Good experience, or the right experience? Why it pays to be picky when picking your board, says new research from Professor Yasemin Kor of Cambridge Judge.
When you’re looking for your next board member, it’s easy to be dazzled by a glittering CV. After all, it’s a high-profile position and you want the person with the most impressive experience, right?
Maybe. But new research suggests that longer CVs don’t necessarily make for a better board. Hiring directors with the wrong type of experience can actually have a negative impact on governance.
Yasemin Kor, Beckwith Professor of Management at Cambridge Judge Business School, looked at how directors’ past appointments influenced the growth of companies in an emerging market, the US wireless communications service industry. Her team looked both at startups and at existing companies that were diversifying into the sector, between 1983 and 1998. She says: “There were definitely some surprises for us. Three main messages came out of the paper: the value of experience in one’s own company; the potentially inhibiting effect of experience elsewhere; and the benefit of true outsiders.”
The first insight concerned the value of directors’ experience within the company itself. The study showed that entirely new startups tended to scale up their operations faster when their directors had accumulated more time on the board, gaining “firm-specific experience”.
Professor Kor says: “The longer they serve, the more they get to know about the specific company – so they can produce specific governance prescriptions that incorporate the unique aspects of its strategy, its capabilities, its main weaknesses and challenges, and so on.”
There was one proviso: these benefits reached a plateau when a director achieved around six years’ experience. “Over time, we see a group-think phenomenon develop,” says Professor Kor. “The whole point of the board of directors is that they provide checks and balances on management. So if the board becomes too cosy and uniform in its thinking – and too comfortable with the managers – it can result in staleness.
“It’s good to have some longer-serving directors, who perhaps have been there since the initiation of the company, because you want continuity. But if you have a high number of board members who have been there for a very long time, there are multiple negative consequences.”
A different picture emerged for established companies diversifying into a new market. If a director already had experience on the board of the parent company, this had a negative impact on the new subsidiary’s ability to generate growth.
She says: “We attribute this primarily to the fact that these directors are entrenched in the parent board operations. It’s almost as if there’s competition for the startup operation to get some board space and board time; and the longer the directors have served on the parent board, the less attention the startup seems to be getting.”
She believes the upshot of this is that companies should set up an entirely new board when starting a venture to compete in an emerging market.
An obvious place to seek directors is from competitor firms, given that they have
managerial experience in the same industry sector – but the study found that those who have already been directors of competitor firms turn out to inhibit growth rather than stimulate it.
The authors have several ideas why this might be so. Professor Kor says: “It could be that it exposes the firm to too much of its competitors’ business models, and it pushes the company to follow strategies that are too similar to what everybody else is doing.
“Managerial experience may be useful because it allows directors to connect with the new company’s managers, as they have gone through similar experiences themselves. But when it comes to directorial experience, perhaps this means they have a more superficial understanding of the industry – they’re prescribing what they’ve seen to have worked without fully understanding the ramifications. That’s our ad hoc explanation; but it’s still a puzzle.”
The third message is that true outsiders – directors drawn from other industries – had a strongly positive effect on growth. She says: “These are people with no experience in the focal industry. They can do the outside-the-box thinking, without entrenchment in the current business models within that industry. If too much knowledge is poisoning the ability of the firm to do strategic renewal or build unique strategy, these true outsiders are the cure.”
However, an over-reliance on outside talent brings its own set of problems, and they can be catastrophic. As a case study, Professor Kor cites one of the most infamous corporate failures of modern times: Enron.
She says: “You see these large corporations where there’s an overwhelming majority of non-executive directors on the board. They assume that they’ve solved the problem of independence and objectivity; that the board’s in tip-top shape and providing fantastic governance.
“But if they’ve been serving too long, they lose that outsider status; they start behaving like insiders, because they’ve become socialised among themselves and with the management. Governance is compromised.”
The take-away, when it comes to hiring directors, is that it’s vital to pay as much heed to the quality of their experience as the quantity. “These three types of experience are all important: the first being specific to the company, the second within the industry, and the third being this diverse knowledge of other industries,” says Professor Kor.
“They all have a role to play. But you have to combine them correctly – otherwise each can become toxic. The magic only works when they come together in the right combination.”
With the world of business changing so rapidly, boards need greater agility and members from a wider diversity of backgrounds. Less, or unconventionally, experienced executives are a good option.
When appointing Board members, organizations have traditionally sought candidates with a specific skill set from a similar background; generally, people with previous CEO experience who have managed an IPO or saved a company from a managerial crisis or the threat of bankruptcy. In today’s rapidly transforming business environment, however, this shared experience can be a hindrance and it is companies led by a Board of diverse genders, knowledge, abilities, personalities, nationalities and career paths, which are more likely to thrive.
Along with managerial experience, successful organizations look for directors with specialized professional backgrounds. They seek out those who know how to create an innovative mindset, and increasingly they appoint professionals who are able to understand and assist in transforming the capabilities of the business to meet the requirements of the new age. To find the best candidate to meet these changing demands, companies need to review the methods and patterns they use to scope and appoint Board members, and make the effort to extend their sights beyond candidates from a general management background.
