510 15 THE BOARD OF DIRECTORS Charles A. Anderson Robert N. Anthony This chapter describes the nature and function of the board of directors, which has the ultimate responsibility for governing a corporation. It describes the board’s activities in normal meetings, in strategy meetings, and in special situations, and it describes the work of three important board committees: the compensation committee, the audit committee, and the finance committee. We focus on large corporations whose stock is listed on a securities ex- change. These corporations must conform to regulations of the Securities and Exchange Commission. Most of the discussion is also relevant to boards of smaller corporations. WHY HAVE A BOARD OF DIR ECTORS? Every corporation is required by law to have a board of directors. The board’s legal function is to govern the corporation’s affairs. However, in a small corpo- ration in which the chief executive officer (CEO) is also the controlling share- holder, the CEO actually governs and the board acts primarily as an adviser. When a corporation grows to a size where it needs outside capital, it may go public by selling shares of stock (as explained in Chapter 14), and the board then represents the interests of these shareholders. The shareholders, who are the owners of the corporation, have a say in the way their company is run. They expect to receive regular, reliable reports on the company’s operations. If the company is profitable, they probably expect to receive dividends. If the The Board of Directors 511 company has problems, the owners need to know about these problems so that they can take any necessary remedial action. A corporation may have many shareholders; American Telephone & Tele- graph Corporation has 2.6 million. Individual shareholders obviously can’t gov- ern the company directly; moreover, most of them are engaged in their own pursuits and will not give much, if any, time to governance. They elect people to act for them. This is the board of directors. SIZE AND COMPOSITION OF THE BOARD The typical board has about 11 members. Some boards, especially those in banks, are much larger. Large boards must delegate much of their work to an executive committee for overall matters and to several committees for specific topics. Most board members typically are “outside directors”; that is, they are not employees of the corporation. At one time, most board members were “in- side directors,” and this is still the case in a few boards. The trend toward out- side directors results from the shareholders’ recognition that the board should have a significant degree of independence from the company’s management. The board is responsible for selecting, appraising, and compensating manage- ment. If the board and management are the same people, the board can hardly perform its governance role in an objective manner. Many outside board members are CEOs or senior officers of other corpo- rations (but not competitors). Other outsiders are lawyers, bankers, physicians (on health-care boards), scientists and engineers (on high-tech boards), retired government officials, and academics. A few people are professional board members; that is, their principal occupation is serving on boards. The number of female and minority board members has increased substantially in recent years. The CEO and perhaps one or two senior members of management typi- cally are members of the board. Board members are compensated. Generally, they receive an annual re- tainer plus a fee for meetings attended. In addition, many companies offer some form of stock compensation and retirement benefits. According to a Conference Board survey, the median basic annual compensation in manu- facturing companies for 1999 (not including stock components) was $35,000. When the value of the stock component was added, compensation totaled $46,000. Board members are elected at the annual meeting of shareholders. The shareholders almost always elect the slate proposed by the incumbent board; thus, as a practical matter, the board is self-perpetuating. The process of se- lecting candidates for filling board vacancies is an important board function. Many have staggered terms; that is, one-third of the board members are elected each year for a three-year term. This practice is intended to make it more difficult for corporate raiders to obtain control of the company. 512 Making Key Strategic Decisions BOARD MEMBER RESPONSIBILITIES In the following sections, we describe the specific activities for which the board is responsible. In this section, we describe the responsibilities of indi- vidual board members. Board members must not personally buy stock or sell their own stock im- mediately after they learn of important developments at board meetings or other activities. Examples of relevant developments include current estimates of earnings, change in dividend policy, a decision to acquire another company or to buy back stock, and changes in senior management. The Securities and Exchange Commission and rules of the stock exchanges impose an “earnings blackout” period of one or two days in which such trading is prohibited. Board members and management must not disclose any of these events to a selected group of interested