Corporate Director’s Guidebook: fourth edition
| Description: |
Corporate Director’s Guidebook, fourth edition detailed contents.
|
|
Committee on Corporate Laws
|
|
Section 1: Structure of the Guidebook
|
|
Section 2: Duties, Responsibilities and Rights of a Corporate Director
|
|
A. Overall Responsibilities
|
|
1. Boardroom Responsibilities
|
|
2. Individual Responsibilities
|
|
3. Director’s Prerogatives
|
|
a. Time Commitment and Regular Attendance
|
|
b. The Need to Be Informed
|
|
c. The Right to Rely on Others
|
|
c. Fairness, Documentation and Policies
|
|
(i) Fairness to the Corporation
|
|
(ii) Documentation of Conflicts
|
|
3. The Duty of Disclosure
|
|
4. The Business Judgment Rule
|
|
6. Areas of Special Concern
|
|
c. Approval of Commitments and Compliance
|
|
with Contractual Obligations
|
|
d. Effectiveness of Internal Controls and Disclosure
|
|
e. Identification of Business Risks and Protection
|
|
f. Counseling of Directors
|
|
C. Change-of-Control and Financial Distress Situations
|
|
Section 3: Board Structure and Operations
|
|
A. Composition–Qualifications and Independence
|
|
E. Director’s Time Commitment
|
|
G. Quality of Information
|
|
I. Conduct and Function of a Director in Relation
|
|
to Management and Other Directors
|
|
Section 4: Deciding to Join a Board
|
|
Section 5: Committees of the Board
|
|
Section 6: The Audit Committee
|
|
E. Meetings with Auditors
|
|
F. Meetings with Compliance Officers
|
|
G. Implementing New Duties
|
|
H. Meetings and Compensation
|
|
Section 7: The Compensation Committee
|
|
C. Disclosure of Compensation Decisions
|
|
D. Independent Advice for the Committee
|
|
E. Other Responsibilities
|
|
Section 8: The Nominating/Corporate Governance Committee
|
|
A. Committee Composition and Other Requirements
|
|
B. Criteria for Board Membership
|
|
D. Recommending Committee Members and Chairs
|
|
E. Chief Executive Officer and Other Management Succession
|
|
F. Other Corporate Governance Functions
|
|
I. Disclosing the Nominating Process
|
|
Section 9: Other Oversight Activities
|
|
A. Philanthropic Activities
|
|
C. Employee Safety, Health and Environmental Protection
|
|
E. Public Policy and Social Responsibility
|
|
F. Legal and Contractual Compliance
|
|
Section 10: Duties under the Federal Securities Laws
|
|
A. SEC Reporting Requirements
|
|
F. Sales by Controlling Persons
|
|
G. Registration Statements
|
|
I. Directors of Foreign Corporations with Securities Traded
|
|
Section 11: Liabilities and Indemnification
|
|
B. Federal Securities Law Liability
|
|
C. Liability under Other Laws
|
|
D. Limitation of Liability
|
|
Appendix: Online Resources on Corporate Governance
|
|
This is the fourth edition of the Corporate Director’s Guidebook. The Guidebook was first issued in 1978, followed by a second edition in 1994 and a third edition in 2001. Since its initial publication, the Guidebook has been relied upon by directors and business executives, together with those who advise them, as well as by students of corporate governance. Indeed, the Guidebook has become the most frequently cited handbook in its field.
|
|
The primary purpose of the Guidebook is to provide concise guidance to corporate directors in meeting their responsibilities. The Guidebook focuses on the role of the individual director as well as the functions of the board of directors and its key committees. Although the Guidebook’s organizing framework is based upon the law, we have made an effort to keep the prose free of legalisms because our target audience is primarily non-lawyers.
|
|
Since the publication of the third edition, the stunning failures of several prominent U.S. corporations, and the disclosure of abuses of office by some of their senior executives, have led to widespread public concerns about the role and responsibilities of corporate directors. To address these concerns, significant federal legislation was enacted in 2002 to improve corporate governance by regulating some aspects of director and officer conduct. The Securities and Exchange Commission and the major securities markets have acted to implement this legislation and to pursue other and broader reform initiatives.
|
|
The public belief that good corporate governance could have prevented these corporate failures has resulted in a new reality in which corporations perceived not to have good corporate governance will be penalized in the marketplace. Indeed, rating agencies and other groups now attempt to measure and evaluate the quality of a corporation’s governance structure.
|
|
This fourth edition of the Guidebook addresses recent developments affecting corporate governance and impacting the role of directors of public companies, such as:
|
|
* the enactment of the Sarbanes-Oxley Act of 2002, which creates some minimum federal standards for the governance of all public companies
|
|
* the adoption by the SEC of new regulations affecting corporate governance and imposing new disclosure requirements, both pursuant to and beyond the Sarbanes-Oxley Act
|
|
* the adoption by the major U.S. securities markets of greatly expanded corporate governance standards for listed companies
|
|
* new standards of independence demanded of a majority of a board’s directors and of members of key oversight board committees
|
|
* the audit committee’s federally-mandated authority separate from the balance of the board of directors as well as from management
|
|
* heightened court scrutiny of the performance and independence of directors.
|
|
This fourth edition not only addresses these developments but also revisits and underscores the basic legal duties and responsibilities of all directors. While the Guidebook provides important guidance to directors of public companies, it continues to have core relevance to all corporate directors, in terms of their duties and obligations as well as boardroom best practices.
|
|
COMMITTEE ON CORPORATE LAWS (2002-2004)
|
|
The Committee on Corporate Laws of the American Bar Association’s Section of Business Law is composed of practicing lawyers, law professors and judges, with corporate expertise, from throughout the United States. In addition to the Corporate Director’s Guidebook, the Committee has developed the Model Business Corporation Act, first issued in 1950, which has been adopted substantially in its entirety by more than thirty states in the United States and in important respects by many other states. The Model Act has played an important role in the development of corporate law in the United States and elsewhere. The Committee serves as the permanent editorial board for the Model Act, reviewing, revising and updating its provisions on a continuing basis.
|
|
The roster of Committee participants during the development of the Guidebook’s fourth edition (including honorary members and liaisons from other ABA committees) is listed below.
|
|
Philadelphia, Pennsylvania
|
|
Charlottesville, Virginia
|
|
San Francisco, California
|
|
Mary Ann Jorgenson, chair
|
|
San Francisco, California
|
|
Philadelphia, Pennsylvania
|
|
SECTION 1: STRUCTURE OF THE GUIDEBOOK
|
|
This Guidebook explains general legal concepts and standards that apply to directors of all business corporations. While our emphasis is on directors of a public company–a corporation with a trading market for its securities–the Guidebook is relevant to every corporate director. It summarizes a director’s functions and responsibilities, analyzes the structure and operations of the board of directors and its committees, and considers the applicable legal standards of director conduct.
|
|
A primary responsibility of directors is to oversee the operation of the business and affairs of the corporation. In doing so, directors must observe high standards of ethical conduct to protect the interests of the corporation, including its reputation. Further, directors should be aware of evolving corporate governance principles, which reflect the expectations of shareholders and other important constituencies and can also suggest ways in which directors can improve their oversight of the corporation. This Guidebook is designed to assist directors in satisfying their duties and in understanding how modern corporate governance principles operate. Equally important, it suggests practices that support effective director involvement. The advice and counsel of good directors can contribute in many ways to the success of the corporation’s business.
|
|
While this Guidebook is geared to the individual director, it is important for readers to bear in mind that directors can exercise their decision-making power only by acting collectively, either as a board or a board committee. However, effective performance of the board’s oversight function often results from an individual director’s recognition that a particular matter of concern warrants inquiry or action. It is also important to recognize that judgment is exercised on an individual basis and that informed judgment depends upon individual preparation and participation as well as group deliberation.
|
|
This Guidebook deals with broad areas of a corporate director’s activities. Its description of director conduct is not intended as legal advice or a suggestion that different conduct will result in violation of the law or potential personal liability. Accordingly, readers should not infer any forecast of litigation or liability based upon failure to conform to recommendations made in this Guidebook. In general, directors whose conduct comes within the framework outlined in this Guidebook will be performing their duties and responsibilities conscientiously Hence, their risk of challenge for deficient performance as a director should be minimized.
|
|
The role of board committees has become very important, and the major securities markets now mandate that public companies have key oversight committees, generally composed wholly of independent directors, with specific delegated powers and responsibilities. Unless otherwise indicated, references in this Guidebook to board functions and director responsibilities should be understood to encompass the activities of committees of the board, to which many board functions are delegated and on whose work the board relies.
|
|
Each corporation is a creature of the corporation statute of a particular state, and the states’ corporation laws can differ in various respects. This Guidebook is based primarily on the Model Business Corporation Act (referred to as the Model Act), which has been adopted (with some variations) in more than thirty states and has influenced the law in other states and abroad. We believe the guidance contained in this Guidebook is generally applicable to all business corporations, regardless of the state of incorporation.
|
|
Public companies are subject to an increasingly comprehensive system of federal regulation, which this Guidebook addresses. With the enactment of the Sarbanes-Oxley Act, the federal securities laws and regulations reach beyond the disclosure obligations of public companies to encompass minimum federal normative standards–in particular, requirements concerning membership qualifications for, and the duties of, the audit committee and additional procedures designed to promote better corporate disclosure, more accurate financial reporting and compliance with legal requirements. In addition, the major securities markets have revised their listing standards to implement some of the corporate governance directives in the Sarbanes-Oxley Act and to mandate additional good governance practices. Corporations are also subject to other regulatory requirements that can affect corporate governance, such as the regulatory regimes applicable to financial institutions, public utilities and other business enterprises that are licensed at the federal or state level. This Guidebook does not address industry-specific regulations.
|
|
Some online resources on corporate governance are listed in the Appendix.
|
|
SECTION 2: DUTIES, RESPONSIBILITIES AND RIGHTS OF A CORPORATE DIRECTOR
|
|
As a general matter, a business corporation’s core objective in conducting its business activities is to create and increase shareholder value. Directors’ activities in providing leadership toward this objective can be described as comprising two basic functions: decision-making and oversight. The decision-making function generally involves formulating corporate policy and strategic goals with management, and taking actions with respect to specific matters. Some matters—such as changes in charter documents, authorization of dividends, election of officers, approval of mergers with other enterprises or corporate liquidation–generally require board action (as well as shareholder action, in some cases) as a matter of law. The oversight function concerns ongoing monitoring of the corporation’s business and affairs and, in particular, attention to corporate business performance, plans and strategies, risk assessment and management, compliance with legal obligations and corporate policies, and the quality of financial and other reports to shareholders, as well as attention to matters suggesting a need for inquiry or investigation.
|
|
In pursuit of both their decision-making and oversight functions, corporate directors have, individually or collectively, various duties, responsibilities and rights, which are more fully described below Although recent changes in corporate governance standards effected by the Sarbanes-Oxley Act, SEC rulemaking and securities market regulations increase the compliance and disclosure requirements that the board and management of public companies must address, they do not change the fundamental principles governing director action.
|
|
A. OVERALL RESPONSIBILITIES
|
|
The basic relationship between the board and management of the corporation is expressed in state corporation statutes. The Model Act is typical in this regard by providing, in general, that all corporate powers shall be exercised by or under the authority of the board of directors of the corporation, and the business and affairs of the corporation shall be managed by or under the direction, and subject to the oversight, of its board of directors.
|
|
This language emphasizes the board’s responsibility to oversee the management of the corporation, which includes the following tasks for the board and its committees:
|
|
* reviewing and monitoring performance of the corporation’s business and its operating, financial and other corporate plans, strategies and objectives, and changing plans and strategies as appropriate
|
|
* adopting policies of ethical conduct and monitoring compliance with those policies and with applicable laws and regulations
|
|
* understanding the risk profile of the corporation and reviewing and overseeing risk management programs
|
|
* understanding the corporation’s financial statements and monitoring the adequacy of its financial and other internal controls as well as its disclosure controls and procedures
|
|
* choosing, setting goals for, regularly evaluating and establishing the compensation of the chief executive officer and the most senior executives, and making changes in senior management when appropriate
|
|
* developing, approving and implementing succession plans for the chief executive officer and the most senior executives
|
|
* reviewing the process for providing adequate and timely financial and operational information to the corporation’s decision makers (including directors) and shareholders
|
|
* evaluating the procedures, operation and overall effectiveness of the board and its committees
|
|
* establishing the composition of the board and its committees, including choosing director nominees who will bring appropriate expertise and perspectives to the board, recognizing the important role of independent directors.
|
|
1. Boardroom Responsibilities
|
|
Stated broadly, the principal responsibility of a corporate director is to promote the best interests of the corporation by providing general direction for the management of the corporation’s business and affairs. Each director brings to the corporation the director’s knowledge, business and other experience, and judgment. Directors should not be reticent. Indeed, to be a “director” is to “direct”–which means to become informed, participate, ask questions, apply considered business judgment and, when necessary, bring a matter to the board’s attention.
|
|
The director should give primary consideration to the corporation’s economic objectives. At the same time, a director should also be concerned that the corporation conduct its affairs with due appreciation of public expectations, taking into consideration relevant legal, public policy and ethical standards. Pursuit of the corporation’s economic objectives will often require attention to the effect of corporate policies and operations on the corporation’s employees, the communities in which the corporation operates and the environment. Several states have adopted legislation expressly confirming corporate directors’ authority to consider, in various decisions they make, the effect of corporate action on constituencies other than shareholders, such as employees, local communities, suppliers and customers. As a general rule, however, the law does not hold the board accountable to constituencies other than shareholders (and possibly creditors if the corporation is insolvent or near insolvency) in overseeing management or in making decisions. Non-shareholder constituency considerations are best understood not as independent corporate objectives but rather as factors to be taken into account in pursuing the best interests of the corporation.
|
|
2. Individual Responsibilities
|
|
To be effective in his or her decision-making and oversight responsibilities, a director must become familiar with the corporation’s operations, including the areas of business and the competitive environment in which it operates. The director must also understand the key drivers underlying the corporation’s profitability and cash flow–how the corporation actually makes money–for the corporation as a whole and also for its business segments. This knowledge should enable the director to make an independent evaluation of corporate and senior management performance, to work with management and other directors in developing or evaluating corporate objectives and strategic plans, and to challenge, support and reward management as warranted. Accordingly, each director should have at least a basic understanding of:
|
|
* the corporation’s business or businesses and the key profit drivers in each
|
|
* the principal operational, financial and other plans, strategies and objectives of the corporation and how they relate to the goal of enhancing shareholder value
|
|
* the economic and competitive risks to which the corporation is subject, as well as risks to the corporation’s physical assets, intellectual property and personnel
|
|
* the ongoing financial condition of the corporation and the results of its operations and of its significant business segments for recent periods
|
|
* the performance of the corporation’s significant business segments as compared to its competitors.
