Delaware courts make liberal use of the demand requirement to dismiss derivative suits.  At the pleading stage, without the benefit of any discovery, shareholders carry the burden of showing reasonable doubt about the board's independence or the failure to engage in a valid exercise of business judgment.  This is, of course, the much cited test from Aronson v. Lewis, 473 A.2d 805 (Del. 1984).  In general, the business judgment component requires shareholders to show a procedural deficiency at the board level, an almost impossible thing to do at the pleading stage.  Much of the law in this area, therefore, turns on whether the board had a majority of independent directors.

In imposing the requirement of a majority, the Court in Aronson noted that the determination was not without controversy.  As the Court reasoned:

• We recognize that drawing the line at a majority of the board may be an arguably arbitrary dividing point. Critics will charge that we are ignoring the structural bias common to corporate boards throughout America, as well as the other unseen socialization processes cutting against independent discussion and decisionmaking in the boardroom. The difficulty with structural bias in a demand futile case is simply one of establishing it in the complaint for purposes of Rule 23.1. We are satisfied that discretionary review by the Court of Chancery of complaints alleging specific facts pointing to bias on a particular board will be sufficient for determining demand futility.

In other words, boards with a majority of independent directors could still, nonetheless, reflect an impermissible bias.  The paragraph left open the possibility that shareholders could show that despite its ostensible independence, the board was subject to the excessive control of the CEO.  

Yet in practice, this safety valve hasn't existed in any meaningful way.  Efforts to establish that the "independent" board was actually biased and controlled by the CEO have largely fallen on deaf judicial ears.  This can be seen from In re Dow Chemical Company, Civil Action No. 4349-CC, Del. Ch. Jan. 11, 2010. 

In that derivative suit, plaintiffs alleged that the board had entered into a contract to acquire Rohm & Haas without taking adequate precautions in connection with the financing of the transaction.  Specifically, plaintiffs alleged that the financing to acquire R&H was dependent upon the completion of a separate transaction with Kuwait (K-Dow) and that the agreement was "illusory."  See Plaintiffs' Opposition to Defendants' Motion to Dismiss, at 8 ("Motion"). 

The case turned on demand excusal.  Plaintiffs asserted, among other things, that the board was not independent.  The court, however, disagreed, characterizing the evidence as "no more than 'mere outside business relationship[s which] standing alone, are insufficient to raise a reasonable doubt about a director's independence.'" 

In addition, however, plaintiffs also asserted that the CEO controlled the board and gave as an example the board's decision to dismiss two officers at the request of the CEO.   As plaintiffs asserted on brief, "Liveris ordered the Board, overnight, to summarily terminate two dissident officers, Romeo Kreinberg and J. Pedro Reinhard, how had urged a long-term strategy upon the Board, which differed from Liveris's," (Motion, at p. 16), a directive that the "Board followed."  Complaint, at p. 16. (emphasis in original).  The Complaint listed Reinhard as "then-CEO and Director." 

In other words, at a pre-discovery stage of pleadings, the plaintiffs provided an example of control, one that at least raised the possibility of control.  The court, however, summarily dismissed the contention and in so doing conducted its own fact finding.  As the court concluded:

• For example, plaintiffs’ argument that Liveris allegedly exercised influence by “order[ing] the Board, overnight, to summarily terminate two dissident officers”—their best argument—falls short. Upon further investigation it is clear that valid business reasons existed to terminate those two officers; they held clandestine meetings and set up a proposed leveraged buyout—all behind the board’s back. Not surprisingly, the board may not have wanted them at the company. On the contrary, plaintiffs paint a different picture, suggesting that the two officers were whistleblowers on the bribery charges brought by the SEC against Dow in early 2007. Pls.’ Opp’n Br. at 16. The complaint, however, states that the officers were engaged in clandestine meetings without the full board or the CEO’s knowledge. See Compl. ¶ 125. Thus, it is far from clear that the board acted as Liveris’ puppets in deciding to fire them.

The need to undertake "further investigation" suggested additional fact finding.  Moreover, the court noted that the board "may not have" wanted the officers at the company.  In other words, even the court wasn't entirely sure of the motivation.  Finally, even if there were grounds for dismissal, the process of an overnight dismissal following a request from the CEO at least suggested control. 

The approach essentially reduces board analysis to a rote head count that makes no serious attempt to assess CEO influence.  In other words, the safety valve noted by the Court in Aronson, that "discretionary review by the Court of Chancery of complaints alleging specific facts pointing to bias on a particular board will be sufficient for determining demand futility," doesn't really exist.   

The irony in all of this is that the court in Dow Chemcial did not even need to make the finding about the lack of control.  The court concluded that the CEO, Liveris, was not interested in the transaction, making it irrelevant who he allegedly controlled.  Yet the impact of the dicta will make it far more difficult for shareholders challenging board behavior to show actual bias.  

The Economist has at least a partial explanation for the crisis currently befalling Toyota:  Bad corporate governance.   A piece in the erudite magazine noted that companies in Japan have "a rigid system of seniority and hierarchy in which people are reluctant to pass bad news up the chain."  Indeed, doing so is viewed as disloyal and "a violation of the traditional consensual corporate culture."

More specifically, the magazine pointed to the lack of diversity on the board.  As the magazine described:  

• The lack of an outside perspective is particularly striking in the case of Toyota’s board. It is composed of 29 Japanese men—all of them Toyota insiders, none of them independent. (Toyota’s first and only non-Japanese board member, one of its American managers, who was appointed in 2007, was swiftly wooed away by an American carmaker.) Most of the rest of Japan Inc is just as lacking in diversity, apart from a couple of honourable exceptions, such as Sony and eAccess. Indeed, there is a greater percentage of women on boards in Kuwait than in Japan.

It is perhaps a fair point but Japan's system of corporate governance has always been driven less by Anglo-American attributes such as independent directors and more by oversight by its main bank.  In other words, officers and directors are kept in check by the banks, not the independent directors.

At the same time, the Economist conflates independence and diverse viewpoints.  While its true that in the US model there are more "independent" directors, there is little evidence that they provide diverse viewpoints. Thus, Exxon has an independent board but could likely benefit in its decision making process from a more pronounced environmental viewpoint inside the boardroom.  

