American corporations today are like the great European monarchies of yore: They have the power to control the rules under which they function and to direct the allocation of public resources. This is not a prediction of what’s to come; this is a simple statement of the present state of affairs. Corporations have effectively captured the United States: its judiciary, its political system, and its national wealth, without assuming any of the responsibilities of dominion. Evidence is everywhere.

• The “smoking gun” is CEO pay. Compensation is an expression of concentrated power — of enterprise power concentrated in the chief executive officer and of national power concentrated in corporations. Median US CEO pay for 2010 was up 35 percent in the midst of a lingering recession, while CEO pay over the last decade has doubled as a percentage of pre-tax corporate income. Yet there has been no justification for current levels of CEO pay based on economic value added.

When Lee Raymond retired as CEO of ExxonMobil at the end of 2005, after six years at the helm of the merged firm and another six as head of Exxon before that, he walked away with more than a quarter billion dollars in realizable equity. In his final year alone, Raymond received in excess of $70 million in total compensation — an hourly wage of about $34,500 calculated at 40 hours a week for 50 weeks. No metric can justify such a raid on the corporate treasury and shareholder equity, but Raymond is only a particularly egregious and early example of what has since become common practice. Little wonder that the driving concern of banks receiving TARP “bailout” money was to pay it back so as to escape any restriction on executive pay.

• Retirement risk has been transferred to employees. During the same period that CEOs were doubling their own compensation, the “best” CEOs of the “best” companies abrogated the century-old commitment by employers to provide pensions to their workers. IBM has been the corporate leader in abolishing a “real” pension system for its employees. The 2006 elimination of on-going defined benefit plans will “save [IBM] as much as $3 billion through the next few years and provide it with a more ‘predictable cost structure’,” TK said at the time. Translation: The worker bees are on their own.

This is the essence of “capture” – CEOs are enriched, while all other corporate constituencies, including government, are left with liabilities. A relatively few autocrats have taken control over the policies and wealth allocation of the United States.

• The financial power of American corporations now controls every stage of politics — legislative, executive, and ultimately judicial. With its January 2010 decision in the Citizens United case, the Supreme Court removed all legal restraints on the extent of corporate financial involvement in politics, a grotesque decision that can have only one effect: maximizing corporate – not national — value. Today’s CEOs have been granted the power to direct political payments and organize PAC programs to achieve objectives entirely in their own self-interest, and they have been quick to use it.

More than $300 million was “invested” by corporations in the 2008 Presidential elections. The totals will be vastly higher in 2012 when the full impact of Citizens United is expressed, and the distribution will be politically agnostic. As Bill Moyers recently noted, President Obama “has raised more money from banks, hedge funds and private equity managers than any Republican candidate.”[1]

• Capture has been further implemented through the extensive lobbying power of corporations. Abraham Lincoln’s warning  about “corporations enthroned” and Dwight Eisenhower’s about the “unwarranted influence by the military/industrial complex” have been fully realized in our own time. Reported lobbying expenditures have risen annually, to $3.5 billion in 2010. Half of the Senators and 42 percent of House members who left Congress between 1998 and 2004 became lobbyists, as did 310 former appointees of George W. Bush and 283 of Bill Clinton.

Capture has focused on particular industries. Two powerful Democratic administrations have not been able even to propose a system of “single payer” health insurance.  Meanwhile, business interests have assured that whatever program of “universal coverage” emerges will lock in the interests of the insurance and the pharmaceutical industries.

History has yet to sort out whether the second Iraq War served any national objectives beyond military and industrial ones, but the suspicion that oil interests played a critical role in the rush to battle is enhanced by Vice President Cheney’s refusal to reveal the names of the participants in his energy transition committee. Simultaneously, the inability to force public disclosure of those participants offers a window into how thoroughly the energy industry controls its own agenda, destiny, and information flow. Not only has the industry succeeded in achieving and maintaining special regulatory and tax treatment; in multiple other ways, it functions virtually as an independent state.

• Capture has placed the most powerful CEOs above the reach of the law and beyond its effective enforcement. Extensive evidence of Wall Street’s critical involvement in the financial crisis notwithstanding, not a single senior Wall Street executive has lost his job, and pay levels have been rigorously maintained even when, as noted earlier, TARP payments had to be refinanced in order to remove any possible restrictions.

While several financial firms have paid civil penalties for their abuses, the amounts involved bear little relation to the malfeasance. US District Judge Jed S. Rakoff recently — and rightly — rejected the $285-million settlement agreed to between Citigroup Inc. and the Securities and Exchange Commission as “neither fair, nor reasonable, nor adequate, not in the public interest.”

Worse, such fines as have been imposed on the financial industry are basically being paid by the government itself. At the same time that various regulatory agencies boast of record setting penalties assessed against banks, the Federal Reserve pays banks interest on money that is not being lent, resulting in an “interest margin” realized by U.S. banks in the first six months of this year of $211 billion — more than ample funding for any penalties suffered.

• Finally, capture has been perpetuated through the removal of property “off shore,” where it is neither regulated nor taxed. The social contract between Americans and their corporations was supposed to go roughly as follows: In exchange for limited liability and other privileges, corporations were to be held to a set of obligations that legitimatized the powers they were given. But modern corporations have assumed the right to relocate to different jurisdictions, almost at will, irrespective of where they really do business, and thus avoid the constraints of those obligations.

As Nicholas Shaxson writes in Treasure Islands, “The privileges have been preserved and enhanced, but the obligations have withered.” Meanwhile, the U.S. Treasury is estimated to be losing $100 billion annually from off-shore tax abuses.

Government cannot and will not hold corporations to account. That much is now obvious.  Indeed, the dawning realization of this truth is what has informed the Occupy movement, but only the owners of corporations can create the accountability that will ultimately unwind the knot of government capture.

The essence of the problem is quite straightforward: a failed system of corporate governance. So is the cause: the unwillingness of trustee owners of America’s corporations to assert their responsibility, legal duty, and civic obligation to monitor and oversee the corporations they invest in. Fiduciary institutions own 80 percent of the outstanding shares of corporate America and thus bear at least 80 percent of the responsibility for present circumstances as well as 80 percent of the onus for saving the system itself. And the largest institutional investors — the Bill and Melinda Gates Foundation, Harvard University, and others — must take the lead because (a) they should and (b) all other courses have failed.

Urban park by urban park, campus by campus, the Occupiers are bearing sometimes inchoate witness to America’s capture by corporate interests. Now, men and women of conscience need to reoccupy the boardrooms of America’s corporations. The boardroom is where the takeover began, and it’s where capture can finally be undone and a government of, by, and for the people, not the corporations, restored to the land.

Robert AG Monks is a shareholder activist and corporate governance adviser who has written widely about shareholder rights & responsibility, government capture, corporate impact on society and global corporate issues.

Mr. Monks is an expert on retirement and pension plans and was appointed director of the United States Synthetic Fuels Corporation by President Reagan, who also appointed him one of the founding Trustees of the Federal Employees’ Retirement System.  Mr. Monks served in the Department of Labor as Administrator of the Office of Pension and Welfare Benefit Programs having jurisdiction over the entire U.S. pension system.

Mr. Monks was a founder of Institutional Shareholder Services (ISS), now the leading corporate governance consulting firm.  He also founded Lens Governance Advisers and co-founded The Corporate Library (now Governance Metrics International).  He is a shareholder in and advisor to Trucost, the environmental research company.

