Emerging Issues in U.S. Corporate Governance: Are the Recent Reforms Working?
Hann, Daniel P., Defense Counsel Journal
The decade of the 1990s was one of increased emphasis on openness, with accelerated institutional shareholder activity and governmental prodding
WHAT IS "corporate governance"? In the 1990s, the term became a buzz word in board rooms throughout the United States and a battle cry for institutional shareholders. Nevertheless, "corporate governance" means different things to different people at different times.
To define and understand the term, it is well to explore its origins and then examine the legal framework and institutional environment associated with it. What is the perceived impact that the corporate governance movement has had and may have on director and officer liability in the United States and the resulting role of corporate counsel when advising clients on these issues? What about the future?
The modern era of corporate governance has at least four origins. First, it can be traced to the excesses of the 1980s, which was a time of rising executive compensation coupled with a frenzy of merger and acquisition activity. Leveraged buyouts and takeovers resulted in many instances in a need to improve performance by publicly owned companies. The takeover craze of the 1980s reflected an era of financially motivated deals that took advantage of undervalued companies and high inflation. The majority of these transactions were highly leveraged and financed through "junk" bonds, a process that arguably led to the savings and loan crisis. In the new decade, highly leveraged buyouts and takeovers have given way to corporate governance as a means to improve performance of public companies.
A second origin of the corporate governance movement is found in increased government regulation and rulemaking. For example, since 1990 the U.S. Securities and Exchange Commission (SEC) has promulgated or amended numerous rules and regulations that provide for improved shareholder communication and understanding. Examples include proxy reforms that make it easier for shareholders to require management to put an item in the proxy statement for shareholder vote and provide for increased shareholder-to-shareholder communication.
Between 1992 and 1995, the SEC also adopted several new rules governing the disclosure of executive officer and director compensation in registration statements, proxy statements and periodic reports. These measures sought to clarify and enhance the disclosure of executive officer and director compensation and, equally important, to provide explicit rationales and bases for compensation. The SEC's stated goal was to make compensation disclosure more clear, concise and useful to shareholders. These rule changes also resulted in the creation of the now-institutionalized compensation committee, which must issue an annual compensation committee report that discloses in the company's proxy statement the specific rationale used to determine compensation paid to the chief executive officers, as well as the compensation policies applicable to executive officers and the relationship of such compensation to company performance. Numerous other rule changes have been adopted by the SEC in recent years, the Plain English Initiative being one, many of which are aimed at facilitating shareholder communication and improving shareholder understanding.
Third, the information age in which we live today has given shareholders and prospective investors unprecedented access to information that they did not enjoy previously. Through electronic media such as the Internet, shareholders are now better able to access information that was previously difficult or impossible to obtain. This technology also has provided shareholders a vehicle with which to communicate with each another. As a result, shareholders, especially institutional investors, now have a relatively easy and inexpensive way to explore and exercise their newfound clout.
Finally, and most important, the 1990s witnessed a significant change in the composition of corporate shareholders. The equity holdings of institutional shareholders skyrocketed. Institutional shareholders primarily are composed of three principal classes of investors--mutual funds, state retirement plans, and corporate pension and retirement funds. Collectively, institutional shareholders hold 40 percent of the market value of America's publicly traded corporations and own more than 70 percent of all U.S. stocks.(1) By way of contrast, in 1950 institutional investors owned a mere 8 percent, 33 percent in 1980, 45 percent in 1988, and by 1990 institutional shareholdings reached 53 percent in the 100 largest corporations in America.(2)
This trend is not limited to the United States, where pension fund assets have grown almost ten-fold since the mid1970s. In Canada, the assets of pension and mutual funds are more than 35 times their value in the mid-1970s. Similarly, the growth in Europe has been equally impressive. In Germany, assets of all institutional investors grew five-fold between 1980 and 1995 and in France the increase was nearly twenty-fold over the same period.(3)
As institutional shareholders invest more in publicly held companies and their holdings become more concentrated, they take an increasingly active role in the way these companies are managed. When large institutional investors become dissatisfied with the performance of a company, they argue that it is financially unrealistic to simply sell off their shareholdings because of the impact the sales would have on share prices. Because the shareholders have taken such large positions in stocks of some of the largest companies in the United States, there is no ready market to dispose of such large holdings.
Also, because it is generally difficult to "beat the market," large institutional shareholders have begun "indexing" their holdings. Once a fund is substantially indexed, there is less opportunity or willingness to change equity positions in the indexed portion of the portfolio. Therefore, when institutional shareholders become dissatisfied with corporate performance, they may not take the easy way out and sell off shares. Instead, they may look for ways to exert pressure on management to improve performance. They have increased their pressure and activism through submission of proxy proposals, tender offers, lobbying for changes in the law, actively reviewing proposals contained in proxy statements, and, rather than automatically voting with management, exercising their independent judgment. Sometimes they try to convince other shareholders to vote with them, and sometimes they deal directly with management to effect change.(4)
Institutional shareholder activism was pioneered by the California Public Employees' Retirement System, known as CalPERS, one of the largest and most vocal of public pension funds in the United States in the late 1980s and early 1990s. By 1993, the world's largest pension fund, the Teachers' Insurance and Annuity Association-College Retirement Equities Fund, known as TIAA-CREF, issued its first comprehensive set of corporate governance principles. This policy statement was revised in 1997 and again in March 2000. It is available on the Internet at http:/ www.tiaa-cref.org/governance.
