If the 1990s were the decade of shareholder value, now is the era of corporate governance. Enron, WorldCom, Tyco and the rest of the big bad guys have transformed the investment world into one in which governance is a valuation criterion up there next to the numbers. IROs responsible for telling the equity story need a whole new approach.
Recent research shows more institutional investors will take a firm stance on key issues like board independence, executive compensation, stock options and audit committee structure when voting their proxies in 2003. Studies also reveal these issues playing a pivotal role in buy-side research and decision-making. In this climate, buy-side investors, corporate governance experts and IR consultants agree that IROs should be incorporating more information about a company’s good governance practices in investor communications.
According to a recent perception study by Thomson Financial, 27 percent of buy-side portfolio managers will be more activist on corporate governance issues over the next year. When asked what they are planning, 40 percent of respondents say they are observing management more closely and 20 percent say they will vote with their feet next proxy season if unsatisfied with management’s proposals. (This perception study was conducted in mid-August 2002 with around 40 buy-side portfolio managers and analysts participating.)
‘The level of scrutiny or active opposition has certainly gone up in the last year,’ says Lisa Rapuano, director of research at Legg Mason. This summer, as US regulators, politicians and exchanges rushed to pass new laws and regulations, a handful of buy-side institutions that were previously quiet on governance issues publicly endorsed governance reform. Among them, Fidelity and Legg Mason were the most vocal.
With about $20 bn in assets under management, Legg Mason has always been reasonably active on corporate governance issues. This year, however, ‘We voted much more aggressively on issues of executive compensation and stock options,’ says Rapuano. Specifically, Legg Mason voted against at least four boards because their compensation policies were too generous.
Bill Miller, CEO of Legg Mason Funds Management, also decided that one of the ways to promote change was to embarrass companies he felt were not practicing good governance. As Rapuano recounts, ‘He mentioned Starwood Lodgings [in the press], for example, because the company decided not to rescind its staggered board this year despite a 70 percent shareholder vote to do so.’
Fidelity Investments, the world’s largest mutual fund company, recently announced it was reviewing its stance on certain corporate governance issues including executive pay. ‘Our board of trustees has asked us to gather information on grossly excessive compensation issues so that they can evaluate whether or not they want to add something to the proxy guidelines,’ says Anne Crowley, a Fidelity spokesperson. In late August, Fidelity also published a summary of its current proxy voting guidelines for the first time.
This move by Fidelity is significant because the firm has been criticized in the past for its failure to publicly endorse corporate governance. As explained by Jim McRitchie, editor of Corporate Governance Network, ‘Mutual funds are less activist because they risk getting bumped out of the companies they are invested in.’ Even though Fidelity is not revealing specifically how it votes on key topics like executive compensation and stock options, its proxy guidelines provide insight into how it stands on these issues.
The rest of the buy side institutions, for the most part, ‘are sympathetic [to corporate governance] but are not going to be out there banging the drum on these issues,’ notes Anne Yerger, director of research at the Council of Institutional Investors. Many buy-side investors are wary of publicizing their views on hot button issues like executive pay but that doesn’t mean they aren’t considering changing the way they vote. As Yerger says, ‘Investors will be taking a harder look at a lot of the issues that end up on the ballot and might be more supportive of alternate candidates for board seats.’
Research also shows that corporate governance is playing a greater role in institutional research and investment decisions. Around 94 percent of buy-side portfolio managers surveyed by Thomson Financial said a company’s corporate governance structure affects their investing decisions. According to another survey by McKinsey & Company, most investors put corporate governance on a par with financial performance when evaluating companies.
Interestingly, McKinsey’s Global Investor Opinion Survey also reveals that investors are willing to pay a premium for companies with high governance standards. Premiums range by region, averaging 12-14 percent in North America and Western Europe; 20-25 percent in Asia and Latin America; and 30 percent in Eastern Europe and Africa. (Completed in May 2002, this study is based on responses from over 200 institutional investors worldwide.)
Some buy-side portfolio managers are also choosing to exclude companies with poor governance altogether. More than 60 percent of institutional investors say they might avoid considering individual companies with poor governance, according to McKinsey’s survey.
Legg Mason recently decided to do just that. ‘We have always considered corporate governance along the way to see if it’s worth getting involved in a company,’ notes Rapuano. ‘But now, if a company has bad corporate governance and compensation policies, we are discouraged from even looking at them.’
Given the buy side’s stronger focus on governance, it makes sense for IROs to communicate more about it. ‘There is a huge agenda here for IR professionals to take a very proactive role in explaining and communicating a company’s corporate governance structure to investors,’ says Paul Coombes with McKinsey in London. ‘IROs should challenge management to disclose more on corporate governance.’
