The Board of Directors: Succeeding in the Future
Corporations, Securities & Antitrust Practice Group Newsletter - Volume 3, Issue 1, Spring 1999
May 1, 1999James Melican
The subject that I would like to address today is the role of the board of directors in corporate governance and, more specifically, how that role is evolving. I think it's fair to say that not so long ago the prevalent notion was that the board of directors would select the chief executive officer, often on the recommendation of the outgoing CEO and then pretty much stay out of the way, barring some disaster of cataclysmic proportions. In other words, the board wold offer advice when and if it was sought and would generally be supportive of whatever actions the CEO wanted to take. In that model, the ideal director for a CEO to have was a peer who would sometimes bring a different perspective, but would not in any way be a threat to the CEO and who believed firmly in noblesse oblige.
Because of developments which have mostly occurred in the last decade, today there are many institutional shareholders who want and expect directors to play a very different role. They are supportive of the theory that activist directors make for a better performing company, and, in their minds, activism means being inquisitive, asking probing questions, challenging management's assumptions, setting clear and measurable objectives, and then moving quickly if the CEO and senior management fail to meet those objectives.
My topic is to discuss how a present day director can deal with the changing expectations which evolving concepts of corporate governance impose on him or her.
To be a truly effective director is a difficult role and not one which should be undertaken lightly. Perhaps the most challenging aspect of the role is to find the time to do it well. A busy CEO, for example, may find that the only time he or she takes or can take perhaps to prepare for a board meeting of a company of which he or she is an outside director is on the plane ride to the meeting. In that case, no matter how effective the briefing materials, unless it's a very long plane ride and the executive is quite familiar with the industry, that probably isn't enough time.
In the case of International Paper, for example, we operate in about ten businesses, five of which are the fundamental drivers of our earnings. We send briefing materials to our directors a few days in advance, including a brief summary of any forthcoming presentations which are not extremely confidential. However, the briefing materials tend to be financially focused and are more of a report on what has happened than an advance indicator of what is likely to occur even in the short term. We also send a packet of a few particularly cogent analysts' reports on our company and industry developments and a select group of newspaper articles which range from competitor actions anywhere in the world to local press clippings reporting on the company's interaction with the communities in which we have facilities. An example of the latter would be an environmental problem in one of our mills which was giving rise to concern in a community.
Generally, I select those materials for our directors. Of course, I recognize that most directors are quick studies and are accustomed without a lot of advanced preparation to listening to presentations, reacting to them, and even making decisions based on them.. That is much easier to do if you have grown up in a particular industry and have enough background and insight to ask the right questions.
We read a great deal about diversity on boards of directors in terms of background, gender, race, sex, et cetera, and that issue seems to have become a focal point for some institutional investor activism, including shareholder resolutions. I have a personal view on this, which I realize many may not share, but I believe that diversity and diverse viewpoints is much more important at the operating level than it is at the board level. It may and probably does look good in the proxy statement to have a very diverse board, but in the couple of hours several times a year directors have to focus on the multiple issues confronting corporations that today often operate around the globe, their opportunity to truly impact how decisions are being made at the operating level is very limited. Based on my own experience, if I were an institutional shareholder, I would think that a more relevant inquiry would be to the extent to which diversity exists among the company's operating and staff executives. I also think that any board, regardless of its composition in terms of gender, race, or other background characteristics, has a responsibility to pursue this issue with corporate management and to monitor the extent to which diversity exists at all levels of the company, not simply on the board.
I also want to discuss a subject that seems to now receive less emphasis than it did just a few years ago. You will recall that the concept of corporate governance guidelines received a great deal of press when, in the Spring of 1995, CALPERS issued its report card following the letters that it sent to the chief executive officers of a number of major American corporations, asking if they had implemented the GM guidelines or some similar version. Those companies which ignored the first request from CALPERS were chagrined when the initial report card was issued and in most instances made haste to respond to CALPERS' inquiry.
