Shareholder engagement remains highly topical in boardrooms across North America. Issuers are recognizing the benefits of speaking directly with institutional shareholders on a broad range of topics beyond financial results, particularly in today’s environment of increasingly influential proxy advisors and the ever-present specter of activists.
The task of engaging with shareholders used to rest with investor relations and senior management. But recently, directors have become more involved in engagements, particularly on matters related to the board, the CEO and executive compensation.
To provide perspective on the director’s role in engaging with shareholders, Steve Chan and Michelle Tan of Hugessen Consulting spoke with Richard DeWolfe, chair of the board of Manulife Financial Corp., and Margaret Foran, chief governance officer of Prudential Financial and chair of the governance committee of Occidental Petroleum Corp.
The role of directors in shareholder engagement is evolving. Who should lead engagements with shareholders?
DeWolfe: I prefer to engage shareholders on behalf of the board without the presence of management. This allows investors to express any concerns that they may have to the board directly—not filtered by management, not couched in language that management may find concerning or offensive. I have maintained a practice of having the head of investor relations (IR) accompany me for the purpose of listening and taking notes.
Foran: I believe that, as a starting point, the majority of engagements should be led by management, whether the corporate secretary or IR. If you talk with your top investors, most will say that it is not absolutely necessary to have a director involved in an engagement. Obviously, there are certain topics that the board needs to be involved in, including executive compensation, CEO pay, and succession. It’s hard to talk to the CEO or someone who reports to the CEO about their own pay.
Should directors directly engage with shareholders? Why or why not?
DeWolfe: We can find 1001 excuses why directors shouldn’t speak with shareholders. Directors are there to represent shareholders’ interest, so it seems ridiculous that there wouldn’t be an obligation on the part of the board to communicate with shareholders. One of the dangers of ignoring shareholders is hastening the arrival of activists.
I encourage all board members to act as observers in any and all investor presentations, to listen and understand the concerns of shareholders. However, not all directors are the best communicators in the sense of being able to articulate the issues or answer questions from shareholders. There should be a few directors who are designated spokespersons for the board and responsible for leading these discussions. This is one of the skills boards should consider as they recruit directors.
Foran: I go back to what I initially said: a lot of this can and should be done by management. There are some instances and there are some subjects that are harder to [discuss] without a director. Also, some investors want to talk to board members, so I think that to categorically say “never” [directly engage] is probably wrong. I think boards have to keep an open mind. I also agree that if you’re not prepared, then it can be a real negative [experience]. Every one of the institutional investors I know has stories of directors who have just been horrible [to work with]. At the same time, a good director who shows oversight, independence, and knowledge of the issue, and is a good communicator is a real plus. A real negative is having a meeting where the director does not do a good job, and at that point, it would be better to not have a director present at [at a shareholder meeting].
Smaller shareholders tend to rely more heavily on the proxy advisors. How can directors effectively engage with this part of the shareholder base?
Foran: Engagement is not just meetings, be it with management or board members. You engage through your proxy statement, your website, and letters, and I think people underestimate the effect that these venues can have. At Prudential, we have a letter to our shareholders from our board as well as the lead director [in the proxy statement], in addition to a video from the lead director that we embed in the proxy statement on our website. That video has gotten an unbelievable number of hits. For some of the smaller shareholders that may not have time or resources to engage, receiving a letter with the video link [to say], “We can’t engage with everyone, we just wanted you to see this, and if you have any feedback, let us know” can be very powerful.
What are your thoughts on engaging with the proxy advisors?
DeWolfe: We undertook engagement with the proxy advisors this year for the first time and I thought it was really helpful. First of all, we found them very responsive. We wanted to address concerns that they had raised about our proxy, and it gave us an opportunity to better understand how their judgments are formed. It gives you an opportunity to discuss your point of view on those things. And I think it would be helpful if more companies did engage them so that [the proxy advisors] were not simply making these judgments, or publishing opinions, without an opportunity to discuss how that advice was formulated.
