Good governance or cheap makeover?

New legislation aims to keep the business scandals of 2002 from repeating. But network vendors may still be glossing over the need for better corporate governance.

New legislation aims to keep the business scandals of 2002 from repeating. But network vendors may still be glossing over the need for better corporate governance.

Corporate governance is becoming the business phrase that defines early 2003, just as the Internet bubble buzzed 2001; New Economy, 2000; and pre-IPO, 1999.

Prodded by federal legislation and new rules from the Securities and Exchange Commission (SEC) and its financial arm, the Financial Accounting Standards Board, corporations have scrambled to remake themselves in the image of honesty. One such trend is the creation - or revitalization - of a board-level corporate governance committee, a tactic of such Network World 200 companies as Computer AssociatesMicrosoftSprint and Sun.

The idea of a board-level governance committee is not new. IBM formed one in 1998. But such committees are gaining teeth as nearly all companies scramble to resculpt their boards to comply with the Sarbanes-Oxley Act, pushed through Congress and signed into law July 30, 2002, in response to last year's billion-dollar accounting scandals and bankruptcies. This law's sprawling attempt to establish good corporate governance covers everything from the definition of independence for independent directors to rules for auditing quality.

Governance committees theoretically are being handed the reins of honesty, although each might have different goals. While Microsoft's governance committee directs compliance with the legal orders that the antitrust judgement has imposed, CA and IBM governance committees oversee board structure itself. CA's committee is tasked with finding directors, reviewing board performance and coordinating the CEO evaluation process, largely in an attempt to clean up the company's longtime bad-boy image. (A separate committee oversees the CEO compensation plan, an area that landed CA in trouble in 2000.) Likewise, IBM's governance committee reviews the qualifications of potential directors and compensation for outside directors, and handles the significant issues pertaining to corporate or public responsibility, such as workforce diversity or environmental impact. Best practices require that governance committees be staffed with a majority of independent directors.

The question remains whether any of this activity is making IT companies more honest. Board-level corporate governance changes are useful to the extent that they provide obstacles to abuses, says Warren Dennis, litigating partner in the corporate governance group for New York law firm Proskauer Rose. But that alone might not be enough, he adds. "The mythology says boards run the company, and management is accountable to the board. But the practical day-to-day operations are run by management, and, consequently, management runs the board," he says.

Loud proclamations of new governance practices could be nothing more than an act. Governance experts agree that badly governed companies, while perhaps complying with the letter of the law, likely will stay badly governed. Conversely, well-governed companies likely will remain so.

Questionable behavior is a trait of particular vendors, says Bernie Lubitz, director of telecommunication technology and services for Martin Memorial Health Systems, a hospital system with 10 locations in South Florida. Recounting his five-year struggle to get MCI WorldCom to rectify billing and service problems, Lubitz says, "I don't have any real answer why the company is so difficult. I've got to think that lack of ethical perspective starts at the top and is passed down to the rest of the employees."

Today, being able to spot a worthy vendor from a charlatan requires knowing how to evaluate the board's real role, understanding the typical ways tech companies go astray and recognizing the signs that trouble is afoot.

Split personalities

Some governance experts say the tech industry is no more badly governed than any other industry. But most agree it is more susceptible to some of the worst governance infractions. Then again, IT companies also tend to employ some good governance practices. For instance, they are open to change.

"Some things are built into the DNA of IT companies that are long-term governance strengths," says Ralph Ward, author of the book Saving the Corporate Board: Why Boards Fail and How to Fix Them. "IT companies are more willing to vote themselves out of business as a company - let's merge, let's consolidate, let's roll up - than a lot of older smokestack-type companies, where they think, 'We've got to stay independent.' "

Ward also points out that IT vendors tend toward smaller boards and more commonly will separate the chief executive and chairman functions than do companies in other sectors. "Tech companies have been a little bit ahead of the curve . . . because when you start out with a venture company, you tend to have those split roles," he says.

Examples from the NW200 include Cisco, EMC, Intel, Nextel Communications and, more recently, Microsoft. This contrasts greatly with the attitude in other industries, particularly venerable Fortune 500 companies. When the CEO is not also chairman it's seen as a vote of no confidence.

However, the value of splitting those roles isn't clear. Ward questions whether chairman is really enough of a job. "It's sort of like being captain of a ghost team," he says. "The CEO has all of the power - the budget, everyone works for his office. If you are solely the chairman of the board, what do you have? You have a piece of paper saying you have legal authority over a body of distracted amateurs, the directors. It's been an uneven match."

Dennis says role separation is "an issue of the cosmos. It's so idiosyncratic and has to do with the personalities, the history of the company."

Some network executives prefer to award contracts to vendors with split top roles. "I don't believe that a CEO should double as the chairman. If they are one and the same person, there are no upper-level checks and balances. The CEO can do whatever he wants in the day-to-day operation of the corporation," Lubitz says.

Plus, Sarbanes-Oxley (and the SEC-imposed rules supporting it), once implemented, could give boards some real power, making the chairman job more worthwhile. New SEC rules adopted in January require independent financial auditors to report their findings directly to the board audit committee, giving that body direct insight into - and better control over - company practices.

