A Lament on Corporate Governance
The following essay, which I wrote for a book with Hank Greenberg about AIG, laments recent decades of changes in corporate governance and is excerpted from the current issue of Directors & Boards, as adapted by its editor, Jim Kristie.
AIG’s founding corporate board in 1967 included luminaries who made AIG into the largest insurance company in the world. In the ensuing decades, AIG enlisted some of its most distinguished corporate officers to serve on its board of directors. Those traditional officer-directors not only knew the company and the insurance business well but were world travelers who understood the demands of building a global financial services company.
The early board appreciated the appeal of nominating some directors from outside AIG for election by shareholders. Such nonemployee directors offered fresh perspectives, opened doors to business opportunities and made decisions when employee directors faced conflicts of interest.
Outside directors who served during the 1970s through the 1980s included former cabinet officials, international business executives, foreign service officers, central bankers and financial accountants. In general, these outside directors served as senior advisors, without intending to second-guess managerial judgments, particularly concerning arcane insurance industry matters beyond their expertise. Outside director Dean P. Phypers (1979–1999), chief financial officer of IBM, noted that this was the standard corporate governance model of the period, at AIG and elsewhere: a collegial body operating in an atmosphere of trust and informality.
A changing model
That model began to change in the 1970s—just as American Home launched its thriving directors and officers (D&O) insurance business. Routinely ever since, in response to national scandals involving corporate misconduct, Congress passed new legislation and the New York Stock Exchange—where AIG listed its shares in 1984—adopted rules that increasingly required corporations to add outside directors to the board. The authorities also first suggested and later required increasing numbers of committees whose membership was limited to outside directors.
These changes were aimed at checking management shirking and enhancing corporate performance, though empirical research never provided much support that such reforms achieved such objectives. Legislators, regulators, and judges seemed to believe that, at the very least, outside directors would be able to exercise independent judgment. On that basis, as a “reform” to respond to crisis, elevating the number and power of outside directors helped forge political consensus. It did not matter whether directors had knowledge of a company’s operations or industry or any other expertise.
Letting political expediency dictate business practice is always dangerous and such universal regulation necessarily overlooked variation among companies. Concerning AIG, its roots as a private company, its long-standing entrepreneurial culture and engagement in the complex field of international insurance all pointed in favor of an inside board. Nevertheless, throughout this period of increased enthusiasm for outside directors on corporate boards, AIG successfully recruited capable people who added the value of their business judgment and experience and put the interests of AIG and shareholder prosperity first.
A board of big leaguers
From 1985 until his death in 1990, AIG’s board boasted William French Smith, President Reagan’s personal lawyer, a partner with the law firm of Gibson, Dunn & Crutcher and former attorney general of the United States. A similarly esteemed outside director from 1991 until his death in 2003 was Barber B. Conable Jr., a pragmatic professor and congressman for two decades before becoming a reforming pioneer as president of the World Bank. Yet another impressive independent director was Lloyd Bentsen (1994–1998), former U.S. senator from Texas, secretary of the treasury, and Democratic vice presidential candidate. In 1955, Bentsen had founded the Consolidated American Life Insurance Company, which he ran until 1967, and later created a billion-dollar private investment firm that formed global infrastructure funds, especially in Latin America.
With outside directors like these—experienced, informed professionals who understood what they could add and appreciated the limits of their expertise—the practice of nominating such directors for election by shareholders made sense. Despite such esteemed appointments, some corporate activists—from institutional investors, such as the California Public Employees’ Retirement System (CalPERS) and Teachers Insurance and Annuity Association–College Retirement Equities Fund (TIAA-CREF), to coalitions such as the National Association of Corporate Directors—campaigned in the 1990s and early 2000s to overthrow the AIG board’s traditional approach to director selection.
These campaigns were part of a national mission to amplify “shareholder voice” in American boardrooms and targeted large corporations. Some campaigns sought to promote diversity or affirmative action, but many urged greater numbers of outside directors, trumpeting their unique ability to render independent judgments rather than having any particular knowledge or expertise. AIG’s board opposed such proposals, citing the company’s decades-long record of profitability and tremendous growth in shareholder value.
The board as a ‘mechanism’
Another activist targeting AIG was an AFL-CIO affiliate, which proposed that AIG adopt a policy requiring that a majority of directors be outsiders. The argument contended that a corporate board is a “mechanism for monitoring management.” Labor union officials argued that meeting a strict test of independence enables directors to “challenge management decisions and evaluate corporate performance from a completely free and objective perspective.” It cited a lone study arguing that “corporations with active and independent boards enjoy superior performance”—though many more studies show that director independence has no effect on corporate performance. The objective in such campaigns was not always to improve performance as much as to strengthen outside directors while weakening management and the CEO.
