Sharing the Responsibility of Corporate Governance

Harvard Business School professor Constance Bagley studies the intersection of business and law, and is interested in how companies can use legal resources as a competitive asset. In this interview, Bagley discusses ways businesses can make ethical decisions.

Tishler: In your recent working paper, Rhetoric and Independence Are Not Enough: Empowering Managers and Directors to Do What Is Right, you challenge the adequacy of the Business Roundtable's assertion that the selection of a well-qualified and ethical CEO is the most important role of a corporate board. What's missing? What else must the board take into account?

Bagley: The Business Roundtable is to be commended for its clear stand on the importance of selecting an ethical CEO. Anyone who ever wondered whether ethics matters need only look at the outflow of funds from the equity markets since the fall of Enron, Arthur Andersen, WorldCom, Adelphia, and other former high flyers.

These scandals demonstrate not only a lapse of ethics but also a disdain for the rule of law. Enron's lawyers and auditors appeared more concerned with exploiting loopholes than ensuring compliance with the letter and the spirit of the securities laws, which require full and fair disclosure of the financial performance of companies and of the risks associated with their business. This attitude is reminiscent of the Roaring Twenties when, according to Representative (and later Speaker of the House) Sam Rayburn, "free from formal control, these few men, proud, arrogant, and blind, drove the country to financial ruin." Like the individuals convicted of insider trading in the 1980s, some of today's business leaders appear to have forgotten that they are fiduciaries who must, in the words of Justice Cardozo, go beyond the "morals of the marketplace" and exemplify not just honesty but "the punctilio of an honor the most sensitive."

Corporate officers and directors are legally required to act in the best interests of the corporation. Contrary to popular belief, this does not mean maximizing shareholder value without regard for the effect on employees, customers, suppliers, the environment, or the communities in which the corporation does business.

The courts in Delaware (where a majority of the Fortune 500 are incorporated) have made it clear that maximizing shareholder return is required only when the breakup of the corporation has become inevitable or there is a change of control. For this purpose, a merger of two publicly held firms will not result in a change in control as long as the combined entity is controlled by a fluid disaggregated group of public shareholders.

Thus, the Delaware Supreme Court ruled that a proposed merger of Time Incorporated and Warner Communications did not effect a change of control of Time even though post-merger 63 percent of TimeWarner would be owned by the former Warner shareholders. As a result, Time directors had no duty to maximize shareholder value and were permitted to rebuff the arguably higher Paramount cash offer for Time that a majority of the Time shareholders favored over the Warner deal.

A number of states have gone even further than Delaware and passed "constituency statutes," which expressly give directors the right to take all stakeholders into account even when a change in control or breakup of the corporation has become inevitable.

Thus, the CEO who asserted, "I have a duty to maximize value for my shareholders. I can't let my own sense of right and wrong get in the way," is just plain wrong as a matter of law. A CEO or board member may choose to do things in the name of the corporation that they would feel wrong doing in their personal lives, but they are not legally required to do so. Directors are not common carriers, or, to put it more crassly, prostitutes in locales where prostitution is legal. Just because something is legal, doesn't mean that a person of integrity has to do it. In the same way that medical ethics do not compel a physician to do something that violates his or her own personal ethics, corporate law does not require directors to check their sense of right and wrong outside the boardroom door.

A myopic focus on shareholder value can not only result in the unfair treatment of non-shareholder constituencies but can even end up hurting the shareholders in the long run. When we call on managers and directors to check their personal ethics at the door when they enter the executive suite or the boardroom, we desensitize the ethical tripwire that is often triggered before a person crosses the line and violates the law. A manager who becomes accustomed to disregarding his or her inner voice in the name of shareholders is more likely to rationalize other actions to the ultimate detriment of everyone, including the shareholders. For example, managing earnings to meet analyst expectations may start out being rationalized as necessary to avoid undue volatility in the stock price but end up being used to artificially pump up the stock price so executives can exercise their stock options, then dump the stock at an artificially high price. To put it differently, if we try to make individuals' ethical systems overly plastic, they will crack or shatter, leaving the person on the slippery slope to illegality.

Executives need to avoid not only impropriety but even the appearance of impropriety if they are to recover America's trust. Lavish executive compensation not only drains the corporate treasury and dilutes the shareholders' earnings, but, perhaps even more importantly, it can lead the recipients to believe that they really are worth five hundred times more than the average worker. This in turn can breed a sense of entitlement, a belief that they are special, that the rules that apply to mere mortals don't apply to them. This, coupled with the notion that "everyone's doing it," led to the downfall of Drexel Burnham, Michael Milken, and others in the insider trading scandals of the mid-1980s. Unfortunately, then as now, the consequences are felt not just by the wrongdoers but by the honest men and women who do their best each day to earn the trust given them.

