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A Season in Corporate Governance Purgatory

Stephen Davis and Jon Lukomnik | January 8, 2008

Barry Diller, chairman and CEO of Interactive Corp., once said: “Corporate governance is completely misunderstood, certainly by the birdbrains who write about it.”

That caution is worth remembering as you review our look ahead to corporate challenges in the 2008 annual meeting season. Those insights, for whatever they may be worth, are presented below.

1. The consequences of non-access to the proxy statement. Given recent drama at the Securities and Exchange Commission, it is tempting to say that the top three headline items for 2008 will be access, access, and access. That’s because in November, SEC Chairman Christopher Cox steered the agency into an unnecessarily polarizing decision that blocks shareholder efforts to have some say in the nomination process for board directors. On a strict party-line vote, the agency interpreted federal securities law in such a way as to override state law provisions and prevent investors from gaining access to the corporate proxy to file board nominations.

It didn’t have to end this way. Cox could easily have delayed a vote until empty Commission seats were filled. That’s what Congress was asking, as were institutional shareholders. Tellingly, even a recent panel of ex-SEC chairs, both Republicans and Democrats, thought the decision too hard-line, particularly as it seemed to run roughshod over state law.

The price Cox paid—or rather, will be asking us all to pay—for taking a rigid line against any shareholder access to the proxy is only now becoming clear. It is the corporate compliance officer, corporate secretary, general counsel, and CEO, along with institutional investors, who will have to help bear that cost as annual meetings roll out this spring.

No, access won’t be on the ballot at many companies. But the SEC decision has seriously poisoned the market atmosphere. Shareholder activists were largely united in support of access and now find themselves comprehensively stymied. Consequences will come in three channels.

First, don’t be surprised if votes for rebel resolutions rise markedly in 2008, partly out of sheer frustration. Watch for telltale vote totals on resolutions that speak directly to board accountability—like those calling for exclusion of broker votes from ballot counts, advisory votes on executive pay, majority rule voting, split chairmen and CEOs, or reimbursement of proxy fight expenses. Second, expect noisy shareowner backing for those resolutions (now headed for JPMorgan Chase and Bear Stearns) that do call for access—and for any court cases that follow, should target companies seek SEC permission to quash such proposals.

Finally, Chairman Cox’s party-line approach threatens to convert the issue of shareholder rights into an election issue. For corporations, that could be a nightmare scenario. So far, Democrats John Edwards, Barack Obama, and Hillary Clinton, as well as Republican Mike Huckabee, have weighed in on corporate governance issues. By November, Democrats could wind up pledging a solidly pro-shareowner SEC, or legislation on access, say-on-pay, majority rule, and other issues. And if the Democrats have a better-than-even chance of winning Congress and the White House, corporations could face statutes and regulations far tougher and less flexible than they would have seen had a Commission majority behaved pragmatically on proxy access.

2. The credit crisis reaction. If the outcome on proxy access is setting the stage for a bitter upcoming annual meeting season, the sub-prime mortgage mess is bound to make board-investor relations even worse. Market volatility and huge losses at firms with credit exposure have raised investor anxiety about whether boards are equipped to evaluate risk and ensure that executives are managing that risk properly. Some funds are already shaping resolutions directly addressing sub-prime failures. We detailed those plans in our December column, “How The Sub-Prime Mess Hits Governance.” But to focus on those specific measures means ignoring a far bigger picture: Directors, for the first time, could start losing their seats. Yes, that’s unlikely, but it is possible. And even the mere possibility will cause friction in the annual meeting season unlike ever before.

Why? Well, some 60 percent of S&P 500 companies have already converted to some form of majority rule voting in director elections. Those that haven’t yet are likely to face one of the more than 100 shareowner proposals calling for majority rule that, according to RiskMetrics, will be filed this year. The plurality system, all but universal just two years ago, is going the way of the dodo bird.

This election reform is about as fundamental a governance revolution as one could imagine. Yet it happened with hardly a shot fired, and 2008 will be a first test. Sub-prime failures will inevitably draw investor spotlights to individual directors on boards notorious for mishandling risk or such basics as succession planning. Watch especially for companies found to have paid bucket loads to CEOs while credit-linked assets tanked. Instead of spinning wheels on non-binding resolutions, funds increasingly will try to get the accountability message across with campaigns against specific board members. And with shareholder aggravation heightened by access and losses, “just vote no” numbers could reach surprising heights. We don’t expect many directors to be shown the door this year, but we do suggest that 2008 will be remembered as the beginning of a new hardball era in director accountability.

3. A new era in dialogue. Some executives have already tried to defuse tensions and cultivate shareowner loyalty by building two-way communication bridges to major shareowners. Note we say “two-way;” dialogue projects won’t win investor confidence if they are merely public relations exercises. Pfizer has gone the distance. So have UnitedHealth, and a handful of other firms. But it is still rare. Indeed, noted corporate lawyer Marty Lipton famously denigrated the Pfizer effort as “corporate governance run amok”—never mind that Lipton himself called for just such dialogue in a 1992 article.

But now, with responsible parties seeking ways to find common ground between investors and corporations, we expect more true dialogue, not less. The best evidence of that: Trevor Norwitz, Marty Lipton’s law partner, recently told a room full of investors and lawyers that meetings with investors are now a fact of life, and the era of telling activist investors to go jump in a lake, are over.

4. Sovereign wealth funds: Capital is capital. For larger companies, the credit bubble that preceded the current credit crisis sometimes made it seem like capital was, if not actually free, then cheap and easily accessible. Now, despite the efforts of the Federal Reserve and other central bankers, the providers of that previously free-flowing money river have themselves turned to a new breed of owner to shore up their balance sheets: sovereign wealth funds.

Just months ago SWFs were demonized as inscrutable and politically driven. But look what can happen when they dangle capital during a liquidity crisis and pay for generous helpings of K Street lobbying. Suddenly SWFs are the stuff of board dreams: loyal, long term, undemanding, and deep-pocketed. They have ridden to the rescue of America’s biggest banks, taking major stakes and pledging to remain in the background. In early 2008 they’ll look like white knights. But don’t be fooled; like domestic institutions, they feature a mix of motives. Once SWFs settle in as regular investors, they’ll behave like regulars—demanding, even if behind the scenes, board and executive changes when companies go south.

So enjoy the peace of the new year. It won’t last long.