Appropriately planned taxes can enhance a company’s overall value by improving corporate earnings, strengthening the PE ratio of company shares, and influencing the way analysts perceive and cover the enterprise. Tax issues are also closely tied to risk. When companies engage in tax planning, they are interpreting laws, an activity made risky by the possibility of disagreement between the company and tax authorities. If not property controlled, tax issues can lead to a finding of material weakness by auditors. Tax planning is therefore a crucial part of risk management.

To understand the impact that tax matters may have on value and risk, boards should be familiar with five main areas: tax cash management, international taxation, tax-efficient supply chain management, transfer pricing and inbound investment.

Tax cash management
Prudent tax planning can unlock one-time or annuity cash flows trapped inside a company. Although tax is one of the largest expenses on the income statement, companies often fail to consider tax issues when trying to improve their overall cash management. This year, Ernst & Young surveyed more than 500 executives from major companies. Only one in four respondents said that their firms considered taxes when reviewing cash management practices.

One of the first things a company should consider is whether it is making the maximum appropriate use of available tax credits. For example, in an emerging area such as climate change, many firms have not yet looked into available offsets for their existing or planned investments in clean technology. Most companies know about the federal research and development (R&D) credit, but they overlook eligible expenses such as investment in plant and equipment designed minimize the environmental impact of R&D. Numerous government programs supply tax credits, deductions and abatements to companies that conduct environment “scrubs” of their business.

Many states and cities offer incentives comparable to those at the federal level, such as credits and grants for companies that provide employee training and development programs. Opportunities in this area are growing now that a number of states have launched their own economic stimulus programs.

Companies may also be able to free up cash by reviewing their transcripts and accounts at the federal, state and local levels. Many companies fail to recognize that interest and penalty miscalculations pose a serious problem for corporate taxpayers. The rules for calculating interest are highly complex, and governments may lack the resources needed to make such calculations accurately every time. If a review does reveal overpayments, these can be kept as cash or applied to another tax liability.

Reviews of transcripts and accounts typically focus on income tax, but can also include sales and use tax, property tax and state employment tax. Concerns about overpayment have led many companies to look especially hard at indirect taxes. For example, opportunities exist to review property taxes and examine whether the plant and equipment on a piece of land can be appropriately depreciated to lower a company’s tax burden.

With many states facing budget problems, state and local governments are concerned about revenue shortfalls. Legislatures have raised taxes and closed loopholes, increasing the complexity of filing returns and preventing some companies from meeting their compliance requirements. In response, some firms are considering whether to outsource the compliance function related to sales and use tax, a step that can lower costs substantially.

In addition to federal, state and local taxes, companies are seeking to manage cash flows linked to foreign taxes. Among the questions board members should be asking in this area:

• How can companies ensure that they are effectively reducing their foreign tax without triggering US tax?

• How will proposed international legislative changes affect the company, particularly its cash flow, effective tax rate and business objectives?

• Has the company taken full advantage of opportunities to access foreign tax credits, cash held offshore, or both from its international operations?

International taxation
The international arena presents companies with a distinct series of tax challenges. First, there has been a marked increase in information-sharing by global authorities. Agreements to exchange tax information between countries have existed for decades, but recently the cooperation has intensified: more countries are using the agreements, and doing so more frequently. Governments worldwide want to lower deficits and stimulate their economies, and they are looking for uncollected revenue from corporate taxpayers. Companies must prepare for increased tax controversy, assembling a defense before it is needed. All planning should be amply and contemporaneously documented, something not always done in the past but now considered a best practice.

Second, the Obama Administration is weighing plans to reform deferral of overseas income earned by US multinational corporations. It’s still unclear what shape such reform might take, but significant change is possible, with the likely result that US multinationals will pay higher taxes on income earned abroad. Certain planning approaches can secure companies’ tax position regardless of how the law may change, and more firms are investigating these approaches as a possible hedge against future uncertainty.

Supply chain management
Tough times have prompted multinational corporations to scrutinize nearly every aspect of their supply chain in an effort to lower costs. Companies are seeking ways to rationalize their supplier base, rethinking the locations where they manufacture goods, and considering whether to outsource (or insource) manufacturing and distribution.

Although greater operational efficiency can reduce costs, high taxes will erode the savings. For that reason, firms are looking to make their supply chains more tax-efficient. They are asking where their most valuable intellectual property is located, a consideration relevant even for companies that are not manufacturers. Services companies, for example, can enter into global contracts in a variety of locations.

Taking a comprehensive approach to tax-efficient supply chain management raises its own operational challenges. Companies must decide whether qualified staff will be willing to move to the chosen location, whether exit taxes will be due when facilities are relocated, and what information technology costs will be incurred in integrating disparate operations.

Transfer pricing
Used correctly, knowledge of transfer pricing can serve as a risk management tool, a means of reducing taxes and a hedge against uncertainty. Annual surveys conducted by Ernst & Young show that transfer pricing consistently tops the list of international tax issues facing multinational companies. Transfer pricing has grown more complex as regulations and audit practices have evolved, and closer collaboration among worldwide tax authorities virtually guarantees that it will continue to be a concern. Two of the main issues uncovered in our surveys relate to permanent establishments and tax controversies.

Permanent establishments are taxable presences formed (often inadvertently) when personnel or property are located in a new country where a company has not set up a formal place of business. They can stem from something as simple as having salespeople repeatedly attend trade shows or exhibit products overseas, even for brief periods. Income tax treaties may afford some protection from this risk, but often a taxable presence is created anyway. If so, the best approach usually is to admit that a taxable presence exists and establish an agreement to treat it favorably. Companies that wish to avoid creating a permanent establishment must understand thoroughly any income tax treaties relevant to its overseas business.

Tax controversies related to transfer pricing are common, and can be expected to become more so. Usually they involve two governments fighting about which one gets to tax the same dollar of corporate income. These disputes speak directly to the issue of where value is created in a company’s global supply chain. Government A might believe, for example, that a foreign-owned factory located inside its borders contributes more value than the company’s other supply chain components. Government A therefore maintains that it should get the largest share of tax remuneration. But another country may play a role in that supply chain as well, leading Government B to argue that it, too, deserves a cut. Companies caught in the middle of such disputes may be subject to double or even triple taxation, an undesirable outcome.

Techniques exist to help companies anticipate and avert tax controversies. Firms can establish an Advance Pricing Arrangement (APA), an agreement between a tax authority and a multinational enterprise that determines the appropriate transfer pricing method used for intercompany transactions. Because APAs deliver a high level of confidence in the correctness of a company’s transfer pricing methods, they can save time and reduce risk by shielding taxpayers from litigation.

APAs can be unilateral, bilateral or multilateral. Under a unilateral APA, a company may negotiate an appropriate transfer pricing method with a single tax authority for use in a single country. Bilateral or multilateral APAs are agreements between a corporate taxpayer and one or more foreign tax administrations allowing multiple governments to pre-agree that a specified amount of profit will be allocated to one jurisdiction rather than another. APAs are complex to set up in some jurisdictions, but they can be extremely helpful under the right circumstances.

Inbound investment
Today’s international business environment provides companies with unprecedented opportunities to invest in the Americas. The global trend currently involves foreign multinationals buying US corporations. This has forced US firms to become familiar with matters they may not have dealt with before, such as tax rules governing payments to a foreign parent.

Companies contemplating their first investment in the Americas, or seeking to supplement their acquisitions in the region, may find approaches that were cost-prohibitive in the past are now attractive options. Recent shifts in profitability and asset valuation, for example, may have lowered the cost of tax-effective supply chain management. By working together more closely, different parts of the organization may be able to reduce the cost of cross-border cash movements and better manage overall financial risk. Inbound acquisitions may also create tax-inefficient structures that could, in turn, present opportunities for the company to rationalize its international tax structure.

Staying on top of legislative changes
All of these issues must be viewed in the context of the rapid and broad-scale changes taking place in Washington. Board members have a responsibility to ensure that management remains up to date on legislative initiatives, particularly those involving healthcare reform and energy. The details are complex and change almost daily, but the stakes are high, so companies must spend the time needed to understand these matters adequately. In particular, boards should ensure that the corporate tax department stays current on legislative developments. One step companies can take in this direction is to require tax directors to give the audit committee quarterly briefings on any new developments. In fact, this is now considered a best practice.

Board members who stay abreast of the five tax issues outlined above will be doing their companies a service. In the process, they may also find themselves acquiring a more holistic view of the enterprise. Taxation may be the purview of accountants and attorneys, but it touches so many parts of the business that boards must pay attention to it as well.

Kate Barton is Americas vice chair of tax services at Ernst & Young, LLP.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

At the same time, however, there’s another story beneath the headlines: For most managers, dealing with complexity has become an ongoing, day-to-day challenge: keeping up with constant e-mails, attending innumerable meetings, connecting with the right people across the matrix to make decisions, coordinating processes across cultures and time zones. It’s exhausting, and many managers are frustrated, overwhelmed, and worried that they might unintentionally be creating the next Lehman.

But it doesn’t have to be this way. While some of the complexity that managers experience comes from globalization and new technologies, a large portion is of their own making. If we want to prevent the next Lehman, and if we want companies to be more successful and managers to be more energized and innovative, then directors have a responsibility to insist that simplification be part of the executive agenda.

