How does a company classify, compensate and define employees? According to Robert J. Nobile, a partner at Seyfarth Shaw, and Kathleen M. Connell, PhD, director of the Corporate Directors Enterprise at UC Berkeley Haas School of Business, a board’s assessment of a company’s risk profile should include due diligence on litigation as it relates to workplace issues.

Robert J. Nobile: The greatest concern of corporations today—and I can see this in dealings with my clients—is the enhanced enforcement that is occurring, certainly at the federal level. The Department of Labor, Occupational Safety and Health Administration (OSHA), Office of Federal Contract Compliance Programs (OFCCP) and the Equal Employment Opportunity Commission (EEOC), have all been literally doing the circuit, speaking nationally about increased enforcement of the equal opportunity, wage and hour, and health and safety laws. In the past, these agencies might have turned the other cheek and been willing to settle more quickly. Today, they are feeling—and I will say this from first-hand experience—very empowered with the authority they now have, and more brazen in pushing matters to litigation that probably would have settled in the past.

Kathleen M. Connell: The heightened exposure for employers is a result of both the stronger regulatory mentality of the Obama Administration and its commitment of necessary resources for enforcement actions. Corporate boards need to become increasingly sophisticated in their understanding of issues in the arena of workplace litigation and employment-related class-action lawsuits.

A proactive director should reframe the board’s discussion of employment matters as a risk- management concern. Boards tend to receive bottom-line employee cost-savings data from the CFO and compensation materials from human resources departments. Neither provides the integrated perspective a board requires to determine the potential “risk exposure” of employment practices. It’s the board’s responsibility to discuss a company’s employment policies in the context of a regulatory environment—understanding that the way a company classifies employees, compensates them and defines their status as full, part-time or contractor must meet stringent national labor standards.

Nobile: In my experience, what boards need to be concerned about is that perhaps a lot of companies are playing a numbers game. Former President Bush used to call it “fuzzy math.” I advise clients they should look very closely at the issue of who is an employee, versus who is a consultant or an independent contractor. The resistance that companies always get—and I hear this from human resources executives—is that the financial officers, the CFOs, the controllers and so on, are very concerned about head count. So, in effect, CFOs will refuse to give human resources the authority to add to head count, while at the same time authorizing thousands and thousands of dollars on independent contractors and consultants doing the work of employees, and are, in effect, misclassified.

There’s real concern everywhere, even at the federal level with the IRS and with many state agencies, about revenue. The government and the states are losing revenue when individuals are misclassified, because taxes are not being withheld and reported appropriately. Consultants take deductions that would be impermissible for an employee to take, such as commuting, meals and other business-related expenses. Quite frankly, it’s a revenue numbers game for the federal and state tax agencies—and when they see an apparent misclassification, they will be aggressive.

Many corporations misuse independent con­tractors. It’s a major issue in terms of potential liability for boards. I’ll give you a real-life example. Several years ago, Arch Financial Services got a call from the head of human resources, who had a lawyer’s letter. The lawyer was representing an “independent contractor” who had been working for this company for about seven years. The contractor’s child became seriously ill. The contractor had a very poor employee-benefits program and most of the expenses were not covered. The contractor sought advice from a private attorney about filing for bankruptcy because he couldn’t pay the medical expenses. The bankruptcy attorney asked him, “Why aren’t these expenses covered? These seem like expenses that would be covered under any normal group health-insurance program.” The contractor explained, “Well, I don’t have group health insurance because I’m not an employee; I’m an independent contractor.”

The lawyer’s letter to the company stated that the employee for the last seven years had been misclassified as an independent contractor. Such misclassification resulted in his not receiving pension benefits or health insurance. The medical bills for the contractor’s child at that point in time were about a quarter of a million dollars. His lawyer presented two options. Make him an employee, put him into the benefit programs, and make sure it’s retroactive so that his expenses are covered; or prepare to defend against a class action on his behalf and everyone else in a similar situation. The company chose to settle, wrote out a nice check, put him into their plans, and then audited and reclassified about 75 other individuals as well. There was potential major liability for this corporation because of the misclassification.

Connell: You’ve identified a perfect example in today’s “new normal” economy, in which companies are reluctant to make a long-term commitment to new employees, rather choosing to make a commitment to a job position. The company seeks flexibility, not knowing the certainty of its future business growth, and chooses a contract employee, avoiding the benefit responsibilities normally attached to a company employee. Utilizing contractor status to avoid issues of overtime, benefits and bonuses may well trigger legal issues leading to litigation and financial exposure.

