Patrick R. Dailey 

If your board has experienced change, and whose hasn’t, then you have experienced the testing of the cultural rules and dynamics by directors. Rough patches do emerge in the behavioral dynamics of any board. These range from mild and virtually undetectable reactions to severe boil-ups. Early recognition and corrective action are essential to preserve the work ethic and spirit of a high-performing board, one that also must satisfy its directors’ expectations for professionalism, adherence to sound governance practices and the protection of one’s personal reputation.

Large Problems Typically Begin as Small Problems

Typically, behavioral problems start small. And just as typical, these problems don’t just magically disappear. Left unchecked, small issues tend to fester and morph into larger issues that become more visible, more destabilizing to the conduct of a board, and more vexing to resolve—the ones we read about in The Wall Street Journal such as Hewlett-Packard, Yahoo, Best Buy, Chesapeake Energy or News Corp. Tackling small problems is easier than large ones.

Understanding Board Culture

Simply, culture implicitly communicates the rules for behaving in a team. Culture teaches the dos and don’ts. And, culture will penalize those who fail to abide by the norms and unwritten rules. Every board develops a unique culture and the ground rules are defined by the factors presented in Figure 1, “The Board of Directors Culture Model.” The five factors capture the elements of board culture which are most significant in defining the cultural ground rules of a board—these factors represent the norms, standards and values that will be learned by newly appointed directors, played out in the everyday functioning of a board, and those factors which will be tested during times of change and re-assessment. For a full description of the board culture model see “Understanding Your Board’s Culture“  (NACD Directorship, September 2011).

Diagnosing Trouble Ahead

Astute board leaders are sensitive to the early warning signals of trouble—those looming rough patches. They have lots of help with best practices and professional advice. Notably, the National Association of Corporate Directors publishes white papers and other resources that advocate good governance practices. These papers are part of a library of recommendations for structuring boards, operating with transparency and independence and renewing board competency. NACD’s Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies is important reading for chairs and all directors for building boards that work.

The task of diagnosing looming trouble typically falls to board leadership: the chairman, presiding director or committee heads, but it is the task of all directors to be alert to matters that impact governance, threaten their fiduciary responsibilities, their reputation and their personal satisfaction from board service. No one wants to be on a lousy board.

“Diagnosing Board Trouble” (Table 1, below) is a reflection of the Key Agreed Principles filtered through behavioral dimensions of the Board Culture Model. The diagnostic factors in the Table present early indicators of behavioral dysfunction. Diagnosing Board Trouble was not created to troubleshoot policy, regulatory or financial threats. The indicators are organized within the five culture factors of the model to facilitate diagnosis and problem solving.

Addressing Problems

Individual Problems. The beauty of addressing problems while they are small is that the problem is likely not entrenched, and a collegial chat from a designated and respected board colleague often brings unwanted behavior and sentiment back within acceptable culture standards. The board moves forward constructively.

Board Problems. Collective problems pose greater risk and challenge in how and when to bring a matter up for discussion. Group dynamics will typically lead a board to discount or dismiss a matter as untrue or irrelevant. Regrettably, formal board evaluation procedures don’t often put much of a spotlight on the behavioral matters addressed in Table 1. So, the task falls to board leadership for testing the waters and pushing forward to open the problematic indicators for discussion. Some boards choose to hand out the Diagnosing Board Trouble chart and empower any board member to bring forward concerns or the need for discussion. If the dysfunction is yet to be ingrained, problem solving can operate without much resistance; if the dysfunction has become ingrained in the culture, the challenge of change and making change stick is formidable. The board must make a commitment to change and have milestones to gauge progress.

Attempting to Correct Individual Behavior Using Group Talk. In the spirit of collegiality and perhaps tact, often the disruption or dysfunction a single director creates for the board is not brought directly to the individual for correction. Instead, the problematic behavior is teed up and discussed as a matter for the full board to correct as if the full board was the culprit—group talk. Not isolating and correcting the problem with the individual will trigger resentment by those who operated within the ground rules and are now puzzled at why they are being corrected. Best to treat the problem director not the full board.

Recommendation

Develop an “Our Way” Statement. Because dealing with “soft issues” is often unfamiliar ground for boards, it is valuable to author a one-page statement of the board’s culture—address beliefs, attitudes and behavioral expectations for the way things should be done. Communicate differing levels of intensity to signal what is of high importance and adherence. Importantly, identify those behaviors that are contrary to the board’s expectations. This brief statement sets expectations for how directors work together.

Tailor the Chart: Diagnosing Board Trouble. To reflect those unique and likely troublesome matters occurring on your board, edit and adjust the diagnostic items in the chart. Discuss the tailored chart and reach consensus among directors that the chart leads the board in the right direction. This supplements the “Our Way” statement as a diagnostic tool. Add the tailored diagnostic chart to your board’s annual board evaluation process.

Provide “Our Way” and the Diagnostic Chart to newly appointed directors. Have a board member or someone from the nominating committee preview these documents with new directors.

Keep it Relevant. Periodically review “Our Way” to ensure it reflects the expected culture of your board. Revise the Diagnostic Chart to enable small problems to be dealt with early on.

Patrick R. Dailey, Ph.D., is a partner in Board Quest LLC, a board of directors consultancy, and serves on the board of the NACD Atlanta chapter. He can be reached at 310-400-9992 or pdailey@boardquest.com.

The New York Times is reporting that Morse is being succeeded by Ken Goldman, who has been serving as CFO of Fortinet, a public computer security company. Yahoo’s board of directors hopes Mayer will restore some vitality to the moribund brand. She is expected to give birth to her first child in the next few weeks, but has said she expects to return to work quickly. The Times notes, “Previous chiefs — four in the last five years, plus two interim chiefs — have failed to carry out their own long-term plans, largely because they have been unable to articulate what it is that Yahoo actually does.” Mayer has been active as of late, recently closing a $7.6 billion deal with Alibaba that gives Yahoo, after taxes and paybacks to shareholders, $625 million. “She indicated Tuesday that employees should expect acquisitions,” the newspaper adds.

Meanwhile, CIO notes that a Yahoo spokeswoman declined to comment on the reasons for Morse’s replacement. In a statement, Mayer described him as “a trusted leader” at the company who has “expertly guided” the company through some tough times and key deals. She added, “I’ve personally relied on Tim’s knowledge and leadership in my first few months at Yahoo. I know I speak for everyone in wishing him the best.”

Thomas J. Saporito

Even as lead directors’ influence and impact has grown, there has been surprisingly little public discussion about what is required of these key board leaders, the qualities they must possess to be effective, and how they should be selected.  Given the bearing lead directors have on board and CEO effectiveness, their requirements for success deserve thorough consideration.

First, let’s look at the evolution of the relatively new role of the lead director. It was created in the post Sarbanes-Oxley era as a compromise for lawmakers who wanted to crack down on corporate misconduct without requiring companies to split the CEO and chairman roles. While some governance advocates believed the lead director arrangement to be less effective than leadership by independent chairmen, heightened regulatory accountability has transformed it into far more than a figurehead.

In February 2010, the Securities and Exchange Commission began requiring companies to include a discussion regarding board leadership structure in their proxy statements. A board must disclose whether it has chosen to combine or separate the CEO and chairman positions, and if it has a lead director or not. The board must also state why it believes its chosen leadership structure is the most appropriate one for the company. This requirement has prompted many boards to expand lead directors’ duties.

Most lead directors I know believe their true mandate is to ensure the internal workings of the board and its relationship with the CEO are operating as effectively as possible. While a board is a legal structure, organized around various governing functions, it is also a constellation of people with different styles, personalities, biases, and agendas. It is, in a way, its own social system, and lead directors must understand that and manage it as such. This is an amorphous directive, especially when tensions are running high in an uncertain business climate that has caused many companies to falter.

Effective lead directors are brokers between the board and the CEO; in a sense, they represent the voice of the board and the voice of the CEO to the board. This dual responsibility can be arduous, and requires an executive with a unique skill set. While each board will have specific needs for their lead director, effective ones fulfill three overarching duties: They promote consensus among board members, become a trusted advisor to the CEO, and create alignment between directors and the CEO. These responsibilities are not black and white. Subtlety, nuance, and human behavior all powerfully impact the interactions between board members and the relationship between the CEO and the board. To manage these forces and steer things in the right direction, an effective lead director must consistently employ good judgment, keen insight, and deep wisdom.

Bring board members to a consensus point of view on important issues
Board members often view key issues like strategy, CEO compensation and CEO effectiveness through different lenses. These are powerful people in their own right, and their varying points of view can cause disagreements that derail decision-making. The lead director must prevent these progress impediments by synthesizing and consolidating different views, representing these opinions fairly and accurately in whatever situation requires intervention, and uniting board members in a common voice. Here is where judgment is crucial. Effective lead directors see what is important, what makes a difference, and what is practical, and this skill helps them guide conversations toward useful dialogue. Securing directors’ trust is equally essential.

“You never want to let an individual director or the board as a whole be surprised,” said Walt D’Alessio, who serves as lead director for Exelon Corporation and non-executive chairman for Independence Blue Cross. “You have to constantly take the temperature of board members on all different kinds of issues, get to know them personally, and build trust with them.” By finding schisms on their boards and healing them, lead directors ensure issues that could spiral out of control don’t ever reach that point.

Interpret the CEO’s needs and expectations, incorporating a psychological perspective
External pressures cause some CEOs to become guarded in their conversations and resistant to vital board feedback. As the key figure connecting the board to the CEO, the lead director is responsible for ensuring an open line of communication. According to RHR International’s own research, 50 percent of CEOs view the lead director as the board representative to whom they can speak most honestly about performance or important decisions. They must build deep trust with the CEO so he or she feels safe in discussing needs and problems, and develop the insight to see beyond the obvious and intuit any concerns the CEO may be holding back.

“Lead directors are problem-solvers, deeply analytical, and effective at asking good questions,” said Freeman Hrabowski, a director who sits on the boards of Constellation Energy and McCormick & Company. Finally, good lead directors maintain an objective clarity that allows them to keep emotions – theirs, other directors’, and the CEO’s – in check and promote rational discussion around unpopular or difficult issues.

