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I. Corporate governance is a matter of money. It is about value. While many of us have long urged this proposition, it has required the experience of several years and scores of initiatives before meaningful conclusions could be drawn by fiduciaries and those who advise them. This is the year in which explicit, public and authoritative recognition of the quantifiable value of corporate governance has been achieved. Wilshire Associates concluded their analysis of the cost/benefit implications of CalPERS' 42 shareholder proposals from 1988 through 1991 (Rewards from Corporate Governance , 1/12/92, Stephen L. Nesbitt): "Shareholder proposals initiated by large pension funds produce excess returns to stocks of targeted companies. This supports the notion that actions taken to enhance management accountability to directors or shareholders increase shareholder value."
Wilshire estimated as much as $136.5 million in net gains attributable to shareholder proposals sponsored by the California Public Employees' Retirement System. And one of the study's most important conclusions is that proxy proposals do not have to win to have an impact. Wilshire notes that "even when proposals fail (to get a majority vote) shareholder value may be enhanced if investors believe management 'got the message' and subsequently will act on their own."
An important paper by John Pound and Lilli Gordon of The Gordon Group demonstrates that companies with more restrictive corporate governance structures are significantly less likely to exhibit outstanding long-term performance relative to their industry peers than firms with less restrictive governance structures. Therefore, efforts to remove restrictive structures can add value.
II. Effective governance in the form of focused monitoring also adds value. A company that has an effective monitoring shareholder is worth more than a company without one. A study by Stern Stewart shows that the mere disclosure of Warren Buffett's plans to purchase shares in a company sends its stock price up, for a total of $622.4 million so far, just from the announcement of his involvement. One reason, of course, is his record as a stock-picker; it's just follow-the-leader. But another reason, and one I would argue is even more important, is his record of influencing management to improve performance.
Even though we can't expect immediate appreciation in the market for non-Buffett monitors, the data strongly points to long-term gains.
This means:
Certain ownership rights, including proxy votes, are literally "worth money." Failure to vote a proxy correctly is as much a violation of fiduciary duty as failure to cash a dividend check.
A fiduciary is obligated to evaluate all options to determine which fit this category, and then to vote prudently, diligently, and for the exclusive benefit of the beneficiaries. It will no longer be possible to ignore conflicts of interest without penalty, whether the challenge comes from government or from the beneficiaries themselves. (Sears case)
In recent years, it has become increasingly popular to create very large employee ownership through ESOPs (often leveraged) with trustees routinely voting the shares in support of management. This cannot continue, in the face of (i) demonstrable value for an anti-management vote; and (ii) the capacity for participants to use derivative litigation.
III. There is good news and bad news from the SEC. The good news is that they are considering reforms to the proxy system. The bad news is that the first very modest effort had the Business Roundtable screaming like Chicken Little that the sky was falling. Three years ago, the California Public Employees' Retirement System and the United Shareholders Association submitted comprehensive, thoughtful suggestions for reform of a proxy system based on technology and shareholder composition that were decades out of date. After years of considering these comments and hundreds of others, the SEC proposed four minor changes. SEC Chairman Richard Breedon described the record-breaking flood of comments as "the second coming." Ultimately, the SEC decided to repropose, adding a year at least to the process.
But there may be some more good news. The Securities & Exchange Commission has announced plans to take significant steps to make it possible for shareholders to respond to a corporate governance issue that has gone from the business pages to the front pages--executive compensation. The proposals for clear disclosure and allowing shareholder resolutions on the structure and criteria for compensation are most encouraging.
I don't want to sound overly cynical, but I can't help contrasting the snail's pace of proxy reform with the fast track on compensation. I suspect that the concatenation of an election year, the emergence of Graef Crystal as a culture hero capable of stupendous performance on national television, the proposal of legislation by Senator Cohen, hearings by Senator Levin and the President's overpaid Tokyo travelling mates are more of the reason than a thoughtful and sustained support for effective shareholder involvement. The prospect of legislation has a marvelous focusing effect on the minds of civil servants.
IV. The BRT--The Empire Strikes Back. Perhaps the most discouraging development to report is the continuing intransigence of The Business Roundtable and the according polarity in the governance field. I have already mentioned the astonishing shrillness of the response to the SEC's proxy reform proposal, labeled at one point "a disinformation campaign" by the United Shareholders Association for its repeated mischaracterization of the impact of the proposals, despite strong objections by SEC Chairman Breedon.
