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It is clear today that corporations and members of these corporate boards view themselves as being under attack. They have muddled through the last decade embattled and scarred. Most of them now realize that they must come to grips with their public responsibility and the responsibility to their shareholders to open up the Board of Directors and its decision-making process, to be more responsive and sensitive to the needs and interests of not only shareholders but also of society. This, of course, is in their enlightened self-interest, and it is not inconsistent with their responsibility to the shareholders. These corporate executives also recognize that if they fail to take significant action over the next few years, they may find that increasing public pressure may result in more close regulation by the federal government with agency intrusion into the corporate boardrooms.
The task, therefore, is to come up with an effective way to require the corporations to address these certain fundamental issues. It is hopeful that this could be achieved without the passage of federal legislation imposing requirements on the corporations. If corporations prove to be non-responsive, the regulation option, however reluctantly, must be vigorously pursued.
I would like to now turn my attention to a discussion of some of the problems that presently exist with typical corporate board structures of major corporations and how changes may be brought about with some artful prodding by Congress and/or the SEC.
III. BOARDS OF DIRECTORS OF MAJOR CORPORATION IN MOST INSTANCES DO NOT
FULFILL THEIR RESPONSIBILITIES
Industrial development over the past century has seen a dramatic transformation from small-scale to large-scale capitalism. Ownership has been divorced from control through the diffusion and purchase of small lots of stock by large numbers of investors. The controlling group of large corporations now consists of directors and officers themselves. Boards of directors in practice do not fulfill the responsibilities established in the theoretical model that holds directors as the accountable group responsible for all results and actions of the corporation, elected by the stockholders and trustee of their interests. The generally accepted purposes of the board of directors are to:
1. monitor the performance of management;
These functions, however, are more illusory than real. Directors have become management appointees and shareholders are an amorphous mass lacking effective representation or the machinery to organize. Management has become self-perpetuating, unmonitored and ingrown. Director nominees are frequently selected from the inside, so that the members of the board of directors are subordinates of the managers they theoretically monitor and control. The result is that management monitors itself, and board meetings tend to be cursory super. ficial affairs. Ray Garrett, former chairman of the Securities and Exchange Commission, acknowledged this when he stated in a recent speech, "The typical, well-orchestrated board meeting, with a quick agenda, followed by some report of general interest on the operation of the business, followed by lunch, all on a tight schedule, induces an atmosphere of compliance and not inquiry that may be dangerous."
And who are these board members? They are usually hand-picked by the chief executive officer of the company and rubber-stamped by the board. People who serve on boards are drawn from a very small segment of society: bankers, corporate lawyers, other chief executive officers and businessmen. They have become inbred. The recent attempts by many large corporations to infuse a sense of public presence into the boardroom by appointing women, blacks and con. sumer representatives have been more cosmetic than part of an overall re. thinking of what criteria ought to be used to select new directors. While this effort is commendable, it is woefully inadequate and superficial.
The motivation for people serving on boards is frequently open to question. Many regard such service as a new feather in their cap or a credential rather
than a serious undertaking requiring a major commitment of time and energy. It is not uncommon to have a chief executive officer of a major corporation sitting on boards of six or seven other major corporations. It is obvious that given these impossible commitments he is in no position to play an active role in the affairs of any of those corporations.
One of the basic problems is the inadequacy of the information presented to board members themselves. There is limited interchange outside the context of board meetings among outside directors. And procedures that would encourage this type of communication are lacking.
But it is fair to say that the attitude of many board members is changing rather dramatically and quickly because of various events. The recent disclosures of illegal campaign contributions, international bribery and general corporate wrongdoing, and most importantly, the increased potential liability of the outside director has resulted in a genuine attempt on the part of many boards and outside directors to try to redefine their role and purpose. As previously noted, they would, of course, prefer to adopt corrective measures themselves rather than run the risk of a new form of government intrusion into corporate activity. Thus it has become clear that voluntary changes of board structure and policy have been and may be forthcoming. Attempts to live up to the theoretical objectives of a board of directors are on the rise.
