The National Association of Corporate Directors has released the results of its 2017-2018 Public Company Governance Survey of over a thousand directors and executives. The survey looked at directors’ outlook for 2018 on key business trends and critical board priorities, the board’s role in overseeing the organization’s culture, the state of board risk oversight—especially cybersecurity risk—and the growing challenge of hedge-fund activist investors.

Trends with most impact. When asked about trends expected to have the greatest effect on their companies over the next year, 58% of respondents identified significant industry change as a key trend, including technology disruption, industry consolidation and shifting regulations. Perhaps as a result, boards identified industry experience as the most desirable attribute in new director candidates. Next, 46% of respondents identified each of business model disruption and changing global economic conditions as key trends, followed by cybersecurity threats (38%), competition for talent (36%) and the uncertain political environment in the U.S. (35%). Reflecting the current deregulatory environment, respondents’ concerns regarding the impact of regulatory burden dropped precipitously, from 58% in 2016 to just 29% in 2017. But environmental, social and governance concerns, while a significant issue for a number of institutional investors, remained low on the list: only 6% of respondents identified climate change as a top-five trend for 2018, while only 2% believe the changing role of business in society is a key trend.

SideBar

In its Annual Corporate Directors Survey for 2017, PwC surveyed 886 directors of public companies and concluded that there was a “real divide” between directors and institutional investors (which own 70% of U.S. public company stocks) on several issues: “[f]rom seeking action on climate change to advancing diversity, stakeholder expectations are increasing and many companies are responding.” But apparently, many boards are not taking up that challenge; PwC’s “research shows that directors are clearly out of step with investor priorities in some critical areas,” such as environmental issues, board gender diversity and social issues, such as income inequality and employee retirement security. (See this PubCo post.)

A recent survey by EY of over 320 institutional investors, one-third of which had over $10 billion in assets under management, also supports the view that investors are concerned about ESG and ESG disclosures. They also take information about ESG into account in making investment decisions. At times, robust corporate attention to ESG is, to some extent, even read to signify sound operational practices overall. Those surveyed broadly concurred that ESG factors play a key role in achieving sustainable returns. For example, 93% of investors either agreed or strongly agreed that “[o]ver the long term, ESG issues—ranging from climate change to diversity to board effectiveness—have real and quantifiable impacts.” Analyzing information over a three-year period, EY concluded that ESG factors have reached an inflection point, playing an increasingly influential role in investment decision-making. Interestingly, EY contends that ESG analysis has shifted over time from a primary focus on corporate governance issues to a now equal interest in environmental issues, particularly climate change. (See this PubCo post.) Notably, large asset managers such as BlackRock, State Street and Vanguard have been taking a more active role on these issues. (See this PubCo post, this PubCo post and this PubCo post.)

Short-term pressures. When asked about the pressures of short-termism exerted by hedge fund activists, 74% of respondents indicated that short-term pressure from external sources compromised management’s focus on long-term strategic goals—slightly (38%), somewhat(28%) or to a great extent(8%). Of respondents associated with companies that were approached by an activist over the last 12 months, 85% experienced this pressure, while, for companies that were not approached, 73% reported this pressure. In an effort to reduce excessive risk-taking to satisfy short-term performance targets fueled by the design of executive comp, the comp committees of 84% of respondents balance short- and long-term performance metrics in compensation, and 83% of respondents reported that “they review overall compensation approaches to ensure they drive the right risk-taking behaviors.”

Board improvement. The five most important areas identified by respondents for board improvement were understanding of risks and opportunities affecting company performance (71%), monitoring of strategy execution (67%), contribution to the strategy development process (67%), oversight of risk management (58%) and CEO succession planning (58%). The NACD interprets the high rank of the need to improve the board’s contribution to strategy development as reflecting the struggle of “many boards…to move from a traditional review-and-concur approach to deep and continual engagement with strategy.” One potential obstacle to this move may be the lack of adequate time during board meetings for in-depth strategy discussions, identified as an important barrier to effective strategy engagement by 51%, up from 44% last year. The NACD also suggests that the identification of all of these areas for improvement may be the consequence of economic and political uncertainty together with some concern over whether managements “are prepared to lead their companies through significant turbulence in the operating environment.” Of board respondents, 54% were confident or very confident that management was capable of appropriately addressing “growing geopolitical risks to their business, while 61% of directors have confidence that management can navigate rapidly shifting global economic conditions.”

