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Corporate Governance: A Board Director's Pocket GuideLeadership, Diligence, and Wisdom
By Eric Yocam Annie Choi
iUniverse, Inc.Copyright © 2010 Eric Yocam, DBA, MS Annie Choi, JD, MIB
All right reserved.
The subjects covered in the governance chapter include Governance Types, Independence and Committees, Governance Practices, Antitakeover Provisions and Shareholder Rights, Bylaws, Shareholders' Meeting, Block Holders, Shareholder Activist and Proxy Advisory Service.
In the broadest sense, governance is the practice of leadership supporting the decision-making that defines expectations, grants power, or verifies performance. The practice of corporate governance is a set of processes, customs, policies, and laws, affecting the way a corporation is directed, administered, or controlled. Shareholder rights, such as antitakeover provisions, block holders, or anything written in the Bylaws, affect how a board director can govern. Any board director needs to be familiar with these items, as they vary from corporation to corporation.
A board director should have a solid understanding about how governance applies to for-profit or nonprofit corporations. For reference, see figure 2.
A for-profit corporation is a corporation intended to operate a business that will return a profit to the owners.
A public corporation is a legal entity permitted to offer its securities (stock, bonds, etc.) for sale to the general public. In most cases, these securities are offered through a stock exchange.
A privately held corporation is a legal entity owned by one or more company founders or possibly their families or heirs or a small group of investors. Sometimes, employees also hold shares of private companies. Most small businesses are privately held. In the broadest sense, the term refers to any business that the state does not own.
A nonprofit organization is an organization with a specific purpose, such as educational, charitable, or other enumerated purpose. It may be a foundation, charity or other type of nonprofit organization.
The United States Internal Revenue Code 501(c) is a special provision where twenty-eight types of nonprofit organizations are exempt from paying income tax at the federal level (IRS, Charities and Nonprofits, 2007). The IRS lists the most common 501(c) organizations, including:
501(c) Description (1) A corporation organized under acts of Congress (2) Title-holding corporation for exempt organizations (3) A charitable, nonprofit, religious, or educational organization (4) A political education organization (5) A labor union or agriculture organization (6) A business league or chamber of commerce organization (7) A recreational club organization (8) A fraternal beneficiary society (9) A voluntary employee beneficiary association (10) A fraternal lodge society (14) A credit union (19) A U.S. veterans' post or auxiliary
Independence and Committees
Having separate committees to nominate, compensate, audit, and govern are more effective at monitoring governance than having the board itself regulate these items (Klein, 1998; Newman and Mozes, 1999; Shivdasani and Yermack, 1999; Gillan Hartzell and Starks, 2003).
Governance Metrics International (GMI) is an organization dedicated to monitoring and rating corporations worldwide on several governance points. The goal of this organization is to provide an easy-to-use tool to show investors and other interested parties how effective the governance practices are for a particular corporation.
The United States ranks fourth for governance practices, but Canada, United Kingdom, and Australia placed in the top three respectively out of the forty-five countries represented in the GMI ranking (Holstein, 2006).
A set of boards that have met shareholder expectations include Citicorp, General Electric, Warner-Lambert, TRW, KeraVision, and the Royal Bank of Canada (Morris, Brotherridge, and Urbanski, 2005).
Boards that fell short of shareholder expectations included General Motors, IBM, Westinghouse, Kmart, Digital Equipment Corporation, Bre X, Credit Suisse, First Boston, Credit Lyonnais, Adelphia, Paramalat, Enron, WorldCom, and Tyco (Morris, et al., 2005).
Antitakeover Provisions and Shareholder Rights
Weak shareholder rights and the existence of anti-takeover provisions indicate weak governance. Strong and effective corporate governance is the ideal state for the board (Gompers, Ishii, and Metrick, 2003).
The bylaws contain detailed management provisions and rules for board directors, officers, and shareholders charged with corporate governance. They provide the structure and rules for governance.
The bylaws include the time and place of the annual shareholder meeting; time and place of the board directors' meetings; specific modality and notices for calling special meetings; and structure for the board of directors, including the making of committees, the duties of officers and board directors, voting and quorum provisions, and many others (Cheeseman, 2003).
