CFO Magazine

Who's in Charge Here?

Listening to shareholders is easy. Making sense of their concerns is not.

Joseph McCafferty - CFO Magazine

September 1, 2010

On the eve of the 2008 elections, Richard Ferlauto, a union-pension-fund executive, noted that if the Democrats were to win big "it will be like Christmas for us."

While the Democrats did, in fact, sweep Congress and take the Presidency, the ensuing weeks hardly matched most people's idea of Christmas: the still-unfolding financial crisis saw the S&P hit a five-year low. But Ferlauto wasn't talking about performance gains; he wanted to find a host of corporate-governance gifts under the tree, and he wasn't disappointed.

The past two years have seen activist shareholders receive a sackful of goodies, from "say-on-pay" initiatives to clawbacks of ill-gotten bonuses to new rules on broker voting to more information about climate change, political spending, and other social issues. And then there is proxy access, the corporate-governance equivalent of a shiny new bike. True, some assembly is still required, but it has leapt off the wish list and now sits under the tree.

But as these governance gifts pile up, the question must be asked: Do shareholders need them, or even want them?

The answer is surprisingly elusive. Determining what investors truly want (beyond consistently healthy returns) is difficult because investor groups are a fractured, noisy, and widely divergent lot. They have different and sometimes competing interests, and different methods of communicating; some may not speak up at all.

CFOs and other senior executives may feel like parents trying to read the lips of children as they sit on Santa's lap. "You might think that the people speaking the loudest are speaking for the larger group, but when you get down to it, the majority may not support [their concerns]," says Robert McCormick, chief policy officer at Glass Lewis, a proxy advisory firm.

"You have a very vocal minority that is doing most of the talking," agrees Peter Clapman, chairman and president of Governance for Owners USA, a corporate-governance advisory firm, "and it can be difficult to determine if those same concerns are held by the broader shareholder base."

What is often referred to as the modern shareholder movement has its roots in a single social issue: ending apartheid in South Africa. In the early 1970s, attorney Paul Neuhauser led a religious group in filing a proxy resolution urging General Motors to end its business in South Africa unless or until apartheid was ended. (That group has since morphed into the Interfaith Center on Corporate Responsibility, one of the most influential social responsibility investment groups and a prolific proxy resolution filer; its members filed 282 proposals this year alone.)

Other social issues, such as labor and environmental practices, became increasingly popular subjects for shareholder proposals, but they were largely ignored by companies; most institutional investors didn't even bother to vote.

It wasn't until the 1980s, during the heyday of corporate raiders backed by Michael Milken, that proxy resolutions (proposals that actually make it on to the ballot; often proposals are either addressed or ignored by companies without getting to the ballot stage) were embraced as a way to force companies to put their takeover defenses up for a shareholder vote. Shareholders embraced these resolutions because they often boosted corporate values, and soon the proxy resolution became a powerful tool for shareholder activism.

Another major boost came from the rising popularity of index funds, which pushed pension managers and other institutional investors to take a more active role in influencing corporate behavior. Until then, investment managers who didn't like certain corporate policies or practices simply sold their shares — they voted with their feet. That became harder to do when index funds (and, later, electronic trading) made it more difficult to walk away from individual companies.

Lost in the Shuffle

Today, the shareholder proposal is the main instrument through which investors make themselves heard, and it's easy to play. All that's required to get a resolution on the ballot is to own $2,000 worth of shares for at least one year, a fact not lost on social activist groups such as PETA, Amnesty International, and Greenpeace, all of which have recently launched shareholder campaigns. This year so far, climate and energy-related proposals alone number more than 100, according to Ceres, an environmental-investor network; all told, 1,000 shareholder proposals have been filed through early August, of which 500 have made it onto the ballots, according to RiskMetrics.

Most governance experts expect the number of shareholder resolutions to continue to increase, resulting in a cluttered and clouded process that can be difficult for shareholders, boards, and management to make sense of. "The misuse of the shareholder proposal process can be harmful in that serious issues and problems can get lost in the shuffle," says Clapman. "It damages the system if resolutions are filed that have no chance of passing."

However, Clapman says that the proxy resolution process set up to put shareholder concerns to a vote can provide an ideal way for company officers to determine which shareholder issues have broad support among investors and which ones are on the fringe. "It's pretty easy to tell what they think by looking at the shareholder votes," he says. "Some issues, like majority voting, are supported by most shareholders and get high voting percentages, while other issues get only single-digit support."

Charles Elson, who heads the University of Delaware's Weinberg Center for Corporate Governance, agrees: "Voting on shareholder resolutions gives you a good sense of where shareholder thought lies."

But not always. Some issues, like compensation, vary hugely from one company to the next in terms of shareholder support. And some experts, including Gary Lutin, chairman of the Shareholder Forum, a Web forum devoted to investor and corporate news, contend that the process can actually amplify the squeaky-wheel effect. Lutin says that most proposals are filed by a small group of institutional investors that includes state and local pension funds, union pension funds, socially and environmentally oriented investment groups, and some activist hedge funds. At most, he says they represent about 5% of all the holdings of a typical large company.

