From the outside in


From the outside in Ethical BoardroomBy John Roe – Head of ISS Analytics




For years, investors have increasingly focussed attention on the quality and effectiveness of boards of directors governing companies in their portfolios. And the attention hasn’t gone unnoticed: to their credit, directors are doing a better job than ever of giving insight into boardroom processes and of engaging with investors on critical issues, such as management performance, strategy, succession, governance and executive remuneration.

In the wake of corporate scandal after scandal, investors are taking a much closer look at the board than ever before. Recent revisions to local stewardship codes and the Shareholder Rights Directive at EU-level have added even more momentum to the effort. These revisions emphasise that investors’ stewardship activities should include monitoring and engaging with companies on matters such as strategy, performance, risk, capital structure and corporate governance, including culture and remuneration. Engagement should be purposeful dialogue with companies on those matters as well as on issues that are the immediate subject of votes at general meetings.

Investors are therefore looking for real-time data that can give them an advantage in understanding how well the board is functioning and indicators of how well it may be executing its fiduciary responsibilities. Directors might be surprised at how deeply some investors are looking, outside in, to get an idea of how the board may be performing.

Over the past year, we have discussed the issue with a wide range of stakeholders and have collected feedback regarding the areas that investors are looking at to evaluate boards of directors and what types of indicators might fall into each of those areas. The areas that we heard most consistently include:

  • Board self-regulation How well does the board identify and mitigate its own weaknesses, encourage underperforming directors to improve and, ultimately, manage its own membership?
  • Composition and structure Does the board have the right set of skills, capabilities and perspectives, to include various measures of diversity and does the board put in place effective checks and balances over various roles?
  • Transparency, engagement and responsiveness How well does the board describe its own actions and engage and respond to feedback from the company’s owners?
  • Track record and outcomes How have companies – both this one and others – performed under these directors’ stewardship and what can special situations at these companies tell investors?
  • Risk management How does the board identify, address and manage critical enterprise risks?

Looking deeper, there are a range of ways that global investors are interested in assessing the board, on these five dimensions below.

From the outside in Ethical Boardroom

This list is just a starting point – and no investor uses, or perhaps would even agree with, all of these factors. And different investors even interpret some of these data points differently, making the issue even more complicated for boards of directors. But it’s important to understand the wide range of perspectives that have been voiced and to see how broadly investors are beginning to cast their nets to gain a better view of board performance.

Investors do recognise that outside-in analysis is likely to miss many important factors that are unobservable outside the boardroom and committee meetings. But that doesn’t mean that investors don’t – or shouldn’t – pay attention to key signs of board performance that are externally observable, for those are often important clues that may lead to further investigation and engagement.

We’ll take a closer look at just a few of these points to illustrate things that boards should be thinking about as they engage with their shareholders and fulfil their director obligations.

Board self-regulation: the ideal board of directors is a perpetually moving target

The shareholders’ needs and expectations from the board are in constant flux. Required boardroom skills constantly evolve – technology management and cybersecurity are the obvious recent examples; investors in companies with significant cyber risk now have a reasonable expectation that the company’s board has the ability to identify, monitor and mitigate cyber risk. But it’s not just skill requirements that are changing – long-established calls for more gender diversity, alongside increasing calls for other forms of diversity, add to changing expectations.

From an investor’s viewpoint, that means that a board shouldn’t be a static body, serving together, year after year; there is a need to constantly evaluate how the environment is shifting, identify new risks the board should be managing and ensuring that the right skills are in the boardroom to manage those risks. The recent increased attention on board refreshment highlights this investor viewpoint. Boards need to embrace that their responsibilities will continue to evolve and the composition of the board will likely need to shift over time to include expertise in emerging areas of need.

Some great boards realise this and are transparent about the company’s evolution of needs from the board of directors. In their annual reports, they discuss emerging company risks, changing company needs and how the board is responding to these changes through education and refreshment. But quality disclosures of this type are still too few and far between.

“Companies are increasingly moving from general board-level performance assessments to having individual assessments of each board member and even bringing in an external assessor in some cases to facilitate the board’s evaluation”

Boards are disclosing more sophisticated board and director assessment processes

Perhaps unsurprisingly, one of the fastest-advancing corporate governance practices is how boards of directors are evaluating themselves. ISS Governance QualityScore tracks how companies disclose that their boards evaluate themselves; for the past three years, this has been one of the top three areas where we are seeing the most companies improve. Companies are increasingly moving from general board-level performance assessments to having individual assessments of each board member and even bringing in an external assessor in some cases to facilitate the board’s evaluation.


Looking at historical data, Europe has led the way in external evaluation for years. Going back three years to mid-2014, 37 per cent of European companies were already using external assessors as part of their evaluation process. (The use of external assessors in Europe compared to the US is unusually high for several reasons, including the UK Combined Code of Corporate Governance, which recommends that an external assessor be used at least every three years.)

American companies show a much more dramatic improvement, but also a much bigger gap; in 2014, 59 per cent of S&P 500 companies and 70 per cent of Russell 3000 companies, only disclosed that they performed a general board assessment. Even then, they did not specify whether it was conducted at the individual director level, or whether they used an external assessor. The disclosed use of external assessors to facilitate board evaluations is still relatively rare in the US.

From the outside in Ethical BoardroomDespite the improvement in disclosures regarding board assessment processes, board evaluation process disclosures often still do not tell investors nearly the volume of information needed, especially regarding the outcomes of the assessments.

After the assessment

Perhaps the biggest question in many investors’ minds is, after the assessment, what happens to the gathered information? Some investors feel that the assessment process has turned into a check-the-box exercise within too many boardrooms. From the board’s perspective, check-the-box behaviour doesn’t necessarily mean that the board isn’t doing anything with the assessment outcomes. Frequently, boards take a standard set of follow-up actions after each set of assessments, such as updating the skill and capability requirements for the next director search. But if the board isn’t working to identify emerging required board skills and capabilities and acting affirmatively to shore up those gaps, it seems that the impact of the board and director assessments doesn’t reach its full potential.

