ASCIJOURNAL OF MANAGEMENT 27 (142), 23-32 Copyright © 1998 ~ Administrative Staff College of India. DAWN-MARIE DRISCOLL W. MICHAEL HOFFMAN Ethics and corporate governance: Leadership from the top sence of ethics in corporate governance ori- The authors, drawing attention 10 the converg ented to the bottom-line, illustrate the pitfalls of ethical complacency and urge directors to work vigilanly to ensure thatthe ethical health ofthe company is constantly being mon. tored, habitualized, strengthened and discussed. cereale aed eee UES aT Attention to corporate governance is not new, nor is the field of business ethics, To cite two examples, the National Association of Corporate Directors (NACD) was founded in 1977 with the explicit mission of enhancing corporate governance and Performance of business entities. With well over 2000 members, its publications, conferences and training sessions for directors help promote high professional standards, Atthe same time the NACD was established, the Center for Business Ethics opened its doors at Bentley College in Massachusetts. Its biennial conferences, extensive research library, executive fellows and the ethics journals, ethics societies and national Ethics Officer Association that the center spawned coincided with an explosion of interest in the field of business ethics." Somuch for the old news. Twenty years after these two organizations began, what is new is the convergence of the two fields of corporate governance and business thics. Today directors realize that within their solemn obligation to represent the shareholders comes the ultimate responsibility for business ethics. Financial oversight is not enough - they must establish, maintain and monitor the ethical culture of the enterprise. Why ethics? One need look no further than to the investment community's rapidly disintegrating confidence in pars of Asia (Lewis, 1998) to realize that maintaining the integrity of business institutions is critical for continued economic success. As former Chancellor William T. Allen of the influential Delaware Court of Chancery said, “Govemance contributes legitimacy to an enterprise” (Allen, 1998). He might have added, “Attention to ethics contributes legitimacy to corporate governance.” ‘The marriage of ethics and corporate govemance is not just a romance. It is a Partnership oriented to the bottom-line with many compelling reasons for the two disciplines to stay together. Consider a few recent headlines: * Ina settlement obtained by the Equal Employment Opportunity Commission, Astra USA, aUS subsidiary of a Swedish company, agreed to pay nearly $10 million to settle24/ ASCI Journal of Management 27 (142) its sexual harassment case. While the board may have been unaware of the ongoing hostile work environment fostered by its former president, Peter Bildman, when the scandal broke it wasted litte time in dismissing him and suing him for his actions, including financial fraud, * AT&T, the communications giant, has been criticized for having an ineffective board of directors after its second-ranking executive, John Walter, was dismissed after seven ‘months work with a separation package of $26 million. According to Business Week magazine, AT&T's directors sit on too many boards, own little stock and lack outsiders with high technology expertise (Bryne, 1996). * Prudential Insurance Company of America agreed to pay over $400 million in 1996 to settle the claims of hundreds of customers ina wide-reaching investigation of deceptive sales practices. The company’s own intemal auditors had wamed its directors as early 35 1982 that some of the company's agents were using trickery and fraud to boost sales (Scism & Paltrow, 1997). Carrots and sticks Directors who habitually read the daily business press need little convincing that a business without ethics is a business at risk. But even many directors who do not Keep up with contemporary business scandals are aware of a major development seven years ago that helped push the subject of ethics up to the board level. The Federal Sentencing Guidelines? adopted in November of 1991, operate like the proverbial carrot and stick, The stick, or threat, contained in the Guidelines is a mandatory system of stiff fines, penalties and even jail time for executives convicted of federal crimes. Increasingly, statutes and regulations adopted to proscribe all types of business Conduct - from price-fixing and polluting the environment to falsifying paperwork ~ consider such violations to be criminal offenses. Suddenly both deliberate acts of malfeasance and unwitting oversights can land executives in serious trouble. Companies and their boards began to pay attention. To avoid harsh penalties (and the resulting likelihood of bankruptcy or closure) diligent executives worked with their boards to implement the carrot aspect of the Sentencing Guidelines. A company could dramatically reduce penalties, or even escape prosecution altogether, if it could prove it had in place, before the offense Occurred, an effective system