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The Board of Directors At Work: Impact Beyond Regulation

The collapse of US investment banks in the fall of 2008 is "one of the most remarkable events in modern economic history." (EN: But it is by no means unprecedented. Similar incidents have occurred regularly in the history of the US markets, and in the economies of Europe centuries prior, and likely throughout history.)

The author is troubled that the problem was not recognized and prevented sooner, as the signs were there and many of the "best and brightest" people (executives, investors, regulators, etc.) could not have been entirely ignorant of them - but failed to recognize the problems and refused to take preventative action.

The excuse the author accommodates is simply that they were distracted: they were focused on taking great advantage of a short-term situation without considering its long-term consequences. If they considered them at all, they certainly didn't consider them to be important, or consider the degree of impact they would have for their own firms. It may also be true that they were prevented from taking action by adhering to policies, procedures, and practices that they had themselves put in place in a previous time, when economic conditions were different.

It's also noted that regulatory requirements and reforms may have done more harm than good. Legislation is often misdirected and myopic, prone to panic about the present without thought to the future, and companies were compelled to behave in destructive ways in order to be in compliance with legal requirements that effectively prevented them from taking actions that would have mitigated the crisis.

There's also a pot-shot at boards of directors, which are often composed of people who are unqualified or uninterested - it is "a place of retirement for senior executives or entrepreneurs," and as such is an assembly of people who are burned-out and out-of-touch.

Most importantly, boards of directors have become impotent: they are merely a social club that provides rubber-stamp approval for the executives without considering or understanding the impact of the decisions they are asked to authorize. In smaller words, they are asleep at the wheel and are clearly not doing their job, which is to help their firms achieve long-term success.

Whose Responsibility?

In recent years, media attention has been given to public disagreements between board members and CEOs, often resulting in the dismissal or indignant resignation of the latter. On one level, these stories demonstrate that boards of directors are taking a firmer hand in corporate governance and reclaiming some of the authority that they regrettably delegated to executives in the past.

Hiring and managing the top executives of a firm are some of a board's main tasks, which have been sorely neglected: executives were selected for their public image, board meetings were not conducted in an orderly or professional manner, and the boards were content to rubber-stamp executive recommendations. It's only when crises arise that boards seek to resume their duties.

And because neither boards nor executives have behaved in a functional manner, governments are stepping in - in some cases using legislation in an attempt to control companies, and in others taking over control by effectively, if not overtly, nationalizing companies. But neither legislation nor nationalization has effectively put things right, and has very often made the situation worse.

The problem is that firms are failing to do what they ought to be doing, and seem reluctant to start doing it. The example is given of Sony, who found itself struggling as a conglomerated corporation against smaller specialized firms. The board reckoned that a change of CEO would put things right - but after doing so, nothing significantly changed. The problem was clear: a different CEO still took the same orders from the same board of directors, who had not changed.

The author also speaks of the incestuous relationship between executives and the boards that govern them: it is not at all uncommon for the CEO to propose the names of directors to the board, effectively staffing the group of people who would govern him with those most likely to give him free rein, and excluding the shareholders from the selection process except to approve or reject his selections.

The balance of power can also swing in the opposite direction, with a more aggressive board of directors that is (too) fast to react to negative financial performance by firing the CEO - which, as previously discussed, creates a situation in which top management is not focused on the long-term success of the firm, but on its immediate ability to generate profits in ways that can be detrimental to its long-term success.

The pendulum swings from one side to the other over time: a period of success leads a board to become inattentive, a period of failure leads them to be overly aggressive. Neither is a sign of good governance, but of myopia and indifference to the factors that really matter: making sound, though not necessarily precognitive, decisions regarding the long-term success of the firm at accomplishing its mission.

As such, the board of directors must seek to pursue a governance process and mechanisms that are be geared to the long-term success of the firm at accomplishing its mission, and tolerant of short-term setbacks and inefficiencies, and with the understanding that financial returns are the result of the firm's success at its mission rather than the primary object of it.

The Board of Directors At Work

It is essential to the future of a company that boards of executives work to pursue the company's long-term development and survival. The author suggests "nobody else in the firm has this mission."

