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GovernanceMetrics International

GovernanceMetrics International. Corporate Governance. The game has changed. The Game Has Changed. Sarbanes.Oxley (Legislation). Political Agendas (Spitzer). Global Accounting Standards (Emerging). Research Independence (Mandated). SEC Revitalization (Enforcement). Effective Governance.

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GovernanceMetrics International

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  1. GovernanceMetrics International

  2. Corporate Governance The game has changed The GameHasChanged Sarbanes.Oxley (Legislation) Political Agendas(Spitzer) Global Accounting Standards (Emerging) Research Independence (Mandated) SEC Revitalization (Enforcement) Effective Governance Pensions Fund (Activism) Auditor Independence (Mandated) D&O Insurance(Expense) Institutional “Buy-Side” Power (Compelling Change) CorporateCulture MeaningfulMetrics

  3. Governance Research Report Findings based upon: • A.T. Kearney survey, interviews, interaction with over 410 corporate directorships, Chief Executive Officers. • Key issues / concerns • Roles and responsibilities of a Board • Culture as a Board responsibility / role • Callard-Research – Independent, institutional • Rated top 5% in efficacy of advice • Highly accurate, proprietary metrics • Governance Metrics International – Independent, institutional research • Governance evaluation • 500 factor scoring index

  4. Compliance has been a distraction to the real job of the corporate board • All ensuring regulatory compliance — three-fourths “very involved” over the last 12 months • 93% have taken a more active role in shaping company performance in the last 12 months • 74% believe further board involvement is needed to ensure performance improvement “Section 404 is a nightmare, especially for multinationals and those who have done lots of acquisitions. Too much documenting and not enough auditing” S&P 500 Director

  5. Growing evidence links quality of governance to company performance and two shareholder value Findings vary but the bottom line is the same… Best Board companies outperform 2:1 28% higher profits and12% higher shareholder returns Pension Fund Study 3% a year more over five years …Well-governed companies outperform

  6. Metrics exist which link Governance to shareholder value

  7. There is a direct relationship between Total Shareholder Return (TSR and GMI scores) Top GMI Scores (8.5 – 10.0) S&P 500 Quintile Sunoco ITT Harley D 5 A 3M Johnson Controls Coventry Health Aetna Rayonier Pepsi 4 B “Independence” Ecolab 3 C Johnson & Johnson 2 D Bottom GMI Scores (1.0 – 3.5) Anh. Busch IBM “Activism” Alcoa Lucent Sara Lee Xerox Williams 1 E Freddie Mac Coors AON Quest Callard and GMI F <-20 -15 -10 -5 0 5 10 15 20 >25 Total Shareholder Return (TSR)

  8. There is a direct relationship between TSR* and GMI Scores Top GMI Scores Bottom GMI Scores *5 Year TSR Average + “500” GMI Scoring Index

  9. This relationship becomes increasingly powerful over time Bottom 10% of 1600 Co. Index Top 10% of 1600 Co. Index Avg. Annual TSR © A.T. Kearney – GMI Delta Between Top and Bottom (x Times) 3.1x 15.7x 9.2x 13.9x Note: *LSS/GMI index criteria — good versus poor governance

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

  11. Culture starts with the Board • Governance and Culture – Three levels of consideration: • Culture of the Board • Culture of Executive Management • Culture of the Organization Each – in descending order – takes cues from above

  12. Culture starts with the Board • Independence : Objectivity • “Club” or Professional Advice? • Committee Structure : Agenda • Probe for issues or “what’s for dessert”? • Nominating Process : who selects / what criteria • Best qualified: or best friends? • Time dedicated : Time really available? • This Board: or one of two dozen? • Compensation : cash or stock • Do it for income: or do it for value contributed? • Philosophy : CEO “RULES” : or CEO the Hired Hand • CEO in charge: or is the Board?

