## Jonathan Charkham

Print publication date: 2008

Print ISBN-13: 9780199243198

Published to Oxford Scholarship Online: October 2011

DOI: 10.1093/acprof:oso/9780199243198.001.0001

# The United States of America

Chapter:
(p. 227 ) 5 The United States of America
Source:
Keeping Better Company
Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199243198.003.0005

# Abstract and Keywords

This chapter is about the publicly held companies in the USA. Ever since independence the states have fought to limit the role of the Federal government. Wherever a company operates it may choose any state in which to incorporate, and the states compete for its business. The recent reforms led by the Sarbanes–Oxley Act (SOX) apply directly only to them and their audit firms. The chief, but not all-powerful, machine for exerting Federal pressure is the Securities and Exchange Commission (SEC) that regulates many of the processes affecting companies, shareholders, and the market, and the traffic between them. The New York Stock Exchange is the dominant institution in the stock market. Meanwhile, control of a US company can pass by replacing enough of the board through the proxy process, but the usual route is by acquiring a majority of the votes through a tender offer.

# Introduction

Like the rest of this book this chapter is about publicly held companies. The recent reforms led by the Sarbanes-Oxley Act (SOX) apply directly only to them and their audit firms and not to privately held companies though these and not-for-profit companies will be affected by parallel changes in Federal or state laws and rules. (A special committee of AIPCA was established under Chairman James G. Castellano to carry such business forward.)

In reality SOX will reach beyond publicly quoted companies partly through its general influence even in not-for-profit organizations, and partly because some of its provisions like the falsification of documents actually apply. Some states have passed or are intending to pass SOX ‘clones’ that do not limit its application to publicly held companies but also cover other companies and not-for–profit organizations.

We have already seen in each country studied how corporate governance holds up a mirror to society in general. The USA is no exception. To understand the greatest of the democracies, therefore, we need to remind ourselves of what the relevant laws, assumptions, and attitudes are, so similar to those of others in many ways and yet so different. Societies in market economies have much in common, but who else would offer as two of their guiding principles ‘sunshine and due process’?

## Federal and state laws

Ever since independence the states have fought to limit the role of the Federal government. Even today the basic laws governing company structure are state laws, with some significant differences between them. Wherever a company operates it may choose any state in which to incorporate, and the states compete for its business. Concerns have been expressed that competition between these states is ‘not one of diligence but of laxity’ (Justice Brandeis (p. 228 ) 1933), or, in Professor W. L. Cary's words, a ‘race for the bottom’ (he had been chairman of the SEC) (Cary 1974: 663). The example of New Jersey is often cited. In 1913 its legislature reintroduced a restrictive approach to corporations. The law lasted only four years because by that time most corporations had transferred to Delaware. Few returned.

Delaware, not an industrial centre by any means, is at the moment the clear winner, with about half of the top 500 companies registered there, partly because of its statutes, partly because the courts and lawyers there have long specialized in governance issues. The Delaware Chancery Court established in 1792 is undoubtedly the pre-eminent judicial tribunal in the realm of company law. Delaware's statute is not substantially dissimilar from the Model Business Corporation Act (which was itself originally based on Illinois legislation) suggested by the American Bar Association and which a number of states use in whole or in part. (For the text see Soderquist and Sommer 1990.) That said, there is competition between states which may favour management's interests, since management decides where to incorporate. The states' legislatures try to attract them. State legislation is subject to some rather loose constitutional limitations, but the key point is a dislike of Federal intervention. Indeed, if a political head of steam builds up in Washington which might lead to Federal intervention a non-legislative solution is found wherever possible; sometimes however the pressure does become too great—as the Sarbanes-Oxley Law has shown.

An example of proceeding by non-legislative means was the incorporation in its listing requirements by the New York Stock Exchange in 1978 of a rule that companies should have audit committees composed of outside directors. Deregulation is part of the same strand of thought, that is, rolling back the boundary of the central government's authority. There is a widespread feeling that those who govern least govern best. Of course, even this principle can be dented to protect vital interests, and there was a time before 1986 when there was pressure on the Congress to control or prohibit hostile takeovers. But this evaporated after the Supreme Court decision in CTS v. Dynamics Corporation of America restored states' rights in this area.

The issue of states rights coupled with a general disinclination among politicians to wish to interfere on corporate governance issues means that the subject tends to be addressed only in the wake of scandals. As in the United Kingdom they are sometimes addressed by non-legislative means. The scandals that led to the setting up of the Treadway Commission did not produce a change in the law, but led to a requirement that companies appoint audit committees composed of non-management directors. The sanction was the Stock Exchanges, first New York and then the others—companies that did not comply would not be listed. The weakness of using the SEC as a back (p. 229 ) door to producing a sort of Federal legislation is that its mandate is concerned with markets. Its mandates reach thousands of publicly owned but not exchange-listed companies, but privately owned companies are beyond its reach. California has adopted a SOX clone.

A series of large-scale corporate failures beginning in 2001, most notably the bankruptcy of energy giant Enron Corp., resulted in the loss of billions of dollars in shareholders' equity. Federal intervention quickly ensued when the Sarbanes-Oxley Act was signed into legislation on 30 July 2002. SOX is mentioned on several occasions in this chapter, notably in its creation of the Public Company Accounting Oversight Board (PCAOB)—see below. SOX, in Title III (Corporate Responsibility), mandates certain governance practices for public companies (section 302). It imposes for example a requirement that a quoted company's annual and quarterly company reports be certified in stringent terms by those signing them off, by declaring

1. A That they have reviewed the report

2. B It contains no untrue statements of material facts

3. C The financial statements…fairly present…the financial situation…and the result of operations. It places on the signatories the duty of establishing and maintaining internal controls: and they must report on their effectiveness. What is more they must have reported to the board or its audit committee ‘Significant deficiencies…in internal controls’, and also on all frauds by employees who have a significant role in internal controls.

There may still not be a Federal Companies Act as there is in the UK for instance, but SOX moves a long way down the road, at least in regard to quoted companies. There have been acidic comments on the cost on companies of implementing SOX—not least in the extra work required to enable executives to justify reassuring statements about internal controls. Some commentators have even wondered whether the SOX requirements will prevent other Enrons.

## The SEC

The chief but not all-powerful machine for exerting Federal pressure is the Securities and Exchange Commission (SEC) which regulates many of the processes affecting companies, shareholders, and the market, and the traffic between them. Its staff are traditionally activist, and since its creation in 1934 it has been regarded as an ‘elite’ Federal agency. There are elaborate and important rules on what information must be provided, when and how it must be lodged, or whither sent and to whom. Although SEC regulation, particularly SEC rules promulgated pursuant to SOX, goes close to the heart (p. 230 ) of corporate governance because it largely controls information, substantive issues relating to, among other things, the fiduciary duties of directors remain with the states, and the Supreme Court (in Green v. Santa Fe) has prevented the SEC encroaching. The SEC, for instance, rules on the disclosure of executive remuneration and states do not. While generally state laws govern what issues must be put to shareholders for approval, it is the SEC which arbitrates whether a shareholder proposal may be excluded from the company's proxy materials.

The SEC looks at the top 100 quoted companies annually (they account for 90% of the market) and looks at the rest on a three-year cycle. This will extend to 500 companies by 2005. Its powers are substantial, including preventing directors serving on other boards. The SEC (item 106) now requires companies to disclose whether they have adopted a code of ethics—to be published and made available to anyone who wants it.

## The law

‘Due process’ has always been a crucial part of the US system, perhaps because it was a way of welding together people of many different races, traditions, and backgrounds. The legal system provided a common basis for them. Access to the system is facilitated by contingency fees (banned centuries ago in England as ‘maintenance and champerty’), by class actions, and by derivative suits. The number of lawyers is high; recourse to the law is a normal part of life; and people do not move far without a lawyer at their elbow. This has a profound effect on corporate governance as it does on many aspects of US life. It is also expensive, as all legal costs are borne somewhere in the price of goods and services.

## The king

The United States have not of course had a king for 200 years, but the image of George III lives on in the tradition of distrust for a centralized governmental power and a desire for checks and balances; it has been reinforced by waves of immigrants with memories of truly despotic governments. For most of the last forty years—but not at the present day—the President's party has not controlled the Senate and House of Representatives—whether intended or not, a triumph for checks and balances over efficiency. The constitution was concerned with public not private power, but a similar concern about concentrated power surfaces elsewhere from time to time, and has in the past led to legislation about monopolies, banks, banking and insurance operations, and bank and insurance holdings in industrial companies. Whenever (p. 231 ) cabals threaten, hackles rise. These are the eyes through which some of corporate America views the potential power of institutional investors.

## Size and natural wealth

Just as Japan's lack of usable land affects so many aspects of Japanese behaviour, the sheer spaciousness of America and the fact that it has so many industrial centres is reflected in US attitudes. To have such a rich and vast economic unity, with geographical diversity, encourages people to move. The attitudes of the old frontier have not yet gone. Those who move often must make friends quickly, and the basic assumptions are still of openness and hospitality. The possibility of renewal is always present. Failure is a setback but unshameful; Lincoln had failed in business twice, Truman once. It has been a world of vision, of risk-taking, of adventure. Perhaps, as the memory of the frontier dims, and the lawyers close in, the spirit of regeneration and adventure will falter. Americans fear both this and the decline of the entrepreneurial spirit and independent self-reliance. And the minerals are not inexhaustible.

## Diversity

The plurality of US society is most striking in its ethnic mix. Unlike many other countries it cannot delve deep into its past to define the origins of its basic inhabitants. Those who originally lived there were largely dispossessed or annihilated, and the Europeans, who came from many countries, were sub specie aeternatis, a recent phenomenon. No one group could claim to be ‘it’, so all are equal (and the US constitution so decrees), though some, particularly the WASPs (White Anglo-Saxon Protestants), are more equal than others. The Lowells may yet speak only to the Cabots, but neither would think of telling other immigrant groups to ‘go back where you belong’—they belong there. Minority religious groups like Catholics and Jews did not take long to be emancipated, because they had never been as disadvantaged as they might have been elsewhere. The balance between the aristocracy of the blood and the plutocracy is different from countries in which there used to be or still survives a formal aristocratic structure, often linked to the land. The USA by and large has an aristocracy of wealth, to which all can aspire. Having said that, being a member of an ‘old’ family with ‘old’ money still counts for something and it also colours assumptions and thinking. The USA of course lacks an honours system which confers recognition without cash, and this has important consequences (as indeed does the retention of such a system in the UK).

(p. 232 ) The old order is changing in that the new waves of immigrants do not see the need to accept the British/US inheritance and its values, and some even baulk at the language. Hispanic influences have grown at an amazing speed, and Spanish is the second language in very many places, the prime language for many, and the only language for some. The demographic centre of the USA has now for the first time shifted west of the Mississippi river.

It would not be surprising to find unevenness or some intolerance in such a heterogeneous society and as a consequence to find pressures from groups who feel disadvantaged on account of race, colour, language, disablement, sexual proclivities, age, and sex—inter alia. This can give rise to egalitarian pressure for ‘democracy’ in many walks of life—at one end bilingualism in schools, and at the other representation on company boards. Today's motto is ‘PC’—Politically Correct; curricula, for instance, in some universities are not allowed to concentrate on European cultural antecedents.

## The UK inheritance

The USA inherited, of course, the English language, the common law, a dislike of despotic systems of government, and, above all, a confrontational and individual approach, not a cooperative or collegiate one. What the USA did not inherit was UK envy. Perhaps this is because the country is so much richer that there is less cause for envy. Be that as it may, Americans do not resent success because they would rather use their energies trying to attain it. The unions want a bigger slice of a bigger cake and so can identify with the prosperity of the business. They have never seen themselves as the storm troops of socialism. But even though their industrial power is waning, they can and do exercise considerable political power.

The USA discarded monarchy and aristocracy and substituted a wealth-measured meritocracy. There are ‘old boy’ networks all over the place and the buddy system is considered by some to be the bane of boards. The Americans are so secure in their individuality that they can become great joiners without fear of impairing it. And boards are among the bodies they join, potential lawsuits notwithstanding.

The emphasis on individuality sits well with a pioneering entrepreneurial society, which needs heroes however tough, and powerful leadership whatever its darker aspects. The typical CEO is heavily personalized by the media (which, in contrast to Japan, find it more profitable to make stories about personalities than products). The style at the top of US companies has been more presidential than collegiate—but the balance is shifting. We consider CEOs' pay below, but it is worth noting here that US heroes in any sphere tend to be exceptionally well rewarded.

## (p. 233 ) The political system

This is no place for a lengthy critique of the system as a whole and the salient features that affect corporate governance can be stated quite briefly:

• The division of power between states and Federal government noted above.

• The two party system, Democrat and Republican.

• The lesser importance of party and party programmes.

• The crucial importance of individuals' campaign funding, which often means they enter office burdened with obligations, and leaves them exposed to multifarious pressures.

• The major role of lobbyists. In recent years, divergent interests have mobilized support so effectively that in some areas an impasse has been reached, that is, ‘lobbying gridlock’—for instance, on tort reform. Traditionally, the business community has had a powerful voice – but as enactment of the Sarbanes-Oxley Act of 2002 proved, legislation in the area of governance can occur in the right circumstances.

US commentators have remarked that there is a lack of deference towards central government. Even if it is much less respected than elsewhere (and that is unproved), some opprobrium attaches to large corporations that disregard its laws. Helped by their control of the media, use of expensive lawyers, and funding of political campaigns, power in the USA now largely rests with these large corporations. But the entrepreneurial spirit has not been extinguished, so that if a big business in an industry is afflicted by bureaucratic sclerosis it will in time let in new thrusting companies who will take their share of power along with profit.

## Openness

The ‘sunshine’ referred to above means openness. The Freedom of Information Acts in the USA give access to government papers that would be locked away elsewhere. The Government in the Sunshine Act (5 USC 552b) gives the public access to agency meetings. Openness pervades the atmosphere. The German and Japanese way of operating quietly and effectively behind the scenes to influence company management would strike Americans as underhanded and wrong (and the lawsuits would start flying). American television programmes are amazingly frank and unrestrained by UK standards. Their laws of defamation do not seem inhibiting. The fear of adverse publicity in the media is a powerful prompter of self-restraint.

‘Openness’ affects behaviour but not human nature. The USA has its fair share of fraudsters, but they have to work on the assumption that discovery (p. 234 ) will be inevitable. Warren Buffett, on taking the chair at Salomon, told the staff they should not do anything they would be unhappy to see on the front page of the New York Times. The fear of clandestine groupings, of conspiracy and cabals, is extreme and is strengthened by fear of ensuing lawsuits. The SEC rules permit up to ten shareholders to meet to discuss a company in which they have invested and about which they are concerned; they have seldom done so, however, for fear of the possibility that they may be sued for an alleged infringement of another SEC rule requiring disclosure by persons holding an aggregate of more than 5 per cent of the company's stock who agree to act together—even if the meeting decided in the event not to take common action. This particular situation was changed by the SEC in the second half of 1992 (see below). To take another example of openness, Schedules 14 D-1 (and 14 D-9) of the SEC regulations require both sets of advisers in a takeover to file details of the fees; if fees are to be fixed by a formula this must be stated.

