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Board duty: take back performance control: increasing the board's effectiveness in establishing and enforcing financial performance objectives will improve its effectiveness in many other areas as well.

THE BOARD OF DIRECTORS has three main duties: exercising fiduciary oversight on behalf of the shareholders, providing counsel to the CEO, and assuring compliance with specific legal and regulatory mandates. Exercising fiduciary oversight, the original and paramount role of the board, has arguably been much diminished in modern times. Indeed, boards of public companies seem to have less and less influence over their companies' financial performance, a state of affairs that has also undermined effectiveness in other areas of board responsibility.

Broadly, modern boards can influence company performance in four ways:

1. Appoint or Replace the CEO. This is the most powerful lever boards currently use to influence a company's financial performance over time, but it is an unwieldy mechanism--episodic and yielding highly variable outcomes.

2. Approve Financial Performance Objectives. All boards "approve" company performance objectives at some level. The vast majority of boards adopt the generic earnings and revenue growth goals proposed by the CEO, or something close to that. These are typically, top down, unimaginative, wrongly (EPS) focused, and more or less toothless objectives that look broadly the same across almost all large public companies.

3. Approve Company "Strategy." This is a high-level review of largely conventional financial plans imbued with catch phrases like "be number one," "be low cost," "beat the competition," and other simplistic nostrums passing for serious thought. Except in extremis, no public company board meets often enough or long enough to have a deep understanding or a constructive influence on business unit or company strategy.

4. Approve Specific Decisions. Boards are required by law to approve certain specific decisions such as share issuances and repurchases, dividends, divestures, and mergers and acquisitions. Many of these decisions impact performance only at the margin, although major divestitures or mergers and acquisitions can have larger and longer-term effects--and here the track record of boards is decidedly mixed.

Collectively, these actions result in the board having only a weak and highly unpredictable influence on company performance over time. A promising opportunity for boards to reestablish their proper oversight role is to assert formal responsibility for establishing and enforcing financial performance objectives. Increasing the board's effectiveness in executing this duty will improve its effectiveness in many other areas as well.

General Recommendations

The shareholders own the company and should, through the board, determine what does or does not constitute adequate financial performance and oversight of their investment. It is the board, not the CEO or management team, that should set, own, and enforce at least the minimum acceptable financial performance objectives of the company. The current practice of most boards, waving through the overall performance recommendations of the CEO, does not accomplish this.

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The primary financial metric on which the board and management should focus is the growth of economic profit over time. Economic profit is simply earnings minus the dollar cost of capital invested to generate those earnings: for example, a company with net earnings of $1 billion, equity capital of $5 billion, and a cost of equity of 10% will have an economic profit of $500 million. Positive economic profits create shareholder value, while negative economic profits destroy value. Growth of a company's economic profit over time is the biggest driver of growth in share price and total shareholder returns, which are the ultimate concern of the shareholders and their boards.

Specific Recommendations

Directors of multibusiness public companies can usefully adopt four practices that will enable them to execute their fiduciary duties far better than most are able to do now:

1. For each business unit, require the reporting of full income statements, balance sheets, and cost of capital--allowing for the measurement of economic profit, economic profit growth, and even individual valuations as necessary. This information would be available for historical as well the projected financial performance of each business unit.

2. For each business unit, establish an absolute requirement that it consistently earn at least its cost of capital (a positive economic profit each year), meaning that it must be creating and not destroying shareholder value. Established businesses that fail this test will be put on "probation" for one or at most two years, during which they must return to consistent economic profitability and value creation. Any business unit that cannot achieve this minimum level of performance will be restructured and its capital will be reinvested in economically profitable business units or returned to the shareholders.

3. Above and beyond simply earning a positive economic profit, hold each business unit accountable for its own unique performance targets, specifically the economic profit and revenue growth that management promised to deliver when its current strategy was approved.

4. Before any annual bonus or other performance-based compensation (short- or long-term) is paid to the CEO, require that all non-probationary business units must earn at least their cost of capital, and that at least two-thirds of the units must also have achieved their individual economic profit and revenue growth targets.

Benefits

Adopting these four recommendations will allow the board to reassert its fiduciary duty to the shareholders in a powerful and constructive way. Among the specific benefits would be the following:

* The board now has an effective mechanism for ensuring that the company's capital is concentrated on creating and not destroying value for the owners. As the typical large public company has about one-third of its capital invested in value-destroying activities, exercising this oversight duty by the board is essential.

* The board now has a more concrete and effective means of linking the CEO's agenda and pay to how well the CEO allocates resources to strategies that create value.

* The board now has a more concrete and effective means of assessing the performance of the executives who run the units, seeing who is most capable of growing economic profits over time.

* By holding the amount of unproductive capital to an absolute minimum, the board is making a direct contribution toward lowering the risk of catastrophic performance failures in the future.

* With the dramatic improvement of information at the business unit level, the board will be in a much better position to contribute meaningfully to discussions about strategy and to evaluate proposed divestitures and mergers and acquisitions.

