The madness of the proxy season is just beginning. Here's a breakdown on what to expect in the ballot box
Kathy Combs wants to talk, but she doesn't have much time. As the corporate secretary at Exelon, a Chicago utility, Combs is juggling a raft of new guidelines and corporate governance rules, on top of the annual madness of the proxy season.
'There's the end-of-year annual reports, we have the new CEO and CFO reporting requirements, the two-day rule for insider trading and prohibition of loans [to senior officials], all already effective,' she says into her speakerphone. 'We're preparing the board for the requirements on the horizon, including proposed rules and pending rules. We've been briefing the board and management and relevant committees on coming changes. We're also drafting changes in codes of conduct.'
She pauses and takes a deep breath. 'I don't know any corporate secretaries that aren't taking these corporate governance reforms very seriously. No-one is taking this year or the proxy season lightly.'
Fueled by Enron, empowered by Sarbanes-Oxley and sanctified by a reluctant Harvey Pitt, shareholders are promising to turn some of this year's annual meetings into a referendum on the state of American corporate governance. Snoozing directors, over-generous compensation packages and cursory audits will not be safe from newly piqued shareholder wrath.
Corporate secretaries, many of whom say they always knew this day would come, are watching warily to see what kind of new regulations and guidelines will come their way. The changes are so sweeping that they will also impact foreign businesses. International subsidiaries of US companies and those that seek capital on US markets, although granted some concessions by the SEC, would still do well to keep on top of new regulations.
Worthy of fairy tales
Observers say it would be impossible to overstate the changes affecting corporate governance this year. Longtime consultants, including some who have been advocating these changes over the last decade, say this proxy season is going to be one for the record books.
'I've been doing this since the mid-1980s,' says Patrick McGurn, vice president of Institutional Shareholder Services in Maryland. 'The changes in the previous 15 years do not equal the changes of the last twelve months.' He reflects a moment and adds, 'It's very exciting. It's also scary.'
It's been more than a year since Enron collapsed, quickly tearing down corporate sand castles and exposing CEO spending sprees worthy of French royalty. No wonder once placid shareholders and pensioners have become as vengeful as an Old Testament god. With a spluttering economy, it was only a matter of time before US lawmakers and regulators set about restoring investor confidence.
The New York Stock Exchange in June issued far-reaching new guidelines requiring shareholders to approve stock option plans and emphasizing the authority of independent directors. These haven't all been adopted yet, but it's clear which way the rules are blowing.
The Sarbanes-Oxley Act, passed by Congress in July, toughens penalties for fraud and establishes a new accounting oversight regime. By forcing executives to certify financial statements, the bill seeks to create a climate of accountability.
While Washington and Wall Street make up the rules, it falls to corporate secretaries and IROs to interpret and play by them. Continuing well into the next year or two, they expect to spend a lot of time finding qualified financial experts; managing the composition of the board; exploring how stock options are valued, expensed and awarded; and listening to shareholders they may have dismissed as 'crackpot'.
Experts say 2003 will be the year the corporate board finally enters the new millennium. 'This will be the watershed year, a transition year,' says John Wilcox, vice chairman of Georgeson Shareholder. It will be a year or two before all the new rules and guidelines are drafted, but everyone involved in corporate governance uses the word 'change' a lot. McGurn says he expects the fine-tuning on the new guidelines and rules to continue for at least another year or so.
Once the dust finally settles, the real work will begin for the corporate secretaries themselves. It's highly likely, observers say, that someday soon shareholder proposals will be included on management's ballot, a potentially radical change that will level the field for activist investors.
Independent directors
By far the biggest changes will come to the board of directors – especially those that have been less than diligent. 'This is a great opportunity for corporate secretaries to clean house,' suggests consultant Carl Hagberg, an expert on the proxy voting process and the editor and publisher of a newsletter, the Shareholder Service Optimizer. 'If I was still a corporate secretary, you know I'd be cleaning house peremptorily. It's usually hard to get directors to step down, even if they're sleeping through meetings. This is when you go to the ones with insider ties, the ones who sit on too many boards, the ones who miss meetings, and you ask them gently to step down.'
If you do have to replace directors, get an early start and leave no resource untried. The scramble to find qualified independent board members, experts warn, could soon be more competitive than the search for new oil fields or the hiding place of Osama bin Laden.
New SEC guidelines are expected to define quite narrowly the experience that will qualify a financial expert for audit committee service. By some estimates, more than half of America's corporate boards will be affected. There is a new push for independent directors who are genuinely independent from the company – not connected to its senior management either by family ties or by business contacts. Wives, husbands and key suppliers do not belong on key committees that oversee a corporation's auditing or nominating.
