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Feature

Ira M. Millstein
Senior Partner
Weil, Gotshal & Manges LLP

Institutional Investors: Think for Yourselves
Institutions should make board selection and removal decisions based on their own standards -- not ‘outsourcing’ that responsibility to the standards and decision-making of an intermediary.

By Ira M. Millstein

Corporate governance systems have a distinct “balance of power” and set of tradeoffs among shareholders, boards, and managers. In some jurisdictions, the power tilts to the managers, but in other jurisdictions it tilts to the shareholders. It may not be a dramatic imbalance, but even a tipping of the scales makes a difference.

Where the balance of power lies impacts how specific laws and regulations deal with the agency problems arising from the corporate form. No work has demonstrated this better than the treatise, The Anatomy of Corporate Law (Oxford University Press, 2004), authored by seven outstanding, internationally well-known and respected academics.

The Anatomy demonstrates that management is the most powerful corporate constituency in the U.S. This balance of power plays out in a variety of laws and regulations that are relatively unfriendly to shareholder interests -- for example, laws and regulations relating to the shareholder meeting, voting on selection and removal of directors, consultation and proxy solicitation, takeover defense, and executive compensation.

The authors of The Anatomy correctly conclude that in the U.S. managerial dominance of the system probably started and continued because things were going well for the economy and corporate America. They note that shareholders have little incentive to exercise their latent legal powers during periods of prosperity and rapidly rising share prices because it would appear their interests are being looked after.

In periods of stress, however, managerial dominance becomes tested and reduced somewhat. We have had such periods in the past, and we are currently coming through a period of the serious crisis in confidence that resulted in Sarbanes-Oxley and a host of new regulations, listing requirements, criminal trials and sentences, best practices, box-ticking intermediaries, and other tests of managerial dominance.

This, together with the rising concentration of ownership in institutional investors, leads me and others to wonder whether we will witness a true shift in power away from the managers over to institutional investors as a class. Or, will the institutions behave as shareholders of the earlier dispersed class tended to do -- that is, fall asleep?

This is the future I want to peer into.

Two Core Elements of Governance
Let’s look at the two core elements of corporate governance to see what a difference in the locus of power might mean, and whether shifting is worth the candle.

Two core elements are needed to ensure that power resides in those who own the company, the shareholders:

• First, and most importantly, shareholders would have the power to select and remove directors. Without this power, shareholders are stripped of their right to chose who should run the company on their behalf. They can only at best, today, ratify the board’s choices.

• Second, the board would have the power to hire and remove management. Without this power, the board cannot ensure that those to whom it has delegated responsibility for running the day-to-day affairs of the company are, in fact, running it in the best interests of the shareholders.

The responsibility of the board to remove management in a timely fashion is now widely recognized and accepted. The power of the board to hire and timely replace management now seems to have become embedded in the U.S. system of corporate governance. We should hope that it remains so.

However, the first and most important core element -- the power of shareholders to select and remove directors -- is not embedded in the U.S. system. Its absence has become glaring. Recent reforms, such as mandated independent nominating committees for listed companies, voluntary adoption by boards of governance guidelines with respect to majority voting, and the forthcoming SEC proposal to change the proxy solicitation rules to allow use of the Internet (and thereby reduce costs), do not go far enough. More would be needed.

Toward a Meaningful Shift in Power
U.S. corporate governance, if it is to result in a meaningful shift in power, will need to evolve to give shareholders greater rights of selection and removal. The conditions for this evolution are now ripe: ownership is increasingly concentrated in the hands of institutional investors and away from dispersed shareholders. It is possible that power with respect to board composition could shift to institutional investors and away from management and the board (although power to run the company day-to day will, and must, remain with management).

The business community has so far been successful in resisting this power shift. Managers and boards will not easily relinquish their ability to control the board’s membership and we cannot deny the existence of their political voice. For example, the response of the business community was an important factor in the SEC shelving its proposed shareholder access rule.

The business community may point to the U.K. experience -- where the right to remove is rarely exercised in practice -- to further an argument as to why those rights should not be granted in the U.S. This would be a simplistic argument, as the existence of these rights gives shareholders the ability to conduct a constructive dialogue with the board, enabling them to achieve their objectives without requiring actual exercise of the rights. It may be that possessing the right negates the need to actually exercise it very often.

However, real rights of selection and removal should not be granted -- and the community beyond managers and boards will have just cause to resist their being granted -- unless institutional investors demonstrate that they can, and will, exercise such rights in a responsible fashion.

This will require institutional investors to commit to exercising judgment -- not following the decisions of others by rote -- with respect to their voting and access decisions.

Intermediaries can provide information about a company, but not a judgment applicable to all shareholding institutions and their varied beneficiaries. Deciding who should be on a board of a particular company and who shouldn’t requires institutional investors to use their own judgment in analyzing the particular circumstances of that company and the needs and expectations of their varied beneficiaries.

Thinking Through the Issues
In making these decisions, shareholders need to think about what the profile of the board under analysis should be. They should ask: In which areas is this board lacking and how can it improve? For example, does it need another financial expert? Does it need someone with in-depth industry knowledge? Does it need someone who can provide a fresh approach to strategic decisions? Does it need someone with a more diverse background who can provide an additional perspective to matters under discussion? Are there any directors who are not contributing and should in any event be removed from the board?

Moreover, institutional investors should reveal their decision-making processes with respect to board selection and removal decisions in the same way as the independent nominating committee is required to under listing standards. This transparency will assist institutions to assure the marketplace of the quality of their decisions.

Institutional investors should thus make board selection and removal decisions based on their own standards. They should not rely on uniform standards prepared by an intermediary.

Standards set by intermediaries are intended to be applied uniformly without regard to the individual needs or circumstances of a company or the varied beneficiary base of the institutions. For example, advice prepared by an intermediary may stipulate that shareholders should only propose directors who are “independent,” according to that intermediary’s standards (for example, disqualification because he or she is a former CEO of the company). However, a shareholder exercising judgment may decide to propose a director who has essential industry expertise, even though not fitting an intermediary’s strict definition of independence.

Institutions, to be “real” shareholders, truly acting for their respective beneficiaries, must begin to think for themselves. They may very well have varied judgments among themselves, but that’s how the marketplace is supposed to work.

More In-Depth Study Coming
The shift in power to institutional investors should not occur until such a shift is credible in the eyes of the marketplace -- for with power comes responsibility. What will it take to make the shift credible? How can we be assured that institutions will use individual judgments (which is how a marketplace, even of ideas, is supposed to work), as opposed to becoming a “herd”? Is it likely that a shift will lead to “better” performing boards than our current system provides?

Such questions require in-depth study. We will make this a priority in our work at the Yale School of Management’s new Center for the Corporation, Governance and Performance.

Until research sheds more light on these issues, there are important steps that institutional investors can take to enhance the credibility of their decision-making processes. The mechanics of their decision-making processes should be transparent, and judgment and decision-making should not be outsourced.

Ira M. Millstein is Senior Partner of the law firm of Weil, Gotshal & Manges LLP (http://www.weil.com) and Senior Associate Dean for Corporate Governance at Yale School of Management (http://mba.yale.edu). This article is an abbreviated version of remarks he prepared for a conference held in Washington, D.C., in December of the Institute of Chartered Accountants in England and Wales. The author can be contacted at ira.millstein@weil.com. Weil, Gotshal Associate Rebecca Grapsas assisted in the preparation of this paper.