(EN: This is not strictly true, but conventional wisdom is that the perspective lengthens as rank increases: the board members set direction in general, top management focuses on a decade in the future, mid-level management have five-year plans, low-level management have annual plans, etc., down to the lowest rank of employee who may focus on the activities of the moment.)

Beyond that, the role that the board plays in a firm and the specific governance tools at its disposal to effect its decisions vary greatly, and can be instrumental in supporting or negating the board's effectiveness. A good practice for one firm may be counterproductive in another. Moreover, merely modeling a general theory or imitating the practices that are effective elsewhere are not sufficient and may be ill-advised. In general, a board should seek to implement a system based on consistent and harmonious practices rather than a pastiche of random principles and practices.

The author suggests some basic principles that should be considered by boards of directors:

  1. Transparency - Because the board represents the interests of others, it must not be clandestine, but open and honest to those it affects. The author stresses this does not mean disclosing all information to anyone, only that information of legitimate interest to others, particularly shareholders and investors.
  2. Specialization - The board itself is an entity that serves a specific purpose and sets for itself certain boundaries. It cannot be everywhere and do everything. It may also divide authority and assign tasks to committees in which only one or a few board members participate.
  3. Collaboration - This refers to collegial decision-making: the input of all members is sought and given fair consideration and the chairman seeks to coordinate rather than control the discussion.
  4. Unity - Board members must focus on a common set of goals to pursue, negotiating conflicts of interests, and ideally looking to those goals that support the long-term survival of the organization rather than momentary issues.
  5. Proactive - The board must proactively pursue goals. It must not merely be a committee to review and ratify the decisions made by the executive staff. Where a board merely does this, especially if it rubber-stamps the CEO's decisions, it is not serving its function.

Tasks and Responsibilities of The Board of Directors

Beyond legal requirements, there are not traditionally accepted definition of duties for a board, and practices differ enormously among firms in different nations or industries, and even those within a given nation or industries. In other words, it is not necessary for a firm to strictly adhere to a single set of practices in order to be successful or admirable, but each should adopt those most productive to its situation.

This said, the author has observed certain tasks and activities to be common to boards:

And as usual: this is a sampling of common functions, not a comprehensive list.

Corporate mission and values

Most companies are established with a basic idea for selling goods and services and creating economic value in the process. The company's founders may have a specific mission in mind, or they may have only a general notion and later discover the need to document their purpose for consistency and clarity.

A mission statement is not a timeless document: as a company evolves, its mission and values must be reviewed. Where the company is moving in a positive direction, it may be necessary to revise the mission accordingly; where it is moving in a negative direction, it may be necessary to control the firm to bring it back into line with its mission.

Likewise, the values of a firm shape a company and encourage its culture in a specific direction. In some firms, the definition of values is left to certain divisions, such as marketing or human resources - however, because values are so critical to the company's direction, the board of directors should actively manage them, and periodically review them.

The mission gives meaning and purpose to the efforts of every person and lends consistency to decisions: it is the end to which all actions and decisions must in some manner lend support. The values describe the manner in which the company will act, or refrain from acting, in the course of pursuing its mission.

(EN: a little more is given on what constitutes a "good" mission, but it's very superficial and likely misleading in its brevity. The point here is not what the mission ought to be, but how it ought to function and that the board should be its author.)

Strategy and resource allocation

The executives of the firm are responsible for analyzing the prospects, evaluate which to pursue, lay plans to pursue them, and determine what resources are necessary to accomplish those plans. However, the board must not be uninvolved in this process: because these decisions will influence and shape the company's future development, the board of directors should seek to participate, and must in any case have the last word.

Of particular importance is that the board should not merely make the decision to approve or reject a strategy, but must understand that which they are given to consider and participate in an active dialogue with the top management team.

Involvement in strategy form is conducive to proper governance and makes it more likely that the board will approve and support the resulting decisions. (EN: The consequence of not being involved is that the board may only learn what the executives care to tell them, and not fully explore alternatives or understand significant details.)

In general, the involvement of the board is in decisions that will impact the firm over the course of several years, and not for a shorter time frame. They must provide in their plans some latitude for executives to execute upon the plan, making adjustments as necessary without circumventing the intent of the strategy. The board should also encourage top executives to take a broad perspective to afford the same flexibility to the lower-level employees to whom authority must be delegated.

