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Rewriting The Rules of Corporate Governance

By Lynn S. Paine

As boards look to the post-COVID era, they will need to assess their readiness to meet three new demands—and address any gaps they find.

Since the onset of Covid-19, corporate boards have faced a string of difficult  decisions. Take  the question of dividend payments: Ordinarily, the  decision would  be  a relatively straightforward matter of applying  a stated dividend policy, following  past practice, or choosing an amount based on shareholder expectations and  the  company’s earnings for the  period. But this  year,  with COVID-19 decimating the economy and looming uncertainty about the depth and duration of the crisis, the decision became a complex matter of weighing and balancing multiple factors — at least for companies flush enough to consider it at all.

Boardroom dividend discussions ranged over a series  of considerations: the  equity  and  symbolism of returning cash  to shareholders at a time  when  employees were  being  laid  off or furloughed; the  potential future opportunities gained (or  lost) by following  (or going  against) government calls  for dividend cuts; the reputational and  signaling effects  of maintaining versus suspending or  reducing the  dividend; the  expectations of shareholders and the proportion reliant on dividend income; the company’s cash position and strategic plans; and what would be prudent in the face of extreme uncertainty. A decision that would typically require only a few minutes of board discussion — if that — became an hour-long (or more)  deliberation. And then  there was the discussion about how to explain the decision in the company’s public communications.

In the end, some  boards decided to maintain the dividend. Others decided to suspend or reduce it. In the UK and Europe, where  policymakers and  central banks  urged  cuts,  the  major banks and many companies followed their guidance. In the U.S., most  of the  large  banks  committed to maintaining their  dividends, though authorities and experts disagreed about the wisdom  of that  choice.   Whatever the  final decision, however, the process of reaching it was far from straightforward.

This is just one example of the  reality  that  boards are facing as a result of COVID-19.  The new environment is characterized by an increasingly complex set of pressures and  demands from  various stakeholder groups,  heightened expectations for societal engagement and corporate citizenship, and radical uncertainty about the future. These factors are complicating board decision-making and challenging the shareholder-centric model of governance that has guided boards and business leaders for the past several decades.

The  shareholder-centric model appears to  be  giving  way to a richer  model of governance that  puts  the  health and  resilience  of the company at its centre. The pandemic has made all too clear that society depends on well-functioning companies to meet its most  basic needs — for food,  shelter, communication, you name it — and  that  companies do not exist solely to maximize  returns to shareholders. It follows  that  boards, which  by law are  a company’s governing body,  should be concerned not just with returns to shareholders, but with the full range of factors that enable the company to create value over time. Paradoxically, this enlarged purview  does not diminish boards’ accountability  to shareholders, but it does  imply changes in the nature and scope of that accountability.

The shareholder-centric model is giving way to a model
that puts the health and resilience of the company at its centre.

Whether COVID-19  is truly  an  inflection point  for corporate  governance is yet to be seen,  but there is no doubt that  the pandemic has challenged core premises of the agency-based model of governance in ways that  have  important implications for boards. In this article, I will suggest three ways the board’s job is likely to change in the post-COVID era.

NEW REALITY #1: More Structured Attention to Stakeholders

Shareholder primacy is  the  cornerstone of  the  agency-based model of governance, but if the pandemic has shown  anything, it is the  importance of each  and  every  stakeholder group  to a company’s ability to function, let alone  thrive  and succeed over time.  In the  face  of COVID-19,  some  companies struggled because  their  customers disappeared. Others saw their  workforce reduced to a skeleton crew  of essential employees. Still others grappled with  supply  chain  disruptions, unsustainable debt  or insufficient capital to fund their operations.

Since the onset of the crisis, it has become common practice for management to update the board on the situation regarding each  stakeholder group,  and  many  boards and  senior leaders have  declared the  health and  safety  of employees and  customers  to be their  top  priority.  Some  investor groups  as well have weighed in on behalf  of putting employees first during this perilous time.

The  crisis  has  validated the  logic  of interdependence behind  the  Business Roundtable’s 2019 statement on corporate purpose, in which  181 CEOs  pledged a commitment to each  of five stakeholder groups  — customers, employees, suppliers, communities and  shareholders —  and  reversed its  endorsement of shareholder primacy. Coming out of this crisis, boards and senior leaders will find it even harder to say that  shareholders — or, for that  matter, any stakeholder group  — has standing ‘primacy’  over all the others. In the life of a company, there are times when employee interests must come first, times when customer interests should take  priority, times  when  public  need is paramount, and times when the interests of shareholders should be the prime  concern. As reactions to COVID-19 showed, much depends on the nature of the interests at issue and  the circumstances of the company.

These lessons from COVID-19 imply a more active role for boards in monitoring companies’ relationships with their  core stakeholders. That  may mean asking  management to continue the COVID-born practice of periodic reporting to the board on the status of each group or, more formally, to establish goals and a reporting process that  will allow the  board to track  the  company’s  performance for  its  stakeholders more  systematically over time.

Boards  will also want  to take a more  active role in ensuring that trade-offs among the interests of its various stakeholders are handled in a way that  is consistent with its obligations to these groups  and with the long-term health of the company. For that, it will be important for directors to have a shared understanding of the  company’s purpose and  strategy, as well as a framework defining the company’s stakeholders and responsibilities to each.

Many companies say they have commitments to all of their stakeholders, and  that  may well be true.  But few boards have  a structured process for  overseeing those   commitments or  for tracking the company’s performance for its non-shareholder stakeholders. If they do, it is not something that  is regularly reviewed  and  discussed in the boardroom in the way that  performance for shareholders is regularly reviewed and discussed. To the extent that stakeholder concerns come into strategy or M&A decisions, it tends to be somewhat ad hoc or by exception rather than a routine part of the analyses that boards receive.

In the wake of COVID-19,  boards will likely face increased pressure to incorporate stakeholder perspectives and  voices, especially those  of employees, into their  oversight and decision processes. They will also be challenged to show that  the company is performing well for all its stakeholders. External pressure aside,  boards that  have learned from COVID-19 will want  to do this for their own purposes.

NEW REALITY #2: More Attention to How Business and Society Intersect

The pandemic has brought home the tight  connection between business and society, and underscored the threat posed  by risks stemming from  large-scale societal problems that  proponents of the shareholder model have traditionally regarded as outside the purview  of business. The pandemic has shown  that,  theory aside,  companies cannot so easily  disconnect themselves from society-at-large.

COVID-19  started as  a  public  health crisis  and  quickly evolved into a financial and economic crisis of epic proportions. As the virus made its way across the globe, few, if any, companies were spared. Some saw demand for their offerings collapse overnight,  while others faced  a deluge of orders. Many had to invent new ways of working in a matter of days, if not hours. Stock prices plunged and then  fell into a pattern of unprecedented volatility. In the face of uneven and, in some cases, ineffective responses by governments and  with economic recovery dependent on stemming the public health crisis, many  companies stepped up to fill the  gap even  as they  struggled with their  own problems. In the many  meetings and  updates during this period, directors found themselves reviewing management’s plans not only for steering the company through the crisis but also for helping combat the virus or aid in the relief effort.

Many  companies rose  to the  occasion, retooling their  production lines to make needed equipment, providing open access to otherwise proprietary information, offering  their  facilities or services to health authorities or bringing their capabilities to bear on the crisis in other ways. Others acquitted themselves less well, and  got caught in the public’s crosshairs for seeking to take advantage of government programs intended for those  less fortunate. Many boards and senior leaders were forced to grapple with vexing  questions of public  responsibility at the  same  time  that they were struggling with a crisis for which they were ill prepared.

For at least a decade, calls have been mounting for business to help address systemic concerns such as increasing income and wealth inequality, environmental degradation, climate change, racial and ethnic discrimination, declining public health and education, rising corruption, deteriorating public institutions and, yes, increasing risk of pandemics. While some  business leaders have heeded the call and found  innovative ways to help address these problems, many  others have  looked  the  other way or defined the problems away as ‘social issues’ and therefore, by definition, outside the scope of their  legitimate concern as business executives and fiduciaries for their shareholders.

COVID-19  has shown  that  these issues  are  not  only legitimate areas of concern for business but also, and more importantly, sources of both risk and opportunity. Like market forces,  societal  forces  can profoundly affect the business and competitive environment. Coming out of the crisis, boards will want to work with their  company’s leaders to ensure that  the  company’s risk management and oversight systems encompass the risks arising from these large-scale societal problems. They will also want  to ensure that  the  company’s strategic planning and  resource allocation processes take these problems into account, so that  the resulting activities, at a minimum, do not exacerbate these problems and, ideally, help to ameliorate them.

