New directors should concentrate on three questions to prepare for the (almost) inevitable crisis.

1. What should a director do in advance to be as prepared as possible?
2. When the crisis arrives, what are the proper questions to ask and steps to take to minimize the impact on the corporation, the shareholders and the directors themselves?
3. What conflicts will emerge that may make coping with the crisis even more difficult? Answers to the second and third are situation-dependent, but thoughtful preparation will pay real dividends.

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Preparing for a crisis will help mitigate its impact. Yet, many boards do little or nothing to prepare, and hence, when the crisis arrives, they start from a defensive and disorganized base. This is particularly untoward, because, in many crisis situations, the company’s responses in the first 24-48 hours will be very important to managing the situation successfully. Directors should be educated on the principal laws which affect their businesses, they understand the nuances of their Directors & Officers liability insurance policy, and they should assemble and “drill” with a core crisis management team. Crisis plans should include, as a minimum, succession planning for illness or death of senior executives (including discussion of appropriate disclosure) depending upon the company, product recall and accounting or financial fraud or possible foreign corrupt practices. Plans to cope with physical, bio- and cyberterrorism should be addressed as well.

Planning for a crisis should be a key part of a company’s risk management process. Prudence suggests a 360-degree view of risks, which should be developed by a group of current and former directors, key executives and operating personnel, working outside the normal chain of command. This group, a “Risk Assessment Committee,” should evaluate risks based on probability and consequence, and should report to the board regularly on areas in which risk mitigation needs to be strengthened. The group’s work should be coordinated with any external enterprise risk management activities and with internal risk management efforts, a crisis will occur when a risk, whether or not anticipated, materializes.

Crises often have ramifications for the on-going operations of the business including but certainly not limited to access to capital markets and retention of key employees. While some of the preparatory work should be delegated to appropriate committees, the full board, at each regular meeting, should address the aforementioned questions in an appropriate sequence. External resources, including counsel, forensic accountants, security consultants and crisis communications support, will need to be involved to provide briefing materials and contingency plans. Screening and selecting these specialized advisors in advance is critical—they will provide major inputs when the crisis arrives. Internal crisis management teams also may be involved. (These teams usually are organized into functional areas such as IT, HS&E and physical security.)

What to do when the crisis arrives? The first step should be to select a leader of the crisis response effort. That leader may be the lead director (or chairman) or the chairman of a major board committee. The leader should supplement the core crisis response team as necessary. The team usually will involve top management, unless there is some evidence of a potential conflict, e.g., financial fraud. The team should include a small group of independent directors, appropriate technical advisors and communications support. To the maximum extent possible, the crisis management activity should be separated from the on-going business, to reduce disruption to employees, suppliers and customers.

It is very important for the board to take initial control of the crisis management process, both to avoid conflicts and to keep management focused on the company’s operations. If it becomes clear that the crisis can be appropriately handled by management without conflict of interest or diverting attention from operations, the board may reassign lead responsibility back to management.

After the team is assembled, the next step may well be to issue a statement regarding the company’s position and/or taking responsibility for the consequences of the crisis event. Simultaneously, the team should start fact-finding, to identify what is known, what is uncertain, and what consequences are likely to result. In the case of senior management health issues, the process may be relatively straightforward; in the case of product recall, illegal payments, or financial fraud, the process may require extensive fact-finding over a period of months and may involve coordination with regulators. (The question of notification of regulators—how much to report and when—is a complicated one, the answer to which will depend on facts and circumstances.) In many situations, fact-finding is a very slow process, requiring reviews of emails, written correspondence, etc. What is thought to be true often turns out to be false and vice versa. It is important that the company inform its outside auditors and its lenders in a timely but appropriate way. The auditors will need to consider interim filings, control opinions and the consequences of forensic work to be done by an independent firm if necessary.  And, to the extent that the company’s loan documents have representations about material adverse events or litigation, or financial covenants and/or capital markets access may be affected, and lenders and investors may need to be informed.