Foster a platform of partnership between the board and the CEO
CEOs and boards must work together in a balanced environment that includes not only board oversight, but collaboration – and the lead director is the engineer of this healthy balance. If a board member gets more involved than is necessary in certain situations, the lead director often steps in to ensure this director is part of the management process, but not dominating it. Similarly, if CEOs bristle at input from directors, the lead director must guide them away from their emotional reaction to a place of productive discussion around issues. Successfully managing these interactions and maintaining a constructive relationship between board and CEO requires a lead director who has wisdom developed through years of boardroom interactions. They analyze and carefully apply lessons learned through past triumphs and failures to current challenges.

The Selection Non-Process
What all these requirements have in common is that they are somewhat intangible. And this is why there is no easily-defined process for identifying and selecting a good lead director. Of course, a formal process does exist: The board’s governance committee orchestrates lead director selection, which is natural given that group’s work around director selection and performance. However, both Hrabowski and D’Alessio agreed that as much or more happens informally than formally when choosing a lead director. One person (though sometimes more) naturally emerges as the trusted person who can step into this critical role.

Contrary to popular belief, pirate crews selected their captain, not the other way around. Each member of the crew had a say and a captain could be replaced at any time they were thought to become ineffective. While lead directors cannot be replaced at any time, their selection format is similar. There is no magic formula or management book that defines the process; it evolves differently for each organization, in a very informal way.  The best way for a board to inject rigor into lead director selection is to actively assess directors’ abilities against the requirements and behavioral qualities listed above. D’Alessio also stressed that the CEO’s input, while not the deciding factor, is very important to consider when choosing a person who will be responsible for facilitating trust and communications between the C-suite and the board.

Dr. Thomas J. Saporito is chairman and chief executive officer of RHR International, a global firm committed to the development of top management leadership.

The WCI seeks to measure companies that generate real economic value—as opposed to mere GAAP accounting value. The index relies heavily on the idea of Economic Margin (EM), which measures the degree to which the company is making money in excess of its risk-adjusted capital cost. It’s expressed as a percentage of invested capital and calculated as operating cash flow minus a capital charge all divided by invested capital. Companies with positive EM (greater than zero percent) are creating wealth; those with negative EM are destroying it.

This article originally appeared in Chief Executive magazine. Click here for the article and complete ranking charts.

While no single metric is the Holy Grail in running one’s business, EM comes closer than most, as it looks at a business the way any true owner would. How effectively is every dollar invested in this business working? It’s a discipline that applies to any firm, public or private, from a local chain of dry cleaners to General Motors. Many private equity firms use some variation of EM in doing their own evaluations; it is useful to know how people whose careers depend upon it size up one’s performance. The rankings look at public companies (minus REITs) in the S&P 500, where the CEO has been running the enterprise for at least three years, in order to fairly judge a leader’s impact on the company.

St. Louis-based Express Scripts, a large pharmacy benefit manager (PBM), landed the top position in 2011, following previous years where it was ranked #57 and #47. The company rose through the ranks largely due to to its success delivering growth through acquisitions, notably the PBM business of WellPoint in 2009, while maintaining and improving profitable operations. Express Scripts has proved skillful in integrating acquisitions, something few companies are capable of getting right.

If the proposed Express Scripts merger with Medco Health goes through, it will be a game-changing deal, doubling ES market share to about 35 to 40 percent in this industry—one where scale is everything. Needless to say, there is much potential synergy on costs, once the two are combined and retail pharmacies are potentially squeezed further. [This explains why the National Community of Pharmacists Association (NCPA) has testified before a Congressional subcommittee against the merger.]

CEO George Paz points to two factors that contribute to his company’s performance: its independence from Big Pharma and its diligence in using research to drive out waste and to make medicines safe and affordable in order to optimize health outcomes. “You can look across the healthcare industry and be hard-pressed to find any sector that makes money when it saves its clients money, yet that is exactly what we do,” he says. “We offer clients innovative ways to lower prescription drug costs and, more importantly, improve health outcomes of members.”

Other firms that consistently rank among the top performers in recent years are Aflac, Apple, Autozone, Gilead Sciences and C.H. Robinson Worldwide. Mike Burdi, Applied Finance Group senior analyst, points to several common elements that these enterprises share. “Do your customers care whether you stay in business?” he asks. “It’s one thing to say that one is customerfocused; most claim to be as a matter of course. But would your customers really miss not having access to what you offer?”

Apple (#5) is a poster child for using these elements, as is Amazon.com (#87). Meanwhile, Netflix (#25) will soon find out where it stands on that front. Apple’s challenge will be to maintain its allure after the loss of Steve Jobs. “In most research on what high-capital-return companies have in common, the common thread is the ability to consistently fulfill an unmet customer need, often when the customer didn’t really realize the need was unmet,” notes Burdi. “This is equally true whether one is big cap or small cap.” – J.P. Donlon

Top 10 Wealth Creators

1. Express Scripts, CEO George Paz
2. Exelon, CEO John W. Rowe
3. Priceline.com, CEO Jeffery H. Boyd
4. Varian Medical Systems, CEO Timothy E. Guertin
5. Apple, [former] CEO Steven P. Jobs
6. Philip Morris, CEO Louis C. Camilleri
7. Halliburton, CEO David J. Lesar
8. Gilead Sciences, CEO John C. Martin, Ph.D.
9. Linear Technology, CEO Lothar Maier
10. MetroPCS, CEO Roger D. Linquist

Top 10 Wealth Destroyers

1. Monster, CEO Salvatore Iannuzzi
2. Alcoa, CEO Klaus Kleinfeld
3. Dean Foods, CEO Gregg L. Engles
4. PerkinElmer, CEO Robert F. Friel
5. Micron Technology, CEO Steven R. Appleton
6. Nasdaq OMX Group, CEO Robert Greifeld
7. Tenet Healthcare, CEO Trevor Fetter
8. Stanley Black & Decker, CEO John F. Lundgren
9. Nisource, CEO Robert C. Skaggs, Jr.
10. Electronic Arts, CEO John S. Riccitiello

Ranking CEO Wealth Creation by Drew Morris and Michael Burdi
Our ranking is based on the performance of companies in the S&P 500 Index (and their CEOs) for the three years ending on June 30, 2011. It considers reported financial results during that period and estimates for the next 12 months. Only companies whose CEOs were in their roles for the entire July 2008 through June 2011 period were ranked. Not ranked are the 13 REITs in the 2011 S&P 500.

The four components of the ranking, explained below, were developed and calculated by the Applied Finance Group (AFG), an independent equity research advisory firm, using their proprietary metrics and data. An again-proprietary weighted combination of each company’s component rankings, taking into account the industry the company is in, is used to produce an overall score: 100 is awarded to the best wealth creator; 1 to the worst. (The list itself shows these overall scores as a sequential ranking.) The component rankings are shown as letter grades with companies in the top 20 percent of each component metric receiving an A grade; the bottom 20 percent receiving an F.

Market (or Enterprise) Value/Invested Capital (MV/IC)
This measure shows the degree to which investors consider the company’s assets valuable, relative to their cost. Market value is what a buyer would have to pay to buy the company outright, that is, to purchase all of the stock and pay off all of the loans, leases and other obligations. Note that market value depends on the stock price. Invested capital is the inflationadjusted total of all of the investments in the business. It does not depend on the stock price. So by its nature, MV/IC reflects the market’s take on the value of the investments made in the business.

The Average of the Past Three Years’ Economic Margins
Economic Margin (EM) measures the degree to which the company is making money in excess of its risk-adjusted capital cost—riskier businesses get relatively higher capital costs. EM is expressed as a percentage of invested capital. It’s calculated as (Operating Cash Flow – the Capital Charge)/Invested Capital. Companies with positive EM (greater than 0 percent) are creating wealth; those with negative EM are destroying it.

EM Change
This is a 12-month forecasted EM, based on the ratio of the most recent EM to the 3-year average.

Management Quality
This AFG-proprietary measure rewards a company with positive EM for growing its asset base, and penalizes one with negative EM for doing the same thing. In other words, if a company is making money and it adds assets in such a way that it can make even more, that’s good. So is selling off a money-losing division. That said, it’s also valid that adding scale can dramatically increase profitability in a business with high fixed costs.

A Validity Check on the Ranking Method
The top 50 companies in the ranking delivered an average Total Shareholder Return (TSR) of 68.5 percent between January 2008 and June 2011 (the period covered in the reported financials). The bottom 50 companies’ TSR averaged -9.3 percent, while the S&P 500’s average was 14.9 percent (without its 14 REITs). The top 50’s median TSR was 40.7 percent; the bottom 50’s was -11.7 percent.

Total Shareholder Return

As the table above shows, the top 50 companies in the wealth creation ranking far outperformed the bottom 50 companies and the S&P 500 between July 2008 and June 2011. Note: TSR = (Change in Share Price over Period + Dividends)/Start-of-Period Share Price.

For more on Economic Margin and how companies scored, see http://www.economicmargin.com/moreinfo.htm.

Peter York

Instead of applying their business smarts to nonprofits, many directors who are new to the nonprofit world use the same narrow perspective that unreflective donors often adopt – that the chief indicator of a non-profit’s performance is the percentage of its budget that goes to programs versus the percentage that goes to infrastructure.  It is simply assumed that the more money that goes to programs, the better.

Yet in the business world, these same men and women certainly encourage management to invest in infrastructure – the technology, talent, research, and other resources – that enables the company to produce its products and services and to succeed on an ever growing scale. Encouraging these standards is precisely how some of the largest and most successful nonprofits such as the Girl Scouts or Big Brothers/Big Sisters have been able to bring the benefits of their programs to larger and larger numbers of people.

Unfortunately, most nonprofits remain stuck in the bind of overhead versus programs, preventing them from scaling up their activities to produce greater impact. Directors with for-profit experience are in a unique position to help.  They understand the logic, economics, and metrics of infrastructure investment. For most, scaling up an enterprise is a core competency. And because breaking out of the overhead/programs mindset is such a fundamental reorienting of the organization and its policies and priorities, it requires not only the support of the board but its active involvement and leadership. Specifically, these board members can:

• Insist on the same expectations for infrastructure investment that exist in the for-profit world. In their oversight roles, directors with for-profit experience should ask to be shown program results, as well as what has been invested strategically to take those programs to scale. In the for-profit world it is simply unthinkable that an enterprise could function on a large scale without systems, technology, marketing, HR support, appropriately compensated leaders and a host of other resources. Success comes with costs, and directors from for-profits should not shrink from applying these fundamental principles to nonprofit boards.

