Category: Corporate Governance
What we need to know about corporate governance—but don’t
In this paper, Seven Gaping Holes in Our Knowledge of Corporate Governance, from the Rock Center for Corporate Governance at Stanford, the authors observe that it “is extremely difficult to produce high-quality, fundamental insights into corporate governance.” Why is that? Well there are lots of reasons. According to the authors, instead of the theory, measurement and analysis that you might expect—given that corporate governance is a social science—the “dialogue about corporate governance is dominated by rhetoric, assertions, and opinions that—while strongly held—are not necessarily supported by either applicable theory or empirical evidence.” And even empirical work from academics has serious shortcomings, often detecting a pattern that is not amenable to specific application or making findings that are too specific to generalize. Or, studies might find correlation but not permit attribution of causation; or it may be hard to suss out key variables that may not be publicly observable. As a result, there remain “central issues where insufficient or inadequate study has left us unable to answer basic questions, and where key assumptions relied upon by experts have not been verified or validated.” The paper attempts to identify some of them and home in on potential further areas of study.
Lots of shareholder proposals on ESG this proxy season—and quite a few anti-ESG proposals too
Notwithstanding legislative and executive action by several states in opposition to the supposed “woke” stances of some businesses on ESG and ESG investing—or perhaps because of it—this proxy season will see a significant number of shareholder proposals related to ESG. (See this PubCo post and this PubCo post.) As described in the 100+-page Proxy Preview 2023 from the Sustainable Investments Institute, As You Sow and Proxy Impact, there have been 542 ESG-related proposals as of mid-February and the number is “on track to match or exceed last year’s unprecedented final total of 627.” Of course, proponents of shareholder proposals don’t often expect to gain a majority vote—even if they did, the proposals are rarely binding. Rather, the goal is frequently to raise the issue for management and shareholders and hope to secure a substantial enough vote in favor to convince management to take action or, as the WSJ reports, to “create pressure for companies to change [or] to take a position on hot-button issues.” The Preview identified as the two biggest changes for the 2023 proxy season a continued increase in climate change-related proposals and, post-Dobbs, a significant number of proposals related to reproductive health. There has also been an increase in proposals identified as “anti-ESG,” and the Preview expects these proposals to increase, despite “the cool reception they receive.” According to a co-author of the report, “[c]omplex environmental and social challenges are not going away just because they prompt controversy….Proxy season will give companies feedback on reform ideas, but there’s no indication attacks on ESG investing are going to dampen investor appetite for facts and disclosure, which make the capital markets work better.”
Audit committee oversight of non-GAAP financial measures
According to audit firm PwC, non-GAAP financial measures play an important role in financial reporting, “showing a view of the company’s financial or operational results to supplement what is captured in the financial statements,” and help to tell the company’s financial story, as the SEC has advocated in connection with MD&A, “through the eyes of management.” Yet, they also have the potential to open the proverbial can of worms, subjecting the company to serious SEC scrutiny and possible SEC enforcement if misused. Just a couple of weeks ago, the SEC announced settled charges against DXC Technology Company, a multi-national information technology company, for making misleading disclosures about its non-GAAP financial performance. According to the Order, DXC materially increased its reported non-GAAP net income “by negligently misclassifying tens of millions of dollars of expenses ” and improperly excluding them from its reported non-GAAP earnings. In addition to misclassification, DXC allegedly provided a misleading description of the scope of the expenses included in the company’s non-GAAP adjustment and failed to adopt a non-GAAP policy or to have adequate disclosure controls and procedures in place specific to its non-GAAP financial measures. Consequently, DXC “negligently failed to evaluate the company’s non-GAAP disclosures adequately.” DXC agreed to pay a civil penalty of $8 million. (See this PubCo post.) So what can a company’s audit committee do to help prevent the types of problems that have arisen at DXC and elsewhere? Audit committees may find helpful this recent article from PwC providing guidance for committees tasked with oversight of the use of non-GAAP financial measures.
COSO introduces “internal control over sustainability reporting”
Under the pressure of institutional investors, environmental groups, employees, consumers and other stakeholders, many companies have sought to demonstrate their bona fides when it comes to ESG through disclosure about their sustainability efforts, goals and achievements, whether in periodic reports or in separate sustainability reports. But, as reporting increases, so do concerns by some about potential greenwashing. How can companies assure the quality of their sustainability reporting and create more trust and confidence among stakeholders? One way might be through effective internal controls. So far, however, according to a new report from Committee of Sponsoring Organizations of the Treadway Commission, known as COSO, ”[f]ew best practices have been established. While some larger institutions have progressed in building controls around environmental, social, and governance (ESG) reporting, many organizations have designed ad hoc controls around certain key sustainable business metrics. Many also perform internal verification and assurance procedures to ensure management comfort with this information. Yet few of them seem to have developed effective, integrated systems of internal control over their material or decision-useful sustainable business information.” Now, leveraging insights gleaned from development of the most widely used internal control framework—the COSO Internal Control-Integrated Framework—COSO has developed the concept of ”internal control over sustainability reporting” (ICSR). In its new report, which weighs in at 114 pages, COSO provides supplemental guidance that explains and interprets how each of the 17 principles in the 2013 version of the COSO ICIF applies to sustainable business activities and sustainable business information. According to the authors, “[i]nternal controls have value beyond compliance and external financial reporting. Effective internal controls can help an organization articulate its purpose, set its objectives and strategy, and grow on a sustained basis with confidence and integrity in all types of information.” As companies seek to “generate sustained value—ethically and responsibly—over the longer term,” with an emphasis on sustainability and ESG, both companies and their stakeholders need effective controls and oversight to provide the reliable and high-quality data needed for “decision making in this changing world.”
