Why companies must seriously consider board refreshment

Boards that fall in lockstep with management decisions are neglecting one of their critical roles: being strong monitors of a company. Refreshment policies that include term or age limits are just one strategy that organizations can employ to keep their boards strong and independent. Corporate governance expert Charles Elson shares insights on board best practices.

What you’ll learn from this episode:

• The role of term limits in keeping a board strong.
• Why individual assessment of board members might not be a good idea.
• How a company can get rid of an underperforming board member.
• Why pay for corporate board members has continued to rise over the years.

Play the episode below or read the edited transcript:

To comment on this podcast or to suggest an idea for another podcast, contact Neil Amato, a JofA senior editor, at Neil.Amato@aicpa-cima.com.

Transcript:

Neil Amato: Charles, thank you so much for being on the podcast today.

Charles Elson: Delighted to be with you.

Amato: You serve on corporate boards yourself, which I think is important to disclose, but also to help our listeners understand that you know of what you speak. On what company boards are you currently a director?

Elson: I’m on the board of Encompass Health, formerly HealthSouth. I’ve been on that board for a while. And I’m also on the board of Blue Bell Creameries, which is the manufacturer of Blue Bell ice cream.

Amato: Broad question to start, and obviously there’s plenty of paths we could take on the corporate governance topic, but we’re going to focus some on board members today. What is the role of the board of directors in ensuring a company has strong corporate governance?

Elson: Critical. The board is there as representatives, fiduciaries, if you will, of the investors to basically hire management, to fire management if necessary, and to monitor management in between those two points, and that’s its job. And governance is critical because governance, if you think about it, regulates the relationship between the board and management, the board in and of itself, and the board and the shareholders. So, appropriate corporate governance in the company itself ensures effective monitoring by the board, which creates – most people believe – effective management and effective corporate results, which benefit all the participants in the corporation itself, whether it’s the investors, the employees, customers, suppliers, et cetera. A well-run company benefits all.

Amato: On the topic of boards and their service, what are board refreshment policies? What does that exactly mean?

Elson: Well, you know, a good monitor has to be objective, and a good monitor has to be fresh, and a good monitor has to have the expertise to effectively monitor. Expertise and independence are really critical, but also a fresh look, which is necessary, I think, to ultimately do your job effectively monitoring. And refreshment policy simply says that once you get on a board, you’re not there forever. You are there for a set time period that needs to be long enough to get to know the job, yet not so long that you become stale and part of the problem. And refreshment, I think, creates a much more effective board. Directors need to have expertise, they need to have independence, but — they also obviously need to have experience in overseeing management of a particular company — but at some point you lose that edge that you need to be a good monitor. And I think refreshment means that you move — ultimately bring new people in.

Now you have to also remember that no one has the market, if you will, on board talent. There are a lot of good people out there, and the more you can bring in, ultimately, the better job the board can do. If a board has been there too long it becomes ossified and you lose that ability to innovate and that ability to, I think, engage in effective oversight, because, if you think about it, you become part of those policies that you need to challenge every so often. You have too much invested in the past, and I think that’s why refreshment is such a good idea. It also recognizes the fact that there’s a lot of talent in this world and no one is indispensable. And the view that, “Oh, I can sort of be here forever because I’m the only one who can do it” really is, A) not true, because, you know, you’re not forever, and secondly there’s a lot of good talent out there that can replace you.

So refreshment means basically turning over a board every so many years to create more effective monitoring by that board.

Amato: So do you think it’s that companies are hesitant to have board refreshment policies, or is it the board members themselves, or both?

Elson: Oh, absolutely a combination. I think, you know, companies get comfortable with the people that are there — we all get comfortable with the way things are — and certainly directors do. They like it. They enjoy it. You know, it’s a nice chance to invest in something you believe in over the long term. But people get comfortable, and most — you know, it’s hard, again, to innovate against yourself, and it’s frankly hard sometimes to say goodbye to something you enjoy. But I think that one has to understand that at some point one’s effectiveness, the longer you’re there, begins to diminish a bit. I think you can’t be there too [long] — you know, if you come into a position and you’re there only for a short time, you don’t understand the organization. It takes a while to learn the organization. But at some point, I think there is the law of diminishing returns. If you’ve been there too long, your return begins to decline vis-à-vis for the effectiveness of the board. You get a little bored with it, I think the argument goes, and there’s other talent, and you need a fresh look, and that’s why I think refreshment is so important. Management is often comfortable with those who’ve been there for a long time, and those who’ve been there for a long time are comfortable, too. And I think that that’s why refreshment is so necessary.

