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Boardroom Excellence A Commonsense Perspective on Corporate Governance
Paul P. Brountas foreword by Paul S. Sarbanes
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Boardroom Excellence A Commonsense Perspective on Corporate Governance
Paul P. Brountas foreword by Paul S. Sarbanes
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Copyright © 2004 by Paul P. Brountas. Published by Jossey-Bass A Wiley Imprint 989 Market Street, San Francisco, CA 94103-1741
www.josseybass.com
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail:
[email protected]. Jossey-Bass books and products are available through most bookstores. To contact Jossey-Bass directly call our Customer Care Department within the U.S. at 800-956-7739, outside the U.S. at 317-572-3986, or fax 317-572-4002. Jossey-Bass also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data Brountas, Paul P. Boardroom excellence: a commonsense perspective on corporate governance / by Paul P. Brountas; foreword by Paul S. Sarbanes. p. cm. Includes index. ISBN 0-7879-7641-5 (alk. paper) 1. Corporate governance—United States. 2. Boards of directors—United States. 3. Directors of corporations—United States. 4. Common sense. I. Title. HD2785.B75 2004 658.4'2—dc22 2004012076 Printed in the United States of America FIRST EDITION
HB Printing
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To my wife, Lynn
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Contents
Foreword by Senator Paul S. Sarbanes
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Note on This Book by Jeffrey Rudman
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Introduction Chapter 1
How Did It Happen— Or Was It Always This Bad?
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My bleak historical portrayal of corporate America is not intended as a blanket condemnation of all publicly traded U.S. corporations. ° The “Good Old Days” ° The Great Bubble ° Making the Numbers by “Making Up” the Numbers ° Wealth Creation and Corporate Hero Worship ° Corporate America Lost Its Moral Compass ° Contributing Factors ° Legislative and Regulatory Corrective Action ° The Sarbanes-Oxley Road Map ° Early Assessment of Sarbanes-Oxley
Chapter 2
Duty of Care and Duty of Loyalty
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It is the right, and obligation, of every director to be informed and to act deliberately, with the diligence and competence of a reasonably prudent person in a similar situation under similar circumstances. ° Business Judgment Rule ° Loss of Reputation and Embarrassment
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Chapter 3
Role of the Board of Directors
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Excellent companies stay excellent by regularly challenging themselves. ° Why Serve as a Director? ° CEO-Dominated Process ° The Undesirables ° Structuring the Board to Accommodate the Corporation’s Requirements ° Overcoming the Knowledge Gap ° An Important Learning Experience ° Questions the Directors Need to Answer ° Who Runs the Company? ° What Should Directors Do? ° Do We Need Professional Directors?
Chapter 4
What Values and Qualities Should Directors Possess?
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The board has no room for insouciant directors who are not committed or who believe they can serve by being passive observers. ° The Five I’s ° Complementary Skills and Experience ° Preparation and Continuing Education ° Disagreement Is a Virtue, Not a Vice
Chapter 5
Role of the CEO
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The CEO should seek to create a board meeting environment that encourages skepticism and serious discussion and enables board members to disagree constructively. ° Know the Board ° Setting the Tone and Corporate Culture ° The CEO’s Role in the Decision-Making Process ° What the CEO Expects of the Board ° Avoiding Surprises
Chapter 6
Board and Committee Meetings Avoid information overload and mind-numbing presentations.
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° Setting the Meeting Agendas ° Risk of Information Overload ° Concise, Focused, and Relevant Presentations ° Size of the Board ° Frequency of Board Meetings ° Executive Sessions ° Lead or Presiding Director ° Board Compensation
Chapter 7
Committees of the Board
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Excessive CEO compensation is the “mad cow disease” of American boardrooms. ° Audit Committee ° Compensation Committee ° Nominating and Governance Committee
Chapter 8
Guidelines, Ethical Codes, and Legal Compliance
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What is needed is a proactive CEO whose message resonates throughout the corporation and instills all employees with the resolve to help create a corporate culture that nourishes integrity and ethical behavior, penetrating all aspects of the corporation’s business and governance. ° Corporate Governance Guidelines ° Code of Conduct and Ethics ° Legal Compliance and the “Noisy Withdrawal” Quandary
Chapter 9
Revolt of the Stockholders
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The 2003 and 2004 proxy seasons will be remembered as the time when stockholder activists took steps to change the way their corporations are governed, their directors are nominated, and their executives are compensated. ° Stockholder Proposals and Rule 14a-8 ° The Issues ° New SEC Rules ° Stockholder Nominations and Other Communications ° Stockholder Access ° Scorekeepers ° Stakeholders
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Chapter 10 Evaluation of Board Performance
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Self-assessment of directors’ performance is receiving increasingly wide acceptance as board members realize that they are in the best position to evaluate their board performance.
Chapter 11 Effect of Sarbanes-Oxley on Private Corporations
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Good corporate governance is good for business, whether the business is large or small, public, private, or even nonprofit.
Chapter 12 Nonprofit Entities
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Trustees and directors of nonprofits would be well advised to consider adoption of changes in their ethical guidelines and codes of conduct along the lines currently favored by profit-motivated corporations.
Chapter 13 Model Board of Directors
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The model board’s membership includes individuals with diverse talents, experiences, personalities, instincts, and expertise that provide the composite skills that produce excellence in the boardroom. ° The Directors ° The Board ° A Few Parting Admonitions ° The Essence of Excellence
About the Author
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Index
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Foreword
P
aul Brountas has written a superlative analysis of the crisis
in corporate governance that in the past several years has undermined the integrity of our markets, proved devastating to millions of investors and workers, and sapped the strength of our economy. Having served as outside counsel to hundreds of corporations over the course of his long and distinguished legal career, and in that capacity having attended literally thousands of corporate board and executive committee meetings, he speaks with knowledge and authority. The appeal of this extended essay will reach a readership far beyond the limits of the boardroom. Paul Brountas’s uncommon experience is fully matched by his uncommon wisdom and a large and welcome measure of solid common sense. Boardroom Excellence: A Commonsense Perspective on Corporate Governance reflects all three. It explains clearly and succinctly what went wrong in the boardrooms of too many of our publicly owned companies and sets out reform measures to ensure that these abuses will not happen again. Written in a forthright and accessible style that avoids the pitfalls of formal legal prose, it will prove invaluable to everyone concerned about the future
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of corporate governance and the fairness and transparency of our markets. This important contribution to the literature on corporate governance is especially timely. Over the past two years, successive waves of corporate failures have focused national attention on pervasive problems with accounting, auditing, and corporate governance practices. We are now dealing with the consequences of those abuses: trillions of dollars in market value gone, investors’ savings lost and their confidence undermined, workers unemployed, the global reputation of our markets badly tarnished. In the public sector, a broad effort is under way to deal with abuses in accounting, auditing, and corporate governance procedures and market practices. With landmark legislation enacted in July 2002, the Congress created the statutory framework for reform, eliminating numerous practices that led to egregious conflicts of interest and providing the Securities and Exchange Commission (SEC) the broader authority, staff resources, and advanced technology it must have to carry out the broad range of its regulatory responsibilities. Implementation of the legislation is proceeding on schedule; the SEC has put in place the new Public Company Accounting Oversight Board, thereby ending the system of self-regulation in that industry that failed so disastrously to ensure the independence of public company auditors. Statutory and regulatory measures are absolutely essential to effective reform, but corresponding efforts must also be undertaken in the private sector. The self-regulatory agencies, the National Association of Securities Dealers and the New York Stock Exchange, have conducted a critical analysis of cor-
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porate governance and conflicts of interest and have adopted and are implementing more stringent listing standards. In addition, there is an urgent need for greater public understanding of just what caused the crisis in corporate governance, of the reforms that corporate management and directors must now adopt, and of the expanding opportunities for shareholders to make their voices heard in the boardroom. Boardroom Excellence: A Commonsense Perspective on Corporate Governance provides a penetrating analysis and a clear prescription for the future and deserves the widest possible readership. While every CEO, director, and prospective director of a public company should find it indispensable, its utility is not limited to corporate executives and boards; it is written for everyone concerned about our capital markets. Paul Brountas has done a first-rate job of explaining what went wrong—and what is needed to set things right. This book could not have come at a better time. June 2004
Senator Paul S. Sarbanes
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Note on This Book
T
he demise of Enron and the attendant revelations have
spawned a body of “literature” almost as capacious as the scandal itself. Much of what has been written was obviously written in haste, some was just an exercise in self-righteousness, and almost all arrived in a prose style long ago dismissed by John Kenneth Galbraith as “free enterprise Simple Simon.” Worse, there was remarkably little by way of commonsensical advice for people who actually sat in boardrooms. Pundits, in their zeal to tell directors how evil and indolent they were, didn’t pause to tell them how they might do a better job. Boardroom Excellence: A Commonsense Perspective on Corporate Governance remedies that lack and perhaps, more astonishing, proves that some lawyers can actually write. Paul Brountas comes from Maine, and its terse and understated qualities are his. His mission is simple: to take forty years of advising officers and directors and distill it into 154 pages without producing either a self-help book or a paean to those who made a bundle and lived to tell about it. Here at last is the true adult voice of a lawyer reminding us that what matters is not theory but experience.
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That experience, Paul’s experience, is now available for all of us to draw on. He explains there never was an Edenic past in which all right-thinking folk admired corporate America. He shows how persons of goodwill gradually slipped from grace, lost their moorings, and let the deviant become the norm. He offers the archetypes of the bad board members—the Sleeper, the Rapper, the Know-It-All—and provides the most comprehensive guide to the best boardroom practices anyone could wish for. The book and movie reviewing industries have, for all time, destroyed the value of high praise, no matter how honestly tendered. Even the worst flick will find a critic in suburban Duluth to hail it as “the best damn movie I’ve seen in years.” So, no such plaudits here, only a restrained plea that those who manage corporations, serve on their boards, or aspire either to manage or to serve take an afternoon off, read what Paul has written, and reflect on the lessons he offers. It will do them— and the country—incalculable good. June 2004
Jeffrey Rudman Cochair, Securities Department Wilmer Cutler Pickering Hale and Dorr LLP
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M
y experience as outside counsel to several hundred cor-
porations and as an attendee at thousands of board and committee meetings over the past forty-three years has taught me some important lessons about corporate governance:
° How recent widespread greed and dishonesty contaminated the corporate environment
° Why corporate executives need committed, independent, and active oversight, advice, and assistance
° Why corporate directors have failed (some miserably) to properly discharge their fiduciary duties and responsibilities
° Why public cynicism has replaced public trust and confidence in our current form of corporate governance Many of these lessons are so obvious that they hardly warrant discussion. But something happened during the past several years, as the management and directors of so many U.S.
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corporations put their personal interests before the interests of stockholders. As a result, many public corporations in America are viewed today with distrust and disdain, a view brought about by executive avarice and a corrosive belief that opaqueness trumps transparency when it comes to public disclosure and that collegiality in the boardroom trumps independence when it comes to corporate governance. How else can we explain:
° Cooked books and phantom revenue ° Enron’s special-purpose entities whose undisclosed special purpose was to enrich insiders
° WorldCom’s and Adelphia’s massive executive loans ° Tyco’s $20 million “tip” to a director and his favorite charity
° Global Crossing’s round-trip “investments” ° Skyrocketing executive compensation and Brobingnagian stock option awards
° Enormous corporate debt that never made it to the balance sheet
° Independent auditors who were so distracted by, if not obsessed with, the huge fees they earned from nonaudit work that they failed to appreciate that their independence might be compromised by their nonaudit services
° The expanding, corrosive culture of excess and hedonism ° The sordid recent history of millions of workers who have suffered painful pension plan losses
° The steady flow of new reports of dishonesty and ineptitude, “perp” walks, lawsuits, and public disgrace that have been so much a part of the opening years of the twentyfirst century.
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During the past twelve months, judges and juries have been listening to senior executives and managers of several of America’s largest corporations defend themselves against charges of illegal corporate activities. The most common defense they have heard from the defendants is, “We did nothing wrong. We presented our proposals to the board of directors, which reviewed and approved them. So the problem lies not with us but with the board of directors, which failed to discharge its fiduciary duties and oversight responsibilities.”
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Chapter One
How Did It Happen— Or Was It Always This Bad?
My bleak historical portrayal of corporate America is not intended as a blanket condemnation of all publicly traded U.S. corporations.
T
ime has a way of distorting memories—making the past look
a lot better than it actually was, particularly when compared to current conditions. Those who believe that the egregious conduct and pernicious behavior of executives at Enron and its ilk is a new phenomenon and yearn for the return of what they view as a golden era when those who ran corporations were compassionate, enlightened, and honest—and dedicated to serving the best interests of their stockholders—are suffering from either amnesia or delusion.
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The “Good Old Days” The fact is that things were not so great in the “good old days.” The early 1900s saw the rise of corporate dynasties in the United States and the immense power of a small group of corporate leaders (Andrew Mellon, J. P. Morgan, Edward Harriman), which led to the successful industrialization of America as they also nurtured an elegant form of corporate aristocracy. The stock market collapsed in 1929, followed by the painful Great Depression of the early 1930s, establishment of the Securities and Exchange Commission, and the remedial legislative action by Congress in the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934. The corporate world as we now know it, with thousands of publicly owned corporations operating globally, began to develop after World War II, grew at a steady rate over the next four decades, and flourished in the last decade of the twentieth century as thousands of high-technology companies were organized by brilliant, fearless scientists, engineers, and entrepreneurs and were financed by a seemingly endless supply of equity capital from venture capitalists, corporate sponsors, and public investors. At the start of the twenty-first century, America was home to thousands of publicly held corporations with millions of new public stockholders who owned equity in corporate America individually or derivatively through participation in their mutual funds, pension funds, 401(k)s, and individual retirement accounts. This new breed of stockholders relied on a system of corporate governance that had existed for decades, where, for many leading corporations, the center of gravity and power was
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the CEO. The board members were friends or business acquaintances of the CEO; the boardroom was expected to be collegial, if not clubby, with directors who neither desired nor were willing to rock the boat; and the checks and balances on board behavior were in large part governed by state corporate laws, particularly the Delaware Corporation Law, which, while still friendly to corporate boards and management, has been amended over the years to promote board independence and protect and enhance the interests of the stockholders. This bleak historical portrayal of corporate America is not intended as a blanket condemnation of all publicly traded U.S. corporations. Most of the executives and directors I have had the privilege of advising are decent, ethical, responsible men and women whose paramount interest has been the enhancement of shareholder value and the creation of a corporate culture that rewards integrity and ethical behavior. They have demonstrated that they can be creative without being corrupt. They do their work quietly and effectively and are rarely noted publicly for their good work and successes. However, what does receive public attention—and lots of it—are corporate scandals, greed, avarice, and fraud, all of which, and particularly those that involve hundreds of millions of dollars or sybaritic behavior, lead the public to believe that the entire system is corrupt. Yet corruption is contagious, and the more widespread it becomes, the more it infects and confuses those who want to do the right thing. Fortunately, there are notable examples of corporations that are governed by exemplary boards and operated by honest, shareholder-oriented executives. It is those corporations that we look to for guidance and seek to emulate.
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The Great Bubble The period of the Great Bubble, beginning in 1999 and ending in early 2001, witnessed a historic increase in the number of public corporations in America; unprecedented increases in the post–initial public offering (IPO) stock prices of newly minted public corporations; growth of a new breed of investment analysts who publicly hyped the stock of their investment banking clients while privately denigrating those clients and their future prospects; a rapidly expanding group of multimillionaires (founders and executives of Internet and dot-com corporations in their mid- to late-twenties); a massive distribution of stock options to the corporation’s executives and employees; and a new, widely accepted stock option program for nonemployee directors, designed ostensibly to align the interests of directors with the corporation’s stockholders. An intense focus on corporate stock ownership developed, and the daily trading price of stocks became the primary engine that drove and influenced the decisions of management and directors. Stock options also had an effect on the business strategy of the corporation’s board and management. As the stock prices rose and the executives, employees, and directors saw the value of their options increase, both management and directors moved the corporation from the traditional long-term strategy to a strategy aimed at maximizing short-term performance. Serving the short-term interests of stockholders and meeting Wall Street’s analysts’ expectations became management’s overriding goal. Each quarter’s operating results determined whether the price would continue to rise. Corporate America became obsessed with quarterly performance and with the unrealistic expectation that each quarter’s earnings would be
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higher than those of the previous quarter. Investors moved from being patient long-term investors to short-term speculators. Performance was measured not in dollars but in pennies. A one- or two-cent shortfall on the quarter’s performance could wipe out millions of dollars of stockholder value. So management began to take—and encouraged coworkers to take—whatever action was necessary to make sure that the quarterly results matched or exceeded the corporation’s quarterly estimates.
Making the Numbers by “Making Up” the Numbers It was not unusual for a CEO to call in the corporation’s sales and marketing executives near the end of a quarter and deliver a compelling end-of-the-quarter warning, along the lines of: “If we don’t meet our quarterly earnings projections, our stock price will take a big hit, the value of your options will fall, your bonus will be in jeopardy, and you run the risk of not being awarded future stock options. So get out there; nail down the orders and sales that we need to make the quarter. I know you can find the additional revenue we need.” This form of challenge was treated by many to whom it was directed as code for: “Damn it, you know how to find the additional revenue that we need. Go get it, and I don’t care how you get it.” To negate that implicit call to create otherwise nonrecognizable revenue, the CEO should have said: “I know if you pull out all the stops, you can produce the additional revenue we need, but I don’t want one additional cent of revenue that does not qualify as revenue under generally accepted accounting principles [GAAP].”
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The failure to add the GAAP qualifier and the intense pressure to make the numbers led employees to make up the numbers and management to include them without ensuring that they were GAAP-proof. This type of activity led to similar questionable activity, which skated close to the line of lawful behavior. And in many cases, it crossed the line—questionable activity that management apparently had little incentive to question. This started, in a manner similar to so many other ethical meltdowns, with seemingly minor offenses. A sales rep, for example, would tell a customer, “Here, take the shipment now, and if you can’t resell it within the next three months, we’ll take it back.” The sales rep would then proceed to include the shipment as revenue, even though the customer had a contractual right to return it. This common failure to follow GAAP revenue-recognition policies as well as the growing tendency to look for loopholes led over time to even more creative fraudulent activities. These were hidden by the perpetrators and were not susceptible to board discovery. The directors had neglected to establish codes of conduct, ethical guidelines, monitoring programs, and a corporate culture that might have prevented the fraudulent acts or at least have helped—if properly administered—to establish a tone at the top and a culture throughout the organization that punished those who believed that “anything goes—but don’t get caught.”
Wealth Creation and Corporate Hero Worship Each quarter’s performance became the overriding concern, and when the forecast results were achieved, millions of people ben-
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efited from the increase in value of their investments. A feeling of empowerment, privilege, and even arrogance developed among the management types who were appearing on the covers of an ever-increasing number of financial publications as well as in flattering, worshipful articles in such stalwarts as the Wall Street Journal and Time magazine. Who would be the next twenty-eight-year-old whiz kid to join the Forbes list of billionaires? Which of the new start-up technology corporations with a corporate history of less than two years would be acquired by Lucent or Cisco for more than a billion dollars of Lucent’s or Cisco’s then highly inflated stock?
Corporate America Lost Its Moral Compass The laser beam focus on wealth creation and the unprecedented growth of individual paper wealth, coupled with the ease with which corporate valuations could be manipulated without detection, fed on itself and became, in the minds of many, the acceptable way to conduct business in America. It created and nourished a zeitgeist of corporate hero worship, in which CEOs were treated like rock stars and ethical conduct and honesty were shunted aside, if not totally ignored. It was bound to collapse, because it was built on greed, hubris, and falsehoods. And just as it began to appear that it would never end, the whole Internet, dot-com house of cards collapsed. Stunned investors throughout America began to ask, “How did this happen?” It happened because corporate America lost its moral compass and there were no corporate cultural precedents on which it could rely. The leading American corporations of the first half of the twentieth century, which were largely controlled by
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insiders (some of whom were even benevolent), did not serve as models for the future. We keep searching for solutions, standards, and rules that will restore integrity, ethics, and public trust and confidence in our corporations. But did that public trust and confidence ever exist? Or was it merely a passive public acceptance of a past system of corporate governance that was tolerated by a relatively small percentage of the population who owned stock but was wholly unsuited to serve the activist millions of Americans who believed in the system and soon learned that those who managed and governed the corporations in which they invested had little interest in earning the trust and confidence of their stockholders?
Contributing Factors A brief look at the major factors that contributed to the deterioration of our system of corporate governance during those years may help in understanding what went wrong and what is needed to create—rather than restore—public trust and confidence in our leading corporations and governing boards. The fact is that a symbiotic relationship developed between selfserving recreant executives who worked their impulses for personal gain and see-no-evil, hear-no-evil, speak-no-evil directors. Scandals occurred and fraud was allowed to thrive because too many of our publicly traded corporations were governed by corporate boards whose directors:
° Lacked independence ° Lacked the required in-depth knowledge about the corporation’s industry, business, and financial affairs and did not devote the time to develop that knowledge
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° Failed to discharge their stewardship responsibilities ° Were not committed and properly prepared ° Failed to coordinate and contribute to the preparation of meeting agendas and to arrange for thoughtful discussion of sensitive board matters and concerns
° Did not meet in executive sessions without management to allow an open discussion and review of management’s performance
° Did not spend enough time at board meetings and committee meetings to properly discharge their duties and responsibilities
° Never fully understood their duties and responsibilities as independent fiduciaries and did not appreciate that their overriding duty was to the stockholders
° Were unaware of—or did not understand—the corporation’s strategy or failed to monitor the execution of its strategy (or both)
° Tolerated a major shift in the balance of corporate power to the CEO
° Failed to confront or criticize management and were reluctant to disagree among themselves for fear of rocking the boat
° Failed to review the CEO’s and other senior executives’ performance critically
° Failed to analyze management’s plans and proposals critically
° Approved huge increases in executive compensation, including bonus awards and stock option grants that were not tied to performance goals and objectives
° Did not understand the corporation’s financial statements or what parts of the business were profitable and why
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° Did not understand and did not question the corporation’s revenue recognition policies
° Adopted complex financial arrangements, including derivative transactions, which neither they nor the corporate executives understood
° Served on too many boards and therefore did not have the time to fulfill their director obligations properly
° Failed to create a corporate culture that demanded integrity and compliance with the highest ethical standards
° Failed to create and maintain an atmosphere of excellence in the boardroom
Legislative and Regulatory Corrective Action So how did corporate America, federal and state governments, and the stock exchanges and regulators respond to these failures? Congress adopted the Sarbanes-Oxley Act of 2002, a comprehensive, wide-ranging law that affects nearly every aspect of the corporate governance of publicly held U.S. corporations. The New York Stock Exchange (NYSE) and Nasdaq adopted comprehensive new corporate governance rules. These rules substantially change the way corporations disclose information to the stockholders and the public at large, and the Securities and Exchange Commission (SEC) has adopted a requirement obligating chief executive officers (CEOs) and chief financial officers (CFOs) of public companies to swear on the dotted line—that is, to certify that their financial statements and reports are accurate and not misleading—exposing these
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executives to possible criminal charges if their numbers turn out to be bogus. Many large and small corporations acted quickly to adopt new “best practices” and approve and implement revisions to their governance structures, policies, and programs. Those who manage and oversee corporations began to recognize that effective corporate governance requires independent, qualified, knowledgeable directors who understand that they occupy a position of trust that demands integrity and a clear and overriding commitment to serve the best interests of the stockholders.