Since the press coverage about three and a half years ago, however, this issue seems to have faded somewhat, and there is, I think, a legitimate question as to whether or not current boards are mindful of the guidelines and are following them. For example, one of the precepts which was incorporated into the GM guidelines, and I think followed by many, if not most others, was that a director should resign from the board if his or her position changed or, at the very least, should tender his or her resignation. The rational for this was, of course, that directors were often chosen because of their position or a particular knowledge that they would bring to bear on a critical subject for the company and, were their position to change, the expertise that they were supposed to contribute would no longer be there or at least not for long.
However, since then many directors have changed positions as a result of mergers, consolidations, retirement, resignation, or other reasons, and there has been very little indication at least in the public domain that directors who found themselves in that position have resigned from the boards of which they were currently members. It is, of course, possible that their resignations were tendered, but given the sense of camaraderie that typically develops among board members, it seems very dubious that many resignations have been accepted. If that is the case, I think in general _ and, of course, there are exceptions _ it is unfortunate, because I do believe that the director who loses his or her position is, after the passage of only a relatively short time, not nearly as current as he or she would have been had they retained their position.
The same concept applies to retirements. Obviously, it is easier to get directors whose age is such that they are in the last couple of years of being chief executive officer of the company that they head. Many companies have a policy to take on or have a policy which permits the CEO to take on an increasing number of outside directorships as he or she draws closer to retirement. For the next few years, these people can be very effective directors, but once five years or more have passed, their knowledge of and interest in current business developments tends to become less acute. Some boards deal with this issue by having a mandatory retirement age, but if there is no such policy or if the retirement age extends into the mid-70s, this is more likely to be a problem. This also becomes an issue in board succession because current board members are then less likely to know the next generation of prospective directors as they themselves become further removed from an active business career.
Another touchy issue that is perhaps best addressed in a corporation's corporate governance guidelines is the question of whether the current CEO should remain a director after he or she has reached mandatory retirement age. This is an issue that a board of directors needs to address early on, rather than deciding on an ad hoc basis on the eve of the CEO's retirement. Unless the CEO is prepared to tender his or her resignation from the board, and particularly if, on the contrary, the CEO is anxious to remain on the board, the board can find itself in the awkward position. A CEO with whom it has had good relations for a period of several years, may wish to remain and the board may prefer that he or she not have any inhibiting influence on the successor.
The point that I'm making is that if a corporation has corporate governance guidelines and if the corporation's nominating or corporate governance committee reviews and revises the guidelines from time to time to deal with current issues, the probability of confronting a governance question which will require the board to make ad hoc decisions, where personalities and even friendships may be very much involved, is minimized. However, in the absence of a study updating the continued existence and effectiveness of governance guidelines in the period of time that has now elapsed since the publication of the CALPERS report, there is little or no empirical evidence as to whether the guidelines are still in use and are being followed or whether they are being revised from time to time to deal with changing circumstances.
I think it is generally accepted that the selection, development, and retention of the right leader, one who fulfills the needs of the organization, is the single most important responsibility of the corporation's board of directors. Many of you have probably read the NACD's recent blue ribbon commission report on CEO succession, which discusses at some length how a board should go about planning the succession process. However, once that process has taken place, what then should the Board be doing to insure that the CEO and the top executive management of the company are really performing?
Under the old model which I described, the board picked the CEO, and then largely stayed out of the way. I think it is now more of an accepted practice that the board should have a clear understanding of the CEO's strategic vision for the company and satisfy itself that he or she is putting plans in place to implement that vision. If the CEO appears to be waffling or if his or her vision for the company seems to be opportunistically based on reacting to developments as they occur, then the board needs to become concerned.
One mechanism for a board to carry out its responsibilities in this area is to monitor on some kind of a formalized basis the strategy and performance of competitive companies. Because many corporations have several different businesses or divisions, it is not always easy to get a side-by-side comparison. For example, notwithstanding that both companies would probably be referred to as paper companies, a corporation that is primarily in the newsprint business would be in a very different competitive environment than one which produced principally consumer tissue.
