Evolving Notions of Board Effectiveness

BOARD EFFECTIVENESS – TRADITIONAL APPROACHES

Maximizing board effectiveness has been an ongoing and somewhat elusive corporate governance objective for U.S. corporate boards, executives and stockholders. While the board’s role in governance is well understood, the performance and outcomes of individual boards in terms of oversight, strategic input, advice to management and maximizing shareholder value, among other functions, are subject to significant variability depending on overall board effectiveness. The effectiveness of the board can mean the difference between serving as merely a required oversight function or serving as a valuable strategic and competitive asset. Achieving a high level of board effectiveness relies on the successful implementation of several key imperatives, including board leadership and composition, operational and deliberative processes, board culture and dynamics and performance evaluation and improvement. Some of the traditional cornerstones of these board effectiveness imperatives are highlighted below.

• Board Leadership and Composition
  • The board consists of directors with the right skills and experiences to effectively carry out its duties
  • The board effectively manages its workflow and uses committees in an efficient manner
  • The board uses governance guidelines, committee charters and other policies to delineate responsibilities for oversight and approval among the board, committees and management
  • The board has a leader (lead independent director or independent chair) that can act as a key intermediary with company management, influence board agendas and build consensus among board members
• Operational and Deliberative Processes
  • Board members receive the right information sufficiently in advance of meetings to review carefully, come to meetings well prepared and focus on discussion of issues, rather than getting up to speed
  • Meeting schedules and agendas are determined well in advance, and directors have adequate input into agendas
  • Executive sessions are routine and documented
  • Board considers adequacy of the information supporting any decision and requests additional information when necessary
• Board Culture and Dynamics
  • The boardroom is a safe space where respect and trust are mutual
  • All board members actively participate in discussion and express their views
  • Board members feel comfortable raising issues and challenging management and do so without hesitation
  • No cliques or factions on the board
• Performance Evaluation and Improvement
  • Board and committee self-evaluations are conducted in a way that generates actionable
    feedback and identifies any shortcomings in board effectiveness and leadership
  • Board takes concrete actions in response to meaningful feedback from evaluations
  • Proxy disclosures support a culture of continuous improvement by describing specific actions taken

DEVELOPMENTS CHALLENGING BOARD EFFECTIVENESS

Current developments facing public companies are presenting meaningful challenges to traditional
approaches to board effectiveness. We examine a few of these developments, how they are impacting boards and how they may force an evolution of best practices for board effectiveness.

1. Challenge Critical Issues Involving Increasingly Complex Subject Matter

Boards today are being faced with increasingly complex risks and opportunities that may dramatically impact their companies’ businesses and the competitive and regulatory landscape. The pace of technological development continues to raise new considerations for boards to contend with, including evolving cybersecurity threats, risks and opportunities from artificial intelligence and the impact of social media on advertising and public perceptions of corporate behavior. At the same time, the uncertain impacts of climate change are forcing companies and boards to evaluate and prepare for physical and transition risks in their own and adjacent industries and requiring boards to wrestle with how to build a sustainable future while reducing emissions in line with established targets. Globalization of industries and the interconnection of international markets are presenting increasing challenges such as the impact of the COVID-19 pandemic (and potential similar pandemic risks in the future), war or political upheaval and economic turmoil in other markets and consequent economic impacts and supply chain dependency and disruption issues. These are of course just a few examples of the increasingly complex issues facing corporate boards as they navigate the currents of rapid change. Many of these challenges are complicated by political dimensions and the possibility of legislative or regulatory responses that may also impact the business.

Responding to these challenges requires an informed and analytical board that either has the expertise, whether through its own members’ experience or relies on management or other experts, to enable it to properly evaluate the risks, opportunities and challenges for a company and appropriately set a course for the most resilient future. Also, complex issues arise quickly and often require immediate action, which puts a premium on advance preparation to enable the board to adapt quickly to rapid developments and chart a course of action. All of this is unfolding against a backdrop of increasing SEC interest in having companies include specific disclosures in public reporting about board expertise in particular disciplines and the process used by the board and management to oversee and manage the risks relating to specific issues such as climate change and cybersecurity. This has put pressure on boards to reconsider their skillsets, even if it is completely unrealistic to assume a reasonably sized board can have a resident expert in every emerging issue facing companies today.

