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BOARDS AND COMMISSIONS

Public sector directors should be activists

Excerpts from a speech by William G. Holland

As Illinois auditor general, Bill Holland has had plenty of opportunity to consider ways to improve the functioning of state government. His conclusion: Members of state government boards and commissions should take a more active role in overseeing their assigned agencies.

Holland, who has held the nonpartisan post for the past five years, is responsible for conducting financial, compliance and performance audits of agencies. He notes that while one-third of all audits have no findings, two-thirds do. Holland points out that the most significant findings in recent years have come from agencies governed by boards.

Following are excerpts from a rare speech by Holland, delivered last October at a luncheon meeting of the Taxpayers' Federation of Illinois.

In considering the audits that troubled me most over the last couple of years, I found a whole group of agencies that have experienced varying degrees of controversy and are linked by a common thread. That is, many of these troubled agencies are overseen — maybe the better word is "overlooked" — by a board of directors.

Now perhaps I am being unrealistic, but I prefer to think of boards as an added layer of protection rather than just another level of bureaucracy. It is the boards — members of which are often appointed by our elected officials — that have the skills and, yes, ideals necessary to oversee, assist and even challenge the day-to-day managers of state government.

Largely due to judicial interpretations of the fiduciary duty of care, the trend in the private sector has been toward activist boards whose directors are informed about the company's business and take an active role in its oversight. I would like to advocate for more activism by government board members.

In the traditional publicly held [private sector] corporation, there is a schism between ownership and control, power and authority. Although shareholders own the business, control is vested in the board of directors. The board, in turn, generally delegates the authority for day-to-day operations to a management team.

What the board cannot give away, however, is its fiduciary obligations. Under equitable and legal principles, the fiduciary obligations of board directors fall into two broad categories: a duty of loyalty and a duty of care. Generally speaking, the duty of loyalty prohibits faithlessness and self- dealing while, in most jurisdictions, the duty of care requires that directors act "with the amount of care that an ordinary prudent person would exercise under similar circumstances" [Thomas M. Schehr, The Wayne Law Review, Volume 42:1617, 1996].

In the past, the duty of loyalty was the primary, if not sole, barometer of whether a board was fulfilling its fiduciary obligations. In many respects, however, the duty of loyalty is a passive obligation, requiring directors to simply refrain from engaging in certain enumerated bad acts. Avoiding lining our own pockets in the course of discharging directorial duties is easy enough, I would like to think. If the duty of loyalty were our only duty, then directors could safely — and legally — snooze their way through most board meetings.

Unlike the duty of loyalty, the duty of care imposes some affirmative obligations on directors. For many years, however, the duty of care remained little more than an "aspirational statement" [Patricia A. Terian, Buffalo Law Review, Fall 1996], while courts and shareholders tolerated directors who were inattentive, passive or simply absent. Until the mid-'80s, the predominant posture of reviewing courts was to defer "to directors' decisions as sacrosanct business judgments and [question] them only if the outcome were egregiously bad" [Leo Herzel, Richard W. Shepro and Leo Katz, Harvard Business Review, January-February 1987]. While this so-called business judgment rule still survives, it is no longer the absolute barrier to legal liability it once was.

The modern theory, rooted in a 1985 Delaware Supreme Court case, is that directors will lose the protection of the business judgment rule — and open themselves up to judicial scrutiny and possible liability — by failing to act in an informed manner while carrying out their fiduciary duties. On a case-by-case basis, courts have said they will no longer tolerate corporate directors who routinely miss board meetings, give crucial financial reports only a cursory reading and fail to engage in meaningful questioning of management before endorsing its recommendations.

According to this recent line of cases, failing to "inform themselves, prior to making a business decision, of all material information reasonably available to them" [Terian] constitutes gross negligence and a breach of the

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duty of care by corporate directors. In short, "blind reliance on top management is [now] risky business" [Terian]. Under this evolved duty of care, for instance, a court imposed personal liability on a corporation's directors for authorizing an all-cash buyout on the sole recommendation of the company's chairman, without first obtaining significant details of the merger.

