Ways to reduce risk in board evaluations: these eight safeguards can make the self-assessment process useful and relevant and reduce the potential liability for the board and individual directors.

• Author: Taten, Bruce M.
• Position: DIRECTOR EVALUATION

EFFECTIVE IN 2004, companies subject to the listing requirements of the New York Stock Exchange will face the prospect of conducting up to four separate "performance evaluations" for their boards and board committees. Other companies may follow suit as a "best practice" or to meet obligations to third parties. Although such performance evaluations--sometimes called self-assessments--have been considered a "best practice" for good corporate governance, they pose new risks that may not be immediately apparent. Perhaps because of lack of experience, perceived risk, or simply the "newness" of the process, there are no widely accepted procedures for conducting board and committee performance evaluations, or for minimizing the risks associated with them.

This article sets forth some practical considerations for structuring a board or committee evaluation. These considerations can protect the directors and the self-evaluation process, while preserving the effectiveness of the evaluation process as a tool for enhancing the operation of the board, its committees, and management.

A widely recommended tool

Self-evaluation has long been regarded as an important tool for boards and committees. Performance evaluations have been recommended by reports sponsored by the American Bar Association, the National Association of Corporate Directors, the Business Roundtable, and the Conference Board. Almost all audit committee charters include a requirement that the committee evaluate its performance each year (although few, if any, companies, have reported the results of that evaluation).

The NYSE has adopted amendments to the Continued Listing Standards stating that a board should "conduct a self-evaluation at least annually to determine whether it and its committees are functioning effectively." The NYSE Listing Standards also require annual performance evaluations of the audit committee, the nominating/corporate governance committee, and the compensation committee. Other exchanges may adopt similar requirements, and there is speculation that the SEC will require the exchanges to adopt uniform corporate governance regulations. Some companies have started evaluation procedures as a matter of good governance; in reaction to outside pressures, such as corporate integrity agreements; or to satisfy the corporate governance requirements of governance rating agencies like Institutional Shareholder Services.

These evaluations, conducted with varying frequency, have taken various forms, and examined different substantive items. They have used a variety of evaluation scales, scoring techniques, and procedural methodologies. They can make the board function more effectively in its oversight role. They can also help the board be more productive in dealing with management and third parties. As Professor Jeffrey Sonnenfeld noted in his Harvard Business Review article entitled "What Makes Great Boards Great?," the success of great boards depends on the ability of the board members to "trust and challenge one another."

Stressful undertaking

But self-assessment involves critical review and can be a stressful undertaking for any individual or organization. In the introduction to the NACD's Blue Ribbon Commission on Board Evaluation is the report that "one member of the Commission recalled hearing, when asking CEOs and directors whether they had engaged in board evaluations, this terse answer: 'Yes, once.'" Many boards have thus shied away from in-depth performance evaluations.

We believe that these types of evaluations involve other risks--both to individual directors and to the companies that they serve. Plaintiffs' lawyers--particularly in securities class actions--would be eager to obtain critical statements that could be used as evidence of inadequacies of the board and its members. Even if the performance evaluations were only slightly negative, they could prolong litigation if plaintiff's counsel could use them to support the proposition that the board was "less than adequate" or "out of touch."

Fortunately, the manner in which performance evaluations are conducted can make them useful and relevant and reduce the potential liability for the board and individual directors. Performance evaluations can be...