parties. For example, they must not make a tele- phone conference call to a selected group, send an Internet message to them, or disclose information at a meeting of such a group. When this information is dis- closed, it must be made available at the same time to the general public. These rules were significantly tightened in 1999 and 2000 by SEC Regulation FD. RELATION TO THE CHIEF EXECUTIVE OFFICER Their titles indicate that the board of directors “directs” and the chief execu- tive officer “executes” the board’s directions, but these terms are not an accu- rate description of the roles of these two parties. In the majority of companies, the chief executive officer is also the board’s chairman and is the principal ar- chitect of policies. Executing these policies is indeed a primary responsibility. The CEO is truly the “chief.” The board selects the CEO and, therefore, wants to give the CEO its full support. The CEO is accountable to the board and may be terminated if the board decides that the individual’s performance was unsatisfactory. The appropriate relationship is one of trust. The board must believe that the CEO is completely trustworthy, provides the board with all the informa- tion it wants and needs, withholds nothing, and doesn’t slant arguments to sup- port a preconceived position. The CEO, in turn, must believe that he or she has the full support of the board. Appraising the CEO A board’s major responsibility is to appraise the CEO. If performance is below expectations, there are two possible explanations: (1) The CEO is to blame, or (2) extraneous influences are responsible. In most cases, both factors are in- volved, and the directors have the extraordinarily difficult job of judging their relative importance. If they conclude that the CEO has made an incorrect de- cision, they may suggest a different course of action. More likely, however, they The Board of Directors 513 may say nothing and mentally file the incident for future reference in evaluat- ing the CEO. The Business Roundtable, a group of CEOs of leading companies, succinctly described the directors’ role vis-à-vis the CEO as “challenging, yet supportive and positive.” An important function of board meetings, conversations, and even social occasions is to give the directors a basis for continuously appraising the CEO. Directors usually cannot make constructive suggestions on the details of cur- rent operations. Occasionally, they may call attention to a matter that should be investigated. Primarily, however, they listen carefully to what the CEO says and do their best to judge whether things are going satisfactorily and, if not, where the responsibility lies. The directors want the CEO to be frank and to give an accurate analysis of the company’s status and prospects; concealing bad news is one of the worst sins a CEO can commit. Nevertheless, human nature is such that directors can- not expect the CEO to be completely objective. Incipient problems may go away, and making them known, even in the relative privacy of the boardroom, may cause unnecessary alarm. Directors, therefore, are on the alert for indica- tions of significant problems. In many well-publicized bankruptcies of public companies, the directors were significantly responsible; they did not identify or act on the problem soon enough. Louis B. Cabot, former chairman of the board of Cabot Corporation, had a frustrating experience with the ill-fated Penn Central Corporation. He joined the Penn Central board about a year before the company went under. From the outset, he was disturbed by management’s unwillingness to furnish the infor- mation about performance that he felt he needed. A few months after joining the board, he wrote the CEO a letter that contains the following succinct de- scription of the director’s role: I believe directors should not be the managers of a business, but they should en- sure the excellence of its management’s performance. To do this, they have to measure that performance against agreed-upon yardsticks. The Next CEO The board cannot tell beforehand whether a candidate will make a good CEO. The best indicator is how well the individual performs in his or her current job. In most instances, therefore, the board looks to senior executives with proven track records as candidates for the CEO position. One of the most important responsibilities that a board assigns to a CEO is to develop a succession plan for the company’s senior managers. The purpose of such a plan is to identify potential CEO candidates, provide them with opportunities for growth, and groom them for higher level positions. The board participates actively in this process by meeting with the CEO (usually once a year) in a meeting devoted largely to reviewing the senior management. Typical questions asked are: How is a key executive performing? What is his or her potential? Who are potential successors for the CEO, now and in the future? 