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The Denver Forum will, on occasion, feature recent speeches delivered before members and guests. These speeches are offered in the public service, and in furtherance of the dialogue of democracy. Restoring Governance to our Corporations By William W. George Former Chairman & CEO - Medtronic, Inc. Crisis in the Corporate World The world is in a state of shock, and rightly so, over the continuing revelations from major corporations of accounting misstatements, fraud, mismanagement, bankruptcy, and excessive executive compensation. Last fall if someone suggested that anything could have exceeded the general public's worries over terrorism and the tragedies of September 11, we would have said they were crazy. The corporate crisis of the past year has done just that, as people are now more concerned about losing their life savings than they are about losing their lives. The current crisis began with the demise of Enron and Arthur Anderson. Now the list of corporate irregularities and failures is growing every day: WorldCom, Kmart, Tyco, Merrill Lynch, Qwest, Xerox, ASEA-Brown Boveri, Swiss Air, Global Crossing, Adelphia, Xerox, Merck just to name a few. One wonders when and how it will end. Five of these companies - Enron, WorldCom, Tyco, Qwest, and Global Crossing - have destroyed more than $460 billion in shareholder value while moving inexorably toward bankruptcy. The irony is that our best companies are being badly hurt as well. Three years ago if I named GE, Microsoft, Intel, Cisco, and AOL/Time Warner, most of us would have agreed that these are five of the best shareholder value creators in history. Yet these five companies have seen their shareholder value decline by a total of $1,500 billion since their 1999 peaks, more than three times the decline of the "bad guys." Yet these are all outstanding companies with leaders working hard to build them for the long term. Our system of capitalism is built on investor trust - trust that corporate leaders and boards of directors will be good stewards of their investments and provide investors with a fair return. There can be no doubt that the leaders of these corporations, and possibly many more, have violated that trust. As a result, investors are losing confidence and withdrawing from the market. In the process, everyone is getting hurt, not just the perpetrators of the egregious acts. These financial setbacks are especially painful for the millions of small investors who made major commitments to stocks over the past ten years, moving their hard-earned savings from bank savings accounts and bonds to equities via stock brokers, 401k plans, pension plans, and private investment clubs. They did so with the hope of earning greater rewards from the equity market, but they always believed they could withdraw their funds as needed. Tragically, many people have seen their life savings literally wiped out by the greed of a few. We are left with the sinking feeling that our leaders are only out for themselves, not their customers, employees, or their shareholders. How else could the CEO of Global Crossing and his fellow insiders cash out more than $5 billion in stock gains as he led his company into bankruptcy, destroying $38 billion in shareholder value along the way? How could the billionaire CEO of Oracle exercise $703 million in stock options just weeks before his company's stock collapsed when he pre-announced a major earnings downturn? Or John Rigas of Adelphia set up schemes to siphon funds from Adelphia shareholders into his family's accounts? Every generation has its examples of corporate thieves who break the law to reward themselves. This time around the excesses are not limited to a few. While the majority of corporate CEOs are honest leaders dedicated to building their companies, far too many got caught up in the quest for personal gain and wound up sacrificing their values and their stakeholders. Call it greed, because that's what it is. It threatens the very fabric of our system. How Capitalism Became a Victim of its own Success How did we get in this situation? Is this a recent phenomenon, or have these activities been going on all along? We are witnessing the extreme excesses of the shareholder revolution that began fifteen years ago. In its early stages pressure from shareholders did a great deal to improve the competitiveness of American corporations, as companies trimmed excess expenses, improved profitability, and increased cash flow. However, the financial rewards from their successes, both corporate and personal, were so great that companies and shareholders alike developed an inordinate focus on short-run results. In a booming stock market, it all seemed to be working. Then capitalism became the victim of its own success. Instead of focusing on traditional measures such as growth, cash flow, and return on investment, the criterion for success became meeting the expectations of the security analysts. Investors and security analysts kept demanding ever higher performance in order to generate inordinately high short-term returns. Driven by the security analysts, expectations kept rising, just as companies were struggling to make their numbers. Companies that met or exceeded expectations were handsomely rewarded with ever-rising stock prices. Those that fell short of expectations, even if they recorded substantial earnings gains, were inordinately punished by the stock market, and the analysts demanded