The Complete Guide to Corporate Governance
Corporate governance is more often than not defined in the public imagination when it doesn’t work.
News stories are rife with corporate governance examples gone awry where a company’s stakeholders, including shareholders, management, customers, financiers, suppliers, government agencies, and the general public, are at each other’s throats.
Notable examples of corporate governance failures include the astonishing bribery and corruption scandal endured by Siemens in the mid-2000s and Enron’s catastrophic implosion.
Siemens, for example, underwent the biggest corruption scandal in the history of the German Federal Republic. As a result of poor corporate governance, where corruption became institutionalized, the company was forced to pay a fine of $1.6 billion US dollars, the largest fine for bribery ever imposed at the time. The total costs, including attorney fees, were $2.8 billion US dollars.
The outlook was so dim for the company that many experts didn’t expect the company to survive. But it did. So today, Siemens has become a two-fold story of failure and redemption.
The company’s recent history has been one of the poor corporate governance examples that nearly drove it into the ground and the right corporate governance model that has rehabilitated and redeemed the company in the eyes of consumers, shareholders, government regulators, and those within the company itself.
Bad corporate governance nearly killed Siemens.
Good corporate governance saved Siemens from the fate of an Enron or a WorldCom.
What Is Corporate Governance?
Like our government, corporations are directed and controlled by a system of internal rules and regulations, and practices.
Corporate governance also balances the sometimes conflicting interests of various relevant stakeholders, including consumers, shareholders, management, suppliers, partners, financiers, governments, and the communities in which they operate. When one or more of these stakeholders are ignored or overruled, scandals or bitter conflicts can emerge.
When there is balance and corporate governance is working as intended, a company can benefit and prosper from the long term stability.
Because corporate governance touches on nearly all aspects of a company’s existence, from its day-to-day activities to its long-term vision and strategy, it can be difficult to ascertain what corporate governance is.
In essence, corporate governance can be seen as the set of rules, controls, policies, and resolutions put in place as an edict to a company’s expected behavior and direction.
Poor corporate governance, exemplified in the case of Siemens in the mid-2000s by the criminally lax attitude towards corruption, led the company as a whole to behave corruptly.
Likewise, the strict supervision and corporate ethical controls, rules, and regulations established by both angry shareholders and government regulators helped the company to correct its harmful behavior and begin a journey towards a financial (and public relations) recovery.
Examples of Corporate Governance
- Leadership or executive team directives or committee charters
- Board of Directors Committee Charters
- Inside and independent board member requirements
- Articles of Incorporation
- Governance documents (e.g., code of conduct or compliance policies)
- Stock ownership guidelines
- Internal corporate controls procedures
- Corporate balance of power rules
- Remuneration guidelines
4 Key Components of Corporate Governance
The leaders and executives of a corporation are responsible for determining a corporation’s comprehensive vision, mission, and business direction. Making strategic decisions and addressing current and future concerns are essential ways for a company to execute on their vision. A strong vision and mission not only gives the corporate body motivation and a strong sense of purpose to move in a unified direction, but it also displays the company’s intention to the general public and the world at large.
Corporate governance must satisfy and hold in balance the many stakeholders involved in a corporation. These stakeholders include consumers, regulators, executives, management, shareholders, financiers, suppliers, and the public at large.
The most prominent stakeholder to which corporations are beholden are often the shareholders who own the company. Shareholder relations form an essential aspect of corporate governance with many companies providing their shareholders with important documents and information about decisions and company considerations.
3. Corporate Citizenship
Although often neglected in favor of shareholder relations, corporate citizenship in the wider community cannot be discounted. Consumers, communities, and the general public engage with corporations on a daily basis, and thus it falls on the corporation to be governed, or behave, in a way that reflects the corporation’s broader message to the world and in a way that respects the public and the environment.
When this aspect of corporate governance is neglected, public relations usually suffer, and regulatory actions often follow.
4. Oversight & Accountability
Strong corporate oversight and accountability, built on a foundation of balancing powers, are crucial for the long-term survival and success. This has everything to do with a company’s corporate governance.
For example, Siemens had weak internal ethical oversight and a culture of corruption that was institutionalized and never questioned. Ultimately, this unacceptable behavior and poor corporate governance were driven by executive greed to enrich themselves at the expense of the other stakeholders, and as a result, the company itself.
The goal of corporate governance when it comes to oversight and accountability is to ensure that leaders and employees work in the company’s interest and of the company’s shareholders and other stakeholders.
What Every Board Member Needs To Know
To accept membership on a Board of Directors is to take on enormous responsibility and potential liability. The board is the guiding force of any for-profit or non-profit organization. They are ultimately accountable for decisions that can impact hundreds of staff, thousands of shareholders, or millions of customers.
To meet these responsibilities and protect the company, board members must know the most vital functions of their prestigious roles.
How To Respect Fiduciary Duties
Board members are considered fiduciaries, and they are legally obligated to act on behalf of their organization.
The nature of these obligations may differ slightly from state to state, but the following duties are recognized in part or whole throughout the country.
Duty of Care
The duty of care (also known as the duty of good faith) is an obligation to give each decision its due consideration. Every decision that is made and handed down should be explored, refined, and submitted to criticism in proportion to its impact on the organization and shareholders.
