Challenging the Current Board Structure: Activism Continues to Evolve
The purpose of corporations, the structure of their boards and the nature of their directors are no longer just abstractions. Now, corporations must seek to diversify the homogenous nature of directors, including their historically similar backgrounds, education and networks. Also, to be sought are broader board actions that go beyond just, “checking the box” or taking a reactive stance towards events. Vigorous, relevant boards are needed to sustain good governance and oversight.
The debate on corporate board structure and resources has been stimulated by the continuing evolution of activism, in particular, employee activism, which is on the rise. In this climate, it is crucial to have a high-performance board, best-in-class governance, and a way of working together that supports the CEO and ultimately the company and its shareholders. The best practice corporate board structure is composed primarily of independent directors, who have no ties to management. These directors take on part-time roles with full-time fiduciary duties.
Event-driven processes will not be sufficient to demonstrate good governance and oversight. Boards will be expected to continuously reevaluate their structure and resources, and plan for succession in order to be in the best position to provide thoughtful oversight.
To Whom Should the Board Answer?
An important aspect when considering board composition includes the constituents to whom the board must answer. Shareholders, as the owners of the company, expect boards to represent their interests and to engage with them. Yet, that has not always been the case. As investor stewardship, including pressure from active owners and activists, has been on the rise over the last decade, so too has the debate about the interests of shareholders versus stakeholders. Decades ago, the only interaction between board members and shareholders was the election of the board, which often occurred only once every three years. It was rare for a shareholder to interact with a member of the board of directors. Instead, shareholders focused almost entirely on management; if they felt the company was being mismanaged, they would “walk with their feet” by selling the company’s shares. We could not be further from this reality today. The largest asset managers in the world are publicly challenging boards to be better overseers of the company’s operations, especially on environmental, social and governance issues (“ESG”). Asset managers also expect robust transparency about how the board oversees ESG issues and demand board members engage with them about these issues on a regular basis. These asset managers are pressing boards for more dialogue and transparency because of their heightened interest in “stewardship” – being good stewards of the capital they are managing on behalf of their ultimate beneficiaries – individual retirees and pensioners.
According to a recent study (“The Specter of The Giant Three,” Bebchuk and Hirst, Harvard Law School Discussion Paper, May 2019), BlackRock, Vanguard and State Street Global Advisors collectively cast about 25% of the votes at S&P 500 companies. It is estimated that these three mostly passive asset managers will collectively own as much as 40% of the votes at S&P 500 companies by 2039. Up until about 15 years ago, passive asset managers were arguably true to their name – only passively interested in directors and corporate governance. Their primary focus was on providing low-cost funds and because “stewardship” activities, like voting analysis and engagement, were costly, they dedicated few if any resources to that function.
Today, due to their tremendous growth in size and ability to scale while keeping fund fees low, passive investors have retained large “stewardship” teams that actively analyze and vote their securities in a way they deem beneficial to the long-term economic value of the company. These stewardship teams also engage regularly with companies, including the board of directors. Many active managers have also built internal stewardship teams to supplement their investment teams, with a key distinction that portfolio managers and research analysts bring insight about the company’s strategy that, arguably, passive stewardship teams do not have. In addition to asset managers, asset owners such as CalPERS and CalSTRS have expansive stewardship teams carrying out stewardship activities focused on issues relating to the ESG issues.
But this surge in stewardship activities implemented by asset managers and asset owners are not without critiques. Some question whether stewardship activities accomplish their stated goal of helping clients (retirees and pensioners) achieve their long-term financial goals. At a recent Congressional hearing, several lawmakers questioned CalPERS about its use of pensioners’ money to pursue stewardship activities despite the fact that the pension itself was underfunded. In the context of shareholder activism, Delaware Chief Justice, Leo Strine, has argued that “the loudest voices mostly represent one interest, that of equity capital, but are not representing the viewpoint of those human investors who entrust their capital to the corporations whose futures are at stake.” Similarly, proxy advisory firms – those research firms utilized by stewardship teams to aid their activities – have become the subject of several pending regulations aimed at increasing federal oversight of these firms and curbing their influence on shareholders. In addition, the pressures continue on boards and companies from activist hedge funds seeking changes on the board in order to pursue an alternative strategic or transactional agenda.
