GovernanceMetrics International

Corporate Governance
The game has changed
Political Agendas (Spitzer) Research Independence (Mandated) Pensions Fund (Activism)
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The Game Has Changed

Sarbanes.Oxley (Legislation) Global Accounting Standards (Emerging)

Effective Governance

SEC Revitalization (Enforcement)

Auditor Independence (Mandated)

D&O Insurance (Expense)

Corporate Culture

Institutional Buy-Side Power (Compelling Change)

Meaningful Metrics

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Governance Research Report

Findings based upon:
A.T. Kearney survey, interviews, interaction with over 410 corporate directorships, Chief Executive Officers. Key issues / concerns Roles and responsibilities of a Board Culture as a Board responsibility / role

Callard-Research Independent, institutional Rated top 5% in efficacy of advice Highly accurate, proprietary metrics
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Governance Metrics International Independent, institutional research Governance evaluation 500 factor scoring index
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Compliance has been a distraction to the real job of the corporate board
All ensuring regulatory compliance three-fourths very involved over the last 12 months 93% have taken a more active role in shaping company performance in the last 12 months 74% believe further board involvement is needed to ensure performance improvement

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Section 404 is a nightmare, especially for multinationals and those who have done lots of acquisitions. Too much documenting and not enough auditing S&P 500 Director

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Growing evidence links quality of governance to company performance and two shareholder value
Findings vary but the bottom line is the same

Best Board companies outperform 2:1

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28% higher profits and 12% higher shareholder returns

Pension Fund Study

3% a year more over five years

Well-governed companies outperform

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Metrics exist which link Governance to shareholder value

GMI Data/Board Metrics Employee satisfaction Turnover? Meritocracy? Standards for ethics conduct Incidents? Actions taken? Performance criteria what gets measured Cash flow or EPS? Balanced scorecards? Customer satisfaction? Regulatory incidents? Litigation frequency? Depth of Board involvement Delegate to CEO? Independent monitoring?
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Industry and peer reputation The data is out there, use it? Accountability and transparency Open or closed? Restatements? Financial indicators/observable impact Insurance premiums Bond rating differentials Equity Cost of Capital differentials Litigation/legal expenses Recruiting budgets/turnover, severance payments

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There is a direct relationship between Total Shareholder Return (TSR and GMI scores)
S&P 500 Quintile
A 5 B 4 C 3 Johnson & Johnson Anh. Busch IBM Alcoa Sara Lee Freddie Mac Coors AON Activism D 2
Callard Kearney - Proprietary Information A.T. and GMI

Top GMI Scores (8.5 10.0)

ITT
Harley D Johnson Controls Rayonier Aetna Pepsi 3M Coventry Health Sunoco

Ecolab

Bottom GMI Scores (1.0 3.5)

Xerox Williams

Lucent

E 1

Quest F

<-20

-15

-10

-5

10

15

20

>25

Total Shareholder Return (TSR)

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Independence

There is a direct relationship between TSR* and GMI Scores

Top GMI Scores
Company 3-M AETNA TSR 15.1 12.3 GMI 9.0 9.5 AON

Bottom GMI Scores

Company ADEL. COORS TSR (1.3) (5.8) GMI 1.5 3.5

ALCOA
ANH. BUSCH COVENTRY HEALTH ECOLAB HARLEY DAVIDSON

3.1
4.1 48.1 9.3 14.1

8.5
9.0 9.0 9.0 8.5

DISNEY
ESTE LAUDER FREDDIE MAC IBM LUCENT

(4.0)
(1.0) (0.6) .7 (41.6)

5.5
3.5 1.0 2.5 3.0

INGERSOLL- RAND
ITT
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3.1
16.3 5.7 11.9 10.4 11.9 17.2

9.0
8.5 9.0 8.5 10.0 9.5 9.5

NETWORK ASSOC.
PROTECTIVE QUEST SARA LEE TENET TEXTRON WILLIAMS

(25.7)
(1.4) (29.6) (2.4) (1.7) (3.1) (17.8)

1.5
1.5 1.0 3.5 1.5 5.5 2.5

JOHNSON & JOHNSON JOHNSON CONTROLS PEPSI RAYONIER SUNOCO

*5 Year TSR Average + 500 GMI Scoring Index

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This relationship becomes increasingly powerful over time

Avg. Annual TSR

Bottom 10% of 1600 Co. Index Top 10% of 1600 Co. Index

15 10.5 10 5 0 -5
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11.4 4.5 6.1

3.4

-3.1

-2.5

-10 -15
Delta Between Top and Bottom (x Times)

-11.2 1 Year
3.1x

3 Year
15.7x

5 Year
9.2x

10 Year
13.9x

Note: *LSS/GMI index criteria good versus poor governance

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Of all Board responsibilities, protecting and growing shareholder wealth is paramount

Culture impacts the interests of all other stakeholders, and thus derivatively has a direct, measurable impact on shareholder wealth. Accordingly, culture as a Governance role and responsibility is neither optional or tangential.

