a statement by the economic development governance practices … · critical issues. we encourage...

The Best of Business ThinkingIn the Nation’s Interest

Corporate Governance Practices to

Restore Trust, Focus on Long-Term Performance, and

Rebuild Leadership Built to Last:Focusing Corporations on Long-Term Performance

A Statement by the Research and Policy Committee of the Committee for Economic Devevlopment

Rebuilding Corporate Leadership: How Directors Can Link Long-Term Performance with Public Goals

A Statement by the Research and Policy Committee of the Committee for Economic Development

A Statement by the

Research and Policy

Committee of the

Committee for

Economic Development

The State of Corporate

America After

Sarbanes-Oxley

Private Enterprise, Public Trust:

Corporate Governance Practices to Restore Trust, Focus on Long-Term Performance, and Rebuild Leadership 1

Corporate Governance Practices to Restore Trust, Focus on Long-Term Performance, and Rebuild Leadership*

Committee for Economic Development (CED) policy statements on corporate governance issues since 2006 have analyzed:

• Howcorporationscouldreformgovernancepracticestoregainthepublic’strustinthewakeofcorporatescandals;

• Howcorporatedirectorscouldpromotethelong-termenduringqualitiesoftheirenterprisesratherthangiveintofinancialmarket“short-termism;”and

• Howdirectorscouldlinklong-termperformanceandpublicgoalstoimprove corporate performance and rebuild their leadership position withinsociety.

Thispurposeofthisreviewistopromotediscussionanddebateonthesecriticalissues.Weencouragecorporateleaders,governmentpolicymakers,andtheinterestedpublictojoinusinthatdiscussionandvolun-teertheirviews.

Analysis

As CED began to consider corporate governance issues in 2002, the highly visible accounting scandals that surrounded the collapse of Enron, WorldComandseveralothermajorcompanies—togetherwiththerevelation of fraud and other acts of malfeasance by corporate execu-tives—arousedpublicoutrage,calledintoquestionthevaluesandethicsof business leaders, and undermined the public’s confidence in public companies.Unfortunately,asweconcludeddeliberationsin2009,publicoutrage is again being fueled by reports of greed, conflicts of interest, and othermisdeeds,andbythegrowingexpenditureofpublicmoneytosupport private businesses as the government attempts to fend off a deepeningrecession.

ThebusinessandacademicleaderswhocompriseCEDareunwaveringadvocatesforthefreemarketsystem,andjustasfirminthebeliefthat

* Private Enterprise, Public Trust: The State of Corporate Governance After Sarbanes-Oxley(2006); Built to Last: Focusing Corporations on Long-Term Performance (2007); and Rebuilding Corporate Leadership: How Directors Can Link Long-Term Performance with Public Goals (2009).

2 Corporate Governance Practices to Restore Trust, Focus on Long-Term Performance, and Rebuild Leadership

businessesandtheirleadersmustearnthepublic’strust.Perceptionsthatfirms flout rules, behave unethically, and use deceptive business processes weakenconfidencein,andsupportfor,thefreeenterprisesystem.Execu-tive compensation untethered to economic value violates perceptions of fairness,leadstomistrust,andcourtsastiflingregulatorybacklash.

Numeroussmallandlargecorporatepolicies,processes,andstructures—fromnuts-and-boltsdecision-makingbylinemanagerstohigher-levelstrategicthinkingbydirectorsandCEOs—haveresultedinthenegativeresultswehavewitnessedoverthelastdecade.CED’scorporategover-nance reports have examined a broad range of reforms in accounting, internal controls, executive compensation, succession planning, and other boardandmanagementpracticesthatwouldrestoreconfidenceandtrustinAmericancorporationsandtheirleaders—ataskmademoreurgentbyourcurrenteconomiccrisis.

CED’s first corporate governance report, Private Enterprise, Public Trust: The State of Corporate Governance After Sarbanes-Oxley (2006), addressed governmental and corporate policies that affect the behavior of publicly tradedcompanies,aswellastheconfidenceofinvestorsinthem.Thereportacknowledgedattheoutsetthatnolawsorpolicieswilleverbesufficient to end all corporate misbehavior (or, for that matter, misbehav-iorinanysegmentofpubliclife).Itconcluded,however,thattrulyindependent and inquisitive boards of directors provide the best safe-guardagainstcorporatewrongdoing,anditrecommendedseveralwaysbywhichcorporategovernancepracticescouldbeimproved.Itcalledforanewsystemoffinancialreportingthatrecognizes“thebrittleillusionofaccountingexactitude”—themisapprehensionthatbusinessaccountscanbemeasuredprecisely—andproposedasubstantiallydifferenttypeoffinancialstatementtomakeclearthenecessaryjudgmentsbehindthenumbers.

