Why Corporate Governance Today?

III. Corporate Governance Issues

CalPERS has neither the resources, nor the expertise, to run the companies in which it holds publicly-traded stock. Moreover, the legal duties of care and loyalty rest with the corporate board of directors, not with the shareholders. For these reasons, CalPERS views its role as that of a catalyst for improved management and accountability.

A decade ago, CalPERS used shareholder proposals as a means to enact general governance reforms (e.g., eliminating the poison pill in the anti-takeover atmosphere of the mid-1980s). In 1991, the System tried a "kindler, gentler" approach. That is, it did not file proposals but only sought to meet with the independent directors of targeted companies. But the experiment was not a success. The following year, CalPERS reverted to filing proposals when necessary.

CalPERS will continue to file proposals, if only to assist its ongoing efforts to meet with a company's independent directors. Once at the meeting, CalPERS' approach is to query the directors about broad issues of governance and structure. Shareholder proposals are not, however, the panacea for all that ails poor performing companies. These proposals represent a tool -- one of several -- which can be used to attract a distracted board's attention and to voice the collective displeasure of company owners.

The issues which CalPERS will raise, in shareholder proposals or informal dialogue, may be categorized into four broad subjects, as this paper next outlines.

Shareholder Freedom to Elect Directors

While shareholders do not legally have the right to select the managers of a company, they do have the right to elect the directors. Since the directors oversee management, it is particularly important that shareholders have the ability to freely and intelligently exercise the proxy vote.

Prior to 1992, the SEC had strict rules limiting the scope of communication between shareholders, as to their pending votes on a given proxy issue. CalPERS was instrumental in convincing the SEC to relax this burden. Now, shareholders can speak with relative freedom about voting issues.

But other problems still hamper the ability of shareholders to influence the selection of directors. For example, many companies persist in "staggering" the terms of their directors, so that shareholders can never remove an entire management slate from office. The elimination of this so-called "classified board" was a favorite subject for proposals in the 1994-95 proxy season, and received strong shareholder support.^[24] Until these problems are resolved, CalPERS will continue to promote:

1. Effective shareholder participation in the selection of management-nominated directors.
   
2. Proxy reform, especially for confidentiality in collection, independence in tabulation and uniformity in the treatment of abstentions and non-votes.
   
3. Meaningful criteria for director qualifications, to be adopted publicly by the board of each company.

Enable Directors to Govern

Traditionally, a company's directors have been tasked with the role of choosing and monitoring its managers. But this is a moot exercise unless the directors also have the power to effect change. Directors should go beyond a basic "watchdog" role, to foster effective policies and act in a strategic capacity. Ideally, directors should have a recognized role in governing the corporation. To this end, CalPERS will continue to seek:

1. True independence of directors, meaning the absence of any monetary, financial or commercial relationship with the company that might impair the duty of loyalty to shareholders. Every board should have a majority of truly independent directors, and some committees should have only independent directors (e.g., audit, nominating and compensation committees).^[25]
   
2. Support sufficient resources for independent directors, to provide the type of research and analysis that is now only available to management directors, and sufficient time be allotted at Board meetings to enable the directors to ask questions so as to better understand the company's operations.^[26]
   
3. Quality control over the extent and accuracy of corporate information provided to independent directors (i.e., the necessary tools to do an effective job of governance).
   
4. Periodic self-evaluation by the Board of its own procedures, practices and performance.

Align Interests of Owners/Managers

In most instances, shareholder trust is well-placed in the care of a company's directors and managers. When it is not, the results can be disastrous. CalPERS strives to encourage:

1. Financial incentives for enhanced share value (e.g., pay or bonuses in the form of stock).
   
2. Increased participation by other institutional shareholders (beyond those that have historically been active in this area), toward a mutuality of interest with management. This "ownership role" is a central thesis of CalPERS' corporate governance program, and we should strive to work in alliance with other institutions.
   