When embarking on the selection process Boards would do well to take stock of their company’s present position, the phase it is at, and where it aims to be in the short and medium-term future. They should then create a profile for the prospective candidate, identifying the skills and experiences needed to complement the Board’s existing talent, and those required to address the foreseeable opportunities and challenges that lie ahead.
It is important that these profiles are sharp enough to identify people with a specific skillset, but not so specific they require a candidate to follow a pre-required career path. Nor so broad that the profile fits no-one entirely, and everyone in part.
There’s been a big push for risk management given the financial crisis and many other things impacting the economy now. So, institutional investor companies’ regulators have been pushing boards to do more oversight of risk management.
One important thing is, it really matters who is responsible on the board for risk management. There’s a lot of controversy right now in terms of whether it should be the board as a whole. Various regulators and groups have taken different stances on this. If you’re a member of the New York Stock Exchange, your audit committee is required to do board risk oversight. The Australian stock exchange is completely different. They say the entire board should be responsible for [risk] oversight, and the financial institutions — a lot of them are required to have a separate risk committee.
You’d better have the entire board responsible instead of delegating this to an audit or a risk committee. And something really interesting was, even if you have a separate risk committee, it seemed to have zero impact overall in terms of what the company does in terms of risk management practices and performance. So there is an instance where it does look like it may be window dressing.
The idea of risk management is not to get rid of risk. It’s to do things within your risk appetite and risk tolerance.
You really have to set in your charter having a whole board responsible. Now, you may decide that certain types of risks are handled by different committees. Obviously, financial risks are generally [handled by the] audit committee. You might have other risks go to other committees where the expertise is, but overall the board has to be responsible.
You have to have much better communication between the board and your senior management. What we found out is, if the only time that you actually talk to senior management about risk practices is during the annual or quarterly board meetings, it’s very detrimental. You really have to have these discussions outside the board meetings, and have an ongoing review of risk appetite and risk tolerance.
Once you’ve identified the key risks, you need to have somebody on the board — and this is part of the problem with delegating it to a committee. The audit committee — which is generally the committee that’s responsible — their expertise is with financial risks: credit risks, market risks, derivatives. They know almost nothing about cybersecurity, and that’s where you’re seeing the big push.
Once the board spends time figuring out where our issues are — maybe that’s when you need expertise there — you can’t expect existing board members to know much about this stuff. If nothing else, have them figure out who is the risk expert they’re going to hire within the firm, and enhance the communications that go on — even if you don’t have somebody on the board specifically who has that expertise.
Finance and accounting people are not experts at any kind of risk outside financial risks. So putting it there, which is the requirement of the New York Stock Exchange, so that the board audit committee will have oversight over risk — it’s just not right. Especially as you expand the number of risks we’re facing, or at least recognize them even if we’ve had them in the past — this notion that it should be the board audit committee, because they’ve always done risk, is not right. They’ve always done financial risks. They just do not have the expertise outside of that.
People generally have looked at whether there is some association between some overall risk management index or score and things like firm variability and stock price. The reason we start at the board is the whole notion that the tone is always set at the top. Forget about worrying about how I do individual risk management. The first thing you’ve got to do is get the whole company on board, and it’s got to start with the board of directors.
There are requirements in the United States and other countries where there’s actually board performance evaluation. Very few people realize this, but you’re supposed to evaluate the performance of your own board. And part of it is putting responsibility for risk management practices and board oversight into the performance evaluation…. We actually did find in our results that companies that do performance evaluations of their boards and incorporate risk management responsibilities in those evaluations — those were the ones who put in better risk management practices. So again, incentives and accountability are key — not just looking at the managers in your firm, but also looking at the board, and getting their incentives aligned with risk management.
One simple way to think about risk management is that all we’re trying to do is avoid risks or at least mitigate them if they happen. That’s only looking at the downside of risk. You can also use risk management to increase the value of the firm. Let’s take on the right risks. Let’s figure out where I have multiple risks in the firm, how they interact with each other — such that I don’t take one that has a big impact somewhere else.
Corporate governance broadly refers to the mechanisms, processes and relations by which corporations are controlled and directed. Governance structures and principles identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and includes the rules and procedures for making decisions in corporate affairs. Corporate governance includes the processes through which corporations’ objectives are set and pursued in the context of the social, regulatory and market environment. Governance mechanisms include monitoring the actions, policies, practices, and decisions of corporations, their agents, and affected stakeholders. Corporate governance practices are affected by attempts to align the interests of stakeholders.
Achieving best practices has been hindered by a patchwork system of regulation, a mix of public and private policy makers, and the lack of an accepted metric for determining what constitutes successful corporate governance. The nature of the debate does not help either: shrill voices, a seemingly unbridgeable divide between shareholder activists and managers, rampant conflicts of interest, and previously staked-out positions that crowd out thoughtful discussion. The result is a system that no one would have designed from scratch, with unintended consequences that occasionally subvert both common sense and public policy.
