According to recent surveys by McKinsey & Company and Russell Reynolds, the quality of a board of directors is a significant factor for institutional investors in making investment decisions. These investors want information on individual directors’ track records and their contributions to the board. They also want to know where they stand on crucial boardroom issues, as well as careful assessments of board performance.
Over the last several years, we have studied a small group of companies that are leaders in boardroom evaluations. In this article, we describe what we have learned from these standard setters, and why we believe that well-managed appraisals can increase a board’s effectiveness and accountability, and improve its relationship with the CEO.
Despite the potential benefits, our research shows that only 40 per cent of major North American companies conduct formal performance evaluations of their boards. Individual evaluations of directors are even less common and more controversial. Surveys by Korn/Ferry and the American Society of Corporate Secretaries indicate that only 15 per cent of Fortune 1000 companies appraise the performance of their individual board members, although it is common practice for boards to evaluate CEOs.
Obstacles to evaluations
The first obstacle to conducting an evaluation is opposition by board members themselves. Simply put, directors and CEOs are reluctant to evaluate high-profile board members. For example, how does one critically assess a peer without causing conflict and harming working relationships? And, is it reasonable to evaluate busy executives who participate on boards on a part-time basis? At the same time, these questions highlight the importance of constructive evaluations in improving the performance of both the individual director and the board itself.
CEOs and boards of directors worry that evaluating the performance of individual board members could drive away good candidates who feel they have already proven themselves. At a time when there is heavy competition to attract top directors, appraisals might deter good candidates. One CEO we interviewed reported that his board strongly resisted a director evaluation plan that he presented to it. Board members told him it “wasn’t worth it” to be on his board if they had to go through an evaluation.
The question of who should actually evaluate the directors is also an obstacle. Board members are peers, and may be reluctant to critique a colleague’s performance. They may also lack the information needed to make an accurate assessment because boards spend relatively little time together, and what occurs in meetings may not be the best gauge of a director’s contribution. “Not every board member contributes actively and asks questions at board meetings,” said one corporate secretary. “A lot of people are very quiet, but they are very effective. They operate in different ways. We’ve got a board member who hasn’t said ten words at a board meeting, and yet one of the other directors said getting that guy on the board was a real home run. It’s what goes on in sidebar conversations, at dinners, telephone calls between meetings, that may really matter.” Indeed, some boards felt individual evaluations might even promote counterproductive behaviour: “I think it leads to the wrong kind of responses, encouraging individual board members to talk when there’s no need for it,” said one director.
Since each director brings a different set of competencies to the board, it can be difficult to establish criteria for assessing members. A universal set of criteria may overlook the different ways in which individual members contribute. Said one board member, “We have several directors who are very knowledgeable about the technology issues this company deals in. But they may not be at all, or nowhere near, expert in financial matters. And some of our directors have a strong financial background. With acquisition and takeover issues, they will play a much greater role than others. You have other directors who have a stronger background in personnel management and can deal more expertly with issues about employment benefit plans or diversity issues. Different directors contribute in different ways at different times. A uniform evaluation cannot capture these different contributions.”
Finally, research on team effectiveness clearly supports the idea that when individuals such as board members are interdependent, it is more important to evaluate and reward the overall effectiveness of the group. Otherwise, individuals tend to optimize their individual performance rather than contribute to the team’s effectiveness. The primary focus in appraisals should be on the performance of the board at the group level rather than the individual level. The implications for reward systems are clear: Director pay should be tied to overall corporate performance through stock and bonus plans, not to individual performance.
The case for individual evaluations
Despite the lack of a consensus on director evaluations, we believe that there is a need for some form of individual appraisal in the overall board evaluation process. A survey on corporate governance by executive recruiters Russell Reynolds in the late 1990s showed that investors strongly feel that boards need to be more aggressive in weeding out under-performing directors. The average size of boards is decreasing, and as a result both the demands and rewards for serving on boards are increasing. Companies today need more from directors than to simply have them show up at meetings and ask questions. An individual assessment is a good way of making performance expectations clear and of actually improving director performance. Support for this view is provided by recent Korn-Ferry surveys of Fortune 1000 board members. The surveys show that in companies where individual directors are evaluated, directors rate the board’s overall effectiveness more positively.
We have found that performance feedback can help individuals evaluate their own skills as directors and motivate them to be more effective contributors. Evaluations can also help directors assess their performance over time as the needs of a board shift, and provide a basis for deciding whether a director should be reappointed. These evaluations demonstrate to investors that the board is holding individual directors accountable for their performance. In the absence of formal reviews, directors are all too often evaluated informally, in a hit-or-miss fashion that provides neither good feedback nor valid data.
Individual director evaluations are an important complement to the evaluation of a board’s overall performance. Certain issues of effectiveness simply cannot be addressed without evaluating individuals, and one of the most important is membership. Board members are usually only replaced for performance reasons, and only in extreme circumstances (e.g., criminal misconduct, conflict of interest, active disruption, very poor attendance/participation record). When they are replaced, they are rarely given an early warning or a chance to improve. In most cases, boards wait for poorly performing directors to retire, or they choose not to re-nominate them when they reach a term or age limit. While it appears from our research that under-performing directors are relatively rare, we believe it is sound practice to identify such individuals through a formal assessment process so that timely, corrective action can be initiated.
Board members are like any other human being. Although there is usually some anxiety associated with getting feedback, they realize it is necessary and helpful. For new directors, thoughtful, comprehensive appraisals are more effective than the feedback that takes place in a happenstance manner, and they can help bring them “on-board.”
