Corporate Governance Notes Chapter 5

Committees of a Board

A board of directors is a non- executive body that meets no more than four or five times a
year to perform its oversight, directional and advisory functions. The time at disposal of
directors is rather limited – in fact too limited to allow different issues that are presented to
the board are comprehensively covered. It is therefore necessary that the board should get
some assistance from certain quarters, other than the management of the company, for expert
advice or briefing on he matters that are placed before it. Forming committees of the board is
one way of getting such assistance.

Advantages of Committees

a. The managers are able to receive unbiased, but competent, feedback from a source
other than the company's management. If the board continues to rely solely on the
information supplied by the management, its role of successful oversight will not be
fulfilled. The management will not be able to influence a board that does not look past
the papers given to it by the management; rather, it will be managed by the
management. This reversal of roles is counter to the spirit of good governance and
should be avoided diligently. Therefore, in this regard, by providing the board with a
professional view from a different perspective than that of management, committees
help to enhance the standard of governance at a corporation.
b. Directors' work load is minimized. The committee members conduct the extensive
work while the Board collects for its consideration a summary report and/or
recommendations. This does not result, at least theoretically, in the dilution of the
board's powers. Although the board maintains the right to make the final decision on
all issues, in order to achieve a meaningful division of labor, the issues themselves are
delegated to different committees. In this way, more work can be completed in less
time, improving the overall efficiency of the board and thus, governance.
c. With the induction of outside consultants or specialists in such committees, the board
can get more detailed and specialized information for a more dependable decision
making. This is perhaps the most important argument in favor of committees and the
role they can play in improving the quality of governance. Board members should be
provided this access to outside specialists without having to rely exclusively on the
company’s own management in order to get an independent view on the issues.
Common Committees

a. Audit Committee: - The relevant laws in countries now require listed companies to
form and audit committee comprising of three or four board members. It is charged
with the responsibility to oversee certain functions on behalf of the board and to brief
the board.
Membership of Audit Committee
In most developed countries the following standards are followed in this regard:
a. All its members are independent non-executive directors (INEDs). In particular, no
executive director is made a member of audit committee to ensure its independence.
Similarly, the chairman of the company, even if he is a non-executive, should not be a
member of this committee.
b. The Chairman of audit committee must be INED.
c. USA law requires that at least one member of the audit committee must have financial
expertise or background. However, such a member should not be an executive or paid
employee/consultant of the company.
d. The audit committee can get however outside professionals to assist it if its members
deem if necessary.

Responsibilities of Audit Committee

 Oversight of Financial Reporting and Accounting Policies: - Before periodic

financial statements like income statement, balance sheet, cash flow statement, etc.
are presented to the board (at the end of each quarter and at year-end), these are
reviewed by the audit committee so that it can brief the board members on the validity
and acceptability of such statements. The audit committee should have sufficient
expertise to discuss the various accounting policies and standards that have been
adopted by the company’s management and to make a judgement on their suitability.
 Liaison with external auditor: - In the process of their work, the members of audit
committee can interact with the financial management team and external auditors of
the company in order to get all the necessary information. In particular, all
communication between the external auditor and management of the company must
pass through the audit committee. This ensures that audit committee remains fully
informed of all aspects of the external audit and that management does not unduly
influence the external auditor. This also enables the audit committee to explain the
matters to Board of directors.
  Compliance with regulatory requirements on disclosure: - The law requires
certain disclosures in the financial statements. The external auditors generally
document in their report if such disclosures have been properly made and meet the
prescribed standards. The audit committee should pay particular attention to this
aspect and brief the board members on such disclosures.
 Monitoring the internal control system: - While describing and implementing
internal control policy and systems is the responsibility of the management of a
company, the audit committee has been assigned the task of monitoring this aspect of
management.
 Oversight of Risk Management Process: - A company is exposed to a number of
risks that threaten its profitable operations, or even its very existence. The
management must identify and seek means of addressing these risks. For example, the
risk of fire at company’s factory or plant can be handled by designing suitable
preventive measures and taking out adequate insurance policy. Similarly risks related
to other operational activities can be mitigated or covered through other available
means like insurance, hedging, options purchasing and safety measures etc.
Management must formulate procedures and systems for this procedure. The Audit
committee is responsible for overseeing all such procedures and their effective
implementation. These are highly technical matters and Audit committee needs to be
extremely careful in dealing with them.

