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Governance lessons from abroad.

Governance Lessons From Abroad

Questions regarding corporate governance in non-U.S. markets are growing as fast as U.S. investors' non-U.S. portfolios. Help is already here for the most fundamental task - helping U.S. investors vote their non-U.S. proxies. Within the last two years, our firm, along with Global Proxy Research Corp., the Investor Responsibility Research Center, Georgeson & Co., Morrow & Co., Fidelity Investments, the Independent Election Corporation of America, Citibank, and others, through a variety of services, has begun to help U.S. investors obtain, translate, analyze, and vote their non-U.S. proxies and attend foreign annual meetings.

On a higher level, U.S. investors, along with corporate attorneys, securities lawyers, and other interested parties, are looking at corporate governance systems overseas to see whether there are any lessons for the U.S. What they have learned so far is that as bad as it seems here, the U.S. corporate governance system is more balanced than most non-U.S. markets. In fact, at two industry conferences in the fall and winter of 1990, experts from the U.K., Germany, and Japan said they were looking at the recent changes in U.S. institutional voting patterns and corporate governance initiatives to see whether there were any lessons applicable for their own countries.

This article addresses the other side of the equation: Are there lessons from abroad for U.S. corporate governance? This article is by no means a comprehensive examination of all non-U.S. markets. Instead, it looks at some of the more intriguing examples from abroad: Canada's poison pill, Germany's two-tier board, and the U.K.'s Promotion of Non-Executive Directors (PRO NED).


Shareholder rights plans, as they are politely known, or poison pills, a more realistic appellation, are among the most controversial securities ever devised. The plans give a board of directors targeted with a hostile tender offer almost unlimited power to negotiate for a higher price, gain time to find a better offer from another party, and/or implement an internal restructuring with greater value than the tender offer. In practice, this is how most pills have been used in the U.S.

But pills also give a target's board the power to resist any hostile tender offer, even one that has the support of a large majority of shareholders. This is so because in most pills, only the board has the power to cancel the pill. If the board refuses to do so, no rational bidder would dare trigger the pill, for it would truly poison the value of his investment.

It defies common sense that such a powerful weapon would be given away without approval of the owners of a company. But ever since the ruling in Household International, boards have been given legal authority to adopt poison pills without shareholder approval. It also defies common sense that a board can refuse to redeem a pill and defeat a takeover attempt, even when a majority of company shares have tendered to a hostile bidder. Yet, this too has been allowed by the U.S. courts, with certain modifications.

Shareholders receive far greater consideration in Canada. The Ontario Securities Commission and the Canadian stock exchanges require that shareholders approve poison pills before their initial adoption. In contrast to the U.S., this clearly is preferential from the point of view of the shareholders. And most Canadian pills include a special provision that gives shareholders the right to bypass the board if it refuses to redeem a pill in the face of a hostile tender offer by approving the bid and redeeming the pill themselves.

The Canadian model provides an important lesson. There is not one iota of evidence that the shareholder vote requirement has limited management powers: Every Canadian pill has won shareholder approval. There is no evidence that the permitted bid feature has made these companies more vulnerable to takeovers. On the contrary, the permitted bid feature, in theory, should motivate the management of Canadian corporations to concentrate on the ultimate takeover deterrent: solid performance on an ongoing basis. Over time, the vote requirement and permitted bid feature should increase demand for Canadian equities, and investors will place more and more emphasis on shareholder voting rights. That, in turn, would lead to higher market valuations, thus further reducing the chances of a takeover.

United Kingdom

In the U.S., there has yet to develop a cadre of professional, full-time, independent directors. If, and when, that happens, the number of board seats held by an individual director, and shareholder pressure to reform board behavior, may become less of an issue. But in the meantime, the reality is that most directors are recruited from other boards, investment and commercial banks, law firms, and academia.

Because of the other demands on their time, lack of a full-time staff for board work, and the fact that management controls the information flowing to the board, we doubt that any outside director could live up to the demands made on him or her by serving on even single board. Yet, a January 1991 search of the Institutional Shareholder Services' (ISS) director data base, based on data from 1990 proxy statements, revealed that among the directors of S&P 5000 companies:

- 79 directors served on 4 boards,

- 37 served on 5 boards,

- 12 served on 6 boards, and

- 2 served on 7 boards.

The U.K.'s PRO NED offers an invaluable lesson. With the encouragement of the Bank of England, PRO NED has developed a roster of eminently talented and experienced men and women, and offers them practical advice on how to be a successful professional director. The following excerpts from PRO NED's Code of Recommended Practice on Non-Executive Directors are self-explanatory:

"Effective Boards are essential to the success of the British business. In qouted companies, Boards are more likely to be fully effective if they are comprised both of able Executive Directors and strong, independent Non-Executive Directors.

