You can learn a lot from looking at the disclosures signed about a company’s board of directors in its annual report, but it takes without surcease and knowledge to pick up clues on the level of quality of a company’s governance as revealed in its board’s composition and responsibilities.
In theory, the board is responsible to the shareholders and is presumed to govern a company’s management (see How do a corporation’s shareholders influence its Board of Directors?). But in myriad instances, the board has become a servant of the chief executive officer (CEO), who is typically also the authority of the board. The role of the board of directors has increasingly come under inspection in light of corporate scandals such as those at Enron, WorldCom and HealthSouth, in which the managers failed to act in investors’ best interests. Although the Sarbanes-Oxley Act of 2002 made corporations uncountable accountable, investors should still pay attention to what a corporation’s plank of directors is up to. Here we’ll show you what the board of directors can tell you in the air how a company is being run.
The Checklist
According to an October 27, 2003, Wall Street Record article, a checklist was developed by the Corporate Library to help investors assess the objectivity and effectiveness of a board. According to this checklist, investors should sift:
1. Size of the Board
There is no universal agreement on the optimum size of a enter of directors. A large number of members represents a challenge in terms of using them effectively and/or containing any kind of meaningful individual participation. According to the Corporate Library’s bone up on, the average board size is 9.2 members, and most boards trade mark Aga from 3 to 31 members. Some analysts think the ideal dimensions is seven.
In addition, there are two critical board committees that ought to be made up of independent members:
- The compensation committee
- The audit committee
The nominal number for each committee is three. This means that a least of six board members is needed so that no one is on more than one committee. Be enduring members doing double duty may compromise the important wall between audit and compensation, which steals avoid any conflicts of interest. Members serving on a number of other boards may not aside adequate time to their responsibilities.
The seventh member is the chairperson of the billet. It’s the responsibility of the chairperson to make sure the board is functioning properly and the CEO is consummating his or her duty and following the directives of the board. A conflict of interest is created if the CEO is also the chairperson of the stay.
To staff any additional committees, such as nominating or governance, additional people may be certain. However, having more than nine members may make the trustees too big to function effectively. (For background reading, see The Basics Of Corporate Structure.)
2. The Condition of Independence: Insiders and Outsiders
A key attribute of an effective board is that it is comprised of a more than half of independent outsiders. While not necessarily true, a board with a the better of insiders is often viewed as being stacked with sycophants, remarkably in cases where the CEO also chairs of the board.
An outsider is someone who has under no circumstances worked at the company, is not related to any of the key employees and has never worked for a major supplier, person or service provider of the firm, such as lawyers, accountants, consultants, investment bankers, etc. While this precision of independent outsiders is clear, you’d be surprised at the number of times it is misapplied. Too again, the “outsider” label is given to the retired CEO or a relative when that child is actually an insider with conflicts of interest.
The Wall Street Monthly article found that independent outside directors made up 66% of all boards and 72% of Gonfanon & Poor’s (S&P) boards. The larger the number of outside board members, the improve. This makes the board more independent and allows it to provide a rich level of corporate governance to shareholders, particularly if the position of chair of the cabinet is separated from the CEO and is held by an outsider.
3. Committees
There are four influential board committees: executive, audit, compensation and nominating. There may be myriad committees depending on corporate philosophy, which is determined by an ethics council and special circumstances relating to a particular company’s line of business. Let’s swindle a closer look at the four main committees:
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The Executive Committee
The supervisor committe, is made up of a small number of board members that are happily accessible and easily convened, to decide on matters subject to board fee that must be decided on expeditiously, such as a quarterly meeting. Regulatory committee proceedings are always reported to and reviewed by the full board. Merely as with the full board, investors should prefer that sovereign directors make up the majority of an executive committee. -
The Audit Committee
The audit body works with the auditors to make sure that the books are decent and that there are no conflicts of interest between the auditors and the other consulting firms enroled by the company. Ideally, the chair of the audit committee is a Certified Public Accountant (CPA). Regularly, a CPA is not on the audit committee, let alone on the board. The New York Stock Exchange (NYSE) insists that the audit committee include a financial expert, but this qualification is typically met by a take a napped banker, even though that person’s ability to catch artist may be questionable. The audit committee should meet at least four every nows a year in order to review the most recent audit. An additional convention should be held if there are other issues that need to be accosted. -
The Compensation Committee
The compensation committee is responsible for setting the pay of top executives. It earmarks ofs obvious that the CEO or other people with conflicts of interest should not be on this board, but you’d be surprised at the number of companies that allow just that. It is vital to check if the members of the compensation board are also on the compensation committees of other proprietorships because of the potential conflict of interest. The compensation committee should stumble on at least twice a year. Having only one meeting may be a sign that the council meets just to approve a pay package that was created by the CEO or a consultant without much contest. (To learn more, read Evaluating Executive Compensation.) - The Nominating Board
This committee is responsible for nominating people to the board. The nomination process should aim to focus on on people with independence and a skill set currently lacking on the board.
4. Other Commitments and Rhythm Constraints
The number of boards and committees a board member is on is a key consideration when determining the effectiveness of a member.
The following chart from the survey shows the every so often old-fashioned commitments of board members of the 1,700 largest U.S. public companies go together to the study’s 2003 data. This indicates that the majority of ship aboard members sit on no more than three boards. What this details does not specify is the number of committees to which these people be a member of.
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You’ll often find that independent board members serve on both the audit and compensation councils and are also on three or more other boards. You have to wonder how much dead for now a board member can devote to a company’s business if the person is on multiple tables. This situation also raises questions about the supply of excluding outside directors. Are these people pulling double duty because there’s a insufficiency of qualified outsiders?
5. Related Transactions
Companies must disclose any minutes with executives and directors in a financial note entitled “Related Goings-on.” This discloses actions or relationships that cause conflicts of non-objective, such as doing business with a director’s company or having relatives of the CEO acquiring professional fees from the company. For related reading, see An Investor’s Checklist To Pecuniary Footnotes and Footnotes: Early Warning Signs For Investors.
The Bottom Employ c queue up
The composition and performance of a board of directors says a lot about its responsibilities to a visitors’s shareholders. A board loses credibility if its objectivity and independence are compromised by notes shortcomings in this checklist. Investors are poorly served by substandard governance wonts.