While it is important that a board have some directors who are independent and others who are financially literate, having a board that works – and works well — requires a mix of directors with significant expertise and experience and the right dynamics. This author, the head of a firm that recruits directors, explains what makes a board work well.
It takes a combination of three things to make a board of directors work well: expertise, experience and good dynamics. A combination of any two, without the third, increases the risk that the board will fail.
In Canada, commentators flag enterprises like Nortel Networks, Atlas Cold Storage or Ontario Power Generation and ask, “Where was the board of directors?” In all of those cases, insiders can explain why the board did not intervene to stop what now appears to be irrational exuberance, unsound implementation or questionable practices. These boards may be excused from liability on the basis that they exercised their duties as directors in good faith and with reasonable diligence, based on their knowledge and experience. Where the facts point to fraud-and perhaps in all of these cases-there may in fact be nothing else that the boards could have done. But before we shrug our shoulders and move on, it is worth asking an important question: Would the presence on the board of more directors with expertise in the business of the enterprise have enabled the board to identify problems sooner? If that is so, would that industry expertise, when combined with business experience and good dynamics, have enabled the board to act sooner? This article will address these questions.
1. Expertise: Knowing “When to Act”
At Russell Reynolds Associates, we have been hectoring our clients and prospects about the need for segmented expertise on a board of directors. By segmented expertise I mean a systematic review of the risks of the business and a determination of the extent to which the expertise of the board members spans those risks. It is not necessary, or indeed desirable, for each director to have expertise in all of the risks of the business. It is their collective knowledge that we are seeking. Without such expertise, a board may not know when it is time to act. It’s not much good having a board with the strength of character to act, if directors do not actually know when it is important to do so. We call this knowing “When to Act.”
The episodic nature of a director’s relationship with the company (quarterly or monthly meetings) precludes gaining expertise in the company’s risks as a result of serving on its board. Instead, expertise comes with immersion, usually as a result of the director’s own operating experience. Nuclear scientists know about fission, but they will not learn enough about finance from serving on the board. Accountants will have financial expertise, but they will not learn enough about fission from serving on the board. So, real expertise needs to come to the board with the directors, based on their own operating experience. If the board needs expertise in fission, it should look for a nuclear scientist not an accountant. If it needs financial expertise it should look for an accountant, and not for a nuclear scientist. If it needs both, it should recruit one of each.
This expertise is not limited to the opportunities and risks that are particular to the industry, such as credit and market risk for a bank, or supply or environmental risk for an energy company. It spans all the issues the company must confront.
For example, this was the basis on which we proposed an entirely new board (except for the chair) for a communications company that had just come through CCAA. In that case, the areas of expertise identified included not only telecommunications and technology, but treasury and corporate finance, regulatory affairs, accounting and control, sales and marketing, and human resources. The chair, the president and many of the board members reported that appointing board members who collectively spanned these areas of expertise as the first selection criterion accelerated the process by which the board was able to come to grips with the relevant issues.
It is more common for us to be asked to seek one or a few new members for an existing board. In such circumstances, we first identify the risks and opportunities of the company’s business by sector, just as we did in the previous example. We then map the expertise of existing directors against that list and do a gap analysis. We recommend to our client that our search focus on filling the gaps. Recently, in response to Sarbanes-Oxley and the OSC’s proposed requirements, many of our assignments have focused on adding financial expertise to boards of directors.
We acknowledge that in-depth expertise is not a panacea for mitigating board of director risk. We recently interviewed an audit committee chair of a publicly listed company. That chair is a CA and has a law degree, has practised accounting and law, and has considerable business experience. On that basis, we think he is a financial expert in the relevant field. He, his audit committee and his board had accepted the advice of the firm’s auditors on the adequacy of information needed to take a provision. However, that decision is now under review by regulatory authorities. If this expertise is insufficient to protect a board, it is reasonable to ask how one ever could get enough expertise on a board.
It follows that increased expertise leads to increased risk of directors’ liability. This is based on the premise that the more expertise a board has, the more it is expected to be accountable. The future of directors’ liability is heralded and exemplified by the requirement for financial expertise on the audit committee and the increased risks that may be associated with sitting on that committee. How long can we go on before human resources expertise is required on the human resources and compensation committee, occupational risk expertise is required on the workplace safety committee, and governance expertise is expected on the corporate governance committee?
