Recruiting Directors: Independence, Financial Expertise Needed

Pity Duane Kropuenske. At a time when scandal and a sluggish economy have made root-canal work seem more appealing than serving as a corporate director, Kropuenske was recently burdened with filling out an entire board roster for his privately held start-up, Riverview Community Bank in Otsego, Minnesota.

Or maybe not. Despite the dire, sky-is-falling warnings about the difficulties banks will have finding directors in the present environment, Kropuenske, 60, went a perfect eight-for-eight in recruiting members for his board. His secret? “It’s all about mutual trust,” he says. All of his board members are investors in the bank and know the management team well. “A lot of them had [bad] experiences with large regional banks and see the importance of that personal-level service. They were actually anxious to be part of the organization.”

The search for independence

Judging by the word coming from bank trade groups, consultants, and governance gurus, Kropuenske’s experience may be an aberration. Experts advise board chairmen and nominating committeesu00e2u20ac”especially those of publicly traded companiesu00e2u20ac”to get comfortable with the notion of searching longer and harder to find qualified independent colleagues.

Why? For starters, “a lot of people simply don’t want to be on boards now, because of the scrutiny,” says Lee Koehn, president of Lee Koehn Associates, a Portland, Oregon search firm. It’s potentially worse for bank directors, who face added oversightu00e2u20ac”and the threat of civil money penalties if things go wrongu00e2u20ac”from industry regulators. “They’re concerned about the liability,” he adds.

Equally trying are the new definitions surrounding independence. While many rules have yet to be enacted, they could carry a particularly potent punch for boards. NASDAQ’s proposed rules, for example, would deem the following as not independent: all bank employees, extended family members of executives, employees of outside auditors, and directors who serve as executive officers for another company where a bank officer serves on the board. With a handful of exceptions, any director who received, or has a family member who received, more than $60,000 from the bank would not be considered independent. And directors who are executives of a company that does more than $200,000 in sales or purchasesu00e2u20ac”or more than 5% of gross revenueu00e2u20ac”with the bank also wouldn’t be considered independent. “When it comes to bank boards, the good-ol’ boy network will no longer do,” Koehn says.

Given that a traditional bank lending relationship could easily surpass some of those thresholds, industry lobbyists are working to dampen the language. In an April letter to the Securities and Exchange Commission, Sarah Miller, director for securities, trust, and investments for the American Bankers Association, argued that the idea that “extending credit or paying interest on deposits … would render a director ‘not independent’ will force [banks] into a ‘Catch-22’ situation: either lose value and legitimate business, … or have the pool of qualified business leaders available to sit on banking organization boards significantly reduced.”

Better, Miller argued, for the exchanges to follow the lead of Sarbanes-Oxley, which excludes banks from insider lending requirements in favor of the Federal Reserve’s Regulation O, which requires such relationships to be carried out on the same terms as those for other customers. That’s an idea that bankers would likely support. “It would be ludicrous to have directors who aren’t customers of the bank,” asserts Kropuenske, who counts all eight of his nonexecutive directors as customers. “If [directors] are going to lure customers to the bank, they have to show their own confidence” by using its services.

But some observers say it’s more likely that the Sarbanes provision will be overturned. “I don’t know if they can continue to say that banks have their own special law for insider lending,” says Bob Calvert, a bank board consultant from Roswell, Georgia. “If no one else can lend to insiders, why should banks be allowed to?”

Regardless of the final wording of such proposals, many banks are already concluding that they must find new directors to boost their boards’ skill and independence levels. Indeed, experts say smart boards often are limiting themselves to one inside directoru00e2u20ac”the CEOu00e2u20ac”while pursuing independents for other board posts. That goes for private banks, too, which regulators are expecting to follow the spirit of new laws for publicly traded firms.

Audit committees: finding qualified experts

Along with the search for independent directors for the full board, banks are faced with the need to review the composition of their audit committees as well. Michael Hansen, chairman and CEO of EverTrust Financial Group, has always been content with the makeup of his board. They’re the type of directors who won’t hesitate to say what needs to be said, even if it might offend the boss. “They’re not afraid of me, and they don’t worry about being liked by me,” he explains.