Although institutional investors play a major role in our public equity markets, far less is known about the governance of those investor entities than about investee corporations. These investors are critical to individuals, equity markets, publicly held companies, the economy — and to the troubling (and conceptually difficult) issue of good versus bad short-termism in investor and investee behavior. Put simply, the fundamental issue is whether institutional investors are part of the problem or part of the solution within the current state of market capitalism. By institutional investors we mean, at a minimum, pension funds, mutual funds, insurance companies, hedge funds and endowments of non-profit entities like universities and foundations. Recent developments in public policy treat shareholders (primarily institutional investors) as part of the “solution.” The Dodd-Frank Act in the United States and the Stewardship Code in the United Kingdom, for instance, essentially place big bets that institutions can and will police the market with new powers and responsibilities. While this is a worthy objective, it rests on unexamined and unsophisticated assumptions.

In a new paper, Are Institutional Investors Part of the Problem or Part of the Solution?, we attempt to outline major descriptive and prescriptive issues relating to these institutional investors (the paper is available from Yale’s Millstein Center here, and from the Committee for Economic Development here). We call for much greater intellectual and institutional effort in addressing these vital but under-analyzed questions. Set out below is the essence of our argument for much more sophisticated analysis of the governance of institutional investors — based on development of much more robust data bases about the critical elements of investor governance and performance.

Over the last twenty years, institutional investors have owned an increasing share of public equity markets — more than 70 percent of the largest 1,000 companies in the United States in 2009, for example. Over the past two years, in response to failures of some boards of directors and business leaders, shareholders, including institutional investors, have been given increased powers to participate in — or have disclosures about — discrete spheres of governance in publicly held corpora­tions. Moreover, during this same period, and in multiple jurisdictions, there have been increasing calls from both the public and private sectors for institutional investors to play a broad “stewardship” role by “engaging” with investee compa­nies to “help achieve long-term sustainable value” and to help curb the excessive risk taking seen as a factor in the financial crisis.

But with these shifts in market and legal powers have come questions about institutional investors which are similar to those raised in the recent past about the corporations in which they invest. These questions relate to goals, strategies, governance, performance and accountability and, importantly, the separation of ownership and control (i.e. agency problems). They boil down to a bedrock query: do investors have the capacity to perform the role now expected of them?

Policymakers who championed the transfer of enhanced powers to investors went well beyond available knowledge in crafting such a response to the financial crisis. This leap of faith is perhaps understandable in light of the severity of the 2008 market seizures and the political pressures that arose in their wake. But there is no mistaking that the approach represents, in effect, a big bet that investor institutions can and will exercise their new rights responsibly, and that such behavior will make markets more sustain­able, less prone to error, and more in sync with the interests of capital providers.

Moves to further empower investors lend urgency to the need to deepen knowledge of investor governance and behavior. Three organizations — the Committee for Economic Development, The Millstein Center for Corporate Governance and Performance at the Yale School of Man­agement, and the Aspen Institute Business and Society Program — agreed to explore this issue, especially because the level of available research effort and prescriptive analysis lags behind the voluminous writing on publicly held corporations. The trio convened a research roundtable in January 2011 with academics, think-tank analysts, leading practitioners and former regula­tors. The purpose was to identify salient areas for future research and analysis.

Our paper outlining the empirical and normative issues posed by institutional investors proceeds from three fundamental and potentially interrelat­ed questions which were identified as central at the research roundtable.

First, do such investors adequately advance the goals of the individuals who give institutions their money—whether those individuals are pension fund beneficiaries, mutual fund investors, insurance beneficiaries or hedge fund investors? The question is the classic “principal/agent” problem: do those who manage trillions of dollars of other people’s money advance the interests of the ultimate beneficiaries — who may be dispersed and disengaged — or their own interests? This question has special salience today because of the many different steps in the investment chain. Agents abound. For example, one common sequence is that an individual contributes money to a pension fund; the trustees and executives, after being advised by an investment consultant, then allocate those monies to both internal and external fund managers, or to managers of fund of funds who in turn distribute the monies to yet other asset managers.

Second, do institutional investors contribute significantly to “undesirable short-termism” in their publicly held investee companies? A number of commentators have argued that institutional investors put pressure on boards of directors and business leaders for increases in short-term share price at the expense of balanced long-term investment, risk management and integrity because of investor strategy (beat composite indices, for instance), compensation (say, for performance during quarter or year) and other competitive factors (e.g. continually outperform peer investors, not just indices). Such pressure from investment managers argu­ably helped cause financial institutions to assume high leverage in an overheated housing market to keep stock price rising in lockstep with other financial service companies. Given these factors, commentators have said: “Unsurprisingly, investment managers focus on delivering short-term returns….pressuring investee companies to maximize their near-term profits.”

Third, can institutional investors become more effective “stewards” of publicly held investee corporations, and how does that “stewardship” role differ from the role of boards of directors to oversee the direction of companies? This issue arises in part from the criticism that institutional investors were passive in the face of problems which caused the credit crisis and the financial meltdown (as opposed to being an active cause of that meltdown through short-term pressures): “….a successful financial system requires the oversight of vigilant market participants… [w]hen pension funds, mutual funds, insurance funds and other major investors are silent, vigilance is absent….[s]uch passivity invites abuse.” This criticism of institutional investor passivity has arisen many times before the most recent crisis. But the stewardship aspiration also stems from a desire to articulate fully the roles and responsibilities of shareholders — embodied, in part, by recent policy initiatives such as the U.K. Stewardship Code and U.S. Dodd-Frank reforms. Such a stewardship role is different than simply selling a stock. As Roger Ferguson, President and CEO of TIAA-CREF, has said: “Better to engage management on governance and strat­egy issues before problems arise and shareholder value plummets.” But given the complexity of many corporate decisions — and difficulties directors themselves have in overseeing multi-factorial business tradeoffs — what is realistic in terms of time, effort and contribution in the relationship both from the “stewards” and from boards/management? Do the investor “stewards” relate to boards, to manage­ment, or to both — and at what level of detail and on what kind of decisions? The answers to these three fundamental questions about institutional investors will, of course, vary with type of investor. Answers will also turn on the interplay between factual research results and analysis of important prescriptive concepts and questions which, when articulated properly, provide the foundation for normative judgments about what are “proper” public policies or “proper” private ordering arrangements to address defined institutional investor “problems.”

The three issues also may be interrelated. For example, beneficial owners who contribute to pension funds may seek steady, long-term growth in their assets, not short-term, up-and-down volatility; fund managers may seek to exploit short-term volatility for their own benefit, even though it is inconsistent with the longer-term objectives of the beneficial owners; and such steady long-term growth may be consistent with a proper investor stewardship role with investee companies played by those who control other people’s money (the money of the beneficial owners). Even if the objectives of beneficial owners are, in fact, short-term, as with investors in some hedge funds, then those objectives may cause undesirable short-termism in investee companies and may preclude a serious stewardship role because of short time horizons (or because trading strategies are largely indifferent to gover­nance concerns).

The paper is intended to spotlight knowledge gaps and identify practical remedies. It contends that addressing these fundamental questions is central to understanding even more fundamental issues relating to the state of market capitalism, issues for individual investors, the potential impact on equity markets, constraints on publicly held companies, and the health of the economy. It seeks to make the case that we need to have as much under­standing about investor entities as we do about investee companies. It points the way analytically towards the variety of issues which need to be addressed in answering the three generic questions — without trying to bias the outcomes. It invites much greater attention to these critical questions from all across the intellectual and policy spectrum.

Our bottom line assertion: the increasingly important role of institutional investors in our economy and our public markets requires substantial new intellectual attention.

Our principle concern is that either public mandates or private efforts are needed to assemble a global database with fundamental empirical information about different types of institutional investors: in particular their goals, time frames, strate­gies, governance structures, governance processes, incentives, compensation practices, transparency, holding periods and market impact — and their view of fiduciary duties, accountability, and the stewardship role. Such a database is a neces­sary prerequisite for efforts to advance understanding of the critical role institutions increasingly play in the functioning of capital markets around the world.

