The Board of Directors bears ultimate responsibility for the oversight of a company’s business and affairs. The Board establishes significant policies; makes fundamental decisions about strategic focus and direction of the company, including evaluation of key opportunities and risks; and approves the hiring, firing, succession planning and compensation of the executive officers who manage the company’s day-to-day business operations. Directors oversee risk management, including internal controls and compliance with laws, and monitor financial reporting and public disclosure. The Board also manages shareholder relations and engagement and sets the tone for ethical business conduct. This chapter describes how members of a Board, and its Audit, Compensation and Nominating & Governance Committees, can best fulfill these duties.

Although our discussion uses concepts from Delaware law, similar principles apply in other states.

Practical Tip: Best Practices and Better Still: The Evolving Standards of Corporate Governance

Directors face a sometimes bewildering array of corporate governance requirements. Where do they come from?

  • State Law. The corporate statutes and court decisions of a company’s state of incorporation provide the basic “rule book” for a Board. State corporate law controls all aspects of corporate life, from the very simple (such as shareholder notice and voting requirements) to the complex (such as fiduciary duties and liability).
  • Federal Law. Federal law, primarily created by Congress and the SEC, regulates the governance of public companies, mandating, for example, entirely independent Audit and Compensation Committees and codes of ethics for CEOs and senior financial officers.
  • NYSE and Nasdaq. The NYSE, Nasdaq and other exchanges impose governance standards on their listed Subject to limited exceptions we discuss in Chapters 9 and 10, requirements include independent Audit, Compensation and Nominating & Governance Committees, a majority of independent directors and executive sessions of non-management directors. All public companies will have an Audit Committee and all listed companies will have a Compensation Committee, both made up of independent directors. The NYSE requires, and Nasdaq suggests, an independent director Compensation Committee. The NYSE requires a Nominating & Governance Committee, while Nasdaq requires either a Nominating & Governance Committee or that independent directors meet in executive session to deal with director nominations. (Chapters 9 and 10 discuss committee requirements of the NYSE and Nasdaq in detail.)
  • Institutional Investors. Institutional investors, as well as shareholder activists and proxy advisory firms, have applied increasing pressure on public companies to adopt corporate governance practices, many of which are now commonplace, that the investors believe are in the best interests of shareholders. Those practices include eliminating staggered Boards, giving shareholders the right to call special meetings, having shareholders approve shareholder rights plans (a takeover defense commonly referred to as a “poison pill,” which we discuss further in Chapter 11), requiring independent chairs and adopting “majority vote” procedures for annual shareholders’ meetings.

In short, many of yesterday’s “best practices” have become today’s baseline requirements. New best practices continue to evolve as companies, regulators, institutional investors and corporate governance commentators debate the many new governance rules and standards that apply to public companies.

This chapter reviews best practices of corporate governance at the time this Handbook went to press in 2021. In Chapters 9 and 10, we describe in detail the governance standards of the NYSE and Nasdaq. We also make suggestions that may help your Board stay abreast of best practices of corporate governance that are sure to evolve in the years to come.

Director Responsibilities

State statutes, court decisions and, increasingly, federal laws and regulations define the duties of directors. Yet even after the implementation of many new regulations, the basic duties of directors remain unchanged. Although there are nuances in the duties imposed by various states, most hold directors to general fiduciary duties of care and loyalty. Some courts have imposed the additional duty of candor.

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Duty of Care

Directors owe the company and its shareholders a duty to exercise the care that an ordinarily prudent person in a comparable position would exercise under similar circumstances. A director is not presumed to have special management skills, but is expected to exercise common sense and apply the skills he or she possesses. The time needed to fulfill the duty of care will increase with the importance and complexity of the proposed corporate action. The following decisions, for example, require substantial investigation and consideration:

  • Merging or selling the company;
  • Establishing or waiving antitakeover defenses;
  • Hiring, terminating or setting compensation for management;
  • Approving debt or equity offerings, or other material financings;
  • Entering into new lines of business; and
  • Approving an annual budget or strategic business plan.

Due care requires directors to apprise themselves of all reasonably available material information prior to making a business decision. Directors can best assess each proposal’s strengths and weaknesses by taking these steps:

  • Ask for sufficient notice of each Board meeting to allow for adequate preparation;
  • Require – and review – written background documentation describing the rationale and key terms of any proposed transaction prior to the meeting;
  • Discuss the proposed issue with the company’s management and legal and financial advisors;
  • Attend meetings in person or by telephone in a way that allows each director to participate and to learn all the information available to the Board; and
  • Make sufficient inquiry – ask questions prior to and at the Board and committee meetings – in order to discuss and understand as fully as possible all the relevant issues, including the risks of executing the business decision.

Practical Tip: No Speeding!

You may want to use this image to illustrate the duty of care for your Board:

“Directors get in trouble for speeding, not for running the car off the road!”

In other words, the Board should act in good faith to make its best thoughtful, considered and informed decisions. If no conflicts of interest exist and the Board follows an appropriate process, courts usually will not second-guess the directors even when, in hindsight, the Board makes a wrong choice, takes a wrong turn or causes the company to suffer a loss.

 
In making decisions, a director may generally rely on information and reports from the company’s officers and employees; legal, financial and other advisors; and Board committees. Reliance, however, must be “eyes open” and prudent. Each director should assess the qualifications of the parties providing information and advice, and then examine the work product. A director may not rely on information or advice if the director has knowledge that would make reliance unreasonable. In reviewing material, the three best rules of thumb are simply:

  • Ask;
  • Ask; and
  • Ask. 

Duty of Loyalty

A director owes the company and its shareholders a duty of loyalty to give higher priority to corporate interests than to his or her personal interests in making business decisions. If a director has a personal interest in a matter, he or she must fully disclose the interest to the Board and will often abstain from voting on or participating in discussion of the matter. Similarly, directors should not pursue, other than through the company, business opportunities that relate to the company’s existing or contemplated business unless disinterested members of the Board, after full disclosure, have decided that the company will pass on the opportunity.

Conflicts of Interest. Conflicts of interest and corporate opportunities arise regularly in the day-to-day conduct of a Board’s business.

A director may, for example, have a corporate opportunity or conflict of interest as a result of:

  • An inside director’s employment or severance arrangement;
  • An issue that is material to the director’s employer; or
  • An interest in the potential purchaser in a change-of-control transaction.

The frequency of conflicts of interest has given rise to a host of mechanisms for conflict management. Using them should permit a Board to act responsibly. Ways to manage conflicts of interest include:

  • A Majority of Disinterested Directors Approve, and Interested Directors Abstain. If only one director, or a small number of directors on a larger Board, has a conflict of interest, a majority of the disinterested directors may approve the transaction. In this situation, a director with a conflict should fully disclose it, including all facts that would be relevant to the Board’s decision, remove himself or herself from discussion at appropriate times, and abstain from voting.
  • A Wholly Independent Committee Approves. The Board may establish an independent committee of disinterested, independent directors to approve a particular transaction. Either the Board chair or disinterested directors will take the lead in establishing the committee. The Board may either delegate the final decision to the committee or ask the committee to make a formal recommendation to the Board for approval. The committee should act independently, with an adequate budget to seek assistance from independent legal counsel and other advisors, as the committee deems appropriate.
  • Shareholders Approve. If all or nearly all directors have a conflict of interest, the Board may ask for shareholder approval of a particular transaction. The proxy statement disclosure to shareholders should describe the transaction and fully disclose all conflicts of interest and other relevant information. The Board may either recommend the transaction to the shareholders or call for a shareholder vote without a Board recommendation.

In unusual situations, such as where all or virtually all directors have a conflict, and where shareholder approval is impractical or the shareholders themselves have conflicts of interest, the Board may take an action that it believes to be “entirely fair” to the company. Public companies rarely act on this basis. Shareholders have the right to challenge a transaction in which the directors have a conflict and the transaction is nonetheless approved by the Board. A court will uphold the action if it establishes that the action was fair to the company at the time the Board approved it.

Duties to Other Stakeholders. The interests of the company and its shareholders, while primary, are not the sole consideration of the Board. Some states have adopted constituency statutes that permit directors to consider the interests of other constituents, including employees, customers, suppliers and communities, when making business decisions. Even in a state without a permissive constituency statute, such as Delaware, directors may take into account – in the absence of a sale of control transaction – various stakeholder interests in a manner consistent with their fiduciary duties as they consider long-term value creation for the company and its shareholders. The Business Roundtable’s 2019 Statement on the Purpose of a Corporation, highlighting the corporate signatories’ commitment to all their stakeholders, garnered significant attention. The Statement has led to conversations among governance professionals and in the boardroom about balancing the interests of various constituents while fulfilling the Board’s duties in a manner consistent with application of the business judgment rule. Chapter 3 discusses company engagement with shareholders and other stakeholders.

In addition, other statutory provisions may mandate the consideration of stakeholders other than a company’s shareholders. When a company becomes or is likely to become insolvent, for example, a director’s duty of loyalty may shift to include the company’s creditors.

Delaware and several other states have adopted laws permitting the creation of public benefit corporations. These hybrid corporations balance shareholders’ financial interest with the best interests of other stakeholders materially affected by the company’s business activities, while creating an overall public benefit. Few companies have adopted the public benefit corporation model, and we would not expect many public companies to utilize this hybrid approach.

Duty of Candor

Delaware judicial decisions have articulated a duty of candor or disclosure. This additional responsibility derives from both the duty of care and the duty of loyalty. The duty of candor calls on directors to disclose to their fellow directors and the company’s shareholders all material information known to them that is relevant to the decision under consideration. In judging whether a director has satisfied his or her duty of candor, courts will examine the materiality of all undisclosed or underdisclosed information.

Judicial Review: Business Judgment Rule

Courts apply the business judgment rule in reviewing most decisions made by directors. Under the business judgment rule, courts defer to the decisions of disinterested directors absent evidence that the directors did not act in good faith or were not reasonably informed about the decision or that there is no rational business purpose for the decision that promotes the interests of the company or its shareholders.

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Enhanced Scrutiny: The Unocal and Revlon Standards

Courts in Delaware and other states apply a more stringent enhanced scrutiny standard when examining transactions involving the adoption of antitakeover measures, implementation of deal-protection mechanisms such as lock-up options, a change of control or a breakup of the company.

When applied in assessing the appropriateness of antitakeover or deal-protection measures, this standard is known as the Unocal standard. In defending its adoption of company deal-protection measures, a Board must show that:

  • The Board had reasonable grounds for believing that a threat to company policy and effectiveness existed; and
  • The measures adopted were proportional in relation to the threat posed. 

If a Board can establish both elements, the action should receive the protection of the business judgment rule.

When a Board elects to pursue a change of control or breakup of the company, the Board has a separate enhanced responsibility: to obtain the highest value reasonably available for shareholders. This standard is commonly referred to as the Revlon standard. A “change of control” in the Revlon context involves a cash merger, a merger in which more than 50% of the consideration is cash or a merger in which a controlling shareholder will result. If, however, a proposed merger will not result in a sale of control, such as in a stock-for-stock merger between two noncontrolled companies, the ordinary business judgment rule applies to the Board’s decision to enter into a merger agreement, as held by the Delaware Supreme Court in Paramount Communications, Inc. v. Time Inc. (commonly known as the Time-Warner case).

Practical Tip: Obtain a Fairness Opinion

Courts give special deference to Boards that seek truly independent third-party advice, such as that of an investment bank, valuation consultant or law firm, to assist disinterested directors in assessing a transaction. An opinion from a reputable third-party financial advisor that a transaction is fair to the company and its shareholders from a financial point of view may substantially reduce the risk of a successful challenge to the Board’s decision under any standard of review. A fairness opinion can also help independent directors make an informed decision.

Without a fairness opinion, you may find yourself in the same unfortunate position as the directors of Trans Union Corporation. In the 1980s, Trans Union’s Board approved a sale of the company. In the case Smith v. Van Gorkom, a Delaware court held that the Board breached its fiduciary duties by acting without adequate information or independent third-party advice. The court concluded that the Board’s decision to accept a market premium without first determining the intrinsic value of Trans Union’s shares left the directors vulnerable to personal liability to the company’s shareholders to the extent a fair price exceeded the sale price.

By contrast, in the 2005 Disney case, a Delaware court placed weight on the Disney Compensation Committee’s reliance on an independent compensation expert. The Committee was entitled to rely on the expert even though his analysis may have been incomplete or flawed. The Committee had selected the expert with reasonable care, the analysis was within his professional competence, and the directors had no reason to question his conclusions. (See “Trap for the Unwary: The Compensation Committee After Disney” later in this chapter.)

Directors should remember, however, that a fairness opinion is only one item in a Board’s toolbox for satisfying directors’ fiduciary duties in a sale-of-the-company transaction, and is not an automatic defense to a fiduciary duty claim. Directors should closely review the supporting analyses for the fairness opinion and make sure they understand the various inputs. In any case, the Board’s reliance upon a fairness opinion must be reasonable.

 

Entire Fairness

Entire fairness, the most demanding judicial standard of review, applies when independent directors have not approved or cannot approve a transaction, and the approving directors have a financial interest in, or other conflict with respect to, a transaction. Transactions are also reviewed for entire fairness when a court finds that a breach of the duty of care occurred or that the Board failed to meet an enhanced scrutiny standard. Under the entire fairness standard, courts conduct a broad substantive inquiry into whether the transaction is fair to the company and its shareholders in light of all the relevant facts and circumstances that existed at the time of the transaction.

Trap for the Unwary: Reliance on Experts Is NOT a Safe Harbor – Keep Your Eyes Open!

As Smith v. Van Gorkom and Disney show, a director has traditionally been able to demonstrate good faith and due care by relying on reports prepared by expert advisors to the company, such as bankers and accountants, regardless of the director’s personal qualifications. There are limits, however, to the safe harbor for a director who “should have known better.”

In the 2004 Emerging Communications case, a Delaware court determined that an outside director who, as an investment banker, possessed special expertise had no right to rely on a fairness opinion of the company’s independent investment banker. The court found that the director violated his duties of loyalty and/or good faith in approving a transaction because, given his background, he should have known that the transaction was unfair to minority shareholders.

The key takeaway: Although as a director you may generally rely on a report prepared by a third-party advisor, if you possess special knowledge or skill, you may not “leave it at the door” of the Boardroom! In your area of expertise, you may be held to a higher standard than your peers.

 

Board Composition

The composition, size and structure of a public company Board varies considerably with each company’s circumstances. The Board of an established Fortune 500 company differs from that of a younger, founder-led technology company. And both of these Boards differ from that of a family-dominated company. Board composition is a strategic asset and should be reviewed in light of a company’s strategic direction.

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A well-assembled Board is diverse. It includes individuals who bring complementary skills relevant to the company’s business and objectives. In selecting director nominees, the Nominating & Governance Committee (or the independent directors responsible for nominations) should consider the candidates’ financial and business understanding, their industry backgrounds, public company experience, leadership skills and reputation. The Committee should also monitor and consider diversity in geography, race, gender, age and skills.

Recently, some states and other regulatory bodies have sought to address diversity on public company Boards. Legislative efforts in the last several years have ranged from aspirational, to specified minimums (requiring either compliance or explanation), to mandatory minimums (establishing penalties for noncompliance). California, for example, passed a law in 2018 requiring public companies with securities listed on a major U.S. stock exchange and headquartered in California to have women on their Boards, and a subsequent law enacted in 2020 requires the same companies to have at least one director from an underrepresented community on the Board, in each case with specific targets based on Board size and passage of time. A 2020 Washington corporate law requires gender diversity on the Boards of public companies incorporated in Washington, while a 2019 Illinois law requires public companies headquartered in Illinois to disclose certain information about racial, ethnic and gender diversity of their Boards in state filings. Numerous other states have passed similar legislation and we anticipate additional states will consider such legislation in the coming years. Even The Nasdaq Stock Market received SEC approval of a listing rule effective 2022 that generally requires Nasdaq-listed companies to provide statistical information relating to directors’ self-identified gender, race and LGBTQ+ status and satisfy an objective to include diverse directors on the Board, or explain why they have not. The new Nasdaq listing rule is discussed in greater detail in Chapter 10.

Every year, a Nominating & Governance Committee (or other independent body) assesses the existing Board’s effectiveness in light of evolving company needs and recommends appropriate nominees to address new circumstances. “Board refreshment” has increasingly been in the spotlight as institutional investors and other constituents put pressure on Boards to critically assess director independence, including a focus on director tenure, and to satisfy gender and other diversity goals or legal requirements.

