THE BOARD OF DIRECTORS AND SHAREHOLDER RIGHTS
INTRODUCTION
Corporations in the United States are incorporated under state law. Under these laws, the board of directors is responsible for managing the affairs of the company in the best interests of the shareholders—as interpreted by the courts of that state, of course. So, how should the board be selected, organized, and monitored by shareholders to ensure that their interests remain supreme? And to what extent can boards enhance or dilute the rights of shareholders through such strategies as changing the governance structures and the bylaws of the company?
A HISTORICAL PERSPECTIVE
Public shareholders, especially dispersed shareholders, need some institution or mechanism to monitor and evaluate managerial performance and to protect their ownership interests in the company. The board of directors has evolved to fulfill this function. The directors are elected by the shareholders and, under state law, are expected to demonstrate unyielding loyalty to the company’s shareholders (the duty of loyalty) and exercise due diligence in making decisions (the duty of care). However, the extent to which directors have effectively done so is hotly disputed and open to interpretation, especially since the Enron bankruptcy.
There is a fairly widespread consensus that for most of the twentieth century, board membership was more like membership in an exclusive private club, with the board members being effectively appointed by and beholden to management. However, in the late 1980s and 1990s, changes took place in the roles and activism of boards. These changes can be traced to a constellation of events.
From World War II to the 1970s
From the end of World War II until the early 1970s, the U.S. economy performed fairly well. U.S. multinationals dominated many markets, and, at least in the 1960s, many Europeans were fearful of American domination of their markets and cultures. These years marked the peak of managerial capitalism. But then came the Vietnam War, the OPEC oil embargo, and the stagflation of the 1970s. The U.S. economy was performing poorly in relative terms, especially compared to Japan. The stock of large U.S. corporations was selling for less than book value, suggesting that these companies were worth more dead than alive. Stock prices languished throughout the 1970s and into the 1980s, causing investors, especially institutional investors, to become increasingly disenchanted with corporate America’s performance.
Boards Again Attract Attention
Some people, of whom perhaps the chief spokesperson was Michael Porter, attributed the anemic performance of the U.S. economy to a faulty corporate governance system that forced managers to focus on share prices rather than on the long-term interests of the company.1 Others thought that the cure advocated by Porter was the disease: Managers and boards had become too cozy and weren’t paying enough attention to stock prices.2 The solutions advocated and implemented by these people were hostile takeovers, LBOs, proxy fights, and recommendations to boards of poorly performing companies concerning corporate governance reforms and ways to improve the boards’ operation. Institutional investors led the way with respect to governance reforms and ‘‘best practices’’ for boards of directors.
The critiques of both camps—Porter and the advocates of a strong corporate control market—led to many of the changes that were observed in the 1990s. In particular, independent directors (those who are not managers of the company) now make up a majority of the board at large publicly traded firms, and board committees have been created or restructured to better serve the public shareholders.
Among the most influential actors with regard to changes in the board of directors and other governance reforms have been TIAA-CREF and Calpers. TIAA-CREF is the Teachers Insurance and Annuity Association—College Retirement Equity Fund; it manages billions of dollars in pension fund contributions. Calpers is the California Public Employees Retirement System; it manages pension money for the state of California. Calpers is the largest public pension fund in the nation and the third largest in the world, with assets totaling more than $166 billion. It is very active in corporate governance issues, both in the United States and elsewhere.
TIAA-CREF, Calpers, and many other institutional investors and public interest groups generally agree on what constitutes an effective board of directors and the policies these directors should follow. As shown in Figure 10-1, these institutional investors have become increasingly important in the United States. From 1990 through 2000, they have increased their ownership of U.S. equities from 31.3 percent to 41.7 percent of outstanding shares. We now turn to the policies they recommend.3
COMPOSITION AND COMPENSATION OF THE BOARD OF DIRECTORS
A company’s board of directors should have a substantial majority of independent directors. These should be individuals with no connection to the company other than a seat on the board, thus minimizing any conflicts of interest with respect to having responsibility for managing the company and simultaneously evaluating and selecting management. The directors’ loyalty should be entirely to the shareholders.
In principle, the requirement that independent directors ‘‘have no connection’’ should exclude not only all full-time employees, but also family and friends of employees and the company’s lawyers, accountants, bankers, suppliers, and customers. However, since these people often have positive contributions to make to the success of the company, they will often be found on boards. Therefore, a third category of director, such as affiliated, is often used; however, these persons do not qualify as outside or independent directors in determining whether the board has a substantial majority of outside members.