Duty of Loyalty
The duty of loyalty is an obligation to hold the organization’s best interest and shareholders as the highest priority. Board members are obligated to avoid conflicts of interest, self-dealing and other situations where their self-interest is placed in direct conflict with their duty.
Duty of Obedience
The duty of obedience is an obligation to respect all laws and governing documents of the organization. The violation of external laws is itself a risk to the organization. The violation of internal laws defrauds the shareholders who have ratified those laws to ensure excellent governance.
How to Advance the Mission of the Organization
The Board of Directors are the leaders most responsible for an organization’s direction and the ones most accountable to the shareholders. For that reason, it is imperative that every member of the Board fully understand the core idea of the organization and the broad strokes of the mission that will make that idea possible.
Board members should understand the mission and articulate it to the officers who will be expected to carry it out and the employees who will action it at every level. Each Board member is responsible for fostering the unity that creates clarity of purpose throughout an entire organization.
How to Assess, Appoint and Compensate Officers
Board members are expected to provide top-level leadership in an organization, steering it toward the most ambitious and profitable goals. However, the decisions that steer the organization must be executed on the ground level by the Chief Executive Officer and other high-level officers.
One way that Board members exercise their duties is by choosing officers who are well-qualified for their duties and compensated well to avoid instability. They must define what is expected of the role, carefully assess the candidates, and make an appointment based on the best available information.
How to Identify and Resolve the Deficiencies of the Organization
Board members must be active in solving the problems that keep the organization from reach its full potential. Understanding problems result from active attendance and participation in each meeting throughout the year, along with the review of any materials produced by the officers and the practice of privately engaging the shareholders.
One of the most effective ways that Board members can resolve problems is participating in Board committees and task forces. Most Boards form regular committees to allow special attention to particular ad-hoc issues or ensure close collaboration between the Board and key subject matter experts in the organization.
How to Protect the Unity of the Board
Every Board member shares the responsibility of ensuring that the Board remains free of the dysfunction that results from apathy, factionalism, and disrespect. The Board must remain a unified force to set an example for the rest of the organization.
Board members should know how to resolve a conflict on the Board by encouraging mediation, finding common ground, and setting firm boundaries. When necessary, they should know when to give up on an idea whose time has not yet come instead of creating a rift.
The Board member who understands these duties will be a credit to their organization. They will build an organization and a legacy that will inspire pride for years to come.
What Is The Role of the Board of Directors?
Let’s consider the compelling reasons, beyond simple legal compliance, to consider establishing a board of directors, what a board of directors can do for you, and how to set up and manage a board of directors.
What is a Board of Directors?
A board of directors (B of D) consists of a select group of individuals jointly appointed to oversee an organization’s management and affairs, and to set its strategic direction.
But wait, you may be asking yourself, isn’t that the CEO or management’s job?
This is a common misconception.
The position of the CEO and management is to manage and to carry out the day-to-day business operations.
It is the job of a board to govern a company.
Think of the Board as the highest-ranking body within a company’s hierarchy. It’s the board’s job to set the strategy for the organization, oversee the CEO and the performance of management itself and, if need be, take corrective measures if performance is lacking.
Two mandates neatly sum up a board’s functions within a larger organization:
A board consults and advises the CEO and management regarding the strategic and operational direction of the company.
A board makes sure management’s actions are in the best interest of various stakeholders, including shareholders, and monitors its performance. This is also known as corporate governance.
The board can consist of insiders or outsiders.
Insiders have some role or stake in the business, such as shareholders, founders, or employees.
Outsiders are people with no ownership interest in the business, such as retired CEOs of other companies, industry experts, or other seasoned business managers.
Typically, both insiders and outsiders are selected for a board based on their organizational or industry knowledge, experience, and business relationships.
Determining the right composition or mix of insiders and outsiders is crucial. Usually, a company’s board should represent the interests of management and shareholders. Although relatively rare in the United States, some corporate boards even include labor representatives who promote and protect employees’ interests.
Ultimately, the ideal board of directors should make decisions that further a company’s goals and interests, thereby benefiting shareholders, management, and workers themselves.
A small business or a private company can determine the mix of their board, but publicly-traded companies are required to have a certain number of outside directors.
Other details, such as the number of members on the board or how they are selected, are determined by the state’s rules. The business is incorporated or by a company’s internal processes and corporate governance documents such as bylaw an operating agreement for LLCs.
Role of the Board of Directors
Ultimately, the board of directors is the final authority and the highest governing body of a company.
It is the board of directors’ role to hire the CEO and general management of a business. They also assess the overall strategic direction of a company. While management may hire individual employees and workers and oversee day-to-day operations, the board of directors is responsible for overseeing the company’s management.
Why Do Companies Need A Board of Directors?
Some companies have no choice but to elect a board of directors. Businesses structured as C corporations and S corporations, whether for-profit or nonprofit, are required by state law to elect a board of directors. The exact rules and regulations can vary by state.
However, there are also important reasons why any business, whether small or large or nom C corporations (e.g., LLCs), may want to elect a board of directors despite no legal requirement to do so.
