posted on 06-06-2019

Board of Directors

Updated October 1, 2019

What is the Board of Directors?

A board of directors is a team of people elected by a corporation's shareholders to represent the shareholders' interests and ensure that the company's management acts on their behalf. The head of the board of directors is the chairman or chairperson of the board.

How Does the Board of Directors Work?

Directors attend board meetings, evaluate management performance, tend to major decisions (such as making acquisitions or selling the company), declare dividends, create stock-option policies (including approving grants to key managers) and establish executive compensation packages. Boards of directors often have several committees dedicated to specific decision-making processes. For example, the compensation committee constructs the executive compensation packages and brings them before the full board for a vote; the audit committee evaluates and hires the company's auditors after bringing its research and judgment before the full board; and the finance committee evaluates merger bids or potential sources of capital.

Directors are elected by the shareholders usually once a year and usually at the annual shareholders' meeting. In most cases, directors have staggered terms, meaning that they will not all be up for re-election in the same year.

Quite often, the CEO of the company is on the board, and the CFO or even the COO might hold board seats. Most shareholders agree that management's presence on the board brings detailed expertise to the board's decision-making processes, but this can also create conflicts between acting in management's best interests and the shareholders' best interests. Independent directors (also called nonexecutive directors) are directors who don't work for the company. Nonexecutive directors are compensated with cash for their directorships; quite often they also receive stock options or stock grants.

The Sarbanes-Oxley Act of 2002 introduced new standards for board conduct to ensure that directors are aware of and accountable for the financial condition of the companies they manage. These new standards include holding the board responsible for the integrity of the company's internal controls, but higher accountability is even more evident in the act's requirement that the board of directors of most public companies have an audit committee. This committee must appoint, inspect, regulate and control the actions of the company's auditing firm. The auditors in turn report directly to the audit committee. Committee members cannot be employees of the company, and companies are required to disclose which members meet the definition of "financial expert." The audit committee must be prepared to address complaints and confidential or anonymous submissions about the company's accounting practices. In most cases, directors are covered by directors' and officers' insurance ("D&O insurance") in order to protect the company against judgments caused by board misconduct.

Why Does the Board of Directors Matter?

The purpose of the board of directors is to make sure management is acting in the best interests of the shareholders. This is why the board of directors lays at the heart of the notion of corporate governance -- it has a fiduciary duty to the shareholders, and only to the shareholders. This can be difficult, especially when the vast majority of information that boards receive about corporate performance comes from management. Board members also aren't "there" everyday and thus generally don't know their companies as well as the managers do. In addition, there is often pressure to agree with executive directors given their day-to-day knowledge of the company. But ultimately, if the shareholders don't think the board is representing their interests well, the shareholders simply elect different directors.