Developments in Best Practices in the Boardroom

Board composition and environmental, social and governance (ESG) issues have been a focus of good governance for several years. 

We featured both of these topics in our memo to boards of directors last year.  In the past year, the focus has continued to intensify and many companies are becoming increasingly responsive on these issues—both in public and private engagements.  There have been significant developments in these areas in 2017 that merit review as companies prepare for 2018.  In addition, the Board of Governors of the Federal Reserve System (FRB) released guidance on board effectiveness that may affect how even non-financial institution boards view their oversight role.

Board Refreshment and the New York City Comptroller

This past September, New York City Comptroller Scott M. Stringer and the New York City Pension Funds launched the “Boardroom Accountability Project 2.0,” calling on companies to make their boards more diverse and to enter into a dialogue regarding their board refreshment process with the Comptroller’s office. 

As part of the campaign, Comptroller Stringer sent letters to the boards of 151 U.S. companies urging them to disclose the race, gender and skills of their board members in a standardized director-qualifications matrix.  Of these 151 companies, 92 percent have adopted proxy access, thus their boards face the possibility of a proxy access candidate or other shareholder proposal if they do not demonstrate meaningful progress in expanding diversity on the board.  This all comes at a time when BlackRock and State Street have started voting against nominating and governance committee members that fail to demonstrate progress in addressing diversity issues, and, in its 2017 Investment Stewardship Annual Report, Vanguard emphasized its focus on gender diversity in the boardroom.

Proxy advisory firms ISS and Glass Lewis have as part of their annual review of voting guidelines included considerations regarding board diversity, a key driver of refreshment.  ISS noted that board composition should be significantly diverse to consider a wide range of perspectives and will highlight a lack of board diversity in its company-specific reviews.  Glass Lewis put companies on notice that beginning in 2019, it will recommend that shareholders vote against the chair of the nominating and governance committee at companies with no female directors (although it seemed to make allowances for non-Russell 3000 companies) and hinted that depending on other company factors, including size, industry and overall governance profile, its no-vote recommendations may extend to other nominating and governance committee members.

Many companies have heeded the warning; according to Spencer Stuart, women and minorities accounted for half of the nearly 400 independent directors added at S&P 500 companies as disclosed in 2017 proxy statements, an increase of 15 percent as compared with 2016 proxy statements.  However, this news is tempered by the fact that nearly half of S&P 500 boards did not appoint a new director and many boards continue to rely on mandatory retirement ages as the driver for refreshment.

In light of the focus on board diversity and refreshment, below are some practical steps that boards can begin to take as they prepare for the 2018 proxy season:

• Critically review board composition and skill set.  The nominating and governance committee should critically reflect on the board’s progress in diversity recruitment and review the skill set of the board against current and projected needs.  
• Enhance the director search process.  The lack of board diversity at many companies results in part from a nomination process that relies largely on the recommendations of existing directors.  Boards should consider how they can enhance the director search process (e.g., soliciting investor recommendations; engaging director search firms; looking outside of existing networks) to identify a more diverse mix of candidates.   
• Review corporate governance documents.  The nominating and governance committee should review its committee charter and the corporate governance principles to ensure that the company’s commitment to board diversity is appropriately reflected.         
• Engage with shareholders.  Institutional investors expect companies to actively engage with them on diversity and board refreshment issues.  Companies should review and, if necessary, revise their disclosures on board composition and diversity and consider discussing their plans for improving board diversity over time.

In launching the Boardroom Accountability Project 2.0, Comptroller Stringer stated, “Diversity isn’t a box to be checked—it’s a strategy for economic success.  Today, we’re doubling down and demanding companies embrace accountability and transparency.”  As investor attention to board diversity and refreshment continues to grow, it will become increasingly important for companies to demonstrate corporate governance practices that support more diverse, independent and effective boards.

Tone at the Top

Tone at the top has been a focus for boards for several years, brought into sharper focus by corporate crises, such as at Wells Fargo, particularly after the report commissioned by Wells Fargo’s independent directors was released.  Tone at the top is also an important feature of governance and social trends, as investors and other stakeholders expect that companies will be responsive from the top down and recognize that company standards, culture and compliance are directed and influenced by those in the boardroom. 

In the past few years, shareholder proposals and city and state legislation have brought gender pay inequality to the spotlight, while gender imbalance in such industries as tech and finance has been making headlines.  The pressure from the top down and the bottom up is likely to result in C-suite diversity becoming a primary focus for public companies. In their role as overseers of management succession, directors should examine closely the candidates and plans presented to them and ensure that the issue of diversity has a sufficient focus.  Tone at the top is meant to inform the tone of the entire company—and after the board, senior management is next in line.  Many companies focused on improving board diversity at the board level, as discussed above, continue to lag in gender and race diversity at the executive officer levels.

Boards should also pay attention to another topic in the news—sexual harassment.  Boards should inquire as to the status of the company’s sexual harassment policies and training, as well as complaints, complaint procedures and complaint resolutions.  Companies should be revisiting their policies, training and procedures to ensure that they foster environments in which employees feel free to raise issues and, if so, to find such issues dealt with fairly.  Boards should ask for confirmation of these efforts. 

While day-to-day HR matters may seem unlikely fodder for boardroom presentations, an ongoing and dedicated commitment to respect in the workplace resonates throughout a company.  As with company-wide compensation plan design and execution, a board should demand to be informed as to the soundness of company-wide harassment policies and procedures and as to the vigilance of their enforcement.

