florida sba 2009 corporate governance annual report

20092009NE W CONSEQUENCE M ACHINE C O R P O R A T E

G O V E R N A N C Eannual report

SBAABOUT THE FLORIDA STATE BOARD OF ADMINISTRATION (SBA)THE STATUTORY MISSION OF THE STATE BOARD OF ADMINISTRATION (SBA) IS TO INVEST, MANAGE AND SAFEGUARD ASSETS OF THE FLORIDA RETIREMENT SYSTEM (FRS) TRUST FUND AND A VARIETY OF OTHER FUNDS FOR STATE AND LOCAL GOVERNMENTS. FRS TRUSTEES ARE DEDICATED TO ENSURING THAT THE SBA INVESTS ASSETS AND DISCHARGES ITS DUTIES IN ACCORDANCE WITH FLORIDA LAW, GUIDED BY STRICT POLICIES AND A CODE OF ETHICS TO ENSURE INTEGRITY, PRUDENT RISK MANAGEMENT AND TOP-TIER PERFORMANCE. THE SBA IS AN INVESTMENT FIDUCIARY UNDER LAW AND SUBJECT TO THE STRIN-GENT FIDUCIARY DUTIES AND STANDARDS OF CARE DEFINED BY THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 (ERISA), AS INCORPORATED INTO FLORIDA LAW. THE SBA HAS THREE TRUSTEES: THE GOVERNOR, AS CHAIRMAN, THE CHIEF FINANCIAL OFFICER, AS TREASURER, AND THE ATTORNEY GENERAL, AS SECRETARY.

THE 2009 CORPORATE GOVERNANCE ANNUAL REPORT DETAILS THE PROXY VOTING AND GOVERNANCE ACTIVITIES OF THE FLORIDA STATE BOARD OF ADMINISTRATION (SBA) DURING THE MOST RECENT FISCAL YEAR.

OUR FIDUCIARY RESPONSIBILITY TO THE FLORIDA RETIREMENT SYSTEM (FRS) AND OTHER MANAGED TRUST FUNDS GOES BEYOND DIRECT INVESTMENT DECISIONS. IT ALSO ENCOMPASSES EFFORTS TO STRENGTHEN THE GOVERNANCE OF COMPANIES IN WHICH WE INVEST. OUR ACTIVE SUPPORT OF

CORPORATE GOVERNANCE REFORMS, PRUDENT VOTING OF COMPANY PROXIES, AND ADOPTION OF INVESTMENT PROTECTION PRINCIPLES DEMONSTRATES OUR COMMITMENT TO THE HIGHEST ETHICAL STANDARDS AND PRACTICES. ULTIMATELY, WE ADHERE TO THE PHILOSOPHY THAT CORPORATE

GOVERNANCE PLAYS AN IMPORTANT ROLE IN ENHANCING OUR FINANCIAL OBJECTIVES AS A LONG-TERM INVESTOR.

A [ C O N T E N T S ]004

I N T R O D U C T I O N

C O R P O R A T E G O V E R N A N C E A C T I V I T I E S

P R O X Y V O T I N G : P O L I C I E S & R E S O U R C E S

V O T I N G S U M M A R Y

M U T U A L F U N D P R O X Y V O T I N G

S H A R E O W N E R A C T I V I S M

B E N C H M A R K I N G SBA P R O X Y V O T I N G

O V E R V I E W O F T H E 2008 P R O X Y S E A S O N

A L O O K B A C K , F O R W A R D , A N D B E Y O N D

017T R E N D S I N B O A R D G O V E R N A N C E

021S E C T I O N 162( M ) / U S I N G T H E T A X C O D E T O M O N I T O R

E X E C U T I V E C O M P E N S A T I O N P L A N S

A N A L Y T I C A L A P P R O A C H E S T O E X E C U T I V E C O M P E N S A T I O N

O V E R V I E W O F S E C T I O N 162( M )C R I T I Q U E S O F S E C T I O N 162( M )

R E A S O N S F O R S H A R E E O W N E R V I G I L A N C E

S A M P L E S O F P E R F O R M A N C E - B A S E D P R O X Y D I S C L O S U R E

034C O R P O R A T E G O V E R N A N C E A N D P O R T F O L I O R E T U R N S

G U E S T C O M M E N T A R Y O F A A R O N B E R N S T E I N

041S O V E R E I G N W E A L T H F U N D S (SWF’ S )

G L O B A L C O D E S O F B E S T P R A C T I C E

IMF P R I N C I P L E S

OECD P R I N C I P L E S

W H O , W H A T , A N D W H E R E ?C O R P O R A T E G O V E R N A N C E I M P L I C A T I O N S

G U E S T C O M M E N T A R Y O F S U B O D H M I S H R A

SWF P U S H B A C K

S O V E R E I G N I N T R U S I O N A N D N A T I O N A L S E C U R I T Y

C O M M I T T E E O N F O R E I G N I N V E S T M E N T I N T H E U.S.C O M P E T I T I V E I N V E S T M E N T L A N D S C A P E

R E C E N T S I G N I F I C A N T T R A N S A C T I O N S

S H A R E O W N E R D I L U T I O N

F I D U C I A R Y R E S P O N S I B L I T Y

066T H E N E W P A R A D I G M O F T H E ‘A L L -P O W E R S ’ B O A R D

G U E S T C O M M E N T A R Y O F D R . A R L E N E A N D E R T

070C A S E A N A L Y S I S O F T H E

2008 TCI/3G V S CSX P R O X Y C O N T E S T

SBA V O T I N G D E C I S I O N S

TCI/3G’ S P R O X Y C O N T E S T A G A I N S T CSXCSX V S . T H E C H I L D R E N ’ S F U N D LLP, E T A L

F A C T O R S S U P P O R T I N G T H E SBA’ S V O T E

CSX A N D TCI/3G’ S P R O X Y S T A T E M E N T S

SBA’ S P R O X Y V O T I N G S E R V I C E S

M E E T I N G S A N D C A L L S

S P L I T T I N G T H E V O T E : T H E SBA D E C I D E S

R A M I F I C A T I O N S O F T H E CSX C O N T E S T

[ A P P E N D I X ]090

C O M P L I A N C E W I T H F L O R I D A S T A T U T E S

091F I S C A L Y E A R 2008 P R O X Y V O T I N G D E T A I L ( B Y I S S U E )

101A C K N O W L E D G E M E N T S

THE SBA’S FIDUCIARY RESPONSIBILITY EXTENDS BEYOND DIRECT INVESTMENT DECISIONS TO INCLUDE CORPORATE GOVERNANCE. THROUGH ACTIVE SUPPORT OF CORPORATE GOVERNANCE

REFORMS AND PRUDENT VOTING OF COMPANY PROXIES, THE SBA WORKS TO ENHANCE SHAREOWNER VALUE AND SUPPORT OUR LONG-TERM INVESTMENT OBJECTIVES.

CORPORATE GOVERNANCE ACTIVITIES The SBA strongly believes in accurate and honest financial

reporting practices by public companies. We support the

adoption of internationally recognized governance practices

for well-managed public companies including independent

boards, transparent board procedures, performance-based

executive compensation, accurate accounting and audit

practices, and policies covering issues such as succession

planning and meaningful shareowner participation. The

SBA also expects companies to adopt rigorous stock

ownership and retention guidelines and to annually seek

shareowner ratification of the external auditors.

In an effort to increase the transparency of its voting

record and voting intentions, the SBA has begun posting

historical and current proxy voting records, as well as other

information about investments and corporate governance

activities on its website [www.sbafla.com]. The effort

goes beyond that of most other institutional and public

investment funds by disclosing votes as they are made and

in advance of the meeting, typically 10 days prior to the

company meeting. Voting information is fully searchable

based on date, calendar range, company name, and SBA

portfolio. Voting data covers every publicly-traded equity

security for which the SBA retains voting authority. The

SBA expects this leadership in the disclosure of its voting

will assist other investor groups challenged with fewer

governance resources and enable them to make more

informed voting decisions.

The SBA also began a partnership with a new nonprofit

project called ProxyDemocracy [www.ProxyDemocracy.org/

data/funds/81] which allows stakeholders to analyze and

even compare the voting decisions of the SBA to those

of a large universe of institutional investors and mutual

funds. The ProxyDemocracy site provides information about

how some institutional investors plan to vote at upcoming

shareowner meetings and provides additional historical

profiles covering the funds’ corporate governance and proxy

voting activities.

As part of the on-going enhancements to public disclosure

the SBA also recently joined RiskMetrics Group’s “Policy

Exchange”, a developing new policy database that allows

interested parties to access and compare the corporate

governance and proxy voting policies across a large and

growing segment of the institutional investor community.

The Policy Exchange features U.S. and international

corporate governance policies and commentary from

leading institutional investors including public pension

systems, and other types of investment organizations. The

Exchange breaks down participants’ U.S. policies into six

issue areas and more than 100 sub-categories, allowing

users to easily compare and contrast the views of various

participants.

PROXY VOTING: POLICIES & RESOURCESThe proxy vote is a fundamental right tied to owning

stock. Pursuant to guidance from the U.S. Department

of Labor, the SBA has a fiduciary responsibility to ensure

proxies are voted in the best interest of fund participants

and beneficiaries. The SBA routinely votes proxies on all

publicly-traded equity securities held within domestic and

internally-managed international stock portfolios. These

portfolios may be managed within either the defined benefit

or defined contribution plans of the Florida Retirement

System (FRS). For omnibus accounts including open-end

mutual funds utilized within the FRS Investment Plan, the

SBA votes proxies on all shares for funds that conduct

annual shareowner meetings.

To ensure that proxies are voted consistently and reliably,

the SBA has developed a comprehensive set of proxy voting

guidelines and procedures. These policies are updated

throughout the year, as needed, and cover a wide range of

financial issues, such as director and auditor independence,

board and capital structures, and the types and level of

executive compensation.

The SBA currently retains four of the leading proxy advisory

and governance research firms: RiskMetrics Group’s

ISS Governance Services, Glass, Lewis & Co., PROXY

Governance, and The Corporate Library. These firms assist

the SBA to analyze individual voting items, monitor boards

of directors, executive compensation levels, and other

significant governance topics.

During the 2008 fiscal year, the SBA continued to use

RiskMetrics Group as our external voting agent. The SBA’s

voting agent executes, reconciles and records all applicable

proxy votes via a web-based database. The SBA utilizes

F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N ( S B A )4

CHART 1: SBA PROXY VOTING STATISTICS(FY ENDING JUNE 30, 2008)

Total Proxies Voted

3,534Total Ballot Items Voted

30,373Total Portfolios Voted

83Distinct Voting Categories

299

F I S C A L Y E A R 2 0 0 8 C O R P O R A T E G O V E R N A N C E R E P O R T 5

SBA FISCAL YEAR 2008 PROXY VOTING STATISTICS

VOTES FOR (ALL BALLOT ITEMS)

73.2%

VOTES AGAINST

(ALL BALLOT ITEMS)

26.0%

ABSTENTION OR “TAKE-NO-ACTION” VOTES

(ALL BALLOT ITEMS)

0.8%

VOTES AGAINST

(MANAGEMENT RECOMMENDED VOTE)

28.2%


three governance research services, in conjunction with

our proxy voting guidelines, in order to execute voting

decisions. ISS Governance Services (ISS), a division of

the RiskMetrics Group, provides specific analysis of proxy

issues and meeting agendas. ISS coverage includes the

Russell 3000 index, which represents approximately

98 percent of the U.S. public equity market, as well as

select coverage of foreign equity proxies. Glass, Lewis &

Company (GLC) research also covers the entire U.S. stock

universe of Russell 3000 companies. The SBA expanded

its subscription to governance research with PROXY

Governance, Inc. (PGI). PGI’s proxy advisories are designed

to add an additional layer of policy review and insight on

U.S. corporate governance issues, through proprietary

executive compensation analytics.

In addition to these three primary research providers, the

SBA subscribes to various specialized services. During

the fiscal year, the SBA continued to utilize corporate

governance research services offered by GovernanceMetrics

International (GMI), The Corporate Library, KLD Research,

and Equilar. From ISS, the SBA receives analysis of

corporate employment activities within Northern Ireland

as well as research tied to the

Protecting Florida’s Investment Act

(PFIA). For additional discussion of

compliance with Florida statutes,

please see the appendix. For more

information on the current roster

of research providers that the SBA

uses, please see the corporate

governance section of our website

at: www.sbafla.com/

VOTING SUMMARYIn the 2008 fiscal year, the SBA executed votes on 3,534

public company proxies covering over 30,373 individual

voting items, including director elections, audit firm

ratification, executive compensation plans, merger approval,

and other management and shareowner proposals. The SBA

voted for, against, or abstain on 73.2 percent, 26.0 percent,

and 0.8 percent of all ballot items, respectively. Of all

votes cast, 28.2 percent were against the management-

recommended vote, up 3 percent from last year.

While the SBA is not pre-disposed to disagree with

management recommendations, we do recognize that some

management recommendations may not be in the best

interests of all shareowners. On behalf of our participants,

we take the fiduciary responsibility to analyze and evaluate

all management recommendations very seriously. We

are particularly attentive to decisions related to: director

elections, executive compensation structure, anti-takeover

measures, and environmental reporting.

Board elections represent one of the most critical areas

in voting since shareowners rely on the board to monitor

management. The SBA supported 74 percent of individual

nominees for boards of directors, voting against the

remaining portion of directors primarily due to concerns

about the candidate’s independence, attendance, or overall

“Always vote for principle, though you may vote alone, and you may cherish the sweetest refl ection that your vote is never lost.”

John Quincy Adams, President of the United States of America (1825 - 1829)

CHART 2: SBA VOTING RELATIVE TO THE MANAGEMENT RECOMMENDED VOTE

0%

20%

40%

60%

80%

100%

2000 2001 2002 2003 2004 2005 2006 2007 2008 Since1995

Approval of AuditorElection of Directors (non-contest)Approve or Amend Omnibus Stock Plan (executive compensation)

0%

20%

40%

60%

80%

100%

2000

2002

2004

2006

2008

Against MRV %With MRV %

CHART 3: SBA PROXY VOTING ON MAJOR BALLOT ITEMS (BY FISCAL YEAR)


board performance. The SBA also withholds votes from

directors who fail to observe good corporate governance

practices or demonstrate a disregard for the interests of

shareowners.

The SBA supported over 98 percent of ballot items to ratify

the board of directors’ selection of external auditor. Votes

against auditor ratification are cast in instances where the

audit firm has demonstrated a failure to provide appropriate

oversight, significant financial restatements have occurred,

or when significant conflicts of interest exist, such as the

provision of outsized non-audit services.

The SBA considers on a case-by-case basis whether

a company’s board has implemented equity-based

compensation plans that are excessive relative to other

peer companies or those that may not have an appropriate

performance orientation. As a part of this analysis, the SBA

reviews the level and quality of a company’s compensation

disclosure in the belief that shareowners are entitled to

comprehensive disclosures of such practices in order to

make efficient investment decisions. Quality disclosure is

found to be severely lacking at many companies, raising hard

questions about the transparency of their compensation

practices. Over the last fiscal year, the SBA supported only

27 percent of all non-salary (equity) compensation items—

while supporting 98 percent of shareowner resolutions

asking companies to adopt an advisory vote on executive

compensation, 55 percent of executive incentive bonus

plans, and 39 percent of management proposals to adopt or

amend restricted stock plans in which company executives

or directors would participate.

Increasingly, the SBA has supported general sustainability

reporting requirements and improved environmental

disclosures. The SBA supported 55 percent of shareowner

resolutions asking companies to publish sustainability

reports, 38 percent of shareowner proposals dealing with

climate change and global warming, and 55 percent of

shareowner resolutions asking companies to produce

reports assessing the impact on local communities.

7

TABLE 1: VOTING RESULTS ON TOP SHAREOWNER PROPOSALS

Number of proposals Support Level (average) YOY % Change in Support

% SBASupportFY 2007

% SBASupportFY 20082005 2006 2007 2008 2005 2006 2007 2008

Require majority vote to elect directors 62 88 46 27 43.7% 48.0% 50.4% 51.2% 0.8% 100.0% 94.6%

Repeal classifi ed board 48 55 41 76 63.2% 66.2% 66.5% 67.5% 1.0% 100.0% 100%

Independent board chairman 29 52 46 26 29.3% 29.8% 26.0% 29.4% 3.4% 100.0% 100%

Political contributions 32 30 30 31 10.0% 22.1% 23.4% 23.1% -0.3% 0.0% 71%

Redeem or vote on poison pill 23 13 15 5 60.0% 50.2% 41.2% 49.7% 8.5% 74.0% 100%

Advisory vote on compensation n/a 4 48 74 n/a 40.1% 42.8% 41.2% -1.6% 51.7% 100%

Claw back bonuses after fi nancial restatement 4 10 10 6 31.0% 23.7% 31.9% 16.8% -15.1% 100.0% 60%

Award performance-based stock options 18 8 6 6 35.6% 35.0% 30.0% 33.3% 3.3% 96.0% 76%

Eliminate supermajority vote 15 23 21 12 63.0% 62.0% 67.5% 62.7% -4.8% 100.0% 100%Source: RiskMetrics Group-ISS Governance Services, “Scorecard of Key 2008 Shareowner Proposals as of Oct. 15, 2008”

CHART 4: SBA PROXY VOTING STATISTICS

(FY ENDING JUNE 30, 2008)

Votes in Favor of Directors

74.0%

Votes in Favor of Auditors

97.7%

Votes in Favor of Merger Agreements

93.1%

All Proposals on Governance Issues

81.3%

TABLE 2: SBA SELECT VOTING STATISTICS (FISCAL YEAR 2008)

FOR AGAINST ABSTAIN WITHHOLD WITH MRV AGAINST MRV

Ratify Auditors 98% 2% 0% 0% 98% 2%

Reimburse Proxy Contest Expenses 100% 0% 0% 0% 100% 0%

Declassify the Board of Directors 100% 0% 0% 0% 98% 2%

Elect Directors 74% 6% 0% 20% 74% 26%

Elect Supervisory Board Member 72% 19% 0% 0% 72% 28%

Approve Reverse Stock Split 85% 15% 0% 0% 85% 15%

Approve Merger Agreement 93% 5% 0% 0% 93% 7%

Approve Sale of Company Assets 48% 52% 0% 0% 48% 52%

Amend Omnibus Stock Plan 4% 96% 0% 0% 4% 96%

Amend Restricted Stock Plan 27% 73% 0% 0% 27% 73%

Amend Stock Option Plan 12% 88% 0% 0% 12% 88%

Approve Increase in Aggregate Compensation Ceiling for Directors and Statutory Auditors 67% 33% 0% 0% 67% 33%

Approve Omnibus Stock Plan 2% 98% 0% 0% 2% 98%

Approve Repricing of Options 20% 80% 0% 0% 20% 80%

Approve Restricted Stock Plan 38% 61% 0% 0% 38% 62%

Approve Stock Option Plan 10% 86% 0% 0% 10% 90%

Approve Stock Option Plan Grants 27% 73% 0% 0% 27% 73%

Adopt or Amend Shareowner Rights Plan (Poison Pill) 11% 89% 0% 0% 11% 89%

Separate Chairman and CEO Positions 100% 0% 0% 0% 3% 97%


Amend Articles/Bylaws/Charter to Remove Antitakeover Provisions 100% 0% 0% 0% 0% 100%

Eliminate or Restrict Severance Agreements (Change-in-Control) 100% 0% 0% 0% 0% 100%

Submit Shareowner Rights Plan (Poison Pill) to Shareowner Vote 100% 0% 0% 0% 0% 100%

Performance- Based/Indexed Options 76% 24% 0% 0% 24% 76%

Submit Executive Compensation to Vote 100% 0% 0% 0% 0% 100%

Global Warming 36% 64% 0% 0% 64% 36%

Equal Employment Opportunity 100% 0% 0% 0% 0% 100%

Report on Corporate Political Contributions/Activities 71% 25% 4% 0% 25% 75%



International shareowner issues have become increasingly

important and the SBA continues to seek meaningful

international standards for corporate governance, fair

treatment of foreign and minority shareowners, equal access

to information, and corporate transparency. Over the past

year, the SBA’s international efforts included advocating for

greater shareowner voting rights in various capital markets

and continuing to improve corporate governance and

regulatory standards in the European Union (EU). The SBA

also works through international shareowner organizations

to seek and develop better corporate governance standards.

MUTUAL FUND PROXY VOTINGIn addition to individual equities, the SBA also receives

proxy statements for mutual fund shareowner meetings.

The meeting described below illustrates some of the issues

relevant to mutual fund proxies. On May 13, 2008, Pioneer

Funds held a special shareowner meeting to elect trustees

and to seek shareowner approval for a number of policy

changes. Pioneer shareowners approved each of the trustee

elections and both policy changes offered by Pioneer. The

SBA voted in favor of eight trustees, while withholding from

two trustees, John Cogan and Mary Bush. We withheld

in this instance

due to the excessive number of board positions held by

these two trustees. Including the Pioneer seat, Cogan

would be on four boards and Bush on five. The SBA believes

that trustees or directors holding positions on more than

three boards, and maintaining full time employment, will

lack the necessary time and resources to fulfill each board

responsibility.

The SBA also had concerns regarding some of the proposed

policy changes to the Pioneer Fund. Shareowners were

asked to approve an amendment to the declaration of

trust. The SBA voted against the amendment, which

would allow management increased flexibility and power

to create or dissolve series or classes within a trust, or

to reorganize, incorporate or liquidate the trust, and to

do so without a required shareowner vote. While we take

into account management’s need for market flexibility,

we believe that shareowners should have a voice in such

potentially significant changes to fund structure.

Similarly, Pioneer asked shareowners to approve a

proposal to reclassify the fund’s investment objective

as a non-fundamental issue. This classification

would allow management to change the investment

objective and the central focus of the fund. The SBA

voted against this proposal as well, due to the extreme

reduction in shareowner control over fund direction which

would be allowed under this proposal. Shareowners take

investment objectives into account when selecting funds

and overarching changes to such fundamental objectives

should continue to be subject to shareowner approval.

SHAREOWNER ACTIVISMThe SBA actively monitors the governance structures of

individual companies, and we may take specific action

intended to prompt changes at those companies. For

example, the SBA frequently discusses proxy voting issues

and general corporate governance topics directly with

public companies in which we hold shares. The SBA

routinely interacts with other shareowners and groups of

institutional investors to discuss significant governance

topics, helping us stay abreast of issues involving specific

firms and important legal and regulatory changes.

As new governance-related rules and regulatory proposals

are released publicly, the SBA periodically submits formal

comment to regulatory oversight bodies such as the

Securities & Exchange Commission, the New York Stock

Exchange, the Financial Accounting Standards Board

0

200

400

600

800

1000

1200

1400

1600

July Aug Sep Oct Nov Dec Jan Feb Mar Apr May June

��

CHART 5: SBA MONTHLY PROXY VOTING TOTALS FOR FY 2008 AND FY 2007


and the Public Company Accounting Oversight Board.

During fiscal year 2008, the SBA submitted several formal

regulatory comments on proposed reforms, including

efforts to improve audit firm reporting and operational

effectiveness, improvements in disclosure from companies

with business links to state sponsors of terrorism, and

support for the petition for interpretive guidance on climate

risk disclosure.

As a long-term shareowner, the SBA considers company

engagement to be an important element in maximizing

shareowner value. During fiscal 2008, the SBA engaged

more than 125 companies to address corporate governance

concerns across a number of issues, including executive

compensation, board accountability, reporting deficiencies,

and environmental practices.

The SBA engaged three companies concerning the use

of dual-class share structures which represent unequal

voting and financial structures. We engaged approximately

15 companies about their existing or proposed executive

compensation practices. Such engagement covered a

wide spectrum of issues, including the use and disclosure

of performance metrics and award hurdles, claw-back

features, ownership/retention policies, and other individual

components of long-term incentive plans (LTIPs). The SBA

also discussed proposed governance reforms with over ten

additional companies during the last proxy season, either

directly with management or board designees.

BENCHMARKING SBA PROXY VOTINGThe SBA continues to protect its shareowner interests

through the proxy voting process. Traditionally, we have

been more aggressive than many of the largest institutional

investors in voting against management recommendations

on certain issues. Such concerns for voting in the best

interest of long-term shareowner value led to only 71.8

percent of votes with management recommendations in

fiscal 2008, and only 74 percent of votes in favor of

directors. More conservative voting patterns in these areas

are typical, and represented by approval levels in the 85 to

95 percent range by the panel of institutional investors.

Table 3 presents a selection of proxy voting statistics for

the SBA and a panel of four of the largest institutional

investors.

The SBA’s assertive stance for shareowner interests is seen

in the votes on individual issues. For instance, poison pills

have the capacity to directly affect shareowner returns in

the event of a potential acquisition. The SBA is considerably

more likely to vote in favor of the submission of a poison

pill to shareowner vote (100 percent “FOR” versus a range

of approval of 22 percent to 67 percent for the larger

institutional investors). The selection of directors is one of

the most essential issues for shareowners, and the SBA

supported 94.6 percent of proposals to require a majority

vote of approval for directors, in contrast with a range of

9.3 percent to 78.6 percent support of such proposals by

others. Another important shareowner consideration is the

degree of board independence from management influence.

TABLE 3: VOTE BENCHMARKING: SBA VS. INDIVIDUAL INSTITUTIONAL INVESTORS

SBA(FY 2008)

BGI iSharesRussell 3000

FIDELITYRussell 3000

Equities

TIAA-CREF Stock

Account Fund

VANGUARD Total Stock

Market Index Fund

Number of Company Proxies 3,534 2,328 11,559* 2,418 2,447

Number of Ballot Items Voted 30,373 16,992 106,749* 17,663 17,736

WITH Management Recommended Vote (MRV) % 71.8 93.3 84.6 85.5 89.2

AGAINST MRV % 28.2 6.7 15.4 15.5 10.8

Key Ballot Item Voting (% of "For" Votes):

Elect Directors 74.0 93.6 89.3 85.9 90.9

Approve Omnibus Stock Plans (Compensation) 1.7 94.0 45.0 68.5 78.7

Submit Poison Pill to Shareowner Vote 100.0 55.6 65.3 66.7 22.2

Separate Chairman and CEO Positions 100.0 17.9 0.9 17.5 0.0

Require a Majority Vote for the Election of Directors 94.6 34.9 40.0 78.6 9.3

Sustainability Reporting 54.5 5.6 0.0 94.4 0.0

Report on Environmental Policies 0.0 0.0 0.0 57.1 0.0

Ratify Auditors 97.7 99.5 100.0 99.9 99.4* Data may double count meetings due to multiple portfolios owning the same stock - voting percentages are not affected.Source: RiskMetrics Group Voting Analytics Database; data represents aggregate vote statistics for each institution’s proxy voting of Russell 3000 companies for the Period July 1, 2007 through June 30, 2008, as reported to the SEC in N-PX fi lings.


This issue is represented, in part, by proposals to separate

the Chairman and CEO positions on company boards. The

SBA believes that even the strongest of CEO’s will benefit

from the perspectives of an independent board and chair.

The SBA voted in favor of 100 percent of such proposals in

fiscal 2008, versus a high of 17.9 percent for the panel of

institutional investors.

OVERVIEW OF THE 2008 U.S. PROXY SEASONThe 2008 proxy season may be most memorable for the

tumultuous decline in securities and the relative calm

of shareowner elections. Proxy season 2008 looks, in

hindsight, to be a transition year. Significant shareowner

reactions to market upheaval, as reflected by proxy voting,

will have to wait for the 2009 season if they are to appear

in force.

There were 1,183 shareowner proposals submitted in

calendar year 2008, according to Riskmetrics Group

tallies. After accounting for voluntary withdrawals and

for proposals omitted due to SEC determinations, 668

proposals made it to shareowner vote. There was a sharp

rise in the portion of proposals allowed by the SEC to be

excluded from proxies. In 2007, only 12 percent of all

submitted proposal were allowed to be excluded. Alarmingly,

over 20 percent of submitted proposals were partitioned in

2008. Of proposals subject to vote, approximately 17.5

percent received majority support. The 2008 results nearly

mirrored those of 2007 when approximately 17 percent of

the 683 proposals won majority support.

The 2008 season was characterized by continued

engagement between companies and investors. This

resulted in a significant number of shareowner proposals

being withdrawn ahead of annual meetings. In 2008, 24

percent of proposals were withdrawn, versus 27 percent in

2007 (as noted in the RiskMetrics Group U.S. Postseason

Review, as of October 16, 2008). In fact, a majority of this

year’s proposals were withdrawn on the issues of pay for

management performance, majority voting for directors,

and the initiation of sustainability reporting by companies.

It is significant to note the types of shareowner proposals

for which little agreement could be obtained. The divide

between company and shareowner positions seems quite

wide for some contentious issues, where less than 5 percent

of proposals were withdrawn voluntarily. Such proposals

also received considerable support once shareowner votes

were tallied. For instance, “say-on-pay” proposals received

average support in 2008 of 42.1 percent of votes cast,

similar to 2007 support levels. Say-on-pay proposals were

included in the proxies of 41 of the Fortune 100 companies

examined in Shearman & Sterling’s 2008 governance

overview. Shareowner input on compensation looks to be

a major theme for the 2009 proxy season as well, with the

potential for federal legislation on the issue. Proposals for

the repeal of classified boards again received significant

support in 2008, with 67.5 percent of votes cast, but this

remains an issue where companies are not likely to make

the switch eagerly.

TABLE 4: CONTENTIOUS PROXY ISSUESLESS THAN 5% OF SUCH PROPOSALS WITHDRAWN

2008 Support

2007 Support

Repeal Classifi ed Boards 67.5% 66.5%

Say on Pay 42.1% 42.5%

Independent Board Chair 29.8% 26.7%

Proposals for the establishment of an independent board

chair received average support in 2008 of 29.8 percent,

but no proposals of this type were withdrawn, signifying

the entrenched positions of boards and shareowners on this

issue. Calls for independent chair were especially strong

at major financial firms. Washington Mutual investors

provided 51.5 percent support for an independent chair and

the board ultimately split the roles of Chair and CEO. The

independent chair proposal at Bank of America received 37

percent support, while votes in favor were lower at Wells

Fargo, JPMorgan, and Citigroup. Wachovia acted earlier,

appointing an independent chair in May 2008.

Director elections exemplified the marginal changes

characteristic of the 2008 season. Proxy Governance

notes that 5.7 percent of all directors received withhold

CHART 6: PROPOSALS SUBMITTED IN 2008

Omitted19%

Voted57%

Withdrawn24%

Source: RiskMetrics Group

CHART 7: PERCENTAGE OF DIRECTORS RECEIVING 20% OR MORE WITHHOLD VOTES

5.7% 5.5%6.9%

7.6%

0%1%2%3%4%5%6%7%8%

All Dire

ctors

Audit

Nomina

ting

Compe

nsati

on

Source: PROXYGovernance 2008 Review


vote rates of 20 percent or higher in 2008. This is up

from 5.2 percent of directors receiving such withhold rates

in 2007. Withhold rates were highest for those directors

sitting on compensation committees in 2008, where 7.6

percent of such directors received a withhold vote in excess

of 20 percent.

The most dangerous actions for directors were poor

attendance and overboarding. Directors attending less

than 75 percent of board and committee meetings faced

high withhold votes 43.7 percent of the time. Meanwhile,

10.1 percent of directors sitting on five or more boards

received high withhold vote results. While the majority

of directors sit on only one board, Table 5 presents some

notable exceptions. The SBA sees reason for concern

when fully employed directors sit on more than three public

company boards. This limit is a more stringent standard

than typically imposed by institutional investors. However,

when considering the increasing amount of time required

for each board seat, it is important that a board member can

fully contribute to each company.

Compensation issues, always a crucial area of proxy voting,

were even more central to the 2008 season. Investors

reacted strongly where high compensation continued in

the face of decreasing performance. Washington Mutual’s

indication that it would not take subprime losses into

account when determining executive bonuses led to more

than 40 percent of shareowners withholding support for

three directors. At Citigroup, the excessive exit package for

CEO Charles Prince led to more than 25 percent opposition

for three compensation committee members.

Table 6 presents an overview of other notable votes at

financial firms during the 2008 proxy season. A common

theme is the disconnect between compensation and related

performance. Shareowners facing substantial declines in the

value of their equity holdings are increasing scrutiny of the

most egregious pay practices. In 2008, the financial industry

became the center of discontent as many of the companies

with the most excessive bonus plans were suddenly subject

to extreme drops in shareowner value. While shareowner

losses were substantial as of the date of 2008 annual

TABLE 5: DIRECTOR OVERBOARD In its 2008 Governance Practices study, The Corpo-rate Library found that approximately 79% of directors serve on one board. The study covered 21,000 active directors and found that over 300 directors serve on four or more boards. Listed below are some of the di-rectors holding the most board seats.

Eugene I. Davis sits on 10 Public Company Boards:

American Commercial Lines Inc.Atari, Inc.

Atlas Air Worldwide HoldingsDelta Air Lines, Inc.

Foamex international Inc.Footstar, Inc.

Global Power Equipment Group Inc.Knology, Inc.

Silicon Graphics, Inc.Solutia Inc.

Carl C. Icahn sits on 7 Public Company Boards:

American Railcar Industries, Inc.Blockbuster Inc.

Federal Mogul CorporationIcahn Enterprises L.P.ImClone Systems Inc.

XO Holdings, Inc.WCI Communities, Inc.

Yahoo! Inc.

The following directors sit on 6 Public Company Boards:

Peter C. BrowningNeil F. Dimick

Robert Alexander IngramBalakrishnan S. Iyer

Shirley Ann JacksonJonathan S. Leff

J. Michael LoshJohn C. Malone

Frederic V. SalernoJacquelyn M. Ward

Patrick J. ZennerSource: The Corporate Library’s 2008 Governance Practices Report

CHART 8: SHAREOWNER RESISTANCE TO COMPENSATION PLANS RISES WITH EXCESSIVE VOTING POWER DILUTION

0%5%

10%15%20%25%30%35%40%

2005 2006 2007 mid-2008

Avg

Vot

es A

gain

st

VPD<=10% 10<=VPD<=15% 15%<=VPD<=20% 20%<=VPD<=25% VPD>25%

��


meetings, losses continued to accelerate throughout the

remainder of the year.

While high-profile votes gained much attention, investor

dissatisfaction of compensation plans remained generally

placid. Shareowners approved over 98 percent of the 469

management-proposed equity incentive plans at Russell

3000 companies, according to RiskMetrics Group.

RMG’s ISS Governance Services unit recommended that

shareowners vote against 18 percent of the proposals. The

SBA voted against 42 percent of such proposals, reflecting

our concerns for many aspects of typical compensation

plans, including the lack of threshold disclosure and high

levels of potential shareowner dilution. On a broader scale,

there were approximately 1,300 total equity plan proposals

during the 2008 proxy season. ISS recommended votes

against 36 percent of all plans, with higher concerns for

plans in the financial and information technology sectors.

Table 7 represents the most frequent reasons cited by

ISS for recommending against certain plans. Excessive

shareowner-value-transfer (or “SVT”) to plan participants

was the chief concern. In addition, a high burn-rate was

a factor for certain plans. The burn-rate is the percent of

common shares outstanding which are granted as restricted

stock or options. Repricing of options without shareowner

approval was another major reason for recommendations

against certain plans. In comparison, the SBA voted against

98 percent of all plans.

A key area of consideration for the SBA, and shareowners

generally, is the degree to which stock and options granted

in the compensation plan will dilute the voting power of

shareowners. RiskMetrics Group has tracked the opposition

to compensation plans in comparison with the level of

voting power dilution (presented in Chart 8). Average votes

“against” a given plan rise steadily as the voting power

dilution of the plan rises. For instance, 2008 plans with

voting power dilution of 10 percent or less received an average

of 13 percent of “against” votes. However, when voting power

Table 6: Notable 2008 Votes at U.S. Financial FirmsCompany 1 year

return as of annual meeting

1 year return as of

2008YE

Activist campaign; compensation or

governance issues

Maximum withhold on direc-tors

"Say on Pay" support

Independent chair

support

Washington Mutual

-73.7% 4/14/08 -99.9%

"Vote no" campaign over executive bonuses,

risk management49.9% - 51.5%

Morgan Stanley -26.9%

4/8/08 -64.5%"Vote no" campaign

over risk management, combined CEO-Chair

9.5% 36.8% -

Citigroup -51.49% 4/22/08 -73.4% Ex-CEO exit pay, CFO

compensation 30.6% 41.9% 18.3%

Bank of America

-27.8%4/23/08 -64.6% - 6.9% 44.9% 37%

Merrill Lynch -47.7%4/24/08 -76.5% Ex-CEO exit package 13.3% 37.5% -

Wachovia -53.1%4/22/08 -83.9% - 8% 30.6% -

Capital One -38.2%4/24/08 -36.9% Pay-for-performance

disconnect 20.9% 35.8% -

Freddie Mac -64.3%6/6/08 -97.8% Pay-for-performance

disconnect 26% - -

JPMorgan Chase

-16.8%5/20/08 -25.3% - 3.5% 39.2% 15.2%

AIG -45.7%5/14/08 -97.3% Material weakness in

internal controls 32.3% - -

Source: RMG 2008 Postseason Report. (2008YE returns calculated independently using NYSE data as of 12/17/08.)

Table 7: Reasons for ISS “Against” Recommendations on Stock Plans

Solely SVT Cost

SVT + Burn Rate

SVT + Repricing Feature

SVT, Burn

Rate, & Repricing

Burn Rate Repricing Repricing + Burn Rate

Other

S&P 500 6 4 0 1 0 2 0 0

Non-S&P 500 145 60 65 19 0 77 11 9Source: RMG 2008 Postseason Report.


dilution was greater than 25 percent, the average percent of

votes against such plans rose to approximately 30 percent.

Sigma Designs, Inc. received the highest opposition levels

for a compensation plan, with 67 percent of votes against.

Sigma’s plan allowed for 28 percent voting power dilution.

Environmental, Social and Governance (ESG) issues were a

major influence again this proxy season. In its postseason

review, RMG noted that over 400 ESG proposals were sub-

mitted in 2008, with approximately half of these making it

to a shareowner vote. Due to company challenges, 15 percent

of proposals were omitted by the SEC. In addition, a relatively

high share of proposals, 33 percent, were withdrawn before

the annual meeting. Average vote support for ESG proposals

was 15 percent, similar to 2007 results.

One of the strongest environmental pushes of 2008 was for

climate change proposals. In Chart 9, PROXY Governance

provides an overview of recent trends in shareowner support

for such proposals. The number of proposals withdrawn due

to settlement [24 in 2008 vs. 19 in 2007] and the number

subject to final vote [26 in 2008 vs. 17 in 2007] continues

to increase. Meanwhile, average vote support rose in 2008 to

22.6 percent, from 20.1 percent in 2007.

In 2007, the SBA began to more fully incorporate the

potential impact of climate change on the long term value

and sustainability of individual holdings. Our votes “FOR”

climate change proposals moved from 0 percent in 2006 to

approximately 40 percent in 2007 and 36 percent in 2008.

Each proposal is evaluated in terms of the scope of the

proposal, its relevance to long-term shareowner value, and

the degree to which the company has addressed the issue.

Table 8 provides an overview of notable environmental and

social proposals brought forth during the 2008 season. Such

high-profile votes typically reflect situations of particular

shareowner focus at the given company.

A LOOK BACK (2008), FORWARD (2009), AND BEYOND (20/20)The events of 2008, primarily the global market turmoil,

combined to create a dramatic year in review. The market

decline has led many to re-evaluate the roles of all market

systems and corporate governance has received its share of

scrutiny. At this stage, it may be useful to recall that the fi eld

of corporate governance shares many of the characteristics

of the democratic process. The positive aspects are well

known, and until 2008, were known well enough to be taken

for granted. America’s legislative and executive branches are

determined by a system of elections in which all are eligible

to participate in the process. However, only a subset of the

population determines the direct benefi ts to be worthy of the

time or resources required to cast an informed vote. Similarly,

while many of the rights bestowed on shareowners are care-

fully monitored by some owners through the corporate gover-

nance process, these rights have been casually ignored by a

large segment of the ownership base. Just as social stability

pacifi es the electorate, low volatility stock market environ-

ments allowed misguided corporate incentive structures to

go unnoticed by many shareowners. The dramatic uptick in

market volatility and decline in securities’ prices has rapidly

upset the foundation previously taken for granted as funda-

mentally solid. Political and corporate leadership now faces

intense justifi cations for actions and relationships, which

were previously assumed to be acceptable practices.