|
|
In addition, a director should be satisfied that effective systems are in place for timely reporting to, and consideration by, the board or relevant board committee of:
|
|
* corporate objectives and strategic plans
|
|
* current business and financial performance of the corporation and its significant business segments, and the degree of achievement of the board-approved objectives and plans
|
|
* financial information, with appropriate segment or divisional breakdowns
|
|
* systems of internal controls designed to manage risk and to provide reasonable assurance of compliance with law and corporate policies
|
|
* material risk and liability contingencies, including litigation and regulatory matters.
|
|
Directors should understand the attitude and commitment of the chief executive officer and senior management to integrity, honesty and ethical conduct-this is sometimes referred to as the “tone at the top”–and whether management’s operating style supports and promotes these values. Directors of public companies also have an important oversight responsibility for the quality and transparency of the disclosures made in SEC filings and in public statements about the business and financial performance of the corporation. Directors themselves are required to sign a public company’s annual report to the SEC, and all directors should understand the significant disclosures in that report and have an opportunity to review it before it is filed.
|
|
Directors should do their homework. They should review board and committee meeting agendas and related materials sufficiently in advance of meetings to enable them to participate in an informed manner. They should receive and review minutes of board meetings and keep abreast of the activities of those board committees on which they do not serve.
|
|
3. Director’s Prerogatives
|
|
Because of important oversight responsibilities, a director has both legal and customary rights of access to the information and resources needed to do the job. Among the most important are the rights to:
|
|
* inspect books and records
|
|
* request additional information reasonably necessary for a director to exercise informed oversight and make careful decisions:
|
|
* inspect facilities as reasonably appropriate for the understanding of the business and the performance of duties
|
|
* receive timely notice of all meetings in which a director is entitled to participate
|
|
* receive copies of all board and committee meeting minutes
|
|
* receive oral or written reports of the activities of all board committees.
|
|
In addition to these rights, and subject to coordination with senior management and reasonable time and manner constraints, a director has access to key executives and other employees of the corporation and to the corporation’s legal counsel and other advisors to obtain information necessary to the performance of the director’s duties. A director should always be able to request that any issue of concern be put on the board’s agenda.
|
|
A director’s access to information is accompanied by the duty not to disclose confidential corporate information to unauthorized persons or to misuse such information for personal benefit or for the benefit of others.
|
|
Directors should regularly assess the effectiveness of the board and its committees and regularly evaluate senior management. To this end, the directors not affiliated with management should periodically meet in executive sessions without management present, and the major securities markets now require such sessions. To facilitate these sessions, many boards designate the nominating/corporate governance committee chair or another director to convene and preside at such sessions if the chair of the board is also the chief executive officer or other management officer.
|
|
The board and board committees also should have access to the corporation’s general counsel and regular outside counsel and the authority to retain their own legal counsel and professional advisors, independent of those who usually advise the corporation, when they determine such independent advice is appropriate. Indeed, the Sarbanes-Oxley Act grants the audit committee the authority to engage independent counsel and other advisors and requires the corporation to pay for the cost of these advisors. Notwithstanding this authority or the right to engage advisors, the board and board committees should expect the general counsel to be available as a resource to advise them as they see fit. Correspondingly, each general counsel must recognize that his or her client is the corporation, as represented by the board of directors, and not the chief executive officer or any other officer or group of managers.
|
|
The baseline standard for director conduct, as formulated in the Model Act, is that every director must discharge his or her duties, including when serving as a member of a committee, (i) “in good faith” and (ii) “in a manner the director reasonably believes to be in the best interests of the corporation.” This baseline standard is central to the mandate often referred to as the “duty of loyalty.” The Model Act also provides that a director must discharge the director’s duties “with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” This mandate, which builds upon the baseline standard, is often referred to as the “duty of care.”
|
|
Parsing the language of these Model Act provisions is helpful in analyzing the components of a director’s duties:
|
|
* in good faith–acting honestly and dealing fairly
|
|
* reasonably believes–although the director’s honest belief is subjective, the qualification that it must be reasonable–that is, based upon a rational analysis of the situation understandable to others–makes the standard of conduct also objective, not just subjective
|
|
* best interests of the corporation–emphasizing the director’s primary allegiance to the corporate entity
|
|
* care–expressing the need to pay attention, to ask questions, to act diligently in order to become and remain generally informed and, when appropriate, to bring relevant information to the attention of the other directors
|
|
* person in a like position–avoiding the implication of special qualifications and incorporating the basic attributes of common sense, practical wisdom and informed judgment generally associated with the position of corporate director
|
|
* under similar circumstances–recognizing that the nature and extent of the preparation for, and deliberations leading up to, decision-making and the level of oversight will vary, depending upon the corporation concerned, its particular situation and the nature of the decision to be made.
|
|
A director’s duty of care relates to the director’s responsibility to exercise appropriate diligence in good faith to become informed in making decisions and overseeing the management of the corporation. In meeting the duty of care, a director should take into account the following considerations:
|
|
a. Time Commitment and Regular Attendance
|
|
A director is expected to attend and participate in board and committee meetings. A director may not participate or vote by proxy
|
|
b. The Need to Be Informed
|
|
Management should supply directors with sufficient and accurate information to keep them properly informed about the business and affairs of the corporation, and directors should not be reticent to request additional information in order to be fully informed. It is important that there be candid discussion among the directors and between directors and management. Each board member must disclose to other members of the board information known to the director to be material to the decision-making or oversight responsibilities of the board or its committees. This obligation of full disclosure may be qualified by legal or other duties to, or rights of confidentiality of, another corporation or other entity, but when this occurs, the limitation or reservation should be made known to the board, and the director subject to the confidentiality limitation or reservation generally should not participate in consideration of the matter.
|
|
When specific actions are contemplated, directors should receive the relevant information far enough in advance of the board or committee meeting to allow study of, and reflection upon, the issues raised. Important time-sensitive materials that become available between meetings should be promptly distributed to board members. On their part, directors should review carefully the materials supplied. If a director believes that information is insufficient or inaccurate or is not made available in a timely manner, the director should request that action be delayed until appropriate information is made available and can be studied. If a director believes the board is repeatedly not provided with the appropriate information to enable the director to vote or act in an informed manner, and is unsuccessful in efforts to remedy the situation, the director should urge the board to consider changing management or, failing such change, should consider resigning.
|
|
c. The Right to Rely on Others
|
|
In discharging board or committee duties, a director is entitled to rely on management and on board committees on which the director does not serve to perform their delegated responsibilities. A director is entitled to rely on reports, opinions, information and statements, including financial statements and other financial data, presented by (i) the corporation’s officers or employees whom the director reasonably believes to be reliable and competent in the matters presented, (ii) legal counsel, public accountants or other persons as to matters that the director reasonably believes to be within the person’s professional or expert competence or as to which the person merits confidence and (iii) committees of the board on which the director does not serve. Such reliance is permissible only if the director has no knowledge that would make the reliance unwarranted. Also, a director who relies on those to whom work has been delegated has a responsibility to keep informed of their efforts.
|
|
A director should inquire into potential problems or issues when alerted by circumstances or events suggesting that board attention is appropriate
|
|
The duty of loyalty requires a director’s conduct to be in good faith and in the best interests of the corporation–and not in the director’s own interest or in the interest of another person (such as a family member) or an organization with which the director is associated. Simply put, a director should not use the director’s corporate position for personal profit or gain or for other personal or noncorporate advantage. Although once void or voidable under common law without further consideration, transactions that present conflicts of interest are no longer viewed as inherently improper if they are approved by disinterested directors or shareholders after full disclosure of material information about the transaction. Even without such approval, if any such transaction is challenged, an interested director is entitled to establish the entire fairness of the transaction, judged according to circumstances at the time of the commitment.
|
|
The duty of loyalty has a number of specific applications.
|
|
Each director should be alert and sensitive to any interest he or she may have that might conflict with the best interests of the corporation. When a director has a direct or indirect financial or personal interest in a contract or transaction to which the corporation is to be a party, or the director is contemplating entering into a transaction that involves use of corporate assets or may involve competition with the corporation, the director is considered to be interested in the matter. A transaction in which any director has such an interest should be approved by disinterested directors or by shareholders. Interested directors should, subject to any confidentiality obligations owed to others outside the corporation (which obligations should be made known to the board), first disclose their interest to the board members who are to act on the matter and then describe all material facts concerning the matter that are known to the interested directors. After such disclosure, the interested directors should abstain from voting on the matter. In most situations, after disclosing the interest, describing the relevant facts and responding to any questions, the interested directors should leave the meeting while the disinterested directors complete their discussion and vote.
|
|
State corporation statutes usually provide procedures that may be used to authorize or ratify interested director transactions, and those procedures should be followed to safeguard both the corporation and the interested director.
|
|
The duty of loyalty encompasses a requirement that a director having access to a business opportunity related to the business of the corporation typically must make it available to the corporation before the director may pursue the opportunity for the director’s own or another’s account. Whether such an opportunity must first be offered to the corporation will often depend upon one or more of the following:
|
|
* the correlation of the opportunity to the corporation’s existing or contemplated business
|
|
* the circumstances in which the director became aware of the opportunity
|
|
* the possible significance of the opportunity to the corporation and the degree of interest of the corporation in the opportunity
|
|
* the reasonableness of any corporate expectation that the director should make the opportunity available to the corporation.
|
|
If a director has reason to believe that a contemplated transaction might be a corporate opportunity, the director should bring it to the attention of the board, disclosing any material information that the director knows about the opportunity If the board, acting through its disinterested directors, or the shareholders disclaim interest in the opportunity on the part of the corporation, then the director is free to pursue it. The obligation to put the corporation’s interests first also applies to opportunities for subsidiaries or affiliates of the corporation.
|
|
c. Fairness, Documentation and Policies
|
|
(i) Fairness to the Corporation
|
|
Disinterested directors reviewing the fairness of a transaction having conflict-of-interest or self-dealing elements are essentially seeking to determine (i) whether the terms of the proposed transaction are at least as favorable to the corporation as might be available from other persons or entities, (ii) whether the proposed transaction is reasonably likely to further the corporation’s business activities and (iii) whether the process by which the decision is approved or ratified is fair. If minority shareholders could be adversely affected, the directors should be especially concerned that the minority interests respecting the transaction receive fair treatment. This concern is heightened when a particular director, a dominant shareholder or a shareholder group has a divergent or conflicting interest.
|
|
(ii) Documentation of Conflicts
|
|
As a general rule, disclosures of conflicts of interest and the results of the disinterested directors’ consideration of the matter should be documented in minutes or reports of the action taken.
|
|
Securities market listing standards now require and, in any event, all companies should have formal written policies designed to promote high ethical standards and compliance with law and corporate policy. The board should see that such policies are adopted, maintained and periodically monitored for effectiveness.
|
|
Independent advice, which may be confirmed by oral or written fairness opinions, appraisals or valuations from investment bankers or others, is often helpful, especially when a transaction is significant and conflicts are involved.
|
|
3. The Duty of Disclosure
|
|
Court decisions have in recent years described a duty of disclosure, which is said to flow from both the duties of care and loyalty. This concept encompasses a duty that directors of a corporation have to furnish shareholders with all material information known to the directors when they present shareholders with a voting or investment decision. It also encompasses a duty of directors to fellow directors and management to inform them of information known to the director that is material to corporate decisions. Some court decisions have held that even where the directors are not recommending shareholder action, they have a duty, independent of disclosure obligations to investors generally under the federal securities laws, not to intentionally mislead or misinform shareholders.
|
|
4. The Business Judgment Rule
|
|
If directors’ decisions are challenged in court by a claimant asserting deficient conduct, judicial review of the matter will normally be governed by the business judgment rule. This rule, well established in case law, protects a disinterested director from personal liability to the corporation and its shareholders, even though a corporate decision the director has approved turns out to be unwise or the results of the decision are unsuccessful. Unlike the standards of conduct encompassed in the duties of care and loyalty, the business judgment rule is not a description of a duty or standard used to determine whether a breach of duty has occurred
|
|
The business judgment rule presumes that in making a business decision, the disinterested directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the corporation. Applying the rule in suits brought against directors by shareholders acting for themselves or derivatively on behalf of the corporation, the court will look to determine only whether the directors–at least those directors making the decision–were disinterested in the matter, appropriately informed themselves before taking the action and acted in the good faith belief that the decision was in the best interests of the corporation. In most states, the court will not review the wisdom of the business decision or its outcome.
|
|
A director should keep confidential all matters involving the corporation that have not been disclosed to the general public. A public company director is sometimes asked by investors, analysts, investment advisors or others to comment on sensitive issues, particularly financial information. However, an individual director is not usually authorized to be a spokesperson for the corporation, and directors should avoid responding to such inquiries, particularly when confidential or market-sensitive information is involved. Even information that is not market-sensitive may be confidential–for example, information about new products or proprietary processes or strategic plans. A director who improperly discloses such information to persons outside the corporation can cause the corporation to violate federal securities laws, can damage investor relations, can trigger personal liability as a tipper of inside information or can harm the corporation’s competitive position. Directors should refer requests for corporate information to the chief executive officer or other individual designated by the corporation to deal with such inquiries.
|
|
6. Areas of Special Concern
|
|
To participate in the board’s important oversight role, a director should assess whether the corporation has established and implemented programs designed to address the following key issues.
|
|
Do the corporation’s disclosure documents (for example, quarterly and annual reports to shareholders, proxy statements, prospectuses, earnings releases and other key communications to shareholders and the financial community) fairly present material information about the corporation and its prospects? A director’s primary responsibility in the disclosure process is to be satisfied that the corporation has procedures that are reasonably designed to produce accurate and appropriate public disclosures. Directors should read filings, raise questions and be satisfied that the disclosure conveys the significant information about the business in an understandable manner. Management has the primary responsibility for implementing appropriate processes, subject to directors’ oversight and periodic review of the steps taken by management. Many public companies have established internal disclosure committees composed of managers who have particular responsibility for the company’s SEC filings and public financial disclosures.
