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RECOMMENDATIONS FROM THE NATIONAL ASSOCIATION OF CORPORATE DIRECTORS

Concerning Reforms in the Aftermath of the Enron Bankruptcy
Updated Version of May 3, 2002

We believe that the New York Stock Exchange, the American Stock Exchange, and the Nasdaq (self-regulatory organizations, or SROs) should endorse a set of general standards for board practices. We therefore recommend that the House Committee on Energy and Commerce ask the Securities and Exchange Commission (SEC) to urge the SROs to develop such standards or adopt an existing set of standards. Furthermore, we believe that the SEC should require public companies to disclose the extent to which they meet these endorsed standards. Public companies not following these practices would be required to describe to their shareholders any plans they have to adopt the practices, or explain why they do not find it necessary to do so. We believe that the SEC has the power to make this requirement without any special action by Congress.

This system would be similar to the ones established in 1993 in the United Kingdom (Cadbury Committee report, now the Combined Code) and subsequently in other countries inspired by the U.K. system, such as Canada (Dey Report). In these countries, stock exchanges require disclosure of conformity to certain recommended practices.

Experience and research have shown that disclosure requirements make a difference. Boards that do not initially conform to recommended practices tend to adopt them eventually, thereby strengthening their governance and, ultimately, the likelihood of improving long-term corporate performance.

U.S. SROs have been reluctant to endorse any particular set of governance policies and practices in part because of the state-based nature of governance in this country. In the U.S., expectations for director performance are set in part by state corporation laws, which vary somewhat from state to state. Although directors have affirmative duties of care and loyalty in every state, these duties differ somewhat in their statutory expression and judicial interpretation. In contrast, the countries mentioned above have unitary federal legal systems. Furthermore, U.S. companies tend to have a strong culture of voluntary governance, creating and following their own codes based on those of other companies, or from the codes of business, legal, and investor groups.

The time has come, however, to consider SRO endorsement of a set of general governance practices. Although our state-based, voluntary system has worked well for the companies it has touched, too many companies remain on the fringes of good governance practice. Mandating public company disclosure of certain core governance practices would require companies to pay more attention to board governance, yet would still preserve flexibility and diversity in their application to individual boards’ needs.

The challenge, therefore, is to select the source and number of practices that should be endorsed for disclosure purposes. There are many valid sets of recommended governance practices. It will be very important to select the right set.

The SROs may wish to use their recently formed governance panels to determine which practices should be endorsed. The panels could examine the many codes that already exist from other nations’ stock exchanges, and from the various kinds of groups listed above. The NACD would be honored to participate in such an effort.

Alternatively, and preferably, the SROs may wish to consider and endorse the following set of practices, which are based on the Blue Ribbon Commissions the NACD has hosted on a variety of governance topics since 1993. These Commissions have considered a broad range of issues, including executive compensation, CEO evaluation, director compensation, director professionalism, CEO succession, audit committees, the role of the board in corporate strategy, and board evaluation. Although NACD periodically updates these reports, their fundamental recommendations have endured.

Our Blue Ribbon Commissions have involved a full range of constituencies, including corporate directors, corporate officers (including CEOs and senior officers), institutional shareholders, accountants, attorneys, retired government officials, and corporate governance scholars. In total, some 300 individuals have been involved in these Commissions, with between 25 and 40 individuals serving on each Commission. Furthermore, in every instance, the recommendations made by these Commissions have taken into account other existing governance codes.

These Commissions’ recommendations, with dozens in each report, number in the hundreds--far too many to be practical for disclosure purposes. However, the Commissions have yielded a core set of recommendations the NACD board considers crucial to good governance. Furthermore, these recommendations are consistent with those endorsed by other prominent organizations in the governance field. These core recommendations follow.

Core Recommendations

  1. Boards should be comprised of a substantial majority of “independent” directors. At a minimum, these directors should meet the definition of “independent director” as defined under relevant SRO standards, although boards may consider adopting even more stringent standards of independence. Furthermore, boards should formulate and adhere to clear conflict of interest policies applicable to all board members.

  2. Boards should require that key committees--including but not limited to audit, compensation, and governance/nominating--be composed entirely of independent directors, and are free to hire independent advisors as necessary.

  3. Each key committee should have a board-approved written charter detailing its duties. Audit committee duties, at a minimum, should include two key elements: a) oversight of the quality and integrity of financial reports and the process that produces them; b) oversight of the management of risk. Compensation committee duties should include performance goals that align the pay of managers with the long-term interests of shareholders. Governance/nominating committee duties should include setting board and committee performance goals and nominating directors and committee members with the qualifications and time to meet these goals.

  4. Boards should consider formally designating an independent director as chairman or lead director. If they do not make such a designation, they should designate, regardless of title, an independent member to lead the board in its most critical functions, including setting board agendas with the CEO, evaluating CEO and board performance, holding executive sessions, and anticipating and responding to corporate crises.

  5. Boards should regularly and formally evaluate the performance of the CEO, other senior managers, the board as a whole, and individual directors. Independent directors should control the methods and criteria for this evaluation.

  6. Boards should review the adequacy of their companies’ compliance and reporting systems at least annually. In particular, boards should ensure that management pays strict attention to ethical behavior and compliance with laws and regulations, approved auditing and accounting principles, and with internal governing documents. In addition to meeting the current requirements for disclosure of management compensation, boards should disclose the total value of each director’s compensation, including the value of any stock options or grants awarded during the year.

  7. Boards should adopt a policy of holding periodic sessions of independent directors only. These meetings should provide board and committee members the opportunity to react to management proposals and/or actions in an environment free from formal or informal constraints.

  8. Audit committees should meet independently with both the internal and independent auditors.

  9. Boards should be constructively engaged with management to ensure the appropriate development, execution, monitoring, and modification of their companies’ strategies. The nature and extent of the board’s involvement in strategy will depend on the particular circumstances of the company and the industry or industries in which it is operating.

  10. Boards should provide new directors with a director orientation program to familiarize them with their companies’ business, industry trends, and recommended governance practices. Boards should also ensure that directors are continually updated on these matters.

We consider the final recommendation to be particularly important. The SROs should be encouraged to consider making director orientation and continuing education mandatory. This would place the U.S. ahead of other countries, where continuing education for corporate directors is not yet mandated. Mandating director education would not be difficult, and the benefits would be great. Many organizations offer industry education, and a small but growing number of organizations, including several leading universities and the NACD, provide education in governance. This type of education seems particularly critical today, when there is a heightened need for directors to maintain a current knowledge of governance issues and practices.

We believe that the SEC has the authority to take action on our recommendations, with the encouragement of your committee, without the need for further action by Congress.

Our proposal would not require any new financial reporting standards. In our view, the current system of a standards-setting body overseen by a public oversight body remains the best approach to financial disclosure standards-setting for public company reporting. True, some have criticized the Financial Accounting Standards Board, as well as the recently disbanded Public Oversight Board, for having overly close ties to business and accounting groups, so there may be a need to ensure greater independence of these groups. The greatest need for stronger independence and oversight, however, may lie in the boardroom itself.

The current system does not need more financial disclosure rules. Rather, it needs stronger oversight of those rules. We believe that the recommendations we have made in this statement can help boards of public companies ensure that their members are informed and independent, and can fulfill their oversight duties with integrity.