There is, however, one point that must be underscored. Institutional procedures must be implemented by these corporations to ensure accountability of directors to shareholders and to the public: reliance should not be placed upon the willing. ness of outside directors in the context of a formal board meeting to raise these reform proposals on his or her own. As a practical matter, it simply will not happen.
The following are a list of objectives that I have referred to repeatedly throughout this statement that I will put forward once again in more detail for your consideration.
1. Definition of Board Role in a Comprehensive Manner.—The board should define in written form its collective role and the role and responsibilities of its individual members. It should be clear to each board member precisely what is expected of him or her as a condition of service on the board. Something so fundamental as this, one would think, would have litle difficulty in being adopted by all corporations. It is surprisng that few have done it.
2. Outside Directors.-At a minimum, at least 60% of the directors ought to be people who qualify as independent outside directors: that is, having no significant financial ties to the company. This is the only way that one can assure independent review of management. Others have called for 100% of independent directors. That may be an ultimate goal that corporations ought to aim for, although there will by necessity need to be a transition period.
It is essential to have a substantial number of outsiders (and at the very least a majority) on the board. If they are worth their salt and fulfill their responsi. bilities they will do the following: effectively review the actions of the chief erecutive officer; objectively appraise and audit company performance; fix officer compensation; bring breadth of viewpoint and respond to board trusteeship concepts without departmental bias; challenge management and ask discerning questions; aspire to upgrade industry standards; and ensure adequacy of community performance and social purpose. These are all challenging tasks which require competence and commitment. It is the role of the independent nominating committee to seek out such qualified individuals.
3. Nominating Committee.-Establishment of a nominating committee consisting exclusively of independent outside directors. This is a critical provision because it will decide who the new members ought to be and whether present members should be renominated. It will also establish the allegiances of the new members brought on to the board and will do away with the notion that the new member owes his or her position on the board to the chief executive officer. The loyalty of the independent outside director must be to the shareholders and not to management.
The nominating committee should establish guidelines on the director-selection process; attempts should be made to move out of the tight circle of friends and business acquaintances that presently form the basis of invitations to join corporate boards. It should require that any person who agrees to serve as a director is willing to make a substantial (and defined) commitment of time to fulfill his or her responsibilities. The committee should define the kind of relevant experience that should be considered when determining the qualifica
tions to serve on the board. A careful yet far-sighted process might open the way for the appointment of more professors of law, business, political science and economics; public interest lawyers (as well as corporate lawyers) ; uni. versity, foundation and public administrators; community leaders, political organizers, and the like.
Compensation paid to outside directors ought to reflect the serious nature of the undertaking and the time commitments involved. (Too frequently compensation is set purposefully low because most of those who serve on boards are already in the highest tax bracket and join boards more for the prestige rather than compensation.) If the corporation wishes to demand the time of its outside directors it ought to pay for it. Higher compensation will also instill a greater sense of responsibility. And the method of compensation ought to encourage more actual participation; (that is, pay only for board meetings attended with additional compensation when called upon to put in more time).
[I should mention that the Center is presently contemplating establishing a project of screening qualified individuals with a diversity of experience who could make a valuable contribution to major corporations but who are not from the traditional mold. The Center has gained significant expertise over the past two years in screening over 100 individuals for service on the Northrop and Phillips Boards.]
4. Audit Committee.-An audit committee consisting exclusively of independent outside directors should be established. The principal purposes of the audit committee are to select and nominate the auditors to the board of directors, to meet with the outside auditors and determine the scope of the audit; and to develop guidelines where appropriate regarding how to handle financial transactions.
5. Other Public Policy Committee8.-In addition to the committees described above and other traditional committees (that is, finance, compensation, and so forth) other committees having clearly defined responsibilities in those public policy areas where the corporation may have an impact should be established. It would be the responsibility of these committees to formulate policy for the company and present it to the board for adoption. The kinds of committees that should be established would depend on the particular industry involved. Some examples are: industrial safety; product safety; environmental impact; and community relations.
