Some Thoughts On Corporate Governance By: Douglas Foshee

I am particularly pleased to discuss corporate governance because I have a vested interest in the battle being fought for control of corporate America. This fight is being waged between institutional investors and shareholder activists on the one hand, and management and corporate boards on the other. The issues at stake include options re-pricing, staggered boards, and the efficacy of poison pills. Furthermore, a blue- ribbon committee headed by the chairman of the New York Stock Exchange has just issued a report on improving the effectiveness of corporate audit committees. Some think that this audit committee initiative is an appropriate response to the recent high-profile problems in companies such as Cendant and Sunbeam. Others think that the result will be that no one in his or her right mind will serve on an audit committee, and that the only true beneficiaries of the proposed improvements will be the plaintiffs' bar and the carriers of directors' and officers' insurance.

I think we will look back on this time as one of the periods of significant change in corporate governance in the history of the corporation. We are now at the inflection point of that change. We are just beginning to see the pendulum swing away from management and toward large institutional shareholders.

In 1998, TIAA-CREF took the step-unprecedented for a public fund-of ousting the entire board and management at Furr's. The following year, CalPERs agreed to back two dissident director candidates at Maxxam. These directors' primary vocation prior to being nominated to this board was politics, not business. These two shareholder actions are merely the tip of the iceberg.

Where, then, does all this activity leave me? I am the CEO of a small, publicly traded company. I do not have the cachet in the public markets of a Hugh McCall, Michael Eisner, or Ken Lay. Even if I wanted to fight this trend, I could not. But the important question remains: should I want to fight it? My answer is "no," and the reason is a very practical one. The most basic tenet of the so-called governance movement is that better governance leads to higher share prices. CalPERs and TIAA-CREF are not involved in activism for altruistic reasons. They are in it because they believe that, if they can force good governance on the companies that are in their portfolios, over the long run these companies will generate superior returns for their constituents.

As is usually the case, academics have tried endlessly to test this hypothesis. The result has been an equal number of empirically valid reports that prove both the positive and the negative of the hypothesis. There is simply too much noise in the data being analyzed to be able to segregate corporate governance as a single variable affecting share price.

But, to my mind, none of that matters. Simple common sense tells us that good governance is more likely to lead to the creation of incremental shareholder wealth than bad governance is. Therefore, as a shareholder, the only question remaining for me is: what is the definition of good governance?

In my view, four pillars constitute the supports of good governance: director independence, relevant experience, equity ownership, and disclosure. It goes without saying that director independence is the most basic requirement for good governance. What exactly is "independence"? Most publications define it in terms of whether you are an employee of the company, whether you have received payment for services rendered to the company, whether you have interlocking directorships on the board, or whether you are an immediate family member of management.

But what if you were a college roommate of the CEO? What if you gave the CEO his or her first job out of college, or vice versa? There are endless kinds of relationships that could affect a board member's ability to act independently and in the best interest of shareholders. Yet relationships of the sort I just mentioned are considered independent and completely acceptable under guidelines issued by CalPERs, NACD, and the Business Roundtable.

If the possibility for a conflict between management and boards exists because of a board member's relationship with management, then that relationship should be disclosed so that shareholders can assess whether it is material enough to cause a problem. Every public company should have a nominating committee consisting exclusively of independent directors to consider such possible problems among all new candidates for board membership.

Relevant experience is the second pillar of sound corporate governance. The perfect board is one in which each board member brings a unique set of skills that, when combined with those of other members, creates an advantage for that company over its competitors. Today's world is too complex for corporate myopia. Myopia results when a company attracts only directors whose experience is in similar companies or in the same industry. Many exogenous factors not directly related to a particular industry can affect a company. Populating a board with individuals having similar backgrounds may result in a failure to see change and to be able to adapt to it.

For example, Nuevo Energy is affected by computing advances, E-commerce, consumer spending habits, and the relative health of foreign economies, none of which is directly related to energy. It is the board's task to bring a broad and diverse perspective to the company in order to balance management's somewhat more focused perspective on the energy industry.

One hundred years ago, boards and management teams were the owners of companies. The reason for this arrangement is as relevant today as it was then-the alignment of management's and the board's interest with that of the shareholders. But conditions have changed in important ways over the past hundred years. Companies are much larger. Ownership is more diverse and predominantly in the hands of institutional investors who, for the most part, do not want board representation. In fact, almost none of the public funds have such representation. Even if they did, would the individuals have ownership and exposure directly, or would they just represent the owner and have no personal financial stake?

How, then, can the board be given an actual sense of ownership? The answer is simple: require each individual board member to make a meaningful investment personally in the companies on whose boards he or she serves. If prospective board members are not willing to make such an investment, then, frankly, they are not committed enough to be effective representatives of all the shareholders' interest. They are more likely to just go along with management's proposals rather than to engage in a constructive debate.

Compensating board members with stock options does not produce sufficient alignment. Board members should have the same exposure in relative terms as the shareholders whom they represent. Each board should set goals for share ownership by directors as a condition of board membership. If you doubt the efficacy of this strategy, ask yourself this question: if the members of management and the board of Pennzoil had been invested significantly in their own company's stock, would they have responded differently to UPR's unsolicited bid? Would Sunbeam's board have decided to oust Al Dunlap as quickly as it did if its members were not all significant shareholders? I think the answers are obvious.

The final pillar of good corporate governance is disclosure. Good governance is not a "one size fits all" issue. Each company is different. Each must adopt governance practices suited to the circumstances which it confronts. While some in this debate recommend a governance agenda that they view as applicable to all companies, most recognize the need for companies to consider major governance issues within the framework of their own businesses.

What should not be subject to debate is the need for and desirability of disclosure. Shareholders need some tangible evidence that their boards and management teams have considered each major governance issue and taken a position on it. A company should not assume that others will fail to notice that it lacks an equity ownership requirement, that it has a preponderance of inside directors and a dead-hand pill, or that its shares are performing poorly.

I am always amazed by the number of issues that seem to magically disappear once they are subjected to scrutiny. As a board member, you should have a thoughtful discussion and debate with your fellow members about important governance issues. When you and your fellow directors reach consensus on these issues, let your shareholders know what you have decided. If they do not agree, you will be sure to hear from them. But at least you will have been honest. As a result of your honesty, institutions can weigh your governance in light of their own principles and views, and they can look to those practices as criteria for deciding whether or not to invest in your company. Director independence, relevant experience, equity ownership, and disclosure are the four fairly simple, straightforward pillars on which a governance platform should be built. In my opinion, the presence of these four pillars makes most of the rest of the governance debate moot. If you adopt them, then investors should not care if you have a poison pill. They will be confident that, even with the pill, you will act in a manner consistent with the interest of all shareholders. Furthermore, if a company has these four pillars in place, the board would never approve something like a dead-hand pill in the first place, and it would likely repeal such devices as staggered boards, which were so popular in the 1980's.

Shareholders are right to demand good governance from their portfolio companies. Management and boards have a responsibility to consider governance issues and to tell their shareholders where they stand on each one of them. The benefits-in the form of incremental increases in shareholder wealth-will accrue to all parties. That, after all, is the purpose of the corporation.