Board Effectiveness Implications

• Board Leadership and Composition
  • Boards need to be forward looking when evaluating the optimal skill sets for the board,
    considering how certain backgrounds and skillsets might make some of the anticipated challenges easier to respond to. Board chairs and lead directors need to drive agenda focus on key emerging risks and opportunities and find ways to prepare the board to address them before the crunch arrives.
• Operational Implications
  • Boards need to ensure that they are receiving appropriate and effective communications
    about complex issues that must be considered, including concise and complete explanations of the issues, executive summaries that condense the meaningful concepts into a digestible basis for discussion and put them in context and, where appropriate, advice from outside experts.
• Performance Evaluation and Improvement
  • Board continuing education may need to be a more demanding and specific regimen of online and in-person learning that keeps directors up to speed on the most important areas of complexity facing a company.

2. Challenge Increasing Social and Political Risks

Boards are increasingly faced with risks related to the impact of social and political reactions to business models, operational decisions, shifts in strategy, diversity, equity and inclusion efforts and other aspects of the business that may not only affect stockholders but also other stakeholders including employees, communities, customers, suppliers and the public at large. There is a shifting perception of the level of corporate responsibility that a company must bear when dealing with complex societal issues, and this can lead to companies being drawn into issues that seem disconnected from the business but relate to the company’s overall influence as a corporate citizen.
Sometimes the issues may be unanticipated and seem to come out of nowhere and can therefore be deeply surprising to board members in terms of how the company’s well-meaning actions are interpreted (or misinterpreted). In other cases, the board may be fully behind company actions or strategies that may face withering criticism from some quarters and need to determine how to respond in a way that protects the company’s reputation and brand. The emergence of anti-ESG activism may force boards on the defensive and require them to carefully balance the interests of stockholders and other stakeholders and the company’s culture against the arguments of those who may disagree and take public and damaging swipes at the company’s brand.

These issues can be very difficult for a board to navigate because they are not evaluated on economics or business outcomes alone. Often, these challenges involve complicated questions of how the emotional, social and political perceptions of large and sometimes opposing constituencies will be affected depending on what steps are taken. Sometimes these decisions seem reduced to seeking the least bad outcome as there are possible negative impacts from every approach.

Board Effectiveness Implications

• Board Leadership and Composition
  • It goes without saying that when dealing with social and political impact issues, strong leadership is required to keep the board focused on the company’s core values and to continually guide and remind the board that staying close to those values should be the first principle in approaching these issues in the short and longer term. From a board composition perspective, board diversity and a well-thought-out skill set can be critically important in allowing the board to deliberate on the complexity of these issues with greater clarity and understanding and avoid blind spots or bias in formulating a successful path forward.
• Board Culture and Dynamics
  • While diversity of experience and viewpoints can be highly valuable in evaluating and responding to social and political developments impacting the company’s business, the subject matter often gives rise to strong emotions, passionate points of view and even heated discussion. This emphasizes the importance of not only building a diverse board but a cohesive one. The board must find ways to build the kind of trust that leads to every member of the board embracing and respecting the contributions of other members and feeling a sense of confidence in the outcomes of the collective decision making of the board as a whole.

