Speech by SEC Commissioner:
Remarks Before the CNMV Corporate Governance and Securities Markets Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
February 8, 2007
Good morning. I'd like to thank the CNMV, and in particular Manuel Conthe and Rodrigo Buenaventura for their efforts to set up this conference and for their kind invitation to join you here. This is an excellent conference, and I'm especially excited to touch on the issue of individual shareholder rights, which is a topic that often gets overlooked in favor of institutional shareholders' rights. In any event, before I begin, I must remind you that the comments I make today are my own and do not reflect the opinions of the staff or the other Commissioners of the Securities and Exchange Commission.
Let me turn to the topic of my talk today. The theme that I'll be addressing is the protection of minority and individual shareholder interests in the U.S. as compared to Europe and other jurisdictions. I'll begin by focusing on why I think it's important to discuss the protection of individual investors' rights. Then I'll discuss some of the differences between the U.S. and European corporate governance models, and in doing so, I'll raise some specific questions as to the impact of the different corporate governance rules on the rights of individual shareholders. Finally, I'll conclude by mentioning some steps that can be taken to protect individual shareholders. Of course, time permitting, I'd be happy to answer your questions on any topic.
II. Overall Thoughts Why Should We Focus on the Protection of Minority and Individual Shareholder Rights?
As you know, most jurisdictions have enacted various rules protecting the rights of minority and individual shareholders. In the U.S., for example, the different states have responsibility for many of our corporate laws, and they have enacted numerous provisions protecting small shareholders from abusive actions of large shareholders and management. For example, under Delaware law: (1) any stockholder can inspect and copy a corporation's stock ledger, a list of stockholders, and certain books and records of the corporation; (2) any stockholder can sue for an appraisal by the chancery court of the fair value of the stockholder's stock in connection with certain mergers; and (3) interested director transactions are subject to heightened approval requirements. Further, the U.S. federal securities laws and the SEC's rules also contain provisions aimed at protecting individual shareholders, such as: (1) requiring heightened disclosure for going private transactions; (2) requiring issuers to send proxy materials to all shareholders; and (3) mandating significant disclosures for related-party transactions.
Obviously, it's not just the U.S. that focuses on minority shareholders. The OECD, in their Principles of Corporate Governance, states that the "corporate governance framework should protect shareholders rights, which includes equitable treatment for all shareholders including minority and foreign shareholders." Moreover, and importantly, "all shareholders should have the opportunity to obtain effective redress for violations of their rights."
So, this raises an important question: why should we care about protecting the rights of individual shareholders? I think there are many reasons for doing so.
First, individual shareholders own a part of the company, and their rights must be protected just as are the rights of any other shareholder. Notably, the interests of individual and minority shareholders aren't always the same as those of institutional and controlling shareholders, which is a point that I'll come back to shortly.
But there are other, very practical reasons for protecting individual shareholder rights, in addition to the legal and moral ones. For example, as John Coffee has noted in a recent article, due to the nature of fraud in European countries, protecting minority rights can be somewhat of a proxy for combating fraud. Charlie Neimeier noted a similar issue in one of his recent articles that is, without adequate protections, controlling shareholders have the ability to extract private benefits to the detriment of minority shareholders.
We can also look at this point from the opposite point of view: if minority and individual shareholders know their interests are protected, companies can attract additional investment from these types of shareholders. This, in turn, can potentially improve returns and raise firm values, if more investors are interested and if the public has confidence that rights of all investors will be protected. So very simply, protecting minority shareholder rights ultimately attracts capital, which benefits issuers and the economy in which they reside. In my view, this justifies regulators and governments who want to support a system that protects minority shareholders.
There has been significant talk of the premium attached to the valuations of European companies when they dual-list in the U.S. One of the primary authors of a report released in the U.S. by the Committee on Capital Markets Regulation notes that there is still an overall cross-listing premium averaging 30 percentage points, which although down from 51 percentage points as recently as 2001 is higher than other markets in the world. Certainly a large part of the reason for that premium is the protection of minority shareholders through U.S. regulation and the rule of law and the decreased likelihood of domination from controlling shareholders.