Establishing a board of directors is not just a formality. Electing a board of directors can alter the course of your business. On the one hand, companies that effectively utilize their board to drive value and maintain a pristine reputation can drive success and growth. A competent board can be a valuable tool for a business.
How A Board of Directors Can Provide Value
- Ethical oversight
- Steering the company towards long-term success
- Reinforcement and embodiment of the company culture
- Strong corporate governance
- Streamlined decision-making
- Credibility and legitimacy
On the other hand, businesses that ignore the need for a board of directors or treat their board as a check-the-box legal maneuver may be leaving immense value on the table or even making a costly mistake.
Benefits of Having a Board Go Beyond Mere Legal Requirements
Electing a board serves an organization in more useful ways than just legal protection. If you are legally required to have one, why not fully utilized this understated tool? You may also want to start weighing the benefits of having a board of directors if you are looking for long-term growth.
As you try to justify the price tag of having a board, consider the following benefits a board of directors can provide to a company.
6 Benefits A Board of Directors Can Provide To A Company
1. New Opportunities
Establishing a board means not only gaining more advocates for the company, but it also means expanding your company’s network. Directors can bring along their networks and business contacts (e.g., partners, investors, and suppliers), which may be relevant for growing companies.
2. Skills and Knowledge
It’s impossible for a founder/CEO to have all the skills, knowledge, and experience to operate effectively in an unpredictable environment. Upper management and the CEO need an objective and fresh perspective from directors that bring expertise from complementary but diverse backgrounds.
3. Strategic Direction
This is perhaps the best way a board adds value. A founder and CEO may be too stubborn or too interested in personal gain to think about long-term success. Instead of being burdened with day-to-day operations, directors can spend more time on key issues and formulate vital strategies such as raising capital, expansions, acquisitions, dispositions or even doing an initial public offering (IPO), etc.
4. Independence and Accountability
Directors are supposed to act independently – free from conflicting interests and work only in your company and shareholders’ best interest. As such, a board can objectively measure the management’s performance and make sure the company stays on track with the business plan. Because the CEO answers the board, the directors can speak frankly and hold a CEO’s actions accountable even if other employees are afraid to do so.
5. Continuity for the Organization
A board can be the perfect way to ensure a smoother transition from one generation of leadership to another. No CEO or founder lives forever, so an orderly succession is critical for the business. Having a board in these types of situations separates the company’s needs from any potential conflicts of interest that could damage or weaken the company in the future.
6. Credibility and Trustworthiness
A board of directors keeps the bigger picture in perspective. The board ensures a balance between being innovative and taking risks while still maintaining compliance and behaving ethically. A business’s credibility and reputation are essential. For example, many financial institutions and investors place great importance on reputation and trustworthiness. Companies with a positive board of directors reputation can often obtain a lower cost of financing, which is crucial for business growth.
The Importance of a Board of Directors for Good Corporate Governance
WorldCom’s board of directors’ dramatic failure to detect and address financial fraud and address general bad behavior by management is one of the key reasons why the company imploded. Even before the revelation of massive accounting fraud, the board already showed a lack of ethical oversight and rigorous decision-making. The company loaned the late CEO, Bernard Ebbers, over $400 million that he used for personal expenses.
Not only was this money never accounted for appropriately, but some members of the board also didn’t even know that the loans had been made. A dysfunctional board and total lack of board oversight of management ultimately created the conditions that resulted in WorldCom’s spectacular failure.
Effective Board Leadership
A properly-governed company always knows what it “is”
How To Fire A Toxic Board Member
A corporation’s board of directors has the important responsibility of steering the company through rough waters, developing strategy, and guiding the company into the future in the interest of the shareholders.
Unfortunately, sometimes a dysfunctional, negligent, or toxic board member can do enormous harm to a company. In some cases, a toxic board may even drive an otherwise healthy organization into the ground.
7 Signs of A Toxic Board of Directors
1. Personal conflicts of interest.
Healthy corporate boards have strict conflict of interest policies designed to ensure that every director’s personal goals are aligned with those of the business.
Organizations that do not have an explicit policy addressing conflicts of interest or ignore obvious signs of conflicts of interest may have a potentially toxic board of directors.
At a minimum, every board’s conflict of interest should address the board’s fiduciary duty, a duty of loyalty, and a duty of confidentiality. A healthy board will take conflicts of interest seriously and spell out disciplinary actions or outright removal procedures for directors who do not comply with agreed-upon policies.
2. Negligence or lack of attendance.
Falling asleep at the wheel of a car can lead to disastrous and even deadly consequences. Likewise, a negligent board that is asleep at the wheel can also result in disastrous results.
Any director who isn’t paying careful attention to the company or participating in board meetings may not only be negligent, and they could also be breaching their fiduciary duty towards shareholders.
The duty of care is generally evaluated according to the “business judgment rule,” under which directors and officers are presumed to make decisions on an informed basis and in good faith.
Needless to say, a board member who skips meetings may very well be a toxic board member.
3. Lack of personal investment in the organization.
While all board members should avoid real or perceived conflicts of interest, they should be actively invested in the company or organization they purport to lead. It just makes sense to select board members who have “skin in the game” and are financially invested in your organization’s performance and longevity. After all, if they aren’t invested in outcomes, you have to ask yourself if they might have higher priorities or other interests that may put the organization at risk.
