Risk & Compliance

Create a Finance Committee at Every Public Company

It’s time to create a finance committee to focus on evaluating acquisitions, monitoring debt levels, and allocating capital.
Robert C. PozenMay 24, 2017
Create a Finance Committee at Every Public Company

Almost all boards of U.S. public companies now have three committees that meet immediately before every board meeting and report to the full board — audit, compensation, and nominating-governance. Committees have become the workhorses of the governance process: with their small size and expert support, they can do more in-depth analysis of complex topics than the full board of directors.

However, since the passage of the 2002 Sarbanes-Oxley Act, the duties of the audit committee, especially, have become so large and complex that it cannot seriously assess broader financial issues.

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Audit committees continue to perform the traditional functions of appointing the company’s independent auditor and reviewing its financial statements. But audit committees now have a long list of other obligations — including oversight of complaints by whistle blowers and violations of ethics codes; approval of non-audit functions by auditors; and review of the management report and auditor attestation on internal controls. The audit committee also holds private sessions with both external and internal auditors as well as the chief financial officer and the head of compliance/risk.

In other words,  audit committees are overburdened by their increased obligations to oversee the details of the reporting and compliance processes. As a result, the audit committee no longer has enough time to seriously consider broader financial topics. If directors are going to have meaningful input into the broad financial issues faced by any public company, they need to form a finance committee with the time and expertise to address the issues.

Approximately 30% of S&P 500 companies have a committee with finance in its name, according to research by Russell Reynolds. That research showed that industrial and consumer companies have the highest percentage of finance-related committees, while technology and financial services companies have the lowest (the latter often have risk committees instead).

What should be the main subjects addressed by an effective finance committee? It should review the company’s pension plans, insurance coverage, cash management, debt issuance, tax strategies and, most importantly, capital allocation.

On capital allocation, finance committees should  concentrate on three subjects —following up on significant acquisitions, monitoring of debt levels, and scrutinizing share repurchase programs.

Of course, boards do a detailed review of significant acquisitions before they occur. Most boards will examine carefully the strategic fit, projected cost savings, potential revenue synergies, and justification for the price. By contrast, boards often do not systematically study, several years later, whether significant acquisitions achieve their objectives.

The finance committee provides a good forum to look systematically at how significant acquisitions fare. The committee may find, for example, that the company typically achieves projected reductions in operating costs but not revenue synergies through cross-selling. So, in the future, the board may decide to evaluate acquisitions without assuming that they will earn additional revenue due to synergies.

Robert Pozen

Robert Pozen

Alternatively, through post-mortems, the committee may find that the company has done a mediocre job of integrating certain types of acquisitions. In response, the board might ask management to present a well thought-out plan for integration before approving any significant acquisition.

A second focus of the finance committee should be on the level and structure of company debt. With interest rates so low, companies have easily taken on more debt. However, since interest rates are likely to rise, boards should be more cautious about their companies incurring high debt levels. Given the risk of rising rates, the finance committee should push for fixed-rate debt with longer maturities, rather than floating-rate debt of short duration.

Directors should obviously take a heightened interest when the company is put on negative watch by a credit rating agency. More generally, in my experience, the finance committee can learn a lot by reading credit rating agencies’ reports. These reports, for example, may point out possible weaknesses in cash flows or potential problems with litigation costs.

On the other side of the balance sheet, directors on the finance committee should monitor the company’s investment guidelines for surplus cash holdings. Corporate treasurers understandably want to maximize the yield on company cash, subject to risk constraints. During this period of low interest rates, some treasurers have reached for yield by investing a portion of the company’s cash in junk bonds or emerging-market bonds. In my view, the extra yield is not worth the risk for cash holdings, which should be held in short-term, high-quality debt as a safety cushion.

Third, directors on the finance committee should pay more attention when authorizing share repurchase programs. From 2014 to 2016, share repurchases ranged from 62% to 71% of the free cash flow of the Russell 1000 companies (excluding real estate and financial services companies ). Roughly half of those repurchases were financed by debt issuance, not out of company profits, according to Absolute Strategy Research.

Share repurchases are sometimes justified as a way to increase a company’s share price. But the 100 companies with the highest buybacks in the S&P 1500 underperformed their indexes from 2005 to 2016. Sophisticated investors see big buybacks as financial engineering — raising earnings per share by reducing the share count without growing revenues.

After approving needed capital expenditures and buybacks to fund employee stock plans, finance committee members should ask tough questions before agreeing to much larger share buybacks — especially if financed by debt. Does the company have internal products or research projects that are likely to deliver returns above its cost of capital? Can the company make a significant acquisition that will generate additional revenues and earnings at a reasonable cost?

In short, finance committees with economically savvy directors can help ease the burden of the audit committees that have a plethora of new detailed responsibilities. Specifically, these directors can fulfill a much-needed role of carefully considering and evaluating the broader financial issues facing companies today.

Robert C. Pozen, the former chairman of MFS Investment Management, is a senior lecturer at the MIT Sloan School of Management and chair of the finance committee of the Medtronic board of directors.