For 20 years, I have been observing and working in boardrooms, as a director in the US and Europe, as a consultant to boards in those continents and Latin America, and as a researcher and author. I have also been leading education programmes for corporate board members at Harvard Business School for the past decade.
My perspective on the current state of boards is that there has been a significant improvement in their functioning in the past two decades. New laws, regulations, guidelines and rising investor and public expectations have had a positive impact. The great majority of boards are less under the thumb of their CEOs than they once were, and are seriously trying to govern their companies. A set of best practices has emerged that are documented in country corporate governance codes, stock exchange listing requirements and company annual reports.
For sure, boards are being asked to do more because of these new expectations. It is also true that too many of these demands focus on matters that are visible from public documents but are not central to what actually takes place in boardrooms. Nevertheless, I find individual directors are willing to accept these additional duties and spend more time on them. Further, I see no evidence that there is a shortage of suitable new candidates for board seats.
This is all good news. However, because so many directors are trying to do more and do it better, they are also frustrated by difficulties that they encounter. The most common concern I hear is: “We don’t spend enough time considering and dealing with company strategy.” Obviously, this is related to a second worry: “We are spending too much time focused on issues related to complying with new laws and rules.” This is a particular concern in the US because of the Sarbanes-Oxley Act.
Directors are also often troubled that they are so regularly criticised about their CEO’s compensation. Finally, they often admit that the trend to bring in more new CEOs from outside is the result of their failure to do an adequate job in ensuring sound management development and succession planning. All these concerns are important because they are about matters that directors consider their core responsibilities.
Limits on board effectiveness
Boards are experiencing these difficulties for several reasons. The first is the increasing emphasis on independent directors. While the precise definition of independence varies from country to country, as does the desired proportion of such directors on each board, the basic idea is the same. Most directors should not have any other connection with the company, past or present.
The goal, which certainly is a worthy one, is to ensure that boards are objective and have no conflicts of interest. However, the problem is that, with this emphasis on independence, boards are usually made up of directors with little current or past knowledge about their company’s industry or businesses. Further, independent directors are truly part-timers. They have other day jobs that limit the time they can realistically devote to each board. Consequently, well-intentioned directors find that they have insufficient time and knowledge to perform their jobs well.
A director’s lack of knowledge is complicated by another problem – the quality of information they receive from management. Oddly, it is not that they receive too little, but that they receive too much, which is often poorly organised and does not illuminate the most significant issues.
Another problem is that boards are often unclear about what role they should be undertaking and, in most countries, their legal duties and responsibilities are broad and vague. The one exception is Germany, where laws are quite specific, but boards there have other difficulties because of their size and the emphasis on co-determination.
Rather than considering carefully what their focuses should be, too many boards simply do what they have always been doing, and respond reflexively to new requirements, such as the Sarbanes-Oxley Act, without explicit attention to how to deal with the additional duties. As a result, directors lack clarity of purpose.
As the old saying goes: “If you don’t know where you are going, any road will get you there.” This is the problem too many boards have. They have no clear criteria to use in determining how to allocate their precious time together. Rather, they focus on whatever issues management feels are most pressing and on what they have traditionally done.
A third problem stems from the basic fact that boards are groups of individuals who must work co-operatively to get things done. The advantage of having many individuals on a board is that there should be diverse perspectives, healthy debate and sound decisions. The difficulty, as anyone who has worked in a group setting or studied social psychology will immediately recognise, is that effective group decision-making takes time and requires skilful leadership.
Achieving effective leadership is a complicated and related matter. First, there is the question of whether the board chair and the CEO should be two individuals (as they are in most European, Australian and Canadian companies) or whether the functions should be performed by the same individual (as is common in the US). My own view is that either structure is workable, but the roles and responsibilities must be clearly defined and agreed.
Regardless of the structure, the person who is in the chair often has difficulty creating agendas and leading discussions to reach consensus in the time available. To some extent, this may be due to a lack of leadership skill on the part of chairs, but I think the more important reason is that all board members legally are equal and they expect to be treated that way by each other. This makes it hard for a chair to control the meetings effectively and requires self-discipline on the part of all the members.
Board concerns and their causes
These impediments to board effectiveness underlie the concerns that so many directors express. For example, complaints that too much time is being spent on compliance and not enough on matters of strategy usually arise because the board has not paid explicit attention to its role. As boards are asked to do more, they simply try to cram more into the same size container, and this does not work.
Additionally, because boards are unclear about their role, directors’ complaints about lack of strategic involvement, while heartfelt, are unclear and vague. How do they want to be involved in strategy? What contribution to strategic decisions do they have the knowledge to make? Where should the line be drawn between the board and management on strategic matters? How can the board provide effective oversight of the company’s strategic direction and progress within the limits of time and knowledge? All are important questions that are too rarely addressed.
I recently encountered an example of this with the board of a financial services company that operates in several distinct businesses. Because almost all the directors were independent, they were unfamiliar with the complexities of these financial service businesses and their underlying economics. Further, the information that management was providing, while well intentioned, was complex and not well organised. On top of all this, the board was intent on complying with the requirements of the Sarbanes-Oxley Act. The directors were frustrated and anxious to get more involved in strategy, but unclear how to do so in the time available and with their limited understanding of the company’s businesses.
Succession planning
While there are a few examples of companies (and boards) that handle management succession well, such as General Electric and Unilever, these are certainly the exceptions. In my experience, when directors complain that they do not effectively monitor management development and succession, the problem is not that they are unclear about the role they should play. Rather, the difficulty is that the topic is not properly addressed due to the constraints of time. It is a longer-term issue and its consideration can always be postponed because of more urgent matters.
