The right stuff

Shareholders and companies alike are acknowledging the benefits of annual elections. A study from Institutional Shareholder Services (ISS) reports 55 percent of S&P 500 companies declassified their boards in 2006, putting directors up for yearly review. This greater accountability might be just the thing needed to push boards to better performance and help reform under-addressed areas like succession planning. Indeed, certain companies are demonstrating a correlation between declassification and stronger succession planning.

There are a lot of positives in declassifying. Companies caught up in compensation scandals are finding that annual elections are a useful tool to reestablish shareholder approval. For example, UnitedHealth Group voted to declassify at the height of the options backdating struggles involving its chief executive. The inference is that if directors are up for annual elections, they will be more careful in management selection. The other plus is that yearly elections give shareholders the feeling that they are able to voice concerns via the ballot box when it comes to proxy season.

Stimulus for change isn’t limited to shareholders. Management is pushing the envelope with even more vigor. ‘In the last two years we’ve actually seen more management proposals on ballots to repeal classified structures than we’ve seen shareholders asking to destagger their terms,’ says ISS’ executive vice president and special counsel Patrick McGurn. Surveys of director dissatisfaction show they are also unhappy with the state of succession planning, according to a corporate governance executive.

Some companies consider declassification key to good governance. ‘We’ve had a declassified board for ages,’ says American Express corporate secretary Darla Stuckey. ‘It was thought to be best practice at the time to elect everybody annually.’

Financial Guaranty Insurance Corporation (FGIC) managing director, associate general counsel and secretary Robert Lamm, though, says there is no right structure. ‘Good boards are thinking about succession planning, regardless of whether they’re declassified or classified,’ he says. ‘[They] don’t really care if they’re classified and therefore they won’t be.’

Nonetheless, ridding the board of entrenched directors is in line with companies’ growing antagonism toward poison pills and other takeover defenses. For shareholders and boards, the demise of the staggered board provides the former greater rights and the latter a catalyst for change.

Switching sides

The debate over whether declassified or classified boards foster strength is shifting. Formerly, it was thought that the takeover defenses provided by a classified board structure fortified a company. Now, it is believed that declassification promotes strength through greater accountability. ‘I really don’t believe in classified boards,’ says Lamm. ‘Boards have a legitimate responsibility to defend the company against hostile actions.’

Enron and WorldCom taught shareholders that boards didn’t necessarily know what was best. McGurn thinks scandals may have a hand in prompting boards to declassify. ‘It’s no longer the CEO’s board,’ he says. ‘Boards can discipline or terminate leaders when necessary.’

UnitedHealth lost several board members last year, then recommended declassification in May 2006 after its options backdating shake-up. In response to the debacle, UnitedHealth secretary David Lubben announced plans to fill five board seats with new independent directors over the next three years. Spokesman Don Nathan thinks it’s too soon to tell whether succession-planning structures will change. ‘It’s something that the board would have to answer,’ he says. ‘The recommendation to shareholders that directors be elected by majority vote is part of the board’s commitment to advance the company’s commitment to governance.’

McGurn says ‘all a declassified board structure does is change one mechanism of accountability: each director will be up at every annual meeting.’ FirstEnergy corporate secretary David Whitehead is dubious about the extent of change annual elections will enable: ‘Even though you have annual elections, you could still have a number of board members elected annually over a number of years.’ Director of pension and policy at the American Federation of State, County and Municipal Employees (AFSCME) Richard Ferlauto says although annual elections ‘mean more accountability,’ they won’t entirely absolve the board of conflict.

In spite of irresolute prospects, McGurn thinks the renewed monitoring function, which holds boards accountable, could improve succession planning. NYSE listing standards making succession planning (and disclosure) part of board responsibility also suggest improved succession planning is on the horizon.

Trendsetters

Only 45 percent of S&P 500 companies maintain staggered boards, compared with 53 percent last year. In a 2006 study by ISS, average shareholder support for proposals to declassify boards among S&P 500 companies skyrocketed to 65 percent. Firms in the S&P MidCap and SmallCap indices are following suit, but have yet to show such dramatic advances.

Some companies are leading the trend to declassify. Last April Staples made the bold move to issue proxy materials requesting shareholders vote in favor of declassification to help ‘maintain and enhance the accountability’ of its board members. Bed Bath & Beyond and Kroger also recently put a stop to staggered boards.

