Blogs & Comment

What are corporate boards ethically obligated to know?

Pressure is mounting on boards to take a firmer grasp of everything from strategy to compensation. But what should be expected?

RBC CEO Dave McKay

RBC CEO Dave McKay, whose compensation soared 44% after his first year. (Kevin van Paassen/Bloomberg/Getty)

Just what are corporate boards obligated to know? More precisely, what lengths are they obligated to go to in order to get to know the things they ought to know?

The topic came to mind when I read today’s story about how the salary of the CEO of Canada’s biggest banks, RBC, had gone up 44% to $10.9 million during his first year on the job. One has to ask: just what information does RBC’s board have at hand that would justify that level of compensation, and that very substantial change in level of compensation?

The question is not a trivial one. In fact, it’s the topic of a program of research we are currently conducting at the Ted Rogers School of Management’s Ted Rogers Leadership Centre. The question, more generally, is about what boards are obligated to know. Of all the things a board could know, which things must it know, in order to do its job properly?

The question turns out to be harder than it sounds. Boards typically need of quite a lot of information, and face plenty of obstacles to getting it.

What do boards need to know? Boards of directors are ethically and legally responsible for the oversight of firms. While it is not the job of directors to manage the firm, it is the job of directors to govern it. Both individually and collectively, directors have fiduciary responsibilities to govern the firm by selecting, paying, guiding, and assisting top management.

Performing those tasks well requires considerable information. In general, directors need to have sufficient information about the firm they are directing, as well as about the industry within which it operates. They need to understand the relevant bits of corporate law, and to have basic financial literacy. With regard to specific decisions, directors may need very special information. With regard to a major strategic decision such as merger or acquisition, for example, directors may need to have detailed information about not one but two organizations, as well as detailed valuations and reliable market forecasts. With regard to setting executive compensation, boards may need not just detailed information about performance, but also information about industry benchmarks as well as information about what a given CEO’s other employment options are.

Why is it so hard for boards to get the right information? The fundamental problem is that most directors are, at least vis-a-vis the specific organization, amateurs. They are (mostly, preferably) outsiders—they are outsiders on purpose—and so by definition they spend much less time in direct contact with the organization than, say, the CEO or other employees. So they are automatically subject to relative information poverty.

The result is that they have to rely on others. Who do they rely on? First and foremost, they rely on insiders, especially the insider with whom they have the most interaction, namely the CEO. But of course, there’s always the worry that the CEO will, shall we say, “filter” information. After all, if no one particularly wants to give the boss bad news, who on earth wants to give the board bad news? Boards also may get information from other firms. The board’s audit committee, for example, ought to be able to get information directly from the firm’s accounting department, but such direct access is not universally available.

Boards also sometimes look to outsiders, a category that includes consultants (such as compensation consultants, strategy consultants, and governance consultants) and professionals (such as external accountants and outside legal counsel). Compensation consultants are a key example here: many large firms make use of those. But anecdotal evidence, at least, suggests that directors often doubt the reliability and value of comp consultants, even after having paid good money for their advice.

That’s why our research is focused on the wide range of structural and procedural principles that we argue boards ought to attend to. The right structures and procedures need to be in place to make sure (or to make it more likely) that boards will be diligent and effective in their pursuit and use of information.

So, for example, how do you ensure that boards will seek and appreciate a wide range of information? Start by having a nominating committee that is dedicated to seeking out real diversity. How do you make sure that boards have the right expertise to make good use of the financial information available to them? Implement a ‘board skills matrix’ to identify gaps in their collective knowledge. How do you make sure that boards make proper use of consultants? Make sure the board has the appropriate budget, but also implement policies to reduce redundant use or other kinds of over-use of consultants of dubious value.

In the end, that’s what governance is about. It’s about not just doing the right things, but putting the right processes in place to make it more likely you’ll do the right things on an ongoing basis. So the shareholders (and other stakeholders) of RBC need to ask not just is David McKay worth $10.9 million, and not just did the board gather the right information in making that decision, but did the board put in place the policies and procedures to make sure that it has the right information, and uses it correctly, on an ongoing basis? That, after all, is what a board is really for.