3. Reduced restrictions on the ability of shareholders to change or control a company's structure and governance. Conflict is inherent in certain areas: compensation of officers, corporate expansion, payment of dividends, stock turnover and communicating information to shareholders.^[27] Shareholders should participate with management in making critical decisions, especially when this type of inherent conflict is present.

In meeting with independent directors, CalPERS is careful to distinguish a related issue, which is shareholder activism for rights to sponsor social causes and human rights. By longstanding policy, CalPERS does not incorporate this issue into its corporate governance program. CalPERS believes its policy is necessary to avoid an inherent conflict both for its own fiduciaries, and those on a corporate board, that would arise if trust funds were invested imprudently or corporate policies were diverted to non-shareholder purposes.^[28]

That is not to say CalPERS is unwilling to evaluate the impact of a selected social concerns that bear a direct relationship to share value. For example, CalPERS incorporated a "workplace practices" screen in its 1994-1995 corporate governance program, but only after it studied whether such practices were likely to add value.

Study the International Markets

CalPERS entered the international security markets in late 1988. Two years later, it began to exercise its voting rights. The System's corporate governance program has included an international component every year since 1992, when it began to research governance issues relevant to certain European countries (e.g., the United Kingdom, France and Germany).

In 1993, this research focused primarily on Japan and the United Kingdom. CalPERS also took a "proactive stance" in proxy voting with regard to dividend payments and board governance in Japan, and the issue of listings on the European stock exchange for companies from the United Kingdom. This also marked the year in which CalPERS adopted specific proxy voting guidelines for its international holdings, separate from the domestic guidelines.

CalPERS has continued its research since then, along with informal activities such as conference and workshop participation on the subject of international corporate governance. Its focus on Japan and the United Kingdom has continued, with some expansion into corporate governance issues in France and Germany. Public reaction to these efforts has demonstrated a widespread foreign interest, especially as to how corporate governance might affect the infusion of new capital into the international markets. This interest has spread rapidly as CalPERS has steadily increased its international holdings.

As on the domestic front, CalPERS has one overriding reason for studying foreign markets -- the enhancement of long-term investment returns. A large and passive investor, CalPERS cannot readily trade its international holdings. Its international stock portfolio is managed by outside managers, largely under a variety of indexes.

In the foreign market, as in this country, indexed trading means poor performers are not usually sold. Rather, they are retained in order to "replicate the market." Once again, corporate governance is one of the few active mechanisms that may be used to enhance the indexed returns.

As this paper earlier discussed, by now several studies have quantified a link between shareholder activism and improved returns. There is scant logic in treating equity ownership differently, depending on the country of origin. CalPERS is hopeful that its success to date in adding value to domestic stock, can be duplicated for its international portfolio.

CalPERS is not, however, yet ready to "export" its domestic corporate governance program. While the philosophy logically has global application, we do not yet fully understand all of the foreign laws, customs and culture that affect the corporate structure, and the rights and responsibilities of shareholders. Further study will enable CalPERS to act within other countries, with the same credibility and respect as it has attained in the U.S.

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24 - This type of proposal accounted for seven of the 12 that won majority votes in 1995. See IRRC Corporate Governance Highlights, May 26, 1995 at 1.

25 - Richard H. Koppes, Ira M. Millstein, et al., A New Compact for Owners and Directors, Harvard Business Review (July/August 1991).

26 - See Robert Todd Lang and Spencer G. Smul, Caution: Monitors on Board, Business Law Today (Jan/Feb 1994) at 50.

27 - "See Security Analysis," supra note 3, at 510-511.

28 - The Board was advised that a company's skill in training and motivating its workforce, may lead to improved economic performance. See Lilli Gordon, "High-Performance Workplaces: Implications for Investment Research and Active Investing Strategies," paper presented to the Board in June 1994.

CalPERS, 8-1-95.
Copyright reserved.
CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
WHY CORPORATE GOVERNANCE TODAY?
A Policy Statement
August 14, 1995
Copyright Reserved

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