ParfumGigi@aol.com

Securities regulators, activist shareholders and hedge funds will step up the pressure for more corporate governance reforms

Tamara Loomis
Corporate Counsel
January 18, 2007

Can there be such a thing as too much information? Former Pfizer Inc CEO Henry "Hank" McKinnell would probably say yes. In the past, Pfizer usually devoted about 10 pages in its annual proxy statement to the compensation of its top executives. But in its most recent statement, released in February, the New York-based drug giant included a 23-page report about its officers' pay packages. One detail that had never been stated so clearly before: McKinnell had an $83 million retirement plan.

Shareholders outraged by the revelation staged a withhold-the-vote campaign to unseat two members of the compensation committee. While the attempt failed, it did get 22 percent of the shares voted. At first McKinnell vowed to stay, but under continuing pressure he finally agreed to step down in July.

McKinnell's fate should be a warning sign to other top executives. That's because Pfizer was just trying to get a jump on new rules from the Securities and Exchange Commission. As of Dec. 15, 2006, all public companies have to disclose the compensation of their highest officers in as much detail as Pfizer did this past spring. Described by McKinnell as a "poster child for transparency," Pfizer was only trying to do what it's done for years -- stay ahead of the curve on corporate governance.

That curve will get a lot a steeper in 2007, thanks to pressure from securities regulators, activist shareholders and hedge funds. In addition to complying with the new SEC compensation disclosure rules, companies will also have to cope with shareholders emboldened by two recent developments: a major change to Delaware's law on majority voting in director elections and a federal circuit court decision on shareholder access to proxy statements. One group of shareholders in particular -- hedge funds -- is expected to cause headaches for management well after the 2007 proxy season ends.

EXECUTIVE COMPENSATION

The new SEC rules that go into effect this winter represent the agency's most significant overhaul of its compensation disclosure regulations in 14 years. For the first time, companies will be forced to shine a bright light on previously hidden or obscured components of their executives' pay packages. Business will have to make the disclosures for their top five officers, including the CEO and CFO, as well as directors. Plus, companies must explain in plain English the rationale for compensation decisions.

The SEC also decided to clarify its rules on the disclosure of stock option grants, a late addition that came about because the backdating scandal broke as the agency was polishing the new regulations. Companies will now have to disclose the date of a stock option grant, the market price on that date and the date the board or compensation committee acted to make the award. Businesses must also disclose if the market price on the grant date is higher than the grant price, and why.

The new disclosure rules are already creating a tremendous amount of work, says Brian Lane, a Gibson, Dunn & Crutcher partner who was formerly corporate finance director at the SEC. "This is a new world order. It's not just taking the disclosure form you've been using for years and putting some window dressing on it," Lane says. "At a minimum, compliance with the rules will require hundreds of professional hours."

Lane adds that the real work lies in the CD&A section (compensation discussion and analysis), in which a company must lay out in detail the reasoning behind its executive pay packages. The explanation must cover such areas as the nature of performance targets, factors considered in adjusting executive pay, impact of accounting and tax treatments on compensation, and the role of executives in determining pay. Lane notes that businesses would be be ill-advised to use templates or boilerplate language in this section: "This discussion really needs to be company-specific, especially in the first year."

Many corporations are having their human resources people spend a day with executive compensation experts from their outside law firms in order to prepare their disclosure materials, Lane says. He thinks it's a good idea: "It's important to consult counsel, because everyone's going to be a pioneer on this."

DISCLOSURE BACKLASH

Past experience suggests that the SEC will be "understanding and flexible" with companies during the first year of complying with the new disclosure rules, Lane believes. Agency officials will be looking for "a good-faith effort," he explains. But experts say not to expect the same level of sympathy from shareholders.

Amy Goodman, a colleague of Lane's at Gibson, Dunn, predicts a "broader fallout" in the 2007 proxy season as both investors and the media look over disclosures that "put apples and oranges together." She's referring to the summary chart required for each exec under the new SEC rules. This table must include salary, stock options grants, earnings on deferred compensation, changes in the value of pension benefits and perks of more than $10,000. Everything on the chart must then be added up for a total compensation figure.

That bottom-line number will produce "a lot of eye-popping moments," says Hye-Won Choi, associate general counsel for corporate governance at TIAA-CREF. After shareholders absorb the new data, Choi says, she anticipates more proposals questioning whether execs are worth the money. Although most observers have focused on the ramifications of the summary pay chart, some say that executive pensions will generate the most stunned silences. Under the new SEC regs, companies must reveal precisely how much each executive has accumulated in his individual pension and deferred compensation accounts. In many instances -- such as McKinnell's -- that figures will reach into tens of millions of dollars, says Patrick McGurn, executive vice president of Institutional Shareholder Services.

While shareholders may get ticked off by the new compensation disclosures, they probably won't be able to change things. Shareholder proposals to reform executive pay packages met with little success in the 2006 proxy season, although there were some notable wins. A majority of shareholders at JPMorgan Chase & Co., Lucent Technologies Inc., Novellus Systems Inc. and Pulte Homes Inc., voted to tie executive pay more closely to company performance. Shareholders at seven other companies (including McDonald's Corp., Wachovia Corp. and Morgan Stanley) voted to cap severance pay.

Though shareholder resolutions are typically nonbinding, sometimes they can pack a punch. Most companies have yet to act on shareholder proposals during the 2006 proxy season. But a study by the Washington, D.C.-based Council of Institutional Investors found that at 61 of the 97 companies where shareholder proposals received a majority vote in 2005, management did something akin to what was asked. That represented a success rate of 63 percent, up from 28 percent the previous year.