• Acknowledge that data about the costs of outcomes is fundamentally lacking. Those infrastructure investments should of course be cost-effective, producing the biggest bang for the buck. But the truth is that most nonprofits have no data about the proper ratio of overhead to programs, no notion of the possible ‘margins,’ no research on the cheapest way to achieve the greatest impact. Unless that fundamental fact is acknowledged, the organization is simply likely to try to keep overhead as low as possible rather than trying to achieve the optimal balance of overhead versus programs.

• Urge the organization to work with other nonprofits to collect data and establish the costs of results in specific programs. In the for-profit world, companies calculate costs and margins for each product or service. The only way for nonprofits to answer the overhead question is to undertake a comparable effort with specific services and programs. By pooling data with organizations that pursue similar programs, non-profits can collectively calculate the cost for particular results and develop realistic cost models that donors and other stakeholders are more likely to accept.

Motivation
Executive compensation policies should motivate high-level managers to make decisions that are compatible with the organization’s strategy. However, many would argue such compensation practices failed to achieve this mission over the past two years, or adequately discourage executives from excessive risk taking. Already a complex issue before the recent economic crisis, executive compensation is now a critical issue for organizations of all sizes.

Authors Harry Cendrowski and Adam Wadecki

In general, while public companies appear to have stolen the executive compensation spotlight, compensation plans for private companies remain an essential motivating factor for employees. These plans can provide smaller companies with the power to attract talented individuals as well as a mechanism to motivate key employees.

There are four fundamental steps directors, executives and others involved in the compensation-setting process can employ in attempting to satisfy stakeholders while also ensuring executives and employees remain properly incentivized.

Executive Compensation Defined
For the purposes of this article, compensation is divided into four elements: base salary, benefits (including perquisites), short-term variable pay and long-term incentives. While the first two categories are self-explanatory, short-term variable pay is compensation not included in base salary that relates to performance achievements over a short period of time (generally a year or less) and most often does not exceed a typical business cycle. Short-term variable pay typically includes bonuses and incentive payments earned when an executive exceeds pre-defined goals. Long-term incentives are compensation components that reward executives for achieving goals over a time period that exceeds one business cycle. The equation below presents a definition of executive compensation using four compensation elements.

Total Executive Compensation = Base Salary + Benefits + Short-term variable pay + Long-term incentives

All other things equal, talented executives will be looking for compensation packages whose expected value is commensurate with their historical experience and expertise, as well as the potential value they can bring to a firm. A compensation package’s expected value is:

Expected Value = ∑ Compensation Element_i x Likelihood of Payout_i

Within this equation, each of the four previously mentioned components of executive compensation is multiplied by its likelihood of payout to arrive at a compensation package’s expected value. Note that the likelihood of payout will generally vary by component. The structure of executive compensation packages, as well as the likelihood of payout, largely depends on the nature of a compensating organization and its strategy.

Step One: Understand the Nature of the Organization and Its Strategy

The first step in devising an appropriate compensation plan requires compensation managers to understand their organization’s current stage of development and strategy for its future. For the purposes of this article, we separate organizations into three categories: start-up, growth and mature organizations. Start-up firms, by definition, are those that are just beginning life. In their nascent stages, these organizations generally do not possess positive cash flows from operations, though they may have some form of revenue stream or established customer base. Growth firms are organizations that are more mature than start-ups, but are continuing down a path of significant year-over-year cash flow growth. These firms generally have positive cash flows, but they may lack historical stability. Some growth companies serve developing markets that may not yet allow the company to experience stable revenues. Mature companies do not see consistent year-over-year increases in cash flows above the rate of GDP growth. They frequently participate in nongrowth industries and generally achieve modest cash flow growth through cost containment rather than revenue expansion. Exhibit 1 depicts these organizational stages with respect to a firm’s operating cash flow.

Exhibit 1: Stages of Development

For several reasons, compensation managers must understand the nature of the organization, its strategy and the metrics it values. A company’s ability to compensate its key employees—and the ways by which it can do so—is greatly dependent on the stage of the company. Executive compensation plans must also reinforce the organization’s strategy in order to ensure long-term value is created for shareholders.

Many start-ups have strategies that are evolving with the milestones that they meet. Their products may not yet be fully developed. However, virtually all start-ups are united in one element of their strategy: they want to become cash flow positive. Positive cash flow allows a start-up to become a viable venture capital candidate. It also signifies the firm has taken a step toward the growth stage. In order to assist a start-up in building cash flow, executives are frequently compensated through long-term incentives. Such a compensation scheme allows the company to preserve cash while ensuring executives are incentivized to build long-term value in the company. Executives cannot realize the full value of their compensation package until a financing or liquidity event takes place. Even with such an event, the full payout of a long-term incentive package might not be realized. Because long-term incentives have less likelihood of payout as compared to annual base salaries, an executive may require greater amounts of such compensation in order to compensate them for the chance that their incentives might not realize their initially estimated future value.

Within the growth stage, base salary and benefits become increasingly standard components of executive compensation. If a company has made it through its start-up phase, its risk has decreased commensurately with its success. Consequently, founders and investors will likely be less willing to provide executives with portions of stock or options befitting a start-up, though these may still be important components of an executive’s pay. Furthermore, the company’s cash flows permit higher base salaries to be paid to these individuals, and short-term incentives, including annual bonuses, become increasingly important in this stage.

By the time a company reaches the growth stage, a foundational strategy is in place. Compensation managers should examine this strategy when tailoring executive compensation packages. For instance, a company might possess a strategy to produce the highest-quality goods on the market. In such a case, an executive compensation package should contain metrics related to customer satisfaction, customer retention, returned items and warranty claims.

Once the organization reaches a mature stage, it will be difficult to motivate employees through long-term incentives, though short-term bonuses are frequently used to compensate key individuals. Unless a mature company is growing revenue in some area of its business, it is unlikely that its value will increase through revenue growth. Rather, its value is likely to appreciate through cash flow and earnings stability. This stability is often a component of mature organizations’ strategy which is sometimes achieved through diversification or divestiture of nonperforming assets.

Exhibit 2: Importance of Plan Components by Organizational Stage

Step Two: Select Appropriate Compensation Metrics
Compensation managers should use a variety of metrics in evaluating the performance of executives, including financial, product quality, operational and internal growth goals.

Financial. In order to more accurately assess an executive’s performance, compensation managers should focus on organizational metrics that most closely resemble the company’s operating characteristics. Two such metrics related to the organization’s finances are operating cash flow and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Compensation managers should use these metrics to manage compensation plans for the same reason they are used or examined by valuation professionals: they perhaps best showcase the operating nature of the business.

Although not an accrual-based metric, operating cash flow, rather than net income, can generally give compensation managers a clearer picture of the company’s affairs. Moreover, operating cash flow takes into account a company’s working capital (receivables, payables, and inventory) while eliminating noncash charges associated with depreciation. EBITDA is similar to operating cash flow; however, it does not take into account working capital or the firm’s capital structure. Capital structure may be an important consideration for many companies as they deleverage their balance sheet and control interest expense in the near future.

Financial metrics are generally used in defining parameters for short-term variable pay or long-term incentives for companies of all stages. For instance, an executive might receive a bonus for achieving market share or earnings growth. Nonfinancial metrics, however, should be incorporated into these components of executive compensation.

Nonfinancial. Other metrics should also be used in devising executive compensation plans. In the early 1990s, Balanced Scorecard pioneers Robert S. Kaplan and David P. Norton asserted that financial metrics should, at most, represent one category of metrics that managers should employ in measuring their firm’s performance. However, while the approach advocated by Kaplan and Norton is now used within the strategy department of many organizations, it appears the philosophy it espouses has not yet been embraced in most compensation plans.

According to Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, executive compensation is typically based on “a blend of earnings targets, sales targets, sometimes the success or failure of dispositions or acquisitions and the company’s stock price.” According to Elson’s description, a Balanced Scorecard-like approach to executive compensation seems conspicuously absent. It is simply a reflection of the environment in which many companies operate: whenever a business is valued, nonfinancial metrics rarely play a part in the valuation. However, these metrics are some of the most important to track, especially in organizations that are focused on achieving high growth levels. As Benjamin Heineman, former general counsel of General Electric and fellow at Harvard’s JFK School of Government, recently stated, “Executive compensation shouldn’t merely compensate individuals for short-term stock price appreciation.”

A balanced approach comprised of numerous metrics should be used in evaluating key executives and managers. The saying, “What gets measured, gets done,” appropriately speaks to the incentives created by executive compensation. Compensation plans will always focus in part on financial metrics. However, the best CPA compensation managers will recognize that financial metrics are outputs of organizational processes; they are not inputs.

The method by which the organization operates will drive top-line growth and bottom-line improvements. Product quality and operations often tie directly to financial results. In general, compensation managers should look to include metrics related to product quality, operations and internal growth—examples of which are shown in Exhibit 3—within their executive compensation plans. Inclusion of these metrics can incentivize executives to achieve organic growth through long-term value creation rather than short-term value inflation that might result through an intense focus on financial metrics alone.

Exhibit 3: Example Nonfinancial Metrics

Inclusion of these metrics in compensation plans can further assist the organization in achieving its financial goals and also help executives cascade compensation metrics down through the organization.

Achieving a Balance of Financial and Nonfinancial Metrics
An appropriate balance between financial and nonfinancial metrics must be achieved for executives to be properly incentivized. The weighting between financial and nonfinancial metrics is dependent on the organization’s stage. Exhibit 4 presents a sample weighting of financial and nonfinancial metrics as well as base salary and benefits. As shown in the exhibit, base salary and benefits grows as the organization matures. This growth in base salary is commensurate with the organization’s cash flow-generating ability. Financial goals are extremely important for start-up companies as they travel down the road to profitability. They are also important for mature organizations looking to gain shareholder value through cash flow and earnings stability. Lastly, nonfinancial goals are perhaps most important in growth companies where profitability has been demonstrated, but sound strategy execution is needed to take the organization to the next level.

Exhibit 4

Step Three: Cascade Compensation Metrics Throughout the Organization
Compensation metrics should reflect the organization’s nature and its overarching goals; therefore, it is imperative that such metrics be appropriately cascaded down through the organization. In smaller companies, this generally means ensuring lower-level managers’ remuneration schemes mimic those of their executives.

