By Louis Corrigan
The CEOs and other top executives who run America's public companies are not demigods; they're employees. And the people they work for are us, the shareholders. As we discussed last week, these corporate managers not only should be responsive to the people who own America's companies, but they are legally required to fulfill some basic obligations.
Accountability, however, goes way beyond meeting SEC guidelines for proper disclosure. Since the early 1980s, managers have been held to an increasingly high standard of accountability after years of essentially ruling the roost, free of meaningful oversight. This new accountability is founded on performance, and the most powerful examples of this change came during the past ten years, as executives at underperforming behemoths such as American Express, IBM, Eastman Kodak, and K-Mart found themselves ousted by disgruntled institutional investors putting new pressure on boards of directors.
The standards of accountability will be raised higher still in the years to come, but they will be broadened, as well. Investors will increasingly learn to rethink the issue of performance as they rethink the goal of ownership and learn to exercise more effective control over the companies they own. But the essence of control remains the same: an effective set of corporate governance policies designed to create an independent board of directors that remains aligned with and literally accountable to the shareholders.
On the face of it, corporate governance is a boring subject in which most institutional investors, let alone individual investors, remain poorly versed -- until a crisis erupts. But governance issues are absolutely crucial if a corporation's managers are to run the company for the shareholders rather than for themselves. The sole purpose of a company's board of directors is to represent the interests of shareholders. Those interests are frequently defined as maximizing the creation of wealth without inflicting unnecessary harm on third parties or undo costs on society. The board's primary means of looking after the business is by appointing and evaluating the CEO and acting promptly if the management is failing to do a good job.
Make no mistake, what is good for a company's managers may not be good for its owners. Managers will often attempt to pay themselves more than they're worth. They may go to extraordinary lengths to hang on to power even when confronted by a fully funded takeover offer that the majority of shareholders favor. Or like RJR Nabisco's infamous CEO F. Ross Johnson, they may acquire a whole fleet of corporate jets to entertain VIPs and carry them to nice resorts. When managers abuse their power, it often ends up costing shareholders. Literally.
As Robert A. G. Monks and Nell Minow of the Washington, D.C.-based LENS fund have argue in their recent book Watching the Watchers, the real challenge of effective corporate governance is striking a balance between power and accountability. Executives must have extraordinary power to set and implement corporate strategy. In a sense, like military leaders, they must be given the authority to determine how to get the job done and to lead the troops in the field. At the same time, however, executives must remain accountable to the board, just as the U.S. military is accountable to the President. Boards must be in the position to offer effective oversight both before and after the fact, to approve corporate strategy as well as to evaluate how its working. Investors can reasonably disagree about what specific governance policies are best suited to establish such a proper balance. But Rogue would like to propose some basics.
A study published in 1993 found that 76% of companies had one person in the dual positions of CEO and Chair. Those numbers may have improved somewhat in the last few years, but it's probably safe to say the majority of firms still allow such double duty. As former ITT chair and CEO Harold Geneen has said, nothing could represent a stronger conflict of interest: The top professional manager "cannot represent the shareholders and impartially sit in judgment of himself."
Concentrating corporate power in one person effectively makes it all but impossible for a board to hold management accountable because a company's Chair, at the very least, sets the tenor for the board's oversight function. At least one study has shown companies that properly split these positions outperform the ones that don't. It's only logical. The possible exception to this rule is in cases where the dual-office holder is also the majority shareholder.
For the middle decades of this century, the boards of America's public companies were all but dominated by management. One study found that even in 1973, a company's own executives filled 38% of the seats in the average boardroom of America's top companies. Through pressure for reform, that number has now dropped to about 25%. Executive search firm SpencerStuart, which often surveys the top 100 American companies, has found some healthy changes in recent years. Between 1988 and 1993, these firms saw a net gain of 128 outside directors. On average, the surveyed firms had three insiders on their boards. At the same time, their boards generally shrank in size from 15 to 13 members. This is a positive trend that has continued in recent years.
Executives of smaller, more closely held companies are more likely to also serve on the board of directors, though this arrangement is somewhat mitigated by the likelihood that these executives are also significant shareholders. Still, to keep the corporation's system of checks and balances in place, boards should be composed almost entirely of outside directors. The company's CEO is perhaps the only executive who should sit on the board, as was the case with 14 out of the 100 companies in the above survey. Even former CEOs probably should not serve on the boards of major corporations because their shadow influence can unnecessarily impede a successor's autonomy.
What constitutes an "independent" director? The criteria vary, but the term generally excludes the company's full-time employees; family members of those employees; people affiliated with the company, such as bankers, lawyers or consultants; anyone who does business directly with the firm, including suppliers, customers, creditors or debtors; individuals connected to non-profit organizations to which the company contributes; and directors or executives at other firms for which the CEO serves as a director. In preparing some similar formal guidelines for board membership, the influential California Public Employees' Retirement System (CalPERS) has also proposed that any director with a company for more than 10 years should no longer be considered "independent."
Possessing a non-executive CEO and board is integrally connected to ensuring that the board itself is not simply a collection of the CEO's cronies assembled to socialize, enjoy some nice perks, and rubber-stamp management's proposals. The reason is simple. Boards typically have nomination, compensation, audit, finance, and executive committees. These committees select candidates for the board, establish executive pay, review auditing and accounting procedures and reports, review the company's capital needs and allocation, and approve decisions between the general board meetings. Each of these committees should be led by an independent director.
