Being a board member became less enjoyable during the first decade of the new millennium. First, boards were blamed for the malfeasance that resulted in the burst of the dot.com bubble in the earlier part of the decade, and now boards are blamed for the misfeasance that resulted in the “Great Recession” in the latter part of the decade.
Congress reacted to the dot.com burst by enacting Sarbanes-Oxley requiring greater independence of members of audit committees. Quasi-government organizations such as the NYSE and Nasdaq expanded the independence requirements from audit committees to other oversight committees, such as compensation and nominating, and to the board itself. Regulators such as the SEC, IRS, and Treasury, as well as banking and insurance regulators, expanded the independence requirements from publicly-held companies to tax-exempt organizations and financial institutions.
In reaction to the Great Recession, the Obama administration is proposing restrictions on the size and activities of organizations that are considered “too large to fail,” and Congress is considering “say-on-pay” legislation, shareholders’ bills of rights, and laws directing how governing boards should be organized and led. However, neither the administration nor Congress recognizes that the move toward independence resulting from Sarbanes-Oxley contributed to the misfeasance resulting in the Great Recession: i.e., management members of the board who understood the business model and strategic direction of their organizations were replaced on boards with independent members not having such understanding.
The purpose of this article is to provide some guidance for consideration of independent directors seeking to become better board members.
1. Observe the expectation and right of reliance
The foremost principle of corporate governance is that boards and their committees are expected, and most states’ laws give boards and their committees the right, to rely upon:
- Officers or employees as to matters for which the director reasonably believes they are reliable and competent;
- Professionals such as lawyers or accountants as to matters that the director reasonably believes are within the person’s professional competence; and
- Duly established committees of the board for matters within their designated authority, which the director reasonably believes to merit confidence.
The concept is that the organization is managed “under the direction” of the board, and the most important responsibility of the board is to select management, including at least a chief executive officer, whom the board believes is reliable and competent in managing the organization.
2. Ask and encourage questions taking into account the impact of the highly improbable, and educate when to stop asking questions
Your role as a board member is to oversee that direction is provided but not to execute that direction or mange the organization unless you believe that the CEO and management are not reliable and competent to do so. A board member does this by asking sufficient questions, so you have a reasonable belief that the CEO and management are reliable and competent in what they are authorized or directed to do.
Your questions should not generally be “how are you going to do this.” Management should have the authority to determine “how.” Your questions are to verify or confirm their reliability and competence in making the “how” determination: “How does this benefit the best interests of the business?” “Is it consistent with our business model and strategy for the future?” “What financial, legal, ethical, strategic and reputational issues have been considered?”
As a director, you should take into account the premise of Nassim Nicholas Taleb’s book, Black Swan, The Impact of the Highly Improbable, that policy makers such as board members must consider all of the possibilities, especially those that could have a high impact, albeit remotely probable, and not just the normal. The current “Great Recession” is the likely result of a failure to take into account the highly improbable, but high impact, occurrence.
into account the highly improbable, but high impact, occurrence. Accordingly, the most important questions that a board should ask are “what if”: most importantly, “What happens if things don’t go as expected?”
Finally, educate other board members when to stop asking questions. A board member can stop asking questions when you reasonably conclude that the CEO and management are reliable and competent to carry out the action being authorized.
3. Understand the organization’s business model and strategic direction
To oversee that direction is provided to the organization, you must understand both the current business model as well as the strategic direction for the future. One of the problems in replacing employed officers with independent directors as a result of Sarbanes-Oxley is that some boards as a whole have become less knowledgeable of the organization’s business model and less understanding of its strategic direction. As boards become more independent, the CEO and management have a greater responsibility in educating directors on the current business model and future strategic direction.
The role of most boards is not to initiate the organization’s strategic direction unless the CEO or management has failed to recommend it, but to agree with the strategic direction recommended by management. Having an agreed strategic direction will give the board benchmarks to measure the CEO’s and management’s performance, and it will focus the board’s attention on the most important matters, those dealing with the organization’s direction.
4. Abide by the principle that a board speaks with one voice
Your duty of care and loyalty as a director requires you to abide by the decision of a majority of the board at a meeting at which a quorum is present. This applies to all matters coming before the board for its consideration. The board speaks with one voice on all such matters, or not at all. Occasionally on matters where it is important to have a single message, a board will speak only through its chairperson or the chairperson’s designee.
If you disagree with a decision, your rights are to vote against that decision, to have your negative vote recorded in the minutes, and when and if appropriate, to ask for reconsideration of the decision. Generally, “what happens in a board room remains in the board room” unless you believe that your remaining silent will result in a material breach of fiduciary duty or violation of law.
5. Assure the board has the expertise to speak with one voice
To be able to speak with one voice, the board must have sufficient expertise to understand how any action it is asked to authorize is consistent with the business model and strategic direction of the organization. This requires boards to assess the collective expertise of the board as a whole: Does the board have the expertise required to oversee the organization’s current business model and its future strategic direction? You should urge the board to make this assessment if it has not done so recently.
