To understand the risks in CEO transitions, the Strategic Communications segment of FTI Consulting recently studied the impact of CEO transitions on enterprise value. FTI Consulting also surveyed members of the financial community to learn how CEO changes affect their investment decisions, expectations and performance guidelines.

CEO transitions are far from rare. Among companies with market capitalizations in excess of $10 billion, nearly a third (31%) announced a CEO transition between July 1, 2007 and June 30, 2010. Among these transitions, 43% were unplanned. In all, the FTI Consulting study evaluated 263 CEO transitions across companies based in 35 countries.

The study also found that the reputation of a CEO is a critical factor in investor decisions to buy or sell a company’s shares. In fact, on average nearly a third of investment decisions are based on perception of the CEO. As a result, leadership transitions put a significant portion of the investment decision at risk as opinions of the new leader are formed.

Knowledge of the industry dynamics and a firm grasp of the company’s challenges and opportunities are crucial for new CEOs, according to investors. However, investors generally grant new CEOs a six-month “honeymoon” to set the vision and strategy for the company while establishing appropriate expectations for key stakeholders. Once this honeymoon period has ended, investors expect CEOs to begin delivering on their strategy.

How investors assess new CEOs

The reputation of a new CEO matters to investors. According to the study, investors indicated that nearly a third (32%) of their investment decision, on average, is based on perception of the CEO (see chart below).

In addition, when asked to name the key factors affecting an organization’s reputation in the investment community, CEO reputation was among the top six factors cited. That was nearly on par with the company’s historical reputation itself and more important than the brand equity of a company’s products and services.

When CEOs change, investors are more than twice as likely to sell shares in a company as they are to buy them. All things being equal, nearly 40% of investors said they would sell a stock solely on the basis of the new CEO, the FTI Consulting survey found, while only 15% said they would buy the stock on the same basis.

Not surprisingly, when a CEO transition occurs, investors will perform due diligence on the new CEO’s qualifications. Their perceptions will be based primarily on the CEO’s track record, which is by far the single most important factor that investors use to evaluate a new CEO (see chart, opposite page).

However, investors are also mindful of the circumstances surrounding a CEO’s departure. Essentially, with greater surprise comes greater value at risk. For this reason, planned successions present the lowest risk (see chart, page 62) and can even have a positive impact on stock prices at the time of the announcement.

While much attention is paid to the market reaction to the announcement of a CEO change, in reality the months that follow present an even greater period of risk — and reward — with a higher potential for both value destruction and value creation. The outcome depends, in part, on how well the new CEO sets the agenda and manages the transition.

As stated above, investors are generally willing to grant new CEOs a six-month honeymoon. This honeymoon, handled well, can buy the CEO time and maintain the company’s value. But handled poorly, this period may lead to serious risk to both the company’s value and the CEO’s reputation.

For example, in late 2010, after Leo Apotheker became CEO of Hewlett-Packard, he failed to establish a clear strategy. Some nine months into his term, HP confused the market by first discontinuing its TouchPad line of mobile tablets, then selling them at a deep discount, and then restarting production. At about the same time, Apotheker said HP might sell its profitable PC division, then said it might not after all. Investors reacted by dropping the price of HP shares some 20% on a single day of trading in August 2011, erasing about $12 billion in market value and leaving the company’s stock near six-year lows. (By
comparison, the S&P 500 that day closed at 1,123.52, down 17.12, or 1.5%.) Including earlier share price declines under Apotheker’s leadership, HP’s stock had lost more than 45% of its value. In September 2011, Apotheker was dismissed from the company.

Once a CEO’s honeymoon ends, he or she must quickly begin to deliver on the new strategy and performance goals. During this period, investors seek evidence of successful execution of the strategy. This should not be confused with financial performance per se, which most investors expect will take at least 12 months to see traction. When a CEO handles this execution period well, the company’s stock value tends to increase; when handled poorly, the company’s value — and the CEO’s career — may suffer.

At Yahoo! Inc., Carol Bartz’s nearly threeyear term as CEO provides an example of the latter. Bartz started with a splash in early 2009, bringing an impressive agenda for a corporate turnaround. Then, during her first six months, she upended Yahoo!’s organizational structure, replaced executives, cut costs and laid off 5% of the workforce. Industry analysts and investors were impressed; the moves, they said, were just what Yahoo! needed. But when the honeymoon ended, Bartz failed to deliver the promised turnaround. In September 2011, less than three years into her reign, Bartz was replaced as CEO; three days later,
she also resigned from the board.

