Lecture Three

Directors:
Duties and Effectiveness
 Board of Directors

• A group of individuals elected to represent shareholders.

• Establish policies for corporate management and oversight, and make
decisions on major company issues.
• Every public company must have board of directors.
• Some private and nonprofit organizations also have board of
directors.
 Board Duties

• Fiduciary duty: directors must place shareholders’ interest

above their own interest
 Duty of loyalty: a director must demonstrate loyalty to
shareholders

 Duty of care: a director must exercise due diligence in

making decisions
 Responsibilities
• The board of directors has a dual authorization:
• Advisory: consult with management regarding strategic and operational
direction of the company.
• Oversight: monitor company performance and reduce agency costs.

• The responsibilities of the board are separate and distinct from those of
management. The board does not manage the company.

OECD Principles of Corporate Governance:

“The corporate governance framework should ensure the strategic guidance of
the company, the effective monitoring of management by the board, and the
board’s accountability to the company and the shareholders.”
OECD (2004)
 Responsibilities
• Approve the corporate strategy
• Identify risk areas and oversee risk management
• Plan for and select new executives
• 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

• https://www.youtube.com/watch?v=fsSIoGaF-8A&list=PL8tJiHbTijTMHf7Iucu
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 Independence
• Boards are expected to be independent:
• Act solely in the interest of the firm.
• Free from conflicts that compromise judgment.
• Able to take positions in opposition to management.

• Requires a careful evaluation of board member’s biography, experience, previous

behavior, and relation to management.
 Operations of the Board
• Presided over by chairman: sets agenda, schedules meetings, coordinates actions
of committees.

• Decisions made by majority rule.

 Board Committees
• Not all matters are deliberated by the full board. Some are delegated to
subcommittees.

• Committees may be standing or ad hoc, depending on the issue at hand.

• All boards are required to have audit, compensation, nominating/governing

committees.

• On important matters, the recommendations of the committee are brought

before the full board for a vote.
 Audit Committee

• Selected number of members of a company’s board of directors who are in

charge of overseeing financial reporting and disclosure.

• The committee assists the board of directors fulfill its corporate governance and
overseeing responsibilities in relation to an entity's financial reporting, internal
control system, risk management system and internal and external audit
functions.

Audit committees meet on average 8 times

per year, for 2.7 hours each.
NACD(2014)
 Compensation Committee

• Independent directors appointed by the Board of Directors, determining and

approving the Executive Compensation Package.

• Independence should be assessed under applicable law and stock market rules.

• Have sound ability.

• Free from any competing interests. Compensation committees meet on average 6

times per year, for 2.7 hours each.

NACD(2014)
 Nominating Committee
• Evaluate the board of directors and examine the skills and characteristics needed
in board candidates.

• Often comprised of the chairman of the board, the deputy chairman, and the
CEO.

• Identify and nominate suitable candidates for various director positions.

• Other duties vary with different companies.

Nominating/governance committees meet on
average 8 times per year, for 1.8 hours each.

NACD(2014)
 Specialized Committees
• Executive • Science & technology
• Finance • Legal
• Corporate social • Ethics / compliance
responsibility • Mergers & acquisitions
• Strategic planning • Employee benefits
• Investment • Human resources /
• Risk management
• Environmental policy development

Prevalence of specialized committees:

• Finance: 31%
• Corporate social responsibility: 11%
• Science & technology: 8%
• Legal: 6%
• Environment: 8%
Spencer Stuart (2013)
 Director Terms
• Two main election regimes:
• Annual election: Directors are elected to one-year terms.
• Staggered (Classified) board: only a fraction (typically a third) of the members of the
board of directors is elected each year, rather than all at once.

• Staggered (Classified) boards are an effective antitakeover protection.

Prevalence of staggered boards:

• Approximately half of all publicly traded

companies have a staggered board.

• Small companies are more likely to have a

staggered board than large companies.

SharkRepellent (2009)
 Director Elections
• In most companies, directors are elected on a one-share, one-vote basis.

• Shareholders may withhold votes but not vote against.

• Four main voting regimes:

Plurality: directors who receives most votes is elected, even if a majority is not obtained.
Majority: director must achieve majority to be elected.
Cumulative: shareholders can pool votes, and apply to selected candidates (rather than one
vote each).
Dual class: different classes of shares carry different voting rights (disproportionate to
economic interest).
 Market for Directors
• Among public corporations in the U.S.:

• Total number of directors: 50,000

• Average tenure on board: 7 years
• Average mandatory retirement age: 72

• Directors tend to retire voluntarily.

• Only 2 percent of directors who step down are dismissed or not reelected.
 Director Recruitment Process
• Director recruitment is a responsibility of the nominating/ governance
committee.
• Identify needs of company.
• Identify gaps in director abilities.
• Identify potential candidates, either through director networks or with
professional recruiter.
• Rank candidates in order of preference.
• Meet with each candidates successively and offer job.
• Put before shareholders for a vote.
 Director Compensation
• Compensation must be sufficient to attract, retain, and motivate qualified
directors.

