25For25 | Page I Table of Contents Table of Contents

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Observations on the Past, Present, and Future 25of Corporate25 Governance In Celebration of ISS’ 25th Anniversary Category Table of Contents Category table of Contents

foreword iv

Investor PersPeCtIves�� on CorPorate�� governanCe ��

These essaysfromthreenotableshareholdercorporategovernancepioneersexploretherisein influenceofinstitutionalinvestors,thecycleofcorporatefailuresandregulatoryresponses,and theCorporateimperative Governance:forinvestors toPast,assert Present,theirrights and andFutureutilizethemconstructively� By Robert A. G. Monks ...... 1

The Corporate Governance Movement: 25 Years Past and Hence By Ralph V. Whitworth ...... 3

The Financial Crisis, Asset Ownership, and Risk Management By Knut N. Kjaer ...... 5

shareholder rIghts and resPonsIbIlItIes

SincetheU�S�DepartmentofLabor’s“AvonLetter”directedERISAfundmanagerstotreat proxyvotingasafiduciaryresponsibility,investorsworldwidehavecometorecognizeproxy votesasanassetandameansofsafeguardingtheirownershipinterests�Thearticlesthat followdiscussinstitutionalinvestors’effortstodischargethisresponsibilityandthechal- Thelengestheyface� Ascendency of Corporate Governance By Michael McCauley ...... 8

Persistent Concerns in Corporate Governance By Jaap Winter ...... 10

The Evolution of Proxy Voting Policies By John D. Phillips Jr...... 12

Asset Owners Cannot Be Passive By Rod June ...... 15

Quo Vadis Corporate Governance? By André Baladi ...... 16

Market-sPeCIfIC Challenges

Governanceconcernsandregulatoryresponsesvaryfrommarkettomarket�Thefollowing essaysexaminetheUnitedKingdom’screativeapproachtoregulationandareaswhereJapan Theisripe Combinedforreform� Code in the United Kingdom By Lindsay Tomlinson ...... 18

Governance Challenges in the Next Quarter Century in Japan By Yuji Kage ...... 19

PersPeCtIves on board leadershIP

Theboardofdirectorsisthefocalpointofcorporategovernance�Thesearticlesfromrepre- sentativesofinvestors,issuers,andacademiaexaminetheevolutionofboardsandcommit- teesThe overRisethepast25yearsandalongwithgrowinginvestorexpectations� of Shareholder Voice and the Increased Role of Boards An Interview with Ken Bertsch ...... 21

Achieving the Board of the Future, Today By Zach Oleksiuk and Robert Zivnuska ...... 23

The Three Elements of Effective Governance Reform By Charles M. Elson ...... 24

The Changes Wrought by Executive Sessions By Ira M. Millstein and Holly J. Gregory ...... 26

The Rise of Audit Committees By Dennis R. Beresford ...... 27

The Case for Independent Board Chairs By Gary Wilson ...... 29

Meeting the Challenges of Tomorrow Today By Margaret M. (Peggy) Foran ...... 31

PersPeCtIves on exeCutIve CoMPensatIon

Theglobalfinancialcrisishighlightedtheimportanceofaligningthemanagement’sinterests withthoseofshareholders�Inthearticlesthatfollow,prominentgovernanceexpertsexamine theriseofexecutivecompensationasagovernanceconcernandinvestors’responsesinthe TheU�S�andCanada� Rise of Equity-Based Compensation: The Bright and The Dark By Lemma W. Senbet ...... 32

Who Controls the Executive Compensation Program? By Frederic W. Cook ...... 35

‘Say on Pay’ Arrives in Canada By Stephen Griggs and Judy Cotte ...... 37

the next 25 years

Ourcolleaguesleaveuswiththoughtsastowhatthenext25yearswillbring,includingthe needforbettercooperationbetweenissuersandinvestors,theroleofacademicresearchin votingdecisions,theunintendedconsequencesofregulation,andthemainstreamingofcor- Keysporatesocialresponsibilityissues� to Reform Over the Next 25 Years By Hye-Won Choi ...... 39

The Future of Corporate Governance and the Board of Directors By Martin Lipton ...... 41

The Federalization of Corporate Governance and its Unintended Consequences By Bonnie Hill ...... 44

The Past and Future of Corporate Governance Research By Reena Aggarwal ...... 46

Corporate Commitment to Sustainability and CSR Reporting: An Enduring Trend By Tim Smith and Carly Greenberg ...... 48

A Look Ahead at the Next 25 Years in Governance An Interview with Nell Minow ...... 50

By Martha Carter and Patrick McGurn Foreword

heyearwas1985,declaredthe“International Asyou’llsoonsee,theresponsesareasvariedand YouthYear”bytheUnitedNations�Careless engagingastheindividualswhowerekindenough WhisperbyWham!toppedtheBillboard toofferthem�Answerstothecentralquestion 100Chart,andthewildlypopularvideogameTetris coverabroadrangeoftopics—fromtheincreas- wasfirstreleased�MikhailGorbachevbecamethe ingprevalenceofindependentauditcommitteesto leaderoftheSovietUnion,asRonaldReaganbegan holdingexecutivesessionsoftheoutsidedirectors hissecondtermasU�S�president�TheDowJones tothespreadofadvisoryvotesonremuneration� IndustrialAveragebegantheyearjustshortof1200 Marketperspectivesspantheglobe—including andendedaround1550,withGeneralMotorsstand- theUnitedStates,Canada,Japan,theU�K�,and ingTnearthetopoftheFortune500�Commodore ContinentalEurope� introducedthefirstmodelofitsrevolutionaryAmiga personalcomputerline,whileSteveJobswasfired Somecommonthreadsweavethroughoutthese25 bytheboardatAppleComputer� variedviewpoints:❙❙

1985alsomarkedtheunofficialstartofthe First,institutionalinvestorshavebecomemean- moderneraofcorporategovernance�Inresponse ingfulplayersinthegovernancedebate,butiden- togreenmailpayouts,ahandfulofpublicemployee ❙❙ tifyingtherealshareownershasbecomedifficult� pensionfundsbandedtogethertoformthe Moran v. Second,boardmembers’mandateshave CouncilofInstitutionalInvestors�TheDelaware Household, Revlon, Unocal, Van Gorkom increasedatanexponentialrateandnow courtsdecidedaquartetofkeycases— ❙❙ threatentoreachoverload� and —that laidthefoundationfor21stcenturycorporatelaw� Third,enhancedcorporatetransparencyhasben- efitedinvestors,butshareholdersfacenewchal- Alsoin1985,RobertA�G�Monksfounded ❙❙ lengesinhandlingthisinformationavalanche� InstitutionalShareholderServices�BobopenedISS’ Fourth,executivecompensationremainsacon- doors25yearsagowithonesimplegoal:tohelp ❙❙ tentioustopic� assetowners,andbyextension,assetmanagers,to carryouttheirfiduciaryobligationstovotetheir Finally,communicationandengagementarea sharesinathoughtfulandinformedfashion� necessity�

Aquartercenturylater,ISSstillperformsitscore Wetakethisfinalpointtoheart�ISShaschanged missionbyprovidingresearch,votingtools,and itspracticesovertheyearstotapintothewealth governanceexpertisetoinstitutionalshareholders� ofdivergentviewpoints�Ourannualpolicy-setting Overthissametimeperiod,however,seachangesin processbeginswithasurveyofinstitutional institutionalownership,regulation,andgovernance investorsandissuersandconcludeswithanopen haveoverhauledtheshareowner-director-manager commentperiod�Movingfarfromtheone-policy- enginethatdrivespublicmarketcapitalism�Tohigh- fits-allapproachof1985,ISSworkswithourclients lightourSilverAnniversary,wewantedtoofferour todevelopandadministermorethan400custom clientsaglobalperspectiveonthesechangesfrom policies� manyconstituentsinthegovernancecommunity� Thegovernanceenvironmentremainsdynamicfor Weinvited25experts—drawnfromallsidesofthe issuers,investors,andforus�Welookforwardto governancedebateandfromeverycornerofthe beingonthesceneasthenexteraintheevolution globe—tooffertheirperspectives�Weaskedeachof ofthepubliccompanyunfolds�Wearehappyto themoneshortquestion:“What,toyou,isthemost haveencounteredsomanypassionateandengaged significantdevelopmentincorporategovernance professionalsalongtheway—includingthosewho overthelast25years?”Fromtheirresponses, havegenerouslytakentheirtimetowriteforour wecompiledthecollectionofessaysthatyouare compendium�Enjoy. preparingtoread� page iv | 25for25 © 2011 Institutional Shareholder Services Inc. Category Investor PersPeCtIves on CorPorate governanCe By Robert A. G. Monks Corporate Governance: Past, Present, and Future

“ The modern business corporation “ Corporate failures emerged as the first institutional claimant DemocracyAct(which,infact,didnotpass);inthe have repeated of significant unregulated power since the earlyyearsofthiscentury,Sarbanes-Oxley;andmost recently,Dodd-Frank� themselves with nation state established its title in the almost metronomic 16th and 17th centuries.” Whateverthesupposedcure-of-the-moment,the regularity. Every resultishighlypredictable:Publicconcerndimin- —Abe Chayes ishes,thelobbiesflourish,andthecyclestarts decade, it seems, again�Criminalmalefactionsdotalmostevery government decade—GeneralElectricandWestinghouseinthe predictably considers electriccompanyconspiracies;ArmandHammer beChayes,aformerKennedyadministration andGeorgeSteinbrennerforviolationofelection and often passes officialandlong-timeHarvardLawprofes- contributionlaws;CharlesKeatingandtheS&L legislation: in the late sor,wrotethosewordsattheoutsetof crisis;IvanBoeskyandMichaelMilkeninthe‘80s; whatmightbethoughtofasAmerica’sown“Thirty WorldComandEnronintheearlyyearsofthis ‘70s, the Foreign GloriousYears”—thatthree-decadespanfromthe decade;andthefinancesectorasawholeinthe Corrupt Practices Act; late‘70sthrough2008whenitseemedpossiblethat newcentury�Outrageinvariablyfollows�Thetalk- in the ‘80s, the privateenterprisecouldoperateonaglobalstage, ingheadsbecomescreamingones,butintheend, freefromtheconstraintsofgovernmentalregulation humannatureappearstotriumphoverallmanner Corporate Democracy andoversight�Thevisionwassimpleandstirring, ofcontrols� Act (which, in fact, andinmanyA waysirresistible:corporateefficiency did not pass); in the couldco-existwithdemocracy�Stanford Law Review Thefailureoftheprivatesectortocapitalizeon theopportunitiesaffordeditovertrentethepastthree glorieuses early years of this Writingin1979inthe ,another decades—apolitewayofdescribingthedisgraceof century, Sarbanes- professor,DavidEngel,preciselyarticulatedthe corporateleadershipduringthe — standardstowhichcorporationswouldneedtosub- Oxley; and most hasassuredthatameasureofgovernmentinvolve- scribeinordertolegitimatethisunregulatedpower mentinbusinesswillbeconsideredpolitically recently, Dodd-Frank.” withinademocraticsociety:❙❙ necessaryfortheforeseeablefuture�Yetvirtually everyonealsoagreesthatroleshouldbeaslimited Disclosefullytheimpactoftheiroperationson aspossible�Risk-taking,whatmarketsbestreward, ❙❙ Citizens United society; iswhatgovernmentsdoworst�Simultaneously,the ❙❙ Obeythelaw; SupremeCourt’s decision,further extendingthe“personhood”ofcorporations,all Restraintheirimpactongovernment—bothelec- butguaranteesthatoncerecoverytakeshold,the tionsandadministration� politicalscaleswilltiltevenmoretowardcorporate power�Whatthecourtgrants,ofcourse,Congress Today,wearesurroundedbythewreckageofthis cantakebackwithlegislationlimitingorexcluding seeminglynobleexperiment�”Self-restraint”proved corporatepoliticalinvolvement,whichcouldthen largelytobenorestraint�Ratherthanlegitimatize ad infinitum. beoverturnedinthecourts,whichcouldthenbe thepowerhandedthem,corporationshaveinsured re-legislatedonCapitolHill Toomuch theultimateneedforinvolvementofgovernment isatstaketogetcaughtonthechecks-and-balances andtheendofthedream� seesaw�What’sneededisasolutionthatapproaches permanency� Thereis,however,asilverlininginallthis�The financialcrisisof2007–2010hascreatedtherare Ifwearenottorepeatthishistory,itleavesgovern- politicalclimateinwhichonecanrealisticallysuggest mentwithlittlechoiceintheregulationcycle,and preemptivefederalaction,particularlytoredressthe almostcertainlyinever-tightersequences�First,the unintendedconsequencesofearlieractions� roleofgovernmentasshareowner,withtherights andresponsibilitiesattendanttheretoasconferred Corporatefailureshaverepeatedthemselveswith bystatelaw,needstobecodified�Ownersofventures almostmetronomicregularity�Everydecade,it expectingtraditionalvalueenhancementcannotbe seems,governmentpredictablyconsidersand governmentbureaucrats�Second,andmoreimpor- oftenpasseslegislation:inthelate‘70s,theForeign tantinthelongterm,alegalenvironmentmustbe © 2011 Institutional Shareholder Services Inc. CorruptPracticesAct;inthe‘80s,theCorporate 25for25 | page 1 Investor PersPeCtIves on CorPorate governanCe Investor PersPeCtIves on CorPorate governanCe

“ For others, ownership is literally a betting fashionedwithinwhichthefiduciaries,actingunder thatwill TheapplyEconomisttoallcomponents ofthisclassatall . slip, and it is mere existinglaws,arebothprotectedfrompeer-group times�Thisdichotomywasaptlycaptured20years unfaircompetitionandarerequiredbytheprospect agoin article“ProprietorsorPunters ” coincidence that the ofgovernmentoversightandenforcementtobeeffec- Forsomeshareowners,controlanddirectionofthe slip relates to a share tivestewardsofequityownership� companyinwhichtheyareinvestediscritical�Their of stock, rather than objectiveisthatportfoliocompaniesshouldbesus- Stiffenedbysuchencouragementandoversight, tainable;theyshouldbeabletofunctioninharmony a horse or a football thiscadreisentirelycapableofdecidinghowitwill withcivilinterestindefinitely�Forothers,ownership game.“ functionasthedominantownerofpubliclytraded isliterallyabettingslip,anditismerecoincidence companies�Thetrusteesaretheappropriategroup thatthesliprelatestoashareofstock,ratherthana todeterminehow“activistowners”aretobecom- horseorafootballgame� pensatedforthevaluetheycontributetotheover-all enterprise�Theycandecidethecorrectmeansby Itmaybethatthepassageofand twodecadeshas which“passiveowners”—particularlythoseselected changedtheconjunctionandtodaytheansweris byformulaandalgorithm—canbestfunction�Also, Punters Proprietors�Itmustbeclearthatamidst theycandecidewhetherclassesofstockprovidea thepanoplyofstockownership,thereisadifference usefulmodeforfunctioning� ofkindbetweenthosewhoinvestthroughimper- sonalmechanismandthosewhoseinvestmentsarea Havingafunctioningownershipclasspermits matterofsentientchoice� manydifficultquestionstobeaddressed�Themost difficultoftheseisthepowerofcorporationsto Afurtherdichotomymightbedrawnbetweenthose influenceandtodominatethegovernmentprocess shareholders—passiveandactive—whochooseto bywhichtheyareregulated�Thepoweroflobbyists functionasstewardsandthosewhodonot�Again, appearstobeenshrinedbytheSupremeCourtwith dualclassesofstockmightbeappropriate�Itiswell itsrepeatedinsistenceon“freedomofspeech”— torememberthatwhenWarrenBuffettinvestsin thatistosay“money”—ofcorporationsinthelaw marketablesecurities,heisusuallyabletosecurea makingandenforcingprocess�Thislicenseseriously specialclassificationthatreflectsthevalueadded erodesthelegitimacyofcorporatepower� byhisinvolvement�Norhasthedualclassprevalent “ A further dichotomy inScandinavialoweredlong-termequityreturns� AfunctioningownershipgroupcanfollowDavid might be drawn EvenAmericanscholarssuchasMartinLiptonandThe Wall Street Journal between those Engel’sadvice:restraintindealingwithgovernment� JayLorschcommentfavorablyonsuchanotion Theownersofacorporationcanlimititslobbyingand inastoryin inMay2010: shareholders—passive campaigningpresence�Oncethisbasicdisciplineis “Providinglong-termshareholdersagreaternumber and active—who established,wecanmoveontotheessentialelements ofvotespershareshouldbecomeapermissible oflegitimacy�Howdocorporationsdealwiththesocial option�” choose to function as consequencesoftheirfunctioning?Again,Engelpro- stewards and those videstheanswer:furnishallinformationtolawmak- Furtherimprovementwouldresultfromthedeter- who do not. Again, ers,berespectfulofthelaw-makingprocess,andobey minationthatstewardship,beingintheinterestboth thelaw�Clearly,progresscanandshouldbemadein ofthecorporationandofsociety,isappropriatelyan dual classes of stock thedirectionofdevelopingamoreholisticaccounting expenseofthecorporation�Makingasumavail- might be appropriate.” system,whichwouldprovideuniformrequirements ableforthosewillingtoundertakethecostsand fortakingintoaccount“externality”costs�Thisisa exposureofstewardshipwouldhelpenlisttheindex projectthattheownershipcadreshouldaddress� fundstoperformthiskeylong-termrole—avitalele- mentsincewhatiswantedisbothlong-termstew- Therecanbenouniversaldefinitionof“shareholder” ardshipandaperspectivefortheinvestmentworld andnopossibilityofarticulatingpurposeorinterest asawhole,incontrasttoindividualcompanies�

About the Author

❙❙ Robert Monks is a co-founder of ISS and a long-time shareholder activist. He also was a founder of LENS Investment Management. He has written frequently on governance issues. He is the author of Corpocracy and The New Global Investors. Along with Nell Minow, he wrote Watching the Watchers, Corporate Governance, and Power & Accountability.

By Ralph V. Whitworth The Corporate Governance Movement: 25 Years Past and Hence

“ Constructive, behind- helast25yearshavebroughtseachanges fundmanagerstovoteproxieswiththesame the-scenes persuasion inthewaybothinvestorsandcorporate diligenceasmakingotherfiduciarydecisions� will work in most boardsapproachcorporategovernance,but Contemporaneously,MonksandNellMinow theimpactonboardroomdynamicsandperfor- foundedInstitutionalShareholderServicesto cases, but successful manceisstillamilewideandaninchdeep�That’s adviseinstitutionalinvestorsonproxyvoting� diplomacy depends on because,overtheyears,whiletherehavebeen Thesegiantstepslaidthegroundworkforchange� alternatives with manychangesinboardroomprocesses,therehave beenveryfewchangesinthewayweselectdirec- Withgovernance-relatedshareholderproposals teeth, so shareholders tors�Withnewattitudesfirmlyinstilledandbetter todayroutinelyreceivingmajorityvotes,most must be prepared to Ttoolsinplace,investorshaveanenormousoppor- observersmaynotrealizethat,asrecentlyas1988, take action when tunity(andresponsibility)overthecomingyearsto aretiredrailwayconductor,RichardFoley,withthe improveboardcomposition� helpofUSA,presentedthefirstshareholderpro- quiet encouragement posaltoreceiveamajorityvote�Notcoincidently fails. They must be Beginninginthe1950s,corporateAmericawit- thatwasthefirstyearof“AvonLetter”enforcement� willing to initiate nessedatectonicshiftinequityownershipaway frompassiveindividualinvestorsandsleepytrust In1992,theSEC,chairedbyRichardBreeden, vote-no campaigns or departmentsintothehandsofmoresophisticated promulgatedthemostfar-reachingreformsof nominate institutionalinvestors�Bythemid1980s,thisphe- executivecompensationdisclosureandshareholder replacement directors nomenongaverisetoapotentiallypowerfulnew votingrulesinthehistoryofoursecuritieslaws� ownershipregimethatcombinedfiduciaryrespon- Thatactionpartiallywasinresponsetoapetition using the new proxy sibilitywithresearchcapability�Despitethisnew forrulemaking,whichIauthoredandsubmittedto access rules or breedofowner,eventodayincumbentscontinue theSECin1990onbehalfofUSA�Thesereforms independent proxy todominatethenominationprocessandwhether streamlinedruleslimitingshareholdercommunica- shareholdersvote“for,”“against,”ornotatall,they tions,brokedownwallsinthearcaneproxysolici- initiatives.” getthesameslateofdirectors�It’sperplexingbut tationprocess,and,forthefirsttime,shareholders truethatthetigerinherentininstitutionalowner- wereallowedtonominateshort-slatesofdirector shipremainslargelytoothless� candidatestoreplaceincumbents�Withinayear, mypartner,DavidBatchelder,wonthefirstshort- Thatsaid,therehavebeenmanysignificantsteps slatecontestatPic-n-SaveCorporation� intherightdirection�BelowIdescribeafew,butby nomeansall,thatcometomindfrommypersonal Ultimately,theSECrulechangesgaverisetothe experience� modernactivistinvestorwhichhaditsrootsinthe earlyactivitiesoftheCaliforniaPublicEmployees’ In1985JayGoldin,RolandMachold,andJesse RetirementSystem(CalPERS)andUSA�In1987, Unruhjoinedforcestofoundthenowtrillion- CalPERS,guidedbyDaleHansonandRichardKoppes, dollar-strongCouncilofInstitutionalInvestors initiateditsFocusGroupshareholderactivismpro- toadvocatetheinterestsofthenewinstitutional gram,andthenextyearUSAlauncheditssimilar investor�Ayearlater,T�BoonePickensprovided Target50program�Justafewyearslater,Monksand thefundingtofoundtheUnitedShareholders Minowintroducedtheconceptofactivistinvest- Association(USA)toorganizeindividualshare- ingwiththeformationoftheLensFund�In1996 holdersbehindimprovedshareholderrights,andI CalPERSpartneredwithRelationalInvestorsto becameitsfirstpresident(probono)� pioneerthefirstmajorinstitutionalfundingofthe concept� AsAdministratoroftheDepartmentofLabor’s OfficeofPensionandWelfareBenefitPrograms, Inanunprecedentedmove,institutionalinves- whichadministerstheEmployeeRetirement torsforcedRogerSmithoutofGMin1990,and,by IncomeSecurityAct(ERISA),BobMonksfirst 1993,similarpressurehadheadsrollingfromthe raisedthepropositionthatshareholdervotes executivesuitesofsomeofAmerica’smoststoried shouldbetreatedaspensionplanassets�Building companies�Twoofthese,JohnAkersatIBMand onthatconcept,in1988theLaborDepartment PaulLagoatWestinghouse,involvedaone-two- © 2011 Institutional Shareholder Services Inc. issuedits“AvonLetter”instructingERISA punchofmultipleshareholderproposalsfrom25for25 |USA page 3 Investor PersPeCtIves on CorPorate governanCe Investor PersPeCtIves on CorPorate governanCe

andpressurefrominstitutionalinvestorsledbyCalPERS�Thatyear, thestatusquo’smostdistinctcharacteristicisinertia�Corporate AmericanExpress’boardalsoreleasedtheirCEO,JamesRobinson, boardsshouldn’tbeexpectedtochangeunlesspushed,buttheyare inthefaceofinvestorpressure� pragmatic�Withenoughencouragement,boardswillridthem- selvesofdirectorswhoarevulnerabletoproxychallenges�They Alongtheway,institutionalinvestors,ledbyCalPERSandtheCalifornia willbegintojettisondirectorswithconflictsofinterest,thosewho StateTeachers’RetirementSystem,developedformalgovernancepoli- sitontoomanyboards,thosewithpoorattendancerecords,those ciesandvotingguidelines�GeneralMotors,coachedbyIraMillstein, whohavestoodasideandallowedcompensationandaccounting publishedthefirstformalgovernanceguidelinesfromthecorporate abuses,thosewhohaveignoredretirementages,andthosewho side�Thesesteps,alongwiththegrowinginfluenceofISS’svotingrec- haveignoredtheresultsofshareholderproposals�Infact,itwould ommendations,usheredinabroadgovernancereformmovement� behoovemanydirectorstogetaheadofthiscurveandheedthe adagethat,“yougottago,beforeyougottago�”Pushingboardsto Then,attheturnofthecentury,cameepiccorporatescandals,which proactivelyevaluateandimprovetheirmembership,however,is broughtsomeofthemostveneratedandcelebratedcompaniesincor- onlyhalfofthesolution;goingforward,it’sjustasimportantthat porateAmericatotheirknees�Withthesesoberingeventswelearned shareholdersassumestrongerrolesinsettingcriteriaforandrec- thattheprogressofwhichwewereallsoproudhadcometonaught� ommendingdirectornominees� Despiteallthetic-the-boxreforms,debilitating,overlydeferential boardroomdynamicsstillprevailed�Thesmokinggunwasskyrocket- Constructive,behind-the-scenespersuasionwillworkinmostcases, ingCEOpaythatborelittlecorrelationtoperformance�Areactionary butsuccessfuldiplomacydependsonalternativeswithteeth,so CongresscametotherescuewiththeSarbanes-Oxleyreformlegisla- shareholdersmustbepreparedtotakeactionwhenquietencour- tion,which,unfortunately,butcharacteristically,focusedonsymp- agementfails�Theymustbewillingtoinitiatevote-nocampaignsor tomsratherthanattackingthedisease�Despitetheproverbial“actof nominatereplacementdirectorsusingthenewproxyaccessrulesor Congress,”corporatedirectorswerestillelectedbyabankruptprocess independentproxyinitiatives�Tosucceedwitheitherapproachandto dominatedbyincumbents,and,byandlarge,institutionalinvestors acceleratetheneededchanges,theymustalsobemuchmorewilling continuedtorubberstampdirectorslates� thantheyhavebeeninthepasttoworktogether,poolresources,and communicateaconsistentmessagetoboards�InRelational’sexperi- IttookthenearcollapseofourfinancialsystemandGM’sbank- ence,wehavefoundthatengagementeffortsinvolvingtwoormore ruptcybeforeCongress,theSEC,and,yes,institutionalinvestors resoluteshareholdersgetthequickestresults� wouldfinallybegintoaddresstherootcauseoffailedboards�The institutionalinvestor-ledmovementtoseparatetherolesofCEO Ironically,ifboardcompositioncanbesignificantlyimprovedthen andchairmanandrequiremajorityvotingindirectorelectionshas thegovernancereformsshareholdershavespentmuchofthe dramaticallyacceleratedsincethe2008crisis�Thisyear,afterget- last25yearsfightingforwilllargelytakecareofthemselves�For tingthegreenlightfromCapitolHill,theSEC,undertheleadership example,whengenuineshareholderrepresentativessitaround ofMarySchapiro,promulgatednewrulesallowinglarge,long-term boardtables,thepositionsofCEOandchairmanwillbeseparatedat shareholderstousecompanies’officialproxymaterialstoputforth virtuallyallU�S�companies,andallcompanieswillhonormajor- replacementdirectors�Thisconceptwasoriginallypresentedin ityvoting�Similarly,classifiedboardtermswillbecomearelicof USA’srulemakingpetitionbackin1990� history,andlargeshareholderswillberoutinelyconsultedonboard nominees�Executivecompensation,themoststubbornissueof Sowhathappensnowandoverthenext25years?Institutional all,willonlycomeundereffectiveshareholderinfluencethrough investorsfinallyhavemostofthetoolsforwhichtheyhavelobbied constantvigilanceandtheworkofnewdirectorswhofeelgenuine overthelastfewdecades,andthereisalargeanddiversegroup accountabilitytoshareholders� ofhighlyqualifieddirectorcandidateswhoareanxioustoserveas trueshareholderrepresentatives�Thisputsthefuturesquarelyin Inshort,positivechangeinboardroomdynamicscommensurableto thehandsofinstitutionalinvestors� theseachangeinownershipisfinallypossible,albeithighlydepen- dentonconcertedshareholderactionand25yearslatetothegame� ThefinancialcrisisandtheSEC’sproxyreformsprovidetheingre- But“betterlatethannever�” dientsforaparadigmshiftinthewayboardsarecomposed,but