This is just one of the reasons why separating the role of CEO and chair of the board, or at least appointing a lead director, is so important. We all need to feel accountable to a higher authority. Contrary to the Business Roundtable's assertion that a lead director is needed only when issues of CEO succession or competence arise, the appointment of a lead director coupled with regular meetings of the independent directors is critical to the independent directors' ability to function effectively as a counterweight to management.

When interviewing candidates for CEO, the board needs to ask probing questions such as, "What is the standard you use when acting as an executive officer of a for-profit corporation? Is it the same standard you use when making decisions in your personal life? If not, how does it differ and why?" The board should ask candidates to describe situations in which they were faced with an ethical dilemma and to explain how they resolved it. Since past behavior is the best indicator of future behavior, the board should ask candidates what concrete steps they took in their prior job to ensure that senior and lower-level managers were conducting the business with integrity. For example, the board might ask whether the candidate ever fired a manager for unethical conduct and how whistle-blowers fared at the prior company.

Q: You've suggested that companies use your decision tree to provide ethical guidance. Can you provide an example of when such a decision tree would work, and when it might not?

A: In many instances, it will be possible to both maximize shareholder value and be a good corporate citizen. Indeed, we should encourage managers to find the "sweet spot" where their actions generate a robust return for their shareholders without exploiting externalities and thereby imposing costs on others without their consent. Yet, sometimes honesty does hurt and bad guys do win. Thus, the fact that creative managers can often come up with strategies that are fair to non-shareholder constituencies while still maximizing shareholder value should not be interpreted to relieve directors and managers of their obligation to consider the effect of each action not just on shareholders but also on others.

My decision tree is intended to provide business leaders with a helpful tool for evaluating the legal and ethical aspects of their decisions. Managers should first ask themselves whether the proposed action is legal. The legality of the proposed action is addressed first to reinforce the notion that legal compliance is the baseline standard. If an action is not in accordance with the letter and the spirit of the law, then regardless of the likely effect on shareholder value, the action should not be taken.

The filter for shareholder value is intended to require consideration early on of whether the interests of the group given the ultimate authority to change management are being served by the proposed action. The inquiry does not stop there, however. Directors and managers must then ask whether the proposed action is ethical and whether it would be unethical to not act. If the board decides to take an action that will have a material adverse effect on shareholders, then that decision and the reasons for it should be disclosed to the shareholders.

For example, a company establishing a manufacturing facility overseas in a country that has much less stringent environmental laws than the United States should consider not only the possibility that those laws might later be tightened, and applied retroactively (as has been the case in the United States with respect to CERCLA), to require costly cleanups that will adversely affect shareholder value, but also to ask what is the cost of installing pollution control equipment and what would be the potential harm created in the event that that equipment is not installed. For example, a board of directors might feel ethically compelled to install $5 million worth of pollution control equipment in a country that does not require such equipment if a failure to do so would cause $100 million worth of damage or certain loss of life or serious physical injury. If the board elects to spend $5 million of the shareholders' money for such equipment, the board should disclose its decision and the reasons for it in its periodic reports to shareholders.

Similarly, in the case of an energy company like Enron, this model would call on directors to be concerned not just with shareholder value when deciding whether to manipulate the trading of natural gas contracts in California, but also the effect artificially jacking up the price will have on California consumers who rely on gas to heat their homes and cook their food. On the other hand, directors negotiating the sale of a Delaware corporation to a company controlled by a single individual would be obligated to accept the offer that offered the greatest currently realizable value to shareholders.

Q: You've done research on the role of shareholders in holding corporations responsible for their actions. Should any of the burden of ethical corporate behavior rest on shareholders? How about the rank-and-file employees?

A: The short answer is that relying on the shareholders is not practical. First, information of the sort that would allow shareholders to police corporate behavior on issues, such as the use of child labor, is not easily accessible. Although some companies, such as Royal Dutch Shell, have started to publish audited reports outlining their performance in such areas as the environment, workplace safety, and community involvement, most firms do not provide this information.

Second, it is not economically efficient for shareholders with a small stake in a number of companies to ferret out sufficient information to enable them to make an informed judgment about whether each company in the portfolio is acting in a socially responsible manner. So-called green funds attempt to invest in socially responsible companies but often their selection criteria, which are often based on the industry a company is in and not the integrity of the individual companies within an industry, are very crude.