Today, with more than $250 billion in assets and serving two million participants, TIAA-CREF has become a master of promoting change in corporate America through quiet, behind-the-scenes diplomacy. It is a longtime champion of good corporate governance through the primary means of effecting change at the board level and submitting shareholder resolutions primarily directed at the elimination of dead-hand poison pill provisions and board independence issues.(5)
It is clear that the significant increase in institutional holdings has resulted in substantial shareholder clout. As institutional investors shift from merely trading to owning, they engage in corporate monitoring and demand accountability. According to John C. Bogle, senior chairman of the board of the Vanguard Group, the "creation of shareholder value is now the pre-eminent priority of corporate management" as a result of the leadership of large institutional investors who have become a "handful of heroes."(6) For more than any other reason, the standards of corporate governance have changed and will continue to evolve because corporate ownership is changing. Regardless of legal obligations, corporations face greater environmental pressures to respond to the evolving definition of a "shareholder."
In order to understand and appreciate the current state of corporate governance, it is important to have a solid grounding in the legal building blocks that give rise to shareholder activism. Today's shareholder rights and remedies flow from a colorful historical background in the United States, as well as a fairly well-established body of corporate law.
A. A Brief History Lesson
In 1919, Henry Ford, one of the captains of American industry, concluded that the Ford Motor Co. was earning too much profit; he wanted to pass the company's good fortune on to the American public by reducing the price of his automobile from $440 to $360. At that time, the company had $132 million in assets, approximately $18 million in liabilities, a surplus of $112 million, an annual net income of $60 million, and approximately $54 million in cash. Although $1.2 million was being paid in annual dividends and an additional $41 million in dividends was paid out between 1911 and 1915, no extra dividends had been paid since October 1915.
Two shareholders, the Dodge brothers, who owned one-tenth of the company, sued to compel an extra dividend of at least three fourths of the cash balance. In Dodge v. Ford Motor Co.,(7) one of the landmark decisions in corporate governance, the Supreme Court of Michigan held that a corporation is created to maximize shareholder profits. In affirming the decision of the lower court to distribute an extra dividend of $19 million, the court held that a "business corporation is organized and carried on primarily for the profit of the stockholders, and it is not within the lawful powers of a board of directors to shape or conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others."
This continues to be the law today. Institutional shareholders often preach with a vengeance that the primarily responsibility of public companies and their directors and officers is to maximize shareholder value.
B. Duties of Directors and Officers
The rules for corporate governance are framed by the rights, duties and appropriate roles of shareholders, directors and executive officers. The cornerstone of these responsibilities resides in the "fiduciary" duties that directors and officers owe to the corporations and shareholders for whom they serve. Traditionally, directors and officers have been subject to two basic duties: a duty of care and a duty of loyalty.(8) However, in recent years a third duty it can be argued that a third duty--the duty to establish controls--has been added to the list, especially in the light of the Delaware Court of Chancery's decision and opinion in In re Caremark International Inc. Derivative Litigation.(9)
1. Duty of Care
Directors and officers owe a duty of care to their corporation and must act with the care that a reasonably prudent person in a similar situation would use under similar circumstances. They must perform their duties in good faith and in a manner they reasonably believe to be in the best interests of the corporation. Prior to making a business decision, directors and officers are required to act carefully in light of their actual knowledge and such knowledge as they should have gained by reasonable care and skill.(10)
The duty of care requires that directors must act with prudence in making decisions. The discharge of the duty of care requires that the board of directors inform itself, prior to making a business decision, of all material information reasonably available to it. Reasonable reliance on others and utilizing all material information reasonably available to them is consistent with this requirement.(11)
In response to concerns about the apparent expansion of director liability stemming from the corporate takeover activity and the court decisions in the early 1980s, many state legislatures in the United States have narrowed directors' standards of conduct. For example, in the context of a corporate change of control, the corporate statutes of many states have been amended to identify specifically a broad range of factors that directors may take into account in exercising their duties. The Indiana statute, for example, makes it clear that a director can consider more than present profit maximization in determining a corporation's "best interests." It provides that "a director may, in considering the best interests of a corporation, consider the effects of any action on shareholders, employees, suppliers, and customers of the corporation, and communities in which offices or other facilities of the corporation are located, and any other factors the director considers pertinent."(12)
The result of these recent statutory changes provides directors with greater insulation and flexibility in exercising their decision-making powers while at the same time placing the traditional notion of fiduciary duties under attack.
2. Duty of Loyalty
The Delaware General Corporation Law, for example, provides that directors and officers owe an "undivided and unselfish loyalty" to the corporation.(13) Directors and officers are required to refrain from engaging in personal activities that would take advantage or injure the corporation. They are strictly prohibited from using their position of trust and confidence to further their own self-interests.
