3. Board of directors - Key concepts.pdf

Module 2 Board of directors Key concepts Learning objectives After studying this section, you should • Understand the functions of the board of directors • Know how board organizes its work by establishing committees • Have a view of the characteristics of boards • Be familiar with potential probl...

Module 2 Board of directors Key concepts Learning objectives After studying this section, you should • Understand the functions of the board of directors • Know how board organizes its work by establishing committees • Have a view of the characteristics of boards • Be familiar with potential problems with boards 2 Example: Board of directors of Microsoft 3 Example: Board of directors of Microsoft 4 Board functions • The board of directors has a dual mandate: ˗ Monitoring: monitor management (company) performance and reduce agency costs ˗ Advisory: consult with management regarding strategic and operational direction of the company • Effective boards satisfy both functions • The responsibilities of the board are separate and distinct from those of management •The board does not manage the company 5 Board functions • Monitoring and advising responsibilities of the board ˗ Approve the corporate strategy ˗ Test business model and identify key performance measures ˗ Identify risk areas and oversee risk management ˗ Hire and fire CEO ˗ Design executive compensation packages ˗ Ensure the integrity of published financial statements ˗ Approve major asset purchases ˗ Protect company assets and reputation ˗ Represent the interest of shareholders ˗ Ensure the company complies with laws and codes 6 Board functions • Legislation regulating company boards differs across countries • Generally, the board’s legal duties (owed to shareholders) are ˗ A duty of trust to exercise a fiduciary responsibility to the shareholders: ▪ Act honestly ▪ Show independence of judgement ▪ Avoid conflict of interest ▪ Act fairly ˗ A duty of care to exercise reasonable care, diligence, and skill as a board members • Business judgment rule – protects board members from liability if they make reasonable decisions ˗ This very important principle is also in the Finnish legislation 7 Operations of the board • Administrated by the chairman ˗ Sets agenda, schedules meetings, coordinates the actions of committees • Decisions are made by the majority rule ˗ However, a common practice is to make a consensus decision without voting • When making decisions, the board relies on materials prepared by management • Periodically, independent directors meet outside the presence of management (“executive sessions”) • In one survey, directors reported spending 20 hours per month on board matters, while a typical meeting lasts between 2 and 6 hours • Board can also make decision in e-mail “meetings” Board organization of S&P 500 companies in 2020: 8 Functions of the board Balancing the board’s efforts An example on how boards should spend their time: Survey results on how boards do spend their time: Performance roles of the board 1. Strategy formulation ˗ Strategic management and leadership ▪ Vision and mission statements ▪ Long-range planning, SWOT analysis etc. 2. Policy-making ˗ Ensuring corporate polices are adequate ▪ The rules, systems and procedures laid down by the board to guide and constrain executive management ▪ financial policies, employment and labor relations policies, marketing policies etc. ˗ Risk management ▪ (eg. failed leadership, disaster, fraud) ˗ Contingency plans Conformance roles of the board 1. The board’s responsibility for monitoring and supervising management ˗ Relationships with managers and supervisors ˗ Routine, regular management reports ˗ Budgetary control systems to ensure conformance with budgetary plan ˗ Management control systems ▪ performance measures (Net profit, Revenue, ROI, ROE etc.) 2. The board’s responsibility for accountability ˗ Avoiding fraud and illegal activities ˗ Statutory reporting to shareholders, regulators, and other stakeholders ˗ Mandatory reporting ˗ Non-financial reporting such as ESG reporting Example: S&P 500 boards in 2020 Source: Spencer Stuart Board Index Board committees • Directors build up committees to work more efficiently – the full board then approves decisions • Most common board committees ˗ audit committee ˗ remuneration committee ˗ nomination committee • Other board committees for the oversight of management ˗ governance and compliance committee ˗ corporate ethics committee • Committees to spread the work of the board ˗ finance committee ˗ strategic planning committee ˗ risk management committee ˗ ad hoc committees for specific issues or projects Example: S&P 500 boards in 2020 Source: Spencer Stuart Board Index Who are directors? 