CHAPTER 6

Embrace the Best of “Good Governance”

Emerging Orthodoxy

A book on governance would be incomplete without taking note of the search for good governance practices over the last thirty years. It began with the shareholder rights movement of the 1980s and 1990s and accelerated with federal legislation following the corporate failures and scandals of the last fifteen years. We have seen good governance initiatives on the part of legislators and regulators, reformers, stock exchanges, activist and institutional investors, and proxy advisory services. Corporate boards have been much affected by these initiatives, and much has changed in boardrooms as a result. The initiatives have spilled over into the nonprofit world as nonprofit boards adopt committee structures and board practices, such as regular executive sessions, that mimic those in the corporate world.

As a result, there is today emerging orthodoxy (accepted wisdom) as to what constitutes good governance. In this chapter, I describe and evaluate that orthodoxy then highlight practices that experience and research suggest are most valuable. My advice to boards and directors is to embrace what’s best and be skeptical of the rest.

Governance Best Practices Flowing from the Shareholder Rights Movement

The shareholder rights movement ushered in vast changes in public company governance. Three are most important:

• From CEO, management, and stakeholder primacy to shareholder and board primacy

• From boards dominated by chairmen/CEOs and inside directors to boards dominated by independent directors representing primarily owners’ interests

• From executive compensation composed of salary, annual bonus based on performance against plan, and many perquisites to compensation composed of salary and short-term bonus with few perquisites plus heavy use of restricted stock and stock options

Good governance practices for public companies spawned by the shareholder rights movement include:

• smaller, more active boards (typically nine to twelve members)

• annual election of directors

• board independence from management (the CEO is usually the only inside director)

• separation of chairman and CEO roles and/or appointment of a lead independent director

• key committees (audit, compensation, governance) composed of independent directors only

• regular meeting attendance (no more directors with membership on a dozen or more boards and predictably spotty attendance)

• regular executive sessions of independent directors

• equity-based compensation (stock and option ownership by management and directors)

• required director skills, especially financial literacy

I watched these changes play out in boardrooms. They led to a new tone of urgency and seriousness about shareholder value. They stimulated a newfound willingness to jettison CEOs of underper-forming companies along with more demanding performance standards. Boards increased their focus on earnings and total shareholder return. They reinforced the focus with equity-based compensation.

Did the changes matter? I think so. In the twenty years from 1960 to 1980, major stock market indices grew hardly at all. In the thirty years between 1983 and 2013, concurrent with the shareholder rights movement, they have soared, increasing by a factor of ten despite two major market meltdowns. While the bull market has had many causes (low interest rates, a technology explosion), it would be hard to argue that the shareholder rights movement, with its focus on earnings and the governance and compensation changes it triggered, didn’t contribute to these results.

Changes in public company governance spilled over into the board practices of many private companies and nonprofits. For example, I observed in both settings creation of audit, compensation, and governance committees and increased frequency of executive sessions.

By 2000, most boards subscribed to good governance orthodoxy. Then came the biggest wave of corporate scandals and implosions in decades. High-profile companies collapsed between 2000 and 2002, including Enron, Adelphia, Tyco, and WorldCom. So did the gold standard audit firm, Arthur Andersen, after being found guilty of criminal charges related to Enron.⁵⁰

There was much public consternation about governance failures at these companies. While it is unclear whether the new governance orthodoxy contributed to the failures (e.g., by inadvertently incenting excessive risk taking with massive stock option grants), it clearly did not prevent them.

One governance scholar observed at the time that examination of boards of the failed companies left one puzzled as to the board’s culpability.

[There was] no broad pattern of incompetence or corruption. In fact, the boards followed most of the accepted standards for board operations: members showed up for meetings; they had lots of personal money invested in the company; audit committees, compensation committees and codes of ethics were in place; the boards weren’t too small, too big, too old, or too young. While some boards had problems with director independence, this was not true of all failed boards and board makeup was generally the same for companies with failed boards and those with well-managed ones.⁵¹

Into this quandary waded legislators and regulators, determined to improve board accountability and performance.

Government’s Efforts to Fix Failed Corporate Governance

The years 2002–2010 were a consequential period for corporate governance legislation. First came the Sarbanes-Oxley Act of 2002 and eight years later the Dodd-Frank Act of 2010. Governance reforms were included in these laws because corporate fraud and failure inevitably led to questions: Where were the directors? Why didn’t boards prevent the failures and scandals? Both laws have had a material effect on boardroom practices and the environment in which governance operates.

Sarbanes-Oxley

President Bush signed the Public Company Accounting Reform and Protection Act (as it was called in the Senate) and Corporate and Auditing Accountability and Responsibility Act (the House of Representatives name) on July 29, 2002. Sarbanes-Oxley, named for the Democratic Senator and Republic Congressman who sponsored the bill, was a direct response to the corporate scandals and failures of the previous two years in which both boards and audit firms were deemed to have failed investors, employees, and the public. The financial shenanigans and unreliable financial statements of Enron, WorldCom, and Tyco, certified with clean opinions by their auditors, made legislative response inevitable.

Five (about half) of the provisions of Sarbanes-Oxley (SOX) relate to governance:

• Corporate and Criminal Fraud Accountability. Criminal penalties are established for manipulation, destruction, or alteration of financial records or other interference with investigations. Whistleblowers are protected.

• Corporate responsibility. Senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. Principal officers—usually the CEO and CFO—personally certify and approve the integrity of company financial reports quarterly.

• Enhanced financial disclosures. Effective internal controls are required to ensure the accuracy of financial reports. Timely reporting is required of material changes in financial conditions and stock transactions of corporate officers.

• Audit independence. Conflicts of interest are limited (e.g., restrictions on providing non-audit services), and audit partner rotation is required.

• PCAOB (Public Company Accounting Oversight Board). An entity to conduct independent oversight of public accounting firms is created.

These provisions are consequential for public company governance. Arguably most important is the effect on audit committees.

Since 1972, when the SEC first recommended that public companies establish audit committees, their importance in corporate governance has grown. In 1987, the Treadway Commission made recommendations aimed at deterring fraudulent financial reporting. In 1999, the Blue Ribbon Committee made recommendations to improve audit committee effectiveness that resulted in changes in listing standards by the New York Stock Exchange and NASDAQ.

The main functions of the audit committee are to oversee the financial reporting process, monitor the choice of accounting policies and principles, monitor the internal control process, oversee the hiring and performance of the external auditor, and ensure open communication among management, the internal and external auditors, and the audit committee.⁵²

SOX affected audit committee requirements in three areas: composition and authority, external audit, and internal control. Specifically, the Act requires that all members of the committee be independent and have the authority to engage special counsel or experts to advise them with funding provided by the company. The Act specifies that the committee must preapprove audit and non-audit services by the external auditor; receive reports directly from the external auditor on critical accounting policies, review material communications with management, and other matters; and ensure the quality of internal control, including procedures to receive and handle internal complaints and protect whistleblowers.

SOX delivered an unmistakable message: with the assistance of the external and internal auditors and any other advisors and experts required, audit committees are to oversee and ensure quality financial reporting and internal control processes that underpin it.

Dodd-Frank

President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 into law on July 21, 2010.

Dodd-Frank was the legislative response to the 2008 financial crisis, regarded as the worst since the Crash of 1929. The crisis included the collapse of large financial institutions like Lehman Brothers and AIG, bursting of the U.S. housing bubble, federal bailouts for multiple companies (including General Motors and Chrysler), and a bear market that cut the value of major stock indices approximately in half before rebounding. At the center of the financial crisis were excessive leverage and risk taking by financial institutions and individuals. Accordingly, the Dodd-Frank Act focuses on the institutional framework for financial regulation, establishing, for example, the federal Financial Stability Oversight Council and the Office of Financial Research and expanding the regulation of hedge funds and the insurance industry.

Dodd-Frank affects corporate governance through Subtitles E (Accountability and Executive Compensation) and G (Strengthening Corporate Governance) of Title IX of the Act (Investor Protections and Improvements to the Regulation of Securities).

Enacted in an environment of public outrage about the role of executives of some financial firms and perceived failure of their boards, Dodd-Frank has a strong emphasis on executive compensation. Executives of these firms made enormous amounts of money in the years leading up to the crisis because of activities that later proved toxic. Many people (including me) believe that the design of executive compensation plans encouraged excessive risk taking and outsized rewards for what proved to be bad bets with disastrous consequences for companies and the country.

Accordingly, Dodd-Frank requires that the compensation committee of the board be comprised only of independent directors, that the board provide more complete disclosures about executive compensation in the Compensation Discussion and Analysis (CD&A) section of the annual proxy statement, and that SOX’s rules regarding clawbacks of executive compensation be expanded.

The Act creates a say-on-pay mandate requiring periodic shareholder advisory votes on executive compensation. It affirms that the SEC has authority to promulgate proxy access rules allowing shareholders under certain conditions to use the company’s proxy statement to nominate candidates to the board. Both provisions fulfill long-held aspirations of good governance advocates.

The Act requires that companies disclose whether the same person holds both the CEO and chairman of the board positions and why. This provision reflects a growing belief that the combined role vests too much authority in one individual and weakens the oversight role of the board. It partially fulfills another aspiration of governance reformers.

Accountability and Executive Compensation. At least once every three years, a public company is required to submit to a shareholder vote approval of executive compensation (say on pay).⁵³ Shareholders are provided the ability to express disapproval of any golden parachute compensation to executives through a nonbinding vote. They must be informed of the relationship between executive compensation paid and the financial performance of the company. The company must report on the median of the annual total compensation of all employees and the chief executive officer’s compensation, including the ratio between the two. All members of the compensation committee of the board must be independent directors. The company must report on incentive compensation with commentary on whether it could lead to material financial loss to the company and whether the compensation is excessive.

Strengthening Corporate Governance. The SEC is permitted to issue rules and regulations that enable a shareholder to use a company’s proxy solicitation materials for the purpose of nominating individuals to membership on the board of directors. Previously, investors who wanted to replace directors had to bear the cost of mailing separate ballots and waging a campaign.

The SEC issued a new regulation providing for proxy access in August 2010. In July 2011, a federal appeals court threw out the regulations on grounds that the SEC did not adequately analyze the costs to U.S. companies of fighting in contested elections. It also said the agency failed to back up its claim the rule would improve shareholder value and board performance.⁵⁴ In the aftermath of this ruling, some shareholders are putting forth proxy access proposals of two types to companies: precatory and binding. Precatory proposals ask the board to take such action as may be necessary to allow proxy access, such as amending the bylaws, while binding proposals directly amend the company’s bylaws.⁵⁵

Dodd-Frank is clearly intended to increase board attentiveness to executive compensation practices, especially as they affect unwise risk-taking by senior executives and lead to excessive compensation based on short-term results. It also represents a win for certain governance reforms.

