The new governance paradigm.

How are boards measuring up? What do institutional shareholders want? Will CEOs lose power? CEOs, outside directors, and institutional shareholders debate the problems of governance.

Twenty years ago, the subject of corporate governance, thanks to academicians, was dry as dust, certainly not the stuff of high drama. But all that has changed. Today, CEOs are pushed out when things go wrong--sometimes unceremoniously as happened at IBM, General Motors, American Express, Westinghouse Electric, and Eastman Kodak. Why after decades of glacial evolution has the accountability system undergone such rapid change in the last few years, culminating in what many people regard as the "Year of Shareholder Activism" in 1993? There are three main forces:

* Changing dynamics within institutional investing.

* Growing assertiveness among outside directors and shareholders.

* Globalization of markets. (There's a tendency to view the governance issue as a purely U.S. phenomenon. It isn't.)

After years of futile carping at company bosses, shareholders, particularly institutions, seem to have the whip hand. Pension funds, mutual funds, and insurance companies now own 60 percent of the publicly held stock in the U.S. versus roughly 8 percent in 1950. In recent years, larger institutions have become dependent on indexing and other long-term passive portfolio strategies. Portfolio turnover at California Public Employees Retirement Systems, for example, is around 10 percent of equities. At New York City's two pension funds, NYCERS and Teachers, turnover is 7 percent. Consequently, the option of voting with one's feet is no longer realistic. Fed up with what they regard as poor performance, institutions demand, and often receive, changes in governance and compensation arrangements.

At the same time, individual shareholders and outside directors are flexing their muscles, insisting that CEOs share power, keep them better informed, and submit to greater performance scrutiny. New proxy rules introduced by the U.S. Securities and Exchange Commission in October 1992, intended to streamline procedures and open communication between companies and shareholders, already have influenced how boards handle executive compensation and outside initiatives.

Governance ferment is not restricted to the U.S. In Britain, the Cadbury Report, issued last August by the private-sector Cadbury Commission, called for changes in the roles of non-executive directors. In Germany, the depth of a recession prompted unprecedented scrutiny of the country's tightly wound governance system. For example, the University of Wurzburg's Ekkehard Wenger was forcibly ejected from the Daimler-Benz annual meeting after he vehemently attacked its management--an unthinkable occurrence at Germany's most prestigious industrial company a few years ago. Unlike the English-speaking economies, where management can be turned out in an afternoon's voting, German managers sit behind a Siegfried line of legal barricades that limit shareholder rights. (A year ago, CalPERS supported a shareholder resolution for a one-share, one-vote ballot system at the annual meeting of the German energy conglomerate RWE.) A highly critical book reflecting this disaffection, entitled "Nieten in Nadelstreifen," which loosely translates to "Nitwits in Pinstripe Suits," topped German best-seller lists for several months in 1993.

Questions raised by the shareholder revolution have just begun to be answered. Should boards re-organize themselves? If so, how? What about board operating policies? If boards ought to have a greater say in companies' strategic affairs and demand closer performance reviews of CEOs, what should be expected of directors? How will their performance be evaluated and by whom? For example, separating the office of chairman from chief executive is popular among shareholder interest groups but not among CEOs. Wachtel Lipton's Marty Lipton and Harvard Business School's Jay Lorsch tout the concept of naming a "lead director," someone distinct from a non-executive chairman, but whose prestige and experience would allow him or her to do things formerly left to the CEO.

Meanwhile, the number and fury of new demands is not without a few paradoxes. If shareholders wish to hold CEOs and directors to more exacting standards, such as limiting the number of boards on which a CEO sits, where will all the crackerjack directors come from? Most CEOs say sitting on two other boards ought to be the maximum. (LENS, a shareholder activist group, says CEOs should sit on no more than one outside board.)

