Guidelines for Formation, Composition and Function of Board Committees

John P. Beavers
Partner, Bricker & Eckler LLP
March 2001

The governing body of most organizations, like the board of directors of a corporation, is often responsible for oversight of the business and affairs of the organization. This is true for the board of trustees of most non-profit organizations, the board of managers of most limited liability companies, and the executive committee of many partnerships.

Generally, most states’ laws governing organizations that allow the separation of management in a governing body, separate of the owners, vest all of the organization’s power and authority in its governing body, except to the extent otherwise reserved to or vested in owners or members. Corporate law and most other organizational laws recognize that a governing body or board does not exercise all of that power and authority directly, but “under the direction” of that governing body or board. In reality, most governing bodies or boards exercise the authority under their direction by delegating to others, such as:

  • Committees of the board;

  • Officers or senior management; and

  • Professionals or other experts, including legal counsel and public accountants.

Many states’ laws reflect this reality by entitling the board as well as individual directors to rely upon information, opinions, reports, or statements, including financial statements and other financial data, that are prepared or presented by committees, officers, senior management, professionals, or other experts.

Most governing bodies or boards perform work, especially oversight, through committees. In order to have access to publicly traded securities markets in the United States, most organizations are required to have, at the very least, an audit committee, a compensation committee and a nominating committee of the governing board. The Securities Exchange Commission (SEC) proxy rules mandate reports from the audit and compensation committees (if either exists). This committee structure permeates not only Fortune 500 companies, but also all for-profit and non-profit organizations that have emerged beyond the start-up phase of their life cycle. Typically, these committees are a condition for any substantial investment in the organization, whether in the form of debt or equity, beginning with the first substantial loan or extension of credit by banks or other commercial lenders.

In December 1999, the SEC1, the New York Stock Exchange (NYSE)2, the National Association of Securities Dealers (NASD), and the American Stock Exchanges (AMEX)3 adopted rules and proposed additional rules following the recommendations of the Blue Ribbon Committee on Improving Effectiveness of Corporate Audit Committees. The purpose of both the adopted and proposed rules is to require greater independence and competence among members of audit committees4. The application of these rules, even the proposed rules, will touch every organization that publicly trades securities in U.S. markets. Moreover, these rules will probably have a much broader application, covering all organizations, whether for-profit or non-profit, where management is separate from ownership. All of the capital markets, not just the securities markets, will likely require the same independence and competence required by the recently announced and proposed rules. These rules are likely to be imposed as conditions to capital not only from public investors, but also from venture capitalists, institutional investors, commercial lenders and angel investors.

Some General Guidelines

A number of trade associations, institutional investors and even some regulators have issued guidelines for the structure and governance of these committees. The American Bar Association offers the following guidelines:

  • The composition of the committee should be appropriate to its purpose. This includes relevant experience and independence from management by all or, at least, a majority of the members of such key committees as audit, nominating, and compensation.

  • The board as a whole should determine whether its committees are following appropriate meeting schedules and have appropriate agendas to enable them to fulfill their delegated functions. Furthermore, each committee needs to keep the board informed of committee activities, including periodic reports at board meetings, circulation of committee minutes, and reports of meetings to all directors. Board members do not fulfill their responsibilities simply by delegating authority to a committee. The full board, including directors not on a particular committee, must make reasonable efforts to keep abreast of the activities of its committee.

  • A committee’s actions must observe the limits imposed by the appropriate organizational laws of most states, which limit the authority of committees with respect to certain board actions. For example, a committee may not normally declare dividends, fill board vacancies, amend bylaws or articles of incorporation, or authorize issuance of stock.

  • The duties of each committee should be clearly defined, typically in bylaws or board resolutions. There should be a periodic review to ensure that the duties assigned are both realistic and consistent with what the committee is actually doing.

  • From time to time, committees undertake special duties and responsibilities. Usually, board or committee minutes, or some other documentation, describing the special duties and responsibilities assigned to or undertaken by a committee should be prepared and included in the corporation’s records.

These general guidelines are likely to be rewritten in light of the SEC, NYSE, and NASD/AMEX rules adopted following the Blue Ribbon Committee. I believe that the resulting guidelines will apply to all of the oversight committees of the governing body or board of any organization.

Audit Committee

The audit committee became a common component of corporate organizations after the NYSE required companies to have audit committees as a condition to having their securities listed for trading. Traditionally, the audit committee oversees the organization’s financial reporting process and internal controls. Because of the reach of NYSE and NASD/AMEX rules, almost every organization with publicly traded securities has a functioning audit committee.

