Tuesday, November 13, 2007

Financial Week: Boards on the Hot Seat

From Nov. 12/07 edition of Financial Week:

Nominating committees in the spotlight amid succession woes in corporate America; watch out for KB Home and Blockbuster

November 12, 2007

Suddenly empty CEO seats at Merrill Lynch and Citigroup are turning up the pressure on boards to do a better job grooming talent from the corporate ranks.

For many companies, the difficult task of overseeing succession planning falls on the board's nominating and governance committee. Just as audit committees took the brunt of shareholder criticism following the Enron and WorldCom blowups, and compensation committees were on the firing line to comply with new Securities and Exchange Commission disclosure rules last year, nominating committees seem headed for the hot seat in 2008.

“Absolutely—the focus is shifting to the nominating committee,” said Richard Koppes, a lawyer at Jones Day and a director at Apria Healthcare Group and Valeant Pharmaceuticals International. “This is the committee that will have to reach out and engage with shareholders on some really tough issues in the coming year.”

Many boards admit they're struggling with succession planning. A study earlier this year by the National Association of Corporate Directors and Mercer Delta Consulting found that roughly half the directors surveyed from public, private and non-profit boards said their boards were “less than effective” at the task.

Such ineffectiveness can carry a high cost: CEOs recruited from the outside earned median pay of $13 million in 2005, compared with $5 million for those promoted from within, according to the Corporate Library, a governance research firm.

At Merrill Lynch, the price tag to replace former CEO E. Stanley O'Neal, whose exit pay was $161.5 million, will likely be much higher that that figure in the end.

“In the race for the CEO spot, often those executives who aren't elevated decide there's no future and leave for another company,” said Claudia Allen, chair of the corporate governance practice at law firm Neal Gerber & Eisenberg. “Some CEOs don't like a powerful No. 2 or No. 3 around and eliminate them. And then there are those companies that need to spend a lot more attention on bench strength.”

Along with succession planning, the nominating committee will have to spar with increasingly empowered shareholders on all things governance. According to governance research firm RiskMetrics, 656 shareholder proposals had appeared on 2007 corporate ballots through Sept. 15, up from 581 last year.

For example, the nominating committee at Axcelis Technologies will have to decide what to do after a shareholder proposal to repeal its classified board structure received 91.4% of the votes earlier this year, the highest support for a governance proposal this past proxy season. At KB Home, a proposal seeking a vote on golden parachute packages garnered 85.6% in favor. And at Blockbuster, 61.9% of shareholders voted in favor of eliminating the company's dual-class structure.

And now that a third of S&P 500 companies allow board nominations to be approved by simple majorities, a major challenge for nominating committees will be figuring out how to handle potential “no vote” campaigns, in which a shareholder asks other investors to vote against one or more directors.

While specifics vary from company to company, the general rule is that any director not receiving a majority of votes in favor of election should tender his or her resignation. The nominating committee then has to find a new candidate, shrink the board size or choose to disregard the resignation.

The New York Stock Exchange has even proposed leveling the playing field with Rule 452, which would bar brokers from voting shares held on behalf of investors, as brokers usually side with management and support its nominees. The SEC has yet to approve the rule, which was supposed to take effect Jan. 1, but will now not be considered until 2008.

“Boards will have a tough time justifying the continued service of a director who has been successfully targeted by such a campaign,” Mr. Koppes said.

Case in point: Many observers think the grass-roots campaign to oppose the re-election of seven of Yahoo's 10 directors—led by shareholder Eric Jackson, who owns just 96 shares—played a role in the board's removal of CEO Terry Semel in June.

Shareholders are also pushing for more access to the director nomination process.

While many directors oppose proxy access, Mr. Koppes said they should be proactive in gathering director nominee suggestions when meeting with key shareholders. A good dialogue between shareholders and the boards, he said, “goes a long way in making investors feel included and avoids confrontation. It's all about engagement.”

Perhaps the biggest challenge for the nominating and governance committee will be figuring out a way to meet with key shareholders to address their concerns. In the past, many directors argued that such meetings were solely the duty of management, but shareholders are increasingly demanding more direct contact with the board.

“Nominating committees will have to take the lead in reaching out to shareholders,” said Mr. Koppes. “Sure, you have to be careful about an individual director carrying out his or her own agenda, but this notion that only management represents the company no longer holds water. Shareholders' representatives are the board.”

Some companies may take the lead of Pfizer, whose board met with its largest institutional investors, representing 35% ownership of shares outstanding, in October. According to a company statement, the directors “participated in a listening role since their primary objective is to grasp what is on the minds of investors.” While Pfizer announced these meetings would be held regularly, company spokeswoman Shreya Prudlo said she couldn't comment on when the next one would take place. FW

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