Ways To Reduce Risk In Board Evaluations

Article by Bruce M. Taten and Robert Barker

Effective in 2004, companies subject to the listing requirements of the New York Stock Exchange will face the prospect of conducting up to four separate "performance evaluations" for their boards and board committees. Other companies may follow suit as a "best practice" or to meet obligations to third parties. Although such performance evaluations — sometimes called self-assessments — have been considered a "best practice" for good corporate governance, they pose new risks that may not be immediately apparent. Perhaps because of lack of experience, perceived risk, or simply the "newness" of the process, there are no widely accepted procedures for conducting board and committee performance evaluations, or for minimizing the risks associated with them.

This article sets forth some practical considerations for structuring a board or committee evaluation. These considerations can protect the directors and the self-evaluation process, while preserving the effectiveness of the evaluation process as a tool for enhancing the operation of the board, its committees, and management.

Self-evaluation has long been regarded as an important tool for boards and committees. Performance evaluations have been recommended by reports sponsored by the American Bar Association, the National Association of Corporate Directors, the Business Roundtable, and the Conference Board. Almost all audit committee charters include a requirement that the committee evaluate its performance each year (although few, if any, companies, have reported the results of that evaluation).

The NYSE has adopted amendments to the Continued Listing Standards stating that a board should "conduct a self-evaluation at least annually to determine whether it and its committees are functioning effectively." The NYSE Listing Standards also require annual performance evaluations of the audit committee, the nominating/corporate governance committee, and the compensation committee. Other exchanges may adopt similar requirements, and there is speculation that the SEC will require the exchanges to adopt uniform corporate governance regulations. Some companies have started evaluation procedures as a matter of good governance; in reaction to outside pressures, such as corporate integrity agreements; or to satisfy the corporate governance requirements of governance rating agencies like Institutional Shareholder Services.

These evaluations, conducted with varying frequency, have taken various forms, and examined different substantive items. They have used a variety of evaluation scales, scoring techniques, and procedural methodologies. They can make the board function more effectively in its oversight role. They can also help the board be more productive in dealing with management and third parties. As Professor Jeffrey Sonnenfeld noted in his Harvard Business Review article entitled "What Makes Great Boards Great?," the success of great boards depends on the ability of the board members to "trust and challenge one another."

But self-assessment involves critical review and can be a stressful undertaking for any individual or organization. In the introduction to the NACD’s Blue Ribbon Commission on Board Evaluation is the report that "one member of the Commission recalled hearing, when asking CEOs and directors whether they had engaged in board evaluations, this terse answer: ‘Yes, once.’" Many boards have thus shied away from in-depth performance evaluations.

We believe that these types of evaluations involve other risks — both to individual directors and to the companies that they serve. Plaintiffs’ lawyers — particularly in securities class actions — would be eager to obtain critical statements that could be used as evidence of inadequacies of the board and its members. Even if the performance evaluations were only slightly negative, they could prolong litigation if plaintiff ’s counsel could use them to support the proposition that the board was "less than adequate" or "out of touch."

Fortunately, the manner in which performance evaluations are conducted can make them useful and relevant and reduce the potential liability for the board and individual directors. Performance evaluations can be supervised — and the relevant information can be collected and reported — in ways that will provide sufficient safeguards to protect the directors, while preserving the effectiveness of the tool for the board, its committees, and management. It is not even necessary for the evaluations to be in writing. The process can be supervised by counsel to help preserve privileges.

Historically, the plaintiff ’s bar has had a difficult time prevailing in suits against individual directors. Courts generally have shown appropriate deference to the business judgment of directors in exercising their fiduciary obligations, and counsel usually does a capable job of ensuring that the minutes of board meetings reflect an appropriate level of deliberation.

The landscape changed substantially in 1996 with the landmark decision of the Delaware Chancery Court in In re Caremark International Inc. Derivative Litigation. In Caremark and in subsequent cases, courts started to hold boards of directors responsible for the oversight of the enterprise-wide compliance activities of the corporation. There can be no doubt that courts have recently been willing to hold directors to even higher standards. Whereas attorneys for plaintiffs formerly faced significant challenges in reaching D&O insurance proceeds and the personal assets of directors, the courts are more willing than ever to entertain personal liability when directors are grossly negligent or use their office for personal gain.

The annual performance evaluation could be just the "smoking gun" a plaintiff ’s attorney would need to shift a burden of proof in a difficult case. The plaintiff ’s attorney will try to demonstrate a lack of due care on the part of the directors, and the evaluation forms can be used to show that the directors themselves recognized unsatisfactory performance. A few ill-chosen words or an innocent remark taken out of context can be completely twisted or blown out of proportion by a talented trial lawyer who would be able to use self-assessments to argue for substantial damages.

