But the Securities and Exchange Commission (SEC) Staff Bulletin—No. 14E (CF) to be precise—issued late last year may prove to be the game-changer required to elevate CEO succession planning to the position it deserves on the board’s list of priorities.

According to this guidance from the SEC, succession is no longer considered part of “ordinary business matters,” the details of which the board does not have to disclose. Instead, succession is now recognized as a fundamental duty, and part of the larger risk-management picture, with serious repercussions if it is not handled correctly. Further, the bulletin recommends greater transparency and shareholder disclosure about the management of succession risk “so that the company is not adversely affected due to a vacancy in leadership.” With access to this board-performance metric, how well boards handle succession is now increasingly a criterion that the investment community will have access to as they evaluate boards.

Addressing the Disconnect
According to Korn/Ferry International’s 34th Annual Board of Directors Study of Fortune 1000 organizations, 84 percent of directors surveyed believe the importance of having a CEO succession plan has increased, but only about half actually have one in place. Why the disconnect and, more importantly, what can be done to resolve it?

This sizable gap between awareness of the importance of succession planning and follow-through did not come as a great surprise to us. Our day-to-day conversations with CEOs and directors reinforce the fact that they get it: Succession planning is crucial; it will now be subject to greater outside scrutiny; adhering to best practices will protect the company’s reputation and value; and the board will be able to defend key leadership decisions, if need be, with solid data.

But the roadblock to implementation of succession planning persists on many boards, a result of several factors that must be addressed, including:

HABIT Succession at most companies was traditionally a process managed mainly by the CEO, with little involvement from the board.

HUMAN NATURE Succession entails dealing with real psychological factors, such as confronting one’s mortality and sensitive leadership choices where there are perceived “winners” and “losers.”

HOW-TO? Boards may not know where to start, what best practices are and how they can learn from boards that do it well.

Now is the time to take action and overcome whatever is standing in the way of implementing a succession practice. Because there is more than one approach, each succession plan needs to be thoughtfully adapted to a particular company and its board.

Start With a Vision
Effective succession planning starts with a mindset, rather than a checklist. It’s not simply about finding someone to replace the CEO, though that is of critical importance. Best-in-class boards start with a broad vision of succession and specific goals that stretch well beyond the boundaries of the corner office.

Properly implemented, succession is an ongoing leadership development process in which CEO succession is a subset. It is designed to provide talent options for key leadership positions at every level. Companies that achieve this goal not only score points in governance and investor circles, they attract the best talent when they become known as academies of leadership development.

Boards that master succession planning don’t have to worry about the prospect of a leadership crisis that could derail plans and progress, subject them to public criticism and potentially have long-term, negative repercussions for the company and shareholder value. They can instead focus on their business assured that regardless of circumstances— an emergency replacement required, short-timed departure or planned retirement—the bases are covered.

When the objective is to establish a world-class succession process, boards must first make succession a priority in word and deed. That means ensuring that succession-related discussions are on the board’s agenda at least once a quarter and, ideally and increasingly with many boards, at every board meeting. Because succession and leadership development, generally, are such complex, multi-faceted topics, board meetings often don’t provide adequate time to examine and discuss succession thoroughly. That is why most leading boards now have an annual or semi-annual off-site meeting devoted to succession discussions, much the way boards have focused on strategy.

ADDITIONAL STORIES IN THE DIRECTOR’S GUIDE TO CEO SUCCESSION:
The Ins and Outs of Successful CEO Transitions
Expect the Unexpected Before the Crisis Calls
Overcoming Resistance to Succession
Executive Compensation Programs Can Help or Hurt CEO Succession

Strategic Alignment
To design and implement a succession process that ensures the most capable leadership is guiding the company, the place to start is with the strategy. Aligning directors on the strategy is an important first step because succession, specifically the key competencies—and their order of priority—that will be required in the leadership team are driven by the strategy. A company guided by a strategy that details growth by acquisitions, for example, will seek very different qualities in a CEO than a company determined to focus on growing existing businesses. The former will seek a future CEO with M&A experience, including post-merger integration, while the latter will emphasize industry-specific experience and a successful track-record running operations.

One word of caution:  Never assume that a future CEO will be a carbon copy of the current CEO, no matter how effective a leader he or she has been. The key is to peer into the future via the strategy and create a profile for the CEO who will be best equipped to implement it.

In our experience, it is not unusual for directors on the same board to hold widely differing views of the strategy and what the company should focus on. An important part of the process is assessing where these views diverge and align, so that directors can come together as a team with a shared view of where the company is headed, as well as the resources required to get them there. Succession, like strategy, is forward-looking and dynamic. Shifts in the strategy resulting from changes in market conditions, economic factors, political circumstances, and a host of other variables, may necessitate shifts in the leadership competencies required.

Addressing Human Nature
Effective succession planning requires continual conversation and collaboration between the board and the CEO. Institutionalizing the process so it is regularly an agenda item enables the board to stay ahead of changing conditions that may affect the standing of potential candidates on a priority list. In addition, revisiting succession routinely will lessen some of the “human nature” concerns that can hinder succession planning, such as associations with mortality and internal competition. Handling succession in a transparent, matter-of-fact fashion—using a process that is perceived by all as fair—can ameliorate the personal sting felt by those being assessed. And establishing succession as a crucial but routine matter obviates the need for “the big talk” among directors and the CEO, increasing everyone’s focus and comfort level.

There are a couple of key areas in succession planning where it is wise, indeed considered a best practice, to engage a third party to work with the board.

One area in which outside, expert counsel is valuable is in helping the board to coalesce as a team around the strategy, which is crucial to effective succession planning and all of the work the board needs to accomplish as a close-knit group. Involving consultants experienced in assessing individual director views, highlighting areas of agreement and disagreement, and facilitating productive discussion on crucial areas of concern will help ensure that the board is focused on the right work at the right level and using its valuable time to good advantage. Concerns or questions about the strategy are far better aired in the appropriate forum, when they can be safely dealt with, than while making an important decision under time constraints, when differences can lead to a divided board and poor choices.

Partnering with a third party for the succession-planning process itself is also an established best practice with distinct advantages, akin to a governance “seal of approval.” With what was once considered the board’s own business now open for all to see, third-party involvement—including exposure to best practices—helps ensure a rigorous, objective process. This will be increasingly important to boards as the shareholder community evaluates how well succession planning is handled and adds that metric to other investment criteria. And in the event that leadership choices are challenged, boards will have the data to establish that they followed the right steps in executing the succession process.

Also critical, particularly to retain inside talent, is the perception that the process is fair and transparent at every turn. Even those who may be unhappy at being passed over for a desirable leadership position are more likely to accept decisions emerging from a process that they perceive as objective and based on fair selection criteria—and less likely to head for the exit.

Pull and Push
Developing and retaining talent—the leadership pipeline—is a critical element of the leadership development process. Hiring talent from the outside is always the back-up choice, unless the company is facing major change (such as a vastly different strategy or significant shifts in its industry) and those in line for succession do not possess needed skills and experience. Even when insiders top the list of successors, however, gaining an outside perspective is crucial to developing the best talent and making the best choices.

