The New Environment
A rash of spectacular corporate failures (many immediately attributable to greedy and criminal executives) has spurred a wealth of scrutiny and regulation of corporate governance. Beyond fraud, interested parties have identified base causes ranging from a breakdown of morality in the 21st century, to excessive executive compensation, to stock option programs that have incented undue concentration on short-term results and to failures of process or will in boards of directors.
The regulatory fallout has generally produced intended enhancements to the "control elements" of boards of directors. The central theme has been to remind directors that they are in a position of trust, with a purpose of restraining management and ensuring the integrity of systems and reporting. Thus, initiatives ranging from the Sarbanes-Oxley legislation through securities commission and stock exchange reforms on both sides of the border in North America have concentrated on the presence of independent directors, independent functioning of the board of directors, specific board approval processes (for nominations, stock option plans, related party transactions, codes of ethics, exemptions and executive compensation), leadership through an independent chairman/lead director, independent functioning of financially literate audit committees and transparent compensation committees, integrity of internal processes, mandated publication of committee reports and the creation of environments hospitable to the reporting of corporate misbehaviours.
There are two significant implications for existing and potential directors. First, directors must now spend increased amounts of time on and attend more rigorously to the affairs of their companies. Management, on the other hand, must accept the increased involvement of directors. Accordingly, along with the "control elements" of boards in the new governance world has come recognition of the positive contributions that good directors and good boards can make. These contributions include: participation in the engagement and ongoing evaluation of the CEO; involvement in the engagement of other senior management; planning for and implementing senior management succession; strategic planning; hands-on problem solving for particular issues that arise from time to time; the identification of risks in the business, strategies to mitigate the risks and suitable communication with respect to these matters; and director recruitment, evaluation and succession planning. Studies published recently have confirmed that well-governed companies outperform their peers and that investors are willing to pay a premium for companies they perceive to be well-governed. In short, there is recognition that, since director quality and attention are increasing anyway, companies should use the qualified people on their boards to deliver positive contributions as well.
Second, it is becoming increasingly difficult to recruit the sorts of directors that the new environment requires. Commitment and time levels associated with directorships are increasing. Legal and reputational exposure and risk are apparent, and have been heightened, along with increased transparency of director activities and critical interest in them. Directors are reducing the number of boards on which they serve and are cautious about invitations to join new boards. Director compensation is increasing, and directors' and officers' insurance coverage now often involves more limited scope and significantly higher premiums.
In this context, how can you build a great board–a board that demonstrably fulfills the required "control elements" and that delivers on the positive promises that the proponents of boards as the cheapest form of consultancy (consultancy that is ongoing, committed and spans a great breadth of expertise) advocate? The answer lies in a long-term, committed and comprehensive process dedicated to building a great board of directors.
The Board's Role
The starting place is an understanding of the board's role. The board of directors has an independent function in the overall corporate setting. It has its own responsibilities to address and contributions to make. It is essential that the board appreciates its role as different from that of management (whose primary responsibility is to propose and execute on corporate strategy).
Many of the corporate governance reform initiatives have identified the need for board and committee mandates as a fundamental aspect of good governance. This attention is well placed. It is important for the board to articulate for itself, management and other interested stakeholders the areas that are its responsibility and those that will fall to others. This begins with a board mandate that describes the sphere of responsibility of the board and expectations of board members, and that carves out a sphere within which management, under the guidance of the CEO, can operate. In the absence of a mandate of this sort, confusion can be expected and is common. Thus, the board may not be involved in important initiatives undertaken by management in the belief that they are within the operational sphere, and board meetings may be taken up with attentiveness to matters that should be within the purview of management (within broad frameworks established by the board).
One of the companies of which I am a director was highly acquisition-minded a couple of years ago. Management brought to the attention of the board certain acquisitions that were proposed or in process, but did not bring others to us, in the belief that they were too small or otherwise contemplated under other authorities. After discussion, the board mandate, which was in the course of development at the time, was clarified to provide that those acquisitions involving a purchase price payable in stock, or greater than a specified amount, or acquisitions that were outside of approved strategies, whatever their size, were to be brought to the board, but that other acquisitions could be pursued without further authority from us. This, incidentally, led us to implement an annual retreat, during which management could propose and the board could become comfortable with an overall strategic framework within which management could operate. Good directors will not come to or stay with a company if their roles are unclear.
The process of developing mandates cascades down from an overall mandate of the board through to mandates of board committees (typically audit, compensation, corporate governance, human resources and nominating, under various names, and sometimes combined), defining the roles and responsibilities of these committees, both vis-Ã -vis management and with respect to the extent of authority delegated by the board of directors. Because of perceived abuses, corporate governance reform has required written (and published) mandates for some of these committees in an attempt to ensure that director responsibilities are made clear. But this is good governance in any event.
Commitment
The development of a great board of directors requires commitment. The commitment is ultimately that of the board itself to the recruitment of quality directors, the evolution of suitable processes, succession planning and holding management accountable (even, indeed particularly, when this is an unpleasant task). Directors depend on other directors for commitment to a team effort. But as boards are being created, and as the evolution to a high quality board first reaches take-off speed, the relevant commitment is often that of management (and/or a principal shareholder), who must take the lead.
