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Who should be on your company’s board?

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What do you get when you put a room full of CEOs from different industries together in a corporate board room and ask them to govern a company?

Several answers could apply but what accompanied the financial crisis was a breakdown in risk management at the top.

It was just two years ago that the “perfect storm” of a decade of excess credit, excessive leverage and uncontrolled expansion by financial institutions precipitated the financial crisis. A common thread was that the boards of these financial firms were oblivious to the risk build-up.

Boards of supervising directors have two primary functions: supporting the creation of long-term economic value, while at the same time controlling the conduct of business in the interest of shareholders and other stakeholders. And yet, these two functions are inherently at odds.

Looking at the composition of boards, it should come as no surprise that so many boards fail to perform.

Boards typically are made up of a collection of CEOs and top executives from different industries. They can provide strong input from a leadership point of view, but often do not have enough specific industry expertise and become far too supportive of management to exercise their controlling mandate, particularly when it comes to overall risk assessment.

This is especially so in companies with widely dispersed ownership where the owners/shareholders are not present at the board table except once a year at the annual general meeting.

Who should be on the board to prevent a governance crisis?

There has been some reform, but companies across different industries need to continue addressing their boards’ composition with the following requirements in mind:

1. A critical mass of industry expertise, as well as the expertise for specialised committee work

Board directors must have relevant industry expertise to advise management on major business issues and the appropriate degree of risk to take. For example, no matter how successful they were  in their own companies, banking board members lacking financial expertise had no way of knowing there might be hidden risk buried in collateralised debt obligations with a triple-A rating. Boards also need members with functional expertise for specialised committee work, like audit and compliance.

2. Sensitivity to interests of both shareholders and other stakeholders critical for long-term value creation

The boards of companies with widely dispersed ownership are continually at risk of being dominated by the concerns of either management or board members to the detriment of the shareholders’ interest. Rather than paid advisors, boards have to be continually open to input from the owners. And in today’s environment where corporate reputations can quickly be broken, boards also have to be open to the collective opinions of other stakeholders, like customers, who are critical for long-term value creation.

3. Board members willing and able to devote the time needed for the board’s work

Much has been said after previous governance crises about restricting the number of board mandates that directors can take on. Some progress has been made. But there is still a widespread tendency to fill the board with high-profile executives often running large corporations or divisions of their own. The job of a CEO is more than a full-time job. How can a CEO possibly devote enough time and energy to understand the full complexity and underlying issues facing the boards of other large companies, especially if they are in completely different industries?

4. Board members with a broad enough perspective to rotate roles and take on committee work

With changing conditions inside and outside the company, the board has to change the allocation of its time and energy. This means altering the attention the full board gives to the work of its specialised committees; it may require the creation of a temporary subcommittee to deal with a particular issue, like corporate strategy during a turnaround. Board members have to be flexible with a broad enough perspective to take on different roles and tasks as required.

5. Strong sparring partners willing to raise the red flag

The moment of truth for a board comes when management starts destroying long-run value, because it can no longer adapt to the changing conditions, or makes decisions that involve taking large, often hidden risk, or engages in behaviour causing critical stakeholders to withdraw their support. It is at these times that board members have to be willing to raise the red flag. This requires board members with sufficient confidence in their judgement to be strong sparring partners of the CEO and Chairman.

In brief, we need boards with enough industry expertise to make meaningful judgements about strategy and risk, with members who can take on the specialised committee tasks, and represent the owners’ views, with enough diversity to capture the interests of other stakeholders important for the long term. And we need board members with enough time and experience to advise the CEO and management on critical leadership issues. This is asking a lot from boards which, for effective discussion and decision-making, typically have 8-12 members. Judgement is needed to decide which of these requirements is essential at different points in the life of the company, combined with a willingness to alter the composition of the board.

Lessons from UBS and Credit Suisse

There are encouraging signs that lessons have been learned about the importance of board composition in the banking industry. There has been a move to strengthen the critical monitoring function of the board in respect to risk management by bringing in more people with real expertise.

Examples are provided by Switzerland’s two largest banks: Credit Suisse and UBS. Credit Suisse faced some tough times a decade ago due to emerging market debt. As a result, it reconstituted its board, brought in more industry expertise and strengthened its risk management committee. UBS, on the other hand, had been flying high – its board members were all very comfortable. All that changed when the financial crisis hit two years ago and Credit Suisse far better weathered the storm than their Swiss rival.

Now we see UBS applying the same lessons as Credit Suisse. Post-financial crisis, UBS has completely reconstituted its board with several new members who have real industry expertise. In addition, the board appointed Oswald Grubel as CEO of UBS in 2009, someone with a track record in leading the earlier turnaround at Credit Suisse. Kaspar Villiger, elected as UBS’ Chairman of the Board in 2009, is a former member of the Swiss Federal Council, whose political experience has been important in assisting UBS in resolving its legal dispute with the U.S. authorities over client tax evasion and with Swiss politicians over management compensation. The result for UBS has been an impressive turnaround.

Reforming the board’s composition proved to be essential for the turnarounds at Credit Suisse and UBS. But in both cases it took a severe crisis to provoke the reform. The big question is whether other companies will reform their boards before they are hit by a crisis. Or will the old maxim continue to apply: no change without a crisis?

Paul Strebel is the Sandoz Family Foundation Professor of Governance, Strategy and Change at the International Institute for Management Development (IMD), the leading global business school based in Switzerland. He directs IMD’s High Performance Boards program.

Image by clagnut [Richard Rutter]

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