Preparing the Future American Boardroom

The American boardroom has been under significant stress over the last two years. Many directors faced their most challenging boardroom moments but rose to the occasion, navigating their companies through the depths of the pandemic and making many tough calls to ensure financial survival and adapt to rapidly shifting conditions.

It was maximum-intensity governance and management. As we learned from our surveys, directors’ time commitment doubled in 2020 when they delved into many urgent matters such as employee health and safety, remote operations, supply chain management, and access to capital and government relief funds. Using (and getting more comfortable with) virtual meetings, boards and management engaged much more frequently, sometimes even weekly, and traditional governance boundaries often blurred, as directors and senior executives worked closely together to navigate through the crisis.

This high-speed governance is barely slowing down, as companies now confront many new strategic and operational challenges, including the “Great Resignation,” accelerating digitalization of every dimension of business, rising inflation, widespread demands for corporate climate action, and the integration of diversity, equity, and inclusion into the fabric of every organization. It has made the job of the board much more difficult than it was before.

What makes the current environment uniquely unpredictable and hard to navigate is the fact that these changes are happening concurrently, interacting with and amplifying each other, creating many unintended and unwanted consequences. Just look at the top trends from our 2022 Director Trends and Priorities survey (in the included chart below) that directors believe will have the biggest impact on their companies over the next 12 months.

Talent scarcity is disproportionately affecting companies’ ability to successfully execute their high-stake digital transformations. At the same time, these transformational technology initiatives may inadvertently expose companies to new cyber risks, which may also disrupt already weakened global supply chains that, coupled with the growing labor market shortages, are driving inflation to levels not seen in recent years. A number of these trends are challenges that many directors did not have to grapple with in their prior operational careers and that they therefore have relatively little experience with.

In the coming year and likely beyond, boards will need to govern their companies through both a telescope—spotting new, over-the-horizon patterns across markets, societies, and geographies and connecting the dots between them—and a microscope by keeping a finger on the pulse of the company’s performance and its key drivers, such as talent, technology, brand, and financial stability.

Overall, board effectiveness now seems more important than ever as the pace of change is relentless and stakeholder expectations about what boards should do and look like are ever-increasing. But the pandemic governance model is likely neither sustainable, nor desirable. We need to maintain distance between boards and management teams to effectively govern businesses for the long-term. The board modus operandi prevalent for the last few decades, however, is unlikely to be adequate.

To position boards to help their companies succeed in a more turbulent future, we need to firmly challenge how boards are composed and structured, how they operate and interact with the business, and how they hold themselves accountable. Although the fundamental legal underpinnings of board governance have not changed, longstanding conventions and unwritten norms that have shaped boardroom practices and behaviors deserve to be revisited.

Recent NACD analysis reveals that directors themselves expect that their boardroom practices will need to change in the coming years. For example, a slim majority expect that in the near future the combination of the CEO and chair roles will no longer be acceptable. Almost 60 percent of directors expect that environmental, social, and governance (ESG) reporting will receive as much scrutiny as financial reporting, while more than 50 percent believe that time commitment to board service will vastly increase. Close to 40 percent believe that a sole focus on shareholders at the expense of other stakeholders will come to be considered inappropriate.

Sensing this turning point in the evolution of board governance, NACD announced last week the 2022 Future of the American Boardroom Initiative, led by a special commission that will convene a diverse, influential group of directors and notable governance practitioners from across the investor, regulatory, and academic communities. The year-long initiative will seek to discover how the prevailing governance model may be adapted, or whether a fundamental reshaping is in order, and will develop guiding principles to help boards build toward high performance in a more demanding, inclusive, and turbulent future.

Although the focus of the commission may shift throughout our meetings, we expect much of the discussion to focus on the following five areas:

1. Stakeholder interests. The expanded notion of stakeholder interests, and ultimately the definition of performance through the lens of these stakeholders, is changing how companies create, preserve, and report value. Put simply, companies cannot succeed when society fails or when the planet’s temperatures continue to rise. These issues are no longer externalities; they pose immediate financial, operational, and reputation risks. Boards must perform a delicate balancing act to account for multiple stakeholder concerns, while simultaneously addressing the expectations of shareholders for growth and long-term returns. This multi-stakeholder approach affects the board’s crucial role in establishing the right incentives for management.

2. Board operating model. The furious pace of change has put strains on traditional board operating models and processes, which may have become bottlenecks to effective oversight. Boards may need to adopt a more fluid and flexible model that maximizes the use of precious board meeting time and a structure to better oversee new and fast-changing issues. Similarly, ever-increasing expectations about the board’s role and engagement may have caused scope creep, with many boards struggling to focus deeply on mission-critical issues.

3. Board independence and management accountability. In recent years, boards have been more deeply engaged on a variety of issues such as strategy, influencing more decisions and becoming more operational. This deepened level of engagement could potentially threaten the independence of the board and its ability to hold management accountable. Simultaneously, in many boardrooms, the CEO still sets the agenda, not the board.

4. Transparency. With increasing public scrutiny of the contributions of boards, boards will need to reassess how transparent they should be about their workings, skill sets, and decisions. Currently, much board activity remains outside the view of shareholders and other stakeholders, and this confidential setting helps support deliberation and discussion. At the same time, the black box in which boards function raises concerns about their engagement and accountability.

5. Board renewal. While boards have started to make progress on diversifying their ranks, far too many boards are still reactive in aligning their skill sets and past experiences with the shifting strategic and risk priorities of the business, and do not sufficiently hold their directors accountable for individual (under)performance.

As part of this initiative, we launched a dedicated NACD resource center on the Future of the American Boardroom that includes relevant articles, guidance, and tools to help your boards engage in meaningful conversation and, where needed, take action to prepare for a more demanding future. Throughout this initiative, we will update these resources and report on the progress of our work.

As we shape our guidance, we would very much like to hear about your board transformation. What fundamental changes have you made or are you making to advance board performance? What new practices have you adopted? What norms have you challenged? Please share with me directly at fvanderoord@nacdonline.org.

Friso van der Oord is senior vice president of content at NACD.

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How Inflation Complicates the Compensation Committee’s Job

It has been a very long time since we’ve dealt with an inflationary economy. So long, in fact, that the term “inflation” may conjure memories of Jimmy Carter’s presidential administration, long lines of AMC Pacers waiting for gasoline, and double-digit mortgage rates—for those of us who go back that far. The idea that this period of inflation may be transitory isn’t much comfort to the decision-makers who are still determining their 2022 plans.

Given that most calendar-year companies approve incentive plan targets in the first quarter of the year, inflation’s impact on executive pay decisions is on the minds of most compensation committee members. Of course, inflation impacts the price of goods and services almost across the board (we are all feeling that currently), but specifically for compensation decisions, there are two main variables to consider: merit budgets (or salary increases) and incentive plan goal-setting. Let’s briefly explore some of the fundamental current challenges with each.

Merit Budgets and Salary Increases

For as long as most people can remember, merit budgets have been reliably steady at 3 percent per year at all levels in an organization. In the past, merit budgets tended to lag inflation rates early in inflationary periods. They may also have tended to be higher than was necessary in the waning days of an inflation cycle. Both tendencies can largely be blamed on time delays in incorporating external information into the decision-making process. The era of 3 percent increases are ending. In December, results from a Pearl Meyer quick poll suggested the number may exceed 4 percent. Some clients are concerned we may end the year above 4 percent if additional actions are required later in the year.

Because the current environment is challenged by inflation, as well as ongoing pandemic and labor difficulties, some management teams might see an increase to the merit budget for the broad workforce as perhaps one of the easier decisions to make this year. It’s a different story, however, for executives.

Boards have generally been more willing to increase incentive opportunities than to provide executives with significant salary increases. This is due to the bias toward performance-based compensation and can be seen in the evolution of executives’ pay mix over the past 40 years. However, incentive plans can be perceived as riskier during inflationary times—to say nothing of the other risks looming—and so higher incentive opportunities may be less valued right now than smaller salary increases.

Every now and then, someone raises the idea of a cost-of-living adjustment (or COLA) for executives. It may seem a logical extension of a COLA for the general population, but beware—it’s not. Competitive salary increases for the general workforce are important, but that standard 3 (or more) percent merit budget can usually accommodate them. COLA for executives, on the other hand, is something that investors and the public cannot understand. The perception of COLA is that it meets fundamental needs like paying rent or putting food on the table; the “need” to maintain the buying power of a $500,000 salary is not viewed in the same way.

Incentive Plan Goal-Setting

It seems as though we’ve been hoping forever that things will get back to normal so we can have greater certainty in our forecasting. While COVID-19 has created exceptional uncertainty, inflation just creates a “normal” amount of uncertainty (which we really don’t need any more of).

Logically, one would think the key is to understand how the company’s results are impacted by price changes through the supply chain and then factor in the company’s ability to pass on these additional costs through corresponding product or service price increases—a seemingly simple calculation to arrive at anticipated financial results. 

However, every item in the supply chain reflects a similar analysis, and supply chains are far more intricate than in previous inflation cycles, so it becomes hugely complex to predict what will happen. By upsetting pricing all the way along the supply chain, inflation introduces additional prediction risk when projecting future results. When compounded with typical executive incentive plan time frames, usually one- and three-year, the projections can become speculative.

Fortunately, understanding these dynamics is the chief financial officer’s responsibility. But at the board level, we need to at least understand the subtleties to develop a feel for whether any changes might be warranted to, for example, thresholds, maximums, or gatekeeper measures in any existing or future incentive plan. This is important when determining and explaining any non-GAAP (generally accepted accounting principles) or judgmental adjustments to payouts. Regarding long-term targets, changes to the mix can be made to deal with higher goal-setting risk by incorporating more time-based stock vesting or options and less performance-based stock, for example.

A complicating factor for directors approving annual goals is that inflation generally results in higher earnings growth than we normally see. When a company has been moving along at a steady, and perhaps more predictable, earnings growth rate of 5 to 8 percent, it is psychologically difficult to set a 15 percent goal. If demand stays strong as inflation increases, you may see companies overachieve during the early days of a cycle. Then, the opposite occurs as inflation cools, and taking earnings expectations back down to pre-inflation ranges becomes similarly difficult, especially for investors.

Plowing Ahead

In reviewing budget proposals this year, boards need to be more focused than ever on assumptions relative to the cost of goods sold and volume projections at higher product prices. Compensation committees may want to think about providing for potential year-end adjustments that reflect the differences between key assumptions and what actually happens. Many did this with volatile US dollar to Euro exchange rates a few years back.

Alternatively, committees might consider increasing the range from threshold to maximum to recognize that results will inevitably vary from assumptions given that the factors are harder to predict. In either case, explaining these changes both to participants and to shareholders will be critical.

Mark Rosen is a managing director and David Swinford is president and CEO of Pearl Meyer.

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A Voice of Reason: BlackRock’s Newest Letter Can Help Boards Navigate Difficult Shoals in 2022

In the middle of Homer’s epic poem The Odyssey, Odysseus heads home—but he has a problem: sea monsters. “We then sailed on up the narrow strait with wailing. For on one side lay Scylla and on the other … Charybdis,” Homer writes from the featured hero’s perspective.

The sailors must progress carefully because a turn too far to the right or left will mean certain death from either a six-headed beast or a whirlpool.

Today’s corporate leaders, faced with numerous dilemmas as they strive to create long-term corporate value, must feel a kinship with Odysseus. But leaders should not fear: good advice on how to navigate the difficult shoals of the modern era comes in the latest annual letter from Larry Fink, CEO of BlackRock, the world’s largest asset manager with more than $10 trillion in assets under management.