Leading boards often gain that external view with the help of a third party who can provide a deep and broad perspective across industries on best practices for succession. A third party will craft a benchmarking process that can be difficult for companies to undertake on their own on a regular basis. Benchmarking data enables companies to assess their own talent against the best outside talent, employing whatever screens they wish, including industry, company size and others. The benchmarking data can also serve as a useful check on succession planning, suggesting gaps in candidates’ skills and experience that will need to be filled if they are to succeed to particular positions.

Boards are increasingly feeling the push-pull of implementing a thoughtfully designed, well-executed succession process. The push? The ability of the investing public to now view and “grade” a process which, if there even was one, was historically handled behind closed doors. No board wants to be scrutinized only to come up short and be exposed as lacking in the leadership development arena. Ensuring a steady flow of capable leadership is essential and safeguards a company’s future by quelling any investor uncertainty about proper stewardship.

But the pull is just as important as the push. More boards are now focused on succession planning, not just because they have to do it, but because they recognize the advantages they gain, long-term, when they get it right. Demonstrating a rigorous succession process, based on established best practices, can have a positive impact on company reputation and value. That can translate into elevating the company’s status as a desirable place to invest as well as an attractive place for talented people to build a career.It is not unusual for directors on the same board to hold widely differing views of the strategy and what the company should focus on. An important part of the process is assessing where these views diverge and align.

Joe Griesedieck is vice chairman and managing director of Board and CEO Services at Korn/Ferry International.

Moody’s released a report on how some large banks have changed their boards to be more effective with strategy. The report reviewed board composition at 20 large  global banks in North America and Europe since the beginning of the crisis in July 2007.

The SEC’s new disclosure rules play an obvious part in the revamping of bank boards. Director nomination standards now require information about the nominee’s experience, qualifications, and attributes and reasons why that person should serve on the company’s board. A new leadership structure rule mandates that a company disclose why it has chosen to either combine or separate the positions of chairman and CEO.

The bank boards included in this report turned over 32 percent of their non-executive directors. This provides boards with an original perspective and new ideas about how to bounce back after the crisis. Author of the report, Christian Plath, said the turnover on bank boards was the most interesting trend post financial-crisis: “The turnover on some of these boards, particularly boards that received extraordinary government assistance, some of those boards saw more than half their board turn over.

Experience in the financial industry is now a much more prominent factor in building bank boards.  Of the 20 banks examined, 46 percent now have outside directors with financial backgrounds. This is up 14 percent from July 2007. Plath said this comes after serious criticism about the quality of board members: “Many of these banks were strongly criticized for not having enough directors with financial backgrounds…All of this points to the criticism that banks were engaged in excessive risk taking…you want some directors on the boards that can know the right questions to ask.”

Banks that received the most government assistance–Bank of America, Citigroup, Lloyds, RBS and UBS–added the most financial experience to their boards, the Moody’s report found.

Several of the banks examined by Moody’s researchers also reduced their board size. Plath said this could be for several reasons concerning the particular bank’s restructuring process. “There are a couple of big advantages of having a smaller board size and one is that it better stimulates discussions at the board level. It enhances the board’s ability to respond in the event of a crisis.” Plath also said that a smaller boardroom means a bigger spotlight for each director: “It also makes it harder for directors to hide in terms of boardroom discussions. It forces all of the directors to speak up.”

The average board size is now 16 members. Bank of America, for example, reduced its board size from 17 to 15. Not every bank downsized the board, however. Four of the 20 banks in the report maintain a board size of 20 or more members. HSBC increased its board size from 18 to 21 members.–Ashley Chaney

Editor’s Note: This is the second in a series of conversations between top executives as they discuss business scenarios that impact the boardroom.

Timothy W. Burns: As you know, I spend a good deal of my time counseling boards of directors and officers on insurance issues. If their company is solvent, and their insurance is strong, directors have historically faced very little risk of personal liability. What keeps me up late at night these days, however, is 1937. Here’s what I mean: Eight years after the 1929 stock market crash, the economy went into a tailspin again. And, I’m concerned that perhaps we haven’t seen the end of 2008.

Lawrence Fine: I guess you’re saying that inevitably, big disasters will have their aftershocks.

Burns: Right. And if it happens again, good insurance becomes of critical importance in protecting the personal assets of directors.

Fine: Directors and officers have been exposed for decades, but earlier in the millennium when the WorldCom and Enron scandals made front pages, plaintiffs seemed to really step up their game in volume and severity. Those actions brought a new level of awareness to the potential exposure to directors and officers. Our litigious society is becoming a danger for everyone.

Burns: With the credit markets tightening in 2007, and then the economy melting down in 2008 and early 2009, it really forced directors and officers to consider how they may be targeted personally. The good news, though, is that except for certain market segments, the D&O market has—at least to date—remained somewhat reasonably priced.

Fine: But there are a number of plaintiffs’ lawyers pushing the envelope with legal theories and increasing settlement demands. That’s partly inspired and supported by a lot of anti-corporate sentiment right now. As a result, plaintiffs, who have always threatened that they would try these cases, have actually been doing that lately, with, unfortunately, mostly positive results from their perspective. It seems that juries are not looking favorably on corporate defendants. So, Tim, let’s take a moment to talk about these new developments and what directors need to be aware of and prepare for.

Burns: A big issue is that institutional investors definitely seem to be competing among themselves to see who gets the biggest settlement. They’re encouraging their lawyers to do the same thing and the bounties that some of these institutional investors are purportedly offering their counsel are designed to confiscate money directly from the personal assets of individual defendants.

Fine: Yes, that poses a difficult and interesting situation. We are now seeing instances in which a particularly competitive institutional plaintiff will seek the money directly from the individual and try to prevent the company or the insurer from reimbursing it. That poses a very difficult circumstance for a board director. This approach can be taken even in the face of a settlement involving the corporate defendant. We’ve had success in diffusing these situations, because a high percentage of the time, the plaintiff counsel is blustering for effect. The job here is to have them convinced by a practical insurer, through an experienced claims analyst, particularly one who is known to the plaintiff counsel, that they should just let it go and move on. From the plaintiff’s perspective, money is money, so how can they turn down the settlement the insurer is offering to pay?  Because we say that there just won’t be any settlement if plaintiff counsel insists on going down the other route, seeking the money from the individual, which, while dramatic from the plaintiff’s point of view, may well be complicated and uncertain to yield results.

Burns: I am concerned that in these changing times, plaintiffs’ lawyers are going to be under increasing pressure from the institutional investors to get more and more. Historically, the dynamics of these cases have favored settlement, but there is a lot of uncertainty out there in this post-crisis environment.

Fine: One reason the plaintiffs are taking more cases to trial is that they are competing for the institutional-investor business. Also, the plaintiff bar has been fragmented and unconsolidated after several of the old-guard plaintiff lawyers were the subject of government investigations, and several of them were sent to prison. The plaintiff lawyers that remain are aggressive litigators, and are much less committed to settling cases, and more interested in making a name for themselves through trying cases. It’s harder to get a reasonable dialogue going in a case.

Burns: Insurers, directors, officers and companies all face a wide array of enemies. It’s not just the plaintiff securities bar anymore. There are derivative lawsuits. There are government investigations galore. The environment is getting continuously more costly and more difficult.

Fine: The competitive nature of litigation means there’s more incentive than ever for institutions to opt out of class actions and seek higher percentage returns. That’s one of the things that the plaintiffs’ lawyers are pitching to them, and that’s just another major complication for any given company in resolving all of the issues they face on numerous battle fronts.