In some cases, it will be necessary to translate high-level organizational metrics for employees to afford them ownership of metrics within their compensation packages. For instance, if directors of a company are concerned with growth in net earnings (as is typically the case), what does this mean to plant managers? Should they be measured on the firm’s growth in net earnings? Would they take ownership of such a metric?

In such a situation, it is best to translate this goal for such an individual so that he or she can directly affect it: the plant manager could instead be measured on the facility’s throughput, labor cost, lead time or product quality, each of which impact net earnings and are under his or her direct control. As such, this process can be more easily facilitated if high-level executives are measured on a variety of metrics outside of those directly related to the firm’s finances. Such a practice allows for a more intuitive cascade of compensation metrics throughout the organization.

Large corporations pose numerous challenges to the aforementioned cascading process. A key element of executive compensation plans for mature companies is the compensation plan of divisional managers. Large corporations are often composed of many divisions, with the degree of autonomy exercised by each division varying by company and industry. Compensation of divisional managers is especially difficult because a division’s financial performance may be distorted by inter-company transactions and accounting methods.

In compensating these individuals, compensation managers should bear in mind that the organization’s goal for the division may differ from that related to the company itself: while the company may be in one phase of organizational development, the division may not resemble the corporation as a whole. In this sense, compensation managers should view the division as its own entity in devising appropriate compensation schemes. They must understand the division’s stage of organizational development and how it differs from that of the complete organization. Divisional managers, where possible, should be more heavily compensated on metrics they can influence, rather than those beyond their control.

Step Four: Monitor Performance of Plans
In monitoring the performance of executive compensation plans, compensation managers need to first make an objective assessment of each executive’s performance. This assessment should include an investigation of the company’s past performance against other firms in the industry, as well as potential future benefits that the executive has been responsible for creating. This latter component is especially important for executives operating in turnaround settings where the company might have been performing poorly prior to the executive’s arrival. Much as one cannot expect a first-year football coach to lead last year’s 0-16 team to an undefeated season, compensation managers should evaluate executives based on realistic expectations that may differ from company to company in a given industry.

The selection of an appropriate peer group against which executive pay is benchmarked is an important component of the executive compensation process. However, in the extreme, deference to peers can eventually lead to “herd behavior” within the executive compensation process: directors may act according to the actions of others, rather than in the best interest of the company they represent. Thus, directors should ensure that their compensation monitoring process examines not only peer actions, but also takes into account any idiosyncrasies that separate their company from its peer group.

Compensation managers must also take into account the accuracy of underlying data used in compensating executives. Most large corporations use accrual-based accounting methods which necessarily require calculation and recording of reserves, estimates, and accruals. This process inherently allows executives and financial managers to exercise subjective judgment in preparing financial statements. The larger the company, the more judgments it must make with respect to accruals. In contrast, smaller companies, especially start-ups, will use accounting methods more closely tied to cash flow—some may even use cash flow-based accounting methods. The “noisier” the data employed by compensation managers in their monitoring of executive pay, the more work they will have to perform in order to discern whether an executive’s actions are commensurate with the company’s strategy.

Harry Cendrowski, CPA, ABV, CFF, CFE, CVA, CFD, CFFA is a founding member of Cendrowski Corporate Advisors.
Adam Wadecki is a manager of operations with Cendrowski Corporate Advisors and specializes in operational analyses and quantitative risk management modeling.

Today, more and more, it’s Evaluation 3.0–a rigorous annual review that includes the CEO’s self-assessment. The review considers numbers, of course, but beams in as well on that less quantifiable aspect of CEO performance: leadership. Consider a few examples of Evaluation 3.0:

-  Microsoft evaluates the CEO against “company culture/leadership objectives.”

-  Xerox applies “Leadership Effectiveness Measures,” such as employee morale, strategic leadership, and enterprise guardianship.

-  Delta asks the CEO to self-evaluate in “strategic planning, financial matters, and leadership.”

-  Fiserv applies criteria for strategic and succession planning, senior team development and performance, client and shareholder relations, ethics and compliance.

While financial results are easy to measure, they reflect the past. Leadership, more difficult to measure, is critical precisely because it predicts the future.

Six key areas of 21st-century leadership may help boards structure a true CEO Evaluation 3.0. AchieveGlobal identified these areas in a 2009 worldwide study. We analyzed 80 recent leadership studies, tested summary findings with executive groups, launched a global survey yielding 971 responses, and identified 42 best practices–some behavioral, some cognitive–sorted into six categories, or zones, of leadership.

Boards may find it useful to compare their CEO’s actions and abilities with those of successful leaders in each of the following six zones.

Zone 1: Reflection (Finding Strength Within)
CEOs who succeed in a turbulent economy regularly consider the limits of their knowledge and strive to grasp the changing big picture. They reflect often on their challenges and the impact of their decisions and actions. These executives openly acknowledge their mistakes as they seriously entertain views that differ from their own. Aware of their natural tendency to overvalue their abilities, these leaders seek an objective picture of their strengths and liabilities, see failure as a chance to learn and grow, and cultivate lifelong learning and development.

Zone 2: Diversity (Finding Value in Human Differences)
An effective CEO can tap the capabilities of under-represented groups, value their contributions and develop their careers. Such a leader fosters collaboration among people very different from one another, whether that difference reflects gender, ethnicity, age, nationality, beliefs, education or work styles. Critical in a global economy is a leader’s deep appreciation of other cultures and their impact on how people process information, express themselves and engage with others. Business history is rife with examples of failed global initiatives headed by leaders blind to the role of diversity.

Zone 3: Ingenuity (Accelerating Innovation)
Leaders who excel in this zone continually rethink the status quo, seeking corporate agility and regular reinvention. They allocate resources to ideas with the greatest potential. They understand that breakthroughs come when leaders at all levels create an environment in which innovation thrives. As they develop ways to share intellectual capital, leaders strong in ingenuity focus R&D efforts by embracing Peter Drucker’s conclusion that the purpose of business is to serve customers.

Zone 4: People (Connecting on a Human Level)
Effective leaders seize opportunities to make human connections with stakeholders and people up and down the supply chain. These leaders know that a sense of belonging strongly affects commitment and action. Though leadership requires dynamism to communicate urgency and boost enthusiasm, these leaders also recognize the need to listen, empathize and show humility. Leaders effective in the people zone model what they expect of others. By encouraging work-life balance, engagement and team-building, they promote a culture that attracts and retains the best talent.

Zone 5: Society (Working for the Common Good)
Corporate citizenship is good for business. It promotes an economy unfettered by excessive regulation. It protects assets through sustainable business practices. It builds open relationships that foster cooperation. As James M. Kitts, former CEO of Gillette and Nabisco, has said, CEOs must “tell the truth”–to the public as well as their boards. Further, our study found that socially-aware executives make fair decisions regardless of any negative impact on themselves, that they reward employees based on merit, not politics, that they groom worthy successors and that they personify the best company values to all constituencies.

Zone 6: Business (Planning and Execution)
Successful CEOs focus on the long-term future rather than analysts’ quarterly expectations. Working with the board, they create strategies that leverage the company’s unique strengths, set workable goals, develop implementation plans in line with company values and establish milestones for judging progress. Even with ambiguity and insufficient information, these executives are decisive, balancing risk, competitive intelligence, industry trends, and the need to control operating costs without compromising customer satisfaction. Employees see them as leaders who can mobilize the workforce to meet ambitious goals.

Why Have CEO Evaluations?
Boards have solid business reasons for their increased focus on CEO evaluation. Apart from helping to meet fiduciary responsibilities, evaluations allow greater objectivity about CEO compensation and they set an example of accountability and dialogue for the entire organization. At the same time, many CEOs now share their evaluations with senior managers to promote a culture of openness and personal development.

So, whether they employ the six leadership zones or other criteria, carefully focused CEO evaluations can bring immeasurable value to the entire organization.

Sharon M. Daniels is CEO of AchieveGlobal, which provides performance-improvement consulting and solutions in leadership, sales and customer service. With offices in 42 countries, the company offers customized learning in 30 languages and dialects.

Diamond was among a distinguished roster of our nation’s decision makers in banking, government, regulatory agencies and stock exchanges convened yesterday at the third annual NACD Directorship Forum convened to discuss the most pressing issues facing corporate boards today. The day-long conference, hosted by the National Association of Corporate Directors and Directorship, brought together more than 150 public company directors at the Union League Club in New York City.

“The demands on directors today have never been greater.  Boards are navigating a constantly changing environment where accountability and leadership is now personal,” said Kenneth Daly, President and CEO of NACD.  ”The key take away today is the urgent need for directors to demonstrate exemplary board leadership, and as the voice of the director, the NACD is helping empower corporate boards including Dow Chemical, Kimberly-Clark, Aetna and Home Depot to lead the way in restoring public and investor confidence through principles-based board leadership known as the NACD Key Agreed Principles.”

Diamond Jr. delivered the Forum’s keynote address and shared his views on the current state and future prospects of the global banking sector, the pending U.S. financial reforms and how Barclays has navigated the recent financial crisis.  Diamond sees banks playing a critical role in the private sector’s ability to drive growth and believes that it is a myth that banks don’t want regulation: “We support greater transparency in derivatives markets, but our clients (corporations, pension funds or governments) need customized derivative products for raising capital and managing risks. Funding and derivatives go hand in hand.”

Delegates at the NACD Directorship Forum also heard from Congressman Spencer Bachus (R-AL), ranking member of the House Financial Services Committee, who discussed the financial reform legislation currently in conference between the House and Senate and its implications for corporate boards.

This approach was reinforced by the panel led by Brian Breheny, deputy director for legal and regulatory policy in the division of corporate finance at the Securities and Exchange Commission along with former SEC Commissioners Paul Atkins, Annette Nazareth and Richard Roberts who discussed SEC activities, the current regulatory environment, shareholder activism and the impact on corporate governance. Opening remarks were made by former SEC Chairman Harvey Pitt.

Participants also heard perspectives from Duncan Niederauer, CEO of NYSE Euronext, who addressed the state of the financial markets, initiatives that have been taken since the global crisis and the current legislative and regulatory environment.

