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Resources

Director Professionalism® Charlotte, NC | April 23-24, 2012

Page Board Excellence: Responsibilities and Strategy in the Current Governance Environment Gregory, Holly. “Preparing for the 2012 Proxy Season.” Practical Law. October 2011, pp. 26-30. 4 “ISS Issues Policy Updates for 2012 Proxy Season.” Weil Alert: SEC Disclosure and Corporate Governance. November 22, 2011, pp. 1-15. 9 NACD Research. “Dodd-Frank: Where Do We Stand?” March 2012, pp. 1-6. 24

Fiduciary Duties of Corporate Boards Millstein, Ira M., Gregory, Holly, Altschuler, Ashley R., and Di Guglielmo, Christine T. “Fiduciary Duties Under U.S. Law.” American Bar Association International Developments in Corporate Governance Subcommittee. March 15, 2011, pp. 1-15. 31 Bridging Board Gaps: Report of the Study Group on Corporate Boards. Columbia Business School, the Weinberg Center for Corporate Governance, with the Rockefeller Foundation, 2011. 69 “Director Liability Appendix – Relevant Cases.” Washington, DC: National Association of Corporate Directors. In binder “The Great Divide: Separating the Chairman and CEO Roles.” Directors & Boards. First Quarter 2010, pp. 21-28. In binder

“Fiduciary Duties.” NACD ExpresSource Custom Research Memo (2012). In binder Stout, Lynn A. and Elson, Charles M. “Point-Counterpoint.” NACD Directorship. April/May 2010, pp. 62-65. In binder “Director Term Limits Come Up for Review.” Directors & Boards. Second Quarter 2008, pp. 18-27. In binder

Advanced Finance: Utilizing Financial Statements to Drive Value: A Guide for Directors NACD Director’s Handbook Series: Getting Behind the Numbers. Washington, DC: National Association of Corporate Directors, 2011, pp. 9-28. 101

Intermediate Finance: Identifying Issues in Financial Statements NACD Director’s Handbook Series: Getting Behind the Numbers. Washington, DC: National Association of Corporate Directors, 2011, pp. 29-37. 121

Audit Committee: Effectiveness in the New Environment Goelzer, Daniel L. “Audit Committees and the Work of the PCAOB.” Public Company Accounting Oversight Board. Presented at the 2011 NACD Board Leadership Conference. October 2011, pp. 1-10. 130

NACD Comment Letter to Public Company Accounting Oversight Board Regarding Mandatory Audit Firm Rotation. December 14, 2011. 140

Nominating and Governance Committee: New Challenges and Opportunities in Board Composition “Leadership Experience Now Most Valuable Attribute for Directors.” NACD Directorship. December 2011, pp. 20-23. 145

“Board Diversity.” NACD ExpresSource Custom Research Memo (2012). 149

“Board Evaluations.” NACD ExpresSource Custom Research Memo (2012). 152

NACD Template for Disclosure of Director Skills and Attributes. 156

Adding Value through the Compensation Committee Ferracone, Robin A. and Martinez, Arthur C. “Taking on Pay for Performance.” NACD Directorship. October/November 2011, pp. 58-61. 160

“Letter from the Co-Chairs.” Report of the NACD Blue Ribbon Commission on Performance Metrics: Understanding the Board’s Role. Washington, DC: National Association of Corporate Directors, 2010.

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General Governance Resources Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies. Washington, DC: National Association of Corporate Directors, 2011. 166 2011 NACD Public Company Governance Survey. Washington, DC: National Association of Corporate Directors, 2011. Handout Report of the NACD Blue Ribbon Commission on Director Professionalism. Washington, DC: National Association of Corporate Directors, 2011. Handout Board Leaders’ Briefing Center. Available at: http://www.nacdonline.org/Resources/RealTimeInformation.cfm?navItemNumber=618 See link

Topic

Further Suggested Reading Norton, David. “Successful Strategy Execution—Part I: What Does it Look Like?” Balanced Scorecard Report. January/February 2012, pp. 1-5. Strategy Norton, David. “Successful Strategy Execution—Part II: What Does it Look Like?” Balanced Scorecard Report. March/April 2012, pp. 1-16. Strategy

Pentland, Alex. “The New Science of Building Great Teams.” Harvard Business Review. April 2012, pp. 1-11.

Board/C-

Suite Relations

Lafley, A.G. “The Art and Science of Finding the Right CEO.” Harvard Business Review. October 2011, pp. 1-10.

Board/C-

Suite Relations

October 2011 | practicallaw.com26

Holly J. Gregory PARTNERWEIL, GOTSHAL & MANGES LLP

Holly specializes in advising companies and boards on corporate governance matters.

Companies should begin preparing now for the 2012 proxy season to ensure they are well-positioned to engage with shareholders on key issues including potential proxy access proposals, as well as other types of shareholder proposals and campaigns targeting specific directors or board committee members in re-election efforts.

The approaching proxy season promises to be an interesting one, especially in light of the new ability of shareholders to bring proposals seeking by-law changes to allow proxy access. Under amended SEC rules, companies may no longer automatically exclude from proxy materials shareholder proposals seeking to amend company by-laws to require future inclusion of director nominees proposed by share-holders in company proxy materials (see Box, Private Ordering of Proxy Access).

This rule change will enable shareholders to seek proxy access standards, on a company-by-company basis, that are more liberal than those in the mandatory proxy access rule that was recently vacated by the US Court of Appeals for the District of Columbia. If shareholders make use of this new shareholder proposal, the 2012 proxy season could be a contentious one.

To get ready for the upcoming proxy season, companies, led by their boards and corporate governance committees, should consider: � Shareholder voting results and other important takeaways

from the 2011 proxy season. � The most likely subjects of shareholder proposals for the

2012 proxy season. � Preparatory steps to take now to identify and address

vulnerabilities and improve shareholder relations.

LESSONS FROM THE 2011 PROXY SEASONThe 2011 proxy season was less contentious than many had expected. This was due in part to shareholder focus on newly-mandated advisory votes on executive compensation and company efforts to understand and address shareholder concerns prior to the vote. The say on pay vote provided shareholders with a new opportunity to express their views on company pay practices and was associated with a decline in the number of shareholder proposals on compensation matters. In addition, companies became more proactive by increas-ing communications and engagement with shareholders on compensation issues in advance of the advisory vote.

Opinion

PREPARING FOR THE 2012 PROXY SEASONIn her regular column on corporate governance issues, Holly Gregory recommends steps that corporate governance committees should take to get ready for the upcoming proxy season.

Copyright © 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.

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Practical Law The Journal | October 2011 27

According to a recently published report by Ernst & Young, highlights from the 2011 proxy season reveal that: � Executive compensation practices received high levels of

support from shareholders in the first year of mandatory say on pay. � Shareholder opposition to director re-election (as

indicated by withhold and against votes) declined. � Company engagement with shareholders on issues of

concern to shareholders increased. � The trends of implementing greater accountability

measures at the board level and eliminating barriers to shareholder action continued. � Shareholders showed significant support for proposals

on social and environmental issues, signifying the growing value that shareholders place on these issues. Support for other corporate responsibility proposals also showed continued growth. � Proposals to appoint an independent board chair received

only average levels of support, with the number of these proposals holding relatively steady year over year, possibly indicating that shareholders believe boards should have discretion regarding the structure of board leadership. � Proposals relating to board diversity grew at a relatively

fast pace, possibly demonstrating that shareholders want more input on the makeup of the board.

(2011 Proxy Season Review: Highlights and Leading Implications, Ernst & Young, July 2011, available at ey.com.)

HOT TOPICS FOR 2012 SHAREHOLDER PROPOSALSThe 2012 proxy season is likely to be an active one for shareholder proposals relating to shareholders’ rights issues, including proposals on: � New proxy access procedures (see Box, Private Ordering

of Proxy Access). � Shareholder ability to call special meetings. � Shareholder ability to act by written consent. � Elimination of supermajority provisions to amend by-laws. � Majority voting in the election of directors.

Many of these proposals started gaining traction in the 2011 proxy season and were among the most highly supported issues.

The effort to change director election standards from plural-ity to majority voting was first the subject of a shareholder proposal in 2005, and average support has risen steadily each year. Majority voting in director elections has proven highly successful in S&P 500 companies and proponents have voiced their commitment to driving its acceptance by the next tier of companies.

In the governance area, companies should expect more share-holder proposals on disclosures relating to: � Board diversity policies. � Political contributions and lobbying (especially given

that 2012 is a presidential campaign year). � Environmental sustainability and risks. � Human rights policies and impacts.

TEN STEPS TO PREPARE FOR THE 2012 PROXY SEASONTo promote supportive and peaceful shareholder relations, companies should make early efforts to identify and address vulnerabilities, engage with shareholders and focus on director nominations and proxy disclosures.

ANALYZE 2011 SHAREHOLDER PROPOSALSThe governance committee should review the shareholder proposals that were submitted to the company for the 2011 proxy season and analyze: � How the company handled the proposals, including the

course and outcome of negotiations. � Any challenges the company made under the proxy rules. � The voting results.

The committee should also review the voting results on man-agement proposals, including the advisory say on pay vote and the advisory say on frequency vote, which may require discussion with the compensation committee. The gover-nance committee should consider whether an unusually high yet non-majority number of votes for a shareholder proposal, or significant yet non-majority opposition to a management proposal, conveys a message about shareholder dissatisfaction that requires attention.

For more information on the say on pay results from the 2011 proxy season, search Dodd-Frank Governance Reforms: Status Report on our website.

For more information on the say on pay rules, search Summary of the Dodd-Frank Act: Executive Compensation on our website.

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For more information on shareholder proposals from the 2011 proxy season, search What’s Market: Stockholder Proposals on our website.

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For a Standard Clause for the by-laws or certificate of incorporation requiring majority voting of shareholders for the election of the board of directors, with explanatory notes and drafting tips, search By-laws or Certificate of Incorporation: Majority Voting Provision on our website.

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For a Checklist of key issues that a board should consider in determining its approach to shareholder relations, search Assessing Shareholder Relations: Questions a Company Should Ask on our website.

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OPINION

The review of shareholder initiatives and voting results at the company level should also be evaluated in the context of the broader proxy season results. The governance committee should seek information on how similar proposals were re-ceived at other companies and general trends that developed during the 2011 proxy season. This will help the committee focus on issues that are likely to emerge in 2012 and determine appropriate actions to address areas where shareholders have expressed concern.

DETERMINE AREAS FOR ACTIONThe governance committee should consider whether responsive action is necessary or appropriate in light of the 2011 voting results or other aspects of shareholder initiatives, and deter-mine what that action should be. The committee should take into account all significant issues, and avoid the trap of only attending to majority vote outcomes.

For example, the governance committee should consider whether to take action regarding executive compensation based on the advisory say on pay vote outcome. In circum-stances where there is a higher than expected negative vote, the committee may advocate outreach to key shareholders to obtain better information about the range of views that the vote represents. Although these matters may be largely within the authority of the compensation committee, they also relate to the typical governance committee mandate. Therefore, the committees should consult with one another on say on pay matters. In addition, after considering the outcome of the advisory say on frequency vote, the board must determine and announce how frequently it will hold the say on pay vote.

The governance committee should also anticipate what matters might be the focus of shareholder proposals and initiatives in the coming year. In particular, it should pinpoint areas of vulnerability, such as those that have been identified by proxy advisors or shareholders as needing improvement.

SCAN THE ENVIRONMENT AND COMPARE GOVERNANCE PRACTICESThe governance committee should receive regular reports about hot topics in the shareholder community, as well as other governance developments and emerging practices. It is helpful for someone in management, often the corporate secretary or chief governance officer, to maintain relationships with key shareholder groups (such as the Council of Institutional Investors (CII) and the International Corporate Governance Network (ICGN)) and proxy advisors (such as Institutional Shareholder Services (ISS)). The committee should also get

reports comparing company governance practices to the recommendations of key investor and business groups and the practices of peer companies.

In addition, every fall, influential proxy advisor ISS engages in “policy outreach” to identify potential areas for change in ISS vote recommendations. Companies can participate in surveys and other ISS outreach activities. At a minimum, reviewing the questions that ISS asks regarding potential policy changes provides insight into how their vote recommendations may change in the coming year.

PREPARE TO ARTICULATE THE RATIONALE FOR GOVERNANCE PRACTICESAs decisions are made about governance practices and structures, the governance committee and the board should discuss and agree on, and record as appropriate, the rationale behind their decisions. Because of the heightened disclosure obligations relating to governance practices and decisions, it is critical that the committee and the board develop and articulate a common view on chief gover-nance practices (such as the structure of board leadership) adopted by the company.

IDENTIFY KEY SHAREHOLDERS AND THEIR ISSUESThe governance committee should identify the company’s top 15 to 20 shareholders and find out: � Whether they have established proxy voting guidelines. � The proxy advisors on which they may rely. � Whether they are likely to have concerns about any

of the company’s governance practices. � The types of potential activist activity in which

they may engage.

In addition to the top 15 to 20 shareholders, it is helpful for the governance committee to identify special interest shareholders who may be likely to bring a shareholder proposal. The company’s proxy solicitor, as well as its gov-ernance counsel, should be able to provide significant insight on these concerns.

The governance committee should also keep an eye on shareholder proposals that are brought at other companies, beginning in the fall. Keeping abreast of SEC no-action let-ters that address company requests to exclude shareholder proposals from the proxy, such as those that deal with the expected proxy access proposals, can provide valuable infor-mation about the issues shareholders are focused on and how the staff is addressing company no-action requests. This can help inform the company’s strategy and efforts to engage with shareholders.

For Standard Clauses for resolutions of the board of directors deciding how frequently a public company will hold a say on pay vote, with explanatory notes and drafting tips, search Board Resolutions: Determining Final Say on Pay Frequency on our website.

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Practical Law The Journal | October 2011 29

OVERSEE SHAREHOLDER COMMUNICATION AND ENGAGEMENT EFFORTSThe governance committee should consult with management about shareholder communication and engagement plans, and be prepared to actively oversee these efforts. Counsel should ensure that time is reserved on board agendas to discuss these matters.

To develop effective shareholder engagement programs and policies, the governance committee and the board should address issues such as: � The key shareholders with whom they should engage. � How their approaches should differ based on the identity

and interests of the particular shareholder. � The situations in which someone from the board should

be involved in engagement efforts. � What to do if a:

z shareholder proposal receives majority support;

z management proposal (such as say on pay) fails to achieve majority support; or

z director receives a significant withhold or no vote.

While management will likely undertake much of the share-holder engagement efforts, the governance committee should approve the approach generally and be kept up to date on progress and any stumbling blocks. The committee and the board should participate in decisions relating to shareholder proposals, shareholder campaigns to vote no or withhold votes on a particular director or set of directors and other forms of shareholder activism. In certain circumstances, the committee chair, the lead director or another board member may be asked to participate in shareholder communications. These efforts can help underscore to shareholders that the board understands its role and is actively engaged.

Management should be encouraged to begin the process early of engaging key investors in discussions about issues that

In a September 6, 2011 statement, SEC Chairman Mary L. Shapiro indicated that the voluntary stay of Rule 14a-8(i)(8) under the Exchange Act, the “private ordering” companion to the vacated mandatory proxy access rule (Rule 14a-11), would be allowed to expire (a copy of the statement is available on the SEC website at sec.gov). Effective on September 20, 2011, companies will be subject to Rule 14a-8(i)(8), which requires companies to include in their proxy materials eligible shareholder proposals seeking the adoption of proxy access procedures. Companies may still be able to raise state law grounds for exclusion. However, Section 112 of the Delaware General Corporation Law expressly allows by-laws granting shareholders access to the company’s proxy for the nomination of directors.

The SEC had voluntarily stayed Rule 14a-8(i)(8) pending the outcome of the litigation challenging its mandatory proxy access rule. Rule 14a-11 was a controversial rule which would have required all public companies, at their own expense, to include in their proxy materials director nominees proposed by certain shareholders.

The SEC’s decision neither to seek rehearing or appeal of the decision striking down mandatory proxy access nor take other action to extend the voluntary stay of Rule 14a-8(i)(8) opens the door for shareholder proposals and negotiations on proxy access on a company-by-company basis. Public and union pension funds who are proponents of proxy

access are likely to bring shareholder proposals seeking to amend by-laws to allow liberal access to the company’s proxy for future shareholder nominations of director candidates. However, due to the effective date of the amended rule, it may be too late for shareholders to bring proposals at some companies for the 2012 proxy season.

In reaction to the news that Rule 14a-8(i)(8) will soon be effective, the Council of Institutional Investors (CII), an association of public, union and private pension funds and other institutional investors (with combined assets exceeding $3 trillion), issued a statement welcoming the opportunity for shareholders to submit proxy access proposals. The statement indicated that CII members are likely to bring these proposals, in particular at companies that they view as having problematic boards:

“ Council member funds and the broader investor community are ready and willing to seek access to the proxy to nominate directors judiciously, at companies where boards have been asleep at the switch or chronically unresponsive to shareowner concerns. The Council will continue to advocate for proxy access because it is a fundamental right of shareowners to have a meaningful voice in the election of directors to public company boards. Proxy access would invigorate board elections and make boards more responsive to shareowners and more vigilant in their oversight of companies.”

(Statement of Ann Yerger, Executive Director of the Council of Institutional Investors, September 7, 2011, available at cii.org.)

PRIVATE ORDERING OF PROXY ACCESS

For more information on the court’s rejection of the SEC’s proxy access rule, search Dodd-Frank Governance Reforms: Status Report on our website.

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were raised in 2011 and issues that are expected to interest shareholders in 2012. Engagement usually takes many forms, including in-person meetings and phone calls with one or more significant or influential shareholders and group meetings or conference calls with a like-minded coalition. An important component of effective engagement is paying attention to the thoughts and interests of the particular share-holder. Topics of concern may vary widely and include: � Shareholder rights, such as proxy access and majority voting. � Governance practices, such as the structure of board

leadership, board composition and diversity. � CEO performance, compensation and succession planning. � Strategic direction and risk mitigation.

EVALUATE BOARD COMPOSITION AND DIRECTOR QUALIFICATIONSThe governance committee should assess the board’s composi-tion relative to the company’s needs and consider whether any additional experience, skill sets or viewpoints are required. It should also evaluate the board’s diversity and consider whether there are redundancies. The primary objective is to have a board comprised of directors who truly understand the com-pany’s business and can guide long-term strategy, while providing oversight and holding management accountable.

In reviewing individual director qualifications, the governance committee should consider, among other things: � How the disclosure of the director’s experiences,

attributes and skills is likely to look. � Whether the director meets the appropriate

independence standards. � Any concerns that shareholders or their proxy advisors

are likely to raise.

IDENTIFY AND ASSESS DIRECTOR CANDIDATESThe governance committee should identify who it plans to recommend for re-nomination. At most companies, directors are elected annually. The committee should avoid letting the re-nomination decision become rote by specifically re- evaluating the director’s: � Performance. � Qualifications. � Added value.

The governance committee should also determine whether the board needs new director candidates and, if so, what attributes should be sought. If necessary, a search firm should be employed to assist with finding these candidates. The committee should also review any suggestions from shareholders, directors and other relevant sources. Where appropriate, names of potential candidates should be provided to the search firm for further vetting.

In addition, the committee should review disclosures and assess whether they adequately communicate the individual director’s qualifications and provide the appropriate composite view of the board.

REVIEW GOVERNANCE DOCUMENTSCompanies should review their by-laws, shareholder meet-ing procedures, corporate governance guidelines, committee charters and other board policies to ensure that they: � Are up to date. � Address areas of shareholder concern. � Reflect best governance practices appropriate

for the company.

RESERVE TIME FOR PROXY REVIEW AND PLAN FOR THE ANNUAL MEETINGThe board and governance committee calendar should provide appropriate meeting time for discussions and deliberations related to the annual meeting and filing of the proxy statement. The board and committee should ensure there is adequate time to review the proxy statement and may wish to engage manage-ment in discussions about how to make the proxy statement a more effective communication tool. For example, they should consider whether the proxy statement is readable and readily conveys the main points in which shareholders (and their proxy advisors) are most interested.

Further, to emphasize the important points from the board’s perspective, as well as communicate the board’s commitment to shareholders, they should consider: � Modifying headings in the proxy statement to reflect

key issues. � Providing a summary at the outset of the proxy statement. � Including a letter from the board.

The views stated above are solely attributable to Ms. Gregory and do not reflect the views of Weil, Gotshal & Manges LLP or its clients.

For more information on the preparation and filing of proxy statements, search Proxy Statements on our website.

For a sample timetable presenting the events that take place before and immediately after a public company’s annual meeting, search Timetable for the Annual Meeting on our website.

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OPINION

For more information on issues that a company should consider in evaluating its governance practices, search Corporate Governance Practices: Commentary on our website.

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For information on director independence standards set by the SEC, NYSE and NASDAQ, search Director Independence Standards on our website.

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November 22, 2011

Weil, Gotshal & Manges LLP

On November 17, 2011, Institutional Shareholder Services Inc. (ISS) issued updates to its proxy voting policies applicable to shareholder meetings held on or after February 1, 2012. This Alert summarizes and discusses implications of those updates for US companies. The ISS proxy voting guidelines and the updates are available at http://www.issgovernance.com/policy.

ISS is generally considered the most influential proxy advisor in the US. Recent studies have found that ISS is able to influence shareholder votes by 6% to 20%.1 In preparing for 2012 annual meetings, corporate counsel, corporate secretaries, and directors (particularly those serving on compensation or nominating and governance committees) should review the ISS policy updates and consider how the changes may affect ISS’ evaluation of director re-elections, executive compensation matters, and other matters for shareholder vote. Note that for the 2012 proxy season, ISS has identified over 50 circumstances that may support a negative vote recommendation (either “against” or “withhold”) in uncontested director elections. A summary of these circumstances is included in Appendix A.

Summary of Key Changes for the 2012 Proxy Season

1. Revised Policy on Pay-for-Performance Evaluation Under a revised policy, ISS has refined its methodology for determining pay-for-performance alignment.

Discussion: Previously, if a company in the Russell 3000 index fell in the bottom half of its GICS industry group in total shareholder return over both a one-year and three-year period, and CEO pay was not aligned with shareholder performance over time (with special emphasis on the immediately preceding year), ISS would recommend a negative say-on-pay vote.

Under the revised policy, ISS will select a narrower peer group of 12 to 24 companies, using as guidelines market cap, revenues (or assets for financial firms), and GICS industry group. Additional guidance on the new approaches for selecting companies for peer groups will be provided in December.

Required Reading: ISS Issues Policy Updates for 2012 Proxy Season

Focuses on Pay-for-Performance and Board Response to Say-on-Pay

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SEC Disclosure and Corporate Governance

Weil, Gotshal & Manges LLP 2

ISS will now focus on: (i) the relative alignment between CEO pay and company TSR within the peer group for a one- and three-year period (with a 40% emphasis on the one-year period and a 60% emphasis on the three-year period); (ii) the multiple of CEO pay relative to the peer group median, and (iii) the absolute alignment between CEO pay and company TSR over a five-year period. The system for evaluating differences in rates of change to identify weak or strong alignment will be provided in additional guidance to be issued in December.

Where the alignment is perceived to be weak, ISS will consider how a number of qualitative factors affect alignment of pay with shareholder interests, including:

The ratio of performance- to time-based equity awards;

The ratio of performance-based compensation to overall compensation;

The completeness of disclosure and rigor of performance goals;

The company’s peer group benchmarking practices;

Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;

Special circumstances related to, for example, a new CEO in the prior fiscal year or anomalous equity grant practices (e.g., biennial awards); and

Any other factors deemed relevant.

Implications: Companies should study the additional guidance that ISS plans to issue in December and assess how their alignment of compensation and performance is likely to be assessed under ISS’ new methodology. Companies should take special care to focus their CD&As on the alignment between compensation and performance, and explain any anomalies.

2. Revised Policy on Board Response to Say-On-Pay Vote Under a revised policy, ISS will recommend votes on compensation committee members and the current year say-on-pay proposal on a case-by-case basis where, in the previous year, the company’s say-on-pay proposal received the support of less than 70% of the votes cast.

Discussion: Previously, ISS would recommend a negative vote for compensation committee members “in egregious situations” or when the board “failed to respond to concerns raised in prior [management say-on-pay] evaluations.” When evaluating ballot items related to executive pay, ISS considered the board’s responsiveness to investor input and engagement on compensation issues (for example, failure to respond to majority-supported shareholder proposals on executive pay topics, or concerns raised in connection with significant opposition to prior year’s say-on-pay vote) on a case-by-case basis.

Under the revised policy, ISS’ case-by-case analysis will take into account: (i) the company’s response to the concerns expressed by shareholders in the previous year, including disclosed engagement efforts with major institutional investors and specific actions taken to address the issues that led to the “low” level of support, as well as other recent compensation actions taken by the company; (ii) whether the issues raised are recurring or isolated; (iii) the company’s ownership

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structure (for example, significant insider ownership); and (iv) whether the support level was less than 50%, which ISS notes will “warrant the highest degree of responsiveness.”

ISS has indicated that the new policy does not establish a bright line test, and that it may apply its case-by-case analysis to companies where the say-on-pay proposal received the support of more than 70% of the votes cast, including companies with significant insider ownership.

Implications: Companies whose say-on-pay proposal received a significant percentage of negative votes (even if the proposal was approved by more than 70% of the votes cast) should conduct outreach with their large institutional shareholders to discuss compensation concerns that contributed to negative votes and discuss what actions the board has taken, plans to take, or is considering in order to address these concerns (within the confines of Regulation FD). ISS notes that “these specific actions should ideally be new rather than a reiteration of existing practices.” In the CD&A, companies should consider disclosing efforts to engage with shareholders and consider their viewpoints (for example, the percentage of shareholders contacted). There may be instances where the board, after considering all relevant facts and circumstances with due care – including the shareholder say-on-pay vote – may decide that no change is appropriate. Where this is the case, the basis for this conclusion should be presented in the CD&A.

Note that shareholder outreach efforts on compensation concerns may be useful in avoiding a shareholder derivative lawsuit alleging that directors breached their fiduciary duties in connection with a failed say-on-pay vote.

3. New Policy on Board Response to Say-on-Pay Frequency Vote Under a new policy, ISS will recommend that shareholders vote against or withhold votes from all incumbent directors if the board implements a say-on-pay vote on a less frequent basis than the frequency that received a majority of the votes cast. When no frequency received a majority, ISS will apply a case-by-case analysis if a particular frequency received a plurality of the votes cast and the board implements a say-on-pay vote less frequently.

Discussion: Last year, US corporate issuers were required to afford shareholders an advisory vote on the frequency with which the say-on-pay vote should be held, and will have to revisit say-on-pay frequency at least once every six years thereafter. Under a policy issued last year, ISS recommended voting for annual say-on-pay votes, rather than biennial or triennial say-on-pay votes. It appears that many large companies are opting for an annual say-on-pay vote.

Where a frequency option received a majority of votes cast and the board implements a less frequent say-on-pay vote, ISS will recommend that shareholders vote against or withhold votes from the entire board (except new nominees, who will be considered on a case-by-case basis). In a situation where no frequency received a majority of votes cast in support, and the board implements a less frequent say-on-pay vote than the frequency that received plurality support, ISS will take a case-by-case approach and consider additional factors in determining its recommendations, including the board’s rationale, the company’s ownership structure and vote results, any compensation concerns or history of problematic compensation practices, and the say-on-pay support level from the prior year.

Although ISS’ rationale for the new policy states that “[m]ajority support for a particular frequency should be viewed as a mandate to the board,” ISS will not issue negative vote recommendations

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where even though the shareholder’s “mandate” is for a frequency other than annual voting, the board implements a more frequent say-on-pay vote.

Implications: Companies that have disclosed they plan to implement a less frequent say-on-pay vote than the frequency option preferred by their shareholders should consider outreach efforts aimed at explaining why a less frequent say-on-pay vote is best for their circumstances. Some such companies may wish to revisit whether to implement the shareholder-preferred say-on-pay frequency.

4. Revised Policy on Incentive Bonus Plans and Tax Deductibility Proposals (Post-IPO Companies)

This year, ISS will apply a more rigorous analysis for the initial approval of equity plans under Section 162(m) of the Internal Revenue Code.

Discussion: Generally, ISS has recommended that shareholders support equity plan proposals solely for compliance with Section 162(m) of the Internal Revenue Code, due to the favorable tax deduction companies may take on performance-based compensation paid to named executive officers. Under the revised policy, ISS will evaluate, on a case-by-case basis, equity plans that are to be voted on for the first time following an IPO even if only for the purpose of obtaining favorable Section 162(m) treatment. ISS will perform a full analysis, taking into consideration total shareholder value transfer, burn rate (if applicable), repricing, and liberal change in control. If appropriate, ISS may also consider other factors such as pay-for-performance or problematic pay practices (such as perquisites). (See Appendix A, p. A-4, for a list of potentially problematic pay practices.)

ISS’ rationale for the policy update explains that the revised policy aligns with the recently proposed Treasury rule related to Section 162(m). The proposed rule would require newly public companies to obtain shareholder approval before awarding certain performance-based restricted stock units to named executive officers before the end of the standard post-IPO transition period to qualify as performance-based compensation.

Implications: Newly public companies seeking initial shareholder approval of an equity plan for Section 162(m) purposes should expect ISS to perform a full analysis and should not consider a favorable ISS recommendation to be a foregone conclusion. Companies should consider this policy change in both plan design and pay practices.

5. Revised Policy on Proxy Access ISS’ revised policy expands and refines the factors it will consider in determining recommendations on proxy access proposals, and broadens the policy to apply to management proposals as well as shareholder proposals.

Discussion: Until now it had been ISS’ policy to recommend that shareholders vote case-by-case on shareholder proposals asking for proxy access, taking into account (i) the ownership threshold proposed in the resolution, and (ii) the proponent’s rationale for the proposal at the targeted company in terms of board and director conduct.

On September 20, 2011, the SEC’s amendment to Rule 14a-8 took effect,2 providing that companies may no longer automatically exclude from proxy materials shareholder proposals seeking to amend

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company by-laws to require future inclusion of shareholder-proposed director nominees in company proxy materials on the ground that such proposals relate to director elections. Of course, companies may seek no action relief for exclusion of such proposals on other grounds pursuant to Rule 14a-8, and some companies may decide to pre-empt shareholder action through management proposals on proxy access.

ISS’ revised policy will apply a case-by-case approach to recommendations on proxy access proposals, taking into account a range of company-specific and proposal-specific factors, including: (i) the ownership thresholds proposed in the resolution, (ii) the maximum proportion of directors that shareholders may nominate, and (iii) the method of determining which nominations should appear on the ballot if multiple shareholders submit nominations. Because ISS supports proxy access in principle, the revised policy de-emphasizes the proponent’s rationale for the proposal. ISS has indicated that its company-specific review will focus on the company’s size and shareholder demographics, rather than the company’s corporate governance profile and practices. ISS has also indicated that its analysis of the appropriateness of the core features of proxy access proposals will be more exacting in the case of binding bylaw amendments than for precatory requests for board actions, since precatory requests permit boards an opportunity to review and revise the proposed procedures and thresholds for proxy access prior to adopting a policy.

ISS’ revised policy does not include any guidance on specific terms in a proxy access proposal that it considers to be favorable or unfavorable, noting that “the access debate is fluid and likely to gain more attention in 2012.” ISS’ executive summary of the updates, however, indicates that “[i]n January 2012, as part of [its] policy update process, ISS expects to provide additional guidance (via FAQs and/or through other reports) based on an examination of the specific proposal texts.”

Implications: It remains to be seen how frequently proxy access shareholder proposals will be brought, whether they will be structured as precatory requests for board action or as binding bylaw amendments, and the range of ownership thresholds proposed in the resolutions (i.e., percentage and duration). Companies should closely monitor proxy access shareholder proposals, as well as corresponding ISS recommendations and shareholder support. As of November 15, 2011, two precatory shareholder proposals seeking proxy access had been filed by Ken Steiner, an individual shareholder involved with the U.S. Proxy Exchange (USPX), a coalition of individual retail shareholders. The proposals, submitted to Textron Inc. and MEMC Electronic Materials, Inc., were the first 2012 access proposals to be publicly disclosed. The Steiner proposals (which are substantially identical) provide a lower threshold of stock ownership for shareholder nomination of directors than that contemplated by the SEC’s vacated Rule 14a-11, which required ownership of 3% of a company’s outstanding shares for a period of three years in order to nominate one or more director (with a 25% cap). The Steiner proposals recommend that the company’s proxy include nominees of “any party of one or more shareholders that held continuously, for two years, 1% of the Company’s securities eligible to vote for the election of directors” or any party of 100 or more shareholders that satisfy SEC Rule’s 14a-8(b) eligibility requirements ($2000, or 1% of a company’s securities eligible to vote, continuously held for at least one year). Companies and boards should follow these developments closely.

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6. Revised Policy on Risk Oversight and Director Elections ISS has expanded the factors it will consider in recommending that shareholders vote against or withhold votes from individual directors, committee members or the entire board, to specifically include material failures of risk oversight.

Discussion: Previously, ISS would recommend, “[u]nder extraordinary circumstances,” a negative vote for individual directors, committee members or the entire board due to “material failures” of “governance, stewardship or fiduciary responsibilities at the company.” Although it would be reasonable to assume that the prior policy would capture material failures of risk oversight, ISS has revised the policy to add an explicit reference to risk oversight to highlight “the significance of risk oversight within the broader concept of directors’ fiduciary responsibilities.” ISS specifies that this addition is not intended to “penalize boards for taking prudent business risks or for exhibiting reasonable risk appetite, but is instead intended to address situations where there has been a material failure in a board’s role in overseeing the company’s risk management practices.”

Implications: Companies that have experienced circumstances that could give rise to a perception of a material failure of governance, stewardship, risk oversight, or fiduciary responsibilities should be prepared to explain such circumstances in both disclosure materials and through outreach to their large institutional shareholders.

7. Revised Policy on Dual-Class Structure ISS will recommend that shareholders generally vote against proposals to create a new class of common stock, regardless of voting rights, unless there is a compelling rationale for the dual-class capital structure.

Discussion: Until now it has been ISS’ policy to recommend that shareholders vote: (i) against proposals to create a new class of common stock with superior voting rights, and (ii) for proposals to create a new class of nonvoting or subvoting common stock if it is intended for financial purposes with minimal dilution to current shareholders and it is not designed to preserve the voting power of an insider or significant shareholder.

The revised policy applies to proposals to create a dual-class capital structure regardless of voting rights, and adds the issuer’s rationale, economic condition, and the expected duration of the new class as new factors it will consider. Pursuant to the revised policy, ISS will evaluate proposals to create a new class of common stock on a case-by-case basis taking into account whether:

The company discloses a compelling rationale for the dual-class capital structure, such as:

The company’s auditor has concluded that there is substantial doubt about the company’s ability to continue as a going concern; or

The new class of shares will be transitory; The new class is intended for financing purposes with minimal or no dilution to current

shareholders in both the short term and long term; and

The new class is not designed to preserve or increase the voting power of an insider or significant shareholder.

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Implications: ISS will support the creation of a dual-class capital structure only in the most compelling of circumstances -- generally occurring when a company is on the brink of liquidation or dissolution. Companies that are planning to implement a dual-class structure should be prepared to explain their compelling need to do so in both disclosure materials and through outreach to their large institutional shareholders.

8. Revised Policy on Exclusive Venue Proposals ISS’ policy to vote against exclusive venue proposals unless the company has in place certain good governance features has been revised to consider such proposals on a case-by-case basis, taking into account a refined list of governance features, as well as the company’s litigation history.

Discussion: In recent years, in response to concerns about “forum shopping” by plaintiffs’ lawyers in shareholder litigation, some companies have sought through bylaw amendments to adopt requirements that shareholder suits be brought in a competent court in the state of incorporation (usually Delaware). ISS will now evaluate such proposals on a case-by-case basis taking into account:

Whether the company has been materially harmed by shareholder litigation outside its jurisdiction of incorporation, based on disclosure in the company’s proxy statement; and

Whether the company has the following “good governance” features:

An annually elected board; A majority vote standard in uncontested director elections; and The absence of a poison pill, unless the pill was approved by shareholders.

ISS updated its policy to reflect the results from its 2011-2012 Policy Survey and a recent policy roundtable discussion with seven institutional investors, which indicated that there was no uniform approach when voting on exclusive venue management proposals, and that large institutional investors would be likely to evaluate factors other than governance, including the company’s litigation history. ISS removed the examination of the company’s special meeting right from the policy, as it believes that this governance feature is less relevant to exclusive venue than it is to other proposals (such as those seeking to provide shareholders with the right to act by written consent).

Implications: Companies that are considering adopting exclusive venue provisions should consider whether they meet the criteria for ISS support and, if not, be prepared to expend extra effort to engage with their large institutional shareholders on this issue.

9. Revised Policy on Political Spending ISS has shifted its policy with respect to shareholder proposals requesting greater disclosure of a company’s political contributions from a case-by-case approach to generally supporting such proposals.

Discussion: Until now, ISS considered proposals requiring disclosure of political contributions and related spending on a case-by-case basis. This issue is receiving attention from the Center for Political Accountability, which has ranked the quality of disclosure of some of the largest S&P 500 companies based on their website disclosure. Pursuant to its revised policy, ISS will now

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recommend that shareholders generally vote in favor of proposals seeking enhanced disclosure of political spending. The revised policy also adds disclosure of the company’s oversight mechanisms related to its political contributions and related spending to the list of factors it considers when evaluating such proposals.

Implications: Given the 2012 presidential election and the US Supreme Court’s January 2010 decision invalidating restrictions on certain corporate political expenditures (Citizens United v. Federal Election Commission), companies should expect shareholder calls for improved transparency and board oversight of corporate political spending to intensify, resulting in an increase of related proposals. Companies should consider whether they have appropriate mechanisms in place for board oversight of political spending and should consider whether to voluntarily enhance disclosure both as to oversight processes and the focus of political spending. As in other areas of potential heightened shareholder activity, companies should be prepared to reach out to their large institutional shareholders to communicate about their approaches to these issues.

10. Revised Policy on Lobbying Activities ISS has clarified the scope of its existing case-by-case approach with respect to proposals requesting information on a company’s lobbying activities.

Discussion: ISS’ revised policy has been amended to broaden its application to proposals seeking information on the company’s lobbying activities generally (including direct lobbying as well as grassroots lobbying activities) and not only to those seeking information on its initiatives. The revised policy also clarifies that it applies to broader efforts to inform or sway public opinion as well as formalized, political lobbying activities.

Implications: Companies should expect to see an increase in proposals relating to corporate political spending and lobbying in the 2012 proxy season, and should consider the activities outlined above in Item 9.

11. New Policy on Hydraulic Fracturing ISS has adopted a policy generally supporting proposals requesting greater disclosure relating to a company’s hydraulic fracturing operations.

Discussion: Hydraulic fracturing, also known as fracking, is a natural gas extraction technique that involves the high-pressure injection of water, sand, and chemicals into a gas-bearing shale rock formation. The pressure creates or exposes fissures, which then are kept open by the sand that remains after the water and chemicals are removed, allowing the formerly inaccessible natural gas to flow to the well for extraction. Fracking has attracted public attention and shareholder proposals due to concerns about its effect on the environment.

The new policy recommends that shareholders generally vote for proposals requiring disclosure of natural gas hydraulic fracturing activities, including measures the company has taken to manage and mitigate the potential community and environmental impacts of those operations. Factors to be considered in forming specific recommendations will focus on: (i) the company’s current level of disclosure of relevant policies and oversight mechanisms; (ii) the current level of such disclosure

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relative to its industry peers; (iii) potential relevant local, state, or national regulatory developments; and (iv) controversies, fines, or litigation related to the company’s hydraulic fracturing operations.

Implications: Companies that engage in hydraulic fracturing activities should assess their current level of disclosure of relevant policies and oversight mechanisms against ISS’ policy and determine whether such disclosure should be enhanced and whether shareholder engagement efforts should be considered.

What You Should Do Now ISS typically provides companies that are in the S&P 500 with prior warning if it intends to issue a negative vote recommendation. Companies then have a very narrow time window (48 hours) in which to engage with ISS on the issue. Companies that are not in the S&P 500 generally do not receive such prior warning. We encourage all companies to become familiar with the circumstances in which ISS may recommended a negative vote regarding director re-election (set forth in Appendix A), or on other proposals that may be included in their proxy statement. Companies may also wish to contact their analyst at ISS in anticipation of or shortly after proxy statement filing to talk through any issues that could cause ISS to issue a negative vote recommendation. In March 2011, ISS issued revised guidelines with respect to engaging with ISS on proxy voting matters, which are available at http://www.issgovernance.com/policy/EngagingWithISS. Note that at the November 18, 2011 meeting of the American Bar Association’s Business Law Section, the Chief of the SEC Division of Corporation Finance’s Office of Mergers and Acquisitions, Michele Anderson, stated that any written materials that companies provide to ISS in connection with such discussions (e.g., powerpoint presentations, memos, data, etc.) must be filed as proxy soliciting materials on the date of first use.

* * *

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If you have any questions on these matters, please do not hesitate to speak to your regular contact at Weil, Gotshal & Manges LLP or to any member of the Firm’s Public Company Advisory Group:

Howard B. Dicker [email protected] 212-310-8858

Catherine T. Dixon [email protected] 202-682-7147

Holly J. Gregory [email protected] 212-310-8038

P.J. Himelfarb [email protected] 202-682-7197

Robert L. Messineo [email protected] 212-310-8835

Ellen J. Odoner [email protected] 212-310-8438

Audrey Susanin, an associate in Weil’s Public Company Advisory Group, assisted in the preparation of this Alert. Reid Powell, a Weil paralegal, assisted in the preparation of the attached Appendix.

1 Stephen Choi, Jill Fisch & Marcel Kahan, The Power of Proxy Advisors: Myth or Reality?, 59 Emory L.J. 869, 886-887 (2010); Jie Cai, Jacqueline L. Garner & Ralph A. Walkling, Electing Directors, 64 J. Fin. 2389, 2404 (2009).

2 On September 15, 2011, the SEC issued a notice of the September 20, 2011 effective date of the amendment to Rule 14a-8, and certain related amendments, once the stay it had previously imposed expired by its terms in the wake of the agency’s decision not to appeal a decision by the D.C. Circuit Court striking down the SEC’s mandatory proxy access rules, Rule 14a-11. (See SEC Rel. No. 33-9259, available at http://www.sec.gov/rules/final/2011/33-9259.pdf, and our earlier Alert, “Proxy Access Update: SEC Decides Not to Appeal But Companies May Receive Shareholder Proposals for 2012 Proxy Season,” available at http://www.weil.com/news/pubdetail.aspx?pub=10450.)

______________________________________________________________________________________

©2011 Weil, Gotshal & Manges LLP, 767 Fifth Avenue, New York, NY 10153, (212) 310-8000, http://www.weil.com ©2011. All rights reserved. Quotation with attribution is permitted. This publication provides general information and should not be used or taken as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. The views expressed in this publication reflect those of the authors and not necessarily the views of Weil, Gotshal & Manges LLP. If you would like to add a colleague to our mailing list or if you need to change or remove your name from our mailing list, please log on to http://www.weil.com/weil/subscribe.html or email [email protected].

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November 22, 2011


Appendix A

Circumstances in Which ISS Will Make a Negative Vote Recommendation in Uncontested Director Elections in 2012 According to ISS proxy voting policies applicable to shareholder meetings held on or after February 1, 2012, ISS has identified over 50 circumstances that may support a negative vote recommendation. Those circumstances are outlined herein. Changes from ISS’ 2011 policies are noted in italics.

Individual Directors ISS will recommend a negative vote (“against” or “withhold”) for an individual director who:

Attends less than 75% of board and committee meetings (or missed more than one meeting, if the director’s total service was three or fewer meetings) unless due to medical issues or family emergencies, and the reason for such absence is disclosed in the proxy statement or other SEC filing

Sits on more than six public company boards Is CEO of a public company and sits on boards of more than three public companies in total

(the negative vote recommendation will apply only to elections for the outside boards) Is responsible for a material failure of governance, stewardship, risk oversight, or fiduciary

responsibilities at the company Has engaged in egregious actions related to service on other boards that raise substantial doubt

about the director’s ability to effectively oversee management and serve the best interests of shareholders at any company

Is an inside or affiliated outside director that serves on the audit, compensation, or nominating committee

ISS may recommend a negative vote for a director who is the company’s CEO if the company has problematic pay practices (see below).

Entire Board ISS will recommend a negative vote (“against” or “withhold”) for all directors (except for new nominees, who will be considered on a “case-by-case” basis) if:

The company’s proxy statement indicates that one or more directors failed to attend 75% of board and committee meetings but the names of the directors involved are not disclosed

The board failed to act on a shareholder proposal that received approval by a majority of shares outstanding the previous year (a management proposal related to the subject matter of the prior shareholder proposal with other than a “for” recommendation by management will be considered a failure to act)

The board failed to act on a shareholder proposal that received approval by a majority of votes cast in the last year and one of the two previous years (a management proposal related to the subject matter of the prior shareholder proposal with other than a “for” recommendation by management will be considered a failure to act)

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Weil, Gotshal & Manges LLP A-2

The board failed to act on takeover offers where a majority of shareholders tendered their shares

At the previous board election, any director received more than 50% negative votes of the votes cast and the company failed to address the underlying issue(s) that caused the high negative votes

The board is classified and a continuing director responsible for a problematic governance issue at the board/committee level that would warrant a negative vote recommendation is not up for election (ISS may hold any or all appropriate nominees, except new nominees, accountable)

The board lacks accountability and oversight, coupled with sustained poor performance relative to peers measured by one-year and three-year total shareholder returns in the bottom half of a Russell 3000 company’s four-digit Global Industry Classification Group (ISS will consider “problematic” governance provisions including a classified board structure, a supermajority vote requirement, a majority vote standard for director elections with no carve-out for contested elections, inability of shareholders to call special meetings or act by written consent, a dual-class structure, a non-shareholder approved poison pill, and will also assess the CEO’s pay relative to the company’s total shareholder returns over a time horizon of at least five years)

There have been material failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company

The board failed to replace management (as appropriate) The company has problematic pay practices (see below) The board implemented an advisory vote on executive compensation on a less frequent basis

than the frequency that received the majority of votes cast at the most recent shareholder meeting at which shareholders voted on the say-on-pay frequency

On a “case-by-case” basis: when no frequency received a majority and the board implements an advisory vote on executive compensation on a less frequent basis than the frequency that received a plurality of the votes cast at the most recent shareholder meeting at which shareholders voted on the say-on-pay frequency, taking into account:

The board’s rationale for selecting a frequency that is different from the frequency that received a plurality

The company’s ownership structure and vote results ISS’ analysis of whether there are compensation concerns or a history of problematic

compensation practices The previous year’s support level on the company’s say-on-pay proposal

A poison pill has a dead-hand or modified dead-hand feature, in which case a negative vote recommendation will be made every year until the feature is removed

The board adopts a poison pill with a term of more than 12 months or renews any existing pill including a pill with a term of 12 months or less without shareholder approval (a commitment or policy that puts a newly adopted pill to a binding shareholder vote may potentially offset a negative vote recommendation)

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The company maintains a poison pill that was not approved by shareholders (ISS will review annually for companies with classified boards and at least once every three years for companies with declassified boards)

The board makes a “material adverse change” to an existing poison pill without shareholder approval

On a “case-by-case” basis: the board adopts a poison pill with a term of 12 months or less without shareholder approval, taking into account the following factors:

The date of the pill’s adoption relative to the date of the next meeting of shareholders (whether the company had time to put the pill on the ballot for shareholder ratification given the circumstances)

The company’s rationale The company’s governance structure and practices The company’s track record of accountability to shareholders

On a “case-by-case” basis: poor accounting practices rising to a level of serious concern (such as fraud, misapplication of GAAP, and material weaknesses identified in Section 404 disclosures) are identified, taking into consideration the severity, breadth, chronological sequence, duration, and the company’s efforts at remediation or corrective actions

All Inside Directors and Affiliated Outside Directors ISS will apparently recommend a negative vote (“against” or “withhold”) for all inside directors and affiliated outside directors when:

The company lacks an audit, compensation, or nominating committee so that the full board functions as that committee

The company lacks a formal nominating committee (even if the board attests that independent directors fulfill the functions of such a committee)

The full board is less than majority independent

Audit Committee Members ISS will recommend a negative vote (“against or withhold”) for audit committee members if:

Non-audit fees paid to the auditor are excessive (e.g., non-audit fees are greater than audit fees plus audit-related fees plus tax compliance/preparation fees)

The company receives an adverse opinion on its financial statements from its auditor There is persuasive evidence that the audit committee entered into an inappropriate

indemnification agreement with its auditor that limits the ability of the company or its shareholders to pursue legitimate legal recourse against the audit firm

ISS will consider a negative vote for audit committee members on a “case-by-case” basis if poor accounting practices, which rise to a level of serious concern (such as fraud, misapplication of GAAP, and material weaknesses identified in Section 404 disclosures) are identified, taking into consideration the severity, breadth, chronological sequence, duration, and the company’s efforts at remediation or corrective actions.

