On February 15, 2007, the European parliament approved the "Proposal for a Directive on Shareholder Voting Rights." This directive comes after the European Commission's consultation in July 2005, on "Fostering an Appropriate Regime for Shareholders' Rights," which ISS had responded to along with many other concerned parties.

The objective of the directive is for foreign shareholders to vote as easily as national shareholders do in European listed companies. This is to be achieved via a variety of measures described in the directive. These include:

* Complete and timely disclosure 21 days before a meeting (Article 5)
* Procedures to add agenda items and ask questions (Articles 6 & 9)
* End of block voting in favor of record dates (Article 7)
* Electronic voting (Article 8)
* Role of proxy holders (Article 10)
* Publication of outcome of votes (Article 14).

This directive is a welcome step, moving forward the Commission's Action Plan. However, it could be years before it takes effect since EU states now have to inscribe this into national law. The provisions in the EU directive set minimum expectations of the information and procedures that should be available to shareholders. Although, EU member states may go beyond the EU directive to advance shareholder rights even further. Going forward, ISS hopes the EU will consider adopting ways to guarantee issuers' adherence to the measures that will ultimately be implemented.

The decision by Aflac--the insurance company known for its television commercials featuring a talking duck--to give shareholders an annual advisory vote on executive pay practices may prompt other major U.S. companies to follow suit.

Over a dozen large companies, including Tyco, Pfizer, Schering-Plough, J.P. Morgan Chase, Intel, and Prudential, have joined pension fund and investor representatives in a working group to discuss possible non-binding votes on compensation, known as "say on pay." Some of the companies involved with the group, such as Colgate-Palmolive, did not receive "say on pay" proposals this year, but still want to explore the possibility of shareholder review on compensation.

"We can say with assurance that close to a dozen companies ... believe the concept has considerable merit," said Timothy H. Smith, senior vice president of Walden Asset Management, a Boston-based fund for socially responsible investing and one of the founding partners of the working group, "but they need to do due diligence to see how it would be put to effect in the U.S. market."

The idea of an investor-issuer working group is not new. In early 2005, the United Brotherhood of Carpenters and Joiners of America, the Sheet Metal Workers International Association, and other labor pension funds founded a work group with companies like Bristol-Myers Squibb, Cinergy, Time Warner, and Chevron to address majority voting in director elections.

The United Kingdom, Sweden, and Australia already have advisory votes on executive pay, while the Netherlands has binding compensation votes. The U.K. rule has been in place since 2002 and has had a significant dampening effect on rising executive pay, according to a study of the 100 largest British companies by London-based New Bridge Street Consultants.

The idea of "say on pay" is catching on among U.S. shareholders. Last year, a first-time proposal filed by the American Federation of State, County, and Municipal Employees (AFSCME) and other investors averaged about 40 percent support at seven companies. AFSCME is one of the founding organizations in the "say on pay" working group, which also includes TIAA-CREF, the Connecticut Retirement Plans and Trust Funds, F&C Asset Management, Hermes, and the Universities Superannuation Scheme of the U.K.

This year, 52 advisory vote proposals are pending, many of them filed by a network of investors nationwide, including Walden, AFSCME, the New York City Employees' Retirement System (NYCERS), and the AFL-CIO. Four proposals so far have been withdrawn.

Georgia-based Aflac is the only U.S. company so far that has publicly said it will give shareholders a vote on executive compensation. Aflac Chairman and CEO Daniel P. Amos consulted with the board and with shareholders, including Smith at Walden, and decided to go ahead with the advisory vote after the company received a proposal from Boston Common Asset Management.

"Our shareholders, as owners of the company, have the right to know how executive compensation works," Amos said in a Feb. 14 press release.

The measure will not go into effect until 2009. By then, Aflac will have released three years of compensation data under the U.S. Securities and Exchange Commission's new rules on executive pay disclosure. The SEC approved the rules in July in an attempt to provide investors a clearer picture of companies' pay practices and related-party transactions.

"We expect that it will become easier for additional companies to embrace 'say on pay,' now that Aflac has opened the door as the first adopter of a shareholder advisory on CEO pay," Richard Ferlauto, director of investment policy at AFSCME, told Governance Weekly.

Aflac's decision may set a standard for other companies to follow, as other frontrunners in corporate governance have done in the past. "Chances are, anything [other firms] adopt now is going to be called 'the Aflac model,' kind of like how Intel and Pfizer reaped the benefits of being the early adopters" on majority voting bylaws and director resignation requirements," said Patrick McGurn, vice president and special counsel to ISS.

Apart from the companies involved in the "say on pay" working group, Smith said, corporate responses to the idea range from cautiously pessimistic to outright negative. Some companies are skeptical that an advisory vote on pay will have the same effect in the U.S. as it does abroad, owing to market differences. Other firms say that a simple up-or-down vote is not specific enough to indicate the particular pay practices (e.g., bonuses, stock option grants, or retirement benefits) that investors may object to.