The NACD Directorship Forum concluded with a first-of-its-kind interactive session titled “Choose Your Crisis ” in which leading crisis experts looked at the disruptions facing global board directors at such companies as BP and Toyota. This engaging discussion will challenge world-class directors and advisors to respond to the diversity of issues involved including board/executive communications, legislative/regulatory inquiries, board/executive changes, litigation, shareholder activism and reputation management.

During the keynote address, Diamond also equated increased financial regulation with an eventual “boost” to private sector economic growth to “balance the necessary public sector action that the current economic situation requires.” He warned that government deficits need to be “tackled” by a reduction in public spending–resulting in an increase in private-sector growth. “If the private sector is to drive economic growth, it needs: access to funding; ability to manage risks; and to carry out business across borders,” Diamond said. The ever-global economy requires financial institutions to manage, not run from, risks associated with borrowing, foreign exchange rates and commodity price fluctuations. Global trade is key to an overall uptick in economic recovery. According to Diamond: “Big banks, properly managed, can have safer models and risk management than small ones.”

View the webcast of Diamond’s speech by clicking here.

Of the 126 C-suite executives primarily from Fortune 1000 companies polled, nearly 94 percent expressed a level of concern about the impact that reform legislation could have on their business’ bottom line.

Among the issues of highest concern:

• Cost of compliance: 68 percent

• Government intervention in business: 52 percent

• Difficulty planning while awaiting reform passage: 42 percent

Nearly all executives agreed that risk management will be a focal point. The uncertainty surrounding reform is believed to negatively affect long-term planning. Executives believe that Congress will continue to expand reform beyond the financial services and healthcare sectors. Thirty-two percent of financial services executives and 30 percent of healthcare executives cited government intervention as their greatest concern. Executives outside the financial services and healthcare industries told KPMG that “reform would slow growth and threaten economic recovery.”

“A perception among these top executives that reforms are potentially a net positive suggests an acceptance that the old rules are out and a new playbook is coming from Congress,” said Henry R. Keizer, vice chair-audit for KPMG LLP.  “It’s likely this is an acknowledgement that some amount of regulatory reform is appropriate to further restore trust in the financial system.”

While executives expect regulatory reform, 66 percent believe accounting standards should be left the same and 67 percent of executives polled feel disclosure requirements should be left the same.

In 2010, 57 percent of executives reported that regulatory reforms have already had an impact on their business plans for the year. Of those making proactive changes in anticipation of increased regulation, 71 percent are making changes to risk management policy while 24 percent are either changing product approval and/or disclosure practices.

Click here for the full report.

The KPMG Regulatory Reform Survey was conducted in March 2010 among 126 C-suite executives from a cross-section of industries, with the heaviest representation from the healthcare and financial services sectors.  About 59 percent of the respondents represent Fortune 1000 companies and about 80 percent of respondents represent companies with annual revenues exceeding US $1 billion.

NACD Directorship: Has the boardroom of 2010 undergone a sea change?
Noski: Yes and maybe no. I think we have the Sarbanes-Oxley compliance aspect nailed down. We spend a great deal of time with strategy and succession. If a business isn’t in duress, the board’s work is fairly straightforward. But if you pick the wrong CEO, you have just wasted the next five years because it takes a few years to assess and terminate the current CEO and then a few years for a successor to get up to speed. So to me, succession is a key skill and a critical responsibility that is sometimes overlooked in the regulatory frenzy.

ADDITIONAL COVERAGE IN THE BOARDROOM GUIDE FOR NEW DIRECTORS:

A Message to New Directors

The Renaissance in Succession Planning and Board Recruiting

Congratulations, You’re the Audit Committee Chair. Now What?

Performance and Pay Alignment: A Top Priority for Compensation Committees

NACD Directorship: What are some of the challenges for new directors?
Bromilow: I have seen new directors struggle in some areas. It’s important for directors to understand the culture. Different companies operate in very different ways, so understanding how to work within that framework is important. To the extent the company is in a unique industry, it may also be a challenge to understand the business model and the special risks. New directors should also understand how the board approaches its oversight role.

For directors new to the audit committee, there is an additional layer of challenge. Financial reporting is complex and audit committee members should understand how the company deals with it. It includes understanding how financial information rolls up, the key players in the finance function and the applicable regulatory and compliance matters.

NACD Directorship: Pfizer is a leader in corporate governance, how do you orient new directors?
Kenney: Pfizer has a very robust director orientation process with scheduled meetings with each of our division heads and other senior leaders over the course of six to nine months. We give directors a significant amount of information to contact any member of senior management, including the controller and treasurer. We provide not only office contact information but also their home contact information. This is management’s way of saying to our directors, “We have confidence that you can go directly to any of these people with questions.”

NACD Directorship: Norm, suggestions for the new director?
Augustine: When I served on one board, we had a board dinner the night before each meeting. At every dinner we would assign one member to talk about his or her life. It changed the tone of the board and its effectiveness. We all looked at each other quite differently when we knew more about each other. It helped us work together much more effectively.

NACD Directorship: How much time do directors now need to devote to board duty?
Kopelman: The surveys indicate this has increased significantly over the last decade, but recently leveled off. Trying to overlay upwards of 175 hours of annual board service—
including review and preparation, travel, board and committee meetings, plus informal calls and emails on top of a full-time staff or line job is surely a challenge both for the executive and his or her employer. Recently retired, seasoned executives seem to be able to get up to speed quickly and devote the ongoing time.

NACD Directorship: Are there specific skills for new directors?
Levine: Independent judgment. The proxy rules from December 16 now require for the first time that boards explain their selection criteria philosophy. For me, that is key—does that person have the ability to have a challenging discussion without becoming too personal? Directors need to keep their cool but also know when to strike it hot. I would also add that they should have a burning curiosity about the important things. It’s important to understand their individual potential contribution as well as how they will impact on the creation of meaningful board dialogue.

Barry: Boards look for specific skills in new directors that may be currently lacking—which can reflect the sector or the company’s condition at the time. So while the specific skills being sought will differ from company to company, there are skills and attributes that are important for all directors. First, directors should bring  broad business experience and an appreciation for contemporary management techniques and leading practices. Second, directors need to demonstrate leadership. This encompasses strategic thinking and planning, decision making, negotiation and problem solving. They also must have the courage to ask tough questions and to probe management when they are uneasy. Third, it’s important for directors to have insight, judgment, integrity and a sound professional demeanor—to disagree without being disagreeable.

NACD Directorship: Should “on-boarding” be a formal process? What special recommendations would you have?
Noski: What I ended up doing was to design my own onboarding. Once I understood the organization, I would advise the CEO or lead director that these are the people that I want to go and spend time with. My early experience was largely trial and error. Now, I work with the board chair or lead director and we have designed a program for incoming directors. Another novel approach is to have a policy of not assigning new directors to serve on committees in their first year.

Bromilow: Boards don’t turn over that quickly, so companies often have an ad hoc onboarding program. Director candidates should conduct due diligence before accepting any nominations, so they will already have some insight into the company. But that doesn’t preclude the need for proper orientation, which should include, at a minimum: the company’s strategic plan; a discussion about the key risks the company faces, how it mitigates those risks and the board’s role in risk oversight; and an introduction to the management team and an understanding of the succession plan.

From PwC’s perspective, audit committee orientation for new members should start with a discussion of financial reporting, including areas of key judgment. Then it should introduce the key players from finance, internal audit and the external audit team. It should also cover how the audit committee discharges its other core responsibilities over areas like compliance.

Kopelman: We have to make a distinction between folks who have never sat on a public board before and those who have a couple of directorships under their belt. You need to make sure that new directors get a grounding in governance—that they thoroughly understand the board’s role and especially how it differs from management’s, both legally and practically. I have seen an informal buddy system—assigning a sitting director to each newcomer—work well. Also, I’m involved with onboarding directors for companies coming out of Chapter 11: You’re parachuting people in who need to start functioning as a team. It will take time for them to gel and function effectively as a group—just look at the Yankees over the last eight years!

NACD Directorship: Norm, what have you seen that works?
Augustine: The best example I can think of comes from Procter & Gamble. As the board would travel to various parts of the world, P&G would arrange for us to visit people in their homes and sit down with real customers—housewives, children and families. We’d ask them about Tide—why don’t you buy Tide? In one case, the reason was that when the housewife had to buy soap she had to walk a considerable distance home with a huge box—so she wanted small packages even if they were less economical. The result was Tide produced and sold in smaller boxes. You can’t merely have the corporate staff tell you what the business is about you have to get out and see it.

NACD Directorship: Scott and Glenn, do you or the NYSE have a view to share?
Cutler: I agree that relationships with management, service providers and customers are extremely important for directors, as is having an understanding of governance. But more than ever, corporate boards have to focus on the company’s stock, its shareholders and what influences their decision-making. There aren’t enough boards that have an active dialogue with shareholders, and boards ought to think more about that.
Tyranski: What does the investing public think? Investors are really counting on boards to reach out and meet with the right person beforehand and ask the right questions.

NACD Directorship: John, in terms of understanding risk, what extra measures should the audit committee be taking?
Morrow: I can’t overstate the importance for audit committee members to get to know the people in the finance function, including the CFO, controller and other significant players. There is so much that can go wrong within the finance function—so much opportunity for fraud and malfeasance—that audit committee members should get to know the character and integrity of individuals in key finance function roles.

NACD Directorship: What about new directors and that highest profile of subjects, compensation?
Ferracone: The compensation committee is certainly where the accountability resides, and the workload has increased due to added regulation and scrutiny. The board members on the compensation committee really do need some structured training. It is often said that many board directors have skills from their careers that are quite relevant but ironically, few have experience with executive compensation. So at Farient, our orientation begins with the framework that provides the new director with a strong but basic background—looking first at a detailed view of the external landscape. We then also capture the compensation history in the company, its peer group, its pay philosophy, its plan designs, as well as internal issues. We then take new compensation committee members through the alphabet soup of technical items: 162(m), 280G, 409A, SEC disclosure rules and long-term incentive valuation models.

Our overarching goal in this exercise is to train the new director to be on the lookout for program design features and scenarios that develop into outliers. Finally, with respect to performance and pay alignment, we show how to test to what extent their company’s performance and pay are aligned.

