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Reader Profile

Dan R. Dalton
Founding Director of the Institute for Corporate Governance
Dean Emeritus, and the Harold A. Poling Chair of Strategic Management in the Kelley School of Business, Indiana University

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

Given the backlash of Sarbanes-Oxley (SOX), the guidelines of the listing exchanges (e.g., NYSE, NASDAQ), and the enforcement of the SEC, can you comment on the increasing trend for publicly traded firms to “go private” and to “go dark”?

Futility and risk come immediately to mind. The “futility” is that it is increasingly difficult to avoid the major elements of SOX and listing exchange guidelines--transparency, independence, and accountability. A dozen states or so have adopted or are considering SOX-like guidelines applying to private companies in their jurisdictions, and for non-profits as well. Other federal agencies have adopted SOX-like guidelines that apply to private entities. Consider, too, that private enterprises that have or are seeking government contracts will find that some compliance with SOX-like provisions will be a requirement.

There are also a host of risks and derivative costs that apply to private as well as “dark” firms. Raising capital from whatever sources will likely find SOX-like requirements as a condition. Insurance companies will have similar guidelines in place for firms to secure D & O insurance and other coverages. Firms distributing financial statements for virtually any purpose (banks, trustees, institutional investors) will be expected to be SOX-compliant. The acquiree/partner in potential M&A transactions will seek the comfort of SOX-like provisions in the due diligence process. Companies with or considering ESOPs (employee stock ownership plans) may expect that the ESOP’s trustee will encourage SOX-like compliance. And, private/dark companies will want to consider that its clients, joint venture partners, vendors, and other business partners that are publicly traded may insist on compliance with the same practices/guidelines to which they are subject.

And there is the issue of legal exposure. Shareholders will almost certainly sue the firm. They will argue -- and will have substantial research support -- that going private or dark will result in far less liquidity, much higher volatility, and a steep decline in the value of the company. Beyond that will be allegations of deliberate misconduct by management and the board of directors. Essentially the argument will be that these officers and directors have leveraged their inside information to their own advantage because stakeholders will not longer be able to enjoy the visibility and transparency of their transactions. Harsh words, and often misdirected, but that returns us to futility and risk.

Much has been said about compensation for senior corporate officers, especially CEOs. Compensation for boards of directors, however, has received far less attention. What comes to mind for you when considering board compensation issues?

CEOs do not set their own compensation. The compensation committee of the board, composed of independent directors, has that responsibility. Notably, however, boards of directors do, in fact, set their own compensation, a point clearly noted in the Model Business Corporation Act. Obviously, this sets the stage for a substantive moral hazard. At the risk of understatement, most of us would find the notion of setting our own salaries and benefits to be tantalizing, but with the challenge of it becoming something less than scandalizing.

That said, I am far less concerned about boards setting their salaries as I am their role in authorizing their own stock options. As learned in a series of sobering reports, we know that stock options for senior officers can be associated with untoward behavior designed to raise the price of common stock to leverage their own stock options. In principle, however, it is the board of directors whose responsibilities include the monitoring of such behavior. Contingent rewards like stock options should be pursued with reason, and the board is the rightful steward of that guideline. A serious potential problem presents, however, when both the officers and the board simultaneously benefit from aggressive option-exploiting behavior. In fact, any time that additional compensation for officers directly informs additional compensation for directors, there is that moral hazard, writ large, to which I earlier referred.

I would add that stock options for board members may indirectly affect their judgment across a series of other decisions. Consider the repricing of stock options. While very narrow circumstances might warrant the repricing of options for officers and employees, is there ever an occasion when board members should benefit from such repricing? Other affected transactions would include stock buybacks, stock reloads, M & A activities, and a veritable host of insider trading issues.

Perhaps the better course, then, is that boards’ compensation should not include contingent arrangements of any sort, and certainly not stock options. Board members should be well paid, and there is substantial evidence that their compensation is steeply increasing. No quarrel as long as the pay is not contingent. There is a timeless adage suggesting that the same person doing the “counting” should not be doing the “accounting.” In many ways, companies with officers and boards with stock options is a textbook violation of that humble guideline.

The independence of boards has many advocates. Is there a downside of this continuing press for independence?

This is one of the great ironies in the new corporate governance environment. Even a casual review of the major guidelines (SOX, Public Company Accounting Oversight Board [PCAOB], the listing exchanges [e.g., NYSE, NASDAQ]) underscores a common theme of board independence. These guidelines refer to the overall board as well as its key committees (Auditing, Compensation, Corporate Governance, Nominating).

While I am strongly in favor of this notion of independence, and it is much broader than I have described, it arrives with a cost – and the irony to which I referred. Because of these guidelines, and the near-total compliance to them, boards have actually never been more dependent. Never been more dependent. Why?

In the past boards comprised three subsets of directors – officers of the firm, independent directors (board members without substantial linkages to the CEO/firm), and affiliated directors (board members with linkages to the CEO/firm). Two of those three categories are now decidedly out of favor. Few firms today have more than two inside directors on the board. And, affiliated directors – because they are not independent – are prohibited from serving on the boards audit, compensation, corporate governance, and nominating committees.

But, all of us might ask ourselves what most affiliated directors had in common. Well, they were generally, for example, consultants, prior officers, suppliers, customers, bankers, and attorneys, and they were all well acquainted with the firm, with the industry.

In the spirit of best-in-class corporate governance, independent directors have many advantages, but firm-specific, industry-specific information is often not among them. A recent best-selling book, Wisdom of Crowds, reminds us of what most of us know intuitively: “one of the quickest ways to make people’s judgments systematically biased is to make them dependent on each other for information.” So, where do independent boards without first-hand information typically look for such information? It is provided in board meetings by the CEO, sometimes by the CFO, and less often by other senior officers. And, board materials are not nearly enough. This places an enormous need and substantial challenge on boards to seek other, outside, sources of high-quality information. And, some boards will do this must more effectively than others. Thus, the irony – independent boards are more dependent, not less.

Dan R. Dalton is the founding Director of the Institute for Corporate Governance, Dean Emeritus, and the Harold A. Poling Chair of Strategic Management in the Kelley School of Business, Indiana University. Professor Dalton is widely published, with over 270 articles in corporate governance, business strategy, law, and ethics. Additionally, his work has been frequently featured in the business and financial press including Business Week, Wall Street Journal, Fortune, Economist, Financial Times, Boston Globe, Chicago Tribune, Los Angeles Times, New York Times, and The Washington Post. Professor Dalton regularly addresses public, corporate, and industry groups on corporate governance issues.