Using Board Advisers Effectively
Paul Sweeney

External consultants often play an integral role in the board's decision making. But it's important to know where to draw the line.

Are consultants the new Barbarians at the Gate?

Martin Lipton appears to think so. Best known as the father of the poison-pill takeover defense, the New York corporate attorney propounded that critical view of outside board consultants earlier this year.

External consultants, declares Lipton, a founding partner at the venerable New York law firm Wachtell, Lipton, Rosen & Katz, are emerging as the handmaidens of public pension funds, hedge funds, and other activist shareholders bent on eroding the vitality of the modern, publicly owned corporation. “Shareholder activism,” he declared in a blistering February 2007 speech in Miami, “is ripping through the boardrooms of public corporations and threatening the future of American business.”
In his take-no-prisoners oration (New York Times columnist Gretchen Morgenson labeled Lipton’s hard-edged rhetoric “something of a rant”), the lawyer cited a number of villains contributing to the “eclipse of the modern corporation.” High on his list are the “parade of lawyers, accountants, consultants, and auditors” working in tandem with shareholder activists and having a “demeaning effect” on boards of directors.

That’s a heady indictment, one that has already excited a fair share of comment in the business press, investment community, and corporate governance circles. Governance observers such as Robert Thompson, an expert in business and securities law at Vanderbilt Law School, agree there’s been an increase in the use of consultants since Sarbanes-Oxley, leading to the conclusion that Lipton’s incendiary language hasn’t been winning him adherents. Of corporate boards’ increased use of consultants, Thompson says, “It doesn’t really trouble me. To say that it’s emasculating the board is an overstatement.”

Paul Regan, president and chairman of the San Francisco forensic accounting firm Hemming Morse, expressed puzzlement at the proposition that outside experts could provoke dissension among directors. Regan, who has been involved in high-profile investigations for the Securities and Exchange Commission, the Justice Department, and attorneys for aggrieved shareholders for nearly 40 years, says: “Boards should seek information from experts. When that information is used properly, it allows [directors] to make better decisions. I don’t see how that has any impact on a board’s collegiality.”

Catherine Bromilow, a partner and U.S. leader for corporate governance at PricewaterhouseCoopers LLP in New York, suggests that rather than disrupt boards, an external consultant can help boards function more smoothly. At one consulting assignment, for example, a special committee that had already been created as a vehicle to improve the board’s effectiveness enlisted her services. Her task, she says, was to conduct “one-on-one, nonattribution interviews” and provide the special committee with a performance evaluation.

It was the board’s decision on whether to adopt her recommendations, Bromilow says. “I just presented my views for them to consider.” The upshot? The directors decided to drop a pension plan because board members were less willing to stand up to management as long as they were not vested. The board also changed its committee structure “because one board member was connected to a company supplier,” she explains.

In a survey conducted by Corporate Board Member magazine at its recent Annual Boardroom Summit conference in New York, board members themselves seem more favorably disposed to outside consultants than Lipton or other critics would have us believe (even if they do appear less than enthusiastic about paying sizeable sums—typically hundred of dollars an hour—for consultants’ services). Indeed, there appears to be widespread acknowledgement that external experts are increasingly necessary if boards of directors are to meet their obligations and fulfill their duties in setting policy at the modern, complex, publicly owned corporation.

When the question of whether outside consultants were having a positive or negative influence was put to approximately 500 directors and officers at the recent Boardroom Summit, the responses did not reflect Lipton’s outrage. Three-fourths of the CEOs and directors surveyed said they believe boards would be well advised to hire outside experts—especially if the board would be making a key decision in an area where it had little or no expertise. At the same time, however, roughly 20%—indicated they shun outside experts.

In the minority view, the routine employment of outside consultants is especially dangerous when it becomes what some consider an expensive crutch. The trouble, some feel, is that too many directors are increasingly fearful of being held liable for negligence. Consequently, this view holds, board members are tempted into relying too heavily on outsiders and, in effect, outsourcing their duty to make key decisions.

