Corporate Governance

Chapter 2:
Legal Obligations of Board of Directors

Resource person: Ms. Rabia Aziz

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Objectives of the Session

• Examine the duties and liabilities that come with directorship.

• Overview of the role of the board and the requirement for independence.
• Review the basic operations of the board. This includes evaluating the
process by which topics are selected, deliberated, and decided.
• Review the process by which directors are elected and removed.
• Examine the legal responsibilities that come with directorship and
• Consider the potential liability directors face when they fail to uphold their
duties.
• Review the Basic Board Models
• Board Committees

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Types of Directors

• Executive Directors
• Non Executive Directors
• Independent Directors

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 Types of Directors

An executive director is a member of the board of directors and an employee of the company. He/she

will have a specific role such as finance director and as such be responsible for the day to day running

of the company within his sphere. 

A non executive director is a member of the board who is not an employee but appointed for his/her

expertise and takes a part in decision making at board meetings. Sometimes non executive directors

may get involved in such things as disciplinary hearings, especially for high ranking employees.

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 Types of Directors

A non executive director is considered as an independent director if he/she fulfill some criteria’s

among other things:

- they are not a substantial shareholder of the company 

-they are not a material supplier or customer of the company, or an officer of a company that is a

material supplier or customer -they do not have any material contractual (or business) relationship

with the company, its executives, management team, auditors or other directors 

-they are free from any business or personal relationship which could, or could reasonably be

perceived to, interfere with their ability to carry out their duty to act in the best interest of the

company 

-their immediate family members do not have material ownership or business interests in/with the 5
 Role of the Board of Directors

The board of directors is ultimately responsible for the company’s business affairs and governance as

stated in its governing documents, including the articles of incorporation, the by laws, and

shareholder agreements.
Many
OECD state lawsout
lays require a corporation
a vision to form a board of of
of the responsibilities directors to represent shareholders and make
the board:
The corporate governance framework should ensure the strategic guidance of the
decisions on their behalf.
company, the effective monitoring of management by the board, and the board’s
accountability to the company and the shareholders

The success of the board of directors depends on the composition, structure, resources, diligence, and

authority of the entire board, as well as their working relationships with other participants of

corporate governance, including management, external auditors, internal auditors, legal counsel,

professional advisors, regulators, standard-setting bodies, and investors. 6

 Roles and responsibilities of boards
of directors are to:

1) Represent shareholders and create shareholder value.

2) Align the interests of management with those of shareholders while protecting the interests of

other stakeholders (customers, creditors, suppliers).

3)Define the company’s mission and goals.

4) Establish or approve strategic plans and decisions to achieve these goals.

5) Appoint senior executives to manage the company in accordance with the established strategies,

plans, policies, and procedures.

6) Oversee the company’s performance by setting objectives, establishing short-term and long-term

strategies to achieve these objectives, and assessing the performance of senior executives in fulfilling
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 Roles and responsibilities of boards
of directors are to:

7) Approve major business transactions and corporate plans, decisions, and actions according to the

bylaws.
8) Develop and approve executive compensation, pension, post-retirement benefits plan, and other

long-term benefits, including stock ownership and stock options.

9) Review financial reports, including audited annual financial statements, quarterly reviewed

financial statements, and other important financial disclosures such as management discussion and

analysis (MD&A) earnings releases and reports filed with regulators (SEC) or disseminated to the

10) Review management’s report on the effectiveness of internal control over financial reporting.
public.

11) Provide counsel to the company’s senior executives, especially the CEO, on material strategic

decisions and risk management. 8

 Roles and responsibilities of boards
of directors are to:

12) Ensure the company’s compliance with applicable laws, rules, and regulations.

13) Approve the company’s major operating, investing, and financial activities.

14) Set the tone at the top by promoting legal and ethical conduct throughout the company.

15) Evaluate the performance of the board, its committees (e.g., audit, compensation, and

nominating), and the members of each committee.

16) Hold the board, its committees, and directors accountable for the fulfillment of the assigned

fiduciary duties and oversight functions.

17) Approve dividends, financing, capital changes, and other extraordinary corporate matters.

18) Oversee the sustainability of the company in creating long-term shareholder value and protecting 9
 Fiduciary Duties of Board of
Directors

Fiduciary duty means that, as shareholders’ guardians, directors must be trustworthy, acting in the

best interest of shareholders, and investors in turn have confidence in the directors’ actions.

The corporate governance literature presents the following fiduciary duties of boards of directors:
- Duty of due care
- Duty of loyalty
- Duty of Good Faith
- Duty to Promote Success
- Duty to Exercise Diligence, Independent Judgment, and Skill
- Duty to Avoid Conflict of Interests 10
 Fiduciary Duties of Board of
Directors

Duty of Due Care - determines the manner in which directors should carry out their responsibilities.

Failure to uphold the set stipulations may constitute a breach of the fiduciary duty of care of expected

directors.
Duty of loyalty - requires directors to refrain from pursuing their own interests over the interests of

the company. Breach of loyalty can occur even in the absence of conflicts of interest if directors

consciously disregard their duties to the company and its shareowners.

