The study—which looked at 170 Fortune 1000 companies whose annual meetings were on or after January 21, filed proxies by late March 2011 and whose CEOs were in their role for the last three years—found that 74.7 percent of the companies’ say-on-pay proposals were supported by at least 90 percent of voters. Only 2.7 percent of the companies had did not have majority support on their proposals.

“One of the most common questions we were being asked was: would proxy advisors like Institutional Shareholder Services be influential on these new votes?” said James Kroll, a senior consultant in Towers Watson’s Executive Compensation Practice, in reference to the say-on-pay and say-on-frequency votes that many companies are facing for the first time this proxy season.

While most companies’ investors approved say-on-pay practices, the 14 percent of companies who received negative ISS recommendations received above-average shareholder opposition. At companies where ISS encouraged a “for” vote, 94 percent also voted “for.” But the 20 companies surveyed who ISS recommended a “no” vote on their say-on-pay provisions received on average 71 percent positive votes; four were rejected by shareholders.

Annual say-on-pay votes have been popular among shareholders so far this proxy season, with annual votes receiving majority support at three quarters of the companies surveyed. Of the companies that recommended triennial votes, a majority of shareholders agreed to only a third.

Doug Friske

Of the decisions made so far, 46 companies chose annual, one chose biennial and 14 chose triennial say-on-pay votes.

“In early January and February, most proxies recommended triennial votes, now most are recommending annual,” continued Kroll. “Companies may be seeing the majority support for annual [votes] from shareholders, which may be driving more businesses to make the annual vote recommendation.”

The study also reported that the median annual base salary for executives increased by three percent. “The pay mix has stayed the same,” explained Olivia Wakefield Lee, a senior consultant at Towers Watson’s Executive Compensation practice. “What has changed is the long- term incentive mix,” with companies using stock options for 33 percent of the mix, as opposed to 39 percent in 2008. Restricted stock has stayed relatively constant, while performance plans make up a higher percentage at 41 this year, over 37 and 36 in 2008 and 2009, respectively.

“Options are not on the verge of extinction, but they will decrease in percentage of the mix,” predicted Wakefield.

Compensation committees and consultants were recently handed new regulations stemming from the Dodd-Frank Act regarding their independence and possible conflicts of interest. Steve Seelig, executive compensation counsel for Towers Watson’s Research and Information Center, advised companies to be on the lookout for more regulations. “We don’t anticipate things to be too tumultuous when it comes to regulations from Washington,” he said, but “there are some regulations pending, and it’s not too early for companies to focus on complying with them, since the rules are somewhat cumbersome.”

While there is currently legislation in the House to repeal the mandated disclosure of CEO pay vs. median employee pay, Seelig said: “I don’t see it going through the Senate or being approved by the President.”

Considering the combination of these types of increased disclosures and shareholder say on pay, companies must be especially cognizant of how they present their compensation practices in their proxies.

There is no formulaic method to encourage shareholders to approve say-on-pay plans, Seelig said. Rather, companies must look at their own shareholders and determine what their concerns are, and what the proxy advisors that most shareholders listen to are recommending.

“The results will change every year,” Seelig explained. “Stay committed to your principals and practices; shareholders will support your approach if they see it’s been thought through.”

This column was written by the research staff at the NACD.

SEC Seeks ‘Deeper Meaning’
As directors already know, companies must include new disclosures in this year’s proxy:

• Risk oversight: More information on risk and compensation

• Compensation for directors: Changes to options reporting in the compensation table

• Director qualifications: “Experience, qualifications, attributes or skills” that led to board appointment/nomination—including how a nominating committee “considers diversity in identifying nominees for a director”

• Leadership: Whether and why a company has chosen to combine or separate the roles of chairman and CEO

What directors may not realize is that the Securities and Exchange Commission is on a relentless search for deeper meaning. Based on past trends, the agency will soon be sending letters to companies about their 2010 governance disclosures. Shelley Parratt, deputy director in the SEC’s Division of Corporation Finance, emphasized at an NACD Capital Area Chapter meeting earlier this year that the SEC does not need detailed descriptions of process, but wants “reasons why.”

When a company explains its compensation decision-making processes but does not explain why it made the decisions, Parratt told the NACD audience, the SEC will ask for enhanced disclosure of the analysis.

Dodd Bill Distilled
Even while comments are still coming in to the SEC on proxy access, there is parallel movement on the Hill. Proxy access is one of no less than nine general governance issues proposed by Sen. Christopher Dodd (D-CT), chair of the Senate Committee on Banking, Housing and Urban Affairs. This new phoenix rose from the ashes of the Restoring American Financial Stability Act, originally proposed last year.

Overall, the new Dodd bill contains governance guidance for most financial companies, including investment advisors and/or private equity funds, and last but not least, non-bank financial companies and some bank-holding companies (which are required to have a risk committee). The bill even includes governance instructions for the Federal Reserve System itself. If you are a director of a financial company, it’s probably a good idea to read the entire 1,336-page bill.

Here is a checklist of the more general governance items, starting with the subsection on Accountability and Executive Compensation:

Say on pay: Proxies would have to include “a separate resolution subject to shareholder vote to approve the compensation of executives.” This provision would not limit the ability of shareholders to make additional pay proposals. Their vote would not be binding and could not overrule a decision by the company or its board. This is in accordance with the NACD’s Key Agreed Principles, founded on the basic premise that corporate governance should be determined by the board (assuming legal and listing compliance.)

Compensation committee independence: Compensation committee provisions cover independence, advice, disclosures and funding. The bill mandates an all-independent compensation committee, indicating that any receipt of consulting fees or any affiliations would disprove independence (think Sarbanes-Oxley audit committee independence). Compensation committees would have the right (but not the obligation) to maintain independent legal counsel and independent compensation consultants. In a move many compensation committees would welcome, the bill states that committees would have a right to obtain funding for advice: “Each issuer shall provide for appropriate funding, as determined by the compensation committee in its capacity as a committee of the board of directors, for payment of reasonable compensation—(1) to a compensation consultant; and (2) to independent legal counsel or any other advisor to the compensation committee.”

Showing admirable legislative temperance, the proposed bill also includes rules of “construction” protecting directors’ business judgment. A typical rule reads: “This paragraph may not be construed to …affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.” Again, this language accords with NACD principles.

Pay vs. performance: In their proxies, companies would have to disclose (using charts if they wish) the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions. The relationship of pay to performance requires use of performance metrics. This will be the subject of NACD’s 2010 Blue Ribbon Commission, co-chaired by John Dillon, retired chairman and CEO of International Paper, and Bill White, retired chairman and CEO of Bell & Howell.

Clawbacks: The bill would mandate recovery of erroneously awarded compensation. No listing would be allowed for companies unless they develop and implement a policy on clawbacks and  recovery from any incentive-based compensation awarded within the past three years based on an accounting restatement, with or without fraudulent intent.

Disclosure of hedging by employees and directors: This would include prepaid variable forward contracts, equity swaps, collars, and exchange funds designed to hedge or offset any decrease in the market value of equity securities granted to or held by employees or directors.

Excessive compensation by bank-holding companies: A “safe and unsound” tag would be put on banks that pay executives or others pay that could lead to material financial loss to the company. Although this would apply only to banks, if approved, it could spread to other industries, so it should be watched carefully.

The Strengthening Corporate Governance subsection consists of three main parts:

Majority vote: In an uncontested election, each director who receives a majority of the votes cast would be deemed to be elected. If a director of an issuer received less than a majority of the votes cast in an uncontested election, the director would tender the resignation to the board of directors. The board could refuse the resignation but it would have to disclose why. (If the number of nominees exceeds the number of directors, each director would have to be elected by the vote of a plurality).

SEC’s right to mandate proxy access: The SEC would have the right to issue proxy access rules. This has been under dispute, with some saying the SEC does not have  jurisdiction in such matters.

Disclosures regarding chairman and CEO structure: These rules  would require that the proxy sent to investors must state the reasons the issuer chose the same, versus different individuals, to serve as chairman of the board of directors and chief executive officer (or equivalent positions). Such disclosure is already required by the SEC.