Third, investors in mutual funds and beneficiaries of pension plans may have little or no control over which companies the fund manager or plan fiduciary selects for the portfolio. Indeed, managers of pension funds subject to the Employee Retirement Income Security Act of 1974 (ERISA) may feel legally constrained to make decisions that maximize the return for plan beneficiaries, even if the beneficiaries themselves might (had they been asked) have preferred more socially responsible investments. This quandary led one pension fund manager to respond to my question of whether she would invest in a company doing business in a country with human slavery by asking, "You mean me personally, or as a fund manager?" While it may be debatable what constraints ERISA imposes on fund managers' right to interject their own moral sentiments into the portfolio-management process, clearly the corporate law does not so constrain directors.

There is a fourth reason: In interactions between individuals or even large organizations with identifiable owners, social expectations tend to create substantial safeguards against attempts to internalize gains while externalizing costs. People who dump their garbage in their neighbor's front yard face social consequences ranging from subtle suggestion to social ostracism, if not outright retaliation. Absentee and anonymous shareholders are unlikely to experience such influences. Thus, as a practical matter, shareholders cannot be made more accountable because they are, in many cases, essentially anonymous. Thus, the modern industrial corporation not only separates decision-making power from the full economic consequences of the corporation's decisions, but it also insulates shareholders from accountability for the consequences of those decisions. So one is left with the question, "If not the directors, then who?"

Of course, the directors cannot and should not be overseeing the day-to-day affairs of the corporation. But the board can do its best to empower every employee to be ethical. Just as total quality management calls on managers to empower each employee to stop the production line if there is a quality defect, so must the board empower any manager to come to a board member without fear of retaliation if the manager believes that something is not right. Warren Buffet did exactly that when he gave managers at Salomon Brothers his home phone number after he took over Salomon in the wake of its Treasury auction scandal and told them to call him if they spotted a problem.

Legal and ethical training for employees is important, as is consistent application of the company's policies on conflict of interest. If the executives get away with cheating on their expense reports or using the company plane to fly their girlfriends around, then employees quickly become cynical about management's professed concerns about honesty. Whistleblowers should be protected through use of ombudspersons, anonymous hot lines, and access to internal counsel. Ideally, the general counsel should report to the board of directors to ensure a clear line of communications. Just as the audit committee meets privately with the internal auditors so should it meet with the general counsel.

Q: Can ethical decision making be taught?

A: It is not enough to exhort managers and directors to be ethical. First, a consensus needs to be reached concerning what it means to be ethical in business. Academics should work with business leaders, community leaders, labor groups, environmentalists, and politicians to articulate a list of the values that most people, both inside and outside of the corporate world, would consider worthy of consideration. These might include such things as providing high-quality goods to customers at the lowest possible price, providing meaningful and well-compensated work for employees, providing a high return to shareholders, or ensuring the sustainability of the planet. No one value would necessarily trump another, and any decision would have to be evaluated by taking all such values into account and balancing them against each other.

Once there is a consensus on which values are important, future business leaders need to be taught how to engage in moral reasoning. Some skeptics argue that ethics cannot be taught, that by the time a person is an adult, their value system is set. Yet, by way of comparison, consider how business schools inculcate in students the belief that providing value to the customer is key to success. No one says, "Value is in the eye of the beholder. You either learn what it is from your parents or you'll never get it." Instead, professors use theory and examples to teach future business leaders why value is important and how to create an organization that fosters value creation. Students are exposed to a variety of ways to provide value, such as total quality management and benchmarking, and are trained how to improve quality while reducing costs. Students learn which techniques have worked well and which have failed, and thereby internalize the need for value creation and create a reservoir for making management decisions.

Similarly, we need to teach future and present business leaders why ethics is important, how to figure out what is ethical, and what conditions tend to push people in the organization to be more or less ethical. As my colleague Sandra Sucher has suggested, in the same way that doctors are taught medical ethics, we can teach future business leaders how to use moral reasoning to determine what is ethical and how to create an organization that reduces the temptation to do the unethical. At a minimum, we should make sure that every business school graduate understands where the legal lines are and why respect for the law is so critical to a successful capitalist system.

Q: What's next for you in terms of research?

A: My research continues to focus on the intersection of law, management, and ethics. I am currently researching and writing a book to be published by Harvard Business School Press tentatively titled Winning Legally: Adding Law to the Manager's Strategic Tool Kit. Winning Legally will provide general managers a framework for understanding the public policies informing the laws regulating business and help managers spot legal issues before they become legal problems. But staying out of trouble is only part of the story. Perhaps more importantly, the book will show managers how to use the law and the legal system as a positive force to create and capture value and to manage risk.