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15
THE BOARD
OF DIRECTORS
Charles A. Anderson
Robert N. Anthony
This chapter describes the nature and function of the board of directors,
which has the ultimate responsibility for governing a corporation. It describes
the board’s activities in normal meetings, in strategy meetings, and in special
situations, and it describes the work of three important board committees: the
compensation committee, the audit committee, and the finance committee.
We focus on large corporations whose stock is listed on a securities ex-
change. These corporations must conform to regulations of the Securities and
Exchange Commission. Most of the discussion is also relevant to boards of
smaller corporations.
WHY HAVE A BOARD OF DIR ECTORS?
Every corporation is required by law to have a board of directors. The board’s
legal function is to govern the corporation’s affairs. However, in a small corpo-
ration in which the chief executive officer (CEO) is also the controlling share-
holder, the CEO actually governs and the board acts primarily as an adviser.
When a corporation grows to a size where it needs outside capital, it may
go public by selling shares of stock (as explained in Chapter 14), and the board
then represents the interests of these shareholders. The shareholders, who are
the owners of the corporation, have a say in the way their company is run.
They expect to receive regular, reliable reports on the company’s operations.
If the company is profitable, they probably expect to receive dividends. If the
The Board of Directors 511
company has problems, the owners need to know about these problems so that
they can take any necessary remedial action.
A corporation may have many shareholders; American Telephone & Tele-
graph Corporation has 2.6 million. Individual shareholders obviously can’t gov-

ern the company directly; moreover, most of them are engaged in their own
pursuits and will not give much, if any, time to governance. They elect people
to act for them. This is the board of directors.
SIZE AND COMPOSITION OF THE BOARD
The typical board has about 11 members. Some boards, especially those in
banks, are much larger. Large boards must delegate much of their work to an
executive committee for overall matters and to several committees for specific
topics.
Most board members typically are “outside directors”; that is, they are
not employees of the corporation. At one time, most board members were “in-
side directors,” and this is still the case in a few boards. The trend toward out-
side directors results from the shareholders’ recognition that the board should
have a significant degree of independence from the company’s management.
The board is responsible for selecting, appraising, and compensating manage-
ment. If the board and management are the same people, the board can hardly
perform its governance role in an objective manner.
Many outside board members are CEOs or senior officers of other corpo-
rations (but not competitors). Other outsiders are lawyers, bankers, physicians
(on health-care boards), scientists and engineers (on high-tech boards), retired
government officials, and academics. A few people are professional board
members; that is, their principal occupation is serving on boards. The number
of female and minority board members has increased substantially in recent
years. The CEO and perhaps one or two senior members of management typi-
cally are members of the board.
Board members are compensated. Generally, they receive an annual re-
tainer plus a fee for meetings attended. In addition, many companies offer
some form of stock compensation and retirement benefits. According to a
Conference Board survey, the median basic annual compensation in manu-
facturing companies for 1999 (not including stock components) was $35,000.
When the value of the stock component was added, compensation totaled

$46,000.
Board members are elected at the annual meeting of shareholders. The
shareholders almost always elect the slate proposed by the incumbent board;
thus, as a practical matter, the board is self-perpetuating. The process of se-
lecting candidates for filling board vacancies is an important board function.
Many have staggered terms; that is, one-third of the board members are
elected each year for a three-year term. This practice is intended to make it
more difficult for corporate raiders to obtain control of the company.
512 Making Key Strategic Decisions
BOARD MEMBER RESPONSIBILITIES
In the following sections, we describe the specific activities for which the
board is responsible. In this section, we describe the responsibilities of indi-
vidual board members.
Board members must not personally buy stock or sell their own stock im-
mediately after they learn of important developments at board meetings or
other activities. Examples of relevant developments include current estimates
of earnings, change in dividend policy, a decision to acquire another company
or to buy back stock, and changes in senior management. The Securities and
Exchange Commission and rules of the stock exchanges impose an “earnings
blackout” period of one or two days in which such trading is prohibited.
Board members and management must not disclose any of these events to
a selected group of interested parties. For example, they must not make a tele-
phone conference call to a selected group, send an Internet message to them, or
disclose information at a meeting of such a group. When this information is dis-
closed, it must be made available at the same time to the general public. These
rules were significantly tightened in 1999 and 2000 by SEC Regulation FD.
RELATION TO THE CHIEF EXECUTIVE OFFICER
Their titles indicate that the board of directors “directs” and the chief execu-
tive officer “executes” the board’s directions, but these terms are not an accu-
rate description of the roles of these two parties. In the majority of companies,

the chief executive officer is also the board’s chairman and is the principal ar-
chitect of policies. Executing these policies is indeed a primary responsibility.
The CEO is truly the “chief.”
The board selects the CEO and, therefore, wants to give the CEO its full
support. The CEO is accountable to the board and may be terminated if the
board decides that the individual’s performance was unsatisfactory.
The appropriate relationship is one of trust. The board must believe that
the CEO is completely trustworthy, provides the board with all the informa-
tion it wants and needs, withholds nothing, and doesn’t slant arguments to sup-
port a preconceived position. The CEO, in turn, must believe that he or she has
the full support of the board.
Appraising the CEO
A board’s major responsibility is to appraise the CEO. If performance is below
expectations, there are two possible explanations: (1) The CEO is to blame, or
(2) extraneous influences are responsible. In most cases, both factors are in-
volved, and the directors have the extraordinarily difficult job of judging their
relative importance. If they conclude that the CEO has made an incorrect de-
cision, they may suggest a different course of action. More likely, however, they
The Board of Directors 513
may say nothing and mentally file the incident for future reference in evaluat-
ing the CEO. The Business Roundtable, a group of CEOs of leading companies,
succinctly described the directors’ role vis-à-vis the CEO as “challenging, yet
supportive and positive.”
An important function of board meetings, conversations, and even social
occasions is to give the directors a basis for continuously appraising the CEO.
Directors usually cannot make constructive suggestions on the details of cur-
rent operations. Occasionally, they may call attention to a matter that should be
investigated. Primarily, however, they listen carefully to what the CEO says
and do their best to judge whether things are going satisfactorily and, if not,
where the responsibility lies.