Directors should anticipate that crises arise with little or no warning, and, at the onset (and perhaps for some time), they will receive little and imperfect information. Pressured decision-making often will be required, without much analytical support. (Note the contrast to the regular board process, with thick binders, detailed presentations and carefully vetted management recommendations.)

The full board should be kept well-informed on a regular basis, but its focus should continue to be to monitor company performance. In the early stages of a crisis, much is likely to be unknown. “Murphy’s Law” seems to apply more often than not, in that new information which emerges is more likely to be negative than positive—unearthed email files may contain all kinds of bad news, and disgruntled employees may emerge with all kinds of stories.

As the crisis develops, certain conflicts are inevitable—and directors should be prepared for them.

First, management will want to take charge of the crisis response, and the internal general counsel will want to take responsibility for oversight of any investigation. Depending on the nature of the crisis, these efforts generally should be rebuffed. Management’s attention should be directed to improving the company’s operations, and unexpected conflicts may emerge which cause management some embarrassment or worse.

Second, legal counsel, whether the company’s lead outside firm or special counsel (choice of which itself is a topic to be addressed), often will advise to disclose as little as it permissible, and to avoid speculation or assertion about unknowns. Crisis communications teams, on the other hand, generally will favor fuller disclosure, and even acceptance of responsibility, in an attempt to “get in front of the problem.” Although there is no perfect balance, directors often will find themselves pulled in opposite directions. Directors need to think through both of these conflicts carefully, for the sakes of the corporation and shareholders they represent, as they focus on their decisions.

In summary, get ready, prepare for your calendar to be torn apart by unrelenting demands for meetings, and expect lots of finger-pointing and conflicting expert advice.

Herbert S. “Pug” Winokur Jr. is chairman and CEO of Capricorn Holdings, Inc., a private investment firm. He has served on a number of public and private for-profit and nonprofit boards, and has attended more than 300 public company board meetings.

Herbert S. Winokur

At present, boards are organized into standing committees (e.g., audit, compensation) and occasionally ad hoc committees. Some entities, particularly financial institutions, have standing risk committees, which generally concentrate on financial risk management. But boards’ agendas have become increasingly crowded with “check the box” activities, and committee and board meetings have expanded to make sure defensive processes are followed. As a consequence, board committee charters have become more “stove-piped,” which hinders board committees from ensuring that risks that cut across the organization are being considered and monitored appropriately. In addition, board members receive information up from within the organizational hierarchy, which is by definition limiting.

A new approach to risk management is needed. Risk mapping offers a substantially more productive method of defining risk than does current practice. Risk mapping requires an in-depth look at all types of risks that could affect the organization. It requires reviews of history, competitive practices, regulatory activities, approaches to personnel and compensation, corporate value systems, intellectual property, as well as brainstorming, simulations and “war gaming” about possible scenarios that could affect the organization.

Given the need to examine known risks and speculate about unknown ones, the board meeting structure and schedule are inadequate to the task. In addition, on most boards only a few independent directors are intimately familiar with the activities of the organization they are overseeing. (Other directors may be chosen for reasons of specific expertise, customer or supplier relationships or diversity.) Other individuals who are likely to have a deep understanding of risks would be senior (including recently retired) executives below the CEO/COO, and perhaps recently retired directors of the organization or of its competitors.

A group of people, perhaps five to eight, drawn from these ranks should be organized to form a risk mapping advisory committee. Outside counsel, brand consultants, enterprise risk management specialists and insurance experts are examples of potential staff that could be chosen to support the committee. Enterprise risk management processes, with the help of outside experts, can be a good complement or support to the advisory committee. It is important that the risk management process be separated from the time and experience limitations that any board faces, so that risks can be reviewed with adequate time from a 360-degree perspective.