Charter provision

In order to assure public investors and other providers of capital that an audit committee exists and remains part of the organization’s structure, organizations are generally required to have access to capital to provide for an audit committee in its governing documents. Both the NYSE and NASD/AMEX refer to this as a “formal written charter” that must specify:

  • The scope of the audit committee’s responsibilities, and how it carries out those responsibilities, including structure, processes, and membership requirements.

  • The audit committee’s responsibility for ensuring that it receives a formal written statement delineating all relationships between the auditor and the company from the outside auditors, consistent with Independence Standards Board Standard 1; the audit committee’s responsibility for actively engaging in a dialogue with the auditor in regard to any disclosed relationships or services that may impact the objectivity and independence of the auditor; and the audit committee’s responsibility for taking, or recommending that the full board take, appropriate action to oversee the independence of the outside auditor.

  • The outside auditor’s ultimate accountability to the board of directors and the audit committee, as representatives of shareholders, and these shareholder representatives’ ultimate authority and responsibility to select, evaluate, and, where appropriate, replace the outside auditor (or to nominate the outside auditor to be proposed for shareholder approval in any proxy statement)5.

Composition

Size. Audit committees are generally required to have at least three members. The actual size of the audit committee depends upon both the size and complexity of the structure and business of the organization and the experience and time of those available for membership in the committee. Based upon surveys of publicly held and mid-cap companies, three members is the minimum, while seven to nine members is the maximum.

Independence. The requirement for organizations with publicly traded securities and the expectations with respect to all other organizations is that members of an audit committee must be “independent.” Today, independence means more than just being from the “outside.” Under the NASD/AMEX rules, which will likely have the greatest applicability, “independence” means “a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.” The following persons shall be expressly excluded from being considered as independent:

  • A director who is employed by the corporation or any of its affiliates for the current year or any of the past three years.

  • A director who accepts any compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year, other than compensation for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation.

  • A director who is a member of the immediate family of an individual who is, or has been in any of the past three years, employed by the corporation or any of its affiliates as an executive officer. Immediate family includes a person’s spouse, parents, children, siblings, mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law, and anyone who resides in such person’s home.

  • A director who is a partner in, or a controlling shareholder or an executive officer of, any for-profit business organization to which the corporation made, or from which the corporation received, payments (other than those arising solely from investments in the corporation’s securities) that exceed five percent of the corporation’s or business organization’s consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years.

  • A director who is employed as an executive of another entity where any of the company’s executives serve on that entity’s compensation committee6.

The recent audit committee rules introduced a new concept of avoiding any “compensation cross link.” This rule excludes from independence any member of the organization’s governing body or board who is an executive of another company where any of the organization’s executives serve on the compensation committee. Any link between the compensation of a member of an organization’s governing body or board and the discretion of an insider of the organization disqualifies that member from independence of serving on the organization’s audit committee7.

Competence. Within a reasonable period of appointment to the audit committee, each member must be competent “to read and understand fundamental financial statements, including the organization’s balance sheet, income statement, and cash flow statement8.” In addition, at least one member must have:

  • Past employment experience in finance or accounting;

  • Requisite professional certification in accounting; or

  • Other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities9.

Exceptions. The NASD/AMEX rules permit limited exceptions to the independence and competence rules. One exception is for small businesses subject to SEC Regulation S-B. However, even for these small businesses, the requirements of independence and competence are likely to be required by either public investors or other providers of capital. Another exception is that one member who is not independent may be appointed to the audit committee, if the board, under exceptional and limited circumstances, determines that membership on the committee by the individual is required by the best interests of the corporation and its shareholders. Even then, the non-independent member may not be a current employee or an immediate family member of an employee10.

Functions

Traditionally, an audit committee’s functions include:

  • Recommending which firm to engage as the corporation’s external auditor and whether to terminate that relationship.

  • Reviewing the external auditor’s compensation, the proposed terms of its engagement, and its independence.

  • Reviewing the appointment and replacement of the senior internal auditing executive, if any.

  • Serving as a channel of communication between the external auditor and the board and between the senior internal auditing executive, if any, and the board.

  • Reviewing the results of each external audit, including any qualifications in the external auditor’s opinion, any related management letter, management’s responses to recommendations made by the external auditor in connection with the audit, reports submitted to the audit committee by the internal auditing department that are material to the corporation as a whole, and management’s responses to those reports.

  • Reviewing the corporation’s annual financial statements and any significant disputes arising between management and the external auditor in connection with the preparation of those financial statements.

