Rutgers, The State University
Department of Finance and Economics
Management Education Building
180 University Avenue
Newark, NJ 07102
Tel: (973) 746-0433
December 23, 2003
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Re: Security Holder Director Nominations
(Release No. 34-48626, IC-26206;File No. S7-19-03)
Dear Mr. Katz:
The SEC's proposed rule changes regarding corporate board elections is of interest because of its possible positive impact on (1) increasing the price of equity shares for the present equity shareholders and (2) improving the quality of corporate governance.
2. Equity Share Prices and the Quality of Corporate Governance:
Equity share prices and the quality of corporate governance are inextricably linked. A recent well-regarded, rigorous and systematic study of the linkage between the corporate governance and equity share prices, is authored by Paul Gompers, Joy Ishii and Andrew Metrick (hereafter GIM). GIM uses 24 different surrogates of corporate governance for a sample of 1400 companies for the time period 1990-1999. They find "that firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures and made fewer corporate acquisitions." Indeed, an investment portfolio strategy based on buying equities of firms having strong shareholders rights and selling equities of firms having weak shareholder rights would have received abnormal stock returns of 8.5 percent per annum for the time period 1990-1999. This means as GIM suggest that the long-run benefits to the equity shareholders of "good" corporate governance should be an important component of a firm's value additivity strategy because it is very much in the shareholders' best financial interest.
Another study investigating the benefits to shareholders from "good" corporate governance is by CalPERS. CalPERS is a leading corporate governance activist who happens to be a large ($154 billion) institutional investor (i.e. state public pension plan). An important dimension of CalPERS corporate governance efforts is the CalPERS Focus List. This list began in 1992 and targeted companies that (1) had poor corporate financial investment performance and (2) had poor corporate governance practices. Before inclusion on the CalPERS Focus List, several steps over a period of time are required. This typically involves contact between companies and CalPERS where discussion is focused on (1) CalPERS corporate assessment of the firm's performance including stock market performance and corporate governance concerns and (2) the firm's case, including an action plan, to avoid being included on this Focus List. The Focus List is usually published in February or March of each year. It does not have a specific fixed number of companies. What has been the stock market performance for the companies after inclusion on the CalPERS Focus List? Alternatively stated, using the standard financial event study methodology, what has been the stock market return performance post inclusion in CalPERS Focus List? Using financial market data for five different time periods, the empirical evidence indicates that (1) for each time period, the samples indicated positive cumulative excess returns (i.e. superior performance for the sample companies), (2) the increase in shareholder wealth was larger for companies having shareholders that are large and widely dispersed and (3) shareholders' wealth increment resulting from inclusion on the Focus List has not diminished over time. More specifically, as an illustration, at the 95% confidence level, inclusion on the Focus List results in increment stockholder returns of approximately 12 percent over the first 90 days beginning five days after inclusion on the list.
"Good" corporate governance can also lead to shareholder value additivity via decisions that increase competition in the market for corporate control. Specifically, for example, the adoption of poison pills reducing the probability of a successful takeover are associated with decreases in shareholder wealth while corporate defensive measures that protect against the initiation and completion of takeovers similarly decrease shareholder value. An excellent overview of value additivity corporate strategies is detailed in Chen, Conover and Kensinger.
A conceptually different empirical estimate is detailed by RT Asset Management, Inc. (hereafter RTAM). RTAM does not estimate the increment to shareholders market return due to "good" corporate governance. Instead, RTAM estimate the dollar magnitude of the shareholder loss due to "bad" corporate governance. Specifically, RTAM estimate the market capital loss to investors due to corporate debacles was $500 billion for 2001.
In summary, "good" corporate governance should be an important component in effective corporate strategy because it enhances shareholder wealth by increasing competition in the markets for corporate control and for corporate directors.
3. Fallacious and Erroneous Non-Economic Arguments
Advocating/Rejecting the SEC Reform Proposal for Corporate Director Nomination
Almost all of the arguments, both pro and con, submitted to the SEC commenting on the proxy rule changes are non-economic in nature and do not have a corporate finance-investment shareholder focus. Alternatively stated, the submitted arguments do not focus upon the SEC proposal as a vehicle that may or may not increase shareholder wealth either short-term or long-term. This section details several of the flawed arguments that lack substantive economic appeal and linkage to shareholder wealth.
A. Corporate Board Nominations, Corporate Board
Elections and Special Interest Groups
Under the proposed SEC rule for shareholder access to company proxy material, it must be stressed that board nomination is not equivalent to board election. To be nominated means that one is on the slate of candidates to be voted upon by the shareholders. Once again, for emphasis, nomination does not mean that you are necessarily elected to the board of directors.
