Corporate directors are confronted with a variety of recently proposed governance standards, while activist investor campaigns are challenging both board composition and board effectiveness by targeting individual directors. Given the high level of personal reputational risk and the associated long-term financial consequences now faced by directors, a hard look at the adequacy of company-sponsored director and officer (D&O) risk mitigation and board compensation strategies is timely.
The Bedrock of Certainty Shifts
Shifting stakeholder expectations are codified in the frequently conflicting governance standards published in recent years. Following the National Association of Corporate Director’s own 2011 Key Agreed Principles, there are now draft voting guidelines from Institutional Shareholder Services (ISS) and Glass Lewis & Co.; standards from groups such as the Office of the Comptroller of the Currency (regulator), CalSTRS (investor), the G20, and the Organisation for Economic Co-operation and Development (influencer); and, most recently, the Commonsense Corporate Governance Principles from a group of CEOs led by JPMorgan Chase & Co.’s Jamie Dimon.
This proliferation of standards reflects differing stakeholder expectations and gives direct rise to new risks for directors. With these new risks and expectations emerge associated questions about the adequacy of current governance strategies, company-sponsored reputation-risk-mitigation packages, and director compensation.
Because the board is the legal structure administering governance, the standards that boards choose to guide their oversight have legal force. Furthermore, detailed, prescriptive standards have instrumental force.
For instance, ISS and CalSTRS are promoting highly prescriptive standards. ISS is exploring specific “warning signs” of impaired governance, including monitoring boards that have not appointed a new director in five years, where the average tenure of directors exceeds 10 or 15 years, or where more than 75 percent of directors have served 10 years or longer. CalSTRS expects two-thirds of a board to be comprised of independent directors, and defines director independence specifically as having held no managerial role in the company during the past five years, equity ownership of less than 20 percent equity, and having a commercial relationship with the company valued at no more than $120,000 per year.
The Commonsense Corporate Governance Principles released this summer was an effort to share the thoughts of the 5,000 or so public companies “responsible for one-third of all private sector employment and one-half of all business capital spending.” Certain background facts may lead some stakeholders to discount the Principles. For example, in addition to Dimon, the list of signatories was comprised mostly of executives who hold the dual company roles of chair and CEO. Also, according to the Financial Times, eyebrows have been raised by CEO performance-linked bonuses of about 24 to 27 times base pay at BlackRock and T. Rowe Price, two asset manager companies with executives who were signatories. Coincidentally, these asset manager companies were ranked among the most lenient investors with respect to the executive pay of their investee companies, according to the research firm Proxy Insight.
These standards can be deployed by checklist, and boards can be audited for compliance to the specifics of the adopted standards. But, more importantly, the very existence of these standards lends them authority through expressive force. What they express—or signal, in behavioral economic parlance—is intent, goodwill, and values. Signaling is valuable in the court of public opinion.
Personal Protection Strategies
As reported in NACD Directorshipmagazine earlier this year, activists often wage battle in the court of public opinion to garner public support when mounting an attack against a company. Emphasizing the personal risks, the Financial Times reported in August that “Corporate names are resilient: when their images get damaged, a change of management or strategy will often revive their fortunes. But personal reputations are fragile: mess with them and it can be fatal.”
Make no mistake: this risk is personal. A director’s damaged personal reputation comes with material costs. Risk Management reported in September that the opportunity costs to the average corporate director arising from public humiliation were estimated at more than $2 million.
Among the many governance standards, pay issues are the third rail of personal reputation risks. “If companies don’t use common sense to control pay outcomes, [shareholders have to question] what else is going on at the organization and the dynamic between the chief executive and the board,” an asset manager with Railpen Investments told the Financial Times recently. Clawbacks may be the most disconcerting pay issue because the tactic places directors personally between both the investment community and regulators.
Governance standards just over the horizon may give boards succor, and reputation-risk-transfer solutions may have immediate benefits. Since 2014, the American Law Institute (ALI) has been developing a framework titled, “Compliance, Enforcement, and Risk Management for Corporations, Nonprofits, and Other Organizations.” Members of the project’s advisory committee include representatives from Goldman Sachs & Co., HSBC, Google, Clorox, and Avon Products; diverse law firms offering governance advisory services; law schools; regulators including the Department of Justice; and representatives from a number of prominent courts. According to the ALI, the project is likely to hold an authority close to that accorded to judicial decisions.
