Law & Governance

Law & Governance 8(8/9) November 0000 : 0-0

Abstract

An influx of first-time directors is invading the boardroom as the pool of traditional directors shrinks. Not only must they become well educated on their company and industry, they must parcel their precious time between staying on top of new regulations and fulfilling their regular board duties. This commentary looks at how to educate directors to perform their directorial duties.

How should directors get educated to perform their directorial duties?

Duke K. Bristow: There is a small presumption built into this question that most directors are not sufficiently educated and that they must become educated to perform their duties. There is little data to tell us whether most new directors have sufficient education to perform their duties. Beyond that, if we take what many pundits and politicians give as the standard for education - that directors simply need to do the right thing, as we often hear - then directors would need very little education beyond what they learned in high school, and perhaps Sunday school.

If we set a higher standard for what directors need to know to do their job, then we are faced with a much more difficult process. And much of that is highly situational. What a director at a venture-backed IPO for a biotech company needs to know to do his or her job well is quite different than what a director at Alcoa or Boeing or Coca-Cola needs to know. Foremost, if a company doesn't already have an education process for new directors, I would encourage it to start one. Some of the director education programs can be a bit perfunctory. Many new directors extend director education into meeting with key customers and key suppliers. As long as those meetings don't disrupt the core business, that's a good way for new directors to become educated beyond the usual meetings with senior management and the general counsel.

Finally, I encourage those who have not previously been directors to sit on additional boards. Private company boards and serious nonprofit boards are good ways for first-time directors to gain experience dealing with board-level politics and other issues. For example, handling a harassment issue at a nonprofit [organization] may put one in a better position when a similar situation occurs at a for-profit [organization].

Stephen M.Wallenstein: There are three prongs to this issue that apply, to a certain extent, to both new and existing directors.

The first thing that is crucial for new directors to understand is the business model. They must read the Wall Street Journal and industry reports from equity analysts to get a really good idea of what the industry is all about. It is very important to meet with senior management and go through some of the same training programs that companies have for new employees. Companies train employees and put them through an educational process to learn about the company's business, but generally don't do so with their corporate board members.

Another prong is the sort of board education that comes from management and the general counsel passing along memos from law firms and accounting firms; bringing in experts to speak at a board meeting about recent trends in corporate governance, key issues of Section 404, and the role of the audit committee; and also bringing in a consultant to work with board members on how they work together.

And the final prong would be attending some of the open enrollment programs at UCLA or Stanford or Duke, where a large number of directors meet with policy makers, lawyers, regulators, judges, and representatives from the institutional shareholder community to give directors oversight about what different groups think and also to look at best practices and compare notes with board members from other companies. A lot of directors probably think they are already well educated, but we've found through our programs that they gain a lot from being exposed to other directors and experts.

Julie H. Daum: This will become more of an issue than people think. I'd like to focus on the new director. In the past, the path to the boardroom has always been fairly prescribed. CEOs were appointed and then invited to serve on other boards. Before they became CEOs, they may already have served on their own boards, but they had certainly attended meetings and learned about governance.

What we are seeing now is an influx of brand new board members. Of the 300 or so people we placed on boards in 2003, more than 40% were first-time corporate board members. Some of that was a result of the Sarbanes-Oxley Act, which requires a financial expert be placed on the board, and many of those were CFOs or auditors who had not been on boards before.

Furthermore, there is a real inflow of first-time board members because of the shrinking supply of the traditional board member. So you are going to have a lot of people going into the boardroom who may have never even sat in their own company's boardroom. As Duke was saying, not only do they need to be fully educated about that particular company, but they need to know what governance is and what it means to serve on the audit or compensation committees.

I think most of them are embarrassed to go to a meeting not knowing that. They would like to be educated on how to be a director and on the key legal and financial issues. While some of them have served on nonprofit boards, which does help them learn about the dynamics in a group situation, there are still many issues about which they need to be fully informed. Many of the people we are placing on boards are asking, "What do I do? How do I get smart before my first board meeting?"

And then you have the issue of ongoing education, which never used to be an issue because there were so few changes in a given year. Now there are constant changes, and people want to hear what everyone thinks about them: What are the regulators thinking, what are the lawyers thinking, what is your board doing? And so there is an exchange of ideas as people learn how to comply with Sarbanes-Oxley.

