ESG & Social Activism

Governance Intro

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Governance Introduction

• In broad terms, corporate governance refers to the set of mechanisms that

a firm uses to align the interests of its decision-makers with those of its key
stakeholders
• In large companies, the people who are empowered to make decisions on
behalf of the firm – professional managers – are, in a sense, agents of all of
the people whose support the firm relies on to survive: its shareholders,
creditors, employees, customers, community, and broader society
• But a company’s stakeholders have few means to actively monitor
managers or to directly hold them accountable to their interests
• Sometimes, the interests of managers may diverge from those of the
stakeholders
Governance Introduction

• For example, managers may be incentivized to pursue excessive executive

compensation, or to pursue a short-term competitive advantage using
legally questionable means that harm broader society, as through bribes of
political officials, accounting manipulation, or tax avoidance policies
• These kinds of issues – where managers’ interests may not perfectly align
with those of stakeholders – are called “agency problems”
• In governance frameworks around the globe, the board of directors is
introduced as the primary solution to agency problems
Boards of Directors

• Boards of directors consist of groups of typically 9-12 high-level executives

who are appointed to serve two critically important purposes in corporate
governance
• First, they serve an advisory function wherein they offer strategic guidance
to a firm’s management
• As advisors, board members should assist management with the firm’s
overall strategy, help to identify and navigate key strategic opportunities
and threats, and assure that the strategy pursued by management is
properly balancing enterprise risk and reward
Boards of Directors

• Boards of directors consist of groups of typically 9-12 high-level executives

who are appointed to serve two critically important purposes in corporate
governance
• First, they serve an advisory function wherein they offer strategic guidance
to a firm’s management
• As advisors, board members should assist management with the firm’s
overall strategy, help to identify and navigate key strategic opportunities
and threats, and assure that the strategy pursued by management is
properly balancing enterprise risk and reward
Boards of Directors

• The second purpose of corporate boards is to provide a monitoring or

oversight function
• Here, directors are to keep a close eye on management and ensure that
they are running the firm in the best interests of its stakeholders
Boards of Directors

• In balancing their monitoring and advisory functions, boards owe two key
fiduciary duties to the company
• The first is the duty of good faith, meaning that they will conduct themselves
honestly and without conflicts of interest
• The second is the duty of care, which means that they will ensure that they
are reasonably informed and will make decisions that they believe are in the
company’s best interests
Boards of Directors

• In most countries, board members are protected by a “business judgment

rule,” which means that courts will not question their decisions ex post so
long as the board acted without conflicts of interest and the directors
believed that what they were doing was in the company’s best interests
• In practice, this means that board members are given broad discretion to
direct corporate managers toward strategic practices and policies that
benefit stakeholders, versus those that principally benefit shareholders
• This makes the board of central importance to ESG, as they act in effect
like an umpire that helps to direct a firm’s leaders about how to call the
shots in a way that best balances the interests of its many stakeholders
Boards of Directors

• Sometimes, what is best for shareholders is also best for stakeholders

• In these cases, the appropriate stance of the board is clear – its
discretion is not so important
• But for many issues central to ESG, boards have to make difficult decisions
that pit stakeholders interests against each other
Boards of Directors

For Workers For Shareholders Overall

• Raise wages • Reduce return on • Raise overall
capital employed productivity
• Provide voice in their
working lives • Raise skills
• Lower turnover
• Increase sum of
profits and wages
Boards of Directors

• When boards are deciding whose interests to prioritize when crafting policy
around issues like unionizing, the board’s discretion plays an extremely
important role in directing the company’s management of its various
stakeholders
• For this reason, I’m often told by board nomination committees that the
most important question they ask new potential directors is “what is your
approach to balancing shareholder and stakeholder interests?”
Boards of Directors

• Given the critical role of the board in protecting shareholder value and
setting priorities when stakeholders’ interests are pitted against one
another, the board is the most important mechanism at play in the
Governance component of ESG, and it also represents a critically important
mechanism for directing the firm’s priorities in the Environment and Social
components
ESG & Social Activism
Selection and Independence

