Three Things Nominating Committees Need to Know

Ruby Sharma is a principal and Ann Yerger is an executive director at the EY Center for Board Matters at Ernst & Young LLP. The following post is based on a report from the EY Center for Board Matters, available here.

Nominating committees are facing heightened scrutiny from investors and other governance specialists who are intensifying their focus on board composition and director qualifications. This is driven by several developments, such as the push for greater diversity in the boardroom (including recent comments by U.S. Securities and Exchange Commission Chair White indicating that she’s requested a review of existing company disclosures on board diversity), [1] increased investor and company interest in board assessments, the growing influence of hedge fund activists who may question board performance and the emergence of, according to many governance specialists, proxy access [2] as a new leading practice.

In this post, we offer three tips for nominating committees facing this changing environment, informed by the EY Center for Board Matters’ review of the US corporate governance landscape, ongoing conversations with investors and the broader governance community, and use of our proprietary corporate governance database. [3]

1. Evaluate and enhance disclosures about director qualifications, board composition and board assessment processes

Most institutional investors we spoke with (more than 75%) said companies are not doing a good job explaining why they have the right directors on the board. [4] Historically, investor understanding of director qualifications has been limited to basic biographic information in proxy filings representing “to the letter” compliance with the requirement to disclose: “… the particular experience, qualifications, attributes or skills that qualified that person to serve as a director of the company … in light of the company’s business.” [5]

Now, companies are increasingly enhancing their disclosures by explaining more about how each director contributes to the board. Some disclosures go further to describe how the board and its committees, as a whole, have the appropriate mix of skills, expertise and perspectives to oversee the company’s key strategies, challenges and risk management efforts.

Companies are making other efforts to enhance the way they communicate to investors, such as by using graphics, tables and letters to shareholders. Some are exploring the use of videos and other media. And some are looking to other markets such as the United Kingdom, Australia and Canada for ideas for how to enhance their own disclosures. For example, some companies may explain how new directors complement the existing board, provide specific examples of industry and functional expertise, illustrate how different forms of diversity combine to provide for a more dynamic board, explain how the board’s expertise is enhanced through additional educational opportunities and discuss how the board assessment process is used to further strengthen the board.

When there are questions about company performance, investors are likely to look more closely at board composition, and when there are minimal or no disclosures demonstrating how directors contribute to the company’s strategic goals, investors may question the performance assessment process. [6] For example, they may ask how the evaluation process is structured, how often it’s carried out and how results are addressed. They also may ask about the role of independent board leaders, other stakeholders and/or third parties in the process. They may also question how board candidates are sourced, the board succession planning process and director education practices.

2. Integrate diversity, expertise and tenure considerations into board composition and succession planning

Nominating committees play the critical role of linking the board’s director recruitment, selection and succession planning processes to the company’s strategic goals. They do this by trying to maintain the best mix of expertise and perspectives in the boardroom to address the ever-changing business environment and oversee the company’s key strategic efforts.

Nominating committees, institutional investors and other governance observers are increasingly weighing additional perspectives in the director selection process, such as diversity (including gender, racial, cultural, geographical, generational diversity), industry knowledge, global perspectives, and expertise in areas such as cybersecurity and environmental sustainability.

An ongoing focus on board composition allows the nominating committee to maintain a balanced mix of fresh insights (from recently appointed directors) with institutional knowledge (from seasoned and longer-tenured directors) and other perspectives in between (based on variations in board tenure). The table below provides some general metrics on board composition, which may be helpful to nominating committees seeking to develop a view about longer-term positioning for their boards.

How does your brand compare?