  • Considering, in consultation with the external auditor and the senior internal auditing executive, if any, the adequacy of the corporation’s internal financial controls. Among other things, these controls must be designed to provide reasonable assurance that the corporation’s publicly reported financial statements are presented fairly in conformity with generally accepted accounting principles.

  • Considering major changes and other major questions of choice regarding the appropriate auditing and accounting principles and practices to be followed when preparing the corporation’s financial statements.

  • Reviewing the procedures employed by the corporation in preparing published financial statements and related management commentaries.

  • Meeting periodically with management to review the corporation’s major financial risk exposures11.

  • Reviewing and discussing the financial statements with management on at least an annual basis.

  • Discussing with independent auditors the matters required by SAS 61 (Codification of Statements on Auditing Standards, AU § 380). Traditionally, SAS 61 required discussion of the auditor’s responsibility under generally accepted auditing standards; significant accounting policies; management judgments and accounting estimates; significant audit adjustments; any disagreements with management, including those over accounting principles, disclosures and the scope of the audit; difficulties encountered in performing the audit; and any material issues discussed with management prior to retention. The required matters now include the auditor’s view of the “quality” of the accounting principles and underlying estimates used in preparation of the financial statements as well as any clarity believed needed in the organization’s financial disclosures or practices. These “quality” discussions will likely include the reasonability and common acceptability of management’s choices of accounting principles as they impact income, asset and liability recognition.

  • Receiving the auditor’s letter of its independence in the auditing process together with any disclosures of interest required by Independence Standards Board Standard No. 1 (Independence Standards Board Standard No. 1, Independence Discussions with Audit Committees).

  • Recommending to the governing body or board whether the financial statements should be made available in reports to the SEC and shareholders and otherwise to public investors.

Enforcement

The enforcement of the audit committee requirements will eventually be contract conditions to obtaining capital. The SEC will indirectly enforce these conditions by requiring organizations with publicly traded securities to disclose whether:

  • The organization’s independent auditors review quarterly the financial information included in the Form 10-Q or 10-QSB Quarterly Reports and, at year-end, any resulting reconciliations and descriptions of any adjustments to the quarterly information previously reported.

  • The audit committee has: (i) reviewed and discussed the audited financial statements with management; (ii) discussed with the independent auditors the matters required to be discussed by Statement on Auditing Standards No. 61, as may be modified or supplemented; and (iii) received from the auditors disclosures regarding the auditors’ independence required by Independence Standards Board Standard No. 1, as may be modified or supplemented, and discussed with the auditors the auditors’ independence (see Section III.B below).

  • The audit committee, based on its review and discussions with management and the auditors, recommended to the governing body or board that the financial statements be included in the organization’s Form 10-K or 10-KSB annual report.

  • The governing body or board has adopted a written charter for the audit committee, and if so, include a copy of the charter as an appendix to the company’s proxy statements at least once every three years.

  • The audit committee members are “independent12.”

Compensation Committee

The compensation committee is now another common component of any organizational structure where management is separate from ownership. Traditionally, the compensation committee oversees whether:

  • The CEO and, to a lesser extent, the other executives are paid too much.

  • Their compensation reasonably relates to personal and corporate performance.

  • Their post-employment benefits properly relate to the best interests of the organization as a whole and are reasonable in amount.

  • There is effective oversight of management’s compensation13.

Charter provision

In order to provide assurance that a compensation committee exists and remains part of the organization’s structure, organizations are generally required to have access to capital to provide for a compensation committee in its governing documents. The coverage of such provisions is similar to those of audit committees previously discussed, except that they reflect the agreed functions of the committee as a compensation committee discussed below.

Composition

Size. Although it is not unacceptable for compensation committees to have as few as two members, they are expected to have at least three members. As with the size of any oversight committee, the actual size of the compensation committee depends upon both the size and complexity of the structure and business of the organization and the experience and time of those available for membership in the committee. Based upon surveys of publicly held and mid-cap companies, three members is the minimum and five to seven is the maximum.

Independence. Independence is expected in compensation committees and can be defined for these committees in the same way it is for audit committees under the NASD/AMEX rules. Under those rules, independence means more than just being from the “outside.” The same “compensation cross link” rule that is applicable in determining the independence of members of an audit committee can also be used when determining the independence of the compensation committee. See discussion under “Audit Committee - Composition.”

Competence. Although defining “competence” is new even with respect to audit committees, members of compensation committees are expected to be able to read and understand fundamental provisions of an employment contract and understand the impact of the provisions thereof on the financial statements, including the income statement and cash flow statement of the organization.

Functions

A compensation committee’s principal functions include:

  • Reviewing and recommending to the board, or determining, the annual salary, bonus, stock options, and other benefits, direct and indirect, of the senior executives.