4. No internal audit committees.
In government, politics, or business, every decision-making body should have an internal process for accountability. Internal accountability is typically maintained for a board of directors through internal committees, particularly an audit committee. This indispensable internal body is in charge of overseeing financial reporting and disclosures, especially for larger companies. A lack of such a committee for a larger company would be a red flag that the board may need to be reformed; for publicly-traded companies, it’s the law.
5. No internal compensation committee.
Another crucial internal accountability body, every board of directors, should have is a compensation committee that includes outsiders and organization insiders.
This committee has the responsibility of determining executive compensation packages, incentives, and bonuses. As a result, it is important to ensure that the internal compensation committee has a healthy balance of skilled outsiders and company insiders.
6. Unbalanced or unrepresentative.
The key to a functional and successful board of directors is one that is well balanced and represents the interests of all shareholders, management, and in some cases, even employees themselves.
A balanced board should have the right balance of executive (insider) and non-executive (outsider) directors. More importantly, a board should also have a healthy mixture of abilities, knowledge, and industry or institutional experience.
7. Too big or too small.
However, depending on the organization’s size, needs, and complexity in question, company board sizes can range from just three (3) directors to as many as 30. As a general rule of thumb, many business analysts consider seven (7) people to be the ideal group size that balances agility and experience.
How To Remove Toxic Board Members
More often than not, a toxic board isn’t the result of poor business practices or a lack of internal accountability, but rather the result of particular, toxic personalities. Unfortunately, the presence of a toxic director or two can completely derail your board of directors and your organization.
The following are signs of a toxic board member:
- Has conflicts of interest.
- Rude, manipulative, abrasive, or threatening.
- Gives or takes bribes.
- Micromanages executive management.
- Refuses to raise funds.
- Skips meetings.
- Cannot be trusted to handle confidential information.
- Expects special treatment or favors.
- Gives favors to family members or professional allies.
- Shows contempt for others.
The best solution to toxic board members begins with prevention through proper recruitment and training.
But what can a business do if an unconstructive board member manages to get a seat on the board?
The first step is always to make the wayward party aware that his or her behavior or lack of responsibility is detrimental to the board’s mission and will not be tolerated.
Many common signs of toxic behavior, such as combativeness, rudeness, or lack of respect for other board members, can be nipped in the bud with quick, coordinated action by the board president or other board members. Depending on the person in question, sometimes gentle persuasion is needed to make them aware of their wayward behavior.
Other times, a particularly abusive board member may need to be sharply confronted or, if their toxic behavior has become an ongoing problem that distracts the board from carrying out its obligations, removed outright. For example, fraudulent behavior, irreconcilable conflicts of interest, or fiduciary duty breaches should not be tolerated.
The following is 4 ways to remove a board member that has become too toxic:
- Resignation through personal intervention
- Leave of absence
- Use organizational bylaws or impeachment
- Term limitations
4 Ways To Remove A Toxic Board Member
1. Leave of absence
Sometimes, a board member’s health or well-being or other priorities such as family or other pursuits may be the underlying cause for their poor performance.
A board member may have an understandable reason for being unable to commit to regular meetings or execute their duties as a board member. Nonetheless, an under-performing board member is a risk to the board and the company and should be removed and replaced if possible.
Suggesting some time off, or perhaps a more extended leave of absence, can help them not only address their underlying issues but also give them a professional, respectful, and tactful way out.
Oftentimes, board members in this predicament may actually be ready to leave or step down and are just waiting for the right opportunity. With a leave of absence, the board member is given an opportunity to reflect and refocus and, should it be in the organization’s interest, be allowed to return at a later time.
The most direct way to remove a board member is simply asking them to step down or resign.
Depending on the person’s relationship with the board, this can be a challenging proposition. Oftentimes a director who is at odds with the company, will not simply resign or step down when asked. However, sometimes personal intervention between a wayward board member can yield the best results. When handled tactfully and judiciously, simply talking to the person in question discreetly can allow all parties to move forward without undue drama or bad blood.
Being tactful is key. Unfortunately, someone who has adopted an adversarial stance will be unlikely to resign without a fight. If this is the case, stronger measures may be necessary.
3. Impeachment via bylaws
Most board of directors operate according to agreed-upon bylaws. These bylaws often include policies on behavior and performance and methods for formally removing members who cause trouble or run afoul of company policies.
Bylaws will vary from one organization to another. However, most bylaws accord the board the ability to impeach a director through a simple two-thirds majority vote. In other words, if a member’s behavior or actions are so egregious as to warrant impeachment, he or she can be voted out of their seat.
4. Term limits
Finally, one of the best ways to build in protections against poor or corrupt board members is to implement term limits.
Once a board member’s term is up, they can be either reappointed to their positions or removed and replaced. This type of limited tenureship not only builds in accountability, but it can also reward high performing board directors while limiting the damage wrought by bad ones.
Always Work With A Business Attorney
When seeking to remove a board member, always work with a business attorney. Depending on the size of your business, state regulations, and specifics of the case, there may be legal implications or stipulations that must be met. It is always prudent to turn to an expert on corporate governance and business law, such as Phillips Kaiser, Houston business attorneys.
