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 National Association of Corporate Directors (NACD) recently released its sixth annual edition of Governance Challenges 2017: Board Oversight of ESG, produced in collaboration with NACD’s five strategic content partners: Heidrick & Struggles, the KPMG Board Leadership Center, Marsh & McLennan Companies, Pearl Meyer, and Sidley Austin LLP. Environmental, social, and governance (ESG) issues encompass a variety of areas in which shareholders have demonstrated an increasing interest: sustainability, diversity and inclusion, human rights, labor practices, executive compensation, employee relations, and board independence.
According to Institutional Shareholder Services, a record number of shareholder resolutions on climate change were filed in 2016, and the average shareholder support for environmental proposals in general has increased dramatically over the last decade—from receiving an average of 11 percent of the vote in 2006 to 21 percent of the vote by June 2016. Shareholder proposals for the 2017 proxy season are also expected to focus on social issues, as there will likely be a regulatory downshift in these areas under the Trump administration.
Drawing from NACD’s report, here are five ways boards can improve ESG oversight this year in response to growing expectations from investors and consumers in this area.
1. Integrate ESG initiatives into company strategy.
How companies consider ESG issues and link them to financial and operational performance demonstrates the company’s approach to creating sustainable, long-term value for investors. KPMG recommends boards set the context for the company’s discussion around ESG issues by asking how they are applicable to the company, customers, employees, and investors. Specifically determine how environmental sustainability can support the company’s financial future. What are the board’s expectations regarding ESG? Will the company broadly address environmental and social issues, or will the company only focus on areas that directly relate to its strategy and operations?
2. Ensure key functional leaders proactively apply ESG in business operations.
All leaders in the C-suite should understand the importance of ESG and how it impacts their functional responsibilities, according to Heidrick & Struggles. For example, does the CFO include ESG elements when conducting financial analysis? Does the CMO clearly demonstrate how the company is committed to ESG goals instead of resorting to greenwashing (i.e., dedicating more effort to claiming to be environmentally responsible than actually doing it)? The board may also consider adding director ESG expertise should the company be recovering from a company-caused environmental disaster or missed opportunities in the marketplace due to lack of attention to ESG.
3. Use executive compensation to support ESG goals.
While many public companies are already engaging on ESG issues, Pearl Meyer research indicates companies fall on a spectrum from conducting basic reporting on ESG to fully integrating ESG into company strategy, culture, and executive compensation plans.
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Alcoa and Exelon are two examples of companies that have linked ESG goals such as greenhouse gas (GHG) emission reduction to executive compensation. At Alcoa, “20 percent of executive cash compensation is tied to safety, environmental stewardship (including GHG reductions and energy efficiency), and diversity goals.” Exelon rewards executives for “meeting non-financial performance goals, including safety targets, GHG emissions reduction targets, and goals engaging stakeholders to help shape the company’s public policy positions.”
To link ESG to financial results, boards can consider the following questions regarding compensation:
Which components of ESG should we link to our business strategy?
How do these ESG factors affect our short-term earnings versus long-term value creation?
What are the leading and lagging metrics that matter, incorporating both financial and nonfinancial metrics?
4. Improve disclosure on the impact of climate change.
The Financial Stability Board’s (FSB) Task Force on Climate-related Disclosures (TCFD) is an organization initiated by the G20 Finance Ministers and Central Bank Governors that has produced recommendations for disclosing climate-related risks and opportunities. The task force recommends that directors consider the following, as summarized by Marsh & McLennan Companies, to promote better disclosure:
Processes and frequency by which the board and/or board committees (such as audit, risk, or other committees) are informed about climate-related issues
Whether the board and/or board committees consider climate-related issues when reviewing and guiding strategy, major plans of action, risk-management policies, annual budgets, and business plans, as well as when they are setting the organization’s performance objectives, monitoring implementation and performance, and overseeing major capital expenditures, acquisitions, and divestitures
How the board monitors and oversees progress against goals and targets for addressing climate-related issues
According to Sidley Austin LLP, it has now become the norm for investors to consider environmental and social issues when making investment and voting decisions. Boards should determine who from the board and management will engage investors on these issues. These representatives may vary based on the severity of the topic to be discussed and which shareholder the discussion is with. Tracking shareholder voting records, and analyzing which types of proposals are seeing increased traction over time, will also provide insight into the minds of investors.
