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Column

Trevor S. Norwitz
Partner
Wachtel Lipton Rosen & Katz

The Devaluation of the Director
Look out — Corporate America today is facing a revolution, the end game of which is management-by-referendum, the shifting of decision-making power away from the board to the shareholders.

By Trevor S. Norwitz

For more than a century, the corporation has been the engine driving the American economy. By allowing investors of all sizes to diversify their risk in limited-liability entities and pool their capital under professional management, the corporate form has fostered entrepreneurial risk-taking and powered unprecedented growth and productivity. One can think of the American corporation as the goose that lays the golden eggs.

Today that goose is an endangered species.

On a microeconomic level, we increasingly see hedge funds accumulating stakes in companies, not as traditional investors who like what they see and want a piece of it but because they do not like what they see and want to change or disassemble it.

Sometimes their ideas have merit and their efforts are handsomely rewarded. In other cases, their conviction that they understand a company better than its own management and board of directors is wildly misplaced, and they wreak significant harm on the entity and its other stakeholders (even though they may secure a short-term benefit for themselves).

Far more troubling, however, is the macroeconomic manifestation of this phenomenon, in which the activist community is openly seeking to shift decision-making power away from the board of directors to the shareholders (which at best refers to a small number of unelected intermediaries but in effect often means the “squeaky wheels” and special interests).

This devaluation of the role of the board of directors as a central and vital component of the corporate governance system represents a fundamental restructuring of the corporate institution and poses a significant threat to the continued vitality and competitiveness of our economy.

A Radical Departure
There is no denying that shareholders have a valuable role to play in engaging with boards: offering fresh ideas and encouraging them to operate according to the highest standards. But the activists want more than influence. They are demanding the ability to dictate to directors, whom they view as their hirelings, and the right to easily get rid of any director who does not heed their bidding.

What this amounts to is the transfer of decision-making power to professional shareholders who are not as well positioned, organized, equipped, or informed as the directors to make decisions and who do not have any fiduciary responsibility for their actions. Indeed, shareholders are generally not unified in their objectives or time horizons, and the most vocal among them often represent special interests.

Such a dramatic and radical departure from the carefully constructed balance of power that has been developed over many years is not justified by perceived flaws in the current system. The solution to the problem of weak governance is to strengthen boards of directors and allow them to operate as intended, not to neuter them.

Unprecedented Onslaught
Corporate directors today face an unprecedented onslaught of new pressures, risks, and opportunities for embarrassment. These include, to name but a few:

growing pressure to deliver short-term results;
heightened expectations in terms of time, compliance oversight, and due diligence efforts;
incessant criticism by gadflies and the press;
a constant stream of governance “enhancements” and shareholder resolutions often designed, in combination with majority voting, to force directors’ hands;
being graded (or degraded) by self-appointed governance watchdogs on standardized one-size-fits-all report cards;
increasingly suspicious and antagonistic boardroom dynamics;
relentless litigation with the ominous specter of personal liability;
the Catch-22 of trying to attract and retain quality managers without drawing fire for excessive compensation; and,
efforts by packs of hedge funds with short time horizons to compel companies to sell, dismember, or recapitalize themselves, or even to renegotiate arm’s-length merger and acquisitions transactions.

Perhaps most insidiously, there is growing pressure on boards to dismantle takeover defenses and lay the companies they are charged with protecting bare to opportunistic raids at the most inopportune times.

‘Just Give Us Your Obedience’
In essence, the shareholder activist community is saying to directors: “Your time has passed. Give us, the owners, the power to make any significant decision and trust us to use it responsibly. We don’t need experience or judgment from you, just obedience and conscientiousness. Your job as a director is to look over management’s shoulders, to make sure they are not overpaid, and to auction the company to the highest bidder when we tell you the time is right to sell.”

This is not the model that has powered a century of entrepreneurship and growth. The future success of America’s corporations will depend in large part on whether boards continue to operate effectively, recruiting talented managers and overseeing and guiding their efforts in a cooperative manner to formulate and execute the organization’s strategy.

That in turn depends, first and foremost, on whether enough qualified individuals are willing to serve as directors in this increasingly challenging environment and whether those who do serve are willing to engage in the kind of prudent risk-taking that made the American economy the envy of the world.

There is no question that the evolution from the clubby, complacent board to the independent, empowered board has dramatically improved corporate governance, but populating our boardrooms with professional hall monitors and bean counters is not a recipe for continued success.

Trevor S. Norwitz is a partner at the law firm of Wachtell, Lipton, Rosen & Katz in New York specializing in mergers and acquisitions and corporate governance (http://www.wlrk.com). He is an adjunct lecturer at Columbia University Law School. He can be contacted at tsnorwitz@wlrk.com.

A longer version of his article originally appeared in the Second Quarter 2007 edition of Directors & Boards.