The Financial Crisis and Corporate Governance Reform
I.
Introduction
In the wake of the recent financial crisis, the Obama administration has declared
regulatory reform of the nation’s financial system among its top priorities. Calls for
increased regulation in response to an economic crisis are nothing new. Examples of
previous crises leading to regulatory responses are many. For example, the Foreign
Corrupt Practices Act of 1977 followed the SEC’s exposure of corporate bribery in
foreign countries, and the Sarbanes-Oxley Act of 2002 (SOX) followed accounting
scandals at Enron, WorldCom and others.1 The primary challenge of this current round
of regulatory reform will be to establish a more effective means of financial oversight
without so restricting the flexibility and efficiency of the financial system that economic
growth is stifled. In order to achieve that necessary balance, any proposed regulations
must be critically evaluated to ensure they effectively remedy specific problems
uncovered by the crisis with minimal intrusive effect on economic growth and the
financial system.
The initial response to the current financial crisis was necessarily centered on
restoring viability to corporations large enough to pose systemic risks to the national
economy.2 The Troubled Asset Relief Program (TARP) provided massive government
bailouts to large companies such as Bank of America, AIG and Citigroup in an effort to
restore confidence and liquidity in the financial system.3 The overall effectiveness and
1
Foreign Corrupt Practices Act, 15 U.S.C. §78dd (1977); Sarbanes-Oxley Act, 15
U.S.C.§7201 (2002).
2
Emergency Economic Stabilization Act, Pub. L. No. 110-343 (2008).
3
Kiel, Paul, Show Me the TARP Money, ProPublica, Feb. 9, 2009,
http://bailout.propublica.org/main/list/index.
efficiency of TARP is subject to debate, but the result was to leave the federal
government with a substantial interest in many large corporations within the financial
system.4
Given the vast resources employed by the federal government to deal with the
exigent circumstances created by the financial crisis, proposed legislation thus far has
understandably been focused on establishing the authority and procedures for a federal
systemic risk regulator.5 This as yet unspecified agency would be charged with oversight
responsibilities for corporations deemed large enough to pose a threat to the economy as
a whole.6 One aspect of this oversight would involve federal takeovers of failed systemic
risk corporations based on the FDIC model for taking smaller failed banks into
receivership.7 In summary, the basic thrust of these initial reform efforts has been
primarily aimed at creating a more viable, unified regulatory structure for dealing with
corporations posing systemic risks, and for establishing an organized takeover process
should the failure of such a corporation occur.
A second prong of the Obama administration’s reform effort, and one that has
been getting significantly more attention lately, has focused on identifying potential
corporate governance reforms that would serve to prevent corporations from repeating
the mistakes that led to the current crisis. Specifically, the administration has sought to
understand why executives and boards at so many major financial institutions failed to
appropriately gauge risk and adhere to sound long-term risk management strategies. Not
Nothwehr, Erin, U. of Iowa Ctr. For Int’l Fin. and Dev.,Emergency Economic
Stabilization Act of 2008 (Dec. 2008),
http://www.uiowa.edu/ifdebook/issues/bailouts/eesa.shtml.
5
H.R. 1754, 111th Cong. (2009).
6
Id.
7
Id.
4
surprisingly, the conclusions drawn from this analysis implicate several factors that
contributed to the failure to assess risk, but they can be broadly categorized as involving
breakdowns in corporate governance. Accordingly, proposed solutions from the
administration and from commentators have offered a broad array of measures aimed at
improving corporate evaluations and awareness of risk.
The focus of this essay is to examine proposed reforms in the area of corporate
governance, and to evaluate whether such reforms might serve to prevent future crises
without being so intrusive as to hamper growth. Broadly stated, governance reform goals
include:
(1) Bringing greater transparency to corporate risk management.
(2) Increasing the accountability of the board to shareholders.
(3) Aligning compensation of top executives with long-term corporate
performance.
(4) Improving risk awareness at the board level.
(5) Improving the procedures for internal evaluation of risk.
II.
Origins of the Current Financial Crisis: The US Housing Market
In order to evaluate whether proposed solutions to lacking corporate governance
standards are likely to achieve these goals, it is important to first understand how
breakdowns in risk management and analysis contributed to the current financial crisis.
