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Subject 4. The Board of Directors
- Establish corporate values and governance structures for the company to ensure that the business is conducted in an ethical, competent, fair and professional manner.
- Ensure that all legal and regulatory requirements are met and complied with fully and in a timely fashion.
- Establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner.
- Establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations.
- Hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance.
- Ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decision that are its responsibility, and to be able to adequately monitor and oversee the company's management.
- Meet regularly to perform its duties and in extraordinary session as required by events.
- Acquire adequate training so that members are able to adequately perform their duties.
An investors or investment analyst must assess the following attributes of the board:
Board Composition and Independence
An independent board director is defined as one who has no direct or indirect material relationship with the company, its subsidiaries or any of its board directors, other than as a board director or shareholder of the company. Stated simply, an independent board director must be free of any relationship with the company or its senior management that may impair the director's ability to make independent judgments or compromise the director's objectivity and loyalty to shareholders.
The board should be comprised of a substantial majority of independent directors. 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.
Independent Chairman of the Board
Is the board chair also the CEO of the company? If yes, the board chair may have too much influence and impair the ability and willingness of other independent directors to exercise their independence judgment. However, many corporate managers argue that it is essential for efficient and effective board functioning that the chairman be the senior executive in the company because only such an executive has the knowledge and experience necessary to provide needed information to the board on questions on strategy, policy and the operational functioning of the company.
Clearly, independence of the chairman of the board does not guarantee that the board will function properly but it is a necessary condition for board independence.
Qualifications of Directors
Directors who have appropriate experience and expertise relevant to the company's business are best able to evaluate what is in the best interest of shareholders. They must be able to contribute business judgment to board deliberations and decisions, based on their experience in relevant business, management disciplines or other professional life.
If directors lack the skills, knowledge and expertise to conduct a meaningful review of the company's activities, and are unable to conduct in-depth evaluations of the issues affecting the company's business, they are more likely to defer to management when making decisions.
Annual Election of Directors
Companies that prevent shareholders from electing directors on an annual basis limit shareholders' ability to change the board composition, for example, when directors fail to act on their behalf, or to elect individuals with needed expertise in response to a change in company strategy.
In a classified or staggered board, directors are typically elected in two or more classes, serving terms greater than one year. Using an example of a three-year staggered board, at each annual meeting, one third of the directors or nominees would be eligible for shareholder ratification for a three-year period.
- Proponents of staggered boards argue that by staggering the election of directors, a certain level of continuity and skill is maintained.
- Staggered terms for directors make it more difficult for shareholders to make fundamental changes to the composition and behavior of the board, by making it extremely difficult for any challenge to, or change in, board control. In circumstances of deteriorating company performance, this difficulty could result in a permanent impairment of long-term shareholder value.
Corporate governance best practice generally supports the annual election of directors as being in the best interest of investors.
Annual Board Self-Assessment
Board members should meet at least once a year to review and evaluate their performance and make recommendations for improvement. The process of self-assessment should focus on board responsibilities and individual members' accountability for fulfilling their responsibilities.
Separate Sessions of Independent Directors
Do independent directors regularly meet without the presence of management, and report on their activities at least annually to shareholders' The purpose of these meetings is to provide an opportunity for those entrusted with the best interests of the shareholders to engage in candid and frank discussions and debate regarding the management of the company, their strategies and policies, strengths and weaknesses, and other matters of concern.
Audit Committee and Audit Oversight
The audit committee plays a critical role in ensuring the corporation's financial integrity and consideration of legal and compliance issues. The primary objective is to ensure that the financial information reported by the company to shareholders is complete, accurate, reliable, relevant and timely.
In most corporations, currently, nominations of board members and for 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 shareholders. Consequently, corporate governance best practice requires that nominees to the board be selected by a nominee committee comprising only 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.
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 that is better than that of a peer group. With shareholders' interest and fairness in mind, the committee should ensure that the executive compensation packages are commensurate with the level of the 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 on the committee. Committees lacking independence could award excessive compensation due to management pressures, could provide incentives for actions that boost short-term share prices at the expense of long-term profitability and value.
Investors should determine whether the composition of the compensation packages is appropriate.
- In general, salary and perquisite awards should constitute a relatively small portion of the total compensation package.
- Bonuses should be awarded based solely on exceeding expected performance to motivate managers to achieve sustainable long-term growth of the company.
- Although stock options and stock awards have been argued to better align the interests of managers with those of shareholders, they don't always result in such an alignment of interests because large firms' managers generally own only a small percentage of the stock. Investors should ask question like:
- Is the accounting for stock options appropriate?
- Is the company required to receive shareholder approval for any share-based remuneration plans?
- What is the stock options' potential dilutive effect?
- Are there any provisions that permit "re-pricing" of stock options? Companies might want to reprice downward the strike prices of stock options previously granted. This would remove the incentives the original options created for management.