|
|
Has the corporation established appropriate policies designed to provide reasonable assurance of compliance with applicable laws and regulations? Are there laws and regulations specific to the industry in which the corporation operates that demand special compliance policies and monitoring? Does the board receive reasonable assurances that employees of the corporation are informed and periodically reminded of those policies, including those pertaining to compliance with (i) codes of business conduct, (ii) anti-discrimination and employment laws, (iii) environmental and health and safety laws, (iv) bribery laws, (v) antitrust laws and (vi) the securities laws, particularly those prohibiting insider trading? The SEC requires every public company to disclose whether it has adopted a code of ethics for its senior financial officers and chief executive officer, which would include standards designed to promote ethical conduct, full and fair disclosure in SEC reports, compliance with laws, internal reporting of violations of the code, and accountability for adherence to the code. In addition, the major securities markets require their listed companies to adopt codes of business conduct applicable to all employees, officers and directors. The subjects addressed in these codes should include conflicts of interest
|
|
In addition, directors of public companies now have some specific duties under the federal securities laws to receive complaints or concerns about the accounting or auditing process and also to determine whether to grant waivers to corporate officers under the corporation’s legal and ethical compliance programs. All boards should periodically review how well such programs are functioning and should be satisfied that they are reasonably effective.
|
|
A program of legal compliance that is well conceived and properly implemented can significantly reduce the incidence of violations of laws and corporate policy It can also reduce or eliminate civil lawsuits, penalties or prosecution against the corporation for those violations of law that occur in spite of such a program. Since the enactment of the United States Sentencing Commission’s sentencing guidelines for organizations, corporations have further reason to review and reassess their compliance policies and procedures. These guidelines greatly increase the penalties for businesses found guilty of criminal violations, but provide significant fine reductions for convicted corporations with appropriate programs in effect to prevent and detect violations of lave
|
|
c. Approval of Commitments and Compliance with Contractual Obligations
|
|
Is there a functioning and effective system in place for approval of commitments of the corporation’s financial and commercial resources? How does the corporation monitor compliance with those contractual obligations that, if breached, could result in substantial liability to the corporation? Although board approval of all or even most corporate commitments is not necessary, the board should be satisfied that a reasonable approval system exists within the organization and should have a clear understanding with management–which may be embodied in a formal policy–as to the type or level of major commitments that require board approval. The board should also understand the systems and procedures the corporation uses to assure compliance with contractual obligations.
|
|
d. Effectiveness of Internal Controls and Disclosure Controls and Procedures
|
|
Does the corporation maintain effective systems of internal financial and disclosure controls and procedures for determining and disclosing financial and other material information about the corporation? Is there a system for monitoring their adequacy? Quarterly review and certification of the effectiveness of systems and procedures that support SEC filings are required of the chief executive officer and the chief financial officer of public companies. Annual evaluation of internal control over financial reporting by management, and attestation of management’s assessment by the external auditor, are also required. The board, generally through its audit committee, should receive and consider reports concerning each of these reviews.
|
|
e. Identification of Business Risks and Protection of Assets
|
|
Does the board receive periodic reports describing the corporation’s programs for identifying financial and other business risks and for managing such risks and protecting corporate assets and employees? In addition to insurance arrangements, such programs should include procedures for protecting intellectual property and safeguarding confidential corporate information, as well as security arrangements for physical properties and personnel.
|
|
f. Counseling of Directors
|
|
Does the corporation provide board members competent legal advice regarding the corporation’s business and affairs and the conduct of its directors? The board should look first to the corporation’s general counsel or regular outside counsel for legal advice on the board’s duties and responsibilities. There may be occasions when an additional outside legal advisor should be specially retained by the board or a committee in connection with a particular matter.
|
|
If, after a thorough discussion, a director disagrees with any significant action proposed to be taken by the board, the director should consider abstaining or voting against the proposal and consider requesting that the abstention or dissent be recorded in the meeting’s minutes. Except in unusual circumstances, taking such a position should not cause a director to consider resigning. However, if a director believes that management is not dealing with the directors, the shareholders or the public in good faith or that the information being disclosed by the corporation is inadequate, incomplete or incorrect, the director should first encourage that corrective action be taken. If that request is not satisfied or the problem continues, the director should encourage the board to replace management and, if such a change does not occur, the director should resign.
|
|
C. CHANGE-OF-CONTROL AND FINANCIAL DISTRESS SITUATIONS
|
|
When the corporation is the subject of a tender offer, merger proposal, proxy contest or other potential change of control, the board of directors will generally have enhanced duties pursuant to federal law and regulations and state statutory and case law. The nature of the board’s duties in responding to such a situation will vary depending upon, for example, (i) the certainty and nature of the offer, (ii) whether corporate managers are participants in the offer or (iii) whether an acquiring group will obtain control (as compared to a situation where the combined enterprise will continue to be widely held, with no new concentration of control). These special situations are beyond the scope of this Guidebook.
|
|
If a corporation is insolvent or nears insolvency, special considerations, also beyond the scope of this Guidebook, arise. Directors may have duties to creditors as well as to shareholders in such situations. For corporations in financial distress, dividends and other distributions, recapitalizations, reorganizations and other major corporate actions should be considered by the board only with the benefit of legal advice from counsel expert in insolvency issues.
|
|
SECTION 3: BOARD STRUCTURE AND OPERATIONS
|
|
Boards of directors should be structured and their proceedings conducted in ways that encourage, reinforce and demonstrate the board’s role as an independent and informed monitor of the conduct of the corporation’s business and affairs and the performance of its management. Board structure and practice will, over time, significantly impact the ability of the board to exercise its powers and discharge its obligations effectively to benefit and advance corporate objectives.
|
|
No one governance structure fits all corporations, and there is considerable diversity among organizational styles. Each corporation should develop a governance structure that is appropriate to its nature and circumstances. Private companies have considerably fewer legal requirements to satisfy than public companies. There is also a significant difference between the corporation that has recently had its initial public offering and one that has been publicly owned for many years with senior management generationally removed from the founding entrepreneurs. Moreover, the demands on a director of a relatively simple enterprise will be very different from those on a director of a large multinational conglomerate with operations raising complex tax, accounting, regulatory and other issues for directors to consider.
|
|
A. COMPOSITION–QUALIFICATIONS AND INDEPENDENCE
|
|
In determining board composition, consideration should be given to both the personal qualities and experience of the individual directors and the overall mix of experience, independence and diversity of backgrounds likely to make the board of directors, as a body, effective in monitoring and overseeing the performance of the corporation and contributing to its success.
|
|
If the board of directors is to function effectively, it must exercise independent judgment in carrying out its responsibilities. Equally important, it must be perceived, by shareholders and other corporate constituencies, to be acting with independent judgment. To encourage an environment likely to nurture independence in fact and to communicate an appearance of independence, most corporate governance commentators have for some time recommended that, in most circumstances, at least a majority of a public company board should be independent of management, and that no more than one or two directors should also be executives of the corporation. Recently, investor and business groups have taken the position that a substantial majority of the directors of a public company should be independent of management.
|
|
The major securities markets now require all listed companies to have a majority of independent directors, unless they are “controlled companies” (in which a majority of the voting power is held by a person or a group). All members of the key oversight committees–the audit, compensation and nominating/ corporate governance committees, or any committee to which executive compensation, nominating or corporate governance duties are delegated–must also qualify as independent directors. Both the New York Stock Exchange and the Nasdaq Stock Market have adopted specific rules as to who can qualify as an independent director and also require the boards of listed companies to make an affirmative determination, which must be publicly disclosed, that each director designated as “independent” has no relationship with the company that would affect his or her independence. Under the New York Stock Exchange requirements, the principles underlying the determination of independence must also be publicly disclosed. In addition, for all public companies, audit committee members must meet the separate definition of audit committee independence set forth in the Sarbanes-Oxley Act, which is, in some respects, more stringent than the major securities markets’ definitions of director independence.
|
|
In general, a director will be viewed as independent only if he or she is a non-management director free of any family relationship or any material business or professional relationship (other than stock ownership and the directorship) with the corporation or its management, and has been free of any such relationship for three years. When making an independence determination, the board should consider all relevant facts and circumstances, and the board should review the materiality of a director’s relationships with the corporation and its management from both the director’s standpoint and the standpoint of the individuals or organizations with which the director has an affiliation. Relationships that have been identified as presumptively inconsistent with a director’s independence include the following:
|
|
* the director is a current or former officer or employee of the corporation or any of its affiliated enterprises
|
|
* the director has a business or professional relationship with the corporation, one of its affiliated enterprises or one of its strategic partners that is material to the director
|
|
* an executive officer of the corporation is serving on the compensation committee of another enterprise that currently employs the director
|
|
* the director has a current or recent affiliation with the corporation’s external auditor
|
|
* an immediate family member of the director has any of the foregoing relationships.
|
|
The fact that a director is independent under the listing standards of a securities market does not mean that a director will be determined to be disinterested in a particular decision. In reviewing director actions in conflict of interest situations, courts are not limited by these standards and will look at the whole range of business and personal relationships between directors participating in the decision and the corporation and its senior managers in determining whether such directors are in fact disinterested.
|
|
In the United States, public companies generally follow one of two models. In most cases, the chief executive officer also serves as board chair
|
|
Each board should determine the appropriate size to accommodate its key needs and objectives, which include:
|
|
* performing its decision-making and oversight responsibilities effectively, including the functions assigned to the key oversight committees
|
|
* satisfying applicable independence standards.
|
|
Other factors that might influence board size are the corporation’s need to maintain a strong community presence, to establish or maintain relationships with large shareholders or other constituencies, or to respond to factors particular to the corporation or the industry in which the corporation operates. In accommodating these needs, board size should not be expanded to a point that interferes with effective functioning.
|
|
There is substantial variation in the size of boards of public companies. Financial services companies and corporations operating complex businesses typically have larger boards, with as many as fifteen or more members. In contrast, the boards of smaller or less complex enterprises typically have eight or nine members. High-technology enterprises and new public companies frequently have boards of as few as five to seven members, although the need for independent directors to serve on the key oversight committees may cause these companies to increase their board size.
|
|
The emerging consensus is that, except perhaps in the very largest and most complex corporations, smaller boards (with eight or nine members) function more effectively than larger boards. Directors serving on a smaller board typically will have more opportunity to participate actively in board deliberations, whereas larger boards may inhibit effective participation by individual members. Large boards often resolve this participation problem through delegation of many significant activities to board committees.
|
|
The number of meetings a board finds necessary or useful varies with the size, complexity and culture of the business enterprise. Some boards prefer more frequent and shorter meetings, whereas others prefer fewer but lengthier meetings. Some boards schedule one extended planning or strategic meeting each year and shorter meetings during the rest of the year. Boards of public companies should hold regularly scheduled meetings at least quarterly. However, most public company boards schedule six to eight regular meetings each year, and hold special meetings as needed.
|
|
Time at board and committee meetings should be budgeted carefully A balance should be sought between management presentations and discussion among directors and management. When possible, concise reports and analyses that can be given effectively in writing, without oral presentation, should be furnished in advance.
|
|
The New York Stock Exchange listing standards now require boards of listed companies to schedule regular meetings of non-management directors to promote open discussion among them and to schedule at least one meeting per year among the independent directors only The Nasdaq Stock Market has a similar requirement for independent directors only These meetings present an opportunity to evaluate the performance and continued effectiveness of management and the board. These meetings are usually coordinated with regular meetings of the board. Such a session can be scheduled as a meeting of a nominating/corporate governance committee (or equivalent) to which all non-management or independent directors are invited.
|
|
In addition to periodic private meetings to evaluate the chief executive officer and other senior managers, there are special occasions when the independent directors may wish to meet separately to consider management-sensitive issues, such as litigation targeted against senior management, a proposed change-of-control transaction or a major change in management. In such cases, special advisors, including special legal counsel, may be asked to help the directors address the issues at hand. Whether the meeting is structured as a special committee meeting, as part of a regular board meeting or as an informal gathering to consider directors’ concerns, holding such a meeting as often as necessary is an appropriate exercise of directors’ responsibilities.
|
|
E. DIRECTOR’S TIME COMMITMENT
|
|
All directors are expected to devote substantial time and attention to their responsibilities–enough time to permit the directors to prepare for and attend meetings of the board and board committees and to stay informed about the corporation’s business performance and competitive position in the marketplace. While the time commitment varies considerably, depending on the size and complexity of the enterprise and the issues being addressed, in general the time required of directors of public companies has increased substantially in recent years as new responsibilities have been added for independent directors, particularly for members of the audit committee. It is not uncommon for a director’s total time commitment to involve 200 hours or more a year, for meeting preparation, travel, meeting attendance, informal consultation with other board members and management, and regular review of materials to keep up with corporate developments.
|
|
Directors entertaining a new or continued board commitment should carefully consider how much time will be required to meet their responsibilities. Additional audit committee processes and duties now mandated by the SEC and the major securities markets require members of that committee to devote more time to their responsibilities than in the past. Directors should not over-commit themselves, and the nominating/corporate governance committee should consider a board candidate’s ability to devote the necessary time.
|
|
In times of possible change-of-control transactions, financial distress, management succession crises or similar circumstances, directors of public companies will be required to devote substantially more time during the critical period.
|
|
Directors have an unavoidable conflict of interest in fixing their own compensation. This problem is not ameliorated if recommendations for director compensation are put forward by management or by a compensation consultant. Recognizing that they have the responsibility to determine their own compensation, directors normally make sure they have the data necessary to reach a fair result, including data on comparable companies together with an analysis of any special factors that may relate to their particular corporation.
|
|
A major objective of board compensation plans should be to align the directors’ financial interests more closely with the long-term interests of the corporation and its shareholders. Director compensation may take a number of different forms, including annual stock or cash retainers, attendance fees for board and committee meetings, deferred compensation plans, stock options, restricted stock grants and life, accident or other insurance. The corporation’s executives generally do not receive additional compensation if they serve on the board. For non-management directors, the aggregate amount of compensation should first be considered before allocation is made to cash payments and other components. Values should be estimated, and taken into account, for any non-monetary items such as stock options or grants and insurance plans for directors.
|
|
The board should be sensitive to and avoid compensation policies or corporate perquisites that might tend to subvert the independence of its non-management directors. To maintain directors’ focus on proper long-range corporate objectives, investor groups recommend, and most corporations now provide, compensation in the form of stock options and/or restricted stock grants on the theory that these forms of equity compensation strengthen the directors’ interest in the overall success of the corporation and better align their personal interests with those of shareholders. Because options alone do not involve acceptance of any economic risk by a director, some investor groups recommend, and some companies now require, directors to purchase a minimum amount of stock in the open market or to accept at least a designated portion of their compensation in stock grants rather than cash. In addition, corporate governance experts recommend, and some companies have instituted, policies requiring a minimum holding period for shares purchased by or granted to directors and executive officers (less sales necessary to fund option exercise and pay taxes). Directors’ retirement arrangements and educational or charitable gift programs geared to their designated beneficiaries–once somewhat widespread–have been criticized by shareholder groups because they are not directly related to corporate performance. As a result, they have generally been reduced or discontinued as a director perquisite.
