EY Center for Board Matters Board Matters Quarterly. April 2016

Transcription

1 EY Center for Board Matters Board Matters Quarterly April 2016

2 2 Board Matters Quarterly April 2016

3 April 2016 Board Matters Quarterly In this issue proxy season preview: a focus on the long term Investors are focused on supporting the long-term, sustainable corporate strategies amid concerns about short-termism in the market. Learn more in our preview. 09 Disclosure effectiveness: Is it on your board s agenda? The financial disclosure process has never been more important or more complex. Find out what audit committees can do to enhance disclosure effectiveness. 13 Three things nominating committees need to know Nominating committees are facing more scrutiny on board composition and director qualifications. We offer tips for committees operating in this new environment. 16 EU audit legislation: implications for audit committees EU companies that are public interest entities need to prepare for the audit legislation taking effect June Board Matters Quarterly April

4 2016 proxy season preview A focus on the long term Heading into the 2016 proxy season, investors are focused on supporting longterm, sustainable corporate strategies amid concerns about short-termism in the market. What investors are saying As hedge fund activism continues and stock buybacks come under increased scrutiny, many investors are questioning whether boards are sufficiently focused on the long term. At the same time, some investors are increasingly integrating company strategy into their perspectives on governance. Corporate environmental and social practices are also coming into the spotlight, and the push for proxy access and board diversity continues. The EY Center for Board Matters talked to more than 50 institutional investors, investor associations and advisors about their corporate governance views and priorities for the 2016 proxy season. Participants included asset managers (with more than US$17 trillion in assets under management), labor and public funds, and faith-based and socially responsible investors. 1 This report brings together this broad-based input and draws on our tracking of governance trends through our proprietary corporate governance database. 2 So what have we learned? Most investors remain focused on whether the right mix of directors, with a depth of diverse skills and backgrounds, are in place to oversee long-term strategies and risk management. For an increasing number of investors, how a company manages and how the board oversees the company s environmental and social impacts is integral to whether the company is being run well for the long term. Particularly given the surge in stock buybacks and continued hedge fund activism, many investors are focusing on whether companies are investing capital and operating for the long term. Many investors are closely watching how companies implement proxy access; companies restricting shareholders ability to use proxy access may damage relationships with investors. Companies should strive to make engagement focused and tailored to the investors with whom they are engaging. 4 Board Matters Quarterly April 2016

5 Investors view board composition as a matter of governance risk in their portfolios. Four areas boards should focus on We asked investors what topics they would like to see boards focus on in Among the top answers cited were: Board composition Investors view board composition as a matter of governance risk in their portfolios. To manage that risk, they evaluate and engage with boards on a number of composition-related factors including: Skill set and subject-matter expertise relevant to industry, strategy and risk. Investors seek assurances that boards have the right portfolio of talents for the company s industry, long-term strategy and risk oversight needs, including the right depth and breadth of complementary skills. Diversity, specifically including gender, race and ethnicity. For a number of investors, diversity across gender, race and ethnicity is important and speaks to the robustness of the nominating process. Some investors have called for disclosure reform to support their ability to analyze board diversity. Board succession planning/balance of director tenure. Many investors remain concerned about the slow rate of turnover on boards. Board refreshment is critical to enhancing board diversity and recruiting expertise aligned with the company s evolving strategy and challenges. Some investors are also increasingly focused on whether directors professional expertise is current, and some investors believe that lengthy tenures may impact board independence. Investors expect boards to have an independent leadership structure. For some, there is no substitute for an independent chair, but others find lead directors to be sufficient provided that the responsibilities are clearly defined and robust and provided that other challenges do not raise questions about the strength of independent leadership. An increasing number of investors are looking at director assessment processes used by boards and considering how to use them as potential indicators of a board s commitment to meaningful review and periodic renewal. S&P 1500 directors and board leadership by the numbers Age (% of all directors) J Tenure (% of all directors) J Gender (% of all directors) J Separate chair/ceo positions Independent chair J J 55% 37% of companies Under 50 (6%) (30%) (35%) Over 68 (29%) 0 2 years (21%) 3 5 years (18%) 6 10 years (26%) years (18%) More than 15 years (17%) Male (83%) Female (17% of companies Board Matters Quarterly April