But BRT's new paper on executive compensation may be a new low in oppositional doublespeak. The paper presupposes that there is no problem relating to executive compensation; that is the point --everyone (and one can expand that to everyone in the world after the President's trip to Tokyo) -- everyone except the BRT knows that there is a problem, that it is serious, and that it relates directly to this country's lack of competitiveness. Even the business press, hardly a mouthpiece for socialism, uses terms like "obscene" and "out of control."
Not according to the BRT. After paying lip service to the concept of pay for performance, the BRT's paper cheerfully concludes that "Very clear avenues of recourse are available to shareholders who are dissatisfied with the performance of their board of directors in matters of executive compensation...." (page 4).
Let's linger briefly on the BRT's suggested "steps available to shareholders who are dissatisfied with the board's administration of salary.." (page 6):
"First, dissatisfied shareholders may open a dialogue with corporate management to discuss their concerns." This sounds a little like a sentence from Alice in Wonderland. Are we all living in the same world? Can you imagine a CEO who would permit, much less welcome "open dialogue" on the subject of his pay?
Did you notice last spring what happened when CalPERS "opened a dialogue" with ITT about Rand Araskog's pay? PERS dropped their resolution authorizing a Shareholder Advisory Committee when ITT agreed to consult with them on appropriate subjects. Almost before their plane got back to Sacramento, PERS learned of the eight figure compensation for Araskog. Their further attempts at "open dilaogue" had no effect. What did have an effect was a visit from "60 Minutes," but you don't notice that as one of the options in the BRT paper.
"Second, if not satisfied with management's response, shareholders may communicate directly with the board of directors." Again, I wonder what world the BRT inhabits. I am unaware of any company that encourages or even permits its directors to meet with shareholders. When Texaco agreed to add to their board an individual suggested in a list prepared by institutional investors, the person they picked from the list was former Congressman and NYU President John Brademas. After his selection, the investors requested an appointment with him. He turned them down. From that day to this no conversation has taken place -- company counsel have taken the position that it is inappropriate for an individual director to meet with particular shareholders. The board operates only as a board, an individual director has no personal significance, his status derives entirely from being a part of the collective board. So much for talking to the board.
"Third, in the event that shareholders are dissatisfied with the board's response, their next recourse is to withhold votes from the board of directors at the annual meeting." In the first place, this accomplishes very little. Even if 99 percent of the shareholders cast "withhold" votes, the director still gets elected. So much for level three of an exercise in futility.
But what is really disingenuous here is that the BRT loves to advocate this kind of shareholder "recourse" while they are doing everything they can to prevent shareholders from having any meaningful system for communicating with each other about these issues. So, sure, withhold your vote, but just don't discuss it with anyone.
"If the first three steps of recourse fail, the fourth step is to mount and/or vote for an alternative slate to replace some or all of the board of directors. Studies have indicated that this step, when taken, has been very successful." Well, this is a subject on which I have made studies; indeed, you might say that my candidacy for election to the Sears' board in 1991 is possibly the only example of an individual contest for election where control was not an issue. Thus, in this micro world, I am the expert. Again, I can only tell you that the BRT either is misinformed or chooses to ignore the simple truth.
These arguments are so patently inadequate that they suggest only one conclusion -- the BRT is so confident of its capacity to intervene in the rule making and legislative process to preserve the present market place inefficiencies that entrench management that it does not even bother to cobble together so much as a "colorable claim." On an encouraging note, the recent report by the National Association of Corporate Directors concluded that the BRT is moving away from its own constituency. Its survey showed that CEOs were far more moderate on most of these issues than the BRT party line.
V. Public recognition "that actions taken to enhance management accountability to directors or shareholders increase shareholder value" is creating a climate of new perceptions. A compensation system out of control is just a symptom of a governance system that is out of control. A proper compensation system, part of a proper governance system, assures that managements prosper as shareholders prosper. There should, therefore, be joint recognition that value-adding conduct is in both of their interests. The emphasis should turn to developing a more independent system of checks and balances -- referred to by some scholars as a state of "creative tension" -- between owners and officers. And the best way to do that is by improving the board.
