Boardroom Revolution
Investors are revolting against poor corporate governance, demanding tighter controls that will boost earnings and stock price.
June 2004
By Kevin Genieser
A new wave of activism has risen in corporate America, driven by large institutional shareholders who claim companies have not gone far enough in their efforts to embrace good governance. These institutional shareholders maintain that good governance leads to superior financial performance and will not be satisfied unless the companies do more to implement good governance policy.
The utility industry has suffered its share of the same scandals that have marred much of corporate America over the past few years, including improper accounting, market manipulation, and executive corruption. With the dramatic destruction of shareholder value and the unveiling of extreme abuses of corporate power, U.S. legislators and market makers have legislated internal structural changes to organizations, claiming that the internal controls in the companies and boards that ran these corporations had failed. The resulting legal and regulatory directives, including the Sarbanes-Oxley Act and new New York Stock Exchange and NASDAQ listing requirements, have been put into place to drive corporations to implement measures of "good governance" (see sidebar, p. 70).
Rating agencies are advocating further change, implementing systemic procedures to evaluate governance and disclosure policies, and they have begun supplying investors with more comprehensive views and ratings criteria based on these analyses. These agencies also believe that companies with clear policies of good corporate governance are less likely to be downgraded or underperform to expectations.
In the utility sector, further demands for good corporate governance also arise from state public utility commissions, some of which were the first regulatory bodies to hold hearings on the corporate scandals within the industry. Their review of corporate governance and related issues like compensation has emboldened many commissions to scrutinize further the utilities they monitor and propose regulatory changes that directly affect the operations of the utilities they regulate, or, in effect, their holding companies.
With these important stakeholders (investors, rating agencies, and regulators), actively evaluating whether utility companies have good corporate governance policies in place, utility boards and managements should be proactively considering if enough has been done to implement the spirit as well as the practice of good governance. This article will examine the goals behind these regulations, highlight the effects they are having on corporations, and pose additional questions to help companies determine if they have implemented the spirit, as well as the policy, behind good governance.
Regulation and Utilities: Have We Gone Too Far?
Many have claimed that the new regulations are unfair to those companies that had done nothing wrong. Utilities, in particular, have been highly regulated, transparent organizations that were viewed generally as good corporate citizens. Governance Metrics International, an independent group that rates corporate governance, found that, despite the scandals, the utility sector received the highest average overall rating with regard to corporate governance.
Critics of the new regulations contend that most of corporate America worked well before this new regulation was put in place and that all U.S. corporations are now suffering for the misdeeds of a few companies. They believe that the scandals that made front page news were outliers, and the problems with some companies were not as dramatic as newspapers and market pundits claim. Skeptics of the new rules also claim that these requirements will do little to prevent future problems; corrupt individuals will always get around laws and regulations.
In addition, the new compliance requirements have significant costs for corporate America. There is a price associated with having a well-informed independent board. More consultants, lawyers, and financial advisors are being retained to help educate and advise the independent board members. This increased compliance burden, critics also argue, only will make doing business in America more challenging. They point to a drop-off in foreign companies listing in the United States, attribute this to a perception that the new requirements are simply too onerous, and conclude that the United States has now become a less attractive place to raise capital.
Other critics of the new regulations claim that this prescriptive regulatory approach does not get to the heart of the problem. They assert that more should have been done to implement change at the top of corporate America. Requirements should have been implemented to separate the CEO and chairman roles, or at the very least, to require a designated lead director.
Finally, many in management fear that we have entered into an era of risk avoidance. By empowering boards to rein in management, executives will be forced to undercut their corporate vision and may be prevented from risk-taking that can create value. Utilities, in general, had always been considered a relatively conservative group. Some argue that that the good governance movement may slow down important strategic efforts, such as restructuring, consolidation and creative financing efforts. With risk aversion as the new mantra, innovation then is at risk.
Supporters of Corporate Reform Respond
Supporters of the good-governance movement argue that the dramatic loss in shareholder value and trust required a comprehensive response. The problems were not confined to one industry or company, but were widespread enough to fundamentally challenge our markets. Trust, they would argue, is absolutely essential for free markets to work, and these regulations are essential steps to restoring investors' confidence. With regard to the reactions of foreign companies, they believe U.S. public companies are setting what will become the global standard. The United States always has been an important leader in setting good corporate practices, and the rest of the world will come to understand the merits of this approach.
Moreover, by the nature of the industry, utilities have a long history of adapting their business practices to comply with the latest regulatory requirements and of implementing the letter of the law. The question that should be considered by utility board members and management is whether more can be done to embrace the spirit versus the requirements of good corporate governance.
Looking first within the board itself, utility boards should evaluate whether their members have an educated view of the company's strategy and can monitor the business and management properly. Are there members on the board that understand how success is defined in the regulatory process, the requirements for running generation fleets well, or what the inherent risks are in expanding non-regulated operations?
