Board Committee Roles and Responsibilities

Board Committee Roles and Responsibilities Chapter V

Chapter Objectives: • Provide an overview of the functions of board committees. • Understand the roles and responsibilities of board committees. • Be aware of the objectives of establishing board committees. • Become familiar with the duties, responsibilities, and composition of the audit, compensation, nominating, governance, and special committees. • Understand the process and emerging practices for the election of corporate directors.

Stanford Financial Group Robert Allen Stanford, the chief of the Stanford Financial Group. June 25 photo, Texas billionaire R. Allen Stanford is escorted into a federal courthouse in Houston http://www.youtube.com/watch?v=2l71ds7PgJc&feature=related

Key Terms Audit committee Compensation committee Enterprise risk management Governance committee Nominating committee Special committee Strategic board Succession planning Tone at the top Whistleblower

Relevance of Board Committees The establishment of board committees can bring more focus to the board’s oversight function by giving proper authority and responsibilities and by demanding accountability for these committees. Listing standards of national stock exchanges require that listed companies form at least three board committees that must include audit, compensation, and nominating committees. In addition to these three mandatory committees, public companies often have governance and other committees such as finance, IT, and disclosure. Average number of directors 9-15

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, the board committee is a subset of the board, and it performs 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 Committees – This committee is usually led by corporate counsel, CFOs, or controllers. It is responsible for reviewing and monitoring the company’s 10-Ks, 10-Qs, and other SEC filings, 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.

Audit Committee Lawmakers (SOX), regulators (SEC rules), and listing standards of national stock exchanges (NYSE, Nasdaq, AMEX) generally require public committees to have an audit committee, which must be composed of independent directors with no personal, financial, or family ties to management. Standards Relating to Listed Company Audit Committees outline these requirements, which relate to: Audit committee members to be independent Audit committee members to select and oversee the issuer’s independent account Procedural process for handling complaints regarding the issuer’s accounting practice The authority of the audit committee to engage advisors Funding for the independent auditor and any outside advisors engaged by the audit committee

Definition of the Audit Committee - A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; and if no such committee exists with respect to an issuer, the entire board of directors of the issuer. (Section 205(a) of SOX) - A committee composed of independent, nonexecutive directors charged with oversight functions of ensuring responsible corporate governance, a reliable financial reporting process, an effective internal control structure, a credible audit function, an informed whistleblower complaint process, and an appropriate code of business ethics with the purpose of creating long-term shareholder value while protecting the interests of other stakeholders (In the context of the agency theory)

Historical Perspective on Audit Committee

Audit Committees Pre-SOX • Voluntary audit committees • Personal and economic ties to management and corporation • Liaison between management and independent auditors • Limited knowledge of financial reporting • Infrequent and short meetings • Lack of proper authority and resources Post-SOX • Mandatory audit committees • Independent members of audit committees • Financial expertise • Appoint, compensate, retain, and oversee independent auditor • Comply with new requirements for “independent” directors • Establish procedures for receipt, retention, and treatment of complaints relating to accounting, auditing, and internal control matters • Have authority to engage advisors • Be given appropriate funding, as determined by the audit committee, for external auditors and advisors • Disclosure of existence of at least one audit committee financial expert, if not, explain why not • Name of the audit committee financial expert and whether independent from management

Audit Committee Relationships with Others Audit Committee Board of Directors Works with other committees, assists board by bringing specialization and expertise in the areas of financial reporting, internal controls, risk management, and audit activities. Audit Committee Management Asks appropriate questions pertaining to the company’s corporate governance structure, internal controls, financial reporting, audit activities, risk assessment, codes of ethics, and whistleblower programs. Management should provide sufficient information. Audit Committee External Auditors Directly responsible for hiring, compensating, and firing external auditors, as well as overseeing their work. External auditors are held ultimately accountable to the audit committee and should submit their reports of the audit on ICFR and the audit of financial reporting to management via the audit committee. Audit Committee Internal Auditor Should be responsible for hiring, overseeing, compensating, and firing the head of the internal audit department (CAE), and internal auditors should report their audit findings directly to the audit committee, being ultimately accountable to that committee.

Audit Committee Oversight of External Auditors The extended oversight responsibilities for the audit committee are: 1. Appointment, compensation, and retention of registered public accounting firms 2. Preapproval of audit services and permissible non audit services 3. Review of the independent auditor’s plan for an integrated audit of both ICFR and annual financial statements 4. Review and discussion of financial statements audited or reviewed by the independent auditor 5. Monitoring the auditor’s independence 6. Auditor rotation requirement

Independent Auditors Communications with the Audit Committee

Audit Committee Effectiveness Audit committee formation Audit committee independence Audit committee members’ qualifications Audit committee authority Audit committee funding Audit committee oversight function Audit committee accountability Audit committee charter Audit committee agenda Audit committee orientation, training, and continued education

Audit Committee Composition Audit committee composition is discussed in terms of size, independence, qualifications, attributes, and resources: Audit Committee Size - The size of the committee usually ranges from three to six members, whereas the SEC rule and listing standards for public companies require at least three independent members and should be composed for at least three months. Audit Committee Independence - The audit committee should be composed of independent, nonexecutive, outside directors.

Audit Committee Composition Member Qualifications - At least one member of the audit committee should be designated as a financial expert. The company’s board of directors should apply the SEC’s definition and consider audit committee members’ experience and knowledge in determining which members qualify as financial experts and, if none qualify, recruit at least one member who meets the required qualifications. Audit Committee Authority/Resources - SOX, recognizing the increased responsibilities assigned to audit committees, authorizes them to engage independent counsel and other outside advisors as they deem necessary and requires the company to provide appropriate funding for such advisors.

Audit Committee Responsibilities Audit committee oversight responsibilities can be grouped into the following categories: Corporate governance Internal controls Financial reporting Audit activities Code of ethics conduct Whistleblower program Enterprise risk management Financial statement fraud

Audit Committee Meetings A combination of formal audit committee meetings with the presence of senior executives and executive meetings with just internal and/or external auditors should improve the effectiveness of audit committee oversight functions. The audit committee should meet at least four times a year to review the company’s quarterly financial reports and as needed to address other important issues. The quality and quantity of meetings can have a significant impact on the effectiveness of fulfilling the audit committee’s oversight responsibilities.

Audit Committee Agenda The audit committee should have a well-defined, written agenda for all of its meetings. The agenda should cover: the minutes of the previous meeting; a review of current financial statements; a review of the current management, independent auditor reports on ICFR including identified material weaknesses in internal control, and the management responses to reported material weaknesses; a review of the established whistleblower programs and the appropriate responses to those complaints; a review of the company’s enterprise risk management to ensure objectives are defined, risks are assessed, and procedures are designed to minimize risks; a review of internal auditors, external auditors, audit plans, scope, and findings.

Audit Committee Reporting Audit committee reports to shareholders include, among other things, a description of audit committee responsibilities, its activities and accomplishments, and its self-assessment of how well it has discharged its assigned responsibilities. Question: What are the main paragraphs in audit committee reporting?

Legal Liability of Audit Committees SEC rules provide the following safe harbors in addressing the concerns about the increased liability of an audit committee member designated as a financial expert: 1. An audit committee financial expert is not deemed to be an “expert” for the purpose of liability under Section 11 of the Securities Act of 1933. 2. The designation of a member as a financial expert does not impose liability, obligation, or duties above and beyond those of other members of the audit committee or the board of directors, nor does the designation affect the liability, obligations, or duties of other members of the committee or board.

Compensation Committee The compensation committee is usually formed to determine the compensation and benefits of directors and executives. Structure: The committee should be composed of all independent directors who rotate periodically. Responsibilities: Committees have a set of responsibilities which they need to follow strictly. Proxy statement disclosure: The committee is directly responsible for ensuring that all aspects of executive compensation are fully and fairly disclosed in the annual proxy statement. Committee responsibilities: Evaluation of directors Design and implementation of director compensation plans Evaluation of senior executives Design and implementation of executive compensation plans

Compensation Committee (Cont.) Performance metrics typically used by the compensation committee include: Earnings per share (EPS) Cash flow Total shareholder return (TSR) Return metrics Economic profit or economic value added (EVA) Revenue Operational metrics Qualitative factors SEC rules require proper disclosure of executive compensation without imposing or even assessing the nature and extent of the company’s executive compensation This is why everything the compensation committee does should be properly disclosed.

Corporate Governance Committee The corporate governance committee should be composed of both executive and nonexecutive directors and should be held accountable for developing and monitoring the company’s governance principles, including the roles and responsibilities of directors and officers. The corporate governance committee should be in charge of establishing the agenda for the company’s board of directors to determine what the board should discuss with management and to what extent. The corporate governance committee should provide sufficient information to the board to enable it to effectively review the company’s performance. This information should consist of both financial and non-financial measures of its performance, its comparison with the industry’s best practices, and the company’s budget.

Nominating Committee The nominating committee is usually responsible for evaluating and nominating a new director to the board, and it also facilitates the election of the new director by shareholders. The nominating committee is responsible for: (1) reviewing the performance of current directors; (2) assessing the need for new directors; (3) identifying and evaluating the skills, background, diversity, and knowledge of candidates; (4) having an objective nominating process for qualified candidates; (5) assisting in the election of qualified new directors.

Public companies may form other standing or special committees to deal with issues requiring particular expertise. Examples: Finance committee to oversee financial activities Outside director’s committee to maintain board independence Executive committee to approve management’s decisions, plans, and actions on a behalf of entire board. Other Board Standing Committees

Conclusion Listing standards require listed companies to form at least three board committees, including the audit, compensation, and nominating/governance committees. Board committees are usually formed as a means of improving the effectiveness of the board in areas where more focused, specialized, and technically oriented committees are deemed necessary. Audit committees act as guardians of investor interests by assuming oversight responsibilities in the areas of corporate governance, financial reporting, audit activities, and compliance with applicable regulations. The audit committee is one of the major standing committees of the company’s board of directors and, as such, works with other board committees, company management, and external and internal auditors to effectively fulfill the board’s fiduciary duties to all stakeholders. External and internal auditors are ultimately held accountable to the audit committee and should submit their reports to the audit committee. The determinants of an effective audit committee include diligence, independence, communication, responsibility, accountability, resources, working relationships, evaluation, functions, and legal liability.

Conclusion The composition of the audit committee, including size, independence, qualifications, and resources, can have a significant impact on its effectiveness. At least one of the members of the audit committee should be designated as a financial expert. Audit committee responsibilities may be grouped into the following categories: corporate governance, internal controls, financial reporting, audit activities, code of ethics conduct, whistleblower programs, enterprise risk management, and financial statement fraud. Audit committee reports to shareholders include, among other things, a description of audit committee responsibilities, its activities and accomplishments, and its self-assessment of how well it has discharged its assigned responsibilities. Responsibilities of the compensation committee can be generalized into three categories: (1) evaluating the performance of directors and senior executives, (2) designing and implementing compensation plans for directors and executives, and (3) disclosing the activities of the compensation committee.

Conclusion Listing standards of national stock exchanges and best practices require a formal annual evaluation process for the board of directors, each major committee of the board, and each member of the board committees. The compensation report should fully disclose the company’s compensation policies. The corporate governance committee should be composed of both executive and nonexecutive directors. The corporate governance committee should be in charge of establishing the agenda for the company’s board of directors to determine what the board should discuss with management and to what extent. The corporate governance committee should provide sufficient information to the board to enable it to effectively review the company’s performance. The information should consist of both financial and nonfinancial measures of its performance, its comparison with the industry’s best practices, and the company’s budget. The nominating committee is responsible for the proper composition of the board, including director independence, skills, diversity, and commitment.

Board Committee Roles and Responsibilities