The penalty for not conforming to any of these rules could be delisting—or not getting listed in the first place. But the bill makes it clear that it will give companies time to conform, and that regulators will make exceptions for small-company size.

Even if this bill is signed into law by the time the next issue of NACD Directorship arrives at your door—always possible with this hasty Congress—its real impact will come through the typical Washington fare of rules and technical corrections.

For just-in-time, confidential answers to governance questions, contact NACD’s confidential hotline, ExpressSource, at nacdonline.org (go to “Governance Resources”).

This column was written by the research staff at the NACD.

On December 16, 2009, the SEC amended its rules governing executive compensation and corporate governance disclosures in proxy statements.  Among other things, the amendments require new disclosure about the effect of compensation policies on risk taking, director qualifications, board oversight of risk, and independence of compensation consultants.  The new rules also require that reporting companies engage their directors in discussions about risk oversight, among other topics.

This direction indicates a regulatory thrust in acknowledging a full understanding of risk and financial performance as the core of enterprise risk management.  The ideas contained in this area are meant to provide both a common sense approach to financial discussions as well as an encouragement to elevate your level of financial understanding, even if you don’t serve on the audit committee.

When Lehman Brothers raised dividends in the first quarter of 2009 and bought back shares, the whole board had to vote.  This was approved 9 months before its failure.  What questions should board members have been asking about leverage and debt?  Lehman’s leverage before bankruptcy was an irresponsible 30 to 1.

Ford’s saavy cash management by former CFO, Don Leclair, and CEO, Alan Mulally, began in late 2006.  Prior to the recession, the company loaded up on $23 billion in debt at a time when credit was cheap.  This was both “brave and prescient.” Their decisions not only helped Ford to gain market share for the first time since 1995, moving its stock to a near five-year high, but generated tremendous public goodwill in their avoidance of bailouts and bankruptcy protection.

Some companies grow too fast and don’t finance the growth effectively. Asking questions about how growth is being financed is one that all board members should consider.

Having the confidence to seek second opinions can strengthen decision making. According to Warren Buffet, as published in his latest annual Berkshire Hathaway shareholders letter, “Don’t ask the barber whether you need a haircut.”  Directors should be aware that banker’s incentives to complete deals are high – it’s an all-or-nothing game.  Without a deal, bankers don’t get paid. Improper incentives can make advice suspect.  Whether hiring counsel for independent directors or additional bankers, this is common sense intuition put into action.

James L Orsini, EVP, director of finance and operations at Saatchi & Saatchi, New York, defines a perfect starting point for enhancing financial discussion: “If directors are going to invest time in financial understanding, I strongly feel the best use of their time is in learning more about how cash flows through an organization and how the corporate treasury functions.”

Net income should always convert to cash and at some point that ends up on a bank statement, which is extremely difficult to manipulate.  That’s why bank reconciliations are so important to auditors.  Being able to ask questions about the build-up of receivables or ones that are aging too long, leads to better board understanding and discussion.

Understand how your company’s gross margin compares to your competitors.  If they exceed industry standards, ask why.  Are inventory levels tracking with accounts receivables?  Is there additional data to demonstrate that goods are being shipped? If there is a significant jump in account receivables, how many accounts contributed to this increase?  Were any special discounts or unusual return policies provided?  What were the payment terms? Becoming more well-versed in balance sheet language and questions, will help to ensure your common sense questions on financial matters are addressed.

Building your financial understanding will continually sharpen your insight.  Consider participating in audit committee conversations to increase your performance as a director.  Audit firms provide board member education.

As a corporate director, the removal of “silo” thinking is important.  There is a shared responsibility for results around the table.  To that end, for those who do not serve on the audit committee, you still have a greater responsibility today to be able to converse on topics that are outside of your field and know how to ask good questions that will have a positive impact on the quality of financial board conversations.

Stuart R. Levine, the founder, chairman and CEO of Stuart Levine & Associates, is a director of Broadridge Financial Solutions, and chairman of the governance and nominating committee and lead director for D’Addario & Company.  He serves on the Advisory Council: The Directorship/NYSE Boardroom Guide for the New Director.

The Concept of Patient Capital

If we’re going to compete nationally and internationally, we have to focus on what some people have characterized as “patient capital.” We have to develop a framework in which investors can invest for the long term, and allow capital to produce what is typically American–innovative products that impact productivity, generate new ideas, and make our goods marketable across the world. Ultimately, this great engine that is the corporation is designed to enhance wealth for those who invest in it.

We should be careful when we reshape the framework of internal governance in a corporation, and not take our eye off the larger ball. In today’s red-hot politicizing of corporate governance principles, we would do well, I think, to thoughtfully approach changes in those principles, changes that affect the relationship between the directors’ exercise of their authority, and their accountability for the way in which they exercise that authority.

The Limits of Director Responsibility
In Delaware’s chartered corporations, the law empowers directors to manage the corporation. But there are limits, and those limits are well described.  Some of the limits are shareholders’ concurrent power to amend bylaws, shareholders’ required votes to approve certain transactions, shareholders’ power to elect directors, and more importantly, to proscribe the process for electing directors, and effective August 1 in Delaware with a new proxy access law, proxy access with the right to propose a short slate.

It bears emphasis to suggest that 14a-8 still blocks the now liberal proxy access that’s available under the Delaware law. HealthSouth is the first Delaware corporation, to my knowledge, to adopt a proxy access bylaw consistent with our August 1 statute. It goes nowhere unless the SEC allows proxy access. I would say to SEC Chairman [Mary] Schapiro and her colleagues, “Chairman Schapiro, tear down that wall.”

Give us the opportunity at the state level to shape proxy access as it suits each individual corporation and its investors. Don’t mandate proxy access in a way that may work for some but not for others…Let us experiment. Let us see how it works.

The Answer to Our Problems
The answer to most of our problems, if not all of them today, is to enhance the quality of directors, and focus them on their attention to their fiduciary duties. For breach of duty of care in most chartered corporations, there is an exculpatory provision: 102(b)(7), we call it. Other states that have copied it call it something else in their code, obviously.
But basically, it says, in order to encourage directors to take a reasonable risk, that they would not be liable for a breach of the duty of care. They’re only liable for breaches–personally liable for breaches of the duties of loyalty, or a failure to carry out the duties of loyalty and care in good faith…It’s an obligation of directors, I think, to see to it that the full range of fiduciary duty, instruction, and assistance be made available to officers as well as directors, and it’s even more important that that happen sooner rather than later.

The other thing that we are concerned about in Delaware, and should be, is that our law is not applied in such a way that it chills responsible risk taking – that risk taking has been the engine that’s driven the corporation. It’s been the source of wealth enhancement for American corporations for almost 200 years.

On Legislating Governance
The politicizing of corporate governance today is remarkable. We have bills in Congress that are variously styled. They’re all hyperbolic. A bill of rights for shareholders–what American is opposed to a bill of rights?  A shareholder empowerment bill–who can be opposed to power to the people?  Who is opposed to strengthening corporate governance, empowering shareholders, or voting for a bill of rights? No one, until you look at what actually might happen. These corporate governance principles, whether you agree with them individually or not, counter-intuitively could not be better for everyone under every circumstance. Yet, all are mandated under each piece of this legislation.

A Belief In Shareholder Democracy
Now, I use the word change. I do not use the word reform. Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares–until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say, that all, much less each, of these proposed changes are truly reform. Reform implies to me, something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.

But when you think about it, it’s ironic that these measures are styled “shareholder democracy,” because each of them actually limits what shareholders can choose. Under the state systems—at least, under ours—all of these listed principles of corporate governance can be adopted by a Delaware chartered corporation, but they’re not mandated. Why? Because we truly believe in a shareholder democracy. By mandating a set of new corporate governance principles that everyone must swallow, as if it were a pill for a disease you do not have, it seems to me, does not enhance majority voting in a shareholder democracy.

The Mouse That Roars
I recognize that in the wider world of things, Delaware’s role is small. Wags have said that Delaware is the mouse that roared. I don’t suggest to you that my ideas about corporate governance are better than anyone else’s. I’m perfectly convinced that many of these corporate governance principles may well help individual corporations. But common sense also tells me to mandate all of these principles for every corporation on a condition of being listed in our markets is counterproductive at best and foolish, at worst. We will continue in Delaware to try to shape corporate governance on a case-by-case basis, and address, and look for and find hopefully that proper balance between director authority and director accountability.