When corporate governance works well, it receives a relatively

small share of the investor’s decision making process. A re-

cent (2007) Ashton Partners survey of 200 portfolio manag-

ers and buy-side analysts revealed that only one-third were

familiar with a corporate governance quotient, another one-

third disregarded corporate governance in their investment

RECENT SBA REGULATORY COMMENTARY

JULY 9, 2008 – SBA COMMENT LETTER TO THE DE-PARTMENT OF TREASURY ADVISORY COMMITTEE ON THE AUDITING PROFESSION (ACAP) REGARD-ING DRAFT PROPOSALS TO IMPROVE AUDIT FIRM REPORTING AND OPERATIONAL EFFECTIVENESS.

JANUARY 18, 2008 – SBA COMMENT LETTER TO THE SEC REGARDING STEPS TO HELP INVESTORS MORE EASILY OBTAIN DISCLOSURE FROM COMPANIES WITH BUSINESS LINKS TO STATE SPONSORS OF TERRORISM.

OCTOBER 24, 2007 – SBA COMMENT LETTER TO THE SEC IN SUPPORT OF THE PETITION FOR INTER-PRETIVE GUIDANCE ON CLIMATE RISK DISCLOSURE.

OCTOBER 3, 2007 – SBA COMMENT LETTER TO THE SEC REGARDING PROPOSALS RELATING TO ELEC-TIONS AND PROXY ACCESS.

JUNE 13, 2007 – SBA LETTER OF SUPPORT REGARD-ING NYSE PROXY WORKING GROUP AMENDMENTS TO NYSE RULE 452.

Source: PROXYGovernance, “Trends in Environmental and Social Issue Campaigns”

CHART 9: SHAREOWNER SUPPORT FOR CLIMATE CHANGE PROPOSALS

0

5

10

15

20

25

30

2005 2006 2007 2008

Num

ber o

f Pro

posa

ls

0%5%10%15%20%25%30%35%40%45%

Supp

ort L

evel

Omitted Withdraw n

Voted Average VoteHigh SBA "FOR"


SBA PROXY VOTING STATISTICS (FISCAL YEAR 2008)VOTES IN FAVOR OF CLIMATE CHANGE PROPOSALS

36%

VOTES IN FAVOR OF SUSTAINABILITY REPORTING

55%

VOTES IN FAVOR OF REPORTING

ON COMMUNITY IMPACT

56%

NUMBER OF PROPOSALS COVERING ENVIRONMENTAL ISSUES

49

decisions, and only a small percentage utilized corporate gov-

ernance in their investment decisions and recommendations,

and only did so when corporate governance was a negative

factor.

It is interesting to note that the subprime mortgage market

also functioned very smoothly, until it didn’t. The ratings

agencies’ passive analysis of collateralized mortgage obliga-

tions was taken for granted until, in retrospect, such oversight

became very relevant. On a grander scale, the corporate gov-

ernance practices of American corporations, the systems for

determining board leadership, and the natural inclination of

management to maintain risk exposure below lethal levels

were seen as inherently suffi cient. After all, the system had

produced benefi cial results for as long as institutional knowl-

edge could recall—i.e. a generation of profi tability since the

lost decade of the 1970’s.

In fact, the market environment of 2006 and early 2007

terminant of macroeconomic prosperity, but dependent upon

it. Corporate governance and risk management were seen as

token to some, but are now increasingly revealed as crucial

with each examination of a corporate downfall.

As clear as the signs of defi cient governance may be when

examining individual corporate breakdowns, the question re-

mains: Is this point in time an infl ection point for corporate

leadership? In light of recent market shifts, has the increased

volatility and heightened risk awareness created a permanent

emphasis on improved corporate governance practices?

One benefi t of recent market events is an enhanced perspec-

tive. Until this year, historical comparisons based on a three

to fi ve year perspective were used to justify excessively risky

behavior. In the course of only a few months, the relative his-

torical time frame has expanded by approximately 80 years.

From this perspective, what was ruled inconceivable or un-

foreseeable has become a current reality with countless par-

allels to an earlier American downturn. While our historical

perspective has been painfully refreshed, it is of key impor-

tance going forward that this experience leads to governance

policies, incentive structures, and risk evaluation with an em-

phasis on enhancing long-term shareowner value.

If there is to be a new paradigm, some of its better qualities

should present early signs of life. Rational incentive struc-

tures will be differentiated from those based on the self-in-

terests of corporate leaders. Current diligence and oversight

by active shareowners will be of increased value in a market

environment where strong corporate leadership is a necessity

rather than a byproduct of the environment. [sba]

set records for low volatility, with risk premiums nearing his-

toric levels. For that matter, the last 20 years have provided

a relatively tranquil environment for equity investment. This

backdrop led some to disregard corporate governance and the

rights of ownership, as many shareowners and corporations

extrapolated prior success indefi nitely forward. Governance

was seen by many as a regulatory drag which reduced the

maximum performance of the corporation.

In hindsight, it becomes apparent that lax governance struc-

tures were not effi cient, but negligent. Excessive execu-

tive compensation packages were not creating shareowner

wealth on a proportional scale, but creating adverse incen-

tives for skewed risk/reward initiatives. Cutting-edge quanti-

tative risk analysis was not creating increasingly effi cient fi -

nancial vehicles, but actually reliant upon tenuous short term

historical assumptions. Cause and effect were transposed

over time as corporate performance was in actuality, not de-

Table 8: Notable Social & Environmental Shareowner Proposals of 2008

ISSUE ISSUE AVG

HIGH VOTE

COMPANY SBA VOTE

Review/Reduce Toxicity of Product Informa-tion

37.2% 38.3% Kroger FOR

Report on/Reduce Greenhouse Gas Emissions 30.5% 39.7% Kroger FOR

Adopt Sexual Orientation Anti-bias Policy 28.9% 52.3% Expeditors Intl. FOR

Issue Sustainability Report 28.6% 39.5% Dover FOR

Review Impact of Oil Sands Operations 28.1% 28.6% Chevron FOR

Report on Community Hazards 9.7% 10.8% ExxonMobil AGAINST

Review Nanomaterials/Product Safety 25.4% 25.4% Avon Products FOR

Set Goals for GHG Emission Reduction 21.8% 33.0% Oneok FOR

Implement Equality Principles 21.5% 52.8% HCC Insurance FOR

Implement ILO Standards 16.8% 29.4% Urban Outfi tters FOR

Review/Report/Amend Human Rights Policy 11.8% 30.2% Halliburton FORSource: RMG 2008 Postseason Report



TRENDS IN BOARD GOVERNANCEWE PRESENT THE FOLLOWING CHARTS AS A VISUAL REVIEW OF THE LATEST TRENDS PERTAINING TO COMMON GOVERNANCE ISSUES. THE CHARTS ARE BASED ON DATA FROM THE RISKMETRICS GROUP’S CORPORATE GOVERNANCE QUOTIENT (CGQ) SCORING METHODOLOGY. THE RUSSELL 3000 INDEX IS USED AS THE BASIS FOR ANALYSIS.

IN 2008, POSITIVE TRENDS CONTINUED TO REVEAL THE SHIFT TO INCREASED SUCCESSION PLANNING (CHART 10), EXTERNAL AUDITOR RATIFICATION (CHART 11), ANNUAL ELECTIONS (CHART 15), AND COMPANY DISCLOSURE OF PERFORMANCE METRICS (CHART 19).

ALTERNATIVELY, THEIR WAS LITTLE CHANGE IN THE AREAS OF BOARD INDEPENDENCE (CHART 16) AND THE NUMBER OF OUT-SIDE DIRECTOR MEETINGS (CHART 17). NEARLY HALF OF BOARDS OF RUSSELL 3000 INDEX COMPANIES CONTINUE TO MAIN-TAIN A COMBINED CEO AND CHAIR (CHART 18). IN ADDITION, WITH THE INCREASED FOCUS OF LATE ON THE SUBSTANTIAL TIME REQUIREMENTS OF DIRECTORS, IT IS INTERESTING TO NOTE THAT ONLY ONE-QUARTER OF BOARDS DISCLOSE A LIMIT ON THE NUMBER OF OUTSIDE BOARDS ALLOWED (CHART 20).


CHART 10: OVER 70% OF BOARDS HAVEIMPLEMENTED SUCCESSION PLANNING

CHART 12: BOARD SIZE CHANGES LITTLE IN 2008

CHART 11: SHAREOWNER ABILITY TO RATIFY EXTERNAL AUDITORS IS INCREASING

CHART 13: FEW CEOs SERVE ON MORE THAN 2 EXTERNAL BOARDS

SOURCE FOR ALL CHART DATA: RISKMETRICS GROUP (RMG), CORPORATE GOVERNANCE QUOTIENT (CGQ) DATABASE, FACTSET RESEARCH SYSTEMS.

0%

10%

20%

30%

40%

50%

60%

2003 2004 2005 2006 2007 2008Board size is less than 6 Board size is >= 6 and <=8

Board size is >=9 and <=12 Board size is >=13

0%

1%

2%

3%

4%

5%

6%

7%

2003 2004 2005 2006 2007 2008

CEO serves on the boards of more than two other companies

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

2003

2004

2005

2006

2007

2008

Shareowners Ratify Auditors at Most Recent MeetingNo Shareowner Ratification at Most Recent Meeting

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2005 2006 2007 2008

No disclosure of a board approved succession plan

Board approved succession plan in place for the CEO


CHART 14: MORE STOCK INCENTIVE PLANS SUBJECT TO SHAREOWNER APPROVAL IN ‘08 AFTER ‘07 DROPOFF

CHART 16: HAS BOARD INDEPENDENCE REACHED A PLATEAU?

CHART 15: LARGE CAPS ARE ADOPTING ANNUAL ELEC-TIONS MOST QUICKLY, THOUGH MID-CAPS ARE LAGGING

CHART 17: NO CHANGE IN 2008 FOR OUTSIDE DIRECTOR MEETINGS AND DISCLOSURE

S&P 500

S&P 600

Russell 3000

S&P 400

30%

35%

40%

45%

50%

55%

60%

65%

3Q 2005 3Q 2006 3Q 2007 3Q 2008

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003 2004 2005 2006 2007 2008

Outside directors meet without CEO an undisclosed number of times

Outside directors meet without CEO and disclose the number of meetings

Outside directors do not meet without the CEO present

0%10%20%30%40%50%60%70%80%90%

100%

2003 2004 2005 2006 2007 2008Board Controlled by Majority of Insiders and Affiliated Outsiders (I and AO >=50%)

Board Controlled by Majority of Independent Outsiders (50% < IO <= 90%)

Board Controlled by Supermajority of Independent Outsiders (IO > 90%)

76%

78%

80%

82%

84%

86%

88%

90%

92%

2003 2004 2005 2006 2007 2008

All of the company's stock-incentive plans subject to shareholder approval


CHART 18: INDEPENDENT CHAIRS LED APPROXIMATELY ONE IN FOUR BOARDS IN 2008

CHART 19: IMPROVEMENTS IN COMPANY DISCLOSURE OF PERFORMANCE METRICS

CHART 20: ONLY 1/4 OF BOARDS DISCLOSE SOME LIMIT ON OUTSIDE BOARD MEMBERSHIPS

CHART 21: COMPENSATION COMMITTEE INDEPENDENCE LEVELS ARE APPROACHING 90%

44%

24%

10%

17%

5%

Combined Chair & CEO Separate CEO & Independent ChairSeparate CEO & Affliated Chair Separate CEO & Insider ChairUnknown

87%

1%

5%

7%

13%

Compensation Committee Comprised of 100% Independent Outsiders

No Compensation Committee Exists

Compensation Committee Includes Insiders

Compensation Committee Includes Affiliated Outsiders

6+ Board Limit6%

5 Board Limit4%

4 Board Limit15%

No disclosure of a policy limiting outside directorships

75%

5%

13%

17%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

2006 2007 2008

Companies with Performance-based Equity Awards,Specific Performance Criteria and Threshold Disclosure

SECTION 162(M)USING THE TAX CODE TO MONITOR EXECUTIVE COMPENSATION PLANS

A N A L Y T I C A L A P P R OAC H ES T O E X EC U T I V E

C O M P E N S AT I O NTwo approaches formulate the executive compensation debate within corpo-

rate governance: “absolutists” and “equivocalists.” Absolutists maintain that

executive compensation is too complicated for shareowners to understand.

Therefore, they argue that shareowners should focus solely on electing a cred-

ible board of directors, which will subsequently appoint a prudent executive

compensation committee. Once an absolutist selects the board and acquiesces

to its executive compensation committee, he or she advocates for the execu-

tive compensation committee’s absolute control over compensation decisions.

In other words, absolutists contend that shareowners should only concern

themselves with executive compensation in as much as they ratify the execu-

tive compensation committee’s membership through the election of the board

of directors. As a consequence, the absolutist will then vote with management

regarding every executive compensation plan and policy. Absolutists tend to

embrace the “arm’s length model” of executive compensation negotiation,

which Lucian Bebchuk and Jesse Fried explain in their book, “Pay Without

Performance: The Unfulfilled Promise of Executive Compensation,” where the

board of directors and officers negotiate the manager’s compensation as part of

arm’s length transactions. With this philosophy, an absolutist would likely never

know of a company’s unsatisfactory executive compensation practices.

While equivocalists agree that the vote for a company’s board of directors is the

most important vote that a shareowner can cast, they understand that execu-

tive compensation monitoring should not stop once they have elected the board

of directors. Equivocalists hold that despite the difficulty in comprehending

executive compensation, shareowners must monitor the compensation plans

and policies adopted by the executive compensation committee. By doing so,

equivocalists argue that shareowners can ensure that the board of directors

is using compensation methods that promote the best corporate governance

practices and that align the interests of officers with shareowners. If the execu-

tive compensation committee fails to adopt sound compensation practices,

the equivocalists will respond through proxy voting with a vote against the pro-

posed compensation plan. Additionally, equivocalists may choose to withhold

support form individual directors responsible for developing the compensation

plans and policies. Therefore, equivocalist philosophy aligns with Bebchuk and

Fried’s “managerial power model of executive compensation,” where the board

of directors and officers can have negative incentives to work together to hide

By capping the salary compensation of executives of U.S. publicly held corporations at $1 million for tax deductibility purposes, Section 162(m) of the IRS Code shifted the structure of executive

compensation packages from a flat salary architecture to a design that includes a minimal base salary plus a performance based premium.

Despite Congress’ intention that Section 162(m) should function as a tool to enhance the value of publicly traded companies’ shareowners by instilling accountability into executive compensation, performance based executive compensation packages almost never fail to gain shareowner approval, despite many packages that consistently neglect to base executive compensation awards on firm performance.

Accordingly, shareowners should employ the elements of Section 162(m) in the monitoring of executive compensation packages at companies in which shareowners own stakes. Furthermore, shareowners should familiarize themselves with Section 162(m)’s terms due to the heightened scrutiny of executive compensation practices in political discourse and the Section’s growing influence over executive compensation under the Emergency Economic Stabilization Act.

22 F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N ( S B A )


or otherwise understate the true value of the manager’s

compensation from shareowners.

The SBA adopts the equivocalists’ perspective. To properly

monitor executive compensation issues, the SBA obtains

executive compensation information from corporate gover-

nance researchers, compensation consultants, and industry

and academic literature. The SBA uses this information to

analyze the compensation meth-

ods of a particular company and

whether the company is employing

best practices by compensating

its executives based on perfor-

mance-based metrics, indus-

try benchmarks, and acceptable

retirement and severance packag-

es. Accordingly, the SBA employs

the language of Section 162(m) of

the IRS Code to determine wheth-

er a company embraces the best

practices previously mentioned.

O V E R V I E W O F S E C T I O N 1 6 2 ( M )Generally, the Internal Revenue Service permits businesses

to deduct reasonable compensation as an expense neces-

sary for operating a business. In response to widely-held

perceptions that executive compensation had surpassed

“reasonable” levels, Congress added Section 162(m) to

the IRS Code through the adoption of the Omnibus Budget

Reconciliation Act (OBRA) of 1993, which capped tax

deductible executive compensation at $1 million. Moreover,

Gregg Polsky illustrated in his 2007 essay, Controlling

Executive Compensation Through the Tax Code, that

Section 162(m) was intended to enhance shareowner

wealth by reducing the overall level of executive compen-

sation and by tying executive compensation to execu-

tive performance, not just existence or tenure. Basically,

Section 162(m) prohibits a publicly held corporation from

deducting compensation expenses for “covered employees”

that exceed $1 million during the taxable year. A “covered

employee” for purposes of Section 162(m) includes the

Principal Executive Officer, or an individual serving in that

capacity, at the end of the taxable year and the com-

pany’s three other highest paid officers. Of course, Section

162(m) would not be a rule without its exceptions, which

exclude the following types of compensation from Section

162(m) constraints on salary-based tax deductions:

1. Commission Compensation

2. Existing Binding Contract

3. Performance-Based Compensation

4. Payments to or from a Tax-Qualified Retirement

Plan

5. Gross Income Excludable and Pay Deferrals

The SBA contends that with minimal effort, shareown-

ers can and should monitor how executive compensation

committees structure executive compensation agreements

within the confines of Section 162(m). For instance, the

first two exceptions are not relevant for two reasons. First,

the CEO and the company’s three other highest paid offi-

cers are not often compensated with commissions, and

second, these officers are not likely to have served for the

same company since 1993, much less served for the same

company without material modifications to their contracts.

Therefore, shareowners generally need to focus on the last

three, with the performance-based compensation excep-

tion deserving the most attention because under Section

162(m) and the NYSE Corporate Governance Standards

Section 303A.08, shareowners have a direct say in the

structure of performance-based compensation plans.

For an executive’s performance-based compensation to

qualify as an exception under

Section 162(m), the com-

pany’s compensation com-

mittee, composed of at least

two outside directors, must

establish pre-determined,

objectively measurable per-

formance goals that contain

substantial uncertainty sur-

rounding their attainment at

the time the goals are estab-

lished. Furthermore, the com-

pany must disclose the compensation plan to the shar-

eowners, who must approve the plan by a majority vote (as

majority vote is defined under applicable state law). Finally,

the compensation committee must certify that the covered

employee attained the performance goals defined in the

plan.

Section 1.162-27 of the Treasury Regulations provides

additional guidance regarding the qualifying elements of

the performance-based compensation exception to Section

162(m). A performance goal will not be pre-established if it

is implemented after an executive has completed twenty-

five percent of his or her service for the period covered by

the performance goal. For instance, if the performance goal

covers a one-year period, the compensation committee

cannot establish the goal after three months have elapsed.

Additionally, the attainment of the performance goal must

be substantially uncertain at the time it is established. A

performance goal based on a percentage of total sales is

“In spirit, the rule aims to get companies and their compensation committees focused on rewarding executives for long-term and sustained value creation, not fleeting short-term factors that could compromise a financial institution’s health. [M]aybe it means that these companies shouldn’t be granting stock options to their executives. Theoretically, don’t op-tions put you in a position of being a short-term trader, as opposed to a long-term investor?”Yale Tauber, Compensation Consultant, Financial Week, October 20, 2008, discussing the TARP

not substantially uncertain because a company is almost certain

to have some sales, so this performance goal will not qualify

under Section 162(m). However, a performance goal based on a

percentage of net income or profits will qualify as substantially

uncertain because a company is not substantially certain to have

income or profits. As such, this performance goal meets the

requirements of Section 162(m) in this regard.

For the purposes of a goal being objectively measurable, a per-

formance goal is considered objective if a third party, who has

knowledge of the performance results, can calculate the amount

of compensation that the covered employee will receive. A

provision that grants compensation based solely upon length of

employment will not qualify as a performance goal under Section

162(m). However, if a stock option grant is subject to the attain-

ment of a performance goal and a vesting schedule, the option

will not be disqualified under Section 162(m) if the compensa-

tion committee accelerates or decelerates the vesting schedule

as long as the performance goal is also met. The compensation

committee does not have the discretion to increase the amount

payable under the performance goal after it has been established

and approved by shareowners, but it does have the discretion to

decrease the compensation. Finally, a plan that permits perfor-

mance-based compensation to be paid upon death, disability,

or change of ownership or control does not fail to qualify under

Section 162(m) so long as the performance goal was met before

the occurrence of any of these events.

Along with performance-based compensation, the SBA sup-

ports the observation of executive compensation plans that have

provisions guaranteeing pay to or from a tax-qualified retirement

plan, income-excludable items, and pay deferrals as these forms

of compensation are tax deductible under Section 162(m). For

instance, income-excludable items, perquisites like automo-

biles, country club memberships, and other fringe benefits, can

be quite sizeable and unnecessary assuming executives should

pay for such items directly. On the other hand, the SBA does not

endorse shareowners becoming so entangled with compensa-

tion monitoring that they try to micromanage every aspect of

a compensation plan’s implementation. Instead, shareowners

should look at the executive compensation package holistically

as it applies to total shareowner return and long-term sustain-

ability for the corporation.

C R I T I Q U E S O F S E C T I O N 1 6 2 ( M )Some scholars have argued, along with corporate officers

and directors, that Section 162(m) runs counter to its intent

of decreasing the number of Brobdingnagian executive

compensation plans. Despite the benefits of shareowner

monitoring of corporate governance structures and the utility

of Section 162(m) in this regard, Section 162(m) has its critics.

These critics contend that Section 162(m) actually decreases

shareowner value through inefficiencies, increased executive

compensation plans, and foregone tax deductions. Expounding

upon Bebchuck and Fried’s arm’s length and managerial power

models, Professor Gregg Polsky claims that a board of directors,

negotiating at arm’s length with an executive, does not need

Section 162(m) because the board of directors will act in the

company’s best interest by paying the executive the minimum

amount required to maximize shareowner return. Therefore,

Polsky argues that Section 162(m) decreases shareowner

value because the tax provision requires the board of directors

to compensate the executive for the risk associated with

uncertain, future performance-based compensation versus

compensating the executive with a certain cash salary at the

time of employment.

On the other hand, if boards do not negotiate with executives at

arm’s length and collude with executives instead, then Polsky

asserts that Section 162(m) may actually inspire more manipu-

lative behavior when structuring executive compensation plans.

To fulfill these subversive goals, the board and the executive

must finagle the firm’s financial results. This increases the

company’s risk by decreasing the quality of information to the

shareowner and the market. As the firm’s risk increases, its

value decreases, so shareowners realize a decrease in value as

well. Finally, Polsky explains that firms face increasingly difficult

odds of meeting Section 162(m) because Congress developed

the $1,000,000 cap in 1993, which due to inflation, translates

to approximately $700,000 in purchasing power in 2007. Said

another way, an executive making $1,000,000 in 1993 would

expect to make approximately $1,400,000 in 2007, all else

remaining constant.

To support his contentions, Polsky drew upon, “Explaining Firm

Willingness to Forfeit Tax Deductions under Internal Revenue

Code Section 162(m): The Million-dollar Cap,” a 2005 study by

Steven Balsam and Qin Jennifer Yin. Balsam and Yin found that

firms chose to forfeit Section 162(m) tax deductions thirty-eight

percent of the time over a five year period from 1994 to 1998.

While a more recent survey may show that more companies are

qualifying more of their executive compensation packages under



Section 162(m), Balsam and Yin’s data demonstrated that

the number of Section 162(m) forfeitures enlarged from

thirty-seven percent in 1994 to forty-one percent in 1997

and 1998. Additionally, America experienced significant

economic growth and expansion during the mid to late

1990’s, while America in the early twenty-first century is

suffering through a more tempestuous economic cycle.

Despite the historic context of Balsam and Yin’s study, their

data furnishes enlightening explanations for when and why

companies decide to forfeit tax deductions under 162(m).

Balsam and Yin’s study found that companies typically

conducted a cost/benefit analysis in deciding whether to

forfeit tax deductions under Section 162(m). The benefits

of claiming all deductions offered an average tax savings of

$300,000 per year, in mid-1990’s dollars, for each of the

companies surveyed, and claiming all deductions reduced

political costs to the firm. However, qualifying all executive

pay plans under Section 162(m) imposed costs associated

with rewriting compensation contracts to conform to the

new rule, seeking shareholder approval of performance-

based compensation plans, decreasing firm value by modi-

fying executive incentives, and compensating executives

for the risk of accepting uncertain, performance-based

compensation. Firms with higher recontracting costs, a

greater number of executives affected by Section 162(m),

and a riskier business environment were more likely to

forfeit deductions under Section 162(m) than were firms

not exposed to these conditions. Companies increasingly

maintained all of their deductions under the tax code

when they had higher political costs, when they had long-

tenured CEOs, when they disclosed greater portions of

executive compensation, and when they had a higher ROA.

Ultimately, Balsam and Yin demonstrate that companies

will claim all deductions up to the point where the benefits

of claiming the deductions do not exceed the costs of

claiming the deductions.

Though the SBA uses Section 162(m) as a tool in making

voting decisions on executive compensation packages and

the performance of the compensation committee, we do not

agree with every provision in Section 162(m). As discussed

in the “Overview of Section 162(m),” the compensation

committee does not have the discretion to increase the

amount of the performance-based compensation pay-

able to the covered employee once the plan has been

established and approved by the shareowners. However,

performance-based compensation will qualify under the

plan if the compensation committee accelerates the vesting

of performance-based stock options so long as the covered

employee meets the performance objective and providing

that the compensation meets all other performance-based

qualifications.

The SBA contends that this provision ultimately grants

the compensation committee improper discretion to

increase compensation after a plan has been established

and approved. For instance, an executive may meet a

performance-based goal under a compensation plan that

pays options, but the vesting schedule for the options may

be set months past the time that the goal is attained. If the

compensation committee knows that the company’s stock

is currently undervalued due to non-public information, then

it could accelerate the vesting of the stock for the execu-

tive prior to the information being made public. Once the

information is released, the stock price will increase and the

executive will realize an increase in the performance-based

pay, which will arise at the discretion of the compensation

committee. Since a compensation committee should not

95%

70%

55%

100.00%

99.50%

100.00%

2006

2007

2008

Vote Levels for Incentive Based Executive Compensation Packages (All Shareowners)

SBA Vote Levels for Incentive Based Executive Compensation Packages

COMPENSATION VOTING TRENDS:SBA VS TOTAL MARKET SUPPORT LEVELS

(% OF FOR VOTES)

SOURCE: SBA, EXEQUITY

have the power to increase a covered employee’s perfor-

mance-based compensation once a compensation plan has

been established, the Treasury Department should amend

its position on Section 162(m) to remove the discretion that

accelerated vesting of performance-based stock options

places with compensation committees.

In its current incarnation, Section 162(m) provides com-

panies with the ability to circumvent Section 162(m) by

deferring compensation until an executive departs the firm.

In other words, Section 162(m) allows companies to use

executive turnover as a means of compensating executives

beyond the tax deductible limit as long as the executive

ceases to be a covered employee by the end of the tax-

able year. Of course, this fosters an environment favoring

“golden parachute” plans that mete out prodigious sever-

ance packages. Additionally, the SBA contends that this

vests improper discretion with the compensation commit-

tee. Furthermore, frequent executive turnover, for the sake

of distributing excessive compensation to the executive,

increases firm volatility, and thus, risk. Therefore, the SBA

endorses the removal of deferred compensation as a pseu-

do-qualified form of compensation under Section 162(m).

The SBA also recognizes the economic strain that Section

162(m) places on shareowners. For instance, Section

162(m) only states that shareowners must be allowed to

vote on a performance-based compensation plan before it

can be qualified for tax deductibility under the provision;

however, if shareowners reject the compensation plan,

the company can still decide to compensate the executive

under the plan, but the company must pay taxes on it. Thus,

shareowners are faced with a dilemma. If the shareowners

approve the compensation plan, then they are officially

saying they agree with the compensation committee. If

the shareowners reject the plan, then they are losing value

because the company’s net income will be reduced by the

tax payments on the compensation. Moreover, the board of

directors can essentially wash their hands of the tax pay-

ments under the compensation plan because they can say

that shareowners decided to vote against the plan and pay

taxes instead. As such, shareowners lose value twice: pay-

ing unapproved compensation and paying the taxes on it.

Finally, another theoretical problem with Section 162(m)

was illustrated by Balsam and Yin, in a study that posed

that firms with riskier environments, lower ROA, and scant

compensation disclosure practices forfeited their tax

deductions under Section 162(m) more frequently than

oppositely positioned firms did. Considering this corporate

mentality, the SBA conceives that a firm which foregoes

the tax shields under Section 162(m) may pay their non-

covered employees less to make up for the tax payment on

the unqualified compensation to its executive. For example,

a company with $10 billion per year in revenue and a forty

percent tax rate can increase a covered employee’s tax-

able income by $600,000 per year for every $10,000

per year reduction in the wages of each of its one hundred

non-covered employees and still return the same earnings.

Therefore, Section 162(m) may harm more than one con-

stituency, such as employees.

R E A S O N S F O R S H A R E O W N E R V I G I L A N C E U N D E R S E C T I O N 1 6 2 ( M )The SBA contends that the above criticisms create reasons

for increased shareowner vigilance under Section 162(m).

By knowing the provision and its weaknesses, shareown-

ers can analyze how a compensation committee structures

its executive compensation packages under the law, how

a compensation committee behaves in relation to the

company’s executives, and the return that a compensation

package provides to shareowners.

Since shareowners must approve a performance-based

compensation plan before it will be qualified under Section

162(m), the SBA encourages shareowners to analyze the

plan in relation to Treasury Regulations Section 1.162-27 to

determine how the plan is structured under the law. As dis-

cussed in the “Overview,” Section 162(m) mandates that

performance-based compensation plans be predetermined

and objectively measurable. Accordingly, the SBA urges

shareowners to analyze the metrics involved in the perfor-

SHAREOWNERS HAVE ONLY THEMSELVES TO BLAME IF EXECUTIVE COMPENSATION CONTINUES TO RISE WITHOUT ANY IMPROVEMENTS IN ITS LINKAGE WITH PERFORMANCE—THEY CURRENTLY HAVE THE RIGHT TO VOTE AGAINST MANY ANNUAL AND LONG-TERM INCENTIVE PLANS AS WELL AS OTHER EQUITY BASED PLANS

THEY VIEW AS NOT REPRESENTATIVE OF MEANINGFUL PERFORMANCE BASED FRAMEWORKS.

WITH MINIMAL EFFORT, SHAREOWNERS CAN AND SHOULD MONITOR HOW

EXECUTIVE COMPENSATION COMMITTEES STRUCTURE EXECUTIVE COMPENSATION AGREEMENTS WITHIN THE CONFINES OF

SECTION 162(M).



mance-based compensation plan to look for objectivity in

measurement. In looking at the metrics, shareowners must

determine how many metrics are disclosed in the com-

pensation plan, how the metrics are defined, whether the

metrics tie performance to compensation, and if the metrics

align managerial interests with shareowner interests.

When considering how many metrics are disclosed in the

compensation plan, shareowners should observe whether

the company uses “proprietary” metrics and what propor-

tion of the compensation plan is composed of proprietary

measures. Regarding metric definition, shareowners should

question whether a metric is qualitative or quantitative.

The SBA contends all metrics should be defined to the

extent necessary for a third-party to determine whether

the particular goal was met and the amount of compensa-

tion due under the plan while simultaneously protecting

trade secrets and business strat-

egy. The SBA promotes using met-

rics that have a strong affinity with

performance and those that can be

reverse engineered by shareowners.

Management can easily manipulate

earnings per share (“EPS”) metrics

in the short-term. While appreciating the efficiencies of

capital markets, the SBA prefers metrics such as total

shareowner return (“TSR”), economic value added (“EVA”),

and other measures that more directly affect stock price

and have less malleability than EPS does. After all, shar-

eowners can align managerial interests with their own more

effectively when performance measures actually relate to

executive performance. As such, shareowners can still use

the constraints of Section 162(m) to ensure that the com-

pensation committee is paying an executive the minimum

amount necessary to align those interests. Along the same

lines, the SBA prompts shareowners to beware of deferred

remuneration, especially if these deferment amounts have

increased as this may signal an impending change in the

corporation’s leadership.

“If I had a quarter for every time I said ‘if I had a nickel…’, I’d have fi ve times the theoretical amount of money.”Steven Colbert, The Colbert Report


The SBA contends that shareowners can employ Balsam

and Yin’s findings to measure whether a compensation plan

is maximizing shareowner return. If a company does not

disclose any compensation plan to shareowners, this means

that a company may be forfeiting significant tax deductions

under Section 162(m). Analyzing such behavior allows

shareowners to investigate further whether a company is

maximizing shareowner return by taking advantage of tax

shields. Moreover, Balsam and Yin’s survey demonstrates

that shareowners need to examine a corporation’s entire

performance if it is forfeiting tax deductions under Section

162(m) because as the study showed, riskier firms and

firms with a lower ROA were more likely to forfeit deduc-

tions under the tax provision than were firms with lower risk

and greater ROA. Moreover, if a firm does forfeit available

tax deductions, shareowners should question whether this

signals that management believes the firm to be riskier than

its peers or the market.

If a compensation committee implements a performance-

based compensation plan after the shareowners reject it,

then the SBA encourages shareowners to consider vot-

ing against retaining all or part of the board of directors

because this behavior imposes a tax liability on the firm,

which decreases shareowner value. We believe shareowners

should also examine changes in the company’s workforce in

order to determine whether the company is using employee

compensation efficiently. Finally, shareowners should be

aware that the United States Third Circuit Court of Appeals

held in Shaev v. Saper that Section 162(m) disclosures

were material regarding a shareowner’s decision to approve

a compensation plan. Therefore, the court permitted the

shareowners to pursue a derivative action since the board

of directors and its officers misrepresented the terms of a

performance-based executive compensation agreement in a

proxy statement to the shareowners.

Ultimately, the SBA encourages shareowners to use Section

162(m) to balance the costs and benefits of the executive

compensation agreement and determine whether it aligns

the corporate officers’ interests with shareowner inter-

ests by facilitating long-term value creation. To provide

shareowners with a picture of how this is done, we have

provided excerpts of insightful proxy disclosures regarding

performance-based executive compensation.

S A M P L E S O F P E R F O R M A N C E - B A S E D P R O X Y D I S C L O S U R E U N D E R 1 6 2 ( M )

The SBA highlights exemplary and inadequate proxy

disclosures relating to performance-based executive

compensation practices required under Section 162(m).

What follows are excerpted sections from two company’s

proxy disclosures, along with analysis of their disclosures’

strengths and weaknesses.

Humana, Inc. – Disclosure de minimis“Upon the recommendation of the Organization &

Compensation Committee (the “Committee”), the Board of

Directors has adopted the Humana Inc. Executive Management

Incentive Compensation Plan (the “Plan”), and recommends

that the stockholders approve the Plan, effective as of January

1, 2008, for awards earned during a five-year period thereafter

(through December 31, 2012.)

Purpose: The purpose of the Plan is to permit the Company to

provide annual performance incentives which link the com-

pensation of selected key executives to certain key perfor-

mance objections and to reward them, when appropriate, for

their efforts in optimizing the profitability and growth of the

Company consistent with sound and ethical business prac-

tices. This Plan links the compensation of the executive with

his/her performance, and provides a direct correlation with the

performance of the Company and its value to our stockholders.

The Company has structured the Plan so that any compensa-

tion paid pursuant to the Plan will be “performance-based

compensation” within the meaning of Section 162(m) of the

Internal Revenue Code.

Under Section 162(m) of the Internal Revenue Code, as amend-

ed, the amount of compensation earned by the Chief Executive

Officer, and the four other most highly paid executive officers of

the Company in the year for which a deduction is claimed by the

Company (including its subsidiaries) is limited to $1 million per

“I cannot reject the view that market fl uctuations mechanically cause changes in CEO compensation with no detectable reverse causality. Further I fi nd that in the aggregate data, increases in CEOs’ pay decrease corporate profi ts. I conclude that in the late ‘90s stock market bubble period, shareholders were taken for a ride and ended up paying huge amounts of money to their CEO for no rational reason.”Uerorgui I. Kolev, “The Stock Market Bubble, Shareholders’ Attribution Bias and Excessive Top CEOs Pay,”

“If the executives’ compensation is tied to the volume of business rather than the quality of business, we should expect dealmakers to be more attentive to the number of transactions than the value they create.”

Nell Minow, The Corporate Library

person, except that compensation that is performance-based

will be excluded for purposes of calculating the amount of

compensation subject to the $1 million limitation.

New Plan Benefits: As described above, the Committee

must select the executive officers eligible to participate in

the Plan. For 2008, eight executive officers, including the

Named Executive Officers, will be participants in the Plan. The

Performance Target for 2008 will be based upon an Earnings

Per Share target goal of $5.45. For 2008, the potential

awards for the participants range from $0 to $2,037,158.

Performance Targets: Under the Plan, the Performance

Targets may be based on one or more of the following prede-

termined business goals as defined in the Plan: (i) stock price,

(ii) earnings per share (“EPS”), (iii) operating income, (iv) return

on equity or assets, (v) cash flows from operating activities, (vi)

EBITDA, (vii) revenues, (viii) overall revenue or sales growth, (ix)

expense reduction or expense management ,(x) market posi-

tion, (xi) total shareholder return, (xii) return on investment,

(xiii) earnings before interest and taxes (EBIT), (xiv) consoli-

dated net income, (xv) return on assets or net assets, (xvi) eco-

nomic value added, (xvii) shareholder value added, (xviii) cash

flow return on investment, (xix) net operating profit, (xx) net

operating profit after tax, (xxi) return on capital or equity, (xxii)

membership goals, or (xxiii) any combination, including one or

more ratios, of the foregoing.

The Committee may determine at the time the Performance

Targets are established that certain adjustments will be made

in evaluating whether the Performance Targets have been met

to take into account, in whole or in part, in any manner specified

by the Committee, any one or more of the following: (i) the gain,

loss, income or expense resulting from changes in account-

ing principles that become effective during the Performance

Period; (ii) the gain, loss, income or expense reported publicly by

the Company with respect to the Performance Period that are

extraordinary or unusual in nature or infrequent in occurrence;

(iii) the gains or losses resulting from, and the direct expenses

incurred in connection with the disposition of a business or the

sale of investments or non-core assets; (iv) the gain or loss

from all or certain claims and/or litigation and all or certain

insurance recoveries relating to claims or litigation; (v) the

impact of impairment of tangible or intangible assets, including

goodwill; (vi) the impact of restructuring or business rechar-

acterization activities, including but not limited to reductions

in force, that are reported publicly by the Company; or (vii) the

impact of investments or acquisitions made during the year or,

to the extent provided by the Committee, any prior year.

Each of the adjustments may relate to the Company as a

whole or any part of the Company’s business operations. The

adjustments are to be determined in accordance with gener-

ally accepted accounting principles and standards, unless

another objective method of measurement is designated by the

Committee. In addition to the foregoing, the Committee shall

adjust any Performance Targets or other features of an Award

that relate to the value of, any Shares of the Company, to

reflect any stock dividend or split, recapitalization, combination

or exchange of Shares or other similar changes in such stock.

The Committee also has the discretion to decrease an award.

Award Payments: Under the Plan, all selected executive offi-

cers or key employees, including the Named Executive Officers

could be eligible for a bonus each year. The precise percent-

age earned shall be based upon a schedule of achievement of

Performance Targets determined each year by the Committee.

Under the Plan, the maximum incentive compensation earned

in any fiscal year by the Chief Executive Officer may not exceed

Five Million ($5,000,000) or Three Million ($3,000,000) for

any other Participant.

