J&J board faces growing dissent

April 26, 2012, 12:35 PM UTC

FORTUNE — Every year, shareholders at public companies vote on whether their board members deserve another term or not. It’s typically a non-event; the average director of an S&P 500 company wins 96% of the vote, according to proxy advisory firm ISS. But the directors of healthcare giant Johnson & Johnson, which hosts its annual shareholders’ meeting Thursday, may face a rockier path to reelection. Investors have begun to turn against the board, with a growing contingent of shareholders voting against J&J’s nominees.

In 2011, the average J&J (JNJ) director won approval from just 88% of shareholders, down from 94% in 2009. That may not sound like a steep decline, but it’s actually quite low for a large corporation, according to Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. “When you get into the 80s, that’s a real problem,” he says.

Two J&J directors — Charles Prince, the former CEO of Citigroup (C), and Michael Johns, the chancellor of Emory University — received support from about 80% of voters, which is well inside the “danger zone,” according to Paul Hodgson, a senior research associate at GMI, a corporate governance ratings firm. “That’s a very substantial proportion of shareholders,” he says. “It should be enough to make a board sit up and take notice.”

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A spokesperson for J&J wrote in an email that the board will analyze voting results after its annual meeting, as it does every year.

Red flags: Disappointing financials, recalls

It’s easy to see why J&J’s shareholders are frustrated. In recent years, the company has been charged with several legal violations and endured a seemingly endless series of product recalls. Its reputation has taken a hit. Back in 2009, before the recalls began, J&J was ranked fifth on Fortune’s World’s Most Admired Companies list. In 2012, J&J’s overall rank dropped to 12.

The company’s financial results have also been underwhelming. J&J’s stock has delivered a total return of 5.3% over the last two years, while the S&P 500 has returned 17.5%. Its net income declined in both 2009 and 2011, in part because the company lost more than $1 billion in sales because of recalls of over the counter drugs.

Investors are typically wary of punishing directors for individual missteps. But J&J’s troubles have been widespread. Two years ago, the Department of Justice charged the company with paying kickbacks to Omnicare (OCR), the nursing home pharmacy operator. Last year, the company agreed to pay a $70 million settlement over allegations that it paid bribes overseas. An Arkansas judge recently ordered J&J to pay $1.2 billion in penalties for illegal marketing practices.

J&J has had to recall millions of bottles of over the counter drugs made by its McNeil subsidiary, citing issues such as bad odors and an excessive amount of active ingredients. After the initial spurt of recalls in 2009, J&J shut down the McNeil plant, promising to revamp its quality assurance practices in order to get production back on track. But recalls keep popping up. As recently as February 2012, the company had to recall more than 500,000 bottles of Tylenol. J&J now says it won’t reopen the plant until late 2013.

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A group of J&J shareholders, including the NECA-IBEW Welfare Trust Fund and the Hawaii Laborers Pension Fund, sued the board in 2010, arguing that directors had ignored red flags. A U.S. District judge dismissed the complaint, but noted in her opinion that the shareholders’ allegations against the board were “troubling and pervasive.”

In J&J’s 2011 proxy statement, the board praised J&J’s CEO, William Weldon, for his handling of the recalls. The statement said Weldon “generally met expectations” in 2010, adding, “Mr. Weldon’s leadership and engagement with employees, legislators, regulators, investors and the news media enabled the company to deal with the issues.”

During a significant portion of 2010, though, Weldon avoided the press. When he first addressed the recalls, he said that they were isolated to the company’s McNeil unit; not long after that, J&J issued recalls of hip implants made by its DePuy division. In April 2010, a J&J spokesperson said Weldon didn’t think that cost cutting played a role in McNeil’s problems. The following July, J&J released a report that conceded that the company’s push to cut costs through layoffs had contributed to its quality woes.

The report also said that J&J’s officers and directors had not breached their fiduciary duties, and pledged to create a new regulatory compliance committee. In an email, a J&J spokesperson wrote, “The Company’s management takes the shareholder concerns and criticisms very seriously.”

Excessive pay

Weldon’s compensation is a sore spot for J&J investors, and may be the primary source of their growing dissatisfaction with the board. The directors on the compensation committee last year — which, in addition to Prince and Johns, included former Xerox (XRX) CEO Anne Mulcahy and former Wm. Wrigley Jr. CEO William Perez — were particularly unpopular with voters. Prince, who famously walked away from Citigroup with about $100 million, is the compensation committee’s chairman.

ISS told its clients to vote against the company’s pay policy, citing a “lack of negative discretion on CEO’s pay magnitude despite ongoing reputational challenges.” Weldon took home $23.4 million last year, according to research firm Equilar, making him the 13th highest paid leader of a large company (he received a 3% bump in his base salary). J&J recently disclosed that Weldon is set to receive more than $140 million worth of benefits and deferred compensation when he retires.

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In 2011 — the first year that the Dodd-Frank Act mandated “Say-on-Pay” votes — 39% of J&J’s shareholders voted against its compensation plan. The company responded by changing its program, focusing more on performance-based pay. But representatives from the American Federation of State, County and Municipal Employees (AFSCME) say Weldon’s pay package was still excessive. “To the executives at J&J who deal with executive compensation, the changes they made were monumental. For shareholders, they just weren’t enough,” says Lisa Lindsley, the union’s director of capital strategies.

AFSCME has also lobbied the company to institute an independent chairman, a proposal that has won support from ISS. Weldon, who recently stepped down as CEO, intends to stay on as chairman. J&J has argued that he should maintain that role, writing in a filing, “Our Board believes that in the context of the upcoming transition to a new CEO, it will be in the best interests of the company to have our former CEO remain as Chairman and work closely with our new CEO to ensure a seamless transition of leadership.”

Lindsley says J&J’s board needs independent leadership. “When a former CEO is the chair, they tend to protect their protégés,” she says. “We just don’t think that Mr. Weldon should have anything to do with the company.”


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