How to Do Director Evaluations Right

Sorry, but being graded on how well you do your job is one more fact of boardroom life brought about by the ongoing push for governance reform. Individual director evaluations are gaining currency at companies with cutting-edge governance practices (for one director’s experience, see the box on page 45), while evaluating boards as a group is fast becoming not just best practice but also, in some cases, mandatory.

Beginning this year, the New York Stock Exchange is requiring the boards of its listed companies to conduct self-evaluations at least annually, and some governance experts expect such exercises to become the norm for any large public company, regardless of where it is traded. “It has not only become acceptable to look at board performance, it has become increasingly necessary,” says Edward Lawler III, a management professor at the University of Southern California’s Marshall School of Business and the director of the USC Center for Effective Organizations. He notes that in a corporate governance survey conducted during the late 1990s by the search firm Russell Reynolds, investors said they felt strongly that boards needed to become more aggressive in weeding out underperforming directors. The governance scandals at Adelphia Communications, Enron, WorldCom, and other high-profile companies have only intensified the sentiment. “My guess,” Lawler says, “is that evaluating board performance is eventually going to become a necessary condition for getting D&O insurance, or at least for lowering its cost.”

Firms that rate companies on their governance practices, such as Institutional Shareholder Services, already take evaluations into account. ISS says it gives credit for board-performance reviews in its scoring system, and is considering doing the same for individual director evaluations in the future.

Some public boards have already gotten the message. In a survey of Fortune 1,000 companies done last year by USC and Mercer, a consulting firm, 56% of the respondents said they conduct formal board evaluations regularly. Only 24% evaluate individual directors, but at large companies the practice is more prevalent: 70% of the big outfits that belong to the Business Roundtable say they performed director evaluations last year, up from 44% in 2002.

The goal of all this corporate navel-gazing isn’t just to identify bad boards and directorsu00e2u20ac”although that’s certainly one objectiveu00e2u20ac”but also to help boards do their job more effectively. “The age of directors’ just coming to a meeting and not contributing in a significant way is over,” says Ed Speidel, national executive compensation practice leader for Buck Consultants. “There’s too much risk for them to be on the board of any public company without being engaged and involved.” Speidel says that while the directors he’s worked with generally contribute to their boards, he’s not sure many of them have been given “a really clear set of expectations. An evaluation process lays out those expectations and gives feedback to both the CEO and the directors.”

That’s exactly what Cinergy Corp. chairman and CEO Jim Rogers says he and his board discovered when they conducted their first formal board assessment in 2002. The directors used a three-page questionnaire to anonymously rate the utility’s board in 13 categories, as well as their own individual performances in 31 more. The answers were forwarded to a consultant who compiled them and presented a summary of the results to the board.

While the process didn’t uncover any glaring problems, Rogers says, it did suggest certain ways in which the board could improve its operations, such as setting up a confidential website where directors can access meeting materials and eliminating some management presentations to the board in favor of sending the information to directors before meetings. To ensure that executives who are making board presentations get them to the directors a week in advance, Rogers also instituted what he calls the “10-day, 10K” rule: Any manager who doesn’t deliver a copy of his or her presentation to Rogers 10 days before the scheduled meeting is fined $10,000. “I haven’t had to enforce it yet,” he says, “but it’s still out there.”

At the diversified manufacturer American Standard Cos., the directors took a different approach to their first evaluation, assessing only the board rather than its individual members and conducting the exercise verbally, as a group, rather than individually on paper. They also used an in-house facilitator instead of a consultant to coordinate the exercise. “The most interesting thing is that we found it a lot more worthwhile than we thought it would be,” says James Hardymon, chairman of American Standard’s corporate governance and nominating committee and formerly chairman and CEO of Textron. “We marveled at how the process helped us come up with items that we thought would help us as board members and as a board.”

Among the initiatives the board undertook as a result of the evaluation, Hardymon says, was a change in which some outside materials, such as analysts’ reports, are distributed to directors as they become available, rather than held until the next board meeting. The directors also agreed to add another member to the board, which at seven people, including chairman and CEO Frederic Poses, had been fairly small for a company of American Standard’s size (2002 revenues: $7.8 billion). And they decided to restructure some of the dinners the board holds before its six regularly scheduled meetings per year. The directors used to routinely invite a newly hired manager to join them. These days they do that “more than half the time,” Hardymon says, but other times they simply ask the new manager to a reception before the dinner, so that the board can use the dinner itself as more of a working session. Finally, the directors agreed to have an outsideru00e2u20ac”a securities analyst, customer, or supplier, for exampleu00e2u20ac”address them at least once a year.