Finally, after the smoke clears, will changes in governance result in better long-term performance from our enterprises? Will we get fancier or better governance? Amoco CEO George Spindler posed the question this way at a Kellogg School conference: "Do we need new procedures or simply the courage to use the procedures we already have?"

In the following CE roundtable, the largest and most hotly debated since we initiated the gatherings, there was little unanimity. Yet, the discussion did yield a few percepts. In the future, CEOs will need different leadership skills. Boards no longer tolerate "splendid omission" and will insist on greater participation, particularly on policy and strategy. CEOs who treat directors like mushrooms (keeping them in the dark while periodically heaping fertilizer on them) are candidates for regicide. More frequent communication with one's shareholders is also a must as CalPERS' CEO Dale Hanson remarks, "Know who your top 20 shareholders are in good times, and maybe they'll remember who you are in bad times."

Relationship investing may be a double-edged sword. On one hand, communications may be enhanced with one's larger shareholders. On the other, expect to receive suggestions for board membership and unsolicited advice on other matters. Expect CEO evaluations to become more regular and formal. Expect directors to begin getting a taste of the same. To date, just 12.9 percent of Fortune 1000 companies say they have director evaluation programs, according to a survey by Heidrick Partners. Director compensation increasingly will include performance-related components such as restricted shares.

At day's end, will CEOs have less power? Yes, no, and maybe, depending on their leadership and participative management skills. Certainly the Mussolini mentality (the trains run on time/the stock is up, so don't meddle) does not apply. The new mediator model continues to evolve.

PRESSURE POINTS

Dale Hanson (California Public Employees Retirement Systems): When I accepted a job with CalPERS in April 1987, I didn't know what the term "corporate governance" meant. We discussed it in theory, but never clearly defined the concept. Today, corporate governance is a sexy topic; it concerns everybody in business: shareholders, management, and boards. Debates rage about proxy reform, compensation disclosure, and communication.

Amid this turmoil, large institutional shareholders, including CalPERS, often are viewed as "black-hatted" activists that target unsuspecting and defenseless companies for reform. For example, CalPERS was involved with GM, American Express, Eastman Kodak, and Westinghouse Electric, and, coincidentally the CEOs were ousted from those companies. However, those were board decisions, not shareholder decisions.

The Investor Responsibility Research Center in Washington called 1993 the Year of the Four P's: performance-based targeting, proxy reform, shareholder proposals, and piling on (which refers to the fact that when institutional shareholders judge companies by the same criteria, the same organizations always end up on the bottom). We focus on companies with excessively low five-year total shareholder returns and measure their performance against their peers'. After the first meeting or two, companies typically discover we do not have horns and tails. If the entire industry is depressed, we won't demand that you change. But if everyone else is doing well, and you're not, expect to hear from us.

Remember, though, that shareholders form only one side of the equilateral corporate governance triangle. They should not fall into the belief that they are more important than the other sides: the board of directors and management.

Here are two guidelines CEOs should follow in dealing with institutional shareholders:

First, know who your top 20 shareholders are in good times, and maybe they'll remember who you are in bad times.

Next, recognize that each shareholder has a slightly different strategy. Some mutual funds will hold a large portion of your shares for the short term. On the other hand, institutions such as CalPERS or New York Pension Fund essentially buy and hold. They will be with you longer, either because of a passive philosophy through indexation or because their portfolios are growing at such a fast clip they need to hold equities.

Arnold B. Pollard (CE): Does CalPERS get involved in the tax penalty for executive compensation over $1 million?

Hanson: Many people think that because CalPERS took a strong stand with ITT recently on the subject of executive compensation that we're all fired up about it. The only time we become concerned about executive compensation is when it heads north, and economic performance heads south.

However, I don't think Congress should be involved in compensation: The provision simply sticks it to the shareholder again in the tax process.

James Thompson (Guinness America): Has CalPERS ever formally or informally nominated a director to a corporate board?

Hanson: Yes. We submitted a list of candidates to Texaco, and several names matched those the company already had been considering.

