Finally, Governance Becomes Possible

Posted by Ira Millstein, Well Gotshal & Manges LLP, and Stephen Davis, Yale School of Management, on Monday August 30, 2010 at 12:33 pm
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Editor’s Note: Ira Millstein is a partner at Well Gotshal & Manges LLP and Senior Associate Dean for Corporate Governance of the Yale School of Management. Stephen Davis is executive director of Yale’s Millstein Center for Corporate Governance and Performance.

Thirty years late, the new Dodd-Frank Act hands shareholders power to influence the composition of boards and shape CEO pay. But will these institutional investors, on whom Americans depend for their financial security, use their authority responsibly? Will corporate boards welcome and accept good faith dialogue with their shareholders? Will both sides forego short term financial engineering and align for the long term performance the country badly needs?

For decades, investors, anxious about a company gone awry, have had little choice but to complain from the sidelines, petitioning finger-wagging resolutions directors could easily ignore. Shareholders tried that to no avail at AIG before its epic collapse. Defenses fortified under-performing boards from pressure they should have faced to better control risks and tie CEO pay to measurable actual performance over time. But resolutions and defenses did not stop short-term funds that piled disabling debt on companies. Aggressive investors could cherry-pick firms for proxy fights or use stock techniques to harass. Long term institutional investors were shackled; the short term prevailed. One result: Too many boards tolerated management excesses and failures that ushered in the financial crisis.

Now comes Dodd-Frank. The hardest-fought governance provision in the Act is one that affirms the US Securities and Exchange Commission’s authority to make it easier for investors to nominate candidates to corporate boards. Code named “access,” such rules promise to put pressure on troubled companies to give investors reasons to stay loyal-or risk rebellion. The market won’t collapse once access is part of the governance furniture. Similar rules exist around the world without causing anarchy. Under new SEC rules, challengers holding stock for at least three years would have to meet a 3% ownership threshold to petition a candidate – and then muster a majority vote to get him or her elected. That’s tough unless a company is floundering or a board deeply out of touch. Still, just the existence of access is a powerful signal that alters the balance of power.

As a concession to business, lawmakers purged an equally sweeping reform from Dodd-Frank. That provision would have required board elections by majority vote. But 73% of S&P 500 companies have already switched to majority vote, and the rest will be under intense pressure to do so quickly. Moreover, Congress approved a step that makes majority voting more potent once installed. Dodd-Frank prohibits arcane ‘broker non-votes’ which routinely added to ‘yes’ totals. That crutch is no more.

All this amounts to a quiet upheaval in the way US corporations will operate. Sarbanes-Oxley, passed in the wake of Enron/Worldcom scandals, was a crackdown on fraud using a battery of government controls and enforcement. Dodd-Frank, by contrast, hands unprecedented rights to investors in the expectation that they will serve as a “neighborhood watch” against corporate mismanagement. We’re not alone in this. Britain’s Financial Reporting Council just launched a ‘stewardship code’ to rouse investor monitoring of corporate boards.

Boards and Investors, both, will need to rethink their respective responsibilities, new or expanded, under Dodd-Frank. The most critical step boards can take is to open dialogue with shareholders. Today, few directors do outreach. They leave it to management. But Dodd-Frank changes imperatives. Boards should invite investor input on nominations, risk and executive compensation policies, while preserving director authority. Some firms (e.g., Pfizer, Coca Cola, Prudential Financial) already pioneer working formats. What dividend do they get in return? The potential for more loyal, long-term investors- especially when firms must take risks to grow.

As to investors, Dodd-Frank places a colossal bet that shareholders will patrol the market. Up to now many, including major mutual funds, have simply voted shares on autopilot. That may have been rational when ballots carried little weight. But investors just paid a brutal price for inattention that runs to the trillions. Funds can tap new Dodd-Frank rights to assist, and hopefully ensure, that corporate boards drive the kind of long-term performance that benefits American savers.

Institutional investors will rightly face rising pressure to assume responsibility for mindful ownership practices which appreciate the uniqueness of each company. Shareholders will need to embrace the transparency and accountability they have long asked of corporate America.

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  3. [...] The Harvard Law School Forum on Corporate Governance and Financial Regulation has posted an article (“Finally, Governance Becomes Possible”) co-written by Working Group member Ira Millstein addressing new requirements found in the Dodd-Frank Act that relate to board composition and executive compensation. [...]

    Pingback by HLS Blog: Millstein on Dodd-Frank « Financial Regulatory Reform Center — August 31, 2010 @ 1:04 pm

  4. Quitean innovation in coporate boards’ practices as well as for institional investors and shareholders’constant vigilance required by Dodd-Frank

    Comment by Gestion des Risques — September 7, 2010 @ 9:54 am

 

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