China’s legislature approved its Cybersecurity Law this past November, solidifying China’s regulatory regime for cyberspace and potentially disrupting foreign companies that use or provide telecommunications networks in China. The law takes effect June 1, 2017, and reflects China’s desire for “cyber-sovereignty” (regulating the Internet in China according to national laws, despite the global nature of the World Wide Web). As the Chinese Communist Party (CCP) faces pressure from slowing economic growth and foreign influence, the Cybersecurity Law is one in a series of laws the Chinese government has implemented recently to uphold state security.
Significant Provisions of the Law
Though the wording of the law is vague, it formalizes many current practices and aims to consolidate cybersecurity authority under the Cybersecurity Administration of China. While the government is expected to offer more clarification on the law through implementation rules, how the law is played out in practice will be the ultimate indicator of the law’s severity. These three aspects of the law have the greatest potential to affect multinational companies (MNCs) doing business in China, according to an NACD analysis:
1. Data localization: Article 37 of the law is one of the most contentious and requires that “critical information infrastructure” (CII) operators store personal information and other important data they gather or generate in mainland China to be storedin mainland China. CII operators must have government approval to transfer this data outside the mainland if it’s “truly necessary.” The definition of CII is a catch-all, including public communication and information services, power, traffic, water, finance, public service, electronic governance, in addition to any CII that would impact national security if data were compromised.
Impact: The broad applicability of the CII definition raises the concern that any company using a telecommunications network to operate or provide services in China would be required to store data in mainland China, possibly even affecting those that store data to clouds with servers located outside mainland China.
2. Support for Chinese security authorities: Article 28 requires “network operators” to provide technical support to security authorities for the purposes of upholding national security and conducting criminal investigations. Network operators are broadly defined as those that own or administer computer information networks or are network service providers, which may include anyone operating a business over the Internet or networks.
Impact: The loose definition of “technical support” creates the concern that MNCs will be required to grant Chinese authorities access to confidential information, compromising private information and intellectual property that may be shared with state-owned competitors. Although not stated in the final version of the law, there is also the possibility that companies may be required to provide decryption assistance and backdoor access to authorities upon request.
3. Certified network equipment and products: For network operators, Article 23 indicates that “critical network equipment” and “specialized network security products” must meet national standards and pass inspection before they can be sold or supplied in China. A catalogue providing more specification on these types of products will be released by the government administrations handling cybersecurity. Under Article 35, CII operators are also required to undergo a “national security review” when purchasing network equipment or services that may affect national security.
Impact: Chinese companies and government agencies have historically relied on computer hardware and software manufactured by foreign companies, although this is now shifting in favor of domestic IT products. Opportunities for hacking and espionage put China at risk of losing sensitive information to foreign governments or companies, and China has already started conducting reviews of the IT security products used by the central levels of government. This provision of the Cybersecurity Law demonstrates China’s resolve to mitigate this risk and may pose a significant barrier to foreign IT equipment manufacturers selling products in China.
How Directors Can Prepare
China’s Cybersecurity Law has been criticized by the foreign business community, and, depending on the law’s implementation, it may make doing business in China for MNCs not only more complex but also riskier. Tom Manning, a China specialist at the University of Chicago Law School and director of Dun & Bradstreet, CommScope, and Clear Media Limited, advises boards to consider the effect of the Cybersecurity Law in the greater context of China’s rise: “The Chinese economy is increasingly more self-sufficient. Domestic companies are growing stronger and are more capable, while multinational companies are finding it more difficult to compete.”
Manning suggests boards conduct an overall China risk assessment, with the Cybersecurity Law as the focal point. While some companies may determine the risk of doing business in China is too high, Manning says, others might decide they need to invest more in China to be profitable. Ultimately, creating alliances with domestic firms, who have a greater influence over the government’s implementation of the law, may be key. “Leading domestic companies have a stake in seeing a better definition of the law, and their interests aren’t unaligned with multinational companies,” Manning says. “Chinese Internet companies can explain to the government how the law will affect their business models and be more effective in doing so than Western companies.”
Although how the law will be enforced remains to be seen, boards can consider the following questions when evaluating the impact of China’s Cybersecurity Law:
Are we storing information generated or gathered in mainland China on servers in mainland China? Do we need to create separate IT systems for China-specific data? Are we reliant on cross-border data transfers, and how would we approach this need with the Chinese government?
What is our risk exposure stemming from the potential loss of intellectual property or encryption information as a result of this law? How would our business be affected should our Chinese competitors gain access to this information?
For computer hardware or software manufactures, are we willing to share our source code with the Chinese government?
For technology firms, how does the law alter the playing field for our company to compete in China against domestic firms?
What additional investments do we need to make in order to comply with this law?
This spring, as usual, most pay-related resolutions in proxy statements will be from corporations seeking shareholder approval of pay packages for named executives. But not all the pay votes will implement this now-familiar “say on pay,” where shareholders look back at the past year’s compensation plan to give thumbs up or down. More shareholders will be proposing their own pay concepts for a vote this season—and many of these proposals will reflect shareholder’s growing interest in social issues.