  13. Which then gives cues to management Culture of Executive Management — Key Factors • Accountability: to whom? What basis? What metrics? • Transparency: clear or opaque? • EPS or cash flow: “hit” targets or create value • Executive style: participative or autocratic? • Promotion path: dictatorial or meritocracy? • Succession: hold the course or fresh ideas? • Reality of conduct and ethics: as preached or as practiced? Which then establishes the “REALITY” for the organization at large

  14. Metrics exist to govern culture • Meaningful metrics – Governance is directly responsible for results. • What is achieved? • How it is achieved? • For instance • Measure value creature

  15. Metrics that measure value creation — relationship of NCFR0I to TSR/GMI • Best companies have a high correlation to TSR • Worst have a poor correlation to TSR — market simply is not giving them same credit Best Worst Company Q NCFR0I TSR GMI Company Q NCFR0I TSR GMI Aetna Alcoa Anh. Busch Ecolab Harley Ingersoll Rand ITT Johnson & Johnson Pepsi Rayonier Sunoco 1.6 0.9 2.8 3.5 2.7 3.2 2.5 1.9 5.5 2.6 1.0 2.5 0.3 8.3 9.5 9.4 10.2 5.3 5.6 14.1 2.2 1.1 12.3 3.1 4.1 9.3 14.1 3.1 16.3 5.7 10.4 11.9 17.2 9.5 8.5 9.0 9.0 8.5 9.0 8.5 9.0 10.0 9.5 9.5 Adel. Coors AON Disney IBM Network Assoc. Protective Quest Sara Lee Textron Williams Xerox 0.9 1.8 1.8 2.3 2.2 1.2 1.4 2.6 1.2 1.1 1.3 0.1 5.6 1.9 4.7 1.2 1.8 (3.7) 8.7 (0.5) (0.3) 1.0 (1.3) (5.8) (4.0) 0.7 (25.7) (1.4) (29.6) (2.4) (1.7) (3.1) (17.8) 1.5 3.5 5.5 2.5 1.5 1.5 1.0 3.5 1.5 5.5 2.5 Callard Research and GMI Proprietary Information

  16. Metrics that measure value creation - EPS vs. cash flow? R2 = 0.31 Value (PE Ratio) Value (Q Ratio) R2 = 0.74 Driver (EPS Growth) Driver (NCFR0I) • P/E is a result, not a value driver • EPS only one element of cash flow • Distorted by options outstanding • Manipulatable in short run • Not integrated with balance sheet or cash flow statements • Q measures enterprise value; being driven by the productivity of assets • CFROI measures cash flow; real return on invested capital • N measures cost of capital; with company specific differentiators © A.T. Kearney – and/or Callard Research Proprietary Information

  17. Metrics exist which link Governance to shareholder value

  18. What Corporate Directors are saying Results of A.T. Kearney survey of over 410 Directors Is this good enough?

  19. Critical business issues that need attention Degree of effectiveness - Self evaluation – Survey Results 49% Probing concerns Monitoring financials 43% Leadership developmentSuccession planning 24% 21% Guiding strategy Monitoring risks 16% Performance warnings 15%

  20. A more proactive board culture tops the list of actions to improve effectiveness What will improve Board effectiveness More proactive board culture Shape meeting agendas MoreprobingBoard culture Mgmtsupportfor probing Process toevaluateBoard Improvecaliber of individual directors SeparateCEO& Chair LeadDirector

  21. Although 55% of the directors were very satisfied with their board structure, most see opportunities to improve What changes should be made to your Board structure? MoreQualifiedDirectors MoreDiverse MoreIndependent Represents All Constituents Representing shareholders across broader businessissues requires diverse skills and perspectives

  22. Boards also need to reinvent how they operate… What are the impediments to monitoring business performance?(Top 3 concerns) Lack of tools and processesproviding early warning signs Amount and type of company information Board culture Insufficient operatingmanagement discussions Directors do not haveenough time Willingness of directorsto challenge the CEO Lack capabilities withinBoard of Directors