Board's Independent Legal and Expert Counsel
The fact that the corporate counsel, which is paid by the management, is charged to advise the board represents a direct conflict of interest. That is, the corporate council cannot be wholly independent with regard to the advice given to the board. The board should have the ability and enough resources to hire independent legal and other expert counsel to help them fulfill their fiduciary duties. Specifically, the board should have the authority to decide whether to hire external counsel, whom should be hired, and how the external should be compensated, etc without having to receive approval from management. This mechanism provides the board with the ability to obtain expert help in specialized areas, to circumvent potential areas of conflicts with management, and to preserve the integrity of the board's independent oversight function.
Statement of Governance Policies
Companies committed to corporate governance often provide a statement of corporate governance policies. Analysts should assess:
- The code of ethics.
- Statements of the oversight, monitoring, and review responsibilities of directors.
- Statements of management's responsibilities with respect to information and access of directors to internal company functions.
- Reports of directors' examinations, evaluations, and findings.
- Board and committee self-assessments.
- Management self-assessments.
- Training policies for directors.
Disclosure and Transparency
The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.
Insider or Related-Party Transactions
Insider or related-party transactions involve buying, selling, and other transactions with directors, executives, partners, employees, family members and so on. They are not illegal or necessarily a violation of any kind. However, directors are supposed to make independent decisions. Receiving personal benefits from the company can create an inherent conflict of interest.
Responsiveness of Board of Directors to Shareholder Proxy Votes
The ability to vote one's shares is a fundamental right of share ownership. Sometimes a company makes it difficult for shareholders to vote their common shares. The ability to propose needed changes can prevent erosion of shareholder value. This could pressure the board or management to change the way they do business.
An analyst should review all such proxies put to the shareholders, determining the shareholders' consensus as reflected in the relative size of the affirmative vote, and determine the directors' response to the vote as reflected in the actions taken by the board and management.
Practice Question 1A board director 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 to be a board director.
III. his wife works for an accounting firm which is the auditor for the company.Correct Answer: All of them
All of them are considered as "material relationships".
Practice Question 2Select the warning sign(s) that a board may not be independent:
I. The board reports on their activities to shareholders every six months.
II. The current CEO of the company serves as the board chair.
III. A board director 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 shareholders at least annually.
IV itself is not a warning sign, as long as the majority of the board directors are independent.
Practice Question 3The board has the authority to decide whether to hire external auditor, whom should be hired, and how much to pay the auditor subject to CFO's (Chief Financial Officer's) approval. True or False?Correct Answer: False
CFO is a member of management. The board should have the authority without having to receive approval from management.
Practice Question 4True or False? A classified board is a good sign of corporate governance.Correct Answer: False
Staggered terms for board directors in a classified board make it more difficult for shareholders to make fundamental changes to the composition and behavior of the board.
Practice Question 5A staggered board:
I. provides more flexibility to nominate new board directors to meet changes in the market place than an annually elected board.
II. may serve as an anti-takeover device.
III. may provide better continuity of board expertise than an annually elected board.Correct Answer: II and III
Practice Question 6Select the correct statements about related-party transactions:
I. Related-party transactions are illegal.
II. Companies have to disclose related-party transactions even if they are non-material.Correct Answer: Neither statement
I. They are not illegal or necessarily a violation of any kind.
II. Current accounting and auditing standards require the disclosure of these transactions (only if material) but no more.
Practice Question 7The role of the audit committee should be described in detail in the proxy statement, including:
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 auditor.Correct Answer: all of them
Practice Question 8The 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 9Select the correct statement(s):
I. All members of the audit committee must be independent board directors.
II. All members of the audit committee must be financial/ or 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 lead them to resolve conflicts regarding financial reporting issues in favor of shareholders instead of management.Correct Answer: None of the above
Although I and II are 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 10Select the correct statement(s):
I. The nomination 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 directors.Correct Answer: II only
I. It is responsible for recruiting new board directors.
III. The practice is recommended.
Practice Question 11John, an Independent Board Member of Company A, borrows $1 million from A at the prevailing market rate of 5.6% to finance his own independent start-up company. Should this situation be considered appropriate corporate governance practice?
A. Yes, as he pays the prevailing interest rate.
B. No, because this is a related party transaction.
C. No, because this creates a conflict of interest.Correct Answer: C
The company should not lend the money to John, no matter he pays the market interest rate or not. Any appearance of conflict of interest should be avoided.
Practice Question 12True or False? A company should have a nomination committee of independent board directors. The only way to nominate a new board director is through the nomination committee.Correct Answer: False
Shareholders should be able to nominate individuals for election to the board under certain circumstances.
Practice Question 13All of the following are core attributes of an effective corporate governance system except:
A. Identifiable and measurable accountabilities for the performance of responsibilities.
B. Fairness and accuracy in identifying inherent conflicts of interest.
C. Delineation of shareholders and other core stakeholders' rights.Correct Answer: B
Practice Question 14Which of the following is a problem that an effective corporate governance system would mitigate or eliminate?
A. To maintain a certain level of continuity and skill of the board, no board member should be removed from the board under any circumstances.