Courts are not insensitive to the repercussions of their involvement in corporate decision-making. As stated by the 7th Circuit in a 1986 case, "it makes directors overcautious, makes people reluctant to serve as directors, drives up directors' fees and officers' and directors' liability insurance rates, and leads boards of directors to adopt ponderous, court-like procedures. But the price is one the courts have been willing to pay."

While you may not agree that the benefits offset the costs, the inevitable result of heightened judicial scrutiny of corporate boards in the private sector has been a trend toward board activism.

Government hoards function in much the same way as their corporate counterparts. There are more than 400 boards and commissions, not including agencies and departments, throughout state government. These boards are responsible for overseeing everything from programs marketing Illinois apples, peaches and wine to running universities and multibillion dollar pension funds. Some of these programs are comparable in size to Fortune 500 companies. And yet, as in the private sector, these government boards often meet only a handful of II times each year. By design or necessity, their meetings are often mere formalities, where directors summarily ratify the recommendations of day-to-day management.

The directors of government boards are fiduciaries, as are their corporate counterparts. Courts have consistently imposed fiduciary obligations "on government employees who exercise discretion on behalf of the government. [Further,] holding government employees to a fiduciary standard is consistent with the theoretical foundations of representative government" [Kathleen dark, University of Illinois Law Review, Volume 1996, No. 1]. Surely the nature of public trust

There are more than 400 boards and commissions throughout state government responsible for everything from programs marketing apples and peaches to running universities.

calls for the exercise of a standard of care that is at least equal to what courts have imposed upon boards of private sector corporations. If, as courts and commentators have found, boards in the private sector are prone to inattentiveness, passivity, lack of information and a kind of corporate narcolepsy, these evils are no less likely to occur in the public sector.

Let me give you an example. In 1995, my office released an audit of the State Universities Retirement System, governed by a board, that questioned more than $56, 000 in administrative expenses, including: payment of both a $7, 000 car allowance and mileage reimbursement to the executive director; payment of initiation fees of $8, 000 and $1, 500, respectively, to not one but two private country clubs, as well as monthly dues and entertainment expenses; and reimbursement of credit card charges for such items as gold tie bars, theater tickets and a leather computer carrying case. The audit also questioned the granting of $28, 000 in bonuses to five members of top management at a time when the pension fund's rate of return on investments was less than 1 percent.

The board members' responses to these audit findings were varied. According to The News- Gazette of Champaign, two members complained that they had not been apprised of audit issues, such as bonuses; however, another board member stated, "We did know what the auditor general's auditors were looking at." Yet another board member pointed out that "the SURS board functions as a strategic body, not a board of control monitoring day-today expenditures." In an apparent attempt not to let the board off the hook, a system spokesperson stated, "We do not keep the board in the dark around here."

Well maybe not in the dark, but apparently not always in the light either. For, less than five months later, a new audit revealed that the pension fund had been used to reimburse political contributions made by fund management, in apparent violation of state and federal election laws. Now the headline in The State Journal- Register in Springfield read: "SURS board: Contributions to campaigns not authorized." Did the board know? Certainly management knew. These are interesting questions that were never fully answered.

Ultimately, the executive director resigned, a new board was put in place and the pension fund was reimbursed for several thousand dollars' worth of questionable expenses, including the political contributions. Significant reforms, aimed at ensuring that such lapses do not occur again, were begun by the pension fund's interim director and have been carried out and expanded upon by the new executive director.

While perhaps the dollar amounts involved in these findings do not seem significant, the number of incidents of questionable spending were, to say the least, alarming to me. Even more disturbing was that literally dozens of questionable expenditures were apparently escaping the board's attention and yet were ultimately being approved by the board.