Amato: You’ve been an advocate of companies having term limits for board members. You’ve kind of touched on it, so I’m going to ask — you know, the term limits accomplish refreshment. Is there any other thing they accomplish? And also what in your mind is a good timeframe for a term limit?

Elson: Excellent question. I think that the key to the term limit is it forces the board to turn over. You know, there are two camps in this refreshment area. One says that we should evaluate directors every year before re-nominating and you keep them as long as they’re effective, and that’s been sort of one approach. The other is a hard and fast rule: After a certain amount of time, they need to go. I do believe after a certain amount of time most people need a change. And I believe that the most effective way for the refreshment is the term limit. Fifteen years or so is probably about right, maybe a little more at some point depending on circumstance, but I think that that’s enough. You know, you get way beyond that, 20-some odd years, I think you’re just not quite as effective. Now there may be exceptions, but I think generally you are.

And the problem is on an individual evaluation, yearly evaluation, which some call for and do not use the term, is that boards have real trouble, I think, asking someone to go. And for that individual whose time has come, it’s hard to say to that individual, “Your time has come. You’re not as effective as you used to be.” I’ve always thought the term limit does the heavy lifting, if you will. It cuts across evenly, across the spectrum evenly. No one has hurt feelings because everyone is subject to them. And an individual evaluation where you have to ask someone to leave, particularly a group that has become closely connected because they’ve been working together for a while, I just don’t think is that effective. And I’ve seen many instances where that process does not winnow out the right people because people feel hesitant to do so. On the other hand, the term I think is much more effective in refreshing the board. So 15 years, maybe a little beyond that depending on circumstance, but I think going beyond 20, let’s say, would be a real mistake.

Amato: In a survey that came out late last year from PwC, boards seem to be against giving specific feedback to individual board members. What does that tell you, that hesitance?

Elson: Well, I think it’s correct, interestingly enough. The problem of individual director evaluation by the board itself — it can be both a sword and a shield, so to speak. In other words, I find that sometimes — first of all, it devolves a little bit into the psychological, and I don’t think that’s such a good idea. I mean, objective factors – Did you attend the meetings? Do you own the requisite amount of stock? Do you have the requisite expertise or independence? That’s an effective way, I think, to evaluate someone. But when you get into more subjective factors — à la, “Gee, I like this person, I don’t, this person has habits that annoy me, they don’t” — I think at that point it becomes counterproductive.

And frankly what I’ve seen as well is that it sometimes becomes a tool to squelch the squeaky wheel, so to speak. In other words, the dissenting director can oftentimes find him or herself on the wrong side of that. In other words, groupthink comes into play and it’s used to silence a dissenting director. I think dissenting directors are very important for a well-functioning board. You need alternative viewpoints, and sometimes that individual evaluation may be used to silence them.

The other problem with it is if someone, let’s say, gets a tough evaluation — and usually it’s done anonymously — they’re going to spend the next year trying to figure out who the stinker was who said something nasty about them. And I think that, too, leads to a disintegration of the cooperative and collegial nature of the board that is so important to preserving it as an effective body. I mean, it needs to be collegial. Boards don’t act individually; they act as a group, and the group has to get along with each other. Having said that, it’s important for the group to respect dissent. But a process by which someone may secretly attack another and hide behind anonymity, I think, destroys the effectiveness of the board to operate as a group.

Amato: That’s an interesting point. You talk about the need to respect dissent, but yeah, if you’re squelching it by people giving kind of a lousy evaluation to the person they don’t want to hear from, that is an example of groupthink that is bad, I guess, for a board’s function.

Elson: Yeah, and I’ve just always thought it was problematic. I think that if you’re going to evaluate, which you ought to do each year when you re-nominate, you ought to look at objective factors. Does the person come to meetings? Does the person own the requisite amount of stock? Does the person in their employment continue to have the appropriate skill set necessary to move forward? I mean, that’s objective, and that’s I think appropriate. When you get into individual feelings about other directors, between directors, I think that that’s just — that’s dangerous. That’s a minefield. That’s why, to me, let the term limit or the age limit do the heavy lifting, and I think both are very effective.

Age limits are important because I think after a certain point all of us are human and all of us, you know, are not going to be as effective as we are at one age than we were at a younger age. And it’s hard when you hit that point to recognize that, when you hit that retirement point. You know, no one wants to say, “I’m not as quick as I used to be,” but it’s not a sinecure where you’re guaranteed a position forever. It’s a working job and I think at some point that all us hit a point we begin to lose our effectiveness with age, and that’s human and that’s perfectly OK. The question is, does the number you put before the board — is your limit the appropriate number? And I’ve always thought that that’s an important thing, both age limits and term limits.

