Making Directors Accountable
To improve corporate governance, reduce obstacles to shareholders' influence.
The many corporate scandals of the past two years have highlighted the importance of effective corporate governance. Cases that are by now notorious, such as Enron, WorldCom, Tyco, and Healthsouth, provided vivid examples of how companies and investors can be hurt when boards of directors do not do their jobs well. How can we improve board performance? One main way is by reducing the extent to which boards are now insulated from, and unaccountable to, shareholders. We need to rethink the arrangements that determine the current power of the board vis-à-vis shareholders.
Have We Done Enough Already?
Of course, in the wake of the corporate scandals, some significant reforms have already taken place or are pending. To begin, the Sarbanes-Oxley Act and the subsequent actions and rulemaking of the Securities and Exchange Commission (SEC) have imposed additional duties on boards and have tightened enforcement. For example, the new legislation prescribes procedures for the audit committees of boards, increases penalties for noncompliance with securities laws, and prohibits the granting of personal loans to executives. Still, as a good corporate system must do, these reforms have left substantial discretion in the hands of corporate boards.
Many important corporate decisions are subject to boards' broad business discretion, with little scrutiny from courts and regulators. Among other things, directors set the compensation (and thus shape the incentives) of the firm's top executives, and they decide whether to accept high-premium acquisition offers. As long as boards enjoy so much discretion on such important business decisions, the selection of directors and their incentives are crucial.
Recent reforms have dealt with this issue by seeking to expand the presence and role of independent directors: directors who do not have substantial connections with the company or its executives other than through their directorship. Although many public companies already have a majority of independent directors on their boards, pending stock-exchange rules would require such composition from all listed companies. Furthermore, pending stock-exchange rules and governance reforms would require that nomination and compensation committees be composed of independent directors.
Although increased director independence could be beneficial, there are reasons to doubt that it magically ensures good performance of boards. After all, mandating director independence does not resolve which few individuals will be selected from the vast pool of "independent" candidates. Nor does the independence requirement determine what incentives the selected directors themselves would have once in office. Many of the directors of Enron, WorldCom, or Tyco would have qualified as independent directors under the pending stock-exchange rules.
Indeed, when filling high-level positions other than those of directors, companies generally recognize the importance of selecting the right people and providing them with desirable incentives. We should therefore consider what can be donebeyond limiting the role of inside directorsto improve the selection and incentives of board members.
The Missing Safety Valve
We should strive to make directors not merely independent of corporate insiders, but also at least somewhat dependent on shareholders. One major way to improve director selection and accountability would be to provide a meaningful safety valve that shareholders could use to replace directors who fail to serve them well.
The current process of director elections is in theory supposed to provide such a safety valve: "the shareholder franchise," observed a well-known decision by a Delaware court, "is the ideological underpinning upon which the legitimacy of directorial power rests." In theory, if directors fail to serve shareholders, or appear to lack the qualities necessary for doing so, shareholders have the power to replace them. That power, in turn, is supposed to provide incumbent directors with incentives to enhance shareholder value.
But shareholders' power to replace directors is largely a myth. Attempts to replace directors via the ballot box are extremely rare even in firms that systematically underperform over a long period of time. By and large, directors nominated by the company run unopposed. Absent a hostile attempt to acquire the company, the risk of being removed in a proxy contest is too remote, even in the event of dismal performance, to provide directors with significant incentives to serve shareholders.
The key to re-election is simply remaining on the firm's slate. Unfortunately, however, incentives to please those making the board nominationsmembers of the nominating committee and sometimes the senior managers who have influence over themare not necessarily the same as incentives to maximize shareholder value. The safety valve of potential ouster via the ballot box is currently not working, and the case for making it more viable is strong.
Reforming Corporate Elections
The SEC is now seeking comments on one moderate step in this direction: a requirement that, at least when certain triggering events occur, firms include in proxy materials distributed to all voting shareholders the names of directors nominated by qualified shareholders (or groups of shareholders) who satisfy minimum ownership requirements. Shareholders cannot now place candidates on the company's ballot; those wishing to nominate an independent candidate must distribute their own proxy cards to fellow shareholders who must then return the cards to the nominators. Permitting shareholders who satisfy some ownership and holding thresholds to place their nominees on corporate ballots would make it somewhat easier to run a candidate not nominated by the incumbent directors.
Supporters of management object strongly to this proposal. Critics claim that shareholder access to the ballot will lead to widespread distraction and disruption. But to the extent that nomination privileges are permitted only to shareholders with a significant stake, such nominations will be concentrated in companies where shareholder dissatisfaction is significant, which will likely be companies that are performing poorly.
Critics also warn that shareholders would elect "special interest" directors and produce balkanized and dysfunctional boards. But shareholder-nominated candidates would not be elected without support from a majority of the voted stock, most of which is held by institutional shareholders. If anything, institutional shareholders are reluctant to vote against management. Should they wish to do so, paternalistic tying of their hands seems unwarranted. "Management," said the U.S. Supreme Court in one of its securities cases, "should not attribute to investors a child-like simplicity."