Where did these bad risks originate? How did so many major financial institutions fail to
accurately perceive the risks they were taking? An examination of activities in the US
housing market over the past decade is helpful.
The sustained rise in housing prices leading up to the current financial crisis
fostered the perception that real estate was an extremely low-risk investment.8 This
belief in turn led to a relaxation of standards for issuers of home mortgage loans. This
relaxation of standards manifested itself primarily in the dramatic increase in the
availability of subprime mortgages.9 Prior to 2000, the issuance of subprime mortgages
was an extremely small percentage of total mortgage originations; however, by 2006
nearly half of all mortgage originations were of the subprime variety.10 These subprime
mortgages were issued with adjustable rates that generally included a low “teaser rate” to
induce borrowers, but reset to higher rates after the first two or three years of the loan.11
Further, many of these subprime loans did not require a down payments or income
verification for borrowers.12 Indeed, the most excessive mortgages did not even require
the borrower to pay the full amount of interest due during the initial loan period.13
Instead, the excess interest was simply added to the principle of the loan.
Issuers justified these subprime mortgages on the belief that housing prices would
continue to increase substantially and indefinitely, and that the increased value of the
properties would be sufficient to enable borrowers to refinance at a reasonable fixed rate
before the adjustable rates reset.14 Furthermore, these subprime loans enabled a large
new group of eligible borrowers to participate in the housing market. The influx of new
8
The Office of Federal Housing Enterprise Oversight index of house prices showed
increases in every quarter from 1991 through the third quarter of 2007.
9
Martin Neil Baily, Robert E. Litan & Matthew S. Johnson, The Origins of the Financial
Crisis, Brookings Institution, Initiative on Bus. & Pub. Pol’y, 14 (Nov. 2008),
http://www.brookings.edu/papers/2008/11_orgins_crisis_baily_litan.aspx
10
Id.
11
Id. at 17.
12
Id.
13
Id. at 18.
14
Id. at 17.
borrowers, along with sustained low interest rates, served to increase housing demand
and also further inflated housing prices.15 In this way, the sustained, rather modest
housing growth of the 1990s became the over-heated housing bubble of the 2000s.
The incentive to issue subprime loans was further enhanced by the ability of the
issuers to transfer the risks associated with them.16 Government sponsored enterprises
Fannie Mae and Freddie Mac, along with private sector commercial and investment
banks, spread the high risks associated with subprime loans throughout the financial
system by means of packaging the loans into mortgaged backed securities (MBS) and
collateralized debt obligations (CDOs).17 These institutions then sold their newly created
securities to investors of all varieties. CDO and MBS issuers were able to market their
products to a broad spectrum of investors by allocating the rights to the cash flows from
these mortgage-backed investment products into “tranches,” or risk classes.18 The CDO
& MBS issuers were then able to convince the credit rating agencies to assign their
highest ratings to the securities in the most senior tranch.19 The high return offered by
these securities, combined with the high ratings assigned to them by credit rating
agencies, made them extremely attractive investments. These factors, combined with a
period of sustained low interest rates and lax federal regulation, led many financial
institutions to borrow more and more money (increase their leverage) to finance their
investment in mortgaged-related assets.20
15
Id. at 18.
Id. at 20.
17
Id. at 22-23.
18
Id. at 25.
19
Id. at 25.
20
Id. at 29.
16
Further compounding the problem, insurance companies, investment banks and
others began selling “credit default swaps” (CDS) which allowed investors to essentially
bet against the risks represented by CDOs.21 These CDS transactions occurred in the
Over the Counter (OTC) derivatives market, and were not subject to standardization or
oversight from any regulatory body. As a result, no one knew the specific terms of these
CDS contracts except the two parties involved, and there existed no public knowledge as
to the volume of CDS transactions an institution had made. Even more importantly, since
there was no regulation of the CDS market, there were no minimum capital requirements
for the selling institutions.
The management of many CDS issuers, most notably AIG, so believed their own
sales pitch regarding the safety the top tranches of mortgaged-backed securities, that they
did not find it necessary to reserve significant capital in the event that the loans
underlying the CDO & MBS products went into default.22 Thus, in 2007, when the crisis
arose and the value of these mortgaged-backed assets was finally called into question,
there were woefully insufficient reserves available to make payment on CDS obligations.
The holders of CDOs suddenly found them near worthless, and the CDS issuers were
unable to honor their contracts. The result was the freezing of capital markets and
catastrophe of the current crisis.