replacement of the CEO. No wonder many CEOs went to extreme measures to satisfy the analysts! In response to this pressure, many companies cut back investments just to make earnings. This in turn severely limited the company's ability to keep growing. However, revenues and earnings do not escalate forever, especially in the face of economic downturns, unexpected events like September 11, and operating problems. To offset these downturns, many executives stretched the numbers and the accounting rules well beyond their intended limits. Some of these accounting schemes, like calling operating expenses capital equipment to avoid the P&L and booking revenues before they are earned, violate even the most basic rules of accounting. Now the chickens are coming home to roost. Huge stock option grants played a role as well. In the past five years stock options went from modest grants to mega grants for top executives, especially CEOs. Because they had no cash impact and were not charged against profits, many executives and boards viewed these grants as free. The effect of these grants was to shift the CEO's focus almost entirely to getting the stock price up - by whatever means necessary. Realizing they could not sustain their earnings, many CEOs cashed in their options for huge gains just before their stock price collapsed. We thought we had a system of checks-and-balances that would prevent these acts from occurring. Tragically, these constraints have collapsed or have been compromised. The demise of Arthur Andersen vividly demonstrates how the auditing firms have compromised their service to the public in quest of personal gain by going overboard to please their clients. In an era of deregulation, the regulators also let their guard down, egged on by politicians being influenced by large contributions from the PACs. The general public played a role in this tragedy as well. We idealized the high-profile personalities that ran these companies and made them into heroes. We equated wealth with success and image with leadership. We venerated the "flash in the pan," while ignoring the real success stories because they are less dramatic and less glamorous. The media turned these short-term earnings artists into the folk heroes of the business community. At the height of the media frenzy, Time made Jeff Bezos, CEO of Amazon.com, its "Person of the Year" without bothering to note that never in its history had his company generated a dollar of earnings. While making wealth, image, and star power the criteria for success, the media overlooked the many solid corporate leaders building quality companies for the long-term. Ken Lay, Bernie Ebbers, and Dennis Koslowski were the focus of intense media worship before their fall. Just one year before he was led off to jail in handcuffs, Business Week named Koslowski "CEO of the Year" for being first on its Nifty Fifty list of top stock performers. I met with Koslowski back in 1998 to talk about acquiring one of his many companies. In our brief meeting he bragged that having his headquarters in Bermuda enabled Tyco to avoid paying U.S. taxes. He described how he automatically issued pink slips to twenty-five per cent of the workers on the day he acquired their company, in order to pay for the steep acquisition price. And how he shut down every research project or investment that wouldn't pay out in the first year. As I walked out of his office, I put my hand on my wallet and held on tight, telling my colleague to cancel further talks with Tyco. You cannot do business with people you cannot trust. Meanwhile, the stock market drove Tyco's value up to $120 billion. Today it is worth less than $25 billion. The lessons from this crisis are evident: if we select people for their ability to drive up their short-term stock price instead of their character, and then shower them with inordinate rewards, why should we be surprised when they turn out to lack integrity? Much to our dismay, we have learned that these celebrity CEOs have been enriching themselves, filling up their personal coffers at their shareholders' expense, and destroying the pensions and life savings of millions of people. In response to these excesses, policy makers and politicians have crafted new laws and regulations to close the loopholes and eliminate the excesses. Some changes in laws, regulations, and accounting rules are both appropriate and necessary, but these changes will not address the deeper issues at stake here. Nor will putting a few executives in jail. It is impossible to legislate integrity, stewardship, and sound governance. Where Have All the Leaders Gone? In this midst of this crisis, we ask ourselves, where have all the leaders gone? Where are today's versions of James Burke of Johnson & Johnson, Walter Wriston of Citicorp, and David Packard of Hewlett-Packard? These men not only built great enterprises but were statesmen in the business community and leaders in addressing societal issues as well. A Time/CNN poll taken this summer reported that 71% of those polled feel that "the typical CEO is less honest and ethical than the average person." In rating the moral and ethical standards of CEOs of major corporations, 72% rated them "fair" or "poor." A similar survey by the Wall Street Journal Europe reported that only 21% of European investors believe that corporate leaders are honest. In the face of these egregious acts, today's leaders of our best-run corporations remain silent. Are they afraid that by speaking