Testimony of Ann Yerger, Council of Institutional Investors, July 29, 2009

Testimony of Ann Yerger, Executive Director, Council of Institutional Investors before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs July 29, 2009

Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee: Good morning. I am Ann Yerger, Executive Director, of the Council of Institutional Investors (“Council”). I am pleased to appear before you today on behalf of the Council.

My testimony includes a brief overview of the Council followed by a discussion of our views on the following issues that you informed me were the basis for this important and timely hearing: • What weaknesses has the financial crisis revealed about executive compensation, board composition, proxy rules, or other corporate governance issues?

• What key legislative and regulatory changes should be considered to ensure shareholders are adequately protected and appropriate incentives exist for optimal long-term performance at companies?

• What information exists about the potential impact of various approaches to improving corporate governance regulation?

The Council

Founded in 1985 the Council is a nonpartisan, not-for-profit association of public, labor and corporate employee benefit funds with assets exceeding $3 trillion.

Today the organization is a leading advocate for improving corporate governance standards for U.S. companies and strengthening investor rights. Council members are responsible for investing and safeguarding assets used to fund retirement benefits of millions of participants and beneficiaries throughout the U.S. They have a significant commitment to the U.S. capital markets, with the average Council member investing approximately sixty (60) percent of its entire portfolio in U.S. stocks and bonds.

They are also long-term, patient investors due to their investment horizons and their heavy commitment to passive investment strategies. Because these passive strategies restrict Council members from exercising the “Wall Street walk” and selling their shares when they are dissatisfied, corporate governance issues are of great interest to our members.

Council members have been deeply impacted by the financial crisis. As a result, they have a vested interest in ensuring that the gaps and shortcomings revealed by the financial crisis are repaired.

What weaknesses has the financial crisis revealed about executive compensation, board composition, proxy rules, or other corporate governance issues?

The Council believes the financial crisis has exposed some very significant weaknesses in the regulation and oversight of the U.S. capital markets. Gaps in regulation, inadequate resources at existing regulators and failures of regulatory will were key contributors. But so were failures in the corporate boardroom.

Council members, U.S. citizens and investors around the globe, have paid the price for these failures. Not only have they suffered trillions of dollars in investments losses, they have also lost confidence in the integrity of our markets and in the effectiveness of board oversight of corporate management.

A comprehensive review and a meaningful restructuring of the U.S. financial regulatory model are necessary steps toward restoring investor confidence in our markets and protecting against a repeat of these failures. But regulatory reform alone is insufficient, because vigorous securities regulation on its own cannot solve many of the issues that led to the current crisis. The Council believes that many corporate governance failures contributed to this financial crisis. And as a result, the Council believes corporate governance improvements are a critical component of the necessary package of reforms.

In some cases corporate boards failed shareowners. Some failed to adequately understand, monitor and oversee enterprise risk. Some failed to include directors with the necessary blend of independence, competencies and experiences to adequately oversee management and corporate strategy. And far too many corporate boards structured and approved executive compensation programs that motivated excessive risk taking and yielded outsized rewards—with little to no downside risk—for short-term results.

Current rules and regulations also failed shareowners. Today shareowners around the world— including in countries with far less developed capital markets than the U.S.—enjoy basic rights that shareowners of U.S. companies are denied. Rights such as requiring directors to be elected by majority vote, giving owners advisory votes on executive pay, and providing owners modest vehicles to access management proxy cards to nominate directors are noticeably absent in much of corporate America. Their nonexistence weakens the ability of shareowners to oversee corporate directors—their elected representatives—and hold directors accountable.

The U.S. has long been recognized as a leader when it comes to investor protection, market transparency and oversight. But the U.S. has fallen short when it comes to corporate governance issues. The Council believes that corporate governance enhancements are a long overdue and essential component of the bold reforms required to restore confidence in the integrity of the U.S. capital markets.

What key legislative and regulatory changes should be considered to ensure shareholders are adequately protected and appropriate incentives exist for optimal long-term performance at companies?

The Council believes a number of key corporate governance reforms are essential to providing meaningful investor oversight of management and boards and restoring investor confidence in our markets. Such measures would address many of the problems that led to the current crisis, and more importantly, empower shareowners to anticipate and address unforeseen future risks.

