Evaluating the Board of Directors: Understanding Corporate Governance
Introduction: When assessing a company’s governance, the board of directors plays a critical role. In the wake of corporate scandals like Enron and WorldCom, where boards failed to act in the best interests of investors, the importance of evaluating the board cannot be overstated. Even though the Sarbanes-Oxley Act of 2002 enhanced corporate accountability, investors should remain vigilant in monitoring the composition and actions of a company’s board of directors. In this article, we will explore the key factors to consider when evaluating a board and its impact on a company’s operations.
Key Takeaways: To understand the governance of a company, investors should consider the following:
- Board Size:
- An optimal board size of 8 to 10 members is recommended by Governance Today.
- The Wall Street Journal’s study reveals that companies typically have an average of 11.2 board directors.
- The board should have a minimum of six members to ensure independent representation on critical committees.
- Critical committees, such as the compensation and audit committees, should be composed of independent members.
- Members serving on multiple boards may struggle to allocate sufficient time to their responsibilities.
- Independent Outsiders:
- An effective board should consist of a majority of independent outsiders.
- Insiders dominating the board may raise concerns about impartial decision-making.
- Independent outsiders are individuals who have no previous association with the company or its key stakeholders.
- Mislabeling insiders as outsiders, such as retired CEOs or relatives with conflicts of interest, should be avoided.
- The board should strive for a balance between executive and non-executive directors.
- If the board chair is a non-executive director, at least one-third of the board should comprise independent directors.
- If the chair is an executive director, independent directors should make up at least half of the board.
- Board Committees:
- The structure and effectiveness of critical board committees are crucial indicators of good governance.
- The four primary committees to evaluate are the executive, audit, compensation, and nominating committees.
- Each committee should have a minimum of three members to prevent conflicts of interest.
- The chairperson of the board should not also serve as the CEO to avoid conflicts of interest.
- Additional committees, such as nominating or governance
Evaluating the Board of Directors: Assessing Committees, Member Commitments, and Conflicts of Interest
- How Are the Board Committees Made Up?
The board of directors typically consists of four main committees: executive, audit, compensation, and nominating. Let’s delve deeper into each committee:
- Executive Committee: Comprised of a small number of readily accessible board members, the executive committee makes timely decisions on urgent matters. The committee’s proceedings are reported to and reviewed by the full board. Preferably, the majority of the executive committee should consist of independent directors.
- Audit Committee: This committee collaborates with auditors to ensure accurate financial reporting and identify conflicts of interest with other consulting firms engaged by the company. It is ideal for the audit committee chair to be a Certified Public Accountant (CPA). However, meeting this requirement often involves retired bankers who may lack expertise in detecting fraud. The committee should convene at least four times a year for audit review and address additional issues as necessary.
- Compensation Committee: Responsible for determining executive compensation, this committee should avoid conflicts of interest. Surprisingly, some companies allow individuals with conflicts, such as the CEO, to serve on this committee. It’s essential to examine whether committee members also serve on compensation committees of other firms, as this can lead to further conflicts. The committee should meet at least twice a year to ensure robust deliberation rather than rubber-stamping decisions made by the CEO or consultants.
- Nominating Committee: Tasked with nominating candidates for the board, the nominating committee aims to bring independent individuals with skills currently lacking on the board. The nomination process should prioritize diversity and independence to enhance board effectiveness.
- What Other Commitments and Time Constraints Do the Board Members Have?
Assessing board members’ commitments outside the board is crucial to gauge their availability and effectiveness:
- Directors typically spend over 200 hours annually on board-related matters, equivalent to one full month of workdays.
- Independent board members often serve on multiple boards and committees, including audit and compensation committees. This raises concerns about their ability to dedicate sufficient time to each company’s affairs. It also highlights potential challenges in sourcing qualified independent directors.
- Are There Related Transactions That May Cause a Conflict of Interest?
Disclosures of related transactions between the company, executives, and directors can unveil conflicts of interest:
- Companies must provide information about such transactions in a financial note titled “Related Transactions.”
- Examples of conflicts include engaging in business with a director’s company or paying professional fees to the CEO’s relatives.
The composition and performance of a company’s board of directors offer valuable insights into its commitment to shareholders. By examining committee structures, member commitments, and conflicts of interest, investors can assess the board’s objectivity and independence. Weak governance practices compromise investor interests and should be scrutinized thoroughly. By adhering to the guidelines outlined in the Sarbanes-Oxley Act of 2002 and evaluating these key factors, stakeholders can make informed decisions about a company’s governance and mitigate potential risks.
Additional Resources for Comprehensive Understanding of Corporate Governance
Websites and Online Resources:
- The Conference Board: A leading global research organization providing valuable insights into corporate governance practices and trends. Visit their website for reports, articles, and webinars on board effectiveness and governance best practices. Link to The Conference Board
- U.S. Securities and Exchange Commission (SEC): The official website of the SEC offers a wealth of information on corporate governance regulations and guidelines. Explore their “Investor Information” section for resources on evaluating boards of directors and understanding disclosure requirements. Link to SEC’s Corporate Governance Resources
- “Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences” by David Larcker and Brian Tayan: This book provides a comprehensive analysis of corporate governance principles, board structures, and their impact on company performance. It offers valuable insights into evaluating board effectiveness and the role of various committees. Link to the book
- “Inside the Boardroom: How Boards Really Work and the Coming Revolution in Corporate Governance” by Richard Leblanc: This book explores the dynamics of boardrooms, the challenges faced by boards, and the evolving landscape of corporate governance. It offers practical advice for evaluating boards and enhancing governance practices. Link to the book
Academic Journals and Research Papers:
- “Board of Directors and Firm Performance: A Review and Research Agenda” by Heli Wang and Paul M. Fischer: This research paper provides an overview of the relationship between board composition, board processes, and firm performance. It highlights the importance of evaluating boards and identifies future research directions. Link to the paper
- “Corporate Governance and Firm Performance: A Comparative Analysis of European Countries” by Roberto Tallarita and Angela Pettinicchio: This academic paper examines the relationship between corporate governance practices and firm performance across European countries. It offers insights into the impact of board characteristics on company outcomes. Link to the paper
Reports and Studies:
- “Board Practices: In-Depth Analysis of Board Composition, Board Responsibilities, and Director Compensation” by Deloitte: This report provides an in-depth analysis of board practices, including board composition, director responsibilities, and compensation trends. It offers valuable insights for evaluating boards and benchmarking against industry standards. Link to the report
- “The Global Board Survey: Governance trends shaping the future” by EY: This comprehensive survey report explores global governance trends and challenges. It covers topics such as board diversity, director tenure, and board effectiveness. It provides valuable insights into emerging governance practices. Link to the report
Professional Organizations and Associations:
- National Association of Corporate Directors (NACD): NACD is a leading organization dedicated to promoting effective corporate governance. Their website offers resources, research, and educational programs for directors and governance professionals. Link to NACD
- The Institute of Directors (IOD): The IOD is a professional membership organization focused on advancing corporate governance and leadership excellence. Their website provides valuable resources, events, and training programs for directors and aspiring board members. Link to IOD