Speech by SEC Commissioner:
Remarks on Governance Reforms and the Role of Directors before the National Association of Corporate Directors
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
October 20, 2003
Good morning, and thank you John and all of you for inviting me to this conference. I think we would all agree that director education has taken on even greater importance in the post-Sarbanes-Oxley world. The National Association of Corporate Directors provides an invaluable service by putting on programs like this. The NACD's comments on our rule proposals have also been constructive and helpful in improving many of the Commission's rules, and I thank you for your productive input.
Let me begin with the standard disclaimer that my comments today reflect my own views, and do not necessarily reflect the views of the Commission or its staff.
If there is one thing we can all agree on, it is that times have changed for corporate directors. In the early 1930s, management guru Peter Drucker was working at Fortune magazine when Alfred Sloan hired Paul Garrett as the first public relations officer for General Motors. When Drucker asked Garrett what his main job was, the story goes, Garrett replied: "To keep Fortune away from GM."1 Nowadays, if you go to any executive suite and pose the same question to a senior officer, director or the cadre of lawyers and accountants that surrounds them, the more likely answer would be: "To keep the SEC away from our company."
The reality, however, is that it is primarily shareholders, not the SEC, who have increased the need for antacids in the executive suite and boardroom. To be sure, the Commission has brought a number of significant accounting fraud cases. In those cases, however, our focus is on illegal conduct. In the current environment, the American shareholder is up in arms about things like poor performance, excessive executive compensation or unresponsive management, even when they aren't illegal. Like the makers of Hebrew National hot dogs, corporate America has to answer to a higher authority.
Looking back on the last year or so, I think all of our lives were very balanced. They were 50 percent Sarbanes and 50 percent Oxley. Most of you are living under the rules, and already are all-too-aware what they are. To put them in context, we need to answer a fundamental question: What is the Board's role in a system of corporate governance that separates ownership from control? The separation of ownership and control is a delicate balancing act that relies on both explicit and tacit agreements among managers, directors and shareholders. I would like to discuss that balance, and the unique ways in which it has worked and, in some cases, not worked, and also talk about our recent initiatives toward increasing the shareholder's voice, and how those reforms could affect the role of corporate directors.
Separation of Ownership and Control: The Board's Role
The separation of ownership and control is one of the most ingenious innovations of capitalism. Historically, it allowed geographically dispersed owners, each perhaps with only a fractional interest in the overall enterprise, to pool their resources in an efficient manner. It also greatly reduces the cost of capital by allowing for efficient secondary markets. A key characteristic of those markets is that changes in ownership do not affect the continued viability of the company. The separation also allows owners to place the company's management into the hands of professional managers who, the theory holds, will have the training and specialization needed to run a complex organization. The law imposes on these managers an obligation to act in the best interests of all of the shareholders as a group. Separating ownership from management also limits the influence of the parochial interests of a small group of shareholders, or even a single shareholder.
Separating ownership and control is not, however, without potential problems. Most directly, it gives rise to some very difficult agency issues. Managers who run corporations have a high degree of discretion over shareholder assets, but do not in their role as managers bear the investment risk of making poor decisions. In Las Vegas lingo, they are playing with other people's money. Managers also have at least one very powerful conflict of interest - their own self-interest or greed. As Berle and Means observed in their 1932 classic study of the corporation, "[t]he separation of ownership from control produces a condition where the interests of owner and of ultimate manager may, and often do, diverge . . . ."2 The potential divergence of interests is one of the main reasons the law imposes fiduciary duties on managers to act in the best interest of shareholders, and to scrupulously avoid self-dealing.
From the shareholders' perspective, I think it is fair to say that, even in the current environment, they do not want the responsibility to oversee the company's affairs. If one takes the mutual fund industry as a case study, it appears that even the largest shareholders tend to be passive investors, much more concerned with the return on their investment than how it is generated. Even if shareholders were more interested in governing, the number of shareholders in widely held companies makes it unlikely that they would be effective in making decisions or even overseeing management's conduct.
It is by design that, despite owning the company, shareholders are a relatively weak constituency. Throughout modern corporate history, the law has purposely erected barriers to shareholder participation in corporate management, since such participation, it was thought, would grind the wheels of progress to a screeching halt.
So, if shareholders as a group - whether because of fractional interests or legal barriers - do not have the means to monitor the performance of management, then who is minding the store? That's where all of you come into play. The director's role is to act in the shareholders' place to hire and oversee management's handling of the corporation's affairs. Boards members obviously are far fewer in number than shareholders, which makes it easier to make collective decisions. Unlike shareholders, directors also must act in accordance with fiduciary duties, which limits parochial interests. The Board's position as guardian of shareholder interests is absolutely fundamental to corporate governance because it provides the check on management that helps prevent potential agency problems from becoming actual agency problems.