A road map for CEO transition

Given the impact of CEO transitions on enterprise value, companies should take concrete steps to prepare for and carefully manage leadership change.

CEO succession planning helps reduce the surprise of a transition and should be an integral part of any company’s preparation for leadership change. However, it must be accompanied with and informed by a robust due diligence on all CEO candidates. In addition, having a deep knowledge of stakeholder opinions on the company, its strategy and competitive position can help to align board decisions with stakeholder expectations, permissions and needs. This can be particularly helpful in addressing the ongoing risk inherent in transitions involving fraud, regulatory investigations, strategic transformations, bankruptcies and restructuring.

Equally important, new CEOs must align their organizations to respond to change by setting the vision and strategy, establishing the appropriate expectations across stakeholder groups, and then engaging with stakeholders through new and diverse communications channels. The study found that six months after the start of the new CEO, stock performance often reversed from the knee-jerk euphoria or disenchantment at the time is critical, 80% of new CEOs have no prior CEO experience. Therefore, there is often minimal publicly accessible independent information of past performance available. For internal candidates, the board and management team can address this paradox by showcasing the depth and breadth of the management bench (and one or more potential successors). This increased level of exposure and positioning can be instrumental in managing unplanned transitions.

Apple Inc. provides a case in point. CEO Steve Jobs’s surprising resignation for health reasons, in August 2011, could have been perilous for the company’s stock. Never before, it seemed, had any company been so closely associated with its top executive. Yet on the day of Jobs’s resignation, Apple’s stock price dropped by only 5% in afterhours trading. This relatively small change resulted from several factors: Apple had announced a succession plan more than two years earlier; Jobs had previously revealed his illness to the general public; and Jobs’s heir apparent, Timothy Cook, was well known and well liked by key stakeholders.

As a result, even the shock of Jobs’s death mere weeks later was quickly absorbed by investors.

Of course, it is not enough for a board to simply name a CEO candidate. The board must also perform due diligence, ensuring that the candidate possesses the qualities investors and other stakeholders seek. In this way, the board helps protect share value.

How do investors assess a CEO? Mainly, they expect a positive track record of past execution, as well as some industry experience. In the FTI Consulting survey, industry experience was identified by nearly 20% of investors as a key factor shaping their initial opinion of a CEO.

Apple again provides a good example. Cook, successor to Jobs and now the company’s CEO, had earned a solid reputation for both execution and industry experience during his 14 years of working for Apple. As the company’s COO, Cook had outsourced much of Apple’s manufacturing, improving the company’s margins. Also, because Cook is an Apple insider, he knows the company’s business and industry, and this smoothed the transition after Jobs’s surprising resignation.

Yet industry outsiders can succeed too, as long as they can demonstrate an understanding of the company’s situation and a relevant track record of execution. For example, Alan Mulally has successfully led Ford Motor Co. despite his lack of prior experience in the auto industry. Mulally became Ford’s president and CEO in late 2006; he had previously served as CEO of Boeing Commercial Airplanes. Under Mulally’s leadership, Ford — which had lost tens of billions of dollars during the recent recession — has posted eight consecutive quarters of net profits. Ford is also the only one of the Big 3 U.S. car companies to have avoided a government-sponsored bankruptcy.Investors, as part of their due diligence on a new CEO, will seek insights from a broad range of information sources, including internal and external stakeholders, both past and present. In particular, the FTI Consulting study found that customers, partners and the candidate’s former colleagues were the sources that most influenced investors’ opinions of new CEOs. In addition, investors will look to the board for reassurance that the candidate’s management approach is likely to be in harmony with the company’s situation and overall approach. Accordingly, companies should leverage perception studies and anecdotal evidence to better understand the stakeholders’ views on a CEO candidate. For the new CEO. During the first six months in office, a new CEO should be dedicated to articulating a new vision and strategy, establishing appropriate expectations and managing internal talent. Investors, in their initial interactions with a new CEO, will be watching to see how well the CEO takes command. It is no longer sufficient to serve as a command and control executive. Instead, investors are looking more for “hard” attributes — including a grasp of the company’s situation and plans for the future — than for “soft” ones, such as leadership style, charisma and personality.