to prevent and detect violations of law. There are three key words here (before, system, and detect). Closing the bam door afier the horse has escaped will not help. The Sentencing Guidelines, which offer ‘commitment to companies to reward good behavior, insists that the good behavior, evidenced by ethics and compliance programs, occur before the bad behavior. System is not an undefined term. The Sentencing Guidelines are’ marked by Structured flexibility (Swenson & Clark, 1991) and call for, at a minimum, seven elements, including standards and procedures, effective communications and a system toteport misconduct. The Sentencing Guidelines element that has caught the attention of boards of directors is the requirement that a senior officer be in charge of the ethics or compliance program.‘While some companies have appointed full time ethics officers”, in other companies, the board signals the importance of ethics by giving its top executive the responsibility. Some do both. For example, at USAA, the diversified financial services company, Chief Executive Officer Robert T. Herres is the Chief Ethics Officer, and Elizabeth Gusich, who oversees the program, carries the title of Ethics Coordinator Designating a senior officer to be responsible for ethics is not the only way a board ‘can show proper respect for ethical conduct. Increasingly the audit committee of the board, comprised only of independent directors, assumes responsibility for ethical oversight. Audit committees have always had responsibility for internal control, but assessing the quality of internal controls involves a consideration of the environment, as well as the day-to-day mechanics of checks and balances. Boards are asking such tough questions as “Does management set unrealistic objectives that can result in pressure on personnel to act unethically to achieve them?” “Does the organization make a concerted effort to hire the best people, to train and motive them and reward or punish behavior appropriately?” “What is management's philosophy and operating style?” Good news/bad news If boards of directors missed the story of the Federal Sentencing Guidelines, they were given a wake-up call in 1996, with the legal case now known simply as Caremark.’ The highly influential chancery court in the state of Delaware, where many corporations are incorporated, issued an opinion in September of that year that changed the standard for directors’ oversight of ethical wrongdoing and ilegalities. Caremark, a medical services company, had been investigated by government regulators for making illegal payments to induce doctors to prescribe Caremark’s services. The company and its executives were indicted and eventually paid $250 million in fines, reimbursements and other penalties. Because of the scandal, the directors of Caremark were sued by shareholders who alleged that the directors breached their fiduciary duty of care to the company by failing to adequately supervise the conduct of its employees. The directors won, but not without a stern warning from the court. The good news is that the court decided the directors did not breach their duty of care, because both prior to and during the government’ investigation of the company, Caremark had designated the Chief Financial Officer as the compliance officer. In addition, they had an ongoing ethics and compliance training program for employees, an internal audit plan designed to ensure compliance with ethics, and a board audit and ethics committee. But the court did not pat the Caremark directors on the head for their attention to ethics. The settlement agreement required the board to take additional steps to ensure that all of Caremark’s business units were in compliance and to reduce the chance of future violations.26 ASCI Journal of Management 27 (1&2) a eee Furthermore, the Caremark case contained bad news for all other boards of directors. The court delivered an unambiguous message that if boards had not paid attention. to ethics and compliance in the past, they should. Failure by boards to insure that a company has adequate corporate information reporting systems may render a director liable for losses caused by noncompliance with applicable legal standards. Ifthe standard for directors was once to pay attention and to take action only when they had knowledge of a problem, now the criterion has changed. The flow of information is a two-way street and directors can no longer claim ignorance as a defense. Caremark has made it clear that directors have an affirmative obligation to find out what is going on. Nothing catches a director's attention more than the word liable. Since Caremark, boards have taken the ethical bull by the homs, specifically authorizing compliance programs and formally electing the compliance or ethics officer. Many boards require regular reports from the ethics officer, in writing and in person. Some meet Privately with the ethics officer, as they do with intemal auditors. To set an example, some boards have drafted their own code of ethics for