6 Oversight of environmental and social risk and value drivers Investors want to know how companies manage and how boards oversee environmental and social-related risks and strategic opportunities, particularly as they relate to long-term performance. Many view environmental and social impacts in a broader business context and approach these topics with questions such as: Is the company s business model viable relative to climate change and the transition to a lower carbon economy? They want to understand how companies are mitigating climate-change-related risks, investing in innovation and considering the impact of new technologies on company strategy and operations. Is the company achieving operational excellence across the supply chain? They want to understand whether companies are using resources efficiently and how they are overseeing their global supply chain, including environmental and human rights practices. Many investors view how companies address climate change and other environmental and social challenges as a proxy for the strength of the board and management and a metric for measuring governance risk. Long-term strategy amid activist hedge fund activities and stock buybacks A number of investors are developing a more holistic approach that combines investment and corporate governance perspectives and that includes strengthened communications between governance teams and portfolio managers. They are evaluating governance decisions through an investment lens and putting engagement conversations about governance in the context of company strategy. Included in this new architecture is the task of evaluating whether hedge fund activist campaigns and corporate capital allocation decisions align with long-term investment goals. US companies are spending record amounts to buy back their own shares. Many investors question whether buybacks are driving long-term value creation. For many, their focus is on understanding why cash is not better off invested in human capital, innovation and other long-term strategies. For some, their focus extends to the broader economic and societal implications of this use of capital. Challenges from activist hedge funds persist. For some institutions, activists represent a welcome safeguard against failing managements, provided that corporate targets are well-chosen, the cases made are informed and the intended Companies are increasingly reaching settlements with hedge fund activists often before an official proxy contest is even announced. What are investor views on this trend? Positive A minority of the investors we spoke with generally viewed this trend positively because it avoids the costs and distractions involved with proxy contests and represents successful company-shareholder engagement. Many believe that their own regular engagement with companies helps inform these settlements, regardless of whether companies reach out to them about the particular circumstances. Depends on the circumstances Just under half stressed that it s a case-by-case situation. For these investors, while settlements are attractive for a number of reasons, they don t want settling to be the default orientation of the company. Some actively managed funds also noted that they buy into companies because they believe in the strategy and in management not in the hope that an activist will initiate change. Negative Around half generally viewed this trend negatively. The cost savings and avoided distraction notwithstanding, these investors have serious concerns that companies are too quick to acquiesce without consulting their other shareholders. Some feel that board seats should not be a bargaining chip, as this practice distorts the board s election process, and some also question whether activists even if constructive and persuasive belong in the boardroom. 6 Board Matters Quarterly April 2016

7 outcomes contribute to the long-term health of the firm. On the other hand, in an environment of a growing number of settlements between companies and activists, many investors have concerns that this activity is driving capital allocation and board composition decisions with a short-term horizon. Proxy access This will be another big year for proxy access, with close to 200 companies expected to face proxy access shareholder proposals. Many investors are closely watching how boards implement proxy access and tell us that boards acting in bad faith (i.e., adopting overly restrictive terms that prohibit, in practice, shareholders ability to use a proxy access right) may damage their relationships with investors. 3 Breakdown of proxy access bylaw terms adopted by more than 180 companies so far 9% 5% ownership with various restrictions on the length of ownership, the ability of shareholders to work as a group and the amount of board representation 91% 3% ownership for at least three years for up to 20% 25% of the board (or, in some cases, two directors): 4% Groups not permitted or restricted to less than 20 shareholders 5% No restrictions on shareholders working together as a group 82% Groups restricted to 20 or more shareholders Making engagement focused and investor-specific in 2016 The current level of engagement requires some investors to develop prioritization plans and be more targeted in their own engagement approach in part to keep the attention of directors who are starting to get more involved in engagement. Also recognize that their governance views and approaches vary. The message for companies is this: Recognize that there is pressure on investors to engage and that they may not have time to talk with you two to three times a year. Companies seeking to engage need to clearly communicate their intent for the meeting and the people who will participate. They should also track what is discussed in meetings and review that record, along with investors policies and voting practices, in advance of meetings to maximize productivity. Companies should also be prepared to discuss governance in the context of corporate strategy. When should directors be involved in engagement? It depends on the circumstances and the investor. Investor views on director involvement in engagement vary. Some investors want to see directors involved much more often in engagement discussions and may have concerns that their views are filtered and distorted through management. Others say director involvement should be rare. Most fall somewhere between these two views, believing that director involvement should be ongoing and periodic and that it should depend on the circumstances involved. Some specific circumstances in which many investors told us directors should be involved in engagement include: When the subject under discussion is directly under the board s purview (e.g., executive compensation, board leadership structure) and when investors seek a view independent from management (e.g., M&A) In times of crisis, when the company is in the headlines and facing high-profile challenges (notably, a minority of investors stated the opposite: that directors should not be meeting with investors when there is a crisis at hand) When the engagement needs to escalate because discussions with management have stalled and/or shareholders do not believe their views are being shared with the board When the company has received a low or failing vote on a management proposal and/or when a shareholder proposal has received majority support When there has been or will be a significant governance change or strategic overhaul Board Matters Quarterly April