Where a company is in several businesses, the responsibilities of the board is to monitor the company's performance in each of those businesses or at least the more significant businesses and not be satisfied simply by following the financial performance of the company as a whole. This requires access to and understanding of a great deal of competitive data and some real digging if there are indications that in one or more areas of the business the company is a distinct under-performer. Since corporate management is generally not terribly anxious to come forward with information indicating that its performance is sub par in some areas of its business, normally there will either have to be a process in place by which all major elements of the business are periodically reviewed by the board, or the composition of the board is such that it has the necessary access and available time to monitor the performance of the company in its various aspects.
I have already referred to the subject of succession planning, particularly as it relates to the selection of a CEO. However, the current expectation is that the board's responsibilities go beyond the task of simply selecting the CEO. Today many companies have management development committees, typically composed of all outside directors, which are charged with the issue of succession planning. I can think of a situation in my industry where at one competitor company every senior executive of the company, including the CEO, retired within a period of less than 18 months. In this particular situation the retiring CEO had held the position for more than 20 years. While I was not, of course, privy to the discussions which took place at the board of this particular company during the few months prior to the CEO's retirement, one wonders why the board wasn't insistent on a more orderly process, one which would have afforded the board an opportunity to monitor the performance of a successor generation of senior operating executives before it was confronted with the task of selecting a new CEO.
There are also situations where a CEO or other senior executive is not as effective as he or she once was for various reasons, running the gamut from health to diminished energy, to simply lack of new ideas. This is, again, a situation where a board, regardless of their respect or affection for a particular individual, has a responsibility to the shareholders to insure that the leadership of the organization is vibrant, enthusiastic, and energized. Again, without careful observation and probing questions, this issue can be difficult to track when a director sees a senior executive only at board meetings a few or even several times a year. In some instances corporate boards have created this problem for themselves since they have put in place golden handcuffs which impose a significant financial penalty on an executive if he or she elects to retire early. Obviously, it would be far better for a company to facilitate or even encourage the process of early retirement for an executive who is devoid of new ideas or of energy to act on those ideas.
I believe that we are approaching a particularly critical time for American business and, indeed, business organizations around the world. It is much easier to be a CEO when the economy is good, prices are going up. Profits are improving, and the stock market is at record highs. Today there are many warning signs on the horizon that much or all of this may be about to change. We are all only too aware of the situation in Southeast Asia, Japan, China, Russia, Brazil and so forth. It is also an indisputable fact that the world economies are much more interlinked than they were just a decade or two ago. In this economic environment, a corporate board has to be especially vigilant that a company has contingency plans to deal with the various eventualities which might confront it.
We have all heard a great deal about Y2K, but that's only one issue. Many things will change very rapidly if we find ourselves in a deflationary environment. In a situation in which earnings are falling from quarter to quarter instead of rising, the expectations of shareholders as to what boards of directors should be doing will, if anything, be increased. In industries that are dependent upon exports or sensitive to imports, the currency devaluations that are taking place and are likely yet to take place may render large segments of American industry at least temporarily uncompetitive on world markets. This is a scenario in which directors will be faced with increasingly difficult decisions, where the interests of key stakeholder groups, employees or their unions, the communities in which facilities exist and employees work, and shareholders concerned about declining earning could well come into conflict.
I think it is likely that in the next few years boards will be asked to make or at least to concur in decisions that will require a great deal of thought and planning and a real strategic vision for the future. Only those individuals who are prepared to accept this role and the time necessary to discharge it should undertake what are likely to be the increasingly challenging responsibilities and tasks of the corporate director.
Mr. Melican is currently Executive Vice President for Legal and External Affairs at the International Paper Company. Mr. Melican is a graduate of Fordham College and the Harvard Law School, and also holds an M.B.A. from Michigan State University. This article is adapted from remarks given by Mr. Melican at the Federalist Society's Conference on Corporate Governance, held in New York City on September 18, 1998.