Rogue Missives Friday, June 27, 1997

You might call it the proclamation that wasn't. Proclaimed, that is. On June 16, the Wall Street Journal reported that the directors of the investment committee of the California Public Employees' Retirement System (CalPERS), the nation's largest public-pension fund, were set to endorse the country's strictest corporate-governance standards. The standards, proposed by CalPERS staff under its general counsel, Kayla Gillan, codify, for the first time, an array of practices deemed necessary to ensure the power and independence of corporate boards of directors.

CalPERS has always been among the country's most activist pension funds, and has played a crucial role in the development of what author Michael Useem has termed "investor capitalism." The fund was instrumental in orchestrating the replacement of CEOs at a number of Fortune 500 companies, including GENERAL MOTORS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>, IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, and EASTMAN KODAK <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EK)") else Response.Write("(NYSE: EK)") end if %>. More recently, CalPERS led a successful fight to force REEBOK <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RBK)") else Response.Write("(NYSE: RBK)") end if %> to de-stagger its board of directors. A proposal offered by CalPERS at Reebok's annual shareholder meeting in May passed with 53% of the vote.

Surprisingly, though, CalPERS' directors have never endorsed an explicit set of corporate-governance standards, which made the report in the Journal all the more weighty. But the real surprise came the next day, when the investment committee announced that instead of endorsing the principles it had chosen to establish a working group to study the proposed standards. It seemed like the classic political decision: set up a committee that would report back months from now. A new draft proposal is scheduled to be delivered to the committee by August.

On the other hand, while staff members feel an understandable set of frustration at the committee's failure to endorse their recommendations, it's perhaps understandable that board members would like to spend some scrutinizing the proposals before making them fund policy. Given the size of CalPERS' holdings (it has $113 billion in assets), the political impact of its decisions, and the fact that the fund plans to use the standards to make decisions on board of directors elections, a more tempered approach may be in order.

In any case, the committee's tabling of any endorsement does not, in any meaningful sense, alter the most important aspect of the proposed standards, which is the institutionalization of an approach to investing that emphasizes not merely shareholder value but also shareholder power. At their heart, what the CalPERS principles seek to do is transform corporate directors from rubber-stamp supporters of management into genuine representatives of shareholder interests.

Ideally, of course, corporate managers should play that same role. But the realities of the system often dictate that managers end up paying more attention to their own perks and their own self-interest than to those of the company as a whole. More substantively, it's easy for managers to fall in love with their own strategies, even when they seem not to be working. Independent boards are able to bring a necessary measure of discipline and control to corporations. In the long run, independent boards could also play an essential role in changing corporations who have grown dependent upon exploitative labor practices or ethically dubious pursuits.

With that emphasis on independent boards in mind, the CalPERS' staff proposals would lead the fund to measure each of the large companies in its portfolio against the standards it has called "fundamental principles." Companies that do poorly could very well find CalPERS voting against re-election of their boards at the next shareholder meeting.

As the Journal reported, those fundamental principles include: a tougher definition of independent director that would exclude any director who had sat on the board for more than 10 years; the appointment of independent directors to a majority of board seats; the selection of an independent director as a so-called "lead director," who would assist the chairman in running the board; the adoption of guidelines outlining the way in which board members who sit on multiple company boards should deal with competing commitments; and the establishment of rules limiting the number of directors over a certain age.

The CalPERS staff also suggested a set of "ideal principles," tougher than those deemed "fundamental," which could be used to evaluate companies down the road. These ideal principles, if ever adopted, might very well effect a dramatic transformation in the basic operation of U.S. corporations. They would require, among other things, the selection of an independent director as chairman of the board, the dismissal of directors who fail to meet performance standards and, most strikingly, the exclusion of all employees except for the CEO from the board of directors. In other words, the ideal standards would make boards truly independent oversight bodies and not, as they tend to be today, curious melanges of insiders and outsiders.

At the same time, it would be a mistake to overestimate the impact of the adoption of the fundamental principles by most U.S. corporations. Although all steps toward shareholder democracy are crucial, the CalPERS proposals are necessarily limited in their potential to effect genuine transformation. It's not entirely clear, after all, how far boards of directors are able to distance themselves from company management, upon whom they rely for almost all of their information. And while the emphasis upon independent directors is welcome, one wonders how long a director has to sit on a board before independence, in the CalPERS sense, starts to seem like a meaningless term.

It's that consideration, of course, that prompted the CalPERS staff to suggest that any director who has served more than a decade no longer be counted as independent. This is, to be sure, a tendentious proposal. As with term-limits proposals for Congress, restrictions on the number of years that directors can serve run the risk of replacing veteran and experienced leaders with novices. In addition, an argument could be made that new directors -- whatever their background -- are more likely to defer to management (precisely because of their inexperience) than are directors who have been around a while. Nonetheless, the guiding principle is essential: directors represent the voices of shareholders, and all measures that make them more responsive to shareholder concerns are good ones.

The struggle to reshape the face of corporate capitalism is necessarily a long one, but it is a struggle in which standards like those offered by the CalPERS staff are fundamental. What we are witnessing is, in a sense, the institutionalization and codification of rules of governance, the replacement of haphazard and hodgepodge customs reminiscent of an old-boys network with a more systematic vision of the appropriate relationship between companies and the people who own them.

-- Jim Surowiecki (Surowiecki)

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