Second, we hope analysts from all across the intellectual spectrum will engage in the three fundamental prescriptive questions which provided the framework for our paper. Do institutional investors carry out the goals of their individual beneficiaries? Do institutional investors contribute to “improper” short-termism? How can institutional investors play a stewardship role in support of longer-term corporate strategies which effectively counters improper short-termism and which meshes appropri­ately with the responsibilities of boards of directors and senior leaders of investee companies?

But we must emphasize that these intellectual challenges require institutional attention and support. We hope the paper can be the basis for workshops convened by regulators, think-tanks, business, law and public policy schools. But beyond conferences to energize work on this critical set of issues, it would certainly be appropriate — and definitely in the public interest — for academic institutions to establish capacity both to conduct and to collect descriptive and prescriptive research in a comprehensive and systematic way.

Study of the many issues raised in this paper (and many more outside of it) is surely appropriate. But it is also necessary to understand these problems holistically — to comprehend the systematic interrelationships that actions on one set of issues may have on other pertinent institutional investor problems. Although research is certainly being conducted on institutional investors in a variety of settings, we are not aware of academic or think-tank centers dedicated to a comprehensive approach to this vital area.

Surely the time for such a comprehensive approach has arrived. The hope for sound public policy or sound private ordering to address increasingly salient issues posed by institutional investors depends on this type of intellectual and institutional effort.

Benjamin W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. Stephen M. Davis is the Executive Director of Yale University School of Management’s Millstein Center for Corporate Governance and Performance. This post is based on a paper by Mr. Heineman and Mr. Davis, available here or here.

This article was first published on the Harvard Law School Forum on Corporate Governance and Financial Regulation and is re-published with the authors' permission.

“We have the best opportunity ever to advance corporate governance,” said Joe Dear, the head of the Californian pension fund, Calpers, in the middle of the financial crisis. Two years later, the crisis is over, but the governance of banking firms seems stuck in the past. Banks still have to fully clean up their balance sheets and really increase their lending to Main Street. Bankers are again giving themselves outsized compensation packages, despite the fact that many owe their survival to a bail-out with public money. Little wonder that public trust in the banking industry and, by extension, trust in business as a whole is very low.

Where are the bank boards? Many of them have been recomposed with new directors who have much more financial markets’ expertise. So why do they remain so out of touch with society and critical stakeholders who can make or break the company as well as out of touch with what’s needed to re-establish the social legitimacy of their firms? The problem is that the world of CEOs and board directors is made up largely of other CEOs and top executives who in a repetitive routine interact mainly with one another, with management, and occasionally with analysts, consultants and government officials.

Board directors in many widely held companies owe their loyalty to those who nominate them – people from the  same world. In the words of Nell Minnow, head of The Corporate Library, “There’s only one thing that matters, and that’s who gets to decide who sits on the board.” As long as directors are nominated by existing board directors on the Nominating Committee, which often includes the CEO, they will continue to empathize with the CEO of the company on whose board they are sitting. Fellow CEOs are not going to raise the red flag because of a little societal criticism, nor will they deny the company’s CEO and his top people an increase in compensation, since they are in a similar position relative to their own board. There needs to be fundamental change.

We are seeing some steps in the right direction. For widely held companies in the U.S., the SEC now has the legal authority to require shareholder nominees to be included with management’s nominees for election to the board. In the U.K., the Financial Services Authority has been given veto power over the nominees to big bank boards. In Sweden, large shareholders form the nominating committee of listed companies. When minority shareholders are legally protected, as they are in Sweden with strong rights to block certain decisions with a minority vote at the shareholders’ meeting, the net performance advantage increases of having large owners nominate the board directors.

Beyond the owners, bringing direct stakeholder representatives on to the board itself is not the obvious next step. Indeed, the experience of NGOs, partnerships, and other diffusely held organizations shows that too many stakeholders on the board often leads to gridlock. The chairmen of some Northern European companies, I have spoken to, believe that the effectiveness of their boards could be greatly improved by having the employee representatives sit on the nominating committee rather than on the board itself. In fact, the contribution of employee representatives on northern European boards is marginal, because management and the directors elected by the shareholders usually meet before board meetings to settle key agenda items.

Membership of the nominating committee, rather than the board itself, more easily can be extended to include the representatives of other critical stakeholders, to ensure that the directors selected are in touch with stakeholder interests and risks. For example, in investment banks, the nominating committee should have members with direct contact or recent experience in frontline trading, back office risk management and the public oversight of the industry; for oil majors, members with subcontractor, drilling platform and NGO experience or contacts.

There are important advantages to a shareholder/stakeholder-based nominating committee:

-It ensures that the shareholders as a whole elect directors from a list of nominees with the societal, industry and other essential expertise and contacts, desired not only by the owners, but also by other critical stakeholders.

-It requires only a limited time commitment (to the nominating committee) from high-powered stakeholders.

-It breaks the monopoly of power that develops on boards and nominating committees dominated by a CEO/Executive Chairman.

-It increases the chances of getting strong sparring partners onto the board, because the directors owe their loyalty, not to the CEO/Chairman, but to the stakeholder representatives on the nominating committee.

A shareholder/stakeholder-based nominating committee would need specific rules of committee governance to integrate the different perspectives on desirable nominees. Moreover, the increased diversity on the board would complicate the life of the chair in getting the board to work together. However, the board does not have a management role; it does not have to be an integrated team. It has to perform the conflicting roles of both supporting and monitoring management. Especially for the latter role, sadly lacking during the lead up to the crisis, more useful diversity and less harmony is needed on the board.

To improve public trust in business, the search for board directors has to extend beyond the world of top executives, to look for other kinds of nominees in touch with the critical stakeholders, who can bring their perspective into the boardroom and involve management in creating long term value, rather than short term gain. To get this in a systematic way, the nominating committee needs a transformation.

This article was first published on February 14, 2011.

Paul Strebel is the Sandoz Family Foundation Professor of Governance, Strategy and Change at IMD, a leading global business school based in Lausanne, Switzerland. He directs IMD’s High Performance Boards program.

Brian Tayan and I recently co-authored a book, titled Corporate Governance Matters, which takes an organizational perspective, rather than a legal perspective, on the important topic of modern corporate governance. Our purpose is to examine the choices that organizations can make in designing governance systems and the impact those choices have on executive decision-making and the organization’s performance. The book relies on an extensive body of professional and scholarly research, and aims to correct misconceptions and cut through the considerable rhetoric surrounding corporate governance. We hope the book provides a framework that enables practitioners to make sound decisions that are well supported by careful research.

Our book covers a wide range of topics regarding corporate governance. These include a discussion of the environment in which the organization competes to understand how various forces influence the mechanisms it adopts to discourage self-interested behavior by management. In addition, we spend considerable time examining the board of directors, including the structure, processes, and operations of the board, along with the board’s functional responsibilities, such as oversight and risk management, succession planning, compensation, accounting and audits, and the consideration of mergers and acquisitions. We also examine the role of the institutional investor to understand how diverse shareholder groups and third-party proxy advisory firms influence governance choices. The book also includes an assessment of commercial and academic governance ratings systems.

Many of the conclusions of the book are phrased in the negative. While the lack of positive correlations may disappoint some, this has important implications for the current debate on governance and your evaluation of the types of governance systems that organizations might require. Some of the central lessons we draw in the book including the following:

Testing Remains Insufficient

First, the lack of positive correlations suggests that most of the best practices—either those recommended by blue-ribbon commissions and high-profile experts or those required by regulators—have likely not been tested, or important influencers have not properly understood the results of those tests. We saw this clearly in the passage of both Sarbanes-Oxley and the Dodd-Frank Act, in which considerable disconfirming evidence was not considered when restrictions were placed on nonaudit services provided by the auditor and greater shareholder democracy was required.

