Recruiting a board of directors
The board of directors is a governing body elected to represent the interests of a company’s shareholders. Board members serve in a twofold capacity: to advise management on strategy and to oversee risk. These roles are carried out with a fiduciary responsibility to shareholders. The board of directors delegates day-to-day management duties of the corporation to various executives, whom the board selects and who are then accountable to the board. In addition, directors have legal obligations under federal securities laws as well as state corporate laws.
In its broadest definition, the role of the board of directors comprises the following:
- Act in best interests of
- Oversee strategy and risk
- Provide CEO oversight and succession
Duties and responsibilities
Board members have a legal obligation to act in the interest of the corporation. Their primary fiduciary duties, which are principally derived from Common Law of Delaware, include the following:
Duty of loyalty: The basic definition of the duty of loyalty is the obligation to take only those actions that are within the best interests of the corporation and not in the fiduciary’s own interest. The duty of loyalty also precludes acting for unlawful purposes and affirmatively requires directors to make a good faith effort to monitor the corporation’s affairs and compliance with law. Therefore, a company’s directors must ensure the following:
- that the company has policies that comply with laws and regulations and that management adheres to them;
- that all actions taken by management have the interests of shareholders above all others;
- that directors remain independent and do not take advantage of their positions to act in their own interests, e., partake in self-dealing.
It is generally accepted under Delaware law that a director’s duty of confidentiality falls under the duty of loyalty. All companies should have comprehensive corporate confidentiality policies that apply to employees as well as directors. Three broad categories of confidential information exist:
- proprietary information that is of competitive, commercial value;
- inside information about finances and strategy; and
- sensitive information regarding board proceedings and deliberation.
Duty of care: The duty of care requires that directors act in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances and in a manner the director reasonably believes to be in the best interests of the corporation. To satisfy the duty of care, it is critical to
- have reasonable knowledge of the company’s business;
- act on an informed, good-faith basis;
- obtain credible information on each issue;
- adequately deliberate the relevant issues; and
- understand the consequences that will flow from each decision before making a decision, which may require the advice of legal or financial experts.
Some corporations have in their charter a provision immunizing directors from personal monetary liability for violating their duty of care. However, a company cannot shield directors from liability if duty of loyalty is breached.
Information in any category that is material and nonpublic may be disclosed by company insiders only in specific ways prescribed by federal securities laws, including Regulation FD. For these reasons, all companies should have comprehensive corporate confidentiality policies that apply to employees as well as directors.
The authorized processes and channels for disclosure of confidential corporate information should be well defined and understood within the company, because improper disclosures can lead to criminal and civil liability in certain circumstances.
There are legal ramifications for some breaches of confidentiality. A damaging leak of confidential material could, in certain circumstances, amount to a breach of the duty of loyalty, which could result in personal liability for damages and limit the director’s legal and contractual protections against such liability.
Both NYSE and Nasdaq require that the majority of directors be independent; however, the definition of independence differs for each exchange. Factors for independence include the director’s or a member of the director’s family relationship to the company or to auditors, clients, and other third parties of the company. Additionally, the IRS and several regulations (including Sarbanes-Oxley and Dodd-Frank) define independence requirements. Companies are required to report director independence in proxy statements. The nominating/governance committee often reviews independence to ensure the board is in compliance with all requirements and regulations.
The business judgment rule: In a practical sense, courts have rarely ruled against a company for a breach of duty of care. Even if a board’s decision turned out in hindsight to be wrong or resulted in a situation that was not in the best interest of shareholders, if a board can show that it followed the standards of the duty of care, courts will not find against the company under the so- called “business judgment rule.” The Delaware Chancery Court has noted that the business judgment rule focuses on the board’s decision- making process rather than on a substantive evaluation of the merits of the decision. Thus, according to the ruling, the business judgment rule “prevents judicial second-guessing of the decision if the directors employed a rational process and considered all material information reasonably available—a standard measured by concepts of gross negligence.”
Various legal indemnifications are afforded to boards of directors that can help shield them from liability, including corporate indemnification as set out by Delaware law, statutory indemnification, and private directors and officers (D&O) liability insurance.
Oversight of strategy and risk
Contributing to corporate strategy—and ensuring the proper oversight of management’s execution of that strategy—is a core responsibility of the board of directors. There are several foundational aspects to the board’s role in this regard. It must first define the corporate strategy and then work with executive management to develop a business model that translates the strategy into shareholder value. Once that model is in place, the board has a responsibility to monitor management’s execution of the strategy through evaluative means that provide measurable indicators of performance.
