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.

Clearly, boards must be careful not to undertake the responsibilities of management. Nevertheless, given the well-publicized mistakes made with respect to MBS, boards will want to subject management at financial-services companies to higher scrutiny and oversight regarding their involvement with these and other exotic securities. To do so, they first will need to determine whether there is sufficient expertise on the board; if not, they will need to acquire it.

The task is easier said than done. MBS comprise a sophisticated alphabet soup of complex financial instruments, including securities backed by subprime, Alt A, negative amortization, home equity and commercial mortgage loans, as well as collateralized debt obligations (CDOs) backed by asset-backed securities (ABS) , and CDOs squared (which are backed by tranches of CDOs of ABS). Investment banks leveraged these securities at 35 to 1. Insurance companies bought them to back obligations such as guarantied investment contracts (GICs), annuities, and funding agreements. Bond insurers then guarantied and reinsured them, and commercial banks’ bought and guarantied them with credit default swaps (CDS).

Defaults on the mortgages underlying these securities triggered steep market value declines, markdowns, capital depletion, rating downgrades, and plummeting stock prices, all of which resulted in limitations on the ability to raise needed equity and write loans and insurance products. Yet, an examination of financial-institution boards prior to and during the meltdown, and even now, reveals a surprising lack of direct expertise in these securities. And although closer scrutiny and oversight may seem a bit like closing the proverbial barn door, many experts believe that there will be substantially more markdowns of MBS. Indeed, Goldman Sachs, in a February 11, 2009 report stated, “We’re only halfway through: We forecast $2.1 trillion in losses from U.S. credit this cycle.” The current environment will continue to present issues associated with MBS, as well as other issues raised by the financial crisis, that will require increased board oversight and related expertise.

In fact, in late February, newly appointed Securities and Exchange Commission Chairman Mary Schapiro indicated that she plans to examine whether boards of banks and other financial-services firms conducted effective oversight during the period leading up to the financial crisis. At the same time, she is considering asking boards to disclose more about directors’ backgrounds and skills and their knowledge of risk management, according to a recent article in The Washington Post.

Asset Liability Analysis
Boards, through their risk oversight committees, might want to increase scrutiny of how assets and liabilities are performing currently: how they perform under a stress test, whether the test imposes enough stress, and the extent to which assets match liabilities, particularly if liabilities are accelerated and assets have to be liquidated to meet them in markets that may become frozen. Boards may also want to inquire more deeply regarding MBS default projections, the assumptions underlying these projections, and the reasonableness of the company’s methodology.With respect to complex financial instruments, it is important to understand the institution’s rights relative to the rights of others. For example, the rights of the institution as a holder of a AAA-rated tranche of a CDO- squared are subordinate to the rights of the AA-rated holder of the CDO of ABS in which the CDO-squared holds the BBB-rated tranche.

Disclosure by companies of additional asset markdowns, after they announced that they didn’t expect any more, has undermined confidence in financial institutions.

Disclosure by companies of additional asset markdowns, after they announced that they didn’t expect any more, has undermined confidence in financial institutions. These markdowns reduced earnings, depleted capital, and eroded confidence among equity investors, sending stocks into a tailspin and limiting companies’ ability to raise badly needed capital. If the experts who believe that there is more to come turn out to be right, it will be even more important for boards to become comfortable with their companies’ mark-to-market methodologies.

The performance of many liabilities can be even more troublesome. Banks face issues with respect to triggers in their credit default swaps that can result in termination events and the need to post capital in the event of a ratings downgrade. Insurance companies issued GICs and funding agreements that can be accelerated in certain events, such as rating downgrades. “Full-flex” GICs can be accelerated under many circumstances—almost at will, and municipal GICs can be accelerated under other circumstances. Annuities have similar considerations. Some funding agreements have short roll-over periods and can be terminated on short notice. Moreover, given the current environment and the likelihood that policy holders will need cash, does the institution have a sound methodology of forecasting cash surrenders? Sadly, many of the assets backing these liabilities are MBS, and their liquidation values have plummeted. As a result, which assets does the institution sell to meet its obligations? These and other variables must be clearly modeled and analyzed, not only for the purpose of avoiding risk, but to understand them and all the attendant consequences.

The declines in the values of assets backing liabilities that are accelerating raises the need for liquidity. Boards should understand the extent of this need and ensure that management has arranged for multiple sources of robust liquidity that can be depended on during a crisis.

Also, boards may want to better understand the extent to which a company is at risk of a credit-ratings downgrade due to capital adequacy and other issues. This is especially important now that rating agencies are downgrading securities backing and backed by financial institution obligations. The agencies are basing these models now on the acceleration of certain liabilities and liquidation values—as opposed to the future cash flows—of the companies’ assets. Downgrades not only can accelerate liabilities, require collateral posting, and trigger rights to recapture ceded reinsurance, they can also effectively preclude the writing of new business for some institutions.

Under some circumstances, it has been productive for board members to meet directly with rating agencies, particularly if a company has been put on review for a downgrade that will limit the company’s ability to do business.

Reserves also are ripe for renewed focus by board directors. Originally, they were considered the purview of the audit committee and informed by the company’s auditors since they form a large part of the factors in dealing with expected losses and the period over which they will occur. Boards now need a much more comprehensive understanding of how management calculates its reserves and whether its methodology is consistent with statutory, regulatory, generally accepted accounting principles, and rating-agency requirements, as well as conventional practices.