During the CEO’s second six months, investors expect to see evidence that the strategy is being executed successfully (see chart below). To stay ahead of investor expectations, a CEO should carefully set the expectations against which he or she wants to be measured. Then the CEO can begin to meet stated financial objectives, improve the company’s financial performance, and boost market performance and valuation over the ensuing 12 months, which is in line with investor expectations. Also, in evaluating performance success, the study reinforced the principle that the investment community values metrics associated with stewardship of capital and cash flow, such as return on invested capital and free cash flow, far more than bottom-line metrics such as earnings per share and net income.

The high value of good communication

For a new CEO, communicating effectively with all stakeholders is critical to managing risk and its impact on a company’s enterprise value. While communications are important at any time of major change, they are especially vital during a CEO transition.

How to communicate effectively? New CEOs should begin by listening to the market. For example, CEOs can conduct research to gauge perceptions and test company messaging. This can help them identify any gaps between what the company says and what its stakeholders actually hear. New CEOs also need to have a well-honed corporate narrative to tell the company’s new story. To achieve this, a CEO should develop a comprehensive communications strategy that is linked closely to his or her vision and strategy. This may involve the development of appropriate messages and channels for different groups, according to what will best reach and persuade them. For example, at The Coca-Cola Co., CEO Muhtar Kent has made a point of communicating his strategy and other changes through new channels to better engage with the company’s workforce, especially those based outside its headquarters. Kent does so, in part, by conducting town halls at bottling facilities and sending text messages to workers’ mobile phones, as many employees of Coca-Cola cannot readily access e-mail, video or other means of communication during the workday.

Also, while many companies focus their communications efforts on the media, the FTI Consulting survey indicates that it is not a terribly influential constituency for investors. When investors were asked for the key external source shaping their opinion of a company, only 27% named the media, far less important than those much better placed to judge the capabilities of an executive, such as customers, business partners and former colleagues (see chart, opposite page).

Call to Action

Because CEO transitions create a potential risk for enterprise value, all companies should make CEO succession planning an integral part of their riskmitigation strategy. At the same time, companies should be aware that CEO succession planning cannot take into account all factors that affect stock value.

When announcing a CEO succession plan, the board should also emphasize the CEO candidate’s track record of execution. Again, this track record is by far the most important factor for investors. Industry experience and personal reputation are a distant second and third.

Once the new CEO is in place, he or she should align the organization by communicating with stakeholders, establishing credibility and setting reasonable expectations among stakeholders.

To protect share value, all companies should remember that surprises increase risk. Therefore, boards should strive to create CEO transitions that are both smooth and well thought out. A CEO’s planned retirement, for example, involves far less risk than a forced resignation. But even when a CEO transition hurts the stock price in the short term, the right management initiatives later can often restore value over the long term.

The Push and the Pull

Today, European corporations find themselves at a crossroads. Governments and commissions are pushing organizations to diversify the gender composition of their boards by adding more female directors. This regulatory push has created some momentum toward diversification.

Corporations in Europe and elsewhere also have access to studies showing that companies with gender diversity on their boards typically outperform their competitors in terms of profitability and good-governance performance. This knowledge constitutes a pull that adds to the diversification movement.

And yet, despite the combined force of these powerful push and pull motivators, gender diversification still is moving far too slowly in many countries. Consider the situation in the United Kingdom. The annual Cranfield University Female FTSE Board Report for 2010 noted an incremental increase of just three additional women on FTSE 100 Index boards over the prior year, a change it called “barely perceptible.”

The Nordic Way

Thus far, authorities in the United Kingdom have chosen persuasion over regulation in their efforts to encourage board diversity, but regulators and political leaders in other parts of Europe have not trodden so lightly.

Norway led the pack with its 2002 mandate stating that at least 40% of the seats on public boards be held by women. State-owned enterprises had four years to comply, while other companies were given until 2008. The mandate has been met. Today, women constitute just over 40% of Norwegian board directors, according to 2010 data from Corporate Women Directors International (CWDI). Norway is the clear frontrunner when it comes to gender diversification at the board level, but other Scandinavian countries also have made impressive strides in this direction. The same CWDI report shows that Sweden (21.9%) and
Finland (16.8%) both are ahead of the United Kingdom in terms of female representation on corporate boards.

