Looking Ahead To The 2006 Proxy Season

As the 2006 proxy season gets underway, shareholder activism shows no signs of slowing. Over the last few years, high-profile corporate scandals and news stories about executive excess and corporate waste have compelled many investors to seek ' or demand ' a more active role in corporate governance matters of the companies they own. Now that most companies have implemented the changes required by the Sarbanes-Oxley Act of 2002 and the stock exchanges, the agenda of the shareholder activist is changing.

In November 2005, Institutional Shareholder Services (ISS), a leading proxy advisory firm, set the stage for the upcoming proxy season with the release of its 2006 corporate governance policy updates. Shareholder proposals submitted to date have followed the same themes, focused on the two hot topics for the 2006 proxy season: Majority voting and executive compensation.

Majority Voting Standards

Majority voting in director elections has received the greatest attention this proxy season. Its popularity has been fueled by the presumed death of the shareholder access rule proposal following the retirement of SEC Chairman Donaldson last June. The shareholder access rule would have, under certain circumstances, required companies to include in their proxy materials shareholder nominations for election as directors. The rule was proposed by the SEC in October 2003, but has languished for more than 2 years due to corporate opposition. Majority voting has emerged as the preferred alternative for many institutional investors.

Most state corporate laws currently provide for plurality voting, where a director nominee is elected by receiving the highest number of votes cast, even if less than a majority. Accordingly, withhold votes do not have an impact on the election. By contrast, majority voting generally requires a nominee to receive an affirmative vote of the holders of a majority of the shares present and voted. Sometimes, the majority-voting standard is even higher, requiring an outright majority of the total outstanding shares entitled to vote. Under a majority voting system, withhold votes can have the effect of preventing a nominee from being elected as a director.

Majority voting has been advocated this year by CalPERs, the largest single institutional investor in the U.S., and by the Council of Institutional Investors. ISS has stated that it will generally support shareholder proposals (both binding and precatory) asking companies to implement majority threshold voting standards in uncontested director elections. ISS will consider voting against a shareholder proposal, however, if a company has adopted formal corporate governance principles that present a 'near equivalent' or 'meaningful alternative' to majority voting.

Despite the broad-based shareholder support for majority voting proposals this year, the kinks have not yet been worked out. For example, how are companies to deal with 'holdover' directors? Currently, in cases where majority voting exists, incumbent directors continue in office as holdover directors until their successors are elected and qualify, regardless of the vote. If a director nominee fails to receive the required votes, would he or she be required to resign immediately? What if there is no successor? Notwithstanding basic governance questions like these left unanswered, shareholder activists continue to push for majority voting to be placed on the proxy ballot.

Executive Compensation

Executive compensation also remains in the spotlight for the 2006 proxy season. In its 2006 policy updates, ISS codified its practice of recommending withholding votes from members of a company's compensation committee for 'poor compensation practices.' The list of poor compensation practices includes, among others: egregious employment/severance agreements; excessive perks that dominate compensation; huge bonus payouts not sufficiently linked to performance; performance metrics that are changed during the performance period; egregious SERP payouts; a new CEO with an overly generous new hire package; and internal pay disparity.

Shareholder proposals relating to executive compensation this season are more tailored than in years past, asking companies to take specific actions in this area. Pay-for-performance is at the top of the list. The United Brotherhood of Carpenters and Joiners of America pension fund alone has submitted 18 such shareholder proposals, asking companies to modify pay policies for senior executives to ensure pay only for superior performance. Pay-for-performance proposals are generally calling for adding performance conditions to stock options or restricted stock, or to grant options with an above-market exercise price or one that is indexed to the performance of peers. ISS updated its policy for 2006 to consider recommending that investors withhold support from compensation committee members at companies with negative 1- and 3-year total shareholder returns where the CEO received a pay increase.

Golden parachute proposals are also prevalent this year. Eight of these proposals submitted by the International Brotherhood of Electrical Workers seek shareholder approval of future severance agreements with senior executives that provide benefits in an amount exceeding 2.99 times the sum of the executives' base salary plus bonus.