Who Elects A Company's Board of Directors?
The Board’s Composition: Not a One-Size-Fits-All Approach
The concept of a board of directors has been around since the 17th-century when the Dutch East India Company first pioneered it. Even though the idea of a board of directors has been known within the business world for hundreds of years, there are only a few hard and fast rules regarding an organization’s board composition.
The following discussion will help you understand the nuances and details of composing your own board – including compliance and legal requirements as well as best practices for selecting board members.
Who Elects A Board of Directors?
The purpose of a board of directors is to help steer the business in its shareholders’ interest. Thus, shareholders ultimately elect members to the board.
For public companies, “shareholder” means anyone, or any organization, who holds the company’s public stock. These shareholders can elect members to the board by voting during an annual meeting or through a proxy statement.
For private companies or smaller businesses like start-ups, the board members are elected by the founder or CEO of the business and the company’s investors, which can also include family shareholders.
Each state’s corporate governance laws may specify a minimum or a maximum number of directors and a specific number of members that must be outsiders. However, the organization’s bylaws largely determine the important details, such as the structure and powers of a board, unless otherwise dictated by state law.
Bylaws are a company’s manual or set of rules that govern how a company operates as long as they do not contradict any federal or state laws.
Bylaws can determine how the board is elected, how often the board meets, voting procedures, number of members for the board, and even age limits (i.e., the mandatory retirement age for board members).
One particular example is term limits for members of the board. When a director’s term limit expires, the board must fulfill the vacancy.
Generally, the term lengths of board members do not expire at the same time. Instead, bylaws for companies in the U.S. typically call for staggered terms, which is an arrangement where only a certain number of members of a board of directors are elected in a given year.
Without staggered terms, all directors must be replaced once their terms expire, resulting in a potentially disruptive turnover.
Like term limits, staggered terms aren’t a requirement; however, companies with strong and effective bylaws often include them. It’s up to an organization’s shareholders or owners to decide whether to have these non-mandatory elements in their company’s bylaws.
Pros and cons of including staggered boards in your bylaws:
- Proponents believe staggered boards provide board continuity. A completely new board can be detrimental if members lack experience and institutional knowledge.
- Another advantage of staggered boards is that staggered terms prevent takeovers by making it harder for hostile acquirers to control a company.
- Opponents argue staggered boards are too effective in preventing a takeover. They ensure the continuity of management, even if current management performs poorly and does not serve its interests.
According to a study by Institutional Shareholder Services (ISS), there’s a significant downward trend of using staggered boards since 2019, and over 80% of S&P 500 companies hold annual elections for all directors in 2015.
Ultimately, the writing of bylaws and the election of a company’s board of directors is up to shareholders. Selecting and hiring the right board members can help a business thrive, grow, and weather uncertain business conditions.
Board Election: The Takeaways
- Shareholders elect the board of directors.
- Corporate governance is more than meeting legal requirements. It is the foundation upon which an organization builds upon, and hence, it may be crucial to require experts who can counsel beyond legal compliance.
Experienced and qualified legal experts, like Phillips Kaiser, can advise and answer questions on all board of directors’ matters, including finding, nominating, electing, hiring, and training of new members.
Powers of the Board of Directors
Theory vs. Reality
According to numerous business textbooks and educational resources, the board of directors (BoD) can appear to have well-defined decision-making powers and clear-cut prerogatives.
In practice, however, this is not necessarily the case.
It is always important to keep in mind that theory and practice do not always perfectly align. Each company with a BoD will have differing board power dynamics, board compositions, and board relationships with management. Ultimately, it must be approached on a case-by-case basis.
In theory, for example, the traditional corporate board is thought to act as a counterbalance to a company’s management team’s ambitions, including the CEO.
According to textbooks, the board of directors has the power to hold executives accountable to shareholders through a combination of various inquiries on the actions of management at board meetings, performance reviews, and executive compensation decisions. In reality, however, many boards of directors do not actually serve this role. Depending on the business in question, the board can sometimes be nothing more than a polite display of corporate governance without taking any real control over the company or financial interest in the business’s performance as they should do.
A weak board of directors is often characterized by a lack of outsider directors, dummy directors with no financial interest in the firm, powerful CEOs who occupy the chairmanship or otherwise exercise total control over board meetings, and a lack of regular board meetings and executive performance reviews. Weak boards wield no actual powers and act as rubber stamps for all of management’s decisions. As a result, soft boards also make companies more prone to mismanagement.
A strong board, on the other hand, may wield significant decision-making powers. Strong boards are characterized by truly independent, outsider directors with financial interests in the business. Strong boards also hold regular meetings that require executives to account for management actions.
Many effective boards even include representatives for the company’s own employees through a process known as co-determination. Healthy boards are often characterized by the inclusion of all stakeholders, with members who represent and advocate on behalf of shareholders, management, outside investors, and workers themselves.
5 Important Powers A Board of Directors Can Wield
1. Hiring management
One of the most important decision-making powers the board of directors can exercise is the hiring (and firing) of top executives, such as the CEO, CFO, and COO. Businesses with a great CEO and management team at the helm can thrive, pivot rapidly according to market conditions, and take advantage of unique opportunities to defeat competitors and bring enormous value to themselves and shareholders.
