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GovernanceMetrics International. Corporate Governance. The game has changed. The Game Has Changed. Sarbanes.Oxley (Legislation). Political Agendas (Spitzer). Global Accounting Standards (Emerging). Research Independence (Mandated). SEC Revitalization (Enforcement). Effective Governance.

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corporate governance
Corporate Governance

The game has changed

The GameHasChanged

Sarbanes.Oxley (Legislation)

Political Agendas(Spitzer)

Global Accounting Standards (Emerging)

Research Independence (Mandated)

SEC Revitalization (Enforcement)

Effective Governance

Pensions Fund (Activism)

Auditor Independence (Mandated)

D&O Insurance(Expense)

Institutional “Buy-Side” Power

(Compelling Change)

CorporateCulture

MeaningfulMetrics

governance research report
Governance Research Report

Findings based upon:

  • A.T. Kearney survey, interviews, interaction with over 410 corporate directorships, Chief Executive Officers.
    • Key issues / concerns
    • Roles and responsibilities of a Board
    • Culture as a Board responsibility / role
  • Callard-Research – Independent, institutional
    • Rated top 5% in efficacy of advice
    • Highly accurate, proprietary metrics
  • Governance Metrics International – Independent, institutional research
    • Governance evaluation
    • 500 factor scoring index
compliance has been a distraction to the real job of the corporate board
Compliance has been a distraction to the real job of the corporate board
  • All ensuring regulatory compliance — three-fourths “very involved” over the last 12 months
  • 93% have taken a more active role in shaping company performance in the last 12 months
  • 74% believe further board involvement is needed to ensure performance improvement

“Section 404 is a nightmare, especially for multinationals and those who have done lots of acquisitions. Too much documenting and not enough auditing”

S&P 500 Director

growing evidence links quality of governance to company performance and two shareholder value
Growing evidence links quality of governance to company performance and two shareholder value

Findings vary but the bottom line is the same…

Best Board companies outperform 2:1

28% higher profits and12% higher shareholder returns

Pension Fund

Study

3% a year more over five years

…Well-governed companies outperform

slide7

There is a direct relationship between Total Shareholder Return (TSR and GMI scores)

Top GMI Scores (8.5 – 10.0)

S&P 500

Quintile

Sunoco

ITT

Harley D

5

A

3M

Johnson Controls

Coventry Health

Aetna

Rayonier

Pepsi

4

B

“Independence”

Ecolab

3

C

Johnson & Johnson

2

D

Bottom GMI Scores (1.0 – 3.5)

Anh. Busch

IBM

“Activism”

Alcoa

Lucent

Sara Lee

Xerox

Williams

1

E

Freddie Mac

Coors

AON

Quest

Callard and GMI

F

<-20

-15

-10

-5

0

5

10

15

20

>25

Total Shareholder Return (TSR)

there is a direct relationship between tsr and gmi scores
There is a direct relationship between TSR* and GMI Scores

Top GMI Scores

Bottom GMI Scores

*5 Year TSR Average + “500” GMI Scoring Index

this relationship becomes increasingly powerful over time
This relationship becomes increasingly powerful over time

Bottom 10% of 1600 Co. Index

Top 10% of 1600 Co. Index

Avg. Annual TSR

© A.T. Kearney – GMI

Delta Between Top and Bottom (x Times)

3.1x

15.7x

9.2x

13.9x

Note: *LSS/GMI index criteria — good versus poor governance

of all board responsibilities protecting and growing shareholder wealth is paramount
Of all Board responsibilities, protecting and growing shareholder wealth is paramount
  • Culture impacts the interests of all other stakeholders, and thus derivatively has a direct, measurable impact on shareholder wealth.
  • Accordingly, culture as a Governance role and responsibility is neither optional or tangential.
culture starts with the board
Culture starts with the Board
  • Governance and Culture – Three levels of consideration:
    • Culture of the Board
    • Culture of Executive Management
    • Culture of the Organization

Each – in descending order – takes cues from above

culture starts with the board12
Culture starts with the Board
  • Independence : Objectivity
    • “Club” or Professional Advice?
  • Committee Structure : Agenda
    • Probe for issues or “what’s for dessert”?
  • Nominating Process : who selects / what criteria
    • Best qualified: or best friends?
  • Time dedicated : Time really available?
    • This Board: or one of two dozen?
  • Compensation : cash or stock
    • Do it for income: or do it for value contributed?
  • Philosophy : CEO “RULES” : or CEO the Hired Hand
    • CEO in charge: or is the Board?
which then gives cues to management
Which then gives cues to management

Culture of Executive Management — Key Factors

  • Accountability: to whom? What basis? What metrics?
  • Transparency: clear or opaque?
  • EPS or cash flow: “hit” targets or create value
  • Executive style: participative or autocratic?
  • Promotion path: dictatorial or meritocracy?
  • Succession: hold the course or fresh ideas?
  • Reality of conduct and ethics: as preached or as practiced?