A common argument is that special interest groups may, under these proposed SEC rules, take the board of directors hostage or some variant theme where they do not act in the best interests of shareholders generally. By best interests of the shareholders, economists mean formulating and implementing a corporate strategy and tactics that maximizes the contemporaneous price of equity shares. Obviously, special interest groups that focus on limited agendas that appeal to a narrow array of shareholders are advocating an agenda that it will be a non-winning agenda. Despite this, 3 M's Chairman of the Board and Chief Executive Officer, W. James McNerney, Jr. states "the pending proposals will serve principally to permit groups with a narrow, specific focus to achieve board representation (with the attendant adverse consequences for the vast majority of stockholders described below)...." The rhetorical questions are (1) why vote for somebody who does not represent one's best interests and (2) how does a director nominee get elected if he/she adversely represents the majority of shareholders.
My own personal assessment of a winning strategy to be elected to a corporate board if there is competition (i.e. alternative board candidates competing for votes from shareholders) in the market for board candidates is to formulate a shareholder value additivity platform that will be perceived by the majority of shareholders to be "better" or more "effective" than that of the other director candidates. In sum, my vote and likely the vote of most stockholders will go to the board candidates that have the most meaningful value additivity corporate strategy (i.e. in the best interests of the shareholders' wealth preferences).
Another view of special interest directors, unfortunately not atypical, is expressed by the Chairman of Apache Corporation, Raymond Plank. Mr. Plank in his comments on the SEC proposal states that "this process will constitute open season to crackpots with single purpose agendas of passionate, often ill-founded concern to them to pursue with new found leverage." Again, the rhetorical question is how can crackpots win a board election if their platform only appeals to crackpots?
Lastly, a different view of special interest directors within a unique economic construct of the firm has been detailed by Wachtell, Lipton, Rosen & Katz (hereafter Wachtell Lipton). They state a commonly held view that "giving shareholders access to the corporate proxy to view an election contest would facilitate the nomination and election of special interest directors." However, and this constitutes their fundamental error, Wachtell Lipton espouses a quite unique view of the firm. One which, apparently, integrates these special interest groups as fundamental constituencies. Specifically, Wachtell Lipton views the firm as not to be managed per se for the benefit of the shareholders but for the benefit of many constituencies such as (1) lenders, (2) suppliers, (3) employees and (4) committees in addition to shareholders. My interpretation is that the above enumerated Wachtell, Lipton constituencies includes one or two members of the so-called "special interest groups." However, Wachtell Lipton's views, like most of the comments using the "special interest group" argument, are vague and ambiguous with regard to which "special interests groups" they have in mind.
A relevant side-note to this discussion addresses the quantity and quality of available corporate director candidates. This is a question rarely addressed yet adequately answered. Michael Price, a former mutual fund chief investment officer and CEO as well as noted value investor, provides some interesting director perspectives, Indeed, Price details some numerics concerning the demand and supply of quality corporate director candidates. According to Price, there are 10,000 companies requiring 60,000 independent directors. He estimates, there are, maybe, anywhere from 500 to 5000 quality corporate director candidates with emphasis on the word maybe. Bottom-line, Price feels, "There aren't good people to put up. That's our big problem, finding directors (a) who have credentials is number one and (b) who have a backbone. You might have credentials but you don't have backbone."
Price's numerical estimates suggests that (1) many, perhaps even most, present corporate independent directors are not quality directors and (2) corporate board size should be reduced because there is a shortage of quality available independent director candidates.
B. The Functioning of Corporate Boards: Legitimate Issues
The questions raised here supposedly are relevant and focus on (1) corporate board disruption, (2) corporate board balkanization and (3) corporate board adversarial relationships. The essence of each of the above arguments, when translated, seems to be that each of these board characteristics are both real and bad. Hence, the SEC proposed rule change regarding shareholders nomination of board candidates is also bad public policy. Candidly, the objections raised seem to miss the central point about the fundamental purpose of boards. Namely, the board members are to act as fiduciaries of the shareholder and to represent the stockholder's best financial interests (i.e. to maximize their firm's equity share prices). Indeed by slight of hand, the normative financial goal of the firm and the shareholders' wealth interests are never addressed. Instead, the behavioral interrelations of the directors seem to be central and take precedence. Thus, these behavioral arguments and variants thereof seem to be a foil to deflect focus away from whether competition in the market for board members increases stockholders' wealth or does not increase shareholder wealth.
One commentator, W. James McNerney, Jr., Chairman of the Board and Chief Executive Officer of 3M, has referred to Jeffrey A. Sonnenfeld's article in the Harvard Business Review, (September, 2002) entitled "What Makes Great Boards Great," as seminal. McNerney cites Sonnenfeld's work as, in essence, support for his views on the foreseeable harm and disruption to the corporate board and as support for his conclusion that "the SEC's proposals are terrible public policy because they risk impairing the continued functioning of effective boards while failing to improve the operation of deficient boards." A careful examination of Sonnenfeld's article suggests none of the above. Indeed, Professor Sonnenfeld would likely never suggest anything as simplistic as what McNerney asserts. Consider the following views of Professor Sonnenfeld.
