In the old days, back before Sir James Goldsmith and greenmail and merger mania, shareholders were a quiet, unobtrusive lot. They followed the ups and downs of the market, rarely attended annual meetings, and dutifully filed company announcements in the trash. Proxy battles were like volcanoes in Wisconsin — few and far between. Recalls Harvey Pitt, former chairman of the Securities and Exchange Commission: “I grew up in an era when shareholder proposals barely got a 2 percent vote.”
These days, shareholders have pumped up the volume considerably. Spurred by a slew of portfolio-punishing accounting scandals — and angered by decades of corporate indifference to their requests — institutional investors have gone on the offensive, pushing agendas and getting in the face of corporate executives. According to the Investor Responsibility Research Center, shareholders filed some 1,126 proposals with corporations this year. In 2002, that number was closer to 800.
In fact, observers say this year’s annual general meetings were more like open season than proxy season, with institutional investors targeting big game. In Minnesota, Gov. Tim Pawlenty turned Pfizer Inc.’s annual meeting into a media circus, pillorying the company for pricing its products above the rate of inflation. Another pension-fund-led campaign, this one against directors at Federated Department Stores, netted a whopping 61 percent withhold vote — even though Federated has outperformed its peers for five years running. Observes Espen Eckbo, founding director of the Center for Corporate Governance at the Amos Tuck School of Business at Dartmouth College: “It’s a new world [for officers and directors], whether they like it or not.”
Apparently, some don’t. According to a new survey conducted by CFO magazine, finance executives appear dismayed by the new investor radicalism. Fifty-six percent of the respondents said dealing with shareholder requests has become a distraction. Fifty-three percent indicated they’re spending more time with shareholders than ever before, yet only 11 percent of the executives polled believe that adopting the recommendations of the shareholder activists will improve their ability to create value for those investors.
In truth, many executives appear to have been soured by the actions of a few high-profile groups. The California Public Employees’ Retirement System (Calpers), the world’s largest pension fund, for example, withheld votes on one or more directors at an astounding 90 percent of the 2,700 companies it holds in its $180 billion portfolio. The hit list included even such pillars of virtue as Coca-Cola director Warren Buffett, long an advocate of shareholder rights. Likewise, Institutional Shareholder Services (ISS), a proxy-services firm that advises institutional investors on how to vote their proxies, told clients to remove Buffett from Coke’s audit committee, citing a conflict of interest. Pitt, now CEO of Kalorama Partners, in Washington, D.C., was taken aback by the Buffett bashing. “When you start attacking Warren Buffett,” he says, “you’ve gone off the deep end.”
Such chutzpah has not gone unnoticed by the SEC, which is currently reconsidering a watershed proposal to give shareholders direct access to board nominations. The reason? “The strident tactics of Calpers and ISS during the recent proxy season,” says one corporate director.
Moreover, the new level of activism practiced by such groups is fundamentally altering the relationships between shareholders and executives. “What’s happening is it’s ‘us and them,’ ” reports Craig Nordlund, senior vice president, general counsel, and secretary for Palo Alto, California-based Agilent Technologies Inc. But Patrick McGurn, senior vice president and special counsel at ISS, believes such divisiveness is a symptom, not a cause. After the Buffett incident, “we were called idiots,” he says. “But if that’s the tenor of the debate the corporate community wants to have, that’s a sign of a bigger issue.”
Send ‘em the Bedbug Letter
The budding radicalism of investors is hardly surprising. Investors may be the owners of companies, yet they’ve rarely been treated as such. Shareholder proposals — which are nonbinding — have been blithely ignored by many corporate boards. In some cases, managers have regarded vocal stockowners as meddlers or, worse, interlopers. “Somehow we’ve lost sight of the fact that with ownership comes certain prerogatives,” says Pitt. “And one of those prerogatives is to be treated as if your views are important.”
The high number of dead (uncast) proxy votes, though, has led many companies to pay lip service to investors. Since in the past 60 percent of proxy votes were dead, notes Eckbo, “the culture of top management has been, ‘We don’t have to pay attention to those guys.'” That sort of thinking, of course, led to the scandals at Enron, Tyco, and WorldCom, where managers treated their companies as personal fiefdoms — and vaporized billions of dollars in shareholder value in the process. “Anything that can change this mind-set is good,” argues Eckbo.
As the Buffett episode shows, however, governance advocates may be overreaching to make a point. Fifty-five percent of finance executives in the CFO survey said shareholder activists have simply gone too far. Many believe investors and advisory firms are starting to take a broad brush to governance, ignoring a company’s particulars and deferring instead to a checklist of governance best practices.