Indeed, many large foreign investors, such as Norges Bank, Hermes and the British Telecom pension plan, favor investment in the U.S. and see the benefits of the Sarbanes-Oxley Act because the U.S. system protects capital better and returns are fair. As discussed later, they would invest even more in the U.S. if certain improvements were made to enhance protections for minority shareholders in public companies.
III. Corporate Governance and the Differences between U.S. and European Models
Having discussed some practical and economic reasons why it's important to protect the rights of individual shareholders, let me now talk about the differences between the U.S. and European models of governance, and the ramifications of these different structures with respect to the protections offered to individual shareholders. First, I'll touch on what "corporate governance" is designed to do, and then I'll discuss just a few of the more significant differences between the jurisdictions.
A. Definition of Corporate Governance
As defined in the IOSCO "Parmalat" report, corporate governance is a "term used to describe a system of overlapping legal, regulatory, organizational, and contractual mechanisms designed to protect the interests of a company's owners (the shareholders) and limit opportunistic behavior by corporate managers who control the company's operations." This definition seems to make a great deal of sense in systems with dispersed ownership structures, where no single investor owns enough shares to control the company, to compel it to take certain actions or to elect board members. In such cases, corporate governance mechanisms should protect investors against corporate managers, whose interests may not coincide.
However, focusing on corporate managers might not be effective in situations where controlling shareholders can exercise management control. Thus, corporate governance mechanisms are not needed to protect against divergent management and ownership interests, but rather to place limitations on the ability of controlling shareholders to exploit minority or individual shareholders. As the "Parmalat" report notes, "[r]ather than acting merely as a check against opportunistic behavior by management, strong corporate governance mechanisms . . . also protect the rights of minority shareholders against possible abuses by controlling shareholders."
B. Dispersed vs. Concentrated Ownership
Let's talk about dispersed vs. concentrated ownership and the issues raised by having controlling shareholders. Of course, this is a broad generalization, but most recognize that there is more dispersed ownership in the U.S. vs. more concentrated majority ownership and more controlling shareholders in Europe. I'm curious as to what my fellow panellists think about this with respect to the rights of individual shareholders. Does this mean that there are fewer protections in Europe because controlling shareholders can dominate companies? Or are there more shareholder rights because of the greater need to protect minority shareholders?
C. Fiduciary Duties
In the U.S. and the U.K., the so-called Anglo-Saxon legal tradition has developed an enforceable principle of fiduciary duties to all shareholders. In other words, directors are viewed under the law as essentially agents and, in some cases, trustees of all shareholders, and they must act accordingly. Minority shareholders have well defined private rights of action against directors and can enforce certain duties owed to them by the company and a controlling shareholder. In civil law countries, such as most of continental Europe, the fiduciary principle is far less developed and the rules-based approach in such countries permits in many cases the controlling shareholder to extract private benefits at the expense of minority shareholders.
D. Regulator-led vs. Shareholder-led Approach
Let me move on to another difference between the different models of corporate governance. As described by the Institute of Chartered Accountants in England and Wales (ICAEW), the U.S. system is one of a regulator-led approach, whereby the SEC establishes rules with respect to disclosure and other matters (and where the states enact laws with respect to corporate governance matters), which apply generally to all companies (with some exceptions) and which serve to protect shareholders of all sizes. By contrast, the U.K. has a shareholder-led approach that relies on shareholders to protect their interests directly. This generally means that it operates on a company-by-company basis. It is difficult and largely academic to say which approach is better since it seems unlikely that either jurisdiction will make wholesale changes, but what are the ramifications for individual shareholders?
Generally speaking, it appears that shareholders have more rights in the U.K. than in the US, especially with respect to board election and major transactions. But in addition to more shareholder rights, there is also more concentrated ownership. Does this mean that small shareholders have more or less rights in the U.K. or U.S.? As an example, under U.K. company law, a 5% shareholder can propose a full slate of directors at annual meeting. But if a company is comprised only of large or institutional investors, I think that true or effective protection for small shareholders is very difficult. For non-institutional or large private shareholders, is there an opportunity to put together a 5% group?