8 When considered by category, environmental and social topics represent the largest proposal category by the overall number of proposals submitted. Preview snapshot: 2016 shareholder proposal landscape so far So far we are tracking more than 600 shareholder proposals submitted for 2016 annual meetings, which is around the same level as this time last year. Around 10% of the proposals have already been withdrawn in most cases because companies have agreed to implement the proposal in part or full, provide additional disclosure or commit to ongoing dialogue on the topic. Environmental and social category continues to lead Proxy access is the most commonly submitted shareholder proposal so far this year. However, when considered by category, environmental and social topics represent the largest proposal category by the overall number of proposals submitted. This year, a growing number of these proposals address climate change. For example, some proposals at energy companies focus on the risk of stranded assets while proposals at utility companies focus on the challenges and opportunities related to distributed generation. Questions for boards to consider Is the board prepared to incorporate strategy in engagement conversations with investors on governance matters? Are there opportunities to enhance the company s communications around board composition and director succession planning and assessment processes? Does the company integrate environmental and social impacts into its strategic thinking and how is the board communicating that to investors? Can shareholder engagement be more focused, productive and investor-specific? Top three 2016 shareholder proposal categories to date (based on proposal submissions) Environmental/social e.g., disclose and oversee lobbying or political spending; increase renewable energy sourcing and/or production; set and report on GHG emissions reduction targets 49% Board-focused e.g., adopt proxy access; increase diversity on the board 34% Compensation e.g., limit accelerated vesting of equity awards; adopt equity holding period 13% Endnotes 1 EY s investor outreach conversations included asking specific and consistent questions to a broad spectrum of more than 50 institutional investors, investor associations and advisors. Investor views vary. All respondents are anonymous, and results are presented in aggregate. 2 Data for 2016 is through 24 February. 3 For information on some of the proxy access terms that are of concern to many institutional investors, see the Council of Institutional Investors Proxy Access: Best Practices, August Board Matters Quarterly April 2016

9 Disclosure effectiveness Is it on your board s agenda? The role of financial disclosures has never been so important. Investors, creditors, analysts and other stakeholders are requiring more insight about a company s performance, strategic direction and exposure to risk. In the absence of clearly communicated financial information from the company, these stakeholders may draw potentially incorrect conclusions about a company s performance and strategic objectives. At the same time, the disclosure process has become more complex. Accounting requirements and government regulations are frequently changing, and web-based and social media channels are altering the methods and means of making disclosures. As a result, many companies are taking a fresh look at how effectively they tell their story. While regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) are examining ways to modernize the disclosure framework, companies are differentiating themselves in advance of any formal standard-setting and rulemaking by successfully adapting to the shifting investor demands and expectations. According to recent research conducted by EY and the Financial Executives Research Foundation (FERF) 1, nearly three quarters of companies are taking action to improve their disclosures and financial reporting. Companies that have successfully improved and streamlined their disclosures cite many benefits, including the following: Enhanced investor confidence due to communication of more meaningful information Increased efficiencies in preparing investor communications and continual evaluation of the relevancy of disclosures Improved coordination throughout the organization, including with the board of directors, regulators and external advisors Strengthened market reputation and leadership The disclosure landscape and calls for improvement Disclosures encompass the traditional required communications, such as annual and quarterly financial reports, proxy statements and earnings release filings, but also include information that may be provided via company websites and social media platforms. Enhancing the effectiveness of corporate disclosures is of paramount importance to companies, investors, creditors, regulators and capital markets at large for a variety of reasons, including helping to ensure that an organization s message is accurate and clear. Board Matters Quarterly April

10 The audit committee s opinion carries a lot of weight. If management and the financial reporting team know they have the support of the audit committee, they may be more willing to make changes. Done right, effective disclosures can boost an organization s reputation, inspire investor confidence and enhance shareholder value. These same disclosures can help lessen the impact of negative news. Done wrong, they can make a bad situation worse. Weak financial communications cause uncertainty for investors; if not properly managed, such communications can significantly damage financial reputation, adversely impacting an organization s market value and cost of capital. The volume and complexity of financial reporting requirements have grown significantly. Financial-statement users often say that disclosure documents contain too much boilerplate language and are repetitive, making it difficult to find the more important information. Some investors and other users have called for new disclosures or improvements to existing ones. Regulators and accounting standard setters have embarked on initiatives to improve the effectiveness of disclosures over the past several years. The Financial Accounting Standards Board (FASB) is developing new disclosure guidance for inventories, fair value measurement, income taxes and defined benefit plans as part of its broader disclosure framework initiative. Additionally, the FASB is currently evaluating proposed guidance on applying materiality to disclosures as part of its broader disclosure framework project to improve the effectiveness of disclosures in financial statements. For International Financial Reporting Standards filers, the International Accounting Standards Board is also making progress on improving the effectiveness of financial statement disclosure. The SEC is in the process of reviewing disclosure requirements in Regulations S-X 2 and S-K and continues to reach out to companies, investors and other market participants for recommendations on how to improve and modernize the disclosure regime. What is the role of the board and the audit committee? SEC Chief Accountant Jim Schnurr recently noted that the audit committee plays a critical role in overseeing management s preparation of reliable financial statement disclosure. 3 In addition to putting the disclosure effectiveness initiative on their agendas, audit committees can take the following steps to enhance disclosure effectiveness: Set the tone for disclosure innovation and effectiveness Boards and audit committees should empower management and proactively support efforts to focus on disclosure effectiveness and disclosure innovation. The audit committee s opinion carries a lot of weight. If management and the financial reporting team know they have the support of the audit committee, they may be more willing to make changes. Audit committees should work with management to instill a disclosure mindset, bearing in mind that repetition and immaterial disclosures are areas for improvement in company communications. When reviewing documents, audit committees should focus on the general manner of presentation and wording of financial communications for clarity, transparency and the use of plain English. Audit committees should challenge management to be innovative and enhance understandability by streamlining the financial reports whenever they can to communicate more succinctly. Be an engaged stakeholder from the start Disclosure effectiveness is a cross-functional journey that involves engaging senior executives, controllers, heads of SEC reporting and investor relations, in-house and external counsel, and board members from the start. Top-down commitment throughout the organization is necessary to sustain the focus on improving the quality of information provided to investors. 10 Board Matters Quarterly April 2016