Burns: The government appears to be getting more aggressive as well, and I guess that’s to be expected after the recent financial turmoil. But this certainly has directors and officers that I talk to worried about their liability.

Fine: Yes. Sometimes dealing with the government can be a longer, more difficult process than dealing with civil plaintiffs, because it is not, at the end of the day, necessarily a predictable decision maker, in that its decisions may not be governed by practical, quantifiable measurements such as dollars. Mary Schapiro (chairman of the Securities and Exchange Commission) has made many public statements about increasing enforcement and cooperating with other government entities. Recently, the SEC has been utilizing Section 304 of Sarbanes-Oxley, the clawback section, to recover bonuses from individuals who they are not even alleging personally committed any fraud, which is pushing the envelope of what it would seem that SOX 304 was designed for. That’s after several years of the SEC not pursuing clawback claims, and receiving some criticism for that.

Burns: Congress is looking to legislatively expand liability exposures for directors and officers, isn’t it?

Fine: The tone in Congress is, in many ways, anti-big business, with several bills currently being pushed which could drastically increase exposures to directors and officers. One such bill would lower pleading standards for all civil litigation and turn back the clock a few decades, so that plaintiffs can get by a motion to dismiss in virtually every case, it would seem. The other bill would undo the Supreme Court decision in the Stoneridge case, and affirmatively  create a civil action for aiding and abetting of securities fraud. It’s always been the case that the government can pursue aiding and abetting claims, and the SEC is probably prepared to do that now.

Burns: Some carriers have opined that this aiding and abetting liability, if it comes to pass, might not be covered under D&O insurance policies. I don’t really see the logic in that view. It appears to me that aiding and abetting would fall within the definition of wrongful acts in a D&O insurance policy.

Fine: We would agree, but it depends on the exact phrasing of allegations. Basically, Chartis’ policies are generally supposed to cover directors and officers for things that they’re alleged to have done in that capacity, and we’re not sure how or why a carrier would argue otherwise.

Burns: We also are seeing the potential that more and more companies may not be there to back up their directors and officers when things start to go wrong on all fronts.

Fine: When a company has bad news that leads to litigation, one of the worst-case scenarios is that the company may have to file for bankruptcy, whether it’s a re-organization or liquidation, as in the case of Lehman Brothers. Your concerns seem warranted, in that bankruptcy filings have been way up recently, and they’ve been leading to increased litigation against directors and officers.

Burns: The good news is that the trend over the past few years has been for companies to increasingly purchase Side A coverage that protects directors and officers in the event the company becomes insolvent. It appears to me that a lot more of these Side A policies are going to be triggered than in the past.

Fine: Side A policies generally are starting to see more action, from derivative suits as well as bankruptcies. For example, in the Broadcom case, $40 million of the settlement was paid by Side A carriers. Probably, some carriers who have been writing Side A coverage have enjoyed years of low activity, and felt it might be relatively low risk. But hopefully, those carriers are prepared to start paying more on Side A policies.

Burns: It certainly appears from those numbers that some of the Side A insurance policies are likely to come into play. What I’m interested in, and I’m sure others are as well, is your view of the recent statistics on securities class-action filings. Securities- fraud class actions were down last year. What do you make of this?

Fine: It’s really a moving target. The numbers for 2009 on the Stanford Securities Clearinghouse website keep increasing as additional suits are added to the list belatedly. The count is now up to 178, nine higher than the 169 suits which were discussed in Cornerstone’s 2009 year-end report and press release. Various other commentators such as Advisen and NERA post consistently higher numbers. So there’s definitely more to the story than just one headline.

Burns: Another recent trend that offers some concern is the rash of under-the-wire lawsuits. And, by that I mean lawsuits filed just before the statute of limitations expires. There are an increased number of cases in which the defendants are sued almost two years after the disclosures on which they are being sued were made. It used to be that your stock would decline, and you’d be sued within the first few days of the decline.

Fine: Directors and officers ought to know that when the stock goes down, they are likely to be sued. The statute of limitations was increased by Sarbanes-Oxley from one year to two years and it gives the plaintiffs freedom to plan when they’re going to get the cases filed, and how they’re going to manage their inventory.

Burns: There do appear to be a lot of game-changing developments out there. The one thing that provides me some comfort is that in the past, directors and officers who have had strong and adequate D&O insurance have not had to pay personal assets. Even with these recent developments, hopefully that trend will continue.

Fine: Good lawyers are expensive these days. Discovery can be a black hole if it’s not managed well and efficiently. The cases are just very expensive, and individual insureds should be concerned about who is spending the limits and how fast the money is going.

Burns: That does pose a concern. You could have a case in which a rogue former officer effectively monopolizes the spending on the D&O policies. And, you’re absolutely right that defense costs seem to be getting more expensive. Boards and directors need to pay attention to who is going to have access to these policies. Given the multiple individuals with access, and sometimes the company itself, it’s important to seriously evaluate how much insurance the board needs.

Fine: People often ask how much is enough insurance. What type of advice do you give?

Burns: Frankly, I’d say that you want to look at what’s been enough in the past, and increase it considerably. Defense costs are rising, potential liability that’s covered under these policies is rising, and at the same time, you’re looking at increasing D&O insurance limits. You should be careful in deciding from whom to purchase D&O insurance.

Fine: There are other more specialized policies for outside directors that probably bear looking at. But we think that directors are best off to make job one focusing on getting the best possible foundation for their insurance program with the best primary policy. Not every gap can be filled by the primary policy, however, because of potential bankruptcy issues and whether the debtor has rights in a traditional ABC D&O policy.

Burns: The economics of the purchase of D&O insurance makes Side A, B and C policies a fact for most companies. The company and the board want to protect the directors, officers and the company from liability from securities claims and other liabilities that are covered under these policies. Because of this fact, it is important to make sure that you’re purchasing the best ABC Side coverage that you can get.

Fine: Have you been seeing carriers in excess positions being asked to pay more money, and has that been going smoothly or not?

Burns: There are a lot of cases in which the settlements are in the multimillion-dollar range. Excess insurance policies are coming more and more into play. That is an unusual development for most excess D&O insurance companies. Many of them are not in the habit of paying claims day to day, in my experience, and you have to do a lot more work to collect from some excess D&O insurers. You may have to file litigation at times with respect to some excess D&O insurers who just were not expecting to have the number of claims and the size of settlements that we’re seeing now.

Fine: We’re seeing that when we go to mediations, which increasingly have a lot of different layers of carriers, one never knows at which level there’s going to be a hard stop or what the reasons given will be.

Burns: That’s a dangerous situation. These cases, in order to be resolved successfully, require that all the parties obligated to participate actually participate in resolving the case.

Fine: The purpose of insurance is to reduce uncertainty and provide reliable protection. You have to be an educated consumer and achieve as much certainty as you can, so saving some money on a premium, but being less sure that the claims will be paid, means that you’ve really got nothing. So in these times, despite occasional overly reassuring remarks from a pundit, anything can happen, and I think that it’s the job of directors and officers insurance to be a reassuring backstop against that world of uncertainty.

1. Truth
This is a powerful principle. It has been stated simply as, “Say what you do, and do what you say.”

Michael Ross

When searching for solutions to problems, there are often several alternatives. Directors and senior management often engage in cost-benefit or risk-reward analysis, and sometimes obtain expert opinions. This is certainly appropriate, but in some instances, decisions can be reached, or at least some alternatives eliminated, by simply sticking to the facts. When an alternative has the “benefit of being true,” it is likely to be a viable one.

