Innovation and disruption are now commonplace in strategy discussions between the board and C-suite. Even innovations outside of a company’s own mission are changing everything from customer expectations to business operations. While the board’s agenda has evolved to include discussion of issues such as emerging technologies and workforce disruption, corporate directors must still contend with evergreen oversight tasks. Directors are feeling stretched, and reasonably so.
NACD’s Master Class board leadership forum convened more than 50 directors recently in Miami, Florida, to sharpen their focus on several pressing board oversight matters. The event highlighted lessons in effective board leadership and explored emerging disruptions that affect strategy and long-term value creation in today’s dynamic business environment. The discussions at Master Class revealed the following takeaways:
Review the outlook on the economy. The U.S. is on track to have its second-longest economic recovery, and it may even become the longest on record, according to Constance Hunter, chief economist at KPMG LLP. Unemployment is at an all-time low, and wages are slowly beginning to rise. Barring any global economic shocks, this could signal that the American economy is likely nearing peak growth. Hunter also reminded directors that though all signs point to stable economic growth this year, an economic downturn in the coming years is still possible.
Pay attention to increased complexity. From social and demographic changes to technological disruption, companies are facing increasingly complex challenges. Addressing these issues will require the board to keep up with today’s dynamic business environment. Being on a board is no longer simply about compliance or risk oversight. Fundamental conversations about company strategy and business models need to become regular topics of discussion. The board needs to ask hard questions of its executive team around the company’s data strategy, whether this team has the requisite set of skills to execute on strategy broadly, and how well the management team understands the competitive landscape and challenges specific to their industry.
Approach technology as an enabler of strategy. Board discussions about technology should focus on the current—or potential—application for the company. Directors should, therefore, approach such dialogues within the context of company strategy. The board should ensure that management understands and meaningfully engages with the company’s technology systems and the staff who use those systems, and assesses how the company invests in technology as an enabler of the broader strategy.
Wake up to disruption. Large companies are beginning to wake up to the disruptive players in their industries. Many so-called startup “unicorns” are now backed by corporate venture capital arms, enabling established, large-scale companies to gain a competitive edge with smaller companies leading transformative ventures and creating disruptive technologies. There are more avenues than ever before for businesses of all sizes to engage with emerging technologies, from pilgrimages to Silicon Valley, or attendance at events such as the annual NACD Consumer Electronics Show Experience, to setting up corporate venture arms.
Think outside—or about—the box. The concept of Innovation dos not have to be limited to a firm’s research and development department. A company can innovate in every facet of its business, from financing to product packaging. One director attending Master Class shared how one of her companies modified its package design for products that customers opened to peer inside. By redesigning the packaging to include transparent plastic, customers were able to see these products through the packaging and, thereby, didn’t feel compelled to open it. This helped the company dramatically reduce the number of products that were spoiled from being opened.
Demand better risk reports. Directors need to push management to enhance the effectiveness of risk reports provided to the board. If risk reports received from management look like audit reports, the board may not be receiving the information it needs to effectively oversee risk. Management teams often present so much information that directors may find it difficult to discern which risks demand the most urgent attention. In fact, the 2017─2018 NACD Public Company Governance Survey reports that in the past 12 months, 79 percent of respondents say they communicated with management about the types of risk information that the board requires.
Communicate what investors want to know. Institutional investors want to know whether the board is capable of being not only the board of today, but that of tomorrow. In this regard, the proxy statement is often underutilized as a way of communicating the board’s strengths and skills that will help strengthen their oversight of the company in the years to come. If effectively used, this document can enrich board-shareholder dialogue. More information is available in the publication Investor Perspectives: Critical Issues for Board Focus in 2018.
The Tax Cuts and Jobs Act of 2017 (“Tax Act”) has sweeping ramifications. These range from mechanical compliance issues (e.g., revised withholding rates for employees) to strategic concerns that must ultimately be decided in the boardroom. For domestic corporations and foreign corporations with U.S. operations, one strategic imperative is a wholesale re-evaluation of the structure of a company’s operations. In this first of two articles, we identify four significant aspects of the Tax Act with which corporate directors should become familiar.
1. Mandatory “Transition Tax” on Deemed Repatriations of Deferred Foreign Earnings. Many corporations have deferred foreign earnings under Accounting Principles Board Opinion No. 23, recording no associated financial statement U.S. income tax liability based on the position that such earnings are indefinitely reinvested in foreign operations. The Tax Act terminates the deferral and imposes a tax liability on deferred earnings regardless of whether they are actually repatriated. The Transition Tax on this “deemed repatriation” is 15.5 percent on the portion of the earnings represented by cash and cash equivalents and 8 percent on the portion invested in non-cash assets. Although most of the provisions of the Tax Act take effect in 2018, the Transition Tax is due on a corporation’s 2017 tax return and will likely cause a charge to 2017 earnings. There is an election to pay the tax in installments over an eight-year period.