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Compensation Committee Members ISS will recommend a negative vote (“against” or “withhold”) for compensation committee members (and potentially the full board) if:

There is a negative correlation between CEO pay and company performance -- particularly for companies that have underperformed their peers over a sustained period

The company fails to submit one-time transfers of stock options to a shareholder vote The company fails to fulfill terms of a burn rate commitment made to shareholders The company has “problematic pay practices.” ISS’ policy regarding problematic pay practices

relates to its vote recommendations on re-election of compensation committee members as well as its recommendations on management say-on-pay proposals and equity incentive plans. Pay practices deemed “most egregious” that by themselves may result in negative vote recommendations include:

Repricing or replacing of underwater stock options/SARS without prior shareholder approval (including cash buyouts and voluntary surrender of underwater options)

Excessive perquisites or tax gross-ups, including any gross-up related to a secular trust or restricted stock vesting

New or extended agreements that provide for: change in control payments exceeding three times base salary plus bonus change in control severance payments without involuntary job loss or substantial

diminution of duties (“single” or “modified single” triggers) change in control payments with excise tax gross-ups (including “modified” gross-ups)

Pay elements that are not directly based on performance are generally considered on a “case-by-case” basis considering the context of the company’s overall pay program and demonstrated pay-for-performance philosophy. Specific pay practices that ISS has identified as “potentially problematic” with potential for a negative vote recommendation include:

Egregious employment contracts (contracts containing multi-year guarantees for salary increases, non-performance based bonuses, and equity compensation)

New CEO with an overly generous new-hire package (excessive “make whole” provisions without sufficient rationale or any problematic pay practices)

Abnormally large bonus payouts without justifiable performance linkage or proper disclosure (includes performance metrics that are changed, canceled, or replaced during the performance period without adequate explanation of the action and the link to performance)

Egregious pension/supplemental executive retirement plan payouts (inclusion of additional years of service not worked that result in significant benefits provided in new arrangements or inclusion of performance-based equity awards in the pension calculation)

Dividends or dividend equivalents paid on unvested performance shares or units Executives using company stock in hedging activities, such as “cashless” collars, forward sales,

equity swaps, or other similar arrangements

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Excessive severance and/or change in control provisions (payments upon an executive’s termination in connection with performance failure or a liberal “change in control” definition in individual contracts or equity plans which could result in payments to executives without an actual change in control occurring)

Reimbursement of income taxes on certain executive perquisites or other payments (e.g., personal use of corporate aircraft, executive life insurance, bonus, etc; see also excise tax gross-ups above)

Overly generous perquisites, including personal use of corporate aircraft, personal security systems maintenance and/or installation, car allowances, executive life insurance

Internal pay disparity (excessive differential between CEO total pay and that of next highest-paid named executive officer)

Voluntary surrender of underwater options by executive officers (may be viewed as an indirect option repricing/exchange program especially if those cancelled options are returned to the equity plan, as they can be regranted to executive officers at a lower exercise price, and/or the executives subsequently receive unscheduled grants in the future)

Other pay practices deemed problematic but not covered in any of the above categories ISS will consider negative vote recommendations against compensation committee members on a “case-by-case” basis if the company’s previous say-on-pay proposal received the support of less than 70 percent of votes cast, taking into account:

The company’s response, including: Disclosure of engagement efforts with major institutional investors regarding the issues that

contributed to the low level of support Specific actions taken to address the issues that contributed to the low level of support Other recent compensation actions taken by the company

Whether the issues raised are recurring or isolated The company’s ownership structure Whether the support level was less than 50 percent, which would warrant the highest degree of

responsiveness ISS will also assess company policies and practices related to compensation that could incentivize excessive risk-taking, for example:

Guaranteed bonuses A single performance metric used for short- and long-term plans Lucrative severance packages High pay opportunities relative to industry peers Disproportionate supplemental pensions Mega annual equity grants that provide unlimited upside with no downside risk

Factors that potentially mitigate the impact of risky incentives include rigorous clawback provisions and robust stock ownership/holding guidelines.

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March 2012

Dodd-Frank: Where Do We Stand?Top 12 At A Glance

By NACD Research

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National Association of Corporate Directors 1

It hAS BeeN exACtly tWo yeARS since the Dodd-Frank Wall Street Reform and Consumer Protection Act was first released out of committee by Sen. Christopher Dodd (D-CT). The rest—introduction to the House by Rep. Barney Frank (D-MA), passage by both chambers and signing into law by President Obama—is history. Or is it? Many provisions of the bill are still pending. In fact, according to one recent count, as of March 1, of the law’s 400 total rulemaking requirements, only 99 (24.75%) have resulted in final rules, 154 (38.5%) are still pending as proposed rules and 147 (36.75%) have not yet been proposed. The governance provisions in the law have followed this general pattern1. Here is a status report on a dozen important rules implementing Dodd-Frank provisions—including commentary previously published in NACD Directorship’s Washington Update column.2

title I: Financial StabilityMandating risk committees for some financial institutions Under Dodd-Frank, the Board of Governors of the Federal Reserve System requires certain financial institutions to establish a risk committee. The provision applies to any publicly traded non-bank financial company supervised by the Board of Governors and to any publicly traded bank-holding company with consolidated assets of $10 billion or more. The board-level risk committee must be responsible for the oversight of the enterprise-wide risk management practices of the company, include the number of independent directors the Board of Governors recommends (based on the nature of operations, size of assets and other appropriate criteria related to the company), and include at least one risk management expert with experience in “identifying, assessing and managing risk exposures of large, complex firms.”

Fed Proposed Rule Jan. 5, 2012; Comments Due March 31, 2012.3

Next StepS If you serve on the board of a financial institution, find a good risk committee charter and adapt it for your use. Take advantage of the work and documents of existing risk committees in successful institutions. Also, make sure the full board continues to oversee risk. This topic is too critical to delegate entirely to a single board committee. Audit committees should continue their active oversight of financial reporting risk. Compensation committees of public companies need to monitor the risks posed by compensation—a required disclosure since February 2010, before Dodd-Frank.4 Nominating/governance committees can ensure that board composition is matched up against not only strategic opportunities but also risks. A risk committee can collate all these risks into one picture for the board.

title II: orderly liquidation AuthorityBank D&O pay clawbacks Under Title II of Dodd-Frank, the Federal Deposit Insurance Corporation (FDIC) has the power to act as the receiver for insolvent financial companies, including publicly held bank-holding companies and non-bank financial companies—a broad term that could conceivably cover any financial firm. In Section 201, the law states that the FDIC may recover “compensation” from “any current or former senior executive or director substantially responsible for the failed condition of the covered company.” The final rule says that a senior executive or director shall be deemed to be substantially responsible for the failed condition of a covered financial company that is placed into receivership under the orderly liquidation authority of the Dodd-Frank Act if he or she:

(1) “Failed to conduct his or her responsibilities with the degree of skill and care an ordinarily prudent person in a like position would exercise under similar circumstances,” and

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Dodd-Frank: Where Do We Stand? 2

(2) “As a result, individually or collectively, caused a loss to the covered financial company that materially contributed to the failure of the covered financial company under the facts and circumstances.”

There’s a two-year statute of limitations, except for fraud, which has no time limit. The FDIC “shall promulgate regulations to implement the requirements of this subsection, including defining the term ‘compensation’ to mean any financial remuneration including salary, bonuses, incentives, benefits, severance, deferred compensation or golden parachute benefits and any profits realized from the sale of the securities” of the company. Weil, Gotshal & Manges Partner Heath Tarbert in Washington, D.C., has warned that almost any financial firm might be vulnerable to FDIC action under this broad provision—including hedge funds. Furthermore, serving on the board of a bank that declares insolvency can raise a general risk of liability, due to a longstanding FDIC policy on “Responsibilities of Bank Officers and D” in effect for the last 10 years. As of Feb. 4, the FDIC has authorized 22 lawsuits in which directors and officers (D&O) were named. Only two of these so far have been dismissed and settled out of court.5

FDIC Issued Final Rule July 7, 2011.6

Next StepS Directors of financial institutions need to keep a close watch on the solvency of the institutions they serve, bearing in mind that even if directors do everything in their power to avoid insolvency, failure can occur due to outside forces beyond their control. A combination of volatile markets, changed accounting rules and changed reserve requirements can lead to findings of insolvency despite adequate oversight by the board. Given the current aggressive stance of regulators, combined with the current weak economy, directors of financial institutions should consider the possibility of insolvency and a resulting loss of past compensation and possible exposure to litigation as “responsible” parties per the definition above. As such, they would be prudent to consider their pay to be entirely at risk and plan accordingly.

title Ix: Investor protections and Improvements to the Regulation of SecuritiesBounties for whistleblowersThe whistleblower provision goes well beyond the one in Sarbanes-Oxley (SOX), which merely protected whistleblowers. This provision offers a reward of 10 to 20 percent for a tip that leads to sanctions of $1 million or more. The tipster, who may be anonymous to the company and known only to the Securities and Exchange Commission (SEC), stands to receive at least $100,000.

SEC Issued Final Rule May 25, 2011.7 Next StepS Use this new rule as the catalyst for reinvigorating your company’s ethics training program. A company-wide focus on ethics can deter not only truly unethical behavior but also frivolous complaints.

Mandated shareholder approval for compensation—“say on pay”—including say on parachutes

This provision, giving shareholders a nonbinding vote on pay, went into effect for companies at annual shareholder meetings in spring 2011. Under the rule implementing this provision, at least once every six years shareholders must vote on the frequency of this pay referendum, which the law says must be held at least every three years. Moreover, in any proxy or consent solicitation material asking shareholders to approve M&A activity, the company must disclose any and all compensation (including the total value) expected to be paid to executive officers based on the proposed M&A activity—aka golden parachutes.

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This proxy must also include a non-binding shareholder vote to approve these compensation agreements. The SEC may exempt small companies from these provisions.

SEC Issued Final Rule Jan. 25, 2011.8

Next StepS Work proactively with your compensation advisor to keep your pay in line with performance so that it gets approval. Whether your shareholders voted to have a say every year, every other year or every three years, it’s still a good idea to keep shareholder attitudes about pay on your radar at all times. Remember, because the vote on pay packages occurs after the launch of a plan, and because all it says is “yes” or “no,” its value is more symbolic than informative. Effective shareholder communications remains extremely important.

Independent compensation committees and consultantsIndependent compensation committees have been required for New York Stock Exchange and NASDAQ companies since 2003, but under a proposed Dodd-Frank rule, the standard for independence tightened. Under the proposed rule, the consultants selected by the compensation committees must be independent as well. The exchanges may choose to exempt companies from this requirement based on size and other factors. Also, by December 2012, the SEC owes Congress a report on “the use of compensation consultants and the effects of such use.”

SEC Proposed Rule March 30, 2011;9 Final Rule Due by June 2012.Next StepS Boards can define independence stringently for their compensation committees now, without waiting for outside definitions. Most companies now use existing definitions from the exchanges (November 2003 listing rules implementing SOX) or from the Internal Revenue Service (implementing the tax code’s Section 162 (m) $1 million cap on tax deductibility two decades ago). However, the SEC is likely to narrow the definition. In anticipation of the SEC’s rule, consider implementing the SOX Section 301 definition of audit committee independence. This rule assumes that the independent director is not an employee or related to an employee, and adds to this longtime baseline that the independent director must not accept consulting fees and must not be affiliated with the company or its subsidiaries. This has been NACD’s definition of director independence since its founding days and NACD recommends it for all boards seeking to build truly independent committees.

Pay-for-performance and pay-ratio disclosures

When disclosing executive compensation in the proxy, Dodd-Frank says that companies must also discuss the relationship between compensation already paid and the financial performance of the company, “taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.” Companies must also disclose the median annual compensation of all employees of the company, excluding the CEO, the total annual compensation of the CEO and the ratio between the two.

SEC to Propose Rules by June 2012; Final Rules by December 2012.Next StepS Allocate agenda time to define corporate performance in a way that is meaningful to the company. As noted above, Dodd-Frank says that boards must include stock price performance and dividend payments. However, boards would be unwise to limit their definition of corporate performance to these indicators. Many nonfinancial factors (such as customer satisfaction and employee turnover) contribute to long-term value, and shareholders know it.10 If CEOs and senior executives do well in these areas, this can and should be considered part of their incentive pay and performance review.11

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Executive pay clawbacksCompanies are required to develop and implement a policy that requires recovery (clawback) of erroneously awarded incentive compensation paid within the past three years of the award. If executives have been paid for reaching a financial goal that in retrospect was not really achieved, they have to give back any amount “in excess of what would have been paid to the executive officer under the accounting restatement.”

SEC to Propose Rules by June 2012; Final Rules by December 2012. Next StepS Since having a clawback policy puts incentive pay at risk, base pay will receive more attention in coming years. Incentive pay—particularly long-term incentive pay—remains important, but boards should avoid placing so much in at-risk incentive pay that it will have a demotivating rather than motivating effect: Honest, hardworking managers should not experience rebuffs or repossession due to accounting technicalities. Meanwhile, audit committee members should be more vigilant than ever when reviewing financial statements to make sure that the accounting treatments chosen are appropriate and that no red flags appear. This will reduce chances of restatements due to error or fraud. If there is a restatement, comply with the clawback provision but don’t stop there; work with management to restore trust in the company’s financial reports.

Employee- or director-hedging disclosureDodd-Frank states that proxy materials must disclose whether any employee or board member of the company holds or was granted any financial instrument to hedge against a decrease in the value of the company.

SEC to Propose Rules by June 2012; Final Rules by December 2012. Next StepS Boards can go one step farther and consider implementing a policy banning this behavior. Of note: Based on Equilar data published in its C-Suite Insight magazine in 2010, 44.2% of Fortune 250 companies have ownership policies that disclosed hedging restrictions. These policies typically prohibit officers from pledging shares as collateral for loans or in margin accounts.

No broker vote on pay, etc. The Dodd-Frank law eliminated broker voting on say on pay and director elections—extending a previous ban from July 2009 under New York Stock Exchange Rule 452 on broker voting in director elections. On Jan. 25, 2012, the NYSE extended the reach of Rule 452 even farther by adding a list of items that brokers may not vote without specific client instructions: de-staggering the board of directors, majority voting for director elections, elimination of super-majority voting requirements, providing for the use of consents, providing rights to call a special meeting and certain anti-takeover provision overrides.

NYSE Announced Most Recent Rule Jan. 26, 2012. Next StepS Build better relations with retail investors. For guidance, see the materials of the Shareholder Communications Coalition (shareholdercoalition.com) and by Broadridge (shareholdereducation.com/proxyprocess.asp).

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Proxy access

Dodd-Frank gave the SEC authority to create rules determining procedures pertaining to proxy access. The SEC passed two rules—one (new 14-a-11) mandating shareholder access federally, another (14-a-8, amended), giving qualified shareholders right to propose proxy access bylaw amendments—an approach referred to as private ordering. The first SEC proxy access rule got shot down in court in July; the second survived and is now in effect. As of spring 2012, shareholders may vote to amend their company bylaws to permit shareholders to nominate board members directly via the proxy statement, bypassing the screen of the nominating committee. This approach is referred to as private ordering because it allows for each company’s shareholders to make their own decisions rather than imposing a mandate.

Two SEC Rules Final But Court Upheld One, Rescinded One.Next StepS Take a proactive approach to shareholder nominations of directors. Get to know major shareholders and get a reading on the kinds of individuals they would like to see on the board. Consider these views in nominating board candidates. If appropriate, consider having the board create and pass a bylaw amendment to permit proxy access under terms the board feels are appropriate for the company—for example, allowing direct nominations for shareholders holding at least 5 percent for two years. (This was what the NACD board of directors suggested to the SEC when the 14(1) 11 federal mandate was out for comment.)

Board leadership structure disclosuresCompanies must disclose and explain their choice of board leadership structure and whether the roles of the CEO and chair position are combined or separated.

Already In Effect Via Proxy Enhancement Rules Final Dec. 16, 2010.Next StepS Companies have already been making disclosures about their leadership structures in response to the proxy disclosure enhancement rules that became effective for spring proxy season 2010—months before passage of Dodd-Frank. Now they can see the messages of other companies—not just peers, but any well-governed companies. Disclosures vary. Good governance is doing what is right for the company. NACD has developed a template for enhanced governance disclosures that can be requested via email at [email protected]. For general governance guidance, the NACD’s Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies can be accessed at NACDonline.org.

title xV: Miscellaneous provisionsConflict minerals Companies must disclose the source of minerals for products and packaging to ensure that the minerals do not originate from sources (e.g., mines, smelters) in regions associated with violent conflict such as the Democratic Republic of the Congo.

Proposed Dec. 15, 2010; Final Rule Due by June 2012.Next StepS Watch this like a hawk. The proposed rule is subject to a wide range of possible outcomes, depending on whether the SEC listens to the activists who want to eliminate the use of conflict minerals at any cost versus the companies who need to reduce or eliminate their use of these minerals within a reasonable timeframe and level of assurance. Including scrap and recycled minerals in the count would make the calculation extremely difficult, for example.

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Endnotes

1 See Dodd Frank Progress Report at DavisPolk.com

2 http://www.directorship.com/focus/print-magazine/washington-update/

3 http://www.gpo.gov/fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf

4 http://www.sec.gov/rules/final/2009/33-9089.pdf

5 http://www.fdic.gov/bank/individual/failed/pls.index/html

6 “Recoupment of Compensation from Senior Executives and Directors.” http://www.fdic.gov/regulations/laws/rules/2000-9400.html#fdic2000part380.7



9 http://www.sec.gov/rules/proposed/2011/33-9199.pdf

10 For a standard list of “Sustainability Guidelines” for important nonfinancial areas, visit the Global Reporting Initiative at http://www.globalreporting.org.

11 For more on performance metrics, see Report of the NACD Blue Ribbon Commission on Performance Metrics (Washington, D.C:, NACD, 2010).

© Copyright 2012National Association of Corporate DirectorsNACDonline.org

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AMERICAN BAR ASSOCIATION

International Developments in Corporate Governance Subcommittee

Fiduciary Duties Under U.S. Law

Ira M. Millstein Holly J. Gregory

Ashley R. Altschuler Christine T. Di Guglielmo1


March 15, 2011

I. What Does Being A Fiduciary Mean?

A. The U.S. Corporate Form and the Role of State Law

In the United States, the corporate model separates ownership from

control. Thus, a corporation is a legal entity, separate and distinct from the persons who

own it, created for the purpose of carrying on business. The owners of the corporation

are its shareholders, and ordinarily they may freely transfer their shares. The

shareholders elect (and may remove)2 the board of directors, who are entrusted to care for

“other people’s money”—that of the shareholders.3 The directors have a fiduciary

relationship with the corporation and its shareholders and are responsible for the overall

direction and management of the corporation.4 Typically, the board of directors delegates

1 Ira M. Millstein, Holly J. Gregory, and Ashley R. Altschuler are partners in the law firm of Weil, Gotshal & Manges LLP. Christine T. Di Guglielmo is an associate. Partner Stephen A. Radin and associates Margarita Platkov, Evert J. Christensen, Jr. and Robert V. Spake, Jr. assisted in preparing this submission, and they have the authors’ gratitude. This paper was prepared as the United States submission for the multinational Comparative Analysis project of the ABA Section of Business Law, Corporate Governance Committee, International Developments Subcommittee and, accordingly, is structured to comply with the template for that project. 2 See Crown EMAK Partners, LLC v. Kurz, 2010 Del. LEXIS 182, at *58-59 (Del. Apr. 21, 2010). 3 PAUL W. MACAVOY & IRA M. MILLSTEIN, THE RECURRENT CRISIS IN CORPORATE GOVERNANCE 128 (2004). 4 See STEPHEN A. RADIN, THE BUSINESS JUDGMENT RULE 1 (6th ed. 2009). For example, Section 141(a) of the Delaware General Corporation Law (“DGCL”) provides that “[t]he business and affairs of every

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the duties of day-to-day management to various executive officers, whom the board (not

the shareholders) selects and relies on.5 The officers are accountable to the board and

have a direct fiduciary relationship with the shareholders.6

In the United States, the corporation exists by virtue of law and owes its

existence to its state of incorporation. The company has only those powers conferred

upon it by the general corporation law of its state of incorporation and its shareholder-

approved articles of incorporation.7 The articles of incorporation and the corporate

bylaws may establish aspects of the relationship between the shareholders and the

directors, provided that such articles and bylaws do not conflict with the statutory

scheme.8 Statutory corporation law, the articles of incorporation, and the bylaws are

“incomplete,” however, in the sense that they cannot explicitly cover all contingencies

and factual circumstances. Therefore, courts play an important role in helping to fill the

interstices of corporate law, including the law of fiduciary duties, and in interpreting the

statutes, charters, and bylaws and resolving conflicts among those documents. In

addition, courts sometimes apply equitable principles to restrict corporate transactions

corporation . . . shall be managed by or under the direction of a board of directors.” DEL. CODE ANN. tit. 8, § 141(a). 5 See, e.g., DEL. CODE ANN. tit. 8, § 141(e) (directors are “fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees”). 6 See Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) (“[T]he fiduciary duties of officers are the same as those of directors.”); Guth v. Loft, 5 A.2d 503, 510 (Del. 1939) (officers and directors owe fiduciary duties to the corporations they serve); Hampshire Grp., Ltd. v. Kuttner, 2010 WL 2739995, at *11 (Del. Ch. July 12, 2010) (“As a general matter, our Supreme Court has found that the duties of corporate officers are similar to those of corporate directors. Generally, like directors, [officers are] expected to pursue the best interests of the company in good faith (i.e., to fulfill their duty of loyalty) and to use the amount of care that a reasonably prudent person would use in similar circumstances (i.e., to fulfill their duty of care).”). 7 E.g., I JAMES D. COX & THOMAS LEE HAZEN, COX & HAZEN ON CORPORATIONS § 1.02, at 6 (2d ed. 2003). 8 See, e.g., Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182, 1194-95 (Del. 2010) (invalidating bylaw adopted by the board as conflicting with the company’s certificate of incorporation and Delaware statutory law).

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that could be permissible under a strict application of the statutory law.9 In turn, state

legislatures at times react to judicial decisions.10 For example, legislatures might step in

to provide directors greater protections in connection with their conduct as fiduciaries

than the courts determined were provided by existing law.11

Thus, the juxtaposition of statutory and common law in the states,

particularly Delaware, provides a contemporary framework for the duties of corporate

directors and officers.12 Based in state law,13 the fiduciary duties that directors and

9 See, e.g., Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971) (enjoining directors’ advancement of date of annual stockholder meeting to reduce the time in which a proxy contest could have been waged because “inequitable action does not become permissible simply because it is legally possible”); Hollinger Int’l Inc. v. Black, 844 A.2d 1022, 1080-82 (Del. Ch. 2004) (while statute permitted controlling shareholder to adopt bylaw disbanding a board committee, that action was inequitable, since the bylaw was adopted for the improper purpose of preventing the committee from investigating alleged wrongdoing by the controlling shareholder). 10 Compare H.B. 19, 145th Gen. Assem. § 2 (Del. 2009) (amending DGCL to allow adoption of bylaws that provide for “the reimbursement by the corporation of expenses incurred by a stockholder in soliciting proxies in connection with an election of directors”), with CA, Inc. v. AFSCME Emps. Pension Fund, 953 A.2d 227 (Del. 2008) (invalidating stockholder-proposed bylaw that would provide for reimbursement of stockholders for reasonable expenses incurred in connection with nominating candidates in a contested election of directors). 11 Compare DEL. CODE ANN. tit. 8, § 102(b)(7) (authorizing exculpation of directors for monetary liability for breaches of the duty of care), with Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (finding liability for breach of duty of care). DGCL § 102(b)(7) was enacted in the wake of Van Gorkom to protect directors from monetary liability for due care violations. See infra notes 108-111 & accompanying text. 12 See R. FRANKLIN BALOTTI & JESSE A. FINKELSTEIN, THE DELAWARE LAW OF CORPORATIONS & BUSINESS ORGANIZATIONS, at F-1 (3d ed. 1998 & Supp.); RADIN, supra note 4, at 3-11. While there have been attempts to “federalize” the law of fiduciary duties, at least to the extent of establishing “minimum standards” of corporate behavior, such efforts have largely failed. In the wake of the collapses of Enron, Worldcom, and other corporate failures, however, Congress passed the Sarbanes-Oxley Act of 2002, addressing to a new degree the internal affairs of U.S. corporations, which traditionally have been governed by state law. The self-regulatory organizations, such as the NYSE and the NASDAQ, also have created stricter listing standards that have affected the internal affairs of listed companies. While these governance reforms do not directly alter the basic fiduciary obligations of directors, they influence the judicial climate, and have more “sharply focused” court decisions on the expectations of director processes when measured by the traditional duties of due care and loyalty, discussed infra. See E. Norman Veasey, Shawn Pompian & Christine Di Guglielmo, Federalism vs. Federalization: Preserving the Division of Responsibility in Corporation Law, in 2 THE PRACTITIONER’S GUIDE TO THE SARBANES-OXLEY Act V-5 (2006); E. Norman Veasey, What Would Madison Think? The Irony of the Twists and Turns of Federalism, 34 DEL. J. CORP. L. 35 (2009). The financial turmoil of 2008-09 has prompted a new wave of proposals to federalize portions of corporate law. E.g., Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified in scattered sections of 7, 12, 15, 18, 31 U.S.C.). 13 Many jurisdictions, including Delaware and the federal courts, adhere to the “internal affairs” doctrine, which provides that the internal affairs of the corporation (e.g., fiduciary duties of directors) are governed

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executive officers owe to the corporation and its shareholders may differ, in theory, in

each of the 50 states. The state of Delaware and its specialized court system are

preeminent in corporate and fiduciary duty law, and many states adopt or look to

Delaware law to govern non-Delaware corporations.14

B. The Role of Directors As Fiduciaries

Directors “stand in a fiduciary relation to the corporation and its

shareholders.”15 In general, a fiduciary is “one who owes to another the duties of good

faith, trust, confidence, and candor” or “one who must exercise a high standard of care in

managing another’s money or property.”16 Fiduciary duties are designed to discourage

misuse of the power delegated to the board and the executive officers, and to help ensure

that fiduciaries take action in the best interests of the shareholders rather than in their

own self-interests. In the most basic sense, fiduciary duties require a director to act

prudently and in the best interests of the corporation and its shareholders when carrying

out corporate functions.

In practice, directors have the following responsibilities:

• Manage the business and affairs of the company while placing good-faith reliance on competent officers, employees, board committees, and outside advisors.17

by the law of the state of incorporation. See, e.g., CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987); Vantagepoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108, 1112-13 (Del. 2005). 14 RADIN, supra note 4, at 5-11. More than fifty percent of all publicly-traded U.S. corporations and more than sixty percent of the Fortune 500 companies are incorporated in Delaware. See Delaware Division of Corporations, http://corp.delaware.gov (last modified Mar. 3, 2011); E. Norman Veasey & Christine T. Di Guglielmo, What Happened in Delaware Corporate Law and Governance from 1992—2004: A Retrospective on Some Key Developments, 153 U. PA. L. REV. 1399, 1403 (2005). 15 See Guth v. Loft, 5 A.2d 503, 510 (Del. 1939). 16 BLACK’S LAW DICTIONARY 658 (8th ed. 2004); see also Briggs v. Spaulding, 141 U.S. 132 (1891); Charitable Corp. v. Sutton, Atk. 400 (1742). 17 See DEL. CODE ANN. tit. 8, § 141(a); id. § 141(e); see also N.Y. BUS. CORP. LAW § 717; RADIN, supra note 4, at 601.

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• Select, regularly evaluate, and, if necessary, replace the executive officers, including the chief executive officer. Determine management compensation. Review succession planning.

• Review and, where appropriate, approve the company’s long-term strategic and investment plans or expenditures and major strategies, including entry into new lines of business, mergers and business combinations, the creation or retirement of significant debt, and the acquisition of significant amounts of equity.

• Select and recommend to shareholders for election an appropriate slate of candidates for the board of directors. Evaluate board processes and performance.

• Review the adequacy of internal control and monitoring systems to comply with all applicable laws/regulations, and make strategic decisions involving issues that foreseeably could expose the corporation to significant litigation or new regulatory constraints.18

C. The Fiduciary Duties of Directors of U.S. Corporations

In the United States, fiduciary duties include the duties of due care and

loyalty. Other duties, such as the duty of candor and the duty of good faith, are subsets of

the duties of loyalty and care.19 Many states have codified fiduciary duties into statute,

but common law continues to provide significant interpretations.20

18 See 1 ALI PRINCIPLES OF CORPORATE GOVERNANCE § 3.02, reporter’s cmt. (a) at 84-85 (2008) [hereinafter, PRINCIPLES]. 19 See Pfeffer v. Redstone, 965 A.2d 676, 684 (Del. 2009) (“‘[T]he duty of disclosure is not an independent duty, but derives from the duties of care and loyalty.’”); Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) (holding that the duty of good faith is a subset of the duty of loyalty). 20 For example, at least four-fifths of U.S. states have enacted statutory provisions codifying the duty of care. See 2 MODEL BUS. CORP. ACT ANN. § 8.30, cmt. at 8-208-09 (4th ed. 2008, Supp. 2009) [hereinafter RMBCA]; see also WILLIAM E. KNEPPER & DAN A. BAILEY, LIABILITY OF CORPORATE OFFICERS AND DIRECTORS § 3.02, at 3-3 (8th ed. 2010). Most of those states follow former Section 8.30(a) of the Revised Model Business Corporation Act, which provided: “A director shall discharge his duties . . . with the care an ordinarily prudent person in a like position would exercise under similar circumstances . . . .” Id. § 3.02, at 3-3-4. At least six states have adopted the amended version of Section 8.30, which provides that directors, “when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.” 2 RMBCA, supra, § 8.30(b); id. § 8.30(b), ann. at 8-208. California and Maryland are examples of states that have not adopted the Model Act, but have similar statutory standards of conduct. See CAL. CORP. CODE § 309(a); MD. CORPS. & ASS’N CODE ANN. § 2-405.1(a).

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1. The Duty of Care

The duty of care, in its most basic sense, is a director’s “duty to act

carefully in fulfilling the important tasks of monitoring and directing the activities of

corporate management.”21 The duty of care requires that, in managing the corporation’s

affairs, directors act:

(1) “in good faith”;

(2) “in a manner the director reasonably believes to be in the best interests of the corporation”; and

(3) “with the care that a person in a like position would reasonably believe appropriate under similar circumstances.”22

The duty of care standard “focus[es] on the manner in which directors

perform their duties, not the correctness of the decisions made.”23 To satisfy the duty of

care when making a board decision, directors must have reasonable knowledge of the

company’s business, approve the company’s significant business plans and extraordinary

actions, act on an informed, good-faith basis, use reasonable diligence in gathering and

considering credible information, adequately deliberate the relevant issues, and

21 1 PRINCIPLES, supra note 18, Pt. IV, Introductory Note at 132; see also Smith v. Van Gorkom, 488 A.2d 858, 872-73 (Del. 1985) (the duty of care is “a director’s duty to exercise an informed business judgment”). 22 See 2 RMBCA, supra note 20, § 8.30(a)-(b); RADIN, supra note 4, at 431-43; see also Brehm v. Eisner, 746 A.2d 244 (Del. 2000); Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993); Van Gorkom, 488 A.2d at 872-73; 3A FLETCHER CYCLOPEDIA OF THE LAW OF PRIVATE CORP. § 1036 (2002 and 2010-2011 Cum. Supp.). 23 2 RMBCA, supra note 20, § 8.30, cmt. at 8-189; see also In re Citigroup, Inc. S’holder Deriv. Litig., 964 A.2d 106, 124 (Del. Ch. 2009) (“[P]laintiff shareholders [are] attempting to hold the director defendants personally liable for making (or allowing to be made) business decisions that, in hindsight, turned out poorly for the Company. Delaware Courts have faced these types of claims many times and have developed doctrines to deal with them—the fiduciary duty of care and the business judgment rule. These doctrines properly focus on the decision-making process rather than on a substantive evaluation of the merits of the decision.”).

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understand the consequences that will flow from each decision before making the

decision.24

Reliance and Delegation. To comply with their duty of care, directors are

empowered to reasonably rely upon, and delegate board functions to, board committees,

corporate officers, and independent advisors, provided the decision to delegate is an

informed one that is made in good faith and that due care is exercised in selecting those

upon whom reliance is placed.25 In doing so, the board of directors “is entitled to the

presumption that it exercised proper business judgment, including proper reliance on the

expert.”26 Directors may not, however, blindly rely on even a carefully selected and

qualified expert. Rather, “directors have some oversight obligations to become

reasonably familiar with an opinion, report, or other source of advice before becoming

entitled to rely on it.”27 Further, in some contexts directors must disclose the

24 See 1 PRINCIPLES, supra note 18, § 4.01; see also Moran v. Household, Int’l Inc., 500 A.2d 1346, 1356-57 (Del. 1985). Examples of cases in which directors failed (or may have failed) to observe their duty of care include Van Gorkom, 488 A.2d 858 (haste in decision making and lack of preparation); Lyondell Chem. Co. v. Ryan, 970 A.2d 235 (Del. 2009) (rapid consummation of major transaction without negotiation of better terms or seeking superior deal); and McPadden v. Sidhu, 964 A.2d 1262 (Del. Ch. 2008) (failure to ensure that sale process employed by interested corporate officer was “thorough and complete”). 25 See DEL. CODE ANN. tit. 8, § 141(e) (directors are “fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors . . .”); see also N.Y. BUS. CORP. LAW § 717; Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1281 (Del. 1989); In re HealthSouth Corp. S’holders Litig. 845 A.2d 1096, 1106 (Del. Ch. 2003); RADIN, supra note 4, at 601. 26 Brehm, 746 A.2d at 261; Cal. Pub. Emps. Ret. Sys. v. Coulter, 2002 Del. Ch. LEXIS 144, at *42-50 (Del. Ch. Dec. 18, 2002). But cf. Valeant Pharm., Int’l v. Jerney, 921 A.2d 732, 751 (Del. Ch. 2007) (acknowledging that reasonable reliance under section 141(e) is a “pertinent factor in evaluating whether corporate directors have met a standard of fairness in their dealings with respect to corporate powers,” but that such reliance “is not outcome determinative”). 27 Hanson Trust PLC v. ML SCM Acquisition Inc., 781 F.2d 264, 275 (2d Cir. 1976); see also Van Gorkom, 488 A.2d 858; In re Del Monte Foods Co. S’holders Litig., Consol. C.A. No. 6027-VCL, slip op. at 37 (Feb. 14, 2011) (“Although the blame for what took place appears at this preliminary stage to lie with [the board’s financial advisor], the buck stops with the Board. Delaware law requires that a board take an active and direct role in the sale process.” (internal quotation omitted)); Valeant, 921 A.2d at 750-51 (reliance on

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compensation and potential conflicts of experts on whom the board relies, and any

conflicts may be subject to scrutiny by a court to determine whether they tainted the

board’s process.28

Directors may not delegate duties that lie at the “heart” of the management

of the corporation.29 That is, directors may not delegate tasks that the directors

themselves are required to perform by statute, the certificate of incorporation, or the

bylaws, nor may they delegate if doing so would effectively strip them of their business

judgment on management matters.30

Duty of Oversight. Directors have a duty to monitor the corporation and

investigate possible wrongdoing of fellow directors, executive officers, and their

subordinates.31 This duty of oversight includes “a duty to attempt in good faith to assure

that a corporate information and reporting system, which the board concludes is adequate,

exists.”32 Any director who has actual knowledge of facts suggesting a material problem

expert report was not reasonable where report did not relate to the current terms of the transaction and was predicated on faulty assumptions); RADIN, supra note 4, at 615-17. 28 Del Monte, slip op. at 29-30; see also id. at 29-39 (discussing the conflict faced by a company’s financial advisor and how that conflict tainted the board’s sales process, despite the board’s apparent good faith). 29 RADIN, supra note 4, at 650. 30 See, e.g., In re Bally’s Grand Deriv. Litig., 1997 WL 305803, at *4 (Del. Ch. June 4, 1997); RADIN, supra note 4, at 650-65. 31 See E. Norman Veasey, Counseling Directors in the New Corporate Culture, 59 BUS. LAW. 1447 (2004); see also 15 U.S.C. 7262 (requiring a company’s annual report to describe and assess the company’s internal controls); Stone v. Ritter, 911 A.2d 362 (Del. 2006) (affirming dismissal where complaint alleged that directors had failed in their oversight duty); ATR-Kim Eng. Fin. Corp. v. Araneta, 2006 Del. Ch. LEXIS 215, at *70-77 (Del. Ch. Dec. 21, 2006) (directors breached fiduciary duties where they “did nothing to make themselves aware of this blatant misconduct or to stop it”); Saito v. McCall, 2004 WL 3029876, at *6-7 (Del. Ch. Dec. 20, 2004) (denying motions to dismiss where directors allegedly failed to monitor the company’s accounting practices and failed to implement sufficient internal controls to guard against wrongful accounting practices). 32 In re Caremark Int’l Deriv. Litig., 698 A.2d 959, 970 (Del. Ch. 1996); see also Stone, 911 A.2d at 370 (holding that director oversight liability requires showing that directors “utterly failed to implement any reporting or information system or controls” or, if such controls were in place, consciously failed to oversee their operation); In re Citigroup, Inc. S’holder Deriv. Litig., 964 A.2d 106, 122 (Del. Ch. 2009) (same).

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in the company has a duty to promptly initiate board or management consideration of the

trouble spot.33 Further, if through exercise of the oversight function a director’s

suspicion of wrongdoing is aroused, or should have been aroused, the director must act

reasonably in light of the information gained.34 On the other hand, directors generally do

not have a duty to “ferret out” wrongdoing, to uncover “hard core” fraud by officers or

directors, or to “predict the future” or correctly evaluate business risk—so long as the

proper monitoring systems are in place.35

2. The Duty of Loyalty

The duty of loyalty requires one with a fiduciary relationship to a

corporation to act in good faith, see infra § I.C.3., and in the best interests of the

corporation, and not in the fiduciary’s own interest.36 Engaging in self-dealing,

33 See Caremark, 698 A.2d at 970; see also Stone, 911 A.2d at 369 (holding that bad faith may be shown where a “fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties”). 34 See Graham v. Allis-Chambers Mfg. Co., 188 A.2d 125, 130 (Del. 1963) (director who ignores either willfully or through inattention obvious signs of wrongdoing will be held liable); cf. Stone, 911 A.2d at 373 (“In the absence of red flags, good faith in the context of oversight must be measured by the directors’ actions ‘to assure a reasonable information and reporting system exists’ . . . .”); In re Dow Chem. Co. Deriv. Litig., 2010 WL 66769, at *13 (Del. Ch. Jan. 11, 2010) (rejecting oversight claims where plaintiffs failed to sufficiently allege “red flags” that would give the directors reason to suspect misconduct). 35 Citigroup, 964 A.2d at 131; Caremark, 698 A.2d at 968-70; Stone, 911 A.2d at 373. In a similar context, former SEC Commissioner Harvey J. Goldschmid has stated:

Some who champion the idea of an active audit committee [of the board of directors] say it will stop venal, hard-core fraud. That I do not consider realistic. An active audit committee will not, when acting alone, be able to catch thieves in most circumstances. Even the most active and effective auditors will have some trouble when hard-core fraud is involved. There are techniques being developed today to try to reach hard-core misconduct, including forensic auditing and other techniques. But when no red flags are flying, even when an audit committee acts reasonably, it will be difficult to spot fraud that is concealed and hard-core. The dangers of hard-core fraud, in short, will only be somewhat deterred or mitigated by an active audit committee.

Post-Enron America: An SEC Perspective (Dec. 2, 2002), www.sec.gov/news/speech/spch120202hjg.htm. 36 See Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993) (“The duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally”); Ryan v. Gifford,

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misappropriating corporate assets or opportunities, having conflicts of interest that are not

appropriately disclosed to the board (with recusal from the interested transaction),

deliberately misleading stockholders, or otherwise profiting in a transaction that is not

substantively or “entirely fair” to the corporation may all be considered breaches of the

duty of loyalty. Directors, officers and, in some circumstances, controlling shareholders,

see infra pp. 33-35, have a duty of loyalty to the corporation and its shareholders.37

Because legislatures and courts place great importance on the duty of loyalty, a director’s

personal liability for breaches of the duty of loyalty cannot be limited by statutory

director exculpation provisions that are contained in many corporations’ articles of

incorporation.38 See infra § III.B.

The duty of loyalty is implicated in transactions in which a director or

controlling shareholder is not independent or has a substantial self-interest that conflicts

with the interests of the corporation. The concepts of disinterestedness and independence

are frequently conflated, but these concepts are distinct under Delaware law.39

The term “independence” means that a “director’s decision is based on the

corporate merits of the subject before the board rather than extraneous considerations or

influences”40 that would “convert an otherwise valid business decision into a faithless

918 A.2d 341, 357 (Del. Ch. 2007) (breach of the duty of loyalty may be shown where directors act “in bad faith” or “for personal gain”). 37 See, e.g., Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156 (Del. 1995); Hollinger Int’l Inc. v. Black, 844 A.2d 1022 (Del. Ch. 2004); In re Maxxam, Inc./Federated Dev. S’holders Litig., 659 A.2d 760 (Del. Ch. 1995). 38 See DEL. CODE ANN. tit. 8, § 102(b)(7) (permitting exculpation of directors for monetary liability for breaches of due care only, and discussed infra section III.B); see also Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 239 (Del. 2009) (because the corporation had adopted an exculpatory provision, the case turned “on whether any arguable shortcomings on the part of the Lyondell directors also implicate their duty of loyalty, a breach of which is not exculpated”). 39 See Veasey & Di Guglielmo, supra note 14, at 1472-73 n.312. 40 Beam v. Stewart, 845 A.2d 1040, 1049 (Del. 2004).

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act.”41 A director is not independent if he or she is dominated by or “beholden” to an

individual or entity interested in the transaction at issue “or so under their influence that

[the director’s] discretion would be sterilized.”42 On the other hand, “[a]llegations of

mere personal friendship or a mere outside business relationship, standing alone, are

insufficient to raise a reasonable doubt about a director’s independence.”43

The term “interestedness” relates to a situation in which a director will

“‘receive a personal financial benefit from a transaction that is not equally shared by the

stockholders.’”44 A director may be considered interested if he or she acted while having

an interest other than as a director of the corporation.45 Normally, a director who acts

with the primary goal of remaining on the board will not be deemed interested for that

reason alone.46

Methods of restricting the improper influence of an interested director

include: (1) recusal at board meetings; (2) abstention from voting on the interested

transaction; and (3) resignation from the board.47 Further, in certain circumstances, some

interested-director transactions can be “sanitized” by law where certain procedural

41 Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984). 42 Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993); Kahn v. Portnoy, 2008 WL 5197164, at *10 (Del. Ch. Dec. 11, 2008). But cf. In re NYMEX S’holder Litig., 2009 WL 3206051, at *6 (Del. Ch. Sept. 30, 2009) (“That directors acquiesce in, or endorse actions by, a chairman of the board—actions that from an outsider’s perspective might seem questionable—does not, without more, support an inference of domination by the chairman or the absence of directorial will.” (footnote omitted)). 43 Beam, 845 A.2d at 1050; In re Transkaryotic Therapies, Inc., 954 A.2d 346, 369 (Del. Ch. 2008). 44 Beam, 845 A.2d at 1049 n.21 (citing Rales, 634 A.2d at 936). 45 See Caruso v. Metex Corp., 1992 WL 237299, at *16 (E.D.N.Y. July 30, 1992). 46 See, e.g., Gantler v. Stephens, 965 A.2d 695, 707 (Del. 2009) (“Here, the plaintiffs allege that the Director Defendants had a disqualifying self-interest because they were financially motivated to maintain the status quo. A claim of this kind must be viewed with caution, because to argue that directors have an entrenchment motive solely because they could lose their positions following an acquisition is, to an extent, tautological.”); Solomon v. Armstrong, 747 A.2d 1098, 1126 (Del. Ch. 1999). 47 ABA COMMITTEE ON CORP. LAWS, CORPORATE DIRECTOR’S GUIDEBOOK 23 (5th ed. 2007).

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mechanisms are satisfied. For example, Delaware48 and certain other states have adopted

“safe harbor” statutes that set forth the precise means by which interested transactions

can be approved:

(1) where the self-interest of the director in the transaction is disclosed to and approved by a majority of disinterested directors;49

(2) where the self-interest of the director is disclosed to and approved by the shareholders entitled to vote thereon;50 or

(3) where the contract or transaction is found to be “fair” as to the corporation.51

Corporate Opportunity Doctrine. When a director or other person with a

fiduciary duty to a corporation takes an opportunity rightfully belonging to the

corporation, the duty of loyalty is implicated.52 Under the test applied by the Delaware

courts, an opportunity belongs to the corporation if:

(1) the opportunity is within the corporation’s line of business and would be of practical advantage to the corporation;

(2) the corporation has an interest or a reasonable expectation in the opportunity; and

48 DEL. CODE ANN. tit. 8, § 144. 49 Note that unlike Delaware, certain other states do not provide safe harbor protection for interested transactions based on disinterested director approval alone. For example, in California approval is sufficient only if the transaction is “just and reasonable.” CAL. CORP. CODE § 310(a)(2). Other states, like New York, allow approval by disinterested directors, but such approval must be unanimous where a vote by disinterested directors does not constitute an act by the board. N.Y. BUS. CORP. LAW § 713(a)(1). 50 While fully-informed, disinterested shareholder approval is a complete defense to a duty of care claim, it is not a complete defense to a claim for a breach of the duty of loyalty. “Rather, the operative effect of shareholder ratification in duty of loyalty cases has been either to change the standard of review to the business judgment rule, with the burden of proof resting upon the plaintiff, or to leave ‘entire fairness’ as the review standard, but shift the burden of proof to the plaintiff.” Wheelabrator Techs. Inc. S’holder Litig., 663 A.2d 1194, 1203 (Del. Ch. 1995); see also Gantler, 965 A.2d at 712-13; RADIN, supra note 4, at 828-46. 51 DEL. CODE ANN. tit. 8, § 144; see also Rosenblatt v. Getty Oil Co., 493 A.2d 929, 937-44 (Del. 1985). 52 See Broz v. Cellular Info. Sys., 673 A.2d 148, 154-55 (Del. 1996); In re eBay, Inc., S’holders Litig., 2004 Del. Ch. LEXIS 4, at *12-16 (Del. Ch. Feb. 11, 2004).

