The effective board of directors: leading practices in board evaluations
May 2014 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
Financier Worldwide Magazine
May 2014 Issue
Long after the tumult of corporate scandals and the global financial crisis, the spotlight continues to shine on the performance of boards of directors. Responding to demands for higher standards to support the integrity and stability of financial markets, regulators around the world are strengthening their corporate governance frameworks, which underpin confidence in these markets. Stakeholders want assurances that boards are providing vigilant oversight.
The need for constructive board evaluation is now recognised as an essential component of good governance practices in order to enhance board effectiveness. In addition to customary board self-evaluations, more regulators are introducing requirements for periodic external evaluations. These new obligations, however, lack specific standards and guidelines, leaving many directors guessing as to the most appropriate processes to undertake.
Today, most European listed companies are conducting board performance evaluations (‘Board Evaluation: A Window into the Boardroom’, Rhee, 31 May 2013, Harvard Law School Forum on Corporate Governance and Financial Regulation). Traditionally, self-evaluations have been the common practice. In 2009, 94 percent of S&P 500 companies and 70 percent of US public companies conducted self-evaluations (‘Board self-evaluations: Striking the right balance’, Directors and Boards, Rubenstein and Murray, July 2010). Yet a 2010 study of 1110 US directors found that only 11 percent felt their self-evaluation was “very effective” (‘Value-add Board Evaluations: What to Look for’, Financial Executive, Shultz, September 2010).
Since internal evaluations are typically carried out by the board chair or led by a board committee (such as the governance committee), the principal benefit of self-evaluation is the internal evaluator’s knowledge of the board and its functioning and the insight this offers. Self-evaluations, however, also have a number of drawbacks. Evaluators may lack assessment expertise, for example, and standard guidelines to direct the process may not exist. As well, evaluators may be hesitant to carry out a robust assessment due to confidentiality concerns or to protect board collegiality. And, of course the evaluator, as a member of the board, may lack objectivity.
To address the weaknesses inherent in self-evaluations, jurisdictional regulators are increasingly introducing the requirement for periodic external board evaluations. Experienced third-party evaluators complement internal efforts by introducing an objective perspective and additional resources and by contributing specialised skills and knowledge of best practices. They can also provide standards and structure to provide greater rigour to the process. As well, external evaluators offer opportunities to benchmark with other organisations.
External evaluations can be particularly beneficial in instances where there has been a change of chairperson, problems requiring tactful handling, a perception of board ineffectiveness, a need for greater transparency or the board lacks the capabilities to conduct an evaluation. Moreover, where there are confidentiality concerns, an evaluator can interview directors and report information to the full board without attribution.
As institutional stakeholders increasingly sought greater assurance of board effectiveness following the global financial crisis, regulators have acknowledged many of the shortcomings of board self-evaluation systems. The UK was one of the first countries to introduce the requirement for external board evaluations. In 2010, the Financial Reporting Council revised the UK Corporate Governance Code to include the following provision: “evaluation of FTSE 350 companies should be externally facilitated at least every three years”.
In the US, according to the report Board Evaluation: Improving Director Effectiveness of the Blue Ribbon Commission of the National Association of Corporate Directors, by 2010 one in five US boards used an external evaluator.
In Canada, the Office of the Superintendent of Financial Institutions issued amended corporate governance guidelines in January 2013. These state: “The Board of a federally regulated financial institution should regularly conduct a self-assessment of the effectiveness of Board and Board Committee practices, occasionally with the assistance of independent external advisors. The scope and frequency of such external input should be established by the Board”. With respect to the effectiveness of oversight functions, guidelines were also amended to clarify that the board “occasionally, as part of its assessment, should conduct a benchmarking analysis with the assistance of independent external advisors”.
Other regulators in Canada are taking board accountability to a higher level. For example, in 2011 the Deposit Insurance Corporation of Ontario (DICO), which is the regulator and deposit insurer for credit unions in the province, updated By-Law # 5 - Standards of Sound Business and Financial Practices. This by-law included new corporate governance standards requiring boards to establish training requirements and qualifications for all directors. DICO assesses the adequacy of director competencies and competency levels as well as policies and practices related to their training and qualifications.
Thus more regulators are setting out expectations for more evaluations – both internal and external. They expect to be able to determine whether the effectiveness of the board was assessed at an appropriate level and for the board to demonstrate who did what, where, when and how. Since there is little direct guidance from regulators regarding how these assessments should be conducted, the following leading practices may be helpful for directors to consider:
Establish clear goals, scope, approach and timeline for the evaluation.
Ensure that all board members: (i) agree on the scope of the evaluation (i.e., directors, committees, committee chairs, overall board); (ii) are committed to the process and how it will be carried out (e.g., observation, discussions, questionnaires, interviews, document analysis); and (iii) agree on the elements to be examined (e.g., agendas, meetings, information flow, performance of committees, board-management relationship, approach to governance, risk, strategy).
For external evaluations: (i) schedule an evaluation a minimum of every three years; (ii) ensure the independence of the external evaluator, i.e., no ongoing or recent relationship with the organisation; and (iii) ensure the evaluator has the necessary expertise, especially knowledge of current governance practices and experience conducting board evaluations for similar organisations.
Include in the evaluation: (i) feedback of appropriate senior executives in order to assess the board’s relationship with management; (ii) evaluation of individual directors; (iii) composition and performance of key committees (e.g., nominating, audit, risk, compensation) to assess essential board functions; (iv) insights from multiple stakeholder perspectives; (v) benchmarking against standards and practices of comparable organisations; and (vi) actionable recommendations.
The board should also provide rigorous documentation to support the completeness of the evaluation process, results of the evaluation and plans to address the results. Directors must also act on these results and document the actions taken.
Never before have boards been subject to such intense performance scrutiny. However, while evaluations may seem to be an additional burden amid myriad other new regulatory requirements, they also represent opportunities for enrichment on multiple levels. For example, evaluations enable boards of directors to enhance team-building, strengthen decision-making capabilities and the board-management relationship, to refine strategic focus and address skills gaps.
These evaluations also present opportunities for boards to strengthen the organisations they oversee. Evaluations help to clarify goals and priorities and reinforce ethical tone and culture.
Such evaluations are also an opportunity to strengthen stakeholder relationships. By participating in these evaluations, boards enhance corporate reputation by demonstrating their commitment to governance excellence and building trust and accountability.
Requirements for board evaluations are expected to elevate on a global scale. As this trend continues, directors should keep in mind that evaluations are only as effective as the process. No board wants to face angry shareholders or proxy advisory firms questioning its governance capabilities. By adopting best practice evaluation strategies, directors can be prepared for the most demanding scrutiny by regulators or stakeholders.
Ingrid Robinson is a senior manager at MNP LLP. She can be contacted on +1 (416) 515 3934 or by email: ingrid.robinson@mnp.ca.
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