U.S. corporations entered the fall season amidst substantial turmoil. There are major governmental initiatives to reform the manner in which boards operate, potentially affecting executive compensation, proxy solicitation, and financial disclosure. The Federal government is deeply involved in running several of the country’s largest corporations. The SEC, chastised for its failure to uncover fraud, is being pushed to heightened regulation and vigilance. Litigation against boards continues to flourish. Confidence in board governance may be at an all-time low.

Against this backdrop, three senior directors discussed the question, “what keeps the chairman up at night?” at a recent NACD New England breakfast meeting. The panel, moderated by Ernest Godshalk, managing director of ELGIN Management Group, and a director of Hittite Microwave Corp., GT Solar International, and Verigy, was attended by:

Amelia Fawcett, chairman of Pensions First Group and Guardian Media Group, which publishes the Guardian and Observer newspapers in the U.K., recently completed a term as a director of the Bank of England, and is a director of State Street Corp.

Bob Posen, chairman of MFS Investment Management (with more than $150 billlion dollars in assets), teaches corporate governance at Harvard Business School, and is author of the upcoming book, Too Big to Save? How to fix the U.S. Financial System.

Mike Reuttgers is lead director of Raytheon, chairman of Wilson Micro-electronics PLC in Scotland, former chair of EMC, and a d irector of NACD New England.

What are the key issues in current Board Governance?

Moderator: I have several lists here of key board issues. They include say on pay, proxy access, and numerous regulatory incursions which are proposed in limitation of the prerogatives of the board. What do you think?

Fawcett: Cash. Balance sheet funding. Scenarios playing around that. Relationship to enterprise risk management. The key issue today is making sure that your company has enough cash. Further, in this crisis, a key issue is “fit for purpose.” Do you have right management and the right board with the necessary skill sets in this current environment? How do you attract and retain? How do you deal with the blurring of boundaries between the roles of directors and management in this environment? Finally, there is of course tremendous reform in compensation and governance;  is it evolution or revolution?

Reuttgers: Cash. Do you have enough? This is especially true in non-profits. But in all organizations, you have to understand cash. “Not all cash is the same.” Who holds it? When and how can you use it? Is it free cash or not? Also budgets; Boards are now rejecting more first budgets than ever before because they are not conservative enough. Revenue projections are too optimistic. It is better to be ahead of budget than behind it. Boards are much more involved in budgets. This involvement impacts long term strategy. This involvement will also impact compensation.

Posen: What does this financial crisis mean for boards and governance? Its impact on boards is negative. Distinguished boards made up of independent directors, at many large institutions, in full compliance with Sarbanes Oxley, none-the-less were clueless. They found that risk assessment, product mix, compensation were all out of whack. This, by the way, proves that Sarbanes Oxley doesn’t get you where you must go. There are more important factors such as:

• Size: Boards are too big, small Boards work better, 5 to 7 directors are optimal.
• Expertise: You may have smart people and you may have independent people, but do you have enough people who really actually understand your industry? Early retirement is a dumb idea; you lose the expertise you need just as it has been fully developed.
• Time: Directors really do not know their companies. They need 2 to 3 full days each month to learn about their companies.

We can tinker with the procedures, but large global company directors cannot be effective with current structures. We should have a small number of directors, each of which is concurrently serving on no more than 2 boards, and their pay should be increased accordingly. This model is needed to monitor effectively everything that needs to be monitored in a modern corporation.

Fawcett: I agree that boards are too large. Forensic examination of company failures shows that large boards may surface the correct issues, but those issues tend to get diluted in discussion when too many people are talking. The key issues are thus not discussed adequately. Another issue is diversity: you need variety of expertises, not variety such as gender. You need “uncomfortable” thinkers.

Posen: We need a cadre of professional directors. Everyone seems to be looking for a sitting CEO; he thinks they should never be directors of other companies. CEOs push for other CEOs but this is not a good reason. The best directors are older and have time to spend; why kick out directors when they are 70? We do that because we are uncomfortable in confronting the small number who “lose it”; but most don’t. Companies should use board evaluations to rid themselves of failing older directors, not throw out the baby with the bathwater.

Moderator: Do the above observations apply to smaller and medium-sized companies?

Posen: Yes, except for proxy access. Say on pay may be a catalyst for internal discussion, but it is “a blunt instrument. Pay is complicated.” There is a problem in communicating information effectively about compensation to shareholders; this is best left to compensation committees.