Boards and Risk Governance
Boards might also want to subject their company’s risk-tolerance levels to more scrutiny. For example, a board might make more in-depth inquiries regarding the price volatility of securities in its investment portfolio that may have to be sold to pay claims or other obligations. Boards may also want to question management regarding the correlation risk along references (issuers) and sectors within the corporate CDOs held in the investment portfolio or guarantied through CDS. For example, they’ll want to know if the company is exposed to the California economy through its municipal bonds or its MBS holdings. What levels of leverage are acceptable, given the price volatility of the securities leveraged?

Moreover, the board should determine that management has a system in place that assures compliance with risk-tolerance levels once they are set—a challenge that proved difficult for many financial institutions in the recent past. The board might also want the risk and business functions of the company to be more separate than they are. For instance, analysts who set the company’s credit criteria should report to the chief risk officer and the latter should report to both the CEO and the board’s risk oversight committee or the full board.

Sell or Hold and TARP
The decision to sell or hold assets, whether to the Troubled Assets Relief Program (TARP) or in negotiated sales to the private sector, involves the need to model future cash flows and assign present values to them. Indeed, a bank may realize more from its MBS by holding them to maturity or until future credit losses become more ascertainable, than by selling now, as the massive liquidations of MBS from margin calls have in all likelihood forced prices down beyond the present value of their future cash flows. Moreover, a bank that sells MBS will forego any subsequent markup and its attendant increase in capital (for this reason, a guaranty of MBS under Section 102 of EESA would be preferable). As a result, selling at depressed prices might be the wrong decision and inconsistent with management’s and the board’s obligations to shareholders. On the other hand, holding MBS will be attended by market uncertainty regarding the extent of future losses. Boards should inquire of management until they become comfortable with the balancing of these considerations.

The decision to take TARP money or other government funding must be made in light of the government’s insistence on lending, which can be inconsistent with the board’s and management’s duties to shareholders to make prudent loans. It also must consider potential dilution of existing shareholders and executive pay limitations that could damage the ability to attract needed talent. Accepting government funds often, maybe always, carries a stigma —a perception that failure is possible.

Government Action and Policy
Boards should be aware of potential legislative and regulatory changes motivated by the financial crisis, how they can impact their companies, whether and how their companies should try to influence their outcomes, and how their companies plan to adjust if these changes are implemented. Perhaps the most visible are the panoply of actions contemplated by the mortgage assistance program, the stimulus package, EESA, and the to-be-announced actions taken by the federal government in connection with banks. Also, changes are being contemplated by state insurance regulators that are likely to impact insurance and financial guaranty companies.

The decision to take TARP money must be made in light of the government’s insistence on lending, which can be inconsistent with the board’s and management’s duties to shareholders to make prudent loans.

The notion of removing ratings from the federal, state, and international regulatory schemes has been weighed and, if implemented, would change the way capital is calculated for depository institutions, insurance companies, and stock brokers. The elimination of the designation of the Nationally Recognized Statistical Rating Organization—another thought that has been advanced by some—would require changes in state legal investment laws, mutual fund prospectuses, and other documents containing investment eligibility criteria, which limit investments to certain rating categories, to allow many institutional investors to continue to purchase debt instruments issued by financial institution (and all other companies).

The Financial Accounting Standards Board, the SEC, and insurance regulators continually debate whether to allow financial institutions to mark to model instead of to market. Boards will need to understand and become comfortable with the reasonableness of substitute valuation methods and models, how their results might impact the company, and whether they are consistent with their auditors’ views.

Some financial-institution boards will be faced with the decision whether to become a bank-holding company and will have to consider the institution’s needs for access to insured deposits as a low-cost source of capital, access to the Fed for low-cost liquidity and to exchange illiquid, high-beta collateral (e.g., highly rated MBS) for treasuries that can satisfy collateral-posting requirements required by CDS and other contracts, and the benefits associated with the imprimatur of government support. On the other hand, boards will have to consider the disadvantages of becoming a bank-holding company, such as becoming part of an unprofitable banking system that competes with unsupervised financial firms, lower leverage limits (although investment-bank leverage limits are likely to be as low in the future), becoming subject to risk-based capital rules of Basel II, increased costs due to the need to install systems necessary to comply with government reporting requirements, increased supervision and regulation attended by additional costs and overhead, and the difficulty in becoming a non-bank holding company if the company chooses to do so in the future.

Long vs. Short Term
Finally, some decisions may be in the interests of the institution, at least in the short run, but may be damaging to the economy as a whole and, in the long run, come back to damage the institution and perhaps the entire sector. For example, lending to less creditworthy borrowers may be above a bank’s risk-tolerance levels; but if all major banks were not willing to make such loans, funding for businesses could be inadequate to maintain operations, which could result in higher unemployment, a further contraction in consumer spending, more business failures, and even an increase in the velocity and severity of the existing economic downturn.

Also, foreclosure might be preferable to forbearance and mortgage modification (including reducing the principal amount of the mortgage) in order to minimize losses associated with home mortgages. But foreclosure would also add to the massive number of homes on the market, exacerbating the downward spiral of housing prices and resulting in more markdowns of MBS and, consequently, further depletion of bank capital. Foreclosures prevent a bottoming of home prices, MBS markups, and the attendant increase in the availability of home-mortgage financing. As a result, home purchases and housing starts, which are the biggest engines to consumer spending, would suffer even more than they do currently. Consequently, because consumer spending constitutes 70 percent of our economy, an early economic recovery would become even less likely.

