Corporate Governance in the “New Normal” Business Environment

I. Introduction

In the wake of the financial crisis of 2008-09, some observers believe that our traditional market-based, capitalistic, macro-economic business environment may be entering a new era, dubbed the “new normal,”[1] in which economic, political and surrounding influences and circumstances will not return to their pre-crisis norms.

These observers predict that this “new normal” business environment may entail, among other things:

• slower or no domestic economic growth;
• higher levels of government involvement in private business through increased regulation, taxation and direct intervention;
• a relatively weak dollar;
• long-term inflation risk; and
• overall increased business risk aversion.[2]

Some also forecast that private sector unemployment will continue at relatively high levels and that commodity prices will continue to rise. This “new normal” business environment is also likely to include the continued growth of corporate globalization (especially involving emerging market countries) and an increased emphasis on environmental sustainability practices by corporations.

Corporate governance practices may play an important role in determining how successfully companies may be able to adapt to this “new normal” business environment. This article discusses some of the corporate governance issues that boards of directors may confront in addressing the risks and opportunities arising out of this “new normal.”

II. How Aspects of the “New Normal” Business Environment Will Impact Corporate Governance

A. Slower (or No) Economic Growth

Some predict that, even after the ultimate “end” of our financial crisis, domestic economic growth is likely to remain at relatively low levels for an extended duration, or that we may experience a prolonged “no growth” period. This will result in an increasingly challenging business environment that, instead of promoting the much desired boardroom focus on long-term value creation, may actually accelerate investors’ emphasis on short-term, activist investing, much like as was evidenced over the pre-crisis years by the rise of day-traders, hedge funds and similar speculative investors.[3]

As many historical investment options become more challenged in a slow or no growth economy, these circumstances may result in increased pressure on boards of directors from institutional shareholders to produce higher short-term returns. Generating increased near-term returns in a slow or no growth economic environment may involve further intensified boardroom efforts to reduce labor and/or supply chain costs and pursue short-term revenue and earnings enhancement goals and objectives.

In some cases, these circumstances may lead boards to implement specific governance policies and practices to boost their near-term share price by, for example, removing takeover defenses such as poison pills, classified boards and supermajority vote requirements,[4] and pursuing more business combinations that can result in achieving additional financial and business synergies. Hedge fund and other short-term investors also may act as “governance arbitrageurs,” seeking corporate governance reform from companies in which they invest[5] in order to drive near-term share price increases to improve their portfolio performance.

As a result, in the “new normal” business environment, boards may struggle to remain focused on delivering long-term value to shareholders in the face of increasing pressure from hedge funds and other activist, short-term portfolio managers who will be starving to generate positive investment returns for their long-beleaguered investors in a slow or no growth economic environment.

B. Higher Taxation

Some commentators expect higher levels of business and individual taxation in the “new normal” business environment.[6] As tax rates increase, the expected tax consequences of strategic and business decisions will become a more significant consideration to boards of directors and could begin to offset the underlying fundamental financial or business motivations to engage in specified transactions.[7]

Similarly, corporate governance practices may also be more impacted by the tax impacts of board decision making. According to one commentator, “[t]he basic intuition for how corporate governance and taxation interact is that tax avoidance demands complexity and obfuscation to prevent detection,” and that “these characteristics, in turn, can become a shield for managerial opportunism.”[8]

Moreover, studies have linked strong corporate governance with lower tax risk in certain jurisdictions.[9] Lower tax risk can result in more certainty around the amount of tax liability and result in a potential for reduced compliance costs.[10] In light of the increasing importance of taxes and the interaction of tax and corporate governance, the idea of “tax governance” is receiving renewed attention.[11]

In the “new normal” business environment, boards may be called upon to revisit the question of how to structure their governance processes to take into account and mitigate against the negative effects of the increased tax consequences from otherwise seemingly beneficial strategic and business decisions.

