U.S. Corporate Governance Today: A Reshaping of Capitalism

This post is by Peter Atkins of Skadden, Arps, Slate, Meagher & Flom LLP.

One way to sum up the “big picture” of corporate governance in the U.S. today is as follows:

We are in the midst of a true revolution in our private enterprise economic system, much of which is being driven in the name of “corporate governance” by multiple parties with an ever-expanding agenda.

This may sound like one of those deliberately extreme statements sometimes designed to stimulate debate—but I offer it simply as a description of where things are. In fact:

• The roster of participants in the U.S. corporate governance arena today is extraordinarily large and diverse, the collective agenda of these participants is very broad, and the level of dedication of these various participants to achieving their agendas is quite high.

• The common purpose or effect of their efforts is to redesign in significant ways the publicly traded business corporation, a central instrument of U.S. capitalism.

• This redesign involves sources of capital, the role of risk-taking, the fundamental purpose of business corporations and the role of directors.

The bottom line reality is that today’s corporate governance reform movement is reshaping materially our private enterprise economic system. Moreover, inadequate attention is being paid to assessing the scope and magnitude of the changes — and the risks they present to our economy. This inattention needs to be corrected promptly, before the law of unintended consequences produces considerable harm to our economic system in the name of “corporate governance.”

Participants in the Corporate Governance Universe Today

There is no question that the ranks of the participants in the corporate governance dialogue have been steadily expanding over the past decade, and as a result of the recent financial crisis and global recession, this has significantly accelerated in the past year or so. These participants now include: (1) the SEC; (2) the NYSE and Nasdaq; (3) shareholder governance activists; (4) hedge funds/other shareholders with shortterm or special economic interests; (5) public pension funds and other institutional investors; (6) corporate governance rating services; (7) proxy advisory firms; (8) academics in various disciplines; (9) labor unions; (10) the President/White House; (11) Congress; (12) the Treasury Department; (13) the Federal Reserve System; (14) the Federal Deposit Insurance Corporation; (15) the Department of Justice; (16) state Attorneys General; (17) the media; and (18) state corporate law (legislatures and courts).

Each of these parties or groups has become an active voice of corporate governance “reform.” The growth of this universe is a clear testament to the dramatically increased visibility and importance ascribed to “corporate governance” in today’s world.

The Breadth of Corporate Governance Issues Today

The ascendancy of corporate governance is further underscored by the breadth of the issues now wrapped in the mantle of this elastic concept. Current corporate governance issues fall into at least the following important categories:

The role of the federal government, including (1) providing government funding and support; (2) government influence on board composition; (3) government influence on senior executives; and (4) government intervention in areas of board decision-making

Board/shareholder “balance of power,” including (1) “shareholder access” — the right of shareholders to nominate directly in a company’s proxy statement alternate director candidates; (2) majority voting in the election of directors; (3) elimination of broker discretionary votes in uncontested elections; (4) elimination of classified boards; (5) requiring cumulative voting; (6) granting shareholders the right to call special meetings; (7) separating board chair and CEO positions and requiring the chair to be independent; (8) additional disclosure about directors, including (a) their experience, qualifications, attributes and skills, (b) public company directorships held during the past five years, and (c) litigation involvement during the past 10 years; and (9) requiring disclosure about a company’s board leadership structure and why it is appropriate for the company.

Executive compensation, including (1) “say on pay” shareholder proposals; (2) requiring independent compensation consultants; (3) requiring companies to develop and disclose “claw-back” policies; (4) barring severance agreements for executives terminated for poor performance; (5) requiring proxy disclosure of specific performance targets for incentive compensation; (6) requiring shareholder approval of pay above a prescribed multiple (e.g.,100x, as provided in one Senate bill) of what the average company employee is paid; (7) requiring expanded compensation-related proxy disclosure, including regarding compensation paid to lowest and highest paid employees, average to all employees, number of employees paid more than prescribed multiple (e.g., 100x) of average employee compensation and total compensation paid to employees paid more than prescribed multiple; (8) making “excessive compensation” non-deductible for federal income tax purposes (e.g., pay above 100x average compensation to company employees, as provided in one Senate bill); (9) requiring “excessive compensation” reports to be filed with the Treasury Department; (10) providing additional requirements with respect to compensation committees regarding (a) enhanced independence standards, (b) direct responsibility for hiring, paying and overseeing compensation consultants, (c) authority to hire and pay outside counsel and advisors, and (d) independence standards to be applied to compensation consultants and outside counsel; (11) requiring discussion and analysis of risk-related overall compensation policies and practices for employees generally, if the risks arising from those policies and practices “may have” a material affect on the company; (12) limiting payouts to families of executives who die in office; and (13) requiring that executive equity awards be held until retirement.