No less than the Business Roundtable, a group of the most important CEOs in America, has endorsed substantial independence of boards. Shareholders will not likely accept anything less.
Even companies that don't anticipate problems aren't exactly laid back. 'It appears that our board members would satisfy most independent definitions that we've seen,' says Ron Heller, corporate secretary at Ingersoll-Rand, the tool manufacturer in New Jersey. 'But once the rules settle to some extent, we will have to do an evaluation.'
Experts recommend companies start working the grapevine for referrals to qualified independent directors, and consider contacting headhunters that specialize in executive searches.
Compensation
Beware the avenging shareholder. Especially if there are antique $15,000 umbrella stands in the company apartment, or a Boeing 737 on call for senior management's travel whims.
The Chief Justice of the Supreme Court in Delaware, where most American companies are incorporated, recently warned that investors could successfully sue boards of directors over matters like excessive executive compensation.
'I would urge boards of directors to demonstrate their independence, hold executive sessions and follow governance procedures sincerely and effectively, not only as a guard against the intrusion of the federal government but as a guard against anything that might happen to them in a court from a properly presented complaint,' warned E Norman Veasey in a recent Harvard Business Review article.
Under the NYSE proposal, investors will have the right to approve nearly all stock option plans, not just the ones set up for senior management. These have usually been handled as routine business, or voted upon by fund managers without input from beneficial shareholders. In a potentially roiling new rule, consent could be required and getting it could prove tricky.
Although there is widespread agreement, in theory, that options should be accounted for, there is no consensus yet on how to value them. A fourth-quarter FASB bulletin (EG 2002) has three different methods to evaluate them. Watch this issue closely and start developing an in-house approach, if you haven't already done so.
The nature of the options themselves is also changing: Instead of a strike price, many shareholders and boards are considering a strike performance. This method is growing more popular as a way to keep executives from cashing in and moving on. If shareholders insist and management resists, remind them it's about accountability.
Audit
In fact, everything is about accountability, which is why honest auditors are going to become the new 'It' consultants.
Shareholder proposals are likely to include suggestions this year that auditors are rotated regularly, and that their non-audit services – and fees – are severely limited and pre-approved. These proposals have been mounting over the last year, and will certainly continue into the next, according to most observers.
TIAA-Cref, the 800-pound gorilla of institutional investors, advocates limiting the fees paid to auditors in an effort to minimize the relationship between the firm and the company.
'If you have to rotate auditors, and they know that in a year or two their work is going to be reviewed by another auditor, they might do it in a different way,' says one corporate secretary who does not want to be identified, though conceding the idea has some merit.
Choosing a strong auditor could be more important than ever. Bush Administration officials, perhaps mindful of the markets as the 2004 election approaches, have promised to step up Justice Department fraud prosecutions against complicit bankers, accountants and lawyers.
Experts advise looking into the available pool of auditors, and winnowing out companies that are unqualified or inexperienced or soiled by recent scandal. Check references, of course.
Ratings
There are lots of reasons for your company to be transparent, accountable and scandal-free. But one of the most compelling trends is the swelling importance of corporate governance ratings. The number of assorted independent agencies purporting to rate a company's corporate governance capabilities grows in proportion to the level of interest.
Regardless of whether the rating is assigned as a number, a letter or a risk factor, it is clear that a bad board will eventually become a leading business indicator, more forward-looking than earnings. Not only that, bad governance could soon be reflected in bond ratings, making it more expensive to borrow capital.
Rating boards is no easy task. 'It's impossible to compare a company that's governed well with one that's governed poorly because there are too many other variables to factor out,' says Wilcox. 'But clearly, companies that are only interested in performance are short-sighted.'
Canada
If things look complicated for US corporate secretaries, pause a moment in solidarity and commiseration for their colleagues north of the border. Canadian corporate secretaries have to master US regulations as well as their own.
'It's very complex here,' says Lynn Beauregard, executive director of the Canadian Society of Corporate Secretaries in Toronto. 'Canadian corporate secretaries are tearing their hair out trying to track what's happening.' Canada's twelve separate jurisdictions are based more on principles than rules, and are more open to interpretation than litigation. Canadian subsidiaries of US companies, and those trading on the US markets, must play by the new rules. Most major Canadian companies deal on the Toronto Stock Exchange, which has posted a comparison of local and US regulations. The diffusion is fanned by political and physical proximity.
Although Canadian companies have not suffered from the epic fraud that has shattered confidence in Wall Street, a number of key institutional investors have recently joined forces as the Coalition for Good Corporate Governance. Wilcox, McGurn and others advise corporate secretaries to listen to investors instead of resisting their concerns. They say this is especially true of large institutional investors, or those who have held company stock for some time and have influence and knowledge. Meet with them privately to find common ground upon which an opposing proposal might be withdrawn. Public confrontation is a last resort.
