|
Description
INTRODUCTION
I. CHANGING BOARD COMPOSITION, 1950-2005: THE RISE OF INDEPENDENT DIRECTORS AND DIRECTOR INDEPENDENCE A. Changing Board Composition, 1950-2005 B. Mechanisms of Enhanced Director Independence, 1950-2005 1. Relationship standards and rules 2. External sanctions and rewards a. Sanctions (sticks) b. Rewards (carrots) c. Reputation 3. Intra-board structures and functions a. Board committees b. The "special committee" c. Executive session; "lead director" 4. Reducing CEO influence in director selection and retention C. Summary of Part I.B II. CHANGING BOARD COMPOSITION: THE SEARCH FOR EVIDENCE THAT IT MAKES A DIFFERENCE A. Uncertain Effect on Firm Performance and Behavior 1. Firm performance tests 2. Discrete task tests a. CEO terminations b. Takeover activity as target c. Takeover activity as acquirer d. Executive compensation e. Avoidance of financial fraud 3. Understanding the evidence a. Tradeoffs b. Sorting (optimal differences) c. Diminishing marginal returns d. Firm-specific vs. systematic effects B. Summary of Parts I and II III. THE RISE OF SHAREHOLDER VALUE, 1950-2005 A. The 1950s: The Heyday of Stakeholder Capitalism and Corporate Managerialism B. The 1970s: The Rise of the Monitoring Board 1. The Penn Central collapse and the absence of performance monitoring 2. "Questionable payments" and the absence of controls monitoring 3. Corporate social responsibility 4. Reconceptualization of the board C. 1980s: The Takeover Movement, Shareholder Value, and the Rise of the Independent Director 1. The monitoring board as safe harbor in the "Deal Decade" 2. Judicial promotion of director independence 3. Summary D. The 1990s: The Triumph of Shareholder Value and the Independent Board 1. Introduction 2. Shareholder value without hostile bids 3. Resolving the paradox through the market for managerial services a. Executive compensation b. CEO termination c. Golden parachutes 4. Markets generally E. The 2000s: New Roles for Independent Directors and New Standards of Director Independence 1. Introduction 2. Contractual vulnerabilities 3. Contracting failures 4. Director independence reconsidered F. Summary III. THE INCREASING INFORMATIVENESS OF STOCK PRICES, 1950-2005 A. Introduction B. Market-Level Empirical Evidence on Stock Price Informativeness: Synchronicity and [R.sup.2] C. Firm-Level Empirical Evidence of More Disclosure by Firms D. Additional Disclosure Because of SEC Regulation 1. Disclosure forcing a. Disclosure integration b. Segment reporting c. Management's discussion and analysis 2. Disclosure permitting 3. Disclosure standardizing E. Additional Disclosure Because of Accounting Pronouncements and Changes 1. APB No. 22, Disclosure of Accounting Policies (1972) 2. SFAS No. 52, Foreign Currency Translation (1982) 3. SFAS No. 95, Statement of Cash Flows (1987) 4. SFAS No. 106, Employers' Accounting for Post-Retirement Benefits Other than Pensions (1990) F. Other Factors Enhancing the Informativeness of Stock Prices CONCLUSION: A NEW CORPORATE GOVERNANCE PARADIGM APPENDIX
INTRODUCTION
"Independent directors"--that is the answer, but what is the question?
The now-conventional understanding of boards of directors in the diffusely held firm is that they reduce the agency costs associated with the separation of ownership and control. Elected by shareholders, directors are supposed to "monitor" the managers in view of shareholder interests. Who should serve on the board of a large public firm? Circa 1950, the answer was, as a normative and positive matter, that boards should consist of the firm's senior officers, some outsiders with deep connections with the firm (such as its banker or its senior outside lawyer), and a few directors who were nominally independent but handpicked by the CEO. Circa 2006, the answer is "independent directors," whose independence is buttressed by a range of rule-based and structural mechanisms. Inside directors are a dwindling fraction; the senior outside lawyer on the board is virtually an extinct species.
The move to independent directors, which began as a "good governance" exhortation, has become in some respects a mandatory element of corporate law. For controversial transactions, the Delaware courts condition their application of the lenient "business judgment rule" to board action undertaken by independent directors. (1) The New York Stock Exchange requires most listed companies to have boards with a majority of independent directors (2) and audit and compensation committees comprised solely of independent directors. (3) The NASD requires that conflict transactions be approved by committees consisting solely of independent directors. (4) Post-Enron federal legislation requires public companies to have an audit committee comprised solely of independent directors. (5) But why has the move to independent directors been so pronounced?