11 The audit committee should confirm and monitor that there is appropriate coordination with key internal stakeholders and timelines for implementing disclosure changes. Involving a company s external auditor is also essential. Challenge and continuously consider how the organization s disclosures can be more effective for investors Investors are not just focused on headline performance numbers. Instead, they want information that will help them best assess performance, evaluate strategy and identify risks. Companies are responding to investor demands differently and are focusing on making their financial communications more streamlined, connected and understandable. According to the FERF/EY report, the three key focus areas in companies improvement efforts are: 1. Disclosing material information and eliminating immaterial information (80%) 2. Reducing redundancies and using more crossreferencing (77%) 3. Eliminating outdated information (70%) Removing immaterial information, redundant disclosures and outdated information may be a good start for disclosure improvement. However, companies should consider plans for more robust efforts, including holistic changes across all financial communication channels. Companies should also consider ways to improve the presentation of information through greater use of bullet points, tables, charts, graphics and infographics to communicate the information rather than simply disclosing it narratively. 4 Benchmarking disclosures and communications against peers and disclosure leaders can identify gaps and areas of improvement. Putting it into practice: a spotlight on General Electric Many consider General Electric (GE) one of the largest high-profile companies to embrace the call to action. In its most recent 10-K and annual report, GE used graphics and a layered style to create a more engaging and streamlined way to communicate with its shareholders. Christoph Pereira, GE s chief corporate, securities and finance counsel, explains that Disclosure documents have dramatically increased in length over the last 15 years as a result of the Sarbanes-Oxley Act and other legislation Yet in today s age, everyone s attention span seems to be getting shorter by the day. 5 GE s 10-K includes 15 introductory pages of charts and graphics covering revenues, earnings-per-share growth, employees and key performance areas in a format that is easily digested. Putting the 10-K summary and introduction sections up front provides investors with a snapshot of salient information that is covered in greater detail elsewhere, such as broad-level strategy and capital allocation choices. The executive summary sets the stage and answers two critical questions that are often on the minds of investors: where have they been? and where are they going? The summary is informative, providing an outlook into GE s key businesses as well as trends and significant developments in a variety of visually compelling formats, such as the use of bullet points. Pereira notes that GE approached its 10-K document with the mindset that quality of disclosure is not about the amount of information, but rather about meaningful, wellpresented information that is tailored to fit the needs of the audience. The new 10-K, especially the 10-K Introduction and Summary section, gives readers a more bite-sized view of GE, while still allowing the reader to delve into all the details by referring to the full 10-K. This layered disclosure approach has been very successful for us. 6 Board Matters Quarterly April

12 An effective, experienced and diverse board is a strategic asset to any company. Encourage a holistic, efficient and effective disclosure program that enhances communication with key stakeholders An effective plan to improve disclosures may require additional documentation about significant judgments (e.g., materiality assessments), as well as better integration of people, data and technology that can benefit from audit committee support and oversight. Audit committees can provide helpful input about the scope and extent of disclosure effectiveness efforts. Companies must consider time, cost and resource constraints, as well as regulatory disclosure requirements. Focusing on improving specific disclosures that are cumbersome or overly complex may be more efficient than trying to rewrite the financial statements and SEC reports from scratch. In order for disclosure effectiveness efforts to be successful and sustainable, they should be treated as a journey and not as a one-time initiative. The objectives of disclosure effectiveness should be embedded into the company s financial-reporting DNA. Conclusion With so much at stake and so much changing, it is imperative that boards take a fresh look at their companies financial reporting and disclosures. Audit committees play a pivotal role in helping to shift the disclosure effectiveness mindset within the company. Boards and audit committees must set the tone at the top for this management-driven initiative, and they should encourage management to make disclosures more clear and informative. More and more companies are recognizing that in the absence of clearly communicated financial information, stakeholders, including activist investors, may draw potentially flawed conclusions about the company s performance and strategic objectives. An effective disclosure process is the key to addressing such issues. Questions for the board and nominating committee to consider Does the company have a plan and process to improve disclosure effectiveness? If so, what are the planned improvements, and how were the targeted disclosure areas identified? If the company is planning to enhance its disclosures, is there a clear timeline and projectmanagement support to meet the deadlines? Does the audit committee interact with the disclosure committee? Do both committees understand the plans to improve disclosure effectiveness? Has the company reached out to analysts and investors to obtain feedback about the quality and transparency of its disclosures? How is technology being leveraged to improve the effectiveness, timeliness, readability and reach of the company s disclosures? Has the board or management considered engaging outside consultants or advisors to evaluate the company s disclosures and benchmark them against peers and analysts expectations? Endnotes 1 Disclosure effectiveness: Companies embrace the call to action, Financial Executives Research Foundation in collaboration with EY, November To the point: Our recommendations for changing Regulation S-X disclosures about entities other than the registrant, Ernst & Young LLP, 20 November Remarks before the UCI Audit Committee Summit, 23 October Disclosure effectiveness: what companies can do now, Ernst & Young LLP, October Reimagining the 10-K Disclosure as a Tool for Good Governance, GE Reports website, accessed 26 January Ibid. 12 Board Matters Quarterly April 2016