Some companies, Smith said, would like to see how investors react to new compensation disclosures before committing to an advisory vote.

The first order of business - our options backdating securities class action list has been updated to add Amkor Technology (NASDAQ: AMKR), Apollo Group (NASDAQ: APOL), Hansen Natural Corporation (NASDAQ: HANS), Quest Software (NASDAQ: QSFT) and Sunrise Senior Living (NYSE: SRZ). The number of companies on the list now stands at 25.

We will continue to update and maintain this list to track all newly filed securities class actions that have options backdating related allegations. The list will also include any previously filed cases that have recently added options backdating allegations.

Another excellent resource is The D&O Diary's list of options backdating related derivative lawsuits, here.

The controversy over Zions Bancorp's market-based plan sheds light on some of the challenges that companies and investors face in determining the fair value of stock options.

Under Statement 123R, companies have significant leeway in their selection of a financial model (e.g., Black-Scholes, lattice, Monte Carlo simulation) to calculate option values. They also have flexibility to make assumptions about the inputs used in these models, such as expected option-term length, stock price volatility, risk-free rate, and dividend yield. These varying assumptions have made it difficult for investors to compare option practices across companies. As more companies expense options for the first time, institutional investors must pay special attention to the assumptions and models that are used to value options.

More significantly, the flexibility in model and input selection has allowed some firms to reduce their option values. An ISS study of 36 companies that filed recent 123R disclosures found that those firms are reporting option values that are 29 percent lower on average (when compared to values ISS derived by using a lattice model with a standardized inputs).

The intent behind 123R is clear. Companies are to improve disclosure and reflect option expense on the income statement for what it is: a compensation cost. While option valuation information had typically been available in financial statement footnotes, the rule sought to improve transparency and give investors a better sense of the economic impact of option grants within GAAP financials. The rule also raised the stakes for companies, which closely watch how option values affect earnings and how investors react.

Ideally, the fair value estimates for options, like all derivatives, would be market-driven. Employee stock options, however, are difficult, if not impossible, to value by market mechanisms, primarily because they are in almost all cases nontransferable. In addition, they typically vest over a period of years, making them unexerciseable for significant portions of the contract length. Employees also typically must exercise (or forfeit) options upon terminating employment with the granting company.

An institutional investor group is voicing concern over the U.S. Securities and Exchange Commission's recent decision to grant preliminary approval to Zions Bancorp's plan to use an auction-based system to determine the fair value of employee stock option grants.

The Zions auction system is the first market-based valuation method to pass muster with the SEC. In 2005, Cisco Systems proposed its own market-based plan, but the agency declined to approve it. Cisco and other technology firms, which historically have issued a significant number of stock options, contend that commonly used mathematical methods, such as the Black-Scholes model, overstate option values.

However, some investors warn that companies may use market-based methods to improperly reduce their reported compensation costs. In a Feb. 5 letter to the SEC's chief accountant, the Council of Institutional Investors (CII) urged the agency to delay approving other market-based valuation methods for at least a month to give investors more time to analyze Zions' plan.

"The ongoing stock-option backdating controversy is a constant reminder that the financial accounting and reporting for employee share-based awards is an area in which there is a high risk of intentional misapplication of accounting requirements," CII General Counsel Jeff Mahoney wrote to the SEC.

Investors advocates have long urged U.S. regulators to require companies to expense options so shareholders could get a better sense of the total cost of executive and employee compensation. In December 2004, the Financial Accounting Standards Board (FASB) heeded these concerns and mandated option expensing in its Statement of Financial Accounting Standards 123R. While option valuation information had typically been available in financial statement footnotes, the new rule sought to improve transparency and give investors a better sense of the economic impact of option grants within GAAP financials.

Statement 123R applies to the first fiscal year that started after June 15, 2005, which means that investors are just starting to see corporate disclosures that address option expensing. To date, about 60 companies have made 123R disclosures.

Under Statement 123R, companies have significant leeway in the models they use to calculate option values. Issuers also have flexibility in the assumptions they make about the various factors, such as expected option-term length and stock price volatility, that are used as inputs for these models. Recent financial filings indicate that companies are using varying assumptions and deriving significantly different values. In some cases, companies are reporting a lower options expense than one might calculate with a standardized methodology and inputs. (Next Tuesday's blog post will offer more on how these assumptions vary and their impact on reported option values)

According to CFO.com today, insurance company Aflac announced yesterday it will become the first major company to provide shareholders with a non-binding vote on executive pay packages. The company reportedly came to its decision in response to behind-the-scenes discussions with union activists. The first vote will take place in 2009 since that will be the first year that the executive compensation tables in Aflac's proxy statement will contain three years of data, reflecting the Securities and Exchange Commission's new disclosure rules.

