Annual meeting debates.
Undeniably, the one word on everybody's lips this proxy season is Enron. The energy giant's collapse continues to have global reverberations, mainly because the issues it brought to light are very much alive in companies all around the world. The cronyism that characterized Enron's board and management, the company's enigmatic numbers, its related-party transactions, its lack of governance checks and balances - all of these problems lurk in developed and developing markets alike. And investor concern about these flaws is flaring up as this year's proxy season starts to get going.
'I have spoken to companies in many different parts of the world and when I ask them what was their reaction to Enron, they say their first reaction was laughter, and their second was fear - because they know Enron is not sui generis,' declares Stephen Davis, president of Davis Global Advisors.
Nell Minow, governance guru and one of the founders of the DC-based Corporate Library, which rates boards of directors and individual directors, agrees: 'Obviously the issue of the year is Enron. And every company should expect that at some point someone will stand up at the annual meeting and ask, Why should we believe your numbers? and want to hear an answer from the CEO - not the CFO - and from the chairman of the audit committee. And every company had better be prepared for that. Because every company is vulnerable.'
There are many specific shareholder resolutions that will emerge this proxy season as a direct result of Enron. Everything from disclosure enhancements to auditor conflicts of interest to board oversight to executive pay practices to employee pension plans will be under the microscope. And companies will have to justify the measures they have in place.
'Shareholders are on alert right now,' summarizes Brad Pacheco, spokesman for the California Public Employees' Retirement System (Calpers), the nation's largest public pension fund with total assets exceeding $151 bn. 'Because of the post-Enron environment, people are quick to jump to conclusions, and you really have to look at the facts before you start making assumptions on issues. That said, shareholders are going to look at everything a lot more closely than they used to.'
Calpers is one of many pension funds that are again major proponents of shareholder activism this year. As of March 1, labor and related funds had presented a record 160 shareholder proposals in the US, compared to just 25 by all non-labor institutions combined. These funds have good reason to be active. Workers at public companies, whose savings pension funds manage, are both employees and shareholders, so they are doubly vulnerable to Enron-type problems.
Moreover, labor funds have overlapping relationships with their portfolio companies. They tend to be more long-term than other institutional investors, and are much less able to get out when a company performs poorly.
Among the resolutions presented by labor funds this year, the most common are those related to board independence. Also high on the list are proposals having to do with auditor conflicts and executive compensation (see chart, page 42).
Who's auditing the auditors?
High on this year's resolution list will be those related to auditor conflicts. Enron's collapse has reminded investors of a long history of accounting disasters, from Cendant, Sunbeam and Waste Management in the US, to Maxwell and Polly Peck in Britain, to Metallgesellschaft in Germany.
So during the 2002 proxy round, shareholders are querying companies about their relationships with their auditors. Moreover, they're pressing companies to keep their auditors and consultants separate, that is, to stop giving consulting work to their auditors. As Davis puts it, 'Just weeks ago we never thought we'd get to a state where it would be possible to imagine auditors separating consulting from auditing, but now that looks like it's going to be best practice in the US and elsewhere. It'll take a year to work through, but I think we'll see a lot of shareholder resolutions that will hammer that issue home.'
In the year's first major test case, Walt Disney shareholders voted 42 percent in favor of an auditor conflict proposal submitted by the United Association of Journeymen and Apprentices of the Plumbing and Pipefitting Industry. The proposal failed to achieve a majority vote but its popularity still amounted to a symbolic victory. 'If 40 percent of your shareholders are unhappy enough to check yes when management is recommending no, then you have a big problem on your hands; and if you don't deal with it this year, you will have a bigger problem next year,' states Minow from the Corporate Library. 'If you consider 42 percent a losing vote, you are not listening.'
In fact, Disney management changed course and supported the proposal, but only after the initial proxy statement had been sent out. By the time the vote came in, the company had already resolved to stop using their auditor for consulting work.
Last year, for the first time, US companies were required to disclose their non-audit fees. According to a survey by the Investor Responsibility Research Center (IRRC), the overall proportion of non-audit fees they paid to auditors was 72 percent (see chart, below). 'We knew the number would be high, but we were shocked to learn it was this high,' gasped the IRRC's director of corporate governance services, Carol Bowie, at the IRRC's New York proxy briefing recently.
In terms of specific proposals, shareholder activists this year are presenting a large number of 'no consulting fees to auditors' proposals. Another popular proposal is to have auditors changed every four years. Still others aim to have companies strengthen corporate boards and specifically their audit committees.
Nick Bradley, managing director of Standard & Poor's corporate governance services, believes that while there are pros and cons related to auditors providing non-audit services to companies, the real debate will focus on the boards. 'There has to be a strong audit committee which is really able to monitor the independence of the audit function,' he maintains.
Indeed, the topics of auditor effectiveness and board effectiveness go hand-in-hand and will undoubtedly be debated in tandem throughout the year. 'You need people on the board who are sufficiently senior and visible to be able to challenge and stand up to management,' Bradley says. 'But if those well-known names don't have the time or the inclination or the ability or resources to effectively monitor management, then clearly they are not serving the interest of shareholders.'