Who Needs Dodd-Frank?
Click to enlarge.
Directors in 2017 may see a new kind of resolution meant to re-assert any Dodd-Frank pay rules that get stalled or repealed this year. As reported in detail in the January/February 2017 issue of NACD Directorship magazine, President Trump may use executive orders to delay or undo Dodd-Frank, and Congress may revive a number of bills to repeal Dodd-Frank, including the parts of the law focused on executive pay. As expected, the president on February 3 issued an executive order outlining core principles that should guide the rollback of Dodd-Frank era regulations. As a result of this potential pullback on pay rule-making, companies may see shareholder resolutions mandating what those rules would have imposed, e.g., mandates for stricter executive pay clawbacks or for pay-versus-performance and pay-ratio disclosures.
Not surprisingly, directors and shareholders have been talking face-to-face about pay in preparation for this season. The 2016–2017 NACD Public Company Governance Survey reveals some interesting trends. In 2016, 48 percent of respondents indicated that a representative of their board had held a meeting with institutional investors over the past 12 months, compared to 41 percent in 2015. The most common discussion topics at those meetings were executive pay and CEO performance metrics and goals. Another common topic was “specific shareholder proposals,” which no doubt included the range of causes noted in our recent post predicting a rise in socially-minded proxy resolutions.
For many companies, measurement of performance includes social goals. In 2016, 80 percent of respondents to the NACD survey indicated that they consider non-financial metrics when evaluating executive performance to determine executive compensation. The metrics they use include, in descending order from 37 percent to 8 percent, the following:
Maintaining good standing with regulators;
Sustainability-related measures, and;
Many of these performance metrics could be considered “social” aspects of pay.
Executive Pay Proposals at Apple, Walgreens Boots Alliance
The 2017 proxy at Walgreens Boots Alliance (WBA) reveals that Clean Yield Asset Management proposed that WBA issue a report linking sustainability metrics to executive pay. The proposal asks the board compensation committee to prepare a report “assessing the feasibility of integrating sustainability metrics into the performance measures of senior executives,” and defines sustainability as “how environmental and social considerations, and related financial impacts, are integrated into corporate strategy over the long term.” The company recommends a vote against this proposal, highlighting its achievements in the field of sustainability, and concluding that preparing this report would not be a productive use of company resources.
On another note, Apple’s 2017 proxy statement contains two shareholder resolutions on pay—one focusing on increasing the requirements for stock ownership, and one that takes a more social turn. In proposal 8, shareholder activist Jing Zhao brings into the current season an economic concern voiced by a significant number of shareholders across several companies in 2016, when the 250 largest companies saw 38 shareholder-sponsored proposals on pay. While the subjects of these proposals varied, most of the 2016 proposals alluded, in one way or the other, to compensation practice reform.
Zhao’s current resolution proposes the following: “Resolved: Shareholders recommend that Apple Inc. engage multiple outside independent experts or resources from the general public to reform its executive compensation principles and practices.”
In summary, Zhao’s proposal takes aim at the identical nature of the senior executive pay below the CEO, and questions the need of a compensation consultant given such conformity. But the supporting details reveal that the proposal is not really about how many advisors Apple engages. Rather, it is about income inequality. Zhao’s commentary goes on to address the larger picture of societal well-being. He quotes Thomas Piketty, arguing that income inequality “has contributed to the nation’s financial instability,” and tracing this inequality to “the emergence of extremely high remunerations at the summit of the wage hierarchy.” (Capital in the Twenty-First Century, Harvard University Press, 2014, pp. 297-298, reviewed here in NACD Directorship).
The response from Apple management addresses the proposal itself rather than the surrounding complaint. Apple’s executive officers “are expected to operate as a high-performing team; and we believe that generally awarding the same base salary, annual cash incentive, and long-term equity awards to each of our executive officers, other than the CEO, successfully supports this goal.”
The Sleeper Issue: Director Pay
The sleeper issue this year may be director pay. The 2015-2016 Director Compensation Report, authored by Pearl Meyer and published by NACD, showed only a modest rise in director pay, and predicted the same for 2017. Nonetheless, director pay is becoming a hot issue for shareholders.
Consider the new guidelines from the leading proxy advisory firm, Institutional Shareholder Services (ISS), which serves some 60 percent of the proxy advisory market. Proxy voting guidelines of ISS and Glass, Lewis & Co. contain updates to discourage perceived director overboarding—and compensation does not follow far behind. It is notable that ISS amended its proxy voting guidelines, effective February 1, 2017, to include director pay. The ISS voting changes also include changes to ISS policies on equity-based pay and other incentives, as well as amendments to cash and equity plans, such as mandatory shareholder approval for tax deductibility. But the most unexpected development was ISS’ support for “shareholder ratification of director pay programs and equity plans for non-employee directors.”