The director or officer "owes loyalty and allegiance to the corporation--a loyalty that is undivided and an allegiance that is influenced in action by no consideration other than the welfare of the corporation. Any adverse interest of a director will be subjected to a scrutiny rigid and uncompromising. He may not profit at the expense of his corporation and in conflict with its rights; he may not for personal gain divert unto himself the opportunities which in equity and fairness belong to his corporation. He is required to use independent judgment. In the discharge of his duties a director must, of course, act honestly and in good faith."(14)
Directors and officers are prohibited from using their position of trust and confidence to further their self-interests. For example, unless certain safe harbors are available a director or officer may not:
* Compete with the corporation to its detriment;
* Usurp a corporate opportunity;
* Realize personal gain from the material, non-public corporate information;
* Use the assets of the corporation for his or her personal gain; or
* Enter into any arrangement that has or appears to have a conflict of interest.
3. Duty to Establish Control
Recent court decisions in the United States can be said to have created a third duty for directors and officers--a duty to establish controls. The board's duty to monitor the conduct of corporate management is said to be a component of the general duty of care. As stated in 1996 in the Caremark International litigation, the board must take reasonable steps to inform itself about potential breaches of administrative and accounting control systems.
Chancellor Allen of the Delaware Court of Chancery observed:
Thus, I am of the view that a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may render a director liable for losses caused by noncompliance with applicable legal standards.(15)
Although directors and officers are not insurers of the integrity of their subordinates or of general corporate performance, they are required to implement reasonable programs to promote appropriate corporate conduct and to identify improper conduct. Even though directors and officers always have been required to perform their duties in accordance with applicable statutes and the terms of the corporation's articles and bylaws, recent decisions such as Caremark and the SEC's new rules governing corporate audit committees suggest that a conscientious board should design and monitor effective internal controls.
According to Professor Melvin Eisenberg of the University of California at Berkeley School of Law:
Fiduciary standards suggest that directors should use due care to have the corporation implement a well-designed, effective control system. Board-directed internal controls create a competitive source of information about management's conduct, perhaps correcting the informational imbalance between directors and executives. Controls may offset any incentives for management opportunism that might otherwise impede the effective monitoring of managers' performance. The board should assure itself that the internal auditors are properly running the system, enforcing the corporate policies established with the system and doing so without intervention by management to countermand the policies.(16)
As a result of recent court decisions and legislation such as the Federal Sentencing Guidelines and recent SEC rule changes, directors increasingly find themselves with an additional duty to establish adequate corporate controls.
4. Business Judgment Rule
The business judgment rule protects corporate transactions and immunizes directors and officers from liability where the transaction is within the powers of the corporation and the authority of management and the decision reflects the exercise of the three fiduciary duties discussed above. When the actions of a director are taken with due regard to these duties, and assuming those decisions cannot be attacked on the basis that they lack a "rationale business purpose," they are said to be protected by the business judgment rule, under which the courts will not second-guess their decisions. The business judgment rule recognizes that not all decisions of directors will result in benefit to the corporation and that directors will not be held personally liable for corporate losses if the business judgment rule is satisfied. If protected by the business judgment rule, directors are not exposed to personal liability as a result of their decision, and those decisions cannot be enjoined.
Board decisions are presumed to be protected by the business judgment rule, but the presumption can be rebutted by a showing that a director had a conflict of interest or the decision was not proper because the directors violated one of their other fundamental duties. However, even if the presumption of the business judgment rule is rebutted, the decision in question does not necessarily result in liability for the directors; rather, the effect of such a finding is to shift to the directors the burden of proving the "entire fairness" of the transaction.
In order to obtain the benefit of the business judgment rule, directors must satisfy five generally recognized elements. First, the rule protects directors against claims for wrongful acts, but not against claims for failure to act, involving a "business decision." Second, the rule protects only disinterested, independent directors who do not have a conflict in the transaction. Third, the rule protects directors only if they have exercised due care by reaching an informed decision after making reasonable inquiry to obtain all relevant information. Fourth, the rule protects directors if they have acted in "good faith" that their decision was in the best interest of the corporation. Finally, the rule protects directors against honest errors in judgment, but it does not provide protection for decisions involving an abuse of discretion.
INSTITUTIONAL ENVIRONMENT IN THE NEW CENTURY
Shareholder activism in recent years clearly has changed the role of the board of directors in the United States. Traditionally, the primary responsibility of the board was one of management oversight. The board would select and hire the CEO, and if the CEO failed to do his or her job or otherwise meet the objectives of the board, the board simply fired the CEO and hired another. Beyond these limited responsibilities, most boards generally did not interfere with the CEO and senior management and rarely got involved in the day-to-day affairs or operations of the company.
The current trend, however, is for the board to be active in developing the company's strategic plans and in serving as an active and involved steward of shareholders' interests. This trend has resulted in the replacement of the "old-boy network" by more professional directors who are better educated about both the company and their responsibilities. The consequence of institutional shareholder activism has been to move boards from one of mere "management oversight" to one of "active oversight."
A. Models of Corporate Governance
As the trend toward active oversight has developed, many different models of corporate governance have been advanced, of which a sampling follows. With the exception of the free market model, virtually all corporate governance models begin with the presumption that boards are too big, too close to management and insufficiently prepared to make critical decisions.
1. Lipton/Lorsch Model
In 1992, the well-known mergers and acquisitions attorney, Martin Lipton, and Harvard University business professor Jay Lorsch co-authored a thoughtful article, "A Modest Proposal for Improved Corporate Governance," in which they argued that typical boards of directors were inefficient and that reform was needed.(17) They stated that the problem did not lie with the current system of laws, regulations and judicial decisions that form the framework of corporate governance, but rather with the failure of lethargic directors to act before shareholders lose value and the corporation dissipates its competitive market position.