These changes are only the tip of the iceberg. Several other European nations, including Spain and France, have passed laws that mandate 40% female board composition for large, public companies within the next four to six years. Additional countries, such as Iceland, Denmark and Ireland, have also passed quotas, with the Netherlands and Italy considering doing the same.

Is the United Kingdom also headed toward a quota system? For now it appears that U.K. regulators prefer to rely on more gentle pressure. As a case in point, the Consultation Document: Gender Diversity on Boards was introduced in May by the Financial Reporting Council (FRC). For the first time, the FRC included a principle recognizing the value of diversity in the corporate boardroom.

The principle states that “the search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender.”

Outside observers might view such pronouncements skeptically since they do not have the force of actual law, but the United Kingdom has a strongly ingrained corporate culture of “Comply or Explain.” The FRC notes that both U.K. companies and their shareholders have broadly accepted the notion that corporations should comply with FRC codes or explain transparently and convincingly how the alternate path they have chosen constitutes good governance.

More Women, Better Governance

Of course, the assertion that having more women on a board really does represent good governance lies at the crux of the push for greater female board representation. Policy-makers certainly believe that having more women on a board is good for a company’s bottom line. “The business case for increasing the number of women on corporate boards is clear,” wrote Lord Davies in his Women on Boards report, commissioned by the British government and published this past February. “When women are so under-represented on corporate boards, companies are missing out, as they are unable to draw from the widest range of possible talent. Evidence suggests that companies with a strong female representation at board and top management level perform better than those without and that gender-diverse boards have a positive impact on performance.”

In making these claims, Davies cited a 2010 McKinsey & Company report called Women Matter that shows companies with the most women on their executive boards outperformed their sector competitors with all-male boards by sizable margins. Looking at data from 2007 to 2009, McKinsey found that the most gender-diverse boards surpassed their competitors by 41% in terms of average return on equity while achieving 56% higher EBIT margins.

The McKinsey study is not an outlier. Other research findings support the notion that women can make a strong, positive contribution in leadership positions. In 2001, a researcher from Pepperdine University in California analyzed 19 years of data (1980 to 1998) and concluded that the 25 Fortune 500 firms with the best record of promoting women to the executive suite were 18% to 69% more profitable than the median Fortune 500 firms in their industries (Adler, Roy D. “Women in the Executive Suite Correlate to High Profits” [European Project on Equal Pay]).

How can we explain the performance gaps in favor of companies with greater gender diversity on the board? Perhaps diversity has some inherent benefits at the board level. Naturally there are many criteria that make someone a good board candidate. Intelligence, accomplishments, capabilities, skills, credentials — these all go into the assessment of a board candidate, but we should not ignore the attributes a candidate brings to the boardroom by virtue of his or her background and personal experience.

When you have 10 men in a room who all have similar backgrounds, experiences and formative influences, their viewpoints and opinions often will be less varied than when people from a range of backgrounds with different experiences and ways of thinking are thrown into the mix.

A case in point: One of the U.K. boards on which I serve has an Italian director, a French director, two American women, a German director and a British chairman. As we look at vital strategic issues, we all come at the problem from slightly different ways, which frequently provokes a healthy and productive debate.

Having women on the board is in some ways a proxy for saying that we want people with different experiences on the board. It is an indisputable fact that most women in the United Kingdom who have achieved corporate success have done so by taking a path somewhat different from that of their male counterparts.

When the Financial Services Authority (FSA) conducts its ARROW governance reviews, it checks diligently to make sure there is an appropriate amount of challenge occurring at that board level. If we look at the big governance failures from the last decade — for example, the Royal Bank of Scotland — we see governance nightmares and homogenous boards dominated by the CEO. Board diversity might have led to more challenge and risk evaluation.

Having a diverse board prone to lively and spirited debate is not an ironclad guarantee against fraud and mismanagement, but it certainly can help from a risk-management standpoint. The Conference Board of Canada recognized this fact nine years ago with a report drawing a link between female board membership and good-governance credentials. The report found that boards with higher female representation tended to pay more attention to audits and risk oversight. Boards with three or more women turned out to be far more likely (94%) to insist on conflict-of-interest guidelines than all-male boards (58%). And nearly three-quarters of boards with two or more women directors conducted formal board performance evaluations, compared with less than half of their all-male counterparts.