“The danger comes when consultants are not used for information but for protection from liability,” says Charles Elson, a law professor and director of the Weinberg Center for Corporate Governance at the University of Delaware. “The board has to make sure that the consultants it hires are independent and competent,” he adds, “and that [directors] not substituting the outsiders’ judgment for their own.”

There is also the danger that, in hiring outside consultants, the board may be encroaching on management’s role in operating the company, rather than setting policy. “If a board hires a consultant to do things that, in the normal course of business, senior management should handle, I think they’re on a dangerous path,” says Charles Wendel, president of Financial Institutions Consulting, a Ridgefield, Connecticut firm that specializes in advising independent and community banks.

Outside consultants come in all flavors. They are available to dispense advice on a myriad of areas including, among other things, information technology, accounting rules, executive compensation, mergers and acquisitions, market research, and corporate governance. And the majority of the time, they provide a valuable resource for the board. “Most boards can pick and choose the expertise they need without giving up their own judgment,” says Thompson, the Vanderbilt law professor.

In some cases, consultants are hard to avoid. When a publicly owned banking company gets involved in a merger or acquisition, for instance, hiring an outside consultant is not only advisable but de rigueur. “Whether you’re the buyer or the seller, it’s customary to engage legal counsel and financial advisers,” says James Rockett, a partner in the San Francisco office of Bingham McCutchen and cohead of the law firm’s financial institutions and regulatory practice.

“Their role is to assist the board in analyzing the transaction and assist in determining that the transaction is fair to shareholders. In every single merger I work on,” he adds, “we go through a carefully documented process to make sure that the board understands the contractual provisions and that the terms are consistent with the norm.”

However, before making a final decision on buying or selling a company and settling on the terms, Rockett asserts, the board must go beyond the advice of attorneys and the investment banker’s fairness opinion. Directors, he says, must also evaluate the strategic elements of the merger, acquisition, or buyout, along with the company’s social and cultural considerations “to make sure that, in the final analysis, they are comfortable with the transaction beyond what their advisers tell them.”

To Joseph Ford, a partner in DLA Piper’s Austin, Texas law office and cochair of the firm’s financial services group, it seems almost preposterous that board members would eschew hiring outside advisers in a change-of-control situation at a corporation. He asks rhetorically: “Why wouldn’t you take all necessary precautions to prevent something from blowing up in your face?”

Having said that, not all consultants—or the need for them—are created equal. Consultants who are hired in a merger or acquisition situation, for example, are sometimes regarded as more necessary than, say, corporate governance consultants who might be advising a company’s board on achieving greater independence.
Meanwhile, the SEC, the New York Stock Exchange, the Internal Revenue Service, and various other rule-setting agencies continue to expand the scope of a director’s duties. According to the 2007 What Directors Think survey of 1,300 directors coproduced by Corporate Board Member magazine and PricewaterhouseCoopers, directors rated their service on the audit committee as the most difficult task, followed by membership on the compensation committee. The task rated as least demanding was “understanding the company’s marketplace.”

Regan, the forensic accountant, likens his role in advising an audit committee to a physician providing a second opinion. “For years, audit committees figured that all they had to do was hire a decent outside auditor, and [in doing so] they had fulfilled their responsibility. But now they can’t delegate that responsibility. They’ve got to actively and vigilantly monitor the quality of financial statements.”

Listing requirements on the stock exchanges now require that the corporate charters of member companies provide board members with opportunities to garner the requisite expertise, notes PwC’s Bromilow. “With all the focus on executive compensation now,” she says, “there is a push to have committees hire their own consultants. People really want to see advisers who are not being used by management. So there’s been a significant increase in boards engaging consultants.”

Jan Koors, a managing director at Pearl Meyer & Partners in New York, where she is an executive compensation expert, is working overtime these days to keep boards abreast of the latest round of proxy disclosure rules. The SEC has promulgated the disclosure rules in three tranches—August and December of 2006, followed by subsequent amendments in spring, 2007—and they add up to several hundred pages in length, or about the size of the Manhattan telephone book. Another area that almost certainly necessitates outside assistance surrounds the most recent rules adopted in connection with Section 409A of the Internal Revenue Code, which govern the tax treatment of deferred compensation in the event of bankruptcy.

