Introduction to Financial Services: Corporate Governance

Introduction to Financial Services: Corporate Governance

Updated February 3, 2020
Introduction to Financial Services: Corporate Governance
Introduction
companies. The Dodd-Frank Wall Street Reform and
Broadly speaking, corporate governance is the system
Consumer Protection Act (P.L. 111-203), among its
through which a public company’s objectives and the
numerous other provisions, expanded the federal regulatory
means for obtaining them are established and monitored by
scope by authorizing nonbinding shareholder voting on
the company’s board of directors and management.
executive compensation, requiring new compensation-
Structurally, the system comprises a web of relationships
based disclosures, and requiring that board compensation
among a firm’s management, board of directors, employees,
committees be solely composed of independent directors.
shareholders, and other stakeholders. Two key focal points
of corporate governance are the corporate board and the
Proxy Advisory Firms
annual meeting of the firm’s shareholders.
Proxy advisory firms provide institutional investors with
research and recommendations on management and
The corporate board consists of a group of individuals
shareholder proposals that are voted on at annual corporate
elected to be the company’s fiduciaries acting on behalf of
meetings. Two firms—Institutional Shareholder Services
its shareholders. Along with company executives—such as
(ISS) and Glass Lewis—dominate the proxy advisory
the chief executive officer—who run the company on a
business. Unlike Glass Lewis, ISS is also a SEC-registered
daily basis, the board helps set the tone for the corporation
investment advisor subject to added regulations.
and broad corporate objectives.
Various academics and business interests have argued that
The corporate annual meeting is a yearly gathering where a
the advisory firms require additional regulation because (1)
firm’s previous year’s performance and future prospects are
institutional investors over-rely on ISS and Glass Lewis for
discussed. At the meeting, a company’s shareholders
voting information and recommendations; (2) public
typically vote to appoint board members and adopt, or
companies (issuers) are not given an opportunity to express
reject, various shareholder- and management-sponsored
concerns over certain of their voting recommendations; and
business proposals that direct a particular course of action
(3) ISS is not adequately disclosing and addressing
by the firm.
potential conflicts of interest when it provides corporate
governance consulting services to issuers. Countering such
The Regulation of Corporate Governance
criticism, the advisory firms have argued that they have
States and the Securities and Exchange Commission (SEC)
little influence over client voting, and they have established
share oversight of corporate governance concerns. In
firewalls that separate their proxy advisory work from the
certain sectors of the economy, such as in banking, other
other services they offer. They also stress that the ongoing
regulators might also share oversight. State-based business
demand for their services reflects their value to clients.
incorporation laws give the states substantial authority over
corporate governance matters. Within the parameters of
In late 2018, SEC staff withdrew earlier 2004 guidance that
state incorporation laws and under federal securities laws,
described how an advisory firm could be deemed an
the SEC oversees the types of information that are available
independent third party able to make recommendations to
to shareholders voting on proposals at the annual meeting
an institutional investor’s investment advisor despite being
and how such information is disseminated. Notably, most
compensated by that advisor (who is required to vote its
shareholders do not attend corporate annual meetings.
client’s proxies in the client’s best interests). Some say that
Under state incorporation laws—mainly those in Delaware,
it has helped lead to an overreliance on the firms.
where most public companies are incorporated—
shareholders have the right to appoint a proxy. A proxy is a
On November 5, 2019, the SEC proposed various proxy
written authorization that delegates the shareholder’s voting
advisory firm reforms under the Securities Exchange Act of
power to another person or, more typically, an institution.
1934 (P.L. 73-291). Among other things, it would codify
controversial SEC guidelines that advisory firm voting
The Sarbanes-Oxley Act (P.L. 107-204) significantly
recommendations constitute “solicitations” that are subject
broadened the federal regulatory scope in corporate
to antifraud rules. The firms would also be required to
governance. The law expanded senior management’s
allow subject companies an opportunity to review and
responsibility for the quality of a company’s financial
respond to their voting recommendations before being
reporting, expanded the audit committee’s independence
given to clients.
from management and its responsibility over company
auditors, imposed constraints on the services that auditors
SEC Chair Jay Clayton said the proposal is intended to
can provide to public companies, and established an
increase the accuracy of advisory firm reporting, a view
independent board to oversee auditing practices at public
shared by business interests like the U.S. Chamber of
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Introduction to Financial Services: Corporate Governance
Commerce. It, however, has been criticized by the two
praised the proposal. The CII, however, has argued that the
dissenting Democratic SEC commissioners, including
proposal would restrict the ability of ordinary investors to
Robert Jackson, who argued that it would problematically
submit useful shareholder ESG proposals.
help to tilt shareholder voting toward incumbent
management. A related view was expressed by the Council
Environmental, Social, and Governance Issues
of Institutional Investors (CII), a large institutional investor
There is a long-running debate about what types of
advocacy group, who said that the reform would increase
information public companies should disclose to potential
the likelihood that advisory firms took “a more
investors and current shareholders. Currently, this debate
management-friendly approach” to their work. Some
has centered on ESG issues, such as political spending,
Members of Congress echoed these views, including
climate change, diversity, and human rights. ESG factors
Senators Sherrod Brown and Christopher Van Hollen.
cover a wide spectrum of issues that traditionally are not
part of financial analysis, but may have financial relevance.
Shareholder Proposal Thresholds
Investors’ and the public’s interests in ESG-related issues
Currently, any shareholder holding $2,000 or 1% of a
have increased in recent years. Shareholder proposals that
company’s voting stock for at least one year can submit a
address ESG issues increased from 40% of all shareholder
nonbinding shareholder proposal on any subject for a vote
proposals in 2011 to 67% of all proposals in 2016.
at the annual meeting. Under securities regulations
originating in 1954, companies can exclude a rejected and
In general, firms discuss ESG-related issues in the
resubmitted proposal from being voted on if
Management Discussion and Analysis (MD&A) section of
their annual financial reports. Any ESG issues discussed in
 it was not supported by at least 3% of shareholders the
the MD&A section are, generally, not subject to an
last time it received a vote;
independent audit. A 2015 study found that 86 of the 100
largest companies in the United States report on ESG
 it was not supported by at least 6% of shareholders and
issues, but the information published by the companies is
has been voted on twice in the past five years; or
not standardized and can suffer from “information

