Boards of directors have two major corporate governance responsibilities: strategy and risk oversight. Within risk oversight, a large concern is compliance with legal and regulatory rules. Strategy and compliance, however, compete for the time and attention of directors. Why does this happen? What is the consequence?
1. Compliance commands attention because of its complexity and riskiness.
Compliance with SEC requirements (e.g., Dodd-Frank Act) and other legal regulations imposes a sense of priority and burden on directors. As a result, board members tend to put their limited energy into compliance issues. Board members want to do compliance matters correctly. If they do not, the consequence may be a derivative lawsuit in which they are named as defendants in their individual capacities. Not withstanding directors and officers insurance, such litigation exposes board members to potential personal liability. Further, reputational risk to the company and to individual directors keeps the spotlight on compliance.
2. Strategy appears to be the domain of management, not the board.
Although directors understand that they play a role in strategy, the board's role is not well defined. The board is supposed to review and advise on strategy.
The business judgment rule, which requires board members to make decisions in good faith and with adequate information, informs the board's role in strategy. The rule may give directors an incentive to play a small role in strategy. By setting a fairly low bar for director involvement in strategy, the business judgment rule may encourage board members to focus instead on the more immediate issue of compliance, except when the board must approve a strategic decision (e.g., a merger or acquisition).
Moreover, the inapplicability of the business judgment rule to certain strategy decisions may compel board members to focus on complying with legal standards. Justice Carolyn Berger of the Delaware Supreme Court explained in 2009:
Courts might open board decisions on executive pay and bonuses to legal scrutiny if they “subvert basic values and standards,” when such matters normally have been protected from challenge under the business judgment rule. (emphasis added).
Another area where boards are held to a different standard is change of control situations. In such situations, boards must satisfy their Revlon duties (Revlon Inc. v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1986)) to achieve the best price available to shareholders. The reason for this duty is that change of control represents the last opportunity for shareholders to obtain a control premium for their shares. Revlon duties reduce the risk that directors, whose jobs may be in jeopardy, will enter into self-interested transactions to the detriment of shareholders.
Recently, the Delaware Chancery Court clarified Revlon duties in HealthGrades and DollarThrifty. The Court emphasized that the process by which the board considers, accepts, and reject offers determines whether it has satisfied its Revlon duties.
To the extent that certain decisions are held to a standard that is more stringent than the business judgment rule, directors will be more concerned about potential liability from a failure to adequately comply with the applicable legal standard. As long as the business judgment rule gives directors an incentive to focus on compliance and risk oversight issues, that will be their priority. Strategy, an area where directors can add value, will continue to take a back seat. This tendency is certainly one reason the NYSE Report on Corporate Governance Principles concludes that good governance requires attention to strategy and compliance.
What implications does a relative emphasis on compliance and risk oversight have for corporate governance? Do you recognize this pattern at your board? What can you do about it?
If you enjoyed this post, you should subscribe to the blog by RSS feed, follow us online, and leave a comment. You can find the subscription option on the sidebar to the immediate right. Also, you should click the Facebook Like button, retweet this post, and Share this post on Facebook or elsewhere.