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Thursday, July 14, 2011

The Sophomoric Placebo of Separating CEO and Chair

Shareholders face the difficult challenge of trying to protect and grow their investments under circumstances where they are not qualified to run -- or be on the boards of -- those companies in which they have invested and where, at least heretofore, they have not had sufficient information, tools, power or the business experience and skills to meaningfully influence, analyze, compare or make decisions about the directors who are representing them or the managers who are running the portfolio companies. Among the many opportunities available to shareholders to empower or influence Boards, the campaign of separating the CEO from the Chairmanship of the Board appears at first blush to be eminently logical (in a high school civics sort way) and easy to grasp and debate, but it is magnificently ineffectual (a mere placebo) with potentially harmful side effects (a nocebo).

The common arguments FOR requiring that the CEO and Chair be separate persons are that (a) the CEO ought not be the chairman of the corporate body which is overseeing him or her, (b) a separate Chairman can raise important questions that would not otherwise be raised at the meeting, (c) separation of roles of authority at the top of the corporation is essential to protect against problems resulting from the abuse of power, (d) being Chairman is a full-time job that would detract from the CEO's performance as CEO, (e) it is a proxy of good governance, (f) it gives shareholders an ability to speak to Chairs as the independent leaders of board to get a better idea of what's going on at the board level, (g) titles are important, (h) the separation sends a message that the CEO is accountable to the Board, (i) the Chairmanship title is an incident of structural power that should not be conferred gratuitously, (j) the majority of directors polled want separation of the roles and (i) institutionalizing the accountability of the CEO by excluding her from the Chairman title and role creates a constructive energy in the board room.

The common arguments AGAINST mandatory separation include: (a) no study regarding whether or not separating the Chair and CEO improves company or board performance (including the most recent Korn Ferry report) demonstrates any correlation between the two, (b) a recent ViewPoints Report of Members of the Lead Director Network (consisting of lead, presiding and non-executive chair directors) indicated that directors believe that the various titles given board leaders to be distinctions without any practical difference and agree that, notwithstanding the view of persons outside the company, these titles do not meaningfully affect the board leader's relationship with the CEO or the board leader's responsibilities on the board of directors, (c) it creates confusion that two heads are running the shop, (d) it undermines the authority of the CEO in other contexts, (e) it sends a negative message that the board does not have confidence in the CEO, (f) the Chairman and the CEO may constantly be contradicting each other, especially where the Chairman has a staff, (g) being the leader of the board requires special skills, such as ensuring full participation, moving the discussion along at the right pace, knowing where each director stands, nurturing a diverse group of people with different styles of participation and from different business cultures, actively managing the board processes, pulling directors together to ensure board effectiveness and assuring that the boardroom environment remains open and multi-sided -- and if the CEO has these skills she should not be precluded from the Chair, (h) separation has adversely distorted behavior at some companies where CEOs have changed titles to become executive chairs (and thus out of reach of shareholder compensation votes while in form appearing to separate the CEO and Chair roles) and promoting COOs into the nominal CEO position, (i) the board is in the best position to choose its leader and should not be constrained from electing the CEO as chair, and (j) under circumstances where shareholders are resource- and information-constrained, there are more effective places upon which they can turn their attention to restrain excess power and promote board effectiveness.


The most common arguments for and against the CEO-Chair separation have failed to consider two factors in Board effectiveness: board composition and resulting board dynamics. While board effectiveness (including its oversight of management and related prevention of the abuse of power) is a function of many factors, the single most important is its composition. Boards work not only through the use of written materials, governance guidelines, committees, structures, processes and agendas but more significantly through the measure each director takes of each other director and members of management. As in every other group, there is a pecking order; some directors are more equal than others. Decisions are made, questions are asked, and the board work is done through the interaction of the differing personal power, heft, experience, skills, attitudes, behaviors, communication and charisma of each director, including the CEO. Inside the boardroom, these dynamics are unspoken but well understood. In substance, the board easily identifies its leader, regardless of where the form or structure places the chairman title. The board will follow the lead of the de facto leader, regardless of which director has the de jure title. The Board Pecking Order cannot be changed by a shareholder or legislative mandate requiring separation of the positions.