Four Sources of Complexity
Nobody gets up in the morning with the intention of making the organization more complex. Rather, like weeds in the garden, complexity continually insinuates itself into the fabric of a company in four principle ways: through changing structures and reporting relationships; through product design and proliferation; through the evolution of work processes; and through unconscious managerial behaviors. Directors need to challenge executives to address each of these sources of complexity, both individually and in combination. Here are some brief descriptions of these complexity-creators and a few ways that directors might work with their executive leaders to counter them:

Structural complexity: Organizational structures are like biological organisms in which cells continuously grow, split, and reform. Reorganizations don’t happen alone, but rather are initiated by executives to align people by function, product, geography, business unit, customer, or some other factor in an attempt to be as competitive and efficient as possible. At the same time, managers add or combine units due to acquisitions or internal growth; and they add or subtract layers based on people’s capabilities and their beliefs about how many people should report to any one manager. The result of all this seismic structural activity is that many organizations end up being fragmented, sprawling, and confusing, without a clear logic to how things were put together—leading to unnecessary costs, poor communications, and the danger that high-risk or poorly performing units get lost in the maze. For example, AIG’s structural complexity was one factor that allowed a small, under-the-radar unit to operate in a way that almost destroyed the company.

To counter this type of complexity, directors should ask executives questions such as:

• How does the structure of the company directly support and advance the business strategy?
• Can most employees explain the logic of how the company is organized?
• How many levels of management are there between the CEO and first line supervisors?

Product complexity: Products and services are the lifeblood of any organization, and managers are constantly looking for new ways to satisfy and delight customers. Unfortunately, it is much easier to add new products than to subtract—so most companies end up with vast portfolios of products and services that are costly to maintain, control, update, support, and sell. In addition, many product developers focus on the technical elegance of their products without worrying about whether their customers, or their own internal colleagues, truly understand how they work and what will happen to them over time. This kind of complexity was clearly at play in the financial crisis, as investment banking wizards created collateralized debt obligations (CDOs) and other arcane securitized products that neither customers nor their own risk managers fully understood—until it was too late.

To counter product complexity, directors should ask for thorough reviews of new products and services to make sure executives fully understand how they work and the risks involved. In addition, directors should make sure that managers are reviewing the entire product portfolio with an eye towards sunsetting and retiring products as appropriate.

Process complexity: Most work in organizations is done through processes. Sometimes these are highly structured and disciplined, such as with manufacturing activities. At other times, the processes are loose and ad hoc. However, no matter how much rigor and six sigma-type efforts managers put into process management, the processes continually evolve and change as new people get involved, new issues emerge, and new ideas are introduced. Changing organizational arrangements and new product requirements further complicate processes, often making it difficult for people to understand how things really get done. The result is that companies often find themselves with convoluted decision-making, multiple committees, un-ending budgeting and planning cycles, and general lack of control. For example, many of the problematic financial institutions in the past year found themselves with fragmented and inadequate risk management and forecasting processes that left them unprepared for the downturn.

To counter process complexity, directors should first agree on the key processes that are most critically in need of being controlled and disciplined (such as risk management, new product commercialization, or succession planning). They then need to periodically ask executives to walk through the “map” of these processes to make sure that the right controls are in place, that roles are clear, and that cycle times are appropriate.

Managerial complexity: In addition to structures, products, and processes, managers also cause complexity through their own ways of directing and leading organizations. Particularly in dynamic environments, when processes and structures don’t provide clear guidance, managers create the neural networks that give people direction about what to do and how to do it. When managers are clear with their instructions, they can actually reduce complexity. But when managers unintentionally give nebulous assignments, open-ended deadlines, conflicting instructions, mixed messages, and foster fuzzy accountability, they create enormous amounts of additional complexity and confusion. For example, leading up to and during the financial crisis, executives at many of the financial firms gave their people extremely mixed messages about continuing or stopping product transactions, were unclear about what data was needed for decisions, and rewarded people for poor performance.

It is impossible to counter managerially-generated complexity completely, since much of it is unconscious and unintentional. But directors can hold a mirror up to their executive leaders to help them make their own assessments about the clarity of their directions, the crispness of their decision processes, and the discipline applied to getting things done. In addition, directors can make sure that executive compensation plans are simple, straightforward, and geared to rewarding the right strategic actions over time versus only short-term performance. Finally, directors can insist that succession plans take into account the ability of managers to simplify their organizations.

Simplification as a Business Imperative
Almost every company quite naturally focuses most of its attention on growth, particularly in today’s highly competitive environment, adding more products, services, geographic locations, and employees. But what companies don’t do very well—unless they are forced by an economic or competitive crisis—is prune these growth shoots. Managers don’t like to say “no” or make choices, especially when they are trying to respond to customer needs, beat their competitors, and satisfy shareholder expectations. So, instead, managers keep adding more plants and fertilizer to the garden and end up with a tangled jungle. But to maintain healthy organizations, managers and executives need to constantly prune while simultaneously fostering growth, without waiting for a crisis to force the issue.

The crisis of the past year forced almost every company to cut back, perhaps faster and more deeply than anyone would have preferred. But as the crisis passes, and companies move back into growth mode, it will be easy to slip back into old patterns as the lessons of Lehman and the pain of the financial downturn fade away. One way to prevent this from happening is for directors to insist that simplification become an ongoing business imperative for their companies, such that executives keep a focus on simplification not only in bad times, but in good times as well.

Ron Ashkenas is a managing partner of Robert H. Schaffer & Associates, a Stamford, Conn., consulting firm and the author of the forthcoming book “Simply Effective: How to Cut Through Complexity in Your Organization and Get Things Done” (Harvard Business Press, December 2009). He can be reached at ron@rhsa.com.

In a June 17 proxy solicitation, reports Bloomberg, Exelon urged NRG owners to expand the company’s board and elect its nine independent nominees who, Exelon claims, have an unbiased perspective to the bid, unlike the “entrenched” board. The NRG shareholders’ meeting is scheduled for July 21.

Exelon increased its bid from .485 to .545 per Exelon share in exchange for 1 NRG share.

NRG, the second-largest electricity producer in Texas, said Exelon’s bid does not reflect the full value the company has created. Due in part to its acquisition of RRI Energy, NRG today raised its 2009 forecast for adjusted earnings before interest, taxes, depreciation and amortization by $325 million, to $2.5 billion. A stock-buyback plan was expanded 52 percent to $500 million.

The quarterly survey, CEO Economic Outlook Index, posted a mark of 18.5, up significantly from the Q1 score of negative 5. The latest figure was still the third-lowest rating in the survey’s six-year history.

Some 51 percent of surveyed CEOs said they plan to cut costs in the next six months, with 49 percent prepared to cut jobs. The Q1 results showed two thirds of chief executives anticipating cuts in both.

Said Business Roundtable Chairman Ivan Seidenberg: “The signs appear less negative than they were last quarter, but no one is ready to suggest [companies] are going to begin hiring to start growth.”

A core responsibility of the board is to engage with management in the development of an effective corporate strategy. After all, corporations are managed “under the direction” of boards, according to most state corporate laws—and therefore the board is ultimately accountable for the quality of the company’s management, including any strategic plans made and pursued by management.

As fiduciaries, directors have a duty to protect the corporation against threats to its long-term viability. To be sure, the level of direction provided by a board varies from company to company. Directors can be strategic assets to the corporation in a number of ways: by serving as a sounding board for management; providing performance-enhancing ideas; and offering constructive skepticism. Most importantly, the board can be a source of strategically relevant competencies.

As boards anticipate regulations to come from the new presidential administration, focus on the more intangible aspects of governance, such as strategy, will likely be redirected toward concrete compliance-oriented tasks. In surveys conducted for more than 15 years, NACD has found that director interest in strategy rises and falls in negative correlation to regulatory change affecting boardrooms. Following any period of regulatory reform, interest in strategy tends to wane while interest in compliance rises.

Directors should stay focused on strategy. Principle VII of NACD’s Key Agreed Principles provides the necessary guidance to create governance structures that enhance a board’s ability to maintain this focus. Sustaining and enhancing the value of a company through a well-conceived plan is vitally important. Even the best leaders can fail if they are fulfilling a bad or poorly implemented plan. Boards can veto poor strategic choices and make sure that management’s plans, well implemented, enable the organization to fulfill its highest potential for the benefit of all.

Current Guidance

Existing guidance on the board’s engagement in strategy has been issued by commissions of directors and governance experts, notably in the Report of the NACD Blue Ribbon Commission on the Role of the Board in Corporate Strategy (issued in 2000 and updated in 2006). We’ll review this universal guidance for engagement and then identify new challenges that boards must address quickly in the current environment.

The nature and extent of the board’s involvement in strategy will depend on the particular circumstances of the company and the industry in which it is operating. While the board can—and in some cases should—use a committee of the board or an advisory board to analyze specific aspects of a proposed strategy, the full board should be engaged in the evolution of the strategy.

The board should be a strategic asset—directors should individually and collectively seek to go beyond mere compliance and add value to the corporation. In general, directors can be effectively engaged in strategy by:

• Providing advice, counsel, and perspective;
• Challenging the underlying assumptions of management;
• Establishing high, realistic standards;
• Identifying additional opportunities and risks associated with the strategies under discussion;
• and Supporting the CEO during challenging periods of strategic implementation.

Corporate strategy is an ongoing process requiring oversight. Management brings vision while boards bring perspective. Management chooses a direction while the board, based on members’ diverse viewpoints, asks: Why? How? What if? As such, boards should be constructively engaged with management on an ongoing basis to support the appropriate development, execution, and modification of the company’s strategy.