About the Author

❙❙ Ralph Whitworth is a founder and principal of Relational Investors, a $6 billion private investment fund. Relational, founded in 1996, was a pioneer in what has come to be known as “activist” investing.

page 4 | 25for25 © 2011 Institutional Shareholder Services Inc. Investor PersPeCtIves on CorPorate governanCe Investor PersPeCtIves on CorPorate governanCe By Knut N. Kjaer The Financial Crisis, Asset Ownership, and Risk Management

“ We have failed as earewitnessingaGreektragedy�We Allotherstakeholdershavecontractsontheirrights, owners, and we have willprobablyseethisplay,withlocal andthelenderhascollateralinthecompanyassets� failed as investors by variants,inmanycountriesoverthe Ownershiprightsarethecompensationforhaving nextfewyears�Thefinancialcrisisisnotover:the theresidualclaim,andcorporategovernanceis fueling a financial secondact,whereingovernmentspresentthebillto aboutprotectingtherightsoftheshareholders,not intermediary industry ordinarycitizens,isjustunderway,andmayprove allotherstakeholders� tobemuchmoredramaticthanthefirst� the dysfunCtIonal sIde of that did not deliver the Markets what the end investors Theplayisaboutthefunctioningofthecapital in the pension plans markets,andwhathappenswhenthereisalackofW needed.” financialdisciplineandtheabsenceofrealchecks Theestablishmentofequitymarketswasapower- andbalancesinthesystem�Atstakeisthesurvival fulforcebehindtheindustrializationandwealth ofthemarketcapitalistsystem�Thewealthcreation creationofEuropeandhassincebeencopied wasprivatized,thecleaningupcostsaresocialized� worldwide�However,wehaveseenthedysfunc- Wewillprobablyseeincreasingpublicdistrustand tionalside—speculativebubblesandsocialunrest� angerduringthenextdecade� Equitymarketsprovidehighrewards,butathigh risk�Gettingitrightmeansbalancingtheforces Investorshaveplayedakeyroleinthistragedy� ofself-interestandprofitononehandandpublic Wehavefailedasownersoffinancialinstitutions, regulation,marketstructure,andaccountabilityon butwehavealsofailedasinvestorsbyfuelinglever- theotherhand� agedinvestmentsintoalternativeassetclassesand complexdebtinstrumentswithoutunderstanding Theissuanceofequitieswasawonderfulinnova- theunderlyingrisks� tion,butitpresentedopportunitiestotransfer the orIgIns of equIty Markets wealthfromsaverstocompanyinsiders�Insome emergingmarkets,equityissuanceisanadvanced, andoftenaccepted,meansofrobbery�Creatinga WhydidasmallcountryliketheNetherlandsrise legalmarketstructureandanequityculturecan toamaritimesuperpowerduringintheMiddle takegenerations� Ages?Partlybecauseoftheinnovationofjoint stockcompanies�Thetechniqueofpoolingcapital Wehaveseen,inallmarkets,twotypesofsystem- madeitpossibletomakebigships�Beforethis aticdestructionofshareholders’value:onerelated financialinnovation,onlygovernmentsorvery totheagent-principaldilemmaandonerelated wealthyfamiliescouldundertakesuchrisky todiscriminationagainstminorityshareholders� investments� Thecostofagentdominancetakesvariousforms, includingoverpayingofexecutives,transferof Theinnovationofjointstockcompaniesdatesback wealthtomanagersfromowners,andmisuseof tothemid1200s,withissuanceoftradedshares strategicopportunities�Theabuseofpowerby forfirmssuchastheBazacleMillingCompanyin majorityshareholdershappensthroughasset France,andtheStoraminingcompanyinSweden� transfersandstripping,internaltransactions, TheEastIndiaCompanyaroseinEnglandin1600� dilutionvianewequityissues,andnepotism�The AndtheDutchEastIndiaCompanyissuedshares historyofbuildinganequitycultureisthestoryof ontheAmsterdamstockexchangein1602,thefirst anongoingfighttoprotecttheequalinterestofall companytoissuestocksandbonds� shareholders;itisaboutpowerandaccountability�

Thesestockownershadajointinterest,andthe Protectingshareholders’interestiscomplicatedby valueofeachsharereflectedtheunderlyingcash dispersionofownership,frompersonalowner- flowsofthecompanies�Creatingthissourceofrisk shiptoindirectownership,throughpensionfunds capitalreducedthecostofborrowing� andassetmanagers�Whentheseindirectowners runlargediversifiedportfolios,theymaylackthe Stockownerstookhigherriskthanlenders�An incentiveandabilitytotakepartinthegovernance © 2011 Institutional Shareholder Services Inc. ownerhasonlyaresidualclaimonthecashflow� ofeachconstituentcompany� 25for25 | page 5 Investor PersPeCtIves on CorPorate governanCe Investor PersPeCtIves on CorPorate governanCeCategory

BobMonkssawthisdysfunctionalsideoftheU�S�capitalmarketwhen complexandleveragedstructuredproductswithouttheappropriate heandNellMinowestablishedInstitutionalShareholderServices25 understandingoftherisksoftheseinstrumentsandtheriskcharac- yearsago�WithISS,Monkscreatedapowerfultoolforinstitutional teristicsofthetotalportfolio� investorsandtheindividualpensionplanmembersbehindthem� Financialmarketsareadaptive,complex,andfragilesystems�We Monkscreatedanetworkthatcouldempowereachclientwithtools mustaddanotherdimensiontotheinvestmentdecisionmodel: tocastvotesefficiently,andwiththeresearchcapabilitytoprovide Integrity�Withoutassessingtheintegrityofhowcompaniesare investorswiththerelevantinformationneededtodecidetheirposition� managed,wemayfailtogetasufficientunderstandingoffuture Eachnewclientaddspositivelytoallthemembersofthenetworkby risks,notonlyofeachinvestment,butalsoofthemarketplaces� increasingtheabilitytoprovidemorecomprehensiveresearch� Privateequityhasoftenprovidedbettergovernancethanwhatis ISSgavemorepowerbacktoowners,butbecamealsopowerfulin normalforthepublicmarkets�IthasbeeneasyforPEfirmstotake itself�Assuch,ISSaimsforthehighestethicalstandards,hasfull listedcompaniesprivatewithlow-costfunding�Forthemarketplace transparencyintothepolicy-makingprocess,andencouragesand andinvestorsthisoutcomeisprobablynotthebestone;however, empowersinvestorstoformtheirownpoliciesandvotingdecisions� movingtoprivatemarketslowersliquidity,increasestransaction Muchhaschangedinthese25years,and,clearly,moreworkremains� costs,andimposeshighmanagementfees� the fInanCIal CrIsIs and a “ What investors can faIlure of ownershIP Iexpectwewillseeatrendtowardmorerobust control, e.g., by the investmentstrategiesbyfinancialinvestors, influence of board strategiesthatemphasizesimplicity(notinvest- Therecentfinancialcrisisispartlyaboutthefail- ingininstrumentsandmarketsyoudon’tfully uresofinvestors�Wehavefailedasowners,and compositions, is that understand),highqualityriskmanagement wehavefailedasinvestorsbyfuelingafinancial the management of (includingindependentassessmentsofprices intermediaryindustrythatdidnotdeliverwhat andrisk),andprudentrisktaking(moreclosely theendinvestorsinthepensionplansneeded� each company acts alignedwiththeobjectivesandgovernance Ownersfailedtounderstandrisksanddidnot with integrity.” structureofthefunds)� pursuestrategiesatfinancialinstitutionsthat wereintheirlong-terminterest� Mostimportantly,Iseeintegrityasanincreas- inglyimportantfactorininvestmentdecisions� Thatbeingsaid,manycompanieswerecontrolledbycorporate Fromtheangleofalargeendowment,pensionfund,orsovereign insiders�Ownerswerenotinapositiontocontrolthecompanies, wealthfund,whenyouhavealongtimehorizonandyou“own suchashavingtheabilitytoappointdirectorsandcreaterealchecks themarketplace”(withadiversifiedportfolio),itfollowsthatthe andbalanceswithmanagement�Evenifownersweresuccessfulin sustainabilityofthemarketsthemselvesisimportantforthelong- appointingdirectors,wemustaskifthedirectorswouldhavehad termreturn,asembeddedintheterm“universalowners�”This thecompetencetounderstand—andhaveanimpacton—thestrat- bringsintegrityinasafactorfortheinvestmentreturn—youmust egyofthecompanies�Today’sissuesareextremelycomplex,and considerexternalitiesofyourinvestmentsevenifyoudonotwant difficultfordirectorstounderstand� toengagein“politics�”

Howtopreventanothermassivedestructionofshareholdervaluein Myviewisthatactingwithintegrityisnotaboutinvestorsenter- financialinstitutionsnotonlyraisesageneralquestionaboutfinan- ingthepoliticalscene�Issueslikeclimatechangeareultimatelyup cialmarketcomplexityandtransparency,butalsofocusesonthe tothegovernmenttoresolvethroughregulation�Butsuccessful moralhazardproblem:ifcompaniesaretoobigtofail,theowners long-terminvestorsanticipatesuchpoliticaloutcomes,knowing don’thavetheincentivetoinvesttimeandresourcestomonitorand thatcostlyexternalitieseventuallywillbepricedintothemarket controlhowthemanagementrunsthecompaniesontheirbehalf� throughregulation�

Also,ofcourse,thereisaquestionofhowthemanagementis Whatinvestorscancontrol,e�g�,bytheinfluenceofboardcomposi- compensated�Withahugelyasymmetricstructure,managementis tions,isthatthemanagementofeachcompanyactswithintegrity� incentivizedtotakeexcessiverisk� Integrityisaboutbeingwholeandcompleteandhonoringone’s the fInanCIal CrIsIs and a faIlure of word;consideringintegrityasaseparatedimensionmeansthatwe Investors alsoassessthegovernancestructureofacompany,thequalityand valuesofthemanagement,andalignmentbetweentheincentive systemthatdrivesthemanagersandthelong-termvalueofthe Manymarketparticipantstookrisksthatweresimplyinappro- company�Italsomeansthatweconsiderhowcompaniesinteract priate�Theypursuedshort-termgainsbutfailedtofocusonrisk withthesocietyandenvironmentaroundthem� management�Investorsfedthefinancialintermediaryindustryand wereoverlyoptimisticaboutthediversificationeffectofalterna- pagetive 6 assetsandalphacapabilitiesofthemanagers�Theyinvestedin | 25for25 © 2011 Institutional Shareholder Services Inc. Investor PersPeCtIves on CorPorate governanCe Investor PersPeCtIves on CorPorate governanCeCategory

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herreactionbewhentheplotisrevealed?Willweseeagrassroots revoltagainstbusinessandmarkets?Willindividualsbecomemore Partlyasareactionofthefinancialcrisis,ownersarenowgetting activeinholdingaccountablethemoneymanagerswhovoteon morepowertoimpactbothboardcompositionandcompensation theirbehalf?Willweseethattheygetachancetovotebythem- structure�Thenextquestionis:Willwebeabletouseit? selves,soweclosethecircleandgetbacktopersonalownership again?Shouldweempowerthemtodoso? Therearemanychallengesrelatedtoboardcomposition:Howto assessthequalityofthefullteamofboardmembers,theindividu- AsentenceintheFinancialTimesnotlongagoprovokedsome als,thedegreeofcomplementaryandrelevantcompetencies,the thoughtontheseissues:Why set maximising shareholder returns as the company goal when interactionwiththemanagement,therealindependence,howto shareholders actually are absent from stewarding the companies? findtherightcandidatestocomplementtheteam�Weneedtodo moreworkonboardbestpracticestandards,ondisclosureofhow ❙❙ theboardworks,andonhowtheindividualmemberswork� “ Our biggest challengeWhatisthepurposeofthefirminthisnewreality?Andiscor- Wehavelearnedthehardwaytheimportance porategovernanceonlyaboutprotectingthe ofcompensationstructure�Compensation as owners now is— interestsofoneofthestakeholders,theowners? systemsmustcreateanalignmentwiththe having obtained many Iseesomeadditionstothemantraofmaximizing owners,andmustbeeasytocommunicate�They shareholdervalue:❙ ❙❙ mustbelinkeddirectlytotheEnterpriseRisk of the rights we have Managementsystemsofcompanies,andinves- Managerelationswithcompanyemployees, torsmustconstantlyaskhowagivencompensa- asked for—how do we society,andtheenvironmentinasociallyintel- tionstructurecontributestotheriskprofileof best use these rights in ❙ ❙❙ ligentandsustainableway� thecompany� constructive and value Managethecomplexityofthebusinessmodel Asforboardelections,thisresponsibilityiseven creating ways?” inawaythatgivestheboardarealopportunity moredemandingforinvestors�Itwilltakemore ❙❙❙tobeinchargeandoverseeenterprisewiderisk� resources,butalsohasthepotentialforcreating betteralignment�Infact,ourbiggestchallengeas Actwithintegrityinallpartsofthebusiness� ownersnowis—havingobtainedmanyoftherightswehaveasked Ifwedefinethemantraasmaximizingshareholdervalueovera for—howdowebestusetheserightsinconstructiveandvalue longterm,theseadditionsarenotinconflict;theywillratherserve creatingways?Wemuststepupandtakeresponsibility� the PurPose of busIness: More than ashelpfulguidance� Power and shareholder value? Accountability MyfriendBobMonkswroteinhis1991book aboutrestoringthebalancebetweencorporations andsocietyandtheimportanceofinstitutionalinvestoractivism� Let’sgobacktotheGreektragedy:Whoarethevictims?One candidateisthememberofapensionplanwho,havingseenthe Theequitycultureisapowerfuldriverofwealthandprosperity;the valueoffuturepensionsdeclinebecauseoffailedinvestmentsin rewardsaregreatbutsoarethedownsiderisks�Gettingitrightis alternativesandcomplexproducts,nowisalsofacingincreased abalancingact�Inshort,Monks’messageis,ifanything,evenmore taxesanddecreasedlevelofpublicservices�Thepensionplan compellingtoday� memberisindirectlyanownerinbusinesseswheremanagershave hugelyenrichedthemselvesattheexpenseofthepensionplanas shareholder,andalsoattheexpenseofalltaxpayers�Whatwill

About the Author

❙❙ Knut Kjaer was until recently president of RiskMetrics Group in New York with direct responsibility for the firm’s global risk management and ISS corporate governance businesses. In 1998, Kjaer became the founding chief executive officer of Norges Bank Investment Management. He now is a member of the investment committee of the Dutch fund ABP, the largest pension fund in Europe, and he is member of the International Advisory Board of China Investment Corp.

© 2011 Institutional Shareholder Services Inc. 25for25 | page 7 shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIes By Michael McCauley The Ascendency of Corporate Governance

“ Today, shareowner nthe1930s,BenjaminGrahamandDavidDodd practicalmarketexperiences,aswellasacademic support for many succinctlydescribedtheagendaforcorporate andindustrystudies�Mostinstitutionalinvestors resolutions routinely governanceactivitybystatingthatshareowners haveimplementedextensiveprocedures,integrat- shouldfocustheirattentiononmatterswherethe ingdifferentareasoftheirinvestmentinfrastruc- surpasses the 50 interestoftheofficerandthestockholdersmaybe ture,wherebycorporategovernanceandproxy percent majority inconflict�Thisincludedquestionsaboutpreserving votingcommitteesdeliberateonspecificproxies, threshold required for thefullintegrityandvalueofthecharacteristicsof managetheindependenceandintegrityofthe ownershipappurtenanttosharesofcommonstock� votingprocess,anddevelopgovernancepoli- passage.” cies�Suchproxycommitteesmeetregularlyand OverthelastI twodecades,corporategovernance routinelyinvolveseniorinvestmentstaffwithinan hasbecomeincreasinglyembeddedintothecalcu- investmentorganization�Thesegovernancegroups lusofinstitutionalinvestors�Althoughgovernance reachconsensusonvotingrecommendationsand concernshavebeenpresentsincetheearly1900s, specificgovernanceconcernswithownedfirms� awatershedeventinthedevelopmentofinvestors’ shareowner aCtIvIsM focusongovernanceissuesoccurredin1988when theU�S�DepartmentofLabor(DOL)issuedits“Avon Letter�”TheDOLletterprovidedinvestorswith Insharpcontrasttothesituationin1988,most guidanceforhowtotreatproxyvotingrightsalong- investmentorganizationstodaydevotesignificant sideotherretirementplanassets,placingcorporate timeandanalyticalresourcesdirectedatevaluating governancefactors—proxyvotingonshareowner thecorporategovernanceatfirmsinwhichthey’ve proposals,companyengagement,shareowner becomeequityowners�Thedefaultviewsofmany activism,andmanyotherrelatedinvestmentpro- investorshasalsoshiftedgreatly,movingawayfrom cedures—underthesamefiduciarystandardasthe predominantlydeferentialsupportofacompany’s coreinvestmentresponsibility� managementandboard,toamorenuancedand comprehensiveapproachbasedonfactsandthe Subsequently,theDOLwentontoprovidemore practicalexperiencesofmarketparticipants�This detailedguidance,in1994,andthenagainin2008, evolutionandexpansionoftheanalysisofcorporate throughvarious“InterpretiveBulletins,”covering governancehasalsooccurredonaglobalbasis,but stockownership(proxyvoting)rights,participa- the advancementshavebeenunmistakablewithin tionincorporatebankruptcyproceedings,and U�S�equitymarkets�Virtuallyallinvestmentmanag- shareownerlitigation�Thebulletinsrequired ersintheU�S�nowhaveestablishedwrittenproxy votingrightstobemanagedwiththesamecare, votingguidelines,includingvotingpoliciesonissues skill,prudence, anddiligenceasanyotherfinancial likelytobepresented,proceduresfordetermining asset,withanaimtoprotectandenhancelong- votesthatarenotcoveredorwhichpresentconflicts termportfoliovaluefortheexclusivebenefitof ofinterestforplansponsorfiduciaries,procedures pensionplanparticipants�Thesecommunications forensuringthatallsharesheldonrecorddate bytheDOLclearlydirectedplanfiduciariestonot arevoted,andfulldocumentationandreporting onlyvoteproxiesinthebestinterestofbeneficia- ofvotingdecisions�Manyinvestmentmember ries,butalsomandatedtheseorganizationshave organizations,suchastheCouncilofInstitutional writtenproxyvotingguidelines�Thesingleregula- InvestorsandCFAInstitute,havedevelopedcodes torydevelopmentoftheDOL’sguidancehashad ofbestpracticesandinvestmentmanualsdesigned numerouslong-termimpactsonissuers,investors, toeducateandinformtheirmembersabout andtheoverallmarket� corporategovernanceprinciplescoveringpublicly tradedequitysecurities�Inaddition,manycoun- Manyinvestors’votingguidelinesarebasedon triesandinternationalbodieshavedevelopedand rigorousempiricalresearch,industrystudies, implementedinternationalpoliciesoncorporate investmentsurveys,andothergeneralcorporate governanceandproxyvotingissues,promulgating financeliterature�Manyotherinvestorsbasetheir guidelinesrecognizingthateachcountryneednot corporategovernanceprinciplesandproxyvoting adopta“one-size-fits-all”codeofpractice� guidelinesontheirowninvestmentviews,their

“ As shareowner governanCe IMPaCts Investor suPPort for activism entails share value shareholder ProPosals concentrated costs and widely disbursed ThelevelofshareowneractivismintheUnited Anothermajorchangesincethemid1980ssur- Stateshasincreasedconsiderablysincethe roundsboththeexpansioninthenewtypesof benefits, investors mid-1980sdueprimarilytotheinvolvementof shareownerresolutions,andthelevelofinves- with large positions publicpensionfundsandotheractiveinstitutional torsupportforthosesameballotitems�Today, shareowners�Empiricalstudieshaveidentifiedthe shareownersupportformanyresolutionsrou- are the most likely potentialtoenhancevalueofinvestmentsasthe tinelysurpassesthe50percentmajoritythresh- investor to obtain mainmotiveforactiveparticipationinthemoni- oldrequiredforpassage,whichwaspreviously toringofcorporations�Sincethelate1980s,many unheardoffordozensoftypesofindividualballot outsized returns to industryandacademicstudiesonshareowner proposals�Notably,severalpolicytopicssubmit- justify the costs.” activismandcorporategovernancehavefoundthat tedviaSECRule14a-8forshareownerresolution shareowneroppositionhasslowedthespreadof andratificationwerenotevenpresentinthemid takeoverdefenses,suchasstaggeredboards,which 1980s—forexample,majorityvoting,proxyaccess, havebeenshowntoimpairfinancialandstock “sayonpay,”andsupermajorityvotingthresholds priceperformance�Asshareowneractivismentails werenotmajorissuesdiscussedbycompaniesor concentratedcostsandwidelydisbursedbenefits, investors�Acrossawiderangeofvotingissues, investorswithlargepositionsarethemostlikely fromdirectorelectionstocompensationplans, investortoobtainoutsizedreturnstojustifythe shareownervotinghasbecomemoreanalyticaland costs�Also,therehasbeenadramaticshiftaway gearedtowardsvaluecreationandincreasingfirm fromtheold“WallStreetWalk,”thetermforthe performance� activedecisiontosellastockratherthanattempt toaffectchangethroughcontinued(orexpanded) investment�WhiletheWallStreetWalkhasn’t goneawaywithinU�S�equitymarkets,norshould itentirely,itssignificancehasgreatlydiminished throughincreasedpassiveinvestmentsanda changeinphilosophyamongmanyinvestors�

About the Author ❙❙ Michael McCauley is the senior officer for investment programs and governance at the Florida State Board of Administration.

© 2011 Institutional Shareholder Services Inc. 25for25 | page 9 shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIesCategory By Jaap Winter Persistent Concerns in Corporate Governance

“ Most institutional fwestepbackalittlefromtherushoftheday, dynamicallymonitoringmarketconditionsacross investors either weseethatthegovernanceoflistedcompanies differentsecuritiesandtradingvenues,sometimes ignore the governance hasbeenproblematicsincetheinceptionofthe seekingtodetecttradeordersofotherparties listedcompany,inmybackyard,inAmsterdam,in gamingonthefactthateverytradeorderpresents aspect of their equity 1602�TheDutchEast-IndiesCompanyVOCwas afreetradingoptionforothertraders�Algorithms investments or only thefirstlistedcompanyaroundtheworldandits aredesignedtodetectothertradingalgorithms� pay formal lip-service first20yearswereashowcaseofclassicgover- Traderswhowanttogoundetected,hide,or nanceissues�Theinvestorsinvestedandwerenot “iceberg,”theirordersindarkorderpoolsof if so pressured by involvedinthemanagementofthecompany,a undisclosedtrading�Highfrequencytradingseeks regulation.” Igroupofdirectorsranthecompanywithoutany tobenefitfrombid-asksspreadandusesstatisti- needtoaccountfortheirmanagement(accounts calarbitragestrategies,byholdinglargevolumes weredrawnupforthefirsttimeafter10years), onlyformilliseconds�Derivativeinstrumentssuch leavingscopeformisappropriationofcorporate asequityswapsandcontractsfordifferenceare fundsbythedirectors,whichultimatelyledtothe usedtohedgetheeconomicriskofequityholdings� precursoroftheDutchsupervisoryboardafter19 Togetherwithsecuritieslendingtheydecouple years� ownershiprightsfromtheeconomicriskembod- iedintheshares�Allthesedevelopmentsmove Thereyouhavethetwopersistentcorporate thefocusofthemarketawayfromthegovernance governanceconcernsinanutshell:therelation aspectofshareownership�Thegovernanceaspect betweeninvestorsandshareholders,orwider, isatbestaneglectedquantityinmoderntrading capitalmarketsandthegovernanceofcompanies, equations�Newtechniquesevenofferpossibili- andthefunctioningoftheboard�Throughoutthese tiesformanipulation,asemptyvotingandhidden 400years,thegovernanceconcernshavestayedthe ownershipexamplesshowus� same,buttheycontinuouslyneedtobeaddressed indifferentcircumstances�Lookingbackhelpsto Moderninvestmentpracticestendinthesame lookforward�Weneedtofocusonthechangesin direction�Institutionalinvestorshavebeenher- thecircumstancesthatmayormaynotforceusto aldedasthenewguardiansofpropergovernance addressthepersistentgovernanceconcernsina forlistedcompanies,inparticularwhenshare differentway� ownershipisdispersedandnocontrollingshare- holdertakestheleadinmonitoringanddisciplining TheEuropeanCorporateGovernanceForumhas management(which,iftheydo,hasitsownprob- startedtoreviewthefirstconcern�Moderncorpo- lemsasweknow)�Butrealityhasnotyetdelivered rategovernancethinkingandtheunderlyingcom- onthegovernancepromiseofinstitutionalinvest- panylawarrangementsassumeameaningfulrole ment�Mostinstitutionalinvestorseitherignore forshareholdersinthegovernanceoflistedcom- thegovernanceaspectoftheirequityinvestments panies�Shareholdershavebeengranteddecision oronlypayformallip-serviceifsopressuredby rightscollectivelyandvotingrightsindividuallyin regulation�Acombinationofmoderninvestment ordertoinfluencethegovernanceofcompanies� theory(“diversifyyourportfoliotoreducetherisk, Thereisagrowingconcernthatthefocusofcapital youcannotbeatthemarketanyway”)andpercep- marketandinvestmentdevelopmentsismoving tionsoffiduciarydutiesofassetmanagers(recently inadirectionthatmakesameaningfulrolefor definedbyBobMonksas“thedutynottoperform shareholdersinthegovernanceoflistedcompanies worsethanyourcompetitors”)leadsmanyinves- lessandlessfeasible�Thefocusofcapitalmarket torsandfundmanagerstoprimarilyfollowand developmentsisverymuchonenhancedtrading replicatethemarket,requiringconstantliquidity mechanismsandliquidityasthekeydeterminantof andshort-termfocus�Solvencyandaccounting optimalpricingandonderivativesasinstruments rulesapplyingtocertaininvestorsmaygivethem tosliceupriskandrewardelementsofunderlying furtherincentivestoavoidlong-termequityhold- valuesindifferentcombinations�Moderntechnol- ings�Long-termownershipformanyinstitutional ogyfacilitatesautomatedtradingstrategiesthatdo investorshasinfactbeenreducedtobeinglong notrequirehumaninterference�Algorithmsdeter- insharesratherthanshort,thatisaboutit�This

page 10 | 25for25 minetiming,price,quantity,androutingoforders, explainswhythefieldisopen© 2011 forInstitutionalactivistinvestors Shareholder Services Inc. shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIesCategory

“ Meaningful engagement, which by definition whoseeopportunitiesforshort-termprofitsby institutionalinvestorswillchangetheirinvestment requires more long- forcingcompaniesintotransactionsthatleadto practicesandstartholdingportfoliosofequity term ownership, at immediatecash-outsforshareholders� investmentsforlongerperiodsoftime,nottrying tofolloworreplicatemarketsfortheseinvest- best can be achieved in Inthewakeofthefinancialcrisis,institutional ments�Thisrequiresamajorshiftintheinvestment relation to a very small investorsarestimulatedtoshowmoresteward- paradigm�Thefinancialcrisiscouldbeacatalystfor portion of the equity shipoftheirinvestmentsbyincreasedengage- suchparadigmshift,asithasrevealedtheexposure mentinthegovernanceofcompaniestheyinvest ofallinstitutionalinvestorstoincreasedvolatility portfolio held by each in�Sofartheengagementofmostinstitutional astheyallhavebecomeinvestorsinmarketsrather institutional investor. investorsislimitedtoacompliancelevel,engag- thancompanies�Someinvestors,pensionfunds This could be stimulated ingbecauseregulationmoreandmorerequires suchasAPGandPGGM,areconsideringmovingat themtohavevotingpoliciesandtoactuallyvote� leastpartoftheirportfoliosintoamoreconcen- and obstacles for it, for Thistypeofengagementistypicallydirectedonly trated,long-termfocusedportfolio�Butasitgoes example in the rules on attheformalitiesofthegovernanceofcompanies; withparadigmshifts,theyareupagainstawallof acting in concert and theinvolvementinthegovernanceofcompanies cynicism(“itwillneverwork”)�Ittakesaboldness isoftennotintegratedintheprimaryinvestment togoagainstestablishedwisdom,whichisunchar- inside information, could decisionprocess�Itleadstooutsourcingofvoting acteristicforinvestors� be removed. It will only effortstoproxyadvisers,whichinfactisanother have a significant impact formofemptyvoting:votingdeterminedbyparties IfthetransformationdoesnothappenIthinkwe whohavenoeconomicexposure� mayfaceafundamentalchoice�Oneoptionisto if a sufficient number of facilitateactivismandtakeoversasultimatebut institutional investors Whilesuchengagementmaybebetterthannoth- prettyharshmechanismstodisciplinecompa- will change their ing,itfallsshortofthemeaningfulengagement niesandtheirmanagement�Theotheroptionis thatcorporategovernancethinkingassumes� toreconsidershareholderdecision-makingand investment practices and Suchmeaningfulengagement,whichbydefinition votingrightswithincompanies�Thecurrentflavor start holding portfolios requiresmorelong-termownership,atbestcanbe acrossEuropeisverymuchthelatteroptionas of equity investments for achievedinrelationtoaverysmallportionofthe thefirstcomeswithhighfalloutcoststosociety� equityportfolioheldbyeachinstitutionalinves- Thegovernanceoflistedcompanieswillbeworse longer periods of time….” tor�Thiscouldbestimulatedandobstaclesforit, offandinstitutionalinvestorshavealottoloseif forexampleintherulesonactinginconcertand shareholderrightsaretoberestricted�Willthey insideinformation,couldberemoved�Itwillonly jumpovertheirownshadowtoavoidit? haveasignificantimpactifasufficientnumberof

About the Author

❙❙ Jaap Winter is partner at De Brauw Blackstone Westbroek in the Netherlands. His practice areas include corporate law and corporate governance. He is professor of corporate governance at the Duisenberg School of Finance in Amsterdam and professor of international company law at the University of Amsterdam. He is a member of the European Corporate Governance Forum set up by the European Commission to advise it on governance developments.

