How Does Your Company Compare?

Since the Sarbanes-Oxley Act (SOX) was signed into law in 2002 and the revised NYSE and Nasdaq listing standards were implemented, certain trends have developed among the corporate governance practices of the 100 largest publicly listed U.S. companies as ranked by revenue in FORTUNE magazine's FORTUNE 500' list (the “Top 100″). For the past 3 years, Shearman & Sterling has analyzed the corporate governance practices of the Top 100. What follows is a summary of our most significant findings with respect to director independence, board leadership, director time commitments and compensation, and shareholder proposals.

Director Independence

The policies of the Top 100 have continued to exceed the NYSE and Nasdaq requirements that a majority of a listed company's board of directors be independent. Fifty-four of the companies surveyed in 2005 have adopted standards requiring that their boards be comprised of more than a simple majority of independent directors. When reviewing actual boardroom figures, the numbers are even more striking: 75% or more of the directors at 81 Top 100 companies are independent. These data may be viewed with some skepticism since questions of independence are decided by the board, and through the adoption and disclosure of categorical standards of independence, NYSE-listed companies can avoid disclosure of relationships below certain materiality thresholds. What is clear is that the number of insiders or company employees serving on the board is on the decline. The CEO is the only non-independent director at 37 Top 100 companies, an increase of two from 2004.

Board Leadership

The vast majority of Top 100 companies continue to follow the traditional paradigm that boards are led by the same individuals who manage the day-to-day operations of the company. Few Top 100 companies have two different individuals serving as CEO and chairman of the board, and the numbers have changed very little in the last 3 years. As of June 15, 2005, chairmen at only 19 of the Top 100 did not simultaneously serve as CEO, compared with 14 such companies in 2003 and 2004. While this increase can be attributed to a handful of well-publicized instances of extreme dissatisfaction with, and ultimate resignation of, the CEO, only four Top 100 companies have implemented explicit policies requiring the separation of the two positions.

The data over the last 3 years suggest that those instances in which different individuals serve as chairman of the board and CEO are more closely related to a company's CEO succession process rather than the adoption of a specific corporate governance policy. The absence of any significant change in this area, coupled with a falling number of shareholder proposals advocating an independent board chairman, may signal that this issue is of less importance to shareholder activists when compared with other issues that are garnering more attention.

The NYSE listing standards require that the name or method of selection of the director presiding over executive sessions of non-management directors be disclosed in a company's annual proxy statement. Despite this rule, no consensus has emerged among the Top 100; rather, the surveyed companies have adopted a wide variety of methods for selecting their presiding directors. Thirty-one companies provide for the rotation of the presiding director according to the subject to be discussed at each executive session, as well as other criteria; 24 have named the nominating/governance committee chair as the presiding director; and 20 require that the independent or non-management directors select the presiding director. Only 28 of the Top 100 have given their presiding directors additional responsibilities beyond overseeing the executive sessions. Despite certain recent high-profile exceptions, neither a strong lead independent director nor an independent or non-management chairman of the board has replaced the traditional paradigm of board leadership.

Director Time Commitments and Compensation

In the wake of SOX and the revised NYSE and Nasdaq listing standards, there was widespread expectation that directors would be required to devote significantly more time in order to fulfill their responsibilities. Those expectations have been fulfilled. The number of board and committee meetings has steadily increased over the last three years. In 2003, 51 Top 100 companies reported holding eight or more meetings of the board of directors during the previous year; that number increased to 54 companies in 2004 and 65 in 2005.

Even more significant is the growth in the number of committee meetings over the last 3 years. In 2003, 81 Top 100 companies reported holding six or more audit committee meetings; that number increased to 86 companies in 2004 and 94 in 2005. In 2003, 67 Top 100 companies reported holding five or more compensation committee meetings; that number increased to 74 companies in 2004 and 81 in 2005. In 2003, 27 Top 100 companies reported holding five or more nominating/governance committee meetings; that number increased to 45 companies in 2004 and 55 in 2005.

More frequent board and committee meetings have placed heavier demands on directors' time, and these demands have focused the attention of investors on directors who serve on multiple public company boards. In 2004, Institutional Shareholder Services (ISS) announced that it would recommend withholding votes from directors who serve on more than six public company boards. During the 2005 proxy season, ISS stated that, in addition to its six-board policy, it would recommend withholding votes from CEOs of publicly traded companies who serve on more than two public company boards besides their own board.

Investor attention to this issue may explain why many Top 100 companies have adopted policies relating to directors' service on multiple boards. Of the companies surveyed, 86 in 2005, compared with 76 in 2004, address the issue, but only 42 Top 100 companies place a limit on the number of boards upon which a director may sit. This is an increase from 2004, when only 29 had such restrictions. Most of the Top 100 companies, however, allow directors to exceed imposed limits if the board determines that simultaneous service will not impair the director's abilities to fulfill his or her responsibilities. Despite investor focus on “over-boarded” directors, at least one director at 45 Top 100 companies served on five or more boards, compared with 42 in 2004.

