Monthly Archives: March 2024

Artificial Intelligence: An engagement guide

Posted by Severine Neervoort and Wendela Rang, International Corporate Governance Network (ICGN), on
Thursday, March 21, 2024
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Severine Neervoort is Global Policy Director, and Wendela Rang is Policy Executive at International Corporate Governance Network (ICGN). This post is based on their ICGN memorandum.

1. Introduction

Artificial intelligence (AI) presents both extraordinary opportunities and complexities for today’s companies. The OECD defines an AI system as “a machine-based system that, for explicit or implicit objectives, infers, from the input it receives, how to generate outputs such as predictions, content, recommendations, or decisions that can influence physical or virtual environments”.[1] An increasing number of companies are using AI to transform existing business models or create new ones, generate greater efficiencies, and enhance strategic decision-making, all of which are critical for their competitiveness. However, AI also poses risks and challenges that company boards and management teams must be able to understand and address.

Investors expect companies to effectively navigate AI-related challenges whilst maximising the benefits of AI integration. Our Investor Viewpoint aims to encourage a constructive dialogue on this fast-evolving and increasingly important technology. We consulted the available sources and engaged with our members to provide a guide for investors and companies. This Viewpoint supports investors in assessing whether a company uses AI in a safe, ethical, and sustainable manner, leading to a series of questions for use in investors-investee dialogue. Also, by proactively using this guide, boards can anticipate investors’ areas of interest and concern, and better assess the robustness of their AI oversight.

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Corporate Culture Homogeneity and Top Executive Incentive Design: Evidence from CEO Compensation Contracts

Posted by Dennis Campbell (Harvard Business School), Ruidi Shang (Tilburg University), and Zhifang Zhang (Warwick Business School), on
Thursday, March 21, 2024
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Dennis Campbell is Dwight P. Robinson Jr. Professor of Business Administration at Harvard Business School, Ruidi Shang is Associate Professor of Accountancy at Tilburg University, and Zhifang Zhang is Associate Professor of Accountancy at Warwick Business School. This post is based on their working paper. Related research from the Program on Corporate Governance includes Pay Without Performance: The Unfulfilled Promise of Executive Compensation by Lucian A. Bebchuk and Jesse M. Fried; The Growth of Executive Pay by Lucian A. Bebchuk and Yaniv Grinstein; and The CEO Pay Slice (discussed on the Forum here) by Lucian A. Bebchuk, Martijn Cremers, and Urs Peyer.

Corporate culture homogeneity refers to the degree to which different individuals within a firm share the same beliefs, values, and preferences. For instance, Handelsbanken and Southwest Airlines, the former notable for its long-standing corporate culture centered on the primacy of human-centered decision-making in banking and the latter for its strong culture of collaboration and empathy among employees, both institute a variety of unique internal management practices to ensure that their preferred corporate values are widely shared and strongly held among employees. The specific content of such strong corporate cultures can be highly idiosyncratic to different firms and difficult for outsiders to classify or replicate. Nevertheless, the high degrees of homogeneity in employees’ beliefs are widely viewed as leading to better alignment between executives and employees within these firms.

Theories and evidence indicate that, due to such increased alignment, corporate culture homogeneity is associated with a range of desirable firm features, such as more delegation, less monitoring, higher employee motivation and coordination efficiency, faster decision-making, less conflicts within firms, and ultimately higher productivity and more stable performance. For example, many aspects of Southwest’s organizational success have been attributed to the homogeneity in this underlying cultural value including faster turnaround of its planes allowing more flights per day, higher customer satisfaction, and better overall productivity. Much of the coordination needed to achieve fast turnaround requires employees from different functions (e.g. customer service representatives, gate agents, and cleaning crew) to work together. This is facilitated by employees having strongly homogeneous shared beliefs in the value of collaboration and would be hindered if some employees either did not share this value or even believed more strongly in the sanctity of individual, and often unionized, functional roles.

Despite these theories, findings, and observations having direct implications for the task and monitoring environments faced by CEOs and their boards, empirical evidence on the role of corporate culture homogeneity in facilitating incentive alignment between firms and shareholders is generally lacking. Our study explores this issue by examining how corporate culture homogeneity within firms is associated with the design of CEO compensation contracts.

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SEC Adopts Climate Disclosure Rules

Posted by Archie Fallon, Robert B. Stebbins, and William L. Thomas, Willkie Farr & Gallagher LLP, on
Thursday, March 21, 2024
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Archie Fallon and Robert B. Stebbins are Partners, and William L. Thomas is Counsel at Willkie Farr & Gallagher LLP. This post is based on a Willkie memorandum by Mr. Fallon, Mr. Stebbins, Mr. Thomas, Adam S. Aderton, A. Kristina Littman, and William J. Stellmach. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? (discussed on the Forum here) both by Lucian A. Bebchuk 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.

On March 6, 2024, the Securities and Exchange Commission (the “SEC” or the “Commission”) voted 3 to 2 to adopt rules requiring registrants to provide additional climate-related information in their registration statements and annual reports, including in their financial statements.

The rules are effective in 60 days after publication in the Federal Register and largely track the rules proposed by the Commission in March 2022, which we summarized in this Client Alert.[1]

The final rules differ from the 2022 proposal, however, in several meaningful ways. Most significantly, the adopted rules do not require companies to disclose Scope 3 emissions. Further still, large companies will only be required to disclose Scope 1 and Scope 2 emissions if material, and smaller registrants are exempted from the rules entirely. Notably, registrants will be required to disclose actual expenses attributable to severe weather events or other natural conditions—as opposed to identifying climate-related risks on each financial statement line item.

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Director Commitments Policies, Overboarding, and Board Refreshment

Posted by Samuel Nolledo and Aaron Wendt, Glass, Lewis & Co, on
Wednesday, March 20, 2024
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Samuel Nolledo is a Research Analyst, and Aaron Wendt is Director of U.S. Governance Policy at Glass, Lewis & Co. This post is based on their Glass Lewis memorandum.

The increasing strain on directors’ time is a growing concern among institutional investors and shareholder advocates. External risks stemming from new technologies, environmental and societal changes, and destabilizing market conditions all demand greater attention and care from the board. As the responsibilities associated with the role expand to cover topics like ESG and cybersecurity risk oversight, as well as increased disclosure and reporting requirements, so do expectations around committee performance and stakeholder engagement.

One of the ways that boards can ensure that directors have sufficient time and energy to fulfill their duties and obligations to shareholders is through a director commitments policy. Director commitments policies can also serve as a method to increase board refreshment, and as a metric of a company’s corporate governance. Some large institutional investors have even incorporated director commitments policies into their own proxy voting guidelines.

In this post, we examine how director commitments policies can serve to mitigate risks relating to overcommitted directors, as well as to promote board refreshment. We also discuss their impact on proxy voting, and how Glass Lewis has integrated these policies into our Proxy Paper analysis and voting recommendations.

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ESG Regulation and Financial Reporting Quality: Friends or Foes?

Posted by Dov Solomon, College of Law and Business, on
Wednesday, March 20, 2024
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Dov Solomon is an Associate Professor of Law at the College of Law and Business. This post is based on an article forthcoming in Finance Research Letters by Dalit Gafni, Rimona Palas, Ido Baum, and Professor Solomon. 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; How Much Do Investors Care About Social Responsibility? (discussed on the Forum here) by Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; and Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

In recent decades, investors and regulators have focused more on companies’ role in advancing long-term, sustainable, global goals. This focus has led to a significant rise in demand for corporate social responsibility (CSR) that reflects a commitment to balance shareholder value with environmental, social, and governance (ESG) considerations. ESG information has become an important consideration for investors who want to invest in companies that prioritize sustainability and ethical practices. As interest in ESG performance increases, so too does the demand for information about firms’ ESG behavior. Given the significance of ESG performance for investors, global rating agencies began rating it to provide investors with comparable ESG metrics.

However, concerns exist that companies may employ nonfinancial ESG reporting as a diversion from subpar financial reporting. Specifically, one major concern is that “bad” companies will try to mask their poor performance, as reflected in the low quality of their financial reporting, by pumping up their ESG activities to achieve better ESG ratings. Another concern is that overinvesting in ESG activities may lead to underinvestment in financial reporting quality.