‘It would be very prudent for companies to do more to communicate the corporate governance practices they have in place,’ adds Coombes. According to Ken Bertsch, director of corporate governance for TIAA-Cref, a lot of companies currently fail to disclose important information about their governance practices to the buy side. ‘We have a lot of discussion with companies where we find out they have been doing things that are very good and have not reported it,’ he says.
For example, many companies have processes in place that require audit committees to approve any other work done by outside auditors. Companies should put that information in their proxy statements and other communications with investors because it would reassure shareholders, notes Bertsch. Often it’s counsel that advises management to put the minimum amount of information in the proxy statement.
But, as Bertsch says, ‘IR professionals should really fight the lawyer [to disclose] this information.’
By the same token companies are sometimes not aware of their corporate governance weaknesses. Rapuano uses a corporate governance report card taken from a National Bureau of Economic Research study called Corporate Governance & Equity Practices Study to tally a company’s corporate governance score. She says a lot of companies are surprised when she tells them they are below average.
‘A lot of companies don’t even know that these things in their bylaws like classified boards and poison pills make them look like bad guys,’ she says.
There is a consensus among governance experts and investors that the first companies to announce corporate governance reforms will be rewarded in the market. ‘There is a unique opportunity to be a leader in a way that makes a difference and doesn’t have an economic cost,’ says Rapuano.
‘In this market where there is so much skepticism, demonstrating strong corporate governance in one form or another is very helpful,’ agrees TIAA-Cref’s Bertsch. Coca-Cola, for example, got a lot of mileage out of the leadership position it took with expensing stock options.
Of course, in the US, a lot of the issues institutional investors are concerned with are included in new corporate governance regulations recently approved by the exchanges. The NYSE, Amex and Nasdaq have all addressed the issues of board and audit committee independence in their governance rules. They also mandated that shareholders be given the opportunity to vote on all equity-based compensation plans. So US-listed companies that do not currently comply with these rules will eventually be forced to.
However, companies should change their practices well before the new standards are enforced, suggests Yerger. ‘NYSE companies, for example, have two years to comply but they need to get on that now or at least be ready to explain why they aren’t in compliance,’ she says. ‘There should be a heightened awareness internally on these issues and anyone speaking with the investing public should be prepared to answer questions on corporate governance.’
Some portfolio managers will be more likely to consider a company if it implements corporate governance reforms voluntarily. ‘If a company said it was adopting best practices now, I would be much more interested in hearing its story,’ says Rapuano, adding that companies proactively moving towards strong corporate governance should work that information into presentations to the buy side. ‘Don’t hide [that information] because you want to make sure investors know about it.’
First steps
Corporate governance reform is a lengthy process and many of the concerns outlined by the buy side – such as board independence – will only be addressed during next year’s proxy season. In the meantime there are steps IROs can take to communicate a company’s commitment to strong governance. Announcing an internal corporate governance policy is one way to send a message to the buy side, for example. Also, nominating a chief governance officer to oversee governance reforms sends a positive signal.
Press releases announcing corporate governance changes may actually be obligatory. ‘If a board votes in new measures in a meeting then the IRO ought to at the very least put out the information because it’s material,’ notes Gregory Pettit, senior managing director and financial relations director at Hill & Knowlton in New York. Press releases announcing new board members or compensation polices have been catching the attention of the media lately. For example, when Computer Associates and Disney strengthened their boards of directors, it was widely reported. Both companies have been criticized for poor governance in the past.
According to Pettit, IROs should consider surveying the buy side to find out what they would like to know about corporate governance. ‘Part of the problem is that the two major conduits to the buy side – sell-side analysts and senior management – have seriously damaged credibility right now,’ he says. ‘So IR professionals need to know how management is being perceived before they promote governance policies they think the buy side is going to like.’ Through a perception study, some portfolio managers will be very up-front about what they would like to hear about corporate governance in investor presentations.
These days it’s all about rebuilding investor confidence. Despite the Sarbanes-Oxley Act and new corporate governance regulations from US exchanges, the final shake-out is yet to come. For now, communicating about corporate governance policies is one way for IROs to reassure institutional investors.
Hot issues
Buy-side investors are calling for companies to reform their corporate governance structures. According to Thomson Financial’s perception study, 90 percent of respondents said companies should change the way they handle corporate governance.
When asked how they would like companies to reform their governance practices, institutional investors had several responses. Not surprisingly, buy-side investors identified better disclosure, board independence and audit committee independence as hot button issues. Specifically, half of the respondents said boards should be independent and another 31 percent said audit committees should be independent. McKinsey & Company’s Global Investor Opinion Survey revealed slightly different results with 52 percent of respondents saying that more broad and timely disclosure is the top governance priority and 44 percent saying independent boards are the most important governance reform. Anne Yerger of the Council of Institutional Investors agrees that ‘independent board structure should be top priority for companies looking to change their governance practices.’