  • Reviewing new executive compensation programs, including benefits, perquisites, and current and deferred pay; reviewing on a periodic basis the operation of the corporation’s executive compensation programs to determine whether they are properly coordinated; establishing and periodically reviewing policies for the administration of executive compensation programs; and taking steps to modify any executive compensation programs that yield payments and benefits that are not reasonably related to executive performance.

  • Establishing and periodically reviewing policies in the area of management perquisites, including use of the organization’s assets, such as automobiles, airplanes, loans or guarantee of the executive’s financial obligations.

  • Reviewing and discussing with the executive, on a periodic basis, his performance in the view of the governing body or board.

  • Planning for executive development and succession in the event of the disability, death or other departure or unavailability of the CEO. However, governing bodies or boards are well advised that the organization’s CEO should have considerable discretion in selecting and retaining members of the management team.

  • Reviewing and recommending appropriate indemnification and D&O insurance coverage of both the executives and the governing board or body and its committees.

  • Reviewing and recommending appropriate compensation of the members of the governing body or board and its committees14.

The structure and components of the compensation package for executives will vary among different geographic locations, organizations’ sizes, and industries. Other considerations include the competitive environment which could lure away the organization’s executives, the culture of the organization, and the style of the executive. There is no “one size fits all.”

Performance evaluations are an important part of the compensation process and the committee’s functions. This requires monitoring by the compensation committee and should result in adjustment of compensation or incentives based upon performance. Executives should receive feedback that includes not only the adjustments to compensation or incentives, but also a discussion of his or her performance.

Similar to an audit committee’s retention of an outside auditor, a compensation committee should hire its own compensation consultant rather than solely rely upon inside personnel or outside specialists selected by management, without participation of members of the compensation committee. Most compensation committees, even of the largest publicly held companies, do not have or need separate or independent staff.

The type of information that a compensation committee should expect from a consultant includes comparisons with comparable or competitive organizations, analyzed by size, segment of business, seniority of executive, and other relevant factors. The committee should have input as to which comparable or competitive organizations are included. The committee typically will want advice as to comparable industry norms and other comparability data.

Enforcement

As with audit committees, the enforcement of the compensation committee requirements will eventually be contract conditions to obtaining capital. The SEC indirectly enforces these conditions by requiring a report from the compensation committee describing the performance factors on which the committee relied in determining the compensation, as well as a discussion of the committee’s general policies with respect to executive compensation, in an organization’s proxy materials.

Nominating Committee

Another common component of any organizational structure where management is separate from ownership is the nominating committee. Although the function of a nominating committee with many mid-cap companies is performed by the CEO, the Business Roundtable recommends that the nominating committee, composed of non-management members, has the final say in composition of the governing body or board.

Charter provision

Nominating committees are not as likely to be memorialized in the organization’s governing documents as are audit and compensation committees. More often than not, the nominating committee’s authority is an enabling resolution of the governing body or board itself. However, expectations will likely increase to provide for charter provisions establishing nominating committees, especially as compliance functions of this committee increase.

Composition

Size. Although it is not unacceptable for nominating committees to have as few as two members, they are expected to have at least three members. As with the size of any oversight committee, the actual size of the nominating committee depends upon both the size and complexity of the structure and business of the organization and the experience and time of those available for membership of the committee. Based upon surveys of publicly held and mid-cap companies, three members is the minimum and five to seven is the maximum.

Independence. Despite trends to the contrary with audit and compensation committees, the CEO remains an active participant on most nominating committees. However, the CEO is typically the only non-outside member. The degree of independence of the remaining members is still not the same as for members of audit and compensation committees.

Functions

The principal functions of a nominating committee are to recommend:

  • The slate of nominees of members to the governing body or board, including those elected by owners as well as those appointed to fill vacancies; and

  • Members of the governing body’s or board’s committees.

If the CEO does not participate as a member of the nominating committee, he or she is often consulted frequently during the committee’s deliberations.

Increasingly, the nominating committee is participating in succession planning for key executives, such as CEOs. As discussed above, governing bodies or boards are well advised that the organization’s CEO should have considerable discretion in selecting and retaining members of the management team.

Enforcement

Enforcement of nominating committee functions is evolving. This evolution depends on the current trend for having:

  • Greater independence in the composition of the members of the governing body or board;

  • An independent member designated as the “lead” member and, in many cases, as the chair of the governing body or board;

  • The membership as well as the chair of the organization’s oversight committees being designated by someone other than the CEO; and

  • Independent members of the governing body or board meet periodically and separately from the other members to review the performance of management and of the body board as a whole.

