There has always been a degree of cynicism in the investment community about how boards of directors are chosen and the standards to which they perform. The stereotypical image conjures a musty club whose complacent (or oblivious) members have a taste for cigars and a talent for synchronized head-bobbing. In recent years many companies have proved this image all too real, and regulators around the world have responded with sweeping reform aimed at improving how boards govern companies.
The efficacy of regulators’ and legislators’ solutions is sparking debate. However, one new arrival in the mandated pantheon of governance best practices is, if done properly, virtually guaranteed to improve performance and investor confidence. While investors have been trying different ways to measure board performance for years, only recently have significant numbers of boards begun to measure themselves. And investors, intensely focused on all aspects of director competency and effectiveness, are becoming increasingly sophisticated in their valuation of both the process and outcome of such appraisals.
The common-sense idea of self-assessment is to have boards reflect on their past experience in order to see what is working and what needs working on. The process takes various forms ranging from independent review and surveys to interviews and group discussions (with or without external facilitation) on individuals, committees and the board as a whole. The quality spectrum of board evaluations ranges from a ‘ticking boxes for compliance’ approach to systematically examining a board’s purpose, tasks, talents, information and agenda.
In the US, TIAA-Cref, Calpers and other institutional heavyweights are firmly behind maintaining a process to evaluate the effectiveness of boards. Ensuring all directors are pulling at the oar is also an investor priority in Canada where, for example, the powerful shareholder advocacy group Canadian Coalition for Good Governance (CCGG) is urging company boards to evaluate individual directors. ‘It’s one of several factors – behavioral and structural – we hope will improve governance,’ says David Beatty, managing director of CCGG. ‘The objective is to have effective boards.’
Beatty has plenty of persuading to do. He estimates only 100 of Canada’s largest companies claim to do board evaluations and as few as 25 – mostly financial or oil and gas companies – do individual evaluations. US exchanges now require firms to do board self-assessments as a listing condition, while in Canada and the UK governance falls under a ‘comply or explain’ regime, and is therefore not mandated.
Beatty is quick to point out that he doesn’t advocate strict legislation in this area. ‘Pressure from owners and us is probably sufficient,’ he notes. He doesn’t believe one size fits all and is sometimes willing to negotiate with management. ‘I’m quite prepared to agree with a chairman who says, We are six people who have worked together for five years and the company has done well. At the end of annual meetings, we discuss what we should be doing more and less of,’ Beatty explains, adding that whatever the board culture, the important thing is to embark on the task seriously.
Beyond compliance
From an IR point of view, it is the rigor applied to the evaluation process that differentiates a firm from its peers, argues John Dinner of John T Dinner Board Governance Services. ‘An issuer with a rigorous board and individual director evaluation process will use disclosure as an opportunity to build investor trust by describing the process in detail and, in overview, the actions taken as a result,’ Dinner explains.
For its part, Institutional Shareholder Services (ISS), which already factors in board self-assessment in its corporate governance quotient (CGQ), plans to add director evaluation as a component in June.
In doing so, it is also likely to subtract several other factors. ‘Things like tenure requirements or mandatory retirement age are artificial restraints,’ says Patrick McGurn, executive vice president at ISS. ‘We are looking for companies that supplant those structural features with a robust director evaluation process – one not meant as a symbolic gesture, but which can lead to genuine reform in the boardroom.’
Initially, ISS will look for companies with a basic director evaluation program in place. In coming years, as they evolve into widespread best practice, McGurn says ISS’ assessment of director evaluations will become more qualitatively refined. ‘IR people will want to make sure the board is communicating the robustness of the process and how it is leading to remediation of problems,’ he points out. ‘If boards are doing something beyond statutory requirements, they should be indicating that to the marketplace. Going forward, it will be a litmus test showing the process is not just one of compliance but one looking to improve the board’s performance itself.’
Ticking boxes
While its board’s self-analysis and disclosure largely reflect statutory obligations, London-based Cable & Wireless is embracing board processes that will naturally lead to good governance. Speaking at the company’s annual shareholder meeting last summer, the company’s chairman Richard Lapthorne said, ‘For me, an essential element of good corporate governance practice is that non-executives, excluding the chairman, meet once a year to address four issues: the quality of the relationship between the chairman and the CEO; how open the CEO is with the board; how apparent the existence of checks and balances is within the executive director team; and whether all issues raised at board and committee meetings have been properly addressed and subsequent questions answered. If the answers to these questions are positive, good governance should result. If the opposite is true, bad corporate governance is more likely to flourish – boxes ticked or not.’
‘You don’t need to run through masses of boilerplate and tick all the boxes,’ adds Louise Breen, director of IR at Cable & Wireless. ‘If you put in place some basic controls and the board members communicate effectively with each other, there shouldn’t be a problem.’ Shareholder confidence in Cable & Wireless has increased as a result of a number of factors, but Breen says the company’s new attitude to board performance is an important part of the mix.
With the investor spotlight turned to boards, companies naturally want to know how they measure up to their peers, particularly when it comes to compensation issues. ‘Analyzing your own and peer groups’ boards helps you draw accurate comparisons and deal proactively with investor questions,’ says Brendan Sheehan, an analyst at BoardEx, an independent corporate research company.
Candor chill
Despite their obvious benefits, self-assessments have never been high on most boards’ ‘to do’ list. While interested parties like the National Association of Corporate Directors (NACD) have advocated self-assessments for over a decade, the practice really became widespread when the NYSE revamped its governance following the Grasso affair. The exchange was apparently so delighted with its own formal self-assessment that it extended the idea to its listed companies. Nasdaq followed suit. There remains, however, much sensitivity to evaluations, particularly those of individual directors. One fear is litigation.
Critical self-analysis by directors might reveal embarrassing information that can be used in civil or criminal proceedings. Notably, Delaware courts have not recognized a privilege of confidentiality for self-evaluations. ‘If anybody knows which directors are non-performing, it’s the directors themselves and other directors,’ notes Richard Leblanc, a lawyer and governance researcher at Toronto’s York University. ‘If I was a shareholder plaintiff’s attorney, that’s the kind of information I would want to know.’
The upshot is, without the cloak of confidentiality, candor is inhibited and the usefulness of self-assessments handicapped. ‘Because of the fear of litigation, some companies do assessments on yellow sticky notes,’ says Leblanc. ‘They are having only oral discussions, not using computers or written questionnaires. What shareholders and regulators want are assessments that are thorough and rigorous with candid input and recommendations for improvement.’
Balanced between the potential for litigation and the IR imperative for transparency and disclosure, IROs walk a fine line. This tension is also evident when it comes to the charters upon which evaluations are based.
‘Company counsel already warns that if you say in a charter you are doing something, you had better be sure to actually do it,’ says Leblanc. ‘For lawyers, the less said the better. IROs can respond by pointing out that this is a legitimate shareholder issue and boilerplate statements about responsibilities do not showcase best practice in this area. The leading-edge companies are looking at this as an opportunity.’
