Crisis Management, An Everyday Part of a Director’s Job
from
January/February 2007
by Randy Myers
The surprise demand of a hedge fund for a seat on your board, as described in the previous story, is just one of the crises you’re likely to face as a director. Financial shenanigans, protests over CEO pay, hostile proxy advisory firms, and shareholder suits are commonplace for directors. If you think you’re immune, chances are you’ve not been in the job very long.
“I’ve had to deal with all kinds of bad news,” says Charles Elson, 47, director of the Weinberg Center for Corporate Governance at the University of Delaware, a board veteran who now serves as a director of funeral-home operator Alderwoods Group Inc., auto-parts retailer AutoZone Inc., and health-care company HealthSouth Corp. With experience, Elson says, directors can learn to handle crises well. “The key is to be as calm, rational, and objective as possible,” he notes. “Carefully and objectively review your options, don’t do anything precipitous, and be very transparent to the outside world as to your actions.”
All boards should have a contingency plan to guide them. In particular, they need to know who their next CEO is, which a surprising number of boards still don’t. Not only is that bad governance, it’s an invitation to trouble. But not every crisis is a board’s own fault, as the following examples make clear.
Operational Bombshells, Financial Explosions
When they’re confronted with an unexpected operational or financial crisis, directors need two things above all else: information, and a credible, candid communications policy that keeps shareholders, the media, and everybody else abreast of what’s going on. To make that come off, directors will almost always need to launch an independent investigation of what happened and
why, and it’s best to do so with the help of their own outside counsel.
Hospital owner Tenet Healthcare Corp. was battered in 2002 after regulators and plaintiffs’ lawyers accused it of price-gouging uninsured patients, exploiting loopholes in the Medicare program to reap as much as $1.6 billion in excess revenues, and performing unnecessary heart surgeries at one of the more than 100 hospitals it was operating at the time. “The stock price collapsed over a period of about 48 hours, and the directors went into crisis mode,” says Edward Kangas, 62, former global chairman and CEO of Deloitte Touche Tohmatsu, who joined Tenet’s board in April 2003 and became its outside chairman three months later.
Rather than panic, the board members played it smart. They hired outside advisers on governance and crisis control and brought in a new president, former CFO Trevor Fetter, now 46, who had left the company in 2000 to run a spin-off. In the months that followed, the board recruited several new members. Tenet’s CEO resigned in 2003 at the board’s request, and Fetter took his place. Kangas says the directors were impressed by Fetter’s commitment to transparency. In the weeks after his return, for example, he approved an open letter to shareholders acknowledging that the challenge to the company’s billing practices “reflects poorly on our hospitals in the communities we serve.” The letter disclosed the results of an internal review of past pricing strategies and laid out details of a new approach Tenet would embrace, along with the expected impact on earnings.
With board encouragement, Fetter continues a policy of openness. The company issues periodic updates on its progress in reforming operating and billing practices, and it has paid out hundreds of millions of dollars to settle various class-action lawsuits. Tenet was an early participant in industry efforts to collect and publish data on the quality of hospital care, and recently became the only large hospital system to participate in a federal pilot program measuring patient satisfaction with hospital services. A $725 million settlement with the U.S. Department of Justice last June wrapped up the investigations by that and other federal agencies into the company’s Medicare practices. “With this settlement,” Fetter said at the time, “the company acknowledges that Tenet made mistakes in its conduct before 2003.” As of mid-November, the stock was still trading at about one-sixth its pre-scandal levels, but the company turned a profit in the first quarter of 2006 and lost money in the second only because of one-time charges that included the settlement with the Department of Justice. At its annual shareholders’ meeting in May, there were none of the protests that had characterized shareholder get-togethers since the bad news broke. “The only way to restore credibility is to be very transparent,” says Fetter. Tenet’s board, he adds, monitors transparency “very closely,” reviewing all public financial disclosures.
Overpaid Pooh-bahs
Executive compensation is often contentious. It can become a crisis if the CEO is taking home millions at the same time that a company’s stock is taking a dive.
Boards are looking for ways to link pay more tightly to performance, but CEOs can be crafty in setting up yardsticks, and it’s hard to take back compensation once it has been awarded, especially if an executive meets the targets written into the fine print. That doesn’t mean it’s impossible. Patrick McGurn, executive vice president and special counsel at Institutional Shareholder Services (ISS), a proxy-voting advisory firm, says good employment contracts should have “clawback” agreements that allow a company to recover previously awarded pay under predefined circumstances, such as restated earnings. Ira Kay, director of the compensation practice at the human-resources consulting firm Watson Wyatt Worldwide, says he sees more companies putting clearer language into employment agreements to specify other situations in which pay can be recovered. The Ontario-based telecom-equipment maker Nortel Networks Corp., in a $2.5 billion settlement of a U.S. shareholder lawsuit over accounting shenanigans, recently agreed to insert into its executive employment contracts clawback clauses that would be triggered in the event of fraud.
