The Board-Centric Annual Meeting

Rasing The Bar For Board Communication

For 30 years shareholders have called the shots at annual meetings. It’s time for boards to take charge.

by John C. Wilcox, Chairman, Sodali

For a growing number of listed companies around the world the annual shareholder meeting has come to resemble a trial by ordeal. Instead of the traditional town-meeting business forum, the annual meeting has morphed into a jousting field where activists, proxy advisors and various special interest groups play a dominant role. This state of affairs has evolved because for the past three decades companies and boards of directors have been resistant to change and defensive about governance reform, while shareholders and activists have taken the lead in successfully promoting greater board accountability and stronger governance rules. Corporate scandals, the financial crisis, escalating CEO pay, declining public trust in business leaders together with enhanced shareholder rights have transformed the annual meeting into an event where companies often focus on damage control rather than showcasing their business.

The challenge for companies is to raise the bar for board communication and thereby shift the focus of the annual meeting away from shareholders and back to the board of directors. A board-centric annual meeting can fulfill important governance, accountability and business functions, while giving shareholders what they have always wanted – greater boardroom transparency and director accountability.

A proposal that we believe could help companies improve communications from the board of directors and develop board-centric annual meetings is set forth in a Working Paper entitled “Materiality in Corporate Governance: The Statement of Significant Audiences and Materiality,” published on September 3, 2015. [search for this title at ssrn.com] The authors are well-known governance experts Professor Robert G. Eccles and Tim Youmans of Harvard Business School. Their proposal builds on the work of the International Integrated Reporting Council (IIRC) and is supported by the American Bar Association’s Task Force on Sustainable Development and the UN Global Compact.

The authors state ambitious goal: “. . . by 2025 the board of directors of every listed company will be issuing an annual Statement of Significant Audiences and Materiality.” They further assert that this goal is applicable to “. . . all listed companies regardless of reporting regime or nationality.”

The Working Paper’s analysis raises the bar for companies and boards of directors in three ways:

• IT ADDS A MATERIALITY STANDARD TO THE LEGAL CONCEPT OF THE BOARD’S FIDUCIARY DUTY;
• IT MANDATES AN ANNUAL WRITTEN BOARD STATEMENT;
• IT REQUIRES COMPANIES TO ADOPT A PROCESS OF “INTEGRATED THINKING.”

These proposals are less radical than they appear. We believe that in practice they would create a governance model that simultaneously increases the board’s power while also satisfying shareholder demand for greater board transparency and accountability. As we have long maintained, aligning the interests of the company and the shareholders is a board responsibility that is best accomplished by the board taking action itself rather than by complying with external governance standards. Viewed from this perspective, the Working Paper’s recommendations strengthen boards rather than weakening them, thereby supporting the basic principle that corporate governance should be board-centric rather than shareholder-centric.

THE “MATERIALITY” STANDARD.

The concept of materiality proposed by the Working Paper is flexible and pragmatic rather than legalistic. It gives priority to the business judgment of the board of directors rather than to a legal definition or an external framework of best practices. It represents a grant of substantial power and discretion to the board, but one that at the same time gives precedence to the economic interests of stakeholders. Its basic assumptions are that: corporate governance should serve business goals; the board is responsible for determining governance policies; the board should explain through the lens of materiality how its governance decisions serve the company’s business goals. This flexible and business-oriented concept of materiality recognizes that every company is unique and that one size of corporate governance will not fit all circumstances. Rules and definitions cannot dictate which audiences and issues are material with respect to an individual company. Only the board and management can make that determination. Governance rules guarantee that shareholders and activists always have the right to disagree with how the board determines materiality and prioritizes audiences. But if a disagreement about materiality does arise, the ensuing engagement between the board and shareholders is more likely to focus on business issues rather than on compliance with a governance check list.

AN ANNUAL BOARD REPORT.

Although demands to improve the quality of board reporting have been part of the governance conversation for more than a decade, the idea of an annual board report has failed to gain traction. Sodali is among those advisors who have called for companies to establish direct communication between boards and shareholders as a means to align their interests. In addition, we have specifically recommended that companies should publish an annual Directors Discussion and Analysis (DD&A) that deals with governance and other board responsibilities not covered by the financial reports, management reports or the annual report to shareholders. [Note with links to Sodali client memos of 2014, 2013] The Working Paper’s recommendation for an annual board materiality Statement takes a big step in this direction.

Small steps have already been taken. Many companies routinely publish a board report or an annual chairman’s letter that summarizes governance policies. Board members are often personally involved in communication with shareholders about controversial proxy issues and contested elections. During the past decade say-on-pay has opened the door to face-to-face communication and robust exchanges between directors and shareholders. It is now common practice for directors to step forward and explain the business rationale for their pay decisions whenever proxy advisors recommend votes against a compensation proposal.