|
|
Perquisite programs, such as club memberships or use of corporate aircraft or company apartments by directors, should be monitored. Charitable donations to any organization with which a director or a member of the director’s immediate family is affiliated should be carefully scrutinized to determine whether they are consistent with appropriate corporate purposes and to make sure that they do not jeopardize the director’s independence or create any potential appearance of impropriety. Any material payments to directors for consulting or other services beyond the regular directors’ fees should be carefully considered as they may impair independence, and in any event must be disclosed to shareholders in the annual proxy statement.
|
|
G. QUALITY OF INFORMATION
|
|
The quality of information made available to directors will significantly affect their ability to perform their roles effectively. Information submitted to the directors should be (i) timely and relevant, (ii) concise but complete, (iii) well organized, (iv) supported by any background or historical data necessary to place the information in context and (v) designed to inform directors of material aspects of the corporation’s business, performance and prospects. Benchmarking data, which allow the board to make comparisons to other corporations in the same industry group, or with similar characteristics, are also important. Agenda-related information should be provided to the directors sufficiently in advance of board or committee meetings to provide time for careful study and thoughtful reflection so as to enable their meaningful participation in meeting deliberations and decisions.
|
|
Traditionally, management has determined the presentations to be made and the matters to be acted on by the board, but that is less so today When there is a non-executive chair of the board or a nominating/corporate governance committee chair or other person designated as presiding or lead director, that director and the chief executive officer should collaborate on the agenda and plans for the meeting. However, any director should always be free to request that an item be included on the agenda. Further, the board should satisfy itself that there is an overall annual agenda of the matters that require recurring and focused attention, as well as periodic reexamination and updating. These matters include the achievement of operational and financial plans
|
|
I. CONDUCT AND FUNCTION OF A DIRECTOR IN RELATION TO MANAGEMENT AND OTHER DIRECTORS
|
|
Perhaps the most important factor for a director to be effective is his or her ability to gain the attention and confidence of management and fellow board members. Effective directors win this attention and confidence by being diligent, interested in the corporation and its business, and courteous and attentive in discourse with management and the other directors. Effective directors act as senior counselors to management without assuming management functions. While a constantly carping boardroom critic will often be less effective in working with the other directors and in counseling management, an attitude of constructive skepticism and informed inquiry is not only appropriate but important in furthering the board’s competence as the monitor of management. Directors should be supportive and helpful in pursuing with management the corporation’s business objectives and in identifying and evaluating its business risks. At the same time, however, they should insist on a careful analysis of management proposals and a fully informed, thoughtful corporate decision-making process. They should not be reticent to challenge or question the chief executive officer and other senior managers when they are uncomfortable with a proposal or to ask for more information or time that they believe is needed to make an informed decision on a proposal or to perform their oversight function. Directors should be scrupulous in informing their colleagues on the board of any information within their knowledge that is material to a board decision (to the extent they are free of confidentiality obligations restricting its disclosure), whether their knowledge comes from personal involvement in the matter or from other sources.
|
|
As the overarching consideration bearing on all that directors do, a director must keep in mind, throughout activities undertaken on behalf of the corporation, that the director is the representative of all of the shareholders. This remains true even if a director is nominated or designated by a subset of the shareholder body (for example, holders of preferred stock), elected in a proxy contest or elected by the board to fill a vacancy
|
|
SECTION 4: DECIDING TO JOIN A BOARD
|
|
An individual weighing an invitation to join a board of directors should study both the corporation and the board and understand why he or she is being asked to join the board. A director candidate should carefully consider the reputation for competence and integrity of senior management and the directors currently serving on the board as well as his or her own ability to monitor and add value to the enterprise.
|
|
If asked to join the board of a private company, the individual should (i) explore what role is intended for an outsider on the board, (ii) determine whether independent professional advice will be available if requested (and, if so, how), (iii) inquire whether an initial public offering or sale of the corporation is contemplated, and (iv) consider taking the steps described below (suggested for consideration in the public company context but may also may be relevant in the private company context), such as reviewing the corporation’s financial information and becoming familiar with its director exculpation, litigation expense advance and indemnification arrangements, and director and officer insurance policies.
|
|
An individual asked to become a director of a public company should consider taking the following preliminary steps:
|
|
* consider whether the opportunity to serve on the board of this public company and to learn about its business is sufficiently compelling to the candidate to engage his or her interest and attention in the face of competing commitments
|
|
* consider whether he or she has (i) sufficient time to perform diligently the required duties, (ii) any scheduling conflicts that would unduly interfere with the board’s normal meeting schedule and (iii) any present, foreseeable or perceived conflicts of interest respecting the corporation, its business or its senior management
|
|
* consider whether he or she can develop a sufficient understanding of the corporation’s business and business model to function effectively as a director
|
|
* meet with the nominating/corporate governance committee chair or other board representative who extended the invitation, and with the chief executive officer and perhaps other senior members of management, to review board organization and procedures and to discuss the principal issues facing the corporation and the committee memberships contemplated for the individual
|
|
* determine the attitude of the chief executive officer and management toward board activity–whether a proactive board and independent director judgment are truly desired
|
|
* review the corporation’s recent public disclosure documents, such as reports filed with the SEC, recent annual reports to shareholders, the most recent proxy statement, interim reports sent to shareholders since the end of the last fiscal year and, if the corporation is recently public, its initial public offering prospectus
|
|
* review press and analyst reports about the corporation to determine how it is viewed by the investment community and the business world generally
|
|
* consider, based on the information received, the financial stability of the current business activities and the corporation’s future prospects
|
|
* understand the structure and processes used by the board to provide effective oversight, including (i) the corporation’s corporate governance principles or guidelines, committee charters and other formal guidelines for board structure and composition, (ii) routine operation of the board and its committees, (iii) the methods employed for monitoring and evaluating board and committee performance and (iv) the procedures used for senior executive officer appointments, evaluation and succession planning.
|
|
If, following a preliminary investigation, the individual understands the corporation’s business activities and has a continuing interest in the directorship opportunity, the following additional steps should be considered:
|
|
* review the membership of, and the procedures followed by, the board’s audit committee, and meet with the audit committee chair to discuss any critical accounting issues recently faced by the corporation, the clarity and transparency of public disclosures respecting the corporation’s financial affairs and the effectiveness of the corporation’s compliance programs
|
|
* review recent examples of the “meeting book” provided to directors in advance of regularly scheduled sessions, meeting minutes and other information regularly provided to the directors
|
|
* identify the corporation’s regular legal and financial advisors and understand their role and participation in the corporation’s and the board’s activities
|
|
* understand, based on appropriate professional advice, the corporation’s director exculpation, indemnification and litigation expense advancement provisions, in charter documents and contracts, and the amount and coverage provided by the corporation’s directors’ and officers’ liability insurance coverage
|
|
* receive a briefing on claims or litigation that involve the activities of the board of directors, or involve any entity with which the candidate is already affiliated.
|
|
To the extent that the director candidate seeks independent professional advice, the reimbursement by the corporation of any reasonable out-of-pocket expenses incurred by the candidate would be appropriate. Correspondingly, it would be appropriate for the corporation to require a confidentiality commitment from the candidate covering material, non-public information regarding the corporation’s business and affairs disclosed to the candidate.
|
|
SECTION 5: COMMITTEES OF THE BOARD
|
|
Much of the work of the typical board of directors of a public company is performed in committee. This delegation has long been recommended and supported by courts and commentators as leading to more effective corporate governance. The Sarbanes-Oxley Act and the major securities markets now require delegation of some significant matters to board committees and limit membership on these committees–in particular, the audit, compensation and nominating/ corporate governance committees–to independent directors. Indeed, the independent board committee is at the core of many measures for effective corporate governance. Because of this division and delegation of responsibility, it is important that there be a regular flow of reports and other information from the committees to the board so that all directors are kept abreast of each committee’s activities and significant decisions.
|
|
Diversity in board structure and size does not allow for a uniform mandate for a particular committee structure. A seven-member board necessarily approaches its work differently than a board with fifteen directors. Except for specific duties delegated to committees of independent directors, some boards function almost entirely at the board level, whereas other boards may act only upon broad strategy, policy guidance and legally required matters while the monitoring and oversight work is mostly handled by committees, with their activities reported to, and in some cases approved by, the board.
|
|
Practice also varies in allocating responsibilities among particular committees. For example, the primary review of legal compliance matters is often handled by the audit committee as part of its oversight of internal controls
|
|
Committee are not meant to suggest a particular board structure or any specific division of committee responsibilities. The important point is that the matters be considered by some group of directors and, when mandated by law or securities market regulations–or in instances calling for disinterested review and approval–by directors who are independent of management and disinterested in the matter at hand.
|
|
The following basic rules and procedures on committee activity should be observed:
|
|
* The membership of each committee should be appropriate to its purpose and, in the case of a public company, in compliance with federal law and securities market requirements. Membership considerations include relevant experience, expertise and, for members of the key oversight committees, independence from management.
|
|
* The board should be kept regularly informed of standing committee activities. This can be accomplished through periodic oral reports at board meetings or circulation to all directors of committee agendas and meeting minutes or written reports.
|
|
* Actions taken by committees must observe the limits imposed by law. The Model Act and the corporation statutes of most states prohibit committees from taking certain board actions, such as filling board vacancies, authorizing dividends or other distributions and amending the corporation’s bylaws. However, recommendations on such matters can be made to the board by committees.
|
|
* The authority and function of each committee should be clearly defined. In the past, this was typically done in bylaws or board resolutions. However, the listing standards promulgated by the major securities markets now call for the duties of committees responsible for audit, compensation and nominating/corporate governance matters to be spelled out in written charters, and the Sarbanes-Oxley Act assigns specific duties, responsibilities and powers to the audit committee. In addition to the purpose, mission and responsibilities of each committee, the charter or resolution should address committee membership qualifications, the process for the appointment and removal of committee members, committee structure and operations (including authority to delegate to subcommittees), reporting to the board, and authority to engage outside advisors, including legal counsel. In the case of the nominating/corporate governance committee, the charter should also address the process for the committee’s recommendations to the board for the appointment of the chair and members of each board committee and for the removal of any committee member during the term of office.
|
|
* The board, or the nominating/corporate governance committee, should periodically review the responsibilities assigned to each committee. This review should consider whether the assignments of duties and responsibility continue to be realistic and consistent with what each committee is actually doing and with each committee’s meeting schedule (for example, frequency and time allotted). As an illustration, if the audit committee meetings are regularly scheduled for one hour just before the board meeting, there likely will not be adequate time to cover the committee’s agenda at some of those meetings.
|
|
* From time to time, a standing or special committee may undertake special duties and responsibilities. A board resolution, or committee charter approved by the board, that describes the responsibilities assigned to the committee should be adopted and included in the corporation’s records. In the case of a special committee directed to investigate questionable activities or transactions that involve a conflict of interest, the scope of the committee’s authority should be specifically articulated.
|
|
A director may rely upon a board committee on which the director does not serve, if the director reasonably believes reliance is warranted. Adherence to the basic rules and procedures outlined above should justify a director’s reliance on committee activity. The standards of conduct for a director in connection with committee service are the same as those for board service generally.
|
|
This Guidebook focuses on the key board oversight committees and does not address other committees such as executive, finance, legal compliance, public policy and strategic planning. One or more of these committees may perform an oversight function, however, and to the extent this is the case, it is addressed by implication. Each board needs to tailor committee functions and responsibilities to its own needs. In the case of regulated enterprises, particular committees may be required or encouraged by regulators (for example, financial institutions may have board committees that specifically monitor the management of financial risks or oversee trust and fiduciary departments). For some committees, it is appropriate for membership to reflect the composition of the board. Thus, an executive committee that frequently acts on important matters such as compliance oversight (as opposed to being a standby resource acting only in administrative or emergency situations) should normally reflect the membership of the board
|
|
If a director or officer is alleged to have engaged in conduct damaging to the corporation or to have violated the law or corporate policy in performing his or her duties, the corporate response and the extent to which that individual should be supported, terminated or otherwise sanctioned should be based upon a review by directors who are not involved in the matter and have no conflicting interest. This review may be best handled by an ad hoc committee specifically appointed for the purpose or an appropriately organized existing committee, which may want to consult with outside counsel or other appropriate experts.
|
|
There are other special situations–for example, tender offers, shareholder rights plans, major criminal investigations, financial distress and management buyouts–where special committee handling may be desirable. These unique, potentially life-changing events for the corporation are not treated here
|
|
SECTION 6: THE AUDIT COMMITTEE
|
|
Since first recommended by the New York Stock Exchange in 1939, the audit committee has become a critical component of the corporate governance structure of public companies. Oversight of the retention and performance of the external auditor is now the exclusive responsibility of the audit committee under the Sarbanes-Oxley Act, which also provides for a special definition of independence for members of the audit committee. The committee also has general oversight responsibility for the corporation’s financial reporting process and internal controls. In addition, the audit committee is increasingly viewed, and is expected to serve, as a forum separate from management in which not only the internal and external auditors, but also others, such as the corporation’s legal counsel, can candidly report and discuss their concerns about accounting, auditing and financial reporting and compliance matters.
|
|
The audit committee of every public company must be composed solely of directors who meet the listing standards for director independence of the corporation’s particular securities market and also the audit committee independence requirements under the federal securities laws, which provide that audit committee members may not directly or indirectly receive any compensation from the corporation–such as consulting, advisory or similar fees–other than their director fees, and may not be affiliates of the corporation.
|
|
The major securities markets require a minimum of three members on the audit committee, and audit committees typically consist of three to five independent directors. The major securities markets also require that all committee members be financially literate and at ]east one member have accounting or financial management experience. In addition, under the Sarbanes-Oxley Act, a public company must disclose in its annual report to the SEC or annual proxy statement whether any member of its audit committee qualifies as an “audit committee financial expert,” a term defined by SEC regulation and focused on accounting and auditing knowledge and experience. If no member qualifies, then the corporation must state why the committee does not have such an expert. If the board determines that one or more of the committee’s members qualifies, then the corporation must disclose the name of at least one audit committee financial expert and whether the expert is independent. Any director who might be designated as an audit committee financial expert should be satisfied that he or she in fact meets the requirements.
|
|
In order to discharge their responsibilities, all audit committee members should have a sufficient understanding of financial reporting and internal control principles to address these important issues in a knowledgeable manner. To support this oversight activity and as part of director continuing education, a growing number of public companies are providing audit committee members with professional advice and continuing education on evolving audit committee concepts and updates on important accounting developments.
|
|
Regardless of these requirements, common sense, diligence and an attitude of constructive skepticism are critical qualifications for an audit committee member.
