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Have You Checked the Mirror? Institutional Investor Focus on Board Diversity Is Closer Than It Appears

We welcome Matthew Fust as our guest columnist this week. Formerly Chief Financial Officer at Onyx Pharmaceuticals and other biopharmaceutical companies (and a longtime The Alexander Group client), he now serves as a board member and adviser for life sciences companies. Matthew is also a senior advisor to Quorum, which advocates for LGBT+ representation on corporate boards.

After many years of increasing diversity in the boardrooms of U.S. corporations, the headlines over the past year have been decidedly mixed.

Recently the Los Angeles Times reported that the percentage of women appointed to Fortune 500 board seats actually declined in 2016, reversing seven years of progress. Directors from diverse racial and ethnic backgrounds hold less than 15% of board seats in Fortune 500 companies. A recent study found less than 0.3% of Fortune 500 directors were openly LGBT. And gender diversity among the ranks of U.S. corporate CEOs continues to increase very slowly, with only 32 female CEOs (6.4%) among Fortune 500 companies this year.

But to paraphrase the ubiquitous warning on automobiles' side-view mirrors, investor focus on diversity of U.S. corporate boards is closer than these less-than-encouraging headlines suggest.

Institutional Investors Are Stepping Up

Early investor activism around corporate board diversity was led by investment funds focused on advancing gender equity, by socially-responsible mutual funds, and by some publicly-traded companies (for example, through organizations like the 30% Club). In the past year, however, "mainstream" institutional investors are increasingly focusing on boardroom diversity, often led by their corporate governance units.

Large public sector pension funds have been taking a leading role. Earlier this year, Massachusetts' Pension Reserves Investment Management Board approved proxy voting guidelines under which it will vote "against or withhold" on all board nominees if less than 30 percent of the company's board is diverse in terms of gender and race.

New York City's Pension Funds have been among the most active public investors, launching in September 2017 a campaign titled "Boardroom Accountability Project 2.0" which calls on the boards of 151 U.S. companies to disclose the race and gender (and, optionally, the sexual orientation) of their directors, along with directors' experience and skills, in a matrix format. This request is particularly noteworthy, since only about 8% of Russell 3000 companies published a board matrix in 2017. More detailed reporting about boards' composition will enable investors to assess, and press for, greater board diversity. A broader set of demographic detail about race, ethnicity and sexual orientation will also aid research and reporting on board diversity.

Even more noteworthy, large investment managers like BlackRock (with more than $5 trillion in assets under management) and State Street Global (with $2.5 trillion) have begun taking substantive steps to advance board diversity.

During the 2017 proxy season, State Street Global voted "against" directors at 400 companies that had not initiated efforts to increase their boards' gender diversity. And in its 2Q17 Investment Stewardship Report, BlackRock noted that it had supported eight shareholder proposals requesting the adoption of a policy on board diversity or disclosure around plans to increase diversity, and at five companies voted against the nominating committee members for failure to address investor concerns on diversity.

Making the Case for Board Diversity

Investors' focus board diversity as a governance imperative is increasingly well-supported. Although most studies to date have focused on gender diversity (which has been easiest to ascertain from limited company disclosures) and largely observe correlative (rather than causal) relationships between board diversity and improved company performance, the studies are directionally consistent across a range of metrics. Some highlights include:
  • A study by Credit Suisse of more than 3,000 companies across 40 sectors, showing that companies with more than one woman on the board have outperformed the broader stock market return by 2.0 - 3.7% annually compared to those that have none.
  • Catalyst's finding that companies with the most women board directors outperformed those with the fewest by 26% in return on invested capital.

Studies on board diversity largely mirror the larger and more robust research on executive leadership diversity, including:

The benefits of increased board diversity appear to extend beyond financial measures, including:

In fairness, not all researchers agree on the magnitude (or even the direction) of the impact of gender diversity in boardrooms, and research on diversity of race, ethnicity, sexual orientation and other dimensions has been slow to develop, both because of low boardroom representation for those groups and a paucity of robust data.