Everyone is also trying to develop best practices, which is kind of an ongoing exercise that you can do only if you have exposure to people who are thinking about it and are doing it in a different context. There is a need for both, and they don't get delivered in the same fashion to the same audience.

It's a new era for board members, and no matter how long you have served on a board, you need to be part of the conversation in figuring out what is going on elsewhere.

Florencio Lopez-de-Silanes: Most of the points have already been touched on, but I will emphasize a couple of aspects that were mentioned. I also believe there are three basic characteristics in this process. First, there needs to be an awareness of what's happening within the firm and the industry overall. Why don't new directors get the same training as executives or new employees? They should get that at a minimum.

The second is the awareness for first-timers, and the reminder for oldtimers, that they have certain duties and responsibilities and need very specific information to make the decisions they are facing. It's also not a bad idea to remind them of how these duties apply in certain situations, so ongoing education on that front is very useful.

And finally, the continuous aspect of the process is a dynamic that goes back and forth because directors must keep up with changes in the law as well as with changes in the corporation. The corporation may go abroad and when it does, you are getting into a new ball game and a new set of rules and markets.

At the end of the day, these points are not to say that you must have prior qualifications, but to make sure that you become a more effective board member. With that in mind, it is much easier to think about what director education really is. It is about increasing the effectiveness of board members and helping them better perform their duties, and not so much about the right way versus wrong way.

Is certification a viable concept in the sense of being rolled out as a national program by universities or associations like the National Association of Corporate Directors (NACD)? If so, how would it work?

Lopez-de-Silanes: Sure, many countries require certification; China, for example. And the reason I mention China is that it immediately evokes something completely different from the United States. This is a country that has had state ownership for decades and one where there is very little business in the sense of publicly owned corporations. Thus, there is very little background to speak of, and in that context there may be reason to certify a director or, at minimum, make sure that that person is getting some kind of education, at least in the developmental stages of that market.

But that is not the case in the United States, which is rich in cultural history with regard to business and in human capital developed through centuries, so there may not be as big a need to certify directors. I tend to believe that for the United States, in particular, certification may not be necessary as a mandate, though I think the right thing to do is to ask companies to make sure they disclose whatever their directors are doing in terms of education, and then you let the markets help themselves.

And so I think that the problems that exist in the United States, with its very competitive market, lie in capturing all of the particular segments that have been mentioned where directors can go to get educated. Some directors may need more education on certain aspects, and some may need education in other areas. It is going to be a challenge to come up with a certificate that fits everyone and encompasses the requirements needed in a very developed capital market like the United States.

Bristow: I'd like to echo Florencio's comments. Certification shouldn't be mandated by the exchanges, by the SEC or, heaven forbid, by Congress. Since 1999, the UCLA Anderson School has offered a director training and certification program as part of a set of directorial continuing education initiatives that we call the Directors Institute. We offer it because our customers want it. They have the choice of sitting for the certification or simply going through the program and not sitting for the certification. Furthermore, I think the rigor of having a faculty decide what is going to be on an exam has a lot of value in terms of driving the content of the curriculum.

The problem with any certification program, whether it's CPA certification or the Bar Association, is you must decide what you are going to examine people on. And so certification is, in a sense, very hard work. What do directors need to know? Can you certify wisdom or honesty? The answer is, obviously, no. Can you certify competency? I think so.

UCLA's program focuses on the things that most often get directors into trouble. Using sophisticated databases, such as the Stanford database, we examined how directors have gotten into trouble, particularly through technical errors and missteps. We then built a program that, at a minimum, made sure that directors wouldn't be appointed without knowing that if they did certain things, it would get them into trouble. We are trying to overcome the presumption that general counsels are constantly looking out for directors and protecting them, as that creates a false sense of security.

Certification is a market response to some directors' wanting to differentiate themselves from others. Venture capitalists and others who encourage the directors of their portfolio companies to come through our program like the fact that, at the end of the day, we test whether or not we have educated them. I have attended programs where, at the end, I thought I knew less than at the beginning.

We give a pretest and a post-test. It's remarkable what discipline that [fact] drives into a system. For one thing, a pretest, which directors almost never get, provides some baseline as to what people in the class actually know.