Director compensation levels have risen over the last three years along with the increased frequency of board and committee meetings. Nearly all of the Top 100 paid their directors an annual cash retainer, and the annual cash retainer amount over this same period increased. In 2003, only three companies reported annual cash retainers in excess of $80,000, but that number increased to nine in 2004 and 11 in 2005. At the lower end of the scale, in 2003, 55 of the surveyed companies reported annual cash retainers in amounts of $40,000 or less, but that number fell to 39 in 2004 and 29 in 2005. In addition to cash retainers for board service, a greater number of the Top 100 reported committee retainers as part of their director compensation packages. In 2005, 91 companies reported committee retainers compared with 80 companies in 2003.

More significant than the increase in the amount of cash compensation being paid has been the evolution in the nature of equity compensation received by Top 100 directors over the last 3 years. Investors have long focused on generous executive compensation packages, and the well-publicized incidences of executives who have enjoyed significant personal gains in advance of a downturn in their company's stock performance have heightened investor attention on equity compensation. Stock options, which only have value if the stock price increases, have fallen out of favor largely because of the concern that options could divert the loyalty of management by keeping their focus on short-term gains in contrast to aligning their compensation with the long-term interests of shareholders.

These concerns are equally as applicable to director compensation, and companies have responded to these concerns. The number of Top 100 companies surveyed in 2005 that reported stock option grants as a component of director compensation decreased to 55 from 70 in 2003. Conversely, the number of Top 100 companies surveyed in 2005 that reported grants of stock and restricted stock increased to 36 and 47, respectively, from 31 and 25, respectively, in 2003. It is likely that the number of companies that offer their directors stock options as part of their overall compensation packages will continue to decline.

Shareholder Proposals

The last 3 years have seen a shift in the numbers and types of shareholder proposals included in the proxy statements of the Top 100. Despite speculation that shareholder pressure, including the number of shareholder proposals submitted, would continue to increase, nearly one-third of the Top 100 companies did not include any shareholder proposals in their proxy statements during the 2005 proxy season. The number of certain “traditional” corporate governance shareholder proposals, which have principally focused on companies' anti-takeover devices, such as poison pills and classified boards, has declined over the past 3 years.

Rather than reflecting a lack of interest of shareholder activists in these topics, the decline is more indicative of the fact that fewer Top 100 companies have poison pills or classified boards. In 2004, 33 Top 100 companies had a poison pill, and 54 Top 100 companies had a classified board; in 2005, those numbers fell to 27 and 38, respectively. From 2003 to 2005, there was a corresponding reduction in the number of shareholder proposals calling for redemption of, or a shareholder vote on, poison pills from 25 to three and in the number of shareholder proposals calling for the annual election of directors from 10 to four. However, this is likely an area in which our survey results may not be indicative of trends among all publicly listed companies. While several Top 100 companies have dismantled traditional anti-takeover devices such as poison pills and classified boards in the wake of shareholder pressure, the Top 100, unlike most other companies, are more likely, by virtue of their size and market capitalization, to be protected from unsolicited takeover attempts without the benefit of other more traditional anti-takeover devices.

In addition, certain “new” shareholder proposals focused on shareholder voting rights have gained prominence. In 2003, no Top 100 company included a shareholder proposal in support of the removal of supermajority voting provisions in its proxy statement, but in 2005, seven of the Top 100 companies included such a shareholder proposal in their proxy statements.

The principal “new” shareholder proposal during the 2005 proxy season related to shareholder requests that companies require that directors be elected by a majority of the votes cast rather than the current plurality necessary to win election. Following the demise of the SEC's proposed proxy access rule, various unions adopted campaigns to have non-binding majority voting proposals included in 2005 proxy statements. As a result, the proxy statements of the Top 100 contained 15 proposals seeking majority voting in director elections while there were no such proposals in 2003. If not for the fact that a number of Top 100 companies joined a working group sponsored by the United Brotherhood of Carpen-ters in return for the withdrawal of a majority vote shareholder proposal, the number would have been higher. Several of these proposals put to a shareholder vote during the 2005 proxy season have received significant support from shareholders. In response to, or in anticipation of, shareholder pressure, a number of companies have voluntarily adopted either majority voting in director elections or a requirement that directors who do not receive a majority of votes cast offer their resignations. The latter approach gives boards significant discretion whether or not to accept such resignations.

Conclusion

It remains to be seen whether the same shareholder pressure that gave rise to such policies in the first instance will compel boards to accept the resignations of directors who have failed to garner a majority of the votes cast in favor of their election. Companies should expect to see more majority voting shareholder proposals submitted in 2006.