Each annual proxy statement describes which experience, qualifications, attributes or skills of each director led the Board to nominate that person as a director for the company. The proxy statement also describes how the Board or the Nominating & Governance Committee considered diversity. If the Board has a diversity policy, the proxy statement describes how the Board implements the policy and includes an assessment of the policy’s effectiveness. 

Practical Tip: What Makes a Good Director? “Noses in, Fingers Out”

Set expectations for your Board members from the outset. Candidates should be ready to devote ample time to learn and give guidance to company officers, while knowing when to stop short of usurping management. An effective director will:

  • Learn about the company. Stay informed by visiting physical locations. Ask questions of management. Learn from informal communication with others.
  • Review (or, as chair or lead director, develop) agendas and related materials in preparation for Board and committee meetings.
  • Attend and actively participate in Board and committee meetings. 
  • Respond promptly in crisis situations.
  • Ask tough, probing questions. Come to each meeting armed with a short list of questions and expect answers. 
  • Insist on clear and responsive answers.

In short, “noses in, fingers out.”

 

Independence

Most public company Boards include both inside and outside (or independent) directors. An independent director is an individual who can exercise judgment as a director independent of the influence of company management. An independent director will be free from business, family or personal relationships that might interfere with the director’s independence. The NYSE and Nasdaq each require that a majority of directors be independent. Each exchange has its own definition of an independent director, and we discuss these definitions in Chapters 9 and 10. Many institutional investors expect that a “substantial” majority of a company’s directors will be independent.

The three core committees – Audit, Compensation and Nominating & Governance – generally consist exclusively of independent directors. Independence standards for Audit and Compensation Committee members are more stringent than those for membership on a Board or other Board committees. The Dodd-Frank Act and the Sarbanes-Oxley Act generally delegate to the NYSE and Nasdaq the rules defining independence. (We provide more information about the Dodd-Frank Act and the Sarbanes-Oxley Act in Chapter 4.) And the NYSE and Nasdaq largely leave to Boards the responsibility to determine whether a director is independent under NYSE and Nasdaq standards.

Board Size

The size of a public company’s Board averages 11 directors but may range from as few as 5 directors to as many as 15 or more, depending on the size and complexity of the company. A company’s charter documents may set the size of the Board or allow the Board to set the size, usually within a permitted range.

Larger Boards can provide increased diversity, better continuity and greater flexibility in staffing Board committees with independent directors. But larger Boards have a cost. A group larger than 10 or 12 can prove administratively unwieldy and may reduce each director’s opportunity for active and meaningful involvement. Board committees can bridge this gap and increase the effectiveness of a larger Board.

Board Structure and Director Terms

The corporate laws of most states permit Boards to be divided into two or more classes of directors. Directors serving on an unclassified Board serve for one-year terms and stand for election at each annual shareholders’ meeting. Directors serving on a classified or staggered Board – one with multiple classes of directors – serve term lengths equal in years to the number of classes of directors.

A company with a staggered Board will divide the number of directors assigned to each class as equally as possible. Staggered Boards typically are composed of three classes (the maximum permitted by the NYSE rules and most state corporate statutes), with shareholders annually electing directors of one of the classes to serve three-year terms. This results in staggered termination dates for the director classes, enhancing Board continuity.

Institutional investors generally dislike staggered Boards. Classes reduce flexibility in changing Board membership annually because directors on a staggered Board typically may be removed only for cause and stand for election only every two or three years. Yet reviewing each class of directors with care every two or three years is a reasonable approach and, as we discuss in Chapter 11, staggered Boards may provide some protection against a hostile proxy contest. More than 90% of the S&P 500 companies now have unclassified Boards. 

Trap for the Unwary: Shareholder Groups Campaign to Abolish Staggered Boards, Adopt “Majority Voting” and Eliminate Discretionary Broker Voting in Director Election

Institutional investors and their advisors, like the proxy advisory firm Institutional Shareholder Services, have encouraged companies to vote to elect all directors annually, and to require majority rather than plurality voting for directors. Critics contend that annual elections for all directors, together with majority voting, hold directors more accountable every year. In addition, some investors and shareholder activists argue that staggered Boards can limit a target company’s stock value in the takeover bidding process. Largely as a result of this pressure, staggered Boards at large public companies have nearly disappeared, and shareholder activists have expanded their efforts to target staggered Boards at mid-and small-cap companies. In addition, approximately 90% of the S&P 500 companies have either adopted majority voting for director elections or adopted corporate governance guidelines that implement a plurality plus policy requiring a nominee to tender his or her resignation if the nominee fails to receive a majority vote. Although Boards do, from time to time, choose not to accept resignations offered by directors who fail to receive a majority vote, this is a controversial decision that a Board should make only after careful thought.

The NYSE has not historically allowed discretionary voting by NYSE member brokers in contested elections of directors. Since 2010, the NYSE has also prohibited discretionary voting by brokers in uncontested director elections at shareholders’ meetings. Now, NYSE member brokers may vote only those shares with instructions from the beneficial owner of the shares at any company, regardless of the exchange on which the company’s stock is listed. Brokers have typically voted in favor of incumbent directors. The prohibition on discretionary voting in uncontested director elections increases the risk that director nominees at companies that have adopted majority voting and plurality plus policies will not receive the needed votes for election.

 

Some companies have adopted term limits or age restrictions for their directors. Term or age limits can serve as a simple mechanism to bring greater age diversity to a Board and, at times, to remove a noncontributing director. Age limits, however, can cause a qualified director who is making valuable contributions to “age out” just when he or she has the time to devote to serving on the Board and its core committees. Implementing term or age restrictions as nonbinding guidelines, rather than as charter document provisions, can provide greater flexibility. Despite the recent focus by shareholder activists on director term limits, only 5% of S&P 500 companies have adopted them, although more than 70% of S&P 500 companies have established a mandatory retirement age for directors.

Board Leadership and Structure

Board leadership rests primarily with the chair and a lead independent director. Increasingly, Boards designate an independent director as chair, or ask an independent director to share Board leadership with an internal chair, usually the CEO. This shared role may be titled lead director or presiding director (presiding over meetings and executive sessions of independent directors). In recent years, both the number of companies separating the roles of CEO and chair and the number of companies appointing independent chairs have increased. In 2019, approximately 75% of S&P 500 companies had a lead or presiding director, and nearly 35% had an independent chair.

Under the SEC’s proxy rules, a company describes its Board leadership structure in its proxy statement and explains why it believes its structure is appropriate given the company’s specific characteristics or circumstances. Issuers must describe whether and why the company combines or separates the Board chair and CEO positions. If the Board chair and CEO positions are combined, then the proxy statement explains whether and, if so, why the company has a lead independent director and the specific role the lead independent director plays in the company’s leadership. The proxy also explains why the company believes its structure is the most appropriate.

Typical duties of a chair include:

  • Developing agendas in consultation with management and other directors and presiding over Board meetings;
  • Interviewing potential director candidates and coordinating with the Nominating & Governance Committee on director, committee and chair appointments;
  • Conducting shareholders’ meetings; and
  • Subject to any independence limitations, sitting as an ex officio member on Board committees of which the chair is not otherwise a member.

An independent chair’s role also includes:

  • Chairing regular meetings and executive sessions of independent directors;
  • Serving as a liaison between the independent directors and management on sensitive issues, including compensation; and
  • Taking the lead in setting short- and long-term goals for management and evaluating progress in meeting expectations.

When the CEO or an inside director serves as the Board chair, many companies designate an independent lead (or presiding) director to coordinate the activities of the independent directors and to:

  • Work with the chair to develop Board agendas;
  • Work closely with the chair and the Nominating & Governance Committee to identify new director candidates;
  • Coordinate with the chair regarding information to be provided to the independent directors in performing their duties;
  • Chair the regular meetings and executive sessions of independent directors;
  • Act as a liaison between the independent directors and the chair; and
  • Take the lead in setting short- and long-term goals for the CEO and in evaluating the CEO’s performance.

Overboarding

It takes a director many hours to adequately prepare for and attend just one company’s Board and committee meetings. Even talented directors can find themselves overboarded if they sit on more Boards than they can properly serve at one time. Nearly a quarter of S&P 500 companies have adopted policies limiting the number of outside Boards on which their CEOs may serve, often setting a limit of one or two public Boards. Even without formal policies, however, an increasing number of S&P 500 CEOs serve on no outside Boards – nearly 60% in 2019, up from 51% 10 years ago. Also, nearly 65% of S&P 500 companies place some restriction on other corporate directorships for their directors, often limiting the number of outside Boards on which their directors may serve to three or four public Boards. Although approximately 10% of directors serve on four or more Boards, the average S&P 500 independent director has two outside corporate Board affiliations, which number has remained relatively constant in recent years.