|
|
Some duties of public company audit committees are required by federal law, SEC regulations or securities market listing standards, while other responsibilities represent good corporate practice. The major securities markets mandate a formal written charter specifying the committee’s duties and responsibilities. The charter must be reviewed annually by the committee and published at least once every three years in the proxy statement sent to shareholders.
|
|
Audit committee members should understand the tasks specified in the committee’s charter and take care that each is performed. To meet their responsibilities, some committees have sought professional advice in developing a charter, a set of procedures and an annual schedule, particularly as new disclosure requirements and filing deadlines require special attention to the scheduling and duration of meetings so that the audit committee is able to fulfill its duties.
|
|
The following list sets forth required duties for audit committees under SEC rules and securities market regulations applicable to public companies. Audit committees of private companies will also find this list useful in establishing the scope of their responsibilities and the content of their meetings.
|
|
Audit committees are required to:
|
|
* select and retain the corporation’s external auditor and determine, for each fiscal year, whether to continue or terminate that relationship
|
|
* review and approve annually the external auditor’s compensation and the proposed terms of its engagement, including the scope and plan of the annual audit
|
|
* approve, prior to each engagement, any further audit-related or non-audit services to be provided by the audit firm, based on the committee’s judgment as to whether the firm is an appropriate choice to provide such additional services and whether the engagement, or the aggregate of such engagements, would impair the firm’s independence
|
|
* establish procedures to receive and respond to any complaints or concerns regarding the corporation’s accounting, internal controls or auditing matters, including procedures for the confidential and anonymous submission by employees of any such complaints or concerns
|
|
* serve as a channel of communication between the external auditor and the board and between the senior internal auditing executive, if any, and the board
|
|
* discuss the corporation’s procedures for issuing quarterly and annual earnings press releases, as well as for providing financial information and earnings guidance to analysts, the financial press and rating agencies
|
|
* review the corporation’s annual and quarterly financial statements, and management certifications thereof, with corporate management and the external auditor, and discuss with them the quality of management’s accounting judgments in preparing the financial statements
|
|
* review the Management’s Discussion and Analysis section in each periodic report prior to filing with the SEC and discuss with management and the external auditor any questions or issues that arise in connection with that review
|
|
* determine whether to recommend to the board that the audited annual financial statements be included in the corporation’s annual report on Form 10-K to be filed with the SEC
|
|
* review any required communications from the external auditor as a result of its timely review of the quarterly financial statements
|
|
* consider, in consultation with the external auditor and the senior internal auditing executive, if any, the adequacy of the corporation’s internal financial controls, which, among other things, must be designed to provide reasonable assurance that the corporation’s books and records are accurate, that its assets are safeguarded and that the publicly reported financial statements prepared by management are presented fairly in conformity with generally accepted accounting principles
|
|
* review management’s annual assessment of the effectiveness of internal control over financial reporting and the external auditor’s attestation of that assessment
|
|
* review and approve the annual report of the audit committee to shareholders required to be included in a public company’s annual meeting proxy statement
|
|
* meet periodically with management to review the corporation’s major risk exposures and consider, with management, risk management programs, including the reduction of present and future litigation risks, and procedures and policies addressing legal compliance
|
|
* for Nasdaq-listed companies, approve any related-party transactions between the corporation and its officers or directors, or their family members or enterprises they control
|
|
* conduct an annual self-evaluation.
|
|
Other duties and responsibilities that many audit committees undertake, and other audit committees may want to consider undertaking, as matters of good corporate practice include:
|
|
* approve the appointment and termination of the senior internal auditing executive, if any, and be satisfied with the reporting structure, performance evaluation, internal audit plans, budget, staffing and other support for the internal audit and control function
|
|
* review the external auditor’s management letter, which comments on any control weaknesses observed during the course of the audit and makes other recommendations arising from the audit, together with management’s responses to that letter
|
|
* review by the full committee, in an in-person or telephone meeting, of quarterly and annual earnings releases before the releases are issued
|
|
* review reports submitted to the audit committee by the internal auditing department, and management’s responses to those reports, and follow up on management’s responses
|
|
* meet periodically with the corporation’s internal disclosure committee or its representatives, if the corporation has such a committee
|
|
* if another committee does not do so, meet privately with the corporation’s legal counsel from time to time to review the status of pending litigation, discuss possible loss contingencies and review other legal concerns, including the corporation’s procedures and policies addressing legal compliance and reduction of legal risk
|
|
* if another committee does not do so, establish and review policies or guidelines for expense reimbursements, perquisites and other benefits provided to senior executives, and be satisfied that the corporation has in place an effective process to monitor compliance with such policies or guidelines.
|
|
The audit committee should meet with the corporation’s external auditor during the planning phase of each annual audit to review the planning and staffing of the audit and to discuss any particular areas that may require emphasis or special procedures during the audit. After completion of the audit, the audit committee should review with the external auditor any problems or difficulties encountered by the external auditor
|
|
The audit committee of a public company must annually receive from, and discuss with, the external auditor its letter as to the auditor’s independence, and must consider any effect on such independence of any non-audit services provided to the corporation by the audit firm. The committee is also required to review with the auditor the quality of management’s accounting judgments.
|
|
The audit committee should understand when significant accounting judgments and estimates have been made that materially impact the corporation’s financial statements. Because corporations sometimes have a choice among several available generally accepted accounting principles or practices to use in the preparation of financial statements, the committee should inquire into the impact that alternative choices would have had on reported results. The audit committee should review, at least annually, with the external auditor and with the chief financial officer or chief accounting officer, the corporation’s critical accounting policies and the major issues regarding, and any changes in, choices of accounting principles. In doing so, some audit committees find it useful to ask the external auditor to indicate to the committee what changes, if any, would have been made in the financial statements if the auditor, rather than management, had been responsible for preparing them.
|
|
As noted above, based on and relying upon these processes and reviews, the audit committee must determine whether to recommend inclusion of the audited financial statements in the corporation’s annual report on Form 10-K to be filed with the SEC.
|
|
Most large public companies have an internal audit function, and the New York Stock Exchange requires its listed companies to have an internal audit function. If an internal audit department exists, the audit committee should routinely meet, in private, with the senior internal auditing executive to discuss the relationship between the internal and external audit programs, to consider any special problems or issues that may have been encountered since their last meeting and to review the implementation of any recommended corrective actions. If the corporation does not have an internal audit function, the committee should consider with management and the external auditor whether such a function should be established and, if not, how the benefits and protections normally obtained from an internal audit function can otherwise be obtained. If the internal audit function has been delegated to an outside firm, the committee should meet with appropriate representatives of that firm on a regular basis, including meeting in executive session. The committee should also review the annual internal audit plan.
|
|
E. MEETINGS WITH AUDITORS
|
|
Most meetings with external and internal auditors should be conducted in the presence of the chief financial officer or chief accounting officer or other members of management responsible for financial affairs. However, as the New York Stock Exchange now requires, the audit committee should also meet periodically with the external auditor and the head of the internal audit staff, if one exists, in executive session without the participation of other management. Typically, in such private sessions, the auditors are asked whether: (i) there are any matters regarding the corporation and its financial affairs and records that make the auditors uncomfortable, (ii) the auditors have had any significant disagreement with management, (iii) the auditors have had full cooperation of management, (iv) reasonably effective accounting systems and controls are in place, (v) there are any material systems or controls that need strengthening and (vi) the corporation has competent and ethical finance and accounting management. Many committees find it useful in this context to have the external auditor describe the two or three issues that involved the most discussion with management during the course of the auditor’s work. Correspondingly, the committee may also meet privately with management to discuss the quality of service provided by the external and internal auditors.
|
|
The committee should also discuss with the external auditor and management the committee’s role in reviewing quarterly financial reports and the procedure by which the external auditor can raise with the committee or its chair reportable conditions that come to the attention of the external auditor during its audit work or during its mandated timely review of the quarterly financial statements.
|
|
F. MEETINGS WITH COMPLIANCE OFFICERS
|
|
The audit committee, unless there is another board committee responsible for such matters, should meet regularly with the officers responsible for implementing the corporation’s codes of ethics and compliance policies. When circumstances warrant, these officers should be afforded the opportunity to meet with the committee outside the presence of any other executive officer or any director who is not independent. In any event, the responsible officer should report to the committee periodically, and the scope and content of such reports should be designed to give the committee, on a timely basis, information about violations of law or corporate codes by senior managers, and the discipline imposed, as well as information that will allow the committee to monitor the effectiveness of the overall compliance program. In addition, the general counsel should meet regularly with the audit committee, or another committee of independent directors, to communicate concerns regarding legal compliance matters, including potential or ongoing material violations of law by the corporation and breaches of duty by senior managers. Some of these meetings should be in private sessions that will facilitate candid discussions between the committee and counsel.
|
|
G. IMPLEMENTING NEW DUTIES
|
|
Because the audit committee of a public company is now required to establish procedures whereby employees and others can report–in the case of employees, on an anonymous and confidential basis, if so desired–concerns or complaints about accounting, internal control and auditing matters, the question arises as to how the audit committee can most effectively and efficiently carry out this responsibility Audit committee members are usually not in the best position to conduct fact-finding or even to receive every complaint or concern in the first instance. Therefore, the committee should create, with management’s assistance, procedures necessary to ensure that information reaches the committee in a form, such as a summary or report, conducive to efficient review and resolution. The audit committee may decide to rely on existing employees or a special ethics or compliance officer to act as ombudsperson, or may decide to outsource this task to a third-party service provider.
|
|
In addition, under new federal requirements, lawyers for public companies (both internal and outside counsel) may, in some cases, be required to report to a committee of independent directors, or to the board, credible evidence that a material violation of securities laws or a breach of duty or similar violation by the issuer or any of its officers, directors, employees or agents has occurred, is occurring or is about to occur. Public companies may determine that the audit committee is the appropriate committee to receive any such reports. If so, the audit committee should have a process for receiving, considering and acting upon such reports, including a standing arrangement for the committee to obtain legal advice from outside counsel as to how to proceed.
|
|
While an audit committee will rely primarily, as a matter of necessity, on the corporation’s accounting, finance, treasury, internal audit and legal staffs, as well as the external auditor, for the information essential to the performance of its duties and responsibilities, the committee must have the authority to employ its own accountants, attorneys or other advisors from time to time. The Sarbanes-Oxley Act empowers the audit committees of public companies to engage advisors and requires the corporation to pay for such assistance. Some audit committees of public companies retain special legal counsel to advise them on a regular or occasional basis. Some commentators have even suggested that an audit committee should have its own staff separate and apart from the staff supporting the board of directors or management, but most committees have not found that necessary or appropriate.
|
|
H. MEETINGS AND COMPENSATION
|
|
The audit committee must address an expanded agenda on an ongoing basis. To deal effectively and efficiently with its obligations with respect to the quarterly financial reports, the annual audit plan, and the year-end financial statements and audit results, an audit committee should meet frequently. For large public companies, the time for filing quarterly reports with the SEC will be thirty-five days after the end of each quarter, and annual reports will be due within sixty days after year-end. Further, earnings releases (usually issued prior to those deadlines) must be furnished to the SEC in public filings, and New York Stock Exchange listing standards require audit committee review of earnings release practices. In these circumstances, it is increasingly common–and good practice for public company audit committees to have an in-person or telephone meeting with the company’s chief executive officer, senior financial managers and external auditor in advance of each quarterly or annual earnings release. In view of their increasing responsibilities, many audit committees now meet more frequently, scheduling meetings each time the board meets and holding additional audio or video conference meetings prior to each earnings release or other major financial announcement.
|
|
When the committee does meet, it is important that other board scheduling not limit the period of time for committee deliberations. Preparation for and participation in committee meetings will require significant commitments of time on the part of the committee members. In view of the time and attention needed for committee affairs, the board, or its compensation or nominating/corporate governance committee, may want to consider providing the chair of the audit committee, or other audit committee members, with a higher level of compensation than other board members. Some boards have done this, while others have determined that differential compensation among board members is unwise because it risks creating divisions within the board and makes rotation of committee assignments more difficult.
|
|
SECTION 7: THE COMPENSATION COMMITTEE
|
|
As executive compensation has become a topic of widespread public discussion and escalating shareholder concern, the role of the board’s compensation committee has received greater attention. A significant criticism of corporate governance in the past few years is the apparent lack of careful oversight by many compensation committees of executive compensation packages, both during the term of employment and at severance. Indeed, real abuses and perceived excesses in executive compensation at some notable public companies are responsible for many of the corporate governance reforms found in the Sarbanes-Oxley Act. Consequently, board compensation committee decisions are now subject to higher shareholder expectations, greater legislative regulatory and judicial scrutiny and intensified public attention.
|
|
The discussion of executive compensation has generally focused on four questions:
|
|
* Are the chief executive officer and the other senior executives appropriately, but not excessively, compensated?
|
|
* Is their compensation reasonably related to personal and corporate performance?
|
|
* Are severance and post-employment benefits properly related to corporate interests and reasonable in amount?
|
|
* Over time, are the compensation programs and policies attracting and retaining the best management for the corporation, and incentivizing the chief executive officer and other senior managers to build long-term value for shareholders?
|
|
The compensation committee is at the center of this discussion. When functioning responsibly, the committee addresses these critical issues and provides credibility and substance to the concept of independent and effective oversight of executive compensation.
|
|
The compensation committee should be composed solely of independent directors. The major securities markets generally require that compensation decisions for executive officers be made by independent directors, whether acting as a compensation committee or meeting in executive session. Insider relationships or interlocking compensation committee memberships are strongly discouraged, trigger additional proxy statement disclosures and may disqualify a director from being independent under securities market listing standards. In addition, the requirements of the federal tax laws for full deductibility of senior officer compensation and of SEC rules for avoiding short-swing profit recapture liability should be considered in determining compensation committee membership. Under the federal tax laws, decisions to pay any of the five most senior executives more than $1 million annually must be made by directors who meet a regulatory definition of “outside director” in order for the compensation to qualify for a full federal tax deduction. SEC rules exempt executive option grants from profit recapture only if the grant decisions are made by “non-employee directors,” as defined in those rules. Each of these terms is similar to, but not the same as, the “independent director” definitions in securities market listing standards. Consequently, prospective committee members should be reviewed against each of these standards.
|
|
Apart from legal considerations, independence from management gives credibility to the compensation committee’s key responsibility, which is to review compensation packages for executive officers on behalf of the corporation. With respect to the compensation for the chief executive officer, even where a director meets the independence requirements of the applicable market’s listing standards, if there are close personal or business ties between the director and the chief executive officer, the director may not be an appropriate choice for membership on the compensation committee. As with board membership generally, diverse backgrounds and experiences can be useful on a compensation committee.