On the other hand, the board’s poor hiring decision can lead to mismanagement and the destruction of shareholder value. For example, in the 1990s, poor management in the face of changing consumer trends led to IBM being called by one commentator “a dinosaur, an implosion, a wreck…”.
2. Firing Management
The former CEO of IBM, John Akers’s, mismanagement of the advent of personal computers led to the largest annual loss in company history. Despite dominating the computer industry in the ’60s and ’70s, Aker’s rigid adherence to an obsolete view of the world allowed Microsoft and other upstarts such as Compaq Computer Corporation to leapfrog IBM. In the end, Aker’s was forced by the board to step down and was replaced by a new CEO who transformed the company for a new era.
Selecting the right managers at the helm of a business is incredibly important. However, knowing when to let go of underperforming managers is also a crucial decision-making power in the board of directors’ hands.
While Akers helped IBM dominate the computer market during the 1960’s era of mainframes, once it became clear that personal computers were the way of the future, the board of directors made the right decision to remove and replace him. Unfortunately for IBM, the move came too late to dominate the personal computer market.
3. Incentivizing good management
Of course, managed selection is only one of the crucial powers accorded to a strong board. Compensation decisions for high-level executives are an important tool used by many boards of directors to incentivize good performance and good behavior on the part of management.
It is not uncommon, for example, for boards to implement so-called “compensation committees,” which are assigned to both insider and outsider directors that make recommendations to the board about executive pay and bonuses. Not only do such necessary subcommittees help to hold management accountable, but they can also incentivize and reward good managers and effective leadership.
Some common ways the board can incentivize outstanding executive performance include tying performance directly to shareholder value production, such as the company’s stock price, revenue generated, or profit margins.
While many CEOs receive a base salary like any company employee, about 50 percent of the average CEO’s compensation may come in bonuses tied to performance metrics as defined by the board of directors.
4. Overseeing strategy
Strategy in the context of corporate governance can be a bit ambiguous and hard to nail down. For the most part, the board of directors does not play a major role in the day-to-day management of a company or business’s operations. That’s the role of the executives, such as the CEO.
However, board members and the board of directors are involved in overseeing the high-level execution of corporate strategies. More importantly, through its various committees, the board can select what strategies and initiatives (not projects) to fund and which to disregard.
This power of approval of management’s recommendations about a company’s future direction is perhaps their most important power and responsibility. Taking on an oversight position allows the board to push back on or test the management’s assumptions.
5. Extraordinary corporate matters
Although rare, there are exceptional situations when the board of directors may be called upon to propose or approve certain extraordinary corporate matters. These so-called extraordinary matters may include amendments to the Articles of Incorporation or Code of Regulations, mergers, consolidations, share exchanges, recapitalization, liquidation, dissolution, sale of company assets, and issuance of specific amounts of stock.
When such urgent matters occur that require the board’s attention, the board can hold an emergency meeting to take action.
Emergency meetings are used to deal with critical issues that cannot wait until the next general board of directors meeting, including potential mergers and acquisitions or the removal of a key executive.
Duties and Liabilities of Board Members
A board of directors’ primary objective is to be responsible for the company and its shareholders. It exists to oversee the CEO and management and, if necessary, balance the self-interests of management with the long-term interests of shareholders and other company stakeholders. Under the U.S. legal system, this duty is known as a fiduciary duty, meaning members of a board are obligated to act in the best interest of another party – the shareholders.
The principle of fiduciary duties consist of the following core duties:
Duty of Care
Directors should make decisions with due deliberation. They should act in good faith, on an informed basis, and in the honest belief that the actions taken are in the company’s best interest.
Duty of Loyalty
This requires board directors to act in the corporation’s interest and its shareholders’ interest rather than in a director’s own personal interest.
Duty of Candor
Directors should communicate honestly and disclose to shareholders all information vital to their evaluation of the company.
These legal terms are well-intended, but how does it translate into the responsibilities of the board members? The exact nature of the duties and responsibilities of a board can vary, depending on your company’s mission, goals, and the industry in which it operates.
Following are ten typical functions and duties of members of the board.
- Hiring and reviewing the performance of top executives. This includes the selection and performance review of the CEO. The board may also have the authority to terminate and replace the CEO.
- Designing executive compensation packages. Corporate boards often include a “compensation committee.” To avoid undue conflicts of interest, it is crucial that a compensation committee not be composed exclusively of insiders who may report to the CEO. Some CEOs may pack their boards with friends and cronies. However, this is considered an example of poor corporate governance and can lead to problems down the road.
- Reviewing and approving primary corporate objectives. A CEO initiates policies, annual operational budgets, and strategies. The board oversees and reviews these executive initiatives and can either confirm these plans or propose changes.
- Supplying the company with competent financial resources such as helping to attract investors.
- Creating and implementing policies and business strategies.
- Identifying risk areas and overseeing risk management.
- Ensuring the integrity of financial reporting and disclosures.
- Approving major asset purchases and other major financial decisions such as mergers, acquisitions, and divestment.
- Ensuring the company is compliant with laws and codes.
