The Responsibilities of Board Service

Serious responsibilities are involved in joining a board.

The proper context for understanding these responsibilities in the private sector is what academics call agency theory. The board exists to solve the principal-agent problem of separation of ownership and control. The owners of a public company, the shareholders, benefit from limited liability (they cannot lose more than they invest), but they need someone (an agent) to lead and manage the company on their behalf. Shareholders have ownership, but as a practical matter, most of the time management is in control. To solve the problem, shareholders elect directors to represent them. The board selects and oversees management on behalf of the owners.

The problem of competing interests between owners and managers is not theoretical. Consider this:

Given competing interests, the board's responsibilities are to (1) ensure the interests of owners dominate those of management by being vigilant about the use of company resources and (2) align the interests of owners and managers through the design of incentives (pay for performance) so that management wins when, and only when, owners win.

As duly elected representatives of the company's owners, the board of directors is responsible for maximizing value over the long-term. There is long-standing debate over whether the proper focus of directors is on shareholder value or stakeholders' interests. While thoughtful directors recognize and are responsive to legitimate interests of multiple stakeholders (owners, employees, customers, suppliers, communities), the cornerstone of board responsibility in the United States is to maximize shareholder value over the long term.

There is an important exception to the criterion of maximizing long-term value. When the board is considering a transaction that involves an inevitable change of control or breakup of the company, directors generally have a fiduciary duty to maximize the value of the company by considering alternative transactions and selling to the bidder offering the greatest short-term value. Once the sale or breakup of the company is inevitable, the board's focus turns to obtaining the most value in the short term for the company.

As fiduciaries, directors have specific legal duties. They also have professional responsibilities. These duties are similar for company and nonprofit boards.

Legal Duties

Directors have fiduciary duties of care and loyalty.

Duty of care requires that directors, in the performance of their responsibilities, exercise the care (watchfulness, attention, caution) that an ordinarily prudent person would exercise in the management of his or her own affairs under similar circumstances. Actions that do not meet this standard may be considered negligent and any damages resulting may be claimed in a lawsuit for negligence.

Directors are required to make informed business decisions by considering all material information reasonably available to them, including adequate review of key transaction documents, either by reading them or having them explained by experts.

Duty of loyalty requires that directors put the interest of the company above their own interest and that of any other organization when a conflict exists. It prohibits self-dealing by corporate directors. They may not use their position of trust and confidence to further their own interests or entrench themselves.

Professional Responsibilities

As a director, I have seldom found it difficult to exercise my duties of care and loyalty. Doing so is my natural inclination. In addition, directors receive reminders and guidance about discharging their legal duties from the board's counsel. They also have access to investment bankers, compensation consultants, and other experts.

What has proven more challenging to me and, I suspect, many directors is sorting out what my broader responsibilities are in difficult circumstances. Here are two examples.

 

What to do about a failing company? I was on the board of a rapidly expanding retailer. Top line growth was high due to increases in same-store sales as well as new store openings. Earnings were good and the balance sheet was leveraged but not excessively.

Then things began to go less well. Revenue growth came increasingly from new stores as same store sales stagnated. Gross margins declined as management cut prices to try to juice sales. Earnings went flat then started to decline. Cash flow was strained as a result of flat earnings and continued expansion. I found myself paying close attention and feeling concerned. I extrapolated trends. I didn't like where things were going.

During this time, management tried to be reassuring. But in the process of what psychologists call sense-making, that is, figuring out what various bits of information might mean, four things occurred in close succession that unnerved me.

First, the very talented president and CEO of the company resigned and took a bigger and better job elsewhere. I thought we should appoint an interim and do a search for his successor. The rest of the board was comfortable with an internal promotion and felt that an interim title would signal weak support and failure would be a self-fulfilling prophecy.

Second, one of the directors pointed out in a board meeting especially poor performance of one of our stores and asked management for an explanation. The new CEO said, "A Walmart opened down the street and that hurt us. But I've competed against Walmart; if we hang in there, they'll let up." I thought this was the dumbest assertion I'd ever heard in a business meeting. I challenged it. The executive softened his stance but only a little.

Third, we did a tour of the company's distribution center. The purpose was to show off the inventory management system, but what I noticed was poor housekeeping. There were boxes in aisles, open cartons, and a general sense of disarray. Soon after, my dad was looking for a particular product that I was sure would be carried in one of the company's stores because we were a category killer retailer. We went shopping. Sure enough, the store carried it, but that day it was stocked-out. My dad wasn't impressed, and I was embarrassed.