Challenges

A shift to this more proactive role of the board would not be without some challenges, but none is insurmountable.

A key cultural adjustment will be in accepting the change in respective roles of the board and the CEO with respect to controlling the creation and enforcement of performance metrics and objectives. Here the board will be taking on a duty that has, at many companies over the years, slipped over to the CEO. But the results of this shift have had two negative consequences: boards have lost the ability to perform their fiduciary duty to shareholders properly, and too much capital is persistently invested in activities that destroy shareholder value. These unintended consequences must be reversed. The board will need some mechanism--such as a lead outside director, a nonexecutive chairman, or a strong finance committee head--to reassert its proper fiduciary role on behalf of the owners of the company.

Creating the business-unit-level financial statements and cost of capital estimates can appear daunting, but it is by no means an impossible task. It requires a consistent set of allocation rules and guidelines (about which no one will be 100% satisfied), and a consistent reporting format so that the critical information is easily captured and highlighted for the board. The overall framework for creating these reports can be established fairly quickly, although it may take a little time for systems to catch up. As this type of information should also be integral to management's own strategic and resource allocation decisions, it should not result in any duplication of effort.

Implications

By taking these measures, the board my find itself at odds with the CEO over important issues, but this is not necessarily a bad thing. If a CEO wants to perpetuate value-destroying businesses, the board should actively intercede and insist on a resolution that quickly yields positive economic profits or else remove that business from the portfolio.

Taking on this more activist role might increase the board's workload; how much will be very company specific. Unfortunately, too much board time has been co-opted by the generally unproductive legal and regulatory requirements imposed on directors by various arms of the government. Nevertheless, directors must make the time to understand the major sources and drivers of economic profit at least at the business-unit level to do their much more important job of actually protecting the shareholders from poor strategic investment practices.

It is difficult to make the case that any other duty is more important or more deserving of directors' time. With proper reporting and good board agendas, meeting this duty should be entirely manageable.

The author can be contacted at pkontes@greenwichadvisorygroup.com.

Peter Kontes is a co-founder and chairman emeritus of Marakon Associates, described by Fortune magazine as one of the "elite half dozen" strategy consulting firms in the world. He has advised top management of some of the world's best-known companies, and has broad industry experience in financial services, branded consumer products, retailing, and manufacturing. He is the co-author of The Value Imperative (The Free Press, 1994), and author of The CEO, Strategy, and Shareholder Value (Wiley, 2010, see excerpt on facing page). He currently is executive-in-residence at the Yale University Graduate School of Management and continues consulting independently.

RELATED ARTICLE: Ask good questions ... and get good answers

Directors must not only ask good questions, they must be firm in their insistence on getting good answers.

For example, during the U.S. stock market's love affair with Enron and other companies in the power trading business in the 1990s and early 2000s, a director at one of Enron's larger competitors was troubled by a curious fact. The accounting treatment of the forward delivery contracts that were driving the reported earnings growth of his company seemed at odds with economic reality. Forward delivery contracts, in this case for the future sale of electricity at specified quantities and prices, must by definition be zero-sum transactions. Based on what actually happens with electricity prices over the life of the contract, one party will ultimately make money and the counterparty will lose the same amount of money on the transaction. Yet based on "fair market" accounting rules at the time, when a new forward delivery contract was sold it was impossible for both the supplier and the customer, using different assumptions (favorable to themselves) in their respective discounting models, to book an initial accounting profit on the transaction. On a larger scale, and so long as the market was growing rapidly, this meant that the total reported earnings arising from these types of contracts were far higher than they could possibly be in reality.

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The director's question was simple: "If we are making so much money on these deals, who is losing?" This question went right to the heart of the specious nature of what the executives at Enron and other power trading companies were touting as the new paradigm, a business model so sophisticated and complicated, they claimed, that only the rarest of human beings--certainly not mere board members--could possibly understand it. But it was not only board members who were bamboozled. In this particular case (and at other similar companies), it was clear that few members of top management understood the economics of these contracts and neither did the salespeople who were paid enormous sums to sell them. They did not have answers for "who is losing?" or other straightforward questions about the economics of the power trading business.

Unfortunately, once this ignorance became apparent, the board did not react by questioning whether the company should be in a business that the management did not fully understand and for which the reported earnings, although conforming to accounting rules, were almost certainly overstated. This would be an extremely awkward discussion with a CEO who was committed to the business. Yet the directors were only asking for a compelling answer to a simple--but deeply insightful--question. If directors cannot ask these kinds of questions in the expectation of getting honest and accurate answers, then there is little point in having board oversight.

From The CEO, Strategy, and Shareholder Value by Peter Kontes, copyright 2010 by John Wiley & Sons Inc., reprinted with permission of the publisher.
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Title Annotation:DUTIES OF THE BOARD
Author:Kontes, Peter
Publication:Directors & Boards
Article Type:Reprint
Date:Mar 22, 2011
Words:2060
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