(FORTUNE Magazine) – - WHEN CARL ICAHN approached Texaco with an unsolicited $14.5 billion takeover plan, Texaco's embattled board backed management, refusing even to present the offer to the company's owners for a vote. Icahn launched the biggest, and perhaps the most hotly contested, proxy fight in corporate history. Only then did the company turn to its shareholders, wooing the support of the institutional investors by making the startling concession that it would grant them a greater role in electing directors. Icahn, acknowledging defeat, characterized Texaco's tactics as ''boardmail.''

At Texaco and at corporations across the the U.S., shareholders are starting to win some control over the businesses they own. Progress is slow, and often bitterly hard won. But after years of paying lip service to the legal principle that directors and managers must answer to shareholders, companies are beginning to honor it. The roles of directors, executives, and shareholders are shifting. What this ultimately will lead to is a change in the way companies are managed. No fever of idealism is spreading through the exclusive confines of America's boardrooms. The fundamental shift from management-dominated boards to shareholder-sensitive ones has practical causes. Shareholders have won a string of victories in recent litigation. More important, institutional investors, once passive supporters of management, are now willing to throw their weight around in proxy fights -- the hot battleground for corporate control. These supershareholders, which own 40% of all publicly traded stock, recently deployed their votes to determine the future of Allegheny International, Centel, Gillette, Irving Bank, and Media General. Managements, which control the voting process, win most proxy battles. But their victory margins are narrowing, and success, as in the Texaco case, is often assured only by making concessions to large holders. Corporations may be moving toward a better balance of boardroom power -- but ambling in the right direction is not the same as being there. Veteran directors say boards often perform best when confronting extraordinary situations such as takeovers, but sometimes slumber through normal times. They agree that the most confident and successful CEOs tend to attract the strongest and most diligent boards. Weaker executives -- the ones most in need of independent boards -- more often get yes-men. And in most corporate boardrooms dissent is stifled by an etiquette that can often lead directors to vote for a CEO's proposals even when they disagree. While waiting for the shareholder revolution to take hold, some consultants, executives, board members, and shareholders are driving to make existing boards better. Here are some of the ways they suggest: -- Directors must realize that their job is to represent shareholders, not rubber-stamp the CEO's ideas. Benjamin M. Rosen, the venture capitalist who is chairman of Compaq Computer, says boards should serve as a check on management: ''I think that the owners of the company should be represented by the directors. That has ceased to happen at lots of companies where management dominates the board.'' Part of the problem is that many CEOs, whom you might expect to be leather- skinned toughies after battling their way to the top, are touchy types who will brook no criticism. Harold S. Geneen, the autocratic former chief of ITT, dignifies the issue: ''The role of the board is not to be a contender against management. Its role is to help management.'' Jack Byrne, chairman of Fireman's Fund, says he rarely sees a split vote: ''In my experience less than 1% of board votes are not unanimous. American business would be well served if 20% or 30% of the votes were not unanimous.'' -- In the ultimate confrontation -- when faced with an incompetent, or worse, unethical CEO -- the board should act quickly. At company after company, boards go along with an ineffective chief executive for years, only to abruptly fire him. Charles Luce, the former chairman of Consolidated Edison, and an outside director of UAL (briefly Allegis), says that the board of the airline pressed CEO Richard Ferris to improve labor relations and profits for three years. Then, after the airline's pilots rebelled by proposing to buy the company, the board fired him. Says Luce: ''With hindsight, perhaps we should have acted sooner.'' The blue-ribbon board of Allegheny International evidently stood by as CEO Robert J. Buckley helped himself generously to the corporate goodies. He collected $1 million in cash compensation in 1984, when Allegheny's earnings were only $14.9 million; installed his son in a $1 million apartment at company expense; put $100,000 on the company tab for wines, including part of J. P. Morgan's collection; and offered $30 million in personal loans to officers and directors at 2% interest. When all this became public in 1986, shareholders sued the board for ''waste of corporate assets, and grossly & improper business decisions.'' Among the directors: Alexander Haig Jr., recently a presidential candidate; Anthony O'Reilly, CEO of H.J. Heinz; Jean- Jacques Servan-Schreiber, the French journalist; and Mark McCormack, head of International Management Group, a sports marketing firm. All subsequently resigned, citing ''personal reasons.'' Allegheny went bankrupt, which put the shareholder litigation in limbo. On the other hand, the board of directors of Praxis Biologics, a fledgling vaccine producer, took the courageous step of firing the