Directors Must Open a Dialogue

by Directorship Editors

MANY MORE DIRECTORS ON the boards of publicly traded companies are independent of management, but they have more work to do before they persuade shareholders that they are acting as good stewards, says Julie Daum, who leads the board practice for executive search firm Spencer Stuart in New York. Here are excerpts from a conversation:

Is it true that boards are merely defending entrenched chief executive officers or has that changed?
I think it has definitely changed. Boards have become empowered both because of the Sarbanes-Oxley Act and the overall environment. They are taking their jobs more seriously, and they are taking their independence more seriously. They are trying to maintain a relationship that is not adversarial with the CEO, but recognizing that they have a different job than the CEO has.

What do you make of the series of high-profile departures recently such as Hank McKinnell leaving as Pfizer's CEO and Steve Reinemund departing from PepsiCo?
I think that's part of this empowerment. There's also a little bit of fear in the boardroom. People are concerned that boards are pulling the trigger relatively quickly on these CEOs. They will not be faulted for removing someone as much as they might be for allowing that person to stay in place and giving them time to prove themselves. Some people would say that's actually a negative—an unwillingness to allow someone's strategy to take place or to allow them to grow into the CEO's job.

So you think tension in the boardroom is having a negative impact on companies?
There are positives and there are negatives. The negatives are that boards are becoming riskaverse and you see some of that in the increased CEO turnover. But I think people are worried that we're going to see risk-aversion in the strategy of the company. The positive is that they are operating more independently and that in general is a good thing.

What does your more recent study show about how many independent directors now sit on boards?
The number of new independent directors on boards in the Standard & Poor's 500 increased 17 percent in our 2006 study and that's up 41 percent over the past five years. So 81 percent of all directors of S&P 500 companies are now independent.

So the notion that directors are just captives of powerful CEOs is not based in reality?
If you look at the three main committees of the board—audit, compensation and governance— all are independent. All companies in the S&P 500 have completely independent committees. Now companies have to put in their proxies where the idea for a new director came from. So if you and I play golf together and I recommend you for this board, it has to be said that a board member or the CEO recommended this individual or that they came about as the result of an executive search. That has had an impact.

I think boards also are very cognizant now of having anything that can be perceived as a conflict. If you and I serve on a board together, it probably means that neither of us should serve on another board with each other. Boards are very conscious of the concept of interlocking boards. It used to be that's where the ideas for candidates came from. You knew somebody from another board and you'd recommend them. Now you're reluctant to do that.

Home Depot is a good example of that. The relationships between directors, those were not situations where someone was getting compensated by the other. But they were serving on the boards of other organizations. Companies are very nervous about that now and are saying, "I don't want people who have a pre-existing relationship like that." The new people who are going on boards don't tend to be friends of the CEO. A lot is changing.

What do you think of Home Depot CEO Bob Nardelli's assertion that his board is the most independent in America (Directorship, September 2006)?
Each board has to determine the independence of each director and they have to declare it in their proxy. Does anybody get compensation or does anybody have a family member working at the company? It's all very well defined. They may very well meet that scale of independence.

But there's independence and then there's independence. I could be your next door neighbor and best friend, but I qualify as independent because we don't have a business relationship. I'm not serving on your board. You're not setting my compensation. We're not doing consulting work together. We would meet the stock exchanges' criteria for independence, but obviously we have a less-than-independent relationship. That's what you can't quantify.

If, in fact, boards are more independent and less inclined to tolerate entrenched CEOs, why have we seen a surge in shareholder activism targeting CEOs and boards?
Shareholders are very upset about compensation. Their voice is the board. Because they're upset with what they see as excessive CEO compensation, relative to performance, they expect that board members will take an active stand on that. But they don't think boards have. Shareholders feel that boards have not done a good job in that regard. They are frustrated. So they're trying to figure out, "How do we ensure that those board members are doing their job?" That's very hard for them because none of them sit in the room.

That's why Institutional Shareholder Services or The Corporate Library use these models where they say, "If somebody sits on more than four boards, they can't be doing a good job." Or, "If somebody serves on another board with a director, they can't be independent." That's why now shareholders are saying they want to have input into who's on the board and who gets elected.

Among the tremendous variety of shareholders, we have some like Kirk Kerkorian attacking General Motors and Nelson Peltz attacking H.J. Heinz in an attempt to get their directors on those boards. Overall, is that healthy?
A Kerkorian is a different kind of shareholder than the large pension funds, which is more what I'm talking about. What needs to happen is that there has to be an easier conversation between the shareholder groups and the board. In the past, it didn't happen at all. There was really no conversation. When they do begin to talk, sometimes they find that the board is trying to do the right thing. The shareholders become more educated. And the board finds that the shareholder groups can be very rational and are trying to do what's right for the company. In the past, there's been a distrust that comes from the lack of communication.

What's the key to creating that communication?
Boards are starting to talk to the shareholder groups. Before, the CEO did the communication. Now you're seeing the lead director might do it or the chairman of the nominating committee starting to do it.

How did it happen that directors, who are supposed to represent shareholders, didn't really talk to them?
It was the norm. But now according to our survey, 22 percent of the S&P 500 reported that their boards had direct contact with shareholder groups. But five years ago, it would have been close to zero. There's definitely an increase. In general, people have found if you talk to the shareholders and explain what you're trying to do, they're very reasonable.

How do people who are not currently directors win a board appointment?
It's really hard. It's as if all of a sudden you decide you want to get married. But there's nowhere to go to find a perfect husband. Whereas if you're looking for a new job, you can say, "I'm a financial officer. I want to work at this kind of company." And you target it. You don't get the opportunity to do that for boards. You have to become known to people who are in the flow of information, including executive recruiters, but not only. You could talk to people you know who serve on boards. You can't say, "I'm interested in your board."

But you could also talk to lawyers who might be involved in deals, either taking a public company or taking a company out of bankruptcy. You need to be known outside your world. If you're in a company, you need to get outside that company. That could be from an industry association. It could be from getting involved in community activities, such as nonprofits. You need to be in a world where people who serve on boards can see you in action.

Is that visibility more important than the underlying skills sets?
If you're not qualified to serve on a board, you're not qualified to serve on a board. If you're talking about these three-day directors' programs, I don't see it. The reason you're qualified is because of your 20 years or whatever of experience. That's what makes you qualified. You're very good at what you do.

Ken Langone is fond of saying that boards are making a mistake by loading up with poets and professors.
I don't agree. You couldn't have a boardroom of professors. But if you're a company in the life sciences, why wouldn't you want somebody who was a specialist in oncology or R&D? That person shouldn't be on your audit committee, but that person should bring just as much to the discussion as somebody else, just on a different topic. I think there has to be a rationale for bringing somebody on. There are some people who look at a university president and say, "This person doesn't have to deal with shareholders." But they run a large complicated institution. They have huge budgets. They have a lot of constituents. They are very smart, very strategic individuals."

The critics would argue that there's also a social element to this board selection process. How do you analyze that?
I think that's changing. Everybody sitting around the table doesn't look the same anymore.