While increasing expertise may increase the risk of liability, the probability of detecting adverse risk should also rise. The answer to minimizing liability is not to elect inexpert directors, but rather to respond to the need for expertise with pay levels that attract competent directors, and with D&O insurance and corporate indemnities that minimize the liability risk for directors. In our experience, the questions asked by D&O insurers have become more focused recently. This should lead to premium differentiation based on board competence.
In any event, we are conscious that the push to increase expertise on a board runs the risk of having the board intervene inappropriately in the management of the company. Yes, we do need to build boards of directors with the expertise to know “When to Act.” But we also need to build boards that have the wisdom to know when not to act, when the best course of action is to advise management and to consent to management’s action. After all, it is only in extraordinary circumstances that the board becomes responsible for managing the company’s business. In ordinary circumstances, it is the board’s responsibility to supervise the management of the company’s business. That’s the difference between policies and procedures. Therefore, once we have identified pools of candidates with expertise in those areas where gaps exist, we move on to secondary selection criteria that give management the room to operate. These criteria are discussed in greater detail below.
2. Experience: Having the “Will to Act”
We have developed methodologies that add expertise to the board and still leave the CEO and management with enough time to run the company without playing “running dog” to the needs of the board.
The first line of defence is a selection process that applies business experience as an overlay on the expertise matrices. Our clients call it “business savvy” or “street smarts.” The second line of defence is having a competent chair.
We have come to understand that our clients prefer to define business savvy as “having experience as the CEO of a publicly traded company.” We call this a “jaws of death” situation, where the slope of the demand curve for such persons is rising and the slope of supply curve for such persons is falling. While not all board members need to be a current or previous CEO, it is important that enough members of a board have the requisite business savvy to ensure the momentum to act swiftly and decisively when action needs to be taken. We call this the “Will to Act.” These are also the people who have the patience not to act.
The foundation of the old boys’ network of directorship appointments is based on getting the “will to act” equation right. Board nominating committees, acting in good faith, are looking for directors who will have the will to act when extraordinary circumstances arise, and the wisdom to offer advice and consent at any other time. Appointing people they know to the board, or appointing people who are known by people they know, are two of the surest ways for nominating committees to achieve this goal. That’s because these nominees have been seen in action. That’s also why it’s hardest for prospects with no experience as directors to get their first board appointment.
It is important to record that the network is now much wider than the group of people who went to Upper and Lower Canada’s private schools and who demonstrated their will to act on the schools’ playing fields. It includes people who have worked their way up the ranks of large corporations, successful entrepreneurs and the people they have had on their boards, and the people who have joined the network as a result of equality-related initiatives. That said, executive search firms who conduct board of directors searches can widen the scope of the network still further. Search professionals at this level usually have broad-based rings of networks that can reach further than most senior business professionals. This widens the potential pools from which to draw nominees. If the recruiters are trusted, the nominating committee may be prepared to accept their confirmation that a nominee has the will to act and the judgment to know when not to act. The more probable case will be that the recruiter must find someone who knows both the nominee and one or more directors on the board, and who is prepared to speak with confidence on the nominee’s business savvy.
We recently acted for a Canadian company seeking a U.S.-based director for its board. A preferred nominee was identified, but headway could not be made until we found a person who was known to the CEO and who could speak to the CEO directly about his experience with our nominee.
In our experience, a reference from someone aboard member knows personally carries vastly more weight than a reference from any other person, no matter how prestigious or pre-eminent that other person might be. Knowing the person giving the reference personally changes the dynamic of the reference. In that case, there is a personal relationship between the board member and the referee as well as between the referee and the candidate. The referee knows that he or she may see the board member again at a conference or a cocktail party and would prefer not to be asked why he recommended such a difficult person.
We do not have a methodology to divide directors or director candidates into behavioural types. Even if we could do this successfully, the value of buy-in for behavioural selection by board nominating committees would be doubtful. Instead, we ask the candidate to tell us stories about tough decisions they have had to make either as an officer or as a director. Often we can flag the issues we want to know about because they have been reported in the media. We want to know if our candidates remember errors they made in the past and what they have learned from them. We then seek to check the stories by talking to people we know who were there at the time. The size of Canada’s population makes this possible. Apparently, it’s harder to do in the United States.
