Boards Of Directors Refocus On Strategy And Risk Oversight

What is on directors' minds these days?

The Spencer Stuart US Board Index 2009 reports that S&P 500 board members put corporate strategy and risk management at the top of the agenda. Why did strategy and risk become the biggest issues on directors' mind in 2009?

Corporate Strategy

In 2009, strategy was a paramount corporate governance concern, with 67% of directors citing it as the item that required the most attention from the board. By comparison, in 2008 only 31% of respondents placed strategy at the top of the agenda.

The Spencer Stuart survey does not address why strategy vaulted to the top of the agenda.

One explanation is that boards were occupied with the public outcry over executive compensation in 2008. After dealing with that crisis, boards returned to two central corporate governance issues -- strategy and risk management.

First, consider strategy. Corporate strategy drives the firm's activities, and, ultimately, its performance. Managers typically develop corporate strategy because managers know the company better than directors. Managers run the day to day operations. In turn, directors review corporate strategy to ensure that it will create shareholder value.

Risk Management

S&P 500 boards also placed more focus on risk management. In 2009, 50% of directors said this was a top concern compared to only 11% in 2008.

The same factors that explain why strategy became a priority also elucidate the emphasis on risk management. Risk management is a core function of directors, who have the duty to act in the best interests of the corporation, not the interests of the managers. Managers and shareholders, who the directors represent, have potentially divergent interests with respect to risk. Managers have incentives to extract value from the corporation by taking strategic and financial risks that may conflict with shareholders' interests.

Recognizing the importance of risk to investors, in December 2009 the Securities and Exchange Commission (SEC) approved rules that require disclosure about the board's role in risk oversight. The SEC concluded that oversight of strategic and financial risk is a core competence of the board. The Commission explains:

[T]he board’s involvement in the oversight of the risk management process should provide important information to investors about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company. ... This disclosure requirement gives companies the flexibility to describe how the board administers its risk oversight function, such as through the whole board, or through a separate risk committee or the audit committee, for example. Where relevant, companies may want to address whether the individuals who supervise the day-to-day risk management responsibilities report directly to the board as a whole or to a board committee or how the board or committee otherwise receives information from such individuals. (pages 43-44)

Further, companies must describe how its compensation policies relate to risk management. Specifically, corporations must discuss whether their compensation policies give employees incentives to behave in ways that are detrimental to the company. For example, an equity compensation package that encourages questionable financial or accounting practices presents a material risk that should be disclosed. I recently discussed compensation and reputation risk under the new disclosure rules.

Conclusion

That directors are refocusing on strategy and risk is a positive sign for corporate governance. Optimally, strategy and risk management are aligned so that they reinforce each other.

This discussion raises interesting questions: How are strategy and risk oversight related? How can strategy and risk oversight mutually promote each other?

Perhaps most importantly, what needs to be done to equip directors to play a large role in strategy and risk oversight?

Douglas Y. Park
Twitter: @DougYPark

If you enjoyed this post, please subscribe to the blog by RSS feed or email.  You can find the subscription option on the sidebar to the immediate right.  Also, click the Facebook Like button below and Like the DYP Advisors Facebook page.