“I am shocked that in this time of extreme financial crisis for the bank that you would spend the time and legal expenses to challenge a resolution of this sort when the bank could simply ask the proponent to withdraw in light of the fact that you were now implementing the advisory vote,” wrote Tim Smith of Walden Asset Management in a letter to BofA executives. Walden was behind one of the say-on-pay proxy initiatives. “Is this a sign that bank executives don’t even know how to have a simple conversation with their shareowners to work out a basic agreement?” he scathed.

The BofA case highlights a well-known fact in the relationship between boards and shareholders: what we have here is a failure to communicate. The financial crisis and swooning stock market have heightened investors’ hunger for more information on corporate governance issues. Frustrated shareholders unsatisfied with structures in place for executive compensation, CEO succession planning, board nominations, and other hotly debated governance issues, are calling for a forum to voice their concerns directly to the board. “The collapse of the economic system has everyone talking about corporate governance… boards need to have a rational dialogue with shareholders,” says Stephen Brown, director and associate general counsel of corporate governance at TIAA-CREF.

Currently, the majority of boards do not have an open forum in which both sides are receptive and willing to meet to hear the other side’s concerns. Proxy resolutions, viewed today by some activists as a way to “knock on the door” of boardrooms, could instead become a last resort should changes be made in how investors and directors communicate with one another.

The news is not all bad. According to a recent survey by Spencer Stuart, data collected over the past 10 years from proxy reports filed by S&P 500 companies and surveys of corporate secretaries and general counsels found that 45 percent of respondents reach out to shareholders in some way. However, despite this number, only recently has progress been made toward regular dialogue that seeks to find middle ground between boards and investors. Pfizer was something of a test case in 2007, when it planned a meeting with large shareholders to discuss governance issues. Last summer, UnitedHealthcare Group created an advisory committee to allow shareholders to suggest new directors. PepsiCo signed a broad set of governance guidelines last June known as the Aspen Principle, which includes a promise to facilitate more communication with their shareholders. The boards of Home Depot, Hewlett-Packard, and Northrop Grumman have held dialogues with shareholders on compensation issues or even to discuss board nominees.

The Reg FD Effect

These companies are still the exception rather than the rule. Over the last several years, major changes have occurred that have curtailed the amount of information disclosed to investor groups. Barry Genkin, partner at Blank Rome, who has advised CEOs, boards, and audit and compensation committees in proxy battles, believes a lot of the unrest began when regulation prevented the amount of information companies made public, known as Regulation Fair Disclosure or Reg FD. “Companies used to meet with analysts and those analysts would write up reports,” says Genkin. “After new regulations intended to prevent ‘selective disclosure,’ companies were limited to only information they could place in an 8-K or press release.” Instead of working out other ways to inform investors, companies simply sent out less information, he says.

Edward E. Lawler III, a professor at the University of Southern California Marshall School of Business and founder and director of the University’s Center for Effective Organizations, believes that the SEC’s more recent efforts to push companies for more disclosure has backfired. “In a failed effort by former SEC chairman Christopher Cox, who pushed for more disclosure—what he got was more paper,” argues Lawler. “It backfired. With 30-page proxy statements, I don’t think people became more knowledgeable.”

“Information didn’t dry up,” adds Genkin. “But it wasn’t as robust.” Overall, Genkin agrees that companies have not dealt well with the disclosure requirements to investors. “A constant communication mechanism needs to happen,” says Genkin. “Enlightened companies who are aware of their company’s communication shortcomings need to be very aggressive.”

Some experts think that boards will soon have little choice but to communicate better with large shareholders. “Early on, investors were rebuffed because they were coming from a single direction,” says Patrick McGurn, special counsel at proxy advisory firm RiskMetrics Group’s ISS governance services unit. “Investors were reaching out and directors did not reach back.” McGurn emphasizes that the old way of communication is being absolved. He advises boards to open the door to large investors, and he says progress is being made, with some boards more actively connecting with their largest shareholders and telling them the changes their board is looking to make. “[Directors] want to stop any backlash that might happen when such information is actually disclosed in a proxy statement,” says McGurn. Establishing an open line of communication could help directors and investors avoid lengthy and costly proxy battles later on.

