“More independent directors” and “separate the role of chairman and CEO” have become the rallying cries – and many believe, panaceas – that will lead to fixes for what’s wrong with corporate governance. The problem, argues this leading governance authority, is that independence and separation are not nearly as important as a director’s competence and behaviour, and how the directors on a particular board interact with each other. With a properly composed board, function will follow form, and so will performance.
What does former U.S. Secretary of State Henry Kissinger know about conducting a proper analysis or review of the $225 million in management fees paid to Hollinger executives and $60 million in non-compete fees paid to Lord Black and colleague David Radler? This question may be more directly posed to former Governor of Illinois and Chair of Hollinger International Inc.’s Audit Committee, James Thompson, and other Audit Committee members, including former U.S. Ambassador to Germany, Richard Burt, and economist, Marie-Josée Kravis – who have collectively been evidently accused of being “ineffective and careless over a prolonged period of time” in former SEC Director Richard Breeden’s recently released report on Hollinger.
And what should or does Dr. Madeleine Albright, a former New York Stock Exchange director and U.S. Secretary of State, know about the technical upside of a complex executive compensation agreement? What does this have to do with the New York Stock Exchange (NYSE) – Grasso pay implosion, and with corporate governance reform in the United States?
The answers to these questions, as many by now know, are less answers than they are sad and stinging commentaries on the state of corporate governance today. This article will discuss this state of affairs and recommend six critical steps that must be taken to improve the practice of corporate governance in Canada and the United States.
What went wrong?
At the centre of the Hollinger fiasco are the discretion and influence of controlling shareholder Conrad Black, and the stacking of the board with so-called “trophy” directors, many of whom were independent, formally at least, but were accused of being considerably less than competent in the Breeden report. “It is difficult to imagine a more flagrant abdication of duty than a director rubberstamping transactions that directly benefit a controlling shareholder without any thought, comprehension or analysis,’ the committee report says…” (New York Times, September 1, 2004). The report also states that Richard Perle, the former U.S. Deputy Defence Secretary and a member of the Hollinger Executive Committee, is alleged to have admitted “signing executive committee resolutions without discussing them or even reading them, and this was a ‘flagrant abdication of duty.'” (The Globe and Mail, September 1, 2004).
Inappropriate action is also alleged to have occurred in the New York Stock Exchange Board of Directors’ approval of former CEO Richard Grasso’s $140-million-dollar pay package. While many of the NYSE Directors were formally independent, their conduct is alleged to have been inappropriate by New York Attorney General Mr. Eliot Spitzer. As with Hollinger, the lawsuits are ongoing and all allegations have yet to be proven in court. Jeffrey Sonnenfeld, the Associate Dean of the Yale School of Management, has been quoted as saying that “He [Mr. H. Carl McCall, the chairman of the NYSE board’s compensation committee] spent his credibility by admitting he had no idea of what was in the documents that he signed.”
What can explain these massive failures in governance? Mr. Spitzer has said that, “What happened at the New York Stock Exchange will be studied in business schools for years to come as a breakdown in board behavior.” Professor Michael Useem of the Wharton School has said that “what transpired behind [boards’] closed doors is what ultimately counts.” And Professor Jay Lorsch of the Harvard Business School argues that “It’s what happens around the table – how people talk to each other, how they interact.” (Please see Leader’s Edge interview with Mr. Lorsch elsewhere in this edition of Ivey Business Journal.) In fact, what went wrong has little to do with some of the more conventional reasons advanced for breakdowns in governance today.
The wrong emphasis
Regulators’ current mantra, their oft-repeated solution for curing what’s wrong with board of directors, is to have more formally independent directors on a board. Other observers say that splitting the role of Chairman and CEO, or reducing the size of a board will improve governance practices.