While directors often find themselves on the boards of companies with out-of-control management, they rarely join boards of this sort knowingly and voluntarily. Accordingly, a significant element in recruiting directors is the commitment of management to providing an environment in which the directors can function, and to being responsive to the views of directors. This is obviously the case in a controlled private company, where a meaningful board of directors is (typically) not mandated (at least until outside investors appear): the board is created because the controlling shareholder feels there is value in having one, and is (ostensibly) willing to be responsive to board concerns. As one progresses to public companies, in which boards and particular director skills are required, the equation does not change from the perspective of a potential director recruit. If management does not appear to be interested in permitting a director to function effectively, the balance should tip a quality candidate against accepting a board seat. In virtually every director recruitment exercise with which I have been involved recently, director candidates have conducted their own (extensive) due diligence on this issue, speaking with management, other directors and outsiders who deal closely with the company, in an effort to understand the commitment to a strong and independent board and the (expressed) willingness of management to expect and accept critical comments and advice.
Management's commitment begins with words. However, there are concrete steps that can and must be taken to translate this commitment into tangible results. As more directors become more independent (in the sense of not being members of management and not otherwise having significant ongoing involvement with the company, whether as relatives, service providers or otherwise), the need for meaningful and timely information increases. New directors must be oriented in terms of learning about the business, learning about existing board mandates and processes, learning about applicable board and corporate policies, obtaining suitable industry and stock market analyst background, accommodating meeting dates and other like matters. The company's commitment to a professional job in the corporate secretary function is highly relevant to having these processes and materials (that will typically include a substantial director's manual) in place. A company that is not committed to educating its directors quickly, to providing them with the material they will need on an ongoing and timely basis, and to suitable meeting processes (designed to facilitate focus, discussion and decision on important issues) will find it increasingly difficult to recruit quality directors.
The commitment to an environment in which directors can perform must also be that of the other directors. Just as no director should walk into a rogue-management scenario, so no director should join a board on which the other directors do not share a comparable view of the board's roles and responsibilities, or comparably high levels of integrity. Directors require a degree of like-mindedness in pursuing core objectives, and solid group support in the inevitable bumps that will come.
A company's commitment is also evident in the time expectations of directors and in director compensation. Companies must assess the nature of the commitment that is expected of directors and align expectations as part of the recruitment process. While it might once have been the case that a director could anticipate attending four half-day meetings a year and reading an hour's worth of material to prepare for each (for a total commitment of less than 20 hours a year), today's expectations are quite different. While companies and views vary, it would not be surprising in the case of an average-sized public company that a director should anticipate attending six board meetings a year, six committee meetings a year, a full-day strategy retreat, a full day's worth of management presentations/company visits and spending several hours of preparation time for each of these matters. Accordingly, the base time commitment is easily in the range of 100 hours, and can quite quickly become 200 hours, per year. In the case of board or committee chairs, and in situations in which the company finds itself in any sort of business, management or governance crisis, the time commitment can easily double.
Directors' compensation in Canada has, historically, been a fraction of that paid to directors of American companies. There is ongoing debate about the manner in which compensation should be paid, whether it should include stock options or other stock-related components, and the virtue or otherwise of required director stock ownership. However it is clear that the overall value of directors' compensation in Canada is increasing sharply and rapidly (up some 50% in the past year alone). Since directors are expected to perform a real job and to dedicate committed time to their responsibilities, they must be compensated accordingly.
Similarly, directors' risk must be addressed. Ultimately, the responsibility for risk mitigation is that of the board itself. Risks of embarrassment and of legal liability are mitigated by directors' doing their jobs responsibly and effectively. When this is done, the only risk that remains is of vexatious lawsuits, and the cost of their defence (which has always been potentially substantial and, in the past couple of years, with the migration of class action proceedings from the United States to Canada, has escalated significantly). Accordingly, appropriate directors' and officers' insurance coverage (the cost of which has also increased substantially in the recent past) must be in place. Directors (and their advisers) are becoming more sophisticated in looking beyond the simple question of the coverage limit to supplementary matters and exclusions.
A Process
The process of building a great board of directors is just that: a long-term, committed and continuous process. The material above has attempted to demonstrate that, before qualified directors can be recruited, there must be suitable environments and commitment. Beyond this, companies must recognize that the development of their board is evolutionary. Ultimately, a board must operate as a collective entity, with a degree of cohesion and satisfactory group dynamics. The board must be comprised of the appropriate number of directors whose skills and interests are suited to the needs of the company for the moment (and some time into the future), and to legal and regulatory requirements that may apply.
All public companies must now (either legally or practically) have audit, corporate governance and compensation committees. Audit committees must (again, either legally or practically) be comprised of independent directors who are financially literate and with a financially expert chairman. Audit committee duties are extensive, and audit committee members are therefore unlikely to be members of other committees. These other committees must be staffed with directors with skills and interests suited to the committees' needs. Realistically, public company boards require a minimum of seven or eight directors once account is taken of the one to two management/principal shareholder directors who are likely to be included.