The Committee has sole discretion to determine whether to

actually pay any or the entire permissible Award or to defer pay-

ment of any Award. The Committee is also authorized to estab-

lish additional conditions and terms of payment for Awards,

including the achievement of other or additional financial, stra-

tegic or individual goals, which may be objective or subjective,

as it deems appropriate. Although the Committee may waive

any additional conditions and terms, it may not waive the basic

Performance Targets as to the business criteria chosen for any

Performance Period.

Awards earned will be paid on or before March 15 of the year

following the year with respect to which it was earned, or such

earlier date as may be required under the Internal Revenue Code

to make the payments deductible under the Internal Revenue

Code for the fiscal year in which they were earned.

HUMANA DISCUSSIONOn the positive side, the plan by Humana acknowledges

Section 162(m) of the IRS Code and provides perfor-

mance metrics by which to measure executive performance.

Additionally, the compensation plan mentions that 2008

performance-based compensation will be based on earnings

per share (EPS), with an EPS target of $5.45 for 2008.

According to Humana’s 2007 Consolidated Statements

of Income, Humana was far below this measure in 2005

and 2006, with a basic earnings per common share of

“Effectively aligning executive pay with company performance remains, in many cases, the stuff of corporate governance fantasy.” Houston Chronicle, “Pay at top truly out of whack,” 11/22/08



Number of Individual Executive Incentive Bonus Plans Failing to Receive Shareowner Support in 2008

(aggregate voting through July)

0

Number of Individual Executive Incentive Bonus PlansVoted AGAINST by SBA in 2008

(among 234 plan votes through June)

103Percentage of Companies in the Russell 3000

Disclosing Explicit Performance Measures(as of most recent proxy fi ling)

17

Maximum Salary Amount That Can Be Deducted from Net Income under Section 162(m) IRC

$1million


$1.83 and $2.97, respectively. Obviously, the diluted EPS

was slightly below this number. However, this represents a

sixty-one percent growth rate in EPS from 2005 to 2006.

In 2007, Humana’s basic EPS grew by sixty-eight percent

over 2006, to $5.00. Since Humana set an EPS target of

$5.45 for 2008, the company only needs a nine percent

increase in basic EPS for its covered employees to receive

performance-based compensation even though this would

be a fifty-nine percent decline in EPS growth compared to

2006-07. Humana’s 2008 EPS target arguably violates

Section 162(m)’s requirement that a performance objec-

tive be substantially uncertain. Furthermore, if the market

expects Humana to continue its EPS growth near sixty

percent, shareowners would not benefit from a 2008 EPS

of $5.45 if management stops at that figure. Therefore,

Humana’s EPS measure gives executives an easy target to

achieve multi-million dollar bonuses, and this target could

incite management to ease up once it achieves the $5.45,

which could actually diminish total shareowner return. As

such, Humana’s plan may not align management’s interests

with the shareowners’ interests.

Other than the EPS measure, Humana’s plan has several

flaws that provide for extensive discretion by the executive

compensation committee in determining the amount of

performance-based compensation to be paid. First, the plan

offers a laundry list of twenty-three “performance targets”

that could determine executive compensation in the future.

These metrics are not fully defined, and the plan does not

explain how these metrics will be weighted in regards to

each executive’s performance. Furthermore, the twenty-

third metric is not really a metric but a blanket statement

that allows the compensation committee to use any combi-

nation of the prior twenty-two ratios or measures. Second,

the plan endows the compensation committee with seven

discretionary factors in determining whether an executive

met a target. Some of these discretionary factors consider

difficult to value items, such as goodwill. Third, Humana

does not mention whether it will always measure its list

of twenty-two performance goals in house or against the

industry. If Humana’s compensation committee decided to

measure internally one year and externally another year, or

if Humana changed metrics each year, then this plan may

not be objective under Section 162(m) in that a third-party

may not have all of the relevant facts to calculate executive

compensation. Considering the Humana plan’s lack of shar-

eowner perspective, the SBA would encourage significant

changes to better define its performance-based executive

compensation under Section 162(m).

P f i z e r - D i s c l o s u r e d e f a c t o

Performance Objectives and Annual Cash Incentive Awards

(Bonus) - Target Award Opportunities

Each Named Executive Officer’s 2007 target bonus award

opportunity was set as a percentage of salary based on sal-

ary grade. The Committee determined the target bonus lev-

els based on its evaluation of competitive market data and

internal equitability. For 2007, target bonus opportunities for

the Named Executive Officers ranged from 60–150% of sal-

ary. These target levels are at or below the market median for

similar positions.

For purposes of Section 162(m) of the Internal Revenue Code

(“162(m)”), the total amount of any bonus that can be paid to

an executive officer in any one year is limited to a maximum of

0.3% of Pfizer’s “adjusted net income” (which for these pur-

poses is defined as operating income from continuing opera-

tions, reduced by taxes and interest expense, and adjusted

for any one-time gains or other non-recurring events). Since

actual bonus amounts are based on the Committee’s assess-

ment of each executive’s level of achievement against his or

her specified goals, an executive’s bonus may be more or less

than target, subject to the overall adjusted net income cap.

2007 Performance Process

The Committee selected and weighted Mr. Kindler’s goals, tak-

ing into consideration Pfizer’s current financial and strategic

priorities. The Committee recognizes that shareholder return

should be emphasized, but also that performance against

this metric may not be reflected in a single 12-month period.

For 2007, 60% of Mr. Kindler’s bonus award opportunity

was based on the Committee’s assessment of Pfizer’s total

financial performance. This weighting was raised from 20%

in 2006. Mr. Kindler’s financial performance for 2007 was

measured by the following metrics:

• Total revenues

• Adjusted diluted earnings per share

• Cash flow from operations

“The debate over the proper role of shareholders in the governance of the modern corpora-tion continues to rage. To be sure, too much shareholder influence risks turning a company into a paralyzed wreck, or maybe worse, an unfocused entity that is unable to stick with a strategy long enough to reap the benefits. Still, it’s difficult to see how a more responsive board is not in the best interests of shareholders. After all, the shareholders own the com-pany. What’s needed is a middle ground – something between the aloof and incestuous “old boys club” of days gone by and a California-style referendum model where each and every board decision is second guessed by Monday morning quarterbacks.” RiskMetrics Group, M&A Insight Note, Wendy’s International ‘New Paradigm’, May 16, 2007

The remaining 40% of his award opportunity was based on

the Committee’s assessment of the following strategic goals:

• Establishing a lower, more flexible cost

base and instituting fundamental change

within the organization

• Progress in advancing research and devel-

oping new products

• Executing a business development strat-

egy to create additional sources of revenue

• Improving internal and external relation-

ships and engaging collaboratively with

colleagues, patients, customers, business

partners, regulators and legislators.

The Committee selected these strategic goals based on its

judgment that they represent areas where Mr. Kindler should

focus his energies to drive Pfizer’s business forward. Mr.

Kindler’s goals were approved by the Board and his progress

was periodically reviewed by the Committee and the Board

during the year.

The specific performance goals and relative weighting between

financial and strategic performance varied among the Named

Executive Officers depending on their individual position.

Initially, Mr. Kindler made recommendations for the goals and

relative weightings for each executive to reflect the priorities

in their respective areas of responsibility. The Committee then

considered and judgmentally adjusted these recommenda-

tions, as appropriate. The financial objectives were weighted

in the range of 45% to 70% for each Named Executive Officer.

The Pfizer Inc financial objective was based on targets of total

revenue of $47.6 billion, adjusted diluted earnings per share

of $2.20, and cash flow of $12.5 billion. The differences in

weightings were based on the Committee’s and Mr. Kindler’s

evaluation of each individual’s priorities and effects on results.

P F I Z E R D I S C U S S I O NPfizer’s performance-based compensation disclosure sig-

nificantly exceeds Humana’s disclosure in terms and qual-

ity. While Pfizer’s 162(m) discussion was not as developed

in its 2007 CD & A as Humana’s was, Pfizer thoroughly

discussed Section 162(m) when Pfizer’s shareowners

approved its current performance-based compensation plan

in 2001. First, Pfizer discusses a specific, limited number of

metrics that it will use to measure executive performance.

Three metrics are related to financial objectives, and four

measures are related to strategic objectives. Therefore,

Pfizer attempts to align management’s interests with shar-

eowners’ interests through narrowly defined standards that

focus on short-term and long-term value creation. Second,

Pfizer explains the weights associated with each measure,

which creates additional transparency in the priorities of the

board and management. Third, Pfizer’s performance-based

program discloses the financial targets for it executives.

Finally, Pfizer’s targets facilitate planning through attain-

ability, but they simultaneously incorporate enough uncer-

tainty to stimulate improvement.

Pfizer’s fluctuations in revenue over the past four years

made the total revenue target reasonably uncertain, espe-

cially considering Pfizer’s reliance on product patents to

maintain revenues. Additionally, Pfizer’s diluted EPS has

not approached $2.20 over the last three years, nor did it

reach this target in 2007. Pfizer’s target operating cash

flows was probably the most relaxed, but the company has

realized volatility in cash flows over the last three years as

well. The SBA would encourage Pfizer to readopt total shar-

eowner return as an executive compensation performance

measure. Additionally, although the SBA respects Pfizer’s

ability to protect trade secrets and competitive business

practices, we would ask Pfizer to better define how it

calculates its strategic objectives; however, the SBA gener-

ally approves of Pfizer’s overall disclosure of performance-

based executive compensation.

1 6 2 ( M ) ’ S F U T U R E U N D E R T H E E M E R G E N C Y E C O N O M I C S T A B I L I Z A T I O N A C T ( E E S A )In light of the global degeneration of financial markets due

in large part to executive behavior in the financial industry,

legislation has intervened again with executive compensa-

tion practices. Under the Troubled Asset Relief Program

(TARP), which is a component of the EESA, the federal

government is attempting to revive the financial sector by

purchasing or insuring troubled financial instruments, such

as mortgage-backed securities. If a company accepts

$300 million or more in assistance under TARP, then the

firm must acquiesce to federal constraints on executive

compensation.

For instance, the Treasury Department confirmed that

TARP decreases Section 162(m)’s $1 million per year

tax-deductible cap on salary for covered employees to


IF A COMPANY DOES NOT DISCLOSE ANY COMPENSATION PLAN TO SHAREOWNERS, THIS MEANS THAT A COMPANY MAY BE FORFEITING SIGNIFICANT TAX DEDUCTIONS UNDER

SECTION 162(M).

ANALYZING SUCH BEHAVIOR ALLOWS SHAREOWNERS TO INVESTIGATE FURTHER WHETHER A COMPANY IS MAXIMIZING SHAREOWNER RETURN BY TAKING ADVANTAGE OF TAX SHIELDS.

$500,000 per year on all forms of executive compensa-

tion, including performance-based cash and options, while

a company participates in TARP. Moreover, TARP excludes

tax deductions on “golden parachute” awards and deferred

compensation, all of which was previously immune to scru-

tiny under Section 162(m).

In addition to the tax provisions, TARP provides “claw-

back” provisions, which allow the firms to recover any

performance-based pay predicated on “materially inaccu-

rate” financial statements. Finally, TARP prohibits senior

managers from receiving incentives to take “unnecessary

risks” that threaten the financial well-being of the firm.

While TARP’s provisions currently apply only to those finan-

cial institutions receiving $300 million or more under the

program, legislators are considering extending its executive

compensation controls to all publicly traded companies,

just as Section 162(m) does now. Furthermore, the CEO,

CFO, and a firm’s next three highest compensated employ-

ees may not be the only individuals snared under TARP

or future legislation driven by TARP. According to a Wall

Street Journal article titled, “Securities Firms Tackle Pay

Issue: Limits on Compensation Are Considered to Head Off

a Public Outcry,” published October 31, 2008, the federal

government may cast the spotlight on the millions of dollars

in compensation received by non-executive level employees,

such as traders and investment bankers. The article illus-

trates that top traders at these firms can out earn CEO’s in

good years, so these lower level

employees may be rightfully

concerned about such an audit.

The Journal article also con-

veys anecdotal evidence that

executives are considering self-

imposed compensation capita-

tions and forfeitures. However,

these altruistic ideations may be

too little too late. With Nicholas

Kristof exposing that Richard

Fuld grossed $45 million in 2007 while he “obliterated”

the 158 year-old Lehman Brothers and the Wall Street

Journal graphically displaying the amount of money infused

into financial companies as compared to the deferred com-

pensation owed to these institutions’ executives, these

executives will need to make swift and drastic changes

to their prior and future compensation levels if shareown-

ers and taxpayers are to take them seriously. For instance,

Goldman Sachs received a $10 billion capital infusion from

the taxpayers while claiming that it owed $11.8 billion

to executives in mostly deferred compensation. Another

example shows J.P. Morgan Chase gaining $25 billion in

capital under the EESA, yet it claims that it owes $8.2 bil-

lion to executives in deferred compensation, some of which

will be paid to former Bear Stearns and Washington Mutual

executives.

Although TARP’s executive compensation restrictions face

the same criticisms as Section 162(m) in that these

restrictions limit shareowner value in a number of ways,

shareowners stand to benefit from knowing TARP’s restric-

tions on executive compensation because these restrictions

provide shareowners with an assessment tool for determin-

ing how a company structures its compensation plan under

the law, whether a non-financial institution is sensitive

to the political and social costs associated with executive

compensation, and how a company’s executive compensa-

tion plan actually increases shareowner value. Therefore,

the SBA recommends that shareowners critically examine

compensation proposals placed before them and to vote

on the merits of the plans, not just the merits of the board

members. This will require shareowners to abandon the

traditional practice of rubber stamping executive compen-

sation plans. By doing so, shareowners stand to increase the

value of their equity investments. [sba]

F I S C A L Y E A R 2 0 0 8 C O R P O R A T E G O V E R N A N C E R E P O R T

ADDITIONAL RESOURCES COVERING SECTION 162(M) AND EXECUTIVE COMPENSATION...

“Section 162(m):Requirements, Implica-tions and Practical Concerns.” by Exequity(September 2008)[www.sbafla.com]

“Perspectives on Executive Compensation,” SBA Executive Compensaiton Study(January 2007)[www.sbafla.com/fsb /Portals /6/CorpGov-ernance /Executive%20Compensation%20(2007).pdf]

“Controlling Executive Compensation Through the Tax Code” (November 2007)Gregg Polsky, Professor of LawCollege of Law, Florida State University

“...executive compensation is too high in the U.S. because the process by which executive compensation is determined has been corrupted by acquiescent, pandering and otherwise ‘captured’ boards of directors.”Jonathan Macey, Law Professor, Yale University

33

CORPORATE GOVERNANCE ANDPORTFOLIO RETURNS

GUEST COMMENTARY BY AARON BERNSTEINGUEST COMMENTARY BY AARON BERNSTEINSENIOR RESEARCH ASSOCIATESENIOR RESEARCH ASSOCIATE

HARVARD LAW SCHOOLHARVARD LAW SCHOOL


Before modern public corporations, most large companies

were owned by trusts or families controlled by people like

Carnegie, Frick, and Rockefeller. They ran their companies

themselves, or hired and fired executives to work under their

direction. There was little question that the owners were in

charge and out to make a profit for themselves. But when

ownership passed to millions of anonymous stockholders

who bought and sold on a daily basis, the corporation was

transformed into a self-perpetuating institution controlled

not by the owners, but by the hired executives.

As early as the 1930s experts realized that this posed a

fundamental governance dilemma: How do investors insure

that management is working in the best interests of the

owners and the corporation as a whole, rather than in their

own interests? This question underlies many of today’s

corporate governance debates. The modern incarnation

of these arguments got underway in the United States in

the early 1980s, when corporate takeovers were raging

and companies were fending off raiders such as T. Boone

Pickens with poison pills and greenmail, and tacking on

golden parachutes for top executives in case the defenses

failed. Such actions gave rise to charges that entrenched

management was putting its own interests ahead of stock-

holders.

The California Public Employees’ Retirement System

(CalPERS) was among the first institutional investors to

respond. At first it tried lawsuits, but when that looked like

a dead end, then California State Treasurer Jesse Unruh,

who joined the CalPERS board in 1982, recruited other pen-

sion funds to form the Council of Institutional Investors to

push for better corporate governance. Since then, demands

for better governance have spread across the country and

around the world. The basic view behind them is that com-

panies will perform better, and produce higher profits and

returns, if they’re governed in a way that ensures manage-

ment remains focused on what’s best for the corporation

as a whole.

It’s now been more than 25 years, so it seems fair to ask, is

there any evidence that this is in fact true? The answer is

yes, although it’s a qualified yes. At this point, a consider-

able body of quantitative evidence has accumulated attest-

ing to the link between governance and positive returns.

There’s also plenty of circumstantial evidence, basically in

the form of many kinds of actors who sink their own hard

dollars into demands for better governance.

Let’s start with the quantitative data, which includes doz-

ens of studies over the years (all done before the 2008

stock market collapse). A recent influential one came

from a rather surprising source: The Association of British

Insurers (ABI). In February of 2008, it published a study

called Governance and Performance in Corporate Britain. An

excerpt from the introduction by the ABI’s Director General

helps to explain why a conservative business group would

pursue such a project.

“The ABI’s leading role in corporate governance stems from

our members’ belief that well-governed companies will pro-

duce better returns for shareholders over time. Longterm

value creation matters to insurers because their holdings

are long-term in line with their liabilities. Yet, while this has

prompted us to undertake serious dialogue with companies

and considered voting, the causal relationship between

governance and value creation has never been demon-

strated. This piece of research does show a clear connec-

Do shareowner demands for better corporate governance lead

to better portfolio returns? Concerns about how companies are governed have been around since the birth of the modern publicly-owned corporation around the turn of the last century.

Some of the time they’ve been political, with critics seeking more a democratic economic system or some other goal not directly related to the company’s financial performance. But much of the time they’ve stemmed from shareowners seeking higher returns and lower risk on their investment.


THIS SECTION IS BASED ON A LECTURE GIVEN BY AARON BERNSTEIN IN JULY OF 2008 FOR THE PROGRAM OF ADVANCED TRUSTEE STUDIES FOR PUBLIC PENSION-FUND TRUSTEES, WHICH IS PART OF THE HARVARD LAW SCHOOL LABOR AND WORKLIFE PROGRAM.

tion between good governance, company performance and

investor return. One important conclusion, not highlighted

in other research, is that good governance reduces volatility

of returns. Moreover, good governance is also a precursor to

good performance rather than vice versa.”

The study used the ABI’s corporate governance ranking

system to examine a wide variety of governance attri-

butes at 654 companies. They include things like director

independence, CEO pay levels, stock dilution controls, and

whether the chairman and CEO jobs are held by one person.

It then compared each company’s score on each attribute

to its performance between 2004 and 2007. It found a

strong correlation between low governance scores and low

performance.

• Each additional low governance score reduc-

es the industry-adjusted return on assets by

1 percentage point a year.

• In addition, companies that have the worst

governance scores in every year underper-

formed the rest by about 3 to 5 percentage

points a year in terms of industry-adjusted

ROA.

• Over a five-year period, the shares of well-

governed companies deliver an extra return

of 37 basis points a month after adjusting for

industry differences.

• The volatility of share-price returns is lower

for portfolios of well-governed companies.

• In addition, well-governed companies deliver

higher returns after adjusting for risk.

Many other studies have found similar results. For example,

a 2004 study by two Georgia State professors looked at

performance by using the Corporate Governance Quotient

produced by RiskMetrics, which ranks companies’ gover-

nance systems for institutional investors. Like the ABI’s

system, the Quotient scores companies on a variety of gov-

ernance factors. They looked at 35 performance indicators,

including total returns over one, three, five, and ten years,

return on assets, on equity, and on investment, plus PE’s,

dividend yields, and so on.

The conclusion was that companies with better industry-

adjusted governance quotients did better on four measures

in all time periods except for one year: Shareholder returns;

Profitability; Risk (measured by stock price volatility); and

dividend payouts and yields. The authors also tried to

pinpoint which specific governance factors were the most

important to performance. To do so, they looked separately

at board composition, compensation, takeover defenses,

and auditing procedures. Here they found that board com-

position to be the most important factor and takeover

defenses the least.

Another 2004 study, by Lipper, a company that analyzes

mutual funds, came at the issue indirectly. It used the rat-

ings of GovernanceMetrics International (GMI), an investor

advisory firm like RiskMetrics, to look at the performance

of mutual funds. It found that large-cap funds overweight

their portfolios with companies that have above average

from GMI. The funds that invest in better ranked companies

outperformed average mutual funds over three and five-year

periods.

A 2003 study by three academics ranked S&P 1,500

companies in terms of policies that enhance shareholder

rights, such as voting rights and takeover defenses. They

concluded that an investment strategy that bought firms

with the strongest shareholder rights and sold firms with

the weakest would have earned abnormal returns of 8.5%

a year. The authors also found that firms with stronger

shareholder rights had higher firm value, higher profits and

higher sales growth.

A 2005 study by Moodys Investor Service found a clear link

between high CEO pay and credit risk. Specifically, it found

that firms in the top 10 percent with respect to ‘‘high unex-

plained bonuses’’ and ‘‘high unexplained option grants’’

experienced dramatically higher default rates and dramati-


“Critics of shareholder activism have argued that challenges to entrenched boards could destroy ‘collegiality.’ I believe that it is time to realize that boards are neither fraternities nor private clubs. Boards composed of ‘colleagues’ that are friendly to management and fail to question poor performance or demand accountability are, in my view, the greatest threat to the vitality of our economic system. With focused and engaged boards, egregious compensation packages, backdating of options and other abuses might well have been avoided, and well-known corporate disasters might not have happened.” Carl Icahn, Letter to Motorola Shareowners, April 18, 2007

cally higher downgrade rates than the middle 70 percent of

the distribution. Moodys suggested three reasons:

• Excessive compensation may be indicative

of weak management oversight.

• Large pay packages that are highly sensitive

to stock price and/or operating performance

may induce greater risk taking by managers,

which may be consistent with stockholders’

objectives, but not necessarily bondholders’

objectives.

• Large incentive-pay packages may lead

managers to focus on accounting results,

which may divert management attention

from the underlying business or even cre-

ate an environment that ultimately leads to

fraud.

Other studies have found the following:

• The likelihood of accounting fraud increas-

es as the share of CEO pay tied to stock

increases.

• Companies that split the chair and CEO jobs

post higher annual returns than those that

combine them.

• A company’s value is negatively affected by

related-party transactions, such as loans to

executives.

Similar results have been found in other countries:

• A 2004 study replicated the one on share-

holder rights for German companies, and

found the same correlation to performance.

• A study of 300 large European companies

that year found a positive correlation of a

set of governance indicators to stock returns

and company value, although not to operat-

ing performance.

• A 2007 study of firms listed in Taiwan used

a broad-brush governance index that looked

at the size of the board and of manage-

ment’s holdings, as well as how much of the

stock is held by large block-owners. It found

what the authors called a “striking” relation-

ship between better governance and stock

performance.

• A 2006 study of Korean public companies

found similar strong correlations between

returns and better governance.

• Deutsche Bank has done half a dozen stud-

ies over the past five years of companies in

Asia, Europe, the UK, and the US, finding

strong correlations between governance and

stock returns every time.

There have been plenty of other studies as well. But before

concluding that the case for good governance is proven,

take a minute to listen to the critics. Not surprisingly, among

them are executives and business groups. Many if not most

have been opposing shareholder demands ever since they

were first made. Of course they have a vested interest in

doing so, since it’s their ability to exercise unfettered power

that’s being challenged. But that doesn’t necessarily mean

they’re wrong.

Management has made many arguments against greater

rights for shareholders over the decades, both in the United

States and in other countries. Mostly these boil down to the

view that management is more likely to maximize profits

and shareowner returns if it has a free hand to manage. One

argument is that giving more rights to shareowner opens

the door to counter-productive micromanagement or to

self-serving demands by minority investors with their own

agenda, like hedge funds or labor unions. Others argue that

one size doesn’t fit all, and that policies which make sense

at some companies, like splitting the chair and CEO jobs,

could be counterproductive at others.

Although these views are certainly plausible, there don’t

seem to be any quantitative studies showing better perfor-

mance at companies with less of what shareholder advo-

cates define as good governance. The closest argument

with a suggestion of statistical backing can be found in

assertions by Martin Lipton, a prominent Wall Street lawyer

at Wachtell Lipton Rosen & Katz who has been among the

most passionate defender of management prerogatives

since shareowners began questioning them in the early

1980s. Lipton and others in the pro-management camp

say that U.S. companies have outperformed those of other

countries over the post-World War II period, so the U.S. sys-

tem of governance must be good and shouldn’t be altered in

fundamental ways.

Of course, this implies that US companies have governance

that shareholders would define as inferior to other countries.

However, it’s not clear that this is a valid premise. As a broad

generalization, it might be argued that that Europe and

especially Australia require more shareholder rights than the

US, although that’s by no means clear. But certainly other

regions of the world lag far behind, especially where state

and family run companies are predominant.

Even so, a few academic studies have cast doubt on all the

ones finding positive links to good governance. This isn’t the

same as quantifying better performance at so-called poorly

governed companies, but it’s still a challenge for the thesis,

or at least a question for it. As long ago as 1996, one study

found no improved operating performance after shareholder

activists achieved a change in a company’s governance

structure.

Other studies, in 1999 and 2003, concluded that a board

with more independent directors had no positive effect on

performance. A 2005 study could find no correlation, posi-

tive or negative, between a range of performance measures


F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N ( S B A ) 38

Basis Points of Monthly Abnormal (Excess) ReturnsFor Better Governed Companies

37

Annual Returns of Companies that Preclude CEOs fromServing as Chairman of the Board of Directors compared

to Non-Independent Chaired Firms

Abnormal (Excess) Returns Gained by Overweighting (Long) Goodand Underweighting (Short) Governance Factors

%

Volatility of Share Prices for Better Governed Companies

Lower

and seven governance factors, such as board

independence, anti takeover devices, and whether

executives and directors owned the company’s

stock. A separate study that year examined 51

factors and found only 10 of them spurred per-

formance, leading them to wonder if many share-

holder demands are superfluous.

A 2006 paper raised a different kind of question

by looking not at whether firms with better governance did

better, but at whether those that changed their governance

to the better forms performed better. The answer: There

was no discernible correlation.

A number of critics of the governance movement argue

that the real problem is investor overreliance on proxy advi-

sory firms. They point out that most institutional investors

use the governance guidelines provided by RiskMetrics,

GlassLewis, GMI, and the other players. This, they say, is a

problem because the advisors all have their own proprietary

definition of governance. Although there’s a lot of overlap,

there’s no standard definition of good governance. The

critics also say that the one-size-fits-all approach used

by many advisors is a blunt instrument that doesn’t serve

investors well.

Whether or not such criticisms suffice to invalidate the

good governance/ performance link, it’s clear that the advi-

sory firms miss a lot of problems. For example, RiskMetrics

gave HealthSouth good governance ratings, even praising

its independent board and annual director elections, just

months before a massive scandal was revealed there in

2003.

Similarly, GMI gave good ratings to companies that soon

after were forced to make major governance changes due

to scandal or performance problems, including Boeing,

AMR, Merrill Lynch, Bristol-Myers, Delta, EDS, Citigroup,

and Xerox. It also gave below-average ratings to top per-

forming companies, such as Dell, Southwest Airlines, UPS,

Starbucks, and eBay.

Still, the point of governance ratings is to flag risks for

investors. The fact that they miss some problems or flag

risks that don’t result in negative outcomes doesn’t neces-

sarily invalidate either the rankings approach or the gover-

nance/performance link. After all, the broad statistical stud-

ies that found them to be successful means that the relative

handful of failures at the companies mentioned here were

offset by hundreds of instances in which the flags worked

at other companies.

In addition to all the quantitative research, there’s another

set of reasons to believe that better governance enhances

corporate performance. This is the circumstantial evidence

mentioned earlier. Basically, a lot of investors have put big

dollars into the belief that it’s true. Obviously they could

all be wrong, just as a much greater number of investors

were wrong about everything from the tech bubble to the

real estate bubble and subprime crisis that precipitated the

financial markets meltdown of 2008.

Still, governance investments have sprung up all over the

globe, and continue to do so at an accelerating pace. One

approach can be found in the focus lists some activist

investors maintain. These lists identify companies with

poor governance in the hope that the negative publicity

will prompt management to agree to changes. Most of the

investors also engage companies on their lists directly in an

effort to induce changes.

Another bet that governance gains enhance

returns can be found in engagement funds.

These are investors who essentially create

an investment fund out of a focus list. At

this point there are dozens of such funds

all over the world. An early example is the

funds run by Hermes, an investment man-

ager owned by the British Telecom pension

fund that invests some $70 billion for 200

odd pension funds, insurance companies, charities, and

endowments. Prior to the 2008 stock market collapse, its

original UK Focus Fund had outperformed the market by

3 percent a year, after fees, since its inception in 1998.

Similarly, before the market rout, Hermes’ European Focus

Fund outperformed the market by 4 percent a year since it

was started in 2002 through mid 2008.

There are now dozens of similar funds in major markets

around the world. Some are relatively passive and look for

well-governed companies to invest in. Others take large

positions in under performing companies with poor gover-

nance and mount major campaigns, including proxy battles,

to improve their governance and performance. One of these

is a US fund called Relational Investors. Run by governance

activist Ralph Whitworth, it has outperformed its bench-

mark by more than 6 percent since he started it in 1996.

In recent years, so many investors have become convinced

about the governance return link that good-governance

stock indices have sprung up in a number of markets. The

idea is that the companies in the index adhere to higher

governance standards, making them more attractive to

investors. Dow Jones started a sustainability index in 1999

that includes a major governance component. FTSE, the

Financial Times London Stock Exchange joint venture,

started a governance index in 2004. The Brazilian stock

exchange started the Novo Mercado, a good governance

index, in 2006. There are also such indices for Japan,

Shanghai, Istanbul, and Korea, as well as one for India, the


““…share certifi cates are not wine, nor are they cheese, and therefore do not somehow gain nobility with age…” Going Private, The Sardonic Memoirs of a Private Equity ProfessionalApril 30, 2007 web post

Middle East, and Africa.

The last bit of evidence about the governance/portfolio

performance link is the most circumstantial of all. It involves

the good-governance programs run by entities such as the

International Monetary Fund, the International Finance

Corporation (IFC), the World Bank, the Organization for

Economic Cooperation and Development, and the United

Nations, as well as efforts by many governments around

the world.

All of these entities have significant staff devoted to

research and training related to governance. They have

drawn up governance codes, put on seminars and confer-

ences, and work with stock markets, investors, companies,

and business groups to push for better governance. They all

say they endorse governance standards because it produces

better returns for investors, which brings economic growth

and political stability.

One interesting development came recently at the IFC,

which is the private lending arm of the World Bank. One of

its jobs is to stimulate economic development in emerging

market countries. One way it does so is by investing its own

capital there, to give other investors confidence in unfamil-

iar markets. In total the IFC has about $1 billion invested in

170 or so private equity firms that invest in such markets.

In mid 2008, the IFC decided to put a governance expert

on every financial team managing its investments. Before,

its governance team would be called in if the investment

manager or client thought it was needed. But it decided

that governance is integral to investment and should be

considered from start to finish.

So what’s the bottom line about all the evidence for and

against the idea that good corporate governance enhances

long-term returns for investors? One conclusion might be

that even after all these many years, governance remains an

embryonic field in some ways. Both the theory and the hard

evidence seem stronger in support of the view that better

governance produces higher returns. But there’s still room

to debate exactly which governance measures should be

adopted by all companies, or by specific ones.

Still, that’s no excuse to dismiss any action. It seems clear

enough at this point that investors will do better, at least

over the long run, if executives are overseen by strong,

independent boards capable of preventing self-dealing. This

may be especially true in the United States, where outsized

CEO pay relative to comparable companies in Europe and

other advanced markets seems to offer a clear signal of

systemic governance breakdown stretching back decades.

It’s probably equally valid in emerging markets, which tend

to be dominated by state- and family-run companies. There

can never be a perfect investment formula, since predicting

the future is impossible. But it seems clear that any strategy

with a long-term horizon is incomplete without a vigorous

good governance stance . [sba]

ADDITIONAL RESOURCES COVERING CORPORATE GOVERNACE AND ITS IMPACT ON OPERATING PERFORMANCE AND STOCK RETURNS...

Gompers, Paul A., Joy L. Ishii, and An-drews Metrick, “Corporate Governance and Equity Prices,” National Bureau of Economic Research Working Paper No. W8449, August 2001.

Bebchuk, Lucian A., Kraakman, Reinier H., and Triantis, Gerogr G., “Stock Pyra-mids, Cross-Ownership, and Dual Class Equity: The Creation of Agency Costs of Separating Control from Cash Flows,” Published in Concentraed Corporate Ownership, 2000

Gillan, Stuart L., and Laura T. Starks, “The Evolution of Shareholder Activism in the United States,” Journal of Applied Corporate Finance, Volume 19, Number 1, 2007, Published by Morgan Stanley


SOVEREIGN WEALTH FUNDSIMPLICATIONS AND EFFECTS ON GLOBAL CORPORATE GOVERNANCE & INVESTMENTSIMPLICATIONS AND EFFECTS ON GLOBAL CORPORATE GOVERNANCE & INVESTMENTS


SWFs have shown a penchant for relatively large and con-

centrated investment decisions. Most obvious to American

stakeholders within the banking sector, SWFs have made

decisive and significant control-oriented purchases. Their

growing influence and powerful asset flows have caused

suspicion and flamed concerns among politicians and other

market participants about their motives. Shareowners, as

well as foreign governments, clearly fear the possibility that

such investments will be based on the desire for political

influence and business control. Some investor groups have

voiced a mirror concern that SWFs have not been willing

to be engaged owners, merely passive and silent investors,

effectively backing management through their reticence.

The weak U.S. dollar has also exacerbated the levels and

types of foreign direct investment over the last couple of

years, much of which is tied to SWFs.

GLOBAL CODES OF BEST PRACTICEIn Washington, lawmakers have called on sovereign wealth

funds to be more transparent about their investments and

objectives. The growing concern also prompted finance

ministers from the Group of 7 to ask the Organization for

Economic Co-operation and Development (OECD) and

the International Monetary Fund (IMF) to examine best

practices for the funds. In early 2008, the U.S. Treasury

forged an agreement with Abu Dhabi and Singapore on a

set of principles that specifies that politics should not influ-

ence the decisions of their funds. During 2008, the IMF

has worked with dozens of sovereign wealth funds to put H alf of all Sovereign Wealth Funds [SWFs] have been created in just the last

decade, yet these funds command assets approaching $4 trillion and are projected to increase to $18 trillion by the year 2012. In the 18 months preceding the summer of 2008, sovereign funds made foreign direct investments approaching $60 billion, primarily in the U.S. financial sector.

With very long-term investment horizons, little to no regulatory requirements, and assets growing seemingly exponentially, SWFs are a unique segment of the investing universe.

F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N ( S B A )

0 250 500 750 1000

National Fund (Kazakhstan)

Brunei Investment Authority

Alaska Permanent Fund Corporation (U.S.)

Fond de Regulation des Recet (Algeria)

National Wealth Fund (Russia)

Oil Reserve Fund (Libya)

Government Future Fund (Australia)

Qatar Investment Authority

Investment Corporation of Dubai

Temasek Holdings (Singapore)

China Investment Corp [CIC] (China)

Reserve Fund for Future Generations (Kuwait)

Kuwait Investment Authority [KIA] (Kuwait)

Multiple Funds [SAMA] (Saudi Arabia)

Government Investment Corp [GIC] (Singapore)

Government Pension Fund-Global (Norway)

Abu Dhabi Investment Authority [ADIA] (UAE)

SOVEREIGN WEALTH FUND RANKING

($ BILLIONS)

SOURCE: SBA, MORGAN STANLEY, RISKMETRICS GROUP

42

F L O R I D A S T A T E B O A R D O F A D M I N I S T R A T I O N ( S B A )

together a voluntary code of best practices and presented a

set of final policies during its fall meeting in October. Angel

Gurria, Secretary-General of the OECD, has stated that new

laws or regulations to govern sovereign wealth funds aren’t

needed, as long as the funds are transparent and invest on

commercial rather than political grounds.

“It’s important to establish some guiding principles. This

will help contain the risk of a backlash in the West and also

establish some kind of trust between investor and invest-

ee,” said Chua Hak Bin, Chief Asian Strategist for Deutsche

Bank Private Wealth Management in Singapore. U.S.

Deputy Treasury Secretary Robert Kimmitt has described

SWF investments as a net positive, but has also stated

that their rapid growth warrants a vigilant stance by the

U.S. government.

SWF disclosures and operational transparency varies wide-

ly. For example, Norway’s Government Pension Fund pub-

lishes its portfolio holdings each year, but others such as

the Abu Dhabi Investment Authority and the Government

of Singapore Investment Corp (GIC) do not disclose any

information about their investments, even avoiding disclos-

ing their total assets under management.

The few SWFs that have made public comments have sig-

naled unfair treatment, noting that Western governments

have not demanded the same levels of transparency from

private equity funds and hedge funds that manage even

larger asset levels and make control oriented investments—

often with an active shareowner agenda. China Investment

Corporation’s President, Gao Xiqing, has stated CIC may

avoid investing altogether in countries that demand too

much disclosure and regulatory hurdles—“If there is too

much political pressure and too much unpredictability, you

just go away.” Manu Bhaskaran, a partner at Singapore-

based investment consultant, Centennial Asia Advisors,

said any code of ethics “should take into account the legiti-

mate interests of the citizens of the country the SWF origi-

nates from, the financial markets they operate in, and other

stakeholders. There certainly should not be a repeat of the

CNOOC or Dubai Ports fiascos where politically orchestrat-

ed hysteria blocked a commercially sensible deal,” he added.

Japan has also called for a “global rule book” to control the

investment activities of SWFs. Hajime Bada, president of

the Japan Iron and Steel Federation, stated, “We need gov-

ernments everywhere to come together to make rules that

would prevent the disorder caused by these funds. Some

countries are using their state funds to dominate certain

industries. The concept of a sovereign fund linking itself

with companies is not a sound road map for future devel-

opment.” An expected stipulation by Japanese industry is

to restrict SWFs from conducting joint takeover bids for

publicly listed companies.

In mid 2007, the Peterson Institute for International

Economics proposed that all SWFs adopt a standard model

for making investments. The proposed standard includes

consideration of the objectives of a particular investment

and the investment strategy of a particular fund; the gov-

ernance of a fund, detailing which government officials are

allowed access to fund information, and which are not; the

transparency of fund activity; and behavioral guidelines,

establishing how a fund is and is not allowed to adjust its

portfolio.

Sebastian Mallaby, Director of the Council on Foreign

Relations’ Center for Geoeconomic Studies, worries that

SWFs could begin to flex their power as shareowners in

foreign corporations by banding together to oust the CEO

of a U.S. corporation. Others ask if this would be a bad

outcome? In strict terms of corporate governance, such

an effect is likely to be viewed as a win for shareowner

activism, assuming the company’s CEO, senior executives

and board of directors are managing the company poorly.

“The logic of the capitalist system depends on shareholders

causing companies to act so as to maximize the value of

their shares….It is far from obvious that this will over time be

the only motivation of governments as shareholders,” writes

Lawrence Summers, former U.S. Treasury Secretary and

recently named Director of the National Economic Council

by President Obama.

SWFS HAVE VARIED GOALS, AND AS A RESULT, OPERATING CODES AND GOVERNANCE PRINCIPLES NEED TO BE EXTENSIVE IN SCOPE:

• Investment of national savings in diversifi ed higher yielding assets to ensure positive risk-adjusted return—which is especially needed for countries converting natural resource wealth into fi nancial wealth.

• Deploying wealth as seed capital in order to develop targeted national industries.

• Foreign investment designed to harness business knowledge and operational expertise for use in the home country.

• Support of domestic companies abroad - in some cases even companies that are subsidiaries of the sovereign funds or holding companies themselves.

While adopting codes and principles aimed at increasing transparency will undoubtedly improve the perception of SWFs and ease suspicion, transparency alone can only go so far and will not eliminate the possibility of abuse or protectionism. A corollary to how SWFs operate and the development of best practice codes is the importance of how target countries deal with SWF investments.