Since the Sarbanes-Oxley Act (SOX) was signed into law in 2002 and the revised NYSE and Nasdaq listing standards were implemented, certain trends have developed among the corporate governance practices of the 100 largest publicly listed U.S. companies as ranked by revenue in FORTUNE magazine's FORTUNE 500' list (the “Top 100″). For the past 3 years, Shearman & Sterling has analyzed the corporate governance practices of the Top 100. What follows is a summary of our most significant findings with respect to director independence, board leadership, director time commitments and compensation, and shareholder proposals.

Director Independence

The policies of the Top 100 have continued to exceed the NYSE and Nasdaq requirements that a majority of a listed company's board of directors be independent. Fifty-four of the companies surveyed in 2005 have adopted standards requiring that their boards be comprised of more than a simple majority of independent directors. When reviewing actual boardroom figures, the numbers are even more striking: 75% or more of the directors at 81 Top 100 companies are independent. These data may be viewed with some skepticism since questions of independence are decided by the board, and through the adoption and disclosure of categorical standards of independence, NYSE-listed companies can avoid disclosure of relationships below certain materiality thresholds. What is clear is that the number of insiders or company employees serving on the board is on the decline. The CEO is the only non-independent director at 37 Top 100 companies, an increase of two from 2004.

Board Leadership

The vast majority of Top 100 companies continue to follow the traditional paradigm that boards are led by the same individuals who manage the day-to-day operations of the company. Few Top 100 companies have two different individuals serving as CEO and chairman of the board, and the numbers have changed very little in the last 3 years. As of June 15, 2005, chairmen at only 19 of the Top 100 did not simultaneously serve as CEO, compared with 14 such companies in 2003 and 2004. While this increase can be attributed to a handful of well-publicized instances of extreme dissatisfaction with, and ultimate resignation of, the CEO, only four Top 100 companies have implemented explicit policies requiring the separation of the two positions.

The data over the last 3 years suggest that those instances in which different individuals serve as chairman of the board and CEO are more closely related to a company's CEO succession process rather than the adoption of a specific corporate governance policy. The absence of any significant change in this area, coupled with a falling number of shareholder proposals advocating an independent board chairman, may signal that this issue is of less importance to shareholder activists when compared with other issues that are garnering more attention.

The NYSE listing standards require that the name or method of selection of the director presiding over executive sessions of non-management directors be disclosed in a company's annual proxy statement. Despite this rule, no consensus has emerged among the Top 100; rather, the surveyed companies have adopted a wide variety of methods for selecting their presiding directors. Thirty-one companies provide for the rotation of the presiding director according to the subject to be discussed at each executive session, as well as other criteria; 24 have named the nominating/governance committee chair as the presiding director; and 20 require that the independent or non-management directors select the presiding director. Only 28 of the Top 100 have given their presiding directors additional responsibilities beyond overseeing the executive sessions. Despite certain recent high-profile exceptions, neither a strong lead independent director nor an independent or non-management chairman of the board has replaced the traditional paradigm of board leadership.

Director Time Commitments and Compensation

In the wake of SOX and the revised NYSE and Nasdaq listing standards, there was widespread expectation that directors would be required to devote significantly more time in order to fulfill their responsibilities. Those expectations have been fulfilled. The number of board and committee meetings has steadily increased over the last three years. In 2003, 51 Top 100 companies reported holding eight or more meetings of the board of directors during the previous year; that number increased to 54 companies in 2004 and 65 in 2005.

Even more significant is the growth in the number of committee meetings over the last 3 years. In 2003, 81 Top 100 companies reported holding six or more audit committee meetings; that number increased to 86 companies in 2004 and 94 in 2005. In 2003, 67 Top 100 companies reported holding five or more compensation committee meetings; that number increased to 74 companies in 2004 and 81 in 2005. In 2003, 27 Top 100 companies reported holding five or more nominating/governance committee meetings; that number increased to 45 companies in 2004 and 55 in 2005.

More frequent board and committee meetings have placed heavier demands on directors' time, and these demands have focused the attention of investors on directors who serve on multiple public company boards. In 2004, Institutional Shareholder Services (ISS) announced that it would recommend withholding votes from directors who serve on more than six public company boards. During the 2005 proxy season, ISS stated that, in addition to its six-board policy, it would recommend withholding votes from CEOs of publicly traded companies who serve on more than two public company boards besides their own board.

Investor attention to this issue may explain why many Top 100 companies have adopted policies relating to directors' service on multiple boards. Of the companies surveyed, 86 in 2005, compared with 76 in 2004, address the issue, but only 42 Top 100 companies place a limit on the number of boards upon which a director may sit. This is an increase from 2004, when only 29 had such restrictions. Most of the Top 100 companies, however, allow directors to exceed imposed limits if the board determines that simultaneous service will not impair the director's abilities to fulfill his or her responsibilities. Despite investor focus on “over-boarded” directors, at least one director at 45 Top 100 companies served on five or more boards, compared with 42 in 2004.

