Risk & Governance Weekly

During October and November, investors in Australian and New Zealand companies will confront a proxy season in which many of the major issues that have driven shareholder anger in other developed markets will feature prominently. Investors are demanding increased accountability from directors over strategies that failed in the absence of cheap capital, and they will sharpen their focus on executive pay. In New Zealand, investors also will be dealing with the first meeting season since major changes to listing rules.

These issues, however, will take place against a significantly different backdrop to that faced by investors in Europe and the United States. Many Australian and NZ companies have posted large losses or significant profitability declines during their most recent fiscal years, and have had to raise significant amounts of capital. In Australia in particular, the past 12 months has seen the effective demise of the externally managed listed-infrastructure fund model pioneered by Macquarie amid increased debt costs and growing unease over the benefits received by the external manager. The demise of a major listed fund manager, Babcock & Brown, has seen funds internalize management and reduce debt. The Australian property sector has also undergone major changes, with property groups cutting distributions, selling assets, and raising equity to reduce debt, while many resources companies were forced into strategic alliances with Chinese state-owned entities and other Asian investors as commodity prices collapsed and other funding sources disappeared.

But in both Australia and NZ, the financial system has remained resilient, with governments in both countries not having to take part in recapitalizing tottering financial institutions. However, both nations have provided extensive deposit and wholesale financing guarantees, especially the Australian government, given much of NZ’s financial system is dominated by Australian banks. In the first half of 2009, the Australian economy, unique among developed markets, recorded two consecutive quarters of economic growth. Across the Tasman Sea, however, New Zealand, despite an absence of major corporate collapses, has been suffering through a prolonged recession.

The global financial crisis coincided with an increased focus from investors in Australian and NZ companies on board accountability and competence, and this is likely to be a major issue this season. Before this year, investors had already shown a willingness to seek the removal of directors with records of poor performance, and this trend likely will increase.

There have already been tangible signs of this increased focus on board accountability. At the end of July, one of Australia’s largest banks, ANZ, announced that Sir Rod Eddington, a director of Rio Tinto and News Corp., would no longer succeed outgoing chairperson Charles Goode. This followed a significant vote against his reelection as a director of Rio Tinto at the dual-listed company’s April annual meetings (with well over half of Australian shareholders voting against) driven by concerns over his role as a non-executive director of Allco Finance Group, which collapsed in late 2008 under high debt levels following a series of controversial related-party transactions. At the OZ Minerals annual meeting in June, almost half of the shareholders voted against the reelection of an incumbent board member after a disastrous 12 months for the mining company, which culminated in the sale of most of its assets to a Chinese state-owned entity to repay debt.

This greater willingness to confront directors over poor corporate performance is at odds with the long-standing willingness of Australian and NZ shareholders to support incumbent nominees. In Australia, where vote results are disclosed, the average vote in favor of incumbent directors has hovered at about 96 percent for many years.

Many boards have already disclosed renewal strategies in a bid to head off shareholder anger. In New Zealand, Fisher & Paykel Appliances, which held its annual meeting in August, announced a series of board changes over the next three years after it was forced into a massive equity-raising this year after a collapse of demand and a declining NZ dollar forced the company to breach debt covenants. Ports and railroads operator Asciano, which will face shareholders at its Oct. 23 annual meeting, announced three new directors, including a new board chair, on Sept. 4 after the incumbent board spent a year attempting to reduce its heavy debt burden, eventually abandoning a plan to sell parts of key assets in favor of a massive equity raising.

The most high-profile board overhaul occurred at Australia’s former state-owned monopoly telecommunications firm, Telstra, where the chairperson, CEO and one other non-executive director departed after the Australian government announced plans to build and fund a state-owned broadband network, posing a major threat to the company’s dominance of much of Australia’s telecommunications infrastructure.

One issue that may play into board accountability considerations for many shareholders is the large number of listed companies that have undertaken dilutive capital raisings with no or limited preemptive rights. In Australia, unlike NZ, most equity raisings have been dominated by placements and not by entitlement offers and the allocation and pricing process of these placements has in some cases resulted in existing shareholders being diluted against their will. There also is likely to be significant retail shareholder anger over dilution from capital raisings during this proxy season, especially at broadly held companies.