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Director Selection

• If the board is supposed to monitor a company’s management on its

stakeholders behalf, you might think that stakeholders should be
empowered to have a strong say in determining who a firm’s board
members are
• In reality, however, stakeholders often have only a symbolic voice in
director elections
• Processes for director selection vary considerably between countries and
companies, but in a typical firm the board itself puts together the slate of
new director candidates each year with little or no input from shareholders
or other stakeholders
• This is typically a task assigned to the board’s nomination committee,
and often with heavy input from the CEO
Director Selection

• The number of directors that the nomination committee puts forward as

candidates will virtually always match the number of open board seats,
meaning that the directors in the company’s slate do not run in contested
elections
• The most common justification for this is that the best candidates might be
less likely to serve if they were worried about the potential damage to their
pride and reputation if they lost the election
• Contested director elections are rare, and are normally only seen in the
context of a takeover battle, when a hostile bidder is attempting to take over
a board
Director Selection

• It is possible for shareholders to run a vying slate of directors – what is

called a “short slate” – to compete with the nomination committee’s
proposed directors outside of the takeover context
• These short slate challenges are extremely rare because they require often
prohibitively costly shareholder outreach and advertising campaigns to
support
• Contested board elections are very difficult to win, so the costs of such a
campaign are unlikely to pay off
Director Selection

• For example, one 2006 study examining data for the decade ending in 2005
found that short slate elections only occurred around 14 times per year in
the US, they usually occur in smaller companies, and they are most often
unsuccessful
• For all these reasons, board elections are almost always uncontested, and
the slate of directors nominated by the board runs unopposed
Director Selection

• Once the board has put together its slate of director nominees, the list is
presented to shareholders for vote in the company’s annual proxy materials
• Director elections typically use a statutory voting system, which means that
shareholders vote on each director on a one-vote-per-share basis
• The most common voting rule used in director elections (and the default
rule in Delaware where most US companies are incorporated) is ‘plurality’
• Under this rule, the set of directors who have the most votes are
appointed, regardless of if they receive a majority support
Director Selection

• To put this all in context, what this means is that if a given company has six
open board seats, the board of directors will give the shareholders six
director candidates to vote on, and the six candidates that have the most
votes will be able to take a seat on the company’s board
• In other words, while the shareholders have a vote, their vote is symbolic—
a director that is nominated by the board will be seated so long as they get
at least one vote
Director Selection

• Because management often has significant influence in who is named to

the nomination committee’s slate, this creates concerns that the board is
easily co-opted by the CEO
• People worry that the CEO may be able to build a board made up of
passive directors and cronies who may be inclined to rubber stamp his or
her decisions and allow agency costs to go unchecked, rather than
exercising effective, independent oversight
Director Selection

• Globally, the most widely-used tool to protect boards from being co-opted
by management is the independence requirement, which requires that a
majority of directors be independent from the company
Director Selection

• In the US, the requirement that the board be made up of a majority of

independent directors is not a formal law or regulatory requirement
• Instead, it became a universal rule here in the early 2000s after a series of
large-scale corporate scandals resulted in the failure of giant companies
including Enron and Worldcom
• In a reactive move meant to rebuild investor confidence after these
scandals by strengthening board oversight, the three largest stock
exchanges in the US –the New York Stock Exchange, the AMEX, and the
NASDAQ – all adopted requirements that listed companies have a majority
of independent directors on their board
Director Selection

• The standards that these platforms used to define independence say:

• That a director can’t be a current or recent employee of the company
• They can’t receive any substantial income from the company aside from
their director fees
• They can’t work for one of the company’s major buyers or suppliers
• The independence rule is meant to ensure that directors do not have a
financial conflict of interest that would preclude them from being able to
actively monitor the company’s management and hold agency costs in
check
• But is this rule enough to guarantee that a board will in fact operate
independently from management?
Disney and Comparative Independence Standard

• Disney had been chronically underperforming after the death of its founder
and creative genius, Walt Disney
• It had made only 5 full length animated features in 11 years, including films
like Aristocats, The Rescuers Down Under, and the Fox and the Hound
Disney and Comparative Independence Standard

