Largely (although not exclusively) driven by last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. Even further changes lie ahead. In this post, I take a look at where we are now, what lies ahead, and what it all means.
Many of the observations in this post were influenced by the commentary during a panel discussion in which I participated on May 11, 2011, entitled “Dodd-Frank and the Rising Tide of Shareholder Empowerment”,” at the Menlo Park offices of the Orrick law firm. The views expressed in this post are my own.
Changes Already Underway
Though many of the rulemakings required by the Dodd Frank Act have fallen behind schedule, a number of the implementing rules already are in place and are already driving changes. In addition, other processes not directly connected to Dodd-Frank are also underway and changing board processes, practices and structure. Here are four specific governance reform processes currently underway:
1. Say on Pay: As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies have had to put their executive compensation practices to an advisory shareholder vote during the current proxy season. The practice of an advisory vote on executive compensation has been in place in many European counties for some time. Many U.S. companies and their advisors resisted the adoption of the requirement here, and others questioned the value of a mere advisory vote.
In ways that I think may have caught some observers by surprise, it appears that – even though the shareholder “say on pay” vote is purely advisory – the implementation of the requirement for a “say on pay” vote is having a significant impact on executive compensation practices. As reflected in a May 2, 2011 Wall Street Journal article entitled “Firms Feel ‘Say on Pay’ Effect” (here) , many companies, scrambling to win shareholder approval in the say on pay vote, have been pressured to alter pay practices. As the article says, “despite some early skepticism, the prospect of such votes has sparked boardroom debate over executive-pay practices that were long-rubber stamped:”
The last minute changes that some corporations have put through to avoid negative votes have included some extraordinary steps. Just before the shareholder vote at Disney, for example, the company dropped certain provisions in its contract with its CEO Robert Iger, as well as other executives removing a provision that would have grossed up any compensation awards to these officials in the event of an ownership change.
The net effect of this process, and board’s desire to avoid a negative vote, is that certain compensation practices may fall by the wayside and all companies will face greater pressure to better align executive compensation and company performance.
A May 3, 2011 memo from the Davis Polk law firm (here) provides a detailed status update on the current round of “say on pay” votes.
2. Proxy Access: On August 25, 2010, the SEC adopted rules, in changes that were to be effective November 15, 2010, to require all but the smallest public companies to include in the proxy materials that board candidates nominated by shareholders who meet certain qualifying criteria. In order to qualify to nominate a candidate, a shareholder or shareholder group must individually or collectively own at three percent of the voting power of company’s shares and must have held those shares for at least three years.
However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules that the SEC had adopted. The petitioners contend that the new rules are “arbitrary and capricious,” violate the Administrative Procedures Act, and infringe on the First and Fifth Amendments. In response to this legal challenge, the SEC on October 4, 2010 issued a stay of the effectiveness of the rules while the legal challenge is pending. A ruling in the legal challenge is expected later this year.
While the implementation of the proxy access rules are in abeyance and the outcome of the legal challenge is uncertain, the likelihood is that in the future shareholder will enjoy greater shareholder access by requiring a company to include in its proxy materials shareholder nominees to the board of directors. As two attorneys from the Saul Ewing firm wrote in an October 29, 2010 article in the Legal Intelligencer entitled “Be Prepared: Shareholder Activism is Here to Stay” (here), “whether under the rules now being considered by the court or some revision thereof, the Dodd-Frank Act, and its focus on shareholder protection and access, ensures shareholder activism is here to stay.”
3. Board Declassification: One of the long-standing objectives of corporate governance reformers has been the elimination of classified or staggered boards, whereby directors were elected for three years terms ensuring that in any given year only a third of the directors are up for vote. The Dodd-Frank Act does not have anything to say directly on this issue. Nevertheless reformers, led by the Florida State Board of Administration, have succeeded in obtaining the voluntary agreement of a number of companies to the declassification of their boards, pursuant to which the companies will put their entire board to an annual vote.
As one recent commentator noted, “the overwhelming trend in corporate governance is toward the declassification of boards.” An April 26, 2011 press release from the Florida Board about its efforts can be found here. A May 10, 2011 commentary by Nell Minow on her Risky Business blog about the board declassification efforts can be found here.
4. Majority Voting: Another longstanding goal of corporate governance reformers has been the implantation of majority voting. In many U.S. public companies, director election requires only a plurality vote, so that a director candidate in an uncontested election who receives only one vote will be elected. In a majority vote model, a director in an uncontested election who fails to receive a majority of votes must offer their resignation.