J.P. Donlon (CE): Al, how did you feel about that process?

Alfred C. DeCrane Jr. (Texaco): We asked Dale if he knew of some qualified board candidates. He gave us a list, but never said we should appoint a certain person.

Donlon: But the person selected happened to have been on his list?

DeCrane: Several candidates were on both lists; the person who took the position happened to be one of them.

Dwight H. Hibbard (Cincinnati Bell): What is the ideal board size?

Hanson: The tendency over the next decade will be toward smaller boards: The average board probably will have nine to 13 members. Right now, the CalPERS board has 13 members. We prefer the majority to be outside directors.

SOCIAL RESPONSIBILITY

Lawrence Perlman (Ceridian Corp.): How do you feel about shareholders who bring social issues into the boardroom?

Hanson: Shareholders shouldn't be involved in social issues--whether it's happy chickens or the morality of smoking. That's not their role. We had two shareholder proposals introduced with AT&T, one pro-life, one pro-choice. And one of the trustees on our board wanted us to take the pro-choice view. I explained I could not speak for the 1 million beneficiaries we have, nor did I want to guess their views. So we passed on both proposals.

It's a disturbing process when any special-interest group decides to buy 100 shares of stock and then use the annual meeting as a forum for its crusade.

Carol O'Cleireacain (former New York City Budget Director): The extreme example you mentioned is ridiculous, but some social issues have economic value to the company. For example, Cracker Barrel fired all its gay and lesbian employees, claiming the right to discriminate against homosexuals. The shareholders disagreed: That's not a smart business policy, because it can quickly lead to boycotts and other serious consumer problems.

Shareholders have an economic right to air their views to the board, which supposedly represents their interests.

Frank N. Liguori (The Olsten Corp.): What happens after the shareholders voice an objection?

O'Cleireacain: Sometimes opinions or circumstances change. For example, we tried to convince Lockheed to focus on its employment practices in Northern Ireland. The company said we were crazy. Of course, that mind-set changed when it needed all our shares to fight off a takeover battle. Then suddenly, the board decided maybe the shareholders weren't so crazy after all. Ultimately, Lockheed decided to look into following different employment practices in Northern Ireland.

Perlman: Carol, did you consider bringing a resolution in the proxy statement to change the employment policy?

O'Cleireacain: We generally try conversation with the board first.

Perlman: In some cases, even though both shareholders and management might wish the policy were different, making the point may be as far as you can go.

Thomas A. McConomy (Calgon Carbon): The question really comes down to: Should shareholders have a say in company policies and decisions? For example, should shareholders have the power to choose the location of a new facility?

Hanson: If the company is foolish enough to approach CalPERS and ask where the facility should be located, naturally, we're going to say, "Yes, locate it here in California." Asking that question invites shareholders into micromanagement--a bad precedent.

McConomy: I'm not asking if the corporation comes to you; I'm asking if you approach the corporation.

Hanson: No.

O'Cleireacain: The board must set the corporation's strategy--including determining plant size, location, and technology.

Hanson: That's true. When General Motors closed a plant in the Los Angeles area, a number of legislators called me and said, "You're a big GM shareholder. We want CalPERS to demand that the plant remain open." Sorry, that's not our function.

STANDARD DEVIATIONS 

Russell Banks (Grow Group): The problem with corporate governance today is CalPERS and other large pension funds that target large corporations for reform. But the rigid standards that are set to control so-called abuses pertain to thousands of other companies as well--companies that are run successfully. Meeting those standards often is a hardship for small firms and ultimately will hurt the American economy.

Bernard J. Kennedy (National Fuel Gas Co.): I agree. I liken the situation to the health-care problem. Some 85 percent of us have access to care today; 15 percent don't. So we're going to make a mess out of the whole system just to correct the problem for the 15 percent. The statistics on governance are even more compelling. Only 2 percent or 3 percent of all companies have been miscreants at any one time. Unfortunately, they aren't always the same 2 percent or 3 percent. My advice: Don't mess it up for the other 97 percent.

