3 Directors

Directors: Duties and Effectiveness
Semester A, 2022-2023
FB5690, City University of Hong Kong
© 2021 City U of HK All rights reserved 1

History of Boards
In the early age of shareholding companies, when directors met

Sat on stools around a long board placed across two sawhorses
The leader sat in a chair
That group was named ‘the board’
The leader was named ‘chair-man’
Society for Establishing Useful Manufactures (SUM), 1791

The structure is similar to today’s typical boards
The board has 13 directors
A committee of inspectors: similar to the audit committee today

Board Duties
Fiduciary duty: directors must place shareholders’ interest above their

own interest.
Duty of loyalty: a director must demonstrate unyielding and undivided
loyalty to shareholders.
Duty of care: a director must exercise due deliberation in making decisions.
Business judgment rule: as long as directors act with all loyalty and
exercise due care, the court will not second guess their decisions.
The process is more important than the consequences.
Allow directors to make decisions without the fear of being prosecuted.

“Why CEOs need to be honest with their boards” (WSJ 2008)
Discussion Questions:
1. Why are CEOs often reluctant to inform directors of bad news promptly?
2. Why did the retired judge, Mr. Walsh, rule in favor of the company (i.e.,
Kinder Morgan Inc.)?

Responsibilities
The board of directors has a dual mandate:

Advisory: consult with management regarding strategic and operational
direction of the company.
Oversight: monitor company performance and reduce agency costs.
Effective boards satisfy both functions.
The responsibilities of the board are separate and distinct from those of
management. The board does not manage the company.
OECD Principles of Corporate Governance:

“The corporate governance framework should ensure the strategic guidance of
the company, the effective monitoring of management by the board, and the
board’s accountability to the company and the shareholders.”
Organisation for Economic Co-operation and Development (2015)

Selected advisory and oversight responsibilities
Represent the interest of shareholders

Approve the corporate strategy
Test business model and identify key performance measures
Identify risk areas and oversee risk management
Plan for and select new executives
Design executive compensation packages
Ensure the integrity of published financial statements
Approve major asset purchases
Protect company assets and reputation
Ensure the company complies with laws and codes

Independene
Independent directors are those who “have no material relationship” with

the company (as defined by the NYSE).
A director is not independent if director or family member has, in the

last three years:
Served as an executive of the listed firm.
Earned compensation > $120,000 from the firm.
Served as an internal or external auditor of firm.
Served as an executive at another firm where the listed firm’s present
executive have served on the compensation committee.
Served as an executive of another firm whose business with the listed firm is
the greater of $1 million or 2% of revenue.

Independence
“Independence” is defined according to regulatory standards.
However, independence standards may not be correlated with true

independence.
Requires a careful evaluation of board member’s biography, experience,

previous behavior, and relation to management.
Boards are expected to be independent.

Act solely in the interest of the firm.
Free from conflicts that compromise judgment.
Able to take positions in opposition to management.

Operations of the Board
Presided over by the chairman: sets agenda, schedules meetings,

coordinates actions of committees.
Decisions made by majority rule.
To inform decisions, board relies on materials prepared by management.
Periodically, independent directors meet without the presence of

management (“executive sessions”).
Directors report spending 20 hours per month on board

matters while a typical meeting lasts 7 hours
National Association of Corporate Directors (2014)

Board Committees
Not all matters are deliberated by the full board.

Committees of the board deliberate topic-specific issues that are critical to
the oversight of the company.
Directors are selected to committees based on their qualifications and
domain expertise (generally).
All boards are required to have audit, compensation,

nominating/governing committees.
On important matters, the recommendations of the committee are

brought before the full board for a vote.
Committees may be standing or ad hoc, depending on the issue at

hand.

Audit Committee
Responsibilities of the audit committee include:

Oversight of financial reporting and disclosure
Monitoring the choice of accounting policies
Oversight of external auditor
Oversight of performance of internal audit function
Monitoring internal control processes and
Discuss risk management policies
Oversight of regulatory compliance
Audit committees meet on average 8 times per

year, for 2.7 hours each.
NACD(2014)

Compensation Committee
Responsibilities of the compensation committee include:

Set the compensation for the CEO
Advise the CEO/BOD on compensation for other executive officers
Determine the appropriate structure of compensation
Set performance-related targets for the CEO
Monitor the performance of the CEO relative to targets
Hire consultants as necessary
Compensation committees meet on average 6 times

per year, for 2.7 hours each.
NACD(2014)

Nominating/Governance Committee
Responsibilities of the nominating/governance committee include:

Identifying, evaluating, and nominating new directors when board seats need
to be filled (voted by shareholders)
Manage the CEO evaluation and succession processes
Hiring consultants as necessary
Determine governance standards for the company
Nominating/governance committees meet on average

8 times per year, for 1.8 hours each.
NACD(2014)

Specialized Committee
Executive Science & technology

Finance Legal
Corporate social responsibility Ethics / compliance
Strategic planning Mergers & acquisitions
Investment Employee benefits
Risk Human resources /
Environmental policy management development
Prevalence of specialized committees:

• Finance: 31%
• Corporate social responsibility: 11%
• Science & technology: 8%
• Legal: 6%
• Environment: 8%
Spencer Stuart (2013)
Thursday, December 15, 202 AC5690 Corporate Governance 14

Director Terms
Two main election regimes:

Annual election: Directors are elected to one-year terms.
Staggered (or classified) board: Directors are elected to three-year terms,
with one-third of board standing for reelection every three years.
Impossible for the board to be ousted in a single year; two election cycles are
needed for a majority of the board to turn over.
Staggered boards are an effective antitakeover protection; but it may

insulate or entrench management.
Prevalence of staggered boards:

• Approximately half of all publicly traded companies have a
staggered board.
• Small companies are more likely to have a staggered board
than large companies.
SharkRepellent (2009)

Director Elections
In most companies, directors are elected on a one-share, one-vote basis.
Shareholders may withhold votes but not vote against.
Four main voting regimes:

Plurality: directors who receives most votes is elected, even if a majority is
not obtained.
Majority: director must achieve majority to be elected, otherwise must
tender resignation.
Cumulative: shareholders can pool votes, and apply to selected candidates
(rather than one vote each).
Dual class: different classes of shares carry different voting rights
(disproportionate to economic interest).
Typically, only one slate of directors is put forth for election; in a

contested election, a dissident slate is also put forth.

Director Compensation
Compensation must be sufficient to attract, retain, and motivate

qualified directors.
Compensation covers time directly spent on board matters, cost of

keeping schedule flexible to address urgent issues, and financial and
reputational risk from corporate scandal or lawsuit.
Revenues Revenues
(median)
> $20 bn $1 - $2.5 bn
Annual Retainer $80,000 $45,000
Committee Fees 10,500 16,200
Non-Retainer Equity 105,800 57,800
Total Director Comp $229,900 $132,600
% Equity 45% 46%

Director Compensation
Companies pay fees for serving on committees.
Fees are intended to compensate for time, expertise, and potential risk
of committee role.
Revenues Revenues
(median)
> $20 bn $1 - $2.5 bn
Audit Retainer $10,000 $10,000
Audit Meeting Fee 2,000 1,500
Audit Chair 20,000 12,500
Comp Retainer $9,500 $5,000
Comp Meeting Fee 2,000 1,500
Comp Chair 15,000 8,250
Nom/Gov Retainer $9,000 $5,000
Nom/Gov Meeting Fee 2,000 1,500
Nom/Gov Chair 10,000 7,500

Director Recruitment Process
Director recruitment is a responsibility of the nominating/governance

committee.
Identify needs of company.
Identify gaps in director capabilities.
Identify potential candidates, either through director networks or with
professional recruiter.
Rank candidates in order of preference.
Meet with each candidates successively and offer job.
Put before shareholders for a vote.
Director recruitment differs from CEO recruitment in that candidates

are ranked in order before interviews take place.

Importance of Professional Experience

Labor Market for Directors
Among public corporations in the U.S.:

Total number of directors: 50,000
Average tenure on board: 7 years
Average mandatory retirement age: 72
Directors tend to retire voluntarily.
Involuntary cases are extremely rare.

Only 2 percent of directors who step down are dismissed or not reelected.

Removal of Directors
Except for retirement, companies may replace a director for a variety of

reasons.
Refresh the board: requires new skills and capabilities on board
Director is negligent or performing below expectation
Director has irresolvable disagreement with other directors or management
Process
Board does not have power to remove other board members
Wait to replace at annual meeting
Encourage to resign
Shareholders have limited rights to remove directors
Pass special resolution if they can demonstrate cause
Vote for removal if election is by majority voting
How does this affect accountability?

Discussion
If you were a director, do you care about your performance as a

director? Why or why not?
Do you think the reputation of a director matters in the job market?
• Poor performance of current directors reduces their likelihood of being asked to join new
boards and raises the likelihood of not being renominated to existing boards (Field and
Mkrtchyan, 2017).
• Directors with a relatively high level of no votes at annual meetings (e.g., 10% no votes)
are more likely to leave the board within two years, move to less prominent board
positions, and experience a decline in the number of their other directorships (Aggarwal et
al. 2019).

Board Characteristics
The Board of Directors of the Average Large U.S.

Corporation
Number of directors 11
Number of meetings per year 8
Independent directors 85%
Independent chairman 25%
Dual chairman/CEO 55%
Lead independent director 90%
Independent audit committee 100%
Independent comp committee 100%
Independent nom/gov committee 100%
Average age 63
Mandatory retirement 72%
Mandatory retirement age 72
Female directors 18%
Boards with at least one female director 93%
Spencer Stuart(2013)

Board Characteristics and Their Effects
Boards are often described in terms of their salient structural features:

size, independence, committees, diversity, etc.
Do these attributes have an impact on the board’s ability to monitor and
advise the corporation?
Do companies with certain structural features perform better/ worse than
those who lack them?
A determination of how to structure the board should be based on

rigorous statistical evidence.
At the same time, it should allow for situational differences across

companies.

Chairman of the Board
The chairman is the liaison between the board and management, and
between the board and shareholders.
The chairman presides over the board, schedules meetings, sets the
agenda, and distributes materials in advance.
The chairman leads the discussion of important items

Strategy, risk, performance, compensation, succession, and mergers.
Shapes the timing and manner in which items are discussed and, therefore,
is critical to the governance system.

Chairman of the Board
Should the chairman be independent?

(+) Clear separation from management.
Eliminates conflicts of interests.
Clear authority to speak on behalf of the board.
(+) CEO can focus on the management of the company.
(–) Artificial separation if dual Chairman/CEO is effective.
(–) Difficult to recruit new CEO that expects to hold both titles.
(–) Complicates decision making.
• No research evidence that an independent chairman improves

or destroys shareholder value.
• Decision to separate should be based on situation.
Boyd (1995); Brickley, Coles and Jarrell (1997)

Independent Directors
Independent judgment is critical to the advisory

and monitoring functions of the board.
(+) Offer objective evaluation of company and management.
(+) Allow for arm’s-length negotiation of compensation.
(+) Make decisions solely in the best interest of the company.
(–) Directors who meet NYSE standards may not be independent.
Social ties may compromise judgment.
(–) Less informed about company than insiders.
(–) Only effective if they are both qualified and engaged.
• Earlier years’ empirical evidence is largely mixed (due to endogeneity).

• More recent studies try to establish a causal relationship:
• Stock return to announcements of independent director sudden deaths is
significantly negative.
• Board independence leads to better firm performance, greater sensitivity of forced
CEO turnover to performance, and greater sensitivity of CEO pay to performance.
Nguyen and Nielsen (2010); Knyazeva et al. (2013); Guo and Masulis (2015)

How to establish causal inferences?
Endogeneity:
Exogenous events:
Sudden deaths (Nguyen and Nielsen 2010)
Policy shocks (Guo and Masulis 2015)
Instrumental variables (Knyazeva, et al. 2013)

Independent Committees
The audit, compensation, and nominating/governance committees are

required to be independent (Sarbanes Oxley).
Specialized committees (strategy, finance, technology, and

environmental, etc.) have no independence requirements and may
include executive officers.

Independent Committees
Are committees more effective when they are independent (either majority
or 100%)?
(+) Objective advice and oversight.
(+) Less susceptible to being co-opted by management.
(–) Decision making may suffer.
Independent directors have a “knowledge gap”.
Management brings important firm-specific knowledge.
• An independent nominating committee incrementally increases the sensitivity

of turnover to performance beyond the effects of board independence.
However, if the CEO is a member of the nominating committee, the
sensitivity declines, consistent with weaker board oversight.
• In an international sample, reforms that raise audit committee independence
improve shareholder value.
• Some early evidence that investment and finance committees benefit from an
insider’s firm-specific knowledge. No evidence for audit or compensation
committees.
Guo and Masulis (2015); Fauver et al. (2017); Klein (1998)

Busy Boards
“Busy” director: director holds multiple board seats (generally 3 or

more).
“Busy” board: a majority of boards are busy.
Total unique directors 29,089
Directors with:
1 board seat 24,144
2 board seats 3,583
3 board seats 1,020
4 board seats 254 Potentially busy
directors
5 or more 88
Corporate Board Member and PricewaterhouseCoopers (2009)

Busy Boards
Are busy directors better or worse corporate monitors?

(+) Bring important experiences from other directorships.
(+) Broad social and professional networks.
(+) May have higher ability or integrity (reason they are in demand).
(–) May be too busy to properly monitor.
(–) May be less available at critical moments.
• Companies with busy directors tend to have worse long-term

performance and worse oversight.
• However, busy boards can better provide advice to IPO firms due to
their experience and contacts.
Falato et al. (2014); Hauser (2018); Masulis and Zhang (2019);

Field, Lowry, and Mkrtchyan (2013)

Interlocked Boards
Interlocked boards: the CEO of firm A sits on the board of firm B,

while the CEO of firm B sits on the board of firm A.
(+) Creates a network between companies.
(+) Facilitates the flow of information and best practices.
(–) Creates a dynamic of reciprocity.
(–) Can compromise objectivity and weaken oversight.
• Network connections generally improve corporate performance.

• Effects are most pronounced among companies that are newly formed,
have high growth potential, or in need of a turnaround.
• At the same time, interlocking leads to decreased monitoring (less to
terminate underperforming CEO; award higher compensation).
• Companies must balance trade-off.
Larcker, So, and Wang (2013); Nguyen (2012); Hallock (1997)

Board Size
Board size tends to be correlated with company revenue.

Small companies (<$10 million): 7 directors, on average.
Large companies (>$10 billion): 11 directors, on average.
(+) Bring more information to the decision-making process

(+) Adapt to complicated operations
(–) Greater cost (compensation, scheduling conflicts, etc.).
(–) More compromises to reach consensus; slow decision making.
• Board size is negatively correlated with firm value for simple firms
and positively correlated for complex firms (those with multiple
business segments).
• Decisions of larger boards are less extreme, leading to less variable

corporate performance.
Coles, Daniel, and Naveen (2008); Cheng (2008)

Diverse Boards
Do diverse boards provide better advice and oversight?

(+) Broader array of knowledge, experience, and perspective.
(+) Encourages healthy debate and lessens “groupthink” (premature
consensus).
(–) Diverse groups exhibit lower teamwork.
(–) May lead to “tokenism”.
• Female directors can enhance boards’ advisory effectiveness by contributing diverse

skills (risk management, human resources, sustainability, etc.).
• Female directors help mitigate the excessive risk-taking of overconfident or
overoptimistic male executives.
• Sudden deaths of female independent directors have negative stock market
reactions.
• Diversity for the sake of meeting arbitrary quotas is detrimental (the cost of
inexperience outweighs the potential benefits). Mentoring and development that
improve director qualification are necessary.
Kim and Starks (2016); Huang and Kisgen (2013); Bernile et al. (2018); Banerjee et al. (2020);
Ahern and Dittmar (2012)

Summary of Evidence
Structural Attribute Findings from Research

Independent chairman No evidence
Independent directors Positive after addressing endogeneity
Evidence for nominating and audit
Independence of committees
committees
Negative for monitoring
Busy boards
Positive for advising
Negative for monitoring
Interlocked boards
Positive for performance
Negative for simple firms
Board size
Positive for complex firms
Negative for tokenism
Diversity
Positive otherwise

Case 1: Yin Guangxia
Yin Guangxia: an example of an inefficient board

A listed company in China mainland.
It inflated sales by more than RMB1 billion between 1997 and 2001, and
earnings by more than RMB0.77 billion.
The accounting fraud is first revealed by a financial media.
After the fraud is revealed, its stock price declines 10% each day for 15
consecutive trading days.
It was named as “China’s Enron”.
The fraud was so obvious but the board did not detect its presence:
Even if the company operates at its full capacity, and 24 hrs/day, it cannot
produce enough products for reported sales;
The selling price is unbelievably high;
Tax refund for foreign sales is not received by the company.

Case 1: Yin Guangxia
Most members in both the board of director and the board of supervisor
are former government officials: they lack both incentives and expertise
to monitor managers.

Case 2: Another Board
Background of board members

Former dean of the Stanford Business School
Former chairman of US Commodity Futures Trading Commission
A former member of UK House of Lords and House of Commons, and
former UK Energy minister
Ronnie C. Chan: Chairman, Hang Lung Group
Former and current presidents of University of Texas M.D. Anderson Cancer
Center
CEOs or chairmen of several other big companies: Alliance Capital
Management, Comdisco, Inc., Belco Oil and Gas Corp., Gulf and Western
Industries Inc., Winokur Holdings Inc., Portland General Electric
Looks good? An efficient board?

Case 3: Lehman Brothers
Failed during the financial crisis in 2008.
http://www.investopedia.com/articles/economics/09/lehman-brothers-
collapse.asp
Board of directors (
https://www.sec.gov/Archives/edgar/data/806085/000110465907013
760/a07-5283_1def14a.htm
)
10 directors: 8 were independent according to NYSE rules
CEO was the chairman
Age: average of 68 (cf. 61 at average large corporation)
Diverse professional background (former CEOs, executives from both for-
profit and non-profit sectors)
Not overly busy
Compensated with a mix of equity
 How does the board of directors look?

Some red flags?

Absence of financial services expertise
Absence of current business experience
No current CEOs of major public corporation
Former CEOs were well into retirement
 Were professional experiences of board members relevant for understanding

the increasing complexity of financial markets?
 Why directors from non-profit sector?
 Too old?

Were the directors really engaged in monitoring the management?

CEO Richard Fuld was “aggressive, confrontation, blunt” and tended to
isolate himself from colleagues
Committee composition
E.g., the theatrical producer was appointed to audit committee and the finance
& risk committee
E.g., finance & risk committee met only twice during the year
E.g., executive committee appeared to be more active than the full board and
committees
 Was the committee structured properly?

 Was oversight quality compromised?

Conclusion
It is easy to achieve the letter of good governance, but it is difficult to

achieve the spirit or the reality of good corporate governance.
Corporate governance is about making sure that the right questions are
asked and the right checks and balances are in place, and not about
superficial construct.

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Directors: Duties and Effectiveness

© 2021 City U of HK All rights reserved 1

In the early age of shareholding companies, when directors met

Society for Establishing Useful Manufactures (SUM), 1791

© 2021 City U of HK All rights reserved 2

Fiduciary duty: directors must place shareholders’ interest above their

© 2021 City U of HK All rights reserved 3

© 2021 City U of HK All rights reserved 4

The board of directors has a dual mandate:

Effective boards satisfy both functions.

OECD Principles of Corporate Governance:

Organisation for Economic Co-operation and Development (2015)

© 2021 City U of HK All rights reserved 5

Represent the interest of shareholders

© 2021 City U of HK All rights reserved 6

Independent directors are those who “have no material relationship” with

A director is not independent if director or family member has, in the

© 2021 City U of HK All rights reserved 7

“Independence” is defined according to regulatory standards.

However, independence standards may not be correlated with true

Requires a careful evaluation of board member’s biography, experience,

Boards are expected to be independent.

© 2021 City U of HK All rights reserved 8

Presided over by the chairman: sets agenda, schedules meetings,

Decisions made by majority rule.

To inform decisions, board relies on materials prepared by management.

Periodically, independent directors meet without the presence of

Directors report spending 20 hours per month on board

National Association of Corporate Directors (2014)

© 2021 City U of HK All rights reserved 9

Not all matters are deliberated by the full board.

All boards are required to have audit, compensation,

On important matters, the recommendations of the committee are

Committees may be standing or ad hoc, depending on the issue at

© 2021 City U of HK All rights reserved 10

Responsibilities of the audit committee include:

Audit committees meet on average 8 times per

© 2021 City U of HK All rights reserved 11

Responsibilities of the compensation committee include:

Compensation committees meet on average 6 times

© 2021 City U of HK All rights reserved 12

Responsibilities of the nominating/governance committee include:

Nominating/governance committees meet on average

© 2021 City U of HK All rights reserved 13

Executive Science & technology

Prevalence of specialized committees:

Spencer Stuart (2013)

Thursday, December 15, 202 AC5690 Corporate Governance 14

Two main election regimes:

Staggered boards are an effective antitakeover protection; but it may

Prevalence of staggered boards:

© 2021 City U of HK All rights reserved 15

In most companies, directors are elected on a one-share, one-vote basis.

Shareholders may withhold votes but not vote against.

Four main voting regimes:

Typically, only one slate of directors is put forth for election; in a

© 2021 City U of HK All rights reserved 16

Compensation must be sufficient to attract, retain, and motivate

Compensation covers time directly spent on board matters, cost of

Committee Fees 10,500 16,200

Non-Retainer Equity 105,800 57,800

Total Director Comp $229,900 $132,600

% Equity 45% 46%

© 2021 City U of HK All rights reserved 17