Subject 7. Board Committees
The Board should delegate certain functions to committees. Under new U.S. regulations, three key committees must be comprised exclusively of independent directors: the audit committee, the compensation committee, and the corporate governance/nominating committee. The new requirements have also greatly expanded the responsibilities and necessary competencies of audit committee members. The credibility of the corporation will depend in part on the vigorous demonstration of independence by the committees and their chairs. Committees should have the right to retain and evaluate outside consultants and to communicate directly with staff below the senior level.
The committees should report back to the board on important issues they have considered and upon which they have taken action. They should meet in executive session on a regular basis with management personnel, if appropriate (because of issues under discussion), and also without such personnel being present. If the company receives a shareholder proposal, the committee most appropriate to consider the matter should review the proposal and the management's response to it.
Investors should determine whether the Board has established a committee of Independent Board Members, including those with recent and relevant experience of finance and accounting, to oversee the audit of the Company's financial reports.
The audit committee of the Board is established to provide independent oversight of the Company's financial reporting, non-financial corporate disclosure, and internal control systems. This function is essential for effective corporate governance and for seeing that responsibilities to Shareowners are fulfilled.
The committee represents the intersection of the board, management, independent auditors, and internal auditors, and it has sole authority to hire, supervise, and fire the corporation's independent auditors. When selecting auditors, the committee should:
- consider the auditors' independence,
- ensure the auditor's priorities are aligned with the best interests of Shareowners, and
- ensure the quality and integrity of the company's financial statements.
When evaluating the audit committee, investors should determine whether:
- all of the Board Members on the committee are independent (note that some jurisdictions permit non-Independent members to be on the committee),
- any of the Board Members are considered financial experts,
- the appointment of the external auditors is subject to Shareowner approval,
- the committee's independence is compromised by the provision of non-audit services. The committee should establish limitations on the type and amount of such services that the auditor can provide. The committee should also consider imposing limitations on the corporation's ability to hire staff from the auditor and requiring periodic rotation of the outside auditor.
- the committee is responsible for the adequacy and effectiveness of the company's internal controls and the effectiveness of management's process of monitoring and managing business risks facing the company. The committee should establish a means by which internal auditors and other employees can communicate directly with committee members.
- the committee and the external auditor had any discussions resulting in a change in the financial reports as a result of questionable interpretations of accounting rules, fraud, or other accounting problems, and whether the Company has fired its external auditors as a result of such issues, and
- the committee controls the audit budget to enable it to address unanticipated or complex issues.
Remuneration / Compensation Committee
Investors should determine whether the Company has a committee of Independent Board Members charged with setting executive remuneration/compensation.
Executive compensation practices provide a window into the effectiveness of the Board. Through the compensation committee, the Board should implement rational compensation practices that respond to the Company's equity policy, including conditional forms of compensation that motivate executives to achieve performance better than that of a peer group. With Shareowners' interest and fairness in mind, the committee should ensure that executive compensation packages are commensurate with the level of responsibilities of the executive and appropriate in light of the Company's performance. All policies should be disclosed to shareholders upon adoption by the full board.
The committee should have only Independent Board Members. Committees lacking independence could award excessive compensation due to management pressures and/or provide incentives for actions that boost short-term share prices at the expense of long-term profitability and value.
When evaluating this committee, investors should determine whether:
- the composition of the compensation packages (that is, the terms and options granted to management and employees) is appropriate and whether the terms are reasonable,
- the Company provided loans or the use of Company property and equipment to Board Members,
- members of the committee regularly attended meetings during the past year,
- there were any public disclosures of the compensation paid during the past year to the Company's five highest-paid executives and its Board Members,
- the Company intends to issue new registered shares to fulfill its share-based remuneration obligations or whether it intends to settle these options with shares repurchased,
- the Company and the Board are required to receive Shareowner approval for any share-based remuneration plans, and
- senior executives from other Companies that have cross-directorship links with the Company are members of the committee. This could create a conflict of interest.
