Glass Lewis’ Approach to Governance in Times of the Coronavirus Pandemic

Aaron Bertinetti is Senior Vice President of Research and Engagement at Glass, Lewis & Co. This post is based on his Glass Lewis memorandum.

The Coronavirus (COVID-19) pandemic is expected to continue for up to 18 months. With the extraordinary impact the pandemic is already having on companies and markets around the world today, Glass Lewis has been scenario planning in order to consider how this will impact governance and broader ESG issues in the present and future.

As an immediate response, Glass Lewis updated its virtual meetings policy last week to give the market certainty about our support for such meetings to preserve company and shareholder interests. In addition, we have continued to regularly update our note on changes in markets globally, including the timing and format of shareholder meetings.

While almost no crisis in the last century appears to be in the same realm as what is unfolding today, Glass Lewis has dealt with natural and financial crises at the macro and micro level before. In times of crisis, we have observed that the contagion often spreads to other types of governance issues beyond those of most immediate concern. Glass Lewis has used the last few weeks to tap our internal governance expertise, consider our approach in prior crises and engage with the market more broadly.

At this stage, Glass Lewis expects all governance issues and most proposal types to be impacted by the pandemic and we will exercise our existing discretion and pragmatism to prioritize timing, certainty, disclosure and voting on any affected proposals. We consider it likely that this will continue to be the case through 2021 and we believe it is important to provide the market with certainty and transparency on our established approach.

Glass Lewis acknowledges that some believe in a prescriptive approach to governance that favors ideological purity over pragmatic principles. We do not believe that discouraging pragmatism, discretion and context serves the interests of shareholders or companies—particularly during a crisis.

What governance issues will the Coronavirus pandemic impact?

In short, all.

While initial attention in some markets has been focused on virtual meetings, it is likely to quickly move to executive remuneration and balance sheets as companies seek to adjust to the new market reality, before other concerns and issues arise over time. While not exhaustive, here are the key governance areas we are paying particular attention to.

Compensation and Balance Sheets

We are already seeing a variety of approaches to changing compensation programs. Some are unlikely to get overwhelming shareholder support, while those that take a proportional approach to the impacts on shareholders and employees look more likely to be widely supported. We expect to see a lot of amendments to existing plans; crocodile tears for maintaining or even increasing executive compensation levels; substantial adjustments to equity compensation plan proposals; and many companies trying to address shareholder concerns in Say on Pay proposals that will be considered in the context of poor pay and performance grades.

Expect a marked increase in shareholder concerns on repricing, dilution, burn rates, hurdle adjustments, changes to vesting periods, caps and cuts on incentives, and the quality of disclosure concerning the limits and exercise of board discretion. Companies with strong pay structures will be challenged to abide by them, and firms with less robust programs will be forced to choose between lying in the bed they’ve made or changing arrangements and all but guaranteeing shareholder ire.

With regards to balance sheets and capital management, widespread pausing of buyback programs, suspending dividends and an increase in capital raisings and placements appear to be a forgone conclusion. Some companies will need to seek more flexibility to carry out capital raisings than shareholders are used to granting in accordance with strict best practice recommendations. Dogmatic application of pre-existing standards by investors could mean the difference between a company surviving this crisis and shareholders suffering even greater losses.

Thankfully, no company has yet dared to entertain shareholder fury by arguing that they need to conserve capital by reducing shareholder returns even further than the crisis already has, while simultaneously arguing for paying large bonuses, repricing grants, adjusting hurdles and increasing the cost and dilution of future compensation. On the contrary, responsible companies hit hard by the crisis have taken early and decisive action to roll back planned salary increases or above-target bonus outcomes, sharing the pain felt by employees and shareholders.

The stark reality is that for many workers, including executives, they should not expect to be worth as much as they were before the crisis, because their free market value as human capital has now changed. There is a heavy burden of proof for boards and executives to justify their compensation levels in a drastically different market for talent.

