The latest client memorandum from Wachtell Lipton partner Steven Rosenbaum hits on a couple of matters we follow very closely, including the errant belief that shareholder democracy will lead to better governed companies.
Never before in the history of American business has the role of the corporate director been more important or more challenging. Boards today must navigate a tremendously difficult business environment featuring intense competition from foreign manufacturers, weak consumer confidence, growing unemployment, volatility in financial and commodity markets and a host of other complex challenges. At the same time, directors are currently undergoing intense public and political scrutiny of their basic role and functioning at the helm of public companies. As we begin to emerge from the worst recession since the Great Depression, the search for root causes of the economic crisis and second-guessing of corporate decisions has generated a multitude of corporate governance reform proposals, legislative initiatives and rule-making that seek to shift decision-making authority from boards to institutional shareholders and shareholder activists. Despite the stated intention of these initiatives, this shift will impede the ability of boards to resist pressures for short-term gain and tie their hands at a time when the need for effective board leadership is particularly acute.
Shareholder activists have been promoting a shareholder empowerment agenda that extols shareholder rights both as an end in itself as well as a means of instilling greater accountability into governance structures. These activists have argued that strengthening shareholder rights will promote long-term value creation, and they have been successful in inserting this agenda into a number of the recent legislative and other reform proposals. In reality, however, the objective of hedge funds and other activist shareholders is to execute trading strategies, take advantage of market volatility and otherwise maximise their returns based on investment time horizons that, in some cases, are a matter of days or even minutes. It is illogical to assume that reforms aimed at increasing the ability of such shareholders to directly influence the management of public companies will promote a more long-term corporate outlook. In short, the overriding emphasis on shareholder rights has been skewing the process of thinking about how best to promote sustainable, long-term growth. Rather than a heavy-handed tipping of the scales in favour of shareholder rights, what is needed is a comprehensive, pragmatic assessment and recalibration of appropriate governance structures and regulations.
Unfortunately, these misguided reform proposals come at a time when it is particularly vital for American companies to have stability and to be encouraged to adopt long-term growth strategies that will secure their future in the global marketplace. Such growth strategies may entail, for example, significant investments in research and development, marketing and plant and equipment that will create value over a long-term horizon but are disfavored by investors with short-term objectives. Increasing the power of such shareholders to pressure companies and their boards to maximise short-term profits and stock prices will impede the ability of American companies to compete with firms that have the advantages of state corporatism, like those in China. The populist attempt to blame American management and boards for the economic crisis runs the real risk of eventually reducing American business and the American economy to secondary status in the world.
In this corporate governance environment, there has been a renewed focus by directors on the proper role and functioning of boards. A study published in September 2009 by Professor Jay W. Lorsch and other members of the Harvard Business School’s Corporate Governance Initiative, based on interviews with 45 directors of public companies, reports a strong consensus among the directors that the key to improving board performance is not government action, but rather action on the part of each board. Directors indicated that matters such as how directors work together and with management to oversee the company could not be effectively regulated by government. Instead, the prevailing belief was that each board should develop structures, processes and practices that are tailored to the company’s needs. The study concludes that directors are keenly interested in obtaining better clarity and a more precise understanding of the proper role of the board, and view this as essential to enhancing board effectiveness.
Our own experience suggests that most boards make a significant effort to be thoughtful about their role and pay a great deal of attention to processes and practices. But it is important to recognise that periodic reviews of board functions and procedures, particularly in light of the current reform proposals, are necessary. There is clearly no “one-size-fits-all” approach to crafting a successful modus operandi for any given board, and board procedures should be fine-tuned to reflect the specific circumstances and challenges facing the company. In principle, however, core board functions should include the following:
- CEO Succession Planning. There is no job that is more important for the board than selecting the company’s CEO and planning for his or her succession. In large measure, the fate of each of the board and the CEO is in the hands of the other.
- Long-Term Strategy. Approval of the corporation’s long-term strategy is an integral part of the board’s role as business and strategic advisor to management. Pressures to focus unduly on short-term stock price performance present real challenges to maintaining long-term growth strategies, and the board’s ability to craft a strategic vision and manage these pressures can be essential to the overall best interests of the company.
- Monitoring Performance and Compliance. Another key element of the board’s oversight role is monitoring the performance of the company and management, including monitoring customary economic metrics as well as compliance with laws and regulations. The board should also monitor government relations policies and practices and matters affecting the public persona and reputation of the company, as well as the “tone at the top” of the company.
- Executive Compensation. Executive compensation policies are currently subject to intense political and public scrutiny. While it is necessary to bear in mind both pay-for-performance and risk management principles, directors should not lose sight of the underlying goal of executive compensation—namely, to attract and retain qualified individuals who will contribute to the long-term success of the company.
- Risk Management. While the board cannot and should not be involved in the company’s day-to-day risk management activities, directors should satisfy themselves that the risk management processes designed and implemented by executives and risk managers are adapted to the company’s strategy and are functioning as directed, and that necessary steps have been taken to foster a culture of risk-adjusted decision-making throughout the organisation.
- Shareholder and Constituent Relations. Shareholder relations have become increasingly complicated as a result of activist trends, and each year they require greater attention by the board. Management should generally be the primary caretaker of shareholder and constituent relationships, but where shareholders request direct communications with the board, it may be desirable for directors, in appropriate circumstances and following consultation with management, to accommodate such requests.
- Effective Functioning of the Board. The board should take a pragmatic approach to formulating procedures that will enable it to function effectively. Some of the considerations that arise include the proper allocation of decision-making responsibility between the board and management, the need to cultivate constructive relationships and open dialogue with management, the scope of information that the board should receive from management, and the time constraints and other practical limitations on directors’ understanding and depth of knowledge of the company’s business.
Our full memorandum highlights some of the significant corporate governance issues that boards face in the coming year, including recent developments relating to executive compensation, CEO succession planning, risk management and director elections. The memorandum also sets forth some practical considerations for boards to bear in mind, including the role and duties of the board, the composition and structure of the board, board committees and procedures, the board’s duties in the zone of insolvency, and principles governing director liability. In order to avoid an overemphasis on process and at the same time effectively discharge the board’s duties to monitor and supervise the business of the corporation, it is necessary to identify the principal matters meriting the board’s focus and create a reasonable program to deal with them. Some of the issues discussed in the memorandum are perennial themes that remain relevant and deserve to be reemphasized from year to year, whereas others have recently come into particular focus. Our full memorandum can be found here.
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