Any advice for boards who expect to receive a negative say-on-pay recommendation from a proxy advisor? Can engagement with shareholders and/or proxy advisors help mitigate this?
DeWolfe: What I would say is that you can’t formulate your pay for performance on the basis of what you think the proxy advisor is going to say. You have to design your compensation systems on the basis of the economics of your business and what you believe will fairly reward management while maintaining the best interest of the shareholders.
If you know that your approach is likely to result in a “no,” it makes sense to engage key shareholders in advance. My suggestion is that it’s easier to explain your position up front rather than falling back and being criticized and then having your explanation seem like an excuse.
Foran: Don’t underestimate your disclosure. Proxy advisors and shareholders read proxy statements very closely. It’s like a test. Even though you may fail the multiple choice [section], if you have a good story, then you are probably going to get extra credit on the essays.
It is much better to make the extra effort and do a great job of telling your story in the proxy, and perhaps reinforce that with a meeting with investors and proxy advisors, than have to use a meeting to try to fill in the gaps in your proxy. To me, a good offense is better than a good defense, so figure out what your investors and the proxy advisors look at and address [those items] in the proxy statement.
People like to hate the proxy advisors, but they are just doing their job. If you are really unique, you need to tell that unique story. If you are going to fail on the quantitative tests, then tell that really good story, and that story is a board story, one the board believes in. You need to light the candle instead of cursing the darkness.
Is shareholder engagement an effective tool in dealing with activist shareholders?
DeWolfe: Director-led shareholder engagement allows boards to get ahead of being the subject of an activist attack. If your board knows the expectations of shareholders in advance, you’re on far safer ground than if you decide to hide in the boardroom and ignore shareholder expectations.
How would you describe your general experience with shareholder engagement?
DeWolfe: Going back probably 10 years ago when this really became a question for the board, my view was that having engagement was better than not having any engagement. However, you can’t just say “Well, we are going to have an engagement program,” and then go off and do it. It needs to be carefully planned and orchestrated to ensure that you are talking to the right people, covering the right bases, keeping track of the subjects of interest and ultimately using that as a way of guiding management in terms of meeting shareholders’ expectations. At the end of the day, it’s really using the board to keep management apprised of shareholder expectations and vice versa so people aren’t surprised. The only surprise people like is a birthday present.
Foran: I started doing this years ago when I was at Pfizer, starting with a meeting with the lead director and chairs of the committees with our top 30 investors. We invited them to Pfizer for an afternoon event and cocktails. This was in 2007, and one law firm called it “governance run amuck”. Now look where we are today.
If you talk with the major institutional shareholders, they will tell you that a rapidly increasing number of their engagements involve board members. So you see engagement evolving. People shouldn’t go crazy, but there are certainly companies and instances where it makes a lot of sense.
This article also appears in Director Journal, the official publication of the Institute of Corporate Directors.
The appropriate length of service by a company director is an emerging issue in corporate governance that yields varying responses among large shareholders, proxy advisors, and directors themselves. Recent board tenure concerns center around a director’s ability to remain independent after extended service, lack of industry expertise and technological familiarity, and poor diversity on corporate boards. Conversely, long-tenured directors can be beneficial because of their deep knowledge of the company acquired through service, the continuity and stability they offer, and their grasp of the historical perspectives that can inform current company strategy. As this issue continues to draw attention from various interested constituencies, corporations should continually assess board composition and consider their current policies on director tenure as shareholders become more attuned to extended service and its implications.
The Current State of Director Tenure in the U.S. and Abroad
No overarching law or regulation currently limits the length of board service in the United States. In fact, few United States public companies address board tenure directly in their bylaws. According to SpencerStuart, approximately 3 percent of company boards in the S&P 500 have specified term limits for directors. Only 17 companies in the S&P 500 set term limits for their directors in 2012, with no company adopting a term of less than 10 years. That same year, board turnover on the S&P 500 reached a 10-year low, reflecting the trend toward directors remaining in their positions.