FIGURE 10-1 OWNERSHIP OF U.S. EQUITIES: 1990 AND 2000
Board Committees
The board should have audit, compensation, and nominating committees made up entirely of outside directors. Furthermore, those committees that are assigned the task of board evaluation, governance, compliance, and ethics should also have only outside members.
The audit committee ensures that the books aren’t being cooked and that shareholders are properly informed of the financial status of the firm. Typically, the audit committee recommends the CPA firm that will audit the company’s books, reviews the activities of the company’s independent accountants and internal auditors, and reviews the company’s internal control systems and its accounting and financial reporting requirements and practices.
The compensation committee normally does the following: (1) recommends the selection of the CEO, (2) reviews and approves the appointment of officers who report directly to the CEO, (3) reviews and approves the compensation of the CEO and the managers reporting to the CEO, and (4) administers the stock compensation and other incentive plans.
The nominating committee establishes qualifications for potential directors. It also puts together a list of candidates for board membership for the shareholders to vote on. In all these cases, the point of having only outside directors is to prevent management from concealing information, deciding on its own pay, and gaining effective control of the company by controlling the board election process.
Diversity should be an important factor in constructing a board. The members should all be qualified individuals, but there should be a diversity of experience, gender, race, and age. However, diversity should not be construed to mean that directors should represent special interests. Instead, the directors should represent all the shareholders. We return to this issue in the section on electing board members, where we explain cumulative voting.
Board Compensation
Compensation for members of the board of directors continues to be a controversial topic. Two issues are bound together. One is how the board members should be compensated. The other is how much time they should spend in their role as directors, which is related to how and how much they should be paid.
A member of a large corporation’s board of directors will normally be paid between $20,000 and $30,000 a year plus fees to cover expenses for traveling to meetings. For example, in 1999 outside directors of C.R. Bard received an annual retainer of $26,000 cash plus $1,200 for each board and committee meeting attended (the committee chair gets $2,400). An additional $4,400 is either paid in common stock based on the stock’s fair market value or added to deferred compensation plans. In 1999, nonemployee directors of Heinz received $30,000 in cash and 300 shares of common stock. In addition, they received $3,000 for each board or committee meeting attended.
Now for the interesting pay question. Why should the outside board members devote time and effort to representing the public shareholders if they have no stake in the company? We have often said that a way to align management’s interests with those of the shareholders is to tie executive pay to the stock price or to have managers own shares in the company. So, why shouldn’t the same arrangement(s) be instituted for outside board members? Why not require independent directors to own stock in the company and tie their pay to performance as well?
To some extent, this concern explains the pay schemes we noted for C.R. Bard and Heinz, where board members receive stock as well as cash, and that for United Industrial Corporation in 2000, where each director was granted an option to purchase 15,000 shares of common stock upon the director’s initial appointment to the board. In fact, between 1995 and 2000, directors’ compensation in the form of stock rose from 28 percent to over 60 percent for the ‘‘average’’ company.4
TIAA-CREF says that ‘‘a reasonable minimum ownership interest could be defined as stock holdings equal to approximately one-half of the amount of the director’s annual retained fee.’’ But still, we would suggest that for many board members, the amount of stock they own in, say, Heinz or United Industrial Corporation is small relative to their overall wealth and is not sufficient to do much in terms of changing their behavior.
With respect to time spent on the job, a common criticism of U.S. boards is that too often the members hold positions on so many boards that they can’t possibly devote the time and attention necessary to carry out their responsibilities to the shareholders. For example, in 1992, an ex–U.S. Secretary of Defense served on the boards of more than twenty for-profit companies and many not-for-profit organizations. The question is how someone, no matter how talented, would have the time to do the job properly for so many companies while still holding a full-time position as well. Therefore, when nominating committees select potential board members, we think they should consider the candidates’ other responsibilities relative to time demands. The rule of thumb that seems to be used is that to do the job properly, a board member needs to devote at least 100 hours annually to the job, although in recent years, with the increased public scrutiny of boards, more hours are probably devoted to the job.
What about other forms of board compensation or quasi compensation? Should board members accept consulting fees from the firm? What about having the company make donations to a board member’s favorite charity? Clearly, both of these payments raise conflict of interest issues.