This group should meet three or four times per year for part or all of a day, outside of the board meeting cycle. Its charter would be first to identify as many risks as possible, and measure them both by the likelihood of their occurring and by the consequences to the organization if those negative events were to occur. Second, the charter would empower the committee to determine what organizational units were responsible for addressing and mitigating these risks and, by default, which risks were not being addressed. The committee would be charged to report to the full board of directors once each year and to provide interim reports as would be helpful. The board would be then both better informed about the organization’s risks and about areas in which additional focus or mitigation would be required.

Some scenarios are worth considering. If, for example, a director of a large financial organization, home builder, insurance or building products company had asked, “What happens if housing prices decline nationally by 5 to 10 percent and stay lower for an extended period?” an interesting discussion might have ensued.

If, in another case, a director of a large financial institution, energy company or pharmaceutical firm had asked, “What is the trade-off between our current short-term profit-maximizing practices and the alternatives of building brand value over a longer period by tightening compliance, safety, and/or lobbying practices?” some important declines in market value might have been avoided. A director of a major research university might have wondered about the trade-offs in allocating endowment to increasingly illiquid investments and the resulting consequences to stability in faculty hiring and construction projects.

Most board meeting structures do not provide opportunities to address and debate the assumptions underlying an organization’s strategy and operations. Management, appropriately, is highly focused on opportunities and challenges in the short run, meeting their operating plan, dealing with problems of people and programs, etc. Spending time on what management may view as theoretical and lowprobability events may be seen as academic and unproductive. But identifying and mitigating risks early, which may involve strategy changes, organizational realignments or just better understanding, certainly should be worth the small investment in time and cost to experiment with this proposed risk mapping approach.

Identifying and mitigating risks early, which may involve strategy changes, organizational realignments, or just better understanding, certainly should be worth the small investment in time and cost to experiment with this proposed risk mapping approach.

Management should be encouraged to provide outputs of its internal risk management activities to the risk mapping advisory committee, and to coordinate those activities with this group over time. (The committee process should be designed to preserve “privilege” and to be sensitive to disclosure issues.)

After the risk mapping advisory committee reports to the board, a number of responses should occur.

• First, the board should ensure that all identified risks of consequence are being considered by one or more organizational units and appropriate steps for risk mitigation are being taken.
• Second, to the extent changes in strategy, processes or procedures are required, they should be taken.
• Third, the board’s nominating committee may want to consider the risks identified as a partial basis for determining what kinds of expertise would be beneficial to obtain from new directors.
• Finally, the board may want, with the help of a crisis consultant or other advisors, to explore possible responses to negative outcomes that might occur.

While it is unlikely that the negative outcomes being studied are the ones that will actually happen, crisis management preparation of any kind is likely to be helpful in any scenario. The new committee could be a potential source of advice should a crisis occur. By repeating this process over time, the organization is likely to reduce the impact of a large and negative surprise on its activities.

Herbert S. “Pug” Winokur Jr. is chairman and CEO of Capricorn Holdings, Inc., a private investment firm. He has served on a number of public and private for-profit and nonprofit boards, and has attended more than 300 public company board meetings.

What is the board’s responsibility?
Directors represent shareholders. Hence, their responsibility, simply put, is to design a compensation system that meets the following criteria: (1) it aligns management’s interests with those of the shareholders as much as possible; (2) it can be relied on to attract, retain and motivate management to achieve the strategic objectives of the corporation as approved by the directors; and (3) it achieves these goals at the minimum possible cost to shareholders.  These criteria are in conflict; a director’s job is to balance them appropriately.

With that in mind, a director should act as if he or she is the owner of the business, and therefore is paying from his or her own pocket. Directors should invest in the business and should encourage management to do so as well.

How should a compensation system work?
First, the director must be clear about the corporation’s strategic goals. Merely setting abstract financial targets, such as EPS growth, or relative standards, such as outperforming the S&P 500, is not adequate. The corporation’s strategy is substantially more complex, and a number of financial and non-financial indicators must be developed which tie to strategic goals, and allow for changes in these goals in response to changing markets and competitive conditions.

