PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 15 pptx

Board members must not personally buy stock or sell their own stock mediately after they learn of important developments at board meetings orother activities.. The Business Roundtable, a

We focus on large corporations whose stock is listed on a securities change These corporations must conform to regulations of the Securities andExchange Commission Most of the discussion is also relevant to boards ofsmaller corporations.

ex-WHY HAVE A BOARD OF DI R ECTORS?

Every corporation is required by law to have a board of directors The board’slegal function is to govern the corporation’s affairs However, in a small corpo-ration in which the chief executive officer (CEO) is also the controlling share-holder, the CEO actually governs and the board acts primarily as an adviser.When a corporation grows to a size where it needs outside capital, it may

go public by selling shares of stock (as explained in Chapter 14), and the boardthen represents the interests of these shareholders The shareholders, who arethe owners of the corporation, have a say in the way their company is run.They expect to receive regular, reliable reports on the company’s operations

If the company is profitable, they probably expect to receive dividends If the

company has problems, the owners need to know about these problems so thatthey can take any necessary remedial action.

A corporation may have many shareholders; American Telephone & graph Corporation has 2.6 million Individual shareholders obviously can’t gov-ern the company directly; moreover, most of them are engaged in their ownpursuits and will not give much, if any, time to governance They elect people

Tele-to act for them This is the board of direcTele-tors

SIZE AND COMPOSITION OF THE BOARD

The typical board has about 11 members Some boards, especially those inbanks, are much larger Large boards must delegate much of their work to anexecutive committee for overall matters and to several committees for specifictopics

Most board members typically are “outside directors”; that is, they arenot employees of the corporation At one time, most board members were “in-side directors,” and this is still the case in a few boards The trend toward out-side directors results from the shareholders’ recognition that the board shouldhave a significant degree of independence from the company’s management.The board is responsible for selecting, appraising, and compensating manage-ment If the board and management are the same people, the board can hardlyperform its governance role in an objective manner

Many outside board members are CEOs or senior officers of other rations (but not competitors) Other outsiders are lawyers, bankers, physicians(on health-care boards), scientists and engineers (on high-tech boards), retiredgovernment officials, and academics A few people are professional boardmembers; that is, their principal occupation is serving on boards The number

corpo-of female and minority board members has increased substantially in recentyears The CEO and perhaps one or two senior members of management typi-cally are members of the board

Board members are compensated Generally, they receive an annual tainer plus a fee for meetings attended In addition, many companies offersome form of stock compensation and retirement benefits According to aConference Board survey, the median basic annual compensation in manu-facturing companies for 1999 (not including stock components) was $35,000.When the value of the stock component was added, compensation totaled

re-$46,000

Board members are elected at the annual meeting of shareholders Theshareholders almost always elect the slate proposed by the incumbent board;thus, as a practical matter, the board is self-perpetuating The process of se-lecting candidates for filling board vacancies is an important board function.Many have staggered terms; that is, one-third of the board members areelected each year for a three-year term This practice is intended to make itmore difficult for corporate raiders to obtain control of the company

BOARD MEMBER R ESPONSIBILITIES

In the following sections, we describe the specific activities for which theboard is responsible In this section, we describe the responsibilities of indi-vidual board members

Board members must not personally buy stock or sell their own stock mediately after they learn of important developments at board meetings orother activities Examples of relevant developments include current estimates

im-of earnings, change in dividend policy, a decision to acquire another company

or to buy back stock, and changes in senior management The Securities andExchange Commission and rules of the stock exchanges impose an “earningsblackout” period of one or two days in which such trading is prohibited.Board members and management must not disclose any of these events to

a selected group of interested parties For example, they must not make a phone conference call to a selected group, send an Internet message to them, ordisclose information at a meeting of such a group When this information is dis-closed, it must be made available at the same time to the general public Theserules were significantly tightened in 1999 and 2000 by SEC Regulation FD

tele-R ELATION TO THE CHIEF EXECUTIVE OFFICEtele-R

Their titles indicate that the board of directors “directs” and the chief tive officer “executes” the board’s directions, but these terms are not an accu-rate description of the roles of these two parties In the majority of companies,the chief executive officer is also the board’s chairman and is the principal ar-chitect of policies Executing these policies is indeed a primary responsibility.The CEO is truly the “chief.”

execu-The board selects the CEO and, therefore, wants to give the CEO its fullsupport The CEO is accountable to the board and may be terminated if theboard decides that the individual’s performance was unsatisfactory

The appropriate relationship is one of trust The board must believe thatthe CEO is completely trustworthy, provides the board with all the informa-tion it wants and needs, withholds nothing, and doesn’t slant arguments to sup-port a preconceived position The CEO, in turn, must believe that he or she hasthe full support of the board

Appraising the CEO

A board’s major responsibility is to appraise the CEO If performance is belowexpectations, there are two possible explanations: (1) The CEO is to blame, or(2) extraneous inf luences are responsible In most cases, both factors are in-volved, and the directors have the extraordinarily difficult job of judging theirrelative importance If they conclude that the CEO has made an incorrect de-cision, they may suggest a different course of action More likely, however, they

may say nothing and mentally file the incident for future reference in ing the CEO The Business Roundtable, a group of CEOs of leading companies,succinctly described the directors’ role vis-à-vis the CEO as “challenging, yetsupportive and positive.”

evaluat-An important function of board meetings, conversations, and even socialoccasions is to give the directors a basis for continuously appraising the CEO.Directors usually cannot make constructive suggestions on the details of cur-rent operations Occasionally, they may call attention to a matter that should beinvestigated Primarily, however, they listen carefully to what the CEO saysand do their best to judge whether things are going satisfactorily and, if not,where the responsibility lies

The directors want the CEO to be frank and to give an accurate analysis

of the company’s status and prospects; concealing bad news is one of the worstsins a CEO can commit Nevertheless, human nature is such that directors can-not expect the CEO to be completely objective Incipient problems may goaway, and making them known, even in the relative privacy of the boardroom,may cause unnecessary alarm Directors, therefore, are on the alert for indica-tions of significant problems In many well-publicized bankruptcies of publiccompanies, the directors were significantly responsible; they did not identify

or act on the problem soon enough

Louis B Cabot, former chairman of the board of Cabot Corporation, had

a frustrating experience with the ill-fated Penn Central Corporation He joinedthe Penn Central board about a year before the company went under From theoutset, he was disturbed by management’s unwillingness to furnish the infor-mation about performance that he felt he needed A few months after joiningthe board, he wrote the CEO a letter that contains the following succinct de-scription of the director’s role:

I believe directors should not be the managers of a business, but they should sure the excellence of its management’s performance To do this, they have tomeasure that performance against agreed-upon yardsticks

en-The Next CEO

The board cannot tell beforehand whether a candidate will make a good CEO.The best indicator is how well the individual performs in his or her current job

In most instances, therefore, the board looks to senior executives with proventrack records as candidates for the CEO position One of the most importantresponsibilities that a board assigns to a CEO is to develop a succession planfor the company’s senior managers The purpose of such a plan is to identifypotential CEO candidates, provide them with opportunities for growth, andgroom them for higher level positions The board participates actively in thisprocess by meeting with the CEO (usually once a year) in a meeting devotedlargely to reviewing the senior management Typical questions asked are: How

is a key executive performing? What is his or her potential? Who are potentialsuccessors for the CEO, now and in the future?

At one company the authors are familiar with, the chairman and CEOheld an annual meeting of the outside directors to discuss succession He re-ferred to it as the “truck meeting” because he always started with the question,

“Suppose I am run over by a truck tomorrow What will you do?” At this ing, two, and sometimes three, managers were identified as potential CEOs.Individuals were added to or eliminated from the list and their relative rankingchanged When this process works properly, an agreed upon CEO candidate isavailable in an emergency, and a person who will take over from a retiringCEO in normal succession is identified

meet-If boards fail to deal effectively with succession, they may be forced to gooutside the company for a new CEO Under most circumstances, this increasesthe risk that the CEO will not succeed since chances for a successful succes-sion are usually better when the CEO position is filled by a proven executivefrom within the organization In some cases, an organization may need a “shak-ing up” and the board may elect to go outside for a CEO who can give the or-ganization new life

NORMAL BOARD MEETINGS

Most boards meet eight, nine, or ten times a year Some meet only quarterly,and a few meet every month The typical meeting lasts two to three hours, but

it may go considerably longer if contentious issues arise

Premeeting Material

Prior to the meeting, board members are sent an agenda and a packet of rial on topics to be discussed This homework usually requires several hours ofwork Directors may query the CEO, in person or by a phone call before themeeting, on matters that require clarification

mate-Current Situation and Outlook

The first substantive topic on a meeting’s agenda usually is a discussion of rent information about the company and its outlook The CEO leads this dis-cussion, perhaps delegating part of it to another senior officer Much of theinformation is financial—that is, condensed income statements for each divi-sion or for groups of division, corporate expenses, and key balance sheet items,such as inventory and receivable amounts There are three ways to present thisfinancial information:

cur-1 Compare management’s current estimate of performance for the wholeyear with budgeted performance for the year What is the current esti-mate of how the company will perform for the whole year? This is themost important type of information However, it is also the most sensitive,and many CEOs do not circulate it prior to the meeting

2 Compare actual performance with budgeted performance for the currentperiod and for the year to date Because the actual numbers are firm,they provide a more objective basis for analysis than the current estimatefor the whole year.

3 Compare actual current performance with performance for the same riod last year A carefully prepared budget incorporates changes in thebusiness and the economy that have occurred since the prior year, andthis is a more meaningful basis for comparison than last year’s numbers

pe-If, however, the budgeted amounts, particularly the estimate of revenue,are highly uncertain, the numbers for last year provide a firmer founda-tion for comparison

Variances between actual and budgeted performance are discussed Areunfavorable variances temporary? If not, what steps will be taken to eliminatethem, or, if they result from unforeseen outside forces, what adjustments in thecompany’s operations will be made?

By reviewing the company’s financial performance and raising questions

or making suggestions to management, directors form judgments regarding thecompany’s affairs Preparing and presenting to the board a report on the com-pany’s performance is an important discipline for management

Other Actions

Next, a number of proposed actions are submitted for board approval Many

of these recommendations come to the full board from committees that havediscussed the topics in meetings held prior to the board meeting; these aredescribed later in this chapter Questions may be raised about the recom-mendations, but usually they are requests for clarification Board membersrely on committee members to explore these matters thoroughly; there is notenough time to do so in the full board meeting Unless new information sur-faces, these recommendations typically are approved

The board also deals with a number of routine items These include quests for approval of capital projects, of signature authority for variousbanking connections, of exceptions to pension plans, and of certain types ofcontracts Except for large capital projects, these items are usually referred to

re-as “boilerplate.” In most cre-ases, they come to the board because state law, porate bylaws, or written policy requires board action They are approved withlittle discussion, sometimes en bloc, despite the fact that the minutes may statefor each of them, “After a full discussion, a motion to adopt the recommenda-tion was duly made and seconded, and the motion was approved.”

cor-Education

A division manager, assisted by senior associates, may report on the activities

of the division This is an educational experience for the directors (Some

board meetings may be held at company plants or other facilities; this also is avaluable educational device.)

The meeting itself and the informal activities that usually are associatedwith it are also educational Directors have an opportunity to appraise bothcompany officials and their own colleagues Judgments about these individualsmay be valuable if the board is required at some time to deal with a crisissituation

Setting Standards

Partly through written policy statements, but primarily through their tudes, directors communicate to management the standards that they believeshould govern the organization’s actions There are two general types of stan-

atti-dards; they might be labeled economic standards and ethical standards,

al-though neither term is precisely correct

With respect to economic standards, the directors communicate the all goals they believe the company should attain: the relative importance ofsales growth, earnings per share and return on investment, and the specificnumbers that they believe to be attainable The board also indicates the rela-tive importance of short-run versus long-run performance In the final analy-sis, board members generally rely on management’s recommendations, but theenthusiasm, or lack of enthusiasm, with which they support a given recom-mendation conveys an important message to management

over-Ethical standards are nebulous Written policy statements are always peccably virtuous, but directors’ actual expectations are revealed in the waythey react to specific ethical problems How does the company deal with its fe-male and minority employees? What happens to an employee who has a drink-ing problem? Does the company have a policy concerning support for thecommunities in which it operates? These and many other issues are loadedwith ethics, and the manner in which the board reacts to them establishes thereal policy, regardless of what is in a written statement

im-It is easy to rely on counsel’s answer to the question, Must we report thisunpleasant development to the Securities and Exchange Commission? The an-swer depends on the legal interpretation of the regulations It is much more dif-ficult for the directors to agree, and to convey to management, that certainpolicies or practices, although perhaps within the letter of the law, should not beallowed or sanctioned Examples include environmental considerations, employ-ment practices in Third World countries, and involvement in political issues

STR ATEGY

A company should have a set of strategies that are well thought out and clearlyunderstood by all managers Strategies include the industry in which the com-pany has decided to operate, its product lines within this industry, the price

and quality position of these products, the targeted customers and markets(local, regional, national, international), the company’s distribution channels(direct sales, dealers, distributors), marketing policies (advertising, sales pro-motion), manufacturing policies (in-house production, plant locations, outsidesourcing), financial policies (balance among borrowing, equity financing, re-tained earnings), and others.

The board usually does not have the knowledge necessary to initiate astrategy or to decide among alternative strategies It must rely on management

to take the initiative, make the necessary analyses, and bring its tions to the board What the board can and should do is described by Kenneth

recommenda-R Andrews in The Concept of Corporate Strategy.1He writes, as a summary,

A responsible and effective board should require of its management a uniqueand durable corporate strategy, review it periodically for its validity, use it asthe reference point for all other board decisions, and share with managementthe risks associated with its adoption

While it is unrealistic to expect directors to formulate strategies, theyshould satisfy themselves that management has a sound process for developingthem The strategy is probably acceptable if:

• It is based on careful analysis by people who are in the best position toevaluate it, rather than on an inspiration accepted without study

• The reasoning seems sensible

• No significant information has been omitted from the analysis

• The results expected from the strategy are clearly set forth so that actualaccomplishment can be compared with them

Strategy Meetings

As a basis for considering strategic plans, many companies arrange a meeting atwhich directors, together with senior managers, spend one, two, or three daysdiscussing where the company should be headed In order to minimize distrac-tions and provide an opportunity for informal discussion and ref lection, thesemeetings are often held at a retreat that is distant from the corporate offices.While company practices differ widely, it is not uncommon for meetings de-voted primarily to strategic issues to be held every year or two

The primary purpose of a strategy meeting is for management to explaincurrent and planned strategies and the rationales for them The explanationsprovide useful information to the directors The quality of the rationale for thestrategies indicates the competence of senior management and the managers ofthe divisions concerned Thus, the strategies provide additional insight aboutthe abilities of the CEO and the participants who may be CEO candidates.Once adopted, a corporate strategy must be adhered to Managementbrings to the board for decision and approval many matters that may impact acompany’s strategy—major capital expenditures, acquisitions, divestitures, and

financing proposals The board ensures that these proposals are consistent withthe adopted strategy If they are not, the company can drift off course and mayget into serious trouble.

DEALING WITH MAJOR CR ISES

In addition to its regular activities, a board occasionally must deal with crises.These usually arise unexpectedly and require special board meetings We de-scribe two of these: terminating the CEO and dealing with takeover attempts

Terminating the CEO

There are times when a board must replace the CEO Failure to act in time is

a major criticism of some boards Although such criticism may be justified oneshould recognize that it is much easier for an outside observer to criticize than

to be in the shoes of the directors who are faced with this decision

The decision to replace a CEO is subjective and usually emotional times there are compelling reasons for taking action—for example, when theCEO is becoming an alcoholic or when his or her corporate performance hasdramatically deteriorated In most instances, however, the case is not so clear.Earnings may not have kept pace with industry leaders because the board dis-couraged management from assuming additional debt that would have enabledthe company to expand Or perhaps the board supported a major acquisitionthat did not work out In such instances, it is not obvious that the CEO is pri-marily at fault

Some-There are, however, several important signals that can alert a board toquestion the CEO’s capabilities:

• Loss of confidence in the CEO If a significant number of directors have

lost confidence in, or no longer trust, the CEO, the individual should bereplaced

• Continuing deterioration in corporate results Earnings may be

signifi-cantly below industry norms or below the budget without an adequate planation The board must act before it is too late

ex-• Organizational instability A CEO who consistently has problems

retain-ing qualified senior executives probably should be replaced

These problems are especially serious in the many new companies ing up in information technology industries In these industries, change israpid, competition is severe, there are no track records on which to base judg-ment, and stock prices may change by huge percentages in a few days, ref lect-ing changes in investors’ opinions about the company’s outlook

spring-It is one thing for board members to begin to doubt the CEO’s ties, but it is quite another thing for them to demonstrate the courage and

capabili-consensus needed to take action The CEO and the directors usually haveworked together for some time; they are good, perhaps close, friends For theCEO, dismissal is a catastrophic event Taking action that will probably destroythe career of a business associate is a difficult decision.

Replacing the CEO precipitates a crisis, not only for the board but also forthe entire organization When it happens, the board must be prepared to an-nounce a successor and to deal with the problems inherent in the transfer of ex-ecutive authority Such action puts a major burden on the outside directors.Nevertheless, this is their responsibility to the shareholders and to the otherconstituencies of the corporation

For example, in early 2000, Jill E Barad, CEO of Mattel Inc the world’slargest toy manufacturer “resigned.” Ms Barad built one of Mattel’s f lagshipproducts, the Barbie doll, from $250 million in annual sales in the mid-1980s to

$1.7 billion in 1999 In the late 1980s, Barbie’s growth slowed, and Ms Baradturned to acquisitions Unfortunately, several acquisitions failed to live up toexpectations A loss of $82 million was recorded for 1999, and Mattel’s stockprice dropped from a high of $45 in 1998 to a low of $11 in early 2000 Theboard acted, and Ms Barad “resigned.” Apparently the board decided thatthere was no suitable successor within the company They selected RobertEckel, formerly CEO of Kraft Foods to be the new CEO

The turnover of CEOs of major corporations seems to be accelerating inthe twenty-first century Mr William Rollinick, a Mattel board member and for-mer acting chairman, observed that when a chief executive stumbles, “there’szero forgiveness You screw up and you’re dead.” The investing community putsboards under considerable pressure to act when things appear to be going wrong.Sarah Telsik, executive director of the Council of Institutional Investors, whichrepresents 110 pension funds with more than $1.5 trillion in assets, believes thatunderperforming CEOs were not losing their jobs fast enough

Too fast or too slow? A board should decide what is in the long-term bestinterests of the company and its stockholders In some instances, immediatepressures should be resisted in favor of long-term considerations In othercases, the board should “bite the bullet.” The decision is not easy

Unfriendly Takeover Attempts

Another crisis event is the hostile, or unfriendly, takeover attempt Board sions vital to the company’s future—even its continued existence—must bemade in circumstances in which emotions are high, vested interests are atstake, and advice is often conf licting The business press reports daily the dra-matic developments of offers and counteroffers, tactics, and strategies as eachside in the struggle seeks to gain an advantage Boards and management spendmuch time preparing offensive and defensive plans

deci-One of the problems in takeover situations is that the board, which sents the shareholders, may have interests that differ from those of manage-ment In most successful unfriendly takeovers, the senior managers of the

repre-target company lose their jobs A common accusation, therefore, is that agement resists takeovers in order to entrench itself, even though the dealwould result in a handsome gain for the shareholders.

man-In these situations, directors must exercise great care in making a sion that is in the shareholders’ interests This is not always easy to determine.What is the intrinsic value of the corporation? What is the real value of the

deci-“junk bonds” being offered to the shareholders? What consideration, if any,should the directors give to the interests of other parties—employees, commu-nities, suppliers, and customers?