Mandatory retirement ages are more common. SpencerStuart reports that 72 percent of companies in the S&P 500 have mandatory retirement ages, which reflects a 6 percent increase since 2003. Of those, the mandatory age exceeds 72 in 88 percent of corporate boards. Over the last 10 years, the percentage of boards with mandatory retirement ages of 75 or older has increased from 3 percent to 24 percent, while the percentage of boards with a mandatory retirement at age 70 decreased from 51 percent to 11 percent. Moreover, some U.S. public companies allow boards to waive the mandatory retirement age for directors, which is typically between age 72 and 75, according to David A. Katz and Laura A. McIntosh, authors of Renewed Focus on Corporate Director Tenure.
The lack of term limits and mandatory retirement ages promotes extended board service. Last year, 20 percent of U.S. corporate boards in the S&P 500 had an average director tenure of at least 11 years. The median age of directors was 63.
Director tenure limits are more prevalent outside the United States. The European Commission notes that an appropriate maximum tenure for a director is three terms, or 12 years. The United Kingdom employs the “complain or explain” model, which presumes that directors are no longer independent after nine years of service unless a company can explain why it has determined that a director remains independent after they reach the presumption threshold. France employs one of the most stringent guidelines for independent directors, capping director service at 12 years, though this does not give France the lowest average director tenure in Europe. That distinction goes to Germany, with an average director tenure of five years., Collectively, Europe has relatively shorter board tenures on average compared to the United States, which is 8.6 years. For reference, Spain has the highest average tenure in Europe at 7.7 years. In Asia, Hong Kong does not limit director service, but companies appointing an independent director to serve longer than nine years must employ a separate vote for the director using a special resolution.
Calls for Change
Recently, shareholder advocates have pushed director tenure to the forefront. Institutional Shareholder Services has been visible in highlighting potential issues with corporate director tenure, with its new Governance QuickScore 2.0 program. The product, which uses specific governance factors and technical specifications to rate company governance, takes director tenure into account. According to ISS, “[a] tenure of more than nine years is considered to potentially compromise a director’s independence.” ISS has not disclosed the weighting that each metric will actually have, so it is unknown how much impact long-tenured directors will have on a company’s QuickScore rating.
ISS has yet to alter its voting policy outside of QuickScore such that tenure can lead to a determination that a director is not independent. ISS does urge shareholders to vote against proposals to limit tenure by mandatory retirement ages or term limits, but it suggests shareholders scrutinize the average tenure of alldirectors if their tenure exceeds 15 years in order to promote independence and alternative perspectives.
State Street Global Advisors (SSGA) revised its view on board tenure in 2014 to reflect its support for board refreshment and planning for director succession. According to SSGA’s Head of Corporate Governance Rakhi Kumar, the new policy is “designed to identify companies with a preponderance of long-tenured directors, which may indicate a lack of refreshment of skills and perspectives . . . . [L]ong tenure may also diminish a director’s independence.” Though SSGA does not consider long-tenured directors to be entirely ineffective, SSGA discourages their presence on committees where “independence is considered paramount,” including the audit, compensation, and nominating/governance committees.
SSGA has indicated that it will screen companies based on whether their average board tenure is above one standard deviation from the average market tenure. If a company has a longer-than-average board tenure, SSGA will further screen it for (a) whether one-third of the non-executive directors have tenures in excess of two standard deviations from the average market tenure and (b) classified board structures. Following this screening, SSGA has indicated it may vote against the chair of the nominating committee, long-tenured directors serving on key committees, and/or (c) both the members of the nominating committee and long-tenured directors at companies with classified boards. SSGA, however, has not provided additional details on how it computes average board tenure.
The Council of Institutional Investors supports board turnover in order to guard against a “seasoned board member” losing his or her independence or thinking more like an insider over time. Further, CII’s policy highlights the high salaries that accompany director positions, and how the compensation fails to promote board refreshment. It is estimated that S&P 500 companies pay independent directors an average annual salary of $250,000. Despite an updated policy, however, CII refuses to deem its policy as endorsing a tenure limit, highlighting that removing long-tenured directors “could rob the board of critical expertise.”