The board must also review its plans against performance, assessing whether the strategy should continue to be followed as written, modified, or abandoned altogether. Regular discussion of such matters is necessary to ensure the company is continuing to pursue the right objectives in an efficient manner.

Control and information systems

To be effective in their function, the board of directors must have access to information about their firms and be able to communicate directives. Many of the recent problems in governance have been blamed on ineffective disclosure and control systems.

Technology has to some degree facilitated the gathering and communication of information in ways that were not previously practical - but in many instances the information systems in modern organizations provide access to such an overwhelming amount of granular data that relevant and important facts are hidden in an incomprehensible clutter of information that, in spite of its volume, may still lack the necessary data to make reliable decisions.

Traditionally, boards and executives have tended to focus almost exclusively on economic and financial indicators, which is essential but insufficient, given that financial performance is only one factor, and is generally the outcome of numerous activities. The numbers do not speak to the innovation, the employee development, quality of customer service, and other factors that are essential to decision making.

Moreover, financial information tends to be standardized due to regulatory reporting requirements, which never did consider the needs of decision makers within a firm. The information that is useful will vary greatly among firms: it will derive from its industry and company type as well as the strategy and values that are idiosyncratic to the firm.

Institutional development

Having a desire to succeed is not sufficient: a firm must also develop its operational competency in order to effect the success that is desired. Some firms are better than others at doing so, and this does not often occur by accident, but by building the competence of the firm as an institution.

In most instances, what distinguishes one company from another are its people - employees and others who make decisions and take actions that are effective and efficient. Candidates are selected for their skills and abilities, but to be effective within an organization, their individual talents must be fostered by their company, and their ability to work efficiently as a group can only be fostered within a firm.

As an aside, the author mentions this as one of the social functions of a firm. While it is their immediate intent to improve their people so they will be more efficient and effective in their jobs, personal development also pays dividends outside the office: people are better members of their families and communities.

Institutional development also includes its stance in regard to all its stakeholders: when it establishes policies and procedures, it is encouraging behavior along patterns that derive from its own values, and in doing so encourages the adoption of its values along with the required patterns.

The author lists the stakeholders with which a company typically interacts, suggestion that a firm should consider how the policies, procedures, and practices reflect its values in each interaction with: shareholders, employees, customers, suppliers, communities, regulatory agencies, and the media.

With that in mind, the board of directors should consider its values in defining policies and monitoring compliance. The task of defining specific details may fall to executives and employees, but the board should establish guidelines.

Corporate identity is often discussed in the context of a marketing campaign - but the character of a firm is demonstrated daily in its interactions with people. No amount of advertising can successfully and sustainably present a company image that is contrary to its actual character.

Firms often consider their relationships with different groups to be different things, and have the misbelief that its relationship with investors is separate and wholly isolated from its relationship with its employees or customers. Aside of the fact that these are not distinct groups (an employee can also be a customer and an investor in his firm), the company itself is a common factor in all of its relationships - and its actions are based on a single set of values and principles as an institution.

A specific example is a firm that makes low-quality products but wants to maintain an air of prestige as a company. Such a facade simply cannot be sustained. It is not only easier, but also inevitable, that a firm should have a reputation that is in line with its actual character.

Executive Committee Oversight

The English model of the corporation persists to this day in that companies are governed by two committees: the board of directors and the board of management, though the latter is more commonly called the "executive committee."

The author returns to his earlier analogy of their being likened to the lungs of a human body: both must be fully functional in order for the body to be in good health. There must also be a balance between them - where one is failing, the other may work harder to compensate, or conversely where one is taking on too much work, the other will rest and atrophy over time.

Ideally, there is a balance and harmony in their relationship - and they should especially avoid working at odds with one another. It is not a struggle to control, but a struggle to cooperate, which requires each to do what it must, but not to impede the other.

However, the two are not equal: the board of directors outranks the executive committee and controls the degree of authority granted to the executives, as employees of the board. It must manage them according to the same principles: valuing their expertise and delegating to them certain authority to take action, but at the same time provide them with guidance for action and correction when necessary.

