May 21, 2019
Introduction to Financial Services: Corporate Governance
Introduction
the audit committee’s independence from management and
Broadly speaking, corporate governance is the system
its responsibility over company auditors; imposing
through which a public company’s objectives and the
constraints on the services that auditors can provide to
means for obtaining them are established and monitored by
public companies; establishing an independent board to
the company’s board of directors and management.
oversee auditing practices at public companies; authorizing
Structurally, the system constitutes a web of relationships
nonbinding shareholder voting on executive compensation;
among a firm’s management, board of directors, employees,
requiring new compensation-based disclosures; and
shareholders, and other stakeholders. Two key focal points
providing for clawbacks of executive compensation under
of corporate governance are the corporate board and the
certain circumstances.
corporate annual meeting.
Proxy Advisory Firms
The corporate board consists of a group of individuals
Proxy advisory firms provide institutional investors with
elected to be the company’s fiduciaries acting on behalf of
research and recommendations on management and
its shareholders. Along with company executives—such as
shareholder proposals that are voted on at annual corporate
the chief executive officer—who run the company on a
meetings. Two firms—Institutional Shareholder Services
daily basis, the board helps set the tone for the corporation.
(ISS) and Glass Lewis—dominate the proxy advisory
Overarching board mandates include assisting in setting
business. Unlike Glass Lewis, ISS is a SEC-registered
broad corporate objectives.
investment advisor subject to added regulations.
The corporate annual meeting is a yearly gathering where a
In early 2019, SEC Chair Jay Clayton stated that the SEC is
company’s previous year’s performance and future
likely to consider whether (1) institutional investors over
prospects are discussed; its shareholders vote to appoint
rely on ISS and Glass Lewis for voting information and
board members and adopt various shareholder- and
recommendations; (2) public companies (issuers) are given
management-sponsored business proposals, advocating a
an opportunity to express concerns over certain of their
particular course of action.
voting recommendations; (3) ISS is properly disclosing and
addressing potential conflicts of interest when it provides
Congress is perennially interested in corporate governance.
corporate governance consulting services to issuers; and (4)
This In Focus introduces and examines several key
these firms require additional regulation. Various
corporate governance issues—proxy advisory firms,
academics and business interests have criticized the
shareholder proposal submission thresholds, and
advisory firms on similar grounds. Countering such
environmental, social, and governance (ESG) disclosures.
criticism, the firms have argued that they have little
influence over client voting and they have established
The Regulation of Corporate Governance
firewalls that separate their proxy advisory work from the
States and the Securities and Exchange Commission (SEC)
other services they offer. They also stress that the ongoing
share oversight of corporate governance concerns. State-
demand for their services reflects their value to clients.
based business incorporation laws give the states substantial
authority over corporate governance matters. Within the
In late 2018, SEC staff withdrew 2004 guidance that
parameters of state incorporation laws and under federal
described how an advisory firm could be deemed an
securities laws, the SEC oversees the types of information
independent third party that can make recommendations to
that are available to shareholders voting on proposals at the
an institutional investor’s investment advisor despite being
annual meeting and how such information is disseminated.
compensated by that advisor (whose required to vote its
Notably, most shareholders do not attend corporate annual
client’s proxies in the client’s best interests). Various
meetings. Under state incorporation laws—mainly those in
observers say that the guidance has helped lead to
Delaware, where most public companies are incorporated—
overreliance on advisory firms.
shareholders have the right to appoint a proxy. A proxy is a
written authorization that delegates the shareholder’s voting
A 2016 Government Accountability Office (GAO) report
power to another person or, more typically, an institution.
(GAO-17-47) surveyed market participants and
stakeholders on proxy advisory firms. GAO found that,
The Sarbanes-Oxley Act (P.L. 107-204) and the Dodd-
although advisory firms influenced shareholder voting and
Frank Act (P.L. 111-203) significantly broadened the
corporate governance practices, that influence varied based
federal regulatory scope in corporate governance that
on an institutional investor’s size or the nature of the voting
included expanding senior management’s responsibility for
policies that were employed.
the quality of a company’s financial reporting; expanding
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Introduction to Financial Services: Corporate Governance
S. 3614, introduced in the 115th Congress, would have
Environmental, Social, and Governance Issues
required larger proxy advisory firms to register with the
There is a long running debate about what types of
SEC as investment advisors, but exempt smaller advisory
information public companies should disclose to potential
firms with $5 million or less in annual gross receipts from
investors and current shareholders. Currently, this debate
such mandatory registration.
