Helping Independent Directors Be Constructively Proactive

This is the second in an occasional series of “how to” columns on directing, which considers how independent directors can be proactive, but in a constructive way. The guidance is intended to assist directors in striking the correct balance between two unacceptable extremes—being unduly compliant toward management, or unduly adversarial. Being independent doesn’t mean you have to be a gadfly, but it doesn’t mean you have to be a rubberstamp either.

The challenge facing independent directors is to avoid becoming a proverbial “fifth wheel,” an unnecessary appendage in the corporate oversight process. If, as a general rule of thumb, you could be entirely absent from the boardroom and it wouldn’t make a difference, then you’re not being constructively proactive, and you’re not earning your keep.

There’s an inherent tension in calling for directors to be constructively proactive, because directors by definition are supervisors, not doers. But think of the best movie directors. Did they wait for the cast to tell them how to make the movie? Corporate directors are the shareholders’ representatives, and the shareholders are the ones putting up the money to run the company. So they get to call the shots. While waiting for issues to come to the board is often advisable—because then they’ll be ripe for consideration—it can also leave directors at the mercy of management. Directors need to be constructively proactive.

Directors need access to information.

Directors need access to quality information from management, and this includes the ability to meet with key managers, auditors and consultants. With advances in technology, companies are able to generate more information and make it more readily available. Information is vital because it reduces uncertainty and helps identify and manage risks. While it’s always possible to have too little information, it really isn’t possible to have too much. The key is for the directors to be able to view, and assess, their company through management’s eyes. That means having access to management’s data base, on a real-time basis.

Directors need to utilize that critical information.

One of the principle difficulties with having access to information is that it leads to the question whether directors actually made use of the information. We’ve become an information-consuming society, and shareholders consume information as much as anyone. As shareholder representatives, directors need to utilize the access they have to quality information. In deciding how to grapple with a particular problem, directors should ask, “What would I want to know if I was a shareholder?” Directors continually need to assess corporate data, trends and projections. With so much data available to directors, it creates a duty to be informed. Ignorance is no longer an acceptable excuse, if it ever was.

Directors must be steeped in issues that could come before the board in the coming year.

This means keeping up with, and being responsive to, current issues. Advanced planning means no surprises. As Louis Pasteur observed, “Chance favors the prepared mind.” Being a director should not be a test of someone’s improvisational skills. As a corollary, this means it’s critical for boards—and board committees—to have “working” agendas. These agendas should be a joint collaboration between management and the outside directors. By-and-large, the timing and substance of most issues will reside—in the first instance—with management. But there are certain issues that every director should insist be raised and discussed. Advanced planning on the coming year’s agenda means there will be no surprises. And no surprises means that directors can contemplate issues and prepare for discussions when they arise.

Directors must have access to internal and external experts.

Directors can’t do their jobs by themselves. It is critical for directors to have adequate expert resources available to ensure that they are not only doing what is expected of them, but that they are proactively seeking to identify problem areas before problems actually arise.

Directors must understand the current business environment.

A lot of credibility that the business community once enjoyed has been squandered and eroded. As scandal after corporate scandal hits the front pages, is it any wonder investors reading about these ethical, moral and legal lapses doubt businesses’ integrity? Re-establishing trust and confidence is not a one-time event or related to a specific statutory obligation—it’s an ongoing process that must reflect a company’s way of life.

Directors must understand the current environment relating to the specific businesses in which their company engages.

A friend of mine related a story of being in a meeting with a new executive who said, “Of everyone in this room, I know the least about this company and I draw my strength from that.” He is now a former executive. Directors must be knowledgeable about their corporation’s business environment and stay attuned to trends, events, and uncertainties, as well as where the company and its competitors stand.

Directors must be steeped in risk management.

As former Citigroup Chairman Walter Wriston aptly put it, “All of life is the management of risk, not its elimination.” Directors should understand significant risks facing the company and satisfy themselves that appropriate and adequate internal controls are in place to check and monitor them. Directors also should ensure risks are appropriately disclosed and explained in company documents.

Directors must develop a proactive mindset, and a methodology toward compliance and ethics.

In the not-so-distant past, conventional wisdom suggested that directors should not go looking for problems. But today, independent directors must make sure companies have in place sufficient mechanisms to allow them to detect problems before they arise, and to have reasonable internal controls in place that serve as an effective deterrent to unethical conduct.

Directors should establish a special compliance committee.