The Sarbanes-Oxley Road Map Much has been said recently about the new rules and regulations designed to reduce, if not eliminate, corporate fraud; create transparency; and give investors the opportunity and right to see the unexpurgated results of operations and the true financial condition of the corporations in which they have invested. The speed with which the new laws and regulations were enacted was breathtaking—and necessary. Despite the fact that many unanswered questions (and therefore unexpected risks) remain, these changes in the laws should serve as valuable tools in the hands of informed independent directors to restrain and eventually eliminate the type of corporate misbehavior that became routine and ravaged the savings and future hopes of not only experienced investors but also—and even more sadly— innocent workers who believed in the market and its integrity and bet their retirements on its continued success. Critics have already begun the attack on the regimen of laws, rules, and penalties created by Sarbanes-Oxley. They
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argue that rigid rules won’t reform the corporate world and that history has proven that morality or ethical behavior cannot be legislated. We have statutes that make bank robbery a crime, but people still rob banks. The critics are partly correct, but the true value of the laws and the accompanying regulations is not so much that they control the business and operations of America’s corporations as that they create a road map to guide those who govern our corporations in creating a corporate culture encouraging and rewarding integrity and responsibility in the same way companies have historically rewarded entrepreneurship and wealth creation. The person who needs to lead the effort to create and maintain a corporate environment in which this culture can thrive is the corporation’s CEO, who has the responsibility for setting the tone at the top. The tone and culture of our business enterprises, as well as the standards, ethics, and values of corporate America, are formulated and enforced at the top—by the CEO with the assistance of senior executives and guidance and oversight from a board of informed, skeptical, and vigilant directors. Stockholders rarely attend stockholder meetings and often do not possess the knowledge required to make important corporate decisions. They elect and rely on directors to perform that responsibility. Stockholders have traditionally had little impact on a corporation’s success, except for their right to vote for or against members of the board and for or against actions submitted to them by the board and management for their approval. However, the days of the passive, if not somnambulant, stockholder appear to be over. Global competition has intensified, and large stockholders, including institutional investors, foundations, unions, and pension plans, have begun
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to take a more active role in ensuring that excellence prevails in the boardrooms of the corporations in which they own stock.
Early Assessment of Sarbanes-Oxley Sarbanes-Oxley was enacted on July 30, 2002, and has been in force long enough to allow at least a preliminary assessment of its effectiveness and its deficiencies. There is no question that this legislation represents an unprecedented penetration of the federal government into the corporate governance domain, historically the prerogative of the states and their respective corporate laws. Some critics fear that the new law will eventually lead to the federalization of corporate law, while others believe that the federal government’s incursion will lead to the recognition and acceptance of corporate governance best practices and guidelines rather than rigid federal dictates. Although it is too early to evaluate the long-term impact of Sarbanes-Oxley, it is not too early to observe how corporate America has reacted to the new law and its accompanying rules and regulations.
Positive Changes Although we may not be able to accurately determine whether public companies are now governing themselves better than they did before Sarbanes-Oxley, it is important to identify some major positive changes effected by the new law:
° An increase in the awareness by directors of their responsibility to provide knowledgeable and independent oversight of management.
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° Progress in efforts to end the country club atmosphere of boards and shift more power to the directors. Many boards have been dominated by strong CEOs and their management team for too long.
° Recognition of the importance of setting the right tone at the top and establishing a corporate culture that promotes integrity and rejects misdeeds and unethical practices.
° The creation of new standards and new challenges for directors, as well as new demands and new risks.
° The need for more effective evaluation of the performance of the corporation’s CEO and the board of directors.
° The adoption of auditor independence rules and increased responsibility assigned to the audit committee, requiring greater diligence, vigilance, and oversight of the corporation’s accounting practices.
° Increased responsiveness of the compensation committee to the demand of stockholders for more balanced, rational, and less extravagant executive compensation programs, including the need for bonus programs that are tied to performance metrics.
° Prohibition of corporate loans to company executives. ° Establishment of a certification process that requires CEOs and CFOs to swear to the accuracy of the corporation’s quarterly and annual financial reports and the risk of criminal prosecution if their certifications are false or improperly obtained.
° Creation of the five-member Public Company Accounting Oversight Board to oversee the accounting and auditing business.
° A dramatic increase in shareholder activism, including a formidable move to obtain direct access by shareholders to the corporation’s proxy statement.
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On balance, Sarbanes-Oxley has awakened corporate America to the need for changes in the way public corporations do business and created a road map that will help corporate executives and directors to develop best practices and avoid the mistakes, corruption, and troubles that gave us Enron, WorldCom, Tyco, Adelphia, and HealthSouth. Most experts believe that Sarbanes-Oxley is working because it has increased transparency and reduced the risk of corporate fraud. It has changed the way in which CEOs view their responsibility for financial reporting and has changed the relationship that accounting firms have with their clients. That relationship has shifted toward the audit committee and away from the CEO and CFO. Audit committees are meeting more frequently than they did prior to Sarbanes-Oxley, and the time spent at committee meetings has increased substantially. The average number of board meetings in 2002 and 2003 increased significantly, which means that directors who serve on multiple boards will be forced to limit the number of boards on which they serve. The do-nothing, rubber stamp boards are disappearing. According to the president of the National Association of Corporate Directors, directors spent about 250 hours a year in 2003 on board work, double the amount spent in 1999, and boards are focusing on critical analysis of the company’s strategy and spending more time communicating outside regular meetings. Abby Cohen, a well-known Goldman, Sachs & Co. analyst, noted that post-Enron companies are putting out the “cleanest” data in a decade. And corporate governance activist Nell Minow, editor of The Corporate Library, an independent research firm focused on corporate governance matters, may have discovered the reason for the change when she noted that
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“boards of directors are like subatomic particles [because] they behave differently when being observed.” The result is that directors are better attuned to and more serious about their board responsibilities.
The Criticisms The new law nevertheless has also inundated corporate executives and board members with new time-consuming obligations, complex rules and procedures, and recommendations for good practices that, if not properly balanced, could result in leaving insufficient time to focus on the business of the corporation and increasing shareholder value. In addition, it has increased corporate America’s cost of doing business. Many of the Act’s critics argue that the cost of complying exceeds the benefits obtained from the improved governance generated by the legislation. They contend that directors are spending too much time and money on SarbanesOxley–mandated codes of conduct, adoption and implementation of board and committee charters, best practices, checklists, and compliance with a constantly expanding list of new rules and requirements, and not enough time on overseeing the company’s business, strategy, and personnel. They have other worries as well:
° There will be overreaction and other imprudent reliance on process rather than judgment.
° The new rules seem to obligate directors to be critical, find fault, and express displeasure. They create an environment in which captious behavior by outside directors is often required to demonstrate their independence and
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thereby result in boardrooms where collegiality and trust are replaced by sniping and suspicion.
° Granting shareholders the ability to communicate directly with board members, rather than through the corporation’s executives, is time-consuming, ineffective, and unproductive. Once you open up this channel, where do you stop? And will directors be inundated with indecorous attacks that lead them to respond by walking?
° Individuals who are best qualified to serve as directors, such as business and community leaders, will be unwilling to serve in a climate that obligates directors to comply with the growing list of tedious governance rules that reduce the time available to them for advising management on the company’s financing needs, acquisition proposals, strategy, and executive team.
° Insistence on a substantial majority of board members who are independent as well as total independence on the board’s major committees will deprive the company of talented directors whose experience and judgment would aid the board in enhancing shareholder value while their lack of full independence would not impair the board’s oversight performance.
° Too much importance is being placed on the creation of a separate nonexecutive chair of the board or lead director. This structural change can lead to confusion as to who runs the company and an irritation to CEOs who see no need for this special position. Board members, after all, ought to feel free to discuss their recommendations as well as their complaints openly and fairly with the CEO.
° Peer evaluation of the directors is a process that not only disrupts the collegiality required in the boardroom for effective governance, but also may serve to embarrass those who are grading colleagues and those who are being
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graded by their colleagues. Again, this requires too much process where less process and more trust and honesty are needed.
° Excessive focus on compliance orientation leads to a “check-the-box” mentality instead of creative thinking. Although some of the criticisms are legitimate, on balance they are far outweighed by the reforms that the act has engendered. Most of the complaints are related to the time and expense required to develop new rules, processes, and best practices and to ensure that management and the directors understand them and the new obligations they impose. The time and expense requirement, however, should substantially decline as the newness wears off and the reforms become part of the company’s ongoing governance and culture. The fears that the management team would become timid and yield the major management decisions to the board and that a serious shortage of candidates for directors would develop have not materialized. John Snow, secretary of the treasury, observed in 2003 that “nothing in Sarbanes-Oxley changes the fundamental norms of good corporate governance,” and the chairman of the SEC, William Donaldson, stated that “good, honest companies should fear neither Sarbanes-Oxley nor the SEC’s enforcement.” As far as costs are concerned, some pundits advise that large corporations can easily offset the additional costs of compliance with the new legislation by cutting back on the much criticized excessive compensation that has been the subject of so many recent shareholder complaints. The expenses incurred by smaller corporations should be offset in part from gains real-
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ized through the application of corporate governance best practices and ethical guidelines that serve to reduce, if not eliminate, the burdensome legal and accounting costs associated with shareholder lawsuits based on alleged misfeasance and fraud. It is also worth noting that in appraising the beneficial impact of the new law when weighed against its costs, it is likely that the highest cost will be experienced by companies that failed to establish any meaningful controls and suffered from an environment that tolerated noncompliance and questionable conduct. Few will sympathize with those companies if they must now pay the price to right their wrongs of the past.
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C h a p t e r Tw o
Duty of Care and Duty of Loyalty
It is the right, and obligation, of every director to be informed and to act deliberately, with the diligence and competence of a reasonably prudent person in a similar situation under similar circumstances.
T
he directors select the CEO and members of senior man-
agement and fire them if they fail to perform. They replace them with executives whose interests, they hope, are aligned with the interests of the stockholders and who are knowledgeable and ethical, and understand their fiduciary duties of loyalty, care, good faith, and candor to their stockholders. Loyalty, care, good faith, and candor. These words describe duties that ordinarily need no definition but have special meaning when applied to corporate governance. These duties arise
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out of the legal relationship established by most state corporate laws in America, which generally tend to follow Delaware law and provide that the business and affairs of a corporation are managed by or at the direction of a company’s board of directors. In practical terms, what do these duties entail? The corporation is managed by its CEO and senior executives. The directors’ principal responsibility, apart from selecting the management team, is to oversee management. And how this oversight responsibility is discharged is generally determined by the corporate laws of the corporation’s state of incorporation, guided by the duties of candor, loyalty, and care. The duty of candor does not require elaborate discussion since that duty is implicit in both the duty of loyalty and the duty of care. This duty requires that the directors ensure that the information that the corporation provides to its stockholders is materially complete and accurate. The duty of loyalty requires a director to act in good faith and in a manner reasonably and honestly believed to be in the best interests of the corporation and its stockholders, while seeking to avoid any conflicting personal gain or economic interest. If a conflict exists, the conflicted director should recuse himself or herself from any deliberation or decision on the matter of self-interest. If a conflicted director does not recuse himself or herself or abstain, the action of the board must satisfy the “entire fairness” test. The burden of proving that a decision is entirely fair is very heavy, similar to the burden of proving a negative. So the fundamental lesson for a director is to act in good faith, avoid conflicts, and abstain if he or she has any conflicting personal or economic interest.
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The duty of care requires that a director be informed. It is the right, and the obligation, of every director to be informed and, after acquiring the appropriate information, to act deliberatively with the diligence and competence of a reasonably prudent person in a similar position under similar circumstances. Being informed is not a passive undertaking. If the CEO doesn’t provide the information the director reasonably requires to make a decision, he or she must insist on obtaining the information; give it careful consideration; and, if necessary, seek the advice of outside advisers before acting. A leading case in which directors were held personally liable for a breach of their duty of care is Smith v. Van Gorkom, a 1985 Delaware Supreme Court decision. In Van Gorkom, the court held that the directors were grossly negligent and therefore were personally liable when they approved a cash-merger proposal that provided the stockholders with a substantial premium over the market price of their stock. The premium ranged from 39 to 62 percent, depending on the methodology employed in calculating the gain. The court found that although the board’s decision led to a substantial premium, its action was grossly negligent because the board was not sufficiently informed and therefore the so-called business judgment rule did not afford them protection from liability. Briefly, the court had these findings:
° The directors did not adequately inform themselves as to the CEO’s role in authorizing the “sale” of the corporation and in establishing the purchase price.
° The directors were uninformed as to the intrinsic value of the corporation.
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° Given these circumstances, the directors, at a minimum, were grossly negligent in approving the sale of the corporation upon two hours’ consideration without notice, without reviewing the terms of the proposed merger agreement, and without the exigency of a crisis or emergency. While the Van Gorkom decision turned on the facts before the court, it serves as a dramatic reminder that board decisions must be made on an informed and deliberative basis. Moreover, the process employed in reaching a decision and the record of how the decision was made are critical factors in determining whether the directors have satisfied their duty of care.
Business Judgment Rule Why is it so important for a director to properly discharge his or her duty of care? Because if the directors are properly informed, act honestly and in good faith, have no personal or financial interest, and exercise their business judgment in a manner they reasonably believe to be in the best interests of the corporation and its stockholders (collectively, the key elements of the business judgment rule), a court of law will not substitute its judgment for that of the board. Being properly informed is essential to the directors’ reliance on use of the business judgment rule. However, this requirement will not be satisfied if the directors fail to select responsible, knowledgeable, ethical executives on whom they can reasonably rely. The business judgment rule provides a judicial presumption that each of the key elements has been satisfied and that the directors have satisfied their duties of care and loyalty in good faith. The judicial rationale for this position is that judges will not replace the
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board’s judgment unless the contesting plaintiff (who has the burden of proof) can overcome the presumption and show bad faith, lack of due care, or the absence of a rational purpose. If this were not the case, it would be unlikely that responsible individuals, who don’t relish being second-guessed, would agree to serve as directors. Although the business judgment rule has broad application to board actions, it does not uniformly apply to all board actions. For example, in the case of an unsolicited or hostile takeover offer, where the board’s response must be proportionate to a reasonably perceived threat, a modified version of the business judgment rule may be applied. In that case, a board may not be required to accept an offer even though the offering price includes a premium over the current market price— except where the corporation has decided to sell control of the corporation. The board’s decision to reject an offer and remain independent is protected by the business judgment rule if the decision is made on an informed basis and in good faith. The modified business judgment rule also applies to a board’s decision to adopt defensive measures, such as a stockholders’ rights plan, otherwise known as a poison pill, where the decision can be supported as a response that is reasonably related to the threat of an offer at an inadequate price or a two-tier tendered offer. In other words, the response must be proportionate to a reasonably perceived threat. As the Delaware Supreme Court colorfully stated in its 1995 decision in Unitrin, Inc. v. American General Corporation, “When a corporation is not for sale, the board of directors is the metaphorical medieval corporate bastion and the protector of the corporation’s stockholders,” and “if a board reasonably perceives that a threat is on the horizon, it has broad authority to respond with a panoply of
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individual or combined defensive precautions, e.g., staffing the barbican, raising the drawbridge and lowering the portcullis.” You will not be surprised to learn that many directors who understand the protections afforded by the duty of care and the business judgment rule remain fearful that their informed decisions may nevertheless be challenged in a court of law. They ask, “So what happens when I am sued despite the fact that I acted in good faith, on an informed basis, without any conflict of interest or personal interests, and with reasonable belief that the actions taken were in the best interests of the corporation? The board fees and benefits can never compensate me adequately for prolonged, expensive stockholder litigation.”
Loss of Reputation and Embarrassment While the director’s concern and fear are not illusory, certain protections against personal monetary liability are built into the system:
° Indemnification—statutory as well as contractual ° Directors’ and officers’ (D&O) liability insurance ° Legislative limits on directors’ liability, which permit corporations to include in their corporate charters provisions eliminating or limiting the personal liability of directors for monetary damages for breach of the director’s duty of care (but not for breach of the duty of loyalty, acts or omissions not in good faith, knowing violation of law, and certain other exceptions) Although directors may not be financially liable for their actions or inactions, they still have litigation risks for the following two reasons.
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First, a director must consider the damaging effect on his or her reputation if the corporation improperly recognizes revenue, improperly records its expenses, or engages in fraudulent activity. The annual directors’ fees and stock options are hardly adequate to compensate a director for his or her loss of reputation and the accompanying embarrassment resulting from the corporation’s unlawful activity. Second, while D&O insurance and indemnification may be a part of the director’s protection against monetary loss, what happens when the D&O insurance is exhausted or the corporation becomes bankrupt? In those circumstances, even if the director successfully defends himself or herself, the legal costs of this defense, which in a complex legal matter can range from $200,000 to $500,000, could be devastating. Several years ago, I met with a client, a very successful and wealthy executive, who was considering serving as a director of a high-tech corporation that had just completed a very successful public financing. In an effort to fully explore his risks, I cautioned him about the potential liabilities a director of a young public corporation might incur if the corporation were to engage in improper or fraudulent activity. He advised me that he had reviewed the corporation’s indemnification obligations as well as the D&O insurance coverage and was satisfied that he would be protected, assuming he satisfied his fiduciary duty of care. He also added that the CEO was a long-time friend who was an honest and effective executive. I told my client that he had asked all the right questions and apparently was comfortable with the answers and protection afforded by the corporation. But I also asked him whether he was aware of the risks of personal exposure if the corporation were rendered insolvent and the D&O insurance funds were
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depleted. I explained that while his performance as a director may have been exemplary, he might be subjected to a demanding pretrial discovery process; a rigorous, time-consuming production of documents; and irritating, if not ugly, depositions, all of which would require the advice and assistance of his own lawyer, whose fees and expenses he would be obliged to pay. I also cautioned him about the possible public embarrassment and the potential tarnishing of his reputation that would be associated with a corporate fraud suit. He responded that I was being too cautious. Although he appreciated my advice, he felt the risks were minimal. So he joined the board, and two years later the corporation was investigated by the SEC for fraudulent revenue recognition. A class-action stockholder suit was commenced, and my client was subjected to regulatory interviews; tortuous plaintiff depositions; and countless hours of preparation with his attorneys, whose legal fees—approximately $300,000—he paid personally because the D&O insurance funds had been exhausted and the corporation had declared bankruptcy. After the dreadful saga ended, he pronounced, “No more directorships for me.” I tell this story not to frighten potential directors or to discourage their board participation, but to make the point that an ethical, knowledgeable director who performs his or her fiduciary duty responsibly may nevertheless suffer financial loss, personal pain, and sleepless nights.
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Chapter Three
Role of the Board of Directors
Excellent companies stay excellent by regularly challenging themselves.
H
aving briefly outlined the role of corporate directors in
terms of their legal responsibilities, let’s explore what directors actually do and what they should do.
Why Serve as a Director? Despite the fact that 2002 was marked by highly publicized corporate governance debacles and inexcusable derelictions by directors in the discharge of their fiduciary duties, most corporate directors are honest, well-intentioned, decent men and
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women. They believe they are serving as directors to promote the best interests of their stockholders. Their motivations for serving as directors may range from the selfless desire to build value for their stockholders to the vain or ego-driven need to be a part of the corporate establishment and to sit side by side with the corporate elite. Between those two bookends, a director serves because the CEO is a friend who needs a sympathetic ear on the board or because the director is seeking to supplement his or her income, increase his or her wealth through stock option awards, make new contacts in the business community, expand his or her knowledge of a particular business or corporation, associate with existing friends, or make new friends. Or it may simply be that he or she enjoys the challenge and intellectual stimulus of serving as a director and assisting executives in the performance of their responsibilities.
CEO-Dominated Process Back in the pre-Enron era, most directors became members of the board because the CEO knew them or knew of them through a friend or business acquaintance or because they belonged to an elite group of “professional directors” who supplemented their retirement income by serving on multiple boards. Even in corporations that had a nominating committee with responsibility for identifying and recommending the election of new directors, the CEO customarily took the lead, participated in the committee’s deliberations, recommended preferred candidates, and persuaded the committee and the board that the candidate should be nominated—and that person usually was. And in the absence of any scandal or challenge, the
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stockholders cast their proxies in favor of the nominee. As a result, the CEO, in a not-so-subtle manner, assembled a board that was unlikely to rock the boat and was expected to be loyal to the CEO and to preserve the “collegiality” of the members. What did many of the boards look like before Enron and Sarbanes-Oxley? Obviously, some boards took great care in vetting their prospective members, selecting nominees who were familiar with the corporation’s business and challenges, understood their fiduciary responsibilities, appreciated the need to provide independent advice, and had the desire and energy to perform their duties responsibly to further the best interests of the stockholders. But other boards were populated with directors who were principally adept at disguising their own ineptitude.