In retrospect, it is not difficult to understand why subprime borrowers, banks, and
other investors borrowed money on the prospect that the US housing market would
21
Cox, Christopher, Chairman, U.S. Securities and Exchange Commission. Testimony
Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government
Sponsored Entities, Investment Banks and Other Financial Institutions. Before the
Senate Committee on Banking, Housing, and Urban Affairs, Sept. 23, 2008.
22
James B. Kelleher, Buffett’s “time bomb” goes off on Wall Street, Reuters, Sept. 18,
2008. http://www.reuters.com/article/newsOne/idUSN1837154020080918
continue to escalate in value. So long as asset prices were rising, it seemed like an
excellent opportunity for consumers to live beyond their means, and for institutional
investors to maximize return. The more troubling aspect of the crisis is how each
institution involved in the securitization of mortgages failed to understand and appreciate
the real risks involved in the underlying assets they issued, held and traded. At no time
did the mortgage originators, loan servicers, MBS and CDO issuers, credit rating
agencies, CDS sellers, or any of the holders of mortgaged backed securities question the
fundamental soundness of these assets and the transparently unsustainable loans
underlying these mortgages.
III.
Failures of Risk Management: Corporate Governance Problems
As the financial crisis has illustrated, too often corporate boards at financial
institutions were either insufficiently aware of risk or greatly underestimated the risks
associated with mortgage-backed assets. Several factors have been identified as
contributing to this problem.
1.
Over-reliance on mathematical models of risk assessment
The use of mathematical models for assessing risk has steadily increased in recent
decades, but the technical assumptions underpinning these models are too often faulty or
no longer reflective of current market realities.23 Further, even when executives did not
trust the accuracy of the technical models, too often the importance of having numerical
support often became more important than the actual accuracy of the numbers
themselves.
23
Avinash Persaud, Why Bank Risk Models Failed, Vox, Apr. 4, 1999.
http://www.voxeu.org/index.php?q=node/1029
2.
Lack of formal structure for risk analysis
Many boards at US financial institutions did not have independent committees for
assessing risk.24 Instead many of these institutions assigned risk assessment
responsibilities to audit committees already overloaded with compliance activities.25
Even where risk committees were present, members often had no significant experience
or training in risk management.26 Further, at many financial institutions there was no
Chief Risk Officer (CRO) with board membership.27 Having a CRO present to keep the
board regularly informed of corporate risk exposure and risk profile is one way to
maintain a high profile for corporate risk management strategies.
3.
Failure to transmit risk information through effective channels
Due in significant part to the lack of formalized structure for risk analysis;
accurate information about risk exposure was not conveyed to the board in a timely or
effective manner. This was especially true in financial institutions, such as Bank of
America, where one person held the position of chairman of the board and CEO.28 CEO
bonuses were commonly linked to short-term stock performance, thus giving CEOs
incentive to take high risks in search of high return, even at the expense of long-term
24
For example, Bear Stearns did not establish a risk committee until shortly before it
failed.
25
KPMG, Audit committees put risk management at the top of their agendas, June 16,
2008, http://www.kpmg.co.uk/news/detail.cfm?pr=3120
26
Francesco Guerrera & Peter Thal Larson, Gone by the board? Why bank directors did
not spot credit risks, Financial Times, June 25, 2008,
http://www.ft.com/cms/s/0/6e66fe18-42e8-11dd-81d0-0000779fd2ac.html
27
Grant Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis,
OECD Steering Group on Corporate Governance, 20, Feb. 11, 2009.
28
Kenneth Lewis was ousted as board chairman of Bank of America on April 29, 2009,
but remains as CEO of the company.
performance.29 Also, corporations without CROs or independent risk committees
provided insufficient structure for risk managers to express potential concerns.
4.
Failure to fully appreciate the risk information that was received.
The composition of boards was another problem. Directors with little or no
experience in the technical aspects of risk management populated many boards. Further,
many boards had non-officer directors lacking serious experience in the financial
industry.30 Examples include John Deutch, former head of the CIA and current professor
of physical chemistry, who sat on Citigroup’s audit and risk management committees,
and Tommy Franks, the retired top US Army General, who sits on the audit committee at
Bank of America. Without sufficient risk management expertise at the board and
committee levels, there can be no meaningful independent analysis of the overall risk
profile.