Decisions based on the assumption, or hope, that “no one will know” are very likely to turn out badly. This is probably truer now than historically was the case because there are so many parties interested in finding the truth for their own purposes. It is not just the press, the various levels of Federal, state and local government and the class action bar. There are also shareholder activists, special interest groups, whistle-blowers and bloggers. They are all out to “scoop” the company with some evidence of the truth that has not been told by the company.

Illustrations of the importance of truth come from many of the investigations of wrongdoing by corporate executives. These investigations often turn from the underlying allegations of substantive violations of law to allegations of obstruction of justice, commonly making false statements to government officials or destruction of documents. How different might the result have been if Martha Stewart had been motivated by truth as a guiding principle during the investigation of her alleged insider-trading.

Truth promotes long-term credibility and inspires confidence among the company’s constituencies. A company’s reputation for truthfulness can facilitate dealings with regulators, help manage investigations into alleged wrongdoing and get the company’s story effectively communicated to the public. We know how we feel about companies whose explanations do not make sense or contradict prior explanations, and it is not good.

2. Disclosure
A general inclination toward disclosure can be a sign of a healthy corporate culture. If the issue is whether or not to disclose material unfavorable facts, stretching to rationalize non-disclosure can be dangerous. A good general indicator of integrity is management’s willingness to disclose material adverse facts. Disappointing financial results or other adverse developments are bad enough, but the failure to make required disclosures compounds the problems. Material misstatements and omissions will cause the company to bear the costs of investigations and litigation, and possibly fines, damages and the loss of credibility with investors and the public.

The disclosure question arises in many contexts, e.g., public company reports and releases to investors, regulatory filings, certifications to creditors, advertisements and promotions and product labeling. Senior management’s propensity to engage in effective disclosure and resist burying salient facts in fine print or behind puffery is an indication of integrity.

There are, however, exceptions to the benefits of disclosure. Competition requires keeping secrets. Strategies for reducing the pressures from Wall Street for short-term profits may include limiting or eliminating disclosure of projections and “guidance.” Shareholder activists tout “transparency” as a bell-weather of good corporate governance, but there are limits. For example, when pressures for disclosure become a de-facto requirement that a company post its code of business conduct on its web site, the benefits of “transparency” may be outweighed by the costs. The incentives to create and take competitive advantage of a confidential, superior code are lost; many companies merely look to see what is prevalent in the industry, and there is a tendency for the substance of the codes to sink to the “lowest common denominator.”

3. Clarity of Communications
The business world is full of important communications. Companies constantly communicate with numerous audiences by a variety of means. Clarity in these communications is a sign of a well-run business and a healthy corporate culture. Fuzzy language is often a pretty indicator of fuzzy thinking.

For the board of directors to discharge its responsibilities, management must give directors clear information about the company’s strategy and its plans for execution. When (not if) problems arise, communications often break down, and what communication there is becomes unclear. The board must insist, in good times and bad, that management give the board concise, understandable information on a timely basis.

For its part, the board must be direct with management about what information it wants, and how and when it wants it. In setting policy, the board must be certain that management understands the policy, the rationale for it and how the board expects to see the policy implemented and its effectiveness measured.

Management should be clear with analysts and investors in describing the company’s strategy, plans and results. Confusion in the marketplace will generally lead to lack of confidence, and that will usually adversely affect shareholder value.

Clarity is also important in communications to customers. In advertising, marketing, promotions, labeling, warranties, disclaimers and customer relations, management should be sure customers know what they are buying and what they are not buying. Putting the bad news in the “fine print” is not likely to be a sensible long-term tactic. Bold print might do a better job.

Employees cannot be expected to perform unless they understand what is expected of them, and the consequences for them and the company of success and failure. To avoid misunderstanding, multiple communications, by various means may be necessary. When it comes to codes of conduct and compliance, effective communications should include the reasons for the rules and illustrative examples.

If management’s communications with regulators are straightforward, the company should gain a reputation for integrity that will pay off in the long run. Regulators will be around forever, and the regulatory, institutional memory is long. Regulators will discover and seize upon inconsistent company communications to various constituencies, e.g., investors, customers and employees.

4. Consent
Consent goes hand in hand with disclosure. It is often the next logical step. Consent is relevant with many constituencies, not just shareholders, but also employees, customers and suppliers.

Consent is not always required, as a matter of law, contract or otherwise. In many circumstances, it is not advisable or practicable to obtain consent. Consent may be implied in some situations, such as, when a customer has full and fair disclosure about the company’s products or services, and makes a purchase. In more sensitive contexts, such as, the confidentiality of personal medical or financial information, advance written consent may be more appropriate.

This is not to say that public companies should seek shareholder consent for actions that do not require shareholder consent as a matter of law. It also does not mean that companies should give counter-parties more consent rights than are customarily negotiated in commercial contracts or corporate transactions. The principle of consent may, however, be instructive in making decisions about the treatment of stakeholders. We know from our personal experience when we think that our consent is required, and how we feel when our consent is obtained and when is it not.

In the recent Selectica v. Versata decision, the Court reiterated well established law upholding garden-variety poison pills and applied those concepts to a different type of pill that carries a low trigger threshold of 4.99 percent designed to protect a company’s tax net operating loss carry-forwards (NOLs).  Beyond upholding an increasingly popular adaptation of the traditional poison pill, the decision serves as a useful reminder of the issues that every director and advisor should consider in crafting corporate defenses.

In the current environment, anti-takeover protections have received renewed focus from all quarters, as target boards, concerned with depressed stock prices, confront opportunistic buyers, while, at the same time, shareholders and institutions increasingly emphasize good corporate governance and board accountability.  One such anti-takeover tool is the shareholder rights plan, or “poison pill”, which has seen a resurgence of sorts, with new pill adoptions expanding in 2008 for the first time since 2004-2005, according to Shark Repellent.

Poison pills are typically structured as rights issues that, once triggered, allow all stockholders (other than the triggering stockholder) to purchase shares at a dramatic discount to market (this is often called the “flip-in” feature).  The classic poison pill is designed to prevent a bidder from acquiring the corporation without the consent of the target board.  Usually, the rights are triggered by an acquisition of between 15 and 20 percent of the company’s outstanding stock, and, prior to that trigger point, the board retains substantial latitude to modify or eliminate the pill in the context of a friendly transaction.  In a hostile acquisition, an acquirer may always pursue a proxy fight or other route to take control of the board, and, once in that position, remove the pill in order to permit an acquisition to go forward.  When used appropriately, poison pills have generally been upheld by courts, including in Delaware.

As necessity is the mother of invention, some companies with significant tax net operating losses (NOLs) have turned to a pill with a low trigger threshold of 5 percent or less to protect those assets against any limitation on their use under Section 382 of the Internal Revenue Code.  Limitations are generally imposed if there is a more than 50 percent increase in the ownership of a company’s stock by 5 percent shareholders over a three-year period.  While still a minority of overall pill adoptions, instances of these so-called “NOL” or “382 pills” have increased from a mere 5 percent of all pills adopted in 2007 to 30 percent of all pills adopted in 2009, according to Shark Repellent.

