by: Issues: May / June 2004. Categories: Governance.

One of Canada’s most outspoken – and respected – critics of corporate governance practices has harsh words – and a valuable message – for board chairmen and directors, particularly those at Nortel.

In spite of the efforts of many business leaders, investors, politicians, regulators, and auditors, there is growing evidence that the current practice of corporate governance in many companies is unsatisfactory and deteriorating. Professionalism seems to be losing ground to incompetence, greed and self-interest. Valuable instruction about what is going wrong and what to do about it can be gained from a closer look at the latest debacle at Nortel.

Granted that Nortel’s business is tough – hi-tech communications components; R&D, engineering and product innovation based; hyper-competition; wheeling and dealing in mergers and acquisitions; managers who are sometimes brilliant but also difficult, selfish characters; a financial roller-coaster; and an accounting conundrum. Big risks, big payoffs!

But however difficult or perilous the industry, there is no excuse for the long series of mistakes made by Nortel’s board or its failure to build a steady, high-quality management team capable of carrying on through cycles of good and bad times. Sadly, these are vitally needed strengths that Nortel has lacked, especially over the last decade or so.

This latest scandal, which saw the CEO and the two highest ranking financial executives being fired “for cause,” is part of a familiar pattern and ranks right up there with the worst blunders that have undermined management’s credibility and investor trust in Nortel and other hi-tech companies. It has caused irreparable damage, especially to the TSE and its customers. In the words of my colleague, David Leighton, the debacle makes make it look like Canadian business and the TSE operate in a banana republic.

After the latest accounting debacle at Nortel, almost $10 billion in shareowners’ wealth went down the drain. Thousands of investors – individuals, pensions and institutions – basically locked in to Nortel because of its prominence in the TSE index and the “30 percent Canadian” investment regulation for funds — were apparently deceived and cheated and left with no recourse except to frustrating, costly, time-consuming legal actions that promise little, if any, pay-back.

Beyond the tangible losses, huge damage was done to management’s integrity and investor confidence, all of which begs for more government intervention to protect misled investors. The front-page headline of one national newspaper blared: “Tattered Nortel implodes: Canadian businesses ‘look like amateurs’ following financial shenanigans, firings.” A well known authority was quoted as saying that, “This is a black eye, no question.” A former investment banker observed that, “This is just another cycle in an all-too-familiar pattern. Incapable boards letting the pirates into the bullion with a free pass to line their pockets. A repeat of the evil theme – greed, dishonesty and incompetence.”

However bad the obvious facts of the latest Nortel breakdown may be, they are mild when one digs under the surface and discovers the really scary basic problem: This disaster happened under the oversight – authority and responsibility – of a board reported to be one of the best.

For example, a recent New York Times article described the board as “stocked with the cream of Canada’s business community, corporate governance experts and several prominent Americans.” Amid widespread, angry calls for Nortel directors to resign, William A. Dimma, an experienced and respected authority on corporate governance, and one who probably knows most of the culprits personally, commented: “It’s a very distinguished board. Who would they recruit who’s any better than what they’ve got?” In other words, few boards are as good as Nortel’s.

The important question is this: Is the Nortel misadventure an isolated one-off, an aberration that can be easily dismissed? Unfortunately, almost daily media reports indicate that it has been, and is often being, repeated. I suspect that what is known about the Nortel fiasco is just the tip of the iceberg in the field of board mismanagement.

Now, let’s examine some of the most obvious errors made by this “distinguished” board. The triggering event of this screw-up was the approval of the now condemned incentive payment scheme. The fact is that any penetrating size-up of the situation would have shown that the bonus plan at the centre of this debacle was wrong for the industry, company, culture, internal systems, managers involved, and the board.

The board, viewing the company from its exalted and removed position, was naïve and lacking in street-smarts about the possible failings of human nature andthe potential for manipulation in an organizational setting. It didn’t understand that the higher the rewards for spiking short-term performance, the higher the likelihood that greedy managers could manipulate the results in order to cash in.

Directors were apparently deceived and abused by opportunistic managers who took advantage of an incentive scheme badly planned and without safeguards. Directors lacked an understanding of due diligence, the need for strict vesting requirements, and the necessity of a passion for a “trust but verify” mind set.

An enabling failure that made the fraud possible was the lack of an adequate control system to red-flag the manipulation of accounting data. No effective internal audit, no evidence of a clear and effective warning from the outside auditor, no instinct for forensic problems. This made for a perfect set up for managers who wanted to cook the books. Where indeed was the audit committee? And the compensation committee?

According to informed observers, this board didn’t understand the frenetic high pressure nature of Nortel’s business. Directors had management experience in industries far removed from the problems of the hi-tech communications business that experienced more changes in one year than most of their previous businesses in the preceding 10 or 15 years.

