Oversight Function

CHAPTER XIII
 Chapter Objectives
• Identify the difference between decision management and decision control.
• Understand the role of the board of directors with regard to decision control and fiduciary duties.
• Understand that the board of directors is ultimately responsible for the business and its affairs.
• Provide an overview of what the oversight function entails.
• Identify and explain the fiduciary duties of the board of directors.
• Gain awareness of the variety of board models recommended in global corporate governance
reforms.
• Identify the board attributes that affect the quality of monitoring and oversight functions performed
by the company’s board.
• Illustrate the importance of an independent board of directors.
• Become familiar with the best practices of determining directors’ compensation.
• Identify and describe the determinants of an effective board of directors.
• Become familiar with board accountability, evaluation, and the legal obligations and liabilities facing
outside directors of public companies.
 Key Terms
•Audit committee financial expert
•Business Judgment Rule
•CEO duality
•D&O insurance
•Decision control
•Decision management
•Duty of care
•Duty of fair disclosures
•Duty of OBEDIENCE
•Fiduciary duty
•Independent director
•Lead director
•National Association of Corporate
Directors (NACD)
•One-tier board model
•Permanent director
•Rotating director
•Staggered board
•Two-tier board model
 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 state laws require a corporation to form a board of directors to represent

shareholders and make decisions on their behalf.

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.
 Board of Directors
Pre-SOX Framework
Personal ties to company management
Economic ties to the corporation
(consulting fees, generous ownership
pensions)
Avoid impairing oversight function of
directors
Improve their working relationships
with management
Post-SOX Framework
The majority of directors should be
independent
Separate the roles of chairman of the
board and CEO
Develop the knowledge and expertise
to provide effective board oversight
Have resources to hire advisors and
independent staff support
Set a “tone at the top” and a corporate
culture that promotes ethical conduct
Periodic evaluation of the
performance of the board of directors
5
 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 their responsibilities
without micromanaging.

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 plans, 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 public.

10. Review management’s report on the effectiveness of internal control over financial reporting.
 Roles and Responsibilities of Boards of
Directors are to:
11. Provide counsel to the company’s senior executives, especially the CEO, on material strategic decisions and risk
management.

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 interests of other
stakeholders.
 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.

MANDATED BY LAW AND SPECIFIED IN COMPANIES’ CHARTERS AND BYLAWS

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
- Fiduciary Duties and Business Judgment Rules
 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 – This is an important aspect 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 good faith and promote the success of the
company to the 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 protects existing value
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 decisions.

Duty to avoid conflicts of interests - Potential conflict of interest may occur when a director: receives a gift
from a third party with whom he is doing business; 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 on the grounds that they
appropriately fulfill their fiduciary duty of care.
 Director-Shareholder Engagement
Some important principles for establishing a director-shareholder engagement program are:
Identify how shareholders, especially institutional investors make their decisions, including who
within the fund, and their voting history.
Design outreach strategies of meeting major shareholders expectations by stratifying shareholder
base by level of ownership or other relevant metric.
Send an invitation from the corporate secretary to top shareholders for meeting and engagement.
Use all channels available and the ones that are most convenient in meeting and engaging with
majority shareholders.
Be proactive by engaging ahead of proxy season when everyone is less busy, but more importantly
before decisions have been solidified.
Make sure directors understand their fiduciary duties and oversight roles and have been briefed on
the unique details of the shareholder they are meeting.
Be well-prepared and ready for the meeting, including having a clear narrative for the company’s
strategy.
Close the feedback loop by seeking inputs from shareholders, taking follow up actions and
informing shareholders about actions taken.
 Board Attributes
Authority: The decision-making authority of the board of directors is granted when shareholders elect
directors to govern the company’s business affairs on their behalf. The board is authorized to hire, evaluate,
compensate, and fire the CEO and approve the top management team which manages the company’s day-to-
day operations.
Leadership: Public companies are required to have a board of directors led by a chairperson. The chair of the
board of directors should be independent and not be beholden to the top management including the CEO.
Board Independence: The national stock exchanges (NYSE, Nasdaq, and AMEX) require a majority of
directors of a listed company to be independent.
Separation of Chair and CEO Roles/ CEO Duality: The board of directors should decide whether it is
appropriate to separate or combine the role of the chair of the board and CEO position and properly
communicate its decision and the rationale to shareholders.
Lead/Presiding Directors: The lead independent director is often referred to as presiding directors,
independent deputy chair or senior independent director. When the board decides to combine the chair and
CEO roles, it should designate a strong lead independent director (LID).
Resources: The board of directors should have adequate resources to fulfill its oversight functions
effectively, including financial, legal, information, and administrative resources.
Diversity: Director diversity in terms of knowledge, expertise, skills, ethnicity, gender, age, and minority.
Number of Directors: 9-15
Number of Meetings: 4-12
 Board Committee
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
 Board Committee
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 committees.