They concluded that more effective corporate governance depends largely on strengthening the role of the board of directors. They characterized their proposal as "modest" because their proposed changes should be implemented by individual boards without further changes in the laws, stock exchange rules, SEC regulations or new court decisions, all of which are politically difficult and time consuming. Their proposal recommended that action be taken unilaterally by self-interested companies and not part of a "deal" with institutional investors. The Lipton/Lorsch model proposes the following reforms:
Board size and composition. Board size should be limited to a maximum of 10 directors with at least two independent directors to each inside director. Smaller, independent boards will be more effective and efficient; directors would not be "professional" directors and would not serve on more than three boards at any one time.
Frequency and duration of meetings. Boards should meet at least bimonthly, and each meeting should take a full day, including committee sessions, with one meeting each year to include a two- or three-day strategy session. Directors also should be expected to spend the equivalent of one preparation day for each meeting day by reviewing reports and other materials provided to them in advance. Each director would be expected to spend more than 100 hours annually on board business, not counting special meetings and travel time. This much time is necessary so that directors can properly carry out their monitoring function. Director compensation would be increased to reflect the additional time expenditures.
Lead director. The Lipton/Lorsch model places a premium on effective independent director leadership. Where the CEO and chairman are the same person, the board should select a leader from among the independent directors and, if necessary, this position could be rotated annually or biannually. The CEO/chairman should then be required to consult with the lead director on issues such as selection of board committee members and chairs, the board's meeting agendas, the adequacy of information delivered to directors and the effectiveness of the board meeting process.
Improved information. In general, directors should receive more meaningful information. They should receive more detailed financial information to enable them to monitor the corporation's performance in relation to its long-term strategic goals, and directors should be able to choose in what format they want data organized and presented.
Corporate and CEO performance evaluation. The board should conduct a performance evaluation each year consisting of three aspects. First, there should be an assessment of the company's long-term financial, strategic and organizational performance in relation to previously established goals. Second, there should be a specific annual review of the CEO's performance. Third, the board should assess its own performance.
Board and shareholders. The board should conduct informal meetings annually with five to 10 of the company's largest shareholders. The primary purpose of these meetings would be to promote better understanding between the board and its shareholders and to provide a convenient and informal opportunity for key shareholders to advise directors of their concerns. This process should promote improved relations and harmony between the shareholders and management.
The proposals advanced in the Lipton/ Lorsch model are aimed at reducing the tension between activist institutional shareholders and management, cutting down much of the proxy resolution activity by institutional shareholders, eliminating the need for additional regulation and legislation, and avoiding the necessity of court intervention to resolve disputes between institutional shareholders and companies.
Lipton/Lorsch is a thoughtful model that in many respects achieves a balance between the free market model and the goals of many institutional shareholders. Many companies in the United States today have adopted many of the proposals advanced by this model, and it is likely that others will follow in years to come.
2. Quinquennial Model
Another model for board reform was advanced by Martin Lipton and another corporate attorney, Steven Rosenblum. This model, which is not inconsistent with the Lipton/Lorsch model, asserts that it is necessary for shareholders, managers and directors to take a long-term view so that a company may invest in the future, maintain vitality and compete in the world economy.(18)
Under the quinquennial model, a company would be under the control of management for five years without shareholder interference so that management could tend to the long-term well-being of the company. Directors would serve five-year terms and would be required to monitor the company against its long-term plan. At the conclusion of the five-year period, the company would undergo a thorough review, and if a director sought reelection at the end of the five-year term, re-election would be based on the five-year performance of the company.
The purported benefits of this model suggest, first, that in order for directors to be re-elected, performance must improve over the proceeding five-year period. Second, because company performance would be evaluated only every five years, directors and management would have sufficient time to focus on the long-term goals of the company without regard to short-term performance anxiety.
Although this model has its advantages, it also faces limitations. Because directors would be subject to evaluation only once every five years, they may become lethargic or ineffective in performing their duties, resulting in a loss in shareholder value that may be difficult to reverse at the conclusion of the five-year period.
3. European (German) Model
Boards in many other countries historically have tended toward the active oversight philosophy, whereas the United States traditionally has used the management oversight philosophy.(19) In recent years the European Union (EU) has debated whether to enact the European Commission's proposal for a European Community Statute (ECS).(20) The ECS consists of both a regulation and a directive. The regulation provides detailed rules for the establishment and operation of a European company, a "Societas Europea."
One of the proposals in the ECS provides that a Societas Europea must adopt one of two types of governing structures--a two-tier board of directors or a single-tier board. The two-tier model is derived from the long-standing and highly regarded German form of corporate organization. In Germany, a private company, known as "GmbH," may elect a two-tier board, whereas a public company, known as an "AG," must adopt a two-tier board.
Under the ECS proposals, companies would be required to have two separate boards--a supervisory board and a management board. The management board manages and represents the company under the direction of the supervisory board. The members of the supervisory board are appointed and may be removed by the supervisory board at any time and are required to provide the supervisory board with information and to respond to inquiries. No person may serve on both the management board and the supervisory board at the same time, except if a vacancy arises on a management board.
