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Future Proofing the Board: Corporate Culture on the Agenda

November 16, 2018

With the spotlight on boards continuing to intensify, the role of individual directors and the effectiveness of the board as a high-functioning team have taken on even greater importance.

While board refreshment, c-suite succession planning, diversity and inclusion, executive compensation and cyber security are not new board matters, they have taken on a heightened sense of urgency. This is so because of a climate where activist investors continue to turn up the heat, the speed of business transformation is relentless, unpredictability and volatility within markets is now the norm. Importantly cultural risk is now being covered in a new manner. Media attention, employee experiences, regulatory intervention, investor perspectives, and boardroom action have all evolved rapidly in highlighting the toxic effects of a culture gone awry.

In its 2017 Annual Stewardship Report, State Street Global Advisors, one of the world’s largest asset managers, noted its revised stewardship program with a focus on environmental, social and governance (ESG) practices on the heels of its “Fearless Girl” gender diversity campaign, which called on more than 700 companies in Australia, the UK and the U.S. with no women on their boards to add at least one woman. State Street noted that within a year, more than 20 percent of the companies responded to their call by adding a woman to their boards.

As activists are savvy at building a case and positioning themselves as a force for good, boards need to be just as sharp at running the right kind of analysis and effectively messaging their decisions - proactively positioning company strategy, operational moves and any leadership, governance and board changes at a time when activist capital continues to be forcefully directed. There is no room for passivity. The key is ensuring the right team is around the table to consider risks and opportunities.

Corporate culture is thus receiving increased media, stakeholder and regulatory attention as a matter of risk, governance and shareholder value. Words like values, behaviors and attitudes are increasingly focused on and used by stakeholders with the ability to shake a business model or alter the reputation of a company. Reputation and trust are at the center of the business conversation. In such an environment, the role of the board is central in shaping corporate culture and in addressing it as a risk factor to the organization.

There is no better 2018 example of large shareholders holding boards accountable than Elaine Wynn’s successful proxy contest at Wynn Resorts.  Elaine Wynn, the company’s largest shareholder, co-founder, and ex-wife of former CEO Steve Wynn, launched a proxy contest to rid the board of long-time directors that she believed took a blind eye to Steve Wynn’s sexual misconduct during his tenure as CEO.  Steve Wynn stepped down from his leadership role in February 2018, but Elaine Wynn undertook a proxy contest to remove one of the board members in a symbolic gesture to restore integrity to the company and mitigate risks to its casino license in Massachusetts.  By July, two legacy directors had stepped down and a new vice-chairman was added at the suggestion of Elaine Wynn.

Many companies are making decisions that weigh social values and behavior as important to shareholder returns.

In March 2018, Citi CEO Michael Corbat announced Citi was instituting a new U.S. Commercial Firearms Policy in the wake of the Parkland, Fla., school massacre. The announcement noted the policy was not meant to be centered on an ideological mission to rid the world of firearms. Citi was criticized by some for wading into social policy and lauded by others for being willing to take a stance in the divisive nationwide gun control debate.

Starbucks closed almost all of its stores for several hours in May 2018, to raise awareness of unconscious bias, in an effort to counter potential criticism that could drive away customers.

Television network ABC cancelled the hit television show “Roseanne” after the show’s star, Roseanne Barr, posted a vile tweet.  In June 2018, the Business Roundtable issued a statement urging the Trump Administration “to end immediately the policy of separating accompanied minors from their parents. This practice is cruel and contrary to American values.”

Against this backdrop of cultural concerns, Sen. Elizabeth Warren highlighted a proposed new bill in an op-ed the Massachusetts Democrat published in The Wall Street Journal on August 14, 2018.  Warren’s "Accountable Capitalism Act" would require companies with more than $1 billion in annual revenue to acquire a federal charter that would force corporate directors to consider the interests of "all major corporate stakeholders — not only shareholders." Warren is seeking to empower employees, customers and communities in corporate actions. It's unlikely the bill will become law (for now) but it indicates the level of dialogue happening in political arenas over corporate responsibility to all stakeholders.

#MeToo Effects

The focus on corporate culture and stakeholder responsibility has been elevated in a very specific way, with the #MeToo movement. While the #MeToo movement has moved through politics, media, and business over the past year, the movement is not new. As leadership teams and boards work to understand and manage revelations from the #MeToo movement, the conversation around persistent pay and leadership gender gaps has been amplified. These gaps are also not new.

In September 2018, CBS Corporation announced that Leslie Roy Moonves would depart as Chairman, President and Chief Executive Officer and six new independent directors were elected to the Board. As part of the transition, it was announced that Moonves and CBS will donate $20 million to one or more organizations that support the #MeToo movement and equality for women in the workplace.

Patterns of behavior that have long been ignored or hidden are being discussed in a bold new way.  Yet there remain a lot of questions on how best to create a culture that not only prevents bad behavior but paves the way for advancement for all.  The current climate has led to a much bolder conversation – including heightened expectations for action – about the responsibility of the board as it relates to culture.

Culture in the Boardroom

Culture is not coming to the boardroom. It is IN the boardroom - across values and behaviors – and should be viewed through the lens of risk management. Business leaders tell us that conduct of senior management teams is an important driver of reputation. If boards uncover behavior which could derail culture, it should be captured as part of risk assessment activity.

A lot has been written recently about the ability of the board to have a point of view when culture is putting the company at risk. Does the board know how to lead and work through necessary conversations during the spotlight of the media and widespread scrutiny? Is there a risk for overreacting? Is there a way to ensure that questions about the CEO’s behavior are handled appropriately? Are robust discussions on strategy, risk management and culture able to occur?

Equally as important is the culture of the board. What is the culture of the board to address these kinds of issues? Does the board’s culture allow for timely escalation of risk issues? Are candid conversations taking place within the committees and full board? How is the board engaging with management?

In 2018, Gartner found that 87 percent of directors report having a good understanding of their organization’s “tone at the top,” but only 35 percent have a good understanding of what the culture looks like at the mid-level, and just 18 percent at the lower levels of the organization.

According to the EY Center for Board Matters, there are continued challenges to organizational integrity that remain top of mind for leadership in organizations.  In EY’s 15th “Global Fraud Survey,” 36 percent of respondents indicated that fraud and corruption pose the greatest risks to their business. While other risks - macroeconomic, cyber, and regulatory - still pose challenges, the importance of a culture of integrity is clear.

Effects of Culture Risk                                               

When governance, culture, ethics, compliance, and monitoring fail an organization or in markets, it can have disastrous effects not just on the company, but on the sector and region. In February 2018, investors in Dubai private equity firm Abraaj asked for an investigation into the alleged misuse of hundreds of millions of dollars in its $1 billion healthcare fund. A Financial Times July 30, 2018 article noted that Abraaj’s difficulties have put the region’s corporate governance in the spotlight.  For years, experts in the region had warned about poor corporate governance standards, which could impact investment.

Global standards in governance help markets and companies keep pace with the rest of the world, or they may suffer a decrease in capital flows if investors view the governance risks to be greater than the rewards of investing in lagging markets. Active oversight of organizational culture is a key component to preventing a governance failure.

To be most effective, a board must support a business’s strategic imperatives. Proactive evaluation of board effectiveness on an ongoing basis should no longer be described as aspirational or “best-in -lass.”  It is a way of working to preempt threats across a multitude of areas (cyber security, c-suite succession planning, transparency, scrutiny of CEO compensation) and to best manage threats when they land at your door.

Future-proofing the board is not a new recommendation. It is this climate that has elevated it in a new way. It has gone from an aspirational “best practice” to an ignore at your own peril.

When future proofing is conducted with close consideration of corporate governance trends and the identification of potential reputational threats, the board will be in a stronger position to preempt threats, such as activists, and create long-term value.

A strategic board functions well as a team, adds value, and communicates effectively. It includes a diversity of views and experience aligned to the Company’s business strategy. This creates a constructive environment where future planning is fully activated, and the board is challenged on critical topics – business issues, culture, innovation, disruptors, and CEO and board succession planning.

Managing Culture

Boards must be able to monitor and oversee a set of qualitative data and subjective criteria that defines culture in an organization, along with the way in which those factors combine to create behavior – from performance reviews and incentive structures to employee training and consequences for inappropriate actions.  Because of this, ethics and compliance training in organizations and tools to measure compliance in a company have become more prevalent.

Yet many directors today are asking how they can go beyond risk metrics, company policies and procedures, checks and balances, reporting methods, employee surveys, data, compliance and regular presentations to the board in a manner that respects the governance structure. Many view it as one of their hardest tasks. How can – and should - the board dig deeper? Should board members talk to employees outside of the standard senior management presentation to the board? What happens when there are policies in place, but employees do not feel “safe” in reporting problems? What happens when a violation of a non-fraternization policy that has been ignored for many years is suddenly activated?  When should the board be notified of an issue?

According to NAVEX Global’s 2018 Ethics & Compliance Training Benchmark Report, there has been a re-evaluation of ethics and compliance programs, particularly regarding training.

In NAVEX Global’s report, they found that 73 percent of organizations are now training their board of directors on compliance. This is well above the past two annual surveys, which were below 60 percent. The 2018 report highlights a growing trend to improve executive-level training and a recognition that current training efforts have simply not done enough to create a norm around what constitutes acceptable workplace behavior.

In its survey, 68 percent of respondents indicated that evolving to a culture of integrity, ethics, and respect was one of the most important Ethics and Compliance program objectives for the organization.

According to the report, ethics awareness is also reflected in hotline reporting trends: there was an uptick in the rate of harassment-related reports made in the fourth quarter of 2017, coincident with the rise of the #MeToo movement.

Global View of a Board’s Role

Over the coming years, global capital inflows are likely to tend towards boards that demonstrate effective oversight of their organization’s culture. Otherwise, a risk premium would need to be attached to investments where questionable culture could create risks and erode shareholder value.

In its 2016 report, “Corporate Culture and The Role of Boards: Report of Observations,” the UK’s Financial Reporting Council (FRC) undertook a project to better understand how boards are steering corporate behavior that will in turn deliver sustainable good performance. Key observations listed as part of the FRC’s findings include:

  • Recognize the value of culture; don’t wait for a crisis to focus on it
  • Demonstrate leadership; boards have a responsibility to act
  • Be open and accountable; it is part of good governance
  • Embed and integrate; corporate risk functions should be empowered
  • Assess, measure, and engage; boards should evaluate and have reporting on culture
  • Align values and incentives; rewards systems should support values
  • Exercise stewardship; engage with investors about culture

Sir Winfried Bischoff, FRC Chairman, summarized the project in indicating that boards are taking action to shape culture, which will drive capital allocation, improve productivity, and deliver sustainable value.

Benefits of Alignment

There is growing evidence that boards understand and are working toward embedding culture oversight into their role overseeing sustainable performance.

Alignment of director compensation with culture (see dialogue box) is an effective way to ensure that incentivizes the board to properly oversee culture, guard against scandals and risks, and promote diversity and inclusiveness as part of its long-term strategic and economic objectives.

Aligning Director Compensation with Culture

Martha Carter and Carol Bowie

Board compensation is another part of the cultural fabric that should not be overlooked. While pay is not generally considered a significant motivator for Board service, it incentivizes behaviors just like any compensation structure. Controversy around director pay lags far behind media and investor criticism of executive compensation, but lawsuits claiming self-dealing and corporate waste by directors approving allegedly excessive pay increases for themselves have been on the rise. And a landmark court case and evolving proxy advisor policy on director pay may instigate even more scrutiny that could fuel activists’ firepower.

A Governance View of Board Pay

Best practice guidance from organizations such as the NACD and various governance groups rests on the principle that director pay reflects a board's approach to oversight of executive compensation, as well as its overall philosophy regarding corporate governance and directors’ commitment to putting shareholder and stakeholder interests ahead of their own.

The general rule of thumb is to ensure that Board pay is meaningful enough to engage directors, and pay fairly for their time and expertise, while avoiding levels and elements such as perquisites, pensions, and performance-based pay that could compromise their objectivity in monitoring -- and challenging – management or that could serve to entrench them. Most U.S. companies now deliver a substantial portion of Board pay in the form of equity awards that explicitly align directors’ interests with shareholders. And the increasing importance of specific Board roles, such as lead director, separate Board chair, and key committee chairs, has led to more compensation for them. At the same time, increased transparency, as more information about director compensation has been disclosed in proxy statements (including the actual amounts paid to each board member) has given shareholders a wider window into board pay practices.

ISS Increases Scrutiny

In the past, Board pay generally fell under the radar of proxy advisors in the absence of conspicuously egregious numbers that could raise questions about directors’ independence. But last year Institutional Shareholder Services (ISS) disclosed a new policy that will have an impact in 2019.

Under its new approach, ISS said it will make a more systematic evaluation of director compensation and, beginning in 2019, recommend that its institutional shareholder clients vote against directors who sit on the Board committee responsible for setting it when the evaluation indicates a recurring pattern of “excessive pay . . . without a compelling rationale.”

Delaware Court Lowers the Lawsuit Bar

In addition, a Delaware Supreme Court decision (Investors Bancorp, Inc. Stockholder Litigation) in late 2017 also raises new risks. In this case, the higher court reversed a Delaware Chancery Court decision that the company’s directors were shielded by the business judgment rule when they granted themselves equity awards that collectively totaled more than $21 million in value.

Board Pay in a New Light

The factors of the Investors Bancorp case are unusual, but the Delaware high court’s ruling could put more arrows in the quiver of activist shareholders. And while it also remains to be seen how ISS will determine “excessive” Board compensation, the implications of both developments should lead more companies to seek shareholder approval of more specific director pay caps and further limit discretion, as well as any exceptional pay without convincing rationale.

Some companies are also re-examining their director compensation programs in light of other forces influencing board culture. The growing focus on regular board refreshment, to ensure an appropriate mix of skills and experience as conditions and company strategy evolve, has led some companies to reduce or eliminate equity grant vesting periods that could disincentivize a director from stepping down early.  As board culture evolves, so should its compensation practices to align governance, culture, strategy, and values in a meaningful way.

Checklist for Next Steps

As shown through many examples, the lack of culture and ethics can bring down an organization and its leadership.  Measuring, managing, incentivizing, and reporting on culture needs to be part of the agenda at board meetings.  Culture will be factored into ongoing benchmarking of overall risk management along with the assessment of business strategy.

A checklist for assessing and acting on culture risks is included below.

  • Be proactive and strategic: assess vulnerabilities before threats happen and build assessments and reviews into the wider strategic business planning process.
  • Understand and communicate: evaluate the landscape of investors’ perspectives, activist targeting, and regulators’ demands, and use communication tools to their fullest effect.
  • Assess board culture: ensure the board is set up for candid conversations.
  • Go beyond the obvious: explore additional ways to take the pulse of the company beyond senior management.
  • Engage and disclose: Undertake a multi-year investor engagement plan with clear metrics and goals around culture.
  • Connect the dots: ensure alignment with incentive structures match values.
  • Review and Refresh: treat the benchmarking and assessment as an ongoing process for reevaluation.

Board members have a responsibility to assess behavior and culture. The board will be expected to have a strong framework in place to address culture, which when done successfully, will have a positive impact on long-term value.