The directors want the CEO to be frank and to give an accurate analysis
of the company’s status and prospects; concealing bad news is one of the worst
sins a CEO can commit. Nevertheless, human nature is such that directors can-
not expect the CEO to be completely objective. Incipient problems may go
away, and making them known, even in the relative privacy of the boardroom,
may cause unnecessary alarm. Directors, therefore, are on the alert for indica-
tions of significant problems. In many well-publicized bankruptcies of public
companies, the directors were significantly responsible; they did not identify
or act on the problem soon enough.
Louis B. Cabot, former chairman of the board of Cabot Corporation, had
a frustrating experience with the ill-fated Penn Central Corporation. He joined
the Penn Central board about a year before the company went under. From the
outset, he was disturbed by management’s unwillingness to furnish the infor-
mation about performance that he felt he needed. A few months after joining
the board, he wrote the CEO a letter that contains the following succinct de-
scription of the director’s role:
I believe directors should not be the managers of a business, but they should en-
sure the excellence of its management’s performance. To do this, they have to
measure that performance against agreed-upon yardsticks.
The Next CEO
The board cannot tell beforehand whether a candidate will make a good CEO.
The best indicator is how well the individual performs in his or her current job.
In most instances, therefore, the board looks to senior executives with proven
track records as candidates for the CEO position. One of the most important
responsibilities that a board assigns to a CEO is to develop a succession plan
for the company’s senior managers. The purpose of such a plan is to identify
potential CEO candidates, provide them with opportunities for growth, and
groom them for higher level positions. The board participates actively in this
process by meeting with the CEO (usually once a year) in a meeting devoted
largely to reviewing the senior management. Typical questions asked are: How

is a key executive performing? What is his or her potential? Who are potential
successors for the CEO, now and in the future?
514 Making Key Strategic Decisions
At one company the authors are familiar with, the chairman and CEO
held an annual meeting of the outside directors to discuss succession. He re-
ferred to it as the “truck meeting” because he always started with the question,
“Suppose I am run over by a truck tomorrow. What will you do?” At this meet-
ing, two, and sometimes three, managers were identified as potential CEOs.
Individuals were added to or eliminated from the list and their relative ranking
changed. When this process works properly, an agreed upon CEO candidate is
available in an emergency, and a person who will take over from a retiring
CEO in normal succession is identified.
If boards fail to deal effectively with succession, they may be forced to go
outside the company for a new CEO. Under most circumstances, this increases
the risk that the CEO will not succeed since chances for a successful succes-
sion are usually better when the CEO position is filled by a proven executive
from within the organization. In some cases, an organization may need a “shak-
ing up” and the board may elect to go outside for a CEO who can give the or-
ganization new life.
NORMAL BOARD MEETINGS
Most boards meet eight, nine, or ten times a year. Some meet only quarterly,
and a few meet every month. The typical meeting lasts two to three hours, but
it may go considerably longer if contentious issues arise.
Premeeting Material
Prior to the meeting, board members are sent an agenda and a packet of mate-
rial on topics to be discussed. This homework usually requires several hours of
work. Directors may query the CEO, in person or by a phone call before the
meeting, on matters that require clarification.
Current Situation and Outlook
The first substantive topic on a meeting’s agenda usually is a discussion of cur-

rent information about the company and its outlook. The CEO leads this dis-
cussion, perhaps delegating part of it to another senior officer. Much of the
information is financial—that is, condensed income statements for each divi-
sion or for groups of division, corporate expenses, and key balance sheet items,
such as inventory and receivable amounts. There are three ways to present this
financial information:
1. Compare management’s current estimate of performance for the whole
year with budgeted performance for the year. What is the current esti-
mate of how the company will perform for the whole year? This is the
most important type of information. However, it is also the most sensitive,
and many CEOs do not circulate it prior to the meeting.
The Board of Directors 515
2. Compare actual performance with budgeted performance for the current
period and for the year to date. Because the actual numbers are firm,
they provide a more objective basis for analysis than the current estimate
for the whole year.
3. Compare actual current performance with performance for the same pe-
riod last year. A carefully prepared budget incorporates changes in the
business and the economy that have occurred since the prior year, and
this is a more meaningful basis for comparison than last year’s numbers.
If, however, the budgeted amounts, particularly the estimate of revenue,
are highly uncertain, the numbers for last year provide a firmer founda-
tion for comparison.
Variances between actual and budgeted performance are discussed. Are
unfavorable variances temporary? If not, what steps will be taken to eliminate
them, or, if they result from unforeseen outside forces, what adjustments in the
company’s operations will be made?
By reviewing the company’s financial performance and raising questions
or making suggestions to management, directors form judgments regarding the
company’s affairs. Preparing and presenting to the board a report on the com-

pany’s performance is an important discipline for management.
Other Actions
Next, a number of proposed actions are submitted for board approval. Many
of these recommendations come to the full board from committees that have
discussed the topics in meetings held prior to the board meeting; these are
described later in this chapter. Questions may be raised about the recom-
mendations, but usually they are requests for clarification. Board members
rely on committee members to explore these matters thoroughly; there is not
enough time to do so in the full board meeting. Unless new information sur-
faces, these recommendations typically are approved.
The board also deals with a number of routine items. These include re-
quests for approval of capital projects, of signature authority for various
banking connections, of exceptions to pension plans, and of certain types of
contracts. Except for large capital projects, these items are usually referred to
as “boilerplate.” In most cases, they come to the board because state law, cor-
porate bylaws, or written policy requires board action. They are approved with
little discussion, sometimes en bloc, despite the fact that the minutes may state
for each of them, “After a full discussion, a motion to adopt the recommenda-
tion was duly made and seconded, and the motion was approved.”
Education
A division manager, assisted by senior associates, may report on the activities
of the division. This is an educational experience for the directors. (Some
516 Making Key Strategic Decisions
board meetings may be held at company plants or other facilities; this also is a
valuable educational device.)
The meeting itself and the informal activities that usually are associated
with it are also educational. Directors have an opportunity to appraise both
company officials and their own colleagues. Judgments about these individuals
may be valuable if the board is required at some time to deal with a crisis
situation.

