By Stephen M. Honig

In the most recent issue of New England In-House, we summarized the articulated Securities and Exchange Commission agenda: proxy reform, heightened disclosure on governance issues, focus on risk management and enhanced compensation disclosure. Since then, we have heard specific proposals from the SEC staff on proxies and have heard philosophical predictions from the SEC’s chair on compensation. We have seen draft federal governance reform legislation of vast scope proposed in Congress, and we have seen continued power politics practiced by the executive branch.
Proposal on proxy reform

In mid-May, the SEC proposed for 60 days of public comment amendments to its proxy rules roughly along the lines anticipated in our previous column:

• Pursuant to proposed amendments to Rule 14a-11, shareholders who have held stock for at least one year, who agree to hold that stock through the next shareholder meeting and who are not seeking to seize control now will be able to compel inclusion of their nominees in the company’s proxy materials or, alternately, be reimbursed for independent proxy solicitation costs.

• To qualify, nominating shareholders must hold at least 1 percent of voting securities for companies with $700,000,000 of market value, 3 percent with $75,000,000 of market value, or 5 percent with less than $75,000,000 of market value.

• Nominations can be for the greater of one director or 25 percent of the total board.

• Nominators are responsible for erroneous disclosures in their proxy materials and will be required to file new Schedule 14N, providing details of their stock ownership.

• Pursuant to proposed amendment to Rule 14a-8(i)(8), management will no longer be able to reject from the shareholder meeting agenda proposals from shareholders that amend company bylaws to facilitate director nomination procedures by shareholders.

Substantial open questions remain; indeed, the proposed amendments garnered only three affirmative votes by the SEC commissioners, with two dissenting. Will the proposed SEC rules trump contrary state corporate laws? Will opening nominations empower shareholders with long-term objectives, such as unions and pension funds, or simply empower predatory short-term interests, such as hedge funds and certain shareholder activists?

Shareholder activists are solidly behind the SEC initiative. Almost immediately after the SEC introduced its proposals, Lucien Bebchuk, director of the program on corporate governance at Harvard Law School and academic leader of the shareholder rights movement, expressed his support in an op-ed piece in The Wall Street Journal and criticized the critics of the proposal.

“It is ironic that opponents of proxy access now raise the banner of company-by-company choices [as opposed to SEC-mandated shareholder rights],” he wrote. “In 2007, the SEC examined whether to let shareholders propose bylaw amendments that would establish proxy access for shareholders seeking to nominate directors. At that time, opponents of proxy access persuaded the SEC to prohibit the inclusion of such proposals on the ballot.”
This support is consistent with Bebchuk’s long-standing economic analysis; he has often cited statistical studies indicating that the greater the insulation of sitting directors from removal, the worse is company economic performance and consequently resultant lower firm value.

Working on compensation

Last month, SEC Chairwoman Mary Schapiro proposed enhanced comp disclosure, promising in congressional testimony that in July the SEC would make new proposals for disclosing approaches to compensating lower-ranking employees and, more interestingly, compensation of “superstars,” such as key traders, key salespeople and celebrity endorsers.

Some of these proposals cover old ground, particularly the emphasis on superstar compensation. In 2006, the SEC floated the “Katie Couric” rule, which sought disclosure of comp information for the three most highly compensated employees who out-earned the defined executives (about whom present disclosure is mandatory). That proposal was not adopted, after strident business assertions that such information would disclose important trade secrets.

The entire question of whether enhanced comp disclosure will advance the populist agenda of reining in excessive comp is unresolved. Past enhanced comp disclosure has had little effect, although the present business environment may change all that.

The focus on compensation of superstars is related to overall risk management: Do compensation regimes reward high-risk business strategies? The interrelationship between focus on risk and methods of compensation cannot be overstated. President Obama’s general outline for an overhaul of the financial markets includes proposals addressing executive compensation, proposals that The Wall Street Journal anticipates will prove acceptable to the banking and financial communities in light of the realization there is a “reduced appetite for risk that took hold after the [financial] crisis.”

