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

Authors Harry Cendrowski and Adam Wadecki

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

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

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

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

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

Expected Value = ∑ Compensation Element_i x Likelihood of Payout_i

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

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

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

Exhibit 1: Stages of Development

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

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

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

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

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

Exhibit 2: Importance of Plan Components by Organizational Stage

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

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

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

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

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

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

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

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

Exhibit 3: Example Nonfinancial Metrics

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

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

Exhibit 4

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

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

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

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

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

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

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

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

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

The Walker Report makes a series of recommendations to improve the governance of British financial institutions, anchored, one may argue, by a dramatically enhanced role for the board chair. While an effective chair is essential to a well functioning board, how much power is appropriate? Does the power shift inherent in these recommendations aggrandise the chair at the expense of the chief executive – and the board itself – by concentrating power in another set of hands?

Walker’s recommendations 7–10 specifically address the chair, dealing with enhanced time commitment to the role, requisite industry experience and business leadership skill, facility in board leadership and administration, and accountability via annual election. The requirements for such skills and experience in the leadership of businesses and boards, while onerous, justified and well articulated, are not novel. Such attributes are rare and immensely valuable and make for appropriate criteria for election to the role.

It is the first of these recommendations that sets the expectation for a fundamentally new understanding of the role of chair – a role that would see a near-singular business focus by the chair on the organization. With such focus, and the effort born of it, the chair would develop an unparalleled opportunity to influence and check the power of management. The assumption is that a strong chair is good for governance insofar as the board will have much greater awareness of what’s going on in the company. This reduces the traditional disadvantage of a board: a vast knowledge gap as compared to management that constrains a board’s ability to assess strategy and evaluate corporate performance.

But are there unforeseen risks in this picture? Several come to mind. First, chair recruitment will be more difficult: will the qualified, potential chairs that corporations need be willing to devote the lion’s share of their time to a single company’s oversight, narrowing the range of active interests from which they may draw credibility?

Second, there is a greater likelihood of confusion between the roles of the chair and the chief executive. Might such an expected commitment appeal instead to those wishing to exercise executive power rather than governance oversight, increasing the chances of putting the chair in conflict with the chief executive and destabilizing relations between the board and management? Third, the independence of the chair could be negated. Will the near full-time involvement of the chair with a company’s management diminish the objectivity of an otherwise outside point of view, and eliminate a critical source of disinterested reflection and feedback?

Finally, it could also see the power of the board skewed toward the chair. Will the influence of directors and their motivation to contribute wane in the face of a much more powerful chair?

Canadian boards, like those in the UK, accept the logic of separating chair and chief executive roles to keep distinct the power to oversee management from the exercise of that power. But the degree of responsibility envisioned by Walker for the chair would not be well received by Canadian directors, as it would re-muddy the distinctions between chair and chief executive and diminish the distributed burden of governance shared by the board as a whole. American boards, already wary of splitting the leadership at the pinnacle of corporate power, tend to interpret Walker’s new model as chair supremacy – and thus as confirmatory evidence of out-of-control boards grabbing power and weakening the very chief executives vital to corporate success.

While there is much to recommend the Walker Report, directors and regulators should revisit the rationale for separating the chair and chief executive roles: to remove the conflict of having someone chair the body that counsels and oversees them and to provide a means for channeling strategic advice to the chief executive via an independent voice. The recommendation to increase the power of the chair in effect begins to reverse that separation by re-conflating the roles and asking the board to counsel, oversee and evaluate an executive largely influenced by its own chair.

David Anderson is president of The Anderson Governance Group, an independent advisory firm dedicated to assisting boards and management teams enhance leadership performance.

This article first appeared in Chartered Secretary.

Originally published in the March issue of Chartered Secretary (the ICSA magazine).

Samantha Carey

For decades, the concepts of cost, efficiency, rationalization, profitability and other metrics used to drive success in business have been deemed taboo when speaking about healthcare. Like the banking industry’s “too big to fail,” the notion that age-old economic principles of supply and demand could not possibly be applied to healthcare is just a fallacy. Two lessons need to be learned: we cannot afford to maintain the status quo, and success is never gained by waiting for someone else to define the box in which an organization should play.

Some of the changes organizations are, or should be, considering:

1. Boards/directors: Board structure, director qualifications and focus are being scrutinized and challenged in all industries today. Nowhere is this more important than in healthcare where boards may be filled with community members, directors who have hung on too long, or individuals who lack the experience or drive to aggressively get their organization back on track.  Leadership will need to be re-evaluated. Boards will need transparency, a strong chairman, and strong independent leadership with relevant turn-around, new-market development and joint-venture experience. Directors must be able to articulate strategy and be ready to step up and work to truly help executive leadership.