has centered on ESG issues, such as political spending,
climate change, diversity, and human rights. Forbes
Proposal Resubmission Thresholds
Magazine recently observed that “Responsible investing is
Currently, any shareholder who holds $2,000 or 1% of a
widely understood as the integration of environmental,
company’s stock for at least one year can submit a
social and governance (ESG) factors into investment
nonbinding shareholder proposal on any subject for a vote
processes and decision-making. ESG factors cover a wide
at the annual meeting. Under 1954 securities regulations,
spectrum of issues that traditionally are not part of financial
companies can exclude a rejected and resubmitted proposal
analysis, yet may have financial relevance.” Investors’ and
from being voted on, if
the public’s interests in ESG-related issues have increased
in recent years. Shareholder proposals that address ESG
it was not supported by at least 3% of shareholders the
issues increased from 40% of all shareholder proposals in
last time it received a vote;
2011 to 67% of all proposals in 2016.
it was not supported by at least 6% of shareholders and
In general, firms discuss ESG-related issues in the
has been voted on twice in the past five years; or
Management Discussion and Analysis (MD&A) section of
it has not received the support of at least 10% of
their annual financial reports. This section is an SEC
shareholders after being voted on three or more times
requirement. Any ESG issues discussed in the MD&A
during the past five years.
section are, generally, not subject to an independent audit.
A 2015 study found that 86% of the 100 largest companies
In 1997, the SEC voted on a never finalized proposal to
in the United States report on ESG issues, but the
raise these resubmission thresholds to 6%, 15%, and 30%,
information published by the companies is not standardized
respectively. SEC officials argued that shareholder
and can suffer from “information overload.” The
proposals unable to make the new thresholds had little
inconsistent disclosure makes it harder for investors to
chance of ultimately prevailing. In December 2018, Chair
measure a firm’s performance on ESG issues relative to its
Clayton indicated that the SEC is reexamining its rules for
peers or across industries.
submissions and resubmissions.
Firms that voluntarily disclose ESG issues could face a
In February 2019, the NASDAQ stock exchange authored a
double-edged sword. On the one hand, additional
letter to the SEC with 300 signatories—including Boeing,
disclosures beyond regulatory requirements could increase
the U.S. Chamber of Commerce, and Chevron—
investor scrutiny and negatively affect firm stock prices.
recommending that the SEC reconsider instituting the
Additional reporting could also be time-intensive and costly
proposed 1997 thresholds. The chamber has also argued
for companies, and it may be of minimal use if it is not
that the current thresholds help fuel wasteful “zombie
material or comparable with reporting by peer companies.
proposals” (often on ESG issues) submitted three or more
On the other hand, investors might positively perceive a
times without earning majority shareholder support.
company that includes additional ESG disclosures.
However, supporters of the current regime, including
Increased disclosure could also reduce future lawsuits as
various pension funds, caution that proposals often need
investors would have greater information with which to
time to incubate and expand their support. As such, they
make investing decisions.
assert that they would be constrained by raised thresholds.
Congress might consider several options regarding public
In 2018, the Council of Institutional Investors (CII, a group
company disclosure of ESG issues. One option is to
of pension funds, other employee benefit funds,
continue to allow companies and investors to determine
endowments, and foundations) examined the impact of
which ESG issues to disclose within the existing regulatory
raised thresholds on ESG proposals. It first noted that
structure. Another option is to direct the SEC to require
nearly all shareholder proposals meet the current
corporate disclosures modeled on financial materiality as
resubmission thresholds of 3%, 6%, and 10%. Then, using a
promulgated by certain international bodies or by the
dataset of 3,620 shareholder proposals at a wide range of
Sustainability Accounting Standards Board, which is a
677 companies, CII examined the impact of three
U.S.-based entity. Requiring companies to report on ESG
resubmission threshold regimes: (1) a “modest” increase of
issues that are financially material to them might make it
5%, 10%, and15%; (2) a “doubling” of 6%, 12%, and 20%;
easier for investors to make better investment decisions.
and (3) the highest increase of 6%, 15%, and 30%, the same
Others, however, question the financial relevance of ESG
as the aforementioned 1997 SEC proposal. CII found that
reporting.
the actual number of ESG proposals that would have
become ineligible under any of the three scenarios during a
Raj Gnanarajah, Analyst in Financial Economics
seven-year period would “not be terribly significant.” The
Gary Shorter, Specialist in Financial Economics
study projected that, of the 3,620 general shareholder
proposals considered, 240 would have become ineligible
IF11221
under the modest resubmission scenario and 470 under the
most stringent scenario.
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Introduction to Financial Services: Corporate Governance
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