Law & Governance

Law & Governance March 2006 : 0-0

Board Independence: Striking the Right Balance

Robert L. Heidrick and Dayton Ogden

Abstract

Three years since the wave of governance reform swept in the Sarbanes-Oxley Act and a slew of new exchange listing requirements, corporate boards have adapted thoroughly to the new governance landscape.
Most directors have embraced their expanded role and responsibilities with a strong sense of purpose and dedication to their fiduciary role. Beyond the "boxchecking" inherent in satisfying the regulatory requirements, boards undeniably are stronger and more independent from management than they were just five years ago. Independent directors now meet regularly in executive sessions, often at every board meeting. Audit committees comprising outside directors have assumed a greater role in approving financials and external financial communications, identifying potential risks to the organization, and ensuring that management is addressing those risks. Compensation committees are coming to grips with the details of CEO compensation plans, even bringing in their own external consultants to help them understand the true costs of compensation plans. In short, boards are more knowledgeable about their companies, more engaged, and in a stronger position to probe and question suspicious activities than in the past.

Through our work, we at Spencer Stuart also have observed a dramatic change in the way boards approach new director recruitment. In the past, a board vacancy may have been filled by a friend of the CEO; today's board nominating committees have assumed the primary responsibility for director recruitment. Most have adopted methodical and transparent recruiting processes with the goal of assembling a board of directors that will add the greatest value to the company.

Unintended Consequences of Governance Reform

All of these developments have reinforced the independence of corporate boards, which was essential in the wake of the scandals that spurred the creation of the governance regulations. But the dramatic increase in directors' responsibilities and personal liability associated with board service has created unanticipated problems for many boards.

One of those challenges is a sharp rise in the difficulty of recruiting new members as the demand for new directors vastly outpaces the supply of the most experienced, knowledgeable, and tested corporate leaders. This has occurred as demand for new directors has grown in response to new governance reform requirements. Boards are having to recruit directors who meet the tightened definition of "independence" and also have the qualifications to serve on key board committees-the audit, compensation, and nominating committees-which must be wholly independent in public companies. Board turnover also has increased as directors continue to pare back the number of board commitments they make.

On the supply side, the most notable change is reduced availability of CEOs for board service. CEOs traditionally have been highly valued as board directors for their general management experience, big-picture view, and knowledge of current business challenges. At the same time, CEOs willingly made time for outside board assignments in the past because they provided opportunities to network and observe different industries.

In the past several years, however, CEOs have been curtailing their outside board commitments. In 1998, CEOs of S&P 500 companies served on an average of two outside directorships. The average today is about one. The 2005 Spencer Stuart Board Index, an annual study of the board composition and practices of S&P 500 companies, found that, among newly recruited directors, about a third were active CEOs and chief operating officers. In 2000, just over half of all new directors served in these roles. Given their own demanding schedules, most CEOs simply do not have the time to serve on outside boards. And, increasingly, boards are limiting their CEOs from serving on more than one outside directorship, if not outright banning outside board service altogether. This is bad news for companies, which benefit from the exposure CEOs get to other industries, business issues, and leadership styles through outside board experience.

In response to the shortage, boards are turning to retired executives, as well as nontraditional board candidate pools-such as direct reports to the CEO, and academics. The Board Index found that 13% of new directors were retired CEOs or chief operating officers, compared with 9% in 2000. Divisional and functional leaders made up 11% of new directors, compared with just 6% in 2000. Academic and nonprofit leaders represented 10% of new directors, versus a mere 2% in 2000.

These individuals can bring valuable perspectives and experience to the board, yet boards considering tapping non-traditional sources for new directors must understand the tradeoffs. In particular, CFOs and other senior functional leadership do not control their calendars and may not have the flexibility they need to fully meet their board commitments. Director candidates from lower levels of an organization or from academic and not-for-profit circles may not possess the depth of management experience or the broad senior-level perspective of CEOs. Finally, retired CEOs, chairs, and COOs are highly experienced, but potentially less current on the critical business issues of the day.

The sheer volume of responsibilities has created other challenges and potential pitfalls for boards. As meeting agendas become more packed with compliance-related issues, some directors have expressed concern that boards have less time to engage in strategic discussions and counsel with the CEO. And as they become more vigilant and steeped in the business, directors must guard against becoming too operationally focused. Directors who go too far-beyond active oversight of management to active management-risk alienating senior leaders and disrupting the optimal board-management relationship. As they grapple with their growing set of new responsibilities, boards must be active, independent voices in governance, without overstepping the boundaries of the role.

