Early in 2009, members of the Harvard Business School faculty's Corporate Governance Initiative met to discuss the impact of the economic crisis on corporate governance in general and on corporate boards in particular. We recognized the legitimacy of many issues raised by the media, the public, and politicians about boards' ineffective oversight of financial services firms and other complex companies whose failing contributed to the current recession.
As we reflected on how and why some boards had fallen short, we came to a tentative conclusion. The problems that surfaced in 2008 and 2009 largely differed, we believed, from those that had prevailed in 2002, when boards failed to identify and stop management malfeasance and fraud. By contrast, the more recent boardroom failures could be primarily attributable to the growing complexity of the companies that boards are charged with governing.
By complex companies, we mean those that operate multiple businesses (in terms of both products and geographies). In our view, these companies create unprecedented challenges for the executives who lead them and for the boards that oversee them. We questioned whether the boards of complex companies receive adequate information to understand the performance issues and risks their companies face. The challenge for the boards of such companies is how to oversee such complexity within the limited time that directors can devote to the task.
We agreed that the best way to test these conclusions and explore the causes of board failures was to go directly to the source: directors serving on the boards of financial institutions and other complex companies. We decided to seek answers to two broad questions: How well did these boards function before the recession, and, more important, what aspects of board functioning troubled board members as they looked to the post-recession future?
We selected as interviewees (1) members of boards of complex public companies whom we both (2) knew personally and (3) believed to be both dedicated and respected by fellow board members. We interviewed 45 directors. Clearly, this was not a random sample. It was intended to be biased toward experienced directors with whom we had prior relationships and therefore had reason to believe would be candid with us.
A strong consensus
Interviewees opinions varied about the difficulties that complexity poses for boards, but there was strong consensus that the key to improving boards' performance is not government action but action on the part of each board. Several directors worried that the government would take action if boards themselves did not. In essence, there was a strong consensus that the key to successful governance rests in the hands of each board. Specifically, it resides in how directors work together and with management to oversee the company and make decisions. In the directors' view, these are matters that cannot be regulated effectively by government.
We use the term understanding because it expresses what the directors seemed to be seeking. They often used the words knowledge and information as well, but their underlying concerns were clearly insufficient understanding on the part of some boards, the causes of the phenomenon, and what they and other directors could do about it.
As important as they believed it to be to understand the company, some directors admitted that complete understanding is an impossibility: “You really can't understand everything that's going on in the company, and the notion that you can is misguided,” one director said. “Unfortunately, I think people do expect directors to know a lot more than they sometimes do.”
A disproportionate number of those who attested to the elusiveness of adequate understanding were directors of financial-service firms. “We had the Enron era; now we have the financial era, where we're taking down the whole world with us, and it can't be because all these people are stupid,” one such director said. “It has more to do with the depth of understanding of what's really going on.”
One director pointed out that even when a board meets as often as 10 times a year (the typical U.S. board meets six times), it is impossible for directors to understand complex financial companies: “One has to understand that board members show up, at a maximum, let's say 15 to 20 days a year. Maximum. And the idea that board members would be close enough, informed enough, experienced enough, engaged enough to have seen some of this coming, and even more, to have been wise enough to figure out how to duck, is just naïve in the extreme.”
The obvious question
Such comments raise an obvious question: Why do directors have such difficulty understanding their companies? Several directors commented on the scarcity of specific industry knowledge on most boards. “I think our thinking is going to be forced to be changed by virtue of the financial crisis, in that I think we're going to place higher value on industry-specific knowledge and less on general knowledge of governance and the general experiential things that come with an all-purpose board,” one director said. Another echoed this view: “The board needs to be asking the right questions. One thing that I've seen just over the last couple of years, and been a champion of, is having at least one board member who is very knowledgeable about the business you're in. It really is helpful, particularly in executive sessions, when you don't have the management there, and you're debating something, or wondering whether you should be worrying about something, to have someone who understands the business a little bit better than you do.”
A third director went further, linking the shortage of specific company knowledge to corporate governance reforms that called for more independent directors: “Strategy is harder, because it requires a familiarity with the business, and an understanding of it, in order to make any sort of informed suggestion. And clearly, I think, if you were to look at boards, there are still huge deficits in certain technical expertise and understanding of the business that persists at boards. One of the things that's been lost, in the notion of full independence and limited insiders and split chairmen and CEOs, is that boards have lost insight into the business as a result of not having, if you will, as free and consistent access to people who are steeped in the business as they might otherwise have.”
This point deserves emphasis. We believe that a major reason directors find it difficult to understand their companies is that the typical board of a large public U.S. company consists entirely of directors who must meet the test of independence. As a practical matter, it is difficult, if not impossible, to find directors who possess deep knowledge of a company's process, products, and industries but who can also be considered independent. â–
The author can be contacted at jlorsch@hbs.edu.