Misclassification of employees was an issue for one company where I served as a director because it had both employees and contractors performing similar duties. The contracted “employees” did not receive overtime or bonuses. They would have been better compensated had they been salaried employees and been paid overtime for their weekends, evenings and holiday employment. In their minds, they were being “abused” because they were compensated at a fixed rate with no inclusion in the company’s benefits or bonus programs.

Yet, they were working excessive hours, well beyond 40 hours a week. Such an arrangement was attractive to the contract employees as a temporary position, but as the contract employees became personally integrated into the culture of the company, the compensation arrangement became contentious. Eventually, the company—under pressure from state regulatory offices—ended the contractor relationship and added additional employee positions.

Many employment practices once viewed as temporary and implemented in a recessionary period have morphed into permanent changes in attitude towards full-time employment. I urge directors to request an employment audit from their human resources department, accompanied by a risk analysis from the general counsel. Such reports would review current classifications of employees and determine whether such classifications and employment practices represent a long-term strategy that is both beneficial to the company’s growth and in compliance with regulatory standards. Perhaps it would be advisable for boards to retain outside legal counsel with specialty in employment law to review the company’s overall employment practices, and to determine whether they’re compliant with existing laws. It’s vital boards of directors understand that utilization of outside consultants, annuitants, part-time employees and even interns carries exposure that they may not anticipate, given the obligations of companies to provide training, healthcare and pension benefits, and to protect such employees against any type of liability that might occur in a workplace environment.

Nobile: If the board, for example, is going to conduct or commission an audit, one of the first things it should certainly do—and you mentioned getting the general counsel involved, and I think it’s an important point to highlight—is make sure whatever audit that’s done is a privileged and confidential audit to the maximum extent practicable. Getting the general counsel involved, perhaps with either internal counsel or outside counsel, could help privilege the report or study, and perhaps prevent it from being discoverable in litigation, which is obviously a critical point. If you’re going forward and conducting an audit, you better be prepared to implement whatever findings the auditor comes out with at the end. If the auditor states that jobs are misclassified—someone is classified as exempt when they should be nonexempt, or is classified as an independent contractor when they should be an employee, or someone is classified as an intern and should be an employee—the company wants to be in a position to argue that the study is a privileged study and, thus, not discoverable. The last thing you would want to see is a class-action lawsuit being filed, based on an audit report, the results of which were not implemented.

Connell: That raises the role of boards in terms of corrective actions. It is generally assumed that human resources practices are the responsibility of management. Boards adopt a hands-off attitude, becoming unwilling to consider modifying personnel policies and then delegate that responsibility to the human resources department.

Boards should be advised to focus serious attention on risk-management responsibilities. Their risk-analysis radar should be broad enough to recognize the potential red flag of poorly defined or executed personnel practices. The plaintiffs’ bar is becoming more sophisticated, as they look at this whole new arena of employee benefits and compensation.

Boards of directors may also choose to define a process for considering their company’s obligations under the new healthcare legislation. Both “best practices” for employment policies and effective healthcare implementation are worthwhile topics for board retreats where more extended discussion is possible.

Nobile: There is no more heavily regulated area of business than the HR side of the business. At the federal level alone in the United States, we have in excess of two dozen statutes that govern every decision that an employer makes, from inception and recruitment through termination of employment. We also have state and local laws in every jurisdiction as well that compound the problems that employers have in terms of compliance.

Quite frankly, I think education is much needed, to show board members some of the trends that are occurring out there. When you look at litigation, right now, wage and hour cases are probably number one in the United States. There are literally hundreds of class actions that are filed against every major corporation, and there have been some phenomenal settlements. Wal-Mart, for example, recently had a $172-million verdict in a wage and hour case. Merrill Lynch had a $37-million settlement in a wage and hour case. But the reality is, no employer is immune from these types of actions, and board members should be aware of the trends and what is happening with other similarly situated companies. What’s going on in industry? What are the plaintiffs’ lawyers focusing on these days?

Connell: As boards report to the Securities and Exchange Commission on their risk-management policies, citing areas where the company might have long-term exposure, potential employment litigation should be included, given the increase in litigation, and the impact that it has on the perception of a company’s brand. As employment litigation exposure increases for companies, it’s vital for boards to become better educated on employment issues—not to micromanage this issue, but to be proactive in defining strategies that are protective of the company’s interests.

It’s important that a company seeks to create a culture where best employment practices are upheld and present, and future employees are respected. Well-formulated employment practices will reduce the likelihood of costly employment litigation and enhance a company’s brand and reputation.

For many years HR executives sought a seat at the table with senior management. Today the HR profession has stepped up, and in most corporations HR has a seat at the table. It is hard to imagine a Fortune 1000 company where the top HR executive is not on the executive management committee or operating committee of the company. HR’s value is being recognized by some of the best companies whose top HR executives have risen to be one of the five named officers in the firm’s proxy statement. With total compensation packages for the senior HR executives at these firms topping over $4 million a year, it is clear that CEOs and boards have understood that effective HR is critical to business success and the HR voice is an important one at the company’s senior management table.