Even if they don’t have clawbacks, says corporate governance advocate Nell Minow, editor of the Corporate Library, boards aren’t helpless. For one thing, Sarbanes-Oxley gives companies the right to take back bonuses or even equity-based compensation awarded during periods of improper accounting that lead to an earnings restatement. Or they can simply ask the CEO to take a haircut. In 2005, for example, directors at Verizon Communications gave chairman and CEO Ivan Seidenberg, now 59, a long-term stock incentive package initially valued at $18.9 million; it would have boosted his total compensation for that year by about 50%, to some $27 million. But after watching Verizon’s stock fall 25% over the course of the year, the board’s compensation committee and Seidenberg agreed to cancel a $7.6 million portion of the long-term stock package. Seidenberg said he and the board didn’t want the issue to become “a lightning rod.”
Management Misconduct
A charge of illegal conduct against a senior executive is obviously troubling to directors and can occur for various reasons, ranging from financial misdeeds to sexual hanky-panky. The immediate prescription is for the board to hire its own lawyers and have them lead a comprehensive investigation into what really happened. Chicago-based attorney Jeffrey E. Stone, head of the trial department at McDermott Will & Emery, says boards should also establish a protocol for resolving the issue with the authorities conducting the inquiry. “It’s important that the investigating entities believe the company is doing what it can to cooperate,” he says, in part to guard against prosecutors’ imputing the alleged transgressions of the executive to the company itself. Still, adds Stone, “smart boards do not lie down and let the government have its way with them.”
If a senior executive is under investigation, the board needs to make its own views on corporate and executive behavior clear, he says. It should put out a message—perhaps in a press release, perhaps in a conference call with analysts, investors, and the media—saying something like, “These allegations are anathema to what we are trying to create. We’re going to investigate. We’re not going to presume what the answer is. But if in fact misconduct occurred, we do not condone it; we condemn it. And we will do whatever we need to do to excise that cancerous conduct from our culture.”
If the board’s investigation turns up evidence of executive wrongdoing, directors must remember that their duty is to shareholders. “It’s terrible if a CEO gets indicted—it’s bad for the company, for the stock, for the company’s reputation and its culture,” Stone says. “But it’s far worse if the CEO
and
the company get charged. Sometimes it may well be in the corporation’s best interest to walk into the government office and say, ‘Here’s what we think happened, here’s how this corporate officer eluded detection and was somehow able to avoid compliance, and here’s how we as an entity were defrauded by this individual.’”
Zale Corp., an Irving, Texas, operator of more than 2,300 jewelry stores across North America, never had to rat out an executive to the Securities and Exchange Commission. But it did move swiftly in May to put CFO Mark Lenz on administrative leave. The reason: Lenz had failed to notify Zale’s auditors in time that $8.2 million in vendor payments that the firm had recorded in fiscal 2005 hadn’t actually gone out until 2006. Zale subsequently allowed Lenz’s employment contract to expire without renewing it, according to a company spokesman, and in September it named Rodney Carter, CFO of specialty retailer Petco Animal Supplies, as group senior vice president and CFO.
Still, the issue of just how much companies should cooperate with prosecutors is controversial. The Big Four accounting firm KPMG avoided criminal prosecution by the U.S. Department of Justice in a 2005 tax-shelter case in exchange for admitting its role in the scheme and agreeing to pay a $456 million penalty and cooperate with the investigation. As part of the deal, it refused to pay legal fees for KPMG employees caught up in the probe. After the firm struck that bargain, 18 people, including 16 KPMG employees, were indicted. The whole arrangement was later sharply criticized by the federal judge hearing the case, Lewis A. Kaplan of the federal district court in Manhattan, who ruled in July that two former KPMG partners had been coerced into talking to prosecutors before their indictment and that their statements therefore could not be used as evidence. At the crux of the coercion claim was the Justice Department’s offer not to indict KPMG if, Kaplan said, the company could deliver to prosecutors “employees who would talk, notwithstanding their constitutional right to remain silent, and strip those employees of economic means of defending themselves.”
Lawsuit Leeches
Once your company has been sued, the first order of business is determining whether it is guilty. “Class-action lawsuits happen all the time; that’s part of being a director,” observes Elson. “You have to evaluate lawsuits very carefully and engage competent legal counsel at the earliest possible stage. Your response must depend on the merits you believe the case has and what counsel advises you on its likelihood of success.”