B. A majority of the board is independent.
C. The board reports on their activities to shareholders once a year.Correct Answer: A
Shareowners should be able to vote to remove a Board Member under certain circumstances. Besides, corporate governance best practice generally supports the annual election of Board Members as being in the best interest of investors.
Practice Question 15The 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 auditor.Correct Answer: A
Practice Question 16If a Board Member leases a company airplane for free personal use, it is an indication of
A. related-party transactions.
B. personal use of company assets.
C. inappropriate executive compensation.Correct Answer: B
On the other hand, if a board director leases his or her own airplane to the company, it will be considered as a related-party transaction.
Practice Question 17Select the incorrect statement(s) regarding good corporate governance practices:
I. Board directors cannot have any material relationship with the company, other than as a board director or shareholder of the company.
II. Board directors cannot use company assets.
III. If a shareholder-approved proposal is not binding, then the company does not have to implement it.
A. II and III
B. I and III
C. I, II and IIICorrect Answer: C
I. Independent Board Members cannot have any material .... .
II. They cannot use Company assets for personal use.
III is true. However, this would be a sign of weak corporate governance.
Practice Question 18Which of the following are problems that an effective corporate governance system would mitigate or eliminate?
I. Proxy voting is not permitted.
II. Board directors are unable to conduct in-depth evaluations of the issues affecting the company's business.
III. A company requires a simple two-thirds vote for passing a shareholder resolution and a simple majority vote to pass board-sponsored initiatives.
IV. The only way for shareholders to submit resolutions to consider specific issues is at the company's annual general meeting.
A. I, II and IV
B. I, III and IV
C. I, II, III and IVCorrect Answer: C
They are all warning signs of weak corporate governance.
Practice Question 19Which of the following is least essential with respect to the attributes of the board than an investor must assess?
A. The independence of its audit committee.
B. The independence of its compensation or nominations committee.
C. The independence of its legal committee.Correct Answer: C
While all subcommittees of the board play an essential role, for some of them, it is particularly important that they be made up of independent directors. When it comes to audit, compensation and nominations, there would just be too much conflict if the directors heading these committees were in fact members of the company's management team.
Practice Question 20Which of the following is least essential with respect to the attributes of the board than an investor must assess?
A. The amount of compensation directors make outside of their directorship role, which may impair their motivation to become effective directors in the subject company.
B. Elections of board members on a staggered basis may reduce shareholders influence over the direction in which management may lead the firm.
C. Elections of board members on an annual basis may be disruptive to its responsibilities of overlooking management.Correct Answer: A
If outside compensation was such a driving force in directors' actions, then chances are that they would have refused the role of director in the first place. Many directors are established executives with hefty compensation levels.
Practice Question 21Which of the following is least essential with respect to the attributes of the board than an investor must assess?
A. The qualification of directors in terms of knowledge of the industry in which the subject corporation operates in.
B. How many special meetings the board has relative to similar companies in the industry.
C. Examine whether the majority of the board members are independent of management's influence, or whether the chairman of the board is in fact a senior executive of the corporation.Correct Answer: B
While a regularly scheduled number of meetings is important to attend, the number of excess or special meetings doesn't say much. In fact, sometimes, a high frequency of meetings could indicate that the company is troubled and that the board has a weak handle on the situation.
Practice Question 22Which of the following statements is false with respect to the responsibilities of the board of directors?
A. Respond to shareholder inquiries about the corporation within an adequate period of time.
B. Acquire the training necessary in order for the board members to carry out their responsibilities.
C. Monitor and oversee the major actions undertaken by management, and ensure that management submits timely and relevant information to the board in order to enable it to make strategic decisions.Correct Answer: A
While it is true that board members must respond to shareholder inquiries, this process is generally done at the annual shareholders meeting. In order words, it would not be possible for a shareholder at any time to pick up the phone and call a director with a particular inquiry. Instead, firms usually have an investors relation department which handles such inquiries.
Practice Question 23Which of the following statements is false with respect to the responsibilities of the board of directors?
A. Submit financial statements to the independent auditors.
B. Hire the CEO and determine the level and composition of compensation for that role.
C. Establish a system of performance measurement and evaluation.Correct Answer: A
The role of preparing and submitting financial statements to independent auditors falls on management. However, the board is responsible for appointing the independent auditor.
Practice Question 24Which of the following statements is false with respect to the responsibilities of the board of directors?
A. Ensure that all laws and regulations are adhered to by the corporation.
B. Approval of all long term contracts entered into by the corporation.
C. Establish corporate values and long term strategic objectives.Correct Answer: B
Generally, the board of directors does not get involved in the micro management of the firm. Tasks, such as entering into long term contracts with suppliers and vendors, are left up to management discretion.
Study notes from a previous year's CFA exam:
d. describe responsibilities of the board of directors and explain qualifications and core competencies that an investment analyst should look for in the board of directors;
e. explain effective corporate governance practice as it relates to the board of directors and evaluate strengths and weaknesses of a company's corporate governance practice;