Largely (although not exclusively) driven by last
summer's enactment of the Dodd-Frank Act, we have entered a watershed period of
corporate governance reform. Processes already now afoot have wrought a
transformation in the relations between corporate boards and corporate
shareholders. Even further changes lie ahead. In this post, I take a look at
where we are now, what lies ahead, and what it all means.
Many of the observations in this post were influenced by
the commentary during a panel discussion in which I participated on May 11, 2011,
entitled "Dodd-Frank and the Rising Tide of Shareholder Empowerment"," at the
Menlo Park offices of the Orrick
law firm. The views expressed in this post are my own.
Changes Already Underway
Though many of the rulemakings required by the Dodd Frank
Act have fallen behind schedule, a number of the implementing rules
already are in place and are already driving changes. In addition, other
processes not directly connected to Dodd-Frank are also underway and changing
board processes, practices and structure. Here are four specific governance
reform processes currently underway:
1. Say on Pay: As a
result of Section 951 of the Dodd Frank Act and the requirements of SEC
rules that went into effect January 25, 2011, all but the smallest public
companies have had to put their executive compensation practices to an advisory
shareholder vote during the current proxy season. The practice of an advisory
vote on executive compensation has been in place in many European counties for
some time. Many U.S. companies and their advisors resisted the adoption of the
requirement here, and others questioned the value of a mere advisory vote.
In ways that I think may have caught some observers by
surprise, it appears that - even though the shareholder "say on pay" vote is
purely advisory - the implementation of the requirement for a "say on pay" vote
is having a significant impact on executive compensation practices. As
reflected in a May 2, 2011 Wall Street Journal article entitled "Firms
Feel 'Say on Pay' Effect" (here) , many companies, scrambling to win shareholder
approval in the say on pay vote, have been pressured to alter pay practices. As
the article says, "despite some early skepticism, the prospect of such votes
has sparked boardroom debate over executive-pay practices that were long-rubber
stamped:"
The last minute changes that some corporations have put
through to avoid negative votes have included some extraordinary steps. Just
before the shareholder vote at Disney, for example, the company dropped certain
provisions in its contract with its CEO Robert Iger, as well as other
executives removing a provision that would have grossed up any compensation
awards to these officials in the event of an ownership change.
The net effect of this process, and board's desire to
avoid a negative vote, is that certain compensation practices may fall by the
wayside and all companies will face greater pressure to better align executive
compensation and company performance.
A May 3, 2011 memo from the Davis Polk law firm (here) provides a detailed status update on the current
round of "say on pay" votes.
2. Proxy Access: On
August 25, 2010, the SEC adopted rules, in changes that were to be effective
November 15, 2010, to require all but the smallest public companies to include
in the proxy materials that board candidates nominated by shareholders who meet
certain qualifying criteria. In order to qualify to nominate a candidate,
a shareholder or shareholder group must individually or collectively own at
three percent of the voting power of company's shares and must have held those
shares for at least three years.
However, on September 29, 2010, the Business Roundtable
and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules that the SEC had
adopted. The petitioners contend that the new rules are "arbitrary and
capricious," violate the Administrative Procedures Act, and infringe on the
First and Fifth Amendments. In response to this legal challenge, the SEC on
October 4, 2010 issued a stay of the effectiveness of the rules while the
legal challenge is pending. A ruling in the legal challenge is expected later
this year.
While the implementation of the proxy access rules are in
abeyance and the outcome of the legal challenge is uncertain, the likelihood is
that in the future shareholder will enjoy greater shareholder access by
requiring a company to include in its proxy materials shareholder nominees to
the board of directors. As two attorneys from the Saul Ewing firm wrote in an
October 29, 2010 article in the Legal Intelligencer entitled "Be
Prepared: Shareholder Activism is Here to Stay" (here),
"whether under the rules now being considered by the court or some revision
thereof, the Dodd-Frank Act, and its focus on shareholder protection and
access, ensures shareholder activism is here to stay."
3. Board Declassification: One
of the long-standing objectives of corporate governance reformers has been the
elimination of classified or staggered boards, whereby directors were elected
for three years terms ensuring that in any given year only a third of the
directors are up for vote. The Dodd-Frank Act does not have anything to say
directly on this issue. Nevertheless reformers, led by the Florida State Board
of Administration, have succeeded in obtaining the voluntary agreement of a
number of companies to the declassification of their boards, pursuant to which
the companies will put their entire board to an annual vote.
As one recent commentator noted, "the overwhelming trend in corporate governance is
toward the declassification of boards." An April 26, 2011 press release from
the Florida Board about its efforts can be found here. A May 10, 2011 commentary by Nell Minow on her Risky
Business blog about the board declassification efforts can be found here.
4. Majority Voting:
Another longstanding goal of corporate governance reformers has been the
implantation of majority voting. In many U.S. public companies, director
election requires only a plurality vote, so that a director candidate in an
uncontested election who receives only one vote will be elected. In a majority
vote model, a director in an uncontested election who fails to receive a
majority of votes must offer their resignation.