Risk management, including (1) requiring creation of a board risk committee; (2) disclosing the relationship of a company’s overall compensation practices to risk management; and (3) disclosing the board’s role in the company’s risk-management process and the effects, if any, that risk management has on the company’s board leadership structure.

Social responsibility/sustainability, including (1) global warming disclosure; (2) political contributions and/or policies reporting; (3) environmental-related disclosure; and (4) sustainability reporting.

Each of these current corporate governance issues no doubt is a legitimate subject for debate. However, in framing that debate, it is critical to not lose sight of the totality of the picture — the cumulative impact of the corporate governance movement today and going forward.

Capitalism vs. Current Corporate Governance

To some significant extent both the categories of corporate governance reform being pursued today and the issues within each category are on a collision course with basic underpinnings of our private enterprise economic system. This system — capitalism, for short — historically has had a number of key underpinnings, including:

Private capital: Reliance on private equity and debt capital— including importantly through private capital-funded public companies — versus governmental ownership and funding is a basic tenet of our free enterprise economy.

Private risk-taking: Equally important is minimal government participation in the basic function of the capitalist system — assessing opportunities to invest in new and existing businesses and weighing associated risks.

Creation of shareholder value: Another central feature of capitalism is recognition that the fundamental role of business corporations —whether publicly traded or privately owned — is to create value for the owners, the shareholders, who drive economic activity by putting their money at risk in reliance on this basic commitment.

Role of directors of publicly traded companies: Publicly traded companies expected and willing to risk the pooled investment capital they represent are essential to maintaining a strong and growing U.S. economy. The key means of achieving this is to assure that boards of directors of publicly traded companies are free to make informed, independent and disinterested decisions as they oversee the business and affairs of their companies.

The U.S. corporate governance movement today is directly challenging each of these underpinnings. Among other examples, this is manifested as follows:

On the private capital front, with the financial system recently on the brink of collapse — stemming from what is widely characterized to have involved a fundamental failure of corporate governance in the risk oversight and compensation areas—billions of federal government dollars have been poured into direct equity ownership and loans to/credit support of major U.S. financial services companies, as well as into an effort to rescue the U.S. auto industry.

On the private risk-taking front, the federal government — through its recent role as major shareholder and creditor of financial services and other companies, and through the heightened focus of the President/White House, Congress and various administrative agencies — has initiated various efforts to regulate and dampen risk-taking in the business world. These efforts have included (1) pressuring changes to the composition of corporate boards; (2) pressuring (or requiring) changes in senior management; (3) proposing expansion of regulation of hedge funds and derivatives trading; (4) proposing federal statutory requirements for the structure of and disclosure by public company boards relating to risk oversight; and (5) proposing limitations on, and greater disclosure of, compensation arrangements perceived as contributing to excessive risk-taking.

On the creation of shareholder value front, the corporate governance movement continues to seek to expand the perceived role of private sector-owned business corporations — and in the process is expanding the model for making “business decisions” from consideration of core shareholder value-oriented factors to inclusion of social responsibility and sustainability issues. The stealth issue is “sustainability” — a developing corporate governance concept that perhaps lacks widespread awareness but has the potential to become the most significant change agent in terms of how the role and responsibility of U.S. business corporations are defined. In its broadest terms, corporate sustainability would have companies take into account in making business decisions protecting and/or enhancing over the long term not only the economic capital of the entity but, as well, the natural environment and resources of the planet and societal values.

On the role of directors of publicly traded companies front, the corporate governance movement is producing a clear and significant erosion in the relative power of the board vis-à-vis shareholders of U.S. public companies. This shift in the balance of power is partly due to the effect of an array of “governance reforms” that have been pushed hard in the past few years and which are currently high on the priority list for, or have already resulted in, implementing action (through shareholder proposals and/or governmental initiatives (legislative and rulemaking)). Among these governance reforms are shareholder access, majority voting for directors, eliminating classified boards, barring broker discretionary votes in uncontested director elections, separating the board chair and CEO positions, granting shareholders the right to call special meetings and increasing intrusion into the areas of director qualifications and board leadership structure.

