Ten Board Challenges For 2005

Tuesday, March 1, 2005 - 01:00

1. Establishing an appropriate tone at the top - Really! The standards of ethics and business conduct that are followed - or not followed - throughout a company impact the bottom line in many ways. (The newly-amended Federal Organizational Sentencing Guidelines are just the latest reminder that board attention to corporate ethics is critical.) However, all too often, "tone at the top" is approached with a compliance mentality. Boards should assist management to focus beyond compliance in constructing clear and meaningful standards of behavior, and then support management in emphasizing that these standards apply to everyone from the board on down. The "tone at the top" should be apparent in every corporate action and every corporate communication.

2. Beginning with the matter of executive compensation. Astronomic executive compensation should only follow astronomic performance. Boards should deliberate carefully in choosing the indicia on which to base executive compensation (and reduce reliance on compensation surveys). Incentive compensation schemes should be aligned with the touchstones the board considers when measuring corporate success generally. Consider how to integrate the agreed "tone at the top" into performance reviews and compensation. Consider whether the compensation multiple of CEO-to-least-compensated-employee is justifiable in terms of contributions to company performance. Does the compensation scheme truly reflect corporate philosophy? Remember, compensation decisions are transparent and are under ever-increasing scrutiny. Boards can expect to be judged by their compensation decisions.

3. Recognizing the fine line between oversight and micro-management. Recent reforms emphasize active board engagement in the corporate enterprise. The challenge, when all is going well, is for the board to actively engage in oversight without managing . Overengagement by a board causes management to become unduly risk averse - hampering management's entrepreneurial activity. Remember, the foundation of corporate governance is "constructive tension" between the board and management. Boards should hire the best management team available and challenge the team to propose and fine-tune the corporate strategy - with a dose of healthy skepticism. Boards need to ensure management is identifying and mitigating risks to the key drivers of corporate performance, testing assumptions and planning for contingencies and crisis. But then the board needs to let management deliver, monitoring performance to assure itself that the right team is in place.

4. Creating meaningful independent board leadership. A CEO cannot be an effective leader in monitoring his or her own performance or in questioning the assumptions underlying his or her own proposed strategy. When boards bow to tradition and give the "Chair" title to the CEO, special care is required in designating an independent board leader - who is recognized as such - for board tasks involving inherent CEO conflicts, such as review of management performance and management-proposed strategies. Independent leadership is key to the fundamental tasks of determining what issues the board should focus on (setting the board agenda), what information should be provided to the board, and what "red flag" circumstances should cause an issue or information to be brought to the board's immediate attention. An independent leader also plays a critical role in positioning the board for frank communications with the CEO when necessary. The leader's role, whether he or she is the "Independent Chair," or the "Independent Board Leader," should be formalized in writing.

5. Understanding that the fiduciary reform dynamic has slowed, but not ended. The pace of governance reform may have slowed, but just as self-interest is the driver of economic activity (as Adam Smith taught), corporate scandal is the engine of regulatory reform. Two and a half years after Sarbanes-Oxley, the SEC continues to refine governance-related rules, and state attorney-generals continue to dig for problems. Corporate America remains only a major scandal or two away from another round of regulation. Therefore, a narrow approach to compliance with governance reforms is dangerous, not only from the perspective of the individual corporation, but from the perspective of Corporate America as a whole.

6. Taking the initiative in shareholder relations. Although the SEC's shareholder access proposal has stalled, pressures for increased shareholder voice in corporate affairs are unlikely to abate. This regulatory pause provides an opportunity to improve voluntarily board relationships with shareholders. Consider whether there are voluntary actions that could improve shareholder participation in the nomination and election of directors or in other key issues of importance to corporate owners.

7. Keeping apprised of evolving standards for director liability. Due care, loyalty and good faith remain the standards for avoiding liability. However, expectations of directors continue to evolve. Areas that deserve special attention include:

Disinterestedness and Independence. These related attributes are key protectors of board decisions from challenge in the courtroom, and thereby key elements in protecting directors from liability. However, they are heavily context dependent when viewed by the courts. Directors are wise to reassess these attributes when facing major decisions, and rely liberally on special committees comprised of directors who are beyond challenge as to the specific issue at hand.

Good Faith. The "duty of good faith" is now established Delaware doctrine. Inattention is no longer subject only to a duty of care standard - and those protective exculpatory charter provisions can no longer be relied on to insulate gross neglect.

Directors with Special Expertise. It has been assumed that directors with "special expertise" were subject to the same risks of liability as other directors. However, this is subject to some question in light of Emerging Communications , in which a non-employee director who was a "principal and general partner of an investment advising firm" was arguably held to a higher standard of care than directors without "special financial experience." Since bad (and complex) facts make bad law, it will bear watching to see how courts interpret this case in the future. Be aware that exculpatory provisions, indemnification and D & O insurance do not provide absolute protection against personal liability. As evidenced by the recently announced Worldcom settlement, even with such protections in place there may yet be pressures from plaintiffs for directors to dig into their own pockets.

8. Managing audit committee duties to avoid losing the "forest for the trees." Recent reforms have imposed a lengthy list of enhanced responsibilities on audit committees. The very length of this list risks turning the audit committee into a formalistic, box-checking body, rather than the engaged and deliberative oversight organ that was intended. Yet, the core task of the audit committee - providing oversight of financial reporting, accounting and internal compliance - has not changed. Thus, the challenge for audit committees is to take a step back and approach their responsibilities with effectiveness rather than box-ticking compliance as the goal. In the end, this focus will allow the boxes to be checked, but through committee effectiveness, rather than by rote.

9. Normalizing the relations with outside auditors. Heightened scrutiny is causing audit firms to assume a defensive posture in their client interactions. (The lesson of Arthur Anderson is not lost on anyone.) In the new environment, many boards have found themselves at odds - whether in form or in substance, justifiably or not - with their auditors, resulting at times in unnecessary (and costly) investigations, broken offerings and delayed public filings. The new reforms fundamentally alter the company-auditor relationship. Given the critical importance of auditors to the enterprise, boards should take care to establish a constructive working relationship with the outside auditor. Engage the outside auditor in a discussion about the changes - and, indeed, the new inherent tensions - in the relationship.

10. Remembering that corporate governance is not an end unto itself. Adoption of governance best practices should not foster board complacency. Best practice is not the end game; the end game is the best competitive performance the corporation is capable of. As boards look beyond reform implementation, the challenge is to get down to business, focusing on corporate strategy and its execution and, in particular, on understanding the key risks to the drivers of corporate performance, and how management is controlling for such risks.

Ira M. Millstein, Senior Partner, Holly J. Gregory, Partner, and David P. Murgio, Associate, practice in the Corporate Governance Practice Group of Weil, Gotshal & Manges LLP in New York City.

Please email the authors at ira.millstein@weil.com, holly.gregory@weil.com and david.murgio@weil.com ; with questions about this article.