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Economic Affairs

Strategic boards: The role of non-executive directors

Non-executive directors can help steer companies' strategy in turbulent times - but only if they are engaged properly

Since the global financial crisis in 2008, equity markets have been through a volatile period, with the current weakness in global economic growth roiling investor confidence. In such tumultuous moments, investors are naturally concerned with the strategic responses of their firms. In particular, there is an increasing interest in the strategic role of corporate boards.

Recently, the Singapore Board of Directors Survey 2015, jointly organised by the Singapore Institute of Directors and the Singapore Exchange (SGX), reported that 55 per cent of survey respondents (comprising SGX-listed companies) dedicated at least one board strategy session in the past year.

The 2015 Board Survey also reported that respondents viewed strategy development and strategy execution as among the top three areas that the board considered to be the most important, while 90 per cent of respondents used indicators to monitor strategy execution.

The survey results are consistent with the expectations of the legal and governance ecosystem in Singapore which views corporate boards as essential instruments in providing strategic direction.

For instance, Section 157A of the Companies Act mandates that a company's business shall be "managed by, or under the direction or supervision of, the directors".

Similarly, Guideline 1.1 of the 2012 Code of Corporate Governance states that a board's role includes providing entrepreneurial leadership, setting strategic objectives and considering sustainability issues during strategic formulation.

TALL ORDER FOR NON-EXECUTIVE DIRECTORS

While it is not difficult to understand the rationale for corporate boards to be more involved in strategic decisions, effective implementation is fraught with difficulties.

To appreciate the challenges, one must be mindful that corporate boards are made up of executive and non-executive directors. Executive directors, as top executives of the firm, are naturally involved in strategy formulation and implementation.


ST ILLUSTRATION: MANNY FRANCISCO

For corporate boards to be involved in strategic decision-making beyond what executive directors are already doing, firms have to adopt policies and implement processes that seek the inputs of non-executive directors in strategic decisions. Simply including strategic issues in the board meeting agenda is not going to cut it if executive directors eventually dominate the discussions and strongly influence the decision.

Involving non-executive directors in strategic decisions may enrich decision outcomes. However, plucking this seemingly low-hanging fruit is also fraught with substantial difficulties.

First, non-executive directors may not be familiar with the strengths and weaknesses of the firms where they serve; neither might they be familiar with the opportunities and threats that these firms face in the local environment.

The unfamiliarity may be compounded in complex and large firms that operate in multiple countries with diverse institutional and competitive environments. Not surprisingly, the 2015 Board Survey reported that SGX-listed companies view business expertise in industry, markets, competition and geography as the most important knowledge to look for in potential directors.

Knowledge of the internal and external conditions of a firm and its operating environments is critical in formulating strategies and monitoring the effectiveness of these strategies. For instance, without the relevant experience, non-executive directors are more likely to rely on the information provided by the CEO or other executive directors when making decisions.

In addition, non-executive directors who lack knowledge may be less willing to challenge the information provided by top executives to avoid the perception of ignorance and are thus more willing to rubber-stamp the proposals of top executives.

Second, an unintended negative consequence of substantive non-executive director involvement in strategic decision- making is losing their objectivity.

Research in behavioural economics has uncovered a host of decision-making biases that reduce the effectiveness of decisions. In particular, two biases may be exacerbated if non-executive directors were to plunge headlong into the world of strategy without understanding the risks involved.

The first is commonly known as confirmation bias, which essentially means that decision-makers unconsciously seek out (or ignore) information that confirms (or disconfirms) their initial judgment.

The second bias is known as anchor and adjustment, where decision-makers often make insufficient adjustments to initial estimates that inform decision- making.

STRATEGIC MANAGEMENT VERSUS CONTROL

One view of corporate governance suggests that the strategy process should be separated into strategic management and strategic control. The former, comprising strategic formulation and implementation, is the responsibility of management. Strategic control, however, is the responsibility of the corporate board, and includes decision evaluation and approval.

According to this view, the task of strategic control essentially rests on the shoulders of non-executive directors, since executive directors are involved in strategic formulation and implementation. In other words, non-executive directors are not actively initiating strategic proposals, but will play a key role in evaluating strategic initiatives proposed by top executives, selecting the initiatives to be implemented and monitoring the implementation outcome.

When non-executive directors are also substantively involved in strategic formulation, they will lose their objectivity and are more likely to be biased when discharging their strategic control role.

One perverse manifestation of confirmation bias is to attribute lower-than-expected performance to poor strategic implementation when the root cause of the problem is the appropriateness of the strategy. Similarly, non-executive directors will find difficulty adjusting initial estimates made during strategic formulation when they subsequently perform their strategic control role.

These biases are counter- effective as firms risk sticking to a current strategy when an appropriate response may be a significant strategic change.

A MEASURED APPROACH

The challenges of unfamiliarity and loss of objectivity highlighted above are not insurmountable. As a start, corporate boards and other stakeholders must understand that there is no one-size-fits-all model of governance, including the level of non-executive director involvement in strategic formulation.

Corporate boards must carefully weigh the costs and benefits of involving non-executive directors substantively in strategic formulation. At a minimum, non-executive directors should provide advice and counsel in the strategic formulation process.

Beyond this, the benefits of greater involvement are likely to be contingent on situational factors. For instance, younger top executives in smaller firms are likely to benefit from more involvement during strategy formulation by experienced non-executive directors, especially those who previously held top executive appointments in similar industries.

Furthermore, the potential costs of such involvement may be mitigated by implementing appropriate policies and practices. For instance, non-executive directors who wish to better understand the operating conditions of a firm should have easy access to such information from the firm's top executives beyond those provided at regular board meetings.

Cognitive biases may also be mitigated with increased awareness. Hence, non-executive directors can also be trained to improve the strategic decision-making process so that more involvement during strategy formulation does not severely compromise their strategic control role.

By working together, the executive management and non-executive directors of a board can help steer companies through turbulent times.

  • The writer is the Associate Professor of Strategy, Management and Organisation of Nanyang Business School, Nanyang Technological University.
A version of this article appeared in the print edition of The Straits Times on October 28, 2015, with the headline 'Strategic boards: The role of non-executive directors'. Print Edition | Subscribe