Summary data S&P 500 S&P 1500 Russell 3000
Average board tenure 10 10 9
Average age 63 63 62
Gender diversity 20% 16% 13%

3. Growing attention to board composition and quality may influence how investors vote in future director elections

Investors historically have voted against director nominees based on triggers such as poor meeting attendance, excessive board service, executive compensation challenges, independence concerns, perceptions of subpar performance and/or unresponsiveness to shareholders. [7]

Now, institutional investors appear to be moving beyond these traditional metrics for evaluating boards. Increasingly investors are calling out the lack of board diversity as a governance issue in engagement conversations with companies, stewardship reports and proxy voting guidelines [8]—with some investors adopting policies of voting against board nominees when they perceive insufficient diversity, such as too few women and/or minority directors. [9]

New policies by proxy advisory firm Glass Lewis reflect the emerging shift to consider board composition and director qualifications in voting recommendations. For example, beginning in 2016, Glass Lewis, which develops its policies with investor input, will recommend that investors oppose the re-election of a nominating committee chair in the event of poor performance and the chair’s “failure to ensure the board has directors with relevant experience, either through periodic director assessment or board refreshment …” [10]

Where do nominating committees go from here?

Nominating committee members should recognize that these developments are occurring as investor votes are becoming more meaningful, with annually elected boards (versus staggered) and with a majority voting requirement (versus plurality). There also appears to be an emerging trend of targeted voting practices, with investors opposing perceived action or inaction by specific directors and committees. For example, we recently found that companies with low say-on-pay votes saw higher opposition votes directed at compensation committee members. [11]

When directors step off the board, whether as planned or unexpectedly, nominating committees need to reconsider overall board composition, what the departure may mean for the board now and going forward, and how best to communicate these changes to investors. An effective, experienced and diverse board is a strategic asset to any company and its investors and there’s an opportunity cost to standing still. The keys to that are in the nominating committee hands.

2015 director opposition votes

Summary data S&P 500 large cap S&P 400 mid cap S&P 600 small cap Russell 3000
Average director opposition votes 3% 4% 5% 5%
Number of director candidates 4,700 2,500 3,200 17,500
Portion of director nominees with more than 20% opposition votes 2% 3% 5% 4%

Questions for the board and nominating committee to consider

  • Are the company’s proxy disclosures adequately showcasing the diverse backgrounds, skills and qualifications of the directors?
  • Is there a robust mix of perspectives—aligned with company strategies and risks—among the current line-up of directors?
  • Based on changing company strategies, risks and challenges, how much board turnover is optimal—in the next one, two or three years—in order to stay on top of these developments?
  • Is the board providing a robust disclosure of the board assessment processes?
  • Does the board follow through with board assessments by reviewing key takeaways and implementing an action plan—with deadlines?
  • When was the last time the selection criteria for director nominees was reassessed and updated?

Endnotes:

[1] See SEC Chief: Board Diversity Is a Priority for Agency in 2016, Wall Street Journal, 27 January 2016.
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[2] Proxy access refers to the right of eligible shareholders to add their director nominees to the proxy materials for the annual meeting or other corporate board elections.
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[3] EY Center for Board Matters’ proprietary corporate governance database covers more than 3,000 public companies listed in the US. Vote results are calculated based on votes cast for and against the proposal.
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[4] See 2015 proxy season insights: spotlight on board composition, Ernst & Young LLP, March 2015, discussed on the Forum here.
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[5] See Securities and Exchange Commission 17 CFR PARTS 229, 239, 240, 249 and 274, February 2010.
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[6] See Accelerating board performance through assessments, Ernst & Young LLP, December 2015.
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[7] Based on a review of proxy voting guidelines and company filings. Examples of a board appearing insufficiently responsive include when a board makes unilateral governance changes on certain matters (such as poison pills) or fails to address a shareholder proposal that received majority support of votes cast.
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[8] For example, see BlackRock’s Proxy voting guidelines for US securities, February 2015; Vanguard’s Our proxy voting and engagement efforts: An update, December 2015; and State Street’s Addressing the Need for Board Refreshment and Director Succession in Investee Companies, February 2015.
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[9] Examples include Walden Asset Management, Trillium Asset Management, Pax World Management.

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[10] See Proxy Paper Guidelines: 2016 Proxy season: An overview of the Glass Lewis approach to proxy advice—United States. Proxy advisory firm ISS does not have a similar policy.
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[11] See Five things compensation committee members need to know, Ernst & Young LLP, November 2015.
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