The supervisory board is primarily responsible for supervising the duties of the management board. This board may not engage in management functions and may not represent the companies in dealings with third parties. The members of the supervisory board are appointed and removed at the general meeting of the shareholders.
Although the ECS and the two-tier model have yet to be adopted by the EU, it is an interesting model nonetheless. Proponents of this model argue that the structure clearly delineates and distributes the responsibilities and powers within a corporation and allows for directors to supervise and act completely independent of management. It also is contended that this proposal minimizes the risk of domination by the CEO and senior management at board meetings.
4. Free Market Model
What best explains the history of corporate America is best characterized as a "free market model." It dictates that corporations and their shareholders, directors and officers are best served, as well as society as a whole, by allowing unfettered market forces to take their natural course without undue governmental influence. Shareholders who are dissatisfied with management performance can voice their dissatisfaction democratically through their shareholder votes or by selling their shares. Companies that are undervalued or underperforming or both, according to the free market proponents, will be subject to the natural market forces that give rise to takeovers and buyouts.
The thrust of the free market model is best explained by this excerpt from Richard A. Posner's seminal treatise:
The separation of ownership and control is a false issue. Separation is efficient, and indeed inescapable, given that for most shareholders the opportunity costs of active participation in the management of the firm would be prohibitively high. What is necessary in the interests of the shareholders is not participatory shareholder democracy but machinery for discouraging management from deflecting an inappropriate proportion of the firm's net income from the shareholders to itself. Whether such machinery is effective depends on the actual mechanics by which the control of the firm is transferred through the votes of the shareholders.(21)
Notwithstanding recent shareholder activism, the free market model has enjoyed substantial support in the United States. For example, it has long been the view of the Association of Publicly Traded Companies (APTC) that every corporation is unique and should be governed in accordance with state law and that governance issues should be tailored to the particular circumstances of each company. The APTC also has stated that if institutional shareholders have issues with management they should be addressed on a one-on-one basis rather than turning them into legislative or media issues. In many respects, the approach taken by TIAA-CREF in recent years is somewhat consistent with this position in that TIAA-CREF attempts to work quietly with boards to effect desired changes.
The free market model dictates that corporations and their management should be left to the devices of the free market system; accordingly, they should reap the benefits or suffer the consequences. A logical extension of this model is that good corporate governance does not guarantee good corporate performance, nor should corporate governance be used to further social or political agendas.
This system has served the United States economy extremely well for more than 200 years and, although no structure is perfect, it is hard to argue with success.
B. Recent Trends and Initiatives
1. Institutional Shareholder Initiatives
Since the 1990s, institutional shareholders have led the corporate governance charge and are principally responsible for the governance trends in corporate America today. Although the agendas of institutional shareholders have changed over time, the following is a list of some of the past and emerging issues on which institutional shareholders have focused.(22)
Executive compensation. Cash and stock compensation, especially for CEOs, should be pegged to company performance.
Director compensation. Compensation should be paid in company stock to better align the interests of the board with those of shareholders. Compensation arrangements should be fully disclosed in proxy statements.
Board structure. A majority of board members should be independent of management and should stand for annual reelection.
Professional directors. Some institutional shareholders have advocated the use of "professional" directors in order to guarantee independence from the CEO and management.
Committees. Committees are viewed as an efficient way for independent directors to provide oversight free of management domination. Independent committees should consist of audit, compensation, nominating, and compliance committees composed exclusively of independent directors.
Staggered terms. Staggered board terms should be eliminated.
Limitation on number of boards. Limits should be placed on the number of boards on which any one director may serve at one time.
Minimum share ownership. In order to align director interests with shareholder interests, some institutional shareholders have argued that directors and officers should hold a defined minimum number of company shares.
Cumulative voting. Cumulative voting should be preserved for shareholders.
Separate chairman and CEO. The function of the CEO and chairman should be separated in order to provide a better system of checks and balances as well as providing more diversity within the top echelon of the corporation.
Increased disclosure. Institutional shareholders have lobbied for more disclosure of financial data, including compensation data, and such disclosure should be in a plain and understandable style.
Repricing of stock options. Repricing of options should be eliminated as it is unfair to shareholders and dilutes shareholder value.
Poison pills. Shareholder rights plans, known as "poison pills, should be eliminated.
Dead-hand pills. So-called "dead-hand" provisions contained within many shareholder fights plans should be eliminated. Although there are a number of variations on dead-hand pills, the common mechanism employed is an attempt to block the power of new directors elected in a proxy fight to exercise their full voting authority to redeem a poison pill, should they choose to do so.
Board retirement policy. There should be a fixed retirement policy for directors.
Board diversity. Boards should be composed of qualified individuals who reflect diversity of experience, gender, race and age.
Fiduciary oversight. Directors should establish an environment of strong internal controls and accountability in order to ensure compliance with all applicable laws and regulations.
In recent years, many institutional shareholders such as CalPERS and TIAA-CREF have issued policy statements and urged large public companies to issue corporate governance guidelines or establish corporate governance committees. As previously mentioned, one of the more thoughtful policy statements is the Policy Statement on Corporate Governance recently revised by TIAA-CREF.
