Universal Proxy, Increased Activism and Director Vulnerability

Rich Fields leads the Board Effectiveness practice and Rusty O’Kelley co-leads the Board and CEO Advisory Partners in the Americas at Russell Reynolds Associates. This post is based on their Russell Reynolds memorandum. Related research from the Program on Corporate Governance includes Universal Proxies (discussed on the Forum here) by Scott Hirst.

Each fall, Russell Reynolds Associates conducts dozens of meetings with investors, activists, and governance lawyers and professionals, focusing on governance trends. In our most recent meetings, we are hearing that the intersection of the universal proxy,[1] an active environment for traditional shareholder activism, and more assertive institutional investors will bring significant pressure on boards and directors concerning board composition and potential director vulnerabilities. Companies should prepare now, before a proxy contest or a campaign against the election of individual directors. This new and challenging environment will require most boards to greatly enhance their review of board composition and individual director vulnerability in the event of a proxy contest. Even if these campaigns do not garner strong investor support, they can publicly reveal board skill gaps and individual director vulnerabilities. We urge boards to talk with their lawyers, bankers, and firms like Russell Reynolds to understand the implications of these newly converging forces.

In the coming proxy season, public companies should expect to face more challenges from single issue activists/groups (e.g., climate and sustainability) as well as economic activists (e.g., traditional investment funds). We also expect to see an even greater increase in shareholder proposals on a wide range of governance topics. While companies have dealt with many of these issues before, they have not faced them with the added impact of the new universal proxy rules which went into effect in September 2022. The universal proxy gives these activists and cause-related groups the ability not just to propose a slate of directors, but it also allows all shareholders the ability to pick and choose individual directors from both company and activist nominees. As ISS noted, the new rules are a “superior” way for shareholders to vote and it is a “dramatically easier” and “cheap” way for activist shareholders to launch proxy fights. As one major investor noted, even if the activist garners only small support, the case against an individual director serving on a board and his or her perceived skill gaps will be highlighted.

In forthcoming proxy contests, we expect the more aggressive activists and single issue groups to target directors who may appear in public company disclosures to have the weakest case for their continued board service. In our early November interviews, a senior leader at one of the world’s largest institutional investors told us that they will be paying much more attention to each director’s qualifications, why each director is serving on a board, and their link to long-term value creation or destruction. Large institutional investors are ready to vote for the best board candidates and will pick among candidates from both company directors and activist candidates.


Mutual Fund Performance at Long Horizons

Michael J. Cooper is Huntsman Chair in Finance at the University of Utah David Eccles School of Business; Hendrik Bessembinder is Labriola Chair in Finance at Arizona State University W.P. Carey School of Business; and Feng Zhang is Corrigan Research Professor in Finance at Southern Methodist University Cox School of Business. This post is based on their recent paper, forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen, and Scott Hirst; Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy (discussed on the forum here) by Lucian Bebchuk and Scott Hirst; The Specter of the Giant Three (discussed on the Forum here) by Lucian Bebchuk and Scott Hirst; and The Limits of Portfolio Primacy (discussed on the Forum here) by Roberto Tallarita.

Most research that considers investor outcomes reports on unconditional or conditional (as in “alpha” estimates) arithmetic means of returns that are measured over relatively short horizons, most often monthly. In contrast, investment and decision horizons can stretch to decades, and differ across investors. We posit that many investors are concerned with the compound returns that accrue over longer horizons, propose that empirical measures of investment performance should therefore consider a variety of return measurement horizons, and report on compound returns to U.S. equity mutual funds at the monthly, annual, decade, and full-sample horizons. We also shed light on the respective roles of return skewness and mutual fund expenses, and we tally the full-sample dollar gain or loss to mutual fund investors in aggregate, on both a fund-by-fund basis and in total. The results verify that compound long-horizon returns often contain important information that is not readily apparent in the distribution of short-horizon returns. For example, some funds with positive monthly performance estimates have negative long-horizon abnormal returns.

We study a broad sample of nearly 8,000 U.S. equity mutual funds during the 1991 to 2020 period. We show that the percentage of funds that outperform market benchmarks decreases with the horizon over which returns are measured. In the monthly data, fund returns exceed the matched-month return to the SPY Exchange Traded Fund (taken as a proxy for the overall market that investors could readily have captured) for 47.2% of observations. The percentage of sample funds that generate buy-and-hold returns that exceed buy-and-hold returns to the SPY decreases to 41.1% at the annual horizon, 38.3% at the decade horizon, and 30.3% at the full-sample horizon. In fact, over 20% of funds fail to even outperform one-month U.S. Treasury Bills at the full-sample horizon.