• In 1984, Disney hires entertainment executive Michael Eisner as its new

CEO
• He had been president of Paramount Pictures, a rival film studio
• Disney tapped Eisner as a turnaround CEO, hoping that he could
reinvigorate their film business
• The company begins producing a new animated features every 12-18
months
• They are blockbusters— The Little Mermaid, Beauty and the Beast,
Aladdin, Lion King
Disney and Comparative Independence Standard

• These films pay dividends for Disney at the box office, in the parks, on
broadway, and on ice
• The company’s performance skyrockets and Eisner is credited as the
genius who orchestrated this miraculous turnaround
Disney and Comparative Independence Standard

• In the mid-1990s, Disney’s succession plan is disrupted when its then-

president and heir apparent is killed in a car crash
• Michael Ovitz, co-founder of Creative Artists Agency, is hired as the new
Disney President in 1995
• When Ovitz is hired, he signed a five-year employment contract with a
very generous severance package
• It says that if he is fired without cause at any time after 12 months in his
position, he will receive a severance payment equal to all of the
remaining salary on his 5 year contract, plus a 7.5 million dollar per year
bonus, plus options
• This kind of clause is referred to as a “golden parachute” in corporate
governance
Disney and Comparative Independence Standard

• After Ovitz begins at Disney, he and Eisner start to clash immediately

• Eisner later admitted that he decided Ovitz must go after only 6 months,
despite being unable to find cause
• Ovitz is officially fired without cause after 14 months
• What is problematic about waiting until 14 months?
• The golden parachute was triggered
• Ovitz ultimately receives a severance payment that totaled $140 million
dollars— $140 million dollars, just for being fired
Disney and Comparative Independence Standard

• Shareholders are understandably irate

• They file a suit against the firm’s directors for breaching their fiduciary duty
of care in the way that they handled the firing
• Usually, what goes on in the board room is a black box— but a lot of
information comes out in discovery when crises become the subject of
litigation
• In this case, a number of useful facts are disclosed in the early stages of
the trial that shed light on the conditions that precipitated this governance
crisis
Disney and Comparative Independence Standard

• The board admitted that they felt considerable pressure from Eisner to
quickly bring in Ovitz as his heir apparent
• Eisner and the chair of the compensation committee flew out to negotiate
Ovitz’s compensation package
Disney and Comparative Independence Standard

• The negotiated compensation package was presented to the full

compensation committee in very broad strokes by an outside compensation
consultant
• The committee only received a bulletpointed term sheet to describe the
contract
• They admitted that they never read – or even saw – the actual contract
• The compensation consultant admitted to never calculating the full value
of the severance package, and it was never discussed by the
compensation committee
Disney and Comparative Independence Standard

• Eisner was obviously very sure that the compensation committee would
approve the employment contract he had negotiated with Ovitz
• He told the press about the appointment before the compensation
committee met
Disney and Comparative Independence Standard

• In the course of the case, shareholders also took a closer look at Disney’s
independent directors
• At the time of this debacle, the directors who were technically
independent on the board included Eisner’s personal architect, his
personal lawyer, and two administrators at his children’s school
Disney and Comparative Independence Standard

• The first thing that the case revealed is a tremendous loophole in our
independence requirement
• Independence standards ensure that a director does not have a
pecuniary relationship with a firm that would present a conflict of
interests, but our standard does nothing to preclude direct pecuniary
relationships with the CEO him or herself
• Eisner’s lawyer and architect, for example, had direct employment
relationships with the CEO that might have made them less willing to
stand up to him or question his judgment
Disney and Comparative Independence Standard

• The case also illustrates an important rule about corporate governance

• Often, companies governance systems begin to weaken after long
periods of outperformance
• CEOs that have delivered outperformance over and over again start to
amass power
• The board and shareholders start to trust their judgement and tend to
relax their oversight
• In some cases a powerful CEO might use this period of relaxed oversight
to build an enabling board that will go along meekly with the CEOs’
decisions
Disney and Comparative Independence Standard

• This is important because we tend to use corporate governance as a

reactive tool
• Companies usually intervene to repair and strengthen their governance
systems after a crisis or a period of underperformance, when investors
demand improvements
• But as the Disney case illustrates, in order for a governance system to
function correctly, it needs to be addressed proactively
• Structures like board independence need to be audited and strengthened
before things go wrong in order to ensure that the company isn’t being
set up for a crisis
ESG & Social Activism
Selection and Best Practices