13 Three things nominating committees need to know We offer three tips for nominating committees facing this changing environment, informed by the EY Center for Board Matters review of the US corporate governance landscape, ongoing conversations with investors and the broader governance community, and use of our proprietary corporate governance database. 1 Nominating committees are facing heightened scrutiny from investors and other governance specialists who are intensifying their focus on board composition and director qualifications. This is driven by several developments, such as the push for greater diversity in the boardroom (including recent comments by U.S. Securities and Exchange Commission Chair Mary Jo White indicating that she s requested a review of existing company disclosures on board diversity 2 ), increased investor and company interest in board assessments, the growing influence of hedge fund activists who may question board performance and the emergence of, according to many governance specialists, proxy access 3 as a new leading practice. Three tips for nominating committees 1. Evaluate and enhance disclosures about director qualifications, board composition and board assessment processes Most institutional investors we spoke with (more than 75%) said companies are not doing a good job explaining why they have the right directors on the board. 4 Historically, investor understanding of director qualifications has been limited to basic biographic information in proxy filings representing to the letter compliance with the requirement to disclose: the particular experience, qualifications, attributes or skills that qualified that person to serve as a director of the company in light of the company s business. 5 Now, companies are increasingly enhancing their disclosures by explaining more about how each director contributes to the board. Some disclosures go further to describe how the board and its committees, as a whole, have the appropriate mix of skills, expertise and perspectives to oversee the company s key strategies, challenges and risk management efforts. Board Matters Quarterly April

14 Companies are making other efforts to enhance the way they communicate to investors, such as by using graphics, tables and letters to shareholders. Some are exploring the use of videos and other media. And some are looking to other markets such as the United Kingdom, Australia and Canada for ideas for how to enhance their own disclosures. For example, some companies may explain how new directors complement the existing board, provide specific examples of industry and functional expertise, illustrate how different forms of diversity combine to provide for a more dynamic board, explain how the board s expertise is enhanced through additional educational opportunities and discuss how the board assessment process is used to further strengthen the board. When there are questions about company performance, investors are likely to look more closely at board composition, and when there are minimal or no disclosures demonstrating how directors contribute to the company s strategic goals, investors may question the performance assessment process. 6 For example, they may ask how the evaluation process is structured, how often it s carried out and how results are addressed. They also may ask about the role of independent board leaders, other stakeholders and/or third parties in the process. They may also question how board candidates are sourced, the board succession planning process and director education practices. 2. Integrate diversity, expertise and tenure considerations into board composition and succession planning Nominating committees play the critical role of linking the board s director recruitment, selection and succession planning processes to the company s strategic goals. They do this by trying to maintain the best mix of expertise and perspectives in the boardroom to address the ever-changing business environment and oversee the company s key strategic efforts. Nominating committees, institutional investors and other governance observers are increasingly weighing additional perspectives in the director selection process, such as diversity How does your board compare? Summary data S&P 500 S&P 1500 Russell 3000 Average board tenure Average age Gender diversity 20% 16% 13% (including gender, racial, cultural, geographical, generational diversity), industry knowledge, global perspectives, and expertise in areas such as cybersecurity and environmental sustainability. An ongoing focus on board composition allows the nominating committee to maintain a balanced mix of fresh insights (from recently appointed directors) with institutional knowledge (from seasoned and longer-tenured directors) and other perspectives in between (based on variations in board tenure). The table above provides some general metrics on board composition, which may be helpful to nominating committees seeking to develop a view about longer-term positioning for their boards. 3. Growing attention to board composition and quality may influence how investors vote in future director elections Investors historically have voted against director nominees based on triggers such as poor meeting attendance, excessive board service, executive compensation challenges, independence concerns, perceptions of subpar performance and/or unresponsiveness to shareholders. 7 Now, institutional investors appear to be moving beyond these traditional metrics for evaluating boards. Increasingly investors are calling out the lack of board diversity as a governance issue in engagement conversations with companies, stewardship reports and proxy voting guidelines 8 with some investors 14 Board Matters Quarterly April 2016