5.
Compensation of corporate officers too closely aligned with short-term
performance.
Another corporate governance matter with direct effects on risk management is
the issue of executive compensation. Compensation packages for corporate officers in
the US have been heavily weighted toward bonus payments for immediate performance
as well as payment in the form of equity.31 This compensation structure often creates a
conflict of interest for corporate managers where their personal remuneration interests are
in contrast to the long-term interests of the corporations. The existence of these conflicts
significantly increases the incentive for executives to take outsized long-term risks in
29
Kirkpatrick, supra at 12-13.
Guerrera & Larson, supra.
31
Kirkpatrick, supra at 13.
30
exchange for immediate high returns. By inflating the short-term stock price at the
expense of long-term corporate performance, executives are able to sell their equity
interests for immediate personal gain. Therefore, even if officers were to conclude that
mortgaged back securities and CDOs were not sustainable investments over the long
term, it was in their own personal financial interest to ignore these risks in exchange for
the maximizing immediate returns these investments offered.
6.
Compensation of lower-level managers too closely aligned with shortterm performance.
Similar to the compensation of executives, investment banks offered bonuses at
the sales and trading levels that were heavily weighted toward short-term performance
and insufficiently tied to longer-term objectives.32 Moreover, while potential losses
incurred with risk-taking would be borne solely by the institution, bonuses rewarding
short-term success were unlimited in size. This compensation structure encouraged sales
people and traders to focus excessively on immediate returns.
7.
Lower prestige and status of risk managers relative to traders
Additionally, there is significant anecdotal evidence that financial institutions
frequently disfavored risk managers in comparison with their counterpart traders. An
SEC report detailed how risk managers and traders at Bear Sterns were placed within
close proximity to one another, suggesting strongly that the risk managers were not acting
independently of influence from their trading counterparts.33 Additionally, there are
32
Id. at 12.
Securities and Exchange Commission, SEC’s oversight of Bear Stearns and Related
Entitites: The Consolidated Supervised Entity Program, Report No. 446-A, Sept. 25,
2008.
33
examples of bank management having little regard for risk managers while aggressively
pursuing the expansion of its mortgage business.34
IV.
Guiding Principles and Goals for Governance Reform
In addressing the problems exposed by the financial crisis, the most immediate
goal of governance reforms should be to restore trust and confidence in the financial
system. To earn that trust, reforms must be targeted to achieve greater transparency
within financial institutions. Further, the public at large must be convinced that reform
measures are being taken for the benefit of “main street” businesses and not merely to
benefit corporate tycoons and politicians.
Additionally, corporate governance reform should foster the long-term goal of
creating stability in financial institutions, and creating more robust risk management
systems. This includes enhancing the formal mechanisms for analyzing risk, increasing
awareness of risk factors within the corporate culture, increasing accountability for
irresponsible risk taking, and reducing incentives to take excessive risks.
With these goals in mind, reform efforts must strike a careful balance between
more innovative, lightly regulated financial markets subject to instability and secure,
heavily regulated markets that may stifle economic growth. While there is widespread
agreement that a more effective regime of corporate governance is needed in the US,
there is substantial debate over the extent of reform necessary to achieve that goal.
Increasing the effort and expense of compliance with regulatory mandates places a drag
34
Caroline Binham, HBOS Whistleblower Says Bank Ignored Alerts on Sales (Update 2),
Bloomberg.com, Feb. 27, 2009,
http://www.bloomberg.com/apps/news?pid=206011020&sid=a.pGKHXuQwEU&refer=u
k.
on growth and tends to stifle innovation. Accordingly, reaction to the current crisis must
be carefully considered and appropriately targeted in order to avoid the negative
consequences associated with over-regulation.
Also, if the response to this crisis places too great a regulatory burden on US
companies, those companies are likely to seek to relocate to foreign markets offering
lighter regulatory restrictions. It is therefore critical that reform measures minimize
unnecessary regulatory hurdles, while effectively confronting the corporate governance
problems exposed by the economic crisis.
V.
Potential Measures for Improving Corporate Governance
In the wake of the crisis, several specific recommendations have been made in
regard to improving corporate governance standards. These recommendations can be
broadly categorized although there is some overlap between categories.
1.
