Part I of this interview appeared in the May 2004 issue of The Metropolitan Corporate Counsel.Editor: In light of the changes in the rules, is it becoming more difficult to find qualified candidates for the governing board?
Kopelman: The general feeling is that finding qualified board members has become much more difficult. From the company's point of view, the new independence rules often serve to eliminate a whole group of people already known to the company, who in years past might have been the ones approached first. Then you have the "super independence" requirements for audit committee members: not only can they have no affiliation whatsoever with the company, but they must meet certain standards in terms of expertise, financial literacy and so on. These factors have narrowed the pool from which to draw, and I think the forward looking companies are looking deeper. For example, it used to be that if the company wished to recruit somebody from another organization, it would settle only for the CEO. Yet many companies have recently adopted policies restricting their CEO's memberships on outside boards. Although a sitting CEO is typically a great resource for a board, we are now seeing executives who are one, two or even three levels below the CEO being approached. From the viewpoint of their employer, giving these executives exposure to board service is often a very good thing. However, the work entailed by board membership today is enormous, and an executive running a division of a large public company may have a great deal of difficulty in taking on the 150 to 200+ hours of annual service that board membership today often demands. Also, in terms of retired CEO's, the trend is for them to cut back to four or five boards, maximum.
Moreover, the candidates themselves are very cautious these days, often with good reason. The chance of one's reputation being tarnished, or worse, is very real. The result is that prospective directors today are engaged in extensive due diligence exercises. In addition to taking the measure of the CEO in a one-on-one, we are counseling them to speak to the chair of the governance committee and perhaps some of the independent directors about the culture of the board and the relationship of the CEO to the board and to senior management. The degree to which the CEO is accepting of independent thought and judgement must be explored in depth. All of this is in addition to the prospective director's review of the company's financial statements, SEC filings and other public documents. There is also the question of liability. What are the major business risks? Is the management team up to the task? Is appropriate insurance in place? Is it sufficient? What happens to the coverage if the company goes bankrupt? All in all, finding good candidates for the board is tougher. But there is a new generation of people, many in their 30s and 40s, with established records in business who are coming into the pool for the first time. I believe that companies with good reputations and good boards will continue to find the people they need.
Editor: You mentioned shareholder-recommended candidates for the governing board. What is the SEC's stance on this?
Dienstag: There are really two different issues here. The first concerns the ability of shareholders to recommend to the nominating committee candidates for inclusion on management's slate of candidates, something the committee can accept or reject. This was part of the SEC rules adopted last November, and there has been very little controversy about it. The second is something that has caused a considerable furor: the SEC's direct access proposal. If adopted, this would give shareholders access to the company's proxy materials in order to nominate their own candidates in opposition to management. In brief, these rules would require a company to include on its proxy card one or more candidates nominated by shareholders owning at least 5% of the company's stock if certain triggering events occur. These triggering events are complex and the debate over them, and, indeed, over the entire concept, has been raging since October, when the rules were first proposed. On one side of the debate there are those who say these rules are mindlessly complicated and an unnecessary intrusion into the corporate governance process. On the other side are those who believe that the proposed rules do not go far enough in addressing the problem of board entrenchment. The latter group seeks much freer access to the company's ballot.
Editor: If a company chooses to have a policy on shareholder-recommended nominees, what are the pitfalls?
Dienstag: I think it is rare to find any company saying flat out that it does not have a policy of considering candidates recommended by shareholders. Under the new SEC rules, companies must state whether they evaluate shareholder-recommended candidates differently from recommendations that come from other sources. I've been reviewing proxies of late, and I find that most companies are saying they do not so distinguish. I think there is a certain danger here. If nominating committees begin to receive recommendations from shareholders that they routinely fail to accept, they run the risk of being accused of falsely representing their policies in the proxy materials. What we are telling issuers is that they must appropriately document their evaluation of candidates, including candidates recommended by shareholders. They should have a procedure in place, minutes of their deliberations and proper recordation in order to evidence the fact that serious consideration has been given to legitimate candidates irrespective of the source. In addition, we are telling our clients that they should candidly state that where a qualified incumbent is available to stand for reelection, he or she will in most cases take precedence over other candidates, including those recommended by shareholders. We think that is, in fact, the practice in most of corporate America, and there is no reason why companies should not be forthright about it.