15 adopting policies of voting against board nominees when they perceive insufficient diversity, such as too few women and/or minority directors. 9 New policies by proxy advisory firm Glass Lewis reflect the emerging shift to consider board composition and director qualifications in voting recommendations. For example, beginning in 2016, Glass Lewis, which develops its policies with investor input, will recommend that investors oppose the re-election of a nominating committee chair in the event of poor performance and the chair s failure to ensure the board has directors with relevant experience, either through periodic director assessment or board refreshment What investors are saying As hedge fund activism continues and stock buybacks come under increased scrutiny, many investors are questioning whether boards are sufficiently focused on the long term. At the same time, some investors are increasingly integrating company strategy into their perspectives on governance. Corporate environmental and social practices are also coming into the spotlight, and the push for proxy access and board diversity continues. The EY Center for Board Matters talked to more than 50 institutional investors, investor associations and advisors about their corporate governance views and priorities for the 2016 proxy season. Participants included asset managers (with more than US$17 trillion in assets under management), labor and public funds, and faith-based and socially responsible investors. 1 This report brings together this broad-based input and draws on our tracking of governance trends through our proprietary corporate governance database. 2 So what have we learned? Most investors remain focused on whether the right mix of directors, with a depth of diverse skills and backgrounds, are in place to oversee long-term strategies and risk management. For an increasing number of investors, how a company manages and how the board oversees the company s environmental and social impacts is integral to whether the company is being run well for the long term. Particularly given the surge in stock buybacks and continued hedge fund activism, many investors are focusing on whether companies are investing capital and operating for the long term. Many investors are closely watching how companies implement proxy access; companies restricting shareholders ability to use proxy access may damage relationships with investors. Companies should strive to make engagement focused and tailored to the investors with whom they are engaging director opposition votes Summary data S&P 500 large cap S&P 400 mid cap S&P 600 small cap Russell 3000 Average director opposition votes 3% 4% 5% 5% Number of director candidates 4,700 2,500 3,200 17,500 Portion of director nominees with more than 20% opposition votes 2% 3% 5% 4% Board Matters Quarterly April

16 The objectives of disclosure effectiveness should be embedded into the company s financial-reporting DNA. Where do nominating committees go from here? Nominating committee members should recognize that these developments are occurring as investor votes are becoming more meaningful, with annually elected boards (versus staggered) and with a majority voting requirement (versus plurality). There also appears to be an emerging trend of targeted voting practices, with investors opposing perceived action or inaction by specific directors and committees. For example, we recently found that companies with low say-on-pay votes saw higher opposition votes directed at compensation committee members. 11 When directors step off the board, whether as planned or unexpectedly, nominating committees need to reconsider overall board composition, what the departure may mean for the board now and going forward, and how best to communicate these changes to investors. An effective, experienced and diverse board is a strategic asset to any company and its investors and there s an opportunity cost to standing still. The keys to that are in the nominating committee hands. Questions for the board and audit committee to consider Are the company s proxy disclosures adequately showcasing the diverse backgrounds, skills and qualifications of the directors? Is there a robust mix of perspectives aligned with company strategies and risks among the current line-up of directors? Based on changing company strategies, risks and challenges, how much board turnover is optimal in the next one, two or three years in order to stay on top of these developments? Is the board providing a robust disclosure of the board assessment processes? Does the board follow through with board assessments by reviewing key takeaways and implementing an action plan with deadlines? When was the last time the selection criteria for director nominees was reassessed and updated? Endnotes 1 EY Center for Board Matters proprietary corporate governance database covers more than 3,000 public companies listed in the US. Vote results are calculated based on votes cast for and against the proposal. 2 See SEC Chief: Board Diversity Is a Priority for Agency in 2016, Wall Street Journal, 27 January Proxy access refers to the right of eligible shareholders to add their director nominees to the proxy materials for the annual meeting or other corporate board elections. 4 See 2015 proxy season insights: spotlight on board composition, Ernst & Young LLP, March See Securities and Exchange Commission 17 CFR PARTS 229, 239, 240, 249 and 274, February See Accelerating board performance through assessments, Ernst & Young LLP, December Based on a review of proxy voting guidelines and company filings. Examples of a board appearing insufficiently responsive include when a board makes unilateral governance changes on certain matters (such as poison pills) or fails to address a shareholder proposal that received majority support of votes cast. 8 For example, see BlackRock s Proxy voting guidelines for US securities, February 2015; Vanguard s Our proxy voting and engagement efforts: An update, December 2015; and State Street s Addressing the Need for Board Refreshment and Director Succession in Investee Companies, February Examples include Walden Asset Management, Trillium Asset Management, Pax World Management. 10 See Proxy Paper Guidelines: 2016 Proxy season: An overview of the Glass Lewis approach to proxy advice United States. Proxy advisory firm ISS does not have a similar policy. 11 See Five things compensation committee members need to know, Ernst & Young LLP, November Board Matters Quarterly April 2016

