The Governance Implications of Business Disruption

In 2018, corporate boards will increasingly be called upon to respond to how innovative competitors disrupt their companies’ business models.  These competitors use technology, scale, and sharp insights into consumers to lower prices, improve products and services, and draw customers away from traditional companies, forcing those companies to cut costs and lose relevance.[1] Blockbuster, Borders, and ESPN are prime examples of victims of nimble disruptors.

Victims typically overlook the trajectory of disruptors, which focus initially on perfecting their business models rather than their products or services.[2]  Flawed governance can lead to such oversight by making it hard for management to identify and respond to warning signs.  The 2017-2018 NACD Public Company Governance Survey cites “business model disruption” as the factor that board members most often predict will have the greatest effect on their companies in 2018.[3]

The good news is that a prudently composed and positioned board of directors can be a highly effective partner with management in confronting disruptive threats.

Basic Fiduciary Considerations

In many respects, leadership responsibility for dealing with business disruption is an extension of the shared leadership approach historically applied to tasks such as strategic planning and risk management.  These tasks incorporate prominent roles for both the board (which can encourage the development of a strategic or risk management plan and oversee management’s implementation it) and management, which develops the specific plan.  The effectiveness of both of these tasks relies upon on an integrated perspective on the long term strategy and risk management, as the case may be.

An effective response to innovation-based business disruption relies on a similar approach; i.e., the board encourages management to identify business disruption threats and to develop responsive strategies, and then monitors the evolution of such strategies.  Management, on the other hand, informs the board as to the nature and source of disruption threats, implements a responsive plan, and supports the board’s ability to monitor the success of that plan.

Ultimately, responsibility for dealing with business disruption is grounded in the board’s fundamental obligation to ensure that the company maintains its long-term value and serves its principal constituents.  As current developments demonstrate, business disruption can seriously threaten sustainability by undermining the financial model on which corporate operations are based.  For that reason, the impact of business disruption on fiduciary duties is exceptionally diverse, affecting elements of governance ranging from information flow to the board, to director engagement, to refreshing the board with new members, to board composition, to the decision-making process and, ultimately, to the nature of the board’s relationship with management.

Specific Implications for Governance

A governance plan to deal with disruption should focus on three related goals:  first, a  change to a boardroom attitude that more readily acknowledges the threat posed by disruption; second, an information system designed to provide the board and key committees with necessary information related to business disruption; and third, policies, procedures, and governance structure changes designed to support the ability of directors and committee members to maintain engagement with business disruption issues.  The aim is to position the board as an informed and attentive partner with executives in identifying and responding to business disruption threats.

Attitudinal Shift: This is the “we get it” concept—increase board awareness of technological disruption and the potential threat it poses to the company and its specific industry sector.  As NACD has noted, such awareness necessarily includes a willingness to pay continuous, focused attention to the shifting sources and paths of disruption.[4]  This includes a willingness to more closely monitor management’s familiarity with customer needs and preferences, awareness of technological and competitive changes that could affect the company’s business model, and ability to identify and implement responsive strategies.[5] This shift in attitude will also prompt directors to re-evaluate how they view the competitive environment, establish organizational goals, and, as noted in more detail below, structure themselves and their activities as a board to be more nimble and decisive.  The shift also encourages directors to monitor a broader set of external factors and how those factors may affect competition. The factors can be socioeconomic, technological, investment related, transactional, and competitive trends in business as a whole (as well as those in their specific industry).[6] For some boards, this shift in attitude may not be easy to accommodate.

Information Reporting System: Require top executives to work with board leaders to identify the types of business disruption-related information that should be brought to the board’s attention (e.g., media articles; judicial decisions; government legislation or regulation; expert advice; educational presentations; participation in external seminars; news developments, corporate filings; management reports; whistleblower and “hotline” reporting); the context in which it is provided (e.g., full original text or abbreviated or edited by management to facilitate board review and comprehension); the frequency with which it is to be provided (e.g., weekly, monthly; per development; as an agenda item at board or committee meetings); and the format through which it is to be provided (e.g., distributed paper copies; email; podcast; confidential online board portal; in person presentations).

Protocols and Structural Changes:

