Taking the guesswork out of proxy voting

Mighty CEOs and maverick raiders alike - all must humble themselves before the power of Institutional Shareholder Services. How a bunch of guys you never heard of decide corporate America's toughest fights. Fortune's Shawn Tully reports.

By Shawn Tully, Fortune editor-at-large

(Fortune Magazine) -- On the steamy morning of July 31, a parade of limos and Town Cars ferried two warring platoons of corporate luminaries to a drab, six-story office building in suburban Maryland. The combatants were H.J. Heinz management, represented by CEO William Johnson, and a team of dissident shareholders intent on storming the company's board.

They were led by hedge fund legend Nelson Peltz and golfer-entrepreneur Greg Norman, for the moment sans his trademark "Shark" chapeau. The prize that morning was the endorsement of one of the most powerful voices in the investment universe, Institutional Shareholder Services.

Convince us: Chris Young, ISS M&A chief (left), and corporate governance expert Pat McGurn.
You Can't Win Them All
ISS has made some excellent calls on board control and pay. On acquisitions--not so much.
Nelson Peltz's Trian Partners sought a voice on the board. Management responded with a highly personal campaign against him. ISS, though, liked his plans for the company. Bottom line: Two of Peltz's five candidates won board seats. Since Trian bought a stake last March, Heinz's shares have risen 22 percent.
BASF, the German chemical company, bid $5 billion for American materials maker Engelhard, which wanted to reject the offer and remain independent. ISS backed BASF's proxy battle to gain board seats, kill Engelhard's poison pill, and force the sale. Bottom line: Engelhard management agreed to a friendly deal.
Home Depot
Last spring Bob Nardelli became the poster boy for CEO greed with a 2005 pay package of $38 million. ISS advised shareholders to withhold votes from all sitting directors. Bottom line: At May's annual meeting shareholders withheld 32 percent of their votes from Nardelli.
In 2005 Cablevision management proposed a plan to lift the total value of cash and equity paid to employees to $1.3 billion, or 16 percent of its market cap. ISS urged shareholders to veto the plan, saying it was at least $500 million too rich. Bottom line: The package was approved. The company has since faced accusations of options backdating.
  • M&A
ISS backed security-software maker Symantec's 2004 $16.3 billion bid for Veritas, which makes storage software. That included a $5 billion premium over Veritas's already lofty stock price. Bottom line: Symantec's shares have dropped 37 percent since the bid became public.
Boston Scientific/Guidant
Medical-device maker Boston Scientific offered $27.3 billion for Guidant in a bitter bidding war with Johnson & Johnson. Both bids lacked compelling synergies. ISS advised Guidant shareholders to accept Boston Scientific's higher offer. Bottom line: Boston Scientific's shares dropped on the announcement of its bid and are now off 37 percent.

Peltz's crew presented a detailed plan for reviving underperforming Heinz (Charts). The company's management mocked Peltz as a shifty marauder whose idea of a big improvement was making ketchup packets easier to open.

"Their whole attitude was 'Why do we have to debate this guy? We're Heinz!'" says Chris Young, a former investment banker who is head of ISS's M&A practice and who chaired the sessions. "They were attacking the messenger instead of addressing the message."

It was no contest: Peltz's Trian Partners won ISS's approval. ISS advised its clients to vote for three of the five directors on his slate, and two weeks later he captured two board seats.

So far, the market approves ISS's decision: Since Peltz arrived, Heinz's shares have jumped 22 percent, putting over $3 billion in investors' pockets. "We couldn't have won without ISS," says Alan Miller of Innisfree M&A, the proxy-solicitation firm that advised the dissidents. (Peltz himself declined to be interviewed.) ISS has also supported dissidents who have shaken up Six Flags (Charts) and Cenveo (Charts), a big printing company.

So what is ISS? It's a research firm that examines proposals presented for shareholder vote at the annual meetings of 35,000 companies worldwide. ISS's 178 analysts, mostly based at its headquarters in Rockville, Md., churn out reports advising clients on how to vote.

But ISS staff members aren't just document hounds. They're constantly meeting with management and dissidents. ISS's clients - which pay about $20,000 to $50,000 a year for its service - cover the full range of institutional investors and include many of the biggest: State pension funds such as Calpers, investment advisors like Capital Research and Wall Street asset managers from J.P. Morgan to Barclays. (ISS also does consulting for the same companies whose proposals it judges, which is a troublesome practice that we'll get to in a bit.)

ISS isn't alone in the proxy advisory game, but it is the industry's pioneer and dominates the business. It was founded in 1985 by Robert A.G. Monks, a Department of Labor official in the Reagan administration and a renowned shareholder activist.

Acting on ISS advice

Two forces are rousing shareholder activism and thus ISS's clout. First is the rise of noisy, aggressive hedge funds, like Peltz's Trian and ValueAct Capital, which are taking major positions in large-market-cap companies.

Second, the SEC now requires all mutual funds to disclose their votes in proxy battles. In the past they usually backed management, partly because no one would ever be able to criticize the mutual funds for not breaking ranks. Now, with their votes public, mutual funds have increasingly bucked management to side with the hedge fund rebels.

How good is ISS's advice? Depends on the subject. ISS's counsel falls into three basic categories: board-control fights like Peltz's attack on Heinz, top executive pay and weighing proposed mergers.

On board battles, ISS is on the side of the angels, and its willingness to confront management is exemplary. On CEO pay, ISS is likewise fighting the good fight. On deals, though, ISS's report card is mixed.

The plus side: Its stubborn insistence that management sell for top dollar brought shareholders extra billions at Chiron, Engelhard and Maytag. The negative: It routinely has endorsed exorbitantly expensive mergers that have destroyed billions of dollars in shareholder value.

"Many funds follow ISS in lockstep," says Damon Silvers, associate general counsel of the AFL-CIO, who covers corporate governance. "Many others are significantly influenced by its research but do their own analysis."

The funds that follow ISS more or less consistently are chiefly index funds and smaller state pension funds, which lack the staff to crunch the numbers and mine documents on big deals. Those funds don't advertise their dependence on ISS, but the proxy solicitors know who they are and that winning ISS's endorsement means getting their votes. ("ISS is their bible," says Silvers.)

By contrast, the large state funds and big players that do lots of active management, including Calpers, TIAA-CREF, and Fidelity weigh ISS research but don't slavishly follow its advice. Calpers, for example, voted in management's favor in the Heinz battle.

Between its lock on the true believers and its sway with the independents, ISS generally holds the cards in close contests. In most proxy votes, between 20 percent and 30 percent of the shareholders are ISS clients, says Miller of Innisfree, the proxy-solicitation firm. "If ISS is on your side, 75 percent of those shareholders vote with you," adds Miller. "If ISS is on the other side, you get 25 percent of those votes."

ISS doesn't just advise shareholders, though. It also advises management, and that threatens to undermine the reputation for independence that is its most valuable asset. ISS provides an influential rating called Corporate Governance Quotient, or CGQ, on the boards of thousands of companies. The rub is that many of the companies that it rates pay ISS around $20,000 a year in consulting fees for advice on how to raise those ratings.

The investors that subscribe to ISS see little evidence that the firm has gone soft on its consulting clients - yet. "So far, we don't see a problem because of the high quality of the people and the culture," says Silvers of the AFL-CIO. But that doesn't mean he isn't concerned.

The consulting side is extremely profitable: In October, RiskMetrics, a firm that sells risk-management systems, agreed to buy privately held ISS for $553 million. "We worry that RiskMetrics will have to ramp up the consulting business to pay for that deal," says Silvers. "For perception and reality issues, it would be better if they didn't do consulting." Adds Nell Minow, co-founder of the corporate-governance research group Corporate Library, who once worked at ISS: "They shouldn't be the pitcher and referee in the same game."

ISS argues, with some justice, that its ratings are objective. A board can get a higher score only by installing an independent audit committee, for instance, or establishing minimum holding periods for executives to own shares. "Paying the fee won't raise the rating," says Pat McGurn, ISS's executive vice president and top corporate-governance expert. "Only improving the board on objective measures will do it."

Executive compensation

ISS faces potential conflicts of interest in its consulting work. However, its approach to executive compensation is straight forward. There, ISS hits the issue head-on: How much of their wealth should shareholders hand to employees? The firm has been a hawk on exposing CEOs who collect huge pay packages for poor performance.

It has also introduced some useful new metrics to measure just how much management pay packages actually cost shareholders. Equity grants to executives are usually valued in terms of dilution - that is to say, the amount by which the issuance of new stock to management reduces the percentage of ownership held by other shareholders.

ISS has improved on that somewhat murky measure by coming up with a yardstick that counts the cost to shareholders of both stock options and shares of restricted stock.

ISS's metric, called Shareholder Value Transfer (SVT), measures what really matters - not the number of shares, but their total cost.