Glass Lewis & Co. pushes back on the idea of an inflexible rule limiting director service. Glass Lewis believes such inflexible limits may not provide benefits or returns for shareholders. Its 2014 proxy policy thus reflects the idea that term and age limits are not in shareholders’ best interests, and that there is no evidence of a connection “between either length of tenure or age and director performance.” Nevertheless, Glass Lewis supports “periodic director rotation” through shareholder monitoring to promote fresh perspectives, new ideas, and business strategies. Glass Lewis notes that if a company does have an age or a term limit, shareholders should vote against the board waiving its self-imposed limit absent extenuating circumstances like a merger.
The Effects of Board Tenure Limits
There is no “one-size-fits-all” approach to board tenure. There are merits to imposing board tenure limits at some companies, specifically the potential to promote the independence of corporate directors by limited extensive service. Some directors may also become complacent or out of touch with the company or industry after extensive service. Replacing long-tenured directors may offer a new opportunity for the company to infuse fresh perspectives into the board, whether it may be in corporate strategy or industry expertise. In addition, boards can use mandatory retirement ages or term limits to avoid otherwise unpleasant conversations with directors whom the board believes should retire.
Despite the potential benefits of mandatory director refreshment, there is no strong indication that long-serving directors are not independent, which is the primary concern of those who criticize extended board service. A “one-size-fits-all” approach to term limits or mandatory board refreshment would restrict or remove experienced, knowledgeable board members arbitrarily and create situational difficulties for the company going forward. As noted above, long-tenured directors are often the most knowledgeable about the company and offer stability, particularly during changes in senior management. In addition, at some companies the most long-tenured directors often exercise considerable influence over less-tenured senior management. These factors balance heavily against any strict rule on board tenure. Additionally, term limits offer the potential to interfere with the development of effective collaboration among board members that have developed strong working relationships over the course of their tenures.
It remains to be seen if the increased attention on board tenure will have a significant impact on the corporate governance of U.S. public companies going forward, or if the international trends will be imitated in the United States. Mandatory term limits applicable to all U.S. companies are inappropriate. Rather, companies should continue to have the choice of whether to impose restrictions on board tenure. The important issue, therefore, is how companies make that choice. We suggest a thoughtful consideration of board composition by nominating committees, boards and shareholders on a case-by-case basis that considers tenure, expertise in the particular industry, knowledge about a particular company, diversity, director competency, and the company’s success over the director’s tenure. Boards must also carefully assess their own composition in light of various experiences, backgrounds, skills, and traits that could enhance board performance. Boards themselves, along with input from their shareholders via annual director elections and shareholder engagement, are best equipped to assess whether to retain or remove their own directors, and should not be burdened by a uniform rule that may potentially yield unintended consequences to the detriment of the company and the shareholders.
Steven Haas is a partner in Hunton & Williams’ Richmond, VA, office. He represents clients on corporate governance and M&A matters. He also regularly counsels clients with respect to corporate governance issues and fiduciary duty litigation.
On March 3, 2015, NACD in partnership with Compensation Advisory Partners, Farient Advisors, Pay Governance, Pearl Meyer & Partners, Semler Brossy, and Steven Hall & Partners, will host its annual Leading Minds of Compensation event in New York. Here, a collective of the nation’s leading experts will provide their insights on compensation challenges directors need to be attuned to in 2015. In anticipation of this event, Semler Brossy’s Blair Jones and Seymour Burchman explore the perpetual issue of pay for performance.
When it comes to executive compensation and company performance, directors commonly go by the following “rule:” The goals for the coming year should exceed last year’s results. Some directors believe that, if performance goals decline, executives should not receive any bonus, even if the business environment won’t allow the company to exceed its prior performance record. But the rule that requires companies to always set higher goals for top-line and bottom-line results should not be considered hard-and-fast. Even as companies aim for long-term, continuous improvement, there are legitimate cases when lowering the bar is acceptable.