The Undesirables Let me recall a few of the undesirables:
° The Fast Reader: About a week before the board meeting, the CEO sent a thick package to each board member, which included the materials to be discussed at the board meeting, along with the CEO’s proposed strategic plan for the coming fiscal year. The CEO requested that each director study the plan carefully and be prepared to discuss management’s proposals and to recommend revisions, additions, or alternatives. At nine o’clock on the morning of the board meeting, immediately prior to the CEO’s convening of the meeting, the Fast Reader director asks the CEO’s secretary for a letter opener and then proceeds to open the package for the first time. Talk about being totally unprepared!
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° The Endearing Friend: He is the CEO’s sycophantic former college roommate who started two corporations over the past four years, both of which failed within their first twelve months. He has never been known to cross swords with the CEO at a meeting and has a 100 percent pro-CEO voting record.
° The Sleeper: He attends meetings to catch up on his sleep. He begins to doze off within the first five minutes and awakens intermittently for a bathroom break. His sleep problem is catching: he has managed to induce two of his fellow directors to doze off at recent dinner meetings of the board.
° The Rapper: He tends to dominate the board discussions and has a view, opinion, or comment with respect to each matter discussed at the meeting. He is often sententious but rarely laconic. And when he runs out of comments, he still continues to dominate the discussion by asking questions that are usually either irrelevant or could have been avoided if he had read the board materials before the meeting.
° The Internet Traveler: Just prior to the start of the board meeting, she powers up her laptop and journeys through her e-mail, the latest stock quotes, the New York Times editorial page, and Amazon.com’s most recent book reviews. On occasion, she moves from her computer to her Blackberry. Mindful of her need to refrain from further disturbing the meeting and other directors’ concentration, she frequently leaves the meeting to take or make calls on her cell phone.
° The Know-It-All: Imperious and implacable, he has the answer to every question and the solution to every problem. He gained this “knowledge” through his vast experience in a broad range of transactions, his connections with important
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people, and his success in defending himself in the seven lawsuits plus two SEC investigations brought against him over the past five years. I trust that these exaggerated stereotypes are, or will soon be, artifacts of the past. They contribute little, if anything, to the work of the board and in fact impede the board in the discharge of its responsibilities. So what are the board’s principal responsibilities, and how should the board best perform them?
Structuring the Board to Accommodate the Corporation’s Requirements How does a director know when a corrupt CEO is lying to the board? The CEO traditionally controls the agenda and management’s presentations to the board. Independent directors are unlikely to acquire the in-depth knowledge and understanding of the company’s business that the full-time management team and employees possess. However, directors can significantly improve their chances of early detection of problems as well as executive lies and deceit if they have a carefully developed understanding of their role and responsibilities, have reached a consensus as to what type of oversight they should provide, and have determined whether they will serve actively and endeavor to provide initiative and enhance stockholder value or less actively as advisers or monitors. Accordingly, the board needs to determine and agree on its role and objectives, the processes and policies to achieve its objectives, and whether it has the right people on its board, including the right mixture of skills and business savvy among its directors.
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Despite Sarbanes-Oxley and the new rules and regulations adopted by the SEC, the NYSE and Nasdaq, as well as the general approval of a long list of “best practices” designed to improve corporate governance, the performance of America’s public boards, while improved, still leaves much to be desired.
Overcoming the Knowledge Gap Effective directors must be more than just familiar with the business of the companies they serve. They must fully understand the company’s business, the type of management and employees it requires, the competition that it encounters, the company’s financial goals and the plan to achieve them, and the company’s strategic direction. However, most directors do not possess, and generally do not have the time to develop and maintain, an indepth knowledge of the corporation’s business. Even the most enlightened outside directors would have great trouble understanding the financial implications (and the opportunities for fraud) inherent in Enron’s “special-purpose entities.” As parttime advisers, the directors must rely on the management team to guide them, but that reliance does not relieve them from devoting a serious commitment of time and energy to fulfill their fiduciary responsibilities. Outstanding credentials and the timely adoption of best practices and implementation of new governance legal requirements mean little if directors do not challenge management and dissent when appropriate, and they will never be able to discharge that critical responsibility unless they know what is going on in the corporation and commit to provide the time required for an enhanced knowledge of the company’s business
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and for the formulation of ideas, programs, and strategies that assist and help guide management.
An Important Learning Experience When I became an overseer of my undergraduate alma mater in 1974 and a trustee in 1984, the college had two governing boards: one comprising trustees and the other overseers. At that time, no one explained why we needed two boards; that’s the way it was when the college was founded in 1794. I spent my first year as an overseer somewhat restrained and mostly silent, believing that it would be presumptuous, if not audacious, for me to start challenging the system as a freshman overseer. But it didn’t inhibit my criticism in subsequent years as I thought more seriously about what I was doing compared to what I believed I should be doing for the college, that is, examining the following issues:
° The relevance of a governance structure established and continued relatively unchanged for nearly two hundred years
° What kind of a board the college should have ° What we as trustees and overseers could and should do to aid and support the administration, faculty, and student body
° The composite skills, experience, and qualities required of board members
° How the boards should arrive at their decisions ° The nature and scope of our relationship with the administration and faculty
° The type of governance the college needed as the twentieth century was coming to an end
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So in 1994, at the request of other like-minded overseers and trustees who saw a need for change, the college formed a special governance committee to consider and recommend changes in the college’s governance to ensure that it “is effective, contributes to its goals and strategic vision, allows members of the Boards to assist the Administration and Faculty in their efforts to make [the college] better and stronger and create an environment in which members of the Boards add value to the institution and those that manage it.” The committee then conducted a two-year comprehensive review of the college’s dual board structure, the size of the boards, the terms of board members, the selection and election process, the roles of the committees, how decisions are to be made, the skills and experiences of board members that the college needed, and the rules and processes of the boards. In 1996, the committee submitted its report, and the governing boards approved all of its recommendations. As a result, we changed the legal structure by combining both boards into a single board of trustees; determined the expertise, skills, and qualities we needed on the board; established a committee structure and committee charter that encouraged active participation and assistance by the members; adopted best practices that worked successfully at other academic, as well as nonacademic, institutions; and created orientation and education processes to help the trustees understand their role and the importance of their involvement, preparation, and focused attention. We also emphasized the need for changes in the social fabric of the board, realizing that structural changes must be accompanied by a social order that values and promotes mutual trust and mutual respect, which in turn allow differences and challenges to be discussed and resolved amicably and positively.
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Board members began to look forward to their committee meetings and board sessions. They ceased being mere observers and took pride in serving as involved fiduciaries motivated to provide needed advice, assistance, and support to those who managed the college. And they helped develop an environment in which service on the board was a rewarding and enjoyable experience that served to make the job of those who managed the college less difficult and more enjoyable.
Questions the Directors Need to Answer This personal experience is not recited here to induce directors to search for governance solutions within their not-for-profit world, but to impress on corporate directors the need for diligently reviewing their existing governance apparatus and for regularly asking and answering the following questions:
° What type of governance structure best serves the company?
° Are we properly structured to do our job? ° Do we have the right membership and the right mix of experience?
° Do we want to do more than observe? How active should we be?
° What processes and best practices should we employ? ° Do we properly set annual goals for ourselves and management?
° Have we determined the type and scope of information that we need from the CEO and management?
° How do we create and maintain mutual trust and respect?
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° Do we properly evaluate management and the board to determine where and how we need to improve?
Who Runs the Company? Most CEOs are not particularly fond of independent directors, especially those who are noisily independent or contentious. Although they welcome the advice, support, and camaraderie of their board members, they do not react well to criticism, disagreement, or skepticism. They believe that as chief executives of their companies, they are charged with the responsibility of running the company, and they are aware that the corporate laws of nearly every state grant them, together with the executives they employ, the right to manage the business and affairs of the company. History has taught us that far too many CEOs do not welcome oversight; in fact, they fear it. The directors, they believe, have neither the statutory right nor the time and knowledge of the business required to run the company. Running the company, they contend, is a full-time job that cannot be performed by part-time watchdogs who meet four or five times a year. So what’s wrong with this position? It ignores a fundamental principle of corporate law.
What Should Directors Do? While it is true that the corporate executives are charged with managing the company, the board of directors is charged by law with overseeing and monitoring the executives’ management of the company. Corporate governance is the oversight of management. To fulfill this oversight responsibility, directors must determine the type and scope of the oversight they will provide. Do they
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want to serve as observers (“watchdogs”), commenting on what they observe and act only when troubles arise; or do they want to assume a more active role and assist management in enhancing stockholder value by participating in the initiation and development of the corporation’s business plans and strategies (“guide dogs”) rather than simply overseeing them; or do they want to perform the role of management (“bulldogs”)? Directors are fiduciaries and as such are empowered to oversee the management—to ensure that it is effective, honest, and dedicated to managing the company for the benefit of its shareholders and to enhance shareholder value. And if it is not, the directors have the right and obligation to replace them. In their capacity as overseers, directors should serve as advisers, monitors, counselors, protagonists, and critics but not as bulldogs.
Oversight Responsibility The board’s principal oversight responsibilities are:
° Advising and assisting the CEO ° Selecting, evaluating, and compensating the CEO and the company’s senior executives
° Replacing the CEO and senior executives if and when appropriate and developing and implementing a management succession plan
° Reviewing and approving management’s strategic plan and business objectives and monitoring the company’s strategic direction
° Overseeing the company’s financial performance and accounting, and monitoring the company’s compliance with its legal and regulatory obligations
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° Managing and resolving any business, governance, or regulatory crisis confronting the company
° Reviewing and approving management’s financial plans, commitments of material corporate resources, acquisitions, divestitures, sale of corporate assets, and other material transactions not in the ordinary course of business These are basic principles of corporate governance and have been adopted (with some variations) by most public corporations and their boards. But although they are generally adopted, they are not universally applied; often, in fact, they have been misapplied. Moreover, many of these principles were forgotten or disregarded by the management and the directors of several of this country’s fastest growing corporations during the Great Bubble of the late 1990s. Directors must constantly remember and adhere to these principles to ensure that they and others involved in governing or advising corporations are not misled by the myth that attributes many of the recent corporate scandals to the board’s failure to manage the company properly or to the board’s interference with management’s purported exclusive right to run the company. Neither is true. The scandals occurred because executives of the affected companies ran the companies primarily for their own benefit, not for the company’s shareholders, and the directors failed to perform their fiduciary duties as independent overseers of the company’s management.
Setting the Tone at the Top The directors have a responsibility to assist the CEO in setting the right tone at the top. Just as in our national and local gov-
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ernments, schools and universities, professional organizations, hospitals, and philanthropic organizations, the tone and culture of our business enterprises and the standards, ethics, and values of corporate America are formulated and enforced at the top— by the CEO, with the advice and assistance of the board of directors. Corporations must create and foster a culture in which the interests of the directors are aligned with those of the stockholders and the directors make informed judgments that benefit the stockholders. In the light of Sarbanes-Oxley, to ensure that the right tone is set at the top, directors of public corporations have these responsibilities:
° Overseeing the corporation’s compliance with applicable laws and regulations
° Adopting and disseminating to its stockholders a code of conduct and ethical guidelines and overseeing their implementation
° Adopting and monitoring corporate programs and policies that promote transparency and full disclosure
° Ensuring that membership of the board includes at least a majority of independent directors
° Establishing an audit committee of the board that is independent, diligent, and financially literate
° Establishing a compensation committee of the board that is independent, adopts fair compensation programs, and prohibits unauthorized loans and perquisites
° Establishing a nominating and governance committee of the board that ensures the recruitment and education of informed directors, avoids conflicts of interest, and promotes ethical and effective corporate governance
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° Ensuring that management has created an insider-trading program, a monitoring program to assess the corporation’s internal controls, and a disclosure committee to ensure accurate, timely, and fair disclosure
° Creating and overseeing implementation of self-assessment programs to evaluate the performance of the board as a whole and the directors individually In addition, the directors must keep abreast of new developments in the corporation as well as changes in their obligations and responsibilities by participating in continuing-education sessions for directors and becoming familiar with new developments as they are reported in newspapers, business, and financial publications and by the corporation’s counsel. Directors should not be reluctant or embarrassed to schedule learning sessions to assist them with a better understanding of the corporation’s principal business activities and profit generators, financial and accounting issues, strategic focus, business and competitive risks, financial needs and new governance rules, standards, and best governance practices. In this era of expensive, protracted, and what some might describe as “take no prisoners” litigation, it is likely that many qualified, experienced individuals will refuse to serve as directors of publicly owned corporations for fear of being exposed to embarrassing, painful, and often costly stockholder lawsuits, derisive criticism, or attacks from stockholders who expect more from their directors. A common refrain these days, particularly in the light of the sweeping breadth, explicitness, and ubiquity of Sarbanes-Oxley and the wide-ranging new rules and regulations promulgated by the NYSE and Nasdaq is, “Who in his right mind would want to serve as a director given the current hostile director environment?”
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Do We Need Professional Directors? The answer is not to disregard the new rules or the existing practices, but to bolster them by creating a corporate governance culture in which independence, integrity, knowledge, and commitment are combined to enable directors to perform their oversight functions responsibly. But skeptics argue that the directors, who are at best part-time monitors and advisers, can never be as knowledgeable about the corporation as the fulltime management team. Therefore, the skeptics say, these directors will never be in a position to provide fully informed oversight. The skeptics do not, however, suggest that the oversight role of the board should be changed or abandoned. Instead, they argue for a change in the makeup of the board. They believe that board responsibilities and obligations have become so complex that only “professional” directors are capable of providing effective service. A director is recognized as “professional,” they explain, if he or she makes his or her living serving as a director, sits on several (four to eight or more) boards, is generally recognized as having extensive experience as a board member and a highly regarded corporate adviser, fully understands the duties of a fiduciary, and engages in continuing-education programs to keep abreast of changes in the laws and in corporate governance best practices. I disagree with those who seek to professionalize boards. First, stockholders might be uncomfortable relying on outside directors who make their living serving as directors, believing, rightly or wrongly, that they may fail to act as independently as they should if their independence could lead to friction in the boardroom, conflicts with management, and a resulting call for
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their early retirement. In short, professional directors might be inclined to avoid conflict or disagreement in order to keep their jobs and director fees. It is likely that this would be particularly true of retired or unemployed executives and others for whom director fees constitute a major or significant part of their income. Also, historically, professional directors have not always been welcomed by other board members for whom service on the board is a part-time activity, principally because some professional directors often exhibit a know-it-all condescension, if not arrogance, toward those nonprofessional directors, whom they view as amateurs. Nonetheless, having one or two directors on the board who qualify as professionals can add great value to the board because of their knowledge and extensive experience, so a judicious blending of professional and nonprofessional directors is advisable.
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Chapter Four
What Values and Qualities Should Directors Possess?
The board has no room for insouciant directors who are not committed or who believe they can serve by being passive observers.
A
board cannot be effective unless its members possess and
exercise good judgment, are financially literate, and are able and willing to assume responsibility. They need as well the courage to say no to management when it proposes actions or policies that subordinate the interests of the stockholders to the interests of management or otherwise serve to reduce rather than enhance stockholder value.
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The Five I’s It is unlikely that even the best-recognized corporate governance experts will agree on what it takes to create the excellent or ideal board. However, a look at the best-run public companies teaches us that an excellent board needs independent, wellinformed, ethical, experienced, proactive directors who possess business and financial savvy and the ability to create a boardroom environment in which the Five I’s of good corporate governance reign: Independence, Integrity, Informed, Involved, and Initiative.
Independence In 2003, the NYSE and Nasdaq revised their definitions of independence as that term applies to the directors of their listed companies; although each has some differences, the definitions are substantially the same. Both the NYSE and Nasdaq provide that a majority of the board members and that all members of the audit, compensation, and nominating and governance committees must be independent, which in effect prohibits any business, financial, or family ties with the company or its employees. The NYSE defines an independent director as one who has no material relationship with the listed company, and Nasdaq defines an independent director as a person who has no relationship that would interfere with the exercise of his or her judgment. With independence comes the ability and courage to challenge management and fellow directors in an environment that encourages constructive skepticism as well as free and open differences of opinion. Independence means:
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° Management will have the benefit of the board’s unfettered, best judgment.
° The board will make decisions on the basis of what is in the best interests of the stockholders.
° The board will expect and demand that management will deal honestly with the directors and ethically in the conduct of the corporation’s business.
° The “don’t rock the boat” attitude that historically permeated the clubby or conflicted board will be a relic of the past, replaced by an attitude that encourages, and in fact demands, free and open discussion and constructive disagreement. There is a danger, however, that the independence requirement may disqualify a highly desirable candidate from service on the board because of a “tainted” business relationship with the corporation. For example, the candidate may be a valued and knowledgeable executive, former executive of the company, or an executive or senior manager of a valued supplier or a customer of the corporation whose business experience in the industry can provide unique insights for the corporation and its other directors. But if the business relationship between the two corporations crossed permissible financial relationship thresholds, this person cannot satisfy the “independence” standard. Nonetheless, since the current rules require that only a majority of the directors be independent, the corporation can still add the director to the board so long as that director does not serve on the board’s audit, compensation, or nominating and governance committees (whose entire membership must be independent). Boards should not be afraid to include directors who are not strictly independent within the meaning of the applicable rules and regulations if those directors can bring needed
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unique skills or valued experience that other directors may not possess. A director of one of my clients was a senior executive of a company that was an important supplier of parts to my client. When the parts that his company supplied became scarce because demand exceeded the industry’s production capacity, that director took steps to ensure that my client was able to acquire the quantity of parts it needed. This was a situation in which a director who failed the independence test was particularly valuable: he was in a position to help meet the client’s procurement requirement and had a special knowledge of the industry in which the client conducted its business. Beware of nostrums that call for total independence of all nonemployee directors.
Integrity Successful companies insist on integrity even at the risk of restraining entrepreneurship, a concept that often is difficult to sell. The CEO, with the advice and consent of the directors, is responsible for setting the right tone at the top and creating a corporate culture that censures extravagance, greed, dishonesty, and self-dealing, and extols decency, integrity, and ethical behavior. Enron had plenty of rules, codes of conduct, checklists, and compliance programs, but apparently they were ignored or violated by company employees and executives while the directors failed to properly oversee and monitor their compliance. Beware of a “check-the-box” governance mentality. Monitoring compliance requires more than simply affirming that the proper boxes have been checked.
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Informed A director may be independent and possess integrity, but what good is a director who is not informed? An individual who agrees to serve as a director should, as a condition to service, commit to spend the time and make the effort necessary to become and remain fully informed about the company’s business, industry, competitors, and finances. Uninformed directors are liabilities, make bad decisions, and consume valuable management and board time. Commitment and preparation for meetings are essential to the director’s discharge of his or her oversight responsibilities, including understanding what keeps the CEO awake at night; maintaining the level of business savvy that permits the director to contribute to the development of the company’s strategy; maintaining a level of financial literacy required to evaluate the company’s financial performance; evincing a willingness to listen; and keeping abreast of new governance requirements by participating in the continuingeducation process.
Involved Effective oversight of management requires availability, commitment, and dedication of the time required to discharge the director’s fiduciary duties responsibly. Directors should be enthusiastic and excited about their service on the board. If they are, they will devote whatever time is required to ensure that they are fully prepared and know enough about the corporation’s business to perform their duties assiduously and intelligently.
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Initiative A director must be proactive, ask questions, insist on answers, listen carefully, participate in the preparation of the agendas for board meetings, and be prepared to take the initiative when management stumbles or needs help. The board has no room for insouciant directors who are not committed or who believe they can serve as passive observers. Directors who lack initiative or fail or are unable to contribute should resign. Effective directors are not afraid of being bold.
Complementary Skills and Experience To properly discharge its oversight responsibility and intelligently challenge management, the board must have knowledgeable members with a wide range of backgrounds, experiences, and skills. Not every director needs the experience and skills that the entire board, as a group, requires to perform its oversight responsibility. One director may satisfy the need for a financial expert on the board’s audit committee who, because of his experience with the preparation, auditing, analysis, or evaluation of financial statements, is in a position to assist those on the board who have great difficulty reading and understanding financial statements and income statements and whose brains have a sclerotic reaction when they attempt to understand such concepts as hedging transactions, the expensing of stock options, revenue recognition principles, and amortization calculations. Not every director needs to be fully informed about the patents and technology that give the corporation’s products
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advantages over its competitors’ products, but every director must know what the corporation produces and markets and the services it provides, as well as how those products and services compare to those of its competitors. A director does not have to be a semiconductor expert to serve as a director of a corporation that sells and markets semiconductor devices, nor does he or she need a degree in microbiology to serve as a director of a biotechnology corporation. However, the board should, if possible, be composed of directors who, as a group, have the experience and skills that are collectively required to make informed board decisions and provide effective board oversight. The composite skills of the board’s members and the ability and willingness of individual board members to complement each other and to rely on each other’s knowledge and expertise will produce an informed board of directors who are not afraid to disagree and can intelligently assess management’s performance and evaluate the corporation’s strategic direction.
Preparation and Continuing Education Notwithstanding their exemplary experience and qualifications, directors who do not come to board meetings fully prepared to discuss and act on the meeting agenda should either resign voluntarily or be removed by their fellow members. In an era when bad corporate governance is under attack and directors are being sued for failing to perform their fiduciary duties, a director who comes to board meetings unprepared should be told that his or her presence is no longer required and be invited to leave.