  • Designated Responsibility. Formally determine whether fiduciary oversight of business disruption matters should be the responsibility of the board as a whole (as with enterprise management) or delegated to a specific board committee with calendar-specific reporting obligations to the full board (as with strategic planning).  The expected monitoring role of governance would be set forth by resolution of the full board, or by charter of the particular committee.
  • Standard of Conduct. Direct the general counsel to periodically advise the board and individual committee members on the scope of their fiduciary obligations for business disruption oversight and related legal developments.  Those obligations would include director preparation, participation in meetings, engagement with management and advisers, and exercise of constructive skepticism with respect to management proposals.
  • Board Composition. Direct the board nominating committee to consider the skills and backgrounds best suited to address business disruption-related matters; i.e., is there a need to appoint directors with specific disruption-related competencies such as experience with disruptor companies, companies that have been affected by disruption, or innovative technologies or directors with more diverse perspectives?
  • Director Refreshment. Revise director refreshment policies and procedures (e.g., term limits; age limits; removal rights; individual and full board evaluation policies; officer rotations) to allow for greater flexibility to add directors and board or committee leaders with necessary expertise and commitment to address business disruption threats.  This would include policies on term limits, age limits, removal rights, individual and full board evaluations, officer rotations, and determining directors’ fitness to serve.
  • Talent Development. Require the board committee responsible for CEO searches and succession and other executive talent development activities to consider the extent to which senior executive-level searches and retention initiatives focus on individuals who are innovative thinkers with expertise in new technology, e.g., digital engagement, artificial intelligence, genomics, and advanced analytics.  The talent development process should seek to project the company as a “career accelerant,” providing its executives with an environment highly conducive to experimentation, innovation, and career mobility, and one that is unencumbered by a corporate or industry tradition of risk-aversion and incrementalism.
  • Intra-Board Coordination. Ensure the coordination of strategic planning and enterprise risk management efforts with the evolution of board oversight of business disruption.  Identify the extent to which the responsibilities of the respective oversight tasks are similar, separate, or overlap, and refine the charter and reporting relationships accordingly.  Avoid the confusion that often arises with committees that possess broad, all‑encompassing portfolios.
  • Decision-Making Process. Review the board decision-making process to identify streamlining options that don’t jeopardize the ability to position individual decisions for business judgment rule protection.  Determine the extent to which major decisions can be made faster to provide greater organizational agility, without limiting participation by key leaders, reducing access to important advisers, or otherwise handicapping the ability of the board to make informed decisions.
  • Identification of Barriers. Identify potential legal and regulatory barriers at federal and state levels to planned responses to particular business disruption threats (e.g., laws relating to antitrust and competition).
  • Conflicts of Interest. Adjust the board conflicts of interest policy to anticipate relationships of officers and directors with potential disruptive companies.  Prompt greater coordination between committees responsible for director independence and conflicts identification and resolution and those responsible for monitoring the potential for business disruption.
  • Board/Management Dynamic. Counsel top executives on the fiduciary expectation of direct board involvement in business disruption planning and strategy.  Clarify for all involved parties the relevant lines of authority and articulate those areas in which the board has specific responsibility (e.g., as with shared responsibilities for strategic planning).

Impact on Director Liability

Director liability exposure is a legitimate concern given the speed with which disruptive companies can change an industry.  Yet, Delaware law has historically extended substantial deference to the board’s method of monitoring business risks.  As long as the board has in good faith adopted and applied a business risk monitoring system, any losses attributable to errors in applying the system (no matter the size of the losses) should be offset by the board’s exercise of business judgment.  The only exception would be if there were deficiencies in the exercise of such business judgment that rose to the level of bad faith; i.e., ignoring red flags.

The less settled question arises in the context of a complete failure by the board to address (or even think about) business disruption risk, especially after being warned by management of the possible threat.  In such a situation, it is conceivable that failure to even consider the potential for business disruption risk would be perceived as bad faith.  There are very few examples under Delaware law of liability in such circumstances.  However, in the current environment there is increasing risk that allegations that incorporate extreme or egregious fact patterns could prompt a different result, especially in jurisdictions other than Delaware.[7]

Summary

Business disruption is one of the most compelling corporate governance challenges emerging in 2018.  It requires a response developed through a partnership between the board and management and may require significant changes to traditional board practices.

ENDNOTES

[1] See, e.g., Natasha Singer, “How Big Tech is Going After Your Health Care”; The New York Times, December 26, 2017.

[2] Id.

[3] National Association of Corporate Directors, 2017-2018 Public Company Governance Survey, accessible at https://www.nacdonline.org/files/2017%E2%80%932018%20NACD%20Public%20Company%20Governance%20Survey%20Executive%20Summary.pdf

[4] Id., see also NACD Weekend Reader, ”Board Lens: Disruption Tops List of Director Concerns According to Latest NACD Survey”;  December 2, 2017 (subscription required)

[5] Id.

[6] Id.

[7] See, e.g.,  In re Wells Fargo & Co. Shareholder Derivative Litig., No. 16-5541, slip op. at 49 (N.D. Cal. Oct. 4, 2017).

This post comes to us from Michael W. Peregrine and Kenneth Kaufman. Peregrine is a partner in the law firm of McDermott Will & Emery and advises corporations, officers, and directors on matters relating to corporate governance, fiduciary duties, and officer and director liability. His views do not necessarily reflect those of the firm or its clients. Kaufman is chair of Kaufman Hall, which provides health care organizations with counsel and guidance in areas that include strategy, finance, financial and capital planning, mergers and acquisitions, and partnerships.