What with all the activity on Capitol Hill, it’s been a busy time for financial regulators, investors and industry groups interested in energy use and production, climate change and corporate governance. Mercer’s RI team tracks legislative and investor initiatives of interest to our clients, and lately, here in the US, we’ve been focusing on three key areas: regulatory and legislative developments in executive compensation, SEC and corporate governance issues, and legislative activity related to energy and climate change.

Developments in executive compensation

As a result of what has been perceived as excessive executive pay, including big bonuses, the Obama administration has acted to provide new rules for companies receiving assistance under the Troubled Asset Relief Program (TARP) and to propose compensation principles applicable to public companies. The new regulations affecting TARP companies, effective June 15, 2009, limit excessive risk in incentive design and place restrictions on bonus, retention and incentive awards for senior executives. Among other matters, the rules also provide for say on pay, ban tax-free perks and prohibit golden parachutes to certain senior employees. A special master has been appointed to review pay and pay structures for certain companies receiving “exceptional assistance.”

For all other public companies, recent compensation principles announced by Treasury Secretary Timothy Geithner are intended to affect the determination of executive pay. In general, the principles aim to align executive pay with sound risk management and long-term growth while promoting transparency and accountability. Specifically, they address the proper measurement and rewarding of performance, the structuring of plans to account for the time horizon of risks, and, among other issues, the alignment of termination payments with the long-term interests of executives and shareholders. In addition, the Treasury will press Congress to act on legislation that will require nonbinding shareholder votes on the executive pay programs of public companies and enhance the independence of compensation committees.

What does this all mean for investors? Investors will need to consider the effect of compensation constraints on the competitive positioning of TARP and non-TARP firms and discuss this with their investment managers or other advisors where appropriate. But, the larger issue for long-term investors is the role that pay structures play in aligning the interests of executives and board members with shareholders, rather than encouraging excessive short term risk-taking. Investors may also need to prepare to play a larger role in setting or approving executive pay.

SEC and corporate governance issues

Investors can expect to have an increased impact on executive pay and the election of board of directors members as the SEC and Congress consider beefing up shareholders’ rights. Under current law, TARP companies are required to seek nonbinding shareholder approval of executive compensation programs. Mary Schapiro, the SEC Chairman, has testified that a proposal approved by the Commission for public comment “would significantly support shareholders’ rights to nominate company directors.”¹ In an open meeting on July 1, the SEC unanimously voted to propose rules amending executive pay and corporate governance disclosures at all public companies. The proposed rules consider a broad package of new corporate disclosures, including additional information on board nominee qualifications, rationale for the board’s structure, and the compensation and potential conflicts of interest of compensation consultants. The proposed disclosure changes would also require greater disclosure of compensation policies for all employees – not just top executives – if those policies may have a material effect on a company’s risk management.

In addition to the SEC initiatives, two bills sponsored by Democrats in Congress address shareholder rights and increased disclosure of corporate governance and compensation items. Senators Charles Schumer, D-NY, and Maria Cantwell, D-WA, have proposed the “Shareholders Bill of Rights of 2009,” and Representative Gary Peters, D-MI, has introduced the “Shareholder Empowerment Act of 2009.” Both bills attempt to increase shareholder rights by requiring that public companies take the following actions:

• Further Steps Forward for Investors   As a result of all these changes, activist investment managers may find an improved environment to target underperforming companies and initiate efforts to make governance changes. Investors may also find new investment strategies and approaches making use of enhanced corporate disclosures, should those be legislated or accepted as best practice. Furthermore, increased corporate disclosure may improve the proxy voting process by making it easier for more investors to actively vote. With enhanced information, consensus may emerge among large shareholders on some issues. Furthermore, more widely available information may help establish a connection between corporate governance and financial performance or risk.

  Hold annual advisory votes on executive pay
  
  
• Allow shareholders to nominate board candidates to appear on management proxy statements
  
  
• Adopt a majority vote standard in uncontested director elections
  
  
• Appoint an independent chairman

Peters’ bill is stronger on pay, including provisions for more corporate disclosure on performance based pay, “clawback” provisions for pay given to executives based on fraud or faulty financial records and requirements for the independence of compensation consultants.² The Schumer/Cantwell bill, on the other hand, has a provision requiring companies to add a risk committee to their boards. While neither bill is assured passage, the SEC plans to implement some of these proposals through regulation, so investors will likely see some changes along these lines.

These initiatives aim to make the investment environment more certain and stable. The changing environment creates a great opportunity to identify investment managers with solid, forward-looking research, risk management tools and rigorous processes. Investors can also take this opportunity to discuss how these initiatives may impact their internal investment decisions. Furthermore, they can ask their existing investment managers and consultants how they have changed their view of risk, their view of the financial services sector, proxy voting, corporate governance, etc. and use the answers to assess their approaches to adapting to the changing landscape.

Energy and climate change

The Obama Administration has made innovation in the energy sector and green job creation a priority in reviving the US economy. The American Recovery and Reinvestment Act of 2009, which the House of Representatives signed into law on February 17, 2009, extends the tax credits that have been essential to the wind energy industry’s growth, incentivizes solar energy production, provides funding for energy efficiency improvement projects in the manufacturing IT industries,³ and provides funding for energy efficiency improvements and renewable energy generation projects within the construction and renovation of public buildings.⁴

The American Clean Energy and Security Act, which the House of Representatives passed on June 26, 2009, aims to implement a federal renewable electricity standard of 20% by 2020 and allows up to 5% energy efficiency offsets. If enacted, this bill will increase demand for renewable energy generation. The bill would implement a cap and trade system, which would effectively assign a market price to carbon in the US. Investors should keep a close watch on this legislation, as it will probably undergo significant changes while being considered in the Senate.

So what’s the bottom line for investors? If the Clean Energy Act is passed, the cap and trade system will alter the US competitive landscape. As we have seen in Europe, companies competitively positioned with respect to their peers in carbon emissions may benefit from the permit system. They will incur lower initial costs of purchasing permits, and may benefit from reselling permits if they continue to reduce their emissions. The playing field has already changed for the US energy sector based on the American Recovery Act. With federal money supporting research and development of energy efficient technology, the wait time for viable pricing and market uptake should significantly decrease. Companies that have developed energy reduction plans and have invested in developing the employee infrastructure to support these plans will benefit the most rapidly as new technologies come to market. Furthermore, the demand for energy efficiency and renewable energy services may significantly increase. Investors have a unique opportunity to seek out investment managers that may be able to take advantage of these changes or evaluate existing managers based on their ability to capture the benefits of these opportunities.

Rolling down the Hill…

Perhaps the biggest opportunity overall is for investors to get ahead of these changes and align their programs with the benefits these initiatives are intended to offer. Investors can look internally at risk management and oversight in order to ensure that proper policies and procedures are in place. These financial and investment reforms also have the potential to alter views on fiduciary duty, lengthening time frames and expanding notions of risk and benefits.

Mercer Investment Consulting, Inc. and the Responsible Investment team look forward to discussing these changes with clients and with investment managers on your behalf. We see reasons for caution and optimism, but above all we believe that diligence in understanding what these initiatives mean for the investment landscape is important for any investor.

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