These results reflect a prominent dimension by which long-horizon returns contain different information than short-horizon returns: the cross-sectional distribution of long-horizon fund buy-and-hold returns is strongly positively skewed, while such skewness is not observable in monthly returns. This positive skewness in compound long-horizon returns is of substantial practical importance. Financial planning (e.g. at pension funds) is often based on assumptions regarding mean returns. Aside from the active debate as to whether the assumed mean returns are appropriate, in a positively skewed distribution a potentially large majority of possible future realizations are less than the mean outcome. Of course, while strong positive skewness implies that many funds underperform, some funds perform very well. Out of 7,883 sample funds, 442 delivered a positive full-sample compound return more than twice as large as the compound return to the SPY over the matched months, and 160 delivered compound returns three times as large as the SPY during the matched months of the full sample.


Corporate Governance & Executive Compensation Survey

Richard Alsop, Doreen Lilienfeld, and Gillian Moldowan are Partners at Shearman & Sterling LLP. This post is based on a Shearman & Sterling piece by Mr. Alsop, Ms. Lilienfeld, Ms. Moldowan and Lona Nallengara and is part of the 20th Annual Corporate Governance Survey publication of Shearman & Sterling LLP.

The Survey consists of a review of key governance characteristics of the Top 100 Companies, including a review of key ESG matters.

Board Size and Leadership

The average size of the board of the Top 100 Companies has decreased from 12.5 directors in 2015 to 11.8 directors in 2021, and 46 of the Top 100 Companies have split the CEO and board chair positions.

Director Independence

Over the last 10 years, the number of companies at which the CEO is the only non-independent director has increased significantly.


Glass Lewis 2023 Policies Guidelines – United States

Brianna Castro is Senior Director of North American Research; Courteney Keatinge is Senior Director of Environmental, Social & Governance Research; and Maria Vu is Senior Director of Compensation Research at Glass, Lewis & Co. This post is based on their Glass Lewis memorandum.

Guidelines Introduction

Summary of Changes for 2023

Glass Lewis evaluates these guidelines on an ongoing basis and formally updates them on an annual basis. This year we’ve made noteworthy revisions in the following areas, which are summarized below but discussed in greater detail in the relevant section of this document:

Board Diversity

Gender Diversity

We are transitioning from a fixed numerical approach to a percentage-based approach for board gender diversity, as announced in 2022.

Beginning with shareholder meetings held after January 1, 2023, we will generally recommend against the chair of the nominating committee of a board that is not at least 30 percent gender diverse at companies within the Russell 3000 index. For companies outside the Russell 3000 index, our existing policy requiring a minimum of one gender diverse director will remain in place.

Additionally, when making these voting recommendations, we will carefully review a company’s disclosure of its diversity considerations and may refrain from recommending that shareholders vote against directors when boards have provided a sufficient rationale or plan to address the lack of diversity on the board, including a timeline to appoint additional gender diverse directors (generally by the next annual meeting).


Why Cryptoassets Are Not Securities

Jai Massari is Cofounder and CLO of Lightspark and Visiting Lecturer at Berkeley Law. This post is based on her Lightspark piece.

FTX’s collapse reiterates the need for comprehensive U.S. regulation of crypto markets. This regulation must have a solid legal foundation, a key pillar of which is a workable framework to distinguish cryptoassets[1] that are securities from those that are not. A new paper provides this framework, by showing why fungible cryptoassets are not themselves securities under existing U.S. federal securities laws. But also why ICOs and similar token sales should be regulated as securities offerings.

In 2014 the sponsors of the Ethereum Network sold 60 million ether tokens to fund the development of the network, which launched a year later. Because of similarities with a traditional common stock IPO, the ether “initial coin offering,” or ICO, raised a fundamental question: are cryptoassets securities under U.S. federal securities laws? The answer to this question, which we have been debating ever since, determines not only whether and how cryptoassets can be sold to the public but also whether we must hold and trade them under the existing rules and market structure developed over the past 80 years for securities.

The Securities and Exchange Commission’s primary theory on whether a cryptoasset is a security appears to be based upon whether the blockchain project associated with a cryptoasset is, at any point in time, “sufficiently decentralized.”[2] If so, the cryptoasset is not a security. This theory was first proposed by the SEC staff in 2018 to address ICOs, which were then all the rage, and was followed by more detailed staff guidance in 2019. But the theory has not aged well. It is impractical—if not impossible—to apply to today’s real life blockchain projects. It is not supported by existing judicial precedent, including the now crypto-famous Howey Supreme Court case.[3] And it has resulted in market distortions that harm both market participants and long-term innovation in the crypto industry.