Here's how it works: ISS takes the top-performing quartile of companies in each industry - from software to autos - and determines the average total value of each company's equity grants, both those it has already made and any new awards requested for the current year. It then takes the ratio of the total equity grants (the dollar amount being transferred to management) to the market cap (the total wealth of the shareholders). The resulting percentage is called the "cap" for the industry, and ISS counsels clients to vote against any pay plan that exceeds the cap, which is adjusted for size and other factors for each company. "If the top quartile of companies can perform well for that cap, everyone should be able to," says ISS's McGurn.

"We find that the best-performing companies in each industry aren't the equity abusers," says McGurn. "They use moderate amounts of options and restricted stock." For example, Wm. Wrigley Jr. Co., a mediocre performer for the past two years, has an SVT of 10.3 percent - far above its cap of 8.16 percent. In comparison, General Mills has an SVT of 6.2 percent, below its cap of 6.73 percent, and generates shareholder returns superior to Wrigley's.

And although ISS tried and failed to block what it saw as excessive equity giveaways at Cablevision, Boeing, Vornado and Aon, its SVT idea is starting to exert a pull on pay practices. "Companies look very carefully at those caps, and I have a lot of clients who are reluctant to exceed them," says George Paulin, CEO of Frederic W. Cook & Co., a compensation consulting firm.

Even when equity comp fits under the SVT cap, ISS targets boards that overpay the boss. If the CEO keeps getting raises while the stock drops, or if a CEO's pay is ridiculously high vs. his peers, ISS recommends that shareholders withhold their votes from members of the board's compensation committee.

In the past those protests have been mainly symbolic. But that's changing fast. In response to shareholder pressure, many big companies are adopting majority voting rules. Under the new regime - now in place at General Motors, McDonald's, Wal-Mart, and hundreds of other companies - any director who doesn't receive a majority of all votes cast is forced to submit his resignation.

ISS has managed to get large numbers of ballots withheld from the board members of Home Depot (Charts) and Occidental Petroleum (Charts) in protest over the huge pay packages for CEOs Robert Nardelli and Ray Irani, respectively. In April it recommended votes against Hank McKinnell's pay at Pfizer (Charts) - including his $83 million retirement package. Not only was his compensation package excessive by any measure, ISS argued, but Pfizer's stock performance was poor. Shareholders withheld more than 20 percent of their votes from two members of the compensation committee. That helped force McKinnell's resignation in July.

Mergers and acquisitions

M&A is ISS's weak point. It has a long record of recommending deals that were doomed from conception, and it has consistently endorsed mergers in which the buyer agreed to vastly overpay. The list of DOA deals that won its endorsement includes AOL/Time Warner, Conseco/Green Tree, WorldCom/MCI, Qwest/US West and Boston Scientific/Guidant.

In many cases, ISS crunched no numbers on how well the combined companies would have to do to justify the inflated purchase prices but cited "fairness opinions" written by the buyer's investment bank - while also reporting the huge fee the same bankers would get if the transaction closed. "Fairness opinions are an oxymoron," quips Minow.

How can ISS recommend deals without closely scrutinizing the numbers? M&A chief Young, who joined ISS in 2004, argues that clients haven't asked ISS to run financial projections on the deals. They're more interested in whether the deals make a good strategic fit or not.

Also, he points out, most of the deals win shareholder approval by an overwhelming margin, and almost all Wall Street analysts applaud them. Young argues further that it's still too early to tell if some of the biggest big-premium deals will pay off, citing the comeback at Hewlett-Packard. Clearly ISS doesn't want to be the sole voice condemning widely praised deals, even when the premiums involved are enormous.

But that may be changing. Young says his clients are getting more critical. "With the rise of hedge funds and skepticism of how boards make M&A decisions, we'll see a lot more opposition to deals," he says. "We're already doing far more in-depth analysis to see if the deals make sense."

ISS is tough on deals where it perceives that shareholders aren't getting top dollar. Last year, for example, Novartis, the Swiss drugmaker, bid $40 a share for the remaining 56 percent it didn't own of biotech company Chiron, and management accepted the offer.

But ISS sensed a bad deal for Chiron stockholders because Chiron's gloomy fortunes were looking up. It had just relaunched a vaccine that British authorities had pulled from the market, and its pipeline products showed new promise. ISS recommended that shareholders vote down the deal, and either go it alone or hold out for a higher price. The gambit worked. Novartis raised its bid to $48, putting an extra $900 million in the pockets of Chiron shareholders.

That's the good face of today's corporate activism. ISS is far from perfect. But it deserves its clients' vote.

Reporter Associate Doris Burke contributed to this article.


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