514 Making Key Strategic Decisions At one company the authors are familiar with, the chairman and CEO held an annual meeting of the outside directors to discuss succession. He re- ferred to it as the “truck meeting” because he always started with the question, “Suppose I am run over by a truck tomorrow. What will you do?” At this meet- ing, two, and sometimes three, managers were identified as potential CEOs. Individuals were added to or eliminated from the list and their relative ranking changed. When this process works properly, an agreed upon CEO candidate is available in an emergency, and a person who will take over from a retiring CEO in normal succession is identified. If boards fail to deal effectively with succession, they may be forced to go outside the company for a new CEO. Under most circumstances, this increases the risk that the CEO will not succeed since chances for a successful succes- sion are usually better when the CEO position is filled by a proven executive from within the organization. In some cases, an organization may need a “shak- ing up” and the board may elect to go outside for a CEO who can give the or- ganization new life. NORMAL BOARD MEETINGS Most boards meet eight, nine, or ten times a year. Some meet only quarterly, and a few meet every month. The typical meeting lasts two to three hours, but it may go considerably longer if contentious issues arise. Premeeting Material Prior to the meeting, board members are sent an agenda and a packet of mate- rial on topics to be discussed. This homework usually requires several hours of work. Directors may query the CEO, in person or by a phone call before the meeting, on matters that require clarification. Current Situation and Outlook The first substantive topic on a meeting’s agenda usually is a discussion of cur- rent information about the company and its outlook. The CEO leads this dis- cussion, perhaps delegating part of it to another senior officer. Much of the information is financial—that is, condensed income statements for each divi- sion or for groups of division, corporate expenses, and key balance sheet items, such as inventory and receivable amounts. There are three ways to present this financial information: 1. Compare management’s current estimate of performance for the whole year with budgeted performance for the year. What is the current esti- mate of how the company will perform for the whole year? This is the most important type of information. However, it is also the most sensitive, and many CEOs do not circulate it prior to the meeting. The Board of Directors 515 2. Compare actual performance with budgeted performance for the current period and for the year to date. Because the actual numbers are firm, they provide a more objective basis for analysis than the current estimate for the whole year. 3. Compare actual current performance with performance for the same pe- riod last year. A carefully prepared budget incorporates changes in the business and the economy that have occurred since the prior year, and this is a more meaningful basis for comparison than last year’s numbers. If, however, the budgeted amounts, particularly the estimate of revenue, are highly uncertain, the numbers for last year provide a firmer founda- tion for comparison. Variances between actual and budgeted performance are discussed. Are unfavorable variances temporary? If not, what steps will be taken to eliminate them, or, if they result from unforeseen outside forces, what adjustments in the company’s operations will be made? By reviewing the company’s financial performance and raising questions or making suggestions to management, directors form judgments regarding the company’s affairs. Preparing and presenting to the board a report on the com- pany’s performance is an important discipline for management. Other Actions Next, a number of proposed actions are submitted for board approval. Many of these recommendations come to the full board from committees that have discussed the topics in meetings held prior to the board meeting; these are described later in this chapter. Questions may be raised about the recom- mendations, but usually they are requests for clarification. Board members rely on committee members to explore these matters thoroughly; there is not enough time to do so in the full board meeting. Unless new information sur- faces, these recommendations typically are approved. The board also deals with a number of routine items. These include re- quests for approval of capital projects, of signature authority for various banking connections, of exceptions to pension plans, and of certain types of contracts. Except for large capital projects, these items are usually referred to as “boilerplate.” In most cases, they come to the board because state law, cor- porate bylaws, or written policy requires board action. They are approved with little discussion, sometimes en bloc, despite the fact that the minutes may state for each of them, “After a full discussion, a motion to adopt the recommenda- tion was duly made and seconded, and the motion was approved.” Education A division manager, assisted by senior associates, may report on the activities of the division. This is an educational experience for the directors. (Some 516 Making Key Strategic Decisions board meetings may be held at company plants or other facilities; this also is a valuable educational device.) The meeting itself and the informal activities that usually are associated with it are also educational. Directors have an opportunity to appraise both company