Conducting an evaluation
To be effective, boardroom appraisals need to have specific, clearly defined steps and practices, and a special commitment from individual directors and the CEO. This is necessary to overcome the hurdles and address the pitfalls that make performance appraisals one of every manager’s least favourite activities. Without the right steps and commitments, everyone involved in the evaluations simply goes through the motions of asking a few questions or setting performance targets that are checked off every year.
The first step in making the appraisal effective is to overcome the discomfort that the evaluation process is likely to generate. The best approach is to have the CEO and the chair of the nominating or governance committee engage the board in a discussion of the potential advantages of the evaluation and the process.
Once the board has committed itself to the formal appraisal process, the next step is to define the dimensions that should be evaluated. Ideally, the nominating or governance committee designs a preliminary set of dimensions covering the essential responsibilities of an effective director. These should be behaviours that both the individual director and their peers can actually observe. The appraisal dimensions should then be presented to the full board and CEO for discussion and debate. Ideally, the final list should include a moderate number of behaviours, say, 15 to 25. If there are not enough criteria, important dimensions may be overlooked. If there are too many, there will be little sense of which ones are the most important. It is best to use a short evaluation form with a simple rating system and space for more detailed written responses.
The assessment needs to recognize the distinctive set of competencies that each director brings to the boardroom. At the same time, there should be a set of general dimensions that describe what is expected from every effective director irrespective of his or her expertise.
These dimensions include:
1. Knowledge of the business: Does this director have an adequate understanding of the company’s strategies, industries, markets, competitors, financials, operating issues, regulatory concerns, technology and general trends?
2. Knowledge of senior management: Does this director know the executive team’s skills and abilities, and are they aware of succession issues? Do they have sufficient personal contact with the company’s senior management beyond the CEO?
3. Initiative: Whenever appropriate, does this director take the initiative to obtain relevant information on boardroom issues? When absent from meetings, do they make sure they are brought up-to-date on discussions they have missed? Do they initiate contact with the board chair or committee chairs when appropriate?
4. Preparation: Do directors come fully prepared to meetings having read advance materials and completed pre-meeting assignments? Do they spend an appropriate amount of time learning about company issues to make informed decisions?
5. Time: Do directors attend a sufficient number of board and assigned committee meetings for consultation or special situations?
6. Judgment and candor: Is a director able to speak his mind constructively even if his views differ from others at a meeting? Is he an effective contributor to discussions? Does he offer innovative ideas and solutions?
7. Integrity: Is the director able to keep the information he receives confidential? Does he demonstrate objective, fair and ethical behaviour?
We recommend that boards take an incremental approach to implementing the evaluation process. The first step should be an exercise in self-assessment undertaken by the individual director, who should not share the results with any committee or other board members. The self-assessment is intended to provide a director with an opportunity to reflect on his or her performance and to prepare them for the next step in the evaluation process.
A self-assessment is not enough
Self-assessments, in and of themselves, are not enough. While quite helpful and non-threatening, self-assessments have some shortcomings. They offer only one perspective; others may see a director’s performance quite differently. Individuals are often biased about their self-image. Some of us, for example, are particularly tough on ourselves, rarely giving ourselves an excellent rating even if we deserve it. Others see few flaws, or no flaws, in our own self.
Because self-assessments need to be balanced by assessments by others, we recommend that a board adopt a second step, a peer-assessment approach. Peers are usually very good at rating performance because one or more of them are likely to be able to observe most of the individual contributions to the group’s performance. The following is a guide to the basic procedures that need to be included in a board’s peer assessment.
A trusted adviser or outsider collects the evaluations and summarizes the results. Each board member receives a summary of their peers’ ratings and comments that assures the anonymity of all the respondents and follows the best practices of 360-degree feedback. The results of the first appraisal are given only to the director so that he or she will know how others regard them, and have an opportunity to change behaviours before others see the results.
The results of the second appraisal – which are typically available a year later- should be provided to the non-executive members of the governance or nomination committee and the board chair, if a nonexecutive fills the role. If the board chair is also the CEO, knowledge of the appraisals could increase his or her power over the board to an undesirable level. In this case, a formal board evaluation of the CEO could help counterbalance his power, or else responsibility for the peer evaluations could be given to the independent directors or non-executive chair. A primary goal of providing appraisal results to the committee charged with director nominations is to identify under-performing directors. To ensure useful feedback, the board chair and committee chair must stress that candid, constructive feedback is part of the evaluation process.
In addition to the peer assessment, the board chairman, CEO and head of the board’s nomination or governance committee should meet every year to assess each director on the same criteria as the peer assessment; the board secretary should keep a written record of the evaluations. The individual results should not be shared with the other directors, but the chair of the nominating or governance committee should provide summary feedback to each director, highlighting specific strengths and weaknesses.
Formal board evaluations, like other recommendations for improving corporate governance practices, are no panacea. Companies can simply go through the motions to satisfy the investment community. As the chairman of one company that recently instituted board and individual evaluations admitted: “I don’t think it’s important. It’s important to others, but it’s not important for good corporate governance. It’s just that there are surveys [best practice surveys of corporate governance]… and we wanted to have the evaluations on our checklist.”
Such attitudes are not likely to enhance boardroom performance, nor are they likely to be acceptable as greater pressure is placed on boards to perform. Evaluations of the CEO, board and board members need to be done correctly so that they create a positive dynamic for the CEO-board relationship. Correctly carried out, they also provide a means for the board and the CEO to hold each other accountable for clearly defined performance expectations, and ensure that both parties always remain focused on their respective responsibilities.