1. THE POLITICAL MECHANISMS OF CORPORAT GOVERNANCE
CHAPTER 2
BOARDS AND DIRECTORS
THE POLITICAL MECHANISMS OF CORPORAT GOVERNANCE

2. Outline Role of Directors Role of Board The Agency Problem
Dependent vs Independent Boards
Risk Management
Executive Reward

3. BOARDS OF DIRECTORS:
THE DNA OF
CORPORATE
GOVERNANCE

4. WHAT BOARDS DO?
Control
Monitoring the management of the company and ensuring accountability.
Strategy
Approving and monitoring the strategic direction of the company.
Counsel
Providing advice and counsel to the company executives on critical matters.
Institutional
Building institutional relationships with investors, stakeholders and the
community
Sources: (Carter & Lorsch (2004:67); Zahra & Pearce (1989); Johnson et al (1996); Daily et al (2003).

5. The Two Primary Functions of the Board

6. Levels of Governance (Dawson 2004)
Business Ethics/Principles
Procedures/Processes
Practices/Behaviour

7. Board Structure and Performance
Source: Determinants of Board Performance Source: Epstein & Roy 2004, p. 4

8. Framework for Analyzing Board Activities
OUTWARD
LOOKING
Providing Accountability
Strategy Formulation
CONFORMANCE
PERFORMANCE
INWARD
LOOKING
Monitoring and Supervising
Policy Making
PAST AND PRESENT FOCUSED
FUTURE FOCUSED
Source: F. Hilmer and R. I. Tricker, 1991.

9. Managed vs the Governed Corporation
The Managed Corporation
The Governed Corporation
The board’s role is to hire, monitor and when necessary, replace management
The board’s role is to foster effective decisions and reverse failed policies
Board Characteristics
Power sufficient to control the CEO and the evaluation process
Independence to ensure that the CEO is honestly evaluated and that directors are not compromised by conflicts or co-opted by management
Board procedures that allow outside directors to evaluate managers dispassionately and effectively
Separate the CEO and chair (or lead outside director)
Board meetings without the CEO present
Committee of independent directors to evaluate the CEO
Independent financial and legal advisers to outside directors
Explicit yardsticks for judging the CEO’s performance
Expertise sufficient to allow the board to add value to the decision-making process
Incentives to ensure that the board is committed to creating corporate value
Procedures that foster open debate and keep board members informed and attuned to shareholders’ concerns
Required areas of expertise that must be represented on the board, such as core industry and finance
Minimum time commitment of twenty-five days per year
Large options package for directors
Designated critic to question new policy proposals
Regular meetings with large shareholders
Board members free to request information from any employee

10. Average 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

11. DIRECTOR’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.

12. Board Judgement
The 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…

13. Business 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.

14. BOARD 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.

15. BOARD 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).

16. Active 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).

17. Passive Boards
There 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 way
Mace (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)

18. The Enron Legacy

19. Enron Asleep at The Wheel
Fiduciary failure
High risk accounting
Inappropriate conflicts of interest
Extensive undisclosed off the books activities
Excessive compensation
Lack of independence

20. Enron’s Rise and Fall

21. Red Flags Known to Enron’s Board
Audit committee told Enron accounting practices “push limits”
Board Approves Fastow’s Code of waiver for LJM1
Whitewing moved off-balance sheet with $1.5 billion
Board approves second Fastow waiver for LJM2
LJM2 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/ IV
Board approves third Fastow waiver for LJM3;
Board told $27 billion in assets off-balance sheet
Board told total revenues jump from $40 billion in 1999 to
$100 billion in 2000: Audit and finance Committees review
LJM procedures and for Y2000 transactions
Fortune article questions Enron’s earnings and accounting
Board told 64% of asset portfolio “Troubled” or “Not
performing”; 45 million Enron shares at risk in Raptors &
Whitewing
Board told of $2.3 billion deficit in market value of Enron’s
international assets
Fastow sells interest in LJM to Kopper
Skilling resigns; Finance Committee told of $ 6.6 billion in
prepays and FAS 125 transactions
Lay defends use of SPEs in online session with employees
Finance Committee told of $800 million earnings write-down
from Raptors; Audit Committee told of closed
investigation into the Watkins letter. $0
$20
$40
$60
$80
$100
Jan-99
Mar-99
May-99
Jul-99
Sep-99
Nov-99
Jan-00
Mar-00
May-00
Jul-00
Sep-00
Nov-00
Jan-01
Mar-01
May-01
Jul-01
Sep-01
Nov-01 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 1
Source: US Senate Permanent Subcommittee on Investigations, May 2002
RED FLAGS –GA INVESTIGATIONS

22. WorldCom’s Rise and Fall

23. WorldCom’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…

24. WorldCom’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.

25. WorldCom’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, and
No director appears to have questioned Ebbers’ competence and fitness to serve as CEO until the disaster was unavoidable” (Breeden 2003:33-5).

