Presentation on theme: "THE POLITICAL MECHANISMS OF CORPORAT GOVERNANCE"— Presentation transcript:
1THE POLITICAL MECHANISMS OF CORPORAT GOVERNANCE CHAPTER 2BOARDS AND DIRECTORSTHE POLITICAL MECHANISMS OF CORPORAT GOVERNANCE
2Outline Role of Directors Role of Board The Agency Problem Dependent vs Independent BoardsRisk ManagementExecutive Reward
3BOARDS OF DIRECTORS:THE DNA OFCORPORATEGOVERNANCE
4WHAT BOARDS DO?ControlMonitoring the management of the company and ensuring accountability.StrategyApproving and monitoring the strategic direction of the company.CounselProviding advice and counsel to the company executives on critical matters.InstitutionalBuilding institutional relationships with investors, stakeholders and thecommunitySources: (Carter & Lorsch (2004:67); Zahra & Pearce (1989); Johnson et al (1996); Daily et al (2003).
6Levels of Governance (Dawson 2004) Business Ethics/PrinciplesProcedures/ProcessesPractices/Behaviour
7Board Structure and Performance Source: Determinants of Board Performance Source: Epstein & Roy 2004, p. 4
8Framework for Analyzing Board Activities OUTWARDLOOKINGProviding AccountabilityStrategy FormulationCONFORMANCEPERFORMANCEINWARDLOOKINGMonitoring and SupervisingPolicy MakingPAST AND PRESENT FOCUSEDFUTURE FOCUSEDSource: F. Hilmer and R. I. Tricker, 1991.
9Managed vs the Governed Corporation The Managed CorporationThe Governed CorporationThe board’s role is to hire, monitor and when necessary, replace managementThe board’s role is to foster effective decisions and reverse failed policiesBoard CharacteristicsPower sufficient to control the CEO and the evaluation processIndependence to ensure that the CEO is honestly evaluated and that directors are not compromised by conflicts or co-opted by managementBoard procedures that allow outside directors to evaluate managers dispassionately and effectivelySeparate the CEO and chair (or lead outside director)Board meetings without the CEO presentCommittee of independent directors to evaluate the CEOIndependent financial and legal advisers to outside directorsExplicit yardsticks for judging the CEO’s performanceExpertise sufficient to allow the board to add value to the decision-making processIncentives to ensure that the board is committed to creating corporate valueProcedures that foster open debate and keep board members informed and attuned to shareholders’ concernsRequired areas of expertise that must be represented on the board, such as core industry and financeMinimum time commitment of twenty-five days per yearLarge options package for directorsDesignated critic to question new policy proposalsRegular meetings with large shareholdersBoard members free to request information from any employee
10Average Size and Composition of UK Boards Source: Higgs, D. (2003). “Review of the Role and Effectiveness of Non-Executive Directors”.London : Department of Trade and Industry
11DIRECTOR’S DUTIES The UK Company Law Reform Bill (2005) Act within the powers conferred;Promote the success of the company for the benefit of its members. Directors must have regard to the long term and wider factors such as relationships with employees, suppliers, customers and the impact of the company’s operations on the community and environment;Exercise independent judgment;Exercise reasonable care, skill and diligence;Avoid conflicts of interest;Not to accept benefits from third parties;Declare an interest in a proposed transaction with the company.
12Board JudgementThe one element that is absolutely essential in the armoury of directors and boards is judgement:“Legally, the board is the highest authority in the company, the ‘fountain of power’, yet top management naturally tends to exercise that power…Board members are expected to provide critical judgement on management performance– which requires an in-depth knowledge of, and intimacy with the affairs of the corporation– and at the same time to assure that this judgement is independent – which requires detachment and distance…
13Business Judgement Rule In recognition of the complexity of business decision making, and in order to allow the essential element of risk-taking in business activity, case law in the United States and in many other jurisdictions recognises the business judgement rule that provides directors broad discretion to make decisions in good faith.As long as there is not evidence of fraud, gross negligence or other misconduct directors will not be held responsible for a business judgement if it proves to be mistaken.Unless there is evidence of fraud or negligence a court will not second-guess directors by holding them liable for any action attributable to a rational business purpose.
14BOARD DUTIES AND FUNCTIONS The OECD Principles of Corporate Governance (2004) Reviewing and guiding corporate strategy, major plans of action, risk policy, annual budgets and business plans; setting performance objectives, monitoring and implementation and corporate performance; and overseeing major capital expenditure, acquisitions and other divestitures.Monitoring the effectiveness of the company’s governance practices and making changes as needed.Selecting, compensating, monitoring and, when necessary, replacing key executives and overseeing succession planning.Aligning key executives and board remuneration with the longer term interests of the company and its shareholders.