17 New EU audit legislation Implications for audit committees The European Union (EU) audit legislation, enacted in 2014, and effective starting in June 2016, will usher in far-reaching changes for companies that are public interest entities (PIEs) in the EU. Definition of a PIE 1 The first question for audit committees to consider is whether their company is an EU PIE or has an EU PIE in its group. PIEs are broadly defined in the legislation as companies that are governed by the law of a Member State that have shares or securities admitted to trading on a regulated market in the EU. Yet, significantly, all credit institutions and insurance undertakings are also defined as PIEs, whether they are listed or not. Therefore, banking and insurance groups will find the new legislation particularly challenging because every subsidiary that they have in the EU is likely to be a PIE. It is important to note that Member States can expand the definition of what constitutes a PIE, and many will do so. For more information on what currently constitutes a PIE, see EY s paper, EU audit legislation: understanding the legislation and how it will affect you. Several key provisions of the 2014 legislation will greatly affect the audit committees of these companies, as we explain below. Yet many audit committees may not be aware of the challenges that lie ahead. Under the law, EU competent authorities must, among other things: Evaluate PIE audit committee performance as part of audit market monitoring reports that they are required to publish every three years Establish a sanctions regime that is applicable to individual PIE audit committee members, other directors and the PIEs themselves (as well as their external auditors) in the event of noncompliance with the law Under the law, audit committees of PIEs must: Rotate audit firms in accordance with local laws Meet specific requirements for monitoring auditor independence, including preapproving expenditure on permissible non-audit services (preapproving expenditure could be difficult where a large entity has subsidiaries in multiple jurisdictions, because different Member States will apply different prohibitions with regard to non-audit services) While much of what has been legislated relating to PIE audit committees is already leading practice in many EU Member States, there are some jurisdictions where the framework will require audit committees to make substantial changes to how they currently operate. The general requirement in the legislation is that every PIE should establish an audit committee. Although Member States can decide to exempt certain PIEs from that requirement, it is possible that some groups of companies might find themselves legally obliged to establish more than one audit committee. This will require a degree of coordination between those audit committees in order to avoid unnecessary duplication of effort while affording full compliance with the law. As the implementation date for the legislation is close, it is essential that audit committees understand the new requirements and start preparing for them now. Board Matters Quarterly April

18 Changes impacting audit committees The changes described below apply to audit committees of PIEs, unless otherwise noted. Performance monitoring For the first time, the legislation requires the European Competition Network and the audit oversight authorities in each Member State 2 to prepare an audit market monitoring report on a three-year basis. The report will focus on topics including concentration levels in the PIE audit market, audit quality and the performance of audit committees, with the first report due to be published in June 2016 and the second in June At this stage, it is not clear how the performance of an audit committee will be assessed, although a better indication will be afforded once the first audit market monitoring report is published in June The way in which the audit committee conducts the audit tendering process will almost certainly form a major part of the assessment. Regardless of the jurisdiction in which they are based, audit committees will have to be able to demonstrate, upon request, to the competent authority that the selection procedure was conducted in a fair manner. It is also possible that the review may include the audit committee s role in the assessment of auditor independence, monitoring the provision of non-audit services and supporting overall audit quality. It could also include a judgment on whether the audit committee is sufficiently independent and comprises individuals who provide the right breadth of sector and accounting or auditing skills. Should there be any breaches of the law, penalties could be imposed on individual audit committee members as well as on the PIE itself. 3 Tendering activity The new legislation will require a PIE either to rotate its auditor or put the audit out to tender after a maximum 10-year period. There is some flexibility for Member States, however. For example, they have the option to adopt a shorter time frame for rotation. They also may choose to let PIEs put their audit out for public tender after 10 years and allow them to keep their current auditor for a maximum of 10 additional years. The audit committee is responsible for conducting a tender consistent with certain legal requirements. It must conduct an audit tender in accordance with the requirements that are specific to the PIE s own jurisdiction. It needs to follow a fair and transparent process when selecting a new auditor. Furthermore, it must be able to demonstrate that the organization of the tender process contains nondiscriminatory selection criteria and has not precluded the participation of smaller audit firms (e.g., those outside the Big Four). Following the tender, the audit committee must recommend the names of at least two potential auditors to the board. One name will be the preferred choice. The choice and preference will then be presented to the shareholders by the board. If the recommendation of the audit committee has been rejected, the board will need to explain why. 4 Monitoring the independence of statutory auditors Auditors of PIEs will be subject to a maximum cap on non-audit fees. The cap equals 70% of audit fees based on a three-year rolling average. Outside a specific list of prohibited services, auditors can provide a range of permissible non-audit services to their audit clients. Prohibited services includes providing accounts preparation, structuring, valuation, legal and payroll services. A list of tax services are also prohibited, although Member States may permit them in certain circumstances. Since audit committees of PIEs will have to preapprove expenditure on permissible non-audit services, they will need to understand the structure of their groups and the different audit arrangements that are in place. The audit committee will need to know which services the PIE requires and which professional services firms will be eligible to provide them. Moreover, if an audit firm from another network (i.e., a network other than the one performing the group audit) is appointed to audit an 18 Board Matters Quarterly April 2016

