Editor: Ken, let's assume that a client has been asked to join the board of a public company. She came to you for advice that would be helpful to her in assessing the risks involved. Before we ask for your answers to some of the questions that the hypothetical client should pose, could you tell us about your background?
Menges: I have been a corporate securities lawyer for 25 years. I have a particular focus on corporate governance and counseling individual directors and corporate management. I am also head of Akin Gump's firmwide corporate finance and M&A section. I have broad experience counseling many different clients.
Editor: The company will provide the prospective director with indemnification as well as D&O insurance. Why should the prospective director be concerned about risk?
Menges: Any prospective director of a public company should intensively analyze that company. The risks to the individual directors are enormous in the event of a catastrophe such as Enron. In the case of Enron, the individual directors had to pay out of their own pockets to settle some of the litigation that resulted from the company's implosion.
Editor: Should the prospective director be concerned about the CEO's leadership style? Does the CEO listen to the board and its members?
Menges: That is an important part of the analysis that a prospective director has to undertake. It's not just leadership style. It's how the CEO and all of senior management communicate with the board - how they treat the board, and whether they view the board as a sounding board or as a rubber stamp.
Editor: Do the independent directors have a strong leader? Do they meet separately in executive session? How frequently?
Menges: These are important fact-finding questions that a prospective director should ask. The structure of the board is also an important consideration - does the board have a lead director or an independent director serving as chairman who serves as a balance to a strong CEO? It is a legal requirement that the independent directors meet in executive session. However, the content, frequency and length of those meetings are not generally legally mandated. Of those issues, content is the most critical.
Editor: How strong is the audit committee and what are the backgrounds of its chair and members?
Menges: This is important because the audit committee of every public company was given greatly expanded responsibilities by virtue of Sarbanes-Oxley. The audit committee is required to be populated with members who have financial backgrounds. It is important to note that the "financial backgrounds" of audit committee members may vary widely. In some cases, general executive experience at other public companies is treated as equivalent to specific financial expertise - prospective directors should find out if there are CPAs on the audit committee of a board or others who are intimately familiar with the rules governing financial disclosure.
Editor: Is there dissension within the board? Have significant numbers of shareholders expressed concerns about the CEO, board or board members?
Menges: As with the question about the CEO's leadership style, this is an important set of issues and sometimes it is difficult to get a candid answer. A prospective director should ask these questions because dissension on the board from the standpoint of the CEO might be characterized by other non-employee directors of the board as "healthy give and take" and frank exchanges of views.
Relationships with shareholders are also important. A prospective director should inquire about shareholder communications, particularly complaints relating to the CEO and board. Concerns of large shareholders are frequently reflected in the reports available from the many services including ISS that rank boards and make recommendations on whether shareholders should vote for or against board members.
Editor: Does the company have issues involving executive compensation? What is the board process for determining executive compensation?
Menges: This question pinpoints the current hot button in corporate America. It is a rapidly changing area, both in terms of the legal requirements imposed on companies for review and disclosure of executive compensation and with respect to the changing environment in the market and on Capital Hill. Each proxy statement must include a lengthy compensation discussion and analysis similar to management's discussion and analysis relating to financial matters that has been in SEC filings for years. The new law will require companies to present their compensation philosophy, compensation programs, and a number of charts covering designated individuals' compensation packages and, in some cases, their individual stock option grants. As to the process question, the prospective director should know who makes the recommendation for executive compensation changes.
There are current proposals in Congress to require companies to have an advisory vote by shareholders on executive compensation. This is a common practice in England and the rest of Europe. Although this practice is unknown in the U.S., there is very close scrutiny of executive compensation by institutional shareholders, especially pension funds such as CalPERS.
Editor: Do board members get adequate information concerning the company and matters to be presented to the board sufficiently in advance of the meeting? Do board members receive in advance drafts of all documents to be filed with public or private regulatory bodies that are required to be signed by them?
Menges: These questions may appear to a prospective director as elementary. Why would you ask a company if they provide board members adequate information when the answer is always "yes?" Yet, if the prospective director asks each board member this question there is a good chance that he or she will get different answers. This is in part because some companies take the position that directors need only summary financial statements and short reports on operational issues and strategic plans.
Editor: Do you have thoughts on the frequency of board meetings?
Menges: This issue is a difficult balancing act, especially in a very large company that has many different lines of business. One can question whether the board provides adequate oversight or asks enough about the company's strategic plans if the meetings are limited to three or four times a year and those meetings occur for less than a full day. In part, that can be offset by the increased frequency of the committee meetings. Audit committees have been meeting very frequently since Sarbanes-Oxley because of the need to meet independently with the accountants, to review the financial statements each quarter and to review earnings releases. The audit committee is also responsible for pursuing internal and/or independent investigations.
Editor: What is the "tone at the top" as it applies to compliance?
