1. The Conference Board of Canada Nouvelles perspectives en matière de rémunération et de ressources humaines 2004 Le 3 novembre 2004 After Sarbanes-Oxley Designing an Effective Governance and Executive Compensation Strategy in the Age of Transparency Bernard Sinclair-Desgagné, Ph.D. International Economics and Governance Chair HEC Montréal and CIRANO

2. Plan de la présentation The Background The Sarbanes-Oxley Act Implications of non-U.S. companies Beyond Sarbanes-Oxley - The paradox of compliance - A statement of the Canadian Council of Chief Executives - Shareholders vs. Stakeholders - What governance experts have to say

3. The background: warnings and trigger Business ethics codes throughout the 1980-90s. Demands for governance reforms throughout the 1990s: Cadbury Report (UK), Rapport Viénot (France), Dey Report (Canada), Principles of Corporate Governance (OECD), GM’s Board of Directors Guidelines, Johnson & Johnson’s “credo”, etc. The Multilateral Agreement on Investment (MAI) failure and the rise of the anti-globalization movement.  Corporate Bankruptcies (Enron, Worldcom, Adelphia, etc.)

4. The Sarbanes-Oxley Act Enacted July 30, 2002 Accounting Standards and Oversight - Establishment of a new accountant oversight panel  Board Composition/Membership - Mandatory registration - Auditing quality control  Inspections  Investigations - Sanctions  SEC oversight - Accounting standards - Board/ FASB Funding/Budget

5. The Sarbanes-Oxley Act Enacted July 30, 2002 Auditor independence  Prohibited non-audit activities - Pre-approved requirement  Audit partner rotation - Audit reports - Audit firm conflict  SEC authority on auditor independence - State authority for standards

6. The Sarbanes-Oxley Act Enacted July 30, 2002 Corporate Responsibility - Audit committee matters - Officer certification - Improper influence on audits  Forfeiture of bonuses/trading profits  Officer/Director bars and penalties - Trading during pension blackout periods - Professional responsibility of attorneys - Funds for investor restitution  Prohibition of personal loans to executives

7. The Sarbanes-Oxley Act Enacted July 30, 2002 Enhanced Financial Disclosures - Accuracy of financial reports - Off-balance sheet transactions - Pro-format financial information  Loans to executives  Officer/Director bars and penalties - Changes in stock ownership - Internal controls - Code of ethics - Audit committee expertise - SEC enhanced review of periodic disclosures - Real-time disclosure

8. The Sarbanes-Oxley Act Enacted July 30, 2002 Analyst Conflict of Interest - Analyst Protections - Disclosure - Appropriations - Changes in stock ownership - Censure authority - Credit ratings agencies - Investment banks

9. The Sarbanes-Oxley Act Enacted July 30, 2002 Corporate and Criminal Fraud  Criminal penalties for altering documents  Destruction of corporate audit records - Debts nondischargeable - Federal sentencing guidelines  Protection of whistleblowers - Criminal penalties for defrauding public shareholders - Investment banks White-Collar Criminal Penalties and Enhancements - Increase in criminal penalties  CEO/CFO certification of financial reports - Prohibiting persons serving as officers/directors

10. Non-U.S. Companies and the Sarbanes-Oxley Act Officer certifications  Loans to directors and executive officers Bonus and other forfeitures in event of restatements “Whistleblower” protection  Reports of personal securities transactions of directors and executive officers Audit committee organization and responsibilities Independence of accounting firm Registration of U.S. and non-U.S. accounting firms with board Disclosure of material correcting adjustments  Codes of ethics for senior financial officers Internal control assessments Off-balance sheet transactions

11. Best Practice Calendars and Agendas for U.S. Corporate Boards and Committees Full BoardAudit CompensationGovernance Committee Committee Committee January X X X X February March X X April X (phone) May X June July X X August September (retreat) X X October X (phone) November X X December

12. Best Practice Calendars and Agendas for U.S. Corporate Boards and Committees Compensation Committee Meeting Agendas  Approves option grants and bonus awards (based on planned designs approved at prior meetings) and drafts financial results being presented to Audit Committee.  Approves compensation (including options) and bonus plans designs for coming year, for recommendation to full Board.  In November: annual committe self-evaluation  Compensation of newly-hired senior executives  Adoption of any golden parachute or other employment agreement  Adoption of equity-compensation plans, subject to shareholder vote

13. Beyond Sarbanes-Oxley The paradox of compliance “There is a negative correlation between the number of complying corporations and the number of white-collar crimes.” Principles-based vs. Rules-based approaches

14. Beyond Sarbanes-Oxley A statement of the Canadian Council of Chief Executives Serving as the chief executive officer is a privilege that comes with substantial responsibilities – to our shareholders, to our employees, to our customers and suppliers, and to the public. Our primary responsibility is to run the company well, in a manner that builds value for the shareholders who have entrusted us with their investments. Specific operational responsibilities include: - Leading the strategic planning process by developing plans, presenting them to the board, implementing them, and suggesting changes; - developing and implementing annual operating plans and budget; - recruiting, developing and retaining talented and motivated employees; - Identifying and managing the risk that the corporation takes; - Putting in place ands supervising a reporting system.