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Best Practices to Strengthen Board Independence

• More rigorous independence standards

• Comparative standard: Independent directors in the UK
• Have not been an employee of the firm within the last five years
• Have not had a material business relationship with the company within
the last three years
• Do not receive additional remuneration other than the director’s fee and
are not a member of share option or pension scheme
• Have no close family ties with directors, senior employees or advisers
• Do not hold cross-directorships or have significant links with other
directors
• Do not represent a significant shareholder
• Have not served on the board for more than nine years
Best Practices to Strengthen Board Independence

• Arms-length board nomination process relying on an independent head

hunter to identify potential candidates
• Rules against being too busy, such as requirements that directors not serve
simultaneously on more than three boards
• This also means a preference for recently retired CEOs
Best Practices to Strengthen Board Independence

• Rules mandating independent leadership on the board, such as an

independent chairman
• Many firms have a CEO who also serves as the board’s chairman, which
can give them undue influence over the board by allowing them to control
the board’s agenda
• Firms are increasingly addressing this by giving the chairman title to a
different individual, often a former CEO or an independent director
• This is called “de-coupling” the CEO/Chairman position
• Some firms that do not want to strip their CEO of the chairman title will
instead endeavor to increase independent leadership on the board by
designating a lead independent director who serves alongside the
chairman and steps in to manage the board’s agenda in decisions where
more independence is needed
ESG & Social Activism
Diversity and Inclusion

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Diversity is Necessarily a Long-term Goal

• Globally, the average

director has served
between 8 and 9 years
Primary Focus of Board Diversity Movement has been on Gender

• In general, marked lack of organic increase of female representation on

public company boards globally
• Many European countries have issued mandatory quotas in recent years
• Norway was first mover, requiring 40% representation in 2004
• Spain, France and Iceland followed with 40% quotas
• Italy and Germany adopted 30% quotas in 2015
• European Commission has proposed law requiring 40% mandate for all
EU companies in 2020
Increased Gender Diversity is a Global Best Practice

US has been resistant to diversity mandates, but some recent momentum

• Somewhat successful voluntary social movement coined the “30% Club”
• Presently, no companies in the S&P 500 have all-male boards
• Over 10% of Russell 3000 still do, but 45% of new board seats on
Russell 3000 firms were filled by women this year
• California is first (and only) US state with a mandate, requiring one woman
on local boards by the end of this year, and 3 on boards with six or more
members by 2021
• Diversity quota began as a voluntary recommendation from CA
legislature but saw little response
• Bloomberg estimates CA law will open up ~700 additional board seats to
women by 2021
Increased Gender Diversity is a Global Best Practice

US has been resistant to diversity mandates, but some recent momentum

• There are a handful of other states considering similar mandates now
• Some states’ diversity mandates go even farther than the California
example by introducing companion quotas for racially or ethnically
diverse directors
• If the states considering diversity mandates now do ultimately follow
California’s example, 3,000 additional board seats would open to women
in the US, ushering a 75% increase in the number of women sitting on
US boards
Increased Gender Diversity is a Global Best Practice

• Quota countries have

outperformed others on
gender representation as a
general matter
Increased Gender Diversity

• States without quotas have seen more modest increases in gender

representation, as demonstrated in recent trends in the US
Gender Diversity “Pipeline Problem”

• Prior board experience is often a requirement for consideration, making it

hard for new female candidates to break into the director pool
• Typically, initial board
experience is gotten when C-
suite executives are appointed
as inside directors at their
home firm
• But gender diversity in the c-
suite is significantly lagging
board gender diversity
Gender Diversity “Pipeline Problem”

• This makes the few women with board

seats especially in demand as boards
face pressure to increase diversity
• Accordingly, women who have a
board seat are nearly twice as likely to
be “overboarded” than men (having
more than 3 simultaneous board
seats)

Source: MSCI 2019 Report

Does Diversity Enhance Performance?