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Preparation is a combined effort of the directors and the corporation. Every new director should attend a comprehensive orientation session as well as periodic continuing-education sessions that are designed to:
° Relate important historic events in the life of the corporation
° Describe the corporation’s governance structure and the role and responsibilities of the board’s committees
° Describe the background, experience, unique skills, and responsibilities of the corporation’s senior executives and managers
° Introduce the directors to the corporation’s senior executives
° Describe the corporation’s business, technology, competitors, and risks
° Familiarize the directors with the corporation’s principal facilities and their functions
° Explain the corporation’s financial statements, particularly principal accounting issues such as revenue recognition and the accounting treatment of matters unique to the corporation
° Review the corporation’s strategic plan and principal business objectives
° Inform the directors of the corporation’s culture, operations, and goals
° Advise the directors of the need for, and the objectives of, the corporation’s major programs, including its compliance program, insider trading program, SEC reporting programs and procedures, and governance and ethical programs and guidelines
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Each director must set aside the time required to prepare for board and committee meetings, actively participate in the board’s discussions, and provide useful advice to management. In short, each member needs to be an active, informed, and constructive participant. The directors should also become familiar with the work of those members of the management team whom they do not regularly hear from at board meetings to determine the corporation’s bench strength and possible future successors to the senior management team. The corporation’s management should regularly supply to the directors, in addition to the materials prepared for board meetings, copies of reports, articles, and analyses of the industry in which the corporation competes. These should include reports and recommendations of knowledgeable securities analysts, articles describing the business and new products and new services of its competitors, market trends that may affect the corporation’s future business, and other writings, surveys, and reports that management reads to maintain its competitive position and plan its strategy. This type of continuing background, industry, and competitive material will allow directors to maintain a current knowledge of major events or advancements that affect the corporation. It will also make the job of management easier when it presents the board with recommendations for development of new products, the expansion (or reduction) of production facilities, the acquisition of complementary companies, the proposed entry into new markets, and proposals for new equity or debt financings. A one- or two-day retreat devoted to a strategic review or other major corporate matters has also proven to be very helpful when management needs more than a couple of hours at a
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board meeting to focus the directors on a material transaction, the strengths and weaknesses of the management team, future potential leaders, new marketing initiatives, and the like. However, management should keep in mind the constant warning: don’t overload the directors with reports and data they do not need, especially minutiae; be prudent and selective.
Disagreement Is a Virtue, Not a Vice The requisite willingness and courage to challenge management comes from independence and an understanding of the role of a corporate fiduciary. Not surprisingly, most corporate executives encourage and welcome the exploration of alternatives, thoughtful board discussion of management’s recommendations, differences of opinion, evaluation and exchange of new ideas, and even constructive criticism. However, a director’s constructive criticism or strong disagreement with management or other board members is not likely to be received positively or unemotionally if the dissenting director is believed by his or her fellow directors to be untrustworthy or self-serving. If trust and honesty permeate the boardroom, board challenges and criticism are perceived as positive expressions intended to benefit the corporation and its management. If directors are reluctant to disagree, or their disagreement is greeted with neglect or derision, the board soon becomes a vacuous receptacle of conformity. Moreover, disagreement by a director usually ignites a discussion among the directors and, as a result of the discussion, a change in what might otherwise have been an ill-advised, unanimous decision. Disagreement and challenges are not always well received, whether they come from management or the board. Therefore,
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directors must be aware that the manner in which they deliver the challenge often determines how the challenge will be received and how effective it will be. Most directors are reluctant to rebuke or reprimand the CEO or senior management openly at board meetings, fearful that they might be viewed as hostile scolds or dissonant adversaries. On the occasions when I have witnessed what might be characterized as “basher” behavior, a palpable tension fills the boardroom, the comforting collegiality dissipates, and embarrassment and anger are evoked, particularly if all of this comes as a surprise or if there is no trust between the affected parties. The result often is an unfortunate, unintended confrontation as well as a time-consuming diversion. This does not mean that a director should not be skeptical or refrain from legitimate criticism or put aside his or her concerns. However, there are cogent ways of communicating that are not denigrating but effectively convey dissatisfaction while at the same time providing helpful, constructive advice. Directors can be audacious without being insolent. The best advice to the basher is not to refrain from criticizing the CEO if it is deserved and serves the best interests of the stockholders, but also not to be captious or self-righteous, and consider delivering criticism and disagreements privately, in a nonhostile manner. For example, directors who are unhappy with their CEO’s performance or with the CEO’s recommendations ought to consider channeling the criticism and advice through the board’s independent chairman or lead or presiding director or, alternatively, meeting with the CEO privately, perhaps at dinner the night before the scheduled meeting. In that setting, the director and the CEO can discuss differences honestly and unemotionally, react to recommendations without
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rancor or embarrassment, and perhaps reach a consensus that can then be constructively presented at the board meeting. If a preboard meeting dinner cannot be arranged, a telephone call prior to the meeting may be adequate. The directors should not, however, seek to reconcile differences by an exchange of reproachful letters or memoranda since they usually evoke rancorous responses “for the record” and do not provide the type of constructive give-and-take that comes with a face-to-face meeting that can serve to clarify a position or ameliorate differences. Moreover, the written word may be construed as an offensive act by the recipient, not because of the content but because of the provocative style in which it is written or simply because it creates a record. So keep it simple, meet personally if possible, and if not, pick up the telephone: talk and listen. Listening is especially critical, keeping in mind the helpful aphorism that “you never learn anything new by listening to yourself talk.” And always remember that you can disagree without being disagreeable.
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Chapter Five
Role of the CEO
The CEO should seek to create a board meeting environment that encourages skepticism and serious discussion and enables board members to disagree constructively.
A
CEO who wants to succeed must establish a productive,
honest, and mutually beneficial relationship with the corporation’s directors, which requires that the CEO obtain a sound knowledge of the abilities and expectations of the directors and a keen awareness of what they need to discharge their duties effectively.
Know the Board To obtain the highest value from their company’s directors, CEOs must diligently seek to know each board member’s background, experience, special skills, special areas of interest,
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strengths, weaknesses, likes, and dislikes. Based on this knowledge, a CEO can generally predict how the directors will react to management’s proposals, thereby enabling him or her to anticipate and prepare for board questions and disagreements and, in so doing, prepare a more informed and effective case for management’s proposals. The CEO should also ensure that the directors have the opportunity to interact with senior management, who can be a reliable source of valuable information to the board. This interaction will help the directors accurately evaluate the performance and capabilities of the senior executives. This responsibility has become increasingly important as directors become more actively involved in oversight duties and as they fulfill the new responsibilities that have accompanied the recent shift in corporate power from the CEO to the directors. The directors should know whom the CEO considers to be his or her most valuable executives and who among the senior management team might be a likely successor. In addition, the CEO should seek to create a board meeting environment that encourages skepticism and serious discussion and enables board members to disagree constructively or, in the words of Harvard Business School professor Walter J. Salmon, to create “constructive dissatisfaction.” CEOs who engage in obscurity are likely to have short tenures. CEOs and senior management must be prepared to be open and speak clearly and honestly to the directors. If the directors are aware of the challenges the executives face, they can and should be helpful. Every board ought have to at least one director who is a trusted, wise adviser to the CEO and can respond quickly and
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impartially when the CEO needs help and wisdom, whether it involves his or her relationship with the board as a whole or with a particular board member or advice regarding the presentation of controversial matters to the board for action. This adviser should let the CEO know he or she will be available when needed to listen and talk over a problem with the CEO and provide the CEO with his or her best judgment. Ideally, the chair (if he or she is not an employee) or the lead or presiding director is best suited to perform this important role. Courage is a word that rarely appears these days in the discussions of corporate governance. How often do you read about courageous CEOs? The rare appearance of the word does not, however, mean that courage may be essential on the battlefield but not in the boardroom. To the contrary, a successful CEO is also usually a courageous executive, and I am reminded of a particularly dramatic act of courage several years ago that proves this point. It involved the CEO of a corporate client who was the founder and CEO of a very successful high-tech company that became one of the country’s leaders in its industry. The corporation’s stock had enjoyed a dazzling increase in value as its business and profits grew. However, the inevitable slump in the industry arrived, and sales and revenues declined, followed by significant declines in income. Despite the revenue decline, the drop in income could be considerably ameliorated by cutting back significantly on the company’s very heavy R&D budget. Securities analysts and some executives recommended this move to reduce the income decline and thereby lessen the drop in the stock price and help to preserve the value of the corporation’s outstanding stock options.
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In a compelling presentation, the CEO argued for continuing the corporation’s R&D spending at the rate budgeted before the industry slump occurred, and the board concurred with this recommendation. The CEO’s persuasive rationale was that the corporation was successful because its R&D program allowed it to become and remain a leading innovator in a highly competitive technological field. Although R&D cutbacks might help profits at that moment, they would inevitably lead to the loss of the corporation’s leadership position in the industry and an overall long-term reduction in the company’s value. When the CEO publicly announced the corporation’s decision and the likely further decline in annual income, he was severely criticized by those who feared the decision would trigger a major decline in the corporation’s stock price. However, after thinking more carefully about the CEO’s rationale for the decision, investors changed their attitudes. The stock did decline in the near term, but only modestly, and it rebounded as the corporation maintained its leadership in the industry. Making a decision that caused short-term investor displeasure took courage and leadership, but it eventually resulted in the market’s exuberant commendation for the CEO’s wisdom and foresight.
Setting the Tone and Corporate Culture The cultures at Enron and its ilk placed a premium on earnings growth—however that growth could be obtained—and on highly risky, “creative” business arrangements and accounting practices. Apparently, little attention was placed on developing or imposing a system of checks and balances on an out-ofcontrol engine that caused a mammoth train wreck. The ethical
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caution lights either didn’t work or their warning flashes were not visible to the passengers, whose peripheral vision was obscured by their intense focus on wealth and fame at any cost. Where were the oversight, integrity, ethical guidelines, and supervision that would have prevented the chaos that ensued? Where was the culture that promoted creativity and success, but also demanded that they be achieved legally and ethically? Were there no moral compasses within any of these organizations that could have averted their collapse? Apparently not. The most important responsibility of the board is to hire, fire, and set the compensation of the CEO. The CEO manages the company on a daily basis and provides, together with the executive team, almost all of the information that the board receives and relies on for its decisions. Corporate responsibility begins with the CEO. If the CEO is dishonest or unethical, it is likely that the company will be dishonest and unethical. The CEO, as the company’s leader, is responsible, with the assistance and advice of the board, for creating the corporate culture and setting the right tone at the top. Directors may be diligent, conscientious, and active yet be incapable of preventing corporate fraud or ethical misdeeds if the CEO tolerates dishonesty or, even worse, is personally dishonest or encourages or tolerates dishonesty within the company. The CEO’s business philosophy, actions, and the tone that he or she uses in communicating with employees reveals and influences the company’s culture and the expected attitude of the company’s employees. The board’s role is to monitor and supervise the company’s culture and ensure that the CEO is sending the company’s management team and employees the right message. It must also identify programs that aid in maintaining the right tone
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throughout the entire organization, including those designed to deter, quickly detect, and vigorously prosecute dishonesty and fraud within the organization. These responsibilities are made more difficult by the fact that directors are not full-time employees and can never have the in-depth knowledge that the CEO and the management of the company possess. For that reason, the CEO, assisted by the senior management team with active oversight from the directors, must take the lead in making the board an active part of the decision-making process, encouraging skepticism and dissent, and proclaiming the paramount importance of honesty and fairness.
The CEO’s Role in the Decision-Making Process Inexperience, ignorance, or fear have historically driven many unsuccessful CEOs to keep their directors out of the decisionmaking process. Why? They were reluctant to disclose early warnings or bad news, based on the mistaken belief that with time, management could get back on track, meet revenue projections, or raise the funds needed to finance the corporation’s business or complete the development of its new line of products. They believed that disclosure to the board of bad news or the need for board help would ineluctably lead the board to believe that management was weak, lacked leadership, and needed to be replaced. They expected that the board would not understand or could not make a difference, firm in their belief that only management could solve the problem—or that a solution would appear deus ex machina.
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If this sounds implausible or you think I’m making this up to prove a point, the reactions I have just described occur frequently and are most common among CEOs and senior executives who are insecure or have had limited experience with corporate boards. I recall a board meeting several years ago, held by a wellfinanced start-up, high-tech corporation, that opened with a shocking announcement by the CFO that the corporation would run out of money within the next five business days. The CFO was fired on the spot, and the CEO was speechless as he listened to the directors’ railings about his failure to give the board a warning of a rapidly approaching financial crisis.
What the CEO Expects of the Board The CEO and the directors must relate to each other as equals in the operation and oversight of the company. To operate effectively, they need to trust and respect each other. While current trends are leading to a reduction of the CEO’s dominance in the boardroom, collegiality and cooperation must be preserved to ensure that the important responsibilities of the board are properly discharged, particularly as the new rules of corporate governance are implemented. Therefore:
° The CEO and the directors must cooperate and work together to create an open board environment where disagreement doesn’t create disruptive tension or animosity.
° Directors must be aware of the CEO’s need for attentive and committed directors who are willing to devote the time necessary to acquire and maintain solid knowledge about the company’s business, finances, competitors, and risks.
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° Directors need to concentrate during board meetings and remember what the CEO and management tell them about achievements, problems, plans, and future strategies. There is nothing more frustrating to a CEO than a director who asks for a discussion or explanation of a matter, a future strategy, or a compensation program that was exhaustively presented and discussed at a recent prior meeting.
° Directors need to assist the CEO in planning the agendas for the board meetings, thereby allowing the CEO to conduct meetings that are relevant, informative, productive, and beneficial to both management and the directors.
° The CEO wants and needs honest feedback from the directors, including advice designed to improve board meetings and enhance director knowledge, as well as frank and helpful criticism when required and encouragement and praise when earned.
Avoiding Surprises CEOs who want to keep their job should never surprise the corporation’s directors with bad news. Rather, they must keep the board apprised of potential future problems before they occur, seek help from the board to avert or ameliorate those problems when they do occur, and make the board an integral part of the decision-making process. This makes good self-protective sense because it lets the CEO benefit from the board’s experience and advice and avoid unpleasant surprises. In addition, if the decision later turns out to be wrong, the CEO can take some comfort in the fact that the mistake was
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not solely his or her mistake, but a mistake made by the entire board after a candid, informed discussion. The responsibility for fully informing the directors does not rest solely with the CEO and senior management. The board also needs to be actively involved in making sure that the flow of information from management to the directors is timely, accurate, and enlightening. This means that the CEO and the management team must prepare board agendas that are designed to inform and update the directors on the performance (including the failures) of the corporation and future business problems and risks, ensure that the reports of senior managers scheduled to make board presentations are relevant and timely, and encourage a thoughtful discussion by the directors of proposals submitted by management to the board for approval. CEOs who observe best practices supplement their board meeting materials with a two- to three-page memorandum that summarizes the good and bad that occurred during the past quarter (or other relevant reporting period), reveals the problems and concerns that keep them awake at night, and focuses on the important matters that will be presented for serious discussion with the board at the scheduled meeting. All matters presented to the board do not deserve equal time or equal effort. The most productive meetings are those that are preceded by the CEO’s memorandum focusing on the key matters to be discussed at the meeting and closing with the following admonition: “The meeting will be devoted to a thorough discussion of the following important matters, for which I need and will seek your input, critical analysis, advice, and recommendations,” thereby invoking the following implicit
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warning: “You now know what’s coming, so you better be prepared.” If the decision, after board deliberation, turns out to be wrong, it is not the CEO’s fault, but the result of a bad decision reached jointly by the CEO and the board and arrived at after careful review and analysis. This approach also underscores for directors that management wants and values their wisdom and advice. Why then would a CEO ever elect to fly solo when it is in the CEO’s and the corporation’s best interests to make the board a part of the decision-making process, particularly with respect to critical corporate decisions?
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Chapter Six
Board and Committee Meetings Avoid information overload and mind-numbing presentations.
E
ffective board and committee meetings require thoughtful
planning by management and informed participation by directors to produce a focused agenda, succinct and relevant board materials for premeeting director review, and management’s prioritization of the matters to be presented and discussed at the meetings.
Setting the Meeting Agendas Most of the board’s work is conducted at its regularly scheduled board and committee meetings. Accordingly, careful attention must be directed to the preparation of the agendas for the
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meetings and the development of the background and other materials submitted to the board for their premeeting review. If there is a nonexecutive chair of the board or if the board has appointed a lead director or presiding director, that person should seek out the recommendations and thoughts of other board members and work with the CEO to develop the meeting agendas. If the board does not have a lead or presiding director, the board should designate a director to perform this function. A similar procedure should be followed for producing committee agendas, with the committee chair, the CEO, and senior management collaborating to develop appropriate agendas. The board and committee agendas should be accompanied by the reports, memoranda, plans, and other materials that are to be discussed at the meetings. They should be delivered to the board and committees sufficiently in advance of the meetings to allow the members to prepare adequately for an informed discussion of the materials and of management’s recommendations and proposals.
Risk of Information Overload The board or committee packages prepared by management and delivered to board members before the meeting provide important historical data regarding the corporation’s past and projected performance (including charts, graphs, memos, reports, recommendations, and analyses) to assist the directors in evaluating management’s proposals and predictions and making informed judgments. These materials are often assembled in multiple heavy, thick binders that, when stacked together, can reach a height of six inches to a foot. How much of this
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mass of material is read before a meeting? I suspect that even the most conscientious director is put off by the sheer volume, not to mention the frequent irrelevance, of the premeeting reports that they are expected to read and comprehend. If you want directors to be prepared, avoid information overload and focus on content and relevance. The best premeeting board materials are the following:
° A thoughtful, well-prepared briefing memorandum from the CEO that reviews recent performance and briefly describes and analyzes the matters to be presented at the meeting, including a discussion of the decisions the CEO is seeking from the directors. This should be accompanied by analyses, best- and worst-case scenarios, and risk factors.
° A one- to two-page memorandum from each of the management team members who will be presenting at the meeting, summarizing (in plain English) the principal elements of their presentations.
° Backup materials that the directors will be asked to refer to and discuss during the course of the meeting.
Concise, Focused, and Relevant Presentations I don’t recall when or how it began, but PowerPoint presentations have become the universally accepted way to deliver lectures, speeches, reports, and proposals. It probably started with consultants and government bureaucrats who are quite adept at producing multicolored charts, graphs, talking points, and datafilled slides that are designed to capture the listeners’ visual senses and enhance their retention capabilities. But like most
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other good ideas, the PowerPoint presentation has become an overused, soporific device that competes with the presenter for the audience’s attention and has, through its overuse, lost much of its effectiveness. Instead of containing one or two pages of concise bullet points, presentations have grown to dozens of slides of heavy text that the presenter reads word for word as well as charts and graphs that are impossible to read or decipher. These mind-numbing presentations have to go. They need to be replaced by animated, relevant, focused, easy-tocomprehend presentations that zero in on the issues that the directors need to know to perform their oversight function effectively and assist management in achieving the objectives and strategies jointly established by the board and management. Equally antithetical to productive board and committee meetings has been the parade of executives and managers who join the meetings to report on the activities of the business unit they manage. Why is this a problem? Shouldn’t the directors have the opportunity to hear from the operating executives and managers and engage in dialogue with them about the performance of their business units? The answer, obviously, is “of course,” but the problem, as in the case of PowerPoint presentations, is that the practice has become bloated. Too many needlessly long management presentations leave very little time for the board and the CEO to engage in thoughtful discussions about matters that require serious board input and corporate action. It is up to the directors to complain to the CEO if they devote too much time to listening to minutiae and to long, sophistical presentations and not enough time on these important matters:
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° Focusing on what keeps the CEO and CFO awake at night
° Carefully reviewing and acting on the reports of the audit committee, compensation committee, nominating and governance committee, and other key board committees
° Evaluating changes in the corporation’s strategic objectives
° Considering acquisition opportunities ° Discussing the CEO’s and management’s performance and business priorities All of these are matters that require serious, timely discussion. They should not be squeezed into the last hour of the meeting or, worse, be addressed while the directors are assembling their materials and making the frantic rush to catch the late-afternoon flight home.
Size of the Board The size of the board depends in large part on the size and complexity of the corporation, the number of directors on the board who are not independent (which determines at least the number of independent directors required to ensure the independence of a majority of the directors), the expertise and nature of the composite skills that the board needs, and the number and size of the committees established by the board, of which three (audit, compensation, and governance) restrict membership solely to independent directors. Most directors prefer small boards that allow the members to interact with each other and learn about their mutual skills
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and experiences while creating a collegial working environment that encourages each director to participate openly. The largest U.S. corporations have twelve or more directors, while the boards of medium-sized to large corporations range from eight to twelve directors and small corporations from six to eight directors. Each board should determine its size based on its particular needs, as well as on its ability to comply with the applicable provisions of Sarbanes-Oxley, the NYSE, and Nasdaq.
Frequency of Board Meetings How often should directors meet? The common legal response is, “as many times as may be required for the directors to properly discharge their fiduciary responsibilities.” The frequency and length of board meetings depend in large part on how active the directors are in performing their oversight responsibilities, the size and nature of the corporation’s business, and the amount of time spent at each meeting. The board should meet at least quarterly to review the quarterly performance of the corporation. In the post-Enron era, many small and medium-sized corporations have increased the number of regular scheduled meetings to six to eight per year and the large corporations to seven to ten, while the average time devoted to board matters by an independent director (including premeeting preparation and travel time) ranges from approximately 150 to 250 hours a year, depending on the size and complexity of the corporation and the nature of the role assumed by the directors. Also, the length of the meetings generally determines in large part the number of regular meetings that will be held annually. Boards that hold two-day meetings or annual strate-
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gic two-day retreats may need only four or five regular meetings per year, while boards that meet from 9:00 A.M. to 3:00 P.M. once each quarter may need to add two to four or more meetings per year to conduct their business. Additional special meetings are held as needed, particularly when important corporate matters arise that need the directors’ attention prior to the next regular board meeting. Telephonic meetings are also commonly scheduled for quick action or to consider a matter that needs to be resolved before the next regular board or committee meeting. Regular meetings are customarily convened at the corporation’s facilities, where face-to-face discussions can take place and reactions of the directors to the discussions can be more accurately discerned. Consideration by the directors of a crisis, a possible acquisition, potential adverse litigation, management changes, and other major issues affecting the corporation may require additional meetings or the extension of regular meetings. Committee meetings should generally be scheduled to coincide with board meetings to minimize travel and allow the committees to report promptly to the board on their deliberations and proposals.