Tyco Corporation offers a recent example of a board member receiving consulting fees as well as having the company donate money to a selected charity. Tyco International paid a total of $20 million to an outside director and to a charity he controls, in return for his help in brokering a major acquisition in 2001. The move drew fire from corporate governance experts, who have advocated more director independence from top management. According to Tyco’s annual proxy statement, director Frank E. Walsh, Jr. received a $10 million cash fee because he was ‘‘instrumental in bringing about’’ Tyco’s $9.5 billion acquisition of finance company CIT Group. Tyco also made a $10 million contribution to a New Jersey charitable fund of which Walsh is trustee.5
Similar donations appear to have been made by Enron.6 On October 31, 2001, Enron named William Powers, Jr., dean of the University of Texas Law School, to its board. Enron announced this appointment the same day it reported that the Securities and Exchange Commission had opened a formal investigation into questionable financial transactions at Enron, including the use of partnerships to hide losses, and Powers was named chairman of a special committee to do an internal investigation and respond to the SEC. ‘‘We had a need to have an independent board member chair this special committee,’’ company spokeswoman Karen Denne said at the time. However, the appointment was criticized because of the law school’s close ties with top Enron officials, including Enron’s general counsel, James V. Derrick, Jr. Derrick had served in key fund-raising positions for the law school, and Enron had made donations to the law school as well as to the business school. So, how independent is Powers? From the outside looking in, too many questions can be raised about implicit connections between Enron and the law school of which Powers is dean.
Powers is not the only University of Texas insider whose independence has been questioned. John Mendelsohn is president of the M. D. Anderson Cancer Center at the University of Texas and a member of Enron’s audit committee. However, M. D. Anderson has received almost $600,000 in donations from Enron and its CEO, Kenneth Lay, raising questions about how carefully Mendelsohn was scrutinizing Enron’s books for the shareholders.
Another member of Enron’s audit committee is Wendy Gramm. Gramm is the director of the Mercatus Center at George Mason University, which has received $50,000 in Enron contributions over five years.
THE CEO AND THE BOARD CHAIR
The board chair is elected by the board members, who, collectively, must select and evaluate the performance of the CEO. If the CEO and the board chair are the same person, an inherent conflict of interest exists. The CEO is effectively selecting and evaluating him- or herself. Nevertheless, at about 75 percent of U.S. companies, the CEO is also the board chair—a situation that is far less common in other countries.
The case for having the CEO and the chair be the same person is one of practicality: Both the CEO and the chair need to be very involved with the business of the company; therefore, combining their roles seems efficient.
SHAREHOLDER RIGHTS
Shareholder rights encompass a wide variety of issues, ranging from voting procedures to rules governing the issuance of new shares, including shares issued for mergers and acquisitions, to access to information, and to the way managers can and do respond to corporate control challenges. We begin with a consideration of voting rights, including a consideration of multiple classes of stock.
In theory, shareholders control—govern—the corporation through their voting rights. These rights enable the shareholders to elect the board of directors and to vote on those issues that affect shareholder control of the company. In reality, there are many obstacles that make it very difficult for the public shareholders to effectively exercise their franchise.
How Many Votes for Each Shareholder?
Let’s begin with the question of how many votes each shareholder should be permitted to cast. As we noted earlier, during the nineteenth century it was not uncommon for shareholders to receive only one vote regardless of the number of shares they owned. This system provided both a way to protect minority interests (those who did not control over 50 percent of the shares) and a way to ensure that the corporation remained socially responsive to local interests, even though the majority of the shares were typically owned by people quite distant from where the company was operating. However, the system had its disadvantages.
The wealth of the major financial contributors to the firm could be held hostage by those with hardly any exposed financial position. How concerned would the small shareholders be with the financial health of the company and its major investors, as opposed to the benefits the company was providing to the local community or to themselves through their nonshareholder connections with the company? In other words, the relationship between the costs of certain investment and financing strategies to the small shareholders and these shareholders’ exposed ownership was way out of proportion to the same relationship for those who had committed large amounts of their personal wealth to the firm. So, voting rights began evolving toward the one-share-one-vote system that is most common in the United States today.