However, the demand among executives for bigger pay packages may be so overwhelming that nothing -- neither greater disclosure nor shareholder displeasure -- can stop it. At a congressional hearing in September, SEC chairman Christopher Cox pointed to §162[m] of the Internal Revenue Code, a 1993 law that capped the tax deductibility of executive salaries at $1 million. Instead of reining in CEO pay, the provision resulted in a proliferation of nonsalary forms of compensation. "This tax law change," Cox said, "deserves pride of place in the Museum of Unintended Consequences."

The new SEC rules could have a similarly perverse effect, says Amy Borrus, deputy director at the Council of Institutional Investors. "I'd like to believe that over time, companies might think twice about doling out lavish perks and other benefits that they'd then be required to disclose," Borrus says. She adds, "Compensation consultants are telling us that when executives see how much their colleagues are making, they may demand that their compensation be raised to match."

STRENGTHENED SHAREHOLDERS

In addition to having more compensation information at their fingertips, shareholders will also benefit from recent actions by the Delaware legislature and the 2nd U.S. Circuit Court of Appeals.

In August, Delaware enacted a major change to its corporate law. The new statute, DGCL §216, empowers shareholders to permanently amend a company's bylaws to require that directors be elected by a majority of votes cast.

Many boards have already implemented a majority voting requirement to appease activist shareholders. More than 150 companies in the S&P 500 now elect directors by majority vote, or require directors to resign if a majority of shareholders withhold their support, up from fewer than 30 at the start of 2005.

But board-initiated majority voting standards -- which do not involve changing a company's bylaws -- can always be repealed by that board or a later board. Directors will lose that luxury at businesses where shareholders decide to take advantage of their new rights under Delaware law. And unlike reforms implemented by a company's board, a shareholder-prompted change to the bylaws can only be undone by the shareholders themselves.

TIAA-CREF is already planning to propose majority voting amendments at a number of companies in its portfolio this spring, says associate GC Choi. The Teachers Insurance and Annuity Association-College Retirement Equities Fund, as it is officially known, has $380 billion under management.

A September decision by the 2nd Circuit will also boost shareholders' power. The ruling came in a case brought by the American Federation of State, County and Municipal Employees against American International Group Inc. AFSCME had asked AIG to include a proposal on its 2005 proxy statement that would amend the company's bylaws on director elections. The union wanted AIG to include shareholder-nominated candidates on the ballot in future elections, if the nominating shareholder owned at least 3 percent of AIG stock.

AIG responded by asking the SEC for guidance. According to a long-standing agency rule, businesses have the discretion of deciding whether to put certain shareholder proposals on their proxies, including nominations for the board (the so-called election exclusion). In response to AIG's query, the SEC said that the company could exclude AFSCME's proposal from its proxy.

The union then sued AIG. While the New York-based insurer prevailed in federal district court, in September the 2nd Circuit sided with AFSCME. In the process the appellate panel also threw out the SEC's election exclusion, finding that the agency had abruptly broadened the exclusion around 16 years ago without articulating a reason for the change.

The problem for companies nationwide, including AIG, is that the SEC has yet to come up with a new rule regarding the election exclusion. At press time the SEC was slated to issue a revised regulation by Dec. 13, but it has already missed an earlier deadline.

In the meantime, SEC chairman Cox has said that the agency would not advise companies on whether to include shareholder nominees on their proxies. Investor groups are also urging the agency to reconsider the entire proxy access issue, not just the election exclusion. Since shareholder proposals typically are filed by Thanksgiving for the following spring's proxy season, the commission's delay meant that many companies were effectively forced to include proposals in their statements -- most notably, for shareholder nominees to the board, according to TIAA-CREF's Choi.

HEDGE FUNDS

Still, activist shareholders may pale as a threat compared to hedge funds. According to a study released in October by April Klein, a business professor at New York University, the number of businesses targeted for change by hedge funds has exploded from just one in 2000 to 66 in 2005. The study found that unlike mutual and pension funds, "hedge funds can and do have a significant, intended impact on redirecting management's efforts," Klein says. "They are getting into the boardrooms, stopping mergers, replacing CEOs."

For example, of the three hedge funds that stated in a regulatory filing their intention to replace a company CEO in 2005, each was successful. (That includes Chapman Capital at FootStar Inc., Strongbow Capital at Duckwall-ALCO Stores Inc. and Pardus Capital Management and Liberation Investment Group at Bally Total Fitness Holding Corp.) Of the 41 funds that put up a candidate for a board seat, 30 accomplished their goal. And of the 14 funds that tried to prevent a merger, 10 got their way. What's even more alarming: Several hedge funds showed a tendency to target fairly healthy companies that had a lot of cash on hand, low debt and solid stock returns.

There's an ongoing debate whether hedge fund activism is a good or bad thing for corporate governance, but Klein's study suggests the latter. She found that, on average, a year after a hedge fund stepped in, earnings per share fell at the targeted company. Klein says all signs point to an increase in this newest form of shareholder activism: "The only way it will stop or slow is if hedge funds stop getting the big returns."

But even companies who don't have a hedge fund at their gate won't be able to rest easy in 2007. "We're all waiting rather breathlessly to see what we will discover," says Borrus at the Council of Institutional Investors. No doubt companies are hoping their proxy statements won't reveal too much hidden treasure.