15BOARD DUTIES AND FUNCTIONS The OECD Principles of Corporate Governance (2004) Ensuring a formal and transparent board nomination and election process.Monitoring and managing potential conflicts of interest of management, board members and shareholders, including misuse of corporate assets and abuse of related party transactions.Ensuring the integrity of the corporation’s accounting and financial reporting systems, including the independent audit and appropriate systems of control are in place, in particular systems for risk management, financial and operational control, and compliance with the law and relevant standards.Overseeing the process of disclosure and communications (2004:24-5).
16Active Boards Active Boards The ideal portrayal of the board is as an active, deliberative and decisive forum for the business: “Boards of directors collectively determine, through the decisions they make, the fate of the corporation…The principal work of a board of directors is to make decisions.” Leblance & Gillies (2005).However boards are inevitably part-time, (due firstly to the necessary extensive external other commitments of directors that enhance the potential contribution they may make to the company; and to the fact that boards that begin to become nearly full-time inevitably stray into operational management, often losing their sense of objectivity and detachment in the process).
17Passive BoardsThere is much evidence that in the past boards of directors enjoyed a fairly passive existence, carrying out their duties, if at all, in a largely nominal wayMace (1971); Lorsch & MacIver (1989).“I served for one fateful year on the board of Penn Central. The education was fast, brutal and highly practical. At each Penn Central directors’ meeting, which only lasted one and a half hours, we were presented with long lists of relatively small capital expenditures to approve, we were shown sketchy financial reports which were rarely discussed in any detail. The reports were not designed to be revealing, and we were asked not to take them away from the meeting. We always had an oral report by the Chief “(Louis Cabot, Harvard Professor)
21Red Flags Known to Enron’s Board Audit committee told Enron accounting practices “push limits”Board Approves Fastow’s Code of waiver for LJM1Whitewing moved off-balance sheet with $1.5 billionBoard approves second Fastow waiver for LJM2LJM2 update: “Q41999: 8 days/ 6 deals/ $125 million”;Executive committee approves third Raptor II“Project Summer” to sell $6 billion in assets fails;Board approves Raptor III/ IVBoard approves third Fastow waiver for LJM3;Board told $27 billion in assets off-balance sheetBoard told total revenues jump from $40 billion in 1999 to$100 billion in 2000: Audit and finance Committees reviewLJM procedures and for Y2000 transactionsFortune article questions Enron’s earnings and accountingBoard told 64% of asset portfolio “Troubled” or “Notperforming”; 45 million Enron shares at risk in Raptors &WhitewingBoard told of $2.3 billion deficit in market value of Enron’sinternational assetsFastow sells interest in LJM to KopperSkilling resigns; Finance Committee told of $ 6.6 billion inprepays and FAS 125 transactionsLay defends use of SPEs in online session with employeesFinance Committee told of $800 million earnings write-downfrom Raptors; Audit Committee told of closedinvestigation into the Watkins letter.$0$20$40$60$80$100Jan-99Mar-99May-99Jul-99Sep-99Nov-99Jan-00Mar-00May-00Jul-00Sep-00Nov-00Jan-01Mar-01May-01Jul-01Sep-01Nov-0123456789101112131415161Source: US Senate Permanent Subcommittee on Investigations, May 2002RED FLAGS –GA INVESTIGATIONS
23WorldCom’s Board Didn’t Prevent the Tragedy As the report prepared for the District Court of New York stated:‘WorldCom’s board didn’t do many things that might have prevented or limited the tragedy.On average the board met quarterly, and the meetings were largely filled with formal presentations to the directors and other routine exercises, including CEO Ebber’s opening prayer.The Audit Committee most vividly exemplified the board’s inadequate time commitment…The Audit Committee spent as little as six hours per year in overseeing the activities of a company with more than $30 billion in revenue, while the WorldCom Compensation Committee met as often as 17 times per year.‘going through the motions’ rather than developing a thorough understanding of the accounting policies, internal controls and audit programs in use by the Company…
24WorldCom’s Board Lack of Independent Members Despite having a separate Chairman of the Board and independent members, the board did not act like it was in control of the Company’s overall direction.Rather than making clear that Ebbers served at the pleasure of the Board, and establishing reasonable standards of oversight and accountability, the board deferred at every turn to Ebbers.Ebbers controlled the board’s agenda, the timing and scope of board review of transactions, awards of compensation, and the structure of management. He ran the Company with an iron control, and the board did not establish itself as an independent force within the Company.