Moreover, US boards are not particularly diverse (between 10 and 15% for women and people of color).  And, as one recent study noted, they seem to be full of people with "friendship ties" to the CEO.  Indeed, efforts to increase diverse viewpoints on the board through facilitating shareholder access to the company's proxy statement for nominees has been mired in portracted opposition, with allegations that it will result in "special interest" directors. 

Japan may need a more diverse perspective on its board, but it is a reform not limited to Japan.

The Commission, in settling the case with Bank of America (which still must be approved by Judge Rakoff), negotiated some corporate governance provisions, some of which were designed to add integrity to the compensation process.  One of the changes was to require greater independence on the compensation committee.  Specifically, BofA must:

• IT IS HEREBY FURTHER ORDERED, ADJUDGED, AND DECREED that defendant BAC shall adopt an independence requirement for members of the Compensation Committee of BAC's Board of Directors ("Compensation Committee") according to the independence standards set forth in Section 10A(m)(3)(B) of the Exchange Act [15 U.S.C. §78j-1(m)(3)(B)]. Such independence standards shall require BAC to include as members of the Compensation Committee only those members who will not, directly or indirectly, accept any consulting, advisory or other compensatory fee from BAC or any affiliate or subsidiary of BAC, irrespective of the size or materiality of such fee, other than compensation in the member's capacity as a member of BAC's Board of Directors or be an affiliated person of BAG or any of BAC's subsidiaries. BAC shall maintain such a requirement for a period of three (3) years following entry of this Final Judgment.

In other words, the compensation committee must meet the same definition for "independent" applicable to the audit committee, a requirement imposed under SOX.  See Section 301 of SOX.  The definition more or less prohibits directors from receiving payments of any kind from the company except fees.  The Commission has labeled the definition "super-independence." 

This is in contrast to the rules of the NYSE that allow directors to receive payments of up to $120,000 without losing their status as independent.  See NYSE 303A.02 ("The director has received, or has an immediate family member who has received, during any twelve-month period within the last three years, more than $120,000 in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service").

The definition in SOX and applicable to BofA's compensation committee still does not take into account friendship or fees.  (One might argue that in fact the NYSE definition does take fees into account but that the definition is not enforced).  In other words, directors are not allowed to accept consulting fees from the company but can accept fees that are in the high six figures.

Nonetheless, the SEC's settlement in this case begs an important question.  Shouldn't the audit committee definition be applied to all of the required committees of the board (nominating, compensation and audit), to ensure greater director independence?  Perhaps it is a requirement that the SEC should encourage the exchanges to implement, rather than impose it on one company for three years.

The primary materials, including the proposed settlement, can be found at the DU Corporate Governance web site.

Corporate governance places heavy reliance on the use of "independent" directors to protect the interests of shareholders.  The stock exchanges require that listed companies have a majority of independent directors.  Delaware, in turn, provides legal benefits to boards with a majority of independent directors, either by facilitating the dismissal of derivative suits or by allowing conflict of interest transactions to be reviewed under the duty of care.  

Yet as we have noted often, neither the exchanges nor the Delaware courts adequately ensure that directors characterized as independent are in fact independent.  The definitions do not, for example, take into account the fees paid to directors, even when they exceed extraordinary amounts (say $700,000).  They also don't take into account friendship.  The exchanges ignore the issue and the Delaware courts have developed a defintion that makes it all but impossible to disqualify directors from being treated as independent because of their friendship with officers serving on the board, particularly the CEO. 

In other words, a board treated as independent can be loaded with persons having a financial incentive to act in the best interest of management or can be loaded with friends of managment who have the same incentive. The directors are called independent but in practice are not.  This is discussed in greater detail in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

This is widely understood but lacking in empirical evidence.  Evidence, however, may have surfaced.  James D. Westphal and Melissa E. Graebner have written a paper, A Matter of Appearances: How Corporate Leaders Manage the Impressions of Financial Analysts about the Conduct of Their Boards, that was recently discussed in the Economist.  The piece looked at management's efforts to fool analysts by making superficial changes in corporate governance.  They would add additional "independent" directors to the board in an effort to create the appearance of greater board oversight

• The authors found that chief executives commonly respond to negative appraisals from Wall Street by managing appearances, rather than making changes that actually improve corporate governance: boards are made more formally independent, but without actually increasing their ability to control management. This is typically done by hiring directors who, although they may have no business ties to the company, are socially close to its top brass. According to James Westphal, one of the study’s co-authors, some 45% of the members of nominating committees on the boards of large American firms have “friendship” ties to the boss—though this varies widely from company to company.

So there are the statistics.  45% of directors on nominating committees have "friendship" ties.  In other words, they meet the definition of independent but in fact have a pre-existing relationship with the CEO. The relationships in some instances, presumably, impair the ability of the directors to act in the best interests of shareholders.

One suspects that if anything the percentage is low.  Presumably there were other directors who had friendship ties that could not be objectively ascertained.  Moreover, one likewise suspects that a similar study done on the compensation committee would generate similar results.

Independent directors are not necessarily independent.  Yet shareholders and investors are led to believe that they are.  It would be better not even to use the term.  Moreover, with "friends" on the nominating committee, there is likely a bias towards nominees who favor management rather than shareholders.  The only way to gain true independence on the board is to facilitate the election of directors who are nominated by shareholders, not the board.  In short, shareholders need changes that lower the cost of nominating and electing directors.  In short, they need access and the SEC should act on the rule proposal that would grant shareholders such authority. 

WOMEN IN CORPORATE GOVERNANCE: HALFWAY UP FROM NOWHERE?  Not quite.  Halfway?  Try 3 percent.  As late as 1997, there were no female CEOs in the Fortune 500.  Jill Barad at Mattel Toy was the first.

Women are, or are soon to be, over 50 percent of our nation’s workforce.  They are 50 percent of the middle managers.  Yet females make up only 8 percent of the corporate officers and 3 percent of the CEOs, despite constituting over 30 percent of the MBA and law graduates since the 1970s (40 percent since the 90s).

