As more details begin to emerge in the scandal surrounding HealthSouth – the country’s largest provider of rehabilitative health care and outpatient surgery whose top executives stand accused of multi-billion dollar accounting fraud – the question again arises: Where were the board of directors and auditors during this time and why didn’t they know what was going on?


The same question has been asked about missing-in-action boards and auditors of other companies – ranging from Enron to WorldCom to Tyco – where all-powerful top executives at times treated the business more like personal savings accounts than publicly-owned enterprises.


As a result, companies not just in the U.S. but abroad are facing a series of corporate governance reforms, both legislative (the Sarbanes Oxley Act passed in July) and regulatory (New York Stock Exchange proposals published in August).


The NYSE proposals would require, among other things, that corporate boards of NYSE-listed companies have a majority of independent directors; that listed companies have audit, compensation and nominating committees composed entirely of independent directors; that non-management directors meet at executive sessions without management present and that they appoint a lead director to preside at these sessions; and that shareholders approve all stock option plans (with some exceptions, such as “employment inducement” options).


In Britain, board reform has been no less pressing, going back to 1992 when a wave of corporate scandals resulted in the Cadbury Committee report which, among other things, recommended that boards of directors of public companies include at least three outside directors as members and that the CEO and chairman posts be held by different individuals.


In January 2003, another report on corporate governance was issued in the UK. Titled “Review of the Role and Effectiveness of Non-executive Directors” and compiled by former investment banker Derek Higgs, the report suggests a number of controversial reforms. These include, for example, that senior independent directors act as liaisons with shareholders at meetings between shareholders and management; that half a company’s directors be independent non-executives; that an independent director chair the nominations committee, and that non-executive directors serve no more than six years on a company’s board.


The Higgs report, which will be used as the basis for a new code on corporate governance, has many current chairmen and board members fuming. A number of British executives have vowed to ignore its recommendations.  


Against this backdrop, Knowledge at Wharton last week interviewed Charles Miller Smith, chairman of the board of international energy company Scottish Power, based in Glasgow, and Robert Mittelstaedt, vice dean of executive education at Wharton and professor of management. In the course of his career, Smith spent 30 years with Unilever, the last five of which he was director of finance and a member of the Food Executive. He was appointed chief executive of ICI in 1995 and served as chairman from 1999 to 2001. He is also an advisor to Goldman Sachs. Mittelstaedt, before he was appointed head of executive education in 1990, founded, ran and sold a successful company in the medical industry. He currently serves on three boards of directors and served previously on three others. He is the co-author of a recent book entitled Knowledge at Wharton on Building Corporate Value.


The two men were asked to consider the changing role of boards of directors in what they say is becoming an increasingly volatile, litigious and risky environment. As Smith noted at one point during the discussion: “The social, political, and economic order will be so much more unstable in the next 50 years than it was in the last 50.”


Knowledge at Wharton: In the UK, the role of chairman of the board and CEO are now generally held by different people, unlike the U.S., where it is estimated that in 70-80% of companies in the Standard and Poor’s 500, one person wears the hats of both CEO and chairman. In your view, what arrangement works best?


Miller Smith: It depends on your culture. In America, you like powerful people having authority. Look at your form of government and the way it has developed since the 1780s. On the one hand you are the world’s greatest democracy, but on the other hand you give great authority to your president. There is a plus and a minus in that. The plus is you get very effective leadership. The minus is that when it goes wrong, it goes wrong spectacularly.


The power of the leader in America, including the presidency, is significantly greater than you see in the UK or in continental Europe. If you take Britain, think of [prime minister] Tony Blair who has to go before members of Parliament every week and answer any questions they choose to ask him.


The CEO of one of America’s largest corporations recently commented that it was inconceivable to split the two roles, whereas a very successful New York venture capitalist also remarked that he has institutionalized a system that divides the role of chairman and chief executive and clearly defines the responsibilities of each. The Brits are more willing, because of their culture, to live with the split in responsibilities and the ambiguities that result from that.


