On Day 9 of the 30 Days to Becoming a Better Investor project, I introduced you to EDGAR. I also mentioned that I would detail some of the key things you want to look for in a proxy statement. In the following paragraphs, I’m going to explain what a proxy is, how you can find it, and what you should look for when you read one.
A proxy statement details the corporate governance issues that are going to be discussed at a company’s annual meeting. This includes information about when and where an annual meeting is going to be held. It also lists the issues to be voted upon at the annual meeting and details what those issues are. Those issues may include:
- Capital structure
- Management compensation
- Insider ownership
- Election of the board of directors
- Conflicts of interest
- Takeover defenses
- Corporate structure
Given all these issues, proxy statements are often very long and complicated. Until I ran across an article on AAII by John Deysher entitled, “The Proxy Edge: Exercising Your Shareholder Rights “, I did not have a good systematic way to review the proxy statements that I received and those of companies I was interested in investing. I now use the shareholder scorecard at the end of that article as a framework to focusing my research efforts when reviewing a proxy. To better explain how I review a proxy, I’m going to walk you through one of my recent reviews.
Microsoft Case Study
If you are a frequent visitor to Fat Pitch Financials, you probably know that I recently purchased shares of Microsoft. As part of my decision to make that purchase, I reviewed the recent Microsoft proxy statement.
Finding the Proxy
The first step I took was to find the most recent proxy statement for Microsoft. I called on my good buddy EDGAR and I clicked on Search for Company Filings and then Companies & Other Filers. On the Companies & Other Filers page I filled in “Microsoft” in the company name box and I clicked the exclude button under “Ownership Forms 3, 4, and 5”. After clicking the Find Companies button, I scanned down the results page for form DEF 14A, which is the definitive proxy. Filings are listed in order by date with the most recent filings listed first. If I want to look at older proxies for previous years, I just continue reading down the list.
Sometime there are also amendments added to the proxy, and they are reported as from DEFA14A. You can see an example of an addition in the Microsoft filings list. It is worth the effort to quickly click on these additional proxy material filings to make sure nothing important is hiding in these additional documents. The recent Microsoft DEFA14A is just an email sent to Microsoft employees encouraging them to vote in the their proxy.
To view a form, click on the “[html]” link next to the form you are interested in viewing. When I clicked on the DEF 14A “[html]” link I get a long list of links. The important link is “1 DEF 14A ddef14a.htm“. The other links are just supporting graphics.
Annual Meeting Information
Information about Microsoft’s annual meeting is listed just below the regulatory filing information. It states:
The Annual Meeting of Shareholders of Microsoft Corporation will be held at the
11100 NE 6th Street
on November 9, 2005, at 8:00 A.M.
Voting instructions follow this information. I also noticed that Microsoft is providing live coverage of the annual meeting on their site and a transcript along with video and audio of the entire annual meeting. That type accessibility is very shareholder friendly and a plus in my book worth 2 points.
Microsoft has one class of stock that has gives owners 1 vote for 1 share, so I give Microsoft a score of 10 points. The questions to ask about Microsoft’s capital structure include:
- Is there a non-transferable super-voting common class of stock? No.
- Is there a widely held class of stock that gets 0 votes? No.
- Are there any additional classes of shares owned by insiders only? No.
- Is there non-cumulative voting of directors? No. I believe you can cast your all your votes for one or two directors, but it’s not clear to me.
Management Salary Compensation
Salary information is listed in the “Summary Compensation Table” on page 5 of the proxy. Given the massive profits of Microsoft, I am impressed that none of the salaries of top management exceeds $1 million. Bill Gates and Steve Ballmer both earned $600,000 in base salary for 2005. Microsoft definitely deserves a score of 10 points in this category. The questions to ask about Microsoft’s managment salary compensation include:
- Is there minimal disclosure in the proxy statement of how salaries are determined? No. On page 7 the “Compensation Philosophy and Practice” and “Components of Executive Compensation” discuss the basis of how salaries are determined.
- Are salaries higher than for executives running similar-sized companies in similar industries? No. A good source for quick executive salary information can be found at the AFL-CIO’s Executive Paywatch. It is pretty common to find technology executives making more than $1 million in base salary in much small and less profitable companies.
- Are past increases in salary not in line with company performance? No. Salaries appear to have only increased moderately over the past three years.
Compensation: Bonuses & Cash Incentives
Ideally, a company would base its incentives on the companies return on assets or return on capital. If Microsoft had such an incentive system, I would give them a score of 10 in this category. However, Microsoft’s compensation incentives have some flaws. The questions to ask about Microsoft’s compensation incentives include:
- Are vesting periods short (less than three years)? No. The stock award and options seem to vest over five years according to the footnotes in the “SUMMARY COMPENSATION TABLE ” on page 5 and 6. In 2005, no stock options were granted to any of the executive officers. I believe Microsoft is phasing out the use of stock options.
