Building A Better Board

William J. Ryan was a man ahead of his time 14 years ago when he insistedu00e2u20ac”after taking over as chairman and chief executive officer at Portland, Maine-based Banknorth Groupu00e2u20ac”that there be no other insiders on the company’s board.

Ryan believed that the rest of the board should be made up of independent directors who would feel free to speak their mindsu00e2u20ac”a courageous position for a CEO to take in what now seems like the prehistoric era of corporate governance.
“I thought it was important to have only independent directors on the board,” Ryan explains. “I saw directors at other banks who were friends of the CEOu00e2u20ac”or their golfing buddies.” But that cozy arrangement doesn’t make for the best decision making in the boardroom, where candor is usually more important than collegiality. “As a CEO, you need good people to challenge you,” Ryan says.

Now the rest of corporate America is finally catching up to Banknorth. The rules by which the corporate
governance game is played in the United States have changed drastically in just a few short years. Such high-profile corporate scandals as Enron Corp. and WorldCom and the reform law they spawnedu00e2u20ac”the Sarbanes-Oxley Actu00e2u20ac”have placed governance practices under intense public scrutiny. This atmosphere, combined with new regulations that deal specifically with director recruitment, is forcing all public companies to adopt a different approach to how they attract outside directors. “It’s a very different environment, in terms of its intensity, compared to three years ago,” says Theodore L. Dysart, a counselor in the global board of directors practice at Chicago-based Heidrick & Struggles International, a leading executive search firm. “Recruiting directors is a much more involved and active process now.”

This sea change in corporate governance will affect virtually all public banks. But larger banks with deeper pockets and wider service areas may have an easier time upgrading their director recruitment practices than community-based institutions, which traditionally have found it more difficult to identify qualified independent directorsu00e2u20ac”particularly those banks located well outside large urban areas. In the past, community bank directors were chosen more for their ability to bring in businessu00e2u20ac”or for their relationship with the CEOu00e2u20ac”than for their acumen as fiduciaries. But experts in corporate governance say even small banks can find competent independent directors if they’re willing to look beyond their immediate communities. “There are a lot of good fiduciaries out there,” says Roger Raber, president and CEO of the National Association of Corporate Directors in Washington. “I have no tolerance for someone who says they can’t find anyone.”

Two new regulations that deal specifically with director recruitment outside the company have done much to redefine the process. Last fall, the Securities and Exchange Commission approved revised listing standards issued by the New York Stock Exchange and the NASDAQ Stock Market that, among other things, require all listed companies to place only independent directors on their nominating/corporate governance committees, which is the body that identifies potential candidates and recommends them to the full board for nomination.

In January, the SEC also finalized a rule that requires all reporting companies to explain to investors in their proxy statements and quarterly and annual financial reports how directors are recruited and nominated to their boards. The intent of these new disclosure requirements is to provide investors with more transparency into the inner workings of the nominating committee and the process through which directors are selected. Among the things that public companies must now disclose are the nominating committee’s charter and details about the specific mechanics for identifying and evaluating candidates. They must also reveal any minimum qualifications that the committee uses to guide its recruitment efforts, along with disclosure of what partyu00e2u20ac”investor, CEO, independent director, or third-party search firmu00e2u20ac”recommended each nominee for consideration.

Over time, these rules could have a transformational effect on the very nature of corporate governance in the United States. Dysart says director turnover at U.S. public companies averages about 15% a year, so it may take a while before the full impact of these new rules is seen in board composition. But the new SEC disclosure requirement will make it harder for companies to surreptitiously place individuals who enjoy a cozy relationship with the CEO or existing directors on their boards. If nothing else, the sunshine effect of full disclosure is likely to produce more director candidates who can stand on their own merits. And for many companies, the new listing requirements will place the recruitment process directly under the control of the board’s outside directorsu00e2u20ac”greatly reducing the CEO’s influence.

Indeed, the day when an imperial chief executive could pack the board with his buddies may be drawing to a close.

“If you have truly independent boardsu00e2u20ac”independent audit committees, independent nominating and compensation committeesu00e2u20ac”what you’ll find is there will be more accountability by boards of directors,” says attorney Robert Bostrom, a managing partner at New York-based Winston & Strawn. “There will be fewer of these preexisting relationships, and a new degree of accountability that should result.”

