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Online Extra: An Acid Test for Boards


For the first time, proxy advisory heavyweight Institutional Shareholder Services is examining companies' stock performances on a standalone basis in forming recommendations to shareholders to vote to reelect directors -- or not. ISS is using the new criteria to test if directors are carrying out their fiduciary responsibilities to ensure the long-term value of the firms that they have been empowered to protect.

As straightforward as that might sound, ISS' new stance has sparked a war of words at Cincinnati-based Fifth Third Bancorp. The reason: ISS has recommended that shareholders withhold their votes to reelect Fifth Third's CEO, George A. Schafer Jr., at the bank's annual meeting on March 28, because the bank's stock has underperformed its peers over the last five years. Yet in terms of corporate governance, by ISS measures, Fifth Third is an overachiever. What matters more? BusinessWeek Associate Editor Emily Thornton spoke separately with ISS CEO John M. Connolly and Fifth Third CEO Schaefer about the ISS recommendation (read both question-and-answer sessions, below).

Excerpts from the interview with ISS CEO John Connolly:

By your own measures, Fifth Third has stellar corporate governance practices. But you've recommended that shareholders withhold their votes to reelect the directors based on its poor performance. What's more important to ISS? Corporate governance or performance?

It's a new corporate directors' performance policy. I don't think you can de-couple corporate governance from performance. That is one of our major themes. You could have a good corporate score, as they do, because of your (board) structure and best practices. But that doesn't mean that it should be de-coupled from performance.

A number of our clients came to us over the last year and said it would be very good if you could begin to identify for us those firms that are at the lowest, lowest level of performance in the S&P 500 or the Russell 3000 index; and whether directors are really protecting the shareholders' rights to create value. That's what directors are there for. ISS is a company that doesn't sit in Rockville coming up with policies in a vacuum.

Yet until now, many people have assumed that good corporate governance leads to good performance.

I would say that good corporate governance leads to mitigating risk. But it doesn't necessarily mean that good corporate governance structure, and principles, and processes ensure best performance. The two have to be looked at together because of the role and responsibilities of a director today. We enacted this policy this year because so many clients kept coming back to us and saying, "Could you comment on the performance of a firm?" We don't necessarily believe that because a firm is at the highest tier of its corporate governance rating, it will be one of the best performing companies. [A great corporate governance score] doesn't necessarily mean that directors can forget about their oversight responsibilities and their responsibility to protect the value of the firm.

Are you really equipped to evaluate if a company's strategy is working or not?

We're not commenting on a strategy. We're commenting on the fact that here is a firm that for three succeeding years has been at the bottom of performance as you look at its peer group, and its total return, or lack of return, to its shareholders.

But you also determined that Fifth Third did not have a sufficient turnaround strategy.

The board has not articulated a turnaround strategy in light of its financial performance. It's not made clear how it's going to deliver greater value to its shareholders in a strategy or communication.

When we look at these issues, we say to ourselves, are we confident in our ability to opine on them. Based on the types of people we have, we believe we are. We believe we are in business to provide our clients with outstanding analysis and assessment across a multitude of issues as it relates to governance and performance. We have people who understand M&A, executive compensation, financial performance, governance proxy issues. Many of our people come from backgrounds of banking, or investment banks, or executive compensation firms, or research firms. We have Ph.Ds. MBAs. And former business executives.

I understand that you are doing more work in the Philippines.

We're a global operation. We have 12 offices around the world. We have a global network that enables us to collect data, answer client service calls.

Is that office doing the analysis for the performance rating?

No, they're not. Why can't you be a global company if you're ISS? Forty percent of our population now sits outside of the US. When I joined two years ago, we had four offices. Today, we have 12. Two years ago, we covered 20,000 companies. We cover 35,000 companies now. Two years ago, we had 850 clients. Today, we have 1,635 clients. So we're a global company that really has the responsibility to address the requirements of our clients, regardless of where they are. Two thirds of our client base sits outside the U.S. The clients are investment managers, pension funds, mutual funds as well as hedge funds.

What is your response to criticism that ISS is conflicted since it provides both proxy advisory services to shareholders as well as consulting services to the companies they own?

We have no conflict. We have a business model that says shareholders and corporations will increasingly leverage corporate governance to mitigate risk and maximize value. We provide tools and information to corporations to help them become much more aware of the best practices and issues associated with corporate governance as it relates to the institutional ownership that they have. I challenge anyone to find that we have ever made a recommendation because we were paid by a corporation. We have a 94% renewal rate among our institutional client base. It's on our web site. We're very transparent. My role as a CEO is to protect the integrity and brand of this company and I'm not going to compromise my integrity or the brand of ISS for any amount of money. We do everything for the best interests of our institutional clients.