What Directors Should Do. Computing the Transition Tax can be extremely complex and requires data the corporation may not have collected in the ordinary course of its business. This is particularly the case where the corporation has acquired companies that earned foreign profits after 1986. The U.S. Securities and Exchange Commission (SEC) has issued guidance, including Staff Accounting Bulletin 118, to assist corporations in applying generally accepted accounting principles (GAAP) to reflect the impact of the Tax Act where necessary information is not yet available. Directors, and in particular audit committee members, should ensure that the corporation devotes adequate resources to preparing a reasonably accurate computation of the Transition Tax in time to make their disclosures for the fiscal quarter or year ended December 31, 2017. Given the many open issues regarding the Transition Tax that may not be clarified by the filing date of the corporation’s tax return, corporations should enlist expert assistance to interpret the law and refine the company’s computation of the Transition Tax.
The deemed repatriation affords many corporations greater flexibility to utilize previously “trapped” cash (i.e., cash that was held by non-U.S. entities that could not be repatriated without being subject to U.S. tax). This cash might be used to fund acquisitions, capital expenditures, debt repayments, stock buybacks or dividends. Directors should ask management to focus on the corporation’s optimal capital allocation and to report to the board concerning available options.
2. Reduction in Corporate Tax Rate from 35 Percent to 21 Percent. The default rate on corporate taxable income drops from 35 to 21 percent, although there are special lower rates for certain types of foreign earnings discussed below. This 40-percent reduction in the corporate tax rate will affect the value of a corporation’s deferred tax assets and liabilities. For example, all things being equal the value of a net operating loss carry-forward may drop by 40 percent. At the same time, however, the lower tax rate may increase after-tax earnings going forward for many corporations. There are many less obvious implications of the rate reduction, particularly in conjunction with other changes in the Tax Act.
What Directors Should Do. Directors should commission a study by the corporation’s tax department of potential changes in the corporation’s legal entity and operational structures to take full advantage of the rate reductions in combination with other relevant provisions of the Tax Act. Such a study will also be useful in completing the corporation’s tax accounting analysis of the impact of the Tax Act under GAAP and related disclosures in the corporation’s SEC filings.
3. Reform of Taxation of International Operations. The Tax Act radically changes the taxation of profits earned outside the United States.
First, it eliminates the deferral of U.S. tax on foreign earnings. Thus, U.S. income tax now will be imposed on most current earnings of foreign subsidiaries rather than being postponed until earnings are repatriated.
Second, as a limited exception, foreign profits amounting to a 10 percent return on certain investments in tangible assets are permanently exempt from U.S. tax.
Third, profits from intangible assets earned outside the U.S. can be taxed at a special rate of 10.5 percent to the extent those profits result from certain types of revenues. Profits earned by domestic corporations from certain foreign sales of property or services are eligible for a special tax rate of 13.125 percent. Both of these special rates are scheduled to increase after 2025, but to levels well below the general 21 percent corporate rate.
What Directors Should Do. Directors should request a thorough review of the corporation’s international footprint as part of the study described above. This review should consider the optimal location not only of the corporation’s operations, but its personnel, tangible assets and intangible assets. Unlike GAAP consolidation, tax reporting must generally be made on an entity-by-entity basis (although consolidation of affiliates within a single country is often allowed). As a result, the corporation’s legal entity structure and inter-company contracts must be carefully aligned with its commercial arrangements. Given evolving changes in the tax laws of other member countries in the Organization for Economic Co-operation and Development (OECD), and particularly under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, structuring operations to accommodate both foreign tax laws and the new U.S. tax regime may be challenging. Finally, in evaluating any structure, directors should consider the prospects for future tax changes in reaction to the Tax Act in jurisdictions where the corporation operates.
4. Changes to Interest and Depreciation Deductions. The Tax Act gives with one proverbial hand—allowing immediate deduction of 100 percent of the acquisition cost for certain depreciable assets—and takes away with the other by limiting deductibility of net interest expense for many corporations. The “immediate expensing” provision applies only to tangible assets like plant and equipment and is phased down beginning in 2023. This new provision is more generous than prior “bonus depreciation” rules because it also applies to used assets, as well as new assets.
The interest expense rule limits certain corporations’ ability to currently deduct net business interest expense amounts exceeding 30 percent of certain thresholds. These thresholds are based on Earnings Before Income and Tax (EBIT) in years through 2021 and—less favorably—on Earnings Before Income, Tax, and Depreciation (EBITDA) after 2021. Disallowed interest deductions generally may be carried forward indefinitely. Interest expense on existing indebtedness is not grandfathered. Regulated public utilities are automatically exempt from these rules. Corporations in a broad spectrum of real property related businesses, farming businesses, and certain other agricultural businesses may elect to have these rules not apply.
What Directors Should Do. Directors should evaluate the impact of these two provisions on their corporation’s capital structure and its investment decisions. They should understand the implications of immediate deductibility of depreciable assets on acquisition structures. For example, acquiring stock may result in a lower internal rate of return than acquiring assets. Regarding the business interest limitations, directors should encourage management to determine whether the corporation is eligible to elect out of these rules and, if not, to explore alternatives to debt repayment, such as preferred equity instruments or other structures, that might mitigate the impact of these limitations.
