A new era in corporate governance?

From the McKinsey Quarterly
Special to CNET News.com
March 27, 2004, 6:00 AM PST

More progress has been made in improving the governance of U.S. corporations during the past couple of years than in the previous several decades.

Part of the remedy, stock exchanges have instituted new reporting requirements in response to high-profile scandals. Taken together with tougher auditing standards under the landmark Sarbanes-Oxley Act, the measures have pushed boards and managers to become far more diligent in preparing and reporting accurate financial information.

But our latest research on board governance in the United States indicates that directors and investors alike feel that, so far, reform has led to only modest improvement. Much more must change before high-quality board governance can be achieved, according to the research.

Although the reforms so far have created more work for finance departments, as well as higher accounting expenses, the direct impact on executives and directors hasn't been particularly troublesome. But the reforms now being demanded by investors and activist advisory groups will be much more of a burden. The investors and directors we surveyed want companies to move toward separating the roles of CEO and chairman, to make directors more independent and accountable, and to scale back and restructure executive compensation so that it is aligned more closely with the creation of long-term value.

It is perhaps understandable that these deeper reforms haven't yet been pursued. As high-profile corporate abuses have unfolded, one after the other, most boards have become preoccupied with reassessing their responsibilities and implementing the new accounting rules. Although directors themselves shoulder a good deal of blame for the lack of profound reform, they join with investors in pointing to CEO resistance as a primary impediment to it.

Certainly, few CEOs see the need for change. The U.S. model of capitalism--with a combined chairman and CEO and a board comprising both insiders and independent directors--has worked well for many companies. So it is hardly surprising that CEOs have little desire to share their power or to sacrifice any of their stature or compensation.

Maintaining the status quo is probably a high-risk option.

Nonetheless, maintaining the status quo is probably a high-risk option. Investors seem intent on pushing a reform agenda--including regulatory change--that will make boards more responsive to their interests. Given the pressure from shareholders and the resistance from management, it will be up to boards to craft solutions that balance the expectations of all parties. Any failure to respond will leave boards more exposed to investors' ire and less prepared to handle a more challenging governance environment.

A clear split
In the summer of 2003 and the winter of 2004, McKinsey surveyed 150 U.S. directors as well as 44 U.S. institutional investors with more than $3 trillion in assets under management. Although the surveys were conducted 12 months to 18 months after the passage of Sarbanes-Oxley, they revealed an even greater appetite for reform than did a comparable survey conducted in May 2002, just before the law's enactment. For activist advisory groups, perhaps the most important item on the near-term agenda is splitting the roles of chairman and CEO.

Both directors and investors believe strongly that this separation must occur if boards are to provide the kind of independent oversight of management that investors demand. Investors are acutely aware that CEOs have tended to dominate boards over the past decade--sometimes with disastrous results--and wonder how a board with the CEO as chairman can oversee management. They also point out that the split structure works quite well in parts of Europe, in Canada and Australia, and in a small number of U.S. companies.

CEOs, though, are resisting the change. Many argue that the combined model has served the U.S. economy well and that splitting the roles might set up two power centers, which would impair decision making. CEOs also point out that finding the right chairman is difficult and that there are real negative consequences for choosing the wrong person. Clearly, they will strongly oppose giving up the power and influence they have worked so hard to accumulate.

Make directors independent--and accountable
Improving a board's performance entails more than separating the roles of CEO and chairman. Significant reforms, ensuring greater independence and accountability, have already occurred in the composition of boards. Recent New York Stock Exchange and Nasdaq Stock Market rulings increase the independence of boards and require listed companies to change certain board practices--for example, by improving the audit committee process and retaining auditors and compensation consultants. Meanwhile, the U.S. Securities and Exchange Commission is exploring ways to promote "shareholder democracy" by making it easier to elect independent board members directly.

Still to come, however, are changes in board practices and behavior that will be essential if directors are to provide independent oversight of executives. Most of the directors we surveyed said that they still depended on management to set the agenda of board meetings. Few respondents felt that they really knew what was going on in their companies, and most believed that this state of affairs would become increasingly unacceptable. The overwhelming amount of material that directors must master before board meetings, coupled with a lack of time and a culture that precludes open and unstructured discussion, has left many board members feeling that they could offer little more than marginal, pro forma counsel.

Increasing the accountability of directors is equally important. Although they report that nearly one-third of their peers are barely adequate or worse as board members, rare--until recently--was the board that evaluated its own performance, whether of individuals or as a whole. In this respect, the change has been dramatic: The percentage of S&P 500 companies conducting board evaluations jumped from 37 percent in 2002 to 87 percent in 2003.

Evaluations of individual directors are also becoming more common--but less so than evaluations of boards--and tend to be done with a light touch. To help ensure that individual directors take part in the oversight and governance of the company, and to clarify their roles and responsibilities, many boards are considering more formal evaluations, which examine the contributions of directors to the boardroom: their professional experience, the roles they play, their participation in committees.

Boards can probably best start by using basic evaluation tools that provide developmental and constructive rather than punitive feedback. Intel, for example, is said to require that all directors complete a structured questionnaire and discuss it with the nonexecutive chairman to identify how they can improve. This fairly unobtrusive approach has apparently raised the performance of individuals and of the board as a whole significantly.