In an unfriendly takeover attempt, the directors of the target companymust rely on legal advice since takeovers inevitably lead to lawsuits The boardalso depends on expert advice from investment banks about the value of thecompany and the true value of offers to acquire it

In practice, when a hostile takeover is initiated, the target company’slawyers, investment bankers, accountants, and other advisers, together withthe board and management, become involved in a hectic struggle that can lastfor weeks or months It is a sixteen-hour-day, seven-day-week effort; nearlyeverything else yields to the intense preoccupation with survival or striking thebest possible deal

BOARD COMMITTEES

Much of the board’s work is done in committees They meet before boardmeetings, hear reports, and prepare summaries and recommendations for fullboard action In this section, we describe the activities of the three commit-tees—compensation, audit, and finance—that deal with finance and account-ing matters

COMPENSATION COMMITTEE

The board determines the compensation of the CEO and the other principalcorporate officers In many boards, a compensation committee, composed ofoutside board members, analyzes what compensation should be and makes itsrecommendations to the full board

The SEC requires that a section of the proxy statement, issued prior tothe annual meeting of shareholders, must describe the work of the compensa-tion committee, the decisions on compensating senior executives, reasons forthe decision, their compensation for the past three years, and comparisons withother companies in the industry

CEO Compensation

When the board sets the CEO’s compensation, it is establishing a compensationstandard for managers throughout the company Their compensation is integrally

related to the CEO’s and this, therefore, is the single most important sation decision the board must make.

compen-In most instances this decision is not easy Most CEOs are ambitious andcompetitive, and compensation is their report card Since proxy statements dis-close the compensation of all CEOs of public companies, each CEO is able tosee just where he or she stands in relation to others Virtually every CEO wouldlike to stand higher on that list

Compensation committees consider three principal factors The CEO’scompensation should: (1) be related to performance, (2) be competitive, and (3) provide motivation Compensation includes not only salary but alsoperquisites and, in most companies, long-term incentive arrangements, such asstock options or performance-share plans These plans, however, are far fromperfect, and compensation committees constantly struggle to find newarrangements or formulas in an effort to relate compensation more closely

on these matters In the end and with all of the information at hand, the mittee makes its judgment as to where in the competitive spectrum they wantthe CEO’s compensation to fall

com-Motivation

Compensation committees ask themselves, How can we structure a tion package that motivates the CEO to do what the board expects? If thecompany has a plan to move aggressively and take unusual risks in the nearterm, with the possibility of significant long-term payoff, the committee can

compensa-structure a compensation plan for the CEO that will reward that kind of havior For example, the CEO might have a multiyear contract that provides as-surance of employment during the high-risk phase, as well as a long-term stockoption plan At the other extreme, a mature company might be interested inmoderate growth but steady dividends The compensation committee mightthen structure a plan weighted heavily toward a fixed salary, reviewed annu-ally, with only modest incentive features.

be-There are many types of compensation arrangements: base salary viewed annually, base salary plus annual discretionary bonus, base salarywith bonus based on a formula, stock option plans, performance share plans,and multiyear incentive plans Benefits play an important part in CEO com-pensation arrangements, especially retirement programs Each plan has itsown motivational features, and the compensation committee attempts tostructure a plan that provides the motivation for the CEO that the boardwants to generate

re-Compensation Reviews

In addition to deciding the CEO’s compensation, the committee also mines compensation for the other senior executives—that is, corporate officersand others whose salary is above a stated level The review process usuallytakes place at a meeting that brings together the compensation committee, theCEO, and the staff officer concerned with compensation and personnelpolicies

deter-At this meeting the CEO describes the compensation history of, andmakes a recommendation for, each executive Usually, a few of the recommen-dations are discussed, and a few changes may be made For the most part, how-ever, the committee accepts the CEO’s recommendations Nevertheless, thereview process is important It enables the compensation committee to be surethat the CEO is following sensible guidelines and consistent policies and is notplaying favorites It also serves to remind the CEO that recommendations tothe committee must be justified