Increasing disclosure requirements
One of the bedrock principles of open markets is that participants should have full
and fair disclosure to all relevant information underlying their investment decisions. This
disclosure is essential to instilling confidence and trust in the market, but also must be
checked by the need for corporations to protect sensitive information.
Efforts to increase disclosure requirements have centered on two types: (1)
disclosure to regulators, and (2) disclosure to the investing public. Mandating disclosure
to regulators is intended to keep federal agencies informed about activity that is currently
unregulated, such as the OTC derivatives market which led to much of the current
economic turmoil. Disclosure of sensitive trading information to regulators would have
the advantage of secrecy. Corporations could share strategic information vital to
assessing systemic risk, such as their positions in the OTC derivative market and the
extent of their leverage. However, it is unclear whether regulators would have the
capacity and sustained resolve to make effective use of this information once the
immediacy of the moment has passed. It is noteworthy that, even under the current
regulatory scheme, national banking regulators had access to sufficient information to
determine that many banks were over invested in mortgage-backed securities, yet the
OCC performed no better than the banks themselves in identifying and averting the
underlying risks associated with many bank’s extensive involvement in this area.35
Disclosure requirements to the public could take several forms. First, a
corporation could include basic information about its risk profile, formal risk
management structure and the risk management credentials of its directors in annual
reports to shareholders. While having to provide this information is likely to force
corporations to pay more attention to risk, it is unclear that general information on such a
complex topic would be of significant benefit to investors. Further, making shareholder
reports longer and more complex runs the risk that average investors will not take the
time to actually read them.
Alternatively, information about aggregate positions in unregulated OTC
derivative markets could be disclosed to the investing public through an information
clearinghouse. This type of disclosure would preserve institution-specific strategic
information while allowing investors and regulators access to information relevant to
35
L. Gordon Crovitz, Derivatives and the Wisdom of Crowds: Smart reform yields more
information, not more regulation, Wall Street Journal, May 18, 2009,
http://online.wsj.com/article/SB124260235584228407.html
determining the presence of systemic risks in OTC markets. Further, making this type of
information broadly available could assist the accuracy of forecasts on topics like interest
rates, corporate credit risk, and foreign exchange movements.36 Thus an informed market
would operate more efficiently and with greater awareness of potential risks.
Finally, a consumer protection measure could be taken by requiring mortgage
issuers to include plain language statements to consumers about loan terms and
conditions, particularly in regard to subprime mortgages. Creating an additional
disclosure form might make subprime borrowers more cognizant of the long-term risks
associated with these mortgages. Including an additional boilerplate form for borrowers
to sign probably would not make a substantial impact, but implementing this type of
disclosure requirement would be relatively simple and inexpensive.
2.
Requiring formalized risk management structure
A further possible measure to strengthen corporate governance is simply requiring
corporations to maintain a more formalized structure for analyzing risk. Several
proposals have been made to achieve more robust internal mechanisms for assessing risk:

SOX mandated the presence of at least one financial expert on corporate
boards. A similar measure could be adopted for a risk management expert.

Requiring the chairman of the board to be an independent director – the
rationale being that CEO’s are more inclined to take outsized risks while
boards should exercise independent oversight of risk management.
Recently, shareholders of Bank of America voted to enact such a division
after widespread dissatisfaction with management’s performance.
36
Id.

Requiring risk committees to have a minimum level of risk management
sophistication. Similar to having a risk management expert on the board,
risk committees could be required to have a threshold number of members
with experience and expertise in the field of risk management.

The explicit separation of risk and audit committee functions. Requiring
corporations to establish a risk committee separate and apart from the
audit committee would allow greater focus on risk management issues,
and decrease the likelihood that audit committees will simply be too
overwhelmed with compliance issues to effectively analyze risk levels.

Mandated frequency of risk committee meetings. Having an expertly
staffed risk committee is of little value if that committee fails to meet
often enough to be effective. For example, Lehman Brothers had an
independent risk committee in place prior to the financial crisis, but it only
met twice in both 2006 and 2007.37 Therefore, a minimum requirement
might be for the risk committee to meet at least quarterly.
3.
Compensation issues
One issue getting a great deal of attention in the wake of the financial crisis is the
compensation of executives. The public and legislators have been incensed recently over
bonuses paid out of TARP funds to current and former AIG executives.38 There has also
been a more general dissatisfaction with steadily rising executive compensation over the
past two decades. Further, as previously discussed, the structure of executive
37
Kirkpatrick, supra at 19.