The weight of literature coming from North American universities should not be underestimated. There are sophisticated articles and papers on many aspects of corporate governance. The measurable is measured, the rest described. The angle of approach varies—economic, legal, behavioural. Academia is more closely interwoven with the commercial world than in some other countries and is apparently influential, though advice tends to vary and some influences have not necessarily proved beneficial. Alongside the learned pieces (often complete with the mandatory algebra) are the popular books, apparently well researched, written like novels, but with better stories. Barbarians at the Gate (Burrough and Helyar 1990) and The Predators' Ball (Bruck 1988) are examples. Alongside these are serious and sometimes polemical works like Power and Accountability (Monks and Minnow 1991), Bidders and Targets (Herzel and Shepro 1990) and Recurrent Crises in Corporate Governance (Millstein and MacAvoy 2003). This last urges an independent board of directors and the separation of the CEO and chairman's role. It must never be forgotten that the lifeblood of academics is publication. In other words, the trees are numerous and the undergrowth tangled: to discern the wood, let alone describe it succinctly, is a far more difficult task than for other countries.

## National power

The author happened to be in New York at the time of the Cuban missile crisis in 1962. What was most striking was the feeling that decisions on war (p. 235 ) and peace would be made right there. This was the centre of power. Since then US military and economic hegemony has strengthened, particularly since the collapse of the Soviet empire. Even so there have been moments of doubt and introspection. In the economic sphere for instance it came as quite a shock in the mid-1980s to see so many Japanese and German cars on the streets—an affront to what had seemed a dominant industry. A spasm of modesty caused thoughtful commentators to enquire whether there was any ingredient of such importance that might be worth examining—their corporate governance systems for instance.

The pessimists were confounded about the US economy, which proceeded to boom—in contrast to Japan where the property bubble burst and the economy was in the doldrums. The Nikkei index, which had been over 40,000, declined to less than 9,000. Germany in the aftermath of reunification found itself coping with structural problems in which rigidity and high social costs contributed to a lacklustre performance and high unemployment. In other words, the grass on the other side of the fence that had looked green in the mid-1980s now looked less inviting. This gave Americans reassurance among other things about the relative merits of their governance systems. And US productivity still marched ahead.

But the USA had a bubble of its own—‘dot.coms’. This was especially damaging in the USA because so many people had rushed in. It would have been bad enough if firms had simply failed, but what happened was that many managements tried to put off the evil day by cooking the books (fraud, misleading accounting, market manipulation, and misfeasance) on an unprecedented scale: $7 trillion of market value was wiped out. Why did boards and managements act like this? Some contend that it was a response to pressures to create shareholder value by forcing up the share price and that on the basis of quarterly reporting—and this affected a great swathe of corporate USA, not just dot.coms. Pro-forma earnings in the hands of some analysts became a shackle rather than a goal to the point that companies strained every nerve to satisfy their expectations. The analysts themselves may have been models of objectivity, but optimism did suit some at least—if the investment banking side of their institutions could obtain or retain investment banking business. Top US lawyer Martin Lipton writing in M&A Lawyer in July 2003 in the course of a convincing analysis referred to remarks by Daniel Vasella in Fortune (18 November 2003): The practice by which CEOs offer guidance about their expected quarterly earnings performance, analysts set ‘targets’ based on that guidance, and then companies try to meet those ‘targets’ based on that guidance, is an old one. But in recent years the practice has become so enshrined in Wall Street culture that the men and women running public companies often think of little else. They become pre-occupied with (p. 236 ) short term ‘success’, a mindset that can hamper or even destroy long-term performance for shareholders. I call this the tyranny of quarterly earnings. The events of 9/11 shook the USA to the core, as well they might. Their consequences will be with the world for years to come. It is difficult even now to define the causes. What has been cruelly exposed are the limitations of power even in the hands of the country with the greatest military supremacy the world has ever seen. It cannot defend itself against individuals prepared to be killed for a ‘cause’; it cannot police the whole world. The Iraq disaster was unresolved at the end of 2004 with appalling costs in terms of life, property, and military expenditure. Will it inhibit the USA taking such an advanced foreign policy stance in future unless its own territorial integrity is threatened? Meanwhile other great nations are stirring. China is set to catch up with the USA economically sometime between 2020 and 2030. The exact timing matters not, for there will be others in the race, notably India and Russia. Such grandiose speculation seems a million miles away from the practical consideration of systems of direction and control of individual enterprises, but it is not so. The greater international competition becomes, the more each of its elements will matter. # The Governance Machine at Work ## The basic framework As noted earlier there is no Federal Companies Act; companies incorporate under the laws of the state of their choice and rather more than half have chosen Delaware. The main features are, however, common to all and familiar to the UK: namely, a board of directors elected by the shareholders and responsible to them for seeing that the company is properly run. Other common features include the directors' and officers' duties of loyalty, care and good faith to the corporation, and the right of any shareholder to sue on the corporation's behalf for breaches of duty, subject to certain procedural hurdles. The USA has many more listed than unlisted companies, but this chapter is confined to companies that are quoted on one of the US stock exchanges or on NASDAQ. We will now examine each of the parts of the machine starting with the Chief Executive Officer, but before we do so we ought to examine briefly one of the most powerful lobbying organizations in the world of US governance—the Business Round Table (BRT)—since its influence is so great and directly affects many of the issues that are exercising commentators around the world. It describes itself as ‘An Association of (p. 237 ) Chief Executive Officers committed to improving public policy’. It interprets this role as meaning resistance to attempts to encroach on the CEO's authority. It has not, for instance, espoused the idea of requiring the separation of the roles of CEO and chairman of the board (though it does not rule it out); it does not warm to the idea that the non-executives on the board should have a recognized leader; and it resists moves to make it easier for outsiders to nominate directors. Their work is a useful reminder that governance is about power and all parties to it regularly ‘speak their own book’. ## The Chief Executive Officer When examining corporate governance in the USA, the place to start is not the board but the Chief Executive Officer. To quote Herzel and Shepro (1990): A reader unfamiliar with American company boards who walked into a board meeting [after reading our discussion of directors] might be surprised and disappointed. Under ordinary circumstances, what would be going on in the boardroom would correspond very little to the Delaware and other state law procedures. The CEO would probably be the chairman of the meeting and completely in charge. Generally, he controls both the agenda and the flow of information to the directors. He dominates the meeting and the board plays a quite secondary role. Shareholders and the market are far more interested in CEOs than directors. When we read about big businesses in the financial press, CEOs usually are the centre of attention and directors are obscure. In fact, under normal circumstances very little attention is paid to directors by shareholders, the market, or the press. ## The change in the balance of power—and how it affects the CEO What the above quotation confirms is that US companies are run by their chief executives (whatever the formal title). The form of leadership is much more individual than collegiate. The balance of power between CEOs and their non-executive colleagues will naturally depend on the personalities. In most cases the CEO's position is far more exalted than theirs, in the CEO's own eyes, in theirs, and in the eyes of the world at large. The universal acceptance of CEO's supremacy has a profound effect within their organization, not least in regard to their relationship with subordinates and their own aspirations. As noted earlier, they are frequently the outward and visible symbol of the business and treated as such by the media—a fact they usually enjoy and are sometimes seduced by. Their pre-eminence is reflected in their pay. The second-highest-paid person gets substantially less than the CEO. (p. 238 ) Viewed through a CEO's eyes such statements about their power might seem extreme. Their tenure of office is generally about six to eight years, and shorter therefore than that of many outside directors. Many are conscious of their vulnerability and do their best to make real colleagues of their board members. The reality seems to be, however, that it is generally accepted as the norm by all the parties concerned that on the spectrum which runs from individuality to collegiality, the place of the CEO is firmly at the end of individuality, and much of what follows, for better or worse, flows from this simple fact. The overwhelming dominance of CEOs has been challenged over the last few years, while boards' influence has increased. In former times they could after entering office slowly mould the board to their will through their power of patronage. The advent of nomination committees has whittled away this power, so that new appointees need not feel personal allegiance to them. So it can no longer be considered disloyal for appointees to convene without the CEO. And the CEO cannot depend on their personal loyalty transcending their duty to the company. Direct responsibility has been sharpened by the requirement for the CEO, and the CFO, to certify personally in quarterly and annual SEC reports that as far as they knew there are no untrue statements or omissions of material facts that might be misleading; and that the financial condition and results have been fairly presented. They also have to make a statement about internal controls. CEOs' dominance was buttressed by their serving as chairman of the board as well. The chairman is in fact elected by fellow directors. Despite the BRT's views the separation of the roles has become a major issue following Sarbanes-Oxley. Government Metrics International (GMI) (29 November 2004) quotes R. Bernstein of Merrill Lynch & Co. as saying that companies with split roles outperformed the others (average return of 22% against 18%). Statistics on exactly how many companies have split roles seem to vary but in the GMI sample only 34% of the 1,154 companies have done so. ## Compensation There is a mass of data on what the British prefer to call remuneration, and the subject itself has become controversial, partly because CEOs are well compensated through thick and thin; this does not seem just, as judged by any standard the sum paid seems relatively and absolutely excessive. Much ink has been spilt on the subject, not least Graef S. Crystal's In Search of Excess: the Overcompensation of American Executives (1991) and Frank Partnoy's Infectious Greed (2003). (p. 239 ) To some extent the figures speak for themselves. Watson Wyatt SCA analysis states that the median of CEO total direct compensation rose from$1.7 million in 1990 to $5.3 million in 2000. Forbes Magazine, 10 May 2004, lists the top ten US earners. The least of these, Todd S. Nelson, got$32,812,000; the top was Reuben Mark of Colgate Palmolive with $147,970,000. Michael Eisner of Disney was described as ‘one of the worst performing US bosses’ and he got$121,200,000. The articles go on to make comparisons with foreign companies. The boss of BP got $5.3 million, the boss of GlaxoSmithKline$4.6, and the boss of Nestlé $5.1 million. The top name in a long list was the boss of UBS, Peter Wuffli, with$6.8 million.

Such figures have given rise to much concern, starting with the explosion of the differential between average pay and the CEO's pay.

More importantly there is the perverse effect of linking pay to performance, which sounds an obvious solution to the problem of appearing to over-reward CEOs in poor years. It appears that whereas salary accounted for a third of total compensation in 1990, this had shrunk to 15% a decade later. That in itself is not significant but the motivational effects of the timing of long-term incentives, and, worse, stock options, is. Especially if options are exercisable in the short term they positively invite executives to ‘cook the books’ so as to be able to cash in. They tempt executives to think of the short term rather than take a long-term perspective. In the autumn 2003 edition of the Securities Reporter, Professor Jeffrey N. Gordon writes, ‘The managers’ concern about the stock price can become pathological…managers will be strongly tempted to produce the financial results the market ‘expects’ through manipulation of the financial results. This was a major ingredient of some of the scandals.' Some commentators consider that options have always been a ‘con’ trick anyway, born of a failure to distinguish between a company and its stockholders. They appeared to be a way of rewarding executives at minimal cost to the company; this was because the money was coming directly from the existing shareholders by way of dilution— which had reached more than 12% of the shares in issue by 2000 (including ‘overhang’). All other payments go through the P&L but options do not. To put it bluntly, they are a swindle. Gordon again: ‘The interactive multiplier effect means that high-powered compensation like stock options raise special moral hazard problems in comparison to other forms of incentive based compensation.’ Rewarding executives by real stock in order to align their interests with other stockholders is a different matter.

Criticism tends to be shrill to command attention. It is not clear yet where the debate will end. There are pressures for better information and for better reflection of results in remuneration. Some critics would focus on the structure of remuneration packages rather than the actual sums. Others (p. 240 ) argue that top talent is rare and it matters greatly to a company to attract and retain it in a competitive market: the American CEO is not especially secure and his removal from office may in the end be abrupt, public, and wounding (so comparisons with regimes abroad where there is no mobility and great security are unfair). The equilibrium which it is the function of the market to maintain depends upon information, and in the event this is often inappropriate or incomplete. The market for CEOs is in any case structurally imperfect and bound to be so. So almost everything depends upon judgements made inside and outside compensation committees. When all is said and done, however, there seems to be a widespread feeling that some judgements have failed to reflect the balance of interests which in the long run can only be disregarded at some risk to company and country.

The Business Round Table acknowledges that ‘there are problems in a few corporations’, but generally considers that its 1990 dictum remains valid: ‘Select, regularly evaluate, and, if necessary, replace the chief executive officer. Determine management compensation. Review succession planning.’ This is supplemented by the following five principles:

1. 1. The committee of the board of directors designated to deal with executive compensation and share-ownership programmes should be composed solely of non-management members of the board of directors.

2. 2. The overall structure of executive compensation and share-ownership programmes should directly link the interests of the executives, either individually or as a team, to the long-term interests of the shareholders.

3. 3. Executive compensation and share-ownership programmes should be designed to attract, motivate, reward, and retain the management talent required to achieve corporate objectives and increase shareholder value.

4. 4. Executive compensation and share-ownership programmes should be designed to create a commensurate level of opportunity and risk based on business and individual performance.

5. 5. Proxy statement reporting of annual cash compensation should be done in a standard format for all corporations in a manner that is easy for shareholders to comprehend. Share-ownership programmes should be separately reported in the proxy in a similarly understandable format.

The Business Round Table's view is, broadly speaking, that shareholders already have all the powers they need including, as a last resort, replacing some or all of the board ; but as we shall see later this power is limited and it is understandable that shareholders should display dismay. Although in the past the SEC did not require management to include shareholder resolutions on executive remuneration in company proxy statements, in 1992 the SEC changed its position. Now, executive compensation is a frequent topic of shareholder proposals included in management's proxy statement. (p. 241 ) Implementing performance-based pay and capping executive severance arrangements are amongst the most common shareholder proposals. Expensing stock options is now required.

The SEC's requirements concerning disclosure of executive compensation have broadened substantially; it now requires substantial disclosure of executive compensation under its proxy rules:

• Disclosure must be consolidated into several tables, designed to be clear, concise and easy to understand.

• A summary table must disclose all forms of compensation to the chief executive officer and the four other most highly paid executives for each of the past three years.

• The compensation committee (or the whole board) would issue a report explaining the specific factors and criteria considered in determining the compensation for each of the executives named in the summary table (and for NYSE and NASDAQ listed companies, the compensation committee must be comprised of independent directors).

• A performance graph is required to compare the cumulative return to shareholders over the past five years to the return on a broad market index such as the Standard & Poor's 500 Stock Index and to the return on an index for a peer group of companies.

• Various forms of compensation are broken down in the table.

• The table must distinguish between annual compensation and long-term compensation.

• Annual compensation consists of salary, bonus (which cannot be aggregated with salary), and other (such as perks, payments to cover taxes, restricted stock, stock appreciation rights (SARs), and stock option plans with above-market interest rates or preferential dividends, deferred earnings on long-term incentive plans, and preferential discounts on stock purchases).

• Long-term compensation consists of awards of restricted stock, accrued dividends on restricted stock, pay-outs under long-term incentive plans, and stock options and SARs.

• In addition to the summary table, there must be a table showing the potential values that can be realized by the named executive officers from the exercise of options and SARs, assuming various rates of appreciation of the price of the stock.

There has been a debate about ‘expensing’ options and a new Financial Accounting Standards Board (FASB) rule is on the way that will require this for their first fiscal reporting period after 15 June 2005. There is a more fundamental question about them, mentioned above (p. 239). If executives (p. 242 ) were to receive shares bought in the market, it would not arise. The cost would go through the profit and loss account and the shares would not be diluted. Furthermore, holding stock rather than options is a more accurate way of aligning shareholders' interests with those of the executives; they feel a drop in the share price more actively than an option going ‘under water’. There would be tax consequences of such a switch. As to small high-tech companies, there are means of offering shares rather than options. As it is, the Wall Street Journal (14 December 2004) reported that the value of options had fallen 41% for CEOs and 53% for other staff between 2001 and 2003.