Striking the Right Balance

How can boards maintain their independent posture and ensure that the benefits of governance reform continue to outweigh the consequences? Boards should make sure they have the right composition, guard against overstepping their role, and maintain an independent, but collaborative posture with management. They can do this by adopting several strategies.

Attract and keep the right people. First, boards must attract and retain the very best directors. This begins with a director nominating process designed to identify the skills and experience needed on the board in light of the unique character and strategic goals of the organization, and recruit directors best suited to those needs.When helpful, boards should consider engaging outside experts and human resources professionals within the organization to help with this process.

Nominating committees should take the lead in director recruitment, but they must approach the process in partnership with the CEO. No qualified director candidate will be willing to join a board without being confident in and comfortable with the CEO. Further, a new director who has the confidence both of the board and the CEO will be in a better position to contribute effectively from the start.

Finally, boards should recognize that, while director candidates still regard board service as prestigious, they nevertheless are more cautious about accepting new directorships. Candidates are conducting careful due diligence aimed at assessing the strength of the business and the integrity of the organization before joining. By setting expectations about the company's values and behavior that are lived and disseminated by management, boards also can improve their chances of attracting the most experienced and effective leaders to the board.

Manage the board's time effectively. The most highly qualified candidates want to join boards where their time and participation will make a real difference. Boards are more likely to attract and retain these outstanding directors if the board and its committees operate efficiently and effectively.

With so much on their plates these days, board and committee chairs must be diligent about running meetings efficiently and focusing on priorities spelled out in their charters. Materials should be distributed well in advance so directors have ample time for review and can focus meeting time for unscripted discussion about top issues. Board and committee chairs also should continually review whether meeting time is being used appropriately.

Leverage the lead director. A lead director or nonexecutive chairman can play an important role in improving the communication among directors and between the board and the CEO. One of the key roles of the lead or presiding director is to run executive sessions of the board, which provide opportunities to surface director concerns and ensure that feedback is shared in a timely way with the CEO. While executive sessions used to be a relatively rare practice among boards, today independent directors are required to meet once a quarter without management-and many conduct an executive session in conjunction with every board meeting.

The lead director also typically has a role in reviewing the agenda in advance of meetings with the CEO and ensuring that directors receive materials well in advance so they are prepared for meaningful discussion at meetings. The lead director should be a strong and trusted board leader who is willing and able to spend the necessary time on these duties.

Make the most of board evaluations. When done right, board evaluations provide a forum for directors to review and reinforce appropriate board and management roles and ensure that issues brewing below the surface are addressed promptly. These can range from operational complaints about meeting length or the composition of the agenda, to larger, potentially thornier issues concerning the board's role in strategic decision making, gaps in knowledge and competencies on the board, and executive and director succession planning.Well-planned and executed evaluations give the board an opportunity to identify and remove obstacles to better performance and to highlight what works well. The board must commit to reviewing the results of the evaluation and be dedicated to addressing issues that are raised through the process.

Offer ongoing director education. Director education and training can help new, less experienced board members understand their role and governance requirements, and ensure that they have the tools to be effective. Accountable in ways they have not been before, even longtime board members should not hesitate to demand training on company processes and risks, as well as key regulatory developments.

Conclusion

The dramatic changes in the regulatory environment and the shift in investor expectations during the past few years have had the effect of making boards reflect more "technical independence." They also have become more independent in practice. As directors take on new responsibilities and more actively monitor management, they are in a better position than in the past to identify and address potential risks. Boards that act with integrity and independence, and provide candid and constructive feedback to management without overstepping their oversight role, are likely to achieve the benefits of governance reform, without falling victim to its unintended consequences.

About the Author(s)

Robert L. Heidrick is the global leader of Spencer Stuart's Industrial Practice. He is a trustee of Illinois Institute of Technology and Rush-Presbyterian St. Luke's Medical Center.

Dayton Ogden is chairman and prior CEO of Spencer Stuart. He serves on the board of the American Business Conference and is secretary and a director of Project HOPE.

Acknowledgment

Reprinted with permission.

The article first appeared in the Corporate Board Member Magazine.

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