Rather than fighting issue by issue, as boards and shareholder activist groups currently do, they should take a bundled approach that allows for give-and-take across issues, thereby increasing the likelihood of meaningful progress. The result would be a step change in the quality of corporate governance, rather than incremental meandering toward what may (or may not) be a better corporate governance regime for U.S. public companies.
Perhaps the biggest failure of corporate governance today is its emphasis on short-term performance. Managers are consumed by unrelenting pressure to meet quarterly earnings, knowing that even a penny miss on earnings per share could mean a sharp hit to the stock price. If the downturn is severe enough, activist hedge funds will start to become interested in taking a position and then clamoring for change. And, of course, there are the lawyers, ever ready to file litigation after a big drop in the company’s stock.
It is ironic that companies today have to go private in order to focus on the long term. Michael Dell, for example, took Dell private in 2013 because, he claimed, the fundamental changes the company needed could not be achieved in the glare of the public markets. A year later he wrote in the Wall Street Journal, “Privatization has unleashed the passion of our team members who have the freedom to focus first on innovating for customers in a way that was not always possible when striving to meet the quarterly demands of Wall Street.” The idea that “innovating for customers” can be done more effectively in a private company is deeply troubling; public companies, after all, are still the largest driver of wealth creation in our economy.
With holding periods in today’s stock markets averaging less than six months, short-termism cannot be avoided completely. Nevertheless, dispensing with earnings guidance—the practice of giving analysts a preview of what financial results the company expects—would mitigate the obsession with short-term profitability. Earnings guidance has been in decline over the past 10 years, but many companies are nervous about eliminating it for analysts who have come to rely on it. Research shows that the dispersion in analysts’ forecasts increases after companies stop giving guidance—presumably because analysts are no longer being fed the answers to the questions. With less consensus among them, the stock market reacts less negatively when earnings are lower than the average view, thereby mitigating the pressure for quarterly results. Instead of providing earnings guidance, companies should provide analysts with long-term goals, such as market share targets, number of new products, or percent of revenue from new markets.
In exchange for the right to run the company for the long term, boards have an obligation to ensure the proper mix of skills and perspectives in the boardroom. Shareholder activists have proposed several measures in recent years to push toward this goal—principally age limits and term limits, but also gender and other diversity requirements. According to the most recent NACD Public Company Governance Survey, approximately 50% of U.S. public companies have age limits, and approximately 8% have term limits. ISS is urging more companies to adopt such limits, and if history is any guide, boards will give the idea serious consideration.
Activists and corporate governance rating agencies are motivated by a sense that boards don’t take a hard look at their composition and whether the skill set on the board reflects the needs of the company. Too often directors are allowed to continue because it’s difficult to ask them to step down. But age and term limits are a blunt instrument for achieving optimal board composition. Anyone who has served on a corporate board knows that an individual director’s contribution has little to do with either age or tenure. If anything, the correlation is likely to be positive. As for age limits, directors who have retired from full-time employment can devote themselves to their work on the board. And as for term limits, directors will often need a decade to shape strategy and evaluate the success of its execution; moreover, directors who have been in office longer than the current CEO are more likely to be able to challenge him or her when necessary. Yet these are precisely the directors who would be forced out by age limits or term limits.
A board serves as a check on a cowboy CEO. Boards often lack the intestinal fortitude for the level of risk taking that healthy growth requires. Board members are supposed to bring long-term prudence to a company, but this often translates to protecting the status quo and suppressing the bold thinking about reinvention that enterprises need when strategic contexts shift.
Conservatism tends to grow with the scale of the enterprise. At a very young company, directors do things early on that, have they not succeeded, would have led to their failure. Fresh boards consider those ambitious things to do. But old boards explore a couple of things that would be very high risk and decide not to pursue them. Because they’ve grown, the risk-reward envelope has changed shape, and there’s a lot more value at stake.
Directors’ risk aversion is driven by fears of bad press. The rise in stakeholder and proxy-analyst pressures has made directors sensitive to any decision that might provoke a negative reaction from the media, proxy-advisory firms, institutional analysts, or activist investors.
During a discussion about a merger, a director might point out that the company is front-page news for other reasons, and that a consolidation would likely fuel further media attention. The risk appetite is out of balance. Many corporate directors are wasting time on image topics when they need that time to debate business issues
Directors too often put self-interest and self-preservation ahead of shareholder interests. They like their board seats, because of the prestige. They can be reluctant to consider recapitalization, going private, or merging, because they might lose their board positions! In many situations, directors have a merger not go through because of who was going to get what number of board seats.
If directors join a board because of status or reputation or are risk-averse because of legal liability, then they are not as interested in making money, and they don’t represent the interests of the shareholders. For a business to thrive, both management and the board must always focus on long-term shareholder value.