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(3) the corporation is financially able to take advantage of the opportunity.53

If the test is met, a fiduciary must first offer the opportunity to the corporation, and the

corporation must reject it, before the fiduciary may take the opportunity.54 The taking of

a “corporate opportunity” will more likely pass judicial scrutiny if it is approved by fully

informed, disinterested directors, or a committee thereof.55

The Duty of Candor. The duty of loyalty (as well as the duty of care) also

includes a duty of candor, which requires that a director disclose the full extent of his or

her interest in a given matter, and abstain from voting on that matter when it is brought to

the full board’s attention, if his or her interest in the matter conflicts with that of the

corporation.56 While directors are expected to share information with each other, they

also are expected to keep all matters involving the corporation confidential unless or until

there has been a general public disclosure.57

53 See Broz, 673 A.2d at 155; Yiannatsis v. Stephanis, 653 A.2d 275, 278 (Del. 1995). 54 Broz, 673 A.2d at 154-55; eBay, 2004 Del. Ch. LEXIS 4, at *12-16. 55 E.g., Oberly v. Kirby, 592 A.2d 445, 466 (Del. 1991); Marciano v. Nakash, 535 A.2d 400, 405 n.3 (Del. 1987). 56 Malpiede v. Townson, 780 A.2d 1075, 1086 (Del. 2001); Malone v. Brincat, 722 A.2d 5, 9 (Del. 1998); see also In re Am. Int’l Grp., Inc., 965 A.2d 763, 807 (Del. Ch. 2009) (“[A] fraud on the board has long been a fiduciary violation under [Delaware] law and typically involves the failure of insiders to come clean to the independent directors about their own wrongdoing, the wrongdoing of other insiders, or information that the insiders fear will be used by independent directors to take actions contrary to the insiders’ wishes.”). 57 See Malone, 722 A.2d at 12 (“The directors’ duty to disclose all available material information in connection with a request for shareholder action must be balanced against its concomitant duty to protect the corporate enterprise, in particular, by keeping certain financial information confidential.”).

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3. The Duty of Good Faith

Under Delaware law, the duty of good faith is a subset of the duty of

loyalty, rather than a separate and independent duty.58 Nonetheless, a director’s

obligation to act in “good faith” remains an important focal point in Delaware corporate

jurisprudence.59 A lack of good faith may be found where a fiduciary “intentionally acts

with a purpose other than that of advancing the best interests of the corporation,” “acts

with the intent to violate applicable positive law,” or “intentionally fails to act in the face

of a known duty to act, demonstrating a conscious disregard for his duties.”60 In short,

“failure to act in good faith requires conduct that is qualitatively different from, and more

culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e.,

gross negligence).”61 If a director’s decision is irrational or so beyond reason that no

responsible director would credit it, then bad faith may be inferred.62 For example, “the

58 Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006); see also Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243 (Del. 2009); In re Citigroup, Inc. S’holder Deriv. Litig., 964 A.2d 106, 122-23 (Del. Ch. 2009); In re Lear Corp. S’holder Litig., 967 A.2d 640, 653 (Del. Ch. 2008). 59 See MACAVOY & MILLSTEIN, supra note 3, at 115-27; Leo E. Strine, Jr. et al., Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law (Harv. Law Sch., John M. Olin Ctr. for Law, Econs. & Bus., Discussion Paper No. 630, 2009), available at http://ssrn.com/abstract=1349971. 60 Stone, 911 A.2d at 369; Lyondell, 970 A.2d at 240-41; Wayne County Emps. Ret. Sys. v. Corti, 2009 WL 2219260, at *14 (Del. Ch. July 24, 2009); In re NYMEX S’holder Litig., 2009 WL 3206051, at *6 (Del. Ch. Sept. 30, 2009); Citigroup, 964 A.2d at 125; see also In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 64-66 (Del. 2006) (holding that conduct motivated by subjective bad faith (i.e., actual intent to do harm) and conduct that involves “intentional dereliction of duty, a conscious disregard for one’s responsibilities,” constitute bad faith, but conduct resulting from gross negligence “clearly” does not). According to the former Chief Justice of the Delaware Supreme Court, good faith “requires an honesty of purpose and eschews a disingenuous mindset of seeming to act for the corporate good, but not caring for the well being of the constituents of the fiduciary.” E. Norman Veasey, Musings on the Dynamics of Corporate Governance Issues, Director Liability Concerns, Corporate Control Transactions, Ethics and Federalism, 152 U. PA. L. REV. 1007, 1009 (2003); see also MACAVOY & MILLSTEIN, supra note 3, at 120-21. 61 Stone, 911 A.2d at 369. 62 See E. Norman Veasey, Delaware Corporation Law Ethics and Federalism, METRO. CORP. COUNSEL, Nov. 2002, at 13.

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utter failure to follow the minimum expectations of . . . Sarbanes-Oxley, or the NYSE or

NASDAQ Rules . . . might likewise raise a good faith issue.”63

The meaning of good faith has important implications in several statutory

contexts.64 A finding of liability based on a failure to act in good faith is particularly

significant in light of charter provisions that exculpate directors for breaches of the duty

of care, which shareholders of most Delaware corporations have adopted.65 Such

exculpatory provisions permit shareholders to protect directors from liability for money

damages for breaches of the duty of care, but not “acts or omissions not in good faith.”66

The duty of good faith also has implications for the transmission of information in the

corporation, as under Delaware law, directors are fully protected when relying in good

faith upon records, opinions, reports, and statements made by officers, employees,

committees, or experts.67 In addition, if directors violate their duty of good faith, they

risk losing directors and officers insurance coverage and their right to indemnification

63 E. Norman Veasey, State-Federal Tension in Corporate Governance and the Professional Responsibilities of Advisors, 28 IOWA J. CORP. L. 441, 446 (2003); see also MACAVOY & MILLSTEIN, supra note 3, at 122-27; Leo E. Strine, Jr., Derivative Impact? Some Early Reflections on the Corporation Law Implications of the Enron Debacle, 57 BUS. LAW. 1371, 1385 (2002). 64 See Veasey & Di Guglielmo, supra note 14, at 1443-44 (observing that good faith is imbedded in the Delaware statutory provisions governing director exculpation, reliance on experts, and indemnification). 65 See, e.g., DEL. CODE ANN. tit. 8, § 102(b)(7) (discussed infra notes 108-111 & accompanying text). 66 Id. 67 DEL. CODE ANN. tit. 8, § 141(e); see also Ryan v. Gifford, 918 A.2d 341, 353 (Del. Ch. 2007); MACAVOY & MILLSTEIN, supra note 3, at 122 (citing Veasey, supra note 62, at 14); cf. Valeant Pharm., Int’l v. Jerney, 921 A.2d 732, 750-51 (Del. Ch. 2007) (rejecting good faith reliance defense where it would have been unreasonable for interested inside director to rely on expert report because report addressed a different, earlier proposed transaction and was based on inaccurate values); In re Emerging Commc’ns, Inc. S’holders Litig., 2004 WL 1305745, at *40 (Del. Ch. May 3, 2004) (director with specialized financial and industry expertise could not claim reliance on expert report opining that merger price was fair because he had unique ability to ascertain the unfairness of merger price).

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and advancement for payment of defense costs and losses incurred in connection with

shareholder litigation and other proceedings.68

Courts frequently are called upon to evaluate the good faith of directors

and officers in the area of executive compensation. A number of Delaware cases have

highlighted the importance of good faith when issuing stock options as part of executive

compensation. The cases suggest that deliberate decisions to “backdate”69 or

“springload”70 stock option grants may constitute bad faith.71 The touchstone of such a

challenge to good faith is the deception of shareholders: a finding of bad faith in

connection with backdating or springloading requires an accompanying culpable lack of

disclosure to, or deception of, shareholders regarding the nature of such grants.72

Other recent decisions in cases challenging executive compensation

indicate that courts place great emphasis on the process employed by directors in

connection with compensation decisions, as opposed to imposing a bright-line test

68 DEL. CODE ANN. tit. 8, § 145. 69 When a stock option is improperly “backdated,” the exercise price at which the grantee may purchase the stock is selected with hindsight to make the award potentially more lucrative for the recipient. 70 “Springloading” is the practice of granting stock options before the company’s release of material information that is reasonably expected to increase the price of the stock, thereby providing the grantee with enhanced value for the option award. 71 See Ryan, 918 A.2d at 358 (“[T]he intentional violation of a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the directors’ purported compliance with that plan, constitute conduct that is disloyal to the corporation and is therefore an act in bad faith.”); In re Tyson Foods, Inc. Consol. S’holder Litig., 919 A.2d 563, 590-91 (Del. Ch. 2007) (“It is difficult to conceive of an instance, consistent with the concept of loyalty and good faith, in which a fiduciary may declare that an option is granted at ‘market rate’ and simultaneously withhold that both the fiduciary and the recipient knew at the time that those options would quickly be worth much more.”). 72 See Tyson, 919 A.2d at 592 & nn.75-76 (observing that granting springloaded stock options “involves an indirect deception” that is inconsistent with the “honesty of purpose” required by a director’s duty of good faith) (citing In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 755 (Del. Ch. 2005); see also Weiss v. Swanson, 948 A.2d 433, 442-48 (Del. Ch. 2008); Ryan, 918 A.2d at 355 n.35, 358.

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delineating “how much is too much.”73 Beyond process, the “outer limit” on a board’s

discretion with respect to executive compensation is that compensation may not be “so

disproportionately large as to be unconscionable and constitute waste.”74

II. The Development Of Fiduciary Duties In The United States

The concept of fiduciary duties in the United States originated from the

law of trusts. Under the law of trusts, a trustee who holds title to, but not ownership of, a

given property is required to act faithfully in managing that property for a beneficiary,

who lacks title, but who in equity could assert the benefits of ownership. Fiduciary duties

also have roots in the law of agency, which involves the delegation of powers to others to

act on behalf of and for the benefit of another.75

As corporations grew in size, ownership by the shareholders became more

widely dispersed, thereby creating a dichotomy between the interests of managers and

directors, on the one hand, and shareholders on the other. To realign these interests,

73 See, e.g., In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 749-50 (Del. Ch. 2005) (explaining that duty of care focuses on board process); In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 56-57 (Del. 2006) (focusing the due care inquiry on compensation committee’s process); Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000) (“Due care in the decisionmaking context is process due care only.”); see also Official Comm. of Unsecured Creditors of Integrated Health Servs. Inc. v. Elkins, 2004 WL 1949290, at *12 n.58, 15 (Del. Ch. Aug. 24, 2004) (distinguishing allegations that directors absolutely failed to deliberate and that they did not adequately deliberate the issue of executive compensation: “a change in characterization from a total lack of deliberation . . . to even a short conversation may change the outcome of [the good-faith] analysis”). 74 In re Citigroup, Inc. S’holder Deriv. Litig., 964 A.2d 106, 138 (Del. Ch. 2009) (plaintiffs had adequately alleged demand futility with respect to allegations that directors’ approval of retirement package for departing CEO constituted waste). 75 See Victor Brudney, Corporate Governance, Agency Costs, and the Rhetoric of Contract, 85 COLUM. L. REV. 1403, 1434 (1985) (explaining that trust and agency law formed the roots of corporate fiduciary duties). Under the agency theory of the corporation, the relationships among shareholders, managers, directors, and others in large corporations can be viewed as governed by contract. Shareholders, in pursuing their interests, must act through their agents, who are the managers and directors. Yet, managers and directors do not always act as diligently for their principal, the shareholders, as they would for themselves. This in turn leads to agency costs which are reduced in part by market forces. But because market forces alone are insufficient, fiduciary duties have formed part of the “standard form contract” among shareholders, managers, and directors and are designed to reduce agency costs. See David Millon, Redefining Corporate Law, 24 IND. L. REV. 223, 231-32 (1991); Melvin Aron Eisenberg, Contractual Freedom in Corporate Law, 89 COLUM. L. REV. 1461 (1989).

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courts began to apply the trustee-beneficiary concept to corporate law. Directors and

officers were initially treated as trustees, who had common-law obligations to act in the

best interests of the corporation’s beneficiaries—the shareholders. But over time, it

became evident that the concept of fiduciary duties of corporate directors and officers

differed from the fiduciary concept applied in the law of trusts and agency.76

Modern courts have recognized that it is incorrect to “equate[] the

standard of fiduciary duty of a corporate director with that of a trustee of a trust,”77

because “[t]he classic trusteeship is not essentially a risk taking enterprise, but a

caretaking one,” while diligent directors must be willing to take prudent risks in order to

fulfill their duties.78 Moreover, in applying fiduciary duties, courts have relaxed the

absolute prohibition against self-dealing transactions under trust law. See Section I.C.2,

supra.

In the seminal case of Guth v. Loft, the Delaware Supreme Court

explained the fundamental duties of corporate fiduciaries as follows:

Corporate officers and directors are not permitted to use their positions of trust and confidence to further their private interests. While technically not trustees, they stand in a fiduciary relation to the corporation and its stockholders. A public policy . . . has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most

76 “Corporate directors are not, strictly speaking, agents of the corporation or its shareholders. Agency is a hierarchical relationship in which the agent is subservient to the principal. Corporate directors … do not take orders from shareholders or from any other constituency in the corporation. Rather, the board of directors is empowered by statute to manage the corporation largely free from any restrictions or right of intervention by others.” See Matthew G. Dore, The Duties and Liabilities of an Iowa Corporate Director, 50 DRAKE L. REV. 207, 210 (2002) (footnotes omitted). 77 Stegemeier v. Magness, 728 A.2d 557, 562 (Del. 1999). 78 Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1148 (Del. Ch. 1994); see also Citigroup, 964 A.2d at 115 n.6, 125 (“In defining [fiduciary] duties, the courts balance specific policy considerations such as the need to keep directors and officers accountable to shareholders and the degree to which the threat of personal liability may discourage beneficial risk taking. . . . [T]he core protections of the business judgment rule [are] designed to allow corporate managers and directors to pursue risky transactions without the specter of being held personally liable if those decisions turn out poorly.”).

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scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its powers. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. The occasions for the determination of honesty, good faith and loyal conduct are many and varied, and no hard and fast rule can be formulated.79

The origins of the “business judgment rule,” discussed infra, and the

judicial reluctance to interfere with directors’ decisions dates back to English law in the

1700s and 1800s.80 In the U.S., the concept underlying the business judgment rule was

first adopted by the Louisiana Supreme Court in 1829.81 In Percy v. Millaudon, the court

wrote that the “test of responsibility [for directors], therefore, should be, not the certainty

of wisdom in others, but the possession of ordinary knowledge; and by shewing that the

error of the [director] is of so gross a kind, that a man of common sense, and ordinary

attention, would not have fallen into it.”82 During the 1800s and early 1900s, courts

throughout the U.S. began to articulate early versions of the rule, leading to today’s

expansive jurisprudence on the subject.83

III. To Whom Fiduciary Duties Are Owed

In Delaware and certain other jurisdictions, directors owe their fiduciary

duties to the corporation and its common shareholders.84 Often, shareholders pursue

79 5 A.2d at 510. 80 RADIN, supra note 4, at 26; see also Foss v. Harbottle, [1843] 67 E.R. 189. 81 RADIN, supra note 4, at 26. 82 8 Mart. (n.s.) 68, 78 (La. 1829). 83 RADIN, supra note 4, at 26-28; see also Hawes v. City of Oakland, 104 U.S. 450, 456-57 (1881) (stating that the rule established in Foss v. Harbottle “should always be adhered to”). 84 See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007) (“It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders.”);

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litigation alleging that directors breached their fiduciary duties. In a “derivative” suit, a

shareholder plaintiff attempts to “stand in the shoes” of the company and assert claims

belonging to the corporation on its behalf. As explained below, a derivative suit is

permitted where the court finds that the board of directors is disabled from pursuing the

corporation’s claims. While under U.S. law directors may be held personally liable for

egregious breaches of fiduciary duty (e.g., acts taken in bad faith), most corporations

have in place statutorily-authorized exculpatory and indemnificatory provisions for

breaches of due care, see infra notes 108-111 and accompanying text, as well as directors

and officers insurance to protect directors from personal liability where the directors have

acted in good faith and in the best interests of the corporation.

In certain circumstances, however, the general rule that directors owe

fiduciary duties only to the corporation and its common shareholders does not apply. For

example, directors may owe duties to other constituencies in certain change of control

transactions or when the corporation has multiple classes of shareholders, including

preferred shareholders. And when the corporation is insolvent or enters the “zone of

insolvency,” directors may be permitted to consider the interests of other constituencies.

These various issues are set forth below.

A. Shareholder Derivative Suits

As explained above, the directors of a corporation—and not its

shareholders—manage the business and affairs of the company.85 This includes the

Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 179 (Del. 1986); Arnold v. Soc’y for Sav. Bancorp, Inc., 678 A.2d 533, 539 (Del. 1996). 85 See DEL. CODE ANN. tit. 8, § 141(a); supra § I.A.

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decision whether the pursuit of a lawsuit is or is not in the corporation’s best interests.86

Accordingly, the concept of a shareholder “derivative” suit developed to enable

shareholders to assert claims on behalf of the corporation that the board would not have

pursued because the majority of the directors are interested in the transaction at issue or

otherwise are disabled from determining whether bringing the suit is in the corporation’s

best interests. A derivative claim belongs to the company and, thus, is brought by a

shareholder in order “to enforce a corporate cause of action against officers, directors,

and third parties.”87

Shareholders typically commence derivative suits against directors and

officers for alleged breaches of fiduciary duty (e.g., mismanagement of the company,

self-dealing, etc.), “waste” of corporate assets, or ultra vires acts (acts outside the

corporate power). Shareholders also may name third parties (e.g., auditors, bankers, or

lawyers) as defendants in derivative suits.88 The relief obtained in a derivative action

inures to the benefit of the corporation, not the shareholder plaintiff.89 Further, a plaintiff

in a derivative action must be a shareholder of the corporation at the time of the

transaction complained of and must remain a shareholder throughout the litigation.90

Demand Requirement. In Delaware and many other states, a shareholder

may not bring a derivative action until (i) the shareholder has made a “demand” on the

86 See Stone v. Ritter, 911 A.2d 362, 366-67 (Del. 2006); White v. Panic, 783 A.2d 543, 550 (Del. 2001); Brehm v. Eisner, 746 A.2d 244, 257 (Del. 2000). 87 Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (internal quotations omitted); Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031, 1036 (Del. 2004). 88 See, e.g., In re Enron Corp. Sec., Deriv. & “ERISA” Litig., C.A. No. H-01-3624 (S.D. Tex.) (naming as defendants various legal advisors, financial institutions, and outside auditors of Enron). 89 See Tooley, 845 A.2d at 1036 (“Because a derivative suit is being brought on behalf of the corporation, the recovery, if any, must go to the corporation.”). 90 See DEL. CODE ANN. tit. 8, § 327; DEL. CT. CH. R. 23.1; 7547 Partners v. Beck, 682 A.2d 160, 162-63 (Del. 1996); Conrad v. Blank, 940 A.2d 28, 41 (Del. Ch. 2007).

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board to initiate the lawsuit, which the board has wrongfully refused, or (ii) the

shareholder has demonstrated that demand would be “futile” and thus is “excused.”91

Some states have a statutory “universal demand” provision that requires demand even

where demand would be futile.92 The demand requirement reflects the universally

recognized “‘basic principle of corporate governance that the decisions of a

corporation—including the decision to initiate litigation—should be made by the board of

directors or the majority of shareholders.’”93

Demand Refused. Before commencing derivative litigation, a shareholder

has the option of submitting to the board of directors a written demand setting forth the

reasons why the company should commence litigation against the alleged wrongdoers.

The effect of the written demand “‘is to place control of the derivative litigation in the

hands of the board of directors.’”94 By making demand, the shareholder waives the right

to argue that demand would be futile.95 After receiving a demand, the directors may

decide, in their business judgment, to pursue the litigation, to resolve the grievance

internally without litigation, or to refuse the demand.96 The board also may determine

not to initiate litigation, but to allow the shareholder to commence and pursue the action

on the company’s behalf.97 If the board refuses the demand, and the shareholder can

91 See Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984); White, 783 A.2d at 550 (citing Brehm, 746 A.2d at 255); Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993). 92 See 2 RMBCA, supra note 20, § 7.42; RADIN, supra note 4, at 4556-65. 93 Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 101 (1991) (citation omitted); see also Hawes v. City of Oakland, 104 U.S. 450, 461 (1881); Aronson, 473 A.2d at 812. 94 Levine v. Smith, 591 A.2d 194, 212 (Del. 1991) (citation omitted). 95 See Grimes v. Donald, 673 A.2d 1207, 1218 (Del. 1996) (“If a demand is made, the stockholder has spent one . . . ‘arrow’ in the ‘quiver.’” (citation omitted)). 96 Rales, 634 A.2d at 935. 97 See Halprin v. Babbitt, 303 F.2d 138, 142 (1st Cir. 1962).

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demonstrate that the refusal was “wrongful,” the shareholder may pursue the litigation.

But if refusal was not “wrongful,” “the stockholders’ ability to initiate a derivative suit is

terminated.”98 The determination whether a refusal is “wrongful” turns upon the same

“deferential ‘business judgment rule’ standard of review” by which business decisions

normally are tested.99 Thus, in most circumstances, it is difficult for shareholders to

demonstrate that the board’s refusal was wrongful.

Demand Excused. In lieu of making a demand on the board, shareholder

plaintiffs typically assert that a demand should be excused as “futile.” Demand futility

occurs when the shareholder derivative plaintiff alleges “particularized facts” that create

a reason to doubt that a majority of the board could have exercised independent and

disinterested business judgment in responding to a demand.100 Demand also may be

excused as futile if the plaintiff pleads particularized facts showing that the nature of the

challenged transaction constitutes a gift or waste of corporate assets or is otherwise so

egregious that it cannot possibly constitute a proper exercise of business judgment.101

Where the shareholder satisfies the burden of pleading demand excusal, the shareholder

may proceed with the lawsuit derivatively, on behalf of the company, without making a

demand on the board of directors.102

98 Spiegel v. Buntrock, 571 A.2d 767, 775 (Del. 1990) (internal quotation omitted). 99 See infra § IV.A.; see also Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 101 (1991). 100 See, e.g., Beam v. Stewart, 845 A.2d 1040, 1049, 1050-52 (Del. 2004) (in considering demand futility, holding that allegations of social friendship, standing alone, do not demonstrate a lack of director independence); In re Citigroup Inc. S’holders Litig., 2003 WL 21384599, at *1 (Del. Ch. June 5, 2003), aff’d sub nom. Rabinovitz v. Shapiro, 839 A.2d 666 (Del. 2003); DEL. CT. CH. R. 23.1. 101 See Aronson v. Lewis, 473 A.2d 805, 814-15 (Del. 1984). 102 Even where demand is excused, however, the litigation may be terminated by a “special litigation committee” (“SLC”) composed solely of disinterested and independent directors who are vested with full authority to act on behalf of the corporation with respect to the litigation. After determining whether pursuit of the derivative litigation will serve the best interests of the corporation, the SLC may determine “to terminate the litigation, to take it over, or to permit the plaintiff’s action to continue.” Strougo v.

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Shareholder Demands For Company Books and Records. Under

Delaware law, shareholders are entitled to inspect company books and records if they

have a “proper purpose” for doing so.103 Often, shareholders argue that a “proper

purpose” includes obtaining information to prepare a shareholder derivative complaint

against directors for breach of fiduciary duty or other violations. Such a purpose may be

a proper basis for a books and records inspection if the shareholder presents “some

evidence suggesting a credible basis from which a court can infer that mismanagement or

wrongdoing may have occurred.”104 Investigating whether a board wrongfully refused a

litigation demand can also be a proper purpose.105 If the court determines that the

shareholder’s purpose for requesting inspection of company books and records is not

proper, however, the books and records request will be denied.106 The Delaware courts

have encouraged would-be shareholder plaintiffs to use the “tools at hand”—a books and

Padegs, 986 F. Supp. 812, 814 (S.D.N.Y. 1997); see also Zapata Corp. v. Maldonado, 430 A.2d 779, 788 (Del. 1981); London v. Tyrrell, 2010 Del. Ch. LEXIS 54, at *37-38 (Del. Ch. Mar. 11, 2010); In re Oracle Corp. Deriv. Litig., 824 A.2d 917, 923, 928 (Del. Ch. 2003); Biondi v. Scrushy, 820 A.2d 1148, 1164 (Del. Ch. 2003). 103 DEL. CODE ANN. tit. 8, § 220; Highland Select Equity Fund, L.P. v. Motient Corp., 906 A.2d 156, 164 (Del. Ch. 2006), clarified, 2007 Del. Ch. LEXIS 37 (Del. Ch. Feb. 26, 2007), aff’d, 922 A.2d 415 (Del. 2007). 104 City of Westland Police & Fire Ret. Sys. v. Axcelis Techs., Inc., 2010 WL 3157143, at *5 (Del. Aug. 11, 2010); Seinfeld v. Verizon Commc’ns, Inc., 909 A.2d 117, 118 (Del. 2006). 105 La. Municipal Police Emps. Ret. Sys. v. Morgan Stanley & Co., C.A. No. 5682-VCL, slip op. at 8 (Del. Ch. Mar. 4, 2011). See supra pp. 22-23 for discussion of wrongful refusal of a demand. 106 See, e.g., City of Westland Police & Fire Ret. Sys. v. Axcelis Techs., Inc., 2009 WL 3086537, at *8 (Del. Ch. Sept. 28, 2009) (rejecting books and records demand where plaintiff failed to demonstrate any credible basis showing that directors breached fiduciary duties), aff’d 2010 WL 3157143 (Del. Aug. 11, 2010); Beiser v. PMC-Sierra, Inc., 2009 WL 483321, at *1 (Del. Ch. Feb. 26, 2009) (rejecting inspection where shareholder did not have a proper purpose because plaintiff sought inspection in order to circumvent a stay of discovery pending in parallel federal litigation); West Coast Mgmt. & Capital, LLC v. Carrier Access Corp., 914 A.2d 636, 638 (Del. Ch. 2006) (rejecting inspection where shareholder did not have a proper purpose); Polygon Global Opportunities Master Fund, 2006 Del. Ch. LEXIS 179, at *2 (Del. Ch. Oct. 12, 2006) (same); cf. Disney v. Walt Disney Co., 857 A.2d 444, 450 (Del. Ch. 2004) (preventing director from publicly disseminating company documents obtained in § 220 inspection because a shareholder “cannot use confidential information received for the proper purpose of investigating and seeking to remediate wrongdoing for the purpose of being a self-appointed publisher of the Company’s propriety information”).

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records request under DGCL § 220—to obtain information to support their claims before

filing derivative complaints.107

B. Exculpatory Provisions for Director Breaches of Due Care

Section § 102(b)(7) of the DGCL is an important enabling provision

authorizing shareholders to adopt, in the certificate of incorporation, a “provision

eliminating or limiting the personal liability of a director to the corporation or its

stockholders for monetary damages for breach of fiduciary duty as a director.” 108 This

statutory provision allows corporations to adopt a provision that exculpates directors109

from monetary damages for breaches of the duty of care,110 but does not shield directors

from liability for actions involving: (1) breach of the duty of loyalty; (2) “acts or

omissions not in good faith or which involve intentional misconduct or knowing violation

107 See, e.g., Seinfeld, 909 A.2d at 120; Beam v. Stewart, 845 A.2d 1040, 1049, 1056-57 (Del. 2004); Brehm v. Eisner, 746 A.2d 244, 266 (Del. 2000); Beiser, 2009 WL 483321, at *3; Norfolk Cnty. Ret. Sys. v. Jos. A. Bank Clothiers, Inc., 2009 WL 353746, at *14 (Del. Ch. Feb. 12, 2009); Saito v. McCall, 2004 WL 3029876, at *1 (Del. Ch. Dec. 20, 2004); In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 279 (Del. Ch. 2003). But see King v. Verifone Holdings, Inc., 2011 WL 284966, at *7 (Del. Jan. 28, 2011) (holding that filing a derivative action before seeking books and records does not, without more, bar a shareholder from pursuing a later-filed section 220 action). 108 Delaware enacted Section 102(b)(7) in 1986 in response to the landmark decision of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), which held that directors had breached their duty of care in connection with a corporate merger transaction. The court held that the directors improperly approved the transaction—even though it provided shareholders a substantial premium above the market price for their shares—because they had not adequately informed themselves about the merger and were grossly negligent in “approving the ‘sale’ of the company upon two hours’ consideration, without prior notice, and without the exigency of a crisis or emergency.” Id. at 874. Most states now have statutes similar to DGCL § 102(b)(7). The statutes help protect corporations’ ability to attract and retain qualified directors by protecting them from claims of gross negligence. See Resolution Trust Corp. v. CityFed Fin. Corp., 57 F.3d 1231, 1239 (3d Cir. 1995). 109 DGCL § 102(b)(7) protects only directors, not officers. Gantler v. Stephens, 965 A.2d 695, 709 n.37 (Del. 2009). 110 Emerald Partners v. Berlin, 787 A.2d 85, 90 (Del. 2001); see also Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 244 (Del. 2009) (holding that section 102(b)(7) charter provision protected directors because plaintiffs failed to demonstrate bad faith and showed, at most, a breach of the duty of care); Wayne County Emps. Ret. Sys. v. Corti, 2009 WL 2219260, at *19 (Del. Ch. July 24, 2009) (dismissing claims against directors because corporation’s section 102(b)(7) provision “eliminates the personal liability of the Director Defendants for monetary damages for breaches of the duty of care, including actions that constitute gross negligence”).

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of law”; (3) unlawful payments of dividends or unlawful stock purchases or redemptions;

or (4) “any transaction from which the director derived an improper personal benefit.”111

C. Indemnification Rights and Directors and Officers Insurance

Many state statutes specifically authorize the corporation to indemnify

directors, officers, employees, and agents in certain situations.112 In some cases,

indemnification may be mandatory pursuant to statute. For example, the Delaware

statute makes indemnification mandatory when the person to be indemnified has been

“successful on the merits or otherwise.”113 Indemnification also may be mandatory

pursuant to a charter, bylaw, or contract provision that provides that indemnification that

otherwise would be permissive “shall” be granted “to the fullest extent permitted by

law.”114 Indemnification is permissive when specified standards of conduct are met,

namely, when indemnifiable persons acted in “good faith and in a manner the person

reasonably believed to be in or not opposed to the best interests of the corporation.”115

111 DEL. CODE ANN. tit. 8, § 102(b)(7); see also In re NYMEX S’holder Litig., 2009 WL 3206051, at *6 (Del. Ch. Sept. 30, 2009) (dismissing complaint because plaintiff failed to “successfully plead[] a failure to act loyally (or in good faith), which would preclude reliance on the Section 102(b)(7) provision”); Prod. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 777 (Del. Ch. 2004); Disney, 825 A.2d at 286, 290 (directors lose the protections of Section 102(b)(7) and may be held personally liable for monetary damages if their actions are found to be not in good faith). 112 See, e.g., DEL. CODE ANN. tit. 8, § 145(a). Note that certain states do not authorize indemnification for employees and agents. See, e.g., N.Y. BUS. CORP. LAW §§ 721-26. See RADIN, supra note 4, at 5171-79, for discussion of public policy considerations with respect to indemnification. 113 DEL. CODE ANN. tit. 8, § 145(c); see also May v. Bigmar, Inc., 838 A.2d 285 (Del. Ch. 2003), aff'd, 854 A.2d 1158 (Del. 2004) (holding officer was entitled to indemnification for legal fees incurred in successfully defending certain claims). 114 See 2 RMBCA, supra note 20, § 8.58(a). It is advantageous for directors to have an indemnification contract because it generally cannot be rescinded without the consent of the director, while charters and bylaws can be amended without a director’s consent. But see H.B. 19, 145th Gen. Assem., § 3 (Del. 2009) (amending DGCL § 145(f) to provide that rights to indemnification or advancement of expenses set forth in the certificate of incorporation or bylaws cannot later be impaired unless such impairment is provided for in the original charter or bylaw provision). 115 DEL. CODE ANN. tit. 8, § 145(a); see In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 66 (Del. 2006) (“[U]nder Delaware statutory law a director or officer of a corporation can be indemnified for liability (and litigation expenses) incurred by reason of a violation of the duty of care, but not for a violation of the duty to act in good faith.”).

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The corporation also may advance legal fees and expenses incurred defending the claims,

if the indemnified person furnishes an undertaking to repay all sums advanced if it

ultimately is determined that he or she was not entitled to indemnification.116

The majority of state statutes also authorize corporations to purchase and

maintain insurance for directors, officers, employees, and agents for both indemnifiable

and nonindemnifiable liabilities.117 “D&O” insurance protects directors and officers

from potential gaps in the availability of indemnification.118 It also provides a means by

which corporations can insure for indemnification and advancement payments to

directors and officers. Limitations on the extent of coverage may be supplied by

insurance law or by public policy considerations.119

D. Consideration of Other Constituencies

Preferred Shareholders. Although directors usually owe their fiduciary

duties to all shareholders, different rules apply when the corporation has multiple classes

of shareholders, including preferred shareholders. Unlike the rights of common

shareholders, the rights of preferred shareholders are fixed by the contract that created the

class of preferred stock.120 Thus, the rights of preferred shareholders depend on their

contracts with the corporation (typically their stock certificates), which, like most

contracts, usually include the implied duty of good faith and fair dealing but do not

include fiduciary obligations. Preferred stockholders do, however, have standing to bring

116 See, e.g., DEL. CODE ANN. tit. 8, § 145(e); Homestore, Inc. v. Tafeen, 888 A.2d 204, 211-13 (Del. 2005). 117 See, e.g., DEL. CODE ANN. tit. 8, § 145(g). 118 See RADIN, supra note 4, at 5577-79. 119 See id. at 5579-83. 120 See id. at 2027-28.

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derivative claims on the corporation’s behalf unless the certificate of incorporation or the

certificate of designations has explicitly limited that right.121

Creditors and the Zone of Insolvency. Directors of a solvent corporation

do not owe fiduciary duties to a corporation’s creditors because creditors do not have an

existing property right or an equitable interest that supports these duties when a

corporation is solvent.122 Rather, the relationship between a solvent corporation and its

creditors is contractual in nature.123 The Delaware Supreme Court has made clear that

creditors “have no right, as a matter of law, to assert direct claims for breach of fiduciary

duty against the corporation’s directors,” whether the corporation is solvent, insolvent, or

in the “zone of insolvency.”124 Creditors of an insolvent corporation may, however, have

standing to pursue derivative claims for breach of fiduciary duty.125 The fact of

insolvency or near insolvency does not foreclose the board’s ability to act in the interests

of shareholders, but directors taking action in the shareholders’ interests may take into

account the creditors’ interests.126 Thus, so long as they appropriately divide their duties

121 MCG Capital Corp. v. Maginn, 2010 Del. Ch. LEXIS 87, at *19-20 (Del. Ch. May 5, 2010). 122 See Simons v. Cogan, 549 A.2d 300, 304 (Del. 1988) (affirming dismissal of class action suit because appellants, holders of convertible debentures, did not have standing to bring breach of fiduciary duty claims against a solvent corporation and its directors). 123 See Katz v. Oak Indus. Inc., 508 A.2d 873, 879 (Del. 1986) (holding that relationship between plaintiff debt holder and solvent corporation was defined by the terms of their contractual agreement). 124 N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 94, 99-103 (Del. 2007); see also Vichi v. Koninklijke Philips Elecs. N.V., 2009 Del. Ch. LEXIS 209, at *69-70 (Del. Ch. Dec. 1, 2009) (applying this rule in the LLC context). Delaware courts have yet to provide a definition for when a corporation is operating in the “vicinity” or “zone” of insolvency. “Insolvency” has been defined as either of two circumstances: (1) when the corporation “is unable to pay its debts as they fall due in the usual course of business” (i.e., the “equity” definition); or (2) “when it has liabilities in excess of a reasonable market value of assets held” (i.e., the “balance sheet” definition). Geyer v. Ingersoll Publ’ns Co., 621 A.2d 784, 787-89 (Del. Ch. 1992). 125 Gheewalla, 930 A.2d at 101-02. The Gheewalla decision does not address, even in dicta, whether creditors of a solvent corporation in the “zone of insolvency” have standing to assert derivative claims. 126 See Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174-75 (Del. Ch. 2006) (where corporation is insolvent or in zone of insolvency, “[s]o long as directors are respectful of the corporation’s

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among the various corporate constituencies, the directors of an insolvent or a nearly

insolvent corporation retain ample latitude to exercise good faith business judgment in an

effort to devise a business plan to save the corporate enterprise.127

Constituency Statutes. Many states—but not Delaware—have enacted

statutes that expressly permit directors to consider non-shareholder constituencies, such

as employees, suppliers, creditors, consumers, the local and national economies, and

society as a whole, when responding to contests for corporate control.128 Most of these

statutes do not, however, require that directors consider such non-shareholder interests.

Rather, the statutes are permissive and allow directors to consider non-shareholder

interests if appropriate under the circumstances.129

IV. How Fiduciary Duties Are Manifested in U.S. Jurisdictions

An understanding of fiduciary duties and how they manifest themselves in

U.S. jurisdictions requires knowledge of the various forms of judicial review130 with

which courts will evaluate director activity—most notably, the “business judgment rule.”

This is because the determination of which standard of judicial review should apply

obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.”). 127 See, e.g., In re RegO Co., 623 A.2d 92, 109 n.35 (Del. Ch. 1992) (where directors of a dissolved corporation, “during the course of winding-up corporate affairs, [are] required to make decisions affecting various classes of interest holders, they are protected from liability in doing so, as long as they act disinterestedly, with due care and in good faith”). 128 See, e.g., LA. BUS. CORP. LAW § 12:92(G)(1); N.Y. BUS. CORP. LAW § 717(b); NEV. GEN. CORP. LAW § 78.138(4). 129 See statutes cited supra note 128; see also RADIN, supra note 4, at 2639-55. 130 See William T. Allen, Jack B. Jacobs & Leo E. Strine, Function over Form: A Reassessment of Standards of Review in Delaware Corporation Law, 56 BUS. LAW. 1287, 1295 (2001); see also Melvin A. Eisenberg, The Divergence of Standards of Conduct and Standards of Review in Corporate Law, 62 FORDHAM L. REV. 437, 437 (1993).

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frequently determines the outcome of the litigation.131 In general, Delaware courts

review fiduciary duty claims by applying one of three types of standards of review: (i) the

business judgment rule; (ii) entire fairness; or (iii) intermediate standards in sale,

takeover, and merger transactions.

A. The Business Judgment Rule

The business judgment rule is a judicial presumption that business

decisions are made: (i) by disinterested, independent directors; (ii) with informed due

care; and (iii) with a good faith belief that the decision will serve the corporation’s best

interests.132 If the party challenging a director decision cannot overcome the presumption

(which is rarely overcome) by alleging facts challenging the process, good faith, or

independence of the board, or by alleging facts suggesting that the directors’ decision

cannot be attributed to any rational business purpose, then the courts will not second-

guess the substance of the decision.133 The presumption, however, does not protect

director decisions that constitute fraud, illegality, ultra vires conduct (acts not within

corporate power), waste, or that were not taken in “good faith.”134 The business

131 See Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1371 (Del. 1995); see also Bradley R. Aronstam, et al., Delaware’s Going Private Dilemma: Fostering Protections for Minority Shareholders in the Wake of Siliconix and Unocal Exploration, 58 BUS. LAW. 519, 523 (2003). 132 See In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 52 (Del. 2006); Beam v. Stewart, 845 A.2d 1040, 1048 n.16 (Del. 2004) (quoting Aronson, 473 A.2d at 812); Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 927 (Del. 2003); PRINCIPLES, supra note 18, § 4.01. 133 Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1162 (Del. 1995); see also Unocal Corp. v. Mesa Petroleum Corp., 493 A.2d 946, 954 (Del. 1985) (“A court will not substitute its own views for those of the directors, if the directors’ decision can be ‘attributed to any rational purpose.’” (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 719-20 (Del. 1971)); 2 RMBCA, supra note 20, § 8.31, cmt. at 8-232-35; RADIN, supra note 4, at 40-44; E. Norman Veasey, The Defining Tension in Corporate Governance in America, 52 BUS. LAW. 393, 394 (1997). 134 See Disney, 906 A.2d at 52-53; ATR-Kim Eng Fin. Corp. v. Araneta, 2006 Del. Ch. LEXIS 215, at *71 (Del. Ch. Dec. 21, 2006) (“[I]t is fundamental that a director cannot act loyally towards the corporation unless she tries—i.e., makes a genuine, good faith effort—to do her job as a director.”); Litt v. Wycoff, 2003 Del. Ch. LEXIS 23, at *26-32 (Del. Ch. Mar. 28, 2003) (business judgment rule does not apply to transactions that allegedly constitute bribery); Cal. Pub. Emps. Ret. Sys. v. Coulter, 2002 Del. Ch. LEXIS

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judgment rule encourages directors to take risks in the decision-making process without

fearing that a court, with 20/20 hindsight, will later second-guess the substance of the

directors’ business decision.135 Stated differently, “[c]ourts recognize that even

disinterested, well-intentioned, informed directors can make decisions that, in hindsight,

[are] improvident” and cause the company to lose money.136

Fiduciary duties, discussed supra § I.C., and the business judgment rule

are two related judicial concepts that affect the directors’ role in managing and

overseeing corporate affairs: the duty of care, for example, establishes for directors a

standard of conduct while the business judgment rule is a form of judicial review of

director conduct. A plaintiff seeking to establish a breach of the duty of care first must

establish facts sufficient to overcome the presumption that the directors acted with due

care. If the plaintiff is able to do so, the burden shifts to the directors to prove that they

did in fact act with the requisite degree of care (i.e., they were not “grossly negligent”).137

The duty of care “in the decision-making context is process due care only.”138 To

overcome the presumption of the business judgment rule, the plaintiff must plead

particularized facts that, if proven, would demonstrate that the directors or officers 144, at *39 (Del. Ch. Dec. 18, 2002) (business judgment rule not applicable because board action was ultra vires); Alidina v. Internet.com Corp., 2002 WL 31584292, at *4 (Del. Ch. Nov. 6, 2002) (business judgment rule does not apply to a decision “‘so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith’” (citation omitted)). 135 See RADIN, supra note 4, at 30-32 (citing Air Line Pilots Ass’n v. UAL Corp., 717 F. Supp. 575, 582 (N.D. Ill. 1989) (“if stricter liability were imposed on directors, the founders of McDonald’s Corporation who put $3 million at risk to patent a novel hamburger manufacturing technique might never have made this profitable decision”)); see also Hawes v. City of Oakland, 104 U.S. 450, 456-57 (1881). 136 Wash. Bancorp. v. Said, 812 F. Supp. 1256, 1267-68 (D.D.C. 1993). 137 RADIN, supra note 4, at 425. 138 Brehm v. Eisner, 746 A.2d 244, 264, 259 & n.66 (Del. 2000) (emphasis in original); see also Ash v. McCall, 2000 WL 1370341, at *8 (Del. Ch. Sept. 15, 2000) (“substantive due care [is] a concept that is foreign to the business judgment rule . . . Due care in the decision making context is process due care—whether the board was reasonably informed of all material information reasonably available at the time it made its decision”).

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“reach[ed] their decision by a grossly negligent process that includes the failure to

consider all material facts reasonably available.”139 Thus, when the business judgment

rule applies, the courts will consider only whether the directors acted in informed good

faith, in a reasonably prudent manner under the circumstances, and employed the proper

processes to reach their business decision—the courts will not decide if the directors’

decision was substantively reasonable. Accordingly, under the business judgment rule,

so long as there is no other breach of fiduciary duty (or violation of law), a director who

performs his or her duties in compliance with the requisite standard of procedural due

care should face no liability as the result of a decision that turns out to be unwise or a

mistake in judgment.140

A director will not be liable for money damages to the corporation or the

shareholders for a breach of the duty of care unless he or she acted with the necessary

degree of culpability—that is, “gross negligence.”141 Under the “gross negligence”

standard, it is not sufficient for a plaintiff to allege merely that directors or officers

“consistently made poor decisions” or that the corporation “suffered losses” because of

those poor decisions,142 or that “there are costs, even great costs, associated with a

business decision,”143 or that “a corporation loses a large amount of money.”144 Such

139 Brehm, 746 A.2d at 264 n.66 (emphasis added); see also Malpiede v. Townson, 780 A.2d 1075, 1089 (Del. 2001); RADIN, supra note 4, at 314-16. 140 See McMullin v. Beran, 765 A.2d 910, 917 (Del. 2000); In re Digex, Inc. S’holders Litig., 789 A.2d 1186, 1194 (Del. Ch. 2001) (although courts “encourage directors to aspire to ideal corporate governance practices, directors’ actions need not achieve perfection to avoid liability”); cf. Smith v. Van Gorkom, 488 A.2d 858, 874 (Del. 1985) (directors had not adequately informed themselves about a proposed merger and were grossly negligent in “approving the ‘sale’ of the Company upon two hours’ consideration, without prior notice, and without the exigency of a crisis or emergency”). 141 RADIN, supra note 4, at 309-10. 142 Andreae v. Andreae, 1992 WL 43924, at *7-8 (Del. Ch. Mar. 5, 1992). 143 Silverzweig v. Unocal Corp., 1989 WL 3231, at *3 (Del. Ch. Jan. 19, 1989).

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allegations improperly challenge the substance of the directors’ or officers’ decisions—

not the process—and thus fall outside the business judgment rule analysis.145

B. Entire Fairness

If the plaintiff overcomes the business judgment rule presumption, the

fiduciary bears the onerous burden of showing that the action was “entirely fair” to the

corporation and its shareholders.146 That is, the fiduciary bears the burden of proving:

(1) “fair dealing”—the process that the board followed was fair and reasonable; and

(2) “fair price”—the price the shareholders received was within a range of fair value.147

Controlling Shareholder Transaction. By definition, a “controlling

shareholder” either possesses “ownership of or the unrestricted power to vote more than

50 percent of the corporation’s outstanding voting securities,” or exercises “actual

control” over the corporation148 or a particular transaction.149 In such circumstances, the

controlling shareholder takes on the status of a fiduciary, and a transaction between a

144 In re Citigroup, Inc. S’holder Deriv. Litig., 964 A.2d 106, 126 (Del. Ch. 2009); Weiland v. Ill. Power Co., 1990 WL 267364, at *12 (C.D. Ill. Sept. 17, 1990); Wilson v. Tully, 243 A.D.2d 229, 238 (N.Y. App. Div. 1st Dep’t 1998). 145 Brehm v. Eisner, 746 A.2d 244, 259, 264 & n.66 (Del. 2000); Ash v. McCall, 2000 WL 1370341, at *9-10 (Del. Ch. Sept. 15, 2000). 146 See Allen, Jacobs & Strine, supra note 130, at 1302. 147 Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1172-76 (Del. 1995); Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983); In re Loral Space & Commc’ns, Inc., 2008 WL 4293781, at *22 (Del. Ch. Sept. 19, 2008). 148 Stephen A. Radin, Fiduciary Duties of Controlling Shareholders, BUS. & SEC. LITIGATOR (Dec. 1999), available at http://www.weil.com/news/pubdetail.aspx?pub=8411; see also Emerald Partners v. Berlin, 726 A.2d 1215, 1221 n.8 (Del. 1999); Kahn v. Tremont Corp., 694 A.2d 422, 423-24, 428 n.3 (Del. 1997); In re John Q. Hammons Hotels, Inc. S’holder Litig., 2009 WL 3165613, at *2 (Del. Ch. Oct. 2, 2009); La. Mun. Police Emps. Ret. Sys. v. Fertitta, 2009 Del. Ch. LEXIS 144, at *28 (Del. Ch. July 28, 2009). 149 Williamson v. Cox Commc’ns, Inc., 2006 Del. Ch. LEXIS 111, at *15 (Del. Ch. June 5, 2006); In re W. Nat’l Corp. S’holders Litig., 2000 Del. Ch. LEXIS 82, at *70 (Del. Ch. May 22, 2000).

