THE ROLE OF NON EXECUTIVE DIRECTORS AND THEIR SELECTION

There has been recent public comment and debate on the composition of boards, director appointment processes, the need for more diversity and on the other hand, on the excessive diversity and lack of experience versus the capability on public sector boards. Many of the views reflected poorly informed perceptions about the role of non executive directors, which is risky if this public perception ever became new policy.

The role of a company

The purpose of a company is to add value, for shareholders and other stakeholders. That is also the main objective of the directors – to add value. Good governance and compliance are simply tickets to the game. While necessary, they have little merit in themselves.

Most companies operate in a competitive environment, often highly competitive – in terms of product markets, access to materials, technology, people, systems and processes, prices, and quality etc. and in terms of ownership, financial markets and performance.

Adding value therefore, requires skill and ability, because a business environment is almost always challenging, uncertain and risky. For example, decisions today with implications over one, ten or thirty years entail substantial uncertainty and risk.

The role of directors

Directors control a company and are accountable for it. They hire management, guide and direct it and manage its performance. Management operates under the delegated authority of the board.

To operate effectively and add value in this context, directors need a considerable level of ability and experience. It needs to be sufficient to understand and debate complex issues, to make sound decisions and to effectively guide, encourage and when necessary censure, or even dismiss, the chief executive. Without a high level of capability, directors, and therefore the board and the company, will not operate effectively and successfully.

Effective boards not only have capable directors but also operate as a team. While directors are individually accountable, without team work, effective performance is unlikely. And the team needs to be capable when the going gets tough, not just when circumstances are benign.

Selection criteria for non executive directors

It is highly desirable to have a core of experienced and successful former chief or senior executives on a board, people who have a good skill base, honed by good, diverse but relevant experience in the business world, who have ‘been there and done that’.

People who have the ability and credibility to guide the CEO and management team, who have done the deals and walked the talk. People who have experienced the blow torch of intense competition and of potential or actual failure and disaster, but who know what success looks like and who really do have good and seasoned judgement of risk.

Good experience in manufacturing or processing typically has much wider value, in terms of directing a successful business. Experience in a good “corporate” context, with good policies, values, systems and processes is valuable and a lack of it is likely to be seriously damaging in developing a “high performance” organisation.

Public sector experience has useful dimensions but may also have material limitations. In New Zealand, too many boards lack this critical core, and it is becoming increasingly difficult to find such people with the necessary breadth and depth of skills and experience.

The weakness of management in New Zealand is part of the problem but this is being seriously compounded by the hollowing out of the corporate sector with increasing foreign ownership and reversion to ‘branch office’ status, and the downgrading of most foreign company management teams here, or their complete removal. For decades, foreign companies have been a vital source of management development and training in New Zealand – and this has substantially diminished over the last decade or so. Small and medium sized companies dominate and few of these invest adequately to develop their organisations and its people.

Around this core of directors, say two to three out of seven, there needs to be a mix of additional skills and capabilities, tailored to the needs of the organisation and with the overriding need to have a board that functions well as a team – so interpersonal skills and compatibility are vital considerations. In addition, independence and diversity of thought are vital – a good board is characterised by a willingness to test, probe and debate vigorously, before typically reaching agreement efficiently and amicably.

Vital characteristics

In my view this means that most directors, perhaps with one exception amongst a board of six or seven or more, need to be familiar with high level business – with its cultures, processes and decision making. Legal, finance and accounting expertise can be valuable, but it should come with real familiarity and experience of the high level business context in which the board will operate and inexperience in this context can be a serious problem.

For example, there is the vital issue of the inability of an inexperienced director to judge management’s performance astutely, and the risk of undue prevarication when the CEO needs to be counselled or removed. This is one of the most important situations that directors have to deal with – and wanting to remove a CEO for poor performance is disappointingly common. It is also one that directors with a professional services rather than a corporate background can find difficult to deal with.

Another important issue is understanding risk, an inability to judge risk astutely and an unduly constrained appetite for risk, when businesses commonly have to identify, assess and deal with many specific and often serious risks.
Another is lack of familiarity and competence with key business tools – ranging from DCF analysis, risk analysis, Monte Carlo simulations, baysian decision techniques, scenario, strategic and operational planning, financial analysis and derivatives – to the tools and techniques of operating a business, such as lean, just in time, time in process, Toyota, Demming, SIPOC, SST. And not forgetting knowledge of performance improvement and organisational development techniques. An experienced business person will have a good armoury of these important skills.

A good director needs to be able to judge when information presented is adequate or not and when more is reasonably needed. They also need to process information quickly and efficiently, to see weaknesses and be able to question management astutely and intensively when necessary. Then there is the ability and experience to make generally good decisions, about large and small or complex issues and having a good sense of how to make a decision about $100k or $100million or $1billion.

Inexperience

With inexperienced directors there is also the risk of damage to the board’s credibility with management, where a director is perhaps naïve, questioning excessively or out of their depth.

An inexperienced director who is an astute and intelligent person will, over the course of months, gain experience and understanding of a board’s processes and how best to engage, but that is only a first small step. It will take a very much longer time for them to gain the business tools, knowledge and experience that will enable a full contribution.

I do like the idea of a left field thinker on a board, who may be inexperienced but who has the personal skills and abilities to make the risks of the learning process worthwhile, even rewarding; but such opportunities are necessarily limited. However, there is the invaluable truism, that ‘you don’t know what you don’t know’, so the absence of the necessary capability and experience on a board can be very damaging as the board’s performance is constrained by its own limitations of knowledge, experience and capability.

This is a critical point!

Conclusion

A board is a high performance, high stakes environment, in which to be part of a strong team is really the only option and without a strong board a company is unlikely to prosper. This has clear implications for the criteria by which NEDs should be selected, and a lack of senior executive – or related experience linked with valuable professional skills and experience in business is, necessarily, a major barrier to selection.

Appointing a new director typically takes many months and a year or more is not uncommon, such are the stakes involved. This is rather at odds with the popular perception of a need for more diversity on boards. Where diversity aligns with better performance I am all for it but I expect that it is more common and acceptable in the Public Sector because there is less explicit emphasis on and measurement of performance and improvement.

I do consider that good directors are seriously underpaid in New Zealand. In substantial listed companies in New Zealand, total directors’ remuneration, excluding the MD or CEO, is typically half of the CEO’s remuneration. A ratio of at least one to one would be more appropriate. It would be a poor board that couldn’t justify that in terms of value added.
The role of a NED is a rich tapestry – challenging, often difficult and always risky. And if it gets a bit quiet you can be sure there will be something coming over the horizon to stir things up – typically these days a takeover bid from overseas.

The above article was taken from an address given by Kerry McDonald, Professional Director and Chairman of the Wellington Branch of the Institute of Directors, to the Canterbury Branch of the Institute of Directors in July 2006. It is taken in its entirety and as it appeared in the August 2006 issue of “boardroom” the monthly magazine of the Institute of Directors in New Zealand. Ysker acknowledges “boardroom” as the source of the article and also wishes to thank Kerry personally for allowing us to publish his speech.

Footnote: Ysker believes that in writing this excellent article, Kerry McDonald has encapsulated both the essence and the pragmatism of the considerations, thinking and planning required when considering candidates for selection as Non Executive Directors.