Board members also should consider ways to improve their own effectiveness by asking themselves the following questions:
- Do the independent directors adequately use the executive sessions to evaluate management and the strategic direction for the company?
- Has a peer review system been set up to provide feedback on other members' participation?
- Are there adequate training programs for directors?
- Are there effective procedures to remove board members that may not be contributing at the level of the rest of the board?
- Do board members have enough time to fully commit to the company? Are they serving on too many different boards?
Looking forward, the board should consider whether its composition is appropriate to evaluate the future business environment. Challenges for the utility sector and opportunities presented to companies are likely to grow in complexity. For example, most believe that Congress eventually will pass an energy bill, if not in 2004 then in 2005. If so, it would include a repeal of the Public Utility Holding Company Act (PUHCA), which inevitably would bring more merger and acquisition activity to the utility sector. With the repeal of PUHCA, management would be freed up to consider more extensive acquisition strategies and possibly more diversification into regulated or unregulated businesses. Do board members believe they have sufficient background to evaluate these new opportunities properly?
As utilities grow in size through mergers, their regional or even national platforms likely will attract board members from a wider pool of more qualified potential candidates.
Utility boards also should be considering if their governance structure would benefit from further structural change. Should the role of chairman and CEO be separated? The utility industry has lagged the broader market in implementing this change, with only 23 percent of the top utilities having separated the roles, versus 34 percent of 1,158 U.S. companies surveyed by Governance Metrics International.
In a related area, increased pressure from some investors has encouraged boards to take a look at their defense mechanisms, devices that many companies put in place in the 1990s and that some argue may prevent appropriate strategic dialogue on transactions that could replace incumbent management. The resulting efforts have included declassifying the boards, removing the poison pills, and eliminating supermajority voting requirements. In recent months, some utilities, such as Allegheny, Xcel, PG&E, and FirstEnergy have implemented some or all of these changes.
With investors, rating agencies, and regulators all scrutinizing utilities for their policies on corporate governance, the focus on better governance likely will not abate in the near term. Utility board members and CEOs should be reviewing their corporate policies to determine if further steps are required to embrace both the spirit as well as the letter of good corporate governance within their organizations.
Kevin Genieser is an executive director in the Investment Banking Division of Morgan Stanley and a member of the firm's Global Energy and Utility Group. He has worked on a range of financing and strategic advisory assignments in the domestic and international power and energy sectors. Contact him at Genieser@morganstanley.com.
Good Corporate Governance: Interpreting the Rules
What are the goals of these new regulations, and how are they defining good governance?
Many of the new good governance requirements focus on making certain that at least a majority of the board is independent. The board members' first duty is to represent the interests of shareholders, not management, and they are required to be clear of any conflicts that would sway them from acting effectively in their watchdog role. Independent directors are not there as friends and personal advisors to the CEO and his team; they are there to ask tough questions, critique strategy and question corporate practices to make certain that the corporate ship is sailing in the right strategic direction.
In addition to re-establishing independence, a tough eye has been turned to information flow more broadly. Many reformers believe that if better controls had been in place and key information had flowed to the board, many of the scandals that rocked the industry would have been uncovered earlier. In addition, both investors and board members are demanding more timely and higher quality information on how companies are run and increased comfort that the inner workings of corporate America are free from infirmities. For example, new regulations have been put in place requiring that corporate financial controls be independently audited on an annual basis.
Many critics have contended that boards historically were dominated by individuals picked more for their prestigious reputations or relationships with the CEO than the skills they brought to the boardroom. They were not expected to spend time fully understanding the business or industry in which the company operated. Strategy and business operations were the purview of the management. Board members were relied upon to bring external perspective to an organization and at times their stature within industry could be used by management to help achieve certain corporate goals. Utilities, in particular, sourced board members from their service territories, looking to add local business leaders, educators and community leaders as directors, rather than individuals with skills in the core business such as regulatory, operational, or strategic expertise.
Under the old regime, time commitments to serve on boards were limited, which allowed an individual to be a director for numerous companies. Serving on multiple boards became another sign of a successful career. However, in this new world of good governance, the demands of board membership are increasingly more rigorous. To comply with the new regulations, board members are required to spend much more time preparing for and participating in board-related functions. To adequately play the role of corporate cop, board members are now expected to have independent views on the industry and the company's position within it. Board members need to have an in-depth view of a company's operations and financial condition so that they can ask the right questions in case things go amiss. They must be able to evaluate corporate strategy and reign in management that drifts too far afield. This desire to achieve independence has been further reinforced by requirements for executive sessions of independent directors, where management (including management who may also be on the board) is absent. These sessions are designed to allow independent board members to discuss a company's prospects, operations and senior executives without being influenced by the management team. -K.G.
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