See, e.g., Liam Pleven, Serena Ng, and Sudeep Reddy, AIG Faces Growing Wrath
Over Payouts, Wall Street Journal, Mar. 16, 2009,
http://online.wsj.com/article/SB123715965204435363.html.
38
compensation in the US has been heavily weighted toward bonuses and equity interests
that encouraged executives to focus on short-term performance.
Since 2007, the SEC has mandated that corporations file Compensation
Disclosure and Analysis (CD&A) reports. These disclosure reports were an initial
attempt at reigning in compensation packages for corporate executives, but mere
disclosure has proved ineffective because it does not limit the specific types of
compensation that led to excessive risk-taking.
Current efforts to reform compensation structures have focused on more closely
aligning the personal financial interests of executives with the long-term performance of
the corporations they manage. Specifically, many financial institutions are reducing
bonuses for immediate increases in stock price in favor of higher base salaries. For
example, in the past month, Morgan Stanley and UBS have more than doubled the base
pay for executives while greatly reducing available bonuses.39 This shift away from
bonuses for short-term performance is likely to be supported by regulatory efforts when
Treasury Secretary Timothy Geithner’s proposed overhaul of executive compensation is
announced in the coming weeks. While Geithner has opposed putting absolute caps on
compensation, he has called for “very, very substantial change” in the regulation of
executive pay.40
One such regulatory change advocated by Mr. Geithner is the introduction of “say
on pay” requirements, which would allow shareholders an up-or-down vote on executive
39
Elizabeth Hester, Morgan Stanley to Boost Executive Salaries as Bonuses Decline
(Correct), Bloomberg.com, May 23, 2009,
http://www.bloomberg.com/apps/news?pid=20601087&sid=aoz7URVpwVro
40
Rich Miller, Geithner Calls for “Very Substantial” Change in Wall Street Pay,
Bloomberg.com, May 22, 2009, http://bloomberg.com/apps/news
?pid=20601087&sid=aCwz3Hlyo9sg
compensation packages.41 While Geithner has not suggested that these votes would be
binding, they do give shareholders a voice in the area of executive compensation and
presumably would increase accountability for compensation committee directors. Similar
to compensation structure reforms, several US companies have voluntarily implemented
“say on pay” policies in the past year.42
4.
Proxy access and the “Shareholders Bill of Rights”
A further means of addressing corporate governance issues includes proposals to
make boards more responsive, and more accountable, to shareholders. The SEC plans to
introduce rule amendments that would greatly increase shareholders ability to include
their own nominated directors on company proxy ballots.43 Under the existing proxy
rules, shareholders who wish to challenge the slate of directors offered by the board must
resort to sending their own proxy materials to shareholders – an extremely expensive
process. Under the proposed new rules, shareholders satisfying a minimum threshold
ownership of voting securities would be entitled to include their candidate (or multiple
candidates, up to 25 percent of the board – whichever is greater) with company proxy
materials.44 These minimum ownership thresholds would be set according to the size of
the corporation, and are proposed as follows45:

One percent ownership in voting securities of a “large accelerated filer” (a
company with a worldwide market value of at least $700M).
41
Id.
Aflac, TIAA-CREF & Verizon are examples.
43
See Security and Exchange Commission, SEC Votes to Propose Rule Amendments to
Facilitate Rights of Shareholders to Nominate Directors, press release 2009-116, May
20, 2009.
44
Id.
45
Id.
42

Three percent ownership in voting securities of an “accelerated filer” (a
company with a worldwide market value between $75M and $700M).

Five percent ownership in voting securities of a “non-accelerated filer” (a
company with a worldwide market value of less than $75M).
Additionally, under the proposed changes, shareholders would be allowed to
aggregate holdings for purposes of meeting these threshold requirements; however, there
would be additional requirements to be met before a shareholder could gain access to
company proxy materials. These requirements are46:

Shareholder would be required to have held their shares for at least one
year.

Shareholders would have to sign a statement of intent to continue holding
their shares until the annual meeting at which directors are elected

Shareholders would be required to certify that they are not holding their
stock for the purpose of changing control of the company, or to gain more
than minority representation on the board of directors.