Why the disparity?  Undoubtedly a glass ceiling still allows women to see but not obtain jobs on the highest rungs on the corporate ladder.  Yet, whether it exists, or doesn’t, any ceiling is more permeable, with many cracks in it (18 million, according to Hillary Clinton, numbering the votes she received in the presidential primaries).

Today the trick for women who aspire to upward progress is to find out where the cracks might be:

            Go Where They Aren’t.  This is the twenty first century.  Fields that were not open to women even 20 years ago are today.  CEOs Susan Ivey (Reynolds America), Pat Woertz (Archer Midland Daniels), Paula Rosport Reynolds (ex-CEO of Safeco Insurance), Lynn Elsenhans (Sunoco), and Ellen Kullman (Dupont) spent most of their careers in, respectively, tobacco, oil and gas, public utilities, petroleum, and chemicals.  Beyond training in business and accounting, none of these women began their careers with specialized technical knowledge.

            Be Financially Literate.  Many women who have reached the very top have done so in sales, or marketing (one, Anne Mulcahy at Xerox, in human resources) rather than in “line” jobs, those with bottom line profit and loss responsibility.  Male CEOs and board members, in particular, emphasize the absolute necessity of line experience for women.  Line experience or not, a CEO will always have plentiful support in finance and accounting.  But as the careers especially of women CEOs whom corporate boards have ousted, such those of Jill Barad at Mattel or Carleton Fiorina at Hewlett-Packard, demonstrate, possession and application of some grounding is essential -- no matter what pathway led to the top or how much staff support one has.  No substitute exists for a basic familiarity with corporate finance, managerial accounting, and capital markets.

            Have Style.  The existing advice books, or most of them, are flat wrong when they suggest that women should act like their male counterparts (“lower your voice,” “take up golf,” “watch Monday Night Football”).  Aggressive or assertive behavior, imitating what they perceive many males do, may well derail a woman’s career, even if after a promotion or two.  The days of “shoulder pad feminism” and Armani pants suits are gone. In the ranks of upper management, corporations want executives, men or women, who represent their corporations well, anywhere and at any time.  Diplomacy, the ability to think strategically, and the ability to show a team oriented approach have supplanted the dated 1970s advice, if it was ever good anyway.

            Develop a Reputation as a Problem Solver.  At Avon Products, CEO Andrea Jung evolved a strategy to retain hundreds of thousands of loyal Avon reps despite the relegation of “Avon calling” home sales to the whip and buggy era.  Charged with masterminding methods for making use of Dupont’s products safer, Ellen Kullman had Dupont spawn an entire new division, Safety, that is Dupont’s largest today. While at Chevron, Pat Woertz oversaw completion, on time and under budget, of an oil pipeline from Northern Alberta to Northern California.

Despite statistics (3 percent) that show only a glimmer of progress, closer examination of the careers of 21 women who have actually become CEOs demonstrates that many more routes than used to, or that readily meet the eye, lead toward the corner office.  

Douglas M. Branson is the W. Edward Sell Chair in Law at the University of Pittsburgh.  His newest book, The Last Male Bastion - Gender and the CEO Suite at America’s Public Companies,” has been published by Routledge Press early in 2010.

The other place where the Act uses listing standards is with respect to staggered boards.  Section 974 would add a new subsection to Section 14 of the Exchange Act to require shareholders to approve staggered board provisions.  The provision relies on listing standards, thereby limiting its reach to public companies traded on an exchange.  Interestingly, the provision does not include a mandatory right to cure but presumably allows for immediate delisting of non-conforming companies.

The provision provides that a company may not have a staggered board unless the company “has obtained the approval . . . of the shareholders."  Specifically, shareholders must approve the provision by the percentage needed to approve amendments to the articles or to adopt a staggered board bylaw. 

The provision looks like it will have little effect.  Staggered board provisions are typically in the articles (although a study by Bebchuk published in 2005 showed that about 10% of the provisions were bylaws).   Those in the articles have already been approved by shareholders.  This does not mean that public shareholders were given an opportunity to weigh in on the provision.  In some cases, approval likely occurred before the company went public. 

The provision leaves open the treatment of staggered board provisions that are approved as part of the reincorporation process.  Reincorporation is usually done as a merger, with the approval of the merger also approving the articles of incorporation of the surviving company.  To the extent that the surviving company has a staggered board, it was “approved” as part of the merger but not approved separately by shareholders.  As a result, companies that adopted staggered board provisions as part of the reincorporation process may be obligated to seek shareholder approval. 

Once the provision has been inserted in the articles, shareholders cannot initiate a change.  State law does not allow shareholders to initiate amendments to the articles of incorporation.  A far better approach, therefore, would be to require companies to resubmit staggered board provisions to shareholders at a regular (three year/five year) interval.   

In the meantime, the bill and a summary are posted at the DU Corporate Governance web site.

SEC. 974. SHAREHOLDER VOTE ON STAGGERED TERMS OF  DIRECTORS.

Section 14 of the Securities Exchange Act of 1934 (15 U.S.C. 78n), as amended by this subtitle, is amended by adding at the end the following:

(k) SHAREHOLDER VOTE ON STAGGERED BOARD OF DIRECTORS.—

(1) LISTING STANDARDS.—Not later than 1 year after the date of enactment of this subsection, the Commission shall, by rule, direct the national securities exchanges and the national securities associations to prohibit the listing of any security of an issuer that is not in compliance with any of the requirements of this subsection.

(2) SHAREHOLDER VOTE REQUIRED.—

(A) IN GENERAL.—No issuer may have a board of directors with staggered terms of service, unless the issuer has obtained the approval or ratification of the shareholders of the issuer, in accordance with subparagraph (B), before the adoption of such board of directors with staggered terms of service.

(B) SHAREHOLDER VOTE.—The percentage of shareholders required to approve or ratify the board of directors with staggered terms of service of an issuer shall be the percentage required by the issuer for an amendment to—

(i) the certificate of incorporation of the issuer, in the case of a board of directors with staggered terms of service adopted pursuant to a certificate of incorporation of the issuer; or

(ii) the bylaws of the issuer, in the case of a board of directors with staggered terms of service adopted pursuant to the bylaws of the issuer.