Cooley Alert: DOJ amps up antitrust enforcement against interlocking directorates
The Department of Justice has stepped up its enforcement of antitrust rules against interlocking directorates. Subject to de minimis exceptions, Section 8 of the Clayton Antitrust Act prohibits the same person from serving on the boards of two competitors. But recently, the DOJ has interpreted the statute more broadly, leading to director resignations where different individuals—who were associated with the same private equity or venture capital firm—served on the boards of competing companies. Companies should take care to assess their Section 8 exposure, as discussed in this excellent Alert from the Cooley Antitrust group, Biden Justice Department Continues Focus on Interlocking Directorates. Be sure to check it out!
Sustainability reports—not a liability-free zone
In April of last year, as described in this press release, the SEC filed a complaint against Vale S.A., a publicly traded (NYSE) Brazilian mining company and one of the world’s largest iron ore producers, charging that it made “false and misleading claims about the safety of its dams prior to the January 2019 collapse of its Brumadinho dam. The collapse killed 270 people, caused immeasurable environmental and social harm, and led to a loss of more than $4 billion in Vale’s market capitalization.” The SEC alleged that Vale “fraudulently assured investors that the company adhered to the ‘strictest international practices’ in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.” Significantly, these statements were contained, not just in Vale’s SEC filings, but also, in large part, in its sustainability reports. In discussing the charges, the press release made reference to the SEC’s Climate and ESG Task Force formed in 2021 in the Division of Enforcement “with a mandate to identify material gaps or misstatements in issuers’ ESG disclosures, like the false and misleading claims made by Vale.” On Tuesday, the SEC announced that Vale had agreed to pay $55.9 million to settle the SEC charges. According to the Associate Director of Enforcement, the SEC’s “action against Vale illustrates the interplay between the company’s sustainability reports and its obligations under the federal securities law….The terms of today’s settlement, if approved by the court, will levy a significant financial penalty against Vale and demonstrate that public companies can and should be held accountable for material misrepresentations in their ESG-related disclosures, just as they would for any other material misrepresentations.”
Workplace sexual harassment has a cost—to the company, to employees, and even to shareholders
Workplace sexual harassment and related misconduct—a toxic boys’-club atmosphere—led to three recent cases against McDonald’s, its management and board. And studies have shown that workplace sexual harassment can have substantial adverse “psychological, health, and job-related consequences” for employees, often resulting in “higher employee turnover, lower employee productivity, increased absenteeism, and increased sick leave costs.” But what is the impact for shareholders? A study in the Journal of Business Ethics, “How Much Does Workplace Sexual Harassment Hurt Firm Value?”, looked at just this question. Earlier studies of the impact of workplace sexual harassment looked at the short-term impact on the market, but this study analyzed the “longer-term effect on firm value starting from the date when harassment risk affects employee morale.” The study found that sexual harassment led to much greater damage—manifested in significant reductions in stock performance and profitability—than previously realized: the stock prices of the group of companies with the highest levels of pervasive harassment underperformed those of an equivalent group with low levels of harassment by about 17%. The study also showed that these “high-SH” companies experienced a decline in operating profitability and an increase in labor costs. One of the paper’s co-authors told Corporate Secretary, “[f]inancial analysts and investors often undervalue intangibles such as the effect of a toxic work environment…But [workplace safety] is indicative of all sorts of other underlying issues, including poor control systems and overall bad governance, which can directly impact employee performance, company performance and stock market value.”
What have studies shown so far about PvP disclosure?
In August last year—12 years after the Dodd-Frank mandate— the SEC finally adopted a new rule that requires disclosure of information reflecting the relationship between executive compensation actually paid by a company and the company’s financial performance: the pay-versus-performance rules. To a significant extent, the approach taken by the SEC in this rulemaking was prescriptive and some of the prescriptive aspects of the rules were quite complex; the SEC opted not to take a “wholly principles-based approach because, among other reasons, such a route would limit comparability across issuers and within issuers’ filings over time, as well as increasing the possibility that some issuers would choose to report only the most favorable information.” But there was some flexibility built into the new rules. How would companies implement the more flexible disclosure requirements? That was the question considered by Compensation Advisory Partners, which published a report on the versions of pay-versus-performance disclosure from the earliest filers among the S&P 500. A similar study of a slightly larger group was conducted by equitymethods. The goal in each case was to try to get a sense of how companies were responding to the new disclosure requirements. What choices were companies making on peer groups, financial measures or “Company-Selected Measures”? How were companies describing the relationship between pay and performance? Just what did the new disclosure look like?
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