One of the apparent puzzles in the empirical corporate governance literature is the lack of correlation between the presence of independent directors and the firm's economic performance. Various studies have searched in vain for an economically significant effect on the overall performance of the firm. Some would deny there is a puzzle: theory would predict that firms will select the board structure that enhances the chance for survival and success; if competitive market pressure eliminates out-of-equilibrium patterns of corporate governance, the remaining diversity is functional. Others would note that corporate governance in the United States is already quite good, and thus marginal improvements in a particular corporate governance mechanism would expectedly have a small, perhaps negligible, effect.
The claim of this Article is that the rise of independent directors in the diffusely held public firm is not driven only by the need to address the managerial agency problem at any particular firm. "Independent directors" is the answer to a different question: how do we govern firms so as to increase social welfare (as proxied by maximization of shareholder value across the general market)? This maximization of shareholder value may produce institutions that are suboptimal for particular firms but optimal for an economy of such firms. Independent directors as developed in the U.S. context solve three different problems: First, they enhance the fidelity of managers to shareholder objectives, as opposed to managerial interests or stakeholder interests. Second, they enhance the reliability of the firm's public disclosure, which makes stock market prices a more reliable signal for capital allocation and for the monitoring of managers at other firms as well as their own. Third, and more controversially, they provide a mechanism that binds the responsiveness of firms to stock market signals but in a bounded way. The turn to independent directors serves a view that stock market signals are the most reliable measure of firm performance and the best guide to allocation of capital in the economy, but that a "visible hand," namely, the independent board, is needed to balance the tendency of markets to overshoot.
This Article develops this general theme through an account of the changing function of the board over the past fifty years, from the post-World War II era to the present. During this period, the board's principal role shifted from the "advising board" to the "monitoring board," and director independence became correspondingly critical. Although other factors are at work, there were two main drivers of the monitoring model and genuine director independence. First, the corporate purpose evolved from stakeholder concerns that were an important element of 1950s managerialism to unalloyed shareholder wealth maximization in the 1990s and 2000s. Inside directors or affiliated outside directors were seen as conflicted in their capacity to insist on the primacy of shareholder interests; the expectations of director independence became increasingly stringent.
Second, fundamental changes in the information environment reworked the ratio of the firm's reliance on private information to its reliance on information impounded in prevailing stock market prices. Over the period, the central planning capabilities of the large public firm became suspect. Instead, a Hayekian spirit, embodied in the efficient capital market hypothesis, became predominant. (6) The belief that markets "knew" more than the managers of any particular firm became increasingly credible as regulators and quasi-public standard setters required increasingly deep disclosure and this information was impounded in increasingly informative stock prices. The optimal boundaries of the firm changed as external capital markets advanced relative to internal capital markets in the allocation of capital. The richer public information environment changed the role of directors. Special access to private information became less important. Independent directors could use increasingly informative market prices to advise the CEO on strategy and evaluate its execution, as well as take advantage of the increasingly well-informed opinions of securities analysts. Independents had positional advantages over inside directors, who were more likely to overvalue the firm's planning and capital allocation capabilities. In the trade-off between advising and monitoring, the monitoring of managers in light of market signals became more valuable. The reliability of the firm's public disclosures became more important. Indeed, by the end of the period, boards came to have a particular role in assuring that the firm provided accurate information to the market.
Thus, fidelity to shareholder value and to the utility of stock market signals found unity in the reliance on stock price maximization as the measure of managerial success. From a social point of view, maximizing shareholder value may be desirable if fidelity to the shareholder residual (as opposed to balancing among multiple claimants) leads to maximization of the social surplus. This is the shareholder primacy argument. Independently, maximizing shareholder value may be socially desirable if stock prices are so informative that following their signals leads to the best resource allocation. This is the market efficiency argument.
Over the period, boards eventually undertook measures that assured management's responsiveness to stock market signals, in particular through the use of stock-related compensation and retention decisions based on stock market performance. But there was an additional twist in the board's intermediation between managers and markets: the board, acting through the independent directors, came to have power to limit the potency of stock market signals in the takeover market. There was skepticism as to whether markets were perfect, even at the height of the prestige of the efficient capital market hypothesis. After the 1987 stock market crash, economists developed increasingly more persuasive accounts of how stock market prices--even though, on average, the best estimate of intrinsic value--could deviate for a substantial time period from economic fundamentals. The board gained power under state law to hinder the operation of the takeover market, i.e., to weigh the reliability of the market price as a measure of shareholder value at a particular time. The problem is this: given the imperfection of market prices, what is the optimal degree of responsiveness to price changes, not just for any particular firm but across the entire economy? Investors may optimally adjust portfolios of liquid financial assets on one time line; managers may optimally adjust internal investment decisions over real assets on another. In light of potentially negative systematic effects from quick responses in the takeover market to imperfect market signals, it may be optimal to have a firm-specific institution that could slow the pace of control market activity to test the market for price reversals. The "visible hand" of the well-functioning board could, in theory, serve this function.