But for this to happen, it's logically essential that the nominating committee be completely independent from management. All too often, the CEO will send a slate of directors to the nominating committee, also composed of that executive's former selections. The entire board then approves the slate, and the shareholders then vote them in. As former CalPERS CEO Dale Hanson has said, "Nominating committees all too often are a sham, pure and simple." That's not the way it should work. And where it does work that way, shareholders should rightly vote against the management slate or offer an opposing slate.
What shareholders need is the opportunity to have their candidates formally considered by the board's nominating committee. The right to run a slate of candidates to compete with the one suggested by the current board is simply a difficult right for most investors to exercise, and usually unnecessary. To make the electoral process work, though, companies must make voting confidential and cumulative. There's simply no reason why shareholders should be forced to elect an entire slate of directors if they are dissatisfied with some of them. Cumulative voting allows shareholders to elect alternates more easily.
Since shareholders depend on boards to look after their interests, they must do all they can to ensure they protect their rights to pressure, or in still rare instances, oust the directors. Until the takeover era of the 1980s, directors were typically up for election each year. To resist takeovers, however, incumbent managements and the boards they created petitioned some well-meaning but ignorant state officials to help strip many shareholders of this right. The result was a system of "staggered" or "classified" boards. Typically, the new model includes three classes of directors, each elected on a three-year cycle. With only a third of the board up for election each year, a hostile bidder would be faced with a two-year battle to gain control of a company, even if he attained a majority ownership stake.
It's often argued that staggered boards ensure board continuity while protecting individual shareholders from the arbitrage vultures of Wall Street who swoop down to pick up shares in companies that are "in play." Yet, continuity per se is hardly an asset if the board isn't acting as shareholders wish. Second, the rights of shareholders in general should not be abrogated because some shareholders are opportunistic in specific instances. Though greed is a powerful force, a board that can genuinely make the case that shareholders will be better served in the long term by supporting the current management will in most cases find a receptive audience. But that case should be made directly to shareholders through a vote. The annual election of directors is one crucial element in forcing such a vote.
It's not enough for directors to be independent from management. They must be positioned to think and act like shareholders. To do so, they must become significant owners in the company they oversee. Again, reasonable investors might disagree on specifics. But we at Rogue like the idea of directors devoting 10% of their total investment assets, or at least $1 million (whichever is less), to buy shares in the companies their serve. Call it a no pain, no gain proposal.
Rogue doesn't often agree with Sunbeam CEO Al Dunlap, but in this case he's right. If shareholders' returns are contingent on a stock's performance, so, too, should a director's compensation. As Michael Useem reported in his book Investor Capitalism, nearly 80% of companies were offering some director compensation in stock by 1995, up from under 40% in 1989. Dunlap led the parade at Scott Paper, where he used 100% stock compensation for outside directors.
We can and should quibble over the amount of compensation, but the form is even more important. Instilling such self-interest in directors is good for corporate performance. Another study cited by Useem compared two groups of Fortune 500 companies whose directors were compensated at equivalent levels. For one group, the directors held $43,000 in stock. The other group, by contrast, owned an average of $311,000. In 1991, the first group of stocks turned in a negative 5% return while the latter group saw share prices rise by 60%.
If directors are not willing to invest a fair amount of their own money in a company -- including their compensation -- they have no business being directors of that company.
Directors often find themselves in the uncomfortable position of knowing far less about the company than the CEO does. This becomes particularly uncomfortable in cases where the CEO fails miserably at the job of running the company or actually defrauds shareholders. Boards do not need to become a shadow management, but they do need to become far more knowledgeable. That entails both more substantive meetings with management to evaluate strategy and execution, plus more hands-on understanding of the business at the level of the factory floor or the retail outlet. The board must understand a company thoroughly and actively seek out problems or opportunities before they become important.
At present, most boards simply don't pass muster on knowing the business. Often rthe directors are often simply overextended. Experts generally believe that a director must spend about 100 hours a year to fulfill even current expectations. That becomes very difficult when, studies show up to 65% of outside directors serve on two or more boards while 89% of executive directors also serve on another company's board. Indeed, one 1992 study of Fortune 1000 directors found that 20% served on four or more boards.
A more recent study by compensation specialist Graef Crystal found that in 1995, 122 directors of Fortune 1000 companies served on eight or more boards. Curiously, the boards on which these directors served also overpaid their CEOs relative to equivalent firms. Most directors also have other full-time jobs. But even without such responsibilities, no one could possibly manage to do justice to so many different directorships. Former Defense Secretary Frank C. Carlucci serves on 14 boards: he literally cannot attend every board meeting that's scheduled because they often overlap.
The proper level of board oversight will require even more time from directors and more thoughtful and diligent oversight. There's simply no way a director can adequately serve more than three companies at one time. Indeed, it's preferable for part-time directors to be focused on one firm alone. Requiring directors to buy a significant number of shares is perhaps the best way to ensure that directors cut down on their own busy schedules and focus on what really matters. If their own money is at stake, the quality of their oversight should begin to matter, even to them.
Corporate boards have generally become far more responsive to shareholders in the last fifteen years. Yet they still have a long way to go. And though governance issues may seem too divorced from investors' basic goal of creating wealth by owning good businesses, they are actually central to that goal. Management serves by the grace of the board that serves by the grace of shareholders. Strengthening that basic system of accountability is important both to the future of American business and to your own portfolio.