Meet the New Board — Same as the Old Board

Increased scrutiny from investors, regulators, the media, and other stakeholders is pressuring public companies to refresh their boards of directors to achieve greater diversity. Shareholders have sued at least a dozen public company boards since mid-2020, accusing them of failing to diversify. From July 2020 through June 2021, investment manager BlackRock voted against more than 1,800 directors at close to 1,000 companies for insufficient action to increase board diversity. Proxy advisory firm Institutional Shareholder Services now recommends withholding votes from, or voting against, directors with nominating or governance roles on boards that don’t have at least one non-White director and at least one woman. The Nasdaq exchange, with the approval of the U.S. Securities and Exchange Commission, will soon require listed companies to have at least two demographically diverse directors (or explain why they don’t).

Diverse boards representing a broader range of experience may be better able to quickly navigate volatile business environments and unexpected disruptions, such as a global pandemic. Recent data from BoardReady, a nonprofit group that promotes corporate diversity, found a positive correlation between the diversity of S&P 500 boards and revenue growth during the pandemic.

Despite increased board refreshment — the addition of new directors with an eye toward ensuring that the board has the necessary expertise and breadth of perspective — many companies still struggle to appoint directors who are women, people of color, or members of other underrepresented groups. Our interviews with board directors (see “The Research”) revealed that corporations go through the motions of refreshment but ultimately accomplish little, replacing an outgoing director with someone similar rather than with a person who has a different professional background, identity, or perspective. We also found that the independence of the board’s nominating committee is often compromised by substantial CEO influence over the process, perpetuating a tendency to select directors who reflect the opinions, and often the identity, of senior management.

The result is the persistence of the very problem that refreshment is supposed to solve: board directors with the same narrow demographic profile (White and male) and the same limited expertise. Dysfunctional refreshment processes compromise board independence and effectiveness in overseeing management of the company, which can affect corporate performance.

In this article, we explain how companies seeking to refresh their boards fall prey to the phenomenon of structural elaboration — a process that is intended to further certain goals but in practice undermines them. We examine the challenges of achieving true refreshment, explain how and why those goals are subverted, and propose ways that companies can more effectively refresh their boards.

Vague Definitions, Loose Processes

One of the most significant factors underlying ineffective board refreshment initiatives is a lack of clear definitions and regulatory guidance. We prefer to define refreshment as a regular, ongoing process of assessing and rebalancing a board’s collective skill set, diversity of identity, and diversity of thought in order to provide the most effective oversight and the best fit between board members and the company’s strategic mission and values. But there is, as yet, no commonly accepted understanding of refreshment — which can vary significantly by context — or how to achieve it.

Governance experts often advocate taking passive approaches, like setting director term limits and mandatory retirement ages. But most companies aren’t doing even that. According to the U.S. Spencer Stuart 2021 Board Index, only 6% of boards in the S&P 500 have explicit term limits for nonexecutive directors. Most (73%) of that 6% set the limit at 15 years or more. Boards are more likely to use mandatory retirement to trigger refreshment: Some 70% report having a mandatory retirement age. However, that age is increasing. Half (51%) of boards with a mandatory retirement age set it at 75 or older, according to Spencer Stuart, compared with 48% in 2020 and 20% a decade ago.

Increasing the board’s size to add diversity has become a common practice, but it’s hardly an effective one: Adding one person from an underrepresented group does little to change the dynamics of a group of directors that has worked together for many years.

Another factor contributing to inconsistent goals and approaches to board refreshment is a lack of regulatory guidance on diversity. The SEC does not require companies to disclose information on board demographics. It does require companies to disclose whether, and how, they consider diversity when hiring directors, but the SEC uses the term very broadly. While diversity commonly refers to characteristics such as gender, race, and ethnicity, SEC guidance on the topic includes characteristics such as functional skills and industry experience. This unfortunately leaves the door open for companies to cherry-pick attributes, and many choose to focus primarily on skills and experience.

Such undefined terminology and nonspecific regulatory guidance enables companies to claim — and even to believe — that they are diversifying their boards when in fact they are simply hiring a new director with slightly different skills rather than one with a truly different identity. Our interviews bore this out. Directors told us that searches often start by focusing on a specific industry and a list of skill sets (such as financial expertise). Only after that first cut do they consider diversity factors. In other words, it is an afterthought. Considering diversity only after skills can reinforce existing inequities, because board members typically tap their existing networks — of people similar to themselves — to identify candidates.

The Influence of the CEO

The other major factor undermining board refreshment is the influence of the CEO: Many directors are chosen based on their predisposition to favor the policies of the existing CEO.

Homophily — a strong bias toward people who are similar to oneself — is a persistent problem in the director selection process. If the majority of current and former CEOs are White and male, then most board members tend to be White and male as well. Our interviews revealed that referrals from the CEO and current board members dominate the process, while referrals from search firms play a minor role. The recruiter we interviewed said that CEOs make 50% to 60% of the nominee recommendations and that only about 10% of candidates are unknown to the CEO or the board.