(C) TRANSITION PERIOD.—In the case of any issuer having a board of directors with

staggered terms of service that, on the effective date of the rule promulgated by the Commission under paragraph (1), was not approved or ratified by a vote of the shareholders of the issuer, the issuer shall not be deemed to be in violation of this subsection if such issuer—

(i) seeks the approval of the shareholders of the issuer at the first annual meeting immediately following the date on which the Commission promulgates rules under paragraph (1); or (ii) in the event that the annual meeting described in clause (i) is scheduled be held fewer than 120 days after the effective date of the rules promulgated by the Commission under subparagraph (1), seeks the approval of the shareholders of the issuer at first annual meeting immediately following the end of such 120-day period.

(D) DEFINITION.—In this paragraph, the term ‘board of directors with staggered terms of service’ means a board of directors of an issuer that conducts an annual election for membership on such board of directors in which fewer than all members are elected to such board of directors.

One of the newest fronts in the corporate governance area has been the consistent decision on the part of most public companies to combine the positions of chairman and CEO.   

The approach is facially inconsistent with the role of the board.  To the extent that the board has as a primary obligation the duty to oversee the CEO, it defies logic to set up boards consisting mostly of independent directors, a status that, while not ensuring independence, does generally ensure that they have no independent source of information about the company except what they get in the popular press or from board meetings, but having them be chaired by the person they must oversee.  The chair typically calls special meetings of the board and controls the agenda.  In short, if problems arise with the CEO, it is the chair who presumably alerts the other directors, something that has to diminish inordinately when the chairman is the CEO.

Nor is this conjecture.  In the realm of global corporate governance, the practice of combining the two positions is the exception.  Indeed, some of the pressure for reform is coming from overseas sources.

As with most matters of corporate governance, it is state (read Delaware) law, there are no practical impediments to the practice, despite the clear disadvantages for shareholders (demonstrating the meaningless of the requirement that the board must act “in the best interests of shareholders). 

Given the widespread refusal to separate the two provisions, any effort to make the separation mandatory will likely result in a raft of hostile criticism.  As a result, regulatory efforts have, so far, been tentative.  Thus, in the Act, Section 973 would add Section 14A to the Exchange Act and require companies to explain their practices.  Specifically, the Commission would be required to adopt a rule that requires companies to explain “the reasons why the issuer has chosen” to combine or separate the two positions.  It is something like what we called for this time last year. 

The proposed provision is not likely to have much affect.  The explanation will likely result in boilerplate.  Moreover, even if the positions are separated, there is nothing in the provision that would require the position to go to an “independent” director.  Nonetheless, it is the first set of tepid steps towards an eventual separation of the two positions, something that will likely await the next corporate governance crisis.  Moreover, by using disclosure rather than listing standards, the provision applies to all public companies and will be subject to enforcement under Rule 10b-5 to the extent that the explanation is deemed to be materially misleading. 

In the meantime, the bill and a summary are posted at the DU Corporate Governance web site.

SEC. 973. DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES.

Section 14A of the Securities Exchange Act of 1934, as added by section 971, is amended by adding at the end the following:

(b) DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES.—Not later than 180 days after the date of enactment of this subsection, the Commission shall issue rules that require an issuer to disclose in the annual proxy sent to investors the reasons why the issuer has chosen—

(1) the same person to serve as chairman of the board of directors and chief executive officer (or in equivalent positions); or (2) different individuals to serve as chairman of the board of directors and chief executive officer (or in equivalent positions of the issuer).

Activist shareholders sometimes seek board positions.  Statistics show that the presence of a non-management director on the board can be beneficial to shareholders.  At the same time, however, the dissident directors may not need indefinite tenure.  This can be seen in connection with the behavior of Carl Icahn and his position on the board of Yahoo. 

Carl Icahn has been a regular advocate for shareholder rights and has sometimes used his economic strength to obtain positions on the board for himself or his nominees.  Microsoft’s failed attempt to acquire Yahoo! last year provided Mr. Icahn with an opportunity to take a position on Yahoo!’s board.  As reported in the Wall Street Journal, he gained a position after threatening a proxy fight.  A few weeks back, however, Mr. Icahn resigned from the Yahoo board, indicating that the board no longer needed an activist director. 

His tenure on the board saw a number of changes.  Jerry Yang stepped down as CEO, replaced by Carol Bartz, who has garnered considerable praise from Mr. Icahn.  (As he wrote, according to the Wall Street Journal:  “I wish you could be cloned because so many of the companies in the country could use a Carol Bartz as CEO.”).  Yahoo also entered a ten-year search partnership with Microsoft. 

With these changes in place, Mr. Icahn deemed his position on the board no longer necessary.  Perhaps the lesson from Mr. Icahn's approach is that boards can sometimes use a spirited outsider to shake up the existing culture and decision making process, if only for a short time.  

In Delaware, courts consider boards independent if they contain a majority of independent directors.  That the board might include some percentage of interested or non-independent directors, who can influence the decision making process, appears to have little relevancy to the court's analysis.  This can be seen In re Nat’l City Corp. Shareholders Litig.

In that case, the Delaware Court of Chancery approved a proposed settlement agreement between National City Corporation (“NCC”) and its shareholders.  The settlement arises from a suit brought by NCC shareholders to enjoin a merger between NCC and PNC Financial Services Group, Inc. (“PNC”).

The economic crises that produced capital, liquidity and credit problems for the financial sector culminating in the Lehman bankruptcy in September, 2008 forced NCC to consider strategic options to prevent failure.  To further complicate the problem, the Office of the Comptroller of the Currency informed NCC that it was “very possible” that NCC would not receive government assistance.  The confluence of circumstances narrowed NCC’s options.  Consequently, NCC began to shop for potential buyers.

UBS initially offered $2.545 billion, a purchase price of less than half the market capitalization of NCC at the time ($6.3 billion).  Prior to a vote to approve the merger with UBS, however, PNC offered $5.45 billion.  On October 24, 2008 NCC announced a proposed merger with PNC.  NCC was successful in negotiating a slight price increase, and the final proposal would have allowed PNC to acquire NCC in an all-stock transaction valued at $5.58 billion. 

