Corporate Governance and Sustainable Value Creation

1
Corporate Governance and Sustainable Value
Creation

• Institute for Sustainable Enterprise
• April 21, 2006
• Beth Young, The Corporate Library

2
What is Corporate Governance?

• System of assigning rights and responsibilities
  to participants in the corporate enterprise
• Narrow view shareholders, management and the
  board are participants
• Broad view all of the above plus employees,
  suppliers, creditors, customers and/or communities

3
Focus on Process

• Corporate governance focuses on the identity of
  the decision maker, the available information and
  the mechanisms available to redress bad decisions
• Examples
• Requirements that independent directors make
  certain decisions
• Shareholders rights to elect directors
• Requirements that shareholders approve
  equity-based compensation plans

4
Focus on Process

• Why does corporate governance focus almost
  exclusively on process?
• Belief by policy makers that
• The right process will more often than not lead
  to the best outcome
• Dictating substantive outcomes is unwise and
  inefficient
• The marketsmost of all, the ability of
  shareholders to sell their stockwill backstop
  corporate governance rules and discipline
  decision makers.

5
Process Affects Substantive Outcomes

• The identity of the decision maker matters
  because of differences in incentives, culture,
  time horizons, conflicts of interest and other
  factors
• The quantity and quality of information provided
  to the decision maker shapes the ultimate
  decision
• Ex executive compensation disclosure
  requirements

6
The Role of Transparency

• Transparency is a necessary but not sufficient
  condition for influencing behavior
• Adequate information allows decision makers to be
  held accountable
• The process of disclosure itself can change
  behavior and the locus of decision making around
  it
• Ex risk management

7
Convergence of Governance and Corporate
Responsibility

• Until recently, corporate governance and activism
  and corporate responsibility activism were very
  separate
• Increasingly, the two are converging
• Governance activists see corporate social
  behavior as a window into business risk, strategy
  and prospects (Ex CII, governance raters)
• Social activists see governance as a way to
  strengthen outside influences and encourage
  optimal decision making processes (Ex campaign
  ExxonMobil, Investor Network on Climate Risk)

8
Accountability

• I promise you, we will never again risk Enrons
  credibility in business ventures without first
  making sure we thoroughly understand the risks.
  Ken Lay, 1987
• One cannot say that the checks and balances
  against excessive power within the old WorldCom
  didnt work adequately. Rather, the sad fact is
  that there were no checks and balances. Breeden
  Report
• Accountability means enforcing decision makers
  responsibility to act in the best interests of
  the corporation.
• Who gets held accountable and by whom?

9
Best Interests of the Corporation

• What does this phrase mean?
• Shareholder primacy norm
• Real-life practice (Ex Time Inc., constituency
  statutes)
• Time horizon
• The problem of measurement/quantification
• Who decides what it means?
• The board of directorsexercising oversight power
• Shareholdersmaking voting decisions
• Courtsdeciding whether directors or officers
  have acted improperly

10
Management Accountability

• The board holds management accountable by
• Hiring and firing
• Compensating
• Overseeing financial reporting
• Participating in/overseeing strategy
• How do/should directors differ from managers?
• Barriers to board effectiveness in promoting
  long-term approach to value creation (Ex
  Coca-Cola director compn, director nomination
  processes, succession planning)

11
Board Accountability

• Shareholders hold the board accountable by
• Dialogue/public criticism
• Electing/removing directors (Ex Marsh
  McLennan)
• Voting on major transactions
• Voting on non-binding shareholder proposal
• Suing for breach of fiduciary duty

12
Shareholders

• Can shareholders effectively promote
  sustainability and long-term value creation?
• Patient long-term capital pension funds,
  foundations and endowments
• Investors with shorter-term liabilities
• Incentives within asset management firms (Ex
  HP/Compaq and Deutsche Bank)
• Quantification and tradeoffs
• Fiduciary duties and responsible ownership
• The shareholder may be innocent in fact, but
  socially he cannot be held innocent. Justice
  Louis Brandeis

13
Executive Pay

• Executive compensation tests the ability of
  boards to integrate strategic planning and
  incentives, hold management accountable and
  uphold commitments to transparency.
• In judging whether Corporate America is serious
  about reforming itself, CEO pay remains the acid
  test. To date, the results arent encouraging.
  Warren Buffett (2004)

14
Executive Pay and Sustainability

• Skyrocketing executive pay is representative of
  growing income inequality
• In 1980, the average CEO made 80 times the
  average workers salary by 2004, that multiple
  had risen to 431.
• Retirement security while workers defined
  benefit plans are frozen or terminated,
  executives pensions grow
• Pfizers McKinnell 6,518,459/yr.
• ExxonMobils Raymond 6,500,000/yr
• ATTs Whitacre 5,494,107/yr.

15
Executive Pay and Incentives

• Corporate governances narrow model of human
  behavior I dont get out of bed for less than
  10,000 a day. Supermodel Linda Evangelista
• What does executive pay incentivize?
• Difficult to tell how incentive pay works
• Almost impossible to tell how compensation serves
  strategic goals
• Little use of non-financial benchmarksthose that
  are used are often fallbacks to provide
  compensation when financial criteria are not met
• Use of market-based criteria duplicates equity
  compensations incentives

16
Equity-Based Compensation

• Pay for performance and alignment with
  shareholdershas this idea held up?
• What have we learned about options?
• Encourage riskier behavior
• No downside
• Executives value them less than shareholders
  think they cost
• Link to accounting fraud, managerial opportunism

17
Internal Pay Equity

• Executive compensation is not only scrutinized by
  outsidersimpact within the company as well
• Becomes part of corporate culturestudies show at
  companies with overpaid CEOs, other c-suite
  executives are usually overpaid as well
• Shared sacrifice and executive pay (Ex AMR,
  Delta, Delphi)

18
Ownership Demographics and Corporate Governance

• Range of ownership structures and demographics
• The role of passive investment strategies out to
  lunch or the ultimate long-term investors?
• Empirical evidence on ownership and monitoring
• Employee ownership

19
Conclusions

• Responsible corporate governance can be a tool to
  promote sustainable business practices, but
  reforms are necessary at the management, board
  and shareholder levels.
• Levers on the shareholder side include
• Organizing beneficial owners
• Strengthening accountability mechanisms
• Continuing to promote transparency
• Taking incentives seriously