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Bill George

Harvard Business School Professor, former Medtronic CEO

Who is Governing Corporations: The Board or Governance Gurus?

The never-ending barrage of proxy proposals from governance experts raises an uneasy question: Who is governing corporations these days – elected boards of directors or self-appointed governance firms?

The 2002 enactment of Sarbanes-Oxley and NYSE listing requirements has led to significant improvements in corporate governance. Boards operate more independently and the relative power of CEOs and their boards has been rebalanced. Even relationships between corporations and the SEC – the official federal regulator of corporate governance – have settled into appropriate equilibrium.

Just as corporate governance gets on track, self-anointed governance gurus – for-profit firms like Institutional Shareholder Services (ISS), the Corporate Library, GovernanceMetrics International (GMI), and Glass, Lewis – are challenging these legally elected bodies for control of corporations. Not satisfied with the improvements, these firms – which are not shareholders at all – agitate to wrest control for themselves and for shareholder activists. They purport to represent shareholders by rating company governance, submitting proxy proposals for consideration at shareholder meetings, and consulting with companies desirous of improving their governance ratings.

The governance gurus wrap themselves in the banner of “shareholder democracy,” although governance of American corporations was never intended to be democratic. The legislators who created governance laws recognized most corporate governance decisions are too complex to be made independently by thousands of shareholders. Only the most important decisions, such as the election of directors and major mergers and acquisitions, require a special shareholder vote.

Like elected representatives in the federal government, corporate directors are elected by shareholders and legally charged with the fiduciary responsibility to govern the corporation. The courts have consistently backed the responsibility of directors to use their “business judgment” in making decisions regarding the corporation´s best interests.

What these governance firms are proposing is not democracy at all, but rather taking control of corporate governance in order to promote an active market of takeovers and force changes in management and boards of directors. Their power is growing because institutional shareholders are unwilling to do the analysis and invest time into voting proxies for their vast array of shares. So they follow these firms´ recommendations – all for a fee.

ISS is the most powerful – and most conflicted – of the firms. It derives its power from its proxy advisory service for institutional shareholders, who currently hold over sixty percent of the shares of U.S.-based companies. Through its recommendations, ISS can influence – if not control – thirty percent or more of the shares voted. The “Corporate Governance Quotient,” ISS´ ratings model, attempts to quantify the quality of firms´ governance. ISS also sells its advisory services to companies anxious to improve their governance ratings, creating conflicts of interest for ISS´ supposedly independent advice. Nevertheless, many companies cater to ISS to improve their ratings and ensure favorable votes on proxy items.

In recent years governance firms have focused on the annual election of all directors, eliminating multi-year terms and staggered boards in order to enable hostile raiders to replace the entire board at a single meeting. They have also insisted on majority votes for directors. Recognizing the importance of director elections, many boards have agreed to reconsider directors´ standing in the absence of majority votes.

But these changes have not satisfied the governance specialists, who are now asking for “cumulative voting” for directors. Cumulative voting means that a shareholder representing one million shares in an election of twelve directors could cast twelve million votes for a single director, perhaps a write-in candidate. Shareholder democracy?

In actions like these governance firms have shown their hand, which is not democracy at all but support for takeovers and management changes. This enhances their relationships with the hedge funds, which usually care more about events that create volatility than they do about shareholder value.

Another focus is “say on pay” resolutions, following the British tradition of giving shareholders an up or down vote on the CEO´s compensation. At first glance, letting shareholders opine on compensation sounds logical, but the problems it creates are enormous. Legally, determining executive compensation is the responsibility of the board of directors, which in turn is delegated to its compensation committee. Determining CEO compensation is an extremely complex task, one that must be closely linked to the firm´s objectives and to employee compensation plans.

Granting shareholders such a privilege raises serious questions about the board´s responsibilities. What´s the remedy if the shareholders turn down the CEO´s compensation? Propose another plan and let the shareholders vote again? The governance firms would likely offer their own alternative to the CEO´s compensation. At this point, the power transfer from the board to the unelected governance firms would be complete and would lead to their next proposal to increase power. Boards that naively attempt to curry favor with ISS and others to win their approval will learn the hard way that these outside firms will never be fully satisfied until they have wrested control from the boards.

I am not suggesting that boards should stonewall these initiatives by dissident shareholders and governance firms. Rather, these unrelenting pressures suggest that board members must step up to their legally-elected leadership responsibilities and become more active in corporate governance. This requires more time and greater leadership. No longer can boards delegate their responsibilities to company management – but neither can they abdicate their duties to governance gurus.

The alternatives are clear: either boards step up to leadership, or our entire system of corporate governance is at risk. The time for leadership is now!