Looking into the future of changes to corporate governanceInterest in corporate governance has increased exponentially over the last several years, as has shareholder and governmental pressure – often successful – for companies to change how they are governed.  Since 2002, we’ve seen Sarbanes-Oxley, Dodd-Frank, higher and sometimes passing votes on a wide variety of shareholder proposals, and rapid growth in corporate efforts to speak with investors.  And that’s just for starters.   

These developments represent the latest iteration of what has become part of our normal business cycle – scandals (e.g., Enron, WorldCom, Madoff, derivatives), followed by significant declines in stock prices, resulting in public outrage, reform, litigation, and shareholder activism.   Now that the economy is rebounding, should we anticipate a return to “normalcy” (whatever that may be)?  Are we back to “business as usual”? 

Gazing into a crystal ball can be risky, but I’m going to take a chance and say “no.”  While our economic problems have abated, I believe that the past is prologue – in other words, we’re going to continue to see more of the same: investor pressure on companies, legislation and regulation seeking a wide variety of corporate reforms, and the like.  Some more specific predictions follow: 

  • Increased Focus on Small- and Mid-Cap Companies:  Investors have picked most if not all of the low-hanging governance fruit from large-cap companies.  Sure, there are some issues that may generate heat and some corporate “outliers” that investors will continue to attack.  However, most big companies have long since adopted such reforms as majority voting in uncontested director elections, elimination of supermajority votes and other anti-takeover provisions, and shareholder ability to call special meetings, to name just a few.  If investors (and their partners, the proxy advisory firms) are to continue to grow, they have to find new targets, and small- and mid-cap companies fit the bill.  They have less experience in dealing with investor pressure and fewer resources with which to address that pressure.  I hate to say “be scared, be very scared,” but some vigilance certainly is in order.
  • Individual Directors’ Skills and Experience Will Come Under Increased Scrutiny:  It’s no news that directors are always the first to be blamed when anything goes wrong – whether or not the problem arises in an area for which the board is directly responsible.  Of course, boards are not responsible for everything a company does, and should not be viewed as guarantors of every corporate activity, but the world at large doesn’t accept that.   Hence the question “Where Was the Board?” whenever anything goes wrong.  So it’s only natural that investors and proxy advisory firms can be expected to question whether the company has directors with the skill sets needed to oversee the prevention of fraud, regulatory violations and other problems.  Just think of Target, where Institutional Shareholder Services recommended a vote against all the members of the Audit and Risk Committee to hold them responsible for the infamous cybersecurity breach (all were nonetheless elected) or JPMorgan Chase, where two directors were for all practical purposes hounded off the board after the “London Whale” scandal came to light. 
  • Pressure for Board Diversity and Board “Refreshment” Will Increase:  It shouldn’t come as a surprise that boards are coming under attack for being “male, pale and stale”.  Some European countries have mandated quotas to assure that more women are added to public company boards, and last year the California State Senate adopted a resolution urging (though not requiring) that public companies add women to their boards.  Other constituencies are making similar claims for board representation.  One way of accelerating diversity (and, arguably, fresh thinking) is to increase turnover on boards – hence the term “refreshment.”  ISS has tweaked its “QuickScore” measure to flag any director who has been serving for more than nine years, and it may only be a matter of time before it deems those long-serving directors to be non-independent or otherwise unsuitable.   (Of course, companies have been grappling for decades with getting superannuated directors off their boards.) 
  • Executive Compensation Will Remain a Key Area of Investor Focus:  It’s been said that executive compensation is the lens through which investors test the quality of a company’s governance.  That’s been the case for a while, and there’s no reason to think that its significance will diminish.  In fact, with the possibility of further SEC rulemaking on disclosure of pay ratios, clawbacks and pay-for-performance, it’s quite possible that the focus on “following the money” will increase. 
  • Continued Federal Incursions into Substantive State Corporate Law:  The enactment of Sarbanes-Oxley in 2002 represented the first major incursion into what had always been the sole province of state corporate law; among other things, SOX imposed specific requirements and prohibitions on the members and activities of audit committees.  To a lesser extent, Dodd-Frank did the same thing vis-à-vis compensation committees and also mandated advisory shareholder votes on executive compensation.   Congress has since enacted laws addressing disclosure of conflict minerals and trading with certain countries, effectively deeming those and other matters to be material regardless of their financial impact.  The pursuit of such “social” laws used to be limited to the Internal Revenue Code, but with tax law becoming a political hot potato that no one wants to touch, the federal securities laws have become the populist legislator’s favorite vehicle for effecting social change.  There’s no reason to think that’s going to change. 
  • Proxy Advisory Firms Will Continue to Exert Influence:  The preceding references to ISS were not accidental.  Despite ongoing pressure from the business community, it’s unlikely that ISS and its principal competitor, Glass Lewis, are going to fold up their tents and go away.  Among other things, their clients need them, which will tend to assure their continued existence.  Moreover, despite the SEC’s recent Staff Legal Bulletin regarding proxy advisory firms, there’s no reason to think that the proxy advisory firms’ business models will undergo appreciable change.  
  • Activism Isn’t Going Away – Though Perhaps It Will Moderate:  Given the extraordinarily high returns on activist activities, it seems unlikely that activism will go away of its own accord.  And activists have demonstrated that when it comes to targets, size does not matter; big and small companies alike are vulnerable.  In fact, given the amounts involved, bigger companies may be more likely than small ones to be the targets of activism.  However, there may be some indications that the growth in activist activities may moderate.  First, there have been some stumbles among activists, including the blunders made by Pershing Square in changing the leadership of J.C. Penney.   A more likely moderating influence is that the success of activist funds to date has led to ever-increasing investment costs, which is already being reported as putting a damper on new money coming into activist camps. 
  • Shareholder Engagement Will Increase, With Complications:  Engagement has proven to be one of the few effective ways of dealing with investor unrest and activism.  It has enabled companies to obtain better voting results on director elections, shareholder proposals and say on pay.  And it has enabled some companies to establish their credibility with their major investors in advance of activist attacks, thereby helping to defend against those attacks.  However, this success has made it more difficult for companies to engage; their major investors are being besieged by many of the companies in which they have invested, reducing the already limited time available for meaningful engagement.  Companies are having to develop innovative ways of engaging, including getting a head start – i.e., right after the annual meeting instead of waiting until next year’s – and conducting governance roadshows. 
  • Strong Performance Will Trump All of the Above:  For those of us who can be described as governance “wonks,” it might be nice to think that good governance and all that the term implies is of paramount importance, and that investors will seek out good governance whether or not the companies in which they invest are performing well.  That’s probably not the case; in fact, it’s probably time for a study demonstrating that when the stock price increases, support of shareholder proposals and other investor initiatives decreases.  That’s certainly been my experience, and many of my friends and counterparts say the same thing.  

The above are just some of the things I see in my crystal ball.  It will be interesting to see if my predictions prove accurate, and I’ll follow up on that in due course.  In the meantime, let us know what you think is coming down the pike.