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Institutional Investors’ Perspective: Priorities For '05

Stephen Davis and Jon Lukomnik | January 11, 2005

Remember the old days when corporate executives stood astride the known world, masters of markets? Today, with fetters such as Sarbanes-Oxley, residents of the C-suite feel they are doing something closer to dancing atop a basketball.


To help keep your balance, here’s an early warning signal of the top 10 issues coming your way in 2005, plus early tips on missteps bound to cause tumbles.

  1. Conflicts of Interest.

    No sighs of relief just because New York Attorney General Eliot Spitzer is aiming to exchange his prosecutor’s job for that of New York governor. In fact, the vote- and attention-getting potential of additional investigations makes scouring the market for more conflicts of interest something of an electoral imperative for all AG’s and governors in waiting.

    What makes Spitzer so newsworthy is his ability to focus like a laser on conflicts that exist in plain sight. The only question is which emperor without clothes will next be exposed: Credit rating agencies paid by companies they rate? Proxy voting advisors who make ballot recommendations for companies that pay them as consultants? What was once accepted is now a ticking time bomb. Mix a disgruntled employee with damning emails, and things could blow.

      Tip: To avoid getting caught in whatever scandals erupt in 2005, keep closely to guidance issued by the staff of the Securities and Exchange Commission. If you run a corporate pension fund, for instance, conduct the diligence necessary to ensure that outsourced proxy voting conflicts are under control. If you ask for a fairness opinion, make sure there’s no implicit threat if the opinion were to be unfavorable.
  2. Climate Change.

    The Kyoto treaty on carbon emissions comes into force this year for every major market except the U.S. and Australia. Expect repercussions in the corporate world from energized shareowners concerned about risks of climate change.

    Big funds—and not always the usual activist suspects—are financing probes into the ways corporations are coping, or ignoring, the problem. Davos, Switzerland meetings of the World Economic Forum are already slated to address the matter, and the United Nations Environment Programme is starting an investor-led project to rally pressure on CEOs.

      Tip: Watch these drives closely for hints of what investors or regulators may want regarding disclosure. Proactive steps by corporations could help head off regulation or lawmaking in Europe, and avoid company-specific pressure here at home. Compliance Week covered the issue of environmental disclosure extensively in 2004, including a cover story in the December edition, and will continue to track the trend in ’05.

  3. European SOX?

    True, the business-friendly Bush administration is unlikely to support any Sarbanes-Oxley look-alike laws. But companies operating in Europe should be prepared for tougher oversight. The recently-installed European Commission is likely in 2005 to adopt new standards on disclosure, financial reporting, auditor rotation and director independence. Plus, if they fail in efforts to gain U.S. reciprocity, European regulators will add their rules on top of SOX.

      Tip: Companies should work to coordinate communications with European business lobbies and the new European Corporate Governance Forum to track the progress of international developments. Companies should also be stepping up efforts to encourage the SEC and Public Company Accounting Oversight Board to negotiate international solutions that ease compliance burdens.

  4. More Cops.

    Some experts have noted that the Republicans now firmly in control of Congress may work to ease the requirements of Sarbanes-Oxley. Does that mean it’s time to relax? Not if you cast an eye on the growing army of gendarmes at the SEC and PCAOB, not to mention those pesky state regulators and attorneys general.

    With budgets swelled in the wake of the Enron scandals, both federal agencies are staffing up for unprecedented enforcement activities in 2005. The PCAOB, for instance, is planning to increase in size by 50 percent, from 300 to 450.

      Tip: Do all your compliance homework. Section 404 of Sarbanes-Oxley may be annoying, distracting, and costly, but don’t drop the ball; executives should expect noteworthy 404 opinions to attract unwanted attention to their corporate books.

  5. Critical Votes.

    Thanks to new proxy voting disclosure requirements, retail investors are suddenly able to get the equivalent of x-rays of their mutual funds to examine how they behave as owners. And it isn’t always a pretty picture; many funds are getting exposed as robotic supporters of management.

    And though this phenomenon has not generated front-page headlines, investors large and small have already begun to exert pressure on fund managers to drop the rubberstamp and begin exercising their responsibilities like true "owners." Corporations should expect this new transparency—and the potential for embarrassment and additional pressure—to trigger much more critical voting by mutual funds in 2005.

    In addition, financial planners could fuel grassroots pressure. That’s partially because Sarah Teslik, ex-director of the Council of Institutional Investors, now heads the Certified Financial Planner Board of Standards. Financial planners have a big influence on individual investment decisions and strategies, and Teslik can be expected to bring her activist mindset to the CFP Board, which would make planners far more conscious about governance risks.

