Part II of this interview appears in the June 2004 issue of The Metropolitan Corporate Counsel.Editor: Would each of you give our readers some idea of your background and experience?
Dienstag: I joined Kramer Levin after having clerked for Judge Jack Weinstein in the Eastern District of New York. Following a brief stint in litigation at the firm, I moved into a fairly broad corporate practice.
Kopelman: With respect to corporate governance, both Abbe and I have been advisors to boards and board committees for over 20 years. I am a long time member of both the American Society of Corporate Secretaries and the National Association of Corporate Directors, organizations at the forefront of the focus on governance practices. In addition, I have served as corporate secretary of a NYSE company, and I have ongoing service as a director of two public companies, one listed on the NYSE and the other on NASDAQ. So I bring some perspective on corporate governance from inside the boardroom.
Editor: The role of the nominating committee has been under scrutiny of late. By way of background, would you tell us about the evolution of nominating committee practices?
Kopelman: Historically, the nomination process was often highly influenced Ñ some would say dominated Ñ by the company CEO. Understandably, the CEO wanted to make sure there were friendly faces sitting around the board table. Few companies had separate nominating committees, and those that did often included the CEO as a member. During the 1980's, we saw many contests for corporate control, including tender offers, management buyouts, proxy fights and so on. There were certainly some abuses. As a result, there was a growing public perception that management was engaged in running corporate America for its own benefit rather than for the shareholders. The more egregious cases contributed to the perception that boards were either asleep at the switch or unwilling to challenge the CEO's "imperial" prerogatives. Eventually, a number of large institutional investors - particularly the largest public pension funds - started to demand more accountability from the companies in which they were invested. The "Wall Street Walk" - if you're unhappy with management, sell your position - was no longer a viable alternative for many of the larger institutional investors, given their enormous portfolios, and their practice of "indexing" at least a portion of their investments - holding all of the stocks in the S&P 500, for example. Remember that institutions hold around 60% of all equities in this country. Given that shareholders elect the directors and the directors elect management, the board of directors became the natural focus of these institutions. In response to this scrutiny, directors began to be more critical in analyzing and evaluating the performance of CEOs and, where they were seen as not measuring up, to fire them. It is difficult today to imagine this as big news, but in point of fact power was beginning to shift under this banner of accountability. Directors, forcibly reminded that their primary responsibility was to the shareholders, also began to examine the ways in which corporate boards were constituted and how they actually operated. Progress was relatively slow, but fairly steady, and by the mid-90's a number of governance "best practices" had started to emerge.
Recently, high profile corporate scandals starting with Enron brought the debate on corporate governance onto the front burner. Congress, the SEC and the securities exchanges (SRO's) all felt compelled to do something to counter a resurgent public perception that corporate wrongdoing was endemic and pervasive. In terms of governance, a good part of the SRO's solution has been to increase the authority and responsibility of the independent directors. The notion is that empowered independent directors will set a strong tone at the top, will serve as a check on the prerogatives of the strong-willed CEO and will stand against the culture of "cutting corners" with which corporate America has come to be identified. Under the new NYSE and NASDAQ corporate governance listing standards being implemented this proxy season, boards of listed companies are required to be made up of a majority of independent directors, and the definition of independence has been significantly tightened. Historically, only the audit committee was peopled with independent directors. Under the new rules, the independent directors have direct responsibility for compensation as well as for governance and nominations. In my view, perhaps the biggest change is the requirement that the independent directors get together in executive session on a regular basis without the CEO being present. This gives the outside directors a chance to compare notes in what is, hopefully, a confidential forum.
I would note here that, although there may be an intuitive link between independent directors and good corporate governance practices on the one hand, and actual business performance on the other hand, the studies trying to show some sort of linkage between the two have been, in my judgment, monumentally inconclusive. Given the lack of any conclusive proof of correlation, I doubt that the FDA would have approved the new SRO rules. In any event, this is where we find ourselves today: governance practices that were merely aspirational best practices a few years ago have now been legislated into the bare minimum.
Editor: So what you're saying is that independence is all very well, but what about directors having some understanding of the corporation's business?
