Report of the NYSE Commission on Corporate Governance

By Cydney Posner

The NYSE Commission on Corporate Governance recently issued its report on its comprehensive review of corporate governance principles undertaken in response to the recent financial crisis.  The report seeks to bring together divergent views to build a consensus on governance principles. Although a number of notable governance failures have occurred in the recent past, the Commission concludes that "the current governance system generally works well." As a result, the Commission's message to anyone advocating further fundamental change is to first consider the strengths and benefits of the current system.

The Commission developed its governance principles in the context of the three key corporate actors: boards and management, both of which owe legal and equitable duties to the corporation, and shareholders, which, although they owe no legal duties, have important but limited rights to vote on fundamental corporate issues. (Interestingly, the Commission also recognized that there are other critical corporate stakeholders including, for example, "the corporation's employees who rely on the corporation to provide jobs and wages, the corporation's customers and vendors, as well as the communities in which the corporation operates and society at large, which look to the corporation to help address society's challenges, to innovate and to promote durable and sustainable economic growth.") Although these three actors have different roles, the Commission emphasized the significance of their interdependence and inter-relatedness in helping the corporation achieve its objectives: "it is unrealistic to expect boards and/or management to adopt policies that look to generate long-term economic wealth for shareholders when shareholders are focused primarily on quarterly results and short-term stock price maximization. Similarly, shareholders cannot be expected to be passive when boards appear to act in their own self-interest or in the interests of management, without adopting policies that are consistent with increasing shareholder value."

The Report sets forth the Commission's consensus on a number of basic principles:

• The board's fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation, and the board is accountable to shareholders for its performance in achieving this objective. The Report notes that, "while directors are supposed to take action in the long-term interests of shareholders, the combination of the decline in classified boards [which the Commission attributes to the increased influence of proxy advisory firms and institutional shareholders] and rise in majority voting requirements has resulted in directors facing increasing pressure to take actions that are primarily intended to increase stock price in the short term if the directors want to obtain the support of investors who focus on annual stock price increases. Additionally, investors who measure results by quarterly returns, as well as managements who are compensated on the basis of short-term results, can magnify the pressure on directors to maximize short-term stock price at the expense of long-term planning." Although shareholders (not to mention holders of various derivatives) have different investment time horizons, nevertheless, a board has the responsibility, subject to its fiduciary duties, to steer the corporation towards policies supporting long-term sustainable growth in shareholder value. Implementation of these policies involves "decisions that, by their nature, involve economic or other types of risk-taking." However, the board must ensure that appropriate risk management systems are in place to avoid excessive risk taking for the sake of short-term stock price increases. Similarly, compensation plans should be designed to encourage long-term value creation. The Commission emphasizes this point regarding long-term value creation notwithstanding its recognition that annualized turnover of stocks traded on the NYSE is now estimated to be over 100%, which means that, on average, an NYSE-listed company experiences trading volume each year that exceeds its total outstanding shares. The Report advocates that companies establish relationships with core long-term oriented investors and contends that directors should ensure that shareholders have a way to express their views about the management and the board. Shareholders have the right and responsibility to hold a board accountable for its performance in achieving long-term sustainable growth in shareholder value. The board must also work with the CEO to create a "culture of high integrity."

• While the board's responsibility for corporate governance has long been established, the critical role of management in establishing proper corporate governance has not been sufficiently recognized. The Commission believes that a key aspect of successful governance depends upon successful management of the company, as management has primary responsibility for creating an environment in which a culture of performance with integrity can flourish. The Commission contends that the current debate over good corporate governance tends to ignore the important role of honest, competent and industrious managers in the following:
  • establishing and monitoring processes and procedures for risk management and proper internal controls;
  • evaluating and developing executive talent according to high ethical standards;
  • creating and maintaining an ethical "tone at the top";
  • having systems for open internal communication about problems without the fear of retaliation;
  • promoting accountability through tailored incentive compensation that encourages, among other things, disciplined and transparent risk taking;
  • providing candid and accurate information to the board, including competing viewpoints, without overloading the board with too much information;
  • encouraging communication between the board and business leaders throughout the organization to facilitate the board's role in succession planning; and
  • developing and communicating the corporation's strategic plan, and key risks, to shareholders and the market.

Although the board may disagree with management over strategy or decisions, this "constructive tension" is a characteristic of good corporate governance so long as the debate is collegial and productive.