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Delaware Chancery’s Moelis II Decision Provides Cautionary Tale for Boards and Activists

Posted by Douglas Rappaport, Jason Koenig, and Jacqueline Yecies, Akin Gump Strauss Hauer & Feld LLP, on
Wednesday, March 20, 2024
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Douglas Rappaport, Jason Koenig, and Jacqueline Yecies are Partners at Akin Gump Strauss Hauer & Feld LLP. This post is based on an Akin Gump memorandum by Mr. Rappaport, Mr. Koenig, Ms. Yecies, Stephanie Lindemuth, Kaitlin Shapiro, and Richard D’Amato and is part of the Delaware law series; links to other posts in the series are available here.

Key Points

  • In West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024) (“Moelis II”), the Delaware Court of Chancery held that a number of provisions in a Stockholder Agreement between a company and its founder were facially invalid, as they unlawfully constrained the board’s discretion in violation of DGCL § 141(a).
  • These provisions required the board to obtain the founder’s consent before taking various actions, limited the board’s discretion over the board’s size and composition, and required the board to ensure significant founder representation on all committees. The Court held that, under DGCL § 141(a), such constraints on the board’s ability to exercise its judgment may only be implemented through amending a company’s Certificate of Incorporation.
  • The case is likely to embolden challenges to provisions in stockholder and activist settlement agreements that grant a particular investor (or its director designee) special governance rights.

Summary

On February 23, 2024, Vice Chancellor Travis Laster of the Delaware Court of Chancery issued his 131-page decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co., No. 2023-0309-JTL. The case involved a challenge to various provisions of a Stockholder Agreement between a company and its CEO, founder and then-controlling stockholder. Plaintiff, another shareholder, claimed that the challenged provisions violated DGCL § 141(a), which provides that “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.”

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Investment Stewardship 2023 Annual Report

Posted by John Galloway, Vanguard, Inc., on
Tuesday, March 19, 2024
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John Galloway is Global Head of Investment Stewardship at Vanguard, Inc. This post is based on a publication by Vanguard Investment Stewardship.

Vanguard’s Investment Stewardship Program

Vanguard’s Investment Stewardship program has a clear mandate to safeguard and promote long-term shareholder returns on behalf of the Vanguard-advised funds and their investors. We carry out this mandate by promoting governance practices that are associated with long-term investment returns at the companies in which the funds invest. When portfolio companies held by the funds generate shareholder returns over the long term, Vanguard-advised funds generate returns for their investors.

The Vanguard-advised funds

Vanguard-advised funds are primarily index funds managed by Vanguard’s Equity Index Group; these funds track specific benchmark indexes constructed by independent third parties.[1] This structure means that managers of index funds do not make active decisions about where to allocate investors’ capital. As a result, Vanguard-advised equity index funds are built to track specific benchmark indexes, follow tightly prescribed strategies, and adhere to well-articulated and publicly disclosed policies.[2]

Vanguard’s equity index funds are long-term investors in numerous public companies around the world. A small portion of Vanguard-advised funds is managed by Vanguard’s Quantitative Equity Group using proprietary quantitative models to select a broadly diversified portfolio of securities aligned with a fund’s investment objective.[3]

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CEO turnovers due to poor industry performances: An examination of the boards’ retention criteria

Posted by Wilson H.S. Tong, Hong Kong Polytechnic University, on
Tuesday, March 19, 2024
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Wilson H.S. Tong is Professor of Practice at the School of Accounting and Finance and Faculty of Business at Hong Kong Polytechnic University. This post is based on an article forthcoming in the Journal of Accounting and Public Policy by Lin Li, Peter Lam, Professor Tong, and Justin Law. Related research from the Program on Corporate Governance includes Lucky CEOs and Lucky Directors (discussed on the Forum here) by Lucian Bebchuk, Yaniv Grinstein, and Urs Peyer; The CEO Pay Slice (discussed on the Forum here) by Lucian Bebchuk, Martijn Cremers, and Urs Peyer; and Golden Parachutes and the Wealth of Shareholders (discussed on the Forum here) by Lucian Bebchuk, Alma Cohen, and Charles C.Y. Wang.

Executive Summary

  1. Industry and firm-specific returns relate to CEO forced turnovers differently across industrial conditions.
  2. CEO forced turnovers relate more to idiosyncratic returns during recessions but more to industry returns during booms.
  3. Stock prices are more reflective of CEOs’ abilities during recessions than in booms.