Implicit in the board’s role to develop and monitor strategy is a coinciding role to measure and oversee risk. Every corporate strategy involves risk, and each company’s unique appetite for risk may be found on a spectrum from risk averse to risk tolerant. The board must agree on the proper appetite for risk and make sure that the corporate strategy remains in balance with that tolerance. Finally, overarching all these considerations is an imperative to ensure the corporate strategy is designed to create long-term value for shareholders.
To fulfill their role to oversee strategy and risk, directors are often confronted with making decisions that are, by nature, affected by underlying economic, geopolitical, market, financial, and technological trends. Therefore, it is critical for board members to understand these macro trends as well as challenges and opportunities related to capital allocation, market position, and operations.
One of the most critical jobs of the board of directors is to ensure the company has the right leadership at the helm to carry out the agreed- upon strategic objectives as well as to oversee a sound CEO succession plan. Doing so ensures continuity of leadership if a CEO unexpectedly departs or is subject to a forced turnover; provides confidence to shareholders and the market; and creates a sense of stability to employees and other stakeholders during times of transition.
Along these lines, the board also participates in an objective evaluation of the CEO on a regular basis to ensure performance and leadership expectations are being met. While financial measures are used quite often to benchmark and measure CEO performance, CEOs are, at their essence, decision makers that must be able to lead, inspire, and garner respect. Thus, the board must be confident that the CEO is making decisions using an informed, objective process and setting the appropriate tone at the top for the entire organization.
Much like its role with regard to CEO oversight and evaluation, it is the board’s role to set and oversee the executive compensation plan for the CEO and other named officers, in accordance with appropriate performance targets and in strategic alignment with the overall goals for the company. The environment for executive compensation is constantly evolving to respond to shareholders, the public, and legislative and regulatory oversight of compensation matters. The ways in which executive compensation plans are structured can have far-reaching implications because they set the tone for performance expectations and cultural alignment.
The organizational structure of a board of directors is dictated by state law, federal regulations, its corporate charter, and by exchange listing rules, but certain aspects are also determined by the needs of each individual company.
There is no regulatory or legal mandate with regard to board size. Rather, each company must take into consideration independence requirements and desired compositional mix when determining board size. Therefore, boards must continually evaluate their composition to ensure they have a good balance of perspectives based upon skills, experience, diversity, age, and tenure, as well as to respond to the changing business environment. Robust evaluations of board effectiveness are key to ensuring boards have the proper mix of skills and objectivity to oversee strategy, monitor risk, and fulfill their fiduciary responsibilities.
Traditionally, board members are elected for one-year terms; some boards have adopted two- or three-year terms with elections of members staggered so that an entire board cannot be replaced in any single year. Increasingly, however, staggered boards (also known as “classified boards”) have fallen out of favor with investors, and today the vast majority of companies hold election of the full board at each annual meeting.
In general, directors are elected by the shareholders either by majority voting, which requires a simple majority of all outstanding votes, or plurality voting, where a director may be elected by virtue of receiving the most votes. The outcomes of these two methods can be vastly different: In a majority vote, even an uncontested director must affirmatively be voted in by a majority of shareholders; with a plurality vote, only one vote is needed to elect an uncontested director. In recent years, there has been a widespread push by shareholders for boards to adopt the majority voting standard.
To evaluate the effectiveness of the board’s oversight, the majority of boards conduct annual assessments of the board’s performance. Types of evaluations include those of the full board, committees, and individual directors. In 2015, 52 percent of the S&P 500 evaluated the full
board and committees and 33 percent evaluated the full board, committees, and individual directors annually. Some boards perform the evaluations in house either through surveys or interviews, while others bring in independent third parties to perform the assessment.
In recent years, the acceleration of regulatory changes and required disclosures have increased the time commitment and workload directors must undertake to effectively perform their fiduciary duties. Consequently, director compensation packages have changed in both design and execution. Typical director compensation arrangements include a mix of cash and equity retainers plus board and committee meeting fees. Most companies provide for additional retainers for nonexecutive chairmen/lead directors and committee chairmen. Stock ownership guidelines and holding requirements are consistent with requirements for senior executives.
Board leadership roles
The roles of the board chairman, lead director, and corporate secretary are all germane to an understanding of the board’s operations and governance structure.
The chairman of the board presides over board meetings and is responsible for scheduling meetings, planning and prioritizing agendas, and distributing materials in advance. The person in this role also must communicate internally and externally as to board priorities, policies, and concerns. In addition, the chairman is expected to preside over discussions involving strategic planning, enterprise risk management, director compensation, succession planning, director recruitment, and mergers and acquisitions.