It used to be that when large banks went trolling for a new director, they often wanted someone with star
power. “They used to say, ‘We want a name CEO,’ ” says Dysart. But a well-known CEO might not make a good director if his ego is so large that he has trouble becoming a team player. “They throw the dialogue off kilter,” he adds. For the most part, community banks have been more concerned about bringing in directors who could be good ambassadors to the area they served but weren’t expected to know much about banking or the intricacies of running a public company.

But the increased emphasis on independence in recent years has fueled the growing practice of banks and other public companies to select directors because of specific skills or experience they bring to the organization. Raber says the composition of a bank’s board often provides clues about its strategic direction. “I look at many of them now, and they basically tell me where the bank is going.” Of course, Sarbanes-Oxley requires all public companies to disclose whether or not they have appointed a financial expert to the board, which has set off a scramble to find qualified directors with either financial or accounting backgrounds. Beyond that, a director whose background matches up with the company’s strategic growth plan can greatly elevate the quality of discussionu00e2u20ac”and oversightu00e2u20ac”that occurs in the boardroom.

Oftentimes directors are expected to help guide management through difficult decisions, and their knowledgeu00e2u20ac”as well as their judgment and business acumenu00e2u20ac”can make a difference.

Raber says he knows of a $2 billion bank in New England that expects to be an active acquirer and thus recruited a new director to its board because the individual has an investment banking background. “It’s good to have someone on the board who knows the intricacies of [the merger and acquisition process] and can say whether this is a good deal,” he says. Banknorth’s Ryan notes that one of the directors on his board has a strong technology background, which has proven to be very helpful as the banking business has become increasingly technology-intensive. And in addition to providing management with an outside perspective on a particular problem, directors can also help managers solve the problem by networking with their own contacts. “It’s not unusual in board meetings to have a director say, ‘I have this friend, and he’s an expert. I’ll give him a call,’ ” Ryan says.

One danger of having such experts on the board is the temptation to micromanage. Raber points out that in the foregoing example of the M&A expert, the purpose of having this person is not for him or her to perform additional due diligence on a proposed transactionu00e2u20ac”that’s the merger adviser’s jobu00e2u20ac”but to give management and other board members an informed and independent assessment. “You don’t want that expert to get involved, operations-wise, but it would be great to have that person on the board,” he says. “Directors have a fine line to walk between being a resource and getting into micromanagement,” agrees Bostrom. “But I think most directors are not there to do that. They’re there to offer their expertise and to provide another view to management.”

If banks are looking for a different kind of director nowadays, they’re also going about the process in a very different way. Dysart says there was a time when banks would only hire search firms to recruit a new director when they wanted a woman or a minority. “Everyone else they knew already through their own network.” In consultation with a company’s CEO, Heidrick & Struggles would draw up a list of 30 or so prospective nominees and then vet each name. Eventually the firm would end up with a short list of the top three candidates, and Dysart would begin by contacting the first person on the list. If that person was interested in serving on the company’s board, Dysart would set up a dinner with the CEO. “I wouldn’t even interview that person,” he says. Moreover, this dinner was merely a social occasion since both partiesu00e2u20ac”the company and the candidateu00e2u20ac”had already made their decision. “You could never speak to someone without offering them the slot,” he says. The firm also worked through its short list one person at a time. The second-ranked candidate would only be contacted if the top-ranked candidate declined.

The situation is much different today. For starters, the search process is managed in a much more dynamic fashionu00e2u20ac”and it is driven by the company’s independent directors on either the nominating or corporate governance committee. “That has completely changed the dialogue,” Dysart says. Not only are public companies taking a more proactive approach, but potential recruits also are asking more questions on their end. “People realize that all you have to trade on is your reputation,” he says. “They don’t want to go on a board and have something blow up and suddenly have a new day job.” In particular, he explains, director candidates want to assess such things as the culture of the organization, the tone at the top, and the organization’s risk tolerance.

In this more demanding environment, Dysart likes to look ahead. Rather than wait for a director to retire or resign, he prefers to approach an assignment from a long-term planning perspective by assessing a board’s needs over the next two to three years, including any openings that are likely to occur. When trying to fill a vacancy, Dysart begins by examining the current board from a diversity standpoint, including the professional backgrounds of its directors as well as its composition by race and gender. Dysart then develops a long list of candidates, just as before, but now he reviews the full list with members of the company’s nominating committee before producing a short list of two or three promising individuals. In another departure from past practices, Dysart meets with all the finalists before setting up formal interviews with the chairman of the nominating committee, other committee members, and the company’s CEO. He also encourages his clients to perform extensive reference and background checks on all candidates before they are nominated.