In addition, because shareholders provide capital for managers to oversee and deploy, financial measures should be designed to supply reasonable returns on capital to shareholders before significant compensation is available to management. Many studies suggest that share price is favorably influenced by earnings growth and increasing returns on capital. This makes sense – these are two of management’s most important responsibilities.  Directors should begin by tying performance to achieving strategic goals and providing a minimum hurdle return for shareholders. Earning enough economic profit to exceed the company’s hurdle rate is a minimum standard; growing economic profit faster than one’s competitors is a better goal. Comparability of compensation for “comparable” positions across companies is not a goal. It is only one metric, and of limited value because companies are different from each other. Be aware that senior executives do compare their pay to that of supposed peers and will push hard to obtain or exceed “parity.”

Second, the compensation system can be considered in two dimensions: type of pay and time period over which it is received. Salary paid regularly during a year is not subject, except in extreme circumstances, to clawbacks and historically has been intended to permit management to maintain a reasonable standard of living.

While the annual bonus is traditionally paid to reward exceptional performance, it has become an entitlement in the compensation discussion; that trend should be reversed.

The bonus may represent 25 percent of salary for middle management and up to a multiple of salary for senior management. It has become common practice to pay the bonus partly in cash and partly in stock, and to permit clawbacks in certain circumstances. The director’s responsibility must include an intense focus on the criteria against which bonuses are awarded. Directors should remember one absolute fact: the circumstances that develop during a year will be quite different from those anticipated at the beginning of the year when the bonus criteria were designed. Hence, directors need to reserve the ability to modify bonus awards subjectively. Remember, management controls the flow of information, and even deeply engaged boards could be on the losing end of an asymmetry of knowledge.

Long-term incentives may involve restricted stock, stock options, cash, or more exotic forms of compensation that typically vest over many years and often are subject to clawbacks. In general, long-term incentive compensation is intended to mirror shareholder rewards over many years, and is typically fixed in advance, with little allowance for subjectivity. The tasks for a director are to determine how to value the various non-cash elements, and to consider the size of the payoffs under different scenarios such as the company’s operating performance, and its stock performance. Well-informed directors should see and disclose “payments” expected under these scenarios. A “best practice” should incorporate a presentation along the lines of the following hypothetical example:

If the company meets its revenue and margin targets as presented to investors, if dividend/share repurchase policies are unchanged, if the stock market increases at seven percent annually, and if the company’s relative valuation is unchanged, then the expected payouts to senior management in five years would be as follows…

The director should also ensure that long-term incentive compensation rewards are based on true absolute performance, not just the results of inflation, relative performance or market tracking. Shareholders and management should share upside appropriately. Restrictions on vesting of deferred compensation should be time and performance-based, to provide proper motivation.

Also consider that the common use of Black-Scholes methodology to value options for compensation purposes makes no sense.  For example: a resource-rich company has $40 per share of natural resource reserves, and no net debt. If its stock fell to $20 per share, an option would seem many times more valuable than an option if the share price were $50. But Black-Scholes methodology produces the opposite result— the option on the higher priced stock is worth about $20 per share, approximately, while the option on the lower priced share is about $8 per share. This result is backwards.

Accounting rules that drove companies to use stock options with no performance hurdles were pathological, and continue to be so. For example, when an executive receives an option grant, the company earnings are charged, based on the Black-Scholes formula. If the executive leaves and the option is out of the money, the company has no way to reverse the earnings charge — another backwards result.

A director should review the percentage of payroll earned by the top five and top 100 employees versus the percentage earned by all employees, and/or the ratio of CEO compensation to that of the lowest level employee to ensure fairness and to be able to respond to stakeholder questions.