Trap for the Unwary: Governance Changes Pave the Way for Increased Shareholder Engagement and Activism

In prior years, institutional investors and shareholder activists focused much of their reform efforts on corporate governance matters – staggered Boards, majority voting and poison pills, among others. As the “best practices” of yesterday have become today’s standard practices, the corporate governance focus of shareholder activists is shifting to more nuanced debates, such as Board diversity and “refreshment” and the Board’s role in overseeing risk management. Given the current governance climate, shareholder activists are also more likely to engage with management and the Board on matters of economic significance to drive financial gains, such as share buybacks, spin-offs, divestitures and corporate transactions.

In addition, activists’ focus has expanded in recent years to matters beyond the traditional governance and economic focus, with growing attention to environmental and social policies. To minimize vulnerability to unwelcome engagement, Boards should remain focused on overseeing the strategic direction of the company and proactively communicating that direction and company initiatives to shareholders. See Chapter 3 for a discussion of how shareholder activism is increasing and evolving, as well as how companies are engaging with investors and other stakeholders.

With these shifts has come an evolution in Board- shareholder engagement. Today, management, Boards, institutional investors and other shareholder activists are engaging in a more regular and direct dialogue than in prior years. Directors are being asked to devote time and attention to engagement with shareholders regarding corporate governance and other matters. Chapter 3 further discusses shareholder activists and how they may seek to engage a company or its Board, including in the company’s proxy process.

Board Meetings and Process

Directors may meet in person or, when appropriate, by telephone or videoconference. When no further material discussion is required, a Board may also act by unanimous written consent in lieu of a meeting. A director’s failure to attend at least 75% of the Board meetings (and meetings of any committee on which the director serves) held within a fiscal year will trigger annual proxy statement disclosure – and often, negative votes.

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Directors can learn some of their most important information in less formal Board gatherings, such as site visits, retreats with senior management to review company strategy, or other efforts to familiarize themselves with the company, its management and corporate governance practices.

The format and frequency of Board meetings depends on the nature of the company and the powers and duties that the Board delegates to Board committees.

Practical Tip: Understand “Group” Decision-Making to Improve Board Behavior

By and large, people will make better decisions as part of a group – so convening a group of intelligent individuals to address tough issues should be an asset of corporate Boards. However, the failures in Board decision-making in Enron, WorldCom and other corporate governance scandals appeared to arise, in significant part, through flawed group decision-making.

Boards can help decision-making by understanding that each director will make decisions differently when serving as part of a group than when acting individually. For example, studies show that responsible and capable people take less responsibility in group settings, in effect becoming “bystanders,” than they would individually. Stress from time constraints or the importance of a decision can accentuate human factors that lead to flawed group decision-making. Here are some practical steps Boards can take to avoid the potential pitfalls of group decision-making:

  • Keep the Board small or use Board committees and executive sessions to discuss decisions in smaller groups, minimizing “bystanders”;
  • Assign a “devil’s advocate” role to a director or group of directors to analyze the downside of critical decisions;
  • Create a nonconfrontational way for newer or more junior members of the Board to make suggestions, raise questions and give their opinions – especially in the critical first year;
  • Assign each director an area of focus, on committees or on a task force, regarding a subject of specific concern for the company; and
  • Identify anomalies or issues as they emerge, before they become crises.

 

Regular Meetings of Board

Most Boards schedule 4 to 12 regular meetings a year to review and discuss company activities and to consider various proposals made by Board committees and management. At regular meetings, a Board may:

  • Review financial and operating results and business developments;
  • Approve fundamental company plans, strategies and objectives;
  • Review management performance and approve senior officer compensation packages;
  • Meet with auditors and review accounting policies and internal controls;
  • Review and approve SEC filings; and
  • Evaluate the company’s corporate governance practices and the effectiveness of the Board.

Practical Tip: Executive Sessions – The Best Things in (Governance) Life Are Free

Unlike some more costly aspects of Sarbanes-Oxley (which we discuss in Chapter 4), executive sessions of independent directors, as a group or as a committee, serve a vital governance function at virtually no cost. In light of the NYSE and Nasdaq mandates requiring executive sessions of non-management and independent directors, companies should adopt a practice of routinely holding executive sessions of independent directors at each Board meeting. The NYSE and Nasdaq have few specific requirements as to the timing, format and substance of executive sessions of non-management directors. An ideal format is to schedule an executive session as the final agenda item at each regularly scheduled Board meeting. Some Boards, however, prefer to break out executive sessions as separate meetings entirely.

The lead director and fellow non-management directors set the tone for these meetings. Before each session, the lead director will develop an agenda based on matters up for consideration at the regular Board meeting or current pressing concerns. While directors usually do not have authority to make decisions while in executive session, they can reach a consensus and carry the discussion back into the formal Board meeting. A good chair or lead director will work with both management and fellow directors to use executive sessions to address critical Board issues over the course of the year.

Executive session proceedings can be informal, sometimes without an agenda. Minutes, if taken at all, generally reflect only the attendees and time of the meeting.

 

Special Meetings of Board

A Board will also call special meetings to act on important matters such as possible mergers, acquisitions or divestitures, joint ventures or securities offerings, or other significant financings.

Board Committees

A strong committee system will allow a Board to function effectively. Sarbanes-Oxley, the NYSE and Nasdaq standards, and SEC rules prescribe the existence, composition and many of the activities of the three core committees.

Types of Committees

The three core committees are Audit, Compensation, and the committee variously known as Nominating, Corporate Governance or Nominating & Governance. All public companies will have an Audit Committee. The NYSE requires, and Nasdaq suggests, an independent director Compensation Committee. The NYSE requires a Nominating & Governance Committee, while Nasdaq requires either a Nominating & Governance Committee or that independent directors meet in executive session to deal with director nominations. (We discuss committee requirements of the NYSE and Nasdaq in detail in Chapters 9 and 10.) Many Boards have more than the three core committees - commonly, an additional committee may be an executive committee, finance committee or risk management committee.

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Audit Committee

Purpose and Authority. The Audit Committee fulfills the Board’s oversight responsibilities related to the company’s internal controls, financial reporting and audit functions. The Committee is directly responsible for the appointment, compensation and oversight of the company’s outside auditor and may engage independent counsel and other advisors as it deems necessary. 

Duties. An Audit Committee has six areas of responsibility:

  • Assessment of the Independent Auditor. The Committee selects, determines the compensation for, monitors the performance of and, when necessary, replaces the outside auditor. Responsibilities include reviewing the outside auditor’s independence, including objectivity and lack of bias. One critical task for the Committee is to preapprove all audit and any nonaudit services (including tax services) that SEC regulations permit the independent auditor to provide.
  • Review of Financial Statements. The Committee reviews annual and quarterly financial statements and financial disclosures. The Committee discusses with management and/or the outside auditor:
    • Earnings releases and guidance;
    • The section of the company’s periodic reports setting out management’s discussion and analysis of the company’s financial condition and results of operations (MD&A), including descriptions of critical accounting principles and policies (we discuss MD&A further in Chapter 4);
    • Management judgments and accounting estimates;
    • Alternative treatments under generally accepted accounting principles (GAAP) that the outside auditor has discussed with management;
    • Off-balance sheet structures; and
    • Material communications between the outside auditor and management, including management letters or disagreements between management and the outside auditor.
  • Internal Controls and Disclosure Practices. The Committee has oversight responsibility for internal controls and financial disclosure practices, including overseeing the company’s internal audit function. The Committee reviews reports from management and the outside auditor about the company’s internal controls, and meets with the company’s internal auditors and its Disclosure Practices Committee to evaluate the effectiveness of the company’s internal control over financial reporting and disclosure controls and procedures. The Committee should inquire into and be comfortable with the basis for the certifications of the company’s CEO and CFO included in periodic reports filed with the SEC. The Committee may also be responsible for oversight of enterprise-wide compliance with the law.
    • Whistleblower Process. The Committee is the “buck stops here” reviewer for accounting and audit-related whistleblower complaints. The Committee sets procedures for, and receives, retains and treats:
      • Internal and external complaints about accounting, internal accounting controls or auditing matters; and
      • Confidential submissions by employees of accounting and auditing concerns.
    • Risk Oversight. Boards differ in how much risk oversight the Audit Committee will assume. NYSE company Audit Committees need to discuss the guidelines or policies that the company uses to govern the process of risk assessment and risk management. But even under the NYSE requirements, an Audit Committee need not oversee all risk. Instead, an NYSE company may have a separate risk oversight committee, or another committee or subcommittee, perform the risk oversight function. In that situation, the Audit Committee performs a general review of the risk oversight processes as well as risk assessment and risk management policies.
    • Compliance with Legal, Ethical and Regulatory Requirements. In addition to its risk oversight function, the Audit Committee should be actively engaged in setting the proper tone – maintaining a culture of honesty and high ethical standards – and providing strong oversight in the areas of legal and regulatory compliance. As part of this responsibility, the Audit Committee coordinates with the Board's Nominating & Governance Committee, or a majority of the Board's independent directors, to monitor compliance with the company's code of ethics for the CEO and senior financial officers (a Sarbanes-Oxley and SEC requirement) and the company's code of business conduct and ethics for employees, officers and directors (a mandate of both the NYSE and Nasdaq).