overload.” The inconsistent disclosure makes it harder for
it has not received the support of at least 10% of
investors to measure a firm’s performance on ESG issues
shareholders after being voted on three or more times
relative to its peers or across industries.
during the past five years.
Firms that voluntarily disclose ESG issues could both
Through the years, various businesses and business interests
benefit and face challenges from the additional disclosure.
have asked the SEC to reconsider the thresholds. The U.S.
On the one hand, additional disclosures beyond regulatory
Chamber of Commerce has also argued that the current
requirements could increase investor scrutiny and
thresholds help fuel wasteful “zombie proposals” (which
negatively affect a firm’s stock price. Additional reporting
according to the Chamber are often related to
could also be time-intensive and costly for companies, and
Environmental, Social, and Governance [ESG] issues)
it may be of minimal use if it is not material or comparable
submitted three or more times without earning majority
with reporting by peer companies. On the other hand,
shareholder support. However, supporters of the current
investors might positively perceive a company that includes
regime, including various pension funds, have said that
additional ESG disclosures. Increased disclosure could also
proposals often need time to gain momentum.
reduce future lawsuits because investors would have greater
information with which to make investing decisions.
On November 5, 2019, the SEC proposed to raise the
shareholder ownership thresholds for submitting proposals,
Members have introduced legislation to increase ESG
including having at least $25,000 of a firm’s voting equity
disclosures, including H.R. 1018, H.R. 3279, and S. 592.
for at least one year. It would also increase the
These proposals do not necessarily require financial
resubmission thresholds from the current 3%, 6%, and 10%
materiality as a consideration for disclosure, but some do,
to 5%, 15%, and 25%, respectively.
such as H.R. 4329. Other options for Congress to consider
SEC Chair Clayton said that such changes “would
include continuing to allow companies and investors to
facilitate
determine which ESG issues to disclose within the existing
constructive engagement by long-term shareholders in a
regulatory structure. Another option is to direct the SEC to
manner that would benefit all shareholders and ... [the]
require corporate disclosures modeled on financial
public capital market.” However, one of the two dissenting
materiality as promulgated by certain international bodies
Democratic commissioners, Robert Jackson, cited research
or by the Sustainability Accounting Standards Board, which
conducted by his office on proxy-access proposals, which
is a U.S.-based entity. Requiring companies to report on
are efforts to allow larger shareholders to nominate
ESG issues that are financially material to them might make
candidates to corporate boards. The staff found that 40% of
it easier for investors to make better investment decisions.
the current number of such proposals would likely be
Others, however, question the financial relevance of ESG
removed after three submissions and would have to wait
reporting.
another three years for resubmission under the current
proposal, thus denying proposals that may enhance
shareholder value, according to Commissioner Jackson.
Raj Gnanarajah, Analyst in Financial Economics
Gary Shorter, Specialist in Financial Economics
Business interests like the U.S. Chamber of Commerce,
IF11221
many of whom have long advocated for such reforms, also
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Introduction to Financial Services: Corporate Governance

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