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Last August, Richard Breeden, the court-appointed monitor in the WorldCom Inc. bankruptcy, prescribed far-reaching corporate governance changes for the formerly scandal-ridden telecom. WorldCom, now doing business as MCI, has already adopted all 78 of the recommendations in Breeden’s report, “Restoring Trust.” Most recently, the company’s board of directors named a non-executive chairman, former U.S. Attorney General Nicholas Katzenbach. But are Breeden’s reforms for MCI the right remedy for other, less errant U.S. companies that are undergoing their own corporate governance checkups? More like a dangerous overdose of quack medicine, say three leading corporate attorneys. When Marty Lipton, a founding partner at New York’s Wachtell, Lipton, Rosen & Katz and special counsel to the New York Stock Exchange Inc. Committee on Corporate Accountability and Listing Standards; Bart Schwartz, general counsel of the MONY Group Inc. and co-author of Corporate Governance: Law and Practice; and Robert Bostrom, managing partner of the New York office of Chicago’s Winston & Strawn, were asked to join a roundtable on Breeden’s WorldCom report, they had plenty to say. (Breeden did not respond to an invitation to participate.) Breeden’s proposals about board composition — including specific requirements for the expertise and experience that directors should bring into the boardroom — came in for especially harsh fire. During an hour-long discussion last December with Emily Barker, the editor in chief of D&O Advisor, and Robin Sparkman, the editor in chief of Corporate Counsel, both sibling publications of Legal Times, the three experts made the case that sometimes the cure for corporate governance ills can be worse than the disease. Emily Barker: How does the Breeden report compare to other standards of corporate governance, such as the new stock exchange listing requirements? Marty Lipton: This report is a compendium of just about every corporate governance suggestion that has ever been made, with the rejection of virtually none of the prior suggestions. And it goes to what I would call the extreme of imposed governance without any flexibility. Governance for the sake of governance, not for the sake of accomplishing an objective. And it sets a pattern that basically pushes a board of directors into more concern with governance and compliance with governance guidelines or rules than with attention to the business of the company. And that’s a serious vice. . . . There comes a point where one has to recognize that governance and indeed boards of directors as such are not capable of preventing fraud, and not capable of preventing management perfidy. At the very best, they are safety valves when a problem develops, or problems have manifested themselves over a period of time to the point where a board of directors should see them and should take action to deal with them. And the idea that a rigid set of requirements will improve the operations, the functioning, the profitability of American business is bizarre and should be rejected. Not just in connection with this WorldCom report, but in connection with all of the corporate governance recommendations. Indeed, just about every one of these proposals was considered by the New York Stock Exchange corporate governance committee, which rejected a good number of the ones that are in this report, and I think quite properly so. Robert Bostrom: To impose this level of requirement in a check-the-box kind of approach to corporate governance really pushes the board . . . well beyond oversight, and begins to interfere with the ability of management to run the day-to-day business of a company. . . . I’d rather see more emphasis on culture and tone at the top and people focusing on issues, as opposed to this very rigid check-the-box approach, which really sets up a blueprint for plaintiffs lawyers. Lipton: Do you think anybody believes that these procedures would have stopped [former WorldCom CEO] Bernie Ebbers from doing what he did? Bostrom: No. Bart Schwartz: Well, as this report points out and as indeed was true in the case of Enron as well, both WorldCom and Enron in some ways had exemplary corporate governance structures in place, at least in form. . . . But in neither case, obviously, did it stop massive fraud and abuse. Bostrom: Also the shareholder focus of these proposals, the electronic town hall approach [as in, for instance, soliciting board nominations from shareholders over the Internet] — not that shareholders shouldn’t have a voice in what’s happening at a company, but to convert it to a democratic town-hall kind of approach — really I think begins to hamstring the ability of management to run a company. Schwartz: And shareholder activism . . . is sort of rigidified and codified in the requirements, which in many cases are charter requirements, which cannot be changed without a vote of the shareholders. So it’s an extreme. Lipton: I think what Breeden overlooks and what the SEC proposal on shareholder access [which would allow shareholders to nominate their own board candidates on the company's proxy] overlooks is the difficulty of obtaining directors of major public companies. Fewer and fewer companies today are willing to see their senior officers, particularly the CEO, serve on more than one