The checklists touted by consultancies such as ISS — which go through proxies for portfolio managers, summarize the issues, offer a yes or no recommendation, and then explain the recommendation — have come in for the most criticism. In fact, half of the respondents to the CFO poll said proxy-advisory firms are not familiar with the fundamentals of their business. And 65 percent said governance checklists fail to account for the individual circumstances of a business. “The problem is, they’re formula voting,” argues Roger Plank, CFO of Houston-based Apache Corp. “I don’t think they make an effort to look at us as an individual company.”
Plank experienced this blunderbuss approach firsthand in a recent document sent by a dissident shareholder group. In it, the investors torched Apache, chiding the company for failing to adopt the group’s vision of good governance policies. But as Plank read through the indictment of Apache, he noticed one small error. In one part of the document, he says, “[the shareholder group] called us by our competitor’s name. Turns out it was just a form letter.”
They’ve Got Issues
If mass-mailings have finance chiefs steaming, so, too, do some of the individual best practices being touted by shareholder activists and their advisers. ISS, for instance, supports a mandatory retirement age for board members, as do many institutional investors (with 70 being the most common age). Hard evidence linking this policy to improved corporate performance, however, is hard to find. Says Jeffrey Sonnenfeld, a Gevity HR Inc. board member and associate dean of executive programs at the Yale School of Management: “There is zero evidence showing that wisdom is a bad thing.”
Moreover, the separation of the CEO and chairman posts — high on the list of many shareholder activists — certainly didn’t improve the fortunes of Enron’s shareholders. In fact, Nell Minow, co-founder of Portland, Maine-based research firm The Corporate Library, says advocates of governance best practices may be off the mark on that point. Minow says that The Corporate Library’s research of 2,000 companies has not revealed a link between conventional best-practice governance structures and better shareholder returns, noting that “structures do not guarantee substantive and genuinely independent oversight.” Minow adds: “People are just grabbing at what’s intuitively compelling.”
Some investor groups are also grabbing onto single issues on which to base their withhold campaigns. This year’s 90 percent withhold vote at Calpers (including the vote against Buffett) was mostly triggered by the fund’s decision to vote against directors at companies that hire their independent auditors to perform other services. “It wasn’t an effort by Calpers to go after every company,” explains assistant executive officer for public affairs Pat Macht. “It was our decision to vote our conscience on the auditor issue.”
Voting their conscience, however, has some investor groups also straying well beyond traditional governance ground and into such areas as ethical pricing and workers’ rights. In response, many management teams have staged preemptive strikes, hoping to avoid media campaigns orchestrated by institutional investors. Coke and PepsiCo, for example, bowed to shareholder pressure this spring, agreeing to put together a report on the impact of the HIV epidemic on their business models (see “A Little Divine Intervention,” at the end of this article). And at Columbus, Ohio-based American Electric Power, management agreed to assess its own efforts to minimize its environmental liabilities — leading a state pension fund to withdraw its proposal calling for such action.
In preparing the report, however, American Electric Power CFO Susan Tomasky says, the power producer’s directors wanted to make sure they were mindful of the interests of all shareholders. But therein lies the rub. Out-of-court agreements between boards and activist investors — often hailed as wins for both sides — would seem to give short shrift to less-vocal investors. “For boards to function effectively,” argues Nordlund, “they have to be truly representative of all shareholders, not just groups of shareholders.”
Hide Your Lunch Money
These days they also have to placate their shareholders’ advisers — not always an easy task. Some believe ISS’s dominant position in the proxy-advisory business has led at times to an adversarial, almost belligerent attitude. “[ISS’s behavior] has been outrageous,” asserts Sonnenfeld. “They’re like the neighborhood bully.”
Steve Bouck knows a little something about the clout of ISS. Last year, Bouck, who is CFO at Folsom, California-based Waste Connections Inc., helped devise a plan that would have tripled the company’s authorized stock shares. The increase (from 50 million to 150 million shares) would enable the company to do a stock split, thus rewarding shareholders who had stuck with Waste Connections through some lean times in the late 1990s.
But soon after managers at Waste Connections formulated the proposal, Bouck received worrisome news. ISS, apparently applying its own formula to the plan, would not support an increase beyond 127 million shares — and thus advised its clients to vote no on the proposal. Institutional investors rarely go against ISS, and this case was no different, as the proposal went down to defeat.
