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Corporate Governance

Best Practices

A Blueprint for the Post-Enron Era

SR-03-05

special report

Members of the Advisory Board

BP plc (UK)

California Public Employees’ Retirement System (CalPERS)

The Chubb Group of Insurance Companies

Heidrick & Struggles

Jones Day

KPMG

McKinsey & Company

Merrill Lynch & Co., Inc.

Pfizer Inc

PricewaterhouseCoopers

Teachers Insurance and Annuity Association—

College Retirement Equities Fund (TIAA-CREF)

Members of the Center

Baxter International Inc.

The Coca-Cola Company

Computer Associates International, Inc.

CSX Corporation

Equiserve

Fried, Frank, Harris, Shriver & Jacobson

Georgeson Shareholder Communications Inc.

Southern Company Services, Inc.

Standard Life Investments Ltd. (UK)

For further information regarding the Center,

please contact Diane Insolia, Center Coordinator at

845 Third Ave., New York, NY 10022

Tel: 212 339 0392

Fax: 212 836 9711

e-mail: [email protected]

The Conference Board creates and disseminates knowledge

about management and the marketplace to help businesses

strengthen their performance and better serve society.

Working as a global, independent membership organization

in the public interest, we conduct research, convene conferences,

make forecasts, assess trends, publish information and analysis,

and bring executives together to learn from one another.

The Conference Board is a not-for-profit organization

and holds 501 (c) (3) tax-exempt status in the United States.

Disclaimer

This report is intended for educational purposes only. Nothing contained in this report is

to be considered as the rendering of legal or accounting advice. Readers are responsible for

obtaining legal advice from their own legal counsel or accounting advisors.

About the Global Corporate Governance Research Center

The Conference Board’s Global Corporate Governance Research Center (Center)

brings together corporations and institutional investors. The Center’s objective is

to assist corporations to enhance their governance processes and thereby inspire

confidence and facilitate capital formation in today’s globally competitive marketplace.

Corporate Governance

Best Practices

A Blueprint for the Post-Enron Era

by Carolyn Kay Brancato

and Christian A. Plath

4 Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board

Roundtable project sponsors

THE CHUBB GROUP OF INSURANCE COMPANIES

The member insurers of the Chubb Group

of Insurance Companies form a multi-billion

dollar organization providing property and

casualty insurance for personal and commercial customers

worldwide through 5,000 agents and brokers. Chubb’s

global network includes branches and affiliates throughout

North America, Europe, Latin America, Asia, and Australia.

Chubb is a leading provider of directors and officers (D&O)

liability insurance.

PFIZER INC

Pfizer Inc discovers, develops, manufactures,

and markets leading prescription medicines for

humans and animals and many of the world’s best-known

consumer brands.

Additional sponsors

KPMG Audit Committee Institute

PricewaterhouseCooopers LLP

Sponsor/participants

Arch Chemicals, Inc.

Avon Products, Inc.

Corn Products International, Inc.

Footstar Inc.

Oak Technology

Spectrum Brands

Wellmark, Inc.

Contributors

Baxter International, Inc.

Gibson, Dunn & Crutcher LLP

Heidrick & Struggles International, Inc.

Potomac Electric Power Company

Stanford Law School’s Executive Education Program

TIAA-CREF

The University of Delaware’s John L. Weinberg

Center for Corporate Governance

About this report

Materials for this report were gathered at a series of nation-wide roundtables held

during 2002 in New York; Washington, D.C. (hosted by Potomac Electric Power Company);

Stanford, California (hosted by Heidrick & Struggles International, Inc., and the Stanford

Law School’s Executive Education Program); Chicago (hosted by Baxter International Inc.),

the University of Delaware (hosted by the John L. Weinberg Center for Corporate Governance);

and at the offices of TIAA-CREF in New York.

Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board 5

Corporate Governance Best Practices

A Blueprint for the Post-Enron Era

contents

7 A New Framework for Corporate Governance

Corporate Governance Practices

10 Role of the Board

13 Corporate Governance Guidelines

14 Board’s Access to Information

16 Board’s Mix of Skills and Individual Director Qualifications

18 Board Independence

21 Board Leadership

23 Board Committee Structure and Size

24 Role of the Nominating/Corporate Governance Committee

26 Role of the Compensation Committee

29 Chief Governance Officer

30 Measuring Company Performance

32 Board and Director Performance Evaluation

34 Succession Planning and Leadership Development

Audit Practices

36 Audit Committee Role and Responsibilities

38 Audit Committee Charter

40 Audit Committee Composition and Independence

43 Audit Committee Communication and Reporting

45 Oversight - Internal Audit

47 Oversight - External Audit

Disclosure, Compliance and Ethics

51 Disclosure Practices

54 Internal Controls

57 Risk Assessment and Management

59 Director and Officer Liability and D&O Liability Insurance

63 Ethics Oversight

Appendices

66 1 Legislation and Proposed Exchange Standards Comparison Chart

94 2 Hypothetical, Inc., Corporate Governance Principles

96 3 Independence Comparisons

99 4 Sample Corporate Governance Committee Charter (General Electric Corporation)

100 5 Sample Director Self-Assessment Worksheet

102 6 Sample Chief Executive Officer Evaluation Form

106 7 Sample Audit Committee Charter and Responsibilities Checklist (Microsoft Corporation)

110 8 KPMG Audit Committee Institute Basic Principles for Audit Committees

112 9 Excerpt from Internal Control: Guidance for Directors on the Combined Code

Report by The Institute of Chartered Accountants in England and Wales

About the authors

Dr. Carolyn Kay Brancato is the Director of The Conference

Board’s Global Corporate Governance Research Center and

the Directors’ Institute. She also served as Director of The

Conference Board’s Commission on Public Trust and Private

Enterprise. She is the author of two books on corporate

governance: Getting Listed on Wall Street and Institutional

Investors and Corporate Governance (both published by

Business One Irwin). Dr. Brancato has appeared as a guest

speaker at major corporate governance programs in the

United States, United Kingdom, France, Germany, Australia,

Sweden, Brazil, Chile, India, Singapore, Hong Kong, Thailand,

Indonesia, Japan, Malta, and Oman.

Christian A. Plath is a Senior Corporate Governance

Consultant with the Conference Board’s Global Corporate

Governance Research Center. He was formerly the director

of global corporate governance research at the Investor

Responsibility Research Center (IRRC) and both writes and

speaks widely on corporate governance issues.

6 Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board

Aksys Ltd.

APAC Customer Services, Inc.

ArchChemicals

Asian Venture Capital Journal

Avon Products, Inc.

Baxter International, Inc.

The Boeing Company

Brobeck, Phleger & Harrison

Brunswick Corporation

The Business Roundtable

CDW Computer Centers, Inc.

Chasm Group

Corn Products International, Inc.

CSX Corporation

Davis & Harman LLP

Deere & Company

DelMonte Foods Company

Diamond Cluster International, Inc.

D.J. Hill & Associates, Inc.

Embassy of France

Equity Office Properties Trust

Footstar, Inc.

Freddie Mac

Fordham University School of Law

Friedman, Billings, Ramsey & Co.,

Inc.

Gear Holdings, Inc.

Genentech, Gibson, Dunn & Crutcher

LLP

Grubb & Ellis Co.

H & Q Asia Pacific

Halo Branded Solutions

Heidrick & Struggles International,

Inc.

J.P. Morgan Partners Asia

KPMG

Marriot International, Inc.

Masters Governance Consulting, LLC

McKinsey & Co., Inc.

Mercer Delta Consulting, LLC

Merrill Lynch & Co., Inc.

Methode Electronics, Inc.

Monsanto Company

Motorola

Newell Rubbermaid

Oak Technology, Inc.

Olin Corporation

Paul, Hasting, Janofsky & Walker LLP

PeopleSoft, Inc.

Pfizer Inc

Potomac Electric Power Company

PricewaterhouseCoopers LLP

Real Networks

Richards, Layton & Finger

Sequoia Capital

Singapore Institute of Management

Skadden, Arps, Slate, Meagher &

Flom LLP

Spectrum Brands

Taiwan Semiconductor

Manufacturing Company, Ltd.

TIAA-CREF

Tribune Company

United Stationers, Inc.