In the wake of COVID-19 boards can expect institutional investors, governments and the general public to renew their  calls for companies to pay more  attention to societal problems and to take a more active role in helping address them. By the same  token, boards themselves will increasingly be expected to oversee the  business and  society  interface. Instead of being  the  exception,  robust oversight over sustainability, corporate responsibility, societal engagement, corporate citizenship, ESG — whatever you want to call it — will become the rule.

NEW REALITY #3: More Attention to Board Composition

The  pandemic’s disparate effects  and  ensuing national outcry over racial  inequity have  put a spotlight on board composition, especially as it relates to directors’ race and ethnicity, a topic on which  the agency-based model has been  ambivalent at best.  In his classic  article on corporate social  responsibility, economist Milton Friedman portrays the ideal “agent” (the theory’s term for a director or manager) as a generic male  wholly devoted to maximizing the wealth of shareholders to the point of suppressing his own personal commitments — and even his responsibilities to family and community. In other words, the theory regards directors’ identities and personal characteristics as largely  irrelevant for their roles.

This void in theory has been  filled in practice by a custom of appointing directors with backgrounds as CEOs or CFOs, positions  traditionally held  by white  men,  and  of drawing board candidates from existing directors’ own networks. The result has been  a self-perpetuating system of boards populated mainly  by white men of a certain seniority and background.

Over the past decade, the gender disparity has been  moderated  somewhat by the  push  for more  female directors. According to a study of 3,000 companies by Institutional Shareholder Services (ISS), the  percentage of board seats  filled  by women went  from  nine  per cent  in 2009 to 19 per cent  in 2019. But racial and ethnic disparities persist and they are stark.  Another ISS study found that only about 12.5 per cent of directors at the 3,000 largest U.S. companies are members of racial or ethnic minorities, even though these groups make up 40 per cent of the population. According to a 2019 study by Black Enterprise, nearly 38 per cent of S&P 500 companies have no black directors on their boards.

A board’s role is to provide strategic guidance and oversight, and directors must bring the appropriate skills to address a company’s specific business needs and circumstances. The pandemic and the national awakening to racial inequities in all walks of life have made it abundantly clear that  a diversity of experience and perspective in the boardroom is also crucial  for boards to do their  job. Monitoring the  company’s relationships with  its stakeholders, assessing strategy, overseeing risk, reviewing societal engagement, assessing pay practices, overseeing management’s diversity and inclusion efforts — these are just a few of the standard board tasks  for which  the insights of directors from different racial  and ethnic groups  would  appear to be essential inputs. Studies  have shown  that  the addition of female directors has altered board discussions and  made them more robust. The addition of more  directors from underrepresented groups is likely to have a similar  effect.

 Like market forces, societal forces can profoundly affect
the business and competitive environment.

Quite  apart from  the  benefits to companies and  from  the moral  case for affording individuals of all races and ethnicities the opportunity to be considered for board positions, the inclusion of directors from minority communities is also important for  combatting the  racial  inequities that  cut  across  society. Experts say  that  the  pandemic’s disproportionate effects  on African Americans and other underrepresented minorities are driven in no small  part  by social and  economic disadvantages borne by these groups.  These disadvantages are unlikely  to be rectified until  more  leaders who  understand these problems occupy  positions of power  and  influence in business and  the boardroom.

Pressure to take  action continues to mount. Institutional investors are  already calling  on boards to disclose their  plans for  adding  Black  and   other  underrepresented  directors to their  ranks, and at least one shareholder lawsuit  has been  filed against directors alleging breach of fiduciary duty based on the board’s lack of racial  diversity. California lawmakers recently passed a bill that  would  require the  boards of publicly  traded companies with  headquarters in that  state  to appoint at least one  director from  an  underrepresented community by 2021. Some companies have pledged to add Black or other underrepresented directors of their own accord.

Navigating a Shifting Corporate Landscape  by Cornell Wright (Rotman JD/MBA ’00)

Many people still believe that shareholder interests are at odds with stakeholder interests , but that is a false dichotomy. Most enlightened businesses view the interests of shareholders and other stakeholders to be largely aligned from a longer-term perspective. That means focusing on how your talent is being managed, as well as your relationships with the communities in which you operate. Failing to address these issues is simply not sustainable.

Some companies still resist this mindset , and in many ways these tensions are inherent in our structures. Even though boards are meant to take account of the interests of all stakeholders, they are elected each year by shareholders. And quarterly reporting is still widely practiced as it is viewed as the easiest metric to measure performance. Compensation systems also reward short-term thinking in many cases, and activist shareholders sometimes demand near-term returns so there are lots of competing factors that can drive short-term views.

This pandemic period serves as a case study for balancing the needs of all stakeholder groups. If you think back to last March when the world went into various stages of lockdown, companies had to think very quickly and prioritize employee safety. They weren’t saying ‘But wait , if we send our employees home, that will impact productivity for this quarter’. Instead they were saying, ‘If we treat our employees properly at this difficult time, that will come back to us in a positive way over the coming months’. This has been a period where companies have had to balance so many different priorities and focus on relationships with employees, suppliers, communities and more. Financial institutions have stepped up to provide accommodations for their customers, for example, like delaying mortgage payments. They recognize that a short-term gain that is a long-term negative for the business doesn’t make sense.

Working with some of the country’s largest corporations, I’ve noticed some shifts in my clients’ priorities. It has happened in stages. Last March, people were very focused on figuring out how to put in place systems that would allow them to operate.  There were concerns around liquidity and fortifying balance sheets, those kinds of things. As time passed, the focus shifted.  I think  the big story for large companies is just how adaptable and resilient they have proven to be. Companies are well past crisis management at this point , and they’ve adapted their business models in many respects.  They’ve figured out how to operate in this new world, which in many respects is very different from a year ago.

The economy is picking up. In Q3 of last year there was unprecedented uncertainty and a massive global slowdown and shutdown.  But as we came through the summer and into the fall, we saw rising markets and confidence because people were seeing light at the end of the tunnel. Today, in Q1 of 2021, the M&A market is quite buoyant . The number one factor that drives M&A is confidence, and there is a level of confidence around where we are today but more importantly, around where the world will be in six, nine and 12 months. We’re seeing a lot of transactional activity across sectors, particularly in technology and healthcare.

Crisis management is an interdisciplinary practice. Any big crisis has many different dimensions to it, so you need multidimensional thinking to address it . You need to look at the financial aspects, employee aspects, suppliers and customers, to name a few. By its very nature, ‘crisis management’ means that you’re focusing on the here and now. That’s why really good crisis management focuses in part on the here and now, but also in part on what’s next . You have to be careful not to be myopic and just solve the problem right in front of you. You need to think ahead to where things are going—and consider where you want to get.

So, when will the economy be healthy again? I’d say two things. First, markets today are very healthy, and that is a function of many factors including the fiscal stimulus strategy from the Bank of Canada, which is creating extraordinary market conditions. Second, at the same time we have a very challenged economy in terms of high unemployment and lack of opportunity. The pandemic has shone a bright light on inequality and the fact that some people are doing really well while others are struggling. Coming out of this, there will be an even greater need to make sure we’re supporting people and helping them get back on their feet.

I hope most leaders would agree by now that a high degree of structural inequality is not good for anyone. One of the great strengths of Canada is our strong social safety net, but we also need to work on genuine equality of opportunity. I believe that will be a big focus in the next six to 12 months as we figure out how to restore what has been lost—and how to continue to build on initiatives that have been underway for some time.

Cornell Wright (Rotman JD/MBA ’00) is the Chair of Torys’ Corporate Department and former co-head of the firm’s Mergers & Acquisitions Practice. In December 2020, he was appointed as an Executive-in-Residence at the Rotman School of Management.

For many boards, it will be necessary to develop
new channels for identifying talent

Boards that have not done so will want to review their director skill matrices and their board succession plans with an eye to enhancing racial  and ethnic diversity in a way that  is consistent with the company’s strategy and the board’s need for other types of diversity — industry, geographic, domain expertise, gender and the like. For many boards, it will be necessary to develop new channels for identifying talent, new  approaches to onboarding directors, and  more  deliberate processes for building board cohesion in order to achieve their  goals and realize  the benefits of having a board whose membership is truly diverse.

In closing

Giving  more  structured  consideration  to  stakeholders.  Paying more attention to how business and society intersect. Reviewing and  addressing board composition. As boards look to the  post-COVID era they will want to assess their readiness to meet these new demands.

At a time when  old assumptions are being questioned, they will also want to ensure that their members have a shared understanding of the  board’s role and  responsibilities — and  of their individual role and  responsibilities as directors. In the  flurry of COVID-inspired activity,  it  is important that  boards not  lose sight of their  central functions as governing bodies of the companies they serve. 

Lynn S. Paine is the John G. McLean Professor of Business Administration and Senior Associate Dean for International Development at Harvard Business School. She is a co-author of Capitalism at Risk: Rethinking the Role of Business (Harvard Business Review Press, 2020).

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