Investors now see corporate governance as a hallmark of the board’s effectiveness and one of the best sources of insight into the way companies operate. In response to this trend, Farient Advisors LLC, in partnership with the Global Governance and Executive Compensation Group, produced the report 2017—Global Trends in Corporate Governance, an analysis of corporate governance practices in the areas of executive compensation, board structure and composition, and shareholder rights covering 17 countries across six continents.
NACD, Farient Advisors LLC, and Katten Muchin Rosenman LLP cohosted a meeting of the NACD Compensation Committee Chair Advisory Council on April 4, 2017, during which Fortune 500 compensation committee chairs discussed the report’s findings in the context of the current proxy season. The discussion was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.
Global Governance Trends
2017—Global Trends in Corporate Governance finds that governance standards around the world have strengthened in response to financial crises and breakdowns in corporate ethics and compliance. Those crises and breakdowns have led to greater pressure from governments and investors, who are demanding economic stability and safe capital markets. In regard to executive compensation, the report notes a number of global governance trends:
Source: Farient Advisors, 2017—Global Trends in Corporate Governance, p. 18.
Most of the 17 countries surveyed (94%) require executive compensation disclosure, although the disclosures made and the quality of these disclosures varies from country to country. Surveyed countries that had the least developed disclosures are South Africa, China, Brazil, and Mexico.
Say-on-pay voting is mandatory in most developed countries, although there is variance on whether the votes are binding or not. For developed countries where the vote is voluntary (e.g., Canada, Belgium, Germany, and Ireland), it still remains a leading practice.
Common leading practices are to use competitive benchmarks, such as peer groups to establish rationales for pay, and to provide investors with information on components of pay packages and performance goals.
2017 Proxy Season Developments
Meeting participants shared a number of observations and practices from the current proxy season:
Continuous improvement on disclosures Council participants indicated they are sharing more information with shareholders, in a more consumable way. “We want to be in the front ranks as far as providing information to shareholders,” said one director. “Instead of asking ‘why should we share that?’ we’re starting to ask ‘why not?’” Another director added, “Over the last few years we’ve moved from a very dense legalistic document to something that’s much more readable. Our board set up a process to do a deep-dive review every two years; this fall is our next review. It’s a way to ensure our disclosures keep pace with current practices and also reflect where we are as a company and board.”
Council members also discussed the status of Dodd-Frank rulemaking, given the new presidential administration and SEC commission. S. Ward Atterbury, partner at Katten Muchin Rosenmann LLP, said, “While it’s unclear exactly what the SEC will do with Dodd-Frank requirements in the future, investors have spoken on some of the issues, especially on things like say on pay and pay for performance. There may be less formal regulation, but the expectations on companies and boards are still there [to provide pay-for-performance disclosure].”
Growing interest in board processes According to one director, “We’re hearing more interest about CEO succession as it relates to strategy. Investors are asking us to describe our process—they understand we can’t discuss specifics.”
Director Pay Dayna Harris, partner at Farient Advisors LLC, discussed the increased focus on director pay: “Given the recent law suits regarding excessive director compensation and an increase in director pay proposals in 2016, Institutional Shareholder Services (ISS) created a new framework for shareholder ratification of director pay programs and equity plans.” ISS’ framework evaluates director pay programs based on stock ownership guidelines and holding requirements, equity vesting, mix of cash and equity, meaningful limits on director pay, and quality of director pay disclosure. ISS’ updated factors for evaluating director equity plans include relative pay magnitude and meaningful pay limits.
Environmental, social, and governance (ESG) issues Meeting participants agreed that social issues, such as ESG and gender pay equity, are increasing in popularity among investors. In particular, nonbinding shareholder proposals on climate change received majority support this year at Exxon Mobil Corp., Occidental Petroleum Corp., and PPL Corp.
Refining approaches to outreach and engagement with investors Meeting participants discussed leading practices for engaging shareholders. Some directors indicated that investors have turned down their offers to speak on a regular basis because of time constraints. One delegate emphasized that just making the offer to meet with shareholders is appreciated, even if that offer is turned down. One director said, “We invited one of our major long-term shareholders to speak at one of our off-site [meetings] as part of a board-education session. It was a different type of engagement and very valuable.”
This blog post is one installment in a series related to board oversight of corporate culture. The National Association of Corporate Directors announced in March that its 2017 Blue Ribbon Commission—a roster of distinguished corporate leaders and governance experts—would explore the role of the board in overseeing corporate culture. The commission will produce a report that will be released at NACD’s Global Board Leaders’ Summit , Oct. 1–4.
A panel discussed how the iconic company became embroiled in scandal.
