if the board is supposed to monitor a company's management on its stakeholders behalf, you might think that stakeholders should be empowered to have a strong say in determining who a firm's board members are. In reality, however, stakeholders often have only a symbolic voice in director elections. Processes for director selection very considerably between countries and companies. But in a typical firm, the board itself puts together the slate of new director candidates each year, with little or no input from shareholders or other stakeholders. This is typically a task that's assigned to the board's nomination committee, and often with heavy input from the CEO, him or herself. The number of directors that the nomination committee puts forward as candidates will virtually always match the number of open board seats. This means that the directors in the company's slate do not run in contested elections. The most common justification for this is that the best candidates out there might be less likely to serve if they were worried about the potential damage to their pride and reputation if they lost the election. So asking someone if they're willing to take a seat on your board is a very different conversation than asking them if they want to run for a seat on your board. Contested director elections are rare and are normally only seen in the context of a takeover battle when a hostile bidder is attempting to take over a board. It's possible for shareholders to run a vying slate of directors. This is something called a short slate in corporate governance, that competes with the nomination committee's proposed directors outside of the takeover context. But these short slate challenges are extremely rare because they require often prohibitively costly shareholder outreach and advertising campaigns to support. And what's more, contested board elections are very difficult to win, so the costs of such a campaign are unlikely to pay off. For example, one 2006 study examining data for the decade ending in 2005 found that the short slate elections only occurred around 14 times a year in the United States, and usually only occurred in smaller companies, and they were most often unsuccessful. For all of these reasons, board elections are almost always uncontested and the slate of directors nominated by the board runs unopposed. Once the board has put together its slate of director nominees, the list is presented to shareholders for vote in the company's annual proxy materials. Director elections typically use a statutory voting system, which means that shareholders vote on each director on a one vote per share basis, or their vote is proportional to their ownership in the company. The most common voting rule used in director elections, and this is the default rule in Delaware, where most US companies are incorporated, is a plurality rule. Under a plurality rule, the set of directors who have the most votes are appointed regardless of if they receive a majority of support. To put all this in context, what it means is that if a given company has six open board seats, the board of directors will give the shareholders six director candidates to vote on. And the six candidates that have the most votes will be able to take a seat on the company's board. In other words, while the shareholders have a vote, their vote is symbolic. A director that is nominated by the board will be seated so long as they get at least one vote. Because management often has significant influence in who is named to the nomination committee's slate, this creates concerns that the board is easily co-opted by the CEO. People worry that the CEO may be able to build a board made up of passive directors and cronies who may be inclined to rubber stamp his or her decisions and allow agency costs to go unchecked rather than exercising effective independent oversight. Globally, the most widely used tool to protect boards from being co-opted by management is the independence requirement, which requires that a majority of directors be independent from the company. In the United States, the requirement that the board be made up of a majority of independent directors is not a formal law or a regulatory requirement. Instead, it became a universal rule here in the early 2000s after a series of large-scale corporate scandals resulted in the failure of giant companies, including Enron and Worldcom. In a reactive move meant to rebuild investor confidence after these scandals by strengthening board oversight, the three largest stock exchanges in the United States, the New York Stock Exchange, the AMEX, and the NASDAQ, all adopted requirements that listed companies have a majority of independent directors on their board. The standards that these platforms used to define independence say that a director cannot be a current or recent employee of the company. They can't receive any substantial income from the company, aside from their director fees. And they can't work for one of the company's major buyers or suppliers. The independence rule is meant to ensure that directors do not have a financial conflict of interest that would preclude them from being able to actively monitor the company's management and hold agency costs in check. But is this rule enough to guarantee that a board will, in fact, operate independently from management? To explore the weaknesses of the current independence mandate, let's use an illustrative case. The case involves Walt Disney Corporation, and it opens in the mid-1980s. At this point, Disney had been chronically