I M F P R I N C I P L E SSome of the largest SWFs set up a working group within

the International Monetary Fund (IMF) to create guide-

lines aimed at soothing fears their investment decisions

may harbor political agendas. Hamad Al Hurr Al Suwaidi,

Undersecretary of Finance in Abu Dhabi and Director of

the Abu Dhabi Investment Authority, is co-chairman of

the group along with Jaime Caruana, Director of the IMF

Monetary and Capital-Markets Department. The code cov-

ers the governance structures of SWFs, how they invest,

and how they disclose information, among other issues.

John Lipsky, the IMF’s Deputy Managing Director, has

noted the IMF wants to assist the funds on issues such as

transparency, governance, disclosure and fund organization.

In early 2008, a U.S. Treasury delegation led by the

Assistant Secretary for International Affairs, Clay Lowery,

met with officials of the Abu Dhabi Investment Authority

and the Government Investment Corporation of Singapore

in an attempt to push the funds to pledge they won’t use

their wealth and investments for political advantage. By

most indications, the final set of principles has been viewed

as incomplete. Criticisms have been levied at the absence of

its treatment of minority stakes, passive investment stipu-

lations, and how they should deal with issues of national

security within their target markets. “While they may

desire to avoid politics, the fact remains that they cannot

invest in a way that is anathema to the parent state, even

if such investments may be legal in much of the world,”

note Stephen Davis and Jon Lukomnik, Compliance Week

columnists.

Although some high profile stakes made in early 2008

within the U.S. financial sector raised awareness in global

capital markets, SWF investment practices remain largely

unknown. Although a few of the European funds, such as

Norway’s fund, make detailed disclosures, the vast major-

ity of SWFs have virtually no transparency in their invest-

ment operations. For example, Abu Dhabi’s fund, known as

ADIA, has a very limited website offering no insight into its

investments. Describing its investment strategies, the SWF

merely states, “ADIA manages a substantial global diversi-

fied portfolio of holdings across sectors, geographies and

asset classes including public listed equities, fixed income,

real estate, and private equity.” ADIA does describe, albeit

briefly, its governance structure, including the names of

its board of directors. Several SWFs with poor disclosure

practices, at least relative to other SWFs, keep their invest-

ment strategies a closely guarded secret and believe if they

provide too much disclosure they may lose their competitive

edge. Further, some fear that an additional level of scrutiny

by the IMF itself could impact global capital flows.

In October 2008, the International Working Group of

Sovereign Wealth Funds (IWG) presented the Santiago

Principles - a.k.a. the “Generally Accepted Principles

and Practices [GAPP]” - to the IMF’s policy-guiding

International Monetary and Financial Committee. The IWG

made public the set of 24 voluntary principles and related

explanatory material and announced it had established a

Formation Committee to explore the creation of a Standing

Group of SWFs. As expected, the GAPP code is a compen-

dium of SWF practices, including fiscal and data reporting.

Of particular significance, is the fact that GAPP is a volun-

tary code, and no SWF is bound to adopt or implement any

of its elements.

THE U.S. TREASURY DEPARTMENT DEFINES SOVEREIGN WEALTH FUNDS (SWFS) AS GOVERNMENT INVESTMENT VEHICLES FUNDED BY FOREIGN EXCHANGE ASSETS, MANAGED SEPARATELY FROM THEIR OFFICIAL RESERVES—GENERALLY FALLING INTO TWO BROAD CLASSIFICATIONS BASED ON THE SOURCE OF THEIR FOREIGN EXCHANGE ASSETS:

COMMODITY FUNDS, such as those found in oil producing nations like Kuwait and Russia, are established through commodity exports, either owned or taxed by the government. They serve different purposes, including stabilization of fiscal revenues, intergenerational saving, and balance of payments sterilization. Given the recent extended sharp rise in commodity prices, many funds initially established for fiscal stabilization purposes have evolved into savings funds. In the case of commodity funds, foreign currency typically accrues to the government, and does not increase the money supply and create unwanted inflationary pressure.

NON-COMMODITY FUNDS are typically established through transfers of assets from official foreign exchange reserves. Large balance of payments surpluses have enabled non-commodity exporting countries, such as China, Singapore, and Korea, to transfer ‘excess’ foreign exchange reserves to stand-alone funds. In the case of non-commodity funds, foreign exchange assets often derive from exchange rate intervention, which then increases a country’s money supply. Monetary authorities take additional steps to lower the money supply and stave off inflation by issuing new debt, but there may be a cost associated with this if the cost of the new debt is more than the returns that the government earns on its foreign exchange assets.



The IMF principles have helped ease, though not extin-

guish, concerns that sovereign funds are shadowy institu-

tions that wanted to take over key U.S. industries, as have

growing concerns about the state of the U.S. economy. As

Chair of the Senate Banking Subcommittee on Security

and International Trade and Finance, Senator Evan Bayh

prefers a more stringent set of operating rules for SWFs,

stating, “moral suasion alone has rarely deterred nations

from pursuing their interests. Incentives for compliance

and meaningful consequences for [SWFs] that refuse to

comply must be adopted. It would be a mistake to give a

multinational organization like the [IMF] responsibility for

oversight, because the IMF lacks enforcement power and

has proven ineffective in discharging many of its current

responsibilities.” He further believes SWF investments

should be limited to only passive stakes, possibly through

non-voting shares.

O E C D P R I N C I P L E SThe Organization for Economic Cooperation and

Development (OECD) developed a common policy posi-

tion for all SWFs to base their investment policies on,

calling for equitable and fair treatment of investors. Its

Code of Liberalisation of Capital Movements, adopted

in 1961, and the Declaration on International Investment

and Multinational Enterprises, issued in 1976 and revised

in 2000, certainly guided the OECD in its efforts. These

historical policy frameworks impart key OECD economic

principles such as non-discrimination, transparency, pro-

gressive liberalization, and free trade.

The OECD is also developing best practices for countries

that are on the receiving end of SWF investments. Many

countries, chiefly the United States, Germany, and Japan

are increasingly concerned about the political implications

of foreign investment. Over the past couple of years, over

a dozen major countries have passed or debated laws to

restrict foreign investment.

In March 2008, the European Commission (EC) adopted

a stance on SWFs by calling for increased transparency,

accountability and improved governance for all funds mak-

ing investments within the European Union (EU). European

Commission (EC) President José Manuel Barroso stat-

ed, “Europe must remain open to inward investments.

Sovereign wealth funds are not a big bad wolf at the door.

They have injected liquidity and helped stabilize financial

markets. They can offer reliable long-term investments

our companies need. To ensure this, we need global agree-

ment on a voluntary code of conduct…” The European

Commission’s SWF communication sets out five principles:

1. Commitment to an open investment environment (inside

and outside of the EU); 2. Supporting the proposals of

international organizations such as the IMF & OECD; 3. Use

of existing instruments at EU and member state levels; 4.

Respect of EC treaty obligations and international commit-

ments (e.g. the World Trade Organization, or ‘WTO’); and 5.

Proportionality and transparency.

The EC’s common approach is intended to avoid uncoor-

dinated national responses that could fragment the EU’s

internal market and damage the European economy. One of

the key principles of the EC’s communication is fostering

a healthy environment for foreign investment in markets

outside of the EU, hopefully opening third country markets

to EU investors in the process. Enacting restrictive barriers

to foreign investment within the EU would most likely not

be conducive and may have negative collateral effects in

markets with which EU countries would like to strengthen

trade relationships.

W H O , W H A T & W H E R E ?Sovereign Wealth Funds (SWF’s) are cash-rich, govern-

ment-controlled, and state-sponsored investment vehicles

that manage surplus savings, primarily of oil and export

rich nation-states in the Middle East and Asia. They have

combined assets that top $3 trillion. and experts estimate

that their vast wealth could surpass $20 trillion in less than

a decade. Though there is no universally accepted definition

of SWFs, all sovereign funds represent wealth related to

either pension funds, social security funds, special purpose

vehicles for state-owned enterprises, or foreign exchange

(currency) reserves as a result of trade surpluses. In a recent

report, Merrill Lynch asserts that central banks, which now

control about $7 trillion in reserve funds, will increase funds

managed by SWFs as part of an ongoing transition away

from currency reserve accumulation and towards long-term,

higher return investment portfolios.

Merrill’s report states, “The central bank tap is now being

turned off,” and, “The era of rapid central bank reserve

accumulation is now over, in our view. An intensified push

toward rebalancing, satiated demand for reserves, and

acquiescence of currency appreciation support this.” The

top three central banks are China, Japan and Russia, with

China’s central bank reserves at around $2 trillion. Merrill

expects central banks to discontinue accumulation of

reserves due to the recent strength of the U.S. dollar, as well

as the large scale repatriation of dollars back into the United

States. As reserve levels moderate, Merrill poses that the

future expansion of SWF assets will increase substantially.

Sovereign wealth funds aren’t a new creation, many of

them have been in existence for decades—and in a couple

of instances for well over a century. But over the last few

years, their investment activity has triggered a wave of

anxiety among investors, international regulatory bodies and

others because of the huge stakes that several funds have

taken in some of Wall Street’s best-known firms. To some

observers, SWFs are saviors, propping up troubled invest-

ment firms that rattled tin cups in their direction. Others

fear the trend is the start of the nationalization of a chunk of

the financial system by governments that could ultimately

use their investments to further political aims that are con-

trary to host-country interests.

Other countries have sought to create SWFs of their own.

Australia and New Zealand have used budget surpluses to

set up sovereign funds with the aim of providing for aging

populations. On the heels of vast new underwater discover-

ies of oil, Brazil plans to use petroleum revenues to create

a SWF, which could reach $300 billion within the next five

years. Initial plans included the creation of a fiscal stabil-


ity fund, comprising a set aside of 0.5 percent of Brazil’s

GDP. Unlike most other SWFs, Brazil’s new fund will have

domestic investment as its main focus, designed to thwart

inflation and lower the cost of debt for private companies.

Abu Dhabi SWF

The Abu Dhabi Investment Authority (ADIA), created in

1976, is the largest SWF with assets likely near $1 trillion.

The ADIA relies heavily on external investment managers,

with about 80 percent of its assets managed externally.

As the city capital of the United Arab Emirates, Abu Dhabi

is ruled by Sheikh Khalifa bin Zayed al Nahyan, who serves

as Chair of the ADIA. The Investment Authority is designed

with broad sovereign investment objectives—its mission is

to enhance the financial security of the Emirate.

ADIA has taken relatively more risk with its portfolio than

other SWFs in the region, and recently made large invest-

ments in U.S. real estate, purchasing the GM building and

buying a 75 percent stake in the Chrysler building. In 2008,

the fund announced plans to diversify geographically, with

a focus on expansion into developed markets such as

Japan. ADIA has a target rate of return of 10 percent. The

Mubadala Development Company, another Abu Dhabi gov-

ernment investment vehicle, has purchased stakes in both

the Carlyle Group and Advanced Micro Devices (AMD).

CHINESE SWF

China Investment Corporation (CIC) was established

in September of 2007 as China’s first SWF in order

to increase the value of China’s huge foreign exchange

reserves, which recently overtook Japan as the largest

holder of U.S. Treasury debt. China’s foreign currency

reserves are growing at about $400 billion each year. CIC

has no dedicated funding source, rather it receives a variable

transfer of foreign currency reserves from the ruling State

Council each year.

Jesse Wang, Chief Risk Officer for CIC, commenting on the

SWFs investment acumen and very short existence stated,

“we’re not so smart that we can always hunt the fattest

rabbits.” CIC has pledged to improve its financial disclo-

sures, with Mr. Wang stating, “we will maintain transpar-

ency of company operations on the premise of safeguarding

our commercial interests and deal with forex investment

business independently by persisting in the principle of

separating government functions from company manage-

ment.” The fund targets a rate of return in the four to five

percent range, but it would like to raise this marginally going

forward.

Prior to its formal creation, CIC made its first major foray into

U.S. capital markets in June of 2007 when it purchased $3

billion of the Blackstone Group ahead of its IPO. The sec-

ond major U.S. purchase occurred in late 2007, when CIC

invested $5 billion in convertible preferred notes in Morgan

Stanley. CIC’s investment transaction with Morgan Stanley

involved convertible preferred shares which require equity

unit conversion into ordinary shares on August 17, 2010.

The convertible units proscribe ownership roles including

the appointment of directors. Through December, CIC had

reportedly lost in excess of $6 billion dollars on its invest-

ments in Morgan Stanley and Blackstone.

Along with other investors in the fund, CIC got trapped in

the Reserve Primary Fund, a U.S. money market fund that

broke the buck in mid 2008 and ending up freezing assets.

The Reserve Primary Fund was the first money market in

the U.S. in 14 years to trade below a fixed $1 net asset

value. CIC’s Reserve exposure included about $5 billion that

CIC had in the fund, representing 11.13 percent of the insti-

tutional-class shares as of September 1, 2008, according

to a regulatory filing by the fund with the U.S. Securities and

Exchange Commission. Although CIC ultimately received a

full refund of moneys that it invested in the fund, the experi-

ence serves as another example of how its U.S. investments

have declined or had significant liquidity problems related to

the global credit crisis and liquidity contraction worldwide.

CIC has even voiced its desire to weigh in on the debate

for global financial regulatory reforms. Jin Liqun, the newly

appointed Chairman of CIC’s Supervisory Board, has said

that China should have a larger role and work with devel-

oped countries as reforms are explored. Some pundits view

China’s role as one of the largest creditors to the U.S. as a

primary driver of its desire to participate. Mr. Jin joined CIC

in September after serving as Vice President of the Asian

Development Bank and China’s Vice Minister of Finance.

CIC’s earlier $3 billion investment in the Blackstone Group

and $5.6 billion investment in Morgan Stanley have both

lost significant value. As a result of its investment losses

tied to Blackstone and others, CIC has been lambasted in

Beijing. CIC’s investment staff seems to be well aware of

the risk that goes with investing in global capital markets.

Mr. Jin recently noted, “Are you going to forgo all of these

benefits, just because of the risks that go with it?”

As a very young organization, CIC has not fully developed its

financial disclosure and very little is known about its invest-

ment portfolio. It has pledged to expand investment report-

ing and its website disclosures have begun to improve over

the last nine months. CIC’s governance structure and board

of directors are detailed publicly. However, asset allocation

and information on its investment strategies is still very

“The most effective policy response [for SWF investing] remains the adoption of a mandatory international code of regulatory conduct to govern SWFs and recipient countries premised on the basis of the broad policy principles proposed by both the OECD and IMF, with active and effective policing of such code by those international bodies and the G7 and World Bank.”Simon Firth and Damian Juric

“Common Ground - The Ins and Outs of the Global Regulation of Sovereign Wealth Funds”The Deal, October 12, 2008


poor relative to institutional investor standards.

CIC strives to become a good steward of its assets, and has

publicly stated its prescription to corporate responsibilities

such as environmental protection, climate change, and

other sensitive areas. CIC Chairman Lou Jiwei has stated,

“We will not invest in industries that harm people such as

defense or tobacco. Although I smoke myself, CIC will not

invest in the tobacco industry.” It also has a strict hands off

approach when it comes to management intervention and

control rights. As a general rule, CIC has not sought man-

agement rights or board representation. Chairman Jiwei has

clarified that most of CIC’s investments to date, “have been

less than 10 percent of the investee’s equity....In our previ-

ous deals, we voluntarily gave up voting power...”

Although not a part of CIC, Citic Securities Company is

one of China’s two biggest investment banks along with

China International Capital Corporation. Citic was created in

1995 by Citic Group, a state-owned conglomerate formed

by the government in the 1970’s. Citic has underwrit-

ten some of the largest stock offerings in China as many

companies became publicly traded. The company reported

assets under management of approximately $30 billion and

aspires to be China’s preeminent investment bank.

RUSSIAN SWF

Russia’s new National Wealth Fund started out with $32.7

billion to invest in February 2008. Moscow’s emergence

as a new global investor has caused much consternation

across Europe and the U.S. In late 2006 for example, the

Russian state bank VTB purchased a stake in European

Aeronautic Defence & Space Company (EADS), the aero-

space conglomerate that owns plane manufacturer Airbus.

After VTB executives stated publicly the EADS transaction

was purely investment oriented, President Putin’s top for-

eign-policy adviser, Sergei Prikhodko, stated Russia might

raise its stake to over 25 percent. Such a threshold would

be enough to block major corporate decisions, and allow for

increased cooperation between EADS and Russia’s ailing

aerospace industry.


Both France and Germany view EADS as a strategic com-

pany, primarily because it supplies key military technology

and offers commercial entry into global aerospace markets.

Ultimately, VTB sold the EADS stake to another state-

owned bank and it plans to transfer the EADS shares over

to a new state-controlled aerospace conglomerate. Shortly

after the VTB disclosure, Germany began drafting restric-

tions on SWF investments, which have been designed to

block purchases by non-European Union controlled invest-

ment groups or companies of stakes greater than 25 per-

cent in “strategic” areas of German industry. Although still

needing approval by the German Parliament, it is expected

to be implemented by the end of 2008 or very early 2009.

As has been widely reported by

Fortune magazine, the line between

politics and financial affairs in

Russia is extremely blurry and has

overlapped numerous times, mainly

to the detriment of foreign shar-

eowners. Both under President

Vladimir Putin and President Dmitry

Medvedev, senior government offi-

cials have been deeply involved in

key decision making at large state-

owned or controlled companies. The

National Wealth Fund could give

the Kremlin more power to influ-

ence global business transactions

and is arguably the best example

of how exploding commodity prices

have launched formerly developing

and/or emerging economies onto the international stage. As

noted by a recent Wall Street Journal article, “A decade ago,

Russian officials were seeking bailouts from foreign lenders

as the country careened toward default. Now, thanks to

a powerful economic rebound fueled by surging prices for

Russian exports of oil and other raw materials, Moscow has

paid just about all its debts and boasts over half a trillion

dollars in reserves.” Most recently, the global credit crisis

has impacted their trade flows and caused additional pres-

sure on their currency.

Similar to other SWFs, the Russian fund has not been

immune to domestic political pressure to spend the money

on internal programs. For example, years earlier in 2004,

Russia started to put money into a budgetary “stabiliza-

tion” reserve fund if commodity prices were to fall and

impact the government’s revenues. As well, there has been

pressure from Russian businesses to use SWF assets to

support the domestic capital markets by injecting funds

directly into the stock market. As a result, the Stabilization

Fund was split into two distinct portions; one is a rainy day

fund capped at 10 percent of GDP, with any excess funds

being funneled into the National Wealth Fund. Both funds

only invest overseas and Russian Finance Ministry officials

have stated they will adopt investment policies restricting

individual equity holdings to less than five percent and will

not seek any management role or board seats. Although the

fund has been publicly touted as supporting Russia’s public

pension system, investment objectives are not clear. As of

late 2008, foreign investments had not been disclosed.

Saudi Arabian SWF

The Saudi Arabian Monetary Agency (SAMA) was created

in 1952, and although strictly speaking is not a pure SWF,

it does boast assets of approximately $327 billion and has

made substantial investments in global equity markets.

SAMA has a board of directors comprised of a governor,

deputy governor, and three representatives from the private

sector. SAMA publishes monthly reports, as well as an

annual report that contains minimal investment details. In

the future, the fund may create a new investment company,

making it one of only a few SWFs that are co-owned by

non-governmental stakeholders. Although separate from

SAMA, Saudi Prince Alwaleed bin Talal Al Saud, nephew

of Saudi King Abudullah, participated in the $12.5 billion

capital infusion into Citigroup and is no stranger to global

investing, having made substantial international invest-

ments including AOL, Apple Computer, Motorola, News

Corporation, as well as real-estate holdings including stakes

in the Four Seasons Hotel chain, the Plaza Hotel in New

York and London’s Savoy Hotel. In late November 2008,

Prince Alwaleed bin Talal Al Saud increased his stake in

Citigroup to close to five percent, as the bank struggled to

strengthen its capital position and stem a steeply declining

stock price.

Qatari SWF

Sheikh Hamad bin Jasim bin Jaber al-Thani, is CEO of the

Qatar Investment Authority (QIA), which boasts assets of

approximately $60 billion. The QIA does not disclose hold-

ings on a comprehensive basis and its financial reporting is

rather poor. Sheikh Hamad has announced Qatar is creating

sister funds, modeled on the QIA, in Finland and Malaysia.

The QIA is an experienced global investor, having made con-

trolling purchases in the past into U.K. supermarket chain J

Sainsbury, Credit Suisse, and French publisher Lagardere

SCA, as well as several Middle Eastern banks. In 2006, it

made investments in China, notably a $205 million stake

in Industrial & Commercial Bank prior to its IPO. Credit

Suisse in March 2006 became the first European bank to

get a license for the Qatar Financial Centre, a self-regulated

business park designed to attract lenders to the Gulf state

0 100 200 300

2007

2008

2009

2010

2011

2012

PROJECTED GROWTH OF RUSSIA’S SWF($ BILLIONS)

SOURCE: MORGAN STANLEY, RUSSIAN MINISTRY OF FINANCE


as part of a plan to diversify the economy away from oil and

gas. A small country, with a population of less than 1 million

people, Qatar controls the globe’s third-largest reserve of

natural gas reserves and 1.3 percent of all global crude oil

reserves.

Kuwaiti SWF

Based in Kuwait City, the Kuwait Investment Authority

(KIA) was founded in 1953, as its predecessor, the Kuwait

Investment Board, was created eight years before the

country gained independence. Many investors consider it

to be the oldest and most experienced of all SWFs. Like

other funds located in the Middle East, the fund’s goal is

to reduce Kuwait’s dependence on commodity revenues,

chiefly oil and petroleum related cash flows. The fund is

autonomous in structure, managing assets entrusted to it

by the government.

KIA manages assets totaling approximately $264 billion

and participated in both the Citigroup and Merrill Lynch

investments with other SWFs in late 2007 and early 2008.

KIA’s investment reporting is very poor, proscribed by law to

be only disclosed to the government. Most recently, it was

tapped as a backstop for the Kuwait KSE All-Share stock

index, which had declined by about a third through mid

November of 2008. The Investment Authority itself may

provide up to 10 percent of all government funds, over $1

billion, in order to support the KSE exchange and stabilize

price moves by adding to liquidity. The KIA will likely set up

a long-term investment portfolio in cooperation with other

state agencies designed to make purchases into the KSE.

French SWF

In late October 2008, French President Nicolas Sarkozy

proposed a new SWF be created to invest in French com-

panies. A so called, “National Strategic Investment Fund

(NSIF)” may be developed to provide loans or acquire stakes

in companies viewed as strategically important. President

Sarkozy proposed the NSIF be managed by state-owned

investment company Caisse des Depots. Caisse des Depots

can be viewed as a pseudo-SWF in and of itself, as it

manages French retirement savings and other assets, and

invests in publicly traded companies, private equity, real

estate and infrastructure, with assets of around $280

billion. The NSIF announcement followed on the heels of

remarks by President Sarkozy at the European Parliament of

protectionist rhetoric warning against the threat of foreign

“non-European capital.” President Sarkozy has announced

the SWF will only purchase minority stakes in French com-

panies and offered to accept foreign investors funds. Paul

Whitfield, a writer for the Deal magazine, opined, “Such

investors are unlikely to find the idea of being a junior part-

ner in a politicized investment vehicle very attractive. They

are also unlikely to be inspired by the fund’s initial invest-

ment: a 33 percent stake in failing French shipbuilder, STX

France Cruise SA, a family owned make of transport and

nuclear power station technology.”

Norwegian SWF

The Government Pension Fund – Global (GPF-Global) of

Norway is likely the most transparent and sophisticated

among all SWFs. It was formed in 1990—as the “Petroleum

Fund”—and was set up to fund future public pension

expenditures and to support the long-term management

of petroleum revenues. Investment management of the

SWF is performed by Norges Bank, an arm of Norway’s

central bank, and invests largely outside the country. The

GPF-Global receives surplus central government oil and gas

revenues and is currently valued at $436 billion.The GPF-

Global is headed by Yngve Slynstad, and overseen by the

Norwegian central bank.

Its investment reporting is exemplary and publishes both

its holdings and other activities on at least an annual basis.

Its annual report, presented directly to the Norwegian

Parliament, is exhaustive and covers virtually all of the

fund’s operations, including discussion of its investment

strategies and implementation of comprehensive ethical

guidelines. The fund has also had one of the highest growth

rates of all SWFs, pulling in over $1 billion every week.

Investment management is primarily done internally, with a

heavy bias towards passive, indexed strategies.

Even though the fund has a huge economic footprint,

because it is highly diversified across global equity indices,

the fund has not historically held individual equity positions

above one percent. In the middle of 2008 however, GPF-

Global began to raise the upper thresholds within its invest-

ment policies from five percent to a maximum of 10 percent

in a single firm. According to the fund’s public statements,

GPF-Global owns on average about 1.25 percent of all

stocks domiciled in Europe and is on track to own 0.5 per-

cent of all publicly traded companies worldwide. Related

to the ownership limit changes was the creation of a new

investment unit, the Capital Strategy Division, designed

to take on larger individual stakes and make concen-

“Whereas influencing international trade flows has long been and continues to be an important political objective and tool, another form of international economic exchange has risen to a level of much greater macroeconomic significance and political concern over the past two decades. This is the purchase and sale of financial assets—such as bonds, stocks, and derivative contracts—across borders, an activity whose growth has vastly outpaced that of traditional trade.”

Benn Steil and Robert E. LitanFinancial Statecraft: The Role of Financial Markets in American Foreign Policy


Amount of Cash Infl ow Received by Norway’s SWF Each Week

$1billion

Projected Value of Sovereign Wealth Funds in 5 Years

Percentage of SWF Investment TransactionsRepresenting Stakes of 10% to 50%

Percentage of U.S. Stocks Sovereign Wealth FundsHave Capacity to Purchase

20%


trated investments across global markets. Currently, GPF

is reported to control over one percent of European equity

markets, and is the single largest foreign investor among

all stocks in the United States, England and France. GPF’s

CEO Yngve Slyngstad has stated, “Our natural hunting

ground will be larger companies...management will naturally

listen more.” In addition to easing individual holding limits,

GPF-Global’s investment managers plan to expand the

benchmark portfolio to include more emerging markets and

also begin to invest in real estate, with a target allocation of

approximately five percent.

Somewhat ironically, the fund may also begin to invest in

commodities, including oil. Currently, its top three stock

holdings are all global energy firms, Royal Dutch Shell, BP

and Total. GPF-Global received a chilly reception a couple

of years ago from politicians in Iceland after the SWF began

shorting the bond securities of several Icelandic banks.

In hindsight, the investments proved to be clairvoyant as

Iceland’s banking system imploded in the fall of 2008.

The Norwegian SWF is viewed by many investors as an

activist fund that extends its investment duties into moni-

toring corporate responsibility. Not only does it routinely

exercise proxy voting rights and publicly disclose its voting

policies, but also frequently engages companies directly

on a variety of corporate governance issues. It has even

divested from a handful of firms over concerns with environ-

mental, social, or governance practices. For example, it sold

its stake in Rio Tinto due to environmental damages and

elevated risks with mining operations in Indonesia. The fund

blacklisted the U.S. company Freeport McMoran Copper &

Gold in 2006, and Rio Tinto was involved via joint venture

in the Grasberg mine in Indonesia.

GPF-Global’s ‘Council on Ethics’ judged Rio Tinto to be

directly involved in the mine and then began to quietly sell

its approximate $1 billion holding. “The Grasberg mine dis-

charges very large amounts of tailings directly into a natural

river system; approximately 230,000 tonnes or more per

day….there is a high risk that acid rock drainage from the

company’s waste rock and tailings dumps will cause last-

ing ground and water contamination,’’ the Finance Ministry

stated at the time. Other company business activities have

been examined in the past including Monsanto, over pos-

sible child labor usage in India, and Wal-Mart, which was

criticized for abusing labor rights at the company’s sup-

pliers. Currently, the fund is restricted from investing in 27

companies and is developing a new set of ethical guidelines

to be approved in the spring of 2009.

Singapore SWF

The Government of Singapore Investment Corporation

(GIC), with assets of approximately $330 billion, is man-

aged by Chairman Lee Kuan Yew, former Prime Minister

along with his son Lee Hsien Loong, current Prime Minister,

as Deputy Chairman. The GIC was created in 1981 as a

way to improve the investment returns of its foreign cur-

rency reserves and also manages Singapore’s mandatory

retirement contributions. The fund posted average annual

returns of just under 10 percent, when put into U.S. dollar

terms, for the 25 year period ending March 2006. This high

performance translates into 5.3 percent above G3 inflation,

as well as exceeding both its equity benchmark, the MSCI

World Equity Index, and its fixed income benchmark, the

Lehman Brothers World Bond Index. GIC has more assets

invested in the United States than in any other global capi-

tal market, with a minimum $34 billion.

GIC’s financial reporting has been very poor and is viewed

by some to be highly secretive. GIC does not disclose any

of its assets, funding cash flows or performance details. It

has only publicly stated that its assets are, “well over $100

billion,” and the fund’s purpose is to outperform an inflation

measure. Historically, GIC has not made many large invest-

ments in publicly traded companies, preferring instead to

overweight global real estate holdings. All of its investment

stakes have been far below controlling levels, and it recently

declined to accept a board seat offered by UBS. The fund

has exercised proxy voting rights, but disclosure and specif-

ic information about such activities is not publicly available.

In late September 2008, GIC enhanced its investment

reporting, providing new information about the fund’s asset

allocation and global diversification. In its first ever annual

report, GIC disclosed it had achieved an average annual

return of 7.8 percent over the last 20 years in U.S. dollar

terms. However, these new GIC disclosures are still rela-

tively poor compared to other large institutional investors,

lacking several key investment management issues such

as assets under management, detailed ownership data,

and other key information that describes the fund’s gover-

nance. The fund also manages Singapore’s foreign currency

reserves. GIC Deputy Chairman Tony Tan stated this newly

issued report, “will assure the investment community and

the countries in which we invest that our activities have

only one purpose -- financial return.”

GIC has an oversight board, called the “Inner Council,”

which approves its general investment strategies and

operations, and includes both internal and external asset

management vehicles. In late 2008, the GIC made a com-

mitment to begin disclosures covering its relationship with

the government, its own internal governance framework, as

PERHAPS THE BIGGEST FEAR AMONG TRADITIONAL INSTITUTIONAL INVESTORS IS THAT INCREASINGLY LARGE EQUITY STAKES IN WESTERN COMPANIES WILL LIE DORMANT WITHOUT ANY

EFFECTIVE STEWARDSHIP BEING DISPLAYED BY SWFS.

SUCH A SCENARIO WILL LIKELY INSULATE UNDERPERFORMING MANAGEMENTS AND MAKE THE PURSUIT OF SHAREOWNER ACTIVISM MORE DIFFICULT AT THE MARGIN.


well as risk management policies and investment controls.

In 2006, GIC’s asset allocation was thought to consist of

approximately 50 percent equities, 30 percent bonds, and

20 percent alternatives (consisting of private equity, real

estate, and commodities). The fund has disclosed holdings

in about 50 Asian hedge funds.

Another highly regarded, and relatively transparent,

Singapore SWF is Temasek Holdings, which has published

an annual report since 2004, Temasek, founded in 1974,

acts as Singapore’s direct investment arm, holding larger

individual stakes in both domestic and foreign companies.

Like some of the other large SWFs, according to a 2003

IMF study, Temasek-controlled firms represented over 20

percent of the market capitalization on the Singapore stock

exchange. The fund has set up offices in São Paolo and

Mexico City.

Although specific voting decisions are not published, there

is evidence that Temasek does exercise its proxy vot-

ing rights and has also stated it, “prepares a shortlist of

candidates for the portfolio company’s board’s consider-

ation.” However, it has not elected directors on any of its

wholly owned companies. Periodically, the fund has made

statements about its holdings and provided other market

commentary. In August 2008, as the company’s largest

shareowner, Temasek expressed its public support for then

struggling Merrill Lynch CEO John Thain. Finally, Singapore

is an example of how one country can successfully run two

co-existing SWFs—one fund that makes global invest-

ments and the other that looks to make only domestic

allocations.

JAPANESE SWF

In early 2008, the ruling political party in Japan was seri-

ously considering the establishment of a new SWF to

oversee the country’s large pension assets and foreign-cur-

rency reserves. As Japan’s foreign-currency reserves are the

world’s second-largest after China’s, and its pension related

funds are enormous, a new Japanese SWF has the potential

to dwarf the Abu Dhabi fund right out of the gate. In June

2008, the Council of Economic and Fiscal Policy, a govern-

mental advisory body, issued a report pushing for reform of

the national pension fund after several years of mediocre

investment performance. Although politically controversial,

the political group within the ruling Liberal Democratic

Party (LDP) is calling for the pension system to provide seed

capital totaling approximately $75 billion. Others suggest

that initial funding should come from Japan’s huge foreign

currency reserves, of which little investment allocation is

publicly known.

A Japanese SWF would most likely eclipse the $1 trillion

mark and may even be closer to $2 trillion in aggregate. The

Financial Times has reported that a small portion of such

a SWF is likely to include an activist investment strategy,

designed with a shareowner-friendly investment philoso-

phy. Such an effort would echo concerns voiced for years by

foreign investors for higher standards of corporate gover-

nance and increased transparency and equity performance.

In planning for the new fund’s governance structure, political

staffers reportedly benchmarked several SWFs and identi-

fied the Norwegian SWF as the best fund for it to emulate.

New SWF designs in Japan are coming on the heels of poor

performance by activist investment managers and contin-

ued resistance to shareowner priorities. For example, just in

the last couple of years, hundreds of Japanese companies

have implemented poison pills designed to deter takeovers

and the longer trend of moving away from cross-ownership

by multiple firms, known as “keiretsus,” has reversed itself.

Korean SWF

Seoul-based Korea Investment Corporation (KIC) is one of

the youngest SWFs, with assets under management around

$30 billion. Formed in 2005, KIC invests a portion of the

country’s foreign currency reserves, making investments

in areas that the Bank of Korea is prohibited by making via

its bylaws. For example, KIC purchased $2 billion of Merrill

0 250 500 750 1000 1250 1500 1750 2000 2250

UBS

Barclays Global Investors

Allianz Group

State Street Global

Fidelity Investments

AXA Group

Capital Group

UAE (ADIA)

Norway (GPF Global)

Singapore (GIC)

Japan Government Pension

Kuwait Investment Authority

China (Investment Corporation)

National Wealth Fund (Russia)

SOURCE: SBA, STANDARD CHARTERED

SOVEREIGN WEALTH FUNDS VERSUS OTHER MAJOR

INSTITUTIONAL INVESTORS($ BILLIONS)


Lynch’s preferred shares along with other sovereign inves-

tors.

C O R P O R A T E G O V E R N A N C E I M P L I C A T I O N S Some pundits worry that greater transparency and reporting

requirements of public markets may steer SWF investments

more toward private equity and exacerbate perceived issues

within the M&A markets, possibly increasing the likelihood

of proxy contests. Other investor groups in Europe fear SWF

investment actions may stifle the removal of anti-takeover

defenses, as political fears increase the desire to protect

national corporate interests. Yet other SWFs have stated

publicly they will abstain from voting their shares entirely,

perhaps in a misguided attempt to avoid political backlash

at the expense of being an active owner. Embedded within

the larger trend of SWF asset growth lies the fact that many

of the new global institutional players operate within a dif-

ferent paradigm than do traditional western investors.

Nassar Saidi, Chief Economist, for the Dubai International

Finance Center (DIFC) believes SWFs should take a more

activist role at companies in which they invest. Many

Western investors couldn’t agree more with this statement.

As SWFs assets have grown, so has the absolute size of

their individual investment holdings. Staff within the Office

of International Affairs of the Securities and Exchange

Commission’s (SEC) think that SWFs may soon, on a col-

lective or even on an individual basis, become the largest

shareowners in some of the market’s largest companies

that are privately owned. Historically, many of the more

secretive SWFs took smaller stakes in foreign firms in order

to avoid disclosure requirements and maintain liquidity.

One central issue is how SWFs conduct and disclose their

proxy voting related to equity investments. In a speech to

investors in early 2008, Treasury Assistant Secretary for

International Affairs Clay Lowery stated, “...some [SWFs]

have an explicit policy not to vote their shares. This may

also be the case for some central banks that hold a portion

of official foreign exchange reserves in the form of equities.

The Swiss National Bank, for

example, explicitly states that it

usually does not exercise its vot-

ing rights at annual shareholder

meetings. [SWFs] that choose

not to vote their shares may be

motivated by a desire to keep a

certain distance from matters of

business operation and poten-

tial political concerns – but that

is for them to say. Whatever

the motivation, their choice not

to vote their shares should be

respected.” At the mid-year

meeting of the International

Corporate Governance Network

(ICGN), Gao Xiqing, President

and Chief Investment Officer,

of China Investment Corporation

(CIC) stated, “We don’t seek

board seats. We don’t vote; we

don’t even want to vote.” It has

been reported that CIC’s invest-

ment in the Blackstone Group

was contingent upon structuring

the deal with non-voting shares.

Other SWFs, most notably the Norwegian Government

Pension Fund-Global, may take different views, both dis-

closing their proxy voting policies ex-ante and their proxy

voting decisions ex-post.

Perhaps the biggest fear among traditional institutional

investors is that increasingly large equity stakes in western

companies will lie dormant without any effective owner-

ship action being displayed by SWFs. Such a scenario will

likely insulate underperforming managements and make

“Traditional investors must address primary governance-related concerns with respect to sov-ereign investment: (1) that sovereign funds will ride the coattails of other shareholders who press underperforming management for change through governance activism; and (2) that their proclivity for non-voting stakes will serve to entrench or otherwise insulate underperforming management.”RiskMetrics Group, “Sovereign Wealth Funds & Emerging Governance Trends,” July 2008

GUEST COMMENTARY

by Subodh Mishra, Governance Institute - RiskMetrics Group (RMG)Author of “Sovereign Wealth Funds & Emerging Governance Trends,” July 2008

The global credit crisis has significantly altered views on sovereign wealth funds (SWFs). Such investment is now seen as less of a concern by many Western politicians and regulators, market participants, and others, who just six months ago loudly touted the need to curb such funding over perceived potential risks related to their lack of transparency and government ownership. Indeed, the global liquidity crisis has worked to mute the voice of those who opposed sovereign wealth fund investment in U.S. and European companies, as corporate issuers from New York to Zurich scramble for much-needed capital. Recently released SWF investment guidance also has served to dampen those concerns. The guidance, crafted by an International Monetary Fund-led working group of roughly two-dozen SWFs, calls on funds to describe and publicly disclose their investment policy, detail their governance framework and objec-tives, and to publicly disclose their “general approach to voting securities.” The guidance, which is subject to home country regulations, has been or will be implemented by working group participants on a voluntary basis. SWF giant Abu Dhabi Investment Authority is one fund that has agreed to fully implement the guidance. Still, investors and others will no doubt continue to focus on the potential implications of sovereign investment and encourage such funds to integrate into the mainstream institutional investor community. Key activities include the following:

ENGAGEMENT: There are good reasons to encourage participation by sovereign investors in mainstream investor forums. In-creased dialogue may encourage sovereign investors to take an active role in ownership by voting shares or otherwise exerting influence to benefit all shareholders. It may also help allay concerns and answer some of the many questions now surrounding sovereign investment.

IMPROVED DISCLOSURE: While the IMF working group principles laid the groundwork for improved disclosure, more can be done. That is not to suggest they disclose over and above what the market expects of other fund managers. Indeed, they should be held to the same standard. However, basic disclosure such as internal governance structures, investment objectives, asset allocation, and political representation should all be discussed—potentially in a report produced annually or in some other manner that is publicly accessible.