Tally sheet disclosure has been proposed by at least one shareholder, and promises to be a prominent issue for the 2006 proxy season. Tally sheets ' which usually detail, explain and total all major pay components, such as base salary, bonus, long-term equity, deferred compensation, supplemental retirement benefit and perquisites ' are increasingly being used by compensation committees in their decision-making processes. The shareholder proposal seeks to include tally sheet disclosure in the compensation committee report included in the company's proxy statement. ISS's 2006 policy update, which includes a sample tally sheet, provides that ISS will note a deficiency and provide cautionary language in its analysis for companies that fail to meet a minimum standard of tally sheet disclosure for CEO compensation.

The SEC proposed rules to enhance disclosure relating to executive compensation in public company filings last month, which may reduce the number of shareholder proposals on executive compensation ' at least those addressing disclosure ' during next year's proxy season. Congress may also be calling for greater disclosure from companies of their executive compensation practices. 'The Protection Against Executive Compensation Abuse Act,' a House bill introduced in November 2005 and praised by many institutional investors, if passed, would codify many of the same issues currently being called for by shareholder proposals, such as disclosure of tally sheets and shareholder approval of golden parachutes.

Social Responsibility

Social responsibility is also drawing the attention of shareholder activists in considering support of shareholder proposals for 2006. Environmental issues and climate change are particularly prominent following ratification of the Kyoto Protocol, which requires the reduction of greenhouse gas emissions by signatory countries. The Kyoto standards will affect some companies more than others, but the potential impact has led to appeals by ISS and others for, at the very least, additional disclosure on plans to reach compliance with these standards.

Social responsibility proposals also got a boost earlier this year from the Staff Legal Bulletin issued by the SEC's Division of Corporation Finance to provide guidance on certain issues relating to the exclusion of shareholder proposals pursuant to Rule 14a-8, which addresses when a company must include a shareholder proposal in its proxy statement. One of such issues was whether companies can exclude proposals relating to environmental or public health issues as relating to the ordinary business matter of evaluating risk. The SEC opened the door for such proposals by rejecting the argument for exclusion where the proposal focuses on the company minimizing or eliminating operations that may adversely affect the environment or public health. On the other hand, the SEC did agree that companies may exclude proposals relating to an evaluation of risk where the company would have to engage in an internal assessment of the risks and liabilities it faces as a result of its operations that may adversely affect the environment or public health.

If You Can't Beat 'Em,
Join 'Em

Shareholder activists are not always looking for a proxy fight, but they are looking for corporate change. Increasingly, shareholder proposals are motivating companies to voluntarily adopt measures that might otherwise not obtain the required shareholder vote. Companies are finding more and more that they can avoid the costs and distraction of a proxy contest ' and improve shareholder relations and value ' by responding positively to address shareholder concerns and accommodate reasonable reforms. The result is often a change on terms palatable to both the shareholders and management.

For example, companies are finding creative ways implement voluntary versions of majority voting. More and more companies are adopting 'modified' majority voting policies. One type of such policy would require a director nominee receiving a greater number of withhold votes than for votes in an uncontested election to tender his or her resignation. The board will then decide whether to accept or reject the resignation within a specified time period (eg, 90 days), with public announcement of the decision. ISS has indicated that such an approach would meet its 2006 policy standards. The SEC has yet to rule on the multiple no-action letter requests submitted during this proxy season by companies that have adopted a modified majority voting standard and are now seeking to omit a true majority voting proposal from their proxy statements under Rule 14a-8 on the basis that the company has already substantially implemented the proposal.

With respect to executive compensation, pending the adoption of SEC rules that will likely force additional disclosure by the 2007 proxy season, companies are already offering more transparency in their disclosures. Compensation committee reports in proxy statements have begun to reference the use of tally sheets in making compensation decisions. A few of those have even provided detail about the actual amounts paid.

Shareholder activists know that some proposals, particularly those relating to 'social responsibility,' usually will receive little support from the average shareholder. They also know, however, that some of those proposals will receive public attention that could pressure companies and industries to effect responsive change. ICCR notes progress on climate change initiatives through shareholder resolutions as one of its key accomplishments for 2005, withdrawing shareholder resolutions on climate change at five oil and gas companies that had taken positive steps to disclose data and reduce damage to the environment caused by their businesses.

Now is the time for companies and their boards to reconsider the role of their shareholders in corporate governance, as the 2006 proxy season pressures more companies to act in anticipation of new requirements and adopt voluntary reforms.

