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 markets—most of all, the ability of shareholders to sell their stock—will 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 Enron’s 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 didn’t 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 directors—exercising oversight power • Shareholders—making voting decisions • Courts—deciding 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 comp’n, 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.” JusticeLouis 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 aren’t 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 worker’s salary; by 2004, that multiple had risen to 431. • Retirement security: while workers’ defined benefit plans are frozen or terminated, executives’ pensions grow: • Pfizer’s McKinnell: $6,518,459/yr. • ExxonMobil’s Raymond: $6,500,000/yr • AT&T’s Whitacre: $5,494,107/yr.

15. Executive Pay and Incentives • Corporate governance’s narrow model of human behavior: “I don’t 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 benchmarks—those that are used are often fallbacks to provide compensation when financial criteria are not met • Use of market-based criteria duplicates equity compensation’s incentives

16. Equity-Based Compensation • Pay for performance and alignment with shareholders—has 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 outsiders—impact within the company as well • Becomes part of corporate culture—studies 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