Elevating board performance: The significance of director mindset, operating context, and other behavioral and functional considerations

By Simon C.Y. Wong

The global financial crisis has prompted debate once again on how to improve the effectiveness of the board of directors at listed companies. What went wrong despite the reforms pursued over the past two decades?

The global financial crisis has prompted debate once again on how to improve the effectiveness of the board of directors at listed companies. In their investigations of the recent economic meltdown, the Organisation for Economic Co-operation and Development, European Commission, US Congress, and others found serious deficiencies in the way boards, particularly at financial institutions, guided strategy, oversaw risk management, structured executive pay, managed succession planning, and carried out other essential tasks.1

What is most troubling is not that boards have failed per se but that their alleged shortcomings have persisted despite the considerable board reforms pursued over the past two decades.

 

What went wrong?

Reforms in the past focused principally on board structure, composition, and processes. Much less attention has been paid to behavioral and functional considerations, such as director mindset, board operating context, and evolving human dynamics.

Yet, examinations of board “failures” around the world, including at leading companies renowned for their corporate governance arrangements, routinely point to deficiencies in these areas – for instance, CEOs who increasingly dominated their boards, non-executive directors who failed to fully grasp their companies’ fundamental performance drivers, and boards that were insufficiently engaged in key activities and
decisions.

Considerable stakes involved

If the quality of board stewardship does not improve, the consequences are likely to be severe. First, the board’s freedom to organize itself, set priorities, and keep sensitive matters private may be at risk. In the UK, for instance, the government is considering “widening” the remuneration committee’s membership so that boards will be more sensitive to “pay and employment conditions elsewhere” in the company.2

Second, shareholders, regulators, and others may be given additional powers to intervene in areas where – due to lack of competence, conflicts of interests, and other factors – they may not be well-suited. Signaling a radical change of approach, the Bank of England has proposed hiring senior supervisors to challenge bank executives on strategic decisions, a function that hitherto has been assumed principally by the board.3

Third, persistently poor stewardship by the board will destroy company value. In North America and Europe, boards of financial institutions that failed to check management’s aggressive forays into US sub-prime mortgages saw their firms decimated during the financial crisis.

Reforms in the past focused principally on board structure, composition, and pro-cesses. Much less attention has been paid to behavioral and functional considerations, such as director mindset, board operating context, and evolving human dynamics.

Measures to help boards reach their potential

Given what’s at stake, there is great urgency for boards to
elevate their performance. Having spent nearly 15 years examining, advising, and interacting with scores of boards in developed and emerging markets, I have concluded that their effectiveness would improve markedly if – alongside establishing core building blocks such as appropriate board size, well-functioning committees, proficient company secretarial support, and professionally-administered board evaluation – they focus their efforts on a handful of behavioral and functional areas. In particular, boards and their members should:

•Think like an owner

Know their companies

Be prepared to “roll up their sleeves”

Take charge of their priorities

Hire a collaborative CEO

Protect their authority and independence

Think like an owner

Boards are vital stewards, responsible for ensuring the long-term viability and health of firms under their charge for the benefit of current and future owners. As such, it is important that they adopt an ownership mindset. Yet, few do so. One US commentator with several board memberships has complained that the vast majority of outside directors are “kibitzers,” passive participants who do not believe it is their role to challenge management beyond asking a few questions at board meetings.

To embed an ownership mindset in the boardroom, companies should start at the director recruitment stage. To assess whether a director candidate is likely to be an effective steward for shareowners, it is useful to ask the following questions:

• How should non-executive directors be involved in strategy development?

What type of information would you need to discharge your responsibilities effectively and how would you obtain it?

In your previous board roles, in which areas did you have the greatest impact?

In a group setting, when have you taken a stance against the then prevailing majority view and what was the outcome?

There are no particular “winning” responses. What’s important is assessing the extent to which a candidate exhibits energy, a proactive attitude, and an independent mind.

Conversely, warning signs include an excessively deferential attitude toward management – for example, inability to recall any occasion when he or she disagreed with the CEO – and an overly passive view of their roles.

Boards are vital stewards, responsible for ensuring the long-term health of firms under their charge for the benefit of current and future owners. As such, it is important that they adopt an ownership mindset.

Furthermore, boards should gauge a candidate’s inherent interest in the firm and time availability because a shortage of either will hinder a director’s ability to think and act as an owner.

