Corporate Governance: The Role and Responsibilities of Boards of Directors, Lecture notes of Business

Download Corporate Governance: The Role and Responsibilities of Boards of Directors and more Lecture notes Business in PDF only on Docsity! NY1:\1015488\03\LRK003!.DOC\99990.1013 1427 THE BUSINESS LAWYER Section of Business Law • American Bar Association University of Maryland School of Law The Professional Board Ira M. Millstein August 1995 • Volume 50 • Number 4 The Professional Board 1429 NY1:\1015488\03\LRK003!.DOC\99990.1013 Through this lens, directorship is no longer an honorarium. It is a major responsibility, which requires the service of professionals. THE BOARD’S EXPANDING ROLE In the past three years, a number of high-profile U.S. boards have adopted a more independent and active approach to governance responsibilities as they attempt to revitalize the corporations they serve. Numerous factors have played a role in this “activation” including, among other things: (i) undeniable and apparent performance deficiencies; (ii) prodding from institutional shareholders (primarily large public pension funds); (iii) evolving judicial interpretations of directors’ duties; (iv) pressures emanating from the corporate takeovers of the 1980s; (v) the need to “re-invent” the corporate enterprise to meet newly emerging global competition efficiently; and (vi) directors’ concern for their own reputations. Remarkably, the actual reordering of boardroom processes to improve directors’ abilities to monitor management and corporate performance has been self-made by boards, without government intervention. This reordering is the first sign of professionalism–directors developing for themselves the standards to live by. Admittedly, many boards that are now active became so in response to serious performance crises. For boards to become more involved at earlier stages, so that in the future red flags and danger signals are detected before a crisis occurs, requires a fundamental change in the status quo in which management tends to dominate the board agenda and the flow of information. That fundamental change is now in process. In the spring of 1994, the General Motors (GM) board issued guidelines setting forth procedures designed to ensure active monitoring of management by an independent board.3 That act, by a board itself, in the right place at the right time, seemed to legitimize change in the boardroom. The GM guidelines have been widely praised, and the California Public Employees Retirement Sys- tem has prodded other boards to consider guidelines adapted to their respective enterprises.4 In the past year alone, the National Association of Corporate Directors (NACD), the Conference Board, and the Business Law Section of the American Bar Association have published treatises on 3. See Robert Simison, GM Board Adopts Formal Guidelines on Stronger Control Over Management, WALL ST . J., Mar. 28, 1994, at A4. 4. Sixty-five percent of 1000 directors from the largest U.S. public corporations recently surveyed by Korn/Ferry International reported that their boards adopted formal written guidelines. KORN/FERRY INTERNATIONAL, 22ND ANNUAL BOARD OF DIRECTORS STUDY 24 (1995) (on file with The Business Lawyer, University of Maryland School of Law) [hereinafter KORN/FERRY SURVEY]. See Judith H. Dobrzynski, A Quiet Board Room Revolution: Power Shifts to Outside Directors, N.Y. TIMES, May 25, 1995, at DI (reporting the results found in the Korn/Ferry survey). 1430 The Business Lawyer; Vol. 50, August 1995 various aspects of corporate governance that, if followed, would significantly improve the board’s ability and motivation to monitor performance.5 Indeed, boardroom change is going international as evidenced by the documents outlining “best practices” for boards that have been published in Canada (the Toronto Stock Exchange),6 the United Kingdom (the Cadbury Committee),7 and Australia (the Bosch Committee).8 It seems reasonable to assume that the European continent will not be too far behind.9 While company-specific guidelines and more general codes of “best practices” properly leave with management the authority to conduct the day-to- day affairs of the corporation, they nonetheless express a change in the balance of corporate power and an extension of board powers into “grey areas” of authority that were long management’s de facto province. Consider the following relatively simple changes addressed in various board guidelines that shift the balance of authority between management and the board: 5. BLUE RIBBON COMMISSION, NATIONAL ASSOCIATION OF CORPORATE DIRECTORS, PERFORMANCE EVALUATION OF CHIEF EXECUTIVE OFFICERS, BOARDS AND DIRECTORS (1994) [hereinafter COMMISSION ON PERFORMANCE EVALUATION]; COMMITTEE ON CORPORATE LAWS, AMERICAN BAR ASSOCIATION, CORPORATE DIRECTOR’S GUIDEBOOK (2d ed. 1994), THE CONFERENCE BOARD, CORPORATE BOARDS: IMPROVING AND EVALUATING PERFORMANCE (1994). 6. TORONTO STOCK EXCHANGE COMMITTEE ON CORPORATE GOVERNANCE IN CANADA, WHERE WERE THE DIRECTORS?: GUIDELINES FOR IMPROVED CORPORATE GOVERNANCE IN CANADA (Dec. 1994) (on file with The Business Lawyer, University of Maryland School of Law) [hereinafter TORONTO GUIDELINES]. 7. COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE, REPORT OF THE COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE (Dec. 1992) (on file with The Business Lawyer, University of Maryland School of Law) [hereinafter CADBURY COMMITTEE REPORT ]. 8. THE BOSCH COMMITTEE, CORPORATE PRACTICES AND CONDUCT (2d ed. 1993) (on file with The Business Lawyer, University of Maryland School of Law). 