These measures, rather than facilitating investors seeking short-term gains, are consistent with enhancing long-term shareowner value.

More specifically, the governance improvements that the Council believes would have the greatest impact and, therefore, should be contained in any financial markets regulatory reform legislation include: • Majority Voting for Directors: Directors in uncontested elections should be elected by a majority of the votes cast.

• Shareowner Access to the Proxy: A long-term investor or group of long-term investors should have access to management proxy materials to nominate directors.

• Executive Compensation Reforms. Recommended reforms include advisory shareowner vote on executive pay, independent compensation advisers, stronger clawback provisions and enhanced disclosure requirements.

• Independent Board Chair: Corporate boards should be chaired by an independent director.

Majority Voting for Directors Directors are the cornerstone of the U.S. corporate governance model. And while the primary powers of shareowners—aside from buying and selling their shares—are to elect and remove directors, U.S. shareowners have few tools to exercise these critical and most basic rights.

The Council believes the accountability of directors at most U.S. companies is weakened by the fact that shareowners do not have a meaningful vote in director elections. Under most state laws the default standard for uncontested director elections is a plurality vote, which means that a director is elected in an uncontested situation even if a majority of the shares are withheld from the nominee.

The Council has long believed that a plurality standard for the election of directors is inherently unfair and undemocratic and that a majority vote standard is the appropriate one. The concept of majority voting is difficult to contest—especially in this country. And today majority voting is endorsed by all types of governance experts, including law firms advising companies and corporate boards.

Majority voting makes directors more accountable to shareowners by giving meaning to the vote for directors and eliminating the current “rubber stamp” process. The benefits of this change are many: it democratizes the corporate electoral process; it puts real voting power in hands of investors; and it results in minimal disruption to corporate affairs—it simply makes board’s representative of shareowners.

The corporate law community has taken some small steps toward majority voting. In 2006 the ABA Committee on Corporate Laws approved amendments to the Model Business Corporation Act to accommodate majority voting for directors, and lawmakers in Delaware, where most U.S.

companies are incorporated, amended the state's corporation law to facilitate majority voting in director elections. But in both cases they stopped short of switching the default standard from plurality to majority.

Since 2006 some companies have volunteered to adopt majority voting standards, but in many cases they have only done so when pressured by shareowners forced to spend tremendous amounts of time and money on company-by-company campaigns to advance majority voting.

To date larger companies have been receptive to adopting majority voting standards. Plurality voting is the standard at less than a third of the companies in the S&P 500. However, plurality voting is still very common among the smaller companies included in the Russell 1000 and 3000 indices. Over half (54.5 percent) of the companies in the Russell 1000, and nearly three-quarters (74.9 percent) of the companies in the Russell 3000, still use a straight plurality voting standard for director elections.4 Statistics are not available for the thousands of additional companies not included in these indices; however, the Council believes most do not have majority voting standards.

Plurality voting is a fundamental flaw in the U.S. corporate governance system. It is time to move the default standard to majority voting. Given the failure by the states, particularly Delaware, to take the lead on this reform, the Council believes the time has come for the U.S.

Congress to legislate this important and very basic shareowner right.

Shareowner Access to the Proxy

Nearly 70 years have passed since the Securities and Exchange Commission (“SEC” or “Commission”) first considered whether shareowners should be able to include director candidates on management’s proxy card. This reform, which has been studied and considered on and off for decades, is long overdue. Its adoption would be one of the most significant and important investor reforms by any regulatory or legislative body in decades. The Council applauds the SEC for its leadership on this important issue.

The financial crisis highlighted a longstanding concern—some directors are not doing the jobs expected by their employers, the shareowners. Compounding the problem is the fact that in too many cases the director nomination process is flawed, largely due to limitations imposed by companies and the securities laws.

Some boards are dominated by the CEO, who plays the key role in selecting and nominating directors. All-independent nominating committees ostensibly address this concern, but problems persist. Some companies don’t have nominating committees, others won’t accept shareowner nominations for directors, and Council members’ sense is that shareowner-suggested candidates—whether or not submitted to all-independent nominating committees—are rarely given serious consideration.

