© Bain & Company 2004

Recruiting directors to join the boards of listedcompanies is a thankless task these days. It’s notsurprising. Rarely have corporate directors facedsuch a deep and widespread erosion of public trust.Boards are seen to provide weak oversight or,

worse, to be complicit in allowing executive greed,rewarding underperformance and failing to preventcorporate excess and even fraud.

Predictably, the loss of trust in corporateoversight has produced two inevitable responses:lawmakers and regulators push for strongerregulation, while activist shareholders strive toexercise greater influence over corporategovernance. Restoring trust is essential, but each ofthose responses, however well intentioned, riskscreating new problems.

In the new era of regulation, directors’attention has become consumed by issues ofgovernance and the accuracy of the next earningspronouncement, instead of focused on helpingcompanies to build sustainable value.

Although the details vary by country, the trendis clearly toward more stringent legislation andregulatory compliance, through measures such asSarbanes-Oxley in the USA and Higgs in the UK.While these requirements have sent a clear signal

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The seven habits of an effectiveboardAlan Bird, Robin Buchanan and Paul Rogers

EUROPEAN BUSINESS JOURNAL

Directors of the boards of listed companies are coming under heavy fire thesedays. Often, they are accused of providing weak oversight or even being complicitin fraud. But the public’s push for stronger regulation of boards will do little toaddress the real issue boards face: corporate underperformance. Only one ineight companies achieves even modest targets for growth. In this article, Bain &Company’s Alan Bird, Robin Buchanan and Paul Rogers explain why boardsmust not focus on appeasing increasingly short-term stock investors who arelikely to head for the doors at the first sign of trouble anyway. Falling victim tothat short-term myopia can be fatal. Instead, boards should concentrate on valuegrowth, by practising seven habits that build their effectiveness. There is noparticular magic in these habits, which most boards have adopted already tosome degree. The question is not whether directors recognise the seven habits,but how well they act on them.

Address for correspondence: Samantha Axtell, Bain &Company, 40 Strand, London WC2N 5HZ.

Alan Bird, partner, Bain &Company, London

Robin Buchanan,partner, Bain &Company, London

Paul Rogers, partner and leaderof the GlobalOrganisation practice, Bain &Company, London

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129THE SEVEN HABITS OF AN EFFECTIVE BOARD

to the fraudulent few that businesses must clean uptheir acts, an unintended consequence has been tomake boards more reactive and risk-averse.

The defensive climate prompted US FederalReserve chairman Alan Greenspan to commentthat ‘a pervasive sense of caution’ is influencingbusiness leaders. How many boards wouldrecognise themselves in Greenspan’s observation?

Empowering investors sounds good in principle,but it can backfire. Pressure from investor groupsall too frequently engenders a simplistic ‘box-checking’ mentality toward complex governanceissues.

More important, one has to ask: Can investorshandle a more active role? The average holdingperiod for a US stock in 2001 was slightly morethan one year – half as long as it was a decadebefore. A growing number of stock traders – daytraders, short sellers, hedge funds, arbitrageurs –have no incentive to act as stock owners.Mainstream investors have also shortened theirhorizons. US mutual funds now turn over thestocks in their portfolios every 11 months, onaverage.

As a result, investors have become increasinglydisconnected from the business fundamentals thatmake companies successful and drive value yearafter year. CEOs and boards feel growing pressureto deliver short-term results at the expense of long-term sustainable performance.

It’s not easy for fund managers to break out ofthis short-term cycle. Investors in their funds –individuals as well as pension fund trustees – oftenuse short-term peer group benchmarks to trackfund performance. Fund managers increasinglyadopt ‘me too’ investment strategies and follow theherd. Those who manage to maintain a longer-term focus often lack the resources to engageeffectively with boards, or rely on corporategovernance staff who lack experience in businessor boardrooms. Together with the industryassociations, these watchdogs risk trivialisingshareholder activism to compliance ‘box-checking’.