- Monitoring and evaluating the attractiveness of return on investment and dividend policy.
With Great Power Comes Great Liabilities?
Because the board of directors has the ultimate responsibility to govern and oversee a company’s affairs, they may be subject to personal liability for breaches of their duties. Investors who claim a board’s action harms them can file private lawsuits. The Securities and Exchange Commission (SEC) can also enforce securities laws by taking action against a director or the entire board of directors.
However, some laws protect directors from personal liability if they acted in good faith and without conflicts of interest. They are not covered if they violate criminal law, willfully fail to deal fairly, or engage in willful misconduct. Examples include failure to disclose a conflict of interest or misappropriating a corporate asset for personal use.
But the reality is that out-of-pocket payments by directors are very rare.
The primary tools to reduce a board of director’s liability are:
- Indemnification agreements
The company agrees to pay for costs associated with lawsuits as long as the director acted in good faith.
- Director insurance
The company pays for liability insurance contracts that cover litigation expenses, settlement payments, and in some cases, damages. This insurance is essential because it may be the only way to protect a director’s personal assets from substantial liability.
Can or Should a CEO Be On the Board of Directors?
You may recognize these recent headlines:
After two deadly Boeing 737 Max crashes and a grounding of these jets, CEO Dennis Muilenburg was removed from his role as chair of Boeing’s Board of directors in October 2019.
Elon Musk stepped down as chairman of Tesla’s Board in October 2018 as part of his settlement with the Securities and Exchange Commission (SEC) regarding his scandalous tweet to take the company private.
Randall L. Stephenson, the current CEO of AT&T, will remain in charge until January 2021, and once he retires, AT&T’s Board has decided to split the roles of the CEO and the chair.
But, what do these headlines mean for your organization?
Let’s look into the overall trend towards more independent boards and how this may change a company’s board of directors composition.
Legally, under most state laws, CEOs can serve on their organization’s board of directors. In fact, it is commonly accepted in the U.S. for CEOs to serve on their company’s board. But, the more complicated and debated question is, SHOULD a CEO serve on their organization’s board?
The board of directors functions as the highest governing body of an organization and oversees management, including executives such as the CEO. Nonetheless, it is quite common for the CEO to serve on the board and be appointed as its chair. The chair has significant influence over both the board and management. To this day, it is still common for CEOs to hold both the chairmanship and the CEO position within an organization.
However, is it a good idea for one person to be the CEO and the chair of the board? How can a board chair who is also the CEO hold himself accountable? It seems there’s a natural conflict of interest for CEOs to serve on the board that supervises their own performance. Naturally, there have been many high-profile cases of self-dealing and lack of executive oversight in companies whose CEOs also chair the board of directors. As a result, there is a growing trend to split the CEO’s roles and those of the board’s chairperson.
According to the Wall Street Journal, a study by Institutional Shareholder Services (ISS) shows more than half of S&P 500 companies have now separated the chairperson and the CEO roles. In 2005, only 30% of the companies in the S&P 500 were split. This increase reflects the growing acceptance of separation of roles as a standard best practice and growing pressure from shareholders for more robust checks and balances.
Whether or not to separate the CEO from an organization’s board is a decision every organization must make based on several factors, including its size and the company’s age. While it sounds reasonable that a board should be independent of the company’s top executives, current research has found no correlation between an independent board of directors and a company’s performance.
Let’s take a closer look at both sides of the argument and what factors should be considered.
The following are a few reasons to separate the two positions:
1. Eliminates conflicts of interest.
One example is executive compensation, which the board must approve.
The CEO voting on his or her own compensation is a conflict of interest.
The CEO could abuse his or her position on the board for his or her own gain.
2. Allows for more robust corporate governance and independence.
Separating roles enables the board to monitor the operations of the company effectively.
3. A CEO who doubles as a board chair may not be as effective in both roles.
Both roles are full-time jobs, so it may be difficult for one person to serve in both capacities effectively.
4. Prevents the board from becoming a rubber stamp for the CEO.
Boards filled with yes-men who greenlight everything the CEO suggests can quickly lead a business down a dangerous path.
The following are a few reasons for the CEO to serve on the board or even double as the board chair:
- More informed decisions. Since CEOs have an inside perspective on an organization’s operations, they can often make more informed decisions. Informed board members lead to better decision-making.
- Gives the CEO higher credibility and authority. A CEO who is also the board’s chair can signify that both the shareholders and the board are confident in the CEO’s leadership.
- No evidence of negative performance on average. Anecdotal evidence indicates that companies should benefit from separating the CEO and board roles. However, research has found that forced separation (i.e., due to investor pressure) can actually be detrimental.
Even when shareholders want to keep a CEO separate from the chairmanship, that doesn’t mean that you should shut the CEO out of board decisions and processes entirely. CEOs should be encouraged to attend and participate in all board meetings. CEOs who are already on their own boards can be designated as a non-voting director, which means they can participate without worrying about any conflicts of interest.
Shareholders should consider having a conflict of interest policy, which specifies when a board member should recuse themselves from voting or discussing issues where a conflict of interest may exist, such as on executive salary or performance review.
Choosing The Next Board Member
How Does A Company Select and Hire A New Board Member?
