The conflict of interest faced by board directors
July 2017 | PROFESSIONAL INSIGHT | BOARDROOM INTELLIGENCE
Financier Worldwide Magazine
July 2017 Issue
Conflicts of interest abound at the board level. They constitute a significant issue in that they affect ethics by distorting decision making and generating consequences that can undermine the credibility of boards, organisations or even entire economic systems.
Many corporations require board members to sign a conflict of interest policy at the time of appointment or to declare any conflicts of interest at the beginning of board meetings. Conflict of interest policies normally specify how directors should avoid conflicts of interest. This narrow focus only scratches the surface, given the scope, responsibilities and dynamics of decision making in the boardroom.
The real danger lies in the extent to which boards and directors are unaware of the many subtle conflicts of interest that they are dealing with. The boardroom is a dynamic place where struggles of ego, power, rules and authority continuously surface, and it is not always clear, in the turmoil of group dynamics, what constitutes a conflict of interest or the manner in which one should participate in board deliberations. Furthermore, director duties tend to diverge from one company to another and from country to country, which adds even more complexity.
When the interests of a broader group of stakeholders, such as a government or society, are added to the mix, this judgment goes far beyond what might be included in a written conflict of interest policy. In this article we seek to analyse conflicts of interest by exploring the conflicting situations, right down to the fundamental purpose of business, in view of helping board directors make better decisions by taking an ethical stand in shaping business in society.
Tier-I conflicts: individual directors v. company
A tier-I conflict is an actual or potential conflict between a board member and the company. The concept is straightforward: a director should not take advantage of his or her position. As the key decision makers within the organisation, board members should act in the interest of the key stakeholders, whether owners or society at large, and not in their own. Major conflicts of interest could include, but are not restricted to, salaries and perks, misappropriation of company assets, self-dealing, appropriating corporate opportunities, insider trading and neglecting board work. All board members are expected to act ethically at all times, notify promptly of any material facts or potential conflicts of interest and take appropriate corrective action.
When board members fail to dedicate the necessary effort, commitment and time to their board work, it can result in a conflict between the board member and the company. Directors often serve on multiple boards in order to benefit from several compensation packages. This can often complicate matters for the respective directors, as they may not be able to allocate sufficient time to governing any one company. Lack of effort, focus and dedication are types of conflict of interest that have not yet received the attention they deserve.
Boards need to have a specific policy in place for dealing with tier-I conflicts of interest between individual directors and the company. This policy needs to specify processes for dealing with major actual and potential conflicts. If possible, the policy should be signed by all directors and be regularly updated. Furthermore, conflicts of interest should be declared at each board meeting.
Control mechanisms could be institutionalised. Industrial and Commercial Bank of China (ICBC)’s supervisory board is partly composed of full time, on-site supervisors. By attending board meetings as non-voting delegates, ICBC’s board of supervisors is able to monitor the performance of directors and senior management, auditing processes and the overall activities and decisions that affect the company in the short and long term. In addition, retiring and leaving directors, presidents and other senior management members must undergo an auditing process by the board of supervisors. This type of institution is rarely seen in Western countries, so a similar and feasible solution is to allow external auditors to play a role here.
Tier-II conflicts: directors v. stakeholders
Tier-II conflicts arise when a board member’s duty of loyalty to stakeholders or the company is compromised. To whom do board members owe their loyalty? This depends very much on law and tradition and the prevailing legal system, social norms or the company’s specific situation. In countries with relatively strong shareholder rights, such as in the US, directors are expected to be accountable to shareholders. However, excessive promotion of the interests of shareholders can lead to conflicts with other stakeholders. Due to different contractual arrangements, the interests of stakeholders are often in conflict. Board members are required to always use ethical and appropriate judgment to make seemingly correct choices when conflicts arise.
In many other countries, directors have a duty to the company, not to shareholders. In Germany, for example, the company is considered distinct from the collective shareholders, which prevents shareholders from claiming that the directors have a duty toward them first and foremost. Shareholders are seen as one kind of stakeholder among a pool of many, and the company does not have a duty to maximise shareholder value. Boards are composed of interested directors, such as representatives of employees, shareholders and other stakeholders. The loyalties of these stakeholder representatives are often divided, and considering that multiple-role directors have to rebalance different interests, the potential for conflict becomes clear.