officials and their own colleagues. Judgments about these individuals may be valuable if the board is required at some time to deal with a crisis situation. Setting Standards Partly through written policy statements, but primarily through their atti- tudes, directors communicate to management the standards that they believe should govern the organization’s actions. There are two general types of stan- dards; they might be labeled economic standards and ethical standards, al- though neither term is precisely correct. With respect to economic standards, the directors communicate the over- all goals they believe the company should attain: the relative importance of sales growth, earnings per share and return on investment, and the specific numbers that they believe to be attainable. The board also indicates the rela- tive importance of short-run versus long-run performance. In the final analy- sis, board members generally rely on management’s recommendations, but the enthusiasm, or lack of enthusiasm, with which they support a given recom- mendation conveys an important message to management. Ethical standards are nebulous. Written policy statements are always im- peccably virtuous, but directors’ actual expectations are revealed in the way they react to specific ethical problems. How does the company deal with its fe- male and minority employees? What happens to an employee who has a drink- ing problem? Does the company have a policy concerning support for the communities in which it operates? These and many other issues are loaded with ethics, and the manner in which the board reacts to them establishes the real policy, regardless of what is in a written statement. It is easy to rely on counsel’s answer to the question, Must we report this unpleasant development to the Securities and Exchange Commission? The an- swer depends on the legal interpretation of the regulations. It is much more dif- ficult for the directors to agree, and to convey to management, that certain policies or practices, although perhaps within the letter of the law, should not be allowed or sanctioned. Examples include environmental considerations, employ- ment practices in Third World countries, and involvement in political issues. STRATEGY A company should have a set of strategies that are well thought out and clearly understood by all managers. Strategies include the industry in which the com- pany has decided to operate, its product lines within this industry, the price The Board of Directors 517 and quality position of these products, the targeted customers and markets (local, regional, national, international), the company’s distribution channels (direct sales, dealers, distributors), marketing policies (advertising, sales pro- motion), manufacturing policies (in-house production, plant locations, outside sourcing), financial policies (balance among borrowing, equity financing, re- tained earnings), and others. The board usually does not have the knowledge necessary to initiate a strategy or to decide among alternative strategies. It must rely on management to take the initiative, make the necessary analyses, and bring its recommenda- tions to the board. What the board can and should do is described by Kenneth R. Andrews in The Concept of Corporate Strategy. 1 He writes, as a summary, A responsible and effective board should require of its management a unique and durable corporate strategy, review it periodically for its validity, use it as the reference point for all other board decisions, and share with management the risks associated with its adoption. While it is unrealistic to expect directors to formulate strategies, they should satisfy themselves that management has a sound process for developing them. The strategy is probably acceptable if: • It is based on careful analysis by people who are in the best position to evaluate it, rather than on an inspiration accepted without study. • The reasoning seems sensible. • No significant information has been omitted from the analysis. • The results expected from the strategy are clearly set forth so that actual accomplishment can be compared with them. Strategy Meetings As a basis for considering strategic plans, many companies arrange a meeting at which directors, together with senior managers, spend one, two, or three days discussing where the company should be headed. In order to minimize distrac- tions and provide an opportunity for informal discussion and reflection, these meetings are often held at a retreat that is distant from the corporate offices. While company practices differ widely, it is not uncommon for meetings de- voted primarily to strategic issues to be held every year or two. The primary purpose of a strategy meeting is for management to explain current and planned strategies and the rationales for them. The explanations provide useful information to the directors. The quality of the rationale for the strategies indicates the competence of senior management and the managers of the divisions concerned. Thus, the strategies provide additional insight about the abilities of the CEO and the participants who may be CEO candidates. Once adopted, a corporate strategy must be adhered to. Management brings to the board for decision and approval