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corporation and its controlling shareholder is treated as an “interested” transaction.150

There is nothing inherently improper about a transaction between a company and its

controlling shareholder.151 Nonetheless, controlling shareholders owe fiduciary duties to

the corporation and its minority shareholders and, thus, may not exercise that control to

the minority’s detriment.152

Accordingly, when a controlling shareholder engages in a negotiated,

cash-out merger with the company, entire fairness review—not the business judgment

rule—usually applies.153 Even if entire fairness review applies, however, the burden of

proving entire fairness shifts from the controlling shareholder to the plaintiff when the

transaction is approved by either: (i) a well-informed majority of the disinterested

(minority) stockholders,154 or (ii) a properly functioning committee of disinterested and

independent directors.155 When such approval is given, a court likely will find the

controlling shareholder transaction to have been “entirely fair.”156

Further, when a transaction with a controlling shareholder is consummated

in the form of a “two-step” transaction—a tender offer followed by a short-form

150 RADIN, supra note 4, at 1215. 151 See Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 846 (Del. 1987); In re MAXXAM, Inc./Federated Dev. S’holders Litig., 1997 WL 187317, at *22 (Del. Ch. Apr. 4, 1997). 152 Thorpe v. CERBCO, Inc., 676 A.2d 436, 442 (Del. 1996); Weinberger, 457 A.2d at 709; Hollinger Int’l Inc. v. Black, 844 A.2d 1022, 1087 (Del. Ch. 2004). 153 See Kahn v. Lynch Commc’ns Sys., Inc., 638 A.2d 1110, 1115 (Del. 1994); cf. Hammons Hotels, 2009 WL 3165613, at *12 (business judgment rule applicable if controlling shareholder does not stand on both sides of the transaction because offer is made by a third party, and if transaction is approved by both a committee of disinterested and independent directors and by a majority of the minority shareholders). 154 See Lynch, 638 A.2d at 1116; Rosenblatt v. Getty Oil Co., 493 A.2d 929, 937 (Del. 1985); In re LNR Prop. Corp. S’holders Litig., 896 A.2d 169, 178 n.52 (Del. Ch. 2005); RADIN, supra note 4, at 1274. 155 See LNR, 896 A.2d at 178 n.52; RADIN, supra note 4, at 1286-1318 (citing cases). 156 See, e.g., Emerald Partners v. Berlin, 840 A.2d 641 (Del. 2003) (affirming holding that merger between corporation and its controlling shareholder was “entirely fair” to minority shareholders because merger price was fair—even though court agreed there were “many process flaws” that raised “serious questions as to the independent directors’ good faith”).

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merger157—business judgment review likely will apply only if the transaction is both (i)

negotiated and approved by a properly functioning committee of disinterested and

independent directors, and (ii) conditioned on an affirmative vote of a majority of the

minority stockholders.158

Despite these constraints, controlling shareholders may act and vote in

their own economic interest, and may not “be disenfranchised because they may reap a

benefit from corporate action which is regular on its face.”159 A controlling shareholder

has no duty to sell his or her shares simply because that sale would benefit the minority

shareholders.160 Moreover, a controlling shareholder may sell his or her shares at a

premium not available to other shareholders.161

2. Intermediate Standards in Sale, Takeover, and Merger Transactions

The interests of directors and stockholders may not precisely coincide in

the case of mergers and acquisitions, and the duties of directors may be different in a sale

transaction (maximizing immediate value) than in a merger of equals (maximizing the

likelihood of long-term value). Thus, the Delaware courts have developed standards of

157 See DEL. CODE. ANN. tit. 8, § 253 (permitting a parent company that owns at least 90% of the stock of a subsidiary to consummate a merger of the subsidiary without a shareholder vote). 158 See In re CNX Gas Corp. S’holders Litig., 4 A.3d 397, 412-13 (Del. Ch. May 25, 2010). But cf. In re Siliconix Inc. S’holders Litig., 2001 WL 716787, at *6 (Del. Ch. June 19, 2001) (special committee of board not required to make recommendation regarding unilateral tender offer by controlling shareholder, followed by short-form merger, and transaction not subject to entire fairness review if not coercive and if appropriate disclosures are made). 159 Williams v. Geier, 671 A.2d 1368, 1381 (Del. 1996); see also Malpiede v. Townson, 780 A.2d 1075, 1100 n.91 (Del. 2001); McMullin v. Beran, 765 A.2d 910, 919 (Del. 2000). 160 RADIN, supra note 4, at 1172. 161 See Thorpe v. CERBCO, Inc., 676 A.2d 436, 442 (Del. 1996); Abraham v. Emerson Radio Corp., 901 A.2d 751, 762 (Del. Ch. 2006) (holding that controlling shareholder may sell control bloc at premium unless plaintiff can show “that the controller knew there was a risk that the buyer was a looter or otherwise intended to extract illegal rents from the subsidiary, at the expense of the subsidiary’s remaining stockholders”); RADIN, supra note 4, at 1199-1200.

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review that are intermediate between the deferential business judgment rule and the more

exacting entire fairness standard.162

a. Revlon: The Sale of Control

In situations where “the board enters into a merger transaction that will

cause a change in corporate control, initiates an active bidding process seeking to sell the

corporation, or makes a break up of the corporate entity inevitable,” the stockholders have

no long-term interest to protect and their only interest becomes one of obtaining the

highest value currently available for their shares.163 Therefore, when such a situation

occurs, the directors’ fiduciary duties shift from protection of the long-term corporate

interests to the “maximization of the company’s value at a sale for the stockholders’

benefit.”164 When these so-called “Revlon” duties apply, a reviewing court will apply

enhanced scrutiny to the transaction to determine the reasonableness of director action

regarding the transaction or potential transaction, rather than the mere rationality of that

action, and will uphold only those director actions that are taken for the purpose of

162 See Veasey & Di Guglielmo, supra note 14, at 1428. 163 Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 928 (Del. 2003); see also Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 241-42 (Del. 2009) (enhanced scrutiny does not apply until either (a) directors decide to sell the company, or (b) a sale becomes inevitable). A “change of control” is the movement of voting power from a fluid, unaffiliated group of public stockholders to a controlling stockholder or group. Paramount Commc’ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 43 (Del. 1994); see also In re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 71 (Del. 1995); In re NYMEX S’holder Litig., 2009 WL 3206051, at *5 (Del. Ch. Sept. 30, 2009). There are at least two ways to trigger a change of control: (i) a purchaser pays cash for more than 50% of a corporation’s stock; or (ii) a corporation under the control of a single shareholder exchanges its stock with another corporation, and, as a result, the controlling shareholder will own more than 50% of the shares of the merged entity. Cf. id. at *5-6 (declining to decide whether a merger providing stockholders with consideration of 56% stock and 44% cash resulted in a change of control). 164 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1985); see also In re Dollar Thrifty S’holder Litig., 2010 WL 3503471, at *17 (Del. Ch. Sept. 8, 2010) (a board deciding to enter into a transaction involving a sale of the company in a change of control transaction is “charged with the obligation to secure the best value reasonably attainable for its shareholders, and to direct its fiduciary duties to that end”); Lyondell, 970 A.2d at 235 (“There is only one Revlon duty—to ‘[g]et the best price for the stockholders at a sale of the company.’” (alteration in original)).

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obtaining the highest value reasonably available.165 In evaluating the value of the

transaction, the directors are not limited to considering only the transaction price, but

may consider the transaction as a whole, including the certainty that the deal will close.166

b. Unocal: Judicial Review of Defensive Measures

A second intermediate standard of review exists for situations in which

directors adopt defensive measures to deter or preclude a hostile acquisition or contest for

corporate control. If a plaintiff challenges a board’s decision to adopt a defensive

measure, such as a “poison pill,”167 the board bears the initial burden of demonstrating

that (i) the directors reasonably believed that a threat to corporate policy and

effectiveness existed, and (ii) that the defensive measures adopted were reasonable in

relation to the perceived threat.168 If the defensive action is found to be “draconian” or

falls outside a “range of reasonableness,” it likely will not pass the test of reasonableness,

notwithstanding the “latitude [afforded the board] in discharging its fiduciary

duties…when defending against perceived threats.”169 If the board meets its initial

165 In re Toys “R” Us, Inc., S’holder Litig., 877 A.2d 975, 1000 (Del. Ch. 2005); see also In re Del Monte Foods Co. S’holders Litig., Consol. C.A. No. 6027-VCL, slip op. at 27 (Feb. 14, 2011) (explaining that a reviewing court will determine whether the directors acted reasonably and in good faith to get the best available transaction, not “whether, with hindsight, the directors actually achieved the best price”); Dollar Thrifty, 2010 WL 3503471, at *19 (observing that the Revlon approach adopts “a reasonableness, rather than rationality, standard”). 166 Dollar Thrifty, 2010 WL 3503471, at *32. 167 Examples of other defensive tactics may include “tilting the playing field” (i.e., providing company information or access to the board) to the advantage of a “white knight,” the inclusion of certain “break-up” fees, “no-shop” or “window shop” provisions in a merger agreement, or other mechanisms designed to ward off an unwanted aggressor. For discussion of defensive and deal protection measures, see RADIN, supra note 4, at ch. III. 168 See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954-55 (Del. 1985); Versata Enters., Inc. v. Selectica, Inc., 5 A.3d 586, 599 (Del. 2010); Air Prods. & Chems., Inc. v. Airgas, Inc., Civ. A. No. 5249-CC, slip op. at 77 (Del. Ch. Feb. 15, 2011) (upholding board’s refusal to redeem poison pill, applying Unocal standard); eBay Domestic Holdings, Inc. v. Newmark, 2010 WL 3516473, at *19 (Del. Ch. Sept. 9, 2010); Yucaipa Am. Alliance Fund II, L.P. v. Riggio, 1 A.3d 310, 336 (Del. Ch. 2010). 169 Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1388 (Del. 1995); see also Versata, 5 A.3d at 606 (“the reasonableness of a board’s response is determined in relation to the ‘specific threat,’ at the time it was

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burden under the Unocal test, then the business judgment rule applies to the directors’

decision.170

V. Conclusion

In the wake of the sensitized environment resulting from the troubled

economic climate, recent corporate failures, allegations of excessive or unlawful

executive compensation, and in light of new federal reforms attempting to encroach on

state corporate law, fiduciary duties will continue to evolve to meet the evolving

expectations for corporate directors.171 Shareholder litigation, mainly under Delaware

law, will continue to involve claims for breach of the duty of good faith and also may

involve the failure to comply with new federal reforms.172 As a result of the courts’

increasingly sharp focus upon director conduct, directors subject to the laws of the United

States should continue, among other things, to increase their understanding of fiduciary

duties and “best practices” of corporate governance; doggedly question management’s

premises and factual support so as to distinguish management self-interest from the

corporate good; anticipate trouble spots and put in place adequate policies, practices and

procedures to safeguard corporate assets and ensure proper monitoring of corporate

activity; and, above all, always act honestly, on an informed basis, and with due care,

while giving good-faith consideration to actions of material importance to the

corporation.

identified”); Omnicare, 818 A.2d 914, 936, 939 (reversing denial of preliminary injunction precluding implementation of merger because the deal protection devices adopted by the target corporation’s board of directors were invalid). 170 Yucaipa, 1 A.3d, at 336; Toys “R” Us, 877 A.2d at 1000-01. 171 See Veasey & Di Guglielmo, supra note 14, at 1436-39. 172 See MACAVOY & MILLSTEIN, supra note 3, at 116.

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b r i d g i n g b o a r d g a p s Report of the Study Groupon Corporate Boards

With Funding Provided by:

Sponsored by:

University of Delaware

Copyright © 2011 Columbia Business School,Columbia University, and the Weinberg Center for

Corporate Governance, University of Delaware

Financial Support Provided by theRockefeller Foundation

69

1

TabLe of ConTenTs

Letter from the Chairs 2

The study group on

Corporate boards 4

introduction 9

summary of

recommendations 12

gaps - Purpose 15

- Culture 18

- Leadership 20

- Information 23

- Advice 26

- Debate 29

- Self-Renewal 32

Conclusion 35

Quotes 37

appendices 46

notes 54b r i d g i n g b o a r d g a p s Report of the Study Group on Corporate Boards1

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3

“There is too greata gap between thepopular notion of

what boards do andthe reality of what theyare capable of doing.

Furthermore, theexisting system limits

the depth of boardoversight. We musteither change thesystem or change

expectations.” Frank Zarb

L e T T e r f r o mT h e C h a i r s

Recent institutional failures, surrounded by general economic turmoil, once again sparked the

familiar question: Where were the boards?2 Although the root causes of the financial crisis went

well beyond governance, boards have been a focus of many reforms. The Wall Street Reform

and Consumer Protection Act of 2010 (the Dodd-Frank Act), a 2,319-page law, required federal agencies

to conduct 81 studies, submit 93 reports, and pass more than 500 rules – including rules directly impacting

the boards of all public companies.3 But the new rules for public company boards are focused on board

process. In addition, boards need a renewed focus on their aspirational purpose and guidance for achieving

it. They need to recognize the gaps between governance ideals and governance realities – recognizing

which gaps can be closed and which may continue, given the process and structure fundamental to our

market’s operation.

To identify and address the most critical board gaps, we assembled a group of significant participants in

the current governance system, including leaders from academia and the accounting and legal professions,

as well as individuals who have led major corporations and boards. Our group also includes a former U.S.

Secretary of the Treasury, a former Chair of the Securities and Exchange Commission (SEC) and of the

Council of Economic Advisers, and the former general counsel of the SEC (serving ex officio). As a

diverse group of leaders and experts, we sought to contribute to what we see as a continuing process

of improvement in board practices and standards and director attitudes, while acknowledging that board

work is an art as well as a science. Our Report aims to show how boards can fulfill their potential in various

critical areas. After discussing dozens of general governance topics, we identified seven core problems.

Then we drew solutions from the laboratory of real life, based on our own experience.

Our solutions are intended to be practical – new routines boards can adopt (and adapt) to improve the

way they operate. We want to give boards a fighting chance to succeed. We hope to contribute to what

we see as the gradual but positive improvement of board practices and standards and director attitudes.

We hope that this Report will be a guide to boards, stakeholders, and policy makers in order to set rigorous

yet realistic expectations for boards and for those who depend on them to deliver. We are grateful to the

Rockefeller Foundation for financial support for the Study Group.

Co-Chairs

Charles M. Elson, Edgar S. Woolard, Jr. Chair in Corporate Governance; and Director of the John L. Weinberg

Center for Corporate Governance, University of Delaware; Of Counsel, Holland & Knight, LLP

Glenn Hubbard, Dean and Russell L. Carson Professor of Finance and Economics, Columbia Business School;

and Professor of Economics, Columbia University

Vice-Chair

Frank Zarb, Senior Advisor, Hellman and Friedman; and Non-Executive Chairman, Promontory Financial Group

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5

T h e s T u d y g r o u po n C o r p o r aT e b o a r d s

Co-Chairs

Charles m. elson – Edgar S. Woolard, Jr. Chair in Corporate

Governance and Director of the John L. Weinberg Center for

Corporate Governance, University of Delaware; Director,

HealthSouth; Vice Chair, Corporate Governance Committee,

Business Law Section, American Bar Association; Of Counsel,

Holland & Knight, LLP

glenn hubbard – Dean and Russell L. Carson Professor of

Finance and Economics, Columbia Business School; Professor

of Economics, Columbia University; former Chairman, Council

of Economic Advisers; Co-chair, Committee on Capital Markets

Regulation; Director, ADP, BlackRock Closed-End Funds,

KKR Financial Holdings (Lead Director), and MetLife

Vice-Chair

frank Zarb – Senior Advisor, Hellman and Friedman;

Non-Executive Chairman, Promontory Financial Group; Director,

Kraft Foods; former Chairman, National Association of Securities

Dealers; former Administrator, Federal Energy Administration

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76

Members

The honorable William T. allen – Director, New York University Center for

Law and Business; Of Counsel, Wachtell, Lipton, Rosen & Katz; former Chair,

Independence Standards Board; past Chancellor, Court of Chancery, Delaware

richard beattie – Chairman, Simpson, Thacher and Bartlett LLP; Chairman, New

Visions for Public Schools; Director, Harley-Davidson, Inc., Heidrick & Struggles,

the Carnegie Corporation, and the National Women’s Law Center

Kenneth a. bertsch – President and CEO, Society of Corporate Secretaries and

Governance Professionals, Inc.

Kenneth daly – President and CEO, National Association of Corporate Directors;

past Partner-in-Charge, National Risk Management Practice, KPMG; former

Executive Director, KPMG’s Audit Committee Institute

richard daly – CEO and Director, Broadridge Financial Solutions, Inc.;

past Member, Executive Committee, and Group President, ADP; Trustee,

New York Institute of Technology

Jon f. hanson – Chairman and Founder of the Hampshire Real Estate Companies;

Chairman, HealthSouth and Pascack Bancorp Inc.; Chairman Emeritus, National

Football Foundation; Lead Director, Prudential Financial Corporation; Director,

Yankee Global Enterprises, LLC

olivia f. Kirtley – Former Chair, American Institute of Certified Public Accountants;

Director, Papa John’s International, Res-Care, and U.S. Bancorp; Board Member,

International Federation of Accountants

peter Langerman – President and CEO of Franklin Mutual Advisers

(Mutual Series Funds); past Director, Division of Investment, State of New Jersey

The honorable arthur Levitt – Senior Advisor, Carlyle Group; former Chairman,

Securities and Exchange Commission and the American Stock Exchange; Co-Chair,

Advisory Committee on the Auditing Profession (U.S. Treasury); Director, Bloomberg LLP

eugene a. Ludwig – Principal, Promontory Financial Group; Managing Principal

CapGen; former U.S. Comptroller of the Currency and former Vice Chairman of

Bankers Trust/Deutsche Bank

The honorable paul o’neill – Special Adviser, Blackstone; former Secretary of

the Treasury; former Chairman and CEO, Alcoa; former Chairman, The RAND

Corporation; Director, Celanese, Kodak, TRW Automotive; Director, Peterson Institute

for International Economics

reuben mark – Former CEO, Colgate-Palmolive; Director, Cabela’s; former Director,

Citigroup; Member, RiskMetrics Governance Council; Chairman Emeritus, Catalyst

damon silvers – Policy Director and Special Counsel, AFL-CIO; Deputy Chair,

Congressional Oversight Panel for the Troubled Asset Relief Program; Member of the

Advisory Committee on the Auditing Profession (U.S. Treasury), Investor’s Practice

Committee of the President’s Working Group on Financial Markets (U.S. Treasury),

Public Company Accounting Oversight Board Standing Advisory Group, and the

Financial Accounting Standards Board User Advisory Council4

The honorable e. norman Veasey – Chief Justice, Delaware Supreme Court,

Retired; Senior Partner, Weil, Gotshal & Manges, LLP; past Chair, Committee on

Corporate Laws, Section of Business Law, American Bar Association; Director,

National Association of Corporate Directors

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8

paul f. Washington – Chairman of the Board, Society of Corporate Secretaries

and Governance Professionals; Senior Vice President, Deputy General Counsel, and

Secretary, Time Warner Inc.; Adjunct Professor, Fordham Law School

ralph V. Whitworth – Founder, Principal, and Investment Committee Member

of Relational Investors LLC; Director, Genzyme; past Chairman, Apria and Waste

Management; Founding President (pro bono) United Shareholders Association

deborah C. Wright – CEO, Carver Bancorp Inc. and Carver Federal Savings Bank;

Director, Time Warner and Kraft Foods; past CEO, Upper Manhattan Empowerment

Zone Development Corporation; and Commissioner of the Department of Housing

Preservation and Development for New York City

Ex Officio

david m. becker – Former General Counsel, Securities and Exchange Commission;

former Partner, Cleary Gottlieb Steen and Hamilton, LLP5

Staff

roger Coffin – Associate Director of the Weinberg Center for Corporate Governance,

University of Delaware; former Partner, PricewaterhouseCoopers LLP

alexandra r. Lajoux – Chief Knowledge Officer, National Association of Corporate

Directors (Secretary for the Study Group)

The Study Group gratefully acknowledges administrative support from

alba bates, Weinberg Center for Corporate Governance, University of Delaware,

and Wilhelmina sanford, Columbia Business School.

i n T r o d u C T i o n

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1110

How can boards improve? Corporate governance is

not subject to easy generalizations. Every company

has unique circumstances, and no two directors are

alike. Furthermore, corporate problems can arise

that do not stem from inadequate governance.6

This Report attempts to bring out the best in our

basic model of governance for public companies –

an independent board overseeing and advising

full-time managers on behalf of the corporation

and its shareholders.

This model poses an intrinsic dilemma. The roles

and responsibilities of directors are designed to

provide direction, oversight, and advice on a

part-time basis for a limited duration to the

professional executives who manage the day-to-

day affairs of the corporation.7 Over the years,

directors have been devoting more time to their

roles, but there is a natural limit to this time.8

Directors were not elected to run the daily affairs

of the corporation – that is management’s role.

Taken to an extreme, full-time, long-tenured

members of a board could themselves become

“insiders” in need of the monitoring and

perspective an independent board can bring.9

The Study Group believes that improvements can

be made within the existing model by changing

the manner in which directors do their jobs. This

change does not merely entail putting in more

hours (although the Study Group recognizes board

service is a significant responsibility entitled to as

much effort as required) but instead may involve

working more effectively. But how?

The aim of this Report is to encourage meaningful

improvement in the effectiveness of public

company directors. As an initial matter, directors

must accept that boards work part time (typically

meeting six times a year for two days per

meeting10) and generally receive the bulk of their

information from management. Directors are not

a full-time board of managers, nor does the Study

Group suggest they should be. Yet directors must

be on the front lines for the constructive oversight

of public companies; regulators alone cannot do

this job.11 To this end, it is worth considering how

to empower part-time boards to a greater extent.

The Study Group is aware of the many governance

solutions already reached – or now under way –

including the following noteworthy initiatives:

• From directors themselves, who have been

working for decades to set voluntary standards,

we have a score of Blue Ribbon Commission

reports from the National Association of

Corporate Directors (NACD). NACD has also

published a set of “Key Agreed Principles”

expressing points of agreement among the

NACD reports and reports from the two other

primary corporate constituencies – CEOs

(represented by the Business Roundtable)

and investors (represented by the Council of

Institutional Investors and the International

Corporate Governance Network).12 The

Corporate Laws Committee of the Section of

Business Law of the American Bar Association

publishes The Corporate Director’s Guidebook,

now in its fifth edition. The Committee is

revising that edition and is expected to publish

a sixth in the spring of 2011.

• Shareholders have provided numerous

resolutions aimed at changing practices for

director nominations and elections, board

leadership, CEO compensation, and myriad

other topics voted on during every proxy season.

Some are advisory or precatory resolutions that

leave boards discretion – the power to make

choices. Others change board processes in

more definitive ways.

• Courts have also offered useful principles for

the board’s work. Case by case, the courts have

carefully identified the fact patterns behind

corporate problems, and, based on the merits of

each case, have judged directors on the processes

they used and on the care, loyalty, and good

faith with which they created and followed these

processes. Taken together, cases involving boards

provide a treasure trove of guidance for boards.

• Congress, regulatory agencies, and the stock

exchanges have put forth a number of “bright-

line” standards for boards in the aftermath of

the Public Company Accounting Reform and

Investor Protection Act of 2002 (Sarbanes-Oxley)

and the Wall Street Reform and Consumer

Protection Act of 2010 (Dodd-Frank).13 Along

these same lines, the New York Stock Exchange

recently issued a set of principles to guide

the interaction of corporations, investors,

and regulators.14

All these efforts (detailed in Appendices A

through C) are commendable, but in our view,

gaps remain between what boards can do and

what they actually do. To close those gaps, we

make recommendations in the following areas:

• Purpose

• Culture

• Leadership

• Information

• Advice

• Debate

• Self-Renewal

The recommendations, summarized and explained

in the following pages, would apply to all public

companies, but directors must evaluate them in

light of their company’s specific needs. Boards

must understand the purpose, plans, and strategies

as well as the strengths and weaknesses of the

organizations they serve. They must appreciate the

instrumental steps required for the board to make

its best contribution to the organization, within

the full scope of its monitoring and advisory role.

Each recommendation will require adaptation and

fine-tuning based on the circumstances at hand.

Our goal is to move in the direction of progress by

suggesting actions boards can take to bridge the

most critical chasms between what they are today

and what they can become tomorrow.

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13

purpose

Boards must understand their purpose: to

ensure that the corporations they serve create

sustainable long-term value for shareholders.

• As individual directors and as a board, strengthen

awareness of long-term shareholder value and

foster it in others.

• Ask with every discussion: How will this decision

affect long-term shareholder value?

• Review and refresh governance documents to

focus on this purpose.

Culture

As part of a “tone at the top,” boards must

practice appropriate rules of engagement

between management and the board –

engagement that serves the long-term interests

of the company and its shareholders.

• When evaluating the CEO, ask: Does this person

understand, respect, and foster the role of

directors as guardians of long-term shareholder value?

• Ask with every discussion: How will this decision

impact our company’s values?

• Consider creating a Values Statement for internal

board use and sharing this statement with

management, shareholders, and the public.

Leadership

The default for board structure should be

the independent Chair.15 However, there are

circumstances when a board may legitimately

choose to join the roles of CEO and Chair. In

such circumstances, we recommend a lead

director empowered to call meetings and

generally act as a first among equals.

• Periodically ask: Does our leadership of the board

and committees – in both the structure we use and

the people we choose – give the board ownership

of its agendas and meetings? If not, make

appropriate changes.

• Run executive sessions routinely before and/or

after – and, if needed, during – the board meeting.

• Hold these sessions occasionally without the

independent Chair/lead director present in order

to evaluate the effectiveness of his/her leadership.

information

Directors should periodically review the

company’s information-reporting format and

content to ensure that they adequately inform

the board and its committees on all topics

relevant to corporate growth and well-being.

Directors should also regularly receive a concise

and comprehensible report in plain English

on risks facing the company, in order of

importance. Any additional information can

be provided in appendices.

• Encourage direct dialogue with the entire

organization by having routine contact with

employees beyond the senior management team.

• Organize periodic meetings with major shareholders,

having counsel present to ensure compliance with

company policies as well as with rules and

regulations, including Regulation FD.

• Make full use of available technology to improve

understanding of the perspectives and sentiments

of all shareholders.

s u m m a ry o f r e C o m m e n d aT i o n s

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advice

Directors should not hesitate to use third-party

experts to advise the board or a board committee

in important matters where they believe that

outside advisors would improve the quality

of the board’s decision.

• Use advisors whenever needed, including for

a regular review of critical risk areas.

• Set a budget for all board expenses, including

expenses for the retention of advisors.

• When engaging advisors, do not limit your

choices to the ones already retained (such as

external auditors), but consider a wider range

of experts as needed.

debate

Chairs should foster an environment of

discussion and debate, recognizing the benefits

of disagreement and dissent, when necessary,

in achieving better decisions.

• As a Chair, encourage constructive skepticism,

debate, disagreement, and, when necessary, dissent.

• As a director, speak your mind and ask questions.

• As a board, build a culture of candor and trust.

self-renewal

Boards should institute a regular, formal process

for board and director evaluation. This process

should be legally encouraged and protected –

and balanced with term limits based on company

needs. Additionally, board members should

receive continuing education on topics related

to their board service.

• Engage in frank and meaningful discussion

about the suitability of the current board

composition for advancing the company’s

long-term value, seeking the views of

shareholders as part of this effort.

• Set a process for rotation of board and

committee leaders.

• Develop policies and practices to ensure

ongoing evaluation and education of current

directors, using the services of an independent

third-party facilitator when needed, and

considering education both on and off site.

The views expressed here represent those

of individual Study Group members and do

not necessarily represent the views of their

organizations. Furthermore, this Report is a

collective document. Although not every

member agreed with every conclusion, this

Report represents a consensus of the views

held by the Study Group as a whole.

“Maybe we should rename directors ‘shareholderrepresentatives’ – then they would pull up to the

table in the right mind-set.” RalphWhitworth

“More often than not, long-termshareholders and stakeholders

share common interests – and it isthe role of thoughtful directors towork with management to set thecorporation on that course towardlong-term value creation.” Damon Silvers

“Corporations are managed under the direction ofa board of directors for the purpose of protecting

and enhancing the corporation's long-term value tostockholders. The directors' fiduciary duties of care

and loyalty, carried out in good faith, are theindispensable means to that end.” E. NormanVeasey

p u r p o s e

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1716

Every institution of integrity wants to excel at

what it does. So what do boards do? In the view

of this Study Group, corporate boards serve a

distinct economic purpose – monitoring and

advising a corporation for the purpose of

creating sustainable long-term value for

shareholders. While shareholder value is the

ultimate goal, boards must, as a consequence,

be concerned with other constituencies whose

effort is required to produce value. We believe

that these two considerations converge in

the attainment of long-term value.

Generally speaking, in addition to making

the fundamental corporate decisions that

they are required to make by law,16 board

responsibilities include:

• Approving corporate goals, strategy,

and planning

• Monitoring and advising business performance

• Controlling CEO and senior management

compensation

• Participating in and approving succession

planning (including hiring, evaluating, and,

when necessary, firing the CEO)

• Taking reasonable steps to ensure appropriate

financial disclosure

• Taking reasonable steps to ensure that an

appropriate risk management system is in place

(and monitoring that system once it is in place)

• Taking reasonable steps to ensure an appropriate

ethical tone at the top

• Participating actively in authorization of

fundamental transactions

• Self-consciously considering board governance17

All of these responsibilities can be boiled down

into one simple goal: the creation of sustainable

long-term value for shareholders. In their role as

guardians of value, however, directors are forced

to pay attention to process – sometimes to an

extreme degree.

Stock exchanges have set forth listing rules on

the structure and composition of boards, and the

Securities and Exchange Commission (SEC) has

issued a number of proxy disclosure rules in this

regard. Boards must devote time to develop and

maintain compliance with these requirements.

Furthermore, every proxy season, scores of

governance proposals appear on company proxies

at shareholder request, attracting additional board

attention to these issues. And looming over all of

this activity is the sure knowledge that, if and when

the matter comes to judgment, the court will focus

on proper process above all.

Given these considerable pressures, it is tempting

to focus on process, letting management run

strategy and letting long-term shareholder value

take care of itself. Yet boards should never

mistake process for purpose.

What matters most is how the board uses its

processes – such as the formation of independent

committees, holding of executive sessions, and

so forth – to further its purpose.

For example, when it comes to strategy and risk

oversight, directors can meet periodically in a

retreat setting to give these areas additional focus

and clarity in light of long-term value.

Regarding business performance and executive

compensation, boards can make sure that the

metrics used to measure and reward performance

include long-term indicators and that the structure

of compensation has a long-term focus. And with

respect to succession planning, boards can do more

to attract, develop, and retain value-building

human capital – especially in key positions, where

unplanned turnover can be detrimental.18

Other areas of board oversight can also benefit

from a long-term value focus. The importance of

risk management, ethics, due diligence, and

governance best practices need no elaboration here,

but disclosure may be an area for improvement.

As directors review annual reports for the

companies they serve, they can ask: Does this

tell me the long-term story? If not, they can

urge management to make this clearer.

Potential: The ideal board focuses on the creation and protection of sustainable long-term wealth for shareholders.

Reality: Many boards lack a sense of their own purpose and focus instead on their process, resulting in an

overemphasis on compliance at the expense of strategic input.

Recommendation: Boards must understand their purpose – to ensure that the corporations they serve create

sustainable long-term value for shareholders.

+ As individual directors and as a board, strengthen awareness of long-term shareholder value

and foster it in others.

+ Ask with every discussion: How will this decision affect long-term shareholder value?

+ Review and refresh governance documents to focus on this purpose.

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19

“It all boils down to integrity.Do you believe your management

team has integrity? If not,it’s time to change.” Jon F. Hanson

“Many governance problemscan be traced to a lack of

ethical values at some levelof the organization. Boards

can change corporate culturethrough example and action.” Paul O’Neill

“Good governance is an essentialpart of a fair and transparentbusiness environment.” Arthur Levitt

C u LT u r e

Definitions of culture vary, but perhaps the

simplest is that culture is the “ideas and the

standards” people have in common; culture creates

a “consistent pattern of thought and action.”19

Culture need not have a flashing light that says

“Culture.” It is conveyed through example, often

anonymously. Indeed, culture can be invisible until

it starts to change. This is certainly the case with

board culture.

Directors cannot anticipate every problem or create

or outsource every solution. So what can boards

provide? Certainly, every effective director must

bring probity, diligence, courage, intelligence,

commitment, and often specialized substantive

information or experience. But perhaps the single

most important trait that every director must bring

to a board is uncompromising integrity.

Over time, boards have a profound effect on the

culture of the organizations they head. This effect

is rightly called “tone at the top,” yet its impact

extends throughout an organization.

The most immediate expression of a board’s “tone”

may be its choice of a CEO and the ways in which

directors work with this leader to maximize and

protect long-term shareholder value while holding

him or her accountable for results. How the board

and management work together to allocate

responsibilities and power is a critical aspect of

board and company culture.

A good board and corporate culture will provide

the setting for effective use of business judgment at

every level in the pursuit of long-term shareholder

value, from rules of engagement between

management and the board to policies that

show respect for all constituencies.

Potential: The ideal board works with management to exemplify, prioritize, and promote proactively the highest possible

norm for ethical values on behalf of the corporation and its shareholders.

Reality: Many boards focus appropriately on selecting CEOs and directors of good character but fail to place attention

on how the board engages with the CEO, management, and the entire organization to serve long-term shareholder value.

Recommendation: As part of a “tone at the top,” boards must practice appropriate rules of engagement

between management and the board – engagement that serves the long-term interests of the company

and its shareholders.

+ When evaluating the CEO, ask: Does this person understand, respect, and foster the role of

directors as guardians of long-term shareholder value?

+ Ask with every discussion: How will this decision impact our company’s values?

+ Consider creating aValues Statement for internal board use and sharing this statement with

management, shareholders, and the public.

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21

“Yes, CEOs and cultures are crucial.But people are flawed, and

systems are fragile. This is whywe need governance.” William T. Allen

“Shareholders have the powerto hold boards accountable

for everything, but boards can’tand shouldn’t do everything.” Paul Washington

“Boards only know what the CEOand CFO tell them. Nothing more.

This is a significant problem.” Richard Beattie

L e a d e r s h i p

Board independence, required by rules and

encouraged by best practices, is essential to good

governance. The value of independence reveals

itself in the dynamics of board meetings. Given the

limited amount of time directors have to do their

work, they must be highly efficient. The leader of

the board must make sure agendas cover key

issues and that meetings follow those agendas,

but the leader should also encourage free-ranging

discussions of fundamental issues, such as strategy

and risk. An effective board leader will also ensure

good time management for the precious few

hours of board meeting “prime time.”20

There are two basic models now in use in the

United States for board leadership: an independent

Chair who is not the CEO,21 and combined roles

with (or without) the use of an independent

lead director.22

The Study Group recommends that the default for

board structure should be the independent Chair.*

However, recognizing that one approach does not

fit all situations, we acknowledge that there are

circumstances when a board may legitimately

choose to join the roles of CEO and Chair. For

example, a combined Chair and CEO may be an

appropriate leadership response to a catastrophic

corporate event. Alternatively, combining the

positions of CEO and Chair may be appropriate

for a company founder who retains substantial

equity ownership. In such circumstances, we

recommend a lead director empowered to call

meetings and generally act as a first among equals.

Whatever model is used, the independent Chair or

independent lead director serving with a CEO-Chair

should be an individual who has no aspirations to

be CEO of the company and who focuses primarily

on facilitating effective board meetings.

*The question of the extent to which

companies should be encouraged to have

an independent Chair of the board is one

that continues to generate divergent views.

Some members of the Study Group believe

that it is inappropriate to have a “default”

position favoring an independent Chair;

rather, they believe that this matter should

be determined without presumptions by

each board on a case-by-case basis and

then regularly revisited by the board.

They note that, while an independent

Chair may facilitate independent oversight

of management, there are other ways

to accomplish that objective, and that

selecting an independent Chair presents

an array of issues relating to the proper

division of responsibilities between the

Chair and CEO. These issues include

perceptions of authority both inside and

outside of a company; appropriate processes

for making decisions; accountability for

those decisions; and the compensation,

rotation, performance goals, evaluation,

and continuing independence of the Chair.

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22

Executive sessions are also valuable, both before the

meeting, to check the agenda and significant issues

to be discussed, and after the meeting, to go over

action items.

The following questions may be helpful to boards

in checking for effective board leadership:

• Are the roles of CEO and Chair clearly defined?

• When the CEO and Chair roles are combined,

is there a lead director who plays a significant

leadership role and galvanizes the work of the

independent directors?

• Does the person chairing the meeting ensure

effective board discussions? Does this meeting

leader work from an agenda approved by

the independent directors in consultation

with management?

• Does the board devote the necessary time

to consideration of long-term strategy and

related risks?

• Does the board fulfill its important role of

CEO evaluation and succession?

Potential: On the ideal board, the Chair ensures robust discussion and well-reasoned decisions on fundamental issues,

such as strategy and risk. Executive sessions are held regularly to ensure independent consideration of these and other

key issues.

Reality: The board Chair, whether as a current or aspiring CEO, may focus too much on running the company instead

of running the board. Board meetings can lack substantive agendas and dynamic discussions of key topics. This puts an

undue burden on executive sessions, which can be brief and perfunctory.

Recommendation: The default for board structure should be the independent Chair.23 However, there

are circumstances when a board may legitimately choose to join the roles of CEO and Chair. In such

circumstances, we recommend a lead director empowered to call meetings and generally act as a first

among equals.

+ Periodically ask: Does our leadership of the board and committees – in both the structure we use

and the people we choose – give the board ownership of its agendas and meetings? If not, make

appropriate changes.

+ Run executive sessions routinely before and/or after – and, if needed, during – the board meeting.

+ Hold these sessions occasionally without the independent Chair/lead director present in order

to evaluate the effectiveness of his/her leadership.

“It is important to builda relationship with managers

beyond the CEO.” Eugene Ludwig

“Most governance problemscan be solved through a

combination of transparency,alignment, and technology.” Richard Daly

“Information is the lifeblood ofeffective governance.” Olivia Kirtley

i n f o r m aT i o n

81

2524

Many governance problems have arisen from

poor management decisions, hidden and often

compounded through inadequate information

disclosure to the board. Boards of directors should

be cognizant of, and cautious about, the emphasis

they place on internal reports. Of course, it is proper

and advisable to rely on the information provided

by management, who are the guardians of the

financial and business information systems in the

company. However, if the board relies solely on

management reports, the risk is that information

may be incomplete, filtered, or edited, even in

good-faith ways. The general name for this

problem is “asymmetric information,” and this

imbalance can weaken the board’s ability to

oversee the corporation properly.24

Certainly, directors can benefit from studying a

variety of information sources beyond the reports

delivered at board meetings and the financial

reports filed with the SEC. As indispensable as

these are for understanding a company,25 they need

to be supplemented through such sources as analyst

reports, transcripts of earnings calls, news in the

financial press, and so forth. At the same time, the

biases and particular perspectives of these outside

commentators must be considered. (For example,

sell-side analysts may place undue emphasis on

near-term performance.) It’s been said that directors

have a duty of curiosity. Rightly interpreted, this

unwritten duty does not mean simply that directors

need to ask questions. They should also have a

general intellectual curiosity about the company’s

industry (or industries) and the economic world

at large.

Boards need to balance external and internal

information, applying their wisdom and experience

to recognize problems, develop solutions, and take

(or direct) action.

In addition, the right technology can speed and

improve the board’s advisory and oversight

work. For example, boards can ensure that their

companies are using the most appropriate solution –

acquired or homegrown – for “enterprise risk

management.”26 Directors can ask for regular

reports on the “hot zones” of risk affecting their

companies, calling upon advisors to help them in

this regard. Reports should be brief; certainly a

report exceeding 25 single-spaced pages would be

too long under most circumstances. Directors can

become familiar with these reports as part of their

oversight of risk and compliance, and can even

use the technology for themselves.27

Directors can also use technology to gain useful

information about the views of their shareowners

while at the same time proactively seeking

opportunities for direct, face-to-face communication.

New and pending regulatory requirements, such

as “say on pay” (requiring companies to have a

shareholder vote on all new compensation plans)

and proxy access (requiring companies to place

the names of shareholder-nominated director

candidates directly on the proxy, in addition to the

candidates recommended by the governance and

nominating committee28) will require boards to have

better and more complete information on the views

of their shareholders. When shareholder

perspectives vary, boards will need to discern the

extent to which certain perspectives are broadly

or narrowly held.

In being responsive to the views and perspectives of

all shareholders, boards should be mindful of their

role as independent fiduciaries for all shareholders

of the corporation. They should strive to understand

the views of all shareholders, including various types

of holders such as hedge funds, public pension funds,

investment advisors, and individuals. Technology

can help boards achieve such an understanding.

For example, sentiment technology and advanced

communications networks at brokerage firms can

provide greater transparency and enable broader

participation in both voting and annual meetings

(see Appendix D for a more detailed discussion).

Potential: The ideal board learns from a variety of sources, including both external and internal sources, such as reports

from analysts and the company’s managers beyond the senior management team.

Reality: Boards often rely too heavily on information management provides, and they interface with middle managers

only when senior managers bring them to meetings or when boards reach out to them under extraordinary circumstances.

Recommendation: Directors should periodically review the company’s information format and content to

ensure that they adequately inform the board and its committees on all topics relevant to corporate growth

and well-being. Directors should also regularly receive a concise and comprehensive report in plain English

on risks facing the company, in order of importance. Any additional information can be provided in appendices.

+ Encourage direct dialogue with the entire organization, having routine contact with employees

beyond the senior management team.

+ Organize periodic meetings with major shareholders, having counsel present to ensure compliance

with company policies as well as with rules and regulations, including Regulation FD.

+ Make full use of available technology to understand the perspectives and sentiments of

all shareholders.

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27

“There are two kinds of gaps thatboards must address – gaps in oversight

and gaps in expertise.” Glenn Hubbard

“Good governance has a humanelement. More than anything else,

boards need practical solutionsgrounded in expertise.” Peter Langerman

“Playing a meaningful role in properlyinfluencing long-term value is fundamental

but challenging. A critical link is advicefrom trusted sources. Getting out ofthe boardroom to meet managementwith different opinions is also veryimportant. And good judgment andcommon sense are a must.” DeborahWright

a d V i C e

Directors can do more to enhance their role as a

source and conduit for expertise through the

regular use of independent advisors.29 Clearly,

boards have the legal authority to retain

independent advisors whenever they need them

and to earmark corporate funds to compensate

these advisors. The Sarbanes-Oxley Act requires

audit committees to be the ones to retain the firm’s

external auditor, and rules being promulgated

under Dodd-Frank encourage the use of

independent compensation consultants. In the

case of fairness opinions advising on the price

paid in acquisitions, use of advisors has become

commonplace and is considered necessary in

determinations of fair value. Boards also have

full legal protection to rely in good faith on

persons they select with reasonable care and

reasonably believe to have expert competence

concerning the matter in question.30

The Study Group believes that each member of

a board should recognize when external advice

can be critical to achieve oversight. Collectively

and individually, directors should not hesitate to

fund the engagement of accounting, legal, or

other expert advisors (consultants) as needed.

The potential benefit is twofold: greater

independence and greater expertise. It bears

repeating that the basic reason for a board’s

existence is the creation of long-term value.

Seeking the perspective of qualified outside

advisors can help to achieve this goal.

This Study Group does not envision a board

meeting in which each director has his or her own

legal counsel or expert advisor. Nor do we advocate

checking every statement made by the CEO and

his or her team. Such developments could erode

valuable board-management trust. However, we do

believe that boards should make a reasonable effort

to seek a second opinion on particularly complex

and critical matters. Although there may be

resistance to this apparent invasion of management

turf, the competent CEO will welcome such support

if the board selects the right areas for its use.

Compensation presents an important case in point.

If a board overpays, it wastes corporate assets; if it

underpays, it may lose the best human capital. To

pay the right amount in the right way, boards must

either possess compensation expertise or retain it.31

One of the unexplored frontiers in governance

is the amount of funds that boards have to spend

on experts (or even on their own compensation

and operating expenses, for that matter). While

there are backward-looking data on how much

boards have spent to compensate board members

and advisors in the past,32 boards do not tend to

construct budgets for how much they anticipate

spending in the future. The amounts allocated for

non-routine advisors range from zero at some boards

to very large and uncontrolled sums at others.

Boards can do better than this ad hoc approach.

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28

Risk is a particularly important area (see

Appendix E). Without the constraint of a board

looking out for the long term, management can

take too many risks. The board can act as a

valuable counterweight to excessive risk-taking

by management. As mentioned earlier, directors

can ask for regular reports on the risk affecting

their companies, calling upon advisors to help

them in this regard. Managers may perceive

such requests as intrusive or untrusting,

but this perception is wrong. Wise managers

will understand that when it comes to the

oversight of risk management, boards need

all the help they can get, both internally and

externally. The use of external advisors to review

critical risk areas can and should be routine.

Potential: The ideal board seeks the perspective of outside advisors on a regular basis, with the full support

of management.

Reality: Boards are reluctant – and management resistant – to spend company funds on outside independent advisors

to review or supplement the judgments of managers and their advisors. Boards often assume that managers and

their advisors already have expertise in all needed areas, and managers may not be keen to prove otherwise.

Recommendation: Directors should not hesitate to use third-party experts to advise the board or a board

committee in important matters where they believe that outside advisors would improve the quality of

the board’s decision.

+ Use advisors whenever needed, including for a regular review of critical risk areas.

+ Set a budget for all board expenses, including expenses for the retention of advisors.

+ When engaging advisors, do not limit your choices to the ones already retained

(such as external auditors), but consider a wider range of experts as needed.

d e b aT e

“The key to a board's informed decision makingis that the directors should probe until they

fully understand the issues, information, andadvice presented, to the point wherethey can explain it to others.” E. NormanVeasey

“Boards need to empower individualdirectors. Too often, a director will

raise a concern about a motionon the table, and the response is,

‘Thank you for sharing. Do we have a secondfor the motion? All in favor? Next.’” Reuben Mark

“Dissent in the boardroom, expressed respectfullyin the company’s best interests, is a healthy thing foreffective board oversight. Diversity of viewpointsleads to more effective decision making.” Charles Elson

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3130

Boards of directors, like other groups of individuals,

are subject to the interpersonal dynamics of the

individuals who form the group. In a board setting,

however, the person chairing the meeting needs

to be mindful of the primary purpose of the board –

to enhance shareholder value – and must be

cognizant of using the board’s time and resources

in furtherance of this goal.

The effective board meeting Chair should make

sure that every viewpoint gets a full and fair

hearing consistent with orderly decorum, within

the constraints that are imposed by time or other

considerations. This may mean tabling discussions,

ending filibusters, or drawing out more reticent

members. Whatever actions are needed, the Chair

must perform them, or the board can designate

another individual to assume the role of Chair.

The burden of ensuring effective meetings does

not fall on the Chair alone, but extends to every

director. The Study Group believes that a good

board will be constructive, respectful, and

professional, with directors making a proactive

effort to understand one another. But this does

not mean “going along to get along.” Achieving

consensus is important, but many boards put

forth too great an effort to achieve it. While strict

parliamentary procedure is usually not necessary

in small groups, boards should still respect due

process in the airing and discussion of ideas.33

Every director must be capable of exercising

healthy skepticism and constructive challenge

to avoid the syndrome of groupthink.34 Each

individual director who realizes something is

wrong has an obligation to say so, and boards

as a group need to encourage debate, not only

in executive sessions but also at board meetings.

On a board that fosters debate, CEOs and

directors will not feel pressured to make

decisions that contradict their judgment or

betray their values.

No board wants individuals or factions who are

unmoved by fact or reason or who are disruptive

or rude. When managers focus on having to

make a presentation to a smart, inquisitive board,

they are inspired to perform at their best. When

they have to prepare for perpetually dissenting

directors who pick fights (often the wrong ones),

their efforts are geared towards appeasement –

hardly an optimal result. Board meetings should

be structured to permit directors to share their

candid views with the CEO without creating

circumstances that diminish the authority of

the CEO in front of subordinates, clearly a

counterproductive outcome. This consequence

does not mean, however, that dissent should

be discouraged. Indeed, effective dissent is

healthy for optimal board performance.

The Study Group believes more can be done

to encourage meaningful dialogue, pointed

argumentation, and, when necessary, dissent.

Consensus has great value when it is achieved

through a full vetting of ideas wisely shepherded

by a judicious discussion leader. However, in

some cases, consensus is simply not possible.

In the end, following a thorough discussion,

some opposing views may remain. In these

cases, a split vote should be recorded with

unapologetic confidence. Meeting minutes

can routinely indicate that measures passed by

a “majority vote following robust discussion.”35

Lack of unanimity should neither increase nor

decrease the liability of directors voting either way.36

On the contrary, it can and should be construed as

a sign of governance strength. Directors should not

be afraid to register dissent, when necessary, in

debates or in board or committee votes.