Good Governance Templates and Report Cards

Today, there are many corporate governance templates, sets of practices asserted to compose the elements of good governance. Institutional investors like TIAA-CREF and CalPERS propagate them to communicate their governance expectations to companies in which they invest and to guide their proxy voting. Others are used by ratings agencies such as S&P, Moody’s, and Fitch as part of their process for assessing company financial risk. Large, international audit firms do work in governance as a service to their clients. Some unions and religious orders are active in governance. They tend to have special interests reflecting the values of their members and the priorities of their organizations.

These organizations produce a tremendous amount of descriptive and explanatory material about their criteria and methods for evaluating corporate governance. Much is publicly available. An informed consumer of this information will recognize a good deal of overlap in assertions about what constitutes good governance. The templates of TIAA-CREF and CalPERS are representative.

TIAA-CREF

TIAA-CREF manages over $500 billion in investment assets on behalf of 3.9 million individual clients. In its statement on Corporate Governance for Portfolio Companies, TIAA-CREF says that its “views on corporate governance are founded on our conviction that good corporate governance should maintain the appropriate balance between the rights of shareholders—the owners of the corporations—and the needs of the board and management to direct and manage effectively the corporation’s affairs.” In its Summary of Proxy Voting Policies, TIAA-CREF says,

The Funds seek to use proxy voting as a tool to promote positive returns for long-term shareholders. We believe that companies that follow good corporate governance practices … are more likely to produce better returns than those companies that do not.

TIAA-CREF makes explicit its views about good governance and the basis for its proxy voting practices through a twenty-page, published policy statement on corporate governance comprising five sections:

• TIAA-CREF’s Corporate Governance Program

• Shareholder Rights and Responsibilities

• Corporate Governance Principles

• Environmental and Social Issues

• Proxy Voting Guidelines

Among the policies:

• TIAA-CREF urges fair treatment of all shareholders by companies in ways both financial and nonfinancial (e.g., clear communication and robust disclosure).

• The organization emphasizes the responsibility of shareholders as providers of capital to pay attention (hold the board accountable, monitor performance) and be constructively active (e.g., promote aligned compensation and demand the integrity of accounting statements).

• TIAA-CREF expects the board to represent the long-term interests of shareholders by overseeing strategy development and implementation, assuring financial integrity, developing compensation and succession planning policies, setting the ethical tone, and holding management accountable.

• Most directors should be independent, and all should be elected annually with a majority of votes cast. A director in an uncontested election who does not win a majority should submit his or her resignation to the board, which should promptly decide the matter and disclose its rationale. Shareholders should have legal and reasonable proxy access.

• With regard to board duties, directors should monitor and oversee management in areas of vital interest to shareholders, holders, directly and through its key committees (compensation, audit, nominating and governance); participate in developing the strategic plan; select and evaluate the CEO and plan succession; and develop an equity policy that determines the proportion of the company’s stock to be made available for compensation, including clear limits on the number of shares to be used for option and other equity grants.

• The board should be neither too large (for collegial discussion) nor too small (to ensure the requisite expertise). Executive sessions and board self-evaluation are expected. The chairman and CEO roles should be separated, or a lead independent director should be appointed.

• Board committees are to have charters and the power to hire independent advisors. They are to report to the full board. Each shareholder initiative is to be reviewed by the relevant committee as is the proposed management response.

• Executive compensation is to be carefully and thoughtfully designed to fit the circumstances of the company. It should be linked to metrics that drive long-term sustainable value. Factors to consider include a mix of cash and equity, a logical performance measurement cycle, and incenting performance but not excessive risk. Compensation should be “reasonable by prevailing industry standards” and “fair relative to pay practices throughout the company.” Caution is counseled with regard to compensation consultants, pay comparisons, and a proper mix of the formulaic and judgmental in performance evaluations and the terms of employment contracts.

• TIAA-CREF offers extensive guidelines for equity-based compensation and the Compensation Discussion and Analysis section of the proxy.

• TIAA-CREF identifies environmental and social issues with which it expects boards to be concerned. These include environment and health, human rights, diversity and nondiscrimination, philanthropy, corporate political influence, and product responsibility.

• TIAA-CREF describes its policies on a long list of proxy voting issues. These range from director elections and auditor ratification to animal welfare and predatory lending. In every area, the organization states its policy, indicating will generally support, will generally not support, or will consider on a case-by-case basis.

CalPERS

CalPERS is the California Public Employees Retirement System, which manages investments that pay for retirement and health benefits for 1.7 million beneficiaries. In mid-2013 it had over $250 billion in assets under management. On its Global Governance (subtitle: Investing with a Sustainable Framework) website, CalPERS states that, “We believe good governance leads to better performance. We seek corporate reform to protect our investments. The global governance team challenges companies and the status quo.”

Since the mid-1980s, CalPERS has been a pioneer in corporate governance activism. CalPERS’s statement on Global Principles of Accountable Corporate Governance addresses the question “What have we learned over the years?”

We have learned that (a) company managers want to perform well, in both an absolute sense and compared to their peers; (b) company managers want to adopt long-term strategies and visions but often do not feel their shareholders are patient enough; and (c) all companies—whether governed under a structure of full accountability or not—will inevitably experience both ascents and descents along the path of profitability.

We have also learned and firmly embrace the belief that good corporate governance—that is accountable corporate governance—means the difference between wallowing for long periods in the depths of the performance cycle and responding quickly to correct the corporate course.

CalPERS’s principles of accountable corporate governance guide its proxy voting and “provide a foundation for supporting the System’s corporate engagement and governance initiatives to achieve long-term sustainable risk adjusted investment returns.”

The document uses the term shareowner versus shareholder throughout “to reflect a view that equity ownership carries with it active responsibilities and is not merely passively ‘holding’ shares.”