POLICY-SETTING: Investors should continue to work with umbrella organizations to influence policy setters crafting guidance for responsible sovereign investment and the receipt of sovereign investment. Codes of conduct and principles are still needed to, for example, encourage companies soliciting sovereign investment to issue non-convertible non-voting preferential shares to sovereign investors who explicitly state their preference for passive ownership. This would allay fears among fellow shareholders that such investors would convert to a voting block likely to routinely back management. Moreover, investors should work to ensure markets remain open to sovereign investment in keeping with OECD guidance to treat such investors equitably.



the pursuit of shareowner activism more difficult at the

margin. In its SWF white paper, RiskMetrics Group pointed

out, “Management’s ability to effectively neutralize a sig-

nificant voting block by seeking out sovereign investment

is a potential concern to all investors and may suggest a

need to push for a code of conduct that requires passive

investors to hold preferential non-voting stock, rather than

common stock.

In a speech in 2008, Clay Lowery with the U.S. Treasury,

opined that SWFs that choose to vote their shares when

they take non-controlling stakes in U.S. companies should

disclose how they voted. He stated that such disclosures

may, “help mitigate concerns” that the funds are using

their ownership for political rather than purely financial

gain. Some SWFs have made promises to disclose future

investment returns and clearly detailing the objective of

their funds, but other more specific reporting remains yet to

be seen by most. Although some have called for disclosure

at a very granular level—including company level invest-

ments—such forthcoming disclosure could theoretically put

SWFs at a disadvantage in the market and place them at a

“competitive disadvantage” to other investors.

A failure to vote may have adverse implications for corporate

issuers, too. At least one Japanese company has com-

plained that sovereign investors do not vote at all, meaning

the firm may have trouble meeting quorum requirements.

Although engaging owners, who routinely exercise their vot-

ing rights is the ideal, partitioning certain investor segments

based on “passive” or “active” investment strategies is not

desireable. One could argue passive shareowners are even

more sensitive to corporate governance issues and should

exercise increased monitoring of the board and manage-

ment activities.

SWF investment may advance efforts to incorporate envi-

ronmental issues into the larger trend towards corporate

responsibility and sustainability. The Norwegian SWF has

formally incorporated comprehensive principles and stock

screening into its investment process and is a leading

advocate of “ESG” (environmental, social, and governance)

concerns. However, Norway is an outlier in this regard, as

virtually all other SWFs do not follow similar practices.

Only Norway and the New Zealand SWF have signed onto

the United Nation’s Principles of Responsible Investment

(UN PRI), however, the Kuwait Investment Authority and

CIC have instituted investment screens around gambling,

alcohol, and other “sin” stocks.

Other SWFs tied to oil and ener-

gy revenue streams may have

a natural incentive to pursue

investments in renewable ener-

gy and alternative fuel sources

as a way to diversify away sov-

ereign risk. For countries that

have signed the Kyoto protocol,

another segue into energy relat-

ed portfolio management may

be carbon and/or emissions related investments. These

issues will undoubtedly be influenced by the diverse cultural

perspectives in SWF countries.

S W F P U S H B A C KSome SWFs say there is no need for a code of conduct,

voluntary or otherwise. In March of 2008, Executive Vice

President and Chief Risk Officer of China Investment

Corporation (CIC) Jesse Wang, stated, “The claim that

[SWFs] are causing threats to state security and economic

security is groundless.” This statement was the first public

commentary by the CIC in response to proposed ground

rules for SWF investment operations. Many Asian fund

officials have pointed to narrowly construed investment

objectives, such as generating higher returns on massive

foreign-exchange reserves, as their primary defense against

foreign charges of political bias. In a letter to U.S. Treasury

Secretary Henry Paulson in March 2008, the Abu Dhabi

Investment Authority stated, “Whilst they operate totally

independently of one another, they were conceived and

operate with one common goal: to invest the proceeds of

a finite oil resource for the current and future benefit of

the people of Abu Dhabi and the United Arab Emirates.

Investment income is used to improve education, health

care, social programs, infrastructure and security. In this

way, Abu Dhabi’s investment organizations are similar to

pension funds, combining a strong focus on long-term

capital returns with a clear public benefit.” Similar to CIC’s

public comments just this year, the letter was Abu Dhabi’s

first public response.

Author of the letter, Yousef Al Otaiba, Abu Dhabi’s Director

of International Affairs, states their government, “has never

and will never use its investments as a foreign policy tool.

This approach is not new - Abu Dhabi investment orga-

nizations have been active, responsible, patient, and [sic]

long-term investors in the US, European and international

financial markets for more than 30 years.” The letter was

sent also to the finance ministers of the other Group of

Seven industrialized nations, the IMF, the World Bank, the

Organization for Economic Cooperation and Development,

and the European Commission. Abu Dhabi’s letter describes

nine “principles” that are aimed at guiding its investment

decision-making. Describing its investments as predomi-

nantly passive, the Authority favors, “small stakes in com-

panies that involve no control rights, no board seats, and

no involvement in the management or direction of firms.” In

another interview, in April 2008, CIC President Gao Xiqing,

promised the fund would become as transparent as the

Norwegian pension fund, considered by many to have the

most detailed disclosures among SWFs. Mr. Gao stated

the fund would soon produce an annual report detailing its

investment operations.

In 2008, a lobbying entity and SWF trade association

In February 2008, Michael McConnell, the U.S. Director of National Intelligence, made statements to congress that one of his top concerns are, “the financial capabilities of Russia, China and the OPEC countries, and the potential use of their market access to exert financial leverage to achieve political ends.”


was formed, called the “Sovereign Investment Council.”

According to the Council’s website, it “exists to help

sovereign investors operate more professionally, use more

commercially understandable investment programs and

to educate the markets, regulators and public about the

goals, organization and operations of sovereign inves-

tors.” Many SWFs imply they are being treated unfairly

and are being singled out for political reasons. They point

to the fact that many hedge funds and private equity

investors do not make any specific holdings or detailed

investment disclosures. While it is true that all investors

are subject to the same regulatory and financial disclo-

sure requirements such as holdings disclosures over five

percent and plans for influencing or acquiring a company,

via Sections 13D and 13G of the Securities and Exchange

Act of 1934, SWFs represent government controlled

wealth, not private moneys. A comparison to hedge funds

and private equity funds may not be entirely appropriate.

S O V E R E I G N I N T R U S I O N A N D N AT I O N A L S EC U RI T Y C O N C E R N SAs government-backed investment vehicles, SWFs have

growing investment clout but also the potential to

extend political decisions across global capital markets,

some involving national security. European Commission

President José Manuel Barroso has stated, “We cannot

allow non-European funds to be run in an opaque manner

or used as an implement of geopolitical strategy.” Deputy

Treasury Secretary Robert M. Kimmitt authored a piece

in the political journal Foreign Affairs suggesting that

SWF investment be welcomed by the U.S., since they

contribute to the long-term stability of the economy. Mr.

Kimmitt states, “As with any form of foreign investment,

countries on the receiving end of SWF investment need

to ensure that national security concerns are addressed,

without unnecessarily limiting the benefits of an open

economy. Such concerns do not stem only from cases in

which an SWF gains a formal controlling share of a com-

pany; they can also arise when an investor seeks board

seats or outsized voting rights - anything beyond a purely

passive investment.” However, Mr. Kimmitt does strongly

caution against the possibility that foreign intelligence agen-

cies could provide non-public information to the investment

managers of such funds in order to assist their investing deci-

sions, a unique form of insider trading.

SEC Chairman Christopher Cox stated, “Unlike private inves-

tors and businesses, the world’s governments have at their

disposal the vast amounts of covert information collection

that are available through their national intelligence services.

Unchecked, this would be the ultimate insider trading tool.”

Although SWFs have certainly generated much concern and

anxiety, it is hard to find concrete examples of sovereign funds

having abused their investment power.

In 2005, Dubai Ports bought British firm P&O involving the

control of 22 U.S. ports. After political backlash, the U.S.

Congress blocked the deal and Dubai Ports was eventu-

ally forced to sell P&O’s U.S.-based operations to a unit of

American International Group (AIG). Also in 2005, China

National Offshore Oil Co (CNOOC) hit a political brick wall

when it unsuccessfully tried to buy Unocal. Australia has

closely examined Chinese acquisitions of Australian mining

firms. Germany has been especially concerned with foreign

access to German technology and has lobbied for comprehen-

sive laws within the EU to regulate SWF investment activity.

Less benign examples of foreign investment in key industries

and controlling stakes in strategic companies abound. In late

2007, Industrial & Commercial Bank of China, wholly owned

by the Chinese government, made a $6 billion investment in

Standard Bank, the dominant South African financial services

company. While not involving sensitive national security con-

cerns, the Standard Bank deal embodies a larger long-term

trend of governments becoming increasingly involved in major

business deals.

The rise in governments as global economic players is in sharp

contrast to the past few decades in which the private sector

seemed to dominate the financial landscape. SWF investment

represents an evolving fusion between state control of busi-

ness and the fundamental principles of capitalism. A handful

of the largest funds represent the sovereign wealth of authori-

tarian nations. As their assets under management increase,

their influence within certain business sectors grows too.

Azar Gat, a political scientist at Tel Aviv University, coined

the term “authoritarian capitalism” to describe this trend.

Some observers are concerned that state capitalism may

foster corruption. With large investments being controlled

by a small number of well connected individuals within the

government hierarchy, it is easy to envision the politicization

of business deals. Examples of this are the “oligarchs” in

Russia and the “princelings” in China.

Russian state-owned OAO Gazprom has become the

world’s largest gas company, controlling about 20 percent

of global gas production, and was previously lead by cur-

rent President Dmitry Medvedev. In early 2006, Gazprom

briefly cut its natural gas supplies to Ukraine in an effort to

put political pressure on a pro-Western government in Kiev

and squeeze out additional profits. Under Putin, the Kremlin

extended its reach into numerous industries, ranging from

titanium manufacturing to aviation. In both Latin America

and Central Asia, governments like Bolivia, Venezuela, and

Kazakhstan have reasserted state control over their oil and

gas infrastructure. Sovereign energy firms now control

almost five times the oil reserves of their private rivals;

Saudi Aramco, the Saudi government’s oil company, can

produce three times as much oil as any other firm. Large

capitalization companies such as ExxonMobil and Royal

Dutch Shell are among the largest publicly traded firms in

the global equity markets, but they are dwarfed by other

government-owned energy companies.

Government-owned oil companies, either partially owned

or wholly controlled, dominate the worldwide energy econ-

omy, controlling more than three-quarters of global oil and

natural-gas resources. Of the top 20 oil producers in the

world, 14 are state-backed, national giants. Their status as

national champions gives them a built-in advantage over

other private or publicly traded wester firms. In late 2007,

publicly traded but state-owned PetroChina briefly eclipsed

Exxon Mobil as the world’s largest company by market capi-

talization, becoming the first company to ever pierce the $1


trillion threshold.

A key advantage of sovereign control is their ability to lever-

age government-to-government relationships and nego-

tiate favorable deals. An even more significant trend is

the advancing technological capabilities many national

firms have gained. Some of the national companies, espe-

cially the partially privatized firms, are about as techno-

logically advanced as many

oil firms in the west. For

example, Petróleo Brasileiro

SA (“Petrobras”) is a world

leader in ultra-deepwater

exploration and StatoilHydro

is a leader in Arctic offshore

operations and subsea pro-

duction technology.

According to a recent report

by the Council on Foreign

Relations, the United States’

current reliance on foreign

governments for financing represents a strategic vulner-

ability. The report, titled, “Sovereign Wealth and Sovereign

Power - The Strategic Consequences of American

Indebtedness,” comes to the conclusion that the longer

the U.S. relies on international central banks and SWFs

to support large external deficits, the greater the risk the

U.S. economy’s need for external credit will constrain the

government’s policy options. It warns that SWFs of foreign

governments that have political objectives contrary to U.S.

values and policy goals could conceivably use large invest-

ment holdings as political and economic leverage.

Bret Setser, a Council Fellow for GeoEconomics state, “this

does not mean foreign creditors are certain or even likely to

use their financial assets as a weapon. It does mean that

they could do so if they want.” “Rather than encouraging

oil-exporting countries to build up assets in [SWFs], the

U.S. should encourage the oil-exporting economies to use

surplus oil revenues to pay a variable ‘oil dividend’ to all its

citizens,” the report recommended. The report also covered

macroeconomic issues and recommended a multilateral

push for greater exchange rate adjustment by the world’s

large creditor countries, stating, “Undervalued exchange

rates contribute to large current account surpluses and

reduce the incentive for private investors in the country

with an undervalued exchange rate to hold foreign claims.”

The Council’s report goes on to suggest, “the United States

could consider requiring the disclosure of sovereign hold-

ings in a U.S. company that exceed one percent of the

company’s market capitalization. This would help outside

observers to assess how - if at all - sovereign investors are

influencing the companies in which they have invested, as

well as allow more accurate analysis of how the investment

choices of sovereign funds and central banks are influencing

a host of markets.”

COMMITTEE ON FOREIGN INVESTMENT IN THE UNITED STATES (“CFIUS”) How SWF investments may influence U.S. economic and

national security has been hotly debated in Congress ever

since laws were amended in October of 2007 by the 12

member inter-agency Committee on Foreign Investment

in the United States (CFIUS), in response to the botched

acquisition of several U.S. port operations by state-owned

Dubai Ports World. CFIUS is a multiagency group that

reviews foreign investments within sensitive industries and

companies, is chaired by the Treasury Secretary, and can

recommend that the President block a proposed invest-

ment deal. CFIUS now takes additional time reviewing

foreign investments in sensitive industries and companies

raising national security. The new amendments also require

SWFs to certify the accuracy and completeness of their

filings with CFIUS—with any misstatements or omissions

potentially leading to rejected deals and/or stiff fines.

The initial U.S. framework for national security reviews

was implemented in 1988 as a

response to growing foreign

investment by Japanese firms,

with Fujitsu’s efforts to acquire

Fairchild Semiconductor in

1987 serving as a tipping point.

Designed to enhance the national

security review process of for-

eign investment under the exist-

ing Exon-Florio Act, in the mid-

dle of 2007 the U.S. Congress

passed the National Security

Foreign Investment Reform and

Strengthened Transparency Act. The Act folded in gov-

ernment-controlled transactions as part of the evaluation.

New rules proposed in April 2008 by the U.S. Treasury

Department were designed to replace older policies that

only covered foreign acquisitions of U.S. companies. One

of the key factors is how much foreign investment can be

viewed as “controlling,” which even after the rule amend-

ments, is still highly discretionary.

Virtually all of the SWF investments in the U.S. have

involved passive stakes below a 10 percent threshold—less

than the general threshold which prompts CFIUS review

and approval. As provided for by the Bank Holding Act, the

Federal Reserve also reviews foreign investments, viewing

equity stakes of less than five percent in banks (including

bank holding companies, but not traditional investment

banks) to be non-controlling. Paul Marquardt, a partner with

Cleary Gottlieb, notes an 11 percent purchase by a SWF

of a bank would not necessarily trigger a notification with

CFIUS, as long as it was a passive investment. SWF invest-

“Would China ever short Volkswagen, for instance, given the number of VW factories in that country? Similarly, might a Middle East-based fund back Halliburton management even at the expense of shareholder value given its base in the United Arab Emirates and presence throughout the region? These are some of the questions that investors face, answers to which may well lie in the internal governance of sovereign wealth funds.”

RiskMetrics Group, Sovereign Wealth Funds & Emerging Governance Trends, July 2008


ments in the form of hybrid securities, such as convertible

preferred shares and trust preferred notes, combine both

debt and equity features, and are considered by some to be

more akin to debt securities. If viewed as a debt investment,

a SWF could theoretically purchase an unlimited amount of

hybrid securities without breaching the 10 percent thresh-

old. Some hybrids are even counted as ‘Tier 1’ investments

on the balance sheet, the most liquid of a bank’s core capital

assets. As a result, some pundits believe these hybrid forms

of investment have lessened the pressure to critically exam-

ine SWF activities from a control perspective.

The large number of SWF investment stakes in the financial

sector that have hovered just below 10 percent of the target

company’s equity have flamed concerns among politicians,

as many observers believe they were purposely kept below

this threshold to avoid bank regulator scrutiny. The Treasury

rules state that a foreign person (synonymous with a com-

pany or SWF entity) is not considered to be in control of

a U.S. entity unless their investment is greater than 10

percent of the voting interest in the entity. Any controlling

stakes automatically trigger CFIUS reviews, although the

Committee can and has conducted evaluations of invest-

ment below the 10 percent threshold. Other rule citations

provide additional criteria, with control defined as, “the

ability to exercise certain powers over important matters

affecting a business,” and includes a majority or “dominant

minority” of voting shares, a formal (or informal) arrange-

ment to act in concert with other investors, or other means

to, “determine, direct, or decide important matters.”

In public statements, the U.S. Treasury has clarified it does

not have any formal criteria for designating control which

involve either a minimum number of board seats or a mini-

mum percentage of outstanding equity share ownership.

Investments made using versions of convertible equity

interests may prompt a CFIUS review because they could

lead to controlling stakes in the future. The CFIUS reforms

enacted in mid 2008 are likely to make preparing notice

more difficult, with additional requirements covering per-

sonal information about the directors and officers part of

the ownership chain of foreign companies. Although “con-

trol” is defined at great length, it still suffers from a lack of

any specific shareholding threshold or to the right to have

seats on the board.

SELECTED PRINCIPLES FROM THE VOLUNTARY SWF CODE OF PRACTICE GENERALLY ACCEPTED PRINCIPLES AND PRACTICES (GAPP)—”SANTIAGO” PRINCIPLES

GAPP 1.2 Subprinciple - The key features of the SWF’s legal basis and structure, as well as the legal relationship between the SWF and the other state bodies, should be publicly disclosed.

GAPP 6. Principle - The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives.

GAPP 8. Principle - The governing body(ies) should act in the best interests of the SWF, and have a clear mandate and adequate authority and competency to carry out its functions.

GAPP 10. Principle - The accountability framework for the SWF’s operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement.

GAPP 11. Principle - An annual report and accompanying financial statements on the SWF’s operations and performance should be prepared in a timely fashion and in accordance with recognized international or national accounting standards in a consistent manner.

GAPP 19. Principle - The SWF’s investment decisions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds.

GAPP 20. Principle - The SWF should not seek or take advantage of privileged information or inappropriate influence by the broader government in competing with private entities.

GAPP 21. Principle - SWFs view shareholder ownership rights as a fundamental element of their equity investments’ value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.


In an October 2008 speech to the U.S. Council for

International Business, Deputy Treasury Secretary Robert

Kimmitt stated, “CFIUS continues to focus solely on genu-

ine national security concerns and reviews annually only a

small portion of transactions – fewer than 10 percent of

transactions involving a foreign investor and a U.S. busi-

ness.” In 2006, only 113 cross-border deals, out of 1,730,

came before CFIUS for review and none were blocked. In

2007, only 125 cross-border deals, out of well over 2,000

in total, came before CFIUS for review and none were

blocked. Emphasizing that reviews related to national

security concerns should be very narrow and adhere to the

principle of regulatory proportionality, he further stated that,

“CFIUS achieves this goal by considering transaction-spe-

cific risks and working with companies to resolve or mitigate

any identified concerns.”

In early 2008, a proposed $2.2 billion takeover of 3Com

Corporation by Huawei Technologies Co., a Chinese com-

pany with close ties to the Chinese government, and Bain

Capital Partners LLC, a U.S. based private equity fund, was

scuttled due to national-security concerns. If finalized, the

deal would have led to a passive ownership stake of 16.5

percent for Huawei. 3Com’s provision to the U.S. military

of sensitive telecom equipment and security software lead

CFIUS to take a dim view of the deal, which was withdrawn

prior to receipt of any formal disapproval. Specific concerns

involved a 3Com unit called “Tipping Point” that delivered

security monitoring equipment to the U.S Department of

Defense. The U.S. has fought repeated computer attacks on

the nation’s defense systems, with Chinese-based hackers

viewed as a major concern.

Since it is not publicly traded, Huawei’s corporate dis-

closures are scant. The firm has stated publicly that it is

owned by its employees, including founder Ren Zhengfei,

a former People’s Liberation Army officer. A 2005 report

by the Rand Corporation alleged that Huawei, “maintains

deep ties with the Chinese military, which serves a multi-

faceted role as an important customer, as well as Huawei’s

political patron and research and development partner.” In

March 2008, shareowners of 3Com

voted overwhelmingly to accept the

proposed $2.2 billion buyout offer even

though the offer was abandoned the

day before. 3Com went ahead with its

special shareowner meeting in order to

be in a position to secure a $66 million

break-up fee. The failed 3Com deal is

an exception however, as most SWF

investments reviewed over the last few

years have been approved.

SWF investments have caused con-

cerns in non-U.S. markets as well. For

example, Singapore’s Temasek has

run into trouble in both Thailand and

Indonesia after buying into family run

telecom businesses with close ties

to governments. In 1987, the Kuwait

Investment Office purchased over

20 percent of British Petroleum (BP)

shortly after it had been privatized. The

British government forced the Kuwait

SWF to sell more than half its stake to

ease concerns about foreign control.

In mid 2008, the Monitor Group, a U.S.

based investment consultant, released

a report concluding that SWFs gener-

ally purchased controlling interests in

foreign companies. The study examined

some 1,100 publicly disclosed equity

SWF transactions worth an estimated

$250 billion between 1975 and 2008.

Monitor Group also focused on more

recent transactions, reviewing 420

publicly reported equity investments

made by SWFs since 2000. Although

tracing the specific country ownership

interests was very difficult, over half of SWF investments

involved majority stakes. Less than 14 percent involved

stakes of less than 10 percent, and over a third of all trans-

actions represented stakes between 10 and 50 percent. In

another group of equal size, Monitor Group was unable to

RECENT INVESTMENTS BY SOVERIGN WEALTH FUNDS &

GOVERNMENT AFFILIATED INVESTORS

Year of Investment Target Investor Value ($ billions)

2008 Rio Tinto Chinalco-Alcoa 14.1

2007 UBS GIC 9.8

2007 Citigroup ADIA 7.5

2007 Citigroup GIC 6.9

2007 Morgan Stanley CIC 5.6

2007 Standard Bank ICBC 5.6

2007 Morgan Stanley CIC 5.0

2007 Merrill Lynch Temasek 4.4

2005 PetroKazakhstan CNPC 4.0

2006 OAO Udmurtneft Sinopec 3.5

2007 Citigroup KIA 3.0

2007 Barclays Plc China Development Bank 3.0

2007 Blackstone Group CIC 3.0

2007 Fortis Ping An Insurance 2.7

2006 NNPC-OML 130 Cnooc 2.7

2008 Barclays Plc Temasek 2.0

2008 Merrill Lynch Korea Investment Corp. 2.0

2008 Merrill Lynch KIA 2.0

2007 UBS SAMA 1.8

2007 Carlyle Group Mubadala (ADIA) 1.4

2007 Och-Ziff Capital Dubai Intl. Capital 1.3

2007 Bear Stearns Citic Securities 1.0

2007 AMD Mubadala (ADIA) 0.6

2008 Credit Suisse QIA 0.6

Source: Thomson Research, Wall Street Journal, SBA


determine the size of investments made, underscoring the

opaque nature of many SWF activities.

Although the number of majority stakes was higher than

most perceptions, Monitor Group noted that there were

relatively fewer majority transactions in sensitive industries

within developed markets. Over the same time period, only

14 individual investments involved majority stakes in com-

panies within the energy, utility, information technology,

telecommunications or financial services sectors. An exam-

ple of how SWFs can and do make investments involving

control and direct board representation was the May 2008

purchase of an 11 percent stake in AEI by the Singapore GIC.

GIC Special Investments, its private equity arm, gained one

seat on AEI’s board of directors as a result of the transac-

tion. AEI operates power generation and distribution and

services, with a presence in 19 countries. More recently, the

national oil fund of Libya, the “Energy Fund,” will reportedly

buy a two to 10 percent stake in Italian oil company ENI.

In accordance with Italy’s securities laws, Libya provided

notice of its intentions to the Italian government, which

EXCERPT OF THE DEFINITION OF “CONTROL” UNDER THE U.S. TREASURY DEPARTMENT’S NEW RULES FOR FOREIGN INVESTMENT IN U.S. COMPANIES:

A. The term control means the power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total

outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to

act in concert, or other means to determine, direct, or decide important matters affecting an entity; in particular, but without limitation, to determine, direct,

take, reach, or cause decisions regarding the following matters, or any other similarly important matters affecting an entity.

(1) The sale, lease, mortgage, pledge, or other transfer of any of the tangible or intangible principal assets of the entity, whether or not in the ordinary course

of business;

(2) The reorganization, merger, or dissolution of the entity;

(3) The closing, relocation, or substantial alteration of the production, operational, or research and development facilities of the entity;

(4) Major expenditures or investments, issuances of equity or debt, or dividend payments by the entity, or approval of the operating budget of the entity;

(5) The selection of new business lines or ventures that the entity will pursue;

(6) The entry into, termination, or non-fulfi llment by the entity of signifi cant contracts;

(7) The policies or procedures of the entity governing the treatment of non-public technical, fi nancial, or other proprietary information of the entity;

(8) The appointment or dismissal of offi cers or senior managers;

(9) The appointment or dismissal of employees with access to sensitive technology or classifi ed U.S. Government information; or

(10) The amendment of the Articles of Incorporation, constituent agreement, or other organizational documents of the entity with respect to the matters

described in paragraphs (A)(1) through (9) of this section

B. In examining questions of control in situations where more than one foreign person has an ownership interest in an entity, consideration will be given to

factors such as whether the foreign persons are related or have formal or informal arrangements to act in concert, whether they are agencies or instrumen-

talities of the national or subnational governments of a single foreign state, and whether a given foreign person and another person that has an ownership

interest in the entity are both controlled by any of the national or subnational governments of a single foreign state.


itself owns 30.2 percent of ENI. Shokri Ghanem, director of

Libya’s National Oil Company, stated the desire for Libya to

gain a board seat if it is able to buy a significant stake in ENI

on the secondary market.

The Monitor Group’s statistics did not reflect many pur-

chases by China and Russia since those countries’ disclo-

sures are especially blurred. The study did conclude the vast

majority of SWF investments represented purely financial

motivations. ”The public dialogue on this subject has been

very long on concern based on speculation, but relatively

short on facts,” said William Miracky, a Monitor Group

senior partner.

C O M P E T I T I V E I N V E S T M E N T L A N D S C A P E SWFs have reduced their overall risk levels during the

latter half of 2008, as global equity markets exhibited

unprecedented declines. As a result, no longer have many

SWFs been willing to come to the rescue of ailing financial

firms and banks given the systemic credit and liquidity

problems in the U.S. and elsewhere. Analysts at Morgan

Stanley recently reported that SWFs have lost between 18

and 25 percent of their assets in 2008.

However, SWFs are a significant player in global investment

markets, due to their size and high asset growth rates.

Some funds have had new weekly cash infusions crossing

above the $1 billion mark. SWFs have allocated an

increasingly greater portion of their overall portfolios to

public and private equities in order to diversify their fast

growing investment holdings, pumping large sums into

hedge funds and private equity firms. Perhaps the poster

child for this trend, 10 percent of Blackstone is owned

by China Investment Corporation. As well, the Mubadala

Development Company of Abu Dhabi owns a 7.5 percent

stake in Carlyle Group. Although sizeable, and exhibiting

very high rates of growth, SWF assets under management

represent only a small fraction of the nearly $165 trillion

global investment market.

In an article for the Wall Street Journal covering the World

Investment Corporation (CIC) and funds in Abu Dhabi. CIC

is working through mandates for a slate of new investment

managers investing about a third of its total assets out-

side of China. This follows on the heels of China’s national

social-security fund, which doled out over $1 billion to

managers since 2006. Forecasters have put the potential

market for investable funds by SWFs at approximately 20

percent of their assets—or $200 billion a year. On a longer

term basis, Merrill Lynch estimates a potential shift of $1.5

trillion to $3 trillion of assets into the global asset-manage-

ment industry in coming years, generating $4 billion to $8

billion annually in extra fees.

SWFs’ impact on emerging markets is also likely to be pro-

found. One worry is that increased investments by SWFs in

several emerging markets that are currently making reforms

to corporate governance practices will mean these markets

no longer need to do so, or will be marginally less inclined.

As noted by Subodh Mishra of RiskMetrics Group, “East and

Economic Summit in Davos Switzerland, Alan Murray point-

edly remarks, “Ask any of the chief executives...whether

they would prefer an investment from an SWF, a hedge

fund or the California Public Employees’ Retirement System

[CalPERS], and they’ll choose the SWF.” The implication is

that CEO’s may prefer SWF investments over other types

of institutional money because they are viewed as more

management friendly and less likely to challenge business

models and governance structures. This could also impact

the dialogue and interaction with the remaining non-SWF

investor base.

Another issue is that U.S. state pension systems could face

increased political pressure to sever direct or indirect ties

to SWFs. In early 2008, a legislative proposal was made

to prohibit CalPERS and CalSTRS from investing in private

equity firms owned or partly owned by a SWF. The bill, ulti-

mately withdrawn, raised concerns about the transparency

of SWFs and the human rights records of their designated

countries. The counter-argu-

ment, of course, is that these

relationships may foster clos-

er ties and increased trans-

parency, and result in better

governed SWFs in the future.

Many SWFs are beginning to

perform their own proprietary

screening for external invest-

ment managers, relying less

frequently on outside con-

sultants. Norway’s govern-

ment pension fund even has

put local investment teams

in New York, Shanghai, and

London in order to monitor

external managers. Numerous

U.S. money managers are

actively pursuing business

with many cash rich govern-

ments, notably with the China


Southeast Asian corporate governance languished for many

years during a period of substantial capital inflows through

the middle to late 1990s. It was not until the region’s 1997

financial crisis that regulators in those markets moved

deliberately to shore-up governance practices in a bid to

attract foreign capital that took flight at the outset of the

crisis.”

Traditional pension funds themselves may need to evolve

over the next decade to be more like SWFs in order to remain

competitive. Since SWF growth rates are outpacing that of

pension plans, the SWFs’ influence will also grow commen-

surately, and as SWFs vie with other institutional investors

in the pursuit of attractive investment opportunities, com-

petition will only heat up. Observers view SWFs as having

more of a “real-time” investment discipline, whereas pen-

sion funds are seen as more static and slow moving. Roger

Urwin, global head of investment consulting with Watson

Wyatt, stated, “I would argue that [SWFs] are setting the

pace. They are ahead of the pack. We have the prospect of

a new landscape. Today, we have one giant (pension funds)

and two little brothers (being SWFs and endowment funds

and foundations). By 2015, the institutional market will be

made up of three equals.”

Some U.S.-based investors did participate in a handful

of capital infusions. William G. Clark, Director of the New

Jersey Division of Investment, actively pursued deals with

both Merrill Lynch and Citigroup in early 2008, as both

firms pursued outside capital, chiefly from SWFs. New

Jersey ended up contributing $300 million for Merrill’s pre-

ferred shares and $400 million in a preferred-share offer-

ing for Citigroup. Mr. Clark stated at the time, “We asked

ourselves, ‘why shouldn’t we take advantage of the same

opportunities’?” Other investors have also been involved in

some of these deals. For example, Davis Selected Advisers

bought $1.2 billion of Merrill Lynch stock

at $48 a share, discounted heavily to the

market value of the company at the time. T.

Rowe Price also participated in the Merrill

preferred share deal.

The pursuit of capital investments by

SWFs has not been limited to U.S. mar-

kets, other countries have actively pur-

sued SWF foreign investment. Nomura

Securities and Daiwa Securities for exam-

ple, both large brokerages, have created

special teams dedicated to attracting

more investments into Japanese compa-

nies from funds owned by foreign govern-

ments. These actions have resulted in several investments

by SWFs in large Japanese firms. For example, Cosmo

Oil sold a 20 percent stake to Abu Dhabi’s International

Petroleum Investment Co., a government-controlled fund;

Sony received investment by another Dubai fund, and the

Westin Tokyo was purchased outright by the Government

of Singapore Investment Corporation. Yutaka Suzuki, an

analyst at Daiwa Institute of Research, has estimated

that SWFs hold a combined three to four percent of many

Japanese large capitalization firms. Historically, Japanese

companies have been sensitive to foreign takeover and may

view SWF investment as less dangerous when compared to

alternatives such as activist hedge funds like Steel Partners

or TCI.

Another variation of the competitive landscape involves

private equity funds. Ironically, many SWFs have competed

with one another for access to the most attractive invest-

ment opportunities with new private equity funds. Some

of these private equity funds have participated in recent

capital infusion into Wall Street firms. For example, TPG

showed interest in the Merrill Lynch deal, but ultimately was

beaten out by Temasek of Singapore, whereas Temasek was

excluded from the Morgan Stanley financing, which pre-

ferred to deal with CIC. The lines can be blurred even further

by partnerships between SWFs and private equity funds, as

hedge fund adviser Och-Ziff Capital Management has a co-

investing agreement with its SWF investor, Dubai Capital

Investment, allowing Dubai to make investments alongside

Och-Ziff. This practice may have hit a tipping point though,

as a December study by the Monitor Group shows that

SWFs have been more inclined in the third quarter of 2008

to enter into joint venture, consorita and partnership struc-

tures to implement their investment decisions. The Monitor

Group notes, “this new trend came at a time when SWFs

have appeared to alter their investment strategies during

the worsening global financial crisis.”

Banking researchers with the Federal Reserve Bank of

San Francisco pointed out in a recent financial note that

with such immense sums to invest, SWFs should struc-

ture their investment holdings in order to track major

indices, rather than doing so strategically with relatively

concentrated equity stakes. Such tactics may have the

double edged effect to soothe political anxiety as well. Other

market observers, such as State Street Global Advisors

(SSGA), point out that SWFs will hit capacity constraints

in their active or strategic equity investments. Coupled

with increasing needs for asset-class diversification and

risk control, it is inevitable that SWFs will adopt more

broad based index oriented investment strategies. Although

most SWFs don’t have clearly defined liabilities, they do

have specific investment return objectives. Given histori-

cal investment practices among institutional investors, the

higher a SWFs’ equity allocation, the higher the probability

of adopting a passive strategy.

0 5 10 15 20 25

Pension Funds

Mutual Funds

Insurance Companies

Official Reserves

Sovereign Wealth Funds

Hedge Funds

Private EquityASSET RANKING BY FUND TYPE

($ TRILLIONS)

SWF ASSET LEVELS ARE RELATIVELY SMALL COMPARED TO OTHER TYPES OF

INVESTORS

SOURCE: MORGAN STANLEY


R E C E N T S I G N I F I C A N T T R A N S A C T I O N S

CITIGROUP

A group of SWFs, including the Abu Dhabi Investment

Authority, GIC, Kuwait Investment Authority, and a former

senior executive made investments in Citigroup. Citigroup

received a cash infusion of $7.5 billion from the Abu Dhabi

Investment Authority, and a follow on investment of $15.4

billion from a group including the governments of Singapore

and Kuwait, former Chief Executive Sanford “Sandy’’ Weill

and Saudi Prince Alwaleed bin Talal. None of the SWFs own

more than 4.9 percent of Citigroup’s stock, in order to avoid

tripping U.S. banking regulations. The 11 percent preferred

shares’ dividends represented a spread of over six percentage

points above the U.S. Federal Reserve’s overnight lending

rate at the time.

The initial mandatory convertible offering bought by Abu

Dhabi yields 11 percent, and allows conversion into as many

as 235.6 million common shares starting in 2010 at a

maximum conversion price of $31.83. Citigroup convertible

preferred shares require conversion after five years as long as

the company’s stock price exceeds 130 percent of the con-

version price. The convertible units proscribe ownership roles

including the appointment of directors. The second tranche

of $12.5 billion in convertible preferred securities offered a

lower yield of seven percent due to a lower conversion price

of $31.62 and their optional conversion.

Citigroup has pursued strategic foreign investment in the

past. In 1991, Saudi Arabian Prince Alwaleed bin Talal

invested $590 million in the form of a private placement of

convertible preferred stock into what was then Citicorp, pro-

viding him with a 15 percent ownership stake.

UBS (SWITZERLAND)

Singapore’s Government Investment Corporation (GIC) made

an investment in UBS, the giant Swiss bank, together with

an unidentified investor from the Middle East, totaling 13

billion Swiss francs and did not involve a board seat. GIC

officials stated, “We are not a strategic investor, nor do we

pursue political aims. Therefore, we do not seek a place on the

board and we do not want to exercise direct influence on the

management.” As of September 30, 2008, the Government

of Singapore Investment Corporation (GIC) owned about 8.2

percent of the firm and was the single largest shareowner,

dwarfing the next largest equity holder by a multiple of four

times.

As noted in the latest RiskMetrics Group proxy analysis, only

56 percent of UBS’ issued share capital were entitled to

vote at the annual general meeting—in excess of 40 percent

of the firms’ equity had no voting rights whatsoever. In late

2008, UBS accepted $3 billion from the Swiss National

Bank (SNB) in order to maintain a sufficient Tier 1 capital

ratio. The SNB capital injection followed two earlier invest-

ments. The earliest recapitalization, a $14.2 billion rights

issue, was approved at the April 23, 2008, extraordinary

general shareholder meeting (EGM), of which the Florida

State Board of Administration (SBA) voted in favor. And the

second was an $11.4 billion private placement of mandatory

convertible notes to GIC and the unnamed Middle Eastern

investor, which was also approved by shareowners at the

February 27, 2008, EGM.

MERRILL LYNCH (UNITED STATES)

In late 2007, Temasek paid approximately $4.4 billion, or

$48 per share, for new Merrill stock and had an option to buy

$600 million of stock by March 28, 2008. The transaction

was designed to stay under 10 percent at all times. Davis

Advisers, which invested about $1.2 billion, also bought

into Merrill at a discount of about 14 percent. At the time,

analysts with Sanford C. Bernstein & Co. estimated the

additional Temasek purchase would be 13 percent dilutive to

existing shareowners. “The dilution to existing shareholders

is probably not on the first page of concerns for manage-

ment,” said Bruce Foerster, President of Miami-based advi-

sory firm South Beach Capital Markets. Reportedly, Merrill

Lynch turned away potential investments by U.S-based

hedge funds, apparently due to concerns over such funds

desire to be involved in management decisions and pursuit of

board engagement.

Merrill also received funds from another group of investors

including the Kuwait Investment Authority (KIA), Korea

Investment Corporation, and Tokyo-based Mizuho Financial

Group. The preferred convertible notes represented by this

second investment included a nine percent dividend and

automatic conversion in 2010, depending on Merrill’s trad-

ing price, with fewer shares if the stock price moved above

$61.31 and more if it dropped below $52.40. Analyst esti-

mates showed that the second round of capital infusion

diluted 2008 earnings by nine percent, which was on top

of the initial transaction’s dilution of more than 10 percent.

Analyst Charles Peabody of Portales Partners LLC stated,

“Double-dipping clearly turned out to be painful for Merrill

Lynch…a very steep price to pay for securities losses, sug-

gesting a desperate need to clean up the company’s troubled

past.” Luckily for shareowners, the dilution was not long-

lived, as Bank of America bought Merrill for $50 billion on

September 15, 2008. However, this and other transactions

that are still being absorbed, represent significant dilution for

existing shareowners.

SIEMENS (GERMANY)

Ironically, given recent legal moves to block foreign deals over

25 percent of a company shares, some German firms have

shown great interest in receiving SWF investment. Siemens,

Europe’s biggest engineering firm, has reached out to several

SWFs in order to expand its investor base, and has the poten-

tial to increase business opportunities inside several high

growth regions. Its main rival, General Electric, announced

in mid 2008 that it had finalized a deal with Mubadala, one

of Abu Dhabi’s investment vehicles, to buy a stake in GE and

create a $12 billion joint venture with the company’s finance

arm in the Middle East. SWF investment into Siemens would

mark a seachange for the companies culture and historical

perspective on large shareowners, which has been wary of

a single large investor. Some market observers have noted

that because it does not have a friendly, anchor investor in

its shareowner base, it could be more vulnerable to activist

investors.

