GOVERNANCE NEED TO HAVES VERSUS WANT TO HAVES: the example of Board Self Evaluation.
Laurence J. Stybel,Ed.D. & Maryanne Peabody
BOARD OPTIONS, INC.
60 State Street, S. 700
Boston, MA 02109
Tel. 617 594 7627
There is a governance trend. Will your Board decide to be a leader or a follower? Ignoring the trend is not an option.
Board of Director Self Evaluation is a procedure required for listed companies on the NYSE and the NASDAQ. Morningstar uses Board Self Evaluation as one of the components for its Board rating system. The National Association of Independent Schools requires Boards of private schools to engage in Board self-evaluation. Board Self Evaluation will be required as a governance procedure for mutual funds. The Government of Finland now requires it for public companies.
According to a Korn Ferry International survey of Directors, 72% indicate that director performance OUGHT to be evaluated.
Only 21% of public company Boards actually conduct such evaluations.
We believe that D&O underwriters are focused on Sarbanes Oxley. By 2007, they will focus on Board of Director Self Evaluation.
Our client Boards have two options: wait until Board Self Evaluation compliance is clearly mandatory and failure to comply has consequences or take a public position in the vanguard of an inevitable governance procedure.
Why take the risk of being in the vanguard?
According to two McKinsey & Company surveys, institutional investors would a premium of up to 18% for North American companies with good governance. They would pay up to 50% extra for Eastern European companies with good governance.
Private companies with exit strategies involving being acquired by larger public companies are taking note of the implications of these McKinsey studies.
Good governance may be a viable component of a private company exit strategy.
And Board Self Evaluation is an inevitable component of good governance.
This article focuses on the history of Board Self Evaluation and some of the options Board members might consider in its adoption.
We have two themes:
(1) Board Self Evaluation is a governance tool. All tools have advantages and disadvantages. We want readers to understand both the benefits as well as the risks inherent in this tool.
(2) Board Self Evaluation is an increasingly mandated intervention. But if Board Self Evaluation is conducted in a punitive spirit, it will surely fail.
DEFINING BOARD SELF EVALUATION
Appendix A outlines some of the differences between Board of Directors Self Assessment, Individual Director Assessment, and Committee Assessment. The examples in the Appendix are indicative and not exhaustive.
When we speak about Board of Director Self Evaluation we define it in the following as:
A structured method for the Board to ask itself, ‘how are WE as a Board contributing to the overall effectiveness of the organization? This structured method is consistently applied over time.
Using this definition, the time spent on Board of Director Self Evaluation may be the only time during the year that the Board asks itself this fundamental question. Most of the meeting tends to focus on reviewing management’s contribution to shareholder value.
THREE VIGNETTES ILLUSTRATING BOARD SELF EVALUATION.
Structuring Half-Baked Ideas.
At a small cap public company, the demands of Sarbanes Oxley had moved Board meetings to focusing on compliance. Much of them time was spent by the Board asking the CEO “have you….” “when will you…..” “why did you……..”
Meetings were starting to get adversarial.
In a structured Board Self Evaluation program, the Board
came to the conclusion that it has two critical roles: (1) protection of shareholder value through audit/oversight of management performance and (2) enhancement of shareholder value through providing its collective wisdom to help management move in new strategic directions. It decided that the demands of its first mission had taken over the requirements of the second.
As a result of this Self Evaluation, the Board created a “Half Baked Idea” program. Whenever management informed the Board that it had a “half baked idea” for its consideration, the Board would refrain from being overly critical and focus instead on being helpful.
The Case of the Trophy Director.
The Nominating Committee was flattered that the CEO of a well-known Massachusetts leader had accepted Board membership. Having this Trophy Director’s name on the masthead gave the whole organization even more cache.’
The Trophy Director faithfully attended full board meetings and tended to vote for whatever the emerging consensus seemed to be.
Everyone understood and accepted the unspoken situation: in return for being able to use the Trophy Director’s name and cache’, the Chairman would not confront this Director’s lack of participation.
This unspoken agreement was destroyed when the Board engaged in a Director Self Evaluation.
In response to the question about how well individual Board members perceived they understood major trends impacting the industry, all but one of the Board members rated themselves and their fellow Board members highly…with one exception. One Board member rated himself low. The Board as a whole rated only one member low. In reviewing attendance records of full Board and committee meetings, all but one Board member had faithfully attended most committee meetings.
This data forced the Chairman to confront the Trophy Director about how this Director was so out of line with the rest of the Board.
The Trophy Director freely admitted to giving this Board low priority. The Director needed to focus on the business imperatives at his own company first. He was grateful for the opportunity to quietly resign. Relations between the Trophy Director and the company continue to be very positive.
The Board was delighted to have the Trophy Director resign with dignity, allowing an opportunity for a more committed leader to occupy the seat.
That is an example of a win-win situation that might have been allowed to fester forever had it not been for Board of Director Self Evaluation.
Re-Structuring Board Participants.
A Fortune 500 company CEO/Chairman liked to bring in his direct reports to Board meetings: CFO, Chief Legal Officer, CIO, Chief Marketing/Sales Officer, Chief HR Officer, Chief Operations Officer. The rationale was that he wanted his Board to freely relate to the corporate C Suite team. He wanted the Board to directly ask the appropriate leaders specific questions. The CEO/chairman felt that there was management development value for his senior people to directly understand the Board’s concerns.
Who could argue against such logic?
This situation was allowed to continue until a Board Self Evaluation was conducted.
The evaluation revealed that the Board would “pull back” on its feedback to the CEO because the Board would not want to embarrass this CEO in front of subordinates.
Once this issue was surfaced, it was quickly dealt with and management attendance was restructured.
A BRIEF HISTORY OF BOARD OF DIRECTOR SELF EVALUATION.
Some of the Boards we surveyed have been engaging in Board Self Evaluation for nearly five years and are proud of what it has accomplished. These Boards were often complying with the spirit of Sarbanes Oxley before there was a Sarbanes Oxley Act.
The real seeds for Board of Director Self Evaluation began in September 2003.
We are referring to the scandal at the New York Stock Exchange.
The New York Stock Exchange is a nonprofit company. During 2001-2002, its Directors included the Comptroller of the State of New York. Other members included the Chairmen and/or CEOs of the following institutions: AIG, Goldman Sachs, Lazard, Lehman Brothers, Merrill Lynch, Daimler Chrysler, Ford Motor Company, Viacom, and Time Warner.
This group of elite leaders approved a compensation package for New York Stock Exchange CEO Richard Grasso in excess of $187 Million. It approved a “stay bonus” of $30 Million for an individual who had been with the organization for over 20 years.
Intense criticism of this pay package resulted in Mr. Grasso’s resignation and the ultimate resignation of the NYSE Board.
The New York State Attorney General Elliot Spitzer has sued Mr. Grasso and the New York Stock Exchange. Attorney General Spitzer noted, “This case demonstrates everything that can go wrong…… The lack of proper information (for Board members’ review) the stifling of internal debate, the failure of Board members to conduct proper inquiry, and the unabashed pursuit of personal gain….”
In the post-Grasso administration, the new NYSE board asked itself how could a group composed of such bright individuals behave in such a rashly stupid fashion?
Psychologists call this as the “El Paso Effect:” the tendency of a group as a collective decision making body to have a collective IQ that is less than the median IQ of the individuals within that group. It gets the name from a psychologist’s family decision to spend its summer vacation in the scalding heat of El Paso, Texas despite the fact that no one in the family wanted ever wanted to go there!
One of the NYSE governance reforms was to require the NYSE Board to engage in a structured program of Self Evaluation of its own effectiveness to insure that the El Paso Effect never come up again.
In a broader sense it said that Boards are responsible for evaluating the performance of CEOs and for itself in a systematic manner.
The NYSE then extended the Board Self Evaluation mandated to all NYSE listed companies.
Not be outdone, NASDAQ mandated it for all its listed companies.
The SEC wants all mutual fund boards to engage in Board self-evaluation.
Standard & Poors has a governance rating index. It includes Board evaluation as one of its components.
The National Association of Independent Schools mandates Boards of private schools to engage in Board Self Evaluation.
Board of Director Self Evaluation as a hallmark of good governance is developing into a global standard. For example, The Government of Finland, now mandates Board of Director Self Evaluation.
PROS AND CONS OF ENGAGING IN BOARD SELF EVALUATION
Benefits revolve around (1) enhancing the public perception of the Board, (2) defining the Board culture, (3) laying the foundation for more favorable D&O premiums, and (4) enhancing Board effectiveness.
Enhancing the Public Perception of the Board.
No Board compensation package can make up for the destruction of reputation when the newspaper headline names you next to the title, “Board Members Asleep at the Switch.”
That was the situation faced by the Board members of the Amelia Peabody Foundation on December 21, 2003.
The BOSTON GLOBE highlighted a cozy and lucrative relationship between Peabody Foundation Board members and its external law firm. The world of foundation governance is often perceived as low hanging fruit for aggressive state
Attorney Generals. Some public companies and many large nonprofits also have foundations as separate legal entities.
Having a structured program for Board Self Evaluation in place is one component to insure key constituency groups that the Board takes its responsibilities seriously.
Defining the Board Culture
A structured program for Board Self Evaluation is one component of a system to attract and to retain competent people to serve on Boards.
Competent professionals are not going to be frightened by a Board culture that says, “We have a responsibility to evaluate the effectiveness of the CEO. And we also have a responsibility to evaluate our own effectiveness in the mission of this organization. We are a good company and this is a good board. That does not imply that we are satisfied with ourselves. Continuous process improvement is something we expect of our management and of ourselves.”
The reverse is also true. Merely introducing this system as an on-going tool can sometimes cause the weakest performing board members to leave unless they are committed to improving their performance as Board members.
In a sense, a properly designed Board of Directors Self Evaluation program does not necessarily result in great surprises. It does force a confrontation with open secrets that most people know but are too polite to discuss within the formal
Board meeting. The two cases we discussed earlier are good examples of this in action.
Laying the Foundation For More Favorable D&O Premiums.
We have spoken with AIG, the largest D&O insurance carrier. We were told that in the future a systematic, on-going program of Board Self Evaluation can be a favorable factor underwriters will take into account when establishing D&O premiums for companies. But this area is a new frontier for insurance companies.
Phase One will be underwriters simply asking “Do You Engage in Board of Directors Self Evaluation.” Phase Two will be underwriters asking Boards, “What Method Do You Use In Your Board of Directors Self Evaluation Program?”
Enhancing Board Effectiveness
Slightly more than half of public companies engage in a regular, systematic form of Board of Director Self Assessment. At the same time, a UCLA survey of Board members indicate that the three top factors associated with Board effectiveness are: (1) presence of strong external Directors (2) an effective Audit Committee and (3) Board Self Evaluation
RISKS OF BOARD SELF EVALUATION
With all these benefits, why do only slightly more than half of all public companies engage in Board Self Evaluation?
The potential benefits of Board Self Evaluation need to be evaluated relative to potential risks. There are three risk factors: time, litigation, and demoralization.
The time requirements for Board membership continue to escalate. Time is a non-renewable resource.
According to one survey, being on the Board of a public company requires 100 hours per year plus an additional 200 hours if one is on the audit committee. Board members can get very angry if they perceive that their valuable time is being wasted.
The implication is that Board Self Evaluation has to be time sensitive.
Board Self evaluations can produce information about sub-optimal behavior. This information could be used in civil or criminal suits/trials. Can such Evaluations be done by law firms and obtain attorney-client confidentiality? Delaware courts, for
example, have not recognized a privilege of confidentiality for critical self-analysis by directors. Consult your attorney for more information about this.
If the Board Self Evaluation process uncovers information that could indicate a serious problem, counsel must be alerted immediately and the matter must be pursued until it is resolved appropriately.
This risk makes it important that there be clear and written policies for the destruction/retention of Board Self Evaluation records. It is also important that those policies be implemented. Again, we recommend you consult with your attorney.
In addition to legal risks, there is a demoralization factor to consider if the Board fails to act on what it has learned.
The very act of doing a Board Evaluation raises expectations on the part of Board members, management, and key constituency groups. If the results of the evaluation uncover problems and the Board fails to respond, then morale will sink to lower levels.
To make an analogy, it is better for morale not to engage in employee climate surveys than to engage in employee climate surveys and then fail to take some decisive action on at least one of the areas of concern revealed by the survey.
FRAMEWORKS FOR BOARD OF DIRECTOR SELF EVALUATION
Each Board of Directors Self Evaluation program needs to be designed with the goals of the Board in mind, taking into account the options available.
We will discuss three options: Board Self Evaluation Structure, Self Evaluation Feedback, and Self Evaluation Follow Up.
In taking on Board Self Evaluation, the Board is committing itself to a multi-year process and not to a one-shot event. For reasons mentioned earlier, the critical
issue is what is implemented. Board buy-in of the process is the most critical variable to insuring follow-through of the action steps.
Most respondents create their own proprietary evaluation forms. These forms are usually cut and paste products based on what is available for no cost.
The advantage of home-grown instruments is that it is inexpensive and tailored to the needs of the organization.
But these advantages also come with costs.
In the event of a law-suit or a negative newspaper article, could it be said that the Board designed the questionnaire to avoid dealing with the most critical elements? If there are powerful people on the Board, might the questionnaire be created to avoid antagonizing those powerful people? This can be a real problem when the designer of the instrument is a corporate employee or the Chairman?
Instruments with High Face Validity. Another option is the use of nationally accepted instruments with high face validity. We will discuss two instruments: The Balanced Score Card and the National Association of Corporate Directors standards for Board of Director Self Evaluation.
The makers of the Balanced Score Card have a protocol for Board Self Evaluation that ties the Board to the larger Balanced Score Card framework. As a conceptual model it is elegant in that it creates a single theme from top to bottom within the company. But it is also cumbersome to administer.
It also assumes that management and governance are similar. To make an analogy, it might be possible to create a performance evaluation tool that could easily be used by the Executive, Legislative, and Judiciary branches of the Federal Government. It would be an intellectually elegant exercise. But aren’t these branches of government designed to be distinct and to have checks and balances on each other?
A second standard is the The National Association of Corporate Directors survey based on the NACD Blue Ribbon Commission on Board Self Evaluation. As NACD readers know, this organization stands for effective corporate governance. Its work is accepted within the for profit world but can easily apply to the nonprofit world. NACD standards cover just about every evaluation contingency, regardless of industry. The use of NACD standards provides a commonly accepted gold standard and thus is a better risk management tool.
Both instruments are time consuming to administer. There are some psychometric problems with the tool making it unclear whether the scores really mean what they say on paper or are a reflection of what psychometricians call Response Bias.
A third option is to take a standard instrument like NACD or Balanced Score Card and keep the general framework, while also customizing it.
This gives our clients the best of both worlds.
Regardless of which method is used, it is important to
keep in mind that this exercise is about commitment to continuous process improvement. Board buy-in to the questions and to the instrument itself is critical.
Once the questions are approved, the instrument can be taken on the web and scored. It can be done by paper and pencil and scored.
An interventionist can arrange telephone or face-to-face meetings with Board members and ask questions based on the instrument.
As mentioned earlier, having clear rules for data retention/destruction is critical. Board members are going to be reluctant to be honest if their honesty will be used against them or the Board at a later date.
Having clear policies for data destruction is critical.
Internal interventionists may have to keep data consistent with whatever the corporate policy is for data retention. External interventionists, however, create their own consistent policies for data destruction. Thus outside interventionists may reduce risks more than internal interventionists.
One positive factor in having a Board member lead the discussion is that it is inexpensive. Board members are more familiar with Board issues than any outside person can ever be. Using a Board member helps people perceive that problems are kept “in the family.”
But this option carries risks.
We have mentioned the data retention risk.
The Board member who is leading the intervention may be one of the problem factors for the Board. Will a fellow Board member stifle or stimulate honest discussion? What are the optics for investors when the interventionist is a Board member?
In a post-Enron environment, Board Self Evaluation is often undertaken for compliance purposes. A compliance system can easily become perceived as a punitive-oriented tool. You know you are in this environment when phrases like “You Ought To” and “You Need To” appear frequently.
One General Counsel told me that regardless of how he wants to be perceived as a business partner. Despite his benign intentions, comments uttered by a General Counsel to a Board member can sometimes be perceived within a Compliance-Punitive perspective.