• Compensation covers time directly spend on board matters, cost to keeping

schedule flexible to address urgent issues, and financial and reputational risk
from corporate scandal or lawsuit.
 Board Structure
• Boards are often described in terms of their salient structural features: size, independence,
committees, diversity, etc.

• Do these attributes have an impact on the board’s ability to monitor and advise the
corporation?

• Do companies with certain structural features perform better/ worse than those who lack
them?

• A determination of how to structure the board should be based on rigorous statistical

evidence.

• At the same time, it should allow for situational differences across companies.
 Board Structure
The Board of Directors of the Average Large
U.S. Corporation

Number of directors 11
Number of meetings per year 8
Independent directors 85%
Independent chairman 25%
Dual chairman/CEO 55%
Lead director 90%
Independent audit committee 100%
Independent comp committee 100%
Independent nom/gov committee 100%
Average age 63
Mandatory retirement 72%
Mandatory retirement age ~72
Female directors 18%
Boards with at least one female
93%
director

Spencer Stuart (2013)

 Chairman of the Board
• The chairman is the connection between the board and management, and
between the board and shareholders.

• The chairman presides over the board, schedules meetings, sets the agenda, and
distributes materials in advance.

• The chairman leads the discussion of important items, including strategy, risk,
performance, compensation, succession, and mergers.

• The chairman shapes the timing and manner in which items are discussed and
therefore is critical to the governance system.
 Chairman of the Board
Should the chairman be independent?

• (+) Clear separation from management.

• (+) Clear authority to speak on behalf of the board.
• (+) Eliminates conflicts.
• (+) CEO has more time to run the company.

• (-) Artificial separation for dual Chairman/CEO.

• (-) Difficult to recruit new CEO that expects to hold both
jobs.
• (-) Complicates decision making.
 Independent Directors
• Independent directors are those who “have no material relationship” with the
company (as defined by the NYSE).

• A director is not independent if director or family member has, in the last three
years:
• Served as an executive of the listed firm.
• Earned compensation > $120,000 from the firm.
• Served as an internal or external auditor of firm.
• Served as executive at another firm where CEO of listed firm was on
compensation committee.
• Served as executive of another firm whose business with the listed firm is
greater of $1 million or 2% of revenue.
 Independent Directors
Independent judgment is critical to the advisory
and monitoring functions of the board.

• (+) Offer objective evaluation of company and management.

• (+) Allow for arms-length negotiation of compensation.
• (+) Make decisions solely in the best interest of the company.

• (-) Directors who meet NYSE standards may not be independent.

• (-) Social ties may compromise judgment.
• Outside directors improve some governance outcomes, such as M&A premiums.

• Their effectiveness depends on their cost of acquiring information about the firm.

Cotter, Shivdasani, and Zenner (1997); Duchin, Matsusaka, and Ozbas (2010); Hwang and Kim (2009)
 Independent Committees
• Committees of the board deliberate topic-specific issues that are critical to the
oversight of the company.

• Directors are selected to committees based on their qualifications and domain

expertise.

• The audit, compensation, and nominating/governance committees are required

to be independent (Sarbanes Oxley).

• Specialized committees (strategy, finance, technology, and environmental, etc.)

have no independence requirements and may include executive officers.
 Independent Committees
Are committees more effective when they are independent (either majority or
100%)?

• (+) Objective advice and oversight.

• (+) Less likely to be influenced by management.

• (-) Independent directors have a “knowledge gap.”

• (-) Management brings important firm-specific knowledge.
• Some evidence that independent audit committees improve earnings
quality.

• 100% independence is no better than majority independence.

Klein (2002); Kliein (1998)

 Busy Boards
• “Busy” director: director holds multiple board seats
(generally 3 or more).

• “Busy” board: a majority of directors are busy.

Total unique directors 29,089
Directors with:
1 board seats 24,144
2 board seats 3,583
3 board seats 1,020
4 board seats 254
Potentially busy
5 or more 88 directors

Corporate Board Member and PricewaterhouseCoopers (2009)

 Busy Boards
Are busy directors better or worse corporate monitors?

• (+) Bring important experiences from other directorships.

• (+) Broad social and professional networks.
• (+) May have high integrity (reason they are in demand).

• (-) May be too busy to properly monitor.

• (-) May be less available at critical moments.
Companies with busy boards tend to have worse long-term
•
performance and worse oversight.

• Busy boards are less likely to fire an underperforming CEO.

• Busy boards award higher compensation.