NACD Directorship: What are some of the smart compensation practices you have seen?
Augustine: The first question many people outside the corporate world ask is whether the CEO for this or that company is worth 250 times the wage of the lowest paid worker. That may seem like quite a disparity. But take the experience at P&G where A.G. Lafley led an effort that rewarded shareholders with billions of dollars in what was essentially a “turnaround.” What was he and his team worth to a shareholder?

I’m a believer in pay for performance, but that is not always so simple. What if companies perform poorly, not because of CEO performance but because of a poor economy? Should the CEO and management then be penalized? When things are going badly management is not enjoying life; the job is much more arduous—dealing with constituencies that are quite unforgiving. This is the last time one would want to risk losing a good CEO. But if we pay generously when things go up, do we not cut pay when things are in decline? It is also noteworthy that in the military they give medals for bravery in retreats, too.

NACD Directorship: Norm, it is nuanced as you say, but we have to deal with it. Any suggestions?
Augustine: Many of the issues around compensation can be resolved through a few smarter practices. “Holding periods” are an example. I strongly believe management should hold the stock resulting from the exercise of options, after selling the necessary amount to pay taxes, for at least three years. I also favor certain clawback provisions, which can be an excellent reminder of the need for long-term performance. Whatever the case, judgment is crucial; don’t trap yourself with formulas alone.

Gershkowitz: The most important issue we are helping clients to address is how to truly ensure that pay is aligned with performance. Virtually every company makes this claim but we now know that it is much harder to achieve than one thinks. Farient has developed a visual representation of alignment that is underpinned by a quantitative model that we use with compensation committees to take a snapshot of their current degree of alignment relative to the broad market, their industry and even a specific peer group.

We also work with committees to run different scenarios to see how it might be possible to improve alignment by introducing new programs or redesigning some features of current programs. For example, using a fixed-share approach to stock option awards will have a different impact on alignment going forward than a value-based approach.

Similarly, a performance-share plan will have a different impact on alignment than a stock option or restricted stock plan. In the current environment, the ability to determine where a company stands in terms of pay and performance alignment and model out future scenarios before approving new plans, plan changes or plan exceptions can be a powerful decision-making and governance tool for compensation committees.

The Boardroom Guide for the New Director Advisory Council

Norman R. Augustine, former chairman and CEO, Lockheed Martin
John J. Barry, partner and leader of the corporate governance group, PricewaterhouseCoopers
Catherine L. Bromilow, partner, corporate governance group, PricewaterhouseCoopers
Christopher Y. Clark, president and publisher, Directorship
Jeffrey M. Cunningham, chairman, CEO and editorial director, Directorship
Scott R. Cutler, EVP/co-head of U.S. Listings and Cash Executions, NYSE Euronext
Robin A. Ferracone, executive chair, Farient Advisors
Todd M. Gershkowitz, senior vice president, Farient Advisors
Steve Kalan, associate publisher, Directorship
Rosemary Kenney, director, corporate governance, Pfizer
Kenneth P. Kopelman, partner, Kramer Levin Naftalis & Frankel; director, Liz Clairborne; president, New York chapter of the NACD
Gregg A. Krowitz, VP/listings strategy and analytics, NYSE Euronext
Stuart R. Levine, chairman and CEO, Stuart Levine & Associates; director, J. D’Addario & Co., Broadridge Financial Solutions
John F. Morrow, director, corporate governance group, PricewaterhouseCoopers
Charles H. Noski, director, ADP, Air Products and Chemicals, Microsoft, Morgan Stanley
Glenn W. Tyranski, SVP, financial compliance, NYSE Euronext
Judy Warner, chief content officer, Directorship

Over-regulation, globalization, changing liquidity profiles, financial complexity—these were just a few of the topics discussed at this year’s Audit Committee Issues Conference. “Against the backdrop of a rapidly changing business environment and a still fragile economy, there are a host of challenges and opportunities confronting business leaders,” said Henry Keizer, KPMG’s Global Head of Audit, during opening remarks. “The key will be to understand your changing business fundamentals and to focus on the areas of greatest impact in the months ahead.” Roundtable participants included Fortune 500 public company directors who serve on the boards of such prestigious companies as AIG, AXA Financial, Comcast, ExxonMobil, JPMorgan Chase, Microsoft, Oracle, PetSmart and UnitedHealth. NACD Directorship’s chairman and editorial director, Jeffrey M. Cunningham, moderated the wide ranging and provocative discussion between these veteran directors and governance gurus.

ADDITIONAL COVERAGE FROM THE ISSUES CONFERENCE:

• Survey results: The Top 10 Concerns of Today’s Audit Committees
• Arthur Levitt: “The Real Governance Problem”
• Donna E. Shalala: Prescient remarks about healthcare reform
• Harvey L. Pitt: “Ten (or so) Golden Rules” for boards

A New Normal in the Boardroom?
The baseline for discussion was set against the question of whether board directors see a return to business as usual or what was referred to as the “new normal.”

“From my experience, I think we’ve learned to imagine the unimaginable,” said Charles H. Noski. “Just consider that several institutions that were around for a century or more don’t exist any longer. In boardrooms today, the talk is routinely about the new normal, which simply means we are still in an economic recession that has occurred globally and broadly, so yes, there is a new normal.”

Another theme repeatedly echoed was the nature of changing business models and not only for financial services, where impending legislation could still rewrite the rules for large banks, insurance companies and private equity. Michele J. Hooper said that while the economic crisis accelerated restructurings at some businesses, others face different but equally daunting challenges. “For pharma companies, there is the constant of pricing pressures, the challenge to develop patents, the time and cost to develop new drugs, changes to sales and marketing models…[these] are global issues for the industry,” Hooper said. “As healthcare budgets are challenged around the world, the pressure on exactly who is going to pay for new drug therapy development is a critical question. The new normal is that change is a constant.”

Even as the worst of the economic storm seems to be receding, populist fervor against big business, the financial sector and Wall Street continues unabated. Directors find that amid competing and sometimes conflicting legislative and regulatory proposals, it’s difficult to even guess which regulatory approach will prevail. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, noted, “There are two problems. First on a macro governmental level, I think we’ve seen an extraordinary shift in the way in which the government interacts with the private economy. On a secondary level for directors, I think we’re seeing a real change in how boards work. But there’s a danger that the regulatory restrictions and demands are forcing boards to make decisions that are not their own.” Added Christopher S. Lynch, “In this politically charged and economically uncertain environment, the challenge for boards of the GSEs (government-sponsored enterprise) is to provide management some contextual perspective on how the business model might evolve.”

Even so, there appears to be new or renewed commitment to growth, which was quite refreshing to hear and led to a discussion of how CEOs are preparing a new set of objectives and a related set of investments to achieve them. For the CEO, that means priorities may have changed. “After finding sufficient liquidity to pay our dividends, I think now the question is, ‘How do we get back on the path to growth?’” said Alex J. Mandl. “Cost-cutting can only take you so far. What kinds of acquisitions, what kinds of investments need to be made—whether it’s in people or systems. Those are the critical questions facing companies today.”

Specter of Overregulation
In addition to complying with new rules and regulations, several audit committee members sounded the alarm on what they fear may be extreme regulation.

“Frankly, I’m very concerned about the role of government, the risk of overregulation and the possibility of being overly burdened by public policy,” said Reatha Clark King. “I don’t hear enough debate about it among directors and I’m very concerned about more government involvement and its impact on the competitiveness of our companies.”

Directors echoed King’s concerns, noting that while boards have gotten beyond the initial onslaught of new compliance activity as the result of the SOX, “the government has an infinite capacity to create new programs, so you have to constantly step it up. The issue for directors today is, ‘What is our business model and what are we going to do to compete?’” said Richard K. Lochridge.

Regulation needs to be properly balanced between the call for greater transparency and measures that would appear to add little value economically. “Business remains uncertain as to the intent of the increased governmental regulation,” said Kathleen Connell. “Is it transparency and accountability for investors, improved risk management to prevent future systemic failures or simply political optics and burdensome reporting? Properly conceived systemic risk-management policies and increased transparency and accountability practices add value to the corporate community, increasing their competitiveness by restoring consumer confidence and assuring investors that businesses are well managed.”

Financial Communications
Earnings guidance would alone be a subject for a lively and divergent discussion. If the company on whose board you serve didn’t stop or change the way it issued earnings guidance, you were in a minority. One exception may apply to technology-oriented companies, however, because the market’s expectations are different. “In the tech world, where there’s still an expectation of growth by investors, there’s a stronger inclination to give some sort of guidance,” said Ray Bingham. “The metrics used have changed over time and certainly, the tolerances accepted around any particular set of numbers have gotten much, much wider as the perception of risk has grown.”

The assembled directors also agreed that their audit committees are more deeply scrutinizing all of the company’s financial communications. In the view of one director, the earnings press release is the most important communication to investors, but there was also discussion about how to manage the volume and complexity of financial and other information that boards receive.

“We’ve set up a series of informal audit committee calls throughout the quarter in which directors can participate with management and our outside advisors to learn more about emerging issues, key assumptions, accounting and financial-reporting alternatives and potential outcomes,” Lynch said. “We’ve requested that management spend more time with our directors to ensure we better understand the complexity of the issues they are dealing with and how those transactions will be presented in our public filings.”

Mary R. “Nina” Henderson suggests receiving financials and the MD&A separately, one in advance of the other. “This permits a deeper dive and fuller review,” she said. “Also, any matter with continuous impact, based on numerous estimates and assumptions, is reviewed frequently, not only at Q and K review meetings.”

The Securities and Exchange Commission has emphasized disclosures and the MD&A in its new rule-making. “This focus on disclosures is likely to continue and will probably increase—particularly with the SEC’s new disclosure rules regarding compensation, risk and governance,” said Teresa E. Iannaconi. “The SEC is very focused on the protection of investors, but they may miss the forest for the trees,” said Holly J. Gregory. “There seems to be little concern about the impact of their regulatory efforts on how boards function. The perspective I’ve heard expressed by SEC staff in discussions about proxy access is ‘Our role isn’t to think about what the impact might be on the boardroom and the corporation. We are here to protect investors.’ But I think it’s reasonable to ask, to what end?”

Added Gregory, “Investors need corporations capable of succeeding over the long term and this requires regulations that are thoughtfully balanced.”