Investors are more concerned about how boards are using assessment data to improve its ability to fulfil its fiduciary responsibilities and maintain a high state of boardroom effectiveness. And they want those impacts to be felt in the near-term, not several years out. In the eyes of many investors, underperforming directors should be afforded the opportunity and means to improve and expectations should be set for that improvement; and if that improvement isn’t realised, the underperforming director should be counselled to step down.

“A few things are certain: the board’s role will continue to become more complex, the skills required will continue to grow and the level of accountability to shareholders will only increase”


But how often does that really happen? How many boards have you served on where a director was permitted to continue to serve – sometimes for years – even though they didn’t make material contributions in the boardroom? It isn’t a secret to investors that some companies allow underperforming directors to continue to serve and even stand for re-election again and again. But in today’s business environment, where shareholders’ expectations about the skills and capabilities of the board are changing and growing, some investors are losing patience with boards that don’t police their own membership effectively.

Unforced director turnover: a controversial signal of board self-regulation

One somewhat controversial measure of how boards are acting on assessments is looking at ‘unforced director turnover’. That’s when a director steps off a board without being compelled to do so – such as hitting a term limit or mandatory retirement age, for instance.

Certainly, boards make an occasional ‘hiring mistake’ and some directors decrease in their effectiveness over time. But it’s surprising – or perhaps it isn’t – to see how infrequently some companies are willing to admit those issues.

Unforced director turnover can be difficult to spot and investors are aware that there can be good reasons for what appears to be unforced director turnover. For instance, some boards adopt their own limits on the number of directorships an individual may have; that can have a ripple effect, causing that director to step down at another board. However, the mere presence of perceived unforced board turnover can be an interesting signal to investors.

The real problem for investors is trying to interpret that signal. Is an unforced turnover situation a sign of a well-functioning board trying to upgrade its membership or is it a case of a high-performing director stepping down from a board where problems may loom? There have certainly been cases of both and similar fact patterns may lead to different interpretations by different investors. But, in either case, a few investors are beginning to use this as a signal for situations to investigate more deeply.

Track record and outcomes: connecting the dots

In the past, the evaluation of a director’s fitness to serve has mainly involved the analysis of that individual’s actions at the company she or he is being elected to serve. But over just the past few years, more and more technology has evolved to allow investors to have a much more holistic view of what directors have done as directors and executives at other companies.

Of course, this often starts with looking at the performance track record of those companies while the director nominee was serving at the outside company. But that’s just the starting point: sophisticated shareholders are now spending more time (usually in high-profile situations) understanding governance, remuneration and activist issues at each of those companies – and the responses that those companies offered to the issues. Especially troublesome are directors that sat on boards where material problems erupted – some investors view those directors as ‘troubled’ and are less excited about them serving on other boards in their investment portfolio. Directors from boards such as Kobe Steel, Wells Fargo, Equifax and even private companies, such as The Weinstein Company, all may face questions from shareholders in public companies where they sit.

Over time, we expect a director’s actions (and in some cases, mere presence) in certain situations at one company to increasingly affect their election results at other companies.

The big caveat: Outside-in board evaluations cannot reveal everything

Outside-in board evaluation is an important step in the due-diligence and engagement preparation process for any investor. But that outside-in analysis cannot reveal everything about the board – and sometimes that analysis is as likely to raise important questions as answer them. Some studies have shown that important boardroom problems often are only seen behind closed doors.

For instance, last year, the Stanford Graduate School of Business released the results of its 2016 Board Of Director Evaluation And Effectiveness survey. The findings of that survey are interesting – in the executive summary, they find that directors frequently report internal issues in areas such as group dynamics (the following list from the report’s executive summary):

Directors do not invite the active participation of all members

  • Directors allow personal or past experience to dominate their perspective
  • Directors do not express their honest opinions in the presence of management
  • Directors are too quick to come to consensus
  • Directors do not understand the boundary between oversight and actively trying to manage the company
  • Fellow board members derail the conversation by introducing issues that are off-topic

But without being in the boardroom, shareholders have a difficult time understanding exactly what dynamics are in play and directors are rarely willing to disclose when they find issues in the boardroom.

Focus on the board not likely to ease

With scandals continuing to occur and board-level risk management practices (among other things) under increasing scrutiny, the list of items that investors are likely to be watching will grow. What is less certain is how assertive shareholders will become and how companies will respond – how will they answer the call for more boardroom transparency? And will investors be willing to hold the board more accountable?

A few things are certain: the board’s role will continue to become more complex, the skills required will continue to grow and the level of accountability to shareholders will only increase.


About the Author:

John Roe is Head of ISS Analytics, a business line of Institutional Shareholder Services focused on developing data and analytics products used by financial market participants, globally. In this capacity, John also oversee the development of ISS’ quantitative methodologies covering compensation evaluation and governance scoring and coordinates the firm’s thought-leadership initiatives.

John frequently speaks at special events such as the New York Stock Exchange Governance Series, the Wall Street Journal Global Compliance Symposium, the Canadian Society of Corporate Secretaries, and the National Association of Stock Plan Professionals. John has been widely quoted in the press on the topics of compensation, governance, and disclosure, including in the Wall Street Journal, Reuters, BusinessWeek, REIT magazine, and numerous local and regional publications. Previously, John led Advisory & Client Service at ISS Corporate Solutions (ICS), a wholly owned subsidiary of Institutional Shareholder Services, where he grew and led a team of governance, executive compensation, and ESG experts.