# The Continuing Evolution of Corporate Governance in the United States

Date November 2, 2004 Thomas A. COLE(Chairman, Executive Committee, Sidley Austin Brown & Wood LLP) HOSOYA Yuji(Director of Research, RIETI)

## Summary

Although there has been a great deal of activity in the United States on corporate governance for many years now, it is continuing to evolve in many ways and I will try to explain these. Since the focus of my remarks is really corporate governance in the publicly-held companies in the U.S., I will define corporate governance as: (i) the framework for how decisions are made; and (ii) how the decision-makers, who are not the owners and very often not significant shareholders, are selected and held accountable.

There are many forces that have led to the development of corporate governance in the U.S. as it appears now. First of all, it is an overly complex system since there is not one set of laws or regulations to decide how corporate matters are to be addressed. Indeed, there are two side-by-side regimes, the federal laws and the state laws, and traditionally corporate governance has been a matter of state law because corporate law itself is determined by each state. The predominant state law of corporations is from the State of Delaware because most of the large public companies in the U.S., regardless of where their operations are, are incorporated in Delaware. There is also, and has always been, a federal law of corporate governance. But after the Enron scandal, the Sarbanes-Oxley statute is really a federalization of corporate law. Independent of written statutes and regulations, the U.S. is a common law system so a great deal of the law on corporate governance comes through judicial decisions. Furthermore, there are the stock exchange rules, market forces (behavior of institutional investors and their demands), and filings of civil or regulatory litigation.

My basic thesis is that U.S. corporate governance has been shaped incrementally over time, resulting in a so-called patchwork quilt. In terms of the broad forces that shape corporate governance, I will identify five and discuss each of them in turn. There is a first threshold question of: "For whose benefit do you operate a corporation?" Then there is the fact that there are so many widely held U.S. corporations. The rise of the institutional investor is another critical factor in how corporate governance has developed, particularly over the last 20 years. Also occurring over the last 20 years has been the law of mergers and acquisitions. Finally, corporate governance evolves through a cycle of scandal, followed by reform.

The long-standing question of, "For whose benefit is a corporation operated?" has not been fully resolved until within the last 20 years. There are two alternative views: One is the broader societal view of what a corporation is about, and the basic theory starts with the fact that a corporation owes its existence to a grant from the state. If it were not for state law, there would not be this separate entity recognized as such, and, importantly, it would not have limited liability. As such, the state could also impose obligations on the directors and management that go beyond serving the shareholders. This first view would say that in addition to broad fiduciary duties to the shareholders, there might also be general duties owed to the other constituencies (employees, suppliers, creditors and communities). The other view is the narrower capitalistic view, which says that those who run corporations (management and boards of directors) have only a general obligation to the shareholders as owners. To the extent that the state wants them to pay attention to the interest of other constituencies, the state must adopt specific rules.

The importance of the answer to this question should be obvious: Form follows function. For example, if there was a broader societal role and responsibility, you might have representatives of the workforce on the board, as in Germany. In fact, in the U.S., the narrower capitalistic view has clearly prevailed with specific regulations imposed relating to the treatment of employees and such. Indeed, statutes relating to the rights of employees are plentiful, such as the Employee Retirement Income Security Act (ERISA), the Occupational Safety and Health Act (OSHA), and the WARN Act relating to plant closings. Clearly, every U.S. director and officer knows that their general obligation is to serve the shareholders.

The second factor in the development of U.S. corporate governance is that there are very widely held corporations. First, the general notion of populism, that is distrust of large financial institutions, led to statutes that prevented banks and insurance companies, for example, from owning a significant percentage of U.S. businesses. That is not to say that institutions do not own a great deal of the U.S. corporate stock, but none of them owns much in and of themselves. Although there are other institutional investors that have the ability to own more and are not limited in the way that banks are, there are forces, such as the insider trading laws, that keep them from wanting to own too much or serving on the corporate boards. Very frequently, directors and officers are not free to trade in the stock of the company on whose boards they serve because there is material, non-public information which has not been disseminated broadly. Therefore, a mutual fund would not want its people to serve on a board, because, in the case of an open-end fund, it has to be ready to redeem its shares on a daily basis. This discrepancy between liquidity versus control has kept even these other types of institutional investors off of corporate boards. Another factor is that there is an extremely efficient capital market with plenty of opportunity for U.S. corporations to raise funds and have liquidity in their stock without having substantial ownership by institutions.