Banks: I'm the president and CEO of a small company. For me, communicating with an institutional shareholder is like communicating with the White House. I can't call and ask to speak with one of the portfolio managers handling our account. They don't even know if they own our shares, because the account's so small. However, if that manager receives a call from a company in which the institution owns 200,000 or 300,000 shares, he will pick up that phone quickly and answer all questions. And if the institution wants to meet with him, he'll do so.

Hanson: That's a valid comment. I have 1,018 companies in my equity portfolio. If every company wanted to come visit, I'd never leave my office in Sacramento; it would be non-stop meetings.

O'Cleireacain: Unfortunately, the problem with talking about corporate governance from the institutional shareholder point of view is that by definition we're talking about the problem cases, the underperformers. We just don't have the ability to follow all the other companies that are doing OK and say the standards don't apply to them. We have to depend on the market analysts to do some of that work.

Banks: The legal profession has made a major issue out of corporate governance standards. If a small company violates the standards set for large corporations, it is vulnerable to a lawsuit. Even if the company is innocent, defending those lawsuits is a hell of a costly nuisance.

J. Carter Beese Jr. (U.S. Securities and Exchange Commission): Legal extortion is taking place in this country. And I worry that too often directors are being choosier about where and how they serve and whether they want to take on personal liability.

Richard N. Daniel (Handy & Harman): It seems directors are becoming more and more defensive. If a company wants to do something aggressive, the first thing board members look at are implications, not economics.

James E. Preston (Avon Products): I disagree. When I bring economic issues before the board, the first question directors ask me is not, "Are our butts covered?"; it's an economic question, a business question, a strategy question.

GREAT EXPECTATIONS

Barbara Hackman Franklin (former U.S. Secretary of Commerce): Perhaps if directors and CEOs concisely outlined their expectations of each other, the legal issue would not come into play as much. For instance, the board should expect two things from the CEO: results and openness. This means both financial results--earnings per share--and delivering what you say you're going to deliver. In the quest for results, directors today are a little less patient with chief executives who offer excuses such as, "The economy turned bad," or "The Japanese did something," or "My predecessor made lousy decisions." That doesn't sell anymore; you have to play the hand you're dealt.

If results are good, usually the board won't articulate its grievances. But when results take a downward turn, the board clamors to be heard and proposes action. If a CEO isn't in tune with his board, he or she had better hope for perpetually good results.

With respect to openness, boards require more of a partnership relationship with the CEO. They want open, timely, honest communication. The days of splendid omission--telling the board only what the CEO wants it to know--are over.

In addition, chief executives must possess superb business skills, but they also must have special leadership skills and a sort of sensitive antennae to hear what's said and not said. They must listen carefully, distill information, build consensus, articulate, and inspire.

On the flip side, executives should expect their directors to: prepare adequately for meetings, care about the enterprise, participate, act for the good of the company and its shareholders, and be forthright.

Donlon: In many companies, the board regularly conducts a formal evaluation of the CEO, but the directors themselves are not formally evaluated.

DeCrane: At Texaco, we sat down with the board and developed a list of what the board expects of management and vice versa. That list appears on the front page of the board book--the reference material in each director's place during a board meeting. Any time somebody wishes to discuss the list again, we're willing to make changes. Our board demands: proper stewardship of Texaco's assets, strong profit performance, succession planning and development of management personnel, minimal surprises, fast response to inquiries, and thinking like owners as well as managers. Management expects: loyalty and pride in the company; independence and integrity; collective breadth of experience; appraisal of executive management; succession planning and review; individual availability for consultation; a good understanding of the business; and active, objective, and constructive participation at board meetings.

Pollard: How will the new open relationship between the board and the CEO make corporations more competitive?