Besides providing shareholders with access to the corporate ballot, additional measures to invigorate corporate elections should be adopted. Under existing corporate-law rules, incumbents' "campaign" costs are fully covered by the company, which provides a great advantage over outside candidates who must pay their own way. To enable challengers to make their case to the shareholders, companies should be required to distribute proxy statements by independent nominees who have sufficient initial support and wish to have such materials distributed. Furthermore, companies should be required to reimburse reasonable costs incurred by such nominees, at least when they draw sufficient support in the ultimate vote.
These measures could be opposed, of course, on grounds that they would be costly to shareholders. But an improved corporate-elections process would be in the interests of companies and shareholders at large. The proposed measures would not expend corporate resources on nominees whose initial support and chances of winning are negligible; the limited amounts expended on serious challenges would be a small and worthwhile price to pay for an improved system of corporate governance.
Incumbent directors are now protected from removal not only by the impediments to running outside candidates but also by staggered boards, on which only one-third of the members come up for election each year. A majority of public companies now have such an arrangement; as a result, no matter how dissatisfied shareholders are, they must prevail in two annual elections to replace a majority of the incumbents.
Staggered boards also provide a formidable defense against removal in a hostile takeover. Because corporate-law rules now allow incumbent directors to maintain a "poison pill" defense to block hostile offers, a hostile bidder can prevail only by inducing shareholders to replace the incumbents with a team of directors who would accept the offer. When the target has a staggered board, supporters of an attractive takeover offer must win two annual electionslonger than a hostile bidder can typically afford to wait.
The entrenching effect of staggered boards is costly to shareholders. In a current empirical study, Alma Cohen and I find that, controlling for other relevant company characteristics, firms with a charter-based staggered board have a lower market value. The reduction in market value associated with such staggered boards is economically significant, with a median reduction of about 5 percent, adding up to more than $300 billion for all such firms. Legal reform that would require or encourage firms to have all directors stand for election together could contribute significantly to shareholder wealth.
Setting the Rules
Another way to reduce the extent to which boards of directors can stray from shareholder interests is to take away the board's existing veto power over changes to the company's governance arrangements. These arrangements are set forth either in the rules of the state in which the company is incorporated or in the company's charter. Under long-standing corporate-law rules, only the boardnot any group of shareholders, however largemay initiate and bring to a shareholder vote a proposal to change the state of incorporation or to amend the corporate charter.
The federal securities laws have given shareholders the power to express their sentiments in nonbinding precatory resolutions. In recent years, for example, shareholders of companies with staggered boards have increasingly initiated proposals recommending annual election of all directors. Such proposals now commonly attract a majority of the shareholder vote, yet boards routinely elect to ignore their passage.
Directors' control over the corporate agenda is often justified on grounds that the U.S. corporation is a completely "representative democracy" in which shareholders can act only through their representatives, never directly. On this view, as long as shareholders have the power to replace directors, corporate decisions can be expected not to stray far from their wishes. But the removal of directors is rather difficult under existing arrangements, and is unlikely to be straightforward even with a reformed election process. Furthermore, shareholders may be pleased with management's general performance but still want to make a particular decision in opposition to management's wishes. Shareholders should be able to make a change in corporate arrangements without concurrently having to replace the board.
Because boards control firms' decisions about whether to reincorporate, states such as Delaware that seek to attract incorporations have an incentive to give substantial weight to directors' preferences. Furthermore, directors' control over charter amendments produces a bias in corporate arrangements: when new issues and circumstances arise, arrangements addressing them are adopted only if and to the extent that these arrangements are favored by the board.
Giving shareholders the power to initiate and approve by vote a proposal to reincorporate or to adopt a charter amendment can produce, in one bold stroke, a substantial improvement in the quality of corporate governance. If shareholders had the power to change governance arrangements, desired changes could be expected to occur commonly without such outside legal intervention as the recent legislation. Shareholders concerned about recent corporate governance failures, for example, could adopt charter amendments that improve the process by which executive pay is set, require separation between the CEO and chair of the board positions, or strengthen the independence of directors or auditors, and so forth.
The Entrenching Power of Existing Arrangements
The weakness of shareholders vis-à-vis boards of directors in publicly traded companies is often viewed as an inevitable corollary of the modern corporation's widely dispersed ownership. But this weakness is partly due to legal rules that insulate management from shareholder intervention. Changing these rules would reduce the extent to which boards can stray from shareholder interests and would much improve corporate governance.
Some may fear that increasing the power of shareholders could adversely affect nonshareholder constituencies such as employees. Insulating the board from shareholder intervention, however, is not a good way to protect these stakeholders: the interests of management are even less likely to overlap with those of stakeholders than with those of shareholders. Those interested in stakeholder protection, therefore, should not support the insulation of boards but rather seek arrangements tailored specifically to their concerns.
Because the special legal rules that insulate management from shareholders are longstanding, changing them will encounter substantial political resistance. The very control that the rules confer on management also gives it substantial power to fight changes in the status quo. Investors should continue to press for corporate governance reforms. ?
Lucian A. Bebchuk, LL.M. '80, Jf '83, S.J.D. '84, Ph.D. '93, is Friedman professor of law, economics, and finance at Harvard Law School. This article draws on three recent works: "Shareholder Access to the Ballot," "The Case for Empowering Shareholders," and (with Alma Cohen, Ph.D. '02) "The Costs of Entrenched Boards," available at his homepage, www.law.harvard.edu/faculty/bebchuk.