22 Dec 2003  Research & Ideas

How to Build a Better Board

Boards need to work smarter and with a design in mind, says professor Jay Lorsch. Lorsch discusses his new book Back to the Drawing Board, co-written with Colin B. Carter.

 

As more and more corporate executives have been paraded on perp walks these last few years, a question has repeatedly been raised: Where was the board? After all, isn't it the board's responsibility to make sure the fox isn't hired to run the hen house? Doesn't the board help protect the interests of investors and employees?

It turns out that many of the boards of imploded companies such as Enron were composed of smart, honest, well-meaning, people. So what went wrong? How did these massive failures of corporate governance occur? More to the point, how do we fix the problem?

Perhaps the problem lies not with the people who serve on boards, but rather the structure of boards themselves, argue Harvard Business School professor Jay Lorsch and consultant Colin B. Carter. In Back to the Drawing Board: Designing Corporate Boards for a Complex World, the co-authors observe this underlying problem: Board members are time-pressured part-timers who lack the knowledge they need to successfully oversee the companies they serve. The remedy isn't necessarily in staggered terms or requirements for outside directors—rather it's making sure board members have the time and information necessary to fundamentally understand the business. And that means a fundamental rethinking of how boards operate.

This going back to the drawing board, Lorsch and Carter conclude, includes reviewing the roles boards serve, how the work is structured, the criteria for choosing board members, methods for keeping board members current, and the behaviors that lead to successful teamwork at the board level. HBS Working Knowledge's Martha Lagace recently talked with Lorsch about his findings.

Martha Lagace: Tell us why the design element of corporate boards is so important.

Jay W. Lorsch: What concerns us is that corporate governance activists focus on things that can be seen from the outside. The reality is that what makes boards effective—and this is the point we make in the book over and over again—is the behavior of the directors inside the boardroom. That really is produced by what we call the design of the board, which is a complex set of variables. Very little of that can be seen from the outside.

Q: Why do you focus on the redesign of boards?

A: Boards face a lot of external pressure to change. It comes from government, e.g., Sarbanes-Oxley; it's true in other countries as well. Some of it also comes from certain institutional investors. But when you come to the internal factors, looking at it from the point of view of a director, you should make changes because they will enable the board to do a better job. The fact is, because of the emphasis on independent directors, boards have limited time and limited knowledge. Therefore, it's very important for independent directors to be in the best positions they can be for developing their knowledge. Those internal pressures are real. Dealing with them should be one of the criteria by which you judge the effectiveness of the design that you put together.

The basic motivating pressures for change inside the boardroom, I think, should be, "How do we do a better job? And to do a better job we've got to use the limited time we have efficiently, and we've got to get the right kind of information." Obviously, if you don't have the right information and you have limited time, you can't do the right thing.

Q: What are some important ways in which boards could improve their own design?

A: The design that a board chooses depends on the role that the board decides to play. And boards do have a lot of leeway within legal frameworks to decide exactly what they're going to do, what decisions they're going to make, what things they want to monitor and oversee, and also the areas in which they want to offer advice and counsel to their CEO.

So given that fact, the first thing a board needs to decide is, "What mix of these things do we want to do which define our role?" Having done that, they then can think more intelligently about how they want to design the board itself and answer questions such as "Who do we want on the board? What committees do we need? What leadership structure do we want for the company and for the board? How frequently do we want to meet? What do we want to put on the agenda at meetings?" and so forth.

The fact is, because of the emphasis on independent directors, boards have limited time and limited knowledge.
— Jay Lorsch

Some of the best practices that have been identified should be rolled into that. We believe every board should evaluate its chief executive officer; every board should oversee formulation of strategy, approve the strategic direction of the company, and monitor how well the strategy is working. It should be concerned about succession; it should have effective audit and compensation committees and all of that.

Q: Around 130 CEOs of major corporations responded to a questionnaire you and Colin Carter sent them. Tell us about how the CEOs saw their boards. Did any of their responses surprise you?

A: Rather than keep talking to directors about how they see their boards, we thought it would be interesting to get the perspective of CEOs and try to understand how they saw their boards. At the end of the day, CEOs are as concerned with the impact of the boards as anybody else. They have got to work with them, and in fact boards are their bosses.

How do they see this? I would say the response that surprised me the most was the extent to which so many CEOs were really concerned that their directors were unable to retain information from one meeting to the next. I think it reflects very well the concern that we had: that directors have limited knowledge. These CEOs were saying the same thing. They were not saying that the directors are lazy; they were not saying that the directors aren't trying to do the job. They were just saying, "Look, given the number of meetings we have and all the other things on these very busy individuals' minds, there are times when we really wonder if they are 'getting it.'"