Amato: Now I’m going to come back to that word you used, that excellent Scrabble word if you can ever make it work, but I’m going to follow up on one thing you said: requisite amount of stock. You were talking about objective factors. I understand meeting attendance. Can you explain a little bit about what you mean on a board member owning the requisite amount of stock?

Elson: Well, I mean, some boards will say you need to own a multiple of your retainer. I mean, I’ve always thought that stock ownership is critical to effective directing because it links your personal economic interests with the success of the company, not a personal relationship with management. And I think that that’s really important. It’s got to be enough that the loss of it is significant to you, that it means something if something goes wrong with it. It’s basically an incentive, if you will, to do your job effectively because if you don’t, you suffer personal wealth loss. Again, different boards have different amounts. Usually, it’s some sort of multiple of the retainer. Years ago, when I first got involved in this business, the empirical work I did seemed to show that at $100,000 in stock, you seem to see a difference in behavior. That was 20-some odd years ago now, 25 years, 28 years ago now. That number has probably gone up quite a bit.

But it’s basically got to be enough that if you lose it, you’re troubled by it, and that’s the appropriate incentive. And again, different boards have different limits, levels that they’ll set on that. Today most directors are paid — well, most of the director fee is in company stock. It usually is between 50% and higher. You know, at one point some companies went up to 100%. I’ve always thought that a balance is necessary because you need to give folks enough cash to pay the tax due on the stock. The idea is that ultimately your relationship with the company is as an investor, and I think that makes for better directing, and that’s why I’ve always thought that stock ownership is an important motivator and an important measuring point, if you will, of someone’s commitment to an organization.

Amato: Now back to that word. I’ve heard it “sinnuh-cure”; you’ve said “sinnuh-sure”. I’m still not sure how to even pronounce it.

Elson: Well, I’m from Atlanta, so you know — [laughter]

Amato: It’s sent me down a pronunciation and etymological rabbit hole. For listeners, the word we’re talking about is spelled S-I-N-E-C-U-R-E. Charles, what does that mean to you and why should board seats not be seen as such?

Elson: Well, it’s an English term, an old — well, originally the theory comes back — I’ve always heard of it in terms of Old England where, you know, you were given a title, a job if you will, and it lasted for life. It was something comfortable that once you were given it, it remained with you for the rest of your life and you were entitled to some sort of a fee or a reward for occupying that position. And it was something that couldn’t be taken away, if you will. It was there forever. And I think that historically people looked at board seats that way. “Once I got it, I don’t leave it until I decide to leave it in retirement or death.” A sinecure was viewed as an expectation of a certain position, title, income stream almost in perpetuity.

That’s the way a lot of people viewed board service, and I think that was a real problem, because if you viewed it that way, your goal was to keep it as long as you could. And historically when management appointed directors — which existed for many, many years in this country when you had basically atomistic shareholdings and no passive shareholders — that it was management who decided whether you stayed or not. And one way to avoid getting replaced and losing the sinecure was never to buck the management. And basically that led to passive boards. You know, they were there for the fee and for the lifetime of pleasure being on a board as opposed to doing the real tough work of directing, which means sometimes arguing with or replacing management.

Thank goodness the board seat is no longer in most places viewed as that comfortable sinecure. It’s now a working position, and that’s why you want stock ownership for directors. You want them to realize that if they aren’t effective in overseeing management, then they have a significant loss of personal wealth. Where you combine all-cash fees for directors and this notion of lifetime appointment, no one would buck management in a way that would interrupt the income stream, and I think that was why we moved to stock-based compensation for directors. It was an appropriate incentive. Their interests were aligned not with the manager who put them there and could keep them there or keep them out of there. It was aligned with the best interests of the company itself.

Amato: And we’ll get back to compensation in just a bit, but one other question I want to ask is if you have a board member who is clearly not fulfilling their duties, how do you get rid of that board member?

Elson: Well, you know, I think a good nominating committee asks them not to stand for reelection. That happens, doesn’t happen that often, and I think in some instances it doesn’t happen often enough. But that’s what has to be done. They’re just simply not re-nominated. And I think that that’s why institutional investors have called for a long time for annual election of directors, so that if someone’s not producing or not effective, they’re not there for three years. They can be moved along. And annual elections, it’s argued, create greater incentive on the part of the director to do their job effectively so they’ll be re-nominated.