Setting Standards
Partly through written policy statements, but primarily through their atti-
tudes, directors communicate to management the standards that they believe
should govern the organization’s actions. There are two general types of stan-
dards; they might be labeled economic standards and ethical standards, al-
though neither term is precisely correct.
With respect to economic standards, the directors communicate the over-
all goals they believe the company should attain: the relative importance of
sales growth, earnings per share and return on investment, and the specific
numbers that they believe to be attainable. The board also indicates the rela-
tive importance of short-run versus long-run performance. In the final analy-
sis, board members generally rely on management’s recommendations, but the
enthusiasm, or lack of enthusiasm, with which they support a given recom-
mendation conveys an important message to management.
Ethical standards are nebulous. Written policy statements are always im-
peccably virtuous, but directors’ actual expectations are revealed in the way
they react to specific ethical problems. How does the company deal with its fe-
male and minority employees? What happens to an employee who has a drink-
ing problem? Does the company have a policy concerning support for the
communities in which it operates? These and many other issues are loaded
with ethics, and the manner in which the board reacts to them establishes the
real policy, regardless of what is in a written statement.
It is easy to rely on counsel’s answer to the question, Must we report this
unpleasant development to the Securities and Exchange Commission? The an-
swer depends on the legal interpretation of the regulations. It is much more dif-
ficult for the directors to agree, and to convey to management, that certain
policies or practices, although perhaps within the letter of the law, should not be
allowed or sanctioned. Examples include environmental considerations, employ-
ment practices in Third World countries, and involvement in political issues.
STRATEGY

A company should have a set of strategies that are well thought out and clearly
understood by all managers. Strategies include the industry in which the com-
pany has decided to operate, its product lines within this industry, the price
The Board of Directors 517
and quality position of these products, the targeted customers and markets
(local, regional, national, international), the company’s distribution channels
(direct sales, dealers, distributors), marketing policies (advertising, sales pro-
motion), manufacturing policies (in-house production, plant locations, outside
sourcing), financial policies (balance among borrowing, equity financing, re-
tained earnings), and others.
The board usually does not have the knowledge necessary to initiate a
strategy or to decide among alternative strategies. It must rely on management
to take the initiative, make the necessary analyses, and bring its recommenda-
tions to the board. What the board can and should do is described by Kenneth
R. Andrews in The Concept of Corporate Strategy.
1
He writes, as a summary,
A responsible and effective board should require of its management a unique
and durable corporate strategy, review it periodically for its validity, use it as
the reference point for all other board decisions, and share with management
the risks associated with its adoption.
While it is unrealistic to expect directors to formulate strategies, they
should satisfy themselves that management has a sound process for developing
them. The strategy is probably acceptable if:
• It is based on careful analysis by people who are in the best position to
evaluate it, rather than on an inspiration accepted without study.
• The reasoning seems sensible.
• No significant information has been omitted from the analysis.
• The results expected from the strategy are clearly set forth so that actual
accomplishment can be compared with them.

Strategy Meetings
As a basis for considering strategic plans, many companies arrange a meeting at
which directors, together with senior managers, spend one, two, or three days
discussing where the company should be headed. In order to minimize distrac-
tions and provide an opportunity for informal discussion and reflection, these
meetings are often held at a retreat that is distant from the corporate offices.
While company practices differ widely, it is not uncommon for meetings de-
voted primarily to strategic issues to be held every year or two.
The primary purpose of a strategy meeting is for management to explain
current and planned strategies and the rationales for them. The explanations
provide useful information to the directors. The quality of the rationale for the
strategies indicates the competence of senior management and the managers of
the divisions concerned. Thus, the strategies provide additional insight about
the abilities of the CEO and the participants who may be CEO candidates.
Once adopted, a corporate strategy must be adhered to. Management
brings to the board for decision and approval many matters that may impact a
company’s strategy—major capital expenditures, acquisitions, divestitures, and
518 Making Key Strategic Decisions
financing proposals. The board ensures that these proposals are consistent with
the adopted strategy. If they are not, the company can drift off course and may
get into serious trouble.
DEALING WITH MAJOR CRISES
In addition to its regular activities, a board occasionally must deal with crises.
These usually arise unexpectedly and require special board meetings. We de-
scribe two of these: terminating the CEO and dealing with takeover attempts.
Terminating the CEO
There are times when a board must replace the CEO. Failure to act in time is
a major criticism of some boards. Although such criticism may be justified one
should recognize that it is much easier for an outside observer to criticize than
to be in the shoes of the directors who are faced with this decision.

The decision to replace a CEO is subjective and usually emotional. Some-
times there are compelling reasons for taking action—for example, when the
CEO is becoming an alcoholic or when his or her corporate performance has
dramatically deteriorated. In most instances, however, the case is not so clear.
Earnings may not have kept pace with industry leaders because the board dis-
couraged management from assuming additional debt that would have enabled
the company to expand. Or perhaps the board supported a major acquisition
that did not work out. In such instances, it is not obvious that the CEO is pri-
marily at fault.
There are, however, several important signals that can alert a board to
question the CEO’s capabilities:
• Loss of confidence in the CEO. If a significant number of directors have
lost confidence in, or no longer trust, the CEO, the individual should be
replaced.
• Continuing deterioration in corporate results. Earnings may be signifi-
cantly below industry norms or below the budget without an adequate ex-
planation. The board must act before it is too late.
• Organizational instability. A CEO who consistently has problems retain-
ing qualified senior executives probably should be replaced.
These problems are especially serious in the many new companies spring-
ing up in information technology industries. In these industries, change is
rapid, competition is severe, there are no track records on which to base judg-
ment, and stock prices may change by huge percentages in a few days, reflect-
ing changes in investors’ opinions about the company’s outlook.
It is one thing for board members to begin to doubt the CEO’s capabili-
ties, but it is quite another thing for them to demonstrate the courage and
The Board of Directors 519
con
sensus needed to take action. The CEO and the directors usually have
worked together for some time; they are good, perhaps close, friends. For the

