by Paul Strebel
Emeritus Professor at IMD

The repeated failure of boards to intervene early enough to avert corporate disasters reflects a serious problem in the boardroom that cannot simply be swept under the carpet. The improvements in corporate governance made so far after each crisis have failed to address a fundamental weakness: boards are out of touch often with those who can make or break a company.

There is a disconnect between the world inhabited by CEOs and board directors on the one hand and the real world of customers, suppliers, employees, and society at large. The world of CEOs and board directors is madeBoard Room up largely of other CEOs and top executives who in a repetitive routine interact mainly with one another, with management and occasionally with analysts, consultants and government officials. They have little if any ongoing contact with those who really know what is going on. Disasters like those at Enron, Swissair, Citibank, BP (many others can be cited), reveal that board directors, especially of companies with widely dispersed ownership, often do not have enough specific industry expertise, nor contact with shareholders, nor other critical stakeholder groups, to support ambitious long-term value creation, or pick up the development of hidden risk before it is too late.

When hidden liabilities start accumulating in the form of, say, aggressive accounting on the frontline (Enron), weak alliance partners that are sapping resources (Swissair), complex derivatives based on mortgages to people who cannot pay (Citibank), repeated equipment failures on drilling platforms in the high seas (BP), these events are so far away from the world of the boardroom that board directors are often the last people to find out, and when they do, it may be too late. Once you appreciate the distance between the boardroom and the real world, the systemic failure of boards to promote value-creating growth and prevent corporate disasters comes as no surprise.

Boards have to go beyond the analysts, consultants, government officials, and get into touch with the company’s critical stakeholders, those that matter for creating long term value, sensing the related risk, and who are relevant during the make or break periods in the life of a company. It is not enough to tick more regulatory boxes, or receive more analysts’ reports. It is not about the board assuming a management role. It is about the board listening to the value critical stakeholders to understand what is going on, so that directors can make the right judgments in supporting and supervising management.

Identify the value critical stakeholders

These are the stakeholders whose input and/or resources are essential for the creation of economic value. They cannot easily be replaced or ignored without damaging the firm’s value creating potential. Lack of sufficient support from them constrains growth and long-term value creation.

At Microsoft, Bill Gates put it this way: ‘‘take our twenty best people away, and I will tell you that Microsoft would become an unimportant company.’’ At investment banks, frontline deal-makers and traders are often value critical, as are back-office risk controllers who understand the risks the firm is taking. By contrast, employees who can easily be replaced are not value-critical. But, if they form a union, which can organize value-destroying strikes, the union is value-critical. Similarly, individual shareholders in a widely held company are not value-critical, but large block shareholders are.

Very large customers and suppliers that cannot easily be substituted for, like the state, or those that determine the operating environment, like the regulators of public utilities, are value-critical stakeholders. In the fast-growth emerging markets, with authoritarian or fragmented political systems, national and local regulators are especially value-critical. Since the growth of public support and passing of legislation to protect the environment, some environmental NGOs have become value-critical stakeholders in mining, forestry, agricultural, and other industries with large environmental impacts. The same is true of influential organizations active in consumer protection, which can affect the reputation of consumer product companies.

One way of identifying the value critical stakeholders is by using enterprise risk analysis to see how value creation could be threatened and who is best positioned to provide a frontline perspective on the actual situation. For major growth initiatives, execution and project risk analysis can help identify the players on the critical path whose buy-in and commitment will be essential to success. For major acquisitions, integration risk analysis can highlight the internal and external stakeholders who are critical for value creation.

Develop communication channels to the value critical stakeholders

Composition of the board

To be in touch with the value-critical stakeholders, we need board directors who are representative of them, and/or can tune into what they are saying. For widely held companies, there is a growing call following the financial crisis for more direct shareholder representation on the boards of the companies they own.

Nominating committee

Rather than direct representation on the board, other stakeholders whose support is critical for value creation can be represented on the nominating committee to ensure that the board directors elected are in touch with the real world.

Special purpose committees

Sometimes, value critical stakeholders are on special committees outside the board such as a risk evaluation committee, a new product committee, or a brand committee, typically including frontline employees, as well as other stakeholders, like customers, suppliers, or joint venture partners.

Regular face-to-face contact

Beyond regular contact with large shareholders, many boards are briefed regularly by top management talent. At some banks, board members meet not only with the chief risk officer, but also one-on-one with her team members. Some chairmen and board directors have CEO approved routines for visiting the shop floor, or retail outlets, town hall meetings with factory employees, or management development seminars, to sample the climate.

Web-based social communication channels

Boards need information about the web reputation of the corporate brand, in addition to whistle-blowing channels for those on the frontline who know what’s going on.

In brief, to reduce exposure to future governance crises, boards require a systematic, but light program for each director to be in-touch with specific value-critical stakeholders.

strebel_paul_VIS5Paul Strebel is an Emeritus Professor specializing in Governance, Strategy and Change at IMD, a global business school based in Lausanne, Switzerland. He teaches in the IMD program High Performance Boards (HPB).