The result of all this is that there is a separation of ownership and control. In a typical U.S. corporation, those who serve as members of management and make decisions have an obligation to the owners, but are completely separate from them. It is also the case that virtually every American household has equity ownership, either as employees through various benefit plans or simply through individual investment in mutual funds. This makes corporate governance a popular and political issue, especially some of the easier-to-understand aspects such as executive compensation. After Enron, governance has been a subject discussed very broadly and not limited to a group of financiers.

Another factor that has shaped corporate governance is the rise of the institutional investor. First, the total value of ownership of equities held by various types of institutional investors is very significant. The majority of the shares of a typical U.S. publicly-held company will be owned by five or 10 corporations, so they can have a great deal of control, but they have not always been active in corporate governance. As a matter of fact, in the 1970s, the Department of Labor had to, in effect, force pension plans simply to vote their shares. For this purpose, consulting groups such as institutional shareholder services (ISS) were developed, and some think that they have too much power and exercise it in an inflexible way.

Index funds also led to an increase in activism on the part of the institutions because they are not managed funds, but rather invest in a broad basket of stocks, either the S&P or the Dow. This is based on the conclusion of a study by Princeton's Burt Malkiel that it is very hard for a managed group of stocks to do better than a broad index. If you are running an index fund and you do not like the way things are going in a corporation - its performance or governance et cetera - you cannot get out of the stock. This leads you to influence how the management is operating.

Finally, there is definitely a political agenda at work given the ubiquitous nature of investment in the U.S. Some of the largest pension plans in the U.S., such as the California Public Employees' Retirement System (CalPERS), are for public employees, with the heads of those funds being political appointees.

Institutions exercise their influence over corporations through a variety of public relations activities. There are corporate governance rating systems that screen and give grades to corporations. Another way, as is done by labor union pension funds, is to annually give out "awards" for the worst corporate boards, which no director wants to win. Another is to withhold votes and embarrass directors, since the results of corporate board elections are reported publicly. There has also been a controversial rule pending before the Securities and Exchange Commission (SEC) for over a year to give institutional shareholders of a certain size that have held their share for a certain period of time the opportunity to nominate their own directors in the company's proxy statement, if there has been a withhold vote of a certain magnitude.

Shareholder proposals are another way in which this activism is expressed. Moreover, institutional investors are free to engage in proxy contests or in actual litigation, although due to time and cost they are less frequently applied. In the class-action litigation system it has become more frequent for settlements to include not only a payment to the shareholders but also for the company to agree to adopt certain corporate governance reforms as part of the settlement.

The merger and acquisition case law, particularly relating to hostile takeovers, is another important component. About the most pivotal single issue in corporate governance is who gets to decide on selling the corporation. The way the case law has developed, it has clearly established the boards as the principal decision-making body. In sum, the law developed beginning in the 1980s clearly established a great deal of responsibility and accountability on the part of directors for important decisions on change in corporate control. Directors were held liable for the first time for gross negligence and had to pay compensation to shareholders for bad decisions about the sale of a company.

Not only do directors have to approve a merger, but they are given the ability to stand between shareholders and bidders. The courts in Delaware and other jurisdictions have validated the so-called "poison pill" mechanism that can be put in place and removed only by the directors, without any say by the shareholders. In the event of a possible hostile takeover bid, it can prevent any party from acquiring more than a specified percentage of a company (typically 10%-15%, sometimes as high as 20%) by creating a deterrent threshold beyond which a buyer could suffer economic dilution. This may make it seem as if the board can absolutely stop a hostile takeover, but even companies with pills stay independent only a third of the time. That is because the shareholder recourse is to change directors if they do not approve of the way in which the takeover bid is being handled.

As such, a kind of balance of power has been established between the shareholders and directors that works reasonably well. This is because, firstly, a majority of U.S. board members are outside directors and not employees of the company, so when they are given decision-making authority they are viewed as not simply acting in their self-interest and for self-preservation. This is an important element of what legitimizes the tremendous amount of power that is put in the hands of the board. It is also the case that when judges look at how these independent boards behave in this context, they are not given the benefit of the doubt and the standard for judicial review is a higher standard than the Business Judgment Rule. The higher standard is captured in the phrase "enhanced scrutiny."

