Getting to Know You: The Case for Significant Shareholder Engagement

I’ll begin my remarks with a premise. It’s a simple belief that I have. And that is: Corporate governance should not be a mystery. For corporate boards, the way large investors vote their shares should not be a mystery. And for investors, the way corporate boards govern their companies should not be a mystery. I believe we’re moving in a direction where there is less mystery on both sides, but each side still has some work to do in how it tells its respective stories.

So let me start by telling you a little bit about Vanguard’s story and our perspective. I’ll start with an anecdote that I believe is illustrative of some of the headwinds that we all face in our efforts to improve governance: “We didn’t think you cared.” A couple of years ago, we engaged with a very large firm on the West Coast. We had some specific concerns about a proposal that was coming to a vote, and we told them so.

The proposal failed, and it was embarrassing for the firm. They responded by reaching out for feedback from all of their largest shareholders—or so they said. They didn’t call their largest independent shareholder—Vanguard—nor did they apparently take into account the very specific feedback we had already provided.

In conversations afterward with them (once we finally got to the board), they told us, essentially, “You guys run index funds. We didn’t think that you cared.”

Well, we do care. A lot! Interesting postscript: Now that this company knows we care, they’ve taken substantive action in response to input from us and others.

A word about Vanguard

Let me pause for a moment to give you some additional context for Vanguard’s point of view. Today we are the largest mutual fund firm in the world. We have $3.3 trillion in global assets under management. We have 159 funds in the U.S., and an additional 123 in markets outside the U.S. In the U.S., we have nearly $1.7 trillion in index equities and an additional $356B in actively managed equity funds.

What that all means is that Vanguard investors collectively own about 5% of every publicly traded company in the United States and about 1% of nearly every public company outside of the U.S.

And, remember, when it comes to our indexed offerings, we are permanent shareholders. To borrow a phrase from Warren Buffet: Our favorite holding period is forever. We’re going to hold your stock when you hit your quarterly earnings target. And we’ll hold it when you don’t. We’re going to hold your stock if we like you. And if we don’t. We’re going to hold your stock when everyone else is piling in. And when everyone else is running for the exits.

In other words, we’re big, we don’t make a lot of noise, and we’re focused on the long term.

That is precisely why we care so much about good governance. Vanguard funds hold companies in perpetuity. We want to see our investments grow over the long-term. We’re not interested in managing the companies that we invest in. But we do want to provide oversight and input to the board of directors. And we count on boards to oversee management.

That perspective informs our approach to corporate governance. So let me share, at the very highest level, our six principles on governance. These are some of the same ideas that the panelists discussed earlier this evening:

1. Independent oversight and, more broadly, appropriate board composition. It is the single most important factor in good governance. If you think about it, we’re in a representative democracy. We empower a group of people to oversee our interests as shareholders, to hire and fire the CEO, and to have a say in strategy, risk oversight, compensation, and so forth. We as shareholders are not there, and that group of representatives needs to be our eyes and ears. Who they are, how they interact, and the skills they bring to the table are critical from a long-term value standpoint.
2. Accountability. Management should be accountable to the board. The board should be accountable to shareholders.
3. Shareholder voting rights that are consistent with economic interests. This means one share, one vote. No special share classes for added voting power.
4. Annual director elections and minimal anti-takeover devices. We believe that shareholders benefit when the market for corporate control functions freely.
5. Sensible compensation tied to performance. The majority of executive pay should be tied to long-term shareholder value.
6. Engagement. I’d like to place my greatest emphasis on engagement tonight, because it serves as a touchstone for all of our other core principles.

At Vanguard, we’ve been on a journey toward increased engagement over the past decade or so. Our peers in the mutual fund industry have as well. Proxy voting is not poker. Our votes should not come as a surprise to companies and their boards.

Our outreach efforts began many years ago by simply posting our proxy voting guidelines on our website, then having ad hoc, issue-driven conversations with companies. A few years later, we began writing letters to companies from our CEO (my predecessor in the role, Jack Brennan, started this practice). We wanted them to know that we were a significant shareholder, and we wanted them to be aware of our guidelines.

As we’ve gone along, we’ve become more targeted in whom we mailed letters to and more prescriptive in our language.