The stakeholder model incorporates the interests of groups that have a stake in the company outside of stock performance. Understandably, shareholder and stakeholder interests can and do diverge. On August 19, 2019, the Business Roundtable (BRT) published a letter, signed by 181 CEOs, that promotes a stakeholder business model; “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.” The Council of Institutional Investors (CII), a non-profit association of U.S. asset owners, issued a response to the BRT letter, expressing concerns about the BRT’s stakeholder statement: The CII “believes boards and managers need to sustain a focus on long-term shareholder value. To achieve long-term shareholder value, it is critical to respect stakeholders, but also to have clear accountability to company owners.”
Thus, the varying groups and interests can make it difficult for a board to interpret the appropriate course of action to represent the company and its diverse shareholders and stakeholders. They need a highly-skilled team around the boardroom table, with robust processes to support their decisionmaking. It is imperative for directors to ensure that they receive accurate and updated information to help manage the evolving expectations of shareholders and stakeholders.
As boards attempt to meet the expectations of a vast array of interests, they are also faced with the common problem of balancing short-term and long-term interests. ESG takes a long-term perspective, while hedge fund activism is often viewed as short-term. Boards must oversee strategy and monitor business risks, while engaging with and understanding a diverse global ownership base. Along with diverse owners, diverse risks have also emerged.
Business Risk is Ubiquitous
When talking about risk and its oversight, we often think of financial risk, cybersecurity and the risks associated with data and information. However, at the “risk” of sounding dismal we can enumerate dozens of business risks from client attrition, to brand fatigue, to health and safety, and natural disasters.
Boards have a fiduciary duty to oversee and monitor risks to the businesses they serve. The framework by which they do this is typically one of several constructs. Either the entire board assumes responsibility for risk oversight, or it falls within the purview of the audit committee, or some companies establish a risk committee. Whatever the appropriate structure, risk is everywhere, and it is ever changing.
Of late, there is heighted concern about human capital risk. And with good reason. Human capital, the foundation of all business, is complex, unpredictable and often misunderstood. Unlike profits or data, there is often no logic to human behavior. Or worse, it can be destructive, malicious or just plain illegal. As such, boards are increasingly on the hook for human capital challenges and changing demographics suggest this trend will persist and expand. Among the many permutations and combinations of human capital risk, below, we explore what we think are (not necessarily in order of importance) some of the issues that pose the most serious threat:
Amazon, Google and Facebook (among others) have all been the subject of employee activism recently. This has taken the form of protests, walkouts, calls for changes in strategy and changes in leadership. No matter the specifics, the engagement has many of the hallmarks of union organizing. Like unions of the past, today’s employee activists believe in their cause and want their organization’s leadership to listen to them and ultimately yield to their demands. Management and the legal team cannot be expected to respond and negotiate without input from the board. Often, demands are about strategy and strategic choices, and the board must be amenable to working through these issues, at least from an advisory perspective.
According to the U.S. Bureau of Labor Statistics, the median tenure of workers ages 55 to 64 was more than three times (10.1 years) that of workers ages 25 to 34 (2.8 years).
The new labor pool changes jobs frequently and boards need to plan for what may be more than a risk, but rather an inevitability. Boards must contemplate return on investment in employees and implications on strategy, stability and continuity when employees move frequently.
Lack of the Right Skills and Knowledge
As the rate of change continues to increase at an exponential pace, so too must the skills and knowledge of a company’s workforce. This is not as simple as an individual course or day long training session. To mitigate risk, boards must think strategically about talent and plan in advance, not only a plan B but also a plan C, as well a succession strategy that takes into account individuals well-beyond just the CEO.