Terms of Reference of Audit Committee

1. Determination of suitable measure for protecting the assets of listed company;

examination of initial declaration of results before publication;
2. Review of quarterly, half-yearly and annual financial statements of listed
company before presenting to Board of Directors.
3. Facilitate the external audit by discussing significant observations resulting from
interim and external audit with external auditors.
4. Assessment of management letter which is issued by external auditors, along with
management response in this regard;
5. Guarantee free communication between external and internal auditor.
Nature of Audit Committee

Despite its apparent importance and influence on the governance of a company, it is wise to
remember that an audit committee is not an executive body. It does not carry out an executive
function at all. It does not draw up accounting policy, neither does it approve it. The
management draws accounting policies and procedures while the board of directors approves
them.

Similarly, an Audit Committee does not perform internal or external audit. It does not issue
any instructions to either auditor. It simply oversees their work and reviews their reports in
order to keep the Board of Directors informed of the status vis-`a-vis the audit matters.

Audit Committee reports to the Board of Directors and gives its reports, findings, advice and
recommendations to the Board. The Board in turn may decide on whatever action needs to be
taken on the basis of Audit Committee’s report or advice. The Audit Committee does not
have the powers or mandate to issue any directives to the management of the company,
including the internal auditor.

Best Practices of Audit Committees

 Managing Its Agenda

An audit committee draws up its agenda on annual basis. A formal program is drawn for the
whole year’s activities covering the various responsibilities falling within its scope. Although
the general practice is to hold an Audit committee meeting at the end of each quarter just
prior to the Board of Directors meeting, better organized Audit Committee meetings are often
more regular than quarterly. The preparation of the annual programme is carried out in
conjunction with the internal and external auditors, so that important meetings are arranged in
accordance with the related accounting and audit events of the year, such as the issuance of a
letter of approval to the external auditor, the beginning of the internal audit cycle, initial
meetings with the external auditor, the date of periodic submission of internal audit reports,
the receipt of internal audit reports.

 Frequency of interaction with Management

Regular contact between audit committee and important managers of the company is essential
to ensure that the work of audit committee is done smoothly. Key contacts in this regard are
the CEO, CFO, Internal Audit Manager, External Audit Firm’s relevant partner. The formal
contact between the Audit Committee and these officials does not erode the Audit
Committee's independence and effectiveness; rather, it should ensure that the Committee
carries out its work more closely.

Regular Executive Sessions

These are formally scheduled meetings between the Audit Committee and key managerial
staff or external auditors of the company to attend to certain important events like discussion
of audit program, review of management letter received from the external auditor, etc.

Regular Evaluation

The Chairman of Audit committee must complete formal self-evaluation annually to identify
improvement opportunities. Each member of the audit committee, and the overall
performance of the committee over the period as compared to previous periods, should be
evaluated in order to make meaningful changes where necessary.

Audit Committee and the External Auditor

Audit committee should maintain constant liaison with the external auditor. In fact all
communication between the external auditor and the company should pass through the Audit
Committee. Similarly, all negotiations with the external auditors on issues like audit time
table, audit fees, audit expenses, etc. must be made in presence of the chairman of the Audit
Committee.

The SECP places the following responsibilities on Audit Committee regarding the
relationship with external auditor:

a. AC after checking the details of the qualifications, experience, past record, etc. of any
firm of auditors whose name is proposed at the AGM for appointment as external
auditor of the company.
b. AC should ensure the independence of the external auditor by verifying that there are
no untoward linkages between the external auditor and company’s management.
c. AC should ensure rotation of external auditors after suitable periods. The code
recommends after every three years.
d. AC should monitor the performance of external auditors and report its findings to the
board of directors.

Situation of Audit Committee in Pakistan

While almost al the companies are complying with the KSE and SECP requirement of having
an audit committee, sadly most audit committees are far from independent. Some companies
nominate their executives, even the director finance, on such committees. Other assign the
chairmanship of audit committee to the chairman of the company. In many companies since
most directors are family members, it is not uncommon to find that one brother is chairman
of the company; another is the CFO while the third is chairman of the audit committee,
thereby totally killing the independence and effectiveness of the audit committee.

The Nomination and Remuneration Committee

It is recommended that this committee should compromise of only non-executive directors.

Its principal function is to ensure that the company succeeds in attracting and retaining good
board members-both executive and non-executive directors. This committee can take help
from outside consultants to ensure that it is in possession of all relevant data and information
needed for formulating meaningful and practical policies relating to recruitment, motivation,
remuneration and retention of competent directors.
Basis of Remuneration

 Fixed salary: - If a company pays only a fixed salary to its directors, it does not
motivate them to work harder for company’s profitability or growth. It engenders an
attitude of status-quo commonly found in public sector companies where directors are
not interested in bringing about any change or improvement in company’s operations
as such a change is not likely to benefit them in any way.
 Performance Based Pay:- On the other hand, a performance based pay or incentive
pay, promotes motivation. It gives the directors a reason for better performance as
they stand to gain personally from company’s profitability and/or growth. However,
for an incentive pay model to work effectively, it should be based on realistic,
achievable targets.

The performance Based pay, or bonus, can be given in various forms, e.g.

a. Cash Bonus, representing a certain percentage of a pre-determined figure like

sales, or increase in sales, profit, or growth in profit, etc.
b. Bonus in the form of free shares of the company. This arrangement can however
be allowed only if permitted by the company’s Articles of Association.
c. Bonus in the form of share options. A share option allows a director to buy the
company’s share at pre-set price but on a future date. The idea is to motivate the
directors to work harder towards improving the market value of the company’s
shares (through better profits and sustained growth) so that they stand to benefit
from exercising the share option.

Balance in Remuneration:

a. The pay should include both the elements: a fixed salary element as well as a bonus
element, in reasonable proportion. The fixed salary should be adequate to sustain a
decent standard of living, while bonus payments should be offered as added incentive
for improvement in overall quality of life.
b. The bonus element should include both a short term and a long-term element, in
reasonable proportion. The scale of bonus payments should preferably be ascending in
nature; that is a lower rate of bonus in initial year, steadily rising in subsequent years.

Situation of Directors Remuneration in Pakistan

The situation in Pakistan is different to the west. In Pakistan Executive directors do not run
the boards-controlling shareholders do. These controlling shareholders do not pay executive
directors anything more than a market salary for a comparable job. Hence, here director’s
remuneration is not really a governance issue as yet.

Due to family control of most listed companies, nominations and/or remuneration committees
either do not exist, or simply play a subservient role in Pakistan’s corporate sector.
THE EXECUTIVE COMMITTEE

Board members are very busy people. It is therefore not possible to summon a board meeting
for every minor issue. At the same time, a considerable number of matters must be brought to
board’s formal attention, which must be deliberated upon and decided on by the board.

 Often has EDs and some INEDs as members

 Meets frequently to dispose of routine executive matters
 Gives detailed report to board on more important matters

The executive committee has following advantages:

a. It reduces the work load for the board of directors by handling many of the relatively
minor matters that would otherwise have to be sent to the board.
b. It studies the issues, seeks detailed information from the management or collects
whatever additional data is required from inside or outside the company on major
issues, so that it is able to provide a more informed and comprehensive brief to the
board.

AD HOC COMMITTEES OF BOARD

a. Created for a situation, purpose or time and liquidated afterwards

b. Investigation committee, often set up to investigate a serious breach of company’s
operational codes. It may draw membership from the board as well as non-board
members to suit the nature of investigations to be carried out.
c. Negotiation committee, often set up when major negotiations with workers union or
government or some external party are be carried out.
d. Project committee, often set up when a company plans to undertake a major project,
or make a acquisition.