Director compensation levels have risen over the last three years along with the increased frequency of board and committee meetings. Nearly all of the Top 100 paid their directors an annual cash retainer, and the annual cash retainer amount over this same period increased. In 2003, only three companies reported annual cash retainers in excess of $80,000, but that number increased to nine in 2004 and 11 in 2005. At the lower end of the scale, in 2003, 55 of the surveyed companies reported annual cash retainers in amounts of $40,000 or less, but that number fell to 39 in 2004 and 29 in 2005. In addition to cash retainers for board service, a greater number of the Top 100 reported committee retainers as part of their director compensation packages. In 2005, 91 companies reported committee retainers compared with 80 companies in 2003.

More significant than the increase in the amount of cash compensation being paid has been the evolution in the nature of equity compensation received by Top 100 directors over the last 3 years. Investors have long focused on generous executive compensation packages, and the well-publicized incidences of executives who have enjoyed significant personal gains in advance of a downturn in their company's stock performance have heightened investor attention on equity compensation. Stock options, which only have value if the stock price increases, have fallen out of favor largely because of the concern that options could divert the loyalty of management by keeping their focus on short-term gains in contrast to aligning their compensation with the long-term interests of shareholders.

These concerns are equally as applicable to director compensation, and companies have responded to these concerns. The number of Top 100 companies surveyed in 2005 that reported stock option grants as a component of director compensation decreased to 55 from 70 in 2003. Conversely, the number of Top 100 companies surveyed in 2005 that reported grants of stock and restricted stock increased to 36 and 47, respectively, from 31 and 25, respectively, in 2003. It is likely that the number of companies that offer their directors stock options as part of their overall compensation packages will continue to decline.

Shareholder Proposals

The last 3 years have seen a shift in the numbers and types of shareholder proposals included in the proxy statements of the Top 100. Despite speculation that shareholder pressure, including the number of shareholder proposals submitted, would continue to increase, nearly one-third of the Top 100 companies did not include any shareholder proposals in their proxy statements during the 2005 proxy season. The number of certain “traditional” corporate governance shareholder proposals, which have principally focused on companies' anti-takeover devices, such as poison pills and classified boards, has declined over the past 3 years.

Rather than reflecting a lack of interest of shareholder activists in these topics, the decline is more indicative of the fact that fewer Top 100 companies have poison pills or classified boards. In 2004, 33 Top 100 companies had a poison pill, and 54 Top 100 companies had a classified board; in 2005, those numbers fell to 27 and 38, respectively. From 2003 to 2005, there was a corresponding reduction in the number of shareholder proposals calling for redemption of, or a shareholder vote on, poison pills from 25 to three and in the number of shareholder proposals calling for the annual election of directors from 10 to four. However, this is likely an area in which our survey results may not be indicative of trends among all publicly listed companies. While several Top 100 companies have dismantled traditional anti-takeover devices such as poison pills and classified boards in the wake of shareholder pressure, the Top 100, unlike most other companies, are more likely, by virtue of their size and market capitalization, to be protected from unsolicited takeover attempts without the benefit of other more traditional anti-takeover devices.

In addition, certain “new” shareholder proposals focused on shareholder voting rights have gained prominence. In 2003, no Top 100 company included a shareholder proposal in support of the removal of supermajority voting provisions in its proxy statement, but in 2005, seven of the Top 100 companies included such a shareholder proposal in their proxy statements.

The principal “new” shareholder proposal during the 2005 proxy season related to shareholder requests that companies require that directors be elected by a majority of the votes cast rather than the current plurality necessary to win election. Following the demise of the SEC's proposed proxy access rule, various unions adopted campaigns to have non-binding majority voting proposals included in 2005 proxy statements. As a result, the proxy statements of the Top 100 contained 15 proposals seeking majority voting in director elections while there were no such proposals in 2003. If not for the fact that a number of Top 100 companies joined a working group sponsored by the United Brotherhood of Carpen-ters in return for the withdrawal of a majority vote shareholder proposal, the number would have been higher. Several of these proposals put to a shareholder vote during the 2005 proxy season have received significant support from shareholders. In response to, or in anticipation of, shareholder pressure, a number of companies have voluntarily adopted either majority voting in director elections or a requirement that directors who do not receive a majority of votes cast offer their resignations. The latter approach gives boards significant discretion whether or not to accept such resignations.

Conclusion

It remains to be seen whether the same shareholder pressure that gave rise to such policies in the first instance will compel boards to accept the resignations of directors who have failed to garner a majority of the votes cast in favor of their election. Companies should expect to see more majority voting shareholder proposals submitted in 2006.