The Director’s Cut
Boards of directors traditionally take a more active role in a company’s story in turbulent economic times. Now is no exception.
By Kristine Blenkhorn Rodriguez
As Messrs. Frank and Dodd work to persuade their respective government bodies to pass their versions of financial re-regulation, many in the finance sector pause. There is a sense of, “We’ve been through this before.” The Sarbanes-Oxley Act was a reaction to the hubris of Enron et al. In 1988, the Insider Trading and Securities Fraud Enforcement Act was created in response to junk-bond magnate Michael Milken’s illegal activities. And even the introduction of the 1934 Securities and Exchange Act was a response to the stock market crash of 1929.
Here we are in the 21st century, still trying to cure what ails us as AIG and Bear Stearns become poster children for irresponsible risk.
Try as we might, the magic formula seems to elude both finance wizards and legislators. There are unintended consequences, and loopholes abound, despite best efforts to design bullet-proof legislation.
“SOX, despite its good intentions, was like a magnet,” says Jay Conger, author of Boardroom Realities: Building Leaders Across Your Board (Jossey-Bass, 2009) and number five on Business- Week’s list of the world’s top 10 management educators. “It drew boards of directors to attend to very focused areas of compliance. So boards watched over the CEO’s and the executive team’s shoulder around compliance issues. You can push for compliance, but if your top executives don’t clearly understand the products—in the most recent wave of Wall Street debacles, the financial products—your company is dealing in…well, you do the math. You have a board that on technical issues kept the company compliant, but failed miserably on strategy and risk oversight.”
“When you see boards that missed questioning paper making 12 percent in a 5-percent interest rate environment, you have to realize that they must have been focused on other issues because, otherwise, healthy skepticism would absolutely have reigned,” says Ken Daly, president and CEO of the National Association of Corporate Directors (NACD) and KPMG’s former lead partner for its national risk management practice.
It’s not just legislation and regulation that prompts increased board activity. Turbulent economic times make any sane board of directors a bit jumpy, no matter how successful their corporate charge is.
“Over the last 10-plus years, the trend has been toward boards becoming more involved,” says Northwestern University Professor and former Bell & Howell Chairman/CEO William J. White. “Obviously, in the last two years, they didn’t do a good enough job of understanding risk/reward tradeoffs. Increased involvement only helps if you’re focused on the right areas.”
Traditionally, board membership has been like getting into a private club, says Milan Moravec, CEO of management consulting firm Moravec & Associates. “The membership, particularly of elite boards, has been very difficult to change. Those choosing board members tended not to ask the right kinds of questions. If you minded your p’s and q’s, didn’t really question things and had good industry connections, you’d get a board seat. You can imagine the consequences of creating a board with those qualifications.”
Traditional board members tended to serve on multiple boards. But those days are over, says Daly. “The involvement of boards is going to pick up. There’s no question about that. They will be more engaged and better resourced. But the days of people serving on four or five boards at a time are gone. The number- one risk nowadays is a reputational one. Serve on the board of a failed company and you gain the kind of celebrity you’d probably rather avoid. Qualified people will serve on fewer boards because the demands of being a board member have increased exponentially.”
...Which brings us to GM
No story on boards in today’s environment would be complete without mention of GM.
“GM is a great example of a board that wants to continue in oversight but is forced into a management role,” explains Daly. “When things go bump in the night, as they have at GM, boards are pressed into managerial areas they’re usually ill-prepared to take on, simply because they don’t have sufficient time to function as management. Nor should they have to in a well-run company.”
When boards become part of management, caution is key, says White. “There is a danger that GM is getting close to going over the edge in certain areas. The most obvious example is having the chairman of the board appear in TV commercials. Traditionally, even the CEO does that only rarely.”
White cites the Opel deal as an instance where the board exercised its oversight right in a healthy way. “Management may not have done a thorough job of analyzing the total situation, including the long-term strategic impact. The resulting dialogue that occurred as part of considering a major deal is what should happen. When you’re looking at recapitalization or divestiture, a board needs to ask the tough questions and step in if necessary, even if, publicly, it’s slightly awkward.”
Most boards could be more aggressive in the way they oversee management without overstepping their bounds, says Stephen M. Davis, Ph.D., senior fellow at Yale University School of Management’s Millstein Center for Corporate Governance and Performance. “Many boards don’t step in because their accountability to owners is weak. For many boards, the accountability between directors and owners is so frayed. Boards traditionally have been insulated from owner backlash. But GM is different because it has faced a dramatic break from its past with exposure to an impatient new owner: the US government, a.k.a. the American public.”