Development

To take full advantage of their respective strengths, management and the board can jointly establish the process that the company will use to develop its strategy, including an understanding of the roles of both management and the board.

There is not always a “bright line” between management’s role and the board’s role, and involvement may vary. The role of management, ideally, is to engage the board in the strategic discussion and ultimately obtain board approval. The role of the board is to evaluate the strategy and challenge underlying assumptions. The board can serve best by providing strategic thinking and enhancement, rather than suggesting specific tactics. It is important to bear in mind these distinct roles so that the board does not usurp management’s role or fail to fulfill its own.

Companies can benefit from establishing clear yet flexible procedures whereby management and the board can exchange ideas through constructive interaction. This will help management develop a sound strategy, and help the board ensure the use of appropriate measurement criteria and benchmarks. It will also ensure that both management and the board fully understand and support the long-term direction the company will take. This “team-oriented” or cooperative approach can also foster a higherquality dialogue between management and the board, and enable management to make use of the expertise and experience of board members.

Evaluation and Monitoring

Once a strategy is approved, the role of the board is to provide ongoing evaluation of the strategy by monitoring implementation and encouraging changes, as events require. Therefore, to participate effectively in the strategic process, directors must thoroughly understand the assumptions and analysis upon which the strategy is based. Management should regularly update the board on the implementation and execution of the strategy. Directors should be prepared to ask incisive questions—anticipating, rather than reacting to, issues of major concern.

The board should ensure that management demonstrates commitment to the strategy, allocates adequate resources to its fulfillment, has a professional and financial stake in its execution, and adequately reports on its progress. The board should additionally monitor execution of the strategy against milestones. On an ongoing basis, the board must be willing and able to recognize whether or not the company has a winning strategy—and, if it does not, must be ready to urge corrective actions. The board should ensure that management makes modifications to the strategy as necessary.

Linking Strategy and Leadership

There is a strong tie between leadership ability and corporate performance. The board must ensure that the CEO has a clear understanding of the corporation’s strategic vision and has concrete ideas on how to implement that vision.

Moreover, the board needs to understand that leadership competencies are not all the same and industry dynamics are constantly changing. The strategic skills that senior managers possess must align with the future strategic challenges they will face. The board should establish achievable executive compensation objectives that reflect the company’s strategy, and define and communicate clear metrics and criteria for CEO evaluation that are tied to long-term strategic goals.

Future Challenges

Directors will always be challenged with finding a winning combination of strategy and risk for their companies. As boards grapple with the current complexities of strategy, the NACD believes the following issues will confront them.

Information is essential but it must be actionable. In strategic planning, the right information can help an organization successfully navigate its way through the marketplace. Directors are generally satisfied with the reliability of information contained in reports they receive from management, but the presentation of that information is often difficult to digest. Management’s main job is to bring the right information to the table. Directors, on the other hand, must then help management determine how the company will act in response to the information over the short, medium, and long term.

Greater Board Engagement

Typically, management develops a strategy with input from the board. In fact, according to the NACD Survey, slightly more than half of companies follow this model, while about 16 percent of boards work collaboratively with management in developing the strategy. Boards and management should consider earlier and greater collaboration when creating, refining, or (in rare cases) overhauling a strategy.

Directors must increase dialogue with management by asking the questions they want answered, rather than receiving information management wants to provide. Finding the right questions to challenge management’s conclusions is a director’s most difficult yet most valuable responsibility. As such, directors can ask management to limit their use of presentations in the boardroom and request unscripted time with the CEO for a free exchange of ideas.

Aligning Board Composition with Strategy

Companies have always tried to recruit accomplished professionals to sit on their boards, but sometimes directors’ backgrounds bore little connection to the company’s strategy. Today, enlightened boards are seeking directors with particular skill sets and expertise to complement their strategic goals. All boards can benefit from continually reviewing and evaluating the board’s size and membership mix to ensure a close fit with the strategic direction of the company.

Directors can develop a matrix of skills and expertise that the board requires in order to identify the leadership needs of the corporation, work with leaders to develop an appropriate strategy, and offer needed perspectives and advice in key areas. For example, a company looking to expand into international markets would seek directors who have business experience in those markets to ensure that the board can appropriately oversee the strategic plans and underlying risks of those plans.

Aligning Goals

The problem of short-termism has been well-established by a variety of studies and commissions, including, most recently, the Aspen Principles (Long-Term Value Creation: Guiding Principles for Corporations and Investors). The Aspen Principles, supported by the NACD, state that companies and investors should recognize that firms have multiple constituencies and many types of investors, and they should seek to balance these interests in accordance with their influence on the corporation’s long-term success.

Generally, companies should not seek short-term profit at the cost of long-term value. To avoid this, boards can develop forward-looking strategic metrics of corporate health. At the same time, boards can emphasize the need to achieve long-term goals while retaining benchmark reviews for the shortand medium-term goals as well.

Conclusion

Corporate performance depends upon corporate strategy. The board’s role in overseeing strategy is crucial. While a number of best practices have emerged, defining appropriate strategic engagement is still among the biggest challenges for boards. Improvement of corporate performance will require board members to become more actively engaged in the process of strategy creation. Directors must begin by requesting both time and information from management.

Boards must request unscripted time with management to probe the assertions and direction of the strategic plan. To foster this dialogue, boards need relevant and concise information—a current snapshot of performance. Improvement will also come from within the board itself. Careful selection of directors with relevant past experiences will enhance the board’s professional skills matrix. Most importantly, boards must have a steady hand to guide the company to long-term success.

Educating directors is vitally important to board success. NACD will deliver the findings in this white paper to boards directly through educational initiatives such as our Director Professionalism Courses and our Board Advisory Services, with the essential goal of empowering directors to act in the face of changing business, economic, and governance conditions.

The NACD White Paper Series I and Key Agreed Principles are not meant to prescribe a specific course of action; they point toward a direction—one that only the board, with management, can choose. The time to make that choice is now. Directors are leading the way to help restore confidence in the corporate governance of U.S. companies through the Director Challenge campaign. To obtain the Principles and White Papers, along with discussion tools for exploring them in your own boardroom, visit www.nacdonline.org/directorchallenge.

Financial institution boards will face many issues associated with the current financial crisis, including issues related to the Emergency Economic Stabilization Act of 2008 (EESA), the recently-passed stimulus program, Obama’s foreclosure prevention program, and whatever else comes out of the Administration and Congress. Many–perhaps most–decisions will require an understanding of the mortgage-backed securities (MBS) that played such a central role in the deterioration of our largest financial institutions.

Clearly boards must be careful not to undertake the responsibilities of management. Nevertheless, given the mistakes made with respect to MBS, boards will want to subject management at financial services companies to higher scrutiny and oversight regarding their involvement with these and other exotic securities. To do so, they will first need to determine whether there is sufficient expertise on the board and if not they will need to acquire it.

The task is easier said than done. MBS comprise a sophisticated alphabet soup of complex financial instruments, including securities backed by subprime, Alt A, negative amortization, home equity and commercial mortgage loans, as well as collateralized debt obligations (CDOs) backed by asset-backed securities (ABS) , and CDOs squared (which are backed by tranches of CDOs of ABS. Investment banks leveraged these securities at 35 to 1. Insurance companies bought them to back obligations such as guarantied investment contracts (GICs), annuities and funding agreements. Bond insurers then guarantied and reinsured them, and commercial banks’ bought and guarantied them with credit default swaps (CDS).

Defaults on the mortgages underlying these securities triggered steep market value declines, markdowns, capital depletion, rating downgrades, plummeting stock prices, all of which resulted in limitations on the ability to raise needed equity and write loans and insurance products. Yet, an examination of financial institution boards prior to and during the meltdown, and even now, reveals a surprising lack of direct expertise in these securities. And although closer scrutiny and oversight may seem a bit like closing the proverbial barn door, many experts believe that there will be substantially more markdowns of MBS. Indeed, Goldman Sachs, in a February 11, 2009 report stated “We’re only halfway through: We forecast $2.1 trillion in losses from U.S. credit this cycle.” The current environment will continue to present issues associated with MBS, as well as other issues raised by the financial crisis, that will require increased board oversight and its related expertise.

In fact, in late February, newly appointed Securities and Exchange chairman, Mary Schapiro indicated that she plans to examine whether boards of banks and other financial services firms conducted effective oversight during the period leading up to the financial crisis. At the same time she is considering asking boards to disclose more about directors’ backgrounds and skills and their knowledge of risk management, according to a recent article in the Washington Post.

Asset Liability Analysis

Boards, through their Risk Oversight Committees, might want to increase their scrutiny of how assets and liabilities are performing currently: how they performed under the company’s stress tests, whether those tests impose enough stress, and the extent to which assets match liabilities, particularly if liabilities are accelerated and assets have to be liquidated to meet them in markets that may become frozen. Boards may also inquire more deeply regarding MBS default projections, the assumptions underlying these projections and the reasonableness of the company’s methodology. With respect to CDOs of ABS and CDOs squared, it is important to understand the institution’s rights relative to the rights of others. For example the rights of the institution as a holder of a AAA tranche of a CDO squared are subordinate to the rights of the AA holder of the CDO of ABS in which the CDO squared holds the BBB tranche.