Statistics verify that these engagements have been highly effective. As a result, “engagement” has become the remedy du jour for companies facing shareholder activism and dissident campaigns. It is important to remember, however, that most engagements are reactive -i.e., launched only after activists or proxy advisors have fired the first shot across the company’s bow. These after-the-fact campaigns come with significant risks for companies. They are stressful, time-consuming, costly, inefficient, difficult to manage and of uncertain outcome. These problems are exemplified by the recent high-profile, last-minute engagement conducted by Bank of America to obtain shareholder approval for combining the roles of CEO and Chairman. Despite achieving a passing vote, the process created a circus atmosphere, attracted unwanted public attention, produced unfavorable commentary in the media, put a spotlight on the company’s underperformance and left a residue of dissatisfaction with the board. This type of confrontation might have been avoided if the board had been fully informed in advance about the negative implications of its decision and had then been willing to provide a convincing explanation and reach out to shareholders before battle lines were drawn.

Prevention is always better than a remedy. A written board report that explains governance decisions, particularly when they are noncompliant or based on extraordinary circumstances, would go a long way toward reducing the risk of confrontation with shareholders. A written board narrative would also reduce the legal risk of selective disclosure that makes many companies reluctant to have their directors engage in unscripted communication with shareholders. In voluntary principles-based governance jurisdictions around the world, including the EU, the board statement would provide an opportunity to justify and give context to governance policies, thereby improving the quality of explanations and strengthening the comply-or-explain system without resort to additional regulation.

In our view, an annual board report would be a vehicle for the board to address in advance the issues and questions likely to be raised by shareholders and activists at an annual meeting. In addition to co-opting these issues, a convincing explanation of the board’s governance policies would also dilute the impact of proxy advisors and reduce the importance of one-size-fits-all governance box-ticking.

INTEGRATED REPORTING ().

The case for an annual board report is rooted in the work of the International Integrated Reporting Council (IIRC), a well-established international movement supported by the global business community. Many companies have embraced the concept of integrated thinking and have issued integrated reports on a variety of topics and in various formats, often relating to environmental practices, safety and sustainability issues.

Integrated management is deemed to have a number of benefits for companies both inside the boardroom and through the ranks of management and employees. Holistic thinking about the business helps break down operational silos and introduces more nuanced perceptions about how the parts of the business interact, how governance policies affect business operations, how cultural and nonfinancial issues affect risk and performance, how short and long-term objectives are linked.

The subject of is beyond the scope of this memorandum, but the relevance of its goals to meaningful board communication, the content of an annual board report and the conduct of a board-centric annual meaning is clear:

An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term. [www.integratedreporting.org]

RECOMMENDATIONS

To raise the bar for director communication and push for a board-centric annual meeting, we encourage companies and boards to take the following steps:

• The board of directors and executive management should become familiar with the IIRC’s concepts of integrated thinking, integrated management and integrated reporting. These topics should be the subject of educational sessions within operating management and at the board’s annual strategic retreat. Integrated reporting should also be discussed with the company’s auditors, financial advisors, management consultants and communications and investor relations professionals.
• The board should take steps to meet the materiality standard described in the Working Paper: “. . . identify audiences relevant to the corporation, their interests (including where they conflict), and the relative weight attached to each.” This will require the board to work closely with management to identify all audiences with a stake in the business and to prioritize their interests in the context of the company’s business circumstances.
• The board should review the company’s ownership profile. As the board is directly answerable to the electorate of shareholders and institutional investors, this audience is of greatest concern in preparing for the annual meeting. The board must have up-to-date knowledge of the shareholders’ governance policies and voting practices, must understand how their interests may be affected by board actions and must be able to prioritize their interests against those of other audiences.
• The board should review, update and benchmark its Corporate Governance Principles. The Principles should be revised as needed to include ESG issues, non-financial metrics, sustainability and the principles of integrated thinking and reporting. The board should explain how its governance principles align with best practice and with peer companies, how it determines the materiality of audiences and how its decisions are expected to achieve long-term economic goals.
• The board should establish a policy for directors to communicate and engage with shareholders proactively. If such a policy is already in place, it should be expanded to include not just governance issues but also the broad array of topics that the board must consider and prioritize in preparing its integrated annual report.
• The board should have a detailed timetable and schedule of responsibilities in preparation for the annual meeting, which should be a collaborative undertaking within the company. The board’s annual report will play an important role in setting the AGM agenda and will influence how shareholders vote on resolutions at the meeting. Directors as well as management should be prepared to engage directly with shareholders on controversial matters in advance of the AGM.
• The board should be well informed about the company’s Investor Relations program. It is the responsibility of both the board and management to ensure that financial and sustainability goals are fully integrated into the company’s periodic meetings with financial analysts and portfolio managers. The messages delivered by the IR team should be consistent with the messages delivered to institutional investors by the board on governance policy and proxy voting issues.
• The agenda for board’s annual self-assessment and its annual retreat should include information and deliberations necessary to prepare the annual board report. The annual retreat may require participation by members of operating management and outside advisors who can provide expertise and information for the board report.