ROCK CENTER FOR CORPORATE GOVERNANCE

ROCK CENTER FOR CORPORATE GOVERNANCE
CASE: CG-11
DATE: 01/15/08
Professor David F. Larcker and Brian Tayan prepared this case as the basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation.
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MODELS OF CORPORATE GOVERNANCE:
WHO’S THE FAIREST OF THEM ALL?
In 2007, corporate governance became a well-discussed topic in the business press. Newspapers
produced detailed accounts of corporate fraud, accounting scandals, excessive compensation, and
other perceived organizational failures—many of which culminated in lawsuits, resignations, and
bankruptcy. The stories ran the gamut from the shocking and instructive (epitomized by Enron
and the elaborate use of special purpose entities and aggressive accounting to distort its financial
condition in 2001) to the shocking and outrageous (epitomized by Tyco partially funding a $2.1
million birthday party in 2002 for the wife of CEO Dennis Kozlowski, which included a vodkadispensing replica of the statue David). Central to these stories was the assumption that
somehow corporate governance was to blame. That is, there was a functional failure in the
system of checks and balances established to prevent abuse by executives.
The need for a governance system is based on the assumption that the separation between the
owners of a company and its management provides self-interested executives the opportunity to
take actions that benefit themselves, with the cost of these actions borne by the owners.1
Economists refer to such a situation as the agency problem. To lessen agency costs, some type
of control or monitoring system is put in place in the organization. At a minimum, the
monitoring system consists of a board of directors to oversee management on behalf of
shareholders and an external auditor to express an opinion on the reliability of financial
statements. In the majority of companies, however, governance systems are influenced by a
much broader group of constituents, including creditors, labor unions, customers, suppliers,
investment analysts, the media, and regulators (see Exhibit 1). In order for governance systems
to be economically effective, they should decrease agency costs above and beyond the direct cost
of compliance and the indirect cost on managerial decision making.
1 This issue was the basis of the classic discussion in Berle and Means, The Modern Corporation and Private
Property, (New York: Harcourt, Brace and World, 1932).
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 2
Broad standards of governance are required by regulatory bodies, based on the recommendations
of expert panels. For example, the Cadbury Committee—commissioned by the British
government “to help raise the standards of corporate governance and the level of confidence in
financial reporting and auditing”—issued a Code of Best Practices in December 1992 that in
many ways provided a benchmark set of recommendations on governance.2 These standards set
the basis for listing requirements on the London Stock Exchange and were in large part adopted
by the New York Stock Exchange (NYSE). Compliance with these standards, however, did not
always translate into effective governance systems. For example, Enron was compliant with
New York Stock Exchange requirements for an independent audit and compensation committee
and a majority of independent directors, but it still failed spectacularly.
Over time, a series of formal regulations and informal guidelines were proposed to address
perceived shortcomings in governance systems as they were exposed. The most important
formal legislation relating to governance was the Sarbanes-Oxley Act of 2002, which mandated a
series of requirements to improve corporate controls and reduce conflicts of interest.
Importantly, CEOs and CFOs found to have made material misrepresentations in the financial
statements were made subject to criminal penalties. Despite these efforts, corporate failures
stemming from deficient governance systems still continued. In 2005, Refco, a large U.S.-based
foreign exchange and commodity broker, filed for bankruptcy after revealing that it had hidden
$430 million in loans made to its CEO. The disclosure came just two months after the firm
raised $583 million in an initial public offering.
Several third-party organizations—such as The Corporate Library, Governance Metrics
International, and Institutional Shareholder Services (ISS)—attempted to protect investors from
these failures by publishing governance ratings on individual companies. These rating agencies
used alphanumeric or numeric systems that ranked companies according to a set of criteria that
they believed (in aggregate) measured effectiveness. Companies with high ratings were
considered less risky and most likely to grow shareholder value. Companies with low ratings
were considered the least safe and had the highest potential for failure or fraud. The accuracy of
these ratings, however, had not been clearly demonstrated, and critics alleged that they
encouraged a “one size fits all” approach to governance.3 The potential shortcomings of these
ratings were exhibited in the case of HealthSouth, which was accused in 2003 of systematically
making false accounting entries and overstating earnings by a total of $1.4 billion between 1996
and 2002. At the time, the company had an ISS rating that placed it in the top 35 percent of
Standard & Poor’s 500 companies and the top 8 percent of its industry peers.4
Despite the difficulty of evaluating corporate governance structures, investors still perceived
strong governance to be important. In a widely touted research report published by McKinsey &
Company in 2002, nearly 80 percent of institutional investors said that they would pay a
premium for a well-governed company. The size of the premium varied by market, from 11
percent for Canadian companies to around 40 percent for companies in countries with weak
2
Cadbury Committee, Report of the Committee on the Financial Aspects of Corporate Governance, (London: Gee,
1992).