Instilling a proper corporate tone, and ensuring that a company's leadership is setting the right standards, is best achieved by charging a special group of outside directors with oversight of that process.

Elevating ethical and compliance concerns to the level of a board committee demonstrates a company's commitment to the right core values.

Moreover, if the outside directors assigned to such a committee are properly trained in how to function effectively, and appropriately employed, they will provide a real demonstration—in actions, not just words—that the company's ethical values are not just given lip service.

Independent directors must understand the motivations of management vis-à-vis specific recommendations to the board.

When management comes to the board asking it to make a decision, the board may not be privy to all the reasons why the directive is being sought. It is a useful exercise for independent directors to understand why management is making specific recommendations, what accounts for the timing of the recommendation, and who is benefited or harmed by the proposed course of action.

Directors must understand options considered, and the reasons that one was selected and others were rejected.

For every decision that is made, it is axiomatic that a number of options have been considered along the way. Directors need to focus on choices and judgments management makes in presenting a recommendation, and the reasons for that recommendation. The purpose here is not to second-guess decisions made, but to be able to support and embrace them, understanding all of the different considerations management confronted before arriving at its conclusions. Of course, part of the effort may well lead to a conclusion that the operative management assumptions underlying a particular proposal may not reflect the board’s carefully considered judgment after a thorough review.

Directors should tie compensation to corporate values.

Directors should insist their company has a core statement of policy regarding the company’s values, and must be able to relate that statement of core values to the company’s compensation program. Compensation should be rethought to reward senior executives for the right things, and to closely align their interests with those of the shareholders. If this is not accomplished, directors are missing a huge opportunity to base compensation on ethical behavior and performance-based objectives. This in turn will help wean analysts and shareholders away from earnings per share, a fictitious number.

By identifying corporate values, and then rewarding managers who achieve them, the incentive to "play games" with earnings over the short term will diminish considerably. When a manager's incentives reside with how the company's stock price—and earnings per share—are faring, it is human nature for managers to attempt to take every available means to increase short-term earnings per share. When compensation is predicated on a long term assessment of how well managers achieve a corporate culture of integrity, the infatuation with earnings per share diminishes.

Independent directors must employ sound methodology for executive compensation decisions.

Assessing levels of compensation cannot be done just by looking at numbers; to that extent, SEC requirements may have contributed to the problem the agency now understandably is trying to remedy. Since the SEC promulgated its compensation disclosure rules two decades ago, executive compensation has gone through the roof. That's partially because the disclosure requirements enabled senior executives to quickly discover what their competitors and peers were making. This in turn created a “Lake Wobegon” problem, where no one wanted to be seen as below average.

In this setting, independent directors can play an important role. By determining the goals the company wishes to promote, they can figure out how to structure incentives. It is critical to determine whether conflicts exist between management’s compensation incentives and the company’s core values. Blind reliance on compensation consultants—who furnish data on pay packages and policies at peer companies—is a potential trap for the unwary. And, of course, it pays to be careful how these consultants are paid, as well.

Independent directors need to ensure their company has a three-dimensional disclosure policy.

Approaching disclosure as an episodic event is no longer possible, if it ever was. Companies must assign clear responsibility for the continuous collection, aggregation, and assessment of corporate information. This includes looking at the practices of the company’s competitors, peers and joint ventures. And those overseeing disclosure policies must develop methodologies that ensure timely decisions are made on the types of corporate data and developments to disclose.

Directors need to compare their company to others in similar industries.

Just because your company appears to be doing better than its competition doesn’t necessarily mean it is. It’s critical to know why you’re doing better, and to be able to explain it cogently. Royal Dutch/Shell’s mischaracterization of its proved reserves is a cautionary tale. While Royal Dutch/Shell was reporting its share of reserves as proved, its partners in the same venture, Chevron-Texaco and Exxon-Mobil, were not. This exposes the weakness in two-dimensional corporate disclosure regimes that focus solely on the company under review, but fail to look at the practices of the company’s competitors, peers and joint ventures. As with Royal Dutch/Shell, if you’re doing better, it could mean your peers are using more conservative measurements or assumptions.

Surviving in the new environment created by The Sarbanes-Oxley Act and the myriad regulatory requirements it spawned is no easy task. But for those directors who take the time to approach their mission with common sense and a constant dedication to shareholder interests, the results will be very gratifying indeed.

This column solely reflects the views of its author, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.