The ALI work product remains a well-protected secret, but the project is expected to recommend standards and best practices on compliance, enforcement, risk management, and governance. It can be expected that the ALI standards will reflect the legal community’s newly acquired recognition of the interactions between the traditional issues of compliance, director and officer liabilities, and economics; and the newer issues of cognitive and behavioral sciences. Such governance standards will likely speak to the fact that while director and officer liability will be adjudicated in the courts of law, director and officer culpability will be adjudicated in the courts of public opinion.
Insurance Solutions Available Now
Boards that qualify for reputational insurances and their expressive force can mitigate risks in the court of public opinion. An NACDDirectorshiparticle noted earlier this year, “ . . . these reputation-based indemnification instruments, structured like a performance bond or warranty with indexed triggers, communicate the quality of governance, essentially absolving board members of damaging insinuations by activists.”
Given the increased personal reputational risks facing directors and the long-term financial consequences arising, it may be time for an omnibus revisit of the adequacy of both director compensation and company-sponsored D&O risk mitigation strategies in the context of an enhanced, board-driven approach to governance, compliance, and risk management.
Following the guidelines of the ALI’s project once they are published is a rational strategy. After all, the work product will be one that will have already been “tested” informally in the community comprising the courts of law, and will be designed to account for the reality of the courts of public opinion. And no firm today has natural immunity to reputation damage—even Warren Buffett’s Berkshire Hathaway appears to be in the ISS crosshairs. Reputational insurances which, like vaccines, boost immunity, are available to qualified boards to counter all that is certain to come at them in this upcoming proxy season. And for those who insist on both belts and suspenders, hazardous duty pay may seal the deal.
Nir Kossovsky is CEO of Steel City Re and an authority on business process risk and reputational value. He can be contacted at email@example.com. Paul Liebman is chief compliance officer and director of University Compliance Services at the University of Texas at Austin. He can be contacted at firstname.lastname@example.org.
Overseeing a company’s corporate governance process and structure, the nominating and governance (nom/gov) committee is essential to a company’s long-term success. In this BoardVision interview—moderated by NACD Director of Partner Relations and Publisher Christopher Y. Clark—Bonnie Gwin, vice chair and co-managing partner of the global CEO and Board Practice at Heidrick & Struggles, and Thomas Bakewell, CEO and board counsel at Thomas Bakewell Consulting, discuss the qualities of an effective nom/gov committee chair:
Sets the right mix between board culture and composition
Facilitates cross-committee communications
Performs effective board evaluations
Spots diverse talents in director candidates
Bonnie Gwin, vice chair and co-managing partner of the global CEO and Board Practice at Heidrick & Struggles (left) and Thomas Bakewell, CEO and board counsel at Thomas Bakewell Consulting.
Here are some highlights from the discussion.
Christopher Y. Clark: Depending on what your definition of best is, why should the best director on the full board be the chair of the nom/gov committee?
Bonnie Gwin: In my opinion, it is an incredibly critical role. You’re talking about a director who is helping guide the board in not just developing a great composition for the board that is strategic and focused…, but also a director who understands the culture of the company and the board that they’re trying to build. You really need an outstanding director who understands that mix between composition and culture and can work closely with the board to get it right.
Thomas Bakewell: Bonnie is spot on in terms of composition and having the right team around the table. The other magic that you need in a terrific nom/gov chair is somebody who can draw people out, spot talent, make sure everybody gets heard, [and] really…build the team. Coming from a baseball town where we have a pretty good manager [who] wins a lot of World Series, we know the value of having a great person who can draw everybody out and get the team to work together. It’s really [about teamwork] … and using a lot of the tools that are available today. One of the trends in tools is…much more thorough and in-depth evaluations. [These are] … not just check-the-box or check-the-list [exercises] but in-depth individual board evaluations to know what’s really going on in the boardroom and among directors.
Clark: NACD [held] a combined meeting of the NACD Audit Committee Chair Advisory Council and NACD Risk Oversight Advisory Council. … It was invaluable for both sets of committee members. How do you feel about [meetings between committees] … whether it’s audit and risk [or] compensation and nom/gov? Do you think those interrelationships of committees should be enhanced or promoted?
Gwin: Generally speaking, transparent communication across all the committees of the board is essential. It’s essential for a high-functioning board. And in particular where you have, for example, [the] nominating [and] compensation [committees], there’s a lot of interplay between them and the issues they’re addressing. I think it’s important to ensure that there [are not only] good transparent lines of communication between those two committees, but frankly across the whole board.
Bakewell: The magic ingredient is how people work together, and part of that key element is how they communicate. The old approach to boards was everybody showed up the day before the board meeting [and] went to the committees. A lot of times people went to every committee [meeting]. What’s the point [now]? You don’t have the time. You don’t have the energy. You don’t have the resources today. So how do you have a board where everybody trusts each other and they communicate? If you’re not on the audit committee and important issues come up…, can you simply pick up the phone and reach out to the audit committee chair, or is there another process that’s very helpful for you to get the information you need?