The primary purpose of these and other committees would be to ensure that all the information will be presented to the board in some responsible forin and in a way that would directly involve members of the committee. This would be preferable to having reports presented to the full board by the management staff which tends to diffuse the responsibility among all board members and which would most likely result in rubber stamp approval.
Each committee (with staff support if necessary) will develop its own expertise and be able to operate more effectively and efficiently. By doing this, it will guarantee that the board will confront the issues involved in the company's activities. The simple process of making the board gather this information, face the issue, and formulate a policy will go a long way toward resolving many of the public policy difficulties corporations find themselves confronted with today. One of the real problems is that these issues are never presented to the boards. They are formulated in an ad hoc, ill-defined manner by lowerlevel management personnel who are more sensitive to corporate profits than social policy or, put another way, are more concerned with short term rather than long term interests of the company.
6. Monitoring Management.--It is imperative to develop a systematic method for reviewing management's performance. This is one of the most crucial tasks that boards perform. If there is an established mechanism which requires that the board regularly reviews the performance of the chief executive officer and his management team, such review will be far more likely to occur than if it is done on an ad hoc basis at the urging of one or more of the outside directors at the board meetings in the presence of those being scrutinized. Standards should be established by which the management performance can be assessed. Goals should be set at the beginning of the year and reviewed at the end of the year. There are various alternative ways to do this, but it should be done on a systematic basis.
Outside directors of the board should be required to meet separately outside the context of the full board meeting. The purpose of these meetings will be to
permit them to exchange information in a more frank and candid manner regarding the feeling each of them has about how management is running the company. It is exceedingly difficult to expect outside members of the board to confront and challenge the chairman of the board, the chief executive officer and his management team in the context of a board meeting. As a practical matter such questions are not raised during board meetings for fear of creating an embarrassing situation for the chief executive officer and disrupting the clubroom atmosphere that presently exists in most boardrooms. If scheduled meetings of only the outside directors occur, this will necessarily stimulate more forthright comments and observations of the individual outside board members, which in turn will lead to more carefully monitored management.
These proposals are certainly not intended to be exhaustive, but they are fundamental. Other more comprehensive proposals have been recently advanced. Two of the more thoughtful and imaginative analyses are the Vader report on "constitutionalizing the corporation" and a new book by Professor Christopher D. Stone entitled "Where the Law Ends: the Social Control of Corporate Behavior."
IV. CONGRESSIONAL ROLE IN THE IMPLEMENTATION OF INSTITUTIONAL
As proposed by the Nader report, one obvious way to implement the above proposals is to require federal chartering for all major corporations over a certain size and set as a condition for chartering, compliance with the previously described institutional structures. Another method, which can be more quickly adopted and is likely to be more palatable to Congress and the corporate community, would be to try aggressively to encourage boards of directors to implement these provisions voluntarily and make what refinements may be appropriate for their individual companies.
Many business leaders and board members acknowledge the fact that free enterprise is predicated on a system of checks and balances and that in matters of corporate affairs the shareholders have lost the power to check management. The check will therefore have to come from two sources if it comes at all: government regulation or the corporation itself. The first step should have government setting standards of corporate structure by way of legislation and require corporations to either adhere to those standards or explain why adherence is not appropriate.
We would recommend that Congress pass new legislation that would require the Securities and Exchange Commission to develop and periodically update structural models similar to those previously described. The new legislation can either itself set forth these models or require the SEC to develop them. The SEC should take more of a leadership role in this area. The Enforcement Divi. sion has done a commendable job under the aggressive and effective leadership of Stanley Sporkin, but more is needed from the Commission.
The Commission itself ought to interpret its mandate broadly. We believe that the SEC presently has the authority to do all that we have proposed in this testimony under its general responsibility to protect the investing public. Certainly information as to how the corporation's board of directors is structured can be construed as “material" information that ought to be disclosed to shareholders and the public. Each corporation over a certain size should then be required to file with the Securities and Exchange Commission, within a certain time, a report stating whether it has complied with these policy recommendations (e.g. 60% of the board must be made of independent outside directors) and, if not, why not. Those corporations that refuse to adopt the various provisions should be required to disclose prominently each year in both the proxy statement and annual report that the board of directors has considered and rejected each recommended proposal of the SEC, with a detailed explanation with respect to each proposal.
