CHAPTER 5

Governance of the Business

The Board of Directors

In the United States, officers of the corporation must be elected, and an annual meeting with recorded notes is required. It is a requirement to establish a board of directors (BOD) when creating a new corporation. The directors have the responsibility and authority of providing effective oversight of the corporation. They have the obligation and responsibility to hire and terminate the CEO and the TMT. The purpose of the board is to provide a system of checks and balances to ensure oversight, help provide accountability, and make recommendations to the TMT. A BOD is not like a board of advisors who merely provide advice, when the BOD makes recommendations, the management must comply.

Smaller family firms often do not utilize a BOD, instead opting for the founder and spouse in the early days to be the “board” (informal governance), and in later years the family council serves this purpose.

Suggested Sample of Board of Directors’ (BOD) Objectives

A primary responsibility of the BOD is to consider the business separately from the needs of the family. The needs of the family are to be discussed in the family council. The family council representatives make recommendations to the BOD on behalf of the family.

Awareness of proper and effective corporate governance has been on the increase in many countries around the world. Because of ethical lapses of companies such as Tyco, WorldCom, and Enron, as well as Arthur Andersen, governments and regulating bodies have increased governance guidelines and expectations for corporations. Since the Great Recession, the pressure on corporations to be good corporate citizens and to act in a responsible manner has increased, not just in the United States, but internationally as well. There has been an increased focus on the stakeholders of a firm, transparency, independent directors, and accountability. Good corporate governance can help accomplish these goals. Investors are also demanding increased governance. A survey of investors showed that they value good governance as being on par with financial considerations when evaluating investments. Investors have also been shown to pay a premium for investing into a firm with high standards of governance (McKinsey & Company 2002).

In the United States, stock market changes and SEC changes tightened and increased corporate governance requirements. The Sarbanes–Oxley Financial Accountability Act (Sarbox) was put into place in 2002 in response to the failings and ethical misdeeds of companies in the 1990s. This act concerns itself primarily with public companies; however, many banks and other stakeholders are requiring that privately held firms align themselves with Sarbox as well. A major concern of Sarbox was that many BODs were found to be overweight with insiders and friends of the CEO. In family firms especially, the boards mainly consisted of insiders and family members who would be loyal to the family leader. Because of the revised regulations, boards are now required to have a balance between inside directors, outside directors, and management.

Boards now have a legal responsibility to oversee the business, and not just to rubberstamp the desires of the CEO. Board members have professional liability if they do not act with the best intentions for the stockholders. Company officers now must sign their name on the financial statements stating as to there their accuracy, and not mislead stockholders. The penalty for failure can be severe, up to incarceration. Penalties for fraud and bribery were increased. Another major emphasis was to make sure companies treated all shareholders equally, including minority (small) shareholders. This has had a huge impact on publicly owned family firms, which commonly made decisions that benefited only the family. As an example of the newer regulations, Robert Mondavi Corporation was forced to sell his family-owned wine company even though he had a significant majority of the stock. The minority shareholders were appalled, became very vocal, and threatened a lawsuit when the firm did not accept an overly generous buyout offer from Constellation Brands. Robert Mondavi did not want to sell the firm that he started, but wanted to pass it on to his son (Siler 2007). The regulations stated that all shareholders (including minor shareholders) needed to be treated with fairness. This should be a cautionary tale to family firms considering going public.

Instituting a BOD is a major area of opportunity for many family firms to improve their corporate governance and company performance. Research has shown that improved decision making occurs in family firms with strong, active boards (Mustakallio & Autio 2001; Mustakallio, Autio, and Zahra 2002; Ward 1988). Research has shown that the contribution of effective BODs made firms less likely to go out of business and they exhibited increased performance compared with their peers (Brenes, Madrigal, and Requena 2009; Wilson, Wright, and Scholes 2017).

Family businesses with strong BODs have been shown to be more effective and have improved decision-making ability (Eddleston, Otondo, and Kellermanns 2008). The research is clear on this point. This is partially due to the beneficial aspects of conflict. Not all conflict is bad; there are also positive forms of conflict such as work-task conflict where there is a healthy debate regarding the best way to do the work. This leads to better decision making (Kellermanns and Eddleston 2004; Eisenhardt, Kahwajy, and Bourgeois 1997; Eddleston and Kellermanns 2007). Diversity of opinion and good debate lead to directors having open communication concerning issues of importance. At board meetings now, viewpoints are presented that normally would have been muted in the past by the amount of insider’s present. By discussing a variety of ideas and solutions to problems, family businesses make better decisions (Aronoff and Astrachan 1996).

Research shows that the more frequently the board meets, the better its performance. Twelve meetings a year is best with four meetings a year the new minimum. Increased board-meeting frequency leads to better knowledge of the business in the case of nonfamily board members, as well as increased commitment and participation (Brenes, Madrigal, and Requina 2009). The vast majority of firms who have a BOD rate its contribution as good to excellent (MassMutual 2002). An updated PWC study shows an increase in the number of family firms utilizing BODs over the last decade. In a survey of 147 family-owned and owner-operated firms, 59 percent reported having a formal BOD (PWC 2014).

To create good debate and foster constructive and positive conflict, the board must have nonfamily members serving on it, as well as people from outside the firm. The usefulness of a BOD, whose membership consists of those with significant experience outside the family and the business, is especially apparent when the firm is run by a charismatic and very powerfully assertive founder or other family member. A broader range of ideas, suggestions, and recommendations can now be discussed, especially those not previously seen as favorable by the family member in control. It is easy to comprehend the difficulty of voting against a father or other relative, especially if this relative is in a senior position. When income, wealth, and future employment are intertwined, having full communication with powerful family members can be difficult.

Research shows that BODs that are balanced between insiders and outsiders enhance company management by adding objectivity. Having nonfamily board members was seen as enabling confidence and trust for family members not active at the firm. Results show that contributions from both family and nonfamily directors complement each other. Family board members have valued experience and knowledge of their business. Conversely, nonfamily board members provide objective vision and a more professional viewpoint. Nonfamily board members often act as arbitrators to help solve conflict in the business and within the family. This provides family members with valued objectivity, which can only be provided by someone outside the family. This helps to prevent resentment and the risk of poor family unity (Brenes et al. 2009).

Herschend Family Entertainment is the largest family-owned entertainment company in the United States with over 10,000 employees spread over six states. It has been family-owned and operated since its inception (http://www.hfecorp.com). It is governed by a BOD of which half consists of outsiders. For a privately held firm, this is a relatively uncommon, yet professional way to govern the business (Bloomberg.com 2018).

Director Compensation

In a large publicly held company, the compensation for directors can be quite large and ranges to hundreds of thousands of dollars, often with awards of stock in the company. In a smaller family business, some firms have begun paying directors the same daily rate as the company CEO. In the 6th Annual 2016 Private Company Board Compensation Survey by Lodestone Global and Forbes Magazine, the average retainer was $24,000 a year with $2,500 per meeting and $1,000 per telephone conference. In total, the median was $36,000 a year. Eighty-nine percent of private companies use cash and 34 percent use equity (stock). The survey reported that the average number of board seats was six with three outsiders. Fifty-seven percent of the boards had a woman member up from 55 percent the previous year. Fifty percent of the respondents of the survey were family-owned businesses. Nearly 50 percent of respondents rated the contribution of the board as indispensable or very effective at driving corporate strategy. The survey included 331 companies in 33 different industries and 39 countries (Tennenbaum 2016).

Duality of Roles: Chairman and CEO

In many firms, the chairman of the board also serves as the CEO. They are serving in dual roles. The BOD’ responsibility is to provide oversight of the business. This responsibility includes oversight of upper management, including the CEO. The directors have hiring and firing authority over the CEO. It is not hard to see the conflict of interest in one person serving in both roles. However, in a family-owned firm or a family-controlled firm, it is especially common specifically among the first generation to have the founder serve in both these roles. The research has shown some conflicting results. However, the latest research shows that the CEO duality issue does not seem to be a problem with the first-generation founder-led organizations. It makes intuitive sense: The original entrepreneur and founder is the reason the firm is successful. The founder should be allowed to run the company as they see fit. The requirement to have an extra layer of decision making, oversight, and the resulting slowdown in communication would be a disadvantage to a small fast-growing organization. In a small founder-led firm, there is not much of a need for the oversight function of the chair of the BOD to be separated from the CEO. The data show that it becomes more of a problem in the later generations (Miller, Le Breton-Miller, and Lester 2011). Other research has shown eliminating the dual roles is not a “panacea” but it is a very complicated issue and one that needs consideration of many variables, such as how strong the leadership and TMT are, the generational stage, board compensation, executive compensation, and level of family control. Braun and Sharma (2007) found nonduality was negatively related to the level of family ownership. This is a counterintuitive finding and suggests rising ownership of nonfamily owners could create conflicts within the power structure itself and cause poor performance. They showed splitting the roles may reduce agency problem II, that of controlling owners negatively dominating over minority shareholders.

Warren Buffet has served on the boards of 19 public firms and believes the roles should be separated to avoid a conflict of interest. When the CEO is underperforming, the dual roles delay making a change in CEOs (Buffet 2014). As of 2018, Buffet’s company Berkshire Hathaway Inc. had 14 members of their board. Of the 14, six are insiders, including Buffet, Jim Buffet (his son), and his partner Charlie Munger. Buffet, however, does serve in multiple roles at his company, as chairman of the board, president, and CEO. He has divided up key managerial roles among four business units. This is an example of the complexity of corporate governance. What works for one firm or may be thought of as a best practice, may not work for another firm. Buffet is widely believed to be one of the best, if not the best investor of all time. No one is suggesting that he not hold dual roles. The company has succeeded greatly because of him and there is no reason to change. The company grew to become one of the largest firms in the country because of his knowledge and skill. When Buffet retires, however, the positions will more than likely be occupied by several people (Berkshire Hathaway Inc. 2018).

In late 2018, Tesla CEO Elon Musk was sued by the SEC for comments made regarding a large Saudi investment in Tesla. The announcement made the stock rise, which hurt short sellers (those with options betting the firm would decline). The government accused him of manipulating the market. The settlement was a $20 million fine, the loss of his position as chairman of the board, and the forced addition of two independent members to the board (O’Kane 2018).

