Board of Directors I (Overview) Corporate Governance | Woochan Kim Legal Duties of Agents Morck, Randall (2006), Corporations, Harvard Institute of Economic Research, Discussion Paper No. 2101 Who is the principal? • • • The debate: shareholder primacy view vs. stakeholderism Laws also define who are the principals. To whom should directors (also include, officers and controlling shareholders) be responsible? However, different countries define them differently United Kingdom and United States • • Assign officers and directors a duty to act for the corporation. But this is often interpreted as a duty to act for the corporation’s owners, its shareholders Germany • This is formalized in the German legal principle of co-determination, which requires members of supervisory board of a large corporation to balance the interests of shareholders, employees, and the State Some U.S. states • Impose a duty to balance shareholders’ interests with those of stakeholders (constituency states) Canada and Korea • The duty of the officers and directors of a corporation is not to shareholders, nor to any other stakeholders, but to the corporation per se What is Corporate Fiduciary Duty Governance? Fiduciary Duty • Having settled the first issue (who is the principal), we should next define how a fiduciary should act for the principal • Fiduciary: corporate directors (also include officers and controlling shareholders) • Two core fiduciary duties of corporate directors • Duty of Loyalty: act in the company’s interests and not in their own self interests (applies only in self-dealing situations) • Duty of Care: act with the amount of care that a prudent person would use in similar circumstances • • • • • Gather the information required to take action Devote sufficient time to reviewing such information Obtain, if useful, the advice of experts Do not delegate to other decision-makers Record the entire decision-making process Business Judgement Rule (BJR) • A standard used by the US court when reviewing board action • So long as directors are acting in good faith, with sufficient information, and not subject to a self-dealing conflict of interest, they should be free from having their business decisions second-guessed by judges. • Rationale behind BJR • • • • Courts are not well-positioned to make business decisions Protect directors from legal action simply based on outcome If sued solely based on outcome, no director would dare to make business decisions Attract qualified individuals to serve as directors by minimizing their financial risk • The conditions are presumed, with the challenger bearing the burden of proving that one of the conditions was not satisfied • (1) Directors acted in gross negligence or bad faith or (2) directors had a conflict of interest Entire Fairness • If the courts finds that there exist conflict of interest, • • • The burden of proof shifts to the defendant (directors) and they must prove that the process (fair dealing) and the substance (fair deal) of the transaction were fair (entire fairness) Fair dealing: relates to process, including how the transaction is timed, initiated, structured, negotiated, and disclosed and how the approvals of the directors and the stockholders are obtained Fair deal: relates to the economic and financial terms of the transaction • Reversion back to BJR using safeguards • • • If approved by disinterested directors or ratified by majority of minority shareholders The burden of proof shifts back to the plaintiff However, BJR will not apply if (1) directors are not independent or (2) controlling shareholder is the counterparty in the transaction What is Corporate Corporate Board Governance? Board’s Key Responsibilities Approves Corporate Strategy and Sets Goals Evaluates Performance and Determines Compensation CEO Succession and Replacement Director Nomination, Training, and Evaluation Ensures Financial Integrity Ensures the effectiveness of internal control system Board Structure One vs. Two-Tier Size Outside Director Ratio Chair/CEO Separation Subcommittees Statutory Auditor One vs. Two-Tier • One-tier board system • • Have one board composed of both executive directors as well as non-executive directors Most of the countries • Two-tier board system • • • Have two separate boards, one exclusively composed of executive directors (management board) and another exclusively composed of non-executive directors (supervisory board) Found in Germany, Austria, Netherlands, and France Supervisory board: typically composed of 20 members (10 elected by the shareholders, 10 being employee representatives) Board Size • In Korea, by regulation, composed of at least 3 directors • If book equity < 1 billion won, only need 1-2 directors • The trade-off • The board should be large enough to provide expertise and diversity and allow key committees to be staffed with independent directors • But, small enough to encourage collegial deliberation with the active participation of all members Outside Director Ratio • Very important when approving self-dealing transactions • The board should be composed of a substantial majority of independent directors • Outside director ratio around the world • • • Very high in the US: typically, CEO and CFO are the only executive directors Relatively lower