Independent directors have a comparative advantage for these different tasks. They are less dependent on the CEO and more sensitive to external assessments of their performance as directors; they are less wedded to inside accounts of the firm's prospects and less worried about the disclosure of potentially competitively sensitive information. They also have credibility in the "checking" of market signals against intrinsic measures of the firm's prospects. In other words, genuinely independent directors might create significant value in the allocation of resources, not just in their firm but more generally as other firms are forced to adapt to the best performers. Thus, one of the hallmarks of the period was the development of various mechanisms of director independence aimed at producing directors who were independent in fact.
This emphasis on the critical role of independent directors as an efficiency-justified strategy for importing stock market signals into the firm's (and the economy's) decisionmaking will strike some as a radical interpretation of the history. I make no claim that the various actors have been fully aware of the implications of each step--much may have happened through inadvertence, and the role of independent directors could have been otherwise--but this is the end point of this non-teleological process.
This Article proceeds as follows. Part I reviews the overall trend of board composition of large U.S. public companies since 1950. On the basis of data assembled from a number of different sources, the fraction of independent directors for large public firms has shifted from approximately 20% in the 1950s to approximately 75% by the mid-2000s. Part I also reviews the strengthening of various mechanisms of director independence that enhanced the independence-in-fact of directors over the period. Part II surveys the empirical studies that fail to find significant economic effects from this pronounced move toward director independence and concludes that the studies are looking in the wrong place. The studies look at board composition differences across firms. Yet if the main advantage of independent directors is to help commit firms throughout the economy to a shareholder wealth maximization strategy, then systematic effects will swamp cross-sectional variation. (7) Part III non-exhaustively canvasses the 1950-2005 period to explore one important driver in changing board composition: the shift toward shareholder wealth maximization as the dominant corporate purpose. Director independence became linked to the monitoring of managerial performance in order to serve shareholder ends. Part III also traces a complementary development: managers who once vigorously resisted board independence as a limitation to their autonomy came to champion the independent board as a buffer from the hostile takeover and as a substitute for greater government intervention in the wake of scandals.
Part IV non-exhaustively canvasses the 1950-2005 period to explore another driver of the change in board composition: the increasing informativeness and value of stock market signals. Informativeness was enhanced by increased disclosure resulting from regulatory initiatives by the Securities and Exchange Commission and the quasi-public accounting standards setting authorities. New information processing technology and increasing investments in securities analysis helped make prices more informative as well. It's not that the disclosure system changed to accommodate a demand for independent directors. Rather, as stock prices became more informative, the concern about the independents' potential debility--their lack of a well-informed view about the firm--subsided. Indeed, an increasingly important element of the independent board's monitoring role came to be the appropriate use of market signals in executive compensation contracts and in CEO termination decisions. Additionally, directors came to have an increasingly important function in assuring the accuracy of the firm's financial disclosure, i.e., "controls monitoring."
Part V concludes with the suggestion that the rise of independent directors, at least in the United States, is tied to a new corporate governance paradigm that looks to the stock price as the measure of most things. Maximizing the stock price serves two normative ends: promoting the interests of shareholders and making use of the information impounded by the market to allocate capital efficiently. In this time of increased shareholder activism, one important question is whether the enhanced independence of directors will create a space for a public firm to resist stock market pressure in the pursuit of currently disfavored business strategies (and whether this would be desirable) or whether the very pressures that give rise to director independence will in the end swamp this possibility.
I. CHANGING BOARD COMPOSITION, 1950-2005: THE RISE OF INDEPENDENT DIRECTORS AND DIRECTOR INDEPENDENCE
One of the most important empirical developments in U.S. corporate governance over the past half century has been the shift in board composition away from insiders (and affiliated directors) toward independent directors. This trend is consistent throughout the period and accelerates in the post-1970 subperiod. This Part describes the trend, looking at a number of studies that use different samples of firms and that apply somewhat different definitions of "independence." In addition to the numerical shift, the independence-in-fact of directors has been buttressed in the post-1970 period by a series of rule-based and structural mechanisms. In its own way, the effort to create independence-in-fact is as striking as the numerical shift.
A. Changing Board Composition, 1950-2005
No single study traces the rise of independent directors over the 1950-2005 period. The study that best captures the changing board composition over the period is Lehn, Patro and Zhao's paper reporting the insider-outsider breakdown for all publicly traded U.S. firms that survived from 1935 through 2000, namely eighty-one predominantly large firms. (8) Lehn et al. find a consistent decline in the average percentage of insiders over the 1950-2000 period, from approximately 50% to approximately 15%, with accelerating change after 1970. (9) The available data, however, apparently do not readily permit a further breakdown of the "outside" directors into "affiliated" and "independent" directors over the entire period. Other studies, typically cross-sectional in nature, examine proxy filings to classify directors. The earliest such study was in 1970. (10) The Securities and Exchange Commission (SEC) did a detailed survey covering 1977-1978, (11) the academic studies began in 1985, and the Investor Responsibility Research Center began its database for approximately 1500 public firms in 1996. (12)
I have put together these studies to construct a "time series" showing the board composition trend over the 1950-2005 period, (13) which is depicted graphically in Figures 1 and 2. (14) These figures show a steady increase in the representation of independent directors on the board, from approximately 20% in 1950 to approximately 75% in 2005. This is a powerful change in board composition that calls out for an explanation.