directors and either formed an ethics committee for the board or incorporated the subject of board ethics into existing corporate governance committees Ethics by example All of the public commitments to ethics initiatives by directors aren’t worth much if the board itself isn’t ethical. Too often, directors forget to look at their own habits and practices. First, who are the directors and how were they chosen? Do they have a personal reputation for integrity? Ideally, independent directors are selected solely by other independent directors, to combat even the appearance of being beholden to man- agement. And independent must be taken literally: no representatives of major suppliers, outside counsel or accounting firms, individuals who went to university with the chief executive officer or even heads of organizations that receive signifi- cant company contributions. They should not hold positions on boards of other directors’ companies, or serve on boards of companies having a major business relationship with the company. Some of the best models for corporate governance are quite clear on the issue of independence. Two are illustrative. The Bosch Report states, “The majority of non-executive directors should preferably be independent, not only of management but of any other external influence that could detract from their ability to act in the interests of the company as a whole.”* The Dey Report states, “An unrelated director is director who is free from any interest and any business or other relationship which could, or could reasonably be perceived to, materially interfere with the director's ability to act with a view to the best interests of the corporation, other than interests and relationships arising from shareholding.”” By contrast, a look at one company is indicative of how not to build a board. Archer-Daniels-Midland Company (ADM) often makes the lists of worst boards.1 & Hoffman ~ Ethics and corporate governance /27 especially after the government started its criminal antitrust investigation of the company and its senior executives for price-fixing and illegal compensation. Angry critics of the company, including large institutional investors and manage- ment experts, derided the board for its inherent conflicts of interest and acquies- cence to management. For example, the son, nephew and brother of the chairman and CEO were directors. Other directors included the father of the company treas- urer and the brother-in-law of a fellow director (chairman of an ADM unit), as well as several presidents of joint partners with ADM. Even the independent directors had a conflict. Two were lawyers used by ADM and two other outside directors were longtime friends of the chairman (Lublin, 1995). ADM eventually paid $100 million in criminal fines and agreed to train its board in corporate governance principles. In addition to its composition, the best boards have carefully considered their mission, although the scope of these missions varies greatly. For example, General Motors’(GM) board quite rightly emphasizes that it represents the owners interest in perpetuating a successful business, including optimizing long-term financial returns. But then the board notes that in addition to fulfilling its obligations for increased stockholder value, the board has responsibility to GM's customers, employees, suppliers and to the communities where it operates* - a notion often encouraged by those in the social responsibility movement, but not universally accepted as necessary by other boards. ‘The Business Roundtable Report is opposite and equally clear. “The principal objective of a business enterprise is to generate economic returns to its owners,” it states.” “The notion that the board must somehow balance the interests of stockholders against the interest of the stakeholders fundamentally misconstrues the role of directors.”"" ‘Whatever side one takes in the debate about stockholders and/or stakeholders and the role of the board, it is crucial that the directors make such decisions and draft their mission. Furthermore, they should include an explicit expression of their obligation to set and oversee the ethical culture of the organization. While some corporate governance commentators have advocated that an independent director chair the board instead of the CEO, it is not necessarily unethical for the CEO to act as chairman. What does matter, however, is the information flow to the board and whether the board culture allows it to make decisions contrary to management's interests. If the agenda is tightly controlled and access to the board is limited, it will be difficult to develop an open environment in which issues are discussed, mistakes are bared and no question or course of action is regarded as inappropriate. No doubt the directors of the United Way of America (included among them such captains of industry as John Akers, the former chairman of IBM; W.R. Howell, the former chairman of J.C. Penney; James Robinson, the former chairman and CEO of American Express; and Edward