One of the most important functions of the board is to insulate the CEO from short-term considerations. Although you can’t shout in media reports that the board is looking out for more than just the profit motive of today’s shareholders, directors still have a responsibility to provide air cover for management decisions that look beyond the next quarter’s, or even the next year’s, earnings.
No one should accept a director role unless he is willing to thoroughly prepare for boardroom discussions. Well beyond reading the briefing books sent out a week or more before meetings, directors should make sure they understand the workings of the company and stay abreast of industry developments. If you don’t take the time and effort to learn the business, the CEO can’t really have a dialogue with you.
CEOs have a responsibility to keep directors in the know. Formal board minutes are sparse and legalistic and can’t be counted on to trigger memories of earlier board discussions and conclusions. It’s easy to lose the continuity of thought from meeting to meeting.
If directors want more communication between their regularly scheduled meetings, a CEO should send an update letter in the middle of each quarter. And he shouldn’t hesitate to pick up the phone. If a CEO is dealing with a highly sensitive subject, he should call the lead director.
Compensation issues are increasingly a big deal; when one comes up, a CEO will talk to the HR committee to make sure they are on the same wavelength. All this between-meetings communication is necessary, because it’s a complex, complicated business. A CEO sends a weekly Sunday morning an informal e-mail to directors. He just wants them to know what’s on his mind.
With most topics, management can overwhelm the board with the facts, but that doesn’t mean management is right. The Venitis paradigm advocates a board of well-informed directors so that management doesn’t have to carry the burden of keeping the board up to speed. When the board has a collective sense of the issues, it can discipline the discussion.
When a company is facing a big decision, the CEO gives directors extra time to conduct due diligence and to deliberate. With key decisions, nobody is going to present an idea and ask for resolution in the same cycle. They’ll let the board know their thoughts and allow for conversation and discussion. The decision might be made at the following board meeting, or maybe the issue gets deferred until their next meeting, and they discuss it again.
Some CEOs would pack the board with like-minded cronies. But most CEOs don’t want a board populated by their golf buddies. Diversity is required in order to bring perspective and specialized knowledge to bear on important deliberations. It’s important to have directors from outside the company with different skill sets.
We abhor the celebrity director — the unengaged board member whose main contribution is star power. A marquee name on the board has a tiny marginal impact on overall corporate image. More likely, directors get a certain amount of prestige and social standing by saying they’re on a board.
There are many professional directors, who’ve retired from full-time employment. By some estimates, about a third of new board members fall into this category, and the concern is that their first interest is the preservation of their board seats. You want it to be a minority group that is doing it for the income.
There is an absence of energetic debate in the boardroom. One reason such debate is lacking is that conflict aversion sets in. On the one hand, that’s surprising, given that the room is full of opinionated, powerful people; on the other hand, it fits with what we know about the psychology of teams.
A fraternity culture can easily take hold in the boardroom, suppressing discussion and disagreement. In the boardroom, the thinking is you have to be equal, don’t be overwhelming or dominant, don’t hurt feelings, and don’t take someone’s chair. It’s all about getting along.
The good board strikes the right balance between the necessities for collegiality and for the board to function effectively as a team. You want to deal with multiple points of view and not make it hard for people to express their views, but you don’t want to have overpronounced collegiality that allows any person to dominate.
A bad habit is when directors take their opinions outside the open boardroom discussions, where they can’t be contrasted and integrated with other views. A director might drop in on the CEO after board meetings, often trying to overturn a decision or divert the direction the board was taking. A director might storm out of many board meetings on principle. He might pride himself on raising difficult subjects, but he isn’t willing to have a debate.
There is a superficial thinking of the corporate governance. The board is a social entity. And the human beings on it — they act like human beings do in groups. The longer individuals are there, the more allies they have, the more they have their dislikes, the more irrational they become in terms of personal conflict. I am amazed that more work has not been done to illuminate the social contract within a board.
Worst of all is when outspoken comments are completely unconstructive, focused on rehashing past mistakes or otherwise unrelated to the questions on the table. We don’t need directors on the sidelines saying, Oh, you missed the shot. You should’ve stayed in that city. Board members should police one another. It’s difficult when you make the CEO accountable for dealing with disruptive personalities.
Instead of aggressively advocating a point of view, directors should ask probing questions. Important decisions should emerge from intelligent stress testing, if only because that will help forge mutual conviction. A rubber stamp might be expedient in the short term, but a casual “sounds like a great idea” won’t have enough tread for a longer journey.
The payoff from the constructive conflict is that it’s their decision, too — and you hope they’ll have your back when the vultures come around. CEOs do not keep their boards in the dark or chip away at directors’ power. They recognize that they and their shareholders will get more value if the partnership at the top is strong. Great CEOs know that if governance isn’t working, it’s everyone’s job to figure out why and to fix it.