Which then establishes the “REALITY” for the organization at large

metrics exist to govern culture
Metrics exist to govern culture
  • Meaningful metrics – Governance is directly responsible for results.
    • What is achieved?
    • How it is achieved?
  • For instance
    • Measure value creature
metrics that measure value creation relationship of ncfr0i to tsr gmi
Metrics that measure value creation — relationship of NCFR0I to TSR/GMI
  • Best companies have a high correlation to TSR
  • Worst have a poor correlation to TSR — market simply is not giving them same credit

Best

Worst

Company

Q

NCFR0I

TSR

GMI

Company

Q

NCFR0I

TSR

GMI

Aetna

Alcoa

Anh. Busch

Ecolab

Harley

Ingersoll Rand

ITT

Johnson & Johnson

Pepsi

Rayonier

Sunoco

1.6

0.9

2.8

3.5

2.7

3.2

2.5

1.9

5.5

2.6

1.0

2.5

0.3

8.3

9.5

9.4

10.2

5.3

5.6

14.1

2.2

1.1

12.3

3.1

4.1

9.3

14.1

3.1

16.3

5.7

10.4

11.9

17.2

9.5

8.5

9.0

9.0

8.5

9.0

8.5

9.0

10.0

9.5

9.5

Adel. Coors

AON

Disney

IBM

Network Assoc.

Protective

Quest

Sara Lee

Textron

Williams

Xerox

0.9

1.8

1.8

2.3

2.2

1.2

1.4

2.6

1.2

1.1

1.3

0.1

5.6

1.9

4.7

1.2

1.8

(3.7)

8.7

(0.5)

(0.3)

1.0

(1.3)

(5.8)

(4.0)

0.7

(25.7)

(1.4)

(29.6)

(2.4)

(1.7)

(3.1)

(17.8)

1.5

3.5

5.5

2.5

1.5

1.5

1.0

3.5

1.5

5.5

2.5

Callard Research and GMI Proprietary Information

slide16

Metrics that measure value creation - EPS vs. cash flow?

R2 = 0.31

Value

(PE Ratio)

Value

(Q Ratio)

R2 = 0.74

Driver

(EPS Growth)

Driver

(NCFR0I)

  • P/E is a result, not a value driver
  • EPS only one element of cash flow
  • Distorted by options outstanding
  • Manipulatable in short run
  • Not integrated with balance sheet or cash flow statements
  • Q measures enterprise value; being driven by the productivity of assets
  • CFROI measures cash flow; real return on invested capital
  • N measures cost of capital; with company specific differentiators

© A.T. Kearney – and/or Callard Research Proprietary Information

what corporate directors are saying
What Corporate Directors are saying

Results of A.T. Kearney survey of over 410 Directors

Is this good enough?

critical business issues that need attention
Critical business issues that need attention

Degree of effectiveness - Self evaluation – Survey Results

49%

Probing concerns

Monitoring financials

43%

Leadership developmentSuccession planning

24%

21%

Guiding strategy

Monitoring risks

16%

Performance warnings

15%

a more proactive board culture tops the list of actions to improve effectiveness
A more proactive board culture tops the list of actions to improve effectiveness

What will improve Board effectiveness

More proactive board culture

Shape meeting agendas

MoreprobingBoard culture

Mgmtsupportfor probing

Process toevaluateBoard

Improvecaliber of individual directors

SeparateCEO& Chair

LeadDirector

slide21
Although 55% of the directors were very satisfied with their board structure, most see opportunities to improve

What changes should be made to your Board structure?

MoreQualifiedDirectors

MoreDiverse

MoreIndependent

Represents

All

Constituents

Representing shareholders across broader businessissues requires diverse skills and perspectives

boards also need to reinvent how they operate
Boards also need to reinvent how they operate…

What are the impediments to monitoring business performance?(Top 3 concerns)

Lack of tools and processesproviding early warning signs

Amount and type of company information

Board culture

Insufficient operatingmanagement discussions

Directors do not haveenough time

Willingness of directorsto challenge the CEO

Lack capabilities withinBoard of Directors

and recognize they need more objective sources of information
...And recognize they need more objective sources of information

What tools does your Board use to monitor performance?

Management bias?

