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Opening keynote 2010: a governance odyssey; Hart and Wallenstein's annual update on the legal environment for directors.

Since the enactment of SOX, an increasingly punitive and hostile environment toward public companies has developed, an environment which recently has been exacerbated by the most severe financial crisis since the Great Depression, a massive recession, high unemployment, federal bailouts and large bonuses paid to employees of the recipient's of such bailouts. We'll see some of the results of this in new regulations for the 2010 proxy season.

Directors need to recognize that regardless of whether the failure of capitalism was attributable to deficient government policy and regulation or to greedy capitalists, stockholders have been hit hard by actions and inactions of boards of directors, managements, regulators and the government. Not surprisingly, regulatory focus has been aimed at the role and functioning of the boards of public companies. Unfortunately, reflecting policymakers' lack of understanding of how boards function and how state corporate laws work, many of the proposed regulations will only serve to further bureaucratize the board and its committees and displace the historic private ordering corporate governance model with a government mandated model.

Where are we and where are we heading?

Since President Obama's inauguration we have seen an unprecedented volume of Federal regulatory and legislative actions and initiatives regarding such issues as executive compensation, risk management, "say on pay," shareholder nominations of directors, compensation committee independence, broker discretionary voting for directors and the separation of the CEO and Chairman roles. These and related matters threaten a Federal takeover of corporate governance.

Of particular note:

1. The House of Representatives passed the "Corporate Financial Institution Compensation Fairness Act of 2009," H.R. 3269, which would give shareholders a non-binding vote on executive compensation and golden parachutes, impose enhanced independence requirements on compensation committees, impose independence requirements on the compensation committee's consultants, and require Federal regulators to adopt rules for "covered financial institutions" restricting incentive-based compensation arrangements that "encourage inappropriate risks. ..."

2. The SEC proposed rules that would require new disclosures in the proxy statement regarding the qualifications and experience of directors and executive officers, the company's overall compensation program as it relates to the company's risk management, the role of the compensation committee's consultant in determining or recommending executive and director compensation, and the board's leadership structure and role in risk management, and which would provide shareholder access to a company's proxy statement to nominate directors and allow stockholder proposals to amend a company's governing documents regarding director nominating procedures.

3. Senator Schumer proposed the "Shareholders Bill of Rights Act of 2009," which would require a non-binding stockholder vote on executive compensation and golden parachutes, confirm the authority of the SEC to adopt rules providing shareholders access to a company's proxy statement to nominate directors, and require the SEC to adopt rules directing the national securities exchanges to prohibit the listing of companies that do not have an independent board chairperson, provide for the annual election of all directors, provide for majority voting for directors in uncontested elections and for the mandatory resignation of any director who does not receive a majority vote, and provide for a board risk committee comprised of independent directors.

What directors can expect in 2010

We believe that directors should recognize the inevitability of material changes in corporate governance and start now to consider how such changes can be best implemented to restore investor confidence and mitigate any adverse affects on the company's business.

The advisory vote on executive compensation provided for in H.R. 3269 will probably pass this year, but is not likely to apply to the 2010 proxy season. Nevertheless, compensation committees should be mindful of the expected 2011 requirements in shaping 2010 compensation.

Some form of SEC-imposed proxy access may be adopted but is unlikely to be applicable for the 2010 proxy season. The SEC will probably adopt rules allowing stockholder proposals to amend a company's by-laws to provide proxy access for director nominations which will be in effect for the 2010 proxy season. Together with 2009 amendments of the Delaware General Corporation Law enabling the adoption of such by-law provisions, the stockholder proposal route may be seen to be preferable to a government mandate of proxy access.

Enhanced SEC disclosure rules regarding the qualifications of directors to serve on the board and any committees on which they serve are likely to be adopted and in effect for the 2010 proxy season. The government's focus on individual director qualifications at Bank of America and AIG may presage regulation of individual director qualifications. Boards and directors should start thinking about how they want such individual information presented.

