I think it was Einstein who defined insanity as repeating the same behavior and expecting different results.

Shareholder Concerns

Perhaps shareholders are taking his advice and finally saying enough is enough. Allowing management to operate with "business as usual" attitudes will not result in changed behavior or outcomes. So this year, it is very interesting to read proxy after proxy where shareholders are insisting on more say in the governance of a number of issues important to them. They want more say in severance issues, executive compensation, the makeup of directors' compensation, separation of CEO and Chairman duties and authority, term limits for outside directors, and on and on. Shareholders are at long last saying to management, "you work for us! We will tell you what you will make and how and under what circumstances you will or will not receive the agreed amounts."

Exhibit 1 summarizes more than two dozen issues that shareholders are insisting be addressed at spring 2005 shareholder meetings. The interesting fact is that each shareholder issue is not supported by the incumbent Board of Directors. Can you imagine how "testy" the atmosphere might become at some of these Fortune 500 companies? Is this all the result of Sarbanes-Oxley (SOX)? Are shareholders becoming more sophisticated? Has their profile changed that much? The answer is "yes," "yes" and "yes." All three are at work here, and it is overdue.

It is hard to say what occurred first to cause the current shareholder outrage. Certainly bondholder and shareholder losses were a loud voice for change; the accounting scandals were also a loud voice leading to new legislation. But while all of this was going on, executives continued to see increasing compensation and obscene severance packages. Some CEOs seemingly made more money failing than succeeding! Carly Fiorina, from Hewlett Packard, received an exit package of $42 million for a poor performance; Harry C. Stonecipher, Boeing's former CEO, was fired for an affair with an employee and is eligible for a $600,000 annual retirement. Not bad. The "average Joe" might not have fared as well.

Executive Compensation

An April 3 article in the The New York Times, "My Big Fat CEO Paycheck," outlined a number of examples where compensation went up while stock prices declined. CEOs at 179 large corporations that had not changed leadership in the last year had pay increases of $9.84 million, or 12 percent, from the previous year. A move toward performance pay remains elusive. Eli Lilly's net income fell 29 percent and its return to shareholders fell 17 percent, yet its CEO's pay increased 41 percent to $12.5 million! Sanmina-SCI, an electronics manufacturer, lost money in its three previous years and shareholders' returns fell 27 percent, yet the CEO's pay increased to $15 million in 2004 from only $1.2 million in 2003. There are some companies where CEO pay did decline as net incomes declined, noting Merck and Aramark. But on balance, executive pay continues to climb regardless of performance. Harvard Law School Professor Lucian A. Bebchuk, author of the new book Pay Without Performance, says that even though the escalation in pay has been described as necessary, much of the pay is not sensitive to performance. This movement by shareholders to demand performance standards is evident in Exhibit 1. The 2002 SOX law does give companies the power, under certain circumstances, to "claw back" bonuses from top executives within 12 months of a restatement due to misconduct. But this provision has not been used much to date.

SOX: The Cost of Implementation

Speaking of SOX, shareholders should demand improved corporate governance from directors and officers when one examines the cost of compliance! A survey completed last fall by Directorship/RHR International reported that the annual cost of compliance with Sarbanes-Oxley and related new SEC and NYSE rules was as follows:

• For companies up to $1 billion in sales, the cost was $1.8 million;
• For companies from $1 billion to $4 billion in sales, the cost was $4.8 million; and
• For companies larger than $4 billion in sales, the cost was $35 million.

On average, the cost of compliance for companies $1 billion and larger in sales was $16 million, an increase of 77 percent from the year before.

The survey also reported that GE would spend $30 million on internal control costs alone, and that AIG would spend $300 million a year in fulfilling these new requirements.

An analysis by AuditAnalytics.com shows that audit and related fees have increased 40 percent this year to $3.5 billion among S&P's 500 companies that have filed fiscal 2004 proxies through April 12. This is on top of the 17 percent increase in 2003. Of course, these increases have an even more significant impact on smaller companies. In fact, companies overall are spending $35 billion to implement Sarbanes-Oxley's §404 alone, which is 20 times greater than some regulators had forecast in 2003. Staples CEO Ron Sargent says the regulations cost his company more than $1 million and that Sarbanes-Oxley is an "overreaction" to what happened at only a few companies. He says "transparency is valuable, but you can't legislate morality. If someone is determined to commit fraud, it could be done with or without legislation." Companies are spending thousands of hours to comply, and shareholders have to wonder if the cost plus lost productivity in other important endeavors is worth it. Let's hope so.

Corporate Governance

But what is good corporate governance, and after all the time and costs to comply, do you have it? Exhibit 2 outlines a number of questions begging for a "yes" answer. And yes, one does not need congressional action to remind us of what does and does not make sense. Boards of directors should be 75 percent independent and should be required to own and hold stock in the company to align their interests with shareholders. And most certainly, audit committees should be 100 percent independent, have selected members who are CPAs, meet with the outside auditors alone more than once a year, and insist that shareholders vote on the annual audit firms retention. Did we really need SOX to wake us up? Apparently yes, and that is why I support its goals and compliance. Time will allow us to moderate its costs as internal controls are improved.

Directors: Duties and Compensation

Boards of directors are charged with a duty of care and a duty of loyalty in carrying out their fiduciary duties. More time is being demanded of them to assure shareholders that they indeed are doing just that. But according to the Directorship/RHR International Survey referred to earlier, only 34 percent of board members reported a high level of dissent at board meetings, and 30 percent feel that they have adequate time to prepare for meetings. (Evidently, 70 percent do not!) Shareholders are demanding more board oversight and are willing to pay more for it. And many are demanding that each stand for annual election and win a majority of votes. In this process, shareholders could show the underachievers the door more quickly (a good idea).

As to directors' compensation, an interesting dilemma may be surfacing: how much to pay and in what form. Directors are spending more time reviewing reports and visiting company locations and constituencies. In addition, they are being paid more—from $176,000 in 2003 to approximately $200,000 in 2004 for the nation's top 200 companies. As directors are paid more, do they begin to lose their independence? How much in cash compensation can a board member make and not be viewed as management in different clothing? A retired professional sitting on five boards at $200,000 each could be tempted to not lose a seat over differing opinions with management; $1 million is a lot of cash to lose. So what is the solution? The shareholders of ChevronTexaco Corp. and Exxon Mobil Corp. have the right idea. Directors are paid 50 percent of their compensation in the form of restricted stock. This provides sufficient cash compensation to attract qualified outside directors and align director and shareholder interests.

Closing: Shareholder Power

So is it "shifting shareholder sentiment" or SOX that is providing the impetus for change in corporate governance? Probably some of both. The losses from 2000-03 in shareholder value, the hyperbolic rise in bondholder losses due to accounting frauds and the continuing obscene increases in CEO compensation—and even more so in severance agreements—was bound to cause an uproar. SOX will do a lot to improve responsible reporting, but continuing shareholder pressure on directors will ultimately improve the system. Shareholders: Keep the pressure on!