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

Corporate Governance Best Practices:

Implications for Commercial Underwriters

Dr. Gail S. Russ

Dr. Meredith DownesAssociate Professors of Management

Illinois State University

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Corporate Governance

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

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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

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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).

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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

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The Stakeholder Perspective

• The board has broader responsibilities Focus is on protecting key stakeholder rights

• Shareholders

• Employees

• Vendors

• Customers

• Society as a whole

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Best Practices

• The board of directors

• Executive compensation

• Anti-takeover measures

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The Board of Directors

• Role is to monitor & evaluate top management

• But, is the board a complete solution?

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Best Practices:Board of Directors

• Separate CEO & Chairman of the Board Role duality gives CEO too much power

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Best Practices:Board of Directors

• Separate CEO & Chairman of the Board Role duality gives CEO too much power

• Appointment of lead outside director

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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

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Best Practices:Board of Directors

• Active board members Not a rubber-stamp board

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Best Practices:Board of Directors

• Active board members Not a rubber-stamp board

• Evidence that the directors are in contact with employees, vendors, & customers

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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

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Best Practices:Board of Directors

• Board composition Insiders versus outsiders

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Best Practices:Board of Directors

• Board composition Insiders versus outsiders “Having a board monitor itself is like having

the fox watch the henhouse.”

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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

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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

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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

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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

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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

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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)

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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

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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

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Best Practices:Board of Directors

• Board committees Key committees at least chaired by outsiders

• Audit, compensation, corporate governance (nominating) committees

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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

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Best Practices:Board of Directors

• Board committees Compensation committee

• Conduct formal evaluation of all company officers (including CEO) and set compensation

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Best Practices:Board of Directors

• Board committees Corporate governance (nominating) committee

• Create charter for board

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Best Practices:Board of Directors

• Board committees Corporate governance (nominating) committee

• Create charter for board

• Conduct formal governance review using an external consultant

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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

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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

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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

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Best Practices:Board of Directors

• Board committees Audit committee

• Select independent auditor– Not also employed for consulting work

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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

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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

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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

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Best Practices:Board of Directors

• Board meetings Frequency of overall board & committee

meetings

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Best Practices:Board of Directors

• Board meetings Frequency of overall board & committee

meetings Attendance

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Best Practices:Board of Directors

• Board meetings Frequency of overall board & committee

meetings Attendance “Executive” sessions

• Lead outside director with term limit

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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

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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

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Best Practices:Executive Compensation

• CEO has substantial stock ownership

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Best Practices:Executive Compensation

• CEO has substantial stock ownership

• Salary, bonuses, & stock options reward superior performance not size of the company

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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

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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

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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

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Best Practices:Anti-takeover measures

• Lack of provisions designed to thwart a hostile takeover Golden parachutes

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Best Practices:Anti-takeover measures

• Lack of provisions designed to thwart a hostile takeover Golden parachutes Poison pill provisions

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Best Practices:Anti-takeover measures

• Lack of provisions designed to thwart a hostile takeover Golden parachutes Poison pill provisions Greenmail