3. Challenge Greater Scrutiny on Individual Directors

The recent corporate governance focus on board diversity, board skills and board refreshment, which has manifested in skills and diversity matrices in proxy statements of public companies, has also over time increased the focus on the attributes of individual directors among investors and activists. Institutional Shareholder Services (ISS) has for some time targeted specific directors (heads of Compensation or Governance committees in particular), in particular for perceived governance weaknesses, but focus on the personal attributes of particular directors, including age, tenure, diversity, skills or independence is a more recent development. Activists, particularly those who are seeking board seats or considering a proxy fight are looking more carefully at existing directors. New Rule 14a-19, the SEC’s “Universal Proxy Rule” now requires companies and activists soliciting proxies for alternative directors to include both the company’s and the activist’s nominees on each proxy card, allowing investors to cherry pick directors for the board in a contested election, focusing on the qualities of each incumbent director. This development could potentially give activists more ammunition when negotiating with companies because of the potential for losing a seat if any company nominees have vulnerabilities such as long tenure or poor skills alignment with changing company priorities. This year, activist investment firm Trian Management LP launched a proxy battle against The Walt Disney Company for a board seat, in part due to issues it had with the company’s succession planning process. Trian sought to install a board member with a campaign focused at replacing a specific incumbent director, citing that director’s lack of experience on other public boards. While Trian ultimately withdrew its proxy contest in response to Disney outlining a deal to address its concerns, this example illustrates the vulnerability that companies may have to these types of challenges in the future. While ISS and Glass Lewis have so far been cautious about supporting activist nominees against company incumbents, it is not hard to imagine that if more of these contested situations take place and there are clear points of contrast between alternative and incumbent directors, one or both proxy advisory firms might support an alternative director, especially if the basis for the activism is compelling in some way. This seems especially true in an environment where Rule 14a-19 allows support of and a vote for one alternative director in lieu of a weak incumbent. As boards and nominating committees consider their own skills requirements and refreshment priorities, they will also have to consider the potential scrutiny of individual board members that may become vulnerabilities in the face of activist challenges.

In the 2023 proxy season, 75 out of 100 of the Top 100 Companies in the United States identified diversity as an important attribute for directors.

Board Effectiveness Implications

• Board Leadership and Composition
  • The board composition priorities discussed in the sections above coupled with increasing scrutiny on individual board members and the potential for more specific challenges to individual directors in the future mean that independent chairs, lead independent directors and nominating committee chairs need to be forward thinking and exercise leadership in driving board consensus on the timing and nature of board refreshment and the qualities the board is looking for and making sure that consensus is continually examined and kept up to date. Leadership needs to also extend to the director search process to ensure that the board has the greatest opportunity to fill vacancies with candidates that best fit the priorities the board has agreed upon. In addition, board leaders should foster awareness of potential vulnerabilities on the board, in order to ensure that any challenges are faced with well thought out responses and realistic assessments of any weaknesses rather than letting the board be caught off guard.
• Board Culture and Dynamics
  • Given the challenges described above and the focus on individual directors, it seems certain that boards will feel a sense that the pace of the need for refreshment is accelerating. Traditional models for ensuring reasonable turnover on the board, such as mandatory retirement age and term limits are blunt tools that may not result in the optimum outcomes in terms of board configuration and deliberation, especially at crucial moments in a company’s evolution. Also, these approaches may lead to a loss of experience, leadership or critical skills at an inopportune time. Boards need to consider whether these methods operate as crutches to avoid difficult interactions about continued service or hobble their plans for refreshment. A flexible approach, where length of service and other factors are considered in the renomination process, may prove more effective, especially if coupled with a board culture that is more accepting of director departures when tenure, skills or other factors call for it, fostered by strong leadership and constant communication about the board’s needs.

WHAT SHOULD BOARDS BE DOING NOW?

Boards should recognize that like many other governance issues, board effectiveness has to be considered in light of changing circumstances.

• Annual board self-evaluation processes should be thoughtful exercises that do not fall into the trap of repeating timeworn questions, instead providing a forum for feedback on the board’s most pressing challenges, and boards should consider including interviews with individual board members on a periodic basis as a meaningful supplement to written questionnaires. Considering a third-party to lead these interviews can also enhance outcomes of the evaluation process.
• Board chairs, independent lead directors and nominating and governance committee chairs need to be vigilant about the challenges the board is currently facing and try to anticipate what is coming. Executive sessions should serve as forums for discussion of these challenges, how the board’s processes and responses are measuring up and the ways the board can be better and more ready to meet them.
• Boards should develop a culture of considering refreshment as part of healthy governance hygiene and not necessarily tied to retirement schedules or mandatory term limits.
• Increasing board diversity should go hand in hand with maintaining an inclusive, respectful and cohesive culture consistent with company values.