The Relationship Between the Board and the CEO

Bank Director spoke to Richard M. Alexander and A. Patrick Doyle both partners from the Washington, D.C. office of Arnold & Porter LLP about the changing dynamic between executive management and boards in a post-Sarbanes-Oxley environment and the challenges faced by both in running a successful institution.

Governance reform has certainly given investors a more powerful voice than ever before in the accountability required of corporate directors. In some sense has it also given more empowerment to boards to stand up to management?

Since the passage of FIRREA in 1989, bank directors have had to grapple with many of the issues that public companies are now dealing with. I think Sarbanes-Oxley was very significant for corporate America, but bank directors have had to manage with these same types of issues for over a decade.

Therefore, what Sarbanes-Oxley has really done is taken the dynamic between boards and managers that has existed in banking for some time and made it more relevant—codified it, if you will. For banks, it has not been the dramatic sea change that the rest of corporate America has experienced.

Nevertheless, every bank director in America is keenly aware that Sarbanes-Oxley has created heightened expectations—particularly in the eyes of investors who read about scandals in the Wall Street Journal. In this way, yes, it has empowered directors to challenge both managers and their accounting firms. Clearly, management now recognizes this phenomenon exists, and they need to address it and understand what boards’ expectations are today.

Conversely, are managements expecting more accountability from their boards today?

I would say more is being expected of directors—both from a regulatory perspective and from a corporate governance standpoint. Bank directors have to spend more time preparing, and the sheer quantity of what they have to read ahead of time has increased. Likewise, there is also a higher expectation by executive management on those managers who have to provide detailed information to the board.

The other part of this trend that goes along with the changes we have experienced in corporate governance as a whole—be it from Sarbanes-Oxley or from the regulatory agencies—is a heightened emphasis on enterprise risk management. Regulators are scrutinizing things such as how involved a board is in the risk management process. How do certain decisions fit in with the business strategy? In essence, the regulators are looking for cooperative working relationships and effective communication between directors and management to ensure that their risk tolerances are appropriate. That is another phenomenon that is changing the dynamic of boardroom governance. So all these things are happening at the same time, and they are creating a much more demanding environment for the board of directors.

Getting into the practical working relationship between management and the board, is it a good idea to allow a retired CEO to continue sitting on the board?

There are often conflicting issues there. Obviously the expertise that a retiring CEO brings to bear can be very valuable.

On a related note, one of the things we have seen in the past 10 to 12 years, since the passage of FIRREA, is a general upgrade in the quality of board members. The days are long gone when a director was put on someone’s board because that person played golf with the CEO. The question of whether you keep a retiring CEO is an interesting one, but an even tougher question is whether, because of that past CEO’s relationships with others on the board, he is going to overshadow and overpower other board members and dominate board activities. I’d have to say, it really depends on the facts of each case and the culture of each institution; I don’t think there is one hard-and fast-rule.

Another conflicting issue involves boards that are made up of former CEOs of companies they’ve acquired. There’s a real question about whether the knowledge that they bring to bear on the current company is an advantage or not.

The movement toward setting up a lead director when the chairperson and the CEO are one person is becoming more of a trend today. Have you seen many banks instituting a lead director to the board?

No, we are not seeing that at all—quite the contrary. What we are seeing is that chairmen of committees—such as the audit committee—are playing a much more significant role today than they ever have before.

What is your advice or position on board evaluations?

In the banking environment, the regulators have long stated that the most important role for the board of directors is ensuring the competency of management. We agree this is clearly one of the most—if not the most—important roles for the board. So to satisfy that mandate, directors must not only make sure the CEO satisfies the initial requirements of the job, but they must ensure an ongoing evaluative process on the CEO’s performance takes place. Such a performance evaluation goes beyond share price— it encompasses how they meet their strategic objectives, how they manage regulatory relationships, and so on.