Mutual funds
The demands of accountability are so sweeping that corporate secretaries and investor relations officers stand to learn a few secrets.
Mutual funds, whose decision-making and even voting has been shrouded in a veil of self-serving secrecy, may be forced to reveal how they vote on all sorts of proposals, under a pending rule change for companies trading on the NYSE. These funds control almost one quarter of all publicly traded shares, and currently represent an enormous blind spot.
Fund managers have argued that it will prejudice their ability to get information from the company, and may tip-off rival funds about their strategies. But over 7,000 shareholders wrote to the SEC to support the requirements, saying they have a right to know how their votes were cast. No less than John Bogle, founder of Vanguard Group, wrote in a December editorial in the New York Times that these firms should be accountable to owners.
By all accounts, the sea change is fast approaching, and corporate secretaries will need more than a good night's sleep to sort it all out.
Georgeson's John Wilcox concludes that there will be more than mere corporate governance at stake in this year's upcoming proxy season. 'This is part of the power struggle between shareholders and managers,' he maintains. 'It's not just about governance, but about who gets to make the decisions, who really has the power. Is the company answerable to its owners or to its board and managers? Those political and power questions are deeply embedded in these proposals.'
IR proxy warriors
Nothing defines investor relations like a company's annual meeting, where you meet your public up close and personal. In a good year it can feel like a party. Other years, it's closer to a funeral with a danish. Either way, for the IRO and everyone else in corporate communications, finance and management, this is the day your report card comes in.
Over in a quiet corner, a powerful fund manager is chatting with an outside director. They could be talking about sports, but it's unlikely. And a sell-side analyst has cornered your CFO by the coffee urn. It's a good time to go over and reintroduce yourself, but – hello! – that claw on your arm belongs to the retired busybody who always takes the mic and goes on about maximizing shareholder value. She won't let you go because you both know how much you hate returning her phone calls.
Here your performance is assessed by your bosses, constituents and that little voice in your head. You want to look nice. You want to eat a good breakfast. And you want to know that you've already done everything you could to make the day as painless as possible.
'If shareholders have confidence, and the stock is stable, or stable-ish, the meetings are calmer,' says Tony Florence, VP of global marketing, governance and legal affairs for Nasdaq-listed Avanex in California. He says the raft of new Sox rules won't affect well-governed companies as much as those that have a lot of ground to cover. 'We don't get shareholders asking what's going on; they ask when business is going to turn around. It's not the same thing.' He says Avanex investors know of the company's rigid code of ethics for senior management, directors and all involved with auditing and finance.
But other IROs have been waiting warily for this year's proxy season. Your company may or may not be suffering avenging investor syndrome, but new and proposed rules on options, disclosure and certification have invigorated even docile shareholders who, until two years ago, were far more trusting of management's decisions.
Sarbanes-Oxley and new rules passed and pending in the SEC and the various exchanges are changing the way many companies handle the equity market. Particularly in smaller companies, the IR department is likely handling much of the new work.
'I wish I had the luxury of being more specialized,' sighs Al Galgano, IRO at Minnesota-based Digital River. 'But in a small company, you've got your fingers in everything. It's a challenge and exhilarating. This season, especially with all these changes, we're really burning rubber.'
Galgano says he's like a quarterback calling the plays: making sure the legal department prepares the proxy, the financial department handles the annual report, the marketing department is on top of the glossy pages, and getting it all to the printer and transfer agent on time.
In a year when it's business as usual, whatever usually works is probably good enough. But for many companies – especially those with limited board independence, poor performance, the whiff of scandal or an uncertain industry – this is not a usual year.
If your company has any of these complex issues, the IR prep for the meeting should have been underway months ago. Canvas shareholders to find out their concerns. Consider retaining a proxy solicitor so you can see where the issues are heading and, if necessary, get the vote in from supportive shareholders.
Even if you've been holding every hand every day for the last four quarters, you can't make a bad year into a bar mitzvah. But you can soften the blow of bad news, emphasize management's message and – above all – prepare your own management team for shareholders' mood, priority issues and potential problems.
One recent development that will directly affect the IR department is the proposed mandatory disclosure requirement of mutual funds to reveal how they vote their proxies. Big funds have strongly resisted, saying it will compromise their relationships with companies they hold, and potentially derail their access to company executives. Smart IROs will take pains to reassure them.
'That disclosure is only fair,' argues Michael Lawson, director of corporate communications of Granite Construction. Employees of the California company hold more than one quarter of the shares, he says, so at least they will know who is voting and how.