WHAT CAN BANK DIRECTORS LEARN FROM RECENT CORPORATE SCANDALS?

It is amazing how varied the response of community bank directors has been to the recent spate of corporate fiascoes involving Fortune 500 companies. In meetings with bank boards throughout the United States, I have observed the sublime to the ridiculous. For many bank boards, the corporate scandals have had no impact whatsoever. Not even a mention in the board minutes. It is as if the tumultuous events of the past year never happened. The attitude seems to be, "That could never happen to us."

Other bank boards have reacted in the other extreme. They have adopted far-reaching corporate governance reforms that have dramatically transformed the composition of their boards and committees and the rules governing them. They now regularly meet in executive session without the presence of the CEO, in some cases breeding distrust and miscommunication. They trust no one - not the CEO, not the CFO, not the outside auditors or attorneys.

What are the right lessons to learn from the corporate debacles?

I believe the biggest lesson is that good corporate governance, while important and useful, does not prevent, in and of itself, corporate catastrophes from occurring.

For at least a decade, the American Association of Bank Directors (AABD) has preached to bank boards of directors the need to evaluate and adopt good corporate governance practices. The Sarbanes-Oxley Act and the proposed rules of the New York Stock Exchange and Nasdaq address many of the same corporate governance principles that AABD has advocated for years to its members. Some of the articles in this issue of Western Banking describe these principles.

Nevertheless, a closer look at some of the companies that were part of the wave of corporate disasters over the past year suggest that corporate governance is not the end-all. Enron and its "cousins" largely adhered to the good corporate governance standards in place at the time. They met regularly, they had boards and nominating and compensation committees consisting of independent board members, the board members were highly qualified individuals, the companies had codes of ethics in place, and many of the board members owned significant amounts of stock in their companies. Yet, the companies engaged in either misfeasance or malfeasance, or both, in some cases with the concurrence of the board of directors.

In an article entitled "What Makes Great Boards Great," in the September 2002 issue of the Harvard Business Review, Jeffrey A. Sonnenfeld argues that it is time to think less about how companies structure the work of the board and more about how companies manage the social system that the board of directors is.

Sonnenfeld points out that both good and bad companies have adopted the "right" corporate governance practices, and many fine companies have not. Following good-governance regulatory recipes does not produce good boards. In his opinion, which I share, the key is not structural, but personal and social.

A well-functioning board requires what Sonnenfeld calls "a virtuous cycle of respect, trust and candor." Respect and trust are functions of the quality of the people serving on the board and their performance on the board. Candor is the willingness to express your true thoughts in a group environment. Sonnenfeld points out, "Respect and trust do not imply endless affability or absence of disagreement. Rather, they imply bonds among board members that are strong enough to withstand clashing viewpoints and challenging questions."

The difficulty of creating an open and frank dialogue among board members has been recognized for some time. In the classic "Groupthink: Psychological Studies of Policy Decisions and Fiascoes," Irving Janis addresses the group dynamics at work that make participants desirous of conforming to the norm rather than speaking out.

Recommended course of action

A bank board's response to the recent corporate fiascoes depends in part on whether the bank or its holding company is publicly reporting, or listed on Nasdaq or the New York Stock Exchange.

Those banks and bank holding companies that are publicly reporting must comply with the corporate governance rules adopted by the Sarbanes-Oxley Act. Those banks and bank holding companies that are also listed on one of the exchanges will need to comply with the applicable rules of those exchanges. AABD has posted a summary of the requirements of the Sarbanes-Oxley Act and the proposed rules of the exchanges on its web site, www.aabd.org.

For the boards of publicly reporting banks and bank holding companies, a question will still remain as to what else should be done at the board level to insure that the mistakes of the past will not be repeated. The boards of banks and bank holding companies not subject to the Sarbanes-Oxley Act or the exchange rules should consider the same question, even though there is currently no statutory or bank regulatory compulsion for their boards to adopt any particular governance practices.

AABD opposes any rules mandating any formulaic approach to the adoption of the "correct" corporate governance practices for banks or bank holding companies not otherwise required by law.

However, we advocate a bank board's engagement in periodically evaluating what mechanisms would be useful in improving the performance and effectiveness of the board. Consideration should be given to establishment of a corporate governance committee or the expansion of an existing committee, such as the audit or executive committee, to undertake periodic reviews

Perhaps even more important is the development of a board that will function effectively through respect, trust and candor. The members of the board need to be qualified for their positions and to perform in accordance with the expectations of the board. They need to have the personal characteristics of integrity, honesty, independence and competence that the other board members can respect. They need the skills necessary to understand the reports that they are receiving from management, to identify and act on "red flags," and to ask management the right questions. They need to require management to provide them adequate and timely information about the bank. They need to believe in individual accountability and be willing to speak out at board and committee meetings even if what they say is counter to the prevailing view.