An intriguing new paper, The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are Not Securities,[4] points us to the right path. The paper analyzes the relevant caselaw and concludes there is scant legal basis to treat fungible cryptoassets as securities, and it sets out analytical approach that is far more satisfying. The paper separates capital raising transactions by blockchain project sponsors or other insiders in which a cryptoasset may be sold—which are typically securities transactions—from the treatment of the cryptoasset, which is not a security. This analytical framework addresses the now apparent challenges created by the SEC staff’s approach and appropriately focuses the SEC’s regulatory jurisdiction on capital raising transactions.


Enforcement Authorities Urge Integration of Corporate Compliance Programs in 2023

John C. Kocoras and Joseph M. Yaffe are Partners at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on their Skadden memorandum.

The fundamental components of effective corporate compliance programs have not changed significantly in recent years.[1] However, United States enforcement authorities are trying to reinvigorate companies’ attention to those programs.

U.S. Department of Justice leaders expressed particular concern this year about whether companies have appropriately integrated their compliance departments. In March 2022, the assistant attorney general for the U.S. Department of Justice’s Criminal Division — a former corporate chief compliance officer — described his perception of compliance professionals’ environments: “I know the resource challenges. The challenges you have accessing data. The relationship challenges. The silo-ing of your function.” He warned companies: “Support your compliance team now or pay later.”[2]

The United States deputy attorney general repeated these concerns in September 2022, explaining that “resourcing a compliance department is not enough; it must also be backed by, and integrated into, a corporate culture that rejects wrongdoing for the sake of profit.”[3] The remarks accompanied her release of a memorandum that federal prosecutors must follow when evaluating the strength of a company’s compliance program in determining how to resolve an investigation.[4] The memorandum challenges companies to ensure that compliance programs have the highest levels of company attention, are resourced appropriately and do not operate in silos.[5]

The emphasis on compliance program integration warrants close attention in 2023. Summarized below are four actions companies should consider to help ensure that their compliance programs are optimized and effectively positioned to respond to government review, along with the business functions that typically should participate. This is of course not an exhaustive list of aspects of compliance programs that warrant attention, but rather suggestions on elements that would likely benefit from a fresh look.


Cybersecurity Disclosures What Progress has been made?

Subodh Mishra is Global Head of Communications at Institutional Shareholder Services. This post is based on an ISS Corporate Solutions memorandum by Senior Editor, Paul Hodgson.

Disclosures on cybersecurity practices for the S&P 500 and the remainder of the Russell 3000 are inching forwards in the face of increased expectations to be introduced by the Securities and Exchange Commission (SEC) in early 2023, though not in every instance. To determine progress, ISS Corporate Solutions assessed data on the Governance Quality Scores (GQS) of companies against a series of 11 cyber security GQS questions, including: “How often does senior leadership brief the board on information security matters?” and “Is the company externally audited or certified by top information security standards?” Data was analysed most recently as of Oct 2, 2022.

Our observations of many of the GQS questions, companies’ disclosure practices have increased marginally in advance of the coming SEC regulations.

Key Takeaways

  • Increases in disclosures include:
    • companies indicating clear approaches to identifying and mitigating information security risks
    • senior leadership briefing boards on information security, only a minimal increase
    • information security training programs
    • the number of companies with independent information security committees in the S&P 500
    • the number of companies with an information security risk insurance policy
  • The number of companies with at least one director with information security experience increased marginally in the S&P 500, though it decreased in the Russell 3000, excluding the S&P 500

A number of companies have moved from general disclosure to a clear approach in terms of disclosing how they identify and mitigate information security risks, with those demonstrating a clear approach increasing by around 2 percentage points in both indexes.


The Flaw in Anti-ESG Logic: Financial Interests of Companies Like Meta Don’t Always Align with Those of Its Shareholders

Frederick Alexander is the CEO of the Shareholder Commons. This post is based on the class action filed against the directors of Meta Platforms (formerly Facebook, Inc.), and is part of the Delaware law series; links to other posts in the series are available here.

In the last few months, there has been an organized effort to falsely argue that companies and institutional investors are inappropriately prioritizing social and environmental responsibility over financial returns. The effort includes state treasurers from Texas, West Virginia, and Florida, as well as anti-ESG activist and fund manager Vivek Ramaswamy.

These critics charge that when companies and institutional investors address systemic concerns (by seeking to reduce carbon emissions or increase inclusivity, for example), they are ignoring financial returns, and instead pursuing a climate or racial justice agenda. In order to protect investors, they argue, it should be illegal for investors to account for any systemic concern, even if the concern relates to profit. 

This argument has a number of flaws. The most obvious is the conflation of motives with methods. It is smart, and in no way duplicitous, for individuals motivated by concerns about the climate to persuade executives and investors that companies can increase profits over the long term by taking steps that reduce emissions, even if doing so is expensive in the short-term. Finding common ground upon which to increase investor returns while preserving social and environmental systems is just a good idea, not a scandal.


