Business Law Today - Corporate Board Diversity: Gaining Traction Through Investor Stewardship
By Pamela Harper
Board diversity, long a step-child of corporate governance, has assumed growing prominence. According to the EY Center for Board Matters' 2018 Proxy Season Review of 60 institutional investors managing $32 trillion in assets, 82 percent of respondents indicated that board composition should be a top priority for 2018, with 67 percent noting that they seek diverse director characteristics and backgrounds.
The business case for corporate diversity in general is well documented. Cited most frequently is McKinsey's study, Diversity Matters, which found a statistically significant correlation between diversity and financial performance. Specifically, companies in the top quartile for gender and racial/ethnic diversity were 15 percent and 35 percent, respectively, more likely to have financial returns above their national industry median. Although McKinsey's study applied to corporate as opposed to board leadership, the findings are nevertheless incontrovertible. Diversity enhances the decision-making process and the financial bottom line.
With respect to board diversity, MSCI Inc's 2016 Women on Board's Report found that U.S. companies that began the five-year period from 2011-2016 with at least three women on its board (deemed the "tipping point" needed for female directors to exert influence on a board) experienced a 10-percent increase in ROE and a 37-percent gain in EPS. In contrast, those without female directors experienced a -1 and -8 percent decline respectively.
Over the past year, momentum in this space has gained traction as a result of three driving forces: (1) asset managers pushing for change, (2) institutional investors calling for accountability and transparency, particularly by pension funds, and (3) regulation mandates.
Asset Managers Take a Stand
Given diversity's potential impact on financial performance, the issue of board diversity is now viewed through the lens of investment stewardship by asset managers. The asset management industry has recently become a catalyst for change when it comes to board composition, with Blackrock, Vanguard, and State Street leading the way for greater board gender diversity.
BlackRock, the world's largest asset manager with $6.3 trillion of assets under management, has received the most prominent coverage, generated in large part by its Annual Letter to CEOs. With respect to boards, BlackRock's CEO Larry Fink announced that Blackrock will continue to emphasize diverse boards, stating that they are "less likely to succumb to groupthink or miss threats to a company's business model." Consistent with the letter, BlackRock's Proxy Guidelines for 2018 stipulate that it "expects to see at least two women directors on every board."
Unlike BlackRock, Vanguard, with more than $5 billion in assets under management, did not assign a metric, but nevertheless advocated for gender board diversity, noting in its Open Letter to Directors of Public Companies Worldwide that its position on board diversity is "an economic imperative, not an ideological choice."
Finally, as a result of State Street's stewardship on board gender diversity, 152 companies added a woman director to their board, and 34 companies agreed to do so in the future. As encouraging as that may be, it regrettably leaves over 600 more companies remaining on State Street's original list of publicly traded companies with all-male boards. Equally compelling, State Street voted against 511 companies that failed to address the gender diversity issue.
Pension Funds Call for Accountability and Transparency
The second emerging trend is the increasing role of pension funds in driving board diversity. For example, California's Public Employees Retirement System (CALPERS) now requests that companies disclose their diversity policy. Similarly, the Massachusetts Pension Reserves Investment Management Board's 2018 proxy guidelines recommend voting against or withholding votes for all board nominees if less than 30 percent of the board is diverse.
New York's pension funds on the state as well as municipal level have been particularly aggressive in placing public companies on notice that they are not only holding them to a high level of scrutiny, but also holding them accountable for board diversification. In March, the New York State Common Retirement Fund, with $192 billion in assets held in trust and the third largest pension in the country, announced that it would vote against electing all of the directors standing for re-election at the more than 400 companies without women board members in which it holds shares. Moreover, for the more than 700 companies in which the fund holds shares where there is only one female director, the Fund announced that it would vote against the members of the governance committee standing for re-election. In making the announcement, New York State Comptroller Thomas DiNapoli said, "We're putting all-male boardrooms on notice€”diversify your boards to improve your performance."
Similarly, last year the New York City Comptroller and New York City's pension funds launched the Boardroom Accountability Project, Version 2.0. In launching the program, New York City Comptroller Scott M. Stringer said, ". . . we're doubling down and demanding companies embrace accountability and transparency." Designed to enhance public disclosure reporting, the Comptroller asked 151 companies to disclose the race, gender, and skills of their board members as well as their board refreshment process.
Mandate by Regulation
Further escalating the dialogue on board diversity is state legislation. Although there are a number of states that encourage or urge companies to enhance board diversity, including the Commonwealth of Pennsylvania through Senate Resolution 255 which seeks a gender minimum of 30 percent by 2020, California is the first state to contemplate mandating board diversity. In January 2018, Senate Bill 826 was introduced in California. If the bill is passed as currently drafted, by the end of 2019, all companies with principal executive offices in California must have a minimum of one female director on its board of directors. As a tiered system, by the end of 2021 the minimum would increase to two female directors if the company has a total of five authorized directors, or to three female directors if the company has six or more authorized directors. Under the bill, each director seat not held by a female during a portion of the year counts as a violation. The penalties, as currently structured, are pegged to the board's compensation schedule with the fine for the first violation equivalent to the average cash compensation for the directors of the company and the second and subsequent violations equivalent to three times the average annual cash compensation for directors.
Notwithstanding these trends, however, the regulatory environment has the capacity to dictate the velocity of momentum in this area, as we have seen with the recent passage of legislation by the House Financial Services Committee. Under H.R. 5756, the voting thresholds for the resubmission of shareholder proposals were raised significantly. In order for a shareholder proposal to be resubmitted, at least six percent of shareholders must have voted in favor of the proposal the previous year, compared to three percent as currently required by the SEC. Similarly, the threshold is raised to 15 percent for the next resubmission and finally 30 percent for a subsequent resubmission, compared to six and 10 percent, respectively, under the current regulatory regime. By raising the thresholds for shareholder support, the potential impact of this legislation on investor activism and board diversity cannot be underestimated.
Supplementing these trends is the emergence of collective advocacy through organizations such as 2020 Women on Boards, 30% Club, Paradigm for Parity, Women in the Boardroom, and others, all of which aim to combat the gender imbalance in corporate and board leadership. They offer resources and guidelines for increasing the number of women on corporate boards over the next few years, which dovetail well with the above-described initiatives.
The dialogue on board diversity continues to be raised nationally and internationally and shows no signs of abatement. According to the Wall Street Journal, ISS Analytics recently released analysis indicate that in the first five months of 2018, women accounted for 248, or 31 percent, of new board directors at the 3,000 largest publicly traded companies€”the highest percentage in 10 years. On the horizon, Glass Lewis, a leading proxy service provider, indicated in its 2018 Proxy Policy Guidelines that beginning in 2019 it will generally recommend voting against the nominating chair of boards without female directors as well as potentially other nominating committee members. Although previously shunned, board diversity can no longer be ignored. The failure to diversify boards is more than an issue of optics. Rather, it is a reflection of an organization's corporate culture and to the extent that it has the potential to negatively impact shareholder value, it is a governance issue and, as Vanguard so aptly observed, an economic imperative.
Reprinted with permission from the July 16, 2018 edition of the American Bar Association's Business Law Section.