CEO, dismissal is a catastrophic event. Taking action that will probably destroy
the career of a business associate is a difficult decision.
Replacing the CEO precipitates a crisis, not only for the board but also for
the entire organization. When it happens, the board must be prepared to an-
nounce a successor and to deal with the problems inherent in the transfer of ex-
ecutive authority. Such action puts a major burden on the outside directors.
Nevertheless, this is their responsibility to the shareholders and to the other
constituencies of the corporation.
For example, in early 2000, Jill E. Barad, CEO of Mattel Inc. the world’s
largest toy manufacturer “resigned.” Ms. Barad built one of Mattel’s flagship
products, the Barbie doll, from $250 million in annual sales in the mid-1980s to
$1.7 billion in 1999. In the late 1980s, Barbie’s growth slowed, and Ms. Barad
turned to acquisitions. Unfortunately, several acquisitions failed to live up to
expectations. A loss of $82 million was recorded for 1999, and Mattel’s stock
price dropped from a high of $45 in 1998 to a low of $11 in early 2000. The
board acted, and Ms. Barad “resigned.” Apparently the board decided that
there was no suitable successor within the company. They selected Robert
Eckel, formerly CEO of Kraft Foods to be the new CEO.
The turnover of CEOs of major corporations seems to be accelerating in
the twenty-first century. Mr. William Rollinick, a Mattel board member and for-
mer acting chairman, observed that when a chief executive stumbles, “there’s
zero forgiveness. You screw up and you’re dead.” The investing community puts
boards under considerable pressure to act when things appear to be going wrong.
Sarah Telsik, executive director of the Council of Institutional Investors, which
represents 110 pension funds with more than $1.5 trillion in assets, believes that
underperforming CEOs were not losing their jobs fast enough.
Too fast or too slow? A board should decide what is in the long-term best
interests of the company and its stockholders. In some instances, immediate
pressures should be resisted in favor of long-term considerations. In other
cases, the board should “bite the bullet.” The decision is not easy.

Unfriendly Takeover Attempts
Another crisis event is the hostile, or unfriendly, takeover attempt. Board deci-
sions vital to the company’s future—even its continued existence—must be
made in circumstances in which emotions are high, vested interests are at
stake, and advice is often conflicting. The business press reports daily the dra-
matic developments of offers and counteroffers, tactics, and strategies as each
side in the struggle seeks to gain an advantage. Boards and management spend
much time preparing offensive and defensive plans.
One of the problems in takeover situations is that the board, which repre-
sents the shareholders, may have interests that differ from those of manage-
ment. In most successful unfriendly takeovers, the senior managers of the
520 Making Key Strategic Decisions
target company lose their jobs. A common accusation, therefore, is that man-
agement resists takeovers in order to entrench itself, even though the deal
would result in a handsome gain for the shareholders.
In these situations, directors must exercise great care in making a deci-
sion that is in the shareholders’ interests. This is not always easy to determine.
What is the intrinsic value of the corporation? What is the real value of the
“junk bonds” being offered to the shareholders? What consideration, if any,
should the directors give to the interests of other parties—employees, commu-
nities, suppliers, and customers?
In an unfriendly takeover attempt, the directors of the target company
must rely on legal advice since takeovers inevitably lead to lawsuits. The board
also depends on expert advice from investment banks about the value of the
company and the true value of offers to acquire it.
In practice, when a hostile takeover is initiated, the target company’s
lawyers, investment bankers, accountants, and other advisers, together with
the board and management, become involved in a hectic struggle that can last
for weeks or months. It is a sixteen-hour-day, seven-day-week effort; nearly
everything else yields to the intense preoccupation with survival or striking the

best possible deal.
BOARD COMMITTEES
Much of the board’s work is done in committees. They meet before board
meetings, hear reports, and prepare summaries and recommendations for full
board action. In this section, we describe the activities of the three commit-
tees—compensation, audit, and finance—that deal with finance and account-
ing matters.
COMPENSATION COMMITTEE
The board determines the compensation of the CEO and the other principal
corporate officers. In many boards, a compensation committee, composed of
outside board members, analyzes what compensation should be and makes its
recommendations to the full board.
The SEC requires that a section of the proxy statement, issued prior to
the annual meeting of shareholders, must describe the work of the compensa-
tion committee, the decisions on compensating senior executives, reasons for
the decision, their compensation for the past three years, and comparisons with
other companies in the industry.
CEO Compensation
When the board sets the CEO’s compensation, it is establishing a compensation
standard for managers throughout the company. Their compensation is inte
grally
The Board of Directors 521
related to the CEO’s and this, therefore, is the single most important compen-
sation decision the board must make.
In most instances this decision is not easy. Most CEOs are ambitious and
competitive, and compensation is their report card. Since proxy statements dis-
close the compensation of all CEOs of public companies, each CEO is able to
see just where he or she stands in relation to others. Virtually every CEO would
like to stand higher on that list.
Compensation committees consider three principal factors. The CEO’s

compensation should: (1) be related to performance, (2) be competitive, and
(3) provide motivation. Compensation includes not only salary but also
perquisites and, in most companies, long-term incentive arrangements, such as
stock options or performance-share plans. These plans, however, are far from
perfect, and compensation committees constantly struggle to find new
arrangements or formulas in an effort to relate compensation more closely
to performance.
Performance
The CEO’s compensation should be related to performance. Superior perfor-
mance should be rewarded with high compensation, while poor performance,
if it does not warrant dismissal, should at least result in decreases or minimal
increases in compensation.
There is justification for the claim that in some companies top-executive
compensation continues to climb without regard to performance. The problem
is complex. In theory, the CEO should be rewarded for increasing the share-
owner’s wealth over the long term. Although this is a splendid generalization,
the criterion is hard to measure, especially on a year-to-year basis.
Competitive Range
Compensation committees look at the CEO’s compensation relative to that of
competitors. They can be sure that their CEO has this information and is likely
to be unhappy if the compensation is perceived as unfair or not competitive.
There are many sources for salary information. They include proxy state-
ments from similar organizations and published surveys. Some consulting orga-
nizations specialize in executive compensation; they provide data and advice
on these matters. In the end and with all of the information at hand, the com-
mittee makes its judgment as to where in the competitive spectrum they want
the CEO’s compensation to fall.
Motivation
Compensation committees ask themselves, How can we structure a compensa-
tion package that motivates the CEO to do what the board expects? If the

