Saturday, December 11, 2004

Cornerstone of the Board: The new steps of director search

See below for an interesting article produced by Spencer Stuart and found in Board Member magazine:

November 03, 2004

Cornerstone of the Board: The new steps of director search
From Spencer Stuart By Julie Hembrock Daum and Tom Neff


The new director recruiting process is not simply a reaction to regulation. Although it is true that most boards now are required to have a totally independent nominating committee, many companies had this prior to the legislative change. The difference is that nominating committees clearly are taking the lead responsibility for selecting new directors. They are putting in place a process that is thoughtful and will result in a more targeted, strategic recruitment.

While both boards and board prospects are following a more rigorous process, both sides benefit from the increased intensity. Boards are giving careful consideration to what type of skills and characteristics they need to add to their board and thus extending offers to people who are best suited to the position. They also are making more use of experts to help them make these decisions. Board prospects also are making more careful choices, as they now have to restrict the amount of board activity.

Boards also are feeling pressure from increased competition for the decreasing number of interested candidates. Demand for directors has increased for the following reasons:

  • The tightened definition of “independence” means some boards have to add directors who meet the definition.
  • Audit, compensation and nominating committees must be independent. Because more work is being done by committee, increasing the workload of the independent directors, new directors are being sought to staff the committees.
  • Audit committees must have a financial expert who meets the Sarbanes-Oxley definition.
  • Turnover is increasing as directors pare back their board commitments.

    While demand has increased, the supply of willing and capable candidates has decreased. There are several causes for the shrinking pool:

  • Board service now requires a heavier time commitment. A typical director now spends as much as four to six weeks a year on board duties — even more if on the audit committee.1 Therefore, people can serve on fewer boards.
  • Some companies are restricting or forbidding “outside” board service for executives.
  • Candidates are more risk averse and concerned about the potential financial or reputational liability of board service.

    Filling a board position is now a more difficult task, with greater consequences for choosing poorly and increased benefits for selecting skillfully.


    Even before Sarbanes-Oxley, 75 percent of S&P 500 company boards had a nominating committee2, yet it wasn’t necessarily an integral part of the director recruiting process. In the past, the CEO often took responsibility for choosing new directors even if a nominating committee existed. Today, the independent nominating committee drives the process. This is a dramatic change. Reflecting the new complexity in the execution of a search, the recruitment process is now more complicated, formal and detailed. A generic director search is outlined in the following 10 steps:

    1. Design a selection process and communicate it to all involved parties.
    2. Assess the board’s needs.
    3. Develop a director specification.
    4. Decide whether to hire an executive search firm.
    5. Create a long list of board prospects from a wide range of inputs.
    6. Review the long list for any kind of potential conflicts.
    7. Narrow the long list to a short list.
    8. Research the prospects on the short list.
    9. Design and conduct a thorough interview process.
    10. Extend an offer.


    The nominating committee is probably designing this selection process for the first time and should be thoughtful about creating an enduring process. In addition, many more people will participate in this process than in prior years, so it is important to decide and communicate who will be involved in each step of the process. In some stages, this may be the nominating committee chair, the CEO, the whole committee or the whole board. The committee probably will also draw upon a member of management to help facilitate the actual process. The general counsel, corporate secretary or the head of human resources are the most frequently included.


    The next step is to review the existing board composition. This evaluation should include confirming board member independence, determining potential retirement dates and identifying board members who may want to (or who should) step down.

    Next, the board must identify needed skills based on the company’s corporate strategy and compare this to the skills existing on the board. These two evaluations — existing board composition and the needed skills — will facilitate a gap analysis. The new board member ought to be proficient in those capabilities that the board requires or will need going forward.


    With the gap analysis in mind, the nominating committee members draw up a detailed director specification that outlines the specific strategic qualities and experiences necessary for the opening. These may include general management or financial expertise, public company experience, prior board experience or particular functional skills such as operations or marketing. Some of the characteristics will be “must haves” while others may be more flexible and should be noted as such.