NCC shareholders subsequently filed suit seeking to enjoin the merger.  The shareholders allege that NCC’s board breached their fiduciary duties and that PNC aided and abetted those breaches.  Specifically, the consolidated complaint claimed that (1) NCC’s board had failed to maximize the sale price, (2) NCC’s board had allowed PNC to buy NCC “on the cheap,” and (3) NCC’s board had failed to disclose material facts in the initial proxy report.

The settlement agreement considered by the court provided that plaintiff shareholders would release their claims in exchange for additional disclosures and attorney’s fees.  Those additional disclosures included:  (1) Potential conflict of interest on the part of Goldman Sachs, who advised both PNC and NCC at various times during the negotiations, (2) status of NCC’s participation in the troubled assets purchase arrangements, (3) NCC’s alternative transaction possibilities, (4) other strategic options for company growth if NCC remained an independent entity, (5) detailed information about the investment agreements and warrants found in reports filed with the SEC, and (6) the method used by NCC’s board to solicit other transaction partners.             

The court acknowledged the difficult financial situation in which NCC found itself in September, while noting that the shareholders faced an “uphill battle.”  This was due to the application of the Business Judgment Rule (“BJR”) in the absence of a showing of the board’s interestedness or disloyalty.  In addition, nothing in the complaint could rebut the presumption of the BJR.  Moreover, NCC had a provision in its articles of incorporation that would force plaintiffs to demonstrate bad faith by the board.    

The shareholders responded that fourteen officers of the company were interested because they would receive change-in-control payments.  However, only one of those officers was on the board.  The one officer did happen to be the company's chairman, president and CEO.  Nonetheless, the Chancery Court concluded that the Delaware Supreme Court has “never held that one director’s colorable interest in a challenged transaction is sufficient, without more, to deprive a board of the protection of the BJR presumption of loyalty.”  Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 363 (Del. 1993).  Balanced against the remoteness of shareholders’ success on their claims, stands the meager benefit of additional disclosures.  The Court found that this balance represented a fair and reasonable compromise.  As such, the settlement was approved. 

The court also addressed the issue of attorney’s fees.  Plaintiff’s lawyers requested $1.2 million in fees.  The court scoffed at such a “pricey” amount, especially when considered in light of the meager benefit produced for their clients.  Thus, the court concluded that a fee of $400,000 was more in line with the benefit received by the shareholder class.    

The primary materials for this post are available on the DU Corporate Governance website

Norway provides an example of how to diversify boards without waiting for the "market" to effectuate change.  The country requires each board to consiste of at least 40% of each gender.  The experience is only in its early stages but appears to be functioning effectively.  In other words, requiring more women in the board room did not destroy Norwegian capitalism and may even have had some positive ramifications. 

Norges Bank Investment Management, a branch of the Norwegian central bank, among other things manages the Norwegian Government Pension Fund, a task that requires investment into the United States.  NBIM has taken upon itself to submit four shareholder proposals calling for the separation of chairman and CEO.  The targeted companies?  Harris Corporation, Clorox, Cardinal Health, and Parker Hannifin. 

At Clorox, the proposed amendment reads as follows:

• “Notwithstanding any other provision of these Bylaws, the Chairman of the Board shall be a Director who is independent from the Corporation. For purposes of this Bylaw, ‘independent’ has the meaning set forth in the New York Stock Exchange (“NYSE”) listing standards, unless the Corporation’s common stock ceases to be listed on the NYSE and is listed on another exchange, in which case such exchange’s definition of independence shall apply. If the Board of Directors determines that a Chairman of the Board who was independent at the time he or she was selected is no longer independent, the Board of Directors shall select a new Chairman of the Board who satisfies the requirements of this Bylaw within 60 days of such determination. Compliance with this Bylaw shall be excused if no Director who qualifies as independent is elected by the stockholders or if no Director who is independent is willing to serve as Chairman of the Board. This Bylaw shall apply prospectively, so as not to violate any contractual obligation of the Corporation in effect when this Bylaw was adopted.”

As NBIM explained:

• The board should be led by an independent Chairman and be in a position to make independent evaluations and decisions, hire management, set a remuneration policy that encourages good performance, provide strategic direction and have the support to take long-term views in the development of business strategies.  An independent Chairman is better able to oversee and give guidance to Corporation executives and help prevent conflict or the perception of conflict. This will in turn effectively strengthen the system of checks-and-balances within the corporate structure and protect stockholder value. 

In short, we have a branch of the Norwegian government trying to get US companies to conform to international practice.  We will provide additional thoughts in the next post.

We are discussing a Report produced by the ABA Task Force on Delineation of Governance Roles and Responsibilities.  The Report is a good overview of the roles played by three interest groups in the governance debate: shareholders, directors, and regulators.

The Report indicates that directors are working harder.  One study reported that they spend 223 hours on board/committee matters and that they meet an average of 9 times a year (although about half of the S&P 500 still meet only 6-8 times a year).  One suspects that the hourly figures are self reported.  More importantly, the issue is not whether boards are meeting more often (in a period of crisis like now how could it be otherwise), the question is what are directors are doing when they meet.

For that to be answered, there needs to be a discussion of exactly what duties arise out of a board's fiduciary obligations.  Yet the Report merely refers to these duties generally.  As the Report notes:

• The board is required to apply its own business judgment as a fiduciary to issues that - as a matter of law - it and not the shareholders must decide. Applying fiduciary judgment in the face of apparently strong shareholder opinions is a particular challenge, given that failure to abide by majority shareholder wishes on non-binding shareholder proposals may lead powerful proxy advisors to recommend votes against directors the following year.

It may be hard but at least for the largest public companies, they are well paid, with some making in the vicinity of $700,000 a year. 

Corporate governance must be more than shareholder access or an increased number of independent directors.  Boards need to be told more, something Delaware resolutely refuses to do.  They weren't required to be told about poison puts in Amylin, or required to review systemic risk in Citigroup.  In other words, the duty to monitor has been given little content by the Delaware courts.  A meaningful analysis of corporate governance practices must include an examination of what directors ought to know and what they ought to do when the get the information.