26. THE REFORM OF BOARDS

27. Specialized Board Committees Adoption
Country
Audit
(1995)
(1998)
Remuneration (1985)
Remuneration
Nomination
(1985)
France –
CAC 40 0%
90%
70%
43%
France- Privatized firms -
100% _
75%
66%
Germany – Dax 30 7% 3%
Japan –
Top 1,300
UK –
FTSE 350
21%
23%
73%
USA –
S&P 500
34%
30%
97% 5%
87%
Source: Goyer (2001). “Corporate governance and the Innovation System in France ’ Industry and Innovation, 8(2):

28. The Transformation from Management Control to Independent Boards
NON -
EXECUTIVES
Chairman
&
Chief Executive
E X E C U T I V E S
Investors
relations
Board
Appointments
Auditing of
Accounts
Executive
Remuneration
Management Controlling the Levels of Power

29. The Transformation from Management Control to Independent Boards
The Board Controlling the Levers of Power
EXECUTIVES
Investors
relations
Board
Appointments
Auditing of
Accounts
Executive
Remuneration
Chairman
Chief
N O N -
E X E C U T I V E S
Senior
Independent
directors
Nomination
Committee
Audit
Source: Taylor (2004)

30. Comparative Analysis of Board Structure in 2003 (Selected Countries)
USA (1) S&P 500
USA (2)
Biotech
USA (3)
Silicon Valley
CAN (4)
UK (5)
NL (6)
ITALY (7)
SPAIN (8)
SOUTH AFRICA (9)
Average board size 11 8 7
12.3
10.8
5.1 14
12.6 12
Average annual board meetings
7.8
6.6
7.4
9.4
>8
6.8 (11) 4
Outside directors (%) 80 78 75 77
52.1
91 (12)
57 (13)
36 (16) 34
Separation CEO & Chairman (%) 23 28 -
83.3 98
Low 68 88
Average outside directors’ age 60
60.7 56 58
57.9
54.1
Have three key committees (%) (10)
100 92
91.3 89
Low (15) 85
Director’s retirement age
70/72 69 70
69.7
Fully independent audit committee (%) 96 91 94 50
Fully independent compensation committee (%) 81
86.7
73 (14)
16.7 67 33
Fully independent nominating committee (%) 83
Average annual director’s pay (cash retainer)
$43,667
$19,630
$24,972
Can $40.000
GBP 35K
E32K
E41.4K
E45.5K
R62K
Lead/Senior Director 36
Formal annual board evaluation 87 86 43 42
Sources: Data for these Spencer Stuart Board Indexes are taken from the most recent company proxy filings.

31. Corporate Governance Quotient Global Rating Criteria

32. ISS Corporate Governance Quotient I
Audit
Audit Committee
Audit Fees
Auditor Ratification
Financial Expert
Charter/Bylaws
Poison Pill Adoption
Poison Pill - Shareholder Approval
Poison Pill - TIDE Provision
Poison Pill - Sunset Provision
Poison Pill - Qualified Offer Clause
Poison Pill - Trigger
Vote Requirements - Charter/Bylaw Amendments
Vote Requirements - Mergers & Business Combinations
Written Consent
Special Meetings
Board Amendments
Capital Structure – Dual class
Capital Structure – Blank check preferred
Board
Board Composition
Nominating Committee
Compensation Committee
Governance Committee
Board Structure
Board Size
Changes in Board Size
Cumulative Voting
Boards Served On – CEO
Boards Served On – Other than CEO
Former CEOs
Chairman/CEO Separation
Governance Guidelines
Response to Shareholder Proposals
Board Attendance
Board Vacancies
Related Party Transactions - CEO
Related Party Transactions - Other than CEO