E. Plurality vs. Majority Voting
Another difference among the various jurisdictions is the way directors are elected. In the U.S., directors are elected by a plurality of shareholders. When coupled with the fact that shareholders in the U.S. are extremely limited in their ability to nominate director candidates, it means that U.S. investors have very little say in choosing directors. By contrast, in the U.K. and other jurisdictions, directors are elected by a simple majority, and directors can be removed at an annual or extraordinary meeting. What are the ramifications of this with respect to individual shareholders?
It seems to me that in U.S., individual shareholders have even less of an ability to influence director elections than in other jurisdictions. They cannot even use their minority status to form coalitions with larger institutional shareholders because a plurality will carry the day. That said, many U.S. companies are now voluntarily adopting majority voting rules, so perhaps the influence of individual shareholders will increase slightly.
Let me go back to the point about increased firm values stemming from protecting minority shareholders. If the U.S. were to make it easier for shareholders to influence the election of directors, would the value of U.S.-listed companies rise? Would institutional and individual shareholders in Europe and around the world be more willing to invest in U.S. companies if they believe that they would have a greater ability to influence director elections? Indeed, Norges and British Telecom have told me that if the U.S. would adopt a form of shareholder access to the proxy system, they would invest even more in the U.S.
F. Different Types of Fraud
According to an article by John Coffee, the different ownership systems dispersed vs. concentrated may lead to different types of fraud. Coffee notes that the U.S., with its dispersed ownership system, is more prone to earnings management and quarterly reporting frauds. These types of frauds are designed to increase earnings and revenues in a given quarter, which leads to increased stock prices and greater value of stock options, and which benefits management over shareholders.
By contrast, in Europe, with the higher proportion of companies controlled by a shareholder or shareholder group, the controlling shareholder has more significant control over management, doesn't need to resort to equity as much as in the U.S., and is therefore not as susceptible to short-term earnings management. Rather, the paradigmatic fraud in European countries is the Parmalat matter, which evidenced the extraction of private benefits from the corporation to the detriment of minority shareholders.
So, again, what does this mean for individual shareholders? As Coffee notes, "in dispersed ownership regimes the villains are managers and the victims are shareholders, while, in concentrated ownership systems, the controlling shareholders overreach minority shareholders."
Given that all shareholders are victims in U.S.-style frauds, does this mean that there is less need to focus on the rights of individual shareholders when seeking to combat fraud? To put it another way, can individual shareholders count on, for example, CalPERS or Fidelity, to protect their interests when it comes to fraud?
Conversely, does this mean that individual shareholders must be more vigilant in concentrated ownership systems because they have no obvious allies whose interests overlap in this regard? If so, how could individuals exercise their corporate rights to protect against the fraud of controlling shareholders? As Coffee asks, "can gatekeepers in concentrated ownership systems monitor the controlling shareholder who hires (and potentially can fire) them?"
IV. What Should Be Done to Best Protect Minority Shareholders?
Having discussed the importance of protecting the rights of individual shareholders and having posed some thoughts and questions as to the differences in rights among the various jurisdictions, I thought that I would highlight some general thoughts about improving the ability of individual shareholders to exercise their rights.
A. Institutional Owners Must Exercise Their Fiduciary Duties
One thing that can be done to assist individual investors is to have institutional investors, who after all, represent small shareholders as pensioners or beneficiaries, become more open about their policies and voting. As set forth in the OECD Principles of Corporate Governance, institutional investors acting in a fiduciary capacity: (1) should disclose their corporate governance and voting policies, including the procedures for deciding the use of voting; and (2) should disclose how they manage conflicts.