- "The highest-performing companies have extremely contentious boards that regard dissent as an obligation and treat no subject as undiscussable."
- "I'm always amazed at how common groupthink is in corporate boardrooms."
- "CEO's who don't welcome dissent try to pack the court, and the danger of that action is particularly clear right now. Recall that Enron board members Rebecca Mark and Clifford Baxter resigned reportedly because they were uncomfortable with paths the company has taken."
- "I can't think of a single work group whose performance get assessed less rigorously than corporate boards."
In sum, it is clear that Professor Sonnenfeld's views do not provide, rigorous or even implicit, justification for McNerney's conclusions or for the (1) corporate board disruption, (2) corporate board balkanization and (3) increased board adversarial relationships theses.
C. The SEC Public Policy: Should It Be Market or
SEC Commissioner Paul S. Atkins provides a useful methodological overview of thinking about public policy formulation in general and evaluating the merits of the Shareholder Access Proposal in particular. Commissioner Atkins states that "I appreciate fully the different sides of this debate. One side of me-call it the free market side-believes that owners of a corporation should decide for themselves how they wish to govern themselves and choose their representatives to oversee management, who are their employees. Let the chips fall where they may, without government telling the owners how to do it. The best protection is that a majority of shareholders must decide any of this, so let the majority of owners rule. The other side of me - call it the pragmatist or the paranoid side can recognize the tears expressed by many that allowing untrammeled shareholders access to the company's proxy card with only procedural safeguards might open the floodgates to special interest groups seeking to hold a company hostage until their pet `stakeholder' issues are addressed.
It is my strong first preference to use a competitive market approach. My second preferred approach, but way back, is to use administrative procedures to simulate competitive outcomes. This means that the rules and procedures (1) should reflect the preferences of equity investors, particularly the wealth maximization behavior of the firm's equity shareholders, (2) should not reflect the preferences of the firm's incumbent executive management particularly if the firm has corporate governance problems and (3) should exclude barriers, in whatever form and however cleverly crafted, that prevent or impede shareholders from nominating an alternative slate of candidates. In other words, the recommended nuts and bolts of the SEC regulatory proposed rule changes regarding corporate board elections should be that set of rules that would least impede shareholders providing a slate of direct candidates being nominated and competing with the, corporate nominating committee direct candidates at board of elections time. However, my strong first preference is to use a competitive market approach and not an administratively crafted set of procedural rules.
One additional point is that this comment submitted by CalSTERS to the SEC regarding the proposed new proxy rules that affords an opportunity to shareholders to participate in the corporate director nominating process is excellent. Two of CalSTERS' points, in particular, are on target with regard to their consistency with economic theory and their positive implications for promoting competition in the market for board members and incentivizing corporate directors to head off corporate underperformance to avoid shareholders access nominations. These points are (1) "the proposed rule should apply to all companies that are subject to the proxy rules" and (2) "that triggers of any kind are inappropriate for the right of shareholder access." CalSTERS deserves applause for their astute remarks.
The flip side of the competitive markets economic case is a paternalistic view where "father knows best." In the case at hand, the paternalistic approach views the nominating committee of the board as nominating candidates that are always higher in quality than that of any alternative candidates set forth by shareholders. As Sullivan and Cromwell state "all shareholders would be best served by permitting the independent directors to determine the slate to be included in the issuer proxy statement, rather than certain shareholders." The Investment Company Institute make the same general point when they assert that "Indeed, independent directors are uniquely qualified to evaluate whether a prospective director is likely to contribute to the continuing independence and effectiveness of the independent directors as a group."
The paternalistic view of market behavior is, of course, fallacious due to (1) its inconsistency with competitive market outcomes and (2) it's demonstrable bad economic effects. To put in historical perspective, Adam Smith's view of economic markets emphasized the salutary benefits of the decision making process of self-interested market participants. This "invisible hand" of the self-interest of market participants argument of Adman Smith leads to his conclusion that "it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interests." Further Adam Smith noted, "By promoting his own interest he frequently promotes that of society more effectually than when he really intends to promote it." It is this reasoning that results in Adam Smith concluding that competition (i.e. the competitive price system) results in an efficient allocation of the firm's economic resources.
SEC Commission Harvey J. Goldschmid has detailed much the same reasoning when he stated "Shareholders, under our free-market system, not only supply capital, but have the right economic instincts. If they understand the system, they want corporate efficiency, honesty, productivity, and profitability. In a macro sense, these shareholder interests are consistent with the nation's economic needs."