The broader implications of the M&A cases over the last 20 years are notable in that courts demand that directors take the same kind of approach as in M&A, even for other kinds of transactions. In the current Disney case involving the U.S. $140 million severance compensation for Michael Ovitz after only 14 months at the company, the court concluded the Disney directors had done a terrible job. On the institutional shareholder reaction to the directors' authority in this arena, they are using their ability to wage a public relations war in a very different way. The governance ratings systems are weighted heavily toward takeover defenses. The stronger the defenses, the lower the governance rating. Even though it is clearly established that poison pills are legitimate devices, fewer companies have them than five years ago because it is just not worth putting them in place on an ongoing basis. On the cycle of scandal and reform, the Enron case is an obvious example - but this is not the first time there has been such a cycle. The securities laws adopted in the 1930s were themselves reactions to the crash at the beginning of the Great Depression in the U.S. In the 1970s, there was the general view that there was bad corporate citizenship (pollution, bribery, bad pension plans), and that led to a whole series of federal law statutes requiring better citizenship. It was about this time that the phrase "corporate governance" came to be used more broadly. In the early 1990s, in view of the success of the Japanese automakers, comments about the compensation of senior executives in Japan being lower than that of their counterparts in the U.S. led to the notion that there was a need to tie the interest of the senior management with that of the shareholders in the form of stock options. This came at a favorable time, as a greater percentage of compensation went into stock options right at the beginning of the greatest bull market in U.S. history. The result was that so many of the top executives did anything to keep the stock going up. Interestingly enough, the Sarbanes-Oxley Act did not really address the issue of stock options, perhaps because it was too politically potent. Sarbanes-Oxley was designed to address the accounting scandals and was quickly assembled, emergency legislation. The general notion is that the act was an expression of the view of the U.S. Congress that all the "watchdogs" (directors, auditors, ratings agencies, SEC and lawyers) over U.S. corporations had failed at the same time. Some of the principal provisions of the Sarbanes Oxley Act are the establishment of a new oversight body for auditors, called the Public Company Accounting Oversight Board (PCAOB), to exercise greater scrutiny. Since the main theme of the Act was that increased independence would improve the system, there were increased restrictions on the ability of audit firms to provide non-audit services to their clients. Other provisions include the internal control certification under Section 404. At the same time, Sarbanes-Oxley was not the only reaction, and the stock exchanges all adopted rules. Prosecutors include such individuals as Attorney General Elliot Spitzer of New York as well as the enforcement division of the SEC, whose budget has much increased. Finally, courts have become more open to attacks on directors and there has been increased erosion of director protections, such as the exculpatory charter provisions. Another interesting development is that while all these reforms have been applied to widely held, for-profit companies, boards of privately held corporations are also following some of the reforms on a voluntary basis, and not-for-profit corporations also are talking about Sarbanes-Oxley-type changes. Today, one of the most prominent features of U.S. corporate governance is that you have a board of directors that is mostly independent, with either a non-executive chairman, such as in the English model, or a so-called lead director selected from among the outside directors. The lead director acts as a liaison and presides over executive sessions (board members meeting without the management present). It is certainly the case that corporate boards are working harder than ever before and chief executive officers are less powerful. And they are anxious about their jobs and about problems in the accounting and financial reporting of the company being pinned on them individually. The institutional shareholders are pretty satisfied with the system, but there are still some issues in dealing with stock options and rotating accounting firms. Further, there are smaller U.S. companies that are questioning the advantages of being public, considering the costs. Finally, non-U.S. companies are wondering why they should list in the U.S. given the liquidity of other markets. This is underscored by the fact that once firms are listed, it is hard to get out. The major flaw in the system is that it is much too complex. An example is the four different definition criteria and tests (stock exchange rules, Internal Revenue Service code, securities laws, and others deriving from recent judicial decisions) that apply when selecting a director for the compensation committee. In addition, there are occasional failures by institutional investors to exercise all of their power in a responsible fashion. Consider the CalPERS case and the withhold-vote campaign against Warren Buffet. Another complaint is the risk of "checklist governance": Because there are so many different things mandated, directors do not have the time to strategize and board meetings can become a matter of going through the motions. There is also a temptation to not be as rigorous with high-performing companies, and the fallacy of expecting that good corporate governance yields good business performance. These are not necessarily correlated. Finally, on top of the very significant cost, one last flaw is that all the emphasis on compliance and fear of liability may be causing corporate boards to be less willing to take the prudent risks that lead to the kind of innovation that is important to the global economy as a whole. ### Questions and Answers Q: Firstly, I understand there is more engagement in the UK by public pensions and more direct negotiation between the investors and the companies. In Japan as well, investors can join forces, but in the U.S. it is very difficult. What is the trend in the U.S. toward allowing pension and investment managers to join together in their discussions with companies? Secondly, in terms of the rights of the shareholders there are also various differences between the systems, such as on dividend