Environmental, Social and Governance Focus

The trend of increasing investor focus on ESG issues continued in 2017.  Shareholder proposals on the full range of ESG topics—from climate change reports to board diversity to employment discrimination—have continued to gain momentum.  In addition, a number of these institutional investors—most notably BlackRock, State Street and Vanguard—have issued statements or guidelines highlighting ESG issues:

• In 2017, BlackRock released its “Investment Stewardship” priorities with climate risk disclosure as one of the five areas of focus, as well as a series of ESG-related white papers.  BlackRock has indicated that it expects the whole board to have “demonstrable fluency” in how climate risk affects the business and how management mitigates risk.
• In its 2017 annual letter to investors, State Street stated its belief that ESG issues can have a material impact on a company’s ability to generate returns in the long term, and it continued to tie corporate scandals to poor management of ESG risks.  State Street has also indicated that it expects companies to disclose information on relevant management tools and material environmental and social performance metrics.
• Vanguard, in a significant shift in spring 2017, changed its voting guidelines with respect to ESG shareholder proposals and now considers proposals on a case-by-case basis, supporting those where there is a “logically demonstrable linkage between the specific proposal and the long-term shareholder value of the company.”

Although these proposals are generally still not yet receiving majority support, three proposals seeking environmental reports from oil and gas or utility companies did pass with support from some of the leading institutional investors, making this an area to watch in 2018. 

A number of institutional investors have urged companies to participate in the Sustainability Accounting Standards Board (SASB) standard-setting process.  In October 2017, SASB released for public comment its latest round of draft industry-specific standards, with the hope of developing a more standardized approach to ESG disclosure.

On the other side of the scale, however, is the November 2017 SEC guidance on excluding shareholder proposals from a company’s proxy statement (Staff Legal Bulletin No. 14I).  This new guidance suggests increased deference to companies on the part of the SEC and may allow companies to exclude more proposals from the proxy statement, particularly in the ESG area, although how liberally it will be applied remains to be seen (particularly because the first company to rely on it did not receive no-action relief). 

In particular, the guidance highlights the board’s assessment of the significance of the policy issue underlying the shareholder proposal.  As a result, boards will likely be asked to assess some of the shareholder proposals companies receive, a change from previous common practice of informing the board or the nominating and governance committee of proposals but not generally seeking direct board action on them.

In light of these developments, some actions we recommend for companies and boards for the coming year in the area of ESG include:

• Review ESG disclosure in SEC filings and outside of SEC filings to consider whether there are areas that could or should be aligned (e.g., what risks are being portrayed as “material” across communications);
• Review how ESG information functions fit within the company’s control environment;
• Develop a process for elevating ESG information and management to the board;
• Ensure investor relations teams are soliciting feedback on ESG issues, pay attention to shifts in institutional investor behavior and know what issues are important to which investors in the company’s shareholder base;
• Keep an eye out for shareholder proposals that are gaining shareholder support over time;
• Prepare a strategy for responding to shareholder proposals, including a process for the board or relevant committee to assess the significance of underlying issues;
• Monitor industry and peer company developments and plan for how to address criticisms or gaps in the company’s approach to ESG compared to others; and
• Ensure ESG programs, initiatives or other evidence of commitment to ESG issues are showcased and emphasized for shareholders.

Guidance on Board Effectiveness for Large Financial Institutions

In August 2017, the FRB issued proposed supervisory guidance addressing effectiveness for boards of directors.  The proposed board effectiveness guidance (BE Guidance) would apply to certain large bank and thrift holding companies supervised by the FRB.

The BE Guidance responds to concerns that boards of directors have been spending disproportionate time and resources on matters outside of their core responsibilities and that distinctions between the roles of the board and senior management have been blurred.

The FRB’s proposal generally has been viewed positively by affected institutions.  At the same time, the practical implications of the BE Guidance will depend not only on how it is finalized after the public comment process, but also on how it is implemented by Federal Reserve examiners in the field.

The BE Guidance would define and explain the following five key attributes of effective boards of directors:

1. Setting clear, aligned and consistent direction regarding the firm’s strategy and risk tolerance.

2. Actively managing information flow and board discussions.

3. Holding senior management accountable for implementing the firm’s strategy and risk tolerance and maintaining the firm’s risk management and control framework.

4. Supporting the independence of the independent risk management and internal audit functions.

5. Maintaining a capable board composition and governance structure.

The BE Guidance is part of a package of complementary proposals, which also includes:

• Streamlining and clarifying previous FRB guidance to align with the BE Guidance;
• Revising previous guidance to clarify which examinations findings should be directed to the board of directors (vs. management);
• Creating a new large financial institution rating system for large bank and thrift holding companies (which would incorporate the BE Guidance); and
• Clarifying the guidance that would apply to smaller bank and thrift holding companies (below the $50 billion asset threshold for the BE Guidance).

The BE Guidance and related proposals signal a potential shift toward a more streamlined and risk-based supervisory approach to defining expectations of boards of directors.  At the same time, FRB Governor Jerome Powell has noted that the FRB does “not intend that these reforms will lower the bar for boards or lighten the loads of directors.” 

Public comments on the BE Guidance are currently due on February 15, 2018.

While the proposal will only affect regulated financial institutions, the focus on the board’s responsibility to guide strategy and oversee compliance and risk management are familiar issues for boards to reflect on periodically. In addition, the spotlight on the independence and stature of the internal audit and risk management function highlights the importance of those areas in all companies in providing critical information to both management and the board.

Finally, at a time when directors may feel that they are suffering from “information overload,” it might be appropriate to consider whether the standard information package strikes the right balance between clear communication of risks and opportunities and sufficient detail to allow for effective oversight.