Markets & Finance

A Problematic Proxy Season


Shareholders have begun flexing their muscles and are preparing to take management to task during companies' annual meetings this year

Proxy season is fast arriving, and many corporations, already suffering from slumping stock prices, are going to have to be prepared to face angry shareholders, who are filling proxy ballots with resolutions ranging from more stockholder say over executive pay to demands for environmental impact statements.

The American Federation of State, County, and Municipal Employees has already filed "say on pay" resolutions with more than 90 publicly traded companies, including Bear Stearns (BSC), Capital One (COF), Citigroup (C), Countrywide Financial (CFC), Merck (MRK), Merrill Lynch (MER), Morgan Stanley (MS), Motorola (MOT), Wachovia (WB), Wal-Mart (WMT), and Wells Fargo (WFC).

While history has shown few of these resolutions actually come to pass with a change in company policies or procedures, there's no question they are time-consuming for the companies under attack.

"Fighting off shareholder activism takes up management and board time, disrupting the company's day-to-day operations," says Amra Balic, a governance analyst with Standard & Poor's Ratings Services, an entity that operates independently from Standard & Poor's Equity Research.

The 2008 U.S. proxy season could be one of the most contentious ever, according to a report in Credit Week, a publication of Standard & Poor's Ratings Services. The potentially antagonistic disputes follow a recent decision by the Securities and Exchange Commission to exclude proxy access proposals (amid strong dissent from one commissioner). Thus, shareholders continue to seek ways to place curbs on executive pay by advocating "say on pay" advisory votes at the annual meetings of publicly-listed corporations.

One of the hottest issues is efforts to link pay to performance. And in an effort to do that, some shareholders are starting to agitate for fewer buybacks, which have traditionally been thought of as a way to return value to shareholders.

"Over half of U.S. corporations use earnings per share (EPS) as a metric for some form of executive pay, and increasing the size of a share-buyback program will in turn raise EPS," says Dan Konigsburg, a governance analyst for S&P Ratings Services. "This is often the simplest and easiest way to manipulate bonus payouts if earnings are disappointing."

S&P equity analyst Marie Driscoll agrees. "Why don't executive-compensation programs use net income rather than EPS? That would be a simple adjustment, and the preferred measurement for shareholders when looking at executive compensation, because EPS is easily manipulated by share count," she says.

In the United Kingdom, shareholders have gained a nonbinding advisory vote on pay, which, some U.S.-based shareholder advocates say, is a step in the right direction and one that should gain traction on this side of the Atlantic. However, at this time, shareholders have little power to change things. Despite a budding movement among shareholders to vote on executive pay, this is an issue currently reserved for outside directors.

"Equity holders haven't been using their power effectively," says Driscoll. "One reason may be that many equity holders are short-term owners focused on quick appreciation rather than influencing how the company is run. It's the long-term investors that care about their power and the sustainability of the company."

However, when it comes to shareholder votes, one share is one share, no matter how long it is held. That's why creditors are sometimes becoming shareholders — to ensure the company acts in the long-term interest of creditors.

"We're looking closely at shareholder activism because we've found that it can often lead to unexpected changes at companies and to surprises for creditors," says Konigsburg. "A working group at Standard & Poor's Ratings Services is studying the links between activism and creditworthiness. It's still too early to say definitively how strong those links are."

However, Konigsburg is able to report that shareholder activism is growing, and not just in the United States but around the globe. In some ways, he says, activists are competing with private-equity firms to target underperforming companies with entrenched management whose value might be increased or unlocked through intervention.

"We've also learned a few lessons over the past year or two about activism, and I'll provide three examples," Konigsburg says. "First, never underestimate small shareholders. On occasion, activists with as little as 1% or 2% of shares outstanding have convinced everyone else to kick out management and change things very quickly."

Second, he says, gaining a single seat on the board is a limited accomplishment, and is much different than winning two or three seats. A single seat still requires convincing everyone else on the board to change things once the director joins. One director, no matter how persuasive, is unlikely to get a decisive number of other directors on his or her side. But two or three people can form a block. "We've seen greater success rates when multiple activists get on the board at the same time," Konigsburg says.

Third, he says, activism is more likely at some firms than at others. Activists tend to focus on companies with disappointing equity performance, entrenched management, or poor corporate governance, because these can be used as a wedge to gain support in a campaign.

Piskora is managing editor of U.S. Editorial Operations for Standard Poor's .

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