Three situations show that circumstances occasionally dictate the need for lowering performance goals. The first situation is when a company is run by executives who consistently deliver outstanding performance, but in an economic downturn oversee a period of falling results that still top the industry. (This example holds true for virtually any company caught in a major economic downturn.) The second is when a company comes off several years of great results, but executives and the board decide to make major investments to enhance long-term competitiveness, lest competitors catch up. The third is a cyclical commodity-based company that, in spite of best-in-class operational efficiencies and rising sales, gets blindsided by volatile raw-material prices, boosting the costs of goods sold by a third or more.
Executives at these companies should not always be expected to demonstrate year-over-year improvement. Asking them to essentially juice results during a single year might even hurt the long-term success of the business. (Deferring an investment to meet current year profit goals may result in losing ground to competitors in the long term. Similarly, deferring maintenance to reduce current year costs can lead to increased downtime down the road.) That’s not to say directors should accept anything less than a long-term record of sustained, rising results, only that for temporary periods decline may fit within that record.
So what steps can a board take to ensure that year-over-year declines are truly exceptions? First, directors should begin every goal-setting cycle with the simple premise that year-over-year improvement is the standard. Second, if management contends that a decline is inevitable, directors should consider the steps management has been taking to anticipate and mitigate the decline. For example, are there valid strategic reasons for a decline, such as ramping up long-term investment? Can the board reasonably expect, based on management’s plans, that investments will lead to future performance that compensates for the decline?
If external forces are contributing to the decline, the board needs to consider whether management explored all reasonable alternatives to avert the decline. Key questions the board should raise include:
If a demand slowdown was forecasted, did management adequately explore new market opportunities to offset declines via new channels, new geographies, or the use of new methods to reach customers (e.g., “big data”)?
If raw material costs were forecasted to rise, did management consider hedging increases or consider alternative sources of supply?
If competitors have breakthrough product launches planned, did management anticipate these launches, and where possible, accelerate its own development of potential competing products?
If manufacturing costs were forecasted to rise, did management either consider reengineering current processes or explore potential cheaper outsourcing solutions?
If disruptive technologies were likely to affect the industry, did management position the company to swiftly take advantage?
As part of examining the steps management is taking, the board should also look at its own actions. Key questions the board should ask itself include:
Was the board involved fully in the development of this strategy, and did executives make short- versus long-term tradeoffs clear?
Have directors demonstrated adequate goal-setting discipline themselves as evidenced by balance and symmetry in their decisions over time?
Were unfavorable circumstances that resulted in more lenient goals balanced by favorable circumstances with more aggressive goals?
If the board is to make exceptions to an otherwise universal standard of continuous improvement, it needs to follow certain standards in adjusting goals. It may be that a board can become comfortable in setting lower goals at threshold and target, but maximum goals require truly superior performance.
Third, once the board makes an exception, it should balance the interests of the management team and shareholders. Shareholders deserve to know that directors have set adequate stretch goals to drive superior performance. Over time, goals should result in performance and payouts that meet four tests:
They are sufficient to generate returns above the risk-adjusted cost of capital, and presumably in turn boost total shareholder return.
They align relative pay and performance with peer companies.
They represent a fair sharing between executives and shareholders of the value created.
The rewards are sufficient to keep executives motivated and engaged.
No director takes the lowering of performance goals for granted. Management has the responsibility to develop, execute, and reformulate a strategy to deliver year-over-year improvements. But times come when exceptions are warranted for the long-term success of the company. The aim then is simply to create the most effective way to reward and motivate executives while keeping performance at the necessary level for sustained success.
An executive compensation consultant since 1991, Blair Jones currently serves as a managing director of Semler Brossy Consulting Group. She has worked extensively across a variety of industries and has particular depth of expertise working with companies in transitional stages. She may be contacted at email@example.com. Seymour Burchman is a managing director of Semler Brossy Compensation Group and has been an executive compensation consultant for over 20 years. His work focuses on reinforcing key strategies and leading to improved shareholder value through the identification of performance measures and goal setting processes. He may be contacted at firstname.lastname@example.org.