Instead, we share the sentiments of Myron Steel, Chief Justice of the Delaware Supreme Court, who recently wrote:

Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares—until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say that all, much less each, of these proposed changes are truly reform. Reform implies to me something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.

This standard should be a precondition to all governance changes, both those mandated by law and those voluntarily adopted. Governance changes are costly, and failed governance changes even more so. They are costly to the firm in terms of reduced decision-making quality and inefficient capital allocation, and they are costly to society in terms of reduced economic growth and value destruction for both shareholders and stakeholders. We believe that careful theoretical and empirical work can go a long way toward better understanding what works and does not work so that changes can be made in a cost-effective manner. There is no question to us that “governance matters.” The fundamental challenge is to understand when and how it matters.

The Current Focus Is Misdirected

Second, the lack of positive correlation signals that much of the discussion focuses on the wrong issues, such as independent chairman, staggered boards, risk committees, and director stock ownership guidelines. As such, efforts to improve governance systems (and the regulations that tend to come with them) are likely misdirected. Instead of focusing on features of governance, more attention should be paid to the functions of governance, such as the process for identifying qualified directors and executives, strategy development, business model analysis and testing, and risk management. To illustrate this point, consider the following sets of questions:

CEO Succession

• Does the company have a CEO succession plan in place?
• Is the CEO succession plan operational? Have qualified internal and external candidates been identified? Does the company engage in ongoing talent development to support long-term succession needs?

Risk Management

• Is risk management a responsibility of the full board of directors, the audit committee, or a dedicated risk committee?
• Do the board and management understand how the various operational and financial activities of the firm work together to achieve the corporate strategy? Have they determined what events might cause one or more of these activities to fail? Have these risks been properly mitigated?

Executive Compensation

• What is the total compensation paid to the CEO? How does this compare to the compensation paid to other named executive officers?
• How is the compensation package expected to attract, retain, and motivate qualified executive talent? Does it provide appropriate incentive to achieve the goals set forth in the business model? What is the relationship between large changes in the company stock price and the overall wealth of the CEO? Does this properly encourage and long-term performance without excessive risk?

In each of these, the first question asks about a governance feature, the second about a governance function. A focus on the latter will almost certainly yield significantly more benefit to the organization and its stakeholders.

A mistake that many experts make is to assume that the presence of the feature necessarily implies that the function is performed properly. That is, if a succession plan is in place, the assumption is that it is a good one; if there is a risk committee, the company takes risk management seriously; if compensation is not excessive, it encourages performance. We have seen clear evidence that this is not always the case. If experts and proxy advisory firms are to add any value, they should shift from a service that verifies that features are in place, to one that evaluates the success of various functions. This no doubt would require a substantial increase in analytical skills and processes, but it is a shift that markets would likely value.

Important Variables Are Clearly Missing

Third, the lack of positive correlation suggests that important variables that impact governance quality have been inappropriately omitted or underemphasized in the discipline. After all, governance is an organizational discipline. As such, the analysis should incorporate organizational issues—such as personal and interpersonal dynamics, and models of behavior, leadership, cooperation, and decision making. Without offering a comprehensive list, we believe the following elements are central to understanding how a governance system should be structured and when and where it is likely to fail:

• Organizational design — Is the company decentralized or centralized in structure? Have internal processes been rigorously developed, or did they evolve from historical practice?
• Organizational culture — Does the culture encourage individual performance, or cooperation? How are successes and failures treated? Is risk-taking encouraged, tolerated, or discouraged?
• The personality of the CEO — Who is the CEO, and what motivates this individual? What is his or her leadership style? What are the individual’s ethical standards?
• The quality of the board — What are the qualifications of these individuals? Why and how were they selected? Are they engaged in their responsibility, or do they approach it with a compliance-based mindset? What is their character?

As evidence, we see some of these aspects in the literature, but often peripherally and without thorough consideration. For example, an analysis of the linguistic patterns of the CEO and CFO is shown to have some relation to the probability that the company will have to restate earnings in the future. Strong leadership, clear access to information, and parameters around corporate risk taking are important in ensuring that the company develops an appropriate risk culture. Directors with extensive personal and professional networks facilitate the flow of information between companies. This can lead to improved decision making by both allowing for the transfer of best practices and acting as a source of important business relationships.

We believe that these types of analyses should be pursued further and with greater rigor. Doing so will require tools and techniques across disciplines. It is a mistake to think that corporate governance can be adequately understood from a strict economic, legal, or behavioral (psychological and sociological) perspective. All of these views are necessary to understanding complex organizational systems.

Furthermore, this necessarily implies that the optimal governance system of an organization will be firm-specific and take into account its unique culture and attributes. Adopting “best practices” will likely fail because that approach attempts to reduce a complex human system into a standardized framework that does not do justice to the factors that make it successful in the first place. This explains why two companies can both succeed under very different governance structures.

Context Is Important

Finally, governance systems cannot be completely standardized because their design depends on the setting. For example, governance systems differ depending on whether you take a shareholder perspective or a stakeholder perspective of the firm, as well as the efficiency of local capital markets and labor markets. They also differ depending on your view of the prevalence of self-interest among executives.

Consider, for example, John Bogle, the founder of Vanguard, who has written about self-interested behavior among executives:

Self-interest got out of hand. It created a bottom-line society in which success is measured in monetary terms. Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. The result is a shift from moral absolutism to moral relativism. We’ve moved from a society in which “there are some things that one simply does not do” to one in which “if everyone else is doing it, I can, too.”

The extent to which you believe this is the norm in society will have a direct impact on the extent to which you believe control mechanisms should be in place to prevent the occurrence of self-interested behavior and the rigor of those controls. Nevertheless, in the end, a balance must be struck. Excessive controls will lead to economic loss by retarding the rate of corporate activity and decision making. Lenient controls will lead to economic loss through agency costs and managerial rent extraction.

As our book seeks to demonstrate, context is critical to designing an effective corporate governance system.

David Larcker is the James Irvin Miller Professor of Accounting and Director of the Corporate Governance Research Program at Stanford University.

Even as political regimes in Tunisia, Egypt, Bahrain and Libya deal with ongoing pressure to change or adapt how they rule, a new study suggests that  a “second wave” of corporate governance appears to be forming among financial markets in that region.

The Second Corporate Governance Wave in the Middle East and North Africa, by Alissa Koldertsova, a policy analyst for the OECD, reports that less than a decade ago, there was no Arabic term for corporate governance.  Today, the study says, only three only 3 out of the 17 MENA countries and territories surveyed – Iraq, Kuwait and Libya - do not currently have any corporate governance code or guidelines.

Egyptian Stock Exchange

The first wave of corporate governance in the MENA region, according to the study, was driven in part by the drive to attract foreign investment, particularly by countries with no petrochemical resources.  Another factor was the development of the financial sector in the region.  A shift toward “market-based organization,” especially in countries such as Egypt and Syria “only accentuated the trend.”

It is “undeniable” that these governance practices have brought about “tangible results,” the study says.

"Corporate governance, or hawkamah in Arabic, is no longer a term that needs defining, nor is its business case unclear. Even from a family business perspective, the case for better governance needs less justification today than it did only five years ago. This is not to deny that market regulators and stock exchanges across the region continue to face challenges in enticing family-owned companies to list their equity. The reluctance of family-owned firms to open their equity to outside shareholders is perhaps a key factor stifling corporate growth and further development of the region's capital markets."

