The return to normalcy. A phrase that has been used repeatedly over the last two years, while the world awaits just that—a taste of pre-COVID life. Since March 2020, the COVID-19 pandemic has made its way across the globe, leaving a lasting impact across all aspects of life. For a long time, it appeared as though the days of water cooler talk and post-work happy hours with colleagues were a thing of the past. While Corporate America seems to be making slow, but steady, progress toward a normal work environment, several challenges remain that boards and executive teams must overcome for success in 2022.
The pandemic has shed light on several issues that were just beginning to gain the attention of key stakeholders. The focus on employees and their safety is more critical than ever as companies have become increasingly diligent in how they approach their human capital management (HCM) strategies. Of course, the conversation around environmental, social and governance (ESG) issues only grows louder as each day passes. Several social justice movements across the U.S. over the last year and a half sparked the conversation on racial equality, forcing companies to reconsider how well represented their workforces are from a diversity perspective. From an environmental standpoint, the U.S. continued to witness several wildfires and other natural disasters throughout 2021, spurring investors to pay close attention to whether corporate leaders are doing their part to protect the planet.
With 2022 in full gear, it is imperative that companies embrace the challenges of the last two years head on. Equilar’s Corporate Governance Outlook 2022 publication, which featured commentary from Donnelley Financial Solutions (DFIN) and Orrick, offered insight into key trends in ESG and human capital management, as well as areas of focus for traditional governance topics such as executive compensation and succession planning. This segment features highlights and expert commentary from the publication.
For the last several years, ESG and HCM were topics gaining tremendous attention in the corporate governance world. The last two years only exacerbated the need for companies to not only acknowledge these issues, but also provide a detailed and thorough overview of their plans to address them. Unsurprisingly, the percentage of companies disclosing their ESG practices has skyrocketed in the last few years. In 2021, nearly 82% of the Equilar 100 (the 100 largest U.S. public companies by revenue) either mentioned or disclosed their ESG policies—an increase from just 10.3% of companies in 2017 (Figure 1). Furthermore, companies are electing to go into greater detail in their proxy disclosures than ever before, with 47.5% of companies providing full ESG disclosures in 2021 compared to 3.1% in 2017.
There is no question that ESG will continue to be an area of interest for investors for the next several years. In fact, 2021 Gartner research revealed that 85% of investors considered ESG factors in their investments in 2020.
“Institutional investors have increased their sophistication on ESG issues, and have more specific expectations of companies, as well as a greater number of available tools to gather the information they desire,” said Carolyn Frantz, Co-Head, Public Companies & ESG at Orrick. “Shareholders can take advantage not only of current and expected SEC reporting requirements, they can make use of the increasing number of voluntary disclosures companies are making, including corporate social responsibility/ESG reports, sustainability accounting reporting and survey responses for ESG ratings providers.”
Of course, in regards to reporting on ESG, each company may have its own approach to deliver its message to shareholders. “Not every company initiates its reporting on the same topics or in the same location or document,” said Ron Schneider, Director of Corporate Governance Services at DFIN. “Some start with website information about topics like corporate citizenship, employee health and safety, and community relations. Others may have some proxy highlights confirming that ESG and its oversight are priority topics receiving board-level attention.”
“Institutional investors have increased their sophistication on ESG issues.”
– Carolyn Frantz, Co-Head, Public Companies & ESG, Orrick
Ultimately, companies must ensure their ESG strategy is adequately aligned with company strategy. Without this alignment, the buy-in from an organization may be a challenge for any company. “The ideal endgame of a mature ESG program is for it to be endorsed at the board and C-suite level, ingrained in the company culture and imbued throughout all levels of the organization,” added Schneider.
In terms of human capital management, the focus on employees and talent has become a significant portion of overall business strategy. Much of this will fall on the plate of a company’s chief human resources officer (CHRO) and other HR leaders. In 2015, Harvard Business Review explained that similar to how the CFO helps the CEO lead the business by raising and allocating financial resources, the CHRO should help the CEO by building and assigning talent and work to unleash the organization’s energy. Managing human capital must have the same level of priority that managing financial capital has received since the 1980s.
Furthermore, in 2019, the Securities and Exchange Commission (SEC) passed disclosure requirements pertaining to human capital. The SEC is also expected to announce new human capital disclosure requirements for topics like employee retention and worker health and safety. Thus, over the next year or two, staying ahead of HCM disclosures will be critical to a company’s overall HCM strategy and, ultimately, governance practices.
The topic of diversity, equity and inclusion (DEI) is becoming increasingly relevant in everyday governance discourse. Without a concrete DEI approach, companies will certainly be caught behind the times and face potential pitfalls from many stakeholders, including investors, the media, customers and the general public. Most notably, board diversity will remain a hot-button topic in 2022 and beyond.