Trying to make executives whole at even further expense to shareholders and other employees is a certainty for proposals to be rejected and boards to get thrown out—and an open invitation for activists and lawsuits onto a company’s back for years to come. Even those companies who project a “business as usual” approach to executive pay will face opposition if employees and shareholders see their own “paychecks” cut. Companies would be wise to avoid this.

Board Composition and Effectiveness

For boards, we see particular risk in the lack of age and gender diversity among company directors, and to a lesser extent management, given men and those aged 65 and over are much more likely to die or become seriously ill. Much like shareholder concerns with overcommitment this lack of diversity presents a systematic risk to portfolios, given directors typically sit on several boards and one sick or deceased director can have a compound effect on the capacity of other directors at those companies, which then spreads to the other companies those directors sit on, and so on.

Reduced attendance rates and changes in committee and board independence are the most likely early consequences, with directors, particularly those already overcommitted, reducing their board seats as the crisis increases demands on their capacity. This will be an important test of succession planning and board renewal programs.

There may also be a risk to the effectiveness of board meetings and decision-making from going entirely remote without specialized software or clear governance procedures, while the demands on directors’ time are increasing. However, that risk is strongly preferable to the director community infecting themselves by not practicing social distancing standards and avoiding the physical board room.

Ultimately, the ability of boards and management to successfully navigate the crisis and outperform their competitors will highlight the stark differences in the effectiveness of boards, directors and their governance structures. In our experience during past crises, well governed companies who made the right decisions during the good times are well prepared and durable during a crisis, and far better positioned to deliver shareholder returns afterwards.

Activism and M&A

During the global financial crisis, poor governance and shareholder returns, particularly when avoidable, inspired a wave of shareholder activism, M&A, lawsuits and consolidation as macro conditions improved. We expect to see similar behavior as a result of the current crisis.

Broadly speaking, the current disruption could result in delays to existing campaigns, if only given the mechanics of moving meeting dates or holding virtual meetings. That said, these same market conditions have revealed new opportunities for activism. Some activity will be driven by survival or opportunism but it seems with inexpensive debt and record high dry powder in private equity, firms, and likely some issuers, are already stalking the hardest hit sectors. Where boards prefer to maintain management focus on day-to-day business health and stability, we expect the ongoing trend for settlements with investors to continue.

Activity could also vary by market cap. Larger firms have been more willing to pursue settlements to avoid potentially costly and distracting shareholder campaigns, whilst mid-level and smaller firms with more variable quality in boards and activist ideas may be inclined to slug it out, taking campaigns to a shareholder vote. Generally, if conditions begin to stabilize in the second quarter we expect the number of contests and deal volume to increase in the second half of this year and into 2021, with an increase in shareholder votes to follow if settlements are not widespread.

Oil and Gas

While many sectors will be hard hit during this time, the unique triple threat to oil and gas companies is worth specific mention. The accumulation of high and poorly rated debt, the Saudi-driven plunge in oil prices and shrinking demand due to the pandemic and social distancing measures threaten the continuing business of many companies in the sector. The threat will be particularly notable for companies involved in fracking, where higher levels of poor debt are now harder to repay or refinance as the price of crude oil falls toward and below the cost of shale oil production.

Some may cheer this development, but from Glass Lewis’ perspective these are still businesses that some of our clients are invested in. We will be closely monitoring how companies respond to protect shareholder value in exceptionally challenging conditions that will likely include many restructures and bankruptcies. We will also be monitoring how the closely-related plastics industry is impacted given the high level of shareholder concern and proposals related to plastics we expect to see this year.

Shareholder Proposals and ESG

Given that shareholder proposals are normally required to be submitted months in advance, for example November—January in the proposal-heavy U.S., the content of most shareholder proposals will likely not include any consideration of the pandemic or related crisis. While shareholder proponents are able to withdraw their proposals prior to them going to a vote, should they choose to let them go forward, the request of the resolution cannot be amended in markets such as the U.S. to reflect current conditions. In short, the impact of the pandemic and related crisis may not be immediately obvious by looking at a shareholder proposal or a company’s AGM agenda.