Brennan, the former chairman of Sears, Roebuck)28 J ASCI Journal of Management 27 (1&2) wished they had paid more attention to ethics and corporate governance, even as a non-profit agency. The prestigious national charity was run by a dynamic and energetic president, William Aramony, who had done a fine job building it into a $3 billion organization, So, the directors paid scant attention when they all received an anonymous letter accusing Aramony of having an affair with a young woman and using United Way money to hush it up. He denied the charge and they ignored it. Unfortunately, that was not the end of the story. The directors’ lack of due diligence resulted in a major public scandal when a newspaper expose revealed the details of Aramony’s indiscretions two years later. Aramony was ultimately convicted of 23 felony counts including conspiracy, fraud, money-laundering and filing false tax retums and received a 7-year prison sentence. After the scandal, the board was faced with some soul-searching. They liked Aramony and believed him. They didn’t delve into details. Board meetings were infrequent. Aramony controlled the agenda and the upbeat reports. Yes, the wrongdoing was the fault of Aramony and other United Way executives who knew it was going on, but the board faced up to its own shortcomings. It added eigit new members, including representatives of local chapters. It created six new board committees with responsibility for areas such as budget and finance. It wrote and distributed a code of ethics and tightened up internal financial controls throughout the organization (Driscoll, Hoffman & Petry, 1995) Other boards can leam from the experience at United Way and scrutinize the number, frequency, agenda and make up of board committees to insure that all viewpoints are heard. On paper, directors are a democracy; one person, one vote. In practice, however, some voices speak louder than others do, Some directors have great influence and others have little. For that reason, directors may choose to rotate service on committees or institute term limits. All bring different experiences and backgrounds to the table and. ‘sometimes a fresh view is beneficial and even essential. Evaluating the CEO and senior management is an important board activity, but the best boards also conduct self-initiated and peer evaluations of the board’s own effectiveness. If a board periodically evaluates itself regarding its candor, about the willingness of directors to raise ethical issues and the respect accorded to each other's views, itis less likely to let difficult subjects slide under the table. The problem of aging directors who sleep through meetings or come to meetings unprepared, directors who do not own stock in the company despite a board policy which encourages it, directors who pointedly solicit the CEO to co-sponsor the director’s favorite charity dinner, directors whose partners are receiving substantial consulting fees from the company, directors whose spouses are royally hosted at the annual board. retreat in the Caribbean, are all examples of serious ethical Problems that need frank discussion and resolution. Only the board that is comfortable and practiced in self-examination and the pursuit of excellence in corporate governance will tackle them head-on,Driscoll & Hoffman - Ethics and corporate gavernance [2° Ethics training: Not for employees only Directors are beginning to understand that setting an ethical tone plays an important role in their deliberations and carries as much responsibility as does fiscal oversight. But while many directors are comfortable and experienced analyzing financial statements, balance sheets, quarterly profit and loss reports and auditors’ reports, it is the rare director who is equally facile discussing ethical principles. And yet directors must not wait until the ethical crisis hits the company to arrive at a board consensus about its ethical values, Chicago Bulls basketball star Michael Jordan doesn’t shoot a three-point shot at the buzzer to win a National Basketball Association game without having made the shot hundreds of times before. Directors need to take the time to practice conversations about ethics and hear each other's views, They might discover that when presented with a hypothetical situation, one director doesn’t see any ethical dilemma, while another is ready to call in outside counsel, government regulators, a public relations firm and a priest. Korn/Ferry International, the international executive search firm, worked in conjunction with the Center for Effective Organizations and The Leadership Institute at the University of Southem California to define several best practices that would improve board performance. Perhaps surprisingly, two of the twenty ideas suggest that boards may need outside help in learning new subjects and developing group decision-making skills. “Boards should spend some time on a regular basis focusing ‘on how they want to operate in terms of decision-making, group discussion and interpersonal relations,” the