Our institutional clients asked us years ago, before I was here, to provide information to companies to make them aware of critical issues. Providing tools and services to corporations represents less than 15% of our revenues. Perception of conflict is prevalent in any industry. It's prevalent in our industry. It's what you do to protect yourself against any real conflict. We have procedures, processes, separate organizations that enable to speak with integrity that we do not have conflict.

Can you imagine a scenario where in the future you would give companies tools to improve their performance?

I can't imagine that. No.

So despite evaluating performance, you don't think it's appropriate to produce research as research analysts do?

Our valuation has nothing to do with "buy" or "sell." Our valuation is an articulation of our policy against the performance of the directors. It has nothing to do with whether a company should sell or buy a stock. There is a huge difference. Our ongoing focus is always going to be around the performance of directors in the boardroom as they carry out their fiduciary responsibilities to ensure the long term value that they have been empowered to protect.

In thinking about Fifth Third, if you look at how it's done over five years, the performance has not been great. But if you look over ten years, it has outperformed the S&P 500. How did you arrive at your performance rating system? Why look at one year, three year and five year returns? Isn't a one-year return too short term?

It's the balance. We use the total shareholder return measurement as the financial indicator of whether the directors have been performing their fiduciary responsibility to protect the shareholder value of that firm. When we do our analysis, there are about 70 companies in the Russell 3000 that are the very lowest level of performance. I think what we try to do is that as we evaluate these companies we're fair, we're balanced, we've had numerous conversations with management, so it was not done in a vacuum. We make no apologies for making difficult decisions that are in the best interest of our institutional clients. I will accept criticism from anyone for making those tough decisions. That is our job. Every time we come out with a new policy, there is a level of criticism directed at ISS -- [such as] why are you coming out, and what qualifies you.

When you have had a firm that has had such a poor performance over so many years, you have to look to the board room and ask some fundamental questions. We're not making a decision or opining if an institutional shareholder should buy or sell an equity. What we are opining on is the performance of the board during that period of time. That's a significant difference.

There is a greater degree of responsibility being exercised by owners around what they should and should not comment on. An owner should have the ability to comment on a director's performance if the returns have been so negative. This policy is about long term performance and the directors' responsibility to ensure that there are long term returns to its shareholders and owners.

Excerpts from the interview with Fifth Third CEO George Schaefer:

ISS has recommended that shareholders should with hold their votes to reelect yourself and other directors at the annual meeting on March 28. What is your view of their recommendation?

Obviously, we were disappointed in their decision that was pretty much based on our share price during a set period of time. If you look at the 10-year average (of the stock's returns), or our returns on assets, returns on equity, or even if you look at the governance rankings of Fifth Third -- we rank better than all of the other banks in the universe in terms of corporate governance -- even with those kind of rankings, (ISS) voted as they did. Of course that's their prerogative.

If you take a ten year average, we've significantly outperformed [in terms of shareholder returns]. Last year, our earnings were up 3%. Our return on equity for the year was 17%. Our return on assets was 1.5%. Those returns are all above the averages for the industry. Our Moody's and S&P ratings are above the averages. If you choose one criteria, that (the stock price) doesn't always seem to be the best gauge.

If your return on assets and return on equity are better than your peers, why do you think your stock price has been recently underperforming them?

At one time, we traded at an extremely high multiple. We still trade above our peer group average. But (the multiple) is nowhere near where it was. At one time, we traded at a multiple of 25 or 30. Now we're at 14. But our performance has been above average by other measures. On rating agencies' ratings, return on equity, return on assets, absolute profits, deposit growth, loan growth, we [compare] extremely well [to our peers].

Why has it been difficult for you to regain the higher multiples that you were trading at before?

Generally, the whole (stock) market, the flat yield curve and the move up in interest rates have been detriments to most of the institutions. That has caused lower valuations.

In reaching its decision to recommend that shareholders with hold their votes to reelect you, ISS pointed out that you lack a demonstrated turnaround strategy. Do you agree with that?

Not at all. The turnaround strategy in our industry is based on deposit growth, loan growth, fee business growth and controlling expenses. We're very focused on those items. We didn't really have a discussion with ISS about a turnaround strategy.

ISS is examining the stock performance of companies on a stand alone basis this year as a way to test if directors are fulfilling their fiduciary responsibilities to protect the value of the firms they govern. Do you feel that you have violated your fiduciary duty in this regard?

One of the directors who ISS is recommending a withhold vote for is Mr. John Schiff who runs the Cincinnatti Financial Corporation. The company owns 13% of our shares. It seems that someone who owns 13% of the shares has more of an interest in our company than any other shareholder.

I have a tough time reconciling how we could get a corporate governance score better than any other bank in their universe and then [they advise stockholders to] withhold vote based solely on share price.

This has been a change for ISS. That's their perogative. They can set up the measures or the strike zone as they see fit. But on the other side, (in terms of other) items such as return on equity, Fifth Third scores in the 75th percentile. That's a measure that they didn't look at. How do you reconcile that?


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