Quotas: Necessary or Not?

At the moment, a majority of both political and business leaders in the United Kingdom seem to favor the current approach of using recommendations and exhortations to build the momentum toward greater female participation on executive boards. The Davies report urged FTSE 100 companies to strive for
at least 25% female board member representation by 2015.

But is this goal realistic? Even Davies had to acknowledge that 18% of the FTSE 100 companies and nearly half of the FTSE 250 companies do not have a single woman in the boardroom. Given the apparently glacial pace of progress toward diversification of FTSE 100 boards, can top U.K. companies possibly double the number of female board members in just five years? Would not hard quotas such as those employed in Norway be a more reliable way of achieving the desired goal of more equitable, diverse and effective boards?

I believe the current path is the right one and that quotas are not necessary. Even without quotas, the Fortune 500 companies in the United States have achieved a higher rate of female board member representation (15.2%) than many of their European counterparts (CDWI 2010 Report: Accelerating Board Diversity).

British business leaders already have shown their capacity and willingness to rise to the occasion and take the necessary bold actions. For example, Sir Win Bischoff of Lloyds Banking Group and Sir Roger Carr of Centrica have led the creation of the 30% Club, a group of chairmen from some of the leading British corporations who have promised to use cross-company mentoring programs, industry forums and political debate to keep the topic of board diversification front and center.

As the name of the group boldly proclaims, the 30% Club hopes to surpass the 25% standard set by the Davies report and rally FTSE 100 businesses to achieve 30% female representation on executive boards.

There are indications that this approach is starting to gain traction. A recent article in The Independent newspaper noted that just the threat of quotas implied in the Davies report had caused a major jump in the number of women hired as nonexecutive directors to FTSE 100 companies (“Boards Double Number of Women Members,” The Independent, May 29, 2011). The paper found that 23% of all new nonexecutive board appointments in the previous six months had been filled by women, a staggering increase from 2010, when less than 10% of such appointments went to female candidates.

The article also notes that French companies are on a similar path, with a 38% rise in the number of nonexecutive board appointments between 2008 and 2010. Surely that trend will only accelerate, since France passed a bill in January that calls for 40% female board membership by 2016 for listed companies, companies that have more than 500 employees or companies with a turnover of more than €500 million.

Take the Carrot or Get the Stick

Guidelines may be preferable to quotas, but if businesses in the United Kingdom and the rest of Europe do not move in the direction of diversifying their boards, these countries soon may find themselves facing them. Lord Davies has said, “I won’t be recommending quotas to the government, as the best solution is one of natural evolution. But if companies don’t take a radical change in attitude and hire more women at the top, then we will have to introduce quotas.”

This sentiment was amplified by EU Justice Commissioner Viviane Reding. In March, Reding challenged publicly listed European companies to sign a pledge representing their commitment to increasing the percentage of women leaders on their boards to 30% by 2015 and 40% by 2020.

Reding warned companies that her committee would be evaluating their progress toward the inclusion of women in executive decision making. “If this has happened by March 2012, I will congratulate the European business world,” she said. “If it has not happened, you can count on my regulatory creativity.”

Whether by carrot or by stick, it seems as though Europe is destined to move toward gender parity on corporate boards. The question for U.K. firms is whether they want to reap the advantages of being in the vanguard of this movement. I believe they should join the wave now rather than get caught later in an ugly
undertow of mandates and quotas.

The shift in power from management to shareholders is inexorable and, most recently, has been furthered by the 2010 Dodd-Frank Act. The era of the proxy process as an annual rubber-stamping ritual of a company’s policies and actions has passed. Investor actions on a myriad of issues such as Say on Pay (SOP) and Say on Frequency (SOF) are growing.

Investor concerns aren’t seasonal. Trying to influence or change investor votes during proxy season is risky at best. It is too late in the game to capture investors’ attention and change their minds. Companies need to engage shareholders systematically throughout the year to understand and address their concerns.