payout, as discussed by people such as Professor Lucian Bebchuk of Harvard University. Can you comment on the direction the U.S. is heading in expanding shareholder rights? A: In terms of the way institutional investors get together, there are limitations in the U.S. The institutions do not want to be thought of as forming a group because then they have group filings. This does not prevent them from coming forward with the same points of view by coincidence. Negotiation does occur with some frequency and shareholders can raise questions to be voted on at the annual meeting. For example, after receiving recommendations from different institutions to declassify its board, McDonalds engaged with the proponents of this shareholder proposal and got the governance committee together with an expert panel to consider the issue. Although it concluded by leaving the staggered board in place, the institutions were pleased that there had been a full and open airing of the subject. This is an extreme and good form of negotiation and engagement between the institutions and the corporation. On shareholder rights, the way in which they have expanded is by the increasing demands that have been placed on the boards of directors to perform well and the potential for liability. Dividend payout and other important subjects in the operation of the company are left to the board of directors, which is the centerpiece of corporate governance in the U.S. Q: How do outside directors, especially when they are in the majority, get information on the actual operation of the company they are responsible for? Do they have independent staff? A: Outside directors have a total right to any information about the companies, and they have a legal obligation (see Caremark) to make sure there is an adequate system of information-gathering and analysis in place to allow them to make decisions. With the potential for liability and their duty of care, boards are very good about asking questions, and any executives that do not provide information could have a very short tenure. Two other paths of information disclosure are whistle-blower provisions, giving direct access to the board on an anonymous basis, and lawyers whose responsibility it is to bring credible evidence of a material violation of the securities laws or material breach of fiduciary duties to the attention of the chief legal or executive officer, and even directly to the board. For the most part, boards do not have independent staff, but they can hire independent counsel. Q: I have heard the new laws to protect whistle-blowers have not worked well. What is your impression of how well these laws work? A: I am ambivalent about whistle-blowing. On the one hand, it can serve a very important purpose, and such courageous behavior should be encouraged. Regrettably, on the other hand, there have been whistle-blowers whose motives were not pure. For example, if a whistle-blower is also a participant in the fraudulent activity reported, there is some uncertainty under the protection devices as to what action to take against the whistle-blower. There is also the possibility that someone whose job performance is bad will suddenly blow the whistle for employment protection. Another odd aspect is that all whistle-blower actions are put into the Department of Labor under the Occupational Safety and Health Administration (OSHA). Q: Despite some troubles, the Japanese auto industry looks much healthier than that of the U.S. Is there a management lesson to be learned from this? A: It may be an example of how you cannot correlate good governance with good performance. One of the pioneers in good corporate governance, for example, was General Motors and their "Shareholder Bill of Rights," which today may seem remarkably simplistic. Q: In the UK there is a so-called corporate governance department or group inside a company who work for independent directors. Do you have any idea about the average number of people in such departments at U.S. companies? A: While there are quite a number of U.S. companies that have people in positions called vice president for corporate governance, they are the minority even in larger companies. Very often corporate governance and related issues are left at the staff level to the legal departments. What makes it difficult is that some of the senior, longer-tenured chief executives are having a difficult time dealing with this new environment. Q: It may be the case that you have senior executives in independent compensation committees who are working to serve their own self-interest. In your own words, what kinds of people become independent directors? How much are they paid? Or what is your ideal profile of an independent director? A: It used to be that the ideal board comprised sitting chief executive officers of other companies because they know how to run a company. Now things have changed significantly. First, the time demands are significant and the pool of sitting CEOs has not gotten bigger, so independent directors are being drawn from different groups to include current or retired chief financial officers given the new regulatory requirement that every audit committee have a qualified financial expert. In terms of an ideal group, you need to construct a board that makes sense for the company instead of following a checklist. I believe that companies are not having difficulty finding new board officers because it is a very stimulating experience and there is no shortage of volunteers willing to learn valuable lessons. On their pay, the average corporate board member gets about U.S.$125,000 a year. In this regard, there are exculpatory charter provisions in the Certificate of Incorporation that are expressly authorized by the corporate statutes saying that a corporate director will not be held liable for monetary damages for breach of fiduciary duty except, for example, duty of loyalty. Trying to work out the right compensation for a board member is very difficult and for a board member, the more money you make the more susceptible you are to an attack based on the duty of loyalty.

Q: Do you think there are more material concerns in Japan than in the U.S. when poison pills are implemented here due to differences in the judicial systems?

A: I am an unabashed fan of poison pills and takeover defenses because I have seen them work well in allowing a board to get more money for the shareholders and in preventing a takeover at an unfair price. But they need to be within a system where there are checks and balances, such as boards that have a majority of independent directors.

*This summary was compiled by RIETI Editorial staff.