Institutional investors involved in corporate governance generally advocate the one-share-one-vote rule. This rule is also often described as the most democratic governance structure. Indeed, the objection to multiple classes of common stock is very similar to the objection to the one-vote-per-owner regime. Multiple classes of shares can be used to separate cash flow rights from control rights. Typically, one group of individuals (usually the founders) retains the control rights and the perks that go with them by holding one class of stock with majority voting rights. They then create a new class of stock with less than 50 percent of the voting rights to sell to the public. The public gets the right to cash flows, but not control of the board and the company. Therefore, the owners of the controlling class can continue to run the company in their own interests, and not those of the public shareholders, without worrying about losing control.
Confidentiality Issues
Advocates of ‘‘good’’ governance also believe that voting should be confidential in order to remove any appearance (or reality) of conflicts of interest, improprieties, or potential retribution involving the existing management and the voters. Consider the following situation: The management of White Pine Products finds itself in the middle of a proxy battle with a group of dissident shareholders for control of the company. A new board has been proposed by the dissident group, and White Pine executives are counting the votes as they come into the company. White Pine executives keep a running tally and know who has voted for and against them. The election is close, and a large block holder, Epsom Benefit Fund, has voted against management. White Pine executives know some of the senior managers of Epsom and call them up to ask them to change their vote. The Epsom managers agree (who knows why, but you can guess), and the votes are changed. Confidential voting would prevent this from happening—or at least reduce the temptation and the likelihood.
ERISA and Institutional Investor Voting Responsibilities
With the passage of the Employee Retirement Income Security Act (ERISA) in 1974 and subsequent legislation and court interpretations of these laws, institutional investors who manage pension funds have increasingly been held accountable for voting their shares in the best interests of the funds’ beneficiaries. These laws impose rigorous fiduciary duties on fund managers of employee pension plans.
The Department of Labor has stated that these duties extend to actively monitoring situations in which ‘‘the activities of the plan alone, or together with other shareholders, are likely to enhance the value of the plan’s investment, after taking into account the costs involved.’’ Furthermore, courts have held that managers of employee stock ownership plans have a duty to pursue the claims of minority shareholders, and have imposed liability on plan fiduciaries for failing to do so. In addition, the Investment Advisers Act of 1940, covering mutual funds, has been interpreted to impose a duty on investment advisers to act as fiduciaries with respect to their customers.
Electing the Board of Directors
Although shareholders elect the board of directors, the process and procedure for doing so matter. We consider two controversial issues: cumulative voting and staggered boards.
Cumulative Voting
Cumulative voting is a way for minority shareholders to elect or increase the likelihood of electing one of their number to the board of directors. Cumulative voting works as follows: Suppose you own 10,000 shares of a company that has 100,000 shares outstanding, or 10 percent of the voting rights, and the corporation has nine people on its board. Without cumulative voting, you would vote for the nine people you wanted, and each person you selected would receive 10,000 votes. In effect, you have 90,000 votes, but you must spread them evenly among the nine candidates.
With cumulative voting, you could take the entire 90,000 votes and award them to a single candidate. Of course, you would not be able to vote for other candidates; however, you could join forces with other like-minded shareholders and elect at least one board member who would represent your views.
People who believe that the directors should represent all shareholders generally oppose cumulative voting. Others see cumulative voting as a way of ensuring that all shareholder views will be represented, not just the views of those who own a controlling interest.
Staggered Boards
Until the market for corporate control heated up in the 1980s, most boards were elected to coterminous annual terms. For example, the 1999 Heinz proxy statement says that seventeen members will be elected to the board and serve for one year.
Staggered boards were developed as a means of fending off hostile takeovers. The process works as follows: People’s Heritage Financial Group, Inc., a Portland, Maine–based bank, has fifteen board members. The board is divided into three classes of five directors each. One class of directors is elected each year for a three-year term. Thus, in any given year, only one-third of the board is up for election. Consequently, a competing owner-management team could never elect a majority of the board and thereby gain control of People’s Heritage in a single year. At least two years would have to go by. And even if a competing team controlled over 50 percent of the shares of People’s Heritage, they would be stuck with a board that was still dominated by the old management.
Today, staggered boards are very common; perhaps as many as half of the publicly traded companies have this arrangement. The argument in favor of staggered boards is that continuity is needed, but why did continuity become necessary only in the 1990s? Another argument, and one that we find more convincing, is that staggered boards may result in higher acquisition premiums being offered to shareholders in order to convert a hostile takeover to a friendly takeover by getting the approval of the existing board.