Agency Problems & Executive Incentive Scheme

To mitigate agency conflicts in a corporation, a proper incentive scheme for the management is considered as essential. The positive incentive is the executive compensation package and the negative incentive is the disciplinary executive forced turnover. Presumably and understandably, such incentives should be linked to firm-specific performance, more precisely, firm performance in excess to the sector/industry performance (so-called relative performance evaluation (RPE)). Indeed, empirical studies in this line of literature typically show that such relative stock performance is positively correlated with executive compensation while negatively correlated with the likelihood of executive turnovers.

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Chancery Decision Heightens Litigation Risk Associated with Reincorporation from Delaware

Posted by Gail Weinstein, Steven Epstein, and Philip Richter, Fried, Frank, Harris, Shriver & Jacobson LLP, on
Tuesday, March 19, 2024
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Gail Weinstein is Senior Counsel, Steven Epstein is Managing Partner, and Philip Richter is Partner at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Epstein, Mr. Richter, Steven Steinman, Andrew Colosimo, and P. Ryan Messier and is part of the Delaware law series; links to other posts in the series are available here.

In Palkon v. Maffei (“TripAdvisor”) (Feb. 20, 2024), the Delaware Court of Chancery held that the reincorporation of TripAdvisor, Inc. (a controlled company) from Delaware to Nevada is subject to the entire fairness standard of judicial review. The court found, at the pleading stage of litigation, that it was reasonably conceivable (the standard for non-dismissal of claims at that stage) that the reincorporation was not entirely fair to the minority stockholders. The court reasoned that the reincorporation may have deprived the minority stockholders of “litigation rights” that they had under Delaware law but would not have under Nevada law given Nevada’s allegedly lower standards for fiduciary duties of directors and controlling stockholders. While the court did not grant the plaintiffs’ request for an injunction, it rejected the defendants’ motion to dismiss claims that the directors had breached their fiduciary duties by approving the reincorporation. Therefore, the reincorporation can close, but the plaintiffs can proceed to seek monetary damages for the reduction in the minority stockholders’ rights under Nevada law.

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Avoiding Hanging Chads in Corporate Voting in 2024

Posted by Paul Washington, The Conference Board and Broadridge, on
Monday, March 18, 2024
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Paul Washington is Executive Director of the ESG Center at the Conference Board and Chair of the Independent Steering Committee of Broadridge. This post is based on his Broadridge memorandum. Related research from the Program on Corporate Governance includes Universal Proxies (discussed on the Forum here) by Scott Hirst; Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable Challenge (discussed on the Forum here) by Bo Becker, Daniel Bergstresser, and Guhan Subramanian; and Private Ordering and the Proxy Access Debate (discussed on the Forum here) by Lucian A. Bebchuk and Scott Hirst.

Executive Summary

In recent years, the U.S. Securities and Exchange Commission (“SEC”) and industry service providers have made significant changes and improvements in processing and reporting proxy votes. The SEC provided new rules for use of universal proxy cards (“UPC”) for proxy fights (“contested solicitations”) and industry initiatives have led to reconciliation of ‘voting entitlements’ well in advance of shareholder meetings and confirmations to shareholders that their votes are reported as cast.

As described in more detail below, systems for processing and reporting votes of shares held “beneficially” in accounts at custodian banks and broker-dealers, are accurate, transparent, and fair. This is critical: When it comes to the largest proxy contests, the votes of beneficial shareholders can represent upwards of 95% of the total shares voted. In most contests, the outcome is known at the close of the polls.

However, when it comes to the remaining 5% of the votes, those held in “registered” form directly on the books of companies (or their transfer agents), the process is largely manual and opaque. Opposing sides count their own votes without providing the daily status reports that all sides receive for votes of beneficial shareholders. Therefore, in the closest cases, final tabulations by election inspectors can be delayed for weeks while attorneys for each side examine the votes of registered shareholders in a “snake pit.” Moreover, in contrast to systems for processing beneficial shares, there are no independent audits of the process or votes by an internationally recognized certified public accountant firm.

When it comes to further improving the U.S. proxy system overall, the “last mile” involves looking at how registered shareholder votes are processed, reported, and audited, and how they can be confirmed on an “end-to-end” basis to shareholders.

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