Enhanced SEC disclosure rules regarding risk management and executive compensation are likely to be adopted and in effect for the 2010 proxy season. Compensation committees should begin now to rethink how executive compensation matters are communicated to stockholders. The complexity of compensation disclosure regulations is rapidly bureaucratizing the compensation committee, much as SOX bureaucratized the audit committee, and compensation committees need to find ways to cut through the complexity and provide simple transparent information to investors. Enhanced SEC disclosure rules regarding board leadership and the board's role in risk management are likely to be adopted and in effect for the 2010 proxy season. Risk management has, of course, always been an integral part of the board's primary focus on strategy and business performance. However, the regulatory treatment of risk management as a separate governance activity will lead to bureaucratization of risk management and may make some boards unduly risk averse. Ironically, the government is allowing failed financial institutions, like Citigroup, all of which had sophisticated risk management structures and committees, to continue their highly risky, but apparently profitable, trading operations leveraged with taxpayer capital.

Enforcement and Activism

Stung by criticism following the Madoff scandal, the SEC Enforcement Division will be more active and hard-nosed, using enforcement techniques more typical of the U.S. Attorneys' white collar crime practices. An early harbinger of its new approach was the announcement by SEC Enforcement Director Robert Khuzami of a broad reorganization of the Enforcement Division, including the creation of five specialized enforcement units, increased staffing, deployment of senior supervisory personnel to investigations, and increased delegation of subpoena power by the SEC to the staff of the Enforcement Division.

There will be continued pressure from activist investors to manage the company for short-term stock price performance. On the positive side, the SEC has adopted rules to curb naked short sales and has investigated instances of rumor mongering and other manipulative behavior, which had highlighted the susceptibility of public companies to opportunistic stock price manipulation. Moreover, the SEC has indicated that it will revisit the definition of beneficial ownership, which may curb the use by activist investors of derivatives to amass greater voting power than their economic investment or to accumulate a large economic stake without triggering 13D disclosure requirements.


Unfortunately, thoughtful proposals from investor and business leaders promoting long-term value creation, such as the set of principles for long-term valuation creation released in 2007 by the Aspen Institute, appear to have been pushed aside in the current environment. At the same time, the erosion of board-centric structures, such as poison pills, classified boards and plurality voting, have left boards particularly vulnerable to the demands of activist investors. Absent a large base of long-term stockholders, which few companies seem to have these days, boards will need to find ways to cope with activists.

Another major challenge for directors in this environment is to maintain an efficient, effective and collegial board. Narrowing definitions of director independence and mandates that the audit, compensation and nominating committees consist only of independent directors tend to disenfranchise directors who do not meet the independence test. Also, the unwillingness of CEOs to serve on other boards has created a challenge to assure that the board has directors with strategic business experience.

On the positive side, recent decisions of the Delaware courts have affirmed that the business judgment rule is alive and well in Delaware and that the standard for holding directors personally liable for employee failures remains high. D&O liability insurance rates for public companies have not increased appreciably, notwithstanding the increased litigation involving subprime and credit market losses.

Service as a director of a public company should, in our view, continue to provide an opportunity for a professionally rewarding experience. But, as we all know, it is time-consuming, laden with legal mandates, and exposed to reputational risk. This will demand that directors be fully informed about their responsibilities and devote the time needed to discharge them. Directors will need to seek ways to better communicate with their investors, will need to understand the initiatives of shareholder advisory organizations and media critics, as well as regulatory and legislative initiatives, and carefully evaluate appropriate board responses.


Robert M. Hart is senior lecturing fellow at Duke University School of Law. He is senior vice president and general counsel of Alleghany Corporation, a New York based diversified international holding company. He received his JD from Duke University School of Law where he served on the Duke Law Journal and was selected as a member of the Order of the Coif.


Stephen M. Wallenstein is executive director, Global Capital Markets Center and Professor of the Practice of Law, Business, and Finance at Duke University's Fuqua School of Business. He received his MA from Harvard and his JD from Yale Law School.
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Author:Hart, Robert M.; Wallenstein, Stephen
Publication:Directors & Boards
Geographic Code:1USA
Date:Sep 22, 2009
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