• Some evidence of link between % of women on board and performance

• Superior return on
sales and ROE
• Lower stock price
volatility
• Less incidence of
bribery & fraud
• Better ESG
performance
Diversity and Performance

Studies linking diversity and performance should be interpreted with caution

• Results of existing research are at best correlational
• Bigger “blue chip” stocks are scrutinized more heavily and so tend to
have more gender diverse boards
• Emphasizing the link between diversity and performance can create unfair,
heightened expectations
Diversity and Performance

What is the mechanism by which diversity improves board performance?

• Mechanism 1: Diversity improves the quality of group decision-making by
enhancing the preparation and effort of other members
Diversity and Performance

• In diverse teams, all group members deliberate more

Diversity and Performance

What is the mechanism by which diversity improves board performance?

• Mechanism 1: Diversity improves the quality of group decision-making by
enhancing the preparation and effort of other members
• This aspect of diversity can make
participation in diverse boards feel more
difficult (and less enjoyable) to members
• It also suggests that we should be
simultaneously pursuing diversity along
many demographic traits, simultaneously
Diversity and Performance

• Focusing on observable metrics

of demographic diversity may
detract from other equally
valuable pathways through
which to achieve it
• For example, firms are less
likely to face pressure to
expand diversity along ethnicity
or nationality, in part because
ethnicity if often less visible and
quotas on this metric would be
more difficult to enforce
Diversity and Performance

What is the mechanism by which diversity improves board performance?

• Mechanism 2: Diversity improves the quality of group decision-making by
increasing the range of perspectives in the boardroom
• Rather than focusing on any particular demographic marker, we should
be optimizing on differences in sources of material
knowledge/experience: E.g., “diversity of thought”
ESG & Social Activism
Broadening the Diversity Lens

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Achieving Board Diversity by Focusing on Material Knowledge
Broadening the Diversity Lens

• Boards have put increasing emphasis on expertise in areas reflecting these

emerging nonmarket risks
Different Kinds of Diversity for Different Strategic Threats/Opportunities

• Age diversity might be especially important for companies facing threats

from disruptive technologies or cyber-security
• International experience/national origin diversity could be especially
important for companies prioritizing global expansion
• Directors from different countries bring diverse understandings of
strategy, finance, risk, regulation, and cross-cultural negotiation
• Studies show that cross-border acquisitions are more successful when a
company has independent directors from the target’s country
Broadening the Diversity Lens

• Emphasis on nonmarket expertise has increased natural opportunities for

increasing other metrics of board diversity
Broadening the Diversity Lens

• Emphasis on
expertise in areas
reflecting nonmarket
risk has increased
natural opportunities
for increasing gender
diversity
Building Diversity Systematically Through a Skills Audit
Broadening the Diversity Lens
ESG & Social Activism
Contingencies

Mary-Hunter “Mae” McDonnell, Associate Professor of Management

Contingencies

• Companies have to foster cultures of

inclusivity, egalitarianism, and open
communication to take full advantage of
diversity
• First-time directors who are women or
racial minorities often report receiving less
mentoring than their peers
Cultivating a Culture of Inclusivity

• Boards are better able to benefit from their diversity when they promote
egalitarian (as opposed to hierarchical) cultures
• Those who hold leadership positions on the board (CEO, Chair, Lead
director) should mindfully elicit and elevate the voices newer members
• Frequently, members on boards with egalitarian cultures talk of how their
leaders go out of their way to encourage discussions of diversity and
champion inclusion
Cultivating a Culture of Inclusivity

• Communication is open, contrasting opinions are shared openly and

collegially and integrated into board decisions
• Board decisions should not involve back-channeling or “meeting before the
meeting”
• Commonly boards that were more egalitarian are also more receptive to
eliciting input from core stakeholders outside of the boardroom (especially
members of the broader management team, shareholders and employees)
• All board members felt they had ready access to these stakeholders
Cultivating a Culture of Inclusivity

• Research on team performance suggests that URMs in a group with a clear

majority in-group need to have a “critical mass” to avoid marginalization and
be empowered to speak up
• Given the size of boards, this “critical mass” typically corresponds to at
least 3
Contingencies

• Companies must attend to their structures to ensure that there is diverse

representation across committees and across leadership opportunities
• Women are more likely to serve
on support committees, such as
nomination and CSR
committees
• Less likely to be appointed to
key strategic committees, like
the executive committee
• Women are also less likely to
chair committees, at all levels of
tenure