Board Committees

As part of their major responsibility, that of overseeing the TMT, there are several committees the directors participate in depending on their level of experience and familiarity. The very crucial audit committee is tasked with overseeing the financials and verifying they are accurate and represent the true financial standing of the business. Directors with financial expertise would be required for this committee. The compensation committee conducts research to benchmark effective and current pay scales for management and key employees. The nominating committee conducts research, recruits, and makes recommendations for future directors to join the board.

How the Board Interacts with the Family

The family council and the shareholder’s council are the two main mechanisms of governance that interact with the board. The family council will elect a family member to represent the family’s wishes and who will sit on the board as a full member/director. The council can request board updates. The shareholder council will be in communication with the board as well as with the TMT. It is at the shareholders annual meeting that the board members are elected or re-elected.

Insiders and Outsiders

In the past, controlling owners would often load their board with family members. In the case of the family-controlled firm, they would load it with friends and allies and a few key family members. This defeats the purpose of a strong and independent BOD that can provide oversight, offer advice, and make recommendations to management. The regulations now state there must be a balance of inside company directors and outside company directors. For publicly held, but family-controlled, firms, the New York Stock Exchange rules permit certain governance exemptions, such as a lower number of outsiders on family-controlled boards.

Multibillion-dollar worldwide media company and family-controlled News Corp is controlled by Rupert Murdoch and his family using two-tiered stock (Carr 2012). He has recently put his two sons on the board, Lachlan his heir apparent and his younger son James. James has a dual role of being a board member and serving as the CEO of 21st Century Fox. Murdoch himself held both the chairman and the CEO role recently (Carr 2012). With dual classes of stock, Murdoch controls a significant majority of the votes and can select board members for their loyalty. Out of the 11 board members, six can be considered insiders; Natalie Bancroft is a former opera singer and member of the Bancroft family who sold the Wall Street Journal to Murdoch. Jose Maria Aznar is the former president of Spain and a friend of Murdoch. Three of the board seats are filled by Murdoch and his sons, and five are possibly outsiders. As is commonly seen, the upper management roles are filled with family members (Newscorp.com 2018). Each director makes over $200,000 per year in compensation (Carr 2012).

The family-controlled Estee Lauder Companies has 17 members on their BOD. Only five can be considered insiders, including four Lauder family members and the President and Chief Executive Officer Fabrizio Freda. It is interesting to note the wide variety of experience on the board: there is an attorney, several finance and banking experts, a tech expert, and Irvine Hockaday Jr., who was the president and CEO of Hallmark Cards, Inc., a family-owned company. This is important as he understands the complexities of a family business.

Estee Lauder Board of Directors (2018)

Century-old, family-controlled Ford Motor company has 10 directors on its board including William Clay Ford Jr., the executive chairman, and Edsel B. Ford II. In addition, they have one other insider, the company President and CEO Jim Hackett (Ford.com 2018). Of the Ford board, 70 percent can be considered outsiders; however, the Ford family controls 40 percent of the votes with their super shares even though they only own approximately 2 percent of the stock (Muller 2010). This provides the family with a dominant amount of control.

Choosing Independent Directors

Family-business owners who had boards with two or more outside directors felt their boards had contributed to the effective management of their company. The following are the benefits of having outsiders on the board:

See Appendix C for the International Finance Corporation Definition of an Independent Director.

Design and Creation of a BOD

Ideally, the family council will have created a written policy covering board member selection, which specifies the criteria for director selection as well as the process for recruitment, evaluation, and approval by the shareholders. By having the family council write this document, there should be some consensus agreement or buy in by a majority of the family members.

The best candidates for a board member are successful peers. CEOs and other high-level executives from other private or closely held companies would add value because they know the challenges of a closely held firm. It will also benefit family firms to have some directors from large Fortune 500 firms. The benefit of a board is the experience and knowledge each member brings. If a company was expecting an upcoming leadership succession to the next generation, it would be ideal to have someone on the board who has previously gone through the process. Similarly, if a business is considering expanding internationally; a board member with international experience would be highly desirable.

Board Evaluation

An area of improvement for family firms is with board evaluation. Few companies evaluate boards. Of those that do, research shows that the greater the evaluation of a board’s performance, the better the company performs. Some firms use an evaluation questionnaire at the end of every director’s tenure. Other firms interview board members and provide individual evaluations (Brenes et al. 2009). Family firms should do a better job conducting formal evaluations of their board’s performance.

Statement of Corporate Governance

Most firms publish a document on their website discussing how the firm is governed and the responsibilities and procedures of the BOD (see Berkshire Hathaway’s Corporate Governance Guidelines in Appendix A).

Summary

In summary, although the research on the increased professionalism and improved decision making with the usage of boards is clear, each family business is unique. There is no prescription for the best or ideal way to institute a BOD. All factors need to be taken into consideration, such as each family is different, industries are different, economies vary, family makeup varies, which generation is in control, size of the firm, and so on. The best way to institute a BOD would be to do what is best for that particular business and family.