For example, on one board with which I am familiar, the question of how to ensure a smooth transition between the current CEO and the next initially came up at meetings five years before the incumbent’s retirement. The topic was put on the agenda of meeting after meeting, but it always was squeezed out by a new acquisition opportunity, or a crisis in a particular business. Suddenly, or so it seemed to the board, the old CEO was going to retire in 18 months, and there was only one internal candidate that he believed could replace him. The other directors did not consider his candidate satisfactory, but they had done nothing in the previous years to address the issue. Not surprisingly, the situation evolved into a bitter dispute between the CEO and the rest of the board.
The root cause of the problem was simply that the topic, which all recognised was the board’s responsibility, was never given priority. It is also true that the lack of time to address this issue (as so often happens) was the result of allowing other discussions to wander about with little or no attempt by the chairman to keep them on track and the inability of other directors to help manage the boardroom dialogue.
Executive compensation
The issue of executive compensation can also be a problem for boards. Many reasons have been put forward to explain why boards end up rewarding their CEOs so richly. Some even suggest that directors, who are themselves CEOs, conspire to make sure that the CEO in question is highly compensated, so that the general level of pay for corporate leaders keeps rising. Perhaps such things go on in some compensation committees and boardrooms, but I have not seen them.
In my experience, the causes are more subtle. The directors involved in compensation decisions, even if technically independent, often find their independence is hard to sustain psychologically. They know their CEO and other top managers from working with them over years of board service. They appreciate the efforts they have put in and the results they have achieved and they want to reward them for their efforts as well as their results. In deciding what is the “right” amount, they usually have only one source of information – the “market surveys” provided by compensation consultants, which are usually flawed because they do not recognise company performance. Further, since the survey information is always organised by quartile, it is difficult for any director to recommend that his CEO should fall below the mean of other CEOs. So we end up with almost all CEOs being in the top half, and more than 25 per cent being in the top quartile. As a result, CEO and executive pay in general keeps rising.
A further problem arises because directors, despite having this connection with management, are too often not aware of the desire of shareholders. In essence, there is an information asymmetry. Directors understand and empathise with what top executives expect but are less aware of shareholder concerns. In the UK, where shareholders are now given an advisory vote on the past year’s director compensation, this has changed, as directors at GlaxoSmithKline, WPP and some other UK companies will doubtless confirm.
Board design
It seems clear that the constraints of time, knowledge and group process make it difficult for many boards to accomplish what the public and shareholders expect of them, and what they, themselves, are trying to do. In my judgment, all the new rules and guidelines in the world will not solve such problems. Rather, the key to improving the board’s capacity to deal with such problems rests in the hands of each board.
These difficulties are likely to get worse unless we can find a way to get directors to step back and reflect together on how they can be more effective and efficient. Fortunately, there is good news on this front. Some new regulations, such as the NYSE and Nasdaq listing requirements in the US and the Combined Code in the UK, are requiring boards to undertake a self-evaluation of their performance on an annual basis. Elsewhere, many boards are doing this on their own initiative. These assessments are like an annual physical exam. The purpose is to identify problems and what should be done about them. They also enable directors to identify opportunities to work together more effectively. I have been involved in many such assessments and I am confident that they can be powerful catalysts for board improvement.
In the case of boards, what is needed is attention to the way the board has been designed and how that design can be improved. The first consideration, as I have already emphasised, must be what role the board wants to play in major issues, such as ensuring compliance to laws, principles and regulations, involvement in strategic questions, and in ensuring healthy management development and succession.
Consideration of the board’s role involves being explicit about which decisions the board should take and which should be the purview of management. It also involves understanding which aspects of company and management performance the board intends to monitor. These are matters that should be considered periodically – perhaps every few years – as company and management circumstances change. Once the board has a clearer understanding of what it wants to accomplish, it then becomes possible to clarify other aspects of its design.
Design choices begin with the size of the board, the proportion of management and independent directors, and the mix of talent and experience the board needs. Explicit attention must be paid to the question of what directors need to know for a board to be effective.
Boards also need to consider their leadership structure – for example, whether they have one person as CEO and chair or two, whether there is a lead director and what the role of committee chairs should be. Of course, this also includes the matter of which committees the board needs – just those required, or others additionally.
Decisions also need to be made about the length and number of meetings, including those of independent directors in the absence of executives. This, of course, depends on the role the board wants to play and the fullness of meeting agendas. A process must be defined for how the annual cycle of the board’s business is to be defined and by whom, and also who will determine the agenda for each meeting.
Design should also include explicit and thoughtful attention to what information the directors need in order to play their role, and when it will be transmitted. Attention must also be given to how to organise the information, so that busy directors can comprehend what is happening within the limits of the available time.
Finally, when I speak about design, this includes explicit consideration of the best procedures for the board to use in handling its major tasks – approving and assessing strategies, evaluation of the CEO and ensuring compliance with laws and regulations.
Making all these choices may seem like a large effort for a group of people who already feel overtaxed. However, in my experience, it is always a pleasant surprise how quickly directors can agree on these matters. And in any case, the improved results always seem to be worth the effort.
Jay Lorsch is the Louis Kirstein professor of human relations at Harvard Business School. He is the author, with Colin Carter, of “Back to the Drawing Board: Designing Corporate Boards for a Complex World” (Harvard Business School Press, October 2003).
