Corporate Governance Best Practices: Implications for Commercial Underwriters Dr. Gail S. Russ Dr. Meredith Downes Associate Professors of Management Illinois State University

Corporate Governance Core concern: How do we make sure that top managers are doing what they’re supposed to be doing?

The Agency Perspective Separation of ownership & control Principals & agents Misalignment of interests What’s good for the managers may not be what is good for the owners

The Agency Perspective The Agency Problem: The misalignment of agents & principals’ interests leads to agents (managers) pursuing strategies that are not in the best interests of the principals (stockholders).

The Agency Perspective The Agency Problem: The misalignment of agents & principals’ interests leads to agents (managers) pursuing strategies that are not in the best interests of the principals (stockholders). Focus is on protecting shareholder rights

The Stakeholder Perspective The board has broader responsibilities Focus is on protecting key stakeholder rights Shareholders Employees Vendors Customers Society as a whole

Best Practices The board of directors Executive compensation Anti-takeover measures

The Board of Directors Role is to monitor & evaluate top management But, is the board a complete solution?

Best Practices: Board of Directors Separate CEO & Chairman of the Board Role duality gives CEO too much power

Best Practices: Board of Directors Separate CEO & Chairman of the Board Role duality gives CEO too much power Appointment of lead outside director

Best Practices: Board of Directors Separate CEO & Chairman of the Board Role duality gives CEO too much power Appointment of lead outside director Former CEO does not continue to sit on the board

Best Practices: Board of Directors Active board members Not a rubber-stamp board

Best Practices: Board of Directors Active board members Not a rubber-stamp board Evidence that the directors are in contact with employees, vendors, & customers

Best Practices: Board of Directors Active board members Not a rubber-stamp board Evidence that the directors are in contact with employees, vendors, & customers Board composition Size Age Diversity Expertise

Best Practices: Board of Directors Board composition Insiders versus outsiders

Best Practices: Board of Directors Board composition Insiders versus outsiders “Having a board monitor itself is like having the fox watch the henhouse.”

Best Practices: Board of Directors Board composition Insiders versus outsiders “Having a board monitor itself is like having the fox watch the henhouse.” The majority should be independent

Best Practices: Board of Directors Board composition Insiders versus outsiders “Having a board monitor itself is like having the fox watch the henhouse.” The majority should be independent Should have formal resolution requiring this AND a written definition of independence

Best Practices: Board of Directors Board composition What is meant by “independent”? No material relationship with the company, either directly or as a partner, shareholder or officer of a firm that has a relationship with the company

Best Practices: Board of Directors Board composition What is meant by “independent”? Five year “cooling off” period before can be considered independent: Former employees of the firm If formerly part of an interlocking directorate in which an executive of the firm sat on the compensation committee of the firm employing the director Same applies to directors with immediate family members in the above categories

Best Practices: Board of Directors Board members (insiders & outsiders) Limits on number of other board memberships Average director spends 176 hours a year for each board position

Best Practices: Board of Directors Board members (insiders & outsiders) Limits on number of other board memberships Average director spends 176 hours a year for each board position CEOs should not serve on each other’s boards (interlocking directorates)

Best Practices: Board of Directors Board members (insiders & outsiders) Limits on number of other board memberships Average director spends 176 hours a year for each board position CEOs should not serve on each other’s boards (interlocking directorates) Directors & their firms barred from doing consulting, legal, or other work for the firm

Best Practices: Board of Directors Board members (insiders & outsiders) Limits on number of other board memberships Average director spends 176 hours a year for each board position CEOs should not serve on each other’s boards (interlocking directorates) Directors & their firms barred from doing consulting, legal, or other work for the firm Significant stock ownership of firm by directors

Best Practices: Board of Directors Board committees Key committees at least chaired by outsiders Audit, compensation, corporate governance (nominating) committees

Best Practices: Board of Directors Board committees Key committees at least chaired by outsiders Audit, compensation, corporate governance (nominating) committees Preferred: Key committees composed entirely of independent directors

Best Practices: Board of Directors Board committees Compensation committee Conduct formal evaluation of all company officers (including CEO) and set compensation

Best Practices: Board of Directors Board committees Corporate governance (nominating) committee Create charter for board

Best Practices: Board of Directors Board committees Corporate governance (nominating) committee Create charter for board Conduct formal governance review using an external consultant

Best Practices: Board of Directors Board committees Corporate governance (nominating) committee Create charter for board Conduct formal governance review using an external consultant Nominate board members

Best Practices: Board of Directors Board committees Corporate governance (nominating) committee Create charter for board Conduct formal governance review using an external consultant Nominate board members Board term limits

Best Practices: Board of Directors Board committees Corporate governance (nominating) committee Create charter for board Conduct formal governance review using an external consultant Nominate board members Board term limits Elections One class of directors Each director stands for re-election each year

Best Practices: Board of Directors Board committees Audit committee Select independent auditor Not also employed for consulting work

Best Practices: Board of Directors Board committees Audit committee Select independent auditor Not also employed for consulting work Do not seek SEC exemption to do so

Best Practices: Board of Directors Board committees Audit committee Select independent auditor Not also employed for consulting work Do not seek SEC exemption to do so Rotate auditors – at least rotate the lead auditor, if not the entire firm, every 5 years

Best Practices: Board of Directors Board committees Audit committee Select independent auditor Not also employed for consulting work Do not seek SEC exemption to do so Rotate auditors – at least rotate the lead auditor, if not the entire firm, every 5 years CEO & CFO should not be former employees of the auditing firm

Best Practices: Board of Directors Board meetings Frequency of overall board & committee meetings

Best Practices: Board of Directors Board meetings Frequency of overall board & committee meetings Attendance

Best Practices: Board of Directors Board meetings Frequency of overall board & committee meetings Attendance “Executive” sessions Lead outside director with term limit

Best Practices: Board of Directors Board meetings Frequency of overall board & committee meetings Attendance “Executive” sessions Lead outside director with term limits Risk assessment function Reports identifying risks & methods of addressing

Best Practices: Board of Directors Board meetings Frequency of overall board & committee meetings Attendance “Executive” sessions Lead outside director with term limits Risk assessment function Reports identifying risks & methods of addressing Access to internal information

Best Practices: Executive Compensation CEO has substantial stock ownership

Best Practices: Executive Compensation CEO has substantial stock ownership Salary, bonuses, & stock options reward superior performance not size of the company

Best Practices: Executive Compensation CEO has substantial stock ownership Salary, bonuses, & stock options reward superior performance not size of the company AND penalize poor performance

Best Practices: Executive Compensation CEO has substantial stock ownership Salary, bonuses, & stock options reward superior performance not size of the company AND penalize poor performance No modification of performance goals No re-pricing or swapping stock options

Best Practices: Executive Compensation CEO has substantial stock ownership Salary, bonuses, & stock options reward superior performance not size of the company AND penalize poor performance No modification of performance goals No re-pricing or swapping stock options Expense stock options

Best Practices: Anti-takeover measures Lack of provisions designed to thwart a hostile takeover Golden parachutes

Best Practices: Anti-takeover measures Lack of provisions designed to thwart a hostile takeover Golden parachutes Poison pill provisions

Best Practices: Anti-takeover measures Lack of provisions designed to thwart a hostile takeover Golden parachutes Poison pill provisions Greenmail