How to Hire a Director

The 2008 proxy season in the United States is revealing hazardous gaps among the responsibilities expected of corporate directors, the way directors are elected, and the way investors treat decisions about how they vote.

Directors stand at the fulcrum of modern American corporate governance. They weigh the perspectives of management against the interests of shareowners. Getting that balance right is what many of the corporate governance battles of recent years have been about. As a result, demands on directors have skyrocketed. They now spend about 200 hours a year, on average, overseeing a corporation. Delaware courts give huge deference to director judgment while ruling repeatedly that the greatest power shareowners have to protect themselves is the ability to elect the board.

Only recently, however, has the process for electing directors begun to catch up to the centrality of the role. Consider that only in the last two years have most S&P 500 companies embraced a majority-vote system where directors who fail to gain a majority of ‘yes’ votes must resign their seats. That sounds like garden-variety common sense. But it represents a swift and profound revolution in Corporate America.

For decades until 2006, virtually every board director gained office in a Soviet-style election where only ‘yes’ votes counted. Investors’ only other choice was to “withhold”—the procedural equivalent of staying home. Plus, boards generally faced ballots in a single resolution that bundled all candidates together; an entire slate could be installed to pilot a public corporation even if only a single share voted yes and every other vote was withheld. A shrinking (but still significant) minority of companies still feature such rules, even now.

Consider, too, then that for decades regulators, investors, and their advisers naturally spent little time or money figuring out how to vote in such meaningless exercises. The New York Stock Exchange even went so far as to declare that unless an election was formally contested, voting for directors was “routine,” a designation that allowed brokerage firms to cast billions of votes on directors on behalf of beneficial owners. Brokers nearly always voted ‘for’ with barely a thought about the quality of the candidates or state of the company. Nor were they alone in that mindset. Until the last few years, proxy services that provide counsel on such matters crafted a simple format that also labeled U.S. director elections “routine.” In reports to investors, they dug little further than the biographical details listed by companies in proxy statements required by regulators. Likewise, standard operating procedure for even engaged shareowners was merely to check the box for the agents supposed to represent them. Results reflected the lack of diligence throughout the investing universe. Even in the most troubled and dysfunctional boards, directors regularly drew more than 90 percent ‘yes’ votes.

Majority rule has suddenly put these habits sharply at odds with reality. Director elections now have real meaning and real consequence. Each director stays or leaves a board depending on the outcome. The investor vote on director elections can be said for the first time to be something akin to a hiring decision.

Would you engage someone to oversee your property based solely on a scan of his 100-word bio? Of course not. You would view a résumé as a good first-step resource to screen candidates, but not one on which to make a final hiring choice.

Expect investors to start thinking along the same lines as they settle into their new powers to elect boards. They surely expect each corporation’s board nominating committee to review candidates in some depth and make selections on the shareowners’ behalf. In the old system, that was all but the end of the story. Shareowners simply rubber-stamped those choices. But nomination committee reports are ever more likely to become recommendations in deed as well as in name; investors will keep for themselves the ultimate decision on whom to hire as their agents—especially at troubled companies. Remember that investors want strongly to support boards who look after their money. But now they need more and better reasons to do so.

That means it is time for a root-and-branch revision of how directors get elected.

A fresh paradigm has to be grounded in twin initiatives. First, to do their job right, investors and their proxy service agents require more than the proxy statement’s customary sketch of a candidate’s professional background. But they should figure out what they need to know to make informed decisions. No one wants a board snowed under with questionnaires or ad hoc inquiries. Investors should put their heads together to devise a common set of queries for director candidates that relate directly to value rather than Securities and Exchange Commission requirements. For instance: What is your philosophy on the relationship between pay and performance? What is your general strategy and practice when you think management has gone astray? What skills or experiences do you bring to this particular board? Candidates should consider thoughtful responses as means to earn the trust and confidence of owners. The Council of Institutional Investors and the National Association of Corporate Directors should collaborate to forge a common questionnaire.

Next, boards should begin experimenting with techniques that give investors insight into how a board performs as a unit, as well as what value each individual director contributes. None of this comes from bio-sketches alone. But it helps nobody if the market treats director elections as a corporate equivalent of political primaries. We suggest some fresh ideas. Communication is one. Early on, a board nominating committee could meet with the company’s largest shareowners to discuss board composition—and invite investors to submit names to the candidate pool. The panel could even use the proposed common investor questionnaire as one tool when screening nominees.

Boards could also experiment with a “hybrid interview” process for board directors, depending on communication experience, candidate willingness and time, and the company’s circumstances. When releasing its proxy statement a board could announce one or more conference calls in which directors would be available for investor questions. Boards could schedule a single call with the entire board at which the Nominating Committee chair starts by introducing the candidates and explaining the panel’s thinking, or the board could make just the chairman and the heads of the audit, nominating, and compensation committees available for calls. Or they could set separate director calls for each candidate. There are lots of options. Whichever way is chosen, director calls could be open to proxy services and investors, using ground rules similar to those applied to earnings calls to keep sessions orderly, pointed, and efficient.

Companies could also open a Web page dedicated to board elections. Content could include individual director responses to the questionnaire that we suggest the CII and NACD develop, as well as transcripts and recordings of any director conference calls. Plus, companies would need to unbundle election resolutions clearly, so that investors could easily vote on each candidate rather than the slate as a whole.

Resistance will doubtless complicate the market’s embrace of such measures. On the investor side, proxy services might balk at the expense of ramping up capacity to analyze boards through director tracking units. Institutions would have to collaborate more than they do now on creating the common director questionnaire. Funds might have to install more internal expertise or purchase more outside research for screening directors at portfolio companies. But investing institutions that fail to take up their new voting responsibilities, especially where portfolio value sinks, could risk their own legitimacy among beneficiaries—not to mention liability lawsuits.

Perhaps the biggest hurdle is on the corporate side. U.S. public corporations today are too often loath to expand director access to investors. In fact, they are more used to steering contact away for fear of sending confused messages about the company to the market, or to protect members from overload.

These may have been legitimate reasons when elections were a pantomime, but now votes shape actual corporate authority. Companies that fail to adapt to that reality run risks of investor insurgency when times get troubled. Just look at Washington Mutual’s April 15 annual meeting, where shareowners stunned the board by toppling a director.

There is a downside to director interviews, of course. Board members who already feel overburdened would face another burden: The additional time commitment could be enough to dissuade some from service. We recognize the real risk of overloading and have suggested ways to mitigate it. But there is an upside as well. Board candidates may greet shareowner attention to their opinions on value as a welcome relief, compared to red tape disclosures authored by regulators. Today’s boards may do best with directors prepared to embrace accountability: The advent of majority rule and an informed shareowner base promises to furnish directors with a greater sense of accountability, give comfort to investors, and transform boards into even more powerful drivers of shareowner value. We’d say that was a risk-return chance worth taking.

Reprinted with permission. © 2008 Compliance Week. All Rights Reserved.