Reviewing these rules would be a Herculean task for most boards, but Koors is familiar with their nuances from A to Z. Experts at other leading compensation consulting firms, such as Minneapolis-based Clark Consulting, which has a dedicated financial institutions practice, are equally reliable and play a key role in helping boards navigate such waters.

The tempo for additional regulations has definitely increased in recent years, experts say. “These new tax rules were adopted as a result of executives’ bad behavior. Every time there’s some new perceived abuse or scandal, a regulator decides there needs to be a new rule. They just keep multiplying.”

And advisers in the area of compensation fill an important niche. They can help the board detail the key components of a compensation package: base salary, the annual bonus (and whether that bonus should be tied to growth in annual sales revenues, company stock price, market share, or some other applicable benchmark), equity, and, often, long-term compensation.

Moreover, as Koors notes, the elements that go into the design of an executive compensation plan also entail, among other things, a detailed understanding of tax and accounting rules, legal implications, and disclosure requirements. Koors describes the level of complexity as “labyrinthine.”

In addition to simply understanding these regulations, directors’ decisions regarding executive compensation matters are now under the magnifying glass in a variety of ways. Not only are Congress, federal regulators, and shareholders more keenly aware of the process, but—as executive salaries have hit the stratosphere—the news media and the public are expressing greater interest as well. All of which prompts Koors to volunteer cheerfully, “There’s no question that this is why I have a job.”

Ronald Janis, a law partner at Day Pitney in New York, cites executive compensation as an issue that is all but impossible for boards to confront without experts lending a hand. “On compensation issues,” he says, “you always need a consultant to provide support and help organize directors’ thought processes, because it’s not something they do all the time.”

The aforementioned What Directors Think survey corroborates the observation that corporate boards typically need outside expertise for many areas today. Only 40% of boards in the survey, for example, reported having a formal budget for educating directors, and by all accounts, most directors remain dependent on management for information. The question of whether boards ought to have more staff and bigger budgets is percolating in corporate governance circles, several sources say.

Yet, PwC’s Bromilow says receiving too much information in what she calls a data dump can sometimes be as thorny a problem as not having enough. “I was called in by one bank board after it had faced some regulatory difficulties,” she says, “and regulators were requiring that more details of transactions go to the board level. But it was more information than a single person could carry. So we looked at what was truly necessary and designed the way information should flow.”

There seems little argument that when outside experts are doing their job and providing boards with sage advice, they are also helping keep directors in the good graces of government regulators—and out of the courts and the newspapers. Yet many experts themselves acknowledge that there’s a downside if boards become profligate in their use of experts.

“Obviously the use of so-called experts can drive up the cost to the bank and, in some cases, their use was really unnecessary,” says Rockett, the San Francisco attorney. “A board needs to have different points of view, but sometimes consultants can get in the way.”

Ford, the DLA Piper lawyer, agrees, saying it’s possible for boards to overuse consultants in an effort to avoid legal liability. Consider the following scenario: By spending money unnecessarily on outside counsel, a company could invite criticism from shareholders and possibly even a derivative lawsuit charging waste of corporate assets. Yet, if such a company kept earnings high, Ford adds, “it would be highly unlikely.”

And if some are heavily reliant on consultants, there remain others like Christopher Murphy who say his bank board manages to keep the use of outside consultants to a bare minimum. Murphy, who is president, chief executive officer, and board chairman at South Bend Indiana-based 1st Source Bank, believes having a strong board obviates the use of outsiders.

“We bring people onto the board because of their expertise—engineering, legal, financial management, retail business experience—as well as their variety of different educational backgrounds, which adds value,” Murphy says. “We think using consulting firms would abdicate our responsibility.”

At the same time, he thinks the growing supply of corporate governance consultants reflects a trend that focuses on simply obeying rules, rather than abiding by ethics and principles. “A consultant isn’t going to solve the problem of whether you’ve been moral or not,” Murphy says. “Too often, rules just become a game. And people never ask the question, ‘Is that right?’ ”

© Board Member Inc. All Rights Reserved