Determining the effectiveness of a board of directors

The board of directors of a corporation is a crucial part of an effective corporate governance system that provides a check and balance between management and shareholders.

In order to determine the effectiveness of a board of directors, investors or investment analysts must assess:

• The composition of the board of directors and whether or not directors are independent – In order to assure that directors are serving shareholders, global best practice recommends that at least three quarters of board members should be independent

• Whether the board has an independent chairman – Many companies have a single individual that serves the dual role of CEO and Chairman of the Board. Some arguments support the dual role as providing the board with in-depth knowledge and experience regarding company strategy and operations. However, other claim that having the CEO chairing, board meetings allows the CEO to control the board’s agenda and diminishes the role of independent board members, particularly when determining management compensation

• Qualification of directors – Directors should bring skills and experience that will assure they will fulfil their fiduciary responsibilities to stakeholders. Corporate governance best practice is for board members to have the requisite industry, strategic planning, and risk management knowledge, not serve on more than two or three boards, and show a commitment to investor interests and ethical management and investing principles

• How the board is elected – All board members may stand for election annually, or staggered elections may take place in which only a portion of the directors are up for election each year. Proponents of staggered elections say that they ensure board continuity. However, strong corporate governance practice says that staggered elections limit the power of shareholders and do not allow changes to the board composition to occur quickly. Annual elections force directors to make more careful decisions and be more attentive to shareholders, because they can cast a vote to keep or eliminate a director each year

• Board self-assessment practices – Boards should evaluate and assess their effectiveness at least annually. The focus of the self-assessment should be on member participation, committee activities and future needs of the board

• Frequency of separate sessions for independent directors – Best practice requires independent board members to meet at least annually, preferably quarterly, in separate sessions without management in attendance. Such meetings allow the independent directors to engage in an open discussion about policies, management, and compensation without concerns about management influence

• Audit committee and audit oversight – The audit committee has the responsibility to oversee a company’s financial reporting, non-financial corporate disclosure and internal control systems. The internal audit staff of the firm should report directly to the audit committee. Best practice mandates that the audit committee consists only of independent directors, has expertise in financial and accounting matters, has full access to and the corporation of management, and meets with auditors at least once annually

• Nominating committee – The nominating committee is responsible for establishing criteria for identifying and evaluating candidates for the board of directors, as well as senior management. Corporate governance best practice requires that the nominating committee consists only of independent directors

• Compensation committee and the compensation awarded to management – The directors should use compensation to attract, retain and motivate talented managers on behalf of shareholders. Compensation should focus on long-term goals and should not be excessive. A common industry practice that is considered poor corporate governance is to use the salary at other companies as a reference point rather than company performance. Another poor practice is the repricing of stock options, which allows management to recoup losses after a stock price decline. Best practice would have the base salary and perquisites as a small percentage of compensation, with bonuses, stock options, and grants of restricted stock awarded for exceeding performance goals making up the majority of a senior manager’s income

• Use of independent or expert legal counsel – The board of directors should hire expert legal counsel as needed to fulfil its fiduciary duties and assess the company’s compliance with regular requirements. A common practice is for internal corporate counsel to advise the board of directors, but this is considered weak governance, because of the potential for conflict of interest. Corporate governance best practice is for the board to use independent, outside counsel whenever legal counsel is required

• Statement of governance policies – Statements provided in shareholder materials about corporate governance policies, and how those policies change over time, can be a great tool for analysts and investors in evaluating a firm’s corporate governance system

• Disclosure and transparency – The purpose of accounting and disclosure is to fairly and accurately present a company’s financial situation. Since investors depend on timely, complete, and accurate financial statements to value securities, providing inaccurate financial data can result in mispriced securities, thus reducing the efficiency of financial markets. In general, best practice supports the conclusion that more disclosure is better. A company should provide information about organisation structure, corporate strategy, insider transactions, compensation policies and changes to governance structures

• Insider or related party transactions – A recent financial scandal involved a CEO who borrowed millions of company dollars through an employee loan program, and then used his authority as CEO to ‘forgive’ the loan. Best practice for any related-party transaction is to have the transaction approved by the board of directors

• Responsiveness to shareholder proxy votes – Management’s response to shareholder proxy matters is a sign of how seriously management takes its fiduciary duties. If an important matter such as executive compensation, a merger, or a governance issue is put to a shareholder vote and management ignores the result of the vote, it is obvious that management is not motivated by shareholder opinion as to what is in the best interest of the shareholders

Conclusion

It is important that the companies you invest in have a strong corporate governance system. The strength and effectiveness of a corporate governance system has a direct and significant impact on the value of the company.