Corporate committee heads [other panelists suggest all directors] should go out and meet with major investors; this is done sometimes but not often enough. Outside directors generally should talk to major investors about compensation but indeed about other issues also. Major investors are more and more important, since changes in New York Stock Exchange rules prevent brokers from casting discretionary votes for street name shares in director elections. This issue is more important than proxy access.

We can solve the proxy access issue without mandating that companies assist shareholders in soliciting shareholder nominee proxies [this is one element of the proposed new SEC Rules covering proxy solicitation]. For example, a shareholder could nominate, have a right to post the nomination on the company website, and should not be required to solicit all proxies, nor require the company to solicit for them. No need to incur this cost, particularly since brokers can’t vote anymore and retail investors tend not to vote; all shareholders proposing a nominee need do is communicate with a small number of major shareholders in order to mount an inexpensive proxy fight. Company proxy materials need not include information about shareholder nominees, just a statement that there are in fact other candidates (referring shareholders to the company’s website). Proxy access really is a cost issue solved by the age of the Internet. Elections will be controlled by institutions and broad solicitation is no longer necessary.

Reuttgers: If you have corporate authority for a large board, but actually a lesser number of sitting members, you should amend the bylaws to reduce the maximum size of your board to equal the number of sitting directors. Leaving open slots will attract shareholder nominations.

Posen: Research has shown that there is no relationship as to financial statement performance or stock value favoring the division of the chair and the CEO. Additionally, the rise of the “lead director” is creating a group of directors whose functionality comes close to an outside chair.

Fawcett: Split roles (splitting the CEO and the chair) tend to increase communication and educate directors. I expect in 10 years this will be normative here in the United States. It may even be mandated [there is legislation before Congress which would in fact mandate such a division]. In the U.K., nothing is legislatively mandated, we operate under the rule of “comply or explain.” What this means is, if you do not feel your company adopted a particular alleged best practice, you can simply explain in disclosure the reasons for not doing so. This approach in the U.K. has expanded to most governance issues, where “best practices” are not mandated but may be availed of, or not.

Audience high points:

• Whenever management schedules a board meeting at a facility (“on site meetings”), you are wasting your time. It is better to drop in. When the directors are coming, the company people at a given site are prepared, rehearsed, etc. You don’t learn anything.
• One company successfully matched every outside director with one senior manager for purposes of mentoring and education.
• In the U.K., corporate social responsibility will be on the short list of key issues for most boards. Same thing is true in much of the rest of Europe. What is the enterprise doing for schools, for poorer countries, for the ecology? This is not an agenda item identified by the panel, nor appearing on typical lists in current circulation purporting to identify key U.S. board issues. It was speculated that preoccupation with the economy, by U.S. boards, has delayed a growth of corporate social responsibility as a key U.S. board issue.
• In response to a question concerning the role of a board in disaster prevention and management, it was noted that all boards should be asking questions about how to handle swine flu, which may well be an extremely significant factor in company performance this fall and winter. It was suggested that boards have an affirmative obligation to inquire and assure themselves as to the sufficiency of planning in this regard.

Commentary:  There was a marked distinction between the generally circulated lists of key board issues (which tended to focus on governmental and regulatory matters), and the key issues presented by these board chairs of large companies. The board chairs on the panel were far more focused on specific issues that bear upon the substantive performance of the board functions; substance, not procedure.

Equally interesting, although much of the literature in the last six months have dwelt on enterprise risk management (perhaps an expected reaction to how many risks were missed leading up to the recent economic meltdown), ERM was mentioned by the panel only in passing and as an element relating to understanding and insuring liquidity.

Some of the lessons suggested by the panel are applicable to privately held companies, some to non-profits, and almost all in one degree or another to small cap and medium cap public companies. The extent to which the involvement of the Federal government in active corporate management will, in the long term, tend to emphasize procedural and bureaucratic safeguards at the expense of paying attention to global strategy should not be underestimated. Although there is much to be said for the government as a major funding agency having significant say in management, the governmental impulse toward one-size-fits-all procedures could have a grave impact on many US companies. With the Congress and the SEC vying with each other to appear more attuned to the protection of the public and the repair of our economy, there may be substantial formalistic governmental involvement ahead of us notwithstanding the lack of concern expressed by the panel as to those risks.

Stephen M. Honig, a director of the NACD New England, is a partner at Duane Morris in Boston where he practices a wide range of business law.