Disclosure by companies of additional asset markdowns after they announced that they didn’t expect any more has undermined confidence in financial institutions. These markdowns reduced earnings, depleted capital and eroded confidence among equity investors, sending stocks into a tailspin and limiting the company’s ability to raise badly needed capital. If the experts who believe that there is more to come turn out to be right, it will be even more important for boards to become comfortable with their companies’ mark to market methodologies.

The performance of many liabilities can be even more troublesome. Banks face issues with respect to triggers in their credit default swaps that can result in termination events and the need to post capital in the event of a ratings downgrade. Insurance companies issued GICs and funding agreements that can be accelerated in certain events, such as rating downgrades. “Full flex” GICs can be accelerated under many circumstances – almost at will, and municipal GICs can be accelerated under other circumstances. Annuities have similar considerations. Some funding agreements have short roll-over periods and can be terminated on short notice. Moreover, given the current environment and the likelihood that policy holders will need cash, does the institution have an efficacious methodology of forecasting cash surrenders? Sadly, many of the assets backing these liabilities are MBS, and their liquidation values have plummeted. As a result, which assets does the institution sell to meet their obligations? These and other variables must be clearly modeled out and analyzed – not only for the purpose of avoiding risk, but of understanding them and all the attendant consequences.

The declines in the values of assets backing liabilities that are accererating raises the need for liquidity. Boards should understand the extent of this need and ensure that management has arranged for multiple sources of robust liquidity that can be depended on during a crisis.

Also, Board’s may want to better understand the extent to which a company is at risk of a credit ratings downgrade due to capital adequacy (and other) issues. This is especially important now that rating agencies are downgrading securities backing and backed by financial institution obligations. The agencies are basing these models now on the acceleration of certain liabilities and liquidation values–as opposed to the future cash flows–of the companies’ assets. Downgrades not only can accelerate liabilities, require collateral posting and trigger rights to recapture ceded reinsurance, they can also effectively preclude the writing of new business for some institutions.

Under some circumstances, it has been productive for board members to meet directly with rating agencies, particularly if a company has been put on review for a downgrade that will limit the company’s ability to do business.

Reserves, too are ripe for renewed focus by board directors. Originally, they were considered the purview of the Audit Committee and informed by the company’s auditors as they form a large part the factors in dealing with expected losses and the period over which they will occur. Boards now need a much more comprehensive understanding of how management calculates its reserves and whether its methodology is consistent with statutory, regulatory, GAAP and rating agency requirements, as well as conventional practices.

Boards and Risk Governance

Boards might also want to subject their company’s risk tolerance levels to more scrutiny. For example, the boards might inquire more deeply regarding the price volatility of securities in its investment portfolio that may have to be sold to pay claims or other obligations.. Boards may also want to question management regarding the correlation risk along references (issuers) and sectors within the corporate CDOs held in the investment portfolio or guarantied through CDS. For example, they’ll want to know if the company exposed to the California economy through both its municipal bonds and its MBS holdings? What levels of leverage are acceptable given the price volatility of the securities leveraged?

Moreover, the board should determine that management has a system in place that assures compliance with risk tolerance levels once they are set – a challenge that proved difficult for many financial institutions in the recent past. The board might also want the risk and business functions of the company to be more separate than they are. For instance, analysts who set the company’s credit criteria should report to the Chief Risk Officer and the latter should report to both the CEO and the board’s Risk Oversight Committee or the full board.

Sell or Hold and TARP

The decision to sell or hold assets, whether to TARP or in negotiated sales to the private sector, involves the need to model future cash flows and assign present values to them. Indeed, a bank may realize more from its MBS by holding to maturity or until future credit losses become more ascertainable than by selling as the massive liquidations of MBS from margin calls have in all likelihood forced prices down beyond the present value of their future cash flows.. Moreover, a bank that sells MBS will forego any subsequent markup and its attendant increase in capital (for this reason, a guaranty of MBS under Section 102 of EESA would be preferable). As a result, selling at depressed prices might be the wrong decision and inconsistent with management’s and the board’s obligations to shareholders. On the other hand, holding MBS will be attended by market uncertainty regarding the extent of future losses. Boards should inquire enough of management to become comfortable with the balancing of these considerations.

The decision to take TARP money or other government funding must be made in light of the government’s insistence on lending which can be inconsistent with the board’s and management’s duties to shareholders to make prudent loans. It also must consider potential dilution of existing shareholders and executive pay limitations that could damage the ability to attract needed talent. Accepting government funds often, maybe always, carries a stigma – a perception that failure is possible.

Government Action and Policy

Boards should be aware of potential legislative and regulatory changes motivated by the financial crisis, how they can impact their companies, whether and how their companies should try to influence their outcomes, and how their companies plan to adjust if these changes are implemented. Perhaps the most visible are the panoply of actions contemplated by the mortgage assistance program, the stimulus package, EESA and the to-be-announced actions to be taken by the federal government in connection with banks. Also, changes are being contemplated by state insurance regulators that are likely to impact insurance and financial guaranty companies.

The notion of removing ratings from the federal, state and international regulatory schemes has been uttered and, if implemented, would change the way capital is calculated for depository institutions, insurance companies, and stock brokers. The elimination of the NRSRO designation–another thought that has been advanced by some–would require changes in state legal investment laws, mutual fund prospectuses and other documents containing investment eligibility criteria (that limit investments to certain rating categories) to allow many institutional investors to continue to purchase debt instruments issued by financial institution (and all other companies).

FASB, the SEC and insurance regulators continually debate whether to allow financial institutions to mark to model instead of to market. Boards will need to understand and become comfortable with the reasonableness of substitute valuation methods and models, how their results might impact the company, and whether they are consistent with their auditors’ views.

Some financial institution boards will be faced with the decision whether to become a bank holding company and will have to consider the institution’s needs for access to insured deposits as a low cost source of capital, access to the Fed for low-cost liquidity and to exchange illiquid, high beta collateral (e.g. highly rated MBS) for treasuries that can satisfy collateral posting requirements required by CDS and other contracts, and the benefits associated with the imprimatur of government support. On the other hand, boards will have to consider the disadvantages of becoming a bank holding company, such as becoming part of an unprofitable banking system that competes with unsupervised financial firms, lower leverage limits (although investment bank leverage limits are likely to be as low in future), becoming subject to risk-based capital rules (Basel II, for example), increased costs due to the need to install systems necessary to comply with government reporting requirements, increased supervision and regulation attended by additional costs and overhead, and the difficulty in becoming a non-bank holding company if the company chooses to do so in future.

Long vs. Short Term

Finally, some decisions may be in the interests of the institution, at least in the short run, but may be damaging to the economy as a whole and, in the long run, come back to damage the institution and, perhaps the entire sector. For example, lending to less creditworthy borrowers may be above a bank’s risk tolerance levels; but if all major banks were not willing to make such loans, funding for businesses could be inadequate to maintain operations, which could result in higher unemployment, a further contraction in consumer spending, more business failures, even higher unemployment and an increase in the velocity and severity of the existing economic downturn.

Also, foreclosure might be preferable to forbearance and mortgage modification (including reducing the principal amount of the mortgage) in order to minimize losses associated with home mortgages. But foreclosure would also add to the massive number of homes on the market, exacerbate the downward spiral of housing prices, result in more markdowns of MBS and, consequently, further deplete bank capital. As importantly, foreclosures prevent a bottoming of home prices, MBS markups and the attendant increase in the availability of home mortgage financing. As a result, home purchases and housing starts, which are the biggest engines to consumer spending, would suffer even more than they do currently. Consequently, because consumer spending constitutes 70 percent of our economy, an early economic recovery would become even less likely.

Because lending to less creditworthy borrowers and forbearance or modification as opposed to foreclosure could have good long-term results only if they were practiced by many large institutions, boards might encourage management to determine whether coordination with federal authorities and other institutions in their sector might be beneficial.

To be sure, boards should not undertake functions that are more appropriately the responsibility of management. Clearly boards should not build their own risk, default or price volatility models, or develop their own reserve methodologies or presentations to rating agencies. Nor should they impose on management a system that, in the board’s opinion, ensures compliance with risk tolerance guidelines. But the extent of oversight and scrutiny over these functions should be determined in large part by what is at stake for the company and its shareholders. It would seem that history has taught us that, given the current environment, the decisions discussed above are high stakes decisions that require high levels of board scrutiny and oversight as well as a deep and thorough interaction with management.

Neil Baron is a Director of Assured Guaranty Limited, a bond insurer, where he serves on the Risk and Audit Committees.

I know that sub-editors take liberties with copy in order to make headlines but this is utterly misleading.

First, risk, as the Chancellor himself acknowledges is inherent to the business of banking. It is only by the judicious taking of risk that business grows. So, the era of risk is not over.

Second, what are we to make of the demand that banks should be responsible? Of course they should. Whoever thought otherwise? It is in defining what it responsible business and how that is policed where the problem lies. If the review announced by the Chancellor helps to answer those questions, so much the better.

Third, what of the boards? For the most part, and current inquiries and investigations will confirm this or not, most directors were and are conscientious people doing their best, according to the context in which they were asked to perform their duties.

Fourth what was that context? In the first place, the banks were seen as hugely successful enterprises oiling the growth of world trade and investment. Senior bankers were courted and feted by politicians and the media. The siren voices prophesying doom were there, but they were few and far between. In second place, directors, including those of banks, under modern theories in the U.S., U.K. and E.U. are supposed to be independent of management. They are expected to exercise their judgement and experience to know what information to call for so as to challenge management and assess the adequacy of internal control and risk management. How can they do that without a much more profound knowledge of the business of banking which risks making them less independent? May be that is a compromise which will have to be made.

