Chapter Objectives: • Identify the difference between decision management and decision control. • Understand the role of the board of directors. • Understand that the board of directors is ultimately responsible for the business and its affairs. • Provide an overview of what the oversight function entails. • Identify and explain the fiduciary duties of the board of directors. • Gain awareness of the variety of board models. • Identify the board attributes that affect the quality of monitoring and oversight. • Illustrate the importance of an independent board of directors. • Become familiar with the best practices of determining directors’ compensation. • Identify and describe the determinants of an effective board of directors. • Become familiar with board accountability, evaluation, and the legal obligations and liabilities facing outside directors of public companies.
Key Terms Audit committee financial expert Business judgment rule CEO duality D&O insurance Duty of care Duty of fair disclosures Duty of loyalty Duty of obedience Fiduciary duty Independent director Lead director National Association of Corporate Directors (NACD) One-tier board model Staggered board Two-tier board model
Role of the Board of Directors The board of directors is ultimately responsible for the company’s business affairs and governance as stated in its governing documents, including the articles of incorporation, the by laws, and shareholder agreements. Many state laws require a corporation to form a board of directors to represent shareholders and make decisions on their behalf. The success of the board of directors depends on the composition, structure, resources, diligence, and authority of the entire board, as well as their working relationships with other participants of corporate governance, including management, external auditors, internal auditors, legal counsel, professional advisors, regulators, standard-setting bodies, and investors.
Roles and responsibilities of boards of directors are to: (1) Represent shareholders and create shareholder value. (2) Align the interests of management with those of shareholders while protecting the interests of other stakeholders (customers, creditors, suppliers). (3) Define the company’s mission and goals. (4) Establish or approve strategic plans and decisions to achieve these goals. (5) Appoint senior executives to manage the company in accordance with the established strategies, plans, policies, and procedures. (6) Oversee the company’s performance by setting objectives, establishing short-term and long-term strategies to achieve these objectives, and assessing the performance of senior executives in fulfilling their responsibilities without micromanaging. (7) Approve major business transactions and corporate plans, decisions, and actions according to the bylaws. (8) Develop and approve executive compensation, pension, post-retirement benefits plan, and other long-term benefits, including stock ownership and stock options. (9) Review financial reports, including audited annual financial statements, quarterly reviewed financial statements, and other important financial disclosures such as management discussion and analysis (MD&A) earnings releases and reports filed with regulators (SEC) or disseminated to the public. (10) Review management’s report on the effectiveness of internal control over financial reporting.
Roles and responsibilities of boards of directors are to (Cont): (11) Provide counsel to the company’s senior executives, especially the CEO, on material strategic decisions and risk management. (12) Ensure the company’s compliance with applicable laws, rules, and regulations. (13) Approve the company’s major operating, investing, and financial activities. (14) Set the tone at the top by promoting legal and ethical conduct throughout the company. (15) Evaluate the performance of the board, its committees (e.g., audit, compensation, and nominating), and the members of each committee. (16) Hold the board, its committees, and directors accountable for the fulfillment of the assigned fiduciary duties and oversight functions. (17) Approve dividends, financing, capital changes, and other extraordinary corporate matters. (18) Oversee the sustainability of the company in creating long-term shareholder value and protecting interests of other stakeholders.
Fiduciary Duties of Board of Directors Fiduciary duty means that, as shareholders’ guardians, directors must be trustworthy, acting in the best interest of shareholders, and investors in turn have confidence in the directors’ actions. MANDATED BY LAW AND SPECIFIED IN COMPANIES CHARTERS AND BYLAWS The corporate governance literature presents the following fiduciary duties of boards of directors: Duty of due care Duty of loyalty Duty of Good Faith Duty to Promote Success Duty to Exercise Diligence, Independent Judgment, and Skill Duty to Avoid Conflict of Interests Fiduciary Duties and Business Judgment Rules.
Board Committee Board committees normally function independently from each other, are provided with sufficient resources and authority, and are evaluated by the board of directors. THUS board committee are a subset of the board and perform specific functions that assist the board in discharging its advisory and oversight responsibilities. Public companies usually have the following board committees: • Audit committee • Compensation committee • Governance committee • Nominating committee • Disclosure committee • Other standing or special committees
Board Committee Audit Committee – composed of at least three independent directors; should be formed to implement and support the oversight function of the board, specifically in the areas related to the internal controls, risk management, financial reporting, and audit committees. Compensation Committee – composed of at least three independent directors; serves to design, review, and implement ‘directors’ and ‘executives’ compensation plans. Governance Committee - consist of both executives and nonexecutives directors; should be established to advise, review, and approve management strategic plans, decisions, and actions in effectively managing the company. Nominating committee – composed of at least three independent directors; should be formed to monitor issues pertaining to the recommendations, nominations and elections activities of directors. Disclosure committees – this committee is usually led by corporate counsel, CFO’s, or controllers. It is responsible for reviewing and monitoring the company’s 10-Ks, 10-Qs, and other SEC fillings, earning releases, materiality issues, conference call scripts, and presentations to the investors by senior management. Special committee – the board of directors may form a special committee to assist the board in carrying out its strategic and oversight function, including financing, budgeting, investment, mergers and acquisitions.
