General Counsel to Directors: Your 10 Most Common Mistakes
from
July/August 2006
by Randy Myers
Corporate board members are smart, accomplished people who bring scads of real-world experience to their jobs. But they’re not infallible, as attorneys who serve as general counsel for public companies will readily attest. Okay, perhaps not readily. When we asked several dozen top in-house lawyers to list the most common mistakes that directors and companies make, only a brave handful agreed to go on record with us. Even they were quick to stress that the boards they serve now aren’t making the mistakes they identified. None were keen on inciting a plaintiffs’ attorney into action.
But despite their professional caution, these general counsel were forthright about what they have observed and learned from their exposure to boards in operation.
Mistake No. 1
Not asking questions
Frankly, this is a little embarrassing. Your parents started drilling the mantra “There is no such thing as a stupid question” into your head when you entered grade school. Maybe the early start said something about how tough this lesson would be to learn. In any event, it apparently hasn’t taken hold for all of you. “This is probably the biggest single weakness of directors who are less effective than others—they’re afraid to look stupid and ask stupid questions,” says Russell B. Stevenson Jr., senior vice president and general counsel of Ciena Corp., a maker of telecommunications networking equipment in Linthicum, Maryland.
Anastasia Kelly, who was executive vice president and general counsel at MCI from 2003 through 2005 after holding the top legal jobs at Sears Roebuck & Co. and mortgage outfit Fannie Mae, agrees. “You get a group of directors in a room,” she says, “all from different companies or backgrounds, all with great experiences, all very smart people, and yet so often I’ve seen them not asking questions because they think they should know the answer.”
That’s bad, of course, since directors who don’t fully understand the issues can’t make informed decisions. Just ask the former directors of Enron Corp., who obviously glossed over the disingenuous strategies that company was using to hide the highly leveraged nature of its balance sheet. Or the former directors of MCI’s predecessor, WorldCom, who clearly didn’t ask enough questions to divine that management was using phony accounting to inflate the bottom line before WorldCom, like Enron, toppled into bankruptcy.
The remedy is to do as Mother said. It might help, too, to remember that allowing your multibillion-dollar company to become insolvent makes you look a lot dumber than asking questions that might have helped you prevent it. “Some of the most effective board members I’ve seen,” says Stevenson, “are those who are willing to say, ‘Look, I don’t understand a thing you’re saying. I don’t think I’m stupid, and I know I don’t understand this as well as you, so why don’t you back up a few steps?’”
Adds Kelly: “If you’re uncomfortable asking a question in the boardroom, then pick up the phone afterward and call the CEO or the general counsel or a fellow director. Just asking questions is an incredibly valuable tool that directors don’t use often enough.”
Mistake No. 2
Failing to understand
the Company and the Risks It Faces
Board members will never have the same deep understanding of a company’s inner workings that management has, but Kelly says too many companies and boards fail to give new directors a solid introduction to the outfit they’re joining and the industry in which it operates. Fewer still follow up with programs that cement a board member’s insight into how the company works. Among other things, Kelly suggests, directors ought to be visiting company facilities and meeting the managers responsible for day-to-day operations.
One of the problems with not having a thorough understanding of the company they serve, adds Carol Ann Petren, former senior vice president and deputy general counsel of MCI, is that directors may not be able to appreciate all the risks the organization faces, including regulatory and litigation perils. That hampers their ability to catch and correct trouble before it segues into a catastrophe. Both Petren and Kelly cite their corporation’s predecessor company, WorldCom, as one where directors didn’t know enough about the business. Neither attorney worked there at the time.
Mistake No. 3
Failing to lead on ethics
and compliance
The accounting scandals of the past decade revealed a shocking lack of integrity—and a failure of compliance protocols—at some widely respected companies. After Congress responded by passing the Sarbanes-Oxley Act of 2002, many companies made concurrence with the act the new centerpiece, and in some cases the sum, of their compliance efforts. Like a number of other general counsel interviewed for this article, George Lykos, senior vice president, chief legal officer, and secretary at Pittsburgh-based Bayer Corp., the U.S. arm of Germany’s Bayer AG pharmaceutical group, says it’s not enough. While stressing that he isn’t speaking of Bayer, Lykos says that companies in general have been “very slow” to make a commitment to ethical behavior at the highest levels of the organization. “I really do continue to fault directors and officers for not leading when it comes to ethical issues,” he says. “And I’m not talking about legal compliance or Sarbanes-Oxley; I’m talking about ethics, which is a far broader term. They assume that the issuance of a policy on a particular matter all of a sudden cures whatever problems they were trying to fix, without doing sufficient follow-up and training to really effect change in ethical and cultural behavior. It isn’t enough, and quite frankly, it’s legally insufficient.”
Even in the narrow area of compliance, Steven S. Heinrichs, senior vice president, general counsel, and secretary at Neenah Paper Inc. in Alpharetta, Georgia, faults directors for taking a “check the box” approach to making sure their companies operate within the law. Boards that get ethics and compliance right set the tone at the top and establish programs that reinforce their message, says Heinrichs. “Those are things that are easy to do from the board perspective,” he adds. “It just involves oversight and providing people with the right incentives.”