many matters that may impact a company’s strategy—major capital expenditures, acquisitions, divestitures, and 518 Making Key Strategic Decisions financing proposals. The board ensures that these proposals are consistent with the adopted strategy. If they are not, the company can drift off course and may get into serious trouble. DEALING WITH MAJOR CRISES In addition to its regular activities, a board occasionally must deal with crises. These usually arise unexpectedly and require special board meetings. We de- scribe two of these: terminating the CEO and dealing with takeover attempts. Terminating the CEO There are times when a board must replace the CEO. Failure to act in time is a major criticism of some boards. Although such criticism may be justified one should recognize that it is much easier for an outside observer to criticize than to be in the shoes of the directors who are faced with this decision. The decision to replace a CEO is subjective and usually emotional. Some- times there are compelling reasons for taking action—for example, when the CEO is becoming an alcoholic or when his or her corporate performance has dramatically deteriorated. In most instances, however, the case is not so clear. Earnings may not have kept pace with industry leaders because the board dis- couraged management from assuming additional debt that would have enabled the company to expand. Or perhaps the board supported a major acquisition that did not work out. In such instances, it is not obvious that the CEO is pri- marily at fault. There are, however, several important signals that can alert a board to question the CEO’s capabilities: • Loss of confidence in the CEO. If a significant number of directors have lost confidence in, or no longer trust, the CEO, the individual should be replaced. • Continuing deterioration in corporate results. Earnings may be signifi- cantly below industry norms or below the budget without an adequate ex- planation. The board must act before it is too late. • Organizational instability. A CEO who consistently has problems retain- ing qualified senior executives probably should be replaced. These problems are especially serious in the many new companies spring- ing up in information technology industries. In these industries, change is rapid, competition is severe, there are no track records on which to base judg- ment, and stock prices may change by huge percentages in a few days, reflect- ing changes in investors’ opinions about the company’s outlook. It is one thing for board members to begin to doubt the CEO’s capabili- ties, but it is quite another thing for them to demonstrate the courage and The Board of Directors 519 con sensus needed to take action. The CEO and the directors usually have worked together for some time; they are good, perhaps close, friends. For the CEO, dismissal is a catastrophic event. Taking action that will probably destroy the career of a business associate is a difficult decision. Replacing the CEO precipitates a crisis, not only for the board but also for the entire organization. When it happens, the board must be prepared to an- nounce a successor and to deal with the problems inherent in the transfer of ex- ecutive authority. Such action puts a major burden on the outside directors. Nevertheless, this is their responsibility to the shareholders and to the other constituencies of the corporation. For example, in early 2000, Jill E. Barad, CEO of Mattel Inc. the world’s largest toy manufacturer “resigned.” Ms. Barad built one of Mattel’s flagship products, the Barbie doll, from $250 million in annual sales in the mid-1980s to $1.7 billion in 1999. In the late 1980s, Barbie’s growth slowed, and Ms. Barad turned to acquisitions. Unfortunately, several acquisitions failed to live up to expectations. A loss of $82 million was recorded for 1999, and Mattel’s stock price dropped from a high of $45 in 1998 to a low of $11 in early 2000. The board acted, and Ms. Barad “resigned.” Apparently the board decided that there was no suitable successor within the company. They selected Robert Eckel, formerly CEO of Kraft Foods to be the new CEO. The turnover of CEOs of major corporations seems to be accelerating in the twenty-first century. Mr. William Rollinick, a Mattel board member and for- mer acting chairman, observed that when a chief executive stumbles, “there’s zero forgiveness. You screw up and you’re dead.” The investing community puts boards under considerable pressure to act when things appear to be going wrong. Sarah Telsik, executive director of the Council of Institutional Investors, which represents 110 pension funds with more than $1.5 trillion in assets, believes that underperforming CEOs were not losing their jobs fast enough. Too fast or too slow? A board should decide what is in the long-term best interests of the company and its stockholders. In some instances, immediate pressures should be resisted in favor of long-term considerations. In other cases, the board should “bite the bullet.” The decision is not easy. Unfriendly Takeover Attempts Another crisis event is the hostile, or unfriendly, takeover attempt. Board deci- sions vital to the company’s future—even its continued existence—must be made in circumstances in which emotions are high, vested interests are at stake, and advice is often conflicting. The business press reports daily the dra- matic developments of offers and counteroffers, tactics, and strategies as each side in the struggle seeks to gain an advantage. Boards and management spend much time preparing offensive and defensive plans. One of the problems in takeover situations is that the board, which repre- sents the shareholders, may have interests that differ from those of manage- ment. In most successful unfriendly takeovers, the senior managers of the [...]