Last year, the National Association of Corporate Directors assembled a blue-ribbon commission on board and shareholder communications. Among its many recommendations was that the governance committee should have oversight of board and shareholder communications and make efforts to ensure that they are open, candid, and productive.

Pfizer’s Breakthrough

The concept of open communications is not new. As far back as 1992, Martin Lipton, a partner at Wachtell, Lipton, Rosen & Katz, and an opponent of “excessive” input by investors, and Harvard Business School professor Jay Lorsch called for the boards of U.S. companies to “meet annually in an informal setting with five to 10 of the larger investors of the company,” according to the paper, Talking Governance: Board-Shareowner Communications on Executive Compensation, co-authored by Stephen Alogna of Deloitte & Touche and Stephen Davis, project director at the Millstein Center at the Yale School of Management and the founding editor of Global Proxy Watch.

“The collapse of the economic system has everyone talking about corporate governance…boards need to have a rational dialogue with shareholders.

- Stephen Brown, TIAA-CREF

“It’s still a very slow and very rare process in the United States for boards to open up dialogue,” says Davis. “The investor relations function tends only to get investors to buy shares when pushing out information, but a two-way dialogue is what is needed.”

An important step toward opening the lines of communication occurred in 2007, when pharmaceutical giant Pfizer’s board decided to plan a meeting with larger shareholders for the sole reason of discussing governance issues. “When it comes to finding channels and pioneering ways of opening dialogue, Pfizer is a good example,” says Davis. Pfizer’s board met with 30 of its largest investors and took questions from them on corporate governance issues. “This is not about strategy, and it’s not about a dog-and-pony show,” Margaret “Peggy” Foran, former senior vice president of corporate governance, associate general counsel, and corporate secretary of Pfizer, said at the time. “[The board] just wants to gather as much information as possible to make the best decisions. I never thought of listening as a dangerous sport.”

Foran, now vice president, general counsel, and corporate secretary of Sara Lee, believes that eventually Sara Lee will follow the example set by Pfizer. She believes informal “listening exercises” involving large investors, lead directors, the CEO, and executives like herself, can lead to an official meeting, such as Pfizer’s. With many issues investors are seeking to address, boards realize that shareholder groups are diverse—and not everyone is going to leave the table happy.

Pfizer director Suzanne Nora Johnson agrees that creating a dialogue can be a positive step in building trust between boards and stakeholders. Yet, she says, the board serves a broad range of sometimes competing stakeholder interests, and it cannot select the ideals of a few at the expense of the many. “There are many different types of stakeholders,” says Nora Johnson. “You have to listen carefully and best evaluate whether the stakeholder has both short-term and long-term interests.” Since the 2007 meeting, the Pfizer board has not met again with shareholders apart from the annual general meeting, scheduled for April. But Nora Johnson says the board found the experience to be beneficial and says it will hold similar meetings again in the future, either annually or biennially.

“I think you will see a lot more informal [meetings between shareholders and directors],” says Foran. “For the past five or six years, boards have gotten more involved, with the help of shareholder proponents like RiskMetrics.” Moreover, Foran says, it’s becoming noticeably routine that all board members are attending annual meetings rather than only a select few.

Yet some directors do not agree that such meetings can be productive. Ashok Shah, a director at Sapient, a technology consultancy, thinks that opening the lines between directors and shareholders could create static. “I believe strongly that the relationship with the shareholder should be with one body in the company,” he says. “Today it’s mostly the CEO and the management team, and having that one relationship with the shareholder is the most productive and healthy method, rather than introducing one more conversation with the board. Otherwise, you have two teams talking with shareholders, which could lead to confusion and contradiction.”