Potential: The ideal board values and leverages debate, disagreement, and, when necessary, dissent.

Reality: Many boards discourage dissent by emphasizing collegiality of discussions and unanimity of votes.

Recommendation: Chairs should foster an environment of discussion and debate, recognizing

the benefits of disagreement and dissent, when necessary, in achieving better decisions.

+ As a Chair, encourage constructive skepticism, debate, disagreement, and, when necessary, dissent.

+ As a director, speak your mind, ask questions, and disagree or even register dissent if needed.

+ As a board, build a culture of candor and trust.

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33

“Volatility and complexity are not going away.Boards need to constantly challenge

their processes and ensure they have the rightcompetencies around the table.” Ken Daly

“To function effectively as amonitor to protect corporatevalue, boards must refresh

their membership ona periodic basis.” Charles Elson

“Balance here, as in other areas of life,is critical. The board should have sufficient

knowledge of the company’s business –including technical details – to ask smart

questions. But the board also needsgeneralists who have diverse knowledge and/or

experience in other fields.” Ken Bertsch

s e L f - r e n e Wa L

Board composition must continue to evolve to suit a

company’s strategy. The average tenure of directors

is now about seven years,37 but some of the turnover

is due to mergers rather than to actual rotation of

directors. Furthermore, the presence of managers

other than the CEO on some boards presents another

opportunity for positive change. If managers will

be providing their views to the board anyway in

their management roles, why should they occupy

a voting board seat? The board can thus expand its

pool of expertise by increasing the percentage of

nonmanagement directors.

Boards today tend to be small, and rightly so:

Deliberative groups much larger than a dozen

members tend to become unwieldy. Given a

limited number of seats, and given the great

range of expertise and experience needed by

every board, each board seat counts, making

board composition a vital concern for every board.

Boards can engage in affirmative succession

planning for their ranks. Every board should have a

self-renewal plan. If boards could calibrate director

tenure to maximize director usefulness, they could

keep their boards vital. Furthermore, there could be

a positive chain reaction. With more board seats

opening up, individuals who have a chance to serve

as directors on other boards would be less inclined

to cling to their current board seats and more able to

move on when the time seems right. Such “enabled

directors,” if supported by the other practices and

resources recommended in this Report, could have

a greater positive impact on the corporations

they serve.

To select the most useful directors, boards need

to pay as much attention to the person as to the

résumé, striving for diversity in both dimensions.

An effective group will be diverse in many ways,

including, as appropriate, not only professional

experience, educational background, and industry

background, but also temperament, worldview,

stakeholder knowledge, age, and general personal

background. And even within industry experience,

diversity is important.38

Although it is necessary and valuable for corporate

directors to spend significant time getting to know

a company before making an informed contribution,

they also need to move on when the time for

departure has come. After 15 years, assuming

changes in the company, the marketplace, and the

director, chances are that someone else may be

more qualified to fill the seat held by that director.

Directors and nominating committees need to seek

the perspective gained by asking: How do I add

value? and Can someone else add more?

Director evaluation is a complex and important

topic worthy of its own report.39 For our purposes,

suffice it to say that board and director evaluation

must be regular, robust, and linked to the company’s

strategy and attendant risks, and results must be

treated anonymously, confidentially, and objectively.

Third parties can help facilitate this process.40

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To encourage renewal among existing board

members, many boards rotate committee leadership

every three years and membership every five years

or so.41 Also, to encourage board renewal, a growing

number of nominating committees are using

executive recruiting firms to locate candidates.42

Some committees tap directly into databases of

available candidates.43

Boards may wish to consider the value of term limits.

It is generally agreed that director perspectives on

a particular company can become stale and even

compromised after many years of continuous service.

It may be difficult to remain objective about a

company one has served for a long time. In the

United Kingdom, after nine years on a board,

a director is no longer considered independent.

Boards can consider imposing term limits of this

nature, or at least informal guidelines for a duration

that makes sense for their industry. Periodic retreats

to build board awareness of business and broader

trends can keep directors current during their

periods of service.

Potential: The ideal board is composed of individuals who complement management’s knowledge and skills in support

of the organization’s strategy. Directors receive regular education, and board and committee membership rotates at

reasonable periods to bring in new perspectives while maintaining some continuity.

Reality: Without the benefit of regular, rigorous evaluation and development, too many directors become complacent

educationally and stay on boards past the point of maximum effectiveness.

Recommendation: Boards should institute a regular, formal process for board and director evaluation.

This process should be legally encouraged and protected – and balanced with term limits based on company

needs. Additionally, boards should receive continuing education on topics related to their board service.

+ Engage in frank and meaningful discussion about the suitability of the current board composition

for advancing the company’s long-term value, seeking the views of shareholders.

+ Set a process for rotation of board and committee leaders.

+ Develop policies and practices to ensure ongoing evaluation and education of current directors,

using the services of an independent third-party facilitator when needed for evaluation, and

considering education both on and off site.

C o n C L u s i o n

“Many solutions to governance problemslie within the board’s power and outside the

scope of government control.” David Becker

“Many directors I talk toabout board service todaybelieve that expectations

of board members areincreasingly inconsistent with

a model based on part-time service.At some point, the gap must be

examined and addressed.” DeborahWright

“Board behavior varies. It falls along anormal curve. Our goal is to move the curve

in the direction of progress.” Reuben Mark

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In this Report, we have tried to identify gaps in

board excellence and suggest ways to close them.

To increase investor confidence, corporate boards

can ask themselves the following questions:

• Purpose – Do we focus on long-term value?

• Culture – Do we follow appropriate rules

of engagement between management

and the board in support of long-term

shareholder value?

• Leadership – Do we have independent

board leaders who ensure effective

discussions in board and committee

meetings and executive sessions?

• Information – Do we insist on a variety of

information sources, including information

derived from advanced technology, rather

than relying on traditional sources?

• Advice – Do we seek outside perspectives to

help the board understand important issues,

especially critical areas of risk, and allocate

funds to accomplish this goal?

• Debate – Do we make a deliberate effort

to include a full range of perspectives in

the boardroom?

• Self-Renewal – Do we keep our directors

informed and replenish board membership

at regular intervals, as required by our

changing environment and strategy?

These changes would all work together to

strengthen the board’s consideration of its own

effectiveness. The full board, under the leadership

of its independent Chair or lead director and with

the support of the governance committee, can

periodically assess all areas covered in this

Report in the light of current events and

performance. Directors should ask themselves

how their boards can “take charge” to improve

their functioning. We want to empower boards

to do better.

Individually and collectively, directors are not

omniscient; they are not more expert than experts,

and they cannot always be expected to ask the right

question, to find the oyster in the pearl, or to spot

the chink in the armor. Yet they can try. Directors

can add value through their collective wisdom,

supported by independent expertise. As advisors,

directors can help CEOs see what they might not

otherwise have seen, and as an oversight body,

boards can also provide a check against the

occasional CEO or management excess.

The voluntary standards we have set forth will

always be preferable to universal bright-line

standards. One bright-line standard does

apply to all boards without exception –

the imperative to identify and bridge gaps

in their own effectiveness. We offer this Report

as a guide to this worthy endeavor.

Q u o T e s

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William T. allen:

“Yes, CEOs and cultures are crucial. But people

are flawed, and systems are fragile. This is why

we need governance.”

“There are two ways to see the board’s role.

One is increasing long-term wealth. The other

is minimizing fraud and abuse. Society loses

when boards focus so closely on the second

that they neglect the first. ”

“Does board independence lead to better

financial performance? No one has proved this.

Is it designed to assure integrity of decisions

even at a cost of performance? Again, it is not

clear either that it does achieve this result, or

that investors would want such an outcome.”

richard beattie:

“Boards only know what the CEO and CFO tell

them. Nothing more. This is a significant problem.”

“If one looks at all the failures of the last four years,

and it is a long list, the boards were not aware of

the risks the companies were taking, because no

one was telling them about the risks.”

david becker:

“Many solutions to governance problems lie

within the board’s power and outside the scope

of government control.”

“Public rage at what a board should not fail to do

is not a proper barometer of what a board can do.”

“The board should not rely too heavily on outside

experts. Bear in mind that to a hammer, every

problem looks like a nail.”

The following quotes are from Study Group discussions and correspondence.

Ken bertsch:

“Not all stakeholder conflicts can be resolved

through focus on long-term shareholder

value, nor does such a focus in any way make

a board’s job easy. Still, a singular, self-conscious

focus on sustaining long-term shareholder

value is the necessary guidepost for boards.

This defines the particular role of the board

in a wider ecosystem, and without such clear

purpose, directors and boards are more

likely to lose their way.”

“Balance here, as in other areas of life, is critical.

The board should have sufficient knowledge

of the company’s business – including technical

details – to ask smart questions. But the board

also needs generalists who have diverse

knowledge and/or experience in other fields.”

Ken daly:

“Asymmetrical information risk is inherent with

board service. The challenge is to recognize when

it becomes dangerously high, and then to know

what to do about it.”

“Directors can’t offer perspective in a void.

They need the support of knowledge and

perspective from qualified advisors, as required

in specific situations.”

“Volatility and complexity are not going away.

Boards need to constantly challenge their

processes and ensure they have the right

competencies around the table.”

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Charles elson:

“Over the decades, the board has admirably

moved from an advisory to a monitoring function.

Unfortunately, it still has yet to meet its potential.”

“Regulations such as Sarbanes-Oxley or

Dodd-Frank serve a purpose, but there is a

dark side to regulation.”

“Dissent in the boardroom, expressed respectfully in

the company’s best interests, is a healthy thing for

effective board oversight. Diversity of viewpoints

leads to more effective decision making.”

“To function effectively as a monitor to protect

corporate value, boards must refresh their

membership on a periodic basis.”

richard daly:

“Most governance problems can be solved

through a combination of transparency, alignment,

and technology.”

“No one wins when a company fails. On the

other hand, to earn returns and stay competitive,

companies must take some risks.”

“Information is the key to success.”

“Over 75 percent of the shares of publicly held

companies can be accessed through the advanced

technology networks in place today across broker-

dealers and other financial intermediaries.”

Jon f. hanson:

“It all boils down to integrity. Do you believe

your management team has integrity?

If not, it’s time to change.”

glenn hubbard:

“Many of the contributions to corporate governance

in recent years focused inward to the board’s

operations rather than outward to the board’s

work in areas such as risk.”

“There are two kinds of gaps that boards must

address: gaps in oversight and gaps in expertise.”

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damon silvers:

“More often than not, long-term shareholders

and stakeholders share common interests – and

it is the role of thoughtful directors to work with

management to set the corporation on that course

toward long-term value creation.”

“Managing corporations is complicated – strong

boards are much better at managing complexity

than regulators or courts or shareholder votes

are – but history shows that without regulators

and courts and shareholder votes, we won’t

have strong boards.”

“Boards ultimately cannot look to anyone else

to tell them what their values must be. But when

boards get values wrong, both board members

personally and everyone else associated with the

corporation pays the price in terms of reputation,

litigation, and lost time and money. That is one

of the deep meanings of being a fiduciary subject

to the business judgment rule.”

e. norman Veasey:

“Corporations are managed under the direction of

a board of directors for the purpose of protecting

and enhancing the corporation's long-term value

to stockholders. The directors' fiduciary duties of

care and loyalty, carried out in good faith, are the

indispensable means to that end.”

“The key to a board’s informed decision making

is that the directors should probe until they fully

understand the issues, information, and advice

presented, to the point where they can explain

it to others.”

olivia Kirtley:

“Disclosure can go a long way in addressing

many issues.”

“The board needs to test sensitivities in critical

areas, such as incentive compensation and

new initiatives.”

“Information is the lifeblood of effective governance.”

peter Langerman:

“Good governance has a human element.

More than anything else, boards need practical

solutions grounded in experience.”

arthur Levitt:

“Job creation is America’s most important economic

priority. Governance is a vital catalyst in producing

that outcome.”

“Good governance is an essential part of a fair and

transparent business environment.”

eugene Ludwig:

“If we take away the board’s discretion, we will

wind up with a bad environment. To make

progress, boards must think out of the box and

try new ideas.”

“It is important to build a relationship with

managers beyond the CEO.”

reuben mark:

“Boards need to empower individual directors.

Too often, a director will raise a concern about a

motion on the table, and the response is, ‘Thank

you for sharing. Do we have a second for the mo-

tion? All in favor? Next.’”

“Board behavior varies. It falls along a normal

curve. Our goal is to move the curve in the

direction of progress.”

“A good CEO will make the board look good; a bad

CEO will make the board look bad.”

paul o’ neill:

“Most governance problems can be traced to a lack

of ethical values at some level of the organization.

Boards can change corporate culture through

example and action.”

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paul Washington:

“Shareholders have the power to hold boards

accountable for everything, but boards can’t

and shouldn’t do everything.”

“Those who favor a split between the Chair and

CEO roles assume that there is a clear distinction

between boards and management, but this is not

true for many issues like strategy.”

“Boards want to hear from the CEO in an

unfiltered way.”

“The board should focus on management processes;

leaders can’t react by gut instinct alone.”

ralph Whitworth:

“Poor boardroom dynamics cause most of our

problems. Authority is concentrated among too

few, and there is too much deference to authority.”

“One problem with bright-line standards is that,

although they are meant as minimums, they

become the norm.”

“Maybe we should rename directors’ shareholder

representatives’ – then they would pull up to the

table in the right mind set.”

“It is not enough to allow dissent. You have to

encourage and welcome it.”

frank Zarb:

“There is too great a gap between the popular

notion of what boards do and the reality of

what they are capable of doing. Furthermore,

the existing system limits the depth of board

oversight. We must either change the system

or change expectations.”

“In the early 1970s, the stock market began to

democratize, and today it includes tens of millions

of middle-class investors. Over the same period,

the basic structure and process of corporate board

governance has improved somewhat, but it is

essentially the same as it was in 1970. Is this a

reality we have to live with?”

deborah Wright:

“Playing a meaningful role in properly influencing

long-term value is fundamental but challenging.

A critical link is advice from trusted sources.

Getting out of the boardroom to meet management

with different opinions is also very important. And

good judgment and common sense are a must.”

“Many directors I talk to about board service today

believe that expectations of board members are

increasingly inconsistent with a model based on

part-time service. At some point, the gap must

be examined and addressed.”

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a p p e n d i C e s

appendiX a

NACD Key Agreed Principles to Strengthen Corporate Governance forU.S. Publicly Traded Companies

The National Association of Corporate Directors (NACD) puts forth these Key Agreed Principles, grounded in the

common interest of shareholders, boards, and corporate management teams, to provide a blueprint to corporate boards

and thereby to help improve the quality of discussion and debate about governance issues moving forward.

i. board responsibility for governance

Governance structures and practices should be

designed by the board to position the board to fulfill

its duties effectively and efficiently.

ii. Corporate governance Transparency


transparent – and transparency is more important

than strictly following any particular set of best

practice recommendations.

iii. director Competency and Commitment


designed to ensure the competency and

commitment of directors.

iV. board accountability and objectivity


designed to ensure the accountability of the

board to shareholders and the objectivity of

board decisions.

V. independent board Leadership


designed to provide some form of leadership for

the board distinct from management.

Vi. integrity, ethics, and responsibility


designed to promote an appropriate corporate

culture of integrity, ethics, and corporate social

responsibility.

Vii. attention to information, agenda, and strategy


designed to support the board in determining its

own priorities, resultant agenda, and information

needs; and to assist the board in focusing on

strategy (and associated risks).

Viii. protection against board entrenchment

Governance structures and practices should

encourage the board to refresh itself.

iX. shareholder input in director selection


designed to encourage meaningful shareholder

involvement in the selection of directors.

X. shareholder Communications


designed to encourage communication with

shareholders.

To learn more,visit

www.nacdonline.org/keyprinciples.

a. NACD Key Agreed Principles to

Strengthen Corporate Governance for

U.S. Publicly Traded Companies

b. Topics of Blue Ribbon Commissions of

the National Association of Corporate

Directors 1993 to 2011 (in order of

original publication)

C. Report of the New York Stock Exchange

Commission on Corporate Governance

(September 23, 2010) – Summary

d. Know Your Shareholders:

Technology and the Boardroom

e. Risk Oversight: 25 Questions

Directors May Wish to Consider

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appendiX b

Topics of Blue Ribbon Commissions of the National Association of Corporate Directors1993 to 2011 (in order of original publication)

appendiX C

Report of the New York Stock Exchange Commission on Corporate Governance(September 23, 2010) – Summary

Executive Compensation:Guidelines for Corporate Directors

Jean Head Sisco, Chair

Performance Evaluation of Chief Executives,Boards, and Directors

Boris Yavitz, Chair

Director Compensation:Purposes, Principles, and Best Practices

Robert B. Stobaugh, Chair

Director Professionalism

Ira M. Millstein, Chair

CEO Succession

Jeffrey Sonnenfeld, Chair

Audit Committees:A Practical Guide

A.A. Sommer, Jr., Chair

The Role of the Board in Corporate Strategy

Warren L. Batts andRobert B. Stobaugh, Co-Chairs

Board Evaluation:Improving Director Effectiveness

Robert E. Hallagan andB. Kenneth West, Co-Chairs

Risk Oversight:Board Lessons for Turbulent Times

Norman R. Augustine andIra M. Millstein, Co-Chairs

Executive Compensation and the Roleof the Compensation Committee

Hon. Barbara Hackman Franklin andWilliam W. George, Co-Chairs

Board Leadership

Jay W. Lorsch andDavid A. Nadler, Co-Chairs

Director Liability: Myths, Realities, and Prevention

Justice E. Norman Veasey, Chair

The Governance Committee

Hon. Barbara Hackman Franklin, Chair

Board-Shareholder Communications

Dennis R. Beresford andRichard H. Koppes, Co-Chairs

Risk Governance: Balancing Risk and Reward

Adm. William Fallon andDr. Reatha Clark King, Co-Chairs

The Audit Committee

Dennis R. Beresford andMichele Hooper, Co-Chairs

Corporate Performance Metrics:Understanding the Board’s Role

John Dillon andWilliam White, Co-Chairs

The Lead Director*

Hon. Barbara Hackman Franklin andIrvine O. Hockaday, Co-Chairs

To learn more, visit www.nacdonline.org.

*Working title.

The New York Stock Exchange Commission on

Corporate Governance has worked to develop a

consensus view on a core set of governance principles

for boards, management, and shareholders. The

group agreed on ten key principles of solid

corporate governance.

1) The board’s fundamental objective should be to

build long-term sustainable growth in shareholder

value for the corporation and its shareholders, and

the board is accountable to shareholders in its effort

to achieve this objective.

2) While the board’s responsibility for corporate

governance has long been established, the critical

role of management in establishing proper corporate

governance has not been sufficiently recognized.

The Commission believes that a key aspect of

successful governance depends upon successful

management of the company, as management has

primary responsibility for creating an environment

in which a culture of performance with integrity

can flourish.

3) Shareholders have the right, a responsibility,

and a long-term economic interest to vote their

shares in a thoughtful manner, in recognition of

the fact that voting decisions influence director

behavior, corporate governance, and conduct, and

that voting decisions are one of the primary means

of communicating with companies on issues

of concern.

4) Good corporate governance should be

integrated with the company’s business strategy

and objectives and should not be viewed simply

as a compliance obligation separate from the

company’s long-term business prospects.

5) Legislation and agency rule making are

important to establish the basic tenets of

corporate governance and ensure the efficiency

of our markets. Beyond these fundamental

principles, however, the Commission has a

preference for market-based solutions

whenever possible.

6) Good corporate governance includes

transparency for corporations and investors,

sound disclosure policies, and communication

beyond disclosure through dialogue and

engagement as necessary and appropriate.

7) While independence and objectivity are

necessary attributes of board members, companies

must also strike the right balance between the

appointment of independent and non-independent

directors to ensure that there is an appropriate

range and mix of expertise, diversity, and

knowledge on the board.

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appendiX d

Know Your Shareholders: Technology and the Boardroom

8) The Commission recognizes the influence

that proxy advisory firms have on the market

and believes that such firms should be held to

appropriate standards of transparency and

accountability. The Commission commends

the SEC for its issuance of the Concept Release

on the U.S. Proxy System, which includes

inviting comment on how such firms should

be regulated.

9) The SEC should work with the NYSE and

other exchanges to ease the burden of proxy

voting and communication while encouraging

greater participation by individual investors

in the proxy voting process.

10) The SEC and/or the NYSE should consider

a wide range of views to determine the impact of

major corporate governance reforms on corporate

performance over the last decade. The SEC and/

or the NYSE should periodically assess the impact

of major corporate governance reforms on the

promotion of sustainable long-term corporate

growth and sustained profitability.

The current proxy voting system is a complex

network highly dependent on technology,

as noted in a recent SEC Concept Release on the

U.S. Proxy Voting System.44 The SEC is currently

soliciting comments from the private sector to

see if regulatory changes are in order.

Meanwhile, one solution does lie in the hands

of the private sector – namely, advanced

communications networks at brokerage firms,

which can provide significantly enhanced

levels of transparency and enable greater

participation in annual meetings through

electronic shareholder forums on the Internet.

Transparency

With respect to transparency, these broker-hosted

networks can be used to understand and/or

survey the unique perspectives, sentiments, and

opinions of institutional and retail shareholders

as a group and of key segments. For example, with

“sentiment” technology, boards can quickly absorb

and comprehend a multitude of comments from

shareholders – and have a high level of confidence

of being in touch – with little or no administrative

effort. Boards and management can use these

networks to facilitate communications with

and among validated shareholders on a range

of topics.

By adapting networks in this way, directors will

have a new channel to understand shareholder

perspectives on how the company is performing

and where there may be concerns, and they can

obtain a better flow of information overall.

Shareholders will have an opportunity for

dialogue in an environment that has the controls,

accountability, and access provided uniquely

by brokerage firm technology networks.

Participation

With respect to participation, these networks can

create greater engagement and more convenience,

which should lead to significantly higher levels

of engagement. Companies can use this same

technology to hold virtual annual meetings in

combination with live meetings.45 Based on the

experience of some companies, adding a virtual

component can expand participation by as much

as ten times.46

Note: From a regulatory viewpoint, there is no

roadblock to the operation of such networks. The

SEC paved the way for these types of networks in

2008, when it expanded on existing exemptions

available for shareholder-to-shareholder

communications and clarified that broker

nominees and other network hosts would not

be liable for statements made by others on

electronic shareholder forums.47

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appendiX e

Risk Oversight: 25 Questions Every Director May Wish to Consider

Corporate profitability is driven by taking prudent

risks after a well-thought-out strategy is developed.

Opportunities may be lost if corporate decision

makers are unduly risk averse. Maintaining the

status quo is a choice, but not always the best one.

Companies require strong and effective assessment

and management of financial, operational,

enterprise, and reputational risk. The entire board

of directors has a key role in developing strategy,

assessing risk, and overseeing risk management.

In developing corporate strategy and a focus on

risk, directors should probe management, advisors,

and each other by asking at least the following

25 questions (though not necessarily in this order):

Strategy and Information

1. What are we aiming to accomplish, and how

(corporate strategy)?

2. What alternative strategies have been

considered/explored?

3. Do the directors receive risk material that

adequately distills vast quantities of risk

information into prioritized summaries with

proposed actions?

4. Are the risks associated with business units

presented to the board in a comprehensive,

holistic manner?

Financial Analysis

5. How do the losses that have occurred compare

to the risks that have been identified? Are the losses

consistent in magnitude and frequency with what

one could expect, given the risk profile presented

to the board?

6. Can management and the board tie profits,

as well as losses, to the presented risk profile?

7. How actively are resources – capital, balance

sheet, talent – redeployed? Does the organization

consistently, and on a timely basis, feed its winners

and starve its losers?

What-Ifs, Assumptions, and Processes

8. What could go wrong or derail our strategy?

For example, could multiple problems

arise simultaneously or sequentially

(the “perfect storm”)?

9. Has management been forthcoming about

any differences among senior leadership

regarding material strategic recommendations and

decisions?

10. What assumptions underlie our strategy,

and which of those assumptions could change/

be wrong?

11. What processes did management use to develop

strategy and identify risk?

12. Have we achieved a common understanding of

what triggers bring an issue to the board’s attention?

Human Capital

13. What capabilities are required to address risks?

Where do we have capability gaps?

14. Is there a common understanding among

management, the board, and board committees

about their respective roles, responsibilities, and

accountabilities on strategy and risk oversight?

15. Does the board have a clear understanding of

where strategy and risk oversight are delegated

and what processes are used within management

and among business units?

Board and Committee Structure

16. Do the board and the appropriate committees

discuss risk appetite with management?

17. How can this discussion become a part of the

board’s regular routine?

18. Are the board and the appropriate committees

meeting regularly with a chief risk officer (CRO)?

19. If there is a CRO, has the board ensured that the

CRO and general counsel have adequate resources

and appropriate reporting lines to bring any

changes in material risks to the board’s attention?

20. Does the board have the appropriate committee

structure for its significant oversight obligations in

the risk area?

Other Issues

21. Does the board have sufficient personnel

(including advisors) and financial resources in

place to enable it to fulfill its risk engagement

responsibilities?

22. Has the board adopted a board leadership

structure that ensures that the independent

directors have a clearly defined leader?

23. Do the board and the appropriate committees

have access to the information they need to provide

oversight in troubled financial times?

24. Have the board and the appropriate

committees reviewed the incentive structure

with strategy and risks in mind?

25. Have the board and the appropriate

committees reviewed board composition and

director skill sets in relation to up-to-date

competencies for oversight of the company’s

strategy, business lines, and material risks?

Source: Report of the NACD Blue Ribbon Commission

on Risk Governance (Washington, DC, 2009).

(Subtitles added.)

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1 Summary of the discussions held May 20-21, September 14-15, and December 1, 2010, with additional comments provided byStudy Group members in early 2011.

2 Fred G. Steingraber and Karen Kane, “Corporate Leaders at Risk as Feds Take Over,” Houston Chronicle, January 10, 2010, stated:“Today, the public at large has joined the chorus of shareholders and the financial media to ask, ‘Where were the boards?’In the fall of 2008, former Medtronic CEO Bill George wrote a blog with this title (October 14, 2008) http://www.billgeorge.org/page/

where-were-the-boards; and Papa John’s CEO John Schnatter wrote an op ed (Wall Street Journal October 25, 2008) with the title“Where Were the Boards?” http://online.wsj.com/article/SB122489049222968569.html. See also The Financial Crisis Inquiry Report:

Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, Official Government

Edition Submitted Pursuant to Public Law 111-21 (Washington, DC: The Financial Crisis Inquiry Commission, January 2011).http://www.gpo.gov/fdsys/pkg/GPO-FCIC/content-detail.html. The report is in two parts: the main report (signed by the group’s six

Democrat appointees) and the dissenting report (signed by the group’s four Republican appointees). The main report finds that“Compensation systems...often...encouraged the big bet.... This was the case up and down the line – from the corporate boardroom tothe mortgage broker on the street” (p. xix). Also, in institutions involved in lending, “there was a significant failure of accountabilityand responsibility throughout each level of the lending system. This...ranged from corporate boardrooms to individuals.” (p. 125)(emphases added). The report acknowledges pre-crisis governance reforms at Freddie Mac and Fannie Mae (p. 122) and AIG (p. 141),but (similar to the reports surrounding the collapse of Enron, per n. 23 below), the 2011 report goes on to tell of apparently imprudentdecisions at a number of financial institutions at the board level. In order of mention in the report, these include Fannie Mae(pp. 179-186, 318); Citigroup (pp. 19, 137, 186, 197, 199, 260-265, 302, 380); Moody’s (pp. 208, 223); Countrywide (pp. 248-250); MerrillLynch (pp. 258-259, 384); AIG (pp. 273, 345, 348,); Bear Stearns (pp. 284-285, 288, 290); Wachovia (pp. 304-305); Freddie Mac (p. 319);Lehman Brothers (pp. 327, 337-339); and Bank of America (p. 384). The dissenting report, found on pp. 411-538, also mentionsboard decisions but focuses on failures at quasi-governmental institutions Fannie Mae (pp. 506, 509, 518) and Freddie Mac (p. 518).All links in this note were accessed March 9, 2011.

3 Source: U.S. Chamber of Commerce report cited in BusinessWeek. See Phil Mattingly, “Torturous Dodd-FrankRulemaking Can Succeed, Regulators Say.” Bloomberg BusinessWeek, September 30, 2010. Accessed March 9, 2011, from

http://www.businessweek.com/news/2010-09-30/-torturous-dodd-frank-rulemaking-can-succeed-regulators-say.html. For a currentsummary of the Dodd-Frank rules impacting the board, see “Washington Update,” NACD Directorship, February-March 2011.

4 Represented by Brandon Rees, Deputy Director, Office of Investment, AFL-CIO, at some meetings of the Study Group.

5 Mr. Becker completed his planned two-year term at the SEC in February 2011. An SEC press release dated February 1, 2011, notes that“Mr. Becker has been the agency’s chief legal officer and a senior advisor to Chairman Schapiro since February 2009. During his tenure,

he helped shape most of the SEC’s major policy and regulatory initiatives and counseled the Commission on virtually every matterthat has come before it.” The Study Group has been fortunate to have his counsel.

6 According to Study Group member Chancellor William T. Allen, “The financial crisis was in no important respect a result of sloppyor inattentive corporate governance. First, it was a financial crisis, not an economy-wide governance-caused crisis. The boards of high-tech companies, industrial companies, natural resource firms, etc., were affected only because credit markets failed. The causes of thefinancial system problems were related to corporate governance only in a tertiary sense. They were primarily macroeconomic, political,and regulatory. Of course, boards of financial firms were affected, and some did better than others (Goldman, JPMorgan, and WellsFargo did better than Morgan Stanley and Citigroup, which in turn did better than Lehman and Bear Sterns). But this does notnecessarily mean there were systemic internal governance failures, even in the banks. Take Morgan Stanley, for example. In retrospectone might criticize the very high leverage that the firm deployed in its capital structure. But in this risky structure, its board andmanagement were taking risks that were required to try to match the returns that highly leveraged Merrill Lynch or others were able togenerate. Diversified shareholders or their representatives were not calling for more conservative strategies; they were demanding thatMorgan Stanley meet the returns of others. While in retrospect there are many failures, in my view, the principal failure in the case ofthe securities operations of large banks was the failure of financial regulators to understand systemic risks and to regulate them, for in

a highly competitive market, only systemic risk regulators can save the individual firms from excessive risk. This is especially truewhen shareholders believe they have the protection of cheap diversification of risk (which they do have in most states of the world).

n o T e s

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For a guide to the business judgment rule, see Stephen A. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Officers

(New York: Wolters Kluwer Law & Business, 2009). In addition, directors have various disclosure responsibilities under federaland state securities laws. See, for example, Escott v. BarChris Construction Corp. (1968); Feit v. Leasco Data Processing Corp (1971);Collins and Aikens (2009).

17 This list is based on one provided by Study Group member Chancellor William T. Allen. A number of organizations have publishedsummaries of director duties, including the American Bar Association, the American Law Institute, The Business Roundtable, and theNational Association of Corporate Directors. See, for example, the Report of the NACD Blue Ribbon Commission on Director Professionalism

(Washington, D.C., National Association of Corporate Directors, 1996/2005). See also Stephen A. Radin, The Business Judgment Rule:

Fiduciary Duties of Corporate Officers (New York: Wolters Kluwer Law & Business, 2009).

18 “Management Turnover as Change Agent.” Liberum Research Report of October 13, 2010. Quarterly turnover numbers for CEOs,

CFOs, boards of directors, and C-level executives (defined to include CEOs, boards of directors, CFOs, COOs, down to VP level)continued to show a drop in turnover for all key categories for the third quarter of 2010.

19 “What really binds men together is their culture – the ideas and standards they have in common.” Ruth Benedict. Patterns of Culture

(New York: Houghton Mifflin, 1934), 16, 46. For additional definitions, see Hervé Varenne “The Culture of Culture,” ColumbiaUniversity. Accessed March 9, 2011, from http://varenne.tc.columbia.edu/hv/clt/and/culture_def.html.

20 Directors spend more time in preparation and education than they do in meetings, but meeting hours are still by far the mostimportant. As observed in note 8, the 2010 NACD Public Company Governance Survey showed that directors spent an average of71.5 hours in meetings but nearly twice as many hours outside of meetings in preparation and education.

21 Split roles. In about half of all U.S. public companies, the person running the full board meeting holds the title of Chair, but not CEO.Most but not all of these separate Chairs are independent. Boards that choose split roles reason that the board oversees the CEO, so theCEO should not lead the board. They also recognize that running a business and running a board require two different skill sets andtemperaments. Individuals who become CEOs tend to have strong egos and high optimism. Motivated by vision, they aim for highgrowth and tolerate high risk. By contrast, the most effective Chairs tend to be consensus builders who try to balance the two. Boardsthat can balance the “dynamic” CEO and the “wise” (and sometimes older) Chair can have highly effective governance.

22 Combined roles. In about half of all U.S. public companies, the person chairing board meetings holds the title of CEO-Chair.Boards that choose combined roles understand that CEO-Chairs do not necessarily lead the board; that role can go to a designated

lead director to preside over executive (all-independent) sessions of the board, help prepare the board meeting agenda, facilitatecommunication between the chair and the board, and lead parts of the full board discussions. Also, whether or not boards have an

independent leader for the board, they have independent leaders for key committees – namely audit, compensation, governance,and (especially on bank boards) risk. Given these safety mechanisms, it would be difficult to increase the independence of the board.

The use of combined roles underscores the close link between boards and management on issues like strategy. Boards that combineroles do so in part to achieve clarity of accountability and leadership – without necessarily weakening independence (indeed,when separate Chairs receive high compensation, this can compromise their independence – typically not a problem withlead directors).

23 See disclaimer on p. 21 of this Report.

24 In some cases, weak oversight can enable fraud. See Deterring and Detecting Financial Reporting Fraud: A Platform for Action

(Washington, DC: Center for Audit Quality, 2010). For example, it is a matter of record that the board of Enron did not receiveall the information it needed to make the right decisions. See Report of Investigation by the Special Investigative Committee of the

Board of Directors of Enron Corp., William C. Powers, Jr., Chair; Raymond S. Troubh; and Herbert S. Winokur, Jr., February 1, 2002(Counsel Wilmer, Cutler & Pickering) (“Powers Report”). http://news.findlaw.com/wsj/docs/enron/sicreport/. See also The Role of

the Board of Directors in Enron’s Collapse, Report Prepared by the Permanent Subcommittee on Investigations of the SenateCommittee on Governmental Affairs, S. Rep. No. 107-70 (2002), dated July 8, 2002. Accessed March 9, 2011, fromhttp://fl1.findlaw.com/news.findlaw.com/hdocs/docs/enron/senpsi70802rpt.pdf.

In the circumstances that existed (including limits in human knowledge), those effects would not have prevented the 2008-09crisis.” Chancellor William T. Allen, note of December 14, 2010. For more on the causes of the 2008 financial crisis, seeEugene A. Ludwig, Lessons Learned from the 2008 Financial Crisis (Washington, DC: Group of 30, 2008). Accessed March 9, 2011,from http://www.group30.org/rpt_05.shtml. Also see The Financial Crisis Inquiry Report: Final Report of the National Commission

on the Causes of the Financial and Economic Crisis in the United States, cited in note 2.

7 Note that the applicable statute in Delaware, replicated in other states, is that the business and affairs of the corporation"shall be managed by or under the direction of a board of directors" Del. C. Ann., tit. 8, Section 141(a).

8 Respondents to the 2010 NACD Corporate Governance Survey reported spending on average 71.5 hours in meetings, 61.8 hoursreviewing reports, 36.4 hours traveling to and from meetings, 20.1 hours receiving education, 8.6 hours representing the company(or board) at events, and 13.5 hours engaged in other activities related to board service. These averages are not additive, but they

indicate an average total of well over 200 hours per year for board service. As for duration of this service, it averages 6.8 years.

9 While it is possible for individuals such as auditors or regulators to devote full time to monitoring a company without losing theirindependence, this is so because they are employed by a separate entity (the audit firm or the government). In the case of an individualdirector, devoting 2,000 hours to the oversight of a single company would make the director economically dependent on the company’sdirector fees and therefore not independent.

10 The most recent data available from the NACD show that the average frequencies for meetings were as follows:

• Board Meetings: 5.6 (9 hours average per meeting)

• Executive Sessions: 5 (1.7 hours)

• Audit Committee Meetings: 5.4 (3.1 hours)

• Compensation Committee Meetings: 4.4 (2.4 hours)

• Nominating/Governance Committee Meetings: 3.9 (2.2 hours)

11 “The SEC oversees more than 30,000 registrants including 12,000 public companies, 4,600 mutual funds, 11,300 investment

advisers, 600 transfer agencies, and 5,500 broker dealers. We do this with a total staff of 3,600 people.” Source: Mary Schapiro,Testimony Before the Subcommittee on Financial Services and General Government, March 11, 2009. Accessed March 9, 2011,from http://www.sec.gov/news/testimony/2009/ts031109mls.htm.

12 See Appendix A, a list of the NACD Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Held Companies,and Appendix B, “Topics of Blue Ribbon Commissions of the National Association of the NACD 1993 to 2011.”

13 New stock exchange listing rules for the New York Stock Exchange (NYSE) and NASDAQ, as directed by Sarbanes-Oxley,were approved by the SEC November 4, 2003. More recently, Dodd-Frank asked the SEC to propose and pass additional corporategovernance rules, including some rules to be enforced as stock exchange listing requirements

14 See Appendix C for the “Report of the New York Stock Exchange Commission on Corporate Governance” (September 23, 2010).

15 See important disclaimer on p. 21 of this Report.

16 State corporation statutes generally list the decisions boards must make – namely, amending the corporate charter; planningmergers or consolidation; selling, leasing, or exchanging all the company’s assets; and dissolving the corporation. In many cases,the full board must make these decisions. Some areas of board accountability can be delegated to a board committee (but not tomanagement), namely declaring dividends; compensating directors and officers; electing officers; issuing/retiring stock, stockoptions, or rights; indemnifying officers, directors, employees, and agents; and reducing the corporation’s legal capital. Althoughthe full board must ratify these decisions as a matter of procedure and may choose to elevate them to full board consideration,the board is permitted to delegate their consideration to a committee. See the Corporate Director’s Guidebook: Sixth Edition

(New York: American Bar Association, 2011) (forthcoming).

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35 Under most state statutes, a director is presumed to have voted for any action taken, unless he or she votes “no,” or files a written dis-sent during or promptly after the meeting. Courts have held that directors voting on the non-winning side of an issue may request theirvote be noted in the meeting minutes. Some corporate bylaws protect this right. ICANN Corporation Bylaws approved October 31, 2002,in Section 23,“Presumption of Assent,” states as follows: “A Director present at a Board meeting at which action on any corporate matteris taken shall be presumed to have assented to the action taken unless his or her dissent or abstention is entered in the minutesof the meeting, or unless such Director files a written dissent or abstention to such action with the person acting as the secretary ofthe meeting before the adjournment thereof, or forwards such dissent or abstention by registered mail to the Secretary of ICANNimmediately after the adjournment of the meeting. Such right to dissent or abstain shall not apply to a Director who voted in favor ofsuch action.” Accessed March 9, 2011, from http://www.icann.org/en/minutes/minutes-appa-31oct02.htm. Some state statutes require this step.

For example, Delaware’s corporate law says a director can “cause” his or her dissenting vote to be entered into the minutes. Courts havenot generally required that minutes state the reason for dissent. When courts examine votes, they look for evidence of a thorough

process, including vigorous discussion.

36 See John P. Beavers and Kevin M. Kinross, “Corporate Minutes: When Less Is More.” The Corporate Board. March 1, 2008.Accessed March 9, 201, from http://www.accessmylibrary.com/coms2/summary_0286-34149945_ITM. Note: If dissent leads to seeminglyirreconcilable conflict, boards can consider using techniques from mediation. See Jon J. Masters and Alan A. Rudnick, Improving Board

Effectiveness: Bringing the Best of ADR into the Boardroom – A Practical Guide for Mediators (Washington, D.C.: American Bar Association,2005). The Federal Arbitration Act generally overrides state laws that would prevent or inhibit arbitration and requires courts to enforcearbitration agreements unless a given state law limitation applies to all kinds of contracts. On the other hand, courts can interpretarbitration agreements narrowly, which can render a previous arbitration decision moot (vacated). See Stolt-Nielsen v. Animal Feeds,130 S. Ct. 1758 (2010). Accessed March 9, 2011, from http://www.supremecourt.gov/opinions/09pdf/08-1198.pdf.

37 According to the 2010 NACD Public Company Governance Survey, as observed earlier in note 8, the average tenure of boardmembers in public companies is now 6.8 years. It has been at this level since 2008. Prior to that it was longer: 7.6 years in 2007 and8.5 years in 2006.

38 Research suggests, for example, that an overly heavy concentration of financial expertise on financial company boards can actuallyhave a negative impact on performance. Bernadette Minton, Jerome Taillard, and Rohan Williamson. “Do Independence and FinancialExpertise of the Board Matter for Risk Taking and Performance?” Charles A. Dice Working Center Paper 2010-14; Fisher CollegeWorking Paper No. 2010-03-014. October 14, 2010.

39 See, for example, Report of the NACD Blue Ribbon Commission on Board Evaluation (Washington, DC: National Association of CorporateDirectors, 2001/2010).

40 For two recent articles on board self-evaluation, see Cindy Overmyer and Neal Purcell, “The Quiet Revolution: Kaiser’s Internal Audit

Expands Governance Role,” NACD Directorship October/November 2010 (written by an internal auditor and a director); and SuzanneHopgood, “As the World Changes, Are We?” NACD Directorship October/November 2010 (written by a director and outside facilitator).

41 The “General Motors Board of Directors Corporate Governance Guidelines” (revised most recently on August 3, 2010) have statedfor many years that “Consideration should be given to rotating Committee members periodically at approximately five-year intervals,but the Board does not believe that such a rotation should be mandated as a policy since there may be reasons at a given point in timeto maintain an individual Director’s committee membership for a longer period.” Other companies with a flexible five-year rotationpolicy for committee memberships include:

• Metropolitan Health Networks

• Mutual of Omaha

• Owens-Illinois

• Whirlpool

• Woodward Governor Company

25 Regarding management reports, this is a valuable form of information. As Friedrich von Hayek has said, “There is beyond questiona body of very important but unorganized knowledge,” namely, “the knowledge of the particular circumstances of time and place.”Friedrich von Hayek, “The Use of Knowledge in Society,” American Economic Review. September 1945, Vol. 35, No. 4. 519-530.But directors need not limit their views to senior management, or for that matter to internal reports. Regarding disclosures to theSEC, it is widely agreed that these documents contain information that is valuable to both companies and their owners.

26 Acquired solutions vary greatly by type and price. See for example “Mid-Market ERP Solutions Comparison Guide,”from Inside-ERP.com, accessed March 9, 2011, from http://www.inside-erp.com/ (registration required).

27 For example, as part of risk oversight, a company can develop a common language and even color code in an electronic dashboardshowing risks to speed and clarify communications about such matters. A “3/3,” for example, presented in red, can mean high risk withhigh likelihood. A “1/1,” presented in blue, can mean a low risk with low likelihood. Risks with degrees in between could be presented

in shades of purple.

28 Proxy access is still pending as we go to press in March 2011, due to a legal challenge. See Business Roundtable and the Chamber of

Commerce of the United States of America v. the Securities and Exchange Commission. September 29, 2010. Accessed March 9, 2011, fromhttp://www.uschamber.com/sites/default/files/files/1009uscc_sec.pdf. Oral arguments will be heard April 7, 2011.

29 After the collapse of Enron, noted governance expert Ira M. Millstein told Congress: “It may be time to consider whetherboards should be encouraged to rely on a small full-time staff or regularly use outside advisors for support. Board work, for largercorporations, requires significant information, time, and attention. For the board as a collective group of individuals who conveneon a part-time basis to fulfill all that we expect may require more support than traditionally has been available. It may be fruitfulfor some staff resources to be explicitly devoted to supporting the work of the board. Independent directors, as a group, couldbenefit from having staff and counsel resources of their own, distinct from staff and counsel hired by management, especiallywhere potential conflicts with the interests of management are apparent (i.e., audit and compensation).” See Testimony ofIra M. Millstein before the U.S. Committee on Banking, Housing, and Urban Affairs, February 22, 2002. Accessed March 9, 2011,from http://banking.senate.gov/02_02hrg/022702/millstn.htm.

30 See, e.g., 8 Del. C. Section 141(e).

31 Bernadette Minton, Jerome Taillard, and Rohan Williamson. “Do Independence and Financial Expertise of the Board Matterfor Risk Taking and Performance?” Charles A. Dice Working Center Paper 2010-14; Fisher College Working Paper No. 2010-03-014.

October 14, 2010.

32 For example, the NACD Director Compensation Report 2010-2011 reports the following figures for total board compensation in

2010: Smaller companies $519,411 (0.22% of revenues); small $779,858 (0.12%); medium $1,137,500 (0.08%); large $1,469,225 (0.03%);“Top 200” $2,277,611 (0.01%). There are also data on the average annual cost of external auditors, who must be retained by the auditcommittee of the board. These costs could be considered a board cost if boards had a budget. Publicly held companies surveyed

by the Financial Executives Research Foundation paid on average $4.8 million in total audit fees for fiscal year 2009. For publiccompanies, the hourly audit fee rate per hour averaged $218 ($186 for smaller companies [“non-accelerated filers”] and $220 for thelarger companies [“large accelerated filers”]. Source: Audit Fee Survey cited in “FEI Survey: Companies Report Signs of StabilizationWith 2009 Auditing Process,” Press Release, June 24, 2010, Financial Executives International. Accessed March 9, 2011 fromhttp://fei.mediaroom.com/index.php?s=43&item=241.

33 The meticulous attention to rules of order and parliamentary procedure seen in large groups – e.g., Robert’s Rules of Order – is notusually effective for a small group, which can dispense with such formalities. Still, the notion of due process can be helpful.

34 Although some research suggests that groups trump individuals for wisdom, a number of scientific experiments have shown thatgroups can fall prey to conformity. How can this be avoided? Automatic negativity is not a solution, but naïve agreement is just as bad.Yet some directors seem to be too conciliatory. Given the relative rarity of newly vacant seats on boards (due to small board size andlong director tenure), the temptation to “get along” becomes a syndrome.

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42 The 2010 NACD Public Company Governance Survey showed that 46.5 percent of public company boards use an executive recruiterto locate director candidates. Use of firms tends to increase with company size, presumably due to the cost involved, reported tobe in the low six figures – more than the typical cash retainer for a director at even the largest firms.

43 The National Association of Corporate Directors has a large (4,000+) database of qualified director candidates available tonominating committees and search firm professionals for a modest charge. See Directors Registry at www.nacdonline.org.

44 See Concept Release on the U.S. Proxy Voting System, July 14, 2010. http://sec.gov/rules/concept/2010/34-62495.pdf.

45 As of March 2011, the following companies have used technology to enable online participation at their annual meetings:American Waterworks Co., ANTs Software, Artio Global Investors, Best Buy, Broadridge, Charles Schwab Corporation, ConexantSystems, Intel, Pico Holdings, Symantec, Warner Music, and Windland Electronics. Some shareholders have objected to annualmeetings that are entirely virtual, but most shareholders welcome having a virtual-meeting option to complement a live meeting.

46 Source: Estimate by Broadridge CEO Rich Daly based on the experience of Broadridge and users of the Broadridge platform

as of March 2011.

47 “Electronic Shareholder Forums,” February 25, 2008, U.S. Securities and Exchange Commission, accessed March 9, 2011, fromhttp://www.sec.gov/rules/final/2008/34-57172.pdf. In this final rule, the SEC stated, “The purposes of new Rule 14a-17 and theRule 14a-2 exemption are to facilitate experimentation, innovation, and greater use of the Internet to further shareholdercommunications. By facilitating such communications on the Internet among shareholders, and between shareholders andtheir companies, we hope to tap the potential of technology to better vindicate shareholders’ state law rights, including theirright to elect directors, in ways that are potentially both more effective and less expensive for shareholders and companies.”