9. In February 1995, the Organization for Economic Cooperation and Development (OECD) sponsored an international conference in Paris which focused on corporate governance issues. It resulted in a directive issued by the OECD ministers stating that corporate governance should be part of the OECD’s agenda. Meeting of the OECD Counsel at the Ministerial Level, OECD Press Release, May 24, 1995, at 5. “Ministers invite the OECD to ... examine the significance, direction and means of reform in regulatory regimes, and undertake exploratory work on corporate governance. . . .” Id. Additionally, the Center for Strategic & International Studies, a think tank that has focused for years on geopolitics and strategy, is now turning to comparative corporate governance issues. Letter from John Yochelson, Center for Strategic & International Studies, to John Nash, National Association of Corporate Directors (May 19, 1995) (on file with The Business Lawyer, University of Maryland School of Law). Corporate governance reform is penetrating academia in Germany as well. This summer, a group of German think tanks, including the Drager Institute, in conjunction with the University of Chicago Law School, hosted a conference entitled Corporate Governance: Structural Reforms in the American and German Corporation Law (June 30–July 1, 1995, Heidelberg, Germany). The Professional Board 1431 NY1:\1015488\03\LRK003!.DOC\99990.1013 (i) separation of the chairman and CEO, or at least the selection– formally or informally–by the board of a “lead director”;10 (ii) board control over the process of nominating and retaining independent directors;11 and, (iii) evaluation of CEO performance by outside directors in meetings solely of outside directors.12 Each one of these changes increases the board’s independence from the CEO as the board positions itself to gain more information about the corporation and its performance, so that it can identify and understand the early warning signals of “trouble ahead.” In defining the scope of board involvement in corporate decision-making, however, a careful line needs to be drawn between board and management responsibility. It is management which must provide both the leadership and creative force in the corporation. This implicates a major element of board professionalism, understanding and defining the limits of the board’s role. Lawyers, for example, understand that in most circumstances they render advice, and that taking or leaving that advice is the client’s role. The limit is when the lawyer’s professional responsibilities require him or her to act when the advice is ignored. The factors in determining the parameters of the board’s role are these: Does the board have access to the same information on performance as management, and does the board have the knowledge of the business to use that information better than, or as well as, management? Will the board take the time, and is it feasible for the board to take the time, to seek out and study the information necessary for informed decision-making? Will board involvement in a particular matter improve overall corporate performance, taking into consideration any relevant costs including the cost of management becoming unnecessarily risk-averse or otherwise unable to react quickly and decisively to certain crises? Take as a starting example “major policy decisions,” which virtually all texts agree are within the board’s province to “review,” “oversee,” “ap- prove,” or even, ultimately, to make. Information is critical to the exercise of judgment as to “major” policy decisions which, depending on the corporation and the circumstances, can include: (i) strategic plans, (ii) financial priorities, (iii) buying or selling a business, (iv) a tender offer for the company, (v) a leveraged buyout or management buyout, (vi) a major labor or commercial issue or dispute, and (vii) management succession. The 10. The separation of the chairman and the CEO reflects the CEO’s loss of domination over the board and recognition that the CEO is accountable to the board as an independent entity. 11. When directors become the board’s choice, rather than management’s choice, board members address each other as peer group members not beholden to the CEO. 12. A separate meeting of outside directors alone changes the dynamics of the CEO/board relationship. 1434 The Business Lawyer; Vol. 50, August 1995 and management interaction. Typically, strategic plans are developed by senior management in the divisions, further developed by the CEO’s staff and then the CEO, approved by the board, and carried out by senior management at the CEO’s direction. Different CEOs vary this mechanism for plan evolution, but, in the end, the CEO and management have the primary responsibility for articulating strategy: they have the greatest knowledge of the firm and its competitive environment, and they must ultimately execute the plan. In contrast, beyond asking questions and approving or disapproving management’s proposal, the role of the board as to strategy is ill-defined.15 There is growing boardroom interest in assuming a more active role in the strategic planning process.16 If the board is independently to consider the merits of management’s strategic and business plans, including the probability of realizing its components, then board committees or individual board members should, at the least, understand the necessary elements of the strategic planning process and consider