There has been criticism of CEOs' salaries for years. I referred earlier to Graef S. Crystal's 1991 book In Search of Excess. The National Association of Corporation Directors' (NACD) report in 2003 drew attention to ‘the simple maths’ (p. 7):

• The average total compensation for the CEOs in the S&P 500 was over $6 million in 2002. • The Institute of Policy Studies in Washington DC reported that CEO pay in the 200 largest companies increased nearly 600% from 1990 to 2000. The federal minimum wage in that period rose by 37%. • The ratio of CEO pay in the largest US companies to the pay of lowest paid employees was 25 × in 1970; 40 × in 1990; 360 × in 2002 (It has peaked in 2000 at 570 × ) (Kevin Murphy, University of Southern California). The whole subject of executive compensation has attracted extensive analysis and comment—often hostile. A slow process of polarization in US society does seem to be taking place. The Washington Post on 20 September 2004 published some details of what it called ‘A Shifting Landscape’. The top fifty of households now accounts (2003) for 49.8% of the nation's income compared with 43.8% in 1967. Other aspects of directors' compensation are considered in their place below, including the role of compensation committees, outside directors' remuneration, and shareholder activism. ## Directors and Boards The structure of the company puts power into the hands of the directors who work together on a single-tier board, and makes them accountable to the shareholders for the way they use it. Their election by the shareholders and their accountability thereafter are the cornerstones of US corporate democracy. But it is a strange form of democracy and it is under state not Federal law. Under rule 14a–4 (and Regulation 14A) directors can be nominated (p. 243 ) singly, in clumps, or as a slate. They do not have to be elected every year— which leads to ‘staggered boards’. And ‘plural voting’ is often allowed. (This means the shareholder can give all his/her votes to a single candidate.) It is common practice for the election of directors to be done that way, not individually. There is moreover no way the shareholders can vote against— they can only abstain (‘withhold their vote’) so abstentions may mean anything from downright opposition to a lack of interest. It is more like Soviet Russia than democratic America. So we can conclude that the shareholders' right to elect the board usually amounts to ratifying the board's nominations (which the CEO often plays an important part in formulating), but it can mean their proposing candidates or a full slate of their own. As election is by a plurality of the votes cast, it would be possible for a shareholder nominee to be elected, alongside the names on the slate that received a plurality of the votes. Shareholder nominees are rare and seldom elected. There are very few such nominations largely on grounds of cost. ‘Official’ candidates' costs are borne by the company, but others who seek nomination pay their own unless they are elected. The SEC during 2004 was still pursuing its proposal to increase shareholders' ability to nominate directors. This has generated opposition, ferocious in the case of the BRT, and there is the possibility of its being challenged in court on constitutional grounds. The reality for many years was that power lay with the CEO; what has happened recently is that the board has begun to become the organ of governance originally envisaged. And shareholders have at last begun to examine more carefully the performance of management and the directors' competence to monitor it. The NYSE and NASDAQ requirements after SOX include regular executive sessions of the non-management directors without management being present. The name of the director presiding must be disclosed in the proxy statement or Annual Report (if there isn't a proxy statement) together with information about how interested parties can communicate with him/her, or with the group. If the group includes non-independent directors the independents must meet at least once a year. At one time boards were dominated by executives, but the tendency over the past decade has been for ‘outside’ directors (the US term for ‘nonexecutive’ directors) to constitute a significant minority or, more usually, a majority. Today, US companies listed on the NYSE or NASDAQ must have a majority of ‘independent directors’. Indeed, the CEO may be the only executive on the board. The CEO may, however, have fellow executives on the board too, typically the president or chief operating officer (COO), financial officer, or a senior vice-president. The nomenclature for the top (p. 244 ) executives varies a great deal. Boards have shrunk in size since 1972, the median for big companies having reduced from fourteen to about ten and for medium-cap companies from twelve to nine. Small companies have about seven. (The figures vary according to the criteria for describing company size. But the picture is clear enough.) The Conference Board 2003 Blueprint on Corporate Governance best practices brings together (p. 11) the view of the American Law Institute (ALI), the Business Round Table (BRT), the NACD, and other relevant bodies. It states that the general board responsibilities should include: • Approving a corporate philosophy and mission. • Selecting monitoring…compensating…and if necessary replacing the CEO…and ensuring proper management succession. • Reviewing the company's financial objectives…including significant capital allocation. • Monitoring corporate performance against the strategic plans. • Ensuring ethical behaviour and compliance with laws and regulation. • Assessing its own effectiveness… The NYSE rules require boards to conduct a self evaluation at least annually to determine whether the board and it committees are functioning effectively. The company may choose how to do this but must say how it proceeds. CB's blueprint pp 32/3 lays out the desiderata, and they are tough. It will be interesting to see how they are achieved in practice. ## Outside and independent directors The movement towards a greater proportion of outside directors accelerated in the late 1970s as a result of some cases of extensive misfeasance by executive directors. The response to this was that in 1978 the New York Stock Exchange made it a listing requirement that companies should have audit committees composed of outside directors. The rules of the New York Stock Exchange and NASDAQ were amended in the wake of the Sarbanes-Oxley Act (having been approved by the SEC). Both now require a majority of independent directors. Independence is defined in the Act (sect. 301) but the rules have been elaborated to exclude people • who in the last three years have had a material relationship with the company such that it might interfere with the exercise of independent judgement; • whose firms have such a relationship; • whose immediate family are employed by the company or its auditors. (p. 245 ) This is not an exhaustive list, but it gives a flavour of the main criteria and illustrates why there is such a difference between being an ‘independent’ and simply a ‘non-management’ director. The recent reforms address the board's processes and are far more prescriptive than before. The non-management directors (including the ‘independents’ of course) are enjoined to meet regularly without management being present. This marks a major change, as in days gone by such gatherings would have been felt by the CEO to be conspiratorial. Companies must now have audit committees, nomination committees, and remuneration committees, each of which is considered below. Three-quarters have executive committees and there is a wide variety of other committees too, such as finance, public policy, planning, and human resources. The system still retains some flexibility. Executive committees are the most common and most important and can be used to deal with urgent matters arising between board meetings (there may be two- or three-month intervals between them) or as a sounding board on general management problems. By their very nature executive directors play an important part on them and may have about a third of the seats. It is said to be getting rather more difficult for companies, especially big ones, to recruit outside directors, partly because of exposure to liability, partly because of the time the office takes, particularly in light of the enhanced expectations of directors under the recent governance reforms. Directors are generally protected from liability arising from business decisions under the business judgement rule. In addition, Delaware corporation law allows companies to eliminate or limit directors' liability for breaches of the duty of case—so long as they had acted in good faith and there was no breach of their duty of loyalty. The Delaware courts have recently focused on the duty of good faith and have indicated that such charter provisions will not protect directors who ignore known risks. In any event, many companies protect their boards with Directors and Officers (D&O) liability insurance. They also usually have provisions for reimbursing directors and officers for expenses incurred in defending litigation, amounts paid out in a settlement of an action, or sometimes because of a judgement. ## Nominating committees The process of selecting director candidates has undergone changes over the past decade. The NYSE and NASDAQ now require listed companies to have nominating committees composed entirely of independent directors. This structure serves both to reduce the CEO's influence and to make choice more (p. 246 ) methodical. Some companies invite nominations from shareholders, or meet with large institutional investors to consult on potential candidates. Nominating committees (which sometimes cover governance issues too and thus become nominating/governance committees) only existed in 46.3% of the companies covered by the National Association of Corporate Directors in their 2003/4 survey. Such committees met on average 3.6 times a year and meetings lasted two hours. Averages of course conceal extremes; in practice only a third of small-cap companies had such committees, whilst most of those in the S&P 500 did (96.2%—up from 85.0% in 2001). Whilst nominating committees are not mandatory under SOX, the SEC rules now require companies to describe in their proxy statements how the committee works, if there is one, who is on it, its policy and standards, and the way it deals with shareholder nominations. If there is no committee the company must still describe the processes and who is involved in them; it must say why it does not have a committee. The rules for this reporting are elaborate. The process is a very long way indeed from reliance on an ‘old boy network’. Even so professional search firms are only used in a minority of cases, which must mean that names are put forward by the chairman, CEO, other members of the board, and the company's advisers. Patronage may be more disciplined, but it is not dead. ## Audit committees Before we examine the role of audit committees we need to clarify a basic point about the audit itself. In the USA its function is directed at accurate market information, which is why the SEC, whose business this is, plays such a central role. In the UK by contrast the auditors are accountable to the shareholders and only to them (the Caparo judgment: see Chapter 6). The end result is often similar, but it is not identical. Furthermore, as US audit is market oriented, the SEC's regulatory authority does not extend to privately held companies. Delaware law does not oblige such companies to have their accounts audited, though as a matter of business practice they may need to so do if borrowing. The Inland Revenue Service (IRS) will expect to see the tax returns authenticated. But there is no company register as there is in the UK and therefore no requirement to file accounts. Publicly held companies had long been required by the SEC to file audited accounts, but this did not prevent frauds (as elsewhere). It was to meet this problem that the New York Stock Exchange made audit committees a precondition of obtaining a listing as far back as 1978, and companies met this requirement. In the early days there was much scepticism about their (p. 247 ) effectiveness: the imposition of a piece of machinery did not of itself ensure it was useful. In a 1988 survey (Report 914), the Conference Board found that times had changed. Audit committees' responsibilities had generally been broadened. They were credited with having ‘brought about improvements in…traditional core areas of their role—external audit, internal auditing, financial controls, and financial reporting. Many agreed that the committees’ work has also improved both the full board's understanding of these matters and also its effectiveness. In particular, audit committees were thought to have improved the procedures, practices and effectiveness of internal audit.’ The Enron case and others illustrated the dangers of lack of independence when the auditors put management's interests first, often against a background in which they derived more income from non-audit work than from the audit itself and the more of such work they did the more they stood to lose from a spat with management. Audit committees should have helped but often prove to be broken reeds. Towards the end of the Worldcom debacle, Cynthia Cooper, an internal auditor who had discovered the accounting mistreatment, went to see the head of the audit committee about it and suggested the committee be told. The chairman said he thought this was premature! The fact that Worldcom had, according to accounting rules, overstated its income by billions of dollars was still not told to the board. There are technical arguments as to whether the principles themselves made sense, but no argument for the lack of transparency to the audit committee and board. The Sarbanes-Oxley Act has faced up to the problem. Section 301 requires exchange listed firms to have an audit committee with responsibility for the ‘appointment, compensation and oversight of the firm's auditors’. Members of the audit committee will be able to engage at the company's expense their own expert advice including, where appropriate, independent legal counsel. The audit committee will be expected to delve into the auditors' qualifications, history, and record of problems and restatements. The Act and the NYSE's rules will oblige the auditor to tell the committee about alternative GAAP treatments discussed with management and about any disagreements. The committee must pre-approve all services provided by the auditor (audit and non-audit). It will make periodic reports to investors about its decisions to pre-approve non-audit services. Certain non-audit services are prohibited: • bookkeeping, information systems design; • appraisals or valuations; • (p. 248 ) actuarial services; • internal audits; • management and human resources; • broker dealing and investment banking; • legal or expert advice unrelated to the audit. The independence of auditors will be reinforced by new conflict of interest provisions and mandatory rotation of the lead audit partner and the audit review partner after five years. Furthermore an accounting firm will not be able to provide audit services to a public company if one ofthat company's top officials was employed by the firm and worked on the company's audit during the previous year (CEO, Controller, CFO, Chief Accounting Officer, etc.). Sarbanes-Oxley requires audit committee members to be independent. One member must be a ‘financial expert’ as defined by the SEC. What this means is: • a thorough education and experience as a public accountant or auditor or a principal financial officer; • an understanding of generally accepted accounting principles and financial statements; • experience with internal controls; • an understanding of audit committee functions. The duties, obligations, or potential liability of the person so designated and the other directors will not be affected (according to SEC rules—Regulation S-K, item 401). In addition to its traditional duties, the audit committee must now hire and supervise the external auditor, oversee compliance programmes, and establish whistle-blower procedures. It will have an enhanced role in ensuring the adequacy of internal controls. All this is on top of the normal range of duties such as • recommending the auditors; • reviewing the scope of the external audit; • reviewing the results of the external audit with the auditors; • reviewing the results of the internal audit with the internal auditors; • reviewing the adequacy of the companies' accounting policies, practices, and systems of controls; • reviewing the scope and adequacy of the internal audit. This list is by no means exhaustive. The terms of reference—which are disclosed in the proxy statement or the annual report—may go into considerable detail and include various specific functions not mentioned above. Their essence is some reassurance about the effectiveness and integrity of the systems of financial control and information; a means of providing both (p. 249 ) internal and external auditors with a privileged and private forum in which to express doubts and concerns even (and perhaps especially) about top management; and a way of getting the outside directors closer to the business. The committee must have a charter and at Annex 5 we reproduce the requirement of the NYSE and NASDAQ. Audit committees used to meet about three times a year on predetermined dates, but there were ad hoc meetings as well if necessary. Now the audit committees of S&P 500 companies meet on average 7.5 times a year; on other large companies the number is 6.8 times. In fact, committee meetings are usually attended by key executives or other corporate employees, some as a matter of routine and some on a ‘when invited’ basis, but all may be excluded by the committee chairman for items it would be inappropriate for them to attend. As directors often have to fly some distance to attend, it is frequent practice for an audit committee to meet within a day or two of the board. This can in practice cause duplication if the same matters are on both agendas—and the same people attend. Indeed, audit committees will have to make sure they are not dealing with matters that are the board's business. It is in practice only too easy to stray. The committee is now required to establish procedures to cover complaints about accounting matters including controls and whistle-blowing on accounting and auditing matters. The committee has, under Sarbanes-Oxley, the right to engage independent counsel and other advisers if they feel it necessary. It is understood that the outside auditors can request a private hearing with the committee when they want one. ## Compensation committee The NYSE and NASDAQ rules following SOX require companies to have compensation committees of independent directors; 94.2% of publicly held companies do so (NACD Survey, p. 21) and they meet about four times a year for an average of 2.5 hours. The NYSE requires them to have a formal charter which details what the committee must cover and how it should report, with particular attention to the CEO and his performance. The committee's remit generally covers only senior management and executive directors including the CEO, but its role is generally broad and covers the company's remuneration policy and guidelines—which takes it into questions of performance. Judging by the volume of criticism about many top executive ‘compensation packages’, the compensation committees concerned have failed in their prime task of reconciling the interests of management and shareholders by producing a ‘fair’ solution. The Disney (p. 250 ) case (2004), for example, attracted widespread comment. Many reasons are suggested for their shortcomings, such as the indirect reciprocity between CEOs, which tempers the severity of their judgement because they dislike being harsh towards those who are in the same position as themselves, and the desire of consultants not to lose business by producing unpalatable advice. The SEC requires companies to include in their proxy a report from the compensation committee or from the whole board if there is no committee, covering: • a discussion of the compensation policies for the executive officers, including the extent to which they are performance based; • an explanation of the reasons for repricing the exercise price of options granted to named executive officers, if such options were repriced during the last year; and • disclosure of the identity of the members of the compensation committee, identifying any members that are employees or officers of the company or have certain other relationships with the company. ## The board at work Thirty years ago a distinguished academic could describe the outside directors as ‘ornaments on a Christmas tree’ (Mace 1971). This certainly is not the case now. Boards have become more assertive and SOX plus the ensuing rule changes have made it difficult for directors to avoid the burden of responsibility. Directors who accept appointment to a board are not generally looking for trouble. They are not, one gathers, doing it primarily for the money. They are more motivated by status and interest. Americans, in discussing the director's role, used to turn to the old adage, ‘If it ain't broke don't fix it.’ The relationship between the CEO and the directors he has appointed, or who have appointed him, made this a natural attitude, but not now. They generally trust him and like him and do not want prematurely to oppose him, much less eject him: they want him ‘to provide strong leadership to pursue economic gains’. They realize his job in the market place is tough enough anyway without the board holding him back. All this, of course, applies to female CEOs and directors too. They are not unduly worried about this in normal times, will ask enough questions to satisfy their consciences, but accept the limitations imposed by their lack of information compared with the CEO. Such attitudes may change in the aftermath of Enron (and the Equitable in the UK). The message in (p. 251 ) both cases was that directors must push hard enough to make sure they really understand the games being played and the risks being run. They will have to face the fact that CEOs vary and the boards depend crucially on the role the CEO wants them to play. Some CEOs dominate and suppress; others encourage and create a collegiate style. It mainly depends on personalities and their interplay: two similarly structured boards can behave in entirely different ways. But Enron and the subsequent change in the law have now marked out the field of play differently. Most importantly, the directors will have to push when there are issues that are unclear. Having said that, they are still at the mercy of a devious or secretive CEO. Directors will assert themselves more readily ‘when push comes to shove’. In other words there may be a point beyond which even a weak board cannot be pushed. Readers of Barbarians at the Gate will remember this can be a long way down the track. We encounter in the USA the same phenomena described in other countries. First, that in times of trouble the tendency is to accord more, not less, power to the leader; second, that contrary to popular myth, there is no greater a tendency to fire the CEO prematurely in the USA than there is elsewhere. CEOs around the world tend to be given the benefit of the doubt for a long time, for reasons of inertia, cowardice, comradeship, and the sheer difficulty of organizing their removal and replacement. Many would go so far as to say (with the benefit of hindsight) that CEOs are often left in post too long. So it is misleading to imply that US boards make little contribution. In many moments of crisis, including, for instance, the sudden death or resignation of a CEO, they may find themselves effectively in executive command for the interregnum. Their role is enhanced when takeovers threaten, not least because these have given rise to so much litigation. In the normal course of business, directors have little to fear from the courts because of the ‘business judgement rule’, that is, the courts are most reluctant to double-guess management decisions, providing directors have not breached their duty of loyalty, good faith, and diligence. In takeovers, however, the courts may well be heavily involved. As this is so, the directors are much more alert to the duty of due care. (Vide the judgment in Smith v. Van Gorkom.) Nowadays, outside professional advice is invariably sought. The balance of power often shifts sharply and suddenly when a company is under attack. Even so, it is not necessarily always easy for directors to reconcile their support for the CEO and the continued independence of the company with their overriding duty to the shareholders. Those who serve on them assert that the USA has many excellent boards. This is surely true, and reflects the will of those CEOs to make them work properly. Even so, many Americans feel that there are few grounds for (p. 252 ) complacency about the general effectiveness of their system and particularly of the operation of the board. They know that they are faced with yet another manifestation of the agency problem. As E. B. Rock put it, ‘Because directors do not generally have significant shareholdings and do not depend on the shareholders, they lack any significant economic incentive to discipline management. To the extent that they are economically or psychologically dependent on management, they have significant incentives not to act as the shareholders’ champion…' (Rock 1991). It remains to be seen whether SOX will lessen this dependence. A quite different problem arises if the board as a whole does not work, either because the directors cannot control the CEO when they should, or because neither he nor they are up to the mark and the whole apparatus is declining in a welter of reciprocal mediocrity. A poor CEO picks poor directors and vice versa. In these circumstances only the shareholders can address the problem. We shall examine their role a little later. ## Boards: frequency of meetings There are two significant features of US boards that are so familiar that they seldom excite comment: geography and frequency of meetings. Compared with the USA, all the other countries studied, the UK, France, Germany, and Japan, have relatively concentrated industrial bases. Any major US company is likely to be widely dispersed at home, let alone overseas. With so many different industrial centres and so much dispersal, it is obviously sensible for US companies to seek their outside directors to match, and so they do. As a matter of mere logistics this would lead one to expect fewer meetings than elsewhere, and so it proves. In addition US companies are obliged to report quarterly, so the amount of public information directors have is greater than elsewhere. All these factors affect what boards do and how they do it. The Conference Board (CB) 2003 survey tells us that the number of board meetings in a year varies from 3 to 13 and that the median is 6. The bigger the company the more frequent the board meetings. There is no appreciable difference between manufacturing, financial, and services. As to duration, the median is four hours throughout—which does of course mask a considerable difference at the extremes—from two to eight hours or even longer. ## The remuneration of the outside directors There is a wealth of information in two surveys by the CB for 2003 and by the National Association of Corporate Directors (NACD). The salient points are: (p. 253 ) • The bigger the company the more they pay • Some industries pay much better than others. • Compensation is normally composed of these elements: 1. (1) a retainer 2. (2) committee fees 3. (3) share grants or options. These are average numbers from NACD (p. 6):  Smaller companies Total$42,892 Medium companies Total $96,191 Top 200 Total$155,575
Table 5.1 gives a closer look at these figures in these three groups (NACD, p. 7).