J. Thomas Presby, a director who serves on multiple boards, including American Eagle Outfitters and Tiffany & Co., isn’t sure if greater communication is the answer. “At this moment, I’m not persuaded. I’ve attended a lot of annual meetings; most are orderly, and there are some but not a lot of questions. No one has stood up and said they need more communication,” he says.

To be sure, shareholders are a varied lot, often equipped with competing agendas and different views on governance. Genkin warns of the shareholder wolves in sheep’s clothes—the investor who is only interested in short-term performance. From his experience, there are shareholders out there looking to pursue their own aims under the guise of everyone’s interest. He notes that boards can hone in on who is legitimately concerned with the company’s long-term well-being and those looking for fast returns. Careful listening is required. “I’ve had activist shareholders approach boards saying ‘we’re your friends,’ while offering views that could be useful to the board,” says Genkin. “Some of the ideas of activist shareholders have become beneficial to the company and it becomes a win-win.”

Good Listeners

Many directors are warming up to the idea of establishing better communications with investor groups. Last fall, Bonnie Hill, a director at Home Depot, told a gathering of directors at an NACD conference: “Directors are accountable to—and should be responsive to—shareholders.” She said it should be the lead director or committee chairs who meets with large shareholders and that the talks should be structured and well planned. “The chairman or CEO should be the first point of contact. Then I think there are directors who might be clearly involved, such as the chair of the compensation committee. But it’s important to identify in the boardroom what kind of communication will take place—and who will do what.”

Some directors say that any outreach should be more of a listening exercise for boards than engaging in a back-and-forth dialogue. “It would certainly benefit the company if there were a more open line of communication between shareholders and directors,” says Charles “Randy” Whitchurch, a director at SPSS and Scan Source. “But this should be more of a one-way conversation, the board ought to be hearing the shareholders. I do not think the board should be the voice of the company speaking to shareholders; that’s the role of management. I think the danger of having a conversation is that it will become more of a two-way debate. Directors aren’t always as tuned into what the company’s message is. You run the risk of directors going off message…having been a CFO of a public company for 17 years, it was very important that we followed clear protocols on who and how we communicated with shareholders.”

Thomas C. Wajnert, lead director at Reynolds American, agrees that the focus should be on gathering feedback from shareholders. “Yes, they should be communicating, but I think it should be in the context of listening,” he says. “I think where the board has to draw the line is engaging in a debate—the board needs to be in listening mode.” Governance Road Show Opening the lines of communication means going beyond a telephone call or email. TIAA-CREF’s Brown suggests a “governance road show,” where a combination of general counsels, corporate secretaries, and lead directors, go out to meet with their investors. The hope is that relations will improve and become more accessible if investors know senior leaders in the company are interested in their concerns. “One firm we work with sends its general counsel to make the rounds with its large investors,” says Brown. “The feeling on our side is: we have access and feel as comfortable picking up the phone as he does.”

“I think the dangers of having a coversation is that it will become more of a debate. Directors aren’t always as tuned into what the company’s message is. You run the risk of directors going off message.”

- Charles “Randy” Whitchurch

Boards are expected to enact a more proactive role in listening to issues concerning shareholders. Experts believe that boards who refuse to adjust their communications strategy risk repercussions during proxy season. “The boards who are worried [about lack of communication with shareholders] are who should be least worried,” says Nell Minow, editor and co-founder of The Corporate Library. “Those who aren’t worried…they’re in trouble.” Minow advises that boards be open to more frequent dialogue, even if that means overhauling the way business is done.

Once the doors to dialogue are opened, rather than a lot of “babbling,” says Foran, it is better to seize the opportunity and narrow the criteria. “Shareholders should use the dialogue constructively— not micromanage,” she warns. “If boards allow shareholders to use the opportunity to talk as a weapon, boards are not using their fiduciary duty in the correct way.” Foran believes that in most cases, investors are trying to learn and understand—not attack. She notes some companies are initiating dialogues before a crisis rather than fending off shareholders made angrier because they feel ignored.