• Shareholders have the right, a responsibility and a long-term economic interest to vote their shares in a thoughtful manner, in recognition of the fact that voting decisions influence director behavior, corporate governance and conduct, and that voting decisions are one of the primary means of communicating with companies on issues of concern. A shareholder's right to vote includes the right to oppose the election of all or any directors. However, shareholders should attempt to engage in "constructive communication" with the corporation before engaging in adversarial conduct or submitting proposals or proxy access nominations. Because of the significantly increased ability of shareholders to influence corporate conduct, it is even more important that shareholders vote responsibly. Institutional investors should establish, disclose and discuss with companies the investors' corporate governance guidelines and general voting policies. Although some institutional investors use third-party proxy advisory services, the Commission argues that this practice does not relieve the institutions of their responsibility to vote constructively, thoughtfully and in alignment with the interests of their clients.
• Good corporate governance should be integrated with the company's business strategy and objectives and should not be viewed simply as a compliance obligation separate from the company's long-term business prospects. Although sound corporate governance should be integral to a company's business strategy and basic operation, the overwhelming number of new governance mandates and "best practice" recommendations over the last decade can lead to a "check-the-box" mentality. This risk is exacerbated by the fact that directorships are not full-time commitments. According to the Report, the following elements of governance obligations should be part of strategy:
  • independent and objective oversight of strategy and management by boards;
  • alignment of interests among shareholders, management and the board;
  • accountability of the board to shareholders and accountability of management to the board;
  • compensation programs that incentivize long-term growth;
  • establishment of criteria that are aligned with the company's business goals;
  • prudent risk management;
  • a culture of integrity; and '
  • consideration of the impact of the corporation's activities on society overall.

 

• Legislation and agency rulemaking are important to establish the basic tenets of corporate governance and ensure the efficiency of our markets. Beyond these fundamental principles, however, the Commission has a preference for market-based governance solutions whenever possible. Corporate governance solutions developed through collaboration and dialogue can result in market-based reforms that are customized to individual companies, providing more flexibility, as well as more practical and sustainable solutions. Shareholders should not be seen as adversaries, and legislation and rulemaking should involve broad principles that encourage such collaboration.

 

• Good corporate governance includes transparency for corporations and investors, sound disclosure policies and communication beyond disclosure through dialogue and engagement as necessary and appropriate. Companies and shareholders should develop best practices to ensure that dialogue is meaningful, results in increased understanding and trust and complies with applicable rules. Investors should also be transparent and required to disclose holdings (including derivatives) on a timely basis, recognizing, however, that certain information regarding trading strategies may be proprietary.

 

• While independence and objectivity are necessary attributes of board members, companies must also strike the right balance between the appointment of independent and non-independent directors to ensure that there is an appropriate range and mix of expertise, diversity and knowledge on the board. Recently, the Report observes, it has become common practice, although certainly not required, for the CEO to be the only non-independent director on the board. However, the appointment of a minority of directors who possess in-depth knowledge of the company and its industry could be helpful for the board as it assesses the company's strategy, risk profile, competition and alternative courses of action and would not impair the properly functioning of the board. Diversity (broadly defined), collegiality and candor are all important to effective functioning of the board, and any qualification requirements should be tailored to suit each company's needs. The Report notes that board service is not expected to be a full-time job: although directors are appropriately expected to act as monitors and strategic advisors, "adding tasks to the board's existing duties should be carefully evaluated and balanced with the effect those tasks may have on the ability of a director or board to perform other critical tasks. Calls for reform [may unintentionally] create a ‘check the box' mentality… to the extent mandates create additional obligations on board members while not taking into account the limited time available to directors to meet the existing demands."

 

• The Commission recognizes the influence that proxy advisory firms have on the market, and believes that such firms should be held to appropriate standards of transparency and accountability. The Commission commends the SEC for its issuance of the Concept Release on the U.S. Proxy System, which includes inviting comments on how such firms should be regulated. The Commission endorses the SEC's proposed study of the role of proxy advisory firms and believes that these firms should adhere to strict codes of conduct and should be required to disclose the policies and methodologies that they use to formulate specific voting recommendations, all material conflicts of interest and the company's response to the firms' analysis and conclusions.

 

• The SEC should work with the NYSE and other exchanges to ease the burden of proxy voting and communication while encouraging greater participation by individual investors in the proxy voting process. The Commission believes that the SEC should establish a committee of market participants and outside experts, including representatives of the various constituencies, to consider its recent concept release on improving the proxy process. In light of the decline in investor participation, the SEC should consider whether there are more effective and efficient ways for individual investors to participate and become informed.

 

• The SEC and/or the NYSE should consider a wide range of views to determine the impact of major corporate governance reforms on corporate performance over the last decade. The SEC and/or the NYSE should also periodically assess the impact of major corporate governance reforms on the promotion of sustainable, long-term corporate growth and sustained profitability. While it's difficult to measure the impact of corporate governance regulations, regulators should consider a wide range of views and perspectives before adopting new regulations, including the practical implications of new regulations on directors' ability to perform their existing duties, the potential costs and benefits to the company and its shareholders and the efficacy of existing regulations. The SEC should consider using more pilot programs, phase-ins and sunset provisions. After all, the Report reiterates, being a director is not a full-time job. (Do you detect a theme here?)

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