Wallenstein: When you think about it, so much goes into being an effective director, and high on that list is how you work and interact with others and what skills you bring to the table of a balanced board.

Given the wide range of industries, market cap, size and so on, I believe it would be very hard to come up with a certification program that would have any meaning for the 60,000 directors in the United States. Sarbanes-Oxley also has an extraterritorial reach, so you would run into the problem of imposing these same certification requirements on board members of foreign issuers, although that is a minor point. There are so many idiosyncratic requirements and so many things that go into making a good director; you have to understand the industry, you have to understand Sarbanes-Oxley, you have to understand roles and responsibilities, but in terms of certification, that is not something we think will grow.

Daum: In some ways, we're seeing a bit of the reverse. People are going through these programs, attend three days, and then say, "We're ready to serve on boards," and they are not. Just because you've gone through a program does not mean you will be a good director. You may be very smart and successful at what you do, but it doesn't qualify you to be a good director - it doesn't even qualify you to be a director.

But you have to be very careful about that qualification because if you say you will admit only certain people into a program, then the whole thing starts to be stretched unrealistically. Education is a great thing, and if you want to test people in the beginning and at the end, it helps them understand what they've learned. But I don't think it should be legislated in any way because there is no way to show that this makes you a better director.

The things that make good directors are, as Steve said, how they interact with your peers, as well as good judgment, wisdom, having been there, done that - a lot of things that can't be taught in a classroom. That doesn't mean you don't need to know the duties and responsibilities, but doing so doesn't make you a good director; it makes you a well-educated director.

Who are the most-qualified candidates to sit on corporate boards today, and how has that changed in the last two years?

Daum: First, there is a difference between qualified and educated directors. In the past, people didn't think about this distinction very much. A good director was an active CEO, and you assumed that with that [experience], you got wisdom: someone who was current in the market; someone who understood what it was like to manage multiple constituencies, including shareholders; and someone who had governance experience. When a board wanted to diversify, it brought on a woman or a minority, and that's how boards were structured. It didn't mean they were the most qualified or the best board members - I don't think people thought about it that much - it was just how boards were structured.

But the old model will not work anymore. Whether people want it to or not doesn't really matter, because active CEOs are being restricted by their own boards from serving on others or are just recognizing that they don't have the time to do so, so suddenly the ideal candidate pool of active CEOs is disappearing very quickly. People now have to think about what the board should look like, who is a qualified candidate, and what makes a good board member.

Over the past year, people haven't thought about it much because everyone has been looking for a financial expert to comply with the Sarbanes-Oxley rule. That was a big shift because that person may not ever be a CEO. But it was mandated, and people have accepted it. So people are grappling with this issue of what makes a qualified board member. Some boards will say, "I still want a CEO, so we'll get a retired CEO." Others will look at it differently, but, in general, most boards are starting to say, "We need a diverse board and that does not mean bringing on a woman or a minority, it means thinking about these nine to 11 seats differently and realizing we need people with different kinds of expertise."

However, you can't just recruit a marketing guy and a financial woman and a person who understands logistics, because then you will have a board composed of people who are not necessarily one-dimensional, but may really understand only one thing and not be able to support the entire board's activity. And if you go too far down into an organization to look for more junior people for the board, you have the problem we talked about earlier. They have never been in a boardroom, they don't know how to be a board member, and while they can grow into the job, you can't have too many of them in the room because then you can't do the business of the board.

This is a very complicated question right now because the obvious answer isn't available, and there hasn't been much research on the topic of what makes a good board member and how you select one based on the qualities you are looking for rather than the resumés.

Lopez-de-Silanes: Julie, you made the point that some people are starting to focus on the specific characteristics a candidate brings to the board: perhaps some industry expertise or special knowledge because he or she has a degree or experience in a certain field, or perhaps the company is global and you need someone who understands how the world works outside of the 50 states. I'll take a different tack.

There is some evidence of what kind of directors tend to be more effective, at least in terms of their fiduciary duties. Right now, there are two kinds of people you can appoint to a board - those who are there because they are supposed to be independent, and those who are there because they are not supposed to be independent - they are supposed to have the interests of shareholders at heart, and perhaps that's because they are shareholders themselves. The key is to understand that you must have someone who is supposed to be independent; you try to make sure that there are no conflicts of interest and everything is well disclosed, and that is what qualifies a person to be a good director. You should also realize that there are other types of directors who are very effective, and they are the ones that have a lot at stake.