‘Too Small to Fail’
I hope that what we will see is a thoughtful, considered, incremental development of the future of principles of corporate governance. There is a publicly traded corporation that says, “Progress is our most important product.” In Delaware, what progress and the development of principles of corporate governance means is, incremental change within a known factual context over time. It’s deliberate, thoughtful, predictable, consistent, and clear. That’s the path we will continue to travel, and I can be sure of one thing absolutely. Delaware is too small to fail.

The search was stymied until I attended a conference where the previous evening’s social event had been bowling. As I mentally slipped on my rented shoes and imagined the large overhead electronic scorecard, the ten-frames format hit me like the thunderous crash of a bowling ball knocking down ten pins.

Beyond mere calendar-scorecard confluence, however, bowling may be the perfect vehicle to channel the 2010 proxy season’s likely ups and downs. Believe it or not, there are around six quintillion (that’s six billion billion for those directors who do not qualify as audit committee financial experts) possible outcomes in your typical ten-frame game of bowling. Considering all the moving parts in the current governance environment, the possible outcomes for the upcoming proxy season may be just as numerous.

Legislation/Regulation
To comprehend the complexity of the upcoming season, take a quick glance around the noisy Beltway Lanes venue. If the alley appears both familiar and crowded, it should. For the second straight season, all eyes will be on Washington, D.C., where members of Congress, staffers from the Securities and Exchange Commission (SEC) and Obama Administration appointees will be looking to make marks in every frame.

The legislative train has already left the station. On Dec. 11, 2009, the U.S. House of Representatives   voted 223-202 to approve the Wall Street Reform and Consumer Protection Act of 2009, sponsored by    U.S. Rep. Barney Frank (D-Mass.), chairman of the Financial Services Committee. The wide-ranging bill, which includes an annual say-on-pay mandate and authorization for the SEC to promulgate proxy- access rules, was pushed to passage solely by the Democrat’s House majority; 175 Republicans and 27 Democrats voted against the bill.

Chairman Frank’s bill will have to be reconciled with any financial-reform legislation that emerges from the U.S. Senate. There, Banking Committee Chairman Christopher Dodd (D-Conn.) backs a somewhat beefier banking reform initiative that includes most of the same governance goodies as Frank’s bill, plus an activist wish list that, among other things, would mandate majority voting in director elections and also force snap votes on retaining classified board structures.

Dodd’s bill has encountered stiff opposition and remains mired before his panel, but governance issues are the least of his concerns. While Frank and Dodd, who recently announced that he will skip a tough re-election campaign this year, will likely fuss over many aspects of the revamp of the regulatory oversight of the financial-services sector, there will be a love fest when it comes to governance. The resulting legislation—half-Frank/ half-Dodd or “FRA-DO”—could do to members of boardroom pay and nominating panels what Sarbanes-Oxley (SOX) did to their audit- panel brethren.

Just a few days after passage of Frank’s bill, the SEC voted 4-1 to finalize a set of new proxy-disclosure rules. “By adopting these rules, we will improve the disclosure around risk, compensation, and corporate governance, thereby increasing accountability and directly benefiting investors,” SEC Chair Mary Schapiro said during the Dec. 16, 2009 open meeting. The SEC made sure that its 129-page set of rules will take effect in time to apply to most issuers during the 2010 proxy season.

Broker ‘No Votes’
The first important item on the corporate governance checklist is the NYSE’s decision to exclude broker “no votes.”  The SEC has approved the NYSE’s decision, and it will be in effect for the 2010 proxy season.

Previously, brokerage firms were allowed to vote their customers’ shares for them, unless the customer specifically instructed the broker how to vote, on all uncontested, non-controversial matters.  Since the overwhelming number of directorship elections are routine and uncontested, this guaranteed a reliably large vote for re-election of directors.  Most retail customers did not instruct their brokers, and most brokers routinely voted for management.

Now, the NYSE has changed those underlying assumptions, amending Rule 452 to prohibit member firms from casting uninstructed votes.  This change, while seemingly technical, has the potential to alter radically the mathematics of proxy voting.  And, since the rule applies to all NYSE member firms, i.e., brokers, without limitation on which markets the brokers may trade, or the underlying securities, the rule change will affect issuers across all markets and exchanges.

Consider a company with 100 shares.  If 80 % are held in “street” name by brokers and 30% of those shares are “uninstructed,” an insurgent need only win 36% of the votes to win a proxy contest, not 51%.  While an active proxy contest may incentivize more shareholders to vote, or to instruct their broker to vote, the fact remains that broker “no votes” gave incumbents a built-in advantage.  And even though a proxy fight presents a classic circumstance where elections are neither routine nor uncontested, given the last-minute way in which many proxy fights can emerge, brokers which already cast their votes for management are unlikely to retract their votes when the proxy fight begins, so management still starts with a lead.  The NYSE’s rule amendment will level this particular playing field.

Even without an actual proxy fight, the NYSE’s amendment of Rule 452 can mean substantial changes.  Many companies have adopted “majority voting,” requiring their directors to obtain an absolute majority of shareholder votes in order to be re-elected, not just a majority of the votes cast.  If broker “no votes” cannot be cast, directors may have a much harder time getting to 50 percent.  Using the above example, if there are 30 uninstructed “no votes,” directors would have to get a super-majority of 50 out of the remaining 70 shares cast, or more than 70 percent — and that assumes all of the other shares are voted.

It has also become common for dissident shareholders to “just say no,” i.e., to refuse to vote for one or more of management’s nominees, to express dissatisfaction but without running a full-blown proxy contest with a competing slate.  Shareholders affirmatively declining to vote will be added to the number of broker “no votes,” to make obtaining a majority even harder.  Using the same example, if 10 percent of shareholders “just say no,” when coupled with the 30 broker “no votes,” incumbent directors need 50 out of the remaining 60 votes to be elected in a majority voting system, or more than 80 percent.  If more than 20 shares are not voted pursuant to a “just say no” campaign, the director cannot be elected at all.  As a result, “just say no” campaigns will be easier to win, and consequently, more common.

Even companies which have kept the old “plurality voting” system, requiring only a majority of the votes actually cast, may be affected, because broker “no votes” cannot be counted toward a quorum.  The most common quorum requirement for shareholders’ meetings is 50 percent, and the greater the number of broker “no votes” which are not cast, the harder it will be to make sure that the minimum number of shareholder votes necessary to have a valid meeting have been cast.

As a result, the NYSE’s changes to Rule 452 will have a significant practical impact, which management and activist investors will both need to take into account.

Delaware General Corporation Law Amendments
Another important change already in place for the 2010 proxy season are recent amendments to the Delaware General Corporation Law which are designed to encourage shareholder voting and activism. In April, Delaware granted corporations express permission to adopt by-laws to give shareholders access to the corporate ballot, on terms and conditions to be set in the by-laws.  The bill also gave companies the right to establish in their by-laws the right for insurgents to be reimbursed for expenses incurred in the solicitation of proxies.  It remains to be seen how many companies will actually adopt such by-laws — but the insurgents themselves may push for those by-law changes.

The Delaware amendments build on developments over the past few years giving shareholders greater rights of access to the corporate ballot.  In 2006, the United States Court of Appeals handed down a decision in AFSCME v. AIG, permitting shareholders to be included in the corporation’s ballot, without having to go through their own formal proxy solicitation process, including the preparation and circulation of competing proxy materials.  The AFSCME union proposed a by-law amendment to that effect, and the company tried to keep it from a shareholder vote, relying on SEC Rule 14a-8, the so-called “town meeting” rule which governs when a company may or may not exclude shareholder proposals from the company’s proxy materials.  The SEC told AIG it could disregard the by-law proposal, and refuse to include it in the company’s proxy material for submission to a shareholder vote, but the Second Circuit reversed the SEC.