company has a plan to move aggressively and take unusual risks in the near
term, with the possibility of significant long-term payoff, the committee can
522 Making Key Strategic Decisions
structure a compensation plan for the CEO that will reward that kind of be-
havior. For example, the CEO might have a multiyear contract that provides as-
surance of employment during the high-risk phase, as well as a long-term stock
option plan. At the other extreme, a mature company might be interested in
moderate growth but steady dividends. The compensation committee might
then structure a plan weighted heavily toward a fixed salary, reviewed annu-
ally, with only modest incentive features.
There are many types of compensation arrangements: base salary re-
viewed annually, base salary plus annual discretionary bonus, base salary
with bonus based on a formula, stock option plans, performance share plans,
and multiyear incentive plans. Benefits play an important part in CEO com-
pensation arrangements, especially retirement programs. Each plan has its
own motivational features, and the compensation committee attempts to
structure a plan that provides the motivation for the CEO that the board
wants to generate.
Compensation Reviews
In addition to deciding the CEO’s compensation, the committee also deter-
mines compensation for the other senior executives—that is, corporate officers
and others whose salary is above a stated level. The review process usually
takes place at a meeting that brings together the compensation committee, the
CEO, and the staff officer concerned with compensation and personnel
policies.
At this meeting the CEO describes the compensation history of, and
makes a recommendation for, each executive. Usually, a few of the recommen-
dations are discussed, and a few changes may be made. For the most part, how-
ever, the committee accepts the CEO’s recommendations. Nevertheless, the
review process is important. It enables the compensation committee to be sure

that the CEO is following sensible guidelines and consistent policies and is not
playing favorites. It also serves to remind the CEO that recommendations to
the committee must be justified.
Board Remuneration
The compensation committee also recommends compensation arrangements
for the board members. Obviously, this is a delicate matter because the board
is disbursing company funds (actually shareholder funds) to its members.
Directors’ compensation is disclosed on the annual proxy statement. Most
companies would like to see their directors “respectably” compensated and,
while compensation usually is not the compelling reason for holding a director-
ship, directors want to feel that they are being compensated on a competitive
basis. On the other hand, most directors want to feel that their compensation is
not excessive and that they will never be criticized for compensating them-
selves improperly.
The Board of Directors 523
Much survey information is available on board retainer fees, board meet-
ing fees, and compensation for committee chairs to help reach a balanced level
of compensation.
AUDIT COMMITTEE
The audit committee is responsible for ensuring that the company’s published
financial statements are presented fairly in conformance with generally ac-
cepted accounting principles (GAAP), and that the company’s internal control
system is effective. Furthermore, the audit committee deals with important
cases of alleged misconduct by employees, including violations of the company’s
code of ethics. It also ratifies the selection of the company’s external auditor.
All companies listed on major stock exchanges are required to have audit
committees, and most other corporations have them. The SEC requires at least
three members of the audit committee to be “financial literate or to become fi-
nancial literate within a reasonable period of time.”
2

Responsibility
Although the full board can delegate certain functions to the audit committee,
this delegation does not relieve individual board members of their responsibil-
ity for governance. In its 1967 decision in the BarChris case, the federal court
emphasized this fact:
3
Section 11 [of the Securities Act of 1933] imposes liability in the first instance
upon a director, no matter how new he is He is presumed to know his re-
sponsibility when he became a director. He can escape liability only by using
that reasonable care to investigate the facts which a prudent man would employ
in the management of his own property.
Directors have directors’ and officers’ (D&O) insurance, but this only
partially protects them against loss from lawsuits claiming that they acted im-
properly. Recent decisions suggest that courts are increasingly willing to exam-
ine directors’ decisions. For example, the shareholders of Oxford Health Care
sued the company for misleading financial statements. Oxford’s stock price
thereupon fell by 50%, a $14 billion drop in market value. The company re-
portedly agreed to settle the case for $2.83 billion. In the 1990s, there were
more than 100 fraud actions annually against SEC firms and many more against
smaller firms.
Audit committee members walk a tightrope. On one hand, they want to
support the CEO—the person whom the board itself selected. On the other
hand, they have a clear responsibility to uncover and act on management in-
adequacies. If they do not, the entire board of directors is subject to criti-
cism at the very least and imprisonment at worst. Their task is neither easy
nor pleasant.
524 Making Key Strategic Decisions
Published Financial Statements
The audit committee does not conduct audits; it relies on two other groups to
do this. One is the outside auditor, a firm of certified public accountants. All

listed companies are required to have their financial statements examined by
an outside auditor, and most other corporations do so in order to satisfy the re-
quirements of banks and other lenders. The other group is the company’s in-
ternal audit staff, a group of employees whose head reports to a senior officer,
usually the CEO or chief financial officer (CFO).
Selection of Auditors
Ordinarily, management recommends that the current auditing firm be ap-
pointed for another year and that its proposed audit scope and fee schedule be
adopted. After some questioning, the audit committee usually recommends ap-
proval. The recommendation is submitted to shareholders in the annual meet-
ing. Occasionally, the audit committee gives more than routine consideration
to this topic.
There may be advantages to changing auditors, even when the relationship
between the audit firm and the company has been satisfactory for several
years. One advantage is that the process of requesting bids from other firms
may cause the current firm to think carefully about its proposed fees. How-
ever, the public may perceive that a change in outside auditors indicates that
the superseded firm would not go along with a practice that the company
wanted. The SEC requires that when a new auditing firm is appointed, the rea-
son for making the change must be reported on its Form 8-K. Also, because a
new firm’s initial task of learning about the company requires management
time, management may be reluctant to recommend a change.
Public accounting firms often perform various types of consulting en-
gagements for the company: developing new accounting and control systems,
analyzing proposed pension plans, and analyzing proposed acquisitions. Fees
for this work may exceed the fees for audit work. The SEC and the stock ex-
changes have strict rules that prohibit a public accounting firm from conduct-
ing an audit if it has consulting engagements with the corporation that might
affect the objectivity of the audit. Some auditing firms have responded to
these rules by setting up a separate firm to conduct these engagements.

The Audit Opinion
In its opinion letter, the public accounting firm emphasizes the fact that man-
agement, not the auditor, is responsible for the financial statements. Almost all
companies receive a “clean opinion”; that is, the auditor states that the finan-
cial statements “present fairly, in all material respects” the financial status and
performance of the company in accordance with GAAP. Note that this state-
ment says neither that the statements are 100% accurate nor whether different
The Board of Directors 525
numbers would have been more fair.
4
The audit committee’s task is to decide
whether the directors should concur with the outside auditor’s opinion and, oc-
casionally, to resolve differences when auditors are unwilling to give a clean
opinion on the numbers that management proposes.
Management has some latitude in deciding the amounts to be reported,
especially the amount of earnings. Since managers are human beings, it is
reasonable to expect them to report performance in a favorable light. Examples
of this tendency, discussed next, are: (1) accelerating revenue, (2) smoothing
earnings, (3) reporting unfavorable developments, and (4) the “big bath.”
Much of the discussion of these topics is complicated by differences in the
meaning of “materiality.” The SEC has tried to lessen the reliance on material-
ity by publishing detailed descriptions of what the term means.
Accelerating Revenue
A company may go to great lengths to count revenues actually earned in future
periods as revenues in the current period, even though this decreases the next
period’s revenues. The following example illustrates:
The SEC sued two executives of Sirena Apparel Group for misleading revenue
estimates for the quarter ended March 31, 1999. They instructed employees
daily to set back the computer clock that entered the dates on invoices until a
satisfactory revenue amount was recorded. Invoices dated from April 12, 1999,

were set back.
5
Not all attempts to accelerate revenue recognition are improper. There
are documented stories of managers who personally worked around the clock
at year-end, packing goods in containers for shipment. This enabled them to
count the value of the packed goods as revenue in the year that was about to
end. Counting goods that actually were shipped as revenue is legitimate.
Smoothing Earnings
There is a widespread belief (not necessarily supported by the facts) that ideal
performance is a steady growth in earnings, certainly from year to year, and
desirably from quarter to quarter. Within the latitude permitted by GAAP,
therefore, management may wish to smooth reported earnings—that is, to
move reported income from what otherwise would be a highly profitable pe-
riod to a less profitable period. The principal techniques for doing this are to
vary the adjustments for inventory amounts and bad debts, and estimated re-
turns, allowances, and warranties.
The audit committee, therefore, pays considerable attention to the way
these adjustments and allowances are calculated and to the resulting accounts
receivable, inventory, and accrued liability amounts. Changes in the reserve
percentages from one year to the next are suspect. The audit committee toler-
ates a certain amount of smoothing, within limits. Indeed, it may not be aware
526 Making Key Strategic Decisions
that smoothing has occurred. Outside these limits, however, the committee is
obligated to make sure that the reserves and accrual calculations are reasonable.
Management may also recommend terminology that does not affect net
income but does affect income from operating activities. Examples are earn-
ings before marketing costs, cash earnings per share, earnings before losses on
new products, and pro forma earnings. None of these terms is permitted in
GAAP; they appear in press releases and speeches.
Reporting Unfavorable Developments

The Securities and Exchange Commission requires that its Form 8-K report be
filed promptly whenever an unusual material event that affects the financial
statements becomes known. The principal concern is with the bottom line, the
amount of reported earnings. Management, understandably, may be inclined
not to report events that might (or might not) have an unfavorable impact on
earnings. These include the probable bankruptcy of an important customer, an
important inventory shortage, a reported cash shortage that might (or might
not) turn out to be a bookkeeping error, a possibly defective product that could
lead to huge returns or to product liability suits, possible safety or environ-
mental violations, an allegation of misdeeds by a corporate officer, the depar-
ture of a senior manager, or a lawsuit that might (or might not) be well founded.
It is human nature to hope that borderline situations will not actually have a
material impact on the company’s earnings.
Furthermore, publicizing some of these situations may harm the company
unnecessarily. Disclosing a significant legal filing against the company is nec-
essary, but disclosing the amount that the company thinks it might lose in such
litigation, in a report that the plaintiff can read, would be foolish.
In any event, the audit committee should be kept fully informed about all
events that might eventually require filing a Form 8-K. One might think that
the CEO would welcome the opportunity to inform the board of these events
because this shifts the responsibility for disclosure to the board. But managers,
like most human beings, prefer not to talk about bad news if there are reason-
able grounds for waiting a while.
Occasionally, a manager may attempt to “cook the books,” that is, to pro-
duce favorable accounting results by making entries that are not in accordance
with GAAP. The audit committee must rely on the auditors (or occasionally on
a whistle-blower) to detect these situations.
The Big Bath
A new CEO may “take a big bath”; that is, the accounting department may be re-
quired to write off or write down assets in the year he or she takes over, thereby

reducing the amount of costs that remain to be charged off in future periods.
This increases the reported earnings in the periods for which the new manage-
ment is responsible. Since the situation that led to the replacement of the former
The Board of Directors 527
manager may justify some charge-offs, and since the directors don’t want to dis-
agree with the new chief executive officer during the honeymoon period, this
tactic is sometimes tolerated. If the inflated earnings lead to extraordinarily
high bonuses in future years, the board may regret its failure to act.
Audit Committee Activities
In probing for the possible existence of any of the situations described above,
the audit committee takes two approaches. First, it asks probing questions of
management: Why has the receivables-reserve percentage changed? What is
the rationale for a large write-off of assets?
Then, and much more important, the committee asks similar questions of
the outside auditors. The audit committee usually meets privately with the
outside auditors and tells them, in effect, “If you have any doubts about the
numbers, or if you have reason to believe that management has withheld mate-
rial information, let us know. If you don’t inform us, the facts will almost cer-
tainly come to light later on. When they do, you will be fired.”
A more polite way of probing is to ask the following: “Is there anything
more you should tell us? What were your largest areas of concern? What were
the most important matters, if any, on which you and management differed?
Did the accounting treatment of certain events differ from general practice in
the industry? If so, what was the rationale for the difference? How do you rate
the professional competence of the finance and accounting staff?”
Usually, these questions are raised orally. Because the auditors know from
past experience what to expect, they come prepared to answer them. Some
audit committees provide their questions in writing prior to the meeting.
Although cases of improper disclosure make headlines, they occur in only
a tiny fraction of 1% of listed companies. Most such incidents reflect poorly on