CalPERS’s Global Principles are organized into four areas: Core, Domestic, International, and Emerging Markets Principles.

Core (i.e., universal) principles cover

• Optimizing shareowner return—governance should focus on optimizing the company’s operating performance, profitability, and return to shareowners

• Accountability—directors to shareowners and management to directors

• Transparency—operating, financial, and governance information readily transparent

• One-share/One-vote—all investors treated equitably

• Proxy Materials—written in a manner to enable shareowners to make informed voting decisions

• Code of Best Practice—to be issued by each capital market to promote transparency, avoidance of harmful labor practices, investor protection, and corporate social responsibility

• Long-term Vision—directors and management to have a vision that emphasizes sustained shareowner value

• Access to Director Nominations—by shareowners

CalPERS’s Domestic Principles of Accountable Governance apply to U.S. companies. They embrace the Council of Institutional Investors Corporate Governance Policies and cover seven areas. There is much overlap with TIAA-CREF’s proxy voting policies. Principles include:

• Board Independence and Leadership. Majority of independent directors, executive sessions, independent board chairs except in limited, explained circumstances, lead director otherwise, retiring CEO not to sit on board (definitely not on committees), independent committees.

• Board, Director and CEO Evaluation. Board talent assessment and diversity (broadly defined), expectations and annual evaluation of board, committees and directors, CEO performance criteria and regular evaluation, CEO and director succession plans.

• Executive and Director Compensation. For executive compensation, structure and components designed by board and disclosed to shareholders; mix of cash and equity including base salary and short-and long-term incentives linked to performance resulting in shareowner value creation; guidelines on timing and nature of performance metrics and hurdles; clawback policy; extensive guidance (dos and don’ts) on use of equity in compensation; severance agreements and retirement plans. For director compensation, cash and stock with equity ownership requirement.

• Integrity of Financial Reporting. Integrated reporting of financial, environmental, social, and governance performance; desirability of convergence to global accounting standards; guidelines on external auditor, audit committee, and audit disclosures.

• Risk Oversight. Policies, procedures, reporting, and decision-making to manage, evaluate and mitigate risk; be a “risk intelligent” company.

• Corporate Responsibility. Policies regarding human rights violations, environmental disclosure, sustainable corporate development, reincorporation and charitable and political contributions.

• Shareholder Rights. Majority voting, special meetings and written consent by shareowners, shareowner resolutions, no greenmail, poison pill approval by shareowners, annual election of directors, cumulative voting right in contested election of directors.

TIAA-CREF, CalPERS, and other institutional investors place high priority on shareholder value and a proper balance of authority between shareholders and boards and boards and management. They value incentive compensation and conservative compensation practices. Broader concerns including sustainability and corporate social responsibility are more recent entries.

Governance Ratings

Public companies are rated on their corporate governance practices by a handful of influential companies, including GMI Ratings, Glass Lewis & Co., and ISS. A younger director recently asked me, “How should I think about the governance ratings?”

I answered with an analogy. There is a lot of similarity between governance ratings and the business school and university ratings and rankings of which I am a veteran as a former b-school dean and university president. In both cases, I have been guided by the same principles:

1. Pay attention to them—they matter. Ratings affect perceptions of quality and can improve performance.

2. Make your goals substantive: quality governance with excellent results for companies, academic excellence for universities. When you succeed, you’ll do well enough in the ratings and rankings.

3. Think independently. Some of what constitutes best practice today will have enduring value, but some will be revised over time. Decide what applies to your situation and act on it.

GMI Ratings

GMI Ratings is “an independent provider of research and ratings on environmental, social and governance and accounting-related risks affecting the performance of public companies.”⁵⁶ GMI Ratings was formed in 2010 through the merger of three firms: The Corporate Library, formed in 1999, which was a pioneer in corporate governance ratings; Governance Metrics International, founded in 2000, which developed in-depth coverage of governance risk profiles of 4,200 U.S. and international companies; and Audit Integrity, founded in 2002, which developed accounting and governance risk (AGR) ratings for 18,000 public companies worldwide.

GMI calls its evaluations of companies ESG (environmental, social, and governance) ratings. It generates ESG ratings for more than 6,000 companies worldwide as well as AGR ratings for approximately 18,000 companies. GMI asserts that its ESG ratings “help investors assess the sustainable investment value of corporations.”

“The ESG Ratings model is based on a carefully crafted list of over 100 ESG KeyMetrics, organized into six individual scoring components”⁵⁷:

• Environmental key metrics produce an environmental rating

• Social key metrics produce a social rating

• Board, pay, and ownership and control key metrics produce, respectively, a board rating, pay rating, and ownership and control rating. These three ratings produce a governance rating.

• The environmental, social, and governance ratings produce an ESG rating for the company

All metrics are derived from publicly available information about the company. “As of February 2012 there are 120 key metrics used to score each company, but fewer than half of those account for nearly 90% of the total possible scoring for all components.” Governance-related metrics account for 72 of the 120 Key Metrics used for scoring.

For each key metric, GMI Ratings uses pass/fail evaluation. Each failed metric is indicated in the GMI analyst research platform by a red or yellow flag to indicate the degree of impact on the company’s rating. Individual company scores are assigned on the basis of these key metric flags, as weighted then converted to percentile ranks from 1 (worst) to 100 (best). ESG ratings are expressed as letter grades:

Percentile	ESG Rating
96–100	A (Superior)
76–95	B (Above Average)
26–75	C (Average)
6–25	D (Below Average)
1–5	F (Failing)

GMI Rankings makes qualified but strong assertions about the value of its ratings for investors, stating, “ESG data and analytics can be valuable tools for both the long and short side of an investment strategy.” Examples cited include:

• “BP’s 2010 Deepwater Horizon explosion and oil spill came after GMI Ratings had warned of the company’s negligence in safety and environmental issues.”

