Earlier this year

Microsoft

(MSFT) - Get Report

took some progressive steps in corporate governance, making groundbreaking decisions to expense stock compensation and eliminate options.

And the company framed its subsequent decision to name two new independent directors as another advance.

But some critics say a handful of items on the company's proxy statement for the Nov. 11 shareholders' meeting represent a corporate governance stumble by the software behemoth. They point to the following:

The re-election of two of the company's board of directors. Critics are objecting because one serves on eight boards and the other sits on the board's audit committee but still has ties to Microsoft.

Pay raises for nonemployee directors to more than $300,000 a year, based on Microsoft's current stock price.

A plan by Microsoft that allows employees to sell out-of-the-money stock options to J.P. Morgan should be on the proxy but isn't, one organization says.

At least one institutional shareholder is acting on the criticisms. "My plan would be to withhold votes on these kinds of issues," says Cynthia Richson, corporate governance officer for Ohio Public Employees Retirement System, which holds 21.7 million shares of Microsoft stock. (Because there is no competing slate, Microsoft shareholders can only voice opposition to a director by withholding a vote rather than voting against a director.)

In particular, Richson said she opposes the re-election of directors Ann Korologos, a former U.S. secretary of labor, and Director Jon A. Shirley, former president and COO of Microsoft. The problem with Korologos is that she serves on the board of seven other companies, including

AMR Corp

(AMR)

, its subsidiary American Airlines,

Fannie Mae

(FNM)

and

Kellogg

(K) - Get Report

.

Shirley, meanwhile, sits on the Microsoft board's audit committee but is not a fully independent director as defined by proxy advisers, because he is a former Microsoft executive and his son works for the company.

Richson said the number of board seats held by Korologos is "way on the high side of excessive." The Council of Corporate Investors has a set policy, followed by OPERS, that directors should not sit on more than five boards.

Glass, Lewis & Co., a research firm that advises institutional investors on proxies and corporate governance issues, sets a limit of five board seats for company CEOs and seven for non-CEOs. A director should spend about 200 hours a year on board duties, which for Korologos would mean a whopping 1,600 hours a year, said Glass, Lewis CEO Greg Taxin.

"This director probably isn't spending as much time on this as we'd otherwise like to see," Taxin said. Korologos could not be reached for comment.

Microsoft spokesperson Rachel Wayne said the board's governance and nominating committee determined that the criteria set by Microsoft's corporate governance guidelines had been met in allowing Shirley on the audit committee.

Wayne called Korologos a "valuable contributor to the Microsoft board with an exemplary attendance record." Wayne noted that the director, as a member of the board's compensation committee, played an "important role" in the creation of Microsoft's new compensation plan announced in July.

That plan replaced stock options for employees with restricted stock awards. At the same time it was announced, Microsoft unveiled a plan to let employees sell out-of-the-money options to J.P. Morgan -- a program that is also drawing fire on the corporate governance front.

Institutional Shareholder Services, another proxy advisory firm, argues that the exchange program is a material enough change to Microsoft's stock option program that it should go to a shareholder vote -- which Microsoft has resisted. Without such a move, the influential ISS has threatened to recommend shareholders withhold votes on directors in the next election.

That's hardly an idle threat, because a director with a 35% no-vote in 2004 could allow a qualified shareholder to put its own candidate on the proxy in 2005 under rules now under consideration by the

Securities and Exchange Commission

, noted Pat McGurn, vice president and director of corporate programs at ISS.

"The clear message we're trying to send out to everybody is, 'No, these have to go to shareholder approval,'" McGurn said.

Microsoft's Wayne said the company's stock plan gives the company the authority to transfer stock without shareholder approval.

New

Nasdaq

rules that require shareholder approval on material changes to stock plans offer an exemption if the current plan allows transfers, McGurn acknowledged. But the J.P. Morgan exchange, a novel approach still awaiting SEC approval, goes beyond what was envisioned as a transfer, he said.

"It's our position this is not as simple as allowing an executive to transfer an option to a charitable organization," McGurn said. "Half of all options outstanding from the company taken from employees -- there's nothing routine or normal about that."

Ken Broad, a portfolio manager at TransAmerica Investment Management, agreed that shareholders should have a say on the sale of options to J.P. Morgan. "Anytime there's a repricing or monetizing of out-of-the-money options, it breaks a contract with shareholders," he said.

In line with its effort to replace options with stock as compensation, Microsoft is also proposing to replace 20,000 options awarded to nonemployee directors with an annual award of 10,000 shares of stock plus 25,000 shares of stock when a director is first elected to the board. Separately, without shareholder approval, Microsoft raised the cash compensation to directors to $50,000 in fiscal year 2004, which began in July, from $35,000 in fiscal year 2003, and started paying directors for acting as committee chairs and attending meetings.

On the basis of the current stock price of roughly $27, a new director would receive $675,000 in stock plus at least $320,000 a year in stock and cash. Microsoft believes the total value of that compensation is in the midrange of what directors at other similar-sized companies receive, Wayne said.

But while other companies also have been raising director pay, Glass, Lewis concluded that Microsoft was still too high. The firm surveyed a swatch of large-cap companies, including

Coca Cola

(KO) - Get Report

,

Altria

(MO) - Get Report

and

Citigroup

(C) - Get Report

, and found that the average pay was $180,000, Taxin said. (One-time compensation for new directors averaged $580,000, closer to Microsoft's award.)

OPERS' Richson agreed the directors would be getting too much, noting that the latest survey from the National Association of Corporate Directors found that the average director pay was $150,000. "In general, I think director pay is probably going to go up just because of the enhanced responsibilities under Sarbanes-Oxley," Richson said. But "$180,000 covers more than enough of the additional duties."