25WorldCom’s Board Didn’t have Control of the Agenda The Chairman of the Board did not have a defined role of substance, did not have control of the board’s agenda, did not run the meetings and did not act as a meaningful restraint on Ebbers…WorldCom met the formal standards, and yet the board did not take action to limit Ebbers’ power.Formalities were usually observed, and yet no director said ‘no’ when the Ebers loans of $408 million came before the Board, no director said ‘no’ to grants of massive volumes of stock options, andNo director appears to have questioned Ebbers’ competence and fitness to serve as CEO until the disaster was unavoidable” (Breeden 2003:33-5).
27Specialized Board Committees Adoption CountryAudit(1995)(1998)Remuneration (1985)RemunerationNomination(1985)France –CAC 400%90%70%43%France- Privatized firms-100%_75%66%Germany – Dax 307%3%Japan –Top 1,300UK –FTSE 35021%23%73%USA –S&P 50034%30%97%5%87%Source: Goyer (2001). “Corporate governance and the Innovation System in France ’ Industry and Innovation, 8(2):
28The Transformation from Management Control to Independent Boards NON-EXECUTIVESChairman&Chief ExecutiveE X E C U T I V E SInvestorsrelationsBoardAppointmentsAuditing ofAccountsExecutiveRemunerationManagement Controlling the Levels of Power
29The Transformation from Management Control to Independent Boards The Board Controlling the Levers of PowerEXECUTIVESInvestorsrelationsBoardAppointmentsAuditing ofAccountsExecutiveRemunerationChairmanChiefN O N-E X E C U T I V E SSeniorIndependentdirectorsNominationCommitteeAuditSource: Taylor (2004)
30Comparative Analysis of Board Structure in 2003 (Selected Countries) USA (1) S&P 500USA (2)BiotechUSA (3)Silicon ValleyCAN (4)UK (5)NL (6)ITALY (7)SPAIN (8)SOUTH AFRICA (9)Average board size118712.310.85.11412.612Average annual board meetings220.127.116.11.4>86.8 (11)4Outside directors (%)8078757752.191 (12)57 (13)36 (16)34Separation CEO & Chairman (%)2328-83.398Low6888Average outside directors’ age6060.7565857.954.1Have three key committees (%) (10)1009291.389Low (15)85Director’s retirement age70/72697069.7Fully independent audit committee (%)96919450Fully independent compensation committee (%)8186.773 (14)16.76733Fully independent nominating committee (%)83Average annual director’s pay (cash retainer)$43,667$19,630$24,972Can $40.000GBP 35KE32KE41.4KE45.5KR62KLead/Senior Director36Formal annual board evaluation87864342Sources: Data for these Spencer Stuart Board Indexes are taken from the most recent company proxy filings.
31Corporate Governance Quotient Global Rating Criteria
32ISS Corporate Governance Quotient I AuditAudit CommitteeAudit FeesAuditor RatificationFinancial ExpertCharter/BylawsPoison Pill AdoptionPoison Pill - Shareholder ApprovalPoison Pill - TIDE ProvisionPoison Pill - Sunset ProvisionPoison Pill - Qualified Offer ClausePoison Pill - TriggerVote Requirements - Charter/Bylaw AmendmentsVote Requirements - Mergers & Business CombinationsWritten ConsentSpecial MeetingsBoard AmendmentsCapital Structure – Dual classCapital Structure – Blank check preferredBoardBoard CompositionNominating CommitteeCompensation CommitteeGovernance CommitteeBoard StructureBoard SizeChanges in Board SizeCumulative VotingBoards Served On – CEOBoards Served On – Other than CEOFormer CEOsChairman/CEO SeparationGovernance GuidelinesResponse to Shareholder ProposalsBoard AttendanceBoard VacanciesRelated Party Transactions - CEORelated Party Transactions - Other than CEO
33ISS Corporate Governance Quotient II State of IncorporationState Anti-takeover ProvisionsControl Share Acquisition ProvisionControl Share Cash-out ProvisionFreeze-out ProvisionFair Price ProvisionStakeholder LawPoison Pill Endorsement Executive and Director CompensationCost of Option PlansOption RepricingShareholder Approval of Option PlansCompensation Committee InterlocksDirector CompensationOption Burn RatePerformance-Based CompensationOption Expensing Board Performance ReviewsIndividual Director Performance ReviewsMeetings of Outside DirectorsCEO Succession PlanOutside Advisors Available to Board Director OwnershipExecutive Stock Ownership GuidelinesDirector Stock Ownership GuidelinesOfficer & Director Stock OwnershipMandatory Holding Period for OptionsMandatory Holding Periods for Restricted Stock Director Education