As an additional measure the current rule allowing companies to block
shareholder proposals related to the election of directors would be sharply narrowed.
Under the proposed changes, qualifying shareholders could submit shareholder proposals
concerning a company’s nominating procedures or nomination disclosure provisions. A
qualified shareholder for purposes of this measure would have held stock worth $2,000 in
46
Id.
market value, or one percent whichever is less, for a period of one year prior to
submitting the proposal.47
Should the proposed changes to proxy access become law, the consequences to
effective risk management are difficult to gauge. Making it easier to vote out board
members will increase the board responsiveness to minority shareholder interests;
however, it is not clear that minority shareholder interests are necessary in line with longterm performance of the company. As has occurred with executives given equity
interests as compensation, the enhanced influence of shareholders may result in policies
that pump up the immediate stock price by pursuing high returns at the expense of
elevated risks. The one-year holding period requirement may serve to alleviate some
shareholder shortsightedness, as those capable of nominating directors will presumably
be invested in the company for the long term; however, once qualified to nominate
directors, the incentive for immediate return will be similar to that of executives with an
equity interest.
Another concern with greater proxy access, and the resulting increase in contested
elections, is the corresponding increase in influence among proxy advisory services such
at RiskMetrics, Glass Lewis and Proxy Governance. There is concern that these services
may succumb to the same conflicts of interests that have recently tarnished the credibility
of the Credit Rating Agencies.48 Perhaps increased SEC scrutiny of proxy advisor
practices could quell such dangers, but currently the possibility of proxy advisor conflicts
remains a potential downside to increased advisor influence.
47
Id.
See, e.g., Interview by Metropolitan Corporate Counsel with Cary I. Klafter, Vice
President, Legal and Corporate Affairs and Corporate Secretary, Intel Corporation (May
4, 2009), http://www.metrocorpcounsel.com/current.php?artType=view&EntryNo=9673.
48
On the other hand, a recent study by the Investor Responsibility Research Center
Institute shows that companies in which minority shareholder interests (usually hedge
funds) won a seat on the board substantially outperformed peers in both the short and
long terms.49 Indeed, according to the study, those companies with greater minority
representation performed better than those with more modest representation.50
An even more dramatic effort to strengthen the power of shareholders has been
proposed by Senator Chuck Schumer. Under his recently introduced legislation, called
the “Shareholder Bill of Rights Act of 2009”, Schumer seeks a federal mandate on many
of the potential remedies discussed above, including: (1) increased minority proxy access,
(2) an independent chair of the board, (3) “say on pay” for shareholders, and (4) the
establishment of a risk committee.51 In addition, Schumer’s bill would require that every
board member be re-elected annually, thereby eliminating “staggered boards.”52 Also,
Schumer’s bill would require that board members in uncontested elections receive a
majority of all available votes or be forced to immediately resign.53
These proposals again raise the question of whether a board beholden to
shareholder interests is actually less likely to pursue short-term gains in favor of longterm growth. Institutional investors, the ones most likely to benefit from increased
shareholder power, did not fare well in the recent crisis in terms of assessing the overall
risk of their investments. Additionally, federalizing corporate governance to the extent
proposed by Schumer would likely result in the courts determining complex issues of
49
Chris Cernich, Scott Fenn, Michael Anderson, & Shirley Westcott, Effectiveness of
Hybrid Boards, Investor Responsibility Research Center Institute, 38 (May 2009).
50
Id.
51
S. Res. 1074, 111th Cong. (2009)
52
Id.
53
Id.
pre-emption, as these new regulations would effectively usurp much of what has
traditionally been governed under state corporate law.
5.
Independent certification of risk management systems.
One additional possibility for enhancing corporate risk management is requiring
independent certification of corporate risk management systems. Such a measure would
subject risk management systems to the same type of outside analysis and review that
SOX brought to corporate accounting. While requiring independent verification of
adequate risk procedures would surely strengthen corporate awareness of risk, a
significant drawback is the substantial expense involved in obtaining outside
certifications. Due to these costs, and the resulting negative effects on growth at a time
when economic stimulation is a top priority, requiring independent certification has not
received seriously attention by the administration. However, if excessive risk taking
continues to be a problem beyond the current round of reforms, certification is likely to
receive more substantial consideration.
VI.