Some may understandably believe that such voluntary efforts will prove fruitless and that only mandatory measures will achieve the desired results. That may be the case. If the political realities would permit such adoption of man. datory proposals, we would be fully supportive without reservation.
There is reason, however, to believe that the approach outlined above may produce significant voluntary compliance. For example, the SEC has recommended the use of audit committees and requires that a corporation disclose the absence of an audit committee in the proxy statements. As a result there has been a substantial increase in the percentage of corporations which now have audit committees. Doubtless, these corporations took such action because it makes good sense from the standpoint of corporate finance and because it would be embarrassing to repeatedly disclose their refusal to heed the SEC's recommendations. This experience augers well for similar voluntary compliance on the other proposals set forth in this testimony.
We believe this may go a long way toward compelling corporations to, on their own, decide to adopt many of these basic institutional reform proposals. Forcing the board of directors to consider each of them, take a position, and to report back to the SEC will undoubtedly, for the first time, give significant leverage to present members of the outside board who are now in the process of rethinking their roles and the board's role. If the experience is similar to that which we had with the Board of Directors of Phillips Petroleum Company and each proposal is analyzed upon its merits and must be defended or rejected with supporting reasons, we would expect that many chief executive officers would find themselves in the rather uncomfortable position of either adopting the proposals or attempting to defend the status quo, which is difficult.
This is at least a modest first step that ought to be taken.
STATEMENT OF ARTHUR D. LEWIS, CHAIRMAN OF THE BOARD, U.S. RAILWAY
ASSOCIATION I accepted the invitation to speak at this conference some months ago and I experienced a little sense of panic when I received the final program and found that I was the last speaker of the day. I wondered what I could possibly say that had not been said already by better speakers. In today's meeting, I sort of feel that I am the caboose in a train of heavily loaded cars with all the freight up front, and, all the cars up front are the big, modern variety, such as Southern Railway's “Big Johns," or the heavy 100-ton hopper cars, or the specially constructed cars for the movement of outsized freight or special produce. In this particular freight train, this is not an enviable position for a caboose to be in.
At this point, I will just have to acknowledge and apologize in advance for some duplication of thought. Whether that is all bad I don't know, since it may be necessary to reiterate certain thoughts if we are to stimulate some of the changes I think must take place in the role performed by the boards of directors of modern American corporations.
The basic legal concept of what boards are supposed to do has not really changed over time. Boards have always had a fiduciary responsibility to represent the best interests of the stockholders, preserve the basic integrity of the assets and maintain the financial position of the company. Similarly, they have always had responsibility, however neglected, to see that the corporation meets its responsibilities to the public. Implied in their responsibilities has been the specific duty of selecting chief executives and their successors and acting as advisors to them. A board was supposed to work with the chief executive officer to set cor. porate objectives and strategies and act as a review board in determining his performance and the performance of his staff. It has, of course, delegated to management the responsibility and authority to run the company. But it cannot delegate to management its ultimate responsibility and accountability to the stockholder and the public.
Thus I do not think that the fundamental underlying role of the board is changing. What is changing is the degree to which boards are being held accountable for their actions. Because accountability has become a demanding fact today, there is an obvious need to reemphasize the need for adequate board performance.
Almost invariably, writers on the subject are critical of board performance. Myles Mace, in his excellent book, Directors: Myth and Reality, came to the conclusion that there was a considerable gap between what directors in fact do and what the business literature said they should do. Peter Drucker, in his book, Management, says: "... There is one thing all boards have in common-they do not function. The decline of the board is a universal phenomenon of this century. Perhaps nothing shows it as clearly as that the board, which in law is the governing organ of a corporation, was always the last group to hear of trouble in the great business catastrophes of this century."
Drucker wrote this before the most recent catastrophes occurred—the new scandals in illegal corporate political contributions and overseas business pay.