Additionally, as tax rates on dividends and capital gains increase in the era of “new normal,” many boards may be less motivated to return corporate cash resources to shareholders through increased dividends or corporate stock repurchase programs, opting instead to reduce debt or increase capital expenditures. Similarly, tax-free acquisition transactions may take increasing precedence over cash buyouts. These impacts will likely change many boards’ long-held perspectives on how best to deliver tangible investment returns to shareholders (particularly as share prices otherwise stagnate).

C. Increased Regulation

The dramatic shift toward “re-regulation” that has occurred during the financial crisis is expected by some pundits to continue in the “new normal” business environment, as our federal and state governments are expected to become ever increasingly involved in private sector enterprises through increased legislation, regulation, judicial intervention, co-ownership, co-investment and otherwise.[12]

This re-regulation will likely not be limited to the financial services industry, but will be extended into all private industry business sectors. The resulting continued blurring of the line between the public and private sectors will mean that a company’s relationship with, and connections to, its regulators and legislators will become increasingly important to a private enterprise’s financial success. Boards will need to focus on how to best manage these relationships and connections in the context of applicable ethical and legal requirements.

As Richard Haass, President of the Council on Foreign Relations, recently observed, “it can’t simply be an afterthought, a question of lobbying or implementation. But rather, the entire issue of government, and the division of labor between the company and government, needs to be something that is thought through from the outset.”[13]

D. Enhanced Focus on Environmental Sustainability

The development, implementation and reporting of environmentally sustainable business practices has become a hot button issue in recent years for corporate governance reform activists, and a large number of shareholder proposals relating to the topic have been submitted to publicly traded companies. This trend is likely to continue and accelerate in the “new normal” business environment. A recent rule interpretation by the Securities Exchange Commission, moreover, may result in a rise in the number of environmental, climate change and other social policy-related shareholder proposals submitted in 2010.[14] (The SEC’s interpretation rejected a previous position on which many companies had relied to exclude such proposals from their proxy statements.)

Because environmental sustainability issues may involve considerations other than maximizing shareholder value in a narrow sense (e.g., protection of natural resources or the values of society generally), boards may be increasingly called upon to strike a delicate balance between, or otherwise reconcile, environmental sustainability considerations and their related non-shareholder constituency proponents against boards’ overarching fiduciary duty to their shareholders.

E. Sustained Higher Unemployment Levels

Some forecasters, including some policymakers at the Federal Reserve, predict higher sustained levels of private sector unemployment in the “new normal” business environment than has been the case over the last 15 years.[15] If these predictions prove to be accurate, companies may be able to attract and retain key personnel more easily, but demand for new employees, products and services may be relatively low compared to historical levels. In their oversight role, boards may need to ensure that employee and executive compensation and benefit arrangements reflect these realities. Similarly, as a result of these “new normal” labor market circumstances, boards may be able to act much more aggressively when pursuing plant/facility locations and related government subsidies and employee concessions.

F. Globalization

Globalization has resulted in increased competition and expanded international operations for many U.S. companies and these effects will likely continue in the “new normal” era.[16] In fact, the rapidly accelerating development of China, India and Russia, with Africa next on the horizon, will likely drive our global economic growth, as well as many companies’ financial prospects, in the “new normal” business environment. Accordingly, boards will need to continue to address these factors, especially adapting corporate governance practices to take into account the ethical business practices of, and companies’ relationships with, foreign governments.

G. Weakening Dollar, Inflation and Rising Commodity Prices

If, as is predicted by some observers, the dollar continues to weaken, inflation remains a long-term possibility[17] and commodity prices rise, the risks posed to companies by these forces will increase in magnitude. Boards will need to devote increased attention to managing the impacts of such factors on their companies’ core business and making strategic and business decisions that specifically take these trends into account.