For example, in the U.S., mutual funds are required to disclose their voting, but this requirement does not extend to all institutional shareholders. Requiring or seeking this disclosure is important for a number of reasons. First, it directly benefits the individuals who are the beneficiaries or trustees of the institutional investor, and allows them more influence. For example, although holders of mutual fund shares or pension recipients are not beneficial owners in the legal sense of the word, they are the beneficiaries of such institutions. So, in a sense they are like individual investors.
More disclosure would enable these "investors" to make better investment decisions. In practical terms, this might not matter to, for example, a California state employee who relies on CalPERS for his or her pension. But it likely does matter to individuals who are invested in mutual funds, because they can vote with their feet and sell their shares if they disagree with a fund's voting decisions. In addition, such disclosure on the part of institutional holders can also provide guidance for individual shareholders.
B. Focus on Corporate Governance to Prevent Fraud
Shareholder rights are also important in the anti-fraud context. As set forth in "Parmalat" report, the breakdown of specific corporate governance structures has allowed fraud to proceed. While some of these governance structures serve to protect all investors, many of them are tailored to the desire to protect individual investors. That said, some of these governance structures might not be adequate to protecting individual shareholders in a company with a single controlling shareholder. So, I think we do need to step back and discuss the role of "good governance" in companies with controlling shareholders. In doing so, I'll discuss a few different types of governance protections.
1. Independence of board members
The purpose of independent directors is to help protect the interests of shareholders from that of management. In companies with diverse ownership structures, this seems like a clear benefit, and boards act on behalf of all shareholders. With controlling ownership structures, though, does requiring independent directors make sense? I think so, although the case for independent directors may not be as clear as it is for companies with diverse shareholder bases.
That is, directors who are truly independent (and honest) can, for example, prevent the outright corporate looting and shady related-party transactions in other words, they can keep controlling shareholders from extracting private benefits from the company to the detriment of minority shareholders. On the other hand, a controlling shareholder who is intent on extracting private benefits from the company can probably get around the prophylactic measure of independent directors.
To put it another way, it's relatively easy to define independence and to impose legal requirements that have the effect of protecting minority shareholders, but it seems slightly more difficult to assure independence and independent judgment in the case of a corporation with a controlling shareholder. For example, couldn't a controlling shareholder merely remove directors if they were too "hands on" or too independent? And wouldn't directors, even independent directors, be answerable primarily to a controlling shareholder over individual investors? On a related-topic which I'll discuss in more detail in a moment even if truly independent, can directors effectively rein in executive pay?
2. Controls on related-party transactions
Having stricter controls on related-party transactions seems to be another important way of reducing the ability of both management and controlling shareholders to undertake transactions to benefit themselves over shareholders generally or individual shareholders in particular. Some jurisdictions require: (1) disclosure; (2) specific board approval of related-party transactions or (3) approval of a majority of disinterested directors of such transactions.
In the U.S., there is combination of these requirements, through the laws and rules of specific jurisdictions. For example, the SEC requires significant disclosure of related-party transactions, while the corporate laws of many states contain various board approval requirements designed to promote disinterested director approval. Once again, however, even these protections which I think are very important might tend to break down in the case of an entity dominated by a controlling shareholder who is intent on extracting private benefits from the company.
While it is true that as some have said with respect to Sarbanes-Oxley that no set of laws can prevent fraud when a number of high-ranking executives conspire, it does seem to me that related-party transactions are more easily hidden and done in the case of a concentrated company with a controlling shareholder. Is their anything specific that can be done about this?
3. Legal protections for shareholders and minority shareholders
Also important to individual shareholders are specific legal protections designed to give concrete rights to minority shareholders. Some of the more important protections are: (1) preemptive rights with respect to additional stock issuances; (2) independent appraisals for buyouts or going private transactions; (3) heightened voting requirements for certain transactions; and (4) direct and quick access to the courts to address any potential violations of these rules.
Moreover, directors should have fiduciary duties to all shareholders, specifically including minority shareholders. Of course, fiduciary duties are only as good as the ability of a shareholder to bring an action for redress. If access to the courts is too difficult, or if particular standards on directors are too lenient, then the existence of amorphous fiduciary duties means very little.