In other words, the annual evaluation forms could be exactly the paper trail that a plaintiff ’s lawyer needs to prove his or her case. And yet, many companies are contemplating creating paper trails with ill-considered words crafted without benefit of any professional advice — and with no legal protections.

Before you adopt an off-the-shelf self-evaluation process, we recommend that you consider establishing appropriate safeguards to shield directors from liability while preserving the best features of an evaluation. We have set forth eight techniques to consider in connection with your board or committee:

Companies that have conducted self-evaluations typically have used (and several consulting and accounting firms currently suggest in their standard forms) a numeric scoring scale. Numbers would range from, say, 1 to 10,with a low score being characterized as "weak," "poor," "unsatisfactory," or something similar. Even professional organizations that recommend evaluations use forms with numerical ratings.

As noted above, there is no need to create additional litigation risk for your company by using terms like "weak,""poor,"or "unsatisfactory." Directors will find it difficult to defend a "poor" or "weak" score on a board or committee evaluation form, particularly in a case where the pivotal question may be whether the board has properly exercised its oversight responsibilities.

Consider using a grading system that reflects the There is no need to create additional litigation risk for your company by using terms like ‘weak,’ ‘poor,’ or ‘unsatisfactory.’ past successes of the board, while pointing to opportunities for greater success. We suggest a grading scale without numbers, containing a continuum from "Less Strong" to "Strong" to "More Strong." Directors simply put an "X" somewhere in the following scale:

Accountants and management consultants may object to the absence of numbers, but keep in mind the purpose of doing all this in the first place. What is important is to prepare the company to take advantage of the immediate opportunities (the so-called low-hanging fruit), while steeling the company for the likely challenges it will face. At the end of the day, does it really matter all that much if a director gets a "1" or a "3"? The goal is instead to provide information about corporate governance opportunities. The suggested scoring system accomplishes this goal without a numerical scoring system that leaves a false impression of mathematical accuracy.

There is no requirement that performance evaluations be put in writing; the fact that the evaluation was conducted could be reflected in the minutes of a board or committee meeting. Some very large companies have already started to adopt this model. But there are obvious advantages to using written evaluation processes. Boards that use a written process should consider adding a section to the applicable record retention policy to provide for the orderly destruction of individual evaluation forms within a reasonable time (usually 30 to 90 days).As discussed in more detail below, counsel should review the evaluations and prepare a summary, and the summary document should be the only document that survives the process.

There simply is no point in keeping copies of the individual evaluation forms for any length of time. As the process progresses, the issues that require attention will become identified and the board’s plan to address those items developed and documented in the minutes. Retaining the individual forms is not likely to be of any benefit in understanding the final recommendations but will retain every ill-considered word — and provides ample opportunity for all those words to be explained with many more words in a deposition.

Of course, your record retention policy should prohibit destruction of any documents in certain circumstances, including a government investigation or the threat or pendency of a lawsuit.

Many directors are happy to have their names associated with their comments. Others may prefer to remain anonymous. It is impossible to know the political dynamic in every boardroom, so anonymous submission of evaluations generally is the safer course. Directors are not a bashful group of individuals; if they want to make their opinions known, they will find a way to do it.

If you use a written self-evaluation, the most helpful material usually comes from the written comments rather than from the particular "score" assigned to a question. Board members who are asked simply to assign scores to a variety of tedious questions will leave the process feeling unfulfilled. Boards that encourage written comments in the evaluations tend to have better discussion of the issues and arrive more quickly at processes to address needed improvements.

Leave a few empty lines after each question — directors shouldn’t feel obligated to comment on every question, but the form should leave ample space for them to add a few written comments that may help crystallize their thoughts or concerns, or to elicit a response from the professionals reviewing the forms. For the follow-up report, including quotations from other directors may well constitute the most meaningful and understandable feedback.

Different courts may have different views about whether a claim of legal privilege will attach to the evaluations if they are conducted under the direction of inside or outside counsel, and the correct answer may be fact-specific. It is clear, however, that to be privileged, such an evaluation must be kept confidential.

We believe that the courts should respect the privileges that attach to a board’s request for legal counsel to assist it in the evaluation process. Counsel should be consulted early in this process, so that appropriate steps may be taken to ensure that privilege attaches as early as possible, and that it is not inadvertently waived. Even if the claim of privilege turns out to be somewhat of a "gray area," asserting the privilege and having conducted the performance evaluation process under the direction of counsel may be beneficial in a settlement negotiation.