The Second Circuit’s ruling means that shareholders can have access to a company’s proxy ballot, but in two steps:  first, the shareholders have to adopt a by-law amendment providing for access, and second, they have to submit nominees.  Unless a shareholder is willing and able to force a special meeting to make the by-law amendment, the two steps will generally occur over two years’ worth of annual meetings.

Following the AFSCME v. AIG decision, in 2008 the same union submitted another by-law amendment proposal, to Computer Associates, asking for the company’s by-laws to provide for reimbursement of an activist shareholder’s expenses of conducting a proxy campaign.  The union’s proposal followed an activist by-law effort made by Professor Lucien Bebchuk at Harvard Law School, who has long urged a more active role by shareholders in the enterprises which they own.

As in AFSCME v. AIG, Computer Associates went to the SEC to seek “”no action” relief, to exclude the union’s proposal.  This time, instead of ruling for the company on a “no-action” letter request under Rule 14a-8 and then risking being reversed by a federal Court of Appeals, the SEC went to the Delaware Supreme Court for guidance.  The SEC asked whether the proposed expense reimbursement by-law was permissible under Delaware law, and the Delaware Supreme Court in AFSCME v. CA said that it was.  Because expense reimbursement is such an important practical part of the decision to wage a proxy fight, the decision can have significant practical effect in encouraging proxy battles.

As if a definitive pronouncement from the Delaware Supreme Court were not enough, in April the state adopted amendments to Sections 112 and 113 of the Delaware General Corporation Law, which expressly permit corporations to adopt by-laws providing for shareholders to nominate directors to be included in the corporate ballot, and to reimburse those shareholders for their expenses.  Thus, shareholders in all Delaware corporations can achieve, in the same two-step process permitted by the Second Circuit in the AFSCME v. AIG case, access to the corporate ballot and reimbursement of expenses incurred to achieve that result.

The April 2009 Delaware amendments were too late for this year’s proxy season, and in the financial market tumult of late 2008 and early 2009 few activist funds were thinking of relying on the two AFSCME decisions to try to push for ballot access via by-law amendment.  But many funds may start to look to achieve that result in the spring of 2010, when most companies hold their annual shareholder meetings.

The SEC’s Proxy Access Proposal
In the midst of these other developments, the SEC is adding its own voice to the ongoing debate about access to the corporate ballot.  In May, the SEC issued a release proposing a new Rule 14a-11 that would provide guaranteed access to the ballot to certain shareholders, so long as access was not prohibited by state law ot the corporation’s charter or by-laws.  The nomination right is subject to significant restrictions, however.

First, any shareholder making a nomination must have been a shareholder for at least a year.  This is obviously designed to ensure that shareholders making nominations have a long-term stake in the enterprise.

Second, the long-term stake must be substantial.  Shareholders making nominations must have at least 1 percent of the shares of a “large accelerated filer” (companies with a market cap of more than $700 million); 3 percent of an “accelerated filer” ($75-$700 million); and 5 percent of a “non-accelerated filer” (less than $75 million).

Third, the proposal requires nominations to be submitted 120 days prior to the date of mailing of last year’s proxy material.  This period is quite long, with the objective being to leave enough time for the shareholder to answer questions concerning his eligibility to make the proposal, and for either side to seek relief from the SEC if necessary before the materials need to be sent, which itself is weeks before the annual meeting.  The effect of such a lengthy nomination period will be to force activists to consider next year’s proxy strategy barely weeks after this year’s annual meeting.  The holding period and size requirements must also be in place as of the submission date, effectively lengthening the holding period from 12 to 16 months.

Fourth, the number of nominees that may be submitted in reliance on this proposed new rule, if it is adopted, is limited to 25 percent (unless the company has a three-person or smaller board, in which case the minimum is one).  To seek control of the board, or even a minority slate between 25-50 percent, a traditional proxy fight will have to occur.

This is hardly the first time the SEC has tried to speak on proxy access, which is the “holy grail” of activist investors.  Activists and many corporate governance gurus claim that proxy access is essential to corporate democracy, and without it boards are unresponsive to shareholders and amount to little more than self-perpetuating fiefdoms.  Persons on the other side of the divide assert, with some justification, that granting direct access to the corporate ballot may encourage mischief and miscreants, and that capital markets already discipline directors adequately.  Both sides make their respective cases hotly.  As a result, every time the SEC has considered proxy access, the issue has gone nowhere, even after the SEC’s two major prior releases on this subject, in 2003 and 2007.  Mary Schapiro, the Obama Administration’s new SEC Chair, has vowed that this time the SEC will act.

But act how?  The proposed 25 percent limit will prevent activist investors from running anything other than a “short slate” campaign.  While “short slate” campaigns have become a more popular way to demonstrate shareholder discontent, and to “poke the camel’s nose under the tent,” activists who want to do more will be frustrated that they still must rely on the traditional proxy fight route.

In addition, some companies will respond by adopting restrictive by-law provisions where they are permitted to do so.  At the very least, the SEC could have conditioned the effectiveness of charter and by-law provisions which prohibit shareholder access on shareholder adoption or ratification of those provisions.

These two limitations by themselves make the SEC’s proxy access proposal appear timid.  Even so, organizations such as the Corporate Roundtable and the U.S. Chamber of Commerce have come out strongly against it, as they have on every prior SEC proposal on this subject.

While Schapiro has vowed to act, on Oct. 2, 2009 she announced that the SEC will not consider the proxy access proposal until February 2010 at the earliest, so there appears to be no chance that the proposal will be effective for 2010.  While the SEC had planned to act on its proxy access proposal as early as November,  Schapiro explained that the SEC needed additional time to review the hundreds of comment letters concerning the proposal.

Proxy Disclosure Enhancements
One set of SEC rule changes which looks like it will be in place in time for the 2010 proxy season is the SEC’s proposed proxy disclosure rules.  Announced in July, with the comment period over in September, it is reasonable to expect these rule changes to be implemented in late fall of 2009, and the SEC has indicated its intent to have at least these changes in place by the start of 2010.

The SEC proposes several “enhancements” to the proxy disclosure process, including additional information on compensation, director qualification and voting results.

In the case of compensation disclosure, the SEC has proposed to enhance the Compensation Discussion and Analysis (“CD&A”) portion of the proxy statement, including the “fair valuing” of stock option grants.  “Fair value” accounting has been controversial whenever it is raised (including in the 2008 financial crisis, when it appeared that many bank assets might have zero value since there was no market for them).  One can expect “fair value” accounting of option grants in the proxy statement also to be controversial.

The proposed compensation disclosure amendments will also require a discussion of how the company’s compensation policies are designed to align executives’ incentives to avoid risk.  The genesis of this proposal in the banking crisis and bank bonus culture is unmistakable.

The SEC also proposes to require a discussion of potential conflicts of interest involving compensation consultants.

The SEC proposes as well to require enhanced disclosure of qualifications of proposed directors in the company’s proxy materials.  Among other things, the proxy materials will have to include additional information about the background of proposed directors, including other boards on which they have served during the past five years, and material legal proceedings in which they have been involved during the past ten years.

Finally, the SEC proposes to require companies to file 8-K reports disclosing the voting outcomes within four business days of the shareholders’ meeting.

Pending Legislation

Predicting the outcome on Capitol Hill of any proposed legislation is difficult, but Sen. Charles Schumer has introduced a bill, titled the “Shareholder Bill of Rights,” which would provide for a non-binding annual shareholder vote on executive compensation (“say on pay”).  The bill would also eliminate classified boards by requiring each director to stand for re-election annually; split the jobs of chairman and CEO, forcing two individuals to hold those positions; and force companies to set up a formal Risk Committee, in addition to other committees such as the Audit and Compensation Committees.

Many activist investors have complained that these changes will not make a meaningful difference in the proxy solicitation process, and they may have a point.  In the past, classified boards were utilized as an anti-takeover device, forcing an activist investor to have to win two consecutive proxy fights over two years’ worth of annual meetings to gain control of the board.  Many types of investors, not just activists, criticized classified boards as anathema to corporate democracy, and most large public companies have abandoned them, often under pressure, opting instead to have all directors stand for re-election each year.  Yet the two-step by-law amendment and election approach endorsed by the Second Circuit in AFSCME v. AIG, the Delaware Supreme Court in AFSCME v. CA, and ultimately the Delaware legislature in its amendments to Sections 112 and 113, still requires two years of successful proxy solicitation.  And the SEC’s proxy access proposal, if adopted, will also require at least two years’ worth of proxy campaigns.  So how much will really have changed?