Industry Reports

Analysts

Customers On-site Visits

Consultants

Investors

board evaluations can focus improvement efforts but may also need more independent views
85% of boards evaluate annually

55% agreed in 2002 that regular, independent, third-party reviews should be executed

…but in 2004, only 24% of Boards have them

Board evaluations can focus improvement efforts — but may also need more independent views

Does your Board have regular, independent, third-party reviews of your governance practices?

NA

1%

Yes

24%

No

74%

“Board evaluations have been a catalyst for how the board gets better… The link to company performance is spectacular”

S&P 500 Director

in our judgment boards need to take action in five critical areas

Monitor corporate performance with forward-looking and non-financial business indicators

1

Strengthen business strategy through diverse perspectives and ongoing attention

2

3

Improve risk monitoring and mitigation

4

Shift from succession policy to successor readiness

Foster a constructively challenging culture, engaging as an owner vs. as a reviewer

5

In our judgment, Boards need to take action in five critical areas
monitor corporate performance with forward looking and non financial indicators
Monitor corporate performance with forward- looking and non-financial indicators

1

  • Rebalance focus on compliance and current performance to include more implications of forward-looking indicators
  • Expand from financials to broader business view
    • Operations • Pipeline
    • Competitive trends • Market shifts
    • Customer satisfaction • Brand value
    • Technology Shifts • Stakeholder concerns
  • Increase board access to information, e.g., digital dashboards or web-based reporting (vs. “the package”)

Represent the shareholder… Monitor the long-term health of the business

strengthen business strategy with diverse perspectives and ongoing attention
Strengthen business strategy with diverse perspectives and ongoing attention

2

  • Shift the board role from review to “debate” — bringing out diverse perspectives
  • Expand oversight role from annual approval to include ongoing verification and support for the CEO
    • Is the company executing effectively?
    • Are different leadership skills needed?
    • Is the strategy still appropriate?
  • Consider new ways to evaluate complex strategies

Assist management in developing a successful, executable strategy

improve risk monitoring and mitigation
Improve risk monitoring and mitigation

3

Beyond Financial Risks:

Business Interruption

Product Failure

Partner Failure

Ensure management has effective monitoring and mitigation plans…and ability to respond effectively

Competitive Challenge

Customer Demand Changes

Supply Chain Interruption

Disruptive Technology

Operating Obsolescence

Environmental Risks

Inflation / Cost Increases

Lawsuits

New Regulation

Reputation

shift from succession policy to successor readiness and broader talent development
Shift from succession policy to successor readiness – and broader talent development

4

  • Be accountable for the top team— not just the CEO
  • Enact “field” observation / board interaction
  • Drive broader talent management (CEO led) as critical to sustain shareholder value
    • Not a list…
    • Beyond “replacement” planning
    • Competencies for key future positions

Identify Talent

DevelopTalent

DeployTalent

foster a constructively challenging culture engaging as an owner vs a reviewer
Foster a constructively challenging culture, engaging as an owner vs. a reviewer

5

  • Set the agenda
  • Challenge assumptions and monitor progress
  • Ensure all voices heard – formal and informal exchanges
    • Across the board
    • Shareholders / stakeholders
  • Take advantage of today’s technology
    • “Right-time” communication and open exchanges
    • Information access
  • Alternate self-reviews and independent reviews
slide31
We surveyed Directors representing 410 large corporate boards companies at the beginning of 2004 and compared this to 2002 findings
  • 38% global and 34% North America only
  • >25 industry sectors
  • 65% > 6 years on Board
    • 82% Male
    • 77% Working
    • 33% with same Industry experience
  • Average on 2.3 boards

% of Directors

Size of Company Represented

(Revenue)

boards are making structural changes but at a cautious rate
Boards are making structural changes…but at a cautious rate

Does your company have separate CEO and Chair positions?

We thought through the advantages of going each way and decided that based on our industry and the alignment needed the combined role might fill expectations better – But to balance the power, we also initiated the Presiding Director.”

2002

2004

S&P 500 Director

No

Yes

60% of the 400 Boards represented in this surveyhave implemented an independent Lead Director

the pressure on boards continues to escalate
Broader-based shareholder activism

Power of institutional investors…over 50 % share of U.S. equities

Regulation

Sarbanes-Oxley

NYSE

NASDAQ

Business Judgment Rule Reinterpretation

The pressure on Boards continues to escalate

A “Trigger point” in corporate governance

conclusion
Conclusion

Governance and culture — bottom line objectives

  • Protect and grow shareholder wealth
  • Ensure ethical, equitable behavior for/toward all stakeholders
  • Trust — but verify — management stewardship
  • Recognize and make change as necessary