out they may invite attacks on their companies? In so doing, they give the impression that they have something to hide or are also part of the problem. Only Henry Paulson, CEO of Goldman Sachs, has had the nerve to condemn these practices, recognizing the larger issue is one of public trust in the capitalist system. Paulson's acts were doubly courageous, as he risked not only criticism from his peers but his customers as well. Andy Grove, chairman of Intel and one of the most authentic leaders of our time, commented recently, "I find myself embarrassed and ashamed to be a businessman." I too am ashamed at the disaster my generation has wrought. Somewhere along the way we lost sight of the imperative of creating healthy corporations for the long-term. The lessons of building great companies like 3M, Coca-Cola, Johnson & Johnson, General Electric, Pfizer, and Procter & Gamble were lost in the rush to make a quick buck. We forgot that those of us who are fortunate enough to lead great companies are the stewards of the legacy we inherited from past leaders and the servants of our stakeholders - our customers, our employees, our shareholders, and our communities. We do not need celebrities to lead our corporations. We do not need executives running corporations into the ground in search of personal gain. What we need are authentic leaders dedicated to running quality companies and building committed organizations serving their customers - leaders that have a clear sense of purpose, consistently practice good values, create enduring organizations, are committed to getting results for all their stakeholders, and who lead with passion, compassion, and their hearts as well as their heads. "Governance is Governance": The Bright Line Between Governance and Management In the wake of these failures, we have criticized every player in the system except the one that is ultimately charged with insuring that these failures do not occur: the board of directors. The board of directors is legally elected by the shareholders as the ultimate governing body of the corporation. It is charged with preserving the company and building it for the long term. Two years ago I gave the keynote address to the National Association of Corporate Directors, warning that "time is running out" for boards of directors to step up to their responsibilities and transform themselves from within. Sadly, we did not act and now we are living with the consequences of our own inaction. In recent years many boards have abandoned their legal and fiduciary responsibilities. They have become more responsive to the CEO and the management than to the shareholders. In so doing, they abandoned their governance role and jumped on the bandwagon to get the company's stock price up. They stopped asking the hard questions about how the company was achieving its numbers, whether it was making adequate investments to build the company for the long-term, and whether its strategies were still valid and being effectively implemented. Ultimately, we will realize the root cause of the current crisis is a massive failure in corporate governance. If this is indeed the cause, we must reform our systems of corporate governance before we can emerge from the crisis, or we will find ourselves back in trouble in the next cycle. This reform begins with establishing "a bright line" between governance and management. In recent years companies have tended to blend the two roles, in part because one person - the chairman and CEO - has been responsible for both governance and management. Boards have ceded their governance responsibilities to the CEO. Now it is imperative that they reclaim it. Here is a ten-step program to restore governance to our corporations: 1. Create principles of corporate governance. The first and most important step is for the independent directors of the board to establish principles of corporate governance. These principles describe the functioning of the board and how the board will conduct itself. These principles are especially critical in times of crisis. After receiving board approval, the principles should be published for all shareholders to see, and each year the board should make a report to the shareholders evaluating the effectiveness of these principles in operations. As with any written document, the principles are only as good as their implementation. In the 1970s Ken Dayton, then chairman and CEO of Dayton-Hudson (now Target Corporation), established a set of governance principles for his company and published a treatise called "Governance is Governance," delineating the bright line between governance and management. These governance principles, which have been adopted by many Minnesota companies such as Medtronic and General Mills, have carried Dayton-Hudson through crises such as takeover attempts, unplanned changes in corporate leadership, and severe economic downturns. Medtronic found its principles to be especially helpful when the company had to go through an involuntary CEO change in the 1980s. Medtronic published its revised principles in 1996 and recently reaffirmed them. 2. Majority of independent directors. Having truly independent directors is essential to an effective governance system. The New York Stock Exchange recently proposed that companies must have a majority of independent directors in order to be listed. Even this modest proposal brought on a barrage of criticism. I believe 50% independent directors is a minimum. Personally, I would like to see it be 70% or more. We also need to tighten up the definition of "independence." Boards need directors who have had no prior association with the company as an employee or as an owner-employee of an acquired company. To insure their independence, no director should receive any additional compensation other than standard board fees: no consulting fees, no speaking fees, no fees for doing business with the company, and no commissions on sales or acquisitions. Nor should any interlocking directorates be permitted between the CEO and any member of the board. 