whether they have been properly accounted for in the plan. While obviously the necessary elements will vary for individual corporations, generically they are likely to include the following: (i) who are the existing and potential rivals; (ii) what are the enterprise’s external environmental factors (economic, social, and political); and (iii) what are the internal characteristics of the organization (goals, assets, liabilities, and structure)?17 These are the broad elements from which a strategic plan emerges, and a board can inquire into these elements to satisfy itself that management is proposing a well-considered course of action. Any board performing its responsibilities ought to be well-aware of those elements in any event. The board also might, at the same time, identify the benchmarks that would inform it of the plan’s progress after a plan is ultimately approved. The board’s involvement in strategic planning, whether aimed at simply understanding and approving the proposal set out by management or aimed at more active participation in devising the plan, may be most ef- fective if it involves director interaction with a broader range of managers than just the CEO in the early stages of plan formulation. But the board must keep in mind the limits: the board cannot write the plan. To do so would be to reduce management’s responsibility for carrying out a plan 15. See, e.g., Gordon Donaldson, A New Tool for Boards: The Strategic Audit, HARV. BUS. REV., July-Aug. 1995, at 99; John Pound, Corporate Governance Affects Corporate Strategy , CORP. BOARD, July-Aug. 1994, at 1; C. Gopinath et al., Changing Role of the Board of Directors: In Search of a New Strategic Identity?, 30 MID-ATLANTIC J. BUS. 175 (1994); Chancellor William T. Allen, Redefining the Role of Outside Directors in an Age of Global Competition, Address at the Ray Garrett Jr. Corporate and Securities Law Institute, Northwestern University (Apr. 30, 1992). While strategic planning seems to be more of a developed science, it is suspected that the elements of board involvement in mission development are similarly fuzzy. 16. See id. 17. SHARON OSTER, MODERN COMPETITIVE ANALYSIS 5 (2d ed. 1994). The Professional Board 1435 NY1:\1015488\03\LRK003!.DOC\99990.1013 that is the board’s and not its own. Again, this requires professionalism and understanding the limits of the profession. MONITORING MANAGEMENT PERFORMANCE AGAINST THE STRATEGIC PLAN The board’s monitoring function has been overwhelmingly process- oriented and focused on management presentations, in monthly board meetings, of the current income statement and balance sheet. This information is, in form and content, largely identical to that presented in the annual report. Frequently, the information available to the director is no more current and insightful than that available to stock analysts. Even with extrapolating to future trends, such presentations may not accurately predict problems. Historical and purely financial performance measures may not provide sufficiently sensitive tools for the board to monitor the strategic plan. If the board is accurately to evaluate management and corporate performance beyond the level of a stock analyst, it needs sharper tools. There is, however, a paucity of academic or other work on just what those tools should be and how the board can obtain them, if they exist. Some tools for measuring plan performance seem obvious and readily available. If the plan calls for doubling the production of nuts and bolts, count nuts and bolts; if the plan calls for increasing market share, measure market share; if the plan calls for “becoming global,” define the term and measure the elements. As to such measurable performance elements, the board needs to itemize them, obtain the relevant information regularly, and then evaluate performance. But the board cannot rely solely on a rear view mirror: it needs some way to attempt to judge not simply how management has done and how it is doing, but equally important, how management is going to do, and whether management has positioned itself for what may be coming. Failing to care about the future can be disastrous. Measuring the ability of assets and management to produce future wealth requires increasing sophistication. As recognized in the 1992 report of the Council on Competitiveness, a corporation’s future resides in, among other things, its: (i) current activities, (ii) stock of scientific and technical knowledge, (iii) skill base, (iv) reputation with various consti- tuencies, and (v) market position. 18 Boards might endeavor to obtain reg- ular information about such non-financial indicia, if they are somehow quantifiable. The Subcouncil on Corporate Governance of the U.S. Government’s Competitive Policy Council echoed this need for a more systematic development of qualitative indicators of corporate performance, 18. COUNCIL ON COMPETITIVENESS, CAPITAL CHOICES: CHANGING WAY AMERICA INVESTS IN INDUSTRY 84 (1992). 1436 The Business Lawyer; Vol. 50, August 1995 including quality of products, customer satisfaction, employee training, and strategic planning. 