Compensation committee – composed of at least three independent directors; serves to design, review,
and implement directors’ and executives’ compensation plans

Governance committee - consists 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

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 committee –usually led by corporate counsel, CFO’s, or controllers. It is responsible for
reviewing and monitoring the company’s 10-Ks, 10-Qs, and other 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.
 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 is based on the
two components of the strategic board and oversight board. It is the natural
offshoot of the emerging corporate governance reforms.
Board Models

One –
Tier
Model

Two-
tier
Model

Modern
Board Model
 Board Models
The passive board. The passive board is the traditional model, characterized by
minimal engagement by directors, and only at the CEO’s discretion. Board members
have the role of ratifying management’s decisions with a limited accountability.
The certifying board. The certifying board model certifies to shareholders that the CEO
meets the expectations of the board in properly managing the company, oversees an
orderly succession process, and focuses on protecting investors and promoting
independent directors.
The engaged board. This model emphasizes the importance of collaboration between
the company’s board and its CEO in providing insight, advice, and support on major
decisions; oversees managerial functions and company performance; and continuously
redefines its roles, responsibilities, and boundaries.
The intervening board. This type of board model works best in crisis situations where
the board holds frequent and intensive meetings to make important decisions about the
company’s governance and operations.
The operating board. This model is most appropriate in the early stage of start-up
companies where executives have specialized expertise but insufficient board
management experience. In this model, the board makes all key decisions, and
management implements the strategic decisions and plans made by the board.
 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 a
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 to that 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”
majority of independent directors.
Lead Director – Demand for Lead Director increased because of the presence of CEO duality, resulting
from growing concern that duality places too much power in the hands of the CEO, which may impede
board independence.

Board Composition – Composition formed 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 through 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.
 Board Characteristics
Responsibilities – The primary responsibility of the board of directors is to make sure 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.

Resources – The 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, a director should not have any relationship with the
company other than his or her directorship that may 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 the board, approved by shareholders, and fully disclosed in public reporting.
 Board Selection
People have been using a plurality voting
system to elect corporate directors. It has
been argued that a plurality vote system
gives too much power to executive directors
Traditional
and management to influence the election of
outside directors.

There have been moves toward requiring

majority vote election procedures for
corporate
directors. For example, the California Public
Employees’ Retirement System (CalPERs)
Now
board
adopted a three-pronged plan to advocate
majority vote requirements.
 Board and Corporate Culture
The corporate culture of integrity, competency, resilience, responsiveness,
transparency, accountability and value-adding philosophy can play an important role
in the continuous improvements and sustainable performance and business success.
Oversee how culture is defined and aligned to strategy: The board of directors should
define and conceptualize the culture that is right for the company.
Create accountability for how culture is communicated and lived—internally and to
key external stakeholders. The board of directors should oversee how management
define, implement and communicate corporate culture to employees internally and to
other stakeholders externally.
Monitor how culture and talent metrics are measured to keep a pulse on how culture is
evolving.
Provide oversight of intentional culture shifts to stay in step with strategy shifts:
Culture must be aligned with strategy and as such culture should shift when strategy
shits.
Challenge the board’s culture: The board of directors is ultimately responsibility for
setting a right tone at the top regarding corporate culture.
 Director Education and Evaluation
• Corporate governance reforms and best practices issued by a number of
organizations recommend continuous education and evaluation of the board
of directors.

• Evaluation of the company’s board should be performed formally and

regularly (at least annually) through either self-evaluation, independent
committee evaluation (audit, compensation, nominating), or outside
consulting evaluations.
 Effective Corporate Boards
1. Create and open an engaging boardroom atmosphere
2. Maximize the value of the board’s time commitment by establishing clear
roles and responsibilities within an appropriate structure
3. Determine the information the board needs and ensure it is delivered in a
timely manner
4. Dedicate time to strategic issues
5. Create a transparent, explicit, and accountable executive pay process
6. Actively engage in CEO succession planning
7. Access the strength of the company’s management talent
8. Monitor the companies enterprise risk management system
 Emerging Board Leadership
Directors report that changes in the regulatory climate, the prospect of an economic slowdown, growing
cybersecurity threats, business-model disruptions,
Directors rate artificial intelligence (AI) as the biggest technology disruptor but also regard it as the
biggest business enabler likely to benefit their organizations.
Strengthening oversight of strategy execution and risk management.
Directors would like their boards to take more action and enhance ESG oversight.
Board oversight of corporate culture is more robust than last year.
The vast majority of directors believe that their boards’ understanding of cyber risks has improved over
the last two years.
Quarterly board agendas typically cover six to seven major governance issues, reflecting the growing
mandate of public-company boards and underlining the difficulty for directors in balancing the breadth
and depth necessary for effective oversight.
Directors spent nearly twice as much time reviewing materials from management as they allocated to
reviewing relevant information from external sources, revealing a heavy dependence on management
views and analysis in fulfilling their oversight duties.
A large majority of directors (88%) agree that their board’s primary role is to guide the organization’s
long-term strategic direction.
Despite calls for increasing gender diversity on public company boards, progress has been scant.
 Director Liability
One way to influence directors’ ethical conduct and create more
accountability for them is to increase their legal liability for poor performance
and business misconduct.

Directors are not reasonably expected to have first-hand knowledge of all

company business affairs under their oversight capacity. Nevertheless,
directors are responsible for ascertaining the validity, reliability, and quality
of information provided to them. In most circumstances, directors make
decisions by relying on information furnished by corporate officers,
employees, and professionals, including legal counsel and accountants. Thus,
the effectiveness of their performance depends on the validity and quality of
the information provided to directors.
 Chapter Summary
Corporate governance reforms have fostered and will continue to enhance directors’ oversight
effectiveness and accountability.
A board should maintain autonomy from the CEO or management.
Boards should engage more in strategic decisions including CEO succession, risk management,
and consulting executives without micromanaging.
The five most prevailing and challenging issues are director independence, executive
compensation, succession planning to replace the departing CEO , cybersecurity and the move
toward profit-with-purpose corporations that extends directors fiduciary duty to stakeholders
other than shareholders.
To improve oversight effectiveness, the board of directors should: (1) engage in active, informed,
independent oversight of the company’s business and affairs; (2) adopt oversight corporate
governance rules, standards, best practices, and other guidance presented in this chapter; (3)
establish and preserve objectivity and independence of nonexecutive directors; (4) receive in a
timely manner adequate strategic, operational, and financial information; (5) communicate with
shareholders key issues affecting the company’s sustainable performance and promote
shareholder democracy; (6) form appropriate board committees to divide oversight authority and
responsibilities and hold these committees and their members accountable for their performance;
(7) perform an annual evaluation of the entire board of directors, its committees, and members of
each committee; and (8) fulfill the fiduciary duties of due care, loyalty, and fair disclosures
established in the general corporation laws of the states and court interpretations of these duties.
 Key Points
• The ultimate responsibility of good corporate governance rests with the board of directors.

• Decision management, which consists of initiation and implementation of strategies, is viewed as the management’s
responsibility whereas decision control, which entails the ratification and monitoring of strategies, is viewed as the
board of directors’ fiduciary duty.

• The board of directors is usually composed of both insiders (senior executives) and outsiders (independent directors).
Nevertheless, the entire board of directors is considered representative of shareholders, responsible for protecting
shareholders’ interests.

• One way to influence directors’ performance and ethical conduct is to hold them accountable and liable for poor
performance and business misconduct.

• The company’s board of directors is ultimately responsible for its business and affairs. The board may delegate its
decision-making authority to the company’s top management team, but it is still responsible for running the company
without micromanaging.

• The primary responsibilities of the board of directors are to: (1) define the company’s mission and goals; (2) establish or
approve strategic plans and decisions to achieve these goals; (3) appoint senior executives to manage the company in
accordance with the established strategies, plans, policies, and procedures; and (4) oversee managerial plans, decisions,
and actions in achieving sustainable shareholder value while protecting the interests of other stakeholders.

• The business judgment rule provides directors with broad discretion to make good faith business decisions and implies
that directors, when making business decisions, must be reasonably informed and rational in such a manner that a
prudent person would concur with the decision.
 Key Points
• A variety of board models have been suggested in global corporate governance reforms and the
literature including one-tier, two-tier, and modern board models.
• Investors, in general, are in favor of the separation of the positions of the CEO and the chairperson
of the board of directors as a means of strengthening the board’s independence and reducing the
potential conflicts of interest, particularly when the company is perceived to be managed poorly.
• Corporate governance best practices suggest that companies designate one director to take the lead at
executive sessions that do not include management.
• Board characteristics including composition, authority, responsibilities, resources, independence,
and compensation significantly influence its effectiveness.
• To be independent, a director should not have any other relationships with the company other than
his or her directorship that may compromise the director’s objectivity and loyalty to the company’s
shareholders.
• The evaluation of board performance should be completed formally and regularly (at least annually)
through either self-evaluation, independent committee evaluation (audit, compensation, nominating),
or outside consulting evaluations.
• Board accountability can be classified into accountability to shareholders for protecting their rights
and interests, accountability for the effectiveness of its operation, and accountability for its
involvement in the company’s strategic decisions to ensure enduring performance and success.
Concluding Remarks and
Questions?
Thank you for your Attention