If the State Universities Retirement System was an isolated incident, I would not be speaking on the topic today. It's not. For instance, the audit of the fund-raising arm of the Illinois Math and Science Academy for the

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two years ended June 30, 1995, disclosed that the Academy's not-for- profit foundation, governed by a board, had reimbursed the executive director for political contributions made during the previous four years. Unlike the State Universities Retirement System board, however, the IMSA board was aware of the reimbursements and gave its approval, apparently without knowing such reimbursements by a not-for-profit agency are generally prohibited by federal law. Following the audit, all reimbursements were repaid to the IMSA Fund.

There are other examples. For instance, Senate confirmation of members of the State Board of Education was held up [last] year, in part because of concerns about the board's oversight of questionable expenditures at that agency. In response to legislative inquiries, one of the members acknowledged, and I quote from The State Journal- Register, "The board didn't know about the problems until the audit, and 'we would have had more oversight had we known those things were occurring.'" That's a little like saying, "I would have checked the dipstick if I'd known the car was running out of oil."

Similarly, when questioned at a Legislative Audit Commission meeting about a Teachers' Retirement System audit showing a single investment manager lost $266 million in less than two years, the president of the TRS board said he was, according to the Chicago Tribune, "unaware of the magnitude of the loss" as cited in the audit until the morning of his appearance before the Commission.

And, despite its troubled past and recurrent allegations of poor oversight, several current and former members of the Illinois State Toll Highway Authority's board testified in a recent trial that "tollway contracts routinely are approved without being read," according to reports in the Tribune.

Unfortunately, I could go on to provide other examples. From my standpoint, as an outside observer with a unique insight into the workings of government boards, many of these instances seem incomprehensible and inexplicable. I can only conclude that, to the extent government boards share many of the same attributes and weaknesses as their private sector counterparts, the lessons learned by the private sector through litigation may be illustrative.

Board members said, 'We would have had more oversight had we known' there were problems. That's like saying,'I would have checked the dipstick if I'd known the car was running out of oil.'

And, at the risk of being accused of valuing form over substance, I agree with most courts that, generally, some formality of process is a bedrock of reasonable governance and essential to document due diligence. While I acknowledge that it is possible for bad decisions to be reached after protracted debate and good decisions to be made off-the-cuff, in my experience many audit findings arise from lack of procedure.

The following dos and don'ts are gleaned from court cases and treatises involving breaches of duty of care by corporate boards of directors. I believe these suggestions are equally applicable to public sector boards of directors. And while many of these suggestions may seem like no-brainers, there are board members who routinely disregard them:

• Attend board meetings. While "older court cases suggest that directors must be almost monumentally indifferent to attendance at and participation in board meetings to give rise to liability ... today, no one should become a director without being reasonably certain that he or she will actively participate in the board's work" [A.A. Sommer Jr., ABA Journal, June 1992].

• Do the homework. Directors should read information that is reasonably available to them. And they shouldn't, if at all possible, do it in the cab on the way to the board meeting.

• Ask questions. A director's reliance on the honesty of management should be reasonable, not visceral.

• Follow up on red flags. A board may not continue to rely blindly on the honesty and integrity of managers and employees once the directors have been put on notice that there is some wrongdoing. If a director does not feel the information is accurate or complete, he or she should be persistent.

• Provide training to new directors. Additionally, a prospective director should take reasonable steps to learn about the agency he or she is being asked to serve.

In summary, I believe the trend toward activism among corporate boards is one that could lead to great benefit in state government. I'm not suggesting that boards must stop delegating the mundane details of everyday operations. I'm also not suggesting that management should not be involved in setting strategic goals and making key policy decisions. And I certainly am not suggesting that increasing the activism of government boards is a panacea for everything that ails state government.

I am saying that when a board is entrusted with oversight of an agency or program, that responsibility is a serious one that requires a certain amount of diligence and due care to ensure that the public trust is safeguarded to the greatest possible extent. Vigilant boards of directors are often the first line of defense against misguided, apathetic or entrenched management. As my office goes about the auditing process, we will continue to remind boards of the crucial nature of their role.

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