4. Sarbanes-Oxley, internal controls and the audit committee relationship
I would be remiss if I didn't at least touch on the Sarbanes-Oxley Act, which has had a huge impact on corporate governance in the U.S. over the past few years. The breadth of SOX is incredible, but a large part of the Act is designed to help prevent fraud by, among other things, improving internal controls, requiring CEOs and CFOs to certify as to the accuracy of their financial reports, and strengthening the independent auditor relationship with the independent audit committee.
Of course, the value of internal controls, an independent auditor and audit committee and CEO/CFO certifications doesn't reside in the fact that these things are merely present; rather the importance of these controls is that they operate effectively and can be overridden only in the rarest of circumstances. Indeed, a report conducted at the height of the last stock market bubble found that in a large majority of the fraud cases brought by the SEC, the CEO, the CFO or both had overridden internal controls and/or booked fictitious revenues. This reminds me of a joke I heard:
A bright and experienced accountant is interviewing for a position of a CFO. During the interview the CEO suddenly asks: "Tell me, what is seven multiplied by three?" The accountant thinks fast and says "22." Once the interview is over the accountant goes out, takes out the calculator and finds the answer 21. Disappointed, he goes home. Next morning he gets a call from the CEO, "Hey, you got a job." The accountant is pleasantly surprised. "Thanks you very much for the job," he asks, "but what about seven multiplied by three?" The CEO tells him: "of all the candidates we interviewed, you came the closest."
Seriously, though, I use this joke to illustrate a point: getting it close isn't good enough, and merely having controls without ensuring their effectiveness doesn't work. Internal controls and independent auditors are great, but if a single executive can sidestep them, how effective are they really? Further, how effective are such controls and independence requirements in a governance structure dominated by a controlling shareholder? Similar to the point I made earlier about independent directors, couldn't a controlling shareholder merely fire an audit committee member if she probed too deeply into the financial? Doesn't a dominant shareholder have as much power as a CEO to override internal controls? What can be done about this? While forensic audits are not required, perhaps one area to concentrate on should be better controls and better follow up of suspicious conduct.
C. Adding Controls over Management, Especially with Respect to Executive Compensation Shareholder Advisory Votes
Let me use this discussion to talk about a topic that is starting to generate discussion in the U.S. shareholder advisory votes on executive compensation. Allowing shareholders to have a meaningful say in executive compensation is crucial, because this issue goes to the heart of the corporate structure. Without adequate compensation structures, management may have an incentive to promote policies enriching themselves at the expense of shareholders. I'm not sure this issue highlights the dichotomy between institutional and individual shareholders, but I think it's important because executive compensation is an area in which I'm not certain that independent directors can exercise significant control. I can think of two reasons why this is.
The Ingrate Dynamic. Being invited to become a director is like being invited to join a country club. In my opinion, when boards select potential director candidates, one major consideration is how the prospective director will get along with the CEO. This leads to what I call the "ingrate dynamic." Given the relative paucity of director positions at public companies, they are highly desirable jobs, and I would guess that most directors are excited and honored to be nominated. Thus, I think there's a natural tendency for directors not to be an ingrate. How can a director be unappreciative by trying to lower the CEO's compensation (particularly when so many directors are CEOs themselves)? Add to this the fact that board is playing with the house's money and not their own when it comes to CEO compensation, and it's not hard to see why compensation has spiraled out of control.
Real Estate Appraisal Phenomenon. Another significant driver of excessive CEO compensation is the use of compensation consultants. I call this the "real estate appraisal phenomenon." That is, when has a real estate appraisal ever come back for an amount less than the contract price of the property? Pretty much never, I think. The property is always worth the agreed-to purchase price. I think it's pretty similar with CEO salaries.
So far, I don't think the issue of shareholder advisory votes has hit critical mass in the U.S., even though such votes are present in other jurisdictions, such as the UK and Australia. It wasn't a part of our executive compensation release, and only a handful of commenters raised this issue during the comment process. That said, I do think that the topic of shareholder advisory votes has gained significant traction over the past year or so, and I'm pretty confident that this could be one of the new hot-button topics in proxy proposals.
