December 9, 2019 Executive Compensation ESG & Human Capital Management Articles

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Boards Need Tighter Leadership Oversight

A company whose board could have benefited from the proactive use of tighter leadership oversight process is Hertz, which was fined this year by the SEC for accounting irregularities that overstated pre-tax income by $235 million.

According to the Hertz board’s investigation, Hertz’s former leaders had applied pressure to financial teams to bend accounting rules to produce earnings that met forecasts. To settle the SEC charges about the past irregularities, which apparently resulted from gaps in a culture of integrity, Hertz agreed in February to pay $16 million. Meanwhile, the board filed a lawsuit in April to claw back $70 million of incentive compensation from the former CEO and former senior leaders to make up for ill-gotten bonuses based on phony numbers.

There are a few questions that arise from this scenario: Were leaders in the company aligned to support the business? Did they have the needed capabilities? Were they accountable for genuine performance?

Regulators and investors have been pressuring boards lately to tighten oversight of a company’s “most important asset,” namely, human capital. As returns on physical assets become less critical to companies — and in some companies become small compared to intangible assets — the return on human assets becomes the primary source of future value creation.

Have boards kept up with the job of overseeing this wealth-creating asset?

To be sure, boards have raised the bar considerably in the last ten years when it comes to leadership succession. For this task, boards routinely review up-and-coming candidates and more capably fill vacant leadership positions with internal promotions. Even if there is room for further improvement, data from ADP in 2019 shows that, at the highest ranks, 21.5 percent of managers were promoted during the last year, while 12.5 percent were hired from the outside. (The remaining managers didn’t change positions.)

But, aside from succession management, do boards have room to improve when it comes to the broader job of providing oversight for leadership effectiveness? Given the complexity of the world today, and given the rising demands on leaders, can the board assure investors that management is exercising the skills, processes, and capabilities that make up the larger part of nurturing great leadership? Are the structures, processes, and programs in place to support a rich and full pipeline of talent to optimize the next leadership generation?

The evidence is that many boards have been less than diligent in this task, even as investors express increasing interest in the issue. Many directors cannot say for sure that the upper ranks of their leaders rise to the levels of excellence needed today. That’s not to say that directors should step into the job of management. In fact, many directors worry they could too easily cross the line from fiduciaries to meddlers. But investors and the public today expect directors — who are often great ad hoc leadership coaches — to a finger on the pulse of leadership competence.

One reason that investors expect the board to offer course corrections is that, with companies facing unprecedented global competition and the speed of innovation, the quality of leadership practices sets companies apart more than ever. Another is the extent to which the failings of companies, ranging from Wells Fargo to Volkswagen to Facebook, can be traced to gaps in leadership effectiveness (particularly with respect to not reinforcing core values and managing risk).

In either case, the opportunity is clear: When it comes to helping companies improve “the way we lead things around here,” boards can play a key role. They can assure outsiders that not just the right CEO leads the company, but leadership alignment, capabilities, and systems for accountability dovetail across the senior ranks and work together smoothly.

We know that the cost of not getting leadership oversight right is huge. If we consider just failed successions, the costs run into the billions — more than $4 billion at Wells Fargo. In PwC’s Strategy& 15th annual study of CEOs, companies in which the board forced the replacement of an unfit CEO could have generated, on average, an estimated $112 billion more in market value in the year before and the year after the turnover — if succession had stemmed from better leadership planning.

The $112 billion figure suggests the amount would be much higher if all leaders, not just the CEO, are taken into account. The $112 billion counted the market value from severance expenses; emergency board meetings; executive search, legal and public-relations fees; slower growth; aborted deal closings; and the departure of valued employees. If we were to add the foregone profits from less-than-outstanding leadership at all levels, the figure would be higher still.

In other words, as leaders are required to deliver results faster with a new level of acumen, the opportunity costs are hard to ignore. How much better could the company run if the board regularly asked what many investors would like to know: How is the company minting, guiding, and evaluating leaders? How well does it train them? Set expectations? them aligned? them on the job? Hold them accountable not just for results but for the manner in which they lead?