3
See “Corporate Governance Ratings: Got the Grade… What was the Test?” GSB No. CG-08.
4
Cited in Jeffrey Sonnenfeld, “Good Governance and the Misleading Mythos of Bad Metrics,” Academy of
Management Executive, February 2004, Vol. 18 Issue 1, pp. 108-113.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 3
regulatory environments (such as Morocco, Egypt, and Russia).5 However, there is considerable
controversy among academics and executives regarding whether strong governance systems
actually resulted in higher market valuations, as the survey indicated. Nor had academics clearly
demonstrated which specific control mechanisms led to effective governance in the first place.
GLOBAL CORPORATE GOVERNANCE
Standards of corporate governance were not uniform around the world, owing in large part to
differences in legal tradition, social and cultural values, and the structure of capital markets in
individual countries. The United States and Britain had adopted a shareholder-centric model of
corporate governance (often referred to as the Anglo-Saxon model). This model emphasized the
increase in shareholder value, in compliance with national laws and regulations, as the primary
objective of the corporation. A unitary board of executive and non-executive directors had
oversight control in the Anglo-Saxon model and was subject to considerable influence by the
chief executive officer. The Germans, along with several other European nations, adopted a
stakeholder-centric model of governance. This model placed more emphasis on the importance
of non-shareholder constituents—labor unions in particular—and reflected the large influence of
controlling owners and major German national banks. The Germans implemented a two-tiered
board structure that more clearly separated oversight from management. The Japanese model
was built around business relationships, with Japanese banks, customers, and suppliers all
influencing board-level decisions. The Korean model had its roots in that country’s emergence
from the Korean War, whereas the Chinese model reflected a transition from communism to a
capitalistic system. The Indian model was influenced by a history of powerful family ownership.
Some organizations had made efforts to compare the governance systems across national
boarders. The governance rating agencies Institutional Shareholder Services and Governance
Metrics International had developed international governance scores. Companies in the U.S. and
Europe often received the highest scores while companies in Japan and those in developing
countries generally received lower scores. Nevertheless, there were many exceptions to this
trend, as companies from around the world moved at different speeds to adopt global standards
of governance (see Exhibit 2 for the ratings scores on selected international corporations).
United States
In the United States, the board of directors served as the most important controlling mechanism
to ensure that the management of publicly traded corporations acted in the interest of
shareholders. The chief executive officers of most U.S. corporations were professional
managers. That is, the chief executive officer was typically not a founder or controlling owner
but instead a professional manager hired by the board of directors to run the company. In fact,
after Bill Gates stepped down as the CEO of Microsoft in 2000 and Maurice “Hank” Greenberg
stepped down as the CEO of American International Group in 2005, none of the 30 companies in
the Dow Jones Industrial Average had a CEO who was a founder or a member of the founding
5
McKinsey & Company, McKinsey Global Investor Opinion Survey on Corporate Governance, 2002,
http://www.mckinsey.com/clientservice/organizationleadership/service/corpgovernance/pdf/GlobalInvestorOpinio
nSurvey2002.pdf (December 7, 2007).
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 4
family.6 Even Google, 10 years old and having recently completed a successful IPO, brought in
an outside professional to serve as formal chief executive officer (Eric Schmidt, previously the
CEO of Novell Inc.), although founders Sergey Brin and Larry Page continued to play active
roles serving as president of technology and president of products, respectively.
The board of directors provided oversight of the actions of professional management to protect
the financial interests of shareholders. The board had four primary responsibilities: the selection
of the chief executive officer; the selection of candidates for the board of directors; evaluation
and review of the company’s strategy, operational execution, capital structure, and published
financial statements; and ensuring that the company was in compliance with all applicable laws
and regulations. As such, U.S. boards served both an advisory role and a compliance role.