So what arrangement works best? The answer is, it depends.


Mittelstaedt: Recent studies suggest that companies in which the chairman and CEO positions are held by two different people perform no better than companies in which the roles are combined. In other words, it’s no guarantee against future scandals. I can’t see any evidence that performance improves by splitting the chairman and CEO role. Because of the scandals, a split may be appropriate in order to defuse the power, to provide the checks and balances needed to ensure that top executives don’t destroy the company.


Miller Smith: I would argue that there is another reason why having two people in the top leadership positions is preferable to single leadership. The nature and character of the world we will be in over the next 50 years will be very different than the one we have seen over the last 50. At the moment the world is focused on Iraq. But once that changes, the social, political, and economic order will be so much more unstable than it was from 1950 to 2000.


Economically, the world has had 20 to 25 years of sustained growth. That just won’t happen again. So we’re in for a shakier time in economic and financial systems. Politically, the world is going to change totally. We have grown up in an era where Europe and America essentially kept control of a world they understood. The Europeans, Brits and Americans might fall out on issues, but they come from the same cultural heritage. The next 50 years we will see the emergence of China and India, two cultures that America and Europe don’t understand.


And then there is terrorism and instability. Don’t think that by winning the war in Iraq we have won the war. We have won a battle. And we have stirred up a billion people. The reality is that America is now taking up a dominant position that it will occupy for the next 100 years, with a great deal of turbulence resulting from that.


The business community must [navigate through] this whole mix. I believe businesses will be extraordinarily difficult to organize and run. The task of running a company will become very much more complicated. Having two people working together at the top will be a better capitalist model in this tougher, nastier world that will confront us in the next 50 years.


Knowledge at Wharton: Is there any reason to change or modify the role of the chairman – who essentially manages the board – and the CEO, who is responsible for running the company on a day-to-day basis?


Miller Smith: No. Another way to view this is that the chairman looks outward to a whole range of intangible issues, including the ethical and moral values of the company, the robustness of its strategy, and the quality of the top executives running the business. He should also be worried about the quality and honesty of the discussion in board meetings and about relationships with shareholders. The CEO is responsible for looking at questions like: Who are my major customers, what are my major pricing decisions, should I take production out of the U.S. and move it to China. What strikes me about CEOs is that they barely have time to think. And in the future they are going to get even busier and the range of issues to be tackled ever more complex.


Mittelstaedt: In situations where one person holds both positions, you will often overhear CEOs talk about how much time it takes to manage the board. The way they say it suggests that it’s a matter of ‘I wish that wasn’t also on my plate,’ not because they want to give that task to someone else but because they wish they could spend less time doing it.


Knowledge at Wharton: One of the requirements of Sarbanes Oxley is that a company must have individuals who are certified financial experts on the board. In Britain, the finance director is often a board member. In the U.S., however, the finance director attends board meetings but isn’t a member. Which system is better?


Miller Smith: I believe you should have a majority of outsiders on the board but also a significant minority of quality insiders. Americans say you can have [these insiders] at the table but they don’t need to be on the board. Yet being at the table but not on the board is one of those intangible dividing lines that shouldn’t be there but in reality is. People just act differently when they have a legal responsibility rather than a table responsibility. So I think it’s a good idea in general to have finance directors on the board.


Knowledge at Wharton: In the U.S. there is frequently an issue of ego involved in the recruitment of a new CEO. If a person is not offered both the chief executive and chair position, it is somehow seen as a lack of confidence in that person’s abilities. 


Miller Smith: That is an issue for America and some other geographical regions which generally have one person in both those roles. India, continental Europe and I think China have systems similar to the UK’s. But I do think the UK system is going to become increasingly more necessary.


Knowledge at Wharton: What is your reaction to the Higgs report?


Miller Smith: I have a couple of reservations, although there is a lot I would support. First, the chairman should continue to chair the nomination committee except when his own successor is involved. Second, the senior independent director should be a safeguard mechanism, not a force for instability.