The Business of Risk
The NACD’s Kenneth Daly said what most audit committee members know all too well: the time commitment to public company board service is “nothing short of unbelievable.” But it’s not the amount of time spent on board work that’s the issue, noted J. Michael Cook, it’s how directors are being asked to use their time. “I know lots of folks who will spend the time—have another meeting, stay longer—if they feel they are adding value and doing something important. What’s frustrating to many people is the amount of time we spend doing things that aren’t very productive…And then, after we do all this great work on risk and risk management, identifying and dealing with the critical risks affecting the business, perhaps the greatest risk—the financial viability of our economy and the financial future of our country—is outside of our control and is being decided for us by people who often are not fiscally responsible in the costs and risks they impose on us.”

Cook raised a point central to any current assessment of the audit committee. With the tremendous focus on risk, there was general agreement that the full board should oversee the strategic risks facing the company. “We see the audit committee’s responsibility for risk often narrowing to risks within the audit committee’s core areas of oversight—clearly financial reporting risks, but also compliance risks, perhaps IT risk, sometimes financial risks,” Mary Pat McCarthy said. “If the board doesn’t have a finance committee, the audit committee may take on that issue as well.”

Cook, who described himself as a “fairly strict constructionist,” said he doesn’t believe committees should be doing work that belongs on the agenda of the full board: “The audit committee exists to oversee one very specific enterprise wide risk and that is the risk of erroneous or fraudulent financial reporting.”

Viewed from a different angle, Bingham suggested that strategy should not be formulated for the avoidance of risk. “In my view it should not be so much the avoidance of risk but rather the requirement that the board understand what kind of risk the company is exposed to and whether there will be an appropriate payback for the risk that’s being tolerated,” he said.

Improving Governance
While criticism of corporate boards has never been more acute, more than half of the audit committee members attending the Issues Conference said the public’s criticism was justified. What measures should be taken to improve board performance? Prepping directors for new roles within the boardroom, evaluating their performance, managing information and ensuring commitment and engagement of individual directors spurred the most comment.

Clearly, there’s no one single rule that applies to all companies; there are various ways to approach both the orientation of new directors and their ongoing contributions as effective board members.

“I know of no highly effective business organizations that don’t evaluate individual performance,” Lynch said. The most effective evaluations, according to Mandl, are led by the independent chairman or lead director or “someone who has the capacity to talk to individuals and as a whole to take the lead.”

Bingham serves on a European board that retains an “expert” to support the board and each committee. The job of these experts is to review management’s reports analytically and assist the board and committees with their work. They are hired externally and supervised by the board.

Greatest Concerns
At the conclusion of each Roundtable—one was held in Miami, the other in Phoenix—directors were asked to rank their concerns. Interestingly, the growing threat of reputation risk, including risk related to enforcement under the Foreign Corrupt Practices Act, generated reaction at both sessions and led to some agreement that “tone at the top” is—or should be—a major area of focus for directors. Bruce Piller of KPMG concurred. “To me, tone at the top is a risk that carries over to a number of areas on the audit committee’s plate—from financial-reporting risk, to the control environment, to fraud risk and compliance.” Reputation risk, said Laban P. Jackson, “is what we worry about all the time. And the thing that I worry about is that our people know that the board cares about how they perform ethically. It is incredibly important to me to get out and meet the people out there and let them know that I care about the work they’re doing.”

The challenge is to communicate tone at the top “deep, deep into worldwide organizations,” said Ellen Odoner. “One key source of support and vigilance can be the legal department. In the United States, reinforced by SOX, inside lawyers recognize that they are expected to play an active compliance as well as business role. It is vital to build the same understanding among the lawyers in far-flung business units.”

Keizer offered a final thought on what should top the agenda of boards and audit committees going forward, echoing the sentiments of directors: “The one key challenge is tone at the top and culture within the organization. Who are we and what do we want to be known for? What’s being measured? What is management being rewarded for? When it comes to culture and tone at the top, we need to make sure that we have learned from the crisis and that we reward the right behavior. That, to me, is the overarching issue.”

Conference Speakers, Panelists and Thought Leaders
Ray Bingham – Director, Dice Holdings, Flextronics International, Oracle, STMicroelectronics
Kathleen Connell - Chair, Corporate Governance Center, Berkeley Haas Graduate School of Business
J. Michael Cook – Director, Comcast, International Flavors and Fragrances
Jeffrey M. Cunningham - Chairman, CEO, Editorial Director, Directorship
Kenneth Daly – President and CEO NACD
Charles M. Elson – Weinberg Center for Corporate Governance, Director, HealthSouth
Holly J. Gregory – Partner, Corporate Governance, Weil, Gotshal & Manges LLP
Mary R. (Nina) Henderson – Director, AXA Financial, Del Monte Foods, Pactiv
Michele J. Hooper – Director, AstraZeneca, PPG Industries, UnitedHealth Group, Warner Music
Teresa E. Iannaconi - Partner, National Office, KPMG LLP
Laban P. Jackson – Director, JPMorgan Chase
Henry R. Keizer – Global Head of Audit, KPMG International Cooperative, and U.S. Vice Chair – Audit, KPMG LLP
Reatha Clark King – Director, ExxonMobil
Richard K. Lochridge – Director, Dover Corp., Lowe’s, PetSmart
Christopher S. Lynch – Director, AIG, Freddie Mac
Alex J. Mandl – Director, Dell, Hewitt Associates, Horizon Lines, Visteon; chairman of the board, Gemalto
Mary Pat McCarthy - U.S. Vice Chair, KPMG LLP, and Executive Director, KPMG’s Audit Committee Institute
Charles H. Noski – Director, ADP, Air Products & Chemicals, Microsoft, Morgan Stanley
Ellen J. Odoner – Head of Public Company Advisory Group, Weil, Gotshal & Manges LLP
Bruce J. Piller – Western Regional Managing Partner, KPMG LLP

In dealing with investors, the CFO faces a special challenge: They must report financial results under GAAP accounting, but augment that information with insight into operational business results and opportunities. This requires a blend of respect for the required reporting structure, creativity in expanding upon that to capture any elements where “reality” may not be completely reflected and, finally, communication skills that illuminate —rather than cloud —the differences between the two.

The EBITDA Quandary
Many companies use EBITDA as one measurement of operating performance because it captures earnings before they are distorted by financing consequences (interest charges), statutory charges (income taxes) and/or accounting non-cash charges required to be reflected in the P&L (depreciation and amortization). To many, this is the “purest” reflection of the actual health of the business, free of distortions. The problem?  EBITDA is not recognized as a GAAP measure. In fact, regulatory requirements actively discourage the use of this measure. Companies using any kind of an EBITDA measure must show a thorough reconciliation from EBITDA to GAAP reported income and run a higher risk of regulatory review as a consequence. This discourages use of a very helpful and insightful measurement that would give potential investors a better insight into the historical operating performance of the company.

More stories in The Director’s Guide to Capital Markets:
Fiduciary Duties in Turbulent Times
Assessing the Balance Between Debt and Equity
Navigating Post-Crisis Dynamics: A Roundtable

There is no doubt that simply (and only) reporting EBITDA would be misleading. In fact, those elements of non-operational risk reflected in GAAP net income are pertinent facts for investors to see and understand. High interest charges reflect a highly levered business, which increases risk. Taxes must be paid if there is reported income and so should not be ignored completely although the complexity of tax accounting adds confusion for many. And depreciation and amortization paint a picture of “usage” against items that have a finite life. Once depleted, the balance sheet may reflect a different level of health. Therefore, the “complete” picture must be preserved and reported, of course.

It is strange, though, that our regulatory requirements don’t encourage reporting additional insights and viewpoints into the business. While potentially confusing to some (the stated reasoning behind the rigidity) it would surely add illumination for others. One could argue, in today’s more complex investing environment of hybrid securities, diffused risk and off-balance sheet line items that those who cannot completely comprehend all aspects of financial reporting may want to think twice about being in the market at all.

There is a second aspect to this distortion of reported risk for investors as well. Any good accountant will tell you that within the GAAP reported figures there are numerous areas where judgments and estimates must be used. It is important—even critical—that investors have more insight into the approaches taken to make these estimates. Assumptions can vary widely and a set of “conservative” financial statements prepared using wildly “aggressive estimates” can be deceptively appealing to risk-adverse investors. Case in point: financial institutions showed more health than they actually held because their assessment of the liability they held as a result of shared risk (through derivatives) turned out to be pitifully off the mark.

The point is this: GAAP accounting— that esteemed, respected foundational element of regulatory filings—is not infallible. Certain characteristics of it may make sense in one arena (accounting properly) but distort results—either positively or negatively— in another arena (investment evaluation). Investors beware: simply looking at reported results will not give you a complete picture. We have all learned a painful lesson in the past 18 months regarding the need for a complete and thorough understanding of investment risk, and this requires detailed financial and operational analysis beyond GAAP accounting. Despite the challenges of reduced staffs in our current era of “lean leadership,” directors and CFOs of companies accessing the capital markets must do their homework, whether making an investment or bringing on investors.

Cynthia Jamison is national director of CFO Services, Tatum LLC.

Human nature often compels us to ignore the inevitable:

- Waiting too long to address the issues, hoping things will get better.

- Waiting too long to address the issues, rationalizing that openly acknowledging distressed conditions will “sink the company.”

- Over-stretching waning liquidity options to make payments and avoid defaults (“borrowing from Peter to pay Paul”).

- Effecting short-sighted deals or taking short-sighted actions as band aids.

Unfortunately, as the meltdowns at Bear Stearns and Lehman Brothers have painfully illustrated, a company’s failure to timely recognize that it is operating with impaired liquidity and to appreciate the severity of the “distress” can prove calamitous. In the more congenial banking environment of years gone by, a company’s failure to meet a maintenance or other covenant would have precipitated a negotiation with the company’s lenders with a view towards waiver of the default and/or amendment of the underlying loan documentation. In today’s credit-constrained world, such a technical default may begin a potentially irreversible slide into bankruptcy.

More stories in The Director’s Guide to Capital Markets:
Assessing the Balance Between Debt, Equity
A CFO’s Perspective
Navigating Post-Crisis Dynamics: A Roundtable

In such situations, directors of financially troubled companies are likely to find themselves caught in the middle of a zero-sum game between “out-of-the-money” stockholders who are willing to have the company “bet the ranch” to salvage their investment and creditors who are loath to see their potential recoveries jeopardized through quixotic endeavors to “maximize” stockholder value. Needless to say, faced with the prospect of financial loss, both stockholders and creditors will be quick to litigate if a course of action chosen by the board of directors threatens to impair their respective interests. As a consequence, directors of all but the healthiest of companies need to understand the contour of their fiduciary duties in the context of financial distress.

