How to make boards do their job

Barry Falls

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Are corporate boards in danger of becoming vestigial organs?

In September 2008, in the biggest bank failure in our history, Washington Mutual’s board was not even consulted as federal regulators arranged the emergency sale of the nearly insolvent company. CEO Kerry Killinger, who served as chair of the board for 17 years, had pushed the strategy of subprime lending well after the housing bubble had already burst. His board-approved bonus structure had excluded mortgage loan losses from the company’s earnings calculation. The new CEO received a $7.5 million signing bonus in a contract approved by the board—for what turned out to be 17 days on the job. It’s little wonder that regulators treated the board as irrelevant during the bank’s emergency sale.

Unfortunately, this was not some isolated fluke. Scenarios of boards and CEOs failing to do their jobs on behalf of the companies’ owners—the shareholders—were repeated time and again during the recent economic meltdown. James McRitchie, who started one of the first websites devoted to improving corporate governance, CorpGov, says that randomly selecting board members from among a company’s stockholders would be an improvement over the current system, in which directors “select themselves and exist in a bubble where they and their CEOs are isolated from reality.” Shareholder activist Robert Monks says, “Can we do without them? Hey, we are doing without them—and not very well. It’s actually worse than nothing because it creates the illusion of something.”

As Jeffrey Sonnenfeld of the Yale School of Management observed in a Harvard Business Review article in 2002, the problems of boards are rooted in their social and cultural systems. CEOs and boards need to “understand the difference between dissent and disloyalty. . . . The highest-performing companies have extremely contentious boards that regard dissent as an obligation and treat no subject as undiscussable.”

Our book offers many suggestions for reforming the dysfunctional system of corporate governance. Some of these would require cooperative action, perhaps by institutional investors—such as the creation of a new class of professional, full-time directors, with extensive industry knowledge, accounting and finance skills, and training in group dynamics. Along with this should come a requirement that every board include a certain number of these “super directors.” To improve the dysfunctional culture of boards, we also propose required initial and on-going training at a “Directors’ Institute” formed by a consortium of major business schools, as well as measures to encourage greater demographic, experiential and perceptual diversity on boards.

Other recommendations we make can be carried out by companies individually. For instance: companies should impose term limits on independent directors. They should require more communication between directors and shareholders, through such steps as quarterly conference calls in which board members have to field questions. And company bylaws should require all directors to have a meaningful percentage of their net worth invested in the company they serve—along the lines of three to six percent—and to hold those investments for a specified period after their tenure on the board ends.

We also believe Congress must strengthen shareholder rights legislation by making changes significantly broader than have thus far been contemplated. For example:

Split the chairman/CEO role. No one can reasonably expect a person to oversee himself or herself. The continuation of combined roles inhibits the board in exercising its responsibilities because it creates an insurmountable imbalance of power. The change should be mandated by law.

Allow shareholders to call an Extraordinary General Meeting. In the UK and many other developed countries, a group of shareholders (usually 10 percent or more) can call for an Extraordinary General Meeting, in which a majority of those voting may remove directors. Some form of this right should be the norm in the United States.

Add some clout to say-on-pay. This measure, allowing shareholders to vote on executive compensation, is currently nonbinding. If executive pay programs fail these votes over three consecutive years, executive pay should be reduced by a meaningful percentage, set in advance in corporate bylaws.

Ban staggered boards. Boards are staggered to thwart takeover attempts, but in reality this simply serves to entrench directors. All directors should stand for election on an annual basis.

Require majority votes in uncontested elections. Currently, corporations can choose to retain a director who has failed to win a majority vote. This is bad policy that sends the wrong signal and defeats the purpose of elections. Fifty-percent-plus-one votes should be a requirement.

Provide easier access to put rival director slates on the proxy. When combined with minimum ownership requirements by those making board nominations, this is a long-overdue reform. There should be holding requirements for stock after the election, as well as before, and there must be better regulation of manipulation by hedge funds and others who can control votes without having actual ownership.

Our recent collective experience underscores how essential corporate governance is to preventing devastating losses and ensuring our economic security. Boards can play the single most effective role in advancing the future opportunities and prosperity of our families, our communities, and our country. If we expect and demand more of them, they will rise to the challenge and answer that call.