The introductory statement to this policy indicates that TIAA-CREF is a responsible long-term investor and "recognizes the overriding stake that our society and our economy have in the development vitality of public corporations." The statement also recognizes that "an ideal system of corporate governance does not guarantee superior performance" and that "superior performance can be achieved despite a governance system that is less than perfect." The statement continues: "Good corporate governance must be expected to maintain an appropriate balance between the rights of shareholders--the owners of the corporation--and the need of the board and management to direct and manage the corporation's affairs free from non-strategic short-term influences."
TIAA-CREF's policy focuses on board structure, shareholders' rights and proxy voting, executive compensation, CEO performance evaluation and succession planning, strategic planning, fiduciary oversight, social responsibility issues, and global standards for corporate governance. The last category, corporate standards for global standards of corporate governance, is an addition to the policy made by TIAA-CREF in 2000 and represents a recognition that TIAA-CREF and all institutional shareholders invest in a diversified international economy. TIAA-CREF advocates that good corporate governance principles should be applied internationally, because institutional shareholders such as TIAA-CREF may become increasingly active outside the United States.
During the 2000 proxy season in the United States, there were few surprises. For example, Institutional Shareholder Services issued its proxy voting policies on March 1, 2000, and recommended:
* Withhold votes for directors who attend fewer than 75 percent of a company's board and committee meetings;
* Withhold votes for directors who implement dead-hand poison pill provisions;
* Withhold votes for directors who ignore a shareholder proposal that is approved by a majority of votes cast for two consecutive years;
* Withhold votes from any inside director who sits on the audit, compensation or nominating committees;
* Vote against all proposals to eliminate cumulative voting;
* Annually elect board of directors;
* Majority of board composed of independent directors;
* Only independent directors on nominating committee;
* Ability of shareholders to call special meetings or act by written notice with 90 days' notice;
* Absence of superior voting rights for one or more classes of stock;
* Requirement for board size to remain within a stated range approved by shareholders; and
* Publish statement on board governance guidelines.(23)
2. Audit Committee Reforms
In December 1999, the SEC adopted new audit committee rules representing some of the most controversial and sweeping rule changes adopted by the agency in recent years. It adopted new audit committee disclosure rules and also approved amendments to the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) listing standards related to audit committees.(24)
These changes represent the culmination of the efforts of the SEC's Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC). The BRC represented a collaboration among the NYSE, the NASD, the SEC and the American Institute of Certified Public Accountants. From the fall of 1998, this group worked to prepare recommendations to the SEC on how best to improve board oversight of the financial reporting process of public companies. The BRC issued its recommendations in early 1999, and they were approved and adopted in December of that year.
The new rules represent substantial changes for corporate audit committees. They require new proxy disclosures beginning for annual shareholder meetings after December 15, 2000, but they also require review of quarterly financial statements by the company's independent auditors beginning immediately.
The thrust of the BRC's recommendations is to ensure that the audit committees play a key role in corporate governance in monitoring the audit process and that there be independent communication and information flowing between the audit committee and the outside auditors, while at the same time providing a forum for candid discussions among members of management, the internal auditor and outside auditors.
The new rules can be summarized generally:(25)
Audit committee member independence. The new rules require that companies have audit committees consisting solely of independent directors. Certain relationships, such as current or former employees and certain family relationships, would preclude such independence.
Qualifications and composition. The rules generally require that audit committees consist of at least three independent members. The NASD, for example, has an exception for small business filers for which only two independent members are required. The rules also require that all audit committee members be financially literate, which, at a minimum, requires that they be able to read and understand fundamental financial statements, including a balance sheet, income statement and cash flow statement. The NYSE rules further require that at least one audit committee member have an accounting or similar financial management background. The NASD requires either past employment experience in finance or accounting or other comparable experience, such as serving as a CEO, chief financial officer or other senior officer with financial oversight responsibilities.
Audit committee activities. The NYSE and NASD both require that the audit committee adopt a formal written charter approved by the board and that the committee review and reassess the charter annually. The charter must specify (1) the scope of the committee's responsibilities and how it carries them out, (2) the committee's responsibility for ensuring that it obtains from the outside auditors a formal written statement delineating all relationships between the auditor and the company, and (3) the committee's responsibility for taking appropriate action to oversee independence of outside auditors. The rules also require the independent auditors conduct a quarterly review of financial statements prior to their filing with the SEC.
Required disclosures. The new rules require that companies disclose in their proxy statements (1) whether the audit committee members are independent, (2) whether the company's audit committee adopted a written charter and, if so, include a copy of the charter at least every three years as an appendix to the proxy statement, (3) an audit committee report in the annual proxy statement followed by the names of all committee members stating whether the committee has reviewed and discussed the audited financial statements with management, discussed with the auditors the matters requiring discussion by all SAS61, received the written disclosures and letter from the auditors required by Independence Standards Board Standard No. 1, and recommended to the full board that the audited financial statements be included in the company's Form 10-K.
