Board to distraction

One of the unfortunate ironies of the current financial crisis is that it began less than six years after the most sweeping overhaul of securities and financial regulation in the United States since 1934.

In July 2002 the Sarbanes-Oxley Act was signed into law. In addition to SOX, the major U.S. securities exchanges increased their regulation of listed companies. The reforms enacted after the Enron Corp. and WorldCom Inc. debacles were intended to weed out corporate fraud. These reforms focused on increasing management and director-level liability for misstatements and on mandating the independence of public company boards.

Yet these regulatory developments have had the unintended consequence of shifting the focus of corporate directors away from overseeing management and protecting shareholder value, in effect deputizing board members and their advisers as arms of the greater regulatory regime.

Despite some of the political hyperbole of late, corporate fraud has not been a major contributing factor to the current global financial mess. By helping to shift corporate board attention away from the preservation of shareholder value to a more inward focus on independence and personal liability of board members, regulatory developments added to a director-level diversion away from fundamental board functions. SOX and its related regulatory developments expanded the personal liability of management and board members for failing to ensure that their corporations adhere to the new standards of disclosure and accounting. These developments, coupled with the fact that the directors of Enron and WorldCom had to personally pay out millions of dollars after the failure of their companies, heightened director sensitivity to the potential for personal liability. Since SOX's enactment, public company boards have generally increased in size and have become dominated by busy executives in unrelated industries and semiretired professionals not well versed in the complexities of the businesses they oversee.

Since the U.S. securities exchange rules enacted in conjunction with SOX mandated that a majority of directors on boards of public companies meet detailed independence criteria, boards in response have simply added more board members who happen to qualify as independent, resulting in larger boards but not greater collective experience.

Generally, "independence" means having few relationships with the companies the independent directors are supposed to be overseeing. The practical result of such independence is to make it difficult for industry veterans with operating experience to serve as directors within the industries they know best.

The new regulations have also increased the workloads of directors. As a result, independent directors with accounting or legal backgrounds are often more in demand than directors with relevant industry experience and operational knowledge. This has created a class of professional directors, familiar with the regulatory regime but often not fully familiar with the businesses they are overseeing.

The unintended result is a toxic mix of personal risk avoidance and inexperience. For example, of the 13 members of the board of directors of General Motors Corp., only the CEO has operating experience in the automotive industry. At Citigroup Inc., only four of the 15 directors have any direct experience in financial services.

Four of 11 directors at Lehman Brothers Holdings Inc. had any experience in financial services; of those four, two are more than 80 years old. The expertise of the directors who are not industry insiders at these companies is provided by a theatrical producer, the former head of Sotheby's auction house and multiple college professors.

The mantra of independence for independence's sake should be reconsidered so as to enable highly experienced people to serve on the boards within industries they understand.

Corporate risk management, and not personal risk avoidance, should be the goal of revisions to the existing regulatory regime. Packing the boards of America's most important companies with well-intentioned but inexperienced professional directors who are overly focused on avoiding personal liability has contributed to the breakdown of corporate risk management in the past several years.

Gordon R. Caplan is a partner in the corporate and financial services department and co-chair of the venture capital practice of Willkie Farr & Gallagher LLP in New York City. Andrew A. Markus is a corporate associate with the firm.