Today’s directors are too often selected for their judgment, their leadership and their business skills. Commendable traits, all, but as this author points out, they’re not of much use unless the directors also know ‘when’ to act. This comes only with a deep understanding of the company’s risks.

The corporate scandals that helped topple the markets and the North American economy last year will lead historians to compare the period – unfavorably – to the South Seas Bubble, a classic, massive economic botch-up that rocked Europe in 1720. In the wake of a shakedown in which trillions of dollars of shareholder value vaporized almost overnight, we must react aggressively, rather than blithely dismiss these systemic failures by merely observing that “there’s more greed than fear in a rising market.” That aggressive reaction calls for us to understand risk before we can initiate reform. We must also ensure that the people responsible for risk management have the will to act when the time comes to do so.

The starting point for such action is staring us in the face; it is our boards of directors.

As we are learning, risk management and knowledge of a company’s business and its business environment are essential responsibilities of a successful board. Managing risk at the board level goes deeper than meeting four or more times a year, or ensuring that internal control procedures are in place. It is a result of a board of directors that understands what the company does and how it does it.

 As trust erodes, it is imperative that board search committees do more than appoint directors who understand the risks of the company’s business and know whether those risks are properly managed. They must also make their selections in ways that are transparent and convincing to shareholders, rating agencies, regulators, the media, and the public at large. In Canada, executives of publicly traded companies have been too slow in resisting recommendations to scrap the practice of appointing themselves to each other’s boards inside the cozy confines of the “Old Boys Network.” If we want to restore investor confidence in the corporate world – and we have no choice but to do so – we need a fresh approach to the way that boards of directors are appointed.

In the past, members of the establishment who often graduated from the same private schools formed a network of overlapping directorships in which men who sat on one public board were invited to serve on others. More recently, the network has grown to include men and women who clawed their way up organizations, such as chartered banks; or in private companies that have gone public, bringing with them a group of directors who have been associated with the proprietor over the years. Board members often were leaders in their industries with the expectation that success and leadership skills in one industry would translate to others. Directors had the business contacts and knew what prospects existed, but not necessarily what challenges the company could face.

Directors could be counted on to understand values, play by the rules, and fit in with the other directors. As leaders, they often said that they did not need formal governance rules because they will do what ought to be done. There are many examples to support this. One of the most spectacular was the decision to fire Neil John McKinnon, the iron-fisted Chairman of the Canadian Imperial Bank of Commerce. After the coup, Mr. McKinnon entered the boardroom one last time and is reported to have said: “I just wanted to see what a room full of bastards looks like.” Still, directors who can make such hard decisions completely missed the Nortels of the past two years. The reason: Today’s directors are too often selected for their judgment, their leadership and their business skills. All are commendable traits. This is where the ‘will to act’ comes from. But it’s not much use unless the directors also know ‘when’ to act.

What is just as essential as having the will to act is having a much deeper understanding of a company’s risks. Sound risk assessment will help boards know when to act, and thereby stop shareholder value from deteriorating long before the company has to announce more drastic measures, such as the firing of the CEO.

Requests for board appointments often illustrate the persistence of “old” thinking. The most troublesome of these requests fall into three general categories:

Find me a director who has been a CEO and who can help our CEO understand how to deal with the board. In fact, it’s the Chairman of the Board’s job to do this. If the CEO is the Chairman of the Board, then it’s the lead director’s job. The CEO’s job is to propose the company’s strategic direction to the board for its approval, then run the company.

Worse still is the request: Find us a director who will fit the culture of this Board. What difference does that make? The board only meets a few times a year, for a few hours at a time.

Finally, companies prefer board members who have a broad business background. Such directors may well provide value from time to time and have the experience to make tough decisions. Still, they may not really understand the business, the risks the company faces, or whether those risks are under control. Usually, they only understand these things in the broadest sense, often by reviewing the financial results.

Unfortunately, financial results are a historical record. Today’s boards have to detect trouble sooner, and that requires specialized knowledge – not leadership or general business knowledge and certainly not cultural fit.

There are a number of key questions board selection committees should be asking. The most important is: What risks does the company face? An understanding of a company’s business environment and the potential risks it could face is essential to ensuring the board’s ability to detect trouble sooner rather than later.

Following an assessment of a company’s risks, the next question is an obvious one: Are there board members who understand the company’s risks? The selection of new directors should be based in large measure on the extent to which the current board collectively understands the company’s risks and opportunities. New director appointments should fill the gaps.

This is an approach to corporate governance that one large insurance company recently used. When the company’s risks were reviewed, it was found that the current directors effectively covered general insurance business, investment management, investment banking, government supervision and actuarial risk. There were gaps though, in accounting and in marketing, so new directors with expertise in these fields were appointed.

Risks in the software shrink wrap business (software that is packaged and shrink-wrapped for distribution) are industry-specific and include risks in innovating, manufacturing and marketing as well as the usual business exposures in raising and managing capital, technology and human resources. In a recent case, these risks were mapped and existing directors were interviewed directly by an executive search firm to assess their understanding of these aspects of the business. After identifying the gaps, the company and the search firm sought board members with knowledge in the missing areas. No one director could be expected to understand all the risks, but several new directors would give the board a collective understanding. The chairman of the board then put in place a governance structure that allowed directors to monitor the risks.

It is important to remember that no one size fits all. In the technology practice, directors have often grown up in their businesses. As a result they have advanced knowledge of the company and its industry and the industry-related risks. What they often lack though, is experience in human resources management, managing capital, finance, planning, and marketing. In these cases, board search committees should look for directors with experience in more general risk areas, who can provide the expertise that the generally younger entrepreneurs need.

The final step is the first question that board selection committees should put to candidates: Does the candidate under review understand the industry risks that the current board members lack?

Finding board candidates with the requisite industry knowledge is important because it is not something that directors can easily acquire. This is because being a director is a part-time job. Directors do other things with the rest of their time. Therefore, directors who are not from the industry, or who do not have the specialization that is needed, are unlikely to learn what they need to know to be effective in providing oversight in their role as director.

When directors who fill these risk gaps have been identified, only then is it possible to go back and add extra criteria, such as the ability to assist the CEO, exercise judgment, obtain regional and ethnic representation, and even a cultural fit. By doing so, directors may also contribute to identifying and growing market opportunities and sales. But the lessons of the last year have demonstrated that directors must first and foremost be able to understand the risks in the business.

By focusing on risk, knowledgeable directors will be better able to spot potential disasters sooner and push management to act. It is too late to erase our generation’s place in history as the one that blew history’s largest stock market bubble and stood by watching while it burst. It is not too late to put in place a foundation for governance that can rebuild wealth for the next generation. It starts with the board. It won’t happen if we do nothing different.