There may be another reason to for boards to seek more open communications with shareholders: majority voting. Some experts think that shareholders may withhold votes for directors who they perceive to be unopen to hearing their concerns. “There is a carrot and stick equation with communicating—with majority voting being the stick,” says McGurn. “If companies don’t dialogue when they’re approached by investors, they’ll see some effort to withhold or vote against.” If that begins to happen, some directors may be putting their largest shareholders on speed dial.

Finding talented and qualified candidates can be a daunting challenge, says Robert Hallagan, vice chairman and managing director of board leadership services at Korn/Ferry International. Hallagan points out that while demand is high for boardcaliber individuals with risk-monitoring experience, there are other factors at work.

The current economy prevents qualified CEOs and directors from dividing their time while facing increased liability. Many experienced CEO candidates are stepping off boards or have stopped joining others. “I can’t imagine a CEO asking permission to go on a new board right now,” says Hallagan.

Finding the right person is only the first step, adds Hallagan. “Boards need to make sure a portion of their agenda is dedicated to the risk discussion,” he says. “There’s no sense of adding someone who has this type of expertise to the board and not have the time set aside on the agenda every quarter.” Asking more questions and prompting management to follow through with answers is imperative to successful risk oversight, he says.

“There is no general prescription, but clearly, boards need to be more attuned to the risks that the company faces,” says Martin Lipton, partner at Wachtell, Lipton, Rosen & Katz. “Directors themselves need to have the background and information necessary to evaluate what they’re being presented with.”

Lipton adds that the board should delegate a specialized committee devoted to risk, conduct periodic tutorials with management or outside experts with respect to risk, and thoroughly review the company’s risk-management system on a regular basis. Lipton maintains such simple actions would benefit a company’s risk conduct immensely.

A trio of legal experts has come out against a to-be-introduced shareholder rights bill authored by Senator Charles Schumer (D-NY).

In an editorial with The Wall Street Journal, lawyers Martin Lipton and Theodore N. Mirvis, and Harvard law professor Jay W. Lorsch, state their anticipatory opposition to the Shareholder Bill of Rights Act of 2009, saying that increased shareholder rights will only result in a continuation of the short-term stockholder focus that brought about recession in the first place.

“The stockholder-centric view of the current Schumer bill simply cannot be the cure for the disease it spawned,” reads the piece.

Morgan commissioned architect Stanford White to build a private club to trump the city’s other clubs that had, according to lore, blackballed the financier and his friends. Cunningham wryly noted that Morgan certainly didn’t require a subprime loan to build the Renaissance Revival mansion and would be positively mystified by how the tables had turned more than a century later, with government now bailing out business. While building the companies that would become General Electric and U.S. Steel, Morgan twice used personal funds to help shore up the finances of the U.S. government.

Against this backdrop, today’s business elite of executives, board directors, institutional investors, journalists, educators, regulators, and corporate governance gurus gathered on December 2 for this year’s forum: “The Way Forward: Leadership in Challenging Times.”

The annual event also recognized the Directorship 100, the list of the most influential people on corporate governance and in the boardroom, and included a full day of moderated panel discussions, keynotes, and peer-group exchanges that focused on the financial crisis, the new administration and Congress, and the forthcoming proxy season. Speakers—drawn from all spheres of corporate governance—included Congressman Barney Frank, former Congressman Michael Oxley, former SEC Chairmen William Donaldson and Harvey Pitt, Delaware Vice Chancellor Leo Strine, Jr., famed economist David Hale, and renowned directors Marsha Johnson Evans, Charles Perrin, and many others.

The Outlook

An overriding theme for the day was the outlook for regulatory reform. While none of the panelists disputed the need for it, Pitt was the most specific about the reforms required. The 26th chairman of the SEC recommended that the scope of each regulator’s authority be clarified so that when problems arise, there is absolute certainty about who should respond. To provide transparent, fully informed markets, Pitt encouraged regulators to force the disclosure of information about all financial markets, including hedge funds. Longer term, he recommended the consolidation of federal regulators into the Federal Reserve and a single other regulator.