The board of directors typically included executive and non-executive directors. Executive
directors included the chief executive officer or any other senior official at the company who
also served on the board. For example, at Johnson & Johnson, CEO William Weldon and
Executive Committee Member Christine Poon were both executive directors on the board in
2007. Executive directors were limited in the committees they served on because of their roles
as insiders. For instance, they generally did not serve on the audit or compensation committees.
As a result, the majority of directors at U.S. corporations were non-executive directors, often the
heads of unaffiliated corporations, nonprofit organizations, or universities. Non-executive
members were typically selected based on their expertise in issues that were of strategic
importance for the company or for specialized financial knowledge. For example, Johnson &
Johnson’s board of directors had six non-executive directors who were current or retired CEOs
of major corporations (including Citigroup, Kellogg, and PepsiCo). These individuals were
presumably selected because of their strategic, operational or financial knowledge. Johnson &
Johnson’s board also had four non-executive directors who were university or health
organization officials (including a former U.S. surgeon general and a professor at Massachusetts
Institute of Technology). These individuals were presumably selected because of their expertise
in science, research and public policy (see Exhibit 3 for the composition of Johnson & Johnson’s
board).
In order to ensure that the board of directors acted without excessive influence from senior
management, NYSE listing rules required that non-executive directors meet outside the presence
of executive directors on a scheduled basis. Furthermore, NYSE rules required that the company
have a majority of independent board members. Independence was a subjective criterion, and
companies were given discretion in defining their own particular standards. In general,
independent directors were those whose objectivity would not be compromised by material
business, charitable or other relationships with the company or company officials. Most
companies believed that all of their non-executive directors were also independent, although
circumstances could arise in which a director’s independence might be weakened. For example,
all non-executive directors at Johnson & Johnson met the company’s independence standards.
However, one could imagine a situation in which the independence of Charles Prince, former
chairman and CEO of Citigroup, might be compromised if Citigroup was involved in one of the
6
Although Cornelius Vander Starr was the founder of the original underwriting companies that became AIG,
Greenberg had been hired as CEO in 1967 when the holding company American International Group was formed.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 5
company’s financing or acquisition deals. Alternatively, the involvement of the Massachusetts
Institute of Technology in major clinical research might be seen as compromising the
independence of non-executive director Susan Lindquist, who was a professor at that university.
As a result, activist investors dissatisfied with a company’s performance sometimes challenged
the independence of certain directors and sought to have them removed.
In some U.S. corporations, the founder or family member who retained a significant ownership
position in the company also served on the board. For example, Edsel B. Ford II and William
Clay Ford Jr. were both on the board of directors of Ford Motor Company, holding a 5.9 percent
and 4.8 percent stake in the company’s shares, respectively.7 Edsel and William were cousins to
each other and the great-grandchildren of company founder Henry Ford. Approximately onethird of companies in the Standard & Poor’s 500 Index had a founder or descendent of the
founder in senior management or on the board of directors.8
Sometimes founding shareholders also exerted significant influence over the company by
holding a separate class of stock which had increased voting rights. For example, six
descendents of Katherine Graham, including Chairman and Chief Executive Officer Donald
Graham, owned 100 percent of the Class A shares of The Washington Post Company. Katherine
Graham’s father had purchased the Washington Post newspaper out of bankruptcy in 1933, and
later Katherine assumed the position of publisher and chief executive officer, taking the company
public in 1971. In doing so, she became the first female CEO of a Fortune 500 company.9 Even
as a public company, the Washington Post was considered a controlled company by the SEC,
because of its dual share class structure. Seven of the company’s 10 directors were exclusively
nominated and voted on by holders of the company’s 1.7 million Class A shares; the remaining
three directors were voted on by holders of the company’s 7.8 million Class B shares.10 As a
result, even though a public shareholder could accumulate a majority of the company’s
outstanding shares, s/he could not wrest substantive control from the Graham family and its
chosen directors.
Dual share classes could be structured in several alternative ways to ensure that one class of
shareholders maintained control. For example, before the sale of the Dow Jones Company in
2007, the Bancroft family owned all Class B shares, which were afforded 10 times as many votes
as publicly traded Class B shares. Approximately 9 percent of publicly traded corporations in
the U.S. had some form of dual class structure.11 Shareholder activists and governance rating
agencies opposed dual class shares, which they believed led to an unnecessary entrenchment of
management.
