Bridging the gap between ownership and control.

• Author: Adams, Edward S.

1. INTRODUCTION II. TRADITIONAL CORPORATE GOVERNANCE AND SARBANES-OXLEY A. Problems in Corporate Governance B. Historical Approaches to Curb Corporate Malfeasance 1. Duty of Care 2. Duty of Loyalty 3. Market Forces 4. Contractual Arrangements C. Sarbanes-Oxley III. ALTERNATIVE APPROACHES TO CURB CORPORATE GOVERNANCE PROBLEM A. Increased Individual Shareholder Activism B. Institutional Investors Must Lead the Charge IV. A NEW SOLUTION: FULL-CIRCLE EVALUATIONS AND THE INSTITUTIONAL INVESTOR. A. Full-Circle Evaluations 1. Critiques of Top-Down Systems. 2. The Full-Circle Structure and the Ability to Implement 3. The General Benefits of Full-Circle Evaluations 4. Full-Circle Problems and Solutions B. A Potential Legal Requirement for Full-Circle Evaluations 1. The Duty of Care. 2. The Duty of Loyalty. C. Company-Implemented Evaluation Systems D. Full-Circle Evaluations, Institutional Investors, and Fraud Prevention V. CONCLUSION I. INTRODUCTION

   Recent corporate scandals have focused attention on the corporate world and investors' ability to monitor its activity. This corporate malfeasance demonstrated the failure of the traditional corporate governance system. In addition, congressional attempts to remedy the situation fail to provide adequate corporate governance tools for investors. Additional measures are needed to allow investors to check management conduct and thus restore confidence in the corporate market.

   These additional tools will work best if they come from within the system. Although new regulations aid the individual investor's cause, they are still inadequate to allow for proper corporate governance. In contrast, the institutional investors are in the best position to implement effective changes in corporate governance. Their extensive holdings allow them to influence management and their decisionmaking. In addition, their long-term approach aligns them with shakeholder and other shareholder interests.

   This Article discusses the benefits of full-circle evaluations and how institutional investors could implement a formal full-circle evaluation system for companies and their management to improve corporate accountability. These evaluations would gather feedback from multiple sources, analyze the information collected, and present it to the company and individual managers. Institutional investors could compare each company's activities, performance, and compensation with other similarly situated companies and provide an independent assessment of corporate conduct. This outside assessment, by an influential investor or group of investors, would act as a powerful check on corporate management.

   The Article goes on to suggest that corporations should take advantage of extensive benefits of full-circle systems and implement their own internal evaluations. These could then be used in conjunction with the evaluations by institutional investors to improve the overall results of management evaluations. Although the corporate benefits should be enough for management to act on its own, these systems could be forced on the corporate world by new requirements of self-regulatory organizations (SROs), or they may some day become mandatory of companies as a necessary requirement to satisfy the duties of care or loyalty.

   Finally, the Article addresses the impact full-circle evaluations could have, possibly even preventing the recent corporate scandals. The evaluations add another tool to prevent corporate malfeasance. Whether implemented by institutional investors, companies themselves, or both, they improve corporate communication and produce benefits that lead to better performance. Although it is uncertain whether these systems could have prevented previous corporate scandals, this Article argues that these systems would have increased the chances of identifying the fraud at an earlier time. In sum, this Article discusses the benefits of full-circle evaluations and argues that implementation of these systems by institutional investors, companies themselves, or both, will provide an effective corporate governance tool.

2. TRADITIONAL CORPORATE GOVERNANCE AND SARBANES-OXLEY

   The traditional corporate governance tools do not adequately protect the interests of shareholders and stakeholders, as evidenced by the increasing number of corporate scandals. (1) There is no one place to lay the blame for the system's failure. Legislation protecting corporate interests, outlandish compensation packages, and the excessively high fees paid to accounting and auditing firms all played their role. In the current corporate environment, the protections typically provided by market forces, corporate duties of care and loyalty, and contractual arrangements attempting to align parties' interests are inadequate. Congress attempted to correct this imbalance with the Sarbanes-Oxley Act, but the Act fails to provide investors with a tool to monitor corporate activity.