Martin Lipton of Wachtell Lipton Rosen & Katz, warned against looking to the board to do that which it is incapable of doing, asserting that many independent directors lack deep knowledge of their company’s industry. He compared this situation unfavorably with earlier boards that often included the company’s investment banker and commercial banker—people who understood the business and could engage in a robust exchange with other board members.

Donaldson maintained that directors have taken their job more seriously since the passage of the Sarbanes-Oxley Act and urged that investor protection not be overlooked in any reforms. Strine agreed that boards have in recent years become more responsive to stockholder demands, including those made by activist investors who urged management to take more risks to generate higher profits. Strine noted that strong safety and regulation was more, not less, important when the stockholders’ voice was potent, especially given that institutional investors who represent long-term shareholders have generally failed to make monitoring excessive risk and leverage a centerpiece of their activism.

Lipton also cited the need for regulators to understand the products and transactions they regulate. Today, professionals with PhDs often design complex financial instruments and if regulators are to regulate them, they will need to understand the instruments properly, he said, adding that regulatory design should reflect this reality.

CEO Succession and Recruitment

Moderator: Jeffrey M. Cunningham, chairman, CEO, and editorial director, NewsMarkets, publisher of Directorship and Global Proxy Watch. Panelists: Theodore L. Dysart, managing partner, Heidrick & Struggles; Linda Fayne Levinson, independent lead director at NCR, director, DemandTech, Ingram Micro, Jacobs, Engineering Group; Charles Perrin, chairman, Warnaco, director, Campbell Soup

CEO succession is arguably the most critical element of any company’s risk management planning. Most notably, Dysart pointed out that sometimes CEOs aren’t ready to relinquish their roles. “The leader is not ready to leave and the board doesn’t take ownership of the process,” added Dysart. He warned that not taking the reins on succession planning could prove to be dire. “[Boards] need to look through the windshield, not the rear-view mirror.”

Oftentimes, Levinson said, the board is unsure what qualities they are looking for in a successor. “If you know a few years out that you’re making a change, there will be new skill sets needed with the new CEO,” added Charles Perrin, chairman of Warnaco. The needed skill sets for a CEO vary with time and situation. Dysart said that a leader’s shelf life rarely exceeds 10 years. Levinson countered that the tenure of a CEO is situational: “Sometimes even three years is too long.”

The reluctance of companies to look inside for successors is a mistake. “People don’t make good choices when they go outside,” said Dysart. The financial crisis has undoubtedly inflicted additional pressure to find the appropriate CEO to lead during turbulent economic times. “Regal leadership is over,” said Perrin. Levinson agreed: “CEOs are willing to be contradicted.”

The New Pay Paradigm

Moderator: Aaron Bernstein, editor at large, Directorship. Panelists: Marsha Johnson Evans (right), director, Huntsman Corp., Office Depot, and Weight Watchers; Charles M. Elson (below, left), University of Delaware, director, AutoZone, Health- South; Steven Hall, managing director, Steven Hall & Partners

Companies are focused on survival and public scrutiny is fixated on executive compensation. Elson noted that while the Senate did not pass “say on pay,” Obama supports it and boards should expect to see greater government involvement. Evans said that compensation committees need to work on reconciling competing interests. “The comp committee sits down, finds a way to use the limited amount of tools, shares, and options available to them, and crafts them into a package.” Hall warned that thinking quarter to quarter instead of long term indicates something is wrong with the company’s strategy. “I don’t think people will say, ‘You earned $5 million, now you’ll get $3 million,’” said Hall. Rather than giving more shares, the amount of shares should stay the same and as a result, pay will drop, he added.

