Feb 152016

Non-Executives are key to productive boardroom conversations

Boards of directors carry many responsibilities of course, and balancing the demands on the board’s time is one of the key challenges for all chairmen.

Many well-informed commentators, such as the Institute of Directors, agree that critical roles for the board include setting direction and strategy, governing risk and monitoring performance.

For Non-Executive directors (NEDs) in particular, fulfilling these roles can be especially challenging; yet they have a unique accountability for the board’s effectiveness in these areas.

non-executivesRoots of failure

Many of the most spectacular company failures in recent years have had their roots in a failed conversation about strategy.

For example, in his book Making it Happen, which describes the failure of the Royal Bank of Scotland, Iain Martin notes how the board conversation about the ultimately fatal decision to acquire ABN Amro moved almost instantly from “Should we do this?” to “Can we do this?”

As Martin relates, an RBS director subsequently rued that the board paid insufficient attention to the critical strategic question of whether the proposed deal made sense.

What can NEDs do to improve their boards’ conversations about strategy?

Most importantly they can recognise that while their own knowledge and experience is valuable, it is often likely to be less influential in their decision making than factors they fail to recognise.

These include a whole slew of natural cognitive biases that surreptitiously drive their individual and collective judgements, such as biases towards optimism, overconfidence, and conformity, as well as the influence of framing and anchoring. These are not flaws in personality or competence of individuals; they are unavoidable human traits.

While NEDs and boards cannot avoid these biases, they can be aware of the pitfalls they can cause and take steps to minimise them through employing specific processes and techniques in their decision-making.

These include methods such as red-teaming, de-correlating errors, “pre-mortems”, and others that are grounded in research and have been proven to improve decision quality.

When specialist external consultants facilitate the board’s strategy conversation these processes and techniques are made even more effective.

The second critical conversation boards must have concerns existential strategic risk – threats that can sink a strategy or kill a company, but which are often outside the scope of enterprise risk management processes.

The first question to ask here is whether the board’s current approach is sufficient to adequately anticipate, assess, and adapt to these threats. It probably is not, for two reasons. First, audit & risk committees’ main focus is usually on the long list of other issues for which they are responsible, specifically audit, operational and financial risk and regulatory compliance.

Too often existential threats get short shrift on audit committee agendas.

Second, since most risk management (as opposed to governance) activity happens in the day-to-day operation of the business – as it must and should – the executive team’s focus is quite properly on short-term operational and financial risks.

However the almost inevitable consequence of this is a risk register that either fails to identify the key strategic threats that the board should be focused on or, if it does include them, applies simplistic estimates of their probability and impact that often categorises them as “moderate”, and thus keeps them off the board’s agenda.

Too often the consequence of these two factors is a board that believes it has effective control and delegation of risk management but which in fact is neglecting its critical risk governance role, particularly when it comes to existential threats to the company’s survival.

Categories of risk

In performing their critical risk governance role, non-executives also need to understand that they are essentially dealing with three very different categories of risk.

The first and smallest of these is the “realm of probability”, or “known knowns.”

In this realm the historical frequencies of a range of outcomes and their consequences are both known, which enables these risks to be described using the language of statistics. This makes them relatively easy to price and transfer via insurance, derivatives, or other means.

These risks are almost always identified on company risk registers. Even so, they can still cause expensive failures, usually due to quantitative risk models not accurately capturing their potential co-occurrence and/or severity.

In the more challenging and larger “realm of uncertainty”, boards confront “known-unknowns,” whose full spectrum of possible outcomes, probability of occurrence, and/or potential consequences are not, and often cannot be, fully understood. In this realm, risks are usually impossible to price and transfer.

Yet, confusingly, these uncertainties are still often described using the language of probability.

However, the probability estimates used reflect not historical frequencies, but rather degrees of subjective belief about the likelihood of a risk’s occurrence and/or the potential size of its impact.

The most frequent risk governance failures in this realm are failing to properly assess the nature of potential threats and not taking steps to adapt to them until it is too late.

The largest of the three realms of risk is the “realm of ignorance”, or “unknown unknowns.” Here directors are unaware of potential threats to the success of their strategy or the survival of their company. However, it is not the case that all of these threats are proverbial “black swans” which are impossible to foresee.

Many adverse outcomes are possible to anticipate and are preceded by weak signals hinting at what lies ahead, which too often are explained away or ignored. Hence the most important source of failure in this realm is a board’s inability to anticipate future risks.