Timing
Compensation and audit committees should meet together at least once each year, preferably before awarding bonuses and long-term incentives. Audit committees need to understand the philosophy and valuation of management incentives. Compensation committees need to understand the assumptions underlying financial statements, such as mark-to-market accounting, off-balance sheet entities, contingent liabilities, pension funding assumptions, etc. This joint meeting should be a “best practice” to help save directors a lot of potential embarrassment.

Different compensation decisions should be made at different times of the year. Salary adjustments should be coupled with discussions of succession planning for a company with a calendar year reporting cycle; early fall is a good time. Bonuses for calendar year companies typically are awarded in March, as full-year financial results are completed. This offers a good opportunity to review company and individual performance. At least one compensation committee meeting should be devoted to a review of the compensation system in its entirety, and to an articulation of the program in a clear, summary fashion. Staggering these discussions allows directors to obtain continuing input from advisors and to provide clear and consistent guidance to management.

Reliance on Compensation Consultants
Compensation consultants provide data to permit comparisons of pay and pay practices across companies and industries. In general, all reputable firms worth retaining will provide roughly the same quality of data. Reliance on external consultants also provides cover for directors faced with shareholder unhappiness, litigation, etc. But these companies have only crude tools to make comparisons across companies; the misuse of Black-Scholes has been cited as an example. Resist by all means the pressure to pay everyone above the mean, and to reward upsides with no penalty for failure or with disregard for shareholders’ capital. And question the consultants carefully; they are seeking to retain a lucrative client.

Role of Executive Search Firms
It may become necessary from time to time to use an executive search firm to attract an external manager to the company. Hiring external candidates often throws compensation systems into disarray. The external candidate will seek to negotiate for what he or she hopes to deliver, while also being paid for what he or she is giving up at the prior position.

A better approach would be to establish the compensation parameters first (including limits on any guarantees for previous employment) and then allow the consultants to screen out people for whom the proposed amount and/or structure of compensation isn’t attractive

Other Compensation Issues
A significant perquisite worth directors’ focus is the use of the company plane. While the current tax rules are very much slanted in favor of the executive, the director has a responsibility to ensure that the policy for private plane use is sensible and subject to defense if attacked in the press or at a shareholder meeting. Use of a private plane for business travel often is extremely productive and even cost-effective. Misuse for personal benefit without adequate reimbursement is inexcusable.

Other “perks” should be eliminated. In general, management is sufficiently well compensated that they can pay for their own clubs, cars, and financial planning.

Treatment of unvested compensation and severance in the event of a corporate takeover or termination for non-performance also needs to be considered. In the former case, except for a small number of senior officers who will be involved in negotiating the transaction, vesting should require a “double trigger”—that is, a change of control and a loss of job or a significant downgrading of responsibility. Other issues such as company-paid life insurance, tax-deferred payouts, etc., should be addressed as they arise but in general, the simpler, the better. Many of these “gimmicks” have unintended consequences as interest and tax rates change, which reduces their usefulness.

– Herbert S. Winokur, chairman and CEO of Capricorn Holdings, has served on numerous public company boards.

If the job of finding great new directors is difficult, so is the job of sitting on a board, especially for the first time. Here is some common-sense advice for new directors. First, and most importantly, remember that directors direct and managements manage.

Why Serve?
Understand why you choose to serve and embrace it. In earlier times, directors often served for prestige, compensation, and fellowship, and their performance rarely was challenged. Those halcyon days are gone. You now must consider reputational risk, substantially expanded (and often last-minute) time commitments—perhaps at little per diem pay—and a more formal environment (which can impinge on candid strategic focus). Do due diligence on the company and its industry, as you will be judged in the court of public opinion—and perhaps even in the courthouse. You’ll need courage, good business instincts, and the rare ability to judge others accurately.

Directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

Reliance on Outside Advisors
As a matter of corporate law, directors are generally entitled to rely on advice from outside advisors, including compensation consultants. Directors should exercise care in selecting experts and shouldn’t hesitate to question those experts as much as necessary.