Fifth, where were the regulators in all of this, and the governments behind them? The regulators were passive and the governments quite happy to see the money lubricated by the banks flowing into their pet projects and into their tax coffers.

Sixth, what do we as a society want of banks and businesses – constantly improving returns, reported on a quarterly basis. Isn’t that perhaps just a tad short term? As the saying goes, you get what you measure.

So, where does this leave us on the question of pay and bonuses. Hindsight is a wonderful thing we all know, but let us not demonise millions of people for the sins of a few. Most bankers worked hard and conscientiously. When they did so they just be justly rewarded. If that includes bonuses, so be it. All they should be is fairly structured to promote the long term success of the enterprise and aligned to meet the interests of the employee and employer in long term sustainability. It may not be so exciting, but it will be more enduring.

Alan Jenkins, chairman & head of international development, at the London-based law firm Eversheds LLP.

Yet, many CEOs tend to simply present strategy to the board rather than engage their board on strategic issues. They typically work through strategy only with their executive team (and often consultants), then present it to the board as a finished product, concluding with: “Any questions?” They hope for as few as possible. Some CEOs believe that this approach is what the board expects from them. Others fear that greater board engagement on strategic issues will result in the board becoming the architect of the strategy—something that clearly lies within the purview of the CEO.

There is a better approach, however, that both capitalizes on the experience of board members and typically achieves greater alignment between the board and management [see chart]. It involves engaging the board at an earlier stage in the strategy development or review process—namely at the first stage, where an analysis of strengths, weaknesses, opportunities, and threats (SWOT) is considered.

Boards we’ve worked with that have gotten the most out of this approach have followed the same steps. First, well in advance of the board strategy or off-site meeting, interviews are conducted with all board members to gather their perceptions of key issues relative to the SWOT analysis. These interviews give the CEO the answers to two vital questions.

 Do board members have a sufficient understanding of the key issues? If there are gaps, it will be important to take time at the outset to provide the board with a better understanding of these topics— either through written information or presentations— to equip the board to effectively engage in strategic debate about these issues.

 Do board members see the key issues in the same way as management? For example, if management feels the corporate brand has lost its luster but the board views the brand as a key strength relative to competitors, this critical issue needs to be discussed and resolved prior to the development of strategic alternatives.

Armed with this understanding, a working session for the board is designed to address and achieve alignment on these SWOT issues. Often this takes the form of an off-site meeting, although some boards prefer to use one or more regular board meetings for this purpose. Regardless of format, the most effective approach is to avoid the “presentation after presentation” design and aim to create a true working session to generate dialogue between management and the board on SWOT issues. It can be helpful to define the roles of the board and CEO at the outset of the process— clarifying that strategy is the CEO’s decision and specifying that the goal of the working session is to provide the CEO with the benefit of the board’s perspective on a range of issues underlying strategy development.

This approach creates a very different dynamic than discussed earlier, where the CEO enters the boardroom already committed to a strategic direction and less open to new ideas and challenges from the board.

Moreover, this approach typically yields excellent insights from the board that might never have been generated otherwise. In today’s challenging business environment, getting the best from your board on corporate strategy is more important than ever.

Beverly A. Behan is managing director of the board effectiveness practice at Hay Group.  She can be contacted at Beverly.Behan@haygroup.com.

The cuts, which occurred last week, followed an announcement on December 11 that the bank would be eliminating up to 35,000 positions, about 10 percent of the combined work force of BofA and the acquired Merrill Lynch. The merger will make Bank of America the nation’s largest bank by assets when it closes early next year.

Cuts at BofA follow a series of firings that have hit many financial firms in recent months as Wall Street attempts to stay afloat in a period of economic decline. Significant job cuts include intentions to eliminate 52,000 at Citigroup, and cuts at Wachovia after it is acquired by Wells Fargo.

Though BofA has not officially confirmed its executive cuts due to privacy concerns, sources within the company have revealed some names, including deputy general counsel David Onorato, compliance/risk executive Helga Houston, e-commerce executive Lance Drummond, West Coast consumer banking head Brad Dinsmore, sales executive Mark Ricci, and Chris Swecker, manager of corporate security.

Third quarter financial statements indicate that BofA and Merrill Lynch employ approximately 300,000 workers between them. The original merger deal, which appraised for about $50 billion, has been diminished by declining share prices to about $20.5 billion.

1. Home Buyers: Real-estate values rose consistently for over a six-year period. From 2000 until 2006, housing was the single best investment for the average American. It was not a scheme as much as it was a way of economic life.

2. Legislators: The Community Reinvestment Act of 1977 forced banks with branches in poor neighborhoods to lend money to people with poor credit ratings, in return for the ability to add a branch or buy another bank. The rule was enforced by private groups such as ACORN.

3. Lenders: Subprime loans were the easy answer to the congressional dictate to lend to lower-income families, so subprime went from 2 percent of loans to 30 percent.

4. Fannie and Freddie: In the late 1990s, pressure was put on Fannie and Freddie to buy the securities backed by these mortgages.

5. Investment Banks: These loans were packaged into CDOs rated AAA, which lulled investment banks into relaxing due diligence standards.

6. Legislators again: The 1995 law permitted the securitization of subprime mortgages, making lenders more indifferent to risk.

7. Home Owners: Housing appreciation allowed anyone stretched too thin, due to borrowing, to sell and refinance.

8. The Media: Journalists fed at the trough of conventional wisdom, and allowed ourselves to be hypnotized by the bull market’s rush. Contrarianism became as dowdy as the Underwood typewriter.

9. The Federal Reserve: During this period, the Fed raised interest rates 17 times, eventually dampening affordability.

10. Speculators: Low affordability led to the exposure of borrowers who were too stretched, and speculators no longer had an incentive to keep up.

11. Rating Agencies: Rising delinquencies fed their way into previously issued securitizations, resulting in downgrades by major credit rating agencies.

12. Securitizers: As homeowners lost value in their homes, default rates began to climb, making assumptions look cockeyed and the structured vehicles and ratings seem hopelessly out of date. As Buffett says, you don’t know who is swimming naked until the tide goes out.

13. Financial Services: Shock waves go through the financial system, resulting in a seizure of credit markets.

14. Regulators: The SEC failed to clamp down on creditdefault swaps, even as analysts predicted a collapse. By the time they intervened, cutting off short-selling, it was too little, too late.

15. The Bad Economy: We thought we had the problem licked when the mortgage banks went under, went broke, or were bought. But a downturn in the economy put pressure on cracks in the foundation.

16. Accountants: In 1988, Basel II, as it is now known, became a controversial requirement for markto- market valuing of assets on the banks’ books.

17. Management: Massive book write-downs of assets led banks to require infusions of capital just when cash became king again. It was called a freemarket failure, but it was anything but free.

18. Capitalism: What had taken place was a paradigm shift in the pricing and assessment of risk that would extend beyond housing and affect the broad spectrum of financial services.

19. The World: Economies around the world, which have forever hitched themselves to the U.S. financial engine, were taken along for the ride.

Snap judgments are already being made by politicians about where to assign blame. With the glaring exception of anyone associated with the Bush administration, do not expect anyone within the Beltway to accept any culpability for America’s debacle.

What you can expect is that leaders in the private sector – and, that will certainly include corporate board members – will figure prominently among the suspects to be hauled in for interrogation before the “Peoples” committees and subcommittees on Capitol Hill. Candidates of both major parties have made it amply clear that the guilty will be admonished, judged, and summarily punished – all in the course of the same afternoon, if possible. For those able to escape actual prosecution, public spirited trial lawyers will ensure the “guilty” are made to pay.

All of this may sound disturbingly Kafkaesque, but the message is already coming through loud and clear: rampant greed, a lack of regulation, poor corporate governance and oversight all helped to precipitate this calamity. Only more, much more, regulation and strictly mandated corporate governance can restore order in the face of a greedy capitalist calamity.

In fact, the verdict is already in. The American public believes that the international market meltdown was the inevitable result of poor management at many levels, including corporate boards sound asleep at the switch.

Indeed, for better or for worse, boards are squarely in the crosshairs.

Boards have already been under relentless pressure for granting big pay packages to underperforming CEOs. Now, directors are coming under fire for what politicians and the news media have convinced the public was precisely the kind of lax oversight that led to Enron and the enactment of Sarbanes-Oxley in 2002 and all that followed. Apparently, none of this government-mandated governance was sufficient to keep the corporate “crooks” at bay. But Congress in its wisdom will not be as lenient this time around.

With the world in crisis mode, how can boards navigate this unprecedented terrain? Never in the past seven decades has there been such urgency for management and boards to work together to achieve real transparency and accountability.

An Air of Calm

The CEO, in particular, and the board of directors must project an air of calm, stable management. Senior executives and the board must be in alignment during this difficult time. There are a number of strategic moves that can and should be made make now.

If practical, consider establishing a special committee of independent directors to help the company navigate the crisis and determine remedies. The lead director should head this effort.

A board-management crisis communication plan should ideally have kicked in by now. (If there isn’t a plan, it is not too late to create one.) The board and management should be in daily contact, certainly with the lead or presiding director and the special committee. The company should know where to reach key directors (chairs of the audit and risk management committees, as well) at a moment’s notice. Make use of additional layers of communication, including videoconferencing, texting, conference calls, and other methods. Be mindful that all such records are discoverable.

The lead or presiding director should take a very active role, pass key information to the rest of the independent directors and relay board concerns to management. Now is not the time for directors to be out of touch.

Areas in which the board can take a leadership role:

Risk Management

• If the board doesn’t already have a risk management committee, create one, drawing from members of the audit committee initially. In a crisis, the risk committee should be meeting regularly, not just once or twice a year. It should appraise the whole board frequently. The entire board must be engaged in risk management.

• Conduct a comprehensive review of the company’s risk exposure, working with the CFO, comptroller and others. The full board could be liable for any management misrepresentations so there must be a policy of zero tolerance surprises or less than frank communication between management and the board.

• Install a risk-assessment process for the committee and board to follow. Some boards draw up a checklist, which the lead director and members of the committee use to query heads of business units. Again, the findings go back to the full board for oversight and action. Expenses & Compensation

• Eliminate all unnecessary board expenses and, if feasible, agree to a cut in director retainers in line with reductions in senior management salaries. Can outside board members afford to work for $1 a year, take a reduced retainer or increase common-share purchases during the crisis?

• Make executive compensation as bulletproof as possible, adopting new, permanent criteria going forward. The public is furious at outsized pay packages, and the board can take steps to make sure the company is not in the line of fire. Conduct a full-blown review of senior executive pay, especially the top five officers and division heads. Scale back restricted stock grants and take a careful look at deferred compensation. Finally, lay out the amended plan publicly in simple terms for all constituents.

• Establish independent standards for any compensation expert working with the board. Toughen pay-for-performance metrics.

• Will the CEO agree to a new, reduced employment contract – not only during the crisis but going forward? In effect, the CEO can set a new standard, which can send a powerful signal to competitors and beyond.

• Will the CEO and senior managers agree to a reduced cash-only salary or a limited grant of common shares during the crisis, redeemable on a set date at the market price? Will they agree to purchase common shares on the open market with their own money or, if they already do, will they buy more?

• Be sure there are no hidden unpleasant surprises against company policy, such as nepotism or outstanding personal loans to directors or executives (banned under Sarbanes-Oxley for years).

• Review all executive perquisites, down to the smallest privilege, and treat them as line item vetoes. Remove them if there is no good reason for them.

• Consider a clawback provision that enables a company to recoup incentive pay from a top executive who, in retrospect, actually failed to meet established performance standards due to subsequently discovered accounting errors or other misstatements for which he or she bears responsibility.

Board Structure & Policies:

• Install a non-executive chairman who has no connection with the company. Governance is moving in this direction, and CEOs who chair their boards and are in crisis mode are less apt to argue now. Boards can make a compelling argument for this arrangement.

• Consider asking a retiring director who is a strong contributor with needed expertise to stay on as a member of the board for an additional year, temporarily suspending age or term limits. NOTE: This shouldn’t be construed as a way to keep underperforming directors who are reluctant to retire.

• Review the D&O policy. Install a crisis plan and practice scenario planning.

• Engage in board-building:

    o Seek outside candidates who are comfortable with risk and crisis, recognize warning signs and aren’t afraid to ask tough questions. Recognize that desirable individuals may be running their own businesses and not have the time to take on board service. The search will be tough.

    o Attract candidates who are actively running businesses or who are, at most, only one or two years into retirement. Companies that ran into trouble have been criticized for larding their boards with consultants, longtime retirees and directors with little crisis experience.

    o Purge the board of directors who aren’t actively contributing.

    o Make it clear that the new governance policies, unless otherwise stipulated, are permanent. Directors who don’t agree with them should be encouraged to retire discreetly.

Boards should look upon the economic crisis as an opportunity for a comprehensive scrutiny of the company’s corporate governance. These actions must be fully disclosed to the company and beyond as new rules of governance going forward. If they’re perceived as window dressing, everyone will suffer, from management and the board to shareholders, customers, competitors, employees and others. The loss in goodwill would be incalculable. By word and deed, management and the board must establish a shared mission and convey to all that they are in it for the long haul and that, together with all constituents, they will weather this storm.

Barbara Ettorre is a principal at The Dilenschneider Group in New York. She can be reached at bettorre@dgi-nyc.com.

The reality, though, is that many boards don’t spend enough time on this line item of the balance sheet. Meanwhile, smart companies like IBM, Microsoft, and GE aren’t just developing intellectual property, they are tying in revenue streams through licensing arrangements and sale of intellectual property (patents, trade secrets, know-how, and industrial designs). Now, these companies are setting up systems to comb their employee base for ideas that can be patented or used to increase their competitive advantage. Good companies say their people are their greatest assets; smart companies know that it is their people’s ideas that are truly their greatest assets.

Corporate boards are responsible for understanding, monitoring, and influencing business assets that have a material effect on the ongoing success of their companies. Many directors think that an in-depth understanding of IP is relevant only for boards of companies that develop or rely on technology. Not so. More and more boards are recognizing that IP protection is a crucial factor in maintaining a competitive advantage. For example, one of the most prolific patent filers is Procter & Gamble, which last year alone, had nearly 280 patents issued on products ranging from shampoos to diapers.

For a board to provide valuable input into the company’s overall plan for its IP strategy, it needs to develop an understanding of IP, monitor the impact of IP on the company, and direct the use of IP to maximize its value. These goals can be accomplished by addressing IP in a threestage process.

At first, board members should look at IP from a defensive perspective, and gain an understanding about how their IP portfolio protects key products and technologies. In the second step, board members should expand their view of IP to include an opportunistic perspective, learning how they can create additional value from their IP. In the third stage, the board should look at the company as a whole and develop strategies to ensure that valuable IP continues to be developed in the future.

Stage 1: IP from a Defensive Perspective

It is essential for the board to gain a basic understanding of IP by taking a high-level look into the company’s current IP situation. A primer on all forms of IP protection, including patents, trade secrets, publications, copyrights, and trademarks would be an ideal starting point.

Management should also provide the board with a high-level view of the patent portfolio. Data should include the number of patents in the company’s possession, pending patent applications, the years patents were applied for and granted, and a general sense of the technology areas covered by the patents. The patents should also be mapped to the current key product lines and revenue streams. It has been shown that patent-protected products support higher margins and protect against competition.

While this basic quantification and trend reporting won’t give the whole picture of patent protection, it is a start to show the company’s tendency toward patenting and whether that tendency is increasing or decreasing. As boards move through the process, this basic chart of patent holdings over time can be developed into an “IP board packet” which will display the IP health of the company at each meeting. These charts should be updated and presented to the board at every quarterly meeting. Exposing directors to trends of patent growth and change will help them develop insights and enhance their governance of this valuable asset.

The mapping of patents will also show which products have little or no protection, which patents are protecting obsolete products, and which products have significant protection. This mapping provides transparency into the patent portfolio, helping to inform a governance discussion as to whether new product lines or revenue streams have protected margins and are less likely to invite competition. It can also be helpful to overlay a line graph (see charts at right) that shows current sales and/or projections for each product, to make absolutely clear when highly valuable products have very weak protection and vice versa.

Management should also present the board with an analysis of the IP held by the company’s competitors as related to each of its major products, including patent holdings. This analysis will allow the board to understand how its IP protection stacks up against competitors on a product-by-product basis and therefore understand competitive pressures.

Next, it is time for management to present to the board an IP strategy that provides a plan for strengthening its IP for defensive purposes. Just as the board understands and approves the business strategy of the company, it should understand and approve the plan for protecting the business strategy through the key competitive barrier of IP. The IP strategy should support the company’s business strategy to create maximum protection and enhanced valuation.

Stage 2: From Defensive to Opportunistic

During the next meetings, the board should learn to look beyond IP solely as a defensive tool and investigate developing an additional strategy that focuses on enhancing the “value” of the company through its IP.

But first, more data is needed from management, which should provide the board with a basic understanding of the value of the company’s IP portfolio by presenting an overall “IP valuation.” The valuation will quantify the value of different components of the IP portfolio. The purpose of this exercise is to start the board thinking about the IP portfolio as an opportunity, not just a cost. Unfortunately, many companies feel that an IP valuation is too costly to conduct. However, there are many ways to value the IP that are not as complex or costly. Many times we find that simple patent strength analysis shows 10 to 15 percent of the company’s portfolio is ripe for abandonment, as it does not support current or future products and has no commercialization value.

Next, it’s time to review the company’s options. Management should present to the board the company’s options, if any, to commercialize the company’s IP portfolio. Options for commercializing the portfolio include licensing or selling parts of it, or developing spin-out companies. Once board members understand the value of their IP portfolio and their options for commercializing it, they need to learn what their competitors are doing to produce value from their portfolios. The board should be presented with a report containing such information. This analysis will allow the board to get a more realistic understanding of its options for producing value from the company’s IP portfolio.

Now that board members have an understanding of the potential value of the IP portfolio and the different options available for commercializing the portfolio, management should present an “IP value strategy,” or a plan for extracting value from the IP portfolio based on the board’s recommendations. It is important—indeed, it is the overall purpose of the three-step exercise— for the board to provide guidance and approval on how the company will utilize its IP, just as the board would provide approval on a major change in the use of any material asset of the company.

