Key Governance Issues for Some Activists
Here’s a look at some of the corporate governance practices that activist investors, including John Bogle of Vanguard Group and William Miller of Legg Mason Inc., believe should be major issues for institutional money managers:
* Earnings “management” and the use of pro forma results. Bogle, in a recent speech, denounced the “byzantine accounting legerdemain” used by many companies to avoid disappointing investors and brokerage analysts from quarter to quarter, potentially at the expense of a long-term focus.
He urged companies to stop giving analysts self-serving “guidance” that sets the bar low each quarter so reported results inevitably beat estimates.
Bogle also said money managers should pressure companies to stop using so-called pro forma earnings to spruce up their results. He noted that in 2001 about 1,500 companies reported pro forma earnings--as he put it, “what their earnings would have been if bad things hadn’t happened.”
Miller, a well-known value-oriented investor who manages the Legg Mason Value Trust fund, sounded a similar theme in a recent letter to his shareholders. Miller mocked one brokerage analyst who recently said a company “exceeded expectations, as expected.”
Miller also said “the problem with pro forma results is that they are too often ‘pro-motional,’ eliminating the negative and emphasizing the positive. When did you ever see pro forma results that indicated the business was doing worse than was reported under GAAP [generally accepted accounting principles]?”
* Overstated pension plan assumptions. Bogle said some companies are using rosy projected returns for their employee pension plans to buff their financial statements. Many firms still assume 9% to 10% annual returns on their pension plans in coming years, when 5% would be more realistic, Bogle said, considering that the plans usually hold bonds and other assets that have generated lower long-term returns than stocks.
The higher the assumed long-term returns, the lower the annual pension plan contributions a company is required to make in the near term. Instead, money that would have been earmarked for a pension plan accrues to the company’s bottom line.
In 2000, for example, IBM was able to boost its earnings by $200 million because it raised its return assumption on its pension plan to 10% from 9.5%. Enron Corp. was more aggressive: It assumed 10.5% annual pension returns.
Bogle said the issue should be on the agendas of the board of directors’ finance committees of every public firm.
* Underreporting of executive compensation. Most major companies don’t treat the costs of employee stock options as an official expense on income statements. That has contributed to an overstatement of earnings in recent years, Bogle said.
When options involve no charge to earnings, they are considered a “cheap” form of compensation--when in fact they represent a cost to shareholders, experts say.
A bill in the U.S. Senate would force companies to charge options costs against earnings. But the bill’s prospects are uncertain.
Though executives should have a chance to be handsomely rewarded, Bogle said, he and others believe option grants are excessive in many cases, bringing even mediocre CEOs tens of millions of dollars a year.
“Executive pay is out of control because [board] compensation committees aren’t doing their job,” he said.
* Auditor independence. Bogle said outside accounting firms may have had little incentive to question the books of companies such as Enron because of an inherent conflict of interest that has developed over the years: A major chunk of the revenue generated by Big Five accounting firms now comes from non-auditing work such as consulting, often performed for the same clients whose books the firms are auditing.
“To some extent this issue is resolving itself a bit,” Bogle said, noting that the major accounting firms are taking steps to separate their auditing and consulting operations.
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Josh Friedman