Executive Pay
This will be the fifth year Australian companies have been required to submit a remuneration report to shareholders, and follows a period where shareholders showed an unprecedented willingness to vote against management on these non-binding resolutions. In the 12 months that ended June 30, more remuneration reports were defeated at large Australian companies than in the three prior years combined. Top 100 companies such as Wesfarmers, Boral, and Transurban saw their remuneration reports defeated in the 2008 season, and in the first half of 2009, OZ Minerals also saw its remuneration report rejected.

Two issues are likely to dominate the attention of investors during the 2009 season as they consider remuneration reports: pay alignment and payments to outgoing executives. Early evidence from the companies that have already released their remuneration reports for the June 30 fiscal year suggests many are trying to demonstrate alignment between executive pay and outcomes for shareholders by instituting fixed pay freezes for senior executives and reducing bonuses, although in many cases bonuses remain substantial. Another feature of the new remuneration reports are the increased efforts by companies such as Suncorp-Metway to explain that the headline total remuneration disclosed for senior executives includes accounting valuations of share-based payments that are unlikely to vest and so have no value.

There are some grounds for suspicion about these corporate gestures. Between 2001 and 2008, the median fixed pay of S&P/ASX 100 executives in Australia more than doubled, while annual bonuses, usually paid in cash, tripled. Adding to shareholder unease over bonuses in Australia has been the generally poor disclosure of the basis on which annual bonuses are awarded--many companies provide no meaningful information on how bonuses are determined other than a general statement about the types of hurdles against which they are awarded--and the increased frequency with which bonuses have come to be awarded over the past five years. According to data from remuneration consultant PricewaterhouseCoopers, 94 percent of top 100 Australian company executives received more than half their target bonus in 2008.
 
In many cases, shareholders this season are likely to question why any bonuses were paid to senior executives following a year of poor performance, while in some cases, firms, such as Goodman Group, that announced no bonuses for 2009, have done so after paying record bonuses in 2008. The other feature of this proxy season is likely to be increased investor sensitivity to termination payments. Companies are likely to have to disclose many more termination payments than in prior years due to management departures in the wake of the financial crisis, and in some cases, companies will be forced to explain significant payments to departed executives who widely are considered to have underperformed. In the last 12 months, the Transurban and OZ Minerals remuneration reports were both defeated largely due to shareholder anger over termination payments to departed CEOs, while media company Fairfax will have to explain a substantial payment to a former CEO for the second time in four years.

Regulatory Changes
Anger over termination payments in Australia has already driven regulatory change. Legislation presently before the Australian Parliament (although unlikely to be in force prior to proxy season) would significantly widen the requirement for shareholder approval of termination payments by amending the existing law to require shareholder approval of payments to directors of more than seven times total annual remuneration. The existing law is effectively useless due to major loopholes and the very high approval threshold; the Labor Party government has proposed reducing the approval threshold to all payments of greater than 12-months base salary (excluding statutory entitlements) and requiring approval for termination payments to key management personnel (i.e., those executives whose remuneration is disclosed in the remuneration report).

Far more significant are changes to the NZSX Listing Rules that took effect in April following a review that commenced in November 2008 in response to the global financial crisis. The stated reason for the changes, which will be reviewed after a year, was to make it easier for listed companies to raise capital in difficult markets.

Two changes significantly reduce the protections available to shareholders of NZ companies, namely: 1) removing the requirement for prior approval of director participation in private placements (another change also increased the amount of capital listed entities may issue over 12 months without prior approval or preemptive rights under a placement from 15 percent of issued capital to 20 percent); and 2) significantly increasing the threshold at which related-party transactions require prior approval from 5 percent of average market capitalization to 10 percent.

The new rules also removed the requirement for prior approval of executive director participation in employee share schemes, although to date in NZ, dilution from equity issues to employees including executives has been minimal.

To date, the listing rule changes appear to have had little impact although they have been in force for less than six months. However, companies that have not incorporated the listing rules into their corporate constitutions by reference, such as Air New Zealand, will have to seek to update their constitutions in line with the changes.  --Martin Lawrence, Australia-NZ Research Team

Governance Exchange members can access the full version of this report by clicking here. RiskMetrics Group plans to hold a webcast to preview the Australian proxy season on Sept. 29. For more information, please click here.