2. CEOs, COOs, Presidents: The right leaders for the future may look different from leaders in the past. They will need to be “transformational” and will need vision and fortitude to gut-renovate their business. Even for businesses that are doing well today, reimbursement will ultimately decline. How will businesses diversify to fully leverage their strengths, capacity and footprint?

3. General Athletes: Individuals are needed who can execute turnarounds, recognize opportunities for new lines of business, new joint ventures or partner relationships. Leaders will also need to improve operations and metrics to drive business-process improvements and patient-oriented outcomes — the operations focus that other commoditized industries have experienced for decades. High-level executives who can lead and influence will be instrumental in revamping the system to deal with and optimize the new volume burden.

4. Compliance: Healthcare providers and service providers will have to demonstrate greater levels of transparency to prove compliance and to handle fraud and abuse enforcement and penalties for false claims. Internally this could result in massive growth in infrastructure (IT and executives capable of gathering and using data and analytics). There are a number of service providers who will benefit tremendously, and many providers who can save time and money (and potential government wrath) through business process outsourcing.

IT leadership: Healthcare needs new internal IT infrastructures, as witnessed by demand for CMIO candidates–a CIO who is an MD; for IT executives who can manage systems for complex reimbursement changes, especially as fragmented markets become consolidated; and for CIOs who can respond to new pressures on EMRs and system-wide information requirements.

There should be no sacred cows within the healthcare reform effort and boards and C-suite executives should not fool themselves that they are victims.  Leadership will need to take control and reexamine everything, while engaging staff at all levels for ideas and improvements.  Organizations should be bolder about bringing on new executives or independent directors from outside the space who can dig in, bring fresh perspective and find avenues of opportunity.

Finally, the new requirements for disclosure of the financial relationships among health entities, including hospitals, physicians, pharmacies, manufacturers and distributors of covered drugs, devices, biological and medical supplies, threaten to pose a major distraction. Rather than treating this as an administrative or custodial burden, an organization-wide commitment to transparency is needed to deliver the outcomes data that will demonstrate improved quality of patient care as a result of these relationships.

The good news is that there will be opportunities for new businesses providing specialty expertise to alleviate the pain for some of the larger organizations. Business Process Outsourcing will be on the rise and executives who know the system will be able to thrive.  Existing organizations can also leverage their infrastructure, adding on new service lines and capabilities.

Healthcare has to improve.  Some companies and systems are already heading there.  For the first time, all healthcare organizations should make changes. Equip your organization to identify and choose the best of them.

Samantha Carey is a partner at CTPartners and a senior member of the executive recruitment firm’s global life sciences and private equity practices.

But there are exceptions – and thereby hangs quite a tale. That even in today’s world certain reputations somehow survive undiminished suggests, not just that these particular business leaders acted shrewdly while the rest of the world crumbled, but that something in their very DNA assures long-term immunity and an abiding, almost mystical, connection to an otherwise disillusioned populace.

Atop that list is, of course, Warren Buffett. His leadership “style” has been much discussed as have the equally durable reputations of contemporaries such as Bill Gates and past exemplars like Sam Walton. One common explanation for this enduring prestige is that they create jobs. In so doing, they garner the persistent gratitude of people who, for whatever reason, cannot understand that, say, Goldman Sachs does so too.

Yet some of those same people may likely know next to nothing about Berkshire Hathaway or the actual work that Buffett does. They have no more concrete reason to associate him with job-creation than Lloyd Blankfein. No, there are stronger forces at play and, perhaps, a few cautionary lessons for officers and directors amid the continuing decline in corporate credibility.

Main Street isn’t Wall Street. Buffett is from Nebraska, Walton Arkansas, and Gates indelibly West Coast. No matter how savvy these men are with respect to the financial markets, they are not perceived to occupy the same private and secretive New York world where the Wall Street mainstays reside.

Work is its own reward. The Buffett and Walton (if not the Gates) mythologies eschew the trappings of success. Buffett drives an old car and lives in a house he bought decades ago. Walton drove a pick-up truck at the height of his success while his office in Bentonville was small and unadorned. Such Spartan habits do more than simply establish a “we’re just plain folks” basis for a relationship with the public. They also minimize the burden of envy that people feel toward jetsetters. Absent envy, what’s left is admiration.

