October 6, 2014

Proxy Advisor Insights

Even if you are already familiar with their voting policies and policy-making processes, I found this King & Spalding memo noteworthy for the additional insights ISS and Glass-Lewis provided directly during their participation in a recent joint Lead Director Network/Compensation Committee Leadership Network meeting. Noteworthy points include:

– Involvement in developing customized voting policies

Both ISS and Glass Lewis work with investment managers to develop customized policies. Glass Lewis noted more than 80% of its 900 clients use a custom policy or process for their voting decisions. And ISS indicated: “Our house views are a benchmark, but most of the ballots [cast on the ISS voting platform] are either client-directed or based on a customized policy. Custom policies are a tremendous growth area for ISS.”

– Board tenure/refreshment

Notwithstanding ISS Governance QuickScore 2.0, which reveals ISS’s view that a director’s tenure of more than 9 years is considered to potentially compromise a director’s independence and so is deemed “excessive,” at the recent meeting, ISS noted a lack of investor interest in director term limits. According to the article, ISS indicated that “investors prefer to scrutinize new nominees on a case-by-case basis, e.g., asking why a board with no women just nominated another man.” And Glass-Lewis indicated that they look for evidence of investor concern about board refreshment or diversity – that their clients “‘look for more information on this [than just statistics].”’

– Recommending votes against directors

Director participants criticized – for several reasons – ISS’s and Glass Lewis’s policies to recommend votes against directors based on their committee membership, e.g., recommending votes against governance committee members when the company doesn’t follow certain governance practices. Directors effectively noted that the proxy advisors’ policies are inflexible, whereas companies are dynamic, and can unfairly target directors who were in fact not involved in the decision-making or were part of a full board decision-making process.

Glass Lewis responded by indicating that the alternative to recommending a vote against committee members was to recommend a vote against the entire board which, not surprisingly, didn’t generate a lot of enthusiam among the directors. ISS seemed to suggest that companies’ full disclosure about what they did would resolve the directors’ concerns; however, I think instead there is simply a huge disconnect between proxy advisory firms’ policy positions for recommending votes against directors and what directors believe is reasonable based on what actually transpires in the boardroom.

Board Tenure Considerations

This thoughtful, balanced memo about director tenure addresses some of the common arguments in favor of and against director term limits, and notes other considerations including international trends and results of studies about the impact of director tenure on board effectiveness. Although authored by a Canadian firm, the considerations apply equally to US companies.

The discussion of studies is particularly noteworthy in view of concerns expressed by some investors and proxy advisors that long tenure equates to a lack of independence from management and, thus, reduced oversight effectiveness. Along those lines, here is a excerpt from Wachtell Lipton’s recent article on director tenure, which logically concludes that the academic studies (footnoted in the article) are not conclusive:

Academic Studies

Academic researchers have examined the question of whether there is an optimal length of tenure for outside directors, with varying results. Studies from the 1980s through the 2000s have shown, for example, that longer tenure tends to increase director independence because it fosters camaraderie and improves the ability of directors to evaluate management without risking social isolation. A 2010 study confirmed that companies with high average board tenure (roughly eight or more years) performed better than those companies with lower average board tenure, and that companies with diverse board tenure performed better than those with homogeneity in tenure. A 2011 study, by contrast, examined a sample of S&P 1500 boards and found that long-serving directors (roughly six or more years)—as well as directors who served on many boards, older directors, and outside directors—were more likely to be associated with corporate governance problems at the companies they served.

One 2012 study found that boards with a higher proportion of long-serving outside directors were more effective in fulfilling their monitoring and advising responsibilities, while another 2012 study found that having inside directors increased a board’s effectiveness in monitoring real earnings management and financial reporting behavior, presumably due to their superior firm-specific knowledge and operational sophistication. On the related topic of board turnover, a recent study of S&P 500 companies from 2003 to 2013 found that companies that replaced three or four directors over the three-year period outperformed their peers. The study found further that two-thirds of companies did not experience this optimal turnover and that the worst-performing companies had either no director changes at all or five or more changes during the three-year period.

A 2013 study on director tenure by a professor from the INSEAD Business School has received significant attention. The study hypothesizes that there is a tradeoff between independence and expertise for outside directors—a prejudgment that is widely disputed—and examines the effect of tenure on the monitoring and advising capacities of the board. After review of over 2,000 companies, the author finds that the optimal average tenure for an outside director is between seven and 11 years, though industry- and company-specific factors create substantial variability. He concludes that nine years is generally the optimal point at which a director has accumulated the benefits of firm-specific knowledge but has not yet accumulated the costs of entrenchment. As a policy matter, however, he suggests that in light of the significant variations across industries and company characteristics, regulating director tenure with a single mandatory term limit would not be appropriate.

Taken together, the academic studies show that conclusions about optimal director tenure are elusive. Common sense indicates that a board should use tenure benchmarks not as limits but as opportunities to evaluate the current mix of board composition, diversity, and experience.

Webcast: “The Art of Negotiation”

Tune in tomorrow for the webcast – “The Art of Negotiation” – during which during which Cooley’s Jennifer Fonner Fitchen, Perkins Coie’s Dave McShea and Sullivan & Cromwell’s Krishna Veeraraghavan will teach you how to negotiate with the best of them in a chock-full of practical guidance program.

– by Randi Val Morrison