Most boards aren’t working as well as they should, and it’s not clear that any systemic reforms will remedy matters. Although governed by bylaws and legal responsibilities, interactions between CEOs and directors are still personal, and improving them often requires the sorts of honest, direct, and sometimes awkward conversations that serve to ease tensions in any personal relationship.
When strong relationships are in place, it becomes easier for CEOs to speak candidly about problems — for example, if the board isn’t adding enough value to decision making, or if individual directors are unconstructive or overly skeptical. For their part, directors should be clear about what they want — whether it’s less protocol and fewer dog and pony shows or more transparency, communication, and receptivity to constructive criticism.
The best leadership partnerships are forged, there is mutual respect, energetic commitment to the future success of the enterprise, and strong bonds of trust. A board does not adopt an adversarial show-me posture toward management and its plans. Nor does it see its power as consisting mainly of checks and balances on the CEO’s agenda. Good boards support smart entrepreneurial risk taking with prudent oversight, wise counsel, and encouragement.
A good CEO turns the focus to the human level, to what’s really going on in that boardroom, and listens to every informed perspective on what goes on there. Corporate governance, the system by which a company’s board of directors and management executives align themselves with shareholders’ interests in order to make strategic decisions, can be a catalyst (or constraint) to value creation. Value creation is a product of business fundamentals and investor perceptions.
Effective corporate governance enhances business fundamentals and investor perceptions, primarily through greater transparency and more effective decision making, and thus generates more value for shareholders.
Well-functioning boards of directors play an increasingly important part in shaping corporate performance and investor perception. In addition to their checks-and-balances roles, boards’ strategic guidance, oversight, and effective decision making can provide invaluable direction and support to companies as they grapple with the challenges of globalization, enhanced business volatility, and intensifying levels of competition.
Following standard practices, as traditionally defined, does not ensure success. Among companies that do achieve best-practice corporate governance, outcomes in performance and quality vary widely. In other words, there is more to governance best practices than most people think.
There are major factors that play an important role in fostering effective corporate governance. The real key to effective governance lies in its practices and processes that are often overlooked precisely because they appear to be mere details. In fact, these details, individually and collectively, have a tremendous impact on governance.
Addressing the magnificent seven factors can create an environment that facilitates proper flow of information, preparation of members, and setting of priorities. In the Venitis paradigm, boards can fulfill their overarching purpose: better decision making and improved investor perception, which are the catalysts to superior value creation.
Consider the magnificent seven hidden factors, the preconditions for achieving corporate-governance success:
Senior leaders’ engagement
A disciplined approach to decision making
Clear, carefully crafted mechanisms and protocol
Keeping things simple
Combining intuition with business models
Establishing a corporate soul based on values and virtues
A robust information infrastructure
The pyramid structure reflects the hierarchy of interdependencies. Engagement, the hardest factor to achieve, depends on the three lower layers of factors being firmly in place. The information infrastructure is at the base of the pyramid because it supports all the other factors.
These seven factors won’t apply to all companies in the same way; there is no one-size-fits-all approach. In implementing them, each company must consider its own particular characteristics and circumstances: its industry, ownership structure, organization, operations, and culture. It’s equally important to weigh the balance of power between the board and the CEO and how evolved the company’s governance policies and practices are.
No board can be expected to make sound decisions without the right information in hand, without open lines of communication, or without clear governance processes and protocols. Yet for many boards, these elements are often missing. Important but nonstrategic matters that should fall within management’s jurisdiction sometimes land in the board’s lap, while truly strategic issues that merit the board’s deliberation are dealt with by company management. Complex issues that merit preliminary analysis by a committee sometimes end up on the main board agenda prematurely, crowding out other matters that are ready for deliberation.
A host of other inefficiencies can impede the decision-making process, from less-than-ideal approval flows to poor meeting dynamics that distract members from the most essential issues. Underutilized or ineffective committees, ambiguous deadlines that create confusion, the absence of confidentiality protocols or guidelines on appropriate deliberation times—all can hamper decision making. Many of these inefficiencies can not only block the board’s ability to respond swiftly to critical company challenges but also undermine the quality of its decisions.
In an effort to ensure proper oversight, boards can also go too far in the other direction. Too much centralization can create needless delays, in turn impeding the company’s ability to execute or to respond in a timely fashion to external change. Boards can adopt any of a number of measures to orchestrate, streamline, inform, and improve their decision making.
The board reviews managements’ approval levels, and segments decision flows, by topic. The goal here is to ensure that the right parties are dealing with the right types of decisions in the right order. Which decisions should be delegated to management? Which ones might require preliminary review by a committee? Which ones should go straight to the board? Which ones might require advanced consultation and alignment with controlling shareholders?
Segmenting approval flows by topic facilitates in-depth analysis (clarifying when certain committees or other types of expertise are warranted). It also helps identify the types of decisions that have urgent deadlines, are confidential, have any statutory restrictions or requirements, or should be supported with additional data. Finally, the process prevents decision bottlenecking. It ensures that managers have the discretion they need to make decisions, and that their decisions are visible to the board. It also ensures that the board is freed up to focus on important elements of its mandate, such as issues of true strategic importance.
