Predicting the challenges boards will face in the years ahead requires an understanding of how they and the governance they have provided has evolved in past years, as well as the challenges they will face in the years ahead. Since I have been serving on and doing research about public company boards over the past twenty-five years, I believe I have a clear sense of the state of corporate governance in the United States and in much of Western Europe. Not surprisingly, my crystal ball for predicting future developments and demands on boards cannot be so clear.
Twenty-Five Years of Progress
Given that there are hundreds of boards on both sides of the Atlantic, it is impossible to make a blanket assessment of how well they are functioning. Nevertheless, based on my experience, and research conducted at Harvard Business School and elsewhere, there is plenty of evidence that in the last quarter of a century boards have become more proactive and are improving their governance capabilities. However, this progress has not eliminated governance failures, from Japan (Olympus) to the UK (Barclays) to the United States (J.P. Morgan). In fact, there are days when, looking at the financial media, I wonder how there can still be so many board room failures in the face of so much progress in so many other board rooms.
Areas of Board Progress
To answer this question, we need to understand what is meant by progress in the manner in which boards govern. There is, I believe, evidence that boards have improved their governance in three broad arenas. First, and most obvious, is the board’s oversight, through their audit committee, of financial reporting and conformity to financial principles. Perhaps the major cause of this improvement has been the Sarbanes-Oxley Act in the United States, which has also influenced the way companies elsewhere think about these responsibilities. This is excellent evidence of the fact that corporate governance improvements spread internationally, even when there is no legal requirement.
A second arena in which boards have improved their efforts is in considering, approving, and judging the results of companies’ strategic initiatives. While in most cases with which I am familiar, it is management’s responsibility to propose strategic moves, there is today a growing trend for boards to review and approve such major decisions, and also obviously to judge how well they are working.
A third issue in which boards have become more proactive is in selecting and overseeing the performance of their company’s chief executive. If one looks back a decade, or more, it was common for the retiring chief executive to select his successor and for the board to rubberstamp the decision. In fact, such board passivity was also common in the other matters I have just discussed. However, today it is the directors who are most actively involved in selecting new company leaders. Of course they may still consult with the outgoing chief executive if they trust his or her judgment. But in the end, most leadership transitions today are clearly orchestrated by the board of directors. While this represents important progress, one aspect of boards’ involvement in top leadership succession is still problematic. This is assuring that there are processes in place to develop the next generation of company leadership internally. I do not suggest that a board can be involved directly in such a process. The actual job placement, coaching, etc., of up and coming executives has to be a management responsibility. Yet boards can, and should do, a better job of monitoring such activities so they will have a talent pool internally from which to select their next leader. I emphasize this point because there is considerable evidence that successors chosen from the inside perform better than leaders brought in from outside the company.
Obviously, boards have not all improved at the same pace or in the same ways in dealing with these major aspects of their governance responsibilities. Why some boards are doing better than others is of course an important question, especially because it not only explains the current situation, but also because it can shed light on what boards must do to be successful in the future!
Determinants of Board Progress
There are several factors which affect how boards perform the activities discussed above: how they use their limited time together; the adequacy of their knowledge and the information they receive; how they manage interpersonal dynamics, which occur in any group whose members are roughly equal in status and influence.
The time directors have together is limited, (in the U.S. an average of six meetings a year of about eight hours each). During such meetings directors have to absorb and understand information often presented by management and debate any decisions that need to be made. The most successful boards develop a pattern of establishing agendas, which focus on critical issues and allow them to use their limited time on the most important matters.
Connected to the effective use of time is the knowledge and information the directors have. A common practice is to send directors information in advance of meetings and to expect them to digest it before the meeting. Boards that do this well are going to be more productive. Such understanding is critically important, since most boards, especially in North America but also in European countries, are required to be made up of “independent” members. This means in essence that most directors join boards with limited prior connection to the company and its industry. Obviously then, effective boards have to be good at educating their members and getting their knowledge base up to speed.
A third factor which affects boards’ success, as suggested earlier, is the manner in which board members interact with each other. To an important extent, boards that have successful discussions around the board table have effective leaders. In Canada and the European countries, this leader is almost always a chairman who is not the CEO. In the United States, boards have been urged to have the same structure, but most still have a CEO who is also Chairman. To ameliorate the obvious problems that this structure can cause, most American boards now also have an independent director act as leader of the other independent directors. In this manner, U.S. boards have established leaders who are not also the CEO. Regardless of the formal leadership arrangement, effective boards have leaders who manage discussions well so the board can reach consensus decisions, based on a thorough understanding of the matters before it.
Effective leaders also have to create and maintain sound relationships between their CEOs and the board. This too is a critically important characteristic of effective boards. If there is tension or misunderstanding between the CEO and the board, especially its leader, the ability of the board to make decisions may be confused and compromised.
Over the past two decades boards have adopted a set of “best practices,” which are aimed at making them more effective in using their limited time, assuring they receive adequate information, dealing with the complexity of group decision making, and their relationship with their CEO. Some of these practices are now matters of law, regulation, or listing requirements, for example, the existence of committees, (audit, compensation, and governance). Boards have adopted other practices because they improve their functioning, e.g., executive sessions of directors and evaluation of the chief executive by the directors, and a tendency to shrink board size to the fewest number of directors practical.
In sum, as I look back on the past few decades, I can clearly discern an important trend in the way many, but not all, boards govern their companies by overseeing strategic direction, selecting and guiding their CEO, and assuring transparent financial reporting. Those boards, which are most effective in doing these things, have adopted the best practices mentioned above. This enables them to overcome the constraints of time and knowledge, and the challenges of group decision making. These boards have been moving in the right direction for improving their governance. The question which confronts all concerned with good corporate governance now, is whether this progress is sufficient to meet the challenges facing companies in the remaining decades of the twenty-first century.
