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Governance Roundup

December 8, 2016

Do we need better pension fund governance?

    In Investment & Pensions Europe, Christopher O’Dea argues that “[t]he urgency of aligning trustee and governance functions to facilitate investment results is clear.  Most US public pension plans are underfunded and they have taken on more risk to try to offset falling returns and lower member contributions.”1

   Representatives from some of America’s largest corporations and investment managers this summer issued “commonsensecorporate governance principles.2 The news is not what they said, as these are pretty standard best practices endorsed by groups like the National Association of Corporate Directors.  The news is who said it, because it is coming from insiders who call on their fellow corporate executives to commit to robust board refreshment, majority vote, proxy access and informal nomination of director candidates from shareholders, and more.  An especially significant section of the principles concerns the obligation of institutional investors to be transparent about their proxy votes and to engage constructively with portfolio companies.

   Participants include:

Tim Armour, Capital Group

Mary Barra, General Motors Company

Warren Buffett, Berkshire Hathaway Inc.

Jamie Dimon, JPMorgan Chase & Co.

Mary Erdoes, J.P. Morgan Asset Management

Larry Fink, BlackRock

Jeff Immelt, General Electric

Mark Machin, Canada Pension Plan Investment Board

Lowell McAdam, Verizon Communications

Bill McNabb, Vanguard

Ronald O’Hanley, State Street Global Advisors

Brian Rogers, T. Rowe Price

Jeff Ubben, ValueAct Capital

Is U.K. corporate governance getting worse?

    Ian Fraser complains that corporate governance codes have made things worse by promoting “a box ticking culture” more directed at compliance than substance.3

    From India: In The Economic Times, Kotak AMC’s Nilesh Shah says that three key factors must be considered in evaluating stocks right now: capital allocation, technology, and corporate governance.4 Of course, capital allocation and mastery of technology in products and operation are in part a reflection of a robust governance structure.

    And a 1996 transcript from a corporate governance discussion with Warren Buffett and Charlie Munger shows that not much has changed, and that if companies had followed their advice, they would have prevented the Enron-era scandals and the financial meltdown.5

CEO Pay is up almost 50% since the financial meltdown.

Nika Knight reports:6

   As global inequality skyrockets, CEOs at the 350 largest corporations in America took in about 276 times the pay of the average worker in 2015, according to the latest numbers from the Economic Policy Institute (EPI).

   CEO pay is up 46.5 percent since a relative low point in 2009, following the 2008 market crash.  “Amid a healthy recovery on Wall Street following the Great Recession, CEOs have enjoyed outsized income gains even relative to other very-high-wage earners,” EPI observes.

   Yet, most of the rest of the country never saw a recovery from the global recession: Middle class jobs have disappeared, the working class has continued to struggle, and child poverty has risen nationwide.

   “From 1978 to 2015, inflation-adjusted compensation of the top CEOs increased 940.9 percent,” EPI writes, “a rise 73 percent greater than stock market growth and substantially greater than the painfully slow 10.3 percent growth in a typical worker’s annual compensation over the same period.”

   And while the average CEO pay technically declined slightly from 2014 to 2015, it was a result of a dip in the stock market and not because of any widespread changes in how executive pay is determined.  For that reason, “CEO pay can be expected to resume its sharp upward trajectory when the stock market resumes rising,” EPI notes.

   EPI reports that “CEO pay is growing a lot faster than profits, the pay of the top 0.1 percent of wage earners, and the wages of college graduates.  This means that CEOs are getting more because of their power, not because they are more productive, or have special talent, or more education.  If CEOs earned less or were taxed more, there would be no adverse impact on output or employment.”

    In a related story, a new report from MSCI finds an inverse correlation between pay and performance:7

   The best-paid CEOs tend to run some of the worst-performing companies and vice versa – even when pay and performance are measured over the course of many years, according to a new study.

   The analysis, from corporate-governance research firm MSCI, examined the pay of some 800 CEOs at 429 large and midsize U.S. companies during the decade ending in 2014, and also looked at the total shareholder return of companies during the same period.

   MSCI found that $100 invested in the 20% of companies with the highest-paid CEOs would have grown to $265 over 10 years. The same amount invested in the companies with the lowest-paid CEOs would have grown to $367.

Mutual fund proxy voting raises conflicts of interest questions.

Gretchen Morgenson writes in The New York Times:8

   “The voting of fund managers is infected by conflicts of interest,” said Erik Gordon, a professor at the Ross School of Business at the University of Michigan.  That is because these giant mutual fund operators don’t just own shares in many big American companies; they also do business with them.

   “Funds often avoid challenging management on executive pay and corporate governance because they want to be included in corporate defined-contribution benefit plans,” he said in an email.  “If a fund irritates a C.E.O. and the C.E.O.’s pals on the board, the fund risks losing business at several companies.”

