Inside the Boardroom
[July/August 2006]
Top REIT CEOs Discuss the Major Corporate Governance Issues Facing the Industry
By Dees Stribling
Corporate governance has been a top issue in the business world since the fallout from Enron and other scandals inspired regulatory reforms. Among the most notable changes has been the Sarbanes-Oxley Act of 2002, which mandated that all public companies implement fundamental changes.
Like all publicly traded companies, REITs have felt the impact of these reforms, though perhaps not as keenly as some other industries, according to REIT CEOs. Section 404 of the law in particular has had a strong impact on businesses, including REITs, mandating that they do an "internal control report" as part of each annual Exchange Act report. According to Section 404, the report must attest to "the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting."
Recently Real Estate Portfolio spoke with several CEOs from leading REITs, asking them questions about the state of corporate governance. What emerged from the discussions is a picture of an industry doing better than most of corporate America, though not perfectly, addressing the issues of corporate governance.
REAL ESTATE PORTFOLIO: What is the most pressing corporate governance issue facing the REIT industry today?
HAMID MOGHADAM
"The challenge now is not to become complacent. REITs are among the leaders in corporate governance and tend to come out on top in surveys about the matter." |
WILLIAM HANKOWSKY: REITs are in pretty good shape in terms of corporate governance, perhaps because there was a generational change recently, with the second generation of executives taking over from the founders. The industry has matured in parallel with Sarbanes-Oxley.
NICHOLAS SCHORSCH: I'd say the most pressing issue is compliance with Sarbanes-Oxley. REITs need to maintain communication internally and manage Section 404 compliance issues through their audit committees. American Financial has five independent directors who are all on the audit committee, forming a very important component of our board management overseeing the Sarbanes-Oxley compliance.
HAMID MOGHADAM: The challenge now is not to become complacent. REITs are among the leaders in corporate governance and tend to come out on top in surveys about the matter. I believe that's because there's good alignment between management and shareholder interests, since management is usually a significant shareholder, with an equity interest.
R. SCOT SELLERS: Generally speaking, the REIT industry is in excellent shape in terms of corporate governance. The industry has made a lot of progress in recent years, especially in terms of board member independence.
DONALD WOOD: I'm not so sure that board independence has been fully achieved. Many public REITs were previously family-owned or controlled businesses that later needed to adapt to a public ownership structure. As a result, true board independence and the separation of the chairman and CEO roles may have lagged other industries that don't share this type of history.
DEBRA CAFARO: Conflicts in sale transactions with UPREIT holders is an issue that is unique to the REIT industry. With UPREITs people who have sold portfolios to the REIT on a tax-deferred basis may have different interests in a sale than public shareholders–the structure makes for different constituencies.
DEBRA CAFARO
"Real estate companies have excelled at governance and disclosure. We're relatively young as a sector in the public market and have come of age at a time when governance is in the spotlight." |
DAVID SIMON: I don't think it's particular to the REIT industry, but in general the most pressing corporate governance issue is majority voting for the election of directors.
PORTFOLIO: How has Sarbanes-Oxley (SOX) impacted your company's operations specifically, and those within the REIT industry in general?
MOGHADAM: It's been expensive and time-consuming, but it didn't result in too many changes for us, though we did tighten some internal controls. Sarbanes-Oxley has caused more focus on senior management and the board centers more on internal control processes. In moderation, SOX is good, but it can end up changing the profile of risk-taking, both in REITs and corporate America, and not for the better.
SELLERS: I believe SOX restricts the willingness of companies to take risks. If you do something deemed by auditors or regulators after the fact to be a little different from what the regulations say—you have an unacceptable result. The default position is, don't take a risk. Management and boards are more timid than they used to be.
SIMON: The biggest impact of Sarbanes-Oxley, in terms of time and money, has been in the accounting area and Section 404 compliance. Simon Property Group has always had well-controlled financial and accounting practices, but SOX requires more formalization of procedures and documentation of those practices. Obviously there was an increase in costs associated with Sarbanes-Oxley.
WILLIAM HANKOWSKY
"Joining a board takes more time than it used to, and it’s a serious responsibility. I’d say it’s difficult to be on more than two or three boards at a time—there are more meetings, and more material to absorb than there used to be. " |
CAFARO: SOX leveled the playing field because it imposed the same requirements and costs on everyone. Ventas was building internal controls in advance of the law, so we were going to incur those costs anyway. We're comfortable with it generally, though some of the 404 measures don't provide value for the benefit obtained.
SCHORSCH: SOX is positive, though expensive during the implementation. However, it won't cost you more in the long run. It helps you sustain best practices. It also encourages first-class governance and operations, and helped us develop a red-amber-green system that flags problems in operations and helps us cure them.
HANKOWSKY: It hasn't been massively disruptive for Liberty, but it did accelerate things underway at the time. It's cost everyone some money, but SOX is harder on small companies than larger ones. The costs are proportionally higher for smaller companies.
WOOD: Like all public companies, we've seen some increase in costs, particularly audit fees, as a result of the requirements of Sarbanes-Oxley. Operationally, though, we haven't really been affected. I think the biggest impact on operations for public companies in general has been because of the Section 404 internal control review.
PORTFOLIO: How difficult is it to find qualified, independent board members? How important a role do they play?