the work of the board of directors and its audit committee. Increasingly, the
courts penalize such boards for their laxity. Directors are aware of the fact
that when serious misdeeds surface, the CEO often leaves the company, but
the directors must stay with the ship, enduring public criticism and the blot on
their professional reputation. Their lives will be much more pleasant in the
long run if they act promptly.
Quarterly Reports
In addition to the annual financial statements, the SEC requires companies to file
a quarterly summary of key financial data on Form 10-Q. Because the timing of
the release of this report usually does not coincide with an audit committee
meeting, most audit committees do not review it. Instead, they ask the CEO to
inform the committee chair if there is an unusual situation that affects the quar-
terly numbers. The chair then decides either to permit the report to be published
as proposed or, if the topic seems sufficiently important, to have the committee
meet in a telephone conference call or an e-mail exchange to discuss it.
528 Making Key Strategic Decisions
Internal Control
In addition to its opinion on the financial statements, the outside auditing firm
writes a “management letter.” This letter lists possible weaknesses in the com-
pany’s control system that have come to the auditor’s attention, together with
recommendations for correcting them. (In the boilerplate preceding this list,
the auditor disclaims responsibility for a complete analysis of the system. The
listed items are only those that the firm happened to uncover.) Internal audi-
tors also write reports on the subject.
Audit committees follow up on these reports by asking management to
respond to the criticisms. If management disagrees with the recommended
course of action, its rationale is considered and is either accepted or rejected.
If action is required, the committee keeps the item on its agenda until it is sat-
isfied that the matter has been addressed.
If an especially serious problem is uncovered, the committee may engage

its public accounting firm or another firm to make a special study. If the prob-
lem involves ethical or legal improprieties, the committee may engage an out-
side law firm. As soon as material problems are identified, they must be
reported promptly to the SEC on Form 8-K.
The audit committee has a difficult problem with internal audit reports.
In the course of a year, a moderate size staff may write 100 or more reports.
Many of them are too trivial to warrant the committee’s attention. (One of the
authors participated in an audit committee meeting of a multibillion dollar
company in which 15 minutes were spent discussing a recommendation to
improve the computer system that was expected to save $24,000 annually.)
Drawing a line between important reports and trivial ones is difficult, how-
ever. A rule of thumb, such as, “Tell us about the dozen most important mat-
ters,” may be used, but what if the thirteenth matter also warrants the
committee’s attention?
In its private meeting with the head of internal audit, the audit commit-
tee assures itself that the CEO has given the internal audit staff complete free-
dom to do its work. The committee also makes it clear that the head of internal
audit has direct access to the audit committee chair if a situation that warrants
immediate board attention is uncovered. The internal auditor normally would
report the matter in question to his or her superior first, but the auditor’s
primary obligation is to the audit committee. The committee, in turn, should
guarantee, as well as it can, that the internal auditor will be fully protected
against possible retaliation.
Internal Audit Organization
The audit committee also considers the adequacy of the internal audit organi-
zation. Is it large enough? Does it have the proper level of competence? For ex-
ample, do the auditors know how to audit the latest computer systems? In many
companies, the internal audit organization is a training ground where promising
The Board of Directors 529
accountants are groomed for controllership. The audit committee may find it

useful to get acquainted with the internal audit staff, as a basis for judging
future candidates for the controller organization.
When campaigns to reduce overhead are undertaken, the internal audit
staff may be cut more than is healthy for the organization. The audit committee
questions such cuts and gets an opinion from the outside auditing firm. How-
ever, because internal auditors do much of the verifying that otherwise would be
done by external auditors, at a much lower cost per hour, external auditors may
not have an unbiased view of the proper size of the internal audit organization.
FINANCE COMMITTEE
The board is responsible to the shareholders for monitoring the corporation’s
financial health and assuring that its financial viability is maintained. The fi-
nance committee makes recommendations on these matters. (Nevertheless, as
emphasized earlier, the full board cannot escape its ultimate responsibility for
making sound decisions on important matters.)
The committee’s agenda includes analyses of proposed capital and operat-
ing budgets and regular reviews of the company’s financial performance as re-
ported on the income statement, and its financial condition as reported on the
balance sheet. The committee reviews the estimated financial requirements
over the next several years and looks at how these requirements will be met. It
also recommends the amount of quarterly dividends. The finance committee
(or a separate pension committee) reviews matters of the pension fund as well
as those of the fund for paying health-care and other post-employment bene-
fits. It reviews the policies that determine the annual contribution to these
funds and the performance of the firm or firms that invest them.
This section describes aspects of these matters that are dealt with at the
board of directors level. Reviews of performance and status are described in
Chapters 1 and 2. The budget preparation process is described in Chapter 6.
Financial policies are discussed in Chapters 9 through 13.
In some companies, the functions described here are divided among three
committees, for budget, finance, and pension, and the names may be different.

Our purpose is to describe what committees do, regardless of their titles.
Analysis of Financial Policies
Financial policies are recommended by management. Tools of analysis are in-
creasingly sophisticated. Using these tools to evaluate risk and return is the re-
sponsibility of management, not the finance committee. These tools help to
quantify risk, but they are not a substitute for a definite policy on risk. An atti-
tude toward risk is a personal matter, and the finance committee should recog-
nize it as such. Each CEO has a personal attitude toward risk, and so does each
individual director.
530 Making Key Strategic Decisions
The committee’s responsibility is to probe management’s rationales for its
policies and thereby assure itself that management has thought them through
and that the policies are within acceptable limits.
Dividend Declaration
One financial policy specifically for the board to decide is the declaration of
dividends. Dividends are paid only if the company declares them; this declara-
tion usually is made quarterly.
Some companies regularly distribute a large fraction of earnings, while
others retain a large fraction (or all) within the corporation. Although generous
dividends may suit shareholders in the short run, they can deprive the corpora-
tion of resources it needs to grow and thereby penalize shareholders in the long
run. Conversely, if a large fraction of earnings is retained, shareholders may be
deprived of the opportunity to make profitable alternative investments of
their own. Thus, the finance committee must balance the interests of the cor-
poration with the interests of individual shareholders.
Some boards take a simplistic approach to dividends: “Always pay out X%
of earnings,” or “Increase dividends each year, no matter what.” Both state-
ments are acceptable guidelines, but neither is more than a guide. In some
industries, a certain payout ratio is regarded as normal, and a company that de-
parts substantially from industry practice may lose favor with investors. Good