There are many board leadership structures -- from Wal-Mart (where the CEO is not even on the board), to Occidental Petroleum and Google (where the former Chairman and CEO is now the Executive Chairman) to Research in Motion (where two founders are Co-Chairs and Co-CEOs) to Apple (where there is no Chair but there are two non-executive co-lead directors), to Yahoo! (where the board leadership consists of a Chief Yahoo! and a non-executive Chair) to Ford (where Bill Ford is listed as Executive Chairman and Chairman of the Board) and to the UK model (with an Executive Chair, a lead director and a CEO). In the end, board effectiveness is determined less by formal structure and more by CEO-Board composition and dynamics, including (i) whether directors trust management and (ii) whether or not the directors -- individually and collectively as a group -- have sufficient credibility, respect and personal power relative to the CEO and each other (regardless of who has what title), to enable them to operate effectively and with the optimum balance of CEO-Board dependence and independence.


In conclusion, it must be acknowledged that there are widely recognized and highly regarded corporate governance experts who advocate belling the CEO cat, but both of the arguments for and against are compelling and persuasive. The answer to the battle of the intellects is contextual -- the winning arguments are determined by the facts and circumstances of each particular board. Given the limited insight and resources available to them, stockholders concerned about potential abuse of power by company leaders should not waste resources on the CEO-Chairman debate but rather focus on areas with greater impact on board effectiveness (to be discussed in an upcoming blog). Leave the board leadership decision -- in substance and in form -- to each board.


































Wednesday, March 2, 2011

Directors are NOT Under Fire! Conduct alleged by SEC in recent cases against outside directors would not be tolerated by boards.

1. If one of your directors leaked material information to anyone in violation of your corporate governance guidelines and insider trading policies, wouldn't your board seek the director's resignation as well as disgorgement? That's the allegation in the SEC's proceeding against Mr. Rajat Gupta, former director of Goldman Sachs and Procter & Gamble (available here). This proceeding should generate no cause for alarm for responsible directors.

2. Wouldn't you ask for the resignations of the audit committee directors (at a minimum) if your audit committee failed to undertake any independent investigations or even ask questions when the committee became aware that (1) three different audit firms had resigned, (2) one law firm resigned after completing a report and then subsequently expressed reservations about the reliability of the information furnished to it by management, (3) an independent consultant was terminated in connection with an investigation it had been retained to undertake, (4) the CEO insisted on running all "independent investigations", (5) the various auditors had issued multiple material deficiency letters, one of which noted that the audit committee itself was a material weakness, (6) management forged the auditor's signature on a consent to the 10-K and filed it, (7) the CEO created a family-owned corporation located in the same plant as the issuer to do subcontract manufacturing for the issuer and engage in the horse breeding/racing business and, of course, without disclosing it until forced to so by auditors who discovered it, (8) the CEO terminated a controller who warned that the company was overvaluing its inventory, (9) the SEC had issued subpoenas and commenced an investigation, (10) the CEO spent $4.7 million in issuer funds to pay for luxury cars, jewelry, art, real estate, use of personal aircraft, prostitutes, horse training, clothing and accessories from Hermes and Luis Vuitton and more than $120,000 for iPods included in gift bags at his daughter's multi-million dollar bat mitzvah? These are the allegations in the SEC's proceedings against Jerome Krantz, Cary Chasin and Gary Nadelman -- former members of the Audit (and Compensation) Committees of DHB Industries, Inc (n/k/a Point Blank Solutions, Inc.). These proceedings (available here) should generate no cause for alarm on the part of responsible directors.

3. The allegations are, of course, merely allegations. Even if the allegations are ultimately shown to have been true, however, these lawsuits -- though interesting -- should not be viewed by ordinary, responsible directors as a source of concern.

Sunday, December 5, 2010

On a Staggered Board? Then Airgas is for you.