36Strategic Role of the Board DirectionMethodFinanceStructureEquity –Public and/or privateVerticalintegrationInternal OrganicgrowthU- formM- formGeography,Product.Debt-Bank, publicHorizontalintegrationMergers andAcquisitions,Spin-off anddivestituresSingle plant,Single productDiversificationRelated orunrelatedRetainedearningsH- formInter-organizationale.g. joint ventures,Franchising,Alliances.DiversificationgeographicTrade creditandnetworksMatrix
37Typology of Directors “ Independent” Directors Non Executive Source Kirkpatrick (2004)Conflict-SensitiveFunctionsPerspective;Objectivity“Independent”DirectorsLongTerm Planning;Oversight of Key RiskAreasStrategy; Continuity;ExpertiseNonExecutive(“Outside”)Management NexusFocusedKnowledge of DayTo Day Operations;CommunicateImplementDecisionsExecutive Directors
38Studies on Strategic Involvement of the Board Strength of InvolvementDescriptionStudiesPassiveStatutory boardsPro-forma (Pahl & Winkler 1974)Minimalist (Pettigrew & McNulty 1995)Statutory (Aram & Cowan 1986)Managerial control (Molz 1985)Ratifying (Wood 1983)Legalistic (Zahra & Pearce 1989)First-level Board (Ferlie et al 1994)Review boardsReview and approve (Molz 1985)Review and analysis (Zahra 1990)Second stage board (Ferlie et al 1994)Third party (Herman 1981)ActivePartnershipCollegial (Vance 1983)Shared leadership (Herman 1981)Participative (Wood 1983)Normative/strategic (Molz 1985)Maximalist (Pettigrew & McNulty 1995)Partnership (Zahra 1990)Source: Stiles & Taylor (2002)
41The Incident of Board Entrenchment and Related Provisions in US Corporations (%)
42Composition of Median CEO Pay in the US ( )62625863666268626056605840435424323799939892866863606146424044403237383842343838Source: Data up to 2001, compiled from Hall B. (2003). ‘Six Challenges in Designing Equity-Based Pay’. Journal of Applied Corporate Finance, 15(3): From 2002, compiled from Salmans, C (2007). ‘Mercer Issues Annual Study of CEO Compensation at Large US Firms’. Mercer LLC 2009; Towers Perrin ‘2009 Proxy Statements Highlight the New Realities in Executive Compensation’; Institute for Policy Studies ‘Executive Excess Report 2008 and 2007’.
43Executive Pay as a multiple of Worker Pay US (1990-2008) Source: United for a Fair Economy: CEO Pay; Institute for Policy Studies: Executive Excess Report 2008.
44Comparison of CEO and Worker pay in the US 1990-2005 ( in 2005 USD) 409.2 %Average CEO pay326.6%296.2%260.6%S&P 500Index106.7%Corporate ProfitsAverage worker pay4.3%Minimum wage-9.3%Source: Institute For a Fair Economy (2006) “Executive Excess”, Washington D.C. Institute For Policy Studies.
45ConclusionsThe analysis of the political mechanisms of boards and directors reveals a great divide between the legal duties and functions of the board, and the actual performance of those duties and functions.Passive boards were prevalent in the past, and the more recent failures at Enron, WorldCom, Tyco and other major corporations, indicate boards completing the formalities rather than the substance of their office.Whether boards can be effectively reformed remains an open question: greater effort is now being made to achieve board independence and best practices but fundamental tensions still exist.Can boards adequately fulfill both the monitoring role and the strategic leadership role that is expected of them?
46ConclusionsTo whom is the board ultimately responsible – simply shareholders or a wider constituency of stakeholders?How can boards offer support for CEOs at the same time as ensuring they do not run out of control?In the Anglo-American world boards have patently failed to restrain the inflation in executive remuneration which poses a serious question regarding the authority and integrity of boards.Perhaps though, the era of the all-powerful CEO was a temporary phase born out of the longest bull market in history.The institutions are now playing a more pivotal role in corporate governance, and the implications for corporate governance of this new development are presently playing out.