Because lending to less creditworthy borrowers and forbearance or modification as opposed to foreclosure could have good long-term results only if they were practiced by many large institutions, boards might encourage management to determine whether coordination with federal authorities and other institutions in their sector might be beneficial.

To be sure, boards should not undertake functions that are more appropriately the responsibility of management. Clearly, boards should not build their own risk, default- or price-volatility models, or develop their own reserve methodologies or presentations to rating agencies. Nor should they impose on management a system that, in the board’s opinion, ensures compliance with risk-tolerance guidelines. But the extent of oversight and scrutiny over these functions should be determined in large part by what is at stake for the company and its shareholders. It would seem that history has taught us that, given the current environment, these high-stakes decisions require deep levels of board scrutiny and oversight as well as thorough interaction with management.Neil Baron is a director of Assured Guaranty Limited, a bond insurer, where he serves on the risk and audit committees.

But beneath all of these details are fundamentals even more important than the hot topics of the day.

In the last issue, I called your attention to NACD’s “Key Agreed Principles to Strengthen Corporate Governance for Publicly Traded Companies.” Now it’s time to build on them. NACD, America’s membership organization for directors, is announcing “A Challenge for Corporate Directors: Renew Commitment to Corporate Governance and Oversight Excellence.”

I recognize that the majority of our membership is performing well, but the recent financial-sector collapse has diminished public and investor confidence in publicly traded companies and we must all make a renewed commitment to corporate governance and oversight excellence.

NACD is challenging not just our 10,000 members, but every board and individual director to lead the charge in improving board performance and corporate oversight by strengthening governance in boardrooms across the country. And it begins with assessing current performance and taking measures to improve.

This campaign is a call to action to urge all boards to assess their current performance. We urge boards to:

• Embrace NACD’s Key Agreed Principles and use them as a framework for determining board practices and as a tool that can be adapted to each board’s specific needs

• Assess the board’s practices with an emphasis in four critical areas: executive compensation, risk oversight, corporate strategy, and transparency

• Commit to continuous director education and knowledge exchange around NACD’s Key Agreed Principles and leading practices that have been identified by NACD white papers

• Provide greater transparency by annually sharing board progress on these commitments

NACD will report on the progress of U.S. boards that have accepted this challenge on a quarterly and yearly basis.

It is time for directors to embrace their responsibility on corporate boards and lead this charge. To learn more and participate in the campaign, visit www.nacdonline.org today. The time is now.

Financial institution boards will face many issues associated with the current financial crisis, including issues related to the Emergency Economic Stabilization Act of 2008 (EESA), the recently-passed stimulus program, Obama’s foreclosure prevention program, and whatever else comes out of the Administration and Congress. Many–perhaps most–decisions will require an understanding of the mortgage-backed securities (MBS) that played such a central role in the deterioration of our largest financial institutions.

Clearly boards must be careful not to undertake the responsibilities of management. Nevertheless, given the mistakes made with respect to MBS, boards will want to subject management at financial services companies to higher scrutiny and oversight regarding their involvement with these and other exotic securities. To do so, they will first need to determine whether there is sufficient expertise on the board and if not they will need to acquire it.

The task is easier said than done. MBS comprise a sophisticated alphabet soup of complex financial instruments, including securities backed by subprime, Alt A, negative amortization, home equity and commercial mortgage loans, as well as collateralized debt obligations (CDOs) backed by asset-backed securities (ABS) , and CDOs squared (which are backed by tranches of CDOs of ABS. Investment banks leveraged these securities at 35 to 1. Insurance companies bought them to back obligations such as guarantied investment contracts (GICs), annuities and funding agreements. Bond insurers then guarantied and reinsured them, and commercial banks’ bought and guarantied them with credit default swaps (CDS).

Defaults on the mortgages underlying these securities triggered steep market value declines, markdowns, capital depletion, rating downgrades, plummeting stock prices, all of which resulted in limitations on the ability to raise needed equity and write loans and insurance products. Yet, an examination of financial institution boards prior to and during the meltdown, and even now, reveals a surprising lack of direct expertise in these securities. And although closer scrutiny and oversight may seem a bit like closing the proverbial barn door, many experts believe that there will be substantially more markdowns of MBS. Indeed, Goldman Sachs, in a February 11, 2009 report stated “We’re only halfway through: We forecast $2.1 trillion in losses from U.S. credit this cycle.” The current environment will continue to present issues associated with MBS, as well as other issues raised by the financial crisis, that will require increased board oversight and its related expertise.

In fact, in late February, newly appointed Securities and Exchange chairman, Mary Schapiro indicated that she plans to examine whether boards of banks and other financial services firms conducted effective oversight during the period leading up to the financial crisis. At the same time she is considering asking boards to disclose more about directors’ backgrounds and skills and their knowledge of risk management, according to a recent article in the Washington Post.

