This new Guide features 23 articles that present the views of 26 experts who look upon the state of corporate governance at the close of 2003, one year after the passage of the Sarbanes-Oxley Act. The authors examine recent developments in legislation, regulation and corporate reform and question whether they will lead to permanent improvements in corporate governance.
The authors are lawyers, corporate directors, management consultants, academics, auditors, institutional, private equity and venture capital investors.
Table of Contents
The Crisis of Corporate Governance: What's Next?
Holly J. Gregory
In the past two years we have experienced a "perfect storm" in the confluence of a stock market bubble, tax laws that favored stock-based incentive compensation, increased focus on quarterly earnings and short-term stock market movements, research reports written by conflicted analysts, audits performed by accountants focused on growing their consulting businesses, and our traditional board deference to an imperial CEO. A failure to address these problems could have indicated a failed system and indeed the U.S. system showed strains, but then it corrected quickly. For the most part, the recent reforms remind us of what we have considered all along to be priorities, including accurate books and records; full and fair disclosure; and fiduciary duties of care, loyalty, and good faith. Reforms in countries and regions as diverse as the United States, the European Union, the Russian Federation, and even China, have a remarkably similar emphasis on director independence, clarification of board and audit committee oversight responsibilities, and management accountability for accurate disclosure. While reform efforts are important, as a practical matter, corporate governance has to be exercised by individuals within a perimeter of ambiguity and discretion that is necessary to foster entrepreneurial activity. In the final analysis, investors all over the world must rely on leading businessmen and women to conduct themselves ethically and honestly in the interests of shareholders.
Adjusting the Machine: Directions for Corporate Governance
Ira M. Millstein
When a system breaks down, a common way to fix it is to look at the various machines that comprise the system, see what went wrong with each machine, and then adjust each part accordingly. Rather than focusing on "macro" machines such as fiscal, tax, and regulatory schemes, this article focuses on the "micro" machines: the corporation itself and various other machines that service it such as law firms, accounting firms, and investment banks. Greed and conflict recently have prevented every one of these machines from functioning properly. The corporate machine, particularly the board of directors, needs to work better if our free capital market system is to continue. In the post-Enron environment, directors who do not attempt to prevent self-dealing, misuses of corporate assets, and other forms of injury to the corporation may face liability for their behavior toward the shareholders. A board needs to ensure it has the necessary information about the company's business, strategy, risks, personnel, potential failures in performance, reporting systems, and other potential issues. A separate and independent leader is needed to help the entire board gather that information and to help set the board's agenda. To get the information it needs about the business and its risks, the board also needs to establish relationships with lower-level managers.
The New Federal Corporate Governance Standards: Sarbanes-Oxley and NYSE and Nasdaq Listing Standards
Guy P. Lander
The Sarbanes-Oxley Act of 2002 is the most important securities legislation since the New Deal. The Act contains 76 civil and criminal sections and runs almost 70 pages. The net effect of its provisions affecting public companies is to create a new set of minimum federal corporate governance standards. The Act and follow-up SEC regulations include detailed audit committee requirements such as committee independence, auditor oversight, accounting complaint procedures, authority to engage advisers, and financial expert disclosure. Other provisions of the Act include code of ethics disclosure, a prohibition on personal loans to directors and officers, a prohibition on interference with the independent auditor, reports of trading in company stock, a bar to future service for a person who violates the anti-fraud provision of the Securities Exchange Act, shareholder approval requirements, education and training of directors, and annual certification of financial statements. The new corporate governance standards are in addition to, and do not change, existing fiduciary duties of directors, which generally are covered in state law.
Moving Toward Excellence: A New Dawn for Corporate Governance
The Honorable Barbara Hackman Franklin
From the ashes of recent corporate failures, a new and better model of corporate governance is arising. A wave of creativity and activism is driven largely by board members' pride and determination to do the job well. Essentials for an effective board include qualities of character, independence, and the ability to work as a group. An important reform is the requirement for a session attended only by independent directors in conjunction with each board meeting. The audit committee is the board entity most affected by Sarbanes-Oxley and the one that constantly monitors what management does. Along with the rest of the board, the audit committee needs to anticipate, oversee, and help address potential risks to the company. Recent rules and regulations, though important, must not become a substitute for good judgment in the pursuit of business excellence.
Care, Loyalty, Et Al.