  • Alignment” defining and agreeing on direction, engaging leaders, and providing structure and support for achieving business objectives.These questions deserve the attention of the whole board. As for implementation, they will tend to fall in the lap of compensation committees and sometimes the nominating and governance committees, which oversee various aspects of leadership such as executive pay, performance management, and often succession. Compensation committees can logically broaden their oversight to evaluate leadership practices overall. They can address oversight from three points of view, each of which comprises three sub-points:

Strategy clarification is the first part of alignment. Strategy is clear when leaders and board members work together with a common understanding of how to execute company strategy. Everyone buys into the same goals, priorities, and timeframes. They address and minimize structural, cultural, and procedural obstacles, as well as make available all resources for strategy execution.

Role definition is the second part of alignment. Roles are defined when members of the leadership team and the board know their key responsibilities for strategy execution and the interdependencies of people on their team. The same holds true for board committees.

Governance and decision rights are the third part of alignment. Governance is clear when leaders have established core values and operating norms, policies and practices for working effectively. They have also identified when and where the leadership team and board members have authority to make decisions.

  • Capability” bringing the full potential of the leadership team to bear on the business.

The first element of capability is clarifying the value proposition. The value proposition is clear — and appealing enough to attract and retain talent — when all leaders understand the financial and nonfinancial rewards of the job and value their work’s intrinsic importance. They have clarified the value of their affiliation with the company and advocate for the organization in bringing in people for the long-term.

The next element of capability is portfolio management. The company has enough top talent with the right skills to execute the current and future strategy. Leaders have built systems and processes to identify potential leaders, continuously assess bench strength, and operate systems and processes to deploy people into critical roles.

The final element of capability is leadership development. The company gives individual leaders the structure, tools, resources, coaching, and opportunities to strengthen their capabilities as individual leaders and as members of the leadership team.

  • Accountability” assuring that you measure what matters most, holding leaders responsible for achieving results and rewarding them for making it happen.

The first requirement of accountability is goal setting. Goals are properly set when leaders and the board have established clear and concise interdependent objectives in a common language for achieving success. These objectives encourage desired behaviors and discourage undesirable ones that may result in unintended consequences and undue risk.

The next requirement of accountability is performance measurement: Leaders have a system to determine the most meaningful indicators of the outcomes (intermediate or final) linked to business success. They exchange feedback regularly to sustain individual and group success.

The final requirement of accountability is a linkage between performance and rewards. Leaders have established clear lines of sight from the work of individuals, teams, and business units to appropriate rewards for financial and nonfinancial performance.

A simple tool for boards to guide their oversight job appears in the sidebar, a checklist of questions to assess the fulfillment of these goals. Of course, the board has always had the fiduciary duty to install the best possible management. But a checklist of this kind helps it look behind the scenes to reveal whether management has institutionalized a culture, practices, and systems for leadership.

The checklist supplies the questions to surgically probe with select people down in the organization to attest that the organization is continuously improving both the current and next generation of leaders. Without such a tool, the board risks governing a company without knowing for sure that management walks the talk — or whether there is fragmented leadership focus and squandered employee effort.

An example of a company whose board has expanded oversight of leadership effectiveness is Abercrombie & Fitch Co. After a period of governance transition early in the decade, the compensation and organization committee’s charter prescribed the committee’s purpose as (among other things) “reviewing and monitoring the company’s organizational development strategies and practices.” Duties include “reviewing and monitoring management depth and strength assessments, leadership development, and talent assessments.”

Dedicated to promoting from within, Abercrombie calls on the board to make sure leaders are in place to make that happen. A case in point is the current CEO, Fran Horowitz, hired in 2014 and promoted up the executive ladder. The board played a key role in overseeing the leadership transformation that included Horowitz. The impact of the board has been clear.

Perhaps the Hertz board would have acted earlier, before the crisis, if it had made a standard practice of holistically monitoring leadership quality. As one example, consider the issue of alignment among top executives. Did the board regularly review the norms, policies, and practices applied by top leaders?

Nearly all companies that amp up oversight will find opportunities to help senior leaders to improve. The benefits are far-reaching. To say the least, when the leadership machine runs well, it attracts outside talent, creates bench strength, generates a magical esprit de corps, and offers a hedge against the risk of departures and retirements. Every executive wants to be part of a winning leadership team. Shouldn’t the board have a role in assuring that systems for that winning team prevail?

View the full article as it was originally published.

Seymour Burchman

Blair Jones

This article was originally published in Directors & Boards.

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