Evaluating approval levels, directors first decide whether current levels allow for sufficient autonomy and agility while properly controlling and mitigating risk. Analyzing the company’s recent performance under current levels and assessing relevant benchmarks is useful. Boards review approval levels on a regular basis, to ensure that they match current business realities and company focus.
The leverages committees to maximize their impact on board effectiveness. Many boards fail to capitalize on the analyses their committees produce. That means they also fail to take advantage of the other benefit that committees provide: alleviating the load of nonurgent issues for the board.
To ensure that committee work is integrated into board decisions, board reviews and, if necessary, redefine how its committees are structured. It looks at their activities, their timelines, and the roles of their individual members.
In addition, the board establishes standard channels and systematic opportunities for allowing committee intelligence to get into the board’s hands when needed. Not all committees need to be permanent, either. A temporary committee can be useful for ad hoc initiatives, such as exploring a potential acquisition or the possible need for an enterprise-wide IT overhaul.
The CEO creates a fast track for urgent decisions. The boards define in advance the types of issues that justify rapid approval and establish procedures that will facilitate speedy decision making. They consider ways to get the necessary information to decision makers quickly and determine which communication channels (videoconference, phone conference, or e-mail, for example) are the most appropriate. This is particularly important in an era of increasing volatility and uncertainty, when problems can rapidly devolve into crisis.
The CEO modifies the organization of board meetings. Agenda management may seem minor, but it can have a tremendous impact on effective decision making. Typically, agendas are developed in a way that presumes equal importance for each item by allocating equal time. That approach almost ensures that critical issues, especially those that aren’t at the top of the schedule, will be shortchanged. In planning the agenda, members consider the relative strategic relevance of each item and allocate time accordingly. That also means minimizing the time allotted to issues already explored in depth beforehand in selected committees.
The almighty CEO cowboy is over. Leading a company today has become a far more complex and more pressurized endeavor, thanks to globalization, market and economic volatility, more influential stakeholders, and more complicated business alliances and partnerships. The sheer speed of business compounds the challenges of due diligence and timely decision making. Moreover, all of these pressures have taken a toll on the chief officers; we’re witnessing shorter CEO tenures, higher CEO turnover, and executive posts going unfilled for longer periods.
Chief officers navigate the business landscape with the support, strategic guidance, and collective wisdom of a well-functioning board. A board cannot function well when its members and company management distrust each other, when crucial information is routinely missing or late, when meeting agendas are overfilled with nonstrategic matters. These disconnects impede cooperation and impair decision making. Ultimately, they can result in an underperforming board that, rather than mitigating company risk, amplifies it.
Corporate governance extends beyond compliance with rules and protocols. It is also about giving the company the power to overcome significant challenges and seize opportunities that build enterprise value. The CEO requires a robust information infrastructure that supports transparency and timely information flow. It requires processes that ensure the efficient and judicious use of time and resources. It calls for an approach to decision making that lets management and the board support, but not impede, each other in classic checks-and-balances fashion. These prerequisites in turn foster cooperation and engagement—the most critical ingredients for effective corporate governance.
Given that the all-powerful CEO is likely a thing of the past, we believe firmly that there is no longer room for laissez-faire boards or board-management power struggles. A powerful way to cultivate the partnership between CEOs, their teams, and their boards—and to govern the company wisely and skillfully to sustained value creation.
Directorship is a part-time job with full time accountability. Inherent in the board-CEO relationship is an information imbalance. However, with the right culture and board leadership, the board and CEO can easily communicate expectations and information.
A CEO’s leadership style can serve as an indicator that the risk of information asymmetry has become too high. Directors establish a level of trust with the CEO to allow for board access to other members of the senior management team, as well as site visits to see the company’s operations. With an expanding board agenda, process and expectation setting are critical. The board should clearly communicate to CEO the types and format of information that need to be presented.
An empowered lead director can help mitigate the risk of information imbalance. By facilitating communication channels and work between the independent directors and the CEO, this leadership position can break down some of the road blocks that may develop between the CEO and directors. The relationship between the CEO and lead director should be transparent.
Culture is critical in effective dialogue between the board and the CEO cowboy. With the right culture, directors can be sure they are aware of the risks that are keeping the CEO up at night. Sharing information via performance metrics, which are focused on what directors need to know, can bridge gaps in information flow. The board has to make winning decisions based on data, models, and intuition.
Directors balance short-term shareholder expectations with generating long-term sustainable profit. The role of the stakeholder, though, is more significant than ever before and expected to grow. Directors balance shareholder return with stakeholder concerns. It’s difficult for the board to address and to communicate with every stakeholder. The board identifies which stakeholders are critical to the strategic plans, and targets communications to those groups.