Although both the BRC and SEC had good intentions, it is questionable whether this additional and burdensome regulation will be effective. It is doubtful that the typical audit committee will be able to prevent the type of financial problems that have plagued companies such as Cendant or, more recently, Conseco. Surprisingly, the corporate reform duo of Lipton and Lorsch has voiced its concerns about the audit committee reforms. According to Professor Lorsch:
The recommendations won't necessarily solve the problems the panel is worried about. How much can you expect an audit committee made up of outside directors to do? To what extent do you really want to have that many people on the board who are familiar with accounting and finance? Is that the best balance? These are questions I don't think that [BRC] committee really thought about it. I'm all for active boards, but if you keep piling stuff on the board, it's not going to work. Each of these things in and of themselves may look sensible, such as more active audit committees and compensation committees doing this or that. But if it gets to be too much, it's going to become a job that is not done well.(26)
Martin Lipton voiced similar concerns and noted that the BRC report "is very ill-considered and should not be adopted. It seriously affects the relationship between management and the board of directors, and creates serious liability problems for members of the audit committee."(27)
C. Corporate America's Response
There is no doubt that the shareholder activism of the past decade has caused corporate America to stand up and take notice. Boards of directors throughout the United States have made changes ranging from subtle to sweeping. The vast majority of public companies have increased the diversity and independence of their boards and put into place many of the corporate governance practices advocated by institutional shareholders. However, there are signs that many of these reforms may have reached their high-water mark.
The 1999-2000 Public Company Governance Survey conducted by the National Association of Corporate Directors (NACD) and The Center for Board Leadership, which was completed in October 1999, represents the most comprehensive survey of U.S. public companies the NACD has ever conducted. The survey questionnaire was completed by 325 CEOs of public companies based in the United States. The findings are extremely instructive. First, corporate performance and strategic planning remain the top two issues for CEOs, followed by CEO succession, corporate governance, knowledge of business, shareholder relations, and board-CEO relations, respectively. Other items included federal and state regulatory compliance, compensation and relations with non-shareholder constituencies. The survey suggests these findings are not surprising since the vast majority of CEOs report positive relations with their boards and their shareholders. They state that they are much more focused on corporate performance and strategic planning.
The survey also found that CEOs continue to make steady progress in most key corporate governance areas, such as board composition and compliance. CEOs continue to seek new directors from outside their peer group and have steadily increased board diversity. The survey also found that well over one third of the companies had all-independent boards and only about one in 10 outside directors has consulting contracts with their companies. In most cases, directors have a role in setting the board agenda, and boards are meeting more frequently than ever before.
Board committees continue to be audit, compensation, nominating, and executive. However, additional committees, such as corporate governance, strategic planning, compliance, and employee benefits, are on the rise. Outside directors also are now receiving more data in a number of key areas, such as financial information on each business unit.
A significant number of CEOs reported having a dedicated compliance officer, and a majority said they have established a "help line" for reporting ethics and compliance violations. CEOs also said that they are satisfied that their codes of conduct are sufficiently comprehensive, relevant to their industry, well disseminated, and effectively communicated throughout the organization and to board members.
Finally, the survey revealed a wide range in director compensation. One in 10 boards awards total pay of under $5,000, while one in 10 pays more than $50,000. The rest cover the spectrum in between, but the most common amounts fall between $10,000 and $20,000. Most compensation includes some stock, and the typical pay package combines an annual fee, a per-meeting fee, and a committee fee.
D. Impact on Director and Officer Liability
As a result of corporate governance reforms and institutional shareholder activism, one would expect that there would be a positive correlation between the increased activism and director and officer liability. But this result has not followed. Although there is some concern that the recent audit committee reforms may trigger increased exposure for audit committee members, most lawyers and insurance underwriters generally reach a contrary conclusion. Although the last 20 years have seen increased exposure to public companies and their directors and officers, the result has been that most companies purchase some type of directors and officers liability insurance to provide for financial protection. D&O insurance also is instrumental in filling gaps in areas where indemnification has been deemed inadequate to provide sufficient protection for directors and officers.
When interviewing applicants for D&O insurance, most underwriters do not even inquire about corporate governance issues. Instead, they look at the financial health of the company and scrutinize the company's periodic reports to the SEC, such as the Forms 10-K and Q. There is no doubt that good corporate governance reduces the risks of litigation and that good governance procedures are consistent with good risk management practices, which in turn are crucial underwriting elements in D&O coverage. The experience of most companies, however, suggests that underwriters currently do not ask hard questions on corporate governance. This being the case, it is not surprising that corporate governance issues have not presented themselves as high-risk areas to directors and officers.
The reason for this result is two-fold. First, while good governance practices are difficult to argue against, they do not in and of themselves guarantee good performance. Second, the legal standard by which the business decisions of directors and officers are governed is well established. Therefore, no matter how effective or ineffective a particular company's corporate governance may be, the resulting performance (and liability) of directors and officers will be determined based on well-established principles of corporate law. No doubt there is more risk today than ever before for directors and officers, but it does not stem from corporate governance activism but rather from the litigious age in which businesses operate.
In order to have better management of director and officer risk and liability, three mandates for good corporate practice should be considered. First, corporate counsel should assist their clients to stay alert to shareholder interests in the ever-changing environment of corporate governance. Second, management and the board should have open and regular communication so that management keeps the board current with meaningful information. Third, the board should keep itself well informed and be sensitive and responsive to issues that are important to shareholders, large or small.
Good corporate governance is an all-encompassing topic and certainly means different things to different people. On the one hand, it deals with the basic elements of corporate law, while on the other, it questions the fundamental role of the free market in American society and elsewhere. The corporate governance movement and the role of institutional shareholders in recent years have been helpful, and in some instances they have improved information, enhanced accountability, and probably helped to correct certain abuses.