7
Ford Motor Company, 2006 form DEF14-A, filed with the Securities and Exchange Commission, April 5, 2007.
8
Cited in: Ashiq Ali et al, “Corporate Disclosures by Family Firms,” Journal of Accounting and Economics, Vol.
44, Issues 1-2, September 2007, pp. 238-286.
9
See Katharine Graham, Personal History, (New York: Knopf, 1997).
10
The Washington Post Company, 2006 form DEF14-A, filed with the Securities and Exchange Commission,
March 23, 2007.
11
Scott Smart et al, “Why Dual-Class Shares Don’t Add Up,” Directorship, Vol. 33, Issue 4, September 2007, pp.
14-15.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 6
In many instances, significant shareholders who were not founding members of the company
also served on the company’s board. For instance, a hedge fund or institutional investor might
purchase a material percentage of the company’s outstanding shares and, either through hostile
or cooperative means, be nominated to the board.12 In theory, the investor should seek board
representation in proportion to his or her ownership position in the company; in practice, many
activist investors sought board representation beyond their ownership percentage. In 2006,
hedge fund Trian Fund Management, run by activist investor Nelson Peltz, successfully won 2 of
12 board seats through hostile efforts after taking a 5.5 percent position in Heinz Co.
With rare exceptions, major mutual fund companies like Fidelity, the Capital Group, and
Vanguard, and large pension funds like California Public Employees’ Retirement System
(Calpers) did not sit on the board of directors even though such companies often held 3-10
percent positions in many publicly traded companies. With limited exceptions, labor union
representatives also did not sit on the boards of American corporations. Both of these
shareholder groups sought to maintain influence through the proxy voting process rather than
through direct board representation.
External Auditor
Although the board of directors was the most prominent controlling force in corporate
governance, the external auditor also served a critical role by ensuring the integrity of published
financial statements. As of 2007, there were four major auditing firms (known as “the Big
Four”): PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG. The
previous fifth major accounting firm, Arthur Andersen, closed in 2002 after the bankruptcies of
Enron and WorldCom, both of which were Arthur Andersen clients.13
The external auditor reviewed the internal controls of the company to assess whether it employed
sound practices in keeping its accounts and also tested selected accounts to determine whether
they complied with Generally Accepted Accounting Principles (GAAP). If the auditor found no
reason for concern that the statements were materially misleading (fraud or error), the firm
expressed an unqualified opinion that accompanied the financial statements in the annual report.
The unqualified opinion generally stated that “the financial statements presented fairly the
financial condition, the results of operations, and the cash flows of the company [for specific
years], in accordance with accounting principles generally accepted in the United States of
America.” The auditor was also required to specify in the opinion if it did not believe that the
company could continue to operate profitably as a going concern. Qualified opinions and going
concern warnings were very infrequent.
After the passage of Sarbanes-Oxley, external auditors were also required to perform an
assessment of the company’s internal controls, in accordance with Section 404 of the law.
Management, too, was required to perform this same assessment and certify that the financial
report “did not contain any untrue statement of a material fact or omit to state a material fact”;
12
See “Sovereign Bancorp and Relational Investors: The Role of the Activist Hedge Fund,” GSB No. CG-06.
13
In 2002, Arthur Anderson was found guilty of obstruction of justice for the destruction of documents relating to
its audit of Enron. As a result of the verdict, the firm lost its SEC license to serve as external auditor. In 2005,
however, the U.S. Supreme Court overturned the verdict on procedural grounds. Nevertheless, the reversal was
too late to salvage the company’s business.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 7
that it “fairly presented in all material respects the financial condition, results of operations and
cash flows of the company”; and that the company “established procedures that maintained
effective internal control over financial reporting.” If a material misstatement or deficiency was
subsequently discovered, the chief executive officer and chief financial officer could be subject
to criminal liability, punishable by fines and prison.
As such, the external auditor was not responsible for the presentation or accuracy of financial
statements but instead served to reduce the risk that statements were misleading by performing a
check on management and its financial reporting procedures. Auditors were required to report
directly to the audit committee of the board of directors to further maintain independence from
the influence of management.