  23. ...And recognize they need more objective sources of information What tools does your Board use to monitor performance? Management bias? Industry Reports Analysts Customers On-site Visits Consultants Investors

  24. 85% of boards evaluate annually 55% agreed in 2002 that regular, independent, third-party reviews should be executed …but in 2004, only 24% of Boards have them Board evaluations can focus improvement efforts — but may also need more independent views Does your Board have regular, independent, third-party reviews of your governance practices? NA 1% Yes 24% No 74% “Board evaluations have been a catalyst for how the board gets better… The link to company performance is spectacular” S&P 500 Director

  25. Monitor corporate performance with forward-looking and non-financial business indicators 1 Strengthen business strategy through diverse perspectives and ongoing attention 2 3 Improve risk monitoring and mitigation 4 Shift from succession policy to successor readiness Foster a constructively challenging culture, engaging as an owner vs. as a reviewer 5 In our judgment, Boards need to take action in five critical areas

  26. Monitor corporate performance with forward- looking and non-financial indicators 1 • Rebalance focus on compliance and current performance to include more implications of forward-looking indicators • Expand from financials to broader business view • Operations • Pipeline • Competitive trends • Market shifts • Customer satisfaction • Brand value • Technology Shifts • Stakeholder concerns • Increase board access to information, e.g., digital dashboards or web-based reporting (vs. “the package”) Represent the shareholder… Monitor the long-term health of the business

  27. Strengthen business strategy with diverse perspectives and ongoing attention 2 • Shift the board role from review to “debate” — bringing out diverse perspectives • Expand oversight role from annual approval to include ongoing verification and support for the CEO • Is the company executing effectively? • Are different leadership skills needed? • Is the strategy still appropriate? • Consider new ways to evaluate complex strategies Assist management in developing a successful, executable strategy

  28. Improve risk monitoring and mitigation 3 Beyond Financial Risks: Business Interruption Product Failure Partner Failure Ensure management has effective monitoring and mitigation plans…and ability to respond effectively Competitive Challenge Customer Demand Changes Supply Chain Interruption Disruptive Technology Operating Obsolescence Environmental Risks Inflation / Cost Increases Lawsuits New Regulation Reputation

  29. Shift from succession policy to successor readiness – and broader talent development 4 • Be accountable for the top team— not just the CEO • Enact “field” observation / board interaction • Drive broader talent management (CEO led) as critical to sustain shareholder value • Not a list… • Beyond “replacement” planning • Competencies for key future positions Identify Talent DevelopTalent DeployTalent

  30. Foster a constructively challenging culture, engaging as an owner vs. a reviewer 5 • Set the agenda • Challenge assumptions and monitor progress • Ensure all voices heard – formal and informal exchanges • Across the board • Shareholders / stakeholders • Take advantage of today’s technology • “Right-time” communication and open exchanges • Information access • Alternate self-reviews and independent reviews

  31. We surveyed Directors representing 410 large corporate boards companies at the beginning of 2004 and compared this to 2002 findings • 38% global and 34% North America only • >25 industry sectors • 65% > 6 years on Board • 82% Male • 77% Working • 33% with same Industry experience • Average on 2.3 boards % of Directors Size of Company Represented (Revenue)

  32. Boards are making structural changes…but at a cautious rate Does your company have separate CEO and Chair positions? We thought through the advantages of going each way and decided that based on our industry and the alignment needed the combined role might fill expectations better – But to balance the power, we also initiated the Presiding Director.” 2002 2004 S&P 500 Director No Yes 60% of the 400 Boards represented in this surveyhave implemented an independent Lead Director

  33. Broader-based shareholder activism Power of institutional investors…over 50 % share of U.S. equities Regulation Sarbanes-Oxley NYSE NASDAQ Business Judgment Rule Reinterpretation The pressure on Boards continues to escalate A “Trigger point” in corporate governance

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

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