Possible Director Question for Management: If you are on a staggered board, ask if any fine tuning of the Certificate/Articles of Incorporation/Organization ("Certificate") and By-Laws is necessary in light of the Delaware Supreme Court's recent decision in the Airgas case {Airgas, Inc. v. Air products and Chemicals, Inc., No. 649, 2010 (Del. Nov. 23, 2010)}.



Staggered Board General Background for the Erudite Director: Staggered Boards have been permitted by Delaware since 1899. They are intended to provide continuity of board oversight and to enhance the bargaining power of a target's board by making in more difficult for a would be predator to gain control of the target without the board's permission. The "dark side" of staggered boards is that they may be used or perceived as tools of entrenchment, and expose their directors and management to criticism from proxy advisor firms and from gadflies and government/union pension fund shareholders. Staggered board are normally created under the terms of the Certificate and of the By-Laws. Typically, both instruments also require a super-majority vote (e.g. 2/3) to amend the staggered board. Reinforcement may also be furthered by including appropriate notice and/or written consent standards.



The Air Products Staggered Board was created by Certificate and By-Law language that proved to be vague when tested in actual circumstances. Although considered "standard" when created, the language was sufficiently lacking in clarity that the Delaware Chancery Court interpreted it to mean that the 3 year terms for the directors were only 3 terms (which could be less than a year in length so long as the began and ended at any time during a calendar year). This vagueness was exploited by Airgas, which had been engaged in a hostile takeover of Air Products and had launched a proxy contest when the Air Products Board declined the Airgas offers -- all of which had been at prices less than the market price. In the proxy contest, Airgas successfully ousted all Air Products directors in the class standing for re-election, and the Air Products stockholders also passed an Airgas sponsored by-law amendment accelerating the date for the next Air Products annual meeting by 8 months -- to January 2011 -- for the purpose of ousting the next class as soon as possible. The Chancery Court validated these actions, but the Delaware Supreme Court reversed.



The Dilemma & the Answer: Typically some flexibility for the annual meeting date is built into the by-laws, but having too much flexibility can undermine the protection intended to have been created by staggering the board. The solution is for the board to discuss, with counsel, where that unique board wants to come out on the matter and then be sure the language is drafted with more precision to achieve that outcome. For example, the Delaware Supreme Court noted that litigation could have been avoided if the language had stated that the annual meeting be held "as closely as practicable in the same month of each year."

Tuesday, October 19, 2010

Director Highlights of Yesterday's SEC Proposed Say on Pay Rule

Yesterday the SEC proposed rules to implement the say on pay provisions of Dodd-Frank. Here are the key points for directors.
  1. Director compensation is not subject to stockholder approval under Dodd-Frank.
  2. There must be a shareholder advisory say on pay vote at the 2011 annual meeting (or other meeting, whichever is first, held after January 21) and no less frequently than once every three years thereafter. The non-binding shareholder vote is required to cover the compensation of the named executive officers as disclosed under Item 402 of Reg SK, which means the tables, the narrative and the CD&A -- including the golden parachute compensation. And, of course, the CD&A must now discuss the impact of any shareholder votes on the comp committee's subsequent compensation determinations.
  3. At least once every 6 years, starting in 2011, stockholders must be given a separate non-binding (under the proposed rules) vote on how frequently to hold the say on pay votes. With limited exceptions, a non-binding frequency vote presented to the stockholders must be in a form that allows them to select from 4 choices: ONE, TWO or THREE years or ABSTAIN. This is NEW. Most proxy cards are structured FOR, AGAINST or ABSTAIN, and some service providers may not be able to reprogram their systems for a 4 choice vote (In that case, the SEC has provided a limited exception). Of course, management can make a recommendation regarding that frequency and is not bound by the vote, in any event. All other things being equal, we think an annual say on pay vote is preferable, even if the shareholders elect a different cycle. An annual vote makes it a routine matter and gives more immediate feedback to the Board and Management rather than delaying the conversation, building shareholder frustration and making the vote a major crisis when it finally arrives.
  4. The SEC has proposed a new table and disclosure regime for proxy statements on mergers, sales, asset sales, other changes in control etc. ( "CICc") and the related say on pay votes. The CICs format includes, among other things, a table breaking out in columnar form the golden parachute components for each NEO: cash, equity, pension/nqdc, perquisites/benefits, tax reimbursement, other and total. For their routine proxy statements companies can (but are not required to) choose to use the CICs format, in which event that disclosure and shareholder advisory vote will count when it comes time for a deal. If companies do not use the CICs format when seeking the regular say on pay vote, then another separate golden parachute vote is required in that Change in Control proxy statement. As expected, even if the CICs regime is used for routine meetings, additional disclosure and a separate vote would be required if the information in the table changes. The practice point, however, is that activist shareholders are expected to press companies (and send in comments to the SEC during the comment period) to utilize the more extensive tabular disclosure mandated by the CICs regime in its annual disclosure even where a merger or other change in control is not involved.
  5. Shareholder say on pay proposals may be excluded from the proxy statement to the extent they duplicate the votes presented to the meeting under Dodd-Frank.
  6. Broker discretionary voting of uninstructed shares, of course, is not permitted on these say on pay votes.
  7. These are just the highlights of most interest to directors. There are provisions for smaller companies and TARP companies and other changes and forms affected by the proposed rule. The rule can change. Comments are due by November 18, 2010, some time after which we should have a final rule.