[FIGURES 1-2 OMITTED]
The limitations of this demonstration are obvious: I have used cross-sectional studies to reclassify the Lehn et al. category of "outsiders" into the more useful "affiliated" and "independent" categories, assuming in particular that the 1970 breakdown of outsiders is applicable to the 1950-1970 period for which there are no earlier cross-sectional studies. (In light of the history discussed below, it is likely that this overstates the fraction of independents on pre-1970 boards, which thus understates the change over the period.) Also, the various studies used different samples and undoubtedly applied different criteria in coding proxy disclosure about directors into the relevant classifications. These classification decisions would have been influenced by whether the researcher was trying to assess whether non-insiders augmented the corporation's capacities (thus referring to affiliated directors as "instrumental" directors) (15) or enhanced monitoring (calling affiliated directors "grey" directors). (16) Notwithstanding the inevitable noise, the overall trend that emerges is quite striking, as reflected by Figure 1 and by the fitted curves of Figure 2.
There has been an additional trend in the latter part of the period toward what Bhagat and Black call "supermajority" independent boards. (17) As recently as 1989, boards with only one or two insiders were unheard of. In a Korn/Ferry 1989 survey of large public companies, 67.5% reported three insiders and 32.5% reported four insiders. (18) By 2003, the pattern was strikingly different: 65% reported two or fewer insiders; 35% reported three insiders; none reported more than three insiders. (19) By 2004, under the influence of Sarbanes-Oxley and the stock exchange listing rules, the shift was virtually complete: 91% reported two or fewer insiders; 9% reported three insiders. (20) Large public firms have moved to a pattern of one, perhaps two, inside directors and an increasing number of independent directors. Some academics and practitioners have characterized the emerging pattern as the cynosure of corporate governance because of its maximum control of managerial agency costs. (21)
B. Mechanisms of Enhanced Director Independence, 1950-2005
The preceding section described the long-term numerical trend away from inside directors and toward independents. Nominally independent directors can of course be passive, ineffectual, and otherwise be found in management's pocket, as famously described in Myles Mace's 1971 book. (22) In 1989, nearly two decades later, Jay W. Lorsch and Elizabeth MacIver argued that the independent director was still more likely to be a "pawn" than a "potentate." (23) Nevertheless, one of the striking elements of the 1950-2005 period was the development of various mechanisms to create and enhance the independence of directors. The genesis of many of these mechanisms was the 1970s wave of corporate governance reform, which tried to establish preconditions for the monitoring board. Indeed, "independent director" entered the corporate governance lexicon only in the 1970s as the kind of director capable of fulfilling the monitoring role. Until then, the board was divided into "inside" and "outside" directors. (24) Further developments favoring director independence occurred in the 1990s as part of the post-hostile bid settlement among institutional investors, managers, and boards. (25) The last wave, post-2002, was spurred by the Enron, WorldCom, and other board failures, which led to new efforts to strengthen director independence in light of the board's additional role of controls monitoring as well as performance monitoring.
Analytically, these mechanisms of director independence can be broken down into four categories: (1) tightening the standards and rules of disqualifying relationships; (2) increasing negative and positive sanctions, such as legal liability for fiduciary duty breach, reputational sanctions, and stock-based compensation; (3) development of intra-board structures, such as task-specific committees and designation of a "lead director"; and (4) reducing CEO influence in director selection and retention by, for example, the creation of a nominating committee staffed solely by independent directors. Without being Panglossian, it does seem that the accumulating effects of changes in each of these mechanisms, as well as the accumulating cultural shift fostered by the successive reform efforts, should have increased the independence-in-fact of directors over the period.