19 As a recent Conference Board study indicates, some companies already rely on qualitative future value indicators such as: (i) quality of output, (ii) customer satisfaction and retention, (iii) employee turnover and training, (iv) R&D investments and productivity, (v) new product development, (vi) market growth, and (vii) environmental compliance.20 Each board can determine what types of qualitative information are relevant to the future of that particular corporation. It is unlikely that one list will fit all. Some of the items mentioned supra may be irrelevant or non- quantifiable, others useful. But the board’s quest for qualitative indicators of future performance should be a useful exercise in and of itself. There is “harder” information available that might be useful to a board in discerning the enterprise’s future. Production rates, inventories, and shipments indicate the current status of the company; orders, buyer inventories, and forecasts of industry sales allow the board to anticipate changes. Such data can be supplemented by ongoing forecasts of costs and prices, leading to current evaluations of future returns on investments, division by division. The board can indeed go so far as to put itself in the place of an entity investing in the corporation by undertaking an updated present value cash flow analysis of the mainstream operations. All of this is a long way of explaining that there may be information, both within and outside the corporation, that could help the board anticipate whether management has positioned itself for the future, whether future operations will meet, or fall short of, plan, and whether the plan is currently viable or needs revamping. This is one professional way of going about the board’s business of monitoring management performance. There are surely others for boards to consider. ALIGNING COMPENSATION OF BOARDS, MANAGERS AND EMPLOYEES Market economies are based on the assumption that most individuals act in their economic self-interest. An important issue for the board to address is how to align the self-interests of managers, directors, and employees with the interests of shareholders. Certainly the board can develop strategy as to executive compensation to a greater extent than is found in current practice. To do so, however, 19. SUBCOUNCIL ON CORPORATE GOVERNANCE AND FINANCIAL MARKETS, COMPETITIVENESS POLICY COUNCIL, THE WILL TO ACT 19-24 (Dec. 7, 1992) (on file with The Business Lawyer, University of Maryland School of Law). 20. Carolyn K. Brancato, Performance Measurement to Capture and Enhance Corporate Success, CONF. BOARD 1995, at 13-21 (draft for comment). The Professional Board 1439 NY1:\1015488\03\LRK003!.DOC\99990.1013 sation has lead to a number of recent shareholder resolutions challenging director benefits – pensions, charitable contributions, life and health insurance – as having little or no connection to the director’s individual performance, while being perceived as creating inappropriate incentives to support the status quo.27 How directors address the compensation issue implicates their credibility with shareholders. Directors are in the unusual position of determining their own compensation. It is for this reason that the NACD Commission suggested full disclosure to shareholders of the components of directors’ compensation including disclosure of the rationale supporting these components.28 Disclosure usually provides a valuable “check and balance.” The SEC has indicated in a July 1995 agency release that it is reviewing the NACD Commission Report to determine whether additional disclosure requirements are appropriate.29 The release contains a proposal aimed at making director compensation information more accessible to shareholders.30 Pay-for-performance compensation systems can possibly be extended throughout the corporation, from the boardroom to the factory floor. Doing so pushes authority, responsibility, risk and reward, all attributes of ownership, upward and downward, to directors, managers, and employees alike. It is an approach that emphasizes the importance of the individual’s contribution to the company’s performance, while creating incentives for every corporate actor to contribute to the overall wealth of the enterprise. Extending the basic elements of compensation alignment from directors and managers on down to the factory floor may be difficult but it is far from impossible. Margaret M. Blair’s book, Ownership and Control,31 and Joseph R. Blasi and Douglas L. Kruse’s book, The New Owners,32 both describe a variety of means available to make stock performance a part of employee compensation. Aligning economic interest and performance is an ideal subject for board prodding. It might yet be the board’s most important contribution to the enterprise’s success, and there is an enormous amount of thinking yet to be done to achieve this alignment. Professionals are not content with the status quo, but constantly search for better ways. 27. See id. at ix. 28. Id. at 19-21. 29. Streamlining and Consolidation of Executive and Director Compensation Disclosure, Securities Act Release No. 7184, Exchange Act Release No. 35,894, 59 SEC Docket 1610, 1612 n.17 June 27, 1995). 30. Id. at 1611-14. 31. Margaret M. Blair, OWNERSHIP AND CONTROL: RETHINKING CORPORATE GOVERNANCE FOR THE TWENTY-FIRST CENTURY (Brookings 1995). 32. JOSEPH R. BLASI & DOUGLAS L. KRUSE, THE NEW OWNERS (Harper Business 1991). 