Gwendolyn S. King
What indeed is required of a director in these troubled and turbulent times? The simple answer is more-more time, independence, disclosure and transparency, financial literacy, governance, independent leadership, and willingness to say "no." As a director, you have a responsibility to weigh fully all the available information about a company and your role on the board before you agree to serve. And once you sign on, you will be expected to serve in good faith, exercising the duties of loyalty and care. Just don't forget the duties of common sense, curiosity, and candor as well as the duty to communicate, to clean up old messes, to avoid conflicts of interest, and finally to deliver.
Navigating Complexity: A Corporate Director's Path
Deborah Hicks Midanek
Restoring the credibility of our capital markets is an essential mission for all of us, especially directors of publicly traded companies. Corporate directors share responsibility for the magnitude of recent problems. Some have failed because they did not have the tools to do the job properly or because they did not fully understand what the job was. Directors should be actively engaged in seeking information and constructively challenging management. Risks that can prevent them from behaving this way include unwillingness to ask questions, complacency, and excessive confidence in the status quo. Rewards include satisfaction in the ability to make a difference when the system needs to be fixed.
Furthering Insolvency: How Did We Get Here from There?
Michael J. Epstein
In the near term, we should expect to see an increase in directors and officers (D&O) litigation surrounding business failures. The most visible activity will result from claims against directors over not having protected all stakeholders, while pursuing the interests of investors. In this era of heightened concern with corporate governance, directors must be well advised of their responsibilities and the consequences of their actions - and inactions. Remember the business judgment rule means that you should use good business judgment and focus on business fundamentals. You should exercise the duties of loyalty, good faith, and reasonableness. Directors must monitor more than shareholder value: They are responsible for assuring that management operates on sound business principles, generates not only earnings but also sustainable positive cash flow, and acts deliberately to press management for change when appropriate.
Is Your Board a Strategic Asset and Source of Competitive Advantage?
Robert E. Hallagan
The first criterion for a high-performing corporate board is having the right people at the right time whose portfolios of skills are continuously aligned with the company's challenges and who continually earn the right to serve each year with no sense of entitlement. As a result of recent corporate scandals, resulting new legislation and regulations, and increased shareholder activism, high-performing directors are resigning from boards and high-performing executives are limiting their board memberships. To overcome these unfavorable trends, boards must follow a rigorous process that includes establishing a governance committee, creating a board succession framework, matching required skills to current board members, creating an ideal board candidate profile, and establishing a candidate search-and-identification process.
The CEO and the Board: Enhancing the Relationship
Richard M. Steinberg
The CEO/board relationship has a long history, its own culture, and differs from company to company. In the current era of corporate governance reform, that working relationship is changing, with increased emphasis on openness and dialogue. Five issues demanding the CEO's and the board's attention and sensitivity are: 1) overseeing risk without opposing the prudent, informed, strategic risks necessary to seize opportunities and enhance shareholder value; 2) balancing the board's two traditional roles as advisor to management and check and balance on management's initiatives, procedures, conduct, and decisions; 3) reaching consensus on the company's ethical values and how they should be implemented in its operating procedures; 4) developing a shared vision of enterprise risk management; and 5) moving beyond compliance and a checklist mentality to conduct insightful, probing discussions of strategy, performance, risks, critical business issues, and the reporting and other issues at which the new rules are directed.
Governance Activism at TIAA-CREF
In the past 10 years, TIAA-CREF, the largest private pension system in the United States, has stepped up its corporate governance activities, adding resources to its corporate assessment program, filing friend-of-the-court briefs on cases with important implications for shareholder rights, developing new initiatives such as an effort to end a form of takeover defense called the "dead hand poison pill," and recommending changes in the process by which equity compensation is awarded to executives. Most of its interactions with boards and managements involve "gentle prodding." Globally, the institution is seeking to foster more meaningful international standards for corporate governance, shareholder rights, and corporate transparency.
