Shenanigan’s Wake

The regulatory oversight framework is broken. The SEC failed to regulate credit default swaps, loosened broker-dealer leverage restrictions at just the wrong time and failed to regulate dark-debt driven hedge fund activities. The Federal Reserve failed to impose reserve requirements on syndicators of collateralized loan or credit obligations. All that will change now.

Importantly, in its entire seventy-five year history, there has never been a visiting committee appointed to review the SEC. We need a committee of non-bureaucrats, non-industry groups, non-politicians, analogous to the visiting committees that accredit and review university excellence.

Meanwhile, there is going to be greater skepticism and scrutiny of board of director oversight than ever before, as a ripple effect of failed companies, regulatory tightening and the push for reform. In some ways, that is not a bad thing, because lax practices still exist, such as the increasing trend of front-loading board meetings with management presentations so detailed and so numerous as to numb the outside directors’ ability to assess strategy and examine any one problem with requisite focus. The ratio of minutes of director discussion to minutes of slide presentations has greatly diminished, as companies’ ability to mine and marshal presentation data has risen parabolically.

That process within the boardroom—that dynamic—needs to be managed by the board itself.

What’s Going On?

Despite greater intensity of director effort, the core challenge for directors trying to fulfill their roles in providing vision and vigilance for public companies remains the same: they passionately desire and dutifully need to know “what is going on” in the important areas of company strategy and management execution in order to do their director jobs well.

Every conscientious director asks: How can I be sure that I know what is going on in the important areas of company strategy and management execution, or that I do not know enough to make an informed decision? How can I feel more confident about decisions brought to the board? How do I know that I’ve been made aware of all matters that the board should be acting on? No one has published a magic formula for director success on those or other questions, but observation of current board decision-making does suggest that a couple of practices are helpful.

The first is, “maximizing the second ninety-five.” To paraphrase comments made by the very best directors: When a management presentation is proposed on a topic (a shortfall from planned revenue or earnings; a routine acquisition of a new, smaller business; senior management reporting realignments, etc.), these directors are mindful that getting the first 95 percent of the decisional information and considerations onto the table is important, but that the last 5 percent of the effort often seems (or should seem) like a second 95 percent in intensity. Vetting the information presented by management should not be crowded into the back end of a time-limited board schedule so dense in management presentations that too little time is left to raise, consider, or go-back-and-ascertain, information or factors critical to good director decisions. That second ninety-five percent is the true value-add of great boards.

It should be noted that no additional director time should be required to permit sufficient time for that second ninety-five percent activity. Directors can and should prune agenda topics aggressively to allow time for director assessment.

Furthermore, when vetting the information provided by management, one helpful director discipline to determine whether the directors are getting a picture sufficient to “know what is going on” related to the decision at hand is tracking the decisional data at hand against the board’s ongoing risk factor review. Here is what that means.

Risk Factors

Public companies’ annual and quarterly filings with the SEC and reports to shareholders contain (often extensive) “risk factor” disclosures that set out the principal risks to execution of the companies’ business plans. For the best boards, those risk factors are not mere disclosure documents. They are “what’s going on” decision tools for each board meeting. By that I mean that the best boards (1) monitor management’s development of the risk factors in the first instance; (2) annually review management’s update of them; (3) annually assess how each business unit’s senior personnel and controls manage each company risk; and (4) evaluate board information provided in connection with important board decisions against the standard that “I will better know what’s going on pertinent to this decision if I understand whether the information assists my evaluation vis-à-vis the applicable risk factors.”What part of the decisional data addresses the risk factors against which the company is managed?

To take an easy example, if the company has identified as a risk factor that a disproportionate percentage of sales occur late in each quarter, how does management’s interim sales report compare to quarterly sales-to-date in prior quarters when the business environment was similar?

More difficult: if a change in stock options granting levels is proposed and risk factors include both attraction-retention of talent and compliance with shareholder approved compensation plans, how do the new option levels both address competitive pressures and at the same time remain within plan constraints that other competitors may not have?

Another: if transactions with affiliates are proposed and the auditor’s report (appropriately) states that it is rendering an opinion on the company’s consolidated financial statements taken as a whole, does the auditor’s engagement letter with the company provide for it to audit the affiliate and what sort of counterparty representations are obtained?

Yet another: if staffing reductions are proposed “across the board,” yet certain business areas are identified as risk factor mission critical, how does such a one size fits all approach impact those areas?

Relatedly, as the best companies refine their risk factor disclosures to align them with evolving particularized business and business environment risks, those risk factors become better board decision assessment tools. In turn, risk factor disclosure itself improves from (at one extreme) a mere generic copy of competitors’ risk factor listings presented solely to satisfy SEC disclosure requirements, to (at the better end of the spectrum) a living, working set of decisional assessment tools which are also disclosed so as to mirror the realities of the business.

Dynamic Capitalism: Competitive Disequilibria and the Belittled Theory of the Second Best

Listening to good stories (presentations) is no substitute for oversight. A director is not simply an “auditor,” i.e., someone who merely “listens” to elements and tests them. A good director is more: He or she (1) shapes the story (by providing input in advance what needs to be covered in management presentations); (2) reviews the whole story (rather than simply sampling); (3) adds and subtracts elements where needed (hardly the role of an auditor); (4) formulates a way of deciding the outcome (ditto); (5) solicits contrary views (ditto), and then (6) forms a judgment and casts an informed vote (ditto, ditto).

Any student of college economics knows that the Pareto model of competitive firms deals in mathematically replicable desiderata imbued with perfect information content which is assessed by innumerable participant observers and results in a competitive equilibrium that can be sensitivity-tested: change one input here, affect one output there. Not so for the decision-making life of a director of a public company, who deals in the realms of incomplete and imperfect information. For directors, the often overlooked but beneficial “theory of the second best” has a lot to recommend itself: where information is imperfect, even a minor change in one initial decisional condition can lead to dramatic, unanticipated and unpredictable ultimate outcomes.

Because small input changes can effect large variance in outcomes, it is important that boards take the time to learn, most efficiently through their committees, from past experience. A formalized process is needed within the M&A, Finance, Governance and Compensation Committees to assess the good, the bad and the ugly lessons of each initiative over time: Where did integration of a prior acquisition falter? Where did due diligence on an acquired product line flag or fail to flag issues with the products or their production costs? What favorable and unfavorable impacts appear to have been associated with prior compensation arrangement changes? The point is to use the increasing capabilities of companies not to simply produce polished PowerPoints, but rather to marshal data for the purpose of “lessons-learned” reviews and to build institutional memory of competencies demonstrated and steps to avoid.

Here are the types of questions that cut across agenda items:

A director’s job is exceptionally hard and exceptionally important. Directors’ watchwords for 2009 should continue to be transparency and conflict of interest oversight. Like Dewar’s, those goals have never varied. That combination remains the Holy Grail of each director’s watch.