The real answer is for institutional investors is a willingness to be even more vocal.  Far too many fund managers continue to be far too passive in their approach to exercising their rights as shareholders, and when there is a proxy fight or even simply a shareholder proposal, too many of them “outsource” their fiduciary responsibilities to the likes of Risk Metrics/ISS, whose blessing they seek before casting their ballot.  The answer for directors, to avoid such consequences, is to manage the company well, to focus on results and long-term enhancement of shareholder value, and to communicate openly with shareholders so that their concerns do not have to be resolved by an effort to oust the board.

Richard Swanson is a corporate attorney with Arnold & Porter.

A so-called “poison put” is a “change-of-control” provision that allows lenders or bondholders to declare a default under the debt agreement and accelerate (or “put”) the debt back to the company at its principal value. The poison put emerged following the famed RJR Nabisco and other leveraged buyouts of the 1980s that left stunned, risk-averse bondholders holding “junk bonds” overnight without any recourse. These provisions came back in force most recently following the wave of large leveraged buyouts (LBO) in 2006 and 2007, which again stung many unprotected bondholders. Following this LBO resurgence, the Credit Roundtable, an association of fixed income investors, issued a white paper in December 2007 (updated in July 2008) recommending that bond indentures include “change of control” covenants (i.e., poison puts). The purpose of such a change-of-control covenant is to provide the bondholders with an opportunity to rethink their original investment decisions if the company is acquired by new owners.

Though the definition of a change of control initially contemplated equity control changing hands (particularly to buyout funds that tended to significantly increase a target company’s leverage), the definition of change of control has since expanded to include an event where a company’s board of directors no longer includes the majority of directors present at the time the debt was issued or were approved by those incumbent directors. This provision is commonly referred to as a Continuing Directors provision. Bondholders are risk assessors and therefore corporate governance, control, and capital structure are each material to the pricing and valuation of bond issues. Bondholders would suggest this protection is also necessary because boards do not owe any fiduciary duty to bondholders (outside of insolvency at least), and bondholders’ only protections are the covenants they are able to negotiate and the company’s duty of good faith and fair dealing. It is not surprising, therefore, that bondholders need to be comfortable with a company’s existing board and management.

Though clearly not intended or approved by issuers as “takeover defenses” like the better known “poison pill,” the poison put has recently gained attention (or notoriety) from stockholder activists and hostile suitors in connection with proxy fights and takeover attempts – being cast as a tool for board and management “entrenchment.” This is in response to issuers publicly appealing to stockholders and the dissidents to withdraw or reduce their nominees to avoid triggering such a provision. This could obviously have disastrous consequences for an issuer, especially given the limited access to refinancing in the current economic environment or when the debt is impaired. Not surprisingly, these dissidents or hostile suitors have demanded that issuers “approve” their nominees or seek a waiver from the lenders to avoid triggering this default – actions which would likely be viewed as irresponsible if triggered by the dissidents or hostile suitors.

Delaware Chancery Court Vice Chancellor Stephen P. Lamb interpreted a Continuing Directors provision in this context in Amylin. In the Amylin case, Amylin was facing competing dissident slates, each of who had requested that the company approve the dissidents’ slates for purposes of the Continuing Directors provisions in the Amylin debt agreements in order for the stockholders to be able to fully exercise their franchise without triggering the poison put. Ultimately, in partial settlement of related litigation by the dissidents, Amylin approved each of the dissident slates solely for purposes of negating a default under the Continuing Directors provision but continued to oppose their election publicly and in their proxy materials. Not surprisingly, the bondholders were not receptive to such “approvals” given that the point of such provisions – from the bondholders’ perspective – was to allow them the unilateral ability to waive such provision in connection with a potential change in control (including, or maybe especially, in the form of a proxy contest). Bondholders clearly want an opportunity to assess the long-term platform of the dissidents and the independence and qualifications of their nominees to confirm their willingness to maintain their investment. Accordingly, the indenture trustee litigated the proper definitional interpretation of the Continuing Directors provision.

Relying on a strict textual interpretation of the Continuing Directors provision, the court ruled that the Continuing Directors provision as drafted did not prevent the Amylin board from “approving” the nomination of the dissident slate while nevertheless opposing their actual election. In particular, the provision did not expressly prohibit board “approval” after the commencement of a proxy fight, and the court was concerned that an interpretation that it effectively did prohibit such approval could severely limit the stockholder franchise (by coercing stockholders into only voting for directors supported by the existing directors).

Though not formally ruled on, the court suggested the right or “power” to approve dissident directors in this context (i.e., while opposing them in the actual election) was subject to the implied covenant of good faith and fair dealing under the indenture – which required that the board must make this approval in the good faith belief that the “election of one or more of the dissident nominees would not be materially adverse to the interests of the corporation or its stockholders.”

Finally, the court also ruled that the Amylin board did not breach its duty of due care (citing a “gross negligence” standard) in failing to learn of and specifically consider and approve the poison put provision – in particular noting the highly-qualified outside legal and financial advisors and the fact that directors did not have an obligation to know every term of the indenture. However, given the magnitude of the effect of a default under a debt agreement, the court expressed the fact that boards should request that their advisors inform them of the default provisions, even if “customary,” including those which could impair the shareholder franchise so that the board will be able to exercise its fully informed business judgment.

The court also informally suggested that boards that actually and intentionally limit the stockholder franchise in this context (i.e., by agreeing that the board cannot approve dissident nominees after commencement of a proxy fight) could face a tough burden in demonstrating the “extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it” in order to satisfy the board’s fiduciary duties.

Given that lenders will likely continue to insist on including these provisions in a typical debt agreement or indenture, directors may feel they are between a rock and hard place. Directors can take comfort from the court’s application and discussion of the applicable gross negligence and duty of care standards in Amylin, but need to be aware of the issues this case presents and heed the helpful warnings offered by the court as follows:

Advanced preparation needed: Companies should review their existing debt (and other material) agreements now to identify the change in control provisions and their potential impact in a proxy contest or hostile takeover – particularly companies who may be currently vulnerable to stockholder activism or takeover attempts. Such provisions can also restrict the ability of a board or stockholders to pursue a friendly takeover offer. The contractual, fiduciary and strategic issues that companies and boards may face are potentially daunting, so advanced and careful planning and preparation will help facilitate a successful result.

Be fully informed: Poison puts are no longer a dirty little secret, and the Amylin case made clear that boards have a continuing duty to protect their stockholders’ interests notwithstanding a need to incur indebtedness and the fact that such provisions are customary and typically required by the debt holders. To ensure compliance with their fiduciary duties, directors should be informed of and attentive to all change of control provisions in new debt and other material agreements going forward – particularly those which may impair the stockholder franchise. Boards should not be passive in these approvals and should ask questions of their advisors to their satisfaction. Future courts may not be as forgiving after the warnings set forth in Amylin. Bondholders are unlikely to drop these provisions for new issues and will likely seek ways to close the loophole identified in the Amylin case.

Boards need to fully understand the impact (financial, business and otherwise) of the company’s refusal to accept the poison put. Each situation will be different and a company’s financing options may be particularly limited in this economic environment or if otherwise in distress, but care should be taken to negotiate these provisions carefully (particularly Continuing Director provisions) and to ensure the Company is receiving commensurate economic and other benefits by accepting these provisions – even if advised that they are “customary.”

A poison put is not a poison pill: Boards should be well advised prior to using the poison put as an affirmative takeover defense (i.e., by a decision not to “approve” a dissident slate under) or giving the appearance of doing so (i.e., by publicly using this provision as leverage against the dissident), as this may draw undesired public criticism and litigation – which could undermine the company’s other efforts to purport to represent the best interests of the stockholders in connection with the proxy fight or takeover response. While not addressed by the Amylin court, boards should also be mindful that using a poison put as a takeover defense may trigger heightened scrutiny of the board’s actions beyond the “gross negligence” and business judgment rule standard – similar to a court’s analysis of the adoption and use of the better known “poison pill.” Although the implied duty of good faith and fair dealing to the lenders may provide a board some flexibility to not approve a dissident slate, the intent, circumstances and manner in which the approval is denied would nonetheless be scrutinized. Similar scrutiny may apply to a board that agrees to such a provision for a new issue when “in play” or otherwise engaged in a proxy or takeover battle.