Executive Sessions Many boards routinely hold executive sessions without management attendance immediately after the regularly scheduled board meeting adjourns. The nonexecutive chair or, if there is none, the lead or presiding director chairs the meeting. The purpose of the executive session is to give outside directors the opportunity to evaluate the proposals and plans recommended by management at the meeting and thereby allow each outside director to evaluate management’s performance. This practice
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encourages candor and provides the freedom to speak openly and avoid publicly embarrassing the CEO and other senior executives. Experience has shown that holding the executive session after each board meeting, whether or not an executive session is really necessary, alleviates the anxiety and tension management may feel if the executive session were called for a specific purpose, leading the CEO to worry: “What did I do wrong?” Whether the executive session is held regularly or only convened on an as-needed basis, it is important that the chair of the executive session meet with the CEO promptly after the session is adjourned and inform him or her of the matters discussed and convey any suggestions or recommendations the session produced.
Lead or Presiding Director Historically, leaders of major U.S. corporations wore two hats, serving as both chair of the board and CEO. This structure makes no sense if you believe that the CEO is the leader of the management team while the chair is the leader of the board. It should therefore come as no surprise that many governance debacles resulted from the failure of the board to have its own separate leader who could represent the interests of the directors when it came to creating the board meeting agendas, determining the salaries and bonuses for the CEO and members of the executive team, and evaluating the performance of the management. As a result of this obvious conflict, most corporations are now either separating the positions and appointing a chair of the board who is independent or permitting the CEO to remain as chair, while adding a new position: the so-called lead
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or presiding director, who will serve as the board’s leader. Although stockholder activists have persuaded some corporations to split the position of chair and CEO, it took the collapse of Enron and similarly misguided corporations to persuade directors as well as CEOs to accept the independent leader concept, which is rapidly becoming more widely accepted as a board best practice. Nevertheless, some business executives continue to reject the lead director concept because they believe it is likely to set off power struggles or lessen the CEO’s authority. However, most boards believe it is a necessary reform that will aid in shifting control of the boardroom from the CEO to the board of directors. Some CEOs are also fearful that assigning the chair’s title to an independent director creates a dangerous and confusing new level of authority. Their response typically has been, “You can’t run a corporation with two leaders.” This position is somewhat specious if you accept the fundamental governance principle that the board monitors the performance of management and therefore its monitoring function should not be led by the leader of the group that is being monitored. Flexible boards have reacted to this fear in some cases by allowing the CEO to retain the title of chair while appointing a lead or presiding director and adding the duties of a lead director to the duties and responsibilities of the chair of the governance committee (who must be independent), with the authority to:
° Serve as a liaison between the CEO and the board ° Assist the CEO in setting board agendas ° Ensure that management provides directors with the information they need to do their job
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° Preside at executive sessions of nonmanagement members of the board
° Ensure that the board’s evaluation of the CEO’s performance is properly conducted
Board Compensation The recent corporate scandals have affected both the demand for qualified, independent directors and the size and mix of directors’ fees. To attract experienced men and women who are willing to make a substantial commitment to board and committee responsibilities and to subject themselves to the risks of costly stockholder litigation, corporations will need to pay their directors annual cash retainers, board and committee fees, and committee chairman retainers that are larger than in the past. They will also continue to award their directors with equity compensation, although the equity portion of their compensation may be reduced while the cash portion increases. Some corporations have decided to eliminate stock options for directors altogether. This change is based on the current belief that the huge stock option packages granted to executive officers and directors during the dot-com boom encouraged them to focus on short-term operating results rather than long-term performance. As a result, the interests of the executives and directors were not aligned with the interests of the stockholders, especially stockholders who invested for the long term. Cash now appears to be the preferred payment alternative, but many of the corporations that still favor an equity component are imposing stock ownership requirements on their directors, which would obligate outside directors to acquire (either by grant from the corporation or by purchase) and retain a min-
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imum number of shares over a specified period (three to five years). It is likely that an increasing number of corporations will adopt board stock ownership guidelines. While surveys conducted by compensation consulting companies are useful, they are difficult to reconcile since the basis on which their surveys are conducted differs widely. For example, a survey may be limited to companies with median revenues of over $1.0 billion and market capitalization of over $5.0 billion, and therefore the data may not be very relevant to companies whose annual revenues and market capitalization are substantially lower. Nevertheless, some of the early 2003 reports indicated a movement by most corporations to lower board compensation, particularly that portion of the compensation payable to directors in stock and stock option awards, which then represented the major portion of the annual compensation paid to outside directors—up to 90 percent in some of the largest corporations. This reduction, however, may be attributable more to the overall significant decline in stock prices than in lower stock and stock option awards. Most corporations also obtain current board compensation data and trends by carefully reviewing the compensation sections (including equity grants) disclosed in the annual proxy statements of those companies with which they compete or are comparable in size in their industry. However, although studying comparables is useful, the determination of board compensation should be based on a carefully developed compensation strategy that takes into account the nature and extent of the directors’ contribution to the success of the corporation. There is no “one size fits them all” when it comes to board compensation. The board should consider the following factors in setting its compensation:
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° What is the board’s role? Are the directors passive overseers, or are they actively engaged in advising and assisting management in developing business objectives and opportunities, such as its strategy (and the success of the strategy), acquisition program, and marketing focus?
° How much time are the directors committing to their board and committee responsibilities?
° What would it cost if the corporation had to pay consultants or business advisers for the type of assistance and advice it receives from its directors? Although it may be helpful as a benchmark for a compensation committee to know what other corporations pay their directors, it is important to keep in mind other factors that affect the corporation’s ability to pay more or less than the surveyed corporations. These include the reputation and standing of the directors as well as the reputation and standing of the corporation; the attraction of service on the board; the revenue and profits of the corporation; the ability to pay directors compensation at or above the median amounts; and the peer benefits a director receives in serving on a board with members whose reputations and standing in the business world are widely acclaimed. Since the adoption of Sarbanes-Oxley, most corporations have taken action to significantly increase fees for members of the board’s audit and compensation committees because the time and effort that members of those committees must devote to comply with the new laws and regulations has increased substantially. Directors will also receive so-called special duty pay for the special services they may be asked to perform, such as serving on litigation or investigating committees that the board
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establishes. However, boards must be ever mindful that stockholders and their lawyers will object to special payments made to directors for the performance of their regular duties and responsibilities. It is unlikely that we will soon again see the type or size of payment that was made to a Tyco director—$20 million, which he shared with his favorite charity—for introducing a possible acquisition candidate to Tyco.
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Chapter Seven
Committees of the Board
Excessive CEO compensation is the “mad cow disease” of American boardrooms.
A
lthough the boards of directors of most U.S. corporations
regularly meet six to eight times a year, much of the work they do is performed by standing committees, principally the audit committee, the compensation committee, and the relatively new nominating and governance committee. In addition, special committees are often established to deal with specific problems or issues—for example, a special litigation committee to monitor major litigation, a special manufacturing committee to oversee the advisability of outsourcing the corporation’s manufacturing operation, a technology committee to oversee new technology programs and budgets, or a strategy committee to focus on the corporation’s strategic direction and alternatives.
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Special committees, however, can lead to tension and rivalries. Management may object because these committees are impinging on its right to manage the corporation, and directors who are not members may object because they become less informed and less involved as a result of the delegation of important oversight responsibilities to the special committees. These committees therefore should be used sparingly and judiciously and must share their data and recommendations with the entire board. Most corporations favor small committees for two reasons. First, the small size enables the members to get to know each other better, facilitates the rotation of committee memberships and chairs, helps spread the workload, makes it easier to convene meetings, and enables the corporation to staff the committee with directors who have the experience and knowledge to discharge the committee’s responsibilities. Second, it allows the corporation to assign its independent directors to committees that must be totally independent without expanding the board beyond its optimum size. Like board members, committee members must rely on information prepared for them by the corporation’s management team or by outside consultants or advisers. It is unlikely that there will be perfect symmetry between the information made available to the board and the committee members, not because management is seeking to withhold information, but because members of the management team are full-time employees and therefore are more informed than nonemployee directors who are part-time monitors and advisers. Directors who are committee members also seek additional information, on an as-needed basis, from outside consultants or advisers
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engaged by the committee, as well as assistance in developing committee-sponsored programs and policies. The composition and responsibilities of the three standing (or core) committees must in large part conform to requirements set forth in Sarbanes-Oxley and by the exchange on which the corporation’s stock is listed.
Audit Committee The audit committee monitors the integrity of the corporation’s financial statements, the independence and qualifications of the independent auditors, the performance of the corporation’s internal and independent auditors, the corporation’s compliance with legal and regulatory requirements, the effectiveness of the corporation’s internal controls, and the nature and extent of any permitted nonaudit services provided to the corporation. It is also responsible for retaining, compensating, and evaluating the corporation’s independent auditors and, if appropriate, recommending their termination. Sarbanes-Oxley requires that all members of the audit committee must be “super” independent: they are not allowed to receive payments other than directors’ fees and must not be affiliated with the corporation. All members must be able to read and understand financial statements. At least one member ought to be a “financial expert.” The corporation is required to disclose annually whether it has at least one “audit committee financial expert” on its audit committee and, if so, the name of the expert and whether the committee is independent of management. If the corporation does not have a financial expert, it must disclose that fact and explain why.
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Audit Committee Financial Expert The term audit committee financial expert was used in the final rules adopted by the SEC to emphasize that the designated person should have characteristics that are particularly relevant to the functions of the audit committee—for example:
° A thorough understanding of the audit committee’s oversight role
° Expertise in accounting matters, as well as an understanding of financial statements
° The background, experience, and ability to ask the right questions to determine whether the corporation’s financial statements are complete and accurate The full board of directors must make the determination of whether an audit committee member qualifies as an audit committee financial expert. This term is defined in the SEC’s final rules as a person with all of the following five attributes: 1. An understanding of generally accepted accounting principles and financial statements 2. The ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves 3. Experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the corporation’s financial statements, or experience actively supervising one or more persons engaged in such activities
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4. An understanding of internal controls and procedures for financial reporting 5. An understanding of audit committee functions To qualify as an audit committee financial expert, a person must have acquired these attributes through any one or more of the following means:
° Education and experience as a principal financial officer, principal accounting officer, controller, public accountant, or auditor or experience in one or more positions that involve the performance of similar functions
° Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor, or person performing similar functions
° Experience overseeing or assessing the performance of corporations or public accountants with respect to the preparation, auditing, or evaluation of financial statements
° Other relevant experience The audit committee must have the authority to engage independent counsel and other advisers it deems necessary to discharge its duties. The SEC rules include a safe harbor for persons determined to be audit committee financial experts. A director who is determined to be an audit committee financial expert will not be deemed an “expert” for any purpose, including, without limitation, for purposes of Section 11 of the Securities Act of 1933, as a result of such designation or identification. In addition, the
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safe harbor provides that the designation or identification of a person as an audit committee financial expert does not impose on the audit committee financial expert any duties, obligations, or liability that are greater than the duties, obligations, and liability otherwise imposed on such person as a member of the audit committee and board of directors. Such determination, however, does not affect the duties, obligations, or liability of any other member of the audit committee or board of directors. The audit committee must adopt a committee charter that will describe the committee’s duties and responsibilities. The charter must also be discussed with the corporation’s independent auditors and be submitted to the full board for its approval.
Internal Controls and Oversight of the Audit Committee’s Effectiveness Section 404 of the Sarbanes-Oxley Act and SEC supplementary rules require:
° The management of public corporations to assess the effectiveness of the corporation’s internal controls over financial reporting and include, in the corporation’s annual report to stockholders, its determination whether the corporation’s internal controls are effective
° The corporation’s independent auditors to report on and attest to management’s assessment of the internal controls In 2004, the Public Company Accounting Oversight Board (PCAOB) adopted a new auditing standard that addresses the
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outside auditor’s role in evaluating the assessment, including requirements that the auditors issue two opinions: one on management’s assessment of the internal controls over financial reporting and one on the effectiveness of the internal controls themselves. The PCAOB’s new standard also requires auditors to determine the effectiveness of the company’s audit committee (including the committee’s independence from management) as part of the auditor’s evaluation of the control environment and requires the auditors to advise the full board if and when they determine that a new weakness exists because of ineffective oversight by the audit committee. The new audit standard generated heated, if not emotional, criticism and opposition from reporting companies, auditors, investors, and governance pundits. The criticism focused on the heavy costs and valuable management time that will need to be committed for compliance with the new requirements. The critics contend that many of the new requirements are duplicative, unnecessary, and too costly, especially for small and medium-sized corporations. While the PCAOB recognizes that audit fees will increase, particularly for large and medium-sized corporations, it concluded that the costs will be far outweighed by the benefits. It remains to be seen who is right as the new requirements are implemented.
Trust, But Verify The audit committee must perform its duties and responsibilities aggressively and intensively. A committee member who is passive or uninformed should be promptly replaced. The complexity of the committee’s work and the importance of its
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position as the primary overseer of the tone at the top require that its members attend frequent meetings and dedicate long hours of preparation. The guiding principle should be, “Trust, but verify.” Committee members must bore into the financials, ask the difficult questions, say no to a transaction that cannot be properly explained, and have the courage to stand up to management and the auditors. The new certifications required of the CEO and CFO, while comforting, will not excuse an audit committee member from liability for the failure to perform his or her oversight responsibility effectively. Members of an audit committee who meet a couple of times a year during a rushed one-hour breakfast meeting before a regularly scheduled board meeting are likely to find themselves as defendants in financial fraud claims brought on behalf of the corporation’s stockholders. Given the complexity and importance of the audit committee’s work, failure to meet at least four to six times a year (depending on the size of the corporation and the complexity of its business and financial statements) will increase the risk that a court of law will find that the committee did not properly discharge its responsibilities. Each member should be aware of the corporation’s critical accounting policies and should have up-to-date knowledge of significant new accounting and auditing announcements, as well as new developments that affect financial reporting, including the following issues, which have been the focus of recent stockholder lawsuits:
° Revenue recognition ° Restructuring charges ° Impairments of goodwill
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° Capitalized expenses ° Bogus revenue ° Derivative transactions ° Special-purpose entities ° Swaps and barter transactions ° Abusive use of reserves Also, a corporation may experience a number of transactions that are not individually material but may be material in the aggregate. Therefore, each of these transactions should be questioned and understood to determine whether the “sum of all the immaterials” is material. In connection with its implementation of Sarbanes-Oxley, the SEC adopted rules to direct national securities exchanges and national securities associations to condition the listing of any company on compliance with the Sarbanes-Oxley’s audit committee requirements.
Compensation Committee The compensation committee has the responsibility for reviewing and approving the corporation’s compensation and benefits policies and objectives; determining whether the corporation’s officers, directors, and employees are compensated according to those objectives; and discharging the board’s duty to determine the compensation of the corporation’s executives. The NYSE requires the establishment of a compensation committee, all members of which must be independent and must act independent of management. Nasdaq provides a similar independence requirement for its listed companies, but in the event of “exceptional and limited circumstances” allows one
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director who need not be independent. The committee must retain its own consultants and seek to compensate management in a reasonable, cost-effective manner. The compensation committee must adopt a charter, approved by the full board, that describes the committee’s duties and responsibilities. The charter will be particularly helpful in eliminating any confusion or turf battles that might arise between the full board and the committee. In addition, the committee should establish principles governing the awarding of bonuses and incentive compensation. For example, it should determine whether bonuses should be tied to long-term corporate performance (rather than short-term stock market performance) in order to eliminate or mitigate the abuses resulting from a short-term focus on quarterly or annual operating results or from the manipulation of the numbers to meet analysts’ expectations. The Nasdaq rules governing executive compensation differ significantly from the NYSE rules. The directors are not required to establish a separate independent compensation committee, but executive compensation must be approved by either an independent compensation committee or a majority of the independent directors. If the full board is to make the final determination regarding executive compensation, all executives serving on the board (including the CEO) must recuse themselves from participating in the board’s deliberations and decisions after the CEO has presented his or her recommendations to the board. Because it has such a visible, direct effect on the corporation’s profits, executive compensation has become one of the most prominent governance issues. Over the past several years, executive compensation surged, largely because of the hefty gains that
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stock-based incentive plans provided. In the minds of many stockholders and regulators, the levels of cash compensation and bonuses paid to the executives of large U.S. corporations were excessive, if not outrageous. However, some supporters might justifiably argue that the compensation of the leaders of America’s largest corporations should be at least equal to or in excess of the lofty compensation levels enjoyed by this country’s top professional athletes, movie stars, and investment bankers. During the stock market boom and the irrationally exuberant, unprecedented climb in daily stock prices during the late 1990s, executive compensation skyrocketed, fueled principally by lavish fixed-price stock option grants to corporate executives that were not tied to corporate performance. If the stock price increased, the executives reaped the benefits even when the corporation’s performance failed to meet its targeted objectives. J. Richard Finlay, chair of Canada’s Center for Corporate and Public Governance, characterized the excessive CEO compensation of that period as the “mad-cow disease of American boardrooms,” which moved “from corporation to corporation, rendering directors incapable of applying common sense.” At the time, directors and compensation committees were apparently devoting substantially more time and effort to compensation matters than to ensuring that the corporation’s financial statements and operating results were being properly reported. For example, WorldCom’s audit committee was reported to have spent three to six hours one year overseeing a company with then over $30 billion in revenue, while its compensation committee met seventeen times that year. Huge stock option grants played a major role in enriching management. These options had several benefits. Until the options were exercised, the recipients (unlike stockholders who purchased and
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owned their shares) had no money at risk; if the price of the corporation’s stock dropped, the out-of-the-money options were replaced with new options exercisable at the then lower market price. Angry stockholders who suffered major losses as the market collapsed called for change and an end to the bounty being dispensed by boards and their compensation committees. It was also a period when favorable, sizable loans to executive officers became common, running up into the billions of dollars. Think of WorldCom’s Bernie Ebbers and Adelphia’s John Rigas. Did the directors who authorized these loans ever ask how multimillion dollar loans might benefit the stockholders? A knowledgeable CEO will want the company’s compensation committee to include as many CEOs as possible, particularly CEOs who customarily receive lofty compensation packages from their own companies. If you are a CEO, who would you select to determine your salary: a CEO or a university professor? A responsible board therefore must guard against a committee that has a high compensation bias. Instead, it should focus on assembling a committee whose members are independent, balanced, objective, and savvy and who will align executive compensation with the long-term interests of the shareholders and tie incentive compensation to the achievement of established performance metrics and strategic goals. Most corporate governance experts emphasize the need for collegiality in the boardroom to allow for free and open discussion, debate, and trust among the directors. However, too much collegiality may lead to superficial or unwise action, and many critics contend that too much collegiality (coupled with
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board lack of diligence) led to the compensation excesses of the late 1990s. If that wasn’t the reason, then what was Michael Eisner, Disney’s CEO, thinking when he hired Michael Orvitz as president of Disney and agreed to pay him $100 million if Disney fired him, which it did fourteen months after he was hired? What were the directors of the NYSE thinking when they authorized a $188 million CEO pay package for its CEO, Richard Grasso? Despite Sarbanes-Oxley and its reforms, compensation committees continue to face a multitude of complex compensation issues. Equities no longer have the holding power they once had as a result of the dramatic declines in stock values since 2001, and stockholders are fed up with large executive salaries and giant bonuses not tied to performance. Compensation committees have typically relied on compensation consultants to advise them on the factors commonly used to develop compensation programs and incentives. This practice has led to the use of peer group surveys and benchmarking, that is, comparisons with the wages of executives paid by competitors or other corporations included in the corporation’s peer group. The “comparable company” approach resulted in higher compensation levels for all executives, including increases to match competitors’ then-excessive compensation levels. In effect, the compensation of executives was not dependent on the performance of their corporations, but on the compensation being paid to the executives of other corporations who qualified as members of their peer group. Following that logic, the compensation committee believed it was acting responsibly. How, it asked, could a diligent committee justify paying its corporate executives less than the amount paid to
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executives in the peer group, regardless of whether the corporation met its performance objectives? In many cases, the corporate executives argued—and the compensation committee agreed—that the corporation had to pay executives aboveaverage compensation to keep its best performers happy and to attract needed new talent, going beyond even the guidelines offered by peer group comparisons. Some critics of excessive compensation awards also attribute the excesses to the compensation consultants whom management retained for independent advice. These critics have wondered out loud whether any of the hired compensation experts ever had the independence of mind, if not the audacity, to advise their corporate clients that their executives were being paid too much and that their salaries should therefore be reduced. It is highly unlikely that this unwelcome advice would have been provided to corporations that left the selection of the compensation consultants to the CEO or CFO. Another lesson that compensation committees should keep in mind in developing their corporations’ compensation principles is that the interests of holders of stock options are not fully aligned with those of stockholders. In fact, it is clear that many of the executives who held sizable stock options in America’s largest corporations never actually had any money in the game. They customarily followed the exercise of their stock options with an immediate sale of the newly acquired shares, primarily to raise the funds required to pay the income tax on the gain realized at the time of the option exercise (the gain being equal to the amount by which the value of the acquired shares at the time of exercise exceeded the option
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exercise price). Those executives who elected to retain the shares they acquired on exercise of their options usually borrowed the funds needed to pay the tax on the gain. In hindsight, that proved to be astute if the value of the retained shares increased, but disastrous if the value of the retained shares declined. In addition, it appears, contrary to past accounting policies, that the grant of stock options will be treated as a corporate expense at the time of the grant (assuming the accounting profession can agree on how to value the option grants). Therefore, compensation committees will have an added incentive to develop equity-based programs for a corporation’s senior executives, such as restricted stock awards, which avoid the stock option tax problems and the corporation’s expensing problems while requiring the recipients to retain the stock they are awarded for a specified period of years, thereby creating the alignment with the interests of stockholders that was originally intended. However, the tax treatment of restricted stock awards can be very burdensome, particularly if the recipient is prohibited from selling the stock for a specified period. Therefore, action by the IRS may be needed if this form of equity compensation is to find favor among corporate executives. While Sarbanes-Oxley has set the standards for the return of good corporate governance, comments made at a roundtable discussion on executive compensation in 2003 by the chief justice of the Delaware Supreme Court indicate that Delaware courts might hold corporate directors legally liable if they do not act in good faith in approving executive compensation packages. The chief justice urged boards to “demonstrate their independence, hold executive sessions, and follow governance
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procedures sincerely and effectively, not only to guard against the intrusion of the federal government but [to] guard against anything that might happen to them in court from a properly presented complaint.” He added, “If directors claim to be independent by saying, for example, that they base decisions on some performance measure and don’t do so, or if they are disingenuous or dishonest about it . . . the courts in some circumstances could treat their behavior as a breach of the fiduciary duty of good faith.”