The Effects of The Credit Crisis

Moderator: Alan Murray, assistant managing editor, The Wall Street Journal. Panelists: Harvard Law School Professor Lucian Bebchuk, and former Congressman Michael G. Oxley, vice chairman of Nasdaq OMX

Oxley, the former Ohio congressman and co-author of the reform legislation that bears his name, contrasted the current regulatory environment with the conditions prevailing in 2001 when the Sarbanes-Oxley Act was adopted, pointing out that the current crisis could not be characterized as a scandal involving criminal misconduct. Oxley raised doubts that criminal behavior would be found to have contributed to the crisis; it is more likely, he said, “that bad decisions had been made by good people.”

Bebchuk suggested that flawed compensation practices have been an important driver of the short-term outlook of corporate managers, which contributed to the current crisis. He described how compensation packages can be redesigned to provide managers with incentives to maximize long-term shareholder value.

Crisis Communications and Wall Street

Moderator: Judy Warner, deputy editor, Directorship. Panelists (from left to right): John Byrnes, executive editor, BusinessWeek, editor-in-chief BusinessWeek. com; Richard Levick, president, Levick Strategic Communications; Greg Farrell, Wall Street correspondent, Financial Times

Richard Levick declared that the battle between new and traditional media is over, and high-authority bloggers are setting the agenda. While the media equation has changed, board behavior has not. “Board members need to be thinking differently about the media. They need to be proactive and they need to be asking themselves how they can work behind the scenes to help,” he suggested.

One way is to cultivate relationships with journalists and correct stories when you see that an error has been made. “The plaintiff’s bar certainly understands what we think of as the new media. FDR had fireside chats on the radio and said we have nothing to fear but fear itself. He was not afraid to embrace new media and neither should we,” said Levick.

As Harvey Pitt, former chairman of the SEC, puts it, “The next crisis isn’t going to be just like this crisis, because this crisis hasn’t been like any before it.”  Very few people are arguing for the status quo and most agree, like Pitt, that we need to update some of the antiquated aspects of the regulatory system. Yet a knee-jerk reaction from Washington and a sprawling, one-size- fits-all regulatory response could just add to the problems Corporate America already faces.

In this month’s cover story, Assistant Editor Django Gold examines how government’s unprecedented ownership of equity and debt could bring a vast change to the role of regulators. In conversations with such corporate governance experts as Pitt, Martin Lipton, and Allan Meltzer, Gold finds that directors face what could be the biggest changes to the rules of the game in their lifetimes. What could avert that fate is a renewed spirit of responsibility and accountability on the part of boards to rein in abuses and set high standards of governance. In other words, a new beginning.

This issue marks a new beginning for Directorship, as well. We are now the official magazine of the National Association of Corporate Directors (NACD). Both organizations embraced this effort to ensure that directors continue to have the very best coverage, research, and events to help inform you and provide guidance from the top thinkers in corporate governance as this unprecedented time in the history of business continues to unfold.

Titled, “Shareholder Activism and the ‘Eclipse of the Public Corporation’: Is the Current Wave of Activism Causing Another Tectonic Shift in the American Corporate World,” Lipton addresses how today’s uneasiness between shareholders and directors ultimately affects the global economy. He stresses that shareholders are interested in short-term gains, thus hurting long-term interests of the company.

Lipton, best-known as the father of the poison pill and an adviser to corporations on mergers, acquisitions, and matters affecting corporate policy and strategy, separated activists into two categories: hedge funds that target more profitable and financially healthy firms, and other entrepreneurial activists, who do not redirect investment strategies of their targeted firms.

Lipton advises directors to be, “vigilant, thorough, and proactive in seeking to balance short-term pressures against long-term goals.” He also explains how the tumultuous relationship between boards and shareholders affects the global economy.

The board-centric model of corporate governance is based on shareholders being confident with their board’s leadership abilities. The current distrust shareholders have toward their boards can ultimately cause competition with global competitors to suffer. American corporations cannot compete with emerging industries in foreign countries if shareholders and directors remain at odds.