Board Models (Cont) One-Tier Board Model - consists of both inside (executive) directors and outside (nonexecutive) directors. Inside directors are perceived as the decision managers and outside directors are assumed to have the power and duty to monitor those decisions. Two-Tier Board Model - The two-tier board system, consisting of a supervisory board and a management board, better known as the German board model, establishes different authorities and responsibilities for members of each board. Modern Board Model - the structure of the modern board based on the two components of strategic board and oversight board is the natural offshoot of the emerging corporate governance reforms.
Board Characteristics Board Leadership – The effectiveness of board meetings depends largely on the leadership ability of the chairperson to set an agenda and direct discussions. The board agenda is usually prepared by chairperson in collaboration with the CEO. CEO Duality – implies that the company’s CEO holds both the position of chief executive and the chair of the board of directors. The are pros and cons of that model, but investors usually prefer to separate the positions. If they don’t, then it is preferable that the company’s board consists of a ‘substantial’ majority of independent directors. Lead Director – demand for Lead Director increased because of the presence of CEO duality, resulting from growing concern that duality places too much power in the hands of CEO, which may impede board independence. Board Composition – in terms of ratio of inside and outside directors, and the number of directors influence the effectiveness of the board. A board size of nine to fifteen is considered to be adequately tailored to the number of board standing committees. Board Authority – is granted trough shareholder elections. SOX substantially expanded the authority of directors, particularly audit committee members, as being directly responsible for hiring, firing, compensating, and overseeing the work of the companies’ independent auditors.
Board Characteristics Continued Responsibilities – the primary responsibility of the board of directors that the companies assets are safeguarded and that managerial decisions and actions are made in a manner of maximizing shareholders wealth while protecting the interests of other shareholders. Resources – board of directors should have adequate resources to effectively fulfill its oversight functions. Resources available to the board consist of legal, financial, and information resources. Board Independence – implies that, to be independent director shouldn’t have any relationship with the company other than his or her directorship that my compromise the director’s objectivity and loyalty to the companies shareholders. Director compensation – best practices suggest that increases in stock ownership, reduction in cash payments, and charges in compensation should be aligned with shareholders long-term interest determined by board, approved by shareholders, and fully disclosed in public reporting.
Director Education and Evaluation Corporate governance reforms and best practices issued by a number of organizations recommend continuous education and evaluation of the board of directors. Evaluation of the company’s board should be performed formally and regularly (at least annually) through either self-evaluation, independent committee evaluation (audit, compensation, nominating), or outside consulting evaluations.
Board Accountability - Accountability to shareholders Accountability for Board Operation. Accountability for Strategic Decisions and Performance.
Effective Corporate Boards (1) Create and open and engaging boardroom atmosphere (2) Maximize the value of the board’s time commitment by establishing clear roles and responsibilities within an appropriate structure (3) Determine the information the board needs and ensure it is delivered in a timely manner (4) Dedicate time to strategic issues (5) Create a transparent, explicit, and accountable executive pay process (6) Actively engage in CEO succession planning (7) Access the strength of the company’s management talent (8) Monitor the companies enterprise risk management system
Director Liability One way to influence directors’ ethical conduct and create more accountability for them is to increase their legal liability for poor performance and business misconduct. Directors are not reasonably expected to have first-hand knowledge of all company business affairs under their oversight capacity. Nevertheless, directors are responsible for ascertaining the validity, reliability, and quality of information provided to them. In most circumstances, directors make decisions by relying on information furnished by corporate officers, employees, and professionals, including legal counsel and accountants. Thus, the effectiveness of their performance depends on the validity and quality of the information provided to directors.
Conclusion The ultimate responsibility of good corporate governance rests with the board of directors. Decision management, which consists of initiation and implementation of strategies, is viewed as the management’s responsibility, whereas decision control, which entails the ratification and monitoring of strategies, is viewed as the board of directors’ fiduciary duty. The board of directors is usually composed of both insiders (senior executives) and outsiders (independent directors). Nevertheless, the entire board of directors is considered representative of shareholders, that is, responsible for protecting shareholders’ interests. One way to influence directors’ performance and ethical conduct is to hold them accountable and liable for poor performance and business misconduct. The company’s board of directors is ultimately responsible for its business and affairs. The board may delegate its decision-making authority to the company’s top management team, but it is still responsible for running the company without micromanaging.
Conclusion (Cont) The primary responsibilities of the board of directors are to (1) define the company’s mission and goals; (2) establish or approve strategic plans and decisions to achieve these goals; (3) appoint senior executives to manage the company in accordance with the established strategies, plans, policies, and procedures; and (4) oversee managerial plans, decisions, and actions in achieving sustainable shareholder value while protecting the interests of other stakeholders. The business judgment rule provides directors with broad discretion to make good faith business decisions and implies that directors, when making business decisions, must be reasonably Informed. Investors, in general, are in favor of the separation of the positions of the CEO and the chairperson of the board of directors Corporate governance best practices suggest that companies designate one director to take the lead at executive sessions that do not include management.
Conclusion (Cont) Board characteristics, including composition, authority, responsibilities, resources, independence, and compensation, significantly influence its effectiveness. To be independent, a director should not have any other relationships with the company other than his or her directorship that may compromise the director’s objectivity and loyalty to the company’s shareholders. The evaluation of board performance should be completed formally and regularly (at least annually) through either self-evaluation, independent committee evaluation (audit, compensation, nominating), or outside consulting evaluations. Board accountability can be classified into accountability to shareholders for protecting their rights and interests, accountability for the effectiveness of its operation, and accountability for its involvement in the company’s strategic decisions to ensure enduring performance and success.