Tuesday, October 5, 2010

Board Impact of the SEC's Proxy Access Delay

On October 4, the SEC suspended its rules permitting certain shareholders to nominate directors on issuer proxy statements (proxy access), pending the outcome of a lawsuit by The Business Roundtable and Chamber of Commerce. Most pundits do not expect these nomination rules to be effective for 2011. This suspension, however, is not a Mulligan, a "do over" or any cause for celebration or relief. The other provisions of Dodd-Frank are still in place, and the importance of doing the work to deal with them (outlined in my September 8 blog below -- "Director Elections in 2011: Yours to Lose" and on my website here) remains undiminished. For example, SAY ON PAY is still in place for 2011. The six principles (TSR, OR/IR, BICS, KISS, CAT and C2C) are just as important to follow for Say on Pay as they are for shareholder nominations of director candidates. [Note, I have updated the July 27 blog "Director's Checklist of Corporate Governance Changes in Dodd Frank" below.] The postponement of this SEC rule that seemed to bother directors the most should be seen as an opportunity to have one more year to improve or fine tune shareholder relations -- especially with the feedback of the extent of your 2011 shareholder say on pay support -- before the nomination rule becomes effective.

Wednesday, September 8, 2010

Director Elections in 2011: Yours to Lose

The 2011 Proxy Season may prove to be very challenging, but it is in the board's power to win or lose it. You have the power, the funding, the operating information and strategic planning that no outsider, shareholder or shareholder group can match. Other than black swan catastrophic failure, the election is yours to lose.

This is not to suggest that money and effort will not be required. Corporate Governance is BIG BUSINESS with strong special interest groups and shareholders vested in the need for ongoing controversy to attract media attention and maintain full employment. Issuers do not get a "pass" by compromising or settling because controversy must continue or the corporate governance business dies. Now, as a result of Dodd Frank and the SEC, the business of corporate governance has gone viral, spreading to companies of all sizes (other than the micro caps for now). This is not about justice but about power. Management and boards who do not thoughtfully exercise their power will watch it transfer to special interest shareholders at the expense of shareholders as a group.

The dynamics of this evolving equity politics require boards to refocus on board basics:
  • TSR -- Maintain and increase long term shareholder value

  • Through OR -- Operating Results -- and IR -- enhanced Investor Relations and

  • BICS -- Best Interests of the Corporation and Shareholders as a group.

And on three shareholder relations principles:

  • KISS -- Keep It Simple Stupid,

  • CAT -- Compensation Aligned with TSR and

  • C2C -- Close to the Constituents.

The biggest challenge is to titrate just the right amount of additional funds, time, energy and effort to pro-actively deal with the new challenges and requirements. Visit our website HERE for our latest slide show on Questions Directors Should Ask Themselves and Management to be Prepared for 2011 as well as other materials forming a complete board primer on Dodd Frank and Winning the 2011 Proxy Season.