report recommended." Many boards that have considered the relationship between ethics and corporate governance have set aside time at board meetings or retreats for training in ethics. In some cases, an ethics crisis at a competitor has prompted them to action; in other cases, government regulators or shareholder lawsuits may occasion the need for off-the-record debates on how the board would resolve a similar situation should it occur at their company. While there is no single correct approach to ethics training for boards of directors, several elements are essential. First, directors must clear their minds of past problems and the present agenda, They should approach the subject of business ethics with few preconceived notions and give themselves permission to openly express their personal values. They should ask, “What do I believe?” “What is truly important to us as a board and a company?” From freewheeling discussion often emerges group consensus, centered on words like “fairness,” “honesty,” “responsibility.” Second, directors should focus on the business at hand. The directors’ choice of company values must be realistic and fit the appropriate competitive and regulatory framework within which the company operates. For that reason, the core ethical principles of a company in the steel industry, for example, may be different from those of a healthcare organization. Finally, the directors should discuss the values30 ASCH Journal of Management 27 (142) eer eects estes atest see they expect their company to exemplify. Some prefer not to use the word ethics at all but to talk about “how we do business.” Ifthe message from the board is “make the numbers,” almost any executive can do so by playing accounting games, pressuring managers and salespersons and taking drastic short term actions that will only hurt the company in the future. A board directive that states “deliver revenues and profits by absolutely adhering to our company’s ethical principles” conveys a far different message. ‘At this point in the training, the board is ready to tackle some hypothetical mini- cases, often drawn from the company's business experiences, or “red flag warnings” that have appeared in officer reports to the board.'? The cases should be short and simple: a shoe manufacturer is opening several facilities in an Asian country known for below-poverty wages, child labor and human rights abuses, Expense account transgressions of a highly valued senior executive are overlooked. while an entry level employee is fired for the same offense. An insurance company’s regional manager approved a claim of a high net worth customer who threatened 0 complain to the local newspaper, reversing the design of the claims clerk, who followed company procedure and rejected it In dissecting the mini-cases, the directors should debate two questions: Do they think there is an ethical issue? What course of action do they pursue, if anything? ‘The variety of answers are often surprising and occasion further debate about which ethical principles the board holds as inviolate and the proper role of the board in setting the moral tone for the company without yielding to the temptation to micromanage. Directors who are ready to tackle the tough issue of ethics at the board level spend theirtime on mini-cases involving directors, sometimes a more difficult assignment. Those cuses are targeted to corporate governance practices and problems. After one such board training session, when the directors realized they could only Complete six of the twenty mini-cases presented. one director asked the facilitators for the right answers to the remaining problems. There are no so-called right answers, he was told, only decisions the board arrives at as it sets its own ethical values in place for the company and for the board itself. The process by which the board arrives at its conclusions and the seriousness with which the board addresses its ethical responsibility are crucial to the appropriateness of the decisions at which the board finally arrives, Conclusion: A warning sign Icis clear that standards for ethical behavior have been raised today for boards of directors and corporate governance generally. Directors have a lot to consider as they rethink their ethical responsibilities and the fiduciary oversight of their respective organizations. But no discussion of business ethics and corporate governance would be complete without a specific mention of one of the warning signs for which directo:be watchful as they strengthen their ethical awareness, decision-making and corporate governance oversight. That red flag is ethical complacency This is one of the most difficult warnings to see since complacency diverts people's attention. In the case of ethical complacency, directors, managers and other employees think that an ethical problem can’t happen to them because “we are good people” or “we just wrote a new code of ethics” or “we've never had a problem” or some other rationalization, AS soon as a company and its directors begin to