The paper suggests the second wave of corporate governance in the MENA region will focus on “implementation as opposed to awareness-raising.”

"It is impossible to foretell whether the second wave of corporate governance in the region will be as effective as the first. Regulators’ capacity to transparently monitor and enforce breaches of existing regulations, and to fine-tune them when necessary, will continue to be tested…Do regional regulators have the capacity to monitor companies' compliance and to take enforcement action when necessary? What measures can be taken to further promote the capacity of relevant regulatory bodies?"

The full article is available for download here.

Depending on whom you ask, when it comes to shareholder activism and corporate governance issues this year’s proxy season is a glass half full, a glass half empty, or a glass completely shattered.

On the pro-activist side:

Provisions of the 2010 Dodd-Frank financial reform bill, and related moves by the Securities and Exchange Commission, mean that shareholders for the first time will be able to weigh in on a number of issues.

The SEC in January adopted final rules that required shareholders get a “say-on-pay” vote on executive compensation and an opportunity to indicate how often they’d like such a vote.

Or, as Paul Hodgson, senior research associate at the Corporate Library, wrote in his Ratings Haiku V:

To say on pay or
Not to say on pay? Three years?
Or each blossom time?

The new rules apply starting with shareholders’ meetings on or after Jan. 21, 2011.

Many companies are recommending an every-three-year vote (one recent tally of 150 proxy statements found 82 companies recommending triennial, 47 annual), but there are exceptions.  Apple Inc. directors, for example, are proposing that the advisory vote be conducted annually.  (But, as previously noted here, Apple’s board opposed a shareholder proposal to adopt a written CEO succession planning policy.  Apple CEO Steve Jobs has had a liver transplant and this January announced he was taking a medical leave of absence.)

Proxy advisory service ISS recommends an annual vote, and in January, a group of 39 institutional investors with more than $830 billion in assets called for annual votes. “The discipline of an annual vote will encourage Boards to be more responsive and accountable on compensation,” said Timothy Smith, senior vice president of Walden Asset Management, one of the group’s members. And a number of major mutual funds have indicated they’ll support an annual vote.

Already this year shareholders have rejected a triennial schedule at Costco Wholesale (52.8% for an annual vote),  Johnson Controls (58.6% for every year), at Monsanto (62.2% for an annual vote), and at Jacobs Engineering (66%).  Monsanto subsequently announced it would conduct an annual say-on-pay vote.

A January analysis by the Latham & Watkins law firm observed that annual say-on-pay votes “may take some of the pressure off director elections” by directing attention to pay issues, while “less frequent votes may allow an unpopular pay practice to continue too long without timely feedback.”   Triennial votes, it suggested, “will provide shareholders sufficient time to evaluate the effectiveness of short- and long-term compensation strategies.”

The new rules also require advisory votes on executive compensation (a majority of Jacobs Engineering shareholders also voted against the company’s compensation practices) and on golden parachute provisions where mergers are in the works, although small public companies with a public float of less than $75 million don’t have to adopt such votes until 2013 annual meetings.  The Dodd-Frank legislation forbids brokers from giving proxies to vote shares without instructions from beneficial owners on matters relating to executive compensation; the change will cut down on the size of the vote and remove corporate leverage in voting broker proxies on pay issues.

Noted attorney Martin Lipton and colleagues, in a recent memo on governance, declares “This latest round of reforms is remarkable not because it has ushered in bold new ideas for improving governance, but rather because of the extent to which it has one-sidedly embraced the shareholder rights agenda and further expanded the ability of shareholders to direct corporate decision-making. As a result of the Dodd-Frank Act and other reforms, boards will increasingly need to solicit shareholder views and support for a range of decisions – including executive compensation and director nominations—that have traditionally been a core responsibility of boards.”

In Mr. Lipton’s view, “we have reached a point of serious debate…as to whether the scales have tipped too far in empowering shareholders and preventing boards and management from managing for the long term.”

Even if proxy access rules are struck down, Mr. Lipton says, “it is likely that activists will pursue shareholder proposals and bylaw amendments to impose proxy access on a company-by-company basis.”  Despite the legal uncertainties, he suggests, “companies will need to engage constructively and proactively with shareholders and, in the cases where directors nominated by shareholders are successfully elected, boards will need to work to minimize the potential for adverse effects on board stability, collegiality and effectiveness.”

He urges boards and compensation committees to “review compensation policies with great care, being mindful of pay-for –performance principles while also seeking to avoid policies that will encourage excessive risk-taking.”

He has commented several times on the increased problems in recruiting corporate directors, given regulatory and investor emphasis on “director independence at the expense of other skills and qualifications.”  Such factors “preclude the candidacy of insiders with extensive, day-to-day knowledge of the company” as well as industry experts with “naturally developed relationships and affiliations in the sector.”  He concludes “given the importance of expertise, there should be no complaint about adding additional inside directors to a board so long as a majority of the board consists of ‘independent’ directors.”

On the hurry-up-and-wait side:

The long-sought proxy access rules, adopted by the SEC last year, are frozen pending an aggressive legal challenge by the U.S. Chamber of Commerce and the Business Roundtable.

The SEC has adopted a rule allowing shareholders with at least three percent of ownership for at least three years the right to have their own board candidates listed on the proxy ballot without the need for an often-expensive proxy fight. The Chamber/Business Roundtable lawsuit asserts, among other things, that the SEC exceeded its authority, violated companies’ First and Fifth Amendment rights, erred in appraising the costs of proxy access, ignored evidence of adverse consequences of the rule, and ignored state laws on proxy access.  The SEC filed its response in January, and the case will be herd by the U.S. Court of Appeals for the D.C. circuit April 7.

A useful analysis of major arguments in the case has been published at the Conference Board’s Governance Center Blog.

An amicus brief supporting the SEC rule has been filed by the Council of Institutional Investors. CII executive director Ann Yerger says proxy access will “make companies more responsive to their shareowners and more vigilant in their oversight of management.”  And a group of 36 law professors, who hold varying views on many corporate governance and legal issues, have filed a brief arguing the SEC rule doesn’t violate the First Amendment.

While corporate pay and proxy issues are dominating the blogs and legal commentary, the 2011 proxy season will include a wide range of environmental, social and governance issues.  The Interfaith Center on Corporate Responsibility, whose members last year filed 308 shareowner resolutions, and withdrew dozens more after conducting dialogues with companies, has tallied 159 resolutions filed so far, SocialFunds.com reported in January.

In an interview with SocialFunds, ICCR executive director Laura Berry noted that at least 25 resolutions address corporate political spending, reflecting concern over the 2009 U.S. Supreme Court decision in the Citizens United case.  Other resolutions seek disclosure on indirect political spending by corporations through trade associations, address labor practices in agriculture, and examine healthcare access and how pharmaceutical companies can address neglected diseases, she said.

On the snarky side, one critic is boldly declaring “corporate governance is dead.”  John Richardson, who blogs on governance, risk and human rights issues at Global Investment Watch, declared at year end that “Corporate Governance as we know it is dead. Gone. Pfffft.  As 2010 comes to a close, we must all come to terms with the fact that this old clunker has seen its day. Its rusted hood ornament and fins are of a bygone era, an artifact of another time.”

After tracing the mid-2000s history of governance issues, and noting the various mergers in the proxy advisory world, Mr. Richardson declares “…the arcane discussions about executive pay, director responsibility and risk are proving to be ever more irrelevant in a world concerned about the influence of the corporate enterprise on society and the environment.  Corporate Governance as a tool for addressing these problems has lost its edge.  While these discussions remain important to the initiated, its backward-looking approach and its failure to influence the ills of global corporate conduct speaks to its ultimate irrelevance.”