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The balance sheet represents the financial position of the business as of a certain day,usually the last day of the fiscal period. This end of period most often coincides with theend of the calendar year or the end of a calendar quarter. Most balance sheets you seewill show the numbers for the current period as well as those for the immediate pastperiod for comparison. This lets you see how the various components of the businesshave changed from one period to the next.

The balance sheet can be divided in many ways, but the most logical and easiest tounderstand is the separation of what we have (assets) from where it came from (includ-ing both liabilities and equity, also known as shareholders’ investment or shareholders’equity.)6 In its most typical format, the balance sheet shows assets on one side (the leftside) and liabilities and equity on the other side (the right side). Let’s see why.

ASSETSThe total assets of the business represent the resources the business owns, including allthe goods and property owned, as well as claims against others yet to be collected. Inthe U.S., these assets are listed in order of their liquidity (nearness to cash) at their his-torical cost to the business, adjusted for certain items we will discuss later.

When you list the assets of the business, you also need to show where these assets camefrom. As we said earlier, the funding for assets arise from three sources: invested capital,creditors, and profitable operations. These sources represent specific stakes that various

Getting Behind the Numbers — Fletcher/NACD 9

SECTION 2

What Comprises the Business?

The Balance Sheet

6 Some accountants use the term equities to mean the right side of the balance sheet—both liabilities andshareholders equity.

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parties have in the business. These are categorized as either liabilities (the business owes moneyto the claimant) or as stockholders’ equity (shareholders’ investment in the business plus undis-tributed profits of the past).

Logically, the claims against the assets will always be exactly equal to the total amount of theassets. By definition, there must always be a claim against the assets by either a creditor or anowner. Let us take a look at the development of a business and the recording of its transactionsby an accountant.

We will learn the concepts and the language by studying a balance sheet for ABC Laboratories(ABC) a hypothetical company based on a real publicly owned medical products/services busi-ness operated for profit. Refer to the financial statements in the back of this handbook as yougo through the accounts.

ABC has organized itself into various divisions, each of which could maintain their own bal-ance sheets and income statements. When ABC reports its financial results to the public it con-solidates all its units into a single set of statements. There are some exceptions to this and wewill cover some of them later.

Current AssetsThe most liquid (cash-like) assets ABC owns are its current assets (assets that will become cashwithin one year). These include cash, marketable securities (expected to be sold in the nearfuture), trade receivables (amounts owed to ABC by its customers), inventories of various prod-ucts, taxes that have been prepaid, and other prepaid expenses such as rent or insurance.

Cash—is just what it sounds like. ABC shows $608 million for year end 2012 and $315 million for2011. This account balance includes bills and coins as well as amounts in checking accountsthat are unrestricted in their ability to be withdrawn. Cash is drawn to the business wheninvestors buy shares from the business, when cash is collected from customers, and when thebusiness borrows money or when it sells one of its assets. Cash is withdrawn from the busi-ness to pay debts of the business. These might include amounts payable for items purchasedon credit, for salaries due, or for utilities. The business must also pay interest and principle onthe money it borrows to run the business or to buy land, plant, or equipment. When the busi-ness is profitable, it may pay cash dividends to its stockholders rather than retain the cash inthe business.

Getting Behind the Numbers — Fletcher/NACD

Section 2: The Balance Sheet

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Short-Term Securities—represent temporary investments in stocks that are very marketable and that usually have verylittle price fluctuation. ABC shows $115 million for 2012, up from $96 million at year end of2011. Again, these investments are to enable the business to earn a return on its cash rather thanhave it sit idle.

Trade Receivables—are established when the business sells products or services on credit to its customers. It iscustomary for businesses to allow its customers up to 30 days to pay the amounts due. The busi-ness must pay its own bills regardless of the agreement it has with its customers. Cash flowbecomes a problem when the business pays its creditors in a timely manner but its customerspay slowly or not at all. The amount booked to trade accounts receivable is usually equal to thesales price of the deal reached with the customer. At the end of each accounting period, theaccountants will assess the likelihood that all the amounts will be collected as planned. To theextent they feel some amounts will not be paid, they will estimate and book an adjustment tothe account for what they refer to as allowance for bad debts—also known as doubtful accounts.The 2012 Trade Receivables account for ABC is shown at the net amount of $2.06 billion afterthe accounts were reduced by the allowance for doubtful accounts that same year ($239 mil-lion). The net amount for the previous year was $1.96 billion. As sales volume increases, youmight expect trade receivables as well as costs to increase proportionately.

Red flag: Notice and flag inconsistencies between changes in revenues, receivables, andcosts.7

Inventories—is the account used to collect costs of the various products ABC has purchased or manufac-tured for resale. It is normal for a business to show its inventories at their cost to the business,whether they bought or manufactured the goods. If the market value of the inventories has fall-en below their cost, the business will usually write the amounts down to reflect this loss evenbefore the items are sold to customers. This involves showing a loss by reducing the asset valueon the balance sheet.



7 Throughout this book, we will give tips to audit committee members. However, all directors, including membersof other committees such as a finance committee, may find these tips useful.

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Note that three categories of inventories are listed for ABC: for 2012 the finished products total$772 million in cost, work in progress totals $339 million, and raw materials total $384 millionin costs. The cost of the raw materials is easy to track, but measuring the cost of work-in-process or finished manufactured products is much harder. The accountant must keep track ofthe labor, material, and overhead costs attributable to each product line. This often leads to con-troversy when the business has multiple or complex product lines. Obviously, ABC must use itscash to pay for items it purchases for resale as well as purchases of raw materials for furthermanufacture. It must also pay for labor used to manage inventory or to manufacture goods. Allof the expenses of running the business to store or to make products must also be paid.

It is to ABC’s good to minimize the inventory it carries if it is to minimize cost invested. Goods donot usually earn a profit while they sit on the shelf. Yet ABC must carry inventory in order to satis-fy customer demands for just-in-time deliveries. Thus, the age old battle: should ABC carry inven-tory that costs them money sitting on the shelf and that may become obsolete, or should it carrysmall amounts of inventory and risk not having the items when customers demand quick delivery?

Red flag: Unexplained inventory growth or decline may suggest that the company is unableto accurately forecast customer demand.

Total inventories— include, a sum total of the value of all inventories (finished products, work in process, andraw materials). For 2012, the inventories totaled $1.5 billion, an increase of $83 million fromthe previous year. Again, as with trade receivables, an increase in sales might be associated witha proportionate increase in inventories.

Prepaid expenses, taxes, and other receivables—arise when the business pays its bills before it uses the services for which it is paying.Examples are rents paid in advance, advertising expenses, and insurance premiums paid inadvance. Amounts owed to the business for other than trade transactions are usually reported asa separate item from trade receivables. ABC’s 2012 statements show $1.2 billion for this com-bined account total.

Total Current AssetsCurrent assets when totaled are $6.4 billion as of December 31, 2012. The company expectedthese to become cash within the 2013 business year as part of the normal business cycle of cashto inventory to receivables to cash.



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Investment SecuritiesThis account includes amounts invested in securities of other businesses. Only those maturingafter one year or planned to be sold after one year are included here. Items planned for maturityin less than one year are included in current assets. Note that these long-term investments areaccounted for at the lesser of their acquisition cost or their current market value. As a conserva-tive principle, if they have appreciated above cost, any increase is not shown in these accounts.ABC held $955 million in investment securities on December 31, 2012.

There are three basic ways to keep track of these investments. These methods include recordingthe investment at cost (if we own less than 20 percent of their stock), at equity (if we own 20 to50 percent of their stock), or as a consolidated entity (if we own more than 50 percent of thestock). For a discussion of these three methods, contact your external auditor or your chieffinancial officer (CFO), who can provide a detailed explanation of the implications for yourfinancial statements.

Property, Plant, and EquipmentThis category of assets, which may also be referred to as fixed assets, includes assets that arenot intended for resale by the business. In most cases, these assets are used to generate theproducts or services that the business offers.

Land—includes just what the term suggests. It is recorded at historical cost and is not restated toreflect any appreciation in value (even though appreciation is expected with land in the U.S.).Nor is the land’s value depreciated over time: land is not considered a depreciable asset. ABCshows $203 million in land owned. It is possible that the land owned by ABC could beappraised today for as much as $2 billion or more.

Buildings—are shown at their historical cost. This amount is eventually adjusted for “wear and tear,” asshown in an accumulated depreciation and amortization account. ABC shows $1.9 billion inthis account for year end 2012.

Equipment—is shown at $7.3 billion for 2012. This represents the cost to buy and install the machineryand equipment for ABC operations. This could include manufacturing equipment or

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handling/distribution equipment. Again, the historical cost is shown and is adjusted through anallowance for depreciation as the historical cost is matched with annual revenues to calculateannual profits.

Construction in progress—is an account to show new facilities that are being prepared for addition to the productionprocess but are not yet ready to generate sales for ABC. The total of $373 million is the costincurred to date and is not usually depreciated until installation is complete.

Total property, plant, and equipment—includes all the previously stated accounts at historical cost ($9.8 billion for 2012). The nextline on the balance sheet shows the accumulated depreciation for all fixed assets since theiracquisition. This amount for 2012 is $5.0 billion and is deducted from the total cost of $9.8 bil-lion to arrive at the net property and equipment amount of $4.8 billion for 2012.

The accumulated depreciation account is increased each year as more of the cost of the depre-ciable assets is removed from the balance sheet and shown on the income statement as anexpense. The historical cost will be spread over the useful life of the asset. For public reportingpurposes a straight line approach is usually made, spreading an equal amount each year. For taxpurposes, an accelerated method is used to depreciate the assets, spreading a larger amount tothe earlier years of the asset’s life. The company wishes to show lower income on the tax returnto minimize the tax payments in the early years of the asset’s life.

The acquisition cost of plant and equipment is spread over the expected useful life of the assetin determining how well the business performed from year to year. Various techniques are avail-able to the accountant to measure the appropriate amount to add to the depreciation accounteach period. Each year’s amount of depreciation is accumulated in the single account on thebalance sheet. The report shows how much was paid for the existing plant and equipment andhow much of that cost has been recognized as an expense over the life of the assets.

Deferred Charges and Other AssetsThis category includes such things as goodwill, intangibles, long-term receivables, and invest-ments in affiliates. For ABC this category of assets totals $752 million for 2012. For somefirms, an account is established for goodwill when another business entity is bought. If thetransaction represents a purchase of assets and the price paid exceeds the fair market value ofthe assets less the liabilities, the price paid in excess is considered goodwill.

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Total AssetsThe various categories of assets on the balance sheet are added together to constitute the totalassets of the business. For ABC, this amounts to $14.5 billion, up from $13.3 billion at year end2011. As you will see when you examine the income statement, ABC grew the business primar-ily from profitable operations, rather than from additional investment or from borrowing.

LIABILITIES AND EQUITYThe business entity has been defined in terms of the assets that have been put together to runthe business. This listing of assets is in fact the business defined in terms of historical cost, orwhat the business paid for the assets. The next question we ask is, who has a stake in theseassets? Said another way, how did the business finance these assets? Did it borrow money tobuy plant and equipment? Did vendors provide materials on credit or on account? Did investorsbuy stock from the firm so that the funds could be used to operate the business? Did the busi-ness make a profit that it decided to retain to operate the business (retained earnings)? Thesequestions are answered in the section of the balance sheet that lists liabilities and shareholder’sinvestment. Once again, we will refer to ABC.

LiabilitiesLiabilities are the accounts to which the business is contractually liable to pay specific amounts.These accounts are separated into current and long-term accounts. The current accounts are thosedue to be paid within the next year. Long-term accounts are due in the next year or beyond.

Current LiabilitiesABC’s 2012 balance of current liabilities totals $4.5 billion and comprises short-term borrow-ing, trade accounts payable, and so forth, ending with the current portion of long-term debt.

Note that ABC has an account for other accrued liabilities. The accrued liabilities are amountsthat ABC knows it owes but for which bills have not yet been received or at least they have notbeen entered in the accounting records. Examples include interest that ABC knows it owes ondebt but for which the bank doesn’t send a bill.

Income taxes payable—are recorded in full amounts for the year even if the company has already paid some of thetaxes in installments. (Income taxes are usually paid in quarterly installments.) ABC has

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calculated its total estimated income tax liability owed to various government bodies as $314 million, and has booked this amount as payable now. The final tax bills will result insome adjustments.

Total Current LiabilitiesAs mentioned, ABC owes a total of $4.5 billion considered to be current. This amount shouldbe paid within one year, much of this due within the next 60 days. This is normal for a businessthe size of ABC. But, like other businesses, ABC has to be careful not to run out of cash.

Note: Recall that ABC has $6.4 billion in current assets and consider now it has $4.5 billion incurrent liabilities. This difference of $1.9 billion is called ABC’s net working capital. It is thedifference between current assets and current liabilities. Many people view net working capitalas a measure of the firm’s safety in liquidity.

Red flag: Remember that ABC’s inventories may not be sold and converted to cash as quick-ly as the liabilities may come due. Timing may become a real issue for ABC unless it has agood relationship with the banks.

Insight: Many firms hold their operating managers responsible for performance against theinvestment they control. One measure of this investment is the net assets, or net working capitalplus all other assets including property, plant, and equipment. For ABC, net assets include the$1.9 billion in net working capital and $4.8 billion in net property and equipment, a total ofabout $6.7 billion.

Long-Term DebtLong-term debt is any debt that has portions coming due after one year. ABC has borrowedmoney on a long-term basis totaling $1.3 billion. For a firm with $14.5 billion in assets, this isa relatively small amount of long-term debt.

Other Liabilities and DeferralsThe category of other liabilities and deferrals includes deferred income taxes. The InternalRevenue Service allows certain expenses on the tax return that may not be allowed in the gener-ally accepted accounting practice. It is possible then that the tax liability that ABC shows in itsincome statement does not exactly match its tax return. This is a complex subject and one thatis under change most of the time.

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Total Other Liabilities and DeferralsABC’s other liabilities and deferrals totaled $1.2 billion at year end 2012. There are varioustypes of deferrals. One type is deferred taxes, as mentioned earlier. The U.S. tax laws allow abusiness to expense certain costs earlier on the tax return than is shown on the published finan-cial statements; this tax difference is reflected in a “deferred taxes” account. Another type ofdeferral is deferred revenue. This is gross income that must be deferred because the goods havenot been shipped by the cut-off date (end of period). Remember, we are trying to match earnedrevenue with incurred expenses.

Shareholders’ EquityABC has about 1.6 billion shares of common stock outstanding. Over the years, as the companysold shares to the public, it received a total of about $1.9 billion in return for these shares. Overthe same time period it has also made a lot of profits (net income), which has been reported onits income statement (statement of profits or loss). Each quarter, when ABC reports its earningsfor the quarter, it also declares a percentage of these earnings to be distributed to the sharehold-ers as dividends with the balance of the profits being retained. It is not unusual for a business todistribute 40 percent of its earnings as dividends and to retain the balance for use in growing thebusiness. As you can see on ABC’s balance sheet, a total of $6.2 billion in past profits (earn-ings) have been retained and employed in the business. Other firms might call this retainedearnings.

Common stock in treasury—is stock that is not outstanding. From time to time a firm may buy its own shares in the mar-ket place. It may use these shares as additional compensation for employees, or it may simplywish to reduce the number of shares outstanding. It may or may not retire these shares. ABCnow has almost 18 million shares in its treasury, for which it paid about $258 million on aver-age over time. If you were to check the current value of ABC stock, it would be about $22 pershare. It can now award as a bonus a share of stock that cost it about $14.60, but for which thecurrent value is about $22.

A final account in this section, called unearned compensation, identifies a number of shares thathave been awarded to executives but that have not yet been earned. They may not be traded bythe executives until they have removed the restrictions which were placed when they wereawarded. For ABC, this totals about $23 million.

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Total Shareholders’ InvestmentTotal shareholders’ investment (also called stockholders’ equity) is the sum of preferred shares(if any), common shares, and retained earnings, which may or may not be adjusted for otherfactors. ABC’s shareholders have a total equity of $7.4 billion of the total $14.5 billion in thefirm. You must remember that the $14.5 billion reflects historical cost of most assets, not cur-rent market value. We do not know the current market value of the assets until they are sold, sowe stick with historical costs as a conservative indicator of value. Certainly, the inventories areexpected to sell for much more than their cost and the land that has been purchased over theyears is probably worth a great deal more than ABC paid for it. If we want to know the currentvalue of ABC’s assets, we could hire an appraiser to establish this value as of the current date.

Total Liabilities and Shareholders’ InvestmentWhen we total all the liabilities and the owners’ equity accounts for ABC we find the total is$14.5 billion. Note that this amount must always equal the total assets of the business, since itis merely a statement of where the assets come from, or how the assets have been financed.

Question: If ABC’s balance sheet grows by $1 billion next year, where will the growth havecome from, and where may it show up on the balance sheet?

Answer: ABC can grow by making a profit on its sales, by borrowing more money from thebank, and/or by selling more shares to the public. It can also sell some of its fixed assets.

If ABC grows this year, any or all of the asset accounts could grow. If it grows, obviously, someof the stakeholder accounts (liabilities and/or equity) must grow. If it borrows money to grow,debt accounts will grow. If it makes a profit, retained earnings will grow. If it sells more shares,the common stock account will grow.

BALANCE SHEET VARIATIONSBalance sheets from different industries and countries will vary in form and terminology. Hereare discussions of a bank and a British company, following financial statements in the back ofthis handbook (starting on page 54).

Bank Balance SheetsBanks operate under a federal or state charter and as such are required to prepare uniformfinancial statements for the Comptroller of the Currency. The balance sheet of a bank is



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sometimes referred to as a statement of condition. This statement will be somewhat differentfrom ABC or any traditional manufacturing, retail, or service business. The accounts may seemopposite. As an example, checking accounts or demand deposits are liabilities to a bank, as itowes the customers money in these cases. Similarly, loans to customers are assets, or receiv-ables. Further, the balance sheet accounts do not have to be subdivided into current or noncur-rent accounts.

AssetsRepresentative assets of a bank may include cash on hand or due from other banks, investmentsecurities, loans, bank premises, and equipment. You should closely review the disclosure ofassets of a bank. At a minimum, you must examine the footnotes that accompany the financialstatements. This will be a starting point to lead you to a more informed discussion with theCFO or the CEO of the bank.

Notice in the KLM Financial (KLM) balance sheet for 2012, the major asset is the loan andleases account which is at $4.46 billion with an associated allowance for credit losses of $60 million. KLM has total assets of $6.9 billion.

Recently, the use of derivatives has become an issue for financial institutions as well as thebusinesses that they have guided in this arena. Be sure you understand exactly how much riskthe institution is taking in any of these complex arrangements. This is an area in which youshould consider getting outside expert advice.

LiabilitiesNotice in the liabilities section of KLM, customer deposits total $4.96 billion. Customers gavetheir money to the bank for safekeeping and to earn an interest. These deposits were loaned toother customers at a rate differential that was designed to render a profit for KLM. So the fundson deposit are a liability for the bank, and the funds loaned out are an asset—in that the fundsare owed to the bank with interest. If KLM invests the unloaned balance in profitable ventures,it may earn a good return for its business.

The security of the investments made by a bank are a good monitor of the skill of the man-agers. Remember that some bank managers are driven to outperform the competition. In theirquest for greater returns on their investments or loans they make, these managers could take onexcessive risk.



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Shareholders’ EquityShareholders’ equity in a bank’s balance sheet is similar to that for any other public company.KLM shows $550 million, including $301 million in earnings that have been retained in thebusiness.

An astute director of a bank will:

• Review the disclosure of the market value versus the book value of investments. Thisreview may indicate that investments have a market value substantially above or below thebook amount.

• When reviewing assets, ask about the any derivative instruments especially mortgage-backed obligations or credit default swaps, to ensure that their underlying risk is under-stood.

• Ask if the firm is liable for any debts that are not included on their balance sheet (“off bal-ance sheet loans.”)

• Pay particular attention to foreign loans and the political stability of the area as well as thegeneral business climate.

• Review the footnote that describes any “related party” loans. Observe the materiality ofrelated party loans and the trend of these loans.

• Evaluate the loan loss reserves. Look for changes and for particular loans which have beenidentified as problem loans.

• Review the footnotes for disclosure on nonperforming loans, loans on which the bank isreceiving no or inadequate income. Pay attention to renegotiated loans, especially in thearea of real estate development.

• Closely review the liabilities for significant changes in trends. Look also at any footnoteswhich describe commitments and contingent liabilities.

• In reviewing the statement of stockholder’s equity, look for any significant changes fromyear to year.

Non-U.S. Balance SheetsWe have included in this handbook the 2012 and 2011 financial statements of a hypotheticalpublic corporation based in the United Kingdom. Because this U.K. firm, which we will call



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GHI, is based in the U.K., its financial statements are slightly different from those of a U.S.-based company.

Rather than list the assets and liabilities of the firm, U.K.-based firms reverse the order of theassets and also deduct the current liabilities in arriving at a net asset position, which is thenequal to the owners’ equity. Note that all amounts are shown in British Pounds (£), worth about$1.60 in U.S. dollars (at the time of printing).

GHI’s balance sheet begins with fixed assets, which totaled £5.575 billion. In these fixed assetsare included the fair value of the brands that GHI owns. Upon purchase, the brands are bookedat fair value and are listed in the accounts as intangible assets. If these brands are deemed tohave lost value, the loss is not shown in the income statement as an expense; rather, it is shownas a reduction in the equity section as a goodwill reserve. Note this section is titled capital andreserves in the GHI statements, while it would be called shareholders’ investment (or sharehold-ers’ equity) in a U.S. statement. Note also that, contrary to U.S. practice, some assets may bewritten up to reflect appreciation. This appreciation is then identified as a revaluation reserve inthe owners’ equity section of the balance sheet.

After fixed assets, GHI then lists current assets (£4.2 billion), from which they deduct currentliabilities (£3.235 billion) to arrive at net current assets of £969 million. When these net currentassets are added to fixed assets, the total assets less current liabilities are calculated to be£6.544 billion.

From this net asset position GHI subtracts long-term debt and other creditor accounts of £2.373 billion and provisions for liabilities (reserves) to arrive at an amount of £3.587 billion,which is total assets less total liabilities. This number is then by definition equal to owners’equity which is disclosed in some detail. Notice in GHI’s balance sheet, a number of referencesto footnotes are shown. As in the U.S., the footnotes provide a great deal of detail about thecontents of the accounts listed.

Money MeasurementAccountants measure everything in terms of a single domestic currency, so that all the businessassets can be consolidated into a single set of statements. For example, if a business owns anoperation in a foreign country, the financial statements must be translated from the local curren-cy to U.S. dollars. This translation of currencies cause “paper” financial gains or losses for thehome company—results that appear better or worse than operating reality warrants.



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Let us now look at the income statement (page 56), which shows how well ABC did inmaking and selling products for the year 2012. Basically, the income statement includestwo categories of accounts—income and expense. Our objective here is to match inflowsand outflows of the business to gauge how well we performed. Our objective is to earnmore in sales revenue in a period than we incur in expenses. We are careful to matchrevenue with expense in order to gain a fair measurement of the performance for thespecific period (month, quarter, or year as an example). The rules are simple: sales rev-enue is recorded when goods are shipped to the customer or service is provided, andexpense is recorded when expenses are incurred (not necessarily when they are paid).

SalesABC earned (invoiced customers) $13.2 billion in sales revenue for goods and servicesdelivered during 2012. This is about a 6 percent increase in sales from $12.5 billion in2011. This amount is net of any returns and allowances related to sales. Remember, thisdoes not include contracts or orders for future delivery—it only includes goods or ser-vices that were actually delivered or provided to the customer during this period.

Total Operating Costs and ExpensesTotal operating costs and expenses include the cost of the goods ABC sold, whether itpurchased them for resale or whether it bought raw materials that it converted throughmanufacture to finished goods. This cost totaled $6 billion or 45 percent of each salesdollar.

The cost of goods sold section of the income statement includes some interestingaccounting concepts. When a business begins to manufacture a product it spends moneyon labor, materials, and various overhead items. Assume a business spends $100,000 on

Getting Behind the Numbers — Fletcher/NACD22

SECTION 3

How Did the Business Perform?

The Income Statement

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these items but does not sell the goods until the next year. If the business were to report thecosts in the year it built the goods and the sales revenue the next year, it would not be matchingrevenue and expense. So the business keeps track of these product costs and reports them as anasset in the inventory accounts. Items that are completed but not sold are in the finished goodsaccount and partially complete items are reported in the work-in-process account whichincludes labor, material, and overhead costs.

When the items are sold the following year, their cost will be reported as an expense so they areproperly matched with the related revenue. Many firms will match their sales and cost of salesto arrive at a gross margin. From this figure they subtract sales, general, and administrativeexpenses to arrive at operating income. From this they subtract interest expense to get incomebefore taxes. Also included in operating expense is the cost to administer the business and tosell and distribute its products—$2.9 billion, or 21 percent of each sales dollar. ABC spent anadditional $1.2 billion to conduct research and development during the year. Total operatingexpenses of $10 billion represents about 76 percent of each sales dollar. This is an acceptableratio for a manufacturing company.

Operating EarningsOperating earnings of $3.1 billion represents the difference between net sales and total operat-ing costs and expenses. This is a key figure in any company, because it points to operationsprofitability (or lack thereof). Some firms may report this as earnings before interest and tax(EBIT). Some go further and report earnings before interest, tax, depreciation, and amortization(EBITDA). To some extent, statement format is a matter of choice.

Adjustments to operating earningsFrom the operating earnings, ABC must also deduct its interest expense and tax expense beforeit determines how much it really made “bottom line.” ABC reported $82 million in net interestexpense (remember, it has some $1.3 billion in long-term debt which calls for interest pay-ments). ABC earned $390 million income from its investment in ZAP holdings (a joint venture).This is in brackets to show it is a reduction in non-operating expenses. ABC also had $26 mil-lion in foreign exchange loss. Subtracting the interest and other non-operating expenses fromoperating income yields ABC an income before taxes of $3.4 billion.

Net EarningsUsing standard tax rates, ABC calculated its tax expense as $951 million, leaving it $2.4 billionin net earnings, since there were no significant accounting changes or extraordinary gains or


Section 3: The Income Statement

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losses to be reflected in this year’s income statement. This amount is added to the retained earn-ings account (earnings employed in the business) on the balance sheet. It reflects how much thecompany grew through profitable operations. On a per share basis this represents an earnings ofabout $1.59 per share (~$2.4 billion income divided by ~1.5 billion shares outstanding). Fromthis income, ABC declared dividends of $1 billion to shareholders. This represents almost 42 percent of net income paid to stockholders as dividends.

Reminder: In trying to measure success for each year, accountants have established an objectiveto match revenue with expense as closely as possible each period. Revenue is defined as salesof products or services, and the revenue may be recognized when the goods have been shippedor when the service has been provided. This recognition is made without regard to the timing ofcash receipt for the sale. A delivery made in December 2012 will be considered a 2012 saleeven though the customer will not receive a invoice until January of the following year and maynot pay until March.

Because the invoice has not been prepared as of December 31, the accountant must “accrue” thesale. Against this accumulation of revenue (inflow or sales), the accountant matches the expens-es that have been incurred during the period. As explained earlier (page 8) for an expense to berecognized, it must be incurred. An expense is incurred when an asset’s cost is used up orexpires. The consumption of supplies, the purchase and use of rent and utilities, the use oflabor, and so forth become expenses for the period in which they were incurred, not the periodwhen they are paid.

As an example, if the business uses a building for which it will have to pay rent next year, therent charge will be accrued at year end so that a better matching of revenue and expense occurs.On the other hand, if rent has been paid in advance, the expense will be deferred because thevalue has not yet expired.

Question: What does the income statement really tell me?

Answer: The income statement tells me how well the business performed during the periodunder review. It compares the revenues earned with the expenses incurred to arrive at a

profit measurement. It usually separates the cost of goods sold from the sales and administrativeexpenses to help the reader understand how the business is doing. An important analysis wouldinclude comparison of this year’s results with last year’s.

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Question: Does the $2.4 billion profit ABC earned on its sales of $13.2 billion suggest goodperformance?

Answer: The answer depends on the industry you are in, the amount of capital required todrive the business, and the investment required of the owners (shareholders). The 18.6 per-

cent return on sales (net income as a percentage of sales) is good for a pharmaceutical firm, butit would be great for an automotive manufacturing firm.

Insight: ABC’s 33 percent return on shareholders’ investment (net income as a percentage ofshareholders’ investment) may seem very good, but when compared to the previous year’s per-formance of 40 percent is actually a decline—even though sales went up. The $700 millionincrease in sales did not produce a significant increase in profits.

Question: What should ABC be doing to improve its performance?

Answer: It will continue to improve its customer service and quality control systems; investwisely in research and development or in the acquisition of new products so that it speeds

up the development and introduction of new and better products; control its investment ininventory and other operating assets; get the most out of its selling, distribution, and administra-tive expense; and develop better ways to capitalize on changes occurring in the healthcare field,especially the concentration of buying power reflected in the managed care and medical consor-tium arenas. In short, it will get even better at doing what it has done for years.

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In the balance sheet and income statement, we have seen how much total money passedthrough ABC’s books in 2012. We saw how each account has changed in balance, howmuch profit was made when expenses were matched with sales revenue, and how muchof that profit was apportioned to the shareholders as dividends. If we look more closelywe can see that trade receivables increased, inventories increased, and prepaid expensesincreased. We can also see that each of the current liability accounts increased exceptfor short-term borrowings, which decreased.

In addition to gleaning insights from balance sheets, we can learn from the statement ofcash flows—another of the financial statements that is required of a publicly held corpo-ration. Look at the bottom of the statement of cash flows to see how much the cashaccount changed over the year at ABC. You can also verify these numbers by examiningthe cash account on the balance sheet for the past two years. ABC’s cash accountsincreased from $315 million to $608 million. What ABC has to do is to explain how this$293 million change occurred. Some of the accounts are difficult to understand, so wewill focus on the major accounts. Remember also that these statements are a consolida-tion of accounts and as such often combine accounts that make it difficult to verify theexact account changes. Basically, the statement of cash flow should explain how muchof the change in the cash accounts are from operations (profit or loss), how much frominvesting in fixed assets, and how much from financing activities (borrowing or payingdividends).

Cash Flow from OperationsThe starting point for determining cash flow is the income statement. We start byassuming that the net income (earnings) is net cash flow from operations. If in fact all

SECTION 4

What Can We Spend?

The Statement of Cash Flows

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revenue (net sales) were received in cash and all expenses were paid in cash, net income wouldrepresent cash flow. For ABC in 2012 this totals $2.4 billion. Any income statement expensesthat we know did not require a cash disbursement at the time will be used to adjust this amount.As an example, we know that $828 million in depreciation and amortization expense wasincluded in operating expenses, but that in fact this was an allocation of an earlier cash flow.Thus, it did not really affect cash flow this year. It was a non-cash expense on the income state-ment. This depreciation expense is included in the costs of products but is identified separatelyin the statement of cash flows.

Also, if accounts receivable increased from one year to the next, we can see that all sales werenot collected. We would need to adjust net cash flow for this. If inventories were increased thiswould have an adverse effect on cash flow. If ABC had reduced these inventories it would haveincreased its cash flow. This is one of the reasons many firms are trying to reduce their invento-ry levels. The cash that is tied up in inventories could be used to earn a positive return ratherthan sitting on the shelf. ABC operations produced $2.9 billion in positive cash flow for 2012.

Cash Flow from InvestingWhen ABC invested to buy new fixed assets, it used cash or borrowed the money. This invest-ing activity has a negative impact on cash flow. The one part of the fixed asset account thatchanged and did not affect cash flow was the depreciation. When the expense for depreciationis deducted from revenue on the income statement, this does not reduce cash flow. Thus, whenyou start with operating income as the beginning cash flow you have to add back depreciation.In total, ABC used $1.2 billion cash in buying and selling properties or securities.

Cash Flow from FinancingThe third category of cash flow is that derived from financing activities: borrowing/repayingdebt, selling shares to the public, paying dividends, and purchasing treasury stocks on the openmarket. ABC used a total of $1.4 billion of its cash flow in financing activities. You may noticethat currency fluctuations around the world resulted in a $20 million negative impact on cashflow as well.

A number of transactions that affect cash flow occur within the business. So it is not possible toprepare the cash flow statement from the abbreviated balance sheet and income statement. Wehave included the cash flow statement from ABC’s annual report in the back of this handbook.Examine this statement for its design rather than the specific details. (Note: You will not be ableto reconcile all the cash flow adjustments that are shown in ABC’s cash flow statement.


Section 4: The Statement of Cash Flows

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Section 4: The Statement of Cash Flows

Do not be concerned! A number of accounting transactions have been consolidated and a num-ber of currencies are used in the consolidation. You should be looking for the line that showshow much cash flow was generated by the operations as compared with investing and financingactivities.)

• Most of the $2.9 billion of operations cash flow was used to buy new fixed assets, pay offdebt, pay dividends, or buy treasury stock on the open market.

• The second category of cash flow is the investing portion. This section isolates the effectsof purchases and sales of fixed assets and investment securities. As you can see in ABC’scash flow statement, the investing activity consumed $1.2 billion of ABC’s 2012 cash flow.

• The third and final category of cash flow is that associated with financing. This includesselling stock, paying dividends, and borrowing or paying of debt. For 2012, ABC used $1.4 billion in the financing activity. Note that most of this was cash dividends paid toshareholders.

ReconciliationAfter considering a small exchange-rate effect, the net increase in cash accounts was $293 mil-lion. Operations provided $2.9 billion, investing used $1.5 billion, and financing used $1.4 bil-lion. You should appreciate that this cash flow is managed by ABC. The management has a rep-utation of being very disciplined in budgeting and cash flow management. Surely, that has aneffect on ABC’s consistently positive performance.

ConclusionIt is very important that you understand the flows of cash through the organization from year toyear. Looking at this process through the three categories will help you build a better under-standing of the long-term strength of the business. Note that ABC can increase its cash flow byselling off assets, borrowing money, or reducing the expenses for research and development.These actions may not be in the best long-run interest of the business. The management teamthat knows how to build shareholder value by strengthening the consistent improvement infuture cash flows will be valued most by the market.

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SECTION 5

How Do You Get Behind the Numbers?

Analyzing Strengths andWeaknesses

Thus far, you have examined the financial statements but have not really tried to put anymeaning behind your review. Now that you know what the numbers are and where tofind them, it is time to get behind the numbers and see what they are really telling youabout the business. One of the ways to do this is to calculate a series of ratios and drawconclusions from this analysis. The following discussion of ratio analysis covers a broadrange of topics.

Remember that each company will have its unique set of financial objectives and eco-nomic parameters around which it must operate. Here we will use a series of ratios tohelp you in your quest to get behind the numbers. You will have to decide for yourselfwhich of the ratios are most meaningful for the company you are concerned with.

For the sake of organization, the ratios have been categorized into five areas. We willtalk about profitability, asset management, liquidity, debt management, and marketvalue. We will complete the analysis by looking at the risk of financial disaster as pre-dicted by the Altman Bankruptcy Prediction Model. In a more comprehensive set ofratios included in this handbook, we focus on liquidity, long-term debt paying ability,profitability, and investor analysis. We also look at ratios unique to banks, utilities, andinsurance.

The profitability ratios will focus on how profitable the business is. Asset managementratios study how well the business is managing the resources it has accumulated.Liquidity ratios will answer the questions about whether the business has sufficient shortterm cash to meet the immediate demands of the business. Debt management relates to

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the business’s ability to pay off its debt—money it has borrowed from banks or other financialinstitutions. Market value measures how well the stock market responds to the management ofthe business. Finally, the Altman Bankruptcy Prediction Model is self explanatory, once youunderstand the earlier ratios. To demonstrate our analytical methodology, we will use the finan-cial statistics from ABC’s 2012 financial reports. You will find it interesting to calculate thesame ratios for ABC using their 2011 results (consolidated on the 2012 financial reports). 2011was a much better year in many ways for them than 2012. Note: We will include the 2011results in brackets in the examples that follow.

ProfitabilityEvery for-profit business seeks to arrive at a positive net difference between its inflows and itsoutflows from running the business. This difference, or bottom line, is called net income. For abusiness such as a nonprofit hospital, the profit objective is replaced by either a desire to maxi-mize services provided within the allocated outflows or to render a set service level at the low-est cost in terms of outflow.

Using both the balance sheet and the income statement, we can begin to see just how well abusiness is performing in this input/output relationship. We can compare the ratios we developwith other similar businesses and/or compare our results with those of prior periods.

A basic measurement of profitability is the relationship between net income (profit) and thesales volume of the organization. This measures how much of each sales dollar goes to the bot-tom line. For ABC the return on sales is:

Net Earnings $2.4 [$2.3]= 18.2 percent [18.4%]

Sales $13.2 [$12.5]

A return of 18 percent on each dollar of sales is very good by any standards. This would becalled a very profitable business. If ABC can sustain this kind of performance, it is certainly acompany to be dealt with by the competition.

Another way to look at the performance is to compare the total business turnover or sales activ-ity to the total resources at risk in the business (the assets). In this case, with $14.5 [$13.3] bil-lion in resources, ABC was able to generate $13.2 [$12.5] billion in sales, a ratio of less than1:1. Obviously, in this manufacturing business, it takes a lot of working capital and plant andequipment to drive the sales effort experienced by ABC. Asset turnover for ABC is:

Sales $13.2 [$12.5]= 0.91 : 1 [0.94 : 1]

Total Assets $14.5 [$13.3]


Section 5: Analyzing Strengths and Weaknesses

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If you consider the resources (assets) we are employing, it is fair to examine how much profitwe made in relationship to the total assets. ABC earned a $2.4 [$2.3] billion net income whileusing $14.5 [$13.3] billion in resources—a return of 16.6 [17.3] percent. The owners should bevery satisfied with this performance since an equivalent investment at 7 [5] percent in govern-ment securities would have provided a return of about $924 [$725] million before taxes.However, its year on year comparison is cause for concern. ABC’s return on assets is:

Net Earnings $2.4 [$2.3] = 16.6 percent [17.3%]

Assets $14.5 [$13.3]

This business would not be considered highly leveraged in that only $1.3 billion of the total$14.5 [$13.3] billion in resources have been provided by long-term creditors and lenders. Over$7.4 [$5.7] billion is being provided by the shareholders via their initial investment and past earnings. Again, observe year on year performance here.

In terms of their equity, the business has given a 32.4 [39.7] percent return on equity.

Net Earnings $2.4 [$2.3]= 32.4 percent [39.7%]

Shareholders’ Equity $7.4 [$5.8]

Another recognized measure of profitability is the statement of net income on a per-share basis.ABC had an average of 1.537 billion shares outstanding at year end and had a net income of$2.446 [$2.334] billion. On a per share basis this represents an EPS of $1.59 [$1.52]:

Net Earnings $2.446 [$2.334] = $1.59 [$1.52] / Share

Shares Outstanding 1.537

It would be fair to ask how much a share of ABC stock would cost today considering it gener-ates $1.59 [$1.52] per share in profits. We will look at that ratio in the market value section.

For most organizations today, the pressure is on to collect receivables (money owed for salesmade on credit) as early as possible and to carry only the inventory required to meet customerservice levels. Obviously, carrying receivables on the books is risky as well as expensive. Thelonger you allow a customer to owe you money, the greater the chance they will encounterfinancial difficulty and maybe never pay you for the goods or services you sold them. ABC had$2.06 [$1.96] billion in trade receivables. Each day the receivables are allowed to sit idle, ABCis losing the use of the money. At 10 percent annual interest, it costs $564,000 [$537,000] perday to carry these receivables.



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Another piece of ABC’s working capital is its inventory, which totaled $1.5 billion at year end.As mentioned earlier, it costs money to store and handle inventory, so many businesses arefocusing on inventory reduction programs. If it costs 25 percent per year to carry inventory onthe shelf (interest, storage, handling, losses). The cost for ABC to carry this inventory is morethan a million dollars per day.

Asset ManagementABC’s management is evaluated in part on how well it manages its receivables and inventory.Let us now look at some ratios that can tell us how it is doing in this department. Receivablesare typically aged to evaluate the likelihood they will ever be collected. It is usual to categorizethe receivables as under 30 days old, 30 to 60 days, 60 to 90 days old, and more than 90 daysold. The over 90 days old accounts are often at serious risk of never being collected. Anothermeasure of quality for the receivables is the average collection period. For ABC this is 57 days.Said another way, on the average, ABC has 57 [58] days sales outstanding (DSO):

Average Receivables $2.06 [$1.96] billion

Average Sales per Day $36 [$34] mil ($13.2 [$12.5] bil / 365) = 57 [58] DSO

The inventory analysis will often look at the number of times we bought and sold our inventory,called inventory turnover. While some large firms, especially those that serve as distributors,carry large quantities and have a relatively low turnover figure, others focus on speeding theturnover by carrying lower quantities and trying to achieve a “just-in-time” inventory system.Remember that inventory is carried in our records at its historical cost (purchased or manufac-tured) so we have to compare inventory levels to the cost of goods sold to get an accurate pic-ture of inventory turnover. ABC had inventory turnover of 7.8:

Cost of Goods Sold $6.0 [$5.4] bil

Average Inventory Balance $0.77 [$0.70] billion = 7.8 [7.7] times

(finished products only)

Another way to look at inventory is to measure the number of days sales in the inventory. IfABC turned its inventory 7.8 times, this represented an average of 47 days inventory in stock:

Days in the Year 365

Inventory Turnover 7.8 = 47 days

Remember that each business has its own set of operational measurements that are critical to itssuccess. As an example, hospitals will be focusing on occupancy rates for their bed capacity,



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full time equivalents (FTE) of staffing support, average cost of tests performed on patients,average length of stay for various illnesses, and speed and completeness of collections of theirreceivables. Banks may be more concerned with the volume of loans outstanding, loan lossreserves needed, delinquency rates, and cost of money. Distributors will on the other hand beconcerned with average margins they can charge for various products and the speed with whichthey can turn their inventory.

LiquidityEvery business is challenged by its cash flow performance. The following ratio examines howwell the firm is prepared to meet its near-term cash obligations. The current ratio relates thecurrent assets (those due to become cash within a year) to the current liabilities (bills to be paidwithin a year). For ABC, the ratio is only slightly better than 1:1, a ratio considered low. Thekey to safety for a company with a low current ratio is the relationship it has with the banks orother lending agencies. If a bill comes due and the firm cannot make the payment, the creditorscan force the business into bankruptcy court. ABC’s current ratio is:

Current Assets $6.4 [$5.6] bil

Current Liabilities $4.5 [$5.0] bil = 1.4 : 1 [1.1 : 1]

This relationship is also examined with the term working capital, which is simply the excess ofcurrent assets over current liabilities. This represents flexibility the business has in timing itscash receipts and disbursements. The smaller the amount, the more careful the business mustbe. In ABC’s case, the net working capital totals $1.9 billion. ABC has a strong current ratio,has a proven track record and a good relationship with the financial markets, so it is not overlyexposed in terms of liquidity.

Debt ManagementIn addition to short-term cash flow management, a business must be concerned with its long-term cash management. We can use ratios that compare debt to assets used in the business, ordebt to the amount of owners’ equity that the business is operating with. A third ratio will lookat the relationship between cash flow from operations (less dividends paid) to the long-termdebt position. ABC has a total debt to assets ratio of 48 [56] percent meaning that 48 percent ofthe assets are provided by creditors and lenders rather than the owners.

Total Debt $7.0 [$7.5] bil

Total Assets $14.5 [$13.3] bil = 0.48 [0.56] : 1 (48% [56%])



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The long-term debt to owners’ equity ratio is extremely important, especially to the providers ofthe debt. They want to be careful that they are not carrying too much risk in the business sincethey do not share in the profits, but merely get their money and agreed interest charges back. Sothey like to keep the debt to equity ratio low, placing the risk on the owners. ABC on the otherhand may prefer to avoid paying interest and may prefer to grow the firm by retaining its ownprofits from operations. ABC has a long-term debt to equity ratio of 0.18 : 1:

Long-term Debt $1.3 bil

Owners’ Equity $7.4 bil = 0.18 : 1

The last debt management ratio we examine is the relationship between cash flow from opera-tions (less dividends paid) and the long-term debt position. In 2012, ABC had $2.9 billion inoperating cash flow and paid out $1 billion in dividends—net of $1.9 billion. With $1.3 billionin long-term debt, ABC’s cash flow to long-term debt ratio is 1.46 : 1. If the long-term debt isdue in 15 years, ABC has some flexibility in dealing with this debt. In any event, ABC’s perfor-mance is sufficient to warrant carrying this much debt. Whether it would want to borrow more isa matter of choice and management’s evaluation as to whether it could effectively employ anyborrowed money at this time.

CFFO less Dividends $1.9 bil

Long-term Debt $1.3 bil = 1.46 : 1

Market ValueFor businesses that are available as investments to the public, the market value ratios are impor-tant in understanding the business. ABC is publicly traded. At year end 2011 it was being tradedat a price about $16.50 on the NYSE. We earlier calculated ABC’s earnings per share as $1.59[$1.52], meaning it was trading at a price earnings ratio of 10.4 : 1 [10.9 : 1].

Price per Share $16.50

Earnings per Share $1.57 [$1.52] = 10.4 : 1 [10.9 : 1]

Another way to look at a public company is to examine the relationship between market value ofthe firm and the book value of owners’ (shareholders’/stockholders’) equity in the firm. Marketvalue of the firm is calculated by multiplying the market price ($16.50) times the average num-ber of shares outstanding (1.558 [1.561] billion). This comes out to $25.7 [$25.8] billion.



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The book value of owners’ equity is $7.4 [$5.8] billion, as shown in the balance sheet. The mar-ket to book ratio for ABC is then 3.5 [10.3] : 1, meaning that the market values ABC’s perfor-mance at 10.3 times the investment the owners’ have made in the business.

Market Value $25.7 [$25.8] billion

Owner’s Equity $7.4 [$5.8] billion = 3.5 : 1 [4.4 : 1]

ConclusionComparison of these ratios to prior periods will show how well the firm has changed its perfor-mance. Using other firms as a benchmark you can compare these ratios to similar data for thecompetition. As you better understand these measurements you will probably develop new onesand discontinue observing some of these. Whatever your technique for analyzing a business, besure you understand how the numbers were put together and what they really mean. Get behindthe numbers and your performance will improve.

The additional ratios that follow cover a range of industries. You should be able to calculatethese ratios now that you have completed this guide. If you have difficulty, consult your chieffinancial officer or your external auditor for assistance.

Now try your hand at calculating the 2012 ratios for ABC and comparing them with the resultsin this section. Use the following pages for your calculations.

NOTE: In many of the ratios, we showed the two latest years for comparison. The firm is not assuccessful in the latest year as they were in previous year.



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Ratio Calculation WorksheetReturn on sales

Net Earnings $______

Sales $______ = ______ percent

Asset turnoverSales $_______

Total Assets $________ = _____ : _____

Return on assets Net Earnings $______

Assets $________ = ______ percent

Return on equityNet Earnings $______

Shareholders’ Equity $______ = ______ percent

Earnings per share (EPS)Net Earnings $_______

Shares Outstanding ________ = $______/Share

Average collection periodAverage Receivables $_______

Average Sales per Day $_______ ($_____ / 365)= ____ days

Inventory turnover Cost of Goods Sold $__________

Average Inv Balance $_________ = _______ times



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Inventory in stockDays in the Year 365

Inventory Turnover _____ = ____ days

Current ratioCurrent Assets $______

Current Liabilities $________ = _____ : 1

Total debt to assets ratio Total Debt $_________

Total Assets $_________ = ______ : 1 (_____%)

Long-term debt to owners’ equity ratio Long-term Debt $_________

Owners’ Equity $____________ = ______ : 1 (______%)

Cash flow to long-term debt ratio CFFO less Dividends $________

L-T Debt $________ = _____ : 1 (_____ X)

Price earnings ratioPrice per Share $____

Earnings per Share $_______ = ______ : 1

Market to book ratioMarket Value $_______

Owner’s Equity $______ = ______ : 1



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“Audit Committees and the Work of the PCAOB”

Daniel L. Goelzer

Board Member, Public Company Accounting Oversight Board

2011 NACD Board Leadership Conference

October 2011

The PCAOB has three ongoing initiatives that could make fundamental changes in auditing: (1) Consideration of ways to promote auditor independence, including mandatory audit firm rotation; (2) Consideration of changes to the auditor's reporting model, including a possible Auditor's Discussion and Analysis requirement; and (3) Consideration of increasing audit transparency by requiring disclosure of the name of the engagement partner and of all audit firms that participated in the audit. Each project could have a significant impact on audit committees and their responsibilities. The speech outlines some questions audit committee members ought to be considering regarding each of the initiatives and urges them to participate in the PCAOB's decision-making by filing comments.