outside board. So the pool of available directors for major companies has shrunk quite dramatically. It’s not liability that directors are concerned about, it’s their reputation that they’re concerned about. And very few people want to subject themselves to the possibility of being targeted for elimination from a board, whether it’s by means of a withhold-the-vote campaign [by shareholder activists] or by means of this direct election contest that’s proposed in the SEC shareholder access proposal, or in Mr. Breeden’s recommendations. Bostrom: One other interesting element . . . is this requirement that . . . a majority of the board have at least three years of service on a large public company board. And when you have a declining population of directors, to have that kind of requirement there further intensifies the difficulty in getting good directors. And, secondly, I think to the extent that you want to get new blood into the process, you want to get directors who . . . maybe reflect the new environment going forward — [the Breeden requirement], in effect, limits the [amount] of new blood you can add to the board. Barker: What about the recommendation that all of the directors, except of course for the CEO, be independent? Lipton: Well, the [New York] Stock Exchange committee debated the issue extensively, not with respect to all but the CEO . . . but whether a majority of the directors [should] be independent or a substantial majority of the directors [should] be independent. And that was very, very carefully considered. And the committee decided that a majority was all that was warranted. There’s a continuing debate about the efficacy of most of the directors being independent. And I think there is no evidence whatsoever that independent directors improve either the governance or the performance of corporations. Indeed, I personally believe that the most important thing for a board of directors is to understand the business of the company, and that it is critical for people who do understand the business to serve actually as directors. Obviously, a board can invite the operating people into the boardroom to advise the board. But [my] experience is that those become presentations to the board and don’t lead to the kind of dialogue that’s necessary for a board to carefully weigh alternatives. . . . Fifty years ago, your typical board had two or three independent directors, and the balance of the board consisted of the senior officers of the company, the investment banker, the chairman of the board of the local bank, and usually the senior partner of the law firm that represented the company. Each of those people was intimately familiar with the business of the company, and each had a strong interest in the long-term success of the company. . . . I for one think those companies were better managed than many of the companies today with largely independent boards. There’s no study that I’m aware of that demonstrates that companies with independent boards are better managed or more compliant with regulation than companies that do not have independent boards. Robin Sparkman: Is there a worst-case scenario in having a fully independent board, from what you’re saying? Because they wouldn’t know enough about the company? Lipton: I think that the Breeden board with . . . all independent directors may well exacerbate the imperial CEO problem rather than alleviate it. Because what you have is one person who understands the business and 10 people who have no idea what the business is all about. . . . Probably the single biggest vice of this report is the composition of the board of directors. . . . First, you mandate the independence of the directors and the diversity of experience of the directors. Then you mandate an audit committee with [independent directors who already have three years of experience serving on the audit committee of another public company, or who possess equivalent expertise]. Then you mandate a compensation committee and a nominating governance committee [also composed of independent directors]. Bostrom: And now the risk management committee as well. Lipton: I don’t know where you get the directors from. . . . Anyone who has any big-company experience takes one look at this and says, “It’s just not workable.” Schwartz: Which, again, is why it cannot be a blueprint for other companies generally. But I have a slightly different perspective on independence. I think this report goes too far, and certainly the requirement that there be only one management director is not something that I would support for any company. . . . If you have three or four insiders on a board of 12, 13, 14, 15, I don’t think it’s a problem. I do think that there is increasing emphasis on the role of the independent directors. . . . You can see that in Vice Chancellor [Leo] Strine’s analysis in a very influential article he published [in 2002] in The Business Lawyer called “Derivative Impact.” And now you can see it coming out in Delaware case law, especially in the Oracle case. [Editor's Note: In In re Oracle Corp. Derivative Litigation, Vice Chancellor Strine found that the independence of two Oracle Corp. directors was compromised because of philanthropic ties between Oracle and the university where both directors were professors.] That’s certainly the way that the law is going. I think