Thoughts on the state of corporate governance

Corporate governance is fundamentally broken. Not because of the long-standing debate between short-term and long-term investors. The issues are more basic. The relevant question is quite simple: Are most corporate directors sufficiently competent, capable, engaged and shareholder focused to assume and adequately exercise the roles they occupy? Where is the academic and investor research directed to those questions? While there are volumes of research on issues of management entrenchment and executive compensation, there is significantly less, if any, directed to essential qualitative questions: Who "should" serve as a director? Are directors more or less likely than management to impede, or disfavor, a transaction that could lead to the loss of their sinecures?

How are directors selected? Is that process effective, whether conducted informally through the recommendations of fellow directors or through an executive search firm? Are the right qualities assessed when directors are appointed? Simply because a proposed director has industry experience does not mean they understand the industry in its current state or the issues that a particular company may face. A senior executive retired for 10 years may have neither a good sense of current industry practices nor an informed view of prevailing market trends or conditions. Having well-known former government officials with no industry experience, while perhaps providing some "reputational" value to a corporate board, doesn't necessarily serve to enhance a board's primary oversight role.

Take, for example, Theranos, a privately held company (with a purported $9 billion valuation) focused on developing new, disruptive blood testing technologies. Wall Street Journal articles over the past several months have raised substantial questions about the efficacy of Theranos' technologies and entire business model. Of its 12-member board when these stories were first published, two were former secretaries of state, one a former secretary of defense, a retired U.S. admiral, a retired U.S. general, a former U.S. senator, and a retired bank CEO. While no one can doubt the exceptional credentials or careers of those individuals, one can certainly question whether they were the best suited to oversee a company at the leading edge of medical technology? With technology trends, and corporate strategies, changing ever more quickly, lengthy CVs and reputation alone cannot ensure an effective alignment of requisite skills and director duties.

After commencing board service, how is a director's performance evaluated, especially as corporate strategy evolves or swerves in new directions? Does any real transparency exist when it comes to evaluating the influence directors have on corporate strategy? Can there be sufficient confidence that a director exercising influence is actively engaged in the oversight process (beyond a handful of meetings each year) or has the appropriate level of acuity to understand changing corporate circumstances? Does self-assessment and self-grading really work? If directors' tenures are tied to some form of self-scoring system, should a sensible investor expect to see any board turnover?

While management remains responsible for results, it does so within parameters established by corporate directors. Some of these directors, like many boards, may offer more, and some less, direction or guidance. Even with enhanced proxy access, with the theoretical ability to "remove" directors, the practicalities are such that it remains nearly impossible to assess, in real time, the effects that director decisions may have on long-term corporate strategies or short-term corporate tactics. How does the annual operating plan, as approved by the board, determine corporate strategies or mandate certain tactics? How does the board's review of strategic business plans, multi-year and otherwise, affect research and development decisions that necessarily inform new product pipelines and, eventually, revenue opportunities? What methods, if any, exist to assess those inherent influences? By watching a company's stock price? If that's the sole determinant, it is surely a lagging indicator, and one which offers a rather limited check. There must be better ways to make, and to monitor, board selections. There must be better ways to assess the continued contributions of those directors than a system dependent on cumbersome proxy access plagued by time lags. Should there exist an association of "professional," certified directors that can offer oversight services across multiple industries? Simply stated, director selection, director performance and director contributions require more effective and transparent forms of continuous evaluation and oversight than currently available.

Beyond selection issues, are directors, once comfortable in their positions, inclined to favor, or disfavor, transactions that may lead to the loss of their corporate income streams? Is "director entrenchment" an issue?

Much is made of "management entrenchment," where management constructs roadblocks to prevent a change of control that may lead to job loss. There is little research, at least readily identifiable, that asks the question about "director" entrenchment. Why wouldn't management, which typically holds significant equity in a company and benefits from golden parachutes or other severance arrangements, seek to enrich themselves through a change of control transaction? Rather than wait one, two, three or four years for time-based equity to vest, why wouldn't management, assuming management is terminated post-closing, prefer the "instant" acceleration that is likely afforded under most severance plans. Absent this acceleration, management would assume the market risks associated with time or performance-based equity compensation - if and when that equity compensation vests it may have a different, and potentially lower, value than when granted. All these risks are inevitably weighed by management against the possibility of immediate equity acceleration and severance payments that could result from a change of control. What do those facts mean? Well, they suggest that management may not reflexively be against most transactions that lead to a termination of employment.

In contrast, is a director inclined to pursue a transaction that might lead to the loss of a board seat? A 2014 survey by the compensation consultants Frederic Cook showed a median total compensation for directors within the technology industry of a little over $200,000 annually. For larger, Fortune 500 companies those amounts are substantially higher. Board positions are lucrative. They are not undertaken for a pittance nor are they assumed any longer solely for prestige. If director compensation provides the principal source of retirement income for a board member, might that lucrative income stream raise questions of "director entrenchment." Is a retiree dependent on board income more or less likely than management to favor a change of control, especially if that management team is looking forward to an immediate, large severance payment? The focus in change of control transactions has traditionally been on management entrenchment. That may not be so appropriate when annual director compensation climbs into the hundreds of thousands of dollars. In that context, the question becomes whether a person serving as a director is likely to relinquish a post that typically requires only a handful of yearly meetings and offers substantial perquisites. That director is probably even less inclined to do so when other board opportunities are not so readily available.

Unlike many a CEO or other "at will" employees, a board member may not be so easily dismissed. Indeed, removal likely requires stockholder action under state law. In that light, the selection, performance, and oversight of directors becomes even more critical. And the influence those directors exert, whether on corporate tactics, strategies or fundamental corporate transactions, require improved understanding and recognition. A failure to appreciate these underlying dynamics, and to further research their implications, leaves matters of corporate governance in a very unsatisfactory state.

Scott M. Wornow is senior vice president and chief legal officer of Atmel.