The PCAOB is also seeking to improve auditor/audit committee communications and to promote audit committee understanding of the relevance of PCAOB inspection observations to audit committee oversight. The speech suggests four broad questions that audit committee members should ask their auditor regarding the auditor's PCAOB inspection and how the inspection results might impact the company's financial reporting. In particular, if the auditor claims that an audit deficiency was merely the result of a failure to document procedures that were performed, or simply the product of a difference of professional judgment, the audit committee should be skeptical and should require the auditor to provide a very specific explanation.

Audit Committees and the Work of the PCAOB I am very pleased to be here today. It is an especially good time to be talking to audit committee members about their role and that of the auditor. Both in the U.S. and abroad, some of the fundamental premises of auditing are under scrutiny, and changes that could profoundly affect both auditors and audit committees are on the agenda. It is critical that audit committee members — who are on the frontlines in maintaining investor confidence in financial reporting — play an active role in the debate.

Nine years ago the PCAOB was created, in the wake of Enron, WorldCom, and other financial reporting scandals, to inspect the audits of public companies and to write the auditing standards that govern those audits. At the same time, Congress put audit committees squarely at the center of the auditor/public company relationship. The result was a sea change — for the better, I believe — in how both auditors and audit committees perform their duties.

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Now, the financial crisis and its aftermath have triggered another re-examination of the operation and oversight of our capital markets. The role of the auditor in providing investors with assurance regarding financial reporting is no exception. Financial statement users have asked whether, to promote independence and professional skepticism, time limits should be placed on the ability of large public companies to retain their auditor; whether the auditor's report continues to have value and relevance to users; and whether the report should expand to include new information. A related issue is whether and how auditor/audit committee communications could be strengthened in the post-crisis environment.

I am going to outline the Board's initiatives to address investors' concerns in these areas. All are controversial, and final decisions have not been made about any of them. However, whether you agree or disagree with them, these projects raise questions that audit committee members should care deeply about. If I leave you with nothing else today, I hope you will take away how important it is that those with practical experience on audit committees comment on our proposals so that the Board will have the benefit of your views.

Before I go further, I want to note that the views I express are my own, and not necessarily those of the Board, or of its other members or staff.

I. Independence/Audit Firm Rotation

I want to start with the most fundamental issue — auditor independence. Audits only have value if they are performed — and appear to users to be performed — by auditors that are independent and that approach their work with an attitude of professional skepticism.

Unfortunately, this is not always the case. The PCAOB's inspection program continues to uncover too many instances in which auditors did not approach some aspect of their work with the required independence, objectivity, and professional skepticism. A brief review of the public portions of the inspection reports we issue will provide you with numerous examples. The auditing of the valuations assigned to illiquid securities, of impairment determinations, and of management estimates, and going concern evaluations are examples of areas particularly prone to breakdowns in skepticism and unquestioning reliance on management.

To address this issue, in August, the Board issued a concept release seeking public comment on ways in which the Board could strengthen auditor independence, objectivity and professional skepticism.[1] The release focuses particularly on mandatory rotation of audit firms. Audit firm rotation — that is, a term limit on how long an audit firm can serve a public company client — has been discussed since the 1970s. There are strongly-held views on both sides of the issue.

Proponents of rotation believe that setting a time limit on the audit relationship could free the auditor from the effects of pressure to keep the client happy in order to preserve the

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relationship. They also point out that rotation would build into auditing a periodic opportunity for a fresh look at the company's financial reporting by a firm that does not have a vested interest in standing by the prior opinions. Beyond that, many simply believe that auditor/public company relationships that go back many decades — 50 or 100 years in some cases — are just incompatible with skepticism and independence.

Rotation opponents have concerns about the costs of changing auditors — both in terms of the time and disruption imposed on the client's financial reporting staff and of the effort that the audit firm must devote to learning a new client's business and financial reporting system. Ultimately, of course, the company bears the cost of that effort. Some evidence also suggests that the risk of audit failure may increase in the early years of an engagement, while the new auditor is still moving up the learning curve, and that rotation could therefore actually reduce audit quality.

The PCAOB is not alone in considering the possibility of mandatory rotation. Recent press reports suggest that the EC is about to publish several far-reaching proposals aimed at enhancing professional skepticism, including mandatory firm rotation after nine years; required joint audits (i.e., two firms must participate in every audit); and the divestiture of audit firm consulting businesses, so that auditors engage only in auditing.

Mandatory rotation would obviously have a major impact on audit committees, as well as on auditors. The committee would no longer have unfettered discretion over whether and when to change auditors. When rotation was required, the burdens of soliciting proposals and hiring a new firm would be unavoidable. Beyond that, some issues raised in the PCAOB independence concept release on which audit committees should speak up include —

• From an audit committee perspective, would audit firm rotation enhance auditor independence and professional skepticism? You see the auditor/company relationship firsthand. Do you believe that term-limiting the auditor would make for better auditing? Would it increase your confidence in the auditor's objectivity?

• Has your audit committee considered implementing audit firm rotation voluntarily? If so, what was the result? If not, why not?

• What is your experience with the cost impact of changing auditors? Does an auditor change impose burdens on the company's financial reporting staff? Are there “learning curve” audit fees associated with a new engagement?

• Are there approaches other than rotation that would enhance audit committee oversight in a way that would meaningfully improve auditor independence?

I have serious doubts that across-the-board mandatory rotation is a practical or cost-effective way of strengthening independence.[2] More tailored approaches, such as requiring rotation of a long-tenured auditor when a PCAOB inspection finds a lack of professional skepticism, or giving audit committees a choice between rotation of a long-serving auditor or periodic joint audits, might be avenues worth exploring. However, after nearly nine years of inspections experience, it is the appropriate time for the

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PCAOB to examine independence. And, it is hard to get away from the idea that we need to do more to promote professional skepticism.

II. Auditor's Reporting Model

The second fundamental premise of auditing under review is what the auditor should report — that is, what the end product of the audit should be. Today, the only visible result of the thousands of hours (and sometimes millions of dollars) that go into the audit is a short, boilerplate, pass-fail report. Few financial statement users bother to read that report — except to make sure that it is in fact the standard, unqualified report.

As in the case of independence, the financial crisis has caused investors to question the traditional approach. Fairly or unfairly, many feel that, in the run-up to the crisis, auditors could and should have provided more information about the risks and uncertainties financial institutions faced. Clean audit opinions, issued just a few months before major institutions either collapsed or required multi-billion dollar government bailouts have understandably raised questions about the value of those opinions.

An informal survey conducted by the Board's Investor Advisory Group illustrates these concerns.[3] The survey found that 45 percent of investor respondents believe the current audit report does not provide valuable information that is integral to understanding financial statements. Almost one in five thought that the standard, unqualified report was of no use to them at all.

In light of this dissatisfaction with the traditional pass-fail report, in 2010 the Board undertook a project to explore whether and how the auditor's reporting responsibilities could expand. Last year and in early 2011, we held a series of focus group meetings with investors, preparers, auditors, and others to get ideas about how to improve auditor reporting. Based on that work, in June, the Board issued for public comment a concept release that focuses on four alternatives.[4]

• Auditor's Discussion and Analysis : The most far-reaching approach would be to require the auditor to provide an auditor's discussion and analysis, similar to management's discussion and analysis. The AD&A would be a narrative report and would provide the auditor with a vehicle to discuss his or her views regarding significant financial reporting and auditing issues. The AD&A might discuss the audit itself, such as risks identified, the audit procedures that addressed those risks, and their results. However, the AD&A could also include a discussion of the auditor's views regarding the company's financial statements, such as an assessment of management's judgments and estimates, of its selection and application of accounting principles and policies, and of difficult or contentious issues that had to be resolved, including "close calls" — decisions that could have gone either way -- and their effect on the financial statements.

• Emphasis Paragraphs : Another alternative would be to require the use of emphasis paragraphs. The auditing standards already permit auditors to include

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additional paragraphs in their opinions to emphasize the importance of particular matters, such as related party transactions or events subsequent to the end of the reporting periods. It might be possible to super-charge the emphasis paragraph concept by requiring auditors to highlight the matters in the financial statements or in the management disclosures that, in the auditor's view, are the most critical to an understanding of the company and its financial position. Emphasis paragraphs could be tied to items disclosed elsewhere or could be used to introduce new information.

• Auditor Assurance on Other Information Outside the Financial Statements : A third possibility would be to require auditors to audit information outside the financial statements, such as management's discussion and analysis, earnings announcements, or non-GAAP information in company releases. This approach would take the auditor's traditional role of attesting to management assertions, but extend it into new areas.

• Clarification of the Standard Auditor's Report : A final idea is to expand and clarify some of the key language in the standard audit report. Some of the terminology that could be clarified includes the meaning of providing “reasonable assurance”; the extent of, and limitations on, the auditor's responsibility to detect fraud; the auditor's responsibility for footnote disclosures; the extent of the auditor's responsibility for financial information accompanying, but outside of, the financial statements; and the meaning of auditor independence.

Changes in the auditor's reporting model could have a profound affect on auditing. They could also have a profound effect on audit committees. Here are a few of the issues you might want to think about and give us your thoughts on —

• Today, auditors communicate to the audit committee much of the information that might appear in an auditor's discussion and analysis. How would audit committee oversight be affected if the auditor's views on such things as management's judgments and choices regarding accounting principles became public? Would the substance and candor of auditor/audit committee communications change?

• In light of the committee's responsibility to oversee company financial reporting, how would an audit committee react to a situation in which the auditor raised questions, in an AD&A report, about some aspect of the company's financial reporting? Would it be necessary to conform to the auditor's preferences? Would the effect be to put the auditor, rather than management, in charge of making the difficult calls?

• How would a requirement that the auditor prepare a free-written narrative report on the company's financial reporting affect the level of audit effort and the nature of the relationship between the auditor and the audit committee? Would the content of these reports be negotiated between the auditor, the committee, and management? Would the lawyers have to become involved?

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In my view, it is doubtful whether financial reporting would benefit from requiring auditors to create their own information about the company's financial reporting or to publish their own views about matters that are within the realm of management judgment.[5] However, even without requiring auditor-created commentary, there is still considerable room to expand the scope and relevance of auditor communications, such as through requiring the auditor to attest to portions of the MD&A or to emphasize the importance of information that management itself has disclosed. As in the case of independence, however, it is hard to conclude that nothing at all should change, given the dissatisfaction of investors -- those for whose benefit the audit is performed — with the current reporting model.

III. Transparency

Before I leave auditor reporting, I want to mention another Board initiative relating to what is in the auditor's report. While more limited in scope, this project — which we refer to as increasing audit transparency — could also make significant changes in the information users receive about audits. The transparency project has two aspects.

First, some time ago, the Board asked for public comment on whether the engagement partner should sign the audit report in his or her own name, along with the name of the firm.[6] (Partner signature is already the norm in Europe and some other parts of the world.) Views were mixed. Auditors were generally opposed to the idea, but there was strong support among investors. Many feel that, at minimum, disclosure in the audit opinion of the name of the engagement partner would be in keeping with modern concepts of transparency and would promote a sense of personal responsibility.

In addition, the Board is considering requiring disclosure by the principal auditor of all of the other audit firms that participated in the audit.[7] Today, in most cases, the audit opinion leaves the impression that all of the work was done by the firm that signed the opinion. That is often not the case.

For example, most large companies conduct operations around the world, and work on their audits is therefore performed in many countries. Typically, the auditors in each country are separate, semi-autonomous firms, even though they are part of the same global network as the principal auditor. At the other end of the spectrum, we are increasingly seeing cases in which a small U.S. accounting firm purports to audit a foreign company with most of its operations in an emerging market, such as in China. The U.S. firm accomplishes this feat by contracting with an accounting firm in the company's home country. Disclosure of participating firms would shine a light on these relationships and give users a better idea of whose work they are relying on when. It would also afford users the opportunity to determine whether particular participating firms have had PCAOB inspections and, if so, what the results were.

This type of information should also be important to audit committees. We know from our inspections that firm quality varies from country to country, even when the firms in question have the same name and are part of the same global network. The extent to

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which the engagement partner at the signing firm understands these quality differences and exercises strong supervision over the work of his or her foreign colleagues also varies. If your company's audit entails work that is performed by multiple firms, including affiliates of the principal auditor, I would recommend that you ask questions about the role of these other firms and how the engagement partner will monitor the quality of their work. This is particularly important if portions of the audit will be performed in emerging markets.[8]

The Board will be making formal proposals on both of these topics later this month. I hope you will consider how these disclosures would impact audit committees and provide us with your comments.

IV. PCAOB Inspections and Audit Committees

The final area I want to mention is the importance that the Board places on the work of audit committees. The Sarbanes-Oxley Act had two broad goals — to create the PCAOB to oversee public company auditing and to strengthen the role of audit committees. We see those goals as linked and inter-dependent. With that in mind, the Board has two initiatives underway designed to support audit committees.

First, we have proposed to update and expand the information that auditors are required to communicate to audit committees.[9] This project clarifies and brings together in one place existing communication requirements. In addition, the proposal would require the auditor to discuss overall audit strategy and risks with the audit committee and to make inquiries to the audit committee regarding matters relevant to the audit. The new standard would also enhance auditor communications regarding the company's policies, practices, and estimates, and the auditor's evaluation of the company's financial reporting. The trick is to accomplish these goals without turning the communication process into a check-the box exercise or burdening the audit committee with detailed information that is not useful.

Second, the Board wants to make sure that audit committees understand the role that PCAOB inspections play and how Board inspections observations may assist audit committees in their oversight and evaluation of their auditor. To this end, the Board is considering publishing guidance to help committees in understanding our inspections. There are statutory limits on how much the Board can publicly disclose about an inspection. But, there are no limits on what any audit committee can ask its auditor about the firm's inspection and its impact on the company's audit. We would like to give audit committees a road map that will lead them through those discussions.

Our guidance is still a work-in-process. However, in my view, there are four broad questions audit committees should ask about their PCAOB inspection.

• Is the PCAOB reviewing our engagement as part of its inspection of your firm?

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The Board does not notify the company when its audit is being reviewed as part of an inspection of the audit firm. Therefore, in order to avoid surprises, audit committees should make sure they will be informed by their auditor if the company's audit is selected for PCAOB inspection. Of course, you might hear about the inspection in another way. As part of reviewing an audit, the Board sometimes interviews the audit committee chair to assess the accounting firm's relationship and communications with the committee. These interviews are usually conducted by telephone. Inspectors are not trying to assess the audit committee, but are trying to understand auditor/audit committee communications and the relationship between the committee and the auditor.

• Did the PCAOB identify issues with our audit in your inspection report?

If the inspections staff concludes that an audit opinion was issued without proper evidentiary support or, worse still, that the financial statements were materially inaccurate, the audit failure will be described in the public portion of the firm's PCAOB inspection report. In many cases, the Board also reports the company to the SEC. Having your engagement cited as deficient in an inspection report should be a significant concern to the audit committee.

Companies are not identified by name in PCAOB inspection reports and the Board does not communicate directly with managements or audit committees. Therefore, you can only learn that we have a problem with your audit or your financial statements from your auditor. Make sure to ask. Many auditors would likely take the initiative to notify the client if it is the subject of an adverse PCAOB inspection finding. Even so, you might prefer to have an early warning. During the course of an inspection and long before the inspection report is released, the PCAOB staff issues comment forms to the audit firm raising questions and seeking more information when something about an audit seems questionable. It may be prudent for audit committees to ask to be notified if a comment is issued regarding their audit. Firms will not necessarily volunteer that information, unless asked.

• If the Board did find a problem with the company's audit, what is the firm's response?

If the PCAOB identified your company's audit as deficient, the auditing standards require the firm to consider the need to cure the problem by performing additional work. Audit committees should understand what the firm intends to do about the deficiency, particularly if the firm's conclusion is that no action is needed. In that regard, two explanations that we commonly hear in response to inspection findings are that the PCAOB's findings are merely the result of a failure to document in the audit work papers procedures that were actually performed, or that the inspection deficiency is simply the product of a difference of opinion on a matter of professional judgment.

Based on nine years of reading inspection findings and discussing them with the PCAOB staff, I would advise audit committees to take both of these explanations with a grain of salt. It is unusual for significant work to be performed, but not documented. And, in the

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PCAOB's view, we do not include matters as audit deficiencies in our reports if we believe that reasonable professionals could reach different judgments concerning them. At minimum, I would urge that, when you hear the words “it was just a documentation problem” or “it was a matter of professional judgment” that your antennae go up and that you require the auditor to provide a very specific explanation of the nature of the problem and why the PCAOB inspectors concluded it was an audit failure. You may well come to the conclusion — as we often do — that there is more involved than a failure to write something down or a difference in professional judgments.

• Did the Board identify any issues with your firm's quality controls that could affect our audit?

The non-public part of an inspection report discusses the Board's conclusions regarding quality control deficiencies at the firm. Examples include inadequate supervision, weak firm procedures in specific audit areas, or an unhealthy “tone-at-the-top.” This part of the report may also cite specific audits that illustrate quality control breakdowns. Audit committees should be curious whether their engagement is referred to in that discussion. More broadly, it would be prudent to ask how the firm plans to satisfy the PCAOB that it is addressing quality control matters, and how the resulting changes in firm procedures and controls will affect your audit in the future.

These questions are just my suggestions. As I noted earlier, however, the Board wants to help audit committees understand the PCAOB inspection process and what it means for audit committee oversight. You are likely to see some guidance on these topics in the near future. I would be interested in any suggestions you might have for what would be helpful to audit committees.

V. Conclusion

As I said at the beginning, the financial crisis and its aftermath have triggered a re-examination of the role of the auditor and of how we can strengthen and maintain public confidence in the credibility and utility of the profession's work. The PCAOB has several important initiatives that are designed to accomplish that goal. I look forward to hearing your views on the initiatives, and would also, of course, welcome any questions.

[1] Concept Release on Auditor Independence and Audit Firm Rotation, PCAOB Release No. 2011-006, PCAOB Rulemaking Docket No. 37 (August 16, 2011).

[2] See Statement on Concept Release on Auditor Independence and Audit Firm Rotation, Daniel L. Goelzer (August 16, 2011) (available on the PCAOB's website at www.pcaobus.org).

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[3] See Report from the PCAOB Investor Advisory Group's Working Group on: Auditor's Report and The Role of the Auditor (March 16, 2011) (available on the PCAOB's website at www.pcaobus.org).

[4] Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards , PCAOB Release No. 2011-003, PCAOB Rulemaking Docket No. 34 (June 21, 2011).

[5] See Statement on the Auditor's Reporting Model Roundtable, Daniel L. Goelzer (September 15, 2011) (available on the PCAOB's website at www.pcaobus.org).

[6] See Concept Release on Requiring the Engagement Partner to Sign the Audit Report, PCAOB Release No. 2009-005, PCAOB Rulemaking Docket No. 29 (July 28, 2009).

[7] See Rule Amendments Concerning the Timing of Certain Inspections of Non-U.S. Firms and Other Issues Relating to Inspections of Non-U.S. Firms , PCAOB Release No. 2008-007, PCAOB Rulemaking Docket No. 027 (December 4, 2008). See also Rethinking the Relevance, Credibility and Transparency of Audits, Keynote Address before the SEC and Financial Reporting Institute 30th Annual Conference PCAOB Chairman James R. Doty (June 2, 2011) and The Public Company Accounting Oversight Board — Recent Accomplishments and 2011 Agenda, Remarks before AICPA National Conference on SEC and PCAOB Developments, Acting Chairman Daniel L. Goelzer (December 7, 2010).

[8] On October 3, 2011, the Board issued a practice alert discussing the risks that auditors face when auditing companies with operations in emerging markets, such as China. Staff Audit Practice Alert No. 8, Audit Risks In Certain Emerging Markets (October 3, 2011). Audit committee members whose companies have operations in emerging markets may find this alert interesting reading.

[9] Proposed Auditing Standard on Communications with Audit Committees and Related Amendments to Certain PCAOB Auditing Standards, PCAOB Release No 2010-001, PCAOB Rulemaking Docket No. 30 (March 29, 2010).

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December 14, 2011 Office of the Secretary Public Company Accounting Oversight Board 1666 K Street, NW Washington, DC 20006‐2803 Re: Request for Public Comment: Concept Release on Auditor Independence and Audit Firm Rotation, PCAOB Rulemaking Docket Matter No. 37 Dear Office of the Secretary: On behalf of the board of directors of the National Association of Corporate Directors (“NACD”), we are pleased to comment on the Public Company Accounting Oversight Board’s (“PCAOB” or the “Board”) Rulemaking Docket Matter No. 037, “Concept Release on Auditor Independence and Audit Firm Rotation” (the “Concept Release”). Founded in 1977, NACD’s mission is to advance exemplary board leadership, and the organization is the only national membership organization created for and by directors. NACD provides extensive board member training and education about leading practices for boards of directors. These educational programs include the responsibilities of audit committees over an issuer’s accounting practices and independent auditors (“auditors” or “audit firms”) under the Sarbanes Oxley Act of 2002 (“SOX” or the “Act”) and state law. In this regard, NACD encourages close interaction between auditors and the audit committee. NACD has a strong interest in the matters discussed in the Concept Release, including potential changes that would impact the role and responsibilities of audit committees under the Act. Overview NACD believes that auditor independence, reinforced through the rigorous application of professional objectivity and skepticism, provides the foundation for a quality audit. Further, NACD believes that the audit committee has, and should retain responsibility for demanding and overseeing that auditors perform at a high level of quality. While auditor rotation can be beneficial at times and should periodically be evaluated by the audit committee, we do not support that this rotation be made mandatory. Given the aforementioned, NACD has not seen evidence that supports the proposition that mandatory audit firm rotation improves the auditor’s independence, objectivity, skepticism, or otherwise improves audit quality, and consequently, the quality of financial reporting. Rather, we believe that mandated audit firm rotation could potentially undermine the statutory responsibility and authority of audit committees to select the best auditor for their companies. It also would increase the cost to companies, and may decrease audit effectiveness.

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Therefore, we believe that the PCAOB should drop consideration of mandatory audit firm rotation, and instead vigorously inspect for compliance with current auditing standards and independence rules and, where necessary, apply appropriate sanctions. Audit Committees’ Statutory Responsibilities Prior to the implementation of SOX, the process for the selection and assessment of the independent auditor typically was controlled by management. The Act established qualifications for audit committee members and delegated to the audit committee specific responsibilities to represent and protect shareholders’ interest in fair and accurate financial reporting. Audit committees now play an essential role in our corporate governance framework by assisting boards of directors in overseeing the quality and integrity of the company’s financial statements. As the PCAOB knows, audit committees are specifically directed to appoint, compensate, and oversee the external auditor. This elevation of the audit committee, supplemented by statutory and regulatory auditor independence requirements (including partner rotation), also greatly strengthened safeguards over auditor independence and mitigated risks that some believe are posed by the issuer pay model. There has been substantial improvement in audit committee oversight of the financial reporting and auditing processes over the past decade. Nevertheless, we recognize that there is room for further improvement. Accordingly, NACD is working to promote a consistent high level of audit committee performance through its director training courses and development of leading and “next” practices, as well as tools designed to support the audit committee’s oversight of financial reporting within their companies. For example, NACD has convened numerous Blue Ribbon Commissions that have issued reports on a variety of topics, including executive compensation, risk oversight, and board leadership. One of the latest results of these efforts, The Report of the NACD Blue Ribbon Commission on the Audit Committee ‐ 2010 (“BRC Report on the Audit Committee”), offers ten principles to guide audit committees. NACD believes that mandatory audit firm rotation could jeopardize the statutory responsibility and authority of audit committees to select the best auditor for a company and oversee its work. The authority of the board and its committees is at the heart of our corporate governance framework, and challenging that authority could result in an undue weakening of the oversight and guidance directors provide for U.S. companies.

Consequences of Mandatory Audit Firm Rotation The PCAOB seems to be implying that audit committees, acting on behalf of all shareholders, are not able to determine the best auditor for their companies on an ongoing basis. To that end, the PCAOB seems willing to interfere with private contracts between audit committees and auditors. This interference may constrain the ability of audit committees to select the audit firms that are best able to meet the particular accounting and auditing challenges presented. Mandatory audit firm rotation may also engender prohibitive disruption and cost for companies without offering any compelling benefits. For example, the complexities of multinational corporations and differing regulatory regimes require companies to use auditors with particular expertise regarding country accounting nuances and laws. Replacing auditors who understand the company’s financial reporting risks and the jurisdictional requirements—and who the audit committee believes is performing well—without having a sound business case would be unnecessarily disruptive to the

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company, its board, and its audit committee, and in some cases, would be prohibitively expensive. It also would create cross‐border accounting and auditing risk—again, without any compelling benefit. Another example is the impact mandatory firm rotation would have when it occurs at a time when a company is going through a significant event such as a corporate financing, merger or acquisition, or change in management. Changing auditors at such a time would greatly expand the cost of the transaction or transition, and potentially affect the ability of the company to execute a transaction. Moreover, an audit firm rotating in would have to meet independence requirements, which would cause companies to have to change providers of its non‐audit services. The time and resources required for management and audit committees to manage all of these transitions would be significant. Moreover, the additional work required for a new firm to get up to speed would add cost and possibly delay to the audit. Finally, we are concerned that that mandatory audit firm rotation would increase accounting and auditing risks during the first years of an auditor’s tenure. Studies have shown that audit quality is enhanced when the auditor develops an understanding of a company’s business and applies that knowledge when performing audit procedures. Improving the Audit Committee’s Oversight of the Auditor NACD and its constituents continue to explore ways to improve the performance of audit committees and their oversight of the external auditor. A number of leading practices are contained in NACD’s BRC Report on the Audit Committee. Below, we share some additional ideas that would further the goals of strengthening audit committees and enhancing audit quality, without the unintended consequences associated with mandatory audit firm rotation. Communications with ShareholdersNACD encourages expanding audit committee reporting beyond the proxy requirements—for example, to provide a more robust description of the audit committee’s activities during the year. Providing greater transparency into audit committee activities and, in particular, its role in overseeing the company’s financial reporting, as well as its selection and evaluation of the auditors, would help shareholders evaluate the audit committee’s performance. One approach might be to enhance the audit committee report in the company’s proxy or, alternatively, the company’s website. This would provide a venue for describing the audit committee‘s criteria for evaluating the auditor’s independence and performance—including the auditor's objectivity and professional skepticism—as well as its policies regarding the auditor’s provision of non‐audit services. Such a report also might describe at a high level how the audit committee oversees the accounting and financial reporting processes of the company, including discussions with the auditor about the quality of the company’s accounting. Enhanced reporting would provide greater transparency into the quality of the audit committee’s performance, the company’s financial reporting, and the caliber of the external auditor.

Appointment, Oversight, and Evaluation of the Independent AuditorAs noted earlier, NACD supports continuous improvement in the caliber and performance of audit committees. Accordingly, NACD is working to promote a consistent, high level of audit committee performance through its board member training courses and development of leading practices and tools designed to support the audit committee’s oversight of financial reporting within their companies. In

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addition to the leading practices summarized in NACD’s BRC Report on the Audit Committee, some leading and “next” practices audit committees could employ include:

• Evaluating the audit plan in a more robust fashion, including the details of the auditor’s risk assessment, the procedures planned to address those risks, and milestones for completion. This includes following up on those milestones and maintaining an “open door” for the auditors to discuss the use of particular accounting policies and operating practices that are necessary to assure the audit will meet the audit committee’s expectations. The consideration of audit risk, including assuring that the audit team has the right experience and resources available to execute the plan, is vital.

• Improving audit quality through the annual evaluation of the audit firm. Annual evaluations should be the primary consideration in the reappointment of the audit firm. Therefore, the committee’s assessment of an audit firm should consider, among other matters:

o Input from the management team about the firm’s understanding of the business and its helpfulness in the early identification of important issues.

o How the firm supported the audit committee’s work. o How the firm supported the chair of the audit committee. o How candid and forthright the firm was in its work with both the committee and the

management o Overall, how effective, efficient, and timely was the resolution of any technical issues.

• Analyzing and discussing the results of the annual evaluation and being responsible for providing feedback to the audit firm. This includes monitoring the firm’s response to any areas needing improvement.

• Taking the lead role in interviewing and selecting the lead engagement partner. This enables the

audit committee to assess the qualifications, including the independence, objectivity, and professional skepticism of the candidates for this role as well as each candidate’s ability to communicate effectively with the audit committee and his/her fit with the company’s business and complexity.

• Monitoring the auditor’s performance. Inspection findings pertaining to a company’s audit are

of critical importance to the audit committee as they reflect the competency of the auditor and can reflect on company management. NACD is working with the Center for Audit Quality to develop tools for improving awareness and framing discussions with the auditor on inspection results and quality control within the audit firm, more generally. NACD would be happy to share our expertise in conversing with board members, and to work with the PCAOB in developing tools to educate audit committees about the PCAOB’s inspection program and inspection reports.

**** NACD supports the PCAOB’s efforts to enhance audit quality. However, we do not believe that mandatory auditor rotation is the way to do so. Before further consideration of such a drastic and disruptive change to the current corporate governance framework is initiated, a strong case must be made that auditor tenure has a significant bearing on audit quality. We do not see auditor independence as the issue. Rather, we believe the focus of the PCAOB should be on the exercise of professional

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skepticism and objectivity by auditors and all members of the financial reporting supply chain in discharging their respective responsibilities. Moreover, we believe that the PCAOB, with its ten years of deep knowledge about its registrant auditing firms, should have good information on ways to improve those traits in particular firms and the public accounting profession. NACD appreciates the opportunity to comment on this Concept Release and would be pleased to respond to any questions regarding the views expressed in this letter.

Sincerely,

Barbara Hackman Franklin Chairman NACD

Kenneth Daly President and CEO NACD

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20 NACD Directorship December 2011

2011 NACD Public Company Governance Survey

Still feeling the aftershocks of the 2008–2009 finan-cial crisis, boards have examined their practices in light of the new regulatory requirements. According to the 2011 NACD Public Company Governance Survey—the 13th such survey conducted in the past 20 years—this marks the first year companies filed proxy statements requiring advisory shareholder votes on executive compensation (say on pay), and the second year under the Securities and Exchange Commission’s proxy disclosure enhancements rule. Despite these changes, almost two-thirds of direc-tors (65.7 percent) believe the current disclosure requirements for corporate governance are ade-quate, while 31.3 percent say they are excessive and should be reduced. Three percent of respondents indicated that the requirements are inadequate and need to be expanded.

Although the governance environment has un-dergone significant change, over 93 percent of re-spondents indicated satisfaction with their current governance structures and practices, and believe they enhance their board’s ability to fulfill its duties.

Boards have also maintained their priorities: stra-tegic planning and oversight, corporate performance and valuation, and risk and crisis oversight continue to be the top three priorities for directors in 2011.

Board Leadership and StructureAfter several years showing increases in the use of independent chairmen to lead the board, the prac-tice seems to have lost steam. There has been a no-ticeable uptick in the number of companies com-bining the roles of chairman and CEO, with 57.7 percent combining the two in 2011, up from 54.3

percent in 2010. In general, larger companies tend to combine the leadership positions. Where the po-sitions are combined, it is a popular practice to des-ignate a “lead director” to represent the voices of the independent directors. Almost two-thirds of sur-veyed directors indicate that their board has a lead director; this percentage is unchanged since 2010. The overwhelming majority (88 percent) believe the position enhances their board’s effectiveness, down slightly from 92 percent in 2010.

Shareholder proposals for independent board chair. In 2011, there were 24 shareholder proposals for establishing an independent board chairman, representing a decrease from 39 proposals in both

Leadership Experience Now Most Valuable Attribute for Directors

The top priority for boards remains strategic planning and oversight.

What Are the Highest Priorities for the Board in 2011?Strategic planning and oversight 72%

Corporate performance and valuation 41%

Risk and crisis oversight 27%

Executive talent management and leadership development

26%

CEO succession 25%

Financial oversight/internal control 17%

Board effectiveness 16%

Director recruitment/succession 13%

CEO compensation 9%

Board and director evaluation 7%

Board culture 7%

CEO evaluation 7%

Relations with shareholders/owners 6%

Board leadership 6%

Disclosure 5%

Information management 3%

Director education and development 3%

Board meeting processes 3%

Corporate social responsibility 2%

Director compensation 1%

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December 2011 www.directorship.com 21

2010 and 2009. In 2011, the proposals averaged 28.9 percent of support.

Board and committee structure. The average board size has fluctuated in recent years. In 2011, there was a slight increase in size to 8.9 members, up from 8.3 in 2010, yet below the average of 9.1 members reported in 2009.

Board committee structure has not strayed far from 2010 practices. As might be expected, the use of audit, compensation and nominating/gov-ernance committees on boards is nearly universal. Beyond the committees mandated by exchange list-ings, the most commonly used committees contin-ue to be executive and finance, which both showed slight increases in use in 2011. Companies with larger market caps are about three times more likely to have a finance committee than companies with smaller market caps.

Some board committees require specialized knowledge; this is no more apparent than on the audit committee. Experience with corporate fi-nance is an essential skill for committee member-ship, and the great majority of audit committees (91.2 percent) require all members to demonstrate financial literacy. A smaller percentage of boards, (16.5 percent) require all audit committee mem-bers to be financial experts.

Board Meetings and ProcessesThe average number of full board meetings in-creased slightly to 6 per year, up from 5.6 in 2010. However, the hours per in-person full board meeting decreased to 6.7 hours in 2011 from 9 hours in 2010.

Directors have also been spending more time in boardrooms and on director activities. In 2011, public company directors averaged over 227 hours reviewing reports, attending meetings and perform-ing other board-related activities. This is a slight in-crease from 2010, when the annual director time commitment averaged 204.5 hours. The increase came primarily in the areas of reviewing reports (81 hours in 2011; 61.8 hours in 2010) and attending meetings (76.7 hours in 2011; 71.5 hours in 2010).

Time in the boardroom is not enough to provide a director with a complete, holistic view of the com-pany. In order to develop a better understanding of both the company’s operations and employees, almost 90 percent of directors make on-site visits. These visits typically occur once a year, although one-third of respondents indicated that they make several visits each year. Slightly more than half of re-spondents (53.8 percent) have visited foreign offices or factories.

Director Competency and EvaluationsRecent financial reform legislation has put a spotlight on boardroom activity and composition. Therefore, it is crucial for boards to demonstrate that accom-plished and experienced directors are at the helm of management oversight. Not only do directors need to represent a balanced mix of skills, but they must also work to stay current through education.

The overwhelming majority (93.3 percent) be-lieve that education enhances the board’s effective-ness. This rationale extends to the board’s primary motivation for receiving director education (for general board improvement), which increased to 71.1 percent in 2011 from 62 percent in 2010.

Board service. Just over one-third of boards have a policy limiting the number of boards on which a director can serve. If such a policy is in place, direc-tors are typically limited to three additional boards.

In 2011, boards largely chose to maintain their existing composition. Over half of respondents (55.7

What Is Your Board’s Leadership Structure?

Chairman is an executive director

57.7%Chairman is an independent director

28.8%Chairman is a non-independent, non-executive director

9.8%No chairman/executive chairman, but separate lead director

2%No disclosure of CEO/chair separation

1.7%

Average Board and Committee Size

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22 NACD Directorship December 2011

2011 NACD Public Company Governance Survey

percent) indicated that their board did not replace a single director in the last year. Twenty-seven percent replaced just one director.

Evaluations. Once a board has found a balanced mix of skill sets and experiences, it must periodically perform comprehensive evaluations to ensure directors are performing in line with the company’s strategic objectives. Almost all boards (91.1 percent)

perform full board evaluations, and slightly less (82.7 percent) conduct committee evaluations. Of the 44.9 percent of boards that conduct individual director evaluations, peer or self-evalua-tion is the most common assessment tool.

One in five boards (19.3 percent) use consultants for full board evaluations. Survey data show that boards using independent consultants are slightly more likely to both replace directors and enlist management feedback for 360-degree reviews.

Integrity, Ethics and ResponsibilityIn the past year, the drumbeat for demonstrated integrity and eth-ics from corporate leaders has continued from the general public,

investors and regulators. More than half of boards (59.8 percent) evaluate the ethical behavior of senior management, commonly using a qualitative assessment. The overwhelming majority of survey respondents also indicate that management is actively pro-moting a culture of integrity throughout their organizations.

Unchanged from 2010, the hotline/helpline is the tool most often used by management to assess the ethical risks throughout the organization. Approximately 83 percent of companies have whistleblower hotlines, which in most cases exist within a larger compliance program and yield regular reports to the audit board or committee. However, whistleblower programs are currently under transition due to the whistleblower bounty program man-dated by the Dodd-Frank Financial Reform Act.

Fifty-two percent of respondents believe the new incentive structure will have no significant effect on their company’s ethical climate; one-third are uncertain about the program’s consequenc-es; and 13.6 percent believe it will weaken their ethical climate. Just 4.9 percent believe it will strengthen the ethical climate.

Attention to Information, Strategy and RiskBoards are generally satisfied with the amount and quality of in-formation they are receiving from management. They are most likely to be content with the information provided regarding cor-porate performance and strategy, slightly less so with data provid-ed on risk management. As with the previous year, the compensa-tion and audit committees most often obtain outside information from independent consultants.

In 2010, the full board surpassed the audit committee as the group primarily assigned the majority of tasks related to risk over-sight. However, the survey finds this responsibility has shifted back to the audit committee.

The majority of directors characterize their company’s long-term strategy as balanced (moderate risk and moderate rewards), an un-surprising choice given the current economic recovery. In 2011, more companies have a formal risk management program: 59.1 percent, up from 54 percent in 2010. Practices in risk management also vary depending on company size. Over 75 percent of mega- and large-cap companies have a formal program, while only 31.1 percent of micro- and nano-cap companies follow the same prac-tice. Just over 55 percent of these smaller companies have informal plans. When asked about effectiveness, those with formal programs were more likely to find that the program informed management and the board of the organization’s risks to a “great extent.”

Director SelectionTo maintain independent thought leadership, it is imperative

Average Number of Board Meetings

Number of in-person meetings per year

Hours per in-person meeting

Telephone meetings (or other electronic

means)

Full board 6 6.7 3.1

Executive session 4.9 1.2 1.6

Audit committee 5.6 2.8 3.3

Compensation committee

4.4 2.2 2

Nominating/ governance committee

3.7 1.8 1.1

Average Annual Director Time CommitmentAverage hours spent per year

Attending meetings 76.7

Traveling to/from board events 34.5

Reviewing reports and other materials 81

Director education 19.6

Representing the company at public events 10.9

Other 14.9

Total* 227.5

*Averages are non-additive.

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that boards have structures in place to protect against board entrenchment. In 2011, the average total length of service for directors was 7.5 years, an increase from 6.8 years in 2010.

Director turnover is typically achieved through resignation upon change of professional status, evaluation or age limits. 2011 saw a substantial in-crease in the use of policies requiring resignation upon change of professional status: 52.4 percent, up from 33.7 percent in 2010. These policies typically require the director to submit a letter of resignation, which the board may then either accept or decline. Of the 48.4 percent of boards that use age limits, nearly half (48.6 percent) use 72 as the mandatory retirement age. The use of term limits to renew and replace board membership declined to 5.9 percent in 2011 from 9.6 percent in 2010. The number and length of terms vary, but most frequently boards set two terms of three years each.

While most directors still come to board ser-vice through personal relationships or network-ing, search firms still place a significant number of director candidates. Respondents are generally pleased with the results of engaging a search firm.

Majority voting. The past year has seen a slight increase in the number of boards that have adopted majority voting, with 40.7 percent using the prac-tice, up from 34.6 percent in 2010. Just over 72 percent of mega- and large-cap companies have ad-opted majority voting, while smaller companies are less likely to have adopted this practice. As of June 21, 2011, there were 38 shareholder proposals for majority voting in director elections, averaging 58.4 percent support. Additionally, there were 18 man-agement proposals for majority voting, averaging 98.6 percent support.

Annual vs. staggered elections. Classified boards are used by 51 percent of public compa-nies, and 49 percent have annual elections. In 2011, shareholder proposals calling for the annual election of directors were presented to 42 com-panies, representing a substantial decrease from 2010, when there were 62 proposals and 2009, when there were 79 proposals.

Boardroom composition. In this period of eco-nomic recovery, survey respondents largely chose not to “rock the boat,” by maintaining their board-room composition. The lack of change could be ex-plained by directors’ satisfaction with their current boards: the overwhelming majority feel that mem-bers’ skills and experiences are appropriate for their company’s strategy.

For many years, survey participants have con-sistently ranked specific industry experience and financial expertise as top attributes in director re-cruitment; however, in 2011 leadership experience was the most important attribute.

Despite the increased call for diversity in the boardroom, the majority of boards have not signif-icantly altered their number of female or minority (based on race and nationality) directors. Nearly 68 percent of boards have one or more female directors, a statistic that has remained fairly consistent over the past several years. However, there is an increase in the number of minority directors on boards: 47.6 percent have at least one minority director in 2011, up from 43.7 percent in 2010. But smaller compa-nies lag behind their larger counterparts. More than 55 percent of nano-cap and micro-cap companies have no female directors on board, and 73.7 percent have no minority directors. D

The 2011 NACD Public Company Governance Sur-vey presents findings from 1,281 public company responses augmented by data compiled by Institu-tional Shareholder Services. The ISS statistics reveal board structures and practices at more than 2,400 U.S. publicly traded companies, and cover compa-nies with annual meetings from Jan. 1 to June 30, 2011. An electronic copy of the complete report is available to all members. Nonmembers may buy the report at NACDonline.org.

Which Attributes and Experiences

Are the Most Important When

Recruiting Directors?

Leadership experience

61.9%Specific industry experience

54.2% Financial expertise

46.6%Strategy development

28.8%International/global experience

17.9%Risk assessment

7.4%Medical/scientific/ technological expertise

5.9%Information technology

5.5%Government experience

4.2%Marketing

4.1%Human resources

2.1%Legal expertise

1.6%

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© 2012 National Association of Corporate Directors. www.nacdonline.org 1 This information from the National Association of Corporate Directors does not constitute accounting, consulting, or legal advice. For such advice, please consult a qualified professional advisor. For a list of NACD Alliance Partners and Associate Members, please visit “About NACD” at www.nacdonline.org. R051710

This resource available to: National Association of Corporate Directors (NACD) Members, NACD Faculty

CUSTOM RESEARCH MEMO

TOPIC: Board Diversity SUMMARY: This memo provides guidance to boardroom leaders on board diversity.

GOVERNANCE PRINCIPLE(S): Principle III: Director Competency & Commitment. Governance structures and practices should be designed to ensure the competency and commitment of directors. Source: Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies. Download a complimentary copy at www.NACDonline.org/LeadingtheWay.

KEY FINDINGS: The primary goal of director selection is to nominate individuals who, as a group, offer a range of specialized knowledge, skills, and expertise that can contribute to the successful operation of the company. It is therefore critical that boards bring the most valuable talent available to the boardroom by expanding the pool of potential nominees considered to include a more diverse range of qualified candidates who meet established criteria. Fundamental characteristics, professional experience, skills, and core competencies of a director should not be–and need not be--waived to achieve diversity. Boards should seriously consider, but not choose based solely on, the distinctive skills, perspectives, and experiences candidates diverse in gender, ethnic background, geographic origin, and professional experience (public, private, and non-profit sectors) can bring to the boardroom. Source: Report of the NACD Blue Ribbon Commission on Director Professionalism 2011 NACD GOVERNANCE SURVEYS Public Companies Gender diversity within public companies has been stagnant in the past year, but minority representation has grown. The 2011 survey responses showed 67.4% of companies had one or more female board members in 2011, compared to 68.6% with females in 2010. For minority directors, there has been a greater growth in presence. In 2011, 47.6% had at least one minority board member, up from only 43.7% in 2010.

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A study of the Fortune 500 companies, developed by Catalyst, showed 92 of those companies have three or more women on their boards, while 59 have zero. These are all companies with at least $5 billion in revenues. Source: 2011 NACD Public Company Governance Survey; Catalyst.org Private Companies Over the past several years, the prevalence of women on private boards has held increased slightly. 67.9% of respondents in 2011 reported having at least one woman on the board of directors. With 36.9% of boards containing a minority director, there was significant growth from 31.8% last year. From 2008 to 2009, directors of ethnic or racial diversity jumped more than 10 percentage points from 20.5% to 31.7%. This growth is most likely the result of the growing need for boards with diverse experience and skills. This is supported by nearly three quarters of respondents who agreed that gender and ethnic diversity are important criteria for recruitment. Source: 2011 NACD Private Company Governance Survey Nonprofit Companies Nonprofit boards are generally more open to gender and ethnic diversity than their public or private company counterparts. A large majority (88.5%) believe that gender and ethnic diversity are important criteria when recruiting new candidates. Nearly all survey respondents indicated they have at least one female trustee, with an average of 5.5 female trustees. This is up from 94.1% in 2008. Almost two-thirds of respondents indicated they have at least one minority trustee (based on race and nationality), but minority representation lags behind gender representation. It is also down from 2008, when 73.4% boards reported having at least one minority trustee. In 2009, boards reported having an average of 3.3 minority trustees. Source: 2009 NACD Nonprofit Governance Survey

CITATIONS SUMMARY: • Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies • Report of the NACD Blue Ribbon Commission on Director Professionalism • 2011 NACD Public Company Governance Survey • 2011 NACD Private Company Governance Survey • 2009 NACD Nonprofit Governance Survey

ADDITIONAL RESOURCES: • NACD Board Advisory Services

For additional updates or insights on this topic visit www.nacdonline.org and use the “search” function, or go to Governance Resources and visit the bookstore.

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ABOUT NACD: Founded in 1977, the National Association of Corporate Directors (NACD) is the only membership organization delivering the insights and wisdom that corporate board members need to confidently navigate complex business challenges and enhance shareowner value. With over 10,000 members, NACD advances exemplary board leadership – by directors, and for directors – by empowering members through education, a forum for peers to share ideas, and an extensive knowledge base of information and publications. NACD fosters collaboration among directors and governance stakeholders to shape the future of corporate governance.

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This resource available to: National Association of Corporate Directors (NACD) Members, NACD Faculty

CUSTOM RESEARCH MEMO

TOPIC: Board Evaluations SUMMARY: This memo provides guidance to boardroom leaders in planning board

evaluations.

GOVERNANCE PRINCIPLE(S): Principle III: Director Competency & Commitment. Governance structures and practices should be designed to ensure the competency and commitment of directors. Source: Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies. Download a complimentary copy at www.NACDonline.org/LeadingtheWay.

KEY FINDINGS: In today’s corporate climate, boards are increasingly responsible and liable for critical strategic decisions. While annual performance evaluations are required of public boards by the New York Stock Exchange, boards are increasingly using evaluations to become more effective enhancers of corporate performance. 91.1% of companies surveyed perform full board evaluations, and 82.7% and 44.9% of respondents performed committee and individual director evaluations, respectively. Source: 2011 NACD Public Company Governance Survey BOARD EVALUATION REQUIREMENTS NYSE-listed companies are required to adopt annual evaluations, as well as the following corporate governance guidelines:

• Qualification standards for directors • Responsibilities of directors • Director access to management and, as necessary, independent advisors • Compensation of directors • Continuing education and orientation of directors • Management succession

The company's website must include its corporate governance guidelines and the charters of its most important committees (including at least the audit committee). Also, the company must state in its

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annual proxy statement (or, if the company does not file an annual proxy statement, in the company's annual report) that its corporate governance guidelines are available on the company’s website and are available in print to any shareholder who requests them. Furthermore, companies listed on the NYSE must have an independent nominating/governance committee to address the committee's purpose and responsibilities, which must include, among other things, overseeing the evaluation of the board and management. Source: Report of the NACD Blue Ribbon Commission on Board Evaluation COMMITTEE EVALUATIONS Regarding committee evaluation, NASDAQ requires that each listed company certify that it has adopted a formal written audit committee charter, and that the audit committee has reviewed and assessed the charter’s adequacy. The NYSE, though, has varying guidelines dependent on the committee:

• Audit committee: each audit committee must have a charter specifying duties of the committee, including evaluations on a regular basis.

