Stocks Get New Grade for Friendliness

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It wasn’t the headline grabber, but the financial reform bill offers something shareholder advocates have been seeking for years: a better ability to challenge public companies’ boards of directors.

The bill’s final language leaves the matter to the Securities and Exchange Commission, which last year proposed improving proxy access, or shareholders’ ability to field candidates for boards of directors.

That proposal would require companies to put on the ballot any candidate who had the backing of shareholder groups owning at least 1% to 3% of the company’s stock, depending on the firm’s size.

Business groups have strongly opposed the idea, arguing it will make board elections disruptive affairs as unions, environmentalists and other interest groups field candidates to push pet concerns.

But shareholder advocates say too many directors have done a poor job looking after shareholders’ interests. Typically, the board’s own members choose a nominating committee that fields just one candidate per opening, a system critics liken to elections in the Soviet Union. Shareholders can vote for candidates who are not on the company’s official ballot, but that route is expensive, difficult and rare.

Many shareholder groups say that opening elections to more candidates would produce boards more likely to put a lid on executive pay and curb reckless risk taking. Many blame do-nothing directors for the financial crisis.

But some boards of directors are better than others. What criteria should an investor use to evaluate a company’s commitment to shareholders’ interests?

Market-research firm Morningstar (Stock Quote: MORN) has boiled it down to an A-to-F rating called a “stewardship grade” that assesses four areas:

Transparency. This focuses on how accurately a company’s accounting procedures and financial disclosures reflect its true conditions. Frequent use of “one time” charges to earnings, or frequent changes in accounting procedures, can hurt the company’s score, as can any other techniques designed to mislead.

Board Independence. Morningstar looks at whether directors really work for shareholders, as they are supposed to, or are too cozy with the firm’s management. A firm gets a poor rating, for example, if the company’s chief executive officer also serves as the board chairman.

Incentives and Ownership. This looks at factors such as how closely executive compensation is tied to the firm’s performance, especially over the long term. A company with vague criteria or one that frequently changes its compensation guidelines will get a lower score. Morningstar likes executives to have sizeable financial stakes in the firm, but doesn’t like too much to be in stock options keyed to short-term results, since that encourages too much risk.

Shareholder Friendliness. This assesses the firm’s openness to shareholder concerns. Criteria include things like whether the board puts issues raised by shareholders on the ballot, whether being elected to the board requires a majority of votes or merely a plurality, which is not considered as good. A firm will get a lower score if it uses a special class of stock that gives extra voting power to select shareholders, like the founder’s family, since their interests may not be the same as other shareholders.

To find the stewardship grade, key the stock’s ticker symbol into the quote box on the Morningstar home page, then click the Stock Analysis tab.

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