But sizable institutional investors are now sufficiently convinced, and are voting in alignment with their updated proxy guidelines. As a consequence, directors and executives should ensure this topic receives attention as companies refresh their boards. Here are some approaches:

Review and update the language in your company's annual proxy statement

Under a 2009 SEC rule, publicly-traded companies in the U.S. are required to disclose whether, and if so how, their nominating committees consider diversity in identifying director nominees. This disclosure is typically included in companies' proxy filings in connection with annual stockholder meetings.

A surprising number of companies take a narrow, lawyerly view of this disclosure, with language such as "The Nominating Committee considers diversity in its selection of director nominees..." without even specifying what constitutes diversity. Worse yet, some use language such as "The Nominating Committee does not have a policy with respect to diversity and does not consider diversity in nominating director candidates..."

Such a narrow approach misses the opportunity to highlight the company's values to investors, employees, customers and other stakeholders. In light of increased activism by institutional investors around board diversity, companies will be better served by embracing language like "Our Governance Committee considers demographics including age, race, gender, ethnicity, sexual orientation, culture and nationality, seeking to develop a board that reflects diverse viewpoints, backgrounds, skills, experiences and expertise."

Accurately capture board demographics

Don't assume that you can assess the diversity of the current board just by glancing around the room. Instead, ask directors, perhaps using the annual D&O questionnaire, to provide information about which demographic groups with whom they identify.

Thoughtfully evaluate current directors, and consider more rapid board refreshment

Although most companies conduct annual evaluations of its board and committees, these exercises can lack substance and become formulaic. A recent survey of directors found that nearly half said someone on their board should be replaced, but only 15% said that their board's leadership had counseled a fellow director or recommended that a director not be re-nominated.

Institutional investors are increasingly focused on long-tenured directors. For example, CalPERS' governance provisions caution that corporate board directors who serve more than 12 years on the same board are at risk of compromising their independence. As one institutional investor representative recently noted, "a corporate board seat should not be viewed as a lifetime appointment."

In addition, scrutiny of the board's capabilities as the company's business models evolve (together with investor pressure to disclose those capabilities in more detail) should provide a strong incentive for boards to undertake regular and thoughtful evaluation of director refreshment and/or board expansion.

"Widen the lens" when searching for new board members

Many board searches, whether through personal networks or conducted by search firms, begin with a similar specification: "Find the CEO of a publicly-traded company." Although CEOs bring a relevant experience to a board, it unavoidably circumscribes a candidate pool that is overwhelmingly white and male: in the Fortune 500, only 6% of CEOs are female and 4% are members of racial or ethnic minorities.

Considering a broader range of candidates can both strengthen and diversify boards. Does a board that already includes multiple current and former CEOs really gain substantively with the addition of another? Or would a cyber-security expert, marketing guru, regulatory affairs expert or former Cabinet member be a more valuable addition?

Nominating Committees should also be aware that stockholder advisory services have tightened their guidelines regarding service on multiple boards. Institutional Shareholder Services (ISS) and Glass Lewis & Co. now recommend that their institutional investor clients vote against the election (or re-election) of directors who sit on more than five public company boards, and impose even tighter limits on public company CEOs - in the case of Glass Lewis, a maximum of two public company seats.

Resist "token" appointments to address diversity objectives

Particularly as the focus on board gender diversity increases, some female executives are becoming skeptical of "just because I'm a woman" consideration for corporate boards. One prominent female life sciences executive I spoke with reported receiving eleven inquiries about board service, "and the year's not over yet."

And finally, keep in mind that while adding a single diverse director is a good step, it's not clear that doing so is sufficient to improve the quality of boards' decision-making. One study focused on gender diversity found that corporate boards need to have at least 30% female directors before they outperform all-male boards. This mirrors a study by McKinsey that found organizational excellence scores for gender-diverse senior teams rose significantly, but only when those teams were made up of at least one-third women.
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