But it goes further than that by underscoring the value of work for its own sake, i.e., the Protestant Ethic. If these men are not working in order to live opulently, they must have less selfish motives. Austerity further inspires confidence because it shows that success has not changed them; they still share our values and are just as trustworthy as when they first opened modest little businesses.

They help others succeed. There’s a common perception that success on Wall Street requires mastering an arcane financial language unique to the financial services industry. It is a language with which many people cannot imagine themselves likewise conversant. Instead, the public reveres those from whom it can learn. No matter how bad the economy, Buffett and Walton earn allegiance because they sincerely explain their success in terms anyone can understand. One post on youngentrpreneur.com says it all:  “I love Warren Buffet! Not because he’s extremely wealthy but he creates his choice of words in a simple fashion.”

They foresee the future. Bill Gates does not live humbly or proffer simple wisdom. Unlike Buffett, some abhor him for his ruthlessness. Unlike Walton–still admired despite Wal-Mart controversies since his death–Gates’ reputation is tied to Microsoft’s.

But Gates shares one quality, at least with Buffett, which bedazzles and continues to generate loyal admiration. He seems to know what’s coming next before anyone else does. The word “visionary” is typically used to characterize his command of the technological future but, on the larger stage, people listen just as intently to his pronouncements on other industries or the economy in general. (His 1996 best-seller was called The Road Ahead.)

Especially during crises, the gift of prophecy is at a premium as crises by definition raise alarming questions about the future. Gates earned his prophet’s stripes by spearheading American technology at a time when it seemed the Japanese owned the future. For those who lived through it, such leadership is remembered and can still cover a multitude of purported sins.

Don’t tread on me. The public will stay loyal longer to fighting spirits who are also underdogs. Buffett and Walton remain underdogs because of their humble beginnings; the brand, reinforced by austere lifestyles, bespeaks courage. In this regard, the Microsoft antitrust case ultimately worked very much in Gates’ favor. First, he took on IBM. Then he went toe to toe with the U.S. government. People warmed to his cause who didn’t know what that cause actually was. 

No one virtue or ingredient can possibly enable a business leader to maintain heroic stature in an environment like today. The key is in the combination. With heartland roots reinforced by conspicuous modesty, they are purveyors of life’s lessons, scrappy combatants against formidable odds, and sympathetic guides who know what problems loom on the horizon for all of us.

Such leaders survive the Great Flood and barely get wet.

Richard S. Levick, Esq., is the president and chief executive officer of Levick Strategic Communications www.levick.com, a crisis communications firm. He is the co-author of Stop the Presses: The Crisis & Litigation PR Desk Reference and writes for www.bulletproofblog.com. Reach him at rlevick@levick.com.

It is telling that for the second year in a row we have given top billing to a regulator. This year’s most influential person in the boardroom is U.S. President Barack Obama. (Last year, it was Congressman Barney Frank, chairman of the House Committee on Financial Services.) Obama and his team have moved quickly, in FDR fashion, to stabilize the markets, shore up the financial system, and inject stimulus into the economy. For now, these measures seem to be working. It is likely that Obama’s team of financial minds will set their sights on putting measures into place to discourage the malevolent behavior that led to crisis. Most executives and directors favor some form of common-sense reform. In fact, many CEOs, such as Goldman Sachs’ Lloyd Blankfein, have been proactive in calling for sensible reforms on executive pay practices and in other areas.

Finally, I want to thank you, our readers, for your input on the list through the numerous polls and online surveys we issued. The Directorship 100 is meant to begin the dialogue, not to end it. So, please join the discussion online at www.directorship.com/D100-2009.

If the job of finding great new directors is difficult, so is the job of sitting on a board, especially for the first time. Here is some common-sense advice for new directors. First, and most importantly, remember that directors direct and managements manage.

Why Serve?
Understand why you choose to serve and embrace it. In earlier times, directors often served for prestige, compensation, and fellowship, and their performance rarely was challenged. Those halcyon days are gone. You now must consider reputational risk, substantially expanded (and often last-minute) time commitments—perhaps at little per diem pay—and a more formal environment (which can impinge on candid strategic focus). Do due diligence on the company and its industry, as you will be judged in the court of public opinion—and perhaps even in the courthouse. You’ll need courage, good business instincts, and the rare ability to judge others accurately.

Directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

Reliance on Outside Advisors
As a matter of corporate law, directors are generally entitled to rely on advice from outside advisors, including compensation consultants. Directors should exercise care in selecting experts and shouldn’t hesitate to question those experts as much as necessary.

We recommend that the following be adopted as standard best practice for directors:

1. Audit Committees should meet regularly with supervisory partners of their firm’s auditors, not just the audit partner, and should require that the auditors disclose conflicts and disagreements about accounting matters and the consequences thereof. Auditors already disclose conflicts with management and “opinion-shopping”, but directors need to understand the “close calls” that accountants are making.

2. Compensation Committees should focus more on actual performance and on compensation expected under different scenarios, and less on consultants’ standard pitches on comparables.  Rewards for performance must be based on realistic goals, taking into account the environment and the factors management controls. In general, paying annual bonuses for performance only relative to an earnings budget should be avoided (because management controls the budget) and relative to peers’ stock performance equally (because management doesn’t control either its own or peers’ stock prices). Further, mark-to-market accounting of financial investments, determination of pension liabilities, and other key P&L components can be manipulated to affect reported profits and compensation. True operating cash flow, and performance relative to competitors, while also not perfect, are worth considering as performance measures. Proper use of deferred payouts tied to actual realizations will go a long way towards realigning managements’ and stockholders’ interests.

3. Boards should receive regular presentations from outside counsel about important trends and cases in corporate law, especially those affecting their duties and their liability. In addition, directors should be assured on a regular basis that each of their primary law firms has brought forward any legal or ethical concerns.

Board Oversight
It goes without saying that boards should focus on economic and financial scenarios covering the full gamut of assumptions. In the current environment, liquidity is a key concern. At other times, expansion or strategic transactions may play a larger role.

Management will always control the flow of information, and even deeply engaged boards will be on the losing end of an asymmetry of knowledge. But directors must exercise due care in decision making and need, as much as possible, to ensure that the information they receive is accurate, complete, timely, and verifiable.

We offer the following suggestions to mitigate, at least partially, the inherent disadvantage directors face due to this asymmetry.

First, ensure that management provides access to, and explanations about, competitors’ performance. Detailed understanding of relative competitive assessment of revenue growth, operating margin, employee turnover, customer satisfaction, and pricing policies will be far more useful than reiteration of historical financials or unsupported projections. Rating agencies face conflicts and their work cannot always be relied on (in any case, ratings often lag reality), and securities research can be superficial and dominated by management or employers. Spend time finding out how the firm is really doing.

Second, create and exploit opportunities to engage informally with employees at all levels of the organization. Plant managers, sales staff, and human resource middle managers, for example, will have a less edited view of how the business is going than you will hear at board meetings.

Third, make sure senior management regularly reinforces the responsibility, under a code of conduct or ethics policy, for every employee to notify an outside board member, anonymously or not, of any planned or known misconduct, whether financial fraud, Foreign Corrupt Practices Act payments, improper behavior, or other improper actions. The purpose of this “honor code” is to give directors more eyes and ears.

Fourth, make sure board meetings include enough time for the independent directors to reflect in executive session on the reports they have received and to raise questions for later follow-up.

It is important for directors to have a good working relationship with management, and, at the same time, one that permits directors to exercise their responsibilities. This relationship best can be described as one with “healthy tension.” Directors and management need to understand that asking probing questions is not done out of suspicion: Sometimes judgments of senior management are just wrong, and directors must press their questions, no matter how uncomfortable this becomes.

Knowing Good from Bad
There is no perfect system for identifying a CEO who lacks honesty, integrity, or capacity. Just as a board needs to know the physical health of top officers, however, it also should (subject to reasonable limits on privacy) understand their financial health, and, as much as possible, their values. Financial circumstances, especially excess leverage, sometimes force desperate people to take improper steps.

One tip after years of experience: In addition to probing executives’ financial health, if a CEO regularly requests less compensation than his/her compensation committee would have awarded, that CEO is less likely to get the company into trouble via excessive risk taking or fraud.

Good luck to all new board members, and, remember, selecting a good CEO and helping him or her achieve the goals set by the board is one of your most important jobs.

Herbert S. Winokur is managing general partner of Capricorn Holdings and has been a director of numerous public companies.

Bob Pozen, chairman of MFS Investment Management and former vice chair of Fidelity, suggested that what’s needed is a re-examination of board structure in the aftermath of the financial crisis. “Some of the most distinguished people serving on boards–take Citigroup, for example–didn’t have a clue about what was going to happen” He suggested that most bank boards are simply too large and that corporations should be monitored by “the smallest board necessary.”