Duty of Good Faith – Its an important of directors fiduciary obligations, and any irresponsible,

reckless, irrational or disingenuous behaviors or conduct can breach that fiduciary duty.

Duty to promote success – directors should act in a good faith and promote the success of the

company to benefit of its shareholders and other stakeholders. Includes: approving the establishment

of strategic goals, objectives and policies that promote enduring shareholders value as well as protect11
 Fiduciary Duties of Board of
Directors

Duty to exercise due diligence, independent judgment, and skill - directors should be knowledgeable

about the companies’ business and affairs, continuously update their understanding of the company

activities and performance, and use reasonable diligence and independent judgment in making

Duty to avoid conflicts of interests - potential conflict of interest may occur when director receives a
decisions.

gift from a third party he is doing business with, either directly or indirectly enters into a transaction

or arrangement with that company, obtains substantial loans from the company, or engages in

backdated stock options.

Fiduciary Duties and Business Judgment Rules - directors operate under a legal doctrine called

“business judgment rules”. Under that law directors that make decisions in good faith, based on

rational reasoning, and an informed manner can be protected from liability to the company’s

shareholders in the ground that they appropriately fulfilled their fiduciary duty of care. 12
Board Models
Board Models

One-Tier Board Model - consists of both inside (executive) directors and outside (nonexecutive)

directors. Inside directors are perceived as the decision managers and outside directors are assumed to

have the power and duty to monitor those decisions.

Two-Tier Board Model - The two-tier board system, consisting of a supervisory board and a

management board, better known as the German board model, establishes different authorities and

responsibilities for members of each board.

Modern Board Model - the structure of the modern board based on the two components of strategic

board and oversight board is the natural offshoot of the emerging corporate governance reforms.

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 Board Characteristics

Board Leadership – The effectiveness of board meetings depends largely on the leadership ability of

the chairperson to set an agenda and direct discussions. The board agenda is usually prepared by

chairperson in collaboration with the CEO.

CEO Duality – implies that the company’s CEO holds both the position of chief executive and the

chair of the board of directors. There are pros and cons of this model, but investors usually prefer to

separate the positions. If they don’t, then it is preferable that the company’s board consists of a

‘substantial’
Lead Directormajority of independent
– demand for Lead directors.
Director increased because of the presence of CEO duality,

resulting from growing concern that duality places too much power in the hands of CEO, which may

impede board independence.

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 Board Characteristics

Board Composition – in terms of ratio of inside and outside directors, and the number of directors

influence the effectiveness of the board. A board size of nine to fifteen is considered to be adequately

tailored to the number of board standing committees.

Board Authority – is granted trough shareholder elections. SOX substantially expanded the authority

of directors, particularly audit committee members, as being directly responsible for hiring, firing,

compensating, and overseeing the work of the companies’ independent auditors.

Responsibilities – the primary responsibility of the board of directors that the companies assets are

safeguarded and that managerial decisions and actions are made in a manner of maximizing

shareholders wealth while protecting the interests of other shareholders.

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 Board Characteristics

Resources – board of directors should have adequate resources to effectively fulfill its oversight

functions. Resources available to the board consist of legal, financial, and information resources.

Board Independence – implies that, to be independent director shouldn’t have any relationship with

the company other than his or her directorship that my compromise the director’s objectivity and

loyalty to the companies shareholders.

Director compensation – best practices suggest that increases in stock ownership, reduction in cash

payments, and charges in compensation should be aligned with shareholders long-term interest

determined by board, approved by shareholders, and fully disclosed in public reporting.

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 Board Committees
• Board committees normally function independently from each other, are
provided with sufficient resources and authority, and are evaluated by the
board of directors.

• THUS board committees are a subset of the board and perform specific
functions that assist the board in discharging its advisory and oversight
responsibilities.
• Public companies usually have the following board committees:

• • Audit committee
• • Compensation committee
• • Governance committee
• • Nominating committee
• • Disclosure committee
• • Other standing or special committees 18
Board Committees

Audit Committee – composed of at least three independent directors; should be formed to implement

and support the oversight function of the board, specifically in the areas related to the internal

controls, risk management, financial reporting, and audit function.

Compensation Committee – composed of at least three independent directors; serves to design,

review, and implement ‘directors’ and ‘executives’ compensation plans.

Governance Committee - consist of both executives and nonexecutives directors; should be

established to advise, review, and approve management strategic plans, decisions, and actions in

effectively managing the company.

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Board Committees

Nominating committee – composed of at least three independent directors; should be formed to

monitor issues pertaining to the recommendations, nominations and elections activities of directors.

Disclosure committees – this committee is usually led by corporate counsel, CFO’s, or controllers. It

is responsible for reviewing and monitoring the company’s SEC fillings, earning releases, materiality

issues, conference call scripts, and presentations to the investors by senior management.