evidence suggests that a record of increasing dividends over time, or at least a
record of stable dividends, is well regarded by investors. By contrast, an erratic
dividend pattern is generally undesirable; it creates uncertainty for investors.
Dividend policy warrants careful analysis. The principal factors that the
board considers are:
• What are the company’s financial needs? These needs depend on how fast
the company wants to grow and how capable it is of growing. Or, as is the
case with some companies, what is needed to preserve the company dur-
ing a period of adversity?
• How does the company want to finance its requirements for funds? It can
meet its needs by retaining earnings, issuing debt, issuing equity, or some
combination of these. Each source of funds has its own cost and its own
degree of risk.
• What return does the company expect to earn on shareholder equity, and
what degree of risk is it willing to assume in order to achieve this objec-
tive? The trade-off between risk and return will determine the appropri-
ate type of financing and thus influence the extent to which earnings
should be retained or paid out in dividends.
These are complex questions. Moreover, the factors involved in arriving
at answers to them interact with one another. Consider the example of Cisco
Systems:
The Board of Directors 531
Cisco was founded in 1984 and shipped its first product in 1985. The company
grew rapidly. In 2000 it was a world leader in networking for the Internet, with
sales of $18.9 billion and net income of $2.7 billion. The following statement is
included in the company’s 2000 Annual Report. “The Company has never paid
cash dividends on its common stock and has no present plans to do so.” Cisco re-
tained all of its earnings to help finance its growth and used its stock to acquire
other companies, which it integrated into its operations.
Cisco’s dividend policy is typical of high-growth technology companies

that need resources to grow but find raising equity in the financial markets ex-
pensive because they have no financial “track record” for new ventures.
Many successful companies have quite different dividend and financing
policies from Cisco’s. Many public utility companies, for example, have long,
unbroken records of stable dividends that are a relatively high percentage of
earnings, ranging from 50% to 90%. Even during the Depression in the 1930s
many of these companies maintained their regular dividends, although divi-
dends exceeded earnings in some periods.
The contrast between Cisco Systems and public utility companies indi-
cates the extent to which dividend policy depends on an individual company’s
circumstances and needs. It also highlights the relationships between dividend
policy, the company’s need for financing, and the methods that it selects in
order to meet its financial requirements.
Pension Funds
The finance committee considers two aspects of pension fund policy: (1) the
amount required to be added to the fund and (2) the investment of the fund.
Size of the Pension Fund
Most corporate pension plans are defined benefit plans. In deciding the size of
the fund required to make benefit payments to retirees, directors tend to rely
heavily on the opinion of an actuary. The actuary calculates the necessary size
of the fund using information about the size and demographic characteristics
of the covered employees, facts about the provisions of the plan, and assump-
tions about the fund’s return on investment and probable wage and salary in-
creases over time. (With available software, the company can make the same
calculation.)
There is no way of knowing, however, how reasonable are two key as-
sumptions: the future return on investment and the future wage and salary
payments on which the pensions are based. Since the actuarial calculations de-
pend on the accuracy of these assumptions, the calculations should not be
taken as gospel. Both of these variables are roughly related to the future rate of

inflation, and the spread between them should remain roughly constant. That
is, when one variable changes by one percentage point, the other variable also
is likely to change by one percentage point.
532 Making Key Strategic Decisions
Pension Fund Investments
The most conservative practice is to invest the pension fund in annuities or in
bonds whose maturities match the anticipated pension payments. Such a policy
is said to “lock in” the ability to make payments. This works out satisfactorily for
employees who have already retired, but not for employees who are currently
working. If the latter group’s compensation increases at a faster rate than is as-
sumed in the actuarial calculations, or if the plan itself is sweetened, the fixed
return will turn out to be inadequate. Under a defined benefit plan, there is no
sure way to guarantee that the cash will be available when it is needed. In any
event, with such a conservative policy, the company gives up the opportunity to
earn the usually greater return from an investment in equities.
Most companies hire one or more banks or investment firms to manage
their pension funds. Voluminous data are available on the past performance of
these managers. However, an excellent past record is no guarantee of excellent
future performance. A firm is a collection of individuals. Investment perfor-
mance is partly a function of the individuals doing the investing, and the per-
formance record may change when these individuals leave or lose their skills.
For many years, when it was managed by Peter Lynch, the Magellan Fund was
the most successful of all mutual funds. After Mr. Lynch left, the fund’s per-
formance was not so huge (but was still above average). Performance is also
partly a matter of luck.
Some companies divide the pension fund among several managers, peri-
odically compare their performance, and replace the one with the poorest
record. This may spread the risk somewhat, but it does not guarantee optimum
performance. Luck and the individual who manages the fund continue to be
dominant factors. It is a fact that some managers are better than others. The fi-

nance committee watches performance carefully. It is cautious about making
changes based primarily on short-run performance, but it does so promptly
when it is convinced that a better manager has been identified.
The finance committee also decides on asset allocation investment poli-
cies: how much in equities, how much in fixed income securities, how much in
real property, how much in new ventures, how much in overseas securities, and
the maximum percentage in a single company or industry.
Companies must also provide for costs of health-care and other benefits
of employees who have not yet retired. The problems of estimating these costs
are similar to those for pension funds, but with the additional complication that
healthcare costs continue to increase at an unpredictable rate.
SUMMARY
In doing its job, the board accepts certain responsibilities. It should:
• Actively support the CEO, both within the organization and to outside
parties, as long as the individual’s performance is judged to be generally
satisfactory.
The Board of Directors 533
• Discuss proposed major changes in the company’s strategy and direction,
major financing proposals, and other crucial issues, usually as proposed by
the CEO.
• Formulate major policies regarding ethical or public responsibility mat-
ters, convey to the organization its expectation that the policies will be
adhered to, and ensure that policy violations are not tolerated.
• Ensure, if feasible, that the CEO has identified a successor and is groom-
ing that person for the job.
• Require the CEO to explain the rationale behind operating budgets,
major capital expenditures, acquisitions, divestments, dividends, person-
nel matters, and similar important plans. Accept these proposals if they
are consistent with the company’s strategy and the explanation is reason-
able. Otherwise, require additional information.

• Analyze reports on the company’s performance, raise questions to high-
light areas of possible concern, and suggest possible actions to improve
performance, always with the understanding that the CEO, not the
board, is responsible for performance.
• Assure that financial information furnished to shareholders and other out-
side parties fairly presents the financial performance and status of the
company. Assure that internal controls are satisfactory.
• Replace the CEO promptly if the board concludes the executive’s perfor-
mance is and will continue to be unsatisfactory.
• Participate actively in decisions to elect or appoint directors.
• Decide on policies relating to the compensation of senior management,
including bonuses, incentives, and perquisites. Determine the compensa-
tion of the CEO. Review recommendations of the CEO and ratify the
compensation of other executives.
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Anderson, Charles A., and Robert N. Anthony, The New Corporate Directors (New
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534 Making Key Strategic Decisions
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