Enron's collapse left many shareholders wondering how the board could have let it happen. The bigger question is what it says about boards that are supposed to be independent. According to Bowie, there's an increase in proposals related to independence and board diversity. Companies are being asked to address issues related to directors' diversity, their role in corporate strategy, how and when they meet, how they are chosen and how they are compensated. As Bowie notes, the major new issue this season is to allow shareholders to vote against the election or reelection of specific directors.
Davis adds that there will be more resolutions demanding the split between the CEO and chairman positions. 'It's just not realistic that directors who are beholden to the CEO are going to be all that tough on the CEO. It happens - we have some independent-minded boards - but as a rule it's not likely to happen.'
Fat cat payouts
Another important debate this year revolves around executive pay. The UK's Labor government, following shareholder revolts at Marconi, Schroders, Royal Bank of Scotland and BT, is creating legislation that will force companies to put their pay practices to a vote. Germany's new corporate governance code and France's newly ratified New Economic Regulations Act also call for improved compensation disclosure.
Although approval of executive pay has long been a recommendation of the Combined Code, the UK's corporate governance bible, less than 10 percent of the London Stock Exchange's top 350 firms voluntarily put their pay practices to shareholder votes in 2001.
The IRRC's deputy director of global shareholder services, Subodh Mishra, says the new UK law should cause that number to increase, and while it is unfortunate that vote results will be non-binding, companies that fail to implement voter decisions risk agitating their shareholders. While some question the legislation's effectiveness - after all, the rule doesn't force companies to change their pay practices just because shareholders want them to - he believes many companies will feel pressure to amend their policies.
In the US, as well, shareholders this year are keeping up pressure to revise executive compensation plans. Proposals are designed to do one of two things: to link top managers' compensation to performance, or to curb what are perceived to be excessive executive payouts. In an extreme example, after certain companies created stock options plans without first receiving shareholder approval, TIAA-Cref drafted resolutions asking them to obtain approval for essentially all-equity compensation plans.
'We'll see bitter battles developing over the issue of stock option accounting and whether boards have to actually account for options in their financial statements as a cost,' Davis predicts. 'Right now, under US Gaap, they don't have to. They can just pour them out as if they are costless. Enron was indirectly an issue here: stock options went out and people cashed out at the top levels while a lot of employees lost everything. It has put other corporations on the defensive.'
Perhaps Enron's greatest impact will be felt in large-scale changes to corporate governance. Many countries had been working on their own governance upgrades, as evidenced by the many legislative actions and other guidelines that are currently being introduced, but Enron will have helped to accelerate their activities. There are important corporate governance codes being considered or introduced in the US, the UK, Canada, France, Germany and elsewhere, and while these may not be in place early enough to change 2002 shareholder proposals, companies should be prepared to answer critiques of their governance structure.
In the US, Calpers' board of administration has urged Congress, the SEC and others to adopt a package of financial market reform principles, and it announced its own action plan to promote market change. The institution has asked the federal government and stock exchanges to take action that will elevate the quality of company audit committee members; create clear, effective laws and regulations to ensure company audits are truly independent; and establish accounting standards that will put an end to 'unintelligible or manipulative' financial statements that confuse and deceive investors.
Across the Atlantic, Germany has introduced its new code of corporate governance aimed at improving the country's governance landscape. It promises to boost boards' inspection and auditing rights, improve shareholder rights, and allow shareholders to participate in annual meetings and cast their votes electronically. Problem is, critics say, the code is entirely voluntary, and some initial measures proposed by the Cromme committee last fall were softened during the consultation process.
In addition, progress in Germany is tempered by the country's adoption of its own takeover code - having rejected the common code proposed by the European Union. Germany's controversial new bill, deemed unfriendly to shareholders, gives companies the ability to adopt takeover defenses without shareholder approval. According to the IRRC's Mishra, 'The new German code would prevent acquisitions such as Vodafone's hostile takeover of Mannesmann two years ago.' During this year's proxy season, German companies can expect to hear criticisms of the new takeover code. (See this issue's Comment, page 25)
The year of Enron
Above all, shareholder resolutions this proxy season will focus on issues Enron brought to the surface. 'Enron is a permanent issue, and everyone is feeling very jittery right now. Everyone thinks that there's going to be a domino effect with other companies, and everyone wants to know which ones those will be,' Minow observes.
While the Enron scandal is bringing companies under a great deal of scrutiny, those same companies will have many new opportunities. Companies that show how they differ from their peers - how their boards offer meaningful, independent oversight, how their disclosure practices provide telling and timely information, and how they make good faith efforts to act in their shareholders' best interests - will gain significant support this season.
'The glass is not half empty, it's half full,' concludes Nell Minow. 'This is your opportunity to set the record straight. If you come out and sell yourself as the anti-Enron, you have a lot of great opportunities.'