Whatever evaluation tools may be adopted, directors must understand that over time their workload will increase, especially in view of the added work of complying with Sarbanes-Oxley and with the new NYSE and Nasdaq Stock Market listing rules. These developments make it essential to have a clearer sense of the effectiveness of the board and its directors and to implement a process for improving both.

Money, money, money
Finally, there is the issue of executive compensation, which both the directors and the investors participating in our surveys regarded as an important element in the recent spate of corporate scandals. And with good reason: The transfer of wealth from owners to top management over the past decade has been astounding. In 1992, the top five executives at the 1,700 largest U.S. companies cashed in options worth $2.4 billion; by 2000, that number had soared to $18 billion. In 2000, moreover, the annual income of U.S. CEOs peaked at a multiple of 531 times the average production worker's wage; in short, the combination of cash, bonuses, stock grants, benefits, and options has decoupled compensation from performance.

Investors and directors, upset with absolute levels of pay and with forms of compensation that have created risky management incentives, want concrete changes. In a few extreme cases, regulators and investors may ask CEOs to return some of the exorbitant sums they have been paid, as Richard Grasso (formerly of the NYSE) recently discovered. Institutional investors such as Vanguard have recently made it a policy to vote their proxies against directors who serve on compensation committees that continue to give CEOs excessive compensation.

The day is drawing nearer when executive pay will be scaled back.

As a result of these pressures, the day is drawing nearer when executive pay will be scaled back. Simpler, more-transparent compensation will be more tightly linked not just to the stock price of a company but also to its overall health--as measured, for example, by market share, product quality, and customer satisfaction. Boards will have the unenviable task of balancing management's inflated expectations with what investors think is fair.

In the past, the board's compensation committee would typically benchmark executive pay against a broad industry average and then, as a show of support and goodwill, peg total compensation to the top quartile. With every company trying to pay its executives above-average salaries, the average inevitably spiraled upward. The solution is for a board to index its CEO's compensation to the average of a more narrowly drawn peer group. Higher compensation would then be awarded only for beating it, over two or three years, in total returns to shareholders. Few CEOs will do so consistently.

While CEO compensation will probably never get back to the levels of 1982, when it was a mere 42 times the average worker's pay, it is equally clear that shareholders will resist compensation levels anywhere near those seen in 2000. Boards will have to understand what groups such as Institutional Shareholder Services and investors such as Vanguard think about compensation and then balance their views against the realities of the marketplace for managerial talent. If boards scale back compensation too fast they risk losing their best managers, but if they don't go fast enough they could remain targets for reform. In any case, shareholders expect a significant--not an incremental--recalibration of executive pay.

In addition, the structure of compensation packages must change. Cash should become a much larger proportion of the total, and special elements, such as forgivable loans and termination bonuses, ought to be scaled back or eliminated. Many companies have already replaced stock options with cash bonuses or with restricted equity, both of which can improve transparency and better align incentives with performance. To prevent the kind of "pump and dump" timing of equity sales that was common in the recent past, some restrictions now being placed on equity awards actually stretch well past an executive's retirement. Restricted equity also gives management more of an incentive to leave companies in the strongest long-term competitive position.

IT's role in governance
The directors and senior executives with whom we work say that the most critical requirement in corporate governance is raising the quality of the strategic dialogue between the board and management. To do so, both sides must see timely information that shows a company's progress in implementing its strategy--information that isn't necessarily found in quarterly financial filings or in today's board books. What's needed is a set of consistent, unbiased reports, delivered routinely to all board members, that paint a broad picture of the company's situation.

Most companies will need to change their IT systems in four ways to achieve this goal. First, they must ensure the integrity of the data, which should be easily traceable back to original transactions. Managers and board members must be able to drill down through performance metrics to find the root cause of problems--or the genesis of opportunities.

Second, more attention must be paid to the timeliness of information, not only to accommodate shortened reporting deadlines, but also to facilitate faster, more flexible decision making. One CEO told us, "Getting data that is one or more months old just isn't enough. I need highly filtered, insightful data at least every other week, preferably weekly." IT systems that are integrated across the company reduce the time needed to reconcile performance data and thus make it possible to deliver information rapidly.

Third, efficient IT systems will tailor reports to the needs and capacity of individual users--from board members looking for insights on strategic risks to managers comparing regional sales data. IT systems should deliver information on business drivers to decision makers according to their individual responsibilities and requirements. One controller told us, "The trick is to move from mountains of data, all synthesized from different sources with different methods, to delivering targeted, consistent, context-specific information. This is hard but drives real performance."

Finally, companies should standardize the gathering of data for reports and automate them where possible to create a common, companywide set of performance measurements--a basic requirement for good governance that a surprising number of companies lack. Standard performance measurements also make it easier to see exceptions and aberrations. The best systems deliver automated warning alerts to senior management and the board when key performance thresholds have been passed (positively or negatively) or use other feedback mechanisms to assure compliance with company policies and standards or with legal and regulatory requirements.

Companies that use their IT systems to improve corporate governance will probably improve their long-term performance as well. Given the effort and expense of meeting the rather narrow concerns of current compliance, the investment is very worthwhile.

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