But the real problem with the watchdog activity

is that boards cannot afford to be distracted fromissues of performance. Collectively, corporateperformance is mediocre: only one company ineight achieves relatively modest targets for growth.

According to our research, just 13% ofcompanies post top- and bottom-line growth of5.5% or better over a 10-year period, while alsoearning back their cost of capital. Companies likeAmerican Express, Dell, Lloyds and Vodafone, toname a few, have managed to exceed this standardby keeping company performance front and centre.

Effective boards focus on sustained value andhow they can contribute to its creation. What candirectors do to affirm that role, and reclaim controlover their agenda? In our experience, successfulboards exhibit seven crucial habits. There is noparticular magic in these habits, which most boardshave adopted already to some degree.

But few boards hold the mirror up to their ownperformance in a practical way and assess wherethey need to improve. The question for directors isnot whether they recognise the seven habits of aneffective board, but how well they act on them.

Own the strategy

Most boards convene special strategy meetings andretreats, but typically they sit throughpresentations of the executive team’s plans.Effective boards ensure that non-executivedirectors contribute to developing the strategy andfeel a sense of ownership of the strategy.

At Vodafone, for instance, each year the boardhelps develop the agenda for a multi-day strategyretreat with senior executives. Each directorcontributes to the list of key strategic decisionsthat need to be made at the retreat. The eventbegins with a highly analytic overview ofVodafone’s markets and competitors, providingdata that will inform those decisions. Instead ofjust including presentations by executives to theboard, Vodafone’s process fosters debate onoptions, investments and returns.

When boards understand the issues at thisdepth and ask critical questions early on – Is thestrategy bold enough? Is it achievable? – they canrespond more quickly to opportunities such asmajor acquisitions when they arise. Decisionsunfold faster. Vodafone’s swift consummation ofthe Mannesmann acquisition aptly demonstratesthe value of such an approach.

CEOs and boards feel growing

pressure to deliver short-term

results at the expense of long-

term sustainable performance

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Build the top team

Boards have a key role to play in selecting,developing and evaluating the executive team. It’suseful to consider the model adopted by manyleading private equity firms: they view theirinvolvement in building the executive team as atop priority – and a clear factor in creating marketvalue. Following an investment, private equityfirms look to replenish top management talentwith people who instinctively act like owners.More often than not, they appoint key executivesfrom outside the portfolio company. Theyrigorously screen for attitude, which turns out to beas important as a strong skill set and track record.

The incentive for boards to get involved indeveloping leaders is powerful. A study by Bain of23 high-growth companies reveals that only aminority systematically try to develop leaders byadvancing the right people through the right jobs.Those pioneering few experienced averageshareholder returns of more than 10% a year abovetheir cost of capital over a 10-year period. But theone in four companies that placed little emphasison cultivating leaders averaged returns of less than1% a year.

Match reward toperformance

Rewards start not with pay systems, but with howthe company chooses to measure success – andhow closely these measures are tied to the driversof long-term value in the business.

The right approach is critical, because CEO

remuneration is the most controversial issue formost boards. They want to attract the best talent,and yet the remuneration benchmarks just keep onrising. Part of the solution lies in ensuring thatexceptional pay requires exceptional performance,and that failure to perform is not rewarded.

One company that has managed to get it rightis Reckitt Benckiser, the UK-based maker ofhousehold cleaning products. Senior managers’

base salaries are well below their competitors’, andlong-term incentives don’t pay out unless thecompany achieves growth rates that are double theindustry average.

But the company’s five-year, £60 millioncompensation plan rewards top executiveshandsomely if they achieve the tough goals – realencouragement to produce results. To earn theirbonuses, Reckitt Benckiser executives must showmeasured progress toward the company’s strategictargets.

Reckitt Benckiser’s plan also ensures that itsmanagement team feels the pain if shareholders aresuffering. Besides using stock-based incentives,Reckitt Benckiser mandates minimumshareholdings of 200 000 shares for seniorexecutives and 400 000 shares for the CEO. Thecompany’s compensation plan prohibits repricingoptions and requires that bonuses be withheld whentargets aren’t reached.