... the factors involved in arriving at answers to them interact with one another Consider the example of Cisco Systems: The Board of Directors 531 Cisco was founded in 1984 and shipped its first product in 1985 The company grew rapidly In 2000 it was a world leader in networking for the Internet, with sales of $18.9 billion and net income of $2.7 billion The following statement is included in the company’s... or striking the best possible deal BOARD COMMITTEES Much of the board’s work is done in committees They meet before board meetings, hear reports, and prepare summaries and recommendations for full board action In this section, we describe the activities of the three committees—compensation, audit, and finance that deal with finance and accounting matters COMPENSATION COMMITTEE The board determines the... it is convinced that a better manager has been identified The finance committee also decides on asset allocation investment policies: how much in equities, how much in fixed income securities, how much in real property, how much in new ventures, how much in overseas securities, and the maximum percentage in a single company or industry Companies must also provide for costs of health-care and other... financial health and assuring that its financial viability is maintained The finance committee makes recommendations on these matters (Nevertheless, as emphasized earlier, the full board cannot escape its ultimate responsibility for making sound decisions on important matters.) The committee’s agenda includes analyses of proposed capital and operating budgets and regular reviews of the company’s financial... source of funds has its own cost and its own degree of risk • What return does the company expect to earn on shareholder equity, and what degree of risk is it willing to assume in order to achieve this objective? The trade-off between risk and return will determine the appropriate type of financing and thus inf luence the extent to which earnings should be retained or paid out in dividends These are complex... Making Key Strategic Decisions target company lose their jobs A common accusation, therefore, is that management resists takeovers in order to entrench itself, even though the deal would result in a handsome gain for the shareholders In these situations, directors must exercise great care in making a decision that is in the shareholders’ interests This is not always easy to determine What is the intrinsic... on its common stock and has no present plans to do so.” Cisco retained all of its earnings to help finance its growth and used its stock to acquire other companies, which it integrated into its operations Cisco’s dividend policy is typical of high-growth technology companies that need resources to grow but find raising equity in the financial markets expensive because they have no financial “track record”... appointed, the reason for making the change must be reported on its Form 8-K Also, because a new firm’s initial task of learning about the company requires management time, management may be reluctant to recommend a change Public accounting firms often perform various types of consulting engagements for the company: developing new accounting and control systems, analyzing proposed pension plans, and. .. probing is to ask the following: “Is there anything more you should tell us? What were your largest areas of concern? What were the most important matters, if any, on which you and management differed? Did the accounting treatment of certain events differ from general practice in the industry? If so, what was the rationale for the difference? How do you rate the professional competence of the finance and. .. has this information and is likely to be unhappy if the compensation is perceived as unfair or not competitive There are many sources for salary information They include proxy statements from similar organizations and published surveys Some consulting organizations specialize in executive compensation; they provide data and advice on these matters In the end and with all of the information at hand, the . in normal meetings, in strategy meetings, and in special situations, and it describes the work of three important board committees: the compensation committee, the audit committee, and the finance. change. Public accounting firms often perform various types of consulting en- gagements for the company: developing new accounting and control systems, analyzing proposed pension plans, and analyzing proposed. of performance and status are described in Chapters 1 and 2. The budget preparation process is described in Chapter 6. Financial policies are discussed in Chapters 9 through 13. In some companies,