Raising the Bar: Re-Establishing Director Credibility

This post is based on a Skadden, Arps, Slate, Meagher & Flom LLP client memorandum by Mr. Atkins.

This article highlights that publicly traded business corporations and their directors have lost the confidence and trust of many, leading to an onslaught of proposed federal legislation which, if enacted, will catapult the federal government into the role of primary regulator of those companies and directors, which heretofore have been regulated under state law. This article further suggests that to stem this tide of federal intervention in an area central to our private enterprise system, U.S. public company directors must act promptly in a concerted, clear and convincing way to restore their credibility. Finally, this article proposes a program for doing so, premised on those directors voluntarily embracing a set of “Basic Principles of Director Oversight” publicly reflecting focused and real commitment by the directors to comprehensive, high-quality board oversight of corporate affairs.

The Current Environment

The financial crisis of 2008-2009 appears to have been largely overcome and the economic abyss it threatened has been averted. In its wake, however, is another quite serious threat. This threat is the product of a combination of circumstances: the psychological trauma of the financial crisis, severe real damage to the economic well-being and prospects of many Americans, a painful recession marked by massive job losses and unemployment, and, ultimately, an overwhelming need to lay blame. The target of this blame for many is American Capitalism — our private enterprise system — and, in particular, those with the responsibility for overseeing it, the boards of directors of the public companies which drive the system.

The charge against directors is strident and indiscriminate — that they have failed to fulfill their responsibility to protect their companies, their shareholders and their country. In particular, that they have missed — or worse, condoned — massive financial risk. And that they have permitted, indeed encouraged, overpayment of senior corporate executives and others and, in so doing, exacerbated out-of-control systemic risk.

Accusers seem to be everywhere — in the White House, in Congress, among financial and other regulators, among state attorneys general, in traditional print and electronic media, on Internet blogs, in the ranks of organized labor, in academia, among investors and on Main Streets across the country.

Loss of confidence and demands for more government regulation and intervention are a natural response to these types of situations — and this one is no exception. The call for “reform” seems to be everywhere, often wrapped in words of outrage against and mistrust of Corporate America and the directors who oversee it. And, in response, actions are being proposed on the legislative and regulatory fronts which would, if implemented, make sweeping changes in the role of the federal government in our economic system.

Of course, students of history might say that this is all just a case of déjà vu and suggest that this cyclical repetition represents no threat at all. They could point to other examples in this country’s history, including to the broad federal legislative response to the Great Depression and, more recently, to the enactment of Sarbanes-Oxley in response to the “Enron Era.” And they could note, with some truth, that America survived the “excess” of federal legislation and government intervention in the economy each time, just like it survived the debacles which gave rise to the legislation and intervention.

However, we should find no comfort in this benign view of history or the lessons some might take from it. I and many others are genuinely concerned that the direction in which the federal government is heading in terms of involvement in the business of doing business is far too intrusive.

But that concern, however deeply and broadly shared and articulated, will not alone change anything. There is a convergence of power and purpose in Washington, supported by many voices around the country reflecting a loss of confidence in the private sector and those who oversee it. Bemoaning lack of confidence or trust, or the consequences which may flow from it, is not enough. What is needed is a re-establishment of confidence and trust.

The Perception of State Law Deficiency

To accomplish this requires a clear understanding of the problem. In this regard, a primary source of discontent with our current system is the perceived laxity of a central feature of state corporate law — the business judgment rule — in imposing meaningful responsibility on corporate directors. The business judgment rule was developed as a key mechanism for permitting informed, disinterested and rational decision-making (particularly risk-taking decisions) by directors on behalf of equity investors, without those directors being inhibited by constant fear of being second-guessed if and when decisions turn out less well than expected — and in some cases quite badly. Such a rule provides seemingly sensible, indeed necessary, protection in a system which relies on attracting private citizens to serve as corporate directors and oversee the management of the multiplicity of business corporations which fuel our economy.

However, the benefit of this important protection is being undermined by a growing sentiment that it promotes lack of accountability which, in turn, leads to poor oversight, excessive risk-taking and self-protectionism. Various state court decisions in areas such as executive compensation (Disney), risk oversight (Citigroup) and corporate governance (Axcelis) are cited as examples of the fallout of an overly protective and insufficiently demanding standard of conduct imposed on directors under state law.