If you determine that the lawsuit is without merit, legal experts suggest that you move for its immediate dismissal. If this doesn’t work, continue preparing your defense but also consider what the cost of success in the courtroom might be. Sometimes boards settle rather than face prolonged bad publicity. But that risks being seen as an easy mark. CBRL Group, which operates the Cracker Barrel chain of family restaurants, certainly stood up for itself. It decided to fight a false claim—that a customer in May 2004 had found a mouse in her soup—and won. The plaintiff and her son were later convicted of extortion.
Restaurants get hit with those sorts of lawsuits (sometimes justified) a lot. Of far more concern to most boards are securities class-action suits, which can lead to enormous settlements. The shareholder derivative lawsuits that follow almost every federal securities class-action claim threaten directors more personally. That’s because the securities suits ordinarily name as defendants only the people who, because of title or role, might have been involved in some wrongdoing. The derivative cases, by contrast, include not just the company but typically the entire board in the list of defendants.
Digimarc Corp., a Beaverton, Oregon, maker of digital-watermarking software, was hit with a federal securities class-action lawsuit and two shareholder derivative suits in 2004 and 2005 after it restated financial results to correct for accounting errors it had discovered. In the restatement, Digimarc shifted $200,000 of its first-half 2004 revenue of $47.2 million between the first and second quarters, revised its first-quarter 2004 profit of 3 cents per share to a loss of 3 cents, and reduced its second-quarter 2004 loss of 10 cents per share to 7 cents. It made no material change to its 2003 revenue of $85.6 million, but lowered net income for that year to 1 cent per share from a previously reported 8 cents per share. While the company’s in-house counsel oversaw the day-to-day response to the securities class-action suit with the help of an outside law firm, the board hired its own lawyer to represent directors in the derivative lawsuits. It also signed up three new members and formed a special committee to oversee the response to those cases.
Convinced that the charges were groundless, the board pushed for dismissal of the derivative lawsuits, claiming that both inside and outside investigations had determined that Digimarc’s accounting restatement had resulted from errors rather than wrongful conduct. A series of court decisions backed the company and its directors.
Institutional Interference
Suppose that when a matter was put to a vote of shareholders, you had to persuade only three or four organizations to support your point of view, rather than thousands of investors. These days it can easily seem that way, thanks to the growing influence of four firms with surprising sway over institutional investors. ISS in Rockville, Maryland, is the 800-pound gorilla of the group, the oldest and by far the largest of the four. Its competitors are Glass Lewis & Co. in San Francisco, Proxy Governance Inc. in Vienna, Virginia, and Egan-Jones Proxy Services in Haverford, Pennsylvania. All four make recommendations about how the likes of big pension and union funds should vote on proxy issues. In some cases the advisory firms have been given authority to make the decisions.
At one time Norman C. Chambers, 57, president, COO, and a director of NCI Building Systems, a Houston manufacturer of metal buildings and other products, may not have appreciated the influence of these firms. He does now. In 2005, ISS advised shareholders to vote against proposed changes to NCI’s long-term incentive option plan, which NCI considered crucial to retaining executive talent. ISS claimed that NCI’s “burn rate”—the total number of equity awards granted in any given year, divided by the number of common shares outstanding—had been too high, raising the question of whether the company was “getting the most bang for the buck” from the awards it was issuing, as Patrick McGurn of ISS put it. Chambers was taken aback by how many investors seemed to be siding with ISS. NCI had to launch a hurried campaign to communicate its side of the story to shareholders, the majority of whom finally backed the company’s proposal. “In hindsight, I think we gravely underestimated the role ISS plays in these sorts of things,” Chambers says. “Now that we know this, we try to take that into account and anticipate it, so we can get in front of our shareholders with our message.”
Can companies persuade a proxy firm to change its mind? McGurn says those being challenged by ISS always have the right to contact his outfit and explain their position. “We think it’s a critical part of the process,” he says. “Some of our competitors actually brag that they won’t talk to a company, but I think it improves the analysis. The more information you share, the better off you’re going to be.” And has ISS ever changed its mind? “Oh, yes,” says McGurn. “We have the ability, up until about five days before the shareholder-meeting date, to issue an alert to our clients, and that sometimes includes a change in our vote recommendation.”
Responding to a proxy advisory firm is most likely to be handled by management, but board members should still know what’s bothering these organizations. “It’s something you need to think about,” says Charles Elson, “just like you need to think about what analysts are saying about your company. If the analysis is correct, you may need to amend your policies.”
In other words, to stave off crises as well as for other reasons, directors should pay constant attention to what’s going on.