19 entity within the group, the audit committee of the PIE will have to consider carefully whether that entity is, itself, a PIE or if it has parents or subsidiaries in the EU that are PIEs. If so, and to the extent that the incoming auditor has been providing other services elsewhere in the group, those arrangements may need to be terminated. Where there are multiple PIEs in a group, that requirement can become increasingly complex to monitor, particularly since PIEs in different jurisdictions may have to rotate their auditors at different times. For example, if a London-based bank has a small subsidiary in Italy that awards its audit to a particular firm, the prohibitions on which services can be provided by that firm apply to the Italian subsidiary as well as to that subsidiary s own subsidiaries and its parent companies within the EU. They also apply to the audit firm s entire global network. If the firm had been providing non-audit services to the bank in London, it would no longer be considered independent once it won the Italian audit and would have to stop providing those non-audit services. 5 Nevertheless, although the prohibitions apply to the audit network globally, they would not prevent the US firm within a network from providing non-audit services to a US parent company. That said, if the US entity were a subsidiary of an EU PIE, while most non-audit services are permissible subject to a threats and safeguards assessment, some services are explicitly banned (e.g., bookkeeping and payroll services and the preparation of accounting records and financial statements). 6 Composition of the audit committee Under the new framework, the majority of audit committee members must now be independent, and one member must be competent in accounting or auditing. Additionally, the legislation states that committee members as a whole shall have competence relevant to the sector in which the audited entity is operating. This is viewed as a significant change from the 2006 directive, which only required one member of the audit committee to be independent and to have competence in accounting or auditing. 7 Auditor s report to the audit committee The law requires the auditor to submit an additional, more detailed, report to the audit committee on the results of the statutory audit. Under the legislation, Member States may impose additional requirements for such reports, including requiring the audit committee to pass this on to the board, along with an explanation of how the audit of the financial statements contributed to the integrity of the PIE s financial reporting and the audit committee s role during the process. 8 Audit committees outside the EU Audit committees of companies that are based outside the EU, but that have EU PIEs somewhere in their group structure, will also be affected by the legislation. For example, any PIEs in the EU will have to abide by the new auditor rotation requirements, and the independence of their auditors will still need to be monitored. The audit committee of a non-eu parent would not, however, be subject to sanctions on individual audit committee members enforced by the EU supervisory authorities. How audit committees can prepare An initial priority will be for an audit committee to ascertain to what extent there are PIEs anywhere in their group structure, a determination that could be informed by discussions with their auditor. If any PIEs are identified, their audit committee should prepare for the new audit legislation by following the steps below: The applicable rotation and tendering requirements for the PIE s audit should be determined, both in terms of length and timing. These will differ according to jurisdiction and the length of the existing audit relationship. Relationships beyond the company s current auditor should be managed. Audit committees of PIEs need to examine whether audit firms other than the current auditor provide non-audit services to other group companies, determine Board Matters Quarterly April

20 the nature of any such services, and ascertain whether those firms would be considered sufficiently independent if they were to tender for the audit in the future. The audit committee should obtain regular updates from its current auditor on its independence. The audit committee should decide how to provide proof that it has carried out the audit tendering process in a fair, transparent and nondiscriminatory manner. The composition of the audit committee should be reviewed to ensure that it complies with the new regulation. Is it sufficiently independent and is it composed of individuals who provide the right breadth of sector and accounting or auditing skills? It may be necessary for the audit committee to consider performing its own skills analysis in order to get an accurate picture. The far-reaching changes from the 2014 EU audit legislation warrant attention from audit committees of companies that are, or include, a PIE under the EU legislation or EU Member State definitions. EY encourages timely consideration of these matters to facilitate fulfillment of related obligations. Endnotes 1 New EU regulatory framework on statutory audit; Article 2(13) of Directive 2006/43/ EC as amended by Directive 2014/56/EU. 2 For a full list, see: 3 New EU regulatory framework on statutory audit; Article 27(1)(c) of the Regulation 537/ Ibid. Article 16 of the Regulation 537/ Ibid. Article 39(6)(e) of the Amended Directive 2014/ Ibid. Article 5(5) of Regulation 537/ Ibid. Article 39(1) of the Amended Directive 2014/ Ibid. Article 11 of the Regulation 537/2014. EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. About the EY Center for Board Matters Effective corporate governance is an important element in building a better working world. The EY Center for Board Matters is committed to bringing together and engaging with boards, audit committee members and investors to exchange ideas and insights. Using our professional competencies, relationships and proprietary corporate governance database, we are able to identify trends and emerging governance issues. This allows us to deliver timely and balanced insights, data-rich content, and practical tools and analysis to boards, audit committees, institutional investors and others interested in governance topics Ernst & Young LLP. All Rights Reserved. SCORE no US ED None Contacts This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com Ruby Sharma Ernst & Young LLP ruby.sharma@ey.com Ann Yerger Ernst & Young LLP ann.yerger@ey.com Mark Manoff Ernst & Young LLP mark.manoff@ey.com John Schraudenbach Ernst & Young LLP john.schraudenbach@ey.com About this publication Board Matters Quarterly is published four times a year and includes articles previously published online and distributed electronically to our subscribers. To access or sign up to receive similar content relevant to board members, please visit ey.com/boardmatters.