Board of directors, globally, are facing increasing scrutiny because of various scandals of some celebrated chief executives. Reputable stock exchanges like the New York Stock Exchange now require companies in their lists to conduct periodic self-evaluation. The practice has even become increasingly mandated in some non-profit organizations.
But what exactly is the best way for a board to evaluate itself? Unfortunately, board directors have generally had little exposure in this area. To investigate the different self-evaluation practices used, Laurence Stybel and Mary Peabody of Board Options Inc studied eight boards that have engaged in self-evaluations for at least two annual cycles in the United States.
They found that companies were using a variety of practices for collecting data and for preserving the confidentiality of this information. They summarize the differences among these practices into four distinct approaches of self-evaluation: informal, legalistic, trusting, and systematic. Each of the approaches has important implications for a company’s board rating, directors and officers (D&O), and various legal issues.
Research indicates that whilst an overwhelming majority of board directors concede that their performance ought to be evaluated; yet, only a small number of boards of public companies actually conduct such assessments. Part of the problem is that organizations don’t know how best to implement a board self-evaluation procedure.
Many simply avoid the practice because they fear alienating individual directors. Others have implemented the process only to become frustrated because it took so much time and produced so few results.
Companies need to address two core governance dilemmas when implementing any self-evaluation procedure: encourage bold decision making by the chief executive without becoming a passive entity that permits imprudent risks; and, maintain an environment of collegiality while avoiding the danger of creating harmonious but dysfunctional “groupthink.”
Any self-evaluation practice should be designed and structured so the board can investigate the following: “How are we as a board contributing to the overall effectiveness of the organization?” During such a meeting, the directors should focus mainly on reviewing management’s contribution to shareholder value. When conducted properly, self-evaluation can be a powerful tool for improving the board’s performance. Studies indicate that self-evaluation is significantly related to board effectiveness with respect to specific functions, such as the ability to balance the interests of different stakeholders.
Benefits and Drawbacks
Board self-evaluation also has ancillary benefits. The practice helps enhance the perceptions of investors, particularly if self-evaluation is implemented before it is required. In fact, according to Board Options Inc, the more seriously a firm takes governance, the more attractive it will be as an acquisition candidate to larger corporations that are particularly concerned about minimizing any potential risks from shareholder litigation.
Typically, board directors are concerned about two types of personal risk. The first is the financial risk (for instance, from a shareholder class-action lawsuit). The second is risk to their professional reputations. A board self-evaluation can alienate directors who feel they should be above the process, especially when they want to preserve their reputations and they know their contributions have been lacking. Sometimes, a director might even resign protest of an impending self-evaluation. But any board that loses such individuals is probably better off without them, and other directors are often more relieved than upset with those type of resignations.
With all the benefits, why do many boards choose not to conduct regular self-evaluation? One of the major reasons is time limitations. Over the years, the time commitment for board membership on the board of a public company typically requires 100 hours per year, and serving on the audit committee necessitates an additional 200 hours. Already pressed for time, many board members perceive the self-evaluation process as additional work that is not necessarily worth the effort.
The possibility of litigation is another factor. Board self-evaluations sometimes produce information about suboptimal behaviour that might then be used in civil suits or criminal trials. To avoid that risk, some companies have considered retaining a law firm to perform the board evaluation in the hope that solicitor-client confidentiality will protect the information.
The design of any self-evaluation program requires continual consultation with the board. The board’s commitment is crucial to ensuring that the new system is actually adopted and used. At a minimum, the structure, feedback and follow-up of the evaluation must be discussed.
In the study by Stybel and Peabody of boards that have conducted self-evaluations for at least two cycles, they found two high-level variables in the protocol for the process: the structure of the data-collection methodology (low versus high) and the confidentiality of data (unimportant versus important). Those dimensions define quadrants of four different approaches to self-evaluation: informal, legalistic, trusting, and systematic.
Informal. Data gathering is often limited to the chairman saying to the board something along the lines of: “This is the time we evaluate our own functioning. We are not going to write anything down, and there will be no details of this discussion in the meeting minutes. Now, is there anything someone wishes to discuss? With that the board can check off that it complied with the requirement for setting aside time for self-evaluation. Confidentiality is not an important issue because nothing will show up in the records and members have been discouraged from writing anything down. But this approach is also likely to yield the least valid information for improving the board’s effectiveness.
Legalistic. This approach is marked by low structure for data collection and tight controls over how that information is collected and later destroyed. If the board culture of the informal approach is, “Let us get the self-evaluation over with,” then the corresponding sentiment for a legalistic approach is, “Let us do what we need to do while minimizing cost, time and hurt feelings.”
A legalistic approach is the minimum that should be implemented by boards under scrutiny from shareholders, the media or other parties.
Trusting. This approach is marked high structure for data collection using or adapting a well-known instrument. The program is viewed as a multiyear effort with the same instrument used on a consistent basis so that progress can be monitored objectively over the period.
Systematic. This approach is marked by two characteristics: a high structure of data collection using a well-known instrument and substantial concern for data confidentiality. As such, the data collection is often performed by a consulting firm or other outside entity with its own policies for data destruction that are more rigorous than the client’s corporate practice. Board members are not allowed to retain their notes and only a general statement is entered into the minutes.
Board-evaluation is a governance tool, and like any tool it has its benefits and drawbacks. At some organizations, the most prudent course of action might be not to engage in self-evaluation. However, board self-evaluation has become an increasingly mandated practice that companies need to learn how best to adopt and implement. The ultimate goal is continuous improvement. To achieve it, board self-evaluation should be an ongoing systematic process with the ultimate beneficiary being the organisation as a whole.
By Captain Sam Addaih (Rtd)