Conflicts of interest: a corporate governance pitfall

Citation

Daily, C.M. and Dalton, D.R. (2003), "Conflicts of interest: a corporate governance pitfall", Journal of Business Strategy, Vol. 24 No. 4. https://doi.org/10.1108/jbs.2003.28824daf.002

Conflicts of interest: a corporate governance pitfall

Catherine M. DailyCatherine M. Daily is the David H. Jacobs Chair of Strategic Management, Kelley School of Business, Indiana University, cdaily@indiana.edu

Dan R. DaltonDan R. Dalton is Dean and Harold A. Poling Chair of Strategic Management, Kelley School of Business, Indiana University, dalton@indiana.edu

Whether a devotee of the arts or otherwise, most observers would likely concede that Michelangelo's Cistine Chapel creation is a remarkable example of fresco artwork. The scope of the paintings depicted on the chapel ceiling is awe-inspiring. In fact, it would be easy to miss some of the finer details of this work as one appreciates the overall creation. In many respects, corporate governance reform has taken on this same character. We by no means equate Michelangelo's artistic talents with those of the architects of recent corporate governance guidelines and proposals, but we do believe that efforts to prevent major corporate failures such as Enron Corporation through increased focus on corporate governance reforms may have the unintended result of failing to appreciate and attend to some of the finer points of reform as a function of focusing on the broader corporate governance landscape.

In particular, issues attendant with conflicts of interest in the boardroom have received relatively little attention, certainly as compared to issues of board independence. While the two issues are clearly interwoven, conflicts of interest represent one of the important subtleties when addressing independence.

Lack of director independence and failed board oversight have been implicated in a host of large-scale corporate failures. In response, legislators and oversight groups have either passed or proposed legislation and guidelines designed to enhance board effectiveness. In mid-2002, the US Congress and President George W. Bush signed the Sarbanes-Oxley Act. This legislation is primarily aimed at improving board independence and effective functioning, especially with regard to board audit committees. Similar guidelines have been proposed in the UK; these are outlined in a report sponsored by the Financial Reporting Council and chaired by Sir Robert Smith (colloquially known as the Smith Report).

In the USA, the New York Stock Exchange (NYSE) and NASDAQ have also reacted to the spate of corporate excesses. Both exchanges have proposed a series of additional corporate governance guidelines to which their exchange-listed companies must adhere. For example, the NYSE's proposed guidelines require boards to specifically determine directors' independence and disclose the nature of these determinations. Similarly, NASDAQ's proposed guidelines specifically prohibit any director from receiving more than $60,000 per year for services other than those provided as a board member in order to be considered independent. Such directors are also expressly prohibited from audit committee service.

While we applaud the intent behind these legislative and guideline changes aimed at strengthening and clarifying issues of director independence, they do not necessarily prevent conflicts of interest in the boardroom. That is, these changes, in concert, paint a beautiful overall picture of director independence; they do not necessarily incorporate or develop some of what we see as the finer points of boardroom conflicts of interest and how to avoid conflicts of interest.

To illustrate, NASDAQ requires the company's audit committee, or a comparable body of the board of directors, to review and approve all related-party transactions. We recommend taking this a step or two further.

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  Because the board as a whole is ultimately responsible for any decision regarding conflicts of interest, we recommend that these discussions be held in an executive session with all disinterested independent members of the board present. Excluding management (inside) directors from the discussion removes a potentially tempering force on independent directors' likelihood of raising concerns, particularly where discussions concern disinterested transactions between a director and management. As importantly, any director with an interest in the discussion should remove him or herself from the room for the same reasons. Without belaboring the point, our recommendation involves directors with an interest in the discussion at hand not simply excusing themselves from the discussion, but recusing themselves from the room during the discussion.

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  Any service or contract that involves either an executive or board member must also be subject to open bidding. Too often these types of transactions are not competitively bid, even when an interested board member excuses him or herself from discussion of the transaction. Whether the transaction at hand involves the purchase of a good or service from a family member of the chief executive officer or from an outside member of the board, the transaction must clearly be the most advantageous option for the firm – and ultimately shareholders.

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  The final recommendation we would offer for avoiding potential pitfalls as a function of boardroom conflicts is disclosing the entirety of this process in the minutes of the board meeting. While it is not necessary, and often not recommended, to divulge the nature of the discussion, the fact that any potentially interested board members recused themselves from the discussion, the fact that the discussion occurred in executive session of the board, and the fact that the transaction was subject to competitive open bidding should all be disclosed. This not only protects the board of directors, but also the company and its management.

Conflicts of interest can never be fully avoided in organizational life. As a result, we believe that full disclosure is an important element of protecting the firm and its owners. Even disclosure, however, may not be enough. Removing interested individuals from any discussion and decision-making role is also necessary. An apocryphal story illustrates the importance of both disclosure and recusing oneself in the case of a conflict of interest.

A judge was to preside over an important case. Prior to the hearing, the defendant gave the judge $20,000 to rule in his favor. The plaintiff, fearing an unfavorable outcome and unaware of the defendant's action, gave the judge $25,000 to rule in her favor. At the beginning of the proceedings the judge shared these transactions with those present in the courtroom, returned $5,000 to the plaintiff, and announced that the case could now proceed on its merits. Would you, as an observer, be comfortable with the judge's disclosure of these events? Or would you be more comfortable if the judge were to recuse himself from the proceedings altogether?