ESG and Incentive Compensation Plans: Are Investors Satisfied?

Matthew Behrens is Counsel and Giulia La Scala is an Associate at Shearman & Sterling LLP. This post is based on a Shearman & Sterling piece by Mr. Behrens, Ms. La Scala, Doreen Lilienfeld and Gillian Moldowan and is part of the 20th Annual Corporate Governance Survey publication of Shearman & Sterling LLP. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr.; and Stakeholder Capitalism in the Time of Covid (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

The “stakeholder” view of corporate governance, which argues that corporate decision-makers have a responsibility to consider the impact of corporate activities not only on shareholders but on society as a whole, has long been debated, with some scholars even finding arguments in the writings of Adam Smith that companies may weigh competing stakeholder claims.[1] Recent years, however, have witnessed the “stakeholder” view no longer confined to the ivory halls of academia, but present in the wood-paneled board rooms of institutional investors and the fluorescent-light-drenched offices of government regulators. For those that would argue that issuers are embracing this view, the continuing growth of ESG metrics in incentive compensation plans has become a primary piece of evidence. For example, this year our survey data shows that 60 of the Top 100 Companies disclose that they incorporate ESG metrics into their incentive compensation programs, which is a 19% increase from last year.

Notwithstanding their seeming embrace of the “stakeholder” view, U.S. issuers are facing increasing pressure to prove that their claims of stakeholder focus are grounded in fact and evidenced by action. To that end, disclosures around ESG metrics in incentive plans are increasingly being challenged as vague or lacking the transparency necessary for outsiders to gain a true understanding of the issuer’s ESG goals and management’s performance against those goals.[2] Notwithstanding this desire for more detailed compensation-related ESG disclosure, issuers face the ongoing challenge of how to define meaningful and objective metrics. Further, as work continues on the establishment of a global set of standards for ESG reporting similar to financial reporting (particularly with respect to climate reporting), questions remain as to whether such a standard would in fact be beneficial.

This article summarizes the current status of incentive compensation disclosures and the challenges to those disclosures, as well as focusing on the work being done to establish a more transparent reporting regime. Finally, the article offers considerations for issuers looking to provide more meaningful disclosure around the use of ESG metrics or considerations in their incentive compensation programs.


SEC Proposes New Rule to Require Investment Advisers to Conduct Additional Oversight of Service Providers

James E. Anderson, Anne C. Choe, and Rita M. Molesworth are Partners at Willkie Farr & Gallagher LLP. This post is based on a Willkie memorandum by Mr. Anderson, Ms. Choe, Ms. Molesworth, Justin L. Browder, Adam Aderton, and Aliceson (Kristy) Littman.

Executive Summary

On October 26, 2022, by a 3-2 vote, the Securities and Exchange Commission proposed to require SEC-registered investment advisers to conduct both documented due diligence before hiring, and continued oversight of, third-parties when outsourcing certain functions necessary to the adviser’s provision of investment advice. Proposed Rule 206(4)-11 appears to be the latest SEC effort to expand registered investment advisers’ obligations through prescriptive rules under the Advisers Act. If adopted, the proposals would require advisers to:

  • conduct due diligence before outsourcing and to monitor service providers’ performance and reassess whether to retain them periodically;
  • make and/or keep books and records related to the due diligence and monitoring requirements;
  • amend Form ADV to collect census-type information about advisers’ use of service providers, including their relationship to the adviser and the type of services rendered; and
  • conduct due diligence and monitoring of third-party record keepers and to obtain reasonable assurances that they will meet certain standards of service.

I. Overview

Many advisers employ a layered approach to serving their clients, providing some services themselves and outsourcing others. Commonly outsourced functions include data and record management, software services, the creation of specific indexes or trading models and tools, trading desks, accounting and valuation services, risk management, artificial intelligence tools developed for trading, and cybersecurity.[1] Advisers often also outsource more clerical, administrative, or essential needs found in many types of businesses, including email, real estate leases, and licenses for off-the-shelf software. Outsourcing generally has expedited and aided investment advisers in providing services to their clients in efficient and cost-effective ways.

The SEC’s proposal seeks to address the risk of third-party service failures that would impair an adviser’s ability to perform required advisory functions by mandating documented due diligence and continued oversight of third parties providing “core advisory services.” The proposal would require investment advisers to conduct detailed diligence before engaging in an outsourced core advisory service, provide disclosure related to these services, conduct periodic monitoring of third-party providers to ensure their reliability, and maintain detailed recordkeeping related to functions necessary for providing investment advisory services.


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