His rant prompted James McRitchie of CorpGov.net to respond: “Richardson appears ready to throw in the towel even before the most significant reform, proxy access, has even been implemented.”  He cites increased numbers of issues submitted to corporate annual meetings and declares “if individuals embrace the importance of corporate governance in both their equities and in how their institutions vote, half the battle will be won.  Corporate governance is far from dead.”

Dead or not, governance continues to intrigue researchers.  The conservative Manhattan Institute for Policy Research has launched ProxyMonitor.org containing information on all shareholder proposals submitted for a vote between 2009 and 2010 at the 100 largest American public companies.

The Institute’s initial analysis of the proxy statements finds that “a substantial percentage of shareholder proposals have little to do with corporate performance or increasing share value. Issue-advocacy groups with social agendas that go beyond shareholder protection as well as labor unions with interests that sometimes conflict with those of the average shareholder are major sponsors of shareholder proposals. Also striking is the large role in shareholder activism played by ‘corporate gadflies,’ individuals who repeatedly initiate shareholder proposals despite having only small holdings in a wide variety of companies.”

A blue-ribbon Commission on Corporate Governance set up a year ago by the New York Stock Exchange declared that amid a turbulent market and regulatory climate and "notwithstanding certain governance failures over the last decade, the current governance system generally works well.”

In its final report, the Commission said "... failures of corporate governance were not the sole reason for the financial crisis of 2008, and ... most of the thousands of public companies in this country are well governed, with hard-working and ethical boards and shareholders..."

The group shied away from taking a stand on hot-button issues such as proxy access, financial regulatory reform and an expanded federal role in corporate governance.  "The Commission found it difficult to reach consensus on many of these specific issues," the report said.

The Commission did add its voice to many in the business community that would like to see the Securities and Exchange Commission address issues posed by proxy advisory firms which often influence the debate and the outcome of corporate governance issues, particularly when it comes to annual meetings.

The SEC has invited public comment on how advisory firms should be regulated, and the Commission report asserts "such firms should be held to appropriate standards of transparency and accountability."

"At a minimum, such firms should be required to disclose the policies and methodologies that the firms use to formulate specific  voting recommendations, as well as all material conflicts of interest, and to hold themselves to a high degree of care, accuracy and fairness in dealing with both shareholders and companies by adhering to strict codes of conduct.  The advisory services should also be required to disclose the company’s response to its analysis and conclusions."

The report stressed the importance of making "long-term sustainable growth in shareholder value" a key corporate objective, and urged companies to "establish relationships with a core base of long-term oriented investors."  Shareholders, it said, "have the right and responsibility to hold a board accountable for its performance in achieving long-term sustainable growth in shareholder value."

In a veiled jab at the growing influence of proxy advisory firms, the report said hiring such firms by institutional investors "does not relieve institutions from discharging their responsibility to vote constructively, thoughtfully and in alignment with the interests of their clients."

In the current climate, the report said, "... there is a risk that the number of new governance mandates and 'best practice' recommendations over the last decade can lead even the best boards to adopt a 'check the box' mentality when trying to adopt and comply with certain corporate governance requirements."

The report noted that at many companies, the CEO is the only non-independent director on the board, but said having more directors "who possess in-depth knowledge of the company and its industry could be helpful for the board."

Without much specificity, the report said the SEC should "consider whether there are more effective and efficient ways for individual investors to participate" in the proxy voting process.  And it urged a cautious approach by regulators in adopting new governance requirements. "Being a director is not a full-time job," and new mandates risk limiting the time directors can spend on other tasks.

The Commission urged that shareholders "attempt to engage in constructive communication with the corporation before submitting proposals or proxy access nominations or engaging in public campaigns which tend to be adversarial in nature."

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), widely considered to be one of the most comprehensive reforms of the U.S. financial industry in years, was signed into law on July 21.  While many provisions of the Act relate primarily to banks and the financial regulatory system, the new legislation will also have a significant impact on corporate governance and executive compensation practices for public companies in general.

These provisions of the Act are most likely to impact disclosure in the 2011 proxy season.

Say on Pay

Beginning with the 2011 proxy season, shareholders of public companies will be given the opportunity to cast an advisory vote, commonly referred to as a "Say on Pay," as to whether they approve of their company's executive compensation practices.  The Say on Pay vote, which will occur at least once every three years, does not allow shareholders to set limits on pay, but instead requires companies to include a resolution in its proxy statement asking shareholders to approve, in a non-binding vote, the compensation of the company's named executive officers.  This means that current executive compensation decisions and practices that will be disclosed in the Compensation Discussion and Analysis within your next proxy statement will be the subject of the Say on Pay vote. 

In its 2011 proxy statement, companies will also be required to include a separate non-binding resolution asking shareholders to determine whether the Say on Pay vote will occur every one, two or three years.

Also, a similar non-binding vote with respect to golden parachutes, or certain payments executives are due to receive upon the termination of their employment following a change in control of the company, would be required in conjunction with any future mergers or similar events if the golden parachute arrangements were not previously subject to the Say on Pay vote.

Executive Compensation Disclosures

The Act provides that the SEC shall require disclosure in a company's proxy statement of the relationship between executive compensation actually paid and the company's financial performance, taking into account any change in the value of the company's shares and dividends and any distributions.  This information may be disclosed by graphical representation.

Companies will also be required to disclose in their proxy statements (i) the median annual total compensation for all employees, not including the CEO, (ii) the CEO's annual total compensation and (iii) the ratio of the median employee compensation to that of the CEO.

Disclosure regarding employee and director hedging

The Act provides that the SEC must enact rules to require proxy statement disclosure as to whether any employee or director, or his or her designee, is permitted to purchase financial instruments that are designed to hedge or offset any decrease in the market value of equity securities granted by the company as compensation to the employee or director or held, directly or indirectly, by the employee or director.

Clawback Provisions

The Act provides that national securities exchanges must require companies to develop and implement a "clawback" policy that requires that, in the event the company is required to restate its financials due to material non-compliance with any reporting requirements under the securities laws, the company will recover from any current or former executive officer who received incentive-based compensation (including stock options awarded as compensation) during the prior three-year period the excess amount that the executive would not have otherwise received except for the misstated financials.  In implementing these policies, companies may need to revise outstanding contracts and stock plans to add clawback provisions where required.  Companies will also be required to develop and implement a policy for disclosure of the company's policy on incentive-based compensation that is based on financial information required to be reported under the securities laws.

Proxy Access

The Act authorizes the SEC to establish proxy access rules that allow shareholders to include director nominees in the company's proxy materials.  The SEC has proposed proxy access rules three times in the past, with June 2009 being the most recent of such proposals.  While the timing and final form of any proxy access rules are uncertain, many commentators believe that the SEC may move quickly to adopt proxy access rules that would be in place for the 2011 proxy season.  The SEC's June 2009 proposal, if adopted without revisions, would establish a right of access to the proxy statement that cannot be superseded by a company's bylaws whereby holders of between one and five percent of a company's outstanding shares, depending on the size of the company, would have the ability to nominate up to 25% of the company's directors.  Shareholders would be permitted to form groups in order to aggregate their shares for purposes of meeting the ownership threshold.

Disclosures regarding Chairman and CEO structures

The Act requires that the SEC adopt rules within 180 days of its passage that require disclosure in a company's proxy statement of why it has chosen to have either the same person or different persons in the position of Chief Executive Officer and chairman of the Board of Directors.  This rule was adopted by the SEC in December 2009.

