Most directors don’t understand the company’s strategy and prioritize short-term gain at the expense of creating long-term value. We recommend four essential changes.
Boards aren’t working. It’s been more than a decade since the first wave of post-Enron regulatory reforms and, despite a host of guidelines from independent watchdogs such as the International Corporate Governance Network, most boards aren’t delivering on their core mission: providing strong oversight and strategic support for management’s efforts to create long-term value.
This isn’t just our opinion. Directors also know they’re falling short. A mere 34 percent of the 772 directors surveyed by McKinsey in the spring of 2013 agreed that the boards on which they served fully comprehended their companies’ strategies. In March 2014, McKinsey and the Canada Pension Plan Investment Board asked 604 C-suite executives and directors around the world which source of pressure was most responsible for their organizations’ overemphasis on short-term financial results and underemphasis on long-term value creation. The most frequent response, cited by 47 percent of those surveyed, was the company’s board. And the result among those who identified themselves as sitting directors on public-company boards? Seventy-four percent.
These are shocking results. How can companies strengthen their boards’ knowledge and help directors build, maintain, and refine a long-term mind-set? A good first step might be to help everyone firmly grasp what a director’s “fiduciary duty” really is. Most legal codes stress two core elements: loyalty (placing the company’s interests ahead of one’s own) and prudence (applying proper care, skill, and diligence to business decisions). Nothing suggests that the role of a loyal and prudent director is to pressure management to maximize short-term shareholder value to the exclusion of any other interest. To the contrary, the logical implication is that he or she should help the company thrive for years into the future.
If directors can keep their fiduciary duty firmly in mind, it should encourage big changes in the boardroom. They will spend less time talking about meeting next quarter’s earnings expectations, complying with regulations (although that, of course, must be done), and avoiding lawsuits, and more time discussing potential new goods, services, markets, and business models, as well as what it takes to capture value-creation opportunities with big upsides over the long term. Let’s look at four familiar areas where change is essential for this to happen:
- Selecting the right people. What’s behind the dramatic increase in interventions by activist shareholders? According to Stephen Murray, president and CEO of CCMP Capital Advisors, a major private-equity firm, “The whole activist industry exists because public boards are often seen as inadequately equipped to meet shareholder interests.” In short, companies keep appointing directors who aren’t independent thinkers and whose experience is too general.
- Spending quality time on strategy. Most governance experts would agree that public-company directors need to put in more days on the job and devote more time to understanding and shaping strategy. While we recommend that board members dedicate at least 35 days a year to the job, the precise number of days a board meets or the mix of field trips isn’t the main issue. What matters most is the quality and depth of the strategic conversations that take place.
- Engaging with long-term investors. While boards may be guilty of pushing executives to maximize short-term results, we have no doubt where that pressure really originates: financial markets. That’s why it’s essential to persuade institutional investors, whose ownership position makes them the cornerstone of our capitalist system, to be a counterforce. Boards can and should be far more active in facilitating a dialogue with major long-term shareholders—and many investors would welcome such engagement.
- Paying directors more. Good capitalists believe in incentives. There is a growing consensus that directors should sit on fewer boards and get paid more. We fully agree, but the even more important issue is to structure that pay toward longer-term rewards. To get directors really thinking and behaving like owners, companies should ask them to put a greater portion of their net worth on the table. This could be achieved by giving them a combination of incentive shares, a portion of which vests only some years after directors step aside, and requiring incoming directors to purchase equity with their own money.
While the thrust of each of these broad changes is relatively simple to articulate, none is easy to make. All of them must fit the specific company and industry context. Introducing them—and making them stick—will require deft handling by board chairs or lead directors, working alongside CEOs. But we need a deep shift in the culture, behavior, and structure of public-company boards. Over time, nothing else will do more to ensure that these core institutions of our capitalist system deliver the kind of sustained value creation that long-term shareholders expect and that our society deserves.
Read the full article, “Where boards fall short,” on the Harvard Business Review website. For more on this topic, visit the Focusing Capital on the Long Term website.