A shareholder meeting is a gathering of all the shareholders of a corporation in order to elect the board of directors and hear reports on the company's business performance. It is usually held annually, but it can be held more frequently. This meeting is part of good governance because the board is accountable to the shareholders.
United States Securities and Exchange Commission (SEC) is looking into strengthening shareholder rights to help preserve the integrity of the board director position as well as ensure more effective corporate governance through shareholder accountability and board transparency (Creech, 2006).
Block holders and other influential shareholder groups can influence decisions at the shareholder meeting. Block holders have a controlling interest in a company. They have enough control over a block of voting shares so that no one stockholder or coalition of stockholders can successfully oppose a motion.
Researchers found that block holders might be good monitors or try to influence the management for their own interest.
Some block holders might have more incentive to monitor than others (Bhojraj and Sengupta, 2003; Cremers and Nair, 2003).
A board member should be aware of block holders and if the block holders' agenda is consistent with effective governance practices.
Influential shareholder groups support majority voting or proxy advisory. Among the influential shareholder groups in the United States supporting majority voting are the proxy advisory corporation Institutional Shareholder Services (ISS), CalPERS, and the Council of Institutional Investors.
A shareholder activist is a person who attempts to use his or her rights as a shareholder of a publicly-traded corporation to bring about social change.
Global Proxy Watch (http://www.proxywatch.com/) tracks shareowner activism across borders and initiatives by companies, governments and stock exchanges to reform or block corporate governance.
Proxy Advisory Service
Proxy voting is the process by which an owner of a security provides the authority or power for a person to act on his or her behalf in voting corporate shares of stock.
Proxy advisory firms wield enormous influence in shareholder elections, as their institutional clients -primarily mutual funds and pension plans-have significant stock holdings compared to other investors.
Unfortunately, these firms are not subject to any required disclosures or oversight regarding their ability to control or influence the outcome of a vote.
Some advisory services also have an inherent conflict of interest in the voting process because they also provide related consulting services, such as corporate governance ratings, corporate governance advice, and other research services, in addition to providing voting recommendations on proposals submitted in shareholder elections.
Five major firms
o RiskMetrics (ISS)
o Egan-Jones Proxy Services
o Glass Lewis & Co.
o Marco Consulting Group
o Proxy Governance, Inc.
Chapter TwoBoard Characteristics
The subjects covered in the Board Characteristics chapter include Board Structure, Board of Directors, Board Size, Interlocked and Interconnected Boards, and Succession Planning.
A board director should understand the basic characteristics of the board on which he or she serves. The structure, size, and composition of the board all affect the board director's ability to govern.
A strong board structure will curb managerial incentives and allow the board, shareholders, and stock market to effectively monitor managers (Ertugrual and Hedge, 2005).
Board of Directors
The Board of Directors is a group of professionals who bring a breadth of skills, experience, and diversity to a company. Typically, the board will appoint one of its members to be the chair of the board of directors.
When selecting a board of directors, the following questions should be addressed:
What additional responsibilities will the board members have? Will they assist in promoting the company or identifying potential sources of capital? Will the board members also become shareholders? Are there any potential conflicts of interest with the candidates? What expertise should the board members have? Will they add diversity of experience and knowledge to the company? Will the board be compensated for meetings and/or paid a board director's fee?
The board size can affect governance (Yermack, 1996). Smaller boards are more effective because they experience fewer communication and coordination problems. Several additional items related to board size:
From 1988 to 1999, the median board size was nine. The target board size for an American publicly traded company is between eight and eleven board directors. When the chief executive officer (CEO) is older, the board size increases. The CEO ownership, CEO as founder, and CEO involvement in board director selection tends to shrink the board size. The board size is proportional to the company size (as measured by total assets).
Contrary to popular belief, effective governance and good financial performance are not necessarily linked to the number of external board directors (Yermack, 1996).
Interlocked and Interconnected Boards
An interesting situation among board membership is when boards become interlocked or interconnected. For more information, see figure 3.
When two CEOs from different companies sit on each other's boards, then it is said that the two boards are interlocked.