This most recent letter is the longest that Fink has ever written in the ten years that he has been reaching out to the CEOs of firms with shares held by BlackRock funds. Fink’s first CEO letter, which debuted in 2012 at under 500 words, simply introduced CEOs to BlackRock’s “value-focused” approach to corporate governance. Since then, Fink’s letters have grown in length and complexity. (For a review of past themes, see this summary from NACD senior vice president Friso van der Oord, who wrote about Fink’s letter last year.)

Fink’s 2022 letter, at more than 3,000 words, covers five main topics and related dilemmas: company purpose, human capital, financial capital, decarbonization, and participative proxy voting. In each area, Fink steers a middle course, discouraging CEOs and boards from either-or thinking, as exemplified by the following questions: What is our purpose? Should we focus entirely on short-term profitability, or should we heed concerns raised by all our stakeholders? What about talent drain? Should we invest heavily in technology, neglecting human capital, or should we put all available funds into our payroll? And what about funding? Should we try to generate as much capital as we can from operations, or should we max out on external financing? Regarding energy, should we embrace alternative fuels and cut all ties with fossil fuels, or should we stay with oil, coal, or gas as a necessary evil? At proxy time, should we ignore smaller shareholder complaints or bend our company’s goals to please the maximum number of owners? Of course, none of these extreme alternatives is correct; each could have monstrously bad consequences.

As for company purpose, Fink warns against a focus on either short-term profits or stakeholder appeasement. While he acknowledges that “the fair pursuit of profit is still what animates markets,” he also notes that only “long-term profitability is the measure by which markets will ultimately determine your company’s success.” Veering too far in the direction of all stakeholders also holds peril: “Political activists, or the media, may politicize things your company does,” he warns. “They may hijack your brand to advance their own agendas.” The middle course is holding company purpose as a “north star.” Stakeholders do not need CEOs to opine on every issue of the day, says Fink, “but they do need to know where we stand on the societal issues intrinsic to our companies’ long-term success.” 

Also eminently middle-of-the-road are Fink’s comments on energy. He announces that although BlackRock has a net-zero emissions goal, the investment firm will not divest all fossil fuels. Fink explains why: “The transition to net zero is already uneven with different parts of the global economy moving at different speeds. It will not happen overnight,” says Fink. He notes that traditional fossil fuels such as natural gas will play a key role both for power generation and heating in some parts of the world. In short, “We need to pass through shades of brown to shades of green.”  

This kind of middle-course, hopeful thinking is exactly the mindset that directors need to adopt in 2022 and beyond as they journey to the ultimate destination of long-term company value. Safe travels!

Alexandra R. Lajoux is NACD chief knowledge officer emeritus. In addition to studying business at Loyola University in Maryland, she studied The Odyssey and other classics at Princeton University with the late Robert Fagles.

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Global Risks in 2022: Refresh Resilience Thinking to Navigate the Uncertainties Ahead

There is much talk in the financial press of renewed optimism, but the world is entering year three of the COVID-19 pandemic with deeper fissures and in a markedly more disorderly state.

People are beyond weary of social and travel constraints, critical systems and processes are experiencing discontinuities and disruptions on a regular basis, and governments are struggling to maintain the goodwill of both their own citizens and counterparts on the international stage.

Economically, too, some countries will likely struggle in the coming years: emerging market economies (apart from China) are projected to be 5.5 percent below their pre-pandemic growth path by 2024, with Latin America and sub-Saharan Africa likely to show the weakest performance. At the same time, though, advanced economies are projected to surpass their pre-pandemic growth path by 0.9 percent. (Notably, much will depend on the trajectory of current and future variants of COVID-19.)

The thread that runs through the Global Risks Report 2022, prepared by the World Economic Forum in collaboration with Marsh McLennan, is “divergence.” This is underscored by the differentiated capacities of countries and local communities to recover from the damage caused by the pandemic over the past two years, the aggravation of schisms between global powers, and the exacerbation of friction between underlying, secular forces of global change.

Boards of directors will need to ensure that their organizations are alert to four key challenges:

Economic volatility and uncertainty. A rapid rebound to growth in some countries has entangled and disrupted supply chains, sent commodity prices soaring by nearly 30 percent since the end of 2020, and driven inflation in the United States to the largest year-on-year increase in 40 years. Higher prices and more expensive debt will affect lower-income households especially hard. This is compounding government struggles to “level up” societies and “build back better” in economic recovery programs—even before factoring in the consequences of major industrial changes from accelerating digital and green agendas.Divided societies. The pandemic has deepened socioeconomic inequality in many countries, with the poorest suffering most where health systems have been overloaded. Globally, migration challenges will generate more flashpoints as harder borders conflict with a greater impetus to escape economic, environmental, and political insecurity. With political polarization as intense as ever, democracy remains a fraught enterprise. Some national governments are eroding the rule of law and consolidating authoritarian powers; elsewhere, trust is in short supply and coordinated dissent the norm.Ambitions outpacing governance. While many businesses have strong decarbonization imperatives, national targets for net-zero emissions are often not adequately underpinned by concrete policies and strategies. Companies pursuing major digital agendas do so against an evolving cyber-threat landscape where the average cost of a data breach is at a two-decade high. As Internet 3.0 comes over the horizon, there is little sign of much-discussed tech industry regulation or a clear plan to address systemic challenges related to decentralized finance and cryptocurrencies. And owing to ever-cheaper space launch systems and greater prizes to be obtained, a rapid increase in orbital and suborbital activity from different national and private-sector players is likely to stretch the utility of decades-old international treaties and protocols.Geopolitical fractures. With economic globalization in retreat, nations of all sizes are deepening core alliances and reinforcing spheres of influence, while global powers are adopting stronger postures and hardening “red lines” on core ambitions. The security lens for national industrial strategies is sharpening, with governments not only wary of foreign investment ambitions but also seeking greater scrutiny of systemically important companies. Broader international coordination efforts struggle to gain traction—the distribution of COVID-19 vaccines to low-income countries, for example, remains far behind schedule.

