Corporate Governance Reform After Enron

Corporate Research E-Letter No. 28, October 2002


by Mafruza Khan

Since the unraveling of corporate crimes at Enron and other high profile U.S corporations, politicians, regulators and corporate executives have all joined in the call for corporate accountability through better corporate governance. Broadly speaking, the term corporate governance refers to the relationship between the investor/owners, directors and management of corporations. At a broader level, corporate governance is the starting point for a discussion about the responsibility of companies and executives toward a wider base of stakeholders -- customers, employees, shareholders, business partners and in particular, the communities within which they operate. This e-letter gives an overview of several key corporate governance issues and reviews related corporate governance reform measures that have been proposed and/or adopted recently.


The election of directors, board independence and related matters are one of the key issues in the debate on corporate governance. Critics contend that crucial board functions and committees are compromised when a majority of the board is not independent because of potential conflicts of interest.

The definition of board independence itself is subject to considerable debate. At a fundamental level, directors are considered independent or outside directors if they are not employed by the company. Other criteria include significant relationships with the company, including business and family ties. The Securities Exchange Act of 1934 defines a non-employee director as one who is not currently employed by the stock issuer; does not receive compensation directly or indirectly other than as a director; has no business relationship requiring disclosure; and is not an "interested person."

As is evident from the post-Enron governance reforms proposed from different quarters, board independence is considered essential for ensuring proper checks and balances in the governance of corporations. For example, according to the New York Stock Exchange's (NYSE) Corporate Governance Rule Proposals, "No director qualifies as independent unless the board of directors affirmatively determines that director has no material relationship with the listed company." In addition, a five-year "cooling off" period is proposed for former employees, persons who have been employed by a current or former auditor, has been an interlocking director, or has family members in these categories. NYSE stipulates that companies must disclose these relationships, when they exist.

Under NASDAQ's Corporate Governance Proposals, a director is prohibited from being deemed independent if any family member of the director is employed as an executive officer of the issuer of any of its affiliates, or has been in the past three years. A three- year "cooling off'" period is also required for former employees or partners of auditors and interlocking directors. An independent director is prohibited from receiving any payments in excess of $60,000 other than for board service, as is any non-employee family member of the director. Directors serving as an executive officer of not-for-profit organizations are not deemed as being independent if the issuer makes payments to that organization and the payments exceed the greater of $200,000 or five percent of either the issuer's or the not-for-profit's gross revenues. Institutional investors have their own set of guidelines for defining director independence. The California Public Employees Retirement System's (CALPERS), definition of independent director excludes former employees who have served in an executive capacity in the last five years and advisers/consultants, customers, suppliers, contractors and family members. A five-year "cooling off" is required for persons who have had any business relationship with the company (other than service as a director) for which the company has been required to make disclosure under Regulation S-K of the Securities and Exchange Commission and for interlocking directors. The CALPERS guideline also states that an independent director cannot be affiliated with a not-for-profit entity that receives significant contributions from the company, but does not qualify what is "significant", unlike the NASDAQ criterion for not-for profits. The Teachers Insurance and Annuity Association-College Retirement Equities Fund's (TIAA-CREF) criteria include no present or former employment by the company or any significant personal or financial ties to the company or its management that could compromise the director's objectivity and loyalty to the shareholders. Suffice it to say there is a problem here. While the examples above have some common ground, there is enough divergence to cause confusion among investors and create loopholes for opportunistic, unethical corporations. Unless the definition of director independence is standardized, it would be an unclear criterion susceptible to manipulation and create the same conditions of inadequate oversight that allowed companies like Enron and WorldCom to engage in fraudulent activities. In other words, while board independence is a necessary condition for corporate accountability, unless there is a standard definition of independence, current measures could be largely ineffectual.

A relatively simple definition would probably work best. We like the definition proposed by the Council of Institutional Investors (CII), "Stated most simply, an independent director is a person whose directorship constitutes his or her only connection to the corporation."

CII is an organization of large public, Taft-Hartley and corporate pension funds and its members include state pension funds, including CALPERS, unions and most of the activist/progressive institutional investors. One would think that at least this subgroup of state and union funds within CII could adhere to a standard definition of director/board independence.


According to a report by the Investor Responsibility Research Center (IRRC) and the Shareholder Action Network of the Social Investment Forum (SIF), IRRC tracked 15 shareholder proposals in 2001 that specifically called for increased board independence. For the complete report, go to


The Enron meltdown has prompted legislative action: the Sarbanes-Oxley Act of 2002. While the Act has been considered a step in the right direction, it still falls short in addressing some critical reforms advocated by corporate accountability groups. These include enhanced board independence, the abolishment of staggered boards, the expensing of stock options and increased disclosure on social and environmental issues.

Earlier this year the New York Stock Exchange, NASDAQ, and the SEC proposed new rules for stricter corporate governance and disclosure practices. In addition to the rules mandated by the Sarbanes-Oxley Act regarding accounting firms and non-audit services, financial disclosure and certification requirements by the CEO and the CFO, independence of investment research analysts and insider trading, both NYSE and NASDAQ propose that listed companies must have an independent board of directors and independent board committees.

The Exchanges also exempt controlled companies from the requirements of a majority independent board. A controlled company is a company in which an individual, group or another company, holds more than 50% of the voting power. A controlled company relying on this exemption must disclose in its annual meeting proxy that it is a controlled company and the basis for that determination. Such companies, however, remain subject to each of the audit committee requirements. The Exchanges also stipulate that non-management directors must meet at regularly scheduled executive sessions without management.


Activist institutional investors have been advocating for governance reforms for over two decades. While it is true that institutional investors are in a position to influence billions of dollars, the power of individual investors should not be discounted. Just as voting is essential for democratic participation in the political process, individual investors need to exercise their rights as shareholders by voting their proxies to make corporations more democratic and accountable. With current disclosure rules adopted by the SEC and capital markets, working and middle class investors should be in a better position to evaluate companies. At the same time, individuals need to hold their pension fund managers and state treasurers accountable.

The two common threads among the proposed reforms seem to be the issue of board independence along with independence of key committees and meaningful disclosure. One simple way of enhancing stakeholder participation and finding knowledgeable directors is to go along the direction of the European model, i.e., recruiting employees as directors. With adequate safeguards, i.e., reputation, cronyism may be avoided. Another way to ensure check and balances is to separate the functions of the CEO and the chairman, again quite common in the European model.

Similarly, in order to broaden corporate loyalty and obligations to stakeholders other than shareholders (i.e., management in a world of Enrons), the law should be amended to state that shareholder gain may not be pursued at the expense of the community, the employees, or the environment.


For SEC rules:

For NYSE corporate governance listing standards:

For NASDAQ rules:

For a good overview on corporate governance issues: