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 SUMMARY: 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. Time
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. Litigation. 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. Demoralization. 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. STRUCTURE 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. Instrument Administration 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. The Interventionist. 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? CONCLUSION
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. REFERENCES
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. http://www2.standardandpoors.com/NASApp/cs/ContentServer?pagename=sp/sp_article/ArticleTemplate&c=sp_article&cid=1021558139012&b=10&r=1&l=EN 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. APPENDIX A: 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. Objective Criteria: 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. Subjective Data: 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. Committee Evaluation Objective Criteria 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 Subjective Criteria 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
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