Franklin: I'm not sure I know the answer. My gut reaction is that more heads are better than one. Someone must be in charge of managing, but the board and shareholders provide support and guidance. That only happens, though, if all parties are candid and actively participate.

CORPORATE COMMUNICATIONS 

O'Cleireacain: The lines of communication between shareholders, the boards that represent them, and management have been tenuous at best, and this severely limits institutional investors from protecting their assets over the long term. I think the three parties should be arranged in a horizontal model--not a triangle as Dale suggested earlier--with the board in the middle. Thus, the board becomes the pivotal institution for communication to and from management and to and from the owners. We don't have that now. Currently, the model is more like a pyramid, with management at the top and shareholders and the board at the bottom two corners. The lines of communication go down, but rarely up as management tries its damnedest to control the information flow.

My horizontal model shows two-way communication, with an empowered, central board. From a shareholder's point of view, the board should filter out inappropriate shareholder concerns, force shareholders to concentrate on important issues, and oversee the firm's strategy.

Thomas E. Capps (Dominion Resources): I don't need my board to filter my communication with my shareholders. I prefer to communicate directly with them. The board doesn't have the expertise, the time, or the tools to do so. If I'm doing my job as chief executive properly, I'm spending 15 percent or 20 percent of my time talking to my various constituencies, including my institutional shareholders.

O'Cleireacain: Then, what role does the board play in your company?

Capps: The board hires or fires the chief executive, rates his performance, and brings guidance and expertise.

Daniel: Letting the board talk to people gives them the impression that the CEO can't handle his job.

O'Cleireacain: You can have a board with strong leadership; as a matter of fact, I think my model requires it. But the necessary level of communication is not happening now.

Thompson: Carol, does your model mean the shareholder will no longer be in touch with management, that everything goes through the board?

O'Cleireacain: That's the extreme case. The board's function is to represent the shareholders' interests. Management has taken on a big part of that role in the past, but boards now are trying to wrest some of that power back, and that's good for shareholders.

Liguori: I think management should be the link, not the board. I don't believe most outside board members could respond to an analyst or shareholder's concerns. And if they tried to, they probably would do an injustice to the company, to themselves, and to the investor.

O'Cleireacain: I'm not an analyst; I'm an owner.

Franklin: It's sort of the same thing.

O'Cleireacain: No, actually it's not.

Liguori: How can board members have the type of details required?

O'Cleireacain: They don't have to have them. But they should know when shareholders want to talk to the corporation. The conversation between owners and management should not take place behind the board's back.

Liguori: I am all for open communication with the board and with my outside investors; it's a two-way street. But if every time I speak to an investor--and I talk to many throughout the year--I have to inform my board, I would do nothing but write memorandums.

Preston: Five years ago when I became chairman and CEO of Avon Products, I learned an important lesson about communication. The company had been under intense scrutiny by a number of shareholder activist groups because of dismal performance for about a decade. During my first year, I discovered that open communication with your larger shareholders and shareholder rights groups can go a long way toward weathering the storm. Through the years, we've built on that lesson. We recently invited between 70 and 100 institutional investors to two meetings, one in New York and the other in California. Two of my outside board members also attended. I presented an update on Avon, similar to what I do for analysts. Then I opened it up for questions. I told the institutional investors that the other executives and I would leave the room if they wanted to talk with my outside board members alone. They didn't. But they gave input to the board and asked questions such as, "How do you assess the CEO?" The feedback from those meetings was terrific. We'll probably have one a year from now on.

Donald J. Zoeller (Mudge Rose Guthrie Alexander & Ferdon): The concept of

governance and management is one the legal profession has had to play catch-up with. We don't have shareholders, but we do have partners, and many of the same questions and problems arise. The only exception is that my partners can get at me more regularly and directly than your shareholders can get at you. Also, the idea of a CEO at a law firm is relatively new, so we now are grappling with what is expected of that position.