Compensation Committee Independence

The Act requires that the SEC issue rules requiring national securities exchanges to mandate that each member of a company's Compensation Committee be independent.  In determining a director's independence, companies will be required to consider relevant factors, including (i) the source of a director's compensation, including any consulting, advisory or other compensatory fee paid by the company to the director, and (ii) whether the director is affiliated with the company or any of its subsidiaries or affiliates.  The independence standards promulgated by the SEC may be more stringent than the policies currently in place at the stock exchanges.

The new listing standards will also require that a Compensation Committee may only select consultants, legal counsel and advisors after taking into consideration independence standards to be established by the SEC.  By July 2011, enhanced disclosure will also be required in proxy statements of whether the Compensation Committee has obtained a compensation consultant and if the consultant's work has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.  The Act also requires companies to provide appropriate funding for the Compensation Committee to hire a compensation consultant and independent legal counsel or any other advisor.

Voting by Brokers

The Act prohibits brokers from using discretionary authority when voting proxies in connection with the election of directors, executive compensation, or any other significant matter, as determined by the SEC.

Majority Voting Standard dropped from the Act

Of note, mandatory majority voting in director elections was originally in the Senate bill, but was dropped from the final version of the legislation.

Joseph Alley, Jr., Terrell E. Gilbert, Jr. and Robert F. Dow are attorneys in the Atlanta-based law firm of Arnall Golden Gregory LLP.

by James Hyatt

Proxy advisory services -- the firms that handle the chore of voting shareholder proxies for institutional investors, and at the same time provide stiff appraisals of corporate conduct – may be about to start receiving their own report cards for a change.

A lot of Corporate America thinks it's about time.

The services' influence has certainly been growing in the wake of corporate scandals and ever more heated debates over ethical behavior and attention to social responsibility issues.

The proxy services play a key role because institutional holders turn to them for advice when voting billions of shares at annual meetings. The services get paid to help manage the actual proxy voting process and they also weigh in on management-vs-shareholder debates over such hot button issues as compensation, the makeup of boards of directors, and proposals on corporate disclosures and behaviors.

For almost a decade, academics, corporate officials, regulators and shareholder activists have kicked around the issues of proxy advisory service behavior and performance: do they exercise too much influence; does their advisory business influence their voting recommendations; is more formal oversight needed?

The Advisory Industry

A lot of the conversation, of course, is aimed either in a veiled way or implicitly at the 800-pound gorilla in the room, RiskMetrics Group and its influential proxy advisory unit ISS Governance – which, by some estimates, advises half the world’s common stock.  RiskMetrics had $303 million of revenues in 2009; of that, almost half or $145 million came from the ISS segment. The company last year issued proxy and vote recommendations for more than 37,000 shareholder meetings in 108 countries and voted 7.6 million ballots representing over 1.3 trillion shares.

RiskMetrics in 2009 had 3,500 clients in 53 countries, including 70 of the 100 largest investment managers, 43 of the 50 largest mutual fund companies, and 42 of the 50 largest hedge funds.

(RiskMetrics in March said it would be acquired by MSCI Inc. for about $1.55 billion in cash and stock, subject to various approvals.  MSCI calculates more than 120,000 indices daily and its Barra unit provides risk models and portfolio analytics.)

In addition to RiskMetrics, other major proxy advisors include Glass Lewis & Co.; Egan-Jones Proxy Services; Marco Consulting Group; Proxy Governance, Inc.; Governance Metrics International; and CtW Investment Group.  (RiskMetrics, Marco Consulting and Proxy Governance are also registered with the SEC as investment advisers.)

New Scrutiny

Questions about proxy advisors have been raised in the past. The Government Accountability Office, the audit arm of the U.S. Congress, took a look at proxy service providers in 2007 and an SEC Compliance Alert in mid-2008 addressed some proxy voting issues as well.

Nonetheless, questions about the performance and role of proxy advisory services continue to simmer.  SEC Chair Mary Schapiro told the Practising Law Institute last November:

“...we'll be asking about the role of proxy advisory firms in corporate voting.  Given the influence that these firms' recommendations have on corporate voting outcomes, we'll probe the need for rules to ensure that advisory firms are basing their research and recommendations on accurate and reliable information.  And, that they are providing adequate disclosure of any conflicts of interest they may have in providing voting recommendations. “

Given the pressures surrounding the new financial services legislation, the SEC may find such steps pretty far down on its agenda.   But regulators are being pressed for action by members of the "Shareholder Communications Coalition," comprised of the Business Roundtable, the National Association of Corporate Directors, the Society of Corporate Secretaries and Governance Professionals, the National Investor Relations Institute, and the Securities Transfer Association, whose members often find themselves the object of proxy service criticism.

In March 2010, the Coalition distributed a “discussion draft” on” proxy advisory services: “The Need for More Regulatory Oversight and Transparency”. Among its criticisms: institutional investors that hire third-party proxy advisory firms often find that firm guidelines “do not evaluate the facts and circumstances of each public company with respect to the matters to be voted on; instead, these guidelines encourage a “one-size-fits-all” or “check the box” methodology.”

RiskMetrics, it notes, provides corporate governance and executive compensation consulting services as well as voting recommendations on proposals at shareholder elections – which, the study suggests, “may create conflicts of interest”.  Moreover, all proxy advisory firms may face conflicts when an institutional client is backing a specific ballot proposal or has instigated a “vote no” campaign against directors.  The SEC, the draft suggests, should examine such situations for conflicts.

The draft report recommends that proxy advisory firms:

--be subject to more robust oversight by the SEC;
--be required to register as investment advisers;
--be subject to conflicts of interest disclosure; and
--have “a complete and total separation” of the proxy advisory business from all other business including consulting and research services.

It also calls for public disclosure of procedures, guidelines and assumptions for making voting recommendations and voting decisions, calls for institutional investors to exercise more due diligence concerning delegation of decisions to proxy advisory firms, and calls on the firms to maintain a public record of all their voting recommendations and voting decisions.

The report concludes: “We believe that proxy advisory services have an oversized impact on the proxy process. Despite their large role, proxy advisory firms generally remain unregulated and unsupervised and often are not transparent with regard to their standards, procedures, methodologies, and conflicts of interest.”

Dual Roles

RiskMetrics’ 2009 annual report acknowledges the “perceived conflict of interest between the services we provide to institutional clients and the services, including our Compensation Advisory Services, provided to certain corporate clients.”  It concedes that “in the event that we fail to adequately manage these perceived conflicts of interest, we could incur reputational damage.”  RiskMetrics spells out its policies regarding conflicts and disclosures here.

Asked for comment on the recent proxy advisory discussions, a RiskMetrics spokesman said the company is awaiting the substance of the SEC’s concept draft “and will refrain from making  any comment before it is available.”

One of the testier critics, Tamara C. Belinfanti, an associate professor at the New York Law School, in a legal studies research paper in 2009 argued “The Case for Increased Oversight and Control” over the proxy advisory and corporate governance industry.

She builds her argument around “agency theory,” or situations where one party uses another party to act on his behalf but where the parties’ “incentives are misaligned” – classically, in the case of corporations, the separation of ownership and control.

Ms. Belinfanti declares: “From an agency theory perspective, ISS presents a lethal combination – significant power and virtually no accountability.” And, she says, “ISS bears minimal residual risk of a poor voting decision vis-à-vis company shareholders.”

She argues for the SEC to regulate the proxy advisory industry “similar to the regulation it is currently contemplating for registered credit rating agencies,” for an oversight board for the industry similar to the Public Company Accounting Oversight Board, and for the mutual fund industry to pay more attention to proxy advisor decisions “and not simply follow the vote recommendations of these advisors.”