Best practices for corporate governance often called for limits on consulting and non-audit
related services performed by the external auditor. Proponents of this standard asserted that the
fraudulent accounting practices of Enron, WorldCom and others were encouraged in part by
conflicts of interest that prevented auditors from challenging the aggressive accounting policies
of these companies. They argued that, because the fees generated by these consulting contracts
substantially exceeded fees earned for audits and corporate tax preparation, auditors did not have
incentive to stand up to management for fear of losing lucrative relationships. Section 202 of the
Sarbanes-Oxley Act addressed some of these conflicts by prohibiting auditors from performing
certain non-audit-related services for their audit clients, such as bookkeeping, financial
information system design, fairness opinions, and other appraisal and actuarial work.
Shareholder activists and governance ratings firms believed that, as rule of thumb, the fees that
audit firms received from a client for consulting work should not exceed audit and tax-related
fees. As an example, in 2000, IBM paid its auditor PricewaterhouseCoopers $12.2 million in
audit and audit-related fees, $7.9 million in tax consulting fees, and $41.3 million in other fees.14
However, in 2006, it paid PricewaterhouseCoopers $53.7 million in audit and audit-related fees,
$6.9 million in tax consulting fees, and only $1.4 million in other fees.15 IBM’s substantial audit
cost in 2006 was due largely to the increased cost of compliance with Sarbanes-Oxley.
Many organizations separately employed internal auditors, who were company employees
responsible for identifying weaknesses in internal controls and making recommendations for
improvement. Senior executives relied in part on the internal auditor’s assessment when
certifying the financial statements. Internal auditors often had dual reporting to the chief
financial officer and the audit committee of the board.
Governance Regulations and Procedures
The board of directors and company management were responsible for compliance with
applicable state and federal law as well as regulations imposed by the Securities and Exchange
Commission. Congress created the SEC through the Securities and Exchange Act of 1934 to
oversee the proper functioning of primary and secondary financial markets, with an emphasis on
the protection of security holder rights and the prevention of corporate fraud. Among its various
14
International Business Machine, 2000 form DEF 14-A, filed with the Securities and Exchange Commission,
March 12, 2001.
15
International Business Machine, 2006 form DEF 14-A, filed with the Securities and Exchange Commission,
March 12, 2007.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 8
powers, the SEC was granted the power to regulate securities exchanges (such as the New York
Stock Exchange, NASDAQ, and the Chicago Mercantile Exchange), to bring civil enforcement
actions against companies or executives who violated securities laws (through false disclosures,
insider trading, and fraud), and to oversee the proxy solicitation and annual voting process.
While rules relating to the proper functioning of securities markets were regulated by the SEC,
the majority of corporate governing rights were granted by state law. State law granted the board
of directors the power to create and amend company bylaws. Through the bylaws, the board
defined the rights and obligations of corporate officers and directors and determined certain
governance procedures. These procedures included the process for nominating and electing
candidates to the board, the method by which the board conducted business and voted on
matters, and the creation of the rules by which the shareholder meeting would be conducted. The
board of directors was also granted the right to create special subcommittees to focus on key
functional areas.
Approximately half of all publicly traded U.S. companies were incorporated in their state of
origin. For example, in 2007, Whole Foods Market was incorporated in the state of Texas,
where its first stores were located. Likewise, medical device company Stryker was incorporated
in the state of Wisconsin where it was founded. The other half, however, were incorporated in
the state of Delaware. Delaware had the most developed body of case law, which gave
companies greater clarity on how corporate governance and liability matters might be decided.
Furthermore, trials over corporate matters were heard by a judge rather than a jury, which
companies felt reduced liability risk. Also, Delaware had fairly lenient interest laws, making it
attractive for lenders, in particular credit card companies such as Discover and Capital One.
The board of directors was also responsible for ensuring that companies complied with the listing
requirements of the exchanges on which its securities traded as well as the Sarbanes-Oxley Act
of 2002. Among the listing requirements of the New York Stock Exchange, the company had to
have at least 400 shareholders, maintain a minimum market value and trading volume in its
securities, as well as demonstrate compliance with certain governance standards. The listed
company’s board was required to have a majority of independent directors; the compensation
committee of the board had to be composed entirely of independent directors; the audit
committee had to have a minimum of three members all of whom were “financially literate” and
at least one of which was a “financial expert”; and the chief executive officer had to certify
annually that his or her company was in compliance with NYSE requirements.
As a result, companies were subject to a complicated intersection of corporate law, securities
law, and listing requirements. For activist investors, the web of regulations provided both
challenges and opportunities as they sought to further their causes and impose change on the
companies they targeted. For example, the activist fund Relational Investors—in an attempt to
stop a three-way deal between Sovereign Bancorp, Banco Santander, and Independence
Community Bank—filed a petition with the SEC, sought to overturn a NYSE rule, and also filed
a lawsuit in the state of Pennsylvania.16 Likewise, the American Federation of State, County,
and Municipal Employees (AFSCME) pension plan, seeking to gain the right to directly
nominate directors to the board of AIG, petitioned the SEC for the right to include a shareholder
16
See “Sovereign Bancorp and Relational Investors: The Role of the Activist Hedge Fund,” GSB No. CG-06.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 9
proposal on the matter on AIG’s annual proxy. When the SEC sided with the company in
rejecting the proposal, the AFSCME filed a lawsuit in federal court in New York to force the
issue, which it lost in the trial but subsequently won on appeal.
Liability
State law treated a corporation as a “person” that had legal standing to sue and be sued,
independent from the shareholders in the company. This legal distinction between the company
and its shareholders protected shareholders from personal liability for company obligations and
for company misconduct. For example, if a company could not meet its required debt payments
or failed to fulfill the terms of a signed contract, the offended party could not sue the
shareholders for recovery.
Management and directors too were protected from personal liability for company misbehavior.
They could, however, be sued for their own personal actions, even when carried out in a
professional capacity. For example, a company director could be personally sued for committing
wrongful acts, such as breach of company trade secrets, misallocation of corporate funds, and the
issuance of incorrect statements. Also, company officials could be sued for employment-related
claims, including wrongful dismissal, failure to promote, sexual harassment, and other violations
of anti-discrimination laws. Companies often purchased directors and officers liability insurance
(D&O insurance) to reimburse officials for such liabilities.17
The most serious lawsuits filed directly against executives and directors, however, were claims
of fraud, which were explicitly excluded from coverage under D&O insurance. Fraud was
significantly more serious than a wrongful act in that it involved an intent to mislead or defraud.
For example, the SEC prosecuted illegal insider trading lawsuits on the basis of fraud, claiming
that company executives made misleading statements to the public about their company’s
prospects with the intent to profit from an artificially high stock price. Illegal insider trading was
punishable with jail time and financial penalties up to three times the profit gained or loss
avoided from such activity. For example, in 2007, Joseph Nacchio, former chairman and chief
executive officer of Qwest, was found guilty of insider trading for selling over $100 million of
Qwest shares in early 2001 at around $35 per share, just months before the stock fell under $10
and then much lower. Nacchio was sentenced to six years in prison and ordered to pay $19
million in fines and $52 million in forfeitures.
United Kingdom
Of all the European models of corporate governance, the British model shared the most
similarities with the U.S. model. The British model, like the U.S. model, was born out of
common law. That is, precedent was more influential in determining governance structure than
detailed statutes passed by legislative bodies. For example, the Companies Act 1985, which
consolidated seven Companies Acts passed by Parliament between 1948 and 1983, imposed very
few governance requirements on companies. Among them, companies were required to have a
board (with a minimum of two directors for publicly traded companies) and the board was
responsible for certain administrative functions, including the production of annual financial
17
A study by Black, Cheffins, and Klausner (“Outside Director Liability,” Stanford Law Review, Vol. 58, pp. 1055-
1159, 2006) demonstrated that directors almost never lose personal money from shareholder lawsuits.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 10
reports. The Act did not specify a required structure for boards, nor did it mandate procedures
for conducting business. Such rules were to be decided by the company’s shareholders through
the company’s articles of association. The tradition of common law in both the U.K. and the
U.S. led to a great deal of flexibility in the development of corporate governance standards in
these two countries, which together were referred to as the Anglo-Saxon model.
In response to broad shareholder assertions that governance standards afforded too much control
to company executives, the British government commissioned the Cadbury Committee in the
early 1990s to provide a benchmark set of recommendations on governance. The committee was
headed by Sir Adrian Cadbury, great-grandson of John Cadbury, founder of the British
confectionary company. The final report of the committee recommended a set of self-regulated
standards of governance known as the Code of Best Practices. The best practices included the
separation of the chairman and chief executive officer titles, the inclusion of independent
directors on the board, the reduction of conflicts of interest at the board level due to business or
other relationships, an independent audit committee, and a review of the effectiveness of the
company’s internal controls (see Exhibit 4 for the 19 recommendations of the Code of Best
Practices). The standards of the Cadbury Committee set the basis for the standards for the
London Stock Exchange.