The ABA Task Force on Delineation of Governance Roles and Responsibilities came out with a Report that received some mention but otherwise disappeared into the morass that is corporate governance.  There is so much going on, between the SEC, the Delaware courts, and Congress, that reports unconnected to specific developments don't get much play.  Having said that, it is a good read and pulls together considerable factual information on the state of corporate governance.

The discussion on the activities of the board of directors deserve particular attention.  Were someone from Mars to read the section, it would seem as if US corporations had dramatically improved their system of governance, with naysayers limited to gadflys and malcontents.  Specifically, the report noted:

• The number of indendent directors has increased over the last 10 years, from 78% to 82%, noting that this understates "the magnitude of this change, given enhanced rigor in the definition of "independence."
• Boards must have nominating committees (at least if exchange traded) consisting entirely of independent directors.  In 2008, 60% of new director nominations came through a search firm, 21% came from independent directors and 9% were recommended by the CEO, down from 14% in 2005.
• Boards contain fewer active CEOs.  Diversity is better. "In 2007, 85% of Fortune 1000 companies had one or more female director, (up from 78% in 2001) and 78% had one or more director from an ethnic minority (up from 68% in 2001). In 2008, approximately one in five new directors came from a diverse ethnic background, and women accounted for 18% of new directors." 
• Directors are working harder.  From one study, directors are reputed to spend 223 hours on board/committee matters.  The average number of meetings has increased from 7 to 9, although nearly half meet "between six and eight times per year"."
• Reliance on an independent chair or lead director has become more common, with the percentage up to 95% for the S&P companies (although only 16% have independent chair's).

Yet complaints about governance abound.  How can that be with all of these improvements?

These numbers obscure many issues.  First, while it is true that there are more "independent" directors on boards, the Report contains no discussion of the definition.  As we have noted over and over, there are serious problems with the definition, including the failure to take into account friendship, the problem of fees, and issues of enforcement by the stock exchanges.  For a system that relies so much on the presence of independent directors as the primary guardian of shareholder interests, surely the definition requires close examination.

Second, the Report lumps together the use of an independent chair and a lead director.  In fact, the discussion would more appropriately focus on the use of lead directors since few companies require an independent chair.  Moreover, the lack of an independent chair relates to the increased percentage of independent directors.  These directors typically have no economic connection to the company.  As a result, they are particularly dependent upon information provided to them as directors.  Yet with the chair and the CEO one and the same, they are highly unlikely to get information critical of the CEO's role. 

As for lead directors, companies deserve credit for their use only if the positions are meaingful.  It is highly likely that the role of lead director in most cases is merely to run any meeting of the independent directors.  In other words, it is often a powerless postion.  The Report should have discussed the role played by this position and tried to assess its success.

Finally, with respect to diversity, the Report does not contain the aggregate data on the number of women and people of color sitting on boards.  The percentage remains low (in the 15%) range.  At most the Report demonstrates that companies have been pressured into having at least one woman and one person of color on their board, hardly a ringing endorsement for board behavior.

We will do a second post with one last comment about the evidence on boards working harder.

We have discussed from time to time the sad state of board diversity in the United States.   Boards in the US are often mirror image boards, with membership looking much like the CEO.  The boards tend to be male, with members having similar experiences, and tend to be undiverse in age.  The number of women and people of color remain around 10%. 

It's not about the need to have the board include a cross section of humanity.  Rather, it's about the board's role.  To the extent that the board is there to provide CEOs with necessary and sometimes difficult advice, it needs to have a variety of viewpoints.

The government in Norway, as we have discussed here before, became fed up with the corporate excuses for not diversifying boards.  The government mandated that, with respect to gender, boards include at least 40% women.  Even in Norway the approach drew objections.  In general, CEOs and boards don't want different viewpoints.  It is easier when everyone operates with the same perspective.  They complained that it would make boards less effective and that there were not enough "qualified" women candidates.

The data on effectiveness remains to be fully developed.  Yet an article in the Financial Times indicates that, anecdotally, the requirement has benefited boards and that, with work, it turns out that there are plenty of qualified women candidates.  First, Norway now has the highest percentage of women directors on boards, with the percentage at 44%.  Second, with men dominating traditional professions used to screen board nominees, companies had to expand the pool and the criteria for board membership.  As a result:

• nomination committees have been forced to look in different areas for suitable female candidates. “They have turned to areas where there are lots of women such as lawyers, academics – and even ministers,” laughs the former energy minister, who now sits on nine boards. Early research on the law suggested many of the women were either economists or lawyers with plenty of ex-ministers too. 

Nor have Norwegian boards had to resort to the use of a small number of women who sit on a large number of boards.  As the Financial Times notes:  "More strikingly, it seems there are more 'golden trousers' than 'golden skirts': according to the Center for Corporate Diversity in Oslo, only two in 10 women hold more than one board position while four in 10 men have multiple directorships."

Third, their presence has had some impact on the decision making within board rooms, consistent with studies showing that the presence of women on federal appeals courts alters the decision making dynamic.  As the article notes:

• Academic studies are divided but Grace Reksten Skaugen, one of the country’s most prominent directors, who is on several Norwegian and Swedish boards, says female directors are less bound by convention and unembarrassed to admit they do not know something. “Women are more willing to ask questions without regard to whether they may be perceived as stupid or awkward questions,” she says.

• Ms Skaugen was herself involved in one of the most prominent examples of that questioning approach: she was among female directors at Statoil who did not accept answers about a corruption probe and called an extra board meeting that led to the resignations of both the chief executive and chairman of the oil company.

• Ms Berdal says the quota law coincided with a debate on corporate governance in Norwegian companies and the combination has led “to a much better discussion”. Ms Breiby agrees, saying that directors no longer “sit” on the boards but “work” in them: “We have really raised the level of discussion in boards.”

Fourth, a collateral consequence is that boards are becoming younger.  The data in Norway shows that "38 per cent of female directors are aged 45 or under, against only 20 per cent of men, while 71 per cent of women non-executives have higher education versus 62 per cent of males."  

