How Boards Get Into Trouble

In an article I wrote for the E-Commerce Times titled “WorldCom’s Failure: Why Did it Happen?” I talked about one of the largest accounting frauds in U.S. history. The upshot of this fraud was that former CEO, Bernie Ebbers, 63, was convicted of orchestrating this US$11 billion accounting fraud and was sentenced to 25 years in prison on July 13, 2005.

That’s how this sad story ended. However, important lessons are to be made from such an outsized fraud — lessons on how proper corporate governance can eliminate much of this type of abuse. So, let’s look at how boards get into trouble and how — if you are a board member — you can protect yourself from the inevitable financial fallout from failures due to poor corporate governance.

A Proactive Board Is a Must

First and foremost, you as a board member have to be very active in the deliberations of your board. You must be sure that your name is in the minutes showing that you were a prudent and active board member. You must avoid minutes that show you are just a “rubber-stamp” member of the board.

Boards were created to be firewalls. That is, they are meant to create a separation of powers between hands-on management (the CEO, COO, etc.) and ownership (the shareholders). A well-constituted board will provide an effective firewall as well as strong checks and balances.

Warnings From the WorldCom Debacle

A great deal of guidance for corporate directors came out of the WorldCom bankruptcy. In fact, a federal bankruptcy court issued a report of investigation in 2003, which contains quite a bit of cautionary direction for board members.

Here is a brief quote from that report: “As enormous as the fraud was, it was accomplished in a relatively mundane way: more than $9 billion in false or unsupported accounting entries were made in WorldCom’s financial systems in order to achieve desired reported financial results.”

This statement about false accounting entries did not permit board members to get away without scrutiny or liability. The report clearly puts blame where blame should be put — not only on the CEO, Bernie Ebbers, but also on the board.

The report goes on to say:

“The fraud was the consequence of the way WorldCom’s Chief Executive Officer Bernard J. Ebbers ran the company … he was the source of the culture, as well as much of the pressure, that gave birth to this fraud,” the Board of Directors certainly shares this blame. “The setting in which it occurred was marked by a serious corporate governance failure,” the report states.

Corporate Governance Failure

“Serious corporate governance failure.” This is the root cause of how boards get into trouble. There is nothing like an active board! To that end, I note that the struggling wireless carrier Sprint Nextel recently announced that it is putting an activist investor on its board — an investor who has been agitating for changes at Sprint Nextel.

In other words, the struggling company was forced to put a corporate gadfly on its board. Many boards don’t overly welcome gadflies/activists. My experience has been that some corporate officers actually prefer a compliant board. This would be one warning to you that, if asked to serve on such a board, you should decline. A good board is one where naysayers, assuming that they are fair and reasonable and are looking out for the stockholders’ interests, are roundly welcome.

Many Boards Have a Bunker Mentality

Several friends and acquaintances of mine have told me just how scared they and their boards are of lawsuits. Their attorneys have advised a simple strategy, which I do not approve of, that they hope will keep them out of trouble.

When this strategy was first described to me by a board member of a large national company, I thought that it was something of an anomaly and did not represent widespread corporate board tactics. Unfortunately, I have since come to learn that it is a rather widespread practice.

This practice requires that all board members return their board books, that tome containing board deliberations along with copious corporate information, to the board chair who then sees to it that the board books are shredded! What remains of the evidence of the board minutes is a sanitized document, sanitized by counsel of course, that merely contains the corporate motions acted upon by the board. This document contains little, if any, information on deliberations. It mostly concerns motions that were passed by the board.

When I first heard of this practice, I was somewhat incredulous. Corporate counsel’s logic is that if the board members are ever subpoenaed to give testimony, they can say that all they remember are the published minutes of the corporation and that their memory is foggy as far as deliberations and other information that is not in the corporate minutes are concerned.

My feeling is that by being an active board member who makes and seconds legitimate motions that go into the corporate minute book, you will have little to fear in the way of a lawsuit. Let your fellow board members call you an activist or a gadfly, if they so desire. You are protecting not only the stockholders of a corporation to which you have a fiduciary responsibility, but you are also protecting yourself. Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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