    Other responsibilities of the Audit Committee include an annual self-evaluation and preparation of an annual report for the company’s proxy statement.

    Charter. The Audit Committee defines its duties in a publicly available charter. The Board should approve the charter, and the Committee should annually review and reassess it. The company then files a copy of its Audit Committee charter with its annual proxy statement at least every three years or makes the charter available on its website.

    Composition. The NYSE and Nasdaq require that Audit Committees consist of at least three members. With a few exceptions, all members of the Committee must be independent and financially literate. At least one member should qualify as an Audit Committee financial expert. (We discuss the Audit Committee financial expert later in this chapter.)

    Independence. Audit Committee members must meet two overlapping independence standards, one established by Sarbanes-Oxley, the other by the NYSE or Nasdaq. The overlapping standards have one critical requirement: no Audit Committee member may be a party to any relationship that would interfere with the exercise of his or her independent judgment in carrying out the responsibilities of a director. (We discuss the NYSE and Nasdaq Audit Committee independence requirements in Chapters 9 and 10.)

    Sarbanes-Oxley and implementing SEC rules have only two criteria for Audit Committee independence:

    • No Compensation Other Than for Board Service. Committee members may not accept consulting, advisory or other compensation from the company or an affiliate of the company, except in the director’s role as a member of the Board or a Board committee. This prohibits such indirect payments as payments to spouses or other close family members, or payments to an accounting, consulting, legal, investment banking or financial advisor affiliated with the director. 
    • No Affiliate or Affiliated Person. Committee members may not be affiliates or affiliated persons of the company. An affiliate is any person that directly or indirectly controls, is controlled by, or is under common control with the company. An affiliated person is a director, executive officer or principal of an affiliate, or anyone the affiliate places on the Board to serve as the affiliate’s alter ego. The SEC provides a safe harbor to allow a person who owns, directly or indirectly, up to 10% of the company’s outstanding shares to serve on the Committee. Anything above 10% ownership will be tested on a facts-and-circumstances analysis under which the company must answer affirmatively the critical question: “Is he or she a party to any relationship that would interfere with the exercise of independent judgment in carrying out the responsibilities of a director?”

    Financial Literacy. Audit Committee members must be able to read and understand fundamental financial statements, including balance sheets and income and cash flow statements.

    Audit Committee Financial Expert. SEC rules implementing Sarbanes-Oxley require that companies disclose in their Form 10-Ks (or in a proxy statement incorporated by reference into Form 10-K) the names of one or more members of the Audit Committee who qualify as Audit Committee financial experts. If the Committee does not have at least one Audit Committee financial expert, the company must explain why in the Form 10-K or the proxy statement incorporated by reference.

Practical Tip: Audit Committee Financial Expert Casts a Wide Net

The SEC has adopted a pragmatic definition of Audit Committee financial expert. Investment bankers, venture capital investors, stock analysts and others may qualify, along with finance professionals. An Audit Committee financial expert is a person who has all five of the following attributes:

  • Understands GAAP and financial statements;
  • Has the ability to assess the application of GAAP to accounting for estimates, accruals and reserves;
  • Has experience:
    • Preparing, auditing, analyzing or evaluating financial statements with accounting issues comparable in breadth and complexity to those that can reasonably be expected to be raised in the company’s financial statements; or
    • Actively supervising someone engaged in those activities;
  • Understands internal control over financial reporting; and
  • Understands Audit Committee functions.

The Board must determine that an Audit Committee financial expert has developed the five attributes through any combination of:

  • Education and experience as a CFO, principal accounting officer, controller, public accountant or auditor performing similar functions;
  • Experience actively supervising a person in those positions;
  • Experience overseeing or assessing the performance of companies or public accountants regarding the preparation, auditing or evaluation of financial statements; or
  • Other relevant experience that the Board determines to be adequate (and which it must publicly disclose).

 

Limitation on Multiple Audit Committee Service. NYSE rules generally encourage Boards to limit their directors to serving on an aggregate of three public company Audit Committees – that is, the company’s plus two others. If an NYSE company does not limit Audit Committee members to serving on three or fewer Audit Committees, the Board must make an annual determination that the simultaneous service will not impair the director’s ability to serve effectively on the Audit Committee. Although Nasdaq imposes no similar limitation, as a practical matter, a limit of three is an excellent rule of thumb. 

Trap for the Unwary: NYSE and Nasdaq Financial Expertise Requirements

Sarbanes-Oxley and SEC rules allow a company, if it chooses, to disclose that its Audit Committee does not have an Audit Committee financial expert. However, NYSE and Nasdaq rules require that the Committee have a member with accounting and financial management expertise (NYSE) or employment experience or other comparable experience resulting in financial sophistication (Nasdaq). A director who meets the Audit Committee financial expert requirements under SEC rules is presumed to satisfy the NYSE and Nasdaq requirements.

 

Meetings. Many Audit Committees will meet eight or more times per year. For example, a Committee may schedule one in-person meeting every quarter to review the company’s proposed earnings release and draft financial statements. The Committee may then follow with a second telephonic meeting in the same quarter to review and comment on the Form 10-Q prior to its filing. Many Committees hold another longer meeting or retreat at least once per year, at a time when there is no pressure to review financial statements, to consider:

  • Critical accounting policies and practices;
  • Internal financial controls; and
  • Disclosure practices and procedures.

The Audit Committee’s own “annual meeting” is the one at which the Committee approves the Audit Committee’s report for the proxy statement and the audited financial statements that will be part of the Form 10-K. At the meeting, the Committee will consider:

  • The auditor’s report;
  • Auditor independence;
  • Procedures and other issues related to financial statements and disclosure;
  • Management’s internal controls report;
  • The draft Audit Committee Report to be included in the proxy statement stating the Committee’s approval of the financial statements; and
  • The appointment of the outside auditor for the new year.

Practical Tip: Use Your Audit Committee in Conflict-of-Interest Situations

Often, a Board will face a situation requiring action by its independent directors. For example, only disinterested directors should approve a transaction between the company and a director. In fact, both Nasdaq and the NYSE require that the Audit Committee or another committee of independent directors approve related party transactions. Rather than form a Special Committee of disinterested directors for each situation, the Board may ask the Audit Committee (or another existing independent committee) to review interested director transactions.

 

Compensation Committee

Purpose and Authority. A company’s Compensation Committee develops criteria and goals for, and then reviews and approves the compensation of, the company’s senior management. The Committee also develops and establishes equity and other benefit plans, and may review and establish director compensation. Its charter should provide the Committee sole authority to retain, compensate and terminate consultants and advisors to assist the Committee in fulfilling its responsibilities.

Duties. The Compensation Committee will:

  • Set Goals and Objectives.
    • Review, approve and evaluate achievement of performance goals and objectives by the CEO and other executive officers in connection with their cash and equity compensation;
    • Set compensation levels to motivate management to achieve stated objectives; and
    • Align the executive officers’ interests with the long- term interests of the company and shareholders.
  • Establish and Oversee Equity and Benefit Plans.
    • Establish, administer and review compensatory benefit plans for executive officers and directors and, to a lesser extent, employees generally;
    • Grant or delegate power to grant stock options and restricted stock awards; and
    • Ensure that the plans yield benefits based on performance.
  • Recommend Stock Plan Approval.
    • Recommend Board or shareholder approval of incentive compensation and equity-based plans.
  • Monitor Compliance with Law.
    • Monitor the regulatory compliance of benefit plans.
  • Approve Public Disclosure.
    • Review and approve public disclosure, including the annual Compensation Committee report to be included in the proxy statement and Form 10-K.