R. SCOT SELLERS
"Shareholders are concerned with transparency and oversight—how various board committees make decisions, and who's on them. We've spent a lot of time helping them understand these processes. That's key."
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SELLERS: We seek board members in the right way, not by hiring friends and associates but by retaining a search firm. The firm looks for the kinds of qualities that we need. Still, it takes a long time to find qualified board members who also want to be on a corporate board. It takes a lot longer than it used to.
CAFARO: We've been fortunate with our board. We've been able to attract a good board without a huge amount of effort—we have six independent board members, plus myself as the management representative on the board. If we wanted to expand to 10 or 12 members, however, we'd have some difficulty attracting qualified individuals.
SCHORSCH: It's very competitive to find qualified board members, the pool is fairly small. We're constantly on the lookout and we have to cultivate a pool of potential individuals.
MOGHADAM: A lot of good people out there are fearful of getting involved with a company that's going to cost them in terms of a lawsuit or liability down the road. If the company is transparent and has good corporate governance, the chances of that are low and recruiting good board directors shouldn't be too much of a problem.
HANKOWSKY: For a while it was very difficult to find board members, but it became easier more recently. In any case, joining a board takes more time than it used to, and it's a serious responsibility. I'd say it's difficult to be on more than two or three boards at a time–there are more meetings, and more material to absorb than there used to be.
DAVID SIMON
"Real estate disclosure is typically quite good compared to corporate America. Most companies issue comprehensive supplemental information packages each quarter and many also provide some level of individual asset information."
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WOOD: It's always difficult to find qualified, independent board members who will be a good fit with existing board members and who bring a complementary skill set to the table. But I don't think that it's gotten any more difficult over the past few years. However, what we have seen is a longer, more involved process by both prospective board members and Federal Realty.
SIMON: Simon Property Group has been fortunate. Over the last four years we've had to find four board members, and we haven't had trouble attracting qualified people to serve. We've benefited from the fact that our new board members weren't new to corporate directorships–they all had previous board experience at other public companies.
PORTFOLIO: How would you evaluate the industry's disclosure overall compared to corporate America? What improvements, if any, need to be made?
CAFARO: Our industry has great disclosure—we have a good Institutional Shareholder Services (ISS) ranking to prove it (real estate is second to utilities, see page 66 for the story on ISS rankings in Investor Insights). Real estate companies have excelled at governance and disclosure. We're relatively young as a sector in the public market and have come of age at a time when governance is in the spotlight.
SCHORSCH: There's better disclosure in REITs than in most of corporate America because real estate is more static. You don't have to understand how a circuit board is made or be an expert in medicine to understand the market for a new pharmaceutical product. But there's room for improvement. Many REITs need to catch up with new regulations, such as on valuing lease relationships or regarding regulations on asbestos exposure.
DONALD WOOD |
HANKOWSKY: On the whole, disclosure is good. It's not a complicated business–not like a financial company with derivatives and hedges and dense financial statements. It has fixed assets that you can list. In the end, there are assets that support the equity.
SIMON: Real estate disclosure is typically quite good compared to corporate America. Most companies issue comprehensive supplemental information packages each quarter and many also provide some level of individual asset information.
MOGHADAM: The REIT industry's disclosure is insanely thorough. The supplemental analyst packages that we and others prepare are almost 40 pages long. Can you imagine GE doing that for each line of its business? They would have to produce something 2,000 pages long. If anything, there's too much disclosure in the REIT world—it's overwhelming, and can take away from what's really important.
SELLERS: There isn't good disclosure on results of reinvestments made on assets sold, what's the internal rate of return, what's the cash gain. That's an area of disclosure that needs to focus on in the industry. But aside from that, disclosure's good.
WOOD: REIT industry disclosures have improved over the past couple of years, providing greater transparency to shareholders on operations and management. For us, disclosure ranges from having disclosed a full copy of our joint venture agreement with Clarion Lion Properties Fund—for the acquisition of stabilized shopping center assets—to a detailed breakdown of the sources of our income.
PORTFOLIO: What governance-related issue, or issues, is causing the most concern for shareholders?
SCHORSCH: Transparency is critical to shareholders and so is compensation.
NICHOLAS S. SCHORSCH |
HANKOWSKY: Shareholders care about independent board members. They are comfortable when they perceive that the board is independent. Otherwise they're concerned.
SIMON: Shareholders are focused on growth in earnings, executive compensation and creating shareholder value.
WOOD: The only significant issue that we had in recent experience was the majority-versus-plurality vote standard. We did have a non-binding shareholder proposal presented at our 2005 annual meeting to move from a plurality to a majority vote standard for electing trustees, a proposal that received strong support from our shareholders. Our board looked hard at the issue and in fact adopted a majority vote standard, which is what we are using to elect trustees at our 2006 annual meeting.
SELLERS: Shareholders are concerned with transparency and oversight—how various board committees make decisions, and who's on them. We've spent a lot of time helping them understand these processes. That's key.
MOGHADAM: This year's hot topic is cumulative voting, but executive compensation is a longer-life concern, because some companies are way out in left field in that regard.
CAFARO: Shareholders are definitely concerned about compensation. They're fair and want to reward talent, but they also have a legitimate concern when it comes to the disconnect between performance and compensation. It happens.
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The executives that Portfolio spoke with included: