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Under investor scrutiny, corporate governance evolved into a crucial value generator

Stephen Davis and Jon Lukomnik | March 22, 2016

If you zoom from the trenches to orbital distance, it becomes clear—and striking—how corporate governance in the United States has transformed seemingly overnight. For decades, corporate governance had been little more than a code word for proxy voting, but now it has emerged as a deeper conversation about long-term value creation. This swift metamorphosis is producing a whole new species of public statements by investors. Governance professionals at corporations now face the challenge of absorbing and incorporating these into strategic thinking. Examples of what we mean in a moment.

Let’s first see what the world looked like until now. Institutional investors began to take widespread note of governance in the early- to mid-1980s, when raiders were loose in the capital market. Union and public sector funds, in particular, thought they had better look at how corporate managements were paying greenmail to entrench themselves. Then the federal government, in the form of the Department of Labor, stepped in through its famous 1988 Avon Letter, which focused on plans covered under the Employee Retirement Income Security Act of 1974. Issued during the Reagan administration, the Avon Letter set a new regulatory standard that reverberates today worldwide. It affirmed the role of investors to oversee public companies and declared the proxy vote an asset of plan beneficiaries, to be exercised to protect value.

Like most rules, despite the good intentions, Avon immediately led to unplanned consequences. Funds that may once have voted by discretion when they saw something questionable now felt compelled to vote every meeting at every holding in every market, regardless of whether agendas were routine or controversial. None but a handful could handle that often-massive responsibility in-house. Most turned to outside vendors such as Institutional Shareholder Services (ISS). Funds increasingly, and ironically, pigeonholed the duty to vote as a matter of compliance—keeping DoL enforcers happy—rather than a factor associated with value protection, which had been Washington’s goal in issuing the Avon Letter. Many funds saw the responsibility purely as a cost center and kept budgets as low as possible. ISS and others responded to the market, building a utility for proxy voting advice.

Naturally, what institutions then produced in outward-directed corporate governance statements looked a lot like compliance documents.  Big funds such as TIAA-CREF and CalPERS led the way with detailed proxy voting decision trees, showing how they would cast ballots across the world given a range of fact permutations. The vote was becoming not so much about the merits and risk of any specific company, but rather about whether certain detailed rules were being followed. And since the rules were slightly different for each institution, companies had to gather sheaves of proxy voting guidelines to gauge how votes might come out. Or they could figure out the algorithms that ISS, Glass Lewis, and others were using. And if companies wanted to avoid negative votes, they would simply swing their governance practices into line with what the majority declared constituted good governance.

Critics, with some cause, contended that the corporate governance industry was an elaborate Rube Goldberg construct with minimal market benefit. In the United States and United Kingdom, for instance, ISS would analyze boards, companies would prepare proxies, and investors would go the trouble of reading and casting ballots in director elections—all while the plurality voting system in the United States and the British practice of conducting votes by a show of hands rather than proxy counts, meant that virtually all such votes were meaningless.

For decades, corporate governance had been little more than a code word for proxy voting, but now it has emerged as a deeper conversation about long-term value creation. This swift metamorphosis is producing a whole new species of public statements by investors.

In 2016, though, the superficial is giving way. Having now gotten used to majority voting in director elections and new rights such as ‘say on pay,’ a critical mass of investing institutions has shown an appetite and capacity to exercise meaningful ownership. To be sure, they still issue proxy voting guidelines. But those guidelines are increasingly prefaced by a coherent statement of values against which institutional investors make decisions. Investors are also releasing new kinds of statements explaining their expectations of governance at portfolio companies even if such matters never come to a vote.

Blackrock’s Larry Fink has grabbed headlines with his annual letters to corporate boards and executives, which have gotten progressively bolder. Wielding $4.6 trillion, he gets heard. But Fink isn’t offering a map of how Blackrock is going to vote proxies. He is instead urging companies to tell investors more about long-term strategy, show shareholders how boards review plans, abandon quarterly earnings guidance, and start taking environmental and social risks seriously. Implicit in his message is the pledge that, when voting, Blackrock will trust a board’s good faith efforts to apply these principles over cookie-cutter governance rules.

State Street Global Advisors has been among the most forward in pioneering the era of new governance messaging. In guidance papers that are almost philosophical in breadth, SSGA chief Ronald O’Hanley and governance head Rhaki Kumar have spelled out views on the culture of corporate boards and on how they should prepare directors to engage with shareholders on board composition and other matters. (Case in point: Evolving Expectations of Long-Term Investors, August 2015.)

Other institutions have followed suit. F. William McNabb, chair and CEO of Vanguard, has started sending similar letters to portfolio companies, in particular urging them to create board shareholder liaison committees to engage with investors. Legal & General Asset Management recently unveiled a guidance memo to boards defining its view on board composition matters.

These statements from big, mainstream investment firms mark a tectonic shift from considering governance principally as a compliance exercise about proxies to seeing it as a contributor to risk management and value creation. Indeed, as more funds begin the journey of integrating environmental, social, and governance factors into the investment discipline, they treat those factors as components of portfolio management more than mere cost centers. That has two major implications for corporations.

For one, those old proxy voting guidelines issued by your investors are still important, but they no longer tell the whole story. Scrutinize the new, broader letters and statements investors issue because they may help point the way to more board leeway as opposed to robotic obedience to governance standards.

Second, the broader statements map possibilities for deeper collaboration among investors and corporations. Long-term thinking shareholders and boards have always had much in common—but that was obscured while governance was considered separate from value. No wonder media reported Feb. 1 on high-level meetings between Berkshire Hathaway’s Warren Buffett, JPMorgan CEO Jamie Dimon, and Fink about the prospect of developing common understandings on governance and long termism. What was unthinkable just a few years ago is now practical. And that’s good—so long as companies appreciate and take advantage of the opportunities now waiting for them.