Some boards even look at their bank’s CAMELS ratings as an evaluation benchmark—not as a report card to check off certain items—but rather as a guidepost to their evaluation. This is useful because if the board sees that the regulatory agency is rating their management in a way that is inconsistent with their own views, then they need to ask alot of questions. I don’t mean to say that boards should hand over their evaluations to the regulators, but rather that boards should avoid having their own assessment of management appear differently from what the regulators’ assessment of management is—that would be a disaster.

Turning the tables the other way, we haven’t seen many formal evaluations of the board by management, and there is a related issue that I worry about in this regard. This is a time in corporate America when we want the best and the brightest on our boards, and one of the challenges companies now face is that there are so many obligations on directors—in terms of time and potential liability—that these things are disincentivizing people from taking board seats. Frankly, we get calls from potential board candidates asking whether they should take a board seat and after we walk them through the pros and the cons you have to be careful—because the cons can add up. Mostly I hear responses such as, “I don’t think I can give that amount of time.” Another common problem is that once directors accept a seat, they often realize they can’t commit the amount of time that is required of them. And in this day and age, when there is a director absent at a board meeting, those absences are really focused upon.

The bottom line is that we don’t see a lot of grading of directors today, but we do see a lot of self-policing.

Are community banks that are private or non-exchange traded under the same microscope regarding evaluation practices?

There is a big difference between banks and public companies in this regard. There is no question that the law imposes an obligation on directors to oversee and supervise. But in the financial institutions industry, regulators expect and require bank directors to take on more of a management role.

Directors of financial institutions of all sizes are much more attuned to the responsibilities that apply to them. This traces back to the late 1980s, to the passage of FIRREA, when directors were faced with the banking crisis and the closing of institutions by regulators and the kinds of civil money penalties that were being imposed on them. As a result of operating under that type of enforcement cloud, they became much more mature, independent thinkers than they would have been otherwise. So the accountability that has resulted from Sarbanes-Oxley has been a part of the lexicon of the banking industry for many years.

In terms of setting up a successful board, how do you go about getting rid of a CEO who is not meeting expectations?

This situation is fact-specific, of course, but if there has been a history of conduct that has led the board to come to the conclusion that a change is needed, the first thing the board must decide is whether the problem can be worked through at all. Is it just a personality problem or an interpersonal relationship problem? Those types of things may be able to be rectified without ousting the CEO. If it is more serious than that, where an officer is engaged in activity that could create liability for instance, then the board may need to involve counsel. They also should organize a committee of independent directors to analyze the issue. This type of situation is one of the hardest issues a board has to face.

What is one of the biggest challenges facing boards in creating a smooth working relationship with management?

The biggest challenge today in the area of maintaining a successful relationship between the board and the CEO and other management is having effective communication—especially with regard to hot supervisory issues, such as money laundering, for instance. Directors have a need to know whether management is staying abreast of these important areas, and likewise, management has to bring the directors into those issues at the appropriate time. If they don’t, it’s a recipe for disaster. If there is a negative report after an examiner’s exit interview, for instance, and management doesn’t communicate this to the board, the directors would have a right to be very upset.

In the current environment, having effective communication on material developments in an organization is one of the principal obligations of management in order to ensure a good working relationship with the directors.

–Richard Alexander, a senior partner in Arnold & Porter LLP, represents a wide range of companies, and corporate directors and officers, in a variety of regulatory, compliance, and investigative matters. He has conducted many internal and other special investigations into possible accounting fraud, money laundering, legal, ethical and internal control violations, self-dealing and other wrongdoing on behalf of management and boards of directors. Since the passage of the Sarbanes-Oxley Act in the United States, he has handled a number of so-called "whistleblower complaints" on behalf of public companies and their audit committees.

–Patrick Doyle, a partner in Arnold & Porter LLP’s Washington office, has a broad background in financial institution regulation and has headed the firm’s financial services practice group since 1993. Mr. Doyle regularly counsels bank holding companies, foreign banks, savings institutions, insurance companies and securities firms on a wide variety of matters, including strategic planning, complex regulatory issues, enforcement proceedings and legislation.

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