What boards must do in the crisis
Top consultants Ram Charan and Tom Neff say company directors have to roll up their sleeves in times like these and take a hard look at risk, targets, pay, and balance sheets.
(Fortune) -- With major companies battered by recession, the spotlight is on boards of directors to take more active roles in response to the crisis. But what should their priorities be? Fortune senior editor at large Geoff Colvin talked to two top consultants: management expert Ram Charan, whose latest book is Leadership in the Era of Economic Uncertainty, and Tom Neff, chairman of Spencer Stuart U.S., the executive-search firm. Key excerpts:
Q.: What should be the top items on a board's agenda in 2009?
Ram Charan: The financial storm is not over. A number of companies I'm looking at are forecasting 10% to 20% declines in revenues. So the first and most important item for the board is to invest time to understand the cash issues, balance sheet issues, leverage issues, and liquidity issues. One- or two-hour presentations are not enough.
Second is rethinking targets for management. You want to motivate management, but you can't just use the old targets with minor modifications; in this era, survival may be an issue.
Third is reevaluating the peer group against which you compare your company. Some of the old peers may be insolvent or may not be relevant because conditions have changed dramatically.
Fourth is rethinking compensation. Most compensation committee chairmen I've met never understood the Black-Scholes model for valuing stock options. If you don't understand it, think of something else.
Tom Neff: Boards have to spend more time thinking about the unthinkable -- scenarios that would have seemed irrational, maybe unimaginable, just a year ago. What if our lead bank disappears? What if we have a liquidity crisis? What if the Dow goes to 6,000? What if our stock keeps dropping and attracts raiders?
The other subject that boards need to focus more on is enterprise risk management. It's not just risk in the sense that banks need to focus on it, but what are the risks in our business model, what are the global risks that could affect our business? It's a holistic approach to the subject, and stress testing what we're doing.
One other thought. Every seat in the boardroom is critically important, and boards need to think about that more strategically. In light of the new challenges and uncertainties, what kind of talent and expertise is needed that isn't sitting around the table today? More directors will be resigning from boards, particularly active executives who just don't have the time or the stomach for this anymore. So boards need to be thinking ahead and have a pipeline of people they're talking to who could be directors.
Q.: Most boards are not very good at imagining all the things that could go wrong. Have you found any ways to help them expand their thinking?
Ram Charan: Yes, a couple of ways. In industrial companies a broad discussion of the balance sheet does not take place. It should focus on two simple questions: Where is the cash coming from, and where is it going? Boards need to really learn the balance sheet, debate it, get management's input, see under different conditions what's the financial risk, which has many, many components. That all needs to come out without the accounting mumbo jumbo. In some places that is happening.
Second, an industrial company I know now has a chief risk officer, and in the past six months he has laid out nine kinds of risks. He has taken the governance committee through it, and the board has discussed it.
Q.: What were the problems in compensation systems that contributed to a lot of the financial industry problems?
Tom Neff: Some of the management teams at financial firms have a huge equity stake, which used to be thought of as a good thing. But I believe that the motivations for driving profits produced risks that some of these institutions just couldn't absorb. So you have to argue the measures were not correct. There was too much focus on growth in profits rather than growth in sound earnings. It's not a good idea to be changing management's objectives quarterly, but compensation committees will have the challenge of setting correct rewards for [executives] who are trying to hit a moving target.
Q.: Companies need better directors and the right directors, yet it seems inevitable that the demands and challenges of being a director are going to increase considerably, right?
Tom Neff: No question. The time demands have changed significantly. It's routine now for boards and board committees to hold telephone meetings in between the regular meetings, and as the time commitment increases, the availability of certain people to allocate that time is just not there. And of course there's the risks associated with it, particularly reputational risks. Boards will be in the spotlight like never before, and nobody wants to be part of a rogue's gallery in an article about a company that's failed.
Ram Charan: People are beginning to realize that boards can create value, and that some boards, by commission or omission, can destroy value.