Shareholders Key to Corporate Reform

Want fundamental corporate reform? Start with shareholders, say Harvard Business School professor Cynthia Montgomery and research associate Rhonda Kaufman. Excerpted from Harvard Business Review.
by Cynthia A. Montgomery & Rhonda Kaufman

If a dike or dam has sprung a number of leaks, there are many possible ways to respond. The initial impulse is to assiduously plug one hole after another, hoping that the situation will right itself. Another approach—and often a more sensible one—is to step back, locate the source of the leaks, and correct the underlying weaknesses. When it comes to corporate governance, for too long we have relied on the first approach. It's time to take a deeper look, see where the stressors in the system lie, and commit to structural reforms.

In the wake of recent corporate failures, numerous suggestions have been made about how to improve governance. Though strongly worded, many of these are surprisingly modest in nature—much like plugging holes in a dike. In fact, nearly all the suggestions lie well within the existing framework of corporate governance. Few reformers have stopped to examine the adequacy of that framework in practice or its ability to support the kinds of changes that are being suggested. ...

Righting The Imbalance

The compromised boardroom climate is a serious obstacle to good governance. Proposals for reform that focus on who sits at the table address only the surface of the problem. As Deming told us long ago, poor outcomes are more often the result of bad processes than bad people. The weak shareholder/board relationship creates an untenable situation for directors. If we expect them to do their jobs, we must give them a structure in which they can be effective.

When people are held accountable for their actions as individuals rather than as a group, they tend to weigh their choices more carefully.
—Cynthia A. Montgomery and Rhonda Kaufman

Make directors accountable to shareholders. One compelling way to increase board accountability is to record individual directors' votes on key corporate resolutions in proxy statements. As Louis Brandeis said in his 1914 treatise Other People's Money, and How the Bankers Use It, "Sunlight is said to be the best of disinfectants.…But the disclosure must be real.…To be effective, knowledge of the facts must be actually brought home to the investor."

Most of our social contracts are built on the assumption that individual accountability influences human behavior. Indeed, the recent move by the SEC to require CEOs to personally attest to their companies' financial statements aims to renew CEOs' sense of accountability. The expectation is that, by affixing his or her name to the document, the CEO will verify its accuracy by asking more rigorous questions: Do I trust the level of analysis? Am I getting the right advice from the right people? Do I need more information? It should be the same in the boardroom. When people are held accountable for their actions as individuals rather than as a group, they tend to weigh their choices more carefully. If individual votes were published, directors would have greater incentive to air their views, thus improving the level of boardroom debate.

As voting information accumulates, shareholder organizations such as Institutional Shareholder Services could use the balloting data to create director scorecards. Such objective information, and any accompanying analysis, would serve as a much-needed supplement to board self-evaluations. (See the sidebar "Are Board Self-Evaluations Enough?")

Separate The Positions Of Chairman And Ceo.

This suggestion is hardly novel—in fact, splitting the positions is a common practice in many boardrooms outside the United States—but in light of our model of corporate governance, it's clear why separating these two roles is vital for maintaining balance in the boardroom. Companies that fuse the roles of CEO and chairman collapse the governance triangle, undermining the system of checks and balances that is essential to responsible corporate governance.

We would also urge shareholders to seek each other out and to work in concert on issues on which they share common ground.
—Cynthia A. Montgomery and Rhonda Kaufman

Reinvigorate Shareholders.

As Michael Jensen observed in a 1993 Journal of Finance article, "Financial institutions such as banks, pension funds, insurance companies, mutual funds, and money managers are natural active investors, but they have been shut out of boardrooms and strategy by the legal structure, by custom, and by their own practices."

There are many reasons why shareholders have remained on the sidelines of governance. Proxy battles are expensive and time-consuming, a lack of information has hampered the oversight process, and institutional investors have been slow to recognize the power their votes could wield. However, as we have seen, the corporate governance system will not function properly until shareholders step up to their responsibilities as owners and actively engage with boards.

To start, in the nomination and election process, shareholders could signal their support (endorsement, neutrality, or nonendorsement) for candidates the board puts forth and vote accordingly. If informed by director scorecards, these recommendations could be even more specific and linked to the performance of individual directors. Some large pension funds like CalPERS, as well as some smaller, socially based funds, are moving in this direction. These funds use their Web sites to publish their governance principles, their votes in proxy elections, and the rationales for the votes they cast.

We applaud these initiatives and urge others to follow suit. Further, this information needs to be delivered directly into the boardroom. Posting principles and votes on Web sites may be sufficient to inform investors of a fund's activities, but if funds want to influence boards, they need to be more strategic in getting this information to directors. In cases where shareholders vote against management proposals, efforts should be made to convey those specific decisions, and their rationale, to the board. With this information, directors' behavior may change; otherwise, the likelihood is high that board members will continue to be unaware of their shareholders' displeasure.

We would also urge shareholders to seek each other out and to work in concert on issues on which they share common ground. While the votes of one institution may not have much impact, those of a critical mass of like-minded institutions very well might.

Over time, active investors could go a long way toward righting the imbalance in the corporate governance system. When boards and managers believe there is a real chance that shareholders will push back on the director slate or block an initiative, their behavior and decision-making processes will shift accordingly. To the casual observer, things may look the same, but the ether in the boardroom will surely be different.

Give Boards Funding.

In the course of normal events, most boards can function well with information provided by management. But on certain Gordian issues—a bet-the-company merger decision, say, or a complex product-liability concern—insight from an external perspective could be very useful.

Although circumstances requiring such experts may be relatively rare, it is important that both management and the board operate with the knowledge that this option is available and that its use is not in itself a criticism of management. When management seeks board approval for a proposed action, it naturally attempts to show the proposal in the best possible light; its presentations are likely to be more balanced and comprehensive if management believes that directors might seek an independent opinion.

It should be noted that there is a precedent for providing directors with independent funding: The Sarbanes-Oxley Act requires that audit committees have their own funds for paying auditors and advisers. Giving budgets to the full boards would simply extend this practice.

About the Author

Cynthia A. Montgomery is a professor at Harvard Business School.

Cynthia A. Montgomery is a professor at Harvard Business School.

Rhonda Kaufman is a research associate at Harvard Business School.