• “Pre-hacking scandal, GMI Ratings rated News Corp poorly for the Murdochs’ disproportionate influence on the board and related party transactions with the family.”

• “GMI Ratings identified weak boards at Lehman Brothers, AIG, Countrywide and General Motors before the 2008 financial crisis.”

These are intriguing assertions, but for anyone trained in research methods, they invite a question about the frequency of false positives in GMI’s ratings (i.e., the number of times a weak rating is not followed by a significant corporate problem).

Glass, Lewis & Co.

GL is an indirect, wholly owned subsidiary of Ontario Teachers’ Pension Fund board. Glass Lewis and ISS are the dominant proxy advisory services to institutional investors.

In its 2013 proxy paper on EQR, GL lists all proxy voting issues then notes, without comment, the board’s recommendation and GL’s. The paper provides descriptive information about the company and a comparison of EQR and several competitor/peer companies on key financial measures. A section follows on each proxy voting issue. For EQR in 2013, there were four: Election of Trustees, Ratification of Auditor, Advisory Vote on Executive Compensation, and Shareholder Proposal Regarding Sustainability Report. GL concurred with the board’s recommendations on all four issues.

On trustee elections, GL compares the NYSE and NASDAQ listing standards on director independence, committees, executive sessions, and so on and notes that GL has stricter standards for favorable proxy voting recommendations. EQR meets these higher standards, which contributed to Glass Lewis’s favorable recommendation on trustee elections.

GL examined the fees EQR paid Ernst & Young for audit (90 percent of total fees) versus non-audit services (10 percent), concluded they were reasonable, and recommended ratification of E&Y’s appointment.

GL did extensive analysis of EQR’s executive compensation and provided substantial commentary about what they liked (alignment of pay with performance) and didn’t like (the structure of the incentive compensation program—too discretionary in their view). They recommended a favorable vote.

The fourth voting item in 2013 was a shareholder proposal from the Office of the Comptroller of the City of New York. It represented a number of public employee pension funds and requested that the board “prepare and make available to shareholders by September 2013 a sustainability report” addressing the company’s efforts involving energy, water, waste, and other environmental impacts. The board recommended against it on the grounds that the company was committed to sustainability, had appropriate policies and practices in place, and provided sufficient public disclosure. GL concurred.

ISS

ISS, originally Institutional Shareholder Services, has been owned by three companies over the last seven years. When corporate directors think of governance evaluation, ratings, and rankings, they usually think of ISS because of its pioneering role in the field. The ISS methodology for evaluating a company’s governance practices that was introduced in 2013 is called QuickScore. It replaced the Governance Risk Indicators (GRId) method that was in place for three years. QuickScore ranks companies in deciles within each of ISS’s four pillars—Audit, Board Structure, Compensation, and Shareholder Rights—and provides an overall governance rating.

What does an ISS governance scorecard look like? I annually review ISS’s report to institutional investors on EQR’s governance along with their recommendations on proxy voting.

ISS’s 2013 report on EQR begins with a table recommending favorable votes for all of EQR’s eleven trustees, ratification of Ernst and Young as the company’s auditor, a favorable advisory vote on Named Executive Officers’ Compensation and a favorable vote on a shareholder resolution that would have required the company to produce a sustainability report. These recommendations concurred with the board of trustees’ recommendations with the exception of the final item.

The report then presents a Financial Highlights section including a comparison of EQR’s financial performance (Total Shareholder Return or TSR) over 1-, 3-, and 5-year periods of 2.4 percent, 22.46 percent, and 13.90 percent, compared with the GICS 4040⁵⁸

TSR of 20.37 percent, 15.00 percent, and 4.86 percent and the S&P 500 TSR of 16.00 percent, 10.87 percent, and 1.66 percent over the same periods.

This section also includes a five-year history of EQR’s stock price compared to an index of real estate investment trusts and the S&P as well as five years of financial and operating performance on measures like profit margin, return on equity and assets, price earnings ratio, and TSR in comparison with five other real estate companies selected by ISS.

The report provides a detailed and informative report on EQR’s Corporate Governance Profile. The section includes a Board and Committee Summary including these topics:

Trustee independence	82% are
Separate chair and CEO	yes
Lead independent trustee	yes
Voting standard	majority
Resignation policy	yes
Number of trustee-owned shares	15,043,000 / 3.3% of shares
Percentage of trustees with stock	100
Attendance <75%	none
Trustees on excessive # of boards	none
Average age	59
Average tenure	10 years
% of women on board	18

Details are provided on each trustee’s independence, affiliations, employment, board compensation, and EQR equity ownership.

The report presents a compensation profile offering an executive pay overview, option valuation assumptions, CEO pay multiples, CEO pay details, and dilution and burn rate under the company’s equity compensation programs.

Next in the report is the company’s ISS QuickScore in the four pillars noted above: Board, Compensation, Shareholder Rights, and Audit. Each pillar comprises three to seven subcategories that may be green-starred (indicating a subcategory has been awarded the highest number of points) or red-flagged (indicating points at the bottom of the range). What follows is the longest section of the report: recommendations on each of the 2013 proxy voting items with supporting analysis. Some sections are extensive, notably the Executive Compensation Analysis, which among other things examines pay related to performance and CEO pay magnitude.