It was reported in October 2018, that in the first year of what we call the #MeToo movement, at least 425 prominent people across industries have been accused of sexual misconduct. The fallout on corporations is incalculable. From reputation ruin, to the ability to attract investors and employees, the consequences can linger and percolate. Boards can try to be proactive and focus on training and culture, however as mentioned above, humans can be irrational and unpredictable, and as such, the board must be prepared. There should be policies and protocols for reporting misbehavior that are trusted. The board must be made aware of issues, as appropriate, and there must be a crisis response plan in place.
As boards find themselves under ever-increasing scrutiny, the ability to dig deep on human capital risk will become even more imperative. As we continue to focus on culture, and amidst the new focus on ESG issues, an appreciation for human capital, and a new focus on its vulnerabilities and risk, will absolutely increase.
Just as the components of risk oversight are evolving, so is the perception and thinking around board performance. There are all types of metrics and tools for analyzing performance at every juncture of the organization and at every stage of one’s career. What about at the level of the board?
Until recently, many boards had an unstructured and occasional approach to performance. Often a key component was attendance at board meetings. Showing up was tantamount to achievement. While attendance is still reported in proxies, this, of course, is only the bare minimum.
What Constitutes Board Performance?
By virtue of its very structure, accurately measuring performance of a board is difficult. Directors are part-time, must be careful to provide oversight and not get into tactical matters, and stay “noses in, fingers out” to borrow a common board governance term. As such, cause and effect can be hard to measure. Did the board’s decision on strategy yield the most recent quarterly results, or was it the masterful execution of the President? Can stock performance be attributed in any way to the board?
Generally, we are moving in the right direction. Recent data indicates that 98% of the S&P 500 companies perform some form of board evaluation. There is however, a vast divergence on what constitutes an evaluation. Is it conducted for the board in its entirety? Individual directors? Committees? Their leadership? How often is it done? What is the methodology? What is the purpose? Is it robust, accurate, and perhaps most importantly, is anything done with the results and does this yield improved performance? To fully diagnose board performance and work towards its improvement, there must be some standardization and definition as to what this means. This does not require completely reinventing the wheel. Some of the best practices of performance evaluation can be borrowed for the boardroom. For example, creativity and task-completion should be assessed, as well as responsiveness to feedback.
There is a level of sensitivity and delicacy that must be embraced when instituting any measure of performance, and in particular, that of board directors. These are senior executives who have typically had great success in their career and may feel that due to their stature and seniority they are beyond evaluation. However, as complexity of the board role increases, so too must the criteria for measuring success in the role. No longer is it enough to rely on past performance. Shareholders, stakeholders and the business environment and culture require this.
Who Should Sit on the Board?
Although the business climate we live in constantly evolves, one of the tools widely used to analyze the board, The Board Matrix, remains the same with leadership, financial and relevant industry experience as prioritized skillsets. Experience as a CEO or on a public company board has historically been a must-have credential. Looking to 2020, we predict high-performance boards will not only have proactively put a process in place to expand (or enhance) the matrix, the most forward-thinking boards will consider additional, relevant skillsets that go beyond the “old matrix” and are in alignment with business strategy. We predict the new matrix will include the following:
- Contemporary versus historical experience: There will be more scrutiny on how “current” a director’s experience is. As the business environment changes at an increasingly rapid pace, the rate at which experience remains current will diminish. More stakeholders will be paying closer attention to board tenure and experience.
- Consumer-Centric Meets Customer-Centric: Both audiences have the same end goal: get people, or a business, to buy what is being sold. The new matrix will include management or board expertise at a company with a multichannel presence which has successfully grown its e-commerce revenues, or someone who brings “consumer” centric experience in support of growth efforts, whether it be capturing online share, implementing omnichannel capabilities or harnessing customers. Directors with a deep understanding of evolving consumer and customer needs, an instinct for brand, and the ability to operationalize consumer and customer acquisition efforts to drive growth and transformation will be in demand.