What are your views on say on pay? Do you anticipate more companies giving shareholders a say on executive pay packages? We welcome your thoughts.

This is the third of a three-part preview of the 2007 U.S. proxy season. This piece addresses shareholder proposals that target takeover defenses.

This year, individual shareholders are taking the lead in filing proposals that target takeover defenses, such as classified boards, "poison pill" plans, supermajority voting rules, and requirements for holding special meetings.

Proposals to declassify corporate boards will be well represented this proxy season. As of Feb. 5, ISS was tracking more than 40 such proposals. Labor pension funds submitted seven resolutions, including a third-time proposal filed at Peabody Energy by the AFL-CIO. Peabody says the proposal was intended to "pressure the company into adopting policies being promoted by union officials that would be detrimental" to the firm, shareholders, and employees.

The Amalgamated Bank's LongView fund has withdrawn a declassification proposal at Martek Biosciences after the company adopted the proposal. New York City's pension funds have also filed proposals to declassify boards, as have a number of individual shareholders. In recent years, U.S. companies have become increasingly receptive to this governance reform. A majority of S&P 500 firms now allow for the annual election of all directors, according to an ISS study on boards at S&P "Super 1,500" companies.

Several issuers that have begun the process of declassifying their boards or plan to put the matter to a shareholder vote have asked for "no-action" letters from the Securities and Exchange Commission on the grounds that the proposals have been "substantially implemented." These companies include Avista, Lear, Piper Jaffrey, and Visteon. Three other proposals to declassify boards have been withdrawn in the face of no-action challenges.

Individual shareholders thus far appear to be the only proponents who have submitted resolutions to limit poison pills, according to ISS records, with a total of 18 filed. Hewlett-Packard sought to exclude a poison pill bylaw proposal filed by investor Nick Rossi, but the SEC staff rejected that request on Dec. 21. Boeing, Home Depot, and Honeywell have asked the SEC for permission to exclude similar proposals. Honeywell argued that it has "substantially implemented" the proposal by adopting a new pill policy in December.

At Walt Disney's annual meeting on March 8, investors will vote on a bylaw proposal by Harvard Law Professor Lucian Bebchuk that calls for a 75 percent vote by directors to adopt or amend a poison pill plan and would impose a one-year limit on pills that are not ratified by shareholders. Management opposes the proposal, arguing that it would limit the board's ability to respond to hostile takeover offers and may not be enforceable under Delaware law. The media-and-entertainment company also warns that the 75 percent threshold would allow "a small group of directors" (such as representatives of an acquirer) "to block action that other directors believe is in the best interests of shareholders."

A similar Bebchuk bylaw proposal received 48.5 percent support at CA last year and prompted the business software company to modify its pill and agree to put the defense to a shareholder vote.

Members of the Chevedden, Rossi, and Steiner families have filed 20 proposals this year seeking to strengthen shareholder rights to call special meetings. The proposal calls for boards to amend bylaws to give "holders of 10 percent of outstanding common stock the power to call a special shareholder meeting."

Shareholder activist Evelyn Y. Davis has submitted at least 14 proposals calling for cumulative voting. Her targets this year include Aetna, General Electric, IBM, Safeway, and Bank of New York. Other individual investors have filed another 10 proposals. Last season, ISS tracked 23 proposals calling on companies to allow for cumulative voting that went to a vote between Jan. 1, and June 30, 2006. Average support for those proposals amounted to 39.8 percent.

Proposals to eliminate supermajority vote requirements also will be well represented this season, according to ISS records. Thirty such proposals were filed prior to Jan. 1, with slightly more than half by members of the California-based Rossi family. The California Public Employees' Retirement System also intends to file proposals on the issue, fund officials tell ISS. Proponents intend to capitalize on strong support for such proposals in recent years. Last year, resolutions to eliminate supermajority requirements averaged 67.8 percent support for 19 proposals that came to a vote between Jan. 1 and June 30, according to ISS records.

While labor funds are less focused this year on takeover defense-related measures, they continue to file at companies that have failed to act on past majority votes on shareholder proposals. This year, union funds will be filing proposals asking companies to create committees to respond to cases where a majority of shareholders supported a resolution and the company failed to act.

The International Brotherhood of Electrical Workers (IBEW) filed such a proposal at Genzyme (where an IBEW-filed golden parachute proposal won 57.9 percent of votes cast last year) and at OfficeMax, where a similar IBEW proposal received 53 percent support in 2006.

Companies Take Action
Meanwhile, a number of companies have acted to dismantle takeover defenses. Last year, at least seven firms, including Amgen, Hilton Hotels, Motorola, and Newell Rubbermaid, terminated their poison pills following majority votes for shareholder proposals requesting the redemption or submission for investor approval of any pill.