In March, we sent out 500 letters to independent chairs and lead directors at companies across the U.S. In the letter, we talked about our six principles for corporate governance and the importance of engaging with shareholders. In just two months, we’ve received 164 responses, and they were almost all uniformly positive, thanking us for reaching out. Directors shared the various formats they use for engagement:

• Sometimes the lead director is in charge of shareholder engagement.
• Sometimes it’s a committee of directors.
• Some companies have board members involved in “investor days” for their industry, where they’re hearing from shareholders.
• And at other companies, the general counsel meets with different investor groups and reports back to the board.

What we’re always advocating for, essentially, is thoughtful engagement. It’s really “quality over quantity”: knowing your shareholder base, knowing what they care about, and knowing how often they want to engage with you.

Engagement is bilateral and comes in many forms.

Engagement is a two-way street. It’s not just about publishing proxy guidelines or investors voicing concerns. There are some great examples of boards being proactive and getting their messages out to investors. Two examples from recent years:

• Microsoft, in a number of instances, has used videos from their directors to communicate the board’s perspective on issues. Whether it’s the lead independent director describing the board’s role in overseeing strategy or the chair of the audit committee describing the board’s perspective on risk management, these insights into the board’s thinking provide helpful context for investors. This is a great example of one form of “one-to-many” engagement that is simple, underutilized, and very much appreciated by us as investors.
• Another example: When Dell announced its intention to go private, we met with the special committee of the Dell board that had to make the decision on shareholders’ behalf to sell at a specific price. We listened to their perspective, their decision-making process. and the things that they took into account. It put us in a better position to decide whether this was a good deal. The more opportunities we have to interact with directors in the normal course, the more we have an increased level of insight.
• An example that was resolved only a few hours ago, of course: DuPont and Trian. It’s a cautionary tale of how no company is truly immune to activist investors. DuPont is well-known and highly regarded, and, most relevant to our discussion here, has been reaching out to investors and acting on their feedback for years. The board gets feedback early, and feedback influences strategy at the company. DuPont and Trian engaged with each other for two years beforehand. But a proxy struggle ensued nonetheless.

Practical engagement around board composition

Sometimes engagement can mean just being crystal clear about your expectations—and about how you think through certain issues. This applies to boards and to investors. For example:

• Do you have a set of written guidelines that spell out the type of expertise or perspectives that you want in your board members (i.e., these are the types of things we’re looking for, and these are the people we believe embody them)? We’re seeing an increasing number of companies offering this kind of perspective, and it’s very helpful to investors.
• Do you have a way to assess appropriate board tenure, both at the aggregate and individual level? Investors might have questions about why, for example, a particular board member has served for 30 years and whether he or she is sufficiently independent of management.

There’s a need to have a framework to raise important questions and have meaningful discussions between boards and investors to help facilitate a level of self-awareness for boards. A framework allows them to say, in essence: We realize that our board is comprised differently (or operates differently) than other firms in our business—and here’s why.

There may be a good reason for a board to be an outlier. There may not be. But let’s provide as much context as we can and invite the discussion. Because investors are going have these questions anyway. In the absence of additional context, they may draw their own conclusions.

Thinking like an activist

The outlier concept extends beyond board composition and gets into matters of business oversight and strategy. The best boards work to understand where their companies might be different or might be perceived as different.

Are those differences strengths or vulnerabilities? Some of this is a defensive mindset. Some of this is the continued evolution of the board’s role in strategy. In many companies, we’re seeing the board’s role move beyond the historical perspective of “review and concur” to becoming more engaged in setting the strategy.

So how does a board inform itself? If you want to, as a director, you can be fed a steady diet of management’s perspective on issues. And in many instances, if left to your own devices, that’s what you get. Management comes in, gives you a presentation, and tells you why this is the right strategy. If that’s all you’ve got, shame on you.

As an aside here: I’m continually sounding the warning about the danger of complacency to employees and leadership at Vanguard. The firm has been doing very well, particularly over the past several years, in terms of cash flow, performance, and large-scale initiatives that we’ve rolled out. It would be very easy for us to feel like we can take a breath, maybe relax a bit. Complacency is a temptation. But we can’t succumb to that temptation. A relentless pursuit of excellence on behalf of our clients continues to drive everything we do. As Andy Grove, former CEO of Intel, put it, “Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” I’d suggest that this is how boards need to be thinking—functional paranoia. Are you getting enough different viewpoints?