Kopelman: To be sure. There is a great cry for independence these days. But certain of the board's principal functions - to provide guidance on strategic direction and to monitor company and management performance - are certainly not the exclusive province of independent directors. The requirement that a majority of the directors be independent might result in a nine-person board consisting of four insiders who know the business inside out and are excellent directors and five independent directors - with all the right credentials evidencing their independence - who know next to nothing about the industry, about the challenges facing the company. My personal view is that independence alone is hardly a panacea. If you examine the board of companies rocked by scandal, you often find a group of people with all of the indices of independence. They often relied on the assurances of the accountants and lawyers - as they are typically entitled to do - and the corporation literally sank beneath their feet, notwithstanding their independence. Similarly, requiring directors to be shareholders - even to a very substantial extent - is not, in my opinion, going to influence to any real degree how these folks approach the problems they encounter as board members. At the end of the day, what really matters is who the directors are as people: their character and ethics, what kinds of experience and expertise they bring to the board's deliberations, how smart they are, and how hard they are willing to work.
Editor: Would you summarize for us the nominating function rules that have been adopted by the SEC, the NYSE and NASDAQ? How do they differ?
Dienstag: The rule set for the NYSE and NASDAQ is short and prescriptive. They tell companies what they have to do, which means delegate the nominating function to independent directors only. The NYSE says this must be accomplished by a nominating committee with a charter; NASDAQ permits either an independent nominating committee with a charter or a majority of the independent directors acting under a formal board resolution. The committee is not required to actually select the directors. It's fine if the committee makes recommendations and the full board has the final say. The SEC, on the other hand, consistent with a good deal of the securities laws, is focussed on disclosure. Companies must disclose whether they have a nominating committee, and, if not, why not. They have to say whether the committee is independent and whether it has a charter. A company must disclose its minimum qualifications for directors and the process for identifying and evaluating nominees. It also has to say who recommended each nominee - other than management nominees and directors standing for re-election. Was it the CEO, management, outside directors, shareholders or a search firm? All of these things are meant to bring sunshine into the nominating process, more transparency. Bringing light to a process that has long been conducted in the shadows may have a very real impact on the nominating process. So, even though the SEC rules don't say you must take this or that action, they may have a greater impact on the nominations process than what came out of the SROs.
Editor: Is there an all-inclusive definition of the term "independent director"?
Dienstag: I would say that there are guidelines rather than a single clear cut definition. The SEC says that a director has to be independent to serve on the audit committee, and a director is not independent if he or she is an affiliate of the company or in receipt of compensation other than for serving as a director. These terms have legal meaning, and they draw a clear line. But what about the rest of the board? Independence here is left to the securities exchanges and NASDAQ. What emerged was a series of bright line tests coupled with an overarching general definition of independence. It's the broad, general definitions that boards are going to have to wrestle with. The NYSE says that a director is independent if he or she has no material relationship with the company. NASDAQ says a director is independent if he or she does not have relationship with the company that interferes with the exercise of independent judgment in carrying out the responsibilities of a director. The relationships that do not lend themselves to quantification are hardest to judge. For example, is a director who goes duck hunting with the CEO disqualified from being independent? I can't imagine. But what if the CEO and the director together own the hunting lodge? That may be a closer call. The NYSE expressly requires the board to look at all the relevant facts and circumstances in determining independence. Given the resurgent activism of large institutional stockholders like CALPERS now weighing in on director independence, we may find boards taking a more conservative approach on the issue.
Editor: Please tell us about the things that ought to appear in a nominating committee charter.
Dienstag: Under the NYSE rules, the nominating committee is really the nominating and corporate governance committee and is obviously charged with much more than just the nominating function. Focusing solely on the nominating function, the charter should include, for starters, a general statement of purpose. The NYSE dictates how this should be formulated - identifying individuals qualified to become board members and selecting or recommending selection of nominees consistent with criteria approved by the board. The NYSE also requires that the charter provide for an annual review of the committee's activities, and it makes sense for that review to include a review of the charter itself, even though adoption and amendment of the charter is the responsibility of the full board. That is just about the entirety of what is required. Although NASDAQ companies are not subject to any particular charter requirements, we suggest they take a look at the NYSE rules for guidance. There are other things that companies ought to consider for inclusion in the charter. For example, the charter might address the responsibility of the committee to formulate director qualifications criteria, procedures for identifying and evaluating candidates and procedures for dealing with shareholder recommendations. I do not believe the charter needs to get into excessive detail, but it ought to serve as a roadmap for carrying out the nominating function.