Board Evaluation: Improving Director Effectiveness

Foreword to the 2010 Edition

Board evaluation holds a mirror up to progress. In 2010, as we begin the second decade of the 21st century, what do we see?

When NACD convened a Blue Ribbon Commission in 2000 to explore the practice of board self-evaluation, this practice was still relatively new. Only a minority of boards were conducting regular, formal self-evaluations. Most of these focused on the board as a whole—not on committees, much less individuals.

Today, board and director evaluations have become commonplace in the boardroom, with a number of organizations, including NACD, advising this activity.

The release of the original 2001 edition of the Report of the NACD Blue Ribbon Commission on Board Evaluation helped to popularize the practice on a voluntary basis, thanks to the clear benefits of this activity. But it was not until mid-decade, following a November 2003 New York Stock Exchange requirement, that evaluations really began to flourish. The “Big Board” required that nominating and governance committees oversee the evaluation of the board, key committees, and management. In 2005, recognizing this activity, we produced a second edition of this report.

Now, in 2010, the practice of board, committee, and director evaluation has become commonplace. The following data from the 2010 NACD Public Company Governance Survey shows the breakdown of evaluations as performed by public company boards:

• Full board evaluation – 90 percent

• Committee evaluation – 81 percent

• Individual evaluation – 50 percent

In most cases, evaluations are done annually, and methods vary. By prevalence, they include evaluation by peers, self-evaluation, evaluations conducted by the governance committee, and/or by an outside facilitator.

Benefits of Evaluation

The intrinsic benefits of evaluation are clear— and more critical than ever before. The main benefit of self-evaluation is improvement of performance. As our original preface notes, feedback against agreed-upon objectives is one of the best ways to change human behavior. And as other governance philosophers have noted, the very act of observing a phenomenon changes it. (Shareholder activists Robert A.G. Monks and Nell Minow cite the Heisenberg Principle in their classic text on corporate governance.)

But a new benefit of evaluation has emerged recently: Evaluation equips boards and their individual members to communicate their value more effectively to shareholders. The reality of majority voting and the potential for proxy access have increased the value of evaluation far beyond where it had been in the past. As we go to press, a high percentage of public companies have instituted majority voting policies. On August 28, 2010 the SEC voted 3-2 on a proxy access rule (Release Nos. 33-9136; 34-62764). On Monday, October 4, 2010, the SEC granted a motion to stay proxy access Rule 14a-11, in response to a lawsuit brought by the Business Roundtable and the U.S. Chamber of Commerce challenging the SEC's adoption of this rule.

This is not to say that the results of evaluation should be disclosed. Indeed, given the developmental purpose of evaluation, they should be treated as entirely confidential, much like medical records. After all, this is about the board getting healthier, not being dragged through a public trial. Companies can, however, derive distinct benefits from disclosing the process and criteria of evaluation. This will go a long way toward restoring stakeholder confidence in boards.

Double-Edged Sword: Key Concerns about Evaluation

It is instructive to ask, “Why did evaluation take so long to become accepted in the boardroom?” When board evaluation first came on the scene, many directors mistakenly believed that its only purpose was to “grade” directors and then ask the ones who got “bad grades” to leave the board. Naturally, few boards embraced this idea at the time because there were no universally accepted criteria for board, committee, or director behavior. Directors did not want to be graded unfairly; nor did they want to grade their own peers based on a set of unfair criteria. Furthermore, some directors were concerned that the results of evaluations might not be treated confidentially— internally and/or externally.

True, a number of boards had developed governance guidelines; those boards did have something to grade against, but the many boards without written governance guidelines found evaluation to be a daunting task.

To be sure, NACD had published recommendations for various aspects of governance, including executive and director compensation, CEO evaluation, CEO succession, and responsibilities of the audit committee—all topics of the earliest NACD Blue Ribbon Commission reports. But the breadth of NACD reports, containing scores of recommendations, did not lend themselves easily to a simple common framework for evaluation.

The original edition of our report answered the main objection to evaluations by creating a framework and process for the objective and confidential evaluation of boards (featured at the end of this report with format modifications based on our experience in customizing the tool). This framework provided just the tool boards needed to conduct evaluations. Now, in this 2010 edition, we are adding NACD tools for the evaluation of committees and individual directors, as well.

Turning Points for Evaluation

A series of events has forced boards to prioritize and clarify their standards and created a lasting national mandate for board self-evaluation.

Stock Exchange Listing Standards. In 2002, following the bankruptcies of Enron andWorldCom, NACD culled a short set of 10 recommended governance practices—a “top ten” out of hundreds. These recommendations—including independence for all three key committees, as well as use of executive sessions for independent directors— were influential in creating the listing standards for NYSE Euronext (NYSE) and NASDAQ.

NACD Key Agreed Principles. Then in 2008, following the financial crisis of that year, NACD realized that some boards were following the “letter” of these recommendations without paying attention to their “spirit.” We joined with the Business Roundtable and shareholder groups to develop 10 recommended governance principles for improving corporate governance in U.S. publicly traded companies.

• A Landmark Report on Performance Metrics. In early 2010, NACD formed a Blue Ribbon Commission on Performance Metrics. Focusing on company and executive performance, the Commission raised awareness of the importance of measurable results.

• Legislative Mandates. In late 2010, it became clear that majority voting and proxy access were likely to become the laws of the land. Boards are now under increased pressure to explain their value. Evaluation provides a communication tool.

Facilitation of Evaluation

Meanwhile, throughout this past decade, while standards for board conduct were being continuously developed and continuously prioritized, a number of organizations, including NACD, began facilitating board evaluations. While the use of a facilitator is by no means universal, one in five boards use a facilitator.

In the past decade, NACD has helped more than one-hundred boards evaluate their boards, committees, and/or individual members. For this purpose we have used a template based on the findings of our original report enhanced by subsequent practices and principles clarified over the past decade (as mentioned above), with additional items customized to the company’s particular situation.

Future of Evaluation

In our pioneering report, we surveyed existing practices, and proposed general guidelines. Today, a decade later, the practice of evaluation has evolved. This 2010 edition of our report keeps the timeless wisdom of the original report, but updates it with new notes, templates, and guidance.

Robert Hallagan

2010 Co-Chair