Akeythemeembeddedinthesereportsisthatdecision-makingbasedprimarily on short-term financial indicators can damage the ability of publiccompanies—and,therefore,oftheU.S.economy—tosustainsuperiorlong-termperformance.Emphasisonreportedquarterlyearn-ings,compensationtiedtoearningspershare,shortenedCEOtenures,and financial reports that fail adequately to inform about company performanceimpedethetaskofbuildinglong-termvalue.Thesephe-nomenaarecommonlyknownas“short-termism,”andCED’srecom-


mendationscalloncorporateboardstousetheirpowereithertoeliminatethesepracticesortocounteracttheireffect.Inoursecondreport, Built to Last: Focusing Corporations on Long-Term Performance (2007),wecallonboardsofdirectorstoaddresstheseproblemsbyputting the long-term interests of the corporate entity at the forefront of their concerns and demonstrating through their actions that those concernstrumpinterestinshort-termpricemovements.

The focus of our third report, Rebuilding Corporate Leadership: How Directors Can Link Long-Term Performance with Public Goals (2009), is on thepotentialcontributionsboardsofdirectorscanmaketoimprovecorporate strategy and long-term performance by engaging responsibly withthesocietyaroundthem.Thecentralconclusionofthisreportisthatcorporate boards and the leaders they select must integrate relevant societal concerns, such as environmental and human rights consider-ations, into corporate strategy to strengthen long-term competitiveness andthesustainabilityofboththecorporationandthesocietyinwhichitexists.Asuccessfulframeworkrequiresthatsocietalandbusinessleadersviewandtreateachothersaspartners,notadversaries.Theiractionsandpublic communications should recognize their interdependence and sharedgoals.

Manycorporateleaders—directorsandCEOs—havefoundthataprincipled,long-termviewfostersgreaterappreciationoftheinterdepen-dencebetweenthecorporationandthesocietyinwhichitoperates.These individuals are leading the development of business strategies that takeaccountofsocietalchallengesasameanstoensuretheircorpora-tions’andsociety’slong-termprosperity.Asimportant,somearespeak-ingouttourgeU.S.politicalleaderstorepairtheirbrokensystemssotheycan begin to solve long-term societal problems that hamper business as wellassociety’sotherconstituents.Buttoofewbusinessorpoliticalleadersarefollowingthesepaths.

Together,thesethreereportsseektorestoreconfidenceandtrustinAmericancorporationsandtheirleaders.PubliccorporationsarethedrivingforceoftheU.S.economy.Theyarethecoreofasystemunsur-passedincreatingjobs,income,andwealth,andindeliveringawidechoiceofgoodsandservices.Corporateleadersshouldunderstanditisin their self interest to repair their corporate practices and to engage responsiblywiththesocietyaroundthem.


Summary of Key Recommendations

The recommendations of CED’s three corporate governance reports can begroupedasfollows:

• Accountable,forward-thinkingleadership• Transparent,honest,andmeaningfulcommunications• Long-term,sustainableperformance

Accountable, forward-thinking leadership:

• Thebestapproachtobuildingahigh-qualityboardistoassigntoatruly independent nominating committee the responsibility for recommendingnewboardcandidatesandforevaluatingtheperfor-manceofexistingboardmembers.Thenominatingcommitteeshould also have the responsibility of recommending committee assignments.

• TheCEOismainlyresponsibleforcarryingouttheboard’sdirec-tions.WhenchoosingaCEO,theboard’sselectioncommitteeshouldbemindfuloftherolethatpersonwillplayinsettingthetoneanddirectionofthecompanywithregardtoethics,integrity,andengagementwithshareholdersandotherinterestedparties.TheboardshouldtieaportionoftheCEO’sandseniormanagement’sperformance compensation to metrics based on the corporation’s performanceonsuchconcerns.

