Study notes from a previous year's CFA exam:
c. describe board independence and explain the importance of independent board members in corporate governance;
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Subject 3. Board Independence
- Independence, which means that the board has the autonomy to act independently and does not only vote along with the management.
- Experience and expertise, which means the board has the competence to evaluate the best interests of the shareowners. Depending upon the business, specialized expertise might be required.
- Resources, which means there are internal mechanisms that allow the board to exercise its independent work, including using outside consultants.
Independence promotes integrity, accountability and effective oversight. We will address experience and resources in later discussions.
The term "Board Member" refers to all individuals who sit on the Board, including:
- Executive Board Members: the members of the executive management. They are not considered to be Independent;
- Independent Board Members;
- Non-Executive Board Members: they may represent interests that may conflict with those of other Shareowners.
An Independent Board Member is defined as one who has no direct or indirect material relationship with the Company, its subsidiaries, or any of its members other than as a Board Member or Shareowner of the Company. Stated simply, an Independent Board Member must be free of any relationship with the Company or its senior management that may impair the Board Member's ability to make independent judgments or compromise the Board Member's objectivity and loyalty to shareowners.
There are many different types of relationships between Board Members and the Company that may be material and preclude a finding of independence, including employment, advisory, business, financial, charitable, family, and personal relationships.
In making determinations regarding Independence, the Board shall consider all relevant facts and circumstances and shall apply the following guidelines:
- Independent Board Members should not be current or former employees of the Company;
- Independent Board Members should not serve as or be affiliated with advisors (including external auditors) to the Company or its senior management;
- Independent Board Members should not do business with the Company.
The Board should be comprised of a substantial majority of Independent Board Members. A Board with this makeup and one which is diverse in its composition is more likely to limit undue influence of management and others over the affairs of the Board. The decisions of such a Board will be more likely to aid the Company's long-term success.
Things to consider for investors:
- Do Independent Board Members regularly meet without the presence of management and report on their activities at least annually to Shareowners?
- Is the Board Chair also the CEO of the Company? If yes, Executive Board Members may have too much influence and impair the ability and willingness of Independent Board Members to exercise their independent judgment.
- Is the Board chair a former chief executive of the Company? If yes, the chair may hamper efforts to undo the mistakes he or she previously made.
- If the Board Chair is not Independent, do Independent Board Members have a lead Member?
- If some Board Members are aligned with a Company-related entity (supplier, customer, auditor, etc.), do they recuse themselves on issues that may create a conflict?
Practice Question 1Which category of board members is considered to be independent?
I. Executive Board Members
II. Independent Board Members
III. Non-Executive Board MembersCorrect Answer: II only
The other two are not independent.
Practice Question 2Which of the following is (are) good indicators of board independency?
I. All board members, including executive board members, independent board members, and non-executive board members, meet quarterly to discuss issues facing the company.
II. Independent board members and non-executive board members constitute 70% of the board.
III. An independent board member, not the chair of the board, serves as the CEO of the company.
IV. One board member is from the Union.Correct Answer: I is false: All independent board members should attend meetings regularly to discuss those issues without influence from executive board members.
II is false: Non-executive board members are not independent: they may represent interests that may conflict with those of those shareowners.
III is false: If a board member servers as the CEO, the member is not considered independent.
IV. It's OK that a board has some members who are aligned with a company-related entity. However, they should recuse themselves on issues that may create a conflict.
Practice Question 3Both the CEO and a Union representative serve as board members. They are categorized as ______.
I. Executive Board Members
II. Independent Board Members
III. Non-Executive Board Members
IV. Independent Executive Board MembersCorrect Answer: I and III
The CEO is an executive board member and the Union representative is a non-executive board member. IV is not a defined category on a board.
Practice Question 4A board member will not be considered Independent if ______
I. his daughter works for the company as a secretary.
II. he used to be the national sales manager for the company but quit before he was elected a board member.
III. his wife works for an accounting firm which is the auditor for the company.Correct Answer: All of them
All of these relationships are considered "material relationships."
Practice Question 5Select the warning sign(s) that a Board may not be Independent.
I. The Board reports on their activities to Shareowners every six months.
II. The current CEO of the Company serves as the Board Chair.
III. A Board Member retires as CEO and is elected to be the Board Chair.
IV. Several Board Members are representatives from suppliers, big clients, and the Union.Correct Answer: II and III
I: The Board should report to Shareowners at least annually.
IV in itself is not a warning sign, as long as the majority of the Board members are Independent.
Practice Question 6A board chair also holding the title of chief executive, from the corporate governance point of view, is ______
A. unacceptable because it is universally prohibited in all jurisdictions.
B. acceptable because the effectiveness of the chief executive would be enhanced by his or her position as the chairperson of the board.
C. unacceptable because combining the two positions may reduce the ability and willingness of independent board members to exercise their independent judgment.Correct Answer: C
A is incorrect; there are some jurisdictions that allow the combining of the two positions.
B is incorrect because it is not the effectiveness of the chief executive that is being questioned. The main issue is whether the board's independence would be compromised.
Practice Question 7A publicly listed company has a 12-person Board of Directors whose composition is as follows:
- The Chairman, who is the past president of the company and was named Chairman on his retirement date four years ago,
- Five members of senior management including the current president, and
- Six outside directors.
Which of the following actions would provide the greatest improvement in the corporate governance of this company?
A. The Chairman of the Board should be an independent director.
B. All members of the Board of Directors should stand for election every year.
C. The company's Vice-President of Finance should be a member of the Audit Committee.Correct Answer: A
If the chair of the board is a former chief executive of the company, it may hamper efforts to undo the mistakes made by him or her as chief executive. It is not clear if it is better to have all members elected annually (more flexibility to meet changes in the marketplace) or if it is better to have staggered board terms (better continuity of board expertise). All members of the audit committee should be independent members of the board.