Effective remuneration systems measure whatmatters – and only what matters. They pay forperformance, with real downside for mediocreresults. And they ensure that rewards are simple,transparent and focused on sustained value creation,balancing short-term and long-term focus.

Ensure financial viability

Sarbanes-Oxley has had its main impact here,focusing on the probity of financial reporting andthe audit process. Yet beyond such issues, boardshave a role in making key financial decisions, suchas ensuring appropriate levels of debt leverage, andscrutinising major investments and acquisitions forvalue.

Directors must be able to understand as well astrust the numbers to provide a challenge wherenecessary.

Worst practices can sometimes be instructive.An external investigation by former US AttorneyGeneral Richard Thornburgh into $11 billion inaccounting irregularities found that WorldCom’sdirectors were often kept in the dark, particularlyin matters involving some of the company’s morethan 60 acquisitions.

The Thornburgh report on WorldCom found noevidence that WorldCom directors monitored debtlevels or the company’s ability to repay obligations.Yet, they ‘rubber-stamped’ proposals by WorldCom’ssenior executives to increase borrowings.

Directors were even told that a $2.65 billioncredit line WorldCom obtained in May 2002

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Ensure that exceptional pay

requires exceptional

performance, and that failure

to perform is not rewarded

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would sit unused on the balance sheet, while thecompany had already decided to use it instead tomake payments to its accounts receivable creditprogramme.

In today’s climate, the first question directorsask must be: ‘Do we have confidence that thefinances are robust?’ Boards need the right skills,sufficient time, access to information and aneffective board process to ensure they cancontribute effectively to key financial decisions.

Match risk with return

Boards typically have formal processes for assessingand managing operational risk that incorporatecommercial, financial and legal considerations. Yet few boards understand the true risks inherentin their companies’ strategies. This is critical: 70%of major acquisitions fail to create value, and 70%of moves made away from the core business andinto new markets also fail.

Indeed, according to Bain research, 18 of the 25largest non-dot.com business disasters during thepast 10 years occurred because owners failed tounderstand strategic risk. The majority of thesecompanies ran into trouble after misguidedexpansion moves into new markets went awry –including Loral’s entry into the Globalstar system,the Enron disaster and the collapse of Marconi.The shareholder value lost in these 25 meltdownsalone amounted to $1.3 trillion.

Furthermore, over 40% of CEO departures notrelated to retirement came after a controversial orfailed ‘adjacency’ move. The message is clear.Boards need to understand and accept the risksinherent in their strategy, and recognise theimplications for required risk-weighted returns.

Manage corporatereputation

Doing what’s right for the board and the companymeans not succumbing unduly to outside pressures.If boards are to avoid the trap of ‘check-box’

compliance and short-term focus, they need to takeaction to reclaim control over the agenda, and totarget those investors who are in for the long term.

Consider Gillette, which had missed WallStreet forecasts for 14 quarters in a row when JimKilts became its CEO in 2001. Kilts’s refusal toprovide specific earnings guidance triggered apredictable outcry from analysts, who questionedGillette’s stability. But Kilts had the board’smandate to make long-term shareholders histouchstone. Internally, Kilts set aggressive cost-reduction targets. Revenue targets were below theold unrealistic expectations but still requiredmarket share gains.

Two years later, when free cash flow haddoubled to $1.7 billion in 2002, analysts changedtheir tune. Said William Steele of Banc of AmericaSecurities: ‘Gillette’s ... focus [is] on longer-terminvestment rather than an unhealthy focus onnear-term pennies.’

The power of the Gillette board’s approach liesin having the confidence to steer by its owninternal compass. Once boards set their course,transparency and effective communication areessential both to manage external pressures and totarget shareholders focused on long-term valuecreation.