Interrogating Resilience

In anticipation of a bumpy 2022 and fresh shocks barely over the horizon, boards of directors should reexamine the resilience of their organizations, asking not only how they fared over the past couple of years but also what they learned and how they have evolved.

Since the next crisis will likely be very different from the pandemic, any review of resilience arrangements should take a fresh look at the operational flows and capabilities that are critical for delivering core business goals—and the different ways in which they might fail. This requires looking not just at one’s own assets and processes but also at the vulnerabilities of other organizations in one’s ecosystem—suppliers, utilities, other service providers, and even customers—as their tolerance for disruption may not align with one’s own.

Rather than overseeing a list of tools (such as risk scenarios, financial buffers, and business continuity plans), directors should look at how their organizations have sought to build “suppleness” by deploying a diverse range of resilience strategies in concert with each other—blending structural “hardening” with greater agility in a crisis. Moreover, the pandemic has illustrated that supportive employee behaviors, especially when empowered by good leadership and effective communication, are a vital lubricant for any resilience strategy.

Indeed, a dynamic resilience culture will ensure firms are alert to changing circumstances, vigilant in challenging themselves about blind spots and shortcomings, and continually looking to adapt response strategies to better achieve critical goals. They will likely find that resilience efforts align well with other agendas, such as environmental, social, and governance (ESG) ambitions.

Every organization should seek to protect itself, but is that enough? When it comes to really large, complex risks, it is important to think more in terms of industrial and local ecosystems. This may shed new light on the role that larger organizations (in particular) might play in supporting systemic or societal resilience.

Some already consider it incumbent on them to take more responsibility for their supply chains, their workforce, and their customers; others, in responding to the pandemic, have deepened their engagement with local communities. This reflects growing momentum within many corporations to place their commitment to all stakeholders in the foreground, blending profit and purpose for sustainable growth. Indeed, those stakeholders (customers, employees, and investors) are already holding companies to an ever-higher bar regarding not only their ESG ambitions but also their actual performance in pursuing them.

Additionally, an increasing number of companies are pursuing a more active role in addressing large-scale public policy challenges that affect their business but can’t be resolved by government alone. Opportunities are proliferating for non-competitive alignment and collaboration between companies and with the government on cross-cutting challenges, such as cyber risk, climate change, artificial intelligence, diversity and inclusion, and the circular economy.

Now is not the moment to ease back on resilience. It’s the time to explore and consolidate new practices. After all, resilience is a journey—not a destination.

Richard Smith-Bingham is an executive director of Marsh & McLennan Advantage and a key contributor to the Global Risks Report 2022.

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Directors Grapple with Tying Incentives to Climate Goals Under Mounting Investor Pressure

In the fall of 2021, NACD, with Farient Advisors and Weil, Gotshal & Manges, brought together compensation committee chairs from Fortune 500 companies to discuss investors’ increasing demands for compensation committees to tie pay and performance metrics to climate goals. Companies are still on a journey to figure out the best way to accomplish this, and many issues around this topic are still unresolved. Participants discussed integrating climate goals into the corporate strategy and tying pay to this, setting climate-related goals, tracking climate metrics, and the best board composition for accomplishing all of this.

Organizations that have climate-related goals are a lot more common than it used to be, and the number of companies setting such goals continues to grow. “According to a study by Farient Advisors and their partners in the Global Governance and Executive Compensation Group (GECN), last year about 25 percent of companies had environmental metrics in their incentive plans. It’s up to 30 percent now,” said Robin Ferracone, founder and CEO of Farient Advisors. Additionally, although only certain industries, such as energy and utilities, used to track climate goals in the past, the range is now broadening to include financial services and technology, among others. “And the range will continue to grow, as both shareholders and management are very interested in it,” Ferracone added. “We are even seeing more mid-cap and small-cap companies starting to get in the game.” For this reason, tying pay incentives to climate goals is the next natural step, as doing so would hold companies accountable to meeting the goals. Investors have been making their desires in this area clear, as they are putting pressure on the US Securities and Exchange Commission (SEC) to require reporting on environmental, social, and governance (ESG) metrics.

As interest in measuring, reporting, and having climate-based incentives for compensation grows, investors have made it clear that they want to see corporate strategy and climate goals integrated. Therefore, boards and companies shouldn’t think of these as separate entities, and once they’ve established an overall business strategy that incorporates climate strategy, they need to commit to executing it fully. As one delegate put it, “What’s exciting to me is [that] when companies speak about strategy and climate, they’re not talking about separate things. They’re thinking, ‘Let me be aware of strategy and understand the commitment and then see how to apply these.’”

Once companies integrate climate targets into their strategy, they also need to start setting performance and pay goals against that, Ferracone pointed out. “Pay follows strategy,” she said. “Pay attention to the ways incentives can be impacted by behavior. For example, you can say, ‘You weren’t supporting our diversity goal or climate platform, so you won’t see it in your bonus.’ It’s the culture things that set the tone.”

It’s okay not to have incentives. Most boards are still figuring out the incentive process when it comes to tying pay to climate goals. Even if companies don’t currently have incentive plans in place that support climate goals, that doesn’t mean that the board shouldn’t pay attention to the strategy in relation to climate goals. Because measuring can happen in multiple ways, directors can give a set of standards on what to measure and report. There are also ways around not tying pay incentives to climate goals if an organization is still not ready to do so. If a company is a stellar performer in its industry and is a leader in environmental practices and communicates these facts well, then the company is more likely to appease investors without tying pay incentives to climate goals. “You have to have all other elements in place and succeed at them to not have [pay incentives] as part of compensation,” said a delegate.