Charter. The Compensation Committee should adopt and periodically review a charter that describes its duties.

Independence. The Compensation Committee should consist of independent directors. The NYSE requires a committee of all independent directors (at least three), and Nasdaq requires either a committee composed exclusively of independent directors (with a limited exception) or that a majority of independent directors on the Board meet in executive session to perform Committee duties. Pursuant to the Dodd-Frank Act, NYSE and Nasdaq have their own rules defining independence for Compensation Committee members. These standards, like those for the Audit Committee, are more stringent than those for membership on the Board or other Board committees. (We discuss the NYSE and Nasdaq Compensation Committee independence requirements in Chapters 9 and 10.) To preserve independence, companies will want to avoid interlocking Compensation Committee memberships. An interlock occurs when an executive officer of one company:

  • Serves on the Compensation Committee of a second company, one of whose executive officers served on the Compensation Committee of the first company; or
  • Serves as a director of a second company, one of whose executive officers served on the Compensation Committee of the first company; or
  • Serves on the Compensation Committee of a second company, one of whose executive officers served as a director of the first company.

Interlocks can create an appearance of inappropriate influence and must be disclosed in a company’s proxy statement and Form 10-K.

Independence of Compensation Committee members plays a critical role in federal income tax deductibility as well. Although 2018 amendments to Internal Revenue Code Section 162(m) mean that companies can generally no longer deduct executive compensation over $1 million per year, transition relief provides that certain compensation paid pursuant to a written binding contract in effect on November 2, 2017, will be grandfathered and not subject to the amended rules (so long as the contract is not materially modified on or after that date). For a company seeking to take advantage of the grandfathering relief, the Compensation Committee must consist entirely of two or more “outside” directors to allow the company to maintain deductibility of executive compensation under Section 162(m). An all-independent Compensation Committee of “nonemployee” directors also allows the Committee’s approval of option grants to executive officers and directors to qualify as exempt purchases under Rule 16b-3 under the 1934 Act.

Compensation Discussion and Analysis (CD&A). In the company’s annual proxy statement and Form 10-K, the Compensation Committee submits an annual discussion that analyzes and describes the bases for the compensation paid to the CEO and other executive officers. Developing the CD&A is an annual part of the Committee’s duties. (We discuss practical tips for drafting the CD&A in Chapter 7.) Smaller reporting companies are not required to provide a CD&A.

Compensation Committee Report. In the company’s annual proxy statement and Form 10-K, the Compensation Committee submits an “annual report.” In it, the Committee confirms that it has reviewed and discussed the CD&A with management. Based on that, it recommends that the Board include the CD&A in the company’s proxy statement and Form 10-K.

Risk Management and Compensation Policies and Practices. The SEC’s proxy rules require companies to assess whether their compensation policies and practices create risks that are reasonably likely to have a material adverse effect on the company. If so, then the proxy statement will need to discuss the relationship between risk management and the compensation policies and practices for all employees, including non-executive officers. (This requirement does not apply to smaller reporting companies.)

Meetings. The Compensation Committee will generally meet at least quarterly. Its “annual” meeting will be held when fiscal year-end results are available to assess how the company’s executive officers performed against corporate and personal goals and objectives for that year and to set new goals and objectives for the new year. The Committee will also meet as needed to establish or recommend changes to compensation plans.

Compensation Consultants: Disclosing Fees and Conflicts. A prudent Compensation Committee will retain outside compensation consultants to evaluate compensation for executive officers. The proxy statement will disclose fees paid to compensation consultants, including if a compensation consultant engaged by the Board or Committee provides other services to the company (e.g., benefits or human resources consulting), if the fees for those additional services exceed $120,000 during the company’s fiscal year.

The proxy statement will not need this disclosure, however, if the Board or Committee used different compensation consultants, or when the other services performed by the consultant are limited to providing certain survey data or consulting on broad-based plans for all salaried employees that do not discriminate in favor of executive officers or directors.

The NYSE and Nasdaq provide that a Compensation Committee must consider specified independence-related criteria when selecting a compensation advisor, as discussed in Chapters 9 and 10. The Dodd-Frank Act requires Compensation Committees selecting advisors to consider factors that may affect the advisors’ independence, including:

  • Does the advisor provide other services to the company?
  • What percentage of the advisor’s total revenue derives from the company?
  • Has the advisor implemented conflict-of-interest policies?
  • Is there a business or personal relationship between the advisor and a member of the Committee?
  • Does the advisor own any company stock?

As long as the Board takes the appropriate factors into consideration, the Board may choose to engage non-independent advisors. Companies, however, will disclose in their annual proxy statements when the Compensation Committee receives advice from a compensation consultant, whether the work of the compensation consultant raised any conflict of interest and, if so, the nature of the conflict and how it was resolved. The NYSE and Nasdaq exempt smaller reporting companies from these provisions.

Trap for the Unwary: The Compensation Committee After Disney

In 2005, the Delaware Court of Chancery absolved directors of liability for the 1995-96 hiring and firing of former Disney president Michael Ovitz. The Board had approved a severance package for Mr. Ovitz of approximately $140 million for his 14-month tenure. While not finding Disney’s directors personally liable, the court sharply criticized their action (and inaction) as falling short of best corporate governance practices. Many lessons of what not to do, wrote the court, could be learned from the Disney Board’s conduct.

  • Engage Your Independent Directors at an Early Stage. Do not deliver decisions on a silver platter! In Disney, half of the Compensation Committee was active in negotiations and the other half came in “very late in the ” Engage your entire Compensation Committee in the “many” early stages of critical employment negotiations.
  • Seek Expert Advice. In Disney, the court allowed the Compensation Committee to rely on an expert, even though the expert’s analysis may have been incomplete or flawed, because the Committee selected him with reasonable care, his analysis was within his professional competence, and the directors had no reason to question his conclusions. So make sure your Committee has the authority to solicit advice, and does, from independent employment compensation experts.
    • Provide Directors with Sufficient Notice and Materials Prior to the Meeting. Provide notice and materials well in advance of any meeting at which an executive employment agreement is to be discussed, including:
      • A plain English term sheet summarizing the key provisions of the arrangements (and, when appropriate, a full draft of the proposed agreement).
      • An analysis of the cost to the company of termination of employment, change of control, , including information relating to reasonableness of terms. Compensation Committee members should expect a spreadsheet making different, alternative assumptions and showing the range of potential payments in the most reasonably foreseeable alternative scenarios that could arise. The court noted that an analysis for the Ovitz employment agreement should have shown the cost to Disney if Mr. Ovitz’s employment terminated during each of the five years of the agreement’s initial term. Show your Board each possible bottom line!
    • Allow Sufficient Time for Discussion, and Document the Process. The Disney court focused on the length of Board discussions, noting how helpful it would have been had the Committee minutes shown that the discussion relating to Mr. Ovitz was longer than discussion of other issues. Insist that your Compensation Committee spend sufficient time on discussion, and document it!
    • Establish Succession Planning. Mr. Ovitz came to Disney as the result of a too-rapid search precipitated by the unexpected death of Disney’s president and the discovery of the then-CEO’s heart ailment. The Compensation Committee can take the lead in implementing a robust succession-planning process so that your company does not find itself in the position of being forced to hire a CEO without having conducted a proper search or made appropriate preparations.

 

Nominating & Governance Committee

The Nominating & Governance Committee, third in the triumvirate of “core” Board committees, monitors the Board itself.

Purpose and Authority. The Nominating & Governance Committee takes the lead in selecting directors, committee members and chairs or lead directors. The Committee may also develop corporate governance principles and policies and recommend them to the Board. The Committee should have the ability to retain, compensate and terminate its own advisors, including any search firm used to identify director candidates.

Duties. The Nominating & Governance Committee will:

  • Select the Director Slate. Identify, evaluate and recommend nominees for directors, and recommend committee members, chairs and lead directors.
  • Oversee Board Governance. Develop, review and evaluate the effectiveness of corporate governance principles, including director and committee member selection guidelines and procedures and director performance criteria.
  • Develop Meeting Procedures. Assist the chair or lead director in developing Board meeting practices and procedures. 
  • Evaluate the Board. Periodically evaluate the effectiveness of the Board and coordinate periodic evaluations of Board committees with committee chairs.