Looking at numbers by industry we find (CB 21) the following examples and median total compensations:

 Building materials $42,702 Paper and allied products$56,750 Printing and publishing $71,500 Computer hardware & office equipment$90,375 Food, beverages and tobacco $123,330 CB reports a wide range of other benefits (p. 35). Apart from D&O cover there is often other insurance and sometimes matching charitable donations. For the background of the outside directors we turn to the Korn Ferry International 2003 study (p. 8), which shows the percentage of boards with one or more of the following:  Retired executives from other companies 94% Investor 89% CEO/COO from other companies 83% Women 79% Table 5.1. Remuneration of outside directors Full value shares or stock options etc.(%) Meeting and committee fees (%) Cash retainers (%) Smaller companies 45 29 26 Medium companies 54 22 24 Top 200 59 16 25 (p. 254 )  Former government official 59% Academic 59% Non-US citizen 16% Commercial banks 31% There are also figures for ethnic minorities. ## Some post-SOX trends in the top 100 companies (Source: Sherman and Sterling LLP 2004) 1. 1. Forty-six of the 100 have exceeded the requirement for or a majority of independent directors—they comprise 75% or more of eighty-one boards. 2. 2. The CEO is the only non-independent on thirty-five boards but in eighty-five he combined the role with that of chairman. 3. 3. Forty-two companies disclosed the name of their finance expert on the audit committees and in seventeen companies all the committee members are experts! 4. 4. Board meetings and committees meetings have become more frequent; so much so that forty-seven companies placed limits on the number of other audit committees their audit committee members might serve. More generally, only twenty-nine limit the number of other boards on which their directors may serve. 5. 5. Eighty-six companies have a mandatory retirement age of directors— usually 70–2. Only five have limits on length of service. 6. 6. Thirty-three have ‘poison pills’. 7. 7. There was a wide range of shareholder proposals on governance issues like splitting the chairman/CEO roles, or six-year terms for outside directors or a vote on poison pills. And there were numerous proposals about various aspects of compensation. # The Banks As we have seen in the sections on corporate governance in Germany and Japan, the role of the banks was once central and is still important. The relationships between banks and companies in both countries are subtle and complex; each reflects the history of the development of the economy, as well as social and national attitudes and behaviour. Naturally, the role the banks play conditions the way they select, train, and deploy their staff. There was a time when the USA might have developed on somewhat similar lines (though early on it had more developed capital markets), but the politico-social history of the USA worked out differently. Perhaps the decisive event was the market collapse in 1929–31. (p. 255 ) Much of the blame for the intensity of the slump was attributed to financiers, and there was a reaction against their alleged abuse of power and influence. This led to legislative curbs on banks in the 1930s. It is unnecessary to give a blow-by-blow account of what occurred (Margaret Blair gives a short summary of the crucial elements in the Brookings Review, Blair 1991). The Glass-Steagall Act of 1933 prohibited banks from underwriting stock or affiliating with investment banks that do, but that has now been replaced. The Bank Holding Company Act of 1956 restricts bank holding companies from owning control blocks in companies not closely related to banking. Potential liability under trustee law encourages bank trust departments to diversify their holdings, and other rules make it difficult or impossible for the bank trust department to act in concert with other institutional stock holders. Banks therefore do not come into the corporate governance picture except in so far as their trustee departments manage shares for clients. These are the record-holders of a significant portion of shares as custodian or fiduciary, in which case their preference is for their clients to vote their shares. Elaborate procedures have been introduced to facilitate this (under the 1986 SEC regulations pursuant to the Shareholder Communications Act under which proxy materials must be forwarded to the beneficial owners). Banks' own holdings are minimal because the law restricts them and they have few funds to spare; they neglect to use the influence they already have. Furthermore, their biggest actual or potential clients are likely to have credit ratings as good or better than their own and are therefore able to get money on better terms and without their help (disintermediation). This has meant that the industrial and commercial companies which do still borrow are usually not the best risks. Banks have, however, been prominent in supplying some of the funds for leveraged buy-outs (LBOs) or other takeovers (and costly this has proved when the overstretched borrower could not repay). Some banks—the investment banks—have been key players, though not as shareholders. It is they who have acted as catalysts of change, not by assessing the quality of corporate governance but by analysing companies to see if the market appeared to undervalue them. If so they hawked the company around (having produced a ‘book’ on it) among potential purchasers to whose greed and egos they might confidently turn. To the extent that the market's valuation did reflect the inadequacy of management, the investment bankers were assuming the shareholders' proper role, though the remedy they applied—a takeover—was often not as good for the parties as a straightforward change of management would have been. It suited the banks, of course, as takeovers and restructuring were infinitely more profitable to them than were (p. 256 ) changes of CEO or board. Investment bankers on the whole do not enthuse about really good boards or active shareholders, since both deprive them of an opportunity to make a killing by producing an inappropriate answer to a misguided question. As if life were not already difficult enough for bankers, ingenious lawyers have exhumed the ancient Common Law concept of ‘fraudulent conveyance’ as a form of action against banks who loaned money to an LBO that failed. (See the Revco case, 1990/1, Wall Street Journal (3 January. 1991).) But such claims are rare. Despite all these problems, a bank may still form a close relationship with customers, and some do. But ‘relationship banking’ depends on mutual trust and good information. It means a company being prepared to pay what is in effect an insurance premium for help in difficult times, and a bank giving its support if such times come. This goes against the grain when treasury departments are profit centres, straining to squeeze the last cent from every transaction. The trouble is that unless the board tells the treasury department to pay (within defined limits) the costs of relationship banking, it will not get it. Companies seldom think the price worth paying in good times and only regret the absence of an umbrella when the storm breaks. US banks, for their part, hemmed in by their law, seldom have the inclination, resources, and staff to try to sell the umbrellas—profitable though this might be. If a bank syndicates or securitizes debts, the tenuous connection between company and lender ceases to exist at all. In good times the company services its debt and repays when due. But if Humpty Dumpty falls off the wall there are likely to be so many pieces that even the marines cannot reassemble him. (See e.g. the Federated Stores case in Lowenstein 1991: ch. 2.) It is not just the company that may get damaged—as the weight of non-performing loans on banks' books shows. An interesting account of Citibank's policy is given in Institutional Investor (December 1991). The banks may not play a part in governance issues, but they may nevertheless be key players in financial machinations that turn out to have facilitated breaches of sound principles of corporate behaviour. Enron is a case in point (Partnoy 2003: 301 et seq.). Enron lived on its traders' ability to borrow money and this in turn depended on the ratings accorded by the agencies. On 28 November they downgraded its debt below investment grade. Enron was virtually dead, and filed for bankruptcy on 2 December. This is not to place blame or praise on the banks involved, such as JP Morgan Chase and Citigroup, but simply to note their importance to the construction of the Enron edifice and the apparent disinterest in its governance. # (p. 257 ) The Public Company Accounting Oversight Board (PCAOB) Title 1 of SOX set up the PCAOB, whose function is described in section 101 as being ‘to oversee the audit of public companies that are subject to the securities laws…in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for public investors’. Its main function is the control part of the accounting profession—which involves registering accounting firms that ‘prepare audit reports for issuers in accordance with section 102’. It has the right to examine them, can fine them or even shut them down. It sets standards. By September of 2004 it had a staff of 237—scheduled to rise to 300. Titles VIII, IX, and XI of SOX deal with fraud and introduce severe penalties for destroying ‘audit and review work papers’. The PCAOB must adopt a standard of registered accounting firms to maintain audit working papers. They must be maintained for at least five years. The destruction of documents in a federal or bankruptcy investigation is made a felony with a maximum twenty years' sentence. The limitation for the discovery of fraud is extended to two years after the act and five years after discovery. The PCAOB moved swiftly into action. On 26 August 2004 it published its reports on 2003 Limited Inspections of four major accounting firms. Before doing so it records that by the time of the Release 1271 firms had registered with the board. Its overview was as follows: In 2003, the Public Company Accounting Oversight Board conducted inspections of public accounting firms for the first time. The Board inaugurated its inspection program with limited inspections of the four largest U.S. public accounting firms, including Ernst & Young LLP, the subject of this report. (There followed Reports on Limited Inspections of Deloitte and Touche LLP, KPMG LLP, and Price WaterhouseCoopers LLP.) In those inspections, the Board identified significant audit and accounting issues that were missed by the firms, and identified concerns about significant aspects of each firm's quality controls systems. The Board's inspection reports describe those issues. Each report refers to some ‘nonpublic’ pages ie matters the PCAOB chose not to reveal. Because Board inspections and inspection reports are new, however, the Board offers a few remarks by way of providing readers with a context for the observations described in this report. The Board's statutorily prescribed mission is to oversee auditors of public companies in order to protect the interests of investors and to further the public interest in the preparation of informative, fair, and independent audit reports. To advance that mission, Board inspections take up the basic task that had been the province of (p. 258 ) the accounting profession's peer review system, but Board inspections do not duplicate the programs and approach of peer review. Board inspections do, of course, examine technical compliance with professional accounting and auditing standards, but Board inspections also examine the business context in which audits are performed, and the ways in which that context influences firm audit practices. Among other things, the Board looks at firm culture, the relationships between a firm's audit practice and its other practices, and the relationship between a firm's national office and its engagement personnel in field and affiliate offices. Through this approach, the Board believes that it can help bring about constructive change in the types of practices that contributed to the most serious financial reporting and auditing failures of the last few years. Toward that end, an essential ingredient of the Board inspection process is an unflinching candor with firms about the points on which we see a need for improvement. That emphasis may often result in inspection reports that appear to be laden with criticism of a firm's policies, practices, and audit performance, and less concerned with a recitation of a firm's strengths. That is because, from the Board's perspective, the inspection reports are not intended to serve as balanced report cards, rating tools, or potential marketing aids for any firm. The reports are intended principally to focus our inspection-related dialogue with a firm on those areas where improvement is either required for compliance with relevant standards and rules, or is likely to enhance the quality of the firm's audit practice. The reports' emphasis on these criticisms, however, should not be understood to reflect any broad negative assessment. The four firms inspected in 2003 are made up of thousands of audit professionals, have developed multiple volumes of quality control policies, and perform audits for a combined total of more than 10,000 public companies. It would be a mistake to construe the Board's 2003 inspection findings as suggesting that any of these firms is incapable of providing high quality audit services. Moreover, the Board does not doubt that the bulk of the firm's audit professionals consists of skilful and dedicated accountants who strive—at times against the competing priorities of the large and complex business of the firms—to make audit quality their top priority. The Board is encouraged by the increasing tendency of persons at the highest levels of the firms to speak of the need for a renewed commitment to audit quality as the firm's top priority. The Board is also encouraged by the firms' recognition of the value of the Board's inspection process. The Board will continue to use its inspection authority to focus the firms on aspects of their practice that may stand as an impediment to the highest quality audit performance. The final standard for audits of internal control, adopted by the board on 9 March 2004, incorporated certain suggested changes and reflected certain basic principles on which the board members agreed: • Audit quality would be best improved in integrating the auditor's examination of internal control into the audit of a company's financial statements. (p. 259 ) • The costs of an audit of internal control must be reasonable, particularly for small and medium sized companies. • Outside auditors may rely on the work of internal auditors and others, based on their competency and objectivity • An assessment of the effectiveness of a company's audit committee is a vital part of an audit of internal control and consistent with existing standards. The by-laws and rules of the PCAOB as of 8 September 2004 deal with the question at some length (p. 140 et seq.) under the rubric ‘Auditor's Objective in an Audit of Internal Control Over Financial Reporting’. The firm of Arthur Andersen doubtless merited severe treatment after the behaviour of some of its partners, but the total destruction of one of the big five, which had wide international coverage, has in the opinion of many left the cupboard unhelpfully bare—as can be seen when investigating accountants are needed and conflicts of interest can become difficult to avoid. # Shareholders It is perhaps a sign of the times that one of the longest sections of this report is devoted to shareholders. For half a century commentators accepted the famous analysis by Berle and Means (1932) that the fragmentation of holdings had deprived shareholders of influence and power (in contrast to earlier days when proprietors retained enough stock to exercise both). The emergence of organizations which administer collective savings is gradually changing the picture, but there are many angles and complications, as we shall see. Before turning to the role, if any, of shareholders in corporate governance, we take in order: • the form in which shares are held; • annual meetings and the voting process; • shareholders' duties; • shareholders' diminishing rights; • who owns what. It is widely appreciated that the USA has what Michael Jacobs dubbed a ‘Board Centred’ model (1991). Evidence suggests, however, that boards are not always self-correcting and self-renewing and that the takeover market is not always the right remedy for persisting deficiencies. Attention has therefore properly focused on shareholders in respect of the role they were originally designed to play—to ensure that the stewardship of their assets remained up to the mark, not by double-guessing management decisions, but by their interest in the composition of the board. ## (p. 260 ) The form in which shares are held American shares are issued in registered form. Many are held by brokers in nominee names (‘street names’). In fact, 70% of all corporate stock was held in street name (by 1987), of which 30% was held in broker name and 70% in bank nominee name. The reasons for such arrangements vary from pure convenience to deliberate obfuscation. Arbs (Arbitrageurs) conceal; pension funds are held in trust. Whatever the cause the result is to complicate the process of voting proxies. There is no need in this chapter to examine all its intricacies, but the curious sounding ‘NOBO’ rules may be cited as an example. These were introduced by the SEC in 1985, requiring brokers to tell issuers the names, addresses, and security position of shareholders who do not object (Non-Objecting Beneficial Owners). Some shares are held as American Depository Receipts (ADRs). For many years the New York Stock Exchange refused to list common stock of companies which had unequal voting rights (the ‘one share, one vote’ rule). Some major companies challenged this rule and the implied (or explicit) threat of their moving to another exchange put the NYSE under severe pressure. The SEC sought to standardize the one share, one vote rule for all quoted companies by adopting Rule 19C-4 in 1985, but the Court of Appeals for the District of Columbia ruled that this was beyond the SEC's authority. US companies often have other kinds of share in issue and many debt instruments. This chapter is concerned mainly with ordinary shares (‘common stock’), because residual ownership attaches to them which provides their owners with potential influence on corporate governance. The issue of whether holders of senior securities should be enfranchised and if so to what extent lies outside its scope. ## Annual meetings and the voting process: corporate democracy in action As in most other countries the real business is not generally fought out at an AGM. J. K. Galbraith opined that ‘The Annual Meeting of the large American corporation is perhaps our most elaborate exercise in popular illusion’ (Galbraith 1967). But its very existence does produce certain consequences. State law usually requires publicly held companies to convene a shareholders' meeting annually. The NYSE expects companies to make certain that at least a majority of the outstanding shares are voted (to ensure a representative vote), and this has resulted in the appearance of proxy solicitors whose task inter alia is to help companies ensure that meetings are quorate and to afford shareholders a convenient method of voting. The SEC requires companies to send search cards to brokers twenty days before the record date so (p. 261 ) that brokers can tell them how many sets of proxy materials they will need for distribution together with the annual report, which has to be made public not more than three months after the end of the financial year. The proxy voting system in the USA is a more important part of the governance process than in any of the other countries studied. In the UK, which is closest to the USA in style and approach, proxy contests rarely occur. As far back as 1934, the SEC was given powers to regulate proxies (the Securities Exchange Act), and its extensive rules cover both the process and content of proxy solicitations. Schedule 14B, for instance, lays down the information which must be given about candidates in a directors' contest. More importantly, the SEC was permitted to vet all proxy materials before they are mailed and insists on wide disclosure about those concerned, costs, and the issues. There is a good account of the whole subject, with cases, in a booklet by R. E. Schrager (1986), which noted: ‘In any given fight, each side spends enormous amounts of time, effort and money, conveying its message to shareholders.