Selectica was a company with significant NOLs.  While NOLs are an inherently contingent asset (because they have value only if the company has taxable income to offset), Selectica’s board received expert advice that it had NOLs of over $160 million.  The board engaged experts on several occasions to analyze the NOLs’ value and was acutely intent on avoiding impairment under Section 382.

Trilogy was a competitor with a contentious relationship with Selectica, marked by patent conflicts and unsuccessful attempts to acquire Selectica, that had begun making open market purchases of Selectica’s stock after its acquisition proposals were rejected. When Selectica realized that Trilogy had amassed 5 percent of its shares, the board again retained experts to analyze the likelihood of NOL impairment and was advised of a substantial risk.  Accordingly, the board lowered the trigger threshold for its existing poison pill from 15 percent to 4.99 percent, grandfathering existing 5 percent shareholders.  Further, the board took the additional step of creating an independent committee to review the pill periodically, including the trigger threshold, and determine whether it remained in shareholders’ best interests.

Despite the 4.99 percent threshold, Trilogy continued buying Selectica stock and intentionally triggered the pill.  After considering several options and consulting with its advisors, the Selectica board opted to employ a share exchange feature in the pill, rather than the more dilutive flip-in feature, and then “reloaded” the pill by issuing new rights.  As a result, Trilogy’s ownership was diluted from 6.7 percent to 3.3 percent; far less dilution than it might have suffered under the pill’s flip-in.  Selectica then filed a motion for declaratory judgment that the NOL pill and share exchange were valid, which Trilogy contested.

In upholding Selectica’s actions, the Court applied the analysis established by Unocal v. Mesa Petroleum and its progeny.  Under Unocal, a board’s defensive actions when facing a possible change in control are subject to enhanced scrutiny because of the “omnipresent specter” that the board may have acted in its own interests and not those of its shareholders.  To have the protection of the business judgment rule, a board must establish that it had “reasonable grounds for believing that a danger to corporate policy and effectiveness existed”, which necessarily include elements of good faith and reasonable investigation, and that its actions were reasonable in relation to the threat posed, and neither coercive nor preclusive.

While Selectica does not represent a significant departure from existing Delaware decisions, the Court, in its application of Unocal, provides at least two important reminders for boards of directors.  First, reasonableness must underlie board action, and perfection is not required.  Based upon extensive expert advice and analysis, the Court determined that the board reached a reasonable conclusion that Selectica’s NOLs represented a valuable corporate asset that was worthy of protection.  Having reached that conclusion, the Court held that a board’s response to a threat against those assets need only be proportionate, not the most narrowly or precisely tailored.

Second, key to establishing reasonableness is a record showing a considered and extensive process, strengthened by expert advice where appropriate.   At each step in the process, the Selectica board built a record that established a basis for ascribing value to the NOLs as a corporate asset, weighed the risk to that asset and showed a measured response to the perceived risk.  Among other things, the Court noted the board’s attempt to find alternative solutions to Trilogy’s triggering of its pill and its adoption of the more moderate share exchange rather than the flip-in.

Notwithstanding the foregoing, we do caution that the Unocal analysis is fact based.  In addition to the facts surrounding the Selectica board’s process and actions, the Court noted that the board was faced not with an amorphous threat of NOL impairment, but with the specific threat of a competitor who sought to use the shareholder franchise to impair corporate assets.  The Court cautioned against companies using NOLs as a “pretext” and warned that NOL pills will continue to be carefully reviewed.  Thus, whether the Court would invalidate an NOL pill or any pill for that matter under different circumstances remains an open question.

Matthew W. Abbott and Steven J. Williams are partners in the corporate department of Paul, Weiss, Rifkind, Wharton & Garrison LLP.  Frances Mi, counsel in the corporate department of the firm, also contributed to the preparation of this article.

There are already a variety of regulatory reform proposals on the table and a broad spectrum of policy actions ready to be implemented by different nations in an effort to address the widespread feeling of discontent flowing from the recent financial crisis. There is an alternative path, however, that may prove to be a more productive and powerful force of change—one that is driven by the corporate sector itself. Progressive companies are taking the opportunity to “lead by example,” promoting the key tenets and principles that will help restore investor confidence. In effect, their day-to-day interactions with all stakeholders demonstrate how to live the right values and ethics.

The starting point for this journey is the board of directors. Collectively, the board has the responsibility for the future direction of the enterprise, its impact on stakeholders and society at large. The board     directly influences the critical management actions to drive short-term financial results, incent long-term value creation and develop strategies and plans that will ensure sustainable growth.

After the recent holiday break, a dozen Fortune 500 directors were asked for their thoughts on the biggest changes they see on the horizon and the implications for the boardroom. Common themes included greater globalization pressures, additional regulatory intervention and the potential rise of national protectionism. Many thought the current flashpoint issue of executive compensation must be addressed quickly to begin restoring investor confidence and credibility on Main Street.

The directors shared the view that a possible long-term, slow growth economic environment, combined with the aforementioned external forces, would challenge boards to become more transparent with key stakeholders on the major decisions that affect the enterprise. They see stake- holders continually “raising the bar” on board performance and taking a more proactive role in influencing the board through enhanced proxy access and more targeted advisory votes.

The fundamental issue to be addressed is how best to rapidly propagate the hallmarks of highly effective boards across the broadest group of companies while promoting the right governance principles and values. When one looks back on the prior decade, from Enron at the beginning, to Bear Sterns and Lehman Brothers at the end, it is easy to conclude that the core    enablers of boardroom change are already taking shape—a large pool of engaged, qualified directors; more shareholder-friendly director election processes; and a viral 24/7 communication cycle that ruthlessly disseminates information on any type of misstep or egregious behavior.

What is still needed is a common forum that brings together the best ideas, innovative practices and new approaches in a non-threatening environment that encourages collaboration and action across boardrooms.

One idea currently building momentum involves creating a closely linked global network of corporate chairmen and lead directors to serve as the primary conduit to more rapidly exchange current best practices, practical insights and actionable ideas. Its mission would help accelerate the development of highly effective boards and promote more progressive shareholder relations and corporate responsibility agendas. As one of the survey respondents concluded, “If I could wave a magic wand today, I would create a self-policing entity that would watch over the large public-company boards and help ensure no one went off the tracks, not the Securities and Exchange Commission, not Institutional Shareholder Services, but a group of practicing chairman and other board members who are fighting the good fight every day, with the goal of looking back in ten years to see a continuous improvement in corporate values, ethics, incentive systems, sustainable business growth and the impact on the global community.”

Keith Meyer is a vice chairman of Heidrick & Struggles and global managing partner of the firm’s Board Consulting Services Practice. Contact him at kmeyer@heidrick.com.

“Greening the enterprise” can begin when companies switch to alternative energy sources and invest in carbon offsets. Or it can start smaller, with a decision to recycle, use energy-efficient lighting and take other steps to cut energy consumption and limit greenhouse gas emissions.  Either way, it’s serious business: respondents at 150 multinational corporations surveyed by Ernst & Young LLP in 2009 indicated that over the next decade, their companies plan to invest $276 billion to manage the effects of climate change.