    Board culture also is very important and boards will want to make sure the candidate will work well within its culture. So, although most of the specifications will be experience-based, personal qualities also will be an integral part of the requirements.


    The board then must decide whether to hire an executive search firm. An external firm can bring a wealth of expertise in designing a process that meets best practice standards. More important, it allows the board to look at a wide universe of candidates, not just those known to the current board. To get the most benefit from the search firm, it is crucial to hire a firm and individuals who work in the boardroom and are facile with recent legislation. The board should do references on the individual consultants to ensure they have a proven track record of necessary expertise and success.

    Traditionally, boards have recruited active and retired CEOs, presidents and chairmen. In 2002, 53 percent of all new directors fell into those categories.3 Many of these candidates were in the board members’ personal networks. Now, they must extend their reach to include active and retired CFOs, retired senior audit partners, professional directors, functional experts and line executives below the CEOs. Many boards don’t have the access to these networks of people. The external search firm does, which is indispensable to finding the best prospects. Along with crucial experience and extensive networks, the search firm also brings an impartial view. The result is that the board gets to choose from the best of a wider pool of competent and appropriate prospects than they would without the executive search firm’s skill and reach.


    With the position specification in hand, the nominating committee (and executive search firm) draws up a long list of candidates. At this point, the committee seeks suggestions from management, board members and other knowledgeable parties. They want to cast a broad net and get a sense of the available universe. The deliverable from this step is simply a reasonable list of people who meet the specifications. Any shareholder recommendations also should be added for consideration.


    Next, the nominating committee or search firm reviews this list to sort out any obvious conflicts. They eliminate those who have board meeting date conflicts, industry conflicts and anyone who may be a competitor of someone who already is on the board. A review for people who work at companies that prohibit board membership should be conducted. They also should examine any pre-existing relationships with the CEO or other board members.


    The wide net cast in the previous step collected names without regard to these issues in order to develop the most comprehensive list. The next steps whittle away at this group to get to a shorter list of potential candidates. This is a striking change from the pre-Sarbanes-Oxley days when recruiting a board member meant the CEO might have considered only a few people.

    The next step — this narrowing process — involves input from a number of sources as well. The long list is the logical universe. The short list is a subset composed of the most preferred prospects for reasons of personal and professional appropriateness.


    The nominating committee reconvenes with the short list and compares these candidates’ suitability against the criteria in the position specification. The CEO almost always is involved in this process, particularly to veto any prospects deemed unsuitable.

    The committee also performs due diligence on these candidates or reviews due diligence from the search firm. At this point they thoroughly check candidates’ references, especially board references. They also consider the candidates’ style and assess cultural fit with the current board and the company. The board members don’t want to begin a conversation with someone whom they don’t believe they might extend an offer. Finally, they further narrow and prioritize the list of candidates.


    There also are changes both to the interview process itself and where the interviews take place. Historically, the company just considered one candidate. In fact, often the candidate would meet with just the CEO. Now the board needs to decide if they will interview more than one candidate. Some candidates, particularly high-ranking executives, do not want to take part in a competitive interview situation. So some boards conduct the interview process with just the first person on the priority list and extend an offer if they like him/her and only go to the next person if he/she refuses. Alternatively, many boards are opting to interview more than one candidate and make a choice afterward. Most will only see two people because they do not want to be in a situation of rejecting very senior people.

    The interview itself also has changed markedly. Previously, it may have consisted only of lunch with the CEO, and the CEO tended to go to the candidate. Now the candidate will interview with several people and the prevailing wisdom is that it is important for the candidate to spend time at the company’s headquarters to get a feel for the organization. As for the interview itself, the CEO will be one of the interviewers, but the board chair (if the CEO and chair roles are held by different people) and the nominating committee chair also will see the candidate. If the candidate is being considered for the audit committee, he/she also will speak with the audit committee chair, the CFO and the outside auditor. In either case, the candidate likely is to meet with other board members. In general, the process is more thorough and careful consideration is given to how the candidate will fit in with the company’s culture and board.

