• Best Practices for Corporate Governance

    Author: Harold P. Reichwald

    This White Paper will be published by Bank Director and is reprinted with permission.

    This article examines the key responsibilities of bank directors in governance and the important practices they should follow. It takes into account what regulators have said in enforcement actions and in litigation surrounding bank failures about the duties and obligations of bank directors.

    Introduction
    As we move through the fourth year of a stressful and chaotic period for banks and other financial institutions, it is important to take stock of events and the consequences they may have for bank governance going forward. Regulatory enforcement actions and litigated cases, as well as periodic pronouncements from the regulatory agencies, have made it clear that bank boards will be and should be held accountable for the actions and performance of the banks they serve. With that in mind, there are some specific practices that each bank board member should keep in mind.

    Oversight
    Directors have broad responsibility for oversight of the bank they serve. Given this responsibility, a director needs to understand fully all elements of the bank’s activities, operations (including products and services) and strategic goals. This requires time and dedication with a determination to ask tough questions of management and fellow board members.

    A board is expected to be competent in matters as varied as enterprise risk management, strategic planning and resource management, adequacy of internal controls, financial statements, liquidity, allowance for loan and lease losses and human resources. As a consequence, a board should have among its members a mix of skill sets and experience such as accounting, financial management, entrepreneurship, credit analysis, personnel management and strategic marketing.

    Example:  A board whose members are renowned in the bank’s geographic community but do not necessarily have the required skill sets is unlikely to be viewed as competent to do the job required. Directors cannot be merely salespersons for the bank’s products and services.

    Independence and Information
    First and foremost, board members must be ready, willing and able to question executive management on its recommendations and decisions. For a board member to do this, she/he must be comfortable that there is an adequate information flow to the board, not so much in terms of sheer volume of reports, memoranda, etc., but rather in meaningful material that can be digested and interpreted and be the subject of a functioning deliberative process at the board level. In this case, more is not necessarily better. To have this meaningful flow of information, the bank’s system of internal controls has to function adequately to ensure that executive management and the board receive all information needed to do their jobs, presented in a way that is succinct and understandable.

    Example:  Executive management may try to manage the board deliberations. This may occur by providing a board package only days before a board meeting with insufficient time for a director to grasp the essential issues. Also, a board package may contain more information than is necessary for the board to deliberate on specific issues and take appropriate decisions. Executive management should provide to the board its own commentary on the significance of the material or data presented in the board package.

    Evaluation of Management
    There is little doubt that skilled executive management of a bank, and in particular, the chief executive officer, is key to a successful and profitable banking operation. Even with such leadership in place, however, directors must not rely on the actions and recommendations of executive management, but rather hold management’s “feet to the fire.” They must ensure management is addressing strategic challenges, specific operational problems and proposing adequate solutions. Directors must be exacting in their appraisal of the competency of executive management and make changes when incompetency or inattention is apparent, sooner rather than later.

    Example:  A CEO who over-promises and is not able to succinctly and cogently present his views and the basis for those views should be questioned rigorously. A pattern of under-performance without adequate explanation should be cause for concern and ultimately board action.

    Independence of Action
    Strong executive management, particularly in the CEO, is often the hallmark of successful leadership, but directors cannot allow themselves to be managed by a dominant CEO or controlling shareholders. Directors must exercise reasonable diligence and judgment in an independent manner, free from allegiances that might derive from their election to the board in the first instance. Friendship and loyalty must be tempered. Service on the board must not be seen as a “hobby” or as an invitation to a social activity but rather as one in which each director has an affirmative duty to satisfy the exacting legal standards.

    Example:  A strong leader is often able to dominate meeting preparation and discussion so as to guide decision-making in favor of a recommended course of conduct. A director’s job is not to merely accept these recommendations but to test them and their foundational analysis. The board should be wary of how the agenda for a board meeting is presented and inquire whether there is any director input into the setting of the agenda, as there should be.

    Regulatory Calls to Action
    One of the most frequent allegations leveled at former directors of a failed bank is that they ignored examination reports and allowed the bank to continue criticized policies and practices to the ultimate disadvantage or failure of the bank. Directors cannot turn a blind eye to unsafe or unsound practices (whether identified by regulators or not), or violations of law. Moreover, it is insufficient for directors to assert that they were unaware of the criticisms.

    Example:  Regulatory criticisms which are not addressed and are restated in a subsequent exam report suggest to the regulatory authority that the board either does not care or is out of touch with the bank’s situation, either of which is strong condemnation of a board’s performance. Every exam report should be the subject of board discussion with a committee of the board being charged with ensuring that corrective action is taken within reasonable time frames.

    Record of Board Actions
    Board minutes (or board committee minutes) are often the only evidence that the regulatory authorities have of the extent of the diligence practiced by the Board. While “the less said, the better” has often guided the preparation of minutes by the board’s secretary, directors who endorse minutes that only record the actual resolution with no discussion noted are asking for trouble from regulators.

    Example: Board minutes are not confidential; neither are they protected by any privilege if disclosure is demanded in litigation. While this could be a real risk in certain litigation cases, nevertheless, the importance of the board’s deliberations being a matter of record is an overriding consideration, especially to the regulatory authorities. The risk of outside disclosure must be reviewed by counsel. Board members should thoroughly review minutes before they are adopted because they become the official record.

    Conflicts of Interest
    The business judgment rule shields directors from liability for decisions made in good faith that turn out to have been wrong or result in losses to the bank. One of the cornerstones for determining whether a director’s decisions are entitled to the protections of the business judgment rule is whether the actions taken are free from self-interest. As a consequence, even the appearance of a conflict of interest must be addressed and disclosed such that the director’s actions are not tainted or subject to criticism. It is always better to decline to participate in a decision if there is a chance participation could be criticized on self-interest grounds.

    Example:  Any proposed transaction with the bank in which a director has any personal or outside interest, relationship or responsibility (financial, professional or otherwise), should be disclosed. When in doubt, disclose!

    Oversight vs. Management
    Among the greatest challenges made to diligent board members attuned to the expectations of the regulatory agencies comes from executive management who may assert that the board and individual directors are micro-managing the bank and have gone beyond the due exercise of their oversight responsibilities. While one might, at first blush, understand why executive management might make such statements, in truth, the relationship between executive management and a dynamic board must be collaborative since each side has different expectations placed upon it by law and regulation.

    Example:  Many banks have a directors’ loan committee to pass judgment on the proposed extension of credit to selected borrowers, generally on the basis of the size of the loan or special complexity. Management proposes the credit and the committee approves or disapproves the proposed credit. In the aftermath of the recent credit crisis and resulting bank failures, the Federal Deposit Insurance Corp. has chosen to target members of directors’ loan committees for alleged gross negligence or failures of performance, to the exclusion of other members of the board. The loan committee members are the final approval authority on proposed credits and seem to have an elevated level of liability. This could dampen enthusiasm of bank directors to serve on such a committee. 

    Board Dos and Don’ts

    Take the job seriously, not as a sideline; devote serious time and energy to the tasks.

    • Read and understand the material presented; do not be shy about asking probing questions.
    • Participate actively in the board’s deliberative process and take steps to ensure that deliberations occur.
    • Recognize problems when they occur and demand proposed solutions be presented in a timely fashion.
    • Do not be intimidated by executive management.

    Membership on a bank board can be an exciting and rewarding experience. With appropriate attention to the expectations and the details, a board member can make a difference.