In some cases a company will have a nonexecutive board chairman; in others, the board has opted to allow the role to be combined with that of the CEO. Despite strong arguments that splitting these two roles results in a higher functioning board, more independence, and more CEO accountability, most studies to date have been unable to correlate corporate performance with having a separate CEO and board chairman. In cases where the roles are combined, there is a lead director who is designated to carry out the same responsibilities as the board chairman.
Most companies require formal, in-person board meetings between four and six times per year, not including committee meetings and additional telephone meetings needed to address pressing concerns. In addition, the Sarbanes-Oxley Act dictated that boards meet in so-called “executive session”—that is, only with nonmanagement members of the board present—at least once a year.
Board actions are debated at board meetings and resolutions are passed when they receive a majority vote, either in person or by written consent. Boards rely on management to provide adequate material, in a timely fashion, to allow them the appropriate amount of debate on the issues at hand. Boards are expected to act independently, without being swayed by management’s views or having been compromised by any conflict of interest.
Boards do not make decisions on the day-to-day operation and management of the company but rather focus on issues that are related to strategy and risk. A typical board agenda, often drafted by the CEO and/or the chairman, would include items such as review of financial performance and targets, budgets, executive compensation, capital management, succession planning, competitive strategy, compliance oversight, litigation, R&D, large-scale capital expenditures, mergers and acquisitions (M&A), and governance matters such as resolutions and bylaws, among others.
Many agenda items are deliberated by the full board, but to allocate the oversight of the vast array of board matters most efficiently, certain areas and responsibilities are delegated to three standing committees: audit, compensation, and nominating/governance. These committees perform discrete, specific duties, then make recommendations and report back to the full board.
The rise of the audit committee in scope and responsibility occurred immediately after the passage of Sarbanes-Oxley, when all eyes were focused on the ways in which boards provided checks and balances on financial reporting and independent risk oversight. Today, audit committees play a vital role in the capital markets’ investor protection framework through their oversight of the audit engagement and their company’s financial reporting process. As corporate risks continue to evolve, so does the scope of the audit committee’s purview, and it has often become the committee charged with oversight of various risks, such as cyber, operational, compliance, and many others that could impact shareholder value.
The primary role of the audit committee is to provide oversight and ensure integrity of the company’s financial reporting, audit process, the system of internal controls, disclosures, and compliance with laws and regulations. Both NYSE and Nasdaq listing requirements require audit committees be composed of entirely independent members; the SEC adopted final rules in 2003 also requiring each audit committee to have a designated “financial expert.”
Much like the transformation of the audit committee, the scope and workload of the compensation committee has also increased dramatically in the last few years as a result of a slew of new requirements and disclosures related to compensation, spawned by the 2010 Dodd- Frank Act. Today, compensation committees meet year-round to review and assess pay and performance targets, to analyze and review disclosures, and to ensure effective shareholder communication with regard to equity plans, incentives, goal-setting, and much more.
The compensation committee’s primary responsibility is to set objectives and goals by which the CEO’s performance will be measured, review CEO performance, recommend executive compensation packages to the board, set board compensation, and hire compensation consultants as appropriate.
The compensation committee, composed of or including independent directors, recommends to the full board the executive compensation plan, which should be designed to attract, retain, and motivate qualified executives. (NYSE requires compensation committees to be composed entirely of independent directors; Nasdaq rules require at least two independent directors.) Shareholders then are given a chance to approve these plans on a regular basis (every one to three years) during the annual shareholders meeting in a “say on pay” vote under final rules adopted by the SEC in 2011.
Shareholder expectations regarding the selection, retention, and succession of the right executive leadership, along with heightened scrutiny about the skills and effectiveness of corporate boards, have brought new levels of awareness about the importance of the work of the nominating/governance committee. Today, this committee often finds itself squarely in the spotlight of many hotly debated governance issues and policies such as the separation of the chairman and CEO, board diversity, the efficacy of director evaluations, CEO succession planning, and others.
The nominating/governance committee is responsible for oversight of composition, governance structure, operations, and evaluation of the board and its committees; assisting the board with CEO succession planning; and identifying, evaluating, and recommending director candidates to the board.
Other committees: Although not required by regulation or exchange listings rules, boards may organize other committees to assist with specific oversight duties such as executive, finance, risk, technology, corporate social responsibility, and other matters.
Bob Wesselkamper, Senior Client Partner and Global Head, Rewards and Benefits Solutions, Korn Ferry Hay Group