Wells Fargo & Co., Volkswagen AG (VW), Mylan NV, and Valeant Pharmaceuticals International are just a few of the companies that have recently experienced high-profile corporate crises stemming from ethics and compliance breakdowns. As corporate directors look to learn from these scandals, the John L. Weinberg Center for Corporate Governance, Association of Corporate Council, and Bloomberg Law® this April co-hosted the event Volkswagen Emissions Scandal—Lessons for Investors, Boards, Chief Legal Officers and Compliance & Governance Professionals.* The panel discussed the VW emissions scandal and lessons for boards of directors and general counsel (GCs) on instituting a corporate culture that promotes ethics and compliance.
Corporate Governance Causes of the VW Scandal
Charles M. Elson, director of the University of Delaware’s John L. Weinberg Center for Corporate Governance, notes in an article that three main governance practices at VW created a perfect environment for noncompliant behavior stemming from a lack of independent shareholder representation on the board:
A complicated web of interests with dual-class stock, pyramidal ownership, and family control. The Porsche and Piëch families own just over 50 percent of VW’s voting rights through their preferred class stock in Porsche Automobil Holding SE, which in turn owns shares of VW (known as pyramidal ownership). Ferdinand Piëch, the grandson of Porsche company founder Ferdinand Porsche, was chair of VW’s supervisory board at the time of the scandal and served as CEO from 1993 to 2002. Piëch’s primary goal is said to have been to create the largest automaker in the world, with less regard for creating profit and shareholder value. This directive from the company leader, in an environment where shareholders outside of the family had little influence over the board, created a corporate culture where employees chose noncompliant behavior over failure when designing the “defeat devices” used to cheat U.S. emissions tests.
The government as a major shareholder. VW was a state-owned enterprise until 1960 when it became privatized and left Germany’s Lower Saxony region with a 20 percent stake in the company. Elson opines that the interest of government officials is to be re-elected, often achieved through high employment rates. Therefore, government representatives on the board of VW were driven to create jobs at VW, the largest employer in Lower Saxony, even if adding those jobs was detrimental to profits.
Labor representation on the board (codetermination). German law requires all companies with more than 2,000 employees to fill half of the board with employee representatives. Elson argues that the board’s ability to provide effective compliance oversight was diluted by labor representatives on the board who were essentially monitoring themselves, and hence more focused on obtaining higher compensation and decent working hours for employees.
In light of these conditions at VW, panelists shared a number of leading practices for GCs and directors in creating a compliant corporate culture:
Lessons for GCs
“You can’t legislate ethics, but you can promote them,” said one panelist. Be the devil’s advocate and stress the importance of risk management and cultural tones at different levels of the organization, i.e., the so-called tone at the top, mood at the middle, and buzz at the bottom.
Ensure your board spends adequate time on compliance issues. Directors are often bogged down by compliance and want to spend more time on strategy, but prioritizing compliance at the board level will create a culture that allows strategy to be carried out successfully.
Get the right information to the board at the right time. According to one panelist, “The GC—as well as risk managers and in-house lawyers—need to be tough enough to speak up and report to the board. At Lehman Brothers, the CEO was known as the ‘gorilla on Wall Street.’ He doubled down on real estate, which the risk officer beneath him knew was risky, but their concerns were never known to the board.”
Remember that your duty is to the company—not the CEO—even if you’re reporting to him or her. “If [you as] the GC [are] aware of a violation, you need to do the right thing and not be swayed,” said one speaker.
Lessons for Directors
Increase your exposure to more employees, including mid-level employees, to get a better sense of the corporation’s culture in practice below the C-suite.
Create straight reporting lines from the compliance officer, chief risk officer, and internal auditor to committee chairs. This empowers these officers to speak openly with board members about their concerns without management present. (See NACD’s brief on Audit Committee Oversight of Compliance, which is open to the public for download.)
* The distinguished panel of speakers included: Robert E. Bostrom, senior vice president, general counsel, and corporate secretary at Abercrombie & Fitch Co.; Charles M. Elson, Edgar J. Woolard, Jr. chair in corporate governance, director of the John. L. Weinberg Center for Corporate Governance, and professor of finance at the University of Delaware; Meredith Miller, chief corporate governance officer at UAW Retiree Medical Benefits Trust; Gloria Santona, retired executive vice president, general counsel, and secretary at McDonald’s Corp.; Professor Christian Strenger, academic director, Center for Corporate Governance at the HHL Leipzig Graduate School of Management; Anton R. Valukas, chairman at Jenner & Block LLP; and The Honorable James T. Vaughn, Jr., justice of the Delaware Supreme Court. Italicized comments above are from panelists that participated in this event. However, this discussion was conducted under the Chatham House Rule, so quotes are not attributed to individuals or organizations.
The complexities surrounding short-termism make it a tough nut to crack. Short-termism in this instance refers to a focus on short-term company performance results at the detriment of achieving long-term strategic goals. But in all its forms, short-termism is not sustainable in a rapidly changing world. That’s why directors need to ensure that the organizations they govern seek a healthy balance in addressing short- and long-term interests of the organization’s senior executives and stakeholders.
Short-termism is certainly not a new concept. In a recent survey of more than 600 public company directors and governance professionals conducted by NACD, 75 percent of respondents indicated that pressure from external sources to make short-term gains is compromising management’s focus on long-term strategic goals. This pressure can affect the board’s risk oversight.
