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Chief executive officer selection and succession planning are two of the most important responsibilities boards face. And corporate boards not alert to the heightened standards for CEO selection may well be courting disaster.

Current volatility has greatly increased the likelihood that many boards will face a CEO succession, and worse, that they will have to make the decision under the gun. Without full dress rehearsal planning, boards leave themselves open to activist investors – and, when a proxy fight looms, directors may find themselves with tarnished reputations, trying to defend the indefensible: inadequate board oversight of CEO succession.

No board is safe, not even one with an established CEO. Canadian Pacific Railway Ltd. found this out when activist investor Bill Ackman came calling to replace CEO Fred Green due to poor performance. When Mr. Ackman challenged them, they were not prepared with their own successor, and the decision was taken out of their hands. In the end, six board members, including the CEO, agreed not to stand for re-election due to insufficient shareholder support, and Mr. Ackman and his six other nominees were elected. Mr. Ackman now has Procter & Gamble and CEO Bob McDonald in his sights.

Few other decisions a board makes can have such painful and public repercussions, as the departure of Yahoo Inc. CEO Scott Thompson illustrates. Activist Dan Loeb and his hedge fund Third Point demanded three board seats by taking dead aim at the board's succession planning, citing value destruction caused by five different CEOs in five years. When they turned up an inaccuracy in Mr. Thompson's résumé, they claimed the board had mishandled his selection as well as six directors. In the end, Mr. Thompson resigned, Third Point got its board seats, and Mr. Loeb got the CEO he wanted – former Google wunderkind Marissa Mayer.

Whatever the emergency that precipitates the need for a sudden change, boards often fall back on having a director step in as interim leader while a search is conducted, as Barclays PLC did recently following the Libor crisis. While this solution may provide a short-term fix, it can delay getting an organization back on track after a CEO's sudden departure.

In one of the most publicized CEO successions of all time, Hewlett-Packard appointed outsider Léo Apotheker, former CEO of SAP, apparently without a single board member interviewing him. A year later they fired him – the third of their four CEOs within a six-year period. Not surprisingly, the board was pilloried in the press, and ultimately independent director Meg Whitman was appointed CEO.

Even in atypical transition scenarios, boards should expect to be challenged on any CEO succession decision – or even cross-examined, as in the case of Duke Energy's takeover of Progress Energy. When Duke, after having stated repeatedly that the CEO of the combined company would be Progress CEO William Johnson, abruptly replaced Mr. Johnson with its own CEO James Rogers, the last-minute switch was seen as arbitrary – and shareholders sued and the North Carolina Utilities Commission had to step in. The Commission not only questioned under oath the two CEOs, but also – in a truly unprecedented move – called four directors on the carpet.

Why are so many boards not mindful of the need for CEO succession planning? We see three key reasons:

  • Historical lack of outside pressure: Until the recent spike in regulation, not to mention activist investors and alarmed shareholders calling for better governance, the heightened marketplace scrutiny just wasn’t there.
  • False sense of security: Boards believe they have checked the box on succession planning by designating one or two internal candidates. But there is no guarantee that those candidates will be ready when the transition comes – especially if it is an emergency change – or even that they will still be at the company, as CEO-ready successors are in high demand. And without benchmarking the internal candidates against the external marketplace via the objective eye of an outside party, all the board really knows is that it has the best internal candidate.
  • Board inexperience: Many chairs have handled no more than one CEO succession in their careers, if any at all, and the same is true of the majority of Fortune 500 board directors.

The days of focusing exclusively on internal candidates without benchmarking against external candidates are gone, as is the common practice of letting the current chair/CEO lead the process. And boards with no plan for an emergency successor in the event of the CEO's death or sudden departure are clearly tempting fate.

Against that day – or the day they face an implacable, deep-pockets activist across the table – boards should adopt succession planning processes designed to stand up to the harshest scrutiny. CEO succession processes should include these five essential steps:

● Create a rigorous CEO job specification, reflecting the key issues facing the organization

● Identify internal candidates and establish tailored leadership development programs

● Map and regularly review leading external CEO talent

● Plan for emergency and non-emergency succession

● Have independent directors, not the current CEO, drive the process

While a bullet-proof process doesn't guarantee immunity from attacks by activists or action by regulators, it does diminish their likelihood, because a rigorous process will yield a better CEO choice in the first place and less unhappiness on the part of shareholders later. Further, in a proxy fight, many shareholders are looking for a good reason to support the incumbent board. An impeccable succession planning process provides one of the best. It also provides an eminently defensible position in the court of public opinion, where battles with activist investors inevitably play out – and where board members' professional reputations, for better or worse, may be indelibly rewritten.

Special to The Globe and Mail

Kim Van Der Zon is based in New York and runs the U.S. board practice at Egon Zehnder, the global executive search firm. Pamela Warren works in the firm's Toronto office. Both work extensively at the board level and have experience with CEO succession.

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