© 2011 Institutional Shareholder Services Inc. 25for25 | page 11 shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIes By John D. Phillips Jr. The Evolution of Proxy Voting Policies

our aPProaCh In aCtIon

“ We support strong llianceBernsteinhasalonghistoryofdevot- investor rights that ingsubstantialglobalresearchresources ExamplesofAllianceBernstein’sprinciples-based hold directors and andseniorinvestmentmanagementtimeto ensuringthethoughtfulandtimelyexecutionofour philosophyinactioncanbefoundinourstrongand management proxydecisions�Weviewourselvesasshareholder earlysupportofproposalsthatempowershare- accountable if they advocatesandtakeourroleasfiduciariesvery holdersbycallingforcompaniestoadoptmajority seriously� votingfordirectors,establishtherightofshare- fail to act in the best holderstocallspecialmeetings,allowproxyaccess interests of their Ourtaskhasgrownincreasinglycomplexover withlowownershipthresholdsforthepurposeof shareholders.” theyears�SpurredA bythepublicoutcryoverthe electingdirectors,separatetheroleofchairman accountingscandalsandcorporate-governance andCEOunlessthereisastrongleaddirectorrole, abusesofthepastdecade,shareholderswithvary- permitshareholdervotesonexecutivedeathben- ingeconomicandpoliticalagendasarenowusing efits,rescindsupermajorityvoting,andrequirethe enhancedproxypowerstochallengeawidevariety boardofdirectorstorecoverexecutiveincentive ofcorporate-governanceissues�Theyarealsousing payuponmaterialrestatementofcorporateresults proxyproposalstoaddressbroadersocialconcerns orfraud�Wehavenotsupportedslatesofdirectors suchasclimatechangeanduniversalhealthcare� atnon-U�S�companieswhenthereisinsufficient informationaboutthem�Formanyyears,wehave Theproxyprocesshasbecomeaneffectivewayto votedtoeliminatetakeoverdefensessuchasclas- bringaboutpositivechangeincorporategover- sifiedboardsandpoisonpills�Wehavealsovoted nanceandpractices�Buteveninvestorgroupsthat againstdirectorswhofailtoenactproposalsthat sharemanyofthesamegoalscandifferwidelyin wefavorandthataresupportedbyamajorityof shareholders� howtheydevelopproxypolicyanddecidewhich exeCutIve CoMPensatIon takes proposalstobefororagainst�Wewoulddivide theseapproachesintotwobroadcategories— Center stage “principles-based”and“rules-based�”

Weadheretoacoresetofprinciplesandassess Theproxyproposalsthatabsorbmostofourtime eachproposalinlightofthoseprinciples�Our andrequirethegreatestamountofresearchare proxy-votinglitmustestwillalwaysbewhatwe executivecompensationplans—boththepackages believeisbestforshareholdervalue�Webelieve presentedbymanagementsandtheresolutions thatauthorityandaccountabilityforsettingand sponsoredbyshareholdergroups�Wehavelongheld executingcorporatepolicies,goals,andcompen- thatmanagement,subjectofcoursetotheapproval sationshouldgenerallyrestwiththeboardof oftheboardofdirector’scompensationcommittee, directorsandseniormanagement�Inreturn,we should,withinreason,begiventhelatitudetodeter- supportstronginvestorrightsthatholddirectors minethemixandtypesofcompensationandbenefit andmanagementaccountableiftheyfailtoactin awardsofferedtotheiremployees�Thoughthis thebestinterestsoftheirshareholders� standardhascontinuedtowinsupportfrommost institutionalshareholdersinrecentproxybattles,it Shareholdergroupsthatfollowarules-based isincreasinglybeingchallengedbyproxyadvisory approachtendtosupportproposalsorvotebased firmsandothershareholderinterestgroups� onanalysisthatwouldimposeone-size-fits-all rulestocontrolcorporateactionsacrosscompa- Payforperformanceisakeyconceptthatunder- nies�Theserule-basedresolutionsandvotingdeci- pinsmanyrecentshareholder-sponsoredresolu- sionsaredesignedtoprescribeandthusdiminish tionsconcerningmanagementcompensationand theauthorityofdirectorsandseniormanagement isparticularlyappealinginthewakeoftherecent inestablishingandexecutingcorporatepractices� financial-marketscollapse�Butwhiletheseresolu- Whileweresearchtheseproposalscarefullyand tionsmayseemreasonableatfirstblush,wehave seektoengagewithproponentstoseewhatwecan foundmanyofthemoverlyrestrictiveand/orbased learn,wetendtoopposeresolutionsthattakea onarbitraryrulesthatcouldharmshareholders’

Table 1: Empowering Shareholders to Hold Directors and Management Accountable

Policy Purpose Impact Timeline of Policy and Status Majority Voting Makes shareholder Resignation of directors AB was early adopter. Plurality voting, which remains in place at voting for directors that receive less than most companies, means that a director is elected with as little truly meaningful majority of votes as one FOR vote, even if ALL other votes are withheld Vote against directors Makes engagement Powerful in AB was early adopter. Voting results suggest that not all not implementing with companies more combination with shareholders follow up by voting against or withholding votes proposals that AB effective majority voting. More for directors in the next year supports and pass by a symbolic at companies majority of votes with plurality voting Clawbacks Incentive Incentive AB was early adopter. There are surprisingly few shareholder compensation is compensation is more proposals for clawbacks forfeited if results are effectively tied to materially restated performance Advisory Votes on Leads to more Broad shareholder AB adopted policy at beginning of 2009 proxy season after Compensation Plans meaningful approval or disapproval finding that the benefits of increased engagement outweighed engagement on initial concerns that advisory votes were too broad to be compensation meaningful Right of shareholders to Empower shareholders Accountability AB was early adopter with a 10% threshold call special meetings to address sufficiently of directors and Few companies have the right for shareholders to call special significant issues management is meetings and thresholds are high, at 25% or more between annual increased meetings Separate role of Provide more effective Improved governance AB was an early adopter. However, we do not require the chairman and CEO board oversight of CEO Chairman to be independent and do not require separation if a sufficiently strong lead director is in place

Someproposalshavesoughttodictatethatnoincentivecompensa- shareholdersonthespecificsoftheircompensationplansandin tionbepaidifthecompany’sfinancialperformancefallsbelowthe addressinginvestorconcerns�Consequently,wesupportthestan- peergroupmedian,basedonvariousfinancialmetrics�Forexample, dardofrequiringadvisoryvoteseveryyear� thisissuearoseinaproxyvoteinvolvingacyclicallydepressed companythathadbecomeaninvestment “ Companies facing shareholder Someshareholdergroupsusetheproxy inourvalueportfoliosbasedonour advisory votes on compensation processtotrytoeffectchangesinthe researchconclusionthatmanagement’s wayscorporationsdealwithsocial, strategywouldbesuccessfulinrestoring tend to be much more interested environmental,andpoliticalissues�Our thecompany’swell-below-averageprofit- in engaging with shareholders overridingconcerninanalyzingsuchpro- abilitytomorenormallevelsoverthenext posalsistheirlong-termeffectonfuture severalyears� on the specifics of their earningsand,hence,shareholdervalue� compensation plans and in Accordingly,wewillvoteagainstpropos- Anessentialpartofouranalysisinthis alsthatwefindundulyburdensomeor casewastoconsiderthebroaderramifica- addressing investor concerns.” thatresultinunnecessaryandexcessive tionsoftheproposedmeasure—which coststothecompanywithnodiscernable wouldhavepreventedmanagementfrom benefitstoshareholders�Wemayabstain receivinganddirectorsfromgrantinganyincentivecompensa- fromvotingonsocialproposalsthatdonothaveareadilydetermin- tion—onthecompany’sabilitytoattractandretainexecutivetalent� ablefinancialimpactonshareholdervalue� Weconcludedthatthisrestrictioncouldproveespeciallytoxicinthe researCh underPIns deCIsIon-MakIng earlyyearsofaturnaroundwhenthepotentialforstock-pricegains fromlowlevelsmaybethemostrewarding�Wewerealsoconcerned thatitwouldputthecompanyatasignificantcompetitivedisadvan- Weapproachourproxy-votingresponsibilitieswiththesamecom- tagecomparedwithcompetitorsthatdidnothavetoabidebysimilar mitmenttorigorousresearchthatweapplyinallofourinvestment incentive-compensationrules� activities�Thisefforthasgrownevenmoreimportantwiththe increasingcomplexityofrecentshareholder-sponsoredpropos- Wehavefoundthatcompaniesfacingshareholderadvisoryvotes als�Inadditiontoourfirm-widepolicies,wehaveseparatevalue

© 2011oncompensationtend Institutional Shareholder Servicestobemuchmoreinterestedinengagingwith Inc. andgrowthproxycommittees,whicharedirectlyinvolved25for25inthe | page 13 shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIes

decision-makingprocesstoensurethatourvotesareguidedbythe Inevaluatingproxyissuesanddeterminingourvotes,wewelcome investmentprofessionalswhoaremostfamiliarwiththecompany� andseekoutthepointsofviewofallparties,includingmanagement, Thechiefinvestmentofficers,directorsofresearch,researchana- directors,interestgroups,activists,andresearchproviders�Westrive lystsacrossourvalueandgrowthequityplatforms,andourfirm’s tobeimpartialandobjectiveincollectinginformationfromasmany seniorlawyersparticipateasappropriateinresearchingproxy sourcesaspossible�Thisprocessalsohelpsustostaycurrentand proposals,determiningourvotesanddevelopingourpolicies�We todevelopnewpoliciesasfreshissuesariseandcircumstances arealsomindfulofourdutytoavoidconflictsofinterest�Wehave change�Ourengagementwithcompaniesandinterestgroupscon- adetailedconflictsofinterestpolicyandmaintainapolicyofconfi- tinuestogrow,withhundredsofmeetingsperyear� dentialvoting�Table 2: AllianceBernstein Seeks Broad Engagement on Proxy Issues

Vote or Proposal Issue We Met With Outcome Approve remuneration Less than 80% approval Chairman of Revised compensation plan; lower disapproval rate at next vote report in prior year’s vote Remuneration Committee and other directors Adopt advisory vote on Received more than Management Urged adoption or AB would oppose directors (Adopted) compensation 50% support Majority Voting Passed by more than Management Urged adoption or AB would oppose directors (Adopted) 50% in prior year’s vote Election of directors Failed acquisition and Management AB voted against directors (Directors resigned after annual excessive risks taken meeting) Lower threshold to 10% Passed by more than Corporate governance AB would vote against directors if not adopted (Adopted) to call special meetings 50% secretary Universal health care Asked company to Representatives of AB heard arguments; concluded that issue was best left to adopt specific proposal interest group federal government and seek national adoption

About the Author

❙❙ John D. Phillips Jr. is a senior portfolio manager for Bernstein Global Value Equities and chairman of Bernstein’s Proxy Voting Committee. He joined the firm in 1994 and was a member of the U.S. Value Investment Policy Group.

“ The bigger challenge wasfirstintroducedtotheconceptofcor- theseveralpublicsecurityexchanges�Initially, was deciding on the porategovernancein1998asaninvestment mostboardswerenotveryresponsive�However, scope of our corporate officeroftheLosAngelesCityEmployees’ wefoundthatsendingjointletterswithpeerplan RetirementSystem(LACERS)�Overthenextseveral sponsorstothesesameorganizationsestablished governance activities, years,theemphasisoncorporategovernanceat averypowerfulcoalitionandcreatedpersuasive particularly in light of LACERSexpandedwiththecreationofaCorporate leveragewithintheglobalinvestmentcommunity� our size and available GovernanceCommitteeandanewslateofasset owneractivities� Inmyopinion,theoptimalformulaforassetowner resources.” engagementisnotanexactsciencewheresuccess IThedecisiontobeanactiveassetownerandto ismeasuredinprecisedollarsandcents;rather,it participateinthecorporategovernancemovement isaveryimportantmeansinfulfillingaplanspon- wasrelativelyeasy�Largeassetownerssuchas sor’sfiduciaryresponsibility�Whenallissaidand CalPERSandCalSTRSbelievedthatbettercorpo- done,assetownerengagementultimatelybenefits rategovernancecouldaddvalueattheirportfolio aplansponsor’smembersandbeneficiaries�Going companiesandwerealreadyengaginginthisspace� forward,assetownerscannotbepassive;theymust Thebiggerchallengewasdecidingonthescopeof bemoreengagedandshouldcontinuetocollabo- ourcorporategovernanceactivities,particularly ratewithotherinvestors�Addingvalueisachal- inlightofoursizeandavailableresources�Much lengeformanagement,butgovernanceisanarea ofthatdecisionultimatelyrestedonproperly wherethereisstillpotentialforimprovement� dischargingfiduciaryresponsibility,complying withinternalinvestmentpolicy,andevaluatingthe degreeofimpactthatwecouldmakeinthecorpo- ratecommunity�

Naturally,themostobviousassetowneractiv- itywastoexercisetherighttovoteoncorporate ballotmeasuresunderourinternalproxyvoting policy�Assetownersshouldavailthemselvestothis importantshareholderrightsothattheycanadd incrementalvaluetotheircompanyownership�

Wealsoengagedinshareholderadvocacyactivities� Thus,wesentlettersthatindicatedourposition onparticulargovernancematterssuchasboard leadershipandindependencedirectlytocompany boardsandmanagement,tothemyriadofinvest- mentregulatorybodiessuchastheSEC,andto

About the Author

❙❙ Rod June is the chief investment officer of the State of Hawaii Employees’ Retirement System. Prior to 2008, he worked nine years as investment officer for the Los Angeles City Employees’ Retirement System.

“ Shouldn’t there be a hereisglobalcorporategovernance todayinstitutionalinvestorsholdingequityassets single global corporate heading? exceeding$12trillion� governance code, Itissaidthatonewaytoforecastthefutureisto ISShasfocusedonenhancingtheinterestsof instead of the analyzethepast�LetusthenstartW byfocusingon shareholders,byincitingleadingU�S�pension approximately 150 thecorporategovernancedevelopmentsofthelast funds(suchasCalPERS,TIAA-CREF,andotherCII codes promulgated 25years,beforeattemptingtosketchitsprospects members),aswellascorporateboarddirectors forthenextquartercentury� andexecutives,toadoptawiderangeofadequate around the world?” CorPorate governanCe corporategovernanceprinciples�Itintervened develoPMents sInCe 1985 at,amongothers,AmericanExpress,Avon, Borden,EastmanKodak,Exxon,Sears,Shearson LehmanHutton,Texaco,WasteManagement,and Thefoundationin1985ofISSbyRobert(Bob)A�G� Westinghouse� Monks,inWashington,D�C�,islikelytoberecorded asthebirthoftheglobalcorporategovernance Theseinterventionsareconsideredtohaveinflu- movement�Whileitcoincidedwiththefoundation encedthecurriculumoftheICGNandofseveral ofboththeCouncilofInstitutionalInvestorsand majororganization,e�g�:❙❙ theIRRCinWashington,itprecededtheinter- ventionsofSirAdrianCadburyonbehalfofU�K� TheCII,whichofteninvitedmetocoverinterna- shareholdersandthecorporategovernanceboard tionalissuesasofitsApril1990AnnualMeeting ❙❙ counselingofIraMillsteinatBethlehemSteel,the inWashington� FordFoundation,GeneralMotors,WaltDisney,etc� ThevariousHermesPensionsschemesin London,andGovernanceforOwnersfoundedby IfirstmetBobMonksinJanuary1990in ❙❙ formerHermesFocusDirectorPeterButler� Washington,atthesuggestionofhisHarvardPensions & TheCorporateLibrary,foundedinPortland, InvestmentsUniversityclassmateDeanLeBaronandTIAA-CREFThe Wall Street Journal executives,aswellasjournalistsfrom Maine,byNellMinow,withformerMaineSenate ❙❙ and � PresidentRichardBennettasCEO� TheMillsteinCenterforCorporateGovernance IwasimpressedbyBob’skeeninterestinhistory, andPerformanceattheYaleSchoolof byhishighethics,andbyhiscosmopolitanculture� Management,whichorganizesmajorinterna- HisfamiliaritywithFrenchauthorslikeAlbert ❙❙ tionalconferences� Camus,AndréMalraux,andMarcelProustamazed me,evenafterlearninghehadstudiedatthe TheParis-basedOrganisationforEconomic InternationalSchoolofGeneva� CooperationandDevelopment/OECD,which publishedtwosuccessiveeditionsofCorporate Hishalf-dozenbooks(twoofwhichwereco-authored GovernancePrinciples(in1999and2004)and withNellMinow)fosteradequatecorporategover- holdsinternationalconferencesinParis�Italso nanceprinciples�ThereportsofNellMinow,assisted monitorscompliancewithitsOECDregulatory ❙❙ transparencystandardsfortheGroupof20� bythehighlyA qualifiedTraitor toISS Histeam Classofexecutives,arealso outstanding�AndBobMonks’biographybyHilary TheGeneva-basedUNCTADIntergovernmental Rosenberg, ,isamustforanyone WorkingGroupofExpertsonInternational interestedincorporategovernance� StandardsofAccountingandReporting/ISAR (whereIcontributedtodevelopcorporategov- IamgratefultoBobforencouragingmyglobal, ernancedisclosurepractices),whichholdsglobal multiculturalpromotionofadequatecorporate ❙❙ conferenceswithmajoraccountingfirms� governancepractices(firstthroughoutEurope andtheU�S�,afterwardinAsia,LatinAmerica,and TheWashington-basedIFC-WorldBankGlobal theMiddleEast)bothbeforeandafterthefounda- CorporateGovernanceForum,dedicatedto tionoftheInternationalCorporateGovernance corporategovernancereformindeveloping page 16 | 25for25 Network(ICGN),whichisreportedtoassemble countries� © 2011 Institutional Shareholder Services Inc. shareholder rIghts and resPonsIbIlItIes shareholder rIghts and resPonsIbIlItIes

TheEuropeancorporategovernanceratingagencieswith Moreover,effortsarerequiredregardingthedemocraticone-share, whichIamintouch(suchasDeutscheSchutzvereinigungfür one-votetenet,whichislessobservedthroughouttheEuropean Wertpapierbesitz(DSW)inGermany,theEthosFoundationin ContinentthanintheU�S�Dittofortheequalityofallshareholders Switzerland,PensionsInvestmentResearchConsultants/PIRCand incasesofcorporatemergersandacquisitions�Thedivestitureto ManifestintheU�K�,andProxinvestinFrance)alsobenefitedindi- NovartisofNestlé’s75percentstakeinitsAlconpharmaceutical rectlyfromtheISSeffect� affiliatepenalizestheownersoftheremaining25percentstakein Alcontothetuneof$2billion�ThesemostlyU�S�-basedminority However,thegradualadoptionofadequatecorporategovernance shareholdershaverecentlyretainedlawfirmstoclaimthehigher practicesbymajorinstitutionalinvestorsandbyafewcorporations pricepaidbyNovartistoNestlé� couldn’tpreventtheS&P500dropof49percentthroughout2000- 2002,andits39percentdropin2008� Furthermore,shouldn’ttherebeasingleglobalcorporategover- “Are there justificationsnancecode,insteadoftheapproximately150codespromulgated for Arestockmarketboom-and-bustcycles aroundtheworld?Aretherejustifications (likethe1609lossesoftheDutchEastIndia having so many different forhavingsomanydifferentcorporateboard CompanyinAmsterdam,the“Mississippi corporate board structures, structures,strategiccorporateobjectives, Bubble,”whichledtothe1720collapseof strategic corporate objectives, votingrighttenets,accountingdisclosure theBanqueRoyalefoundedbyJohnLawin standards,executiveremunerationcrite- France,the1825U�K�and1836U�S�panics, voting right tenets, accounting ria,peergroupbenchmarkingmodels,or the1873Viennastockmarketcrash,the disclosure standards, executive corporatecitizenshipnorms?TheCII,the 1907U�S�stockmarketcrash,the1929Black remuneration criteria, peer ICGN,andtheOECDcouldcontributetothe Fridaystockmarketcrash,the1987Black formulationofsuchacode(publishedin MondayU�S�stockmarketcrash,orthe2001- group benchmarking models, or thesixofficialU�N�languages),thusmirror- 2004Enron,Parmalat,WorldComdownfalls) corporate citizenship norms?” ingsomewhattheachievementofthe1948 nowlikelytorecureverydecadeorso,as UniversalDeclarationofHumanRights� predictedbycertainpundits? Summa de arithmet- ica, geometria, proportioniLastbutnotleast,sincethefoundationof et proportionalità Someexpertsfearthat(despitetheeffortsoftheG-20andother modernaccountingbyFra’LucaPacioliinhis regulatoryendeavors)the60percentequitiesratioofcertainmajor in1494,theworldhas pensionfundsriskstobereducedinfavorofTreasuryBonds,and hadtocopewithseveralaccountingsystems,whichhavenowbeen possiblyeveninfavorofgold(+500percentsince2001),otherpre- condensedtotwo:theInternationalFinancialReportingStandards ciousorraremetals,commodities,andfarmland� (IFRS)oftheInternationalAccountingStandardsBoard(IASB), ProsPeCts for the next quarter Century andtheU�S�GenerallyAcceptedAccountingPrinciples(GAAP)of theFinancialAccountingStandardsBoard(FASB)�Iparticipated intwodozensessionsfocusedontheIFRSoftheIASBatUNCTAD Adequatecorporategovernancereformsappeartoberequired inGeneva,aswellasadozenFASBsessionsorganizedbytheCIIin inthebankingsector,soastoavoidrepetitionsofthe2007-2008 Washingtonoverthelastdecade�It’sdifficulttoforeseehowclose financialbreakdown�Thelatterisallegedtohavebeencaused wearetoasingleglobalaccountingsystem� mainlybyschemesdescribedbyWarrenBuffettas“weaponsof massdestruction�”InJuly2010forinstance,theSECfinedGoldman Mayalltheseissuesberesolvedby2035! Sachsarecord$500millionforincompleteinformationinmarket- ingtheAbacusFund�

About the Author

❙❙ André Baladi is the co-founder of the ICGN in Geneva, Switzerland. He is an honorary international participant of the Council of Institutional Investors, and is a member of the IFC-World Bank Global Corporate Governance Forum, the OECD Consultative Corporate Governance Group, the International Advisory Board of the NYSE-Euronext Stock Exchange, the Swiss Association of Financial Analysts, and the Advisory Team of UNCTAD’s Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting.