Audit Committees-A More Visible and Demanding Role
Mark C. Terrell and Scott A. Reed
The audit committee's responsibility to effectively oversee the integrity of the financial reporting process has become a mandate of the capital markets in the aftermath of the sweeping changes affecting corporate governance. The audit committee's oversight role is a critical element of the financial reporting process. An audit committee member's role is more time-consuming and challenging than ever. Audit committee members must be independent of management, engaged, experienced, ethical, inquisitive, and intuitive to provide effective oversight and help rebuild the public's trust in the capital markets. Although the audit committee process has been changed fundamentally by recent corporate accountability reforms, many of the underlying concepts have been debated and considered since the 1999 report of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees and the 1987 report of the Treadway Commission. Current challenges that audit committee members face include balancing practicality and priorities with the new governance environment; ensuring the committee avoids a "checklist" mentality and focuses on substance as well as form; and instituting required changes in attitude, culture, and overall approach.
Five Red Flags Over Texas: The Enron Failure and Corporate Governance Reform
Charles M. Elson and Christopher J. Gyves
A dramatic change in approach to corporate board composition, conduct, and responsibility has occurred at the legal and regulatory level, largely in response to a perceived failure by the Enron board to have prevented management conduct that led to the company's downfall. Because the Enron board had significant relationships with company management, both transparent and latent, it had difficulty recognizing numerous warning signals including waiver of the company code of ethics, stock sales by executives, external auditors taking large consulting fees and engaging in internal audit work, and individuals in the company's finance department with connections to the external auditor. The key common element of the numerous resulting governance mandates following Enron and other corporate incidents has been a focus on the independence of corporate directors.
How Governance Concerns Are Reshaping Executive and Director Compensation
Edward C. Archer
The governance renaissance is transforming how Corporate America does business, but for many shareholders the most visceral target of criticism has been executive compensation. Genuine improvements in governance of compensation programs will be judged by the extent to which boards exercise rigorous oversight, provide clear and concise disclosure, and incorporate meaningful and effective performance hurdles balancing short- and long-term cash and stock incentives. For many boards, the first step in improved governance of pay programs is a re-examination of how competitive information on executive compensation levels is gathered and analyzed. Stock options will be among the first targets of compensation governance reform. Executive employment agreements, retirement benefits, and board pay also will be re-examined. There also is renewed interest in customizing board member pay to reflect differing responsibilities such as committee memberships.
D&O Insurance: Understanding Board Member Risk
Recent corporate scandals come on top of increased securities litigation and competitive pressure on premiums in the past couple of years to create a strain for directors and officers liability insurance (D&O) underwriters. Immediate changes are required to protect the ability of these carriers to offer D&O insurance. Entity coverage, which has diluted the protection available to directors and officers, needs to be regulated. The quality of insurance companies participating at every level of the D&O program must be ensured. D&O underwriters must understand the true nature of the risk they are being asked to assume. Finally, D&O insurance premiums must be aligned with the current level of securities exposure.
The Emergence of the Corporate Governance Officer
Robert B. Lamm
As a result of recent corporate scandals and related reforms, a growing number of companies now have corporate governance officers. While the CGO may fit into a number of places in the corporate organization chart, the optimum position is likely to be that of corporate secretary, or at least in the corporate secretary's department. More important than the CGO's formal reporting structure is the "tone at the top" stemming from board and management support for good governance and the CGO's role in implementing it. The CGO's principal responsibilities can be broken down into three areas: (1) developing and assisting in the implementation of governance policies, systems, and practices; (2) engaging in internal and external communications regarding governance; and (3) implementing continuous improvement in governance.
From Concept to Corporation: How Corporate Governance Evolves Over the Lifespan of a Technology Company
Corporate governance has a very different harmony in a start-up technology company than it does in most mature-stage corporations. Rather than a CEO with operating, financial, and marketing skills, an early-stage venture needs a "chief concept officer" who can articulate a vision, gather others to assist in implementation, and take an idea from concept to business plan. The board of directors, usually composed of stockholders who are the main source of funds, should act as a group of involved mentors, provide a source of contacts, and closely monitor management. The audit committee is concerned largely with information gathering and verification. Seasoned advisors also are needed to help the company identify and benchmark its progress and failures and continuously adjust and focus its business model.
Keeping a Watchful Eye on Your Investments
In this tough economic environment, private equity investors and other institutional investors are scrambling for solutions to prevent their portfolios from declining in value. Private equity board members have to do more than just ensure proper financial reporting and attend board meetings of their portfolio companies. They need to be sensitive to early warning signs of business failure and to focus on leading indicators of people and operating performance rather than just financial performance, which is a lagging indicator. Directors need to create a culture of open discussion and to feel free to ask questions about business strategy and context, critical performance metrics, continuous improvement processes, performance targets, and overall parameters of business success.
Lost in the Shuffle: Insider Ownership and Corporate Governance Reform
Dennis I. Simon
The Commission of Public Trust and Private Enterprise of the Conference Board and other organizations are recommending separation of the CEO and chairman roles while new New York Stock Exchange and Nasdaq, in their listing standards, as well as other organizations are calling for a majority of independent directors. These recommendations are at odds with the prevailing governance structures of most mid-size public companies, which include former family businesses with significant continued involvement by family members and companies still run by their entrepreneurial founders. As the business/financial community continues its dialog about corporate governance, it should consider that different standards and practices are best suited to companies of difference sizes and stages of development.
GovernanceMetrics International: A Detailed Approach
To avoid oversimplifying corporate governance into a few "litmus test" issues, GovernanceMetrics International has developed a set of 600 factual indicators (with answers of "yes," "no," or "not disclosed") to assess a company's governance profile. They are divided into seven broad categories: 1) board accountability, 2) financial disclosure and internal controls, 3) remuneration, 4) ownership base and potential dilution, 5) market for control, 6) shareholder rights, and 7) corporate behavior. Ratings, conducted every six months, are relative; companies are measured against each other both domestically and globally with scores ranging from 1 to 10. Once scores are assigned, analysts prepare written reports summarizing a company's overall governance profile and highlighting particular items that merit investors' attention. No ratings are confidential. Subscribers have access to all of GMI's ratings.
Keeping Score: Rating Governance in the Post-Enron World
Patrick S. McGurn
Institutional Shareholder Services scores corporate governance practices on a percentile basis from zero to 100, the first score measuring the company against others of comparable size and the second measuring it against industry peers. Components of the rating scores fall under seven core topics: 1) board structure and composition, 2) charter and bylaw provisions, 3) laws of the state of incorporation, 4) executive and director compensation, 5) qualitative factors, including financial performance, 6) director and officer stock ownership, and 7) director education.
The Corporate Library's Governance Rating Approach: Compensation, Accounting, and Strategy
There is no disclosure requirement that reveals the courage and integrity required for effective oversight by directors. That can come only from a review of the decisions they make. The Corporate Library has developed a system for rating boards, with grades from A to F, based on dynamic indicators and assessments of the board's effectiveness in areas where the CEO's interests may conflict with the interests of the shareholders. Factors considered in the rating analysis include CEO pay, the company's financial reporting (for the purpose of evaluating the audit committee), the company's overall strategy, CEO succession planning, director stock ownership, what the board says it is doing in its governance policies, how the board responds to a crisis, and other indicators of the board's leadership and ability to add value.
Measure for Measure: Why and How Standard & Poor's Rates Corporate Governance Practices
Andrea Esposito and Dan Konigsburg
Standard & Poor's approach to evaluating corporate governance is an interactive analytical process that involves direct contact with company managers and directors and some of their professional advisors. The agency's governance scores are intended to act as a single, global benchmark to interpret differing governance structures in different companies, countries, and environments. Guided by the overarching principles of fairness, transparency, accountability, and responsibility, the analysis and conclusions fall into four categories: 1) ownership structure and external influences; 2) shareholder rights and shareholder relations; 3) transparency, disclosure, and audit; and 4) board structure and effectiveness. S&P's ratings are made public with permission of the rated companies.
International Trends in Corporate Governance: A Study of Leading Indicators
A recent study compares international corporate governance developments in Belgium, Britain, France, Germany, Japan, the Netherlands, Portugal, and the United States in four categories: board structure, voting rights, disclosure, and takeover defenses. Findings, mainly in 2002, reveal both slow progress and striking weaknesses in the architecture of corporate governance. In particular, new measurements designed to test management influence over boards expose a major underlying problem: boards are far less independent than is generally recognized, even when they appear to be stocked with outsiders. The fresh data raise questions about risks associated with inadequate oversight of management, suppressing scores of every surveyed market but France, where advances in law, code, and practice yielded a modest rise. Overall, the study seems to show a disconnect between the reformers and the reformed. Despite forceful initiatives by legislators, regulators, stock exchanges, and code-writers, who responded to public demand with far-reaching corporate governance changes, companies have made remarkably slow progress on the ground, exhibiting reluctance to embrace reform.
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