Either the Compensation Committee or the Nominating & Governance Committee will:

  • Establish director compensation practices; and
  • Determine procedures for the selection, review, development and succession of executive officers.

The Nominating & Governance Committee may assist the Audit Committee in monitoring ethical codes. Sarbanes-Oxley provides for a code of ethics for the CEO and senior financial officers, and both the NYSE and Nasdaq mandate a code of business conduct for employees, officers and directors.

Charter. The Board should approve, and the Nominating & Governance Committee should annually review, a written charter describing the Committee’s duties.

Composition. Like the Audit and Compensation Committees, the Nominating & Governance Committee should be composed of independent directors. The NYSE requires a Committee of all independent directors (at least three). Nasdaq mandates either a Committee composed exclusively of independent directors (with a limited exception) or that a majority of independent directors on the Board make director nominations.

Director Qualifications and Board Diversity. Companies must disclose in their annual proxy statements a description of each director’s or nominee’s experience, qualifications or skills that qualify that person to serve as a director. These qualifications may include any specific past experience that would be useful to the company, the director’s or nominee’s particular area of expertise, and why the director’s or nominee’s service as director would benefit the company. Diversity policies are also part of proxy statement disclosures, if the Nominating & Governance Committee (or Board) has a policy to consider diversity when identifying nominees. The proxy statement will disclose how the Board implements the diversity policy, and how the Nominating & Governance Committee (or Board) assesses the effectiveness of its policy.

As described in “Board Composition” earlier in this chapter, numerous state statutes establish diversity goals or mandatory minimums for the Boards of public companies incorporated and/ or headquartered in those states. Nasdaq has a listing rule related to Board diversity, and Board diversity is an area of increasing focus for institutional investors, shareholder activists and proxy advisory firms. Even investment banks are weighing in on the topic, as shown by the recent Goldman Sachs policy decision to underwrite IPOs in the United States and Europe only if the issuer has at least two (as of 2021) diverse directors on its Board.

Meetings. The Nominating & Governance Committee will meet periodically to discuss and set governance procedures, to evaluate or select the nominees for election as directors at the annual shareholders’ meeting, and to recommend members to the Board. There is no set recommended number of meetings for the Committee. 

Practical Tip: Mirror, Mirror on the Wall: Does Your Board Conduct a Self-Evaluation?

Evaluating the Board and its core committees (Audit, Compensation and Nominating & Governance) on an annual basis has rapidly become a “best practice” for public companies. The NYSE’s listing standards require annual self- evaluations in corporate governance guidelines and committee charters, and many Nasdaq companies conduct evaluations as part of a healthy corporate regimen. No single method has emerged as the “best” evaluation practice, yet these five practical tips have emerged as consistent guidelines:

  • Choosing a Leader to “Own” the Process. For the Board, this should generally be the chair (if independent), the lead director or the chair of the Nominating & Governance Committee. For evaluating a committee, it will be that committee’s chair. The director responsible for the evaluation process has a number of decisions to make, the discussions are sensitive, and the evaluation needs to get done – all good reasons to entrust the process to one person. 
  • Deciding on Written or Oral – or Both? The director responsible for the evaluation process should make a threshold decision as to whether the inquiry and the results should be written or oral. Talk to the CEO, Board chair and general counsel, as there are many opinions – and no perfect answers. Often, the questions are written, the evaluation itself is a live interview and a summary of the results – including how your Board will address any shortfalls – is in writing. Alternative formats include written questionnaires and a single Board or committee meeting focused on self- evaluation.
  • Assessing the Board as a Whole. Ask your fellow directors: How is the Board performing its responsibilities of strategic planning, financial and risk oversight, succession planning, executive evaluation and compensation?
  • Assessing Individual Director Performance: Independence and Suitability Annually and Overall Performance Periodically. The most difficult part of any Board self- evaluation is assessing individual director performance. On an annual basis, the Board needs to make independence assessments and determine suitability of the directors for service on its core committees. A Board could assess individual directors’ performance annually, but it is probably sufficient to make these assessments every second or third year (which could be part of a regular renomination process for companies with staggered Boards).
  • Shortcomings? Address Them – Promptly. Self-evaluation will almost certainly reveal some shortcomings. Before completing the evaluation process, develop proposed solutions. And ask the director who “owns” the process to report back to the Board at an appropriate time on success in addressing any issues.

 

Other Committees

More than 70% of S&P 500 companies have more than the three core committees. Other common Board committees include:

  • Finance Committee. A finance committee usually reviews the company’s financing policies and procedures and recommends potential debt or equity financings and similar activities. The Board may also delegate to a finance committee the authority to approve certain kinds of transactions when approval is required between regularly scheduled Board meetings.
  • Executive Committee. An executive committee can make decisions for the company regarding administrative situations or in an emergency, when the full Board is not readily available to act.
  • Risk Oversight Committee. Because NYSE rules require an Audit Committee to discuss “guidelines and policies to govern the process” by which an NYSE company undertakes risk assessment and management, Audit Committees historically have overseen the company’s risk management function. Companies need not adopt one approach to risk oversight and management, however. Exchange rules allow companies to establish separate committees or subcommittees to perform the risk oversight function, as long as the processes undertaken by the committee are overseen by the Audit Committee. Boards should put in place a risk management system that brings to the Board’s attention the most significant risks faced by the company and that allows the Board to understand and evaluate those risks, the relationship among the risks, and the ways in which the company’s and management’s ability to handle the risks is affected by the risks themselves. The system can consist of a review by a separate risk oversight committee or subcommittee, or a regular review by the Audit Committee, combined with a periodic review by the full Board. Many companies allocate risk management responsibilities among several committees. This is appropriate so long as the committees coordinate efforts and relay information to one another and to the full Board. The company’s proxy statement will describe the Board’s role in the risk oversight of the company, how the Board administers its oversight function (the Board as a whole? a risk committee? the Audit Committee?), and the effect this has on the Board’s leadership structure. The proxy statement will also describe whether the individuals who supervise day-to-day risk management report directly to the Board or provide their input to the Board or committee through another means.
  • Special Committee of Independent Directors. The Board may establish a Special Committee of disinterested directors to evaluate litigation, transactions or other special situations that require arm’s-length review. These situations may include a change of control or assessment of strategic alternatives, shareholder litigation, contracts with or special compensation to a director or a director affiliate, allegations of wrongdoing by a director or an officer, or any other situation in which management or other directors have a conflict of interest.

Trap for the Unwary: Cybersecurity (or the Risk du Jour)

In recent years, high-profile breaches have catapulted the issue of cybersecurity, as well as victim companies and their Boards, into the spotlight. The Board’s critical roles in overseeing both risk management and crisis management mean that the full Board should be informed and engaged on cybersecurity-risk issues, even if a committee is primarily responsible for risk oversight.

The Board should make sure that the company is regularly assessing cybersecurity vulnerabilities, which could include an outside consultant’s cybersecurity-risk audit, and directors should be educated about the possible consequences of a breach. Management and the Board may work together to create an incident response plan. The Board should consider the SEC’s disclosure guidance specific to cybersecurity and should carefully review the company’s existing disclosures regarding cybersecurity risk, updating them as necessary.

Board Compensation

Public companies compensate independent directors for Board and committee service with a combination of cash and securities. Some companies also permit their nonemployee directors to participate in company-deferred compensation or other benefit plans. Outside director compensation varies considerably from company to company. Employee directors generally receive limited or no additional compensation for Board service.

In the current environment, with directors serving on fewer Boards and dedicating more time and care to each Board on which they serve, companies have continued to increase director compensation. Directors who assume the highest levels of responsibility, including independent chairs or lead directors, committee chairs and committee members, earn more in proportion to their responsibilities. The Board or the Nominating & Governance Committee should periodically evaluate the company’s director compensation package against peer companies to ask: “Are we competitive? Do we appropriately match rewards to Board effort, risk and results?”

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Cash Compensation

Most companies pay their directors an annual cash retainer for Board and committee service. Cash retainers for Board service generally range from about $50,000 to $200,000 or more per year. Directors may receive additional compensation for committee service, service as a committee chair or lead director and, sometimes, for meetings. In recent years, the annual cash retainer amount for Board service has increased while the number of companies compensating Board members for meeting attendance has declined.

