Aug 142016
 

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Earl R Smith II, PhD
DrSmith@Dr-Smith.com

Dr-Smith.com

The years since the 2002 passage of Sarbanes-Oxley have seen a number of positive trends in board structure, management, operation and influence. At the same time, counter trends have highlighted companies which have attempted to maintain the ‘old paradigm’ of business as usual. These attempts have often resulted in conflict between management and the board of directors.

The CEO of a rapidly growing company faces a series of challenges regarding the board. How these challenges are met can have a dramatic impact on the future of the company.

The Impact of SOX on Boards

Sarbanes-Oxley, and some of the court cases that have resulted from it, has highlighted the liabilities that directors are exposed to if they act casually towards their primary fiduciary responsibility – to protect and extend shareholder value. As a result most directors have become much more proactive as well as much more careful when accepting board seats. 1)An interesting subset of directors is those venture capitalists who sit on the boards of companies that they have made an investment in. These board members understandably have primary allegiance to their venture partners and the institutional investors which have invested in their fund. The argument that the relatively short term perspective which drives the agenda of venture capitalists is somehow closely aligned with other shareholders who will be involved in the company long after the venture capitalist has been paid off is clearly specious. It is all too easy to envision a set of circumstances within which the desire of the venture capitalist to recover an investment and realize a significant profit in the process (most venture capitalists have targets of ten times their investment) can conflict with the long-term interests of the other shareholders. The mere fact that the remaining shareholders will be substantially diluted by the liquidity event should be sufficient to demonstrate the problem. The agenda of these directors often leaves a company in a very difficult position. It must either seek additional rounds of funding or incur substantial amounts of debt in order to pay off investors. There is a substantial conflict between the agenda of the venture capitalist and the long-term interest of the residual shareholders. As a result, some VCs have begun nominating directors from outside their fund. These ‘professional directors’ are independent of management and provide effective oversight without incurring the liabilities that a fund officer might. Management may face a board which, conscious of its own liabilities and responsibilities, becomes insistent on a broader and more determinative role in decision making.

In the immediate aftermath of the passage of law, the prevailing wisdom was that it would apply mostly to large public companies. Most of these companies spent a substantial amount of time, energy and resources coming into compliance with the new regulations. Many CEOs soon realized that these efforts were also having a very positive impact on the quality of corporate governance and performance.

As more time passed it became clear that the improvements in the quality and consistency of governance were a primary, if unanticipated, benefit of the law. Private companies began to look at the issue of board effectiveness and some decided that a proactive board was a corporate asset that could add value and reduce risk. 2)There is some evidence that private companies that are SOX compliant will trade at a premium when acquired.

This trend was partially driven by an increased activism on the part of sitting directors. Private companies presented a particular challenge for them. It became clear that, even in the face of a management team that controlled most of the equity, a director can be held liable for negligence or dereliction of duty and might be particularly vulnerable to actions brought by minority shareholders. Courts have not been sympathetic to arguments that, since the majority of shareholders were opposed to what might be recognized as ‘best practices’ such as effective and independent board oversight, directors should be shielded from liabilities. Because the statute advanced these ‘best practices’, boards of directors – even of private companies – have increasingly focused on compliance.

The generally accepted wisdom has become that the guidance supplied by Sarbanes-Oxley can be productively applied to private as well as public companies. Boards of closely held companies and sole proprietorship, although technically exempt from the provisions of the law, have begun to push towards compliance. In doing so, the boards have been seeking to fulfill their appropriate role in corporate governance and management.

Challenges

For the purposes of this article I want to focus on three stages of board growth and operation – the in-house board, the rise of the insurgent board and the fully functioning, collaborative board of directors.

As a company grows the role and responsibilities – not to mention the liabilities – of its board members expands along with it. Senior management needs to facilitate and support these changes. It is critical that they insure that the board their company has is the one that it needs.

Critical issues tend to surface when boards move from one stage to another. As with most experiences, it is the process of change that causes vertigo and sets countervailing forces into conflict. In Battle at the Cottage Gate, I described how battle lines are frequently drawn around such issues. These destructive and wasteful conflicts can rage for months; leaving the future direction of the company in the hands of the victors. And that result is sometimes less than desirable.

The best CEOs approach these transition periods with enlightened self interest – meaning that they seek long term improvements even in the face of short term discomforts. 3)My experience has been that one in five or six CEOs even seriously consider these challenges through the lens of enlightened self interest and, of those, one or two will follow those interests to a re-thinking and reorganization of their board of directors. The operative issue seems always to be control – the CEO has it and won’t give it up – and board oversight is seen as a form of control – one that the CEO can’t bring himself to submit to. A board at any stage represents a countervailing power center – and a direct challenge to the supremacy of the management team and CEO in particular. 4)A useful example might be the sometime uncomfortable balance of power and prerogatives between the Executive and Judicial branches of the federal government of the United States. Presidents frequently see the court as challenging their vision for the country and interfering with the perfection of that vision. But the courts have an important role in tempering the more extreme tendencies of the Executive.

The concentration of power in the hands of the CEO and senior management team during the early stages of corporate growth was probably the only viable alternative available. But as a company grows that concentration of power becomes a liability and a limiter of potential. The challenge is to manage an orderly devolution of power and prerogatives. As a company matures the sovereignty held by the CEO needs to be distributed amongst other parts of the company – including the board of directors. If this does not occur the results will most probably be that the company enters a stable stasis within which the possibilities of growth and change are limited – or enters a downward spiral toward extinction.

The In-House Board: In the early stages the board is often no more than a response to a legal requirement. It is not seen as an aid to growth and certainly not a key player in the management of the company. Most initial boards are made up of founders and their relatives or friends. They tend to be small and meet infrequently. The records of their meetings and decisions are generally poorly documented. Information provided to directors who are not part of the management team is usually fragmented and focused in the direction that management wants to take the company.