The only serious problem expressed in the article was the inchoate concern that somehow these women would be inexperienced enough to be controlled by management.  While of course this can happen (it can happen to men, even with the right "experience"; after all, no one knows the company like management), the lawyers and ministers selected to sit on these boards would not seem to pose much systemic risk of this.  Moreover, it is an interesting criticism since boards in general have a reputation of being captured by management, even with members who have the right experience. 

Here is another example of government interference in the market, something ordinarily to be eschewed.  Yet the market (including the one in the US) seems incapable of putting more than a marginal number of women on the board.  Remember that it is management that nominates directors and management that apparently does not want the diversity that would come with a greater number of women (and perhaps a greater number of diverse view points).  It is, in the end, the promise of shareholder access and the removal from management of the exclusive right to control board membership that contains the promise of greater diversity.

As we debate increased regulation, we return to one of the most common shibboleths raised by opponents.  Additional regulation will cause the pool of eligible directors to shrink.  Certainly, the stories of departing directors have increased, with companies like General Motors and AIG cleaning house.

So is the pool really shrinking?  As we noted, resignations would in fact provide a perfect opportunity to expand the pool and frankly bring to the boardroom some much needed diversity.  The number of women and people of color in the boardroom is anemic.  Diversity is about providing the CEO with a full range of advice and feedback to make him/her more effective.  Loading up boards with people who resemble the CEO may well be the worst thing for someone managing huge businesses.

Evidence suggests that the pool is not shrinking but that companies are forced to reach outside their traditional sources.  According to reports in the WSJ on a study done by Directors & Boards, the number of women among new directors has increased substantially.

• In the first three months of the year, 38% of new directors – 38 of 101 appointments – were women, according to data compiled by quarterly journal Directors & Boards.  That's the highest number and percentage since the publication began counting in 1994.

Moreover, some of the companies selecting women during this period are among the largest.

• Some of the new appointees are joining big companies.  Microsoft named to its board Maria Klawe, president of Harvey Mudd College; Chiquita Brands International named Kerrii Anderson, former CEO of Wendy's International; ConAgra Foods named Joie Gregor, who served as assistant to the president for presidential personnel under George W. Bush; and VF Corp. named Juliana Chugg, senior vice president at General Mills. Directors & Boards tracks every new director it notices, monitoring press releases, specialized websites and appointment announcements it receives.

And why is this the case?  CEO's are less willing to serve.  As a result, "boards are being forced to look at a broader pool of candidates."  Moreover, once the number of women on the board increase, "they may be opening doors to other women's candidacies."

This is only a single three month period.  It may not continue.  Moreover, other studies in the article suggest that no great surge in women on the board is taking place.  Finally, the analysis says nothing about other under represented groups.  Nonetheless, it does belie the notion that increased regulation or increased board duties somehow shrinks the pool.  It merely requires companies to take broader perspective on the nature of the pool, something they should be doing anyway.

Jon Macey at Yale published an editorial in this weeks WSJ contending that the recent spate of congressional interference in the economy (mostly bailout money) was the "first step in an ongoing porcess to socialize American finance."  It's a provocative thesis.  Unfortunately, the essay doesn't really address the issue and is really little more than a challenge to a litany of reforms in the corporate governance area that Macy does not like (and digs at people like Chris Dodd that have little bearing on this thesis).  The piece is particularly critical of say on pay, accusing the government of implementing a system that "shareholders have rejected in the past." (Is this really true? Go here for the other side).

Put aside that not all shareholders have rejected say on pay, the more salient issue is how criticism of the practice contributes to Macey's contention that finance is becoming socialized.  Moreover, Macey has, in the past, expressed almost talismatic reliance on the market to police all things wrong with corporate governance.  But surely there is widespread agreement that with respect to risk taking and executive compensation, the market approach has failed.  Yet his essay offers no solution other than snippets that suggest he would continue to rely on the market. 

Thus, he opposes limits on golden parachutes because "many top executives need to be pushed out."  The absence of golden parachutes "will lead to the kind of managerial entrenchment that has crippled the economy."  In effect, this is an admission that boards of directors cannot be counted on to replace inefficient management (something he acknowledges in his book, Corporate Governance, where he asserts that the CEO often has "captured" the board).  In other words, the current system doesn't work.  Moreover, to the extent that executives need financial inducements to leave, presumably they would prefer exessive inducements to stay and only take the exit package as a last resort.  In other words, Macey really opposes all mandated limits on executive compensation, a dicey position given the obvious excesses that have occurred in recent years.

No one, including this Blog, enjoys the government's deepening involvement in the corporate governance process.  The idea that the CEO of GM could only be ousted because the President of the United States essentially fired him is highly unfortunate.  But it reflects a failure of a corporate governance model implemented by Delaware and largely supported by academics like Jon Macey.  It is, therefore, no great surprise that he would criticize the government solution without mentioning the source of the problem.

There are many many problems with the Delaware model of corporate governance.  We have noted that Delaware applies the business judgment rule to duty of loyalty decisions (read executive compensation) when the board consists of a majority of independent directors.  The approach entirely ignores the fact that this allows the interested influence to remain in the decision making process.  Moreover, as we have noted time and time again, the Delaware courts use a number of devices to pre-terminate the exploration of director independence, often not letting the allegations get past a motion to dismiss.  For a more complete discussion of these issues, read Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  The result is that independent boards are often not independent at all.

We have likewise noted that directors have an economic incentive to do what the CEO wants.  Sitting on the board of a public company can be an incredibly lucrative proposition.  In 2007, the directors of Goldman Sachs received around $700,000 in total compensation.  The Delaware courts, however, have an almost categorical rule that fees are not taken into account in determining whether directors are independent.  Because fees can clearly be material, the only analytically defensible basis for the approach is that the CEO has no ability to terminate the material income stream.  (The Delaware Courts use less definsible justifications including the argument that applying the materiality analysis would result in the elimination of "regular folk" from the board). 

While legally true (only shareholders can fire directors), in fact it is practically incorrect.  The best way to lose the comfortable sinecure of a board seat is to not be renominated.  The best way to not be renominated is to irritate the CEO.

With that in mind, we turn to In re: Affiliated Computer Services, Inc. Shareholder Litigation, 2009 Del. Ch. LEXIS 35 (Del. Ch. Feb. 6, 2009).   The case is a relatively straightforward demand excusal case where, as usual, shareholders had their case dismissed for failing to make demand.  The Chancery Court concluded that the board in fact contained a majority of independent directors.