Stage 3: Future IP Development

In the third stage, the board should look at the company as a whole to ensure that the ongoing development of valuable IP continues. Specifically, the board will monitor the people, processes, and metrics required to continue to drive IP development to serve as a strategic competitive barrier for the company.

Management should now focus on ways to ensure continued development of key IP. Specifically, human resources should share tactics for bringing in and retaining key innovators, including how they find and hire key inventors, how they develop inventors within the company (e.g., mentorship programs), and how they retain inventors (remuneration and incentives). Additionally, management should report their successes by documenting the number of inventors who have filed patents, the number of patents per inventor, the longevity of inventors at the company, and other key personnel metrics related to innovation. Here, the board plays an extremely valuable role in governing the fundamental talent behind the company’s innovations.

Management should discuss the processes in place to continually develop IP, including processes to extract inventions, develop targeted inventions, look at competitive IP, document inventions, review IP, and ensure that the IP protection strategy and IP value strategy are resourced and properly managed.

It is imperative to focus on ways to measure the company’s success in driving IP development. Management should introduce to the board IP-related “key performance indicators” (KPIs) that measure whether the company’s IP development processes are on track. The KPIs should measure the factors that drive IP development, including culture, people, and patent development. KPIs may also include the number of inventors who have filed patent applications, the number of invention disclosures filed, and other metrics.

In the final step, members of management should present their strategy for increasing KPIs, including process improvements they plan to implement. They should also present an annual update of the IP value and protection strategies.

At this point, board members will be fully educated on how IP can and is supporting their business. They can use this knowledge to help monitor IP development and ensure that IP is creating value and providing key protection for the company. They know the questions to ask and the indicators to look for to make sure their IP house is in order. As a result of this IP education, directors will be able to provide much stronger oversight of the company.

Many U.S. boards don’t cope well with a crisis and some directors are now striving to anticipate, and avert, trouble.

Part of the problem is ill-prepared board directors who fail to ask the right questions or adequately scrutinize management, governance specialists told the WSJ.

In the wake of the financial turmoil, more boards will ask themselves, “Are we well prepared for the unforeseen crisis?” said Jerry W. Levin, former chairman of retailer Sharper Image Corp. and a director on four public company boards.

“For an extremely complex financial institution like Lehman, that set of directors probably wasn’t the best group to populate its board–or help prevent its collapse,” said Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware business school.

Assessing corporate risk is a particular weakness. In 2006 and 2007, when Lehman was amassing mortgage-backed securities and questionable real-estate loans, the risk committee of its board met twice each year, the WSJ’s review of regulatory filings show.

A person close to the board says risk was discussed at four committee meetings and 25 board meetings in 2008.Now, the WSJ reports, more boards may take a bigger role in risk management.

During a Sept. 9 roundtable held by the National Association of Corporate Directors, 24 chairmen of audit committees agreed “the whole board needed to be engaged” in monitoring risk, an association official says.

What’s a corporate director to do? Be prepared:

* Pick directors with temperament, skills and experience to spot warning signs

* Engage in regular scenario planning

* Choose independent law firm as future crisis adviser

* Create an effective risk-management committee

* Appoint a nonexecutive chairman

* Develop and practice an emergency communications system

* Prepare for special committee to explore crisis’s cause and remedies

Source: WSJ reporting

In an interview with the Financial Times, Loshcer said Germany’s competitiveness could be at risk and a top priority in his second year of leadership will be to better diversity management.

“The management board are all white males. Our top 600 managers a predominately white German males. We are too one-dimensional,” he said. Of 15 divisional heads, 11 are German even though 80 percent of Seimens revenues are derived from outside its home country.

Siemens has instituted a mentoring program among senior managers. Among Loshcer’s charges are four Germans, two Chinese, a South African, a Pakistani, and American, and a Brazilian.

According to an article by Joann Lublin in today’s The Wall Street Journal on building the post-bankruptcy board, there are different approaches. Usually, these boards are selected by creditors, but some lawyers, investors, and executives believe such an approach can result in an ill-equipped board, raising the risk of a repeat bankruptcy. They suggest a collaboration between management, incumbent directors, and creditors when a company sets out to select board members after emerging from a bankruptcy.

Most businesses remain troubled in the wake of a bankruptcy, the WSJ found, and that is the reason a rigorous effort should go into board selection. An example of the collaborative approach method has been demonstrated by Northwest Airlines. Mirant Corp., NRG Energy, and Northwestern Corp. have all used similar approaches.

The story offers a cheat sheet in building an effective post-bankruptcy board:

• Persuade creditors, bondholders, executives and current directors to accept an outsider as a neutral broker.
• Seek consensus from those key players about the idea makeup.
• Create a wish list of attributes, candidates, and mix of temperaments.
• Screen incumbent directors as well as new candidates.
• Find enough prospects with multiple skills to allow tradeoffs.

One outstanding way for senior executives to show their commitment to leadership development is to actively participate in leadership development programs. Depending on their skill sets they can be active teachers or simply show their support by attending sessions. A number of highly visible CEOs in fact have been excellent role models of how senior executives should behave in this respect.

When Roger Enrico was the CEO of PepsiCo, he regularly taught sessions on leadership with his direct reports. Similarly Bob Eckert of Mattel has sponsored numerous leadership development programs at Mattel and has taught and participated in them. When asked why he participates in Mattel management development programs, Eckert doesn’t hesitate. He says it is because he learns from the programs and it gives him a chance to see the company managers in action. He adds it also shows his support for talent development.

Enrico and Eckert exemplify what effective leaders of HC-centric organizations need to be. It is not the hero or imperial leader who can single-handedly take an organization by its neck, shake it, and send it in the right direction. It is a leader who can turn leadership into a team sport and who can develop a company of leaders.

In a business world that is turbulent, constantly fluctuating, and intensely competitive, what is needed is an organizational ability to adapt and constantly learn. This in turn requires having leaders at all levels who can lead change. A very important part of the leadership activities of managers at all levels should be searching for better and newer ways to do business, new approaches to organizing, and of course for changes in the environment that should alter the business strategy.

Where possible, the search for better alternatives ought to involve experimentation, use of metrics to validate the effectiveness of new procedures, and sharing learnings with others. Admittedly this type of mind-set and behavior needs to start with leadership by the CEO, but at its very core is the principle that leaders everywhere in the organization need to ensure that learning, experimentation, and attention are focused on what is happening in the external environment.

Jeffrey Pfeffer and Robert Sutton, in The Knowing-Doing Gap, make a statement that captures my feeling about how managers should think about their jobs. According to Pfeffer and Sutton, the major job of managers is architecting organizational systems that establish the conditions for others to succeed. In other words, good managers are a combination of coaches and builders that enable performance by others. They help define success as well as identify relationships and processes that will lead to it. This applies at every level of the organization. In a shared leadership organization the expectation is that leaders at all levels are thinking about and creating systems and situations where teams, individual contributors, and entire business units are able to be successful.

The Changing Role ofthe COO finds that the need for, and the definition of, a COO is determinedby the relationship between the role and that of the CEO, including theirrespective personalities and the needs of the particularbusiness.  A risk assessment of the CEO “goingit alone” and internal talent management considerations are also used to determine the role of the COO.Some have said that the COO position is evolving from the number two spot in acompany to a leadership “on demand” role that changes focus with changing businessstrategy.

What’s more, the report finds that companies, in order togrow more quickly in an increasingly competitive business world, are becomingflatter, with the CEO now going directly to the heads of lines of the businessfor answers. 

“The scope and intensity of leadership demands today callfor a team approach at the top,” said Fr. Robert J. Kramer, principalresearcher at The Conference Board, and author of the report, in astatement.  “Some companies are decidingthat the composition of that corporate leadership team need not include a COO.Others are changing the duties for which a COO is responsible.”

The report is based on in-depth interviews with executivesfrom companies that represent diverse industries and a literature review.  Those executives surveyed include heads ofhuman resources, regional heads, COOs, CEOs, heads of business units, and headsof company research.

]]> http://www.directorship.com/coos-dont-just-fade-away/feed/ 0 http://www.directorship.com/drucker-in-the-boardroom/ http://www.directorship.com/drucker-in-the-boardroom/#comments Thu, 01 Jan 1970 00:00:00 +0000 Elizabeth Haas Edersheim http://www.directorship.com/?p=4476 Although generally known throughout his storied professional life for his work with chief executives, Peter Drucker advised hundreds of boards of diverse organizations around the world, constantly reminding them of the need to stay true to their role as a constructive “adversary of top management.” It is a role he thought boards didn’t always live up to. “There is one thing all boards have in common, they do not function,” he once wrote. “The original board, whether American, English, French, or German, was conceived as representing the owners. Each board member had a sizable stake in the enterprise. But large companies in advanced countries are no longer owned by a small group. Their legal ownership is held by thousands of investors; the board no longer represents the owners, or indeed anyone in particular.”

Still, Drucker, often called the father of modern management, knew that the board should actively participate in the strategic agenda of the company. In helping it fulfill this vital role, Drucker’s primary tools were a set of well-directed questions and thought-provoking suggestions—the kind of tools for which he is famous. As Drucker correctly predicted, this role of constructive adversary of top management is increasingly critical in the “Lego World.” Legos were a favorite analogy for Drucker to demonstrate how the pieces of a company—its people, products, ideas, and physical assets—fit together and connected and interconnected to build out the two-dimensional proposition of “what products at what price?”