As discussed in an April 19, 2011 Westlaw Business
article entitled "Corporate Governance: Assertive Activist Investors" (here), the 2011 proxy season is the "culmination of a major
drive to install majority voting standards," and shareholders at a number of
companies have voted in favor of shareholder proposals calling for majority
voting standards.
Changes Just Ahead
1. Compensation Ratios: In
one of legislation's lesser noted provisions, Section 953(b) of the Dodd Frank Act directs the SEC to
amend its executive compensation disclosure provisions to require reporting
companies to disclose the ratio between total annual compensation of their CEO
and the median annual compensation of their employees. Rules implanting these
provisions are required to be adopted before the end of 2011.
As University of Denver Law Professor Jay Brown notes on his
Race to the Bottom Blog (here), these disclosure requirements potentially could be
"powerful." As Professor Brown notes, the compensation ratio disclosure would
shift the executive compensation dialog away from a comparison between
executive compensation at different companies toward a comparison within the
company itself. The provision rather obviously reflects an intuition that there
is a disparity between the compensation paid to executives and the compensation
to other company employees.
These provisions are controversial and there already is a move underway to repeal this provision. But if the
provisions become effective and reporting companies are required to disclose
the compensation ratio as specified in the Dodd-Frank Act, it seems likely that
what will follow is a protracted discussion around issues of compensation
fairness and compensation equity, particularly as popular notions about
the appropriate ratios develop over time. Companies whose ratios suggest
greater compensation disparity are likely to face added pressure on executive
compensation issues.
2. Compensation Clawbacks: Another
of Dodd-Frank's executive compensation requirements is set out in Section 954, which requires to SEC to direct the national
exchanges to impose new listing standards directing public companies to
implement compensation clawback provisions. Under Section 954, companies making
accounting restatements of prior financials must recover from any current or
former officer all incentive-based compensation paid during the preceding
three-year period above what would have been paid without the misstated
financials. According to a May 12, 2011 CFO.com article about the
provisions (here), the SEC plans to propose and adopt rules implanting
these requirements between August of this year and year-end.
The Dodd-Frank clawback provisions go far beyond the
clawback requirements instituted in the Sarbanes Oxley Act. The SOX provisions
were limited just to the CEO and CFO, where as the Dodd-Frank provisions are
applicable current and former executive officer. SOX clawed back only the year
prior to the restatement, whereas the Dodd Frank provisions reach back three
years, and are applicable without regard to fault or wrongdoing.
The clawback provisions also have proven controversial. The CFO.com article cited
above notes that these provisions have a "potentially far-reaching impact" that
may "result in serious reconsideration of how incentive compensation plans are
designed." It is also possible, as another set of commentators has noted, that companies who in future find that they must
restate prior financials may face litigation (or rather their officers and
directors may face litigation) on questions whether a compensation clawback is
required, against whom it should be enforced, and for what types or amounts of
incentive compensation.
What it All Means
Though rule-making delays and litigation have delayed the
implantation of some of the Dodd-Frank Act's requirements, many of the
changes Dodd-Frank required are already here and others are just around the
corner. These changes, and the other corporate governance reforms being pursued
by shareholder advocates have a number of significant implications,
beyond just the most obvious practical effects.
1. Heightened Scrutiny: Not
all companies are going to give in on executive compensation issues or on board
process issues like board declassification and majority voting. (Indeed, there
are certainly a number of serious commentators who question the value or even
the wisdom of many of these reforms). But while different companies may respond
to these developments in different ways, companies that resist these governance
developments may face heightened levels of scrutiny, both from shareholders and
from the media.
A very recent example of this kind of scrutiny involves
the Internet media company, LinkedIn, which has recently filed to conduct an
initial public offering of its securities. In two interesting but highly
critical commentaries on the DealBook blog (refer here and here),University of Connecticut Law Professor Steven Davidoff
takes LinkedIn to task for adopting "a governance structure that not only
disenfranchises its future shareholders, but contains elements that have been
heavily criticized by corporate governance advocates." Among other things,
Davidoff criticizes Linked In for its dual share class structure that ensures
that the company founders will retain voting control of the company; for
adopting a staggered board; and for instituting onerous by law provisions.
In referencing Davidoff's critique of LinkedIn here, I am
expressing no opinions in whether or not his criticisms are valid or whether
LinkedIn fairly may be criticized. Rather I cite his analysis to show the kind
of scrutiny all companies are likely to face if they pursue practices or
implement policies that fly in the face of the current trends in corporate
governance reform. This level of scrutiny is only likely to increase as other
reforms, such as the compensation ratio disclosure requirements, go into
effect.
2. Increased Litigation Risk:
Companies that resist shareholder driven reform initiatives may not only face
scrutiny, but they (or their directors and officers) may also face an increased
likelihood of litigation. In a recent post (here), I noted the apparent trend in which companies who
experience a negative "say on pay" vote may find themselves facing shareholder
litigation relating to the companies' compensation practices. As noted above,
there are others of these current reforms - for example, the clawback
provisions - that could also encourage shareholder litigation.