Healthy and vibrant boards think like an activist in the very best sense. They ask:

• Where should we be pushing harder or taking costs out? What are the management team’s blind spots?
• What are the board’s blind spots?
• And how do we correct that? Some boards bring in sell-side analysts that have a “sell” on the company to tell them what they’re missing.

If all the board is listening to is management’s perspective, they may be surprised when an activist shows up and says, “Hey, your cost structure is way out of line with your competitors.”

Glenn Booraem, who heads up Vanguard’s corporate governance team, was just telling me about a conversation he had last week with an activist. The activist’s premise was, “As long as there are unhappy shareholders, activists have a role.”

This particular activist has a theory about maximization mindset versus sufficiency mindset. An owner is going to have a maximization mindset: the owner wants to maximize the value of an investment over time. So as an owner, if you have significant money on the line, you might make different decisions than what this activist described as some boards’ sufficiency mindset. If a board has a sufficiency mindset, then a presentation by the management team seeking approval for a big initiative might be met with, “Yeah, that looks good. That looks reasonable. You’ve made a sufficient case to make this capital investment.”

But if you’re looking at the presentation with a maximization mindset—you’re spending your own money, in essence—you might say, “Can you do it for 5% less? 10% less? 15% less?”

This activist’s contention was that some boards aren’t pushing hard enough because they’re not in the owner’s seat and aren’t thinking as owners of the organization might think.

Changing nature of activist investors

The nature of activist investing has changed significantly since the 1980s. Today, we’re seeing a greater trend toward constructive activists rather than destructive activists. Activists are not inherently good or bad. They often raise legitimate questions.

When activists raise legitimate questions and tie their business cases to long-term shareholder value, that gets our attention. I can think of several cases where a board wasn’t asking the right questions and eventually lost touch with how the company was being run and being perceived by investors. If the first time we’re hearing from a company in our role as shareowners is when the company is under siege by activists, that’s not good. The company is inherently on the defensive at that point. And they’ve lost control of the narrative, at least to some degree. Generally speaking, activism most often happens when something is broken.

I’ll share two instances where Vanguard has sided with activist campaigns in recent years.

• Canadian Pacific Railway: In 2012, activist Bill Ackman identified some vulnerabilities in Canadian Pacific Railway. We agreed—as did many other large investors—that the company had been poorly run and governed. Ackman brought in an experienced CEO and a number of directors they thought could make a difference. It’s been an activist success story by and large.
• Commonwealth REIT. Another example of us supporting an activist: In 2014, Corvex and Related Companies waged a successful campaign to replace the entire board of Commonwealth REIT. This was a company with a track record of poor performance and poor governance, and they were ultimately held accountable. Commonwealth was using a third-party management firm, RMR, that was run by family members of Commonwealth leadership. RMR extracted value from the public company. They didn’t operate it well, but they were paid well nonetheless. We supported wiping the slate clean. In the case of Commonwealth, we were the largest shareholder. We were important to Corvex’s case, but at the end of the day, I don’t think they needed us. Eighty-one percent of Commonwealth shareholders voted to remove the company’s board.

A caveat

There is a caveat that I want to mention, and it has to do with backbone. We’re talking about how dangerous it is for companies to essentially write off any particular group of shareholders. Part of the board’s role is to listen. If someone’s going to buy up 5% of the company, you should at least listen.

That said, it doesn’t mean that the board should capitulate to things that aren’t in the company’s long-term interest. Boards must have a backbone. To be frank, board members cannot be more worried about their own seats than they are about the future of the company they oversee. Boards must take a principled stand to do the right thing for the long term and not acquiesce to short-term demands simply to make them go away.

Don’t be dissuaded by common concerns

We do hear concerns from boards who haven’t fully embraced more significant shareholder involvement. The most common are:

• “Strong shareholder engagement will disintermediate management.” This is not what large shareholders want in an engagement program. Boards will often choose to include management for legal support and to talk about operational issues. And then there are those matters that are the exclusive province of the board, such as CEO compensation, which we believe are appropriate for discussion with the board alone.
• “We’ll get tripped up on Reg FD issues.” Just to be clear, large shareholders are not looking for inside information on strategy or future expectations. What they’re looking for is the chance to provide the perspective of a long-term investor. Companies individually have to decide how to best manage that risk, but it shouldn’t be by shutting out the shareholders completely. Firms can train directors, include their legal counsel in shareholder conversations, and set clear boundaries for discussions.
• “There is no time in our agenda.” Boards should talk about how much time to allot to engagement. I would say, of course, that time for engagement with significant shareholders should be on the board’s agenda. Investors are an important constituency whom boards represent.
• “This would be too difficult to implement.” Leading companies already have substantive engagement programs in place. The Shareholder-Director Exchange Protocol is available online and offers guidance on setting up engagement programs.