SPLIT PERSONALITIES

O'Cleireacain: Speaking of positions and job responsibilities, there's one rather controversial issue we haven't touched on today: whether the chairman and CEO positions should be separate. I believe they should be two distinct jobs, because it's impossible for one person to evaluate himself or herself in two halves.

T.J. Dermot Dunphy (Sealed Air Corp.): I plan to separate them at Sealed Air as soon as I'm ready to give up the CEO's job. |Laughter.~

Perlman: That's an example of a cookie-cutter corporate governance solution that would be a mistake if applied to all companies. It confuses company leadership and board leadership. Choosing a lead director may make sense, because directors, by and large, are notoriously unorganized, but you have to be careful about confusing the market, the customers, and the employees as to who's leading the corporation.

Hibbard: I'm just going through the process of separating myself from the CEO job and becoming an outside chairman of the board. While I don't necessarily feel companies must have an outside chairman, I do believe they need an authoritative member of the board who can provide leadership and maintain a good rapport with the CEO.

The board must ensure that the company formulates a strategic game plan and vision that offer an opportunity for success over the long term.

Donlon: Do you give directors long-term performance shares?

Hibbard: No. I don't believe in handing anything to anybody, including board members. I advocate offering options to the board: Give directors five-year options, and they're locked into the long-term interest of the business.

Thompson: I don't believe in offering options and health insurance and retirement plans for directors. However, I do think directors should be expected to purchase, out of their own pockets, some shares on the open market. And any shares given to them as directors' fees should be restricted in that they cannot be sold until they leave the board.

Donald W. Goldfus (Apogee Enterprises): Options are not free. They go in at market value.

Thompson: Yes, but then directors have an interest in running up the price of the stock to get their options out. This offers the wrong incentives to directors.

ECONOMIC INDICATORS 

Donlon: Will economic performance be better or worse after corporate governance reform?

Shaun F. O'Malley (Price Waterhouse): Voltaire said, "Any virtue taken to extreme becomes a vice." I've seen activist boards that are too active, that invade management's prerogatives and end up hurting performance in the long run. The same thing can be said about massive communication. The U.S. has the most informed ownership group in the world. The need for more and more information becomes a narcotic. Too much of a good thing is harmful.

J. Michael Cook (Deloitte & Touche): Some companies will be better, and some will be worse. While the new regulations, new responsibilities, new controls, and new costs may hinder some companies, overall, I would be more optimistic than pessimistic.

David A. Olsen (Johnson & Higgins): I'm also optimistic. My company is private, and our managers and board members are all the same people--which is good and bad. After our discussion today, I'm kind of delighted we don't have outside directors.

Frederick J. Mancheski (Echlin): We've been fortunate in that our board has worked well--no significant upsets or controversial issues--but I'm not sure what the future holds. I was reassured by Dale's comments and finding out firsthand what CalPERS is doing, since it owns some of our shares.

Lawrence W. Leighton: (21 Inc.): I'm president of a U.S. holding company controlled by European investors, and I sit on the board of both American companies and European ones. So I have one foot on each side of the governance issue: That makes it all the more difficult to predict the results of changes in governance.

Wallace Barnes (Barnes Group): The rising expectations of all constituencies in the corporate arena--whether they are shareholders or employees or management--have imposed enormous strains on the traditional governance structure. I'm living with the situation in my own company now. I hope the system will improve soon, because at the moment, it's operating marginally.

Richard M. Miller (Willis Corroon): On the contrary, I think things are good right now, but I think they will get even better. Corporate governance will become an outgrowth of the total quality management program. It will include compensation-based pay for quality performance; quality service to clients; quality communications to all constituencies (employees, shareholders, clients); and quality management by the chairman, CEO, executive staff, and the board of directors. The governance model--whether it's horizontal lines, triangles, or circles--makes no difference. The bottom line is that success will only result when everyone in the organization is involved in total quality management.