The fear with interlocked boards is that the CEOs can mutually support each other's agenda, including possibly their compensation package and more favorable consideration. They could also possibly influence the selection of new board directors and hinder the ability to facilitate social cohesion among other board directors.
When two or more board directors sit on the same multiple boards, then those boards are said to be "interconnected."
Interconnected boards may point to groups of board directors having a different focus besides the interests of shareholders.
Board of directors filled with board director appointees who are sympathetic to the CEO are likely to overcompensate and under monitor the chief executive (Fich and White, 2004).
The same researchers suggest that mutually interlocking board directorships that are prevalent among corporations are responsible for the production of sympathetic board directors.
Succession planning is planning for who will fill executive and board positions that become vacant, for example, the CEO, senior executive team, and the board itself.
It also involves reviewing board composition. Being aware that knowing who will fill key positions (should they become vacant) keeps the company moving toward its goals.
More progressive boards are shifting from the short-term, tactical recruiting of board directors to a longer-term strategic approach to building boards in response to the direction and needs of the business.
Chapter ThreeBoard Director Characteristics
The subjects covered in the Board Director Characteristics chapter include Activities Prior to Joining a Board, Types of Board Directors, Term of Board Directors, Recruitment of Board Directors, Notable Board Directors Listings, Board Director Qualifications, Board Director Expertise, Board Director Leadership Skills, Board Director Trustworthiness, Personal Knowledge Management, Board Director Professionalism, Ethics Applied: Insider Trading, and Board Directors and Officers Liability Insurance.
A person awarded a position on a company's board should feel both a sense of honor and obligation to the board director position.
Board directors monitor a company's financial performance and the success of its products, services, and strategy. They are expected to follow developments that affect the business and set aside any potential conflict between their personal or individual business interests to support the well-being of the business that they serve.
Ideally, board directors should have backgrounds and contacts that differ from, but complement, the background of the officers of the company and other board directors. The most effective board is a group of professionals who bring a breadth of skills, experience, and diversity to a company.
Key components to a successful board are board directors with leadership skills, trustworthiness, and good business ethics.
Activities Prior to Joining a Board
Consider gathering and reviewing the following items before taking on the responsibility of joining a board:
A description of the members' responsibilities A brief biography of the CEO A list of the current board members, titles, and associated board member affiliations A board organizational chart
The company's or organization's most recent audited financial statements The long-range road map and financial plan A company's annual report A company's or organization's newsletter, brochure, or any available publications
Evaluate the board directors' tenure, that is, the amount of time a person holds a governance position at a company since a board director's tenure can be viewed as an important indicator of effective corporate governance.
The average board director's tenure is three terms or approximately nine years. However, the board director's tenure that is considered a long tenure can range from 15 to 20 years for some boards. Senior board directors are more likely to make decisions favoring management (Vafeas, 2003). Typically, tenure from 10 to 15 years of directorship for a particular company is long enough for a board director given the amount of change to technology, financial dealings and business strategies involved in the current business environment (Canavan, Jones, Potter, 2004).
Types of Board Directors
A board director is a person chosen to govern the affairs of a corporation or other large institution. A board director may be an inside director, that is, a director who is also an officer, or an outside, or independent, director. For more information, see figure 4.
An executive director is a person dedicated full-time to his or her role in relation to the management of the company.
A non-executive director, or independent director, is considered to be an outsider to the company. This position is typically held by a person who is not part of the management of a company. He or she is brought in for his or her expertise. He or she also lends a more impartial view in relation to strategic decisions.
A board with a majority of independent board directors is more effective in monitoring the management than a board with a minority of independent board directors (Hermalin and Weisbach, 2003; Klein, 1998).
The chairperson of the board, the presiding board director over the other board directors on the board, leads the board of directors.
The chairman/CEO duality is when a single person is both chairman of the board and CEO. For more information, see figure 5.
The costs of separating these roles between chairman and CEO by assigning these roles to different people outweigh the benefits (Coles and Jarrell, 1997).
Excerpted from Corporate Governance: A Board Director's Pocket Guide by Eric Yocam Annie Choi Copyright © 2010 by Eric Yocam, DBA, MS Annie Choi, JD, MIB. Excerpted by permission.
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