From Tone at the Top to Checks and Balances:
Learning From The Lessons of History

H. Stephen Grace, Jr., Ph.D.

The Institute of Internal Auditors
General Audit Management Conference 2003
March 10, 2003

Objectives and Background

The title of my remarks is "From 'Tone at the Top' to 'Checks and Balances': Learning From The Lessons Of History." The focus of my remarks will be directed to issues which I believe all of you here today understand quite well. That is, in seeking to improve corporate governance, simply emphasizing "the tone at the top" will not get it. What we must put in place is an effective set of checks and balances. We will look at why emphasizing only "the tone at the top" falls short; and we will look at what is required to put in place an effective set of checks and balances.

First, let me say a little bit about our organization and our interest in improved corporate governance. H.S. Grace & Company, Inc. is a team composed exclusively of senior executives who assist in the diagnosis and resolution of critical corporate problems. As such, we are keenly interested in and have spent much time over the past 7-8 years, analyzing and addressing the problems and opportunities associated with corporate governance. We believe that corporate governance is either a win-win or lose-lose, not just for the participants but for all of society. Corporate governance is not a zero-sum game with shifting of power from one party to another; it is a matter of all of us winning or all of us losing.

We are seeing, and will continue to see, a shift from emphasizing tone at the top almost to the exclusion of other efforts, to an approach directed toward the development of effective sets of checks and balances. Emphasizing the tone at the top really reflects a lack of understanding of human behavior. Furthermore, this emphasis on tone at the top overlooks important lessons of history. Our belief is that you must have an efficient, effective set of checks and balances among the participants in the corporate governance process. And you will note that we see this not as a three-legged stool as many people talk about it, but with many legs - one of which is internal audit. We believe that each of these groups - the board of directors, board committees, senior management, internal audit and the external auditor - occupy important roles.

There is an interesting quote of Margaret Mead that we believe is particularly applicable to the internal audit function. She said, "Never doubt that a small group of thoughtful committed citizens can change the world, indeed it is the only thing that ever has." This ties directly into our belief that the internal audit function, properly positioned and properly supported, can powerfully impact the quality of corporate governance.

Problems With Overemphasis on "Tone at the Top"

Let us look at the problems with the approach of just emphasizing the tone at the top. We all observe human behavior in action every day, and in spite of 5,000 years of wonderful guidance, spiritual and philosophical, about the paths human behavior should follow, breakdowns in behavior continue to occur.

I will touch upon some of this guidance for a moment because it is so powerful and so correct. Let's go back approximately 2,300 years. Here is Aristotle saying from Book 2, Chapter 5 in his politics, "There is the greatest pleasure in doing a kindness or service to friends or guests or companions, which can only be rendered when a man has private property." Aristotle emphasized that man's greatest joy comes from giving himself and his possessions.

Go back 300 years before that to Isaiah and this powerful quote, where he emphasizes the value to an individual of reaching out, of sharing themselves and their possessions with those around them: "Thus says the Lord: share your bread with the hungry, shelter the oppressed and the homeless; clothe the naked when you see them, and do not turn your back on your own. If you bestow your bread on the hungry and satisfy the afflicted; then light shall rise for you in the darkness, and the gloom shall become for you like midday." (Isaiah 58:7-10)

Anywhere from the time of Isaiah to perhaps as much as 600 or 700 years earlier, from the east we have the Tao Te Ching with its wonderful words, again emphasizing that the more we do for others, the happier we are; the more we give to others, the wealthier we are: "The Master has no possessions. The more he does for others, the happier he is. The more he gives to others, the wealthier he is."

Coming forward to just a couple hundred years ago, these are the powerful words of Immanuel Kant, the philosopher, emphasizing the existence of a moral law within us: "Two things fill the mind with ever new and interesting admiration and awe: the starry heavens above and the moral law within. ... I see them before me and connect them directly with the consciousness of my existence." (The Critique of Pure Reason, 1781)

Then there is Carl Jung, in the first half of the 20th century, with his statement, often quoted, that every one of his patients over 35 who had fallen ill did so because he had lost that which the living religions of every age have given to their followers - that same moral law of which Kant has spoken. "Among all patients in the second half of life ... that is to say, over 35 ... it is safe to say that every one of them fell ill because he had lost that which the living religions of every age have given to their followers, and none of them has been really healed who did not regain his religious outlook." (Modern Man in Search of a Soul, 1933)

And very recently, we have the wonderful words of Mother Teresa, the little girl from Albania who forever changed the face of the earth with her Simple Path, and particularly the last two lines of it, "the fruit of love is service; the fruit of service is peace": "The fruit of silence is prayer; the fruit of prayer is faith; the fruit of faith is love; the fruit of love is service; the fruit of service is peace." When you read of Mother Teresa or people who have met her, they all talk about this unrivaled sense of peace, in spite of the fact that she was involved in work which most of us could not even fathom for ourselves.