“ The systemic failures heongoingdevelopmentoftheU�K�Corporate thendowntotheshareholders�Whiletheydon’tvote of the financial crisis GovernanceCode,formerlytheCombinedCode, ontheindividualelementsoftheCode,shareholders hasbeenthemajoreventforU�K�-listedcompa- canenforcetheirviewsthroughvotingonresolutions have made it difficult nies�TheCodeisalsoanimportantexperimentwhich, atgeneralmeetings�Obviouslythekeysanctionis to claim that any ifexecutedoneffectively,shouldpointthewayforcor- removalofadirector,and,withthispower,sharehold- porategovernancetodevelopworldwide�Isitagood ersarewellpositionedtoensurecompaniesarerunin corporate governance modelforglobalgovernance?Iwouldsay,unequivo- shareholderinterests� system has worked cally,yes,but,tobefair,thejuryisoutonthisone� Thestructurecouldnotbemoresimple�Boardsof well.” Inallwalksoflife,theU�K�isstronglyinfavourofaT directorsruncompaniesinthebestfinancialinterests principles-basedapproach�Theviewisthatregula- ofshareholders�Theyreportontheirapproachagainst tionsareinflexibleandwillalwaysbecircumvented� abackgroundofbestpracticerecommendationssetout Ifwecanestablishbroadprinciplesofbehaviourand intheCorporateGovernanceCode�Andshareholders sticktothem,resultsarelikelytobemuchbetter� caninfluencetheirapproachthroughproxyvotingwith realpowerattachedtoit� Thispreferenceforprinciples,notrules,extendstothe waycompaniesaregoverned�AlthoughU�K�company Doesitwork?BeforethefinancialcrisisIwouldhave lawcomprisesthousandsofpages,theessenceremains feltverycomfortablesayingyes�Corporategover- quitesimple�Companiesarerunbyunitaryboardsof nanceofU�K�companieshadgenerallybeeneffective directorsinthebesteconomicinterestsoftheirshare- andwasalsoonanimprovingtrend�ItwasaU�K� holders�Inturn,theshareholdershaveconsiderable successstory�Butthesystemicfailuresofthefinancial power�Ifashareholdermajoritylosesconfidenceina crisishavemadeitdifficulttoclaimthatanycorporate boardofdirectorsanditsactivities,theshareholders governancesystemhasworkedwell�Iwouldjustnote canquiteeasilyremoveandreplaceit�Thisdoesnot thatthecrisisuncoveredmanyotherfailings,notleast happenveryoften,butitconditionsthewayinwhich bygovernmentsandregulators�Butcorporategover- boardsoperate�Thebasicprinciplesarethereforevery nancedidnotcoveritselfwithglory� straightforwardandcaneasilybetracedbacktothe originalcreationoflimitedliabilitycompanies� Canwefixit?Yeswecan�Followingthecrisis,theCode wasreviewed,andasignificantstepwastaken,which Havingestablishesthesebasicprinciples,howthen wastointroduceaStewardshipCodelayingsome shouldboardsofdirectorsoperate?Thatiswherethe obligationsoninvestorstositalongsidethoselaidon CorporateGovernanceCodecomesin� corporatemanagementsbytheCorporateGovernance Code�Again,thisStewardshipCodeisprinciples-based Theprinciplesunderpinningacceptableboard andoperatesonafreedomwithdisclosurebasis� structurehavebeenelaboratedinthisCode,which Thiswillconsiderablystrengthenthemonitoringand hasevolvedinanumberofdiscretestepssinceits enforcementbyshareholdersoftheGovernanceCode� inceptionin1992�Againthisisallverysimple�The Itisalogicaldevelopmentwhichshouldreinforcethe boardistobeaunitaryboardandthekeyconceptsare effectivenessofcorporategovernanceintheU�K� independenceandseparationofpowers�Theintention istocreatechecksandbalancesinthepowerstructure Inconclusion,theU�K�CorporateGovernanceCode ofthecorporation�So,thepostsofchairmanandCEO andtheassociatedStewardshipCoderepresentbest aretobekeptindependent�Thereshouldbeabalance practicestandardswhichseektoapplyaprinciples ofexecutivesandnon-executivesontheboardandthe basedgovernanceapproachtoastraightforward majorityshouldbeindependent�Directorsshouldnot companylawframework�Ithinkitisthebestmodel beprotectedbylongtermcontracts�And“sayonpay” forcorporategovernance,anditcertainlybeatsthe isalreadyafeatureintheU�K� alternatives�Wesimplyhavetomakeitwork� About the Author Anabsolutelykeyfeatureisthattherequirements oftheCodearenotmandatory�AspartoftheListing ❙❙ Lindsay Tomlinson is the managing Rules,companieslistedintheU�K�areobligedto director of BlackRock. He joined reportonhowtheyhavechosentoapplytheCode� BlackRock when it acquired Barclays However,theyarefreetodecidenottocomplywith Global Investors in 2009. At that anypartsofitwhichtheirrespectiveboardconsiders time, he had had a range of senior tobeinappropriateintheparticularcircumstances management roles at BGI over more oftheindividualcompany�Thecompanymerelyhas toexplainwhyithaschosennottocomplywiththe than 20 years. page 18 | 25for25 letteroftheCode�Monitoringandenforcementis © 2011 Institutional Shareholder Services Inc. Market-sPeCIfIC Challenges Market-sPeCIfIC Challenges By Yuji Kage Governance Challenges in the Next Quarter Century in Japan

“ The introduction of siswellknownespeciallyamongthe matter�Theinconvenienttruthisthatevensmaller ‘truly’ outside seats to readersofthiscompendium,wehave amountsmaynotnecessarilybejustifiedatmany the board room should seensignificantdevelopmentincorporate companieswithpoorcorporateperformance�For governanceinmanycountriesoverthelastquarter example,6directorsofoneofthemajorJapanese bring meaningful century�InJapan,theFinancialServicesAgency banksreceivedmorethanyen100million,even impact to companies (FSA)hastakenmeaningfulstepsin2010toregu- thoughthebank’smarketcapitalizationhassub- in changing the latepubliccompanies,including:❙❙ stantiallydecreasedoverthelastdecade� atmosphere of the Disclosureofcrossshareholding,resultsof Thatsaid,itisnotsoclearthatthesereformsof board room, where Avoting,andexecutiveremuneration(including corporategovernancehavecontributedtothe boards used to silently disclosureofthenamesofalldirectorsearning meaningfulimprovementofreturnsoninvestment ❙❙ aboveyen100million—about$1�25million) forinstitutionalinvestorsglobally,especiallyin endorse the CEO’s Japan�Thesadrealityisthattheyhavesuffered Requiringthenominationofatleastone“truly tremendouslypoorinvestmentperformanceforthe proposals.” outside”directororstatutoryauditor,through long-term,especiallyoverthelastfewyears� TokyoStockExchangeguidelines�

Thekeyquestionhereshouldbehoweffectivelycor- Theseregulationsshouldhaveapositivelong- porategovernancehasalignedwiththeinvestment termimpactoncorporatemanagementinJapan� process�TheICGNPrincipleson“Responsibilitiesof Needlesstosay,thepracticeofcrossshareholding InstitutionalInvestors,”inwhichIparticipatedas seemstohavebeenthemajorobstacleforeffective oneofthemembersoftheICGNcommittee,clearly corporategovernanceinJapan�Overthelastquar- describesthatbothshouldbeintegrated,butinreal- tercentury,itsrateisperceivedbymanycorporate ity,itseemstobealongshot� executivestohavefallenfromvirtuallywellover 50%downtothe20-30%range,andmajorbanks andtradingcompanieswererecentlyreportedto Themajorreasonwhyitisdifficulttointegrate significantlycutbacktheircrossshareholdingsin corporategovernancewiththeinvestmentprocess responsetothisFSArule,andtheintroductionof isthatthereisasubstantialgapbetweenthetwo� InternationalFinancialReportingStandards(IFRS)� First,thereisadifferentfocusonimplementa- Theintroductionof“truly”outsideseatstothe tion,althoughbothsharethesameobjectiveto boardroomshouldbringmeaningfulimpactto seekbetterperformance�AsnotedintheOECD companiesinchangingtheatmosphereofthe Guidance,corporategovernanceisfocusedonthe boardroom,whereboardsusedtosilentlyendorse structureandmechanismingeneraltogovernthe theCEO’sproposals�Infact,manydirectorsof companyeffectively,butinvestmentprofession- companieswithsuchoutsidedirectorsorauditors alsprimarilyfocusontheanalysisofindividual admitthattheCEOhastoanswersuchbasicbut companies�Peoplemayassumethatgoodgover- primitivequestionsas“Whydoyoucontinuethis nanceshouldleadtobetterperformanceoverthe unprofitablebusiness?”tosuchoutsiders,which long-term,butpractically,itisnoteasytoprove arerarelyaskedbytheinsidedirectors� this�Investmentprofessionalssometimesusethe word“long-term”asanexcuseforfailingtodeliver Regardingexecutiveremuneration,itisreported sufficientresultstoday� thatsome290directorsreceivedaboveyen100 millionastotalremunerationin2009-10,andthe Second,thenecessaryskillsettoaccomplishthetwo highestknownfigureisyen890million� goalsshouldbedifferent�Itshouldbenaturalfor corporategovernancetobethejobofprofessional Thismaysuggestthatexecutiveremuneration lawyers�Ontheotherhand,thenecessaryskillset inJapanissubstantiallylowerthanitswestern forinvestmentprofessionalsshouldbe analytical counterpart,implyingthatcorporategovernance capabilityofmacroandmicroeconomicissues� worksmuchbetterinJapan�Needlesstosay,the amountofremunerationmattersless;thepropor- Third,thereareorganizationalbarriers:thecor- © 2011 Institutional Shareholder Services Inc. tionforthemanagementamongtotalprofitshould porategovernanceteamispositionedseparately25for25 | page 19 Market-sPeCIfIC Challenges PersPeCtIves on board leadershIP

fromtheinvestmentgroupinmanymajorinstitutions�Sometimes, sufficientgovernancestructureandmechanisms,acompanyislikely theCIOisnoteveninchargeofgovernanceissues�WheretheCIO tostumblesoonerorlater,providingsignificantlynegativelongterm isinchargeofbothgroups,governanceissuesdonotnecessarily impactonitsprofitability�Second,asformerICGNChairmanMark seemhighonhisorherprioritylist,astheCIOissobusytryingto AnsonofOakHillsCapitalpointedoutinhispresentationattheICGN improveinvestmentreturns� annualconferenceinWashingtonin2006,thequalityofgovernance affectstheperformanceofeachstockmarketthroughitsinfluence Allthreeissuesmakeeffectivedialogueandcoordinationbetween onthelevelofequityriskpremium�Onamacrobasis,thebetterthe thetwogroupsratherdifficult�Buy-selldecisionsonindividual governance,thelowertheriskpremium,thereforethebettertheper- stocksdonotusuallydependongovernancejudgments,oratleast, formance�Thus,itshouldbemeaningfulforinvestmentprofessionals governancedecisionsareonlyoneofanumberofkeyfactors�This tothinkaboutgovernanceissues� seemstobenaturalfromaninvestmentperspective,asthefuture performanceofindividualstocksshoulddependonseveralfactors Forgovernanceprofessionals,cooperationwithinvestmentprofes- includingstrategy,management,andR&D�Althoughhighqualityof“ The major reasonsionalsshouldbeindispensable,asthelatter why it havethedirectimpact governanceisanimportantnecessarycondition oncompanymanagementthroughthepurchase tosupportthesefactors,itmaynotbeasuffi- is difficult to integrate andsaleofshares�Infact,analystsandportfolio cientcondition�Still,itcouldnotbedeniedthat corporate governance with managerswhoownsomemeaningfulamount investmentprofessionalstendtoundervaluethe the investment process is ofaspecificcompany’ssharesforameaningful governanceaspects� timeshouldbemajorsupportersofitsmanage- that there is a substantial ment,andtheirviewsshouldbemostconvinc- Ontheotherhand,thegovernancegroupusually gap between the two.” ingtomanagement�Theycouldsellthoseshares makesitsdecisionsindependentlyfrominvest- whentheyaredisappointedbymanagement� mentconsiderations,primarilyfromalegal DepartingfromtheWallStreetRulebecauseof perspective�Butsomemeasures,forexample thelargeamountoftheirholdingscouldbetoo improvementofboardstructures,maynotnecessarilybeeffective simplistic�AreconsideredWall StreetRuletogetherwithvotingand ataspecificcompanyatleastfortheshort-term�Someengagement engagementbygovernanceprofessionalsshouldbeeffectivetools byactivistsmaynotbringexpectedresultsbecauseofpossible toenhancemarketdiscipline� failuresofstockselection� Thebottomlineis,howeverchallengingitseemstobe,theintegra- However,therealitybothpartiesfaceisdefinitelysub-optimal�There tionofthegovernanceprocesswiththeinvestmentprocess,espe- shouldbesomethingforbothsidestoreconsider�Fortheinvestment ciallywiththeanalysisofindividualcompanies,shouldimprove side,governanceshouldmatter�First,asnotedbyDavidFisherof theeffectivenessofeachmeasureofcorporategovernance,andbe CapitalGroup,oneofthetopinvestmentprofessionalsintheworld, acriticalagendafortheCEOsandCIOsofthemajorinstitutional governanceshouldbethemajorfactorinriskmanagement�Without investorsinthenextquartercentury�

About the Author

❙❙ Yuji Kage is a member of the board of the Securities Analyst Association of Japan, a member of Japan Association of Corporate Executives and Japan Association of Corporate Directors, and advisory board member of several major institutions including CFA Institute of Japan.

An Interview with Ken Bertsch The Rise of Shareholder Voice and the Increased Role of Boards

You have said that the most significant devel- “ We have perhaps opments in governance over the last 25 years are the rise of the shareholder voice and the strugglingwiththischangingdynamic�Someinvestor put too large an increased role of boards of directors. What understandingofboardroomdynamicsisessentialfor emphasis on board fueled these developments and when did they Thatmaking is accountabilityone of the challengesmechanisms shareholderswork� face, ‘independence’ (as become evident? since they’re not in the boardroom. How can boards assure shareholders that they are look- imperfectly perceived ing out for shareholders’ interests? from outside the Ithinkit’saprocessthatbeganwithconcernson boardroom) and not socialresponsibilityissuesinthe1970s�Themajor necessarily enough impetusinthe1980swasaheightenedsenseof Ithinkit’saboutcommunication,awillingnessto on the right forms of vulnerabilityamongcompaniestotakeovers,and talk�Itmeansthegovernanceofficeratthecom- investors’concernsaboutthewaycompanies panyisavailabletoinvestorsandreachesoutto accountability, or on respondedtothatthrough,forexample,poison them�Itwillsometimesmeandirectorstalkingto ways to promote pills,andmoregenerallyaperceivedlackofatten- investors,althoughthathastobemanaged�Ithink investor understanding tiontotheviewsofinvestors�Eventuallythisback youwantthedirectorsfocusedondoingthejob� andforthledtoincreasedinvestorfocusonthe Theyshouldbeawareofshareholdersandtheir of boards.” boardofdirectors� views,butnotbeconsumedwiththosecommu- nications�FrommystandpointatMorganStanley Boardsarethefulcrumformanaginginterest InvestmentManagement,Ithinkit’sparticularly betweenshareholders,otherstakeholders,and importantfordirectorstohavesomewillingnessto management,andtryingtogetthebalanceright�So talktoalargeshareholderwhenthatshareholder Ithinksomeinvestorrageinthe1980seventually requestsadiscussion� convertedintoconstructivefocusontheboardof directorsandhowtoimproveit�Alotofthatfocus Obviously,companiesshouldusetheproxystate- wasaboutmakingboardsmoreindependentand menttocommunicateasbesttheycanonthequality alsomakingthemmoreenergetic,asinexercising ofgovernance�Oneofthebestnewrequirements,I authorityinthelong-termmanagementofthe think,hasbeenforcompaniestodiscussqualifica- company�Butwehaveperhapsputtoolargean tionsoftheirboardnominees,andagoodnumber emphasisonboard“independence”(asimperfectly ofcompaniesareusingthatquiteeffectivelyand— perceivedfromoutsidetheboardroom)andnot maybetotheirsurprise—tocommunicatebetter necessarilyenoughontherightformsofaccount- thethoughtbehindhowthisboardisconstructed, ability,oronwaystopromoteinvestorunderstand- whatthevariousskillsetsare�Hopefullybehind ingofboards� thescenesthisdisclosurediscipline maybelead- ingtosomeadditionalthoughtaboutwhethera AsItalktoportfoliomanagersandotherinves- givenboardreallydoeshavetherightskillsets� tors,mostdofeelthattheboardisveryimportant� Beingforcedtodescribethattotheinvestingpublic Thosewhohavebeenaroundalongtimefeelthe actuallyisusefulinmakingsurethatpeoplethink boardismoreimportantthanitusedtobe�But throughhowtheycandescribethequalificationsof almostuniversallytheyfeellikeit’sveryhardto Howtheboard do investorsandthe benefitbalance fromofskills this?� Does it provide graspthestrengthandqualityofaparticularboard� transparency or does it put pressure on the board Theyhaveahardenoughtimeinjudgingmanage- to ensure that they have the requisite skills? mentquality;theboardisevenhardertoknowand evaluatebecauseitiscollegialandmostlyprivate� Obviouslyyoucanmakejudgmentsaboutthequal- ityofboarddecisionsafterthefact(thatis,afterit Ithinkit’sboth:Itputssomepressureonboards isapparentaboardmadedecisionsthatworked tomakesurethattheyhaverequisiteskillsandcan outpoorly),butthenitmaybetoolate� describethem,andtheyshouldbeabletodescribe Howthem� has the role of the board of directors Bottomlineisthatboardsaremoreimportant,and increased? You mentioned engagement – is this investorshaveanincreaseddesiretoholdboards © 2011 Institutional Shareholder Services Inc. accountableinmeaningfulways�Ithinkallpartiesare 25for25 | page 21 PersPeCtIves on board leadershIP PersPeCtIves on board leadershIP

limited to large firms? Can we expect this to extend to the mid- and small-cap issuers? Ithinktherehasbeenabitofashift,atleastinsomeareas,toward directorswithmoresubjectmatterknowledgeintheindustrythe companyisoperatingin�Therehadbeensomuchfocusontheinde- Wehaveasmanydiscussionswithdirectorsofsmallercompanies pendenceandthere’sbeenashiftfromthattowardtheviewthat aswithlargercompanies�Thereasonforthatmaybethatwewould certainindustrieshavetechnicalissuesthatrequiredirectorstoask tendtohaveabiggerstakeinsmallercompanies�Thatsaid,wealso deepquestionsontechnicalsubjects�Itdoesn’tmeantheyshould getrebuffedbyboardsofsomemid-sizeandsmallercompanies, bemicromanaging,butitdoesmeanthatsomeofthedirectorsneed anditisclearlargercompaniesingeneralaremuchmoregearedup theappropriateskillbackgroundsothatthereisbalanceonthe tohavein-depthdiscussionswithshareholders,includinginvolv- Whichboardandsothattherightquestionsgetasked� industries will have greater challenges identifying and ingdirectorsinsomecases�Someofthisisjustafunctionofsize� nominating highly qualified directors? Aggressiveoutreachtendstobemorecharacteristicofbigcompa- niesthathavethestafftodothis,andthatwanttomakesuretheir ducksareinarow�Theywanttohearaboutissuesearlyratherthan Doatthelastminute� you see the relationship between small- Iamnotsure,butperhapsfinanceandpharmaceuticals�Therearea and mid-cap issuers and the shareholders lotofpeopleinfinance,butthefieldchangesrapidly,puttingapre- becoming more collaborative? What obsta- “ There has been a bit of a miumonthosecurrentlyinvolved,orwithvery cles, in addition to staffing, prevent a more shift, at least in some areas, recentexperience,butconflictsofinterestmay collaborative relationship? limittheirabilitytoserveonboards�Inoiland toward directors with more gasexplorationandproduction,youruninto subject matter knowledge thesamecompetitiveconcerns�Withregardto in the industry the company pharmaceuticals,academiaisanaturalsource Ithinkitofteniscollaborative�Manysmalland ofdirectors,butthereissuchawebofbusiness midcapsarelookingtotheirinvestorstopro- is operating in.” relationshipsbetweenthelargercompanies videsomeinsight�That’sjustbeenhappening andnearlyallrelevantacademicprogramsthat asamatterofcourse� Does this put additionalsomeinvestorsraiseindependenceconcerns� scrutiny on the nominating committees? Will institutional investors look more closely at nominating Ofcourse,therearemanyexamplesoftensionbetweenmanage- committees? mentandpublicshareholdersatsmallercompanies,andsome ofthisisnaturalandtobeexpected�Forexample,whenaprivate companygoesthroughanIPO,manychangesareinvolved,andthe smallergroupthathadrunthecompanywillcomeundernatural Itdoesputmorepressureonthenominatingcommitteestodoa pressurefromexpectationsofawidercircleofowners�Thereare goodjob�Ithinkinstitutionalinvestorshaveprobablyfocusedan alsomoreissuesaroundtakeoversanddefensesatsmallercompa- appropriateamountofattentiononnominatingcommitteesinthe nies,whichcanberealflarepointsbetweeninvestorsandboards, UnitedStateswhereatleastthereisanexpectationofindepen- andsometimeswithinvestorswhoareexcessivelyfocusedonshort- dence�Ithinkthatnominatingcommitteeshavehadadifficulttime termresults�SoIthinktherearesomeinevitableconflicts,butthat withthis�They’vegonebackandforthoverthelastdecadeorsoin ithelpsforpeopletotalktoeachotherandtounderstandwhere usingoutsidesearchfirmsandthenbeingdisappointedwithwhat Whatthey’recomingfrom� are some of the most important skills that companies will theyweregetting,goingbacktoword-of-mouthamongboardmem- look for in directors in the coming years? bers�Theyprobablyarealittlebitlessreceptivetoword-of-mouth fromtheirexecutivesuite,alittlemorefromtheoutsidedirectors�

About the Author

❙❙ Ken Bertsch is the CEO and president of the Society of Corporate Secretaries and Governance Professionals. Prior to assuming this position in December, he was head of corporate governance for Morgan Stanley Investment Management.

By Zach Oleksiuk and Robert Zivnuska Achieving the Board of the Future, Today

“ Today, boards see hepast25yearshaveincludedmanysignificant Recognizingthis,shareholdershavewithheldtheir representing changesintherealmofcorporategovernancein supportfordirectorstheydeem“over-boarded�”This theUnitedStates,butnoneismoremeaningfulto shareholderconcernhasbeeninternalizedbycompanies shareholder interests therightsofshareholdersthanthetransformationofthe —from2001-2006therewasa170percentincreasein as paramount, and roleofdirectors�FadingfastarethedaysofCEOspopulat- thenumberofcompaniesthatlimitoutsideboardservice ingtheirauditcommitteeswitholdschoolfriendsand bytheirCEO� shareholders are moviestars;shareholdershavecometodemandahigher helping boards to standardofindependence,commitment,andfocuson Althoughthereisnogenerallyacceptedstandardforthe shareholderconcerns� numberofcompaniesadirectorcanusefullyoversee, understand T mostinvestorsagreethatshareholdersbenefitwhen shareholder concerns.” Theratioofinsidertoindependentdirectorsonpublic directorsfocustheireffortsonasmallnumberofissuers� companyboardsisincreasinglyskewinginfavorofinde- Anarrowfocuscanbestpositionadirectortoskillfully pendentdirectors�Thelast10yearsalonehaverevealed envisionandsteercorporatestrategy,identifymanage- significantnewstatutoryandregulatoryrequirementsfor mentfailuresorpotentialabuse,andnurturethegrowth boththeindependenceofdirectorsandtheindependent ofshareholders’investments� compositionofkeycommittees,suchastheauditand compensationcommittees�Thesechangesmirrorthe Today,boardsseerepresentingshareholderinterests expectationsofshareholdersabouttheneedforindepen- asparamount,andshareholdersarehelpingboardsto dentvoicesintheboardroom�Most,ifnotall,majorinsti- understandshareholderconcerns�Forissuesranging tutionalinvestorsstatetheirpreferenceforindependent fromexecutivecompensationtoriskmanagementto boardcompositionintheirproxyvotingguidelines� independentleadershipwithintheboardroom,sharehold- ershaveusedmultipletoolstoencouragedirectorsto Thisisnottoimplythatcollegialrelationshipsbetween addressshareholderpriorities�Techniquesleveragedby managementandboardsareunimportant�Rather,thedrive shareholdersinclude:engagingwithdirectorsdirectlyon towardindependencestemsfromthebeliefthataboard company-specificcorporategovernanceissues;working composedlargelyofinsidersmaynotbeabletoindepen- withregulatorsandlegislatorstoestablishnewdisclosure dentlyrepresentshareholderinterestswhendirectingthe requirements;usingshareholdervotestoholddirectors company’saffairsandactingasacheckonmanagement� accountableforeffectivelyrepresentingshareholders’ Independentdirectorsarebestsuitedtoprotectshare- interestsintheboardroom;andsubmittingshareholder holderassetsfrommisappropriation,excessiverisktaking, proposalstoenactcertaincorporategovernancereforms� andmanagementfailure� Thesevariedmethodsservetorevealtodirectorsthekey concernsofshareholders,thusempoweringindependent Notonlyaredirectorsonboardstodaymorelikelytobe directorsbyprovidingthemwithevidenceofshareholders’ independent,theyarealsoworkingsignificantlylonger desireforincreasedindependence,andindependentlead- hours�From1987to2007,directorsreporteda68percent ership,intheboardroom�Astrikingexampleofsuccessful increaseinthenumberofhoursworkedinservicetothe engagementbetweenshareholdersandtheirboardsisthe board,toapproximately16hourspermonth�Thefearof evolutionofboardleadershipintheUnitedStates�In2009, missingredflagssignalingsignificantproblems,especially 95percentofboardsforS&P500companiesreported inthewakeofthespectacularcorporatefailuresofthe havinganindependentleadorpresidingdirector;thisrole lastdecade,hasdrivendirectorstotaketheirrolesmore wasnotevenmeasuredin1999� seriously�Simultaneously,newregulationsandincreased shareholderscrutinyhaveaddedtotheaccountabilityof Shareholderstodayarenotwillingtosettlefordirec- corporateboards�Asaresult,thedaysofboardssimply torswhoarereluctanttoscrutinizeorunabletoguide takingtheircuesfrommanagementaremovingbehindus� managementteamstowardstrategiesthatcreatevalue forinvestors�Theyexpecttoberepresentedbyfocused, Longerhoursalsomakeitmoredifficultfordirectors independent,andeffectivedirectors�Muchtothebenefit toaddvaluewhilesittingonalargenumberofboards� ofpubliccompanyshareholders,thisexpectationiswell Servingasadirectorforalargenumberofcompaniescan onitswaytobeingmet�Shareholderactionoverthe causeadirectortobelessfocusedonthecompaniesthey last25yearshasbroughtU�S�investorstheboardofthe helpguide,whichimpairstheirvalueAbout the Authors toshareholders� future,today� ❙❙ Zach Oleksiuk is a vice president on ❙❙ Rob Zivnuska is director of BlackRock’s BlackRock’s Americas Corporate Governance Americas Corporate Governance and and Responsible Investment team. Responsible Investment team.

“ To fulfill their oversight nmyview,themostmeaningfulandsignificant directorindependencepromotesobjectivity,the responsibilities changeincorporategovernanceinthepast requirementthatboardmembersmaintainequity effectively, directors 25years,withimportantimplicationsforthe ownershipinthecorporationgivesthedirectorsan futureofthefield,involvesboardcomposition�The incentivetoexercisetheirobjectivitywithdiligence� must be independent boardoriginatedasamechanismformonitoring Whenmanagementappointstheboardofdirectors, of management and management�Unfortunately,duetocompositional andthesedirectorshavenostakeinthecorporate must hold a personally changes,boardsevolvedintomanagement-dom- enterpriseotherthantheirboardseats,thedirec- inated,advisory-typepanelswhichwereunable torssimplyhavenopecuniaryincentivetoactively meaningful equity stake toeffectivelymonitorthegroupthattheywere monitormanagement�Whendirectorsshirktheir in the enterprise.” Icreatedtowatch�WhenIfirstenteredthefield, dutytomonitormanagement,stockholderinterests thiswasanissueatmostU�S�companies�Muchof areleftunprotected�Themosteffectiveincentive myworkinacademeandasaboardparticipant, fordirectorstoaddresstheirresponsibilitiestothe andmuchofthethrustofthemoderngovernance shareholdersistomakethemsignificantstockhold- movement,hasbeentorekindlethathistorical ersaswell�Bybecomingequityholders,theoutside managerialoversightrolethroughcompositional directorsassumeapersonalstakeinthesuccessor reform�Thestartingpointforthisisquitesimple failureoftheenterprise� andcanbereducedtothreestraight-forward elements:independence,equityownership,anda Itisimportantto notethatwhileequityowner- viableelectionprocess� shipprovidestheincentivetomonitor,italone doesnotprovidetheproperobjectivitytofoster Thefirsttwoconcepts,independenceandequity, effectiveoversight�Independencecreatesthis arecentraltoactivemonitoring�Tofulfilltheir objectivity,andthatiswhymoderngovernance oversightresponsibilitieseffectively,directors theorydemandsbothequityownershipandinde- mustbeindependentofmanagementandmust pendence�Independentdirectorswithoutequity holdapersonallymeaningfulequitystakeinthe ownershipmaybeobjective,buttheyhavelittle enterprise�Independenceinvolvestheabsenceof incentivetoengageinactiveoversight�Equityown- anyeconomicties,eithertomanagementortothe ershipprovidestheincentivetoexerciseobjective companyitself,otherthanequityownership�It oversight�Ontheotherhand,equity-holdingdirec- providesadirectorwiththedistanceandobjectiv- torswhoarenotindependentmayhavetheproper itynecessarytoexaminemanagementactioninthe incentivebutlackthenecessaryobjectivity�Infact, mostproductivemanner�Economicrelationships itwasalackofrealboardindependencethatchar- withmanagement,includingconsulting,service acterizedmostofthecompaniesthatwereimpli- provision,orotherindirectarrangements,may catedinthefinancialscandalsandmeltdownofthe cloudadirector’sjudgmentandmakeitmoredif- pastdecade�Independenceandequityownership, ficultforhim/hertoreviewmanagementconduct actingintandem,arethekeystoeffectivecorporate objectively�Alackofindependencecanleadto governance�Judicial,regulatory,andinvestorpres- ineffectivemonitoringif,forexample,itmakesa surehasmadethesetwoelementsofgovernance directortoocomfortablewithmanagementandits reformarealityinmostU�S�publiccompanies� representationsorplaceshim/herinsuchaclose relationshipwithmanagementthats/hecannot Thethirdreformelement—avibrantboardelection effectivelydisengagehim/herselfinordertoreview process–isalsocriticalinitseffectontheboard managementconductobjectively�Keepingdirectors conduct,butisstillinanearlystageofadoption� distancedfromcompanymanagementallowsthem Formuchtoolong,peoplehaveviewedtheirboard toconductthereflectivereviewofmanagement seatsassinecures—tobeoccupiedaslongasthey practicesthatpublicshareholdersexpectandthat choosetoremaininoffice�Thisdoesnotcreatethe isnecessarytolong-termcorporatesuccess� necessarysensitivityandaccountabilitytoshare- holderintereststhatmustdefineatrulyeffective Coincidentandcomplementarytoitsemphasison boardmember�Asmanagementmustfeelaccount- directorindependence,moderncorporategover- abletotheboard,somusttheboardbeaccountable nancetheoryalsostressestheneedfordirectors tothegroupthatelectsthem–theshareholders�

page 24 | 25for25 toholdanequitystakeinthecorporation�While Whilemuchhasbeendoneinthepast25years© 2011 Institutional Shareholder toServices Inc. PersPeCtIves on board leadershIP PersPeCtIves on board leadershIP

createindependent,equity-holdingboards,thedrivetoopenupthe thebiggestimpedimenttoavibrantcontest,thefundsrequired boardelectionprocessisarelativelynewone–butofequalimpor- tomountarealchallenge�Thesimplestsolutiontothisproblem tancetoeffectiveboardgovernance� istoprovidesomesortofreimbursementofreasonableexpenses tochallengersinnon-controldirectorialelectionchallenges�If Unfortunately,foravarietyofreasons,inmostpubliccompaniesthe oneissuccessfulinproposingandelectingadirector,thenone’s shareholderelectionprocessfunctionsasamereformalitytoratify expensesshouldbereimbursedbythecorporation�Ifanindividual theactionsofagenerallyself-perpetuatingboardandmanagement� isunsuccessful,butlosesonlybyasmallpercentage,thenitisclear Fortheelectiontoserveastheappropriateaccountabilityvehicle,it thattheeffortwasoveralegitimateissueandsomeportionofthat isimportantthat,fromtimetotime,thereistherealpotentialthat individual’sexpensesshouldbereimbursed�Shouldthechallenging itfunctionasatruecontestovercorporatepolicyanddirection�To candidateorcandidateslosebyasignificantvote,thennocorporate accomplishthis,weneedtoleveltheplayingfieldabitbetweenthe fundsshouldbeexpendedforthesupportoftheeffort� incumbentboardandtheshareholdersintheelectoralprocess� “ While giving shareholders Delawarelawnowprovidesestablishment Traditionallyinaproxycontest,theexpenses access to the company’s proxy forsucharegimeuponanappropriate ofthechallengingpartyaresolelyborneby for director nominees has shareholderorboardvote�Byremovingan thatparty,whiletheboardusesthecorporate importantfinancialimpedimenttomore treasurytofinancethepresentationofits some visceral appeal, it really vibrantcorporateelections,theelection position�Thishasbeenanobviousimpediment does not address the biggest processwouldnolongerbeasimpleformal- tofosteringvibrantelections,asallsharehold- impediment to a vibrant itybutarealforumforinformeddebateand erseffectivelysubsidizetheboard’scandidacy ultimateexpressionofshareholderwill�This whilethechallengerisforcedtopersonally contest, the funds required to wouldaccomplishanimportantgoal�Theelec- bearthecostofacampaign�Ifthechallenge mount a real challenge.” tionitself,ormerelythethreatofacontested involvesalegitimatedebateoncorporate election,wouldencouragebetterdirectorial directionandpolicy,thereisnogoodreason andmanagerialaccountabilitytoshareholders whyshareholdersofthecorporationshould andultimatelymoreeffectivecorporateper- fundthecostofpromotingoneview-pointandnottheother�This formance�Thisapproachwillproveultimatelymuchmoreeffective asymmetryiscertainlyproblematicinthatitactstostiflethoughtful thanthefinalproxyaccessruleadoptedbytheSEC(whichamong discussionandre-examinationofcorporatepolicy,whichultimately otherproblems,unfortunately,doesnotincludesmallshareholders leadstolessenedaccountabilitybytheincumbentboardand initsreach)� managementtoshareholders�Thatiswhyreformisnecessary,and explainsthecurrentcontroversyoverproxyaccess� Boardindependence,equity-ownership,andvibrantelectionsarethe threeelementsthathavedefinedrealgovernancechangeinthepast Whilegivingshareholdersaccesstothecompany’sproxyfordirec- 25years�Theyare,inmyview,thekeytothefutureofthefieldand, tornomineeshassomevisceralappeal,itreallydoesnotaddress ultimately,realinvestorprotection,andmoresuccessfulcorporations�

About the Author

❙❙ Charles Elson is the Edgar S. Woolard Jr. chair in corporate governance and director of the John L. Weinberg Center for Corporate Governance in the Alfred Lerner College of Business & Economics at the University of Delaware.

By Ira M. Millstein and Holly J. Gregory The Changes Wrought by Executive Sessions

“ This single practice verthepast25years,theboardcultureof discussspecificitemsraisedintheboardsession� of directors meeting U�S�publicly-tradedcompanieshaschanged Minutesofthesesessionscanbecriticallyimportant dramatically;theboard-createdpracticeof inshowingdowntheroadthattheoutsidedirectors without the CEO or holdingregularexecutivesessionsoutsidethepres- actedwithcareandingoodfaith� enceofmanagementhasbeentheprimarydevice other members of Attheendofanexecutivesession,thedirectorstypi- shapingthiscultureshift� management present callyagreeonwhatfeedbackshouldbegiventothe Beginningintheearly1990sandacceleratingthrough- CEO�Often,theleaderofthesessionwillmeetwiththe on a regular basis is outthedecade,leadingboardsinstitutedthepracticeof CEOtotalkgenerallyabouttopicsthatwerediscussed directly responsible holdingO“executivesessions,”which,countertowhatthe andtoprovideamorespecificmessageas appropriate� termimplies,aresessionsoftheoutsidedirectorswith- Justaswiththeholdingofexecutivesessions,thereg- for the palpable outcorporateexecutivespresent�Thisbestpracticewas ularpracticeoffollowingupwiththeCEOasamatter change in boardroom bornfromthepracticalexperienceofseasoneddirec- ofcoursehelpsshiftcultureandexpectations,sothat torsseekingtocreateanindependentculture,notfrom regularfeedbackcomestobeviewedasconstructive culture.” anyregulatoryorshareholdermandate�Executiveses- forboththeboardandtheCEO� sionswerefirstformalizedintheGMboard’sprinciples Thissinglepracticeofdirectorsmeetingwithoutthe ofcorporategovernanceintheearly1990s,andthen CEOorothermembersofmanagementpresentona quicklyadoptedvoluntarilybyanumberofprominent regularbasisisdirectlyresponsibleforthepalpable boards�Afteradecadeofvoluntaryexperimentation changeinboardroomculturesincethedaysaquarter andexperience,thescandalsof2001and2002ledboth centuryagowhenboardsoftenearnedthedescription NASDAQandtheNewYorkStockExchangetoimpose, of“parsleyonthefish�”Whathasemergedisaculture asaconditionoflisting,arequirementthatboardshold ofboardaccountability,independent-mindedness,and regularexecutivesessionsofnon-managementand willingnesstotakehardactionwhennecessary�This independentdirectors�Asaresult,itisnowcommon- culturereflectsachangeinawarenessaboutwhatis placeforoutsideandindependentdirectorstomeet expectedofdirectors� regularlywithoutmanagementpresent—oftenatthe endofeveryboardmeeting� Byprovidinganopportunityfordirectorstoshare theirassessmentsofmanagementintegrityand Generally,theboardchoosesanon-executivechair- performance,strategicdirection,successionplanning, manoranappropriatelyempoweredleaddirectorto oranythingelseontheirminds,executivesessions conveneandleadtheexecutivesession�Manyboards encouragecandor,frankdiscussion,and,whenneces- scheduletimeforanexecutivesession,evenifforonly sary,actionaboutissuesthatmaybedifficulttodiscuss 10or15minutes,asamatterofcourse,ateverymeet- withmanagementmembersintheroom�Executive ing�Thisregularityfosterscomfortwiththeprocessby sessionsoftenalsogenerateideasforenhancements directorsandmanagersalike�Agendasforexecutive orimprovementsinboardprocess�Basedonthemany sessionstendtobefairlyopen-ended�Itisnotunusual opportunitieswehavehadtoobserveboardsinaction, forthedirectorstoconveneinexecutivesession andfromourparticipationinnumerousdiscussions withoutanyplannedagenda,simplyasanopportunity inpeergroupsessionsamongdirectorsandadvisors, totalkaboutanythingthatisontheirminds�Common itisreadilyapparenttousthatexecutivesessionsare topicsincludeissuesrelatedtothemanagementand indispensableandanessentialboardpractice�They corporateperformance,keystrategicproposals,and wereinventedbyboardstofosterindependentthinking theevaluation,compensation,andcredibilityofthe andaction;theyhaveprovensuccessful,and,asaresult, CEOandotherkeymembersofthemanagementteam� arehighlyvaluedbydirectors� ExecutivesessionsalsoprovidetheopportunityAbout the Authors to ❙❙ Ira M. Millstein is a senior partner at the international law firm of Weil, Gotshal & Manges, where, in addition to practicing in the areas of government regulation and antitrust law, he counsels boards of directors on corporate governance matters. He also is the senior associate dean for corporate governance, and a visiting professor in competitive enterprise and strategy at the Yale School of Management.

❙❙ Holly J. Gregory is a partner in the international law firm of Weil, Gotshal & Manges, where she counsels corporate boards on the full range of corporate governance issues, ranging from adoption of best practices to board investigations to relations with shareholders.

“ It can be argued that saseniormanagerintheLosAngelesoffice publishedsuggestionsonthingssuchas:auditcom- the rise in importance ofErnst&Ernstin1971,Iwasaskedto mitteecharters;suggestedannualworkplans;ques- and substance of meetwiththechairmanoftheauditcom- tionsthatcommitteememberscouldaskofmanage- mitteeofoneofmyfirm’slargestclients�Thiswas mentorexternalauditorsatcommitteemeetings; audit committees abigsurpriseas:(a)Ididn’tknowtheclienthad andmanyothermatters�Mostofthosesuggestions has led the way for anauditcommittee;and(b)Ididn’tknowwhatan weredescribedas“bestpractices”andfew,ifany, increased corporate auditcommitteewas!Itturnedoutthatthechair- emergedasrequirementsoverthatperiod� manofthecommitteewasalmostasuninformedas governance in most I�He’drecentlybeengiventhatresponsibilityand Duringthisperiod,activeauditcommitteesmight other aspects of board justwantedmeA toreviewthecompany’sfinancial meetseveraltimesayearforafewhourseachtime� activity.” statementswithhimsohewouldn’tlooktoounpre- ThenewcommitteesbeingappointedpertheNYSE paredwhenhehadtomeetwiththeCEOandCFO andNASDAQlistingrequirementsmightmeetonly togooverhisnewduties� threeorfourtimesayear–oftenforanhourorless themorningortheafternoonofaregularboardof Auditcommittees,ofcourse,havecomealongway directorsmeeting�Clearly,theworkofthoselatter sincethen�Infact,itcanbearguedthattherisein committees,whileadheringtotheletterofthelist- importanceandsubstanceofauditcommitteeshas ingrequirement,wasoftennotofmuchsubstance� ledthewayforincreasedcorporategovernancein mostotheraspectsofboardactivity�Ifnothingelse, Overtime,theNYSEandNASDAQlistingrequire- ithasbeencommonlyagreedforthepastdecadeor mentsweresupplementedthroughspecific sothatthosedirectorsservingonauditcommittees procedurestheauditcommitteeswereexpectedto arelikelytospendmoretimeontheirboardduties perform�Muchofthiscameintheverylate1990s thanotherdirectors� andearly2000s,morespecificallyasaresultofrule changesbasedontheReportandRecommendations Goingbacktothetimeofmy1971meeting,there oftheBlueRibbonCommitteeonImprovingthe wasnorequirementthenforpubliccompanies EffectivenessoftheCorporateAuditCommittee� tohaveauditcommittees,althoughtheNewYork ThatCommitteehadbeenappointedbySEC StockExchangehadendorsedtheconceptallthe ChairmanArthurLevittasaresultofearlierfinancial waybackin1939�In1972theSECrecommended reportingandauditingproblems� thatregistrantsappointauditcommitteescom- prisedofoutsidedirectors�Butarequirement Evenwiththerequirementsforauditcommittees followednottoolongafter,atleastforNYSE-listed andrulesforspecificprocedures,toomanyofthose companies,intheformofa1977listingrequire- committeesstillwerenottakingtheirresponsibili- mentforauditcommitteeswithentirelyindepen- tiesasseriouslyastheyshould�ThencameEnron dentdirectors�NASDAQlistedcompaniesbecame andWorldComin2001�Asubsequentreportby subjecttoasimilarrequirementin1987� aSpecialCommitteeinvestigatingtheWorldCom matternotedthattheauditcommittee,“…met Throughoutthelate1970s,80s,andintothe90s, betweenthreeandfivetimesperyearbetween auditcommitteesthusbecamemoreofastandard 1999and2001�Meetingslastedaboutonehour practiceforpubliccompanies�However,there exceptthattheFebruary2002meeting,likelyin remainedverylittleconsistencyinwhatthose responsetoheightenedawarenessgrowingout committeesactuallydid�Inthelate1970s,theSEC oftheEnronscandal,lastedclosertotwohours� PracticeSectionoftheAmericanInstituteofCPAs WebelievethattheBoard–andinparticularthe issuedguidancetoauditorsofpubliccompanies AuditCommittee–playedsolimitedaroleinthecould oncommunicationswithauditcommitteesthat oversightofWorldComthatitisunlikelythatany improvedcommitteeoversightofexternalaudit� butthemostflagrantandopenfinancialfraud However,inotherrespectsthereremainedrela- havecometotheirattention�” tivelylittleconsistencyinwhatthosecommittees actuallydid� Ofcourse,EnronandWorldCombegatthe Sarbanes-OxleyActof2002�Thisputrealteethinto © 2011 Institutional Shareholder Services Inc. Individualaccountingfirms,lawfirms,andothers theauditcommitteefunction�Boththeneed25for25 |for pageand 27 PersPeCtIves on board leadershIP PersPeCtIves on board leadershIP

“ Many of the ways in which corporate thespecificdutiesofanauditcommitteewerenow forsmallercompanies)�Oftheremainder,most governance in general thesubjectoffederalsecuritieslawalthoughmany assignriskoversighttotheauditcommitteeasper ofthespecificsemergedthroughsubsequentSEC NYSElistingrequirements,althoughsomenow has been influenced regulations� reservethatresponsibilityforthefullboard�Risk so dramatically in managementcanrunthegamutfromfinancialrisks the past couple of Auditcommitteecompositionalsoisnowregulated suchascashflowandaccesstocapital,toopera- withallmembersexpectedtobeabletoreadand tionalrisksandevensuchstrategicrisksasthe decades had their understandfinancialstatements�Further,in company’sreputation� antecedents at the general,atleastonemembershouldbean“audit audit committee.“ committeefinancialexpert,”whicheffectively Tosummarize,manyofthewaysinwhichcorpo- meansheorsheshouldbequiteconversantwith rategovernanceingeneralhasbeeninfluencedso generallyacceptedaccountingprinciplesandother dramaticallyinthepastcoupleofdecadeshadtheir auditcommitteeresponsibilities�Theserequire- antecedentsattheauditcommittee�Pressurefor mentshavecausedboardstorecruitmoredirectors moreoutsideandthenfullyindependentdirectors withfinancialbackgroundstofillauditcommittee certainlycamefromthisfirstbeingpartofaudit positionsinrecentyears� committeerecommendationsandthenrequire- ments�Likewise,havingmuchoftheworkofthe Addingtotheauditcommittee’sgovernanceeffec- boardbeingdoneatthecommitteelevelrather tivenessistheSarbanes-Oxleyrequirementthat thanbytheboardasawholeoccurredmorefre- CEO’sandCFO’snowmustpersonallycertifyand quentlyfirstwiththeauditcommittee�Intoday’s personallysignthequarterlyandannualfinancial worlditisnotuncommonforadayofcommittee statementsaswellastheinternalcontrolsover meetingstolastlongerandcovermorethanthe thosefinancialreports�Thisprobablywasalways subsequentfullboardmeeting! implicitbutSOXmakesitexplicit�Ofcourse,thisis supplementedbyanactivedisclosurecommitteeat Finally,theextensiveinteractionbetweenboard mostpubliccompaniesthesedays� membersandcorporateexecutivesbeneaththe leveloftheCEOandhis/herdirectreportsmay Whilethelargemajorityofauditcommitteeactivi- havehappenedmorefrequentlyandearlieratthe tiesstillrelatetoaccountingandauditingmatters, auditcommitteethanotherareasofcorporate today’scommitteesalsoarequiteofteninvolvedin governance�Assomedirectorshavesaid,ifyouare overseeingriskmanagement�Todate,onlyabout newtoaboard,besuretojointheauditcommittee 10percentoflargercompanieshaveformeda asthat’swhereyouwilllearnthemostaboutthe boardriskcommittee(withmuchlessernumbers company!

About the Author ❙❙ Dennis Beresford is the Ernst & Young executive professor of accounting at the J. M. Tull School of Accounting at the University of Georgia’s Terry College of Business. He serves on the board of directors of the National Association of Corporate Directors and is a member of the Public Company Accounting Oversight Board’s Standing Advisory Group.

“ With today’s higher merica’smostseriouscorporategovernance andJohnson&Johnsonactuallyhavebylawsthat standards of corporate problemistheImperialCEO—aleaderwho requiretheCEOtoalsoserveaschairman� governance, why do isbothchairmanofthecompany’sboardof directorsaswellasitschiefexecutiveofficer�Such ManyEuropeancountriesrequirethatthechair- we still have Imperial aCEOcandominatehisboardandisaccountable manandCEOpositionsbeheldbydifferentpeople� CEOs? And what can tonoone� Andnotsurprisingly,EuropeanCEOsgenerally be done about it?” receivelesscompensationandlavishperksthan Thisarrangementcreatesaconflictofinterest, AmericanCEOs�Whilethegapisnarrowing,several becausethechairmanisresponsibleforleading recentstudieshaveshownthatU�S�CEOsofmajor anindependentboardofdirectors�Theboard’sA companiestendtogetpaidonaveragetwoorthree primaryresponsibility,onbehalfoftheowners,is timeswhattheirEuropeancounterpartsreceive� tohire,overseeand,ifnecessary,firetheCEO�Ifthe ThereisnoevidencethattheAmericanCEOs CEOisalsothechairman,thenheleadsaboardthat performanybetterforshareholders�Byrequiring isresponsibleforevaluating,compensatingand separatemanagementandsupervisoryboards, potentiallyfiringhimself� Europehasshiftedthepowerbalancetotheboard andowners,andawayfrommanagement,andit Theresultofthisconflictofinterestisexcessive appearsthattheownersaregettingmorebangfor CEOcompensationandundeservedjobsecurity� theireuroinexecutivecompensation� Entrenchedmanagementleadstoempire-building, continuedadherencetoflawedbusinessstrategies, ImperialCEOsarenotlikelytowillinglyrelinquish resistancetochange,thestiflingofhealthydebatein poweranddirectorshavelittleincentivetochal- theboardroom,anddestructionofshareholdervalue� lengethestatusquo�Inaddition,shareholderpro- Failuresofboardleadershipandoversightwerea posalsrequestingseparationofthechairmanand commonthreatatbanksatthecenterofthefinancial CEOpositionsencounterstrongoppositionfrom crisis�Itisnocoincidencethatmanyofthesewere mutualfunds,whichareoftenledbyanindividual headedbyacombinedchairmanandCEO� whoholdsthepositionsofchairmanandCEO� However,separatingtherolesofchairmanandCEO Withtoday’shigherstandardsofcorporategov- canbeaccomplishedsomewhatpainlessly�Isug- ernance,whydowestillhaveImperialCEOs?And gestthatstockexchangesandtheproxyadvisory whatcanbedoneaboutit? firmsrequirethatwhenacompanynamesanew CEO,itmustalsonamean“independentdirector” ImperialCEOsarealegacyofanerawhendirectors aschairman�CEOs,bydefinition,arenotindepen- wereappointedbytheCEOandprovidedminimal dentdirectors,sothiswouldeffectivelyseparate oversightoverhisleadership�Notwithstandingthe thetwopositions� increasedroleofnominatingcommitteesinthe currentenvironment,mostdirectors—eventhose ProxyadvisoryfirmssuchasISShavebecomevery whoaretechnicallyindependent—havevarying influentialwithinstitutionalinvestors�Theyfocus degreesofindependence� oncorporategovernanceissuesandrecommend whethertheirinvestorclientsshouldwithhold Ibelievethesimplestepofseparatingthepositions votesfromacompany’sproposedboardnominees� ofchairmanandCEOwouldresolvethispernicious ThesefirmsrecommendseparatingtheCEOand corporategovernanceproblem�Itwouldreininthe chairmanroles,butdonotrequireitinorderto ImperialCEOandshiftpowertoanindependent supporttheproposedslateofdirectors�Instead, board,actingasitshouldintheinterestofshare- theyallowfora“leaddirector”whoissupposedto holders,nottheCEO� helpthechairman/CEOwiththeboardagendaand presideovermeetingsofindependentdirectors Today,despitegrowingshareholderopposi- withoutmanagementpresent� tion,theCEOandthechairmanremainthesame personin65percentoftheS&P500companies� Ihaveservedontheboardsofthreemajor Surprisingly,suchbluechipcompaniesasGeneral Americancorporationsthatevolvedfromchair- © 2011 Institutional Shareholder Services Inc. Electric,ExxonMobil,UPS,Deere,Caterpillar,CSX, man/CEO,tochairman/CEOplusleaddirector,25for25 |to page 29 PersPeCtIves on board leadershIP PersPeCtIves on board leadershIP

“ The chairman/CEO plus lead director separatingchairmanandCEO�Inmyexperience, Whilemanyfactorsaffectstockprice,itisinterest- model is actually thechairman/CEOplusleaddirectormodelisactu- ingtonotethatDisney’sshareshaveappreciated worse than the allyworsethanthechairman/CEOmodel,because 30percentinthesixyearssincethechairmanand investorsfalselybelievetheleaddirectorhasthe CEOrolesweresplit,afterhavingfallen20percent chairman/CEO model, powertoprotecttheirinterests�Infact,thelead inthepreviousfiveyears� because investors directorhaslittlepracticalpowerandisfrequently falsely believe the selectedbythechairman/CEO�InAmerica,hewho ThesimplechangeIsuggesttoeffecttheseparation sitsattheheadofthetablerunsthemeeting� ofchairmanandCEO–requiringthatanindepen- lead director has the dentdirectorbecomechairmanwhenanewCEO power to protect their IsawthistensionfirsthandontheboardofDisney� isnamed–wouldincreasetherightfulinfluenceof interests.” Adominatinglong-timeCEO,MichaelEisner,who ownershipinthegovernanceofAmericancorpora- wasalsochairman,hadledthecompanyvery tions,andleadtoextinctionoftheImperialCEO� effectivelyformanyyears�However,thecompany’s This,inturn,wouldimprovecorporateperfor- performanceeventuallydeteriorated,whichmade manceanddecreasetheneedfornew,expensive shareholdersincreasinglyimpatient�In2004, andintrusivegovernmentregulationstocontrol dissidentshareholderscarriedoutawithhold-the- managementexcesses� votecampaign,whichpressuredtheboardtoname anindependentchairman,whowaspreviouslythe leaddirector,andtheCEOretiredshortlythereafter�

About the Author

❙❙ Gary Wilson structures and finances large transactions including the acquisition of Northwest Airlines; Northwest’s purchase of Continental Airlines; and Progress Rail. He also is the creator and general partner of private equity funds including Manhattan Pacific Partners, an investment fund; Thayer Lodging, a hotel investor; and Clarity China, which invests in Chinese companies.

“ Offering a variety titscore,corporategovernanceisessen- Ascriticalasitistoensurethatshareholders of avenues for tiallytherelationshipbetweenacompany, havesufficientinformationtomakedecisions,itis shareholders to itsmanagement,itsboard,anditsshare- equallyimportantthatshareholdersfeeltheyhave holders�Thebusinessfundamentalsanddrivers avoice,andthatthecompanyislistening�Offering communicate their maydifferacrossindustries,butthephilosophy avarietyofavenuesforshareholderstocommu- thoughts and behindgoodcorporategovernance—andthe nicatetheirthoughtsandconcernstotheboardis concerns to the underlyingprocesses–isverysimilarforall essential�Inadditiontotheexecutivecompensa- companies�Itdoesn’tmatterifyouaredealingwith tionwebsiteandtheindependentdirectors’email board is essential.” differentbusinessesorindustries;goodboardsare address,Prudentialproactivelysolicitedfeedback goodboards�TheyA alwayshavetogetthejobdone fromshareholdersonthe2010proxycard�With right,inaneffective,efficient,andethicalmanner, over2,600shareholdercommentsreceived,the andwithaviewtowardlong-term,sustainable boardgainedvaluableinsightregardingtheissues value�Havingapassionforcorporategovernance, ofmostimportancetoourshareholders� andbeingcommittedtoworld-classgovernance practices,meansmakingsurethatshareholders Comingupwithnewandeffectivewaystoincrease areheard,andthatthingsaredoneintherightway� quorumwillalsocontinuetobeachallengein Fairnessandrespectforpeopleiscritical� thefutureenvironment�Recognizingthat,histori- cally,registeredandsmallershareholdershave Successfullynavigatingtheever-changinglandscape notparticipatedintheproxyprocess,Prudential ofthegovernancearenawillrequireaconstantfocus implementedanovelincentiveprogramtoencour- oncommunicationandengagementwithsharehold- agetheseshareholderstosubmittheirvotein2010 ers,atalldifferentlevels�Inadditiontofocusingon andbecameengagedintheircompany�Leveraging thegovernanceprofessionalsatlargeinstitutions, ourverystrongenvironmentalsustainability engagingregisteredandretailshareholdersisalsoa programenabledustodesignaverysuccessful keyelementthatcannotbeignored� programthatresultedinanadditional23percent ofourregisteredsharesbeingvotedin2010,as Findingeffectiveandinnovativewaystocommu- comparedto2009� nicatewithshareholderswillbecomeincreasingly vitalascompaniescontinuetocompetefortheir Weliveinanexcitingworldand,whiletherehave attention�In2010,Prudentialfocusedintentlyon beendramaticchanges,Ibelievewehaveonly communicatingwithregisteredshareholders�Fully justbeguntoseetheextentoftheimpacteffective awareofthedemandfordisclosureinaformatall communicationandengagementcanhave�Ongoing shareholderscanunderstand,wewenttogreat regulatoryreformintheareasofexecutivecom- lengthstoensureourproxymaterialswerewrit- pensationandcorporategovernancewillcontinue teninplainlanguage�Inaddition,theGovernance todrivecompaniestoseekbetterwaystocom- Committeeproposeda“StateoftheCompany” municatewithandengagetheirshareholders�As letterintheproxy,signedbyeachdirector,detailing governanceprofessionals,weneedtoensurethat theboard’sworkthroughouttheyearoncompen- wearebeinginnovative,thoughtful,andrespectful, sationandgovernanceissues�Thiswasrecognized andthatwecontinuetostriveforwaystopresent throughoutthegovernancearenaasaground- newinformationinawaythatpeopleunderstand breakingsteptowardopeningthelinesofcommu- it,areinformedbyit,andprovidefeedback� nicationbetweentheboardandtheshareholders� About the Author

❙❙ Margaret M. (Peggy) Foran is chief governance officer, vice president, and corporate secretary at Prudential Financial. She has held similar roles at Pfizer. Foran recently was appointed a director at Occidental Petroleum after the company averted a proxy fight with Relational Investors and the California State Teachers’ Retirement System.

