The Importance of Director Self-Evaluations
BoardRoom IQ, February 25, 2013
Authored By Jonathan F. Foster and Steven A. Rosenblum
The boards of directors of the more than 5,000 public companies in the United States play the primary role in overseeing these companies, focusing on key issues including strategic direction, financial statements and capital structure, and management performance. One of a Boards’ most important roles is evaluating the CEO and the other senior executives. Yet, evaluations of directors are a relatively new effort. Effective director evaluations are a critical component of good governance. An effective board can contribute significantly to a company’s success, while an ineffective board may fail to see warning signs and allow issues that might have been managed successfully to snowball into serious problems.
Given the importance of the board’s role, a critical governance issue is who in the best position to evaluate the performance of directors. According to the Spencer Stuart 2012 Board Index, 83% of Fortune 500 companies have directors who serve one-year terms. This trend has been driven by governance advocates seeking more influence over director elections. However, director elections are a blunt instrument for director evaluation.
With public companies that have hundreds if not thousands of shareholders, it is cumbersome, at a minimum, and, in most cases, impractical for shareholders to evaluate directors. Shareholders have imperfect information; they are not in the board room. In addition, proxy contests are expensive and often involve some element of self-interest on the part of those initiating the contest, and withhold authority campaigns are typically centered on some broad policy issue, not the individual performance of the directors.
As a result, it is the board itself that is usually best suited to evaluate its own performance. Since the adoption of the NYSE’s corporate governance rules a decade ago, which include the requirement that a board “should conduct a self-evaluation at least annually to determine whether it and its committees are functioning effectively,” director self-evaluations have become standard practice in public companies. The board has the skills to evaluate performance. After all, evaluations of the company’s CEO and senior management are among the board’s core roles. The challenge is to find a way to apply these evaluation skills successfully to the evaluation of the performance of the board itself.
The board should consider what it seeks to accomplish through the self-evaluation process, which will likely depend on what areas of board performance are most in need of improvement. For example, are there issues with how the board agendas are set? The flow of information between the company and the board? Interactions between and among directors? Individual director commitment and energy?
There is no one correct way to conduct a board self-evaluation. Each board should determine what will be most effective for that board. Discussion of the board’s performance as a group is productive if directors are comfortable raising and discussing issues openly and frankly in a group setting. Some mechanism for collecting information anonymously may be needed if there are sensitive issues that are unlikely to be surfaced in any other manner. The use of outside consultants, counsel or standard questionnaires may be helpful for some boards. Including legal counsel in the process may also help to maintain privilege over written documents used in the self-evaluation process, and an appropriate document retention policy may be adopted so that documents are not retained after they have served their purpose. Importantly, however, the board should not abdicate its self-evaluation responsibility entirely to outside advisors or forms.
Typically, the non-executive chair, if there is one, or the lead director or chair of the governance and nominating committee, will take the lead in conducting or overseeing the self-evaluation process. Evaluations are usually done both for the entire Board and for each committee. The best self-evaluation process will necessarily involve constructive criticism and directors should not only accept that, but encourage it. No matter how good a board is, and how good individual directors are, there is always room to improve. Directors should not feel defensive about receiving criticism, and the criticism should be delivered in a manner designed to promote improved performance, not hurt feelings.
While the board as a whole should generally understand and discuss the issues surfaced through the self-evaluation process, if there are significant issues with respect to an individual director, it may be best to address those issues privately with that director. In that case, the primary focus should be on helping the director to address the issues and improve performance. Of course, if a director is clearly underperforming, ultimately the board or its governance and nominating committee will need to consider with whether the director should be renominated.
The self-evaluation process can and should be done confidentially. The company can disclose that it regularly conducts a robust self-evaluation process, and may consider disclosing how the process operates. But just as a company does not disclose the content of its evaluation of senior executives, the content of the board’s self-evaluations should remain private. This confidentiality is essential to ensuring candor, and shareholders can take comfort in knowing that the self-evaluation process is in place.
The board should recognize that the self-evaluation process requires a significant investment of time. But, it is time worth spending. Just as a good board takes seriously its role in evaluating the performance of the company’s business and management, so should the board take seriously the evaluation of its own performance.
Jonathan F. Foster is a Managing Director of Current Capital and Steven A. Rosenblum is a Partner in Wachtell, Lipton, Rosen & Katz. The views expressed are the authors’ and do not necessarily represent the views of their firms.