      Tip: Make sure someone is responsible for overseeing corporate governance, and not just for complying with rules. The job should also involve staying in intimate touch with shareowners, their voting habits, and their governance preferences.

  6. Global Reach.

    A quiet revolution that is likely to accelerate in Britain in 2005 could have major reverberations for U.S. companies. The issue involves The Pensions Act in the UK, which—among other things—raises the professionalism bar for trustees, requiring them to be conversant with certain documents and to have knowledge of matters relating to their duties. The act also includes provisions requiring companies to report certain information to pension scheme members, or to a new pension regulator.

    Knowledge breeds action, and the disclosure requirement will likely lead to increased shareowner activism, not only in the U.K., but in the U.S. and other markets. According to reports, Tony Blair is expected to call a general election in May, and the government wants to demonstrate that it is acting to shore up pension security.

      Tip: Ensure that corporate governance outreach includes not just U.S. funds, but U.K. funds with big stakes in North America.

  7. Nosy Parties.

    Leading investment funds are getting sophisticated about using partnerships to advance far-reaching industrial strategies, even at reluctant companies.

    One example is Pharma Futures, a “scenario planning” project that was sponsored by major pension funds in the U.S., U.K and the Netherlands. In December 2004, the group released a bold report that identified flaws in the business models of large pharmaceutical companies, and highlighted ways that the sector can manage change to improve long-term profitability. The report was unique for its breadth, but also for its source: disparate global investors and leading pharma executives.

    In 2005, corporations should expect invitations to join similar groups, and should get comfortable with the fact that they may eventually feel pressure from such entities.

      Tip: Understand the links between investors who focus on your industry, as well as your current owners. Ask questions like, “If our top three institutional investors published an industry report using input from our competitors’ CEOs, what would they look for? What would they recommend?”

  8. Expensive War.

    Now that the Financial Accounting Standards Board has delivered its final statement on share-based payments, the bitter clash over stock option expensing has finally come to an end.

    Or has it?

    High-tech companies are still fighting to have the FASB standard reversed or delayed, and the incoming Congress may be more hostile to expensing. In addition, pension giant TIAA-CREF—which was the lead investor proponent of expensing—is stuck in a governance squall that may actually weaken the momentum for expensing. As Compliance Week reported on Dec. 21, two of the TIAA-CREF trustees were operating a side business aimed at profiting from regulations to expense options. In theory, outcome is now less certain.

      Tip: Though the outcome may be less certain than many expect, companies must still prepare for expensing. That has less to do with the FASB mandate, and more to do with your shareholders. In 2005, companies that expense options will likely be bestowed with greater shareowner confidence. So you can fight it or leverage it. Your choice.

  9. Counting Lessons.

    The year 2005 is the moment when harmonized international accounting standards should finally become a reality. The early impact will be in Europe; starting Jan. 1, 2005, some 7,000 public companies under EU authority are required to report financials using International Financial Reporting Standards.

    But the U.S. now faces a key decision: To swallow global standards, which result in dilution of U.S. control over them, or to stay clear. Adoption would likely mean more work by corporations.

      Tip: Watch and wait for the big boys to decide, but start probing to see what impact conversion might have. The research isn’t easy—the published standards span more than 3,000 pages—but executives should start getting familiar with the controversial international standards sooner, rather than later.

  10. Majority Rule.

    Time is running out on the way U.S. corporate directors get elected. As we wrote in our debut column for Compliance Week in January, the archaic ‘plurality’ voting system means a solitary share—in fact, a director voting for him or herself—can elect an entire slate, even if every other vote is withheld.

    In 2005, expect as many as 80 “blue chip” stocks to face dissident shareowner resolutions calling for elections by majority vote. That wave, in turn, could ignite a national investor push for state statutes—beginning in Delaware—that would require majority rule. The International Corporate Governance Network—the voice of $10 trillion in investor capital—is already preparing just such a push early in the new year.

      Tip: Pick your battles; there will be plenty to fight in 2005, so think twice before attacking these resolutions head-on. Majority rule is tough to argue against, and doing so could make executives appear petty once the business press jumps onboard. In addition, these resolutions could gather unprecedented shareowner support in ’05, forcing companies to expend resources and goodwill on what could be a losing cause. If it looks like the resolutions become a fait accompli, executives would be wiser to give up the battle and instead expend their energies ensuring that majority voting makes for better and more responsive boards.



This column solely reflects the views of its authors, and should not be regarded as legal advice. It is for general information and discussion only, and is not a full analysis of the matters presented.