In our annual missive last year, we wrote about the need to restore trust in our system of corporate governance generally and in relations between boards of directors and shareholders specifically. We continue to be troubled by the tensions that have developed over roles and responsibilities in the corporate governance framework for public companies. The board’s fundamental mandate under state law – to “manage and direct” the operations of the company – is under pressure, facilitated by federal regulation that gives shareholders advisory votes on subjects where they do not have decision rights either under corporate law or charter. Some tensions between boards and shareholders are inherent in our governance system and are healthy. While we are concerned about further escalation, we do not view the current relationship between boards and shareholders as akin to a battle, let alone a revolution, as some media rhetoric about a “shareholder spring” might suggest. However, we do believe that boards and shareholders should work to smooth away excesses on both sides to ensure a framework in which decisions can be made in the best interests of the company and its varied body of shareholders.
Posts Tagged ‘Ira Millstein’
Concerns about the responsible use of corporate power remain high in the wake of the financial crisis. Although these concerns have been focused primarily on the financial sector, there is spillover to corporations in every industry. Tough economic conditions, slow job growth, political dysfunction and general uncertainties about the future continue to undermine investor confidence and fuel public distrust (with Occupy Wall Street an example). This in turn intensifies the scrutiny of corporate actions and board decisions, and may skew the regulatory environment in which companies compete.
All corporate governance participants – boards, executive officers, shareholders, proxy advisors, regulators and politicians – have both an interest and a role to play in rebuilding trust in the corporations that are the engine of our economy. In our annual reflection, we offer thoughts on how, without the need for regulatory intervention, boards and shareholders can seize the opportunity to rebuild trust and, by doing so, help resolve some of the tensions that are stalling our economic recovery.
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.
As the 2010 proxy season nears, we encourage both boards and shareholders to rethink the contours of their relationship. We expect institutional shareholders to have greater influence in director elections this year given the increasing prevalence of majority voting requirements and, for the first time, the absence of discretionary voting by brokers of uninstructed shares. Institutional shareholder power will expand further in 2011 if the SEC moves forward with proxy access rules and Congress enacts legislation mandating majority voting and “say on pay.” In this environment, boards and shareholders will be well served by considering in an open way how this shift in influence should be reflected in changes in behavior.
For boards, the challenge will be to understand the key concerns of the company’s shareholder base and get out ahead on these issues. Boards should also consider whether company disclosures and communications can be improved to better inform shareholders and encourage them to make company-specific decisions through a long-term lens. This will require devoting more attention, resources and creativity to communications and relations with shareholders. Boards that are insensitive to shareholder concerns risk bruising election battles, while providing further inducement for the homogenized governance mandates currently percolating in Washington.
The Private Equity Group at my firm has recently issued its third annual survey of sponsor-backed going private transactions. The survey analyzes and summarizes the material transaction terms of going private transactions involving a private equity sponsor in the United States, Europe and Asia-Pacific.
We surveyed 39 sponsor-backed public-to-private transactions announced from January 1, 2008 through December 31, 2008 with a transaction value (i.e., enterprise value) of at least $100 million (excluding target companies that were real estate investment trusts). Fifteen of this year’s surveyed transactions involved a target company in the United States, 13 involved a target company in Europe and 11 involved a target company in Asia-Pacific.
The survey’s key conclusions for the United States transactions include the following:
• 2008 witnessed a 97% collapse in aggregate transaction value for sponsor-backed going private transactions when compared to 2007. The largest transaction announced in 2008 had a transaction value of approximately $2.1 billion, a 95% decline from the largest transaction announced in 2007. There was also a 76% decline in transaction volume when compared to 2007.
• The percentage of club deals involving two or more private equity sponsors declined significantly in all transaction sizes in 2008. Only 7% of the 2008 transactions constituted a club deal whereas 37% of the 2007 transactions did so.
• The tender offer again made an appearance in 2008, continuing a trend that started in 2006. The same cannot be said for stub equity. There was no transaction in 2008 in which the sponsor offered stub equity to the target’s public shareholders.
• Not surprisingly, the credit crisis continued to adversely impact the debt-to-equity ratios of sponsor-backed going private transactions. Equity accounted for an average of 64% of acquiror capitalization for transactions between $100 million and $1 billion in value and 51% of acquiror capitalization for transactions greater than $1 billion in value.
• The credit crisis has forced sponsors to tap alternative financing sources, including traditional mezzanine lenders and hedge funds.
