Category: Board Composition

Competing Stakeholder Expectations Raise Personal Risks for Directors

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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

nirkossovsky

Nir Kossovsky

paulliebman

Paul Liebman

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.

Governance Implications

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 Directorship magazine 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 NACD Directorship article 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 nkossovsky@steelcityre.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 paul.liebman@austin.utexas.edu.

Three Ways to Build a Strategic-Asset Board

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The business environment is rapidly and fundamentally changing—and directors are expected to keep pace. In response to this state of extreme volatility, the Report of the NACD Blue Ribbon Commission on Building the Strategic-Asset Board explores how boards can position themselves to capably usher their companies into the future by focusing on continuous improvement. At the 2016 NACD Global Board Leaders’ Summit, Commission co-chairs Bonnie Hill, director of California Water Service Group and former Home Depot lead director, and Richard H. Koppes, director of NACD and the Investor Responsibility Research Center Institute and former deputy executive officer of CalPERS, discussed the Commission’s key findings with NACD Director of Strategic Content Development Robyn Bew.

NACD Blue Ribbon Commission Report on Building the Strategic Asset Board

Members of this year’s Blue Ribbon Commission came to a consensus early in their discussions that “board refreshment”—an increasingly popular term in the corporate governance community as various stakeholders turn their attention to board composition and director turnover—is a limiting, and even simplistic, concept. Instead, directors need to figure out how they can make themselves strategic assets to the companies they serve by instilling a continuous-improvement ethos into the culture of the boardroom. Over the course of the conversation, Hill and Koppes suggested that directors consider the composition and functionality of the boards in the following ways:

How do directors’ skills need to align with company strategy? Businesses evolve rapidly, and boards need to respond in kind. Here, directors need to consider how they are keeping abreast of the issues facing their organizations and whether the skills that initially garnered them a seat at the boardroom table still align with the current and future direction of the company. Sometimes this means deciding to leave the board.

Internally, new-director onboarding practices provide an opportunity to communicate about the board’s culture and governance principles, including reinforcing the idea that board service is not a lifetime appointment. Externally, boards can communicate to stakeholders that a director’s departure was in keeping with the board’s governance practices and does not reflect poor service on the director’s part.

What are the board’s processes for continuous improvement? Maintain a pipeline of boardroom talent and have a multi-year succession plan in place so that open board seats can be filled with highly capable candidates. These plans should include designating successors for committee chairs and the independent chair or lead director. For sitting directors, continuing education programs can help to refine or amplify skill sets. Evaluations, including at the individual-director level, are essential tools for continuous improvement when they are conducted regularly and periodically involve an independent third party. They help ensure that the board’s processes are functioning well, enable directors to be more nimble in their own self-improvement, and ultimately fine-tune the board’s strategic contribution to the organization.

How do stakeholder perspectives affect the board? Shareholders—especially institutional investors—are paying closer attention to issues surrounding board composition. Considering that institutional investors read thousands of proxies each year, the onus is on individual boards to effectively communicate how each director makes valuable contributions. More and more leading boards are going beyond the basic biographical information required by the SEC and listing exchanges and providing additional context. In addition, if there is any concern that a director slate could be a point of concern for investors, boards should reach out to those constituencies well in advance of proxy season to explain their position. Should investor dissatisfaction with the board lead to an activist engagement, panelists agreed that, while sometimes both parties ultimately agree to disagree, the board needs to hear out that point of view and seriously consider if their position might add value.

For detailed recommendations on how to enhance your board’s continuous-improvement processes in seven key areas, download the Report of the NACD Blue Ribbon Commission on Building the Strategic-Asset Board. In addition, read this article from the current issue of NACD Directorship magazine for more insights from Bonnie Hill and Richard Koppes on the creation of the report.

Maximizing Talent to Create a 21st Century Board

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Identifying what expertise is needed on the board and orchestrating different—if not conflicting—points of view into constructive conversation can be a challenge. During a session at the second annual NACD Diversity Symposium on the opening day of the Global Board Leaders’ Summit in Washington, DC, panelists James Lam, director and chair of the risk oversight committee at E-Trade Financial Corp. (E*TRADE); Myrna Soto, director of Spirit Airlines and CMS Energy Corp.; and Charlotte Whitmore, vice chair and chief, brand strategies, of Analytics Pros., discussed how boardroom talent and a robust mix of perspectives are critical to ensuring a company’s success.

Maximizing Talent to Create a 21st Century Board

Conversation centered around two themes:

1. Striking a Balance. When considering the future needs of the company, Lam recommended that directors think about their business and its risk profile and then consider the following questions: “What are the key megatrends that will impact the business?” and “What director skill sets will be needed to mitigate this potential impact?”

Considering the continuously growing list of threats and disruptors facing businesses—such as cybersecurity, globalism, and climate change—some boards debate the need to focus on recruiting subject-matter experts to help them oversee these risks. But panelists agreed that new perspectives should replace long-standing expertise.

“Seasoned directors can be a voice of reason,” Soto said. “New executives can be what you need to push the strategy. When you have that diversity of thought, you really challenge the strategy, but it comes down to the nominating committee and how it thinks about what the next director is going to bring to the table.”

Drawing on her own experience, Whitmore concurred. Whitmore is cofounder of the data analytics start-up, Analytics Pros, and knows what it’s like to both recruit directors whose business experiences are different from her own and to be recruited to a board because of her particular expertise. At her own company, Whitmore said she has learned from more seasoned directors that taking actions to grow the company too quickly might do more harm than good. “They bring a sensibility to corporate culture that’s not just about driving results,” she said. In her role as a director, she said her older colleagues often look to her data-analytics savvy to discover new ways to support the organization.

2. Facilitating Dialogue. Having diverse perspectives around the board table does the company no good unless they are heard. Effective director onboarding is vital to acquainting a new director with the company and establishing both the board’s expectations of the new recruit and what that director expects of fellow board members and management. A director’s ability to successfully contribute to the conversation is contingent on the conditions on which they were onboarded. Soto said that she turned down several directorships based on what she learned about the companies’ governance structures. Lam recalled having his own agenda during his onboarding at E*TRADE, ensuring, for example, that he was able to meet with the risk committee and senior management.

In addition, the lead director plays the very important role of ensuring that all directors are heard. When new directors are called upon to join the board of a company in crisis or during a transition—such as a CEO succession—the lead director can be instrumental in managing and balancing the perspectives and experiences represented around the table and getting the full board to a point where it feels comfortable not only in making major decisions, but also in communicating those decisions to stakeholders outside of the boardroom.