The Sarbanes-Oxley Act of 2002 requires that CEOs and CFOs certify the accuracy of their companies’ publicly reported financial statements with a “to the best of my knowledge” qualifier. When this requirement was under consideration in congressional committee, the drafters of the legislation at one point envisioned that directors would also certify financial statements with the same caveat. Following intense lobbying against that provision by John Snow, then Chairman of the Business Roundtable and now Secretary of the Treasury, this requirement was rejected. Snow and his supporters argued that directors could not have a sufficiently detailed grasp of the financials to fulfill the certification requirements. Frankly, the same could be argued of CEOs in large, complex organizations who rely on others to verify the numbers and demonstrate reasonable diligence when certifying.
If the CEO is willing to certify, and directors trust the CEO implicitly as they have proclaimed so often, why would directors not feel comfortable adding their own certification to the financial statements? Perhaps directors trust their CEOs only to the extent that they will not be held to a reasonable standard of diligence if the CEO just happens to be wrong.
Commit to Independence and Care
Even though directors don’t have the CEO’s responsibility to certify the financials, it seems at least reasonable to expect independent directors to commit to a comparable standard: to declare publicly that they will act independently (duty of loyalty) and will take the time and expend the effort (duty of care) required to exercise their responsibilities fully. Directors should make that public commitment by executing an oath of independence and care annually, with each board making its own determination about the content and degree of specificity of their oath.
Five cornerstones of good governance: adhere to duty of loyalty, honor duty of care, be consistent across all companies, avoid exceptions, put shareholders’ interests first.
Such an oath would not be a promise to always be right, but it would be an oath to do what is right in good faith and to the best of the individual director’s ability. Just as Sarbanes-Oxley did not impose any real additional burden of responsibility on CEOs and CFOs, an oath for directors would simply affirm that they understand their responsibilities completely and undertake fulfilling them with the utmost seriousness and honesty.
Ensure Transparency and Fair Disclosure
Investors have the choice of investing in multiple industries and thousands of companies within those industries. Most of the information investors receive about a company’s performance comes from or is heavily influenced by management. With so much competition for their capital and so much information in the hands of management, why should investors ever have to expose themselves to risk because of poor or incomplete information?
Before investors make a decision, they should ask three questions: Why should they have confidence that a company’s management and board of directors are focused on managing the business to create real value instead of managing stock price? Why should they trust the company to report the results of its performance with integrity and honesty? And what evidence do they have that management fully discloses the risks it takes to earn an acceptable return and to enable investors to determine whether future anticipated return justifies those risks?
One way shareholders can get answers those questions is to pose them to management and the board. Shareholders and prospective shareholders should reasonably expect that a company’s management and board would be willing to tell them everything they need to know about the business to evaluate the soundness of their investments. This should exclude, of course, information that would compromise the competitive position of the business. Management and boards constantly must make the trade-off between full disclosure with transparency and the need to preserve a competitive advantage.
Companies routinely choose to withhold information because they consider it immaterial. Clearly companies cannot disclose every detail. However, if investors feel that they need specific information because they consider it material, such as the impact of a group of secondary events, the burden should fall to companies to explain why they will not disclose information. If shareholders do not like the answer, they should choose another investment. The kind of information that is important to investors may differ markedly from that which is material to the company. For example, an undisclosed $10 million options benefit to an executive might not be material to a major company’s earnings. It would, however, be quite relevant to the individual who received it. It might also be very significant to investors who have placed their trust in that individual and who rightly should expect the board to tell them how their money is being spent.
Investors who own securities directly and professional fund managers who serve as fiduciaries for many investors all share a certain degree of responsibility for ensuring good governance in the companies they own. The federal government is subject to the will of the electorate—its leaders serve at the pleasure of those who vote—and directors who bear responsibility for protecting shareholders’ interests should be subject to their input.