Visit the NACD Board Leaders’ Blog again for the second installment in this series.
George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. Thoughts expressed here are their own.
Performance management relates virtually to everything that is important to a company’s progress—execution of its strategy, the customer experience, investor expectations, executive compensation, and the board’s oversight itself. In spite of the importance of performance to a company’s success, there is very little literature on board oversight of performance management. Given the complexity of the global marketplace, the accelerating pace of disruptive change, and ever-increasing stakeholder expectations, how should the board oversee the performance management process so that it is effective in driving execution of the strategy and in its efforts to incent the desired behaviors across the organization?
In August 2017, Protiviti met with 18 active directors during a dinner roundtable at a National Association of Corporate Directors (NACD) event to discuss this topic. As the ultimate champion for effective corporate governance, the board engages management with an emphasis on four broad themes: strategy, policy, execution, and transparency. With effective performance management touching each of these themes, many organizations use some variation of a balanced scorecard that integrates financial and nonfinancial measures to communicate what’s important, focus and align processes and people with strategic objectives, and monitor progress in executing the strategy.
Our discussions with the directors identified six important concepts to consider when overseeing performance management.
Return on Expectation
Performance management must embrace the appropriate metrics, given the strategy management seeks to implement and the entity’s expected investments. Alignment with strategic priorities is a challenge. As one director noted, most organizations have yet to bridge the gap between efforts to attract and retain employees and efforts to engage and align them.
The directors agreed that managing the balance between short-term and long-term performance presents particular challenges when determining executive compensation. Executives must be rewarded for performance, and long-term shareholder interests must be preserved. The prevailing view was that performance management should be linked to the storyline articulated in investor communications. However, directors should not allow stock price performance to dominate the spotlight so much that it detracts management from focusing on business fundamentals and strategic drivers.
Performance management must focus on operational excellence in the structure, or business model, in place to execute the strategy. Alignment starts with defining performance expectations, as set forth by the strategy, and communicating those expectations across the organization. Performance measures should be used to track the execution of the strategy at the organizational, process, and employee levels so that accountability for results cascades down into the organization. Tracking for these measures allows for necessary midcourse adjustments to be made on a timely basis to achieve performance targets. Metrics must be linked the reward system in a manner that ensures people are incented in the right way, consistent with the strategy. The impact of incentive compensation on behavior and risk taking should be a board priority.
With this topic sparking considerable discussion, several directors noted that while most boards assess and understand the tone at the top, they neither assess nor understand the tone in the middle. One director suggested the use of organizational health and effectiveness surveys to gauge how employees perceive the current leadership culture and compare that perception to the culture they desire. Gaps in perception revealed by such surveys almost always provide informative insights into what’s really happening in the business and what people below senior management really think. They also reveal opportunities for leadership development and improving the tone at the top and in the middle. The consensus of the group was that boards should encourage and, if necessary, push management to consider culture-related measures that make sense for the company. As one director noted, “What gets measured matters.”
The customer base should be segmented, and metrics should focus on the needs of each targeted segment. Customer experience metrics should address the distinctive attributes of the value proposition underlying why customers choose the company’s product or service over other alternatives and provide insight into what a company needs to do once issues are identified. To that end, these metrics should reach beyond nonfinancial areas and address quality, responsiveness, and other critical aspects of the brand promise, both expressed and implied. Less than half of the directors in the roundtable indicated that their top executives reported on one or more customer experience metrics. Several directors noted that when it comes to the customer experience, and even culture across the company, it is incumbent upon board members to “do some homework.” As one director put it, “Try to do your own research and be a ‘secret shopper.’”
Innovation and Resilience
Metrics should inform the organization’s focus on innovation, changes in technology and the business environment, emerging disruption, and market opportunities. The directors at the discussion dedicated a portion of the evening to innovation as a source of new revenue-generating opportunities and a driver of a positive, thriving culture. Among the key points made, the directors agreed the board should encourage consideration of innovation in the performance management process with emphasis on establishing an “innovation pipeline” with reporting on progress through the pipeline.
Monitoring for “Perfect Narratives”
When it comes to performance management, there is a risk of gaming the system. It is human nature for management to instinctively want measurements to reflect positive results. As one director noted, “Flawed stories are better than perfect ones.” It’s a positive when the performance management process identifies one or more areas requiring attention and improvement. So-called perfect narratives, a term used by the director referenced above, tend to raise questions about the rigor under which performance is measured and monitored, as well as the authenticity of the results.
These points get to the bottom of an essential question: do the CEO and executive team really want to know the unvarnished truth about the culture? The customer experience? Innovation? The effectiveness of the business model?
When executive management commits to managing by fact and earnestly seeks genuine results, the board can stand behind them with confidence when results are communicated to shareholders.
Dig into deeper insights from Protiviti by visiting their Board Perspectives piece on board oversight of performance management.