Over the years, I have found ISS’s descriptive and analytical work informative and useful. I have at times disagreed with their GRId and QuickScore ratings of EQR, finding them formulaic versus considered. Fortunately, ISS’s voting recommendations often appear to reflect considerations beyond what the ratings alone might indicate.

Evaluating Good Governance

Practices that make up good governance orthodoxy have emerged over the last thirty years from the shareholder value movement, federal legislation, and governance ratings. To what extent do they contribute to great governance? Corporate Governance Matters, a book I use in my graduate governance course and to which I referred in the previous chapter, reviews research on the relationship between governance practices and corporate financial performance.

Shareholder-Friendly Practices

Corporate Governance Matters (CGM) begins with an examination of the relationship between shareholder friendly practices and corporate performance:

As we will see throughout this book, many studies link measures of corporate governance with firm operating and stock price performance. Perhaps the most widely cited study was done by Gompers, Ishii, and Metrick.⁵⁹ They found that companies that employ “shareholder-friendly” governance features significantly outperform companies that employ “shareholder[-]unfriendly” governance features.⁶⁰

Gompers, Ishii, and Metrick used 24 governance rules to construct a governance index as a proxy for the level of shareholder rights at about 1,500 large firms during the 1990s. They found that an investment strategy that bought firms in the lowest decile of the index (strongest rights) and sold firms in the highest decile (weakest rights) would have earned abnormal returns of 8.5 percent per year between 1990 and 1999. They found that firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and made fewer corporate acquisitions.

These are eye-opening findings for shareholders and boards. Using a continuum between the extremes of “tilts toward [shareholder] democracy” to “tilts toward [management] dictatorship,” the authors conclude that governance practices that favor management (including board) entrenchment are related to lower corporate performance and shareholder value. They divide these shareholder-unfriendly practices into five groups:

• Delay—tactics for delaying hostile bidders (e.g., classified board)

• Voting—voting rights (e.g., unequal shareholder voting rights or supermajority requirements to approve a sale or merger)

• Protection—director/officer protection (e.g., golden parachutes)

• Other—various takeover defenses (e.g., poison pills)

• State—state laws (e.g., business combination law, fair price law)

Most of the twenty-five variables across these five categories are anti-takeover measures, that is, they make it more difficult to acquire the company.

The authors find that boards and management that are more insulated from the market for corporate control oversee companies with inferior financial performance and shareholder returns compared to boards and managements that are less insulated. The difference in excess returns to shareholders of more democratic versus dictatorship portfolios was significant: 23.3 percent versus 14.1 percent between 1990 and 1999.

Good science requires the ability to replicate studies and generate similar findings. Given the importance of the Gompers, Ishii, and Metrick study, there have been a number of efforts to confirm their findings. At least one study⁶¹ appears to, but several do not. While it is intuitively appealing that a lower level of anti-takeover practices will result in better returns to shareholders, and some studies support this conclusion, not all do. Larcker and Tayan conclude, “Currently, researchers have not produced a reliable litmus test that measures overall governance quality.”⁶²

Nonetheless, the shareholder rights movement resulted in most boards dismantling most takeover protections. This makes sense. Boards represent shareholders. If in doubt, the tilt should be toward them. Today the burden of proof is clearly on the board and management as to why a particular practice that might reduce the company’s exposure to the market for corporate control is in the best interest of shareholders.

Board Structure and Composition

Much good governance orthodoxy focuses on board attributes that are structural and easily measured. In my experience, directors are often skeptical about whether these attributes really affect corporate performance in a robustly positive way.

Is separating the chairman and CEO roles better than a combined chairman and CEO? Does having a lead independent director make a difference? What about more outside, independent directors? Does the presence on a board of particular kinds of professionals (e.g., financial experts) matter? Do company policies restricting the number of boards on which a director can serve make sense? What about board size: are smaller boards better than larger? What about diversity of directors?

CGM reviews research on the relationship between these attributes of boards and company performance and concludes, “A casual reading of this information indicates that very modest evidence supports the adoption of many of these attributes.”⁶³

I would emphasize very modest at least as much as supports. Also, the type of research on which the findings are based is not capable of establishing with certainty a causal relationship between the variables studied and corporate performance, further weakening the very modest evidence that supports adoption of these attributes.

CGM summarizes research findings on the relationship between board structure and corporate financial performance in the following table:

Summary of [Corporate] Performance Effect for Selected Board Structural Characteristics⁶⁴

Board Structure Attribute	Findings from Research
Independent chairman	No evidence
Lead independent director	Modest evidence
Number of outside directors	Mixed evidence
Independent directors	No evidence
Independence of committees	Evidence for audit committees primarily
Representation of:
Bankers	Negative evidence
Financial experts	Positive for accounting professionals only
Politically connected directors	No evidence
Employees	Modest evidence
Busy boards	Negative evidence
Interlocked boards	Evidence for performance, against monitoring
Board size	Evidence for small boards (in simple companies) and larger boards (in complex companies)
Diversity	Mixed evidence
Female directors	Mixed evidence

In other words:

• There is no evidence that having an independent chairman (versus combined chairman and CEO) is related to better corporate performance.

• There is modest evidence that having a lead independent director is related to better corporate performance.

• Having directors who serve on too many boards (busy boards) is related to worse corporate performance.

• Most variables have a mixed or ambiguous relationship with corporate performance.

Given the highly equivocal research findings about these governance attributes, following are some lessons from experience—my own and that of other veteran directors with whom I have conferred—about attributes I deem most important.

Independent Chairman v. Chairman and CEO. This choice is highly situational and person-dependent for a board. Reformers who favor a universal requirement for independent chairmen view it as an always-desirable antidote to the problem of imperial CEOs. For example, David Nadler, in a thoughtful commentary on the subject, concludes,

Today, given the evolution of governance in this country and in the interest of sustaining governance of the highest quality, I recommend that boards formally designate a nonexecutive chairman. In my opinion, other things being equal, the nonexecutive chair should be regarded as the superior structure because it provides more clarity of board leadership and offers more advantages.⁶⁵

This is overkill. A board should be able to choose whether to separate or combine the roles, depending on the company’s leadership needs and the people involved.

For example, I have no doubt that Equity Residential is well served by Sam Zell serving as chairman, as he has for twenty years, with another executive—currently David Neithercut—serving as CEO. Zell is a visionary in real estate. Part of his value to EQR is the broad overview and network of relationships he develops through involvement in multiple companies, deals, and financing arrangements. Zell’s focus is the world and EQR’s place in it. Neithercut’s is on the management of EQR’s business—its properties and residents, strategy, people, operations, and financing. Zell and Neithercut are highly complementary and have the great chemistry required for an effective partnership between chairman and CEO.

By contrast, it is clear to me that in some situations, a single leader serving as chairman and CEO is more effective.

As described earlier, in 1999 Tim Solso became chairman and CEO of Cummins, Inc. At the time, Cummins was soon in the throes of recession after two decades of relentless change and improvement but struggling profitability.

The story of Cummins’ survival through the recession, followed by a decade of growth and profitability, is extraordinary.⁶⁶ In crisis, Cummins needed strong, unambiguous leadership. Its tradition was to have a single chairman and CEO. Tim Solso made big bets and, with a leadership team led by his long-time colleague and great operating executive, Joe Loughrey, executed them brilliantly. I have no doubt that the situation required a chairman and CEO, and fortunately for Cummins, Solso was right for the job. It would have been regrettable for the Cummins board to have to contort the leadership arrangement with a separate chairman to meet a universal standard of structure at the most senior level.

Lead Independent Director and Executive Sessions. I served on boards for many years when the concept of a lead independent director did not exist. Creation of this role has been a very positive development. On two boards where I serve, we have both a non-CEO chairman and a lead independent director. It’s that valuable.

The lead director chairs executive sessions of the independent directors. Executive sessions used to be rare and nearly always signaled crisis. Now they are standard practice and extremely valuable. The lead director works with the chairman and CEO or chairman/CEO to ensure that matters of concern to independent directors are on the agenda. The lead director is a focal point for both independent directors and management who can confer with him or her on any matter of concern. I give the development of lead directors as well as frequent executive sessions an A+ in contributing to good governance.

Independent Directors, Committees, Busy Boards, and Board Size. Public company boards now, by and large, comprise exclusively independent directors with just one insider: the CEO. Overall, this is a good thing. Shareholders have a clear set of interests, and executives can have incompatible interests like high compensation unrelated to performance. Even though some non-independent directors in the past provided very valuable service (e.g., members of law firms and investment banks who knew the company well), their conflict of interest was problematic.

Independent directors compose the full membership of public company audit committees and, in most cases, compensation and governance committees. This is a good because it is in the work of these committees that the interests of shareholders—not management—must be paramount. CGM’s report that there is a positive relationship between financial experts on the board and corporate performance should be no surprise. Financial expertise on at least the audit committee is absolutely essential to effective monitoring of financial statements and the system of internal control on which their quality depends.

Research confirms that directors should not serve on too many boards. It’s a matter of attention. In electing directors, shareholders are buying a share of each director’s time, focus, experience, and judgment. It would be very difficult for the CEO of a major company, which is a 24/7/365 job, to be a director of more than one or two companies beside her own. Calendar conflicts alone will create attendance problems, and attendance is the cornerstone of attention.

Board size is an important matter. I served on a large public company board with fifteen members at one time and on another with six. The former was too large for full involvement of all directors. The latter was too small for a proper range of experience and opinions and to get committee work done well. In my experience, this piece of governance orthodoxy—that boards should have from nine to twelve directors—is right. Even here, though, flexibility is essential. For example, a board may temporarily expand in size to bring on new directors in anticipation of the departure of long-serving members of the board, much like having two runners in a lane during the baton pass of a relay race.

Board Diversity. CGM reports that ethnic and gender diversity—that is, the presence of minority and women directors on boards—has a mixed relationship with corporate performance. Some studies show a positive effect. For example, Credit Suisse Research Institute reported that shares of companies with a market capitalization of more than $10 billion and with women board members outperformed comparable businesses with all-male boards by 26 percent worldwide over a period of six years.⁶⁷ A study by Catalyst⁶⁸ came to similar conclusions. However, CGM observes that “the study did not include control variables, so it likely omits important explanatory factors, such as industry, company size, or capital structure. More rigorous studies find no relationship between female board representation and performance.”

Most corporate boards today are largely made up of white, male directors. Women and minorities make up about 15 percent and 7 percent, respectively, of large company boards. In a forward-looking company, diversity has value for two reasons. One is talent. Women and minorities have been coming up fast in the American workplace and are now better represented than ever, including at the most senior level. The same is true of international employees in global companies. Boards need to put out a Welcome! sign to these cohorts as both employees and directors.

The other reason is fairness. Board service is a privilege and responsibility. A fraction of the population shouldn’t have a corner on privilege or be disproportionately saddled with responsibility. America works best when doors are open and selection is based on merit. We can look back and appreciate absurdities like private university medical schools admitting few if any Jews. Some of the love of the University of Michigan and University of Illinois I found among Jewish alumni is because these great public universities welcomed them when top privates didn’t. The same is true of the color barrier in baseball, de facto quotas on African-Americans in the NBA in the 1950s, and so on. Boards should reflect the impressive educational and professional achievements of women and minorities. This is a development in which no board should want to be last.