ADVANCED MICRO DEVICES (UNITED STATES)

A recently created investment firm of the government of Abu

Dhabi, named Advanced Technology Investment Company

(ATIC), is investing approximately $8.4 billion in Advanced

Micro Devices (AMD) as part of a financial rescue plan for

the company. As part of a complex transaction, AMD and

Abu Dhabi will be co-owners of a new company that will take

over AMD’s factories in Germany. ATIC plans to make a $1.4

billion investment in the new joint venture, tentatively called

the Foundry Company, and then make an additional $700

million payment to AMD for its share of the new company’s

assets. ATIC has also committed to expanded funding total-

ing up to $6 billion for upgrades to existing facilities and

a new chip factory construction. Mubadala Development

Company already holds an approximate eight percent stake

in AMD, and as part of the ATIC deal will invest an additional

$314 million in AMD shares, boosting its total ownership to

just under 20 percent. The main driver of the AMD deal was

an immense debt load that has hampered the company’s

ability to invest in advanced production capabilities and chip

research in order to keep up with rival Intel.

S H A R E O W N E R D I L U T I O NMany of the financial investments made by SWFs into

U.S. investment banks and financial services firms involved

the issue of convertible preferred shares that paid high

dividends of between seven to nine percent and an equity

conversion premium of 20 percent. Many of the invest-

ments offered hefty levels of dilution for existing shareown-

ers. Peter Hahn, a former managing director at Citigroup

and fellow in corporate finance and government at City

University’s Cass Business School in London, stated, “The

dilution could be huge….[SWFs] have a claim on ownership;

they are in a privileged position to get the dividend and they

bought in at a lower price than most shareholders.” Some

of the investments are estimated to reduce future earnings

per share (EPS) figures by well over 20 percent once future

equity conversions take place.

Such high levels of dilution have caused concern among

some advisors and long-term shareowners. As many financial

and banking firms were in severe distress and a vacuum for

capital developed, most shareowners were more than willing

to suffer dilution in exchange for cash injections. But as time

went on, and as additional capital only delayed further losses

in some cases, shareowners grew more and more skeptical of

proposed SWF deals. For example, the corporate governance

research provider PIRC recommended in November 2008

that shareowners of Barclays Plc, the huge British bank, vote

against the lender’s planned $7.4 billion fundraising from

investors in the Middle East. Under the deal, the two SWF

investors could end up owning approximately 30 percent of

the bank. PIRC viewed the investment as significantly dilu-

tive and offers no advantage over the alternative of participa-

tion in the UK government’s rescue package for the banking

sector.

In mid November, PIRC’s managing director Alan MacDougall

stated, “At least a part of the company’s investor base should

send a clear, unequivocal message that they do not think this

was a good solution to the bank’s current situation, and that

it has come at a heavy price for existing shareholders.” Some

of the Barclays new securities will pay annual dividends of 14

percent to SWF investors from Abu Dhabi and Qatar. Some

banks, including some in the U.S., have been reluctant to

participate in credit stabilization programs because of oner-

ous operational requirements levied in exchange for access

to government capital. In addition to PIRC’s cold reception,

the Association of British Insurers, which represents about

a fifth of all UK shares, also voiced concerns about Barclays’

proposed fundraising. Since investors were not given the

same opportunity as SWF investors, many shareowners

became disgruntled and viewed the deal as an abuse of their

pre-emption rights to buy into such deals on the same terms.

As a way to assuage investor concerns and improve the

bank’s corporate governance structure, a few days prior to

the vote on the plan, the firm offered to place every board

member up for reelection during the next annual general

meeting in April 2009. Barclay’s has a classified board, with

individual directors being elected every three years, unless

their service exceeds nine years, in which case they are

elected on an annual basis. The bank also carved out about

a fifth of the prior allocation to Middle Eastern investors for

existing shareowners, allowing them to participate in the

higher yielding transaction. Although the deal was approved

as amended on November 24, 2008, almost a quarter of

Barclays shareowners voted against the plan, a huge protest

level. In addition, both Chairman Marcus Agius and John

Varley, CEO, were called on to resign.

F I D U C I A R Y R E S P O N S I B I L I T Y



At the core of most institutional investing is a strong

emphasis on fiduciary responsibility and standards of pru-

dence for the exclusive benefit of an asset owner, or ben-

eficiary. Although SWFs have been under the microscope

for much of 2008, one issue that has not received enough

attention is the topic of fiduciary responsibility (or lack

thereof) - what duties should SWFs have when managing

their assets? For pension plans, retirees are naturally the

objective and focus for investment activities. For SWFs

however, it can be difficult to ascertain the specific goals

and/or objectives for many funds. Since they have been

largely created to invest surplus funds or currency reserves,

the beneficiaries are proscribed within a nation-state, but

without much clarity for specific liabilities.

Benn Steil, Director of the International Economics at

the Council of Foreign Relations, argues that public pen-

sion funds, most notably the California Public Employees

Retirement System (CalPERS) in the U.S., can be viewed

as SWFs too. Mr. Steil notes that if California were its own

national economy, it would be the eighth largest in the

world. If the two largest U.S. public pension systems’ assets

were coupled, CalPERS with the California State Teachers

Retirement System (CalSTRS), California would rank as the

second largest SWF in the world, just behind the United

Arab Emirates. Some observers, largely because of their

history of shareowner activism and corporate governance

engagement, argue that U.S. pension funds are just as polit-

ically conflicted, or have the potential to be, as are SWFs.

With governance structures that are either politically

appointed or directly elected, pension systems can certainly

be viewed as sovereign entities. With investment policies

influenced by state legisla-

tures and other public policy

goals, pursuit of economically

targeted investments—some-

times involving foreign policy

matters—retirement vehicles

can clearly be used for politi-

cal purposes. However, one

large distinction that retire-

ment plans have when compared to SWFs is their strong

fiduciary responsibility towards their beneficiary members.

Such objectives and legal requirements are almost univer-

sally absent from SWFs.

Most institutional investors, either directly as a retirement

plan, or indirectly as registered investment advisors, have

strict fiduciary and prudence standards with which to

comply (at least in the U.S. and most developed countries).

In the U.S. for example, many retirement plans have some

fiduciary responsibility framework, with many governed by

the Employee Retirement Income Security Act (ERISA) of

1974. The vast majority of SWF’s, as government con-

trolled investment vehicles with broad, national investment

objectives, do not have any clear guidelines in place. The

SWF assets are, in most cases, universally owned by the

citizenry of the country.

Many foreign capital markets have similar fiduciary codes

for investment managers, many with aggressive standards

and extensive regulatory requirements. Should SWFs be

treated in a similar fashion? What, if any, prudence or fidu-

ciary responsibility should SWF’s have in order to effectively

and efficiently invest their sovereign assets? Are attempts

by SWF’s to be apolitical (by avoiding controlling interests

in firms and avoiding public scrutiny) costing them in the

long run?

These are questions that most SWFs have not focused

on and many pundits have overlooked. In a posting to

the Harvard Corporate Governance blog, staff attorneys

from Wachtell, Lipton, Rosen & Katz state, “Preferred

governance frameworks would establish clear divisions of

responsibilities to facilitate the operational independence

of the SWF, and governing bodies would be appointed in

accordance with defined procedures and with adequate

authority to function in an independent manner.” With such

independent policies and procedures, coupled with a strong

fiduciary responsiblity, SWFs could avoid much of the scru-

tiny laid at their feet. A clear fiduciary standard would guide

SWF investment activity and clearly prohibit investment

decisions based on social and/or political motivations of

their home countries. [sba]

ADDITIONAL RESOURCES COVERING SOVEREIGN WEALTH FUNDS...

Peterson Institute[www.petersoninstitute.org]

SWF Institute[www.swfinstitute.org]

GSWF Radar[www.swfradar.com]

The Monitor Group[www.monitor.com]

OECD - Sovereign Wealth Funds and Recipient Country Guidelines:Report by the Investment Committee[www.oecd.org]


A clear fiduciary standard would guide SWF investment activity and

clearly prohibit and mitigate investment decisions based on social

and/or political motiviations of their home countries.

THE NEW PARADIGM OF ‘ALL-POWERS’ CORPORATE GOVERNANCE

GUEST COMMENTARY BY DR. DARLENE ANDERTDIRECTOR, INSTITUTE FOR RESPONSIBLE CORPORATE GOVERNANCE

FLORIDA GULF COAST UNIVERSITYCENTER FOR LEADERSHIP AND INNOVATION

While the Sarbanes-Oxley Act of 2002 (SOX) changed

the requirements for transparency and financial disclosure

for the CEO and CFO, it remained too silent concerning

director-to-director transparency and the role of the Chair,

Executive Committee or other autonomous committee to

take action without full board knowledge and consent. This

is a re-occurring directorship problem as previously high-

lighted by Enron, Disney, and other exigent cases that are

now expanded with such cases as Fannie Mae – Freddie

Mac and the sub-part issues in our economy. These cases

point to the need for director-to-director transparency and

disclosure if board members are to avoid unsubstantial

board action.

In 2003, participating Fortune 1,000 board members

responded to my personal research survey and indicated

clearly that corporate governance was not a perfunctory

role. Yet, there continue to be structural and control/power

issues plaguing directorship excellence simply due to the

absence of commonly held protocols that prescribe how

boards exercise collective powers and interconnectedness.

Interestingly, there are legal formats that govern directors

and place “all powers” with the full board and not individual

board members. These documents are the Model Business

Corporation Act (MBCA) and the Delaware General

Corporate Law (that applies to over half of the Fortune 500

companies chartered in Delaware). Each establishes a one-

director one-vote or an egalitarian structure as the basis for

board work. This structure provides directors equal voting

opportunities. Yet most members of boards of directors

have risen through the ranks of a pyramidal and hierarchical

management structure that sanctions veto powers by an

overseer. It is therefore, natural for directors to see the Chair

as holding veto powers or an imaginary vote-and-a-half.

In reality, it is the whole Board performing en masse through

a meeting or through a signed consent document that con-

stitutes Board action. This concept outlines the “board due

process”. Acts by individual board members occur ONLY as

the result of specifically and purposefully delegated author-

ity, authenticated by corporate documents or minutes,

which is described in the primary documents listed below

for your review. Individual board member action should not

deny or negate the voting rights granted to fellow board

members or negate the directors’ ability to fulfill the fidu-

ciary responsible to the shareholders and the organization

as a whole.

The Delaware General Corporation Law states: a majority of

the total number of directors shall constitute a quorum for

the transaction of business unless the certificate of incor-

poration or the bylaws require a greater number. Unless the

certificate of incorporation provides otherwise, the bylaws

may provide that a number less than a majority shall con-

stitute a quorum which in no case shall be less than 1/3 of

the total number of directors except that when a board of

1 director is authorized under this section, then 1 director

shall constitute a quorum. The vote of the majority of the

directors present at a meeting at which a quorum is present

shall be the act of the board of directors unless the certifi-

cate of incorporation or the bylaws shall require a vote of a

greater number (bolding added for emphasis).

The Delaware General Corporation Law further states, that

in the absence of a meeting:

(f) Unless otherwise restricted by the certificate of incor-

poration or bylaws, any action required or permitted to be

taken at any meeting of the board of directors or of any

committee thereof may be taken without a meeting if all

members of the board or committee, as the case may be,

Current events continue to offer steadfast corporate governance professionals new

lessons that reinforce the focus of: (1) the powers of the Board, (2) the role of the Chair, and (3) the expectation by individual directors to expect and exercise boardroom due process to redress issues, and now, (4) the need for transparency between and among directors.

THIS SECTION IS BASED ON RESEARCH DEVELOPED BY DR. DARLENE ANDERT

SURROUNDING THE 2003 HEWLETT PACKARD BOARD SCANDAL AND OTHER

MORE RECENT GOVERNANCE EVENTS.


68F I S C A L Y E A R 2 0 0 8 C O R P O R A T E G O V E R N A N C E R E P O R T

consent thereto in writing, or by electronic transmission

and the writing or writings or electronic transmission or

transmissions are filed with the minutes of proceedings of

the board, or committee. Such filing shall be in paper form

if the minutes are maintained in paper form and shall be in

electronic form if the minutes are maintained in electronic

form (bolding added for emphasis).

MODEL BUSINESS CORPORATION ACTSubchapter “A” titled “Board of Directors” - §8.01 titled

“Requirements of and Duties for the Board of Directors”

(b) states: All corporate powers shall be exercised by or

under the authority of, and the business affairs of the cor-

poration managed by or under the direction of, its board of

directors, subject to any limitations set forth in the articles

of incorporation or in an agreement authorized under sec-

tion 7.32 (titled “Shareholder Agreements”) (bolding

added for emphasis).

Further, the MBCA further addresses “Actions without

Meetings” in §8.21 and states: (a) Except to the extent that

the articles of incorporation or bylaws require the action be

taken by the board of directors at a meeting, action required

or permitted by this Act to be taken by the board of directors

may be taken without a meeting if each director signs a con-

sent describing the action to be taken and delivers it to the

corporation. (b) Action taken under this section is the act of

the board of directors when one or more consent signed by

all directors (bolding added for emphasis) are delivered to

the corporation. The consent may specify the time at which

the action taken is to be effective. A director’s consent may

be withdrawn by revocation signed by the director and deliv-

ered to the corporation prior to delivery to the corporation

of unrevoked written consents signed by all directors. (c) A

consent signed under this section has the effect of action of

the board of directors and may be described as such in any

document Bolding added for emphasis).

Further, when the corporate bylaws indicate the use of

Roberts Rules as the meeting process protocol, that further

places restrictions on the Chair to remain a neutral organizer

of the Board’s debate-based interactions. This egalitarian

concept unfortunately may remain an inconsistent stan-

dard to corporate governance structures and processes,

and directors may not understand its full application and

implications to the balance of power of the full board to act.

As a point of parallel comparison, our society is structured to

impede the creation of a single all-powerful person exerting

full and complete control to rule the masses. These balanc-

ing concepts have now found their time in the structuring

of corporate governance. CEOs report to the Board as a bal-

ance to the powers and control of the position. The Board

is balanced and controlled by a host of regulatory agencies,

Wall Street, watchdog organizations, and the force of its

own stockholders.

These sources give rise to the easy and logical conclusion

CORPORATE GOVERNANCE IS THE SYSTEM OF INTERNAL CONTROLS AND PROCEDURES BY WHICH INDIVIDUAL COMPANIES ARE MANAGED. IT PROVIDES A FRAMEWORK THAT DEFINES THE RIGHTS, ROLES, AND RESPONSIBILITIES OF DIFFERENT GROUPS—MANAGEMENT, BOARD, CONTROLLING SHAREOWNERS, AND MINORITY OR NON-CONTROLLING SHAREOWNERS—WITHIN AN ORGANIZATION. THIS SYSTEM AND FRAMEWORK IS PARTICULARLY IMPORTANT FOR COMPANIES WITH A LARGE NUMBER OF WIDELY DISPERSED MINORITY SHAREOWNERS. AT ITS CORE, CORPORATE GOVERNANCE IS THE ARRANGEMENT OF CHECKS, BALANCES, AND INCENTIVES A COMPANY NEEDS TO MINIMIZE AND MANAGE THE CONFLICTING INTERESTS BETWEEN INSIDERS AND EXTERNAL SHAREOWNERS. ITS PURPOSE IS TO PREVENT ONE GROUP FROM EXPROPRIATING THE CASH FLOWS AND ASSETS OF ONE OR MORE OTHER GROUPS.

In general, good corporate governance practices seek to ensure that:

• Board Members act in the best interests of Shareowners;• The Company acts in a lawful and ethical manner in its dealings with all stakeholders and its

representatives;• All Shareowners have the same right to participate in the governance of the Company and

receive fair treatment from the Board and management, and all rights of Shareowners and other stakeholders are clearly delineated and communicated;

• The Board and its committees are structured to act independently from management, individuals, or entities that have control over management and other non-Shareowner groups;

• Appropriate controls and procedures are in place covering management’s activities in running the day-to-day operations of the Company; and

• The Company’s operating and financial activities, as well as its governance activities, are consistently reported to Shareowners in a fair, accurate, timely, reliable, relevant, complete, and verifiable manner.

HOW WELL A COMPANY ACHIEVES THESE GOALS DEPENDS, IN LARGE PART, ON THE ADEQUACY OF THE COMPANY’S CORPORATE GOVERNANCE STRUCTURE AND THE STRENGTH OF THE SHAREOWNER’S VOICE IN CORPORATE GOVERNANCE MATTERS THROUGH SHAREOWNER VOTING RIGHTS. THE SUCCESS OF THE BOARD IN SAFEGUARDING SHAREOWNER INTERESTS DEPENDS ON THESE FACTORS.

SOURCE: CFA CENTRE FOR FINANCIAL MARKET INTEGRITY

that the basic structure for Board work is as an egalitarian

body of directors with equal opportunity to express voting

rights. I propose the term governequity to describe this

situation.

BOARD TRANSPARENCYThe logical next phase of growth for corporate governance

is the increased, even mandated, transparency between and

among board members. Our legal system embeds a require-

ment for discovery and disclosure between adversaries to

prepare a case for trial. Board members may soon demand

the same disclosure by fellow board members to inform

issues before the board and as method of elimination of

vacuous voting.

James G. Sheehan, Medicaid Inspector General of New York

Office, along with the America Health Lawyers Association

issued reports stressing the increased focus on the concept

of “duty to inquire”. Simply put, passive voting in the board

room fails – board must move beyond mere reaction to full

engagement on issues before the Board.

Boards are better served to seek full board debate and col-

lective action, in which each member exercises a vote that

can be delegated but not officiously denied. Obfuscating the

practice of egalitarian corporate governance is the absence

of director-to-director transparency, and acts indicating

some members seem to be more equal than others is gov-

ernance of old.

CONCLUSION

The new “all powers” Board will: (1) embrace and exercise

the powers of the full Board, (2) balance and define the role

of the Chair and eliminate the passive practice of wholesale

delegation of individual board member voting rights, and (3)

obligate individual directors to practice transparency and full

disclosure in the matters that come before the board and

(4) provide board due process and utilize the board table to

redress issues -- avoiding the public domain as the forum

for debate.

Individual board member differences should create the

foundation for solid fact-finding and the corresponding

rigorous debate that informs the decisions of the full board.

Ignorance, willfulness, personal agendas and ego do not

serve the shareholders and distort the ultimate value of

board work. Governymity, defined as governance free from

identification, conducted by the unnamed few, lacks the

transparency and vehemence demanded by the new para-

digm of corporate governance professionalism. [sba]

“If we assume that all shareholders want to maximize the value of their shares and that each share-holder receives a noisy signal about the desirability of a given decision, then the decision favored by a majority of shareholders is likely to be the most effi cient one.”

“Management Always Wins the Close Ones”Yair Listokin, Associate Professor of Law, Yale Law School

ADDITIONAL RESOURCES COVERING FUNCTION AND EFFECTIVESNESS OF BOARDS OF DIRECTORS...

Delaware General Corporation Lawwww.delcode.state.de.us

Model Business Corporatin Actwww.abanet.org /buslaw/library/onlinepublications

“Flattery Will Get You Everywhere...”James Hall and Ithai SternAcademy of Management JournalVol. 50, No. 2, 2007

“The Role of Boards of Directors in Corporate Governance: A Conceptual Framework & Survey”Renee Adams, Benjamin Hermalin and Michael WeisbachOhio State UniversityFisher School of BusinessNovember 2008 Working Paper

“The Next Frontier in Corporate Governance: Engaging the Board in Strategy”Jeffrey Kerr & Williamr WetherOrganizational DynamicsVol. 37, No. 2, 2008


SBA PROXY VOTE DECISIONMAKING A CASE ANALYSIS OF THE 2008 TCI/3G VERSUS CSX PROXY CONTEST


SBA VOTING DECISIONSProxy voting occurs when a company’s shareowner is autho-

rized to exercise the voting rights of another shareowner in

the same company. Typically, a shareowner that plans to

vote at a company’s shareowner meeting will solicit the

voting rights of the company’s other shareowners through a

proxy statement. In addition to vying for other shareowners’

voting rights, a shareowner may issue proxy statements to

persuade other shareowners to vote in accordance with the

soliciting shareowner’s plan. The Securities and Exchange

Commission governs these solicitations under Section 14

of the Federal Securities Exchange Act of 1934. Generally,

Section 14 demands that proxy statements disclose the

material facts surrounding the solicitation, which includes

a description of how the soliciting shareowner plans to vote

the shares at the meeting. If a proxy solicitation is found

to be misleading to the extent that it materially affected

a shareowner’s decision to allow a proxy to vote his or her

shares, then courts have prevented the soliciting party from

voting the accumulated proxies or have invalidated the

votes cast on those shares. Therefore, shareowners, who are

soliciting for proxy rights or for a consensus in a voting plan,

must comply with the SEC proxy rules to protect the votes

of the absentee shareowners and avoid violating federal

securities laws.

The rise of large institutional investors as shareowners in

public corporations has brought with it a rise in the number

of proxy solicitations. Occasionally, large institutional inves-

tors will issue proxy statements to other shareowners in an

attempt to amass enough votes so that the institutional

investors can effect change in the owned company. This is

called a proxy contest. Most often, institutional shareown-

ers use proxies to challenge the composition of a company’s

board. In other words, shareowners do not believe that the

company’s board of directors has taken the necessary steps

to maximize shareowner value, so shareowners will vote

to remove members of a company’s board of directors and

try to replace these directors with their own candidates.

Of course, this is called a proxy contest for a reason; some

companies, via their challenged board of directors, may

vehemently resist such platforms by engaging in a costly

proxy battle and possibly by pursuing litigation if it feels that

the challenging shareowners have violated federal securi-

ties laws in their pursuit of the proxy contest. Companies

may also use courts to hedge against the possibility that

shareowners may agree with the dissidents since courts can

enjoin dissidents from voting their shares and their proxies.

Generally, corporations are free to use corporate resources

to defend members of their board of directors, the corporate

bylaws, and any other challenged business practice during

proxy contests.

While proxy contests are costly and may deplete shar-

eowner value through the consumption of the company’s

resources in fighting the proxy contest, the challenging

shareowners typically agree that the benefits resulting from

a proxy contest surpass the costs involved to conduct them.

To accentuate shareowner value further, some members of

the investment community have propositioned companies

to adopt bylaw amendments that will provide for shareown-

er reimbursement for the expense of waging a proxy contest

This section provides insight for the SBA’s constituents and the institutional investment

community regarding the SBA’s voting procedures, specifically in the context of a proxy contest.

We define “proxy voting” and “proxy contest.” Next, we touch on the methods that the SBA employs to exercise its voting responsbility on the composition of the board of directors, proposals to amend or change corporate bylaws, and in a proxy contest.

These issues are explored in detail by reviewing the SBA’s approach to voting in The Children’s Investment Fund (TCI) and 3G Capital Partners’ (3G) proxy contest against the board of directors of CSX Corporation (CSX) and against CSX’s proposed amendment to the company’s bylaws. We conclude with a discussion of this proxy contest’s broader ramifications for the investment community.


ALL OF THE PROXY RESEARCH MATERIALS MENTIONED IN THIS SECTION ARE AVAILABLE ON THE SBA’S WEBSITE AT:

www.sbafla.com/fsb /CorporateGovernance /tabid /378 /Default.aspx

against a company if a shareowner realizes an increment of

success in the proxy contest, such as seating a new mem-

ber to the board of directors. For instance, the American

Federation of State, County, and Municipal Employees

(AFSCME) recently submitted such a proposal to Apache

Corporation, a Houston-based energy company. Charles

Elson, Director of the John L. Weinberg Center for Corporate

Governance at the University of Delaware, believes that this

is a better solution than providing dissident candidates with

access to the company’s proxy cards; however, consider-

ing the SEC’s amendment to Rule 14a-4 creating greater

access for dissident shareowners, which will be discussed

later, it is unlikely in the near term that shareowner reim-

bursement will become a widely accepted practice.

As an institutional shareowner that invests funds on behalf

of many of Florida’s citizens, the SBA fulfills its fiduciary

duties by carefully monitoring proxy contests and by partici-

pating in them in a way that will maximize the return to its

constituents: fund participants and beneficiaries. To exer-

cise its fiduciary duties under Florida Statutes, the SBA will

only consider factors that affect the SBA’s investments,

and it will not subordinate the interests of the SBA plan’s

participants or beneficiaries to its own or other interests

when voting its shares. Accordingly, the SBA relies on a

number of quantitative and qualitative resources in fulfill-

ing its fiduciary duties while voting proxies. First, the SBA

has developed a number of internal policies that it employs

when making any voting decision, whether the vote regards

routine matters or the vote regards substantive issues chal-

lenged in a proxy contest. The SBA’s internal policies focus

on the corporate governance practices of the companies

that it owns because a particular company’s corporate

governance practices affect the rights of, and returns to,

its shareowners. In general, the SBA’s policies promote

measures that expand shareowner rights and maximize

shareowner returns, and its policies shun measures that

act contrary to these goals. Recently, the SBA submitted

its internal voting guidelines for an audit, and the auditor,

Glass, Lewis & Co., found that the SBA’s internal voting

policies were well developed and exceeded industry stan-

dards in many regards.

In addition to using its internal policies, the SBA subscribes

to four leading proxy advisory and corporate governance

research firms: Risk Metrics Group, Glass, Lewis & Co., The

Corporate Library, and PROXY Governance. Similar to our

internal policies, the SBA employs these firms’ services

whether the SBA is voting on routine issues or on issues

challenged in a proxy contest. These firms assist the SBA

in analyzing individual voting items and in monitoring

boards of directors and executive compensation levels. By

subscribing to a number of firms, the SBA receives a bal-

anced analysis of proxy issues and meeting agendas for

its domestic and foreign securities, and this diversification

enables the SBA’s investment staff to leverage the particu-

lar strengths of each research provider’s analytical models.

Aside from the advice of others, the SBA conducts its own

review of the corporation when deciding on how to vote its

shares. The SBA considers the company’s financial perfor-

mance over the short-term and long-term, and according

to the internal policies discussed above, the SBA assesses

the company’s corporate governance practices. In regards

to a proxy contest, the SBA will review the proxy state-

ments from the competing sides and weigh the positives

and negatives of each argument. For example, if the proxy

contest involves the removal and replacement of members

of the company’s board of directors, the SBA will rate the

proposed slate of directors put forth by each party using all

of the SBA’s tools: internal voting policies, external advice

from proxy voting and governance research firms, and the

proxy statements from the competing parties. Once the

SBA has synthesized this data, it will determine the opti-

mal vote to maximize shareowner value and cast its vote

accordingly.

The SBA also tracks its own performance in regards to its

past voting decisions. For instance, the SBA will observe

TOTAL RETURN SWAPS (TRS) DEFINED:

A “total return swap” is an agreement between two entities “to swap periodic payment[s] over the life of the agreement.” Additionally, the swap is a derivative, which references an underlying asset, such as an equity security. In the case of equity securities, one party, the “long” party, receives the fi nancial benefi t of owning the shares, such as dividends and increases in share price, from the “short” party in exchange for paying the short party interest payments and compensation for any decreases in share price. The short party continues to be the record owner, so it typically retains all voting rights.

In the CSX case, TCI, and eventually 3G, the long parties, purchased TRSs referencing CSX common stock held by different banks, the short parties, in an agreement that TCI and 3G would receive the fi nancial benefi ts of owning the CSX securities, such as increases in the securities’ value and dividends resulting from the securities, while compensating the banks for decreases in the CSX’s securities’ value and interest payments. This allowed TCI and 3G to increase their exposure to a greater number of CSX shares without investing the large sums of money to actually acquire those shares.

Source: Robert W. Kolb and James A. Overdahl, Futures, Options, and Swaps 691 (Blackwell Publishing, 5th ed., 2007).


how it voted on a past issue and then consider that vote in

the context of a company’s present performance. If the SBA

voted for a new director and the director facilitated posi-

tive change and increased shareowner value for the com-

pany, then the SBA has evidence that its voting procedures

worked. Proxy voting items that lend themselves naturally

to such an ex post facto analysis include executive com-

pensation practices, mergers and acquisitions, and adoption

of shareowner friendly or shareowner unfriendly provisions,

such as allowing shareowners to approve the company’s

auditor, which the SBA deems as shareowner friendly, or

adopting poison pill provisions, which the SBA deems as

shareowner unfriendly. In addition, the SBA extensively

benchmarks its votes against the policies and voting deci-

sions of other public pension funds and leading institutional

investors as well as against the recommendations from its

proxy advisory and corporate governance research firms.

Accordingly, the SBA can track how it performs against

the industry in regards to how it votes for management and

shareowner proposals in comparison to how others vote or

recommend voting for management and shareowner pro-

posals. Moreover, the SBA can determine the value added

by its voting decisions versus the value added by the voting

decisions or recommendations of others.

To provide its constituents and the institutional invest-

ment community with a tangible example of the proxy

voting process, this report illustrates how the SBA voted

in a recent proxy contest by dissecting the proxy contest

that two institutional investors, TCI and 3G, waged against

CSX. First, this report presents the history of the contest by

detailing TCI, 3G, and CSX’s actions during the fight among

the parties. Next, the report examines CSX’s civil action

against TCI and 3G for alleged violations of securities laws.

Third, the report will demonstrate how the SBA decided to

vote in the case by showing how the SBA’s various tools

affected its voting decision. The report will enumerate the

ramifications of the TCI/3G versus CSX proxy contest in a

separate section. Finally, the report will touch on the results

of the proxy contest to date.

TCI/3G’S PROXY CONTEST AGAINST CSXThe investment strategy that ultimately culminated in a

proxy contest between the railroad company, CSX, and

activist hedge funds, TCI and 3G, began in the latter part of

2006 when TCI began to investigate investment prospects

in the U.S. railroad industry. After analyzing and comparing

companies across the railroad industry, TCI determined that

CSX had trailed the performance of its peers as based on

key measures, such as operating margin, free cash flows,

return on invested capital, and productivity. Moreover, TCI

claimed that CSX’s positive performance in regards to its

stock price was a result of general market forces, not as a

result of the performance of CSX’s management team. TCI

also wanted to see better corporate governance structures

at CSX, which included a change to the company’s bylaws

that allowed shareowners to call a special meeting. TCI

believed that it could engage with CSX management to

improve operational, financial, and governance performance

of the company, thereby increasing the returns to TCI and

ultimately, to all of CSX’s shareowners.

To accomplish these goals, TCI began entering into Total

Return Swaps (TRSs) that referenced CSX shares. TRS

transactions are also known as “contract-for-differences”

in Europe. For instance, TCI had purchased TRSs referenc-

ing 1.7 percent of CSX’s total outstanding shares by the end

of October 2006, the first month in which TCI invested in

CSX. TCI engaged in this investment strategy because it

allowed TCI to gain exposure to CSX shares; however, this

strategy mitigated the capital outlay that TCI would have

faced had it actually purchased CSX common stock. More

importantly, TCI was initially able to avoid the SEC report-

ing requirements under Section 13(d) of the Securities

Exchange Act of 1934 (Exchange Act) because it spread its

TRS agreements over a number of parties, including Credit

Suisse, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan

Stanley, UBS, Deutsche Bank, and Citigroup.

Section 13(d) requires that once an investor, or group of

investors acting together, acquires more than five percent

of an issuer’s securities, the investor or group of investors

must disclose its ownership of more than five percent of the

securities to the issuer of the securities, to all exchanges on

which the securities are traded, and to the SEC within ten

days of acquiring such ownership. Section 13(d)’s disclo-


AS AN INSTITUTIONAL SHAREOWNER THAT INVESTS FUNDS ON BEHALF OF MANY OF FLORIDA’S CITIZENS, THE SBA FULFILLS ITS FIDUCIARY DUTIES BY CAREFULLY

MONITORING PROXY CONTESTS AND BY PARTICIPATING IN THEM IN A WAY THAT WILL MAXIMIZE THE RETURN TO ITS CONSTITUENTS: FUND PARTICIPANTS AND BENEFICIARIES.

TO EXERCISE ITS FIDUCIARY DUTIES UNDER FLORIDA STATUTES, THE SBA WILL ONLY CONSIDER FACTORS THAT AFFECT THE SBA’S INVESTMENTS, AND IT WILL NOT

SUBORDINATE THE INTERESTS OF THE SBA PLAN’S PARTICIPANTS OR BENEFICIARIES TO ITS OWN OR OTHER INTERESTS WHEN VOTING ITS SHARES.


Date SBA Meets with CSX Management to Discuss TCI/3G Proxy Contest

5/9/08

Percentage Increase in CSX Stock Price over the 14 Month Investment by TCI/3G

33%

Percentag of Total Market Trading on April 2, 2007 represented by 3G Stock Purchases

89.6%

Date SBA Splits Vote - Supporting 2 Members of Dissident Slate and 9 Members of incumbent CSX Board of Directors

6/25/08


sure requirements are important to protect market integrity

because it allows companies and the market in general to

possess material information that might affect changes in

shareowner value, such as changes in a company’s owner-

ship. Section 13(d)(3), which mandates that a group of

investors acting together must reveal its investment in an

issuer’s securities once it surpasses five percent owner-

ship in those securities, is important in this proxy contest

because this was a central issue in the court case filed

by CSX, which claimed that TCI and 3G had violated this

Section of the Exchange Act. Furthermore, Section 13(d)

requires an investor or group to report a number of fac-

tors surrounding the purchase of the securities, including

whether the purpose of the purchases is to acquire control

of the issuer of the securities, any plans or proposals which

such persons may have to liquidate such issuer, to sell its

assets to or merge it with any other entity, or to make any

other major change in the issuer’s business or corporate

structure. Additionally, the Section requires that an inves-

tor, or group of investors acting together, to report any

“information as to any contracts, arrangements, or under-

standings with any person with respect to any securities

of the issuer, including but not limited to transfer of any of

the securities, joint ventures, [and] loan or option arrange-

ments.” As such, TCI believed that it was imperative for

it to enter into TRS agreements with a number of parties

to avoid this reporting requirement while simultaneously

retaining the ability to pressure CSX.

While TCI certainly had its eye on effecting change at CSX

at the beginning of its investment in the company, TCI did

not have its sights set on a proxy contest with CSX when it

first purchased TRSs referencing CSX’s stock. Instead, TCI

contacted CSX in November 2006 to notify it of its initial

and growing ownership interest in the company, and the

hedge fund requested a meeting with CSX’s management

on November 14, 2006. In its discussions with CSX, TCI

explained its position in regards to CSX’s underperformance

and listed changes that the company should implement to

increase shareowner value. CSX disagreed with TCI’s posi-

tion and refused to implement TCI’s proposals because it

held that the company’s stock had improved dramatically

under its relatively new CEO, Michael Ward. Accordingly,

the relationship between the two entities quickly soured.

Therefore, TCI ramped up its investment in CSX to apply

greater pressure on the company.

By the time TCI had stopped investing in CSX as an indi-

vidual entity in late 2007, it had controlled nearly fifteen

percent of CSX through direct investments in shares of

CSX’s common stock and through indirect investments in

TRS agreements referencing CSX’s common stock. TCI

attempted to coerce CSX management to adopt its pro-

posals through a number of methods, including continuing

to demand meetings with CSX management, approach-

ing CSX management at industry seminars, making its

demands publicly known through industry conferences

and public press releases, discussing leveraged buy-out

options with CSX’s financial advisors, concentrating its

TRS arrangements with banks likely to vote for TCI’s pro-

posals as the court opined in the legal discussion below, and

corresponding with other hedge funds, such as 3G Capital

Partners.

On its own initiative, 3G first focused on the U.S. railroad

industry as an investment option in late 2006 and early

2007. However, it appears from the facts in the court

case that TCI convinced 3G that it should focus on CSX.

Therefore, 3G contacted CSX’s investor relations depart-

ment in February 2007 to inquire about the company. On

February 9, 2007, 3G made its first investment in CSX

when it purchased 1.7 million shares of CSX’s common

stock. One week later, 3G increased its position in CSX stock

to approximately two percent of CSX’s total outstanding

shares. Following this early acquisition of CSX shares, 3G

halted investment in CSX for a little over a month and com-

menced pressuring the company to implement many of the

changes that TCI had desired. 3G resumed purchasing CSX

shares in March and April before curtailing its CSX invest-

ment until August 2007 when it purchased its first TRSs

referencing CSX stock. By the time that it had halted its

investment in CSX, 3G had acquired a position just under

five percent of CSX’s total shares outstanding in both com-

mon stock and TRSs. Of course, 3G continued to push CSX

for changes by calling for meetings with CSX management,

approaching CSX management at industry conferences,

and forging an alliance with TCI. As it had done with TCI,

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

5,000,000

5,500,000

6,000,000

6,500,000

Dai

ly T

radi

ng V

olum

e

Total CSX Shares Traded

Total CSX Shares Purchased by 3G

TOTAL MARKET TRADING OF CSX SHARES VERSUS 3G TRADING OF CSX SHARES ON APRIL 2, 2007


CSX rebuffed 3G’s solicitations for corporate transforma-

tions.

Since CSX communicated to TCI and 3G that it would not

succumb to their demands, TCI and 3G prepared to battle

CSX’s perceived intransigence through a proxy contest. In

the late summer and throughout the autumn of 2007, TCI

unwound most of its TRSs with six of the eight banks where

it held such positions, and it concentrated its TRSs with

two banks that it believed would vote as it did, Citigroup

and Deutsche Bank. Additionally, TCI increased its vot-

ing capabilities by converting some of its swaps to actual

shares of CSX common stock. 3G did not need to perform

these financial gymnastics because its TRS position was

only a small portion of its total exposure to CSX. As early as

April 2007, TCI approached potential candidates to run on

a dissident slate of a board of directors; however, TCI and

3G finalized their slate of dissident candidates in the late

autumn and early winter of 2007.

At approximately the same time that the entities were

finalizing their dissident slate of candidates to run for

the CSX board of directors, TCI, 3G, and their candidates

(Group) filed a Schedule 13D on December 19, 2007 with

the SEC, declaring that they had formed a “group” for pur-

poses of Section 13(d). On January 8, 2008, the Group

filed a “Stockholder Notice of Intent to Nominate Persons

for Election as Directors of CSX Corporation,” (Notice).

Realizing the cost and effort that an effective proxy contest

requires, CSX board member, Edward J. Kelly, III met with

TCI’s founder and managing partner, Christopher Hohn,

on January 17, 2008, to bridge the differences between

the parties. However, the chasm separating CSX and the

Group proved too wide, and the Group amended its Notice

on January 21, 2008.

Although the legal case involved in this proxy contest had

not yet begun, the legal mechanism was ignited on February

22, 2008, when CSX filed its preliminary proxy statement

with the SEC. The Group followed suit with its own prelimi-

nary statement on March 10, 2008. Following these initial

filings, CSX and the Group, combined, filed over forty proxy

solicitations throughout the proxy contest. In an attempt

to stymie the Group’s efforts, CSX filed a claim against the

Group in the U.S. District Court for the Southern District of

New York on March 17, 2008. The Group subsequently filed

counterclaims against CSX and its chairman, president, and

CEO, Michael J. Ward. The legal challenge, outlined below,

SECTION 13 DISCLOSURE REQUIREMENTS...

SECTION 13D - requires any person to report his or her holdings of an issuer’s securities registered under Section 12 if that person acquires, either directly or indirectly, benefi cial ownership of fi ve percent or more of the total outstanding shares of those securities. Within 10 day of acquiring such a position, the person must report his or her position to the SEC, the issuer of the securities, and any securities exchanges on which the security is listed. The acquirer of the securities must report his or her identity and factors surrounding his or her identity, the source and amount of funds used to acquire his or her position, THE PURPOSE FOR THE ACQUISITION AND PLANS FOR CONTROLLING THE ISSUER, the number of shares that the person benefi cially owns or has the right to acquire, and any contracts, arrangements, or understandings with any person with respect to the securities. In Rule 13d-1(i), the SEC has restricted these securities to classes of voting shares only; therefore, the acquisition of fi ve percent or more of an issuer’s non-voting shares does not require reporting under Section 13(d).