Publicly traded companies, however, were not legally required to adopt these standards. Instead,
they were required to issue an annual statement to shareholders stating whether they were in
compliance with the Code or, if not, their reasons for noncompliance. The practice of comply or
explain put the burden on public shareholders to lobby for change if they deemed the company’s
explanation for noncompliance unacceptable. Supporters of the comply-or-explain approach
thought that it provided an appropriate mechanism for encouraging the adoption of sound
governance standards without legally mandating them. The vice chairman of the Institute of
Chartered Accountants of Scotland offered his praise: “It will be quite easy to see which
companies are cocking a snook…. It’s the reverse of Gresham’s Law: good practices should
drive out bad.”18
Critics of the Cadbury Committee report claimed that the voluntary adoption of governance
practices did not go far enough to raise oversight standards. A representative of the British
Labour party called the Code “rather vague” and a “recipe for inactivity.” She went on to say
that “practical guidelines should have been laid down.”19 Another critic of the Cadbury report
believed the enforcement mechanism of relying on shareholders to protest lack of compliance
was weak and did not go far enough: “If it becomes clear there isn’t compliance, then there
should be legislation.”20
At the request of the British government, former investment banker Sir Derek Higgs published a
report in 2003 that evaluated the role, quality and effectiveness of non-executive directors. The
recommendations in the so-called Higgs Report were combined with those of the Cadbury
Committee in 2003 in what became the Combined Code. Notable recommendations of the Higgs
Report were that at least half of the board of directors should be non-executive directors, that the
18
Richard Waters, “The Cadbury Report: Self-regulation seen as the way forward,” Financial Times, May 28, 1992.
19
Alison Smith, “The Cadbury Report: Labour attacks voluntary approach,” Financial Times, May 28, 1992.
20
Norma Cohen, “Criticisms of Cadbury Report Emerge,” Financial Times, June 11, 1992.
Models of Corporate Governance: Who’s the Fairest of Them All? CG-11 p. 11
board should appoint a lead independent director who serves as a liaison with shareholders, the
nomination committee should be headed by a non-executive director, and executive directors
should serve not more than a six-year term.21 The Higgs Report also advised boards to
“undertake a formal and rigorous annual evaluation of its own performance and that of its
committees and individual directors.”22 These standards were to be included in the annual
comply-or-explain report.
Higgs believed that the elevated status of non-executive directors on the board would be “pivotal
in creating conditions for board effectiveness.”23 Together, the Cadbury and Higgs reports had
the effect of shaping the board of directors into a monitoring and control body as much as a
strategy-setting body.24
According to a survey by accounting firm Grant Thornton, two-thirds of the U.K.’s 350 largest
companies did not fully comply with the provisions of the Combined Code. The most frequent
areas of noncompliance were: failure to disclose the terms and conditions by which nonexecutive directors were appointed (45 percent); audit committee did not have at least one
member with relevant financial experience (21 percent); and the audit committee did not review
the effectiveness of internal auditors (21 percent).25 For example, EasyJet PLC, in its 2006
annual report, stated that it was in compliance with the Combined Code, with the exception of
four areas: specific option grants prior to 2000 did not have performance features attached to
them; the company did not have a senior independent director during the entire year; nonexecutive directors no longer serving on the board of directors were not required to hold shares
from exercised options for one year; and the chairman of the board served on the audit,
remuneration, and nominating committees for part of the year (see Exhibit 5 for the EasyJet PLC
2006 comply or explain report).26
Germany
German law mandated that corporations operate under a two-tiered board structure which
separated the oversight and management functions. The management board (Vorstand) was
responsible for day-to-day decision making on such matters as product development,
manufacturing, finance, marketing, distribution and supply chain. The management board was
overseen by the supervisory board (Aufischtsrat), which was responsible for appointing members
to the management board, the approval of financial statements, and decisions regarding major
capital expenditures, mergers and acquisitions, and the payment of dividends. No managers
were allowed to sit on the Aufischtsrat.