Waste Connections came back with a revised scheme this year, limiting the size of the increase to equal 100 million shares. ISS backed the new plan, which then received a green light from shareholders. But the initial ISS recommendation cost Waste Connections time and money, forcing management to rejigger its initial plans.
Until recently, few executives were willing to publicly criticize ISS — another indication of the firm’s newfound influence. But growing resentment over proxy-advisory firms has led some to start questioning the business model of the firms. And some say the consultancies should either advise institutional investors or public companies — not both. (For more on alleged conflicts at ISS, see “Shakedown Street?” at the end of this article) Nordlund of Agilent, for example, believes ISS shouldn’t charge a corporation for advice while acting as paid adviser to the shareholders of that corporation. “The two-way conversation between companies and investors,” he says, “ought to be accessible without a toll charge.”
Executives at ISS, however, defend the firm’s actions. McGurn believes the lion’s share of criticism should be directed at unresponsive officers and directors, not proxy-advisory firms. “The real question,” says McGurn, “is why have boards ignored supermajority no votes?” Besides, adds Charles Elson, director of the University of Delaware’s John L. Weinberg Center for Corporate Governance, “you’re free to take ISS’s advice or not.”
Likewise, Calpers’s Macht says officers at the giant pension fund are interested in only one thing: doing right by investors. “No one should fear what Calpers is doing,” she says. “What we have tackled has improved these companies. And it’s improved returns for all shareholders.”
The clout of powerful share-holder activists and advisers will likely increase if the SEC passes its proposed director access rule. The proposal, an amendment to Exchange Act Rule 14a-8, would allow institutional investors (under certain circumstances) to nominate their own directors the next year. The triggers? Hard to predict, although the commission has floated the idea of giving shareholders the right to nominate board members if withheld votes top 50 percent of all votes cast for directors.
Shareholder-rights advocates almost universally praise the proposal (although many would like to see the threshold lowered). They say directors and officers have protected their positions for years by staggering director elections over three-year periods (what’s known as classified boards). Given the high costs of mounting a proxy fight — and the short odds of winning one — few shareholders have taken up the challenge. Last year, for example, dissident stockowners at natural-gas utility El Paso Corp. reportedly spent nearly $6 million in a failed attempt to oust incumbent board members. Little wonder that supporters such as Ann Yerger, deputy director at the Council of Institutional Investors, believe the SEC proposal would finally give a voice to long-suffering investors. “Shareholders sitting on the board,” says Yerger, “is the ultimate in governance.”
Critics, however, say the amendment could force corporate boards to kowtow to narrowly focused investor groups rather than risk withhold campaigns. “There are groups, mostly Calpers, attempting to hijack the director-nominating process,” insists John Castellani, president of Washington, D.C.-based chief-executive group The Business Roundtable. “We’re on the threshold of turning proxy season into a political campaign.”
There is also fear that the director access proposal could make a kingmaker out of ISS, a charge McGurn vigorously dismisses. “If we know access will be triggered,” he offers, “we’ll think long and hard about our recommendation.”
Nevertheless, corporate executives could find themselves accommodating powerful shareholders whose key benchmarks have little to do with earnings per share or economic value added. Board members backed by union pension funds, for example, might push for overly generous human-resources policies. “[Some of the proposals] do kind of make the hairs on your neck stand up sometimes,” says Plank. “I don’t get the sense that some of these groups want to advance the interests of all shareholders.” Managers of one small fund, for instance, wanted Apache to nominate board members from a particular ethnic group, even though that group makes up only about 2 percent of the U.S. population. “Let’s say we tumble to that,” posits Plank. “How many 2 percenters are there out there? How big will our board have to be?”
Fun It Ain’t
Rather than building an addition to the executive suite, investor-relations executives advise CFOs to rethink how they deal with shareholders. The rethinking must start with the assumption that IR is simply going to take more time these days. It might also require hiring additional staff. “This is an expensive activity, and it’s resource-draining,” acknowledges American Electric Power’s Tomasky. “Nobody wants to do this for fun.”
By ratcheting up the dialogue between shareholders and management, however, CFOs can at least help their companies stay ahead of controversies. “We do have to get over the notion some executives have,” says Tomasky, “that shareholders ought not to care about governance issues.” Besides, says Louis Thompson, president and CEO of the Vienna, Virginia-based National Investor Relations Institute, ducking their issues will only make things worse. “By the time an issue is in the lap of a company’s corporate secretary, it’s already a contentious issue.”
Finance executives can expect their fair share of contentious issues in the coming years. Shareholder activism, it would seem, is not going to simmer down any time soon. Officials at Calpers are already planning their campaign for next proxy season. “Executive compensation will be front and center [in 2005],” promises Macht. “So it won’t get any easier for some of these companies next year.”
Probably not. “I think we’re going to be dealing with this for some time,” laments Plank. “These days, everybody wants to get their agenda across.”
John Goff is technology editor at CFO.
Although The Securities and Exchange Commission’s proposed shareholder access rule has plenty of supporters among institutional investors, opponents believe the rule would increase the already considerable clout of shareholder advisory firms, particularly Institutional Shareholder Services (ISS).
Patrick McGurn, senior vice president and special counsel at Rockville, Maryland-based ISS, rejects the charge, claiming executives at the firm would be cautious about recommending a withhold vote that could lead to a board shakeup. Besides, he adds, “companies have the keys to changing our recommendations.”
One way, apparently, is to hire ISS. Indeed, the firm’s business model (and that of a few other firms, such as corporate-governance rating agency GovernanceMetrics International) has come under fire for supposed conflicts of interest. Critics claim ISS is working both sides of the governance street, advising institutional clients on how to vote on management proposals while coaching corporate issuers on how to get their proposals passed. What’s more, the ISS’s flagship product, a governance-rating system known as CGQ (Corporate Governance Quotient), seems akin to a marketing tool–one that helps the firm sell other services. At a panel discussion conducted by the SEC in March, AutoZone Inc. CEO Stephen Odland raised the issue: “It’s interesting [that] when you get a [governance] rating, you have to buy [the firm’s] services to understand its ratings and correct some of the assumptions made in them.”
At the very least, it appears that purchasing ISS’s Web-based governance products can help a company’s directors and officers deduce what kind of recommendation ISS will give on a particular management proposal. To some, that smacks of a shakedown, albeit a legal one. Bill Calder, a spokesman at Intel Corp., says that in the past, his company has “paid for certain services from ISS because it was important to understand how it’s analyzing our data for large institutional shareholders.”
But supporters say ISS plays a vital role in reining in abuses. And McGurn argues that any criticism should be aimed at executives who blithely ignore shareholders. “If companies are going to accuse us of accepting money for improving a company’s corporate governance,” he adds, “I’ll take that every time.” —J.G.
A Little Divine Intervention
As anyone who has ever Attended catholic school will attest, getting on the wrong side of a nun can be a tactical mistake of monumental proportions. Imagine, then, how some corporate executives must feel knowing they’re on the wrong side of entire orders of nuns.
That’s exactly the position executives at some companies find themselves in, thanks to their policies on HIV/AIDS. Merck, Pfizer, and Abbott Labs, among others, have all been targeted by the Interfaith Center for Corporate Responsibility, a group of 275 faith-based institutional investors with over $100 billion in assets. The ICCR argues that most businesses have ignored the impact of AIDS on sales in key markets like China and India. “The infrastructure of society is breaking down,” says Sister Vicki Bergkamp, a nun who belongs to ICCR member The Adorers of the Blood of Christ, an order of Catholic women that helps children of AIDS victims in Tanzania. “No company should make money when this happens.”
While pharmaceuticals companies do sell their AIDS medications wholesale in some poorer nations, the cost still works out to hundreds of dollars per year — well beyond the reach of most of those afflicted. Activists at the ICCR would like to see the companies give up their HIV/AIDS drug patents in emerging markets, allowing local companies to make generics. So far, ICCR officials say they’ve met with stiff resistance. “It’s a huge dilemma for them — making a profit versus the ethical issue,” grants Daniel Rosan, ICCR’s program director for public health. “But our campaign is about saving lives and protecting the interests of shareholders.”
Despite long odds, the ICCR has had success. This year, the group submitted a shareholder proposal to The Coca-Cola Co., asking executives to study the effect of HIV on growth projections. The resolution received a 98 percent yes vote. Bergkamp, a professor at Friend’s University in Wichita who headed up the campaign at Coke, believes consumer-goods companies can use their marketing expertise to help educate the poor about AIDS. She would also like to see Coke put its supply-chain expertise to use. “Part of their strength is their distribution system,” she says. “We can use that system to distribute medicine.”
And how do powerful executives react when they find out they’ve got a 9:30 meeting with Sister Vicki? “Sometimes they approach us with a little trepidation,” admits Bergkamp. That’s understandable. While she says that most of her corporate sit-downs are convivial, “10 to 15 percent of our meetings do get confrontational.” —J.G.
Findings from CFO’s survey of 105 finance executives.
Note: Figures may not add up to 100% due to rounding.