Special committee – the board of directors may form a special committee to assist the board in

carrying out its strategic and oversight function, including financing, budgeting, investment, mergers

and acquisitions.

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 Board independence

Independence is critical in that , it ensures that directors are able to take positions
in opposition to those of management when necessary

From a regulatory standpoint, independence is evaluated by the degree to which a

director is free from conflicts of interest that might compromise his or her ability
to
act solely in the interest of the firm
Factors that may challenge Independence:
-Close Ties with Management
-Board member’s background,
- Education, experience, values, and personal relation to management

Debate on Independence VS relevant experience

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 Board independence

Independence is: having “no material relationship with the listed company (either
directly or as a partner, shareholder, or officer of an organization that has a
relationship with the company).

A director is not considered independent if the director or a family member

• Has been employed as an executive officer at the company within the last three
years.
• Has earned direct compensation in excess of $120,000 from the company in the
last three years.
• Has been employed as an internal or external auditor of the company in the last
three years.
• Is an executive officer at another company where the listed company’s present
executives have served on the compensation committee in the last three years.
• Is an executive officer at a company whose business with the listed company
has been the greater of 2 percent of gross revenues or $1 million within the last
three years.
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 Duration of Director

Staggered Board (classified Board): is a board that is made up of different classes of directors.

Usually, there are three classes, with each class serving for a different term length than the other.

Elections for the directors of staggered boards usually happen on an annual basis. 

Advantage :

-Board continuity

-Anti Take over Provision: hostile acquirers have a difficult time gaining control of

companies with staggered boards.

Disadvantage:
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-Less accountable to shareholders than annually elected boards
 Board size

Depends on the size of the corporation. Normally 7-11

large boards:
Pros:
-greater specialization,
Optimal size be there to handle all the Cons and to achieve
benefits
Cons: of the Pros
- additional cost
-slow decision making
-less candid discussion
-Diffusion of responsibility
-Risk aversion 24
 Board size

Relation between Board size and Firm Performance:

Some empirical research suggests that inefficiencies grow
with larger boards

Another stream of research suggest that large boards are

beneficial for Complex firms, but negatively related with
Simple firms.

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 Board diversity

Improve the Decision making by ensuring that the board has the full
array of knowledge in terms of market dynamics, customer behavior,
employee concerns to succeed operationally and culturally.

Reach a consensus quickly because social similarities shape their

perception and decision making.

Detract from the quality of decision making.

Heterogeneous group exhibit lower level of team work
Differences among team members can lead to less information
sharing, less accurate communication, increased conflict, lower
cohesiveness, and inability to agree upon a common goal.
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 Directors Election

the board of directors is elected by shareholders on a one-share, one-vote basis.

Directors win an election by obtaining a plurality of votes

Three main alternatives system of voting

dual-class voting
stock, majority voting,
and cumulative voting
A company with dual class shares has more than one class of common stock.
Each class has equal economic interest in the company but unequal voting rights.
Example Class A shares, Class B shares.
In majority voting a director is required to receive a majority of votes to be
elected. Even in an uncontested election, a director can fail to win a board seat
if over half of all outstanding votes are withheld from him or her.
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 A rare form of voting is the Cumulative voting. This allows a shareholder to
concentrate votes on a single board candidate instead of requiring one vote for
each candidate.
A shareholder is given a number of votes equal to the product of the number of
shares owned times the number of seats the company has on its board. The
shareholder can allocate those votes among board candidates as he or she chooses

Investors or groups of investors that own at least 3 percent of the

company’s shares continuously for three years are eligible to nominate up to 25
percent of the board. This right is known as proxy access.

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 Operation Of the Board

-Meetings of the board of directors is presides by chairman .

-The chairman is responsible for setting the agenda, scheduling meetings,
and coordinating actions of board committees.

-Traditionally, the CEO has served as the chairman of the board in most
corporations. Now the requirement is for a nonexecutive director to serve as chair.
-Board actions take place either at board meetings or by written consent.

-At a board meeting, resolutions are presented to the board and voted upon.
An action is complete when it receives a majority of votes in support.

When the board acts by written consent, a written resolution is circulated among
board members for their signatures. The action is complete when a majority of the
directors have signed the document.

Because board actions by written consent do not require advance notice, they can
occur more quickly than actions taken at board meetings. 29
Operation Of the Board

In addition to attending meetings of the full board, independent

directors meet at least once a year in executive session, in which
executive directors are not present.
This practice was mandated by SOX. While no formal actions are taken at these
meetings, executive sessions give outside directors an opportunity to discuss
candidly the performance of management, operating results, internal controls,
and succession planning. The lead independent director presides over these
meetings.

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Operation Of the Board

-Directors report spending approximately 20 hours per month on

board matters.
-Increased regulatory requirements in recent years have done much to lengthen
board meetings.
-Still, most directors believe that the agenda is structured to make efficient use
of their time and that 20 hours per month is sufficient to satisfy their duties.
-To inform its decisions, the board relies on materials provided by
management.
-Survey data indicates that the quality of this information might not be adequate.

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