Perhaps of greatest significance in terms of the role of public company directors is the changing nature of the director election process, especially the prospect of its politicization and use to promote special agendas. This is due particularly to the combination of (1) majority voting for the election of directors (implemented by many companies already; possibly to be legislatively mandated for all public companies); (2) the elimination of broker discretionary votes in uncontested elections (recently implemented by the NYSE with the SEC’s approval); (3) fewer and fewer classified boards, resulting in all company directors being elected annually (implemented by many companies already; possibly to be legislatively mandated for all public companies); (4) the likely advent of an SEC or federal legislatively mandated proxy access rule; and (5) the resulting ability of shareholder proponents of almost any issue that is not supported by a board to threaten or proceed to turn it into a “recalcitrant director/board” issue when board-sponsored directors are proposed for election at the next annual meeting.

The power shift also is being influenced by efforts to limit board judgment in key areas—most notably, at the moment, regarding executive compensation, including through proposed prescriptive legislation (e.g., requiring shareholder approval of defined “excessive compensation” and making it non-deductible), precatory shareholder votes (e.g., “say on pay”) and additional compensation-related public disclosure (e.g., relating to “excessive compensation” and “claw-back” policies).

A Note of Caution

As the foregoing indicates, the corporate governance movement in the U.S. has reached a point where it is causing real changes in our private enterprise economic system. This appears to be occurring without an open and critical assessment of the scope and magnitude of the changes — and of the risks they pose to the system.

The lack of sufficient focus on the downside is understandable. “Corporate governance” is a phrase that is being used today like “motherhood” and “apple pie” — that is, if something is a matter of “corporate governance,” it must be good. There seems to be an almost automatic stigma associated with challenging issues characterized as “matters of corporate governance” or involving “corporate governance reform.” This general phenomenon has been dramatically reinforced by the recent near collapse of our financial system and the severe economic recession the U.S. has experienced over the past year and a half — which, in a highly visible, highly charged way, have caused the finger of blame to be pointed at corporate America. In this environment, it is not surprising that many people choose to not openly challenge “corporate governance reform” or raise questions about the effects of and risks associated with it.

Yet, at this important juncture, it is critical that those questions be raised and fully vetted. Some reshaping of U.S. capitalism may be necessary, but this should not occur without a full understanding and weighing of consequences. The danger we face is that we lose perspective on the value of what we have had for a long time — an economic system which, over time, has been the most vibrant and competitive in the world. To be sure, it has stumbled on occasion. However, each time it has had the strength and resiliency to recover and move forward.

Recent times reflect a major — and scary — stumble, and appropriately highlight the need for governmental scrutiny. However, that scrutiny needs to be tempered by the long-term perspective and the principle of restraint which that perspective dictates.

The very essence of capitalism is that it fosters risk-taking — and that “mistakes” will be made. The objective of reform should not be simply to eliminate risk. Rather it should be to assess where risk is truly systemically unacceptable — such as, perhaps, in the unregulated world of derivative securities — and needs to be mitigated. Where the line should be drawn often is not clear. But what is clear is that overreaction, however understandable, is dangerous. In this regard, for example, the plethora of corporate reform legislation recently introduced at the federal level reflects this overreaction mentality and should be thoroughly reassessed in light of the long-term perspective and principle of restraint noted above.

What is equally clear is that we are well into the danger zone when it comes to the governance pressure being imposed on directors of public companies. While it may not be the popular mythology, I believe that most directors of public companies these days do take their jobs seriously and try to act in the best interests of shareholders and, where appropriate, other constituencies. The job is getting more difficult and the need for quality independent directors is ever-increasing. Boardbashing and imposing specific limits on how directors can exercise honest business judgment — particularly in the executive compensation area that is a key tool for boards as they oversee their companies’ businesses — are not conducive to improving the availability of quality directors. Moreover, turning the board election process into annual threatened or actual “vote no” campaigns against directors based on special agendas promoted by special interest groups will further disincentivize quality directors from serving — as well as adversely influence the independent director decision-making so avidly sought by corporate governance advocates.

The grass is not always greener elsewhere. And it is possible to kill the economy that over time has laid the golden egg. Whatever other mistakes may have been made, we should be exceedingly careful to not make that one under the auspices of corporate governance reform.

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  1. dan boxer
    Posted Wednesday, July 29, 2009 at 8:57 pm | Permalink

    This is an very insightful analysis, although I do think the concept of the non-monoithic shareholder has a role in the discussion

  2. Peter Salmon
    Posted Friday, October 2, 2009 at 2:35 am | Permalink

    Very helpful and a useful checklist of issues

    I will, if you do not object take the liberty of referencing you in a soon to be published blog post