• Compensation committee: each compensation committee must have a charter that addresses its duties including an annual performance evaluation of the committee.

• Nominating/governance committee: each committee must have a charter that specifies committee duties including not only board and management evaluation (as noted above) but also an annual performance evaluation of the committee.

Source: Report of the NACD Blue Ribbon Commission on Board Evaluation BOARD BUSINESS PLAN Developing a board business plan prior to evaluations is a value-creator for boards. An ideal business plan clearly defines specific performance goals for the board. Regularly checking performance (both committee and individual director) against the plan’s goals will add an important dimension to the board’s evaluation process. If the business plan is not met, the board must take corrective actions. This may include replacing one or more directors, or challenging the board’s performance in other ways. An effective evaluation process offers a measureable and more objective means for determining what follow-through will be required to keep the board on a high-performance course. Source: Report of the NACD Blue Ribbon Commission on Board Evaluation

BOARD EVALUATION CRITERIA To be effective, boards must have the right people, the right culture, the right issues, the right information, the right process, and the right follow-through. Throughout the evaluation, one clear objective must always be met: to provide guidance that creates superior long-term shareholder value.

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• Right People: People are the primary building block. A board composed of the wrong people will be ineffective and largely under serve the firm. While the company can perform well under such an arrangement, the shareholders would rely too much on management skills.

• Right Culture: If the board does not have an open, trusting environment that inspires and celebrates active, spirited debate, no further progress can be made.

• Right Issues: If a board has the right people and the right culture, but focuses on the wrong issues, the board cannot add shareholder value, the main objective of a board.

• Right Information: As the board identifies its key issues, it will know what further information it must seek.

• Right Process: Having the right people, culture, issues, and information goes a long way. However, the board needs the right process to evaluate and refine its performance in all these areas.

• Right Follow-Through: The term “follow-through” is shorthand for the right spirit of accountability and continuous improvement. Nothing is static; boards can always improve. An effective board seeks accountability and continuous improvement from whatever rigorous assessment it adopts.

Source: Report of the NACD Blue Ribbon Commission on Board Evaluation EXPOSURE TO LEGAL LIABILITY Liability is an issue when creating a formal director evaluation process, especially regarding its documentation. If the board is confronted with accusations of alleged negligence, documentation of the existence and parameters of a formal evaluation process may be very helpful. However, the documentation of individual director evaluations may have negative legal consequences. For example, if record of a highly negative evaluation exists with proof that the board failed to act, the board could be held liable. The decision to document and maintain records should be reviewed by legal counsel prior to implementation of such a program. Potential risks of liability, though, should not prevent a board from implementing a formal evaluation process. Such a process has positive ramifications for a board both operationally and legally. A company may even decide to destroy documents of a delicate nature. Source: Report of the NACD Blue Ribbon Commission on Board Evaluation

CITATIONS SUMMARY: • Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded

Companies • 2011 NACD Public Company Governance Survey • Report of the NACD Blue Ribbon Commission on Board Evaluation

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ADDITIONAL RESOURCES: • NACD White Papers Series I: Risk Oversight, Transparency, Strategy, and Executive

Compensation • NACD Board Advisory Services

To continue to help you navigate the current regulatory environment, NACD’s Board Advisory Services team can facilitate a customized board evaluation or education program presented in the context of your industry and operating environment, and in the privacy of your boardroom. To receive a complimentary consultation, please contact Steve Walker, director of Board Advisory Services, at 202-572-2101 or [email protected]. For additional updates or insights on this topic visit www.nacdonline.org and use the “search” function, or go to Governance Resources and visit the bookstore.

ABOUT NACD: Founded in 1977, the National Association of Corporate Directors (NACD) is the only membership organization delivering the insights and wisdom that corporate board members need to confidently navigate complex business challenges and enhance shareowner value. With over 10,000 members, NACD advances exemplary board leadership–by directors, and for directors–by empowering members through education, a forum for peers to share ideas, and an extensive knowledge base of information and publications. NACD fosters collaboration among directors and governance stakeholders to shape the future of corporate governance.

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Template for Disclosure of Director Skills and Attributes Responding to the SEC’s New Proxy Enhancement Rules Regarding Board Composition

Background

On December 16, 2009, the Securities and Exchange Commission (SEC) issued a final rule adopting amendments to their proxy disclosure rules. The final rule became effective February 28, 2010.

• The final rule requires new disclosure on a wide range of issues, including compensation and risk, director qualifications, company leadership structure, and the board’s role in the risk management process.

• The new rule relating to director qualifications requires companies to disclose for

each director and director nominee the particular experience, qualifications, attributes, or skills that qualify the director or nominee to serve as a director of the company and as a member of any committee that the individual serves on or will serve on, in light of the company’s business. More importantly, the rule does not prescribe what qualifications must be considered by directors and thus disclosed; rather, the rule directs the disclosure of any qualifications the board has chosen to consider for each director. For example, if financial literacy is among those qualifications, this must be disclosed.

• In addition to the expanded narrative disclosure regarding director and nominee

qualifications, the rule requires disclosure of any directorships held by a director or nominee at any time during the past five years at public companies and registered investment companies.

• The new rule also lengthens to ten years the time during which disclosure of legal

proceedings involving directors is required. In light of these new requirements, NACD believes that companies may find it useful to create a template for these disclosures. NACD offers the following template as a guide. It is important to note that the template is only relevant for director qualifications, attributes, and skills.

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XYZ, Inc. Election of Directors Nine directors have been nominated for election at the 2010 Annual Meeting to hold office until the 2011 Annual Meeting and the election of their successors. The nine nominees for election are listed below. We do not know of any reason why any of the nominees would be unable to serve as a director. If any nominee is unable to serve, the shares represented by all valid proxies will be voted for the election of such other person as the board may nominate. Corporate Strategy Our strategy for 2010 – 2015 aims to place XYZ, Inc. as the leading provider of our products/services in the global market. To fulfill this goal, we are focused on maintaining our leading market position in our existing markets and expanding profitably into new products, services, and geographies. Our strategic goals are supported by our ongoing investments in several areas: protecting and enhancing our brand; improving product quality; enhancing customer service; expanding our supply chain and distribution platforms; and supporting the sustainable well-being of our employees and communities. The competencies we seek in our directors must support our strategy and actions. The nominating and governance committee oversees the evaluation of individual board members, committees, and the whole board, with the assistance of a third-party facilitator when needed. The evaluation seeks to ascertain, among other things, whether the board and its committees are functioning effectively and have the necessary skills, backgrounds, and experiences to meet XYZ, Inc.’s evolving needs. Qualifications for All Directors To be considered for board membership, all individual directors of XYZ, Inc. should possess wisdom and financial literacy. Our board believes that directors should be committed to representing the long-term interests of all shareowners. The directors we seek must exhibit a commitment of both time and active attention to fulfill their fiduciary obligations. Generally, this means that directors should ensure that they have the time to prepare for meetings; attend board and committee meetings and the annual meeting of shareholders; consult with management as needed; and address crises should they arise. We also expect our directors to stay informed about issues that are relevant to the company. Ongoing director education provided either by the company or by a third party is an important part of this requirement. The nominating and governance committee’s evaluation of nominees takes into account the ability of nominees to contribute to the diversity of gender, ethnic background, and professional experience represented on the board. The committee reviews its effectiveness in balancing these considerations when assessing the composition of the board. Below we identify the key qualifications and skills our directors bring to the board that are important in light of XYZ, Inc.’s strategic direction. The directors’ individual

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qualifications and skills that the board considered in their renomination are included in the directors’ individual biographies.

• Leadership experience1 • Finance experience • Industry experience • Public relations experience • Government experience • Strategy formation experience • International experience • Governance experience

Board Skills Matrix The chart below summarizes the specific qualifications, attributes, and skills for each director. An “X” in the chart below indicates that the item is a specific reason that the director has been nominated to serve on the board. The lack of an “X” does not mean the director does not possess that qualification or skill. Rather, an “X” indicates a specific area of focus or expertise of a director on which the board currently relies.

Board of Directors

Required Expertise

D1 D2 D3 D4 D5 D6 D7 D8 D9 Leadership X X Finance X X X Industry X X X X Public relations X Government X X X X Strategy formation X International X Governance X X 2010 Nominees for Director The nominating and governance committee has nominated the following candidates for election as directors. All of the nominees are independent under New York Stock Exchange corporate governance rules, except the chairman, who is also the chief executive officer. The board of directors recommends a vote FOR the election of each of the following nominees. 1 Boards may wish to expand and define each of these skills or attributes.

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John Doe John Doe is the president and CEO of ABC Risk Consulting Company, a position he has held since May 2007. As a retired partner of Global Professional Services firm (GPS), Mr. Doe is a recognized expert on corporate governance, executive compensation, and corporate board transformation. After retiring from the firm in 2005, he began serving on the XYZ, Inc. board. Having served on and chaired the audit committee as a director, as well as having served as an audit partner, John routinely counsels audit committees in critical areas, such as risk oversight. He possesses extensive SEC and other regulatory experience, and is especially knowledgeable about the financial services industry. He received his bachelor's degree in accounting from the University of Delaware. He is a CPA (inactive status) in New York. Mr. Doe is also a member of the National Association of Corporate Directors. Mr. Doe has no current or recent legal transactions pending against him. Disclosure of Specific Attributes and Skills for John Doe

Desired Expertise

Discussion of Skills and Attributes

Finance Mr. Doe’s financial expertise comes from a career of audit and accounting experience at GPS, as well as from serving as the audit committee chairman at XYZ, Inc., a Fortune 500 firm. Mr. Doe also provides financial and audit instruction to directors from around the country at NACD’s Director Professionalism® courses.

Industry

Mr. Doe has extensive contacts with experts from organizations within this industry. His deep knowledge and understanding of the various players and influences in the retail sector is an asset.

International

As a partner for GPS, Mr. Doe oversaw operations in Asia, specifically in Japan and South Korea. He has a deep knowledge of business practices in both countries and aids in XYZ, Inc.’s growth in these countries.

[Photo]

Continuing Education in 2009: Description and Provider

Governance conferences In-house training Webinar ABA seminar University seminar

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58 NACD Directorship October/November 2011

Repartee | Robin A. Ferracone and Arthur C. Martinez

The relationship between the compensation committee chair and the outside pay consultant has been reshaped both by the macro business environment and regulation. For an inside look at this changing dynamic, NACD Directorship asked a veteran compensation committee member to go one-on-one with a compensation consultant. Arthur C. Martinez is former CEO of Sears and today a public company director whose board service includes compensation committee chair of both PepsiCo and AIG, director of IAC Interactive, HSN and Liz

Claiborne, and lead director of International Flavors and Fragrances. Robin A. Ferracone is the founder and executive chair of Farient Advisors.

Robin A. Ferracone: You’ve proven from your experience and track record that you don’t shy away from the hot seat. So given that we just finished our first proxy season with the partial implementation of Dodd-Frank, now is a particularly good time to reflect on executive compensation. What have you seen that has changed?

Taking on Pay for Performance A conversation about what has —and hasn’t—

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Arthur C. Martinez: The spotlight clearly has moved to the compensation committee, and that’s not unwarranted. There have been numerous—I would say serial—excesses in CEO and executive compensation, which have served to inflame regulators, the media and the general public. And while the regulation may feel and seem heavy-handed, there’s no question that the only thing that is rewarded in any meaningful way is performance. The early going on Dodd-Frank has been pretty benign, and demonstrates that most companies do act in a responsible way and most compensation committees do provide appropriate oversight. There are a number of implementing regulations still to come on areas like proxy access, which could be more problematic.

Ferracone: One of the things that didn’t happen this year was investors voting against compensation chairs. They did use their say-on-pay “no” votes to voice their opinion about whether they liked the compensation program, but they seemed to be reserving their director election “no” votes for next year, if needed. How are compensation committee chairs responding to the demands created by say on pay?

Martinez: There’s no question that the time demands have gone up pretty geometrically in terms of monitoring pay practices inside the company, taking a more active role with the management team, designing the programs that are relevant and appropriate for the company, and serving as the lead, if you will, for the rest of the committee and being able to distill complex matters into relatively straightforward proposals. I think you’re quite right that investors have given comp committee members and chairs a little breathing room here.

Ferracone: How does that differ from past practice?

Martinez: In the past, frankly, their only remedy was to vote against comp committee members when director elections were held. That’s still in the wings if problematic pay practices exist or companies that did not receive a large majority vote on say on pay don’t do something to reform their pay programs—that is the ultimate tool for investors. While everybody used to talk about financial liability

for directors, I think the bigger liability is public humiliation.

Ferracone: I think that’s right. Now that we’ve talked about what’s changing, I think an equally important question is, what’s not changing?

Martinez: Mainly, the drift away from plain vanilla stock options. And that’s been in the making for two or three years, with more performance-based stock awards and performance cash awards coming into long-term compensation plans. Investors and proxy advisory services often feel that those at-the-money stock options are not as performance-driven. I think it’s an argument worth considering: an equivalent reward with straightforward and very measurable performance statistics to work against is preferable. Secondarily, I would say that there’s been a reasonable cap on the growth of the base salaries for CEOs in the current business environment.

Ferracone: Yes. Those things aren’t changing because they were trends that were happening before Dodd-Frank as well. Investors have told us that they’re very focused on pay and performance alignment, and that alignment factored heavily into their say-on-pay voting decisions. In addition, we’re waiting for new disclosure requirements around pay and performance from the SEC. So how do you think the pay and performance considerations are factored into the decision making for your compensation committees?

Martinez: There is a clearer link than there’s ever been. In the past, too much option-based compensation could be influenced by a rising tide and not the performance of the enterprise. Performance metrics need to be made clear whether it’s EBITDA growth, earnings-per-share growth, ROIC or cash flow—the metrics that seem right for the company in its market and its competitive situation. The awards can no longer be purely time-vested, but must be delivered on the achievement of specific goals with a reasonable threshold and a very reasonable maximum. The rewards are no longer uncapped. It’s up to each comp committee to figure out exactly what are the right metrics, but it’s a relatively short list.

Ferracone: Comp committees also have to get clear philosophically on how they’re going to

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60 NACD Directorship October/November 2011

Repartee | Robin A. Ferracone and Arthur C. Martinez

respond to unintended consequences. Are they going to play by the numbers? Are they going to use some discretion? How do you handle it when management does all the right things but the financial and stock price performance doesn’t reflect their performance?

In addition, I noticed that an interesting performance concept in PepsiCo’s CD&A is “performance with purpose.” Can you comment on this as a way to gauge executive performance and pay?

Martinez: “Performance with purpose” was the opening rallying cry for Indra Nooyi when she took over as the CEO, now almost five years ago. PepsiCo has always had very strong performance metrics and a long record of successful delivery of financial results. And Indra’s feeling was we certainly couldn’t—and shouldn’t—consider abandoning our focus on performance, but in a larger context there is more to running a business than financial results. Her belief is that talent sustainability is the bedrock of any enterprise—the quality of the people and how they are managed, treated, incentivized and developed. Then you also have to consider environmental sustainability, as we all live on this big ball they call Earth and we have a role in ensuring that it remains a healthy place for our families and future generations. Human sustainability—our communities require food, water, all of the things required to sustain life, if you take a true holistic view of a corporation’s role in the ecosystem of the world.

That rallying cry touched a nerve inside the company. It motivated and excited a younger generation of executives. What we have done at the comp committee is to integrate the purpose metrics into our evaluation and compensation decisions about our senior executives—as in the past with diversity, if it wasn’t built into your business objectives and into your rewards system it didn’t get a lot of attention. This has now become a set of strong internal beliefs that drive the organization. And we have taken all of that into account as we’ve made comp decisions.

Ferracone: Investors have communicated with us through our research that they feel the value

of these types of measures should play a role in compensation programs. They help express the personality and the strategy of the organization while not necessarily giving up on the financial results.

Martinez: Make no mistake about it, PepsiCo has not lost its focus on financial performance as a key driver of shareholder wealth creation. It continues to have an admirable record in that regard.

Ferracone: Yes. And so that’s exactly why strategic measures don’t substitute for financial measures, but they can play an enhancement role. Let’s switch gears. One of the things that Dodd-Frank

was intended to do was give the compensation committee the power to hire its own resources and to empower the compensation committee a little bit more in general. I was just wondering, in your view, whether the comp committee does have more power in the process.

Martinez: The comp committee has more powers, and the dynamics have reset the balance in some ways between management and the compensation committee. One of the key elements is the use of independent consultants. The mandate is that the consultants do no work for the company and that they are solely accountable to and hired by the compensation committee. Looking back over five or 10 years, it was more of a management-led process than a committee-led process. I think we’re in a much healthier balance right now.

Ferracone: Now we call that being collaborative, yet independent. We like to work in concert with

with more than 30 years of consulting experience, robin a. Ferracone ad-vises clients in all aspects of executive compensation strat-egy and design. she is the author of Fair Pay, Fair Play: Aligning Executive Performance and Pay (Jossey-bass, 2010) and writes the “Executive Pay watch” blog on Forbes.com. Prior to founding Farient in 2007, Ferracone was pres-ident of mercer’s Human Capital business, chair-man of the u.s. west region at marsh & mclennan Companies (mercer’s parent company), and CEO of sCa Consulting, an executive com-pensation consult-ing firm she co-founded in 1985 and sold to mercer in 2001.

Robin A. Ferracone

“PepsiCo’s ‘performance with purpose’ was the opening rallying cry when Indra Nooyi took over as CEO.... This has now become a set of strong internal beliefs.” —Arthur C. Martinez

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our comp committees and management, but at the end of the day we still feel it’s our job to make sure that we’re providing an independent opinion. Comp consultants today need to come to the table with a number of skills that they may not have had in the past, because they need to understand not just the compensation subject matter in-depth but also their clients—that is, the company’s strategy, its culture and its people. There’s a sensitivity there that wasn’t required in the past. As a result, I feel that not only has the role of the comp committee changed, but the role of the compensation consultant has changed as well.

Martinez: I would add the word “trust” there, in the sense that the management team has to trust the objectivity and the good intentions of the comp consultant, and not treat them as an adversary.

Ferracone: I think trust on all sides is important, and consultants have to earn that trust by behaving in a transparent way. We hear stories that certain people will say one thing to management but something different to the committee, and that is exactly the way to destroy trust.

Martinez: It’s also a very good way for the comp consultant to get fired.

Ferracone: Agreed. What are the things you would advise a new compensation committee chair to do?

Martinez: Have a clear appreciation of the workload and commit to it. Then develop a clear understanding of the compensation culture at the company. Unless you’re a very new company,

every company has built up a series of practices and expectations about what gets rewarded and measured, and there are nuances and quirks in the compensation culture of the company.

I would recommend to a new chair that he or she sit down with all of the executive officers and ask, “What do you think about our programs? What would you do if you were in my position to change those programs? What do people in the company think about these programs? What are the things that drive them crazy?” Understand the attitudes that are brought to the table by the other members of the committee. Everyone is a product of his or her own experience, and sometimes, frankly, you’re a prisoner of your own experience.

Finally, be very sure that you’re comfortable with your comp consultant. Make sure they understand what’s going on in the marketplace and in the company, its strategy, the business, the culture, and can respond or react appropriately to management’s proposals and that they’re there for the committee whenever they’re needed. It’s a daunting deep dive from day one.

Ferracone: What you’re saying is that someone really has to forge a partnership with external resources—the comp consultants in particular—but there are also the internal resources sitting down with management and discovering what’s on their minds and what’s on the minds of the other compensation committee members.

Martinez: We also need to recognize that we are in one of the more difficult and challenging macro situations that anyone has seen in the last several years, and so we must be sure that compensation programs take into account a dramatically changing and volatile environment.

I think the one thought I’d leave for compensation committee members and chairs at this point in time would be to be sensitive to the macro environment but not compromise principles.

Ferracone: What I will take away from our conversation today is that the comp committee chair is truly in the middle these days—between shareholders and management—and needs to be made of and do the hard work of steel to get so close to the flame without being burned. D

In addition to his deep board service, arthur C. martinez was named the 12th chairman and CEO of sears, roebuck and Co., in 1995. martinez joined sears in 1992 as chairman and CEO of its retail arm, sears merchandise Group, and retired as chairman and CEO of sears in 2000. Previously, he was vice chair-man of saks Fifth avenue in New york City and a member of that company’s board of directors. From 1987 to 1990, he was group chief executive for the retail division of batus Inc., which included saks Fifth avenue, marshall Field’s and other chains. He also was a member of the batus board and the company’s ex-ecutive committee.

Arthur C. Martinez

“Investors have told us that they’re very focused on pay and performance alignment, and that alignment factored heavily into their say-on-pay voting decisions. ” —Robin A. Ferracone

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Report of the NACD Blue Ribbon Commission on Performance Metrics 1

Directors are expected to oversee corpo-rate and executive performance, but this is not always easy—especially in large,

complex companies. To fulfill their oversight re-sponsibilities, directors require clear and focused metrics to measure and communicate the finan-cial and non-financial criteria that are critical to the success of their enterprise. A clear under-standing of corporate and executive performance will empower boards to excel in these important responsibilities. Establishing the appropriate metrics to determine executive progress in achieving stra-tegic goals and competitive success is a critical board task, yet given the company-specific nature of such decisions, little helpful guidance is avail-able in the governance literature. This is the issue our Commission was formed to address. As directors, we see a lot of numbers—mostly historical data from financial reports. While this information is critically important, there is much more at work in an organization. Directors rarely receive regular reports on other critical issues, such as executive development, workplace safe-ty, or product innovation. While many companies are now enhancing their reporting on these areas, more can and should be done. Directors must focus on the information needed to understand what the company is truly accomplishing in core areas. In an effort to create more efficient methods of measurement, accountants, consultants, and regu-latory agencies have devised and circulated scores of metrics, both financial and non-financial. In turn, this has led to a great quantity of evaluation tools without a true sense of quality and priority. Boards may receive too much data without evalu-

ating what impact it has on the achievement of corporate goals. The lack of meaningful metrics is only one obstacle to overcome; director com-prehension of the board’s role in metric selection and monitoring also needs improvement. In addi-tion, directors have an affirmative duty to oversee performance for both the short- and long-term health of the enterprise. Yet, directors often defer to management to establish the metrics by which the board will judge the success of the manage-ment team. Improving director understanding of met-rics is likely to improve the board’s ability to link pay to performance. While this report does not focus specifically on compensation, the Commis-sion recognizes that metrics are indispensable for determining executive pay. With an improved un-derstanding of both the board’s role with respect to establishing the metrics by which performance is assessed, and the types of metrics that can be used to track the critical elements that contribute to corporate performance, boards and compensa-tion committee members are better positioned to create meaningful incentives and to identify pay practices that may be misaligned. In order to properly understand metrics, the board must first put a spotlight on three areas: the board’s role in selecting metrics, the relation of metrics to compensation, and how to effectively communicate the metrics structure to sharehold-ers. To this end, in the chapters that follow, we recommend six imperatives to guide boards as they consider the performance metrics used by their company:

1. Understand and agree on the company’s key performance metrics. These key metrics, set

Letter from the Co-Chairs

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Report of the NACD Blue Ribbon Commission on Performance Metrics2

for both the enterprise as a whole and for major business units, should be used to track progress against the company’s strategy.

2. Establish company performance metrics to cascade throughout the entire enterprise. The board should ensure that management has used the metrics to establish more robust and detailed metrics at lower levels.

3. Track company performance against metrics on an ongoing basis. Metrics need to be set annually and monitored over time.

4. Establish consistent and appropriate executive performance metrics. These measures should be used not only for compensa-tion of top officers, but also for managers through-out the organization.

5. Reward executives based upon performance as measured by appropriate metrics. Deter-

mine compensation payments based upon an as-sessment of performance, including consideration of risk, for top officers and other levels of man-agement.

6. Communicate with shareholders regarding how the company has paid for performance. Use clear language to convey the reasons and re-sults of pay.

This report seeks to provide guidance in these areas. Undertaken with care, the effort to improve performance metrics will empower corporate di-rectors to help build stronger corporations. We hope that directors will find that this report is valuable to them in working with their manage-ment to develop and use appropriate metrics for their companies.

John DillonWilliam WhiteOctober 2010

Letter from the Co-Chairs

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Key Agreed PrinciPles to Strengthen Corporate Governance For U.S. Publicly Traded Companies

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Published by: National Association of Corporate Directors

Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies

© Copyright 2011 National Association of Corporate Directors Two Lafayette Centre 1133 21st Street NW, Suite 700 Washington, DC 20036 (202) 775-0509 NACDonline.org

Permission is hereby granted to download, store in machine readable form, and print these Principles provided that NACD is cited as follows: “Reprinted with the permission of the National Association of Corporate Directors. Copyright National Association of Corporate Directors, 2009”. Reference: Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies”. All other rights are reserved.

Director of Research, Peter R. Gleason Research Manager, Kurt L. Groeninger Research Analyst, Kate Ianelli Chief Knowledge Officer, Alexandra R. Lajoux Associate Editor, Suzanne L. Meyer Design by O2 Collaborative Inc. ISBN 978-0-943176-43-7

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Key Agreed Principles 1

Over The PAsT decAde, a host of detailed corporate governance best practice recommendations have arisen from a variety of organizations representing the views of shareholders, management, and directors. These best practice recommendations agree on many key points (at least at the theoretical level); however, some important differences in viewpoints remain. Overall, the development of varying best practice recommendations has been positive: it has added richness to the discussion of corporate governance practices and has underscored the room for variation in practices at the highest levels of excellence. legitimate concerns arise, however, about the overly prescriptive use of best practice recommendations by some proponents, without recognition that different practices may make sense for different boards and at different times given the circumstances and culture of a board and the needs of the company.

In an effort to recognize significant areas of common agreement and interest and to move beyond highly prescriptive and rigid recommendations of best practice for publicly traded companies, National Association of Corporate Directors (NACD) puts forth the following key principles to strengthen corporate governance—key principles that we believe most companies, boards, shareholders and shareholder groups will also support.

These Key Agreed Principles reflect the distillation and articulation of fundamental principles-based aspects of governance on which there appears to be broad consensus. they are intended to describe the current baseline consensus and thereby to help improve the quality of discussion and debate about governance issues that have not yet gained consensus. We would like to acknowledge the extraordinary and pro bono efforts of Ira Millstein, Holly Gregory, and their colleagues at Weil, Gotshal & Manges LLP—Kasara Davidson, Ofer Eldar, Christopher Evans, and Lyn Fay—for their analysis of corporate governance best practices and identification of the commonalities that were the basis for the principles.

The Principles can be given effect in a variety of ways. Boards are encouraged to use them in thinking through and tailoring their own governance structures and practices to meet the needs of their respective companies. shareholders are encouraged to consider these principles in assessing the governance of companies.

It has often been said that “one size does not fit all” when it comes to corporate governance. The Principles are intended to assist boards and shareholders to avoid rote “box ticking” in favor of a more thoughtful and studied approach. It is expected that NACD, Business roundtable (BRT), and other thoughtful proponents of effective governance practices (like those referenced in Appendix A) will continue to advocate their own views about the details of corporate governance best practice. Boards and shareholders should consider these more detailed viewpoints which, while similar in many respects, reflect and will likely continue to reflect some important differences.

2011 Update from NACD: We wish to extend our deepest gratitude to The Business Roundtable and the Council of Institutional Investors, who were essential in developing the NACD Key Agreed Principles, published in 2008. In recent years, the NACD initiated a challenge asking America’s directors to adopt the Principles, assess their governance practices, make changes where needed, and commit to continuing education and transparency. To learn more, please visit the NACD Challenge website at nacdonline.org.

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2 National Association of Corporate Directors

i. Board responsibility for governanceGovernance structures and practices should be designed by the board to position the board to fulfill its duties effectively and efficiently.

ii. corporate governance Transparency Governance structures and practices should be transparent— and transparency is more important than strictly following any particular set of best practice recommendations.

iii. director competency & commitment: Governance structures and practices should be designed to ensure the competency and commitment of directors.

iv. Board Accountability & Objectivity Governance structures and practices should be designed to ensure the accountability of the board to shareholders and the objectivity of board decisions.

v. independent Board leadership Governance structures and practices should be designed to provide some form of leadership for the board distinct from management.

vi. integrity, ethics & responsibilityGovernance structures and practices should be designed to promote an appropriate corporate culture of integrity, ethics, and corporate social responsibility.

vii. Attention to information, Agenda & strategyGovernance structures and practices should be designed to support the board in determining its own priorities, resultant agenda, and information needs and to assist the board in focusing on strategy (and associated risks).

viii. Protection Against Board entrenchmentGovernance structures and practices should encourage the board to refresh itself.

iX. shareholder input in director selection Governance structures and practices should be designed to encourage meaningful shareholder involvement in the selection of directors.

X. shareholder communications Governance structures and practices should be designed to encourage communication with shareholders.

The National Association of Corporate Directors (NACD) puts forth these Key Agreed Principles, grounded in the common interest of shareholders, boards and corporate management teams, to provide a blueprint to corporate boards and thereby to help improve the quality of discussion and debate about governance issues moving forward.

To learn more, visit NACDonline.org/keyprinciples.

Key Agreed Principles

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Key Agreed Principles

This dOcumenT Assumes that companies comply with applicable governance-related provisions required by the Dodd-Frank Act of 2010, the Sarbanes-Oxley Act of 2002, rules of the Securities & Exchange Commission (“SEC”), stock listing standards, and all other applicable laws and regulations, as well as company articles and bylaws. For example, it is assumed that most publicly traded U.S. corporations now have a majority of independent directors; that independent directors hold periodic executive sessions without members of management present; that such sessions are convened and presided over by an independent director chosen by the independent directors; and that audit, compensation, and nominating/governance functions are undertaken by independent directors usually organized in committees.

The Key Agreed Principles that follow are grounded in the common interest of shareholders, boards, and management teams in the corporate objective of long-term value creation (through ethical and legal means), the accountability of management to the board, and ultimately the accountability of the board to shareholders for such long-term value creation. The Principles provide a framework for board leadership and oversight in the especially critical areas of strategic planning, risk oversight, executive compensation, and transparency. Principle I emphasizes the responsibility of every board to design its own governance structure and practices, and that boards should take into account in designing and explaining structures and practices. Principle II emphasizes the importance of the board explaining how it has tailored governance structures and practices to meet its own needs. Principles III through X describe the key fundamentals.

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The board of directors, as the central mechanism for oversight and accountability in our corporate governance system, is charged with the direction of the corporation, including responsibility for deciding how the board itself should be organized, how it should function, and how it should order its priorities. The board’s fiduciary objective is long-term value creation for the corporation; governance form and process should follow.

Shareholders and management have important viewpoints about governance structures and processes, and shareholders elect directors and have authority for certain critical decisions. However, it is the board that is charged with selecting and evaluating senior executives; planning for succession; monitoring performance; overseeing strategy and risk; compensating executives; approving corporate policies and plans; approving material capital expenditures and transactions not in the ordinary course of business; ensuring the transparency and integrity of financial disclosures and controls; providing oversight of compliance with applicable laws and regulations; and setting the “tone at the top.” Ultimately, therefore, the board must decide how best to position itself to fulfill its fiduciary obligations.

The corporation today faces pressures and scrutiny from a variety of stakeholders (for example, employees, customers, suppliers, special interest groups, communities, politicians, and regulators) having diverse interests in its operation and success. Moreover, shareholders are increasingly diverse and the capital markets and the business and social environment are increasingly complex and challenging. In addition to individuals who hold shares directly, investors now include a growing variety of entities that invest monies on behalf of their beneficiaries and have diverse time horizons, strategies, and interests in the corporation. These include hedge funds, private equity and venture capital funds, public and private pension funds, mutual funds, sovereign wealth funds, insurance companies, banks and other types of lenders, and derivative product holders. In responding to the pressures facing the corporation, the board must understand the diverse interests of stakeholders and investors, and consider competing demands and pressures as necessary and appropriate while ensuring that the corporation is positioned to create the long-term value that all shareholders have an interest in as a unified body.

This is the context in which the board must order its governance structures and processes, providing both oversight and guidance to management regarding strategic planning, risk assessment and management, and corporate performance. Serving as a director is demanding and—in addition to significant substantive knowledge and experience relevant to the business and governance needs of the company—requires integrity, objectivity, judgment, diplomacy, and courage.

i. Board responsibility for governanceGovernance structures and practices should be designed by the board to position the board to fulfill its duties effectively and efficiently.

“ The board’s fiduciary objective is long-term value creation for the corporation; governance form and process should follow.”

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A variety of structures and practices may support and further effective governance. Boards should tailor governance structures and practices to the needs of the company in a pragmatic search for what is most effective and efficient. Governance best practices should be adopted thoughtfully, and not by rote reliance on the recommendations posited by any entity or group. However, every board should strive to understand generally the parameters of and variations in standards of best practice recommended by NACD, BRT, and other thoughtful proponents of effective governance practices (like those referenced in Appendix A).

Every board should explain, in proxy materials and other communications with shareholders, why the governance structures and practices it has developed are best suited to the company. Some boards may choose to disclose their own practices in relation to a set of recognized best practice recommendations, identifying those areas where their practices differ and explaining the board’s rationale for such differences. Whether or not a board discloses its practices against a defined set of recommendations, it is the disclosure of governance structures and practices generally and the rationale for divergences from widely accepted best practices that is important. Disclosure of the practices adopted and adapted by the board, along with the rationale for unusual aspects, is far preferable to the adoption of any prescribed set of best practices. Valuing disclosure over rigid adoption of any set of recommended best practices encourages boards to experiment and develop approaches that address their own particular needs, and avoids rigidity. Boards that explain their practices should be rewarded and not penalized for decisions to adapt best practice to their own needs.

ii. corporate governance Transparency Governance structures and practices should be transparent— and transparency is more important than strictly following any particular set of best practice recommendations.

“ Boards should explain to shareholders why the governance structures and practices it has developed are best suited to the company.”

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A board’s effectiveness depends on the competency and commitment of its individual members, their understanding of the role of a fiduciary and their ability to work together as a group. Obviously, the foundation is an understanding of the fiduciary role and the basic principles that position directors to fulfill their responsibilities of care, loyalty, and good faith.

However, an effective board is far more than the sum of its parts: it should bring together a variety of skill sets, experiences, and viewpoints in an environment conducive to reaching consensus decisions after a full and vigorous discussion from diverse perspectives. While the board should reflect a mix of diverse experiences and skill sets relevant to the business and governance of the company, each board must determine for itself, and review periodically, what those experiences and skill sets are and what the appropriate mix should be as the company faces different challenges over time.

Typically, a board will want some persons with specialized knowledge of relevant businesses and industries and the business environment in which the company functions who can provide insight regarding strategy and risk. Director qualifications and criteria should be designed to position the board to provide oversight of the business.

Directors need to exhibit a commitment of both time and active attention to fulfill their fiduciary obligations. Generally, that means that directors should ensure that they have the time to attend board and committee meetings and the annual meeting of shareholders, prepare for meetings, stay informed about issues that are relevant to the company, consult with management as needed, and address crises should crises arise.

The board may wish to articulate guidelines that encourage directors to limit their other commitments. Such guidelines assist in communicating expectations about the commitment that is expected. Given the considerable variation in individual capacity, boards should apply their judgment and assess directors’ commitment through their actions, rather than rely on rigid standards.

iii. director competency & commitment: Governance structures and practices should be designed to ensure the competency and commitment of directors.

“ Director qualifications and criteria should be designed to position the board to provide oversight of the business.”

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Boards are accountable to shareholders for the governance and performance of the corporation, and must provide active oversight of the management of the corporation. Accountability in the oversight of the corporation is premised on the ability of the board to be objective and distinct from management. While actual board objectivity is key, reassuring shareholders that the board is structured to lessen the likelihood of undue management influence is also important.

Listing standards require that a majority of directors qualify as “independent,” and reserve key functions relating to audit, compensation, and nominating/governance matters to independent directors. (Heightened standards of independence apply to audit committee members.) Listing standards also define certain relationships that are inconsistent with a finding of director independence while otherwise leaving to board discretion the determination whether a director has family, business, consulting, charitable, or other relationships with the company and its management that might undermine objectivity.

Boards are encouraged by listing standards to disclose the standards they apply in determining director independence and must disclose, by category or type, the relationships that they consider in their assessment. Disclosure serves as a significant disciplining force for board independence decisions. Given to the impossibility of defining all the relationships with a company that may arise for directors and director candidates, and the likelihood that many relationships outside the per se prohibited relationships provided by listing rules and SEC regulations will be significantly attenuated, it is advisable that boards retain discretion to decide independence on a case by case basis. Application of board judgment to the independence determination (within the framework provided by listing standard and applicable SEC regulations) is preferable to application of the more rigid standards prescribed in some best practice recommendations.

Executive sessions—usually including both independent directors and those outside directors who do not qualify as independent— without members of management present should be held regularly; more often than once or twice a year. Such sessions provide the opportunity for open discussion of management’s performance and management proposals regarding strategies and actions. Executive sessions are critical in establishing an appropriate environment of objectivity and candor. Most boards also spend time in the board meeting alone with the CEO to provide the CEO with the opportunity for candid exchange outside the presence of executives and staff. In addition, the independent and other outside directors should have the opportunity, from time to time, to meet alone with the chief financial officer, general counsel, and/or other key senior officers outside the presence of the CEO.

Careful respect should be given to maintaining the distinction between the role of the board and the role of management. Undue board involvement in matters of management may interfere with the board’s ability to provide objective oversight of management performance.

iv. Board Accountability & Objectivity Governance structures and practices should be designed to ensure the accountability of the board to shareholders and the objectivity of board decisions.

“Disclosure serves as a significant disciplining force for board independence.”

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The board provides oversight of management and holds it accountable for performance. This requires that the board function as a body distinct from management, capable of objective judgment regarding management’s performance. Therefore, some form of independent leadership is required, either in the form of an independent chairman or a designated lead or presiding director. (Rotation of the leadership position among directors or committee chairs on a per-meeting or quarterly basis is not favored because it does not promote accountability for the independent leadership role.) Boards should evaluate the independent leadership of the board annually.

The decision as to the form of independent leadership should be made by the independent directors. If the independent directors determine that it is in the best interests of the company to have independent board leadership in the form of an independent lead director, with the CEO or other non-independent director serving as the board chair, the independent directors should explain why that form of leadership is preferable and also provide the independent lead director with authority for setting the board agenda, determining the board’s information needs, and convening and leading regular executive sessions without the CEO or other members of management present.

v. independent Board leadership Governance structures and practices should be designed to provide some form of leadership for the board distinct from management.

“ Accountability in the oversight of the corporation is premised on the ability of the board to be objective and distinct from management.”

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The tone of the corporate culture is a key determinant of corporate success. Integrity, ethics, and a sense of the corporation’s role and responsibility in society are foundations upon which long-term relationships are built with customers, suppliers, employees, regulators, and investors. The board plays a key role in assuring that an appropriate corporate culture is developed, by communicating to senior management the seriousness with which the board views the matter, defining the parameters of the desired culture, reviewing efforts of management to inculcate the agreed culture (including but not limited to review of compliance and ethics programs) and continually assessing the integrity and ethics of senior management.

Assessment of management performance and integrity are at the heart of effective governance, and should factor into all board decisions – not only in hiring and compensation matters. In particular, boards should assess management integrity and ethics when considering management proposals; assessing internal controls and procedures; reviewing financial reporting and accounting decisions; and more generally, when discussing management development and succession planning. The board should pay special attention to how members of senior management approach their own conflicts of interest, for example, in addition to any proposed related-person transactions involving management, the conflicts inherent in compensation decisions and the use of corporate assets in the form of perquisites.

vi. integrity, ethics & responsibilityGovernance structures and practices should be designed to promote an appropriate corporate culture of integrity, ethics, and corporate social responsibility.

“The tone of the corporate culture is a key determinant of corporate success.”

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In today’s dynamic and volatile business and financial environment, a key challenge for boards comprised primarily of outside and independent directors is to develop their own sense of corporate priorities and their own view of the matters that are most important to the success of the company. Boards must develop their own viewpoints to provide management with meaningful strategic guidance and support and to focus their own attention appropriately. Therefore, the board must be actively engaged in determining its own priorities, agenda and information needs.

Directors need significant information about the company’s business and its prospects based on an understanding of opportunities, capabilities, strategies, and risks in the competitive environment. While directors must—and should—rely on management for information about the company, they need to recognize that their ability to serve as fiduciaries depends on the degree to which they can bring objective judgment to bear. Therefore, directors cannot be unduly reliant on management for determining the board’s priorities and related agenda, and information needs.

For most companies, the priority focus of board attention and time will be understanding and providing guidance on strategy and associated risk–based on the underlying understanding of the company’s strengths and weaknesses, and the opportunities and threats posed by the competitive environment—and monitoring senior management’s performance in both carrying out the strategy and managing risk. Management performance, corporate strategy, and risk management are the prime underpinnings of the corporation’s ability to create long-term value. Directors should strive for a constructive tension in discussions with management about strategy, performance, and the underlying assumptions upon which management proposals are based. Directors should actively participate in defining the benchmarks by which to assess

vii. Attention to information, Agenda & strategyGovernance structures and practices should be designed to support the board in determining its own priorities, resultant agenda, and information needs and to assist the board in focusing on strategy (and associated risks).

“ Boards must develop their own viewpoints to provide management with meaningful strategic guidance and support.”

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success, and then monitor performance against those benchmarks. They should also establish (and disclose to the extent practical in light of competitive realities) a very real and apparent link between the strategy, benchmarks for success, and compensation.

As emphasized by the Sarbanes-Oxley Act and related SEC regulations and listing standards, the board plays a critical role in oversight of compliance, financial reporting, and internal controls, as well as in organizing the board’s own processes. However, these functions should follow naturally from an understanding of the importance of the board’s objective judgment in its role as a fiduciary and a primary focus on corporate strategy and performance (within an appropriate framework of integrity and ethics as discussed above). In normal circumstances, compliance, oversight of financial reporting and controls, and governance issues should not demand the majority of board time and therefore should not overwhelm the board’s agenda.

Information flow to the board should be sufficient to support understanding of the company’s business and the critical issues the company faces, and enable participation in active, informed discussions at board meetings. It should not be so voluminous as to overwhelm. While the board must have access to any information that it wants, generally the board should assert discipline and not overwhelm management with requests for information outside the scope of what management uses to manage. The board and management should work together to define the type and quantity of information that is of most use, and to identify the timeframe in which information should be provided. (It is in the area of agenda and information flow that independent board leadership is particularly necessary.) Crisp reports distributed in advance of meetings should obviate the need for lengthy management presentations in most board and committee meetings, so that maximum time is preserved for discussion.

As expressed in more detail below, the board should also strive to communicate with shareholders about corporate priorities.

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The board needs to ensure that it is positioned to change and evolve with the needs of the company. This requires that directorship never be viewed as a sinecure. Some boards rely on age limits and/or term limits to assist in moving directors off the board. Some boards also require directors to offer their resignation upon a significant change in job responsibility. These mechanisms do not substitute for evaluating the contributions of individual directors in the context of re-nomination determinations and, in appropriate circumstances, determining not to re-nominate based on the evolving needs of the company or underperformance by the director.

In addition, the board and its committees should conduct self-evaluations periodically in the interest of continual self-improvement. Such self-evaluations do not need to be unduly complicated, but should provide an opportunity for the board and its committees to reflect and should culminate in a significant discussion about areas for further effort and improvement. Board policies regarding the conduct of evaluations should be disclosed.

As fiduciaries, boards need the ability to negotiate regarding takeover approaches, and anti-takeover defenses are important in providing negotiating leverage. At the same, time boards should understand that many shareholders view anti-takeover devices as unduly protective of the status quo. Boards should give careful consideration to whether anti-takeover devices are in the best long-term interests of the company. If the board adopts an anti-takeover measure, it should take special care to communicate to shareholders the reasons why, in its considered viewpoint, the measure is in the best interests of the company, and it may wish to consider providing shareholders with the opportunity to ratify within a reasonable time frame.

viii. Protection Against Board entrenchmentGovernance structures and practices should encourage the board to refresh itself.

“ Boards should consider the contributions of individual directors as well as the evolving needs of the company in determining board composition.”

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Voting procedures for director elections should be designed to promote accountability to shareholders by providing shareholders a meaningful ability to elect or decline to elect directors in uncontested elections. Companies should adopt majority voting through appropriate provisions in articles of incorporation or bylaws (to the extent consistent with state law). In an uncontested election, a candidate who fails to win a majority of the votes cast should be required to tender his or her resignation, and the nominating/governance committee should recommend to the board whether to accept or reject the resignation, depending on the circumstances. (Any board decision not to accept the resignation of a director who has failed to receive a majority of the votes cast should be carefully thought out, and the explanation for such decision should be fully disclosed to shareholders.) In contested elections, directors should be elected by plurality voting.

Shareholders should have meaningful opportunities to recommend candidates for nomination to the board. The nominating/governance committee should disclose a process for considering shareholders’ recommendations. Particular attention should be paid to a process for obtaining the views of long-term shareholders who hold a significant number of shares.

iX. shareholder input in director selection Governance structures and practices should be designed to encourage meaningful shareholder involvement in the selection of directors.

“ Companies should adopt majority voting through appropriate provisions in articles of incorporation, bylaws or state laws.” “

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Shareholders have a legitimate interest in the governance of their companies. The fundamental role of shareholders in corporate governance is to elect directors capable of directing management in the best interests of the company and its shareholders. Receptivity to shareholder communications on topics relevant to board quality and accountability may prove beneficial in helping to improve mutual understanding while avoiding needless confrontation.

The board should carefully consider critical non-binding proxy proposals that attract significant support from shareholders. The board should take special care to ensure that it fully understands the issue and should communicate both with the proponent and the shareholders at large regarding the board’s thinking on the matter. Such communication can be had through the proxy statement, annual report, annual meeting, and other meetings and correspondence with the proponent and other shareholders (subject to compliance with Reg FD).

Boards should also consider reaching out and developing stronger relationships with investors through candid and open dialogue. In particular, boards should consider ways to engage large long-term shareholders in dialogue about corporate governance issues and long-term strategy issues, recognizing that the board’s fiduciary duties with respect to these issues mandate that the board exercise its own judgment.

Board communications with shareholders on these issues should involve one or more independent members of the board—usually the board chair, the lead director, or the appropriate committee chairs. In most instances, the CEO or other members of management should also participate. The board should establish processes for communications to ensure that any communications with shareholders are authorized by the board.

Executive compensation is an issue of particular concern for many shareholders. The board and the compensation committee should consider ways for shareholders to communicate their views and concerns regarding executive compensation, and should take these views and concerns into account, again recognizing that ultimately the board as fiduciary must make compensation decisions. Some boards may wish to consider seeking advisory shareholder votes on executive compensation, while some boards may explore other means of obtaining shareholder viewpoints.

The board should also consider ways to enhance the communication opportunity provided by the annual meeting, taking into account shareholders’ expense and convenience when selecting the time, location, and mode of meetings (i.e. in-person meetings, meetings via electronic communication, or both). All directors should attend the annual meeting, and shareholders should have the opportunity to ask questions, subject to appropriate procedural rules (for example, those designed to ensure that a variety of shareholders can be heard from in the limited time available).

X. shareholder communications Governance structures and practices should be designed to encourage communication with shareholders.

“ Boards should consider reaching out and developing stronger relationships with investors through candid and open dialogue.”

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We encourage you—shareholders, corporate management teams, legislators, directors—anyone with a stake in the outcomes of boardroom excellence—to become familiar with these Principles and continue to participate in the discussion about leading practices in corporate governance.

Visit nAcdonline.org/keyprinciples for opportunities to help strengthen corporate governance in America.

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