15. Beyond Sarbanes-Oxley A statement of the Canadian Council of Chief Executives In addition to managing the corporation and delivering results, we must report clearly and accurately on the results of our decisions and be accountable for our actions. While the level and form of compensation is a matter to be decided by the boards of individual companies, we understand the frustration felt by investors when senior executives are rewarded handsomely for past performance that proves to be short-lived. We continue to believe that executive compensation should be tied significantly to both short and longer-term performance, but suggest that boards could consider a heavier emphasis on compensation tied to sustained appreciation in shareholder value. For example, boards could consider the payment of some or all performance-based pay in the form of stock that must be held until retirement or departure, or a requirement that a significant portion of after tax proceeds from the exercise of stock options remain invested in company shares for a minimum period.

16. Beyond Sarbanes-Oxley A statement of the Canadian Council of Chief Executives Canada’s existing rules and regulations ensure that a material mis- represention would expose chief executives to significant consequences through the courts and regulating bodies as well as the marketplace. We would, however, encourage governments and regulators to enforce these rules more vigorously and ensure that penalties for violations better reflect the gravity of the offence. Just as boards decide how best to align the interests of chief executive officers with those of shareholders through the provision of bonuses and other incentives for meeting designated performance targets, compensation agreements also could provide for sanctions that would complement and reinforce legal and regulatory penalties.

17. Beyond Sarbanes-Oxley A statement of the Canadian Council of Chief Executives Codes of ethics. In order to serve the interest of our shareholders, it is not enough to make business decisions guided only by what is permitted by the letter of law. Sustainable growth in sharehoder value requires that we set high ethical standards for operating our businesses and champion a corporate culture based on doing what is right. We recognize that it is the actions rather than just the words of the chief executive that sets the tone for the behavior of employees within our companies and that determines the company’s reputation with customers, suppliers and other stakeholders.

18. Beyond Sarbanes-Oxley Shareholders vs. Stakeholders – an old debate Friedrich Hayek: “The present tendency not only to allow but to encourage such use of corporate resources [in the service of some “public interest”] appears to me as dangerous in its short-run as in its long-run consequences. The immediate effect is greatly to extend the powers of the management of the corporations over cultural, political, and moral issues for which proven ability to use resources efficiently in production does not necessarily confer special competence; and at the same time to substitute a vague and indefinable “social responsibility” for a specific and controllable task.”

19. Beyond Sarbanes-Oxley Shareholders vs. Stakeholders – a recurrent debate “[The] directors have fiduciary responsibilities to shareholders which, while allowing directors to give considerations to the interests of others, compel them to find some reasonable relationship to the long-term interests of shareholders. [...] A Delaware Supreme Court's decision to enable directors to give consideration to the interests of others does not suggest that the court intended to authorize redress of an adverse impact on a non-shareholder constituency at the expense of shareholders.” - American Bar Association -

20. Beyond Sarbanes-Oxley Shareholders vs. Stakeholders – a recurrent debate Moderate social pro-activism Cadbury Report (UK), Rapport Viénot (France), Dey Report (Canada) Principles of Corporate Governance (OECD) GM’s Board of Directors Guidelines Johnson & Johnson’s “credo”, etc. “The present status enjoyed by the business community also yields certain duties towards intangible, yet fundamental, features of the social fabric – such as trust – that legitimize their business activity.”

21. Beyond Sarbanes-Oxley What governance scholars have to say. Management guru Peter Drucker (1993) Step back on equity-based incentives “One of the basic problems is that management has no way to judge by what criteria outside shareholders value and appraise performance. The stock market is surely the least reliable judge or, at best, only one judge and one that is subject to so many other influences that it is practically impossible to disentangle what, of the stock market appraisal, reflects the company’s performance and what reflects caprice, affects the whims of securities analysts, short-term fashions and the general level of the economy and of the market rather than the performance of the company itself.”

22. Beyond Sarbanes-Oxley What governance scholars have to say. George Baker (2002): “Problems do not arise from a lack of available performance measures, but from a lack of undistorted performance measures. To determine the weight to be placed on a given performance measure, what matters is not the correlation between this measure and firm value, but whether both would always move in the same direction and proportion as the executive’s effort.”

23. Beyond Sarbanes-Oxley What governance scholars have to say. Gerard Sanders and Mason Carpenter (1998): “Results from a sample of large U.S. firms support this perspective, suggesting that firms manage and cope with the information processing demands and agency issues arising from internationalization through higher, longer-term CEO pay, larger top management teams, and the separation of chairperson and CEO positions.”

24. Beyond Sarbanes-Oxley What governance scholars have to say. Kevin Murphy (1999): “The paucity of relative performance evaluation in options and other components of executive compensation remains a puzzle worth understanding.”

25. Beyond Sarbanes-Oxley What governance scholars have to say. Organizational behavior expert Steven Kerr (1975) On the Folly of Rewarding A while Hoping for B… Bengt Holmstrom and Paul Milgrom (1991) The desirability of providing incentives for any one activity decreases with the difficulty of measuring performance in any other activities that make competing demands on the executive’s time and attention.

26. Beyond Sarbanes-Oxley What governance scholars have to say. Bernard Sinclair-Desgagné (1999, 2002) Two tasks A and B. Task A is routinely monitored, but not task B. The principal commits to investigating about task B when task A’s outcome is high. The executive is penalized after the investigation reaches a negative conclusion. On average, however, the executive is better off when an investigation takes place.