• Ensurethatthecompanyhasastrongsuccessionplanandgrowsmanagerialtalentinternally.Inthepast20to30years,wehaveseenanevolutionfromCEOswhowerenurturedanddevelopedwithinacompany,andwhousuallyservedatthewilloftheboardwithoutacontract,toagreaternumberofCEOswhoarehiredfromoutsideand,forlegitimatereasons,areemployedbycontract.Developinginternal talent, in addition to providing direct benefits to the com-pany, reduces pressure on compensation committees to offer incom-ingCEOsexorbitantcontracts,completewithup-frontsigningbonusesandseveranceguarantees.

• TheCompensationcommitteeshouldadoptmeasurable,specific,andgenuinely challenging goals (financial, strategic, operational, and social)fortheperformanceoftheirbusiness,andjudgemanagementbythem.


• Thecompensationprocessmustberunbyacompensationcommitteecomposedofindependentdirectors.Andcompensationconsultants,whenused,mustbeentirelyindependentofmanagement.Inselect-ingconsultants,thecommitteemustcomprehendhowtheprocessoffixingtopmanagementcompensationhasbrokendown.Whetherornot consultants are used, the compensation committee should have direct authority over all terms of any management contract, including allformsofcompensation.

• CompensationcommitteesshouldtakecaretodeterminewhetheracontractforaCEOistrulynecessary.Ifthecommitteedecidestouse a contract, it should understand the potential consequences of all contractprovisions.Allcontractsshouldhavereasonable“sunset”provisions.Neitheraresignationnoranoticeofnon-renewalforanemploymentagreementshouldautomaticallygiverisetoseverance.

• Aligncompanyexecutives’financialinterestsandincentiveswiththelong-termhealthofthecompanyanditsstockprice.Althoughspecific conditions should dictate a company’s policies, in general top executives should be expected to purchase over time a substantial numberofshareswiththeirownmoney(notjustfromcompensationawards)andtoholdsharesequaltoanappropriatemultipleofbasesalary.Thatis,executivesshouldhaveasubstantialequityinterestintheir company and should be required to act as ‘buy-and-hold’ investors.Vestingandexerciseperiodsforequitygrants—optionsorshares—shouldbeincreasedbeyondexistingpracticeandtiedtomulti-yearperformance.Forsimilarreasons,directorsalsoshouldberequiredtobuyandholdthecompany’sshares.

• Severancecompensation,likeallotherformsofexecutivecompensa-tion,shouldbereviewedcarefullyagainstcriteriasetbythecompen-sation committee of the board, and the board should publicly provide fulldetailsofawardsandexplainpubliclytoshareholdersthereason-ingbehindsuchawards.

• Thecompanyshouldhavetherighttorecapturetopexecutivebonusesiffinancialresultsbywhichtheywerejustifiedturnoutnottohavebeenachievedwhenaccountsarerestated.

• Thecompensationcommitteeshouldbevigilanttoconstructpaypackagesthatmotivateexecutivestomaximizethecompany’slong-


termeconomicvalue.Forexample,thecompensationcommitteemaywanttospelloutthelong-termconcernstheyexpecttheirCEOand other executives to address, such as employee retention, customer satisfaction,environmentalsustainability,developmentofnewproductsormarkets,adaptabilitytochangesinpublicpolicies,orotherindicatorsofthecompany’slong-termhealth.

• Engagemajorshareholdersinadialogueaboutexecutivecompensa-tionprograms.Investorgroupsrecentlyhavebeguntoseekadvisoryvotesonexecutivecompensation,toallowshareholderstoexpressgeneral approval or disapproval of the company’s executive compen-sationplan.However,anadvisoryvoteseemsacrudeandunneces-saryinstrumentforcommunicatingaboutthiscomplextopic.Asimpleup-or-downvotecouldsendmixedandconfusingsignals.Moreimportant,weseenoreasonforshareholderstovoteonlyonacompany’sexecutivecompensationplanamongalloftheothermajordecisionstakenbyaboardofdirectors.Becausethegoalofthosesupportingavoteistoopenadialogueaboutpayissues,weurgecompensationcommitteestoinitiatethedialogueupfront.