   BlackRock and Vanguard dispute this notion, saying they put their customers’ interests first in their voting.  “We weigh all factors that could affect the long-term value of our clients’ assets,” Ed Sweeney, a spokesman for BlackRock, said in a statement, “including the hundreds of public pension plans, nonprofits, foundations, endowments, educational institutions and individual investors we serve.”

* * *

   On matters involving executive pay, in the most recent 12 months, [BlackRock and Vanguard] overwhelmingly supported compensation practices at the companies in the Standard & Poor’s 500-stock index.  BlackRock supported executive pay at 98.3 percent of those companies in the most recent year, and Vanguard voted in favor of pay practices in 98.1 percent of its votes.  (Vanguard disputed this, saying it voted yes a mere 96 percent of the time.)

   By the way, both companies supported the pay practices at Wells Fargo, whose executives are under fire for overseeing a pervasive program that prompted many employees to set up sham accounts to generate fees and make quotas.

   As head of BlackRock’s investment stewardship unit, Michelle Edkins oversees its voting.  On executive compensation, she stressed that the firm voted against pay practices or compensation committee members at 10 of the 50 companies with the highest-paid chief executives this year.  She also said that BlackRock discussed compensation matters with half of those companies.

   Beyond pay, BlackRock and Vanguard both supported management by voting against most proposals requiring that a company’s board be led by an independent chairman.  Shareholders in favor of this idea contend that such a move would reduce management’s grip on the board and bring more accountability to corporations.

   BlackRock voted nay on 95 percent of such proposals, Proxy Insight found, while Vanguard rejected 100 percent of them.

Do institutional shareholders have an unlimited capacity to monitor firms, or are they subject to attention constraints?  And if they are, what are the consequences for firm governance?

    Alberto Manconi, Elisabeth Kempf, and Oliver Spalt found the following:9

   When our proxy indicates a high level of distraction, fewer questions are asked during earnings conference calls.  Further, we find that institutional investors are less likely to make proposals in shareholder general meetings, and they are less likely to make large changes to their portfolios.  These patterns are consistent with a diversion of shareholder attention (i.e., distraction), and support our conjecture that attention is not unbounded for institutional investors.

   Our main finding is that, when shareholders are distracted, managers make more value-destroying acquisitions.

    A new report from the Roosevelt Institute shows that the hidden costs of our financial services will impose as much as $22.7 trillion of unjustified costs on our economy between 1990-2023.10

    Gerald Epstein and Juan Antonio Montecino measured “three components: (1) rents, or excess profits; (2) misallocation costs, or the price of diverting resources away from non-financial activities; and (3) crisis costs, meaning the cost of the 2008 financial crisis.”

    Even if you take out the costs of the 2008 financial meltdown, the numbers are staggering.

   First, we estimate the rents obtained by the financial sector.  Through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities, bankers receive excess pay and profits for the services they provide to customers.  By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers.  We estimate that the total cost of financial rents amounted to $3.6 trillion–$4.2 trillion between 1990 and 2005.

   Second are misallocation costs.  Speculative finance does not just grab a bigger slice of the pie; its structure and activities are often destructive, meaning it also shrinks the size of the economic pie by reducing growth.  This is most obvious in the case of the financial crisis, but speculative finance harms the economy on a daily basis.  It does this by growing too large, utilizing too many skilled and productive workers, imposing short-term orientations on businesses, and starving some businesses and households of needed credit.  We estimate that the cost of misallocating human and financial resources amounted to $2.6 trillion-$3.9 trillion between 1990 and 2005.

   Adding rent and misallocation costs, we show that, even without taking into account the financial crisis, the financial system cost between $6.3 trillion and $8.2 trillion more than the benefits it provided during the period 1990–2005.

    We are long overdue for an Airbnb/Uber-like disruptive force to undercut these fees, though the financial services industry will spend hundreds of millions of shareholder dollars to prevent it.  In a related story, ValueEdge Advisors interviewed Empire of the Fund author William Birdthistle on the conflicts of interest and hidden fees in mutual funds: “[I]t takes an impressive amount of cheek to declare that a rule putting the best interests of investors over side-payments to investment firms is bad for American investors.”11

    An update on proxy access from Holly Gregory’s Sidley Corporate Governance Report:12

   Through the collective efforts of large institutional investors, including public and private pension funds, and other shareholder proponents, shareholders are increasingly gaining the power to nominate a portion of the board without undertaking the expense of a proxy solicitation.  By obtaining proxy access (the ability to include shareholder nominees in the company’s own proxy materials), shareholders will have yet another tool to influence board decisions.

   Approximately 40% of companies in the S&P 500 have now adopted proxy access. We expect that proxy access will become a majority practice among S&P 500 companies within the next year.