No carte blanche: Boards do not have the unfettered right to grant an “approval” to circumvent a Continuing Directors provision as a result of the implied covenant of good faith and fair dealing applicable to commercial agreements. In particular, boards are required to make a “good faith” decision that the election of one or more of the dissident nominees would not be materially adverse, or pose danger, to the interests of the corporation or its stockholders. Companies should take care that their public opposition to the dissident nominees does not go beyond “election puffery” to avoid potentially undermining the credibility of a board’s “good faith” decision to approve the nomination by the dissidents. Perhaps more importantly, the failure to meet this standard could also indicate a duty of loyalty breach – for which directors may be personally monetarily liable (and without D&O coverage).

Expect scrutiny in hindsight: Courts will likely apply greater hindsight scrutiny in future cases and may expect to see “evidence” of fully informed and good faith decision-making. Boards should take care to get expert legal and, as appropriate, financial advice and should exercise their business judgment in good faith and on a fully informed basis. Boards and their advisors should create a good “record” of the decision making process.

Be well advised: Directors and officers are entitled to reasonably rely on expert advisors selected with due care. The need to observe proper process and decision-making will likely necessitate the early involvement of experienced outside legal and, in some cases, financial advisors.

Ryan D. Thomas is a partner in the Corporate and Securities Practice Area at Bass, Berry & Sims PLC, and counsels boards and companies on corporate governance, shareholder activism, mergers and acquisitions, and securities matters. Thomas K. Wedeles is an associate in the Corporate and Securities Practice Area at Bass, Berry & Sims PLC.

What’s changed for board directors in light of the financial crisis?
I’ve learned as much in the last two years as I have in the last 20. We should be required to write Counterparty and Risk on our agendas in bold, capital letters. Previously, the board discussed risk on an annual basis. And it was something managed by the compliance department. I sat on a board as all this began to unfold. When we stepped up our discussions with the risk management officer, we were surprised by the number of areas we would ask about and he would say, “That’s not under my purview.”

Is there a potential boards could get too risk averse?
We may have the equivalent of Depression babies in the boardroom. If we run our companies like the last two years were the norm, then definitely there’s going to be too much focus on risk. But certainly there wasn’t enough in the past.

How does a board get its arms around risk?
Old fashioned sensitivity analysis. The analysis that was usually presented to the board for a given transaction was one-dimensional or the sensitivities were tested in too narrow of a band and failed to take into account enough of the exogenous events in the real world. Part of this, of course, can be attributed to management selling their initiatives and part of it is just a process to which we fell victim. Once you properly illuminate the risks, then you can intelligently think about “go or no go,” mitigation, and offsetting actions.

Concentration intensifies risk. Should we all become more diversified?
Diversification can be a bit of a mirage. In the mortgage market, if you look at some of the hybrid instruments that we now call toxic—they took groups of BBB-rated credits, put them into structures with diversity of regions and industries and called them AAAs, but they were still just a bunch of BBBs. And when things hit the fan, unsurprisingly, they behaved like BBBs and collapsed. If you go back to some of the old-timers who did work in the banking industry back in the 1940s and 1950s, using basic risk-management concepts, they found effective ways of managing risk within otherwise homogenous product lines. Plainly, they were better at underwriting. They had no choice, because they couldn’t count on passing the risk off through some exotic securitization.

If you are going to be obsessive about market share does that lead to additional risk?
Obsessive pursuit of market share often relies on lower prices and increased subsidies. This is particularly true in mature or commoditized industries. We see this happening today in the wireless telecom sector and we saw it with the mortgage bull market. In these industries, the only way you materially increase market share is by taking more risk or accepting lower returns and it usually requires both. You hear “We’re better at servicing or we’re better at sourcing,” but at the end of the day, it’s a commodity. So anyone growing significantly faster than the pack is, by definition, taking more risk.

There’s a fixation on compensation these days. What’s your take?
You know this is one area that has been a colossal failure on the part of boards. Can we all agree that you simply should not leave the determination of compensation to a process dominated by those being compensated? Reform has to start with a vigorous attitude by the compensation committee. Human nature is a constant; what changed over the years were the perverse incentives compensation committees allowed to creep into our system. We hear a lot of talk about short-termism these days, but it starts with executive compensation that is heavily weighted toward annual cash bonuses and equity incentives that essentially get reset once a year. It’s no wonder our financial sector became so amazingly creative and skillful at trading short-term cash for long-term tail risk while dressing it all up as growth. This is exactly how their incentives were set. For decades, Alfred Sloan enforced a system at General Motors where management received a nice base salary and then ten percent of the profits over a return of six percent. By the mid-1970s, the concept of requiring a return on investment before paying incentive compensation disappeared. It may sound simplistic, but both the financial crash and the demise of our auto industry were really all about perverse incentives.

What types of investment opportunities do you look for, companies you think have poor governance?
We invest in companies that we think are underperforming against their potential in terms of their stock price value. That usually means there is a problem in their operations or capital allocation or some fundamental area of performance. Poor governance, more specifically poor board dynamics, invariably accompanies that underperformance. We leave it to the academics to decide whether there’s a causal effect there.

How about some of the proposed regulatory changes for boards, things like proxy access?
That will be very powerful—less so for activist investors and more so for mainstream investors. It will spur a massive self-help movement in corporate boardrooms. If we weren’t already convinced that the model of the modern corporation is broken, if not bankrupt, then the events of the past few years had to tell us that, if not those from earlier in the decade when the most admired companies in the world collapsed before our eyes. As we struggle to think about how to improve our corporate governance regime, I can’t find a better answer than to foster more involvement from the owners.

Should CEOs and boards focus on the broadest possible group of stakeholders?
I think they should stay focused on the long-term investors. If they get confused or try to make it too complex or think that they’re serving multiple constituencies of their shareholder base, they will be led astray. What they really should focus on is the stock certificate. It’s a very simple contract. When the owners are confident in the future, then everything else falls in place.

How should directors view their role today, if any differently than before?
I think guidance is as much a part of their role as oversight and risk management. To the extent that you’re out there looking for directors, you do have to look for people who listen and are still willing to learn and willing to serve an apprenticeship regardless of their age. I was on a board where we were having a discussion about the spec we wanted for a new director search. The CEO said he would like to have a CEO on the board: “I could really benefit from that,” he said. And I said, “Gee, we’ve got four CEOs on this board already. You’ve just proposed an entire reorganization of the management structure. Did you consult any of them on what they thought about it?” He said, “No” and I said, “Let’s start using the CEOs we’ve got.” That’s sounds a little confrontational, but it was an issue that was in the boardroom and we were having a frank conversation. It’s interesting that almost by their nature, the “Type A’s” we hire for CEOs don’t readily reach out and seek advice, because they’re driven and they’re confident. So board members have to be willing to engage and give their views, at times confront, and make certain that management hears their input.

Against this backdrop, three senior directors discussed the question, “what keeps the chairman up at night?” at a recent NACD New England breakfast meeting. The panel, moderated by Ernest Godshalk, managing director of ELGIN Management Group, and a director of Hittite Microwave Corp., GT Solar International, and Verigy, was attended by:

Amelia Fawcett, chairman of Pensions First Group and Guardian Media Group, which publishes the Guardian and Observer newspapers in the U.K., recently completed a term as a director of the Bank of England, and is a director of State Street Corp.

Bob Posen, chairman of MFS Investment Management (with more than $150 billlion dollars in assets), teaches corporate governance at Harvard Business School, and is author of the upcoming book, Too Big to Save? How to fix the U.S. Financial System.

Mike Reuttgers is lead director of Raytheon, chairman of Wilson Micro-electronics PLC in Scotland, former chair of EMC, and a d irector of NACD New England.

What are the key issues in current Board Governance?

