BOARDS AND DIRECTORS

1
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 (200467) 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 boards role is to hire, monitor and when necessary, replace management The boards role is to foster effective decisions and reverse failed policies
Board Characteristics 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 CEOs 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
DIRECTORS DUTIESThe 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 companys
  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 FUNCTIONSThe 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 companys
  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.

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BOARD DUTIES AND FUNCTIONSThe 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 corporations
  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 (200424-5).

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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
  corporationThe 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
Enrons Rise and Fall
21
Red Flags Known to Enrons Board

• Audit committee told Enron accounting practices
  push limits
• Board Approves Fastows 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 Enrons 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 Enrons
• 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.

22
WorldComs Rise and Fall
23
WorldComs Board Didnt Prevent the Tragedy

• As the report prepared for the District Court of
  New York stated
• WorldComs board didnt 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 Ebbers opening prayer.
• The Audit Committee most vividly exemplified the
  boards inadequate time commitmentThe 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
WorldComs 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 Companys 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 boards 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
WorldComs Board Didnt have Control of the Agenda

• The Chairman of the Board did not have a defined
  role of substance, did not have control of the
  boards 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 200333-5).

26

• THE REFORM OF BOARDS

27
Specialized Board Committees Adoption
Country Audit (1995) Audit (1998) Remuneration (1985) Remuneration (1998) Nomination (1985) Nomination (1998)
France CAC 40 0 90 0 70 0 43
France- Privatized firms - 100 _ 75 _ 66
Germany Dax 30 0 7 0 3 0 7
Japan Top 1,300 0 0 0 0 0 0
UK FTSE 350 21 100 23 100 7 73
USA SP 500 34 100 30 97 5 87
Source Goyer (2001). Corporate governance and
the Innovation System in France 1985-2000
Industry and Innovation, 8(2) 135-158
28
The Transformation from Management Control to
Independent Boards
29
The Transformation from Management Control to
Independent Boards
The Board Controlling the Levers of Power
30
Comparative Analysis of Board Structure in 2003
(Selected Countries)
USA (1) SP 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 gt8 6.8 (11) 12 9.4 4
Outside directors () 80 78 75 77 52.1 91 (12) 57 (13) 36 (16) 34
Separation CEO Chairman () 23 28 - 77 83.3 98 Low 68 88
Average outside directors age 60 60.7 56 - 58 60.7 57.9 56 54.1
Have three key committees () (10) 80 100 77 92 91.3 89 Low (15) 85
Directors retirement age 70/72 - 69 70 - - 80 70 69.7
Fully independent audit committee () 98 100 96 91 - 94 100 100 50
Fully independent compensation committee () 96 100 94 81 86.7 73 (14) 16.7 67 33
Fully independent nominating committee () 91 100 88 83 - Low Low 67 28
Average annual directors pay (cash retainer) 43,667 19,630 24,972 Can 40.000 GBP 35K E32K E41.4K E45.5K R62K
Lead/Senior Director 36 - 12 - 83 - 0 - -
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. www.spencerstuart.com

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

• 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
• 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 Issues. 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
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)
Passive 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
(1980-2008)
58
62
62
66
63
62
68
62
60
56
60
58
54
40
43
37
32
24

37
38
38
42
34
38
93
98
92
86
68
63
60
61
46
42
40
44
40
32
99
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) 21-23. 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
US1990-2005 ( in 2005 USD)
409.2
Average CEO pay
326.6
296.2
260.6
SP 500 Index
106.7
Corporate Profits
4.3
Average worker pay
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.