Saturday, January 08, 2005

Directors on Notice

The New York Times
January 8, 2005

Directors on Notice

The New York State Common Retirement Fund has just done the cause of better corporate governance a service. As part of a broader $54 million settlement largely engineered by the fund, 10 former directors of the telecommunications giant WorldCom have agreed to fork over $18 million of their own money to settle a class-action lawsuit brought by the fund and other angry investors who lost hundreds of millions of dollars when the company collapsed in 2002, the largest bankruptcy in history.

WorldCom is an extreme example of what can happen if a board utterly fails to do its duty. Bernard Ebbers, the swashbuckling founder, was allowed to manage the company as a personal fiefdom. Among other shenanigans, WorldCom failed to deduct billions in expenses and was eventually forced to restate its results for 2000 and 2001, reducing its pretax income by an astonishing $74 billion.

Directors as well as company officers have almost always relied on company insurance to bail them out in situations like this. But the retirement fund and the other plaintiffs appear to have insisted from the start that any negotiated settlement include a penalty that would personally hurt board members in their wallets - the very wallets they sat on while Mr. Ebbers ran the company into the ground. As Gretchen Morgenson's account of the negotiations in The Times made clear, the plaintiffs were just as interested in sending a signal to complacent boards of directors elsewhere as they were in recovering losses, which in the case of the retirement fund amounted to $300 million.

One downside to the settlement is that the effort to frighten away the bad actors that still exist in corporate America could deter talented people from ever getting involved. This would run counter to the interests of investors, Congress, the Securities and Exchange Commission and the stock exchange, all of whom have been asking for a greater role for independent directors.

But this concern is outweighed, in our view, by the benefits. The WorldCom settlement will make boards elsewhere sit up and take notice. Lazy or incompetent board members, who in the past might have happily coasted along forever, enjoying the rewards of their post without doing the work, may decide to steer clear of a role that could expose them to financial penalties.

In strictly financial terms, no settlement is ever going to make bilked investors whole or anywhere near it. What will protect investors are boards that are effective in overseeing the companies they govern - who ask tough questions and do not ignore red flags that could prevent disasters like Enron and WorldCom from happening in the first place.