As discussed in an April 19, 2011 Westlaw Business article entitled “Corporate Governance: Assertive Activist Investors” (here), the 2011 proxy season is the “culmination of a major drive to install majority voting standards,” and shareholders at a number of companies have voted in favor of shareholder proposals calling for majority voting standards.
Changes Just Ahead
1. Compensation Ratios: In one of legislation’s lesser noted provisions, Section 953(b) of the Dodd Frank Act directs the SEC to amend its executive compensation disclosure provisions to require reporting companies to disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees. Rules implanting these provisions are required to be adopted before the end of 2011.
As University of Denver Law Professor Jay Brown notes on his Race to the Bottom Blog (here), these disclosure requirements potentially could be “powerful.” As Professor Brown notes, the compensation ratio disclosure would shift the executive compensation dialog away from a comparison between executive compensation at different companies toward a comparison within the company itself. The provision rather obviously reflects an intuition that there is a disparity between the compensation paid to executives and the compensation to other company employees.
These provisions are controversial and there already is a move underway to repeal this provision. But if the provisions become effective and reporting companies are required to disclose the compensation ratio as specified in the Dodd-Frank Act, it seems likely that what will follow is a protracted discussion around issues of compensation fairness and compensation equity, particularly as popular notions about the appropriate ratios develop over time. Companies whose ratios suggest greater compensation disparity are likely to face added pressure on executive compensation issues.
2. Compensation Clawbacks: Another of Dodd-Frank’s executive compensation requirements is set out in Section 954, which requires to SEC to direct the national exchanges to impose new listing standards directing public companies to implement compensation clawback provisions. Under Section 954, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. According to a May 12, 2011 CFO.com article about the provisions (here), the SEC plans to propose and adopt rules implanting these requirements between August of this year and year-end.
The Dodd-Frank clawback provisions go far beyond the clawback requirements instituted in the Sarbanes Oxley Act. The SOX provisions were limited just to the CEO and CFO, where as the Dodd-Frank provisions are applicable current and former executive officer. SOX clawed back only the year prior to the restatement, whereas the Dodd Frank provisions reach back three years, and are applicable without regard to fault or wrongdoing.
The clawback provisions also have proven controversial. The CFO.com article cited above notes that these provisions have a “potentially far-reaching impact” that may “result in serious reconsideration of how incentive compensation plans are designed.” It is also possible, as another set of commentators has noted, that companies who in future find that they must restate prior financials may face litigation (or rather their officers and directors may face litigation) on questions whether a compensation clawback is required, against whom it should be enforced, and for what types or amounts of incentive compensation.
What it All Means
Though rule-making delays and litigation have delayed the implantation of some of the Dodd-Frank Act’s requirements, many of the changes Dodd-Frank required are already here and others are just around the corner. These changes, and the other corporate governance reforms being pursued by shareholder advocates have a number of significant implications, beyond just the most obvious practical effects.
1. Heightened Scrutiny: Not all companies are going to give in on executive compensation issues or on board process issues like board declassification and majority voting. (Indeed, there are certainly a number of serious commentators who question the value or even the wisdom of many of these reforms). But while different companies may respond to these developments in different ways, companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media.
A very recent example of this kind of scrutiny involves the Internet media company, LinkedIn, which has recently filed to conduct an initial public offering of its securities. In two interesting but highly critical commentaries on the DealBook blog (refer here and here),University of Connecticut Law Professor Steven Davidoff takes LinkedIn to task for adopting “a governance structure that not only disenfranchises its future shareholders, but contains elements that have been heavily criticized by corporate governance advocates.” Among other things, Davidoff criticizes Linked In for its dual share class structure that ensures that the company founders will retain voting control of the company; for adopting a staggered board; and for instituting onerous by law provisions.
In referencing Davidoff’s critique of LinkedIn here, I am expressing no opinions in whether or not his criticisms are valid or whether LinkedIn fairly may be criticized. Rather I cite his analysis to show the kind of scrutiny all companies are likely to face if they pursue practices or implement policies that fly in the face of the current trends in corporate governance reform. This level of scrutiny is only likely to increase as other reforms, such as the compensation ratio disclosure requirements, go into effect.
2. Increased Litigation Risk: Companies that resist shareholder driven reform initiatives may not only face scrutiny, but they (or their directors and officers) may also face an increased likelihood of litigation. In a recent post (here), I noted the apparent trend in which companies who experience a negative “say on pay” vote may find themselves facing shareholder litigation relating to the companies’ compensation practices. As noted above, there are others of these current reforms – for example, the clawback provisions – that could also encourage shareholder litigation.