As green issues move higher on the corporate agenda, board members must ensure that management considers the tax implications, both positive and negative, of investments and activities related to climate change. Ideally, this will be done while such initiatives are still in the planning stage. Directors can maintain proper focus on green tax issues by keeping in mind the following principles:

1.  Going green can improve corporate performance.
Companies are greening in response to real business imperatives, such as the need to protect and grow the revenue base. Organizations that design and manufacture climate-friendly products and services can take market share from competitors. Energy-efficient organizations that sell their credits on the carbon market can also profit in the new environment. Cost reduction is another imperative. By integrating clean tech into the value chain, companies can realize energy efficiencies that encompass operations, real estate, facilities management and IT. A recent McKinsey report suggests that in the U.S. alone, energy efficiency could save more than $1.2 trillion through 2020.

A third business imperative involves responding to government regulations in the form of mandated compliance and incentives to promote green behavior. Such regulations include the Environmental Protection Agency’s rule requiring companies to disclose their greenhouse gas (GHG) emissions starting in 2010, or the mandate by California Assembly Bill 32 to reduce GHG emissions. Finally, companies must manage the expectations of shareholders, employees, customers and the news media. All of these stakeholders increasingly hold businesses accountable for their environmental actions (or lack thereof). As companies move to address sustainability issues, they will likely make significant capital investments, and perhaps even develop new intellectual property. As firms respond to these four business imperatives, they will confront tax issues at the global, federal and state levels.

2.  Climate change offers a window on the future.
Given the tumult of the last two years, trying to predict what will happen tomorrow may seem futile. Nevertheless, companies (and boards) must try. Although there is no crystal ball, involvement in sustainability initiatives can help directors sharpen their future vision of the enterprise. Mainly that is because the need to reduce carbon footprints, and to assess the risks related to climate change, are concerns that most companies have only recently begun thinking about seriously. Sustainability also creates new market opportunities, alters consumer preferences and buying patterns, reshapes procurement criteria to ensure green purchasing and offers the chance to transform business processes. Directors will take on additional responsibilities in light of new rules and regulations, and will need to manage the risks that emerge as those responsibilities evolve. Many of these risks and opportunities have tax implications. Giving the tax department a seat at the table during future sustainability planning can help the organization anticipate, measure and evaluate tax implications for each green business plan. In advising companies on a strategic course of action, directors inevitably peer into the future to discern what lies ahead. Keeping abreast of tax-oriented climate change influences can help them do it more effectively.

3.  Numerous tax incentives exist to offset investments in energy efficiency.
Many of the investments needed to reduce a company’s carbon footprint can be offset substantially by government incentives. About $430 billion in climate change stimulus funding was made available globally in the last year, much of it in the form of incentives such as tax credits and grants. In the United States alone, the American Recovery and Reinvestment Act of 2009 (ARRA) provides more than $90 billion in tax incentives, grants and loan guarantees. Economic payback models that do not include the full suite of tax incentives could be misleading and result in decisions to scrap projects that otherwise would meet payback criteria. In fact, companies may be able to shave years off the payback period of their investments in energy-efficient technologies and renewable energy programs. Organizations that build or retrofit structures with new lighting or temperature-control systems may discover ways to deduct the associated costs, either on a current basis or over an accelerated period. Even conducting a retrospective review of capital investment from prior years may help identify refunds or additional tax savings. Effective planning is the key to accomplishing any of these objectives successfully. Tax directors can advise on which incentive programs are applicable, and whether incentives can be combined so that the company receives all allowable benefits.

4.  Carbon management requires compliance.
Apart from the many sustainability activities that companies are undertaking voluntarily, there are mandated programs in the U.S. and abroad. Potential U.S. legislation mandates a cap and trade system, which could result in increased costs throughout a company’s supply chain. Multinational companies may already be dealing with GHG regulation such as the European Union’s Emission Trading Scheme. This legislative and regulatory activity is driving a rapidly expanding carbon market, and companies that intend to capitalize on the acquisition of carbon credits and offsets should involve their tax departments early in the process. Tax can provide valuable input on such issues as the appropriate accounting model for the company’s particular carbon management strategy. It can also identify the character and timing of potential gains or losses — a crucial consideration in the absence of GAAP or IFRS directives.

In addition, companies may find themselves exposed to new consumption taxes linked to energy. Just as many countries have for years taxed fuel used for transportation, so are the European Union, Canada, Australia and others now applying similar excise taxes to various forms of fuel consumption. Companies may also face less obvious tax consequences related to climate change. Existing and potential future trading schemes allow organizations to meet their carbon emission obligations through offsets: planting trees in non-forested areas in exchange for an offset credit, for example. What are the tax implications for international offset projects?  Will the company realize taxable income from the sale of the credit? Will intercompany transfers of the credits create transfer-pricing issues? Are there ways to structure offset projects to minimize the tax impact? These questions must be considered carefully, and well in advance.

5. Cooperation between boards and tax can help the company respond more effectively to climate change.
Directors and corporate tax departments should monitor the results of global conferences on climate change—not because any single meeting will determine the exact direction of government initiatives, but because tax incentives and penalties developed by different countries will probably be designed around commitments made at those sessions. Tax departments can help companies prepare for the new compliance burden of any such initiatives, while monitoring international and domestic developments at various levels of government. Working more closely with boards, tax can help align corporate behavior and policies with the dynamics of climate change and sustainability. This kind of cooperation can enable the company to achieve both compliance and competitive advantage.

There is uncertainty about which companies will thrive in the new world of green business. What is clear, however, is that climate change and sustainability are about more than corporate social responsibility or concerns about global warming. While climate change certainly has a political dimension, it also affects the bottom line, which includes significant tax implications.

To advise company management, boards must focus on costs, potential benefits and risks to the organization. Board members should attempt to derive maximum value from their tax departments by including tax professionals early in the design and implementation of any corporate initiatives related to climate change.

Here are some examples of U.S. tax incentives to invest in energy-efficient technologies:

Federal

• Incentives for on-site renewable energy production
• Tax credits for manufacturing advanced energy components
• Credits and incentives to help offset the cost of increasing a building’s energy efficiency
• Deduction for cost of eligible energy-efficiency equipment in construction
• Loans for manufacturers to re-equip, expand and establish manufacturing facilities to produce advanced technology vehicles and their components
• Investment tax credits for qualifying energy facilitie
• R&D tax credit

State

• Credits and incentives to help offset costs of making a building more energy efficient
• Credits for renewable energy production
• Recycling incentives
• Credits for programs to train workers on sustainability
• Funding for “shovel-ready” projects

Kate Barton is Americas vice chair of tax services at Ernst & Young.

Steve Starbuck is Ernst & Young global organization’s Americas leader, climate change and sustainability services.

The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.

ExecuNet, a private membership network for senior business executives and those who recruit them, compiles the Recruiter Confidence Index (RCI) based on a monthly survey of executive search firms. It is recognized as a leading indicator for the economy and the executive job market.

Mark Anderson, president and chief economist of ExecuNet, says he started to notice a turn-around in about May or June of last year.

“Our number of searches were up even more and we saw an increased landing of our executive members,” says Anderson. He notes that even though executive jobs have jumped higher coming out of past recessions, this will be a slower rebounding process.

“We have been tracking recruiter confidence since 2003 after that recession and executive jobs were increasing more rapidly than they are at this point…The quarterly increase in 2009 was 5.7 percent, but the annual average is not going to be at this rate,” he says.

Unlike the massive layoffs in January 2009, 33 percent of executive search firms report hiring to meet the recent assignment growth. Twenty-one percent of recruiters say companies will be adding new executive jobs, up from 14 percent in December.