Short-term or “short-sighted” stock gains by activist hedge funds make long-term investments in their businesses less attractive. Lipton writes that shareholders are short-sighted and are only interested in the short-term bottom line. It is the responsibility of directors to ensure that the company’s long-term investments reflect the company’s best interests.

]]> http://www.directorship.com/board-control-seen-shifting-to-shareholders/feed/ 0 http://www.directorship.com/a-chewable-poison-pill/ http://www.directorship.com/a-chewable-poison-pill/#comments Thu, 01 Jan 1970 00:00:00 +0000 Gretchen Michals http://www.directorship.com/?p=4171

Harvard Professor Lucian Bebchuk has been trying to get companies to adopt a measure into their bylaws that would put restrictions on how they can use the controversial takeover defense to ward off unwanted suitors. Bebchuk’s Bylaw, as it is known, is intended to put limits on how poison pills can be used.

After early rejections by CA and others, Bebchuk changed the proposal to make it more palatable to boards. Since then, the bylaw has been adopted by AIG, Time Warner, and more recently, CVS, Disney, Bristol-Meyers Squibb and JCPenney.

Columbia Professor John Coffee believes the poison pill is still evolving. He says a “chewable pill,” one that would require readoption or shareholder override by a majority vote, is necessary.

Richard Ferlauto, pension and benefit policy director of the American Federation of State, County and Municipal Employees, thinks the shift to bylaw-change efforts “is really the wave of the future for corporate-governance activists.”

Opponents aren’t convinced. “It’s another gimmick to enhance shareholder power at the expense of the board,” says Marty Lipton, of law firm Wachtell, Lipton, Rosen & Katz, credited with inventing the poison pill more than 20 years ago. “It’s more of a nuisance than anything else, and it isn’t going to overhaul the way business is done.”

Bebchuk believes the benefits of adopting his proposal outweigh any surrender of power. He says he will likely target more companies next year.

1. MAINTAIN COLLEGIALITY and the culture of a common enterprise with the CEO and senior management, while you continue to increase monitoring of performance and compliance in response to pressure from shareholders and regulators.

2. ASSURE SHAREHOLDERS and other constituents (including regulators) that the CEO and senior management are being properly evaluated and that there is a continuously reviewed management succession plan.

3. UNDERTAKE A COMPREHENSIVE REVIEW of risk management and overall risk-management procedures in the company.

4. RE-EXAMINE BALANCE SHEET ISSUES, including leverage, debt maturities, share buybacks, and dividend policy, in light of the prediction by Alan Greenspan, and others, that there is a 50 percent chance of a recession.

5. DEAL WITH THE EXECUTIVE COMPENSATION ISSUE by developing specially tailored programs to minimize criticism, properly documenting the discussions and decisions of the compensation committee, and complying fully with the new Securities and Exchange Commission rules. At the same time, directors will need to cut through the media and political gadflies’ criticism of executive compensation in order to enable the company to attract and retain the best available executives, and reward outstanding performance. They will also need to address directors’ compensation, which should be adjusted to reflect the increased time commitments and responsibilities borne by directors.

6. STRIKE THE RIGHT BALANCE in responding to shareholder corporate governance initiatives, accepting those that do not interfere with management of the business and rejecting those that limit the power of the CEO and the board. Majority voting, which has received very significant shareholder support, is an example of a proposal that should be accommodated. Limits on executive compensation, splittingthe role of chairman and CEO, and efforts to impose shareholder referenda on matters that have been the province of the board are examples of proposals that should be resisted.

7. ANTICIPATE ATTACKS by activist hedge funds seeking management, structural, or strategy changes to boost the price of the stock, and develop business, financial, and legal strategies to avoid or counter them.

8. REGULARLY REVIEW that the CEO and senior management are setting “tone at top” that stresses professionalism, integrity, transparency, legal compliance, and high ethical standards.

9. RESIST THE TREND to have the audit committee or a special committee of independent directors investigate almost all whistle-blower complaints, recognizing how disruptive such investigations are, and being judicious in deciding what really warrants investigation. When an investigation is warranted, resort to outside advisers only when there is a real conflict or need for special expertise, and continue to obtain professional advice from the company’s officers and regular advisers.

