ISS Looks Like It's Channeling Icahn

The proxy advisory firm says Fifth Third's CEO should go despite stellar governance

What are shareholders supposed to do when a company with stellar corporate governance practices loses value for five years? Should they vote to reelect the CEO to the board of directors or oust him?

That's the question facing the 148-year-old Cincinnati-based retail bank Fifth Third Bancorp (FITB ). On Mar. 10 proxy advisory firm Institutional Shareholder Services Inc. in Rockville, Md., advised its money manager clients to reject the bank's CEO, George A. Schaefer Jr., for reelection to the board. Why? "Consistent underperformance" of the bank's stock over the last five years, both on an absolute basis and relative to its peer group.

Yet Fifth Third is an overachiever in corporate governance. It has better practices than 99.8% of the companies in the Standard & Poor's (MHP ) 500-stock index, according to the ISS report. "Effective corporate governance is a key ingredient to a company's success," Schaefer boasted in 2003, when ISS scored the bank highly. "We are pleased to have these efforts recognized by ISS."

That was then. Now, shareholders may vote to get rid of Schaefer at the company's annual meeting on Mar. 28 based on the recommendation by ISS that they withhold their votes for directors up for an uncontested reelection, including Schaefer. "I have a tough time reconciling how we could get a corporate governance score better than any other bank in the universe and then [ISS advises a no-vote] based solely on share price," says Schaefer.

In the past, ISS, like other proxy advisers, considered stock performance only in the context of an overall score on corporate governance criteria ranging from board members' independence to executive compensation. Now, ISS' general philosophy is starting to resemble that of self-styled shareholder activists such as Carl Icahn and Kirk Kerkorian. Their message to corporate boards: Create value or scram.


ISS is answering the call of more investors who agree. In a survey last October, 58% of ISS' clients said long-term financial performance should be a factor in vote recommendations for or against directors. So ISS now evaluates companies' returns on a stand-alone basis over one-, three-, and five-year periods with weightings of 20%, 30%, and 50%, respectively. "Job No. 1 for the board of directors is to produce returns for shareholders," says ISS special counsel Patrick McGurn.

ISS says its clients' focus is shifting to companies' performance in part because so much progress has been made on many corporate governance fronts during the past five years. ISS is targeting only the worst performers, and even then the financial results aren't examined in a vacuum. ISS says it won't ding CEOs who are new or appear to be taking substantial actions to correct matters.

Yet the definition of sufficient corrective action is fuzzy. In Fifth Third's case, ISS said the bank lacks a "demonstrated turnaround strategy." But in 2005, Fifth Third added 63 banking centers and increased its salesforce by 1,400 positions.

Some analysts worry that ISS is overstepping its expertise by making tough calls on performance. On Mar. 16, Richard X. Bove of investment bank Punk Ziegel & Co. fired off a research note calling ISS' advice "totally inappropriate" and pointing out that Fifth Third's assets have increased tenfold since Schaefer took over in 1990. Nell Minow, a former president of ISS who now runs governance researcher The Corporate Library LLC, warns that ISS may create "incentive for earnings manipulation that may not be in the shareholders' long-term interest" -- precisely the sort of activity good governance is supposed to prevent.

ISS argues that Schaefer presided over the erosion of nearly 7% of shareholder value over the last five years. But rival proxy adviser Glass, Lewis & Co. in San Francisco is advising clients to reelect Schaefer in part because Fifth Third has outperformed the S&P 500, with less volatility, over 10 years. "Who wouldn't like a stock that has returned 10% annually to shareholders over 10 years with very little volatility?" wonders Glass Lewis Chief Executive Gregory P. Taxin.

Schaefer will learn the answer at the bank's annual meeting. Meanwhile, ISS estimates that CEOs of as many as 70 other companies it evaluates may be on the hot seat this year. Expect sparks.

By Emily Thornton

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