In Brief

Microsoft Agrees to Hold a Triennial Pay Vote
Microsoft has become the first U.S. company to agree to hold a triennial advisory vote on executive compensation. The software giant’s example, if followed by other issuers, could put pressure on U.S. lawmakers to allow firms to hold triennial rather than annual “say on pay” votes.  

In a Sept. 18 blog posting, Brad Smith, Microsoft’s general counsel, and deputy general counsel John Seethoff said the company’s board decided to conduct a triennial vote at the Nov. 19 annual meeting after receiving a triennial vote proposal from the United Brotherhood of Carpenters and a request for an annual advisory vote from Walden Asset Management and the Calvert Group.

Microsoft's decision “elevates the triennial approach as an alternative that merits close consideration, both by investors as well as by companies,” Ed Durkin, director of corporate governance at the Carpenters, said in an interview with RiskMetrics Group's Governance Exchange.

Microsoft's lawyers said the board considered the merits of both resolutions and concluded that a triennial pay vote was preferable. Among the reasons cited by the Redmond, Washington-based company were: 

• Our compensation program is designed to induce and reward performance over a multi-year period. Say-on-Pay votes should occur over a similar timeframe. 
• A three-year cycle will provide investors sufficient time to evaluate the effectiveness of our short- and long-term compensation strategies and related business outcomes. 
• Most compensation programs can’t be changed overnight. Triennial votes give the Board and the Compensation Committee sufficient time to thoughtfully respond to shareholders’ sentiments and implement any necessary policy changes.
• Pre-existing Board requirements to seek shareholder approval of employee stock plans and other compensation-related matters give our shareholders an opportunity to provide feedback even in years when Say-on-Pay votes do not occur.

Durkin said Microsoft officials deserve credit for trying to get a “more informed vote” on their pay practices. “They're not trying to take a vote less often; they're trying to create a situation that when they do take a vote, investors have been able to deliberate thoughtfully on their plan.”

In late July, the Democratic-controlled House of Representatives approved legislation to require U.S. issuers to hold annual pay votes, although some Republicans argued that triennial votes would be less burdensome on issuers. The Senate likely will consider the issue, along with other governance reforms, in the coming months. The Carpenters union, which had filed more than 20 triennial proposals, has withdrawn the resolutions and plans to focus on lobbying lawmakers. Two dozen U.S. companies, including Intel, Apple, and Occidental Petroleum, have voluntarily agreed to hold annual votes on compensation, according to RiskMetrics Group data. 

In other news this week, investors at General Mills gave 51.2 percent support to a shareholder proposal seeking an annual advisory vote. The result at the Minnesota-based food company is the 22nd majority vote at a U.S. issuer this year, up from 11 in all of 2008, according to RiskMetrics data. --Ted Allen

Governance Exchange members can find more comments from Ed Durkin of the Carpenters and can join the online dialogue on this topic by clicking here.

Conference Board Calls for Pay Reforms
In a report released Sept. 21, the Conference Board called on companies to restructure their executive compensation practices in order to restore trust with investors.

The Conference Board’s Task Force on Executive Compensation, comprised of directors, shareholders, academics, and governance experts, said that corporations and shareholders should take “meaningful action” to restore lost credibility.
 
“We believe that a rules-based, ‘check the box’ approach cannot substitute for thoughtful board action discussed with shareholders,” said Robert E. Denham, a partner in the law firm of Munger, Tolles & Olson, and Rajiv L. Gupta, a former chief executive officer at Rohm and Haas, who are the co-chairs of the task force.

“At the same time, we believe compensation committees and boards must be free to develop compensation programs that reflect their shareholders' interests and fit their companies' business objectives,” noted Denham and Gupta.

The task force’s report recommends that public companies:

• Establish a clear link between pay, strategy, and performance;
• Provide compensation that is fair, affordable, and clearly aligned with actual performance;
• Eliminate controversial pay practices, such as multi-year employment contracts that provide for generous severance payments, tax gross-ups on severance payments and perks, executive perks that are not available to other managers, “golden coffin” death benefits, and stock-option repricings that are not approved by shareholders;
• Demonstrate credible board oversight of compensation; and
• Foster transparency with respect to compensation practices and appropriate dialogue between boards and shareholders.

According to the Conference Board, several corporations have already adopted these principles, including AT&T, Cisco Systems, Tyco International, and Hewlett-Packard. The California State Teachers’ Retirement System also has endorsed the pay recommendations.

“Perhaps more importantly, we have significant support from investors and leading voices on executive compensation, reflecting that the report represents interests on both sides of the debate,” Denham and Gupta said. --Alicia Caramenico

Nasdaq Panel Suggests “Comply or Explain” Approach
In a notable departure from traditional U.S. regulation, the Nasdaq Stock Market’s Listing and Hearing Review Council has expressed support for a “comply or explain” model for corporate governance and is seeking comment on nine potential best practices. 

In a discussion paper sent to companies in August, the Nasdaq listing council expressed concern about adding to the “heavy workload” of corporate boards by adopting a new set of mandatory listing requirements. “On the other hand, there are a number of governance practices which a prudent board should regularly consider and to which the shareholders of a public company are entitled to expect transparency,” the council noted.  

In advocating for a “comply or explain” approach, the listing council cited the example of European markets. The Nasdaq council is seeking comments on the following governance topics:

• Should independent directors meet in executive session (without management) at every board meeting?
• During executive sessions, what items should be on the agenda? The council suggested various topics, such as the company’s “tone at the top,” the use of self-evaluations, and risk management strategies.
• Given the demands on directors’ time, should there be a limit on the number of outside boards on which a director can serve?
• Should the company require its directors to participate in continuing education programs?
• Should shareholders vote annually on appointing the outside auditor?
• Should the company adopt some form of advanced resignation requirement to address the circumstance where a director fails to receive majority support?
• Should the company develop a process to facilitate shareholder communications with directors?
• To facilitate independent board leadership, should the company either have an independent chairman or an independent lead director?
• Should all directors be elected annually?

The deadline for submitting comments is Oct. 30. --Ted Allen

SEC Spotlight

SEC to Proceed to Trial in Bank of America Disclosure Case
On Sept. 21, the Securities and Exchange Commission said it will proceed to trial against Bank of America over its disclosures to investors about bonuses to Merrill Lynch employees.

A federal judge has rejected a $33 million settlement that the agency negotiated with the company and set a Feb. 1 trial date. U.S. District Judge Jed Rakoff questioned why the agency hadn’t sought payments from individual executives. (For more on his order, please see the Sept. 18 edition of R&GW.)   

The SEC said it will “vigorously pursue” its case against Bank of America, which acquired the ailing brokerage firm in a government-arranged deal a year ago. The agency has accused the company of misleading investors about more than $3 billion in bonuses received by Merrill employees soon after Bank of America shareholders approved the acquisition last December.

“We firmly believe that the settlement we submitted to the court was reasonable, appropriate, and in the public interest,” the SEC said in a statement, according to Law.com. Bank of America also had defended the settlement as appropriate.

The SEC, which previously said it didn’t have sufficient evidence to pursue civil charges against Bank of America executives, now indicates that it may do so. “We will use the additional discovery available in the litigation to further pursue the facts and determine whether to seek the court’s permission to bring additional charges in this case,” the agency said.

Bank of America continues to maintain that its proxy disclosures were appropriate. “We intend to vigorously defend ourselves in court,” a spokesman told The Washington Post.

The company also faces investigations over the transaction from New York Attorney General Andrew Cuomo and the House Committee on Oversight and Government Reform. Meanwhile, Bank of America continues to overhaul its board, adding DuPont Chairman Charles Holliday Jr. He is the sixth new director to join the bank’s board this year, according to Bloomberg News.  --Ted Allen

Sustainability Risk

China Takes Great Leap Forward in Renewable Energy
China is in the midst of some interesting changes, at least in the energy world. Once the woolly mammoth in the room when it came to avoiding international climate change commitments, the country is now showing the rest of the world what it's capable of doing: Colossal hydro dams. Gargantuan wind farms. Massive solar fields.