Given the vital function of the Board, it should not be surprising that Sarbanes-Oxley and other reforms the Commission has proposed focus on - you guessed it! - the board of directors. For the most part, Sarbanes-Oxley and Commission and SRO rules re-affirm the primacy of the Board in overseeing corporate affairs. There are, however, several areas where boards of directors have been seen - to be frank - as abdicating their responsibilities. These include oversight of financial reporting, executive compensation and Board nominations. Some reforms in these areas also seek to affirm the Board's role and enhance its efficiency in carrying out the oversight function. Importantly, others seek in some ways to reduce the Board's role in favor of more direct participation by shareholders. Our reforms in the areas of financial reporting tend to be more on the continuum toward increasing the Board's effectiveness, while our recently proposed Board nomination reforms would tend to give some power back to shareholders.
In the area of financial reporting, one of management's most important functions is to provide full and accurate information to the company's owners and potential owners. For nearly thirty years, the audit committee has been evolving into the primary way by which the Board carries out it obligation to protect shareholders' rights to this information. Sarbanes-Oxley further recognized the primacy of the audit committee in this role by requiring that audit committees of listed companies: be entirely independent; be directly responsible for hiring and firing auditors; have procedures for addressing complaints regarding financial reporting; and have the ability to engage advisers who are independent of management and the auditors.
The Commission also adopted rules requiring disclosure of whether the audit committee has an audit committee expert. The goal of this rule is not to have the audit committee re-audit the financial statements, but rather to have at least one person with real expertise who can help assure that the audit committee and the Board ask the right questions.
I have spoken to many executives and directors who say it is now more difficult to find people to serve on the audit committee. While there have been some unintended consequences of Sarbanes-Oxley, I don't think that narrowing the audit committee pool can be counted among them. The audit committee expertise requirement, for example, raises the bar - and that was intended.
I have also heard that the candidate pool has shrunk because qualified individuals cannot serve on as many Boards given the increased responsibilities. Maybe I'm missing the point, but I think that is the point. I frankly question whether it was ever possible for an executive with a full time job also to do an effective job as the member of three or four Boards or audit committees. The days of the trophy Board, where distinguished citizens are given directorships because of their status rather than qualifications, hopefully are gone for good. Also gone should be the days of the "Old Board Network" where the deal was "you name me to your Board and I'll name you to mine." While I do not underestimate the value of collegiality in the boardroom, the focus needs to shift from finding directors who work best with the CEO, to finding directors who add the most value for shareholders, although the two may not be mutually exclusive. As one corporate governance expert has observed, "What was once an honorary way to cap off a career is now a real job with real expectations and a time commitment of at least a few hundred hours a year. It's very different now than six golf games and a few meetings a year."3
Executive compensation is another area in which many shareholders feel the Board has not been meeting its obligations. While the separation of ownership and management means that the wealth opportunities of managers and owners will not always be perfectly aligned, there is something wrong when managers achieve unthinkable riches, especially when the owners' investment disappears. A complete disconnect between performance and compensation is a stark red flag that something is wrong with the system.
Executive compensation should not be a get rich quick scheme. Hopefully you hire your senior executives for the long-term; and if that is the case, then the goal should be to compensate them fairly over the full term of their employment. As the shareholders' surrogate you should ask yourselves whether the shareholders are getting their money's worth from executive pay, and whether you are providing proper incentives for longer-term performance goals.
I am not necessarily advocating regulatory reforms in this area. The market is usually the best way to deal with these issues. If reforms do come, it will be because shareholders are not getting the information they need to evaluate the issue. Companies should make sure there is full and open disclosure about executive compensation in their filings, even if it means going beyond the minimum requirements of our rules. If you are embarrassed to disclose what you are doing, that is a good sign you are not on the right track.
The Nomination Process
All of the measures I have discussed so far attempt to clarify directors' responsibilities and give Boards the tools necessary to do the job effectively. Sarbanes-Oxley, however, does not speak to one very important piece of the puzzle - namely, how to get the right group of people to serve as directors. After all, only if the right people are on the Board will the reforms be carried out as the statute intends.
In the critical area of director nominations, it is somewhat anomalous that the Board itself has almost exclusive control over who serves as a director. Although the situation has worked without significant problems at many, and maybe most, companies, there is an obvious risk that entrenchment will lead to complacency. A widespread sense has developed that the nomination process is not so much being run by the Board as dominated by powerful CEOs. At some companies, it appears that the CEO hires the Board instead of the Board hiring the CEO. It is this situation that gave rise to the current calls for revolution.
In the past, more shareholder voting took place in person at annual meetings that were widely attended by shareholders, so nominations from the floor had real meaning. Today, most voting is done through proxies delivered before the meeting, so floor nominations are too late to garner significant votes. Largely as a result of the massive corporate scandals, but also more generally because of unresponsive Boards, there has been a sense lately that the regulatory obstacles to shareholder participation in the nomination process are not optimal in terms of protecting shareholders.
In response to this concern, the New York Stock Exchange and Nasdaq market are finalizing significant changes that will affect the way nominating committees operate. For one thing, the new rules will require that all nomination decisions be made by independent members of the Board. Removing the CEO from the formal process, and putting it in the hands of non-management directors, is more likely to result in a process where the Board acts as the owners' surrogate. If the independent directors are truly independent and take the responsibility seriously, then that is a significant step that should improve the effectiveness of the nomination process and quality of nominees.
For the reforms to be effective, however, the directors who serve on the nominating committee will have to be truly independent. Much of the focus in defining independence has been on whether the director has financial relationships with the company that are likely to compromise his or her independence. In my view, personal relationships with the CEO - living in the same community, kids at the same school, moving in the same social circle - are just as likely to undercut independence. In deciding who serves on the nominating committee - and any other committee where independence is required, for that matter - you should not hesitate to go beyond what the rules require to find members who are truly independent in the broadest sense of that word. The NYSE and Nasdaq standards would both require Boards to make an affirmative finding that there are no factors materially affecting independence. That is a step in the right direction if Boards meet the spirit of those standards. Regardless of whether shareholders like some or all of the Board's director candidates, they should demand, and Boards should deliver, a process that puts the decision in the hands of independent directors whose loyalties to shareholders are beyond question.
In addition, because sunlight is often the best cleanser, the Commission recently proposed rules that would make the nomination process more transparent. If adopted, our rules would require companies to disclose how they go about selecting directors, and provide information about if and how shareholders can participate in the process.
Finally, as all of you are well aware, the Commission recently put out for comment proposed rules that would allow shareholders to include nominees on the company's proxy card if certain triggering events occur. The issue the Commission is trying to address with that proposal is a very real one. A closed nomination process dominated by powerful CEOs, and the entrenchment of directors, led to an unhealthy coziness in some instances between ostensibly independent directors and the executives whose performance they were supposed to oversee. When the Board acts as a rubber-stamp for management, it does not necessarily act in the best interest of shareholders.
The access proposal is a natural response to the widespread perception among some shareholders that the nomination process has been co-opted by management. Given that perception, it is not difficult to understand why they would want to do the job themselves. Unlike other reforms that seek to improve the way the Board functions, this proposal removes some of the regulatory barriers to effective shareholder participation in the proxy process for electing directors. As such it represents a potential redistribution - rather than a reaffirmation - of the Board's current role.
One obvious question is: Do shareholders need access to the proxy? If shareholders feel that a company is poorly governed and unresponsive, the most readily available and commonly used remedy is to vote with their feet and put their hard-earned capital where it will earn a better return. If enough shareholders vote no-confidence by selling their shares, the cost of the firm's capital will increase to the point where it will either reform or it will go out of business. For several reasons - including indexing and tax consequences - selling is not an attractive option for all shareholders. It is those shareholders who most need a road to reform from within.
Under our new proposal, the theory goes, a small percentage of large, long-term shareholders - with nothing but the best interests of the company and all fellow shareholders in mind - will act in a neutral and unbiased manner to further the corporation's interests by nominating a candidate for the Board who is better than management's nominee. I agree with this proposal in theory, but to paraphrase no lesser an authority than Homer Simpson, "Communism works . . . in theory."
I know that there are some very serious concerns about our latest proposal and the potential effects it will have on the corporate boardroom. As I noted when the rule was proposed, I share many of these concerns. Our purpose, as stated in the proposing release, is to open the process "where evidence suggests that the company has been unresponsive to security holder concerns as they relate to the proxy process."4 While that is a noble goal, and while I agree that the rule could have a positive effect on some poorly governed companies, I am concerned that the rule's reach will not be so limited. To use a military analogy, we may be dropping a cluster bomb when a surgical strike is more appropriate. I am also very concerned about the potential competitive effects the proposal could have, especially for companies that compete in global markets. I am sure all of these issues will be addressed during the comment process, and I urge you to give us your views.
However, the reaction of many companies to the proposal needs to be more constructive. Some companies are denying that there is any problem, which is akin to denying that there is a six-thousand pound elephant in your living room. The proxy access proposal is a symptom that there may be a bigger problem. There is a palpable feeling that the corporate boardroom has become too clubby. Some of the most scandalous behavior we have seen does not involve accounting fraud, but rather more subtle instances of executives treating the corporation as their own private fiefdom. There is not a Board out there that could not stand a little forthright introspection on governance issues.
So I'll leave you with this question: 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 shareholders - 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 action may not be as great. And, regardless of whether or not the access rule eventually is adopted, fostering a more cooperative relationship with shareholders in the area of Board nominations will pay dividends in the long run. After all, they are not only the company's owners, they are your bosses.
Thank you. I'd be happy to take your questions.
1 Peter Hay, The Book of Business Anecdotes 145 (Wing Books 1993 ed.).
2 Adolf A. Berle, Jr. & Gardiner C. Means, The Modern Corporation and Private Property 6 (McMillan 1932).
3 Ben White, More Politicians, Executives Say "No, Thanks" to Director Seats, Wash. Post p. E1, E4 (February 27, 2003) (quoting Dana R. Hermanson, research director at the Corporate Governance Center at Kennesaw State University).
4 Security Holder Director Nominations, Exchange Act Rel. No. 48626 (October 14, 2003).