- Are incentives based on non-return measures like earnings per share, sales levels or stock price? Yes. According to page 7 of the proxy, “The performance-based commitments used to determine bonuses will vary for each executive based on his/her responsibilities and may include financial or strategic measures, including but not limited to: revenue, contribution margin, innovation, product development and implementation, quality, customer satisfaction, or developer community satisfaction.” I’m subtracting 2 points for this vague set of measures that includes sales.
- Does the proxy lack a disclosure of how bonuses are determined? No. Page 7 and 8 give some information on how bonuses are determined. I would like to have seen more detail on exactly what metrics are used, however.
- Are there any Golden Parachute agreements? No. I did not spot any in this proxy.
Microsoft gets a total of 8 points for compensation incentives.
Compensation: Stock Options/Restricted Stock
If a company does not have a stock option or restricted stock incentive plans, I give them 10 points for this category. However, Microsoft does have a restricted stock incentive plan, so I ask the following questions:
- Are the restricted stock issued in modest quantities? Yes. However, given Microsoft’s shift from stock options to restricted stock it is a bit difficult to analyze this. Plus 2 points.
- Does the company treat option exercise as a compensation expense? Yes. Microsoft has started expensing all stock-based compensation. (I didn’t spot this in the proxy, but I found it doing a quick Internet search.) Plus two points.
- Is the option/restricted stock strike price at or above the stock’s price at the time of grant? Yes. The value is based on the closing price on the date of grant according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
- Is the vesting period greater than three years? Yes. The vesting period is over five years according to a footnote on the “SUMMARY COMPENSATION TABLE “. Plus two points.
- Are the restricted shares “funded” with shares repurchased on the open market? Not clear. I do not believe Microsoft’s proxy addresses this issue.
Given the above, I give Microsoft 8 points in this category.
Insider Ownership of Shares Outstanding
According to the table titled, “INFORMATION REGARDING BENEFICIAL OWNERSHIP OF PRINCIPAL SHAREHOLDERS, DIRECTORS, AND MANAGEMENT” on page 5, executive officers and directors own 13.79% of the outstanding shares of Microsoft. That gives Microsoft a score of 4 point out of 10 in this category. To earn ten points, insiders need to own more than 40% of outstanding shares.
Board Composition & Board Committees
I ask the following five questions regarding the Board:
- Are at least 2/3 of the board outside directors? Yes. Only Gates, Ballmer and Jon Shirley are obvious insiders. Plus 2 points.
- Is each outsider truly an outsider? Yes. According to what I read in the proxy I believe so. If I was concerned about the number of insiders, I would research each Board member more thoroughly. Plus 2 points.
- Is the Chairman of the board an outside director with no ties to management? No. Bill Gates is the Chairman.
- Are any insiders on the audit, compensation, governance, or nominating committees? No. I checked the table on page 2 of the proxy to answer this question. Plus 2 points.
- Are votes/seats held by insiders commensurate with shareholdings? No. Insiders hold three seats or 30% of the seats. Insiders only own a bit more than 13% of shares.
Microsoft gets a total score of 6 points for this category.
Conflicts of Interest & Related-Party Transactions
Page 9 of Microsoft’s proxy lists any potential conflicts of interest and related-party transactions in the section titled, “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS “. I asked the following questions regarding conflicts of interest:
- Does the company occupy a building leased from management or an affiliate? No.
- Does the company engage in business with another company owned or controlled by management? Yes. Microsoft does business with Corbis Corporation, which is solely owned by Bill Gates.
- Did the company buy real estate or businesses from management or affiliates? No.
- Did the company make loans to management on generous terms? No.
- Does management receive excessive perks? No.
I give Microsoft a score of 8 in this category.
I do not belive Microsoft has engaged in any takeover defenses, so I give them a full score of 10. Some takeover defenses include, staggered board of directors, poison pills, restrictions to call special meetings, ability to issue unlimited preferred stock, and super-majority voting requirements.
Microsoft details much of their corporate governance in their proxy and they also provide a link to a more comprehensive governance guidelines. I give Microsoft a full score of 10 in this category.
Microsoft has no re-incorporation strategies, so I give it a full 10 points for this issue.
Microsoft appears to have fairly good corporate governance, which is shareholder friendly now. If I did the math right, Microsoft gets an 86 in my review.
There are a lot of details buried in these filings. If you would like to get a sampling of what can be unearthed, I recommend visiting Footnoted.org. Michelle Leder is a pro at reviewing these documents and she reports on her interesting findings daily on her site.
Like everything, it takes a bit of practice to review proxy statements efficiently and thoroughly. Start by going through all the current proxies of the companies you own. Hopefully, you won’t find anything too shocking and new to you in your search. If you do, it might save you some heartburn in the future. After you go through a few of these proxies, you will get a lot more efficient at it and you will be prepared to start reviewing proxies of companies that you are potentially interested in investing in the future.