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

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

4 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

5 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).

6 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

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

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

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

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

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

12 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

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

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

15 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

16 Best Practices: Board of Directors Board composition  Insiders versus outsiders

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

18 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

19 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

20 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

21 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

22 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

23 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)

24 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

25 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

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

27 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

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

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

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

31 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

32 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

33 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

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

35 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

36 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

37 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

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

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

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

41 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

42 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

43 Best Practices: Executive Compensation CEO has substantial stock ownership

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

45 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

46 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

47 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

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

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

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