1. Relationship standards and rules
A straightforward way to strengthen director independence is to select candidates who have no ongoing (or even prior) relationship with the corporation other than as a director. Over the 1950-2005 period the relationship measure of independence tightened considerably. Initially the relationship test focused narrowly on the director's employment status. Those who were not current officers were, by definition, outsiders, (26) including non-executive directors who had what would be regarded today as a disqualifying material relationship--such as employment with a supplier or a customer, or with the firm's investment bank or law firm. (27) This consensus was reflected by the 1962 New York Stock Exchange statement that accepted a description of an outside director as simply one who is non-management. (28)
Standards tightened considerably in the wake of the 1970s corporate governance crisis, which for the first time produced a concerted demand for "independent" directors. The well-publicized business failures of the period led to increasing acceptance of the "monitoring model" of the board, which required independent directors. (29) The contemporaneous revelations of widespread corporate bribery and illegal campaign contributions at home and abroad, so-called "questionable payments," spurred the SEC to insist on independent directors in the settlement of various enforcement actions. (30)
The unresolved question was what exactly constituted "independence"--how should one deal with economic interests and personal ties that would potentially undercut independence. Federal regulatory guidance, stock exchange listing standards, state fiduciary law, and "best practice" pronouncements have all played a role in line-drawing.
The 1978 Corporate Director's Guidebook, an influential product of mainstream corporate lawyers, drew a two-level distinction: first distinguishing between "management" and "non-management" directors, and then between affiliated and non-affiliated non-management directors. (31) A former officer or employee was to be regarded as a managerial director. A director with other economic or personal ties "which could be viewed as interfering with the exercise of independent judgment" was an affiliated non-managerial director--for example, "commercial bankers, investment bankers, attorneys, and others who supply services or goods to the corporation." (32)
In 1978, the SEC went so far as to propose proxy disclosure that would categorize outside directors as "affiliated" or "independent, with the obvious intention of using disclosure to obtain Chairman Harold Williams' objective of boards staffed principally, if not entirely, by independent directors. (33) In response to corporate objections, it rapidly withdrew the proposal, (34) lamely explaining that "the ability to exercise independent judgment is not solely dependent upon the label attached to a particular director. (35) On the NYSE front, its 1977 audit committee listing standard, which required staffing by "directors independent of management," split the difference: it permitted directors from organizations with "customary commercial, industrial, banking, or underwriting relationships with the company" to serve on an audit committee unless the board found that such relationships "would interfere with the exercise of independent judgment as a committee member." (36) That definition remained intact until 1999, when the criterion of audit committee independence was significantly tightened in response to the prodding of the Blue Ribbon Committee on Improving Audit Committee Effectiveness. Audit committees were required to consist of at least three "independent directors," and the "customary" economic relationships of the 1977 were now off limits for committee members. (37)
Another federal regulatory tightening of the "independence" standard came through the 1996 IRS criteria for "outside" directors who could approve performance-based remuneration that was excepted from the $1 million deductibility cap on executive compensation established by section 162(m) of the Internal Revenue Code. (38) Those criteria disqualified a former officer of the corporation and a director who receives remuneration from the corporation "either directly or indirectly, in any capacity other than as a director." (39) The criteria also place stringent limits on the extent to which the director could have an ownership interest in or be employed by an entity that received payments from the corporation. (40) In turn, the IRS regulations influenced the SEC's 1996 rules specifying independent director approval of certain stock-related transactions as a condition of exemption from the short-swing profit recapture provisions of section 16(b) of the 1934 Securities Exchange Act. (41) The definition of a "non-employee director" with such approval power followed the substance of the IRS regulation. (42) The tests of economic distance for director independence established by these two important federal regulatory agencies were important benchmarks. (43)
State courts grappling with the right of shareholders (as opposed to the board) to maintain derivative litigation alleging corporate wrongdoing were another important source of heightened standards of director independence midway in the period. The "questionable payments" scandal of the 1970s led to a spate of shareholder derivative suits. Corporations sought to take control of the actions to avoid their potentially disruptive effects and to eliminate alleged "strike suits." In the important decision of Zapata Corp. v. Maldonado, (44) the Delaware Supreme Court held that even for a "demand-excused" derivative action, a "special committee" constituted of independent directors could nevertheless obtain dismissal of the action if it demonstrated this was in the best interests of the corporation. In its dismissal request, the special committee had the burden of demonstrating its independence. This, of course, increased the demand for directors with minimal prior connection to the corporation and its management, and helped ratchet up the independence standard. Moreover, the standards developed in derivative litigation in the 1970s and early 1980s also set criteria for the bona tides of directors who needed judicial sanction for their approval of target defensive measures in the face of a hostile bid. (45)
Throughout the 1980s and 1990s, various panels and "blue ribbon" committees developed somewhat influential "best practice" guidelines for relationship tests. The most important exposition, the American Law Institute's ("ALI's") 1992 Principles of Corporate Governance, recommended that the board of a public corporation "should have a majority of directors who are free of any significant relationship with the corporation's senior executives." (46) "Significant relationship" was defined in a way to disqualify many affiliated directors, both through categorical exclusions relating to the firm's principal outside law firm or investment bank, and through attention to customer/supplier relationships crossing a relatively low ($200,000) economic materiality threshold. (47) The Principles of Corporate Governance also called for the firm's nominating committee to engage in a more individualized review of factors that could undermine the independence of particular directors. (48) The ALI project had influence beginning in 1982 with its tentative first draft, whose "significant relationship" test was similar to the final version. (49)
Ultimately, the Enron corporate reform wave at the end of the period worked a sea change. (50) Seeking to avoid corporate governance legislation, the NYSE in 2002 initiated a significant revision of its board composition standards. A majority of directors were required to be independent, and stringent independence criteria applied to all such directors, not just audit committee members. (51) Under prodding from institutional investors, issuers, and the SEC, the NYSE revised the proposals over a yearlong period, adding and subtracting stringency. The 2004 version (as further refined) contains a general standard requiring an affirmative board determination that a purportedly independent director has "no material relationship with the listed company" (including "as a partner, shareholder or officer of an organization that has a relationship with the company"). (52) It also has a series of carefully defined exclusions and safe harbors that cover in detail the effect of prior employment, familial ties, consulting relationships, and charitable ties. And, of course, the SEC, exercising regulatory authority under Sarbanes-Oxley, specified minimum conditions in 2003 for director independence for directors who serve on the audit committee. (53)
2. External sanctions and rewards
A different mechanism for director independence focuses on incentives--sanctions and rewards, sticks and carrots--for particular director behavior. Most commonly these are economic, but reputation matters too.