Fich and Shivdasani (2006); Core, Holthausen, and Larcker (1999)

 Interlocked Boards
Interlocked boards: the CEO of Firm A sits on the board of Firm B, while the
CEO of Firm B sits on the board of Firm A.
• (+) Creates a network between companies.
• (+) Facilitates the flow of information and best practices.

• (-) Issue of “conflict of interest”.

• (-) Can compromise objectivity and weaken oversight.
Network connections generally improve corporate performance. Effects are
•
most pronounced among companies that are newly formed, have high growth
potential, or in need of a turnaround.

• At the same time, interlocking leads to decreased monitoring (less to

terminate underperforming CEO; award higher compensation).

• Companies must balance trade-off.

Larcker, So, and Wang (2010); Hallock (1997); Nguyen-Dang (2009)

 Board Size
Board size tends to be correlated with company revenue.
• Small companies (<$10 million): 7 directors, on average.
• Large companies (>$10 billion): 11 directors, on average.

• (+) Large boards have more resources.

• (+) Allow for greater specialization.

• (-) Greater cost (compensation, scheduling conflicts, etc.).

• (-) Slow decisionLarger
• making.
boards tend to provide worse oversight (when company
size is held constant).

• Large “complex” firms (those with multiple business segments)

benefit from larger board size while large “simple” firms do not.
Yermack (1996); Coles, Daniel, and Naveen (2008)
 Diverse Boards
Do diverse boards provide better advice and oversight?

• (+) Broader array of knowledge, experience, and

perspective.
• (+) Encourages healthy debate.

• (-) Diverse groups exhibit lower teamwork.

• (-) May lead to “tokenism.”
• Evidence on the relation between diversity and corporate performance is largely
inconclusive.

• Modest evidence that female representation improves governance quality.

• Diversity for the sake of meeting quotas is clearly detrimental (the cost of inexperience
outweighs the potential benefits).

e.g. Gul et al. (2011)

CABCHARGE – case discussion
• Cabcharge Australia Limited was founded in 1976 by Reginald
Kermode. It was listed on the Australian Securities Exchange (ASX) in
December 1999. Its key activities include the provision of taxi-related
payment, booking and dispatch services; taxi payment software
development; and the development of taxi-related hardware and
software such as taxi security cameras, equipment and meters.
CABCHARGE’s remuneration structure
• For many years up to 2011, Cabcharge’s remuneration structure
comprised two components – fixed annual remuneration (FAR), and
short-term incentives (STI) that were based on individual performance
and overall Group performance.

• The company justified Kermode’s annual cash salary but failed to justify
the STI of senior executives and the increases in director fees of non-
independent directors.

• Investors, who frequently voiced protests against Cabcharge’s

remuneration reports at annual general meetings (AGMs).
Two-strikes rule
• On 1 July 2011, new legislation known as the ‘two-strikes’ rule was introduced
in Australia to hold directors accountable for executive salaries and bonuses.

• A strike occurs when a company’s remuneration report for the year receives a
‘no’ vote of 25% or more from shareholders at the company’s AGM.

• On the second strike, the shareholders conduct a spill vote at the same AGM
to determine whether the board should stand for re-election. If the spill
resolution passes with a simple majority of 50% or more, a spill meeting for
re-election is required within 90 days.
First strike not followed by re-election
• The first strike came with 40.6% of shareholders rejecting the
remuneration report.

• Only 13.8% of shareholders voted for a spill meeting, which fell vastly
short of the 50% required to pass it.
Revisions on compensation structure
• The remuneration committee was reconstituted as the Corporate
Governance Committee (CG Committee).
• A long-term incentive plan (LTIP) for executives was established key
elements of which included offering performance rights and options
assessed over a four-year period and no re-testing of performance.
• 45.3% of shareholders voting against the remuneration report.
New CEO
• Kermode announced his resignation from Cabcharge on 28 April 2014.
He passed away two days later.

• Cabcharge restructured the remuneration package of its new CEO

through the introduction of a LTIP.

• 96.0% of shareholders vote in favor of adopting LTIP. However, 57.4% of

votes against the remuneration report, the highest ever. This was
largely attributed to the fact that total senior executive remuneration
had increased by 37.2%.
Independence issues
The remuneration committee should consist of a majority of independent directors, be
chaired by an independent Chairman and have at least three members.

However, the independence of majority of the members on the CG Committee, including

the Chairman, was questionable given that all of them had been in Cabcharge for at least
10 years.

Many of Cabcharge’s directors had been serving on the board for more than 12 years
prior to the passing of Kermode.

Kermode had been both CEO and Chairman for 34 years, and this was criticized by
investors and governance experts.
Discussion Questions

• Do you feel that Kermode’s compensation package was reasonable?

In companies where a director is a controlling shareholder, what
measures should be in place to prevent him from paying himself
excessively? Evaluate the effectiveness of the measures implemented
by Cabcharge.

• Evaluate Cabcharge’s board independence. Should there be stricter

rules with regards to board independence?