Once they come on board, companies should strive to strengthen directors’ commitment to the firm. This is best achieved by involving them meaningfully in substantive board work. At the same time, emotional bonds can be deepened through social interactions, such as group visits to facilities abroad, dinners with management members, and other informal social gatherings.

Financial tools can, within limits, also help tighten the connection between directors and their firms. To strengthen directors’ sense of being an owner and long-term focus, some companies require outside board members to receive their fees in stock and buy shares using their own money and restrict disposal of shares acquired until they have retired from the board.

Lastly, it has been noted that passion for the company can be passed from one board generation to the next through overlapping tenures between the retiring directors and their successors.

Know their companies

For a board to add value, individual directors must possess a strong understanding of the company and its industry. Many CEOs, however, wish their outside directors have a better grasp of the business and competitive environment.

Deeper knowledge would certainly enhance non-executive directors’ contributions to board discussions. More importantly, it could also enable boards to better appreciate the strategic significance of seemingly minor developments – such as a gradually widening gap between reported profits and cash flows – or the hazards that may lurk beneath ostensibly sound courses of action.

Due to the belief that outside directors without close links to management and the company are better monitors, the trend globally has been to populate the board with “independent” directors. The drawback is that such directors usually lack deep familiarity with the companies on whose boards they sit. In financial institutions that collapsed during the financial crisis, it appears that the non-executive directors – most of whom were independent – largely failed to appreciate the risks that their firms were taking and were genuinely surprised when their banks’ condition deteriorated rapidly.4

Consequently, there is a heightened need to ensure that outside directors know their companies well. While some companies do a good job on director induction and ongoing knowledge development, poor practices are pervasive, particularly the emphasis on passive learning through perusing written materials and attending lectures and presentations. At some companies, quality of information is also a problem. It is either not enough, too much, or the wrong kind.

To bolster non-executive directors’ understanding of the company, written materials provided to the board must improve. Furthermore, interactive, experiential activities should be emphasized.

To bolster non-executive directors’ understanding of the company, written materials provided to the board must improve. All board papers, for instance, should contain a summary page explaining the topic to be discussed, key issues to consider, potential impact on the firm, and action required from the board.

Furthermore, interactive, experiential activities – for example, visits to factories, suppliers, and customers – should be emphasized. Such mode of information acquisition will likely yield a deeper understanding of the firm’s business and industry dynamics than passive absorption of written reports and lectures. One FTSE 100 chairman remarked that after site visits, “non-executive directors usually ask more insightful and penetrating questions.”

Importantly, information shared with the board should include dissenting opinions. One bank chairman invites the research analyst with the most bearish view of the firm to address the board. Another chairman asks “outlier” analysts holding diametrically opposite opinions of the company to engage in a debate before the board.

Given the complexity of some industries – financial services, global mining, and pharmaceutical, to name a few – there may be a limit to which outside directors are able to acquire the requisite depth of knowledge solely through service on the board. While not all outside directors need to be industry experts, a good proportion of them must possess strong company and industry expertise in order for the board to contribute to strategy development in a meaningful way, challenge management effectively, and monitor performance robustly

Be prepared to “roll up their sleeves”

There is broad acceptance that listed company boards should operate on the basis of “noses in, fingers out.” That is, they should probe and offer guidance but let management handle execution and other details. This advice is sound with respect to most matters that come before the board.

Good stewardship, however, calls for fuller contributions from the board on key corporate decisions and activities; particularly those that affect its ability to govern the company effectively. Consequently, it is necessary for boards to engage intensively in such critical areas as strategy development, succession planning, and executive compensation.

Boards are now expected to devote greater attention to risk management oversight and remuneration of below-board staff. However, because most boards still meet only 8-10 times a year, it is critical that they prioritize their activities and manage their time efficiently.

Substantive board involvement in strategy development brings important benefits. It enables companies to tap the skills and experience of non-executive directors while strengthening their understanding of, and commitment to, their firms.

It has often been said that the board’s most important role is to “hire and fire the CEO,” a short-hand for the responsibility to ensure that the right leadership team is in place at all times. To discharge this duty effectively, the board must actively steer succession planning and leadership development. Yet, the board’s stewardship is arguably weakest in this area.

In the US, a recent survey revealed that only 42% of directors felt their board’s role in succession planning was effective.5 Fortunately, directors have started to realize that their involvement in succession planning must grow. According to Spencer Stuart, 57% of the respondents to its 2010 US board survey identified it as a priority issue, compared to 19% in 2008.

Given the unpredictability of CEO tenure – even at well-performing companies6 – and the long lead time needed to develop CEO-caliber leaders, boards must pay close attention to succession planning at all times.

In markets where dispersed share-ownership is the norm, compensation has long been seen as an important tool to align the interests of executives and their firms. However, many boards appear insufficiently engaged in setting executive remuneration, delegating key activities to the human resources department and compensation advisers.

To elevate board performance in this area, directors need to re-orient their views on involvement in setting executive pay. A veteran UK remuneration adviser has noted “some non-executive directors feel that they got the short end of the stick to be on the remuneration committee and adopt a laissez-faire attitude, letting the HR department be in charge.”

Yet, setting remuneration is one of the most vital and challenging board responsibilities. Boards, for instance, need to ensure a strong pay-for-performance linkage. Moreover, they must be willing to stand firm on unreasonable pay demands while ensuring that executives feel they have been treated fairly. According to a Nordic bank chairman, “You need to be careful that the executives do not interpret the board’s decisions on bonuses to mean the board thinks they are not good enough.”

Recently, attitudes have begun to shift. According to the 2010 Spencer Stuart board survey, US directors identified executive compensation as the most important board issue, with 80% of respondents listing it as a key topic.

To ensure active board involvement does not lead to micro-management and other inappropriate interference, the board must be led by a chairman who does not harbor ambitions to be the CEO and is genuinely content to play a behind-the-scenes role.7

To build cohesiveness and avoid misunderstanding, the board should periodically agree among its members and with the CEO areas where:

• Management will lead (e.g., strategy development, operational matters)

Board will lead (e.g., CEO succession planning, remuneration for top management)

Board and management will share authority (e.g., leadership development for senior executives, relations with shareholders and other external parties)

Take charge of their priorities

As the board’s responsibilities have broadened over the years, its workload has grown. Following the global financial crisis, boards are now expected to devote greater attention to risk management oversight and remuneration of below-board staff. However, because most boards still meet only 8-10 times a year, it is critical that they prioritize their activities and manage their time efficiently.

Rather than depending solely on management and standing calendar items to inform them of issues requiring their attention, boards should also annually decide their top 3-5 priorities for the next three or more years. Because boards, compared to management, are less able to rely on operational, financial, and share price metrics to gauge their performance,8 doing so will also provide them with a clear yardstick to evaluate how well they are fulfilling their responsibilities.

Specific board priorities will, of course, vary across companies and time. In start-up enterprises and firms in distress, the board may need to devote a substantial amount of time to strategy and operations while in mature, well-functioning companies, the board may concentrate on setting challenging performance targets, directing succession planning, and keeping management egos in check.

With growing confidence in senior management, the board of an emerging market bank decided to reduce its involvement in operational matters – including lending decisions – so that it could focus on strategy. Conversely, following a corruption scandal the board of an international food services company started to spend more time on operations – in this case, by evaluating potential risks arising from its far-flung operations and putting in place mechanisms to prevent a recurrence.

Boards can free up time at their meetings by asking sub-committees to shoulder more of the workload. According to the company secretary of a leading mining company, “It is important to farm general monitoring functions to sub-committees so that the whole board can focus on the most important tasks.”

In addition, board agendas should be prioritized so that routine and “backward-looking” matters consume a modest amount of time. Similarly, items for discussion should be organized so that formal presentations take up no more than half of the allocated time.

Hire a collaborative CEO

Boards are highly reliant on management to provide them with information on the company. Executives who report to boards know all too well that they can enlighten outside directors or keep them in the dark through their choice of words or the tone in their delivery. As one financial executive put it, management presentations could be delivered “in such a complex way that [the non-executive directors] would be prevented from asking whether the emperor is naked, for fear of looking stupid.”

Fortunately, executives are increasingly conscious of the importance of keeping their boards fully informed. One Canadian bank chairman summed up recent trends in his country with the following remark: “I think [Canadian CEOs] are less imperial, more consultative, and know much better in this day and age how to use a board as a sounding vehicle to try out ideas to get a debate going up front before making decisions.”

Collaboration with the board should be built into the CEO’s job description and feedback provided regularly. To evaluate the CEO’s cooperativeness with the board, one UK firm includes the following questions in the annual board evaluation survey:

Does the CEO share enough information with the board?

Were all of the questions that the non-executive directors wanted answered answered?

How well does the CEO get along with the chairman and other directors?

Trust, of course, is built over time through repeated encounters. On their part, CEOs must be equally forthcoming about successes and failures and be willing to ask for help. Correspondingly, boards can gain the CEO’s trust and confidence by demonstrating an ability to add value and not micro-managing the executive team.

Protect their authority and independence

To be effective, the board must possess adequate authority and independence from management. Board authority, however, ebbs and flows. Sometimes, such as when it cedes the chairman’s role to the CEO, the board consciously reduces its authority. In other cases, authority recedes gradually and without notice, until it is too late. Accordingly, boards must be ever vigilant about preserving their standing and objectivity.

Combining the chairman and CEO roles is one of the most significant ways to rob boards of their authority. As a matter of principle, it is highly problematic for a board, whose principal task is to oversee management, to be led by the head of management. The board’s standing is particularly damaged when, as commonly practiced in the US, a well-performing CEO is “rewarded” with the chairman’s title.9

Boards can take a number of steps to protect their authority and independence. First, as the discussion above suggests, boards should ensure that the chairman and CEO positions are occupied by different individuals.

Second, boards need to be on top of succession planning and leadership development so that CEOs will not be able to hold them hostage. At a European retailer, the board’s failure to identify a successor to the chief executive enabled him to successfully extract from it the chairman’s seat as well.

Third, given that a successful CEO’s clout will grow, boards should pay attention to the relative status of people in the boardroom, particularly vis-à-vis the chief executive. Discussions with chairmen and direct observations of boardroom dynamics have revealed that CEOs are not always respectful of non-executive directors whom they perceive to be less qualified than they are.

As a principle, boards should ensure that the statures of non-executives are equal to or greater than the CEO’s and comparable to each other. At one UK company, the chairman has deliberately recruited to the board individuals who are chairmen at other listed companies. That way, the board is more likely to be respected by the highly successful CEO and non-executive directors will also treat each other with regard. Relative stature between the chairman and the CEO is particularly important. One UK senior independent director explained, “You need a person who can tell a CEO that he is acting like an idiot when necessary.” In Britain, chairmen are usually a decade or so older than their CEOs, which enhances the chairman’s ability to serve as mentor to the chief executive.

Lastly, boards should put in place term limits for directors and the CEO, with flexibility on the exact timing of exit.

Director term limits are intended to ensure new perspectives come into the boardroom and the board remains sufficiently detached from management. One European chairman believes that “although you don’t want too much turnover, you need a constant flow.”

Perhaps surprisingly, some CEOs support term limits for their ranks. At a European company, the successor to a long-tenured chief executive acknowledges the risks that an increasingly dominant CEO poses to the board and the company and has pledged to remain in this post for 6-8 years at most. Term limits may also make sense due to evolving company requirements for the CEO position.

Conclusion

At the end of the day, boards that operate to their potential are characterized by constant tensions within the boardroom because strategic and other challenging issues are brought to the fore and its members, committed and knowledgeable, look to contribute in a substantive way. With mutual esteem and an esprit de corps between the board and management holding them together, coupled with management’s respect for the board’s stewardship role, this tension – rather than leading to endless bickering and gridlock – helps to facilitate healthy and constructive debate and improves decision-making. As former UK Financial Reporting Council Chairman Sir Christopher Hogg has noted, “Good boards are pretty uncomfortable places and that’s where they should be.”

The steps outlined in this article, applied pragmatically and sensibly, should help boards get there.

This article has been adapted from the author’s Northwestern University School of Law working paper (available at http://ssrn.com/abstract=1832234).

 

About the author

Simon C.Y. Wong is a partner at investment firm Governance for Owners, Adjunct Professor of Law at Northwestern University School of Law, and Visiting Fellow at London School of Economics and Political Science. He has also served as an independent advisor to several institutions, including the OECD and a strategy consulting firm.

Previously, Simon was Head of Corporate Governance at Barclays Global Investors and a management consultant at McKinsey & Company. Simon started his professional career as a securities lawyer with Linklaters & Paines and Shearman & Sterling, and also served as Principal Administrator/Counsel at the OECD.

Simon writes and speaks regularly on corporate governance and capital markets-related topics. His publications are available at http://ssrn.com/author=436348.

Email: [email protected]

Twitter: @SimonCYWong

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.