- Human Capital Experience: With both corporate culture and corporate activism “in the boardroom” a spotlight on executive compensation and ongoing #MeToo issues, having perspective on culture oversight, talent management and compensation, recognition, and reward systems should be more of a priority.
- Evolution of the “Digital Director:" Cyber remains important. However, big data, privacy, artificial intelligence and experience with emerging technologies will be emphasized.
Not having a succession plan in place can lead to difficult, awkward conversations with respected fellow directors. Many boards do not have a well-articulated succession plan, and this is at a time when more stakeholders are asking how a board plans for evolution and future state director selection. Without a framework grounded in the 1-3-5-year business strategy, a hard conversation with a fellow director about performance or relevance can become a very difficult one. Again, the boardroom is very human. It is not fun to bring up the subject of refreshment with a fellow director – and friend.
With the spotlight on board performance even brighter, we predict the most forward-leaning boards will prioritize: director succession planning; lead director succession planning; and committee effectiveness.
High-performance boards will leverage an ongoing “future proofing” process that helps drive performance and manage risk. It will include the regular review of:
- Board structures and board processes for compliance of governance requirements.
- Board structures and board processes for effectiveness, efficiency and impact.
- Prioritization of committee work (high, medium, low) and how best to leverage committees.
- Key criteria, skills and capabilities for lead director, committee chairs and the full board.
- Contributions of individual directors, group dynamics and committee effectiveness.
- Lead director and committee chair performance.
- Rotation of committee members (including the chair) after five years.
On the Subject of Board Quotas: Abstract to Reality
Gender diversity quotas have moved from the “never in the United States” to reality. There have been quotas in Europe for the past 15 years. In the United States, board quotas have been controversial. California made headlines in September of 2018 with legislative action towards instituting gender quotas for boards. Governor Jerry Brown signed a bill that any public company that has principal executive offices in California must have at least one woman on its board by December 2019. Illinois has a bill that requires public companies headquartered in Illinois to have at least one female, one African American, and one Latino individual on the board. Pennsylvania has a bill. New Jersey has legislation introduced that is similar to California. Not only are quotas controversial, some argue prioritizing one form of diversity over another violates the constitution. We predict more quotas on the horizon for the United States.
We predict the high-performance board of 2020 will be known for its functioning across:
- Future-Proofing: Boards must develop immediate - and long-term succession plans to align the board with the company’s go-forward strategy and account for planned director departures. This goes well beyond recruitment and refreshment. The future-proofing framework is an ongoing, integrated way of working that is not “reactive” or event-driven.
- Relationship with the CEO: Individual directors will be more closely scrutinized on their ability to leverage their expertise in support of the CEO, ask the right questions, and focus on the most important issues.
- Diversity: Diversity is multifaceted – gender, ethnicity, age, geography, industry and thought – and is inseparable from qualifications. Let’s stop talking about “why” to do it – get it done.
- The New Matrix: In 2020 and beyond, there will be more focus on new skillsets to complement the widely-used matrix of today. The “new matrix” will more directly reflect the full picture of company strategy. It will include skillsets previously dismissed as “too risky” or “not heavy” enough. We will see more first-time directors bringing new types of experience across marketing and brand, e-commerce and human capital. This will have positive implications on diversity in the boardroom.
- Succession Planning and Committee Effectiveness: While investors expect boards to proactively drive a process that identifies gaps in skills and experience, investors will expect to see an approach to deal with those gaps. Having a process in place paves the way for “difficult conversations” regarding board refreshment. Additionally, to truly evolve the board in alignment with strategy, boards must have available openings.
The challenges to companies, and hence their boards of directors, are increasingly complex and unpredictable. To remain competitive the very foundation of board structure, composition, performance and expectations must be examined. The assumptions we make about boards can no longer be taken for granted. Corporate governance in its current form came into focus in the 1970s. The most successful companies will be those that evolve and transform in accordance with new realities, new demands, new markets and new challenges.