that’s the way policy is going. Bostrom: I’m probably a little closer to Bart than to Marty on this. . . . Marty’s been at the high-powered [board meetings] where there’s a big, important issue, [and] I’ve sat through, as Bart has, a lot of more mundane, routine board meetings. And you do see the subtle pressure for the senior executives who are members of the board to sort of nod and go along with the CEO. It’s just intrinsically part of the process. You’re not going to stand up in front of 10 or 11 outside people and challenge and confront your CEO. It’s just not going to happen. It may happen outside of the boardroom, but not in the boardroom. Barker: Breeden talks about director compensation, raising it in terms of cash, but also basically ruling out all forms of equity compensation, such as stock options, restricted stock for directors. I’m wondering what you all think of that. Lipton: It depends on the fad of the moment. Equity compensation for directors was something that was urged by shareholder activists and institutional investors. Most companies responded by saying, “OK, we’ll align the directors’ interest with that of shareholders by giving them stock options or restrictive stock” and so on. Then all of a sudden the fad turned to be, no, having a stock interest, an equity interest in the company, induces them to keep their eyes closed to management cooking the books in order to get the stock up, because they have this conflicting interest in getting the stock up. It’s all nonsense. . . . Most of these people, for $150,000 a year [the annual director compensation recommended by Breeden], are going to act as they’re supposed to act. They’re not going to close their eyes or participate in corporate misdeeds. And it doesn’t matter whether the $150,000 is in stock, or stock options, or cash, or a combination of it. Schwartz: One of the provisions of the Breeden report is that it specified that the directors shall not receive any equity, but recommended an annual retainer of $150,000, and a requirement that directors reinvest [a quarter of that amount] in the company stock. Well, there’s no difference whatsoever between giving somebody $150,000 and requiring him or her to invest $50,000 of it in the company stock, on the one hand, and giving somebody $100,000 and $50,000 of restricted stock, on the other hand. Bostrom: The interesting point the report makes [here], though, is the transparency issue. That everyone understands $150,000 in cash is $150,000. But if you’re awarding restricted stock, stock options, etc., it’s more difficult for the shareholder to understand how much compensation is being given to the director. I’m not so sure I agree with that, but I’ve heard the point made. But then you could argue that you should never give any executive anything but cash compensation because it becomes extremely difficult to evaluate on a cash basis what an executive’s getting, with the wide array of calculations, and formulas, etc., that go into determining the cash value of stock awards. Barker: In fact, this report prescribes a five-year moratorium on giving any stock options to executives. Lipton: It’s a little difficult to recruit executives within the confines of this report. I mean, it’s one thing to say, “You can’t do this, you can’t do that, you can’t do the other thing.” But then you want to go out to recruit a key executive, and that executive says, “Well, this is what I have at my present employer. And these other three companies are offering me this. And you tell me that your charter has been amended, so you can’t match these. I have no interest in working for you.” Sparkman: We have torn apart Mr. Breeden’s hard work here. Just pick out one thing that you do like, that you think is a good model, from the report. Schwartz: I think the idea of greater emphasis on disclosure of cash flows, rather than GAAP accounting, which is subject to manipulation in the most extreme case and inadvertent distortion in other cases by things like reserves and amortization of intangibles — I think that’s a good idea. . . . But it’s really something that the policy-makers need to think about. . . . I don’t think it’s the sort of thing that companies can modify on their own. Lipton: As I said before, this embraces all of the proposals that have ever been made. Half of the proposals are just fine — or at least the concepts underlying half of them are just fine. The unfortunate thing is, it goes too far, and then locks them in through a charter amendment. Bostrom: I’d agree with Bart — the transparency [requirement for cash flow] is critical. I think another one, which is much smaller but nonetheless very important, is the focus on an ethics officer, reporting lines for the ethics officer, and how that’s going to play out in the organization. . . . Getting to the “tone at the top,” the culture issue, having an ethics officer with an established function within the organization [and] appropriate reporting lines helps to send a message to the employees — not just the senior executives, but the employees — that the company focuses on these issues. Emily Barker is editor in chief of the American Lawyer Media publication D&O Advisor, where this article first appeared. Robin Sparkman is the editor in chief of ALM magazine Corporate Counsel.

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