When we talked previously about whether large shareholders can be qualified directors, there is no reason to believe that they are not qualified to be directors, particularly because they may suffer a lot based on what they do. Now, should they be checked? Yes. Do they have conflicts of interest? You bet. So what you need to do is make sure that you are aware of the costs and have mechanisms in place that will allow you to understand the problems they may present. Some are likely to be very aggressive, and to have primarily the interests of shareholders at heart. But others may not actually be like what people fear most in independents or outsiders in that they are not interested in taking huge bets because they just want to play it safe. So you may find some who want to limit risks and some who will want to take large risks, because that's what owning stock is about.

Bristow: Julie made an interesting point in that there's a sort of one-size-fits-all requirement built into that question, yet I think the answer varies by company. It is company-specific and even situational within a company. What challenges face a company that it can foresee, and what challenges will it face over the next year that it can't foresee? In some cases, figuring out which director is going to rise to the occasion would require clairvoyance. So we're stuck with the one-size-fits-all solution, and the one size that fits all is the best directors. And the evidence would indicate that the best directors are those highly experienced ones who are already on several boards, and are quite possibly CEOs.

What little evidence or objective data we have would be from watching venture capitalists, because they are highly motivated to make their companies successful as rapidly as possible. We often see venture capitalists sitting on 10 or 12 boards - which, in a public company context, we would think of as bad governance - yet they are clearly motivated to have perhaps the best governance. I'm not suggesting that everything that venture capitalists do is a model of good governance, but you can't argue that they are not aligned with the shareholders, which is a key principle on which we base much of what we say about good governance.

So using that model, it seems as though Sarbanes- Oxley, if anything, has taken us in the opposite direction, because the implication under Sarbanes-Oxley is that if you are on four or five boards, you probably are too busy to sit on an additional one, and perhaps you should even drop one of the boards you are already on, which is the point Julie was making about the qualified candidate pool shrinking. I think this is an unintended consequence that is going to have some detrimental effects that we will have a very hard time measuring.

But it is hard to imagine that a company in a basic industry wouldn't benefit by having Warren Buffet join its board and become a major shareholder in the company. I can't imagine in the current environment that Warren Buffet is looking to join more boards; he's probably being encouraged to join fewer. That is an important observation we didn't consider when Sarbanes-Oxley was drafted.

Wallenstein: Julie summed it up quite well. Two years ago, the ideal candidate for a board was a sitting CEO. That still may be the ideal candidate in a different kind of world, but that is not possible today because a large public board requires 200 to 250 hours a year of service, so it is no longer feasible for CEOs to sit on more than one board other than their own.

However, as there has been a tremendous rise in the need for financial experts on boards, that means full employment for many retired accountants and CFOs, a trend that will probably continue. It is becoming very tricky for people with full-time jobs to sit on boards, so we will likely see more retired people or semiretired people join boards, those with flexible schedules. Otherwise, how will they attend 12 audit committee meetings in a year? And, of course, you want independent directors, not just because they don't have conflicts of interest, but because when it is crunch time in the boardroom, they can be strong and stand up to the CEO. And some of those people are pretty acerbic, so you have to be careful. Can they interact well with others when things are going well, but stand up to the CEO when they aren't? It's not an easy call.

About the Author(s)

Duke K. Bristow, Financial Economist, The Harold Price Centre for Entrepreneurial Studies, Program Director UCLA Anderson School

Florencio Lopez-de-Silanes, Director, International Institute for Corporate Governance, Yale University

Stephen M.Wallenstein, Executive Director, Duke Global Capital Markets Center and Senior Lecturing Fellow, Duke School of Law and Fuqua School of Business, Duke University

Julie H. Daum, Practice Leader, North American Board Services, Spencer Stuart

T.K. Kerstetter, Corporate Board Member

Acknowledgment

Reprinted with permission. This discussion first appeared in the Corporate Board Member's 2004 Academic Council Supplement, Emerging Trends in Corporate Governance.

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