Fawcett, now chairman of Pensions First Group and Guardian Media Group, which publishes the Guardian and Observer newspapers in the U.K., and a director of State Street Corp., pointed out issues tend to get lost when a board has upwards of 17 or 18 members. What’s needed, she suggested, is “diversity of thought and experience. That’s diversity with a small ‘d.’ Those [financial] institutions whose boards were diverse tended to fair better because of the wide body of expertise.”

Pozen also questioned the wisdom of mandatory retirement for directors, calling it “wrong.” Directors age 60 and older  have both the experience and the time needed to devote to board service.

Noting that “two out of three deals fail,” a director in the audience asked what the board’s role should be after a merger or acquisition?  Ruettgers, who served as chairman of EMC, a data storage company that grew largely by aggressively pursuing an M&A strategy, said the board set up a separate acquisitions committee to review some smaller deals that didn’t need to rise up to the full board level. The board’s role, too, Ruettgers suggested is to compel management to put together a process for integration that can be monitored.

Governance reform, whether legislated or mandated by the Securities and Exchange Commission, looms large. Say on pay, proxy access, broker vote, and the separation of the chairman and CEO role are all up for debate. Drawing from her U.K. experience where “almost nothing is legislated,” Fawcett noted that these issues are addressed on a “comply or explain basis.” Posen predicted that hedge funds would become more active users of these procedural changes. “This opens the door to activist shareholders,” he said.

All business executives and board members would do well to consider the odds against Lincoln and how forcefully he inspires, while reprimanding, his general:

Lincoln’s Message to George B. McClellan
April 9, 1862:

Washington, April 9, 1862

Major General McClellan.

My dear Sir,

Your dispatches complaining that you are not properly sustained, while they do not offend me, do pain me very much.

Blencker’s Division was withdrawn from you before you left here; and you knew the pressure under which I did it, and, as I thought, acquiesced in it — certainly not without reluctance.

After you left, I ascertained that less than twenty thousand unorganized men, without a single field battery, were all you designed to be left for the defense of Washington, and Manassas Junction; and part of this even, was to go to Gen. Hooker’s old position. Gen. Banks’ corps, once designed for Manassas Junction, was diverted, and tied up on the line of Winchester and Strausburg, and could not leave it without again exposing the upper Potomac, and the Baltimore and Ohio Railroad. This presented, (or would present, when McDowell and Sumner should be gone) a great temptation to the enemy to turn back from the Rappahanock, and sack Washington. My explicit order that Washington should, by the judgment of all the commanders of Army corps, be left entirely secure, had been neglected. It was precisely this that drove me to detain McDowell.

I do not forget that I was satisfied with your arrangement to leave Banks at Mannassas junction; but when that arrangement was broken up, and nothing was substituted for it, of course I was not satisfied. I was constrained to substitute something for it myself. And now allow me to ask “Do you really think I should permit the line from Richmond, via Mannassas Junction, to this city to be entirely open, except what resistance could be presented by less than twenty thousand unorganized troops?” This is a question which the country will not allow me to evade.

There is a curious mystery about the number of the troops now with you. When I telegraphed you on the 6th. saying you had over a hundred thousand with you, I had just obtained from the Secretary of War, a statement, taken as he said, from your own returns, making 108,000 then with you, and en route to you. You now say you will have but 85,000, when all en route to you shall have reached you. How can the discrepancy of 23,000 be accounted for?

As to Gen. Wool’s command, I understand it is doing for you precisely what a like number of your own would have to do, if that command was away.

I suppose the whole force which has gone forward for you, is with you by this time; and if so, I think it is the precise time for you to strike a blow. By delay the enemy will relatively gain upon you — that is, he will gain faster, by fortifications and reinforcements, than you can by reinforcements alone.

And once more let me tell you, it is indispensable to you that you strike a blow. I am powerless to help this. You will do me the justice to remember I always insisted, that going down the Bay in search of a field, instead of fighting at or near Mannassas, was only shifting, and not surmounting, a difficulty — that we would find the same enemy, and the same, or equal, entrenchments, at either place. The country will not fail to note — is now noting — that the present hesitation to move upon an entrenched enemy, is but the story of Manassas repeated.

I beg to assure you that I have never written you, or spoken to you, in greater kindness of feeling than now, nor with a fuller purpose to sustain you, so far as in my most anxious judgment, I consistently can. But you must act.

Yours very truly,
A. Lincoln