Mittelstaedt: I worry a little about its proposal that board terms be limited to six years, because it’s hard to make a contribution as a good director in any less time than that. There are very few boards in this country I know of that limit terms. In some cases you can serve a term but then must leave the board for a specified period, like two years, after which time you can be reelected.


Terms between six and eight years seem like a good number. Anything longer than that you become part of the wallpaper.  


Knowledge at Wharton: What is the likelihood that shareholders in the coming years will have more of an activist role in getting directors elected, or conversely, ousted?


Miller Smith: If you believe that the next 25 years won’t be as good economically as the last 25 years, then all of us as investors are going to be progressively unhappier in the coming decades, especially as pension provisions worsen. We will all as individuals get more uncomfortable and nastier. That will affect fund managers who at the margin will find it more and more difficult in a tough environment to outperform. One of the ways they can react is to be seen as more activist. Institutions are going to get more brutal in their dealings with companies.


Mittelstaedt: My concern about shareholder activism is that I’m not sure everyone understands how a board works. You need board members who are competent and can make a difference in the strategic direction of the company rather than members who will simply represent the interests of the shareholders in a narrow way. You can’t take people who have no expertise but who own shares, put them in as directors and expect them to help the company perform. That’s what worries me about a populist type of approach to electing directors.


Knowledge at Wharton: The business press keeps reporting not only on recent, sometimes exorbitant, increases in compensation for CEOS but also on increases for board members as well. The question arises, should board compensation increase when a company is performing poorly?


Miller Smith: No it shouldn’t and yes it may, because you have to attract talented people to run troubled as well as successful enterprises.


Mittelstaedt: You have to separate CEO compensation and board compensation. On board compensation, what you are seeing in this country is not that people are saying they won’t serve but that they will serve on fewer boards. Because the work load has gone up so dramatically, this year you will see increases in compensation for board service on many boards in the U.S.


Miller Smith: If I’m right, and the world will be much more difficult economically, politically and socially, then there will be fewer heroes in the next 25 years, so probably rewards will moderate because of the press and institutional pressures. But another bull market would change perceptions.  


Mittelstaedt: I think what we will see in the U.S. – because of the outrageous compensation of some CEOS – is more and more push for demonstrable ties between performance and compensation. Yes, stock options were supposed to do that, but the amount of options given out were at the discretion of the board and nobody looked at the details.Yet in many cases you just saw continuing layering on of huge numbers of options to the point where some high-tech companies had 15-20% overhang of options out there which, if all exercised, would have shifted substantial ownership of the company to management.


Boards are now required to disclose that they went through a process of trying to document [an executive’s performance] but it’s not always specific documentation. There is a boilerplate sentence or two that a company can get away with stating that the compensation committee considered a variety of factors, but it has the potential to be vague. I think you will see more push by activists to have the board document a clear relationship between compensation and performance.


Knowledge at Wharton: If you could change the way companies and boards operate in one particular way, what would it be?


Miller Smith: I would require absolute transparency on how the company is performing, so that you could, in five pages, really understand what was happening in the context of strategy and performance, both in terms of profit and cash. It’s very interesting that reports to shareholders in my lifetime have gone from about an inch thick to about five inches. Yet I don’t really believe that transparency has increased.


It’s the board’s responsibility that when the financial statements are sent out they properly display not the best view of the company but the real view. Problem areas should not be put further and further back in the appendices.


Mittelstaedt: I would add that independent directors have to take their responsibilities much more seriously than in the past. Behavior has already changed dramatically. My guess is that the Sarbanes Oxley legislation is going to be looked back on as terrible in terms of its specifics, but its impact has already been huge in terms of palpably shifting power in the boardrooms. Directors who previously were afraid to speak up are suddenly asking a lot of questions. They are engaged in a way that is very different from how it was.


I think we have to send somebody to jail in this country because CEO behavior in some cases has been so outrageous. When people actively try to steal from companies, that destroys confidence in markets in a way that is irreparable if it goes on too long.