As the 2006 proxy season gets underway, shareholder activism shows no signs of slowing. Over the last few years, high-profile corporate scandals and news stories about executive excess and corporate waste have compelled many investors to seek ' or demand ' a more active role in corporate governance matters of the companies they own. Now that most companies have implemented the changes required by the Sarbanes-Oxley Act of 2002 and the stock exchanges, the agenda of the shareholder activist is changing.

In November 2005, Institutional Shareholder Services (ISS), a leading proxy advisory firm, set the stage for the upcoming proxy season with the release of its 2006 corporate governance policy updates. Shareholder proposals submitted to date have followed the same themes, focused on the two hot topics for the 2006 proxy season: Majority voting and executive compensation.

Majority Voting Standards

Majority voting in director elections has received the greatest attention this proxy season. Its popularity has been fueled by the presumed death of the shareholder access rule proposal following the retirement of SEC Chairman Donaldson last June. The shareholder access rule would have, under certain circumstances, required companies to include in their proxy materials shareholder nominations for election as directors. The rule was proposed by the SEC in October 2003, but has languished for more than 2 years due to corporate opposition. Majority voting has emerged as the preferred alternative for many institutional investors.

Most state corporate laws currently provide for plurality voting, where a director nominee is elected by receiving the highest number of votes cast, even if less than a majority. Accordingly, withhold votes do not have an impact on the election. By contrast, majority voting generally requires a nominee to receive an affirmative vote of the holders of a majority of the shares present and voted. Sometimes, the majority-voting standard is even higher, requiring an outright majority of the total outstanding shares entitled to vote. Under a majority voting system, withhold votes can have the effect of preventing a nominee from being elected as a director.

Majority voting has been advocated this year by CalPERs, the largest single institutional investor in the U.S., and by the Council of Institutional Investors. ISS has stated that it will generally support shareholder proposals (both binding and precatory) asking companies to implement majority threshold voting standards in uncontested director elections. ISS will consider voting against a shareholder proposal, however, if a company has adopted formal corporate governance principles that present a 'near equivalent' or 'meaningful alternative' to majority voting.

Despite the broad-based shareholder support for majority voting proposals this year, the kinks have not yet been worked out. For example, how are companies to deal with 'holdover' directors? Currently, in cases where majority voting exists, incumbent directors continue in office as holdover directors until their successors are elected and qualify, regardless of the vote. If a director nominee fails to receive the required votes, would he or she be required to resign immediately? What if there is no successor? Notwithstanding basic governance questions like these left unanswered, shareholder activists continue to push for majority voting to be placed on the proxy ballot.

Executive Compensation

Executive compensation also remains in the spotlight for the 2006 proxy season. In its 2006 policy updates, ISS codified its practice of recommending withholding votes from members of a company's compensation committee for 'poor compensation practices.' The list of poor compensation practices includes, among others: egregious employment/severance agreements; excessive perks that dominate compensation; huge bonus payouts not sufficiently linked to performance; performance metrics that are changed during the performance period; egregious SERP payouts; a new CEO with an overly generous new hire package; and internal pay disparity.

Shareholder proposals relating to executive compensation this season are more tailored than in years past, asking companies to take specific actions in this area. Pay-for-performance is at the top of the list. The United Brotherhood of Carpenters and Joiners of America pension fund alone has submitted 18 such shareholder proposals, asking companies to modify pay policies for senior executives to ensure pay only for superior performance. Pay-for-performance proposals are generally calling for adding performance conditions to stock options or restricted stock, or to grant options with an above-market exercise price or one that is indexed to the performance of peers. ISS updated its policy for 2006 to consider recommending that investors withhold support from compensation committee members at companies with negative 1- and 3-year total shareholder returns where the CEO received a pay increase.

Golden parachute proposals are also prevalent this year. Eight of these proposals submitted by the International Brotherhood of Electrical Workers seek shareholder approval of future severance agreements with senior executives that provide benefits in an amount exceeding 2.99 times the sum of the executives' base salary plus bonus.