But what is the relationship of executive reward to risk? Consultants and scholars disagree.
Treasury Secretary Timothy Geithner has specifically equated “imprudent risk-taking” to excessive pay packages. Current Treasury Department guidelines for Troubled Asset Relief Program recipients require twice yearly meetings with an institution’s senior risk officers to review pay plans, generally limit pay plans that create “unnecessary and excessive risks” and bar pay plans that could encourage earnings manipulation.

But critics of this analysis point out that senior officers are in fact compensated to undertake at least certain levels of risk in order to drive profits.

Even Professor Bebchuk, champion of shareholder democracy, questions the advisability of limiting incentives for risk-taking. He notes that financial service companies rely on large amounts of borrowed money; that leverage encourages the taking of risks to achieve large gains.

Bebchuk suggests that granting restricted stock options and giving shareholders an advisory vote on executive pay may exacerbate the problem; as for banks, share prices are now so depressed that shareholders themselves may have an appetite for executive choices that involve undertaking substantial risk. He also recommends other possible metrics for fixing executive pay, including basing of bonuses on something other than per share earnings.

Finally, at least one well-respected study asserts that certain criticized practices, such as large bonuses and stock options, were most prevalent among companies with lower risk profiles. This study suggests that other practices drive high-risk profiles: large pensions, multiplicity of performance measures, excessive overall total payment and rewarding return on equity. These areas generally are not identified either by current regulatory pressure from the Fed or by comp reform advocates.

Another kind of Bill of Rights

In May of this year, Senate Democrats introduced a bill requiring many governance reforms that the SEC announced early this year as part of its regulatory agenda. The stated premise of the bill is that our financial meltdown was caused by failures of corporate governance; that premise may be accepted as common wisdom but is worthy of separate analysis outside the scope of this column. Key provisions of this bill include:

• non-binding mandatory shareholder vote on executive comp and golden parachutes;
• shareholder access to company proxy mechanisms, proposing eligibility metrics inconsistent with the SEC proposals described above;
• separation of board chair function from the CEO;
• prohibition of staggered boards;
• requiring uncontested director candidates to receive a majority of votes cast and contested director candidates to receive a plurality of all possible votes; failing to reach such threshold, that director would be required to resign; and
• mandating an independent Risk Committee.

Fed flexes muscle

The executive branch, riding its power derived from funding bailouts, has filled the press with examples of the use of sheer economic muscle to control the qualifications of corporate officers and directors and even their specific identities. In May, regulators pressed Bank of America to revamp its board with experienced bankers, and in June the Federal Deposit Insurance Commission pushed Citigroup to change top management, even proposing a lowering of the Fed’s ranking of the bank so as to subject it to more direct government control.

Describing the future federal role in the General Motors and Chrysler bankruptcies, The Washington Post noted that the government “will weigh in on ‘core governance’ issues but refrain from day-to-day decisions” — a proposition that seems dubious for a government that has already fired GM’s CEO and dictated its capital structure.

Finally, last month the SEC brought its first litigation against corporate management for failing to disclose company risk. In a civil action against Countrywide Financials’ CEO, CFO and COO, the commission accused the officers of falsely assuring investors that Countrywide underwrote only low-risk mortgages.

Although the case alleges knowing misstatements (rather than negligence), in that the defendants are accused of not disclosing any mortgage risk (even while contemporaneous internal e-mails discussed “toxic” loans), we can anticipate a future action being asserted, premised on “reckless disregard” of director fiduciary duty.

The bottom line

American corporate governance is being rapidly and radically altered. This alteration, by and large, is accepted in many political, financial and legal quarters as either penance for financial failures or an unavoidable price for being bailed out.

All this federal activity may not be necessary. Public opinion, the press, heightened awareness by the SEC as to its regulatory role, private litigation and the business logic of not wanting to repeat past errors all may drive governance toward higher standards without need for massive new direct federal interference.

Few people believe that the federal government is equipped to manage our economy, and few favor nationalization of business governance. There is a delicate balance between the governmental role of leveling the playing field and the private role of playing the business game.

In the search for our post-capitalist economic model, we must beware our present direction. There will be more than a few “Uncle Sam” avatars running around the governance playing field this summer. Some of them aren’t needed, and some will be without the proverbial clue.

Stephen M. Honig is a partner in the Boston office of Duane Morris.