Washington “To the Rescue”

As matters stand today, a wave of reactive proposed legislation has been introduced in Washington. None squarely proposes to abolish the business judgment rule. But the premise of this legislation is that the federal government must intercede in the traditionally state-governed area of oversight of business corporations because the current system is not working adequately. In short, directors are being accused of not doing their jobs because they are not held to a high enough standard of conduct under state corporate law, and the federal government must come to the rescue.

At the moment, the proposed federal legislative “fixes” aim at:

  • greater empowerment of shareholders vis-à-vis directors (e.g., mandatory majority voting in the election of directors, eliminating classified boards, requiring shareholder access to company proxy statements in the election of directors, granting shareholders the right to call special meetings, requiring cumulative voting and mandating annual “say on pay” votes by shareholders);
  • increased public disclosure about directors (e.g., regarding their experience, qualifications, attributes and skills), about pay practices (e.g., disclosure of specific performance targets for incentive compensation, and disclosure regarding compensation paid to the lowest and highest paid employees and related matters) and about risk-taking (e.g., 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 effect on the company, and disclosing the relationship of a company’s overall compensation practices to risk management);
  • mandating certain board structural requirements (e.g., that every board have a risk committee, and that every board separate the board chair and CEO positions, and that the chair be independent); and
  • mandating certain specific pay practices (e.g., barring severance agreements for executives terminated for poor performance, requiring that executives hold equity awards until retirement, and requiring companies to develop and disclose claw-back policies).

Once this bridge is crossed — once Washington intercedes so directly and broadly in the regulation of state chartered business corporations — there is no place to draw the line. It is entirely possible that the business judgment rule, and other important elements of corporate governance, will end up on the legislative chopping block in Washington. The checks and balances of federalism will no longer operate to prevent this.

A (Difficult) Path Forward

Some clearly would applaud this outcome. I would not — but that is beside the point. The real point is: Do enough people see this as a significant danger to our economic system (and to our political system of pluralism supported by respect for states’ rights absent demonstrable and substantial systemic risk) that they are prepared to counteract the Washington tide — and, if so, how can this be done in a timely and effective way?

I offer the following suggestion as to “how.” I believe the answer lies in the willingness and ability of public company directors across the country to unite in common commitment to a set of voluntary principles of conduct which demonstrate that vigilant, independent and honest oversight can be counted on as the driving forces of Corporate America.

The genesis of this suggestion lies in a comment by Chancellor Chandler in the Citigroup decision. The chancellor observed that “…director liability is not measured [under Delaware law] by the aspirational standard established by the internal documents detailing a company’s oversight system.” The question it provoked is whether a set of principles could be developed for director conduct which would be higher than the standard of fiduciary duty (and potential liability for breach) attaching under state corporate law, and judged sufficiently meaningful and credible to warrant acceptance by current critics of director conduct and persuade Washington to stand down.

Not an easy task, I suspect, as a matter of substance, timing or persuasion. However, it seems one worth exploring as a means of upgrading the perception (and perhaps the reality in some cases) of board conduct without proceeding down the current path of federal government intervention.

Critical Elements

For any program of this nature to work, it would need at least the following critical elements:

  • A set of Basic Principles of Director Oversight (Basic Principles) which reflect focused and real commitment to comprehensive board oversight of corporate affairs, including self-evaluation of compliance to reinforce quality oversight and support credibility.
  • A means of galvanizing broad and demonstrable support for the program among U.S. public company directors.
  • A mechanism for communicating that support to Washington and other constituencies promptly to, at minimum, slow down the federal legislative freight train now on the track effectively to preempt state corporate law.