Directors are ultimately elected with the blessing of voting shareholders or investors. However, shareholders don’t always get to decide which candidates are included on the ballot. The nominating committee is responsible for nominating individuals to fulfill a vacancy.
What is the Nominating Committee?
In order to carry out all of its duties effectively and expeditiously, the board of directors works through committees. Committees are believed to improve a board’s effectiveness and efficiency by focusing on knowledgeable members and specialized duties.
Some standard committees include an audit and risk committee, an executive committee, a communications committee, and a CEO compensation committee. One of the most important committees is the nominating committee, which is sometimes referred to as the governance committee. The nominating committee is tasked with many responsibilities, including recruiting high-caliber candidates for the board and orienting new board members.
Searching, vetting, and selecting candidates are challenging tasks. The nominating committee must be thoughtful and careful throughout the process to ensure the mix of individuals on the board can lead to the synergy needed to produce optimal results for the shareholders.
Exact duties can vary, but the following are a few duties of all nominating committees during the process for finding and selecting new board members:
Identifying qualified candidates
Nominating committees can select candidates they or other board members recommend. They can also turn to executive search firms to find qualified candidates that fit their criteria.
Reviewing the bylaws
Reviewing the bylaws to make sure nomination procedures are being followed accurately.
Screening and evaluating the candidates to assess their qualifications and fit for the board.
Seeking input from management
Asking and receiving input from management for their candidate selections. Since 2002, the NYSE and NASDAQ require independent directors to make up the nominating committee (e.g., management is barred from being on the committee.) The committee can still ask for management’s thoughts and opinions on personnel selections.
Presenting nominees to the board
Presenting the nominees to the rest of the board. The board votes on each nominee. The selected nominees are then placed on a ballot for shareholders to vote.
Developing an orientation process
The newly elected board members go through an orientation process to learn about their new duties and responsibilities. Even the most qualified directors need training and development to effectively use their skills and qualifications and understand what is expected of them.
Evaluating Whether the Board’s Composition is the Right Mix
Boards of directors have been around for ages. But, what worked in the past may not work in today’s environment. The best path forward is to continually evaluate a board’s performance relative to its composition. A static approach does not work; a board must use a dynamic approach to adapt quickly in an ever-changing economic, regulatory, social, and political environment.
There is not a one-size-fits-all answer to what a successful board should look like, which makes finding the right mix of talent a difficult task indeed. Even the most specific bylaws may not contain requirements beyond the size of the board and the process for electing directors. Bylaws generally place few or no requirements regarding how to determine who should or can be a director. Yet, having the right mix of individuals on a board is critical to having a successful board.
The following are a few questions to ask when examining whether the composition of your board is appropriately relevant to the tasks and challenges at hand:
“A static approach does not work; a board must use a dynamic approach to adapt quickly in an ever-changing economic, regulatory, social, and political environment.”
Skills and Qualifications
Are the current board members’ skills and qualifications suitable for a changing future?
Even if they have the right knowledge and experience, are board members committed to the organization’s mission?
For example, are they on the board because it will look good on their resume, or do they strongly believe in what the organization is trying to do? A helpful tool is having a document outlining the qualities, such as specific experience, qualifications, attributes, or skills, a company and shareholders seek when finding the best potential members for a board.
An example of this is using a recruitment grid.
Beyond meeting the NYSE and NASDAQ (if applicable) requirements for having a majority of independent directors, does the board have enough outsider directors?
Even if a member technically meets independence requirements from regulations, is the member truly independent in thought and action?
Is “groupthink” an issue, or are members objective and comfortable enough to interject when they have differing opinions and insights?
Tenure and New Blood
There is increased pressure from investors and shareholders for companies to bring on new and younger board members. This can be accomplished by adopting age-based mandatory retirement policies, term limits, or better evaluation processes to gauge the board’s effectiveness and whether the board needs to be refreshed to meet the shareholders’ goals and objectives.
In recent years, diversity has been a hot topic everywhere, including in the boardroom. The word can mean many things, from “diversity” in skills and qualifications, ethnicity, age, and gender.
Embracing diversity doesn’t mean finding individuals merely to check some boxes and appear diverse.
The objective is to look beyond the traditional population of board candidates and go beyond the board’s usual networks to select a talented board representing the diversity of the people or consumers the organization is serving.
It means taking a holistic approach to unlock the strategic, financial, and social benefits of having a more diverse and representative board. All companies are becoming more and more aware of the benefits of having a more diverse board.
According to key findings from the 2020 Women on Boards Gender Diversity Index, the upward trajectory in embracing diversity is exemplified by women holding over 20% of board seats in 2020, which increased from 16% in 2017.
Board Composition: The Takeaways
- Corporate governance is more than meeting legal requirements. It is the foundation upon which an organization builds, and hence, it may be crucial to require the help of experts who can counsel beyond legal compliance.Experienced and qualified experts, like Phillips Kaiser, can advise and answer questions on all board of directors matters, including the finding, nominating, electing, and training of new members.
- Review with a corporate governance lawyer to ensure all federal and state laws and regulations are being followed when deciding on the board’s composition and structure.
- Review your organization’s bylaws and update, if necessary, to address potential conflicts of interest or new rules for your board’s composition.