February 28, 2019

Climate Change: Top Engagement Priority for Many Investors

In Morrow Sodali’s latest institutional investor survey, 85% of respondents said that climate change was their most important engagement topic (up 31% from last year) – although when it comes to disclosure, they’re more focused on getting human capital details. Maybe this result isn’t too surprising given that the 46 global survey participants are all signatories to the UN’s Principles for Responsible Investment – but their combined $33 trillion of assets under management is nothing to sneeze at (and yes, the “Big 4” US institutional investors – BlackRock, Vanguard, State Street & Fidelity – are all PRI signatories).

When it comes to voting, the survey says that governance policies & practices are by far the most important factor. Also, some investors are more willing these days to nuance their voting decisions based on information gained in engagements, but some continue to rigidly adhere to stated policies. So you just have to know who you’re dealing with. And be aware that the cost to nuanced decision-making is a greater demand for transparency and director involvement in engagements (87% said that director involvement helps their evaluation of a company’s culture, purpose & reputational risks). Here’s a few other hot topics that will continue to impact board meetings, engagements and disclosure (also see this “Harvard Law” blog):

– Board composition & competence – skills & qualifications are the most important factor in evaluating directors, with diversity lagging behind

– Executive pay – pay-for-performance, rigor of performance targets and the inclusion of long-term performance targets are all important, and investors are beginning to engage collectively on this topic

– Human capital management and corporate culture – including succession planning to prepare for the risk of abrupt executive departures that could result from a scandal

Audit Committees: Tech’s Impact on Financial Reporting

Tech disruption is coming to an audit near you. Whether it’s turning to tech firms for the “data gathering” phase of the audit, or ensuring that automated financial record-keeping and reporting is accurate – which are both increasingly common according to this WSJ article – audit committees need to oversee the related financial reporting risks. Fortunately, the “Center for Audit Quality” has released a tool for audit committees that explains the impact of emerging technologies on the oversight framework. In addition to identifying other helpful resources, the CAQ’s tool contains suggested questions for a number of key tasks.

Large-Cap Directors: Bad News for Small-Caps?

If the director recruitment industry is any indication, experienced large-cap directors are in high demand. And for good reason – they’ve likely had first-hand involvement with a variety of board, management & shareholder situations. But since small-caps tend to have more retail shareholders, fewer resources and different types of business issues, that large company experience could be a double-edged sword.

In this blog, Adam Epstein covers six potential “negatives” – and makes it clear that impressive credentials don’t negate the need to find the right fit and remain attuned to director & board performance. Here’s an excerpt:

Form over substance: If a large-cap company is akin to an aircraft carrier, many small-caps are more like speedboats. The former takes dozens of people and extended periods of time to change speed or course, while the latter can take one or two people and happen in a matter of seconds. When you try and operate a speedboat the same way as an aircraft carrier, it’s pretty easy to hit other stuff… or sink. Every small-cap investor has a story about a portfolio company that sunk – or came needlessly close to it – because a newly-appointed board member from the large-cap world unconsciously redirected the board’s attention away from key existential threats to never-ending boardroom box-checking.

Misplaced emphasis on proxy advisors: Large-cap companies are typically more than 80 percent owned by large institutional investors. Those investors, in turn, can place a high degree of emphasis upon third-party advisors that educate institutional investors how they should consider voting on various annual proxy proposals. These so-called proxy advisors (e.g., ISS, Glass Lewis, etc.), can be highly impactful on board appointments and director compensation, among other things, and large-cap board members can get transfixed upon remaining within the good graces of ISS, et al. Regrettably, many large-cap emigres assume that their small-cap colleagues should be equally concerned about proxy advisors, despite the fact that many small-caps are majority owned and traded by retail (i.e., nonprofessional) investors who don’t care one iota about what any proxy advisor says… about anything. The result isn’t pretty, because when small-cap boards lose primary focus on strategy, innovation, culture, and capital formation, and instead become enamored with proxy advisors, bad things tend to happen.

Corporate finance disasters: Large-cap companies rarely need to access the equity capital markets, and when they do it’s almost always from a position of strength and leverage – strong balance sheets and extremely liquid stocks. On the other hand, many small-caps are serial capital raisers, and often transact financings from positions of weakness and vulnerability – everyone knows they are running out of money and their stock is illiquid. Here’s the rub: when I was an institutional investor, many of our portfolio companies either waited too long to raise “must have” capital, or they turned down “market terms” all because a large-cap board member noisily applied big company corporate finance sensibilities to a marketplace they didn’t understand – at all. This problem is exacerbated by the fact that “other” board members are often overly deferential to the new board member who operated, governed or advised famous companies. Just because someone works on an Indy 500 pit crew, doesn’t mean they are the best person to change the brakes on your Lexus.

Liz Dunshee