This would also happen when certain board members exercise influence over the others through compensation, favours, a relationship or psychological manipulation. Even though some directors describe themselves as “independent of management, company, or major shareholders”, they may find themselves faced with a conflict of interest if they are forced into agreeing with a dominant board member. Under particular circumstances, some independent directors form a distinct stakeholder group and only demonstrate loyalty to the members of that group. They tend to represent their own interest rather than the interests of the companies.
To deal with tier-II conflicts, directors need to disclose their relationship with stakeholders. This gives them an opportunity to declare, in advance, who they represent. Even if the law requires all directors to represent the interests of the company, identifying their connections with specific stakeholder groups improves transparency and avoids the risk of conflicts of interest. It is also crucial to specify who nominates new directors, who decides on directors’ compensation, how the pay structure and level are determined, and how pay is linked to performance and function. In performing their duties, all directors need to put aside their ego, follow rules in discussions, respect others, and avoid toxic behaviour in the boardroom. Coalitions can be beneficial when they are aimed at acting in the best interest of the company, but they can be harmful when they are formed with the aim of dominating the board or benefitting a particular stakeholder group.
Tier-III conflicts: stakeholders v. other stakeholders
A tier-III conflict emerges when the interests of stakeholder groups are not appropriately balanced or harmonised. Shareholders appoint board members, usually outstanding individuals, based on their knowledge and skills and their ability to make good decisions. Once a board has been formed, its members have to face conflicts of interest between stakeholders and the company, between different stakeholder groups, and within the same stakeholder group. Board members have to address any conflicts responsibly and balance the interests of all individuals involved in a contemplative, proactive manner.
If a board is composed of interested directors who remain loyal to their respective stakeholders, then it is necessary for stakeholder representatives to cooperate and find the optimal coalition to address common interests. Directors on boards must keep in mind the interests of weak or distant stakeholders to ensure their interests are not overlooked.
Tier-III conflicts of interest can be minimised when directors and boards ‘slice the company pie’ properly in an effort to support cooperation and avoid inducing sabotage, riots, retaliation, fines, in-fights or legal actions. Wise decision making requires understanding deep-rooted conflicts between stakeholders and the company, between different stakeholder groups, and between subgroups of one stakeholder group. No company can survive without the input of each stakeholder group: responsible shareholders, understanding debt holders, innovative employees, satisfied customers, happy suppliers, great products and services, friendly communities as well as effective and efficient government.
Tier-IV conflicts: company v. society
Tier-IV conflicts are those between a company and society, and arise when a company acts in its own interests at the expense of society. The doctrine of maximising profitability may be used as justification for deceiving customers, polluting the environment, evading taxes, squeezing suppliers and treating employees as commodities. Companies that operate in this way are not contributors to society. Instead, they are viewed as value extractors. Conscientious directors are more likely to act as stewards for safeguarding long-term, responsible value creation for the common good of humanity. When a company’s purpose is in conflict with the interests of society, board members need to take an ethical stand, exercise care and make sensible decisions.
Tier-IV conflicts between the company and society are philosophical. Solving them requires directors to act as moral agents and be able to distinguish ‘good’ from ‘bad’. Do companies compensate stakeholders because they are useful, because they are protected by law? Or do they do so because stakeholders contributed to the success of the company? Should companies consider the interests of future generations who have not directly contributed to profitability and who are not represented on the board? Should companies make corporate sustainability investments because they are popular, because they portray the company in a favourable way and increase profitability in the long run, or because they are a way to show true gratitude?
A company is the nexus that links the interests of each stakeholder group within its ecosystem. The board is the decision-making body and its successes and failures are determined by the ability of its board directors to understand and manage the interests of key stakeholder groups. It is not an easy task to balance the interest of different stakeholders when shareholders are the ones who put in money and are often more visible and demanding. There are no ‘one size fits all’ solutions to corporate governance issues, and there are no straightforward answers to managing all the conflicts of interest given the unpredictable nature of firm and business environment contexts, boardroom dynamics and human behaviours. In principle, decisions at the board level should be ethical and reasonably balanced. An ethical board sets the purpose of the company, which in turn influences all dealings with stakeholders. The four-tier analysis of conflicts of interest can help board directors anticipate and identify potential conflicts, deal with conflicts and make sensible decisions to chart a course for the future of the company.
Didier Cossin is professor of finance and governance and Hongze (Abraham) Lu is a research fellow at IMD. Mr Cossin can be contacted on +41 (21) 618 0208 or by email: email@example.com. Mr Lu can be contacted on +41 (21) 618 0505 or by email: firstname.lastname@example.org.
© Financier Worldwide
Didier Cossin and Abraham Hongze Lu