Asset Liability Analysis

Boards, through their Risk Oversight Committees, might want to increase their scrutiny of how assets and liabilities are performing currently: how they performed under the company’s stress tests, whether those tests impose enough stress, and the extent to which assets match liabilities, particularly if liabilities are accelerated and assets have to be liquidated to meet them in markets that may become frozen. Boards may also inquire more deeply regarding MBS default projections, the assumptions underlying these projections and the reasonableness of the company’s methodology. With respect to CDOs of ABS and CDOs squared, it is important to understand the institution’s rights relative to the rights of others. For example the rights of the institution as a holder of a AAA tranche of a CDO squared are subordinate to the rights of the AA holder of the CDO of ABS in which the CDO squared holds the BBB tranche.

Disclosure by companies of additional asset markdowns after they announced that they didn’t expect any more has undermined confidence in financial institutions. These markdowns reduced earnings, depleted capital and eroded confidence among equity investors, sending stocks into a tailspin and limiting the company’s ability to raise badly needed capital. If the experts who believe that there is more to come turn out to be right, it will be even more important for boards to become comfortable with their companies’ mark to market methodologies.

The performance of many liabilities can be even more troublesome. Banks face issues with respect to triggers in their credit default swaps that can result in termination events and the need to post capital in the event of a ratings downgrade. Insurance companies issued GICs and funding agreements that can be accelerated in certain events, such as rating downgrades. “Full flex” GICs can be accelerated under many circumstances – almost at will, and municipal GICs can be accelerated under other circumstances. Annuities have similar considerations. Some funding agreements have short roll-over periods and can be terminated on short notice. Moreover, given the current environment and the likelihood that policy holders will need cash, does the institution have an efficacious methodology of forecasting cash surrenders? Sadly, many of the assets backing these liabilities are MBS, and their liquidation values have plummeted. As a result, which assets does the institution sell to meet their obligations? These and other variables must be clearly modeled out and analyzed – not only for the purpose of avoiding risk, but of understanding them and all the attendant consequences.

The declines in the values of assets backing liabilities that are accererating raises the need for liquidity. Boards should understand the extent of this need and ensure that management has arranged for multiple sources of robust liquidity that can be depended on during a crisis.

Also, Board’s may want to better understand the extent to which a company is at risk of a credit ratings downgrade due to capital adequacy (and other) issues. This is especially important now that rating agencies are downgrading securities backing and backed by financial institution obligations. The agencies are basing these models now on the acceleration of certain liabilities and liquidation values–as opposed to the future cash flows–of the companies’ assets. Downgrades not only can accelerate liabilities, require collateral posting and trigger rights to recapture ceded reinsurance, they can also effectively preclude the writing of new business for some institutions.

Under some circumstances, it has been productive for board members to meet directly with rating agencies, particularly if a company has been put on review for a downgrade that will limit the company’s ability to do business.

Reserves, too are ripe for renewed focus by board directors. Originally, they were considered the purview of the Audit Committee and informed by the company’s auditors as they form a large part the factors in dealing with expected losses and the period over which they will occur. Boards now need a much more comprehensive understanding of how management calculates its reserves and whether its methodology is consistent with statutory, regulatory, GAAP and rating agency requirements, as well as conventional practices.

Boards and Risk Governance

Boards might also want to subject their company’s risk tolerance levels to more scrutiny. For example, the boards might inquire more deeply regarding the price volatility of securities in its investment portfolio that may have to be sold to pay claims or other obligations.. Boards may also want to question management regarding the correlation risk along references (issuers) and sectors within the corporate CDOs held in the investment portfolio or guarantied through CDS. For example, they’ll want to know if the company exposed to the California economy through both its municipal bonds and its MBS holdings? What levels of leverage are acceptable given the price volatility of the securities leveraged?

Moreover, the board should determine that management has a system in place that assures compliance with risk tolerance levels once they are set – a challenge that proved difficult for many financial institutions in the recent past. The board might also want the risk and business functions of the company to be more separate than they are. For instance, analysts who set the company’s credit criteria should report to the Chief Risk Officer and the latter should report to both the CEO and the board’s Risk Oversight Committee or the full board.

Sell or Hold and TARP

The decision to sell or hold assets, whether to TARP or in negotiated sales to the private sector, involves the need to model future cash flows and assign present values to them. Indeed, a bank may realize more from its MBS by holding to maturity or until future credit losses become more ascertainable than by selling as the massive liquidations of MBS from margin calls have in all likelihood forced prices down beyond the present value of their future cash flows.. Moreover, a bank that sells MBS will forego any subsequent markup and its attendant increase in capital (for this reason, a guaranty of MBS under Section 102 of EESA would be preferable). As a result, selling at depressed prices might be the wrong decision and inconsistent with management’s and the board’s obligations to shareholders. On the other hand, holding MBS will be attended by market uncertainty regarding the extent of future losses. Boards should inquire enough of management to become comfortable with the balancing of these considerations.

The decision to take TARP money or other government funding must be made in light of the government’s insistence on lending which can be inconsistent with the board’s and management’s duties to shareholders to make prudent loans. It also must consider potential dilution of existing shareholders and executive pay limitations that could damage the ability to attract needed talent. Accepting government funds often, maybe always, carries a stigma – a perception that failure is possible.