Short-termism manifests itself in many ways. The more common example is focusing on quarterly earnings at the expense of funding long-term sustainable growth. But it can also lead to the pursuit of several risky activities, including: M&A deals for growth’s sake without clear linkage to the overall corporate strategy; releasing new products to market without sufficient testing; allowing cost and schedule considerations to undermine safety on significant projects (e.g., deferring maintenance or taking risky shortcuts); and taking on excessive leverage to pursue activities that are currently generating attractive returns.
Underlying the evidence of short-termism is a complex series of root causes. Globalization, technological developments, improved transparency, and reduced transaction costs have facilitated capital flows, enabling investors to reallocate their assets to seek higher yields with greater ease. Hedge funds and other activist shareholders are also acquiring small stakes in a company with the objective of steering profits to shareholders immediately (through higher dividends, stock buybacks, asset spinoffs, or downsizing in lieu of investing in innovation that will improve productivity and drive future growth, for instance). Still another cause is the existence of compensation structures emphasizing executive pay over the near term to the detriment of long-term shareholder interests. These compensation models skew management’s decision-making toward maximizing short-term profits even at the cost of taking on excessive risk.
Following are six concrete steps the board can take to ensure short-termism does not compromise risk oversight:
1. Focus the board’s oversight on risks that matter. If risk management is focused primarily on operational matters, chances are management is not focusing attention on the right question: Do we know what we don’t know? To face the future confidently, both management and the board need to focus the risk assessment process on:
a. identifying and managing the critical enterprise risks that can impair the organization’s reputation, brand image, and enterprise value; and
b. recognizing emerging risks looming on the horizon on a timely basis.
Even though the day-to-day risks of managing the business are important, they should not command the board’s risk oversight focus except when truly pressing issues arise.
2. Lengthen the time horizon used to assess risk. Focusing on quarterly performance, annual budgets, and business plans may lead to a risk assessment horizon of no more than three years. That period may be too limiting because strategic opportunities and risks typically have a longer horizon—even with the constant pressure of disruptive change on business models. For example, the World Economic Forum uses a 10-year horizon in its annual risk study. Longer risk-assessment horizons are more likely to surface emerging issues, along with new plausible and extreme scenarios, that might have been missed with a shorter time frame. Thus, the board needs to satisfy itself that management is using an appropriate horizon.
3. Understand and evaluate strategic assumptions. Management’s “worldview” for the duration of the strategic planning horizon is reflected in assumptions about several topics: the enterprise’s capabilities; competitor capabilities and propensity to act; customer preferences; technological trends; capital availability; and regulatory trends, among other things. Directors should weigh in on management’s assumptions underlying the strategy. Doing so could reveal insights into the external environment and internal operating impacts that could invalidate the critical assumptions underlying the strategy. This is a useful approach to understanding sources of disruptive change.
4. Integrate risk and risk management with what matters. Short-termism can render risk to an afterthought to the formulation of strategy. Risk management similarly can become a mere appendage to performance management. The strategy, therefore, may be unrealistic and may involve taking on excessive risk. In addition, performance management may be overly focused on retrospective, backward-looking lag metrics. The board should ensure the strategy-setting process considers risks arising from strategic alternatives, risks to executing the strategy, and the potential for the strategy to be out of alignment with the organization’s mission and values. Directors also should insist that prospective, forward-looking leading metrics be used to complement the more traditional metrics used to manage the day-to-day business operations.
5. Watch out for compensation imbalances. Publicly listed companies on U.S. exchanges are required to disclose in the proxy statement whether the company’s system of incentives could lead to unacceptable risky decision-making in the pursuit of near-term rewards. The compensation committee typically conducts a review for excessive risk-taking in conjunction with its oversight of the compensation structure. Board concerns with respect to short-termism are a red flag for the compensation committee to sharpen its focus on the potential for troubling compensation issues that could lead to bet-the-farm behavior. A key question: Do key executives have sufficient “skin in the game” so they will be incented to take risks prudently in the pursuit of value-creating opportunities?
6. Pay attention to the culture. Short-termism can contribute to a dysfunctional environment that warrants vigilant board oversight. For example, management may continue to execute the same business model regardless of whether market conditions invalidate the underlying strategic assumptions. Also, operating units and process owners may be fixated on making artificial moves (e.g., deferring investments) and manipulating processes (e.g., cutting costs to the bone) to achieve short-term financial targets. Instead, the strategy should be focused on fulfilling customer expectations and enhancing the customer experience by improving process effectiveness and efficiency. These and other red flags warrant the board’s attention because they signal the possibility of unacceptable risk-taking that must be addressed.
If short-termism is a concern of the board, directors need to ensure their risk oversight process isn’t compromised by it. A strong focus on linking risk and opportunity can help overcome some of the “blind spots” that a myopic, short-term outlook can create.