Equity Compensation

Most public companies make initial stock grants to directors upon commencement of Board service. Directors then often earn additional grants as part of an annual compensation package. Many public companies pay annual retainers exclusively with equity grants, rather than cash. It is common for initial restricted stock grants to be larger and have longer vesting periods (e.g., two to four years), and for annual grants to be smaller and have shorter vesting periods (e.g., one year or immediate vesting). Although some companies continue to grant options to directors, the composition of equity awards for Board service has largely shifted to restricted stock awards.

Practical Tip: Stock Ownership Goals

Does equity or cash compensation provide better incentive to directors without encouraging excessive risk?

While some companies believe equity-based compensation may encourage directors to act in ways that could increase the short-term value of their equity stakes at the expense of the company’s long-term interest, most companies believe that equity can better align the interests of directors with those of shareholders.

These companies may:

  • Establish minimum goals (based on a number of shares or dollar amount) for stock ownership by directors;
  • Integrate these goals with a compensation plan that allows directors to elect to receive a portion of their annual compensation in stock; and
  • Give each director two to five years to achieve the stock ownership goal.

 

Trap for the Unwary: Hart-Scott-Rodino Filing Requirements

Directors who exercise options for or otherwise purchase large amounts of company stock (in 2020, stock with a value in excess of $94 million) should be aware of individual filing obligations created by the Hart-Scott- Rodino Antitrust Improvements Act of 1976. Fluctuations in the trading price of a company’s common stock could cause the value of a director’s holdings to surpass thresholds obligating the director to make a filing with the Department of Justice and the Federal Trade Commission. Failure to make required filings could result in substantial monetary penalties for the individual director and company disclosure obligations.

Liabilities and Indemnification

A public company’s directors and officers may be subject to personal liability under statutes relating to employee benefits, tax, antitrust, foreign trade, environmental and securities matters. As discussed previously, directors are also liable for breaches of their duties of care, loyalty and candor. To encourage individuals to serve as directors and officers, state laws permit companies to limit director liability and indemnify their directors and officers against some of this exposure.

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Limiting Director Liability

Delaware and states that follow the Model Business Corporation Act permit charter documents to include exculpation or raincoat provisions that eliminate the personal liability of a director to the company or its shareholders for monetary damages for some breaches of director duties. However, corporations cannot limit directors’ liability in situations that involve:

  • Breach of the duty of loyalty;
  • Intentional misconduct or a knowing violation of law;
  • Unlawful payment of dividends;
  • Transactions from which the director derived an improper personal benefit; or
  • Breach of the duty of good faith. (Although Delaware does not grant this permission, most Model Business Corporation Act states allow a corporation to limit director liability in situations that involve a breach of the duty of good faith.)

Practical Tip: The Best Way to Limit Liability? Keep Informed

Even the most robust charter provisions limiting director liability are subject to limitations, particularly in today’s dynamic legal and business environment. The most effective ways for you as a director to reduce your exposure to fiduciary claims are to:

  • Adopt effective corporate governance and compliance procedures;
  • Monitor your Board’s compliance with those procedures; and
  • Actively oversee the business and operations of the company.

Actively inquire into and be informed about the corporate decisions that the Board will consider. Use the questions that we suggest in this Handbook. Comply with the duty of loyalty to the company. Create a robust record that demonstrates that you and your fellow directors have met your respective duties of care and loyalty. Do these things, and the business judgment rule will generally protect you from personal liability.

 

Indemnifying Directors and Officers

The corporate laws of nearly all states provide for both mandatory and permissive indemnification of directors and officers, and related rights.

Mandatory Indemnification. A company typically must indemnify every director or officer who successfully on the merits defends an action or claim brought as a result of his or her status as a director or officer. Some states require the director or officer to be wholly successful on the merits, while other states, including Delaware, provide for mandatory partial indemnification to the extent of the individual’s successful defense.

Permissive Indemnification. The corporate laws of most states permit a company to indemnify its directors and officers against expenses incurred in specified actions if they acted in good faith and in a manner that they reasonably believed to be in, or not opposed to, the company’s best interests. Directors and officers may receive indemnification in a criminal action or proceeding if they had no reasonable basis to believe that their conduct was unlawful. However, indemnification usually is not available for actions by the company for amounts paid in settling derivative actions or when the directors or officers are found to be liable to the company.

Advancement of Expenses. Most states also permit a company to advance defense costs to its directors and officers. State law typically provides that the company may require the director or officer to sign an agreement (an undertaking) to repay any advanced amounts if it is ultimately determined that the individual’s conduct did not meet the applicable standard of conduct to entitle the individual to indemnification.

Protection Against Subsequent Amendment to Rights. A Delaware corporation may not eliminate or impair a right to indemnification or to advancement of expenses arising under a provision of its certificate of incorporation or its bylaws by amending the provision after the act or omission occurs. The one exception to this is that the provision in effect at the time of the act or omission may explicitly authorize the elimination or impairment after the action or omission has occurred.

Indemnification Agreements

It is becoming increasingly common for companies to enter into indemnification agreements with their directors and, less frequently, their officers. To the extent a company’s charter documents provide for broad indemnification rights and specifically state that these rights are contractual, indemnification agreements may not seem to provide substantial additional protection. But in reality, an agreement may provide great comfort to directors and officers. It adds clarity and provides protection against future alterations of charter documents. If any contractual rights are broader than those provided by statute, courts may subject the contract rights to review on public policy or reasonableness grounds.

D&O Insurance

Most public companies purchase insurance to cover liabilities arising from their directors’ and officers’ actions on behalf of the company, known as D&O insurance. This insurance provides a potential source of reimbursement to the company for indemnification payments it makes to its directors and officers. D&O insurance may also motivate individuals to serve as directors and officers by reducing their exposure to personal liability from potential gaps in the availability of indemnification and, in situations such as insolvency, where the company cannot adequately indemnify its directors and officers. Most D&O insurance policies include entity coverage, which also insures the company directly for its liability on certain defined claims without diluting available coverage for directors and officers.

Practical Tip: Know Your Coverage

D&O insurance coverage is subject to exclusions similar to those that apply under state law to corporate indemnification obligations, including:

  • Claims arising out of personal benefits to which the director or officer was not legally entitled;
  • Claims arising out of criminal or fraudulent acts;
  • Losses arising out of illegal payments to directors and officers; and
  • Losses arising out of violations of insider trading laws.

An insurance broker can provide detailed information and recommendations regarding appropriate D&O insurance coverage. Insurance counsel or other experts can also analyze your company’s D&O insurance needs. Liability counsel can advise your company on the terms of D&O insurance coverage, particularly terms relating to retentions and exclusions. The Board should periodically evaluate the coverage to ensure that it continues to meet the evolving needs of your company.

 
In addition to D&O insurance policies that concurrently cover directors, officers and the company, many companies also purchase supplemental “Side A” coverage that covers only directors and officers. This avoids a claim in a bankruptcy context that D&O insurance proceeds of the general policy are assets of the debtor’s estate and are not available to indemnify directors and officers. We provide a visual guide to D&O insurance in Appendix 3.

Practical Tip: The Cautious Director: Six Questions to Ask Your General Counsel Every Year

To help ensure that your company has taken the necessary steps to reduce its own exposure to liability as well as that of its directors and officers, ask your company’s general counsel these six questions annually:

  • Do we have a robust system for oversight of enterprise-wide compliance with law? Do we identify and disclose material risks as part of the process for determining the effectiveness of financial controls or the process for certifying financial statements?
    • Who owns this process?
    • What is your role in our enterprise-wide risk management program?
    • Is there anything about the oversight program that you would improve?
  • Have we established and kept current reliable policies, controls and procedures for gathering, assessing and in a timely manner reporting financial and other 1934 Act information and for communicating with investors?
  • Would you do anything, if you had the authority, to improve our internal financial controls or our disclosure practices and procedures?
  • Are the terms of our D&O insurance coverage sufficiently broad? What are the limits? Did we negotiate aggressively to expand coverage?
  • Are our D&O insurance coverage limits high enough? (This question is especially pertinent if your company’s market capitalization is growing quickly and might outstrip earlier coverage.)
  • Would you suggest any changes to our certificate or articles of incorporation and bylaws to provide the maximum liability limitations and indemnification permitted by law?