Of course, many CEOs and board members remain wary of evaluating themselves, particularly as individuals. Governance experts say that’s understandable. Board evaluations, Mercer warns directors, can raise delicate issues in ways that might, without an effective process, produce heated arguments or exacerbate existing rifts. And some directors find the whole notion of subjecting themselves to evaluation off-putting. “These are people who have been very successful in their business, academic, or governmental careers, and this may not be what they feel they signed up for,” says James DeLoach, managing director and global governance leader at Protiviti, a risk consulting firm. Adds USC professor Edward Lawler: “I’ve talked to many chairs and board members who say it would be insulting to evaluate these people, or that they wouldn’t put up with it if they were a board member.”

While Lawler says he understands these concerns, he’s also quick to note that directors are, after all, getting paid for their services. They’re also arguing for accountability elsewhere in the organization, and usually assessing the CEO. “I think what’s good for the goose is good for the gander,” Lawler concludes, “and I think it’s a reasonable and important activity to engage in.”

So does Wallace Stettinius, a senior executive fellow at Virginia Commonwealth University School of Business and a member of the audit and compensation committees at Cadmus Communications, a NASDAQ-traded printer and graphics company that he previously served as chairman and CEO. “We’ve always had an informal system of evaluating the board,” he says, “but now we’re trying to formalize it.” He adds that his fellow directors are “open to understanding that we need to have a process whereby we talk about the performance of individuals and the board in general, and they are willing to look at ways that might be done without compromising the collaborative nature of the work we do.”

Attorney Bill Ide of McKenna Long & Aldridge in Atlanta says that implementing a board evaluation process just makes good legal sense in an age when directors are being held to higher and higher standards of performanceu00e2u20ac”by investors, by regulators, and in some cases by the courts. He points to a May 2003 ruling by chancellor William B. Chandler III of the Delaware Court of Chancery that allowed a shareholder lawsuit to go forward against directors of Walt Disney Co., surprising many legal experts who expected the business-friendly state to swat it down.

The lawsuit against Disney alleges that the directors breached their fiduciary duty by failing to stop chairman and CEO Michael Eisner from awarding a severance package valued at approximately $140 million to Michael Ovitz, who had been the company’s president for just 14 months. (For more on the suit, see www.boardmember.com/issues.)

By permitting the suit to go forward, Ide says, the Delaware court has clarified what it expects directors to do in fulfilling their fiduciary duties. “The court’s language makes it clear that a director must be proactive and that following process is very important,” he says. A corporate board member himselfu00e2u20ac”he chairs the governance committee at financial-services firm AFC Enterprisesu00e2u20ac”Ide describes board evaluations as a “visible manifestation of directors’ being responsible by going through a process. And more and more, process is going to be important in demonstrating that your meetings are run properly and that you have the information systems and procedures in place to ensure you’re fulfilling your oversight function.”

While an evaluation that covers those fundamentals of good governance is critical, Ide thinks companies that don’t also use evaluations to improve the way individual directors work with one another will forfeit a chance to improve board productivity. AFC is voluntarily setting up a board evaluation procedure, he says, and he plans to recommend that the board create an evaluation process for individual directors to help them become more effective in their jobs. “I don’t know if my committee will accept it,” he says, “but I view that as an important benefit to be offered to make them individually and collectively more efficient.” Of course, in some circumstances director evaluations may shine a spotlight on board members who aren’t pulling their weight. Without a formal evaluation system, Lawler says, “a board is in an indefensible situation if it wants to dismiss somebody or demonstrate that someone needs to change their behavior.” Conversely, going through that formal process can make it easier for a director who’s under criticism to change. “To some degree, getting that feedback is not only a demand for them to change, it can also be a license for them to change,” Lawler says.

Ultimately, boards have few good reasons not to evaluate themselves. Like Glinda, asked by The Wizard of Oz’s Dorothy whether she was a good witch or a bad witch, board members today face an army of stakeholders demanding to know whether they are good directors or bad directors. It only makes sense for them to have an answer they can defend.

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