If your company doesn’t have an engagement program already underway, start where you are. Start now. The landscape has shifted, and companies cannot afford to be insular. The engagement train has left the station, and the leading companies are on board.

Shareholder engagement establishes common ground

A big part of the engagement process is establishing common ground, getting to the things that the shareholder and the board both know to be true, and getting to the things that they’re both trying to accomplish. There should be an extraordinary degree of alignment between the interests of the shareowners and the board, because the board represents the shareowners.

One critical benefit of good relationships that I’ve seen is being able to provide background on some of the votes we’ve cast. As you know, shareowners have only two votes: for or against. But not every “for” vote is “absolutely for.” A good relationship allows us to fill in those shades of gray between “absolutely for” and “absolutely against.” We may vote “for” but have reservations at the margin. If we don’t share those reservations, then the company has no opportunity to consider addressing those issues and might be very surprised to find that our vote has changed the next time. Or if we vote against the company’s recommendation, a good relationship allows us to share why we voted that way and what the company would need to do to get our support.

If all we’re doing is simply voting, it doesn’t give the company the full picture. So the company is flying blind, in a way.

From Vanguard’s point of view, we’re in the relationship to maximize the value of the longest of long terms for our fund investors. We understand that things don’t always go up in a straight line. So if we have a good relationship with a company, they have a great opportunity to tell us their story. If there are performance problems, for example, either own those problems or tell us what you’re doing to fix them. For example, “We know we’ve got cost problems. We’ve got this initiative underway to trim $1 billion in costs for the next three years, and we think that’s going to address our problems.” Whatever the particular issue might be.

It’s worth noting that in the vast majority of cases, we’re happy to engage with management, too. Many times the questions or concerns we have are ones that we’re very comfortable relaying to management and getting management’s perspective on. In fact, many companies are including in their proxy statements more information about the engagement they’ve done with their investors. We’ve seen tables that show “what we heard” and the corresponding “what we did.” We think that’s a great trend.

So much of engagement gets back to the idea of self-awareness and knowing the places in which you’re an outlier. Unless you know where you stand, both from a competitive standpoint and with your investors, you’re a sitting duck.

Looking ahead: The future of engagement

I’ll close my remarks with a few thoughts addressed directly to board members of public companies: We count on you to oversee the companies that our clients invest in. It’s an important role. In the U.S. alone, Vanguard invests in some 3,800 publicly traded companies. We place a great deal of trust and confidence in you. And trust and confidence are built upon open communication. We want to continue to increase the levels of engagement we have with boards. We believe that directors—and investors—are moving in the right direction on that front.

As we look ahead, I believe we can do more.

• One idea: The Shareholder-Director Exchange that I mentioned. It provides a protocol and some tools and guidelines for institutional investors and directors to talk. It’s a wonderful idea, and it has great promise. There’s an open question on how best to measure the effectiveness of engagement on a wider scale. But from our perspective, every positive change that we can help to effect is a win for our investors.
• Another possible channel that I’m passionate about: The creation of standing Shareholder Relations Committees on public boards. It could be an incredibly effective way for boards to gather those outside perspectives I discussed earlier. Frankly, we’re surprised that more boards don’t solicit our views on general industry topics. For example, we have a very successful actively managed Health Care Fund—the world’s largest health care fund, by a wide margin, at more than $50 billion in assets. I would think that the directors of pharmaceutical firms or biotech firms would be interested in talking to our portfolio manager to hear her opinions and outlook for the industry. There is a great opportunity for dialogue between investor and director on that level as well.

You, as directors, have a great opportunity to tell us how your bring value to investors. We want to listen. When you post a video to the company’s website, we’ll watch it! When you give a good explanation of an issue in your proxy statement, we’re reading it very carefully. When you provide context, we’re taking it in.

We are listening to your perspective. We want you to be aware of ours. We are your permanent investors. We care very deeply about the role that you play for our clients. And we thank you for doing the job well.

Thank you for listening.