In recent years, many companies have separated the CEO and chairman roles in an attempt to limit CEO power and influence. In addition, the nominating committee is supposed to be made up of independent directors — who do not currently hold executive management positions and who satisfy additional conditions that establish their independence. Nevertheless, directors described the nominating committee as a symbolic rather than substantive player. “There was no independence,” said one interviewee; rather, the board nominating committee’s decision reflected a choice that company management had already made.

CEO influence over a process that is meant to be independent stems from a number of factors. First, the CEO is usually the only insider board member and is thus the main conduit of information about the company to the board — so the board tends to value the CEO’s insight into what skills and experience the company needs. Second, board members need a good working relationship with the CEO. Even if the CEO has not recommended a candidate, most candidates will want to talk with the CEO before accepting an offer to make sure it’s a good fit. Third, the CEO might have better access than the nominating committee to prestigious, high-status candidates.

Best Practices to Freshen Your Board

How can boards avoid these pitfalls and achieve meaningful refreshment? Leaders who want to change the culture of the board should take the following actions.

Focus on diversity of identity and thought in a meaningful way. Boards should specify what they mean by diversity, making sure to explicitly state that diversity of identity encompasses gender, race, and other such attributes. They can then evaluate nominees against that definition. Prudential Financial, for example, specified in its 2021 proxy statement that “ ‘diverse’ includes people of color, women, LGBTQ+, differently-abled, and veterans.” Boards should also encourage nominees to talk about what type of diversity they believe they would bring to the board. These practices will serve companies well, because institutional investors are increasingly demanding public disclosure of such information. In describing its approach to evaluating corporate board diversity, BlackRock has said, “We expect boards to disclose their approach, actions, and progress toward achieving diverse representation, including the demographic profile of the incumbent board.” In addition, new Nasdaq rules require companies listed on its stock exchange to disclose data on the diversity of their board members in terms of race, gender, and LGBTQ+ status. If they don’t have two members who fall into those categories, they must explain why.

Make refreshment, not replacement, the norm, and refresh frequently. Long tenures tend to compromise the true nature of director independence, so set earlier mandatory retirements and shorter term limits. Institutional investors like BlackRock and Vanguard oppose the reelection of directors who have served on a board for more than nine years. Many boards are considering limiting tenure to seven years. In industries where business models and operational contexts change fast, tenures might need to be even shorter.

Boards can also adopt a rotation system, setting, for example, a five-year term for each director, with staggered hiring. This would systematically move some members off the board each year while regularly bringing in new people.

Conducting regular, formal evaluations of individual directors would also be an effective tactic. Today, less than half of S&P 500 boards conduct such evaluations. In a 2021 survey of corporate directors by PwC, 47% of U.S. directors thought that at least one fellow board member should be replaced. Evaluating the board and rebalancing its mix of skills, identities, and perspectives on an ongoing basis will ensure the best fit between the board and the firm’s strategic mission and values.

Activists are focusing on individual director skills when pressuring companies to refresh their boards. In May 2021, activist hedge fund Engine No. 1 successfully pressed ExxonMobil to add three new directors, forcing three existing ones off the board. The hedge fund asserted that the existing directors lacked the appropriate industry experience and were not transitioning the company to a low-carbon future quickly enough.

Limit CEO involvement in director selection. A CEO might recommend that the board consider a particular person, but after that, they should step back from the process. The CEO should not have a vote in the hiring decision, implied or otherwise. A tactic that could help reduce CEO influence over director hiring would be to use an executive session — a board meeting without the CEO or chairman — to discuss board nominees.

In general, boards hold executive sessions when discussing sensitive topics, including CEO performance and compensation, or when there is a scandal of some kind. We think boards could normalize the use of executive sessions and reduce any stigma associated with them by holding them more frequently, including when evaluating director candidates. The New York Stock Exchange requires executive sessions once a year and Nasdaq at least twice a year, although neither specifies that the sessions be used in the nominee search and hiring process.

Work to change culture. Board refreshment and culture go hand in hand. It’s hard to truly refresh an old, stagnant board with new people and ideas unless culture also changes. A group of directors with similar experiences, opinions, skills, and identities will naturally tend toward consensus much too often. In a 2019 PwC survey, 43% of U.S. directors said that it was difficult to voice a dissenting view in the boardroom.

Prompt directors to think about and freely discuss the existing board culture, including their own behavior and whether it needs to change. Consider hiring a consultant to help diagnose and possibly change your board culture. Focus board discussions on constructive interaction, including new ideas and fresh perspectives, rather than consensus. Encourage board members to voice their opinions, especially when they challenge the consensus. And reward directors who bring fresh insight and new dynamics to the board, perhaps giving them higher profiles through special assignments.

Define and clearly state what values and behaviors you expect from board members, then evaluate current directors against those expectations. Evaluating director candidates in the same way can help bring in new people who may help change the culture.

Regulators and investors are paying more attention to board refreshment and diversity. Companies can head off potential trouble by improving how they nominate and hire new directors. Hiring a director with the same attributes as their predecessor is not board refreshment, but rather replacement. Our research highlights the practices that are confounding efforts to include new people with diverse identities and perspectives. By identifying and understanding current practices and the risks they pose, companies can amend their processes to ensure that they invigorate their boards with new types of people and fresh thinking, which will benefit the company and its stakeholders.