RSM Resources

When The Home Depot fired Robert Nardelli earlier this year after a six-year reign as CEO, some observers wondered: Did his $210 million in cash severance, stock awards and other deferred compensation symbolize a board out of touch with angry shareholders and employees?

Not necessarily.

"This was an instance where the board agreed to those provisions on the front end of his employment, and it reflected compensation he was supposed to earn over an extended period of years," says C. Warren Neel, executive director of the Corporate Governance Center at the University of Tennessee.

"His package was not tied to stock performance, but to other measures — such as cash flow and expansion of sales — where he did hit the mark. But in the end, the market didn’t value those accomplishments in the way the board expected."

Experts hold up The Home Depot as one of the more visible examples of companies where the goals of management and corporate directors fell out of alignment with the interests of shareholders and employees. Indeed, while Nardelli did increase sales and net income during his tenure, much of the increase came through aggressive cost-cutting that hurt the retailer’s reputation as a knowledgeable resource for do-it-yourself homeowners. As a result, the company’s stock, adjusted for splits, rose only 10 percent from 2000 to 2006. By contrast, the stock for Lowe’s home improvement stores jumped nearly 180 percent during the same period.

While cozy relationships between corporate directors and CEOs are nothing new — especially in family-run private companies where board members and executives may be related to one another — regulatory changes are altering the landscape. For example, under the Sarbanes-Oxley Act of 2002 (SOX), public-company audit committees must be composed entirely of independent directors. And boards of all companies listed on the New York or NASDAQ stock exchanges must maintain a majority of directors outside the company’s management team.Outside directors, it is reasoned, would be free during executive session — ostensibly closed meetings — to discuss matters related to management oversight.

Despite these rules, some problems persist. Since private companies aren’t subject to SOX or exchange regulations on corporate governance, some have little incentive to formalize board-management relationships. Among public companies, Neel says some boards have committee bylaws that allow management to attend sessions when they wish. In the worst-case scenario, he says, some CEOs disregard so-called "executive session" meetings by insisting they must be present during any board conversation.

"When you look at the health of the management-board relationship, these are important issues to consider," Neel says. "Does management always attend committee meetings or come only when requested? Does management allow for the executive session of outside directors in every board meeting? When SOX was passed, it empowered boards with a defense to say, "We need some level of independence, and we need to meet in executive session." But that hasn’t happened in every organization."

Balancing the duty of curiosity

At first glance, it’s fair to say the push to add outside eyes to corporate boards was meant to ensure greater accountability and financial transparency. But, experts say, board members must balance professional curiosity about how management runs the company with keeping an appropriate distance from day-to-day decision-making.

"As we continue to hear new ideas for tighter controls on corporate governance, the question is: Where is our system heading?" said Steve Odland, chair of the corporate governance task force for the Business Roundtable, in a speech last fall to the National Association of Corporate Directors. "How far can we go in changing the governance of our companies without jeopardizing the free market system that is our greatest competitive advantage in the global economy? Where is the fault line where we cross from fixing what is wrong — to damaging what is right?"

In his remarks, Odland cited the results of a 2006Business Roundtable survey as evidence that changes in corporate governance were taking hold. Key findings included:

• 91 percent of companies reported installing an independent chair, lead director or presiding director.
• 91 percent of companies reported establishing procedures to ease shareholder communications with directors.
• 85 percent of companies said their boards would reach at least 80 percent independence by the end of 2006.
• 75 percent of companies planned for executive sessions (independent of management) at every board meeting in 2006.

Those measures represent good progress, but Neel emphasized that any long-term progress results from joint efforts between board and executive leadership.

"Board members need to be aware that their actions are a magnification of "tone at the top" set by company management," he says. "If the culture at the top of a company aligns with the standards set for those at the middle and bottom, it’s not likely you’ll find problems."

Identifying board-management issues

Does the relationship between your board and management team need a check-up? If so, here are a few tips to help diagnose common problems.

Expand board recruiting. Experts say problems can occur when the CEO is the only person recruiting new directors. That approach reinforces negative perceptions about "overly cozy" board-management relationships. A better alternative is to designate key outside directors to recruit talent in their networks to add new perspective for available board positions.

Offer board training. When many companies recruit directors, they have no back-end strategy for bringing those talented newcomers up to speed on the nuances of the company, its industry, and competitive strengths or weaknesses. Experts say the lack of training — especially for outside directors — often slows a new board member’s ability to make thoughtful, well-reasoned contributions.

Match skills with needs. CEOs and board members should regularly discuss the long-term goals of the company and use that dialogue to help design the skill sets of future directors. Be very objective about determining how the skills and talent around the board table will match what the company needs to be successful, Neel says. If the current talent mix doesn’t fit those needs, CEOs should challenge the governance committee to begin replacing directors.

Emphasize open communication. On some boards that have been together for a long time, Neel says close relationships can cause directors to pull their punches when discussing sensitive topics. At the same time, a CEO who limits or prohibits board members from communicating with other company leaders may lose credibility with directors seeking a second opinion on company goals or strategy.

"Trust without appropriate questioning, or constructive skepticism, can lead to disastrous circumstances," Neel says. "In that sense, the principle of ’trust, but verify’ remains verysound."