Communication is key. Delegates agreed that one area where companies can improve is with communication. Organizations need to communicate and share their strategy, climate goals, and success stories with shareholders regularly, especially if they don’t have incentive plans in place that support climate goals. Companies shouldn’t wait until there is an activist on their doorstep to engage with investors and other stakeholders; they should make communication with stakeholders via their websites, reports or other disclosures, and investor days part of their standard operating procedures. “Being strategic is the best way to be proactive,” said Ferracone. Boards also need to make sure that what companies are doing internally is aligned with what they are telling the public. “Take inventory of what your company is publicly disclosing about climate and whether there is a clear link to the company’s strategy. Investors and other stakeholders want to understand how the company’s strategic direction supports ESG and vice versa,” added Lyuba Goltser, a partner with Weil, Gotshal & Manges.

A crucial element of strategy is setting goals because a company needs to know where it’s going to achieve that strategy. However, setting goals may feel like an uphill battle for some organizations, as addressing climate change and environmental issues are long term in nature and companies are used to setting short-term goals. “Companies need to start thinking of some of these goals in terms of longer-term planning, because climate change is long term,” said Ferracone. “But they can break down the long term into short-term goals in terms of [asking], ‘What steps do we take to get to long term?’” It is the board’s responsibility to help management and the organization as a whole to see this bigger picture and then to determine the best way to implement the task of breaking it into smaller pieces. Once they’ve established the interim steps, boards can then think about how to integrate those steps into short-term bonuses.

Start with the basics. Goals don’t need to be detailed to start with. They can be broad and top-line goals, such as meeting supply chain targets or goals for reductions in carbon/greenhouse emissions or water consumption goals. They can also be more community-based, such as changing community attitudes toward the dangers of underage drinking, or they can be internal, such as tracking diversity, equity, and inclusion (DE&I) measures. If a company finds that it has many initiatives within silos, it needs to consolidate those initiatives around key themes.

Be accountable. Boards need to hold management and the company as a whole accountable for executing the strategy and meeting climate goals—both long term and short term—for climate-based pay incentives to work, delegates agreed. One of the best ways to encourage that accountability is to communicate all goals and milestones publicly, according to several delegates. “It can say, ‘Here’s where we want to be in 2028. And here’s what we will do next to get to that goal,’” said Ferracone.

If companies aren’t sure what direction to take for a long-term goal, they need to listen to their investors and ask them good questions about their priorities. “If we are not focusing on what investors want, then we’re failing,” said one delegate. “Have constant curiosity and always be listening to shareholders. And use those [steps] to drive the agenda.”

The group agreed that for companies to tie pay and performance to climate goals, companies also need to set and track metrics related to their climate goals to collect data to inform their decisions around incentives. While a growing number of companies have started tracking such metrics, the vast majority are still honing their approach to the measurement process. Big, top-line questions remain: What measures are important to an individual company? What is the baseline? Where does it want to be? By when? What are its goals?

Investors are now asking companies to put baseline measures into their broader goals and strategy. Companies can get creative with how they start thinking about tracking climate-based behaviors while they’re still figuring this out. Here are some examples:

Some mid-cap knowledge-worker companies have virtual power purchase agreements with solar or wind facilities.When seeking financing, some companies are launching bonds or buying bonds for projects that are green.Some mid-cap companies are collaborating with suppliers to optimize their use of motor vehicles to drive fewer miles.When one delegate’s company acquires another company, it looks at the acquisition’s vehicle fleet and asks them to retire older, less efficient vehicles.The audit committee at one company monitors the company’s supply chains with a checklist; the committee then reviews policies and procedures throughout the supply chains and reports on these frequently.One company that supplies a service instead of a product reviews its people diversity and tracks the percentages of its female and ethnically diverse leaders and asks other questions around its DE&I practices as well.

As shareholders put more pressure on companies to set and track metrics for climate goals, boards must ensure that the organization institutes these practices if the company isn’t already following them. This is especially important because investors are also putting pressure on regulators to require ESG disclosure, and boards will need to be prepared. “Investors want SEC rules to include metrics and clear guidance on this, or on climate change in particular, because there are not enough metrics on this,” said Goltser. “We will see more concrete disclosure on rule-making in these areas.”

As boards become more involved in tracking ESG goals and eventually tying such goals to pay incentives, they need to make sure that they have the right levels of expertise and oversight for their organization’s individual needs. However, debate still exists about where oversight for ESG should lie and what kinds of expertise are necessary for effective oversight. Who should oversee ESG? Where oversight for ESG resides depends on the board’s makeup. It rests within the audit or risk committee on some boards, while it’s overseen by the governance committee on others. And some larger companies with boards that can support more specialized expertise have created a separate ESG committee. There is also some debate about whether ESG would be best overseen by the entire board rather than assigning responsibility for ESG risks to a single committee.

Have the right skills mix. Companies also have to decide what mix of skills they want on their boards regarding ESG. There is significant debate over whether having several individual ESG experts is necessary or if having generalists with competencies in certain areas would be more beneficial to the organization. “Boards need to have thoughtful discussions about which would work better for them,” said Ferracone. “It’s not a knee-jerk reaction.” The right mix will also depend on the size of the company. “There is no one-size-fits-all answer,” said Goltser. “Companies just starting out will focus on only the audit committee. Not every board needs an expert. Larger, more mature companies divide things up over committees.” Boards may also want to consider including ESG in their training agenda. The group concurred that training by outside experts seems to be the best option. “We brought in climate change experts with two different points of view. It was very educational,” said one delegate.

What was clear among participants is that the climate journey that boards are on is both dynamic and complex. It is also a part of a broader, evolving trend around ESG. The desire for ongoing dialogue and learning is strong among board members, as is the realization that progress in this area will not be linear. But as with all business challenges, the board members present were focused on what they believed to be the best outcomes for their companies, investors, and broader stakeholders.