Direct Lines of Communication
As fiduciaries for shareholders, boards have an obligation to communicate directly with them and to establish mechanisms that allow investors to have contact with them. For example, independent directors should meet at least once annually with institutional investors. These meetings should, of course, be webcast to comply with the Regulation Fair Disclosure act of 2001. At a minimum, a company’s annual report and website should prominently display e-mail and postal addresses that shareholders can use to contact the board and individual directors.
Directors should make a public commitment by executing an oath of independence and care annually.
The ability of investors to communicate directly with directors imposes an additional and considerable burden on board members. The Internet and e-mail have empowered individual shareholders to express their views more openly. Boards have voiced concern that if shareholders can contact its members individually, directors will be overburdened. Undoubtedly boards will have to sift through some less-than-constructive correspondence, but the benefit of knowing shareholders’ views and pursuing constructive dialog will be worth the extra effort.
The board should have staff support (independent of management) and resources required to receive, evaluate and, if appropriate, respond to communications they receive from investors. Management should not screen communications or control the process. Their doing so would certainly compromise a healthy checks-and-balances system.
In practice, few companies provide mechanisms for direct communication between shareholders and directors. Some large pension funds, however, have taken steps to make shareholder feedback easier. The New York City Pension Funds, for example, have proposed that six of the companies it invests in establish offices with staff that report to a committee of independent directors to facilitate communication with investors.
A Meaningful Voice in Director Selection
In the United States, to be nominated for important elected government positions, candidates must first present their credentials and platforms to voters in primary elections. The winners of those primaries then run against other nominated candidates in a general election. The election process for boards of directors for corporations is different. A group of existing directors, the nominating committee, puts together the slate of candidates, usually with a great deal of input from the CEO. Almost always, a single candidate is nominated for each open position, and that predetermined slate is put forward to the shareholders for a vote.
In selecting directors, nominating committees should expand their candidate selection process beyond the CEO’s handpicked slate.
This concept may not be fatally flawed. Nominating committees should, however, expand their candidate selection process beyond the CEO’s handpicked slate. They should actively solicit input and suggestions from shareholders and others who have a stake in how the company is run. Boards should also explain in detail to shareholders why each candidate was nominated, what expertise the candidate brings to the job, and what makes the candidate truly independent.
The following hypothetical help-wanted ad could serve as a good blueprint for developing the criteria boards use for nominating directors and in explaining the candidates’ appropriateness to investors. Nearly every characteristic described in this “want ad” has been endorsed by one or more better governance commissions or panels.
Help Wanted: Independent Director
Person independent of management influence willing and able to devote the time and effort required to collect, analyze and understand all reasonably available information with regard to the company, or to oversee such processes, to make informed and defensible business judgments in the best interests of all present and future potential shareholders. Highest integrity is mandatory.
Primary areas of responsibility include becoming constructively engaged in the company’s affairs through strategy approval and validation; providing oversight of management to ensure the company’s performance, condition, and risks are known, understood, and disclosed; ensuring the adequacy of control and information systems and compliance.
Must be prepared to devote the time required to understand the company and, based on judgment and information, to anticipate what will make it successful and what evolving risks it will face. Must be willing to challenge the CEO and management, to ask questions and assess answers objectively, to be skeptical of all information presented, to collect independent information, and to look at trade-offs from the shareholders’ perspective.
Expertise in an area such as finance, audit, international operations, technology, marketing, or operations is a plus. Communication, leadership, and team-building skills are required. Must understand that while “plausible deniability” may be a legal defense, it fails to satisfy fiduciary obligations to shareholders and could very well result in public embarrassment and/or termination. Compensation commensurate with responsibility and performance.
Information given about each nominee might include not only work experience, education, and other directorships, but also anything else that could influence independence, including relationships among directors and officers or common affiliations with schools, clubs, boards, and other organizations. This is not a legal or regulatory test, and it certainly doesn’t imply that all relationships are detrimental to independence. It is simply a commonsense test. The burden of disclosure is on the board and the interpretation of whether or not independence is compromised is left to shareholders.