1440 The Business Lawyer; Vol. 50, August 1995 BOARD PROFESSIONALISM The role of the board is expanding and is likely to continue to do so in the areas outlined supra and in others. This expansion is leading to, and ultimately will require, a more professional board: a board with standards for its own performance, with a sufficient knowledge base and expertise to perform, and with a constant dissatisfaction with status-quo thinking. More specifically, as boards become more active and involved, the job of director will become more demanding and complex. The board, truly and more appropriately participating, for example, in strategic planning, monitoring management performance against that plan, and setting compensation at all levels to provide appropriate alignment with each other and shareholder interests, will require greater expertise and time-commitment. Directors will need ever-increasing company and industry-specific or other relevant expertise, and improved access to broader information about the corporation, its core industry, and the environment in which it functions. And as directors are required to pay greater attention to and expend more time on boardroom issues and to develop greater expertise about the business of the corporation, greater effort will be required in selecting directors having the requisite time, expertise, and commitment, in creating appropriate incentives for directors, and in providing adequate information and education for directors. While we should not hear any significant calls for requiring “official” director certification in the United States, many U.S. boards will do their own certification simply through the process of selection and periodic performance reviews. They will seek competent, credible, knowledgeable candidates who are capable of, and willing to, do their homework.33 DIRECTOR SELECTION AND INCENTIVES Board service, as noted, places increased demands on directors to understand the complexities of the corporation and its industry. Time demands on directors are thus increasing and will continue to do so. As a result, the traditional pool of CEOs who are looked to as director candidates may shrink. A CEO running his or her own company should not have the requisite time to commit to any more than one additional board, if that.34 As the pool of CEOs available as board candidates shrinks, boards will be required to broaden their search to find outside director candidates. 33. See Ronald J. Gilson & Rainier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, Presentation at the Salomon Brothers Center and Rutgers Center Conference on The Fiduciary Responsibilities of Institutional Investors (June 14-15, 1990). 34. But note that, at present, according to the Korn/Ferry survey, only 18% report that they had limited the number of boards on which their CEO could serve, generally to two other boards. See KORN/FERRY SURVEY, supra note 4, at 24. The Professional Board 1441 NY1:\1015488\03\LRK003!.DOC\99990.1013 Boards, as noted, should consist of “leaders” who are intelligent, energetic, curious, and credible. CEOs clearly fit the bill. And CEOs themselves might identify, as potential board members for other corporations, future leaders in their own corporation. Board service on other corporations for these future leaders can be a rounding experience. Other “leaders” can be found in universities, foundations, religious and financial institutions, the pools of former government officials, politicians, and recently retired CEOs and senior executives, and the “other” professions such as law. 35 All such candidates must be willing, however, actively to participate in the boardroom. There is no longer any room for directors with prestigious backgrounds and titles but who lack the capacity, energy, or interest to engage fully in boardroom deliberations. A healthy by-product of a deeper and broader search for candidates may be increased diversity and fresher perspectives, as more women, minorities, and younger executives are invited to the boardroom. As the position of director becomes more demanding, more effort will be required to create appropriate incentives for service. Certainly, the men and women who are of a caliber to be invited, and choose to accept, the challenging role of director are primarily motivated by what Chancellor William T. Allen of the Delaware Chancery Court has termed “soft concepts”: pride, self-respect, a sense of service, and an understanding of the legal and social requirements of the governance paradigm.36 Nonetheless, directors, like all humans, are also motivated by economic self-interest.37 The Report of the NACD Commission referred to earlier duly recognizes the importance of self- respect and pride as motivating factors for directors’ performance, but also recognizes that such factors exist in all professions.38 Yet, the best in every field expect to receive remuneration commensurate with their skill level, their marketability to other organizations competing for their valuable time and expertise, and their productivity: that is, their ability to contribute to the overall wealth of the organizations which they serve. As discussed supra,39 directors should be compensated at a level to incentivize them to perform. This is a logical extension of the philosophy underlying the link of CEO pay to corporate performance and underlies the concept of alignment. 35. If the candidate has provided services to the corporation, however, he or she may not qualify as “independent”. 36. Memorandum from Chancellor William T. Allen to the 1993 Tulane Corporate Law Institute, Corporate Governance: The Internal Environment 10-11 (on file with The Business Lawyer, University of Maryland School of Law). 37. See Robert Stobaugh Director Compensation: A Lever to Improve Corporate Governance, DIRECTOR’S MONTHLY, Aug. 1993, at 1 (on file with The Business Lawyer, University of Maryland School of Law). 38. See COMMISSION ON PERFORMANCE EVALUATION, supra note 5, at 13. 39. See supra notes 21-27 and accompanying text.