CEO who held 48% of the stock. Last year, five members of the six-member board asked the sixth, David H. Smith, to leave as chief executive. Apparently they regarded his performance as poor, and felt it was in the best interests of the other shareholders to remove him. But in March, Smith, who founded Praxis and remained its chairman, decided he wanted the CEO's job back. He demanded a special shareholders meeting to vote on a new slate of directors. Since a Smith victory was inevitable, the other five board members resigned. As the sole director, Smith selected three new board members, who promptly voted unanimously to restore Smith as chief executive. -- The dual job of CEO-chairman of the board should be split. Korn/Ferry International, the executive recruiting firm, figures that board chairmen recommended 80% of the directors who joined major companies last year. Four out of five chairmen were also the companies' chief executives. In addition to choosing the members of the board, the chairman-CEO also controls the agenda. Says Murray Weidenbaum, former chairman of Reagan's Council of Economic Advisers and a director of three companies: ''It's awkward, to put it mildly, to have the same person preside over the governing process and present the main proposals.'' Among the companies that split the jobs: Compaq Computer, RJR Nabisco, Motorola, and Texaco. A SEPARATE, independent chairman might help boards tackle one of their trickiest responsibilities: executive compensation. While it is usually the job of outside directors to stipulate management pay, CEOs never seem to be far away from the process. Rand Araskog, now CEO at ITT, participates in the meetings of several committees of outside directors, including the compensation committee -- ''for information purposes,'' as he puts it. Araskog is not the only one, and presumably he leaves the room when his pay is discussed, but his presence surely lingers. Managements also pay the consultants that advise directors on compensation. The bill payer's pressure is not always subtle. Says Robert Salwen, a compensation consultant at William M. Mercer Meidinger Hansen Inc.: ''At one company we created a very elaborate incentive plan. The company had spent lots of money to retain us, and we produced state-of-the-art arrangements. But in the end the CEO went into a room with his chief lieutenant and came out a few hours later with the new pay program without any input from us.'' -- Boards should continue to be dominated by outside directors, and to function efficiently, they should be smaller. Outsiders, considered more independent of management and more responsive to shareholders, outnumber insiders on the boards of most major companies. But Heidrick & Struggles, the executive-search firm, found that over 40% of the chairmen of the 1,000 biggest U.S. companies served on four or more boards in 1987. Simply put, these valuable directors are spreading themselves too thin. They are taking too much time away from managing their own companies, or spending too little time overseeing the affairs of companies of which they are directors -- or both. Says one candid CEO of his own board members: ''They often have to have blind faith in management. It would take them a month to really understand some of the decisions they make.'' CEOs and other popular candidates should limit themselves to fewer outside boards, and work harder on each. This shrinking of the pool of potential directors should hasten the trend to smaller boards. Many seasoned directors agree that the average board with 14 members is too large to be effective. SOME BOARDS will resist reform. They will continue to bow to CEOs who, in some cases, seem to be dedicated solely to protecting their jobs. Take the board of Santa Fe Southern Pacific. After the stockholders voted to rescind the transportation company's poison pill in May, CEO Robert D. Krebs announced he would recommend that the board keep the takeover defense despite the owners' mandate. Perhaps no group of directors have so poorly served their shareholders as those in the savings and loan industry. The boards -- often comprised of local businessmen who see civic, social, and commercial benefits in their membership -- are collectively responsible for losing money at the rate of $15 billion this year. Says a lawyer who represents many financial institutions: ''I have a thrift client that's $300 million in the hole that never turned down a real- estate loan and never made a loan to anyone who put up a penny. That's very typical.'' In June the Federal Home Loan Bank Board, which regulates thrifts, closed two California S&Ls -- North America Savings & Loan, and American Diversified Savings Bank -- at a record cost of $1.35 billion in cash. The government agency has filed a total of $100 million in suits against the board members of both institutions, charging fraud and negligence. The government has grossed $200 million by suing S&L directors over the past six years, and hopes to realize $100 million in 1988 alone. THE LEGAL process is gradually changing the relationship between directors and shareholders. Federal law is taciturn and vague on the responsibilities of directors. State laws go a little further, usually requiring board members to act with loyalty, honesty, and care. In practice that meant that directors who avoided self-dealing, fraud, and extremes of negligence were free to exercise their business judgment however they saw fit. But the explosion of shareholder litigation that began in the