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Wachtell Lipton Offers Thoughts for Boards of Directors in 2020

In hindsight, 2019 may come to be viewed as a watershed year in the evolution of corporate governance.  After years of growing alarm about endemic short-termism, the sustainability and competitiveness of businesses over a long-term horizon, and the role of corporate policies in contributing to socioeconomic inequality, there has been an emerging consensus that the prevailing corporate governance system is broken.  Initially, in the aftermath of the financial crisis of 2008, this critique was focused on short-termism as a root cause of systemic destabilization and decay.  In subsequent years, the concept of sustainability gained traction, and ESG (environmental, social and governance) principles were embraced by shareholders and corporations alike as the next frontier in corporate governance best practices.  This in turn laid the foundation for the latest iteration of corporate governance modernization:  the advent of stakeholder governance, and the realization that the pursuit of wealth maximization for shareholders as the sole raison d’être of corporate governance has been a principal accelerant of short-termism and socioeconomic inequality.

Perhaps remarkably, the key proponents of stakeholder governance – which posits that the fiduciary duty of management and the board of directors is to promote the long-term value of the corporation for the benefit of all its constituents and not solely to maximize shareholder wealth – have been a subset of institutional shareholders, namely, the major index funds such as BlackRock, State Street and Vanguard, as well as other shareholders with a long-term investment horizon.  Their reasoning has generally been that, in order to thrive, corporations must focus not only on profitability but more broadly on their social purpose and sustainability, and in that regard, it is essential to consider the interests not only of shareholders but also those of employees, customers, suppliers, the environment, communities and other constituencies who are critical to the success of the corporation.

In the last few months, several milestones have solidified this formulation of corporate governance.  In August, the Business Roundtable embraced stakeholder governance in a statement signed by 181 high-profile CEOs:  “[W]e share a fundamental commitment to all of our stakeholders….  Each of our stakeholders is essential.  We commit to deliver value to all of them, for the future success of our companies, our communities and our country.”  In November, the British Academy echoed this theme in its “Principles for Purposeful Business,” and earlier this month, the World Economic Forum issued its “Davos Manifesto 2020:  The Universal Purpose of a Company in the Fourth Industrial Revolution,” which states:

The purpose of a company is to engage all its stakeholders in shared and sustained value creation.  In creating such value, a company serves not only its shareholders, but all its stakeholders – employees, customers, suppliers, local communities and society at large.  The best way to understand and harmonize the divergent interests of all stakeholders is through a shared commitment to policies and decisions that strengthen the long-term prosperity of a company.

At this point, much of the focus on stakeholder governance has shifted from the question of whether a board of directors should take into account the interests of other stakeholders, to how a board should do so.  In the coming year, directors will need to grapple with a host of questions about the practical implications of this new paradigm – such as how to adjust existing board functioning to reflect stakeholder governance, questions about the contours of the board’s legal obligations, and what, if any, modifications should be made to communications and engagement efforts with shareholders and other stakeholders.

In many respects, an embrace of stakeholder governance is best characterized as a recalibration rather than a sea change.  The board’s objective continues to be the long-term health and profitable success of the corporation, and it must continue to exercise its business judgment to achieve that outcome.  To be clear, the essence of stakeholder governance is not about altruism, nor does it enable boards or companies to promote the interests of some stakeholders at the expense of others for reasons that are not squarely anchored in the best interests of the corporation.  Indeed, shareholder concerns about the prospect of zero-sum trade-offs between shareholders and other stakeholder interests should be mitigated to a large extent by the fact that shareholders are the ultimate beneficiaries of the financial value of the corporation.  Profits are not the sole objective of the corporation, but they are one of the objectives that a well-functioning corporate governance regime must seek to achieve.

In addition, the exercise of considering multiple stakeholder interests, and the risks and opportunities they entail for the corporation and its business plan, is hardly a novel endeavor for boards.  The core function of the board remains the same:  it is tasked with overseeing the evaluation and synthesis of varying objectives and interests, and concomitant risks and opportunities, while contributing the perspectives and experiences of directors to formulate a strategy and then determine the steps to execute that strategy.

