Corporate Governance Best Practices

Corporate governance determines the policies and procedures that direct and control a business and its decision-making process. Effective and efficient systems are vital to maximizing an organization’s strength, value and sustainability, as they help build relationships with stakeholders and ensure accountability, fairness, ethical behavior, transparency and regulatory compliance. Strong corporate governance also plays a key role in risk management, helping to reduce director and officer liability claims and positioning organizations to defend against them if they arise.

Business leaders should be proactive in establishing optimal corporate governance frameworks within their companies. This article provides an overview of best practices for achieving this goal.

Ensure Board Decision-making Is Independent

To enhance outcomes, corporate board members must be free to make decisions without undue influence from management. This can be accomplished by implementing several strategies, including the following:

• Ensure independent, nonexecutive members make up most of the board, while insiders (e.g., the CEO, chief operating officer and chief financial officer) remain in the minority.
• Assign independent, outside directors to the audit, compensation and nominating committees.
• Set mandatory term limits for directors to encourage fresh perspectives and reduce complacency.
• Ban or limit stock sales by directors to reinforce their commitment to the organization’s long-term success.
• Bar the exercise of options for a relatively long period (e.g., three, five or seven years) to promote long-term growth.
• Prohibit the exercise of options unless the stock meets or exceeds a specific benchmark.
• Charge the cost of option grants against current income, making the financial impact of these grants transparent.
• Award executives stock that must be held for several years to align their gains and losses with shareholder interests.
• Require shareholders, not just the board of directors, to vote on all stock option grants, adding a layer of oversight to reduce self-interested decision-making.
• Attendance at board and committee meetings
• Level of preparedness and engagement
• Ability to ask challenging and relevant questions
• Frequency of offering innovative and practical solutions
• Willingness to take and make constructive feedback

Require a Minimum Level of Stock Ownership

Requiring directors to own a minimum amount of company stock (e.g., a $250,000 equity stake) can encourage alignment of their interests with those of shareholders. Stock ownership also promotes long-term thinking and fosters accountability. However, an exception to this guideline applies to new directors who may be exempt from immediate stock ownership requirements; this allows time to gradually build an equity stake without creating short-term financial pressures that could influence their decision-making.

Reform Option-related Compensation Practices

Bringing increased discipline to granting options can reduce directors’ and officers’ temptation to artificially inflate the prices of stocks through short-term earnings maneuvers with the hopes of cashing in large option gains. Such actions improve governance and address compensation issues; certain accounting rules provide incentives for option grant abuses and stock price manipulation, potentially leading to questionable or even fraudulent accounting practices. Here are suggestions for reforms:

Separate the Roles of the Chairperson and CEO

Role separation can enhance corporate governance by having one individual, the CEO, in charge of creating overall strategies and running the company and another, the chairperson, chiefly responsible for leading the board in overseeing top management. This helps the chairperson and CEO avoid conflicts of interest and improve board oversight while dividing the roles that may be too much for one person to handle effectively. Separated roles may also improve underwriter confidence in governance practices, potentially leading to more favorable terms and rates for directors and officers (D&O) insurance by reducing the risk of liability-producing incidents, such as financial restatements.

Hold Board Meetings Without the CEO

Conducting board meetings without the CEO’s presence can facilitate open and unbiased discussions. These “executive sessions” can be focused on sensitive topics (e.g., CEO performance, succession planning and internal controls). These sessions allow board members to speak candidly and align on important governance issues without the influence of management. Executive sessions can be held at the beginning, middle or end of a board meeting. It is also essential for these meetings to still follow a standard process and to remain focused on the agenda.

Evaluate the Director’s Performance

The board of directors should regularly assess director and officer performance and evaluate if they have met the goals and standards set forth for them. Areas that should be evaluated include:

Several methods can be used to evaluate directors and officers, including self-evaluations, peer evaluations and external party evaluations. Evaluation standards should reflect both company-specific and industry benchmarks to ensure relevance and objectivity.