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Culture starts with the Board

Governance and Culture Three levels of consideration: Culture of the Board Culture of Executive Management Culture of the Organization

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Each in descending order takes cues from above

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Culture starts with the Board

Independence : Objectivity Club or Professional Advice? Committee Structure : Agenda Probe for issues or whats for dessert? Nominating Process : who selects / what criteria Best qualified: or best friends? Time dedicated : Time really available? This Board: or one of two dozen?
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Compensation : cash or stock Do it for income: or do it for value contributed? Philosophy : CEO RULES : or CEO the Hired Hand CEO in charge: or is the Board?
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Which then gives cues to management

Culture of Executive Management Key Factors
Accountability: to whom? What basis? What metrics?

Transparency: clear or opaque?

EPS or cash flow: hit targets or create value Executive style: participative or autocratic? Promotion path: dictatorial or meritocracy?
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Succession: hold the course or fresh ideas?

Reality of conduct and ethics: as preached or as practiced?

Which then establishes the REALITY for the organization at large
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Metrics exist to govern culture

Meaningful metrics Governance is directly responsible for results. What is achieved? How it is achieved? For instance Measure value creature

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Metrics that measure value creation relationship of NCFR0I to TSR/GMI

10.0 9.0 8.0 7.0

Value (Q)
6.0 5.0 4.0 3.0 2.0 Textrom Xerox Quest 1.0 0.9 Williams Adel. Coors Rayonier IBM Network Asso. Disney Anh. Busch ITT Sara Lee Johnson & Johnson AON Pepsi Ecolab Ingersoll Rand Harley

Best companies have a high correlation to TSR Worst have a poor correlation to TSR market simply is not giving them same credit
Worst

Aetna Protective Sunoco Alcor

-4

-3

-2

-1

10

11

12

13

14

20 15

Value Driver (NCFROI)

Best Company
A.T. Kearney - Proprietary Information Callard Research and GMI Proprietary Information

Q 1.6 0.9 2.8 3.5 2.7 3.2 2.5 1.9 5.5 2.6 1.0

NCFR0I 2.5 0.3 8.3 9.5 9.4 10.2 5.3 5.6 14.1 2.2 1.1

TSR 12.3 3.1 4.1 9.3 14.1 3.1 16.3 5.7 10.4 11.9 17.2

GMI 9.5 8.5 9.0 9.0 8.5 9.0 8.5 9.0 10.0 9.5 9.5

Company Adel. Coors AON Disney IBM Network Assoc. Protective Quest Sara Lee Textron Williams Xerox

Q 0.9 1.8 1.8 2.3 2.2 1.2 1.4 2.6 1.2 1.1 1.3

NCFR0I 0.1 5.6 1.9 4.7 1.2 1.8 (3.7) 8.7 (0.5) (0.3) 1.0

TSR (1.3) (5.8) (4.0) 0.7 (25.7) (1.4) (29.6) (2.4) (1.7) (3.1) (17.8)

GMI 1.5 3.5 5.5 2.5 1.5 1.5 1.0 3.5 1.5 5.5 2.5
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Aetna Alcoa Anh. Busch Ecolab Harley Ingersoll Rand ITT Johnson & Johnson Pepsi Rayonier Sunoco

Metrics that measure value creation - EPS vs. cash flow?

R2 = 0.31
Value (PE Ratio)

Value (Q Ratio)

R2 = 0.74

A.T. Kearney Proprietary Information Proprietary Information - and/or Callard Research

-40

-20

20

40

60

-10

10

20

30

Driver (EPS Growth)

Driver (NCFR0I)

P/E is a result, not a value driver EPS only one element of cash flow Distorted by options outstanding Manipulatable in short run Not integrated with balance sheet or cash flow statements

Q measures enterprise value; being driven by the productivity of assets CFROI measures cash flow; real return on invested capital N measures cost of capital; with company specific differentiators
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Metrics exist which link Governance to shareholder value

GMI Data/Board Metrics Employee satisfaction Turnover? Meritocracy? Standards for ethics conduct Incidents? Actions taken? Performance criteria what gets measured Cash flow or EPS? Balanced scorecards? Customer satisfaction? Regulatory incidents? Litigation frequency? Depth of Board involvement Delegate to CEO? Independent monitoring?
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Industry and peer reputation The data is out there, use it? Accountability and transparency Open or closed? Restatements? Financial indicators/observable impact Insurance premiums Bond rating differentials Equity Cost of Capital differentials Litigation/legal expenses Recruiting budgets/turnover, severance payments

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What Corporate Directors are saying

Results of A.T. Kearney survey of over 410 Directors
Question Culture is an important concern for the Board Not a major concern delegate to CEOs If important, how should the Board be engaged Monitor through CEO Independently monitor by Board (trust but verify) How to monitor Existing committee structure Audit Other Create other means Officer position Outside audit What to monitor Employee indicators Market/customer indicators Incident indicators Financial indicators Percent 70% 30% 40% 60% 70% 60% 40% 30% 40% 60% 70% 60% 100% 100%

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Is this good enough?

