to ask three questions:
(1)
What’s the nature of the game we’re in? (2) Where is it going? (3) How
do we make money in it? These are simple questions—yet, as Charan
observes, “incredibly, in some organizations today they rarely get
asked, let alone answered.”
Probably the most common
reason a strategy fails is that the business’s leaders haven’t looked
realistically at the nature of the game. How good are the assumptions
about the external environment? What are the competitive dynamics—how
could unexpected new players or changing economic circumstances disrupt
the plan? EDS’s leaders did all the right things to prepare their
company for growth. But then they failed to consider risks that should
have been plain to see.
Is the board up to the job?
You
and your fellow directors aren’t exempt from reality checks either.
Outsiders are frequently baffled by a board’s failure to act in what
hindsight reveals was an obvious crisis. Surely somebody saw what was
happening. Why didn’t he or she speak up?
“One of the
most difficult things is to sense when you cross the invisible line
from complete confidence in management to questioning it,” says Robert
Mittelstaedt, the business-school dean. “You have to consciously put
yourself in that mind-frame.” Sometimes the obstacle is time pressure.
“You go into a meeting, and something comes up that you didn’t expect,”
Mittelstaedt says. “But you’ve all made your schedules to return,
you’re in a rush to wrap up, and you don’t have time to go back for a
big-picture review.” In other cases, the gestalt is too clubby to
permit critical analysis and discovery. “The politeness factor and the
consensus factor are powerful,” says Charan. “In many boardrooms it’s
very important not to contradict a peer.”
A clear sign
that it’s time to bear down is when the CEO waffles or dissembles.
Russell E. Palmer, 71, has seen this happen all too many times in his
long career. Formerly managing partner of Touche Ross (a predecessor of
Deloitte & Touche) and dean of the Wharton School at the University
of Pennsylvania, he now heads his own investment firm and sits on the
board of Honeywell. Says Palmer: “You can get a sense that a CEO either
isn’t being straight or doesn’t know the answers when he or she says
things like, ‘We are in the process of studying this,’ or ‘We’ll get
back to you or try to work this into a presentation for future board
meetings.’” When that happens, press the evasive CEO to change his
ways. “If the members don’t think he’s sufficiently forthcoming, that
should come up in the CEO assessment,” Bossidy says. “They should agree
in executive session, and then the lead director should meet with him
after, one-on-one, and say, ‘You’re doing a lot of good things, but you
are not forthcoming, and here are the things you need to do to change
that.’”
Except when there’s a serious compliance issue,
no board is eager to fire a CEO. But if he or she can’t shape up, it’s
imperative to do it—and do it quickly. “I’ve seen companies go off the
track, and I can tell you that in almost every single case the boards
were reluctant to act fast enough,” says Palmer. They hold back for a
variety of reasons—close personal relationships with the CEO,
reluctance to second-guess him, wishful thinking about his ability to
turn things around, or even fear. “They think, ‘God, where do we go
from here if we do that? We don’t have anybody in the company to
replace him, and it’s going to take us six months or a year to find
one.’”
When all else fails—when you know things are rushing downhill and you can’t get your fellow members to face the reality—there’s only thing left to do: bail out. “I’ve resigned from three boards where I couldn’t see a good outcome,” says Palmer. “In every case I made absolutely the right decision; there was no good outcome.”