However, muscle gained from legislation won't stop crooked managers intent on deceit. Ward says: "It's still going to be possible to hide something in the closet from the board of directors. And I think directors know that." Likewise, Dennis questions who would be willing to sign up as the independent financial expert - one who has no interests as a stockholder, customer, partner or supplier - now required for a board's audit committee. The liability for that role is high, he says.

Users performing due diligence on their potential vendors should ask if the company has adopted new board-level governance committees or recently revised the charter of existing ones. A glance at the biographies of board members, available in the investor-relations section of most corporate sites, also could be helpful. In particular, members of the audit committee are far more empowered with governance matters than ever before.

Ask, too, if the board conducts formal, periodic evaluations of the CEO and ties compensation decisions into those reviews, Ward says. If so, the board likely has true and significant control over the CEO, he says.

High-tech weakness

On the downside, network vendors are particularly susceptible to one of the worst kinds of governance weaknesses: inflating valuations. The issue arises because no values exist for many assets that IT vendors commonly exchange. Dennis offers the example of the regional network service provider that owns fiber in Southern California but wants to grow nationally. Rather than laying new fiber nationwide, it exchanges fiber access rights with carriers serving other regions.

Such like-for-like exchanges are honest, Dennis says, and benefit cash flow. But no standard value has been set "for the right to pass an electron on someone else's network," he says. So corporate management and accountants guess that value. As these folks are pressured to grow the company, they might succumb to temptation and use ridiculously inflated made-up values.

Qwest landed itself in trouble because of such "swap transactions" in which it exchanged optical capacity, and payment for such, with another carrier. Logging that exchange as revenue while simultaneously failing to properly note certain expenses artificially inflated revenue. In September 2002, it wound up restating $950 million in revenue booked between 2000 and 2001.

Such temptation isn't restricted to exchange of networks. It involves any intangible asset, says Fred Kaen, professor of finance for the University of New Hampshire in Durham and author of the recently published book A Blueprint for Corporate Governance: Strategy, Accountability and the Preservation of Shareholder Value.

For tech companies, intangible assets such as engineering reputation and brand name tend to be worth as much or more than their physical assets, such as corporate real estate. "But placing a value on intangible assets is much more difficult than placing a value on tangible assets. So, more wiggle room exists for how to report value of the assets," Kaen says.

Dennis recommends that customers routinely skim vendor financial reports to watch for irregular transactions. Those should be more apparent now, if the vendor abides by the SEC's January ruling that companies disclose off-balance-sheet arrangements in their quarterly and annual reports. "If you see an irregular transaction and it doesn't make sense to you, it probably doesn't make sense," he says.

Other red flags, such as resignations or changes in outside auditors or law firms, might be easier to spot. The SEC has proposed that lawyers who spot material wrongdoing engage in a "noisy withdrawal" if the company refuses to alter course. Such a resignation, claimed for professional reasons or similar verbiage, would signal Wall Street and the SEC that something is amiss, Dennis says. Lawyers are balking at the proposal, saying a noisy withdrawal compromises attorney-client privilege and forces them into a watchdog role. However, Sarbanes-Oxley requires the SEC to establish rules of conduct for lawyers. So whether noisy withdrawal or some other resignation policy becomes law, customers should take a shift in lawyers or auditors as a warning.

A second problem for IT companies is the board with conflicts of interest. In addition to the pressure that all public companies have in finding independent financial specialists for their audit committees, tech firms face another challenge - the company-town environment of Silicon Valley, which remains the deepest source for potential directors.

"You have a hothouse environment, so it can make it a little harder to meet current best practice of so many degrees of separation," Ward says.

A final area where tech companies face the temptation of abuse is in using and reporting stock options. Many tech companies need to conserve cash to pay for growth. Offering stock options for employee compensation is one way of maintaining cash. "This compensation scheme sets up the potential for the owner/managers to use creative and aggressive accounting to make the company look as good as possible to public investors and thereby drive up the stock price," Kaen says.

One such abuse was failure to properly note the effect of stock options on overall financials. However, in this down market, options aren't the lure they once were. Most companies have bowed to political pressure and begun to expense them using a method called fair value. Fair value is a realistic estimate of the cost incurred to the company should employees exercise their options. The Financial Accounting Standards Board has issued new rules on how to execute the fair value method and has mandated more "prominent" and frequent disclosing of how stock options affect financials.

Network executives who determine how their vendors report options can better understand claims of financial growth.

Friends and small print

Look to the footnotes in proxy statements, quarterly and annual reports, and other formal SEC documents to get an idea on how serious companies are about their governance ethics. A proxy statement that notes a CEO lost a yearly bonus because of poor stock-price performance signals that the compensation committee is powerful, Ward says. Lubitz further recommends pulling Dun & Bradstreet reports, which indicate status with creditors, and looking at stock performance. He taps the wizards in his finance department to give him insight.

For Doug Jackson, director of technology customer services at University of Texas at Dallas, other IT professionals are the best sources of information on a vendor's governance practices. "We always check around with our peers and find out who has had a good experience with a vendor and who hasn't," Jackson says. "The corporate attitude permeates from the boardroom to the salesforce, and talking to other people that deal with the specific company on a regular basis is probably the best thing you can do."

For corporate governance, the lesson learned in 2002 is that everyone - the board, the accountants, the lawyers and even the customers - must be watchdogs.


Copyright © 2003 IDG Communications, Inc.

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