Nominating and Governance Committee The nominating and governance committee is charged with identifying qualified individuals to serve on the board of directors, recommending the director nominees to the board for the annual meeting of stockholders, and developing corporate governance principles and guidelines. The NYSE rules require that director nominations be approved by a nominating and governance committee composed solely of independent directors, while the Nasdaq rules require that nominations be approved by either an independent nominating committee or a majority of the independent directors. In addition, if the board conducts annual or other periodic evaluations of its performance or the performance of individual directors, this committee is responsible for developing and conducting the self-evaluation process. The committee needs to adopt an orderly process for the selection of director candidates, including:
° Determining which talents, skills, and functional expertise are missing from the board and conducting an orderly
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search for experienced candidates who can fill the gaps in core competencies
° Selecting directors who are known to have good business judgment and are independent and unafraid to challenge conventional wisdom
° Establishing reliable processes for conducting due diligence on director prospects and ensuring that no invitation is extended to a prospect unless the committee so votes and authorizes one of its members to extend the invitation, ensuring diversity in the boardroom Some large stockholders, including institutional investors, pension funds, and unions, have urged that at least one member of the board of directors be nominated by stockholders; others have urged that two candidates be nominated for each directorship up for election, allowing the stockholders to select between the nominees. While the annual meeting proxy statements from U.S. corporations include an invitation to stockholders to submit recommendations for board membership, these invitations have produced few serious stockholder responses until recently. This lassitude has been diminishing, and a growing, well-organized movement has developed among stockholder activists seeking to require the nominating and governance committee to change the process and afford stockholders a limited right to participate in the nomination of directors. To facilitate the process, some stockholder groups are seeking to maintain a pool of professionally qualified independent director candidates. The resistance to this stockholder effort stems largely from the belief that each of the independent directors selected by a nominating and
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governance committee represents the interests of the stockholders and is not beholden to any special constituency. Therefore, structuring the process to guarantee a specific slot for a stockholder-designated nominee is unnecessary and disruptive, and it improperly casts doubt on the independence of the nominees selected by the nominating and governance committee (see Chapter Nine).
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Chapter Eight
Guidelines, Ethical Codes, and Legal Compliance
What is needed is a proactive CEO whose message resonates throughout the corporation and instills all employees with the resolve to help create a corporate culture that nourishes integrity and ethical behavior, penetrating all aspects of the corporation’s business and governance.
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o comply with new SEC, NYSE, and Nasdaq rules, listed
companies are required to adopt corporate governance guidelines, codes of conduct, and legal compliance rules.
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Corporate Governance Guidelines The governance guidelines provide a framework for the conduct of the board’s business and should include the following information:
° A listing of the principal duties and responsibilities of the directors
° The obligation of the directors to become and remain informed about the corporation’s business, including: The principal operational and financial objectives, strategies, and plans of the corporation The results of operations and financial condition of the corporation and of significant subsidiaries and business segments The relative standing of the business segments within the corporation and in relation to competitors The factors that determine the corporation’s success The risks and problems that affect the corporation’s business and prospects
° Determination that effective systems are in place for the periodic and timely reporting to the board on important matters concerning the corporation, including: Current business and financial performance, the degree of achievement of approved objectives, and the need to address forward-planning issues Future business prospects and forecasts, including actions, facilities, personnel, and financial resources required to achieve forecast results Financial statements, with appropriate segment or divisional breakdowns Adoption, implementation, and monitoring of effective compliance programs to ensure the corporation’s compliance with law and corporate policies
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Material litigation and governmental and regulatory matters Monitoring and responding (where appropriate) to communications from stockholders
° Director qualification standards, including: Independence Size of the board Limit on other directorships Tenure and retirement Duties of lead director (if appointed) Selection of new director candidates
° Board meeting processes and procedures, including: Selection of agenda items Frequency and length of meetings Advance distribution of materials Executive sessions Board committees’ membership and charters Director access to management and independent advisers Director compensation (and form of compensation) Director orientation and continuing education Management evaluation and succession Performance evaluation of the board Board interaction with institutional investors, the press, and customers
Code of Conduct and Ethics Sarbanes-Oxley requires each public company to disclose in its reports whether or not (and if not, why not) it has adopted a code of ethics for its senior financial officers. The NYSE,
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however, requires each listed company to adopt and make publicly available a code of business conduct and ethics for the company’s directors and all its employees and corporate governance guidelines addressing matters specified in listing standards. Nasdaq requires each listed company to adopt a code of conduct addressing, at a minimum, conflicts of interest and compliance with applicable laws and regulations, a compliance mechanism, and disclosure of any waivers to executive officers and directors. The code of conduct is intended to deter wrongdoing and promote the conduct of the corporation’s business in accordance with high standards of integrity and in compliance with all applicable laws and regulations. These include:
° Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships
° Full, fair, accurate, timely, and understandable disclosure in reports and documents that a corporation files with, or submits to, the SEC and in other public communications by the corporation
° Avoidance of conflicts of interest, including voluntary disclosure of any potential relationship or transaction that might give rise to such a conflict
° Compliance with applicable governmental laws, rules, and regulations
° The prompt internal reporting of code violations to an appropriate person or persons identified in the code
° Accountability for adherence to the code While new laws, rules, and regulations may serve as guidelines for the creation of public trust and confidence in the cor-
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poration’s accounting and disclosure systems and compensation practices, the corporation will not earn that trust and confidence unless it is led by a proactive CEO who believes in corporate integrity and ethical behavior, acts ethically, talks explicitly and repeatedly within the corporation of the need to promote integrity, denounces overreaching, and makes believers of the corporation’s officers, employees, customers, suppliers, and advisers. This message must resonate throughout the corporation and instill in all employees the resolve to help create a corporate culture that nourishes integrity and ethical behavior, flowing from both the top down and the bottom up and penetrating all aspects of the corporation’s business and governance.
Legal Compliance and the “Noisy Withdrawal” Quandary In January 2003, the SEC adopted rules that set standards of professional conduct for attorneys appearing and practicing before the SEC in any way in the representation of corporations subject to SEC regulation. In addition, the SEC approved an extension of the comment period on the “noisy withdrawal” provisions of the original proposed rule and publication for comment of an alternative proposal. The rules adopted by the SEC will, among other things:
° Require an attorney to report evidence of a material violation, determined according to an objective standard, up the ladder within the corporation to the chief legal officer (CLO) or the chief executive officer of the corporation or the equivalent.
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° Require an attorney, if the CLO or the CEO of the corporation does not respond appropriately to the evidence, to report the evidence to the audit committee, another committee of independent directors, or the full board of directors.
° Clarify that the rules cover attorneys who provide legal services to a corporation with which they have an attorneyclient relationship and who have notice that documents they are preparing or assisting in preparing will be filed with or submitted to the SEC.
° Allow a corporation to establish a qualified legal compliance committee (QLCC) as an alternative procedure for reporting evidence of a material violation. The QLCC would consist of at least one member of the corporation’s audit committee, or an equivalent committee of independent directors, and two or more independent board members. It would have the responsibility, among other things, to recommend that a corporation implement an appropriate response to evidence of a material violation. An attorney can satisfy the rule’s reporting obligation by reporting evidence of a material violation to a QLCC.
° Allow (but not obligate) an attorney, without the consent of the corporation, to reveal confidential information related to his or her representation to the extent the attorney reasonably believes it necessary to prevent the corporation from committing a material violation likely to cause substantial injury to the financial interests or property of the corporation or investors; prevent the corporation from committing an illegal act; or rectify the consequences of a material violation or illegal act in which the attorney’s services have been used. In addition, the final rules establish an objective, rather than a subjective, triggering standard, involving credible evidence
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based on which it would be unreasonable, under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur. As proposed, the rule would impose a duty on outside counsel to effect a noisy withdrawal as counsel if the corporation fails to respond within a reasonable period of time to reported violations or if it fails to respond appropriately. The noisy withdrawal obligation would require counsel to give prompt notice to the SEC of its withdrawal. In this notice, it would indicate that the withdrawal was based on professional considerations and promptly disaffirm any opinion, document, affirmation, characterization, or the like in (or incorporated in) a document filed with or submitted to the SEC that counsel has prepared or assisted in preparing and that counsel reasonably believes is or may be materially false or misleading. It was no surprise that leading securities practitioners objected to the noisy withdrawal provision on several grounds, in particular because its application would constitute a damaging encroachment on the attorney-client relationship. Although I am unable to predict how the SEC will resolve the issue (I expect a compromise will be the result), the new rules, with the mandatory up-the-ladder reporting scheme and the statutory protection of whistle-blowers, will significantly strengthen the ability of the board of directors to perform their critical oversight responsibility and create a corporate environment free of dishonesty, fraud, and illegal activity.
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Chapter Nine
Revolt of the Stockholders
The 2003 and 2004 proxy seasons will be remembered as the time when stockholder activists took steps to change the way their corporations are governed, their directors are nominated, and their executives are compensated.
I
n his February 2003 annual letter to the stockholders of
Berkshire Hathaway, Warren E. Buffett, chair of Berkshire’s board, made the case for greater involvement by large stockholders in reforming corporate governance. He wrote: When the manager cares deeply and the directors don’t, what’s needed is a powerful countervailing force—and that’s the missing element in today’s corporate governance. Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by big owners. The logistics aren’t that tough: The ownership of stock has
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grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty—or even fewer— of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior. In my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved.
Stockholder Proposals and Rule 14a-8 Rule 14a-8 under the Securities Exchange Act of 1934 generally requires a corporation to include proposals submitted by stockholders in the corporation’s proxy statement for presentation to a vote at a stockholders’ meeting. This rule permits an owner of a relatively small number of the corporation’s shares to present a proposal to the stockholders unless the corporation can convince the SEC to issue a letter stating that it will not recommend enforcement action against the corporation if it excludes the proposal from the proxy material because it falls within one of the thirteen provisions of the rule that permit exclusion or does not satisfy the rule’s procedural requirements. The most commonly used exclusion has been the “ordinary business exception.” This allows the corporation to exclude a stockholder proposal if the staff of the SEC determines that it relates to the corporation’s ordinary business. Advocates of greater stockholder involvement have substantially increased their participation in the annual meeting proxy process over the past several years. In 2003 and 2004,
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stockholder advocacy groups filed a record number of stockholder resolutions for inclusion in the annual meeting proxy statements of many of America’s largest publicly traded corporations. The stockholder-proposed resolution route was traditionally used primarily by stockholders advocating social and environmental reforms. In the aftermath of Enron, however, this practice has become increasingly popular among those stockholders who are advocating changes in corporate governance designed to make America’s publicly traded corporations more trustworthy and stockholder oriented.
The Issues Past proposals have encompassed a number of important corporate governance issues, including:
° Pay disparity and excessive CEO compensation ° The separation of the CEO and chair positions ° Elimination of classified boards ° Stockholder approval of poison pills ° Expensing of stock options ° Tying executive pay to performance ° Performance-based indexed stock options ° Executive severance arrangements ° Director-election processes, including stockholder nominations for board positions
° Board diversity ° Mandatory binding effect of majority stockholder vote
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Among the leading social issues encompassed by the proposals are these:
° The environment, including climate change and measurement of greenhouse gases
° Health care and health issues ° Global labor standards ° Drug development ° Human rights ° Equal employment opportunities ° The global AIDS crisis Historically, angry stockholders voted with their feet. If they didn’t trust corporate management or disapproved of the corporation’s performance, they would sell their shares and invest the proceeds in other corporations whose management and directors reacted positively to stockholder concerns about corporate governance issues and social issues. Now these stockholders are angry and prepared to fight rather than walk away. Their battle cry is, “We are owners of the company, and we no longer intend to walk away from the battle, but are determined to fight for what we believe.” Although stockholder resolutions are not binding (even when they do receive a majority vote), they nevertheless put public pressure on the corporation’s management and board and constitute a public expression of anger or dissatisfaction. This can embarrass management and eventually lead to less resistance by management and the board—and even acquiescence.
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While the movement toward increased stockholder participation may be healthy and timely, many boards caution that it would be a mistake to mandate that stockholder proposals that receive a majority vote should bind the corporation. They submit that independent directors are presumed to have the ability and knowledge to determine whether implementation of a stockholder-approved proposal, although meritorious, would be harmful or inimical to the corporation’s operation; could adversely affect segments of the corporation’s business; or would, on balance, be detrimental to its relationships with its employees, customers, or suppliers. These boards further contend that if the directors don’t have the requisite knowledge or experience or if they fail or refuse to listen to the stockholders, the remedy is not to turn over the governance of the corporation to thousands of stockholders. Instead, they suggest, the boards should function as every representative form of government does: with stockholders submitting their own nominees for election to the board and voting for directors who more accurately reflect the views of the stockholders or who, if they disagree with the stockholders, are able to demonstrate that their disagreement is based on their independent and informed judgment of what is in the best interests of the corporation and its stockholders. They might also find comfort in the words of Thomas Jefferson, who warned, “You should not undertake great departures on marginal majorities.” Despite strong resistance by this country’s mutual funds, the SEC decided in early 2003 to require all publicly traded mutual funds to disclose annually how they voted the shares of stock of corporations they own on matters submitted by the
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corporations for action by their stockholders at annual stockholders meetings. This disclosure will, for the first time, allow stockholder advocacy groups to determine how the funds voted. This information will be particularly helpful to stockholder advocacy groups in planning strategies intended to secure favorable fund votes for their proposals and negative votes on matters presented by the board and management whom they oppose. While the availability of the funds’ voting records may lead to increased pressure and lobbying by stockholder activists aimed at convincing the funds, particularly those with substantial stock ownership, to vote with them, no assurance can be given that the funds, which have their own agendas and areas of interest, will be persuaded to do so by the stockholder activists. Nonetheless, the new voting disclosure requirements will certainly create important opportunities for battle-trained stockholder advocacy groups to influence the votes of some of the largest owners of stock in America. This, in turn, may increase the power and influence of stockholder advocacy groups and enhance their opportunities to win proxy fights that they have historically lost. This new SEC reporting requirement is also in line with statements made by SEC commissioner Cynthia A. Glassman, who warned that “regulations can only go so far”; they “cannot legislate ethical behavior.” She noted the important role of insiders and “gatekeepers” (including stockholders; inside management; and outside parties such as auditors, attorneys, and audit committee members) in preventing breakdowns in corporate governance, while adding, “Active and informed investors act as another check on corporate management. . . . The notion of an educated shareholder as a good corporate citizen dovetails with good investor education.”
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While confrontation is often necessary, stockholders who seek changes in corporate governance or a corporation’s position on social or economic issues should first consider a positive educational approach. If that doesn’t work, they should consider the stockholder-proposal confrontational approach. Providing the management and board with a thoughtful and balanced position paper setting forth the benefits of the action proposed by the stockholders—and following this with an inperson information session with management, during which the proponents can present their position, answer management’s questions, and focus on the merits of the proposal—may lead to agreement between the stockholders and management and obviate the need for a confrontational, public proxy battle. Moreover, education can be a two-way street: management may be able to persuade the stockholder proponents to drop their proposal or defer it. Calpers, the country’s largest public pension fund, maintains a “Focus List,” which identifies companies that Calpers believes should follow better corporate governance practices. Companies that are added to the Focus List are generally subject to widespread criticism, which can be embarrassing to the named companies and generate anger from their stockholders. Once a company is included in the Focus List, Calpers requests a meeting to discuss how the company intends to address Calpers’s concerns about the company’s corporate governance. If the company refuses to meet or to make the changes, Calpers attempts to apply pressure through stockholder proposals or proxy campaigns. However, Calpers undertook a more active role in 2004 designed to persuade corporations to improve their corporate governance by withholding votes for the reelection of incumbent
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directors of corporations in its investment portfolio who authorized excessive executive compensation or approved the selection of accounting firms that audited the corporation while also performing consulting work and “nonaudit services” for the corporation. Calpers’s renewed activism came at a time when many business groups and corporate governance experts were challenging several of the new rules proposed by the SEC, particularly those proposals that would permit stockholders to submit resolutions for the nomination of board members and require the corporation to provide those nominees access to the corporation’s proxy. The 2003 and 2004 proxy seasons will be remembered as the time when bold action was initiated by Calpers, other large investors, and stockholder advocates seeking to change the way their corporations are governed, their directors are nominated, their executives are compensated, and their defenses against unsolicited takeovers are approved. The success of their advocacy will depend on their ability to persuade directors that the proposals they advocate are reasonable, are important to the corporation, require immediate action by the stockholders, and are designed to enhance shareholder value and instill stockholder confidence and trust in the governance of the corporation. The risk is that multiple stockholder-sponsored proposals may be confusing and perceived as overkill and may dilute or turn off otherwise favorable stockholder reactions while generating fervent opposition from management and the board because of their number, complexity, and lack of relevancy. Focus, persuasion, and open communication, including coordination among advocacy groups with different agendas, are therefore critical to the corporation’s support of the proposals and ultimately to stockholder approval.
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New SEC Rules Because of the increasing popularity and use of stockholder proposals and the movement to limit application of the ordinary business exception, the SEC in 2003 undertook a comprehensive review of its proxy rules regarding stockholder proposals. That review resulted in the SEC’s adoption of new rules requiring public companies to disclose their processes for nominating corporate directors and procedures for stockholder communications with directors. It also resulted in a controversial proposal that would allow stockholders, subject to the satisfaction of certain requirements, the limited right to participate in the nomination of directors of public companies through direct access to the corporation’s proxy statement.
Stockholder Nominations and Other Communications In November 2003, the SEC adopted new proxy statement disclosure requirements intended to “increase the transparency of nominating committee functions and the processes by which stockholders may communicate with boards of directors.” The SEC also adopted new disclosure standards that require the disclosure of information regarding stockholder communications with directors. Stockholders have historically been frustrated by their inability to communicate with the management and directors of the company whose shares they own. Their letters were too often unanswered, their suggestions for director nominations were ignored or, if answered, usually authored by the company’s investor relations personnel. The new provisions apply to proxy statements first mailed to stockholders on or after January 1, 2004.
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Disclosure of Nomination Process The new disclosure standards require companies to disclose important additional information regarding a company’s process of nominating directors, including the nominating committee charter, if any; nominating committee member independence policies; candidate selection criteria and procedures; policies with regard to candidates recommended by stockholders; procedures for stockholder nominations; and information concerning decisions by the nominating committee not to include a candidate named by large, long-term stockholders.
Disclosure of Communications Between Stockholders and Directors The new disclosure standards also require companies to disclose significant additional information regarding stockholder communications with directors, including whether a company has a process for communications by stockholders to directors and, if not, the reasons that it does not; the procedures for communications by stockholders with directors and whether such communications are screened and, if so, by what process; and the company’s policy regarding director attendance at annual meetings and the number of directors who attended the prior year’s annual meeting.
Stockholder Access In October 2003, stockholder activism received an even greater boost when the SEC proposed a rule that would afford stock-
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holders a limited right to participate in the nomination of directors of public companies. Currently, stockholders are asked to vote for the election of a slate of candidates nominated by the board and heavily influenced by the CEO. The election of the slate is virtually ensured unless it is contested in a proxy fight, which can be very expensive, divisive, and often damaging to the company. The new rule, if adopted, would arm stockholder activists with a new weapon for influencing corporate boards, designed to permit stockholders to act when they are not satisfied with the board’s nominees. The proposed rule contemplates a two-step, two-year process. In the first year, the triggering event is either (1) a majority stockholder vote on a proposal requesting stockholder access to the corporation’s proxy submitted by a stockholder or stockholder group holding 1 percent of the company’s stock (for at least one year), or (2) the decision of the holders of more than 35 percent of the votes cast to “withhold” their votes for the board’s one or more nominees. In the second year, the election occurs when the stockholder-nominated board candidates run as challengers to the board’s nominees in the company’s proxy statement. To be eligible, stockholders must have the right under applicable state law to nominate a director, and the stockholders submitting the nomination must have beneficially owned more than 5 percent of the company’s voting securities for at least two years and intend to continue to hold them through the date of the proposed election of directors. The number of stockholder nominees is determined by the size of the board: one nominee for boards of eight or fewer, two for boards of nine to nineteen members, and three for boards with twenty or more members. In effect, therefore, it is likely
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that successful implementation of the proposed rule would result in the election to an average-sized board of only one or two watchdog directors. Nonetheless, the proposal has been the subject of heated debate and intense criticism and has sparked over fifteen thousand comment letters, mostly from opponents of the rules. The Business Roundtable has taken the position that the proposed direct access rule exceeds the SEC’s statutory authority and that if adopted would establish a new federal right to gain access to company proxy materials to nominate directors in the absence of any corresponding state privilege. Its rationale is that absent express congressional authorization, the SEC lacks authority to regulate corporate governance, and Sarbanes-Oxley didn’t give it the authority to create the proposed rule. Most of the critics, including several business groups and knowledgeable corporate lawyers, oppose the proposed rule because they believe that the new NYSE and Nasdaq director independence rules (together with the new disclosure standards requiring more robust disclosure of the nominating committee processes and the consideration of candidates recommended by stockholders) make the nomination process more transparent and accessible and substantially less CEO dominated. They propose waiting to see how the Sarbanes-Oxley reforms and the new rules work. They also believe that providing stockholder access to the company’s proxy ballot will result in challenges at corporations where no problems exist; lead to the creation of special-interest directors who will use their position to promote their personal agendas; result in time-consuming, disruptive annual election contests; create friction between the boardnominated directors and the stockholder-nominated directors;
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and discourage qualified director candidates from serving as directors of public companies. The SEC’s proposal addresses the special-interest concerns by requiring that the stockholder nominees must be independent and have no ties to the nominating stockholder group. Proponents of the rule contend that the “special-interest” argument is specious because the election of stockholder nominees to the board is dependent on favorable votes from large stockholders with no relationship to the sponsoring group. As for the potential negative impact on incumbent directors if the proposal is adopted, only time will tell. However, there is a danger that the risk of being challenged publicly for reelection may, in addition to being time-consuming, deter directors from agreeing to serve, fearing that they may be subjected to a nasty proxy contest that could adversely affect their reputation and standing in the community. Both the opponents and advocates of the proposed stockholder access rule have legitimate concerns. However, even if the proposal is not adopted, the debate should be beneficial because it will reinforce the need for electing better directors and aid in persuading boards to nominate them.