Companies May Have Gotten a Break in 2011

By many broad measures, it might seem as though the 2011 proxy season passed without the storms that SOP and SOF votes threatened. Most executive pay plans were approved, even the majority of plans that received negative recommendations from proxy advisers. According to the global law firm Latham & Watkins, only 2% of the companies that filed proxy statements by June 23, 2011, failed SOP votes — 71% of the Russell 3000 secured more than 90% approval.

However, the 2011 proxy season may not have fully reflected the depth of investor sentiment and the pressure that investors will continue to apply. Research conducted by FTI Consulting (“What Are Investors Saying About Say-On-Pay?” February 2011) found that investors viewed SOP votes as more than an issue of pay. Many saw SOP as a referendum on company and executive performance and a forum to air their displeasure. This past year, investors had to digest thousands of compensation packages. We suspect that they didn’t have sufficient time to fully digest the implications of SOP and SOF. Nevertheless, their strong preference for annual SOP votes clearly indicates a desire to keep management on a tight leash. We expect investors to keep leveraging their newly acquired rights — and for them to be better prepared to do so in the future.

Companies were not sufficiently prepared for SOP and SOF votes either. Many were surprised by shareholder pushback and negative recommendations from the proxy advisory firms. A key factor in the negative recommendations was a disconnect between compensation and performance as measured by total shareholder return. A prominent financial services company, for example, received a recommendation against the chief executive’s pay. Although it finally passed, it did so with less than 60% of the vote. And three other management recommendations (of eight) were thwarted.

Other companies with negative recommendations passed the vote. But average support was only 72% vs. 92% for those with a favorable recommendation. Companies with pay/performance disconnects and subpar shareholder support (70% is generally regarded as the inflection point) are essentially “on notice.” Support for their SOP votes could erode next year if management doesn’t discover and remedy the issues.

It is important to note that although SOP and SOF votes are “advisory,” they have teeth. Their influence extends into boardrooms and legal domains. Negative investor sentiment on SOP can be directed at compensation committee directors. To wit, at companies where SOP votes failed, these members garnered an average of 13.5% fewer votes than other directors on the ballot. Furthermore, losing a vote on pay can expose a company to damaging litigation. Four companies that failed to secure SOP approval had shareholder derivative lawsuits filed against them, alleging breach of fiduciary duty and corporate waste.

More Investor Concerns Are Brewing

Historically, strong recoveries following recessions have generally produced a calming of the public mood and dissipation of the rancor previously targeted at those institutions perceived to be poor corporate citizens. Given the muted economic recovery, corporate performance may not sustain its current pace, fracturing business confidence and undermining shareholder returns. Public angst, represented by the Occupy Wall Street protests, along with regulatory agency actions and government legislation, may continue to influence investors and drive demands for more influence over corporate affairs.

Some areas to watch

Oversight of Political Spending. Support for disclosure and oversight of corporate political spending is surging on the heels of the 2010 U.S. Supreme Court Citizens United decision. While a high-profile proposal at Home Depot was soundly defeated, a corporate political disclosure and accountability resolution captured a majority vote — at Sprint Nextel the resolution passed with 53% of votes cast. Close on these heels, resolutions from the U.S.-based Center for Political Accountability, which requires companies to divulge details of their political contributions, gained more than 40% of the vote at the annual meetings of four more companies.

Proposals concerning the oversight of political spending are multiplying, and support for them is rising:

• In the first half of 2011, according to Institutional Shareholder Services, shareholders filed 78 proposals seeking disclosure and oversight of corporate political spending, up from 48 during the first half of 2010.
• According to the Council of Institutional Investors, the average support for the 39 proposals that came to vote as of June 2, 2011, was 31%. Six years ago it was 9%.

Proxy Access
While not enacted as planned by the Securities and Exchange Commission, proxy access is back. Companies will have to allow shareholders to submit proposals requesting that the board implement proxy access or that the company’s bylaws be amended to implement proxy access.

The consequences are difficult to anticipate. It is likely that some companies will be targeted by investors in 2012, particularly poorly performing ones with long-standing governance issues or those with weak or shareholder-unfriendly boards. The chairman of the SEC supports broad-based proxy access, so there might be further developments.