Shareowners can now only ensure that their candidates get full consideration by launching an expensive and complicated proxy fight—an unworkable alternative for most investors, particularly fiduciaries who must determine whether the very significant costs of a proxy contest are in the best interests of plan participants and beneficiaries. While companies can freely tap company coffers to fund their campaigns for board-recommended candidates, shareowners must spend their own money to finance their efforts. And companies often erect various obstacles, including expensive litigation, to thwart investors running proxy fights for board seats.

The Council believes reasonable access to company proxy cards for long-term shareowners would address some of these problems. We believe such access would substantially contribute to the health of the U.S. corporate governance model and U.S. corporations by making boards more responsive to shareowners, more thoughtful about whom they nominate to serve as directors and more vigilant about their oversight responsibilities.

As such, Council members approved the following policy endorsing shareowner access to the proxy: Companies should provide access to management proxy materials for a long-term investor or group of long-term investors owning in aggregate at least three percent of a company’s voting stock, to nominate less than a majority of the directors. Eligible investors must have owned the stock for at least two years. Company proxy materials and related mailings should provide equal space and equal treatment of nominations by qualifying investors.

To allow for informed voting decisions, it is essential that investors have full and accurate information about access mechanism users and their director nominees.

Therefore, shareowners nominating director candidates under an access mechanism should adhere to the same SEC rules governing disclosure requirements and prohibitions on false and misleading statements that currently apply to proxy contests for board seats.

The Council is in the process of submitting a comment letter to the SEC on the Commission’s outstanding proposal, Facilitating Shareholder Director Nominations.

While we have some suggested enhancements, the Council by and large is very supportive of the proposal. We firmly believe that a federal approach is far superior to a state-by-state system.

The Council believes Congress should support the SEC’s efforts by affirming the Commission’s authority to promulgate rules allowing shareowners to place their nominees for director on management’s card. The Council believes the SEC has the authority to approve an access standard. However others disagree, and the Commission is likely to face unnecessary, costly and time-consuming litigation in response to a Commission-approved access mechanism. To ensure that owners of U.S. companies face no needless delays over the effective date of this critical reform, the Council recommends Congressional affirmation of the SEC’s authority.

Of note, the Council believes access to the proxy complements majority voting for directors.

Majority voting is a tool for shareowners to remove directors. Access is a tool for shareowners to elect directors.

Executive Compensation Reforms As long-term investors with a significant stake in the U.S. capital markets, Council members have a vested interest in ensuring that U.S. companies attract, retain and motivate the highestperforming employees and executives. They are supportive of paying top executives well for superior performance.

However, the financial crisis has offered yet more examples of how investors are harmed when poorly structured executive pay packages waste shareowners’ money, excessively dilute their ownership in portfolio companies and create inappropriate incentives that reward poor performance or even damage a company’s long-term performance. Inappropriate pay packages may also suggest a failure in the boardroom, since it is the job of the board of directors and the compensation committee to ensure that executive compensation programs are effective, reasonable and rational with respect to critical factors such as company performance and industry considerations.

The Council believes executive compensation issues are best addressed by requiring companies to provide full, plain English disclosure of key quantitative and qualitative elements of executive pay, by ensuring that corporate boards can be held accountable for their executive pay decisions through majority voting and access mechanisms, by giving shareowners meaningful oversight of executive pay via non-binding votes on compensation and by requiring disgorgement of illgotten gains pocketed by executives.

• Advisory Vote on Compensation: The Council believes an annual, advisory shareowner vote on executive compensation would efficiently and effectively provide boards with useful information about whether investors view the company’s compensation practices to be in shareowners’ best interests. Nonbinding shareowner votes on pay would serve as a direct referendum on the decisions of the compensation committee and would offer a more targeted way to signal shareowner discontent than withholding votes from committee members. They might also induce compensation committees to be more careful about doling out rich rewards, to avoid the embarrassment of shareowner rejection at the ballot box. In addition, compensation committees looking to actively rein in executive compensation could use the results of advisory shareowner votes to stand up to excessively demanding officers or compensation consultants. Of note, to ensure meaningful voting results, federal legislation should mandate that annual advisory votes on compensation are a “non-routine” matter for purposes of New York Stock Exchange Rule 452

 • Independent Compensation Advisers: Compensation consultants play a key role in the pay-setting process. The advice provided by these consultants may be biased as a result of conflicts of interest. Most firms that provide compensation consulting services also provide other kinds of services, such as benefits administration, human resources consulting and actuarial services. Conflicts of interest contribute to a ratcheting up effect for executive pay and should thus be minimized and disclosed.

• Stronger Clawback Provisions: The Council believes a tough clawback policy is an essential element of a meaningful “pay for performance” philosophy. If executives are rewarded for “hitting their numbers” – and it turns out that they failed to do so – they should not profit. While Section 304 of the Sarbanes-Oxley Act gave additional authority to the SEC to recoup bonuses or other incentive-based compensation in certain circumstances, some observers have suggested this language is too narrow and perhaps unworkable. The Council does not advocate a re-opening of the Sarbanes-Oxley Act, but it does recommend that Congress consider ways to cover cases where performance-based compensation may be “unearned” in retrospect but not meet the high standard of “resulting from misconduct” required by Section 304.

• Enhanced Disclosures: Of primary concern to the Council is full and clear disclosure of executive pay. As U.S. Supreme Court Justice Louis Brandeis noted, “sunlight is the best disinfectant.” Transparency of executive pay enables shareowners to evaluate the performance of the compensation committee and board in setting executive pay, to assess pay-for-performance links and to optimize their role of overseeing executive compensation through such means as proxy voting. The Council is very supportive of the SEC’s continued efforts to enhance the disclosure of executive compensation, including its recent proposal to require disclosures about (1) how overall pay policies create incentives that can affect the company’s risk and management of risk; (2) the grant date fair value of equity-based awards; and (3) remuneration to executive/director compensation consultants. We believe the disclosure regime in the U.S. would be substantially improved if companies would have to disclose the quantitative measures used to determine incentive pay. Such disclosure—which could be provided at the time the measures are established or at a future date, such as when the performance related to the award is measured—would eliminate a major impediment to the market’s ability to analyze and understand executive compensation programs and to appropriately respond.

As indicated earlier in my testimony, the Council believes that a federally imposed standard for majority voting for directors and a SEC-approved access mechanism will be two of the most powerful tools for addressing executive pay excesses and abuses. Their absence in the U.S. corporate governance model effectively insulates directors from meaningful shareowner oversight. We believe enhancing director accountability via both mechanisms would help rein in excessive or poorly structured executive pay packages.

Independent Board Chair The issue of whether the chair and CEO roles should be separated has long been debated in the U.S., where the roles are combined at most publicly traded companies. Interest in the issue renewed in recent years in the wake of Enron and other corporate scandals and, most recently, in response to the financial crisis.

The U.S. approach to the issue differs from other countries, particularly the U.K. and other European countries which have comply-or-disclose requirements regarding the separation of the roles and/or recommend it via nationally recognized best practices. According to the Millstein Center for Corporate Governance and Performance at the Yale School of Management: Up until the early 2000s, the percentage of the S&P 500 companies with combined roles remained barely unchanged in the previous 15 years, at 80%.

Today, approximately 36% of S&P 500 companies have separate chairs and CEOs; this is up from 22% in 2002. However, only 17% of S&P 1500 firms have chairs that can be qualified as independent and the incidence of independent chairs is concentrated on small and mid-cap firms. This is in sharp contrast to the landscape of other countries.

At the heart of the issue is whether the leadership of the board should differ from the leadership of the company. Clearly the roles are different, with management responsible for running the company and the board charged with overseeing management. The chair of the board is responsible for, among other things, presiding over and setting agendas for board meetings. The most significant concern over combining the roles is that strong CEOs could exert a dominant influence on the board and the board’s agenda and thus weaken the board’s oversight of management.

Chairing the Board: The Case for Independent Leadership in Corporate North America 

The Conference Board Commission on Public Trust and Private Enterprise discussed the issue in its post-Enron corporate governance report.

The Commission suggested three approaches— including naming an independent chair—for ensuring the appropriate balance of power between board and CEO functions, and it recommended that “each corporation give careful consideration, based on its particular circumstances, to separating the offices of the Chairman and Chief Executive Officer.”