   1. Problems in Corporate Governance

      The problem associated with the separation of corporate ownership and control has been a popular topic in the corporate law area since the 1930s, when Berle and Means brought the issue to the fore. (2) They observed that because management often has little, if any, of its own capital invested in the corporation, an incentive exists to exploit the shareholder wealth in the form of higher management salaries, bonuses, and perquisites. (3) Other modern scholars have viewed the corporation as an agency relationship in which the shareholders are the principals and management personnel are the agents. (4) Shareholders receive the firm's profits, growth, and capital appreciation while managers are often paid handsomely for their expertise. (5) This agency relationship is beneficial to both parties because shareholders have capital but lack management expertise, while the managers do not have the requisite capital but possess the necessary management skills. (6)

      However, as U.S. shareholders have had to learn all too well in recent times, the risk of management exploitation of shareholder wealth and investment is great. (7) Shareholders in the past had developed various strategies to reduce the risk of agency costs, (8) "including corporate law fiduciary duties of care and loyalty owed by boards of directors to shareholders; market forces; and contractual arrangements between management and shareholders that aim to align management's financial interests with those of the shareholders." (9)

      Although these methods have made a noticeable impact, (10) recent revelations of corporate malfeasance and scandal, (11) in the cases of Enron, WorldCom, (12) Adelphia, Qwest, and Tyco, for example, make it apparent that strategies used by shareholders in the past are no longer enough. "The market collapse has inflicted trillions of dollars of losses on investors who have watched with dismay the exposure of the rigged IPO market, the auditor-independence fiasco, and the massive upsurge in financial and accounting fraud." (13)

      Many have sought to explain how so much corporate fraud, on so many levels, was permitted to occur, and why investors were left unaware until it was too late. (14) It seems that this new trend in corporate malfeasance cannot be attributed to one factor alone, but can only be explained as a result of a culmination of circumstances, including: legislation in the 1990s that primarily protected corporate and financial interests, instead of the interest of shareholders; (15) unprecedented increases in executive compensation; (16) and skyrocketing increases in fees paid to accounting firms by their corporate clients for consulting services. (17) Commentators also criticize Congress, the SEC, and the courts for not preventing "the worst stock market debacle in the history of postwar America." (18)

      Whatever the reasons for such misconduct, the fear is that investor confidence may be permanently lost for at least a generation. (19) Those who want to encourage reinvestment into the stock market are more desperate now than ever to find effective ways to further restrict management from exploiting corporate wealth and to encourage consumer confidence in the market again. (20)

   2. Historical Approaches to Curb Corporate Malfeasance

      Since the inception of a corporate-like form where there exists a separation between ownership and control, the persons whose capital is at risk (i.e., shareholders) have developed strategies to help reduce the risk of agency costs. (21) The problem of agency costs has been addressed in a variety of ways, including corporate law fiduciary duties of loyalty and care owed by boards of directors to shareholders, market forces, and contractual arrangements between management and shareholders that aim to align management's financial interests with those of the shareholders. (22)

      The Journal of Corporation Law

      1. Duty of Care

         Fiduciary duties began the change, and have remained, as a means of protecting shareholders' interests. (23) The most basic duty, the duty of care, requires boards of directors to manage the business and affairs of the corporation for the sole benefit of the shareholders. (24) This duty requires a director to discharge his duties and to make business decisions with the care of a "reasonably prudent person" in like circumstances. (25) The Model Business Corporation Act section 8.30(a) states:

         A director shall discharge his duties as a director, including his duties as a member of a committee: (1) in good faith; (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner he reasonably believes to be in the best interests of the corporation. (26) Courts have interpreted this standard of care to be a relatively low threshold for the board of directors to meet. (27)

         Moreover, so long as a conflict of interest is not apparent, the business judgment rule often insulates the board from potential liability for business decisions. (28) Under the...