But the simple answer is you just don’t re-nominate them. But that’s hard to do in a group of people who work together so closely over long periods of time. And that’s why, again, I like the term limit, because I think sometimes that’s a way to — or the age limit. It’s a way to accomplish that when you have a tough time doing it otherwise.

It’s also actually kind of the tough thing, too, about removing a director is that sometimes, again you don’t want to set up a procedure where you remove the squeaky wheel. The squeaky wheel sometimes is very important for a boardroom, and that’s why I think you have to be real careful with that process. And sometimes frankly a director who a lot of folks think are not all that effective can surprise you and become very effective in times that you never expected. So I think that removal of someone has to be careful.

The key is on the intake you need to be really careful who you bring in, because once they’re there, odds are they’re going to be there as long as they basically want to, the end of their term, if you will, if you have term limits or an age limit. And it’s pretty difficult to ask someone not to come back.

Amato: Median compensation for board seats at large public companies has been reported to be $270,000. Is board service a full-time job?

Elson: Well, it is becoming much more involved than it was. The National Association of Corporate Directors came out with a report in 1996 on director professionalism, and I think at that time we estimated to really do your job, it took about 190 hours a year. Today that number is much higher, I would guess probably 280, 290, maybe 300 — a plethora of committees, oversight committees and time in those committees, whether it was compensation, audit, nominating, governance. There’s just a lot more to do, more involved. Boards are much better at monitoring than they were, and it takes more time to do that effectively.

Also the regulatory regime has changed and there’s much more significance, emphasis in regulatory review of what boards are doing, whether it was the Caremark case or new challenges in the Caremark arena, whether it was Sarbanes-Oxley, Dodd-Frank — that had impact on the functioning of certainly audit and compensation committees. It’s just a lot more involved, and there is risk obviously with it. Litigation risk is significant, whether — you know, risk vis-à-vis shareholder suits or governmental risk. And for that reason you’re seeing more compensation.

Also compensation is in the form of equity. Companies have done well, and as the equity value has gone up, the compensation goes up, which is a good thing because you’re aligned with the other holders. You’re there to represent them, to be their fiduciaries, and you should be one, too. And if they’ve done well, you’re doing well. If you don’t do well, they don’t do well. None of you do well, and I think that’s the appropriate way to think of compensation.

But if you think about it, you know, you’re getting — let’s say it’s 300 hours a year. You’re getting the services of folks for certainly much, much less than you’re paying your executive team, and ultimately in the context of a large-scale organization — let’s say you have 10 directors at $270,000. That’s $2.7 million to run a board, which effectively is the overseer of the whole success of the organization. It’s the circuit breaker that protects the investment. It’s not that big a number if you think about it, certainly for the company or for the investors to pay the group that is protecting their interests.

So the entire board’s compensation is but a drop in the bucket compared to what you’re paying your executive team, so I don’t find the number excessive. And frankly it hasn’t moved all that much in the last 20 years. You’re talking from let’s say $180,000 to $250,000, $260,000, and that’s a move, but over 20 years, it isn’t that significant.

Amato: And as you make the point, if it’s more stock-based compensation, as the market has done well, then obviously that compensation goes up. So yeah.

Elson: Exactly, it’s direct alignment, and that’s the way it should be.

Amato: Today we’ve touched on several topics. Obviously, there are so many more we could go into, but on board refreshment, on feedback among board members, compensation. In closing, what steps can organizations take to have stronger leadership from their boards?

Elson: I think, No. 1, the board needs to be independent of management. The board needs to hold a significant, personally meaningful equity in the company itself to align their interest with the company as opposed to management. I think you need to design a board around appropriate expertise so the right questions can be asked of management. I mean, and each member of the board brings a different expertise to the table and it’s helpful in its evaluative aspect. I think the board itself needs to refresh itself every so often. I think that’s healthy for good, effective monitoring. And I think that’s accomplished through term limits and age limits. And a sensitivity on the part of the board to the changing nature of the business, and sometimes, you know, you have to rotate people along. And I think the easiest way to do it is frankly through the term limit and through the age limit.

But the key is that board service isn’t for the benefit of the director; it’s for the benefit of the organization and ultimately the benefit of the investors. And if you think about it, the investment class in the United States isn’t limited to a small group of people on Wall Street. It’s through our retirement funds, mutual funds — it’s all of us. And the better our organizations do, the more secure retirement all of us will have. And, frankly, the better a company does, the better all of us as consumers and producers and investors and employees will do. You know, a rising sea floats every boat. I think that’s true of the corporate setting.

Amato: Charles, thank you so much.

Elson: You’re very welcome. Very much enjoyed speaking with you about this.