|
|
While the chief executive officer will often meet with the compensation committee, the chief executive officer should not be present during all of its deliberations. The same is true of the corporation’s senior compensation or human resources executive. Both the reality and the appearance of independent oversight are important
|
|
The compensation committee should:
|
|
* review and approve corporate goals and objectives relevant to chief executive officer and senior executive compensation and evaluate their performance in light of those goals and objectives
|
|
* establish (or recommend to the board) the compensation and benefits of the chief executive officer and senior executives
|
|
* review all employment and consulting agreements with executive officers and directors
|
|
* establish and periodically review executive compensation programs and take steps to modify any executive compensation program that yields payments and benefits that are not reasonably related to executive and corporate performance or appear excessive in practice
|
|
* make recommendations to the board with respect to incentive compensation plans and equity-based plans generally
|
|
* establish and periodically review policies in the area of senior management perquisites
|
|
* if another committee does not do so, consider the form and amount of director compensation
|
|
* participate in preparing and be satisfied with the annual report on executive compensation included in the corporation’s proxy statement
|
|
* conduct an annual self-evaluation.
|
|
In fulfilling these functions, the compensation committee should recognize that compensation can play an important role in attracting, retaining and motivating the management talent that is critical to the corporation’s success. At the same time, the committee must be sensitive to the widespread concern that in some cases chief executive officers and other senior executives have been paid too much while employed or after their severance, especially when the corporations they lead have not been performing well.
|
|
The compensation committee should be guided by the basic principle that a significant portion of an executive’s compensation should be tied to the economic objectives and performance of the corporation. There should also be an appropriate balance between short-term pay and long-term incentives. Developing that balance, while correlating executive compensation to the corporation’s economic goals, is a challenging task. Many commentators now assert that stock options do not effectively motivate management to advance the best interests of the corporation because, prior to the exercise of the options, the optionee has limited downside risk. Moreover, stock options may lead management to focus unduly on short-term rises in stock prices. Consequently, many committees are refocusing their attention on restricted stock grants or options whose exercise price is indexed to corporate performance compared against market indices or a peer group, or that vest only when specified internal performance goals are met. Compensation committees are also requiring retention or holding periods for stock, whether granted or obtained on option exercise, in order to align executive pay more effectively with long-term performance.
|
|
The committee should also review the benefits and perquisites provided to senior executives, particularly when approving employment contracts. Important among these are benefits provided upon retirement or other termination of employment. There is widespread public concern that these benefits are not sufficiently related to job performance. In addition, committee members should be satisfied that they understand the interplay and potential outcomes of all compensation arrangements–fixed, incentive, benefits, perquisites, deferred compensation and severance–and scenarios, including change-of-control transactions, so that unintended and disproportionate benefits do not accrue to senior executives.
|
|
The structure and components of an executive compensation package will vary among industries and among companies. While benchmarking against peer companies is sometimes used as a tool to help determine executive compensation, the corporation should avoid simply matching or exceeding the compensation structure of a peer company. Company size, financial condition, industry characteristics, competitive factors, location and corporate culture are all relevant factors.
|
|
The proper design of a compensation program is just the starting point. Application of the program requires at least annual performance evaluations of the participating executives against pre-established performance targets (which may include comparison against the performance of comparable corporations), as well as ongoing review of the program’s effectiveness. The committee should keep the board informed of the results of these periodic reviews.
|
|
The compensation committee should become familiar with, and receive legal advice as to, legal restrictions on compensation to officers and directors. For public companies, the Sarbanes-Oxley Act prohibits most personal loans and extensions or arrangements of credit from the corporation to its directors and executive officers. In addition, if the corporation is required to prepare an accounting restatement due to material non-compliance, as a result of misconduct, with any financial reporting requirement under the securities laws, the Sarbanes-Oxley Act requires the chief executive officer and chief financial officer to reimburse the corporation for any bonus or other incentive- or equity-based compensation received during the twelve-month period following the first public issuance or filing with the SEC of the financial document that is subsequently restated. Any profits realized from the sale of securities of the corporation during this twelve-month period must also be paid over to the corporation.
|
|
Regardless of the requirements of the federal securities laws, in circumstances in which there has been a restatement indicating that the bases on which incentive-based compensation has been paid are no longer correct, the compensation committee or other independent directors should consider whether action should be taken to recover any such compensation on the basis of unjust enrichment. In addition, if the restatement has resulted from misconduct, the committee or other independent directors should consider whether action should be taken to discipline or dismiss, as well as to recover compensation paid to, any employee involved in the misconduct.
|
|
C. DISCLOSURE OF COMPENSATION DECISIONS
|
|
SEC proxy rules require a report from the compensation committee in the annual meeting proxy statement, describing the performance factors the committee relied on in determining the compensation of the chief executive officer, as well as discussing the committee’s general policies with respect to executive compensation. The committee members should participate in the report’s preparation and be satisfied with the final report, in view of the fact that the report is published over their individual names and sets forth the bases for their compensation decisions, which may be called into question if compensation arrangements are challenged.
|
|
The compensation committee should closely scrutinize the corporation’s policies relating to the disclosure of executive officer and director compensation. The committee should seek appropriate assurances from management and legal counsel that all disclosures required by law and by the applicable securities market are being made, and that rules related to shareholder approval of stock option plans and the reporting of trades in the corporation’s securities are being observed.
|
|
D. INDEPENDENT ADVICE FOR THE COMMITTEE
|
|
The compensation committee should be empowered to hire its own specialized legal and compensation advisors to assist in the evaluation of director, chief executive officer and senior executive compensation so that it need not rely solely upon corporate personnel or outside specialists selected by management for advice and guidance. The compensation committee should have full authority, set forth in its charter, to approve all advisors’ fees and other terms of engagement and should make clear that the advisors work for the compensation committee and not management. Any advisor should have direct access to the compensation committee without the presence of the chief executive officer or other senior executives.
|
|
E. OTHER RESPONSIBILITIES
|
|
Other responsibilities that the compensation committee may undertake include:
|
|
* reviewing and monitoring the effectiveness of employee pension, profit-sharing, 401(k) and other benefit plans, taking into account the importance of retaining and motivating the employees of the corporation, as well as the overall cost to the corporation of such programs
|
|
* if not done by the nominating/corporate governance committee, planning for senior executive development and succession
|
|
* if not done by the audit committee, reviewing policies or guidelines for expense reimbursements and perquisites provided to the chief executive officer and other senior executives
|
|
* reviewing management’s perquisites, such as use of corporate aircraft, housing, relocation and automobile allowances, and loans made or guaranteed by the corporation (although, as noted above, federal law prohibits most personal loans/guarantees to executive officers and directors).
|
|
SECTION 8: THE NOMINATING/CORPORATE GOVERNANCE COMMITTEE
|
|
The board committee known in the past as the “nominating committee” has been transformed into the “corporate governance committee” or the “nominating/ corporate governance committee” by an increasing number of public companies. The change in name reflects the expanded role of the committee to address corporate governance principles and practices, in addition to selecting director nominees and making committee assignments. Although some functions of a nominating/corporate governance committee are prescribed by the major securities markets’ listing standards, smaller public companies may prefer to combine these functions with those of other committees of independent directors, such as the compensation committee. The independence and quality of director nominees are critical to creating a board with a majority of independent directors and enhancing the effective functioning of the board.
|
|
A. COMMITTEE COMPOSITION AND OTHER REQUIREMENTS
|
|
The nominating/corporate governance committee should be composed solely of independent directors. In general, absent special circumstances, the Nasdaq Stock Market requires that director nominations be selected, or recommended for the board’s selection, either by an independent nominating/corporate governance committee or a majority of the independent directors acting in executive session. The New York Stock Exchange requires that each of its listed companies have a nominating/corporate governance committee composed entirely of independent directors, with a written charter that addresses the committee’s purpose to identify individuals qualified to become board members and to select, or to recommend that the board select, director nominees. The New York Stock Exchange also requires this committee to develop and recommend to the board a set of corporate governance principles applicable to the corporation.
|
|
B. CRITERIA FOR BOARD MEMBERSHIP
|
|
One of the most important functions of the nominating/corporate governance committee is to establish, or recommend to the board, criteria for identifying appropriate director candidates. The principal attributes of an effective corporate director include strength of character, an inquiring and independent mind, practical wisdom and mature judgment. In addition to these personal qualities, the committee may want to establish individual qualifications such as technical skills, career specialization or specific background experience. In recent years, public companies have added to their desired board profile gender and ethnic considerations, recognizing that diversity can contribute significant value in providing additional perspectives to board deliberations. The articles of incorporation or bylaws or board policies may include other qualifications for directors, such as age limitations or relevant background or experience.
|
|
In mounting a search for a new director, many committees construct a profile of skills and experiences that the board currently lacks or, in the view of the committee, needs to strengthen. Focusing on the strengths and weaknesses of the current board’s profile of directors has proven helpful in directing the search toward candidates who can provide needed additional talent and experience to the corporation.
|
|
Most corporate governance commentators recommend that a board of directors of a public company should be composed of a substantial majority of independent directors, and the major securities markets require a majority of independent directors, as defined by each market. In looking at the issue of independence, the committee should also bear in mind the broader judicial standard of disinterestedness that will be applied when conflict of interest matters are reviewed in court, and should therefore consider the full range of business and personal relationships between director candidates and the corporation and its senior managers.
|
|
Because it is important for the board to receive candid input from senior management, the committee should consider how best to effect appropriate access to management. Some nominating/corporate governance committees determine that senior officers of the corporation other than the chief executive officer should also serve as directors, whereas others decide that attendance at board meetings by senior officers in a non-director capacity is sufficient to facilitate the board’s ready access to information regarding the business and operations of the corporation. It is not unusual to use one or two board positions for senior executives other than the chief executive officer in order to evaluate their succession prospects and to facilitate a peer relationship and firsthand contact with them.
|
|
All boards should consider the desirability of some limiting principle on the length of director tenure to enable the board to gain fresh perspectives from new board members from time to time. Some public companies establish term limits and/or a mandatory retirement age for directors.
|
|
The principal nominating function of the nominating/corporate governance committee is to approve and select, or recommend that the board select, director nominees, including both incumbent directors and new candidates. The committee also recommends candidates to be elected by the board to fill an interim director vacancy.
|
|
Typically, the nominating function entails periodic review by the committee of the performance and the contributions of current directors as well as the need for, and qualifications of, prospective new directors. This review is a key element of good corporate governance because the board is likely to adopt the committee’s recommendations and, unless a contest is mounted, the majority of the shareholders’ votes is likely to be cast for the nominees put forward by the board.
|
|
All directors, including management directors, should be encouraged to suggest candidates for the board, but the committee should have the leading role in the final determination. There is a growing interest in having the nominating/ corporate governance committee be more responsive to shareholder recommendations for director nominees, and a committee may be wise to reach out to its major institutional investors and other shareholders for suggestions. The committee’s charter should give the committee the authority to retain and terminate any search firm to be used to identify director candidates, including the authority to approve the search firm’s fees and other retention terms. The non-executive chair, if there is one, as well as the lead or presiding director or nominating/ corporate governance committee chair, should be prominently involved in the recruiting process in order to reinforce the perception as well as the reality that the nominating decisions are being made by the committee, and not by the chief executive officer or other managers.
|
|
One of the criticisms often directed against corporate boards is that initial election (often by the board to fill a vacancy) is tantamount to an award of tenure until retirement. A thoughtful review by the committee of a director’s boardroom performance and the needs of the board, before deciding whether to recommend renomination, is the most effective mechanism to address this criticism. The committee should evaluate each director who is approaching the end of his or her term in light of that individual’s participation and contributions as well as the standards or criteria that have been developed for board membership and the needs of the board for certain types of background experience and expertise. It is the committee’s responsibility to determine, in each case, whether renomination of a director is appropriate. The committee may find it helpful to seek the views of the other directors. Considering the interpersonal relationships involved, such a review requires a procedure for director review that the board recognizes as fair and discreet.
|
|
D. RECOMMENDING COMMITTEE MEMBERS AND CHAIRS
|
|
In addition to nominating directors, the nominating/corporate governance committee will also often make recommendations to the board regarding the responsibilities, organization and membership of all board committees. The committee should recommend to the board the types and functions of board committees, together with the qualifications for membership on each committee. Consideration should be given to a policy of periodic rotation of committee memberships, and the responsibilities of chairing committees, among the directors. Because of the skills and background experience now required for audit committee members, a policy of rotation may be more difficult to implement for members of that committee.
|
|
E. CHIEF EXECUTIVE OFFICER AND OTHER MANAGEMENT
|
|
One of the most important decisions that a board makes is selecting a new chief executive officer and providing for succession plans so that the corporation does not suffer due to a vacancy, especially an unexpected one, in leadership. The nominating/corporate governance committee will often have the responsibility for recommending to the board a successor to the chief executive officer in the event of retirement or termination of service. The committee may also review and approve proposed changes in other senior management positions, with the understanding that the chief executive officer should be given considerable discretion in selecting and retaining members of the management team. In order to carry out these functions, the committee should–to the extent not done by another board committee–review the performance of the chief executive officer and members of senior management on a formal basis at least annually, and should periodically update succession planning and related procedures. The committee should also be sure that the corporation has in place emergency procedures for management succession in the event of the unexpected death, disability or departure of the chief executive officer and should review with the chief executive officer management’s plans for the replacement of other members of the senior management team.
|
|
F. OTHER CORPORATE GOVERNANCE FUNCTIONS
|
|
In addition to addressing director nomination or renomination, committee membership rosters and management evaluation and succession, the nominating/ corporate governance committee typically addresses some or all of the following tasks and issues:
|
|
* developing, recommending to the board and monitoring a statement of corporate governance principles or guidelines (now required of companies listed on the New York Stock Exchange)
|
|
* evaluating the effectiveness of the board and board committees
|
|
* evaluating the effectiveness of senior management
|
|
* providing for director education programs
|
|
* reviewing the board’s committee structure, including each committee’s charter and size as well as the possible addition of other committees, such as finance or public policy committees
|
|
* reviewing the corporation’s director policies, such as compensation, retirement, indemnification and insurance
|
|
* examining board meeting policies, such as meeting schedule and location, meeting agenda, the presence and participation of non-director senior executives and written materials distributed in advance of meetings.
|
|
As discussed earlier, a growing practice in U.S. public companies, which generally do not have a non-executive board chair, is to designate a non-management director as the presiding or lead director. The nominating/corporate governance committee should consider whether such a designation is appropriate for the board and, if it concludes that it is, should propose a candidate and a description of responsibilities to the board. In many cases, it will make sense to have the chair of the nominating/corporate governance committee act in this leadership role.