By the early 2000s, AIG’s board included a combination of inside and outside directors who respected each other and worked well together with [Maurice] Greenberg. The board included 10 outside directors—a majority of the 18-person group as stock exchange rules by then required. The most senior was M. Bernard Aidinoff, the partner in the law firm of Sullivan & Cromwell who had represented AIG in its initial public offering, the establishment of Starr International Company (SICO), and many other transactions. Some held impressive internationalist credentials, such as Carla Hills, former U.S. trade representative with whom AIG had worked on trade in services. Ambassador Hills is a trained lawyer and Washington-based international consultant, with expertise that includes risk management. From that same walk of life, and also a trained lawyer, was William S. Cohen, former U.S. senator from Maine and secretary of defense, a committed internationalist with sound business judgment and expertise in Asia.
Others brought a diverse range of viewpoints. Ellen V. Futter, elected in 1999, ran the American Museum of Natural History and had been president of Barnard College. Futter, yet another lawyer, had chaired the Federal Reserve Bank of New York during a term when Greenberg was vice chair before succeeding her as chair. Elected in 2001 was the internationalist Richard C. Holbrooke, a senior U.S. diplomat who served in the Carter and Clinton administrations, including as ambassador to Germany, where AIG was eager to expand. Greenberg believed that Holbrooke’s knowledge of Germany would prove useful to AIG.
Despite impressive people, policies and performance at AIG, its board did not pass muster with the corporate governance gurus of the day and their national campaign for “shareholder democracy.” A 2000 report published in a trade magazine suggested as much, along with how misguided this campaign was. It listed what it called corporate America’s “five worst boards” and “five best boards.” The report stressed that it was not interested in a company’s financial performance, such as growth or profitability, but only in a dozen board attributes that then defined “good governance,” such as size, ratio of insiders to outsiders, women, minorities, and committee processes.
This approach is akin to a ship captain stressing the arrangement of deck chairs while ignoring leaks that could sink it. Using this approach, after noting that AIG “enjoyed enviable profitability and growth,” these “experts” listed AIG as having the “third worst board.” The “third best board,” under this approach, was that of Enron Corp., which the next year was revealed to be a multibillion-dollar fraudulent cypher, with scarcely any assets, income, or substance.
More power to the board
In response to such debacles as Enron, in 2002 Congress passed the Sarbanes-Oxley Act. It adopted a one-size-fits-all regime of governance and auditing including yet more power for outside directors. The New York Stock Exchange marched in lockstep with an additional set of homogenous requirements. The new regime’s added roles for outside directors led AIG’s board to have a nominating and corporate governance committee. The committee met often and quickly produced newly required governance guidelines, committee charters and ethics codes, and stricter conceptions of “independence.” The latter had the effect of stripping Futter’s “independent” status because the Starr Foundation had made substantial donations to the American Museum of Natural History that she ran, though the foundation would have supported the museum whether Futter or someone else headed it, as it had since 1973 when it made its first gift to the museum.
A related novel requirement was an “executive session” of the board, a separate meeting to occur around regular board meetings but solely for outside directors. No management directors were permitted, under the theory that they wield too much power in the boardroom, resulting in the “structural bias” of the outside directors, compromising their capacity for “independent judgment.” Another fashion begun in corporate America during this period was the “lead director,” chosen from among the outside directors.
The world had changed
These changes and devices—enacting into law what activists had sought for a decade and AIG shareholders had rejected—upset the unity that AIG’s single board historically demonstrated. It effectively incubated a group of outside directors with newfound inspiration to challenge insiders. Some of AIG’s outside directors became more assertive, many beginning to ask questions on matters beyond their competence. Some questions struck Greenberg as naïve, uninformed, or worse, and he would say so. They might call for a tutorial on the ABCs of insurance, international trade, or corporate structure that was an inappropriate use of board time. The traditional mutually supportive and respectful relationship among board members frayed.
Greenberg was growing impatient with the new universal regime in corporate America where outside directors came to rule over territory they did not always understand. He knew his corporate world had changed and believed it was not for the better. But the worst was yet to come.
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[To friends who have not yet obtained a copy of the book from which this essay is excerpted but are interested in getting one: email me and I'll see if we can find an extra copy to send.]