Calls from investors for more women and underrepresented minorities on boards of directors continue to grow louder. While mandates and quotas passed by the states of California, Washington and others have been effective in increasing the prevalence of directors from underrepresented groups, they haven’t gone mainstream and will not likely be seen at a federal level any time soon.
However, new Nasdaq listing rules, approved by the SEC on August 6, 2021, are likely to have an outsized impact on the corporate governance world in a way that previous legislative mandates have not achieved completely. The rule requires most Nasdaq-listed boards, other than exempt entities and companies with boards consisting of five or fewer members, to have at least one woman in addition to at least one member of any gender from underrepresented groups defined by race, ethnicity or sexual orientation. In lieu of compliance, Nasdaq-listed companies can explain why they cannot or will not meet these requirements in public disclosure.
Ultimately, not only does this mean that companies must meet standards, but they should also take a step back and assess their current succession plans. “The approval of Nasdaq’s new listing rules, along with legislative efforts in states like California, have led many companies to reassess the composition of their boards and add or replace board members to meet these requirements,” said J.T. Ho, Co-Head, Public Companies & ESG at Orrick. “Companies are beginning to recognize the importance of building diversity into their board succession planning, as losing even one diverse board member can make a significant difference. Strategic board succession planning can be a tool for adding new diverse board members without having to expand the board.”
The new Nasdaq rules are sure to propel companies to implement a plan to track progress toward diversity—the proxy is a good place to start. In 2021, 89.9% of Equilar 100 companies included board composition disclosures related to gender, nearly nine percentage points higher than the 80.8% of companies that did the same for ethnicity or race (Figure 2). Meanwhile, an equal percentage of companies included gender as a part of their board or director assessment process as those that included ethnicity or race—in both cases, 84.9% of the Equilar 100.
Additionally, calls for greater diversity will come in the form of recommendations from proxy advisors. Both ISS and Glass Lewis have updated their guidelines to recommend a vote against the chair of the nominating committee if certain diversity thresholds are not met.
Nasdaq’s action is an indicator of continuing pressure from the market, which has become the predominant driving force behind the push for board diversity. Without a doubt, this pressure will continue in 2022 and for years to come.
“Strategic board succession planning can be a tool for adding new diverse board members without having to expand the board.”
– J.T. Ho, Co-Head, Public Companies & ESG, Orrick
While executive compensation may not receive the same level of attention as it did a decade ago, it remains an area that must be addressed extensively to ensure shareholder satisfaction. A decade following its inception, Say on Pay continues to play a pivotal role in providing shareholders a platform to voice discontent over executive compensation pay practices. In particular, shareholders seek for executive pay plans to align with company performance and shareholder return, and when that alignment is not present, executive pay is likely to come under some level of scrutiny.
Over the last several years, the overwhelming majority of companies have passed Say on Pay. However, a recent trend emerged in 2021 that showed that investors may begin to crack down a bit more heading into 2022. In 2021, the percentage of Equilar 500 companies—the 500 largest U.S. companies by revenue—that received more than 95% approval for Say on Pay declined for the fourth straight year, with just 29.5% of companies accomplishing this feat in 2021, a 35.4% decline since 2017. The percentage of companies that failed Say on Pay more than doubled since 2017, with 3.4% of Equilar 500 companies failing. It will be interesting to see how the trends in Say on Pay pan out over the next fiscal year.
Another area of executive pay that companies should place an emphasis on is the use of ESG metrics and goals within incentive plans. While it’s evident that companies are making a more concerted effort to disclose exactly what they are doing with respect to ESG practices, many companies are also looking to provide incentives to those executives who meet certain ESG targets and goals. In 2021, 21.5% of Equilar 500 companies elected to tie executive bonuses to an ESG-related metric, with 10.3% choosing an unweighted or group metric and 11.2% selecting an individual weighted metric (Figure 3).
Although nearly 80% of Equilar 500 companies did not assign an ESG metric to their bonuses, it would come as no surprise if this figure decreases substantially over the next few years, particularly with the attention around long-term ESG strategy expected to heighten even further. “Companies should be careful to select only metrics that are important to a company’s long-term success to avoid the perception of window dressing or a method to inflate executive pay,” said Ho. “Companies should also focus on areas where data is available, reliable and well understood to facilitate rigorous goal setting and ensure pay results are reliable and defensible.”
With the world anxious to move into a post-COVID era, it is more critical than ever that companies remain astute and well advised on their governance practices. Those companies that stay ahead of the curve and establish and reinforce sound practices will certainly thrive in this new era of governance.
Amit Batish is Editor-in-Chief of C-Suite and Director of Content at Equilar.