Another important principle pertains to delegation of authority: it is generally accepted that authority and responsibility must be balanced, and that nothing should be done by a higher-ranking authority that could be more effectively accomplished by a lower-ranking one. In some instances, it would be dysfunctional to delegate (allowing the CEO to set his own compensation); in other instances, it would be dysfunctional not to do so (to require board approval to purchase office supplies).

Transparency is also an important principle: a board of directors and an executive committee will have differences of opinion and wish to influence strategy to suit them, but to withhold information from the other party in order to deprive it from considering factors that should be taken into account in a decision is highly dysfunctional. Because the board outranks the executives, it has the power to respond in a punitive manner when executives hide information - but it should also assume the responsibility of setting a good example in its own behavior. Openness and honesty are the foundations of trust, which itself is the foundation of all relationships.

The author also suggests that initiative is an important principle - not merely responding to the actions taken by the other party, but initiating ideas and being proactive in the conversation. Failure to do so causes a firm to become mired in business-as-usual and fail to evolve in the ways it must in order to remain relevant and competitive in its industry.

Returning to the notion of delegation and separation of power, these are decisions that are made in each organization: some functions are assigned to one or another, but the author does suggest that certain functions are specific to one or the other across all organization. A list of examples:

The CEO Selection Process

The selection of a chief executive officer is one of the most significant activities of the board of directors: this individual is their primary and, in some cases, sole point of contact with the entire corps of employees who handle the day-to-day affairs of the firm.

The CEO is bound to execute upon the mission set by the board, but has a great degree of latitude and authority in the manner in which he does so: he selects the executives of the firm and directs their work; he designs the information and control systems; he promotes transparency between the board and the firm; and he sets the tone and direction for the rest of the organization.

In the US, particularly, CEOs are often selected for their celebrity image: shareholders and the public are impressed by a charismatic figure with little knowledge or consideration of his actual qualifications. He concedes that this practice seems to be waning, but star power is still a factor and it may, over time, resurface.

The future of the firm is very much at state in the CEO selection process: mistakes and bad choices will be very costly for the organization, in both the short and the long term, and a poor choice can cast doubt on the competence of the board members in the minds of the shareholders who elect them, as well as in the minds of all stakeholders (employees, potential employees, regulators, etc.) and will impact their expectations of and interest in continuing to interact with the firm.

Most often, a CEO is selected after getting rid of the current one. Except where death or retirement has created a natural vacancy, this general results from the board's extreme dissatisfaction with the way in which the current CEO is running the firm. Because a coup is inherently political, it may be driven by irrational motives: the reason a firm is failing may not have to do with the way in which the board's plan is being executed, but the plan itself; or it may be a matter of impatience.

Whatever the case, the CEO is scapegoated and run out. This should have been, but is not always, preceded by a careful analysis of the problem to determine that a change of chief executive will solve the problem, and to ensure that the decision is based on sound reasoning rather than emotion.

It is essential for a board of directors to define a competency profile for the CEO. Doing so will enable them to be objective in the selection of an officer, and provide a similarly objective basis for evaluating the actual performance of the individual who is appointed to the position. While these competencies will vary according to the industry and the firm, there are a few that the author believes can be applied universally:

  1. The candidate must be capable of assuming, communicating, and implementing the company's mission. If the candidate disagree with the mission in a significant way, he will likely be unwilling to support it, and may subvert it.
  2. The values of the candidate must also align to those of the firm. A CEO cannot effectively lead a company if he disagrees with its values. He can pay lip-service and act in a disingenuous manner to make it seem as if he does, but the true nature of his character will emerge and he will not be an effective leader.
  3. The candidate must demonstrate the ability to think in board terms - to see the big picture of where the firm is, and look past the horizon to where it ought to be. This ability has sometimes called "strategic thinking" or "vision" A CEO whose capacity to think and plan is limited to the short term tends to get los in the weeds and fail to evolve the business over time.
  4. In the present age, the ability to manage complexity and negotiate among competing objectives is a key competency. As markets have globalized, culture has changed, technology has progressed, and there are far more variables, each of which is subject to greater variance, than in previous times. A CEO must have the intellectual, practical, and moral capacity to manage ths complexity.