© 2011 Institutional Shareholder Services Inc. 25for25 | page 31 PersPeCtIves on exeCutIve CoMPensatIon PersPeCtIves on exeCutIve CoMPensatIon By Lemma W. Senbet The Rise of Equity-Based Compensation: The Bright and The Dark

“ A well designed equity- nthinkingaboutthemostsignificantdevelop- inshareholderwealthovertheyears� based compensation mentinthefieldofcorporategovernanceover can serve as a key thelastquarterofacentury,Ihavebeeninflu- However,therewasadarksidetothepay-per- encedbythetwolandmarkeventsofthelastdecade, formancemovement�Therewereseveralcasesin mechanism for whichhaveprofoundlysharpenedtheroleoffinance whichexecutivepayrosedramaticallyeventhough corporate governance.“ inthepublicdomain�Inthewakeofthelastdecade, thecompaniesweredoingpoorlyandtheirstock theburstoftheinformationtechnologyboomand priceswereplummeting,suggesting,onthesurface, theensuingmassivecorporatescandalstriggereda insufficientlinkagebetweenpayandlong-term collapseofwell-knowncompanies,suchasEnron, corporateperformanceandthepossibilitythat WorldCom,I andAdelphia�Moreover,bytheendof executiveswerepaidexcessively�Infact,thepublic thelastdecade,theburstofthehousingbubbleand concernaboutexcessivepayleadtotheadoptionof thesubprimecrisisledtoashutdownofthecredit theSection162(m)oftheInternalRevenueCode, marketandacollapseofvenerablefinancialinstitu- whichendedupcreatingunintendedconsequences tionswhichgotrescuedbypublicfunds� bydistortingthestructureofcompositiontobe heavilybiasedtowardincentivepay,withadra- Thereisanongoingdebatebothinacademicand maticriseinoption-basedcompensation� policycirclesontheextenttowhichcorporategov- ernancefailuresmighthavecontributedtothese Theglobalfinancialcrisishasnowgenerated landmarkepisodes�Thereisnearconsensuson extensivedebateontheroleofexecutivepayinthe thelinkbetweenthescandalssurroundingthedot� propagationofthecrisis�Thisinturnhasweighed combubbleandfailuresincorporategovernance� inprominentlyinthedebateaboutfinancialpolicy However,thelinkbetweentheill-designedincen- reformpertainingtoourlargestfinancialservice tivefeaturesofcompensationandfinancialcrisisis companies�Theissuehereismoreaboutexcessive stillbeingdebated�Itisclear,though,thatexecu- risk-takingstemmingfromaggressiveincentivefea- tivecompensationandgovernanceingeneralhave turesofcompensation,ratherthanexcessivepay� receivedwidepublicattention� Thus,overthelast25yearswehavewitnessed:(a) Thelast25yearsalsosawarobustpay-for-perfor- extensivedebateonexcessivepay;(b)theadvent mancemovement�Thelong-standingquestionhas of162(m),(c)financialexcesses;and(d)acrisis beenwhetherexecutivecompensationstructures ofepicproportions�Equity-basedcompensation, providesufficientincentivesforexecutivestoalign particularlystockoptioncompensation,hasbeen themwithshareholders�Agencytheorysuggests centraltotheseissues�Thisleadsmetoconclude thattheprimarymeansbywhichshareholders thereisoneaspectofcorporategovernancethat ensureincentivealignmentistotieexecutivepay hasbecometheunifyinglinkfortheseissues, tocompanyperformance�Infact,consistentwith namelytheriseofequity-basedcompensation,and this,duringthelate1980sandearly1990sthere Iconsiderthisasthemostsignificantdevelopment wasanincreasedpressurefrominstitutionalinves- Theover positithelast25years�ve and the dark: tors,suchastheUnitedShareholdersAssociation, theCouncilofInstitutionalInvestors,andlarge Welldesignedequity- statepensionfunds,forcompaniestotieexecu- basedcompensationcanserveasakeymechanism tivepaycloselytocompanyperformance�The forcorporategovernance�Shareholder-manager pay-for-performancemovementhadanimpacton incentivealignmentleadstovaluecreationand thestructureofcompensation,withdramaticshift contributestotheoveralleconomicgrowthand towardequity-basedcompensation,inclusiveof employmentcreation�Thisispositivenews� bothequityparticipationandoption-basedpay� However,thereisalsoadarksidetoequity-based Theaccumulatedacademicevidenceovertheyears compensation�Flawedcompensationschemes suggeststhatasubstantialportionofCEOwealth candestroyvalueanddetractfromtheoverall is,infact,tiedtocompanyperformance,andbetter economicperformance�Asanexample,compen- page 32 | 25for25 incentivealignmenthasbeenasourceofincrease sationschemesthatmotivateexcessivefocuson© 2011 Institutional Shareholder Services Inc. PersPeCtIves on exeCutIve CoMPensatIon PersPeCtIves on exeCutIve CoMPensatIon

. short-termprofitstomeetshort-runanalysts’expectationscan withstockoroptionsandaligningthemwithshareholderscanhave destroylong-runshareholdervalue�Moreover,ifthestockisover- theperverseeffectofpushingexecutivestotakeonextrarisk valued,equity-basedcompensationmayincentivizethemanager toover-investormanipulateearningstojustifythefirm’scurrent Thereisevidencesuggestingthattheincentivestructureofpay stockprice�Somehaveconvincinglyarguedthatsuchmanipulations isdifferentbetweenfinancialandnon-financialfirms(DeYoung, havecontributedtothecorporatescandalssurroundingthedot�com Peng,andYang(2009)�Inparticular,thesensitivityofexecutivepay Excessivebubble(Jensen2005)� pay debate: tovolatility(vega)divergedbetweenbanksandnon-banksafter 1999�Asaconsequence,anargumentcanbemadethattherewere Thereisalsoawidelyheldviewthatexecu- incentivesforexcessiverisk-taking,asreflectedinmorecreditrisk tivecompensationintheU�S�isexcessiveinthesenseitishigher andmoreprivatemortgagesecuritizations�Oneconsequenceof thanthatrequiredtoretainandmotivateexecutives�Inthe1990s thisformofrisk-takingisanelevatedlevelofsystemicriskinwhich averageCEOcompensationincreasedsignificantly,bothinabsolute banksbecomeespeciallystressedduringeconomicdownturns� andinrelativeterms�Theinflation-adjustedlevelofaverageCEO payforS&P500companiesstoodat$14�7millionin2000,five However,thisissuggestiveandacausationisyettobeestablished� timestheaverage10yearsbefore�Onanothermetric,the2000levelBusiness Week Overall,whetherflawedincentivesincompensationarethecritical wasabout400timesthatofaverageemployeecompensation,up driverofthefinancialcrisisremainsanempiricallyinteresting fromonly42timesin1980(see ,Sept�11,2000)� questionforfutureresearch� “ Overly generous compensation lookIng ahead: the next Butwhatisexcessive?Presumablyitishigher packages with large-sized stock 25 years paythantheexecutivecouldcommandina option grants may have created competitivemarketforexecutives�Itissafe incentives for managers to tosaytherehavebeeninstancesofmega Imakethefollowingpredictionsbasedona stockoptiongrantsbeingmadetoundeserv- manipulate company financial simpleguidingprinciplethatIbelievewill ingtop-levelexecutives�Forinstance,Dennis statements in order to drive up prevailoverthenext25years�Theprinciple Kozlowski,formerCEOofTyco,wasgranted stock prices, contributing to the isthatthelevelofexecutivepayshouldnot nearlysixmillionoptionsvaluedat$81mil- belegislatedorregulated,directlyorindi- lionattheverytimethathewasallegedly corporate scandals of the post- rectly�Inparticular,thechoiceofcompensa- lootingthecompany�However,itisdifficult dot-com era.” tionstructuresshouldbelefttothefirm,and togeneralizefromthesecasesaboutwhether regulatoryandtaxreformsshouldnotfavor theaveragelevelofexecutivecompensation 1. Section 162 (m) willoneformofcompensation be repealed. overanother� Sectionwasexcessive� 162 (m) and the rise of option-based compensation: Thisruleisamisguidedeffort toregulatethelevelandstructureofexecutivecompensation,and Section162(m)wasenactedin1993asameansofmitigating shouldberepealed�Companies,throughtheirboardsandshare- excessivepay�Thestatuedisallowstaxdeductibilityforallcom- holders,willbefreetodeterminetheoptimalformandlevelof pensationpaidto“proxy-namedexecutives”inexcessof$1million, executivecompensation�Inthosecaseswherecorporateboards unlesssuchcompensationis“performance-based�”However,it arenotexercisingthisfunctioninaresponsibleway,therewillbe endedupcreatingunintendedconsequences�Onanaftertaxbasis, changesincorporategovernanceinstitutionsorothermechanisms performance-basedcompensation,particularlystockoptions, (e�g�,“sayonpay”)toenhancethepowerofshareholderstomonitor becamelessexpensivethanbasesalariesandstockgrants�Stock 2.executivecompensationdirectly� Longer vesting periods will prevail: optionsdidsatisfythe“performance-based”test,sincetheyare directlylinkedtotheunderlyingstock�Thismusthaveleadtoa Duetolongervestingperi- dramaticriseinoption-basedcompensation�Infact,theaverage ods,therewillbeimprovedlinkageofpaytolong-termperformance grant-datevalueofoptionssoaredfromnearzeroin1970toover andlesstocashoutbasedonshort-termfavorableresults�Even $7millionin2000(HallandMurphy,2003)� bonuseswillbebasedonmulti-yearmetricstobetteralignexecu- tives3. Shareholderswithlong-termshareholderwealthmaximization� will directly influence executive pay: Overlygenerouscompensationpackageswithlarge-sizedstock optiongrantsmayhavecreatedincentivesformanagerstomanipu- latecompanyfinancialstatementsinordertodriveupstockprices, Shareholderswillhaveamoredirectmechanismforinfluencingthe contributingExecutive payto andthecorporatescandalsofthepost-dot-com financial crisis: era� levelandstructureofexecutivecompensation�Alltop-management compensationplans,includingsalary,equity-basedcompensation, Executivecompensationhas andseverancepackageswillbesubjecttoashareholderproxyvote� beenaprominentandvisibletargetofregulatorsandpolicymakers Duetolimitedexperienceandinformationpossessedbyindividual inresponsetothecrisis�Akeyquestioninthesepolicyresponses shareholders,anadvisoryvotewillprevailinwell-governedcompa- iswhether,andtowhatextent,flawedcompensationstructuresat 4.nies�Thus,goodgovernancewillberewarded� Compensation committees will be independent and finance financialfirmscontributedtothecrisis�Giventhatshareholdersof © 2011leveredinstitutionsbenefitfromexcessiverisk,payingexecutives Institutional Shareholder Services Inc. 25for25 | page 33 PersPeCtIves on exeCutIve CoMPensatIon PersPeCtIves on exeCutIve CoMPensatIon

“ This crisis has inspired literate: more, and even Compensationcommitteeswillbecom- financialcrisisledtheU�S�governmenttoacquire invasive, regulation posedentirelyofindependentdirectorstoensure exorbitantownershipstakesinourlargestcompa- both in the financial thatcompensationissetinanarms-lengthbargain- nies�Ithasalsoemergedasadominantcreditor� ingprocess�Thecommitteeswillbeaidedbycom- and non-financial pensationcommitteessupportedbyindependent Thiscrisishasinspiredmore,andeveninvasive, sectors, and the role compensationconsultants� regulationbothinthefinancialandnon-financial of the government in sectors,andtheroleofthegovernmentincorpo- Equallyimportant,compensationcommitteeswill rategovernanceandfinancialregulationhasactu- corporate governance havesufficientexpertiseinfinancetosufficiently allyexpanded�Thus,theroleofthegovernment and financial understandthecompensationcontractsandthe incorporategovernance,includingexecutivepay, regulation has actually methodsusedtovalueproperlytheincentivefea- throughdirectownershipandimplicitguarantees 5.turesinthesecontracts� There will be more expanded disclosure involv- islikelytoincreaseunlessthependulumshiftsasa expanded.” ing all elements of pay: resultofsomebacklashfromindustry�

Disclosurewillbemore However,theincreasingroleofthegovernment explicitandexpandedtocoverallelementsofexec- isconsistentwithwhatishappeningaroundthe utivecompensation,includingretirementbenefits, world,sincestate-ownedcorporationsinfastgrow- severancepackages,perquisites,andotherdirect ingBRICs(Brazil,Russia,India,andChina)have orindirectschemesofcompensation�Moreover, emergedasseriouscompetitorstothetraditional financialtransactionsbyexecutives,particularly corporations,withtheresultantstatecapitalism hedgingtransactions,thataffectpay-performance emergingasanalternativeformofthetraditional sensitivity,willbedisclosedtoboardsandcompen- corporategovernance�Atthistimeitisdifficultto 6.sationcommittees� There will be increasing state dominance of predicttheeconomicconsequencesoftheglobal governance around the world: trendintheincreasedstateroleingovernanceof corporations� Wehavealready witnessedtheadventofpayczarasaconsequence ofTARPbailouts�Forthefirsttimeinhistory,the

About the Author ❙ Lemma W. Senbet is the William E. Mayer chair professor of finance and director of the Center for Financial Policy at the Smith School of Business at the University of Maryland. His colleagues, Michael Faulkender, Dalida Kadyrzhanova, and N. Prabhala, contributed to this article.

page 34 | 25for25 © 2011 Institutional Shareholder Services Inc. PersPeCtIves on exeCutIve CoMPensatIon PersPeCtIves on exeCutIve CoMPensatIon By Frederic W. Cook Who Controls the Executive Compensation Program?

“ The likelihood of hemostsignificantdevelopmentincorpo- tendedtoregardthemselvesascustodiansofthe continued high pay rategovernanceofexecutivecompensation corporation�Thismindsetfosteredahighdegreeof for executives and duringthepast25orsoyearshasbeenthefrom loyaltyandcommitmenttoimprovethecorpora- shiftinpowerto tocontrolapubliccompany’sexecu- tion’sperformanceandtoleaveitinbettershape increasing ratios of tivecompensation themanagementandits fortheirsuccessorsthanwhentheystarted� executive’s pay to staff theboard’scompensationcommitteeand average workers will itsindependentadvisers� CalPERSwassoonjoinedbyotheractivistinvestors andtake-overtypes,suchasT�BoonePickensand keep executive pay a Thisshifthasbeenpartofalargerinitiativeto CarlIcahn,whorecognizedopportunitiestoprofit hot issue, useful to Tmakeboardsmoreindependent,active,andeven throughtargetedinvestmentsincompanieswith those who wish to proactiveinexercisingtheirfiduciaryresponsibili- weakmanagementanddepressedstockpricesby tiestooverseetheactivitiesofthecompanyandto takingbiginvestmentpositionsandforcingchange� undermine board hireandcompensatetheCEOandmanagement� Theseeventsledtoresponsesbycorporationsto prerogatives or protecttheirindependence(poisonpills),protect achieve other Imarkthestartofthismovementtotheactions management(goldenparachutes),andbuyoffthe byCalPERStopreventtheretiringCEOofGeneral aggressor(greenmail)� objectives.” Motorsfromremainingontheboard,and,later, toinstallanindependentdirectoraschairmanof Notwithstandingthesedefensivereactions,boards theboard�Thethen-prevailing“Wall-Streetrule” graduallystartedturningtheirattentionoutward wasthatifinvestorsdidnotthinkacompanywas toadvanceshareholderinterests�Thisshiftinfocus wellrun,theyshouldsellthestock;otherwise,they wasdeftlyreinforcedbyasubstantialchangein shouldnotinterfere�CalPERS,averylargeinvest- managerialincentivesfromanoperationalfocus mentmanagerofpensionfundsforstateemployees (i�e�,profits)toashareholderfocus(i�e�,changes inCalifornia,decidedtobucktheWallStreetrule� instockprice)�Thischangeinfocusfrominternal Itsreasoningwasthatduetothesizeofitshold- managerialintereststoexternalshareholderinter- ings,itwasdifficulttosellitspositioninindividual estswasreinforcedbythenewnotionintroducedmaximize the value of stockswithoutdisruptingthemarket�So,instead theduringthistimethattheprimarypurposeofa corporation for shareholders. ofsellingshares,itadoptedastrategytobecome publiccorporationwasto anactivistinvestortochangeboardgovernanceto makeitmoreresponsivetoshareholders’concerns� Thechangesinmanagerialincentivestoalign Backthenitmaybesaidthatmanyboardswere executives’interestswiththeinterestsofinvestors inwardlooking,ratherthanactivelyfocusedon inbetterperformancehavehadsomeveryposi- advancingshareholdersinterests�Boardswere tiveeffectsonthetypicalexecutivecompensation lessindependentthantoday,withnewdirectors program:❙❙ oftennominatedbytheCEOhimself�Whilethe boardtechnicallycontrolledtheexecutivepay ❙❙ Morevariabilityinpayearnedbyperformance, program,thepracticalrealitywasthatitwasheav- ❙❙ Stockownershipguidelinesandretentionratios, ilyinfluencedbyproposalsandpoliciesdeveloped bymanagement�Expertadvisers,totheextentthey Reductioninemploymentagreementsandmod- wereinvolvedatall,werenotindependentand ❙❙ erationofseverance/CICprovisions, workingonbehalfoftheCompensationCommittee, Eliminationorsubstantialdiminutionofexecu- butratherwereretainedbyandbeholdentoman- tiveperks,specialbenefits,supplementexecutive agement�Theresultwaspayprogramsthat,while ❙❙ retirementplans,taxgrossups,and modestinmagnitudebytoday’sstandards,were lessfocusedonperformance-basedcompensation Eliminationofspecialretirementbenefitsand andmorefocusedondeferredcompensation,spe- perksforretiringCEOs� cialbenefits,andperquisites�Executivestendedto Likemostevolutionarychanges,thisshiftinfocus behomegrownandtostaywiththecompanytheir toshareholders’interestshashadconsequences wholecareer,forbetterorworse�Onebrightspot thatsomemayregardasnegative: © 2011 Institutional Shareholder Services Inc. inthisotherwiseweakmodelwasthatexecutives 25for25 | page 35 PersPeCtIves on exeCutIve CoMPensatIon PersPeCtIves on exeCutIve CoMPensatIon

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❙❙ Short-termbehaviortomeetorbeatanalysts’earningsestimates, Whatwillthefutureholdforcorporategovernanceofexecutivecom- pensation?Inmyexperience,mosttrendscontinueuntiladisruptive Tendencytotreatemployeesandemployeebenefitsasacost forceoccursthatstartsanewtrend�Absentsuchadisruptiveforce, ❙❙ ratherthanasanasset,and Ienvisionafurthershiftinpoweroverexecutivecompensation Aconvergenceofexecutivecompensationdesignandpractice fromtheboardtoshareholdersasaresultofseveralfactors�These intoa“one-sizefitsall”approachthatmeetsthe“check-the-box” includelegislativeandregulatorydevelopmentssuchas“sayonpay,” requirementsofactivistshareholdersandtheiradvisers� proxyaccess,andmajorityvoting,aswellasthegrowinginfluenceof activistinvestorsandproxyadvisoryfirmstoinfluencevotingout- Finally,theshiftincontroloverexecutivecompensationfrom comesandpunishdirectorswhoareinsufficientlyattentivetotheir managementtoindependentcompensationcommitteeshashadthe demands�Finally,thelikelihoodofcontinuedhighpayforexecutives followingpositivegovernanceeffects: ❙❙ andincreasingratiosofexecutive’spaytoaverageworkerswillkeep executivepayahotissue,usefultothosewhowishtoundermine Increasedfocusonvariablecash-andequity-basedcompensa- boardprerogativesorachieveotherobjectives� tion,whichfostersgreateralignment “ Investors will also need to recognize betweenrealizedpayandcompany that compensation policy is a Whethersuchchangewillbepositive performanceasmeasuredbyboth strategically important dynamic for dependsontwofactors:theinvestors’ operatingresultsandchangesinshare- agendaandthedegreetowhichtheyare ❙❙ holdervalue, a corporation, and that individual sufficientlyinformed�Thereisadanger Enhancedlevelofexecutiveownership design (rather than strict adherence thatinvestorpowermaybeusedtofacili- inthestockofcompaniestheylead, to broad ‘best practice’ principles) tateapoliticalorsocialagendarather whichcreatescommonalityofinterest can have a profound effect on the thananappropriatebusinesspurpose� ❙❙ withshareholders, Andevenifinvestorsusetheirinflu- degree to which the overall program encetosupportappropriatebusiness Moretransparencyindisclosureof supports sustainable value creation goals,thevalueoftheirinfluenceisvery executivepayaswellastheaccount- muchdependentonknowledgeofhow ❙❙ abilityofcompensationcommittees, for long-term investors and other executivecompensationsystemsactually Morebalancedandreasonablepeer stakeholders.” operate�Forexample,informingviews groupsforsettingtargetpayandfor ontherelationshipbetweenpayand comparingactual,realizedcompensa- performance,investorsmustrecognize ❙❙ tionaswellasperformanceagainstthemarket, thedistinctdifferencebetweentheoretical,ortarget,payandreal- izedvalue(e�g�,Black-Scholesvalueversusrealizedoptiongains)� ❙❙ Betteruseandlessmisuseofsurveydatatojustifyexecutivepay, Investorswillalsoneedtorecognizethatcompensationpolicyis Shiftincontrolofcompensationconsultantsfrommanagementto astrategicallyimportantdynamicforacorporation,andthatindi- ❙❙ thecompensationcommittee,and vidualdesign(ratherthanstrictadherencetobroad“bestpractice” principles)canhaveaprofoundeffectonthedegreetowhichthe TransferofresponsibilityforCEOpayanalysesandrecommen- overallprogramsupportssustainablevaluecreationforlong-term dationsfromtheCEO’sstafftotheCommittee’sindependent investorsandotherstakeholders� advisers�

Theonethingwecanbeassuredofisthatcompensationpolicyand relatedgovernanceprocesseswillcontinuetoevolve,astheyshould�

About the Author

❙❙ Frederic W. Cook is the founding director of Frederic W. Cook & Co., a compensation consulting firm. Before founding the firm in 1973, he worked as a principal at Towers Perrin.

By Stephen Griggs and Judy Cotte ‘Say on Pay’ Arrives in Canada

of directors, that the shareholders accept the “ The results of ‘say on approach to executive compensation disclosed in neofthemostrecentsignificantgovernance the Company’s information circular delivered in pay’ votes held have developmentsinCanadahasbeenthearrival advance of the [insert year] annual meeting of been overwhelmingly ofshareholderadvisoryvotesoncompensa- shareholders. tion,commonlyknownas“sayonpay�”Theunique positive.” approachto“sayonpay”inCanadaisnoteworthy andspeakstothepowershareholdershavetoaffect significantchangewithoutregulatoryintervention� Theresolutionisnotfocusedonthequantum ofcompensationbutratheronthepoliciesand Themovementtoward“sayonpay”inCanadabegan proceduresthatrevealacompany’sapproachto inOearnestin2009whenapproximately17share- executivecompensation,althoughquantumcould, holderproposalsfor“sayonpay”werefiledwith insomecircumstances,berelevant�Acompany’s Canadiancompanies,manyofMouvementwhichreceived d’éducationmajor - approachtocompensationshouldreflectthelinks etity desupport�Many défense des actionnairesoftheseproposalswerefiledby betweenitsstrategicobjectivesandcompensation, Canadianinvestoradvocate usingfinancialandnon-financialmeasuresover orwiththeassistance anumberofyears�All14companiesfirstoffering oftheShareholderAssociationforResearchand “sayonpay”inCanadaagreedtouseCCGG’sform Education�Ultimately14largeCanadiancompanies, ofresolution�Webelievethatthiscooperative includingallofCanada’sbanks,agreedtogivetheir approachofdevelopingaworkable“sayonpay” shareholdersa“sayonpay”vote� policyinconjunctionwithcorporateissuershas beenuniquetoCanada� Atthesametime,shareholderproposalsrequesting “say on Pay” gaIns aCCePtanCe “sayonpay”werebeingfiledintheUnitedStates andnumerouscompanieshadagreedtoprovideit toshareholders�Therewaslittleuniformityinthe “Sayonpay”hascontinuedtogainacceptance resolutionsputtoshareholders,however,which acrossCanada�Todate,42companies,approxi- ledtodifficultycomparingvoteresultsbetween mately20percentoftheS&P/TSXCompositeIndex, companies�Althoughlegislating“sayonpay” haveadopted“sayonpay,”andnumerousothers wasalreadybeingdiscussedintheUnitedStates, haveconfirmedtoCCGGthattheyintendtodoso� Canadianregulatorsandlawmakersdidnotshow Adoptionof“sayonpay”hasbeenbroad-basedand anyinterestintheissue�TheCanadianCouncilon includescompaniesfromvirtuallyallindustriesand GoodGovernance(CCGG)decidedtogetinvolved marketcapitalizations�Allcompaniesadopting“say toensurethat“sayonpay”resolutionsinCanada onpay”havecontinuedtouseCCGG”srecommended wereconsistent,encouragedcompaniestoengage formofresolution(withonenon-materialvariation), constructivelywiththeirshareholders,andoffered whichwillsimplifytheprocessforshareholdersand shareholdersameaningfulwaytocommunicate allowforameaningfulcomparisonofvoteresults theirviewsonexecutivecompensation� betweencompanies�AsrecommendedbyCCGG,all CCgg and “say on Pay” companiesarealsoholdingtheirvotesannually�

Theresultsof“sayonpay”votesheldhavebeen Inthesummerof2009,CCGGbegantodevelopits overwhelminglypositive�Ofthe42companiesthat policyon“sayonpay”�Indoingso,CCGGworked committedto“sayonpay,”25includedtheresolu- withthe14companiesthathadagreedtohold“say tionintheir2010proxyballots�Thevotesinfavour onpay”votestoensurethatitconsideredtheirper- ofthecompany’sapproachtoexecutivecompensa- spectiveand anypracticalobstaclestoimplementing tionrangedfrom86�3percentto99�2percentwith “sayonpay�”AnimportantpartofCCGG’spolicywas theaverageat94�39percent�Thishighlevelofsup- theformulationofamodelresolutionthatcouldbe portlikelyindicatesthatcompaniesarereachingout, usedbyallcompaniesholding“sayonpay”votes� atleasttotheirlargestshareholders,todiscusstheir TheResolved,CCGGmodel on an resolutionadvisory basisreads andas notfollows: to dimin- approachtoexecutivecompensationinadvanceof ish the role and responsibilities of the board any“sayonpay”vote�Italsosuggeststhatshare- holderswillusetheiradvisoryvoteresponsibly,as © 2011 Institutional Shareholder Services Inc. hasbeentheexperienceinotherjurisdictions25for25 |� page 37 PersPeCtIves on exeCutIve CoMPensatIon the next 25 years

“ All but one of the companies that have CCGGhasalreadynoticedsignificantimprovements 55percentoftheS&P/TSXCompositeIndex,have adopted ‘say on pay’ inthedisclosurepracticesofcompaniesthathave sinceadoptedCCGG”smajorityvotingpolicy� have also adopted adopted“sayonpay”andsomehavealsoimproved theircompensationplans�CCGGencouragedcompa- Indeed,allbutoneofthecompaniesthathave majority voting, niestoprovideshareholderswithaplainlanguage adopted“sayonpay”havealsoadoptedmajority suggesting that the overviewoftheircompensationplans,includinga voting,suggestingthattherateofacceptanceof rate of acceptance descriptionofthecompany’skeystrategicobjectives sayonpaymightmirrorthatofmajorityvoting� andhowcompensationisstructuredtomotivate Itmayalsosuggestthatcompanieswithmajority of say on pay might managementtoachievethoseobjectiveswhilealso voting,wheredirectorsfacethepossibilityofbeing mirror that of majority managingrisk,andseveralcompanieshavealready removedbyshareholders,recognizethat“sayon voting.” doneso�Perhapsmoreimportantly,severalcompa- pay”votesprovideshareholderswithamiddle nieshavemadesignificantchangestotheircompen- groundthatbenefitsboardsaswellassharehold- sationplanstobetteralignexecutives’compensation ers�Ifshareholdersaredissatisfiedwithaboard’s withtheirperformance�Inaddition,numerous approachtoexecutivecompensation,theycan companieshaveincludedintheircircularacommit- expresstheirviewsthroughanegative“sayonpay” menttoengagewiththeirshareholders,bothlarge voteratherthantakingthemoreextremestepof andsmall,andhaveprovidedadescriptionofthe votingagainstdirectors� engagementprocesstheyintendtofollow� the future of “say on Pay” Although“sayonpay”isverynewtoCanada,early indicationssuggestthatitwillhaveapositive impact�Somecompaniesareshowinganincreased CCGGexpectsthatthenumberofcompaniesadopt- willingnesstoengagewithshareholders,improv- ing“sayonpay”inCanadawillcontinuetoincrease� ingthedisclosureoftheircompensationplans,and OurexperiencewithmajorityvotinginCanadamay improvingthelinkagesbetweenpayandperfor- proveprescientinthatregard�In2005,CCGGurged mance�Moreover,thefactthat“sayonpay”was Canadiancompaniestoadoptamajorityvoting broughttoCanadabyshareholders,incooperation policywhichwouldeffectivelyallowshareholdersto withCanadiancompaniesandwithoutanysupport vote“for”or“against”directors,inspiteofthefact fromregulators,isareminderofthepowershare- thatpluralityvotingisenshrinedinCanadiancorpo- holdershavetoimprovecorporategovernance rateandsecuritieslaws�Althoughtheideainitially whentheyworktogethercollaboratively� metwithresistance,approximately127companies,

About the Authors

❙❙ Stephen Griggs is the executive director of CCGG and Judy Cotte is the general counsel and director of policy development. CCGG is a coalition of most of Canada’s largest institutional investors who collectively manage approximately $1.4 trillion in assets.