D. Corporate Shareholders Democracy: Catchy Phrase or
Useful Economic Concept
This section discusses the concept of "shareholder democracy" and whether and under what conditions it is a relevant economic concept providing insights into "good" corporate governance with linkage to shareholder wealth.
Corporate shareholder democracy is a catchy phrase that has a patriotic ring. However, it needs further examination to determine whether it is a relevant economic concept that provides clarifying insights into corporate governance. In this regard, it is important to distinguish between (1) representative democracy and (2) popular democracy. Representative democracy has important economic appeal as a corporate director nomination and election vehicle. This nomination and election vehicle is linked to corporate value additivity and corporate shareholder wealth via affecting underachieving or poorly performing companies. Popular democracy has much less conceptual appeal due to it's uncertain linkage to shareholder value and its likely significant costs and, perhaps, non-operationally in the director election process.
It is sometimes said that shareholders can always sell their shares, so why should shareholders ever complain. The companion argument is that if there is a breakdown in political democracy, citizens will find it onerous to move to a new country. Hence, this reasoning leads to the proposition that participation in the political process by citizens is more important than participation in the nomination of corporate board candidates by shareholders. Both the analogies, the underlying economic foundations and the economic conclusions are suspect and not compelling.
4. Summary, Conclusions and Motivating Parting Comment:
The SEC's proposed rule changes regarding corporate board elections is a modest first step improvement in corporate governance. This is, in part, because the present board election process is flawed and deficient. As Chancellor William B. Chandler III and Vice Chancellor Leo E. Strine, Jr. of the Chancery Court of Delaware have stated "As of now, incumbent slates are able to spend the companies' money in an almost unlimited way to get themselves re-elected. As a practical matter, this renders the corporate election process an irrelevancy, unless a takeover proposal is on the table and a bidder is willing to fund an insurgent slate." Further, the present SEC proposed rule linkage to increased shareholder wealth is likely marginal. Perhaps, in the multiperiod scenario where there are further rule changes in this regard that there may substantial corporate equity value additivity. However, there are several other corporate governance proposed changes that may have greater value additivity implications for the corporate equity shareholders.
Some parting words of wisdom from SEC Commissioner Cynthia Glassman, who poses a governance challenge to corporate executives, are "Rather than circling the wagons to oppose regulatory reform, why not try to be more proactive and deal with valid shareholder concerns? Why not approach your biggest and most active shareholder - whether or not you think your company has governance issues - and see if there are ways to make the nomination process more transparent and accessible? If enough companies undertake their own meaningful reforms, then the perceived need for more SEC may not be as great. And, regardless of whether or not the access rule eventually is adopted, fostering a more cooperative relationship with the shareholders in the area of Board nominations will pay dividends in the long run. After all, they are not only the companies owners, they are your bosses."
James L. Bicksler
Professor, Finance and Economics
Rutgers University, School of Business
Anson, Mark, Ted White and Ho Ho, "The Shareholder Wealth Effects of CalPERS' Focus List," Journal of Applied Corporate Finance, Spring, 2003.
Atkins, Paul S., "Statement by SEC Commissioner," Remarks at Open Meeting Regarding Shareholder Access Proposal," Washington, D.C., October 8, 2003.
Chandler III, William B., and Leo E. Strine, Jr. "The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State," prepared for Penn Law and Economics' Institute Conference on Control Transactions, February 8-9, 2002.
Chen, Andrew H., James A. Conover and John W. Kensinger, "Proven Ways to Increase Share Value," Journal of Applied Finance: Theory, Practice, Education. Spring/Summer, 2002.
Ehnes, Jack, "CalSTERS' Comments on the SEC Proposal Rules Provided Access for Shareholder Board Nominations," December 4, 2003.
Glassman, Cynthia A., "Remarks on Governance, Performs and the Role of Corporate Directors, "Speech before the National Association of Corporate Directors, October 20, 2003.
Goldschmid, Harvey J., "Statement by SEC Commissioner: Remarks on Proposed Rules for Shareholder Access to Company Proxy Material," Commission Open Meeting, October 8, 2003.
Gompers, Paul, Joy Ishll and Andrew Metrick, " Corporate Governance and Equity Prices, " Quarterly Journal of Economics, February, 2003.
McNerney Jr., W. James, "3M's Comment on the SEC Proposed Rules to Provide Access for Shareholder Board Nominations," December 5, 2003.
Plank, Raymond, "Apache Corporation' Comments on the SEC Proposed Rules to Provide Shareholder Board Nominations," December 5, 2003.
Sonnenfeld, Jeffrey A., "What Makes Great Boards Great," Harvard Business Review, September, 2002.
Wachtell, Lipton, Rosen & Katz, "Comment on SEC Proposed Rules to Provide Access for Shareholder Board Nominations," November 14, 2003.