The quest for an independent board
Elsevier Food International Vol.7, no.2, May 2004 Len Lewis
“The ultimate measure of a man is not where he stands in moments of comfort, but where he stands at times of challenge and controversy.” The late civil rights leader Martin Luther King Jr had larger issues in mind, but the words aptly describe the key role of non-executive directors in a global business community that has been rocked by scandal and lost the confidence of investors and consumers alike.
In a post-Enron world, the harsh light of day has been let into the once impenetrable inner-sanctum of the corporate boardroom. As such, independent directors have become an increasingly important commodity—raising questions about operations, fiduciary responsibility and business practices that impact good governance.
But there are several questions to be answered. Are there enough independent directors serving on company boards and are they independent enough to say and do the right thing for the good of the entire company and its shareholders? Or is this position merely an extension of the “old boys network”, the corporate version of political patronage that carries a hefty paycheque and prestige for people who do virtually nothing?
Roger Raber, president and CEO of the US National Association of Corporate Directors, added: “Our data and surveys show a significant increase in outside directors. Because of corporate reforms, all public companies must have a majority of independent directors. But we’re also seeing a significant run-up in a ‘super majority’ meaning 75 per cent of the board is composed of outside directors.”
However, Cynthia Montgomery, professor of business administration at Harvard Business School, Cambridge, Mass., the author of extensive research on corporate governance issues is somewhat less enthusiastic. “Some good things are happening because companies feel it’s necessary. There has been a shift on boards—but it’s not seismic,” she said.
The role of non-executive directors
A recent report by The Conference Board noted that a medium-sized board ranges from nine to 12 members—depending on the industry—with between eight and ten being non-executive or outside directors. The number of outside directors has also been spurred by the addition of women and minorities in the boardroom in order to address diversity issues. Moreover, over 90 per cent of companies surveyed, have audit and compensation committees and nearly 60 per cent have nominating committees, all three of which are normally composed entirely of non-executive directors.
While money is not and should not be the motivating factor behind a directorship, these can be lucrative positions, with base compensation averaging about US$45,000 in manufacturing companies, US$43,000 in financial companies and US$40,000 in service companies like retailers. These figures may include an annual retainer, per meeting fees and separate payments for committee service. However, when stock components are added, the amounts can increase significantly according to the Conference Board.
Since Enron, the larger issue of corporate governance and the effectiveness of outside directors is something that can no longer be dismissed by companies that want to increase internal efficiencies and avoid becoming an investment risk, thereby increasing a company’s cost of capital.
The role of non-executive directors in the UK was detailed in the so-called Higgs Report, a 126-page document released last year and authored by Derek Higgs, a director and senior advisor to numerous UK firms. The report to the Chancellor of the Exchequer and the Secretary of State for Trade and Industry covered such topics as:
• The population of non-executive directors in the UK.
• How they are appointed.
• Their independence and effectiveness.
• Accountability.
• Compensation.
• And what can be done to strengthen the quality, effectiveness and independence of non-executive directors.
The report built upon the Cadbury Code, which was instituted in the early 1990s to strengthen the role of non-executive directors. In the US, moves to increase non-executive directorships were largely the result of legislation enacted after the corporate scandals wreaked havoc on the stock market.
“We’ve had directors say that they are merely the parsley on the fish or that the most important attribute of a corporate director is the ability to yawn with your mouth closed,” said Nell Minnow, editor of The Corporate Library, Portland, Maine, research and consulting firm that also rates the effectiveness of boards. However, post-Enron reforms including the Sarbanes-Oxley legislation and listing standards by the NASDAQ and New York Stock Exchanges put a lot of emphasis on non-executive directors. Before that, the New York Stock Exchange didn’t even require a majority of directors to be independent outsiders and now they do,” said Minnow.
“The role of the director, inside or outside, has always been the same. They are held to the strictest standard developed by our legal system—the fiduciary standard—and that means you owe shareholders the duty of loyalty and care. And one of the fundamental principles of law is that we don’t create structures or roles for no reason. And if an outside director is there to rubber stamp the CEO then they are there for no reason,” she said. “Ideally, the CEO should be the only inside director. In general, there’s no reason for any insider to be on the board.”
Director compensation
But can they render good judgements on issues facing the company if their future and compensation is closely linked to the CEO and other executives on the board? “That’s why in corporate governance we have the nominating committee controlling that instead of the CEO. Nominating committees are composed entirely of independent directors. I can tell you more about the genuine independence of a board member’s mind and spirit by looking at the CEO’s compensation than by whether they went to college together,” Minnow noted.
