Boards of directors at U.S. firms are increasingly using finance committees featuring financial experts to oversee complex finance-related matters. Since 2003, most U.S. public firms have been required by NYSE and NASDAQ to have audit, compensation, and governance committees. Finance committees are the most common voluntary board committees in the U.S., and many influential firms (e.g., GE, Verizon, GM, Coca Cola, etc.) use or once used finance committees to handle complex financial issues. GE established a Finance & Capital Allocation Committee in December 2017, but Robert C. Pozen argues that GE should have adopted a finance committee much earlier and insists that every public company create a finance committee [1] [2]. We agree that finance committees can be critical for firms with complex financial issues, particularly if such issues cannot be effectively overseen by the audit committee or the board as a whole.
Despite the importance of finance committees, we lack understanding of why firms turn to them and how they increase efficiency. In a new study, we examine two questions: first, why do firms create finance committees and, second, when and how do these finance committees benefit boards? [3] We find that firms are more likely to use a finance committee when they have complex financial issues, and finance committees improve financial performance when, for example, they are fully independent or boards have small audit committees.
We identify as a finance committee any committee whose title includes any of the following words: “finance,” “invest,” “acquisition,” “M&A,” “merger,” “asset,” “budget,” “capital,” “credit,” “risk,” “loan,” or “pension.” Many firms call their finance committees a “Finance Committee,” although some give more specific names such as “Merger and Acquisitions Committee” or “Capital Allocation Committee.” Of our sample of over 20,000 U.S. public firms (excluding financial and utilities industries) from 2003 to 2017, 13 percent have a finance committee, and these firms account for 39 percent of the total market value of the firms in the sample, indicating that finance committees are common in large firms.
Our study also reports rich descriptive data about finance committees. Firms tend to add financial experts to the board when they create a finance committee, making those firms more similar in composition to audit committees than to the other two mandatory committees, compensation and nominating/governance. Some firms finance committees are temporary. For example, GE’s board dissolved its finance committee the year after it was created, whereas Verizon’s finance committee has existed since 2013.
First, we examine why a firm creates and uses a finance committee. We manually read hundreds of proxy statements from firms that have a finance committee, and in them firms often state that their boards created finance committees to address financial issues. If finance committees exist to oversee and advise management on financial issues, complex firms with intense finance-related work are more likely to benefit from a finance committee and thus are more likely to have one. As expected, we find that firms are more likely to use a finance committee when they have defined benefit pension plans, have issued debt or equity, and actively pay dividends. Our study also finds that firms with large capital expenditures and restructuring are more likely to create a finance committee.
Anecdotally, many audit committees also act as a kind of finance committee. Audit committees often oversee finance-related issues in addition to their core work of monitoring audit-related subjects. Some firms use the name “audit and finance committee,” and others state that the duties of finance committees will be reallocated to the audit committee when the finance committee is dissolved, suggesting work overlap between the two committees.
How does this inter-relation between the audit and finance committees affect firms’ creation of finance committees? We expect that firms are more likely to create a finance committee when their audit committees are overburdened with their core duties and thus unable to effectively oversee finance-related matters. Empirically, we find that firms with material weaknesses in internal controls or past restatements are more likely to create a finance committee, possibly to take some of the audit committee’s workload. This finding suggests that boards can use finance committees to ease the burden on other existing committees.
If adopting a finance committee makes boards more effective, then firms can expect improved financial performance after setting up one. We find that finance committees are associated with a lower cost of debt and higher buy-and-hold returns following mergers. Furthermore, finance committees are more effective in lowering the cost of debt for firms with small audit committees, likely because small audit committees are occupied with their core audit-related work and are unable to oversee finance-related issues.
Lastly, we examine whether finance committee characteristics such as permanence, independence, and financial expertise affect their success. We find that fully independent finance committees are associated with higher investment efficiency and merger performance, suggesting that independence is important.
Overall, we show that firms use finance committees to oversee finance-related matters and to ease the burden on audit committees. While a separate finance committee is no panacea, one with the right characteristics can benefit firms. We also show that the ideal structure of board committees varies, with some firms preferring temporary finance committees. Some firms put the finance committee function at the board level or assign the work to their audit committees, whereas others designate a separate finance committee. In addition, our empirical evidence regarding the interplay between audit and finance committees suggests that boards likely account for this interconnection when determining their structure. Finally, as the first to study finance committees as a separate topic, our paper provides evidence that boards evolve to respond to new environments and to perform their monitoring and advisory roles.
ENDNOTES
[1] Pozen, R. C. (2018). What GE’s board could have done differently. Harvard Business Review blog. https://hbr.org/2018/07/what-ges-board-could-have-done-differently
[2] Pozen, R. C. (2017). Create a finance committee at every public company. cfo.com. https://www.cfo.com/governance/2017/05/create-finance-committee-every-public-company
[3] Basu, S., & Lee, E. I. (2021). Antecedents of and outcomes after finance committee use. Working paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3845798
This post comes to us from Professor Sudipta Basu and PhD candidate Eunju (Ivy) Lee at Temple University. It is based on their recent article, “Antecedents of and Outcomes after Finance Committee Use,” available here.