Investors should determine if the Company has a nomination committee of Independent Board Members that is responsible for recruiting Board Members.
In most corporations, currently, nominations of Board Members and executive officers of the Company are made by Board Members, most often at the recommendation of, or in consultation with, the management of the company. In such circumstances, the criteria for selection of nominees may favor management's best interests at the expense of the interests of Shareowners. Consequently, corporate governance best practices require that nominees to the Board be selected by a nomination committee comprised only of Independent Board Members.
The committee is responsible for:
- Recruiting new qualified Board Members;
- Regularly examining the performance, independence, skills, and expertise of existing Board Members;
- Creating nominations policies and procedures;
- Succession planning of executive management and the Board.
Investors should review the committee's practices of recruiting Board Members who act in the best interests of Shareowners. They should also review:
- The criteria for new Board Members, and whether the new nominees complement the Board's current portfolio of talents;
- The composition, background, and areas of expertise of existing Board Members;
- How the committee searches for candidates;
- Whether the Company has a succession plan for executive management;
- The committee's reports, which should include issues such as the number of meetings held and meeting attendance during the past year, as well as the committee's policies and procedures.
Investors should determine whether the Board has other committees that are responsible for overseeing management's activities in certain areas, such as corporate governance, mergers and acquisitions, legal matters, or risk management.
Practice Question 1The role of the audit committee should be described in detail in the proxy statement, and include ______.
I. the members
II. the role of the committee
III. analysis of the selection process of the external auditor
IV. how the auditor is to be evaluated
V. fees paid to the auditorCorrect Answer: All of them
Practice Question 2The audit committee should ensure that the external auditors ______
I. have authority over the audit of the entire corporate group, including foreign subsidiaries and affiliated companies.
II. are independent of management influence.
III. prepare the financial statements in accordance with generally accepted accounting principles (GAAP).
IV. conduct the audit in accordance with generally accepted auditing standards (GAAS).Correct Answer: I, II and IV
III. The external auditors don't prepare the financial statements.
Practice Question 3Select the correct statement(s) based on "A Manual for Investors":
I. All members of the audit committee must be Independent Board Members.
II. All members of the audit committee must be financial accounting experts.
III. Because external auditors are hired by the Board, the non-audit fees paid to them by the Company tend to influence the auditors in a way that leads them to resolve conflicts regarding financial reporting issues in favor of Shareowners instead of management.Correct Answer: I
I: "... has established a committee of Independent Board Members, including..."
Although II is not required, these practices are highly recommended.
III: Note that the non-audit consulting services are usually approved by the management, not the Board.
Practice Question 4Select the correct statement(s).
I. The nominations committee is responsible for recruiting top executives.
II. Executive compensation plans may affect the number of shares outstanding and the market valuations of the Company's securities.
III. All members of the nominations committee must be Independent Board Members.Correct Answer: II and III
I: The nominations committee is responsible for recruiting new Board Members.
Practice Question 5Regarding corporate governance, which of the following is most likely a reason for concern when evaluating the compensation committee? The compensation committee ______
A. includes members of executive management.
B. purchases shares on the open market to fund stock option commitments.
C. discloses information about compensation paid to executives and board members.Correct Answer: A
The compensation committee should be independent from executive management.
Practice Question 6The audit committee should ensure that if there are any conflicts of interest between the external auditor and the Company, they should be resolved in favor of the ______.
C. external auditorCorrect Answer: A
Practice Question 7Based on the "A Manual for Investors", investors should ensure that all members of the ______ are Independent Board Members.
I. audit committee
II. remuneration/compensation committee
III. nominations committee
A. I, II and III
B. I and II
C. None of them. These are recommended practices but they are not required by the manual.Correct Answer: A
Investors should determine whether the Board has established these committees of Independent Board Members (although some jurisdictions permit non-Independent members to serve on these committees).
Study notes from a previous year's CFA exam:
e. describe responsibilities of the audit, compensation, and nominations committees and identify factors an investor should consider when evaluating the quality of each committee;