This ‘rubber-stamp’ characteristic can be tolerated – indeed, can be highly productive – because the company is more a ‘project’ overseen by a ‘project manager’ (the CEO) with the help of a senior project team. But, for most companies, this period is short-lived and matters soon become far more complex. As the company grows, management may seek to augment the board by bringing new members on who have the capability to help the company grow. I have written elsewhere about how this strategy can cause real problems and significant liabilities.

In-house boards are easy to identify. Power and prerogative tends to be almost completely in the CEO’s hands. A review of the minutes of the board’s meetings, should they exist at all, will generally show a lack of substantive exchange. Such boards do not generally address problems unless the solution has been decided upon before hand. 5)The maxim that guides the CEO is generally ‘never ask a question unless you know the answer before hand’. Some questions tend to be avoided altogether. For instance, three questions that are almost never addressed by in-house boards are 1) Do we have the right CEO? 2) Is the compensation scheme in place appropriate or excessive? And 3) Who will succeed the current CEO? The information that the board members receive is tightly controlled by the management team. The board sees only what management team wants it to.

Board members tend to be complicit in this arrangement and seldom aggressively push for access to additional information or insist on the presentation of competitive perspectives. Most information which board members receive is at an executive summary level. They generally do not countervailing perspectives which might conflict with the interests and intention of the senior management team. If the board focuses at all on significant problems, they tend to be in the area of regulatory compliance. And even then, their actions and decisions tend to be a rubber stamp for the CEO. In short, the in-house board tends to be a ceremonial one. 6)And, as some directors have found, a potential source of significant liability

The Insurgent Board: As the company grows the appropriate structure, composition and role of its board also evolves. The seating of the first independent director is usually a sign that this process has begun. It is generally triggered by management’s recognition that running the company has become much more complex and that access to additional experience – perhaps in the form of highly experienced mentors and/or oversight – is required. Perhaps the issue of compliance has become a much more serious matter or maybe the demands of adequate quality control or financial reporting is beginning to be outside the scope and capabilities of the senior team – or perhaps the management team has begun to feel seriously out of its depth. Maybe the CEO’s image of invincibility has been pierced by a serious misjudgment. Or there might be stress fractures developing – serious disagreements among members of the management team. For whatever the reason the value, function and appropriate role of the board of directors becomes an issue.

Enlightened management begins to see that the board’s value will increase if directors provide effective oversight. 7)I have worked with CEOs who could not bring themselves to accept the need for this kind of change in the role of the board – and the devolution of power and prerogatives that accompany it. For the most part their companies became stuck in the ‘early stage’ patterns and lasted only as long as the CEO did not retire. New behaviors begin to surface during and between the board meetings. It is likely that the initial conflicts between the board and management will be focused on specific issues or outcomes. Board members will begin to speak out on issues that concern them. They will also begin to take their fiduciary responsibility to the shareholders much more seriously. But, during this phase such actions may be sporadic and uncoordinated.

Members become increasingly aware that the information that management is providing is insufficient for their needs. Directors start to push for a more thoroughgoing analysis of alternatives. During this time, board members will begin to schedule meetings which exclude the CEO and management team. Board deliberation will occasionally be behind-closed-doors. This development can cause significant angst for management and the CEO may see it as a direct challenge to their authority.

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References   [ + ]

1. An interesting subset of directors is those venture capitalists who sit on the boards of companies that they have made an investment in. These board members understandably have primary allegiance to their venture partners and the institutional investors which have invested in their fund. The argument that the relatively short term perspective which drives the agenda of venture capitalists is somehow closely aligned with other shareholders who will be involved in the company long after the venture capitalist has been paid off is clearly specious. It is all too easy to envision a set of circumstances within which the desire of the venture capitalist to recover an investment and realize a significant profit in the process (most venture capitalists have targets of ten times their investment) can conflict with the long-term interests of the other shareholders. The mere fact that the remaining shareholders will be substantially diluted by the liquidity event should be sufficient to demonstrate the problem. The agenda of these directors often leaves a company in a very difficult position. It must either seek additional rounds of funding or incur substantial amounts of debt in order to pay off investors. There is a substantial conflict between the agenda of the venture capitalist and the long-term interest of the residual shareholders. As a result, some VCs have begun nominating directors from outside their fund. These ‘professional directors’ are independent of management and provide effective oversight without incurring the liabilities that a fund officer might.
2. There is some evidence that private companies that are SOX compliant will trade at a premium when acquired.
3. My experience has been that one in five or six CEOs even seriously consider these challenges through the lens of enlightened self interest and, of those, one or two will follow those interests to a re-thinking and reorganization of their board of directors. The operative issue seems always to be control – the CEO has it and won’t give it up – and board oversight is seen as a form of control – one that the CEO can’t bring himself to submit to.
4. A useful example might be the sometime uncomfortable balance of power and prerogatives between the Executive and Judicial branches of the federal government of the United States. Presidents frequently see the court as challenging their vision for the country and interfering with the perfection of that vision. But the courts have an important role in tempering the more extreme tendencies of the Executive.
5. The maxim that guides the CEO is generally ‘never ask a question unless you know the answer before hand’. Some questions tend to be avoided altogether. For instance, three questions that are almost never addressed by in-house boards are 1) Do we have the right CEO? 2) Is the compensation scheme in place appropriate or excessive? And 3) Who will succeed the current CEO?
6. And, as some directors have found, a potential source of significant liability
7. I have worked with CEOs who could not bring themselves to accept the need for this kind of change in the role of the board – and the devolution of power and prerogatives that accompany it. For the most part their companies became stuck in the ‘early stage’ patterns and lasted only as long as the CEO did not retire.

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