Corporate governance experts pay considerable attention to issues involving boards of directors, and with good reason. Boards are responsible for monitoring all aspects of a business (its strategy, capital structure, risk, and performance), hiring and firing the CEO, and answering to shareholders when something goes awry.
Because of the importance of these roles, companies are expected to adhere to best practices, some mandated by regulatory standards and stock exchange requirements and some advocated by experts.
One of the most widely held beliefs in corporate governance is that the CEO of a company should not serve as its chairman. In fact, over the last decade, companies in the S&P 500 Index received more than 300 shareholder-sponsored proxy proposals that would require a separation of the two roles. Shareholder groups have targeted prominent corporations including Walt Disney, JP Morgan, and Bank of America to strip their CEOs of the chairman title.
Companies, in turn, have moved toward separating the roles. Only 53% of companies in the S&P 500 Index had a dual chairman/CEO in 2014, down from 71% in 2005. Similarly, the prevalence of a fully independent chair increased from 9% to 28% over this period.
Despite the belief that an independent chair provides more vigilant oversight of the organization and management, the research evidence does not support this conclusion. One study found no statistical relationship between the independence status of the chairman and operating performance, while another found no evidence that a change in independence status (separation or combination) impacts future operating performance. Additional research actually found that forced separation is detrimental to firm outcomes: Companies that separate the roles due to investor pressure exhibit negative returns around the announcement date and lower subsequent operating performance.
Many believe that staggered boards harm shareholders by insulating management from market pressure. Under a staggered board structure, directors are elected to three-year rather than one-year terms, with one-third of the board standing for election each year. Because a majority of the board cannot be replaced in a single year, staggered boards are a formidable antitakeover protection, and for this reason many governance experts criticize their use. Over the last 10 years, the prevalence of staggered boards has decreased, from 57% of companies in 2005 to 32% in 2014. The largest decline has occurred among large capitalization stocks. While it is true that staggered boards can be detrimental to shareholders in certain settings — such as when they prevent otherwise attractive merger opportunities and entrench a poorly performing management — in other settings they have been shown to improve corporate outcomes. For example, they benefit shareholders when they protect long-term business commitments that would be disrupted by a hostile takeover or when they insulate management from short-term pressure, thereby allowing a company to innovate, take risk, and develop proprietary technology that is not fully understood by the market. One study found staggered boards improve long-term operating performance among newly public companies. Other studies also suggest that staggered boards can benefit companies by committing management to longer investment horizons.
Just because a director satisfies the independence standards of the New York Stock Exchange does not mean he or she behaves independently when it comes to advising and monitoring management. For example, a 2009 study examined directors who are independent according to NYSE standards (“conventionally independent”) and those who are independent in their social relation to the CEO based on education, experiences, and upbringing (“socially independent”). The researchers discovered that board members who share social connections can be biased to overly trust or rely on CEOs, regardless of whether they’re considered independent by NYSE standards. Those board members were more likely to pay CEOs more and less likely to fire a CEO following poor operating performance.
Other studies reach similar conclusions. One study found that directors appointed by a CEO are more likely to be sympathetic to his or her decisions and therefore less independent. The greater the percentage of the board appointed during the current CEO’s tenure, the worse the board performs its monitoring function. While independence is an important quality for an outside director to have, NYSE standards do not necessarily measure its presence (or absence).
Interlocked directorships occur when an executive of Firm A sits on the board of Firm B while an executive of Firm B sits on the board of Firm A. Corporate governance experts criticize board interlocks as creating psychological reciprocity that compromises independence and weakens oversight. While some evidence suggests that interlocking can create this effect, research also suggests that interlocking can be beneficial to shareholders. Interlocking creates a network among directors that can lead to increased information flow, whereby best practices in strategy, operations, and oversight are transferred across companies. Network effects created by interlocked directorships can also serve as an important conduit for business relations, client and supplier referrals, talent sourcing, capital, and political connections. For example, one study found that network connections improved performance among companies in the venture capital industry, while another found that companies that share network connections at the senior executive and the director level have greater similarity in their investment policies and higher profitability. These effects disappear when network connections are terminated. Other studies have found board connections lead to more successful mergers and acquisitions, and greater future operating performance and higher future stock price returns.
Many experts believe that CEOs are the best directors because their managerial knowledge allows them to contribute broadly to firm oversight, including strategy, risk management, succession planning, performance measurement, and shareholder and stakeholder relations. Shareholders, too, often have this belief, reacting favorably to the appointment of CEOs to the board. But empirical evidence is less positive. Studies have found no evidence that a CEO board member positively contributes to future operating performance or decision-making and finds CEO directors are associated with higher CEO pay. Additionally, a survey by Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University finds that most corporate directors believe that active CEOs are too busy with their own companies to be effective board members. Over the last 15 years, the percentage of newly recruited independent directors with active CEO experience has declined. Companies instead are recruiting new directors who are executives below the CEO level or who are retired CEOs.