|
|
If the responsibility for director compensation is not given to the compensation committee, the nominating/corporate governance committee should address that issue periodically, applying the considerations outlined in Section 7 of this Guidebook.
|
|
I. DISCLOSING THE NOMINATING PROCESS
|
|
The SEC requires expanded disclosure in the proxy statement about the procedures and policies followed by the nominating/corporate governance committee in considering director candidates, including those proposed by shareholders. These disclosure requirements are intended to increase shareholder understanding of the nominating process. Accordingly, the nominating/corporate governance committee should review its procedures and policies to ensure that they fit the committee’s circumstances and operations and are sufficiently formalized to satisfy the scrutiny of public disclosure.
|
|
SECTION 9: OTHER OVERSIGHT ACTIVITIES
|
|
Boards of directors may undertake other oversight functions (often delegated to special committees of the board) that may include attention to the following categories of activity.
|
|
a. PHILANTHROPIC ACTIVITIES
|
|
A corporation may devote a reasonable amount of its resources to community support, public welfare, or charitable, scientific or educational purposes. It is appropriate that a program of charitable giving have a philosophy, purpose and budget and that it be rationally related to the corporation’s best interests.
|
|
Corporate officers and employees frequently participate actively in the governmental process on behalf of the corporation by seeking to influence legislative activities, shape regulations, or encourage or prevent government action. The actions and political positions taken are often highly visible and may affect the reputation of the corporation. Accordingly, they should be monitored by the board or one of its committees, and in the first instance, by legal counsel, for there are often regulatory implications. In addition, there are legal limitations and prohibitions on political contributions by corporations and individuals.
|
|
C. EMPLOYEE SAFETY, HEALTH AND ENVIRONMENTAL PROTECTION AND PRODUCT SAFETY
|
|
Corporate policies and practices with respect to employee safety, health and environmental protection, and product safety are not only matters of legal compliance but also involve concerns and values that go beyond obedience to law, such as business reputation and employee morale. Further, deficient programs or miscues (for example, a product recall) can significantly impact financial performance. In the case of many businesses, compliance with environmental standards, whether government-mandated or self-imposed, is particularly important, for violations can have a material financial impact, trigger state or federal civil or criminal investigations, and pose special problems of adequate public disclosure.
|
|
Workforce issues have become a matter of greater economic and public policy concern to corporations and hence to boards of directors. These include:
|
|
* codes of business conduct for employees, officers, and directors, which are required by the major securities markets for their listed companies
|
|
* laws and regulations protecting employees who report corporate misconduct from retaliation, including state laws and such federal laws as the Sarbanes-Oxley Act
|
|
* commitment of the corporation to equal opportunity and providing a workplace free of discrimination
|
|
* concerns of retired employees and future retirees, in particular, as to the administration of their pension and health benefits
|
|
* mechanisms for employees to report questionable accounting or auditing matters on an anonymous basis, as required by the Sarbanes-Oxley Act
|
|
* policies and procedures safeguarding the corporation’s intellectual property and, as a related matter, rules protecting against the unauthorized use by employees of intellectual property owned by others
|
|
* regulatory duties of plan fiduciaries (directors and others) under the Employee Retirement Income Security Act of 1974.
|
|
E. PUBLIC POLICY AND SOCIAL RESPONSIBILITY
|
|
An increasing number of corporations, especially corporations with a high international profile, have recognized the value to the corporation and its reputation of having policies and practices relating to the concept of global corporate citizenship, and some international organizations have promoted compacts or charters embodying such principles. These principles relate to such matters as ethics and integrity in corporate dealings, scientific integrity, employee health and safety, environmental practices, employment practices, board diversity, quality control, community investment and promotion of sustainable development and human rights in countries where the corporation does business. Some corporations give responsibility for oversight of these matters to a separate committee of the board, often styled as the public policy committee.
|
|
F. LEGAL AND CONTRACTUAL COMPLIANCE
|
|
In recent years, particular attention has been given to the board’s responsibility to oversee compliance with legal requirements. Many public companies assign such oversight to the audit committee, which meets regularly with the company’s internal general counsel or regular external corporate counsel to be briefed on legal compliance and claims. With the increased burdens placed on public company audit committees, some boards have elected to form a separate compliance or legal affairs committee. Irrespective of which board committee is charged with oversight of legal compliance, directors should ensure that a process is in place to encourage appropriate attention to legal compliance issues (including compliance with contractual obligations) and claims against the corporation, and the timely reporting of significant legal matters to the board or an appropriate board committee. For public companies, the Sarbanes-Oxley Act and the SEC’s lawyer conduct rules may require, in some circumstances, that legal counsel report evidence of material violations of the securities laws or fiduciary duty to a committee of independent directors or to the board. The board should consider the processes in place to satisfy these requirements and how it will address any such reports.
|
|
In recent years, many corporations have adopted and familiarized their boards with crisis management programs designed to organize the response to a corporate crisis, such as a natural disaster, terrorist activities or civil unrest. Such programs provide for back-up systems and records, employee safety and business operation procedures during the emergency. Some corporations develop crisis management programs for possible product defect, tampering or recall situations. Board-level participation in monitoring the development of such programs manifests the significant degree of the directors’ concerns and, at the same time, provides an objective review of management’s plans for response, lends credibility to the response and ensures that board members are kept appropriately informed.
|
|
SECTION 10: DUTIES UNDER THE FEDERAL SECURITIES LAWS
|
|
Federal and state laws regulate the disclosure practices and securities transactions of public companies and their directors, officers and employees. The federal securities laws are administered by the SEC and affect many aspects of the day-to-day operation of public companies. Violation of these laws can result in significant criminal and civil penalties, imposed not only on the corporation but also on directors individually. Directors need to be particularly attentive to their own, as well as the corporation’s, compliance with these laws. Review of programs and policies designed to maintain compliance with the federal securities laws, absent a legal compliance committee, is often delegated to the audit committee.
|
|
A. SEC REPORTING REQUIREMENTS
|
|
Federal law requires public companies to file periodic reports with the SEC, including an annual report on Form 10-K and quarterly reports on Form 10-Q. Reports on Form 8-K are also required for disclosure of quarterly earnings releases and a broad spectrum of other specified events and may also be used for voluntary disclosure of information. The SEC’s proxy rules require that the annual meeting proxy statement be accompanied or preceded by an annual report to shareholders. Many of these reports are required to include specified financial and other information.
|
|
The corporation’s annual report on Form 10-K, which contains the last fiscal year’s audited financial statements and mandated management comments on recent financial performance and important trends and uncertainties, is the most detailed of the required reports filed with the SEC and must be signed by a majority of the corporation’s directors. Separate and apart from the audit committee’s involvement, all directors should review and be satisfied with the corporate processes used to prepare the Form 10-K and understand the significant disclosures in that report
|
|
Directors are not expected to verify independently the accuracy of underlying facts contained in earnings releases or reports filed with the SEC. However, the audit committee and the board should be satisfied that there are disclosure controls and procedures in place reasonably designed to achieve the timeliness, accuracy and completeness of annual and quarterly reports as well as all other reports and public releases. In addition, the chief executive officer and chief financial officer of public companies are required by the Sarbanes-Oxley Act to review and, based on their knowledge, certify the material accuracy and completeness of quarterly and annual reports. Quarterly assessments of disclosure controls and procedures and annual assessments of internal control over financial reporting are also required. Audit committee members of public companies should be familiar with these certifications and assessments and the procedures undertaken to support them
|
|
The SEC’s Regulation FD (for fair disclosure) provides that material information about a public company may not be disclosed on a selective basis by the corporation or its agents to marketplace participants, such as analysts, brokers, investment advisors and shareholders who may act on the information. Rather, the corporation must take steps to disseminate such information in a manner that makes it broadly available to all members of the public at the same time. Violations of this regulation have resulted in SEC enforcement actions and fines against public companies and corporate officers. Regulation FD has caused public companies to adopt more restrictive policies regarding the persons who are authorized to communicate with securities analysts and others. Directors should be careful not to disclose non-public information about the corporation and its business.
|
|
Many public companies have established specific policies and procedures dealing with insider trading and communications. These programs are designed to ensure that the corporation makes complete, accurate and timely disclosure of material information, complies with disclosure requirements and satisfies other securities law obligations. These programs also help directors and other insiders to comply with insider trading and other applicable laws and the corporation to meet its obligations under Regulation FD to avoid improper selective disclosure of material information. The audit committee (or the legal compliance committee, if there is one) generally should monitor the establishment and operation of such compliance programs.
|
|
The federal securities laws prohibit corporate insiders, including directors, and the corporation itself from purchasing or selling securities, either in the open market or in private transactions, when they possess undisclosed material information about the corporation. The corporation or an insider in possession of such information may not trade until the information is publicly disseminated. The federal securities laws also prohibit insiders from revealing material, non-public information concerning the corporation, or giving a recommendation to buy or sell based upon such information, to others who trade on the basis of such information. As a general rule, the federal securities laws also prohibit the recipient of a tip from acting on material, non-public information obtained from a corporate source. Under the SEC’s Rule 1065-1, directors (and officers) can mitigate the risk of insider trading liability by adopting plans in advance for scheduled sales and purchases of the corporation’s securities.
|
|
Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy, sell or hold a security. Some believe that information may be considered material if, upon disclosure, it would likely affect the stock price. If there is any doubt whether undisclosed information is material, legal guidance should be sought or, as a practical alternative, the information should be treated as material.
|
|
Violation of these insider trading laws triggers strict sanctions. The SEC has an aggressive program of discovering and proceeding against insider trading violations. The violator is liable for any profit made or loss avoided. In addition, a court can assess a penalty against the trader, the tipper or the tippee of treble damages–three times the profits made or losses avoided–and criminal sanctions are also available. The Sarbanes-Oxley Act gives the SEC the power to prohibit any individual from serving as an officer or director of any public company if the individual has violated the antifraud or insider trading laws and demonstrates unfitness to serve as an officer or director. The SEC also has the authority to award informants who report a violation up to ten percent of the amount of the penalty recovered.
|
|
Many public companies have developed procedures requiring senior executives and directors to contact corporate counsel, the corporate secretary or another designated person before trading in the corporation’s securities so that any proposed transaction can be reviewed in the light of the current state of public information. The growing corporate practice is to require that all trades by senior officers and directors be cleared in advance by the corporate general counsel or another designated person. Many public companies have established corporate policies prohibiting insiders and their affiliates from trading in the corporation’s securities during specified “blackout” periods. The board of directors (directly or through its audit or legal compliance committee) should periodically review corporate information and insider trading policies and procedures in view of Regulation FD and insider trading prohibitions.
|
|
Directors, executive officers and large shareholders of public companies must report to the SEC all of their holdings of, and transactions in, the corporation’s equity securities and must disgorge to the corporation any profits realized from buying and selling, or selling and buying, such securities within any six-month period. When a person first becomes an insider (a director, executive officer or more-than-ten-percent shareholder), a report of beneficial ownership of the corporation’s equity securities must be filed on Form 3. Thereafter, whenever there is a change in that beneficial ownership, a report on Form 4 must be filed electronically within two business days. Annual reports on Form 5 are also required in some cases. These reports must be electronically flied on a timely basis with the SEC. Any delinquency in making such filings must be disclosed in the corporation’s annual meeting proxy statement, and civil monetary fines can be imposed for filing delinquencies. An insider is normally deemed to be the owner of securities that are owned by a spouse or child living at home, and may also be deemed to be the owner of securities held in a trust of which the insider is a trustee, settlor or beneficiary or of securities owned by a corporation controlled by the insider.
|
|
Profit disgorgement is required if an insider purchased the corporation’s securities within six months before selling its securities and vice versa (i.e., sales within six months before buying). Any “profit”–measured as the difference between the prices of any two “matchable” transactions during the six-month period (i.e., the highest-priced sale and the lowest-priced purchase)–must be paid over to the corporation. The requirement is intentionally arbitrary and, subject to tightly defined regulatory exemptions, applies to all transactions within any six-month period regardless of whether the individual had inside information or, in fact, made a profit on an overall basis. This provision is aggressively enforced by the plaintiffs’ bar, which monitors SEC filings.
|
|
Some transactions, such as the grant and exercise of stock options and the acquisition of securities under employee benefit plans, may be exempt from the purchase and sale triggers of the short-swing profit rules if procedural requirements established by SEC regulations have been satisfied. Absent an exemption, the receipt of an option, the acquisition of securities through a benefit plan or the acquisition of a derivative security related to the value of the corporation’s common stock normally will be considered to be a purchase of the underlying security and could give rise to accountability In addition, other indirect changes in ownership, such as reclassifications, intracompany transactions, pledges and mergers, may also be considered a purchase or sale transaction for purposes of the short-swing profit rules.
|
|
A retiring director may be subject to profit recovery based on transactions occurring even after the director departs. Thus, if a director purchases shares of the corporation, resigns and sells shares within six mouths after the purchase, liability may be imposed for any short-swing profit even though the individual is no longer a director at the time of the sale. In short, unexpected liability may result from the application of the short-swing profit rules.
|
|
Directors, officers and more-than-ten-percent shareholders also are prohibited from selling the corporation’s shares short
|
|
This regulatory regime is highly technical. Legal counsel should be consulted before committing to a transaction in the corporation’s securities or in options or other derivatives geared to its securities.
|
|
F. SALES BY CONTROLLING PERSONS
|
|
Unless an exemption is available, the federal securities laws generally require registration with the SEC of the corporation’s securities by controlling persons before they may be offered or sold to the public. (Who is a controlling person is a sophisticated question of law and fact as to which legal guidance is advisable
|
|
G. REGISTRATION STATEMENTS
|
|
Directors should take diligent steps to assure the accuracy of their corporation’s registration statements filed with the SEC in connection with any offering (including in a merger or acquisition) of the corporation’s securities to the public. Whether or not a director signs the registration statement, the director is liable for any material inaccuracy or omission in the registration statement, including information incorporated by reference from other filed documents, unless the director establishes that, after diligent steps, the director was not aware of the inaccuracy or omission.
|
|
The director’s primary defense to registration statement liability is due diligence. To establish this defense, the director must show that, after reasonable investigation, the director had reasonable grounds to believe, and did believe, that the registration statement did not contain any materially false or misleading statements or any material omissions that made the registration statement misleading. Actions required by the director to satisfy the due diligence standard will vary with the circumstances. During the registration process, directors are well advised to satisfy themselves that the corporation has developed and utilizes appropriate corporate disclosure controls and procedures reasonably calculated to ensure the registration statement’s accuracy and completeness. Although all registration statements should be prepared with appropriate care, certain registered offerings may have a higher potential for liability, such as an initial public offering, a follow-on equity offering or a financing or reorganization of a public company that has experienced problems. Accordingly, the filing of registration statements for such offerings should ordinarily be preceded by a board meeting or meetings with counsel, accountants and management present at which there is discussion of the disclosures in the registration statement. Each director also should personally review the document for accuracy, with particular attention to those statements and disclosures in the registration statement that are within the director’s knowledge and competence.