The board apparently knew so little about the company’s operations that it did not even know how it made money – how revenues, expenses and profits were made, booked, adjusted and finagled. This made directors unaware of the risks they were taking in controlling the business and the legal mess to which they were making themselves vulnerable.

The nominating committee failed to add the missing talents needed to round out the board’s ability to do its job. Like many other boards, the nominating committee seemed intent on reproducing themselves by nominating nice, proper, politically correct, compatible pals who wouldn’t rock the boat or press any tough questions that might embarrass colleagues who were resting on past accomplishments, and unable or unwilling to make the effort necessary to do the job required.

Lastly, the board may have lacked an evaluation and elimination process to identify and get rid of directors who were ineffective. There must have been several.

If, as reported, the old footballer and former bank CEO John Cleghorn took the lead in recognizing and addressing trouble, he should have realized this game was lost before he pushed the board to get its act together.

Given the individual and group culpability of this board, it owes shareholders some resignations, presumably starting with the chairman. If this does not happen investors will learn even more about the kind of honour, ethics and responsibility this group applied to its trusteeship and oversight duties.

Now, what should the board have done? This gets back to its legal duties to “manage or supervise the management of the business,” with the provisos that this be done “honestly and in good faith” and with “care diligence and skill.” In addition to overseeing the well-understood basic tasks of delegated management, the board is particularly responsible for performing the following critical tasks:

  • Increasing shareholder wealth
  • Ensuring the development of the best possible CEO, top management team and organization
  • Providing leadership in identifying and addressing the major make or break problems and opportunities that will determine success and/or failure;
  • Prevention of major material mistakes and disasters
  • Demanding integrity and proper ethics throughout the organization
  • Ensuring the formulation and implementation of a strong, competitive business strategy/model and
  • Taking a well-informed position of thorough examination and either constructive criticism and request for change or approval and support for management on all major policies, plans and recommendations.

Obviously, if a board is to perform these tasks there must be iron-clad demands for each director to take his/her share of the responsibility. This requires the following:

  • Obtaining the information needed to understand the company, its businesses, profit centers, organization, customers, operations, revenues, expenses, profits, competitors and environment
  • Analyzing this information and putting it together in a penetrating size-up – strengths, weaknesses, problems, opportunities, action options, and recommendations – of the key parts of the business
  • Being prepared to take a wise and constructive position on issues and problems to be addressed in board deliberations
  • Having the commitment, courage, wisdom, sensitivity, and political savvy to add to the value of the board by using their power, influence, and judgment in the best interests of the shareholders to whom they are accountable.

These are the undeniable responsibilities and requirements of directors individually, and the board collectively. Without an excellent performance of these tasks, any corporate governance system fails. All the available evidence regarding the Nortel board’s latest disaster points to the conclusion that individually and collectively, directors failed almost completely to perform these duties and prevent the scandal that resulted.

If this is the sad story of a “distinguished” board with some of the best available directors, what about all the rest who, presumably, are worse? Clearly, investors and corporate governance practices are in deep trouble. Moreover, much more than legalistic, superficial guidelines, regulatory requirements, polite cajoling and superficial short courses in how to be a director are needed if repeat performances are to be avoided.

The Nortel story is also one of failed leadership. The chair’s job was to make his “all-star” group into an effective team that worked well with management to identify, focus on, diagnose and fix Nortel’s basic problems. This he failed to do. As well as running an effective board, it was also a critical part of his job to make the chair/CEO relationship work well. This also seems to be lacking.

It is important to emphasize that it takes a huge commitment of time and hard work to be an effective director. The zillion other commitments that these “all-stars” had to many other boards and activities must have severely inhibited, if not negated, their abilities to be effective directors of a major, complex, problem-ridden corporation like Nortel.

The addition of John Manley to Nortel’s board could be a good move, depending on how well he contributes to its turnaround in leadership, governance and management. Essentially, he is joining a group of strong individuals who lack a tough-minded, no-excuses type leader and coach who could make them into a team that can succeed in doing its job effectively.

Necessary change must begin with directors fully understanding, committing to, and competently performing their duties and responsibilities as explained above. Courageous leadership from the many honest and competent leaders now on the job is absolutely imperative to make this happen.

The necessary matching commitment from the new, largely unknown and unproven CEO must be based on a healthy dose of intelligent self-interest and a concern for the company and its shareholders, and an open acknowledgement of the important role and contributions of individual directors and the will to engage them accordingly.

Otherwise, the SECs, attorneys general, OSCs and the Sarbanes and Oxleys will, with public urging, continue to make further political and bureaucratic inroads in the field of corporate governance and the free enterprise system. Let there be no misunderstanding or underestimating the potential harm this will cause: The direct and indirect costs of complying and defending will be incalculable, if not crippling, to the board system as it now operates.

Writer’s note: I wish to thank my colleague, David S. R. Leighton, for suggestions in the preparation of this article.