SECTION 13F - mandates that institutional investment managers must report their positions that exceed at least $100 million in equity securities, as defi ned under 13(d)(1), held in accounts over which the institutional investment manager exercises investment discretion. The institutional investment manager must report the name of the issuer and the title, class, CUSIP number, number of shares or principal amount, and aggregate fair market value or cost or amortized cost of each other security (other than an exempted security) held on the last day of the reporting period by such accounts. Additionally, the institutional investment manager must report detailed information about transactions of $500,000 or more involving such securities. The SEC has authority under this Section to make exemptions to the reporting requirements, but it has not yet availed itself of such authority.

SECTION 13G - provides more detail regarding the statement of equity ownership that is required to satisfy the reporting requirement of Section 13. For instance, this Section states that a person, who acquires, either directly or indirectly, benefi cial ownership of fi ve percent or more of the total outstanding shares of an issuers securities, must report his or her identity, residence, and citizenship and the number and description of the shares in which he or she has an interest and the nature of his or her interest. Furthermore, this Section requires the acquirer to report material changes in his or her position, and IF MULTIPLE ACQUIRERS ACT TOGETHER IN ACQUIRING, HOLDING, AND DISPOSING THE ISSUER’S SECURITIES, THEN THE GROUP OF ACQUIRERS WILL BE DEEMED A PERSON FOR PURPOSES OF SECTION 13. Finally, this Section states that for purposes of calculating an acquirer’s percentage of outstanding shares owned, the total number of outstanding shares excludes the number of shares held by or for the issuer or any subsidiary of the issuer.

became as heated as the proxy contest itself.

CSX CORPORATION VERSUSTHE CHILDREN’S INVESTMENT FUND MANAGEMENT LLP, ET AL.On March 17, 2008, CSX filed a complaint against TCI and

3G alleging violations of Sections 13(d) and 14(a) of the

Exchange Act. As previously stated, Section 13(d) requires

an investor or group of investors to disclose its holdings

of an issuer’s securities when those holdings surpass five

percent of an issuer’s total outstanding shares. The investor

or group must disclose these holdings to the issuer of the

securities, all securities exchanges on which the issuer’s

securities are traded, and the SEC within 10 days of acquir-

ing more than five percent of those securities. Section 14(a)

of the Exchange Act makes it unlawful for any person to

solicit shareowner proxies by means proscribed by law or

rule. For instance, proxy statements soliciting proxies can-

not contain false or misleading statements, and a person

cannot violate other securities laws or rules as a means of

soliciting proxies.

CSX complained that TCI filed its Schedule 13D statement

ten months after TCI had surpassed Section 13(d)’s five

percent reporting threshold because representatives of

TCI had admitted to CSX that TCI owned fourteen percent

Timeline for TCI/3G versus CSX Proxy Challenge

SBA SPLITS VOTE FOR TWO DISSIDENT MEMBERS and FOR NINE of TWELVE CSX MEMBERS

SBA MEETS WITH EXECUTIVES FROM CSX, INCLUDING CEO MICHAEL WARD

CSX Seats 4 Dissident Board Members

Appeals Court Upholds Trial Court's Decision

Shareow ners Vote

Trial Court Allow s Group to Vote Shares

CSX Wages its Proxy Battle

TCI/3G (Group) Wages its Proxy Battle

TCI and CSX Meet to Avoid Proxy Fight

3G Builds Dissident Slate

TCI Builds Dissident Slate of Directors

3G Pressures CSX

3G Invests in CSX

TCI Pressures CSX

TCI Invests in CSX

09/2006 06/2007 04/2008 02/2009

(10/2006)

(2/2007)

(11/2006)

(03/2007)

(10/2007)

(11/2007)

(01/2008)

(02/2008)

(03/2008)

(05/2008)

(06/25/2008)

(06/11/2008)

(09/15/2008)

(9/17/2008)



of the company’s shares. Additionally, CSX alleged that

TCI and 3G had collaborated as a group before report-

ing their group status on the Schedule 13D. In regards to

the Schedule 13D itself, CSX claimed that the filing was

materially defective in that the Group did not accurately

disclose its reasons for holding CSX securities. Similarly,

CSX asserted that the Group violated Section 14(a) by fil-

ing a preliminary proxy statement that did not fully disclose

the Group’s interests in CSX, so the proxy statement was

materially misleading. Under both laws, CSX argues that

the Group failed to disclose all of its agreements, contracts,

understandings, and relationships regarding CSX shares by

not releasing all information about the Group’s TRSs and

agreements reached with individuals to run on the Group’s

dissident slate for CSX’s board of directors. Due to these

alleged non-disclosures and materially defective disclo-

sures, CSX claimed that the Group had violated the compa-

ny’s bylaws by submitting a defective “Stockholder Notice

of Intent to Nominate Persons for Election as Directors

of CSX Corporation.” As redress for these violations, CSX

requested the court to declare that the Group had violated

the securities laws and the company’s bylaws and that

the Group should file new disclosures that comply with

securities laws and the company’s bylaws. Furthermore,

CSX wanted the court to enjoin the Group from purchas-

ing any additional CSX securities or derivatives referencing

CSX securities until the Group complied with securities

laws and to enjoin the Group from voting the shares and

proxies that the Group controlled after allegedly violating

securities laws. Furthermore, CSX asked the court to order

the Group to unwind any of its purchases of CSX securities

that occurred after it allegedly violated securities laws. CSX

stated that all of the company’s shareowners would suffer

“irreparable harm” if the court did not grant the relief that

the company requested.

Other than the portion of CSX’s complaint that stated for-

malities, such as Christopher Hohn’s status as managing

partner of TCI or TCI and 3G’s geographic forums of busi-

ness organization, the Group did not concede to any of these

allegations. Instead, the Group denied all of CSX’s accusa-

tions against the individual members of the Group and those

against the Group as a whole. Arguing against CSX’s claims,

the Group averred that its individual members had not col-

laborated in their actions before filing the Schedule 13D.

Furthermore, the Group asserted that its members never

beneficially owned, i.e. the power to vote and

the power to direct the disposition of, more

than five percent of CSX’s shares as individu-

als or as a group until the Group’s existence

was declared on its Schedule 13D. Conversely,

the Group maintains that a majority of TCI’s

holdings in CSX were in the form of TRSs

referencing CSX shares, and the TRSs did

not confer the rights of beneficial ownership,

such as voting power, upon TCI or the Group.

Moreover, the Group held that CSX was fully

aware that a majority of TCI’s exposure to the

company was through swap agreements.

In addition to denying CSX’s allegations, the

Group filed several counterclaims against CSX

and its chairman, president, and CEO, Michael

Ward. Among other things, the Group alleged

that CSX and Michael Ward had filed the law-

suit as a “scorched earth” method to prevent

shareowners from casting their ballots for

the dissident board candidates. Furthermore,

the Group contended that CSX and Michael

Ward had violated insider trading laws by not

disclosing material, nonpublic information to

shareowners and by granting CSX’s senior

management “spring loaded” stock options based on mate-

rial, nonpublic information.

Finally, the Group argued that CSX had violated its own

corporate bylaws by not providing sufficient notice of any

supposed deficiencies with the Group’s “Stockholder Notice

of Intent to Nominate Persons for Election as Directors of

CSX Corporation.” While the District Court for the Southern

District of New York certainly faced a difficult task in sort-

ing through all of the claims and counterclaims, almost

twenty party filings subsequent to the initial complaint and

answer, and over five hundred pages of post trial documents

from the parties and interested third persons before render-

ing a decision, Judge Lewis A. Kaplan dismissed all of the

0%

20%

40%

60%

80%

100%

120%

Group's Avg. Monthly Volume CSX Avg. Monthly Volume

TOTAL CSX SHARES TRADED VERSUS TOTAL GROUP SHARES TRADED OVER PRIOR 10 MONTHS

(PERIOD ENDING JULY, 2008)


Group’s counterclaims, some of CSX’s claims, and focused

on two questions: (1) whether the TRSs did, in fact, confer

beneficial ownership upon members of the Group, and if so

(2) whether the Group could avoid filing a Schedule 13D by

merely disclaiming the existence of a group. The court found

that the TRSs were structured in a way to possibly grant

beneficial ownership to the Group’s members and that the

Group could not avoid being a group through “formal incan-

tations” that they had not formed a group.

To answer these questions, the court looked at the sub-

stance of both the TRS agreements and the actions of the

Group’s members in their efforts to change CSX. Judge

Kaplan’s decision blasted the Group’s tactics, stating

that its members purposefully coordinated their efforts in

attempt to “defeat the purpose” of Section 13(d)’s report-

ing requirements. In regards to the first question, the court

found that the TRSs may have endowed the Group’s mem-

bers with beneficial ownership in CSX because the swap

arrangements in this case allowed the Group’s members to

accumulate physical shares of CSX stock quickly through

private party transactions. For example, TRS agreements

are private party transactions between the short party and

the long party. Therefore, these parties can alter the terms

of the TRS agreements as they choose. Judge Kaplan

acknowledged that the TRS agreements involved in this

case were cash-settled arrangements, which means that

the parties typically satisfied the TRS contracts by paying

their monetary obligations. However, Judge Kaplan also

noted that since the parties could alter the terms of their

contracts so long as they agreed, then the Group could have

asked the banks to settle the TRSs “in kind,” which means

that the banks would have transferred record ownership of

the CSX shares to the Group’s members in exchange for

cash.

Furthermore, the court determined that the Group’s mem-

bers intentionally consolidated their swap arrangements

with parties over whom they exerted at least tangential

financial control to ensure that these parties would vote

in a manner favorable to the Group should a proxy contest

arise. Specifically, Deutsche Bank held 9.1 percent of CSX’s

common stock. Additionally, the court accepted CSX’s

argument that Hohn felt he could influence the Deutsche

Bank’s voting of its shares in a proxy context because TCI

and Austin Friars Capital, a Deutsche Bank hedge fund, had

similar desires to possibly take CSX private and because

TCI had discussed using Deutsche Bank as a financier in

a leveraged buyout of CSX if it did take the company pri-

vate. Though the court never reached a conclusion as to

whether TCI and Deutsche Bank had an implicit or explicit

agreement as to how Deutsche Bank would vote its shares,

Judge Kaplan stated that it was possible considering TCI’s

relationships with the bank and its hedge fund as well as the

“aberrant” transfers of CSX shares into and out of Deutsche

Bank around the record date of owning CSX shares for vot-

ing purposes.

To assist in its interpretation of Section 13(d), the court

turned to the SEC, which sided with the Group’s interpreta-

tion in this case. The SEC advised the court to look to Rule

13d-3 stating that the rule should be interpreted more nar-

rowly than the statute. Accordingly, the SEC advised that

the Group had not violated the disclosure rules because the

cash-settled TRSs did not confer voting power and invest-

ment power, i.e. beneficial ownership, upon the Group or its

members. It is important to note that the SEC only enter-

tained the questions of law in this case, not the questions

of fact. Therefore, the SEC may have found differently if it

had functioned as the finder of fact in this case. Although

the court did not rely on the SEC’s guidance entirely, the

court partially accepted the SEC’s guidance on beneficial

ownership by stating that determining beneficial ownership

requires “[a]n analysis of all relevant facts and circum-

stances in a particular situation . . . in order to identify each

person possessing the requisite voting power or investment

power.” Ultimately, the court never determined whether

the Group’s members enjoyed beneficial ownership status

in CSX shares because even if the TRSs did not confer

beneficial ownership upon the Group’s members per se, the

court determined that the Group had employed the TRSs as

a vehicle to evade Section 13(d)’s reporting requirements,

which would then strip away the Group’s ability to avail

itself of the law.

Accordingly, the court found that in regards to the second

question, sufficient direct and circumstantial evidence

existed to show that TCI and 3G had acted as a group well

before these parties disclosed their group status in the

Schedule 13D. For instance, the court relied on TCI and

3G’s multi-year relationship preceding the CSX venture,

the conversations about CSX between the parties, 3G’s

purchase of CSX shares following conversations with TCI,

In the late summer and throughout the autumn of 2007, TCI unwound most of its TRSs with six of the eight banks where it held such positions, and it concentrated its TRSs with two banks that it believed would vote as it did, Citigroup and Deutsche Bank.

Additionally, TCI began converting some of its swaps to actual shares of CSX common stock to increase its voting capabilities.


and the entities “parallel” proxy contest preparations as

examples of such circumstantial evidence.

In regards to CSX’s allegations that the Group and its mem-

bers violated Section 14(a) in respect to the Group’s proxy

statements, the court found that neither the Group, nor its

members, violated this provision. While the court enjoined

the Group from violating the law in the future, it determined

that it could not enjoin the Group from voting its shares or

proxies or force the Group to unwind purchases of CSX’s

shares, despite the court’s findings as discussed above,

because the Group and its members’ actions did not cause

irreparable harm to shareowners. Therefore, the parties

sought redress in an expedited appeal to the Second Circuit

Court of Appeals. At the time of writing, the Second Circuit

has not issued an opinion; however, it did issue a summary

order on June 11, 2008, affirming Judge Kaplan’s decision

not to enjoin the Group from voting its shares at CSX’s

annual shareowner meeting on June 25, 2008. As a result,

shareowners elected four of the dissident candidates to

CSX’s board of directors. The SBA voted in this shareowner

election for two of the dissident candidates. In the next

section, we discuss how we arrived at our voting decision.

FACTORS SUPPORTING THE SBA’S VOTEThe SBA relied upon all of its voting resources in evaluat-

ing CSX and the Group’s positions: internal voting policies,

external advice from proxy voting and governance research

firms, proxy statements of the parties, discussions with

CSX management, the legal case, and media coverage of

the contest. The SBA has constructed voting policies that

guide its voting decisions as a diligent investor, and the SBA

uses these policies in accordance with the laws of the state

in which a company is incorporated. It is important to note

that these are summaries of more extensive internal poli-

cies, which will be discussed as well. For this analysis, the

sections discussing “Voting Rights,” “Corporate Boards,”

“The Board of Directors,” and “Procedures and Annual

Meetings” provide especially

helpful summaries.

The SBA recognizes the impor-

tance of voting for board of

director candidates in its vot-

ing guidelines because mem-

bers of a company’s board of

directors serve as the share-

owners’ elected representatives

in overseeing a company, much

as politically elected officials,

such as senators, serve as the

elected representatives of U.S.

citizens. Additionally, barring

extraordinary circumstances,

shareowners must issue some

type of majority vote to remove a member of a company’s

board of directors. Furthermore, shareowners may vote

against a member of the board only at the expiration of

that member’s term, which may be annually, biannually, or

staggered. Therefore, the SBA gives great consideration in

casting our vote in board of director elections. Specifically,

our guidelines show that we analyze director nominees on a

“case-by-case” basis. To examine a particular nominee on

a case-by-case basis, the SBA’s internal voting policies call

for us to conduct an analysis of the highest degree possible

on each nominee if detailed information on the nominee

exists. As a general rule, we typically vote “FOR” a director

up for reelection; however, we list particular instances that

may stimulate us to vote “AGAINST” a director, including:

• Lack of stock ownership;

• Poor attendance at meetings; e.g., less than

75% attendance rate;

• Impaired director independence;

• Negligence in board committee perfor-

mance;

• Rejection of a material shareowner pro-

posal;

• Service on three or more companies’ boards;

and

• Poor performance across all company

boards upon which the individual serves as

a director.

The SBA gives great weight to these factors because they

can determine a particular director’s ability to improve or

deteriorate shareowner value. For example, a director’s

interests will not be aligned with the interests of shareown-

ers if he or she does not own shares in the company for

which he or she serves because he or she will not have a

vested interest in the company’s long-term performance.

Similarly, if a director is a company insider and thus, lacks

independence, then he or she may have interests that align

with management and not with shareowners. Since the

presence of these factors in a director will deteriorate a

company’s internal corporate governance, it can negatively

impact the company’s value.

When faced with a proxy contest, the SBA’s internal vot-

ing guidelines direct us to vote on a case-by-case basis


just as our guidelines for voting on director nominees do.

To perform our case-by-case appraisal, the SBA considers

two important questions: whether the dissidents have dem-

onstrated that the company needs change in its board of

directors, and if so, whether the dissidents can effect such

change better than the board’s incumbents can.

Similar to the factors that the SBA uses in its consider-

ation in electing board of director candidates, the SBA has

developed factors to ponder when voting in a proxy contest,

including:

• The company’s past performance relative

to its peers

• The market in which the company operates

• The measures taken by the board to address

challenged issues

• The historical activism by the dissident

shareowners, board activity, and votes on

related proposals

• The strategy of the incumbents versus the

dissidents

• The independence of directors

• The experience and skills of incumbent and

dissident director candidates

• The governance profile of the company

• Any evidence of management entrench-

ment

When dissidents seek board control, the dissidents must

provide a well-reasoned and detailed business plan, includ-

ing the dissidents’ strategic initiatives, a transition plan

that describes how the dissidents will accomplish change

in control of the company, and the identification of a

qualified and credible new management team. The SBA

will compare the dissidents’ plan against the incumbents’

plan, and we will compare the dissidents’ proposed board

and management team against the incumbents’ team.

When dissidents seek minority board representation, as in

the CSX proxy contest, the SBA imposes a lower burden of

proof on the dissidents. In such cases, the SBA’s policy does

not require a detailed plan of action, nor do we require proof

that the dissidents’ plan is preferable to the incumbent plan.

Instead, the dissidents must prove that change is preferable

to the status quo and that the dissident slate will add value

to board deliberations, including by, among other factors,

considering the issues from a viewpoint different than cur-

rent management.

The SBA has developed policies for making voting decisions

on proposed changes to a company’s bylaws as well. As

stated in the proxy guidelines, the SBA votes on proposals

to limit or expand the shareowners’ ability to call special

meetings on a case-by-case basis. Specifically, if a proposal

prevents shareowners from calling a special meeting or lim-

its the shareowners’ ability to call a special meeting, then

the SBA will vote “AGAINST” these proposals. Conversely,

if a proposal allows the shareowners to call a special meet-

ing or if a proposal expands the shareowners’ ability to call

a special meeting, then the SBA will vote “FOR” these

proposals.

Of course, the SBA must have the resources available to

conduct thorough analyses, such as the proxy statements

arguing the incumbents and dissidents’ positions, our

proxy voting services’ recommendations, the news media’s

descriptions of the parties actions, meetings with the dis-

sidents and incumbents’ representatives, the statements

detailing the positions of other shareowners and inter-

ested parties, and the transcripts of any legal proceedings.

Fortunately, the SBA had all of these resources available for

the proxy contest between TCI/3G and CSX.

CSX AND TCI/3G’S PROXY STATEMENTSCSX filed its preliminary proxy statement with the SEC on

February 22, 2008. CSX sent its proxy statement to shar-

eowners on April 25, 2008. In this proxy, CSX informed its

shareowners that TCI and 3G intended to challenge the

composition of CSX’s current board of directors by nomi-

nating five dissident candidates for CSX’s board. Of course,

CSX urged shareowners to vote “FOR” the company’s

twelve director nominees and to not sign or return any of the

Group’s proxy cards. Additionally, CSX informed shareown-

ers that they could revoke any of the Group’s proxy cards by

voting and submitting CSX’s white proxy card. To promote

its cause, CSX outlined the legal proceedings between CSX

and the Group that had occurred through April 4, 2008,

and it listed the director nominees for whom CSX wished

shareowners to elect as well as their qualifications. As in

any general proxy statement, CSX also disclosed its per-

ceived independence of the director nominees in relation to

CSX, the company’s committees serviced by each director,

and the compensation that each director received for their

service at CSX.

In regards to amending the bylaws to allow shareowners

to call a special meeting, the company recommended that

shareowners vote for the company’s proposal, which would

allow shareowners of 15 percent or more of the company’s

outstanding voting stock to cause CSX’s board of directors

to call a special meeting of shareowners on items of inter-

est to shareowners. However, the CSX proposal stated that

it had incorporated “procedural safeguards” to protect the

Company and shareowners’ resources against “substantial

administrative and financial burdens, and disruptive effects,

that serial shareholder meetings on the same matter would

impose on the Company.” These “procedural safeguards”

stated that shareowners could not call a special meeting on

an item that had had been voted upon within the preceding

year or an item that would be voted upon at the next annual

meeting of shareowners if the annual meeting was to occur

within ninety days of the date of the special shareowner

meeting. It is interesting to note that CSX’s entire board of

directors is voted upon every year at the annual shareowner

meeting, so CSX’s proposal would preclude shareowners

from calling a special meeting regarding the composition

of the board of directors. Actually, CSX’s board of direc-


tors had already adopted this amendment to the bylaws

on February 4, 2008; however, the Group was challeng-

ing it with another proposal, which conflicted with CSX’s.

Therefore, the Group sought to have CSX’s bylaw amend-

ment repealed. In its proxy statement to the shareowners,

CSX requested that voters reject the Group’s proposal to

repeal any changes to the company’s bylaws that the board

of directors had made between January 1, 2008 and the

annual meeting.

The Group filed and published its own proxy statement,

which argued “for” its dissident slate of directors, “against”

CSX’s bylaw amendment regarding special shareowner

meetings, and “for” the repeal the amendment regarding

special shareowner amendments already adopted by the

board of directors. Of course, the Group outlined the evolu-

tion of the proxy contest from its own perspective, such as

the Group’s noble, beneficent actions in the face of CSX’s

uncompromising responses. In the first proposal of its proxy

statement, the Group listed its dissident slate of directors

and their qualifications, and it urged voters to elect all five

dissident directors. The Group stated that it believed four

of five proposed directors would improve CSX’s operations

because these four individuals had significant experience

in the transportation industry. These four individuals are

Timothy O’Toole, Gary Wilson, Alexandre Behring, and

Gilbert Lamphere. The Group nominated Christopher Hohn

as its fifth dissident candidate because the Group believed

Mr. Hohn would provide a needed “shareowner perspective”

on CSX’s board of directors. The Group also urged voters

to support CSX’s nominees, other than Elizabeth Bailey,

Steven Halverson, Robert Kunisch, William Richardson, and

Frank Royal, for these were the individuals whom the Group

intended to replace with its nominees.

In proposals two and three, the Group’s proxy statement

discussed its position on the bylaw amendments discuss-

ing special shareowner meetings. The Group stated that

CSX’s proposal placed significant and unnecessary limita-

tions on the ability of shareowners to call a special meet-

ing. Additionally, the Group claimed that the CSX proposal

placed undue burden and hardship on shareowners who

wished to call a special meeting. The Group said that the

CSX proposal was deceptive in that it looked shareowner

friendly on its face while making it nearly impossible to

exercise its very limited rights. The Group went as far as

arguing that the bylaws violated Virginia’s laws governing

corporations, which was part of the Group’s counterclaims

against CSX and Michael Ward. In response, the Group pro-

posed its own bylaw amendment to allow shareowners to

call special meetings. The Group’s proposal did not contain

the time limitations contained in CSX’s proposal, and the

Group stated that its proposal reflected a similar proposal

that was “overwhelmingly” approved by shareowners at the

2007 annual meeting; a proposal not implemented by the

board, but replaced by CSX’s own amendment nine months

after shareowners called for it and only

then to attempt to appease the shareown-

ers and distract them from supporting

the dissidents. Since CSX’s amendment

was deficient, the Group claimed, then it

should be repealed, which was the Group’s

fourth proposal in its proxy statement.

In addition to their initial proxy solici-

tations, CSX and the Group filed over

forty complementary proxy statements

that outlined their different perspectives.

Most of these statements focused on the

operational and financial performance of

CSX. Furthermore, the parties developed websites or added

content to existing websites arguing their positions. Overall,

the parties spent millions of dollars arguing their respec-

tive positions. Interestingly, the parties shared the same

strategy for the company; however, their proposed means

for achieving the strategy differed significantly. As such, the

analyses and recommendations of the SBA’s proxy voting

services provided much needed third-party perspectives.

SBA’S PROXY VOTING SERVICESThe SBA dissected the CSX proxy contest analyses

and recommendations of three proxy reporting services:

Glass Lewis & Company, Risk Metrics Group, and PROXY

Governance, Incorporated. The SBA has worked with Glass

Lewis and Risk Metrics Group for many years while the SBA

has employed PROXY Governance for a little more than a

year and continues to fold their research into our decisions.

...the court accepted CSX’s argument that Hohn felt he could influence the Deutsche Bank’s voting of its shares in a proxy context because TCI and Austin Friars Capital, a Deutsche Bank hedge fund, had similar desires to possibly take CSX private and because TCI had discussed using Deutsche Bank as a financier in a leveraged buyout of CSX if it did take the company private. Though the court never reached a conclusion as to whether TCI and Deutsche Bank had an implicit or explicit agreement as to how Deutsche Bank would vote its shares, Judge Kaplan stated that it was possible considering TCI’s relationships with the bank and its hedge fund as well as the

“aberrant” transfers of CSX shares into and out of Deutsche Bank around the record date of owning CSX shares for voting purposes.

THE FOLLOWING EXCERPTS PROVIDE EXAMPLES OF THE MEDIA’S TREATMENT OF THE PARTIES INVOLVED IN THE TCI/3G VERSUS CSX PROXY CONTEST AS WELL AS THE IMPACTS OF THE CONTEST.

Illustrating U.S. Government concern with the proxy fi ght, Florida U.S. Representative Corrine Brown stated, “Unknown and unaccountable hedge funds owning or controlling freight railroads [that haul sensitive military cargo] is something that should be closely scrutinized by Congress and the federal agencies that have jurisdiction.” – Source: Andrew Morse, “TCI’s Tack Gets Off Track In U.S., Japan; CSX, J-Power Rebuff Hedge Fund’s Advances,” Wall Street Journal at C1, February 27, 2008.

Discussing Christopher Hohn, TCI’s founder: “Mr. Hohn may have a kind heart when it comes to giving, but in business he has a hard head and last year he became involved in a showdown with the bosses of Germany’s mighty Deutsche Borse, the Frankfurt stock exchange. He [Mr. Hohn] won and chief executive Weiner Seifert [Deutsche Borse] was forced to resign.” - Source: Nick Craven and Brendan Montague, “Generous Hedge Fund Boss Tops Philanthropist League,” Daily Mail, June 28, 2006, available at http://www.dailymail.co.uk/news/article-393015/Generous-hedge-fund-boss-tops-philanthropist-league.html

Highlighting the market’s view of the proxy fi ght, Morgan Stanley analyst William Greene stated, “The upcoming proxy fi ght may distract management from improving operations at a time when service will be a key driver to volume and earnings growth.” – Source: Andrew Morse, “TCI’s Tack Gets Off Track In U.S., Japan; CSX, J-Power Rebuff Hedge Fund’s Advances,” Wall Street Journal at C1, February 27, 2008.

Exemplifying a CSX-friendly shareowner’s view of the Group’s actions: “Charles Heimerdinger, a shareholder and retired Air Force sergeant, who, in a moment worthy of Lou Dobbs, took the [microphone] to blast the Brits for trying to steal a genuine piece of Americana, [stating,] ‘You blokes better watch out. We already helped save you from the Huns twice!’” – Source: Douglas McCollam, “Train in Vain,” Conde Nast Portfolio.com, June 25, 2008, available at http://www.portfolio.com/news-markets/top-5/2008/06/25/No-Decision-in-CSX-Proxy-Fight.

Showing the Group’s distaste for CSX adjourning the annual shareowner meeting and reconvening it on July 25, 2008 to fi nalize the shareowner vote: “They’re stalling, and it’s f*ing outrageous, and you can quote me on that,” said Marc Weingarten, a partner in the New York offi ce of Schulte Roth & Zabel who represents TCI.” – Source: Douglas McCollam, “Train in Vain,” Conde Nast Portfolio.com, June 25, 2008, available at http://www.portfolio.com/news-markets/top-5/2008/06/25/No-Decision-in-CSX-Proxy-Fight.

Demonstrating how the tension between the Group and CSX concerned even seemingly trivial matters: “Though TCI had at one point accused CSX of holding its shareholder meeting in a “swamp,” the place was dry — at least until the rains came.” – Source: Michael J. de la Merced, “A Hedge Fund Struggle for CSX Is Left in Limbo,” The New York Times, June 26, 2008, available at http://www.nytimes.com/2008/06/26/business/26board.html?ref=worldbusiness

Responding to TCI’s claim that the sight of CSX’s annual shareowner meeting, CSX’s Gentilly Yard outside New Orleans, was held in a swamp: “CSX executives said holding the meeting at Gentilly would let shareholders see the progress that the company had made in rebuilding the yard after Hurricane Katrina nearly three years ago.” – Source: Michael J. de la Merced, “Hedge Fund Struggle for CSX is Inconclusive,” International Herald Tribune, June 26, 2008, available at http://www.iht.com/articles/2008/06/26/business/board.php

Offering rare personal insight into Christopher Hohn’s thoughts about his recent proxy battle with CSX, TCI’s founder stated, “While we’re not going to rule out taking an activist stance on existing investments…we are going to be more cautious about it…because quite frankly activism is hard. It has been very profi table for us, but it is unpredictable and expensive. Just look at CSX. We’ve already spent over a year trying to effect change and paid out more than $10 million in legal fees on the proxy fi ght.” – Source: Loch Adamson, “Christopher Hohn Rethinks Activism,” Alpha, available at http://www.iimagazine.com/Article.aspx



This report highlights the evaluations and advice of these

different firms; however, the SBA encourages readers to

visit the links to these reports to fully understand the level

of research that these firms provided to the SBA.

Glass Lewis’s report opened with its vote recommendation.

It recommended that shareowners should “withhold” their

votes on CSX’s proxy card and split their votes among the

director candidates on the Group’s proxy card. A “withhold”

vote in regards to members of the board of directors is

essentially the same as an “against” vote. Glass Lewis sup-

ported two of the dissident candidates: Alexandre Behring

and Gilbert Lamphere. In regards to the proposals to amend

CSX’s bylaws to allow special shareowner meetings, Glass

Lewis recommended that shareowners vote for the Group’s

proposal and to approve the Group’s proposal to nullify

the bylaw amendments adopted by the board of directors.

To support its recommendations, Glass Lewis thoroughly

analyzed CSX in relation to its own performance, its per-

formance as compared to its peers, and its performance as

related to the market. [See the Glass Lewis report, “CSX

Corporation 2008 Contested Proxy.” Particularly, review

the sections titled, “Company Profile,” “Competitors/Peer

Comparison,” and “Pay-for-Performance.”] Additionally,

Glass Lewis examined the proxy proposals in detail. Under

“Proposal 1.00: Election of Directors,” Glass Lewis dis-

cussed the background of the TCI/3G versus CSX proxy

contest and outlined the arguments and actions of both

parties during the contest. Glass Lewis concluded that

since CSX share price and operating margin had lagged its

peers and the market between 2003 to 2007 and that due

to the independence and the railroad experience of Messrs.

Behring and Lamphere, then shareowners should vote

“FOR” these two candidates and withhold support from

the rest. In the sections discussing the bylaw amendments,

Glass Lewis summarized the perspectives of both parties

and concluded that the Group’s proposal warranted shar-

eowner support because it represented good, shareowner-

friendly corporate governance practices.

Risk Metrics Group and its subsidiary, Institutional

Shareholder Services, published two reports that examined

the CSX proxy contest and proposed voting recommenda-

tions to shareowners. Since both reports were published by

entities within the same firm, i.e., a parent and its subsid-

iary, this discussion synthesizes their analyses and advice

from their reports and refers to them both as “Risk Metrics.”

Risk Metrics’ analysis differed significantly from Glass

Lewis in its scope of analysis and its recommendations on

the election of the board of directors. Like Glass Lewis, Risk

Metrics advised shareowners to vote on the dissident proxy

card and withhold their votes from CSX’s proxy card. Unlike

Glass Lewis, Risk Metrics recommended that shareowners

vote “FOR” four of the dissident candidates: Christopher

Hohn, Alexandre Behring, Gilbert Lamphere, and Timothy

O’Toole. The only dissident candidate that Risk Metrics

did not support was Gary Wilson. Risk Metrics based its

advisements on extremely detailed financial, operational,

and governance analysis of CSX Corporation.

To summarize, Risk Metrics believed that Messrs. Behring,

Lamphere, and O’Toole provided much needed industry

experience to the CSX board of directors, and that Mr. Hohn

brought a valuable shareowner perspective to the board-

room. Regarding the bylaw amendments and the Group’s

proposal to repeal the bylaw amendment adopted by CSX’s

board of directors, Risk Metrics concurred with Glass Lewis

in that shareowners should accept the Group’s proposals

and reject CSX’s proposals. Risk Metrics employed innova-

tive evaluation techniques that the SBA found particularly

helpful. [See the Risk Metrics Group report, “M&A Edge

Analysis: North America, CSX Corp (CSX) Proxy Fight with

TCI/3G” pages 11 – 51, which provide Risk Metrics analysis

of whether board change was needed and whether the dis-

sident board candidates should add value to CSX’s board

effectiveness.]

Specifically, Risk Metrics reviewed the track records of the

dissident candidates and CSX’s incumbents. Risk Metrics

stated that the incumbent directors, whom the Group

had targeted for removal, had an average tenure of fifteen

years as members of CSX’s board of directors, and during

these fifteen years, CSX’s stock performance had under-

achieved its peers. Additionally, none of CSX’s incumbents

had any railroad experience. In fact, the entire CSX board

lacked railroad experience except Mr. Ward, the CEO, and

Mr. McPherson, whom CSX put forth as a board nominee

during the 2008 proxy contest. Furthermore, Risk Metrics

compared CSX with Canadian National railroad, where Mr.

Lamphere served as a director from 1998 until 2005. Risk

Metrics found that CN had outperformed CSX in many

financial and operational metrics, including EBIT margin,

ROE, Return on Capital, Free Cash Flow Return on Capital,

Operating Ratio, Expense Control, train velocity, dwell time,

and safety. Therefore, Risk Metrics concluded that Mr.

Lamphere could offer CSX the same improvements that he

brought to CN.

The SBA’s newest proxy voting service, PROXY Governance,

Inc., also published a report on the proxy contest. This report

is linked with the other reports. PGI based its advice to shar-

eowners on thorough analysis of the financial, operational,

and governance performance of CSX as well; however,

PGI reached different conclusions. In regards to the board

of directors, PGI’s recommendation aligned with Glass

Lewis’s recommendation that shareowners should vote on

the Group’s proxy card to elect the dissident candidates,

Messrs. Lamphere and Behring, and to “withhold” from the

other dissident candidates. In contrast with Glass Lewis,

PGI recommended that shareowners vote “FOR” all of man-

agement’s nominees that the Group supported in its proxy

statement. PGI differed from Glass Lewis and Risk Metrics

in its recommendation to support management’s proposal

on the special shareowner meeting issue. PGI reasoned that

management’s proposal on the special shareowner meeting


amendment was reasonable and responsive to shareowner

concerns.

MEETINGS & CONFERENCE CALLS WITH THE PROXY CONTESTANTSTo gain additional insight into the positions of CSX and the

Group, the SBA participated in a number of face-to-face

meetings and conference calls with representatives from

the competing sides. Our first meeting occurred on May 9,

2008, at the SBA’s offices. David Baggs, Vice President

of Investor Relations, Oscar Munoz, Chief Financial Officer,

and Michael Ward, Chief Executive Officer, attended the

meeting on behalf of CSX. The SBA’s Corporate Governance

Office and several other senior investment managers repre-

sented the SBA. The SBA staff questioned CSX’s leader-

ship on a number of issues related to the proxy contest

specifically and CSX’s corporate governance and corporate

performance issues generally, such as the experience of

CSX’s director nominees versus the experience of the dis-

sidents’ nominees, CSX’s views on the Group’s business

proposals, CSX’s executive compensation practices, CSX’s

intentions of separating the company’s chairperson of the

board of directors position from the CEO position, and the

bylaw proposals on special shareowner meetings.

In regards to the proxy contest, CSX maintained that its

directors had the necessary experience to lead CSX for

success and that CSX’s proposal addressing special shar-

eowner meetings was shareowner friendly while capturing

necessary procedural controls to prevent waste of corporate

resources. CSX asserted that the dissident’s business plan

would actually destroy corporate value and thus, shar-

eowner value.

Of course, the SBA scrutinized the candidness of CSX’s

representatives, particularly, that of the CEO and chairman

of the board, Michael Ward. For instance, the SBA ques-

tioned Mr. Ward as to why this proxy contest had reached

such tense levels and had resulted in a full blown proxy con-

test when, historically, many of these contests settle. Mr.

Ward replied that Mr. Edward J. Kelly III, a CSX board mem-

ber, had actually tried to settle the dispute with Mr. Hohn of

TCI by offering Mr. Hohn three board seats at CSX, including

Mr. Hohn and Mr. Behring, as well as another board position

on which CSX and the Group would mutually agree on an

acceptable candidate; however, Mr. Hohn was unwilling

to accept the offer according to Mr. Ward. Interestingly,

Risk Metrics Group noted that the trial records from CSX’s

legal case against the Group showed that Mr. Ward’s com-

ments were a half-truth. According to Risk Metrics Group,

Mr. Ward admitted in testimony that he had wanted “no

as the answer from” Mr. Hohn, and Mr. Ward instructed

Mr. Kelly that if Mr. Hohn did agree to certain conditions,

then Mr. Kelly should attempt to “kill it on the standstill.”

The “standstill” refers to a standstill agreement that Mr.

Kelly proposed to Mr. Hohn. A standstill agreement typically

involves the target company, CSX in this case, making an

offer to the hostile party, the Group in this case, to purchase

the hostile party’s shares for a premium or to make other

concessions in return for the hostile party’s promise to end

its campaign against the target company. Sagely, Mr. Hohn

rejected CSX’s standstill agreement.

CSX CORPORATION

CSX, incorporated in November, 1978 and based in Jacksonville, Forida, is a major U.S. transportation company. Surface Transportation, which includes the Company’s rail and intermodal businesses, provides rail-based transportation services, including traditional rail service and the transport of intermodal containers and trailers. The Company operates primarily in two business segments: rail and intermodal. The rail segment provides rail freight transportation over a network of approximately 21,000 route miles in 23 states, the District of Columbia, and the Canadian provinces of Ontario and Quebec. The intermodal segment provides integrated rail and truck transportation services and operates a network of dedicated intermodal facilities across North America. CSX’s principal operating company, CSX Transportation, Inc. (CSXT), provides a link to the transportation supply chain through its approximately 21,000 route mile rail network, which serves 23 states east of the Mississippi River, the District of Columbia, and the Canadian provinces of Ontario and Quebec. CSXT serves 70 ocean, river and lake ports along the Atlantic and Gulf Coasts, the Mississippi River, the Great Lakes and the St. Lawrence Seaway. CSXT also serves thousands of production and distribution facilities through track connections to more than 230 short-line and regional railroads.

The rail and intermodal segments together serve four primary lines of business: merchandise, coal, automotive and intermodal. The merchandise business comprises nearly 2.7 million carloads per year of aggregates, which includes crushed stone, sand and gravel, metal, phosphate, fertilizer, food, consumer, agricultural, paper and chemical products. The merchandise business generated approximately 50% of the Company’s revenue in during the fiscal year ended December 28, 2007 (fiscal 2007), and 38% of volume. Coal, which delivered approximately 1.9 million carloads of coal, coke and iron ore to electricity generating power plants, ocean, river and lake piers and terminals, steel makers and industrial plants, accounted for approximately 26% of the Company’s revenue and volume in fiscal 2007. Automotive, which delivers both finished vehicles and auto parts, generated 8% of the Company’s revenue and 6% of the Company’s volume in fiscal 2007. Through its network of more than 50 terminals, Intermodal serves all major markets east of the Mississippi River and transports mainly manufactured consumer goods in containers, providing customers with truck-like service for longer shipments. For fiscal 2007, Intermodal accounted for approximately 14% of the Company’s total revenue and 30% of volume. The Company’s main competitor is Norfolk Southern.

Source: FactSet Research Systems, Inc.


More importantly, Mr. Ward’s inappropriate control over Mr.

Kelly in regards to Mr. Kelly’s negotiations with Mr. Hohn is

a prime example as to why the SBA desires for companies to

make the CEO position and the chairperson position sepa-

rate. If Mr. Ward had not exhibited undue influence over Mr.