Transparent, honest, and meaningful communications:

• Directorsshouldpromotehonestyinreportingnotonlyonfinancialresults and other non-financial aspects of their company’s operations, butalsoontherisks,opportunitiesandresultsofitssocialinterac-tions.Suchreportingshouldshowhowthecompanyevaluatesthelong-termimpactofpotentialcostsandbenefits.Butasidefrommandated environmental and labor reporting to government regula-toryagencies,corporate“sustainability”reportingshouldremainwithinthepurviewandatthediscretionoftheindividualcompany(as it exercises its responsibility for honest and full communication withshareholders).Directorsshouldusetheirauthoritytohelpthecompanytofindafirm-specificwaytocommunicateeffectivelywithshareholdersandthepublic—throughtheregularannualreporttoshareholders,inaseparatepublicreport,orinsomeotherway.

• Auditcommitteesmustbeautonomousandvigorous.Inordertopresent a company’s position accurately, the board of directors must haveaccesstoallpertinentdata.Thiswilloccuronlyifaboard’saudit committee is competent, independent, and establishes effective control over both the internal auditors and the independent outside


auditors.Therelationshipbetweentheauditcommitteeoftheboardandtheoutsideandinternalauditorsiscrucial.Theauditcommitteeshould exercise the same tone of control over the internal auditor as it does over the external auditor, extending to decisions of hiring, firing,andcompensation.

• Financialinformationisinherentlyjudgmentalandfinancialstate-mentswouldbemoreusefuliftheyweregovernedbyfewerrulesanddisplayedmoreofthejudgmentthatliesbehindestimatednumbers.Stockanalysts,theinvestingpublic,andregulatorsmustrecognizetheinherentlyjudgmentalcharacterofaccountingstatementsandfinancialinformation.Rangesofvaluesratherthanprecisenumbersshouldbeexplainedandunderstoodassuch.Inaddition,financialstatementsshouldbesupplementedwithnon-financialindicatorsofvalue.

• Managementshouldmakeafull,timely,andtransparentdisclosureofitscompensationtoshareholders.Thecompensationdiscussionshould be presented in one place in the company’s disclosure and shouldincludeallformsofcompensation.Disclosuresshouldbecomprehensiveandeasilyunderstandable,andtheyshouldmakeclearhowtopofficerswouldbecompensatedunderplausibleretirementorchange-of-controlsituations.

• Fortheirinternalassessmentsofperformance,werecommendthatdirectors encourage management to adopt reporting systems that focusattentionon“valuedrivers”andlong-termrisks,suchasthoseproposedbytheEnhancedBusinessReportingframework.Direc-tors may consider requesting reports on such metrics as part of the informationprovidedintheboardpackage.Companiesalsoshouldvoluntarily provide information derived from those systems to complementpublicfinancialreports.

• Directorsregularlyshouldconsiderhowthecompanyplans,manages,andcommunicatesitsinteractionwithsociety.Theboardshouldinsist that management report regularly to it and to the public on non-financialperformance,includingsocialperformance.Toinstitu-tionalizetheprocess,theboardmaywanttoestablishaspecialcommitteeorempoweritsgovernancecommitteetotakeresponsibil-ityforoversight.Thatcommitteeshouldreporttothefullboardandappearregularlyonitsagenda.


• Directorsshouldrecognizethevalueofcorporatecommunicationwithshareholdersandthepubliconissuesthatbearonthecom-pany’sreputationandbrandvalue,evenwhensuchcommunicationmay not be required by regulation or fit neatly into financial disclo-sureformats.Boardsthathaveanon-executivechairorleaddirectormaywanttoconsideracommunicationsroleforthatpersononsuchissuesandtopics.

Long-term, sustainable performance:

• Theboardofdirectorshasultimateresponsibilityfortheperformanceofthecorporation.Directorshaveanobligationtoactasstewardsofthecorporation’slong-termeconomichealth.Theyshouldwidenthepurviewoftheirdeliberationstogiveweighttosocietalissuesthatimpactthefirm’slonger-termperformance.

• Directorshavealegalobligationanddutytoaddressthelong-termperformanceofthecorporation.Directors’fiduciarydutiesincludebroader societal concerns that affirmatively affect the corporation’s performanceandlong-termsustainability.Tomeetthatduty,direc-torsmustconsidertheconcernsofall—notjustcurrentshareholders,managers,orotherpowerfulconstituents—whoareinapositiontoaffectacompany’slong-termperformance.Intoday’senvironment,boardsmustknowthattheyareempoweredtorejectactionsthatproduce only short-term financial results at the expense of the long-terminterestsofthecorporation.Compensationpolicies,forexample, should not be designed to promote purely short-term share-priceenhancement.