Last month, the board of McKesson, a San Francisco-based healthcare services firm, amended the company's poison pill to let it expire on Jan. 31. The board also agreed to ask shareholders to vote to institute annual elections for all directors.

"These actions demonstrate our board's continuing commitment to strong, stockholder-focused, contemporary corporate governance practices, which we believe are consistent with our goal of creating long-term, sustainable value for McKesson stockholders," John H. Hammergren, the company's chairman and chief executive officer, said in a statement.

In December, Schering-Plough said it will rescind its poison pill and accelerate the declassification of its board from 2008 to this year's annual meeting. The New Jersey-based pharmaceutical company also plans to recommend that shareholders vote to reduce the 80 percent supermajority requirement to simple majority approval for the removal of directors, and for mergers and acquisitions.

Marathon Oil and IBM recently said in regulatory filings that they will ask for shareholder approval at their 2007 annual meetings to eliminate supermajority voting rules. 3M, FedEx, and Lockheed Martin are among other companies that recently lowered their vote requirements, according to The Wall Street Journal.

What is the true impact of employee stock option expense?

Recent ISS research has found that the average S&P 500 company may report option expense under FAS 123R nearly 30% lower than calculated by ISS. As reporting season heats up, investors need consistent and timely data and analysis to help them assess the quality of companies' stock option expense disclosures.

Join ISS' Patrick McGurn and Jeffrey Mahoney of the Council of Institutional Investors on Thursday, February 15, 2007 at 1:00 pm EST for a Webcast on options expensing. The Webcast will discuss the new options expensing rules, what we've learned from the first wave of disclosures, and the implications for institutional investors.

To register for the Webcast, please visit here.

More South Korean companies are bracing for the possibility of securities class-action lawsuits now that a legal grace period has expired.

South Korea adopted securities class-action legislation in 2004 that was modeled in part on U.S. laws. However, the Korean legislation contained various hurdles that have deterred class claims. The law exempted firms with less than 2 trillion won ($2 billion) in assets from lawsuits over conduct before Jan. 1, 2007. "Now that the grace period has ended, all [listed] companies should prepare for a possible class action," attorney Chung Dong-yoon warned in a recent article in The Korea Herald.

Based on U.S. litigation trends, the attorney estimates that Korea's 1,600 listed firms could face about 30 securities class-action suits each year. So far, no successful class suits have been filed.

The Korean law still contains other requirements that discourage lawsuits. To file a class suit, an investor must assemble a group of 50 shareholders who collectively hold at least .01 percent of a firm's outstanding shares.

An international coalition of 13 institutional investors has endorsed the right of U.S. shareholders to have an annual advisory vote on executive compensation practices.

In a letter to Securities and Exchange Commission Chairman Christopher Cox, the investor group argued that advisory votes on executive pay would "improve communication between shareholders and directors; encourage pay-for-performance practices; increase focus on individual company circumstances and strategic goals in the development and evaluation of executive compensation plans; and provide a counter-weight to upward pressure on executive compensation from enhanced disclosure requirements."

The group urged the SEC to take action to establish shareholder votes on pay through regulatory action or through exchange listing standard changes. The investors also said they would support legislation to provide such a right. U.S. Rep. Barney Frank, the chairman of the House Financial Services Committee, introduced a bill in 2005 that called for votes on pay plans, but the measure stalled in Congress, which was then controlled by Republicans.

So far this proxy season, labor pension funds and other U.S. investors have filed more than 60 proposals seeking advisory votes on pay practices.

The Jan. 25 letter, which was orchestrated by the Universities Superannuation Scheme of the United Kingdom, was signed by eight other U.K. institutions, two from the Netherlands, one from Australia, and the Connecticut Retirement Plans and Trust Funds. Among the other signatories are ABP Investments from the Netherlands; Hermes Equity Ownership Services, F&C Asset Management, the Local Authority Pension Fund Forum, and Shell Pensions Management Services, all from the U.K.; and UniSuper Management from Australia.

Such advisory votes are required in the United Kingdom, Australia, and Sweden, while Dutch firms must submit pay policies to a binding shareholder vote. According to the international investor group, the votes in these markets have made companies more receptive to shareholders on compensation issues. The investors cited the example of British drugmaker GlaxoSmithKline, which adjusted its remuneration plan after a 51 percent negative vote in 2003. In Australia, shareholder opposition prompted gaming company Tabcorp to withdraw an options plan for its CEO last year, while packaging firm Amcor agreed to increase performance hurdles and extend vesting schedules, according to the investor group. Other firms in these markets now are using longer-term performance targets in incentive plans and have improved their pay disclosure.