These reforms focus on board structure, which underlies the NYSE governance reforms that apply to listed companies, including mandating the independence of a board’s three principal committees – audit, compensation and nominating/corporate governance. The real question, however, is whether these suggested reforms will work? My own research findings, as well as others’, suggest that they may not. Empirical data confirm that there is no causal relationship between structural independence of boards – that is a majority of outside directors, the split of chairman and CEO and the size of the board – and corporate financial performance. (See my previous paper published in the Ivey Business Journal, September/October, 2003.) So far as the literature on board independence is concerned, Professor James Westphal of the University of Texas, Austin, has written that: “Nearly two decades of research find little evidence that board independence enhances board effectiveness. Studies have, however found a negative effect.” And so far as the literature on director independence is concerned, professor Westphal says that, “The most important predictor of director effectiveness is not independence, but strategic experience that matches the company’s needs.” Ten years earlier, in 1994, when the Dey guidelines were first announced, (Where Are the Directors, TSX report), Ivey Emeritus Professor Donald Thain was more critical: “The result is recommendations that have no systematic base in fact and stated logic.” Why, therefore, do regulators appear to be downplaying if not ignoring the work of governance scholars such as Thain, Westphal, Lorsch, Sonnenfeld, et al.?
Part of the answer is given by Professor Westphal, who, at the time of the enactment of the Sarbanes Oxley Act and NYSE governance guidelines, asked: “Why, then, have regulators paid little attention to academic research on corporate boards? Again, part of the problem is poor communication of research findings by business schools, but part of the blame also lies with regulators, who are often not receptive to academic research in formulating policy…Regulators seem more concerned about the impressions that their policies will create than about formulating policies grounded in rational principles and empirical evidence.” (J.D. Westphal, “Second Thoughts On Board Independence: Why do so many demand board independence when it does so little good?” September/October 2002, 23:136, The Corporate Board, pp. 6-10).
(I would add that the onus is also on academics, as part of their service ethic, to inform the public policy debate within their communities. They should shape their empirical findings into recommendations that are specific, tangible and feasible, both for regulators and for boards.)
That regulators do not turn to some academic research is indeed unfortunate, since the consequences of the rush to regulate director independence are significant. It raises corporate costs without necessarily enhancing corporate value, and ironically, may do little to improve corporate governance or even lessen corporate failures. The ultimate goal of regulations should be to demonstrate that complying with proper corporate governance regulation enhances shareholder value. If corporate governance guidelines work, complying with them should make for a better board and greater shareholder returns. Which is to say, importantly, that any guidelines need an empirical foundation.
In fairness, it needs to be noted that the problem for corporate governance researchers is that boards of directors are the most closed of all types of institutions in the modern nation. Few people, other than directors themselves, invited members of management, or certain professional advisors, have ever witnessed a board of directors in action. Almost always, boards have never been studied directly in any rigorous manner, over an extended period of time. Board confidentiality is strong. So having researchers examine boards is akin to determining what makes for a good hockey team by reading the sports pages in the cafeteria, that is, never entering the arena or locker room. For the field of governance to continue to advance, more research on boards-in-action must occur.
The power of controlling shareholders in Canada
Decision-making failure in boardrooms has less to do with the lack of supposedly independent directors and the split of chair and CEO and more to do with independence of mind, and the competencies and behaviours of those directors sitting around the board-table, including how they are chosen, how they are led, how they work together, and how they are retired from the board. Moreover, what is especially important in Canada, in addition to these factors, is the governance “posture,” or power, of the dominant shareholder. For example, Conrad Black communicated to me on one occasion that he considered the subject of corporate governance to be “overworked.” Interestingly, Lord Black’s views are shared by other controlling shareholders, albeit in a less acute form. The company is often viewed as simply “their” company, to be run as they see fit. One commonly held view is that minority shareholders can “buy apples” if they don’t like the way the company is being run.
My research on control-block boards confirms that the dominant shareholder – “Controllers” I call them – wields significant power in the boardroom. In fact, some of my respondents have said that the governance of these types of boards is one of the greatest governance challenges that Canada faces. There was a general consensus that control-block boards are governed less effectively than widely-held boards. As well, a number of senior, experienced directors that I have interviewed refuse to sit on these types of boards.
Public “Profile” as a proxy for independence?
A smart “Controller” CEO or dominant shareholder (or both) will “outsmart” independence regulations by nominating or influencing the nomination of directors who may “look” independent, but certainly do not act that way within the boardroom. Such directors are beholden to management or the controlling shareholder. In other words, independence is inherently hard to regulate because it is a state of mind and includes social and personal relationships that are hard to detect.
Moreover, regulating independence may have the perverse incentive of focusing on an individual’s “name” rather than his or her competence. Take former political leaders, for example. Though I would not suggest that former politicians are not “competent,” broadly speaking, within their sphere of public policy, one of my respondents indicated that, “government is not governance.” For example, “Watch out for people [former politicians] who ‘rent their names’. Look at [former politician X] at [Company ABC], [former politician Y] at [Company DEF], who got in over his head, and [former politician Z] at [Company GHI]. … [Former government official Y] for instance can’t even read a P and L statement. They are ‘enthusiastic amateurs.'” (director).
I have developed what I call a “competency matrix,” in which I discuss and assess very precise competencies that certain directors possess. For example, Drs. Albright and Kissinger have a tremendous sense of public policy and knowledge of international, geo-political relations. But they may lack the knowledge and proficiency in the technical aspects of executive compensation and financial expertise. Certain former politicians have been accused of “renting their name” in order to obtain directorships under the guise of independence. Therefore, it is quite rational behaviour on the part of a Controller-CEO or shareholder’s part to say that “if the regulators want independence, I will give them independence.” They then deliberately set out to recruit high-profile, but often ineffective, directors.
The behaviour of former politicians therefore warrants further examination. Within boardrooms, they tend to make excellent “Consensus-Builders.” On occasion, depending on the politician and their external contacts, they may make excellent “Counsellors.” Political types are very adept at using humour, goodwill and well-developed interpersonal skills to bridge the gap between competing points of view, inside and outside of boardrooms. But a politician’s chief deficiency, because they are used to reading briefing notes at a higher policy level, is that they frequently do not initiate or challenge, or force issues as shareholder representatives, because they are accustomed to practicing the “the art of the compromise.” Many politicians that I have observed (again, not all) tend to act collectively and prefer to move to a consensus and to react, rather than to act as individuals and express dissent. To be a “Challenger” or “Critic,” a director needs to have read and understood the finer details of the materials and information – the minutia. Delving into this level of detail may not be the way a former politician’s mind works. This is precisely why a board composed of several former politicians may be an indication that it is ineffective. Hollinger is the latest example.
My larger point is that the sheer act of regulating independence may lead to the appointment of less capable directors. In the search for independence and to please regulators, boards appoint people with a high publicly favorable profile, who are or may be, in practice, ineffective directors. As a result, it is not unusual to find that some companies with such directors ultimately fail. It is also not surprising that the literature reveals no causal relationship between director independence and corporate financial performance. And directors who are not independent are not necessarily non-effective. In an unintentional way, regulations based on independence may be doing more harm than good. The most common complaint I get from CEOs about highly independent directors is that they are too detached from the company and its strategic environment – “They don’t know anything about the business” is a common response.
Therefore, I have advised regulators that, ultimately, (i) director independence is very difficult to regulate, and (ii) it matters less than we think, in terms of individual director and total board effectiveness, and ultimately, corporate financial performance. I am not suggesting that independence is not important to corporate governance, only that it is not a sufficient condition for an acceptable level of competence and behaviour.
Moving beyond independence
There are numerous corporate governance myths, perpetuated in part by U.S. rating agencies and others, about what “matters” so far as “effective” corporate governance is concerned. For example, Jeffrey Sonnenfeld argues that, “The ratings services evaluate the corporate governance of firms by mixing together empirically based standards and the myths and clichés of ‘the Street.’.” (“Good Governance and the Misleading Myths of Bad Metrics,” Academy of Management Executive, February 2004: 109). He goes on to address the corporate governance myths of age, split CEO/board chairman, director equity, former CEO, independent board and outmoded standards of attendance, size and others. He concludes with a discussion on “the missing ingredient: the human side of governance.”
In “Building Better Boards” (Harvard Business Review, May 2004: 102), management consultant David A. Nadler states that, “The key to better corporate governance lies in the working relationships between boards and managers, in the social dynamics of board interaction, and in the competence, integrity and constructive involvement of individual directors.”
My own work with boards confirms Sonnenfeld’s and Nadler’s findings. “One of the more promising recent studies was conducted by Richard Leblanc, a Canadian researcher… His findings give a significant boost to the thesis that board process is the most important factor, with membership (director characteristics) as next in importance, followed by board structure (a distant third). He concluded: ‘Clearly, board structure is not as important a factor in determining board effectiveness as is normally believed; board membership and director competencies are quite important; and most significantly the behavioural characteristics of individual directors are crucial, if not determinant, of overall board effectiveness.’.” (Lorin Letendre, “The Dynamics of the Boardroom,” Academy of Management Executive, February 2004: 102).
Sonnenfeld’s criticism about corporate governance myths, and Nadler’s and my own views on board process lead to the following conclusion: What is readily measurable, e.g., board structure, may impact corporate governance less than we think. What is not readily measurable, such as board membership and board process (including the competency and behaviour of directors), may matter more in impacting board effectiveness, and ultimately may be shown to impact corporate financial performance.
This may explain why rating agencies appear to be cluttered with “noise.” For academics, this represents a challenge to identify and begin to measure what really impacts board and individual director effectiveness. For this to occur, they must liaise with the community of practicing directors and boards.
Moving from a structure-based to a competency and behavioural-based board
When I assess a board of directors, its committees, the CEO or individual directors, I observe the board in action and conduct in-depth, qualitative interviews with individual directors. My conclusion is simple, yet complex. The decision-making effectiveness of aboard is a function of the independence of mind, competence and behaviour of the directors sitting at that table. It is complex because of the egos and fear of individual directors involved.
During a board meeting, the questions that a director asks and the very words chosen demonstrate his or her understanding of an issue. To ask a question, you need to have read the materials, be prepared and, more importantly, have invested the time, to understand the complexities of the interdependent issues. This is a very high performance bar. Thus, non-performing directors, who are nonetheless sophisticated, will simply remain silent, assuming their colleagues do not know that they do not know. What happens with ineffective boards is that more and more directors sit silent, assuming their collective incompetence is not noticed. This silence is “deafening” and it is often at this juncture where governance decision-making failure occurs. Directors do not have the competence to challenge manage mentor professional advisors and provide that final check on shareholder money. And directors often confirm their lack of competence with me in the candid interviews. In the words of one chairman and CEO: “So, like geniuses in a room, they sit there like Moses – nodding their head. I can describe a couple of them, when they don’t know what they’re looking at, especially lately.”
“So why don’t you get help?” I ask directors. “Because I don’t want to admit that I don’t know” is a typical response. Without credibility, directors cannot operate. And admitting what they perceive to be a personal weakness does precisely that. What is the consequence of not knowing what you need to know as a director and not admitting so? Directors think no one else knows they do not know. But Controller-CEOs know, Controller-shareholders know, and they not only know but will see to it that these directors, who may know little about the business to begin with, will continue to be kept in the dark. Conrad Black, for instance, evidently was “well aware of Richard’s (Perle) shortcomings.” (The Globe and Mail, September 3, 2004.)
External advisors also know that directors do not know, and they too may capitalize on this lack of competence by baffling boards and committees with industry jargon and presenting complex recommendations at the 11th hour. Even independent advisors privately admit that they find it challenging to keep up with the sheer pace of change in their respective fields. One compensation consultant, for instance, said to me that “you will not understand the mechanics of executive compensation unless you give up your day job.”
Building better boards: What needs to be done?
In my forthcoming book, I put forward an acronym for building effective boards that might well be “CB-S-R” – the identification of directors with the mix of competencies and behavioural patterns that match the strategy of the firm and then the lively pursuit and recruitment to the board of people who meet these requirements.
I believe that “C-B-S-R” sets a tone and direction for effective corporate governance reform. But other steps need to be taken and I describe them briefly below.
1. Boards must institute a competency and behavioural-based matrix for director recruitment, continuing education and director tenure. Whether they do so, or do not, should be disclosed to shareholders. It should be kept in mind that it would be difficult for a board to justify to shareholders why it does not nominate competent directors with the requisite skills, or why it continues to retain those directors lacking them.
This will mark the end of the era when casual acquaintance and cronyism is the chief criteria for selection to a board. Directors will be chosen very carefully, and specifically for their behavioural characteristics and competencies. No longer will being a member of “the old boys network” or being beholden to the controlling shareholder be a sufficient criteria for board membership.
Focusing on competency and behaviour will also increase the accountability of individual directors to fellow directors and shareholders. Members of various committees of the board will be held more responsible for the activities of the committee, since they are deemed to have the competency to serve on that committee. For example, members of the Audit Committee will have to take more direct responsibility for any mistakes in the financial statements. They cannot hide behind the excuse that their auditors and financial officers were incompetent: they were elected to their position presumably because of their competence to judge the competence of the auditors and financial officers. Members of the Compensation Committee will need to possess compensation literacy, including the ability to link pay to performance and approve incentive and equity-based plans; they will also need to defend such decisions to shareholders. Members of the Risk or Conduct Review Committee (or their equivalents) will need to be competent in this area as well, ensuring that management has the appropriate standards and processes in place to detect and mitigate against risk acceptable to the board, and that the company has an effective corporate ethics program, including a code of business conduct and ethics.
2. As well as board and committee charters, boards must have a position description for the chair, the CEO, the chairs of principal committees and individual directors. Ideally, position descriptions should be provided for the chief financial officer, corporate secretary and general counsel. These position descriptions should reflect best practices.
These types of position descriptions should be disclosed to shareholders. If a controlling shareholder, regardless of his or her formal position, usurps the power outlined in any of these governance position descriptions, then that ought to be disclosed to shareholders.
3. The performance of individual directors should be evaluated, including their competencies and behaviour, based on their applicable position description(s). There are various ways that individual director assessments may be conducted, and about which I have written. That it is done in a constructive yet rigorous manner is what counts. That director evaluations are done, or not done, should be disclosed to shareholders, although, again, it is difficult to justify why the performance of individual directors should not be assessed.
4. The results of such assessments should be integrated into the decision on continued director tenure and succession planning. Non-performing directors, for whatever reason, must be asked to resign from the board. When the call is made by the chair of the board or the chair of the governance committee, the board must support the decision.
The results of individual director assessments should be integrated within a comprehensive director education and development program, not only for the board and for committees, but for individual directors. The developmental program for incumbent directors must make wise use of their time and resources, in a format preferable to them, which may include private tutorials or assistance.
Assessing individual directors will lead to more effective board mechanics. Directors elected for their specific competency and behavioural characteristics will not tolerate inefficient board operations. Because of their greater exposure and competence, they will demand it. It will lead to a greater use of consultants and advisers by boards, particularly board committee chairs. They will know what they need to know in order to properly fulfill their obligations and will insist that they have access to the best advice available and the information they deem they need to make informed decisions, and because of their competencies, they will know what that information is.
Equally important, assessing individual directors will end the practice of retaining ineffective and dysfunctional directors on boards, simply because it is inconvenient to remove them.
