Corporate governance has been a hot button issue since the collapse of Adelphia, Enron, Worldcom and others. The Securities and Exchange Commission (SEC) is keeping the heat on public companies by requiring broader and deeper disclosure on how corporations are actually governed—most of which can be found in the proxy. If you wanted to find a company that was "ideally" governed in line with shareholders' interests, it would be the proxy statement that you would turn to for most of the information.
Unfortunately, many individual investors don't know what to do with the proxy statement—they don't know how to vote on certain issues, or feel that their votes do not count for much. Many shareholders simply toss their proxies in a file or, worse, the trash. But with it, they are throwing away their votes—and their shareholder right to keep management's interest in line with their own.
As a portfolio manager for a mutual fund, I read proxy statements carefully during my initial company analysis and on a regular basis once a position is taken. And, needless to say, I always want my votes counted. Although proxies are written by attorneys and can make for some dry reading, they are generally arranged in sections that lead to organized analysis. Here are some tips on getting the most out of a proxy, sequentially organized according to a typical proxy's format.
The SEC requires that shareholders receive a proxy statement prior to any shareholder meeting. The statements must disclose all important facts about issues on which shareholders are asked to vote, including the election of directors and the approval of other corporate action, or even solicitations by other shareholders. The information contained in these statements must be filed with the SEC before any shareholder votes are solicited.
That's why the proxy statement will start with information on when and where the annual meeting is to be held. It will also provide a detailed outline, in the form of a Q&A, of the proposals that are to be voted on. If you can get to the annual meeting—go! Even if you're not a shareholder and are checking the company out, most firms will allow you to attend their annual meeting, although you won't be able to vote unless you're a shareholder. You'll meet management, hear about the firm's prospects and get to ask questions. It's the one time of year when you'll have management's undivided attention, so take advantage of it. You'll probably meet like-minded investors whom you may wish to exchange information or stay in contact with. Berkshire Hathaway's meeting draws thousands of intelligent shareholders who look forward to their marathon Q&A with Warren Buffett.
Proposal One in most proxies is the election of directors. Who you vote for is critical, since they are your representatives who oversee management, making sure outside shareholders are treated fairly. Here's how to proceed with this section.
The external auditors play an important role in today's financial scene. More than one firm has been sunk by "accounting irregularities," which sometimes mask outright fraud.
For most public companies, I generally like to see a "Big 4" accounting firm—Deloitte & Touche, KPMG, PricewaterhouseCoopers and Ernst & Young—or a strong regional firm doing the audit. They tend to have higher-quality people and a better knowledge of accounting systems and regulatory issues.
Many audit clients have switched in recent years from Big 4 firms to regional firms for cost and other considerations. This is acceptable as long as there are no accounting controversies triggering the change. Any time a firm changes auditors, the reason behind it is required to be disclosed in an 8-K filing.
Firms are now required to separately list fees paid for audit, tax and consulting services for the last two years. Beware of companies that pay more for consulting services than audit services. Major consulting assignments should not be handled by the audit firm or any other outside firm with financial responsibilities, to avoid potential conflicts of interest.
This section of the proxy will contain a Compensation Committee Report. Read this section and try to understand the committee's compensation philosophy and how executives are actually rewarded.
Compensation is usually some combination of cash (salary/bonus) and equity (options and/or restricted stock). Together they are intended to attract, motivate and reward executives who are expected to manage for short- and long-term success.
From a shareholder's standpoint, salaries should be reasonable and commensurate with others holding similar positions in the same or a comparable industry. The best way to get information to compare executive compensation is to check out other proxies on SEC's EDGAR Web site (www.sec.gov/edgar.shtml) for this data.
Bonus programs should be disclosed in writing and be tied to a company's performance, ideally its return on assets or capital rather than its return on equity. [Return on assets is calculated by taking net income and dividing it by total assets; return on capital takes net income and divides it by the sum of shareholder's equity plus net debt (total debt less cash and cash equivalents). The return on equity calculation takes net income and divides it by shareholder's equity. In these calculations, you should use averages (average total assets, average shareholder's equity and average net debt) to eliminate distortions occurring when a company issues equity or debt during the year—using beginning shareholder's equity or capital doesn't address this.] Return on equity can be easily manipulated upward by adding financial leverage, which may not be in the company's long-term interest. Likewise, tying a bonus to earnings or cash flow growth encourages executives to ignore the assets and capital necessary to generate them. A company may add product lines or distribution channels or accept new customers that increase earnings and cash flow but the capital requirements may be so high the return on capital actually declines!
A bonus tied to share price appreciation may also lead to unintended results. I know of several companies that bought back large amounts of stock using borrowed money in an attempt to keep the share price high. Their balance sheets became leveraged and liquidity became an issue, causing the share price to ultimately decline. Beware of "show up" bonuses where the bonus is "determined at the discretion of the board of directors." These lucky executives need only "show up" to earn their bonus!
Finally, make sure the combined cash compensation matches the company's financial performance. If executive compensation marches continually upward while results go sideways or down, something is definitely wrong. One of the most effective programs I've ever seen requires executives to earn high returns on capital and beat the returns on capital of the peer companies—by doing so, they can earn substantial compensation!
Most companies now have some type of option or restricted stock plan to reward long-term performance. Like Warren Buffett, I prefer that there be no options/restricted stock incentives but instead cash incentives where executives can do very well if performance is extraordinary. However, if a firm has an options/restricted stock program, it should contain the following elements:
This section is normally buried toward the back of the proxy—for good reason. It highlights transactions and relationships that, while not illegal, should be examined carefully for unethical behavior. If there are too many of these transactions, it can indicate the firm is being run as a personal piggy bank for management.
The most common examples include:
Shareholders are sometimes asked in the proxy to approve various anti-takeover measures that primarily serve to entrench management. Generally, I vote against these. The most common include:
Don't throw those proxies in the circular file!
Remember, you as a shareholder own the company and management works for you.
Exercise your rights carefully—and do not vote for any director or proposal that would limit those rights. If you don't understand a proposal, don't vote for it.
And make sure you DO vote for those that align management's interests with your interests—you'll never be sorry.