For most companies the window for shareholder proposals opens in November. The next few months should provide some visibility into whether activists will avail themselves of this opportunity. Given the time lines for distributing proxy materials, managements will not have much time to evaluate and craft responses to these proposals. Companies that might be vulnerable should preempt the situation — they should start the process early and be prepared to respond if necessary.

Environmental Sustainability Measures
Investor concerns over corporate responsibility and the environment have been nascent for some time. It is difficult to know when an idea reaches an inflection point and becomes front and center, but these topics may have already done so:

• A record 109 proposals were filed with 81 companies in the United States and Canada during the 2011 proxy season.
• Ernst & Young reported that corporate social responsibility proposals grew to 40% of all shareholder proposals in 2011, vs. 30% in 2010.

Other issues on our watch list include:

• Shareholder actions by written consent
• Shareholder power to call special meetings
• Forthcoming SEC regulations on the ratio of CEO pay to median employee wages (which are strongly supported by the public sector, unions and socially responsible investors)

Although shareholder proposals on these topics are generally rejected, a few have passed and may be indicative of growing support. We expect that more will pass.

Many corporate governance protocols being implemented in the United States, such as SOP, were adopted in Europe years ago. Companies should be attuned to developments in the European Union. The United Kingdom is instituting the Stewardship Code, requiring institutional investors to attest to their responsibility for the companies in which they invest. A key provision of the Corporate Governance Code requires annual re-election of all directors. Gender balance on boards is being debated, and the European Commission is examining how corporate governance overall can be improved.

Keeping Shareholders onBoard

It’s essential that companies engage shareholders throughout the year to address concerns. Ongoing engagement can yield dramatic improvements to a company’s credibility with investors, as the Dow Chemical Co. experienced between 2008 and 2011.

Dow was hit by a near “perfect storm” of events that shook investor confidence and drove its stock price down 60% from late 2008 to the market bottom in early 2009. Immediately upon Dow’s commitment to the large and transformational acquisition of Rohm & Haas, the global economy plunged, causing uncertainty in the credit markets, unprecedented low demand for chemical products and ultimately the collapse of a $17.4 billion joint venture in Kuwait just 48 hours before its expected close.

To rebuild investor confidence and build support for the transformation story, Dow launched an investor engagement program. Milestones for execution were laid out, and as each one was met, Dow communicated to investors that it was following through on its near-term strategic objectives and executing ahead of schedule. As performance strengthened, the company expanded its dialogue with investors and the media to include the more innovative aspects of the company’s transformation and to highlight the growing investment and value of its R&D portfolio, which long-term would play a major role in the company’s transformation. To ensure that Dow’s message was resonating with investors, the investor relations team regularly measured the impact of its communications on different stakeholder groups and refined the message when needed. The team also provided greater transparency through more detailed operating information, access to more of the company’s leadership and use of more pervasive, digital communications methods. Dow ultimately succeeded in restoring investor confidence — its stock price recouped the losses of late 2008, and 87% of Dow’s shareholders approved of the company’s executive compensation, a strong endorsement.

Few companies manage investor sentiment as well as this, and yet many could easily do much better. In our experience, companies that build investor confidence and manage their concerns follow these practices and recommendations:

Understand the Company’s Points of Vulnerability

The 2011 proxy season provided a number of indicators of what investors view as good practices regarding compensation. Highly desired: transparent disclosure of how compensation is determined, performance-based compensation and longer vesting periods. Large severance payments and “golden parachutes” are objectionable (McCahery and Suatner, Tilberg University research paper). Ahead of the next proxy season, companies should analyze their compensation plans to identify disconnects between pay and performance and identify best practices.

Understand the Composition and Sentiment of the Shareholder Base
It is critical to know which shareholders are influenced by proxy advisers. Companies should target new shareholders who have a history of filing proposals or who take social issues into account when investing; in particular investor classes most likely to take their governance grievances public, such as socially responsible investors; activists; foundations; faith-based organizations; special interest groups; and state, municipal and union pension funds. Companies can also revisit the 2011 votes to identify the active shareholders and determine where the company’s responses were weak.

Work with the proxy advisers
If a company received a negative recommendation on SOP from the proxy advisers, it should consider engaging with them during the off-season to make its case. Companies subjected to inappropriate peer group comparisons, incorrect compensation calculations or any other inaccuracy should attempt to resolve the issues. An early resolution or correction is less stressful than tackling the issue during proxy season.