    At the same time, the candidate also is interviewing the company. The pool of soughtafter prospects is a relatively small, elite group. People with in-demand professional expertise have many choices, so they are likely to investigate the company thoroughly. They have the luxury to be very particular about whether to join a board and which board to join.

    Just as the company and the board benefits from the more methodical search process, potential candidates profit from the new recruiting practices as well. They meet more people than just the CEO and can ask board members questions to determine if the position is a good fit. Previously, they may not have had the opportunity to truly evaluate the company and make a considered decision. The external search firm helps educate the candidates just as it helps the company. Potential directors are more cautious in their approach to a new board request. In the new environment, both sides will conduct more thorough due diligence. While the company or search firm checks for any criminal and/or SEC issues, the candidate will have a professional examine the company’s D&O insurance.


    Finally, and at last, an offer will be extended. If more than one candidate has been interviewed, it is important to quickly and professionally communicate with him/her. Many times the search firm will handle this; however, the company should be involved in deciding upon the appropriate response.


    Many more companies likely are to follow this type of process in the coming year. Both the SEC and Sarbanes-Oxley regulations recently have put forth requirements that took effect January 1, 2004, and affect the disclosures for the upcoming 2005 annual meetings.

    Currently, companies must state the members and functions of the nominating committee. Under the new rules, a company also must disclose information about both the standards and the process by which new directors are chosen and the process by which shareholders may make a nomination. If an outside search firm is hired, the functions it performed for the nominating committee must be detailed.

    A review of proxies for companies in the S&P 500 confirms that many companies already are in compliance with some of these new rules.4

    The 2004 proxy disclosures can be summarized as follows:

  • The sources of the new nominees are being disclosed (i.e., whether the nominee was recommended by company management, non-management director(s) or search firm).
  • A general disclosure that a search firm was engaged and recommended a particular candidate as a potential board nominee.
  • In some instances, the search firm engaged is identified by name.
  • In many instances, there is a disclosure (either in the proxy or in the nominating committee charter) which states that the committee retains the sole authority to engage a search firm in the future.


    Clearly, the recruiting process is longer, more complex and more meticulous than in the past. The stakes are higher for the company, the board and for the candidate. It is no wonder that many nominating committees are choosing to hire executive search firms to aid in the search for the most appropriate addition to a board. Results from a 2003-2004 National Association of Corporate Directors survey showed that nearly 50 percent of nominating committees utilized a search firm.5 The benefits of hiring outside experts include enabling the board to cast a wider net into the applicant pool and to conduct a transparent and inclusive process. With the candidate pool shrinking as executives take fewer board positions and with the public scrutiny intensifying as Congress and the SEC examine boards more carefully, we expect that many more director searches will be undertaken with the expertise of a search firm.


    The new steps for selecting board members may have started out as a reaction to the new requirements of Sarbanes-Oxley and the SEC, but today the benefits extend beyond solely complying with regulation. The defined new processes help companies better identify the skills needed to enhance the board and, as such, increase the likelihood of recruiting directors with these skills. To tap into a wider universe of potential candidates, many companies now see the advantage of partnering with an executive search firm that not only possesses these contacts, but also can bring impartiality to the director selection process. Despite the time-consuming extra steps, the end result is worthwhile for companies — the members of the board are a more cohesive and effective unit that truly is a competitive asset for the company.

    1. The New York Times. “Looking for a Few Good Directors.” July 4, 2004, first page of Business Section.
    2. In this article, the “nominating committee” is used to refer to the “governance committee” as well.
    3. The 2003 Spencer Stuart Board Index.
    4. The 2004 Spencer Stuart Board Index.5. NACD–DM Extra, March 5, 2004, page 2.

    Copyright 2004 Spencer Stuart.

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