33. ISS Corporate Governance Quotient II
State of Incorporation
State Anti-takeover Provisions
Control Share Acquisition Provision
Control Share Cash-out Provision
Freeze-out Provision
Fair Price Provision
Stakeholder Law
Poison Pill Endorsement  
Executive and Director Compensation
Cost of Option Plans
Option Repricing
Shareholder Approval of Option Plans
Compensation Committee Interlocks
Director Compensation
Option Burn Rate
Performance-Based Compensation
Option Expensing  
Board Performance Reviews
Individual Director Performance Reviews
Meetings of Outside Directors
CEO Succession Plan
Outside Advisors Available to Board  
Director Ownership
Executive Stock Ownership Guidelines
Director Stock Ownership Guidelines
Officer & Director Stock Ownership
Mandatory Holding Period for Options
Mandatory Holding Periods for Restricted Stock  
Director Education

34. The Learning Board Model
Source: Garratt (2003)

35. Key Risks Areas Business risk Legislative risk People risk
Disaster risk
Asset management & resource
planning.
Business interruption.
Change: organisational/
technical/ political.
Construction activity.
Feasibility studies.
Foreign exchange operations.
Information systems/ computer
networks investments.
Operations & maintenance
systems .
Transport (air, sea, road, rail).
Project Management
Purchasing contract mgmt
Treasury and finance
Design & product liability
Directors’ & officers’
Liability.
Employment procedures,
training, discrimination &
Harassment.
Environmental issues.
Fraud prevention/
detection/ management.
Legislative requirements
Occupational Health &
Safety
Public risk & general liability
Ethics & probity
Issues.
Human, animal &
plant health.
Professional
Advice.
Reputation & image
Security
Contingency, disaster
&emergency planning
Fire detection/ fire
prevention

36. Strategic Role of the Board
Direction
Method
Finance
Structure
Equity –
Public and/
or private
Vertical
integration
Internal Organic
growth
U- form
M- form
Geography,
Product.
Debt-
Bank, public
Horizontal
integration
Mergers and
Acquisitions,
Spin-off and
divestitures
Single plant,
Single product
Diversification
Related or
unrelated
Retained
earnings
H- form
Inter-organizational
e.g. joint ventures,
Franchising,
Alliances.
Diversification
geographic
Trade credit
and
networks
Matrix

37. Typology of Directors “ Independent” Directors Non Executive
Source Kirkpatrick (2004)
Conflict -
Sensitive
Functions
Perspective;
Objectivity “
Independent”
Directors
Long
Term Planning;
Oversight of Key Risk
Areas
Strategy; Continuity;
Expertise
Non
Executive
(“Outside”)
Management Nexus
Focused
Knowledge of Day
To Day Operations;
Communicate
Implement
Decisions
Executive Directors

38. Studies on Strategic Involvement of the Board
Strength of Involvement
Description
Studies
Passive
Statutory boards
Pro-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 boards
Review and approve (Molz 1985)
Review and analysis (Zahra 1990)
Second stage board (Ferlie et al 1994)
Third party (Herman 1981)
Active
Partnership
Collegial (Vance 1983)
Shared leadership (Herman 1981)
Participative (Wood 1983)
Normative/strategic (Molz 1985)
Maximalist (Pettigrew & McNulty 1995)
Partnership (Zahra 1990)
Source: Stiles & Taylor (2002)

39. Red Flags for Investors

40. Board Defences

41. The Incident of Board Entrenchment and Related Provisions in US Corporations (%)

42. Composition of Median CEO Pay in the US
( ) 62 62 58 63 66 62 68 62 60 56 60 58 40 43 54 24 32 37 99 93 98 92 86 68 63 60 61 46 42 40 44 40 32 37 38 38 42 34 38 38
Source: 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’.

43. Executive 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.

44. Comparison of CEO and Worker pay in the US 1990-2005 ( in 2005 USD)
409.2 %
Average CEO pay
326.6%
296.2%
260.6%
S&P 500
Index
106.7%
Corporate Profits
Average worker pay
4.3%
Minimum wage
-9.3%
Source: Institute For a Fair Economy (2006) “Executive Excess”, Washington D.C. Institute For Policy Studies.

45. Conclusions
The 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?

46. Conclusions
To 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.