Busy, successful Board members have limited tolerance for interventionists who wag fingers in faces. They even have limited tolerance for people who are not wagging fingers but are only perceived as wagging fingers.
In our survey, Board members who have spent 5+ hours on a compliance-oriented Board of Directors Self Evaluation usually end up angry and frustrated by the whole process.
Continuous Process Improvement is an alternative and more effective theme for Board of Directors Self Evaluation.
That theme constantly stresses that we are a great company with a great board. A commitment to a structured system of Board Self Evaluation is part of the Board’s on-going continuous process improvement.
We are good. And we can always be better. We will constantly strive to do so.
Board Self Evaluation is an on-going, positive and well thought through process. It is an organization development intervention with the organization being the Board and the beneficiary being the corporation.
Dr. Laurence J. Stybel and Maryanne Peabody are co-founders of Board Options, Inc. Its mission is “Helping Boards Be Even More Effective Problem Solving Units Through the Application of Practical Behavioral Science” Their website is www.boardoptions.com. Tel. 617-594-7627.
BOSTON GLOBE, “Philanthropist’s Millions Enrich Family Retainers,” December 21, 2003.
Erma, Juhani & Kivinen Jarno. “Finnish Corporate Governance.” EUROPEAN LAWYER. April 2004.
FINANCIAL TIMES, “New York Stock Exchanges Faces $10m Bill for Ex-Chief’s Legal Fees.” May 27, 2004.
Herzeca, Louis and Ku, Ruth. “Directors Take an Active Role.” NEW YORK LAW JOURNAL, September 29, 2003, p. 1.
Standard & Poors Board of Director Ratings.
Martinez, M.J. “N.Y. State Sues Grasso, New York Stock Exchange.” Associated Press, May 25, 2004.
Wiles, Russ. “More Responsibility, scrutiny Await Mutual Fund Directors.” ARIZONA REPUBLIC. May 2, 2004.
Differences between Board Evaluation, Committee Evaluation and Individual Director Evaluation.
Board of Director Effectiveness
The purpose of this process is for Directors to look at their Board Structure, membership, Committees, and processes to so that the Board can determine whether it is set up and operating in such a way as to get the work of the Board accomplished.
A portion is objective and an audit can determine if the structure and processes are in place.
Board composition – numbers of Board members, terms of office, determination of skills needed on the particular Board and a process for recruiting Directors with those skills.
Numbers of meetings held per year, set calendar, meeting agenda, timeliness of correspondence to Directors before meetings and follow-up minutes after meetings.
Record of formal votes taken and a mechanism for follow-up
Committees that need to be established (depends on organization): e.g., Governance, Nominating, Audit, Compensation, etc.
The presence and participation of outside Directors.
The role of the chairman – who takes the role
Procedures for disclosing conflict of interest.
Executive sessions for outside Directors
The Board’s role in strategy planning
The Board’s role in the operating budget
The Board’s role in succession planning.
The Board’s role in CEO evaluation.
The Board’s role in meeting with outside auditors.
In addition to objective data, qualitative (subjective) data should be sought as well. Feedback from directors can be gotten regarding their understanding of their roles, their perception of the board’s preparedness to perform those roles, their perception of whether they receive information necessary to help them in their decision-making and any suggestions they have for improving Board effectiveness.
The Audit Committee has __ members
The Audit Committee meets __ times per year
The Audit Committee has among its members a financial expert
All members of the Audit Committee are financially literate
The Audit Committee hires the outside auditor
The Audit Committee meets with the outside auditor without staff present
Responsibilities of the Audit Committee
Procedures for distribution of information prior to meetings
Procedures for receipt of minutes after meeting
Information is sought from committee members regarding their perception of their committee as a working group, how they communicate to the total Board, how they would measure their effectiveness, any suggestions for improved processes, etc.
Individual Director Effectiveness
Some of this evaluation can be objective, for example, attendance at meetings and preparedness at meetings
Some of the material may be more subjective:
Knowledge of the industry
Knowledge of the organization
Amount of time and effort expended
Willingness to ask difficult questions
Ability to keep discussion on topic
Offers constructive suggestions
Participation in discussion
Subjective data is elicited from board members regarding individual members and their unique contribution to the Board