Are Advisory Firms Conflicted in this New Governance Normal?

10/01/2012 04:16 EDT | Updated 10/02/2012 05:12 EDT

A major organization knows it is not running efficiently and that over the years, systems have been spliced on to other systems, behaviour has become entrenched, innovation has stalled and the bureaucracy has run amuck. The balance sheet is not looking good and tweaking the system hasn't helped.

The Board of Directors has called for change. A leading consulting firm has been called in to handle the assignment. The appointment of this firm is a bit of a mystery but nobody questions it. After all, this firm has a high profile in the business community. It wasn't an open bidding process. The initial fee is set at $1 million. A hundred of the firm's consultants descend on the organization and take up residence. At the end of Year 1, the consultants declare that the project is much more complex than they imagined and request another $1 million. The board isn't happy but grants it. At the end of Year 2, the consulting firm requests another $1 million. The board decides to shut down the project. Three years later, the culture of the organization hasn't changed, some of the IT systems have improved slightly but the project isn't considered a success.

This is not an unusual story. We see it in the news all the time; so much so that it doesn't give anybody pause. It is a common occurrence in public sector projects; cost over-runs, projects that go on and on with no end in sight. In the case just outlined, it so happens, the past Chairman of the consulting firm involved sat on this organization's board. A conflict of interest? Perhaps especially if there wasn't an open bidding process. A compromised process in that other board members didn't speak up when the project initially went over budget.

Another real example: if a lawyer has drafted anti-takeover devices to entrench management, such as poison pill, should that same lawyer act on behalf of a special committee of the board? This is an inherent pro-management bias, is it not? What about an investment bank that has also done work for management? This is a potential conflict too.

When boards engage law firms, should they use the same firm that management uses? We don't think so. Law students are taught that you cannot act for two clients whose interests are, or could be, adverse, e.g., a husband and wife in a divorce, a purchaser and vendor of a home, and so on. You can only act for one client at a time. Governance is really no different. The job of the board is to control management in the interests of shareholders. So how can a board use the same law firm that management uses? The interests of the board are inherently adverse to management.

When a board negotiates compensation for the CEO, it should have independent compensation consultants and lawyers. Richard sat beside a CEO at a conference once who remarked to him "I will outgun any compensation committee." When Richard asked why, he replied that they do not have the expertise or resources. Well, maybe they should.

In Sarbanes-Oxley, we now have auditors who cannot do non-audit related services for management, absent explicit approval. The Securities and Exchange Commission, in implementing Dodd-Frank, announced a few months ago that compensation consultants working for the board must now be independent from management. Proxy advisors may be regulated prohibiting their offering consulting services to management. The same rule should apply to lawyers.

Beyond that, boards must examine their practices and ensure that those members who have present or past affiliations with firms who may consult to the board are selected in an open and fair process. Management should have no part whatsoever in pre-selecting friendly advisors. The board must be free to retain its own unconflicted advisors so they are not "out-gunned." They set the tone from the top and ensure transparency of decision-making. Shareholders will lose when this does not happen.