Scorekeepers In 2003 and 2004, there was a substantial increase in the influence of the “scorekeepers” who analyze, judge, and rate the corporate governance and accountability practices of publicly held corporations. Institutional Shareholder Services, which was founded in 1985 and serves as a proxy adviser to many institutional investors during the annual proxy period, has created the
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Corporate Governance Quotient to rate most publicly traded corporations on approximately eight corporate governance factors and more than sixty subsets of the major factors, including board structure (staggered or annual board elections), board composition, charter and bylaw provisions, separation of chairman of the board from CEO, executive and director compensation,
supermajority
voting
requirements,
director
independence, directors’ and officers’ stock ownership, and director education. These scores are available to subscribers— including large stockholders, mutual funds, and pension plans— and influence the corporate governance reputations of the scored corporations. A corporation that scores poorly risks being viewed negatively by institutional and other large investors, which in turn may use the low scores to bolster support for their proposals. Other scorekeepers that influence corporations that they rate include the Domini 400 Social Index, TIAA-CREF, Calpers, the AFL-CIO Office of Investment, and the Council on Institutional Investors. In 2003 the Investor Responsibility Research Center helped develop a corporate governance rating system based heavily on quantitative factors. The influence of these organizations on the corporate governance and social responsibility of the corporations they evaluate has increased substantially as a result of their efforts to make U.S. corporations more responsible to their stockholders and the communities in which they reside. They are also a reaction to the corporate excesses and abuses that have provoked broader stockholder activism as well as new legislative and regulatory initiatives designed to create public trust in critical elements of our corporate world and economic system.
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However, scorekeepers that rate corporations on fifty to sixty issues may be less effective than if they rated them on ten or fifteen of the major factors that determine good corporate governance. Too much information diminishes the value of the information, and the most important findings are often lost in the shuffle. In addition, a corporation may be very profitable, highly ethical, and resolute in abiding by the most conservative financial accounting and reporting rules and yet be ranked below less successful corporations as a result of the low scores it receives because all of its directors are not independent; or all of its directors are not elected annually (but instead on a staggered basis); or its directors decide in good faith to retain its shareholder rights plan; or its directors failed to attend prescribed corporate governance continuing-education programs during the past year; or one or more directors have passed the scorekeeper’s mandated retirement age. Therefore, although the published ratings may provide useful information, investors should be judicious in how they are applied and measured.
Stakeholders Throughout the 1990s, the interests of the stockholders dominated while the stakeholders were largely ignored. However, the recent successes of stockholder activists have also had a salutary effect on the rights of stakeholders—that capacious group that shares a stake in the corporation and includes employees, managers, customers, creditors, suppliers, and the communities in which the corporation conducts its business.
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The stakeholders contend that the corporation must consider the impact of its decisions on more than just the stockholders. Outsourcing to India or China may enhance corporate profits. But it may also result in the termination of the U.S. employees who formerly performed the now-outsourced operation while adversely affecting the corporation’s relationship with its suppliers, its community, and the services the community offers to its residents. Environmental policies, climate change, minority employment policies, employee health care programs, retirement benefits, educational and advancement opportunities, and human rights are among the issues that affect stakeholders and also affect the corporation’s operations, profits, and ultimately the value of each stockholder’s investment. As stakeholders continue to voice their concerns and attempt to balance their interests with those of the stockholders, directors will be confronted with a long-standing position of stakeholders: that the board owes a duty not only to the stockholders but to the corporation, which in turn allows the directors to decide to take action that may serve to enhance the interest of its stakeholders even though that action may result in a reduction in stock value. This Solomonic decision, while legally allowable, will test the resolve of the best of directors.
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C h a p t e r Te n
Evaluation of Board Performance
Self-assessment of directors’ performance is receiving increasingly wide acceptance as board members realize that they are in the best position to evaluate their board performance.
S
elf-evaluation, which has been receiving increasingly wide
acceptance, is based on the belief that the directors themselves are in the best position to evaluate their performance. Many corporate governance advisers recommend that the board conduct a self-evaluation of its performance every two years because more frequent review may be unnecessary and the process is time-consuming and often disruptive. However, the
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NYSE requires that the boards of its listed companies evaluate their performance annually. While assessment of the performance of the board as a whole has not been a controversial practice, peer evaluation, or assessment of the individual performance of each director, has not been generally favored, primarily because directors don’t want to be put in a position of criticizing their colleagues. Nevertheless, assessment of individual director performance is gaining acceptance as fiduciaries struggle in the post-Enron era to gain the trust and confidence of stockholders. The value and acceptability of board assessment are dependent, in large part, on the process used in conducting the assessment. Most boards are likely to assign the assessment function to the nominating and governance committee, which, having the responsibility for selecting and nominating director candidates, should also have a thorough knowledge of how well the board is performing and which board talents and expertise are needed for improved board performance. In the assessment of individual board member performance, each director should be asked to evaluate his or her codirectors on these abilities:
° Independence and willingness to challenge management ° Knowledge of the corporation’s business ° Experience ° Commitment ° Preparation ° Competencies ° Contributions ° Personal characteristics
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° Ability to function as part of a team ° Concern for the stockholders The assessment criteria should correspond in large part to the criteria established for the nomination of directors, be linked to the principal duties and responsibilities that the board is expected to perform, and be benchmarked against the board’s agreed-on goals and objectives for the relevant assessment period. The assessment will prove to be beneficial to the directors, as well as to management and stockholders, only if the process encourages directors to perform the difficult task of critiquing the performance of their colleagues individually and as a group. This requires honesty, fairness, courage, and a good dose of diplomacy. In conducting its evaluation, the board should evaluate and compare its performance against its duties, responsibilities, and specifically approved objectives as benchmarks. The objectives might include a reexamination and updating of the corporation’s management succession plan, modification of the corporation’s executive compensation program, review of the advisability of moving a significant manufacturing or service operation overseas, or consideration of adoption of an acquisition program (or modification of an existing program). The review should include a thoughtful discussion and analysis by the directors at a board meeting specifically scheduled for this purpose, as well as a review of responses of the directors to a board performance survey or evaluation questionnaire. Organizations that focus on corporate governance issues and the education of corporate directors have developed extensive checklists and guides for assessing board and individual
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director performance. Some of these may also be used to conduct or assist in the evaluation process. Since the enactment of Sarbanes-Oxley, the number of boards engaged in formal, written board assessments has increased substantially. However, many directors are wary of formal questionnaires and written assessments. They fear, usually based on counsel’s advice, that written assessments, particularly negative comments and criticisms, are discoverable and might be used against them and subject them to potential liability in future lawsuits or investigations. Nevertheless, written questionnaires may be prepared that elicit needed information and provide helpful advice to directors who need it without at the same time condemning them or subjecting them to future lawsuits. Also, open discussions of board performance can be productive if directors are willing to listen impassionately to criticisms or suggestions for improvement without evincing resentment against those who are critical. Following are some of the types of questions that, if properly answered, would help in evaluating both the board and individual director performance. Evaluation of the Board
° Are the directors independent, enthusiastic, informed, and fully committed to serving on the board?
° Do the directors have business savvy and the requisite knowledge about the corporation’s business and competition?
° Do the directors have the right experience and the desired mix of skills and expertise the board as a group requires?
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° Are the directors prepared for board meetings? ° Has the board determined its duties and responsibilities and the expectations of each director?
° Has the board identified and prioritized those issues it believes should be discussed with management on a regular basis?
° Is the board willing to challenge management when required and fire executives who are mediocre?
° Does the board review, approve, and monitor the operating and strategic plans developed by management?
° Does the board have an up-to-date, corporatewide succession plan in place?
° Does the board regularly evaluate the performance of the CEO and other senior executives?
° Has the board adopted a management compensation plan that fairly and effectively rewards performance?
° Have the directors and the CEO created a relationship that promotes open and frank discussion?
° Have the board and its committees been productive and effective?
° Does the board work well with the CEO and other executives?
° Are the directors properly and fairly compensated for their services? Evaluation of the Individual Directors
° Is the director committed? ° Does the director attend all scheduled board and committee meetings?
° Is the director prepared for the meetings and in a position to make informed decisions?
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° Does the director understand his or her fiduciary duties and legal obligations?
° Is the director available to the CEO for consultation or advice when needed?
° Is the director objective, or does he or she tend to rubberstamp management?
° Is the director too passive, indifferent, or unwilling to challenge management?
° Does the director contribute positively with constructive criticism, creative solutions, and positive recommendations?
° Does the director have good judgment? ° Does the director have inestimable value, special skills, unique knowledge, or special relationships or contacts that are helpful to both other directors and management?
° Does the director interfere with management—that is, does he or she seek to manage the corporation rather than oversee its management?
° Is the director obdurate or acerbic? ° Is the director aware of the corporation’s compliance programs and procedures, including its code of conduct and ethical guidelines, and has he or she made an effort to ensure that they are implemented and observed? While it is not a universal practice and most have chosen not to adopt it, the boards of some public corporations have invited periodic review of the board by the corporation’s management. Who among the management team is asked to participate and the nature and scope of the assessment and method employed to conduct it will vary among corporations, depending in large part on the willingness of the directors to be criti-
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cized by management and how they respond to management’s criticism. Unless the assessment is properly and sensitively planned and conducted, management will be unlikely to be candid or courageous. Therefore, a less formal type of assessment through one-on-one discussions with members of the senior management team may be more productive. The board’s periodic review of its performance as measured against its objectives and responsibilities can provide helpful information as well as guidance, but directors should be wary of spending too much time on checking the boxes, which can be both unproductive and disruptive. They should be mindful of the sad experience of the gardener who continually pulls up his plants by the roots to see how well they are growing.
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Chapter Eleven
Effect of Sarbanes-Oxley on Private Corporations
Good corporate governance is good for business, whether the business is large or small, public, private, or even nonprofit.
W
hile the Sarbanes-Oxley Act will dramatically change the
way publicly held corporations behave by mandating specific, comprehensive corporate governance rules and guidelines, most of the act’s provisions have no legal application to privately held corporations. However, that does not mean that the governance systems and best practices that publicly held corporations are adopting in response to the new federal law will be ignored by privately held corporations.
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The fact that a corporation is not publicly owned does not excuse it from conducting its affairs openly and ethically, and it does not mean that the corporation cannot benefit from developing a more effective system of corporate governance. In the post-Enron era, there will be increasing pressure on privately held corporations, nonprofit institutions, and universities and colleges to adopt some of the reforms and new governance structures and practices that their public counterparts have already adopted, because they are confronted daily with many of the problems that public corporations ordinarily face. In addition, the owners of private corporations and the trustees of nonprofit institutions are likely to conclude that the new rules and best practices make good business sense and will benefit and enhance the value of their entities. If the new rules restore honesty, fairness, and ethical behavior to public corporations, they are likely to become objective standards by which both public and private corporations and nonprofits will be judged. Because compliance with many of the key requirements of Sarbanes-Oxley is costly and time-consuming and is likely to produce some unintended consequences, most private corporations will elect to ignore them unless they derive significant benefits from their compliance—for example:
° Improvement in their financial reports resulting from the application of many of the new audit committee requirements, the latest auditing standards, and generally accepted best governance practices
° Improved participation and assistance from independentminded directors operating within thoughtfully developed committee structures
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° Reductions in the relentless increasing cost of directors’ and officers’ liability insurance
° Enhancement of opportunities to obtain equity funds as well as bank loans from venture investors and banks that favor companies that have and observe codes of conduct and ethical guidelines Except for small, family-owned businesses, which have their own unique benefits and problems, most private corporations have a long-term exit strategy or liquidity strategy. In the case of venture-financed corporations, the venture investors typically plan to take the corporation public, merge with a public corporation that has an active market for its stock, or sell the corporation or its assets for cash or freely tradable securities. The public investors or potential purchasers of the corporation will expect that the corporation has operated its business honestly and ethically. In addition, in the case of the acquisition of a private corporation by a public corporation, the key employees of the acquired corporation, and particularly those who become executives of the acquired corporation, will be bound by (and therefore must be familiar with) the Sarbanes-Oxley requirements and restrictions. This includes the requirement to certify to the accuracy of financial statements, the prohibition of corporate loans to executive officers, and the restrictions on insider trading. Moreover, a private corporation that is about to launch an IPO will be able to perform more comfortably in the public arena if it has a prior history of operating as if it were a public corporation—that is, its board has experience with independent
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directors; the directors serving on its audit committee are financially literate; it has adopted, observes, and enforces a code of ethics; and its executive compensation system is fair and will withstand careful public scrutiny. When the prospectus is written for the IPO, the corporation’s historical governance structure and practices will be closely scrutinized. If they portray a disciplined corporation that has followed generally accepted governance best practices, investors are more likely to view the corporation favorably and have greater confidence in its management and directors. Even if the corporation never goes public, the ripple effect of Sarbanes-Oxley will change the way many small, private corporations manage their affairs. Private corporations that are ethical and have good corporate governance and independent directors are more likely to attract and retain loyal employees, customers, and suppliers. In short, good corporate governance is also good for business, whether the business is large or small, public, private, or nonprofit.
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C h a p t e r Tw e l v e
Nonprofit Entities
Trustees and directors of nonprofits would be well advised to consider adoption of changes in their ethical guidelines and codes of conduct along the lines currently favored by profit-motivated corporations.
N
o one really believes that colleges, universities, hospitals,
museums, and other charitable and nonprofit entities should be managed and operated using the same rules, objectives, strategies, and practices that are employed by this country’s leading public corporations. So why should directors and trustees of nonprofit entities be concerned about the changes brought about by the Sarbanes-Oxley Act when that act applies only to corporations whose stock is publicly traded? After all, the instances of fraud and “perp” walks by executives of nonprofits
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have been rare and almost inconsequential when compared with the dreadful fraud and carnage that have plagued corporate America during the past five years. Directors of publicly held corporations are guided by a transcendent fiduciary duty to enhance shareholder value. The trustees of colleges and universities have multiple fiduciary obligations to a wide range of constituencies, including the student body, faculty, administration, and communities in which they are located. Their success is judged not by how much profit they create for their stockholders, but how well they fulfill their educational objectives. Nonetheless, while no one can responsibly believe that the Boston Symphony Orchestra should be managed like a business using the best practices, strategies, and governance objectives employed by, for example, General Electric, Microsoft, or Merck, all of us can and should recognize the value of the major changes and reforms that are taking place and the governance best practices that are being adopted and applied to regain public trust and confidence in corporate America. Because of their composition, size, and goals, most nonprofit boards may not function with the same level of overall enthusiasm, commitment, and knowledge as the directors of for-profit corporations. The nonprofit boards are customarily much larger and serve multiple constituencies with differing, and sometimes competing, objectives. For fundraising purposes and overall institutional support, nonprofit entities prefer boards with as many participants as possible short of creating a town meeting environment. Trustees of nonprofit entities are often the most generous and devoted donors, so broad participation makes sense financially. However, to avoid confusion,
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preserve interest, and ensure responsible stewardship, most of the serious work of governing is performed by board committees, with significant control and leadership assigned to the committees and their chairs. Most trustees of nonprofits understand that their responsibility is not to manage the entity, but to provide oversight, with specific emphasis on evaluating management and determining the compensation of the CEO and management team; approving the annual budget; reviewing and approving the entity’s mission and its near- and long-term strategies; and ensuring that the entity’s code of conduct, compliance programs, and ethical guidelines foster integrity and proper behavior. Believing that they serve primarily to promote charitable and philanthropic goals, many trustees and overseers of nonprofit entities do not feel bound by the “accountability” required of corporate fiduciaries, a belief that is reinforced in part by the fact that episodes of fraud and corruption in the charitable and philanthropic world have been relatively rare. However, given the exposure of Sarbanes-Oxley, trustees and directors of nonprofits, particularly those that receive funds from private donations or government grants or contracts, would be well advised to consider adoption of changes in their ethical guidelines and codes of conduct along the lines of those currently favored by profit-motivated corporations, conduct more intensive reviews of their compensation packages, and use greater care in reviewing the affiliations and independence of members of their audit, compensation, and nominating and governance committees. Directors and trustees of nonprofits, in exercising their oversight responsibility, are bound by the same fiduciary duties of loyalty and care as profit-making
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corporations and therefore are obliged to ensure that their entities operate honestly and ethically. Moreover, directors of many public corporations serve on the boards of nonprofit entities while many of the CEOs and senior executives of nonprofit entities also serve as valued members of corporate boards, relationships that could influence the management of the nonprofits to adopt some of the corporate world’s governance best practices that evolve as a result of the changes mandated by Sarbanes-Oxley. Most of the best practices and fiduciary responsibilities described elsewhere in this book for directors of profitmotivated corporations, and particularly the principles embodied in the Five I’s of boardroom excellence described in Chapter Four, apply as well to the boards of nonprofit entities. By employing these principles and common sense, while adjusting for the differences in the objectives of profit-making versus nonprofit entities, conscientious directors and trustees of nonprofits who are willing to challenge management, ask the tough questions, and provide thoughtful oversight and direction will achieve the same level of boardroom excellence that their counterparts in the corporate world produce guided by the same basic principles.
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Chapter Thirteen
Model Board of Directors
The model board’s membership includes individuals with diverse talents, experiences, personalities, instincts, and expertise that provide the composite skills that produce excellence in the boardroom.
E
mboldened by a better understanding of how and why so
many prominent, large U.S. corporations, beginning with Enron, succumbed to management fraud, scandalous behavior, and board neglect, I have developed my own version of the ideal or model board of directors of a publicly owned U.S. corporation. My model is based in large part on my experience with boards of several hundred corporations founded during the thirty-year period commencing in the early 1970s, which were funded by a then relatively small group of experienced venture
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capital firms or private investors. Those corporations were generally founded by senior or midlevel executives, engineers, scientists, or entrepreneurs who had spent several years in responsible operating, engineering, and marketing positions at large U.S. corporations, such as IBM, General Electric, and Xerox. The founders had little, if any, experience managing a corporation or dealing with corporate boards or stockholders. Most of the venture investors did have substantial board experience, having served on the boards of the corporations they helped finance. Partners of the principal venture firms that financed the new enterprises customarily served as directors of those enterprises and worked closely with management to:
° Add to the board experienced directors who possess skills and expertise the board needed or desired
° Find and employ key members of the management team ° Provide guidance and advice to management in the development and monitoring of the corporation’s strategic plan
° Help develop compensation and benefits plans for executives and employees
° Raise additional equity funds for the corporation when needed These directors were also usually:
° Knowledgeable, committed, and actively involved ° Independent of management ° Willing and able to disagree and to challenge management ° Aligned, as major stockholders, with the interests of the corporation’s stockholders
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° Unafraid to fire the CEO and other senior executives if their performance warranted termination and to locate and recruit their successors In the 1970s and 1980s, venture capital investors (VCs) were long-term investors and understood that it would take up to ten years before they could expect to trigger a liquidity event that would allow them to profit from their investment, either by creating a public market for the corporation’s stock or by merger with another corporation or a sale of its business and assets. However, beginning in the late 1990s and continuing through the initial years of this century, the VCs investment goals changed substantially. The long-term investment objective of the average VC shifted from seven to ten years to two to three years. In many cases, it dropped below two years. This short-term focus, coupled with a growing misdirected tendency of certain venture investors to seek to manage the corporation rather than provide oversight to its management, helped make the venture investor a less attractive candidate for the model board, despite the fact that he or she had many of the qualities and attributes of a highly desirable board member. The search for an ideal board member is a frustrating exercise. The ideal board does not require a board of like-minded, like-qualified directors. What is necessary is a combination of individuals with diverse talents, experiences, interests, instincts, and expertise that together provide the composite skills that produce excellence in the boardroom. Although a board’s composition and needs will vary depending on the company’s business, size, location, financial performance, and competition, the exemplary board of a publicly traded U.S. corporation should be made up of directors
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who contribute complementary expertise and skills and possess certain exemplary qualities, traits, and characteristics.
The Directors A majority of the members of the board must be independent (as defined by the regulations of the exchange on which the corporation is listed), and each director should:
° Be enthusiastic about serving on the board and be prepared to provide that service in a timely and constructive manner
° Have business or professional know-how and experience, or equivalent executive or managerial experience derived from association with academic, nonprofit, or government entities
° Have a real interest in the business conducted by the corporation
° Be focused on enhancing stockholder value ° Understand and faithfully discharge his or her fiduciary duty of loyalty and duty of care
° Be willing to agree not to serve on more than two or three other boards
° Be willing and able to commit annually to the board up to 125 to 150 hours for a small to medium-sized corporation and up to 250 hours for a large corporation
° Be committed to remain fully informed about the corporation’s business, products, industry, and competition
° Have the ability and the will to say no, to rock the boat, and to disagree with and challenge management,
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while carefully refraining from assuming management’s role
° Possess integrity and commitment to high ethical standards
° Possess sufficient knowledge and experience with accounting and financial matters so as to qualify as being financially literate
° Understand and diligently discharge the responsibility for selecting, compensating, and, when necessary, terminating the CEO and senior executives and selecting their successors
° Possess sound business and strategic judgment and the ability to oversee and monitor management’s development and implementation of the corporation’s strategic plan
° Be capable of developing and evaluating fair compensation and incentive and benefit plans for the executives and employees
° Understand the need for—and require management to provide—prompt, fair, and full disclosure of material events affecting the corporation
° Be willing and able to function as part of a team ° Be willing to resign and depart the board—noisily if appropriate—in the event the CEO and management refuse or are unable or unwilling to create and maintain a corporate culture that demands integrity and ethical behavior at every level of the corporation’s workforce
° Be committed to asking the right questions and evaluating management proposals, always guided by the need to answer the paramount question: “How does this benefit the stockholders?”