a. Sanctions (sticks)
The most potent stick during the period was the risk of monetary liability for breach of various duties under state fiduciary law and the federal securities law; both sets of duties foster director independence by requiring director attention to the business and affairs of the corporation, a precondition to the exercise of independent judgment. (54) But how real was such liability exposure? Early in the period, liability for breach of the duty of care uncomplicated by self-dealing was famously described as the "search for a very small number of needles in a very large haystack," (55) and risk of securities fraud liability was non-existent. At the end of the period, Professors Black, Cheffins, and Klausner tell us that liability in duty of care cases is still quite rare and that outside director liability exposure in securities fraud litigation is limited to rare "near-perfect-storm" cases. (56) Nevertheless the directors' perception of risk seems to have increased over the period, perhaps because of lawyers' exaggerations, (57) perhaps because of scare-mongering by liability insurers, (58) or perhaps because of the saliency of outlier cases like Enron and WorldCom, in which outside directors paid out-of-pocket to settle claims. (59)
Indeed, a better (though softer) measure of director apprehension than monetary payouts may be the series of liability insulation mechanisms that were adopted during the period. State corporate indemnification statutes diffused rapidly in the 1950s, and soon covered all negligent behavior. (60) Director and Officer ("D&O") insurance arose in the 1950s and 1960s to cover liability that was not indemnifiable. (61) Yes, these measures protected directors, but their promotion, which required concerted political activity at the state level, presumably stemmed from growing liability concerns and the risks of liability "loopholes." The most famous liability insulation measure was the mid-1980s adoption by Delaware (and then quickly by other states) of director exculpation statutes for breach of the duty of care. (62) This followed immediately upon the visible ratcheting up of liability standards in Smith v. Van Gorkom. (63)
In the immediate aftermath of the Enron et al. financial scandals, it appeared that state courts, particularly the Delaware courts, might become more receptive to liability theories that would increase a director's monetary exposure for the insiders' wrongful behavior, on the ground of directors' failure to undertake adequate inquiry or oversight. (64) These new theories of director malfeasance often flew under the banner of "good faith." (65) The speculative flurry was soon put to rest, however. Prolonged litigation over the $130 million severance paid by the Walt Disney Company to former president Michael Ovitz ended in victory for the directors (but after eight years of litigation), despite behavior that fell far below "best practices." (66) In affirming, the Delaware Supreme Court made it clear that "gross negligence (including a failure to inform oneself of available material facts), without more" does not constitute bad faith, (67) which seemed to require something like scienter, "intentional dereliction of duty, a conscious disregard for one's responsibilities." (68) Subsequently, the Delaware Supreme Court went even further, holding that "bad faith" was not an independent basis for director liability but rather one precipitating condition for liability under the duty of loyalty. (69) Nevertheless, the protracted litigation, the courts' willingness to set forth in embarrassing detail the deficiencies of directors' decisionmaking processes, and the implicit threat about liability "next time" may increase directors' vigilance and independence.