5. Assessment of board leadership is vital, including acting to remove ineffective chairs of boards. The chair should have a position description and be held accountable by the rest of the board for fulfilling his or her duties. In other words, the board chair should be assessed by all directors and the results of this assessment should be integrated with chair succession planning. Weak chairs, viewed as such by their peer-directors, should step down if they are unwilling or unable to improve their performance. The board should ensure that strong, effective chairs are adequately compensated, i.e., that the compensation reflects performance and workload. Paying for director performance is a wise use of shareholder money.
6. Lastly, the general level of boards’ accountability to shareholders must improve. A board specifically elected because of its members’ specific competencies and behavioural characteristics that does not deliver acceptable rates of return to the shareholders will have to explain the reasons for its failure.
The focus on competency and behavioural characteristics of directors may ultimately lead to elections of individual directors, rather than slates of directors. Shareholders will know why and for which competency a particular director is being nominated. If it is clear that he or she does not have the competency or some other characteristic that is essential for the success of the corporation, shareholders will be inclined to vote against election or re-election. Shareholders who propose nominees should also be responsible for doing so on the basis of competency and behavioural characteristics.
Conclusion
If the purpose of regulations is to provide for better corporate governance, the current emphasis on board structure should be augmented by a concern for director competence and behaviour. Until this change is made, it is unlikely that regulations will be any more effective in the future than they have in the past.
Will there be a major shift from “structure-based boards” to “performance-based” ones? Or, at the beginning of the twenty-first century, is the situation very much as it was in 1990s, when there was great optimism for reform because of the growth in importance of the institutional investor, the increase in litigation — and when nothing much really happened? Inspite of the spurt of activity represented by Sarbanes-Oxley and the implementation of rules and regulations for listing on exchanges and reporting to governing agencies, will the results be the same as they have been since the 1990s?
Will anything happen?
While there is always considerable resistance to change, there are a number of signs that the revolution will take place – that there will be a shift from structure oriented to competency/behaviour built boards.
If change is to occur in a major way, it must be driven by boards of directors themselves, reacting to scandal and saying that “change must take place.” Boards of directors must believe that change is necessary in order for them to better fulfill their legal and their corporate responsibilities.
There is no question that there are many directors on many boards who believe that they need to change, not because regulators or shareholders or anyone else is telling them that they must, but rather because with the increasing complexity of business, they know that, under current circumstances, they cannot adequately fulfill their duties. The one theme that is constant from my interviews and observing and working with boards is that directors are deeply concerned with the ineffectiveness of many of the boards with which they are associated. Even directors on boards of companies with acceptable rates of return for their shareholders and no signs of serious legal or other problems indicate a concern that their board is not doing as good a job as they intuitively believe it should.
The scandals of the corporate world in the first few years of the twenty-first century have created, within corporations themselves, a climate for change. The problem for many directors and board members is that while they intuitively know there is a need for change if they are to fulfill all the obligations of directors, both legal and practical, they have little general knowledge about what the change should be.
The Role of the Regulator
Searching for and promoting a greater understanding of how boards make decisions, and the factors that lead to board and director effectiveness, does not imply that more rules and regulations need to be imposed. Rather, it should lead to fewer. As chairs of nominating committees seek directors not on the basis of their external profiles and relationship to existing board members, but rather on the basis of competence, behavioural characteristics and their fit with the strategic direction of the firm, the need for specific rules should decline. The role of the regulator should move much more towards one of researching the relationship of corporate governance to corporate performance-of finding the issues that really matter in governance and providing information to organizations on how to deal with them. Indeed, moving away from structure-based boards would be a major step in reducing the need for specific, stultifying rule-making. Moving towards competency and behavioural-based boards would encourage the risk-taking and entrepreneurship that are part of the essence of capitalism. As the change takes place, regulators will be in a position once again to do what they were intended to do in the first place – make certain that there is a level playing field for all.