The more interesting thing is the facts.  It seems that the outside directors irritated the CEO.  The consequence?  He insisted that they all resign.  As the opinion noted:  "That same day, Deason (by letter from a New York lawyer purporting to act as counsel to ACS, but delivered through Deason's personal counsel) demanded the immediate resignation of all of the outside directors of ACS, whom the letter accused of various breaches of fiduciary duty, and named four candidates to replace them."  Two days later, the board held a special meeting.  What did the directors do?  Resign, conditioned upon reviewing the candidates proposed by the CEO.

On November 1, 2007, at another special meeting of the Board of Directors, the independent directors informed Deason and the management directors that, because of Deason's and management's conduct, they felt compelled to resign from the Board and not to stand for re-election. However, to ensure that their successors were truly independent and to protect the Company's minority shareholders, the independent directors also stated during the November 1 special meeting that they were prepared, prior to their resignation, to immediately begin the process of reviewing Deason's suggested nominees and any additional nominees proposed by the Company's shareholders. 

Whatever the significance of the assorted allegations of misconduct and breach of fiduciary duty, one thing was clear.  The CEO wanted the directors out and they left.  It is a rare public example of what happens to independent directors when they no longer have the confidence of the CEO. 

While the public nature of this fracas is unusual, the takeaway is widely understood.  The CEO can effectively terminate a director, albeit at the next meeting when he or she is not reelected.  As a result, the CEO can terminate the fees.  Fees, therefore, ought to be tested under the same materiality test as any other income stream received from the company.  But this being Delaware,  fees are simply ignored in the determination of independence.  

The Journal reports that the number of CEO firings is on the rise.  The article doesn't have much perspective, merely noting that there has been a spate of dismissals since the first of the year.

• William Watkins, ousted Monday at Seagate Technology LLC, is the sixth CEO of a publicly held company to be replaced in just the last eight days. His exit follows the departures last week of CEOs at Tyson Foods Inc., Borders Group Inc., Orbitz Worldwide Inc., Chico's FAS Inc. and Bebe Stores Inc.

It would be nice to attribute the behavior to a more active role played by boards in the oversight of public companies.  Alas, it is more likely cyclical.  When markets are down (in this case, way down), more CEOs find themselves unemployed.  But the numbers can be misleading.  Last year, when the bottom fell out, the number of CEO departures increased slightly, from 56 of the S&P 500 to 61.  Moreover, the WSJ noted that the number reflected the companies that "changed" CEOs.  Thus, some of them likely retired or left without board impetus.

There are probably few functions more important for the board of directors than oversight of the CEO and other top officers.  Unfortunately, there is reason to believe that directors receive skewed information about CEO performance and, in fact, are "captured" by top officers.  This is a consequence of weak fiduciary standards and a definition of independent director that does not ensure independence.  In short, it is a problem of Delaware law.

One of the most tone deaf companies when it came to the environment (specifically global warming) had to be Exxon.  Perhaps the most profitable company in the world (at least when gas prices were over $3 a gallon), the company almost managed to lose a shareholder revolt (spearheaded by the Rockefellers) over environmental practices and the need to separate the chairman and CEO. 

On this Blog, we asked about the role of the board.  It was clear that many of the positions were driven by the CEO, Rex Tillerson, and that a more effective board would have tried to bring his views and positions more in line with the mainstream.  We attributed the failure to a "mirror image" board, one that looked like the CEO and was likely to give the CEO only the advise he/she wanted to hear. 

It turns out that Exxon has seen the light and its CEO has now joined the call for a green house gas tax.  It is quite a change, as the article noted.

• The speech signals an evolution in the thinking of Mr. Tillerson, who became chief executive and chairman of Texas-based Exxon, the world's largest Western oil company, in 2006. Mr. Tillerson now calls the issue complex and challenging to understand, but -- in contrast to Exxon's previous party line -- he doesn't question whether fossil fuel use has contributed to rising global temperatures. In 2007, when he gave his last big speech on climate change, he said he didn't support any particular policy for curbing carbon-dioxide emissions.

We applaud Tillerson for coming around on the issue, although Exxon still needs to make a larger mark in the realm of alternative energy sources.  But we still can't help but wonder whether the conversion would have occurred much sooner and at much less cost had the board been a more active source of alternative views for the Exxon CEO.

The NY Supreme Court ruled on the class action brought by shareholders alleging that the forced merger between Bear Stearns and JP Morgan violated the board's fiduciary duties.  The case dismissed the suit on a motion for summary judgment. 

It is hard to argue with the decision and, frankly, presents a good example of how the business judgment rule ought to work.  There was an opportunity for discovery and an exploration of the underlying facts.  The opinion demonstrates relatively conclusively that the board operated under severe conditions, including financial turmoil and weak capital markets.  The fact that the company was originally sold for $2 a share (a price subsequently raised to $10) illustrates that the process was far from perfect but given the difficulties confronted by the board a not unreasonable outcome.  As the opinion noted, it could have been worse, something that Lehman Brothers would discover first hand.

We do note this observation, however.  The court took the opportunity to praise the board.  The opinion pointed out that three directors (Schwartz, Cayne and Greenberg), "were also members of Bear Stearns' management."  The other nine members, however, were outside directors.  They were described as having "broad business and life experience" and the accompanying footnote set out their highly credentialed background.

Fair enough and were we looking at the board from the perspective of this transaction alone, it would be hard to find anything but the most professional of conduct.  But this is a classic example of the type of board that could be viewed has having been captured by management.  Several members of management sat on the board and a number of directors served with them for long periods, providing plenty of time to be captured (if they weren't already when they joined).  It was also an undivese group, not particularly likely to provide top management with differing views.  They were well paid (providing incentives to not "rock the boat") and, in 2006, attended only six board meetings.  Many also served on multiple boards, which presumably stretched their attention span. 

The question, therefore, isn't about the mishandling of the merger with JP Morgan, but how the board allowed Bear Stearns to get into the position where a shotgun merger was the only real salvation.