Note: The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes are not attributed to those individuals or their organizations, with the exception of cohosts.

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2021 Turbulence Connects Credit Ratings With Cyber Ratings and Insurance

A little over a year ago, I wrote a piece discussing how the pandemic was affecting those managing cyber risk. I had three big conclusions: The first was that a pandemic was not an unforeseeable occurrence, although obviously the details were unpredictable. The second was on the need to build resilient organizations that could withstand work from home, including the crucial need to communicate, manage, recruit, and onboard staff from anywhere. Third, I made the point that digital transformation really is resiliency. For some time prior to 2020, many organizations treated digital transformation like a special project instead of making it the core of the business model. The pandemic made everyone think differently about how the Internet and mobile apps make their businesses work.

Those three points still hold true today, and importantly, it hasn’t just been boards and their executive teams that have experienced changes. Hackers have likewise shifted their focus to those very same businesses that rely heavily on their digital infrastructure to deliver on their mission and vision. This shift in tactics by digital assailants is at least part of why a Gartner survey revealed that 88 percent of boards are seeing cyber risk as business risk. This maturation of perspective from cybersecurity as a technical issue to cybersecurity as a business risk relates directly to how connected organizations have become to their digital business models, and, frankly, to customer expectations.

Credit rating agencies have also recognized this digital shift and have adjusted their rating models and research to account for this. After all, cyber risk is business risk. In its latest report on cyber risk, Moody’s Investors Service identified that organizations failing to adapt their cybersecurity practices to the new remote and hybrid work patterns will be most at risk, especially during transition periods. This is further shown by the increase in the cybersecurity talent gap, which makes proper security practices difficult to staff.

Further complicating matters will be the increase in regulatory oversight that Moody’s predicts will emerge as governments increasingly see supply chain problems as a challenge to national security. Moody’s also indicates that cyber-risk quantification will be increasingly adopted to help organizations translate technology to business language and to provide a common benchmark for organizations to evaluate their cyber risk. Ratings agencies will broadly adopt cyber-risk quantification to help understand the relative differences between an organization’s cyber-loss exposure and control posture.

Those are the same factors that are affecting the scoring components used to build global cyber ratings. Credit rating companies are looking to understand how often and to what degree companies are going to experience cyber losses and not just data breaches. Since the pandemic began, there has been a huge swing away from attackers focusing on monetizing personal identifiable information and toward them using ransomware attacks. Such attacks can involve “triple extortion,” in which the attackers demand a ransom three times: first, to allow for the recovery of information; second, to not publish sensitive information online (doxing); and third, to not contact customers demanding they also pay to not have their data disclosed. This triple threat has placed many on notice, including cyber insurers.

As a result, cyber insurers are increasingly limiting coverage to limit their exposure. They are also looking to gather more information to better inform their underwriting models on potential payouts. Underwriting departments are looking to cyber rating firms to assist with this. In addition to projecting loss potential for organizations, rating firms are looking to better understand what series of risk triggers and kill chains an organization has and which they defend against well. In much the same way that high liability limits for a life insurance policy require a biometric screening, so, too, will organizations looking for cyber-insurance policies be subject to more invasive examinations. This includes internal assessments of system configurations and processes.

As cybersecurity, credit ratings, and cyber insurance continue to converge, the impacts of 2021 will continue. As a result, the future of cyber ratings will include more quantification, and eventually, more public disclosure about security performance and loss exposure, similar to the way corporate and sovereign credit ratings are handled today. This will benefit everyone, as it creates more clarity around how cybersecurity should be managed and gives boards better direction about how their executive teams are performing.

As vice president and head of cyber-risk methodology for BitSight, Jack Freund, NACD.DC, has overall responsibility for the systemic development and application of frameworks, algorithms, and quantitative and qualitative methods to measure cyber risk. Previously, Freund was director of risk science and board advisor at quantitative risk management start-up RiskLens. He has spent his career consulting, building, and leading technology and risk management programs for Fortune 100 organizations, including TIAA, Nationwide Mutual Insurance Co., and Lucent Technologies.

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Governance Leaders Discuss Diversity, Innovation as They Look to 2022

Reflecting on the past year and preparing for a new one filled with novel challenges regarding strategy; innovation; diversity, equity, and inclusion; and more, NACD gathered directors and governance experts last month to discuss the topics that are top of mind for boards. The panel comprised Stephen Brown, senior advisor to the KPMG Board Leadership Center; Dorlisa K. Flur, a director at Sally Beauty Holdings; Claudia Fan Munce, a director at Best Buy Co., Bank of the West, Corelogic, the NACD Northern California Chapter, and Parity.org; Dan Mayfield, a partner at Farient Advisors; and Warren de Wied, a partner at Fried Frank.

Highlights from the Leading Minds of Governance virtual panel, moderated by NACD director of partner relations Lindsey Baker, are included below:

How can a board rethink its director recruitment strategy to attract the right mix of skills and diversity?

Dorlisa K. Flur: If I look at my public boards, there are two extremes to how we approach board recruitment. One uses what I would describe as an evergreen personal network. There’s a constant flow of names coming from board members, executives, professional services firms, etc. We’re always screening referrals and keeping a list based on expertise for when we have an opening.

The other extreme is using an industrialized search process, whether a search firm is involved or not. This approach starts with a multi-year view of board succession and defines the skills-based criteria that will be needed. Then we go out into the world looking for individuals that fit the immediate [specifications]. Either of these extremes requires the board of directors to have the intent to broaden the pool of candidates. It is easier to go out and find people that look like you. One of my boards officially adopted the Rooney rule to ensure we didn’t stop there.

Ultimately, building a diverse board requires looking at different talent pools. This requires you to seek out diverse registries online, feeders from universities or businesses that have a track record in developing diverse talent, search firms with broader reach, etc. Then—I can’t underscore this enough—there must be a welcoming environment when they join the board. Otherwise, it doesn’t matter what you’ve done [during recruitment].

What sorts of steps can a board take to help change diversity both on the board as well as beyond the board?

Claudia Fan Munce: There is a group dynamic aspect to it, but what we’re looking at is the individual courage to try to influence that group dynamic. I think that a diverse board is almost a chicken-and-egg situation. If you have a diverse board, chances are you’ll have a very open, very welcoming environment. Boards need to appreciate that this is about us helping the company and that diverse perspectives are what we bring as a value-add as diverse board members.

I’m Chinese; I grew up in Brazil. Asking “dumb questions” was never really something that I was afraid of. . . . If you start with yourself and are able to reach across the table to ask questions about somebody’s comment, you start building that group dynamic that becomes very valuable, and you will see the pile-on effect.

One thing that is amazing is the caliber of people that you see around the boardroom table. It can become intimidating—you read [someone else’s] bio and think, “Wow, he is from that industry; should I even be making a comment about that when we have such an expert on the other side of the table?” You really have to take it on yourself that the reason you’re there is to help bring a level perspective and not just scan whatever is presented to you. With that, you start to develop that very open, very diverse encouragement around the table.

There’s been so much discussion around ESG [environmental, social, and governance issues] in the governance space, but there still seem to be a lot of questions. How can a board break down ESG oversight?

Stephen Brown: I call it the ESG jungle—there’s so much out there. I believe in not complicating things that are [already] complex. We have these three letters—ESG. Let’s focus on the “E” and “S”. We’ve always been focused on the “G” and a lot of times when people say “ESG,” the G is silent. The E is something that most people understand; if they didn’t understand it before they froze in Austin, Texas last year with that snowstorm, they get it now. It’s right in front of their faces. It’s the S that folks have trouble with.

To chop down the jungle, boards should know their three to five issues. What are the three to five environmental and social issues that truly, materially affect long-term enterprise value? Understand that, get alignment with the board and management on those things, and then you know where to start to drill down. But when there’s alignment on those issues, it becomes easier to hack through the jungle.

What have you found to be some of the best practices that directors can engage in to encourage innovation, and what useful tips and tricks do you have to share with us?

Dan Mayfield: The innovative boards that I work with are allocating more time to define, implement, and execute on strategy (that now includes all aspects of ESG) through collaboration with management. If you consider an agenda for most committee meetings, the committee, to cover a broad range of topics, must move through the agenda quickly, sometimes in 10- to 15-minute increments. There comes a point when directors should ask the right questions, which may include, “Are we dedicating enough time for management and the board or committee to have meaningful discussions around strategy?” at the right time. Because of the focus on talent and broad human capital needs across the organization, there is a growing imperative, especially since COVID, for more connection between board members and management on this topic. Innovative boards recognize this shift and spend more time considering the emotional, financial, and physical well-being of all employees. When I start working with boards and management, questions that I ask include: How would you describe the dynamic between leadership and the board? How are you working with management to meet the needs of the organization and ensure that there is a meaningful plan in place to attract, retain and motivate talent? What next steps should we consider to ensure that we link talent development to compensation? At the end of the day, innovative boards are asking the right questions, working more closely with management, considering talent more broadly, and working hard to align the interests of the company with the interests of all stakeholders including shareholders.

Let’s look ahead to 2022. How can directors manage all the various demands placed on them?

Warren de Wied: I’ve got a mantra. It’s not original, and it’s not terribly insightful, but think about vision and supervision. There are two fundamental parts of the job. One is setting a course for the company; the other is oversight and monitoring. If lawyers are asked to put together a summary of corporate governance requirements, they may produce 100-plus pages of materials, between summarizing New York Stock Exchange or Nasdaq rules, SEC [US Securities and Exchange Commission] requirements, proxy advisory firm policies, and policies of major institutional investors, and these regimes are evolving all the time. The list of things for which directors are expected to take responsibility grows every year. It’s easy to get lost in these things. 

Looking ahead, directors will have to think a lot about political risk in the United States. We’re at a point where the divide between people on different areas of the political sphere is more palpable than ever. We have a seesawing between regulation and deregulation. Obviously, the risk goes in a more problematic direction than simply shifts in regulatory policy, but the 2022 political risks are going to escalate into 2023 and 2024. Another key area is technology. It’s a pretty significant thing that Facebook is rebranding itself and moving toward a metaverse. Today, you can attend a concert inside Fortnite. Virtual technology has potential for dramatic expansion. What does that imply for the way companies operate? For a board member, these areas—technological and political risks, along with global economic issues already under scrutiny such as supply chain and human capital challenges—are just some of the areas to focus on.

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Broken Trust Upsets CEO Candidates, Search Consultant

This is a version of a Directorship magazine article exclusively for NACD members. If you are an officer or director of a public, private, or nonprofit organization, you can become an NACD member to view the complete article and related resources. The scenario presented here is anonymized to protect identities.

The dilemma: Karen chairs a government-owned utility board. The CEO recently announced their long-expected decision to retire.

The board appointed a professional search consultant selected from the government’s list of approved providers. The board had a long list of skills and attributes that it wanted in its candidates.

As expected, finding candidates with the skills the board was seeking proved difficult. In addition, all the shortlisted candidates were then employed and on salaries above pay brackets for this level of appointment within the government sector. No candidate was highly enthusiastic about moving to the public sector at a lower salary.

To help candidates understand the nonmonetary benefits of the role, Karen and her board arranged for the three preferred candidates to have coffee with the outgoing CEO and to hear firsthand how rewarding the appointment would be. Unfortunately, the CEO’s secretary misunderstood the process and asked the internal human resources department to schedule the appointments. Now the three preferred (yet still hesitant) candidates have received a standard email asking them to come for an interview, rather than a conversation, and asking for curricula vitae (CVs), reference details, and other data.