Conclusion

Although the new audit committee rules established on the recommendation of the Blue Ribbon Committee apply only to organizations with publicly traded securities, the rules will likely have a much farther reaching impact. Any provider of capital will likely require compliance with the same or similar rules by any organization, for-profit or non-profit, taxable or tax-exempt, whose management is separate from its owners. By following the above guidelines, companies can ensure that their board committees not only satisfy the Blue Ribbon Committee rules, but also function in a way that best benefits their organization.

Bibliography

A. General

ABA Comm. On Corp. Laws, Corporate Director’s Guidebook, Section of Business Law, 2d ed. (1994).

ALI Principles of Corporate Governance: Analysis and Recommendations (1994).

Committee on Corporate Laws, “The Overview Committees of the Board of Directors,” 34 Bus. Law. 1837 (1979).

Kolb, “The Delegation of Authority to Committees of the Board of Directors: Directors’ Liabilities,” 9 U. Balt. L. Rev. 189 (1980).

Varallo, Gregory V. and Dreisbach, Daniel A., “Fundamentals of Corporate Governance: A Guide For Directors and Corporate Counsel,” (1996).

B. Audit Committee

SEC Release No 34-42266 (December 14, 1999).

NYSE Release 99-39 approved by the SEC in SEC Release No. 34-42233 (December 14, 1999).

NASD Release 99-48 approved by the SEC in SEC Release No. 34-42231 (December 14, 1999).

Conference Board, New Directors in Internal Auditing (Research Report No. 94, 1990).

Greene & Falk, “The Audit Committee--A Measured Contribution to Corporate Governance,” 34 Bus. Law. 1229 (1979).

Kessel, Mark, “Building a Better Audit Committee,” 8-FEB Bus. L. Today 5 (1999).

Mautz, Robert B. & Neumann, R., Corporate Audit Committees: Policies and Practice (3d ed. 1980).

McCauley, Daniel J. Jr., & Burton, John C., Audit Committees, C.P.S. (BNA) No. 49 (1986).

Reinstein, Callaghan & Briotta, “Corporate Audit Committees: Reducing Directors’ Legal Liabilities,” 61 U. Det. J. Urb. L. 375 (1984).

C. Nominating Committee

Bacon, Jeremy, Corporate Directorship Practices: The Nominating Committee and the Director Practices (1975). D. Compensation Committee

Foulkes, Executive Compensation: A Strategic Guide for the 1990’s (1991).

Friedheim, “Measuring Executive Performance,” Presented at the Corporate Governance Conference, Jan. 13, 1992.

Footnotes

1 SEC Release No 34-42266 (December 14, 1999).

2 NYSE Release 99-39 approved by the SEC in SEC Release No. 34-42233 (December 14, 1999).

3 NASD Release 99-48 approved by the SEC in SEC Release No. 34-42231 (December 14, 1999).

4 The Blue Ribbon Committee was appointed in September 1998 to study and recommend improving the reliability of financial statements of organizations doing business in interstate commerce. The Blue Ribbon Committee issued its report and recommendations in February 1999. The SEC, NYSE and NASDAQ/AMEX responded with new rules in December 1999.

5 See Rule 4310(c)(26) of the NASDAQ/AMEX listing rules. See also Rule 303.01(B) of the NYSE Listed Company Manual.

6 See Rule 4200(a)(15) of the NASDAQ/AMEX listing rules. See also 303.01(B)(3) of the NYSE Listed Company Manual.

7 See 303.01(B)(3)(3) of the NYSE Listed Company Manual.

8 See Rule 4310(c)(26)(B) of the NASDAQ/AMEX listing rules. See also 303.01(B)(2)(b) of the NYSE Listed Company Manual.

9 See Rule 4310(c)(26)(B) of the NASDAQ/AMEX listing rules. See also 303.01(B)(2)(c) of the NYSE Listed Company Manual.

10 See Rule 4310(c)(26)(B)(iii) of the NASDAQ/AMEX listing rules.

11 See the ABA Comm. On Corp. Laws, Corporate Director's Guidebook, Section of Business Law, 2d ed. (1994) and the ALI Principles of Corporate Governance: Analysis and Recommendations (1994). .

12 See SEC Release No 34-42266, ibid.

13 See the ABA Comm. On Corp. Laws, Corporate Director's Guidebook, Section of Business Law, 2d ed. (1994).

14 See the ABA Comm. On Corp. Laws, Corporate Director's Guidebook, Section of Business Law, 2d ed. (1994) and the ALI Principles of Corporate Governance: Analysis and Recommendations (1994).

More Board and Executive Governance articles ...