Clark: Please give us one last piece of wisdom.
Gwin: The piece of wisdom I would share is the importance of long-term succession planning. We’ve talked about that several times, but I really think, looking at board composition [and] board dynamics… over the next four or five years…is very important.
Bakewell: I would say my secret sauce is [that when looking at director candidates] it’s not so much [looking at] … particular talents, [because] everybody can look at a resume and see what somebody has. They’re going to see if they’re a CEO, [or] they’re skilled in marketing. The real magic is [asking], “What is their true personality? Are they a ‘driver’ personality? Are they a curmudgeon?” Sometimes boards need curmudgeons. … Is somebody a strategic thinker, or is their skill set not [being] a strategic thinker but taking strategy and converting it into action? What have they done in their past experience that really makes them qualified for this role?
Clark: Well I think we’ve got all the synapses popping. I wanted to thank the both of you for joining me today.
Leading boards increasingly take an approach to board succession that goes beyond traditional placement and even planning. They don’t want to be caught flatfooted in the event of unexpected departures of directors, multiple retirements, strategic evolution that calls for new skills on the board, or the sudden appearance of an activist investor demanding seats at the table.
Bonnie W. Gwin
Theodore L. Dysart
At its most advanced, this approach includes establishing relationships with potential candidates even when foreseeable board vacancies lie far in the future. At a minimum, it involves identifying robust candidates across the various sets of competencies the board might need down the road, and then keeping tabs on them, looking for opportunities to get to know these individuals, and learning how they might one day fit into the company’s future. Boards that employ this approach:
Manage foreseeable vacancies and skill-sets as a portfolio. Through detailed assessment, boards can identify critical gaps in their committees or expertise, and zero in on the skills they will need. They can then develop a competency index that enables them to manage succession planning holistically, not as a series of one-offs.
Continually identify a broader range of potential candidates to address expected (and unexpected) vacancies. The board of a leading consumer company, for example, maintains what they call an “evergreen book” of 40–50 potential candidates they keep their eye on from year to year. Similarly, the board of a leading financial services company, facing four vacancies in the next five years, conducts periodic “lit searches” and at any one time is aware of a dozen or so potential candidates.
Engage potential candidates before they’re needed.Activist investors, for example, are well aware of annual meeting cycles, and they use this time pressure to push through their proposed director candidates. Boards must, therefore, either be able to conduct rapid searches for world-class alternative candidates or face the prospect of a proxy fight. Boards that have already engaged with candidates and gotten to know them will not only understand who would best fit the bill but also who has the stomach to enter the fray. Moreover, these candidates will better know the company. We find that this not only gives the company an edge in convincing widely sought executives to join the board, but also helps ensure a faster, more productive start when they do.
Anticipate cultural fit. Through proactive engagement, board members can get a sense of how potential candidates might improve upon (or poison) the atmosphere of candor and collegiality that effective boards require.
Boards differ in how they engage with potential candidates, but the process is usually jointly owned by the CEO and an independent director. In some cases, the CEO takes the initial meeting with potential candidates. In others, the lead director or a member of the nominating committee makes initial contact. In all cases, the encounters should be informal, get-acquainted sessions, not formal interviews. The subject of board membership should be brought up only as a casual point of conversation with no commitment to timing and with no certainty that things will move forward.
Why, then, should potential candidates agree to meet? Because the worst that can happen is that they have made contact with the CEO and board of a prominent company and established relationships that could lead in any number of directions.
By identifying and engaging with potential colleagues, boards can reap big dividends, enabling themselves to:
Respond faster, more flexibly, and more effectively to unforeseen events
Refuse to settle for less-than-ideal candidates
Evolve the board in step with the company’s long-term strategy
Strengthen the board’s culture, both through thoughtful appointments and the board’s better understanding of that culture
As we have found, once the process begins to pay off—in a faster search in an emergency, the successful recruitment of an accomplished leader, a rapid and smooth onboarding of a new director, or the fine-tuning of the board’s culture or mix of skills—board members get firmly behind it. Most importantly, they give themselves a perpetual head start on one of their most important responsibilities.
Bonnie W. Gwin is vice chair and managing partner of Heidrick & Struggle’s board practice in North America. Theodore L. Dysert is a vice chair in Heidrick & Struggles’ Chicago office, where he is a leader in the global board practice and an active member of the CEO practice.