❙❙

“ Corporate governance eareatacriticaljunctureincorporate Companiesneedtochangetheirwayofthinking� is more than governanceintheUnitedStates�Many Governanceisnotsimplycomplianceitemsor declassifying boards ofthestructuralreformsthatsharehold- boxchecking�Governanceshouldnotbeinter- ershaveaskedforhavebeenimplemented�Many pretedasshort-termmeasuresorthingsthat or completing a social leadingcompanieshaveadoptedbestpractices proxyadvisoryfirmswantbutnotshareholders� responsibility report— suchasmajorityvotingindirectorelections�The Governanceshouldbeintegratedwithstrategy, it is about making Dodd-Franklegislationprovidesshareholders performance,andgoals�Corporategovernanceis withadditionalrightsincludingtheadvisoryvote morethandeclassifyingboardsorcompletinga sure companies’ oncompensationandproxyaccess�Thereforms socialresponsibilityreport–itisaboutmaking governance processes areWastepintherightdirectionandanattemptto surecompanies’governanceprocessesaddress address conflicts, align strengthentransparencyandaccountabilitybut conflicts,aligninterests,andincreasethelikeli- structuralreformsarenotenoughtobringabout hoodofgooddecisionmakingsothatcompanies interests, and increase bettercorporategovernance�Formarketstowork areabletoreachtheirobjectiveofmaximizing the likelihood of good wellandbeefficient,shareholdersandcompanies ❙❙ long-termperformanceandshareholdervalue� mustdotheirparttoensurethatthegoalofthe decision making so Shareholdersshouldunderstandthatthegoalof reformsareachieved� that companies are governanceisnotsimplytovoteeveryproxybut toenhancereturnsbyreducingrisk�Companies Inmyview,theprimarygoalofthereforms, able to reach their thatdonothaveproperboardoversightof whetheritistheadvisoryvoteoncompensation objective of management,donothaverationalcompensa- orproxyaccess,istoencouragecollaboration tionpoliciesalignedwithshareholders,donot maximizing long-term betweencompaniesandshareholderstodevelop haveeffectivecontrolsofrisk,anddonothavea privatesolutionstogovernanceproblems�Hereare performance and strongmanagementteamincreasetheirinvest- someideasonhowthiscanbeachieved: shareholder value.“ ❙❙ mentrisk�Goodcorporategovernanceisnota guaranteethatcompanieswillperformwellbut Thereneedstobegreaterdialoguebetween itcertainlyisacontributingfactor�Shareholder companiesandshareholdersandadesireto policiesandpracticesshouldbedrivenbythe developprivatesolutionstogovernanceprob- needtoincreasethelong-termvalueoftheir lems�Bothshareholdersandcompaniesshould holdingsandgenerategoodreturnsforunderly- recognizethatitisintheirmutualinterestto ❙❙ ingbeneficiaries� seekcommongroundratherthanbeconfronta- tional�Shareholdersandcompaniesshouldtalk� Shareholdersshouldalsounderstandthatitis Thediscussionscouldtakeavarietyofforms, theroleoftheboardandmanagementtorun whethertheyarein-personortelephonicand companiesandshouldnottrytomicromanage couldcoverarangeofgovernancepolicyissues orencroachupontheresponsibilitiesofboards� inadditiontofinancialandeconomicissues�We Boardsontheotherhandshouldclearlyarticu- needtodevelopmodelsthatareflexibleandyet latewhattheyaretryingtodowiththecompany meaningfulandengenderincreasedtrustand andthecompany’sbusinessstrategyoverthe understanding,leadingtoabetteralignmentof short-andlong-termandthenensuremanage- ❙❙ interestsbetweencompaniesandshareholders� ❙❙ mentexecutesonthestrategy� Thesediscussionsshouldleadtothecreationof Executivecompensationwillcontinuetobean market-basedsolutionstogovernanceproblems issueofconcernforshareholders�Compensation ratherthanmorelegislation,whichcanrestrict decisionsareameasureoftheboard’sper- flexibilityifitistooprescriptive�Market-based formanceandindependence�Compensation solutionsaretheidealandforthistohappen, committeeswillneedtoclearlyarticulatethe shareholdersandcompaniesmustworktogether rationaleandphilosophybehindtheirdecisions� todevelopsolutionstogovernanceconcerns� Shareholdersshouldrespondbyvotingonthe However,privateorderingcannotbesuccessful qualityofthereasoning�Shareholdersshould ifcompaniesarereluctanttotakeonreformsfor evaluatewhethertheboardhassetpoliciesthat fearofbeingcompetitivelydisadvantaged� arelong-termoriented,integratedwithbusiness strategy,anddesignedtodrivevalue� © 2011 Institutional Shareholder Services Inc. 25for25 | page 39 the next 25 years the next 25 years

“ Shareholders should ❙❙ ensure that their Successionplanningandriskmanagementwill supplementalresearchusedbyshareholdersto internal governance becomegreaterprioritiesforcompanies�Boards identifyoutliercompaniestobeincludedingover- ❙❙ policies and practices mustlookaheadfiveto10yearsandsetstrategy nanceinitiativesandcampaigns� andgoalsandidentifythecompany’smostsig- Shareholdersshouldensurethattheirinternal are consistent with nificantchallenges�Boardsmustmakesurethey governancepoliciesandpracticesareconsis- haveanexecutiveteaminplacethatcanexecute the policies that tentwiththepoliciesthattheyadvocateforthe onstrategyandensurethatfinancialincentives they advocate for companiestheyown�Theyshouldmakesure arealignedwithmeetingclearlyarticulated toproperlyaddressandmanageconflictsand the companies they milestoneswithoutexcessiverisk-takingthat devoteappropriateresourcestoproxyvotingand own. They should couldunderminethelong-termsustainabilityof ❙❙ ❙❙ governanceanalysis� make sure to properly thecompany� Shareholdersandcompaniesshouldbemore Proxyadvisoryfirms,whilecomingundergreater address and manage mindfuloftheneedtointegrateconcernsabout scrutiny,willcontinuetoprovidethenecessary socialresponsibilityintobusinessplanning� conflicts and devote serviceofprovidingrecommendationsonproxy Sociallyresponsiblepracticesmayhelpmitigate appropriate resources decision-making�Itshouldberecognizedthat riskforcorporations�Forshareholders,reduc- suchresearchisnotdevelopedinavaccuumand to proxy voting and ingnegativeexternalities,suchaspollution,can reflectsanamalgamationoftheviewsoflarge helptomitigateportfolioriskaswell�Companies governance analysis.” institutions�Ulimately,however,theadvisoryfirms shouldexaminesustainabilityrelatedrisks, provideonlyrecommendations;thedecisionsare developstrategiestoaddressthem,anddisclose theresponsibilityofinvestorswhoshouldvote theresultsoftheirdeliberations� inalignmentwiththeireconomicinterestsand shouldcommunicatetheirpoliciestocompanies andthemarket�Theadvisoryfirmsalsoprovide

About the Author

❙❙ Until September 2010, Hye-Won Choi served as senior vice president for corporate governance at TIAA-CREF. In 2009, she was appointed co-chair of the Securities and Exchange Commission’s Investor Advisory Committee.

By Martin Lipton The Future of Corporate Governance and the Board of Directors

“ Institutional uchhaschangedinthecorporate hard-earnedreputationisthreatenedbyproduct shareholders, hedge governancelandscapeoverthepast25 ❙❙ failure� yearsand,withoutadoubt,Institutional funds, activist Determineexecutivecompensation,achieving ShareholderServiceshasplayedacentralrolein thedelicatebalanceofenablingthecompanyto investors, and shapingitsevolution�SinceISSwasformedin1985, recruit,retain,andincentivizethemosttalented ithasbeenattheforefrontofacrusadebypublic corporate raiders are executives,whileavoidingmediaandpopulist andunionpensionfunds,academics,activistshare- today able to exercise ❙❙ criticismfor“excessive”compensation� holders,andcorporateraidersforashareholder- considerable influence centricgovernancesystem� Interviewandnominatedirectorcandidates, over both corporate M monitorandevaluatetheboard’sownperfor- governance matters Todaythecrusadehasaccomplishedvirtually mance,andseekcontinuousimprovementin everyobjectivethatitoriginallysetouttoachieve� ❙❙ boardperformance� as well as key business Theshareholderrightsmovementhassteadily Providebusinessandstrategicadvicetomanage- pushedforward,spurredbytheSEC’sshareholder decisions of public mentandapprovethecompany’sbudgetsand communicationsrulesadoptedin1992,andthen companies, and ❙❙ long-termstrategy� galvanizedbytheEnronscandalin2001andthe takeover defenses financialcrisisstartingin2007,bothofwhich Determinethecompany’sriskappetite(financial, have been significantly precipitatedextensivelegislativeandregulatory safety,reputation,etc�),setstate-of-the-artstan- scaled back.” changesthatencompassedmanyofthepolicies dardsformanagingrisk,andmonitorthemanage- promotedbyISS�Institutionalshareholders,hedge ❙❙ mentofthoserisks� funds,activistinvestors,andcorporateraiders Monitortheperformanceofthecorporationand aretodayabletoexerciseconsiderableinfluence evaluateitagainsttheeconomyasawholeand overbothcorporategovernancemattersaswell ❙❙ theperformanceofpeercompanies� askeybusinessdecisionsofpubliccompanies, andtakeoverdefenseshavebeensignificantly Setstate-of-the-artstandardsforcompliancewith scaledback� legalandregulatoryrequirements,monitorcom- ❙❙ pliance,andrespondappropriatelyto“redflags�” Inanefforttothinkaboutthefutureofcorporate Takecenterstagewheneverthereisaproposed governanceandtheboardofdirectors,weneedto transactionthatcreatesaseemingconflict startwithwhatweexpecttheboardtodotoday betweenthebestinterestsofstockholdersand andtheruleswehavesetgoverninghowdirec- thoseofmanagement,includingtakeovers,merg- torsareselected,howtheyfunction,andhowthey ❙❙ ers,andrestructuringtransactions� relatetoshareholders—notonlythelegalrulesbut alsotheaspirational“bestpractices”thatinfluence Setthestandardsofsocialresponsibilityofthe corporateanddirectorbehavior�Wealsoneedto company,includinghumanrights,andmoni- lookathowcorporatemanagementandboards torperformanceandcompliancewiththose areperceivedbythemedia,thepublic,andelected ❙❙ standards� officialsinthepost-financialcrisisera,andexamine ❙❙ Overseegovernmentandcommunityrelations� thereputationalandothernon-legalpressuresthat directorsface� Paycloseattentiontoinvestorrelationsandinter- ❙❙ facewithshareholdersinappropriatesituations� Weexpectboardsto: ❙❙ Adoptcorporategovernanceguidelinesandcom- mitteecharters� ChoosetheCEO,monitorhisorherperformance, andhaveadetailedsuccessionplanincasethe Werequiretheboardtobemadeupofamajorityof CEObecomesunavailableorfailstomeetperfor- independentdirectors�Whiletherulesofthestock ❙❙ manceexpectations� exchangesrequireonlyamajority,theguidelines ofmanyinstitutionalinvestorsandgovernance Planforanddealwithcrises,especiallycrises advisoryorganizationshavespecifieda“substan- wherethetenureoftheCEOisinquestion, tial”majorityoraspecificpercentage�Infact,many wheretherehasbeenamajordisaster,orwhere © 2011 Institutional Shareholder Services Inc. majorcorporationstodayhaveboardswhoseonly25for25 | page 41 the next 25 years the nextCategory 25 years

Director Independence.

non-independentdirectoristheCEO�Further,thedefinitionof Therewillcontinuetobeasubstantial independenceisperiodicallyadjustedbygovernanceactivistsand majorityofindependentdirectorsoncorporateboards�There advisoryorganizationstobemorestringentthanthedefinitionin willbesignificantgenderandethnicdiversity�Whilewewillnot thestockexchangesrules� prescribepercentagesforgenderdiversity,wewillbesomewhere betweenthenewU�K�CorporateGovernanceCode:“Thesearchfor Itisinterestingtonote,however,thatdirectorindependenceisnot boardcandidatesshouldbeconducted,andappointmentsmade,on clearlythefundamentalkeystoneof“good”corporategovernance� meritagainstobjectivecriteriaandwithdueregardforthebenefits Theworld’smostsuccessfuleconomyrecommendedwasbuiltbycompaniesthat ofdiversityontheboardincludinggender”andthe40percent hadfew,ifany,independentdirectors�Itwasnotuntil1956that femalequotaimposedbylawinNorwayandactivelybeingconsid- requiredtheNewYorkStockExchange thatlistedcompanies eredoradoptedinotherEuropeancountries� havetwooutsidedirectorsanditwasnotuntil1977thattheywere tohaveanauditcommitteeofallindependentdirectors�In Thetrendtowardsmallerboardswillbereversedinordertohavea 1966whentheStandardOilCompanyaddedoutsidedirectors,theevery day sufficientnumberofindependentdirectorsfortheaudit,nominat- NewYorkTimesreportedthatitwouldrequiretheboardtorethink ing,andcompensationcommitteesandtoadddirectorswhohave itsscheduleofmeeting at11a�m� “ The world’s mostspecialexpertiseand successful arenotnecessarilyindependent�Forexample, thefinancialcrisiscalledattentiontodirec- Inadditiontoindependence,wethinkdirectors economy was built by torsoffinancialinstitutionswhodidnothave shouldhaverelevantbusinessexperience,lead- companies that had few, if theexpertisetofullyunderstandtherisksof ershipability,andthestrengthofcharacterto any, independent directors.” complicatedderivativesandotherhigh-tech challengemanagement�Finally,weseekgender financialinstruments�Toremedythesituation, andethnicdiversity;availability,andcommit- thebankingregulatorsarenowinsistingthat mentsuchthatfewifanyboardandcommittee Board Committees andexperiencedbankersbeadded Director Education. totheboards� meetingsaremissed;andwillingnesstoserveforcompensation thatdoesnotfullyreflectthescopeoftheexpectedcommitment Aseparateriskcom- andtheexposuretolitigationandreputationaldamagewhensome- mitteehasbeenmandatedforfinancialinstitutionsand,evenifnot thinggoeswrong� mandatedfornon-financialcompanies,willlikelybecomecommon atcompanieswhereriskplaysasignificantrole�Forexample,the ThecombinedeffectoftheSarbanes-OxleyAct,theDodd-Frank BPGulfofMexicospill,andBP’sacknowledgmentthatitwasnot legislation,thestockexchangegovernancerules,SECregula- preparedforit,followedaBPrefineryexplosionin2005thatresulted tions,andpressurefromISSandotheradvisoryorganizations inaspecialreview,byacommitteechairedbyJamesBaker,that istoexaltshort-termshareholderinterestsovertheinterests criticizedtheBPboardfornotproperlymonitoringtheriskofthat ofotherstakeholders—andoftheAmericaneconomyandthe typeofaccident�Toassistboardsandcommitteeswithevaluatingand Americanpublic�Theassumptionthatempoweringshareholders monitoringrisksandotherspecializedorcomplexissues,therewill andpromotingtheirinterestswillleadtobetterperformanceand begreaterresorttoobtainingopinionsofexpertconsultants�Boards moreefficientmanagementofcorporations,andthatshareholder willhaveregulartutorialsbybothcompanyemployeesandoutside interestsarethereforealignedwiththoseofotherstakeholders,is experts�Boardretreatsfortwoorthreedayswillhavelongeragendas simplisticandcontradictedbytheshort-termtradingobjectives Directortofulfillthe Duties.needfordirectoreducationaboutspecializedissues� ofmanyofthemajorinstitutionalinvestorsandhedgefunds�To quotethetitleofabrilliantspeechViceChancellorLeoStrineof Todateourcourts,Caremark evenincasesinvolvingmulti- theDelawareCourtofChancerygaveatStanfordUniversityinMay billion-dollarlossesbyfinancialinstitutions,havecontinuedto 2010:“OneFundamentalCorporateGovernanceQuestionWeFace: adheretothecustomary -casestandardfordetermining CanCorporationsBeManagedForTheLongTermUnlessTheir whetherdirectorshavemettheirdutiesofcare�Earlierthisyear, PowerfulElectoratesAlsoActAndThinkLongTerm?” however,theEuropeanCommission,inaconsultationpaperseeking commentsonoptionstoimprovecorporategovernanceinfinancial Whiletheupheavalprecipitatedbytherecentfinancialcrisishas institutions,suggestedstrengthening“legalliabilityofdirectorsvia notfullysettledandthecontoursofthepost-crisiscorporategov- anexpandeddutyofcare�”Andthepossibilitythathigherstan- ernancelandscapearestillbeingshaped,somecorporategover- dardsofcarecouldeventuallybeimposednotonlyondirectorsof nancepolicieshavebecomefirmlyentrenchedandwillverylikely financialinstitutions,butondirectorsofallcorporations,isreal� continuetoholdsway,whereasothersmaycontinuetodevelop Specializedcommittees,useofexpertconsultants,tutorials,and and/oremergeasparticularlyrelevanttoboardsofdirectors�A expandeddirectoreducationprogramswillgoalongwaytoenable fewthoughtsaboutthefuturecorporategovernanceandboard Timeboards Demandstomeeteven of Boardastrengtheneddutyofcare� Service. functioningofpubliccompaniesaresetoutbelow,althougheach companywillneedtoassessandtailoritspoliciesinviewofits Lookingoutevenfurtherinto individualcircumstances� thefuture,thetimedemandsofboardservicewillresultinmore useofmodernconferencingandcommunicationtechnologyso

thattraveltimeisreduced,committeescanmeetconveniently Thisreviewofthecorporategovernancelandscaperaisessome apartfrommeetingsofthewholeboard,andspecialmeetingswith ultimatequestions:❙❙ outsideconsultantscanbeconvenedwheneverneeded�Indealing withimportantissuesandcrises,companieswillhaveveryfrequent Willwebeabletoattractthequalifieddirectorsweneedinlight specialmeetingsandresortwidelytooutsideexperts� ofthelimitationsontheirabilitytotakeactionsandadoptpoli- ❙❙ ciesthatshareholdersseekingshort-termperformanceobjectto? Asaresultoftheincreasedtimedemandsofboardservice,com- Willthepressureforshort-termperformanceleadtothe“Eclipse binedwithliabilityrisks,potentiallyhigherstandardsofcare,and ofthePublicCorporation,”a1989prognosticationbyfamed theneedforlarger,morediverseboardswithspecialexpertise, ❙❙ HarvardeconomistMichaelJensen? directorrecruitingwillbecomeanincreasinglycriticalchallengefor manycorporations�Therewillbeasignificantincreaseindirector Willthepressureforshort-termperformanceresultinbusiness compensationinordertomeettheincreasedcommitmentoftime decisionsthatsoadverselyaffectstakeholdersandtheeconomy directorswillneedtomakeandtheincreasedthreatoflegalor thatthegovernmentisforcedtobecomeintrusiveinthemanage- reputationaldamagetowhichtheyareexposed� Separation of Chairman and CEO. “ We should recognizementofpubliccorporationsor that tolimitthepowerofshareholders toinfluenceboardsofdirectors? Thisisthe the purpose of corporate onekeygovernancechangethatthegovernance governance must be to Whilethesearereasonableruminations,Ithink activistshavenotyetachieved�Whilesepara- encourage management thattheywillnotcometopass�Instead,compa- tionofchairmanandCEOroleswasultimately niesandtheiradviserswilladjusttotherealityof droppedfromtheDodd-Franklegislation,it and directors to develop thenewgovernanceregimeandtheresponsibili- doesrequiredisclosureofwhethertherolesare policies and procedures tiesofCEOsandboardsofdirectorswillbecome split—somethingtheSEChadalreadyrequired that enable them to best morechallenging�And,hopefully,wewillover companiestodiscussinproxystatements�In timerealizethedrawbacksofconceptualizing lightofthestrongsupportforseparationinthe perform their duties (and corporategovernanceasprimarilyameanstodis- activistgovernancecommunityandtheimplicit meet our expectations)…” ciplinemanagers,toarbitrarilylimitthecompen- endorsementbyCongressandtheSEC,pres- sationofexecutives,andtoprovideconvenient surethroughshareholderproxyresolutionswill waysforinstitutionalandactivistshareholdersto continuetogrow�Itisreasonabletoassumethat dictatecorporatepolicyinordertoachievetheir inaShareholderfewyearsseparationwillbemorewidespread� Control. short-termprofitinterests�Instead,weshouldrecognizethatthe purposeofcorporategovernancemustbetoencouragemanagement Inadditiontoadvisoryshareholdervotingon anddirectorstodeveloppoliciesandproceduresthatenablethem executivecompensation(“sayonpay”)prescribedbytheDodd- tobestperformtheirduties(andmeetourexpectations),whilenot FranklegislationandproxyaccessadoptedbytheSECfollowing puttingtheminastraitjacketthatdampensrisk-takinganddiscour- authorizationbyDodd-Frank,SECrulespermitproxyresolutions agesinvestingforlong-termgrowthandtruevaluecreation�TheSept� designedtoinduceorforcethecompanyto(a)dissolvetakeover 23,2010,reportoftheNYSECommissiononCorporateGovernance defenses,(b)makeiteasierforshareholderstocallspecialshare- recognizestheproblemandstatesthefirstprincipleofgovernanceas holdermeetings,(c)authorizeshareholderstoactbywritten follows:“Theboard’sfundamentalobjectiveshouldbetobuildlong- consentinsteadofashareholdermeetingandconductcampaigns termsustainablegrowthinshareholdervalueforthecorporation…�” toobtainfullcontrol,and(d)enableshareholderstoshapedirector Hopefully,alongwithanascentacademicrecognitionoftheproblem, nominatingproceduresandCEOsuccessionplanning�Togetherwith theNYSEreportpresagesanevolutionthatwillreversetheunfortu- NYSErules,effective2010,thateliminatedbrokerdiscretionary nateconsequencesofthecorporategovernancedevelopmentsofthe votinginuncontestedelections,activistinstitutionalshareholders pastquarter-century� willbemoreabletoheavilyinfluence,ifnotdictate,business actions,policies,andstrategiesatmostmajorpubliccompanies�

About the Author

❙❙ Martin Lipton, a founding partner of Wachtell, Lipton, Rosen & Katz, specializes in advising major corporations on mergers and acquisitions and matters affecting corporate policy and strategy and has written and lectured extensively on these subjects.