According to the NACD the top three issues for public company boards have remained the same over the past three years: strategic planning and oversight, corporate performance and valuation, and CEO succession. It is easy to see that many of these board issues have people implications as do some of the major responsibilities of boards.

While HR representation as a key member of the senior management team has become accepted practice today, there is surprisingly few HR executives adding value as members of corporate boards. Research presented at last year’s annual conference of the National Association of Corporate Directors (NACD), revealed that less than 2 percent of all director seats are filled with executives with an HR background. In fact Julie Daum, who heads Spencer Stuart’s corporate practice, has said that she estimates that the percentage of HR executives on S&P 500 boards is “minuscule.” There are a number of reasons for this lack of representation of HR on the board, but the point is that HR should have a seat at the board of directors table.

HR Proves its Worth
As a function, HR has clearly earned and retained a seat at the senior management table by adding value and making significant contributions that are recognized by the senior management team and the organization. To earn a seat at the boardroom table, the contributions made by HR executives must earn the same high level of recognition and esteem from board members as they have earned from their corporations. In the current business climate, boards are spending increased time and energy on a host of HR related issues, from CEO succession planning and executive compensation to managing large-scale layoffs and off-shoring without losing key talent and damaging the culture and reputation of the firm. This current difficult business climate presents a unique opportunity for exceptional HR executives to prove their worth at the board level.

Boards typically average 50 to 70 hours of face time together in a year. With so little time together all board discussions must be meaningful and productive to the organization. At board meetings today directors want to have an intelligent discussion on major issues rather than presentations of material sent to them prior to the board meeting. It is the dialogue and the important decisions that follow that are critically important.

One of the most important roles of the board, if not the most important one, is to make sure that there is a competent management team in place to manage the company’s business. Evaluating the performance and results achieved by the senior management team, especially the CEO, is probably the most critical responsibility of board members. When necessary, replacing and naming a new CEO is one of the key responsibilities shared by all board members. This means that the board has to be the driver of CEO succession planning. Attracting, retaining, and motivating CEOs through up-to-date, attractive yet reasonable compensation philosophies and plans is another key full board responsibility, even though the board compensation committee will study this and make recommendations to the full board for action and approval.  While the board provides advice to the CEO in many areas, the board is responsible for making sure the company has a strategic direction, approving financial plans and results, major acquisitions and divestments, dividends and stock buybacks, compliance, risk and crisis oversight, and corporate governance. According to the NACD the top three issues for public company boards have remained the same over the past three years: strategic planning and oversight, corporate performance and valuation, and CEO succession. It is easy to see that many of these board issues have people implications as do some of the major responsibilities of boards.

It is obvious that board members’ responsibilities have grown significantly in the past few years as has the scrutiny of board actions by shareholders, especially in the area of executive compensation. This has been making headlines almost every day for TARP companies. To help boards deal with this intense pressure for board governance and excellence, board committees are spending more time meeting and taking on bigger roles. Two very important board committees are the audit committee and the compensation or human resources committee as some companies call them. This is certainly not meant to diminish the important roles other board committees play in corporate governance. Since Sarbanes-Oxley was enacted in 2002, the oversight responsibilities of the audit committee members have greatly increased. In fact, a SOX requirement is that at least one member of the audit committee have a finance background. There is no such requirement that the compensation committee have at least one member of the committee with a compensation or HR background, yet the responsibilities of the HR committee have also greatly increased.

One of the most important roles of the board, if not the most important one, is to make sure that there is a competent management team in place to manage the company’s business. Evaluating the performance and results achieved by the senior management team, especially the CEO, is probably the most critical responsibility of board members.

Most directors today come from the ranks of CEOs, whether active or retired. However, there are now consultants and head-hunters, including those at Heidrick & Struggles and Spencer Stuart, two of the leading board search firms,  who believe that the assumption that CEO-level generalists continue to make the best directors may no longer be true. The big picture and general broad experiences of CEOs may not be enough to equip board members with what they need to guide the organization through increasingly complex and nuanced issues in some areas. From this perspective, two functional areas of expertise that should be represented on the board are finance and human resources.

