The Battle for the Soul of Capitalism

For decades, American capitalism has been dominated by chief executive officers who took big risks and transformed entire industries. Fred Smith created FedEx and, in so doing, a new overnight delivery business. Michael Dell helped create the personal computer industry with his eponymous company, and Bill Gates made the PCs accessible to millions with his software. CEOs midwifed the Internet and biotechnology, both thoroughly disruptive ideas. Other CEOs, such as Sandy Weill, have been consolidators, building empires out of assets that others held in scant regard. And, in a third category, “hired-gun” professional managers such as Jack Welch and Lou Gerstner completely repositioned major corporate icons by putting them through gut-wrenching changes. Arguably, the risks these CEOs took helped create the most robust form of capitalism the world has ever seen.

Today, however, the question is whether CEOs and their boards will pull back from taking game-changing risks. Publicly traded companies face blistering new attacks from shareholder activists, who act in tandem with labor unions, hedge funds, pension funds or some combination thereof. One thread of the emerging shareholder ideology is that American companies should be governed more like their European counterparts, with separate chairman and CEO roles and annual shareholder votes on executive compensation, for example. In fact, a “Big Four” of European pension funds including Britain’s Hermes Pensions Management, with combined assets of $800 billion, has emerged as a powerful force in trying to import European governance concepts into the U.S. “There’s been a movement toward the democratization of certain governance functions or the withdrawal of authority from the board of directors back to the shareholders,” Fred Smith tells Directorship. “That movement, if left unchecked, will lead to a confused state of affairs.”

Elsewhere, nearly five years after the enactment of the Sarbanes-Oxley Act and new rules from the stock exchanges, major power has clearly shifted from CEOs to their boards. For better or worse, some of the tools that motivated CEOs and their management teams, such as rich compensation packages and stock option grants, have fallen into bad odor. CEOs of publicly traded companies have less flexibility to manage the way they see fit because of the pressure to separate the functions of CEO and chairman of the board, or lead director. Independent directors also are required by law to meet in executive session without the CEO present, altering the dynamic of CEO-board interaction.

As power tilts toward boards, it is clear to most observers that boards are more risk-averse than managers. Boards, many of which meet just six or eight times a year, typically want to mitigate risks, not find new ways of taking them. Moreover, despite some limited protections for business at the state level, the climate of litigation is pervasive. And the tide of governmental regulation keeps rising, manifesting itself in new forms: A federally appointed monitor told Bristol-Myers Squibb it had to fire its CEO, and a Delaware judge waded into the middle of an effort to take over Caremark, blocking the deal at least temporarily.

In this environment, many individual directors feel somewhat shell-shocked. Far from feeling empowered, they legitimately fear that a boardroom career may be hazardous to their personal financial health. Some decide to stick with their day jobs and forgo directorships. Others continue to serve on boards but obsess about compliance and procedure. That only adds to the culture of risk aversion.

Who’s in Charge?

The question in boardrooms, increasingly, is, “Who’s in charge?” Could it be that American capitalism is changing its structure and is moving toward a more European, more highly regulated model at the very moment, competitiveness gurus argue, that it needs to become more innovative in the face of emerging giants such as China and India? “In the boardroom, the fear of shareholder activism, hedge funds, and the litigation and tort environment are like a triple whammy,” says Deborah Wince-Smith, president of the Council on Competitiveness in Washington. “I think it is absolutely having an impact on our innovation and on our competitiveness.” Adds James K. Glassman of the American Enterprise Institute in Washington: “The American capitalist model has worked extremely well, and fooling around with it, even at the edges, could be somewhat dangerous.”

Consider the “who’s in charge” question behind the Home Depot case. In many ways, it was a silent coup d’état. Ralph Whitworth of Relational Investors, who was threatening to use his 1 percent stake in the company to launch a punishing proxy fight, was able to persuade the company’s board to add a pro-Whitworth director and agree to rotate four major directors off the board next year, including co-founder Ken Langone.