Editor: What should the governing board do if a particular shareholder-recommended nominee is not qualified or is clearly unsuitable?
Dienstag: All the SEC rules say is that the company must disclose its process whereby shareholders are able to submit their recommendations. There is no obligation to disclose the reason for the company's rejection of a shareholder recommendation. In the event a company determines that a shareholder-recommended candidate is unsuitable, we recommend that it document that determination in a record of its proceedings. In response to the SEC rules, companies are adopting lists of minimum qualifications for board membership and disclosing those qualifications in their proxy statements. If a shareholder-recommended candidate clearly fails to meet the qualifications, and if the rejection of that candidate is properly documented, the company should not have a problem. The fact that companies are required to establish criteria for board membership, therefore, should be helpful in dealing with the clearly unsuitable candidate.
Kopelman: This is an interesting issue, and it can be more complicated than appears at first glance. For example, if the criteria for board members refer to the fact that each director must have the ability to represent all of the shareholders, the company may have something to fall back on when a group of shareholders recommends what is called the one-constituency candidate, the candidate who comes to the board with a single agenda. But the mere fact that a shareholder-recommended candidate is recommended by, say, a labor union, does not, in and of itself, automatically render that person a one-constituency candidate, incapable of representing all shareholders. As Abbe indicates, the candidacy must be evaluated properly, and if the decision is to reject it, that decision must be properly documented.
Dienstag: The SEC does go on to say that if the nominating committee receives a recommendation from a shareholder or shareholder group that has held more than 5% of the company's common stock for at least a year, the company must disclose, in its proxy statement, receipt of the recommendation and whether it has chosen to nominate the recommended candidate. The caveat here is that the recommending shareholder or shareholders and the candidate must consent to the proxy statement disclosure. Obviously the threshold is quite high at 5%, so this particular rule may not be often invoked. Nevertheless, it is there. Even in this case, the company is not required to disclose its reasons for not nominating a recommended candidate. But, depending on the circumstances, it might make sense to do so.
Editor:. What about companies to which the new rules are not applicable? Say, private companies which do not have the disclosure concerns of a NYSE listed enterprise. What advice are you giving them about the nominating committee function?
Kopelman: Public companies that are not now subject to the listing standards of the NYSE or NASDAQ, and private companies that believe they are going to go public at some point, need to be forward looking, to anticipate where they will be in one, two or five years. Assembling an appropriate board is not something that can be accomplished overnight. To these companies we are saying that planning is essential. This planning includes, in addition to assembling the right board, creating a culture, a set of procedures and a structure that are responsive to the requirements of the SEC, the securities exchanges and NASDAQ, even if compliance is not presently required. A company cannot suddenly become a publicly listed enterprise and expect all of these things -the independent board, the committee structure contemplated by the SEC and the exchanges, the procedures that build shareholder trust and the culture of a public company -to emerge overnight. Even in the case of the truly private company -the family business or the company owned entirely by one person -some of what appears in these new rules may be beneficial. I have counseled a number of these truly private companies that have taken the line that an independent governing board -one that brings outside experience and expertise to the company -is a very positive thing.
I hasten to add that the cost of compliance -drafting charters, setting up procedures, utilizing the time of directors to discuss compliance issues -can be pretty high. And most directors will rightly tell you that the primary business of the board remains the business of the company, not the procedures of corporate governance. So, an appropriate balance has to be struck, particularly for private companies that are not subject to any of the new governance rules.
Editor: Is there anything you would like to add?
Dienstag: As with any legislation intended to modify entrenched behavior, the rules themselves can only accomplish so much. There is always a possibility that companies will manage to be in full compliance with the letter of the rules but carry on with the old, clubby corporate nominations process. For this reason, many people are advocating more extreme changes, such as a liberalized shareholder nominations process that goes well beyond the proposed SEC rules, term limits for directors, and regular turnover in the board room, so as to open up the process to greater shareholder participation. It is my personal view that the new rules, and the shareholder activism that they are spawning, should be given a chance to work their impact on the governance of corporate America before we turn to newer and more radical measures.