16 Source: Spencer Stuart Board Index CEOs as directors • Are directors with CEO-level experience “better” directors? (+) Managerial, industry, and functional knowledge (+) Contribute to advisory functions: strategy, succession, shareholder/stakeholder relations (+) Contribute to oversight: risk management, performance measurement (-) Active CEOs are busy, unavailable on short notice, miss or are late for meetings (-) Can be bossy, poor collaborators, poor listeners • In recent years, there has been a decrease in active CEOs serving on outside boards as companies limit their directorships 17 Importance of special expertise • Companies need directors to advise on specialized areas ˗ Research, development, and production ˗ Company turnarounds and restructuring ˗ Regulations and law ˗ Mergers, acquisitions and divestitures • In some cases, board advisers or board observers are invited to attend board meetings for this purpose • When does the company need permanent representation with specific knowledge? When should this be done on a temporary or advisory basis? 18 Professional directors • Professional directors serve on boards as their primary career. (+) Considerable experience, have witnessed multiple successes and failures (+) More time to dedicate to boardroom responsibilities (+) Extensive personal and professional networks (-) Might be too “busy” if they serve on many boards concurrently (-) Might not be effective monitors if they view directorship as a form of “active retirement” 19 Example: Statistics on the S&P 500 boards in 2020 Number of Other Board Affiliations for Independent Directors Chair’s Relationship with the Company 20 Source: Spencer Stuart Board Index Number of woman on boards Independent Chair Background Board Average Tenure for Independent Directors Independent Chair Tenure How are directors recruited? • Director recruitment is a responsibility of the nominating/ governance committee ˗ Identify needs of company ˗ Identify gaps in director capabilities ˗ Identify potential candidates, either through director networks or with professional recruiter ˗ Rank candidates in order of preference ˗ Meet with each candidate successively and offer job ˗ Put before shareholders for a vote 21 Is being a director worth it? • Compensation must be sufficient to attract, retain, and motivate qualified directors • Compensation covers time directly spent on board matters, cost to keeping schedule flexible to address urgent issues, and financial and reputational risk from corporate scandal or lawsuit Example: S&P 500 companies’ non-employee board member compensation in 2020 Source: Spencer Stuart Board Index Board attendance rates 23 Board evaluations • The entire board, committees, and/or individual directors are evaluated for effectiveness in carrying out responsibilities • (Self-)evaluations may review ˗ The composition and skills of the board ˗ Meeting structure and process ˗ Effectiveness in setting strategy and in monitoring performance ˗ Director relations with each other, management, and shareholders • In regulated industries like finance and insurance, supervisory authority monitors the capabilities of board and individual board members Example: Board, Committee and Director Evaluations in S&P 500 firms 24 Removal of directors • A company may replace a director for a variety of reasons (+) Requires new skills and capabilities on the board (+) Company wants to “refresh” the board (+) Director wishes to retire (+) Director reaches mandatory retirement age (–) Director is negligent or performing below expectations (–) Director has irresolvable disagreement with other directors or management • Shareholders often do not know the real reason a director leaves the board 25 Removal of directors • The process for removing a director is complicated • The board does not have the power to remove a fellow board member. It must either: ˗ Wait to replace the director at the annual meeting ˗ Encourage him/her to resign • Shareholders, too, have limited rights to remove directors ˗ Pass special resolution, if they can demonstrate cause ˗ Vote for removal, if election is by majority voting • Does this reduce accountability? 26 How would perfect board look like? • Should every board consist of independent board members and have few members? ˗ Firms have to decide what experience and expertise is optimal for their firm ˗ Each firm would decide on its own what is the best board • Is there a positive correlation between board quality and firm performance? ˗ Hard to say • Can we even assume there is…? ˗ Hard to say – we will soon get back to this question 27