Government Action and Policy

Boards should be aware of potential legislative and regulatory changes motivated by the financial crisis, how they can impact their companies, whether and how their companies should try to influence their outcomes, and how their companies plan to adjust if these changes are implemented. Perhaps the most visible are the panoply of actions contemplated by the mortgage assistance program, the stimulus package, EESA and the to-be-announced actions to be taken by the federal government in connection with banks. Also, changes are being contemplated by state insurance regulators that are likely to impact insurance and financial guaranty companies.

The notion of removing ratings from the federal, state and international regulatory schemes has been uttered and, if implemented, would change the way capital is calculated for depository institutions, insurance companies, and stock brokers. The elimination of the NRSRO designation–another thought that has been advanced by some–would require changes in state legal investment laws, mutual fund prospectuses and other documents containing investment eligibility criteria (that limit investments to certain rating categories) to allow many institutional investors to continue to purchase debt instruments issued by financial institution (and all other companies).

FASB, the SEC and insurance regulators continually debate whether to allow financial institutions to mark to model instead of to market. Boards will need to understand and become comfortable with the reasonableness of substitute valuation methods and models, how their results might impact the company, and whether they are consistent with their auditors’ views.

Some financial institution boards will be faced with the decision whether to become a bank holding company and will have to consider the institution’s needs for access to insured deposits as a low cost source of capital, access to the Fed for low-cost liquidity and to exchange illiquid, high beta collateral (e.g. highly rated MBS) for treasuries that can satisfy collateral posting requirements required by CDS and other contracts, and the benefits associated with the imprimatur of government support. On the other hand, boards will have to consider the disadvantages of becoming a bank holding company, such as becoming part of an unprofitable banking system that competes with unsupervised financial firms, lower leverage limits (although investment bank leverage limits are likely to be as low in future), becoming subject to risk-based capital rules (Basel II, for example), increased costs due to the need to install systems necessary to comply with government reporting requirements, increased supervision and regulation attended by additional costs and overhead, and the difficulty in becoming a non-bank holding company if the company chooses to do so in future.

Long vs. Short Term

Finally, some decisions may be in the interests of the institution, at least in the short run, but may be damaging to the economy as a whole and, in the long run, come back to damage the institution and, perhaps the entire sector. For example, lending to less creditworthy borrowers may be above a bank’s risk tolerance levels; but if all major banks were not willing to make such loans, funding for businesses could be inadequate to maintain operations, which could result in higher unemployment, a further contraction in consumer spending, more business failures, even higher unemployment and an increase in the velocity and severity of the existing economic downturn.

Also, foreclosure might be preferable to forbearance and mortgage modification (including reducing the principal amount of the mortgage) in order to minimize losses associated with home mortgages. But foreclosure would also add to the massive number of homes on the market, exacerbate the downward spiral of housing prices, result in more markdowns of MBS and, consequently, further deplete bank capital. As importantly, foreclosures prevent a bottoming of home prices, MBS markups and the attendant increase in the availability of home mortgage financing. As a result, home purchases and housing starts, which are the biggest engines to consumer spending, would suffer even more than they do currently. Consequently, because consumer spending constitutes 70 percent of our economy, an early economic recovery would become even less likely.

Because lending to less creditworthy borrowers and forbearance or modification as opposed to foreclosure could have good long-term results only if they were practiced by many large institutions, boards might encourage management to determine whether coordination with federal authorities and other institutions in their sector might be beneficial.

To be sure, boards should not undertake functions that are more appropriately the responsibility of management. Clearly boards should not build their own risk, default or price volatility models, or develop their own reserve methodologies or presentations to rating agencies. Nor should they impose on management a system that, in the board’s opinion, ensures compliance with risk tolerance guidelines. But the extent of oversight and scrutiny over these functions should be determined in large part by what is at stake for the company and its shareholders. It would seem that history has taught us that, given the current environment, the decisions discussed above are high stakes decisions that require high levels of board scrutiny and oversight as well as a deep and thorough interaction with management.

Neil Baron is a Director of Assured Guaranty Limited, a bond insurer, where he serves on the Risk and Audit Committees.

The firm expects the 2009 proxy season to include an all-time high in withold votes for directors, increased focus on regulatory matters, much greater attention to how boards manage risk—particularly true at banks and other financial service firms.

Shareholder proposals to achieve more shareholder input on executive compensation will also see a significant rise in support, as will proposals that seek to limit CEO power by splitting the CEO and chairman roles.

At the top of Obama’s agenda will be filling his cabinet, and his selection of Treasury Secretary is one of the most vital appointments. That selection, named last month, is Timothy Geithner, who Obama plans to nominate to the post. As the president of the Federal Reserve Bank of New York, he has enjoyed a rapid rise through the ranks and has been praised for his role in helping to develop the bailout plan. Larry Summers, who held the Treasury post under Clinton and later endured a contentious reign as president of Harvard University, was named to head the White House National Economic Council.

A pressing question is whether Obama will continue with current Treasury Secretary Henry Paulson’s plan to overhaul and consolidate the regulatory framework under the Federal Reserve. It is likely that there will be some restructuring, but probably not on the scale that Paulson recommended. Expect Obama to select a new Securities and Exchange Commission chairman, in the mold of Arthur Levitt, who will be a strong advocate for shareholders. That could mean new rules for proxy access and broker votes, and, to the dismay of directors, less restrictive tests for shareholder proposals.