In March this year, Ms. Belinfanti posted a more acerbic comment about RiskMetrics on The Huffington Post, prompted by the MSCI acquisition announcement:  “ISS is incompetent and it is only a matter of time before markets and regulators realize ISS…is a ticking time bomb waiting to explode.” She noted that ISS had given high governance ratings to Lehman Brothers and AIG before their financial woes.  And she said MSCI’s governance rating was “in the bottom 2.5% of all S&P 400 companies in terms of corporate governance,” declaring the merger agreement “belies the reliability of its own corporate governance ratings system.”

"Prudent Man" Standards

A recent posting at the Harvard Law School Forum on Corporate Governance and Financial Regulation by attorneys at Latham & Watkins LLP raises other issues, commenting on “The Parallel Universes of Institutional Investing and Institutional Voting”.

SEC and Labor Department ERISA rulings, they note, require that institutional investors vote portfolio shares under “prudent man” standards, which often has resulted in outsourcing voting mechanics and recommendations to the proxy advisory firms. (The burden is huge; there are more than 10,000 public U.S. companies.)  Other investment managers have created an internal “corporate governance” staff to vote portfolio shares.

The result, the authors argue, is that voting policies are often applied in a one-size-fits-all fashion that doesn’t take into account a company’s particular circumstances. And, they declare, “economic ownership and economic decision making have been effectively decoupled from voting decisions throughout most of the investment management world.”

The separate interests of the investment community and the governance community, they argue, mean that public companies “need to engage in constructive and separate dialogues with each constituency. “Too often, corporate governance issues are seen as a distraction from a company’s goal of creating economic value for its shareowners. Although this may be true, it is also somewhat beside the point because voting decision makers at the company’s institutional shareowners demand otherwise.”

James Hyatt, a retired reporter and editor for The Wall Street Journal, has been writing about business ethics and social responsibility issues since 2005.

When it’s time for salary reviews at Xcel Energy, a Minnesota-based energy company, earnings per share are not the only thing that matters.  In its 2009 corporate proxy statement, Xcel explains how a range of sustainability metrics fit into annual incentive objectives for all executive officers and how it weighs greenhouse gas reductions and safety performance alongside earnings per share.

Company spokeswoman Patti Nystuen told the sustainability group Ceres, “Xcel believes strongly in providing long-term incentive opportunities that deliver awards on the achievement of specific performance goals linked to the success of the company and its long-term strategy in the core utility business.  These include financial and environmental goals."

Xcel is one of a small but growing group of pioneering companies, increasingly aware of the power that policies on executive pay can exert on sustainability behavior.

Seventy-five per cent of Xcel's award incentives have a performance-based vesting schedule based on earnings per share growth.  The remaining quarter of Xcel's awarded incentives are performance-based, relating to aspects of their environmental strategy, such as decreases in emissions.

"In 2007, payouts of annual incentive awards for the NEOs (named executive officers) and all executive officers, including those reporting to the chief executive, were determined entirely by attainment of corporate goals, which included targeted earnings per share, an environmental metric related to carbon dioxide emissions, and safety," Nystuen said.

Across the Atlantic

In Europe, the Netherlands seems to be ahead of other nations in tying remuneration to sustainability objectives.

Dutch banking and insurance giant ING said recently that social, ethical and environmental objectives are to form a component part of its top management executive pay structure.

“ING has formulated corporate responsibility ambitions and priorities, combined with a long-term plan and concrete targets,” the company says in its 2009 corporate responsibility report. “These targets are also part of the performance objectives of our Executive and Management Boards.” The company said there will also be a program for senior managers to work on real-life cases at NGOs in developing countries.

At least three other Dutch firms – chemical company Akzo Nobel, life sciences group DSM, and mail operator TNT – have tied executive compensation to environmental improvement and other objectives, including employee and customer satisfaction.

And in one case, the linkage of pay to sustainability has been introduced to justify potentially controversial management decisions.   The oil giant Royal Dutch Shell, in a disclosure regarding its development of Canadian oil sands resources, makes the point that the company is “actively managing environmental and social impacts,” specifically noting that  “performance on sustainable development is a key feature of management targets and remuneration.”

On the Boardroom Agenda?

These initiatives come in the wake of two reports from organizations, based on opposite sides of the Atlantic, which have argued that the integration of sustainability into executive pay structures is one of the best ways for businesses to marry the twin objectives of sustainability and profit.

The first, published last month by Ceres, the Boston-based coalition of institutional investors and environmental organizations, reveals that an increased focus on corporate governance following the financial crisis of the last few years has now forced environmental sustainability onto boardroom agendas.

"Corporate scandals and the current economic crisis have heightened demands for new approaches to governance, particularly in relation to executive compensation and risk management,” say the authors of the report The 21st Century Corporation: The Ceres Roadmap to Sustainability.

“As sustainability has risen up the corporate, investor and public policy agendas, it has become more fully integrated into these governance expectations," they add.

The report calls on boards to undertake a root-and-branch reorganization of remuneration structures and base executive pay partly on a CEO's ability to integrate sustainable practices into day-to-day operations.  It also highlights the fact that many regulators and shareholders are putting pressure on boards to do a better job of aligning executive pay and performance standards tied to more than short-term profits.  In this top-down corporate governance structure, it calls on companies to name directors who have expertise in environmental sustainability issues.

Critical Challenges

Meanwhile, in its third Remuneration Theme Report, the European Sustainable Investment Forum (Eurosif) has revealed that most European companies fail to link executive pay to environmental, social, and governance (ESG) performance.

The report highlights some critical challenges and opportunities for companies in relation to remuneration, incentives and long-term sustainability.  Research highlights and recommendations for shareholders and regulators include:

• 29% of FTSE Eurofirst300 listed companies have some commitment to linking remuneration to ESG performance – although concerns exist around the extent to which performance targets are set as ‘soft targets,’ thereby guaranteeing a minimum level of bonus.
• Financial institutions account for 23% of the FTSE Eurofirst300 index but only 16% of financial institutions have an ESG-linked remuneration system.
• Shareholders should engage with companies by voting against unacceptable remuneration packages and calling for and taking part in shareholder dialogue in determining remuneration policy.
• Regulators should promote active dialogue between companies and shareholders by legislating for a binding “say on pay” vote and setting appropriate guidelines to promote good remuneration practices and disclosure.
• In the aftermath of the global financial crisis, remuneration policies and specifically the level of bonuses of senior executives of companies and traders continue to hit the headlines.  Investors and regulators have expressed concern that remuneration structures may have contributed to excessive risk-taking and are asking for a stronger focus to be placed on long-term reward schemes and sustainable growth.

Much Work Still to Do

Although steadily increasing, examples of such strategies remain fairly thin on the ground and it is clear that much work remains to be done in strengthening their influence.  For example, a 2009 research paper written by academics at IESE Business School and Arizona State University found that in general firms with an explicit environmental pay policy and an environmental committee do not reward environmental strategies more than those without such structures, suggesting that these mechanisms often play a merely symbolic role.

A major challenge: linking today's compensation package to policies and practices whose impact may not be felt for many years to come.

One means of improving the situation, as outlined in a recent report by a group of advocacy organizations that included the U.K.'s PLATFORM and Friends of the Earth, could be to link executive pay to companies’ long-term financial, environmental and social performance, for example through company bonds and equity held in escrow accounts for directors and released after 10-20 years.

Debates over corporate governance and accountability in the wake of the recent global financial crisis have already highlighted the crucial importance of top executive pay policy as a means of influencing business behavior.  The reports and initiatives outlined above extend this reasoning, by revealing that management remuneration packages are now also recognized as an increasingly important weapon in the armory of campaigners seeking to achieve sustainability objectives.

Andrew Williams (TheGreenExpert@btinternet.com) is a U.K.-based freelance writer.