…Both managements and dissidents retain a supporting cast of lawyers, investment bankers, and proxy solicitors…and often hire public relations specialists.’ Unless shareholders come under the ERISA legislation (which broadly speaking covers pension funds in the private sector), they do not have to vote. If they choose not to, management may vote the proxies provided that it has indicated how it intends to cast its votes and the shareholder has signed and returned the proxy and ‘marked the boxes’ in regard to specific items. If a properly signed proxy is returned without an indication of how to cast the vote, management can choose how to do so. Shareholders can use the proxy system negatively, that is, they can resist management's proposals. They can also launch competing proposals of their own—including candidates for the board. Indeed, this is a way of getting control of a company without a takeover bid. Some candidates put themselves forward on a platform of putting the company up for sale or liquidating it. We noted earlier that the SEC is considering a rule change to make it easier to access the proxy statement and make nominations for the board. Shareholders' access to the proxy statement is limited via an SEC rule that confines shareholder proposals to matters that are not ‘ordinary business’. Until recently it was impossible to raise the issue of excessive executive compensation, for instance (the SEC is in the process of changing this prohibition). Shareholder proposals are in any case generally ‘precatory’, that is, they do not bind management, though it does appear that management often heeds and acts on shareholder proposals that are passed, or might pass, even though there is no formal legal requirement for them to do so. Until recently proposals tended to be on politico/social issues like the (p. 262 ) environment and South Africa. There were twenty-one resolutions on Northern Ireland in 1990 (the New York Comptroller's Office was the most active in leading them). It must be irritating for the board to find general meetings raking over such issues, but they have the consolation of knowing they pre-empt the time and attention that might more fruitfully be spent on governance issues. The 1980s saw proxy contests become more prominent (but not more numerous), and they were used from time to time as a cheap way of getting control of the board. The data on this type of proxy contest for the twenty years till 1977 show that about twenty-five contests occurred annually and that the dissidents were successful in getting full control in 15% of cases or partial control in 32%: a rate of between twenty and twenty-five contests per annum is thought to have continued well into the 1980s. In 1983, for instance, there were twenty-five such contests, of which eleven were for full and four for partial control. Management won in 36% of the cases and the dissidents in 40%, an unusually high proportion. Proxy contests were also used in conjunction with a tender offer in an attempted takeover to put management on the defensive (e.g. AT&T/NCR), or were coupled with other takeover tactics, like ‘putting a company into play’: that is, the dissidents' purpose was to force up the share price by attracting bids or restructuring. From the beginning the Annual General Meeting was the only regular appointment for all shareholders to face the directors (if they had all turned up in a big company it would have needed a baseball stadium). In keeping with national attitudes it was structured to be confrontational. It was moreover the only regular occasion on which resolutions could be launched at management. This battlefield is still visible in the landscape but nowadays major shareholders and companies find that dialogue out of the limelight is more constructive. This is for instance the stance taken by TIAA-CREF, the largest institutional investor. The preliminary report by ISS (Institutional Shareholders Services) on the 2004 season is titled A Law Corporate Governance World: From Conflict to Constructive Dialogue’. That does not mean the disappearance of shareholder resolutions—far from it: ISS reported that boards moved to implement more than 70 majority votes on previous shareholder resolutions. More than 40 companies took action on their poison pills while 50 moved to introduce the annual election of directors. ‘Vote-no’ campaigns became more frequent and pushed some companies into adopting governance reforms. Other companies kept ahead of the game by introducing changes—like the appointment of independent lead directors with real authority at Boise Cascade and General Electric Co. ‘Withhold’ (p. 263 ) votes on the re-election of directors reached new heights—in the Federated Department stores case it was more than 50%, and promptly ignored! We may reasonably conclude that increasing and more effective shareholder activity, publicly or privately conducted, is part of the much wider movement towards improved accountability. ## Shareholders' duties In most countries shareholders have no duties once they have subscribed for their shares or bought them in the market. If they own the shares beneficially they may vote eccentrically or not at all. If they hold them as trustees they may still throw the papers away, and in the UK over 80 per cent of all holders routinely do so. In the USA the Labor Department requires the trustees of corporate pension plans which fall under the ERISA legislation (which covers most of them) to vote their shares or see that investment managers do so. Trustees must monitor their managers to make sure they comply; unless the trustees specifically reserve the voting rights for themselves the managers must vote. What is more, the votes must be cast in the interests of the beneficiaries. ## Shareholders' diminishing rights Shareholders' rights vary according to state statute, but usually include the right to elect directors as is general practice, as a slate not individually. The NYSE Listed Company Manual ensures a degree of uniformity and covers the frequency of reporting (§203). Most US public companies publish their results quarterly. They are not obliged to send copies to shareholders (except for the annual results), but usually do so. Shareholders can bring a class action against the directors on behalf of all the shareholders (or those who bought or sold stock during a specified period). Alternatively they can bring a derivative suit—that is, they purport to sue on behalf of the company, which gets any ensuing benefits. Under Delaware law they generally need the board's consent to do this if it has a majority of disinterested directors—who can refuse if it is acting in accordance with the business judgement rule. If there is no such majority or if the action is not protected by the business judgement rule—for example, alleged waste of corporate assets—they do not need the board's permission to sue. If they win or settle the court may require the company to reimburse their costs where the action conferred a ‘specific and substantial benefit’ upon the company; but they may well fail, because when they reach the substantive issues they may butt up against the business judgement rule which is (p. 264 ) designed to let directors run businesses without having to worry about shareholders with the benefit of hindsight suing them for mistakes. The waves of takeovers during the 1970s and 1980s were only possible because control could so easily be acquired through open purchases in the stock market (without even having to offer to buy more than a bare majority of shares). There were no protective banks or interlocking shareholdings to stand in the way as there are in other countries; the NYSE had long insisted on ‘one share, one vote’; finance became even easier to raise; and accounts (which had to be produced quarterly) lacked that enveloping opacity that shrouds companies' assets in some other regimes. As this is so, incumbent management sought to protect its own position, partly from a genuine desire not to see its life work broken on the wheel of financial opportunism and a belief that they knew better than the shareholders how to protect their interests, partly from personal fear, greed, and love of power. To achieve their ends management was obliged to seek shareholders' permission to limit or reduce their power: and shareholders often gave it. The courts, however, generally permitted management to introduce poison pills without consulting their shareholders first. The whole issue of poison pills is covered below pp. 227 and 228. The SEC in its laudable aim to regulate the flow of information has in some cases made it far more difficult for the shareholders to monitor a company and take effective action to correct poor management. When it comes to proxy battles, management holds all the money and most of the cards: it may even reduce the board and make access to shareholders' names and addresses difficult or hideously expensive. Various state legislatures have moved to protect their own, for example, Boeing by Washington; Norton by Massachusetts; and Armstrong World by Pennsylvania. We shall consider this further in the section on takeovers: the point here is that the protection of management led inexorably to a diminution of shareholder rights. And they may be further threatened by states introducing ‘other constituency’ provisions. These provisions have muddied the waters by permitting directors to consider the interests of other constituents than the shareholders—which can provide a convenient excuse for putting their own interests first. An incompetent management that does not wish to be dislodged can argue that it was resisting a bid which would have been to the shareholders' advantage on the grounds that other interests would not have benefited or had been harmed by it. In the long run shareholders can only prosper if all the other main interests—customers, employees, and creditors—have been satisfied first, but there is no excuse for (p. 265 ) neglecting the shareholders' interests and thus removing one of their effective means of redress. Of course shareholders still retain their right to sell in the market, but if they see a board quite clearly underperforming or milking the company remorselessly, they cannot easily change its composition and they may not even get a chance to accept the offer if a bidder appears. The price of protecting good management from the depredations of the takeover artists has been to bring the mediocre within the corral and disarm the shareholders. One kind of shareholder has been singled out by law for special attention—mutual funds. In the 1930s some began to act as monitoring intermediaries, but the 1936 Tax Act and the 1940 Investment Company Act forced them to stop. There were many contributing reasons but the main one was the general suspicion of the financial sector and the fear of its power over industry. American public opinion has always been mistrustful of accumulation of economic power and feels safer when it is fragmented. Recently however, new SEC regulations were issued requiring mutual funds to disclose their proxy voting policies and actual proxy votes. One of the reasons given for the new regulations was to motivate funds to be more active as corporate shareholders. SOX plus the NYSE rules are intended to boost shareholder confidence by ensuring greater transparency in SEC filing and in the report and accounts. There will have to be for instance an expanded MD&A disclosure. There will also have to be detailed discussion of critical accounting policies, off balance sheet transactions, and certain contingent obligations. ‘Proformas’ must be accompanied by more disclosure, including a discussion of what a closely related GAAP measure would be. The practical effect of these additional requirements will be to discourage the use of pro-forma information. Rules are being formulated to improve the information available to shareholders, for instance corporate governance guidelines, and the committees' terms of reference. Across the board a great deal of additional information will now become available to shareholders one way or another. The CEO and CFO will have to certify that the company's financial statements are accurate and that internal controls are effective. If moreover a company is required to restate its financials because reporting requirements have not been met in a material way, management will forfeit any bonus or equity compensation. They in turn will demand comfort from the independent auditor and legal counsel. What this means in practice is that management will have to satisfy the board about the internal control structure, financial reporting, and (p. 266 ) compliance. The SEC advises that a special committee should monitor disclosures as well as the audit committee. A company's form 10-K will in the future include a report on internal control. All this is designed not only to improve transparency as between company and shareholder, but also to satisfy shareholders that appropriate checks and balances are in place. Does all this mean that shareholder activism will be unnecessary? Unfortunately not. Flawless and honest governance is one thing and sheer commercial competence another. As always, shareholders will need to concentrate on this issue above all else. ## Shareholders: who owns what? According to Proshare's 2003 share ownership handbook, drawing on the ICI/ISA share ownership survey, 49% of all households had some type of equity—i.e. 52.7 million—and these had 84.3 million individual investors. Private shareholders and not-for-profit organizations held 36.7% of US equities in all, down from 50.7% in 1990. Many are totally passive; they are generally viewed as supportive of management, with good reason. They do not have to vote their proxies and management can usually do it for them. Institutional investors, mainly pension funds, private, state and local, mutual funds, insurance companies, etc. have the lion's share of the rest, that is 46.1% of the equity market in 2002. This compares with 38% in 1981 and 53.3% in the 1990s. The breakdown is as follows:  Private pension funds 12.9% State and local pension funds 8.5% Mutual funds 18.3% Life insurance companies 6.4% According to the flow of funds accounts published by the Federal Reserve, institutional shareholders held 48% by the third quarter of 2003, with mutual funds at 21%. Foreign holdings now account for 10.9%—up from 6.9% in 1990. Some of the Management Buy-Out (MBO) funds perform the role of monitoring shareholders. There have recently been examples of funds being set up (like the LENS fund) with the avowed purpose of taking a large enough stake in underperforming business to influence management and secure improved performance. ## (p. 267 ) The role of individual shareholders Except for the mega-rich or the proprietor who retains a substantial proportion of the stock, the situation is still as Berle and Means (1932) described it. Even if they had the knowledge and motivation (which would be rare), individual shareholders would be faced with the problem that for them to be active would mean incurring a private cost for a public benefit. Others would stand aside, do nothing and yet reap benefits; this is called the ‘free rider’ problem. The only way the private shareholder can act economically is in concert with others. Of course, individual shareholders can perfectly well support the initiatives of others and this means the institutions. It is to their position we now turn. ## The role of the institutions: the relationship between investment policy and corporate governance It is quite wrong to suppose that anyone concerned with institutional investment wakes up in the morning with corporate governance in their mind as the determining issue in choice of manager, portfolio strategy, or stocks. What they want of course is profitable investment, and the traditional way of achieving it is through straightforward market operations. If a stock disappoints one sells (exit). This is the so-called Wall Street Walk. In principle institutional shareholders face the same basic choices as private ones, with one exception—their fiduciary duties prevent their taking certain kinds of risk. The US private shareholder may put all his money into a handful of local companies and stick to them through thick and thin. The institutional shareholder must to some extent spread risk and this has led to a somewhat indiscriminate acceptance of the principle of massive diversification, in which the golden rule seems to be ‘Nothing succeeds like excess.’ It is not restricted by the capacity to understand; one public pension fund has, for instance, 1,400 stocks and does more than 8,000 stock transactions a year. How far to diversify is a matter of policy and we know from O'Barr & Conley's (1992) study that the choice of policy depends more on ‘inheritance’ than on objective and deliberate selection. Fund managers tend to stick with their predecessors' policy (not necessarily with the actual stock selection) . There seem to be five choices: 1. 1. A passive portfolio (see ‘index’ funds below). 2. 2. An actively managed heavily diversified portfolio. 3. 3. A concentrated portfolio. 4. 4. A ‘target’ fund. 5. 5. Hedge funds. (p. 268 ) Portfolio managers may choose any of them or indeed a combination of all of them. Each affects an institution's potential or actual role in corporate governance. It seems gradually to be appreciated by owners or trustees that for fund managers (who are acting at one or two removes for beneficiaries) to over-diversify is neither helpful to the beneficiaries nor to the prospect of developing an interest in corporate governance. Coupled with heavy trading, it is costly and incompetent. The cost of trades shaves off the beneficiaries' capital; Lowenstein estimates that in 1987$25 billion was spent in trading stocks, an amount equivalent to one-sixth of corporate profits and 40 per cent of all dividends paid out that year. What they trade is largely an unknown quantity, since they lack the resources to study the underlying companies in depth.