The other hot-button issue for directors in the light of the new administration is “say on pay.” Obama introduced the Senate’s version of the bill in 2007 and has rallied around it ever since. With the public outcry against excessive compensation in the midst of the credit crisis, expect Obama to do everything he can to confirm his sentiment that “the American people should not be spending one dime to reward the same Wall Street CEOs whose greed and irresponsibility got us into this mess.” Such a push towards say on pay and a general curb on executive compensation was inevitable following the credit crisis; remember that fellow presidential candidate John McCain was also a supporter of say-on-pay legislation.

Directors are certainly hoping that Obama makes good on his promise to reach across the aisle. Just how far that hand is extended could make the difference between reasonable regulation and new rules that make life more difficult for those who sit on the boards of public companies.

Thesurvey reports that virtually all directors are independent outsiders and techcompanies are splitting the roles of chairman and CEO. Moreover, nearly halfhave officially appointed a lead director, according to an examination of 100tech companies by Spencer Stuart, an executive search firm that specializes in recruitingdirectors.

TheSarbanes-Oxley rules, implemented after the Enron fiasco, have beencontroversial in Silicon Valley. Noted venturecapitalist Tom Perkins–who is credited with exposing the spying scandal lastyear at Hewlett-Packard–has complained that many directors are fixated oncomplying with rules rather than guiding companies.

But JohnWare, senior director of Spencer Stuart’s Silicon Valley office in San Mateo, told thenewspaper that regulatory pressures have spurred companies to appoint directorswith more financial expertise, train them better, and weed out directors whowere sitting on too many boards to be effective.

Thefirm’s survey indicates that five years after Sarbanes-Oxley took effect,outsiders comprise 83 percent of directors of valley companies, up from 75percent in 2003. Ninety-seven percent of companies have a designated financialexpert on their audit committees, compared with 11 percent in 2003. And almosttwo-thirds of valley companies split the roles of chief executive and boardchairman, compared with 35 percent of Standard & Poor’s 500 companies.

“Silicon Valley is not a place for cronies,” Ware said.“It is a place to work, and it’s a place where boards are independent from theCEO. That was an evolution at some companies, and not necessarily easily done.”

The battle pits two leading corporate governance experts against each other: Lucian Bebchuk, a Harvard Law School professor and ardent shareholder-rights proponent, and Martin Lipton, a Wachtell, Lipton, Rosen & Katz founding partner who has been a stalwart defender of the viewpoint that it is management’s prerogative to do what is in the best interest of the corporation since he dreamed up the poison pill to help companies fend off corporate raiders more than two decades ago.

How their increasingly acrimonious duel plays out is likely to influence many of the corporate governance debates now going on in boardrooms, the Securities and Exchange Commission (SEC), and Congress. The central issue is whether directors of a public company owe their primary fiduciary duty to its shareholders, as Bebchuk insists, or have to consider the prerogatives of all the stakeholders, as Lipton maintains.

In 2005 lectures at Cardozo and Yale Law Schools called “The Myth of the Shareholder Franchise,” Bebchuk argued that the governance structure of most U.S. companies disenfranchises their true owners, the shareholders. His sharp critiques have put powerful intellectual firepower behind rising shareholder demands for more control over corporate boards, from the proxy access proposal on director elections currently under consideration at the SEC, to Say on Pay, which would give shareholders input into executive compensation. (Editors’ note: Say on Pay, sponsored by Rep. Barney Frank (D-Mass.) passed in the House by a 2 to 1 margin in April. Barack Obama sponsored similar legislation in the Senate, but the Senate Committee on Banking, Housing, and Urban Affairs has yet to take action on the proposal.)

“The fear of replacement is supposed to make directors accountable and provide them with incentives to serve shareholder interests.” –Lucian Bebchuk, Harvard Law 

Lipton did not sit idly by. He rebutted Bebchuk’s world view with a pointed essay in the May issue of the Virginia Law Review called “The Many Myths of Lucian Bebchuk.” The article, co-authored by Wachtell colleague William Savitt, strikes at the heart of the widely accepted argument that a company’s primary goal is to maximize shareholder value. In addition to calling out Bebchuk in the title, Lipton challenges the very notion that corporations are the private property of stockholders, and does so in language so forceful that it might sound like heresy coming from almost anyone else in Corporate America. “Shareholders do not ‘own’ corporations,” he says. “They own securities—shares of stock—which entitle them to very limited electoral rights and the right to share in the financial returns produced by the corporation’s business operations.”

Directors, Lipton and Savitt argue, are not merely representatives of stockholders who have a legal responsibility to put investor interests first. Instead, they assert, the role of a director is simply and dutifully to seek what’s best for the company itself, which means balancing the interests of shareholders as well as other stakeholders such as management and employees, creditors, regulators, suppliers, and consumers. They conclude that Bebchuk’s postulate that the shareholder enjoys the position as the board’s primary client is a myth of corporate law, and should be understood as such.

Careful What You Wish For

Lipton vs. Bebchuk is one of those topsy-turvy clashes that has caused corporate governance experts to line up on either side of the debate, and has led to the presence of some strange bedfellows. Lipton first began articulating his director-centric position in a 1979 article published in The Business Lawyer called “Takeover Bids in the Target’s Boardroom,” years before the stakeholder view gained prominence in the late 1990s. But he has since gained backing from several of the most articulate stakeholder theorists, including University of California at Los Angeles corporate law professor Lynn Stout. Two years ago, she penned a piece called “Takeovers in the Ivory Tower: How Academics are Learning Martin Lipton May be Right.”