Even though it is considered a large institution with $26 billion in assets, Banknorth does not use search firms to help recruit new directors. CEO Ryan says his bank knows its local markets well enough to identify qualified candidates on its own, but it takes much the same approach that Dysart advocates. The institution has added four new directors over the last three years, and will add two more over the next two years when current members reach a mandatory retirement age of 72. Banknorth has been an active acquirer in recent years and frequently has recruited an independent director from one of the institutions that it has purchased. But it also recruits new directors from its six-state franchise area, which extends from Maine to upstate New York.

When Banknorth anticipates the need to recruit a new director, the board’s six-member nominating and corporate governance committee develops a target list of three to five prospective nominees. Committee members, as well as Ryan, interview each of these individuals, and when the opening finally occurs, one of these “candidates-in-waiting” is recommended to the full board.

The bank evaluates prospective directors from the standpoint of diversity, geography, and their individual skill sets. From a geographic perspective, Banknorth wants its board to be representative of the communities it serves. And when it comes to diversity, the nominating committee breaks that down by age, gender, and raceu00e2u20ac”again reflective of the communities that Banknorth operates in.

Although Ryan is actively engaged in interviewing potential candidates, he cannot prevent the full board from nominating a director candidate to shareholders. “No, I don’t have veto power,” he says. “I am just like the other directors.” And this raises the issue of just how much influence the CEO should have over the selection process.

David H. Baris, a partner at the Washington-based law firm Kennedy, Baris & Lundy and executive director of the American Association of Bank Directors in Bethesda, Maryland, agrees that CEOs should not be voting members of their boards’ nominating committees. “But the connotation is, they shouldn’t be involved at all, and I think that’s wrong,” he says. “They should have input into the process. You don’t want the CEO to be excluded.”

What seems to be most important is a sense of balance. If CEOs shouldn’t be permitted to pack the board with their cronies, neither should they be forced to work with board members with whom they have a strong objection based on a prior experience. If collegiality is no longer the overriding concern when recruiting directors, it’s still crucial that a CEO and board be able to work together effectively. And if a candidate who elicits a strong negative reaction from the CEO ends up being nominated for election, it may be a sign that the recruitment mechanism is flawed. “If the CEO is going to be that surprised, there’s something wrong with the process,” says Bostrom of Winston and Strawn.

Publicly held community banks that are not listed on either the NYSE or NASDAQ are not required to have independent nominating committees, although Baris still thinks it’s a good idea. He also says that smaller institutions will have to change how they recruit directors in this new environmentu00e2u20ac”in part because bank regulators are watching them more closely. “It’s very anecdotal at this point, but we’re getting feedback that examiners are asking more questions about board issues and governance, even at nonpublic institutions,” Baris says. And of course, all institutions that file financial reports with the SECu00e2u20ac”whether they are NYSE or NASDAQ-listed or notu00e2u20ac”must now disclose how they recruit new directors.

The process is not much different than with a large bank. Smaller institutions that experience little turnover may not have a standing nominating or corporate governance committee, so it may be necessary to form one. Vince Van Nevel, a managing director at Louisville, Kentucky-based Professional Bank Services, advises his clients to begin by developing a profile of the kind of director they would like to attract. Since few community banks use third-party firms to perform director searches, the collective network of current board members, including the CEO, will provide most of the leads, although local law and accounting firms can also be helpful. Most community banks still want someone who can help develop business for the institution, but candidates with a corporate backgroundu00e2u20ac”particularly a senior position in a public companyu00e2u20ac”can be very valuable. Banks that are expanding into new geographical markets may want to add directors who are familiar with those locales. Or banks that are entering a new business or greatly expanding an existing one may seek candidates with a background in that market.

When it comes to recruiting directors, small banks are often limited by the size of their communities, particularly if there is more than one institution in the same market. It may be necessary to look beyond the immediate market, especially if a bank is searching for a financial expert who meets the requirements of Sarbanes-Oxley. But it is possible for community banks to find good directors. “You don’t need to be a multibillion-dollar institution to find good people,” says Van Nevel. “I think they’re out there to be had, but banks are having to learn how to do it.”

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