3. Selection of board members. Given the current state of affairs we face in the corporate world, it is time to rethink the kind of people we need as independent directors. First, we need to choose board members more for their values than their titles. All too often in the past we have chosen directors for the positions they hold, rather than their commitment, time availability, and competence as a board member. Many boards give top priority to stacking their boards with sitting CEOs, even if they have little time to devote to outside boards. Of course, committed CEOs can be outstanding directors, but why not take advantage of the many former CEOs and other top executives who have the time and inclination to serve on boards. The latter represent underutilized talent that can become exceptional directors. Boards also need to carefully assess the diversity of backgrounds and experience they need on the board in order to provide the soundest guidance and advice to management. It helps if they have some knowledge of the business, but a more important criteria is being experienced in sound corporate governance. Diversity is essential so that directors represent different points of view and are willing to challenge each other as well as the management. In recent years the Medtronic board has been greatly diversified as many of the business people who helped build the company retired from the board. Among the nine independent directors who make up 90% of the board, Medtronic has two CEOs, two university presidents who are also technologists, two medical doctors, two people deeply involved in health care, and a venture capitalist. Boards should insure that their new board members attend professional directors education programs, as well as return every few years for an update on the latest thinking in corporate governance. These programs could insure a minimum background for all directors in terms of their knowledge of governance. 4. Governance and Nominating Committee. All boards should establish a governance and nominating committee, composed solely of outside directors. This committee is responsible for maintaining the principles of corporate governance, for nominating people for election to the board, for evaluating existing directors, for conducting the evaluation of the chairman and the CEO, and for developing a succession plan for the CEO, including the selection of new CEOs. The governance committee is charged with organizing the board and establishing its committee structure, identifying independent directors to chair each of the board committees. Only independent directors - and not the CEO - should serve on board committees. 5. Lead Director. There continues to be great controversy over whether the positions of chairman of the board and CEO should be held by the same person. In the U.S., one person usually holds both roles, whereas in Europe most companies insist that two people hold these very different roles. Several European countries mandate this separation by law. In my experience I have been CEO with an outside chair, held both positions at once, and have been chair with a separate CEO. Although it can work both ways, on balance, I prefer to see the two positions combined so that there is no conflict or confusion about the company's direction and strategy. `If one person is both chair and CEO, then it is imperative that the independent directors elect a lead director to organize them and insure their independence. My preference is for the lead director to be the chair of the governance committee, as these functions are closely aligned. All three of the boards I have served on most recently - Target, Novartis, and Medtronic - have elected lead directors who organize the independent directors and serve as an advisor to the CEO. 6. Audit and Finance Committees. In the wake of the current crisis, very tight definitions are being established for the qualifications of the audit and finance committees to insure that adequate exists on the committee to insure the veracity of the financial statements. These committees should meet privately with the external auditors, the CFO, and the company's internal auditors. It should also pass a rule prohibiting outside auditors from receiving any additional consulting fees from the company, something the Medtronic board did recently. 