3. Changing Judicial Attitudes: A
very strong principal traditionally informing judicial scrutiny of board processes
and decision making has been a broad judicial deference to the boards
themselves. With the shift towards greater shareholder empowerment, courts may
also be less inclined than perhaps they were in the past to defer to boards.
This notion that evolving corporate governance
norms may affect judicial consideration of board process and functioning was
highlighted in the Chancellor Chandler's August 9, 2005 opinion in the Walt Disney Shareholder
Litigation, where Chandler observed that "in this era of Enron and
WorldCom debacles, and the resulting legislative focus on corporate governance,
it is perhaps worth pointing out that the actions (and the failures to act) of
the Disney board that gave rise to this lawsuit took place ten years ago, and
that applying 21st century notions of best practices in analyzing whether those
decisions were actionable would be misplaced."
The Chancellor's unmistakable implication is that
heightened 21st century standards will be applied to 21st century board
actions - in other words, as corporate governance standards change, boards will
be held to standards of conduct reflecting the changed governance norms and
expectations. And in an era of growing shareholder empowerment, that reality
may translate into increased judicial expectation for boards to address
shareholder initiatives.
Conclusion
There is of course within all of this extensive room for
serious debate about whether or not these changes ultimately will advance or
impede corporate performance and what impact all of this will have on the
relatively competitiveness of U.S companies in a global marketplace. But
whatever may be said along those lines, it seems clear that the changes brought
about in the current round of corporate governance reforms are here to stay and
will require corporate officials to adapt to the new environment.
Meanwhile, In Another Universe: Things
that are commonplace now (the Internet, arthroscopic surgery, the E-Z pass toll
collection system, open-on-the-bottom condiment containers, etc.) were
virtually inconceivable just a short time ago. Rivka Galchen's article entitled
"Dream Machine" in the May 2, 2011 issue of the New
Yorker provides a fascinating glimpse of even more
fantastic changes the future may bring, in the form of "quantum
computing" -- that is, computing based on the principles of quantum
mechanics.
The promise of quantum computing is the vast improvement
in computational power it could provide. As an example of a problem not
otherwise resolvable through conventional computing but that could be solved
through quantum computing is "prime factorization." That is, it is easy to
multiply two large prime numbers but very difficult to take a large number that
is the product of two primes and to deduce the original prime factors. To
factor a number of two hundred digits would take a conventional computer longer
than the history of the universe but would only take a prime computer an
afternoon.
The explanation of how a quantum computer would
accomplish this involves a scientific theory known as the Many
Worlds Interpretation. It entails the "counterintuitive reasoning" that
"every time there is more than one possible outcome, all of them occur." So if
a radioactive atom might decay and it might not, it both does and doesn't.
From this, the many implied small branchings "ripple out until everything
that is possible in fact is."
According to Oxford physicist David Deutsch,
the Many Worlds theory explains how quantum computers might work. According
to Deutsch, a quantum computer would be "the first technology that allows
useful tasks to be performed in collaboration between parallel universes." The
quantum computer's processing power "would come from a kind of outsourcing of
work, in which calculations literally take place in other universes."
The Many Worlds theory to which Deutch refers to explain
quantum computing's theoretical operation seems (to me at least) to have more
to do with the imaginative world of literature than it does to science. Perhaps
my feeling in this respect is due in part to the unmistakable parallels between
the Many Worlds theory and a short story written by the Argentine writer, Jorge
Luis Borges.
Borges's story, The Garden of Forking Paths, involves Dr. Yu Tsun, who
is a descendant of a scholar (Ts'ui Pên ) who wrote an
indecipherable novel about labyrinths. In this story, Dr. Yu meets a
British sinologist who has uncovered the mystery of Ts'ui Pên's novel. The
British sinologist described his interpretation of the novel as
follows:
In all fictional works, each time a man is confronted
with several alternatives, he chooses one and eliminates the others; in the
fiction of Ts'ui Pên, he chooses-- simultaneously--all of them. He creates, in
this way, diverse futures, diverse times which themselves also proliferate and
fork. Here, then, is the explanation of the novel's contradictions. Fang, let
us say, has a secret; a stranger calls at his door; Fang resolves to kill him.
Naturally, there are several possible outcomes: Fang can kill the intruder, the
intruder can kill Fang, they both can escape, they both can die, and so forth.
In the work of Ts'ui Pên, all possible outcomes occur; each one is the point of
departure for other forkings. Sometimes, the paths of this labyrinth converge:
for example, you arrive at this house, but in one of the possible pasts you are
my enemy, in another, my friend.
And so, I will leave you with this thought: In at least
one universe, the quantum computer will become a working reality. The question
that remains to be seen is which universe. Or to put it another way --
the possibility that there might be another universe in which the airline does
not lose my luggage does not do me much good in the universe in which my luggage
has been lost.
Read
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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