Moderator: I have several lists here of key board issues. They include say on pay, proxy access, and numerous regulatory incursions which are proposed in limitation of the prerogatives of the board. What do you think?

Fawcett: Cash. Balance sheet funding. Scenarios playing around that. Relationship to enterprise risk management. The key issue today is making sure that your company has enough cash. Further, in this crisis, a key issue is “fit for purpose.” Do you have right management and the right board with the necessary skill sets in this current environment? How do you attract and retain? How do you deal with the blurring of boundaries between the roles of directors and management in this environment? Finally, there is of course tremendous reform in compensation and governance;  is it evolution or revolution?

Reuttgers: Cash. Do you have enough? This is especially true in non-profits. But in all organizations, you have to understand cash. “Not all cash is the same.” Who holds it? When and how can you use it? Is it free cash or not? Also budgets; Boards are now rejecting more first budgets than ever before because they are not conservative enough. Revenue projections are too optimistic. It is better to be ahead of budget than behind it. Boards are much more involved in budgets. This involvement impacts long term strategy. This involvement will also impact compensation.

Posen: What does this financial crisis mean for boards and governance? Its impact on boards is negative. Distinguished boards made up of independent directors, at many large institutions, in full compliance with Sarbanes Oxley, none-the-less were clueless. They found that risk assessment, product mix, compensation were all out of whack. This, by the way, proves that Sarbanes Oxley doesn’t get you where you must go. There are more important factors such as:

• Size: Boards are too big, small Boards work better, 5 to 7 directors are optimal.
• Expertise: You may have smart people and you may have independent people, but do you have enough people who really actually understand your industry? Early retirement is a dumb idea; you lose the expertise you need just as it has been fully developed.
• Time: Directors really do not know their companies. They need 2 to 3 full days each month to learn about their companies.

We can tinker with the procedures, but large global company directors cannot be effective with current structures. We should have a small number of directors, each of which is concurrently serving on no more than 2 boards, and their pay should be increased accordingly. This model is needed to monitor effectively everything that needs to be monitored in a modern corporation.

Fawcett: I agree that boards are too large. Forensic examination of company failures shows that large boards may surface the correct issues, but those issues tend to get diluted in discussion when too many people are talking. The key issues are thus not discussed adequately. Another issue is diversity: you need variety of expertises, not variety such as gender. You need “uncomfortable” thinkers.

Posen: We need a cadre of professional directors. Everyone seems to be looking for a sitting CEO; he thinks they should never be directors of other companies. CEOs push for other CEOs but this is not a good reason. The best directors are older and have time to spend; why kick out directors when they are 70? We do that because we are uncomfortable in confronting the small number who “lose it”; but most don’t. Companies should use board evaluations to rid themselves of failing older directors, not throw out the baby with the bathwater.

Moderator: Do the above observations apply to smaller and medium-sized companies?

Posen: Yes, except for proxy access. Say on pay may be a catalyst for internal discussion, but it is “a blunt instrument. Pay is complicated.” There is a problem in communicating information effectively about compensation to shareholders; this is best left to compensation committees.

Corporate committee heads [other panelists suggest all directors] should go out and meet with major investors; this is done sometimes but not often enough. Outside directors generally should talk to major investors about compensation but indeed about other issues also. Major investors are more and more important, since changes in New York Stock Exchange rules prevent brokers from casting discretionary votes for street name shares in director elections. This issue is more important than proxy access.

We can solve the proxy access issue without mandating that companies assist shareholders in soliciting shareholder nominee proxies [this is one element of the proposed new SEC Rules covering proxy solicitation]. For example, a shareholder could nominate, have a right to post the nomination on the company website, and should not be required to solicit all proxies, nor require the company to solicit for them. No need to incur this cost, particularly since brokers can’t vote anymore and retail investors tend not to vote; all shareholders proposing a nominee need do is communicate with a small number of major shareholders in order to mount an inexpensive proxy fight. Company proxy materials need not include information about shareholder nominees, just a statement that there are in fact other candidates (referring shareholders to the company’s website). Proxy access really is a cost issue solved by the age of the Internet. Elections will be controlled by institutions and broad solicitation is no longer necessary.

Reuttgers: If you have corporate authority for a large board, but actually a lesser number of sitting members, you should amend the bylaws to reduce the maximum size of your board to equal the number of sitting directors. Leaving open slots will attract shareholder nominations.

Posen: Research has shown that there is no relationship as to financial statement performance or stock value favoring the division of the chair and the CEO. Additionally, the rise of the “lead director” is creating a group of directors whose functionality comes close to an outside chair.

Fawcett: Split roles (splitting the CEO and the chair) tend to increase communication and educate directors. I expect in 10 years this will be normative here in the United States. It may even be mandated [there is legislation before Congress which would in fact mandate such a division]. In the U.K., nothing is legislatively mandated, we operate under the rule of “comply or explain.” What this means is, if you do not feel your company adopted a particular alleged best practice, you can simply explain in disclosure the reasons for not doing so. This approach in the U.K. has expanded to most governance issues, where “best practices” are not mandated but may be availed of, or not.

Audience high points:

• Whenever management schedules a board meeting at a facility (“on site meetings”), you are wasting your time. It is better to drop in. When the directors are coming, the company people at a given site are prepared, rehearsed, etc. You don’t learn anything.
• One company successfully matched every outside director with one senior manager for purposes of mentoring and education.
• In the U.K., corporate social responsibility will be on the short list of key issues for most boards. Same thing is true in much of the rest of Europe. What is the enterprise doing for schools, for poorer countries, for the ecology? This is not an agenda item identified by the panel, nor appearing on typical lists in current circulation purporting to identify key U.S. board issues. It was speculated that preoccupation with the economy, by U.S. boards, has delayed a growth of corporate social responsibility as a key U.S. board issue.
• In response to a question concerning the role of a board in disaster prevention and management, it was noted that all boards should be asking questions about how to handle swine flu, which may well be an extremely significant factor in company performance this fall and winter. It was suggested that boards have an affirmative obligation to inquire and assure themselves as to the sufficiency of planning in this regard.

Commentary:  There was a marked distinction between the generally circulated lists of key board issues (which tended to focus on governmental and regulatory matters), and the key issues presented by these board chairs of large companies. The board chairs on the panel were far more focused on specific issues that bear upon the substantive performance of the board functions; substance, not procedure.

Equally interesting, although much of the literature in the last six months have dwelt on enterprise risk management (perhaps an expected reaction to how many risks were missed leading up to the recent economic meltdown), ERM was mentioned by the panel only in passing and as an element relating to understanding and insuring liquidity.

Some of the lessons suggested by the panel are applicable to privately held companies, some to non-profits, and almost all in one degree or another to small cap and medium cap public companies. The extent to which the involvement of the Federal government in active corporate management will, in the long term, tend to emphasize procedural and bureaucratic safeguards at the expense of paying attention to global strategy should not be underestimated. Although there is much to be said for the government as a major funding agency having significant say in management, the governmental impulse toward one-size-fits-all procedures could have a grave impact on many US companies. With the Congress and the SEC vying with each other to appear more attuned to the protection of the public and the repair of our economy, there may be substantial formalistic governmental involvement ahead of us notwithstanding the lack of concern expressed by the panel as to those risks.

Stephen M. Honig, a director of the NACD New England, is a partner at Duane Morris in Boston where he practices a wide range of business law.

“The proposed rule is a historically significant reform that will enable investors to hold corporate boards accountable and restore investor confidence in the capital markets,” Joseph Dear, chief investment officer at the California Public Employees’ Retirement System, the nation’s largest state pension fund, wrote in the pension system’s comment letter to the SEC.

Meanwhile, corporate advocates have asked the SEC to refrain from adopting marketwide access standards or at least delay adoption until 2011. In contrast to their position in 2007 when the agency last considered the issue, most issuer representatives now are arguing that shareholders should have the ability to file resolutions that seek company-specific access provisions.

The question of giving investors the ability to nominate directors to appear on management proxy statements has been debated by the commission since the 1940s. In May, the SEC voted 3-to-2 to propose a marketwide access rule over objections from the agency’s two Republican commissioners. The proposed Rule 14a-11 would require all public companies and registered investment companies to permit qualifying shareholder groups to offer nominees for up to 25 percent of the board.

The draft rule requires a one-year holding period and includes tiered ownership thresholds based on market capitalization (or net assets for investment firms). For issuers, the minimum holding would be 1 percent at “large accelerated” filers (those with more than $750 million in publicly traded securities; 3 percent at “accelerated” filers ($75 million to $750 million in traded securities); and 5 percent at “non-accelerated” filers (less than $75 million in traded securities). The agency rulemaking release also includes a proposal to amend Rule 14a-8(i)(8) to permit investors to file bylaw proposals that seek more permissive access provisions.

The agency received more than 450 comment letters from investors, issuers, proxy solicitors, academics, and individuals by the Aug. 17 deadline. SEC officials have said they hope to have a final rule in place before the 2010 proxy season.

The SEC also received comments from various international institutions, which observed that proxy access provisions in the United Kingdom and other markets have led to more board accountability and better communication with investors. “Our experience in markets like the Britain, Australia, and the Netherlands is that these rights are rarely used. Instead, because of greater accountability to the shareholders whom they represent, boards tend to put forward qualified candidates that are more responsive to shareholder interests,” wrote Daniel Summerfield, co-head for responsible investment at the U.K.’s Universities Superannuation Scheme.

While most public pension funds and labor investors generally support the rule, other investors raised concerns or expressed opposition. Although Barclays Global Investors said it supported the principle of allowing long-term investors to propose board nominees, the investment firm called for a “narrowly tailored” approach with a triggering requirement (such as a 50 percent withhold vote) for access rights.

The United Brotherhood of Carpenters said it opposes a federal uniform access rule and urged the SEC to amend Rule 14a-8 to enable investors to file access proposals in 2010. The union noted that other reforms, such as better disclosure rules and the widespread adoption of majority voting in director elections, have made boards more accountable.

Corporate Opposition
Corporate advocates, including the National Association of Corporate Directors and the Society of Corporate Secretaries & Governance Professionals, generally opposed a marketwide rule, calling instead for the SEC to permit “private ordering” by allowing investors and companies to devise their own access rules. The proposed Rule 14a-11 “would deprive stockholders of their ability to exercise their rights under enabling state laws to implement the specific form of proxy access that they believe best fits their particular company and fellow stockholders, or alternatively to choose to forego entirely the costs and burdens of proxy access,” Cravath, Swaine & Mooreand six other corporate law firms argued in a joint comment letter.

In response, CalPERS argues that forcing investors to seek proxy access on a company-by-company basis “will cost shareowners and companies significant time, and unnecessary expense.” Based on the SEC’s 1997 data on the costs for shareholders to offer proposals and for companies to respond to them, the pension system estimates that it would cost $351 million to attempt to put proxy access in place at Russell 3000 companies.

In the SEC adopts a marketwide rule, the corporate law firms have asked the agency to delay the effective date until 2011 to give issuers and shareholders time to address the complex issues raised by access. The firms also noted that it would be difficult for investors to meet the proposed 120-day deadline for nominations at firms with early 2010 annual meetings. The corporate lawyers also said the commission should give investors the right to opt out of a uniform rule by either a stockholder vote or ratification of board action.

The Altman Group, a proxy solicitation firm, said it would be a “serious mistake” for the SEC to adopt a marketwide access rule soon after approving the New York Stock Exchange’s ban on broker votes in uncontested board elections. Instead, Altman said the SEC needs to first address “important” issues, such as the rules on issuer-shareholder communications and other “proxy plumbing” issues.

Priority for Larger Holders
Many commenters, including the Council of Institutional Investors (CII), CalPERS, and the AFL-CIO, urged the SEC to drop its proposal to use a “first-in” standard to determine priority if multiple groups seek to nominate board candidates who exceed the 25 percent limit. Instead, the investors called for giving preference to the investor group with the largest shareholding. “What matters most is not who is the fastest to nominate but what investor or group has the greatest stake in the director election and ultimately, the long term performance of the company,” CII stated in its comment letter.

The Calvert Group disagreed, arguing that a “first-in” approach would be fairer. “Allowing the largest shareholder group to essentially ‘trump’ the first smaller, but no less committed or relevant shareholder submission, is not good governance,” according to Calvert, an investment firm that offers socially responsible investment funds.

Alternatively, the Ohio Public Employees Retirement System(OPERS) called for a two-fold approach based on the length of ownership and the largest beneficial ownership. The pension fund also said a 25 percent cap on nominees was too restrictive and should be closer to 50 percent. OPERS and other investors said the limit on nominees should be based on the total number of board seats, not simply those up for election, as the later approach would reward firms with classified boards. CalPERS and many investors called for allowing at least two shareholder nominees, regardless of board size, pointing out that a single dissident director can be more easily shunned by a recalcitrant board.

Differences Over Eligibility Rules
There were a variety of opinions expressed by investors and issuers over the economic stake required to nominate directors. T. Rowe Price and TIAA-CREF asked the SEC to set a 5 percent ownership requirement at all companies, rather than permitting lower thresholds at larger companies. “[I]n order to use the company’s resources to nominate a director, a significant amount of capital must be represented and 5 percent is an acceptable threshold,” TIAA-CREF wrote in its comment letter.

In its letter, the Australian Council of Superannuation Investors (ASCI) said a 3 percent threshold should be sufficient to deter “frivolous or vexatious nominations.” Barclays called for a sliding scale of 5 to 15 percent based on market capitalization to “protect shareholders and the companies they own from the unnecessary distraction and expense of including director nominees for whom support is limited and whose likelihood of election is low.”

The coalition of seven corporate law firms suggested that the SEC impose a 5 percent threshold for a single investor and a higher threshold (7-to-10 percent) for investor groups. The National Association of Corporate Directors endorsed a 5 percent threshold (with no aggregation of holdings), and a 10 percent standard for micro-cap firms.

There also were disagreements over the required ownership duration to submit a nomination. The Change to Win (CtW) Investment Group, the AFL-CIO, the union-affiliated Amalgamated Bank, and TIAA-CREF all asked the SEC to increase the minimum time period for offering nominees from one year to two years. “A two-year holding period requirement would better ensure that shareholder-nominated directors are properly focused on long-term value creation for the company’s investors,” CtW wrote in its letter.

Some corporate advocates also endorsed a longer holding period. A group of corporate governance officers from Intel, Microsoft, Pfizer, and more than 20 other issuers said a “two- or three-year holding period would be more appropriate.”

However, T. Rowe Price said it did not object to a one-year holding requirement, and CII agreed that such a standard “should be sufficient to limit the access mechanism to long-term shareowners.” The Association of British Insurers and ASCI argued that there should be no minimum time period. “It is a core principle that the holders of the same capital instruments must have the same rights regardless of the period they have held them,” the British group wrote.

The AFL-CIO and CII were among the investors that asked the SEC to clarify the rule’s “continuous ownership” provisions to take into account the fluctuations in share ownership that may occur during the year as institutions rebalance their portfolios or lend shares. Noting that most institutions will recall loaned shares so they can vote them, the labor federation argued that the right to nominate directors “should be based on the number of shares beneficially owned, not shares that are held on loan.”

The Society of Corporate Secretaries & Governance Professionals asked the SEC to include a resubmission requirement for investor groups that repeatedly offer nominees; if a shareholder nominee failed to win at least 25 percent support, the nominating group would be barred from offering candidates at the company for two years. “Such a threshold would also ensure that other shareholders would be given a chance to suggest nominees who may be more satisfactory to the company’s shareholders,” the corporate group said in its comment letter.

More generally, a group of 80 professors led by Lucian Bebchuk of Harvard University, urged the SEC “to be careful to avoid eligibility or procedural requirements that would undermine or unnecessarily detract” from the proposed access rule. “In evaluating these requirements, it is important to keep in mind that, no matter how moderate eligibility or procedural requirements may be, shareholder nominees must still meet the demanding test of getting elected before they can join the board,” the professors wrote.

Ted Allen is director of publications at RiskMetrics. For a copy of RiskMetrics Group’s comment letter, please click here.