Menges: "Tone at the top" is a very important catchphrase for a critical aspect of corporate governance, namely the mindset of senior management about compliance and their willingness to set a compliance-oriented tone for the company as a whole. It can refer to whether a company is willing to bite the bullet and incur the costs of a compliance program, lose business to a competitor that is willing to bend the rules or get rid of wrongdoers in order to be consistent with the words in the company's mission statement.
Editor: Are employees at all levels made aware of the importance of compliance and provided with compliance training and an adequate means of reporting and seeking advice with respect to compliance issues?
Menges: Depending on the company's line of business, the scope and cost of a compliance program will differ. A company involved in a highly regulated business like the pharmaceutical industry will probably have a wider range of compliance issues than a company that is involved in sales and marketing of consumer goods. Compliance is important in both contexts, but different. Therefore, digging into what the company in fact does with respect to compliance is important.
Editor: What should the background, compensation and status of the general counsel be?
Menges: The extent to which the prospective director is protected against legal risk is highly dependent on the quality of the legal advice that the company is getting. In most larger companies the burden of providing such advice (and reaching out to outside counsel for specialized counseling) falls on the general counsel. Therefore, the legal skills, status, compensation and role of the general counsel are critically important to the prospective director. It is also important to determine how the general counsel interacts with the board - is the general counsel truly respected and valued and is his or her advice sought by the board? Is the general counsel present at board and committee meetings? Is the general counsel present only to serve as a gatekeeper for memorializing the actions of the board? Or, is the general counsel there primarily to address important issues?
Editor: What is the process for selecting a new general counsel?
Menges: As a matter of best practice, the board should be consulted. The search process itself is typically run by senior management. The CEO would be empowered to find a new general counsel in the event of a vacancy. However, the enormous responsibility that the general counsel of public companies has also requires that the board know who the person is and have some say in whether that person is the optimal candidate for the job.
Editor: Does the general counsel regularly meet separately with the independent directors and audit committee?
Menges: It is important to find out how much access independent directors and audit committee members have to legal and financial experts. Asking this question is a way to try to address that issue.
Editor: Do members of the legal department attend management committee meetings, including those involved with planning?
Menges: It is important for a prospective director to know whether members of the legal department attend meetings of significant management committees. It is increasingly common for public company management to have disclosure committees that meet periodically throughout the year, especially prior to quarterly or annual reports being filed with the SEC, and for those committees to go through a fairly lengthy review of company operations to determine if appropriate disclosures are being made. If the legal department is involved actively in those committees, that is another assurance that the legal aspects are being covered. If on the other hand the legal department is not involved in meetings of the disclosure committee before the 10-Q or 10-K is filed, that would indicate a lack of input by the legal department, which could lead to a compliance failure.
Editor: What role should outside counsel play?
Menges: First, the prospective director should seek information with respect to the company's regular outside counsel. Then the prospective director should examine how long that counsel has been representing the company and how the firm was selected. Is it a firm that appears to have a personal relationship with the CEO? That issue alone is not fatal, but potentially a risk factor. Is the outside counsel one that has relevant expertise in the company's industry and with public companies? As you peel back to a different layer, the prospective director should ask how often the directors hear from outside counsel. Is outside counsel's view always filtered by the general counsel or other management personnel or is there direct contact with outside counsel? How often do board members have the opportunity to independently communicate with outside counsel as to issues that may be of concern to the outside directors?
Editor: Do the legal department and the compliance function have the staff and tools necessary for them to discharge their compliance responsibilities, including recourse to the assistance of qualified outside counsel?
Menges: This question is important because one of the things the prospective director needs to figure out is what happens down the road when the inevitable bump in the road occurs. Is the company adequately staffed to fulfill its compliance responsibilities? Is it appropriately managed to deal with surprises? In the context of legal and compliance issues, some companies may view the legal and compliance function as a "cost center" and not adequately invest in those functions until they are forced to do so as a result of a problem.
Editor: How is the compliance function organized?
Menges: Compliance has a strong legal component that is most efficiently handled if there is a close working relationship between legal and compliance. In some companies there is a complete separation of the legal and compliance functions. No one structure is perfect.
Editor: What is the quality of the internal audit function?
Menges: In a well-run company there should be a strong internal auditor, one with extensive background in the field and who has sufficient clout within the organization to get to the bottom of issues no matter who is involved.
Editor: What is the process for selecting outside auditors and for review of possible conflicts?
Menges: This question is important because many public companies have chosen to or have been forced to change outside auditors in the past several years for a variety of reasons. The process that a company follows involves the audit committee, which is statutorily charged with making the decision on engaging a new auditor, but all directors should be invited to provide input.
There are bright line restrictions on services relating to certain services that may not be provided by the independent auditing firm that certifies a company's financial results. If the auditor gets substantial sums from a company for services not related to an audit, it may have a conflict of interest.
Editor: What is the succession plan for the CEO? What is the overall succession plan or policy with respect to board members?
Menges: The existence of a succession plan provides a prospective director with the assurance that the board is dedicated to planning for the future and that there will be continuity in the company's leadership. It also reflects that the CEO has included the board in what is probably the single most important action that the company will take.
Published March 1, 2007.