While the basic calculus for assessing environmental or social shareholder proposals on the basis of materiality to the returns or risk of a business hasn’t changed, the context has, significantly. Approaching these issues from a long-term perspective is still crucial, but ensuring that companies are able to operate in the short- to medium-term is also a very important consideration. Those companies hardest hit by social distancing as a result of the recent crisis, including in the airline, restaurant or hotel industries, may be considering a wholly different set of material benefits and risks than at their prior AGM. Moreover, companies in all industries will be looking at ‘black swan’-type risks, such as preparedness for climate change, from a new perspective and reconsidering how robust their governance structures truly are.

In the meantime, investors should be mindful that many of the shareholder proposals this proxy season may not adequately account for companies’ current circumstances or constraints. Issues that appeared accretive in the context of a strong market may not make as much sense in the midst of this crisis and the very material challenges that many companies are now facing in the short to medium-term. This is particularly true for proposals asking companies to undertake resource-intensive actions or reporting that would undermine their ability to respond to more immediate concerns that are also in shareholders’ interests.

Equally, companies should be mindful not to use the crisis to dismiss or hamper the ability of shareholder proponents to put forward their resolutions, speak at virtual meetings and have shareholders vote on such matters. Poor behavior or treatment towards shareholders will likely only encourage more activist attention and will certainly be reflected in future shareholder votes on directors and recommendations from proxy advisors.

How Glass Lewis uses context, discretion and pragmatism?

Glass Lewis’s contextual approach is already built for extenuating and unusual circumstances such as this pandemic and the many issues discussed above. Our guidelines ensure we can apply the appropriate discretion and pragmatism to prioritize timing, certainty, disclosure and voting on such proposals. We generally intend to rely on this feature of our guidelines as opposed to continuously updating them for new issues or novel approaches we encounter throughout the season.

Disclosure and Explanation

Effective disclosure and rationales provided by companies will be particularly critical to our exercise of discretion in making judgements about whether changes made as a result of this crisis are justified and address material shareholder concerns. We will also assess the reasonableness of proposed changes and outcomes by considering if they are consistent and in proportion to the impact on shareholder interests and employees. Particularly with regard to executive pay, we expect boards to proactively seek changes that align with employee and shareholder experiences, recognizing that executives might need to take a pay cut. Further, companies that we believe have a good track record on governance, performance and the use of board discretion prior to the pandemic will be afforded more discretion in our analysis than those that do not.

Timing and Certainty

In times of crisis, it is particularly important that the timing of decisions is not delayed or postponed significantly on matters that are material to a company’s ability to address risks, manage operations and maximize shareholder returns. Similarly, when uncertainty abounds, there is material value created by companies that can provide certainty to the market and receive it from their shareholders. That allows both parties to move forward with confidence in the company’s ability to respond and, in extreme cases, remain solvent.

As with the pandemic, those companies that move fast and decisively during a time of crisis, in cooperation with their shareholders, are more likely to contain the damage and identify opportunities for positive outcomes that are in all parties’ interests. Glass Lewis will exercise discretion when considering governance issues where there is a clear material benefit to shareholders for supporting proposals that bring timing and/or certainty of decisions and outcomes.

Voting

Shareholder voting is a primary tool for shareholders, particularly for passive and index investors, to ensure that the timing, disclosure and certainty of such decisions is prioritized. Many matters require a shareholder vote despite the current crisis. This is a primary reason for our support of virtual meetings, which provide compelling advantages in timing, certainty and preserving the fundamental shareholder right of voting.

Final Thoughts

Good governance is relevant in all types of weather, boom or bust, but there is no better way to observe the effectiveness of governance than in a crisis. Those companies with poor structures will be exposed as they seek to rapidly amend glaring weaknesses in their policies.

No company is perfect, but in our experience the better governed ones will be well prepared and provide shareholders with certainty, effective disclosure and a consistent approach that reasonably considers the impact of their decisions on shareholders, executives and employees. In times like these, that is in everybody’s interests.

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