Because many institutional investors can't afford to follow all of the issues at every one of their holdings on their own, they often rely on proxy advisory firms, like RiskMetrics, Glass Lewis, and Proxy Governance, to make recommendations on how they should vote. But since these firms have to satisfy the same vocal minority, whose members tend to be their largest clients, they often support activist causes, acting as echo chambers, increasing the influence of the vocal minority. "The [reliance on] proxy advisers results in a process where shareholders are directed to conform to the 'good governance' views adopted by vocal, policy-oriented investors," says Lutin. "It isn't good."

The echo-chamber effect is further exacerbated by the fact that the whole notion of governance policy took hold at a handful of funds and its definition didn't change much as it moved out into the broader investment community. Today, many mutual-fund companies and money managers are under increasing pressure to open a governance office, and it's a safe bet that when they do they will take the natural approach of hiring someone who has graduated from this school of good-governance theory. "This can lead to a lot of insularity," says Lutin. "They all hang out at the same bars, so to speak."

Open Season on the Proxy

Bellying up to that same bar is the Securities and Exchange Commission, which, under Obama appointee Mary Schapiro, is now, as the University of Delaware's Elson puts it, "slanted toward more discussion of environmental and social issues." The SEC has also made it easier for shareholders to get proposals onto the proxy. In past years, the SEC gave many companies permission to ignore certain shareholder proposals under what is known as the ordinary business exclusion. That is, if the shareholder proposal dealt with an issue that was related to the ordinary running of the business, companies could get permission to keep them off the proxy.

This year, the SEC has defined such exclusions very narrowly and granted very few. Issues that could be left off the proxy in the past, such as succession planning or risks associated with potential environmental liabilities, are now being put to a vote. "The SEC is increasingly reluctant to disqualify resolutions on substantive grounds," says Clapman. Elson puts it more succinctly: "It's open season on the proxy."

That's not to say that environmental and social issues are not important, but critics claim they now garner a disproportionate share of attention and can distract management from running the business. They can also create tension between management and shareholder groups. "The more issues you have to address, the harder it becomes to run the business," says Elson.

A study conducted last year by Navigant Consulting for the U.S. Chamber of Commerce found that "while [proxy] proposals may be successful in making qualitative changes in companies' actions, there is little-to-no evidence that those changes have an impact on the bottom line of target firms."

Worse, Navigant found that they may have a negative effect on performance over the long term. While one explanation may be that inherently troubled companies are more likely to face a bevy of shareholder proposals, the Navigant results are consistent with other studies that find no correlation between good corporate-governance ratings and economic performance. In other words, for all the work that shareholder activists do to improve companies' governance policies, those improvements appear to have little impact on the one measure of success that nearly all shareholders care about: better returns.

Can You Hear Me Now?

Amid all these changes, companies have begun moving away from their past habit of ignoring or battling against shareholder activism and are now more willing to listen to shareholders' governance concerns. But that doesn't mean they're particularly good at responding.

One of the problems is structural: shareholder relations is an activity that falls into two distinct camps. In one, the investor-relations team, often with oversight from the CFO, communicates with portfolio managers and other constituents that make investment decisions and are concerned with performance and valuation. In the other, the corporate secretary or chief governance officer, often with oversight from general counsel, communicates with governance directors at pension and investment funds.

The result is that companies can get mixed signals from their investors. "The CFO might have a great relationship with a portfolio manager of a large fund, and then be completely caught off guard by what he perceives as a hostile shareholder campaign by the same fund," says Lutin. CFOs should push for a more integrated communications process, he says.

Another problem is that companies often pay investors what might be called "ear service." During road shows they open the floor to governance issues, but they don't act on what they hear. "It's not enough to sit and listen," says Patrick McGurn, special counsel for Institutional Shareholder Services. "Putting a happy face on relations with investors, with no intention of taking into account anything they say, will backfire on you."

Not everyone thinks that companies should engage in an open dialogue with investors on governance issues. When Pfizer set up a meeting with large shareholders with that aim in 2007, heavyweight Wall Street lawyer Martin Lipton, of Wachtell, Lipton, Rosen & Katz, wrote in a memo: "While corporate-governance activists are applauding today's announcement by Pfizer that members of its Boards of Directors will invite its largest institutional shareholders to a meeting where they will have an opportunity to provide comments and perspective on the company's governance policies and practices including executive compensation, this is another example of corporate governance run amuck."

To a large extent, the concerns of opponents circle back to the aforementioned echo-chamber effect: they fear that "improved" governance will simply lead to "one-size-fits-all" or "check-the-box" approaches. They also argue that certain good-governance no-nos, such as allowing the CEO to double as chairman, or having a staggered board, have done nothing to hamper the performance of, respectively, Berkshire Hathaway and Google.

It's also worth noting that shareholder activism tends to be cyclical, peaking when returns are down or after periods of widespread governance failures, such as the recent financial crisis or the accounting scandals of the early 2000s. A recovery will prompt most shareholders to resume their intense focus on quarterly earnings. This time around, CFOs might regard that as a very welcome holiday gift.

Joseph McCafferty is a freelance writer based in Boston who covers finance and corporate governance.