late Sixties -- much of it related to takeover fights -- has given courts ample opportunity to make directors' standards tougher. A 1985 decision in Delaware, where roughly half the largest corporations are incorporated, sent terror through the boardrooms. Ruling on a shareholder suit, the state supreme court found the ten board members of Trans Union Corp. personally liable for damages. The directors settled the case for $23 million. The court judged that these directors were negligent when they agreed to sell the railcar-leasing company to the Pritzker family's Marmon Group in a hasty, two-hour meeting dominated by the CEO. Among other lapses in judgment, board members failed to read the sale contract before they approved it and did not get an opinion on the fairness of the price from independent advisers. As it happened, Trans Union's directors didn't have to part with a nickel. An insurer paid $10 million of the settlement, and the Pritzkers came up with the rest. Still, the Trans Union ruling made many people worry that by serving on a corporate board they risked personal bankruptcy. WHILE THE COURTS pummeled directors from one side, insurance companies have been bashing them from the other. Even before the Trans Union case, the smaller purveyors of directors-and-officers insurance began fleeing the D&O market, leaving major insurers such as American International Group and Chubb with more demand than they could handle. The risks were getting higher, and they weren't making money. Some companies whose directors were most at risk -- financial institutions, utilities with nuclear power plants, firms dealing with environmental hazards, and almost any company involved in a takeover -- found they could insure their directors only at an exorbitant price. In some cases, premiums increased as much as 9,000% in a single year. Corporations that did get coverage often found it was so worm-eaten with exclusions as to be almost worthless. The policies sold to S&Ls, for instance, rarely covered suits by regulators. Thus was the ''liability crisis'' begotten. By the mid-Eighties, when the hysteria peaked, the perceived risk was so great that only madmen and lepers were expected to join corporate boards. That's not what happened. In the first place, the danger of personal liability was never as great as advertised. Yes, a few rotten directors such as Spencer H. Blain Jr. of Empire Savings & Loan of Mesquite, Texas -- who agreed to a $100 million personal judgment for fraud -- were stripped of just about everything but their socks. But according to Lewis S. Black, a prominent Delaware attorney, such punishments are extremely rare: ''The number of cases where damages have been assessed against directors is very small. They can probably be counted on one hand.'' The crisis, such as it was, is just about over. The cyclicality of the insurance business has already begun to calm the D&O market. A few newcomers such as Aetna jumped into the business last year, with a full range of directors' policies. The new competition halted most price rises. Even more reassuring to boards, 35 states have passed laws that enable corporations to write provisions into their bylaws that protect directors from the risk of personal liability in most cases except those involving gross malfeasance, such as fraud. The result, according to Arthur Fleischer Jr., a partner at the law firm Fried Frank Harris Shriver & Jacobson: Most board members are at less risk of personal liability than they were a decade ago. Thanks to the liability crisis, directors are also earning a lot more. The scare kept the supply of outside board members down, which raised prices. The threat of increased liability also gave directors an excuse to vote themselves a sweeter deal. ITT, among the most generous of companies, pays directors $80,000. They work hard for it, says Araskog: 24 to 36 full days a year. The , average director makes $50,000 a year for each major outside board on which he serves. (It almost always is a he: 92% of directors are white males.) Roughly $35,000 of the pay is cash. To avoid the appearance of overpaying directors, most companies offer a few hidden benefits, which provide the balance of directors' pay. Thomas H. Paine, of the Hewitt Associates compensation firm, figures that the most valuable benefit is retirement pay, offered in one form or another by many major companies. Usually available to directors who have served six years or so, this cash payment often amounts to $25,000 a year for life. Paine calculates that to cover this sum in the future, a company must set aside about $15,000 every year the director serves. So, the perk is worth an extra $15,000 to a director. Directors take on enormous responsibilities, and the good ones deserve every penny they get. At most major companies the money invested in attracting and keeping talented board members is not consequential, while the decisions they make almost always are. Shareholders should worry less about how much directors are paid, and more about how they are paid. A few chief executives, such as Sanford Weill of Commercial Credit Group, believe in all-stock compensation. His directors are paid $50,000 of the company's stock each year. Says Weill: ''We all think as shareholders, because we all are shareholders.'' THAT PROBABLY works better than the notion, pioneered by Hewlett-Packard and Hospital Corp. of America, of giving directors part of their pay in discounted stock options. In practice, directors are more likely to identify