underperforming after the death of its founder and creative genius Walt Disney. It had made only five full-length animated features in 11 years, including films like Aristocrats, The Rescuers Down Under, and the Fox and the Hound. Though many of these films have cult followings, they do not all have the lasting cultural resonance or box office success of the more modern movies in Disney's animated library. In 1980 for Disney hires entertainment executive Michael Eisner as its new CEO. Eisner had been president of Paramount Pictures, a rival film studio. Disney tapped Eisner as a turnaround CEO, hoping that he could reinvigorate their film business. And boy, did he ever deliver. The company began producing a new animated feature every 12 to 18 months, and they were blockbusters. The Little Mermaid, Beauty and the Beast, Aladdin, Lion King. These films paid dividends for Disney at the box office, in the parks, on Broadway, and on ice. The company's performance skyrocketed, and Eisner was credited as the genius who orchestrated this miraculous turnaround. In the mid-1990s, Disney's succession plan is disrupted when its then-president and heir apparent is killed in a car crash. Michael Ovitz, co-founder of Creative Artists Agency, was hired as the new Disney President in 1995. When Ovitz is hired, he signed a five-year employment contract with a very generous severance package. It says that if he's fired without cause at any time after 12 months in his position, he'll receive a severance payment that's equal to all of the remaining salary on his five-year contract, plus a $7.5 million per year bonus, plus options. This kind of a clause is referred to as a golden parachute in corporate governance. Well, after Ovitz begins at Disney, he and Eisner start to clash immediately. Eisner later admitted that he had decided that Ovitz must go after only six months, despite being unable to find cause to fire him. Ovitz is officially fired without cause after 14 months. What's problematic about waiting until 14 months? The golden parachute was triggered. Ovitz ultimately receives a severance payment that totaled $140 million. $140 million dollars just for being fired. Shareholders are understandably irate. They file a suit against the firm's directors for breaching their fiduciary duty of care in the way that they handled the firing. Usually what goes on in the boardroom is a black box, but a lot of information comes out in discovery when crises become the subject of litigation. In this case, a number of useful facts are disclosed in the early stages of the trial that shed light on the conditions that precipitated this governance crisis. The board admitted that they felt considerable pressure from Eisner to quickly bring in Ovitz as his heir apparent. Eisner and the chair of the compensation committee flew out to negotiate Ovitz's compensation package directly. The negotiated compensation package was presented to the full compensation committee in very broad strokes by an outside compensation consultant. The committee only received a bulletpointed term sheet to describe the contract. They admitted that they never read or even saw the actual contract, and the compensation consultant admitted to never calculating the full value of the severance package. It was never discussed by the compensation committee. Eisner was obviously very sure that the compensation committee would approve the employment contract he'd negotiated with Ovitz. He told the press about the appointment before the compensation committee met. Ovitz was literally already remodeling his office before his employment package was officially approved by the board. In the course of the case, shareholders also took a closer look at Disney's independent directors. At the time of this debacle, the directors, who are technically independent on the board, included Eisner's personal architect, the person who had designed his home, his personal lawyer, and two administrators of his children's school. So what can we learn from this case? The first thing that the case reveals is a tremendous loophole in our independence requirement. Independent standards ensure that a director does not have a pecuniary relationship with a firm that would present a conflict of interest. But our standard does nothing to preclude direct pecuniary relationships with the CEO, him or herself. Eisner's lawyer and an architect, for example, had direct employment relationships with the CEO that might have made them less willing to stand up to him or question his judgment. The case also illustrates an important rule about corporate governance. Often, companies governance systems begin to weaken after long periods of out performance. CEOs that have delivered out performance over and over again start to amass power. The board and shareholders start to trust their judgment and tend to relax their oversight. In some cases, a powerful CEO might use this period of relaxed oversight to build an enabling board that will go along meekly with the CEO's decisions. This is important because we tend to use corporate governance as a reactive tool. Companies usually intervene to repair and strengthen their governance systems after a crisis or a period of underperformance when investors demand improvements. But as the Disney case illustrates, in order for a governance system to function correctly, it needs to be addressed proactively. Structures like board independence need to be audited and strengthened before things go wrong in order to ensure that the company isn't being set up for a crisis.
