Boards’ primary roles inherently at odds

WHAT do you get when you put a group of CEOs from different industries together in a corporate boardroom and ask them to govern a company? Several answers could apply, but what accompanied the financial crisis was a breakdown in risk management at the top.

It was just two years ago that the ‘perfect storm’ of a decade of excess credit, excessive leverage, and uncontrolled expansion by financial institutions precipitated the financial crisis. A common thread was that the boards of these financial firms were oblivious to the risk build-up.

Boards of supervising directors have two primary functions: supporting the creation of long-term economic value; and controlling the conduct of business in the interest of shareholders and other

stakeholders.

These two functions are inherently at odds. On IMD’s ‘high-performance boards’ program, we examine the tension between these two roles with board members from companies around the world. Many participants come to the realisation that their respective boards are not balancing these two essential functions. Indeed, prior to the crisis, many bank boards failed to perform their primary fiduciary function of controlling the conduct of the

business.

Looking at the composition of boards, it should come as no surprise that so many fail to perform. Boards typically are made up of a collection of CEOs and top executives from different industries. They can provide strong input from a leadership point of view, but often do not have enough specific industry expertise and become far too supportive of management to exercise their controlling mandate, particularly when it comes to overall risk assessment. This is especially so in companies with widely dispersed ownership where the owners/shareholders are not present at the board table, except once a year at the annual general meeting.

Who should be on the board to prevent a governance crisis?

There has been some reform, but companies across different industries need to continue addressing their boards’ composition with the following requirements in mind.

1) A critical mass of industry expertise, as well as the expertise for specialised committee work.

Board directors must have relevant industry expertise to advise management on major business issues and the appropriate degree of risk to take. For example, no matter how successful they were in their own companies, banking board members lacking financial expertise had no way of knowing there might be hidden risk buried in collateralised debt obligations with a triple-A rating. Boards also need members with functional expertise for specialised committee work, like audit and compliance.

2) Sensitivity to interests of both shareholders and other stakeholders critical for long-term value creation.

The boards of companies with widely dispersed ownership are continually at risk of being dominated by the concerns of either management or board members to the detriment of the shareholders’ interest. Rather than paid advisers, boards have to be continually open to input from the owners. And in today’s environment where corporate reputations can quickly be broken, boards also have to be open to the collective opinions of other stakeholders, like customers, who are critical for long-term value creation.

3) Board members willing and able to devote the time needed for the board’s work.

Much has been said after previous governance crises about restricting the number of board mandates that directors can take on. Some progress has been made. But there is still a widespread tendency to fill the board with high-profile executives often running large corporations, or divisions of their own. The job of a CEO is more than a full-time job. How can a CEO possibly devote enough time and energy to understand the full complexity and underlying issues facing the boards of other large companies, especially if they are in completely different industries?

4) Board members with a broad enough perspective to rotate roles and take on committee work.

With changing conditions inside and outside the company, the board has to change the allocation of its time and energy. This means altering the attention the full board gives to the work of its specialised committees; it may require the creation of a temporary sub-committee to deal with a particular issue, like corporate strategy during a turn-around. Board members have to be flexible with a broad enough perspective to take on different roles and tasks as required.

5) Strong sparring partners willing to raise the red flag.

The moment of truth for a board comes when management starts destroying long-run value, because it can no longer adapt to the changing conditions, or makes decisions that involve taking large, often hidden risk, or engages in behaviour causing critical stakeholders to withdraw their support.

It is at these times that board members have to be willing to raise the red flag. This requires board members with sufficient confidence in their judgment to be strong sparring partners of the CEO and chairman.

In brief, we need boards with enough industry expertise to make meaningful judgments about strategy and risk, with members who can take on the specialised committee tasks, and represent the owners’ views, with enough diversity to capture the interests of other stakeholders important for the long term.

And we need board members with enough time and experience to advise the CEO and management on critical leadership issues. This is asking a lot from boards, which, for effective discussion and decision-making, typically have eight to 12 members.

Judgment is needed to decide which of these requirements is essential at different points in the life of the company, combined with a willingness to alter the composition of the board.

• Paul Strebel is a professor at IMD, the global business school based in Switzerland. He directs IMD’s High Performance Boards program.