Lowenstein had not changed his tune in 2004; writing in Barron's on 11 October he pointed out that ten well-regarded value funds had handsomely beaten the market between 1999 and 2003 with average annual returns of 10–80% against the S&P 500–0.57%. This group held their shares for an average of five years; the average holding period of a domestic equity fund is apparently ten months. To run a value fund means holding one's nerve during parts of the cycle which others appear to be doing better.

## Index funds

Even a big fund will only hold a small proportion of the equity of any given firm. This would suggest non-intervention on the ‘free rider’ principle—a fund would bear the cost and hassle and the benefits would go to others. But there is another way of looking at it. An index fund is locked in—the investor cannot sell even when bad things are happening to a company. It can therefore be correct to say ‘if you cannot sell, you must care’. In other words institutions cannot just turn a blind eye but should take action.

Index funds started about twenty years ago and were the first investment product of the ‘basket’ variety. Many are based on the S&P 500—the ‘plain vanilla’ index (which comprises 400 industrials, 40 utilities, 20 transportation companies, and 40 financial institutions; 474 of the shares are listed in the NYSE). This index is capitalization weighted.

There are many indices. They vary from the NASDAQ composite containing 4,000+ companies (though it is unclear whether any funds attempt to track it) to the WILSHIRE 5000 total market index which includes 6,500+ companies. Some funds do track it, but they tend to be expensive. At the other end of the spectrum there are funds that track the thirty companies that comprise the Dow Jones Industrial Average.

(p. 269 ) The growth of index funds is dramatic. The Columbia Project research shows that $342 billion of assets were so managed in May 1991 (up 25.8% from December 1990) by the top fifty-three money managers: the top fifteen managers manage about$300 billion out of the total $342 billion, and nearly$100 billion was in the hands of the biggest, Wells Fargo Nikko Investment Advisers.

The annual survey of assets linked directly to all the Standard & Poor indices (S&P) showed that at the end of 2003 there had been a 36% rise over the twelve-month period to $1.2 trillion. Of this$1.1 trillion was based on the S&P 500. In 1983 the figure had been $44 billion. ## Actively managed heavily diversified portfolio Much the same considerations apply as the index funds, except that fund managers have the option of selling if they feel the company's performance warrants it. Even so, whilst they remain shareholders they will come under increasing pressure to vote; and if they fall within the scope of the ERISA law they must do so. If funds continue to diversify, as they now do, beyond the range of both knowledge and resources, they are unlikely to have enough of either to play a part in corporate governance even if they wished to do so. In fact they are content not to bother as their eyes are firmly set on the criteria by which they are judged. They are not judged on their effectiveness in corporate governance matters—a different world from the league tables of performance which overhang them like the sword of Damocles. No wonder so many funds simply replicate in their portfolios the firms that constitute a particular index, in the proportion in which the index is itself calculated: the managers do it in self-defence. They know that otherwise three-quarters of them will in any year underperform the index. ## A target fund The difference between a concentrated portfolio and a target fund is one of intention. In the former the investment is made because of a company's perceived potential and present competence. In the latter present performance is deemed to be below potential and the objective is to get management in place better qualified to produce results. RAG Monks's Lens fund was an example of this as is the Hermes Lens Fund in the UK. ## (p. 270 ) A concentrated portfolio There is available to the institutional investor, within the law, a totally different strategy—concentration, that is, buying more of fewer stocks and holding them. The ultimate example of this kind of fund is Warren Buffett's Berkshire Hathaway Corporation. The principles behind it are, first, not to invest in a company until you thoroughly understand it—including its strategy; to have a big enough holding for it to matter to you, and to them; and to maintain good contact with the company to ensure the board's stewardship is up to the mark—think long and trade little. The size of the holding must vary with the size of the company and the size of the fund, so the number of different shares in the portfolio will depend on both. Lowenstein (1991) calls concentration ‘Patience and Selectivity’. Concentration incidentally does not mean putting all one's eggs in one basket. Twenty to forty stocks would be enough (in the views of some) for all but the biggest funds, where the resultant holding would constitute too large a chunk of the equity of all but the biggest companies (see Lowenstein supra p268). Clearly a portfolio of this kind is much more likely to lead to closer relations between shareholders and companies and it usually does. Such funds, over time, often seem to do well. ## Shareholder activity The above analysis shows how differing policies produce different pressures and opportunities. The shareholders' role has always been a ‘longstop’ one— there was never any need for them to intervene whilst present performance and future prospects were satisfactory. Boards resent encroachment—for instance, the 1992 revision of the SEC rules to make communication easier between shareholders who are not bent on acquiring control. The modest changes were notable for the vigour with which the conflicting arguments were pressed. ‘Leave us alone and keep off our backs,’ said management, ‘or you will inhibit our risk taking—and what do you know about our business anyway; you're just market gamblers.’ ‘We own you,’ respond the shareholders, ‘and as good Americans we believe in accountability. If you aren't accountable to us, where else is there? We don't want to run your business but we have a right to feel that the stewardship of our assets is in good hands.’ This indeed is the crux of the US dilemma—a dislike of concentrations of power (in this case in the hands of the institutions), versus a respect for effective accountability. The conflict is nicely poised. (p. 271 ) One of the problems with shareholders' activism is that, like the old English legal adage ‘He who comes to Equity must come with clean hands’, those of some institutions do not. Federal Reserve Board Governor Susan Schmidt Bies, speaking in February 2004 at the Economic Club of Memphis, Tennessee, weighed in on a whole series of issues from inadequate disclosure to ‘directed brokerage’, ‘soft dollars’, ‘market timing’, and inadequate internal management. In short, the corporate governance of some mutual funds is itself suspect. But progress is on the way: on 31 August 2004 mutual funds reported for the first time on how they had used their proxy votes; what that shows is a wide variety of activity. Indeed the propensity to vote was inverse to the size of net assets (see Table 5.2). Some public pension funds were the most proactive of all the US institutional groups. Some had no taste for it, others feared political interference, because the businesses they might wish to reproach may well have the ears of their political masters as contributors to campaign funds. ‘Mr Governor, we have been generous contributors to your campaign funds—get your pension fund off my back.’ In any case, the Columbia project research showed that in 1990 the public pension funds controlled only 8.3% of equities. Most private pension funds—which have as we have seen a legal obligation to vote—have parallel fears, of upsetting suppliers or customers, or even simply because of an unspoken non-aggression pact: ‘You don't vote against my company and I won't vote against yours.’ It is commonly argued that money managers are totally preoccupied with their place in the league tables, measuring their performance against that of competitors. This is true, but we should not draw the inference from it that dismissal waits round the corner. In 1989, 32 out of 427 were terminated with an average of 7.6 years' service (cf. 1987, 8.7 years). The fact is that fund managers often build up good personal relationships with those who hire them, and will be given the benefit of the doubt for a long time (‘he's going Table 5.2. Size and voting records of institutions Size of fund (US$m.)

Voting score (%)

Fidelity

513

25

American Funds

393

50

Vanguard

355

75

Franklin Templeton

100

45

Janus

72

71

Oppenheimer

56

70

American Century

55

100

(p. 272 ) through a bad patch’). This is so, although there is now a powerful new consultancy profession whose members help trustees pick fund managers— another manifestation of the pervasive tendency to diffuse responsibility in the face of possible litigation. In short, fund managers are not prevented by fear of dismissal from taking an interest in corporate governance. They simply do not feel they are paid to do it; are not measured by their success in it; and lack the skill and resources they would need to do it properly. Vote they must if they are managing funds covered by the ERISA legislation and the trustees order it, and they must follow whatever guidelines they are given. But that does not make them care. ‘They vote woodenly,’ as one commentator said of a big index fund manager.

Money managers and even banks' trustee departments also come under pressure. They can find themselves with a conflict of interest. The Investor Responsibility Research Center knows how widely attempts at persuasion occur. The answer often suggested is for voting to be confidential, but this is widely opposed by some business groups precisely because it is likely to be effective. Proxy solicitors oppose it as it weakens their position; and there are certain technical problems.

Apart from the strenuous efforts of a handful of public sector pension funds and the work of some representative organizations, there are few signs of shareholder activism. On rare occasions a public-spirited private shareholder (with sufficient means) enters the lists. A notable example a decade ago was Robert Monks, who founded Institutional Shareholder Services in Washington DC after a successful career in industry and the Administration. Among his more spectacular forays was a tilt at the board of Sears, a company whose results had been mediocre for some time. He failed to win a seat on the board, but his attempt hassled the company into defensive actions of a questionable nature and certainly drew the attention of the investing community to the alleged shortcomings of the board. It may have been pure coincidence, but the company made some radical structural changes not very long afterwards.

As we noted above, focus funds present a more direct challenge; there seems little doubt that US management is angry at the hint of greater shareholder activism and perhaps a little frightened, judging by the vigour of its reaction. They would argue that the temporary holders of share certificates bought as mere counters for trading purposes are not and cannot be true owners in any real sense of the word. But this argument would not apply to any shareholders or group of shareholders who deliberately set out to implement the alternative strategy—concentration rather than diversity, holding rather than selling, meaningful stakes rather than penny numbers, knowledge and loyalty rather than ignorance and unconcern. With such a policy which emphasizes ‘voice’ as a useful alternative to ‘exit’ goes a natural (p. 273 ) desire to reduce the legal constraints which now impede it, particularly as joint action by shareholders may on rare occasions be desirable. There are indeed already straws in the wind. Some big funds do intend to concentrate their portfolios. And ‘concentrated’ funds have been established as a vehicle for a number of investors (private or institutional) to get together so that the sums they put into any one company require attention and interest by all the parties.

The changes in the law and NYSE rules that followed Enron have increased the potential oversight role of the shareholder:

• They will approve equity compensation plans.

• They will review more closely the voting history and procedures of registered investment companies through which they won shares.

The changes are more profound than this however. It may well be that there will be more attempts to make board nominations by access to their companies' proxy statements and, if necessary, to make proposals to change the companies' by-laws to facilitate this, if supported by a qualifying proportion of outstanding shares. The SEC has indicated that it may change the proxy rules to provide such shareholder access. How far this will go remains to be seen. Many resent the managerial abuses (and sometimes crimes) that resulted in a wave of scandals, but others are concerned that there should be a sense of proportion. Most of American management is able and honest and needs no new shackles. The debate has a long way to run. In essence it is about the balance between enterprise and accountability. Shortage of the former leads to stagnation. Shortage of the latter leads to incompetence or fraud or both.

# The Stock Market

The New York Stock Exchange (‘The Big Board’) is the dominant institution; NASDAQ is also important but it tends to cater for smaller, newer high-tech companies—some of which graduate to the NYSE each year (in 2002, 36 did so).

There were 2,746 companies listed in the NYSE in August 2004, of which 59 had been added during the previous twelve months. Of this total 451 were non-US companies; 351 were quoted in ADR form. At August 2004 the market capitalization of domestic companies quoted on the NYSE was $11.5 trillion (compared with NASDAQ$2.7 trillion, Tokyo $3.2 trillion, and London$2.4 trillion). In the year 2000 it processed 300,000 orders a day. The daily value of trades for 2003 was $38.5 billion. In the year to 31 August 2004 there were 73 domestic IPOs (initial public offerings) which raised$30.9 billion.

(p. 274 ) This bunch of statistics from recent years is intended merely to give a sense of scale to the operation of the greatest capital market in the world. Furthermore US investors in 2001 held about $1,550 billion dollars of non-US equities, up from a mere$60 billion in 1987 (source: Federal Reserve Board Flow of Funds). As noted above, the NYSE trades extensively in non-US companies. At 31 August 2004 their market cap stood at $5.9 billion. IPOs raised$5.8 billion. The NYSE states that if the foreign equities was a stand-alone market it would be bigger than any outside the USA.