Similarly, the potential stick of directors' liability under the federal securities law was muted by institutional realities, yet the fear remained. Even if managers' wrongful conduct could be framed as also constituting a disclosure violation, the applicable liability standard that emerged over the period for directors' liability was a "scienter" test: whether the directors had knowledge of the wrongful disclosure (or were reckless in not knowing). (70) Moreover, plaintiffs' attorneys in securities class actions have no incentive to prove scienter because this could undercut the D&O insurers' obligation to fund settlements. (71)
Yet for disclosure in connection with a public offering of securities, directors have a "due diligence" obligation to assure the accuracy of the disclosed statements. A recent WorldCom decision on this due diligence obligation means that directors cannot necessarily rely on an auditor's certification where there are "red flags" in the issuer's financials. (72) Rather than face a trial on what precisely they knew or should have known, and opposed by a public pension fund plaintiff who insisted on personal liability for the directors rather than simply insurance proceeds, the WorldCom independent directors agreed to settle the litigation. Each director's contribution was designed to be approximately 20% of his or her net worth, approximately $20 million in total. (73) In general, the "shelf-registration" rules that permit immediate issuance of debt and equity securities by large public firms heightened the negligent disclosure liability risk for directors. (74) Since detailed knowledge about the corporation's financial disclosure enhances the capacity for independent judgment, WorldCom--which creates additional reasons for directors to acquire such knowledge--should enhance director independence. (75)
b. Rewards (carrots)
There were a number of innovations during the period aimed at creating incentives for good performance by outside directors. (76) Circa 1950, director compensation was low and sometimes nonexistent. The tradition, going back to the nineteenth century, was not to pay directors, on the view that the opportunity to monitor management was reward enough for a substantial stockholder. (77) As it became desirable for firms to put "outsiders" on the board and necessary to compensate them for their time, significant compensation became common; indeed, it became increasingly lavish throughout the period. (78) Such compensation, of course, can undercut independence if the CEO has influence over director retention.
One 1990s-era governance innovation was to compensate directors in stock (or stock options) to strengthen the alignment of director and shareholder interests. (79) Despite some evidence that suggests a connection between stock-based director compensation and improved governance, (80) stock-related compensation was hardly a panacea. Few directors actually acquired a great enough equity interest to generate a strong incentive effect (assuming that incentives are increasing in ownership levels). Directors typically obtained their equity stake through annual stock-based compensation rather than an initial grant of stock options or restricted stock. Over time the stake accumulates, but this also undercuts director independence where the CEO has influence over director retention.
More seriously, perhaps, stock-based compensation may create a distinctive set of perverse incentives for the directors, as demonstrated by the wave of financial disclosure problems in the late 1990s and early 2000s. The director receiving stock-based compensation, like the similarly compensated CEO, may be tempted to accept aggressive accounting rather than stock-price-puncturing disclosure. (81) It is important to remember that with respect to disclosure obligations, the public board has a dual duty--not only to the firm's shareholders, but to capital market participants more generally. This is because of the positive (negative) externalities associated with accurate (misleading) disclosure. (82) With such divided duties, it's hard to know which way to set the optimal stock-based incentive effects. (83)
c. Reputation
Reputation provides another sort of stick or carrot that could enhance director independence. Presumably directors would not want to be associated with a poorly performing firm or a firm that is stigmatized because of a business scandal, and instead would want to be associated with a bellwether firm. But the incentive effects of reputation consist not merely in the director's subjective distaste for embarrassment and his preference for respect, but also in the business opportunities, including other directorships, that are affected by reputation. (84) The effectiveness of reputation-based incentives is limited by the noisiness of reputation markets. Plainly a director suffers a reputational sanction if there is a financial catastrophe or major legal problem at the firm. In the more typical case of firm underperformance or a minor legal problem, however, there may be little or no reputational effect. (85)
In general, reputation markets became more effective over the period, particularly beginning in the 1980s. The salience of hostile takeovers drew media attention--newspapers, books, magazines, and movies--not simply to the actors in a particular case but to governance activity more generally. (86) High-stakes transactions gave rise to high-stakes litigation, which often was closely followed by the business press. Delaware courts issued opinions that publicly evaluated the behavior of directors as well as other corporate actors, often in harsh terms. (87) Indeed, in light of the Delaware courts' reluctance to impose monetary liability on directors, the most significant independence-enhancing effect of litigation is probably through improving the operation of the reputation market rather than through the threat of monetary sanctions. (88)
Reputation markets also became more effective because of the activity of activist institutional investors. For example, beginning in the 1990s CalPERS publicly targeted firms (and their boards) for poor performance and for noncompliance with its corporate governance code. (89) Other activist shareholders also began to use press campaigns to promote change. (90) A 1993 article by Professor Joseph Grundfest unleashed what became the institutional investor's reputational strategy of choice: a "just vote no" campaign against directors as a group or individually. (91) A full-blown proxy campaign to replace the board or particular directors was not attractive to the institutions because of familiar collective action problems. Yet they could "just vote no" against management's candidates, and publicize their reasons for doing so. (92) The potential embarrassment factor of being a targeted director heightened the potency of reputation markets.
