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The Recommended Practices in Forming the Boards of Directors

21-Sep-2022

By: Alaa Abdul Aziz Abu Naba’a

MACC, CIA, CPA, CRMA, CICP

Expert in Internal Auditing, Control, and Governance

Other than the content of the regulations or rules of governance of public entities, profit-making, and non-profit organizations, issued by competent bodies in several countries; which define the criteria of the board formation, the maximum and minimum numbers of members, the number of executives, non-executive and independent members, putting in consideration the importance of the size and nature of the organization’s activities, the roles and responsibilities of the board and its members, as well as the practical experience, knowledge, specialized skills, personal traits (that are collectively known as “competencies”), etc..  In this article, I will address a range of recommended practices relevant to this topic, which will enhance the effectiveness of boards.

The Role of the Nomination Committee in Forming the Boards of Directors

The appointment process of a board member differs from that of senior executives in one main aspect, in appointing the executives, the organization prepares a list of the best candidates, interviews them, then selects the best candidates based on the assessment of the best competencies and qualifications. On the other hand, in appointing the board members, the organization prepares a list of the best candidates, giving priority to the candidates with the best competencies, then the list is introduced to shareholders for voting.  

The nomination committee of the board, if any, is responsible for recommending clear policies and criteria for the board membership and should give recommendations for the board about the nomination of new members or reelection of the current members, in addition to the preparation of a description of the competencies required for the board membership. Moreover, the nomination committee should periodically review the organization’s needs for appropriate competencies, and it should provide a job description for all the members, define the strengths and weaknesses of the board, and suggest solutions to handle the weaknesses in accordance with the best interest of the organization. 

The method of preparing the list of candidates differs from one organization to another. Some organizations highly rely on the personal and professional relations networks of the current CEO or board members, while others rely on a third-party consultant or research firms to prepare the list of candidates from a wider range of candidates.   According to the National Association of Corporate Directors (NACD), about 50% of the US organizations use the services of a third-party company to help them in the process of finding the needed candidates.

In the preparation of the list, the composition of a board that meets the strategic, operational, and practical needs of the organization should be considered. It is also essential to consider that the culture of the board should reflect the culture of the organization, along with maintaining a good relation between the board members and the senior management.

The Impact of the Most Prominent Risks that Concern the Boards of Directors

Many of the modern studies indicated the five below risks as the most prominent risks that threaten the strategic and operational levels of boards; such risks have a direct effect on the selection process of the board members who shall manage such risks:

1. The global and domestic economic conditions that cause deterioration in the growth opportunities;

2. The change and strictness of the legal requirements;

3. The information security, privacy, and threats of cyber breaches that might disrupt key operations and/ or damage the reputation. 

4. The rapid development and the emergence of new technologies, which may disrupt the business model of the organization.

5. Attracting and maintaining talented individuals and leaders, and the difficulties of job replacement.

    

   Succession Planning

Succession planning is one of the key responsibilities of the nomination committee.  Many organizations do not keep an updated list of the potential candidates of the board members in anticipation of any sudden unplanned succession, assuming that the board will be able to go on without one of its members.  Therefore, it is recommended that the nomination committee considers the determination of essential and/or crucial roles in the board that are necessary for running the organization, it also should define and assess the potential successors for prospective opportunities.

Succession planning ensures the smoothness and sustainability of the workflow in the board by enabling the board to consider the overall future goals of the organization as a whole. 

Members Rotation

Many studies have indicated that regarding the governance practices in the developed countries, 20-30% of the new board members are first-time members, (i.e., they did not occupy such positions before).

In June 2016, the American review “Chief Executive” published the findings of the study of the relation between the “market value of firms” and “the term of service of the board members”, in 3000 firms. The most prominent findings of the study indicated that there is a significant correlation between the market value of the firm and the term of service of the board members, as the longer the average term of service of the board member, the more the increase in the market value of the firm. However, the increase will go on for an average of 8-9 years, then a rapid decline in the market value will be witnessed.

The Most Important Factors that Affect the Number of Board Members:

According to the recommended practices, a periodic revision of the regulation of the board, at least once every 1-3 years, should be conducted, among the issues that should be highlighted is the suitable number of the board’s members, taking the following in consideration: 

1. Statutory requirements.

2. The maturity level of the organization and the work environment.

3. The size of the organization and the diversity and complexity of its operations.

4. The competence level of members.

5. Quorum difficulty level.

6. The Cost.

    

   The Required Qualifications for the Members of the Board of Directors at the Individual and Collective Levels

The nomination of the board members is one of the main responsibilities of the nomination committee. The process usually begins with an assessment of the organization's needs and an identification of the deficiencies in the targeted competencies of the board, then a list of potential candidates whose competencies should fill the gap of the identified deficiencies is prepared. The list may include members that did not previously occupy such positions. Perhaps, for this reason, more than half of the organizations in the developed countries are open to hiring board members who have no previous experience in board membership, because organizational compliance (the board’s responsibilities and competencies, obligations as a member, and rights) can be easily learned compared to the rest required competencies.

I: The Required Competencies on the Individual Level:-

On the individual level, the board members should possess knowledge according to the three following levels:

1. Proficiency: Proficiency is the ability to use knowledge in situations that are likely to occur, and handle such situations without having to refer extensively to research and technical assistance, hence it is recommended for the board member to have full knowledge of the following eight areas: domestic and international markets, industry, operations, laws and regulations, technology, accounting and financials, control, and risk management. 

2. Understanding: Understanding is the ability to use general knowledge in situations which are likely to occur, in order to detect the significant deviations from the correct norms and work methods, and to be able to conduct the needed research to find reasonable solutions. That’s why a board member should have an average level of knowledge of at least two areas of the below eight areas:  domestic and international markets, industry, operations, laws and regulations, technology, accounting and financials, control, and risk management. 

3. Appreciation: Appreciation is the ability to detect the obstacles or anticipate their occurrence, determine the additional needed research, or the needed assistance.  Therefore, it is recommended that a board member should have (not expected to be proficient at) an understanding of the fundamentals of management (organization, planning, direction, and control), leadership skills, communication skills, and critical thinking, as well as the knowledge in some areas such as governance, reading and understanding of financial statements and reports, economics, commercial laws, taxes, and information technology.

    

   Board members should demonstrate their competencies through the development of their skills, knowledge, and expertise relevant to the activities of the organization.
   II: The Required Competencies at the Collective Level:

Collectively, it is recommended that board members should have, together, the needed information, experience, and skills to perfectly carry out the responsibilities assigned to them by regulations and governance systems.

Based on the above; if we assume that we want to form a board of directors of nine members, the following table shows the distribution of areas of knowledge and experience expected of them, assuming that they all have knowledge (level three) in governance, reading and understanding of financial statements and reports, strategic planning, and other disciplines.

One of the matters that many of the rules of governance focus on: the ongoing training and qualification of the board members, according to the saying of “Al Farouq”, Omar Ibn Al-Khattab, may Allah be pleased with him," Learn before you lead”.

The formation of boards of directors in the Arab world may be one of the topics that have not been in the focus of the legislative and regulatory authorities, or research and development centers. Therefore, I recommend that consideration be directed to this important topic to achieve higher levels of corporate governance, which will benefit the rest of the activities of economies in all countries.

In conclusion, there is no successful and failed organization, but there is a successful board of directors and a failed board of directors.