As noted earlier, Lowenstein estimates that as far back as 1987 the total cost of commissions and other trading expenses exceeded $25 billion—more than one-sixth of corporate earnings that year. Unfortunately high turnover does not guarantee that liquidity will be maintained in times of financial disruption. Less than 1% of the total float was traded on Black Monday (19 October 1987), that is,$21 billion, but the Dow fell over 500 points.

No analyst or stockbroker ever made a cent in the short term by advising clients to ‘hold’ even if that was the best advice (in the long term their honesty might well produce rewards). Action is the name of the game, with every morsel of information used to titillate clients' palates. The US trading machine is greased by soft dollars, that is, a rebate on commissions paid to a fund manager by the broker in the form of services of various kinds. The subject is shrouded in secrecy and the fund managers' employers often do not know, or shut their eyes; published guesses are that the soft dollar business is worth $1 billion per annum and involves a third of all institutional brokerage business. The practice encourages churning, but those who benefit of course defend it, and it is not illegal. The SEC published a release indicating permissible limits and investment managers who do it or intend to do it must make disclosure. The tidal wave of governance reform has not spared the NYSE itself. Speaking on 23 September 2004 the CEO John Thain spotlighted these changes: • The board is much smaller (about 11 as against 27) and is now independent, barring the CEO. • The role of the chairman has been separated from that of the CEO. • The regulatory function is being separated from that of ordinary business. • The creation of a board of executives, which meets in the same day as the main board, but separately. There was a very public and unedifying row about the terms on which Richard Grasso, the previous CEO, departed. ## (p. 275 ) Hedge funds I used to regard hedge funds as a sort of glorified and ‘scientific’ betting shop with sophisticated techniques and an armoury of jargon with no relationship whatsoever to the companies whose shares they were buying or selling (or indeed with the commodities in which they were trading). Like all gambling institutions those who run them benefit most. Investors in them are interested in ‘absolute returns’, not the state of the market and certainly not in any of the underlying securities being dealt in. The degree of sophistication of these funds is often as formidable as their jargon is impenetrable, but even having Nobel Laureates among the advisers is no guarantee of success as the case of Long-Term Capital Management demonstrated. Hedge funds are significant, indirectly, to governance issues, simply because ‘shorting’ in the market will tend to depress the share price and thus send a signal to the board. They may not wish to heed the signal, but that is another matter. As these funds grow and a greater proportion of shares floats around in various forms (and is often borrowed) one does begin to wonder about the point at which the fundamental principles of accountability may be vitiated. ## Private equity firms The Wall Street Journal of 10–12 September 2004 led on page M1 with the headline ‘For sale again and again and…’. It cited the case of the Simmons bedding company, which has changed, hands six times since October 1986. The emergency of private equity firms has intensified a process that was always in evidence to some extent as companies grew and investors wanted a share of the action. For those who engineer these deals it is a lucrative process; for the principals there is the prospect of profitable exit in due course. Their relevance to corporate governance is the dividing line between quoted and unquoted companies. The regime governing the latter is less demanding. There may be cases where a board is attracted by this prospect, but it is unlikely to be the prime determinant of a decision to ‘go private’. There is however an associated problem about conflict of interest if the management of a company that is being bought by a private equity firm intends to continue to run it; it has an incentive to ensure that the terms of the purchase are not too demanding. The existing shareholders on the other hand want the highest price possible. There are some fears that the sheer success of the movement may lead to excess. In the words of the article quoted, a venture bubble may be starting. Bubbles are a concomitant of free markets, but they hurt when they burst. In (p. 276 ) Acquisition Monthly of November 2004 the writer said (in the UK) that these funds were ‘over financed, over competitive and over here’. The top nine already had £160 billion under management. # Takeovers As we have seen, control of a US company can pass by replacing enough of the board through the proxy process, but the more usual route is by acquiring a majority of the votes through a tender offer. There is no equivalent to the UK's Takeover Panel to police the process, though the SEC imposes certain requirements and constraints; for example, the secret accumulation of stakes is regulated by Section 13 (d)(1) of the Exchange Act, which requires beneficial owners to make a Schedule 13D filing with the SEC within ten days of crossing the 5% threshold, and give full details of their identity and intentions. Changes of more than 1% thereafter or of intentions must be promptly notified; but bigger stakes can legally be accumulated during the so-called ‘10-day window’. In the Norlin case (1984), a 37% stake had been accumulated before the notification date. Since then the introduction of poison pills has made it difficult to accumulate a large stake in the open market. Contested bids, or as Americans call them, ‘hostile takeovers’, first became common in the 1960s. They were, and are, an invitation to shareholders to accept an offer, whether or not the board recommended it. At first they were welcomed as an instrument for sharpening or replacing poor management, and their increasing numbers put corporate America on notice that management could not disregard shareholders' interests (for instance, by building up cash mountains whilst being mean with dividends). Naturally management did its best to persuade shareholders to refuse an offer, blandishing them with stock splits, raised dividends, and optimistic news. The tender offer was for control, not necessarily for total ownership. There used to be no US requirement that such an offer must extend to all the shareholders. Viewed in that light they were a step forward from proxy contests, which do not necessarily imply any shares changing hands. Incidentally, unequal treatment for shareholders took various forms. It might mean paying a lower price to the minority shareholders after control had changed, or depressing the stock price by cutting the dividend or by other means. It could mean paying a premium to a predator for the stake he had accumulated (greenmail), or it could mean freezing the predator out by paying a premium for everyone else's shares (the Lollipop defence used in 1985 by UNOCAL against T. Boone Pickens). Fairness, it appears, is at a (p. 277 ) discount, but less than in those days. The SEC now requires an offer to be made to all shareholders, but not for all the shares. The final step in the developing takeover saga came in the mid-1970s after Morgan Stanley decided to break with what had been accepted practice and act for a ‘hostile’ bidder. This marks an important turning-point. The focus was no longer a correction to a defective system of corporate governance—it was to do with empire-building: the skill of the management of the target company became an irrelevance (though it might affect the price). (A study by Herman and Lowenstein showed that there was a change about 1980. After then, broadly speaking—though there remain many exceptions—the target companies were as well managed (and sometimes better) than the bidders.) The dual nature of the market, which meant that there was generally a premium for control over the normal trading price, meant also that shareholders' attention was focused on the premium and scarcely on the quality of the management they were abandoning by tendering their shares (or for that matter on the bidder's management). That premium is remarkably constant—34% in 2001, 33% in 2002, 29% in 2003, and 25% in the first half of 2004—taking the bid price against the market price the previous day. Many professional fund managers find the premium irresistible; indeed they feel legally obliged to accept a tender offer. It is as if a ‘For sale’ notice hangs over most of corporate America. With finance available mergers have multiplied—there were 5,914 completed deals in 2003 worth$447,767,000,000.

Some years ago beleaguered corporate management cast around for ways of defending itself, and the ingenious legal profession produced some brilliant answers. In essence they were all based on a single principle. A company would set in place an arrangement which in normal times would lie dormant. Only a tender offer would activate it. Then, once the alarm bells rang, management could set the machinery in motion to change, grant extra shares, and so forth, the result of which would be to make it virtually impossible for the bidder to succeed. These were the so-called ‘poison pills’. An alternative strategy was ‘Crown Jewels’, that is, to give a third party an option to buy a prime asset to stop the bidder getting it. Yet another was a ‘supermajority’ provision, for example, a requirement that there be a 75% majority to remove a board of directors. These devices were often challenged in the state courts (which might not necessarily produce consistent judgements), but generally they seem to have survived, at least in certain forms. And in most cases management introduced them without consulting the shareholders. ‘Supermajority’ provisions (which have in any case proved a less effective tactic) have to be approved by the shareholders.

(p. 278 ) Opinion is still divided on whether the shareholders have benefited. Two things seem to be true. On the one hand, entrenching management means that if there is a takeover bid the board can usually exact a bigger premium (from an opening price that would probably have been higher but for the protective mechanism). On the other hand, if no takeover bid is in the offing, shareholders fare worse if management is deeply entrenched. It must be remembered that two-tier offers were permitted and that any resultant non-accepting minority might be mercilessly squeezed at a later date: the principle of equal treatment for shareholders was and is notably absent. Poison pills have rarely if ever been swallowed—it is not their purpose, which is delay—but they have been effective in preventing hostile two-tier offers, which have all but disappeared. Companies with poison pills tend to fetch better prices than those without, because they strengthen management's bargaining position and bidders cannot go direct to shareholders over management's heads. However, they may deter bidders from attacking a company where management is incompetent. They are based on the principle that it is right for management to nanny shareholders and understate the agency costs implicit in management's personal interests. Companies did not have to consult their shareholders before putting a poison pill in place, but shareholder activism has often targeted such arrangements and many have now been dismantled.

In a smart mixture of metaphors many companies have now ‘dismantled their poison pills’—18 in 2002, 29 in 2003. They have now been renamed— more elegantly—as ‘shareholders’ rights plans’, but new ones fell to a ten-year low in 2003—just 99. It looks as if 2004 will see a similar number of plans being dismantled as the previous year. Whether this will increase M&A activity remains to be seen.

After poison pills has come legislation. There have been some recent instances of normally leaden-footed state legislatures galvanized into instant action to protect some beloved industrial enterprise at the behest of the unlikely combination of its management and its labour unions. (The protective legislation for Armstrong World Industries and Norton are cases in point.) Indeed, some state legislation has been so overprotective that many enterprises, in Pennsylvania for instance, exercised their right to opt out, perhaps through fear that it might affect their share price adversely.

The Pennsylvania Statute is one of the most extreme and enshrines in law an ‘other constituencies’ clause: that is, directors are empowered to take into account constituencies other than shareholders when they make decisions— especially relevant in a takeover bid. The directors are exempted from suit from any interested party. The statute also contains a ‘disgorging’ provision which makes a failed bidder who sells his shares at a profit within eighteen (p. 279 ) months give it to the target company. Moreover, shareholders who acquire more than 20% of the shares are disenfranchised unless ‘disinterested’ shareholders have first approved their purchase (of more than 20%).

During the 1980s imaginative methods of financing takeover bids proliferated, of which the most prominent was the issuing of bonds graded as being below investment level (junk bonds). Very often these were used as part of the arrangements by which existing shareholders were replaced by management in some combination with those who financed them (management buy-outs/leveraged buy-outs). LBOs are not new in the USA and were known in the old days as ‘bootstrapping’. What was new was their number, size, and sophistication.

The LBO movement started quite quietly and was conservatively managed. Kohlberg Kravis and Roberts (KKR) were one of the leading firms organizing them. The principles on which they operated were to avoid cyclical industries, ensure margins were adequate, and maintain careful supervision. From the point of view of corporate governance, the resulting structure could be compared either with a holding company or an active supervisory board whose meetings had substance. Operating management of the new entity (itself well motivated by its substantial equity stake) was generally given a free hand, but KKR (and other firms) stood in the background keeping a fatherly eye on the success of the new enterprise. Because of the conservatism of the original choice of targets many early LBOs were wildly successful. Companies which had been taken private were refloated a few years later at a vast profit. At the time of writing (2004) KKR announced a record distribution to its shareholders.

One of the main points of divergence between the interests of shareholders and CEOs is the quality of growth. Shareholders want long-term increases in income and value and may be prepared to make short-term sacrifices to achieve it, provided it is soundly based. That is, however, a slow grinding business, often beyond the span of office of a CEO. His temptation is to try to take the short cut—growth by diversification, aided by some accounting rules that often created an illusion of growth where little or none existed. With growth the CEO's status (and rewards) could be enhanced rapidly; acquisition is quicker than organic growth. However, the idea that management skills were always transferable across industries proved not to be true and led to the markets tending to price down conglomerates on the convoy principle, that is, a disparate group moves at the pace of the slowest main business in it.

By the 1980s, therefore, some of the unwieldy conglomerates assembled in the 1970s were looking vulnerable and duly became targets of ‘bust up’ LBOs (55% of completed LBOs in 1988). Tears need not be shed; what investment (p. 280 ) banks had cobbled together in unholy conglomeration, LBOs might legitimately rend asunder. Some of the early break-up artists made fortunes.

All these well-publicized successes attracted more players into the game and competition became fiercer. Money was pumped in until at one time there was enough to buy 10% of quoted companies. The prices rose to amazing levels, so the financial burdens on the new entities became heavier. Less attention was paid to the cyclical nature of business so that cash flows and profits could very easily become insufficient to service the debt. And supervision became laxer. The results of these excesses are well known and with us still—restructuring and bankruptcies for businesses, bad debts for bankers, junk bonds for investors living up to their name. Such movements come in waves and many waves finally break on the rocky shore of Chapter 11—like Worldcom and Global Crossing.

The threat posed by the takeover market is more widespread than first appears and is not confined to companies for which bids have actually been made. Many have sought to render themselves unattractive by ‘restructuring’ and were aided and abetted in this by investment bankers. One said in my hearing at a public seminar in 1986, ‘Restructure or our 26-year-olds will get you.’ Restructuring or recapitalization meant borrowing vast sums (which were paid to shareholders), often at the same time retiring equity. The present shareholders had a windfall, but the company was often so weakened that it could not sustain a downturn in business. Academics who had preached the virtues of leveraging as a new faith found gearing a dangerous god. Sad to say, the effects of such policies have not yet worked themselves out.

It is unnecessary to explore the financial excesses of the 1980s and late 1990s in detail, fascinating though they are. Lowenstein, writing in 1988, was among the commentators who felt that whatever virtue there may have been at one time in using the market to secure management changes had long since been outweighed by the cost and damage inflicted on US industry by those who exploited apparent imperfections in the market to make massive short-term gains. Displacing poor management is one thing; replacing good management at great cost with a group that is no better, in a structure which has less industrial logic, is quite another.

# Commentary

When times are good and industry is flourishing, no one takes an interest in corporate governance, however ominous the signs or flawed the hero in charge. As Margaret Blair puts it, ‘In good times, with markets growing, capital cheap, and competition limited, almost any governance system can (p. 281 ) seem to work well. The test comes when markets are flat or shrinking, capital costs are high, and competition is tough’ (Blair 1991: 13). This test is here now. That is why there is so much interest in the subject.

There is no system of corporate governance in the world that is perfect. Companies, like people, are born, grow, and die. In the economic sphere what needs to be emphasized is the capacity for renewal and the avoidance of waste, in an ever more competitive environment. How does that of the USA shape up, in regard to the two universal criteria?

## Dynamism

Management, however individual or collective, must be able to drive the business forward without undue bureaucratic interference, or fear of litigation, or fear of displacement. This is the first and crucial principle for an entrepreneurial free market economy in a competitive world. This is or should be the management's right and its charter.

The first potential source of infringement of this charter is government. No one doubts, however, that it is the government's task (whether at Federal or state level) to hold the balance between the competing interests in the economy—producers and consumers, employers and employees, providers and users of capital. Fifteen years ago there were very few complaints from the CEOs' side that government or state law as manifested by bureaucratic interference was considered an undue or unfair handicap, even though many governmental requirements impose costs (e.g. in respect of the environment). SOX and the subsequent rule changes have changed this perception, though few would say unfairly.