Two-thirds of directors believe that the liability risk of serving on boards has increased in recent years, and 15 percent of directors have thought seriously about resigning due to concerns about personal liability. However, the actual risk of out-of-pocket payment is low. Directors are afforded considerable protection through indemnification agreements and director and officer liability insurance. Indemnification agreements stipulate that the company will pay for costs associated with securities class actions and fiduciary duty cases, provided the director acted in good faith. Insurance provides an additional layer of protection, covering litigation expenses, settlement payments, and, in some cases, amounts paid in damages up to a specified limit. These protections have been shown to be effective in protecting directors from personal liability. One study found that in the 25 years between 1980 and 2005, outside directors made out-of-pocket payments — meaning unindemnified and uninsured — in only 12 cases. A follow-up study of lawsuits filed between 2006 and 2010 finds no cases resulting in out-of-pocket payments by outside directors (although some of these cases are still ongoing). The authors conclude that “directors with state-of-the art insurance policies face little out-of-pocket liability risk. … The principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss.”
In order for a company to generate acceptable rates of returns, it must takes risks, and risks periodically lead to failure. If the failure was the result of a poorly conceived strategy, excessive risk taking, weak oversight, or blatant fraud, the board can and should be blamed. But if failure resulted from competitive pressure, unexpected shifts in the marketplace, or even poor results that fall within the range of expected outcomes, then blame lies with management or poor luck.
Even within the scope of its monitoring obligations, a board won’t necessarily detect all instances of malfeasance before they occur. The board has limited access to information about the operations of a company. In the absence of “red flags,” it relies on the information provided by management to inform its decisions. A board usually doesn’t seek information beyond this except in a few cases (if it receives whistleblower information, for example, or believes management isn’t setting the right tone through words or behavior).
Still, evidence shows boards are punished for losses. A 2005 study showed that director turnover increases significantly following financial restatements and that board members of firms that overstate earnings tend to lose their other directorships as well. Similarly, directors who served on the boards of large financial institutions during the financial crisis (such as Bank of America, Merrill Lynch, Morgan Stanley, Wachovia, and Washington Mutual) became targets of “vote no” campaigns to remove them from other corporate boards where they served.
The degree to which a director should be held accountable depends on a fair-minded assessment of whether and how the director might have contributed to the failure and whether it is reasonable to believe that he or she could have prevented it.
Boards and management regularly use key performance indicators or metrics to oversee their businesses. These metrics typically cover financial and operating matters and are specific to each company and within industries. Metrics may be financial or operational, qualitative or quantitative, absolute or relative, or focused on short- or long-term performance.
Metrics are critical to understanding and managing trends in the business and are often used to determine compensation. As metrics may garner close attention from analysts and investors, boards should understand how their companies’ metrics are chosen, developed and reported.
Choosing and Defining Metrics
Many different considerations go into choosing and defining which metrics are appropriate for a company. Ideally, the metrics will reflect the important aspects that show how the business is performing; whether measuring the number of customers or employees or amount of products or services provided to customers. Directors may inquire of management:
- How does each metric relate to the company’s strategic objectives and provide useful information to assess the company’s progress?
- How do the metrics track the company’s performance and prospects?
- Do the metrics serve as indicators of risk for the company?
- Which metrics do peer companies and others in the industry use, and in what ways are the company’s metrics intended to differ or align?
Board members should understand how the metrics are defined and calculated. Metrics should be readily verifiable with a transparent calculation methodology that explains any changes to the calculations. Directors could ask:
- How are our metrics calculated compared to our competitors?
- What judgment on the part of management goes into calculating the metrics and how can that change over time?
- What internal controls and procedures are in place to check the calculation of the metrics?
- Have we publicly explained the areas where our metrics require judgment on the part of management?
Companies generally disclose key metrics on a quarterly and annual basis in their public reporting. Directors might inquire:
- How much public emphasis do the metrics warrant?
- Does the reporting sufficiently explain the calculation and impact of the metrics?
- How does the management’s discussion and analysis (MD&A) narrative use those metrics to explain changes in the company’s financial results?
- How do the risk factors relate to potential changes that may affect the metrics?
- Are the metrics GAAP measures, non-GAAP financial measures requiring additional disclosure or operational measures?
- Are the metrics reported consistently and publicly in compliance with Regulation FD?
Using Metrics in Compensation
Pay-for-performance and say-on-pay measures have increased the focus on the interaction between performance metrics and executive compensation. Directors can ask:
- What is the intended relationship between the metrics and executive compensation?
- What impact do the metrics have on incentivizing behavior that could increase risks or undermine the company’s strategic objectives?
- What discretion does the compensation committee retain based on the chosen performance metrics?
- How will proxy advisory firms view the impact of the metrics on compensation?
- How will proxy advisory firms and investors, who often focus on the rigor of performance goals, view the impact of the metrics on compensation?
Directors may benefit from open dialog with management on these issues and from understanding external views on the company’s metrics. These steps can assist boards in understanding the business, considering the views of investors, assessing risks and determining appropriate levels of compensation.