Engage Shareholders
Companies should engage shareholders and stimulate a dialogue on policy changes and the reasons driving them. Management should put mechanisms in place to hear investor concerns and respond with communications that explain decisions and demonstrate that it listens to investors. If shareholder sentiment on an issue is strong and broad-based, management should consider changing policy.

It is important to know how shareholders evaluate performance. In our research we have found that investors prefer measures related to value creation and executive stewardship, such as return on invested capital and free cash flow generation. They are less interested in earnings per share or overall growth statistics. This may not apply to all shareholder bases, but it pays to ask the question.

Shareholders have spoken. They want to vote on SOP every year. As proxy season approaches, companies need to articulate their compensation strategy and how pay is determined. The proxy is the selling document. It should present the case completely to avoid additional filings. Supplementary filings can be perceived as evidence of shareholder resistance.

Be Prepared

Proxy season is not the beginning and end of a company’s engagement with its shareholders. It is a point in time that reflects the effectiveness of management’s relationship with its investors.

Even now shareholder advocates are working to exploit the shifting balance of power and taking on more corporate governance issues. They are using the off-season to shape the discussions and air their side of the debate. If companies wait until the 2012 proxy season to air their positions, they could very well find themselves scrambling to respond to concerns that have been festering for months.

“Our survey respondents have a front-row seat to the increased scrutiny brought on by stricter regulatory enforcement,” says Stephen Dillard, head of Fulbright’s global disputes
practice. When times are tough, companies sue to recoup money owed them and laid-off employees seek redress. In the United States, and for larger multinationals in particular, intellectual property and patent litigation also were high on respondents’ radar.

Regulatory action, too, seems to be waxing, with 28% of respondents expecting such suits to increase this year. “Businesses are operating in a global climate of intense scrutiny and significant enforcement. Companies are handling increasing numbers of internal investigations and regulatory proceedings, often as a result of whistle-blowing allegations,” says Lista M. Cannon, managing partner of Fulbright’s London office and co-chair of the firm’s International Investigations practice.

In another sign of greater regulatory scrutiny, securities suit filings in the United States are on track to set a new record this year, according to Advisen Ltd.’s firstquarter report on securities litigation. “The credit crisis was a watershed event in this arena,” says John Molka III, the report’s author. “The easing of the credit crisis, however, hasn’t resulted in fewer securities suits being filed. The elevated level of filings in 2010 and 2011 may represent a ‘new normal.’”

As the litigation landscape continues to sort itself out, company executives need to be ready to head off an even more litigious future. Here are some flash points.

Host Countries Are Stepping Up Enforcement

Even in the developing world, once known for lax rules, many nations are increasing regulatory actions involving export controls, customs, labor and employment rules, data privacy and antibribery regulations. Hot spots of international regulatory risk include China, Mexico, Southwest Asia, United Arab Emirates, West Africa and Western Europe.

The U.K. Bribery Act Is Making Itself Felt

April 2010 saw the enforcement of the Anti-Bribery Reform Law and a sharp spike in U.K. companies hiring outside counsel to help with internal investigations. This year the percentage of companies doing so has declined.

Contracts Continue to spark disputes

In the Fulbright & Jaworski survey, more than 40% of U.S. companies and more than half of those in the United Kingdom faced pending legal action related to contracts in 2011. In the United Kingdom, contracts sparked the highest number of suits, whereas labor and employment posed a larger problem in the United States.

In Japan, Securities Suits Are Also on the Rise

Various types of claims have been increasing steadily since 2004, when Japan revised its Securities and Exchange Law. One notable crossborder case involved Toyota Motor Corporation’s U.S. shareholders, who filed a class action suit alleging that the company’s insufficient disclosure of risk related to widespread vehicle recalls was a “misstatement” — a kind of claim more likely to lead to damages under the revised securities statute.

Regulators Increase Scrutiny

More companies are finding themselves the targets of regulatory investigations by a wide range of government agencies in both the United States and the United Kingdom. Some 40% of respondents had attracted government attention, up from 37% in 2010. Approximately 50% of the insurance, energy, healthcare and manufacturing sectors have had at least one regulatory proceeding commenced against them.