We recommend that the following be adopted as standard best practice for directors:

1. Audit Committees should meet regularly with supervisory partners of their firm’s auditors, not just the audit partner, and should require that the auditors disclose conflicts and disagreements about accounting matters and the consequences thereof. Auditors already disclose conflicts with management and “opinion-shopping”, but directors need to understand the “close calls” that accountants are making.

2. Compensation Committees should focus more on actual performance and on compensation expected under different scenarios, and less on consultants’ standard pitches on comparables.  Rewards for performance must be based on realistic goals, taking into account the environment and the factors management controls. In general, paying annual bonuses for performance only relative to an earnings budget should be avoided (because management controls the budget) and relative to peers’ stock performance equally (because management doesn’t control either its own or peers’ stock prices). Further, mark-to-market accounting of financial investments, determination of pension liabilities, and other key P&L components can be manipulated to affect reported profits and compensation. True operating cash flow, and performance relative to competitors, while also not perfect, are worth considering as performance measures. Proper use of deferred payouts tied to actual realizations will go a long way towards realigning managements’ and stockholders’ interests.

3. Boards should receive regular presentations from outside counsel about important trends and cases in corporate law, especially those affecting their duties and their liability. In addition, directors should be assured on a regular basis that each of their primary law firms has brought forward any legal or ethical concerns.

Board Oversight
It goes without saying that boards should focus on economic and financial scenarios covering the full gamut of assumptions. In the current environment, liquidity is a key concern. At other times, expansion or strategic transactions may play a larger role.

Management will always control the flow of information, and even deeply engaged boards will be on the losing end of an asymmetry of knowledge. But directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

We offer the following suggestions to mitigate, at least partially, the inherent disadvantage directors face due to this asymmetry.

First, ensure that management provides access to, and explanations about, competitors’ performance. Detailed understanding of relative competitive assessment of revenue growth, operating margin, employee turnover, customer satisfaction, and pricing policies will be far more useful than reiteration of historical financials or unsupported projections. Rating agencies face conflicts and their work cannot always be relied on (in any case, ratings often lag reality), and securities research can be superficial and dominated by management or employers. Spend time finding out how the firm is really doing.

Second, create and exploit opportunities to engage informally with employees at all levels of the organization. Plant managers, sales staff, and human resource middle managers, for example, will have a less edited view of how the business is going than you will hear at board meetings.

Third, make sure senior management regularly reinforces the responsibility, under a code of conduct or ethics policy, for every employee to notify an outside board member, anonymously or not, of any planned or known misconduct, whether financial fraud, Foreign Corrupt Practices Act payments, improper behavior, or other improper actions. The purpose of this “honor code” is to give directors more eyes and ears.

Fourth, make sure board meetings include enough time for the independent directors to reflect in executive session on the reports they have received and to raise questions for later follow-up.

It is important for directors to have a good working relationship with management, and, at the same time, one that permits directors to exercise their responsibilities. This relationship best can be described as one with “healthy tension.” Directors and management need to understand that asking probing questions is not done out of suspicion: Sometimes judgments of senior management are just wrong, and directors must press their questions, no matter how uncomfortable this becomes.

Knowing Good from Bad
There is no perfect system for identifying a CEO who lacks honesty, integrity, or capacity. Just as a board needs to know the physical health of top officers, however, it also should (subject to reasonable limits on privacy) understand their financial health, and, as much as possible, their values. Financial circumstances, especially excess leverage, sometimes force desperate people to take improper steps.

One tip after years of experience: In addition to probing executives’ financial health, if a CEO regularly requests less compensation than his/her compensation committee would have awarded, that CEO is less likely to get the company into trouble via excessive risk taking or fraud.

Good luck to all new board members, and, remember, selecting a good CEO and helping him or her achieve the goals set by the board is one of your most important jobs.

Herbert S. Winokur is managing general partner of Capricorn Holdings and has been a director of numerous public companies.