Good corporate governance, however, does not guarantee good corporate performance and cannot take credit for the world's prosperity. While corporate governance will continue to play an important role in the world economy in years to come, it should not be viewed or used as a vehicle to effect social or political change. Lorsch and Lipton suggest that corporate governance activism may have reached its peak; the pendulum may now be swinging the other way. If this is the case, institutional shareholders will be more successful in effecting change by working with management rather than promoting their changes through the media and increased legislation.
In the final analysis, the American economy for the most part has prospered under a free market system with comparatively little governmental intervention. Whether the issue is corporate governance or any other form of economic regulation or intervention, it would be unfortunate to tamper with a proved recipe for success. Sometimes it is easy to lose sight of the forest for the trees, and as Professor Lorsch recently said:
I have immense respect for institutional investors ... but I think at the moment they're going too far; they're getting a little bit silly. They're having contests for what's the best board. And that's aided and abetted by the business publications. I really don't think any of that's very useable. In fact, I think it puts a focus on the externalities.(28)
Corporate governance too often places form over substance. At the end of the day, what really matters is whether a board and the executive officers are making good business decisions in compliance with the law and enhancing long-term shareholder value. Everything else arguably is window dressing.
(1.) BNA Corporate Governance Report, Vol. I, No. 6, page 62 (November 2, 1998).
(2.) B.T. Lo, Improving Corporate Governance: Lessons from the European Community, 1 GLOBAL LEG. STUDIES 1 (1993).
(3.) How and Why Corporate Governance is Changing Worldwide (Toronto Stock Exchange News Release, July 9, 1998).
(4.) C.W.F. Grienenberger, Institutional Investors and Corporate Governance, Preparation of Annual Disclosure Documents, pages 315-58 (Practising Law Institute, 1996).
(5.) P.C. Clapman, New Focus for TIAA-CREF: Executive Pay, Poison Pills and Global Governance Standards, DIRECTORSHIP, at page 6 (April 2000).
(6.) Supra note 1.
(7.) 170 N.W. 668 (Mich. 1919).
(8.) See, e.g., IND. CODE [sections] 23-1-35-1(a)(1) and (2).
(9.) 698 A.2d 959 (Del. 1996),
(10.) Barnes v. Andrews, 298 F. 614 (S.D. N.Y. 1924).
(11.) H.G. HENN & J.R. ALEXANDER, LAWS OF CORPORATIONS 623 (West Publishing Co., 1983).
(12.) IND. CODE [sections] 23-1-35-1 (d).
(13.) DEL. CODE ANN.
(14.) See IND. CODE [sections] 23-1-35-1(a)(1). The duty of loyalty encompasses a duty of good faith, and the duty of good faith is sometimes described as a separate fundamental duty, as it is in the Indiana Code. This general standard of care imposed on directors was developed as part of the common law duties of directors and is in addition to any disclosure responsibilities imposed by the U.S. federal securities laws.
(15.) 698 A.2d at 970.
(16.) The Board of Directors and Internal Control, 19 CARDOZO L. REV. 237 (1998).
(17.) 48 Bus. LAW. 59 (1992).
(18.) A New System of Corporate Governance: The Quinquennial Election of Directors, 58 U. CHI. L. REV. 187 (1991).
(19.) The European model is described in Lo, supra note 2.
(20.) Amended Proposal for a Council Regulation on the Statute for a European Company, 1991 O.J. 34; Amended Proposal for a Counsel Directive Complementing the Statute for a European Company, 1991 O.J. 34.
(21.) ECONOMIC ANALYSIS OF LAW 303 (2d ed. Little Brown, 1977).
(22.) Grienenberger, supra note 4.
(23.) ISS Changes Guidelines on Director Elections, Cumulative Voting, CCH Corporate Secretary's Guide, at pages 37-38 (March 7, 2000).
(24.) SEC Rel. No. 34-42266, December 22, 1999, and SEC Rel. No. 34-42231-3, December 14, 1999.
(25.) See PricewaterhouseCoopers Audit Committee Update 2000.
(26.) R. Arensman, A Board Expert Targets "Mickey Mouse" Governance Rules, 3 CORPORATE BOARD MEMBER, No. 1, at pages 28-29 (Spring 2000).
(27.) P. Keating, A Surprise Witness on the Stand, 2 CORPORATE BOARD MEMBER, No. 4, at pages 72-73 (winter 1999).
(28.) Arensman, supra note 26.
IADC member Daniel P. Hann is senior vice president and general counsel of Biomet Inc., Warsaw, Indiana. He holds a B.A. degree (1977)from California State University at Fullerton, an M.S. (1979) from the University of Illinois and a J.D. (1984) from Indiana University.
The author thanks Dane A. Miller, Ph.D., and Berkley W. Duck for their comments on drafts of this article.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: Emerging Issues in U.S. Corporate Governance: Are the Recent Reforms Working?. Contributors: Hann, Daniel P. - Author. Journal title: Defense Counsel Journal. Volume: 68. Issue: 2 Publication date: April 2001. Page number: 191. © 1999 International Association of Defense Counsels. COPYRIGHT 2001 Gale Group.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.