U.S. Chamber of Commerce

USG Corporation

Weil, Gotshal & Manges, LLP

Wellmark, Inc.

Wink Communications

WKB Advisory Services

Woodhead Industries, Inc.

Acknowledgments

Participating companies and organizations

A number of facilitators and subject matter discussants

provided special input at the various sessions including:

William K. Brown Jr., Catherine T. Dixon, John W. Edwards II,

June Eichbaum, Anthony S. Galban, Randolf Hurst Hardock,

R. William Ide III, Cary I. Klafter, Richard Koppes, Jon J. Masters,

Nicholas G. Moore, Ronald Mueller, David Nygren,

John F. Olson, Scott A. Reed, Laraine Rothenberg, Alan

Rudnick, Richard Steinberg, Mark C.Terrell, John T. Thompson,

William Torgerson, and Carol Ward.

We are also grateful to Professor Charles E. Elson for

inviting the following members of the Delaware courts to

give us their perspectives: Vice Chancellor Stephen P. Lamb,

Justice Myron T. Steele, Vice Chancellor Leo E. Strine, and

Justice Joseph T. Walsh.

Finally, we would like to thank Donovan Hervig and

William K. Brown for providing draft materials for this report.

Timothy Dennison editor

Peter Drubin design

Pam Seenaraine production

Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board 7

A New Framework for

Corporate Governance

The Enron bankruptcy, accompanied

by the WorldCom debacle and other

corporate scandals, has caused a sea

change in the attention given corporate

governance and in how directors are

viewed by the public, shareholders,

employees, and the courts.

Directors need to be sensitive and responsive to this

new level of scrutiny and exposure. To address this

new emphasis on corporate governance, The Conference

Board’s Global Corporate Governance Research Center

convened a major Director/Senior Executive Roundtable

Project. Meetings were held throughout the year 2002

in New York; Washington, D.C.; Stanford, California;

Chicago; and Wilmington, Delaware. More than

100 directors and executives took part in sharing their

thoughts on evolving corporate governance “best prac￾tices” in the post-Enron era.

Parallel to these efforts, in June 2002, The Conference

Board convened a Commission on Public Trust and

Private Enterprise (Commission on Public Trust)1 to

address the circumstances which led to the corporate

scandals that were widely reported during 2001-2002

and the subsequent decline of confidence in companies,

their leaders and American capital markets. The

Commission’s work articulates a series of principles

and best practice suggestions in three major areas—

executive compensation, corporate governance, and

audit and accounting issues—as they relate to publicly

held corporations.2

This blueprint best practices report is the result of both

the Roundtable Project and the Commission’s work and

is intended to serve as a compendium of leading corpo￾rate governance practices boards and management

should consider within the context of each company’s

unique circumstances.

“Corporate governance” is defined in this report as a sys￾tem of checks and balances between the board, manage￾ment and investors to produce an efficiently functioning

corporation, ideally geared to produce long-term value.

There are several aspects to this governance system that

should be noted at the outset:

1 Any governance system throughout the world is the

product of a series of legal, regulatory, and best prac￾tice elements. Each country’s regulatory and corporate

law system will shape the specifics of its corporate

governance. Corporate governance systems in the

United States have been shaped by sets of pressures

from: the Securities and Exchange Commission (SEC)

with its regulatory oversight, stock exchanges with

their listing requirements; the U.S. Congress enacting

wide sweeping federal legislation; the courts, espe￾cially those in Delaware that, with case law, set prece￾dents; and institutional investors engaging in dialogue

with corporations and which use certain proxy voting

tactics such as the filing of shareowner proposals.

8 Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board

1 The 12-member Commission—co-chaired by Peter G. Peterson,

Chairman of The Blackstone Group and Chairman of the Federal

Reserve Bank of New York, and John W. Snow, former Chairman and CEO

of CSX Corporation and former Chairman of The Business Roundtable—

included prominent leaders from business, finance, public service, and

academia. Although the Commission was sponsored and supported by

The Conference Board, it enjoyed absolute independence and authority

in its findings and recommendations, and was financially supported by

the Pew Charitable Trusts.