Rather than circulating the evaluation forms, it is better if one individual — preferably counsel — summarizes the comments and scores into a single document. Circulating copies of the evaluation forms likely would negate any value to completing the forms on an anonymous basis (even without identification by name, handwriting usually is distinctive) and may cause directors to be less forthcoming.

The final report of the evaluation (if any) should be as carefully written as board minutes. Because the choice of language is so important in summarizing the performance evaluation, we recommend that the summary report be prepared by someone who will be sensitive to the litigation risks associated with the language chosen in crafting the document. Appropriate candidates for preparing the summary would include inside counsel, outside counsel, and a consultant with appropriate legal training and experience. Obviously, management and the board must trust the person or persons selected to write the report. The summary should not be prepared by the CEO’s administrative assistant or a member of management (other than the general counsel).

Board and committee evaluations are time-consuming and, if done properly, require a healthy dose of introspection. Because they are so time-consuming, most companies have undertaken the evaluations once every two or three years.

Proposed NYSE standards would require annual performance evaluations for each committee and the full board. Yet there is virtually no guidance about the required content of those evaluations.

We suggest that there are at least three items that should be assessed on an annual basis:

Confirm that the committee has addressed all of the tasks for which it is responsible under SEC regulations or its charter (and, in the case of the full board, its governance guidelines).

Evaluate the board’s or committee’s activities in reviewing the succession plan for senior management (if this is not already part of the board’s or a committee’s charter).

Comment upon training topics that would be germane for the board for the upcoming year.

Additional evaluation items could then be added every other year or every third year. Alternatively, certain items could be evaluated on a rolling or staggered basis so that the process does not become stale or a burdensome formality.

Many boards have established a practice of documenting an annual set of performance objectives for the board at the beginning of each year. We expect that this practice may become less prevalent as individual committee charters become more formal and companies adopt written governance guidelines. But if your board does establish such written objectives, directors should monitor its performance in meeting those objectives as part of its annual review. Your board should not adopt unrealistic goals in its governance documents — adopting policies and procedures that cannot be met will simply establish liability once failure occurs.

Identification of training needs is an evolving process and will change over time as the issues facing the corporation change. One successful approach is to ask the directors to identify the key strategies needed to achieve the company’s objectives and the challenges the company might encounter in executing those strategies. The board’s advisers can use that feedback to identify additional education and training that is most helpful to the board.

Topics might include strategic opportunities, lean manufacturing techniques, succession planning programs, use of financial derivatives or off-balance- sheet financing, market segmentation issues, competitive issues, R&D needs, and future risks. Although there certainly is a place for training in areas such as new accounting pronouncements and legal requirements, that training generally can be provided by professionals in numerous forums — including formalized director education programs now available from numerous universities, law schools, and business schools. Training that the company can organize and provide that would be uniquely meaningful to the directors often is best linked to the company’s strategic plan and operating results.

The NACD’s Report on Board Evaluation cites a 2001 McKinsey study that identifies nine key attributes necessary for long-term corporate success. We suggest that, in addition to the annual assessments identified above, the board may want to review those attributes and ask whether management and the board collectively have identified the company’s opportunities for long-term success. Such a review can be conducted orally as part of a board meeting discussing the evaluation process.

Once the board has completed the evaluation and received the counsel’s presentation, the board and its counsel should ensure that each concern is addressed in the minutes of the board meeting and either disposed of at the meeting (with appropriate documentation in the minutes) or addressed in the board’s follow-up plan. To the extent necessary, the board should assign the follow-up to the corporate governance committee. No board report should identify a concern without a notation in the minutes describing how the board addressed that concern — or that the board determined, in its judgment, that it was not appropriate to address the concern. Typically, the committee chairman or board chairman will go through an open checklist of items from the evaluation process and report at each meeting about any outstanding issues still being addressed until all of the concerns have been resolved.

You may find that some directors use the evaluation process to identify weaknesses in the board — or weaknesses in individual directors. Adding new directors can strengthen a weak board. And while the evaluation process is not intended to cause the removal of board members, directors may decide for themselves that they need to be more involved or may, for a variety of reasons, choose to resign. A director may, for example, determine that he does not have sufficient experience, or that his experience is not being used because he is a director. (A director may create more change as a consultant to the board giving strategic advice.)

Performance evaluations can be an effective tool to improve the effectiveness of the board in exercising its oversight role. By taking simple — but important — safeguards, directors can enjoy the benefits of the performance assessment tools while minimizing exposure to increased liability. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.