While the United States and Australia spend months and years debating climate bills aimed at using market mechanisms to reduce absolute carbon emissions, China, is making quick decisions and shovels are hitting the ground. General indifference towards human rights continues to be an issue in the country, as evidenced by the development of the Three Gorges Dam, but from a carbon perspective, China's advances are positive news.

The Chinese power industry emitted more than 3.1 billion tons of carbon dioxide (CO2) in 2008, the highest amount in the world. This number will not decline going forward, but is likely to increase by up to 40 percent by 2020 as a result of expected economic growth. The country's National Development and Reform Commission recently released a report on energy and emissions in China up to 2050, showing that the current world leader in carbon emissions will emit more greenhouse gases (GHG) each year until 2030, when such emissions are expected to peak. However, the emissions intensity (grams of carbon dioxide equivalent per kilowatt hour produced, or g/kWh) of Chinese power production is expected to decline over this same time period. This is a direct result of aggressive growth in low-carbon-generating energy capacity, namely, nuclear and renewable energy.

What's important to note is that despite this enthusiasm, coal is still the fuel of choice in China. Coal as a percentage of installed capacity for Hong Kong and mainland China companies in RiskMetrics Group’s Electric Utilities (International) Sector ranges from 60 percent to 96 percent, with coal continuing to be a major part of all capital expenditure programs. Nevertheless, climate negotiators at the Copenhagen summit in December can expect to hear plenty about renewable energy from the Chinese delegation. China has long maintained that country-to-country emission comparisons should be performed, on a per-capita basis. Having the world's fastest-growing renewable energy capacity might give it some additional negotiating leverage, if everyone can look past all that coal.

By the end of 2008, Chinese installed wind power capacity reached 12.21 gigawatts (GW), making the country the fourth-largest wind power generator in the world. Since 2001, the average growth rate in installed capacity has been greater than 45 percent annually, and capacity is expected to double again in 2009. Compare this with the original growth targets set by the government of 10 GW by 2010 and 30 GW by 2020. Having already surpassed the original 2010 target, the country could reach its 2020 target at the end of next year, according to the Global Wind Energy Council. It now expects to reach 100 GW of installed capacity by 2020. These incredibly aggressive targets will be met largely with the building of seven 10-GW+ wind farms around the country, one of which began construction earlier this year in Gansu province. No other country in the world could accomplish these feats by harnessing on- or offshore wind. China is achieving this phenomenal growth in alternative energy use through tax breaks and subsidies along the value chain, renewable-energy quotas for power suppliers, and lack of interest in community resistance.

Approximately 50 megawatts (MW) of solar capacity were added by China in 2008, which for solar is still material. The government has announced plans to expand the installed capacity to 1,800 MW by 2020, but like the wind targets, this goal may also be reached early as a result of a feed-in tariff for utility-scale solar projects expected to be passed later this year. Case in point, an agreement was reached in September between U.S. company First Solar and the Chinese government to develop a 2 GW solar project in Inner Mongolia. The project will be built in phases and be complete by 2019. First Solar said the project would not have been possible without the feed-in tariff.

The Three Gorges Dam caused a substantial uproar among environmentalists and human rights groups around the world due to its predicted impact on the river, upstream and down, and the people living along its banks, thousands of whom were displaced. The bad news for these groups is that major dam developments in China are expected to continue, as at least five 3.5-GW-plus plants are in development, helping the government reach its goal of 190 GW installed by 2010. The power produced will help the huge country meet its voracious energy needs, contribute to reduced emissions intensity overall, and be positive from a carbon perspective, yet the net benefit of these projects is highly debatable.  --Daniel Bida, Intangible Value Assessment Team

This article previously appeared in RiskMetrics Group’s Weekly Stock Monitor newsletter.

Meetings to Watch

This section alerts readers to forthcoming shareholder meetings that have particularly interesting or controversial issues on the agenda.

The Sept. 11 edition of Risk & Governance Weekly incorrectly reported that three companies successfully challenged climate change resolutions at the Securities and Exchange Commission. The proponent, the New York City funds, has indicated that only two companies were allowed to omit those resolutions.