Tuesday, July 27, 2010

Director's Checklist of Corporate Governance Changes in Dodd Frank

UPDATED ON OCTOBER 4, 2010.
This post is a director’s summary of the key corporate governance provisions applicable to most public companies of the July 21, 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). See a Special Director's Primer on Dodd-Frank on my website (here), including a Director's Slide Show and a Management-Board Timetable to deal with the provisions discussed below.

Governance Changes with Potentially Large Impact

1. Proxy Access. The Act authorizes the SEC to require companies to include nominees submitted by shareholders and to follow certain procedures in relation to proxy solicitation materials. Stockholders who have held 3% of the company's stock for 3 years can nominate on the company's proxy statement the 25% (rounded down) of the current full board size (and at least one director in any event). On October 4, the SEC put its newly promulgated rules ON HOLD, pending the outcome of a lawsuit by The Business Roundtable and Chamber of Commerce. Most pundits do not expect the new rules to be in effect for the 2011 proxy season, but.... The legislation has increased the power of the more well organized and special agenda stockholders. While the rules are not likely to make hedge funds any more or less effective in their campaigns, the rules should lower hedge fund costs. Public employee, union and social activist funds will be the primary beneficiaries of proxy access, and many have director candidates at the ready. As a practical matter, however, rather than actually nominating competing candidates, these shareholders are more likely to use their new power in negotiations with management.

2. Majority Voting. The Act does not require majority voting for uncontested director elections. We expect public pension funds and union funds to continue to press issuers to voluntarily adopt majority voting because it is a relatively inexpensive, reasonably effective tool of intimidation. To use the majority voting weapon virtually requires no holding periods, minimum ownership requirements, responsible alternative candidates, alternative visions or business plans. We predict that issuers will successfully counter arguments for majority voting with the argument that proxy access obviates the need for – and is a more responsible approach than -- majority voting. Nonetheless, the proxy access power may be so significant in particular cases that the shareholder is able to negotiate a majority voting concession from management and the board.

3. Say-on-Pay. At least once every three years, a proxy statement must include a separate non-binding shareholder vote to approve the company’s executive compensation as disclosed in the proxy statement. At least once every six years, the shareholders must vote by separate resolution on the how frequently to have the say-on-pay vote ( every year, every two years or every three years). More frequent voting should keep the company in better touch with investors, reduce the likelihood of pent up shareholder anger and make the compensation issue “routine,” but issuers may be subject to other circumstances (e.g. cost constraints, labor union -such as the Carpenters Union -negotiations, etc.) that press for less frequent voting.

4. Pay Ratio Disclosure. Companies will be required to disclose the median annual total compensation of all employees other than the CEO, the annual total compensation of the CEO and the ratio of the two. These three data points, standing only in relation to each other and without context, are meaningless, will be misinterpreted and are potential flash points. It will be important for companies to provide that context – such as depth, scope and complexity of the business, number of employees, revenue, earnings, assets, geographic expanse and so forth to support the compensation level of the CEO. The compensation discussion and analysis portion of, and the new executive summaries in, proxy statements should be revised accordingly.

5. Responding to these Changes: Close to the Constituents. Briefly stated, Management and the Board, in a well-coordinated effort, must engage and listen to shareholders more than ever and make a concerted, continuous effort to provide meaningful shareholder education in a straightforward, understandable manner on every occasion, including the proxy statement. More on this in a separate update.
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Lower Impact Governance Changes

6. Board Leadership and CEO Disclosures. The Act redundantly orders the SEC to require issuers to disclose in their annual proxy statements the reasons why the company has chosen to combine or separate the board chairman and CEO positions. This provision is substantially similar to current SEC regulation.


7. Broker Discretionary Voting. Stock exchanges must prohibit broker discretionary voting in connection with the election of directors, executive compensation or any other significant matter, as determined by the SEC. NYSE requirements already prohibit such voting in connection with the election of directors and equity pay plans. Adding additional areas of prohibition is not expected to make a difference in the outcome of these votes.