take ethics for granted, they are in danger, even if the company once went to great lengths to develop its ethical culture and reputation. Directors must therefore be alert to subtle signs of ethical complacency. Or better yet, they should work vigilantly to make sure this curse never sets in by making sure that the ethical health of the company is constantly being monitored, habitualized, strengthened and discussed. Its the responsibility of directors to ensure that ethics is always in the forefront of the company’s list of obligations. This starts with the conduct of the board of directors itself. By so doing they will be providing the kind of leadership that their corporate governance responsibilities demand. Authors Dawn-Marie Driscoll is President, Driscoll Associates; Executive Fellow and Advisory Board Member, Centre for Business Ethics, Bentley College; Member, Board of Governors, Investment Company Institute and Chair of its Directors Committee; and Faculty, Ethics Officer Association, USA. W. Michael Hoffman is Founder and Executive Director, Centre for Business Ethics, Bentley College; was a founding member and President of the Society for Business Ethics as well as the first Executive Director of the Ethics Officer Association, USA Notes 1. "The Center has been central in the development of business ethics as afield. It's been a model in that ithas brought together practitioners with people form academia.” Rich- ard De George, President, International Society for Business. Economics and Ethics. in Origins of a movement (Waltham, MA: Center for Business Ethics, 1996), p. 5. 2. United States Sentencing Guidelines, Chapter 8, Sentencing of organizations (Wash- ington D.C., November 1, 1991), 3. The Ethics Officer Association, founded in 1991, now includes over 500 members Based in Belmont, Massachusetts, itis a nonprofit organization comprised of individu- als who are responsible for implementing and administering their organization's eth- ies/compliance and business conduct programs 4, The Ethics Coondinator is part of the Office of the CEO and works closely with USAA’s Ethics Council, a group of senior-level executives who review issues of major signifi- cance and take appropriate actions 3. Inve Caremark International inc, Derivative Litigation, 1996 WL 549894 (Del. Chan- cery C.A, 13670). 15 September 1996, 6. The report goes on to explain, “Independence js more likely to ve assured when the director (i) is nota substantial shareholder of the company, (ii) has not been employed32./ ASCI Journal of Management 27 (142) in any executive capacity by the company within the last few years, (ii) is not retained as a professional adviser by the company (either personally or through their firm), (iv) is not a significant supplier to the or customer of the company, and (v) has no signifi- cant contractual relationship with the company other than as a director. Guideline 1.1 Working Group representing Australian Institute of Company Directors, Australian Society of Certified Practicing Accountants, Business Council of Australia, Law Council of Australia, The Institute of Chartered Accountants in Australia & The Securities Institute of Australia, Corporate practices and conduct (Bosch Report) (3rd. Ed. 1995). Guideline 2. Toronto Stock Exchange Committee on Corporate Governance in Canada, “Where were the directors?” guidelines for improved corporate governance in Canada (ey Report) (December 1994). 8. General Motors Board of Directors, GM board of directors corporate governance ‘guidelirtes on significant corporate governance issues (January 1994; revised August 1995; revised June 1997). 9. The Business Roundtable, Statement on corporate governance (September 1997), pel. 10, The Business Roundtable, Statement on corporate governance (September 1997), p. 34, I. Board Meeting in Session: Twenty “Best Practices” to Improve Board Performance (New York, NY: Korn/Ferry International, 1997), p. 9. 12. For examples of red flag issues for directors, see Dawn-Marie Driscoll and W. Michael Hoffman, “Doing the right thing: Business ethics and boards of directors.” Director's Monthly, 18 (November 1994), 1-7. References Allen, W-T. (1998). Independence, integrity and the governance of institutions. Director's Monthly, 22 (1), 13, Byme, J.A. (1996, Novemiber 25). The best and worst boards. Business Week, p. 85. Driscoll, D.M., Hoffman, WM., & Petry, E.S. (1995). The ethical edge: Tales of organiza- tions that have faced moral crises. New York: Master Media Ltd Lewis, M. (1998, May 31). The world’s biggest going-out-of-business sale. The New York Times Magazine, 34-69. Lublin, J.S, (1995, October 17), Is ADM’s board too big, cozy and well-paid?" The Wall Street Journal, p. BL ‘Scism, L. & Paltrow, S.J. (1997, August 7). Prudential’s auditors gave early warnings about sales abuses. The Wall Street Journal, p. | ‘Swenson W. & Clark, N. (1991). The new federal sentencing guidelines: Three keys to understanding the credit for compliance programs. Corporate Conduct Quarterly, 1 (Winter), 1-3