3. Intra-board structures and functions
Another important mechanism for director independence is the creative use of board structure to create a spirit of teamwork and mutual accountability among independent directors that helps foster independence-in-fact. Structural innovations multiplied over the period, including: board committees tasked with specific functions, "special committees" for specific legal or transactional issues, and various institutions to restrain the CEO's agenda-setting authority, such as the "lead director" and the "executive session."
a. Board committees
One particularly important innovation was the board committee assigned a specific key function. Beginning in the 1970s, "best practice" pronouncements called for three specific committees: the audit committee, the compensation committee, and the nominating committee, each with a majority of independent directors. (93) Each committee is functionally tasked in areas where the interests of managers and the shareholders may conflict. Independence-in-fact may be enhanced in two respects. First, the ownership and accountability for a specific critical task may lead to greater autonomy from the CEO in performing that task. Second, the practice of acting jointly and autonomously in a targeted area may carry over to other important roles of the board, such as evaluating managerial performance and strategy. The potential for enhanced independence from this structural/functional mechanism source grew gradually over the period, beginning in the 1970s. One limiting factor was that only at the end of the period, via a NYSE rule, were these committees necessarily staffed solely by independent directors. (94)
The most important board committee was the audit committee, a major objective of corporate governance reformers. Although calls for the creation of an audit committee began as early as 1939, (95) critical mass did not coalesce until the 1970s. (96) In 1974, the SEC began requiring disclosure of the existence of an audit committee (or lack thereof), (97) and in 1978 the SEC published general guidelines for what an audit committee should do. (98) The NYSE began requiring audit committees in 1977. (99) Indeed, by 1979, virtually all NYSE-listed companies had audit committees, and for 92% of the firms, the members were non-management directors. (100) By the end of the 1980s, the NASDAQ and the Amex introduced audit committee requirements as well. (101) Current standards, through both exchange listing rules and Sarbanes-Oxley, mandate audit committees for every publicly owned company, as well as stringent standards of independence and financial expertise. (102)
Instituting the compensation committee came somewhat later than the audit committee. For example, the SEC began to require disclosure of whether a firm had a compensation committee and the committee's composition only in 1992. (103) Throughout much of the period, it was common for management directors to sit on the compensation committee, although outsiders were typically the majority. (104) Nominating committees (separately discussed below) also became more prevalent during the period, (105) in response to pressure from institutional investors. (106) Compensation and nominating committees, both staffed by independent directors, are now required by the NYSE listing standard. (107)
At best, functionally tasked board committees should enhance independence, particularly in regard to the targeted task. Actual practices, until the post-Enron reform wave, made the committees less effective in that regard. For the audit committee, management hired (and fired) the auditor and also determined the level of more lucrative non-auditing consulting work assigned to the auditor, undercutting the auditor's allegiance to the audit committee. This managerial power over the auditor relationship was, of course, known to the audit committee members and would have dampened their independent engagement with significant auditing issues. Sarbanes-Oxley, passed in 2002, now gives the audit committee power (and responsibility) over the firm's auditor relationships and audit policies. (108) This, in turn, should make the audit committee a stronger source of director independence.
The compensation committee also has a similar story of dampened independence. In setting executive pay, compensation committees typically have relied on the compensation consultant who also provided firm-wide compensation and human resources guidance. Such a management-retained consultant, earning the largest portion of its fees from the firm-wide assignment, is unlikely to make recommendations or offer viewpoints that senior management would find distressing. Reliance on such a consultant will inevitably dampen the committee's independence. (109)
b. The "special committee"
The model for the maximally independent board committee is the "special committee" that a company sets up in cases where the interests of senior management seem to most directly conflict with the corporation's. This structural innovation came into widespread use beginning in the 1970s, but only in a limited set of circumstances. (110) One case was a control transaction, such as a management buyout, in which management is part of a group that seeks to buy out the public shareholders; (111) or a parent-subsidiary merger, in which it is assumed that the target management's allegiance is likely to be towards the controlling shareholder who appointed them. (112) Another case was a shareholder derivative suit, in which officers and directors allegedly violated a fiduciary duty to the corporation. (113) In these cases the nominal independence of the committee was buttressed by the committee's hiring of independent advisors, particularly independent legal counsel. Such independent advisors, whose allegiance was not to management, could drive the process and promote the directors' sense of independence. However, "special committees" had little pervasive effect on board practice. Most often, they were convened... |
More articles from Stanford Law Review
Should we have lay justices?, April 01, 2007
Criminal procedure within the firm., April 01, 2007
Genomics and toxic torts: dismantling the risk-injury divide., April 01, 2007
Not a Suicide Pact: The Constitution in a Time of National Emergency.(..., April 01, 2007
Immunity for immunizations: tort liability, biodefense, and bioshield ..., April 01, 2007
Looking for additional articles?
Click here
to search our database of over 3 million articles.
|