with the interests of shareholders when they buy their stock at market prices with their own money. A director holding stock options, discounted or not, could face serious conflicts of interests. Consider, for example, the instance of a board deciding whether to increase the dividend. Most outside shareholders might like that, but option holders would benefit more by reinvesting the money to boost the company's future value. Unfortunately, nearly all financial incentives devised to guide board members' behavior can backfire. Retirement plans encourage directors to stick around until they are vested, regardless of whether they are useful or not. Stock compensation plans, like Commercial Credit's, have much to recommend them. But the wisest course might be to offer directors a handsome cash package and nothing else. If they use the money to buy company stock, so much the better. More money might solve one of the most vexing problems of corporate governance. Strong companies generally attract better directors than weak ones. The troubled companies that most need firm, independent guidance from their boards are least likely to get it. Qualified people need a powerful inducement to join these hapless companies. Higher pay might help. Says compensation expert Graef Crystal: ''You may say these directors are rich already, but they seem to like getting more money.'' DON'T EXPECT directors, no matter how highly paid, to grow fat and lazy. The new group of activist shareholders will make sure they stay alert. First aroused by the seductive rhetoric of raiders such as T. Boone Pickens Jr., a self-styled champion of shareholder rights, the institutional investors became increasingly irate as managements used shareholder money to fight takeovers. These supershareholders viewed the greenmail, golden parachutes, poison pills, and expensive legal maneuverings as nothing more than executives' attempts to keep their jobs, while denying the owners a higher price for their stock. Now institutions, like adolescents newly aware of their own potential, are testing to see how far they can push managements. In 1985 a group of pension funds created the Council of Institutional Investors, whose members now control assets of over $200 billion. It is promoting a ''bill of rights,'' which calls for equal voting rights for all shareholders, among other things. Demanding more control over the enterprises they own, aggressive institutions such as the New York City Retirement Funds ($8.2 billion in stocks) have called upon managers to account for their actions. Disappointed by the performance of General Motors, for example, the Council invited GM chief Roger Smith to a face-to-face session with institutional investors. After the meeting in January, 1987, he pleased the investors by announcing a stock buyback and the reform of a management-bonus plan they had found objectionable. (GM had awarded executives cash bonuses at the same time it suspended profit-sharing payments to union workers.) Not all executives are so accommodating. Richard Koppes, chief counsel of the California Public Employees' Retirement System, says M. Anthony Burns of Ryder System, is one of several CEOs who refused to meet with major investors when they were promoting shareholder proposals. Others were Edwin I. Colodny of USAir and William R. Laidig of Great Northern Nekoosa. Later, after close ! votes, each of them met with their major investors. In proxy fights for company control, more institutions than ever before are voting against managements. These battles are back in style partly because they can be less expensive for the raiders than tender offers. More important, states from Delaware to California have enacted daunting anti-takeover laws that leave raiders few other alternatives. GILLETTE shareholders, for example, are using their proxies to show their dissatisfaction. In April they voted in a proposal, opposed by the board, to prohibit future greenmail payments. Gillette did win the vote on its slate of directors -- but by a razor-thin 52% to 48%. Says A. Camille Nichols of the Florida State Board of Administration, a pension fund manager that controls 500,000 shares of Gillette: ''That result was not a vote of confidence for the board.'' Insiders usually win proxy fights because they control the process. Icahn calls that ''the home-court advantage.'' Managements can spend almost unlimited amounts of the shareholders' money on the battle, they largely determine which proposals are listed in the proxy statements, and they often count all abstentions as votes for their side. Institutional investors are trying to neutralize some of this bias. At Ryder System, for example, the California pension fund proposed confidential voting of proxies, so that large shareholders could vote without fear of reprisals. CEOs have been known to try to influence corporate pension managers' votes by talking to the chiefs of the companies that employ them. The Ryder board opposed the measure, and won. Over time, such measures are more likely to win. With victory, shareholders will raise their demands: They will want to vote directly on crucial issues, such as whether to sell the company. Chief executives, for so many years the power center of most corporations, may find that those genial fellows sitting around the long, oval table have metamorphosed into a many-headed monster demanding ultimate control. Some CEOs will feel like hirelings. Others will welcome the new dynamism. Either way, shareholders will be better off.