Nor is stakeholder governance inconsistent with well-established principles of corporate law and the existing fiduciary duty framework for directors.  There is no legal impediment to embracing stakeholder governance.  Instead, the board has a fiduciary duty to promote the best interests of the corporation, and in fulfilling that duty, directors must exercise their business judgment in considering and reconciling the interests of various stakeholders and their impact on the business of the corporation.  Moreover, in exercising their duties of care and loyalty, directors are afforded the safe harbor of the business judgment rule in seeking to promote sustainable long-term investment and ESG principles in a manner designed to enhance the long-term value of the corporation.  Indeed, the special genius of Delaware law in particular, and one of the primary reasons why it has become the indisputably preeminent jurisdictional choice of most U.S. public companies, is that it has been animated by a fundamental sense of pragmatism and its fiduciary duty framework has afforded corporations the breathing room they need to address evolving business challenges as well as expectations of shareholders.

In other respects, however, the shift toward stakeholder governance may be subtle but profound.  A focus on the corporation and its co-dependencies with varying stakeholders, rather than more narrowly only on shareholder interests, should broaden the lens and sharpen the focus on the corporation’s purpose and long-term strategy across multiple dimensions.  For example, instead of concentrating on the quarterly financial results and financial outlook of the company, a consideration of broader stakeholder interests may prompt a more nuanced, multifaceted assessment of value that includes assets and liabilities that are impactful but, in some ways, outside the four corners of the company’s balance sheet – like the caliber of employee skillsets in the face of rapidly evolving technology, or the suitability of the company’s production processes and facilities to stay ahead of the curve in anticipating customers’ needs.

Among the critics of stakeholder governance, a common mantra has been that “accountability to all is accountability to none.”  Yet, the practical reality is that asset managers and institutional investors continue to be uniquely situated to exert tremendous influence and pressure on public corporations, and accordingly, the viability of stakeholder governance hinges on their support.  Shareholders are the only corporate stakeholders who have the right to elect directors, and, in particular, the “big three” asset managers – BlackRock, State Street and Vanguard – collectively own approximately 20% of the S&P 500 companies.  In order for this new paradigm to work for all stakeholders, the major asset managers and institutional investors must demonstrate real conviction not only in the tone of their policy statements but also in their voting decisions and engagement efforts.  At the same time that boards of directors are considering the ways in which they must recalibrate their processes, mindset and culture to achieve the benefits of stakeholder governance, a similar exercise may be warranted for many institutional investors.  They must refrain from insisting on short-term performance that discourages long-term strategies, and from investing in and outsourcing engagement to activist hedge funds.  Instead, they must embrace the same purpose, culture, stakeholder, sustainability and ESG principles that are reflected in the statements of the Business Roundtable, the British Academy and the World Economic Forum and engage directly with companies to achieve the mutual understanding and support that is critical to a flourishing economy and a tranquil society.

If investors are successful in working together with companies to effectuate stakeholder governance, the result will be to raise rather than lower the bar – in effect, shareholders as well as other stakeholders are not watering down accountability, but rather they are demanding more from corporations.  It is not enough to prop up the company’s stock price with a stock buyback program or substantial cost-cutting initiatives.  Nor is it sufficient to produce good quarterly results unless those results are building blocks in a longer-term strategic plan.  Value is not limited to stock price and dividends, and performance and success will be measured using multiple types of metrics.  Moreover, it is simplistic to suppose that these metrics will cancel each other out or obfuscate an objective review of the corporation’s performance.  Instead, a more multifaceted articulation of corporate purpose can be used to cultivate a richer, more thorough assessment and understanding – both by boards as well as shareholders and other stakeholders – of the corporation’s ability to compete and succeed in growing its business, winning customers, cultivating and retaining a talented workforce, serving as an engine of prosperity in local communities and fostering a reputation with regulators as a best-in-class corporate citizen.

As we look forward to 2020 and beyond, it is clear that the shareholder-value maximization model of corporate governance is politically and commercially unsustainable in view of the acute challenges confronting this generation.  Environmental and human capital risks, as well as the systemic instability generated by widespread economic inequality, are substantial and increasingly near-term risks for corporations operating in every business sector.  Directors must meet this challenge by focusing not just on profits, but also on the corporation’s broader purpose and role in the economic and societal ecosystem in order to build a sustainable and long-term value proposition.

With this background and context, in the coming year, boards will be expected to:

This post comes to us from Wachtell, Lipton, Rosen & Katz. It is based on the firm’s memorandum, “Some Thoughts for Boards of Directors in 2020,” dated December 9, 2019.

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