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Mutual funds call for corporate board accountability

Stephen Davis and Jon Lukomnik | May 3, 2016

for DeAnnWelcome to proxy season 2016.

As they do every year, corporate-specific developments dominate the news.  Yes, the problems at Valeant, the succession battle at Viacom, and the almost daily reports of another activist situation fascinate. But there is a forest hiding amongst all those trees. Understanding the macro corporate governance trends can keep you from being tomorrow’s headline.

There is one overwhelming focus in this year’s proxy season: Board accountability. From proxy access to the debate about dual-share-class controlled companies to diversity in the boardroom, what many of today’s hot-button issues have in common is an underlying philosophy that says directors should be accountable to shareowners. But this year there’s a difference. Major mutual fund companies are providing an echo chamber for traditional governance-focused investors, such as public pension funds, as they join the banging of the accountability drum.

Consider, for example, Vanguard’s new 2016 position on proxy access. But first, let’s spotlight proxy access itself. Proxy access allows external shareowners meeting certain hurdles to nominate a minority of directors. Just two years ago, it basically did not exist at any major American company, despite a decade of painfully polarizing debate in the governance community. Indeed, a proposal from the SEC to mandate it in line with the Dodd-Frank Act was derailed by the courts after a challenge from the Chamber of Commerce. The court basically told shareowners not to rely on regulation, but to fight for proxy access on a company-by-company basis, a process known as “private ordering.” Many observers thought proxy access dead in the water. However, New York City Comptroller Scott Stringer took up the court’s challenge. Stringer, and his lead governance expert Michael Garland, led a groundswell of institutional investors in campaigning to make proxy access the new normal. Today some 200 companies, including about a third of the S&P 500, boast proxy access bylaw provisions.

And the issue isn’t going away. As of the writing of this column, proponents have filed more than 200 new proxy access proposals for 2016. If successful, they could almost double the number of companies featuring this governance provision. And early indications are that they will be successful: One key proponent recently told a private meeting that there has been a marked shift in how companies are responding to their efforts. Whereas last year they were fighting the proposals, this year they’re negotiating to have the proposals withdrawn in return for the companies adopting a reasonable form of proxy access.

There is one overwhelming focus in this year’s proxy season: Board accountability. From proxy access to the debate about dual-share-class controlled companies to diversity in the boardroom, what many of today’s hot-button issues have in common is an underlying philosophy that says directors should be accountable to shareowners.

Which brings us to Vanguard. Not all proxy access proposals are created equal. From the governance activist perspective, not all are even reasonable. Perhaps the key variable is the percentage of share ownership that must be reached to trigger access. Given the dispersed share ownership of most public U.S. companies many institutional governance activists feared that proxy access with high thresholds of 5 or 10 percent would be hollow, in that companies would theoretically offer proxy access rights, but those rights would be unusable. As a result, most institutional investors, but not all, favored 3 percent, which was the threshold included in the court-blocked Securities and Exchange Commission proposal. Most, but not all. Vanguard was a key holdout for a higher threshold—which would make it more difficult to use proxy access. To understand the criticality of the threshold issue, consider that less than a year ago, Vanguard’s position that it would only vote for proxy access proposals that included a 5 percent threshold prompted influential New York Times columnist Gretchen Morgenson to ask if Vanguard was one of “the skunks at the proxy access party.” Time change: Vanguard is a rearguard player no longer. This year, Vanguard changed its policy to align with the majority of institutional investors at 3 percent.  Given Vanguard’s massive U.S. equity holdings, the echo chamber just got louder. A shrinking handful of other fund companies, notably Fidelity, continue to oppose access altogether or opt for higher thresholds. Our prediction: More will fall into line by next year.

Of course, proxy access isn’t the only board accountability issue. The question of dual-share-class companies has emerged as a flash point. These companies, which generally give extra voting rights to insiders, or reserve classes of directors for election only by insiders, are hugely controversial. Proponents argue that they allow companies to ignore short-term market pressures and invest for the long-term. But opponents—led by the Council of Institutional Investors, which recently called for an end to initial public offerings with unequal voting rights—argue that there is no evidence of long-term outperformance with such features. They say unequal voting rights merely serve to entrench boards and managements.  Two recent studies from the Investor Responsibility Research Center Institute and ISS also suggest there is no evidence of systemic outperformance by dual-class companies.

But it’s another finding in the most recent study that is raising eyebrows. It finds that dual-class companies have exceptionally long-tenured and non-diverse boards. For example, some 23 percent of dual-class companies have average board tenure of 15 years or more, compared to only 6.8 percent of non-controlled companies. This is not just an academic argument; the lengthy tenure of directors at Viacom has figured prominently in the power struggle at that dual-class company.

Perhaps because of that, there is also another gap at dual-share-class companies. Some 58.2 percent of dual-share-class companies have only one woman or no women on their boards, compared to 51.6 percent of non-controlled companies. The figures are even more striking when minority representation is considered. Nearly 60 percent of dual-share-class companies have no minorities on their boards. The comparable figure for non-controlled companies is 43 percent. Both levels are striking for their resistance to social trends and equity. But the evidence suggests that the path to change is easier at non-controlled companies.

Against that backdrop, the fact that T. Rowe Price quietly changed its proxy voting guidelines this year to vote against certain directors at dual-share-class companies is big news.

Meanwhile, even away from the dual-share-class controversies, other mutual fund companies such as State Street Global Advisors and Blackrock have advanced their own stances to encourage board refreshment.

The echo chamber for board accountability is growing.