POISON PILLS, SUPERMAJORITY RULES, AND GREENMAIL
Poison pills and supermajority rules are devices that management can use to defend itself against a hostile takeover, although a case can be made that such devices may also benefit shareholders. Greenmail refers to premium payments made to individuals to get them to stop trying to gain control of the company. Supermajority rules simply require that more than 50 percent of the shareholders approve a merger or sale of the company. Typically, the percentage is two-thirds, but it could be as high as 90 percent. Naturally, the higher the percentage, the easier it is for the existing management team to retain control of the company.
Poison pills are corporate charter provisions, financial security issues, or other contractual provisions that either transfer wealth or ownership from the takeover group to the target company’s shareholders or force the takeover group to pay off a substantial debt if the takeover succeeds. For example, if the managers of Downwest Bank wanted to make it difficult for an outside group to gain control of the bank, they could issue rights to buy preferred shares in Downwest to the existing shareholders of Downwest. In the event of a hostile takeover of Downwest, these rights would be convertible into the shares of the acquiring company at a bargain price. These provisions are called shareholder rights plans, although critics have dubbed them management rights plans.
A Shareholder Rights Plan at First Virginia Banks (FVA)
In 2001, FVA had a shareholder rights plan that effectively gave common shareholders a right to buy for $450 common stock in the company having a market value of $900 in the event that a person or entity were to acquire 20 percent or more of FVA’s common stock. However, the rights would not be exercisable if the stock were acquired at a price and on terms determined by the board of directors to be adequate and in the best interests of the shareholders. The effect of this poison pill is to make any hostile takeover of FVA very expensive to the competing control team.
Evidence About Antitakeover Devices
What is the evidence regarding the effect of these antitakeover devices? Well, the general consensus is that the majority of these provisions hurt shareholders, although exceptions occur. Generally speaking, institutional investors oppose these provisions. TIAA-CREF’s corporate governance policies say that:
The board should submit any antitakeover measure for prior shareholder approval.
The board should oppose any action to adopt supermajority rules.
The board should require equal financial treatment for all shareholders and limit the company’s ability to buy back shares from certain investors at higher-than-market prices (greenmail).
BOARD GOVERNANCE AND FIRM PERFORMANCE
Numerous academic studies have been undertaken in recent years in an effort to determine whether many of the issues we covered in this chapter are, in reality, related to firm performance. The evidence turns out to be mixed, and the jury remains out. But, little by little, evidence is accumulating that suggests that governance reforms and the increasing focus on governance issues have affected corporate investment and financing decisions and have brought shareholder concerns to the forefront.
Indicative of the accumulating evidence is a 1998 study by Paul W. MacAvoy and Ira M. Millstein of the performance of companies that responded to a Calpers corporate governance survey of 300 companies that asked whether the boards had reviewed and adopted governance procedures thought to be consistent with the long-term interests of shareholders. Calpers gave the responses grades from A to F. What MacAvoy and Millstein did was to take these grades and compare them to the company’s EVA.7 They concluded that ‘‘over [the 1991–1995 period] the 63 companies receiving the highest Calpers grade achieved average annual, industry-adjusted returns on capital that were 700 basis points higher than the returns on the 44 firms rated ‘C.’’’
Do we know anything else? Well, no theory of boards—corporate or otherwise—yet exists, even though boards have been around for hundreds of years and have been subjected for years to the same criticisms of how well they function and who they really represent that are heard today. Back in 1776, Adam Smith had already noted that the directors (boards) of joint stock companies should not be expected to be as vigilant in watching over other people’s money as in watching over their own. It turns out that he was quite right!
What we do have are stylized facts. Among these are the fact that despite the attention accorded to outside board membership, there is little evidence that firm performance is positively correlated with the ratio of inside to outside board members. What is positively correlated with the outside-to-inside ratio is the likelihood that the board will adopt governance policies approved by institutional investors with regard to executive pay, poison pills, and mergers and acquisitions. With regard to actual financial performance, though, what does seem to matter is the size of the board: The smaller the board, the better the firm’s performance.
We also believe that boards have become more active in replacing CEOs than in the past. Through the first ten months of 2000, thirty-eight of the country’s largest corporations replaced their CEOs, compared with only twenty-three during all of 1999 and fewer in the 1980s. The companies doing so included Campbell Soup, Procter & Gamble, Gillette, Lucent Technologies, and Mattel.