Corporate culture. While a significant majority (79%) of directors expressed confidence in management’s “ability to sustain a healthy corporate culture,” the NACD seems to question whether that confidence was well-founded. In particular, the survey points to the extremely high percentage (92%) of directors who based their impressions about corporate culture on reports from the CEO. Few heard different perspectives from departments such as internal audit (39%), compliance and ethics (30%) and enterprise risk management (20%), while 41% held confidential conversations about possible culture issues with non-executive employees,and 48% visited different company locations to gain a better understanding of corporate culture. As a result, the vast majority of directors (87%) were very familiar with the “tone at the top,” but their understanding of corporate culture among the general employee ranks was substantially lower. Most respondents (76%) said that they discuss whether “compensation practices are driving the right behaviors, while 56% of boards formally review the CEO’s effectiveness in leading the company culture. However, far fewer boards report that they have integrated culture-related metrics into executive-compensation plans, perhaps the board’s most powerful tool to reinforce CEO accountability. Only 11% of boards consider employee-turnover metrics and 11% assess workplace diversity measures, while 37% use employee-engagement levels and 33% use customer satisfaction as nonfinancial metrics when determining CEO pay.”

Recently, serious lapses in desirable corporate culture have emerged as flashpoints at many businesses and even entire industries, often with significant negative press coverage and severe economic consequences. Another report from the NACD, The Report of the NACD Blue Ribbon Commission on Culture as a Corporate Asset, suggests that boards would be well-served by paying more attention to oversight of company culture—not just for scandal avoidance, but also “as a way to drive sustained success and long-term value creation.” But unfortunately, the report asserts, corporate culture “does not get the level of boardroom attention it deserves until a problem arises.” According to the report, oversight of culture should not be limited to overseeing executives, but should extend throughout the company, and directors should be on the lookout for local deviations from the desired culture. However, as noted above, in this survey, only half of directors reported that they had a moderate or high understanding of the “‘buzz at the bottom’—the collective behaviors, norms, and values at the front lines of their organizations, among their rank-and-file employees.” Accordingly, in overseeing corporate culture, the report suggests that directors acquire some “firsthand visibility” into “how the culture is lived” by regularly spending some “time ‘on the ground’ where business is being done, in order to gain exposure to a cross section of employees at different locations and levels of seniority.” (See this PubCo post.)

Cybersecurity risk. Boards appear to lack confidence in their companies’ ability to address cybersecurity risk. Thirty-seven percent of board respondents were “confident or very confident” that their companies were “properly secured against a cyberattack,” down from 42% last year, while 60% were slightly or moderately confident. About half (49%) were “confident or very confident” in the ability of management to address cybersecurity risk. Of course, the decrease in confidence may be reasonably related to their increased knowledge about the issues: only 15% reported that they had no or very little knowledge of cyber risk, down from 22% in 2015. Almost a quarter of directors (22%) were unhappy with the quality of information they received from management regarding cybersecurity risk, in particular, insufficient transparency into problems (44%) or absence of effective internal and external benchmarking (41%).

CEO succession planning. Over half of director respondents (58%) reported that a critical priority for board improvement for the following 12 months was CEO succession planning, up from 47% in 2016. Discussion of succession planning with investors increased substantially from 8% of respondents in 2016 to 19% in 2017.

Facing heightened expectations, boards are slow in adapting. Based on the survey, the NACD sees “mixed results against this heightened expectation of continuous improvement”:

Director Recruitment: For the second year in a row, search firms continue to be the most utilized resource (39%) for identifying new directors. Respondents cited a desire for more diverse candidates (52%) and difficulty finding unique skill sets/ backgrounds (39%) as the top two reasons for engaging a third party (i.e., a search firm).

Board Culture: Fifty-eight percent of respondents report that their boards should improve the candor of boardroom conversations over the next 12 months. Moreover, lack of candid feedback is seen as a major obstacle to making board evaluations more effective. Only 54% of public company boards today actively discuss their boardroom culture and underlying problems in executive session.

Board Operations: A majority of respondents (more than 50%) believe that their boards allocate enough time to key governance issues, including executive compensation, cyber risk, and regulatory compliance. However, directors acknowledge the need for improvements in board operations. Fifty-six percent report that it is important to improve the rigor of board decision making in 2018, while 58% say that their boards must get better in following through on recommendations that come out of board meetings.

Director Education: Forty-five percent of board respondents said that not enough time was allocated to director education in board meetings over the last 12 months. The amount of time directors currently dedicate to formal education is 21 hours annually, a slight increase from last year, when it was 18.5 hours.

Board Evaluations: Sixty percent of respondents now evaluate individual director performance in the evaluation process, up from 41% last year. Most individual director evaluations are conducted annually (growing from 79% last year to 89% this year); it is less common to conduct them every two years (9%) or three years (5%).

Board Tenure Limiting Mechanisms: Fifty-two percent of respondents report using age limits. Despite the reliance on this mechanism, only 37% of respondents that use age limits find them to be effective or very effective in ensuring the right board composition.

Board-Shareholder Engagement: For the first time since 2014, half of all respondents (50%) had a board representative meet with institutional investors in the prior year. The percentage of respondents reporting that they have been approached by an activist has dropped to the lowest point in two years. Sixteen percent of all respondents indicated they had been approached in the prior 12 months, versus 22% in 2016 and 19%  in 2015."