Some Common-Sense Advice for New Directors

October 15, 2009, www.directorship.com
by Herbert S. Winokur

The task of finding outstanding and committed new directors is not an easy one, and it is likely to get even harder. More directors will be needed as creditors increase their influence, whether through government investment in financial institutions or through debt restructuring at over-leveraged companies. Yet the availability of top candidates is shrinking due to factors that more board service less attractive, such as the increasing time commitment required, need for more industry expertise, regulations governing pay and accounting, and litigation risk.

If the job of finding great new directors is difficult, so is the job of sitting on a board, especially for the first time. Here is some common-sense advice for new directors. First, and most importantly, remember that directors direct and managements manage.

Why serve?
Understand why you choose to serve and embrace it. In earlier times, directors often served for prestige, compensation, and fellowship, and their performance rarely was challenged. Those halcyon days are gone. You must now consider reputational risk, substantially expanded (and often last-minute) time commitments—perhaps at little per diem pay—and a more formal environment (which can impinge on candid strategic focus). Do due diligence on the company and its industry, as you will be judged in the court of public opinion—and perhaps even in the courthouse. You’ll need courage, good business instincts, and the rare ability to judge others accurately.

Directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

Reliance on Outside Advisors
As a matter of corporate law, directors are generally entitled to rely on advice from outside advisors, including compensation consultants. Directors should exercise care in selecting experts and shouldn’t hesitate to question those experts as much as necessary.

We recommend that the following be adopted as standard best practice for directors:

Audit Committees should meet regularly with supervisory partners of their firm’s auditors, not just the audit partner, and should require that the auditors disclose conflicts and disagreements about accounting matters and the consequences thereof. Auditors already disclose conflicts with management and “opinion-shopping”, but directors need to understand the “close calls” that accountants are making.
Compensation Committees should focus on actual performance and on compensation expected under different scenarios, and less on consultants’ standard pitches on comparables. Rewards for performance must be based on realistic goals, taking into account the environment and the factors management controls. In general, paying annual bonuses for performance only relative to an earning budget should be avoided (because management controls the budget) and relative to peers’ stock performance equally (because management doesn’t control either its own or peers’ stock prices). Further, mark-to-market accounting of financial investments, determination of pension liabilities, and other key P&L components can be manipulated to affect reported profits and compensation. True operating cash flow, and performance relative to competitors, while also not perfect, are worth considering as performance measures. Proper use of deferred payouts tied to actual realizations will go a long way towards realigning managements’ and stockholders’ interests.
Boards should receive regular presentations from outside counsel about important trends and cases in corporate law, especially those affecting their duties and their liability. In addition, directors should be assured on a regular basis that each of their primary law firms has brought forward any legal or ethical concerns.

Board Oversight
It goes without saying that boards should focus on economic and financial scenarios covering the full gamut of assumptions. In the current environment, liquidity is a key concern. At other times, expansion or strategic transactions may play a larger role.

Management will always control the flow of information, and even deeply engaged boards will be on the losing end of an asymmetry of knowledge. But the directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

We offer the following suggestions to mitigate, at least partially, the inherent disadvantage directors face due to this asymmetry.

First, ensure that management provides access to, and explanations about, competitors’ performance. Detailed understanding of relative competitive assessment of revenue growth, operating margin, employee turnover, customer satisfaction, and pricing policies will be far more useful than reiteration of historical financials or unsupported projections. Rating agencies face conflicts and their work cannot always be relied on (in any case, ratings often lag reality), and securities research can be superficial and dominated by management or employers. Spend time finding out how the firm is really doing.

Second, create and exploit opportunities to engage informally with employees at all levels of the organization. Plant managers, sales staff, and human resource middle managers, for example, will have a less edited view of how the business is going than you will hear at board meetings.

Third, make sure senior management regularly reinforces the responsibility, under a code of conduct or ethics policy, for every employee to notify an outside board member, anonymously or not, of any planned or known misconduct, whether financial fraud, Foreign Corrupt Practices Act payments, improper behavior, or other improper actions. The purpose of this “honor code” is to give directors more eyes and ears.

Fourth, make sure board meetings include enough time for the independent directors to reflect in executive session on the reports they have received and to raise questions for later follow-up.

It is important for directors to have a good working relationship with management, and, at the same time, one that permits directors to exercise their responsibilities. This relationship best can be described as one with “healthy tension.” Directors and management need to understand that asking probing questions is not done out of suspicion: sometimes judgments of senior management are just wrong, and directors must press their questions, no matter how uncomfortable this becomes.

Knowing Good from Bad
There is no perfect system for identifying a CEO who lacks honesty, integrity, or capacity. Just as a board needs to know the physical health of top officers, however, it also should (subject to reasonable limits on privacy) understand their financial health, and, as much as possible, their values. Financial circumstances, especially excess leverage, sometimes force desperate people to take improper steps.

One tip after years of experience: In addition to probing executives’ financial health, if a CEO regularly requests less compensation than his/her compensation committee would have awarded, that CEO is less likely to get the company into trouble via excessive risk taking or fraud.

Good luck to all new board members, and, remember, selecting a good CEO and helping him or her achieve the goals set by the board is one of your most important jobs.