"The main tasks of the Non-Executive Director are to contribute an independent view to the Board's deliberations; to help the Board provide the company with effective leadership; to ensure the continuing effectiveness of the Executive Directors and management; and to ensure high standards of financial probity on the part of the company. If they are to succeed in these tasks, the Non-Executive Directors will need to enjoy the full support of the Chairman, and will need to be provided with the information which in their view they require in order to carry out their duties.

"The Non-Executive Directors should be consulted on major issues of audit and control. Their task will be facilitated by the establishment of an Audit Committee... The committee should be composed mainly or wholly of Non-Executive Directors, and its chairmanship and quorum should reflect this: The Non-Executive Directors on it should have the right to see the auditors alone if they wish."

Many of these principles already are reflected in ISS's and institutional shareholders' proxy voting guidelines. ISS, for example, recommends that shareholders carefully consider their votes on director nominees when the majority of the board is insiders or outside directors with some affiliation to the company (e.g., the company's investment banker or outside counsel), especially when company performance is lacking. We feel even more strongly that the audit, compensation, and nominating committees of the board be composed exclusively of independent directors. In 1991, a few active shareholders will be taking matters even further, sponsoring shareholder proposals to require that a majority of the board, and all directors on audit, compensation, and nominating committees, be independent directors. It is also worth noting that in 1990, the state of Michigan embarked on a bold experiment by creating a statutory independent director with special responsibilities and powers.


German corporations have been among the most successful global competitors of the post-war era. It is only natural that U.S. corporations have adopted many German manufacturing techniques. But U.S. experts, notably University of California (Berkeley) Law School Professor Richard Buxbaum, are also looking at the board structure of German companies to see whether there are any lessons applicable to U.S. governance.

Boards of directors of German corporations are divided into two tiers. The "Vorstand," or management board, is responsible for daily management decisions. The management board is appointed by the "Aufsichstrat," or supervisory board, which oversees the management board and participates in long-term strategic decisions. The supervisory board is, in turn, partly elected by shareholders and partly by company employees. Depending on the company, the employee representatives may represent one-third to one-half of the supervisory board.

In Germany, like Japan, banks are by far the dominant shareholders. The three largest German banks, Deutsche Bank, Dresdner Bank, and Commerzbank, control over 60% of the shares of German corporations, through their direct holdings and through customer holdings, which are voted by the banks. (Germany is considering limiting German bank holdings in nonbank companies to 5%, in order to, believe it or not, improve the competitiveness of German corporations.) A senior executive of the "Hausbank," the company's lead bank, also sits on the supervisory board, usually as chairman.

The possible lessons for U.S. corporate governance are too great to do justice here. But let us look at a few implications of the German board system. The first significant difference is that the German managerial board is far more involved in company decisions than its U.S. counterpart. As noted in the U.K. section, much of the discussion about U.S. corporate governance concerns a perceived failure on the part of the board, independent directors in particular, to provide effective oversight on behalf of shareholders.

Another point is the presence of bank representatives on the supervisory board. Because the banks are so intertwined with nonbank corporations (the banks are both shareholders and creditors, and provide investment banking and commercial banking services), their incentives are markedly different than a typical U.S. institutional shareholder. Because they are both shareholder and creditor, they are forced to adopt a "total return" approach, meaning they constantly think in terms of long-term profit maximization for their equity investments and commercial loans together.

This, along with cultural and legal differences, may partly explain why junk bond-financed hostile takeovers and leveraged buyouts are nonexistent in Germany. Nearly all the academic literature has shown that junk bond-financed takeovers and buyouts in the U.S. have been successful because, in effect, they rob Peter to pay Paul: The wealth created for shareholders is provided in part by bondholders, who see their bond values drop precipitously after the company levers up.

The implications for the U.S. are striking. The obvious point is that allowing banks to sit on the boards of U.S. corporations could have prevented many of the highly leveraged transactions of the 1980s and the aftermath we are experiencing today: Chapter 11 workouts, bank failures, and lawsuits attempting to recoup shareholder and bondholder losses through charges of fraudulent conveyance.

But there is no reason to stop with banks. U.S. institutional shareholders - pension funds, investment managers, insurance companies, and so on - invariably are both stockholder and bondholder in the same companies. The lesson for them is not necessarily to gain a seat on the board, although, over time, it seems obvious that institutional investors will find it in their best interest. Instead, the immediate lesson is that they should adopt a total return approach and analyze every corporate transaction from that perspective. Pension funds especially, by virtue of their de facto long-term time horizons, may find the total return approach the best way to complete their transformation from traders to permanent corporate owners.