In the selection process itself, poor organization and a clandestine selection process are acutely problematic. There is much to be considered, and discretion is important, but either factor taken to extremes becomes damaging.

The author gives the example of Accor as a particularly bad selection process: the board decided to replace their CEO with the nephew of one of the founders, but to avoid the appearance of nepotism, the firm hired and external recruitment firm - which was a tremendous waste of time and energy, but was also damaging to the reputation of the firm as the financial press had given its support to a more competent candidate and investors were shocked when the firm appointed a far less qualified individual.

CEO Compensation

In recent years, outrage over CEO compensation packages has been at a fevered pitch, particularly in the financial sector where firms spinning toward bankruptcy (and even a few that have been bankrupted) continued to provide lavish compensation to their executives and golden parachutes for those whose were accused of ruining their companies.

(EN: This is generally the case where a compensation package is based on certain metrics that can be met, even when the firm's overall performance is failing, contractually binding firms to hold to their compensation agreements. While this causes a great deal of public outrage, the real question is why the agreements were arranged in the first place ... and why didn't the board recognize that it was compensating executives for things that do no matter or, worse, giving them financial encouragement to do things that harm their firm.)

This is primarily seen in the US, because executive salaries in Europe have traditionally been more modest - which is not to say they were not inflated or poorly conceived, just that the total amount of compensation is less.

Things were not always thus: the author considers testimony given at a US congressional hearing in 2004 that demonstrated that in 1980, CEO compensation was about 40 times that of the average employee at a firm, but by the year 2000, it had gradually increased to become almost 500 times more. Aside of being thoroughly demoralizing to the employees of such firms, it creates a situation in which a CEO can become fabulously wealthy in a very short amount of time, and has little reason to consider the long-term welfare of his firm.

The author suggests that decisions pertaining to executive compensation are "as much philosophical as technical." It must provide fair compensation for the value provided, be high enough to compete for executive talent with other firms, be rigged to encourage the desired performance, etc.

The author suggests an analogy between CEOs and major-league athletes, whose salaries have also ballooned in recent decades. The star player on a successful (hence popular) team can make far more than others who do essentially the same job. He suggests that this is not really a good analogy, because an athlete is compensated for largely individual skills, whereas a CEO is merely coordinating the activities of others and the performance of the firm is more to do with the work of many than that of a supremely talented individual.

(EN: I don't think that effectively dispels it. Athletes depend on teammates as well. But more importantly, it's a bad analogy because the CEO is not like an athlete, but more like a coach - and I expect that the salaries of superstar coaches are just as inflated when compared to their peers. And I expect that the ability of a coach to manage his team and get fans to pay to watch the games is objectively worth a lot more than one who does the same job but produces poor results.)

Whatever metrics are used to gauge CEO performance, they must be rigged to produce results. Particularly when metrics are tied to compensation, it should be clear that a poorly-conceived system will lavish rewards on CEOs who do not perform and even encourage them to act in ways that make the numbers look good, but may be detrimental to their companies.

Some criteria should be applied in any case:

  1. Compensation should be based on performance related to the accomplishment of the purpose of the firm
  2. It must also be equitable, providing financial a financial reward that is neither too much nor too little for accomplishing the goals.
  3. It should be transparent, such that when an executive's compensation seems to be out of order, it will come as no shock.

Ultimately, the best safeguard is to ensure the decision about executive compensation is carefully considered and open to debate, and refined through this process to ensure that the system is effective and appropriate.

Some Final Thoughts

This chapter has focused on the role of the board of directors and its contribution to the firm's long-term success and survival.

The author sees two dangers in present thinking on this topic. First, there is too much emphasis on legal reform, which is not an effective approach: no company ever became successful or avoided tragedy merely by complying with the letter of the law. Second, there seems to be a temptation to react against executive misconduct by giving too much power to the board of directors. For a firm to be healthy, there must be a balance, not merely a shift from one extreme to the other.

The task of the board of directors is to define success and create conditions that will enable to company to remain successful in the long term. To do so, it must avoid the extremes of neglect and overbearing control, and participate in activities that genuinely add value to the company.

Yet another bizarre metaphor follows about the board being likened to the part of a railroad company that builds railways - tracks and switches - and the executives as the navigator who plans a course across that system to a desired destination.

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