The next step is often to compile a list of desirable skill and experience sets (beyond independence) that will be optimal to have on the board. While attention is often (unduly) focused on CEOs (or retired CEOs) of comparable companies as director candidates, other specific sets that are frequently relevant include financial expertise (accountants, financial officers or investment bankers), human resources, communications, legal, entrepreneurial, large business, international, sales and marketing or mergers and acquisitions expertise, connections or abilities relating directly to aspects of the company's business (manufacturing, professional services, research and development) that are likely to be of particular importance in the foreseeable future.
Companies often spend too much of their time focused on these factors to the exclusion of important "table stakes" factors. Personal qualities that are essential in all good directors include integrity, independence and common sense. The range of issues that can be relevant to a board is extensive, and it is enormously important that directors approach their tasks with unquestioned integrity and an ability to make sound judgments, whether in their area of distinctive expertise or otherwise.
Directors must be courageous. It is of the essence of the director's role to be questioning and skeptical in holding management to account. Ultimately, one of the most important things that the directors do is to appoint, monitor, evaluate and ultimately address CEO failure and succession issues. The latter, in particular, cannot be done by directors who lack the courage to face up to real failings or the unsuitability of the existing CEO, or the willingness to effect change where it is required.
The board must be comprised of directors who not only have the required skill sets, but who also have the diversity of those skills and experiences suited to the needs of the company.
Beyond this, the board must consider questions of leadership. This applies most obviously to the Chairman, who may be recruited independently as such, or who may emerge out of an existing group of directors, but it also applies to the chairs of each of the board committees and within specific areas of expertise. Each director should be expected to exercise leadership in areas of his or her distinctive expertise, as well as in any case in which common sense suggests that board initiative is needed.
These considerations (correctly) suggest that no director search is likely to be quick and immediate, and that concerted effort is required. Companies should always be building their potential director network. It is far easier to meet candidates in the context of having them introduced to other directors and management for the ostensible purpose of "getting to know the company," rather than in the context of explicit director recruitment efforts that might lead to embarrassment if offers are not ultimately forthcoming (particularly when candidates are emerging from network lists provided by current directors). Good companies create lists of potential directors by tapping their networks of existing management, directors and friends (including investors, bankers, lawyers, accountants and other advisers). The recruitment process typically involves meetings of potential candidates with key members of management as well as with members of the nominating/corporate governance committee and other directors (as well as reference checking, both by the company and the candidate). The question of "fit" of a candidate with existing directors is an important consideration. It means that the process is often not expeditious, and that it is difficult to recruit more than one or two directors at a time. Most director searches in which I have been involved and which have started from scratch (that is, without a "warm list" of candidates who have been introduced to and considered by other directors already, and particularly when there is no "criteria list" of what the company wants in terms of skills and experience from its next director nominees) have taken some 6 to 12 months to complete.
Companies are turning increasingly to executive search firms to expand their networks and to professionalize their director recruiting effort. As specific skill and experience sets become more important, and as director candidates become more cautious about accepting board seats, the quest for suitable directors becomes at once both more focused and more extensive. Most executive search firms now include a director search capability that can be deployed to find directors who will satisfy defined criteria.
Given the learning curve that directors must climb, companies should anticipate that a director will be on a board for a minimum of (about) three years, even though director elections are typically held on an annual basis. Accordingly, a director's experience and abilities should be assessed against the needs of the company over a time horizon of this sort. Companies must also consider questions of director rotation, since it is accepted as matters of both good business and good governance that there is benefit in the introduction of new directors and the retirement of long-serving board members (some companies have director term limits or mandatory retirement).
The building of a great board of directors continues beyond the recruitment, orientation and ongoing functioning stages. Evaluation of board and individual director effectiveness is now (either legally or practically) mandated. Companies are experimenting with various board and director evaluation and assessment techniques, ranging from lead director interviews through highly structured questionnaires administered personally (in hard copy or online). A board of directors will improve itself constantly if the "back end" encouragement of continued director interest, enhancement of board processes and culling of directors who cannot or will not contribute appropriately, or who have outlived their utility to the board, is undertaken in a committed fashion.
Recognizing that a board has its own job to do, it is clearly a best practice, and it is becoming a mandated one, that boards set aside time in each meeting (and often in a more focused and organized way on an annual basis) to assess the effectiveness of meetings and procedures. Good boards will include in every meeting agenda template an item that is a consideration of the meeting that has just occurred and of the material that was provided in anticipation of that meeting, in an attempt to ensure that board processes improve on a continuous basis.
Great boards do not happen by accident. They are the result of understanding the roles and responsibilities of the board, the commitment of management and existing directors to attaining the best that corporate governance can offer, and of recruiting and feedback mechanisms that will ensure a virtuous corkscrew upward.
Originally published in Corporate Governance, Federated Press, vol. 3, no. 2 – 2003.