2 The Commission issued its first set of findings and recommendations,

Part 1: Executive Compensation, on September 17, 2002. Part 2:

Corporate Governance and Part 3: Audit and Accounting were released

on January 9, 2003. The full text of the Commission’s report and recom￾mendations and a full list of the Commission’s members can be found at

www.conference-board.org/knowledge/governCommission.cfm

Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board 9

2 Global corporate governance research at The

Conference Board concludes that corporate gover￾nance models do not necessarily vary by country (e.g.

there is no one “U.S.” model of corporate governance

compared to an “Asian” model, or a “European”

model). Governance systems are largely determined

by the ownership structure of the company, regardless

of its geographic location. Thus, wherever the corpo￾ration is located, certain best practice elements, such

as the number of “independent” directors, will vary

depending on key ownership structures such as:

• companies with widely held and dispersed

shareholders;

• companies which are closely held by blocks

of investors;

• companies which are family-owned businesses;

and

• newly privatized businesses where the

government retains a residual investment.

3 Whatever the regulatory framework and the company’s

overall governance structure, this project suggests there

are a series of best practices which companies can and

should consider to generate long term value for the

corporation. It is fair to say that many boards have

begun to embrace good governance, although the colle￾gial format that is the basis for board interaction still

tends to discourage open disagreement. Change there￾fore tends to come either if there is an individual direc￾tor/CEO/senior executive who is a corporate

governance champion or if there is a crisis. Post-Enron,

companies can no longer look upon corporate gover￾nance as something thrust upon them from the outside.

In every boardroom around the country, directors are

asking themselves questions such as:

• Is the board managed as effectively as

the company is managed?

• What processes do we need to put in place

to make us more aware of “red flags” in

company operations?

• How do we fulfill our monitoring role and yet

rely on management and external experts such

as accountants, attorneys, and consultants?

• How can corporate governance processes be

used to help keep our company viable and restore

public confidence in the capital markets?

• How will instituting corporate governance best

practices reduce corporate risk?

The catastrophic corporate failures of Enron, WorldCom,

and other companies have eroded confidence and shaken

corporate America to the core. The result is that corpo￾rate governance is more likely than ever to move from

something done as a result of external pressures to some￾thing boards can not afford to dismiss if they want to

properly manage risk, provide internal efficiencies in

running the corporation, and assure growth.

Of course, the landmark enactment of the Sarbanes￾Oxley Act and the listing requirement changes proposed

by the major U.S. stock exchanges provide a rigorous

framework for a whole host of federally mandated inter￾nal controls and corporate governance reforms3 (see

Appendix 1). This document is intended to go beyond

what is required by law and capture best practices4 for

internal corporate governance reform; in short, it is

intended to be a blueprint for success.

3 The New York Stock Exchange (NYSE) and NASDAQ have both proposed

changes to their listing standards and are expected to be updated to conform

to final SEC regulation at which point they will be resubmitted to the SEC for

final review, public comment, revision (if required), and final approval.

4 This document provides an overview of leading practices related to

corporate governance and, although references are made to issued or

proposed changes to regulations and listing standards, is not meant to

provide a comprehensive review of these changes. The impact of the

Sarbanes-Oxley Act and any final and proposed rules of the major U.S.

stock exchanges and the SEC have been closely tracked by many law

firms, accounting firms, consultants and other organizations. (See for

example, KPMG LLP, Sarbanes-Oxley: A Closer Look, January 2003 –

available at www.kpmg.com/aci – for discussion of some of the elements

of the Sarbanes-Oxley Act impacting audit committees and the status of

related issued or proposed SEC regulation.) Audit committees and senior

management should consult with legal counsel and accounting advisors

in the application of the Sarbanes-Oxley Act and any final and proposed

rules of the major U.S. stock exchanges and the SEC.

10 Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board

Corporate governance best practices are based on two

basic legal requirements that shape the fiduciary role of

the director:

• the duty of care to be informed and exercise

appropriate diligence in making decisions and to

oversee the management of the corporation; and

• the duty of loyalty to put the interests of the

corporation before those of the individual director.

