How to fix corporate leadership in four easy steps

While many culprits have been identified in the spectacular collapse of so many iconic American financial and manufacturing firms, none bears more responsibility than the individual directors, the cream of the capitalist crop, who sat atop America’s largest and most influential corporations while executive compensation, product offerings, quality control, risk management and internal financial controls failed.

Something is seriously wrong with the U.S. model of corporate leadership.

At Lehman Brothers Holdings Inc., for example, the 10-person external board of directors included nine retirees, four of whom were more than 75 years old; one theater producer; and one former Navy admiral, according to a report in September. Only two had direct experience in the financial services industry.

Until three years ago, when I became the CEO of the San Diego City Employees’ Retirement System, I served in senior capacities in NYSE-listed companies and was CEO of one of the largest independent broker-dealers in the country. When I joined SDCERS, it was a public pension system synonymous with mismanagement and ethical lapses (e.g., my predecessor and several former SDCERS trustees are still under state and federal indictments). However, today a new SDCERS board and management team are operating in a model of board governance that is superior to most public companies. While many of the following governance concepts have been debated, and resisted, for decades, today they are working well at SDCERS. Indeed, if the following governance practices had been in place at more public companies, the recent economic meltdown might have been mitigated or avoided altogether.

Separate the chair and CEO positions. Until April 29, Bank of America Corp.’s Kenneth D. Lewis held three big jobs: chairman, chief executive and president. Is it possible that no one individual, no matter how brilliant and experienced, might not be able to handle these three assignments in today’s complex business and political environment? Could Mr. Lewis have been spread a bit too thin? The bank’s shareholders thought so, and they stripped Mr. Lewis of his chairman’s role, approving a shareholder proposal calling for an independent chairman. It’s too bad this effort came so late, was so contentious and didn’t have the support of BofA’s board until the proposal was approved. It should have happened years earlier.

At SDCERS, the CEO and board president positions are held by two different individuals, with the president elected by the other trustees while the CEO is hired and supervised by the board. (Indeed, SDCERS’ CEO is not even on the board.) Splitting these two positions and focusing their differing responsibilities creates a healthy check and balance, and provides appropriate oversight of the CEO’s performance. It also ensures that the board’s agenda will include a full range of issues and not be controlled by any one individual.

Remove CEO control over director selection. Corporate boards, even those with “independent” nominating committees, are too often composed of individuals approved by or beholden to the CEO, who is, in most cases, the board chair. As a result, a director’s personal loyalty to the CEO can affect his or her judgment and decisions, an issue that has become more pronounced with the escalation in director compensation and perquisites. One lesson we should learn from recent events is that public companies must select the most qualified and independent directors possible, with the CEO’s involvement in their selection kept to a professional minimum.

At SDCERS, the CEO has no control over trustee selection for its 13-member board. Five trustees are elected by SDCERS’ members. Additionally, seven are citizen trustees, who do not participate in the SDCERS plan and are nominated by the mayor and confirmed by the city council in public proceedings. In addition, the mayor appoints a trustee without confirmation. While I can encourage a citizen to seek appointment to the SDCERS board, it is up to the mayor and city council to nominate and approve these trustees.

There is no doubt that the CEO’s job is easier if he or she has control over director selection, but it’s just not appropriate. The board’s responsibility is to manage the CEO, not the other way around. SDCERS’ selection process ensures that the CEO’s relationship with trustees is professional and at arm’s length, and that the CEO’s performance and compensation will be evaluated objectively. There is no “old boys’ network” at play here.

Recruit directors who actually understand the company’s products and services. In the movie, “The Hunt for Red October,” Capt. Marko Ramius defects to the U.S. with his super-secret submarine, Red October. Russian Navy Capt. Tupolev, an aggressive, driven and ultimately reckless officer, finds Red October, but in his zeal to destroy it, he recklessly fires a torpedo that misses its target and circles back to destroy Tupolev’s own submarine. Just before his sub is destroyed, Tupolev’s second-in-command says: “You arrogant ass, you’ve killed us.”

Replace torpedo with “toxic financial assets,” and the story’s similarity to the behavior of many American financial institutions is striking. Directors of the financial firms that fired toxic assets into the marketplace had no clue what their companies were selling or the risks they were taking. In fact, directors too often lack an in-depth understanding of the products their companies sell or the risks those products pose.

At SDCERS, the board includes member representatives who, because they are participants in the plan, have a detailed understanding of the products and services we deliver. They use the product, they study the product and they know its features inside and out. Their knowledge of our business ensures that SDCERS’ products and services perform as expected and, if they don’t, the board and management will get almost immediate feedback noting the problem.

Get corporate compensation under control. Public company compensation is out of control and has lost its connection to fundamental precepts of compensation management. Corporate compensation committees and their consultants have failed shareholders and the public by instituting pay practices that motivate risky and reckless behavior.

My compensation as SDCERS’ CEO is only 5.7 times that of our receptionist’s. Would I like to make more? Of course. But the fact is the rewards of public service and the challenges of the job persuaded me to accept the board’s employment offer. The board offered enough to attract qualified candidates and not a dime more.

Indeed, since I have been at SDCERS, I have recruited a former private-sector CFO as well as CPAs, MBAs and graduates of Duke, Harvard, Notre Dame and Virginia without offering risky pay packages or incentives that can lead to bad behavior. The fact is outstanding people will work for reasonable salaries if the work is satisfying, challenging and rewarding.

In a recent news article, the CEO of a large public company justified his jumbo bonus on the fact that the company, which just experienced its most profitable year measured by earnings per share, is “in a cyclical industry, (and) that’s the way it goes.” But is that the way it should go? Were the company’s record earnings per share due to exceptional management or did a booming economy — for which the CEO deserves no credit — improve the company’s performance? In fact, it’s more likely that the CEO wasn’t so exceptional when the booming economy lifted all boats, including the one he and his management team were riding in.

In short, directors should start living up to the fundamental principle of U.S. corporate governance: that a corporation’s business and affairs “shall be managed by or under the direction of a board of directors” (Section 141, Delaware General Corporation Law). Responsibility for setting corporate strategy; selecting, compensating and evaluating the CEO; and ensuring the enterprise’s financial integrity rests squarely with the corporation’s directors.

Given SDCERS’ recent past, it may be surprising that its current governance structure is more independent and more effective than many public companies. However, if the SDCERS governance model were more widely adopted, public company governance would be more effective, shareholder and public confidence would be greater, and our economy more competitive.

David B. Wescoe has been the CEO and administrator of the San Diego City Employees’ Retirement System since May 2006. Mr. Wescoe, a lawyer, has served as the general counsel, CEO and chief financial officer of several public and private corporations. SDCERS disclaims responsibility for any private publication or statement of any SDCERS employee. This commentary expresses the author’s views and does not necessarily reflect those of SDCERS, any SDCERS trustee or other members of SDCERS’ staff.