Unlocking the Secrets of a Proxy Statement

These dense documents deserve close inspection

The corporate proxy statement--which most public companies will issue over the next three months--is fast becoming required reading. Now that Enron's implosion has raised concerns that cronyism and poor corporate governance might be commonplace, investors should pay closer attention to these dense legal documents, which provide details about the pay and perks of a company's top executives, directors, and outside accountants. "You need to determine whether you can rely on the directors and top management to act responsibly when things go bad," says Ken Bertsch, director of corporate governance at TIAA-CREF, which manages $290 billion in assets. "The proxy statement can help you do that."

Tyco International (TYC ), for one, has firsthand experience of the closer scrutiny investors are giving proxies. The day after it filed its latest statement with the Securities & Exchange Commission on Jan. 28, investors pushed Tyco's share price down 20%. The reason? A disclosure that Tyco paid $10 million to an outside director and another $10 million to a charity he controlled fanned concerns about potential conflicts of interest. The company said the payments were for the director's help in arranging an acquisition. This came on top of worries about accounting irregularities that already had pummeled Tyco shares.

Companies typically file proxy statements about six weeks before their annual meeting to inform investors when and where the session will be held. If you're a shareholder, you'll get the statement in the mail. Or you can obtain any public company's proxy statement via the SEC's EDGAR database (www.edgar-online.com). The statements are listed on EDGAR as form DEF 14A filings.

What should you look for in a proxy statement? Start with the "Summary Compensation Table." Here, you'll see how much the CEO and the four highest-paid executives earned annually over the past three fiscal years in salary, bonus, stock options, and any other compensation. If the execs got raises, check if the hikes are in line with those at similar companies. To help you wade through the legalese, the AFL-CIO's Web site defines common proxy statement terms at www.aflcio.org. Click on Executive PayWatch, then database, then proxy statement.

As for bonuses, this year you probably won't see the big numbers of the 1990s. But be on the lookout for signs that companies are making up for skimpy bonuses by handing out overly generous stock option grants, says Bertsch. At Cisco (CSCO ), for instance, CEO John Chambers and the four highest-paid executives received zip in bonuses in fiscal 2001 that ended July 31 (table). Although Cisco lost $1 billion in the year, Chambers received option grants worth an estimated $121.6 million, while four senior vice-presidents each got at least $13 million in grants. Cisco spokeswoman Terry Anderson says the grants' size is based on industry standards. Shareholders benefit, she adds, because employee stock options encourage long-term commitment.

For more detail on stock options, flip to a table called "Options Grants in the Last Fiscal Year." Here, companies estimate what the options grants would be worth based either on the Black-Scholes options pricing model, or the assumption that the company's stock rises 5% and 10% annually over the options' life.

The options grants section will also tell you whether a company has repriced previously granted options for top execs. When a stock's market price falls far below the option purchase price--a common occurrence over the past two years--some companies cancel the old options and substitute new ones that will turn profitable at a lower price. This can be a cause for concern because it signals to execs they'll be rewarded no matter what. The Investor Responsibility Research Center, which analyzes proxy statements for institutional investors, found that in the past year or so, 111 of the approximately 2,000 companies it reviews, including Sprint and Novell, repriced options for some top executives.

Also scan the employee compensation section for unusual gifts or payments. Mattel's (MAT ) 2000 proxy statement disclosed that departing CEO Jill Barad's contract gave her $7.2 million in loan forgiveness and $3.3 million to cover personal tax expenses.

Are company directors cronies of the CEO or an independent group acting on behalf of shareholders? To find out, look at the directors' brief biographies listed in the "Election of Directors" section. The majority of directors shouldn't be company employees, and they ideally should have experience managing similar companies.

Other must-reads are "Related Party Transactions" and "Certain Relationships." Is an outside director's son employed at the firm? You'll find out here. More important, these sections will tell you whether directors are moonlighting for the company in ways that could conflict with their role as management watchdog. "You want to see that outside directors are really independent, not the investment bankers, lawyers, or outside vendors of the firm," says Howard Schilit, director of the Center for Financial Research & Analysis. For example, Costco's (COST ) latest proxy statement reveals that it paid one outside director's company $1.5 million for providing insurance, while a second director's company got $1.3 million for merchandise sold to the discount retailer. Costco CEO James Sinegal said doing business with outside directors is not necessarily, a conflict of interest. In these instances Costco asked for competitive bids--and those directors' companies had the best prices, he said.

Check the "Director Compensation" section for data on directors' stock holdings. Outside directors should own a good chunk of company stock to align their interests with shareholders. That's why you need to check the footnotes to see how much of the total stock holdings are in options grants. One rule of thumb: Longtime directors should have company stock holdings equal to three years of their annual retainer.

The section on accountants is also important reading. Last year, the SEC for the first time required companies to reveal the additional fees they pay auditors--and the disclosures have proved interesting. Enron's auditor, Arthur Andersen, was criticized for multimillion-dollar contracts, which exceeded the auditing fees it earned. At Agilent Technologies (A ), for fiscal 2001 ended Oct. 31, auditor compensation included $15.2 million for various services, on top of audit fees of $2.9 million.

Investors learned from Enron that it's important to get a sense of how the company treats its insiders. The proxy statement is an essential guide through that culture.

By Susan Scherreik

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