H. Increased Business Risk Aversion

Many politicians and other commentators believe that an excessive level of risk taking by financial institutions was a prime reason for our financial crisis. As a result, through legislation, SEC disclosure rules and litigation, many boards of directors of both financial and non-financial companies will be strongly encouraged to become more business risk averse. The impact this changed perspective will have on strategic and business decisions, as well as executive compensation practices, may further exacerbate our “new normal” business environment.

III. Other Governance Trends that May Continue in the “New Normal” Environment

The financial crisis seems to have inspired or provided momentum to a number of “opportunistic” corporate governance practices that may not be directly linked to the financial crisis. Some of these practices have been, or are proposed to be, mandated by legislators or regulators, while others have been adopted only voluntarily or in response to shareholder pressure.

These practices include majority director voting, the elimination of classified boards, the elimination of broker non-votes in director elections, permitting shareholders to more easily call special meetings and, potentially, the grant of a proxy access right to significant shareholders so that they may nominate their own director candidates.

One effect of many of these reforms is to change the relative balance of power between directors and shareholders in favor of shareholders by permitting shareholders to more easily affect director elections, as well as some of the decisions being made in the boardroom. This may result in the potential for politicization of the director election process and use of the election process for narrow special agendas that are of interest only to some shareholders. In the area of executive compensation, proposed legislation and regulation could further erode the board’s power by mandating advisory shareholder votes on executive pay (“say on pay”) and restricting the types of executive compensation arrangements a company may enter into without shareholder approval (e.g., certain change in control payments).

These corporate governance practices, and the accompanying loss of board discretion and the foundations for the business judgment rule, will likely continue to be a challenge for boards in the “new normal.”

IV. In Conclusion

A “new normal” business environment will challenge and change many long-held board governance precepts and will force directors to approach the governance of their companies with entirely new macro perspectives on how best to make strategic and business decisions that are in the best interests of their shareholders.

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About the Authors

Steven Barth is a partner in the national law firm of Foley & Lardner, LLP specializing in corporate governance matters and Joshua Agen is an associate.

Foley & Lardner is currently hosting a series of 13 webinars on timely corporate finance and governance issues as part of its ninth-annual National Directors Institute.

To register and view upcoming events, see: http://www.foley.com/ndi.

Sources:

• [1] See PIMCO Secular Outlook 2009, A New Normal (available at http://www.pimco.com/LeftNav/Viewpoints/2009/Secular+Outlook+2009.htm).
• [2] See id.; Mohamed El-Erian, Secular Outlook – A New Normal (May 2009).
• [3] Cf. Sree Vidya Bhaktavatsalam, Individuals Rushing to Bear-Market Funds From JPMorgan to Pimco, Bloomberg (Nov. 24, 2009).
• [4] Robin Greenwood, et al., Hedge fund investor activism and takeovers at 27 (2007).
• [5] See Yvan Allaire, et al., Hedge funds as “Activist Shareholders”: Passing Phenomenon or Grave-Diggers of Public Corporations? at 5 (Jan. 2007).
• [6] See El-Erian, Secular Outlook – A New Normal.
• [7] See Mihir A. Desai, et al., Taxation and Corporate Governance: An Economic Approach (April 2007).
• [8] Id.
• [9] See Centre for Tax Policy and Administration, Tax guidance series – Corporate governance and tax risk management at 9 (July 2009).
• [10] See Desai, et al., Taxation and Corporate Governance: An Economic Approach, supra n. 7.
• [11] See Centre for Tax Policy and Administration, Tax guidance series – Corporate governance and tax risk management, supra n. 9, at 9.
• [12] See El-Erian, Secular Outlook – A New Normal; McKinsey Quarterly interview with Richard Haass (October 2009).
• [13] McKinsey Quarterly interview with Richard Haass (October 2009).
• [14] See SEC Staff Legal Bulletin 14E.
• [15] See Joshua Zumbrun, Strong Growth Could Come With High Unemployment, Forbes Magazine, July 15, 2009.
• [16] See El-Erian, Secular Outlook – A New Normal.
• [17] See id.

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