Module 24.1 LOS 24. D and 24.e: Effective Corporate Governance Audits and Other Best Practices

In order to determine the effectiveness of a board of directors, investors or investment analysts must assess:

  • The composition of the board of directors and whether directors are independent, at least three-quarters of board members should be independent.
  • Whether the board has an independent chairman.
  • Qualifications of directors. Directors should bring skills and experience that will assure they will fulfill their fiduciary responsibilities to stakeholders, which includes not serving on more than 2 or 3 boards.
  • How the board is elected. Strong corporate governance practice says that staggered elections limits the power of shareholders and doesn’t allow changes to the board composition to occur quickly. Annual elections force directors to make more careful decisions and be more attentive to shareholders because they can cast a vote to keep or eliminate a director each year.
  • Board self-assessment practices. Boards should evaluate and assess their effectiveness at least annually.
  • Frequency of separate sessions for independent directors. Best practice requires independent board members to meet at least annually, preferably quarterly, in separate sessions without management in attendance.
  • Audit committee and audit oversight. The audit committee has the responsibility to oversee a company’s financial reporting, non-financial corporate disclosure, and internal control systems. The internal audit staff of the firm should report directly to the audit committee. Best practice mandates that the audit committee consists only of independent directors, has expertise in financial and accounting matters, has full access to and the cooperation of management, and meets with auditors at least once annually.
  • Nominating committee. The nominating committee is responsible for establishing criteria for identifying and evaluating candidates for the board of directors as well as senior management. Corporate governance best practice requires that the nominating committee consists only of independent directors.
  • Compensation committee and the compensation awarded to management. The directors should use compensation to attract, retain, and motivate talented managers on behalf of shareholders. Compensation should focus on long-term goals and should not be excessive. A common industry practice that is considered poor corporate governance is to use the salary at other companies as a reference point rather than company performance. Another poor practice is the repricing of stock options, which allows management to recoup losses after a stock price decline. Best practice would have base salary and perquisites as a small percentage of compensation, with bonuses, stock options, and grants of restricted stock awarded for exceeding performance goals making up most of a senior manager’s income.
  • Use of independent or expert legal counsel. The board of directors should hire expert legal counsel as needed to fulfill its fiduciary duties and assess the company’s compliance with regulatory requirements. A common practice is for internal corporate counsel to advise the board of directors, but this is considered weak governance, because of the potential for conflict of interest.
  • Statement of governance policies should be provided to shareholders
  • Disclosure and transparency. The purpose of accounting and disclosure is to fairly and accurately present a company’s financial situation.
  • Insider or related-party transactions. A recent financial scandal involved a CEO who borrowed millions of company dollars through an employee loan program, and then used his authority as CEO to “forgive” the loan. Best practice for any related-party transaction is to have the transaction approved by the board of directors.
  • Responsiveness to shareholder proxy votes. Management’s response to shareholder proxy matters is a sign of how seriously management takes its fiduciary duties. 

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