As noted, the quest for a truly independent board has been accelerated by corporate reforms mandated by such legislation as Sarbanes-Oxley and the stock exchanges. “The exchange has been pretty specific but even they didn’t go far enough. They say that if you’ve been an employee of the company, including a former CEO, and have been away for three to five years then you are considered independent. But we (NACD) feel he should get off the board completely and no director should have a financial relationship with the company beyond directors’ fees. That means no family members or someone who works for another business that provides services to the company.”
Minnow refers to herself as something of a hard-liner when it comes to compensation for non-executive directors, believing that they should all be required to be shareholders. “Of all the studies that have been done trying to correlate best practices in governance with reduced risk, the most reliable measure is director stock ownership. We like to see directors own a lot of stock. In fact, I’d like to see them all get paid in stock and be required to hold it for three years after leaving the board. But there is no such requirement among corporations,” she said.
Director compensation is always a hot button in the press, but money is not the prime mover for anyone taking the post, according to NACD’s Raber. “Most people do it because they think they can make a difference. If someone asks how much he or she is going to be paid—that’s a red flag. I don’t know many directors who are dependent on fees for their livelihood. Of course, they should be paid, but we hear more criticism about executive compensation,” he said.
Assessment
Nonetheless, non-executive directors have to earn their keep and this means regular assessments or report cards on their activities. “It starts with the selection process and due diligence on such things as integrity and expertise. Once they’re on the board, we’re seeing a lot more focus by boards on self-assessment,” he said.
Harvard’s Montgomery has mixed feelings about these self-evaluations. On the plus side, the close working relationship between board members gives them first-hand knowledge about each other’s strengths and weaknesses. On the other hand, board members may be reluctant to criticise each other and if the board is weak to begin with, their evaluations may breed other weak directors, she said.
Part of this assessment procedure has to do with how much time non-executive directors devote to board business. Some recent research indicates that an average of five hours a month is spent on board business, but Raber calls this totally unrealistic. “There’s no way a director can fulfil responsibilities in 60 hours a year. If people look at their fiduciary responsibility as just attending five or six meetings a year—forget it. Part of the due diligence process is making it clear that they are not only expected to be involved in board meetings, but pre-board meetings, reviews of materials, committee meetings and generally staying up to date on all business. It’s not unusual to see someone spending 200 to 250 hours on board issues,” he said.
However, this also depends on how independent a non-executive director really is, according to Montgomery. “Independence is measured in a very crude way. It’s often just a state of mind.”
Long live the network
Nearly half the non-executive directors of public companies in the UK were appointed because of personal contact with another board member, but only four per cent were appointed through a formal interview.
These were among the findings of a survey of more than 600 directors by MORI, a British-based market and public opinion research agency, which conducted its research following last year’s launch of the Higgs Report. Among the company’s other findings:
• 81 per cent of non-executive directors received some sort of briefing after taking the post, but 62 per cent never received any training.
• Only 38 per cent of non-executive directors have been given objectives for their role and 76 per cent have never been given a formal, personal performance review.
• Chairmen are more likely to discuss company business with investors than they are with non-executive directors.
• 92 per cent of outside directors are satisfied with their role and 31 per cent believe their experience and knowledge are their most important contributions to the company.
• 25 per cent believe that lack of time is the biggest barrier to greater effectiveness of non-executive directors.
Has the time come for companies to hang “help wanted” signs outside the boardroom door?
A recent study by consulting firm Ernst & Young in the UK indicated that qualified business people may be less inclined towards becoming non-executive directors, with approximately 40 per cent of respondents, noting that these positions have become too risky, too high profile and too time consuming.
“This survey should ring some alarm bells,” said Gerald Russell, managing partner of Ernst & Young. “At a time of intense scrutiny of the corporate governance process, and when we need high quality executive directors more than ever, it is clear that many experienced candidates are getting increasingly nervous about the risks associated with the role.”
Asked if it’s harder to find qualified people these days, Nell Minnow of The Corporate Library noted: “That’s a myth. People being asked to actually do some work may be saying no more often. But there are many highly qualified, dedicated and honourable people who want to be directors. It just may take more calls to find them because you can’t just round up the usual suspects any more.”
Roger Raber of the National Association of Corporate directors, agreed. “There are a lot of good people out there. The challenge is to find someone to chair an audit committee. That’s the person with the high profile. They don’t necessarily have a higher liability. But the focus is on the chair of the audit committee these days and it’s difficult to get someone already on the board to take it on.”
However, he noted that it is becoming more difficult to get sitting CEOs to sit on boards of other companies. “There has been a decline in the availability of serving CEOs and if a company says they can’t find outside directors, it’s often because they are looking for sitting CEOs,” said Raber.
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