ISS says that if the equity plan is on the ballot under which non-employee director grants are made, ISS policy would assess the following qualitative factors:
The relative magnitude of director compensation as compared to similar companies;
The presence of problematic pay practices relating to director compensation;
Director stock ownership guidelines and holding requirements;
Equity award vesting schedule;
The mix of cash and equity-based compensation;
Meaningful limits on director compensation;
The availability of retirement benefits or perquisites, and;
The quality of disclosure surrounding director compensation.
These values are not new. NACD went on record supporting such concepts in our Report of the NACD Blue Ribbon Commission on Director Compensation, issued in 1995. Every year since then we have issued an annual survey on director compensation with Pearl Meyer (cited above), reinforcing these key points.
In explaining the rationale for its policy update, ISS notes that there have been several recent lawsuits regarding excessive non-employee director (NED) compensation. For a summary of these lawsuits, see the Pearl Meyer/NACD director compensation report cited above.
ISS notes activity behind the scenes re director pay. According to the proxy vote advisor, “some companies have put forth advisory proposals seeking shareholder ratification of their NED pay programs,” and further, “ISS evaluated several director pay proposals during the 2016 proxy season, and we expect to see more submitted to a shareholder vote.”
Say on Pay for Directors?
Given the new interest in director pay, might it become subject to “say on pay” in the U.S.? Such a mandate has already begun overseas. Since 2013, Switzerland has had an “Ordinance against Excessive Compensation with Respect to Listed Companies.” The law mandates annual shareholder votes on the total pay awarded in any form by the company to its directors and, in a separate vote, to its senior executives. The pay period can be retrospective (last year) or prospective (next year). So far, after an initial wildensprung of rebellion against some boards, approval ratings have been very high. The 2017 proxy season may continue this trend—or contain surprises. Given volatility in the global economy, and in shareholder sentiment, it is wise to avoid complacency.
The upset presidential election victory of Donald J. Trump and the Republican party’s victory in races for the House of Representatives and the Senate signal major changes ahead in both the federal government’s approach to growth and the Federal Reserve’s approach to monetary policy. Most evident among forthcoming policy changes will be a return of supply-side tax cuts, large operating fiscal deficits, and a move back toward more traditional monetary policies that, over time, should lead to higher short and long-term interest rates.
Below is an outline of my views on the implications of a Trump presidency for economic growth, taxes and infrastructure, central bank policy, and interest rates and trade.
My firm anticipates that the Trump administration will attempt to achieve the economic equivalence of a strategic breakout with respect to the pace of economic growth. In other words, with the economy mired in a long-term sluggish growth path below 2 percent, the administration will turn to deficit spending, infrastructure, and fiscal stimulus to achieve stronger economic growth. The administration will also seek to reform Dodd-Frank in a significant way, which would be a boost for Wall Street, and will also move to inject private competition into the health care system.
While there will likely be a faster pace of growth in the near term, uncertainty about the role and status of the U.S. in the global economy may combine to create longer-term issues, particularly involving free trade that, ironically, act as a drag on growth.
Taxes and infrastructure
From a purely economic point of view, it will be difficult to lift the long-term growth trend much above 1.5 percent without significant tax reform and productivity-enhancing changes related to tax investments and improving national infrastructure. Given the major demographic challenges associated with the aging of the Baby Boomer generation, and the gradual entry of the Millennial generation into the workforce, the underlying conditions of the post-Great Recession economy are not conducive to a quicker pace of growth unless there is major tax and entitlement reform.
In our estimation, based on visits to policymakers in Washington, the order of operations for the first two years of the Trump Administration will likely proceed in the following fashion.
A move to engage on comprehensive tax reform will likely be one of the primary orders of business in January 2017. We expect the Trump administration to work with Congress to craft a deal that would revolve around lower individual and business tax rates along with an end to corporate tax inversions. Under these conditions, an attempt to lower individual tax rates based on the framework set out in the House Republican blueprint released in June of this year of 12, 25, and 33 percent, would be the most significant tax reform since 1986.At the heart of Trump’s tax plan is the intention to reduce taxes on pass-through entities (eg, sole proprietorships, limited liability companies, S Corps., and so on) to 15 percent, which would decisively favor the middle market, which accounts for 40 percent of GDP and employs one-third of the labor force.
The probability that a bipartisan bill on a multi-year infrastructure project will pass is high. The glue that would hold this together would likely be parallel legislation that would seek to tax the $2.6 trillion in corporate profits being held abroad. There is growing realization in both political parties that the infrastructure around the country has been allowed to slip into such disrepair that it has become something of a national embarrassment.
It is important to note that a robust infrastructure is not an economic panacea. It is a long-run productivity-enhancing policy that is more of a legacy issue, as opposed to something that will jump start economic activity in the near-term. If there is no tax reform, then growth will remain decisively in the sub 2 percent range.