Henry Moniz, vice president and associate general counsel for compliance at the cable television and film production company Viacom Inc., criticizes boards that view their commitment to ethics and compliance as “a dose of medicine you have to hold your nose and take every year.” Beyond providing appropriate training and reinforcement to all employees, Moniz advises companies to keep their governance and compliance officers apprised of the organization’s strategic initiatives. “That allows those functions to take corrective approaches and anticipate issues,” he says, “as opposed to just reacting to something after it takes place.”
Mistake No. 4
Not insisting on a crisis-management plan
The way your company reacts to a crisis can stain its reputation—think of how Firestone at first tried to ignore allegations of fatal defective-tire accidents in the 1990s. The company didn’t begin recalling tires until 2000. Or it can burnish its reputation—think of Johnson & Johnson’s widely admired openness in handling the Tylenol-tampering murders in 1982. Despite the stakes, most companies respond poorly when a crisis strikes. “They fail,” says Moniz, “because they don’t have clear protocols and procedures for dealing with compliance failures and related problems.” More specifically, he says, they neglect to choose attorneys with the precise expertise to address the problem at hand, don’t bring in forensic accountants when the crisis relates to a bookkeeping issue, lack a broad strategic-communications policy, and fail to train their executives and directors to deal with the media.
“Reacting to a breaking crisis has always been, and will be, a real area of vulnerability for directors and corporations,” warns Anastasia Kelly. “I’ve been in three companies and advised a bunch of others, and it is very hard to convince senior management and directors to take the time to do risk identification, risk mitigation, and, more importantly, crisis preparation. After 9/11 lots of companies went through that exercise, but today it’s not on a lot of people’s radar screen. Companies should routinely do this and have a senior team leader in charge.”
Mistake No. 5
Speaking out in a crisis before the facts are in
Everyone appreciates leaders who are willing to take a stand for what they believe. Few appreciate leaders who take a stand before they have all the facts—yet companies and boards do it all the time. “I’m still surprised, in this day and age, how often you see boards commenting far too early that they have confidence in management or allowing comments like that to be disseminated, only to find out later that there are some gray areas,” observes George Lykos of Bayer.
Viacom’s Henry Moniz says boards and companies that talk too soon risk losing credibility if they later have to reverse their stand. Case in point: Former Enron Corp. chairman Kenneth Lay, speaking on October 23, 2001, just two months before the company filed for bankruptcy protection, told Wall Street analysts that he and the Enron board “continue to have the highest faith and confidence” in chief financial officer Andrew Fastow “and believe he is doing an outstanding job as CFO.” As reported by Fortune senior writers Bethany McLean and Peter Elkind in their book, The Smartest Guys in the Room, Lay told employees later that day, “I and the board are also sure that Andy has operated in the most ethical and appropriate manner possible.” The next day Fastow pleaded guilty to pocketing $45 million through his partnership’s dealings with Enron—a figure later calculated to be $60.6 million—and was fired. Fastow was sentenced to a 10-year prison sentence and testified at the trial of Lay and former Enron CEO Jeffrey Skilling. A Federal jury found both guilty of numerous fraud and conspiracy charges.
Mistake No. 6
Relying on the wrong outside counsel
Many boards have relationships with trusted outside legal advisers, and some rely on those relationships too heavily during a crisis. “Often boards will call in their regular outside counsel, maybe even people who have been involved with the conduct in question or at least have some understanding of it,” says Moniz. “That’s a mistake. You need somebody who’s truly independent and doesn’t have a real tight relationship with management.” Besides bringing a biased perspective to the case, Moniz says, your regular law firm may not have the expertise to handle, say, a Securities and Exchange Commission allegation of accounting fraud or wrongdoing by senior management.
Lykos castigates companies that worry more about cost than quality when retaining outside counsel. “I don’t want to create an inference that high prices mean the best lawyers; that’s also not true,” he says. “But I do think companies, particularly companies confronted with significant bet-your-company litigation, often don’t realize it very quickly and therefore allow cost considerations to dictate retention of counsel to an extent they should not.”
Mistake No. 7
Failing to understand attorney-client privilege
For an executive trying to work through a touchy legal problem, attorney-client privilege is a beautiful thing. It allows the executive to communicate openly and honestly in soliciting advice from an attorney, without worrying that what he says will be used against him in court. Unfortunately, directors sometimes overestimate the protection that the privilege affords. “One thing that’s always amazing to me is that no matter how many times you explain it, directors and officers never seem to fully understand attorney-client privilege,” says Lykos. “They seem to have the view that if you pass any document under the nose of an attorney, it magically becomes privileged, and therefore they can write anything they want as long as an attorney sees it. And that’s not the law. The privilege is very specific. In order for a communication to be privileged, the person must be seeking the advice of a lawyer and asking that lawyer to give an opinion on a set of facts.”
The issue is timely now that prosecutors routinely compel companies to waive attorney-client privilege in exchange for leniency in the penalties they receive. In an oft-cited example of what that can mean for individual officers and directors, several executives of the software company Computer Associates International pleaded guilty in 2003 to obstructing justice and conspiracy to commit securities fraud. The case revolved around alleged lies they told a law firm that their employer had hired to investigate the government’s allegations of accounting fraud at the company. CA waived attorney-client privilege as part of its effort to cooperate with the federal government, Moniz says. Once it did that, the executives speaking to the company’s attorneys had no more protection than they would have had in talking directly to prosecutors.
Mistake No. 8
Underestimating regulators
After watching several executive perp walks over the past few years, it’s difficult to imagine that board members could underestimate the seriousness of having government regulators looking into their business. Yet they do, insists Judith Starr, who before being named general counsel of Pension Benefit Guaranty Corp. in July 2005 was chief counsel of the Financial Crimes Enforcement Network at the Treasury Department and assistant chief litigation counsel in the Securities and Exchange Commission’s Division of Enforcement. Starr recalls a case during her SEC tenure when she and representatives of two other regulatory agencies attended a corporate board meeting at the invitation of the company’s management, to answer questions about a proposed consent decree.
“This particular corporation had compliance problems with three different regulators, and it was not the first time they’d been in trouble,” she recalls. “It was something very serious, and we were showing up to show how serious it was and make sure this consent decree was going to be entered into and things were fixed. It was a fairly high-profile situation.”
After outlining the terms of the consent decree, the regulators asked the board members if they had any questions. Starr says she was stunned when one of the company’s independent directors turned to her and asked whether signing the consent decree would impute any personal liability to him. “Instead of paying attention to the fact that this was a repeat compliance problem, that it was serious, that there were three regulators in the room who were all going to be very interested in the commitment of the corporation, this person was looking after his own hide, and that was the first thing he thought about,” she recalls.
Directors, Starr admonishes, have a fiduciary duty to put the company’s interests ahead of their own. “You’re there on the board to try to do the right thing,” she says, “and if you find out you’ve been asleep at the wheel, you’d better pay attention to that instead of looking over your shoulder. And this was a situation where the board had not just been asleep at the wheel but had been in a deep coma. So it was a great concern. If you want to raise a red flag in front of a regulator, if you want to get your regulators really worried and upset, do something like that person did. You’re not going to make a good impression.”
Moniz too thinks directors don’t take regulators seriously enough. “Board members frequently believe that once the company’s version of events gets out there, the government will pack up its tent and go away,” he says. “That’s a real common sort of reaction.” And obviously a wrong one. As Starr says, “Regulators practice graduated enforcement. They will come in first with warning letters, but if you don’t pay attention and you force them to keep coming in, sooner or later you’re going to get hit with a really nasty penalty.”
What happened to the company whose director was more worried about his own liability? Criminal charges were filed against it the next year, but no penalties were personally incurred by the worried director. Because the criminal investigation is continuing, Starr declines to name the company.
Mistake No. 9
Giving too much leeway to rainmakers
It’s easy to rein in the guy who violates the company’s code of conduct by trying to shake down suppliers. It’s quite another thing to censure the salesman or trader who’s bringing in millions by skating close to, if not over, the boundaries of legal or ethical behavior. Says Starr: “What I saw at the SEC, in case after case, was the board giving excessive latitude to the performers bringing in the bucks, even if they were getting dangerously close to the compliance line. Those are the kinds of cases where you wind up with regulatory actions.”
Enron was, again, a classic example. Among other things, its board appeared myopic about what was going on with the company’s West Coast power-trading operations, where employees relied in part on bogus transactions to inflate profits, using schemes with names like Fat Boy and Death Star.
Starr says compliance officers have complained to her for years that sales and marketing executives undercut their efforts to enforce strict compliance with rules and regulations governing corporate behavior. Somewhat hopefully, she adds that she thinks this is changing, at least at leading companies.
Mistake No. 10
Getting caught up in the dilemma of false options
Your company has been hit with lawsuits alleging that some act or product caused somebody harm. Should you settle or go to court? Too often, says Lykos, directors assume that’s an either-or question. “This is a repetitive mistake that just continues to amaze me every time I see it,” he says. “It is entirely possible to take a principled legal position that there are certain kinds of cases relating to the problem that the company will not settle and will defend, and that there are other cases in which it is prepared to enter into settlements. Yet there seems to be an ongoing belief, especially in the mass-tort context, that you have to either defend all the cases or settle all the cases, but that somehow you can’t do both. You get caught up in the dilemma of false options.”
Lykos has some experience in this area. In 2001 his employer, Bayer, voluntarily withdrew its anti-cholesterol drug Baycol from the market after it was linked to a serious muscle-wasting disease and several deaths. Even though Bayer won five favorable verdicts out of six that went to trial, it settled almost 3,000 cases through February 2005, for a total of $1.1 billion. It is still fighting other suits in court. “We’ve adopted a very principled approach in which we are prepared to enter into reasonable settlements on cases where people suffered actual injuries taking our product,” Lykos says. “We are not going to settle cases in which people did not suffer an injury taking our product, or in which the settlement demand is, in our view, unreasonable or disproportionate to whatever damage they’ve suffered. I don’t think those are inconsistent experiences.”
Serving on a corporate board isn’t easy. Avoiding these common mistakes should be.