Last month, Exxon Mobil Corp. appointed a leading climate scientist to its board. Exxon’s move underscores the growing pressure shareholders are exerting on the issue of climate-competent boards.
Climate competency of boards—and broader corporate attention to escalating climate change risks—isn’t just a hot topic for one set of shareholders and one oil company. It is a key investor imperative for all sectors of the economy.
Look no further than the new guidelines from the G20’s Task Force on Climate-related Financial Disclosure to understand how profoundly expectations are shifting. The task force, chaired by Michael R. Bloomberg, was created by the Financial Stability Board at the request of the G20 ministers to help companies identify and disclose which climate risks have a financially relevant impact on their business. The task force’s very first recommendation focuses on the governance practices of companies for climate change, including deeper board engagement on the topic.
So what does it mean for boards to be climate competent? Climate competency means much more than just getting one person with expertise on a corporate board. So while we applaud the important step that Exxon has taken, it’s only a first step.
At the end of the day, a climate-competent board is one that can make thoughtful decisions on climate risks and opportunities that a company is facing. When trying to set up a climate-competent board, companies should think holistically about what needs to be done for boards to achieve competent, informed decision-making on this issue.
1.) Put board systems in place for climate change oversight. Boards need to have a committee that is assigned formal responsibility to oversee climate change. By doing so, companies can ensure that boards oversee how climate risks are integrated into operations and decision-making on an ongoing basis. Numerous companies have dedicated board sustainability or environment committees that can be leveraged for this purpose. Companies like Citigroup, Ford, and PG&E have specifically identified climate change as a key focus area in the charters of their board public affairs or sustainability committees. Having the issue identified in such an explicit manner ensures it will be discussed systematically in committee meetings.
2.) Include directors with expertise in climate change on boards. When climate change is a material risk to a company, boards should recruit directors with expertise on that material issue. Such companies should also explicitly identify climate change expertise as a board qualification. This means making it a part of board skill matrices. It’s worth noting that two of the country’s largest pension funds, CalPERS and CalSTRS, recently amended their global governance guidelines to ask portfolio companies to recruit directors with climate change expertise.
3.) Train the full board on climate change. Boards and management should provide climate-related training opportunities to all board members, or, at a minimum, to relevant committee members. Organizations like The Co-operators have detailed systems in place to train its board on sustainability issues that are crucial to their businesses, including leveraging external experts for this purpose. Certain groups offer education curriculums where issues like climate and sustainability are addressed.
4.) Consult stakeholders and shareholders to inform directors’ understanding of climate change. Internal training sessions are key, but it’s just as important that directors reach out to external stakeholders, including investors, to share firsthand the company’s different approaches to climate change learn from voices outside of management. Investors in particular are critical groups to engage. Having this broader multi-stakeholder perspective can help directors make better-informed decisions. In 2016, shareholders filed a record 172 shareholder resolutions on climate change and sustainability. Given that directors are fiduciaries to investors, director-investor dialogues on climate trends will provide an important context to board discussions on this issue.
5.) Be more transparent. Finally, and perhaps most importantly, we need more transparency on climate-related board decisions. We need to know whether boards are prioritizing climate change as a material issue. Companies have to do a better job of disclosing how climate trends are affecting corporate strategies and risks that are relevant to investors.
Market and shareholder scrutiny of board engagement on climate issues is only going to grow sharper with time. While companies will be impacted differently by these risks, few industries are immune. Climate change affects 72 out of 79 industries and 93 percent of the capital markets, according to SASB’s Technical Bulletin on Climate Risk.
The key for board members now is to ensure that they’re well positioned to exercise informed oversight so that they can make thoughtful decisions on this escalating issue.
Veena Ramani is program director, Capital Market Systems, at Ceres.