21st Century Governance Challenges
While predicting the future, as I suggested earlier, is always risky, there is already ample evidence of a few significant challenges that will face even the best boards in the future. In fact, I believe these challenges will become even greater as we look to the future. The first, and most important of them, is the growing complexity of the companies that require governance. When I speak of complexity I refer to the number of factors that management and boards must understand, and the rate at which these are changing. For example, companies involved in the mobile devices market face a great deal of complexity today, as new devices are developed, manufactured, and sold. Similarly, the failure of so many financial institutions in 2008-2009, and still today, is often related to their complexity, according to the directors who served on their boards. In this instance, there were, and are, many financial products not well understood by senior managers, let alone company directors. In both of these examples, not only are the products intrinsically complicated, they are also changing rapidly, and this is another source of the complexity that may confront boards in the future. It is hard enough for directors to grasp the facts about a company with complicated products, but even more difficult when these products are changing rapidly and frequently.
Another related source of complexity, which will continue to affect companies and their boards in the future, is the already present trend for so many companies to become global. Operating in many countries around the world with different economic conditions, laws, and cultures, creates a great deal of added complexity for any board. In my judgment, the trend for more and more companies to be global is already well established, and this source of complexity is not going to abate.
As more companies become more global, another and parallel source of complexity is the rapid flow of information. It is a trend which is evident in all types of business, but especially so in financial institutions, when literally many thousands of significant transactions take place hourly around the world. I am not suggesting that boards must stay on top of all these transactions; rather, my point is that the speed of transactions and data can produce significant changes in results very rapidly. This represents another immense challenge for directors. The speed with which J.P. Morgan was able to lose two billion dollars (or was it three billion, or nine billion?) is a prime example of how the speed of transactions increases the challenges directors face.
Another challenge that boards are likely to face is the rising expectations of the groups whose interest boards are supposed to protect. At the top of this list in many countries are shareholders, who are directly and indirectly asking boards to do more to oversee their companies. Most often, such appeals for improved governance are communicated to boards by shareholders approaching various government entities for change in regulations and or laws. (For example, in the US the pressure for boards to do more to oversee executive compensation was initiated by certain shareholders, who influenced the drafters of the Dodd-Frank Bill). This pressure for more active oversight by boards also comes from shareholders more directly, as they put forth proposals for changes in governance practices at specific companies. A prime example of this has been the elimination of staggered boards in the US. Over the past several years, more and more companies have succumbed to such proposals, to the point where on most boards directors are now elected annually. Does this lead to better governance? Some institutional shareholders (especially union and pension funds) believe it does. From their perspective, it is especially helpful in not allowing boards to become entrenched and block takeover attempts.
In my own judgment, these sorts of initiatives, which change board election procedures or limit the board’s power to develop defenses against unwanted takeovers, or even give shareholders a voice in approving top executive pay, really do very little to improve board effectiveness. This fact has been substantiated in a survey conducted by Harvard Business School and Harvard Law School faculty of American directors who expressed the same conclusion. I believe this struggle to influence governance will continue to plague boards until boards and shareholders find a better way to interact and influence each other.
Clearly the present methods of communication and dialogue between shareholders and boards are not adequate. Quarterly earnings calls are too frequently a matter of stock analysts probing for hints about short term results. Shareholder proposals usually involve some means of harassing boards and limiting their power. Neither of these common means of communication between companies and their shareholders is helpful in improving governance, yet they are likely to continue into the future, unless other means are found to enable shareholders and directors to communicate in a more positive fashion.
On the subject of the relationship between shareholders and boards, there are two other related issues, which I believe are going to be the focus of future debate and hopefully positive change. The first is a recognition that shareholders who hold company stock for only days or weeks are not truly owners, and therefore their rights to try to influence the governance of companies should be limited. Surely such investors have the right to gamble in the stock market on a short term basis, but not to try and influence boards about the long term direction of a company. Secondly, and perhaps even more importantly, the question of the ultimate purpose of governance is likely to be the subject of an increasing debate on both sides of the Atlantic, but especially in the United States. In America over the past several decades, the idea of the sanctity of shareholder value has taken hold as the ultimate purpose of the corporation. However, in the last couple of years, the debate about the true purpose of the corporation in the American economy has intensified, and there are growing voices in the business and financial community who argue that corporations will have to be governed for the good of all their stakeholders, not just shareholders. If this view prevails, a growing challenge for boards will be determining how best to balance seemingly conflicting demands.
While my forecast about the future challenges likely to confront boards can only be informed guesses, I shall conclude with a prediction of which I am confident. Given all the challenges facing companies, and the limited capacity of shareholders to meaningfully govern the companies in which they invest, boards of directors will continue to be the critically important actors in firm governance.
The article draws many of its themes from the new book “The Future of Boards” (Harvard Business Review Press, 2012), edited by Jay W. Lorsch.
About the author
Jay W. Lorsch is the Louis E. Kirstein Professor of Human Relations at the Harvard Business School. He is an internationally recognized expert on corporate boards of directors and the author of two path-breaking books about corporate boards: Back to the Drawing Board: Designing Boards for a Complex World (with Colin B. Carter, 2003); Pawns or Potentates: The Reality of America’s Corporate Boards (with Elizabeth MacIver, 1989) and is editor of The Future of Boards (2012). He is currently Chairman of the Harvard Business School Global Corporate Governance Initiative and Faculty Chairman of the Executive Education Corporate Governance Series. He has also served on the boards of many public companies in both the U.S. and Europe.