Martin Lipton, a founding partner of Wachtell, Lipton, Rosen &Katz, specializes in advising corporations on mergers and acquisitionsand matters affecting corporate policy and strategy.

Holly J. Gregory and Ira Millstein of Weil,Gotshal & Manges this week announced the release of an annual memo by the firm thatidentifies areas for focus by corporate governance participants in the coming year.

In the memo, titled Rethinking Board and Shareholder Engagementin 2008, Millstein, Gregory, and colleague Rebecca C. Graspas, said they predict and encourage increased efforts by boardsto engage shareholders in less combative, more cooperative interaction andcommunication this year.

And while the firm says it supports shareholders’ intent torebalance corporate power, it cautions that “the forces for change should abateonce an appropriate balance is achieved, or a new imbalance will result.”

“Gone are the days when shareholders can broadly claim that boards areinactive, inattentive, and intractable or captives of management. The new reality is that boardsare already engaged in an unprecedented level of dialogue withshareholders, and many show real interest in finding ways to furthersuch communication.” — Memo from Weil, Gotshal & Manges

“Boards are well-advised to be open to shareholdercommunications on topics that bear on board quality and attention toshareholder value,” the memo explains, “communications that are likely toimprove mutual understanding and avoid needless confrontation.”

“Gone are the days when shareholders can broadly claim that boards areinactive, inattentive, and intractable or captives of management,” the memo continues. “The new reality is that boardsare already engaged in an unprecedented level of dialogue withshareholders, and many show real interest in finding ways to furthersuch communication.”

The notice comes not long after a similar year-ahead memo was released last month by Martin Lipton,co-founder of Wachtell, Lipton, Rosen & Katz. His note suggested that “limits on executivecompensation, splitting the role of chairman and CEO, and efforts to imposeshareholder referenda on maters that have been province of boards should beresisted.”

The recent memo by Weil, Gotshal and Manges urges more of an open dialogue with shareholders and a more balanced approach to corporate governance on the part of boards and investors.

Lipton also suggested that boards should resist the trend of“having the audit committee or a special committee of independent directorsinvestigate almost all whistle-blowing complaints, recognizing how disruptivesuch investigations are, and being judicious in deciding what really warrantsinvestigation.” (Lipton’s views on corporate governance were the topic of a recent Directorship cover-story. See “Bebchuk Vs. Lipton, December/January.)

Gregory says the Weil Gotshal memo, which is an annual exercise, is in no way intended as a response or a counterpoint to the Lipton memo. “Our piece is designed to focus directors on key issues for the coming year. Cleary this year our piece does reflect a view that is different than Marty’s. It’s the product of different experiences and philosophies about governance.”

Eckert’s response showed that he clearly established the consumer as his primary focus, although even that seemingly noble gesture does not come without pain and unintended consequences. When Judy Warner, assistant managing editor, talked to Eckert for our Special Report on Crisis Management, he told her, “We can’t control the events of the world.” True, but despite the arguable difficulty, global companies have an obligation to control all aspects of their supply chain. The lesson for board members is “be prepared.”

Certainly, Mattel’s CEO and other chiefs have a duty to customers and the public at large to sell safe products. That raises a larger question for directors: To whom does the board answer? Is it just to shareholders or to all stakeholders? This question has loomed since boards were first created. As Washington Editor-at-Large Aaron Bernstein reports in our cover story, Bebchuk vs. Lipton, the debate has emerged with new vigor, and a touch of vitriol, as these two corporate-governance eminences advance their arguments.

As we look out for our stakeholders, I want to invite you to have a look at our new website at www.directorship.com, where we are now providing daily coverage of board and corporate governance news. While you’re there, sign up for our weekly newsletter, Governance News.

Joseph McCafferty

jmccafferty@directorship.com

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.