Your goal should be an “expertise” board, composed of persons each having particular skills or expertise needed for the board to have as a whole all of the skills and expertise necessary to achieve its future objectives. This is in contrast to a “constituency” board, which is composed of persons who represent the view of a particular constituency (such as the US Congress or a state legislature). Unlike a constituency board, assembling an “expertise” board requires the organization to assess the core competencies present among its management team’s members; to prioritize the additional competencies necessary for its future operations; and to recruit persons having those competencies for nomination as board members.
The major benefit of an “expertise” board is a focus on the best interest of the organization as a whole because its members are selected to bring to the table particular skills or expertise that, when taken with the skills of expertise of the other members, are to achieve the agreed best interests of the organization in the future. Having an “expertise” board also avoids problems of a constituency board whose members view their duties as representing the best interest of the separate constituency that each member represents, often resulting in:
- Partisanship similar to Congress and state legislatures;
- Decisions watered to the least common denominator; and
- Favoring particular constituencies rather than the organization as a whole.
Boards should evaluate and inventory the individual skills, experience and other expertise of each of its members; determine the expertise needed in the foreseeable future; and then determine whether to fill any gaps in such expertise through:
- Recruitment of new or additional directors;
- Education of directors to enhance expertise; or
- Availability of advice of advisers to provide missing expertise.
6. Urge your board to grant authority by setting goals and enforcing limits
The board should not prescribe “how” management should conduct business. Instead, it should set the goals or identify the benchmarks to be achieved by management, allowing management to determine “how.” A board that has the available expertise to understand the organization’s business model and strategic direction can set economic and non-economic goals. This is often done annually through adoption of a business plan, which should articulate the goals for the ensuing year. The board should measure the CEO’s and management’s performance based upon their achieve of these goals.
Although the board should not prescribe “how” management achieves these goals, management should understand that the board expects these goals to be achieved legally, ethically and in compliance with the organization’s policies. This is typically accomplished with articulated codes of conduct and internal controls enforced through forfeitures and even claw-backs of compensation.
7. Consider Steven Davis’s first rule of executive compensation
Steven Davis, CEO of Bob Evans, observed in a directors’ education session conducted at the Ohio State University Fisher College of Business in August 2009 that “The first rule of executive compensation is that shareholders get paid first.”
The point of Mr. Davis’s rule is that the executives are not entitled to performance or incentive compensation unless the executives are leading the operations of their organization to have earnings available for dividends to shareholders.
If boards and compensation committees had made this simple rule a condition to any of their executives receiving performance or incentive bonuses, there would not have been the AIG or Merrill Lynch bonuses that outraged the public earlier this year.
Mr. Davis’s rule applies to any organization, for-profit or nonprofit. The organization’s leaders should not be entitled to performance or incentive compensation or bonuses unless they are leading the operations of their organizations to result in growing net worth, capital or surplus.
Boards and compensation committees should consider making this rule a condition to payment of any performance or incentive compensation. Compensation committees should consider defining as a “stop” to any incentive compensation failure for net worth (or, for non-stock organizations, capital or surplus) to increase for any performance period. In addition, as discussed above, boards and compensation committees should articulate codes of conduct and internal controls enforced through forfeitures and even claw-backs of compensation.
8. Encourage regular meetings with key management
To regain the knowledge lost by boards as employed officers were replaced with independent directors, encourage your board to meet regularly with key management other than the CEO. Some of the key oversight committees such as audit and compensation should consider meeting in executive sessions separately with key management without other management members being present.
Benefits of regular meetings with key management are that:
- It opens communication channels between the board and key management;
- Doing so regularly usually does not offend CEO;
- It facilitates the board’s federal and state obligations not to impede whistle blowing by encouraging communication both from employees to the board, hopefully without anonymity, and from the board to employees; and
- Board and management will each learn from the other.
Generally, familiarity of management with the board and vice versa will not breed contempt but will foster trust and eliminate contempt.
Boards need to mitigate the loss resulting from Sarbanes-Oxley when management members of the board who understood the business model and strategic direction of their organizations were replaced on boards with independent members not having such understanding. This loss can be mitigated by inviting key management to serve as resources to the board at board meetings.
9. Don’t Forget about Mentorship
Mentorship is one of the major functions of board members (the others being direction and oversight). Mentorship is making available to management each board member’s skill and expertise of having been there and having done it before.
Benefits of mentorship include
- Making it less lonely at the top of management;
- Providing coaching and fostering relationships between board members and management; and
- Making board members and management each accessible to the other.
10. Remember that “one size does not fit all,” and improvement won’t happen overnight
Governance is the aggregate of an organization’s culture, methods, processes, systems and controls for:
- Providing direction to the business, operations and other affairs of the organization (i.e., the organization’s mission or purpose); and
- Executing or carrying out that direction (including the organization mission or purpose).
However, it is important to note that because governance of an organization is the aggregate of many things, including its culture, what may be appropriate in terms of governance of one organization may not be appropriate for another.
Culture usually cannot be changed overnight. Just as it typically takes two generations of football coaches to find a successful replacement to a great coach, it takes two generations of board members to institutionalize a change: One generation initially adopts the change, but it does not become institutionalized until a succeeding generation agrees to retain it.
So, when you consider improving the practices of your organization, keep in mind it may not happen overnight. You will likely have to be a steward for the practice, carrying it through to the next generation that succeeds you on the board.