Some Thoughts About Basic Principles

The Basic Principles should mandate that a board will be committed to identify and publicly disclose all key areas which it determines are appropriate for board oversight. Among the key areas of oversight expected to generally be identified are: (1) financial systems, controls and reporting; (2) disclosure controls and reporting; (3) operations of material business segments; (4) identifying and understanding material risks inherent in and taken by the company, and evaluating the efficacy of the company’s risk-management programs; (5) evaluating key management strengths, weaknesses and performance; (6) establishing and monitoring compensation policies and practices; (7) succession planning; (8) nominating and governance policies and practices; (9) health, safety and environmental policies and practices; (10) tax policies and practices; (11) diversity policies and practices; (12) asset protection policies and practices; (13) public/governmental affairs policies and practices; (14) privacy/data protection policies and practices; (15) corporate sustainability and reporting; and (16) other material company specific areas appropriate for board level oversight (e.g., technology-related matters in a technology driven company).

The Basic Principles should mandate that a board identify, implement and disclose a responsible framework for performing quality board oversight. This framework would be expected to include, among other things: (1) in all cases a majority of, and in many cases exclusively, independent, disinterested directors performing the oversight function; (2) identification of desired/required director experience and skills for the particular oversight area; (3) use of outside advisors/consultants/specialists at the sole discretion of the board or committee performing the oversight function; (4) direct interaction with and support from appropriate company personnel; and (5) in some cases, attendance of directors at educational seminars/programs to obtain or enhance relevant knowledge.

The Basic Principles should mandate that a board will invite and evaluate commentary from its company’s shareholders and employees as to (1) possible additional areas that should be the subject of board oversight and (2) possible improvements to the board’s framework for performing quality oversight.

The Basic Principles should mandate that a board will evaluate annually whether it has fully satisfied each of the foregoing mandates, and report its findings publicly.

And finally, the Basic Principles should mandate that a board go on record that it will, and expects each and every other company person to, act at all times honestly, with integrity and in compliance with law.

A simple and straightforward set of principles such as those set forth above represents a clear commitment to responsible oversight in a very public way. It will expose publicly the key areas of oversight as perceived by the board (and if shareholders or employees see it as too limiting, they will have a voice) as well as the directors’ definition of a responsible framework for quality oversight (again subject to comment by shareholders and employees). By voluntarily subscribing to these principles, a board will be putting itself publicly on the line with all constituencies that its commitment is, to the best of its ability, to oversee the business and affairs of its company thoughtfully, carefully, comprehensively and proactively, and to send a clear message that such business and affairs are to be conducted legally and ethically. Having done so, directors are likely to be highly motivated not to fall short of their public commitment — even while voluntarily accepting a higher standard of conduct than may be imposed as a matter of fiduciary duty under state law.

Some Thoughts About Process

The program outlined above represents a positive initiative for those who oversee our private enterprise system to seek to regain credibility at a critical time. No doubt it has some flaws. But perfection is not the goal. An actionable plan is. And time is of the essence. A key ingredient for success is developing widespread support for the initiative and channeling it into effective communication on the Washington legislative front and to other important audiences. Existing director organizations may have a role in implementing this initiative; however, a grass roots response from independent boards across the full geographic and business spectrum of U.S. public companies may well have a more potent impact. In addition, broader support than just from public company directors may well be available (e.g., from state governors and other officials, members of the U.S. Senate and House of Representatives, various investor groups and even shareholder activists which may see the affirmative commitment imbedded in the Basic Principles as a better step forward than federal legislative fiat). This support should be marshaled as well.

A Final Thought

The private enterprise system is central to America’s strength and vitality. It should not be tampered with lightly. I believe that a commitment to responsible stewardship of this system by the key group responsible for overseeing it — the directors of U.S. public companies — should be given a chance. As a risk assessment matter, the risk that they will not keep that commitment is exceedingly small. On the other hand, the risk of harm to our system, intended and unintended, from Washington continuing on its current path of preemption of state corporate law is quite real. Taking that risk even without the program outlined above, and clearly with that program, is simply not a responsible act.

Peter Atkins is a partner for corporate and securities law matters at Skadden, Arps, Slate, Meagher & Flom LLP.

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One Comment

  1. JGP
    Posted Friday, November 13, 2009 at 11:38 am | Permalink

    Mr. Atkins is struggling too hard to save a failed public company governance model.

    Federalization is a necessary step in flushing a long history of abuse and looting of share owner wealth by agents protected from accountability by Delaware and other states.

    The only principle worth discussing is board accountability – in all respects – to the share owners. Anything less is a manipulation of ownership rights.