And with an impatient new owner comes the onus to act swiftly, which worked to the detriment of former GM CEO Fritz Henderson. Henderson’s brief eight-month stint in the lead role at GM is unusual, but so is the situation, says Conger. “From the standpoint of board dynamics, it’s unusual for a CEO to be ousted so quickly. Many board members are usually former or current CEOs, so the empathy factor is in play. Usually, a chief executive gets a honeymoon period and the benefit of the doubt that accompanies it.” Conger speculates that Henderson’s quick oust was based on several major decisions the board felt went awry—in this case, GM’s string of divestitures.
Davis applauds the move in theory. “Although it may have looked from the outside like Mr. Henderson was taking GM in a positive direction, the insider’s view must have been different. This independent group of directors acted very swiftly to head off what they thought were problems. That’s the way it’s supposed to work, proactively instead of reactively. That’s a board doing its job.”
The new board member
The effect of our current economic environment and the failure of several household names is multifaceted. One major result? A new type of board member.
While we mentioned that board members most likely will no longer serve on several boards at one time, an even more effective modifier exists: Proxy.
On July 1, 2009, the SEC voted to approve an amendment to New York Stock Exchange Rule 452, eliminating broker discretionary voting of uninstructed shares in uncontested director elections. The amendment became effective January 1 of this year, and applies to all publicly held companies.
Kimberly K. Rubel and Jae En Kim, of the Corporate Securities and Practice Group of Drinker, Biddle & Reath LLP, explain the ruling succinctly in a July 2009 Securities Alert: “Shareholders can hold shares of public companies directly or indirectly in ‘street name’ through a financial intermediary, such as a broker. These intermediaries seek instruction from beneficial owners who hold shares indirectly as to how to vote on items put forth at a meeting of shareholders. NYSE Rule 452 permits brokers to exercise discretion to vote on routine items if they have not received voting instructions from the beneficial owner of the shares at least 10 days prior to the meeting. Previously under Rule 452, uncontested director elections were considered routine items, but the amendment recategorized [sic] them as non-routine items, meaning that, beginning with meetings held on or after January 1, 2010, brokers can no longer vote shares without instructions from the beneficial owner.”
Rubel and Kim go on to describe the consequences for public companies: “Historically, brokers that have not adopted proportionalvoting have tended to vote uninstructed shares in favor of the board slate of director nominees. New Rule 452 will likely result in fewer votes ‘For’ board nominees, and for companies with majority voting, this could make it more difficult for the nominees to achieve the majority ‘For’ vote required for election.”
In essence, the amendment no longer allows brokers to give companies votes that belong to investors who do not exercise those votes. This action could make dissenting campaigns more impactful and in some cases make it harder to achieve a quorum.
The amendment’s impact was already felt late last year, when entities such as American Funds sent out voting materials with “PLEASE VOTE NOW” and “YOUR VOTE IS VERY IMPORTANT. VOTING NOW HELPS YOUR FUNDS LOWER OVERALL PROXY COSTS AND ELIMINATES PHONE CALLS.”
Davis is not surprised by the pleading tone. “It’s not just the amendment that’s changing the game. The rise of social networks in addition to this amendment, I think, will have a huge impact in board elections. The Obama campaign’s successful use of social networking is proof that it is a powerful tool. Social networking has begun an epic migration into the capital markets and the collective power of individual investors will begin to be felt through that channel, especially since the previously inactive shareholder votes now can’t automatically be counted as a win for the company’s agenda.”
Davis cites organizations such as ShareOwners.org as game changers that foreshadow what’s to come. The nonprofit organization’s website tells visitors it “was founded to create a voice for the average retail investor, who has not been heard in the corporate boardroom, Washington policy debates, or by the decision-makers in large financial institutions, including mutual funds.”
Davis sees organizations such as this being a force for positive change. “If you look at the garden-variety proxy statement, bearing in mind that this is the principal communication between a board and investors, it’s almost impenetrable, even to a very intelligent investor. The message this conveys is that the board is checking off the boxes so the company lawyers are happy. If ShareOwners.org and its counterparts can force companies to have to communicate in plain English with shareholders, that’s a wealth of good right there.”
White sees the change to the proxy process as a deterrent to some would-be board members. “It will be too easy for shareholders to nominate candidates who represent special interests or are not fully qualified. We could end up with a lot of beauty contests.”
Moravec is not a fan of the change either. “I don’t think people out there can really get organized to set up a worthy challenge to current board members. It’s a joke. You have to be extremely wealthy to do that. Instead, it’ll pick up fringe groups that have one cause to promote.”