Striking a Balance: How Far Should Governance Reforms Go?
In considering the broad range of potential responses to the current problems with
corporate governance in the US, a threshold consideration is determining to what extent
these reforms should be implemented at the federal level. Matters of corporate
governance have traditionally been determined under state corporate laws, and courts
have held that federal agencies may not enforce governance requirements without
specific authorization from Congress.54
The first significant federal legislation in the area of governance came in 2002
with the passage of SOX. While some commentators maintain that all governance
regulation is best handled at the state level, federal regulation in this area appears certain
to increase in the near term. These new measures will effectively raise the floor for
governance regulation, and allow states to adjust their own specific requirement upwards
from the federal minimums. Given that the federal standards will be minimums, with
states able to enact more stringent measures, Congress should proceed cautiously when
placing new governance requirements on corporations. By showing restraint in enacting
reforms, Congress can avoid the negative growth effects of over-regulation while
ensuring that benefits of diverse solutions to corporate governance problems continue to
accrue at the state level.
A second threshold issue is how federal governance reforms can be tailored to
target only those companies that pose significant threats to the financial system. By
limiting the application of mandated federal reforms to only large companies, the most
troubling risk management problems revealed by the current crisis can be effectively
targeted without placing potentially heavy burdens of compliance on smaller companies
that do not significantly threaten the financial system.
Of course, tailoring reforms according to company size necessarily involves
issues of line drawing. One possible place to draw the line for proposed reforms such as
the establishment of a risk committee, having an independent chairperson, and “say on
54
See, e.g., Bus. Roundtable v. S.E.C., 905 F.2d 406, 412 (D.C. Cir. 1990); Sante Fe
Industries, Inc. v. Green, 430 U.S. 462, 477-478 (1977).
pay” measures is at the “large accelerated filer” designation already used by the SEC.
Exempting smaller companies will allow them more flexibility and fewer compliance
issues, while still safeguarding the financial system from excessive risk taking by large
institutions.
With federal governance reforms appropriately targeted, the first goal should be to
restore trust in the financial system. In order to restore trust, greater disclosure and
transparency is needed, particularly in the unregulated OTC derivatives market – where
CDSs were negotiated and traded. Mandating public disclosure of aggregate OTC
market information through a clearinghouse would be a positive step in increase
awareness of systemic risks arising from the OTC derivatives market. With greater
certainty established, public trust of the financial system will increase.
As a further means of restoring public trust, and of creating more effective risk
management systems, measures should be taken to ensure that a robust risk management
structure exists at every large US corporation. Mandating the presence of a risk
committee, separate from the audit committee, would be an uncomplicated yet positive
step in that direction. An additional requirement that the risk committee have at least
one person with significant risk management credentials would also be prudent.
Requiring this basic level of internal structure should present only a small hurdle for large
companies, as most have already stepped up their risk management structure in the wake
of the crisis.55
On the issue of executive compensation, giving shareholders a non-binding “say
on pay” would help to ensure that greater attention is paid to compensation packages both
55
Enterprise Risk Management Symposium, Survey of Actuaries and Corporate Risk
Experts, May 11, 2009.
in quantity and in type. Establishing this additional check on pay should help prevent
incentives to take excessive risk for short-term returns. Further measures on
remuneration, such as hard caps on executive pay or foreclosing certain types of
remuneration, lack flexibility and could unduly restrain US companies in global
competition for top executive talent.
Finally, the argument that increasing board accountability, through increased
proxy access and more frequent elections, will improve risk management is unconvincing
without credible evidence that shareholders are better suited to judge risk than the boards
themselves. Indeed, by shortening election cycles and increasing contested elections the
pressure on board members to encourage shortsighted, immediate return only intensifies.
For this reason, measures that substantially alter the balance of power between boards
and shareholders should not be included in the federal floor for corporate governance
standards. Rather, states engaged in a “race to the top” for shareholder rights would be a
more appropriate testing ground for these measures.
VII. Conclusion
Federal reform of corporate governance regulation is a critical part of the Obama
administration’s effort to overhaul regulation of the financial system. In enacting these
reforms, the administration must appropriately target new requirements in order to restore
confidence and achieve stability without hampering economic growth. In order to
achieve this balance, regulation should be focused on increasing risk awareness and
decrease incentives to assume imprudent risks in return for higher short-term returns.