• The go-shop provision continued to be a common feature of going private transactions in 2008 with 53% of surveyed transactions including this form of post-signing market check. Interestingly, sponsors were more resistant this year to giving a significantly reduced go-shop break-up fee (only one transaction had a go-shop break-up fee of less than 50% of the normal break-up fee).
• Although far from the norm, there was an increase in 2008 in sponsor-backed going private transactions with a financing out (20% in 2008 compared to 3% in 2007).
• When compared to pre-credit crunch transactions, the 2008 transactions reveal a material decrease in the number of MAE exceptions.
• Reverse break-up fees were again the norm in 2008, appearing in 87% of all surveyed transactions (a slight increase from 84% in 2007). In an effort to limit the optionality built-in to the reverse break-up fee structure and incentivize sponsors to consummate the transaction, target boards in a significant minority of surveyed transactions negotiated for a higher second-tier reverse break-up fee or a higher cap on monetary damages.
• Interestingly, specific performance provisions enforceable against the buyer were very rare in 2008. Only 7% of the 2008 transactions permitted the seller to seek specific performance against the buyer rather than be limited to a reverse break-up fee or monetary damages (whereas 33% of the surveyed transactions in 2007 allowed the seller to seek specific performance).
The survey is available here.
Lucian Bebchuk’s suggestions regarding bank executive compensation didn’t go far enough in controlling levels of executive compensation and their growing inequities. Experts continuously present suggestions to link pay to performance through a variety of stock options and other mechanisms. None of them is impervious to the gaming which takes place, and none has halted the escalation.
The responsibility to set and monitor compensation is in the boardroom. Boards have avoided that responsibility and remained tone deaf to the public’s concern. Structuring transparent, understandable fair compensation, even in the millions-of-dollars range, is one thing; failure to consider the risk of perverse escalating outcomes and perks is another. Institutional shareholders have the voice and capacity to put spine in the boardroom by communicating on compensation to Compensation Committees, filing proxy resolutions, and voting against directors believed to be improvident. Then, in turn, they should report to their beneficiaries what they have done.
Recent events in the financial markets and the ensuing economic turmoil has shattered the trust of investors, regulators and Main Street in financial institutions and the capital markets on a global scale. The crisis has heightened focus on the importance of risk management at all corporations and has encouraged a fresh look at the role of the board in risk oversight. Although the manner in which a board fulfills its risk oversight responsibilities is a matter of business judgment, directors should bear in mind that conduct will be judged by investors, regulators, the media and others with the benefit of 20-20 hindsight. There is benefit to be had in going beyond the standards of care set by Caremark and its progeny, which require board oversight of an effective compliance and reporting system. Remembering that “best practices” provide a zone of comfort with respect to avoiding director liability, we set forth below ten areas for the board to enhance its focus in 2009 in light of the current environment. They are all related in some respect to enhancing the board’s ability to oversee management’s efforts to identify and avoid, mitigate or manage risk, with the caveat that specific actions to be taken will vary for each company.
1. Apply judgment in tailoring governance structures and processes to the current needs of the company. Remember that adopting a one-size-fits-all check-list approach to corporate governance is fundamentally inconsistent with effective governance. Care should be taken to avoid bowing to pressures to adopt practices that may not be in the company’s interest, while at the same time actively considering the viewpoints of key shareholders on appropriate matters. Boards should tailor their governance practices and structures to the company’s unique needs. The Key Agreed Principles to Strengthen Corporate Governance of U.S. Public Companies published in October 2008 by the National Association of Corporate Directors with support and input from The Business Roundtable and the International Corporate Governance Network (available here and briefly outlined in the Appendix to this document) reflect an effort to distill and articulate fundamental principles-based aspects of governance on which there is broad consensus. The Key Agreed Principles capture the current baseline consensus among boards, managements and shareholders about a range of effective governance practices. Their articulation may help improve the quality of discussion and debate about those governance issues that have not yet gained consensus, and also serve as a touchstone for boards in tailoring governance and avoiding a rote approach. We urge boards to gain familiarity with the Principles and consider them in tailoring their own governance structures and practices to meet the needs of their respective companies.