7. Compensation Committees. To insure its independence from management, the board should hire its own independent compensation consultant. Preferably this consultant would only work for boards of directors and not for the companies themselves. Neither the CEO nor any member of management should be involved in setting the CEO's compensation, nor in setting board fees. In 1996 Medtronic's board compensation committee hired its own consultant, taking management out of the loop on CEO compensation and board compensation, something that has proven to be very effective. There is no question that CEO compensation has run away from reality in the past decade, as CEOs on average are paid ten times more than they were a decade ago while the real wages of workers have declined. In part, these excesses will be corrected by the decline of the stock market and the likely expensing of stock options. Even so, we need to establish some guidelines so that the situation does not reoccur in the next boom period. One example would be to peg the CEO's compensation to a multiple of the average employee's salary. Consideration should also be given to placing limits of the sale of company stock by CEOs and other insiders while they are in office, unless they acquired the stock with their own funds. My greatest concern with executive compensation are the grants made by compensation committees to executives who do not perform or are terminated. All too often these committees make excessive payments to these executives, sometimes to avoid lawsuits, or they adjust performance targets for the CEO and the management to enable them to earn more. These moves are simply wrongheaded, and they destroy the integrity of incentive systems. At the executive level, it should be "pay for performance." Period. 8. Executive sessions. To insure the independence of the board, the independent directors should meet regularly in executive session. I find this works best if the board meeting begins in executive session with the CEO, and concludes with an executive session without the CEO present. These executive sessions are much more open and often lead to rich discussions of the most vital issues facing the company. Of course, it is essential that the lead director convey the essence of the discussion to the CEO. 9. Board chemistry. The chemistry of the board is an elusive but essential characteristic. It is important that board members are respectful of each other, but not to the point where they hesitate to challenge each other, the CEO, and members of management. There are times when a single director must be prepared to stand against management and the rest of the board if he or she feels strongly that the company is headed in the wrong direction. It is not healthy for the CEO and individual board members to be too close as that can destroy independence. Nor should the CEO lobby individual board members between meetings to support his point of view. Several years ago Medtronic was considering the acquisition of a drug delivery company to complement its drug delivery business. One of the board members with vast pharmaceutical experience objected to the acquisition, as he believed it would inevitably pull the company into the pharmaceutical business, something we knew very little about. Although the board gave preliminary approval to the acquisition by an 11-1 vote, I decided that he was correct and pulled the acquisition off the table. Had it not been for his courage to stand against the management and the rest of the board, Medtronic would have made an acquisition that would have taken us in the wrong strategic direction. It is very difficult to build board chemistry if the board meets only for half a day, six times a year. Board knowledge and chemistry can be enhanced with off-site visits to company locations and one extended meeting per year, preferably off-site, to review the company's strategies in depth. These longer sessions give independent directors deeper insights into the company's business, and help build relationships, something that can be vital in times of crisis. 10. Reestablishing the bright line between governance and management. The bottom line is that directors must step up to their governance responsibilities, taking control back from the management. The first nine steps can be put in place, but unless the independent directors are prepared to establish that bright line between governance and management, it will all be for naught. Will this reduce the power of the CEO to manage the company? Not in my opinion. The best CEOs want to have a strong, independent board, and look to the board for advice and counsel, not just approval, on a wide range of important matters. Just look at Jack Welch at GE, Dr. Dan Vasella at Novartis, and Bob Ulrich at Target - all very strong, competent CEOs - and how they interact with their boards. All three use their boards effectively to help them guide the company while moving aggressively to succeed in the marketplace. Having a clear line between governance and management will keep the board from usurping the CEO's prerogatives just as it will constrain management. This will help restore the balance to decision-making and insure the stability of the corporation. Conclusion The severity of the governance crisis demands bold action in order to restore investor confidence and insure these problems do not recur. The modest criminal measures proposed by the President will not get us there. Rather, we need to transform our systems of governance from within. Doing so requires courageous and visionary corporate leaders and directors, not just people who react to the events of the last year and insure they are "unlike Enron." Nor can they simply figure out how to "game" the latest changes in the system so they can master them. Transforming corporate governance and boards of directors is the only way to insure the viability of the corporation and ultimately the capitalistic system. Doing so requires authentic leaders of our corporations and our boards of directors. 19 September 2002