The search consultant is furious, saying that the candidates are now upset because they feel that their privacy has been breached when they had not yet said that they were willing to take the position. The consultant has already invoiced 70 percent of their fee and now claims the process has been thwarted.

What can Karen do to help her board recover from this disaster and, hopefully, recruit one of their preferred candidates?

Julie Garland McLellan, nonexecutive director and board consultant: This is the sort of disaster that happens when directors don’t fully engage with board- and C-suite-level recruitment. The board needs to get its act together fast. It can’t abdicate its responsibilities to the CEO and search consultant. If the CEO’s retirement decision was expected, their board should have been prepared.

First, Karen needs to bring together a small group of directors to serve as a nominations committee or task force. They should go through the long list of requirements that the board has compiled and rank these into groups of “essential,” “highly valued,” and “nice to have.” The board needs to understand what the characteristics are that the candidate must bring, and what the skills are that the candidate can develop with its support and leadership.

That will help the consultant to find candidates who are willing to take on the role.

Then, Karen needs to have a frank conversation with the consultant, apologize for making them look bad in front of some high-profile candidates, and focus them on creating a list of realistic candidates who are keen to fill the role and don’t need the outgoing CEO to sell it to them.

The board should have a brief conversation with the current CEO to explain the disappointment that the board feels at the CEO’s poor delegation of such an important task and to request that the CEO, personally, reach out to each of the candidates and apologize for what happened.

The board should prepare for the eventual succession and develop a plan for supporting the new CEO. It should review delegations and create stronger oversight for the early days of the new CEO’s tenure. Much of this, but not all, will fall to Karen as the chair.

Finally, the board needs to consider its own processes for CEO succession to ensure it is better placed next time. To lose one set of candidates is unfortunate—to lose two would appear to be careless.

To read other expert opinions on what Karen should do, see the November/December 2021 issue of Directorship magazine, now live. Check out the full and previous issues of the magazine here.

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Stakeholder Capitalism Revisited: What Boards Can Do to Adapt

Board service has evolved over the last few decades, requiring directors to be knowledgeable on more issues facing companies than ever before: risk management, financial concerns, corporate governance, material disclosures—the list goes on. This reflects the growing complexity of the business environment, with environmental, social, and governance (ESG) issues permeating many conversations these days, including in the boardroom.

In addition, stakeholder capitalism emanating from ESG concerns is quickly becoming one of the most talked-about concepts among directors and officers. Stakeholders are using their influence to demand change around multiple facets of ESG-related issues. It is not a buzzword but a movement.  

What Is Stakeholder Capitalism?

In essence, stakeholder capitalism is when an organization works to create value by meeting the demands of its various stakeholders as opposed to exclusively concentrating on profit and shareholders’ demands.

It is not a novel concept—in fact, as discussed in a piece on Investopedia, corporations were largely guided by the stakeholder philosophy until the 1970s, when the focus shifted to shareholders. After a hiatus of several decades, boards are once again faced with recognizing the relentless demands of the non-shareholder stakeholder.

Stakeholders can be any group with an interest in an organization, such as shareholders, employees, customers, and suppliers. From a pragmatic standpoint, people want to work for, invest in, and buy from companies with like-minded values and missions. Companies must better understand how to attract and retain talent in a fiercely competitive labor market, while simultaneously recognizing that customers and investors are all demanding that they demonstrate their commitment to the principles of sustainability and ESG protocols.

It’s the dawn of a new balancing act for the board, and the pressure to act is coming from all sides:

Customers are filing class-action suits against companies they allege have made false claims about the sustainability of their products.Employees are choosing where to work based on how socially responsible their current and prospective employers are.Regulators are demanding more detailed disclosures on climate-related matters, diversity and inclusion, and more.Investors are targeting boards of directors in litigation, alleging breaches of their duty to address ESG.

All these threats—including litigation—can result in enormous costs for businesses and for individual directors and officers.

What Boards Can Do

History shows that people and their organizations don’t shift their focus quickly enough to address emerging issues. What actions should boards be taking to adapt to this shift back toward stakeholder capitalism?

Become educated on the broad array of ESG issues facing your organization. What are stakeholders demanding? How should the board respond to those demands? Boards should turn to trusted advisors well versed on the issues. Working with outside counsel to fortify ESG frameworks can reduce potential litigation and, at a minimum, provide additional defenses if litigation does ensue.Understand the methodologies and criteria used by the organizations assigning you an ESG rating. There are many ESG rating firms, with very little correlation on results or method. There is no central regulatory standard that explicitly states the “level” required to achieve even a passing grade. For these reasons, the most important factor in ESG evaluation is change.Be authentic in your actions. Implement systems that measure and monitor change. Demonstrate positive change in method, practice, or outcome that exhibits willingness, effort, and an improvement in the ESG risk profile.Understand your fiduciary responsibilities. Better understand how your fiduciary responsibilities are tied to the emerging issues referenced above. Ignore stakeholders’ needs and you risk breaching your fiduciary duties.Review and strengthen your directors and officers (D&O) insurance coverage to make sure it will address these emerging issues as comprehensively as possible in the event of a vulnerability.

Everyone wants to avoid regrets, and this certainly applies to the evolving area of ESG and its impact on the board.

Think about the situation emerging, evaluate what your organization has done and is doing to address change, and engage others with expertise to counsel you. Do all of this on a regular basis and wrap it with a D&O insurance policy that is cutting-edge, and you should never have regrets.

Jack Flug is a managing director at Marsh and leads the US Financial and Professional Liability (FINPRO) claims practice. Maureen Gorman is a managing director and the ESG leader in Marsh’s FINPRO practice.

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