3. Changing Judicial Attitudes: A very strong principal traditionally informing judicial scrutiny of board processes and decision making has been a broad judicial deference to the boards themselves. With the shift towards greater shareholder empowerment, courts may also be less inclined than perhaps they were in the past to defer to boards.
This notion that evolving corporate governance norms may affect judicial consideration of board process and functioning was highlighted in the Chancellor Chandler’s August 9, 2005 opinion in the Walt Disney Shareholder Litigation, where Chandler observed that “in this era of Enron and WorldCom debacles, and the resulting legislative focus on corporate governance, it is perhaps worth pointing out that the actions (and the failures to act) of the Disney board that gave rise to this lawsuit took place ten years ago, and that applying 21st century notions of best practices in analyzing whether those decisions were actionable would be misplaced.”
The Chancellor’s unmistakable implication is that heightened 21st century standards will be applied to 21st century board actions – in other words, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.
There is of course within all of this extensive room for serious debate about whether or not these changes ultimately will advance or impede corporate performance and what impact all of this will have on the relatively competitiveness of U.S companies in a global marketplace. But whatever may be said along those lines, it seems clear that the changes brought about in the current round of corporate governance reforms are here to stay and will require corporate officials to adapt to the new environment.
Meanwhile, In Another Universe: Things that are commonplace now (the Internet, arthroscopic surgery, the E-Z pass toll collection system, open-on-the-bottom condiment containers, etc.) were virtually inconceivable just a short time ago. Rivka Galchen’s article entitled “Dream Machine” in the May 2, 2011 issue of the New Yorker provides a fascinating glimpse of even more fantastic changes the future may bring, in the form of "quantum computing" -- that is, computing based on the principles of quantum mechanics.
The promise of quantum computing is the vast improvement in computational power it could provide. As an example of a problem not otherwise resolvable through conventional computing but that could be solved through quantum computing is “prime factorization.” That is, it is easy to multiply two large prime numbers but very difficult to take a large number that is the product of two primes and to deduce the original prime factors. To factor a number of two hundred digits would take a conventional computer longer than the history of the universe but would only take a prime computer an afternoon.
The explanation of how a quantum computer would accomplish this involves a scientific theory known as the Many Worlds Interpretation. It entails the “counterintuitive reasoning” that “every time there is more than one possible outcome, all of them occur.” So if a radioactive atom might decay and it might not, it both does and doesn’t. From this, the many implied small branchings “ripple out until everything that is possible in fact is.”
According to Oxford physicist David Deutsch, the Many Worlds theory explains how quantum computers might work. According to Deutsch, a quantum computer would be “the first technology that allows useful tasks to be performed in collaboration between parallel universes.” The quantum computer’s processing power “would come from a kind of outsourcing of work, in which calculations literally take place in other universes.”
The Many Worlds theory to which Deutch refers to explain quantum computing’s theoretical operation seems (to me at least) to have more to do with the imaginative world of literature than it does to science. Perhaps my feeling in this respect is due in part to the unmistakable parallels between the Many Worlds theory and a short story written by the Argentine writer, Jorge Luis Borges.
Borges’s story, The Garden of Forking Paths, involves Dr. Yu Tsun, who is a descendant of a scholar (Ts'ui Pên ) who wrote an indecipherable novel about labyrinths. In this story, Dr. Yu meets a British sinologist who has uncovered the mystery of Ts'ui Pên’s novel. The British sinologist described his interpretation of the novel as follows:
In all fictional works, each time a man is confronted with several alternatives, he chooses one and eliminates the others; in the fiction of Ts'ui Pên, he chooses-- simultaneously--all of them. He creates, in this way, diverse futures, diverse times which themselves also proliferate and fork. Here, then, is the explanation of the novel's contradictions. Fang, let us say, has a secret; a stranger calls at his door; Fang resolves to kill him. Naturally, there are several possible outcomes: Fang can kill the intruder, the intruder can kill Fang, they both can escape, they both can die, and so forth. In the work of Ts'ui Pên, all possible outcomes occur; each one is the point of departure for other forkings. Sometimes, the paths of this labyrinth converge: for example, you arrive at this house, but in one of the possible pasts you are my enemy, in another, my friend.
And so, I will leave you with this thought: In at least one universe, the quantum computer will become a working reality. The question that remains to be seen is which universe. Or to put it another way -- the possibility that there might be another universe in which the airline does not lose my luggage does not do me much good in the universe in which my luggage has been lost.