Drive effective boardprocesses

An effective chairman sets the tone from the topand ensures a governance model that works inpractice. He or she also focuses the agenda onissues of performance and reviews boardeffectiveness regularly. An able chairman builds ateam of directors with the right mix of skills andexperience. The board of an acquisitive company,for example, should be well represented with deal-making expertise and judgement, while thedirectors of a fast-moving technology companyneed a sound view of the industry’s futuredirection.

No formula exists, of course, but the chairmanmust find an appropriate combination of skill, willand values, and then knit directors together intoan effective group.

A board’s ability to add value depends heavilyon how well directors can work with the chairmanand CEO. To that end, a chairman must be clearon the value a board can contribute, and ensurethat directors have ample opportunities to fulfiltheir roles.

131THE SEVEN HABITS OF AN EFFECTIVE BOARD

Few boards understand the

true risks inherent in their

companies’ strategies

EBJ 16.3 3rd 30/9/03 11:10 am Page 131

What information is given to directors and howis it packaged? How should the agenda beorganised and focused? How can the chairmanensure that each director is given sufficient time?How can he or she demonstrate willingness tolisten and act?

Ensuring effectiveness is the primary job of anyboard, regardless of the processes it adopts or thenorms that guide its decision making. The focus of

any review of board effectiveness should be oncollective, rather than individual, performance.Most important, it should reflect how well a boardperforms on the substantive business issuesunderlying all seven habits, not just matters ofboard process. Indeed, reviews of boardperformance need to evaluate how the seventhhabit – driving effective board process – applies toeach of the others: owning the strategy, ensuringfinancial viability and so on.

Globally, corporate governance practices arebeginning to converge, but important regionaldifferences remain. Governance structures vary byregion – in the proportion of non-executivedirectors, for instance, and whether the authorityof the chairman and CEO is separated orconcentrated in a single person. In some countries,boards have more decision authority, while othersare largely advisory.

The country in which a board resides willinfluence how much progress it can make on theseven habits. In the UK, for instance, where boardstend to be smaller and half of the directors arenon-executives, the quality of the chairman andhis or her relationship with the CEO colourseverything else.

Effective leadership and a sound workingrelationship create a powerful board, while poorleadership or a flawed relationship can lead todysfunction, deterring dissent and tough action.

In the USA, the fulcrum of power is located

between a single, powerful chairman/CEO and theboard’s non-executive directors, who typicallymake up three out of every four members.Although US boards tend to be active, advising onstrategy, sanctioning initiatives and providingoversight, CEOs still set the agendas. Theproblems inherent in such an approach havebecome all too clear in recent years. A dominantchairman/CEO can make it difficult for directorsto contribute and guide effectively.

Elsewhere, the customary role of a board, itscomposition and its stance with seniormanagement place practical limits on how far itcan go in addressing all seven habits. In somecountries, for instance, boards are viewed as a wayto concentrate business experience and to rewardpast achievement.

Companies in Japan and Korea typically followthis model. The result is larger boards populatedwith current and former employees or grouprepresentatives. Building the top team or matchingreward to performance in executive compensationtypically is not the province of such advisoryboards.

Similarly, large supervisory boards that place apremium on representing all major stakeholders, asmany German boards do, don’t usually engagedirectly in setting strategy, which is handled by asubset of directors on a smaller management board.

Despite these variations in practice andtradition, the seven habits remain valid asaspirations for directors in all countries. They offera practical way for boards to address the diversechallenges and constraints that prevent them fromperforming their roles effectively – some of themstructural, some arising from wrong-headedexternal pressures or shortcomings in values,capabilities and focus.

Whatever else the current duress in businessproduces, we have reached a turning point in therelationship between the board, the managementteam, regulators and the investment community.The trajectory and character of companies in thecoming years will be decided in large measure byhow well boards can improve their owneffectiveness and regain initiative. If that happens– when that happens – boards will be back in thebusiness of building great companies.

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An able chairman builds

a team of directors with

the right mix of skills

and experience

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