The presence of employee representatives on the German supervisory board is a difficult concept to translate into U.S. terms. There is no standard definition of "employee interest." In the context of a takeover, for example, a twenty-year-old man looking forward to a lifetime career at the company where his father worked has a different goal than an employee close to retirement, for whom a takeover would add substantially to his retirement nest egg. The dilemma is most acute for the trustees of U.S. corporate pension funds, but even public pension funds have to consider the long-term tradeoffs when they accept a takeover premium: Job layoffs eventually become a drain on the economy, thus harming the growth potential for their equity holdings.

Nevertheless, there already are some parallels in the U.S. American labor unions, and individual employees are aware that the company stock held both individually and through their retirement plans offers a new tool to influence management decisions. Richard Foley, a brakeman at Santa Fe Southern Pacific, made history in 1988, when his shareholder proposal to redeem Santa Fe's poison pill won a majority vote. In 1990, an investment manager known to the author made plans to form an investment management firm for the explicit purpose of pooling labor union equity holdings under one roof and to take action through the shareholder proposal process when necessary.

With all that said, the author does not advocate adopting the German two-tier board as the American model. By limiting shareholders to the supervisory board, the German model removes shareholders one step further from the corporate power center. But it does suggest that U.S. institutional investors explore the ramifications of the current U.S. alternative: shareholder advisory committees. Both Travis Reed, a former Undersecretary of the U.S. Department of Commerce, and the California Public Employees' Retirement System (CalPERS) have sponsored shareholder proposals within the last three years to form advisory committees at troubled corporations. The idea is akin to the German supervisory board: to provide the managing board with extra advice on strategic issues and to increase shareholders' understanding of the corporation's long-term objectives.


It is hardly news that the post-war state of grace is over and that the U.S. now competes in a highly competitive global market. U.S. corporations have responded beautifully on the operations side: relocating plants to where labor costs are low, studying cultural patterns to learn how to penetrate foreign markets, implementing cross-border mergers and ventures to gain global synergies, and more.

What still needs to be done is to reform our corporate governance system with an eye toward global competitiveness. As noted by Michael Jacobs, Director of Corporate Finance at the U.S. Treasury Department, effective corporate governance can provide a competitive advantage for both U.S. goods and services and U.S. securities.

Through a variety of initiatives, U.S. corporations and institutional shareholders have begun to experiment with new solutions to corporate governance problems. They are using many of the lessons from abroad outlined in this article.

Paralleling the shareholder vote requirement for Canadian pills, for example, Bear Stearns Cos. Inc. announced in its 1990 proxy statement that "the Board of Directors believes that stockholders should have a significant voice in decisions relating to the ownership and control of the company." The company proposal to restrict its ability to adopt a poison pill (or pay greenmail or adopt a parachutes) without shareholder approval was endorsed by a wide margin. Lockheed Corp. and other companies have experimented with a "chewable pill," which, similar to its Canadian cousin, contains a provision for automatic redemption under certain circumstances.

Efforts are also underway with regard to the U.S. version of PRO NED. The Council of Institutional Investors, in conjunction with ISS, has prepared a formal definition of inside, affiliated outside, and independent directors. With the support of CalPERS, ISS recently completed a data base profiling all the directors of S&P companies. CalPERS recently announced that as a follow-up, it would be working with the Business Roundtable on a new survey of corporate boards.

The newly created Boardroom Consultants and other organizations are starting to offer outside directors independent advice. Robert A.G. Monks, ISS's former president, and present head of Institutional Shareholder Partners; Leslie Levy, president and CEO of the Academy for Corporate Governance; and other businessmen, shareholders, and consultants are after the ultimate goal. As I write, they are talking with potential independent directors and exploring financing opportunities to establish an American PRO NED. Given the strong energies being applied, I would not be surprised to see a U.S. PRO NED developed through private sector initiatives within the next year or two.

Lessons from the German two-tier board and the advantages of having bank representatives (or at least their total return outlook) are also being studied in the U.S. by shareholders and other interested parties. Here, too, concrete steps have been made - CalPERS' shareholder advisory committee proposals foremost among them.

The potential advantages of adopting some lessons from abroad are enormous.

Howard D. Sherman is Vice President of Institutional Shareholder Services Inc., a Washington, D.C., corporate governance advisory firm to pension funds and other large investors. He is Director of the firm's proxy advisory service.
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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests
Author:Sherman, Howard D.
Publication:Directors & Boards
Date:Mar 22, 1991
Previous Article:What I look for in corporate performance.
Next Article:The shareholder advisory committee.

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