Audit Committee Practices

Substantial evidence from academic studies suggests that management has the ability and, at times, willingness to manipulate reported financial results. CGM cites a study by Burgstahler and Dichev⁶⁹ which found that

[c]ompanies are much less likely to report a small decrease in earnings than a small increase in earnings, even though statistically the distribution between the two should be equal. This suggests that management might manipulate or overstate results to meet targets. Other studies support this conclusion.⁷⁰

Management lives in a pressurized environment of stretch earnings targets and financial incentives to achieve them. A diligent audit committee of independent directors with one or more financial experts is essential. In partnership with the independent and internal auditors, the committee ensures that management’s use of discretion in accounting estimates and judgments does not impair the accuracy of financial statements.

Executive Compensation Practices

The board is responsible for determining how and how much to pay executives. It is one of the big things for the board to get right. If total compensation is too high, shareholders’ resources are wasted. If too low, the company will not be able to attract and retain needed leadership talent. If the compensation mix is wrong, executives’ incentives are distorted and performance can suffer. An important question, therefore, is whether there is evidence of a connection between the quality of governance and executive pay practices and results.

There is, in fact, some evidence that stronger governance results in more conservative executive compensation while weaker governance results in excessive compensation.

One study investigated the relationship between corporate governance and CEO pay levels and the extent to which the higher pay found in firms using compensation consultants is related to governance differences.⁷¹ Weaker versus stronger governance was found to explain much of the higher pay in clients of compensation consultants. The authors measured governance strength versus weakness in over two thousand public companies with eight variables. Five were assumed to relate negatively to stronger governance:

• Number of directors on the board

• Percentage of inside directors

• Percentage of directors sixty-nine years of age or older

• Percentage of directors who are busy (i.e., serve on at least two boards)

• Percentage of outside directors appointed since the current CEO’s term began

In other words, a larger number of directors and higher percentages of directors in the other four categories indicate weaker governance. By contrast, a smaller number of directors and lower percentages of directors in these categories signify stronger governance, as does a sixth variable: the presence of an outside chairman. Two additional variables from the company’s charter are also included as indicators of governance strength: annual versus staggered director elections and a single versus dual class of shares.

Another study came to a similar conclusion: weak governance systems are correlated with excessive compensation.⁷² The authors found an inverse relationship between the quality of oversight that a board provides and the level of compensation within the firm. In this case,

Companies with weak board oversight are defined as those with dual chairman/CEO, boards with a larger number of “gray” directors (directors who are not executives of the company but who have other financial connections to the company or management as a result of serving as a lawyer, banker, consultant, or other provider of services), boards on which a large percentage of outside directors are appointed by the CEO, boards with a large percentage of old directors, and boards with a large percentage of busy directors.⁷³

These findings square with my experience. A strong compensation committee of truly independent directors and a strong board in total are essential to making executive compensation competitive but not excessive and ensuring that pay is tied closely to performance.

How Good Is Good Governance?

In my experience, there are five good governance practices that are clearly valuable and should be embraced by public company directors:

• a strong board comprising primarily independent directors with the time and commitment to be attentive and diligent

• shareholder-friendly policies that reduce board entrenchment

• appointment of an independent lead director and regular executive sessions of independent directors

• a strong audit committee of independent directors to ensure quality financial reporting

• compensation designed by a committee of independent directors that ties pay to company financial performance and total shareholder return over a sustained period

Other practices, like board size and whether to combine or separate the chairman and CEO positions, are best left to the discretion of the board.

Directors know that a “check the boxes” mentality does not guarantee great governance. They question formulaic methods of evaluating and rating governance and seem to understand intuitively what careful scholars like Larcker and Tayan conclude:

[R]esearchers have not produced a reliable litmus test that measures overall governance quality …⁷⁴ and we have seen that most structural features of the board have little or no relation to governance quality. We have seen that more auditor restrictions have no impact on financial statement quality, that commercial and academic governance ratings systems largely lack predictive ability, and that regulatory requirements for many mandated governance practices have neutral or negative impacts on corporate outcomes and shareholder value.⁷⁵

The implications are clear. Directors should embrace practices such as the five above that are, in my experience, demonstrably valuable. They are entitled to skepticism of strongly asserted but unsupported claims about good governance practices. Perhaps they would be wise to follow the lead of Myron Steele, Chief Justice of the Delaware Supreme Court, who said,

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.⁷⁶

Conclusion

Some good governance practices should be embraced while others remain under scrutiny. Still, public company governance in America is better today than in the past for three reasons.

First, boards are far more attentive to shareholder value. This is as it should be. Shareholders are the legal owners, risk takers, and residual claimants of the company after everyone else is paid. They elect the board and rightly expect directors to represent their interests to management while being attentive to related matters as reflected in the Pyramid of Purpose in Chapter 1.

Second, old-style CEO dominance is rare. Most boards today have a healthy and actively engaged relationship with the CEO. Most directors are independent and have been recruited and selected by an independent governance committee. Executive sessions of the independent directors have changed the balance of power with the CEO.

Third, boards and their governance practices are in a fishbowl. While I don’t agree with every metric used by proxy advisory services and others who evaluate governance, the evaluation process has value. In the same way that student evaluations make for more attentive teachers, evaluation of governance contributes to directors’ attention to their duties and care in their decisions.

The lessons of experience count in governance. In the next chapter, experienced board chairs, CEOs, and directors offer their thoughts on great governance.