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For 2016, a Mix of Trends Both Old and New

Stephen Davis and Jon Lukomnik | January 5, 2016

for DeAnn

It’s time for our annual predictions of the major corporate governance trends for the new year. Before we dust off our crystal ball, though, we need to check our record for 2015. How did we do?

We missed—but by only a hair—our leading prediction that, for the first time, a majority of S&P 500 companies would split the chair and CEO jobs. Spencer Stuart’s latest Board Index shows the percentage inching up a notch to 48 percent rather than crossing the line to a majority. Still, 48 percent is yet another record. Moreover, a new high of 29 percent of S&P 500 boards featured not just a separate chair, but a chair who is fully independent. Ten years ago, the comparable figure was a mere 9 percent. The trend is clear, even if momentum lagged the pace we forecast.

We also predicted, wrongly, “an unprecedented assault on proxy advisers” triggered by (now former) SEC Commissioner Daniel Gallagher. Gallagher, as you may recall, was prodding corporations to hit ISS and Glass Lewis for inaccuracies in their reports, and to use new SEC protocols in Staff Legal Bulletin 20 to bring complaints to his personal office. Bitterness against the two advisers remains high in CEO suites, but relations in 2015 never broke into the open warfare we expected. This could be because companies feared consequences of an all-out assault; after all, the advisors could hypothetically have lashed back with negative vote recommendations. But hostilities were avoided, more likely, because institutional investors undertook time-consuming efforts to meet new SEC rules on monitoring proxy advisors while the advisers, in turn, beefed up their own internal quality controls. They made themselves less of a target.

We were dead-on with several other 2015 prophecies, though. For one, we accurately foresaw the return of proxy access as a flashpoint issue at U.S. annual meetings. Access came from nowhere to become the single biggest story of the season, with more than 100 shareholder resolutions, record-high votes in favor, and a record number of behind-the-scenes agreements between investors and boards to introduce mechanisms for shareholder nominations of directors. Even tech icon Apple introduced proxy access as the year ended, providing emphatic punctuation to that trend.

So what do we expect will unfold in 2016? For one, we predict that proxy access will remain the overriding issue. Some big funds that held out against the emerging common nomination eligibility standard of 3 percent ownership, with stock held a minimum of three years, will likely join the bandwagon.

Second, we forecast that critics would mount sustained efforts to roll back Dodd-Frank by trying to insert measures into must-sign bills. They did just that, but efforts largely failed in the face of White House and Democratic legislator resistance. The only related initiative that made it through was language tucked into December’s omnibus budget bill barring the SEC from adopting rules requiring companies to disclose political contributions.

We also guessed that the beneath-the-radar phenomenon we dubbed “i2i”—investor-to-investor engagement—would progress to a sophisticated stage, amplifying shareholder influence. Proof was the surge in investor support for a common proxy access standard in 2015.

Finally, we predicted, correctly, that enhanced audit reporting in Britain would result in new models of disclosure that might stimulate an appetite among investors for similar advances in the U.S. Vodafone and Rolls Royce audit reports, in particular, point to the future of enhanced audit reporting. And sure enough, investors, auditors and regulators in the U.S. are moving to breathe life into the audit report. Draft new rules from the Public Company Accounting Oversight Board, for instance, will require audit firms to reveal the engagement partner responsible for each issuer’s audit as well as the names of other accounting firms contributing to the audit, beginning in 2017, assuming the SEC approves. That’s a modest start.

So what do we expect will unfold in 2016? For one, we predict that proxy access will remain the overriding issue. Some big funds that held out against the emerging common nomination eligibility standard of 3 percent ownership, with stock held a minimum of three years, will likely join the bandwagon. That means the 54 percent average vote in favor should climb higher in 2016—but we actually think there will be fewer votes, as advisers counsel boards to engage and settle, rather than spend resources on losing campaigns. So, paradoxically, a critical mass of shareholder support for proxy access—once the most polarizing issue in U.S. corporate governance—should pave the way for a greater outbreak of peaceful agreements than ever before.

Second, we will stay out on a now-familiar limb and forecast that 2016 will be the milestone year when more S&P 500 corporate boards name a separate chair, rather than hand the job to the CEO. The historical trend would point in that direction anyway. But we expect the pace to accelerate as more big institutions such as Blackrock and State Street Global Advisors train governance attention on board quality, including diversity, refreshment, and leadership. Nomination committees will be under more scrutiny than ever to demonstrate evidence of board effectiveness.

Third, we see the rise of stock buybacks as a lightning rod for both shareholder dissent and divisions. As short-term pressures influence corporations to deploy earnings in repurchases instead of investment in other long-term capital deployment, institutions with decades-long time horizons are increasingly balking. Buybacks are championed by some investors as a useful capital discipline; others see them as what the Economist memorably termed “corporate cocaine,” feeding rapacious short-term shareholders while impairing companies’ ability to sink investments into growth opportunities. This could be the year when arguments over buybacks between boards and investors—and indeed between different types of investors—gain center stage. Indeed, some institutional investors reportedly are developing shareholder proposals targeting the links between buybacks and executive compensation metrics based on earnings per share, stock price, and total shareholder return.

Fourth, we see 2016 as the year when environmental risk breaks through to the mainstream of the investor world, though some might argue it has already. The Paris COP21 climate accord is one reason. Leading investing institutions such as CalPERS formed part of the negotiations. But the proliferation of civil society advocates and media attention make it a harder subject for mainstream investors to avoid. Also, fund companies that have signed the Principles for Responsible Investment will have to show that they are managing climate risks in some fashion or risk exposure as failing in their fiduciary duties. A 2015 CFA Institute/IRRC Institute study revealed that half the portfolio managers and analysts globally already consider environmental issues when making investment decisions. The proportion in the U.S. lags, but only slightly, at 45 percent. Either way, it seems clear that we are at the tipping point for environmental considerations to go mainstream.

Finally, we resurrect a prophecy from 2014: Economic inequality will again gain traction as a governance issue, this time turbocharged thanks to the politics of the U.S. general election. A December 2015 Pew Institute survey showing that, for the first time in recent memory, the middle class was not the majority in America, and that the middle class is falling behind financially suggests there is plenty of fuel to feed this fire. Candidates on both sides of the partisan divide already are lambasting corporate greed in areas ranging from drug pricing to corporate inversions to, of course, CEO pay. The movie The Big Short, an Oscar contender, adds fuel by slamming Wall Street. Boards, as we have cautioned before, may have to be proactive, watching this trend and reviewing their social profiles to avoid harsh spotlights and even potential new populist regulation.

In sum, we predict both a consolidation of existing trends—separate chair and CEO; increased attention to environmental issues in investing; agreement on proxy access standards—together with new trends which feed off the fracturing of long-established beliefs—such as it’s an unabated positive to use buy-backs to boost stock price and that the U.S. is a middle-class society. In 2016, expect those old doctrines to collide with a changed reality.