Direct Nominations by Shareholders
Several respected governance experts have suggested that shareholders be given the right to directly nominate one or more directors by popular vote. This has already been tried in some companies, including United Airlines, now in bankruptcy, where selected directors were nominated by the union. But this solution implies that a “specially nominated” director would represent shareholders differently or better than other directors. Because all votes are equal on a board, and all directors are obligated to represent shareholders, selecting a special interest director could tend to let other board-nominated directors off the hook as fiduciaries for all shareholders. Finally, while one outspoken director can make a difference, it takes a very unique director to voice a strong dissenting position in the face of the kind of peer pressure that exists on so many boards.
Electing—and Removing—Directors
To hold directors accountable as individuals and as a group, shareholders need a mechanism that allows them to actually vote directors into and out of office. Fundamental to the election process in a democratic society is choice among candidates. As a nation, the United States has consistently derided countries that claim to have free elections, but in practice place only one candidate for each position on the ballot. This is precisely how boards of public companies are elected.
Other respected organizations use a different process. Most colleges and universities conduct elections for trustees (the equivalent of directors) by offering voters a choice among several candidates for each seat. This model could have significant advantages for shareholders in public companies by giving them real power to actually choose their fiduciary representatives. By choosing from multiple candidates, all nominated by the board, shareholders would no longer have to vote against a nominee to make a no-confidence statement. They could actually vote in favor of the nominee they wanted.
Obviously, shareholders or the board would determine the details of such a process for a specific company. For example, if four new directors were required, a slate of eight nominees could be put forward and the four candidates receiving the most votes would prevail. Another way would be to propose two nominees for each seat and the winner would hold that seat for the term of office. Cumulative voting is yet another process that has been used in a few companies. In this model, shareholders can divide up their allotted votes in any way they see fit. For example, if five director seats are up for election, and a shareholder owns 1,000 shares, he has 5,000 votes to cast. He may cast all 5,000 for only one director, or split them up among the nominees. Thus, a minority of shareholders may be able to elect one or more directors by giving all of their votes to selected nominees.
In companies where proposals similar to those just described have been made, management often has responded that multiple candidates will “politicize” the process of director selection. They have also maintained that attracting directors would become more difficult if the nominees had to face the prospect of losing an election. The first objection is simply inconsistent with the proposal. Prospective directors would not be expected to campaign among shareholders for nomination. Rather, nominating committees would nominate more than one candidate for the positions available.
Regarding the second objection, one must question whether or not qualified director candidates would feel sufficiently insecure to participate in a true election. Losing an election to a good candidate would hardly be a disgrace. The other part of the objection deserves more consideration. Finding multiple candidates for board positions might complicate the task of the nominating committee. It would necessitate a search for a greater number of qualified candidates. However, given the large number of directors sitting on multiple boards, the scarce time that these directors have available to devote to each board, and the potential conflicts that can arise from interlocking directors, shareholders would surely benefit from a broader field of qualified director candidates. Although nominating multiple candidates would complicate the nominating committee’s task, the benefits to shareholders and governance could be significant.
Are there enough available, qualified director candidates? If previous experience on the board of a large company is an important qualification, the supply is definitely limited and shrinking. But it seems that might not be a critical qualification, especially given recent examples of lapses by certain boards composed of directors with considerable previous experience.
Boards should also explain to shareholders why each candidate was nominated, what expertise the candidate brings, and what makes the candidate truly independent.
Some other concerns are more legitimate. The increasing risk to directors from plaintiff’s lawsuits over lack of independence or care is likely to reduce the number of qualified candidates willing to serve, at least until this risk is mitigated. A few directors and officers (D&O) insurance providers are addressing this issue from a financial liability perspective. The real solution to the problem of shareholder lawsuits is for directors to demonstrate clearly their adherence to higher standards of loyalty and care in fulfilling their responsibilities.
