The Shareholder Rights Express Rolls On

Well, the shareholder rights express continues to roll down the track.

You’ve probably already seen my past columns and other Compliance Week articles dwelling on current or past reform efforts at the Securities Exchange Commission or Congress, intended to enhance shareholders’ abilities to elect corporate directors and otherwise influence what goes on in corporate boardrooms.

Consistent therewith, in July the SEC proposed a host of additional proposals calling for further disclosure surrounding such matters as compensation policies and how they drive risk; director and nominee qualifications; the board’s leadership structure; and potential conflicts of compensation consultants. To some extent these new proposals continue initiatives begun long ago, now moving to a higher level. They’re also part of the reaction to failures in the boardrooms of financial institutions that dragged down much of the financial system.

Whatever the precise origin of each particular proposal, they’re now on the table. And while the SEC may modify them somewhat before finalization, we should make no mistake: these will become final rules companies must address.

Some have already said the plans are no big deal—that the disclosures are not onerous and companies and their general counsels, corporate secretaries, and compliance officers are positioned to get the necessary information. That may be a fair assessment for the most part, but let’s consider some areas where these rules, when finalized, will cause real angst.

Compensation Discussion & Analysis

First, the scope of the Compliance Discussion & Analysis will be further broadened to require “information about how the company’s overall compensation policies for employees create incentives that can affect the company’s risk and management of that risk.” The SEC says such disclosure can help investors know whether a company’s incentives can tempt employees to take excessive risks. Indeed, the proposal sets forth (with some precision) the kinds of circumstances that would need additional disclosures.

Based on recent history, this new rule is reasonable and makes sense. We’ve seen evidence that compensation policies of the major investment banks—now in bankruptcy or having been acquired—were at least partially responsible for these massive Wall Street failures.

But distinguishing the drivers of failure on a conceptual basis from specific cause and effect can be challenging, to say the least. Were the compensation policies of, say, Merrill Lynch and Goldman Sachs so very different that they drove different behavior? Or did one of these firms’ executives have the good sense to jump off the collateralized debt obligations bandwagon soon enough, where the others did not? It’s interesting to ponder whether disclosures under the proposed rules for these two firms, with diametrically opposed outcomes, would really have been much different.

And what would AIG have disclosed about its London-based financial products unit that brought the company to its knees? It’s interesting to wonder what the disclosure would have been, when the company itself saw little risk in the unit’s activities.

With that said, I actually do believe the new rules may very well change behavior for the better. (More on that in a moment.)

Enhanced Director and Nominee Disclosure

[D]istinguishing the drivers of failure on a conceptual basis from specific cause and effect can be challenging, to say the least.

The SEC also proposes to expand current rules to require disclosure of the “particular experience, qualifications, attributes, or skills” of persons nominated to the board of directors (new and incumbent directors alike). The disclosures include the nominee’s particular expertise and a description of why his or her service would benefit the company. Other required disclosures include legal proceedings involving the individual for an extended period. The stated goal is to help investors determine whether a particular director and the board as a whole is appropriate for the company.

With the increasing ability of a company’s owners to nominate candidates for board seats and for their votes to influence who sits at the table, it certainly makes sense for shareholders to have information necessary to make informed judgments. Nobody can reasonably question whether having more relevant information is a good thing. But we can wonder whether it’s possible for any investor to know enough about an individual, based on a few paragraphs of text, to make a meaningful judgment about whether that individual should be selected to represent the investor’s best interests.

A relevant analogy might be voting for your House or Senate representative, based solely on, say, a one-page description of the individual’s background and skills. In such contests for political office we have debates, speeches, news reports, editorials, and commentary (not to mention political advertisements), and even then it can be challenging to determine who is the best candidate.

This gets back to the larger issue of who is best positioned to select the directors of a company, and my past columns speak to that issue. But suffice to say here that having a bit more information is unlikely to make much difference in shareholders’ ability to make informed judgments.

Compensation Consultants

Another requirement relates to compensation consultants. Disclosures would be expanded to include fees paid to the consultants when they are involved in additional services beyond determining or recommending executive and director compensation, along with a description of the additional services.

This relates to what the SEC describes as the “appearance, or risk, of a conflict of interest that may call into question the objectivity of the consultants’ executive pay recommendations.” This has long been a matter of debate, and the disclosures may well be useful. Frankly, regardless of whether questioning compensation consultants’ objectivity in a particular instance is justified (my experience is that in recent years there need be little concern) I’ve been advising my board clients that it usually is best simply to avoid any problem and use different firms as needed.

Leadership Structure

Details would need to be given about the company’s leadership structure and why it’s the best one for the company, along with whether and why there is a combined or separate chairman and CEO. Also called for is information about a lead director and his or her role. Interestingly, the SEC states that this requirement isn’t intended to influence a decision regarding a board’s leadership structure. That makes sense, and I’ll accept the statement at face value.

I’m wondering, however, what disclosures we might see. With tongue in cheek, I can see a statement such as: “Because our CEO was recently promoted from within, we believe he’s still too green and untested to give him the chairman’s title. But in a few years we will likely bestow him with the chairman mantle as well, so we will finally get back to the point where we have one point of authority in and leadership of our fine company.” No doubt you can dream up other disclosure scenarios, and it will be interesting to see what the lawyers ultimately come up with.

Board’s Role in Risk Management

Now we get to some of the good stuff. The SEC’s proposal, making explicit reference to the “role that risk and the adequacy of risk oversight have played in the recent market crisis,” requires information about the board’s role in the company’s risk-management process. It calls for a description of how the company “perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company.” Information would address such matters as whether the board carries out these responsibilities by the board as a whole or a board committee, to whom persons who manage risk report, and whether and how the board manages risk.

Let’s now get back to what I believe is by far the most significant aspect of these coming rules: the potential to see behavioral change among managements and boards in how they deal with risk. Disclosure in these areas by itself, in my mind, provides little if any benefit. But it is likely to prod company leaders to consider, perhaps more seriously than ever before, what they are really doing to indentify, analyze, and manage risk effectively.

Disclosing how compensation policies affect the way risk is managed in the organization requires an assessment of just what the risks are, how they are managed, and how they are linked to the company’s strategy, performance measures, and management’s incentives and compensation. Disclosing what the board is doing to manage risk means directors will need to dig more deeply into what management is doing to manage risk, and how the board can feel comfortable that it is truly carrying out its oversight responsibilities.

Sunshine is the best disinfectant, and that’s worth remembering here. Required disclosures by themselves won’t do much, but they are likely to be a catalyst for management and boards to look in the mirror (or rather into their organizations) and do what needs to be done to make positive disclosures.

Of course there’s always the possibility that boilerplate language will rule the day, and no meaningful change will happen. The skeptic in me says that may occur here, but the optimist says this opportunity will be seized and risk management made more effective. Time will tell.