Fiduciary Duties: Solvent Companies
A bedrock principle of Delaware law is the notion that directors of solvent companies owe fiduciary duties of loyalty and care to the corporation and its stockholders.

In contrast, it is equally well established that fiduciary duties are not owed to creditors of a solvent company. Such creditors are presumed to be able to protect themselves contractually or through creditors’ rights laws. Similarly, the directors of a solvent company do not owe fiduciary duties to holders of the shares of a Delaware corporation’s preferred stock. Again, such holders are deemed able to protect themselves through the negotiated provisions of the certificate of designation and/or the stock purchase agreement by which they became holders.

Beyond these seemingly simple principles, the analysis becomes more complicated and revolves around whether the company is, in fact, solvent or not. Ironically, while a company’s solvency can change (literally) from one day to the next (as the implosions at Bear Stearns and Lehman Brothers vividly demonstrate), the need to prove or disprove solvency “after the fact” can result in lengthy and expensive litigation. Indeed, the issue of insolvency in the Iridium bankruptcy case took 50 days of trial and testimony, 52 witnesses, seven experts and 866 exhibits. For a troubled company, professional financial advice in the form of a solvency opinion may be needed to assess solvency at any given point in time.

Fiduciary Duties: Insolvent Companies
A corporation is deemed insolvent under Delaware law when (i) there is a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof or (ii) it is unable to pay its debts as they come due. The test is forward-looking: it is not enough for a corporation to meet its current obligations; it must be able to meet its future obligations as well. The fiduciary analysis focuses on the board’s belief at the time and whether that belief was reasonable.

The state of insolvency, in and of itself, does not change the focus of directors’ duties, which is the corporation itself. In Nelson v. Emerson, the Delaware Chancery Court stated that: “It is settled Delaware law that an insolvent company is not required to turn off the lights and liquidate when that company’s directors believe that continuing operations will maximize the value of the company.”

At the same time, however, the Delaware Supreme Court also made it clear in NACEPF v. Gheewalla that when a corporation is insolvent, creditors have standing to assert derivative (but not direct) claims against directors for breach of their fiduciary duties. The logical underpinning of this conclusion is that, upon insolvency, creditors take the place of stockholders as the principal constituency injured by any fiduciary breaches that diminish the value of the corporation.
Fortunately, in balancing conflicting stockholder and creditor interests, directors remain entitled to the “business judgment rule” presumption that they are acting independently, in good faith and with due care. Insolvency notwithstanding, the rule continues to protect directors so long as they act on an informed basis, in good faith and in the best interests of the corporation.

However, because creditors of an insolvent company can bring derivative actions for breach of fiduciary duty, directors’ actions, even though protected by the business judgment rule, can be subject to litigation. Accordingly, directors need to take special care in distressed situations to ensure that they have built a record of staying informed and taking actions that best serve the entire enterprise rather than any single group of stakeholders. Such care is especially warranted when a controlling stockholder is a principal party to a transaction such as an exchange offer or a down-round financing. In such situations, the more exacting “entire fairness” standard of review may be applicable, and a board may be well advised to secure both a fairness opinion and a solvency opinion from an independent financial advisor to buttress it’s decision-making process.

Duties in the Zone of Insolvency
Between the relative bright lines of solvency and insolvency lies the oft-referenced “zone of insolvency,” where the company is on the brink of becoming insolvent. The concept was first introduced into Delaware jurisprudence in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., a case in which the Delaware Chancery Court articulated the possible conflicts that might arise in the context of impending insolvency:  “[I]n the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.”

Until relatively recently, Credit Lyonnais was cited for the proposition that directors of a corporation in the zone of insolvency owe fiduciary duties to both stockholders and creditors. In more recent cases, however, the Delaware courts have called this view into question. In Production Resources Group, LLC v. NCT Group, Inc., the Chancery Court observed that Credit Lyonnais was intended to operate as a “shield” against stockholder suits (alleging that directors had acted to protect creditors) rather than as a “sword” for creditors to force directors to favor creditor interests.

Similarly, in Gheewalla, the Delaware Supreme Court affirmed that fiduciary duties do not shift to creditors: “[W]hen a solvent corporation is navigating in the zone of insolvency, the focus for…directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its [stockholders] by exercising their business judgment in the best interests of the corporation for the benefit of its [stockholder] owners.”

It is generally difficult to ascertain when a company enters the zone of insolvency. While the tests for insolvency are easy to state, their application can be difficult – especially where there are unknown or contingent liabilities.

Although the Delaware courts have not defined the boundaries of the “zone of insolvency,” at least one case, Adlerstein v. Wertheimer, set forth several factors to be considered:

• Was the company facing a liquidity crisis?
• Was there a dearth of trade credit?
• Was there insufficient cash to meet payrolls?
• Did the company’s auditors refuse to issue a going concern opinion?

Other “signposts” demarcating the zone of insolvency might include the fact that a company

• has been financing losses through asset sales or short-term borrowings;
• is in an industry or sector that is experiencing a downturn;
• is emphasizing short-term profits over generating positive cash flow;
• is extending its accounts payable over lengthening periods of time
• is taking aggressive accounting positions.

When a company is operating within the zone of insolvency, many otherwise ordinary decisions by the board of directors will be subject to increased scrutiny by stakeholder constituencies and, potentially, by the courts:

• failing to reduce costs;
• collateralizing unencumbered assets to raise cash;
• continued declaration of dividends;
• sales of assets for arguably less than “reasonably equivalent value”
• failure to consider a sale of the company; or
• pursuing financing alternatives without making contingency plans for a bankruptcy filing.

Often, companies struggling in the zone of insolvency are forced to turn to controlling stockholders for liquidity through Private Investments in Public Equity Securities, (PIPEs) and down-round financings. These types of transactions are frequent targets of litigation and should be carefully reviewed by a committee of independent directors with the assistance of highly qualified advisors.

Business-as-usual thinking, unquestioning adherence to existing business models and playing defense in response to critics do not create the game-changing dynamics needed to reduce risk of business failure in troubling times and loss of competitiveness during periods of economic recovery and growth. Nor are they likely to bring relief from the increasing role of government in the private sector. Board leadership in the pursuit of excellence through reassessment and renewal can bring about significant improvements on all fronts.

During the worst financial crisis in decades, corporate boards and management teams have been shoring up liquidity and profitability while responding incrementally to major challenges to our governance, risk and compensation models. Signs of recovery are now emerging amid continuing economic uncertainty, government involvement and threats of activist litigation. These conditions call for boards to seize the initiative and undertake a holistic process of reassessment and renewal to improve corporate governance and set the tone that will extend a culture of renewal to the realm of management and corporate performance.

The National Association of Corporate Directors is a leading advocate for board renewal through the issuance of “Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies.” These consensus guidelines provide a foundation on which boards of all types of entities can build a program to improve oversight effectiveness. From this baseline, boards can engage management in reassessments of strategy and business models for relevance, timeliness and alignment. Such actions would serve to improve a board’s ability to steward its organization’s creation of long-term value.

The following kinds of questions can help corporate boards spur the renewal process.

• Does the company articulate and follow values that are supported by its customer base, employee base, and other stakeholders?
• Is corporate strategy consistent with the organization’s values, long-term goals and financial objectives?
• Is the company’s business model effective in our changing global economy? Is it aligned with strategy and supported by resources and processes needed to achieve desired goals?
• Do company culture, systems and processes support the timely and objective flow of key information regarding events, trends, risks and opportunities? Is there sufficient transparency at all levels of management, between management and the board, and between the company and its stakeholders?
• Does the company have the financial strength and organizational resilience needed to survive and even thrive in downturns such as the one recently experienced? Is robust stress testing used to assess impact and ensure liquidity during major declines in economic conditions?
• Is a simple yet effective enterprise risk management process in place with appropriate oversight of the board of directors? Does the risk management function have sufficient organizational stature and access to ensure transparency and objectivity in decision making?
• Is the compensation committee adjusting its focus to place more emphasis on long-term success and health of the organization with an appropriate balance of risk and performance?
• Do human resources practices effectively balance cost, compensation and other factors to motivate employee loyalty to the company, its products and strategy?
• Is the audit committee ensuring that key elements of governance and control are not being sacrificed in the search for needed improvements in related cost effectiveness? Is it supplementing its oversight responsibilities with appropriate encouragement and support of the CFO and others upon which it relies for execution of governance procedures?
• Is the finance and investment committee reexamining its fiduciary oversight role to actively monitor investment policies and asset allocations following a time when passivity and overreliance on outside fund managers contributed to a broad spectrum of wealth erosion?
• Does the governance committee seek independent, qualified board members of diverse backgrounds to provide effective oversight and guidance to management? Does the implementation of diversity also consider factors such as diversity in culture, geography, industry, form of organization and mindset to foster a healthy mix of collegiality, creative tension and expertise in decision-making?

I have seen the subject matter of many of these questions individually addressed by boards and managements with significant positive results. For example:

• Management’s use vigorous stress testing and analytical forecasting highlighted the need to reduce liquidity risk through debt covenant relief and major refinancing. This process enhanced management credibility with financial institutions and resulted in a successful refinancing amid tumultuous market conditions prior to the recent financial market meltdown.
• Audit committee support and encouragement of global financial management beyond the confines of the boardroom were instrumental in cementing a natural governance alliance within the company through visible demonstrations of “tone at the top.” Lasting improvements in corporate governance were achieved. I personally benefitted from such audit committee support during my management career and now it is my turn to do the same as an audit committee chair.

By driving a holistic reassessment of our governance and business models on a combined basis, corporate boards can foster a culture of renewal that produces synergistic improvements in overall corporate performance, contributes to the restoration of growth in our economy and reduces the populist hostility that facilitates excessive government involvement in the private sector.

William A. Tsacalis is president of Tsacalis Associates, LLC, an advisor to managements and boards on corporate governance, strategic finance and board and management effectiveness. He can be reached at btsacalis@yahoo.com.