Tally sheet disclosure has been proposed by at least one shareholder, and promises to be a prominent issue for the 2006 proxy season. Tally sheets ' which usually detail, explain and total all major pay components, such as base salary, bonus, long-term equity, deferred compensation, supplemental retirement benefit and perquisites ' are increasingly being used by compensation committees in their decision-making processes. The shareholder proposal seeks to include tally sheet disclosure in the compensation committee report included in the company's proxy statement. ISS's 2006 policy update, which includes a sample tally sheet, provides that ISS will note a deficiency and provide cautionary language in its analysis for companies that fail to meet a minimum standard of tally sheet disclosure for CEO compensation.

The SEC proposed rules to enhance disclosure relating to executive compensation in public company filings last month, which may reduce the number of shareholder proposals on executive compensation ' at least those addressing disclosure ' during next year's proxy season. Congress may also be calling for greater disclosure from companies of their executive compensation practices. 'The Protection Against Executive Compensation Abuse Act,' a House bill introduced in November 2005 and praised by many institutional investors, if passed, would codify many of the same issues currently being called for by shareholder proposals, such as disclosure of tally sheets and shareholder approval of golden parachutes.

Social Responsibility

Social responsibility is also drawing the attention of shareholder activists in considering support of shareholder proposals for 2006. Environmental issues and climate change are particularly prominent following ratification of the Kyoto Protocol, which requires the reduction of greenhouse gas emissions by signatory countries. The Kyoto standards will affect some companies more than others, but the potential impact has led to appeals by ISS and others for, at the very least, additional disclosure on plans to reach compliance with these standards.

Social responsibility proposals also got a boost earlier this year from the Staff Legal Bulletin issued by the SEC's Division of Corporation Finance to provide guidance on certain issues relating to the exclusion of shareholder proposals pursuant to Rule 14a-8, which addresses when a company must include a shareholder proposal in its proxy statement. One of such issues was whether companies can exclude proposals relating to environmental or public health issues as relating to the ordinary business matter of evaluating risk. The SEC opened the door for such proposals by rejecting the argument for exclusion where the proposal focuses on the company minimizing or eliminating operations that may adversely affect the environment or public health. On the other hand, the SEC did agree that companies may exclude proposals relating to an evaluation of risk where the company would have to engage in an internal assessment of the risks and liabilities it faces as a result of its operations that may adversely affect the environment or public health.

If You Can't Beat 'Em,
Join 'Em

Shareholder activists are not always looking for a proxy fight, but they are looking for corporate change. Increasingly, shareholder proposals are motivating companies to voluntarily adopt measures that might otherwise not obtain the required shareholder vote. Companies are finding more and more that they can avoid the costs and distraction of a proxy contest ' and improve shareholder relations and value ' by responding positively to address shareholder concerns and accommodate reasonable reforms. The result is often a change on terms palatable to both the shareholders and management.

For example, companies are finding creative ways implement voluntary versions of majority voting. More and more companies are adopting 'modified' majority voting policies. One type of such policy would require a director nominee receiving a greater number of withhold votes than for votes in an uncontested election to tender his or her resignation. The board will then decide whether to accept or reject the resignation within a specified time period (eg, 90 days), with public announcement of the decision. ISS has indicated that such an approach would meet its 2006 policy standards. The SEC has yet to rule on the multiple no-action letter requests submitted during this proxy season by companies that have adopted a modified majority voting standard and are now seeking to omit a true majority voting proposal from their proxy statements under Rule 14a-8 on the basis that the company has already substantially implemented the proposal.

With respect to executive compensation, pending the adoption of SEC rules that will likely force additional disclosure by the 2007 proxy season, companies are already offering more transparency in their disclosures. Compensation committee reports in proxy statements have begun to reference the use of tally sheets in making compensation decisions. A few of those have even provided detail about the actual amounts paid.

Shareholder activists know that some proposals, particularly those relating to 'social responsibility,' usually will receive little support from the average shareholder. They also know, however, that some of those proposals will receive public attention that could pressure companies and industries to effect responsive change. ICCR notes progress on climate change initiatives through shareholder resolutions as one of its key accomplishments for 2005, withdrawing shareholder resolutions on climate change at five oil and gas companies that had taken positive steps to disclose data and reduce damage to the environment caused by their businesses.

Now is the time for companies and their boards to reconsider the role of their shareholders in corporate governance, as the 2006 proxy season pressures more companies to act in anticipation of new requirements and adopt voluntary reforms.