Why Increased Scrutiny May Be Good for Business

In some ways, shareholder interference has led to better governance.
Theodore Roosevelt MallochOctober 20, 2011

Over the past few years, a disturbing number of corporate entities have been the subject of embarrassing and problematic failures, fraud, ethical lapses, and outright scandals. Everything from financial irregularities to burnouts by senior executives and excessive compensation arrangements to fraudulent misdeeds has been the ruin of many preeminent institutions, not to mention some of their CFOs. These failings have played out in courtrooms and settlement talks as scorned shareholders and reprimanding regulators demand retribution from officers, directors, and corporations.

So many companies seem to have lost their way, beset by loss of reputation, budget deficits, or irrelevancy of mission, that it’s difficult to keep track. Even more companies have thrived, and some are stronger than ever. Why do some companies realize success and others encounter difficulties? While competent leadership is crucial, one key reason is good governance.

The bar of expectation for governance at nonprofits, government services, and the business sector has risen considerably during the past decade. The higher scrutiny will result in better governance at more companies. As both officers and directors, CFOs will play a key role in helping to keep their board on the right path. They may need to insist on the board doing performance self-reviews and being open to outside verification and auditing procedures by third parties.

4 Powerful Communication Strategies for Your Next Board Meeting

4 Powerful Communication Strategies for Your Next Board Meeting

This whitepaper outlines four powerful strategies to amplify board meeting conversations during a time of economic volatility. 

Other contributing factors to this shift toward better governance include a significant increase in mergers, acquisitions, and takeovers around the world; increased aggressiveness by institutional shareholders; a reduction in cross-shareholdings and the influence of banks; the growth of venture-capital markets; and the issuance of the Organisation for Economic Co-operation and Development’s “Principles of Corporate Governance.”

Increased globalization has also turned up the pressure on corporate boards to enhance their governance structures. Recent trends include a greater emphasis on shareholder value and corporate responsibility, a growing perception of the need for independent directors and committees, and the need for better disclosure of relevant financial information.

Let’s not forget recent U.S. laws that have influenced corporate practices. The Sarbanes-Oxley and Dodd-Frank laws, with their ramifications for governance and transparency, are changing core practices of capitalism and finance, not only in the United States but also around the world. More than ever, boards, CEOs, and CFOs are adapting to the new cry for corporate responsibility. Those who take a lead in setting high standards for themselves are gaining respect and value for their enterprises.

One area they need to pay attention to is potential shareholder tender offers. A tender offer changes the rules for boards because directors have potential conflicts when there’s a takeover attempt. Compounding the problem is the fact that different states have different approaches to how companies can react. Pennsylvania law, for instance, protects the board at all costs, but this approach may actually weaken the board in relation to management since management, in effect, can ignore shareholder value.

Delaware, where most companies are incorporated because of favorable legislation, has a different approach. Under Unocal v. Mesa Petroleum and subsequent cases, Delaware courts have developed a structure of rules for takeovers midway between the business judgment rule and the “entire fairness” test, which is traditionally applied when the board is conflicted. This intermediate standard of review is a “reasonably related” or proportionality test: is there a threat here to corporate policy and is the response “reasonable”? Independent directors must play the key role. Were they informed? Did they have independent advisers? Were they independent of management? This standard of review underscores the role of the board over management.

Other prominent cases, such as Paramount Communications v. Time, indicate that the board can pursue a strategy not favored by a majority of the shareholders. Similar types of conflicts are present in mergers: for example, once a company is for sale, the directors must seek the highest price “reasonably available.” For tender offers, it should be emphasized that there is continuing and intense competition in the market for corporate control, which puts major responsibilities on boards. As such, the market for corporate control is, in a sense, strengthening board functioning and corporate governance.

Good governance is surely becoming a significant factor today in making investment decisions. Except in highly publicized cases of dysfunctional boards or fraud, corporate-governance practices now receive scrutiny not only after prolonged evidence of bad performance. In fact, while there is a debate over the economic value of corporate governance, it seems to pay high dividends.

Still, if society wants companies to have good corporate governance, it has to agree on what information is really needed.

Theodore Roosevelt Malloch is a research professor at Yale University. The author of Doing Virtuous Business (Nelson 2011), he is CEO of The Roosevelt Group, a leading strategy firm on business ethics, corporate governance, and fiduciary responsibility.