2. Take a fresh look at board composition and director competency. While a board is more than the sum of its parts, it requires key skill sets and experiences to be positioned to provide and oversight of risk and compliance. The nominating/corporate governance committee should review with rigor the composition of the board and determine whether the board is comprised of people with the optimal mix of experience given the business, circumstances and nature of the risks facing the company. The right mix of competencies will change over time as the company evolves and care needs to be taken to avoid a mindset of “permanent tenure” for directors. The board should use the evaluation process (as well as term/age limits where appropriate) to refresh itself periodically. It is not enough to pull together a distinguished group of men and women if those directors do not have the expertise necessary to understand the fundamentals of the company’s business as the business changes over time and the attendant risks. Given the emphasis on independent directors, boards need to take special care to ensure that persons on the board have industry specific expertise and distinct sources of information about the intricacies of the business and related risks. The board should consider ways to ensure that it is not simply dependent on management for its understanding of the business and the industry. The nominating/corporate governance committee should ensure that company-specific director education and orientation programs are presented to the full board periodically, especially programs that address risk oversight and risk management generally, providing directors with the opportunity to learn about specific risks affecting the company and changes in business conditions and legal standards that may impact on risk.
3. Consider implementing some form of independent board leadership. The ability to exercise effective oversight may be compromised where the board lacks any defined leadership for the independent and non-management directors. Management has natural conflicts and blind spots — in monitoring CEO performance, providing risk oversight and evaluating the strategic plan. The long-range trend is toward a separation of the chair and CEO positions, with an independent director filling the chair role, and that trend is likely to accelerate as shareholders seek assurances that the board is strongly positioned to provide objective judgment in its review of management decisions in key areas. The board — and in particular the independent directors assisted by the nominating/corporate governance committee — should evaluate whether to appoint a separate independent chairman or a strong lead director to assist the board in fulfilling its oversight responsibilities, and should explain its choice to shareholders. For companies that combine the roles of CEO and chairman, expect increased pressure from shareholders to separate the positions or at a minimum create a strong lead director position with an appropriate range of responsibilities. Indications are that independent board leadership will be a “hot button” issue for shareholders during the 2009 proxy season.
The National Association of Corporate Directors, with the support of the Business Roundtable, recently released Key Agreed Principles for Strengthening Corporate Governance. The Principles identify the core areas that boards, management and shareholders agree should be the basis for good corporate governance and cover topics including independent board leadership, protecting against entrenchment of the board, shareholder participation in corporate decision making, and board communication with shareholders. In recognition of the legitimate concerns that exist about the rigid and prescriptive use of best practice recommendations by some proponents, the Principles are intended to reflect a distillation and articulation of fundamental principles-based aspects of governance on which there appears to be broad consensus. They are also intended to stimulate informed debate about issues on which consensus does not yet exist.
The International Corporate Governance Network, a global network of institutional investors, has welcomed the Principles, emphasizing that “[t]his is a good start which we believe should encourage further discussion on how to improve practice in corporate governance and develop much better understanding between companies and the shareholders who own them. The ICGN believes this is a constructive way towards long term value creation, which has become all the more important in the light of the current economic crisis.”
The principles are available here. A comparison of Significant Views on Corporate Governance Best Practice, which is Appendix A to the report, is available here. A comparison of Sarbanes Oxley, SEC and Listing Rule provisions related to the composition and functioning of the board of directors of a publicly traded company, Appendix B to the report, is available here.
We have just released our annual memo identifying areas for focus by corporate governance participants in the coming year: “Rethinking Board and Shareholder Engagement in 2008″ (co-authored with our colleague Rebecca C. Grapsas). In the memo, we predict — and encourage — increased efforts by boards of directors to engage shareholders in less contentious, more cooperative interaction and communication. While we salute shareholder activism’s stimulus for rebalancing corporate power in the past twenty years, we caution that the forces for change should abate once an appropriate balance is achieved, or a new imbalance will result. Boards are well-advised to be open to shareholder communications on topics that bear on board quality and attention to shareholder value, communications that are likely to improve mutual understanding and avoid needless confrontation.
At the same time, shareholders have the responsibility to act as concerned and rational owners who make decisions based on knowledge of the nuances; who avoid rigid, box-ticking methods of judging good governance; who don’t abdicate to proxy advisors their responsibility to use judgment; and who avoid activism for activism’s sake. In this spirit, we lay out good practices of board-shareholder engagement in the areas of (1) board composition and independent leadership, (2) corporate performance disclosures, (3) executive performance, compensation and succession, (4) strategic direction, and (5) societal concerns, including climate change and other issues. Finally, we suggest that it may be time for a dialogue on the limits of shareholder power. The full text of the memo is available here.