Board diversity milestone:

    General Motors has become the first major industrial company in the United States to have a board that is evenly split between men and women.  Motto notes:13

   Two other S&P 500 companies – student loan corporation Navient and utility company American Water Works Company – have more women than men on their boards.  Only two other S&P 500 companies also have a 50/50 split on their boards: broadcast company Tegna and the parent company for fashion brand Michael Kors, according to data released last week by Equilar.

But overall, lukewarm support for gender diversity on boards:14

   According to a new survey of 884 directors of public companies, 10 percent of current board members think the ideal number of women on a corporate board is somewhere between 20 percent of the board and zero.  Zero!  One in 10 directors mulled over the prospect of sharing a conference table with women and thought, “I could tolerate zero women, or maybe a very tiny proportion of women, but that is absolutely it.”

   The head of PwC’s Governance Insights Center, which conducted the survey, told Fortune that the not-unpopular desire for a board with as few women as possible is largely attributable to the old-school men who populate most corporate boards and, thus, the survey base.  The average age of a board member of a major U.S. company is 63 and rising, and 83 percent of PwC’s survey participants are men.

   Just as disconcerting as the 10 percent in the “few to no women, please” club is the 43 percent of participants who said the “optimal” share of women on a corporate board is 21 to 40 percent.  (Women currently occupy 20 percent of S&P 500 companies’ board seats.)  This means that more than half of all board members think women deserve significantly fewer than half the seats on corporate boards.  Since women make up more than half of the world’s population, this suggests that more than half of current board members think women are inherently less capable of serving in corporate leadership positions.  Another 43 percent said women should occupy 41 to 50 percent of board seats; only 5 percent thought the “optimal” proportion of women was greater than 50 percent.

    On a brighter note, Jane M. Von Bergen writes that there is some modest progress on board diversity, based on a new report from the Forum of Executive Women:15

       In 2015, the report notes, women filled one-third of the 60 board openings at the Philadelphia region’s top 100 public companies.  In that same year, the number of companies with at least 25 percent of their boards made up of women rose to 19 percent from 14 percent.  The number of companies with no women on their boards decreased from 35 to 27.

       Even so, women held only 14 percent of all local public-company board seats, up just slightly from 2014. In 2009, women held 11 percent of the seats.

       In 2015, the report says, only six public companies in the region had a female chief executive.  And only 11 percent of public companies’ top earners were female, up from 9 percent in 2009.

    An IRRCi/Tapestry Report on stock buybacks calls for better disclosure of the calculus and justification.16 To learn how companies make decisions about share repurchases, Tapestry Networks interviewed 44 directors serving on the boards of 95 publicly traded U.S. companies with an aggregate market capitalization of $2.7 trillion.  The report found:

   In recent years, Standard and Poor’s 500 companies have repurchased their shares at a remarkable rate.  S&P 500 companies acquired $166.3 billion of their own shares in the first quarter of 2016, more than in any other quarter since the financial crisis.  In each of the last nine quarters, at least 370 S&P 500 companies repurchased shares, and over the last three years, S&P 500 companies spent over $1.5 trillion on buybacks.

    In part this is due to macro-economic factors like tax laws that discourage companies from bringing cash earned outside the United States and a low-growth, low-interest-rate environment.

    ValueEdge Advisors Vice-Chair Nell Minow wrote in The Huffington Post that while buybacks can be a valid use of excess cash for companies, the increase in buybacks, and particularly the increased use of debt to finance them, is a concern:17

   Concerns about misaligned incentives and the increased use of debt shift the burden of proof to require much more specific disclosure about the process and calculus used to quantify the benefits of buybacks.  Shareholders need to know whether they are getting their money’s worth from buybacks and from the executives and directors who approve them.

The World Bank moves forward on integrated reporting.

    In an interview, Giorgio Saavedra, Integrated Reporting Lead in the Corporate Reporting group of the World Bank, talked about why integrated reporting is a priority and what they hope to achieve:18

   As the WBG evolves to better position itself to meet the 2030 Development Agenda, having a holistic view of the strategy, governance, performance of the institution against the strategy, and the risks to achieving the strategy is essential to support more informed decision making.  Embedding the elements of the IR framework into our corporate reporting can facilitate organizational alignment with our strategic goals and help management understand the linkages between the various factors that affect our strategy and long-term sustainability.

   We also see significant benefits in our role as a multilateral development institution in promoting the widespread adoption of IR by our clients to improve transparency and accountability.  For example, in a time when the public sector is expected to work in partnership with the private sector to address some of today’s key social challenges, adoption of IR can provide the framework for a more holistic approach to decision making, transparency about risks and how these are being managed.

Companies are not reporting climate change risk.19

    Scientific American says that the financial disclosures filed with the SEC do not do an adequate job of reporting climate change risk:

   When issuing marketing materials and press releases, U.S. companies frequently warn that rising global temperatures could cost them money.  They tout specific green projects, like solar roofs and increased efficiency.  But when it comes time to report to the Securities and Exchange Commission, the same companies stick to broad terminology and sanded-down statements.