Despite that, there was a nagging worry, sparked mostly by Thomas Gaffney, the chairman of $700 million EverTrust’s audit committee. Gaffney had been whispering in Hansen’s ear for years about beefing up the board’s financial expertiseu00e2u20ac”pleas that had been listened to and politely put aside. Then came Enron, Global Crossing, and WorldCom. The Sarbanes-Oxley Act was next, followed by a host of proposed exchange rules. Suddenly, Gaffney’s advice took on an added sense of urgency.

So it was last fall, with the ink barely dry on the new legislation, that the Everett, Washington-based banking company set off to search for another “financial expert” to supplement Gaffney’s know-how. “We thought with the new laws that there would be a rush for the best people, so we’d better beat everyone else to the punch,” Hansen says. And a good thing, too. After a yearlong search process, EverTrust wound up with not just one, but two new directors who spend their days as certified public accountants. One was caught just before he signed onto another board.

“As the CEO, I’m expected to make a buck. And the more distracted I am by all this corporate governance stuff, the less effective I’ll be,” explains a satisfied Hansen. “If I’ve got qualified people for my audit committee, it allows me not to worry about Sarbanes-Oxley compliance or SEC compliance or FASB compliance, because I’ve got some people who are a lot smarter than I am who are thinking about those things.”

Anecdotal accounts suggest that Hansen’s early-bird-gets-the-worm approach has not been widely adopted by the banking industry. While some banks have taken modest steps toward filling out their boards, many still lack a full complement of financial types overseeing key audit functions. “I haven’t heard many banks expressing much concern about it,” says David Bochnowski, chairman and CEO of NorthWest Indiana Bancorp and head of the corporate governance committee at America’s Community Bankers, a thrift trade group.

For publicly traded banks, this is no time for foot-dragging. Under Sarbanes-Oxley, the SEC is expected to ensure that audit committees of publicly traded companies have at least one member who is familiar with generally accepted accounting principles and has some experience preparing or auditing financial statements of “comparable issuers” and applying GAAP standards to things like estimates, reserves, or accruals.

By early next year, public companies must disclose whether they have at least one such financial expert; those that don’t must say why in their filings. “We think most companies will not want to try explaining why they don’t have one,” says Tom Visotsky, president of Corporate Board Executive Search, a Richmond, Virginia-based firm launched last year to help boards find audit committee members.

For privately held banks, it might be another story. In a May statement, the three primary banking regulatorsu00e2u20ac”the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserveu00e2u20ac”jointly indicated that they would not apply Sarbanes-Oxley and exchange requirements for audit committees to nonpublic institutions. At the same time, however, they encouraged banks to regularly review their policies and procedures and promised that they would do the same, leaving open the door for alterations later on.

Filling the gaps

So what are the best methods to go about the search process? There are plenty of options. Banks can conduct searches themselves, usually through the chairman or a nominating or search committee. This makes sense, because they typically know key players in their communities and can target individuals with the right expertise and connections. Kropuenske, for example, spent four months sifting through his list of investors before settling on his directors.

But given the demands and scrutiny, more banks are hiring executive search firms to manage the process or are using consultants to help winnow the field. When fast-growing Umpqua Holdings Co. recently went looking for two new directors to boost its grasp of the Portland market, CEO Ray Davis turned to Koehn. Using a recruiter “brings a more objective point of view about who you should bring on the board,” says Davis, who previously recruited directors on his own. It also brought him in contact with candidates he otherwise might not have reached, including Gary Destefano, president of Nike USA.

Andrea Redmond, co-head of the board services practice of Chicago-based Russell Reynolds argues that using a search firm brings an “independent perspective” to the process. With a firm, “you’re not just taking the name of somebody who knows somebody. You’re thinking first about what value you want that individual to addu00e2u20ac”someone with a strong financial background, or has sat on other boards, or is a sitting CEOu00e2u20ac”and then getting introduced to people who are outside of your network.”