The problem for Lipton is that while Stout and others such as Vanderbilt University law professor Margaret Blair have fleshed out his views with impressive scholarship, their work may lead to conclusions that run counter to his pro-company perspective. For example, if the directors’ duty is to balance the interests of all corporate stakeholders, should they be given explicit guidance on how to go about doing that? And should they be held liable if they fail to do so in some egregious manner? What happens when a company, even unintentionally, rips off creditors, employees, or the community in a way that enriches its shareholders?

Similarly, Bebchuk’s many admirers may rue where they wind up. Governance reformers in the United States have been led by public and labor pension funds that have invoked shareholder rights to demand more accountability from directors, allowing them to score victories such as Sarbanes-Oxley and majority voting agreements at hundreds of companies. But many have waved the shareholder banner largely out of expediency: After all, the argument for more board accountability to stockholders fits snugly into the reigning ethos that a company’s purpose is to maximize value for its owners.

Yet their true beliefs, certainly prevalent among most union leaders, who ultimately hire and fire the union pension fund managers, lie much closer to the stakeholder view, which was widespread among business antagonists such as the anti-globalism forces of the 1990s. Warns Blair: “The labor and public funds are making a tactical mistake using the shareholder-ownership argument. It’s easy to sell, but they’re not going to like the outcome, which will put more power in the hands of private-equity firms and others who have a short-term interest in a company.”

“Shareholders do not ‘own’ corporations. They own securities – shares of stock – which entitle them to very limited electoral rights and the right to share in financial returns.” –Martin Lipton, Wachtell Lipton

While Lipton’s stakeholder view has been gaining some support in the academic and corporate world, it’s unclear whether it will upend the conventional wisdom that a company is the property of stockowners. Indeed, Bebchuk starts his attack by citing a widely quoted 1988 ruling by the Delaware courts that “the shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests.” He points out that corporate law gives boards the authority to hire and fire management and set the company’s overall direction. But there is a parallel relationship, says Bebchuk, in that directors “are expected to serve as the shareholders’ guardians,” so stockholders in turn must have the power to replace them. “The fear of replacement is supposed to make directors accountable and provide them with incentives to serve shareholder interests,” he says.

Bebchuk’s “Myth of the Shareholder Franchise” article goes on to demonstrate just how infrequently U.S. directors are actually challenged, much less unseated. His conclusion: The franchise that shareholders putatively hold under corporate law is in practice, a myth. The remedy he proposes is more expansive than the proxy- access proposal now before the SEC. To turn shareowner power into a reality, he recommends directors be elected by a secret ballot open to rival candidates nominated by shareholders. To put them on an equal footing with the management slate, challengers should be reimbursed from corporate coffers if they receive a threshold number of votes, perhaps a third of those cast.

While Bebchuk hasn’t fully addressed the stakeholder theory directly, he discusses how his proposals would benefit shareholders in his “Myth” article, which appeared in the May Virginia Law Review issue featuring Lipton’s attack as well as articles by Stout; former Chief Justice of the Delaware Supreme Court, E. Norman Veasey, who is now a senior partner at Weil, Gotshal & Manges; and others. While Bebchuk’s focus on shareholders is certainly the mainstream perspective, Lipton and company advance an alternative view.

A “Team Production”

The stakeholder proponents advance their position by rebutting the notion that shareholders have “ownership” of a public company. They point out that a stock purchase conveys none of the traditional rights that come with conventional property ownership. To support this, they cite the following: Shareowners can’t take possession of the company’s assets, nor can they exclude anyone from company property. They do not even fully control the company’s ultimate fate, since directors have the right to decide whether or not to put a possible sale up for a shareholder vote. In this corporate world view, assets are owned not by investors, but by the corporation itself, a legal entity that stands apart from its many, often shifting stockholders. Further, in the event of a default, it is the creditors who own and decide a corporation’s fate, whereas shareholders are left owning valueless shares.

Lipton even contradicts the long-established idea that directors act as agents on behalf of shareholder “principals.” Rather, he says, Delaware corporate law requires directors to oversee the company “in accordance with their independent business judgment,” he writes.

Stout, Blair, and other stakeholder theorists have backed up his analysis with an elaborate critique of the conventional view of corporations. The standard theory of the firm that underlies Bebchuk’s position views companies as enterprises owned by investors who put up the cash, and use contracts of various sorts to engage everyone needed to make them a success, from executives and employees to creditors and suppliers. Contract law, in this view, is back-stopped by government regulation, and protects the interests of everyone except the investors. In exchange for shouldering all the risk, investors get the “residual” value, i.e., whatever’s left over after all other parties get their contractual dues. The board is appointed to look after the interests of the firm on behalf of these “residual claimants,” its owner-shareholders.

The stakeholder critics say this model doesn’t capture what really happens in a public corporation. In their view, a company is actually a “team production.” They mean not a workplace team but one comprised of everyone—and every social institution—that makes it possible for a company to function: not just investors, executives, employees, suppliers, and creditors, but also customers, communities, taxpayers, lawmakers, and the society whose rules and norms govern economic activity.