    This has had significant impact already.  Stefanie Heerwig writes in MultiBriefs:20

   Three of the four largest U.S. coal producers are now bankrupt, including Alpha Natural Resources and Peabody Energy.  The former acquired Massey Energy in 2010, increasing its net debt level to $2.4 billion by 2011.  The latter acquired Macarthur Coal and entered bankruptcy with liabilities of $10.1 billion.

   According to the latest report by the Carbon Tracker Initiative, these risky maneuvers and failures could have been avoided if companies would have considered the impacts of climate change policies in their business strategies.

When will companies have to improve their disclosure of climate change-related risk?

    The SEC is considering requirements that would give investors better information about the way portfolio companies are assessing and managing climate risk.21

    Alan L. Beller, a director of the Sustainability Accounting Standards Board (SASB), writes about the efforts to quantify sustainability in financial reports:22

   [I]n the 21st century, financial information doesn’t provide a complete picture of corporate performance. . . .

  . . .73 percent of institutional investors indicated that they take sustainability (environmental, social, and governance) issues into account in their investment analysis and decisions, to help manage investment risks.

* * *

   Disclosure of performance on sustainability topics that would be decision-useful to investors, be cost-effective and sensible for companies and that would be equal to the quality that markets expect for financial information can best be accomplished via a clear focus on material information and on an industry-specific market standard.  Just as the markets have a standard for material financial information – US GAAP – the markets need a standard for material sustainability information.

   This is the need SASB was created to address.  SASB standards are designed to help companies effectively disclose material sustainability information and comply with regulatory obligations, working within the framework of existing U.S. securities laws.  SASB’s provisional standards have been developed, and SASB is embarking on a project to make the provisional standards final, in both cases through processes that are designed to produce standards that are cost-effective and decision-useful, and to embody in those standards industry-specific sets of disclosure topics and metrics that are reasonably likely to constitute material information for companies in that industry.

1    https://www.ipe.com/pensions/pensions/briefing/us-pension-governance-upgrading-for-the-21st-century/10014873.fullarticle
2    http://www.governanceprinciples.org/wp-content/uploads/2016/07/GovernancePrinciples_Principles.pdf
3    http://www.ianfraser.org/britains-scandalous-corporate-failures-invite-a-governance-revolution/
4    http://economictimes.indiatimes.com/markets/expert-view/corporate-governance-capital-allocation-and-technology-to-mark-out-outperformers-by-2020-nilesh-shah-kotak-amc/articleshow/53446484.cms
5    https://corpgov.law.harvard.edu/2016/06/01/the-buffett-essays-symposium-annotated-20th-anniversary-transcript/
6    http://www.mintpressnews.com/ceo-pay-almost-50-since-2008-recession/218410/
7     http://www.marketwatch.com/story/study-shows-highly-paid-ceos-often-run-the-worst-performing-companies-2016-07-25
8    http://www.nytimes.com/2016/09/25/business/your-mutual-fund-has-your-proxy-like-it-or-not.html?_r=0
9       https://corpgov.law.harvard.edu/2016/10/21/distracted-shareholders-and-corporate-actions/
10    http://rooseveltinstitute.org/overcharged-high-cost-high-finance/
11    https://valueedgeadvisors.com/2016/07/13/william-birdthistle-on-whats-wrong-with-mutual-funds-and-how-to-fix-it/
12    http://www.sidley.com/~/media/update-pdfs/2016/06/final-proxy-access-client-update-june-2016.pdf
13    http://motto.time.com/4501731/general-motors-gender-parity-board/
14    http://www.slate.com/blogs/xx_factor/2016/10/12/male_corporate_board_members
15    http://www.philly.com/philly/business/labor_and_unions/More-companies-on-board-with-women-on-boards.html
16    http://irrcinstitute.org/wp-content/uploads/2016/08/FINAL-Buybacks-Report-Aug-22-2016.pdf
17    http://www.huffingtonpost.com/nell-minow/cant-boards-find-a-better_b_11645654.html
18    http://www.forbes.com/forbes/welcome/?toURL=http://www.forbes.com/sites/christopherskroupa/2016/10/26/how-integrated-reporting-is-changing-the-role-of-the-accounting-profession/&refURL=&referrer=#33dd0c833169
19    https://www.scientificamerican.com/article/climate-risk-is-poorly-represented-in-company-financial-filings/
20    http://exclusive.multibriefs.com/content/the-danger-of-missing-climate-change-policies-in-business-forecasts/natural-resources
21    http://www.wsj.com/articles/companies-might-have-to-disclose-their-carbon-related-risks-1473820113
22    https://listingcenter.nasdaq.com/ClearinghouseArticle.aspx?id=319&version=9

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