In defining a system of board practices that leads to

board effectiveness, it is clear that instituting governance

best practices will provide the company with an internal

effectiveness structure and a tool to manage corporate

risk. The key to accomplishing this is to: make certain

that the company’s board is managed as well as the com￾pany itself is managed. Each board will be run differ￾ently according to the company’s stage of development,

ownership structure and size, and the mix of skills, and

personalities of the individual directors. The “one size

doesn’t fit all” rule clearly applies. On the other hand,

there are basic legal requirements, as well as “manage￾ment” skills that boards can and should adopt no matter

their configuration.

Corporate Governance Practices

Role of the Board

A strong and effective board should have a clear view of its role

in relationship to management. The board’s duty is to focus on guidance

and strategic oversight, while it is management’s duty to run the company’s business,

with the goal of increasing shareholder value5 for the long term. CEOs and management

need to work with the board to establish the right kind of processes and communications

to ensure that the company is running effectively and in accordance with the board’s

basic fiduciary oversight requirements. The ultimate responsibility for directing the company,

however, lies with the board, since most state corporation statutes generally provide that

the business of the company shall be managed under the direction of the board.

The specifics of the board’s role will vary with size, stage and strategy of the company,

and talents and personalities of the CEO and the board.

5 U.S. corporate law dictates that companies be run for the benefit of

shareholders, while European companies have more of a “stakeholder”

focus. Most U S. observers note, however, that companies can not create

shareholder value without taking stakeholders into consideration. A full

discussion of the shareholder versus stakeholder debate is beyond the

scope of this report.

Corporate Governance Best Practices: A Blueprint for the Post-Enron Era The Conference Board 11

As defined by the American Law Institute, The Business

Roundtable (BRT), the National Association of Corporate

Directors (NACD), and other relevant bodies, general

board responsibilities should include:

• approving a corporate philosophy and mission;

• selecting, monitoring, advising, evaluating,

compensating, and—if necessary— replacing

the CEO and other senior executives and

ensuring orderly and proper management

succession;

• reviewing and approving management’s

strategic and business plans, including

developing an in-depth knowledge of the

business being served, understanding and

questioning the plan’s assumptions, and

reaching an independent judgment as to the

probability that the plans can be realized;

• reviewing and approving the corporation’s

financial objectives, plans, and actions,

including significant capital allocations and

expenditures;

• reviewing and approving material transactions

not in the ordinary course of business;

• monitoring corporate performance against the

strategic business plans, including overseeing

operating results on a regular basis to evaluate

whether the business is being properly managed;

• ensuring ethical behavior and compliance with

laws and regulations, auditing and accounting

principles, and the corporation’s own governing

documents;

• assessing its own effectiveness in fulfilling these

and other board responsibilities; and

• performing such other functions as are

prescribed by law, or assigned to the board in

the corporation’s governing documents.6

To ensure maximum board effectiveness, boards need to

shift their entire emphasis—they can no longer be just

“advisors” who wait for management to come to them.

Their new role requires they provide active oversight of

the company’s business to minimize corporate risk and

promote creation of shareholder value. In the wake of

the corporate scandals, the new challenge for boards

will be to go beyond their traditional advisory role and

increasingly focus on their oversight role. As fiduciaries,

boards must be active monitors of management.

Board dynamics need to be right for directors to add

real value to the company. While boards need and

value collegiality, this should not turn into complacency.

Directors need to feel that they can raise objections and

still be seen as team players.

An effective board plays an integral role in the strategic

planning process. Management develops the strategic

plan, while the board reviews and approves it. Directors

require a host of both internally-produced and exter￾nally-gathered information (see box) to effectively

review and evaluate strategy. Sufficient board time

should be devoted to discussing the strategic plan—

openly and regularly with the CEO and in executive

board sessions—so that all board members understand it

well enough to track its progress in an informed manner.

In addition, the board should spend one “retreat” session

per year on strategic oversight.

The fundamental strategic questions boards

should ask themselves:

• Is our board managed as well as our

company is managed?

• Does our board have the strengths it

needs to achieve our strategic goals?

• How well does our board track our company’s

success in reaching its goals?

6 National Association of Corporate Directors (NACD), Report of the NACD

Blue Ribbon Commission on Director Professionalism, 2001 Edition, p. 1.