If directors are to be held more accountable for their actions, they will have to work harder to fulfill their duties. With greater responsibility should come increased compensation. The benefits of fewer surprises and better governance will justify high pay for board service.
Directors Should Account for Their Decisions
Ultimately, shareholders can hold directors more accountable for their actions if they elect them and can remove them. To make informed decisions about who fulfills their fiduciary responsibilities, shareholders need more information about how well individual directors perform. Directors should disclose dissenting opinions on important issues and explain decisions that may not appear to reflect the collective will of the shareholders.
Boards are composed of more than one person presumably because shareholders and management will benefit from the wisdom, knowledge, and experience of multiple individuals with differing expertise and diverse views. Maintaining such diversity is an espoused objective of most boards. The vast majority of votes by boards, however, are unanimous, and when they are not, this fact is seldom disclosed or explained.
Issues of strategy, compliance, risk, and monitoring are complex and answers are often neither black nor white. Are share holders to assume that after short presentations by management that directors with vastly different expertise and experience almost always agree? While the dynamics of all boardrooms differ, it is more likely that dissenting directors toe the line to show commitment and unity.
Such unity can be very important, especially in the short term, but at the same time shareholders deserve to know what each director really thinks. It is also true that confidentiality and competitive advantage sometimes demand that dissenting opinions are not disclosed in the short term, but longer term there is little reason why individual opinions should not be disclosed.
Each board should establish policies and procedures to disclose board votes as soon as practical. Explaining dissenting opinions and recognizing that such dissent reflects the reality of tough trade-offs doesn’t show disloyalty or lack of trust in management. The logic underpinning minority views could be given by individual dissenters or as a group. Such views would not necessarily be attached to “no” votes, but could simply be used to disclose the alternatives considered and the trade-offs made. The Supreme Court has dissenting and minority opinions, as do special commissions and others.
One might realistically hope that explaining dissenting or minority views would encourage greater debate and less unanimous voting. Without explanation, dissenting votes can be interpreted as lack of loyalty. With explanation they become thoughtful views to be considered.
When boards of directors do not act in conformity with the majority will of shareholders, they have an extra obligation to explain their decision. (They, of course, run the risk of being replaced if they cannot convince shareholders, over a reasonable amount of time, that they have acted correctly.) If directors are convinced that they have made the right decision, they should stand by it publicly.
The Conference Board has recommended separate board chairman and CEO positions and that every company should have a chairman independent of management.
The objective of every widely held public company should be to have a board composed solely of independent directors other than the CEO.
In practice, boards have made many decisions that have raised significant shareholder concerns. These include approving poison pill provisions to guard against hostile takeovers; paying greenmail (repurchasing stock at a premium to prevent takeover); establishing classified boards, which encourages continuity through long terms of service and staggered elections; eliminating cumulative voting; approving excessive compensation; and approving acquisitions and mergers. Even though these practices have generally served to entrench existing managements and boards, undoubtedly each may have been justified in specific instances. These practices are so troublesome because shareholders have no effective recourse against them other than expensive litigation or proxy contests, which are not economical for single shareholders.
Corporations do give shareholders an opportunity to express their will. Each proxy season shareholders vote on hundreds of proposals. Usually, management prepares these proposals, but some are prepared by shareholders. In many instances, even when a majority of shareholders has voted for or against a proposal, directors have ignored the majority will. For example, when Lucent shareholders voted to eliminate classified directors and to elect all directors annually, the board noted that although the proposal received an affirmative vote of the majority of those who voted, the total fell short of the 80 percent of all outstanding shares that would obligate the board to amend its certificate of incorporation. Some shareholders have taken actions to prevent boards from disregarding the majority will. New York City Pension Funds have presented proposals to Gillette, Goodyear Tire and Rubber, and Wisconsin Energy that would force them to adopt proposals passed by a majority. Boards that continue to routinely ignore shareholder votes without explaining why may force such corrective action. At the least, the fact that shareholders are putting forth such proposals argues strongly that directors should communicate more effectively with them.