8. Say-on-Golden Parachutes. Proxy statements seeking shareholder approval of an acquisition, merger, consolidation or proposed sale of all or substantially all of a company’s assets must disclose “golden parachute” payments and, in the unlikely event this compensation was not previously voted upon under the regular say-on-pay votes, must include a separate nonbinding shareholder resolution to approve such agreements. This provision, like many of the corporate governance provisions of the Act, is redundant. Companies already discuss these agreements on an annual basis in the proxy statements, and the golden parachutes will be part of the mandated regular say-on-pay voting. Furthermore, in the unlikely event that a precatory vote on the parachute is required, what is the impact if the stockholders were to vote in favor of the deal but against the parachute?

9. Compensation Committee Composition. Stock Exchanges are to require compensation committees to meet new “independence” standards that include consideration of the source of compensation for the director (such as consulting, advisory or other compensatory fees paid by the company) and whether the director is affiliated with the company. The vast majority of committees already meet these standards.

10. Compensation Committee Consultant Standards. Compensation committees will be required to consider certain independence factors (to be determined by the SEC) with respect to their consultants, legal counsel and other advisers. Companies are required to disclose the performance and possible conflicts of interest of compensation consultants. These provisions have some procedural implications, none of which is material. Many companies already have these policies in place.

11. Compensation Committee Authority. The Act redundantly grants compensation committees the power of hiring and overseeing compensation consultants, legal counsel and other committee advisers and requires companies to provide appropriate funding for these advisers. These practices are already in place for the vast majority of committees.

12. Pay-for-Performance Disclosure. The Act requires companies to disclose in their annual proxy statements the relationship between executive compensation and the company’s financial performance, basically as measured by total shareholder return. Many issuers are already following this practice.


13. Compensation Clawbacks. Companies must develop, implement and disclose policies with respect to the clawback of incentive-based compensation paid to current or former executive officers following a restatement. For all but a handful of companies, complying with this requirement will be an academic exercise.

14. Hedging disclosure. Issuers must disclose in their annual proxy statements whether employees or directors of the company are permitted to hedge any company equity securities granted as compensation or otherwise held. Issuers and Boards who have not yet adopted anti-hedging policies should do so, but we expect the impact of the legislation in this area to be negligible.

Changes Affecting Certain Classes of Companies

15. Financial Institution Compensation Restrictions. Bank holding companies and certain other financial institutions will be prohibited from providing executive officers, employees, directors or principal shareholders with compensation that is excessive or that could lead to material financial loss to the financial institution. The SEC already requires disclosure of such compensation, and we have come across no proxy statement of any financial or other institution acknowledging that compensation of this nature is being paid to employees.


16. Disclosure of Say-on-Pay and Say-on-Golden Parachute Votes by Institutional Investors. Institutional investment managers subject to Section 13(f) of the Securities Exchange Act of 1934 must disclose their say-on-pay and say-on-golden-parachute voting records annually. Mutual funds already make these disclosures. The Act has broadened the list to include other institutional investors (e.g. banks), but if the previous experience with mutual fund disclosure is any guide, this requirement is another non-event.


17. Board of Director Requirements for Nationally Recognized Statistical Rating Organizations. The Act substantially increases the oversight, liability, disclosure obligations and procedural requirements for credit rating agencies. In addition, at least one half of the Board (and no fewer than two) directors must be “independent” as described in the Act, and some of them must be users of the ratings. Director compensation must not be linked to corporate performance and must otherwise be structure to “ensure” independence of judgment. The maximum term of board service is a non-renewal 5 years. Among their duties, directors are required to oversee policies and procedures for determining credit ratings, conflicts of interest and the effectiveness of internal controls for credit rating. Compliance with this requirement is not expected to be burdensome.

18. Smaller Public Companies Permanently Exempt from Sarbanes-Oxley Internal Control Requirements. The Act exempts smaller public companies from compliance with the internal control auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act. This is good news for these companies, who had previously been relying on the SEC’s discretion (which had run out) in postponing the effective date.