The wall at the Ellis Island Immigration Museum may seem like a strange place to go to understand investor reaction to last month’s milestone decision in the Disney case. But some truths are universal and cut across both time and place. The museum quotes an Italian immigrant who stepped off the boat in New York about a century ago: “Before I came to America I had heard that the streets were paved with gold. But when I got here, I discovered three things. First, the streets were not paved with gold. Second, they were not paved at all. Third, they expected me to pave them.”

For good or ill—and we’ve heard arguments both ways—courts are not prepared to bring even clearly asleep directors to book. U.S. lawmakers are neither willing nor able to do that job either. The Disney decision leaves no ambiguity: If institutional investors expect boards to be awake and operating to advance shareowner interests, the investors themselves will have to make sure that happens.

What does this mean for compliance officers? Should companies gird for a sudden upsurge in fund activism at 2006 annual meetings? Not necessarily. There is a school of thought—best voiced by Harvard Law School’s Lucian Bebchuk—that investors simply cannot oversee board competence owing to curbs on their rights.

Justice William Chandler III’s Disney opinion contended that shareowners have all the power they need to punish incompetent directors and rectify corporate strategic mistakes. But Bebchuk, in a Financial Times column, ticked off the garden-variety obstacles investors face. “Shareholders’ power to replace directors is now largely a myth,” he asserted. Further, investors have little ability to change corporate charters. And, he concludes, managements have usually unchallenged authority to block takeover bids through defenses such as poison pills. Unlike all other major markets, boards at U.S. companies can impose such defenses without first having to obtain shareowner approval.

Bebchuk has a point; these are all real hindrances to investor rights. Some would argue that handcuffs are the reason some investors go passive while others resort to militancy instead of behind-the-scenes dialogue with corporate managements. An expansion of shareowner powers to elect and oust directors, change corporate charters and vote on poison pills would clearly strengthen the logic of the Disney judgment.

So expect some funds to read Chandler, realize that board competence now hinges more clearly than ever on investor scrutiny, and still find excuses to go limp.

But compliance officers should not relax just yet. The Disney ruling’s real but so far unheralded power is that it will accelerate a profound trend. Until recently, activist funds have focused attention on controversies such as options accounting and executive pay. Important as they are, these are peripheral to the issue at the heart of U.S. corporate governance: board competence and accountability. Increasingly investors are aiming activism squarely at directors.

What’s the evidence? The Disney suit itself is Exhibit A. Directors were deposed and called to testify. And, while Chandler didn’t discipline the directors, his opinion surely embarrassed them. Exhibit B is the recent disgorgements investors won against directors at WorldCom and Enron. But Exhibit C, the smoking gun, is the fact that big institutions have taken up a call for vote reform that would introduce majority rule in director elections.

Today nearly all U.S. corporations use a plurality system, whereby a single share voted ‘yes’ can elect an entire slate of board directors, even if every other share’s vote is withheld. Further, director nominations are normally bundled into a single resolution, making it more complicated for investors to single out individual directors. No wonder funds and proxy advisors long treated board elections as “routine”—they were and are largely meaningless, as even Disney justice Chandler conceded in a 2003 scholarly paper.

After investor prompting, the American Bar Association convened a panel to explore alternatives to the current system. At the International Corporate Governance Network meeting in London in July, some 550 delegates—most of them investors—voted by straw poll on the four options the ABA floated. A paltry 3 percent backed the current plurality method; 69 percent supported majority rule. Bodies including the Council of Institutional Investors and the AFL-CIO wrote to favor majority rule; the ABA pledged to release all comments on its four options this month (see related coverage below, right).

Some corporations have read the writing on the wall and have acted accordingly. In June, Pfizer pioneered a hybrid election rule in its bylaws. From now on, any Pfizer director failing to earn a majority of ‘yes’ votes among the total cast must submit a resignation, which the board can then decide to accept or reject. A newly chastened Disney, as well as other companies like Circuit City and ADP, followed suit last month with variations of majority rule.

If the Pfizer system spreads widely—as now seems entirely possible, if not likely—it would make directors more accountable far earlier than anyone anticipated. The 2006 proxy season will see funds treating votes for each director far more seriously, as the era of routine elections will have ended. That means companies, in turn, will have to pay far more attention to justifying director candidacies. Already, research groups see investor demand rising for more extensive profiles of directors, allowing greater scrutiny of competence, pay, attendance and dedication. The Corporate Library, for instance, is about to roll out unprecedented compensation data for 20,000 U.S. nonexecutive directors.

So, what should compliance officers and executive management do? First, consider adopting the Pfizer solution. After all, if your shareowners vote against a director, chances are the board really should reconsider his/her appropriateness for service.

Second, nominating committees need to explain the rationale for nominations—both generally and with regard to individual directors—in DEF 14A proxy statements. Right now, the standard proxy includes a perfunctory biography of the nominees, and that's all. The typical disclosure provides little or no justification for why the nominees are appropriate, why the nominating committee selected them, or what other candidates were considered. That information is critical to institutional investors—it not only provides context and reason, but instills confidence in the board's well-articulated processes and commitment to transparency.

Finally, consider instituting a real board review process if your company doesn’t already have one. One of the most salutary effects of formal board reviews is that it provides a mechanism to remove inattentive or otherwise problematic directors.

Remember, the Disney ruling cleared directors of negligence, but not of incompetence. Read Chandler: “Ornamental, passive directors contribute to sycophantic tendencies among directors and ... imperial CEOs can exploit this condition for their own benefit, especially in the executive compensation and severance area." That’s a reminder more investors will heed—spurring do-it-yourself means to energize boards.

This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.

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