|
|
Federal law requires that public companies soliciting proxies for shareholder votes on the election of directors or other matters furnish each shareholder with a proxy statement. Where actions other than election of directors or other routine business are to be taken, a draft must be filed with, and typically will be reviewed and cleared by, the SEC. In other cases, only the final proxy statement, as mailed, is filed with the SEC. Directors should be attentive to the procedures followed in preparing the corporation’s proxy statements. It is good practice for every director to review a reasonably close-to-final draft of a proxy statement before it is mailed or flied with the SEC, particularly those sections that deal with matters about which the director has personal knowledge or contain a report of a committee on which the director serves.
|
|
I. DIRECTORS OF FOREIGN CORPORATIONS WITH SECURITIES TRADED IN THE UNITED STATES
|
|
A large number of non-U.S. corporations from almost sixty countries file reports with the SEC because their securities are traded on U.S. securities markets. Traditionally, the federal securities laws have required these “foreign private issuers” to file annual reports and other material information distributed to their shareholders with the SEC, but have not otherwise sought to regulate their corporate governance and other internal practices.
|
|
The Sarbanes-Oxley Act’s reporting and corporate governance requirements generally apply to non-U.S. corporations that have securities registered with the SEC. The SEC, in adopting rules under the Sarbanes-Oxley Act, has considered the concerns of foreign private issuers and made some rules inapplicable to them or included special provisions addressing their concerns. Directors of foreign private issuers should be aware of the general categories of substantive U.S. corporate governance requirements that may apply to their corporations.
|
|
SECTION 11: LIABILITIES AND INDEMNIFICATION
|
|
Directors may incur personal liability for breaches of their duty of care or duty of loyalty or for failure to satisfy other applicable legal requirements such as the federal securities laws.
|
|
The Model Act provides that directors have met their duty of care to the corporation if the directors, acting in good faith, discharge their responsibilities with an informed judgment, with the measure of care that a person in a like position would reasonably believe appropriate under similar circumstances, and in a manner they reasonably believe to be in the best interests of the corporation. Courts have not often sustained damage awards against directors for breach of this duty of care but have indicated that they may impose liability for gross negligence or obvious or prolonged failure to participate diligently or to exercise oversight and supervision. Recent decisions of the Delaware Chancery and Supreme Courts, as well as increased public awareness of and sensitivity to corporate governance issues, underscore the need for directors to take an active, rather than a passive, role in meeting their duty of care if liability is to be avoided.
|
|
As discussed earlier in this Guidebook, state courts have also imposed a duty of disclosure among directors themselves and to shareholders as to material facts within directors’ knowledge.
|
|
In transactions in which a director has a conflicting personal interest, extra precautions must be taken to avoid improper self-dealing and to satisfy the applicable legal requirements. The Model Act and most state corporate statutes prescribe procedures that may be followed to obtain approval, authorization or ratification of interested director transactions. The scope of protection gained from following these statutory procedures varies from state to state.
|
|
In addition to liability for breach of duties, directors can also be liable for authorizing unlawful dividends or other distributions. The distributions that are unlawful and give rise to director liability vary from state to state. Generally speaking, unlawful distributions are those causing, or made during, insolvency or those violating applicable laws or prohibited by the corporation’s articles of incorporation.
|
|
B. FEDERAL SECURITIES LAW LIABILITY
|
|
As discussed in the preceding section, directors can be personally liable under the federal securities laws, in some cases even where they act in good faith. In certain circumstances, negligence will by itself be sufficient to establish liability. In other situations, liability will be imposed without a finding of fault or intent to deceive, subject only to due diligence or other defenses.
|
|
C. LIABILITY UNDER OTHER LAWS
|
|
Directors also can be subject to personal liability under other state and federal statutes, such as environmental laws. Good faith and careful monitoring of management programs directed toward corporate legal compliance should provide substantial safeguards against personal liability
|
|
D. LIMITATION OF LIABILITY
|
|
The Model Act and a majority of state corporation statutes permit the shareholders to authorize a provision that will eliminate or limit the liability of directors to the corporation or its shareholders for money damages for breaches of certain duties, most frequently the duty of care (at least if that duty has not been so disregarded as to bring into question the director’s good faith). For instance, the Model Act permits, with shareholder approval, inclusion of a provision in the articles of incorporation eliminating or limiting directors’ personal liability for money damages, except liability for the receipt of a financial benefit to which the director is not entitled, the intentional infliction of harm on the corporation, an unlawful distribution or an intentional violation of criminal law. Some state statutes have additional exceptions. Protection from liability generally applies only to monetary liabilities to the corporation and its shareholders and not to injunctive relief or to liabilities to third parties, and these exculpatory provisions may not be effective to protect a director from liabilities created by violating federal law.
|
|
The Model Act and most state corporation statutes specify the circumstances in which the corporation is required or permitted to indemnify directors against liability and related reasonable expenses incurred in connection with their service as directors. The Model Act provides that indemnification for reasonable expenses (including court costs and attorneys’ fees) is mandatory if the director has been wholly successful in the defense of any action, on the merits or otherwise. Indemnification is not mandatory if the director is not wholly successful.
|
|
The Model Act’s generally applicable standard for permissible indemnification is that the individual director must have acted in good faith and with a reasonable belief that his or her conduct was in the best interests of the corporation. In the case of criminal proceedings, the director must also have had no reasonable cause to believe his or her conduct was unlawful. The Model Act provisions, which have been adopted in substance by many states, give corporations the power to indemnify directors in actions by third parties, including class actions, for expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement of the actions. In derivative actions brought in the name of the corporation itself, indemnification is allowed for expenses (including attorneys’ fees), but if a director is found liable, indemnification is allowed only with court approval. Further, the Model Act provides that amounts paid in settlement of a derivative action may be indemnified if approved by a court. In the case of settlements or certain adverse court determinations in third-party actions, indemnification is permitted if authorized by the court or upon a determination by a majority of directors not involved in the action, by the shareholders or by independent legal counsel that the director met the applicable standard of conduct.
|
|
Many corporations have charter or bylaw provisions mandating indemnification whenever it is legally permissible, and some corporations have also entered into indemnification contracts with their directors to provide mandatory indemnification to the fullest extent the applicable statute permits. The advantage of an indemnification contract is that it cannot be rescinded without the consent of the director, whereas a charter or bylaw provision may be subject to amendment, although typically the amendment will not be applied retroactively Recent court decisions make it advisable to specifically obligate the corporation, by contract or bylaw provision, to reimburse directors for reasonable costs incurred in enforcing the indemnification to which they are entitled.
|
|
The Model Act and most state corporation statutes permit the corporation to advance funds to directors to pay or reimburse reasonable expenses incurred by them in defense of a matter prior to the final disposition of the proceeding and before final determination of their right to indemnification for those expenses. Directors generally must provide the corporation with an undertaking to repay any funds advanced by the corporation if it is ultimately determined that they are not entitled to indemnification. As a general rule, advances for expenses are discretionary and made on a case-by-case basis upon authorization of the board of directors, unless, as is often the case, mandatory advances are required by the articles of incorporation, bylaws or contract. Provisions mandating indemnification, without making reference to advances, may be construed judicially as not also mandating advances
|
|
Most corporations purchase directors’ and officers’ liability insurance covering (i) the corporation for any payment of indemnification and advance of expenses and (ii) directors and officers, if the corporation is unwilling to pay (perhaps because of a change in control) or is unable to pay (perhaps because of insolvency or because the claim is one where indemnification or advance is not authorized under state corporate law but is permitted to be covered by insurance) amounts required by its indemnification and expense advance obligations. The Model Act and the relevant statutes of most jurisdictions permit the corporation to pay the premiums for this insurance. Because of recent uncertainty regarding the ability of directors and officers to access policies that also cover the corporation, some corporations have been exploring alternatives for coverage.
|
|
Certain areas of activity, such as environmental, employee benefit or antitrust matters, are often excluded from coverage. Conditions in existence at the time application for the insurance is made also may be excepted. Directors’ and officers’ insurance provides uncertain coverage in the case of punitive damages and generally excludes coverage for fraud and criminal penalties and fines.
|
|
It is important to recognize that coverage is not available in every case. Most policies are written on a “claims made” (as compared to an “occurrence”) basis, covering only defined claims against directors during a specified period. In addition, the terms of coverage are very complex and can vary greatly from insurer to insurer, and the coverage provided under policy language differs. Insurance markets change rapidly, and insurers may assert numerous reservations or defenses when claims are made. Therefore, directors are well advised to obtain an analysis of coverage from experts, who can also provide knowledgeable insight respecting current market conditions. As with every insurance policy, care must also be taken in completing policy applications and questionnaires.
|
|
As discussed throughout this Guidebook, the legal requirements and constituency expectations that public company directors must address have changed significantly since 2001. Despite these changes, the core values associated with the corporate director’s role–good faith, general oversight, informed judgment and dedication to the corporation’s best interests–continue to be the touchstone for evaluating all directors’ conduct.
|
|
In that vein, we conclude with these basic points:
|
|
* A director must exercise independent judgment for the overall benefit of the corporation.
|
|
* To meet the duty of care, a director must be diligent and invest significant amounts of time and energy in monitoring management’s conduct of the business and compliance with the corporation’s operating and administrative procedures.
|
|
* When making boardroom decisions, a director should be comfortable that he or she is appropriately informed and has had the time to deliberate carefully
|
|
* A director is entitled to rely on performance by others of properly delegated functions and on reports, opinions, information and statements of the corporation’s officers, legal counsel, accountants, employees and committees of the board on which the director does not serve, when under the circumstances it is reasonable to do so.
|
|
* The duty of loyalty requires that a director not use her or his corporate position for an unauthorized personal benefit, gain or other advantage at the expense of the corporation.
|
|
* Conflicts of interest (including corporate opportunity situations and a director’s transactions with the corporation) are not inherently improper. Although such transactions were once void or voidable under common law without further consideration, corporation statutes provide procedures under which they may be properly disclosed and dealt with. It is the manner in which an interested director and the board deal with a conflict situation that determines the propriety of the transaction and the director’s conduct.
|
|
* The Sarbanes-Oxley Act and the revised listing standards of the major securities markets have added specific requirements for board and committee oversight, particularly in the case of the audit committee, and have significantly raised expectations that the corporation’s corporate governance practices are effective.
|
|
* A periodic review of indemnification, expense advance and insurance protections for directors is advisable.
|
|
* Directors who act within the framework of conduct outlined in this Guidebook will be performing their director functions conscientiously, thereby reducing the risk of being found liable for deficient individual performance as a director.
|
|
* This Guidebook should not be viewed as a substitute for legal consultation and advice.
|
|
APPENDIX: ONLINE RESOURCES ON CORPORATE GOVERNANCE
|
|
AFL-CIO Executive Paywatch http://www.aflcio.org/corporateamerica/paywatch
|
|
American Bar Association, Section of Business Law http://www.abanet.org/buslaw/home.html
|
|
Committee on Corporate Governance http://www.buslaw.org/cgi-bin/controlpanel.cgi?committee=CL260000
|
|
Committee on Corporate Laws http://wwwc.buslaw.org/cgi-bin/controlpanel.cgi?committee=CL270000
|
|
Committee on Federal Regulation of Securities http://www.buslaw.org/cgi-bin/controlpanel.cgi?committee=CL410000
|
|
American Bar Association Presidential Task Force on Corporate Responsibility http://www.abanet.org/buslaw/corporateresponsibility
|
|
American Society of Corporate Secretaries http://www.ascs.org
|
|
Association of Corporate Counsel http://www.acca.com
|
|
The Business Roundtable http://www.brt.org
|
|
CATO Institute: Corporate Governance http://www.cato.org/current/corporate-governance/index.html
|
|
The Conference Board http://www.conference-board.org
|
|
Corporate Governance Network http://www.corpgov.net
|
|
The Corporate Library http://www.thecorporatelibrary.com
|
|
Council of Institutional Investors http://www.cii.org
|
|
Institutional Shareholder Services http://www.issproxy.com
|
|
Investor Responsibility Research Center http://www.irrc.org
|
|
NASDAQ Stock Market, Inc. http://www.nasdaq.com
|
|
National Association of Corporate Directors http://www.nacdonline.org
|
|
New York Stock Exchange http://www.nyse.com
|
|
U.S. Securities and Exchange Commission http://www.sec.gov
|
|
Asian Corporate Governance Association http://www.acga-asia.org/index.cfm
|
|
Berlin Center of Corporate Governance http://www.bccg.tu-berlin.de
|
|
Bourse (Paris) http://www.bourse-paris.net
|
|
Corporate Governance Japan http://www.rieti.go.jp/cgi/en/index.htm
|
|
European Commission–Company Law 6r Corporate Governance http://europa.eu.int/comm/internal_market/company/index_en.htm
|
|
European Corporate Governance Institute http://www.ecgi.org
|
|
Federal Commission for the Securities Market (Russia) http://www.fcsm.ru
|
|
Global Corporate Governance Forum http://www.gcgf.org
|
|
Gruppe Deutsche Borse http://www.exchange.de
|
|
Institute for International Corporate Governance & Accountability (George Washington University Law School) http://128.164.132.19/iicga
|
|
Institute of Chartered Secretaries and Administrators (United Kingdom) http://www.icsa.org.uk
|
|
Institute of Directors (United Kingdom) http://www.iod.co.uk
|
|
Institute of Directors in Southern Africa http://www.iodsa.co.za
|
|
International Corporate Governance Network http://www.icgn.org
|
|
The International Institute for Corporate Governance (Yale School of Management) http://iicg.som.yale.edu/index.shtml
|
|
Johannesburg Stock Exchange http://www.jse.co.za
|
|
London Stock Exchange http://www.londonstockexchange.com
|
|
Organisation for Economic Co-operation and Development http://www.oecd.org
|
|
Proxinvest (France) http://www.proxinvest.com
|
|
Tokyo Stock Exchange http://www.tse.or:jp (Japanese) http://www.tse.or.jpenglish/index.shmtl (English)
|
|
VIP-Association of Institutional Shareholders http://www.vip-cg.com
|
|
World Bank Corporate Governance http://www.worldbank.org/html/fpd/privatesector/cg
|
|
To order copies of the Corporate Director’s Guidebook, Fourth Edition (Product Code 5070440), contact the American Bar Association at service@abanet.org, 800/285-2221 or order online at www.ababooks.org.
|
|