Fourth, we decided to borrow money because earnings were stagnant, the balance sheet was strained, and growth was chewing up cash. Management told the board what the interest rate would likely be, and we deemed it acceptable. I'll never forget learning soon after the bond offering that the final rate was more than a third higher than we had expected—a junk bond rate! I was shocked. The public debt market was telling us something very different about the risk profile and credit worthiness of the company than we were hearing from management.

I sat down over a weekend and thought about what I had been experiencing. Something about it seemed familiar. Then I remembered a presentation by John Hackett, the brilliant chief financial officer of Cummins, I had heard a decade earlier. His title was "How Companies Fail." It was a "stages" approach, like Gail Sheehy's life phases in Passages or Elisabeth Kubler-Ross's process of grief in On Death and Dying. I was stunned to realize, based on Hackett's stages of how companies fail, that I was a director of a company midway through a process that could result in bankruptcy.

The question was what to do? This was a difficult situation for a director. I had legal duties of care and loyalty and the protection of the business judgment rule. But I was deeply concerned about the company's prospects. Financial failure would be the antithesis of my responsibility as a fiduciary, deeply harmful to shareholders and stakeholders alike. But in conversation, I found that others on the board were not nearly as concerned as I, and management was relentlessly reassuring.

I had a great desire to flee. I felt like a passenger on the Titanic who was convinced we'd hit an iceberg and were likely to go down while everyone around me was still enjoying dinner and dancing. Resigning from the board was an option, of course, because directors can do so at any time and are not obliged to provide an explanation. But it seemed to me that cutting and running without making the best case possible to my board colleagues as to what I believed was happening and, more important, what actions needed to occur to rescue the situation would be irresponsible.

So I put together a short presentation and shared it with the chairman and independent directors. It included five actions the company had to take for me to continue in good conscience as a director: conserving cash, halting new store openings, closing money-losing stores, discontinuing a related diversification, and evaluating whether we had the right CEO or needed to recruit one fully up to the difficult job facing us.

The board discussed my analysis and recommendation. They disagreed. I resigned. Eighteen months later, the company declared bankruptcy.

I took no pleasure in it, and I don't intend this as an "I told you so" tale. Rather, it is a story of the real nature of a director's responsibility in a difficult business situation. Absent extreme good luck, most directors will experience some failures because pursuing returns for shareholders involves risk. I've always liked my dad's notion that in tough situations your conduct has to allow you to look yourself in the mirror in the morning. That's a good standard to guide a director in a tough spot.

 

What to do about a possible conflict of interest? Directors have to be attuned to potential conflicts of interest when they consider joining or remaining on a board. They must honor their duty of loyalty to the company if push comes to shove. And independent directors must be prepared to challenge the prevailing wisdom, including backing up conviction with resignation if necessary.

It would be nice if conflicts were all crystal clear. Then deciding how to handle them would be easy. But they're not. I had an experience that illustrates the point. The story is short because my board service lasted exactly one meeting.

It occurred while I was dean of the business school at the University of Michigan. I became acquainted with Sam Wyly, one of our graduates. Sam was a successful, colorful, and sometimes controversial Texas entrepreneur. We had several meetings. Sam visited the school, and I ultimately asked him to consider a $10 million gift to fund half the cost of constructing a much-needed new building on campus. Through this process, we got to know each other, and Sam invited me to join the board of a public company, Sterling Software, of which he was chairman. He and his brother Charles were major investors.

I engaged in careful due diligence and determined that the company was solid and had a good reputation. I was confident in my ability to be independent in thought and action as a director because that's my makeup. (Like most university professors, I am skeptical of authority and don't like anyone telling me what to do.) So I joined the board.

I thought things would be fine until I attended my first meeting. There, I was surprised to find myself thinking and feeling uncomfortable about the concurrent timing of Sam's major gift to the school and my joining the board as an independent director of a public company he chaired. Could I be as independent as I naturally was? With Sam, his brother, and his son all on the board, I wasn't sure I could. I decided to play it safe and never find out. I went to Sam after the meeting and told him I was concerned that I could find myself in a conflict between my roles as dean of the business school to which he was a donor and an independent director. Out of an abundance of caution, I had decided it would be best for me not to serve on the board. Sam was gracious, and that was the end of it. It was a decision that cost me a lot of money—several million dollars in light of stock and options and the later sale of the company—but it passed the "look yourself in the mirror" standard.