Serving more than seven decades as our leading observer and strategic adviser to business—and as the author of 39 books on management—Drucker, who died in 2005 at age 95, developed a unique perspective on the healthy balance between preservation and change. His theories still revolutionize the way companies operate in the age of the Internet, changing demographics, and the knowledge worker (a term Drucker coined).

The timelessness of Drucker’s thinking continues to amaze even his newest readers. Nobody knew how to capitalize on the past and make way for the future like Drucker. His writings are all about business as an innovative agent of change; he provided solid, practical advice on how to succeed with start-ups as well as with established companies. Should a business stick to what it knows best, or should it take a risk and make a foray into a different area? His laser-like, penetrating questions helped management and the board see their challenges in a new perspective and arrive at innovative answers to strategic dilemmas. Here are some of Drucker’s thoughts, questions, and the cases he referenced as he took on the art of boardroom strategy.

Location, Location, Location

John Bachman, the retired managing partner of the financial services firm Edward Jones, remembers how Drucker got into a contentious discussion with Ted Jones, the chairman of the board. The discussion began with Drucker asking Jones, “How do you decide where you put your offices?” Jones, being clever, said, “Well we do it like the baseball player, Wee Willie Keeler. We hit ‘em where they ain’t.” He went on to explain that they targeted cities where there were no competitors and Edward Jones would be the only game in town. Drucker, pushing him, asked, “Why would you do that?” Jones responded, “Because we do better.” Drucker asked how much better and suggested that they look at the facts. When they did, they found that Edward Jones did 25 percent better where there were competitors. Jones had parsed the market geographically and had defined the customer as the rurally located American with no alternative access to the stock market. After some persistent challenging by Drucker, Edward Jones came to see that its customers were actually people who wanted personal service and relatively low-risk investments, regardless of location. Drucker’s questions fundamentally changed the board’s understanding of the Edward Jones customer and hence, the company’s value proposition.

Early Warnings to DEC About Tsunami

In a 1985 letter to a member of the board of Digital Equipment, Drucker asked if they had thought about the assumptions the business was built upon: “I have a strong feeling that the company—and indeed every other second-tier computer company in the United Statess—has to rethink its basic business assumptions and strategies. I have the distinct impression that the basic rules of the game have changed. First, that the Japanese have decided to adopt IBM as the standard has simply made IBM the standard. The basic strategy of a company like DEC…was to offer an alternative to IBM and thereby [try to] prevent the establishment of one standard in which a DEC would not have a separate identity but would be another IBM-compatible supplier. When the Japanese decided…to adopt IBM as their standard, they…made obsolete the basic assumptions of the smaller American computer companies…But perhaps more serious is…that the entry of the three Japanese companies on the world market has freed IBM from all restraints…Up until a year or two ago IBM very carefully nurtured enough competition to avoid accusations of being a monopoly. It seems to me dangerous to depend on mistakes made by the big competitors especially if the competitor’s pockets are so deep that they can write off a mistake without much pain. What does this mean, assuming my reasoning is correct, for DEC? Can they maintain a traditional strategy or is it time to think through the basic assumptions on which their business rests? Do let me know what you think of my questions.”

The DEC board chose not to question the assumptions underlying the company’s “traditional strategy” despite new external realities. DEC was acquired by Compaq in 1998 after years of poor results.

How P&G Lost Its Way

In 2001, during a period of performance decline at Procter & Gamble, Drucker was asked by the board to review a position paper that was meant to address this decline, which had preceded a broad slow down in the U.S. economy. Drucker followed up his review with a letter to the board:

“In a consumer boom you actually lost market share in some of your most important brands. There are three plausible explanations:

“Incompetent people can be dismissed out of hand. The same people, who today do not produce results, performed magnificently only yesterday.

“The basic assumptions and strategies on which the business operates no longer fit reality. P&G is already re-thinking its basic theory of business, adapting it, changing it, re-focusing it.

“The knowledge, the competence, and drive of performing people are misdirected or inadequately utilized.

“Your position paper is concerned primarily with explanation number three. Your paper argues that traditionally P&G has focused on optimizing its market capital–brands–and has treated the information, knowledge, and passion of people as an ‘input,’ that is, the traditional economist’s ‘labor’ and a ‘cost.’

“It makes no sense, however, to look for an explanation of P&G’s recent malperformance in faulty or inadequate utilization of the intellectual capital. There has never…been a company that has done a better job than P&G in developing people, putting them where the results are, and making high performers out of them. Rather, it may be precisely the very perfection of the P&G system that has become a straightjacket and tends to imprison the individual’s knowledge in the silo of a specialty, a brand, or a market segment, rather than allow it to become a company asset. That approach is, so to speak, a ‘planned economy.’ Worse, it does not utilize the individual’s motivation and passion, the ‘fire in the belly.’ As in any planned economy, performance standards are minimums below which the individual is not allowed to fall. The exceptional performer does so despite them rather than because of them. And he or she is thus also encouraged by the system to keep his or her information and knowledge to themselves rather than contribute them to the company.”

Under the leadership of then P&G CEO A.G. Lafley, who worked closely with Drucker, P&G effectively turned itself around by listening to the exact prescription Drucker advised—it abandoned its rigidity and enabled everyone to recognize the consumer as the ultimate boss.

If Only GM Had Listened

Beginning in 1939, Drucker and Alfred Sloane, then CEO and chairman of the board of General Motors, had a running disagreement. Sloan believed that management was a science. He saw General Motors’ success as a result of the company’s ability to optimize its distinctive economies of scale, manage the flow of money and investments, and provide an expansive dealer network that encouraged trade-ins while selling new cars. Drucker, on the other hand, believed that management was a practice and that the practitioner’s job was to continually challenge the theory and bounds to redefine the “what,” not the “how.”

By failing to reassess its “what,” today’s GM is a sickly shadow of the robust corporation that Sloan built and that thrived for 70 years. Its market share in the United States exceeded 55 percent through 1960. Today, it is less than half of that. In 1980, GM was still the most sought after company to work for by college engineers, according to MIT’s placement office. Today, it is not even in the top ten.

What happened? Customers’ values changed to reflect major shifts in society, taste, and culture. Americans wanted convenience, safety, fuel efficiency, and commuting comfort. Rather than listening and connecting with these values, GM invested in quick fixes and patches—solutions built from their old way of doing business—while the company continued to decline.

Meanwhile, Toyota quietly adopted the Drucker approach, continuously redefining their approach to “what.” At the time, the idea of a Japanese auto running in NASCAR would have been unthinkable. Toyota passed GM last year as the number one automobile company in the world; it’s expected to become number one in the U.S. market this year.

In one of his last conversations, Drucker shared what his advice to the GM board would have been. He would have told them: “Lock yourselves up in a room and assume in two years that you will not make another car anything like the ones you make today.” Then, he would have asked them, “‘how can you use your strength, your position, and your scale to redefine the transportation industry?’ Are they asking those questions?”

The Art of the Boardroom

Anyone reading today’s headlines would conclude that boards need Drucker’s advice more than ever. They need his clarity and often his ethical guidance. To perform effectively, Drucker would say that a board should:

• Understand and embrace the board’s unique mission to be a constructive adversary, even towards the CEO and his or her executive team.
• Guard the ability to have a truly external and longer-term perspective, one that, for example, values innovation and the development of human capital.
• View social responsibility as a necessary, engrained characteristic of the organization. Directors should focus on activities that enhance their organization’s knowledge and abilities in production and marketing but they should also realize the wonderful opportunity to bring responsibility to an organization.
• Balance their role as overseers of the executive team with their critical role as a valuable “sounding board.”
• Challenge their own assumptions and biases—and check the date stamp on their frame of reference—that might otherwise preclude their effectiveness as directors.
• Help ensure thoughtful and sensible succession planning from one era of management to the next.
• Establish effective methods of reporting and communications up and down the organization.
• Conduct detailed self-performance monitoring and tracking evaluations with metrics tied to targeted results.

Elizabeth Haas Edersheim is author of The Definitive Drucker: Challenges for Tomorrow’s Executives—Final Advice from the Father of Modern Management. She is the founder of New York Consulting Partners and a former partner at McKinsey & Co.

Sidebar – P&G’s Lafley on Drucker: curiosity and humility were two of his greatest assets

As I’ve looked back on the conversations and countless hours spent reading Peter Drucker’s books and articles, I’ve thought about what made him so extraordinary. For me, it comes down to five things.

First and foremost, Peter’s basic rule was the importance of serving customers. “The purpose of a business is to create and serve a customer,” he said. Plain and simple. Second, Peter insisted on the practice of management. He had little patience for detached theory and abstract plans.

The third characteristic was his gift for reducing complexity to simplicity. His curiosity was insatiable, and he never stopped asking questions. The fourth defining Drucker strength was his focus on the responsibility of leaders. “The CEO,” he said, “is the link between the inside, where there are only costs, and the outside, which is where the results are.” For many reasons, businesses become inwardly focused. The CEO has primary responsibility for bringing the outside in, for ensuring that the organization understands the views of the market, current and potential customers, and competitors.

The fifth and most important of Peter’s many attributes was his humility. He treated everyone with deep respect. “Management is about human beings,” he wrote. “Its task is to make people capable of joint performance, to make their strengths effective, and their weaknesses irrelevant.”

- From the forward of The Definitive Drucker: Challenges for Tomorrow’s Executives—Final Advice from the Father of Modern Management.