These ideas are reflected in the "New Compact Between Owners and Directors" developed by "The Working Group on Corporate Governance," an ad hoc group of eight lawyers who represent corporate officers and institutional shareholders. Their compact specifies board (and shareholder) responsibilities. It says first that the outside directors are responsible for evaluating the CEO. Second, it provides that the outside directors should meet alone at least once a year. Finally, the compact establishes the role of the board in finding new directors. It says that directors should establish qualifications for board members and that they should communicate those qualifications to shareholders. The directors (not the CEO) should screen candidates.
The "Compact" also provides that shareholder evaluate directors. There is a lot of interest in making room for better directors by getting rid of some who are not doing so well. The working group that produced the compact is now talking about developing a source for good independent director candidates, as the institutional investors in Great Britain have done. This is similar to the widely circulated proposal by law professors Ronald J. Gilson and Reinier Kraakman suggesting that institutional investors create "a market for independent directors" by "recruiting a class of outside directors to actively monitor public corporations, much as LBO sponsors or universal banks in Japan and Germany actively monitor their own companies." In Britain, the institutional investors have underwritten a firm that has been very successful in finding independent directors for British companies. In this regard it is noteworthy that NACD study concluded that 72 percent of CEOs believe that shareholders should have the opportunity to nominate board candidates. I would be remiss not to say that this certainly does not represent the prevailing attitude of The Business Roundtable, but it is noteworthy that a broader constituency of companies expresses a more ecumenical viewpoint.
Similarly, Marty Lipton's memo to clients advocates: direct contact by the CEO with the larger institutional holders on a regular basis, prompt substantive response to institutional shareholder communications, more comprehensive presentations to boards with respect to business strategy, documented justification for retaining management when the corporation does not perform up to peer standards, compensation keyed to long-term performance, attitude of partnership, rather than confrontation .
VI. Where does that leave us?
The question is still unanswered as to whether there is a real constituency for corporate governance. The so-called successes of governance have been in creating awareness, a climate of consciousness of ownership. There are owners, they do follow what is happening, they can act, they are a majority. And yet action is limited to "cosmetics." Even the recent initiative on executive compensation by the SEC faltered by requiring all shareholder proposals on the subject to be advisory only.
When you talk about something real like a by-law change or some other mandatory restraint, reality asserts itself. We are learning from the compensation area that the key to SEC action is the threat of legislation in the Congress. Thus, we derive some hope from the continuing viability of the bills introduced by Senators Levin and Cohen.
Senator Cohen's bill (S 2030) mandates confidential voting. Let me assure you that this is an absolute essential to effective corporate governance. No institutional fiduciary is going to commit commercial suicide; if there is any chance at all that a customer can find out about an adverse vote, there will be no adverse votes. In addition, the bill provides for the direct nomination by shareholders of candidates for the board. This is the only way to insure the possibility of genuinely independent directors.
VII. Where am I? For purposes of this proxy season, I am still in the maws of the SEC.
On February 20, the Secretary of Sears Roebuck received my nomination for election to its Board of Directors. This year, at least the nominating committee hired a "head hunter" to find out who I am before rejecting me. And, this year, the company has graciously undertaken to make available a shareholder list for me. Much else, however, remains the same -- the SEC still has not produced a form of ballot that permits me to solicit votes competitively, I still cannot talk with institutions prior to management's circulation of its proxy, the employee benefit plan trustees can continue to vote all the shares for management, and notwithstanding a pending suit, refuse to communicate with beneficiaries as to how they have voted. Nor, will I know until receiving management's proxy which shareholder resolutions are required to be included. This may give you some idea as to how far we have to go if the objective is to have meaningful participation by shareholders in corporate governance.
LENS The LENS Fund focuses on value. It gives institutional investors the opportunity to focus on specific underperforming companies, companies in which the investor already has a substantial portfolio investment. The LENS Fund allows investors to leverage the investments they already have, by purchasing an additional block of the outstanding shares. That block, combined with LENS investors' other holdings, allows shareholders to realize substantial values by making it possible for them to provide effective monitoring. Investors in the LENS Fund can achieve superior profit with low risk by influencing the direction of underperforming portfolio companies.
Like the Exxon proposal, the LENS fund is designed to surmount the barriers imposed by the collective choice problem, and to permit effective -- and cost-effective -- shareholder involvement.