So we have tremendous guidance that has been given to us about the path that human behavior should take. But what all of you sitting here today know is that we continue to have breakdowns in human behavior. The Latin poet Ovid recognized this 2,000 years ago when he said, "The better things of life I see and approve, the worst things of life I follow." And what Ovid was saying 2,000 years ago, my good friend Rabbi Samuel Karff said to me in a note on a recent article of ours. He talked of human nature's capacity for noble deeds and disgraceful acts. Sadly, as we know, both are part of human nature and behavior, that capacity to go in either direction.

It is our observation, and I suspect that it is one that is shared by the majority of you here, that we cannot simply rely on ethical codes and moral persuasion to carry the day. Are these codes and moral guidelines important? Most certainly. They are very important and we should never lose sight of them. In fact, even though Sarbanes-Oxley calls for a code of ethics, there is a real question about whether a new, additional code of ethics is needed. We have had a tremendous code of ethics with us for over 4,000 years. That code of ethics is the Ten Commandments. Regardless, the fact is that, in spite of these wonderful guidelines and the guidance that we have received, the tendency for breakdowns in human behavior is always going to be with us.

Other lessons of history also have something to say about why simply emphasizing tone at the top will not get us where we want to go in terms of improved corporate governance. When we look at the lessons derived from the evolution of political governance, what do we see? We see a history for the most part of kings, monarchs, and dictators. However, we also know that throughout this history, continual structural stresses and troublesome issues arose. There was a consistent failure in "the tone at the top." Too often we had the type of breakdowns that the poet Ovid cited to us earlier and Rabbi Karff talked about in human nature's capacity for the noble deeds and disgraceful acts. And what happened over time in too many cases has been well characterized by Lord Acton: "Power tends to corrupt, and absolute power corrupts absolutely."

The knowledge gained from history, its writings and critical events, became the backdrop for and genesis of an historic event when 11 score and 7 years ago, 55 men said, "We proclaim these rights to be self-evident." A living democracy was formed. Democracy is still a continuing experiment, one that is built on a foundation of effective checks and balances. Our forefathers understood human nature's capacity to go off the track, and built in checks and balances in the Executive, Legislative and Judicial branches. While the system may seem onerous and time-consuming, our forefathers gave us and the world the best form of political governance we have experienced to date.

The Checks and Balances Framework

Clearly, emphasis only on the "tone at the top" will not deliver substantial improvement in corporate governance. Simple reliance on codes of ethics, while always important, will not get us there either. What is required is a corporate governance structure that incorporates effective, efficient checks and balances. Before building the checks and balances framework, lets just take a quick look at the evolution of corporate governance. Here is a thoughtful quote from Courtney Brown, from the preface of his book Putting the Corporate Board to Work: "Members of governing boards have a prestigious status in society - more prestigious than the present nature of their activities can support. It is a status that reflects the popular belief and expectation that governing boards do indeed govern. Building on that popular belief and expectation, the work of governing boards can and should be clarified and strengthened to the ultimate benefit of corporations of all kinds and of society at large."

Interestingly, Brown is no corporate gadfly. Instead, he served as the Dean of the School of Business at Columbia, and was a member of a number of prominent boards. His statement in the mid-70's puts a finger on the issue of concern today, and that is that corporate boards must in fact govern. Corporate governance is not a zero-sum game. When we look at the five participants I have set out here, the incorporation of effective checks and balances is not about shifting power from one participant to another. This is about the dynamic definition of the roles and responsibilities of each and every participant in a manner that optimizes potential synergies. Good governance results in a bigger pie, more to be shared by all of the participants. Poor governance has exactly the opposite effect.