According to Anderson, there are several signs in the economy that point to further executive job growth. “We are seeing hiring increases quarter by quarter by quarter. It will definitely be growing in the coming year,” Anderson adds.

However, as more and more companies are willing to take calls from recruiters, they could be facing issues of retention. “As the recovery happens, retention is going to be a major issue for boards,” he says. “There is a disconnect between company attitudes and executives and if they don’t pay attention to this issue, they could lose some key players as the company rebounds.”

The ExecuNet RCI survey results show recruitment at the highest level of confidence since May 2008.

“Envy, among other ingredients, has a mixture of the love of justice in it.
We are more angry at undeserved than at deserved good fortune.”
—William Hazlitt

“With public sentiment, nothing can fail. Without it, nothing can succeed.”
—Abraham Lincoln

Although neither was a market expert, Hazlitt and Lincoln hit the nail on the head. Their observations describe today’s public perception towards business with remarkable clarity: Greedy executives and financiers are responsible for the current economic crisis because they’re interested only in making money, often at the expense of the public good.

At least that’s what a broad swath of society thinks in the wake of the biggest financial meltdown since the Great Depression.

Whether this perception is accurate or not, the public’s anger and outrage are boiling over at corporate boards, those charged with overseeing corporate America. Directors are squarely in the middle of the debate, whether they realize it or not.

Public confidence towards business–and those who administer it–is at an historic low. So, the outcry for more regulation is spurring government regulators, Congress and others to react to the loss of public confidence by enacting tighter laws that address accountability and transparency.

The Obama administration is pushing some of the most widespread reform proposals in more than 70 years, intended to strengthen the nation’s financial regulatory system for the next several decades. Treasury Secretary Timothy Geithner has hailed the reform as “not modest repairs at the margin, but new rules of the game.”

How did it come to this?
Just as there is nothing new under the sun, there is nothing new in market reform. Excesses inevitably lead to contractions, bailouts, business failures, loss of public confidence, reform and regulation. In recent decades, the guilty parties have ranged from savings and loans and underfunded dotcoms to Enron, WorldCom, subprime mortgages, Lehman Brothers, AIG, banks, GM, Bernie Madoff and hedge funds. Along the way, Japan, Asia, Russia and Argentina have had their culprits, too.

What is important for directors to remember is that this crisis is taking place in the wake of governance reforms mandated by Sarbanes-Oxley, some of the most sweeping in modern history. There is precedent for the level of oversight that also makes good business sense.

The public’s attitude about negative developments at a corporation…can result in a major hit to reputation and billions in lost market capitalization.

Yet, not a week passes where some well-meaning soul doesn’t come into our office to say, “I want to be on some boards.” These are decent people who want to do the right thing.

We always ask, “Why?”
Their responses are along the lines of “My time has come” or “Two or three boards would give me the income I want going ahead in life.” Or, worse, they cannot offer a view. These individuals have not thought about the full range of responsibilities they will need to face, about the work they will have to put in to make their time on a board successful for the company, or about the personal commitment they will need to make.

They want prestige. They want money. They want to get in the game. Not to put too fine a point on it, but ego and greed are what got us into this mess.

Board service today requires enormous work and oversight, experience and business savvy, ethics and good judgment. An outside directorship at a multinational company with complicated operations can involve hundreds of hours a year in meetings, conference calls, travel and study.

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Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage. Indeed, the recent financial industry debacle is perhaps most surprising for its predictability in light of mundane realities accepted by social scientists of the center left and right.

It is well known that businesses aggressively seeking profit will tend to push right up against, and too often blow right through, the rules of the game as established by positive law. The more pressure business leaders are under to deliver high returns, the greater the danger that they will violate the law and shift costs to society generally, in the form of externalities. In that circumstance, if the rules of the game themselves are too loosely drawn to protect society adequately, businesses are free to engage in behavior that is socially costly without violating any legal obligations.

Moreover, the ability of any particular firm to resist imitating the overly risky, but law-compliant behavior of competitors will be compromised to the extent that managers face criticism or even removal for not keeping up with so-called industry leaders whose high, short-term returns have pleased a stock market filled with short-term investors looking for alpha.

Similarly, when power and influence over corporate activities is exerted by those whose primary interest is immediate gain and who have little or no intention to stay invested until the full costs of risky activity are borne — e.g., certain institutional investors who invest the money of others — corporate managers will have an incentive to be responsive to their demands.

When the marketplace presents opportunities for corporations to generate immediate gains through transactions structured so the profits are taken up front and the risks are perceived as minimal, corporations seeking to please a short-term-focused market are likely to seize them. Risks might be sold immediately to others, or theoretically contracted away through arrangements that look like insurance but don’t involve counterparties meeting the standards that apply to insurance companies. Or perhaps the risk is structured to kick in several years down the road.

Likewise, when institutional investors with strong voting clout encourage corporations to increase leverage in order to engage in stock buybacks, increase dividends or reap higher trading gains, responsive corporate boards may leave their corporations without adequate capital to weather tough times, times when many of the proponents of leverage are likely not to be around as stockholders anymore.

If an industry senses that the United States Treasury has its back in the event that risky activity threatens the industry’s health, its leaders may respond even more freely to these market incentives, because they view the industry as having a form of insurance from the taxpayers. When the industry and its leaders have also designed compensation systems that reward managers for generating short-term profits through risky activity — systems often implemented with the encouragement of investors desiring to give managers a strong incentive to pump up stock prices — managers who might otherwise be more focused on the long-term health of their employers are encouraged to go hellbent for leather for immediate gain, too.

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather then durably.

Distilled down, what is most critical is that robust prudential regulation protecting society from risky corporate activity abated, precisely when corporations faced increasingly strong pressures to engage in much riskier endeavors in order to generate short-term results. In the financial sector, this potent cocktail was chased by several governmental interventions to rescue the industry when its “innovative” activities threatened its health, a course of conduct that suggested that the financial industry could take risks other industries could not, because it had a de facto form of federal insurance.

There is, of course, much that is simplified about this description. But, it is in the main true. And it suggests that policy makers need to be mindful of the relationship between the power of the stock market to influence corporate policies and the strength of prudential regulation. Because even diversified long-term stockholders are likely to have an appetite for risk that exceeds what is socially prudent, there will always need to be strong rules of the game to govern industries whose failure poses socially unacceptable risks.

There is no escape from the fact that although corporations are sometimes seen as owned by those who own their equity and elect their boards, the actions of corporations affect a broader range of constituencies, including workers, creditors, consumers and society more generally; no sensible regulatory system can ignore that fact.

The difficulty is compounded when those who directly influence public corporations are not primarily end user investors focused on the long term and keenly worried about excessive risk — think workers who must invest in mutual funds for retirement — but far more likely to be financial intermediaries whose investment horizons are often less than a year.

Strong regulatory standards are indispensable, not simply for society, but also for end-user long-term investors themselves, who bear the long-term costs of corporate idiocy.

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

There is nothing new about the insight that the more incentives businesses have to generate short-term profits, the more likely it is that they will engage in excessively risky activity, especially if they believe that the risks will be borne by others if they come to fruition. We simply have another hard-learned lesson to point to about the costs of ignoring these realities.

In shaping the future, policy makers might therefore focus on two key objectives: re-instituting sound prudential regulation over financial institutions critical to the overall well-being of our capital markets and economy, and implementing policies that focus stockholders and boards on the objective of having corporations produce wealth in both sound, durable fashion.

Ideally, we want a system where corporate boards are highly accountable and responsive to their stockholders for the generation of sustainable profits. But for that policy objective to be achieved, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock prices. So long as many of the most influential and active investors continue to think short term, it is unrealistic to expect the corporate boards they elect to strike the proper balance between the pursuit of profits through risky endeavors and the prudent preservation of value.

Leo E. Strine Jr., vice chancellor of the Delaware Court of Chancery, is also the Austin Wakeman lecturer in law of Harvard Law School, an adjunct professor of law at the University of Pennsylvania and Vanderbilt law schools, and a Crown Fellow with the Aspen Institute.

The board of directors of Target Corp., for example, which won a bitter proxy battle against Pershing Square Capital Management earlier this year, have just approved amendments to its articles of incorporation that would end its staggered board beginning with the 2011 shareholders’ meeting.

Staggered boards came to prominence largely as a defense against unwanted takeover bids. With a staggered board of directors—sometimes referred to as a classified board—shareholders elect three or four directors each year in a class, most often for a term of three years, making hostile takeover attempts more difficult.

By staggering the election of directors, hostile bidders face more than one proxy fight to gain control of the target firm. Particularly when combined with a poison pill, the staggered board makes for potent defense against an unwelcome takeover.

In theory, staggered boards offer benefits to shareholders when compared with unitary boards, including greater stability, greater independence for outside directors, and a longer term perspective, all things shareholders should want, too, according to Guhan Subramanian, a professor of business and law at Harvard, writing in The New York Times. Also, because companies increasingly require that board candidates win a majority of votes cast, directors would seemingly value the right to face election every three years, rather than every year. It is not unusual in Europe, for example, for shareholders to elect directors to six-year terms but retain the right to remove them from office at any time.

Yet opponents of staggered boards find them less accountable to shareholders and a breeding ground for a fraternal atmosphere inside the boardroom that serves to protect the interests of management more than those of shareholders. Furthermore, they contend that unitary boards are stable as well, because the vast majority of board elections are uncontested.

The central argument of institutional investors and other opponents of staggered boards, however, is that staggered boards rob shareholders of the economic benefit of hostile takeovers. The facts support them.

According to a study conducted by three Harvard University professors, including Subramanian, and published in the Stanford Law Review in 2002, in the nine months following a hostile takeover bid, shares of companies with staggered boards increased 31.8 percent, compared to an average of 43.4 percent at companies with unitary boards.

Although hostile takeovers remain rare, the fact remains that shareholders elect directors to represent their interests. If staggered boards deter takeovers, or lessen the premiums paid for shares as a result of takeovers, staggering the board creates a conflict between the board and the shareholders it represents.

Another study by Harvard and Wharton professors examined how 24 governance mechanisms affect shareholder value. The study found that governance mechanisms that strengthen shareholder rights tend to improve share price, while mechanisms favoring management, including staggered boards, and tend to erode value.

So, perhaps not surprisingly, under pressure from institutional investors, there has been a tremendous decrease in the percentage of companies with staggered boards. Among the Standard & Poor’s 500, for example, only 34 percent have a classified board. According to RiskMetrics, 79 publicly traded companies themselves placed declassification resolutions on their ballots in 2008. There were 54 company-sponsored proposals in 2007 and 72 in 2006.

This year saw more of the same.

• In April, Brocade Communications shareowners supported proposals by California’s two largest pensions to do away with the company’s supermajority vote requirement and to elect all directors annually. Leading proxy advisors—RiskMetrics Group, Glass Lewis & Company and Egan-Jones Proxy Services—had all recommended that Brocade shareholders support CalSTRS and CALPERS over management.

• This June, shareholders of the luxury retailer Saks voted to put directors up for election annually in a move to make the board of the struggling retailer more accountable. Shareholders also voted for a proposal that required directors to receive a majority of votes to be elected, rather than a plurality.

• McGraw-Hill fended off an unsolicited bid from American Express in the late 1970s in a much publicized battle, and in the mid-1980s, the company’s shareholders adopted a staggered board and other takeover defenses.

In recent years, a McGraw-Hill shareholder doggedly proposed that the company eliminate its staggered board, and in its proxy statement just this past March, McGraw-Hill urged shareholders to vote against the measure. The proxy argued that the staggered board “increased board stability” and “enhanced the ability to protect shareholder value in a potential takeover.” However, within months, McGraw-Hill reversed course. It has now recommended that shareholders eliminate the staggered board at next year’s annual meeting.

But if Senator Charles E. Schumer has his way, the jig’s up. Legislation that he introduced in May would kill staggered boards forever. He introduced a “shareholder bill of rights” which would give shareholders a “say on pay” and would require that the positions of chairman and chief executive be separated at publicly traded companies. Sen. Schumer’s bill would require that corporate directors receive at least 50 percent of shareholder votes in order to remain on the board and ban staggered boards.

With or without Sen. Schumer’s bill, the number of companies with staggered boards will continue to decline, and for the companies that retain staggered boards, the pressures for “reform” can only mount. Yet managing that transition to a unitary board may also prove difficult.

It will be important, for example, to make certain that the company has done everything it can to create value for shareholders. Companies that have significantly underperformed the market or their peers will be more vulnerable.

Up until 2006, for example, the board of Anheuser-Busch was staggered, with one-third of the directors up for election each year. In response to shareholder pressure, Anheuser-Busch amended its certificate of incorporation to de-stagger the Anheuser board and provide for election of all directors each year. Anheuser-Busch was in the midst of this process when InBev announced its bid. Given the high price offered, and Anheuser-Busch’s poor historical performance, it was game over.

Since resolutions to de-stagger boards often seems to be linked with a requirement that directors receive a majority of shareholder votes, the value created by the board and its individual members must be readily discernable to outsiders.

In personal experience, as a meeting of a CEO search committee broke up, one of the directors turned plaintively to his peers and asked if any other director had less than 50 percent of the votes from the proxies received. The chairman told him, “No, everyone else has at least 60-some percent,” and turned away. It was sad to see the director fumble with his papers as he tried to regain dignity and the embarrassment of the other directors as they tried to shift the conversation. It was awkward for everyone in that room.

The NYSE requires that the boards of all listed companies evaluate performance annually. Yet as recently as 2006, only about one-quarter of public boards had instituted any systematic review of director performance.

The importance of maintaining positive working relationships in the boardroom makes it difficult for most boards to address poor performance. Unfortunately, with the advent of majority voting, reviews of director performance will take place in public with investors axing directors who seem unlikely to foster shareholder value.

Considering the stature of most directors, the prospect of delivering a rebuke is unpleasant. However, from everyone’s perspective, that’s better done quietly than publicly.

Gregory T. Carrott is managing director at Cavoure, a Chicago-based executive recruitment firm.

Presenting Partner: Egon Zehnder International Contributing Partners: KPMG ACI and Hodak Value Advisors

The focus for this year’s annual boardroom summit will be to define and discuss the following issues in the context of today’s ever-changing regulations:

• The New Director Profile
• Audit Committee Challenges & Priorities
• Getting in Front of CEO Succession
• Activists and the Board
• Executive Compensation

Participation at NACD Directorship Boardroom Summits is limited to public company board directors and corporate officers.