Standing back

Non-executives are uniquely positioned to stand back from the routine, day-to-day tasks, and drive effective board conversations about strategic risk governance. Once again structured processes and techniques will help them to meet this challenge. For example, the anticipation of existential threats can be substantially improved through an understanding of the likely sources of such risks.

Study of past corporate failures reveals that the most fatal combination is one of a few common external shifts combined with failures in the strategic risk governance process.

One of our clients employed a structured and facilitated risk governance conversation to identify four threats that their board wished to focus on, none of which was described in the existing risk register. For each existential risk an adaptation or mitigation strategy was identified, along with early warning indicators and a board process for monitoring them. The board recognised that the executive team and middle management had neither the time nor the inclination to search for the often-weak early signs of existential threats that might never materialise. They realised that this critical monitoring function was clearly a board role.

Normally, such monitoring will require the help of an external, specialist service provider, which is unencumbered by conflicts of interest and not deeply invested in the assumptions that underlie the current strategy. Without effective monitoring all the difficult work that a board may have accomplished in anticipation and assessment will be undone if insufficient forewarning of an emerging, anticipated threat fails to allow sufficient time to implement adaption and mitigation tactics.

Retail signs

Consider the UK retail sector, which is undergoing significant structural shifts as previously dominant players, such as Tesco, experience the uncomfortable sensation of being attacked by competitors with both superior quality and lower cost offers.

The emergence of the low cost discounters was the early warning signal. However some senior executives dismissed this sign by asserting that: “UK housewives will never want to shop at discount outlets!”

At the time this observation appeared true. But it also became a strategy assumption that was never tested, since the steady progress of Aldi and Lidl was assumed to be irrelevant. The early warning sign was missed and when the financial crisis hit, shoppers’ preferences shifted quickly towards the discounters, and left the established mass-market chains struggling to adapt.

While this shift in consumer preference has not yet proved fatal for any mass market retailer, their failures in anticipation, assessment, monitoring and mitigation have been very costly. In 2014 Tesco experienced market share loss, a falling share price, an accounting scandal leading to a serious fraud investigation, the replacement of the chairman and CEO and reported a £6.3bn loss, it’s worst ever result and the largest reported loss in the history of the UK retail sector.

Challenge for Non-executives

The role of the non-executive is an increasingly visible, demanding and difficult one. Non-executives are expected to demonstrate independence of thought and apply sound judgement in conditions of great pressure and ambiguity.

The range of subjects that non-executives must comprehend and the pace of evolution in the breadth and depth of knowledge required are dizzying. If non-executives’ judgement is found wanting they may be held personally liable. Students of governance question the feasibility of the critical role that non-executives are now expected to play.

Is their role feasible? In his book Thinking, Fast and Slow, Nobel Prize winner Daniel Kahneman sets out his powerful and remarkable conclusions about the psychology of judgement and decision making, following decades of research into the topic. He concludes that it is immensely difficult for us all to avoid biases in our decision making, about which we are mostly sublimely ignorant.

Yet the constant self-questioning of our judgements would be “impossibly tedious”. Kahneman says the best that can be done is to recognise when mistakes in judgement are most likely to occur, and to take steps to minimise them when the stakes are high. Nowhere is this more true than in the case of non-executives who are tasked with governing existential strategic risk.

Yet the challenge is not an impossible one to meet. Non-executives need to ensure that their board has the right structure. Without the right number and balance between executive and non-executive directors an effective board conversation is near impossible.

They also need to use the right processes. Given the stakes and the problems, using appropriate methods and external expertise and facilitation can be of great benefit. Lastly they need to ensure that the right systems are in place, especially for monitoring early-warning indicators and learning from failures, both other’s and their own.

© 2016 Britten Coyne Partners

About the author

NeilPhotoNeil Britten CDir is a director at Britten Coyne Partners, international experts
in board strategic risk governance.

Neil is a UK Institute of Directors, qualified Chartered Director, non-executive chairman and director with over a decade’s board level experience of strategy, risk governance and strategic performance monitoring.

Prior to roles as a professional director he was Vice President for a major international consulting firm focused on strategy and strategic change and an executive with a major oil and chemicals conglomerate.

His experience spans work, in the UK, France, Australia and over 20 other countries, as an executive in and advisor to mostly large, multinational corporations in technology, oil & gas, consumer goods, manufacturing and financial services sectors. He has also acted as an advisor to private equity investors in start-ups and SMEs.

Neil has an engineering degree from Bristol, and an MBA from INSEAD.