Independent directors sank Nortel

It is now five years since Nortel Networks filed for bankruptcy in 2009, after prolonged illness. Tragic as it is, the Nortel saga is valuable for its lessons in corporate governance. The emphasis in recent decades has been on directors’ independence and a bare oversight function for boards. The Nortel experience raises questions about their adequacy as universal principles.

Boards are the last line of defence in troubled or underperforming companies. When business is floundering and there is a churn at the top, as was the case in Nortel, the board’s role must be more expansive and robust. Nortel had five CEOs in its last 12 years with none completing the standard five-year term.

In recent corporate theory, directors’ role is essentially passive. Boards are expected to monitor managements, with a focus on “agency costs.” The framework is not quite sensitive to potential differences in individual companies. A more passive role and limited concern with agency costs might be sufficient for a company doing well in business and run by an effective management team. But they might not for underperforming companies facing business headwinds, leadership instability and other challenges.

To be clear, Nortel ticked the boxes in terms of having independent directors and a diverse matrix of skills on its board. Reflecting the stress on director independence, the CEO was the only full-time director on Nortel board since 2001. The other directors — all part-time, external — had excellent credentials and represented diverse backgrounds. As William Dimma pointed out, Nortel could not have done better in picking board candidates.

Yet Nortel’s board has come in for criticism. The irony is, the directors were only acting the role assigned to them in corporate theory. Being largely independent, they lacked adequate knowledge of the company’s business. As a monitoring board, the tendency was toward conservatism and caution while a dash of entrepreneurialism and courage might have produced better results.

Nortel board’s conservative leanings are apparent in two major decisions that contributed to the final outcome. One was accepting the recommendations of Wilmer Hale, the U.S. law firm engaged to inquire into the accounting restatements, and the other, filing for bankruptcy protection on the advice of financial advisors. Wilmer Hale recommended the “termination with cause” of CEO Frank Dunn and his team in 2004. This was implemented. The move triggered a leadership crisis and expensive shareholder lawsuits that blocked major business plans. Nortel did not recover.

The decision to file for bankruptcy protection was also made on advice from external experts — in insolvency and restructuring. Questions linger about the advisors’ conflicts of interests and the benefit they derived from providing professional services in Nortel’s bankruptcy proceedings. Filing for creditor protection had serious business consequences and weakened Nortel’s ability to sell some divisions. It culminated in formal bankruptcy some months later, marking the end of Nortel.

The decisions raise some important questions. Corporate law provides a safe harbour for directors to rely on expert advice, but a question is whether boards can supplant their judgment with that of external advisors. This would be a negative outcome of a protective legal device. Second, the external

Times of crisis call for more proactive boards

directors’ lack of hands-on knowledge of Nortel’s business and markets was probably a factor in their readiness to adopt external advice.

Significantly, the boards that made the two fateful decisions — accepting Wilmer Hale’s recommendations in 2004 and advice for bankruptcy filing in 2009 — consisted of different individuals. Yet the two were similar in complexion, made up of part-time directors with sound credentials but inadequate knowledge of Nortel’s business. The characteristics of the boards coupled with notions about the oversight function encouraged conservatism. It would not be in the DNA of such boards to be entrepreneurial and make bold decisions.

There are some other important features in Nortel’s unravelling. At least since 1996, the company’s business results were indifferent. As a result, Nortel lacked the financial strength and resilience that would help in weathering exogenous shocks such as market downturns. It is not clear how far the board was engaged with Nortel’s business performance. Also, the churn in Nortel’s leadership indicates deficits in succession planning, which is also a board responsibility.

The Nortel episode offers important takeaways. It underscores the problems with stressing director independence. This, by definition, excludes executives from boards. A natural consequence is that boards lack adequate knowledge of companies’ business and markets. This handicap would undermine directors’ ability to provide effective strategic guidance, particularly in times of leadership instability. There is a need to ensure adequate business knowledge for boards. Having a business and strategy committee of the board to constantly scan the business environment can be helpful. The committee can enhance the efficacy of directors in business oversight and in providing strategic guidance, which are increasingly recognized as board responsibilities.

The monitoring function relegates boards to a more passive position. It hampers directors’ ability to calibrate their function as situations demand. The need for board intervention will be greater in companies lacking effective leadership and/ or facing business challenges. In these situations, adaptive boards would be more appropriate. A stress on the adaptive quality can help directors switch from simple monitoring in good times to a more proactive role as needed. The business committee of the board can supply the inputs needed for providing effective guidance. Adaptive boards of this variety can, hopefully, prevent outcomes such as Nortel.