in UK: instead, board chair and CEO titles are typically held by different individuals Just above the legal requirement in Korea Regulation on Outside Director Ratio in Korea • Outside director ratio = number of outside directors / total number of directors (excluding statutory auditors) • Regulation based on firm size (book asset value) • • Book assets < 2 trillion won: at least 25% outside director ratio Book assets > 2 trillion won: at least 3 outside directors and more than 50% outside director ratio • Board size dropped significantly in Korea after the legal requirement on outside director ratio was introduced • Typical board size and composition of firms above 2 trillion won: 3 outside directors + 2 inside directors or 4 outside directors + 3 inside directors Regulation vs. Comply or Explain • UK • No mandatory requirement on board structure • Established a voluntary code (e.g., Combined Code on Corporate Governance) • Companies should either comply or explain why not complying • Korea and US (after Sarbanes-Oxley Act) • Mostly enforced by mandatory requirements • Korea Exchange also introduced Comply or Explain system on matters not regulated • Corporate Governance Report: assets > 2 trillion won (2019~), > 1 trillion won (2022~), > 0.5 trillion won (2024~), all (2026~) Terms Used in Korea • Inside Directors • • • Also known executive directors Most of them are resident, but some are not (e.g., non-resident inside directors) Officers: senior executives appointed by the board (e.g., CEO, CFO, COO); some officers are directors as well • Outside Directors • • Also known as non-executive directors Loosely called directors in the U.S. Chair/CEO Separation • Separation of CEO and chair or appointment of a lead director is appropriate • Chair/CEO Separation around the world • • • Mostly split in UK Used to be combined in US (instead have higher outside director ratio), but now mostly split Still rare in Korea (mostly limited to financial holding companies and former SOEs; recently, some family-controlled firms) Board Committees • Key functions • Independent judgement (committees exclusively composed of outside directors • Efficiency (division of labor) • Means to empower outside directors • Types of committees • Audit, nomination, and compensation + governance + related-party transactions • Commercial Code: audit, outside director nomination (listed companies with assets > 2 trillion won) • Act on Corporate Governance of Financial Companies: + nomination, compensation Governance Committee • Responsible for the company’s governance structure/practice • Should act as a constructive mediator between management and shareholders (or stakeholders) • Comes in many names • Past (nomination/governance committee), present (ESG committee) • Also functions as a related-party transaction committee Related-party Transactions Committee • Justifies the fairness of related-party transactions • Can serve as a safeguard for D&O • The committee members must be truly independent Compensation Committee • Attract and retain senior executives • Align the interests of managers and shareholders • • • • Give performance-based pay, such as stock options or stock grants Set goals and evaluate performance Limit executives from unwinding stocks (interest alignment + prevent short-termism) Other stakeholders: in many cases, lack good measure of performance Nomination Committee • Establish the company’s leadership structure • Nominate directors (inside and outside directors) • Structure BoD and board committees (e.g., outside director ratio, independent chair) • CEO succession planning and senior executive nurturing • Comes in many names • Commercial Code: outside director nomination committee (mandated for listed companies with assets > 2 trillion won; 50% outside director ratio) • Act on Corporate Governance of Financial Companies: nomination committee (nominate candidates for outside directors, representative directors, CEOs, and audit committee members) • Can be combined with governance committee Audit Committees • Listed companies with assets > 2 trillion won • Audit committee: at least 2/3 of outside director, outside director chair, at least one accounting or finance expert • Uniqueness of audit committee • Members elected at the shareholders’ meeting • Audit committee decisions cannot be overturned by the board • Voting rights of large shareholders limited when electing audit committee members • Companies with assets < 2 trillion won • (100 billion won < assets < 2 trillion won): resident auditor or audit committee • (book equity > 1 billion won, assets < 100 billion won): auditor or audit committee • (book equity < 1 billion won): none of them are required Statutory Auditor (or simply auditor) • Unique to Korea and Japan (adapted from the German supervisory board) • • • Serves functions of audit committee, but not a BOD member Do not be confused with external auditors Resident auditor vs. non-resident auditor Meeting Solely Composed of Outside Directors • Outside directors should meet periodically (at least once a year) without the presence of executive directors • Proceedings should be kept confidential • In this case, the independent board chair or lead (or presiding) independent director should preside over this meeting
