A Call to Action in the Boardroom

June 10, 2010

By Barrett J. Stephens

The financial crisis has left public confidence towards corporate boards at an all-time low. Transparency, executive compensation, board independence and accountability are, once again, at the forefront of public debate. In light of these developments, the SEC has proposed revising its proxy access rules to enable large-company shareholders with at least one percent ownership to list their own director candidates on the proxy ballot. On its face, it is easy to argue how this amendment would strengthen the accountability of directors to shareholders. As Sarbanes-Oxley illustrated, however, corporate governance regulation is governed by the law of unintended consequences. We believe that this proposed regulation will have a significant unforeseen impact on board culture and director succession that can be detrimental to the shareholders it seeks to benefit. As outside owners, shareholders are rarely exposed to the nuances of board culture and the impact of individual personality on overall board effectiveness. In our work advising hundreds of boards, we have found that the best boards have a unique identity and chemistry that saturate their work. A great board is created when everyone knows their responsibilities, holds each other accountable and is mutually committed to the long-term success of the company and its stakeholders. The required balance among the group of openness, commitment, trust, and equality is difficult to achieve and easy to lose. Increasing the ability of shareholders to rearrange the board, with no consideration of the effect such changes would have on boardroom culture, will only hamper a board’s functioning. What’s more, making board elections more like political elections will make the boardroom susceptible to the same short-term thinking and vote-getting mentality that we too often see in our elected officials.

But if the amendment’s unintended consequences are cause for concern, its underlying purpose—to make boards more accountable—is beyond question. Responsible boards will see the SEC’s action as one more reason to recommit themselves to excellence. Having relevant industry and functional experts on the board is necessary, as is matching the make-up and expertise of the board to corporate strategy. In over 30 years of working with corporate boards, however, we have found that the most common reason for a board to underperform is its inability to remove ineffective or disruptive directors and replace them with individuals who have the time, interest and expertise to make an impact. Boards tend to procrastinate when deciding if and when a director should be asked to resign. A board that debates management, strategy and operations with vigor will suddenly become sheepish when it comes time to address a fellow director’s underperformance. The board either ignores the issue and waits for it to resolve itself or goes to the other extreme, conducting a 360 degree peer review to formally expose a problem and hiring an outside firm to help handle the project’s sensitivities.

The fate of Lehman Brothers makes for a good example of the perils of inaction. Its board was chronically ineffective in dealing with director succession and refused to create a governance framework with the necessary banking, risk management and regulatory experience. When Lehman declared bankruptcy in September 2008, five of its directors were between the ages of 73 and 80 and had served for an average of almost 16 years. While a director’s age and tenure does not determine his or her effectiveness, when combined with other signs it can indicate that the board may not be adjusting its perspective to keep pace with the rapidly changing business landscape. We will never know if having different directors would have saved Lehman. But we can be fairly certain that under the new SEC regulations, Lehman’s shareholders would have performed the boardroom housecleaning that Lehman itself refused to do.

Both regulators and activist shareholders will continue to become more involved in proxy elections until boards do a better job recognizing and removing underperforming directors. In addition, as many companies have changed their strategic outlook to adjust to the new economy, boards need to reassess whether they have the requisite industry and functional expertise to help guide their companies and management teams to meet their new challenges and opportunities. If an assessment and gap analysis reveals areas where the board needs strengthening, the Nominating and Governance Committees will need to start building a director succession roadmap and pipeline immediately, to address the issue before discontent shareholders decide to take matters into their own hands.

In all likelihood, the implementation of these new rules will take place with next year’s proxy season. Boards therefore must make an honest review of their performance a top priority today. Even the most activist of shareholders, after all, is unlikely to launch a campaign against a responsive board that is fulfilling its responsibilities with diligence and care.

Barrett J. Stephens is a Managing Director at RSR Partners. RSR Partners is the leading board recruiting boutique founded by Russell S. Reynolds, Jr.

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