While having financial expertise at the board level seems obvious, why HR? Because to be successful, companies must strategically manage compensation, succession, talent and talent development, labor relations, global operations, ethics, culture and integration of acquisitions, and change, just to mention the short list. Top performing companies never lose sight of the importance of these people-related management issues. CEOs, CFOs or other generalists or functional experts outside of HR can’t provide the strategic focus and oversight needed. Asking the right questions and providing the necessary leadership on discussions of these topics/issues in the boardroom requires a deep HR background. Similar to auditing, finance or law, mastery of HR management requires many years of senior-level HR job experience, including working closely with the HR committee of the board. Only after a successful career of such experiences does a person have the required HR skill sets for dealing with all of the people-related topics that are increasingly capturing board attention, e.g. managing CEO succession, compensation, change, organizational culture and global operations.

The Importance of Human Capital
How many times over the years have we heard that “people are our most important asset” and that the “quality of our talent is the key differentiating factor” of our company? Most people reading this article would have to say “many times and often.” Truly successful companies do think that way and manage their human capital very well. It gets the proper attention at all management levels and in the boardroom. Boards today require a diverse group of directors with diverse industry and talent skill sets. Having a board of only generalists, regardless of how much successful experience they may have, no longer makes sense nor is it good corporate governance. Independent directors are a definite requirement of the audit and compensation committees as is the need for the proper skill sets of members of those committees. It now should seem apparent that HR is, and always will be, a necessary skill set for every board-level compensation or human resources committee.

Like the glass ceiling for women on boards many years ago which has been shattered, the glass ceiling on boards for HR executives is starting to crack as the best of the best HR executives are proving their worth on boards. Executive search firm recruiters who do board searches say that they are now recommending HR executives to their clients looking to fill board seats. However, their clients still mostly request CEO and CFO backgrounds unless the search involves filling multiple board seats for a company. In those cases, a diverse background of skills and industries is often explicitly sought, and people with HR backgrounds are being considered and nominated to boards.

There are a few notable examples in industry today where directors with HR experience and backgrounds are adding significant value to the boards they are serving on:

• William T. Conaty serves as a director of Hewitt Associates. Bill spent his entire career with General Electric Company and served as the Senior Vice President of Corporate Human Resources from 1993 to 2007. He was the architect behind many of GE’s widely recognized HR practices and has been a role model for turning HR organizations into strategic business partners. Russ Fradin, the CEO of Hewitt, said “Hewitt specifically wanted Bill on the board because of his HR background and that now he is making significant contributions to the board discussions and decisions.” The obvious place for HR executives to serve on boards will initially be for those companies like Hewitt who serve the HR industry. These will be HR consulting firms, as well as payroll, executive search, and training and development companies.

• Jill Kanin-Lovers serves as a director on the boards of Heidrick & Struggles International Inc., BearingPoint Inc., Dot Foods Inc., and First Advantage Corporation. Jill is the former Senior Vice President for Human Resources and Workplace management of Avon Products Inc. Prior to Avon she held senior HR positions at IBM and American Express. Jill is a real HR thought leader having over 50 publications on HR and teaching in executive programs at Rutgers.
• Michael A. Peel serves on the board of the Select Comfort Corporation and is on the board of directors and an officer of the Walker Art Center. Michael is currently Vice President for Human Resources and Administration at Yale University. Before moving to Yale, he was with General Mills as Senior Vice President of Worldwide Human Resources from 1991 to 2007.. Under his leadership, General Mills appeared on Fortune’s list of “100 Best Companies to Work For” six times since 1997.

These few examples point out that there are some executives with HR backgrounds qualified to serve on boards. The HR talent is out there and available to serve on boards and the Compensation Committees of boards. Good corporate governance demands the appointment of directors who bring special skill sets and competencies to a more independent and diverse board. As we see in the news everyday, in today’s difficult and highly competitive dynamic global business environment, people issues – from executive compensation and CEO development and succession to senior management recruitment and bench strength to company values and culture, provide ample agenda items for board discussions and decisions. The number of these people related issues at the board level is increasing.

There is definitely a growing trend (even if slight) of HR talent serving on boards.  This trend should increase and grow significantly in the near and long term future. It must be remembered that the people above and many more like them are basically business people first and HR experts second, having served on executive management and operating committees for a large part of their careers. This broad experience enables them to participate in the discussions and decisions on all topics which reach the board level, and not just the people related topics. They just happen to also have the experience and skill set to take a leadership role on the board for the most difficult and emotional topics the board has to deal with—those that require a lot of discussion where mistakes made are very costly and impact peoples lives – the people related issues. It is often effective management of these issues-and geting them right-that differentiates the best from the rest.

Bob Bogart is an HR executive currently working with Mullin associates as an executive coach and EVP of the firm. He previously worked for The Thomson Corporation as EVP, HR prior to the company’s acquisition of Reuters. He is also a volunteer of SCORE and counsels small business owners. He may be contacted at bob.bogart@yahoo.com.