The ground is less certain in regard to litigation. In the USA the law is seen as a unifying force, a way of ensuring equality for all the heterogeneous elements in society. At one time the business judgement rule provided directors with a nearly impregnable defence against lawsuits alleging they had made a poor decision. In the case of Smith v. Van Gorkom a considerable dent was made because the Court ruled that the process by which the decision had been reached was inadequate. Over the last few years cases have moved further down this track. The rule still lives, dented it is true. Perhaps the feeling that litigation lurks in the wings is pervasive; it might be worth a behavioural study. Section 102 (b)(7) of the Delaware General Corporation Law, which permits corporations to include in their charter a provision eliminating personal liability of a director for a breach of a fiduciary duty (except for breaches of the duty of loyalty or good faith) also put into corporations' hands a powerful weapon to protect its directors (p. 282 ) from lawsuits. And, if it can be obtained in the market, there is always directors' and officers' insurance, expensive as it is.

There are indeed some signs that the old common law concepts of loyalty and good faith may be getting a new lease of life. They were very much to the fore in a well-publicized lawsuit concerning the Disney Corporation and the compensation paid to Michael Ovitz on his dismissal. The London Financial Times made the most of it with a headline on 11 October 2004, ‘Pension Funds test Disney on Governance’, ‘How Disney Crossed Delaware’ on 21 October, and ‘Directors Face a Disney Doomsday’ on 25 October. The case made other headlines—including shareholder activism and proposals for some new independent candidates for the board.

There was much talk about outside directors being inhibited from accepting office because the threat of litigation outweighed any potential reward, though it was impossible to measure the effects. My own judgement is that it is an element to be considered, but not yet a matter for deep concern. If it became really difficult to find good candidates it would be truly serious because sound boards are the keystone of the structure.

As regards displacement, US CEOs do not in general look more vulnerable than their counterparts elsewhere. There is a great deal of discussion on the effects of the fear of takeover, and it is difficult to determine to what degree it exists, and what its effects are. To those who deny the existence of what they cannot measure, it is insignificant. How much fear of takeover matters depends on many variables, such as the vulnerability of the company, the personality of the CEO and his age, and the stockholding position. Certainly Americans' traditional robustness—about picking themselves up and starting again—would suggest that fear of displacement would not generally loom large, were it not for the vigour of their defence against bids, often far in excess of what might profit their shareholders, not just in the short or medium term but on any reasonable time scale.

We are dealing here with a psychological issue, in which the subjects may not themselves realize how deeply their thinking has been affected. A robust CEO who prides himself on his macho view of life may assert vehemently that market pressures mean nothing to him; he invests what he and his board feel essential for the long-term well-being of the company. And he may be wrong simply because subconsciously he has set his sights too low, in unknowing recognition of what his instinct tells him the market will stand. The important point to make is that the market, which in some ways acts as a spur, in others acts as a shackle, because of the complexity of managerial motivations. And managers whose firms ‘go private’ seem to relish the diminution of risk.

(p. 283 ) Business may be an economic activity, but man is not just an economic animal. He looks to his job for other satisfactions—the pride of construction, the warmth of camaraderie, and the excitement of mental stimulation. It is a source of power and influence and a means of recognition. These multiple satisfactions account for people working long hours after they have accumulated more riches than they could spend in a dozen extravagant lifetimes. They are the cause of CEOs defending their territory and achievements so fiercely, often in the face of economic logic. These are the reasons why the fear of takeover is so damaging—it absorbs the nervous energy that would otherwise go into the proper task of driving the business forward.

What are we to make of the economic consequences of takeovers? It is easy to accumulate a mass of literature on US takeovers and takeover defences and funding, some set out as blueprints, others as factual accounts, and others as drama like Bruck's The Predators' Ball. The language is colourful: ‘poison pills’, ‘junk bonds’, ‘White Knights’ and ‘Black Knights’; and many of the principal players larger than life, dealing in billions. Some are disgraced; many bask in luxury. Is the USA the richer? The creation of real wealth can only come from investment and production, but the transfer of wealth is justified if in fact a better use of resources ensues. Hard evidence on whether 2+2 sum out to 10, 5, 4, 3, or less, is hard to come by. But there is no doubt that in the opinion of many US commentators (Eisenberg 1989 is one example of many) a large number of good businesses have been destroyed and many others emasculated.

It is part of the function of the market in the USA to reallocate resources to those who will make best use of them—over a reasonable time scale. The time scales of decision between investor and industry are totally different. An investor may decide to switch from a chemical company into textiles and achieve the change in a single telephone call. Company management, hemmed in by its present plant, people, and commitments, may take a decade to change direction radically. A system which places so much emphasis on shareholders' immediate values may be at a competitive disadvantage with others which take a longer-term view. There is a great entrepreneurial spirit and it is free, but not quite as free as it thinks it is.

## Accountability

Some writers refer to ‘The Imperial CEO’, meaning that he is the master of his world. He is the hero who charges into battle, and, later after winning his struggles, rides off, rich and content into the sunset. Not for him the dulling and irresolute rumination of a committee. That atypical spasm in the 1980s when the more collegiate systems of Germany and Japan seemed to give them (p. 284 ) competitive advantage has long since disappeared; their relatively poor showing in the 1990s seemed to confirm to Americans that their way was best.

The American recipe was not to ape the longer time scales those systems facilitated, but to move smartly in the opposite direction under the banner of ‘shareholder value’. This was interpreted to mean ‘shareholders’ immediate value' and led to the tyranny of quarterly earnings, in which juicy options plus a desire at least to match analysts' expectations led to the figures often being massaged in ever more sophisticated ways. Officialdom stood by. The processes of governance atrophied as boards met for too short a time and the individual members had no opportunity, or leadership, or inclination, to become more deeply involved. External auditors served the management who often awarded them lucrative consultancy contracts, instead of serving the shareholders.

As a general principle, the greater executives' freedom of action, the greater the need for accountability. The two go hand in hand. The concept of accountability in this context derives to some extent from its counterpart in the political sphere, where it is the main prophylactic against tyranny. A strong board and vigilant shareholders may be crucial in stopping a dynamic and powerful CEO from running amok. In business, accountability is essential as a means of maintaining standards of competence. The way in which it is exercised is of secondary importance.

The general feeling in the USA among thoughtful commentators has for many years been that US management is often not accountable enough. The board does not often work properly, and shareholders seldom work at all: management may fear the market but its tendency will be to entrench itself in the ways described earlier and reward itself well enough to reduce the financial consequences of displacement.

We can appreciate the gloomy summary at the beginning of Jacob 1991:

Lack of communication prevents investors from understanding management's long-term goals and objectives. Shareholders trade stocks so often and hold such broadly diversified portfolios that they cannot possibly keep up with the business activities of the companies they own. Because most US investors are detached from the businesses they fund, they rely on outward manifestations of what is really going on within the company; namely, quarterly earnings and other accounting measures of performance. These numbers only measure the past; they do not explain the future. When they are dissatisfied with corporate performance shareholders sell stock, rather than trying to discern the causes of poor performance and using their collective voice to communicate their concerns to management.

Companies exacerbate the problem by stacking their boards with directors handpicked by top management and insulating themselves from the oversight (p. 285 ) traditionally provided by shareholders and lenders. In recent years companies have consistently disenfranchised their owners; they want access to capital with no strings attached. But a lack of trust makes investors hesitant to fund projects with no visible results for extended periods of time.

Jacob's gloom turned out to be justified by the 1998–2001 collapse of high flying companies like Enron, Wordcom, Adelphia, Global Crossing, Tyco, and many others. In an address to the Commercial Club of Chicago, Illinois, in November 2002, Martin Lipton described the measures that will lead to a ‘Tectonic shift in power away from the CEO to the board, board committees and Shareholders’. Many of them have been described in the discussions on board and shareholders. Lipton stressed the practical consequences, like allowing enough time for the board and its committees, especially the audit committee to attend to business thoroughly.

There is always a danger of making the mistake that because the quality of the people individually is high, the quality of the board as an entity necessarily follows suit. It does not. Many a company has foundered despite having good talent aboard. The dynamics of the board are largely in the hands of the CEO, who can make or mar it. In my conversations with many able ones I was struck by the way they seemed to fall into two camps: those who were very powerful and admitted it, and those who were very powerful and did not— though I cannot say with certainty which group used its board better! If some boards work better than others it is because the CEO wills it. The new reforms are designed to ensure he does.

The audit, compensation, and nomination committees, have as unspoken objectives the task of improving the board's dynamics, of giving the outside directors a real role, of deepening the flow of information, and of improving collegiality among the independent directors. The potential importance of the nomination committee is sometimes underestimated by those who do not understand the far-reaching consequences of the CEO's grip of patronage. The acid test of the balance of any board is its capacity to stand up to the CEO when really necessary. Of how many US boards is this actually true today? This capacity does not imply constant friction but the degree of reciprocal respect between CEO and director necessary for real accountability.

The second part of the problem concerns the accountability of the board to shareholders. In the USA, as elsewhere, weak CEOs and weak boards allow companies to drift and decline. In cases where shareholdings are widely dispersed the Berle and Means analysis (1932) is still valid—no one has the interest and few the knowledge to intervene. Now when shareholdings are becoming more concentrated the analysis no longer holds—there are many signs of action. In looking at the vast panorama of US companies and the (p. 286 ) regiments of institutional shareholders, it is clear that at the moment action is confined to few of the latter in relation to relatively few of the former. But the situation is changing.

# Future Developments

At the end of the final chapter there is list of items that can be regarded as ‘unfinished business’. There is some overlap with the following, as some themes are of international significance. Most of those below, however, are USA-specific:

1. 1. Starting at the top, most companies resist separating the role of Chief Executive from that of chairman.

2. 2. It remains to be seen how the SOX requirement for one of the members of the audit committee to be a financial expert actually works out in practice, both in regard to the standard required and to its effect on other members of the committee.

3. 3. The rules governing the election of directors will continue to attract attention—especially staggered boards, plural voting, and the impossibility of recording a negative vote as well as abstentions.

4. 4. The debate on transparency has focused on boards and market. The Enron case—and others—show that transparency between management and board may also be of paramount importance, and arguably comes first.

5. 5. The recent emphasis on accountability was overdue. There will need to be a careful eye on the balance between that and drive. If board members see themselves primarily as monitors there might as well be a two-tier system. The success of unitary boards depends on a sensible balance being maintained. There could easily be too much process and not enough decisions.

6. 6. Stopping fraud is important and the post-SOX world should make life tougher for the fraudsters. But ‘the bomber will always get through’. Improving internal controls is proving expensive and doubtless it is generally a sound investment and there is a cost limit beyond which it is a mistake to go. When it comes to the transfer of funds the security of IT systems is paramount but one does not need a platoon of Marines to guard a cash box.

7. 7. Despite the minimalists, Corporate Social Responsibility is a concept that will have increasing ramifications; but there is no point in being CSR-perfect, and bankrupt.

8. 8. Shareholder activism is growing. We can expect it to become better focused and sharper, though not necessarily more public.

9. (p. 287 ) 9. Accounting and audit will gradually become international, though this will be difficult for the USA to absorb given the fundamental difference in approach.

10. 10. Possibly as a reaction to scandals, companies' ethics programmes are attracting more attention and many have specific officers assigned to them with a duty to report to the board. Most US companies have some kind of whistle-blowing procedures (86%). There is of course a distinction between compliance (which means obeying the law and regulations) and morality, which means behaving ethically in all circumstances. The company is now required by the SEC to adopt a code of ethics some elements of which are basic, like avoiding conflicts of interest, confidentiality, and compliance. Many executives are practising members of one of the world's great religions; do they all behave ethically all the time? If not, will a company code make the difference? An ounce of conspicuously ethical leadership is worth a ton of precepts and codes of ethics; and how does that sit with greed?

11. 11. The governance rating game has begun, with ISS and S&P to the fore, as well as the Corporate Library. I counted nearly 100 items, some of which are common to all. It will be interesting to see how ratings develop—the weightings in particular, and how at the end of the day they cope with the behavioural unquantifiables which all on boards know well. The more that people believe that good performances and good governance go hand in hand, the greater the tendency will be to try to put numbers to the latter as well as the former.

12. 12. Beyond SOX and all the governance reforms, most of which were arguably overdue, there lurks the danger of believing we can use structural solutions to solve behavioural problems. Total conformity to all the new requirements will not of itself produce results. It is how people behave that matters most—displaying the ancient virtues of candour, trust, and integrity. Without these, plus sheer competence, ‘people’, and leadership skills, we are doomed to disappointment. (Enron and Worldcom are examples.) J. A. Summerfield made this case with great eloquence in the Harvard Business Review, 1 September 2002 (ISSN Number 0017–8012). We have to see structure and process—even ethics statements—for what they are, road markings and signposts. Someone still has to pick the route and drive the car.

# Audit Committee Requirements

NYSE Requirements

NASDAQ Requirements

Audit Committee Charter The audit committee charter must specify the committee's purpose, which must include (i) assisting board oversight of the integrity of the company's financial statements, the company's compliance with legal and regulatory requirements, the independent auditor's qualifications and independence, and the performance of the company's internal audit function and independent auditors and (ii) preparing an audit committee report that SEC rules require be included in the company's annual proxy statement.

The charter must also detail the duties and responsibilities of the audit committee, including:

• appointing, retaining, compensating, evaluating and terminating the company's independent auditors (this includes resolving disagreements between management and the independent auditor);

• establishing procedures for the receipt, retention and treatment of complaints from company employees on accounting, internal accounting controls or auditing matters, as well as for the confidential, anonymous submissions by company employees of concerns regarding questionable accounting or auditing matters;

• having the authority to engage independent counsel and other advisors as it determines necessary to carry out its duties; and

• receiving appropriate funds, as determined by the audit committee, from the company for payment of compensation to the outside legal, accounting or other advisor employed by the audit committee.

Note: The foregoing charter requirements correspond to the requirements of Exchange Act Rule 10A-3.

• at least annually: (i) obtaining and reviewing a report by the independent auditor describing the independent auditor's internal quality control procedures; (ii) reviewing any material issues raised by the auditor's most recent internal quality control review of themselves; and (iii) assessing the auditor's independence;

• discussing the annual audited financial statement and quarterly financial statements with man agement and the independent auditor,

• discussing earnings press releases, as well as financial information and earnings guidance that is given to analysts and rating agencies;

• discussing policies with respect to risk assessment and risk management;

• meeting separately, from time to time, with management, with the internal auditors and with the independent auditors;

• reviewing with the independent auditor any audit problems or difficulties and management's response to such issues;

• setting clear hiring policies for employees or former employees of the independent auditors;

• reporting regularly to the board of directors; and

• evaluating the audit committee on an annual basis. The Company's website must include the charter of the audit committee and its annual report must state that the charter is available on its website and is available in print to any shareholder that requests it.

Audit Committee Charter The audit committee charter must now specify all of the duties and responsibilities of the audit committee under the Act, including:

• Appointing, retaining, compensating, evaluating and terminating the company's independent auditors (this includes resolving disagreements between management and the independent auditor);

• Establishing procedures for the receipt, retention, and treatment of complaints from company employees on accounting, internal accounting controls, or auditing matters, as well as for the confidential, anonymous submissions by company employees of, concerns regarding questionable accounting or auditing matters;

• Having the authority to engage independent counsel and other advisors as it determines necessary to carry out its duties; and

• Receiving appropriate funds, as determined by the audit committee, from the company for payment of compensation to the outside legal, accounting or other advisors employed by the audit committee.

Note: The foregoing charter requirements correspond to the requirements of Exchange Act Rule 10A-3.

In addition, each issuer must certify that it has adopted a formal written audit committee charter and that the audit committee has reviewed and reassessed the adequacy of the charter on an annual basis.