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Critical business issues that need attention

Degree of effectiveness - Self evaluation Survey Results
0% 10% 20% 30% 40%
Probing concerns

50%
49%

60%

Monitoring financials
Leadership development Succession planning
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43%

24%
21% 16% 15%
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Guiding strategy

Monitoring risks
Performance warnings

A more proactive board culture tops the list of actions to improve effectiveness
What will improve Board effectiveness
60%

More proactive board culture

40%

20%
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0%

Shape meeting agendas

More probing Board culture

Mgmt support for probing

Process to evaluate Board

Improve caliber of individual directors

Separate CEO & Chair

Lead Director

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Although 55% of the directors were very satisfied with their board structure, most see opportunities to improve What changes should be made to your Board structure?
33% 33% 26% 22%

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More Qualified Directors

More Diverse

More Independent

Represents All Constituents

Representing shareholders across broader business issues requires diverse skills and perspectives
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Boards also need to reinvent how they operate

What are the impediments to monitoring business performance? (Top 3 concerns)
0% 10% 20% 30% 40% 50%

Lack of tools and processes providing early warning signs

Amount and type of company information

Board culture
Insufficient operating management discussions
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Directors do not have enough time Willingness of directors to challenge the CEO Lack capabilities within Board of Directors
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...And recognize they need more objective sources of information

What tools does your Board use to monitor performance?
100%

Management bias?

75%

50%

Industry Reports Analysts Customers On-site Visits Consultants Investors

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25%

0% Management reports Informal management discussions Electronic dashboards 3rd party and other
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Board evaluations can focus improvement efforts but may also need more independent views
Does your Board have regular, independent, thirdparty reviews of your governance practices?
NA 1%

85% of boards evaluate annually 55% agreed in 2002 that regular, independent, thirdparty reviews should be executed but in 2004, only 24% of Boards have them

Yes 24%

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No 74% Board evaluations have been a catalyst for how the board gets better The link to company performance is spectacular S&P 500 Director
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In our judgment, Boards need to take action in five critical areas

1 2 3 4 5 Monitor corporate performance with forward-looking and non-financial business indicators Strengthen business strategy through diverse perspectives and ongoing attention Improve risk monitoring and mitigation Shift from succession policy to successor readiness Foster a constructively challenging culture, engaging as an owner vs. as a reviewer
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Monitor corporate performance with forwardlooking and non-financial indicators

Rebalance focus on compliance and current performance to include more implications of forward-looking indicators Expand from financials to broader business view Operations Pipeline Competitive trends Market shifts Customer satisfaction Brand value Technology Shifts Stakeholder concerns

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Increase board access to information, e.g., digital dashboards or web-based reporting (vs. the package)
Represent the shareholder Monitor the long-term health of the business
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Strengthen business strategy with diverse perspectives and ongoing attention

Shift the board role from review to debate bringing out diverse perspectives Expand oversight role from annual approval to include ongoing verification and support for the CEO Is the company executing effectively? Are different leadership skills needed? Is the strategy still appropriate?

Consider new ways to evaluate complex strategies

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Assist management in developing a successful, executable strategy

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Improve risk monitoring and mitigation

Beyond Financial Risks:

Business Interruption Product Failure Partner Failure Competitive Challenge Customer Demand Changes Supply Chain Interruption Disruptive Technology Operating Obsolescence Environmental Risks Inflation / Cost Increases Lawsuits New Regulation Reputation

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Ensure management has effective monitoring and mitigation plansand ability to respond effectively

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Shift from succession policy to successor readiness and broader talent development
Be accountable for the top team not just the CEO Enact field observation / board interaction Drive broader talent management (CEO led) as critical to sustain shareholder value Not a list Beyond replacement planning Competencies for key future positions

Identify Talent

Develop Talent

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Deploy Talent

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Foster a constructively challenging culture, engaging as an owner vs. a reviewer

Set the agenda Challenge assumptions and monitor progress Ensure all voices heard formal and informal exchanges Across the board Shareholders / stakeholders Take advantage of todays technology Right-time communication and open exchanges Information access Alternate self-reviews and independent reviews

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We surveyed Directors representing 410 large corporate boards companies at the beginning of 2004 and compared this to 2002 findings 38% global and 34% North America only >25 industry sectors
% of Directors
30% 25% 20%

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65% > 6 years on Board 82% Male 77% Working 33% with same Industry experience
Average on 2.3 boards

15% 10% 5% 0% <$1B $1-4B $5-9B $10- >$20B 20B

Size of Company Represented (Revenue)

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Boards are making structural changesbut at a cautious rate

Does your company have separate CEO and Chair positions?
2002 2004

86%

77%

14%
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23%

We thought through the advantages of going each way and decided that based on our industry and the alignment needed the combined role might fill expectations better But to balance the power, we also initiated the Presiding Director. S&P 500 Director

Yes

No

60% of the 400 Boards represented in this survey have implemented an independent Lead Director
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The pressure on Boards continues to escalate

Broader-based shareholder activism Power of institutional investorsover 50 % share of U.S. equities Regulation Sarbanes-Oxley NYSE NASDAQ Business Judgment Rule Reinterpretation

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A Trigger point in corporate governance

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Conclusion
Governance and culture bottom line objectives Protect and grow shareholder wealth Ensure ethical, equitable behavior for/toward all stakeholders Trust but verify management stewardship Recognize and make change as necessary
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