Let me be clear on one point: We hear so much about the evils of capitalism and our capitalistic society. We must be careful not to consider human greed and foolishness as some inherent component of capitalism, or indictment of capitalism. Human greed and foolishness have been evident throughout history - in all cultures and in all kinds of political experiments. It is exactly what Ovid meant in his quote we touched on earlier - I approve the good things, but often follow the bad!!

Let us turn now to building the framework. This framework starts right at the top with the board of directors. We have always recognized that an essential role of the board of directors was to have an effective CEO succession plan in place. What is increasingly being recognized, and what is absolutely critical if, in fact, the board is going to "govern", is that the board of directors understand, approve, and monitor the strategic and operational aspects of the business.

There are multiple board committees that play important roles in ensuring that boards effectively govern. These include the nominating/governance committee, the audit committee, and the compensation committee, as well as others.

The ethics of board members must focus on responsibility, accountability, and service. Board members must understand their responsibilities, they must be accountable in addressing those responsibilities, and they must bring an attitude of service, and not of entitlement, to their role. To be effective in addressing the duties of the board, board members must be informed, involved, and, appropriately, have skin in the game.

Board members must understand the business; they must take the time and make the time to remain informed. They must be involved - the role of the board is to govern, not to be a friendly counselor or sounding board for the CEO. Oversight is not a friendly job. A certain level of friendship may develop among board members and between board members and senior management over time, based on the trust and mutual respect derived from the way the participants address their responsibilities.

The issue of skin in the game continues to be a challenging one. We, for a long time, have been concerned about the inherent conflicts of board members, members of the audit committee, etc. holding a large number of stock options. There is no doubt that having skin in the game helps ensure a board member's interest in addressing their responsibilities. There continue to be challenges as to the proper manner by which a board member's interests can be made to parallel those of the shareholders.

Senior Management is next. They must emphasize and support ethical behavior among employees at all levels, continually question whether decisions being made and actions being taken are in the best interest of shareholder value, and work to improve the efficiency and effectiveness of their relationships with the board.

Internal audit must be independent. Internal Audit must be placed in the proper structure in terms of its own operation as well as the overall corporate governance structure. Internal audit must receive the required support from the board, senior management, and others, and must have the required access to ensure that it can successfully address its responsibilities. Internal Audit must be accountable to the appropriate parties.

A quick word about other important areas in the corporate governance structure. A firm's legal staff must be qualified, must be independent, and must continually carefully assess who is their client. A firm's outside partners are also important. It goes without saying that the public accountants occupy an important role in the set of checks and balances in the corporate governance process. They are there to provide certain assistance to the board and management. Outside legal counsel is important. The role of major creditors is worth examining, as are the relationships between underwriters and a company's staff. The goal is always transparency, ensuring that these relationships are competitive, meeting ordinary and customary market terms, and that existing relationships between these parties and senior management and board members fall within customary and ordinary guidelines.

An important part of the corporate governance structure is the oversight and control system ("OCS"), or systems, utilized by the board, senior management, and others. In the case of the board, their OCS must go well beyond the P&L statement and the balance sheet. Cash flows should be tracked along with other key value drivers. This information provides timely, accurate insight into the operations of the business and aids enterprise wide risk management and oversight.

Interestingly, tracking items such as cash flow does not impose a major additional burden on the firm, as everyone here today knows. Firms should have in place business unit cash receipts and disbursement forecasts. Why would they have these? For the simple reason that senior financial management must understand both its long term financing needs and its short term cash management situation. These are both derived from the business unit receipts and disbursement forecast. The point is that with that information in place, it is fairly straightforward to take one additional step and to use this information to track actual cash receipts and disbursements occurring at the different business units.

These forecasts can be run through a business unit control center; the information can be funneled to the board and audit committee as well as senior management, and they can observe on a very timely basis the business unit's success in achieving the goals that have been set out. As we all know, cash receipts and disbursements are very straightforward items to track.

Inherent in the oversight and control system is the issue of enterprise wide risk management. There is much that could be said about this topic of course. In fact, the entire hour could have been spent discussing it. Suffice it to say that enterprise wide risk management addresses the identification of actual and potential risks and the monitoring of these risks and is a critical element in the oversight and control systems of the board, senior management, and others.