The Council believes separating the chair/CEO positions appropriately reflects the differences in the roles, provides a better balance of power between the CEO and the board—particularly when the CEO dominates the board, and facilitates strong, independent board leadership/functioning.

What information exists about the potential impact of various approaches to improving corporate governance regulation?

Empirical evidence from companies in the U.S. and countries around the globe support the reforms recommended by the Council.

Majority Voting for Directors Majority voting for directors is not an alien concept. It is standard practice in the United Kingdom, France, Germany and other European nations. And as discussed, it is also in place at some U.S.

companies. The experiences in these countries and in the U.S. indicate that majority voting is not harmful to the markets and does not result in dramatic and frequent changes to corporate boards.

Shareowner Access to the Proxy

 Shareowner access to the proxy is a common right in countries around the globe. According to Glass Lewis, the shareowners of companies in the following countries are provided an access mechanism: Country Requirement Australia Minimum of 5% Canada Minimum of 5% China Minimum of 1% Finland Minimum of 10% Germany Minimum of 5% of the issued share capital or shares representing at least €500,000 of the company's share capital India Deposit of INR 500, refundable if the nominee is elected Italy Minimum of 2.5% of the company's share capital Russia Minimum of 2% of the voting stock South Africa Minimum of 5% UK Minimum of 5% or at least 100 shareowners each with shares worth a minimum of £100 Full Text—Page 17 In addition, a handful of U.S. companies—including Apria Healthcare and RiskMetrics—have voluntarily adopted access mechanisms. And Delaware recently revised its corporation code to allow corporate bylaws to require that a company's proxy include shareowner nominees for director along with management candidates. The experiences in these countries and in the U.S. indicate that proxy access is not harmful to the markets. Indeed these mechanisms have rarely been used by owners in these markets—powerful evidence that the existence of the mechanism may enhance board performance and board-shareowner communications.

Advisory Vote on Compensation

According to the CFA Institute Centre for Financial Market Integrity, the following countries have some form of shareowner vote on executive compensation: • Australia • France • Germany (51% of companies researched provide such a vote) • India • Italy • Poland • Switzerland • Taiwan • UK10 10 CFA Institute Centre for Financial Market Integrity, Shareowner Rights across the Markets: A Manual for Investors (2009), http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2009.n2.1.

Again, the experiences in these markets suggest that advisory votes on compensation are not harmful to the markets. And the fact that few compensation schemes are voted down suggests that shareowners are careful stewards of their voting responsibilities and that advisory votes do not require dramatic “rearview mirror” adjustments to pay.

Independent Board Chair

Non-executive chairs are common in many countries outside the United States. Some 79 percent of companies in the United Kingdom’s FTSE 350 index report that they have independent chairs.11 Splitting the role of chair and CEO is the norm also in Australia, Belgium, Brazil, Canada, Germany, the Netherlands, Singapore and South Africa.

 Again, the experiences in these markets suggest that independent board chairs are not harmful to the markets.

Conclusion

The Council is not the only group advocating corporate governance reforms. The Investors’ Working Group, an independent task force co-sponsored by the Council and the CFA Institute Centre for Financial Market Integrity, issued July 15 a report recommending a set of reforms to put the U.S. financial regulatory system on sounder footing and make it more responsive to the needs of investors.

Noting that “investors need better tools to hold managers and directors accountable,” its recommendations include six corporate governance reforms: • In uncontested elections, directors should be elected by a majority of votes cast.

• Shareowners should have the right to place director nominees on the company’s proxy.

• Boards of directors should be encouraged to separate the role of chair and CEO or explain why they have adopted another method to assure independent leadership of the board.

• Securities exchanges should adopt listing standards that require compensation advisers to corporate boards to be independent of management.

• Companies should give shareowners an annual, advisory vote on executive compensation.

• Federal clawback provisions on unearned executive pay should be strengthened.

The Administration, legislators and regulators have also recognized the need for corporate governance enhancements. The Council commends the SEC for its bold efforts to date, and it applauds the Obama Administration and leaders on Capitol Hill for evaluating corporate governance issues and, in some cases, proposing formal reforms. Many of these proposals would address the key governance shortfalls identified by the Council.

Thank you, Mr. Chairman for inviting me to participate at this hearing. I look forward to the opportunity to respond to any questions.