All of these participants, Lipton would argue, are residual claimants to varying degrees, because all have invested something in the company that can’t be fully protected by law or contract. For example, Microsoft customers invest what economists sometimes call “sunk costs,” which extend beyond the purchase price, when they spend time and effort to learn Excel and other programs that they then depend upon for personal or business tasks. Sure, they can sue if the company favors shareholder interests over theirs, or they can choose to simply stop being a customer. But Microsoft’s goal is to balance all claimants’ interests so the company will succeed. And it’s the board’s job to make sure that the company does. “Directors need to maximize the total economic benefit that a company provides for society as a whole, not just for shareholders but for everyone else with a sunk cost in it, including employees, executives, customers, and creditors,” says Stout.

Lipton deploys the stakeholder philosophy to denigrate proxy-access proposals by Bebchuk and others. Giving shareholders too much direct control over the board, he argues, opens the door for some or all investors to exploit the company’s assets for themselves, to the detriment of other participants. If that happens, the company’s other residual claimants may refuse to participate, damaging the enterprise. The board’s role is to be the neutral, independent mediator of all those with a stake in the company’s activities, he argues, to make sure all parties are treated in a fashion that will ensure their continued participation in the company’s success. As Lipton put it in his law review attack on Bebchuk, “Case after leading case confirms that directors—not shareholders—are vested with the right and independent obligation to direct the management of corporate affairs.”

Common Ground?

Bebchuk offers a few pragmatic objections that shed light on the further elaboration needed to apply the stakeholder theory in the boardroom. For example, he points out that corporate law in Delaware and most other states allows directors to take stakeholder interests into account, but generally doesn’t require them to do so. So Lipton and others who resist proxy-access proposals are really relying on nothing more than mere wishful thinking that directors will balance stakeholder interests if they’re insulated from direct exposure to stockholder voting. Protecting boards from ouster by unhappy shareowners, says Bebchuk, leaves them accountable not to all stakeholders, but to no one. “Stakeholder theory is interesting, but the bottom line is that it uses stakeholders to justify insulating boards from shareholders,” he says.

Lipton’s response is that a board has a direct duty not to stakeholders per se, but to the corporation. “The board can and should take into account the interests of stakeholders to promote the interests of the corporation, but it doesn’t have a fiduciary duty to customers, suppliers, or employees,” he says.

Still, it may not be enough to say that directors can balance stakeholder interests and therefore should be left free to do so. For more than two decades now, Bebchuk and other critics have been demanding more shareholder input to counterbalance what they perceive as boards that have been captive to management. Lipton and his followers just as ardently believe that there is an equal and opposite danger in boards becoming beholden to a share-holder view that may be colored by short-term thinking or hidden agendas. If shareholders and stakeholders could begin the task of spelling out formal guidelines that ensure that boards put the interests of the corporation before all else, including those of the CEO, and in such a manner that both shareholder and appropriate stakeholder rights are considered, then the two camps might find they have more in common than they’re now willing to concede.

From “The Myth of the Shareholder Franchise”

By Lucian Bebchuk, Virginia Law Review, May 2007 

A WELL-KNOWN…Delaware opinion states that “[t]he shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests.” Similarly viewing the shareholder franchise as a key mechanism for making boards accountable, another landmark Delaware opinion states: “If the stockholders are displeased with the action of their elected representatives, the powers of corporate democracy are at their disposal to turn the board out.” I…argue …however, that shareholders do not in fact have at their disposal those “powers of corporate democracy.” As a result, the shareholder franchise does not provide the solid foundation for the legitimacy of directorial power that it is supposed to supply.

The shareholder franchise is largely a myth. Shareholders commonly do not have a viable power to replace the directors of public companies. Electoral challenges are rare, and the risk of replacement via a proxy contest is extremely low. To restore accountability and place our corporate governance system on solid foundations, the shareholder franchise should be transformed from a myth into a reality. The reforms put forward … would provide shareholders with a viable power to replace directors. They would thereby improve the accountability and performance of corporate boards. Such reforms, which would benefit investors and the economy, are long overdue.

From “The Many Myths of Lucian Bebchuk”

By Martin Lipton, Virginia Law Review, May 2007 

IGNORING DECADES of salutary historical development and the overwhelming lessons of observed boardroom behavior, Bebchuk advocates the abandonment of the traditional process for selecting and retaining directors of U.S. public corporations. In its stead, Bebchuk offers a novel electoral system of his own recent invention—a regime specifically designed to encourage costly proxy contests and frankly founded on the premise that corporate directors will not do their jobs absent the constant fear of imminent replacement.

Bebchuk’s prescription is policy revolution masquerading as reform. Indeed, it is increasingly clear…that Bebchuk has become a deconstructionist who seeks to overthrow the fundamental framework of existing corporate law. The Bebchuk approach would discard the management concepts of U.S. corporate law that have nurtured the most successful economy in the world. It would transfer the basic responsibility of corporate management from directors to shareholders. And it would thus leave management and directors subservient to the whims of shareholders (or, perhaps more accurately, to the demands of the most vocal of them), no matter how self-serving they may be, no matter how parochial their interest, no matter how inconsistent with long-term corporate performance, and no matter how destructive to the economy as a whole.

The traditional wisdom for many shareholders is they don’t wantinside information, which restricts their ability to trade. But if I’mgoing to hold the stock for three to four years anyway, then going onthe board adds a level of value and brings perspective and independence.