Improve Audit Committee Effectiveness

The audit committee conducts multiple important duties. It monitors and oversees financial reporting, disclosures and compliance requirements; the choice of accounting policies and principles; the hiring and evaluation of external auditors; ethics and whistleblower hotlines; internal control processes; internal audits; and risk management. As such, enhancing the role and effectiveness of the audit committee can strengthen a business’s overall corporate governance. Key practices for an effective audit committee include:

• Strong financial literacy to critically assess financial statements and disclosures
• Independence from management and auditors to allow for impartial oversight
• Frequent meetings to stay current on important issues
• One-on-one meetings with external auditors, senior management and internal teams to ensure they are well-versed in the financial aspects of the business
• Close examination of financial reporting and accounting policies to ensure compliance with all regulations and the generally accepted accounting principles
• Separate auditing and consulting services, if offered, to maintain objectivity when performing the annual audit
• Established procedures to receive, investigate and respond to complaints to create a safe and effective way for employees or others to report issues.

By implementing these practices, organizations can strengthen their corporate governance, improve accountability and foster a culture of transparency.

Provide Directors With Relevant and Timely Information

Ensuring directors receive necessary information in a timely manner is essential to support informed decision-making. Companies should strive to provide their boards with information packets containing pertinent information relevant to the issues on the upcoming meeting agenda. These packets should be clear and manageable, highlighting executive summaries and key points to facilitate quick review and comprehension. Information should be made available well in advance of each board meeting to allow directors adequate time to prepare and evaluate the materials thoroughly.

Limit Time Devoted to Board Service

Directors must balance commitments and responsibilities to devote adequate time and attention to board matters. To accomplish this, the National Association of Corporate Directors has stated individuals should not sit on more than four boards simultaneously. Excessive board commitments can lead to disengagement and diminished capacity to fulfill board responsibilities. It is also important to note that an assertion that a board member did not have adequate time to remain fully apprised of relevant corporate matters is not a valid defense to D&O insurance claims.

Avoid Conflicts of Interest

Avoiding conflicts of interest is paramount to maintaining integrity and trust, and organizations should have procedures to identify and mitigate potential conflicts of interest among board members. Additionally, “side deals,” which may involve the receipt of consulting or legal agreements, participation in lease agreements, or contracts to purchase or supply goods and services involving board members, can cast serious doubt on independence and should be avoided. Board members should also not provide brokerage or investment banking services to the company. Regular conflict-of-interest evaluations can reinforce the board’s commitment to transparency and unbiased governance.

Eliminate Corporate Board Interlock

Corporate board “interlock” occurs when a board member serves on a different company’s board or as a part of their management, potentially leading to quid pro quo deals, collusion or other improprieties. Interlocking relationships can also divert time and energy, undermining their commitment to the company. If an interlock exists between two competing companies, antitrust issues may arise, exposing the company to significant legal risks. Organizations can prevent these scenarios by establishing policies with procedures to identify interlocks, especially during mergers and acquisitions; monitoring board member activities; and providing education on the risks of corporate board interlocks.

Declassify the Board

Declassification requires all directors to stand for board reelection every year instead of serving staggered terms. This can help increase the board’s level of diversity and accountability and make it more responsive to shareholders, enhancing the organization’s value. However, annual elections may also pose challenges to board stability and continuity, potentially weakening the board’s anti-takeover profile. Organizations must weigh the benefits of accountability and improved shareholder support against stability considerations when deciding on board structure.

Seek Board Diversity

A diverse board can bring varied perspectives, enhancing board effectiveness and improving decision-making. These viewpoints can lead to higher rates of innovation through new ideas. Diverse boards can also improve an organization’s reputation and appeal to a wider range of customers while more completely representing its shareholders. Diversity can be achieved by creating inclusive recruitment practices that foster a working environment that promotes different perspectives, backgrounds, skills and experiences.

Conclusion

Robust corporate governance offers significant benefits to an organization. It can improve a business’s decision-making, accountability and efficiency while mitigating risk and promoting ethical behavior. Effective governance can also help reduce director and officer liability claims, strengthen a business’s reputation and build stronger stakeholder relationships. Business leaders should routinely seek initiatives to enhance their corporate governance practices and ensure the organization remains resilient and well-positioned for future success.  

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This Risk Insights is not intended to be exhaustive nor should any discussion or opinions be construed as legal advice. Readers should contact legal counsel or an insurance professional for appropriate advice. © 2024 Zywave, Inc. All rights reserved.