After voting to declassify some companies let existing director terms run their course, which means the board continues to be staggered up to three years after the crossover. In 2004, 15.5 percent of declassifying boards took this route, including FirstEnergy, Manor Care and The Dow Chemical Company. ‘For us going from classified to non-classified was a non-event,’ says Richard Parr, vice president and general counsel at Manor Care. ‘We have pretty robust corporate governance anyway.’ He demurs on whether succession planning will change once declassification comes into effect.

Whitehead also says changes in succession planning at FirstEnergy will be difficult to predict: ‘If there were to be an overhauling of our board in a given year, you’d never know exactly when it would be.’ Though he says ‘I can’t tell you we’d do anything significantly different,’ he thinks variation on the board in age and expertise will improve decision making in succession planning.

New strategies

Annual elections could redefine the topography, spurring boards to amend disparaged board practices. ‘Succession planning is one of those areas where most boards admit that they’ve failed,’ says McGurn. ‘The board is there to monitor the performance of senior management and if necessary to change management.

Elevated monitoring on the board resulting from declassification will hopefully diminish malcontent in succession planning. New studies suggest the interest in this area is high. A 2007 report on succession planning by Colin Thompson, executive editor of Europe’s Print Manufacturing Plants, illustrates modern succession planning tactics. A 2006 succession planning survey report from the Society for Human Resource Management states ‘more than half of human resource (HR) professionals surveyed indicated that their organization has either a formal or informal succession plan in place.’

Good succession planning is integral to ‘any organization’s continuity strategy,’ says Thompson. Though HR serves a primary role in ‘implementing initiatives and leading succession planning efforts,’ responsibility for resources often falls to the president or to the CEO.

Thompson highlights the importance of identifying and developing internal talent: ‘84 percent of organizations’ succession plans utilize structured methods to evaluate employees annual performance.’ The report also stresses long-term focus and assessing future skills.

Corporate secretaries ground Thompson’s findings in practical methodologies. Lamm emphasizes the importance of strategies like a rights plan. ‘As long as we have that kind of mechanism in place that allows boards time to think, I don’t think a classified or a declassified board is going to think any better,’ he says. A corporate governance executive at a major investment management firm suggests infrastructures to develop internal talent make for better succession choices.

Taking the long view

Succession planning is problematic. Thompson’s report cites evidence that ‘outsiders in top jobs stayed for a short time’ stimulates renewed concern: ‘Companies made changes that looked superficially good but which were perhaps not in the long-term interests of the organization, and moved on before their sins could find them out.’ A prominent corporate governance executive concurs that outside directors fail more often.

In this climate of management upheaval, examining the short-term and long-term potential of successors is vital. When Mark Hurd took the reins as CEO of Hewlett-Packard in 2005, he was a relative unknown hired from the outside. In his first year, the stock went up 40 percent. Then the board-directed spying saga erupted. Hurd claims his focus was not on governance because it was not the most pressing factor at the time. Perhaps a long-time insider would have tuned into the board dysfunction sooner.

Home Depot’s hiring of outside CEO Robert Nardelli was great in the short run; he upped company profits significantly. It wasn’t until later that he came under fire from shareholders for his excessive compensation package, an issue that exploded in a disastrous annual shareholder’s meeting at which none of the company’s directors appeared. After the fact, it’s easy to say inside talent might have been the better choice. Either way, short-term solutions to boost share price can become long-run problems.

And it would seem the fraught corporation isn’t learning from its succession errors; the corporation is rapidly losing board members who might have provided insight into what works at Home Depot. In March, directors Thomas Ridge and Angelo Mozilo opted out of re-election for the May annual meeting, and four members will reach retirement age by 2008. Even if insight is garnered from mistakes, it can still lead to informed succession choices.

Thompson cautions that bringing in outsiders should not be overdone. A failing business needs to recruit from outside to satisfy investors, he admits. But companies might be better served developing their own talent than by recruiting and paying off failures.

Long-term financial security hinges on developing people who understand the organization’s culture. ‘Those responsible for succession planning need to know as much as possible about the future of the business,’ says Thompson. The case for inside talent could refute companies’ knee jerk reaction to conflict: hiring outside CEOs. And annual elections mean directors have more at stake with respect to satisfying shareholders, which could see directors looking inward for talent.