“ The boardroom is not riortotheSarbanes-OxleyActof2002(SOX), corporategovernancethatareequallypolitically a place for politics, corporategovernancewasgenerallycon- driven,leadingtowhatIcallthePoliticizationof but rather a place sideredtobeamatterofstatelawandwas CorporateAmerica�Politicizationinthiscontextis largelyaddressedinanapoliticalmannerbystate thereplacingoftheopenmarketplaceofgover- where the interest of legislaturesandcourts�Wehadanopenmarket- nanceideaswiththejudgmentofCongress,which all shareholders must placeofideastryingtoreachconsensusonwhat isinessencereactive,short-termthinking,with be considered rather constitutesgoodgovernance-policiesthatare insufficientappreciationforthecostandunin- consistentwiththerightsofshareholders,yetbest tendedconsequencesoftheregulation�Thereisa than that of a select foreconomicgrowth…withtheshareholdersbeing significantbodyofacademicresearchandopinions few or those with theultimatedeciders�Andithashaditseffects—P regardingthecostsandbenefitsofSOXandno special interest.” wideacceptanceofmajorityvote,declineinpoison generalconsensusoneither�Whatbecameclear pills,increasedresponsivenesstononbinding howeverwasthat,contrarytowhatwasintended, shareholdervotes,andincreasedcommunication SOXsubstantiallyincreasedtheannualauditcosts betweenboardsandshareholders,tonameafew� ofpublicly-tradedcompanies,particularlywith Today,however,thatmarketplaceisbeingreplaced respecttocompliancewithSection404�And,it bypolitics—Congressionaldirectivesthatleadto isclearthatsmallpubliccompaniesweredispro- increasedcost,uncertainty,andunintendedconse- portionatelypenalizedwithregardtothecostof quencesaspoliticianslurchfromideatoideabased compliance,anotherunintendedconsequencethat onthewhimsofagivenconstituency� iscurrentlybeingcorrected�

Withintheopenmarketplaceduringthepast Asidefromthephilosophicissueofwhetheritis twenty-fiveyears,ISShasevolvedasadominant appropriateforthefederalgovernmenttousurp forceinproxyandcorporategovernanceadvis- theroleofthestatesinthisarea,thereisgeneral ing,alongwithGlassLewis,GovernanceMetrics agreementincorporateAmericathatthepolitici- International,TheCorporateLibrary,andseveral zationthatwehaveseensinceSOXhaslong-term others�Furthermore,eachproxyseasonanumber negativeramifications�Eveninareaswhichwere ofactivistinvestorsandself-appointedgovernance traditionallytheprovinceofthefederalgovern- expertssubmitshareholderproposalswithan ment-e�g�,securitiesregulation-weareseeing expectationthattheproxyadvisorswillrecom- Congressgetinvolvedforpoliticalreasons�For mend“for”theirproposals�Inmostcases,man- example,wehaveproxyaccessbecauseCongress agementeitherfightstheproposalsorreachesa authorizedtheSECtomakeithappen�Whether compromisewiththeadvocates�Thishasbeen ornotproxyaccessintheformadoptedisagood anannualritualasboardsofdirectorsstruggleto orbadideaisnottheissue�Whatisatissueis implementbestpractices�Atthesametime,these theunanticipatedconsequences�Itappearsthat boardsmustmakedecisionswithcalculatedrisks Congressisgivingmorepowertospecialinterests believedtobeinthebestinterestsofshareholders� tothedetrimentofshareholdersgenerallyand Thesedirectorsareadiversegroupofindividuals largerinvestorswithgreatereconomicrisk� frombusiness,academe,not-for-profits,andgov- ernment�Theyareelectedbytheshareholders,and Theboardroomisnotaplaceforpolitics,butrather togethertheybringabreadthofexperienceand aplacewheretheinterestofallshareholdersmust provideacriticalbalancetothedecision-making beconsideredratherthanthatofaselectfewor processintheboardroom� thosewithspecialinterest�Itisaplacewhere businessexperienceiscriticalandwheredecisions SincetheenactmentofSOX,alsoknownasthe thatinvolverisksmustbeweighedagainstboththe PublicCompanyAccountingReformandInvestor long-andshort-termbenefitforallshareholdersin ProtectionAct(intheSenate),andCorporateand anunbiased,rationalmannerwiththebestexpert AuditingAccountabilityResponsibilityAct(inthe adviceavailableratherthanpolitics�Unfortunately, House),wehaveseenotherfederallawstargeting unlessthetrendofpoliticallydrivencorporate page 44 | 25for25 © 2011 Institutional Shareholder Services Inc. the next 25 years the next 25 years

“ Unfortunately, unless the trend of politically governanceenactedbyCongressisreversed, driven corporate Americanfreeenterprisewithitsjobsandvalue governance enacted by creationwillbejeopardized� Congress is reversed, Thepasttwenty-fiveyearshaveseenunprecedented American free enterprise changesincorporategovernance�Therehavebeen with its jobs and periodsofgreatprosperityandperiodsofrecession� Wehaveseencorporatecorruptionandgovern- value creation will be mentdysfunction�Andinallofthis,somehowthe jeopardized.” beliefthatgovernmenthastheanswerforcorporate Americaisnotacomfortingthought�Itismybelief thattheopenmarketplaceaswe’veknownitis stillthebesthopeforthecontinuedprosperityof America’sfreeenterprisesystem�

About the Author

❙❙ Bonnie Hill is president of B. Hill Enterprises, a corporate governance consulting firm. She is also co-founder of Icon Blue, a boutique brand-marketing company. Hill has over 36 years of experience in both the private and public sectors and over 19 years of experience as a corporate director.

role of boards of dIreCtors

“ But if governance is verthepast25years,interestincorporate important for firm governancehasgrownsubstantiallyamong Studieshaveexaminedorganizationalstructures performance, then we marketparticipants,policy-makers,and academics�CorporatescandalssuchasEnronand ofboards,suchasboardsize,independence,the need to address a WorldComandthefinancialcrisisof2008areper- electionprocess,meetingattendance,member number of follow-up ceivedtobeatleastpartiallydrivenbyfailuresin expertise,andboardcompensationstructures� Recentlyresearchhasfocusedonboardfunctions questions. For example, corporategovernance�Soundcorporategovernance mechanismscanbemandatedbylegislationsuch andtheirspecificoutcomes�Forexample,studies how do we measure astheSarbanes-OxleyActof2002andtheDodd- findthatalargerproportionofindependentboard good governance? OFranklegislationof2010intheUnitedStates,while membersisassociatedwithhigherfirmvalue, higherturnoverofpoorlyperformingCEOs,and Why does governance inothercountriestheyhavecomeintheformof codesofconduct�Inadditiontomandatedregula- moreresponsiblemanagementcompensationpoli- matter? What aspects tion,thefirmitselfandmarketparticipants,par- cies�Althoughcurrentresearchshowsthatboards of governance matter ticularlyinstitutionalinvestors,playanimportant ofdirectorsplayacriticalroleinthegovernance roleinthegovernancestructureoffirms� offirms,thereisstillmuchanalysisthatneedsto under what institutional bedone�Whatfactorsmakeforaneffectiveboard? settings?” Corporategovernanceresearchhasbeeninterdis- Whatistheimportanceofaboard’scomposition, expertise,andincentivestructureonfirms? ciplinary,usingvaryingperspectivesbycallingon exeCutIve CoMPensatIon scholarsfromseveralfields,includinglaw,economics,finance,accounting,andmanagement,toexam- inetheissues�Inthe1990s,governanceresearch wasdrivenbyscholarsinlawandfinance,and Financialeconomistshavewrittenextensively focusedonvariousaspectsoflegalandinstitutional abouttheimportantroleoftheincentivesafirm featuresatthecountrylevel�Manyinfluentialstud- usestoalignmanagement’sinterestwiththatof ieshaveexaminedthecross-countrydifferences shareholders�Shareholdersandregulatorshave betweencountrieswithdifferentlegalsystems beenoutragedbythefactthatexecutivescontinue andshareholderrights,andhavefoundthatstrong toreceiveexcessivecompensationevenasthe investorprotectionisassociatedwithcountries firmstheymanageteeteredonthebrinkofdisaster� withhighereconomicgrowthandmoredeveloped Regulatorsaroundtheworldhaveeitherimposed financialmarkets�Atthatstageofresearch,we orareconsideringimposingrestrictionsonexecu- knewverylittleaboutgovernanceatthefirmlevel� tivecompensation�Academicresearchhasledto However,inthelast10years,academicresearch majorchangesincorporatecompensationprac- hascloselyexaminednotonlytheeffectofgover- ticesinthepast�Scholarsarecurrentlyexamining nancemandatedbyacountry’srulesandregula- issuesrelatedtoclawbackprovisionsand“sayon tions,butalsothegovernancemechanismsthat pay”inmanagement’sdecisionmaking�Therecent firmshaveadoptedvoluntarily� financialcrisishashighlightedtheneedforfurther the IMPortanCe of CorPorate researchondesigningcompensationstructures governanCe thatwillalignmanagementcompensationwithsus- tainablelong-termfirmperformance� role of shareholders

Ittookafewyearsforacademiatoestablishthat corporategovernancedoesmatterforfirmsand Severalstudieshavedocumentedthestrong markets�Researchershavefoundthatcorporate connectionbetweeninstitutionalownershipand governanceisrelatedtofirmperformance,access corporategovernance�Morerecently,myownwork tocapital,costofcapital,andotheraspectsofafirm hasfoundthatanincreaseininstitutionalowner- thatimpactvalue�Butifgovernanceisimportant shipisassociatedwithanincreaseincorporate forfirmperformance,thenweneedtoaddressa governance�Wealsoshowthatinstitutionsare numberoffollow-upquestions�Forexample,how takingtheirfiduciaryroleseriously;moreand dowemeasuregoodgovernance?Whydoesgover- moreoftentheyareexercisingtheirrighttovote nancematter?Whataspectsofgovernancematter ratherthansimplyexitingfromtheinvestment� page 46 | 25for25 underwhatinstitutionalsettings? © 2011 Institutional Shareholder Services Inc. The NexT 25 Years The NexT 25 Years

“Theapproachto evaluatinggovernance New types of institutional investors, such as private local, industry, institutional, and other differences. hasmostlytakenaone- equity firms, hedge funds, and sovereign wealth Future research must address what combination of size-fits-allapproach, funds, have emerged and their roles have become governance mechanisms is important for particular the subject of academic studies. Scholars in law types of firms. This research will be important for whichisnotthemost and finance are looking into concerns about the policy-making and will move us away from the one- effectivepracticeto so-called “empty voting” that some market partici- size-fits-all approach to regulation. Global iN NaTure follow.Thereshould pants accomplish by using derivatives and using the securities lending market. Although regulators besomediversityin have given shareholders more rights, some market governancepractices participants are concerned that certain types of Financial markets are global in scope; firms have acrossfirms,andboth shareholders will use the new rights only for their the option to raise capital in different countries and own short-term benefit. Researchers still need to investors can make investments anywhere in the regulatorsandresearchers do much more to guide the policy debate on the world. Capital seekers and capital providers export musttakeintoaccount extent to which shareholders should be given addi- governance from one country to another. Academic thedifferencesin tional rights. The key questions in this area are to research has reported a convergence in governance what extent should shareholders delegate powers standards across countries. There are “best prac- managerialand to the board, and when is direct shareholder activ- tices” in governance that apply for most large firms, institutionalstructures.” ism needed? Will shareholders use the given rights and these policies have led to the development for their own short-term gains? What can we learn of codes of good governance. Research, including from the differences in voting rights and proxy mine, indicates that the market rewards firms for voting mechanisms in different countries? investing in good governance. It is only natural that The oNe-size-FiTs-all approaCh governance research be global in nature, and that it To GoverNaNCe should have both a macro and a micro focus. FuTure oF CorporaTe GoverNaNCe researCh The approach to evaluating governance has mostly taken a one-size-fits-all approach, which is not the most effective practice to follow. There should The financial crisis has clearly proven that we are be some diversity in governance practices across far from aligning the interests of investors, manag- firms, and both regulators and researchers must ers, directors, corporations, and society. We have take into account the differences in managerial and yet to achieve consensus on what is good gover- institutional structures. nance, how to measure it, how to achieve it, and what is the outcome of good governance. Research Initially, academic studies used an equally weighted in corporate governance has made great progress, index of several governance attributes as a proxy and our understanding of governance mechanisms for good governance. But certainly the same index and their impact has improved considerably. But is not appropriate for all types of firms around the the fact is that the research is still in its infancy. I world. Academics are aware of this shortcoming, believe that academic research will continue to play but there is little theoretical guidance toward an an important role in examining governance issues “optimal” model of corporate governance. in a comprehensive, rigorous, and unbiased manner. Our analysis will help guide policy-makers and drive One of the more challenging areas in corporate market practices, resulting in strong global financial governance research is to increase understanding markets that can be trusted by the public. of the optimal governance practices that allow for

About the Author

❙❙ Reena Aggarwal is the Robert E. McDonough Professor of Business Administration and Professor of Finance at Georgetown University.

By Tim Smith and Carly Greenberg Corporate Commitment to Sustainability and CSR Reporting: An Enduring Trend

“ The majority of nthelast25yearstherehavebeencountless, stimulatingnewlegislationandfutureregula- S&P 500 companies notablechangesingovernancepoliciesand tions�CompaniesthatarecommittedtoCSRare now publicly declare practicesbycorporations�Thesechanges likelybetterequippedtofacesuchchallenges�For mirrorashiftinthinkingandbehaviorbycompa- example,acompanythatisalreadymonitoringand their commitment to niesandinvestorswherebothattitudesandactual settinggoalstoreduceitscarbonemissionswillbe act as responsible behaviorhavechangeddramaticallysince1985� aheadofthecrowdwhencarbonpricingbecomes corporations and do theregulatorynorm� Oneremarkablechangeforbothinvestorsand some sort of CSR or companieshasbeentherapidlyexpandingsupport And,asweknow“whatismeasuredismanaged�” sustainability forIcorporatesocialresponsibility(CSR)leadership, AcommitmenttoCSRreportingcanhelpdecrease reporting.” aswellassustainabilityreporting� acompany’sgeneralbusinessrisks�Amanagement committedtoindepthreportingwillknowwhich ThemajorityofS&P500companiesnowpublicly ESGoperationsneedimprovementandtakethe declaretheircommitmenttoactasresponsiblecor- necessarymeasurestodoso,reducingpossible porationsanddosomesortofCSRorsustainability liability�Conversely,ignoringtheserisksenhances reporting�Similarly,thereisasurgeofcommitment thepossibilitythatacompanywillfaceanESG byglobalinvestorswhointegrateEnvironmental, relatedlegalorregulatoryrisk� Social,andGovernance(ESG)issuesintotheinvest- avoId rePutatIonal rIsk and mentprocessandsupportmeaningfultranspar- buIld PublIC trust encyandbusinessleadershipinCSR�

TheexpansionofcompanyCSRworkandreport- Inlightoftherecenteconomicmeltdown,public ingisglobalandgrowing�In2008,theconsulting trustinbusinesshassubstantiallydeclined�The groupKPMGreportedthat79percentofthelargest 2009EdelmanTrustBarometerreportedthat 250globalcompaniesproduceCSRreports�Overall Americantrustincorporationsdeclinedfrom58 supportforthistrendisgrowinginallindustries percentin2008to38percentin2009�Trustisa andcountries,whilethelevelofimportanceplaced crucialfactorforfuturelong-termbusinessprosper- onCSRdependsonthecompany’sindividual ityconsideringmanyconsumersmakepurchasing industryandgeographiclocation�AnewAccenture decisionsbasedontheirperceptionofcompany studytitled,“ANewEraofSustainability:UNGlobal trustworthiness�AccordingtoAccenture,“in2008, Compact-AccentureCEOStudy2010,”showsthat 91percentofconsumerssaidtheyhadboughta companiesinvolvedintheAutomotive,Banking, productorservicefromacompanytheytrusted, Mining,Energy,andUtilitiesindustriesseesustain- whereas77percenthadrefusedtobuyaproduct abilityissuesasveryimportantcomparedtocom- orservicefromadistrustedcompany�”Accenture paniesinthecommunicationsandITfields� alsostatesthat“sustainabilityhaslongbeenviewed asoneofmanyelementsincompanies’strategies ThebusinesscaseforCSRleadershipandsustain- tobuildtheirmarketreputation�”Acommitment abilityismultifaceted�Somecompellingpointsare toCSRreportingcanhelpprovetostakeholders summarizedbelow� deCrease regulatory and andconsumersthatacompanyisaccountableand lItIgatIon rIsks trustworthy�TheDell2009CorporateResponsibility Reporthighlightsthisstating,“duringtimeslike these,wemustcontinuetobuildtrustwithcustom- ersandstakeholdersbydemonstratingourpositive Thebusinessworldischanging�“Allcompaniesface impactonsocietyandtheplanetanddeveloping adirectimpactfromdecreasingnaturalresources, meaningfulmeasuresforreportingourprogress�” risingpopulations,anddisruptionfromclimate oPPortunItIes to reduCe Costs change�Andwhatmaybeasubtleeffectnowwill and enhanCe revenue onlybecomemoreintenseoverthenextfivetoten years,”accordingtoMarkParker,CEOofNike�

Meanwhile,theseglobalchallengesarealready Manycompanieshavealreadyfoundmultipleways page 48 | 25for25 tocutoperationalcostsutilizingtheirsustainability© 2011 Institutional Shareholder Services Inc. the next 25 years the next 25 years

programsasaguide�Forexample,Applereducedpackagingfor ThenumberofinvestorsanddollarsthatpubliclysupportthePRI theircomputers�Thisinitiativeenabledthemtofitmoreproducts principlesisgrowingatarapidrate�RecentlysupportforthePRI intoacargoholdandreducewaste,transportation,andfuelcostsby grewfrom362signatoriesand$14�778trillionin2008to785 usingfewershipmentcarrierswhilestillshippingthesamenumber signatoriesandapproximately$20trillionin2010�Assupportfor ofcomputers�Othercompanieshavebeenabletosavecostsby PRIanditsprinciplesgrow,itwillbeadvantageousforcompanies exploringnewmaterialsfortheirproducts,improvingenergyeffi- toimprovetheirsustainabilityinitiativesandtransparency�Itis ciencyatfacilities,andbyenhancingworkforcesafetyprograms� alsonotablethatmanymainstreamfinancialinstitutionssuchas GoldmanSachsandJPMorgancurrentlyacknowledgetheimpor- LeadershipinCSRcanalsoimproveacompany’sefficiency,produc- tanceofESGtoinvestments� tivity,competitiveedge,long-termsurvival,andabilitytoattract labor,investors,andconsumers�CSRReportingalsohelpscompa- Moreandmorecompaniesareurgingtheirsupplierstomeethigh niesbetterintegrateandgainstrategicvaluefromexistingsustain- standardsinESG�Supply-chainguidelinesoftenincluderequiring abilityefforts,andidentifygapsandopportunitiestoenhancetheir supplierstomeetspecifiedenvironmental,social,andgovernance revenueintheiroperations� “ The number of investorsperformancelevelsorstronglyencouragingthem and topublishaCSR report�Asthistrenddevelops,itislikelythat Thenumberofcompaniesthatprovidesus- dollars that publicly support manycompanieswillbegintofacepressure tainabilityreportingisincreasing�Therefore, the PRI principles is growing todoCSRreportingfromtheircorporate ifacompanydoesnotdoCSRreporting,itis at a rapid rate.” customers� highlylikelythatitscompetitorsareandthatit islaggingbehinditspeers� Insummary,oneoftheremarkablechangesin advantages In reCruItIng labor thelastquartercenturyhasbeentheconsider- ablegrowthofcommitmentbycorporationstoCSRandsustainabil- ityreporting�Therearemanyreasonsforcompaniestomoveinthis AcompanythatunderstandsCSRissuesanddisclosesitssafety direction,butthebottomlineisthatitisgoodforbusiness� practices,non-discriminationpolicy,workerbenefits,etc�,willbe seenasagoodemployerandbebetterabletocompetefortop Here“Ourare approachsomequotes has createdfromcorporate value notleaders only forthat our illustratestakeholdersthis andview: talentinitsindustry�Interestingly,sustainabilityisalsoalready society, but also for Intel” becominganimportantconcernforprospectiveworkers�A EuropeanbankingCEOtoldAccenturethat,“asurveyofgraduates seekingemploymentintwoofthecompany’skeymarketscitedper- “It is our view that successful—PaulS�Otellini,PresidentandCEOofIntel companies are those that see busi- formanceonsustainabilityissuesasthemostimportantfactorin ness objectives and sustainability objectives as interlinked” helpingthemchooseapotentialemployer�”Additionally,companies withappreciativeemployeeshavelessemployeeturnoverandcan savenew-hiretrainingcosts� —ExxonMobil’s2009CorporateCitizenshipReport advantages In beIng resPonsIve to “We also know that the successful companies of the 21st century will be those that understand global sustainability issues and offer esg Investors viable solutions.”

AccordingtothePrinciplesforResponsibleInvestment(PRI),“there “Good things happen—AlanMulally,PresidentandCEOof when we integrate sustainability intoFord ourMotor isincreasingevidencethatESGissuescanbematerialtoperfor- products, services and solutions. We improve our competitiveness manceofportfolios,particularlyoverthelongterm�”Increasedsav- and create and capture customer value. We save money, reduce ingsandprofitderivedfromcorporatesustainabilitywillobviously our environmental impact and improve employee satisfaction. resultinbettershareholderreturns�Moreover,forthelong-term investor,acompanywithaforward-lookingviewonmanagingsus- tainabilityissuesisencouraging� —JimOwens,ChairmanandCEOofCaterpillar

About the Author

❙❙ Tim Smith is a senior vice president at Walden Asset Management, and Carly Greenberg is a Walden summer associate and a student at Brandeis University.

An Interview with Nell Minow A Look Ahead at the Next 25 Years in Governance

Over the past 25 years, there’s been a significant “ Board composition is shift in how institutional investors have handled their responsibilities as shareholders, and how aslongastheexecutivescontrolwhoisonthe what matters, and boards have exercised their oversight over board�Ithinkboardcompositioniswhatmatters, that will include the executives. Do you expect that these trends will andthatwillincludetheabilityofshareholdersto votedirectorsofftheboardthroughmajorityvote ability of shareholders continue over the next 25 years, or will the pace of these trends become more gradual? Withrequirementsand the arrival ofproxy “sayaccess� on pay” votes as a to vote directors off marketwide requirement in the United States, the board through do you expect any meaningful changes on how majority vote companies compensate their executives, or will Thepacehasbeenaccelerating,andIthinkitwill the pay-setting process continue to be driven by requirements and continuetoaccelerate�Astheupheavalsofthefirstst executives and management-hired consultants, proxy access.” decadeofthe21 centuryhaveshown,govern- with investors and board members largely play- mentsarereallyatalosswhenitcomestoimpos- ing a passive or reactive role? inganykindofaccountabilityoncorporateexecu- tives,anditreallyisincreasinglyclearthatit’sleft totheshareholders�Asitbecomeseasierandmore routineforshareholdersaroundtheworldtobein Theonlywaytoaddressexecutivecompensation touchwitheachotherontheseissues,thepacewill istogetridofcompensationcommitteemembers Docontinue you expecttoaccelerate� to see a growing convergence whodoitbadly�EverytimeIgetinterviewedabout in governance standards across international executivecompensation,whichisacoupleoftimes markets? “Say on pay” is one example where that aweek,andacoupleoftimesadayduringproxy appears to be happening. season,Ialwaysaskthejournalist:Couldyou pleaseputthenamesofthecompensationcommit- teemembersinthestory?I’vebeenveryunsuc- cessfulinthat,butI’mgoingtokeepitup,andI It’shardtosayrightnowwhetherit’sgoingtobe thinkitisgoingtochange�Ithinkthatyouhave a“racetothebottom”ora“racetothetop�”But tomakeitverypersonal�You’vegottogetridof certainly,theemergingeconomiesarewatching compensationcommitteememberswhodoitbadly� carefullysothattheydon’trepeatthemistakesof Ithink“sayonpay”isnice,butthat’stheonlything theestablishedeconomies�AndIthinkit’sreally Dothat’sreallygoing you expect thatto retailbemeaningful� investors will play a goingtobeacost-of-capitalissue,andthatwhoever greater role in shaping corporate governance hasthebestgovernancesystemisgoingtohavethe over the next 25 years or will most of them con- lowestcostofcapital�Sotherewillbesomeconver- tinue to be passive or just support management Overgence, thebut nextthere 25will years,besome whatcompetition types of governanceaswell� most of the time? issues do you expect to be the most significant points of contention between investors and issuers? Will the most contentious issues relate to board independence, shareholder nominations Ithinkretailinvestorsasagrouparegoingto to the board, takeover defenses, or executive shrink,butIthinktheirinfluenceisgoingtogrow� compensation. Afewretailinvestorshavebeenscaredoffbythe volatilityofthemarkets,andwhocanblamethem? Iwouldnevertellsomebodyasanindividualtobe astockpickerunlesstheyarereallygoodandmake Iwouldlisttheminthisorder:boardcomposition, ittheirfulltimejob�WhatIoftensayisyou’renot No�1;executivecompensation,No�2;andevery- goingtoplaybasketballagainstMichaelJordanfor thingelse,No�3�Inthat“everythingelse”category, money�They’rebettingthattheycandobetterthan inadditiontotheitemsthatyoulisted,Iwould theprofessionals� includepoliticalcontributions� However,Ithinkthatthoseinvestorswhoarevitally Idon’tusethetermboardindependence,becauseI engagedenoughtobestockpickersandwhoarenot don’tbelieveinwhatIcall“resumeindependence�” justdaytraders,butwhomakeameaningfulcom- page 50 | 25for25 Ithinkthatthereisnosuchthingasindependence mitment,willtakeadvantage© 2011of Institutionaltheopportunities Shareholder Services Inc. the next 25 years the next 25 years

thatareavailableonYahoomessageboardsandMotleyFool�comto I’mabigfanofthe“complyorexplain”approach,whichimposes becomemoreactivelyinvolved�Ithinkthattherearealotoflarge minimumstandardsandencouragesparticularityandinnovation� institutionalinvestorsouttherewhowillfollow�Theywon’tbelead- Iadvocatethatweestablishabasesetofstandardswithstrong Doers, youbut expecttheywill anfollow increaseanoutspoken in retail shareholderactivist� activism? incentivestoexceeditinamannerthatisappropriateonacom- pany-by-companybasis�

Privateorderingisnotenoughcurrentlybecauseoftheinadequacy Idothinkthattherewillbe�IlookatMotleyFool,whichspeaks ofshareholderpowers�Delawarelawallowsforprivateorderingof toretailinvestors,and,retailstock-pickinginvestors,andthey’re proxyaccess,andyetnotonecompanyhasadopteditbecauseit’s verysophisticatedabouttheseissues,andIthinkthatpeople“ The onlywho way tomore addresstheoretical thanreal�Atthesametime,thereareacademicsout followthemandwhorelyonthemwillbecome there,andIpresumelawyersinprivatepractice, moreinvolved�Andtherearealsogroupslike executive compensation is whoarealreadycirculatingmemossayinghere MoxyVote�comandtheShareholdersEducation to get rid of compensation arethewaystocircumvent[theSEC’s]proxy Networkthatwillmakeiteasierforindividual committee members who access[rule]�Theyusetermslike“circumvent” investorswhodon’twanttobeactivetoatleast and“thwart,”whichareobstructive�Whydon’t bemoreintelligentandthoughtfulabouttheway do it badly.” theycirculatememossayinghere’sthewaytoget Whiletheyvote the� prospects for new governance legislation appear themostoutofit?Italwaysstrikesmeasabsurd unlikely after the Republican takeover over of the U.S. House, thattheverysamecompaniesthattalkaboutthe what governance issues should be addressed by federal legisla- purityofthemarketplacedon’twanttosubmittheirdirectorstoa tion over the next 25 years? Besidesmarkettest, the orlongtheir listcorporate of Dodd-Frank-relatedgovernancepolicies rulemakingstoamarket thattest are� underway, are there any other investor production issues that you think the SEC should be addressing?

Ithinkwewillseesomeincreasingstepsawayfromfederalism� Proxyaccessisagoodexample,andIexpectproxyaccesstobe upheld,orifitisdismissedontechnicalgrounds,itcanberein- Ithinkthey’vegotaveryfullplateforrightnow,solet’sseehow statedeasily�IthinkthatDelawarewillplaylessofarole,andmore thoseshakeout�Forme,theNo�1priorityforshareholdersshould Areofcorporategovernancewillbeamatteroffederal there certain governance issues that should belaw left� to private bemajorityvoting[inboardelections]�Ithinkit’sreallyimportant ordering, such as independent board chairs, or should the gov- thatshareholdersthrowsomedirectorsout,andIthinkthatwill ernment or take a greater role in mandating certain minimum haveasalutatoryaffectoneverybodyelse� standards?

About the Author

❙❙ Nell Minow is a co-founder of The Corporate Library. Minow also was one of the founders of ISS and served as president of the company. She also served as a principal at LENS Investment Management.

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