Daly is a proponent of the proxy process, with certain conditions. “I don’t think anyone wants politicking with the proxy process. The NACD recommends proxy access that lines up with the nominating governance committee. That committee knows the talent around the table and they know how it fits with company strategy. It prevents someone from getting on a board with a hidden agenda—unionizing, for example. That’s not proper. It also prevents the opportunistic candidates from applying successfully— the equities fund manager who wants to jack up the stock price to get rid of the company and profit.”
Davis, too, sees the upside to the proxy process change. “If the post-crisis rules and regulations truly go into effect, it will fundamentally alter the accountability of boards to investors—for the better. Assuming majority rule is required for a director to be elected, for the first time in US history, every public company board member will be vulnerable to ouster. Previously it was almost impossible to vote out a director. Boards will now be exposed to investors in a way they never have been before.”
This exposure will require board members who are seasoned enough to withstand standard, documented individual evaluations on a regular basis, says Conger. “In the future, the board will not be able to stand or fall together. Shareholders will start to hold individual board members more responsible for their action or inaction on key items.”
Conger also sees more insiders being added to boards, despite the push for outside directors. “You’ll see more CFOs and COOs, and possibly heads of HR on the board, because members are realizing that if the CEO is the only voice and puts on his or her best face all the time, they’re not really getting an accurate picture of the company or where it’s headed.”
The new chair
If a new type of board member is important, then a new-generation chair is imperative.
Moravec uses the example of a chair he knew who was called in to take over a distressed company. “He realized the way the board had operated in the past didn’t work. He didn’t want a gentlemen’s club where everyone whispered. He welcomed dissension and wanted negotiation over differences. He had two people on the board who had different opinions regarding the company’s strategy—both very vocal. After they had argued it out for some time, he said, ‘Now you two be silent. I want everyone else in the room to tell me what you heard these two say and where you sit on the issue.’ The only questions he allowed other board members to ask were clarifying ones—nothing that required elaboration. These two parties ended up getting new insights into the issue and came up with a third solution that was more innovative and a bigger risk.
“This chair changed the tone of board meetings and took a previously dormant session, where things were decided in the men’s room, to a useful exercise for the company. Now that’s a properly coached chairman, and every company now needs one.”
“You don’t want insider outsiders as your chair,” says Conger. “By that I mean someone along the lines of a retired CEO, a banker with close company ties or the audit firm’s most senior partner. Splitting leadership roles on a board is a good thing. You don’t want a board dominated by a CEO who also serves as chair. You really want a lead director and a non-executive chair in order to invite a much more active board.”
Conger goes out on a limb to say that in 10 years, we’ll see nonexecutive chairs in 80 to 90 percent of US companies, compared to the 17 to 18 percent currently in S&P companies. “We’ll look a lot more like boards in the United Kingdom in the next decade, in that respect,” he says.
Crisis as opportunity
In all his years of consulting, Moravec says the moments of true leadership among board chairs do stand out. He cites a recent experience, in which the chairman of a new board challenged the members to help the Midwestern manufacturing company in question to succeed. He did so simply by saying, “You never want a serious crisis to go to waste, ladies and gentlemen. This is an opportunity to do things we could not do before. The fact that our industry is mired in the worst recession in a decade allows us to confront problems that have festered for years.”
What this chairman realized, says Moravec, is that the company’s failures had created it anew. “People need to recognize that broken organizations are new organizations,” he explains. “When a company breaks or is unable to perform, you have to recreate it. Going back to the old and tinkering with it a bit doesn’t work. If you have an ice hockey team and you lose four key players, then the next season it’s a different team. You plan differently. You play differently. The team performs differently. It’s the same with companies. An astute chair realizes that. If only we had more of them over the past decade, things might have turned out differently for some very big names.”
And the survey says . . .
For its 2009 Public Company Governance Survey, the National Association of Corporate Directors surveyed over 600 public company board members and used the proxy statements of some 3,750 public companies. Among its findings:
• Strategic planning is the top concern among board members, followed by corporate performance and valuation.
• Risk oversight became a much bigger issue than in past surveys, jumping from fourteenth to sixth place. In 58.5 percent of boards surveyed, the audit committee has primary responsibility for risk oversight. The full board is responsible in only 29.8 percent of the cases. And approximately 5 percent of companies have a risk committee in charge of this area.
• Separate roles for the board chair and CEO have risen over the past four years, with 49.1 percent of boards implementing this strategy.
• Management and finance experience are in high demand for board members, clocking in as the top two desired areas. Marketing and external audit experience were also identified as key competencies.