• Actingintheshareholders’interests,theboardshouldconstructivelyengagewithmanagementtopromotethedevelopmentoflong-termstrategies.Suchengagementshouldavoidthepitfallofmicroman-agement;rather,itshouldfocusontheprocessofreviewing,apprais-ing, and enriching management’s plan, and on holding management accountableforitscontinuingevolutionandexecution.Tobeclear,wearenotsuggestingthatboardsusurpmanagementfunctionsbyformulatingindependentstrategies.Ourrecommendationisthatdirectors exercise their duty to ensure that management has a long-termimplementationplanforastrategy,supportedbyriskassess-ment,whichenhancestheenduringvalueofthecompany.After


reviewingandapprovingastrategy,theboardshouldstayinvolvedbyholding management accountable for that strategy and ensuring that oversightpracticesareinplacetoassesstheenterprise-wideriskstothecompany.Directorsshouldmeasureexecutives’performanceagainststrategicgoals.

• Choicesofformsofcompensationshouldpromotethelong-termvalue of the firm, rather than exploit favorable accounting or tax treatment.Wenotethatrecentchangesinaccountingforstockoptions require that options be expensed on the accounting state-mentsofpubliccompanies.Theexpensingofoptionsshouldneutral-izeabiasthathasfavoredtheiruseinrecentyears.Thecompensationcommitteemustalsomakecleartheeffectofitscompensationdecisionsonstockholderdilution.

• Thecorporateboardandtheleadersitselectsmustintegraterelevantsocietal concerns, such as environmental and human rights consider-ations, into corporate strategy to strengthen long-term competitive-ness and the sustainability of both the corporation and the society in whichitexists.Asuccessfulframeworkrequiresthatsocietalandbusinessleadersviewandtreateachotheraspartners,notadversaries.Their actions and public communications should recognize their interdependenceandsharedgoals.

• Theboardshouldplayanactiveroleinencouragingcompanyman-agement to evaluate the options available and to decide explicitly whatitoughttodobasedonsoundbusinessgroundsthatincorpo-ratealonger-termview.Onceadecisionhasbeenmadeandjustified,the board should monitor implementation and continue to evaluate the company’s strategy on the basis of long-term costs and long-term benefits.

• Politicalleadersshouldunderstandthecoststheyimposeonbusinessandsocietyatlargeiftheydonottakeactiontoimprovepoliticalgovernanceandpolicymaking.Theyneedseriouslytoaddressreformsinethics,lobbying,redistricting,earmarks,andotherlegisla-tiveproceduresandexecutivepracticestobreakthelogjamholdingbackpolicyreformsinsubstantiveareassuchasglobalclimatechange.


Conclusion

The conduct and performance of America’s leading corporations in recent yearshaveseriouslyunderminedconfidenceinU.S.businessesandinbusinessleaders.CEDpolicystatementsoncorporategovernanceseekto improve the system of corporate governance and to restore public confidenceinbusiness.Puttingbusinessesonsoundeconomicandethical footings and restoring public trust in business are critically importanttooureconomyandsociety.U.S.businessleadersshouldconsiderhowtheirbusinessprocessescanbeimproved,howtheycanimprovebusiness’sethicalstanding,howtheirbusinessstrategiescanbetterrecognizetheirinteractionwithsocietalissues,andhowtheypersonallycanmakeadifferencebysupportingsoundpublicpoliciesthataddresssociety’skeyconcerns.

CED is a non-profit, non-partisan organization of more than 200 business leaders anduniversitypresidents.Since1942,itsresearchandpolicyprogramshaveaddressed many of the nations most pressing economic and social issues, including educationreform,workforcecompetitiveness,campaignfinance,healthcare,andglobaltradeandfinance.CEDpromotespoliciestoproduceincreasedproductiv-ity and living standards, greater and more equal opportunity for every citizen, and animprovedqualityoflifeforall.Formoreinformationwww.ced.org.

Committee forEconomic Development

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Washington, D.C. 20036202-296-5860 Main Number

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Corporate Governance Practices to Restore Trust, Focus on Long-TermPerformance, and Rebuilding Leadership

Publisher(s): Committee for Economic Development

Date Published: 2009-02-11

Rights: Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported

Subject(s): Community and Economic Development

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