Kelly in these negotiations, then Mr. Kelly and Mr. Hohn may

have reached an agreement. The SBA also participated in a

number of conference calls with both parties. The SBA’s

proxy advisory services, Glass Lewis and Risk Metrics,

hosted these calls, and participants were allowed to ques-

tion the proxy contestants. Despite investor participation

in these calls, the proxy contestants simply restated their

respective positions with no significant new information

revealed by the parties.

SPLITTING THE VOTE: THE SBA DECIDESFor the entire stock position of 1,156,413 shares, the SBA

voted in favor of all of CSX’s nominees except three; we

abstained from voting on two and withheld our vote from

one. We voted in favor of two of the dissident candidates -

Alexandre Behring and Gilbert Lamphere - because based

on all of the information presented, our determination was

that these two individuals brought much needed railroad

experience to CSX’s board of directors. We abstained from

voting for the other dissident candidates. Additionally, we

voted for the Group’s proposal to amend the bylaws to allow

shareowners holding fifteen percent of CSX’s voting stock

to call a special meeting without the conditions imposed

by CSX’s proposal. The SBA favored this proposal because

it did not limit shareowners’ right to vote, and it increased

potential accountability for CSX’s board of directors. The

SBA found CSX’s argument unpersuasive that CSX’s pro-

cedural safeguards were needed because shareowners

will typically not pursue strategies that waste corporate

resources since such strategies will decrease shareowner

value. In fact, corporate resources are usually wasted by

actions of the board of directors or corporate managers,

not shareowners. Since the SBA voted for the dissident

bylaw amendment on special shareowner meetings, then

we also voted to repeal the bylaw amendment on special

shareowner meetings that CSX’s board of directors had

previously adopted.

Since the SBA voted for some of the incumbent candidates

and some of the dissident candidates, the SBA is said

to have “split” its vote. Vote splitting is unusual in proxy

voting. Prior to 1992, SEC rules virtually precluded vote

splitting despite state laws permitting it. In 1992, the SEC

amended Rule 14a-4(d), the “Bona Fide Nominee” rule,

because the SEC acknowledged that the old rule unneces-

sarily constrained shareowners from exercising their full

voting rights. The old rule stated that when faced with a

proxy contest regarding a corporation’s board of directors,

then shareowners could only vote on the company’s proxy

card, which could only contain the company’s nominees

for the board of directors, or on the dissident’s proxy card,

which could only contain the dissident’s nominees for the

board of directors, but not on both proxy cards. Therefore,

if the dissident’s proxy card slated a few nominees seeking

minority representation on the board of directors, then shar-

eowners would not be able to exercise their votes for the

full board of directors if those shareowners wanted to vote

for the dissident candidates. For example, the CSX case

involved twelve director-nominees. CSX put forth twelve

nominees. The dissidents, i.e. the Group, put forth five

nominees. Under the old rule, a shareowner wishing to vote

for some of the dissidents could vote for no more than five

nominees, wasting the opportunity to vote for at least seven

other candidates. As amended, Rule 14a-4(d) allows the

parties to list “bona fide nominees” on their proxy solicita-

tions so long as the dissident slate seeks a minority position

on the board of directors and the company’s candidates are

clearly distinguished from the dissident’s candidates.

If the CSX vote had been an all or nothing vote as would

have been the case under the old SEC Rule 14a-4(d),

then the SBA likely would have voted the entire dissident

slate, which would have possibly eroded more of CSX’s

incumbent board of directors than it did. CSX realized this

possibility, so it created a universal ballot that included all

nominees and permitted shareowners to vote for any nomi-

nee they wished as long as only a total of twelve nominees

were selected. In addition to Rule 14a-4(d) as amended,

Virginia law, under which CSX is incorporated, allowed this

procedure because it requires that a corporation’s directors

be elected by a plurality and that shareowners may vote

THE RETURNS TO HEDGE FUND ACTIVISM

Hedge fund activism creates some positive abnormal returns due to the stock market’s favorable reaction to the public disclosure of activism. For instance, “the fi ling of a Schedule 13D, revealing an activist fund’s investment in a target company, results in large positive average abnormal returns, in the range of 7-8 percent, during the announcement window,” which is the twenty days preceding the hedge fund’s fi ling of a Schedule 13D and the twenty days following the fi ling.

Source: Alon Brav, et. al., The Returns to Hedge Fund Activism, 64 Financial Analysts Journal 45 (2008).

by written ballot and the written ballot may be submitted

by electronic transmission, such as a fax. This procedure

allowed the SBA to exercise its entire vote by voting for the

dissident and incumbent candidates that it desired to elect.

RAMIFICATIONS OF THE CSX CONTESTThe CSX proxy contest and its attendant legal case shocked

many people in the corporate finance and legal communi-

ties. Legal commentators have called Judge Kaplan’s

legal opinion “expansive” as compared to the actual word-

ing of Section 13(d) and Rule 13d-3(a). For instance,

Judge Kaplan’s decision may require parties to equity swap

arrangements to start reporting their aggregated equity

swap positions as soon as those positions exceed Section

13(d)’s five percent threshold despite the SEC’s current

guidance that cash-settled equity swap contracts do not

confer beneficial ownership upon the long party. This may

require parties to equity swaps to implement information

systems that will track their positions. Additionally, if Judge

Kaplan’s decision actually confers beneficial ownership on

the long party to an equity swap arrangement, then the

long party may need to guard against insider trading liability

under Section 16 of the Exchange Act. Section 16 requires

direct and indirect beneficial owners, among others, to file

a statement with the SEC if such beneficial owner owns

more than ten percent of any class of an issuer’s securities

registered under Section 12 of the Exchange Act. Section

16 deems beneficial owners of more than ten percent of an

issuer’s securities to be “insiders” of the issuer. Therefore,

beneficial owners who violate Section 16 will incur insider

trading liability.

Keep in mind that Judge Kaplan’s ruling is not final prec-

edent. While the Second Circuit upheld Judge Kaplan’s

decision not to enjoin the Group from voting their shares

at the shareowner meeting, the Second Circuit Court of

Appeals may disagree with other portions of Judge Kaplan’s

decision and clarify any uncertainties, i.e. the beneficial

ownership question. Even if the Second Circuit agrees with

Judge Kaplan or does not clarify the uncertainties surround-

ing his position, then the SEC may provide further guidance

on its rules or amend them if necessary. For that matter,

Congress may amend Sections 13 and 16 of the Exchange

Act if needed. However, Judge Kaplan did what judges must

do, which is to interpret the law as applied to a given set

of facts. This requires looking at the language and intent

of the law and determining how the parties’ words and

actions relate to the law. Given the facts of the case, Judge

Kaplan determined that the substance of the Group’s TRS

arrangements possibly conferred beneficial ownership upon

the Group and its members because the Group admitted

that it entered into the TRSs to

acquire a position that would

allow it to exert influence

over CSX, and the Group did

attempt to exert influence over

CSX. Additionally, the Group

entered into to TRSs that

allowed it to convert the swaps

to actual voting shares in CSX

stock, and TCI consolidated

TRSs with holders of CSX vot-

ing stock, whom TCI believed

would vote those shares in

favor of the Group’s dissident

proposals. Additionally, the

Group accomplished all of this

for a long period of time with-

out appropriately disclosing its

exposure to CSX as required by

Section 13(d) of the Exchange

Act. Judge Kaplan determined

that such behavior would sub-

vert the intent of Section 13(d), which is to provide the

market with transparency of corporate ownership so that

the market can determine the prognosis of investing in a

particular corporation. When Congress enacted Section

13(d), it determined that the market needed such transpar-

ency to maintain market integrity.

The TCI/3G versus CSX proxy contest demonstrates why

corporate issuers of securities are concerned with shar-

eowner transparency on a global scale. As shown in the

above discussions of Section 13(d), U.S. securities laws

mandate that shareowners must disclose their holdings of

an issuer’s securities when these holdings pass a certain

threshold. Additionally, these shareowners must disclose

their intentions in regards to holding the issuer’s securities,

such as whether the shareowners intend to gain control over

the issuing corporation. The language of Section 13 makes

these disclosures necessary if the shareowner enjoys direct


AVERAGE SHAREOWNER RETURN OF CSX VS PEERS SINCE DISSIDENTS SEATED ON BOARD OF DIRECTORS

(SEPTEMBER 17, 2008 THROUGH JANUARY 2, 2009)

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

% T

ota

l Sto

ck R

etu

rn (

TS

R)

CSX Norfolk SouthernCanadian National Burlington NorthernUnion Pacific

or indirect beneficial ownership of the securities, if the

shareowner aggregates his or her holdings individually or

as a member of a group, and if these holdings are in direct

shares or are a result of “any contracts, arrangements, or

understandings with any person with respect to any securi-

ties of the issuer, including but not limited to transfer of

any of the securities, joint ventures, [and] loan or option

arrangements.”

Globally, France and Germany have taken recent steps to

increase shareowner transparency along the lines of the

U.S. model. In France, recent shareowner actions to replace

management at French companies have fueled the call

for greater shareowner transparency there. The Autorite

des marches financiers (AMF), which is the regulator of

France’s securities markets, is considering requiring shar-

eowners to report their holdings once those holdings reach

three percent of an issuer’s securities. This represents a

two percent decrease in the current reporting requirements,

and the revised requirements also include derivative hold-

ings, such as swaps. Furthermore the AMF is considering

mandating that shareowners file a declaration of intent in

regards to their holdings. The AMF is pondering setting this

threshold at twenty to thirty percent of an issuer’s voting

shares. While the AMF is constructing its new guidelines,

Germany has already taken action. On August 19, 2008,

Germany’s legislature passed the Risk Limitation Act,

which implemented expanded reporting requirements for

shareowners “acting in concert” and imposed a duty for

shareowners to disclose their aggregate holdings in an

issuer’s securities and the shareowners intentions for hold-

ing the securities. The German legislature enacted the Risk

Limitation Act in response to shareowner activism against

the Deutsche Borse, a German stock exchange, which was

lead by Christopher Hohn of TCI.

Since the U.S. has long standing transparency laws, which

Judge Kaplan’s decision arguably expanded, the cry for

greater shareowner transparency has not been as loud

domestically. Instead, The Conference Board, which is a

non-profit organization that conducts economic, business,

and business management research, has called for issuers

of securities to increase monitoring of trading activity in

their issued shares. The Conference Board stated that its

recommendation is based on the recent actions of using

TRSs by TCI and 3G to effect change at CSX. According

to The Conference Board, corporations should “avail them-

selves of securities surveillance service providers” to obtain

information unavailable in public filings about hedge fund

activity.

Although the cry for revised transparency laws has not

sounded in the U.S., corporations have increased their use

and expanded the scope of their “poison pills” after the

TCI/3G proxy contest with CSX. A poison pill is a mecha-

nism that companies employ to prevent a hostile takeover.

For instance, a company faced with a hostile takeover may

allow its existing shareowners, except the hostile party,

to purchase more of the company’s shares at a discount,

which dilutes the value and rights of the company’s shares,

making the company unattractive to the hostile party

because the hostile party must acquire more shares to

effectuate its takeover of the company. According to a Wall

Street Journal article, “Poison Pills Target Derivatives,”

at least two corporations, Louisiana-Pacific Corporation

and Micrel Incorporated, modified their shareowner-rights

plans to allow derivative investments, such as TRSs, to

trigger the companies’ poison pill provisions. In the article,

Ronald Gilson, a Stanford University law professor, stated

that companies are no longer concerned with the votes that

activist shareowners hold themselves, but with the influ-

ence that they can exert over other shareowners to vote in

the activists’ favor. By employing these poison pill provi-

sions, corporate directors and managers seek protection

from the tactics used by TCI and 3G against CSX.

It is important to note that the SBA disfavors poison pill

provisions for two circular reasons. First, these provi-

sions may prevent a corporate takeover that will increase

the value of the company. Second, poison pill provisions

help to entrench corporate directors and managers who

may have created the corporate conditions that inspired a

hostile shareowner to seek change. By entrenching these

directors and managers, shareowner value may deteriorate

further because needed change will be impossible to enact.

Therefore, the SBA votes “against” poison pill proposals.

As of January 2009, it is too early to determine whether

Messrs. Hohn, Behring, Lamphere, and O’Toole have ful-

filled their promises to improve CSX’s operating, financial,

and governance performance now that they serve on CSX’s

board of directors. Albeit a very short time frame, since the

proxy contest took place CSX has marginally underper-

formed its peers in terms of total stock return. The SBA

will continue to monitor the company’s performance and

evaluate the long term performance impact of this notable

contest for control. [sba]

ADDITIONAL RESOURCES COVERING PROXY VOTING AND EQUITY RESEARCH...

CSX Proxy Research Advisories from: • RiskMetrics Group (RMG)• Glass, Lewis & Co. (GLC)• PROXYGovernance, Inc. (PGI).

“CSX Proxy Fight With TCI/3G,” “CSX Proxy Fight With TCI/3G,” RMG M&A Edge Analysis:North AmericaRMG M&A Edge Analysis:North America

SBA Corporate Governance Prinicples & SBA Corporate Governance Prinicples & Proxy Voting GuidelinesProxy Voting Guidelines

All of these documents can be viewed at the All of these documents can be viewed at the following link:following link:

www.sbafl a.comwww.sbafl a.com



APPENDIX

SUDAN AND IRAN

On June 8, 2007, the Protecting Florida’s Investments Act (“PFIA”) was signed into law. The PFIA requires the State Board of Administration, acting on behalf of the Florida Retirement

System Trust Fund (the “FRSTF”), to assemble and publish a list of “Scrutinized Companies” that have prohibited business operations in Sudan and/or Iran. Once placed on the list of Scrutinized Companies, the SBA and its investment managers are prohibited from acquiring those companies’ securities and are required to divest those securities if the companies do not cease the prohibited activities or take certain compensating actions. The implementation of the PFIA by the SBA does not affect any FRSTF investments in U.S. companies. The PFIA solely affects foreign companies with certain business operations in Sudan and Iran involving the petroleum or energy sector, oil or

mineral extraction, power production or military support activities. To read more about implemen-

tation of the PFIA, please see the divestment section of the SBA’s website.

CUBA

The Free Cuba Act of 1993 (Section 215.471, Florida Statutes) was passed by the Florida Legislature, in accordance with federal law. Section I of the Act prohibits state agencies from

investing in a fi nancial institution or company domiciled in the United States that does business of any kind with Cuba or any company doing business in or with Cuba in violation of federal law. Sec-tion 2 of the Act prohibits any state agency from investing in any fi nancial institution or company domiciled outside of the United States if the President of the United States has applied sanctions against the foreign country in which the institution or company is domiciled. In order to comply with this legislation, the Cuban Affairs Section at the U.S. State Department and/or the Treasury Department’s Offi ce of Foreign Assets Control (OFAC) are contacted periodically to confi rm that no sanctions have been implemented. Since the Act’s inception, sanctions have never been issued

against any country.

NORTHERN IRELAND

Section 121.153, Florida Statutes, directs the SBA to invest its assets in companies that are making advances in eliminating ethnic and religious discrimination in Northern Ireland. Sec-

tion 121.153 also directs correspondence with fi nancial institutions with which the SBA maintains accounts in order to gauge their exposure, if any, to operations and/or subsidiaries in Northern Ireland. During fi scal year 2008, confi rmation was received from Bank of America, Barclays Global Investors, Mellon Bank, and Wachovia Bank indicating there were no operations or activities of any kind in Northern Ireland. Regions Financial indicated very limited exposure, with four loans to individuals in Northern Ireland.

Pressure for affi rmative action to increase Catholic (or sometimes Protestant) representation stems from both the MacBride principles themselves, as well as Northern Ireland’s fair employ-ment laws. In the U.S., 17 states and more than 30 cities and counties have current laws invoking the MacBride principles and a majority of all U.S. state pension assets support the principles. Since the MacBride Principles campaign began in 1984, shareowners have reached agreements on MacBride implementation with 56 of the 69 publicly-traded fi rms (including affi liates or fran-chises) that currently have more than 10 employees in Northern Ireland. According to ISS Northern Ireland statistics, there are 157 public and private operations in Northern Ireland that have parent fi rms based in the U.S.

Total employment of U.S. subsidiaries and affi liates stands at approximately 24,000 employees, with the majority of U.S. companies exhibiting fair employment representation and most having affi rmative action programs. ISS noted that approximately one-third of U.S. companies operat-ing in Northern Ireland have an under-representation of either Catholics or Protestants. However, Catholic representation among U.S. companies rose to 49 percent in 2006, up from 46.6 percent at the end of 2005, and 45.1 percent in 2004. Census fi gures show the overall Northern Ireland population to be 44 percent Catholic.

During the SBA fi scal year ending June 30, 2008, there were six shareowner resolutions support-ing the MacBride principles, with the SBA voting in favor of each proposal. General support levels

for the proposals averaged 10 percent, with none of the proposals passing.

COMPLIANCE WITH FLORIDA STATUTES



GLOBAL PROXY VOTING STATISTICS: FISCAL YEAR 2008


ROUTINE/BUSINESS

Accept Consolidated Financial Statements and Statutory Reports 80% 0% 5% 0% 80% 20%

Accept Financial Statements and Statutory Reports 84% 5% 2% 0% 84% 16%

Acknowledge Proper Convening of Meeting 75% 0% 0% 0% 75% 25%

Adopt New Articles of Association/Charter 95% 5% 0% 0% 95% 5%

Amend Articles/Bylaws/Charter -- General Matters 85% 8% 0% 0% 85% 15%

Amend Articles/Bylaws/Charter -- Non-Routine 77% 16% 0% 0% 77% 23%

Amend Corporate Purpose 100% 0% 0% 0% 100% 0%

Appoint Auditors and Deputy Auditors 0% 75% 0% 0% 0% 100%

Appoint Censor(s) 100% 0% 0% 0% 100% 0%

Approve Allocation of Income and Dividends 87% 3% 1% 0% 87% 13%

Approve Auditors and Authorize Remuneration 95% 4% 0% 0% 95% 5%

Approve Change of Fundamental Investment Policy 100% 0% 0% 0% 100% 0%

Approve Dividends 93% 2% 2% 0% 93% 7%

Approve Financial Statements/Allocation of Income/Discharge Directors 62% 19% 4% 0% 62% 38%

Approve Investment and Financing Policy 74% 0% 26% 0% 74% 26%

Approve Minutes of Previous Meeting 74% 0% 0% 0% 74% 26%

Approve Remuneration of Directors and Auditors 80% 13% 0% 0% 80% 20%

Approve Special Auditors’ Report Regarding Related-Party Transactions 80% 17% 3% 0% 80% 20%

Approve Standard Accounting Transfers 100% 0% 0% 0% 100% 0%

Approve Stock Dividend Program 100% 0% 0% 0% 100% 0%

Authorize Board to Fix Remuneration of Auditors 86% 10% 0% 0% 86% 14%

Authorize Board to Ratify and Execute Approved Resolutions 93% 3% 0% 0% 93% 7%

Authorize Filing of Required Documents/Other Formalities 97% 0% 0% 0% 97% 3%

Change Company Name 100% 0% 0% 0% 100% 0%

Change Date/Location of Annual Meeting 100% 0% 0% 0% 100% 0%

Change Location of Registered Offi ce/Headquarters 50% 0% 0% 0% 50% 50%

Designate Inspector or Shareowner Representative(s) of Minutes of Meeting 75% 0% 0% 0% 75% 25%





Designate Newspaper to Publish Meeting Announcements 100% 0% 0% 0% 100% 0%

Elect Chairman of Meeting 46% 0% 0% 0% 46% 54%

Elect Members of Audit Committee 93% 7% 0% 0% 93% 7%

Elect Members of Election Committee 79% 7% 0% 0% 79% 21%

Elect Members of Remuneration Committee 0% 0% 0% 0% 0% 100%

Miscellaneous Proposal: Company-Specifi c 76% 2% 0% 0% 76% 24%

Other Business 1% 98% 0% 0% 1% 99%

Other (various issues) 82% 0% 0% 17% 82% 18%

Prepare and Approve List of Shareowners 100% 0% 0% 0% 100% 0%

Ratify Alternate Auditor 100% 0% 0% 0% 100% 0%

Ratify Auditors 98% 2% 0% 0% 98% 2%

Reimburse Proxy Contest Expenses 100% 0% 0% 0% 100% 0%

Subtotal 92% 6% 0% 0% 92% 8%

DIRECTOR RELATED

Amend Articles Board-Related 97% 0% 0% 0% 97% 3%

Amend Quorum Requirements 100% 0% 0% 0% 100% 0%

Approve Decrease in Size of Board 100% 0% 0% 0% 100% 0%

Approve Director/Offi cer Indemnifi cation Agreements 100% 0% 0% 0% 100% 0%

Approve Director/Offi cer Indemnifi cation/Liability Provisions 86% 14% 0% 0% 86% 14%

Approve Director/Offi cer Liability and Indemnifi cation 96% 4% 0% 0% 96% 4%

Approve Discharge of Auditors 50% 0% 0% 0% 50% 50%

Approve Discharge of Board and President 86% 0% 5% 0% 86% 14%

Approve Discharge of Management and Supervisory Board 50% 0% 0% 0% 50% 50%

Approve Discharge of Management Board 46% 42% 2% 0% 46% 54%

Approve Discharge of Supervisory Board 38% 52% 1% 0% 38% 62%

Approve Increase in Size of Board 98% 2% 0% 0% 98% 2%

Approve Remuneration of Directors 87% 5% 2% 0% 86% 14%

Authorize Board to Fill Vacancies 100% 0% 0% 0% 100% 0%





Classify the Board of Directors 0% 100% 0% 0% 0% 100%

Company Specifi c--Board-Related 90% 5% 0% 0% 90% 10%


Determine Number of Members and Deputy Members of Board 100% 0% 0% 0% 100% 0%

Elect Alternate/Deputy Directors 100% 0% 0% 0% 100% 0%

Elect Board Rep. for Holders of Savings Shares and Fix Remun. 50% 0% 0% 0% 50% 50%

Elect Directors 74% 6% 0% 20% 74% 26%

Elect Directors (Opposition Slate) 40% 4% 0% 28% 40% 60%

Elect Members and Deputy Members of Corporate Assembly 0% 0% 0% 0% 0% 100%

Elect Supervisory Board Member 72% 19% 0% 0% 72% 28%

Eliminate Cumulative Voting 62% 38% 0% 0% 62% 38%

Establish Range for Board Size 64% 36% 0% 0% 64% 36%

Fix Number of Directors 88% 8% 0% 0% 88% 12%


Subtotal 74% 6% 0% 19% 74% 26%

CAPITALIZATION

Amend Articles/Charter Equity-Related 67% 0% 0% 0% 67% 33%

Amend Articles/Charter to Refl ect Changes in Capital 77% 5% 0% 0% 77% 23%

Approve Bond Repurchase 0% 0% 0% 0% 0% 100%

Approve Increase in Authorized Capital 100% 0% 0% 0% 100% 0%

Approve Increase in Common Stock and a Stock Split 100% 0% 0% 0% 100% 0%

Approve Issuance of Equity/Linked Securities without Preemptive Rights 66% 30% 0% 0% 66% 34%

Approve Issuance of Shares for a Private Placement 80% 20% 0% 0% 80% 20%

Approve Issuance of Shares Pursuant to Share Option Scheme 67% 33% 0% 0% 67% 33%

Approve Issuance of Warrants/Convertible Debentures 80% 6% 0% 0% 80% 20%

Approve Reduction in Share Capital 92% 0% 0% 0% 92% 8%

Approve Reduction in Stated Capital 100% 0% 0% 0% 100% 0%

Approve Reduction/Cancellation of Share Premium Account 100% 0% 0% 0% 100% 0%





Approve Reverse Stock Split 85% 15% 0% 0% 85% 15%

Approve Stock Split 94% 3% 0% 0% 94% 6%

Approve/Amend Conversion of Securities 94% 6% 0% 0% 94% 6%

Authorize a New Class of Common Stock 100% 0% 0% 0% 100% 0%

Authorize Capital Increase for Future Share Exchange Offers 67% 33% 0% 0% 67% 33%

Authorize Capitalization of Reserves for Bonus Issue/Rise in Par 92% 0% 0% 0% 92% 8%

Authorize Issuance of Bonds/Debentures 90% 10% 0% 0% 90% 10%

Authorize Issuance of Convertible Bonds without Preemptive Rights 100% 0% 0% 0% 100% 0%

Authorize Issuance of Equity/Linked Securities with Preemptive Rights 98% 0% 0% 0% 98% 2%

Authorize Issuance of Warrants with Preemptive Rights 80% 20% 0% 0% 80% 20%

Authorize Issuance of Warrants without Preemptive Rights 38% 38% 0% 0% 38% 63%

Authorize New Class of Preferred Stock 0% 100% 0% 0% 0% 100%

Authorize Reissuance of Repurchased Shares 29% 71% 0% 0% 29% 71%

Authorize Share Repurchase Program 86% 9% 2% 0% 86% 14%

Cancel Company Treasury Shares 100% 0% 0% 0% 100% 0%

Company Specifi c - Equity Related 76% 22% 0% 0% 76% 24%

Eliminate Class of Common Stock 100% 0% 0% 0% 100% 0%

Eliminate Class of Preferred Stock 100% 0% 0% 0% 100% 0%

Eliminate Preemptive Rights 70% 10% 0% 0% 70% 30%

Eliminate/Adjust Par Value of Common Stock 100% 0% 0% 0% 100% 0%

Increase Authorized Common Stock 73% 27% 0% 0% 73% 27%

Increase Authorized Common Stock/Authorize New Preferred 0% 100% 0% 0% 0% 100%

Increase Authorized Preferred and Common Stock 25% 75% 0% 0% 25% 75%

Increase Authorized Preferred Stock 19% 81% 0% 0% 19% 81%


Reduce Authorized Common and Preferred Stock 100% 0% 0% 0% 100% 0%

Reduce Authorized Common Stock 100% 0% 0% 0% 100% 0%

Set Global Limit for Capital Increase to Result From All Issuance Requests 100% 0% 0% 0% 100% 0%

Subtotal 76% 20% 0% 0% 76% 24%





REORGANIZATION / MERGERS

Acquire Certain Assets of Another Company 50% 50% 0% 0% 50% 50%

Amend Articles to: (Japan) 82% 18% 0% 0% 82% 18%

Amend Articles/Bylaws/Charter -- Organization-Related 39% 61% 0% 0% 39% 61%

Approve Acquisition 91% 6% 0% 0% 91% 9%

Approve Affi liation Agreements with Subsidiaries 100% 0% 0% 0% 100% 0%

Approve Disposition of Assets and Liquidate Company 100% 0% 0% 0% 100% 0%

Approve Formation of Holding Company 100% 0% 0% 0% 100% 0%

Approve Merger Agreement 93% 5% 0% 0% 93% 7%

Approve Merger by Absorption 89% 0% 0% 0% 89% 11%

Approve Sale of Company Assets 48% 52% 0% 0% 48% 52%

Approve Spin-Off Agreement 58% 42% 0% 0% 58% 42%

Approve Transaction with a Related Party 80% 18% 0% 0% 80% 20%

Change State of Incorporation 38% 63% 0% 0% 38% 63%

Company Specifi c Organization Related 87% 8% 0% 0% 87% 13%

Issue Shares in Connection with an Acquisition 97% 2% 0% 0% 97% 3%

Other 47% 53% 0% 0% 47% 53%

Waive Requirement for Mandatory Offer to All Shareowners 100% 0% 0% 0% 100% 0%

Subtotal 88% 9% 0% 0% 88% 12%

NON-SALARY COMPENSATION

Amend Employee Stock Purchase Plan 80% 20% 0% 0% 80% 20%

Amend Incentive Stock Option Plan 0% 100% 0% 0% 0% 100%

Amend Non-Employee Director Omnibus Stock Plan 4% 96% 0% 0% 4% 96%

Amend Non-Employee Director Restricted Stock Plan 6% 94% 0% 0% 6% 94%

Amend Non-Employee Director Stock Option Plan 9% 91% 0% 0% 9% 91%

Amend Omnibus Stock Plan 4% 96% 0% 0% 4% 96%

Amend Restricted Stock Plan 27% 73% 0% 0% 27% 73%





Amend Stock Option Plan 12% 88% 0% 0% 12% 88%

Amend Terms of Severance Payments to Executives 10% 90% 0% 0% 10% 90%

Appoint Internal Statutory Auditors 100% 0% 0% 0% 100% 0%

Approve Employee Stock Ownership Plan 100% 0% 0% 0% 100% 0%

Approve Employee Stock Purchase Plan 55% 44% 0% 0% 55% 45%

Approve Incentive Stock Option Plan 0% 100% 0% 0% 0% 100%

Approve Increase in Aggregate Compensation Ceiling for Directors 93% 7% 0% 0% 93% 7%

Approve Increase in Aggregate Comp. Ceiling for Directors and Statutory Auditors 67% 33% 0% 0% 67% 33%

Approve Increase in Aggregate Compensation Ceiling for Statutory Auditors 100% 0% 0% 0% 100% 0%

Approve Non-Employee Director Omnibus Stock Plan 0% 100% 0% 0% 0% 100%

Approve Non-Employee Director Restricted Stock Plan 0% 100% 0% 0% 0% 100%

Approve Non-Employee Director Stock Option Plan 18% 82% 0% 0% 18% 82%

Approve Omnibus Stock Plan 2% 98% 0% 0% 2% 98%

Approve or Amend Option Plan for Overseas Employees 100% 0% 0% 0% 100% 0%

Approve Outside Director Stock Awards/Options in Lieu of Cash 48% 52% 0% 0% 48% 52%

Approve Repricing of Options 20% 80% 0% 0% 20% 80%

Approve Restricted Stock Plan 38% 61% 0% 0% 38% 62%

Approve Retirement Bonuses for Directors 78% 22% 0% 0% 78% 22%

Approve Retirement Bonuses for Directors and Statutory Auditors 77% 23% 0% 0% 77% 23%

Approve Retirement Bonuses for Statutory Auditors 50% 50% 0% 0% 50% 50%

Approve Share Plan Grant 100% 0% 0% 0% 100% 0%

Approve Special Bonus for Family of Deceased Director 100% 0% 0% 0% 100% 0%

Approve Stock Appreciation Rights Plan 0% 100% 0% 0% 0% 100%

Approve Stock Option Plan 10% 86% 0% 0% 10% 90%

Approve Stock Option Plan Grants 27% 73% 0% 0% 27% 73%

Approve Stock/Cash Award to Executive 0% 100% 0% 0% 0% 100%

Approve/Amend Bundled Compensation Plans 89% 11% 0% 0% 89% 11%

Approve/Amend Deferred Compensation Plan 63% 37% 0% 0% 63% 37%

Approve/Amend Employee Savings-Related Share Purchase Plan 100% 0% 0% 0% 100% 0%





Approve/Amend Employment Agreements 100% 0% 0% 0% 100% 0%

Approve/Amend Executive Incentive Bonus Plan 55% 44% 0% 0% 56% 44%

Approve/Amend Profi t Sharing Plan 100% 0% 0% 0% 100% 0%

Company-Specifi c Compensation-Related 67% 23% 0% 0% 67% 33%


Subtotal 27% 73% 0% 0% 27% 73%

ANTITAKEOVER RELATED

Adjourn Meeting 87% 11% 0% 0% 87% 13%

Adopt or Amend Shareowner Rights Plan (Poison Pill) 11% 89% 0% 0% 11% 89%

Allow Board to Use All Out. Capital Auth. in Event of Tender 0% 100% 0% 0% 0% 100%

Company-Specifi c--Organization-Related 25% 75% 0% 0% 25% 75%

Consider Non-Financial Effects of Mergers 0% 100% 0% 0% 0% 100%

Eliminate/Restrict Right to Act by Written Consent 42% 58% 0% 0% 42% 58%

Eliminate/Restrict Right to Call a Special Meeting 70% 30% 0% 0% 70% 30%

Opt Out of State’s Control Share Acquisition Law 100% 0% 0% 0% 50% 50%

Other 100% 0% 0% 0% 100% 0%

Permit Board to Amend Bylaws Without Shareowner Consent 100% 0% 0% 0% 100% 0%

Reduce Supermajority Vote Requirement 100% 0% 0% 0% 96% 4%

Require Advance Notice for Shareowner Proposals/Nominations 0% 100% 0% 0% 0% 100%

Subtotal 86% 13% 0% 0% 84% 16%

SHAREOWNER PROPOSALS-ROUTINE/BUSINESS

Company-Specifi c -- Miscellaneous 1% 92% 0% 0% 92% 8%

Initiate Payment of Cash Dividend 0% 100% 0% 0% 100% 0%


Separate Chairman and CEO Positions 100% 0% 0% 0% 3% 97%

Subtotal 68% 30% 0% 0% 32% 68%





SHAREOWNER PROPOSALS-DIRECTOR RELATED

Add Women and Minorities to the Board 50% 50% 0% 0% 50% 50%

Amend Articles/Bylaws/Charter - Call Special Meetings 91% 0% 0% 0% 0% 100%

Amend Vote Requirements to Amend Articles/Bylaws/Charter 100% 0% 0% 0% 0% 100%

Change Size of Board of Directors 50% 0% 0% 0% 50% 50%

Company-Specifi c Board-Related 47% 35% 0% 0% 30% 70%


Elect a Shareowner-Nominee to the Board 29% 71% 0% 0% 71% 29%

Establish a Compensation Committee 100% 0% 0% 0% 0% 100%

Establish a Nominating Committee 0% 100% 0% 0% 0% 100%

Establish Director Stock Ownership Requirement 0% 100% 0% 0% 100% 0%

Establish Mandatory Retirement Age for Directors 0% 100% 0% 0% 100% 0%

Establish Other Board Committee 0% 100% 0% 0% 100% 0%

Establish Term Limits for Directors 0% 83% 0% 0% 0% 100%

Other 28% 3% 0% 21% 28% 72%

Other 99% 1% 0% 0% 6% 94%

Remove Existing Directors 13% 75% 0% 0% 63% 38%

Require Director Nominee Qualifi cations 1% 99% 0% 0% 99% 1%

Require Two Candidates for Each Board Seat 0% 100% 0% 0% 100% 0%

Restore or Provide for Cumulative Voting 94% 6% 0% 0% 6% 94%

Subtotal 71% 13% 0% 4% 18% 82%

SHAREOWNER PROPOSALS-CORP GOVERNANCE

Amend Articles/Bylaws/Charter to Remove Antitakeover Provisions 100% 0% 0% 0% 0% 100%

Company-Specifi c--Governance-Related 67% 20% 0% 0% 21% 79%

Eliminate or Restrict Severance Agreements (Change-in-Control) 100% 0% 0% 0% 0% 100%

Other 0% 100% 0% 0% 100% 0%

Reduce Supermajority Vote Requirement 99% 1% 0% 0% 1% 99%

Submit Severance Agreement (Change-in-Control) to SH Vote 100% 0% 0% 0% 0% 100%





Submit Shareowner Rights Plan (Poison Pill) to Shareowner Vote 100% 0% 0% 0% 0% 100%

Subtotal 81% 13% 0% 0% 13% 87%

SHAREOWNER PROPOSALS-SOCIAL/HUMAN RIGHTS

Adopt MacBride Principles 100% 0% 0% 0% 0% 100%

ILO Standards 31% 62% 7% 0% 62% 38%


Subtotal 43% 49% 8% 0% 49% 51%

SHAREOWNER PROPOSALS-COMPENSATION

Company-Specifi c--Compensation-Related 47% 53% 0% 0% 53% 47%

Increase Disclosure of Executive Compensation 0% 100% 0% 0% 100% 0%

Limit Executive Compensation 0% 100% 0% 0% 100% 0%

Limit/Prohibit Executive Stock-Based Awards 0% 100% 0% 0% 100% 0%


Performance- Based/Indexed Options 76% 24% 0% 0% 24% 76%

Report on Executive Compensation 0% 100% 0% 0% 100% 0%

Submit Executive Compensation to Vote 100% 0% 0% 0% 0% 100%

Subtotal 78% 22% 0% 0% 23% 77%

SHAREOWNER PROPOSALS-GENERAL ECONOMIC ISSUES

Employ Financial Advisor to Explore Alternatives to Maximize Value 0% 100% 0% 0% 79% 21%

Report on Bank Lending Policies 0% 100% 0% 0% 100% 0%

Subtotal 0% 100% 0% 0% 90% 10%

SHAREOWNER PROPOSALS-HEALTH/ENVIRONMENTAL

ANWR 38% 62% 0% 0% 62% 38%

Cease Tobacco-Related Advertising 0% 100% 0% 0% 100% 0%

Environmental - Related Miscellaneous 0% 100% 0% 0% 100% 0%





Genetically Modifi ed Organisms (GMO) 0% 100% 0% 0% 100% 0%

Global Warming 36% 64% 0% 0% 64% 36%


Phase Out Nuclear Facilities 0% 100% 0% 0% 100% 0%

Prepare Report on Foreign Military Sales 0% 100% 0% 0% 100% 0%

Prepare Report on Health Care Reform 0% 100% 0% 0% 100% 0%

Report on Environmental Policies 0% 100% 0% 0% 100% 0%

Weapons - Related 0% 38% 62% 0% 38% 62%

Subtotal 35% 64% 2% 0% 64% 36%

SHAREOWNER PROPOSALS-OTHER/MISC.

Company-Specifi c -- Shareowner Miscellaneous 61% 39% 0% 0% 38% 62%

EEOC- Sexual Orientation 100% 0% 0% 0% 0% 100%


Prepare Report/Promote EEOC-Related Activities 35% 65% 0% 0% 65% 35%

Report on Charitable Contributions 0% 100% 0% 0% 100% 0%

Report on Corporate Political Contributions/Activities 71% 25% 4% 0% 25% 75%

Report on Government Service of Employees 0% 100% 0% 0% 100% 0%

Subtotal 61% 38% 2% 0% 37% 63%

SOCIAL PROPOSAL

Other 9% 91% 0% 0% 91% 9%

Social Proposal 11% 89% 0% 0% 89% 11%

Subtotal 10% 90% 0% 0% 90% 10%

TOTAL 73% 12% 0% 14% 72% 28%


SBA BOARD OF TRUSTEESGOVERNOR CHARLIE CRIST

CHAIRMAN

CHIEF FINANCIAL OFFICER ALEX SINK

TREASURER

ATTORNEY GENERAL BILL MCCOLLUM

SECRETARY

SBA EXECUTIVE DIRECTOR & CIOASH WILLIAMS

SBA INVESTMENT ADVISORY COUNCILBETH MCCAGUE, CHAIR

ROMAN MARTINEZ IV, VICE CHAIR

JOHN H. HILL, JR.JOHN JAEB

JAMES DAHL

ROBERT KONRAD

SBA OFFICE OF CORPORATE GOVERNANCE

MICHAEL MCCAULEY, SENIOR CORPORATE GOVERNANCE OFFICER

TRACY STEWART,CORPORATE GOVERNANCE MANAGER

JACOB WILLIAMS,SENIOR CORPORATE GOVERNANCE ANALYST

JERRY RUMPH,CORPORATE GOVERNANCE INTERN

ACKNOWLEDGEMENTS...

THE SBA OFFICE OF CORPOR ATE GOVERNANCE WOULD LIKE

TO ACKNOWLEDGE AND THANK THE FOLLOWING INDIVIDUALS

FOR THEIR ADVICE AND AS SISTANCE IN DEVELOPING

THIS YEAR’S ANNUAL REPORT: SUBODH MISHR A, MARC

GOLDSTEIN, PAUL WANNER, CHRIS YOUNG, CAROL

BOWIE AND STEPHEN DEANE OF RISKMETRIC S GROUP/

INSTITUTIONAL SHAREOWNER SERVICES; THE ENTIRE

STAFF OF THE COUNCIL OF INSTITUTIONAL INVESTORS;

ED HAUDER OF EXEQUIT Y; BOB MCCORMICK OF GL AS S,

LEWIS & CO.; HOWARD SHERMAN OF GOVERNANCEMETRIC S

INTERNATIONAL; DROSTEN FISHER AT THE MONITOR GROUP;

AND ANDY EGGERS OF PROX YDEMOCR ACY.