Our methodology, which sorts candidates first by expertise and second by business savvy, has proved to be a powerful tool for promoting equality candidates. We recently assembled and reviewed the list of women who serve as the CEO, COO or on the senior management committee of the FP’s list of the top 200 Canadian companies. We found the list to be a modestly sized one, particularly when limited to line positions. Under our methodology, sorting first by expertise, we are able to identify senior women on their way up. Some of our clients are prepared to draw from this list in the expectation that the candidates’ business savvy will grow over time. In the meantime, board expertise can be enhanced, and the will to act can be carried by other directors.
A competent chair
If business savvy is the first line of defence for ensuring that management has the time and room to operate the business, then a competent chair is the second line of defence. In our experience, effective leadership of the board by the chair is vital to the success of managing a board that has expertise. One chairman said to me that we should pay him a fee for training the directors that we had proposed for his board who had expertise but limited business savvy. He then confirmed that during the year, the board’s overall expertise enhanced its ability to supervise the management of the company. In another board, the chair found that expertise and business savvy also has to be thoughtfully distributed in each of the board committees as well. In that case, the exuberance of the governance expert at the committee level ran the risk of eroding the authority needed by the CEO to run the business on a day-today basis.
3. Dynamics: Board climate review
We have now concluded that knowing when to act and having the will to act are not, by themselves, adequate for ensuring that a board will be effective. Aside from having industry expertise and business savvy, a board must take steps to ensure that the environment in which it operates can replicate and sustain best practices in corporate governance. We call this a Board Climate Review.
This Board Climate Review is different than a board compliance review, or a board performance review. Below, we differentiate among the three types of review.
Board Compliance Analysis: In this review, the bylaws, policies and procedures relating to the board of directors are compared to the applicable legislative and regulatory requirements. Actual practices are measured against best practices such as OSC guidelines, Sarbanes-Oxley requirements or the Higgs Report. As well, board and committee Terms of Reference are compared against the board and committee minutes to ensure that Terms of Reference requirements are being met.
Board Performance Evaluation: It is not sufficient for the board members to have the “Will to Act” if they do not know “When to Act.” Board Performance Evaluation concerns itself with directors’ competencies, experience, performance and capabilities. This is the process that we have referred to above in our gap analysis.
Board Climate Review: Many failed boards have, in fact, been compliant. Which is why, quite often, the collective values and attitudes of directors are more accurate predictors of success. These surveys generate data and observations about how well the board is functioning in terms of relationships, values and attitudes, and identify areas for improvement.
In the Board Climate Review, Russell Reynolds Associates engages in intensive interviews with each director and develops data on matters such as the board’s values and attitudes. We identify the clarity of objectives and the board’s implementation skills to achieve them, and the bureaucracy that stands in the way. We assess the willingness to use different approaches to achieving results, going beyond collaboration to persuasion and the willingness to rock the boat. We look at board leadership, board diversity, and committee size and composition.
The information developed is then shared with board members and helps to build an environment in which the board can operate more effectively together. While Russell Reynolds Associates adds value to this process through its methodology and experience, the real value is derived from the boards’ own review of the material and its discussion of it. This, in turn, creates a more effective and efficient board and ensures that management’s time is not wasted babysitting a board that is dysfunctional.
Our experience in recent years confirms the importance of recruiting on the basis of expertise as well as business savvy. Expertise in both the industry-specific risks of the business as well as all the other risk parameters increases the probability that the board will identify issues of concern and thus know when to act. Business savvy, under the guidance of a competent board chair, helps ensure that the board has the will to act when it is time for action and the wisdom to advise and consent most of the time, so that management can run the business. However, neither, or even both, seems to be a complete answer in the absence of an effective board climate. This is not rocket science. For years, our clients have talked about the importance of “board chemistry.” All we have done is isolate “board chemistry” from “industry expertise” and “business experience” and then broken “chemistry” down into its component parts, such as values, objectives and operating style. On that basis, chemistry can be analyzed and improved, and so lead to a more effective and efficient board of directors.