D. Shareholder Access
Let me conclude with a brief discussion of shareholder access, that is, the ability of shareholders to nominate candidates for director. This has been a big issue in the U.S. the past few months, and although it doesn't specifically relate to the rights of individual shareholders, I do think it highlights the fact that in the U.S., individual shareholders have almost no power to influence the election of directors.
Recently, the Second Circuit court of appeals issued an opinion that opened up the door to shareholder access by holding that a shareholder proposal that seeks to amend the corporate bylaws to establish a procedure by which shareholder-nominated candidates may be included on the corporate ballot cannot be excluded from corporate proxy materials under the SEC's proxy rules. The end result of this case is far reaching: as it currently stands, it has opened the door wide open, at least in the territory covered by the Second Circuit, for shareholders to submit proposals establishing procedures by which shareholder-nominated candidates can be included on corporate proxy materials.
The big question, of course, is what the SEC will do next. So far, we've postponed consideration of this topic three times. In my opinion, the Commission should take this opportunity to fashion a rule that provides for some moderate measure of shareholder access to the proxy ballot. By that I mean a system that permits a significant shareholder (who owns at least 5% of the company's shares) that has held shares for at least a year to be able to have a minority slate of nominees placed on the company ballot. I believe that companies will ultimately benefit from such provisions in that shareholders will find shares of such companies more valuable. Moreover, such a system will simply promote better discussions between business and major shareholders in the U.S. A far more permissive system in the U.K., which allows a 5% shareholder group to nominate a full competing slate of directors is never used because good discussions with shareholders make it unnecessary. Unfortunately, it does not appear that there will be easy consensus on what we should do.
But failure to reach an absolute consensus on shareholder access should not stop the Commission from taking steps to ensure that shareholders have access to the ballot. Simply put, I would be opposed to any Commission action that has the effect of overturning for lack of a better word the Second Circuit's decision, without taking a meaningful step in the direction of providing more general and final rules allowing shareholder access. If we can't agree on a specific course of action, then I think it would be wise not to do anything this proxy season and let the Second Circuit's interpretation stand. Then, after we see what really happens during proxy season, we can act or not act as we see fit, with the benefit of real-world information. Call this a court-imposed pilot program.
In summary, for the reasons I have stated, it seems to me that the U.S. has a system of regulation and company law that provides significant protections for minority shareholders and is viewed in that fashion by foreign investors. Sarbanes-Oxley is the latest additional set of protections for shareholders. The U.S. system of protecting minority shareholder rights has been very effective in helping attracting great amounts of foreign capital to the U.S., and I think that the adoption of similar, Sarbanes-Oxley types of provisions by most countries indicates the widespread view that such regulation is a positive for local markets.
However, weaknesses remain in the U.S. system, according to some foreign investors. For example, independent directors have not been able to control the level of executive compensation, which often has no relation to performance. New S.E.C. compensation disclosure rules may help, as well as the new activism seeking non-binding advisory approval of compensation packages by the shareholders. Foreign investors also believe that a reasonable form of shareholder access to the proxy is required in the United States. I am told by foreign investors that they would invest even more billions in U.S. equities if shareholder access to the proxy were part of our system.
As for the European system, I think that in general the European civil countries should consider whether the prevalence of large controlling shareholders is causing in some cases the view (perhaps wrongly) by investors that minority shareholders can be exploited, and, as a consequence, is hampering greater foreign investment. If so, some of the protections for minority shareholders that I previously discussed may be appropriate.
In conclusion, good corporate governance can help ensure the rights of individual shareholders. The overall goal of the regulatory system and the rule of law are to protect capital in part through the protection of minority and individual shareholders. Given their different systems of regulation, the different jurisdictions should rightly focus on improving different aspects of their regulatory regimes.
I'd like to thank you for your time and attention. I'd be happy to answer any questions.