Therefore, the warning signal to all of us, not just in the United States and the U.K., but also around the world, is that there is a very common problem of directors who have difficulty keeping up with what's going on in the company because of the number of meetings and the time between them. It is one of the things that leads us to be concerned about design—providing better information.

Q: What can be done? Hold more meetings?

A: You could have more meetings; but I think a better remedy is more efficient use of their time by providing directors with better information. As we mention in the book, encourage directors to get out and do things between the meetings to learn more about the business. Provide them with interim reports about what's going on, not just a report at the meetings.

With information technology, there is no reason why directors can't get much more frequent reports about what's going on. The CEOs can also do some things themselves, such as writing memoranda and emails to the board between board meetings. There is a lot of stuff that could be done to help directors keep up.

Q: As you wrote in your book, more and more boards have been adopting at least some best practices. But even boards that have adopted all of them find it difficult to integrate theory and practice. Tell us about some of the stumbling blocks.

A: First of all, two stumbling blocks—often—are time and knowledge. But there are other stumbling blocks as well. The fact that boards are groups of people is in a sense a stumbling block, because groups have a hard time working together and so they need effective leadership. One of the things we think that you need to pay more attention to is how the discussions of the board are being led. Even experienced CEOs and chairmen sometimes find it difficult to lead a discussion among people who are essentially their peers or even in some cases their bosses. It isn't easy to tell somebody to shut up when he or she is heading off in the wrong direction. Leading such discussions is much more complicated than people realize.

I think another stumbling block, though, is that sometimes boards tend to operate as though they are in a rut. They tend to operate from habit. Why is that? I think in many respects it goes back to the fact that these are very busy people with limited time, and they never stop to ask, "Can we do this better?"

One of the pleas of our book is, "For God's sake, stop and design this stuff: It isn't rocket science once you stop to think about it." But many boards just don't take the time to do that and as a consequence they either respond to some of this nonsense that comes from external institutional investors, such as "Should we have a staggered board?" or "How many boards can directors serve on?" Things like that really don't have much to do with anything. So boards are so distracted by all that, they don't really focus on "How can we do our job better?" That's what this book is all about: trying to get the focus on working smarter.

With information technology, there is no reason why directors can't get much more frequent reports about what's going on.
— Jay Lorsch

You can talk about the limits of time, the limits of knowledge, the complications of group process; but you've also got to recognize that there is a negative inertia and that that is a huge stumbling block. So while the book is about design, it's also really a plea for recognizing that change has to come from the inside.

Q: You have studied boards of directors for a number of years. How would you like to see boards evolve in the next ten years or so?

A: I'd like to see more boards paying attention to the ideas that we put forward in the book, which are about really designing themselves so that they have developed a way of operating which is consistent with the needs of their company. And that they don't do this just once, but realize that they have a responsibility to examine their design and the way they are working periodically. It doesn't have to be every year, perhaps; but every couple of years they should pause and ask, "Are we working the way we want to work, have conditions changed, should we do something different because we have a new CEO or because the new CEO is a more experienced person in whom we have more confidence?"

It is important to stress that companies are likely to get more complex in the future. As they get more complex, it is going to become even more difficult for directors to meet their responsibilities. This is another reason why design is so important.

From Back to the Drawing Board

by Colin B. Carter and Jay W. Lorsch

Behind closed doors
Most of the work done by a board takes place in the privacy of the boardroom. That is where directors discuss maters among themselves and with management, offer advice, assess proposals, and make decisions. Rarely, if ever, does any information on how the members contribute as individuals or work together as a group escape to the world outside.

The same is true about the more limited interactions among board members and with managers outside of the boardroom. E-mails, phone calls, committee meetings—all are exclusive to the participants. It's almost impossible for anyone "outside the circle" to get an accurate reading on whether pressing issues are receiving the appropriate scrutiny with pertinent information at hand, and whether decisions are being made with due consideration and thorough discussion—in sum, whether the board is performing to its potential. That the work of boards takes place "behind closed doors" is the major reason we are skeptical about many of the current proposals for board reform.

Take, for example, a 2002 recommendation of the New York Stock Exchange: that the name of the director who presided over meetings of the independent directors be disclosed in a proxy statement.1 This is a very useful prescription. Board members attending such meetings are likely to talk with one another more frankly than they would if the CEOs and/or other managers were present. If the name of the presiding director is made public, readers of the proxy statement are more likely to feel reassured that "all's well" on the governance front. The independent directors are meeting alone and are "on top of things," is the expected reaction.

But it could be false comfort. In reality, no one—except the directors in attendance—will ever find out whether or not the meetings are actually serving their intended purpose. The behavior of the board members cannot be controlled from outside the boardroom. The directors might meet for a few minutes or many hours. They may or may not deal with significant matters. Their leader may or may not have a deep grasp of the issues or the skill to help them reach a consensus. As important as such a new requirement is, all that it can do is give boards the opportunity to do the right thing. What actually happens behind the closed door depends upon the directors in the room.

Directors who truly want to build an effective board need to look far beyond any externally imposed rules and procedures. The starting point is taking an honest look at how-and how well-they work with one another. An effective board is both supportive and challenging of management, and reaches consensus while encouraging dissent—balances that are hard to achieve. ... As we focus on board behavior, we must remind ourselves that how board members act together is not random. As we have argued throughout, the behavior of board members is determined by the design of each board: its membership, its structure and process, and its culture.

Boardroom misbehavior
There are a number of things that can go wrong behind the closed doors of a boardroom, and through our work with boards and in discussions with hundreds of directors and senior executives, we can say with some confidence that we really have seen them all. Some common examples:

The CEO is defensive and not open with the board. As a result, discussions often become tense and questioning difficult. The directors feel inhibited and withhold their opinions.

Management presents poorly organized material to the board, or simply reports each decision as a fait accompli. As a result, the board is left without the opportunity to explore alternate courses of action.

The directors feel their contributions aren't sought or valued. This can lead to a passive board, where directors "turn off" and don't even try to make a contribution.

Directors use meetings to score points with each other, perhaps to prove that they are very wise or have read their board reports. Or, they take up time describing how wonderfully things are done in other companies where they have experience. As a result, board discussions become "performances" that fail to tackle the issues critical to the company.

When management reports bad news (and all companies have some of that), board members "shoot the messenger." As a result, such news comes more slowly in the future, and often too late for corrective action.

Directors talk a lot, but listen much less. They expect to be treated with deference, and their "conversations" are mostly one-way. As a result, directors don't have their own views tested adequately, and don't learn what managers know and think.

The CEO consistently monopolizes the meeting time telling directors what has been happening in the company and the industry. As a result, too little time is left for other agenda items and for discussion among board members.

The independent directors' "executive sessions" are disorganized and lengthy. As a result, board members are frustrated at the wasted time, and the CEO is left in a state of rising anxiety and, at least figuratively, is pacing the floor. "What are we doing in there?"

The chairman is overly concerned with finishing meetings on time. As a result, important discussions are truncated; the last items on the agenda are discussed in haste as directors close their briefcases and head for the door. Often, as we have said, this problem is exacerbated by an overly full agenda.

The CEO and chairman (or CEO and lead director, when the former chairs the board) have no agreement on the activities each should undertake. Consequently, the content of the agenda may not be well planned, and the independent directors are confused about who is playing what part in leading the board deliberations.

Directors deal with the CEO's subordinates by contacting them directly and without alerting the CEO. Alternatively, directors believe they should have no interactions with the CEO's direct reports because they know she disapproves of such contact. In the first case, directors might undermine the CEO's relationship with his subordinates. In the second, directors remain ignorant about what the executive team is thinking.

This lengthy list reflects the difficulty of the board's task. It also reflects a root cause of ineffective (or detrimental) board behavior: To be effective, a board must constructively manage two sets of relationships: one among the board members themselves and one between the directors and senior managers, particularly the CEO. Every board must deal with this web of relationships in which problems can become self-reinforcing and hard to fix.

Without a pattern of behavior that avoids the kinds of problems we have just listed and that nurtures productive working relationships, directors find it difficult, if not impossible, to accomplish anything meaningful in their limited time together.

Reprinted by permission of Harvard Business School Press. Excerpt from Back to the Drawing Board: Designing Corporate Boards for a Complex World by Colin B. Carter and Jay W. Lorsch. Copyright 2004 Harvard Business School Publishing Corporation.

Footnotes:

1. See New York Stock Exchange, "Corporate Governance Rule Proposals," 1 August 2002, available at http://www.nyse.com/pdfs/corp_gove_pro_b.pdf (accessed 16 May 2003), as amended by Amendment No. 1, 4 April 2003, available at http://www.nyse.com/pdfs/amend1-04-09-03.pdf (accessed 16 May 2003), subsec. 3.