Addressing Corporate Governance Skeptics

Let me briefly comment on two topics that are embedded in this issue of seeking improved corporate governance structures. The first deals with the issue that certain individuals may say, well, corporate governance is a different problem than political governance, and checks and balances will be overly cumbersome and time consuming, and are just not appropriate for business governance. In response to that, I would say these individuals would do well to look at two business governance models, the general partnership model and the holding company model, where we see highly effective business governance in place. In the general partnership model, each of the investors is a general partner, with one of them being the managing general partner. The individuals representing the various general partners are informed, involved, and their employer has real skin in the game. These individuals understand their responsibilities, are accountable to their general partner (not the managing general partner), and bring an attitude of service to their role.

The holding company is one where you could have the CEO, COO, CFO, the Internal Auditor and perhaps others meeting with various key subsidiary leadership. Again, these individuals are not there to manage the businesses, but they are there to understand, approve, and monitor the operations. Most of these individuals are informed, involved, and have skin in the game. They understand their responsibilities, they are accountable to the holding company in the performance of these, and they bring an attitude of service to their job.

The second topic I want to briefly address regards new change agents that are emerging, change agents driving improvements in corporate governance. In the past, as we all know, the big players were the institutional investors and the plaintiffs' bar. We believe a new change agent is emerging - the D&O underwriters. These underwriters are not telling firms what to do. But by asking the proper questions, the D&O underwriters will force firms to address their corporate governance structure. Interestingly, the members of both the Institute of Internal Auditors and Financial Executives International welcome penetrating inquiries by the D&O underwriters. These inquiries aid in ensuring effective governance, starting with the board and encompassing all of the participants. All of us will be more effective in the performance of our jobs.

Concluding Remarks

As I move toward offering our concluding thoughts on improving corporate governance structures and the role of Internal Audit, let me make clear to you the depth of our involvement with these issues. H.S. Grace & Company is a team of senior executives. We provide specialized financial and operational advisory services. We consult on complex commercial litigation, which is an exploding area today. We advise on issues of corporate governance, oversight and control. We publish the Audit Committee Resource Book, the initial volume of which is on display in the conference bookstore. Very shortly it, and the new companion volume, will be available through the IIA. We utilize a strategic think tank, Grace & Co. Consultancy, Inc.

Grace & Co. Consultancy was organized shortly after the crises at Sunbeam and Cendant. These crises crystallized the need for us to work on improving corporate governance.

Grace & Co. Consultancy has 17 outstanding individuals on its Board of Advisors, all senior executives with extensive experience. We write and speak on corporate governance and related issues. From the material you received prior to the conference, you had the opportunity to review the group of Advisors, many of whom have served in senior financial management positions. The group includes four past chairmen of FEI, and a past chairman of the Financial Executives Research Foundation.

When our firm says Internal Audit is at the hub of all activity, we do not speak conceptually. We understand Internal Audit's contribution to the effectiveness of the Board's oversight and control systems and to management's control processes. We understand Internal Audit's role in identifying areas of risk and ensuring the integrity of internal processes. In our corporate governance advisory work, we help position the Board to govern, and to be able to demonstrate it is governing. An important component of that is ensuring that Internal Audit is properly structured and positioned in the corporate governance structure, that it has the required support and access, and that it be accountable to the appropriate parties. All of you here today know this is necessary for you to do your job. We know it too.

This leads me to my conclusion. St. Thomas Aquinas made the statement that "holiness is nothing else but a resolution made, the heroic act of a soul that surrenders to God." That is, an individual makes the decision to lead a holy life. I believe the overwhelming majority of members of boards, senior management, and internal and external audit have made a resolution to live and work ethically. They have integrity, they believe in codes of ethics. It is up to us to put in place systems of checks and balances which encourages and supports them.

Organizations such as FEI and IIA, institutional investors, the D&O underwriters, and firms such as ours can work together. We can learn from history. We can avoid the mistakes of the past. We can all win with a corporate governance structure and culture that will withstand the test of time.


H. Stephen Grace, Jr., Ph.D.
March 10, 2003

Disclaimer
Dr. Grace opened his address thanking the IIA, and recognizing the IIA's outstanding work in the area of corporate governance.  He then set out that, given his role as Vice Chairman of Financial Executives International ("FEI"), it was important to clarify that his remarks were his own, and did not represent the views or positions of FEI which has a well defined set of procedures for developing its positions.