There’s no shortage of choices. Big search firms, such as Russell Reynolds, Heidrick & Struggles, and Spencer Stuart, boast expertise, contact networks, and national databases. Smaller regional firms claim that knowledge of local markets and clients is most important. Another alternative: Do most of the work yourself, with some help along the way from an outside consultant. Consultants like Calvert won’t actually do the recruiting, but will guide directors through setting selection criteria and even conduct some interviews.

In the current environment, audit committee slots are “clearly the most difficult” board seats to fill, says Redmond. “Not only do candidates need to meet some stringent qualifications and have the willingness to take on those responsibilities, serving on an audit committee today is a very big time commitment.” Visotsky says many existing directors who technically qualify as financial experts would just as soon not take on the added risks and liability. “A lot of those individuals don’t want to have that target painted on their chests.”

This would appear to argue for professional assistance. In addition to digging up candidates that might otherwise not be readily apparent, using a search firm can help a board avoid shareholder skepticism of the results. “It’s not just about hiring someone who’s a qualified financial expert. It’s about using an independent process to find that person,” Visotsky says. “If you sit around the boardroom and everyone asks, ‘Who do you know?’ then even though the person you find might technically be independent, they’ll seem less independent to outsiders because of how they were found.”

Audit committee candidates include CPAs, certified financial planners with proven track records, tax experts, investment bankers, local university accounting or law professors, former bankers, or well-respected chief financial officers of local companies. “You need someone with a financial background who can read financial statements, look at the cash flows, and identify potential frauds and translate those financial shenanigans to other directors,” Calvert says.

Even with the advantages afforded by a search firm, some bank boards still prefer to do it themselvesu00e2u20ac”particularly in the case of the audit committee member. “We were looking for someone to share our innermost secrets with, and our feeling was that using a search firm to help fill such an intimate position would be like using one to find a wife,” recalls Hansen.

The board of Union Bankshares, a $1.1 billion community holding company in Bowling Green, Virginia, polled directors and their professional services folks to come up with candidates with the audit expertise required. “We talked with directors, with our CPAs, and attorneys” and came up with a list of business leaders across central and eastern Virginia, says D. Anthony Peay, Union’s chief financial officer. The end result: Ronald Tillett, a former state finance secretary and treasury secretary and a managing director for Morgan Keegan & Co., joined the board in April. “He more than fit the bill” and soon will become audit committee chairman, Peay says.

Finding qualified people on your own can be a challenge, though, particularly for small-town banks. “In smaller communities, there usually isn’t a very wide selection of people who fit the profile, and many of them might not be interested in serving on a community bank board,” says Steve Johnson, a partner at the Minneapolis law firm Lindquist & Vennum, whose clients include many rural banks.

There might be only one CPA in town, for example, and if that person handles the financial affairs of one of the existing directors, it could pose at least the appearance of a conflict of interest. “If the CPA has a [board-level] disagreement with someone who’s also his client, it could influence his decision making,” Calvert explains. Adds Koehn: “In a small town, you’re probably best off not going to the local CPA or law firm, because you’ll be turned down.”

That sometimes leads rural banks to neighboring communities. The problem with that approach is twofold: first, outsiders probably won’t understand the subtleties of the community, and second, there’s an almost built-in reluctance to tap a leader from a rival community as a director of the local bank. “It’s a Hatfield and McCoy situation,” Calvert says. “There can be some concern that information from your bank might somehow get over to the bank in that neighboring town.”

Regardless of who’s running the show, what’s clear is that finding good independent directors or audit committee members is becoming more of an art for boards. An important first step is divorcing the search process from management. Pat McGurn, vice president of Institutional Shareholder Services, a Rockville, Maryland firm that advises big investors on proxy issues, says nominating and governance committees, stocked with independent directors, should run the search. “If the CEO is running the nominating process, you shouldn’t be too surprised if some of his allies wind up on the board,” he says.

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