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The Board The board, as the governing body of the corporation, should:
° Be as small as practicable but large enough (and include enough independent directors) to allow it to staff the three principal board committees (audit, compensation, and nominating and governance) and, unless independent directors are expected to serve on more than one committee, optimally include between six and nine independent directors
° Ensure that a majority of the members of the board are independent
° Be composed of individuals who possess the complementary expertise and skills the board requires
° Select one of its members to serve as the lead or presiding director to coordinate the board and committee agendas and actions with the CEO of the corporation, serve as a link between the board members and the CEO, and preside at executive sessions of nonexecutive members of the board
° Schedule up to six regular, full-day board meetings annually (and up to eight or more for large corporations)
° Schedule at least four regular meetings of the corporation’s principal board committees (except for the audit committee, which should meet more frequently)
° Schedule committee meetings the day or evening before the regular board meetings to permit unrushed, thoughtful discussions
° Advise each board member to expect to commit up to 125 to 250 hours (or more for larger or more complex entities) annually to the performance of board and committee responsibilities
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° Pay its directors fairly for their services, including their time spent at board and committee meetings; for their services as committee chairs; and for their time devoted to special assignments and preparation for board, committee, and management meetings
° Require that the audit, compensation, and nominating and governance committees each adopt a written charter defining its duties and responsibilities and be led by a chair with expertise or experience (or both) in the matters for which the committee is responsible
° Adopt guidelines that limit a director’s participation on other boards unless otherwise expressly permitted by the board
° Ensure that the board’s membership includes directors who have CEO, executive, or senior management experience; knowledge of the industry in which the corporation competes; and experience in developing or monitoring strategic plans, executive compensation programs, and evaluation of senior executive performance
° Work with management to ensure that the corporation has developed an appropriate corporate strategy and monitor management’s execution of that strategy
° Conduct periodic evaluations of the performance of the board as a whole, as well as the performance of each board committee and each board member individually
° Ensure that the corporation has adopted appropriate compliance programs, a corporate code of conduct, corporate governance and ethics guidelines, and corporate disclosure policies and is committed to their enforcement and prompt and fair disclosure
° Adopt a director compensation plan that provides fair and appropriate compensation (both cash and equity) for each nonemployee director
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° Ensure that if it does not have a formal retirement policy or a limit on the number of years a director may serve, the board adopts and implements a policy of periodically adding new directors to provide fresh ideas and missing but needed skills and experience and to replace directors whose performance becomes marginal or inadequate
A Few Parting Admonitions To assist directors who may find it difficult, if not painful, to remember the elements essential to achieve excellence as a director, I submit the following short list of admonitions:
° If excellence requires that you spend more time in preparation for board meetings and development of a more profound understanding of the company’s business strategy and obstacles, do it.
° If you cannot attend prescheduled board and committee meetings, resign so you can be replaced by someone who can.
° If you agree to serve on a board committee or as a committee chair, perform that responsibility diligently, fairly, and on time.
° If you are not enthusiastic about serving on the board, resign.
° If you are unwilling or unable to rock the boat when needed or to challenge management or your fellow directors when appropriate, either change your attitude or don’t seek reelection at the next annual meeting.
° If you do not have the knowledge or experience with accounting and financial matters so as to qualify as being financially literate, acquire it.
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° If you have not read and do not understand the materials distributed for board deliberation and action, read and understand them.
° If you observe dishonest, unethical practices or lapses in integrity, stop them.
° If you do not have the knowledge necessary to assist management in providing fair compensation, incentives, and benefits for the company’s employees, acquire it.
° If you forget that your responsibility as a director is to oversee management, and not to perform the management function, relearn it.
° If you do not know the basics of your role as a director, master them or, better still, retire graciously.
° If you talk too much and are unable to listen attentively to management and your fellow directors, stop and start listening.
The Essence of Excellence Experts may differ on what is needed to instill public trust and confidence in America’s major corporations and financial markets. Evaluating a corporation’s board to determine whether it merits being rated excellent requires both objective and subjective assessments. The objective assessment is easier to accomplish because it involves comparing what the directors do to what they should do. If the “should do” checklist properly describes the board’s duties and responsibilities, the resulting rating should provide a relatively accurate, objective evaluation of the board. The subjective assessment is more daunting because it encompasses an evaluation of important human attributes,
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including experience, attitudes, personality, ethical values, diplomatic skills, communication skills, courage, honesty, toughness, fairness, and the ability to set the right tone. Therefore, even if the board as an entity and the directors individually are conscientious, committed, and well intentioned, excellence will be absent in the boardroom unless the directors:
° Trust and respect each other ° Are fully committed to serving the best interests of the stockholders rather than their own or management’s best interests
° Are willing to challenge management and fellow directors and to be challenged in an environment that welcomes constructive skepticism as well as free and open differences of opinion
° Are able to set a tone at the top that censures extravagance, greed, dishonesty, fraud, self-dealing, deception, and disloyalty and extols integrity, ethical behavior, and decency
° Successfully establish a corporate environment that embraces, embodies, and nurtures a culture that rewards those who deserve to be rewarded and dismisses those who deserve to be dismissed Although no board is or will be perfect, a board whose members possess and are guided by these skills, qualities, attitudes, and values has the ability, power, and incentive to intervene; shape the corporation’s direction; and, through the process of acculturation, create a corporate environment in which excellence will flourish and endure not only in the boardroom but throughout the entire corporation where ethics and integrity will be at the core of every decision it makes.
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About the Author
P
aul P. Brountas is senior counsel at Wilmer Cutler Pickering
Hale and Dorr LLP, an international law firm with over 1,000 lawyers in 12 countries. He joined Hale and Dorr in 1960, became a senior partner in 1968, and was appointed senior counsel to the firm in 2003. At Hale and Dorr, he served as chair of the firm’s corporate department, executive committee, and strategic planning task force. Since the merger of Hale and Dorr and Wilmer Cutler and Pickering on May 31, 2004, he has served as senior counsel to the firm. While his practice has encompassed most areas of corporate and securities laws, he has focused on the representation of start-up and emerging growth companies; venture capitalists; issuers, investors, and underwriters in public and private financings; companies, stockholders, and investment bankers in mergers and acquisitions; and corporate directors, both as counsel to corporate boards and as outside counsel to independent directors. Brountas has earned a reputation as one of the nation’s leading high-technology lawyers. The National Law Journal selected
him as one of the “100 Most Influential Lawyers in America,”
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Boston magazine named him one of “Boston’s 100 Most Powerful People,” and Electronic Business magazine named him one of the top ten high-technology lawyers in the United States. He is also listed in The Best Lawyers in America and in Chambers USA America’s Leading Lawyers. His clients have looked to him not only for legal advice, but also for his judgment as a business counselor and problem solver. Brountas has been a frequent lecturer and speaker at professional and trade association programs, ranging from venture capital financings, joint ventures, and public offerings to mergers and acquisitions, corporate governance, and duties and responsibilities of directors. For several years, he served as a guest presenter at Harvard Business School’s entrepreneurial management course. He is the author of Counseling the Public Company, published as part of Massachusetts Business Lawyering by Massachusetts Continuing Legal Education. In 1987 and 1988, Brountas served as national chairman of the Committee to Elect Michael S. Dukakis president of the United States. He served as chairman of the board of trustees and president of the board of overseers of Bowdoin College, where he received his undergraduate degree. Brountas received his law degree from Harvard Law School and in 1954 was awarded a Marshall Scholarship for study at Oxford University, where he received B.A. and M.A. degrees from the Oxford Honors School of Jurisprudence.
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Index
A Accounting firms, relationship between clients and, 19 Achieving excellence: admonitions to directors for, 150–151; objective vs. subjective criteria for, 151–152 Adelphia, 2, 19, 96 Agendas, 69, 71–72 ALF-CIO Office of Investment, 124 American General Corporation, Unitrin, Inc. v., 29–30 Archetypes, of undesirable directors, 35–37 Assessment. See Evaluation of board; Evaluation of individual directors Attorneys, SEC standards for conduct of, 107–109 Audit committee, 87–93; charter of, 90; compensation for members of, 82; composition of, 87; frequency of meetings of, 92; knowledge of members of, 92–93; oversight of effectiveness of, 90–91; responsibilities of, 87, 92; and Sarbanes-Oxley Act, 19, 87, 90, 93 Audit committee financial experts, 87–90; attributes and experience of, 88–89; safe harbor for, 89–90 B Board meetings: agendas for, 69, 71–72; executive sessions following, 77–78; expressing disagreement at,
59, 62; frequency of, 19, 76–77; guidelines on processes and procedures for, 105; materials provided to directors prior to, 69–70, 72–73; presentations at, 73–75; retreats as, 57–58, 77 Board members. See Directors Board of directors: complementary skills and experience of directors on, 54–55; considerations in setting compensation for directors, 82; as responsible for corporate corruption, 3, 12–14; restructuring, 39–41; size of, 75–76; structuring, 37–38; vs. nonprofit board of trustees, 140–141. See also Evaluation of board; Model board of directors Buffett, Warren E., 111–112 Business judgment rule, 28–30 Business Roundtable, 122 C Calpers, 117–118, 124 Candor, duty of, 26 Care, duty of, 27–28, 141 CEOs, 61–70; board member selection dominated by, 34–35; certification requirement for, 14–15, 18; as chair of board, 78; on compensation committee, 96; corporate governance centered on, 6–7; courageous, 63–64; ethical behavior by, 107; hero worship of, 11; how to
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express criticism of, 59–60; independent directors as viewed by, 42; information given to directors by, 67–70, 72–73; relationship between directors and, 61–63, 67–68; responsible for tone at top and corporate culture, 16, 52, 65; revenue increases demanded by, 9–10. See also Executive compensation Certification requirement, financial statements, 14–15, 18 CFOs: certification requirement for, 14–15, 18; and keeping directors informed, 67 Charters, committee, 90, 94, 149 “Check-the-box” governance mentality, 22, 52, 133 Code of conduct and ethics, 105–107; activities covered by, 106; requirements for, 105–106; vs. actual behavior in corporation, 107 Cohen, Abby, 19 Collegiality: disrupted by peer evaluation, 21; excessive, and executive compensation, 96–97; past emphasis on, 2, 7, 35 Committee meetings: agendas for, 69, 71–72; frequency of, 92; materials provided to directors prior to, 72–73 Committees, 85–102; audit committee, 19, 87–93; compensation committee, 18, 82, 93–100; compensation for members of, 82–83; information given to/sought by members of, 86–87; nominating and governance committee, 100–102, 119, 120, 128; size of, 86; special, 85–86 Compensation, for directors, 80–83, 149. See also Executive compensation Compensation committee, 93–100; charter of, 94; and compensation for directors, 82; composition of, 93–94, 96; and executive compensation levels, 95–100; increased responsiveness of, 18; responsibilities of, 93 Compensation consultants, 97, 98 Continuing education, of directors, 56–58
Corporate America: corruption in, 2, 7; GAAP revenue-recognition policies not followed in, 9–10; “good old days” of, 5–7; Great Bubble period of, 8–9; long-term vs. short-term focus of, 8–9; moral compass lost by, 11–12 Corporate corruption: actions and characteristics of directors contributing to, 12–14; as contagious, 7; examples of, 2; introduced by not following GAAP policies, 9–10; legislative and regulatory actions to correct, 14–15; responsibility for, 3 Corporate culture, CEO’s responsibility for, 16, 52, 65. See also Setting tone at top Corporate governance: factors contributing to deterioration of, 12–14; Five I’s of, 50–54, 142; legislative and regulatory actions to correct, 14–15; in nonprofits, 139–142; outmoded system of, 12; in private corporations, 135–138; questions for directors to ask about, 41–42; reforming, through stockholder activism, 111–112, 113, 116–118 Corporate governance guidelines, contents of, 104–105 Corporate Governance Quotient, Institutional Shareholder Services, 124 Corporations. See Corporate America Corruption. See Corporate corruption Costs: of PCAOB auditing standard compliance, 91; of Sarbanes-Oxley compliance, 20, 22–23 Council on Institutional Investors, 124 Courage, CEOs exhibiting, 63–64 D Decision-making process, CEOs keeping directors out of, 66–67 Delaware Corporation Law, 7 Direct access rule, 119, 120–123 Directors: admonitions to, to achieve excellence, 150–151; communications between stockholders and, 21, 119, 120; corporate governance guidelines on, 104, 105; desirable characteristics and skills of, 49–55,
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Index 58–60, 146–147; and deterioration of corporate governance, 12–14; effects of Sarbanes-Oxley on, 17–18, 19–22; interaction between management and, 62; knowledge of, 37, 38–39; motivation for serving as, 33–34; preparation and continuing education of, 55–58; professional, 34, 47–48; questions about governance to be asked by, 41–42; relationship between CEOs and, 61–63, 66–70; serving on multiple boards, 19, 146; undesirable, archetypes of, 35–37. See also Evaluation of individual directors; Independent directors; Lead or presiding director; Selection of directors Directors’ and officers’ (D&O) liability insurance, 30, 31, 32 Disagreement, how directors should express, 58–60 Disney, 97 Domini 400 Social Index, 124 Donaldson, William, 22 Duty of candor, 26 Duty of care, 27–28, 141 Duty of good faith, 25, 99–100 Duty of loyalty, 26, 28, 141 E Ebbers, Bernie, 96 Eisner, Michael, 97 Enron, 5, 19, 38, 52, 64, 143 “Entire fairness” test, 26 Ethics. See Code of conduct and ethics Evaluation of board: assessment criteria for, 129–130; caution on, 133; frequency of, 127–128; by management, 132–133; objective vs. subjective, 151–152; questions for, 130–131; written, 130 Evaluation of individual directors: assessment criteria for, 128–129; increasing popularity of, 128; negative effect of, 21–22; questions for, 131–132 Excellence. See Achieving excellence Executive compensation: “comparable company” approach to, 97–98; excessive, 95–100; loans as, 18, 96;
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Nasdaq rules on, 94; stock options as, 95–96, 97, 98–99 Executive sessions, 77–78 Experience, of directors, 54–55, 146 F Fiduciary duties: of directors of public corporations, 25–28; failure of boards to discharge, 3; of trustees of nonprofits, 140, 141–142. See also specific duties Financial experts, audit committee, 88–90 Financial statements, required certification of, 14–15, 18 Finlay, J. Richard, 95 Five I’s of corporate governance, 50–54, 142 G Generally accepted accounting principles (GAAP), revenue-producing activities outside, 9–10 Glassman, Cynthia A., 116 Global Crossing, 2 Good faith, duty of, 25, 99–100 Governing board. See Board of directors Grasso, Richard, 97 Great Bubble period: collapse of, 11–12; corporate hero worship during, 11; GAAP ignored in, 9–10; overview of, 8–9; wealth creation during, 10–11 H Harriman, Edward, 6 HealthSouth, 19 I Independent directors: on audit committee, 87; CEOs’ view of, 42; on compensation committee, 93–94; defined, 50; knowledge of, 37; pros and cons of requirement for, 21, 51–52 Informed directors, 53 Initial public offerings (IPOs): during Great Bubble period, 8; private corporations launching, 137–138 Initiative, directors with, 54
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Institutional Shareholder Services, 123–124 Integrity, of directors, 52 Investor Responsibility Research Center, 124 Involved directors, 53
activities of, 148–150; venture capital investors (VCs) as members of, 143–145 Morgan, J. P., 6 Mutual funds, voting disclosure requirements for, 115–116
J Jefferson, Thomas, 115
N Nasdaq: code of conduct requirement of, 106; compensation committee requirements of, 93–94; director nomination rules of, 100; independent director definition of, 50; new corporate governance rules adopted by, 14 National Association of Corporate Directors, 19 New York Stock Exchange (NYSE): code of business conduct and ethics requirement of, 105–106; compensation committee requirements of, 93; director nomination rules of, 100; independent director definition of, 50; new corporate governance rules adopted by, 14; performance evaluation requirement of, 128 “Noisy withdrawal” provision, 107, 109 Nominating and governance committee, 100–102; board assessment as responsibility of, 128; disclosure of functions and processes of, 119, 120; responsibilities of, 100; selection of director candidates by, 100–101 Nonprofits, 139–142; board of, vs. corporate board of directors, 140–141; fiduciary duties of trustees of, 140, 141–142
L Lawyers, SEC standards for conduct of, 107–109 Lead or presiding director: controversy over concept of, 21, 78–79; duties of, 79–80; executive sessions chaired by, 77; role in agenda preparation, 72 Legal compliance, SEC standards on, 107–109 Liability: for approving executive compensation packages, 99–100; for breach of duty of care, 27–28; D&O liability insurance, 30, 31–32; protections against, for directors, 30; with written board assessments, 130 Litigation, as risk for directors, 30–32, 46 Loans, as executive compensation, 18, 96 Long term, shift from focus on, 8–9, 145 Loyalty, duty of, 26, 28, 141 M Management: board evaluation by, 132–133; interaction between directors and, 62; materials provided to directors by, 57, 73; oversight of, 26, 42–44; presentations by, at board meetings, 74 Meetings. See Board meetings; Committee meetings Mellon, Andrew, 6 Memos: CEO-director disagreement in, 60; included in board meeting materials, 69–70, 73 Minow, Nell, 19–20 Model board of directors, 143–150; attributes and skills of directors on, 145–147; suggested structure and
O Orientation, of directors, 56 Orvitz, Michael, 97 Oversight: of audit committee’s effectiveness, 90–91; failure of boards to discharge, 3; of management, activities for, 26, 42–44; and skills and experience of directors, 54–55 P Peer evaluation. See Evaluation of individual directors
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Index Performance evaluation. See Evaluation of board; Evaluation of individual directors Performance, quarterly: and activities not adhering to GAAP, 9–10; as corporate focus in Great Bubble period, 8–9; results of high, 10–11 PowerPoint presentations, 73–74 Preparation, of directors, 55–58 Presentations, at board meetings, 73–75 Private corporations, and SarbanesOxley Act, 135–138 Professional directors, 34, 47–48 Proxy statement: SEC rule on stockholder access to, 119, 120–123; stockholder proposals included in, 112–113 Public Company Accounting Oversight Board (PCAOB), 18, 91–92 Q Qualified legal compliance committee (QLCC), 108 Questions, for directors to ask about governance, 41–42 R Retreats, for directors, 57–58, 77 Rigas, John, 96 Rule 14a-8, Securities Exchange Act of 1934, 112 S Safe harbor, audit committee financial experts, 89–90 Salmon, Walter J., 62 Sarbanes-Oxley Act of 2002, 15–23; and audit committee, 19, 87, 90, 93; code of ethics requirements of, 105; costs of complying with, 20, 22–23; criticisms of, 15–16, 17, 20–23; enactment of, 14, 15, 17; independent director requirement of, 21, 51–52; and nonprofits, 139–142; positive changes due to, 17–20; and private corporations, 135–138; value of, 15, 16 Securities Act of 1933, 6, 89 Securities and Exchange Commission (SEC): audit committee require-
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ments of, 88–90, 93; certification requirement of, 14; corporate attorney conduct standards of, 107–109; direct access rule of, 119, 120–123; disclosure rules of, 119–120; establishment of, 6; “noisy withdrawal” provision of, 107, 109; voting disclosure requirements of, for mutual funds, 115–116 Securities Exchange Act of 1934, 6, 112 Selection of director candidates: by CEO, 34–35; by nominating and governance committee vs. stockholders, 100–101; by stockholders, 101–102, 115, 120–123 Setting tone at top: CEO’s responsibility for, 16, 52, 65; directors’ responsibility to assist in, 44–46, 65–66 Shareholders. See Stockholders Short term: CEO causing displeasure in, 63–64; corporate focus on, in Great Bubble period, 8–9; stockholders’ concern with, 9; venture capital investors’ (VCs) concern with, 145 Size: of board of directors, 75–76, 148; of committees, 86 Skills, required of directors, 54–55, 146–147 Smith v. Van Gorkom, 27–28 Snow, John, 22 Special committees, 85–86 Special duty pay, for directors, 82–83 Stakeholder interests, and stockholders, 125–126 Standing committees, 85. See also specific committees Stock options: for directors, 80, 81; effect of, during Great Bubble period, 8–9; as executive compensation, 95–96, 97, 98–99 Stockholder activism, 16–17, 111–126; by Calpers, 117–118, 124; corporate governance reform through, 111–112, 116–118; educational aproach to, 117; increase in, 16–17, 18; new SEC proxy rules facilitating, 119–123; “scorekeeping” as, 123–125; and voting disclosure
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requirements for mutual funds, 115–116; vs. stakeholder interests, 125–126. See also Stockholder proposals Stockholder proposals: increase in number of, 112–113; issues encompassed by, 113–114; new SEC proxy rules on, 119–123; as nonbinding, 114–115; and Securities Exchange Act Rule 14a-8, 112 Stockholders: communications between directors and, 21, 119, 120; direct access by, to proxy statement, 119, 120–123; disclosure of nominating committee functions and processes to, 119, 120; effects of SarbanesOxley Act on, 18, 21; increased number of, 6, 12; as long-term investors vs. short-term speculators, 9; selection of director candidates by, 101–102, 115, 120–123. See also Stockholder activism
T Telephone: for board meetings, 77; for discussing disagreements, 60 TIAA-CREF, 124 Time: required for Sarbanes-Oxley Act compliance, 20; spent by directors on board work, 19, 76, 146, 148 Tone at top. See Setting tone at top Trustees, nonprofit, fiduciary duties of, 140, 141–142 Tyco, 2, 19, 83 U Unitrin, Inc. v. American General Corporation, 29–30 V Van Gorkom, Smith v., 27–28 Venture capital investors (VCs), as board members, 143–145 W Wealth creation, with high quarterly performance, 10–11 WorldCom, 2, 19, 95, 96
