Governance Snapshot: Areas of focus for the 2023 AGM Season

2022 – Looking Back to Look Forward

In considering the issues that companies are most likely to face, our first step is always to review the focus areas in the prior year to understand the evolution of market expectations. While remuneration and election of director proposals again remained the most consistently contentious issues in 2022, there was growing scrutiny on a number of other issues, including bringing the wider stakeholder lens to pay decisions, talent retention and board level oversight of ESG and sustainability.

2022 proxy voting data confirms that remuneration-related proposals continued to receive the highest proportion of dissent, with shareholders placing particular scrutiny on quantum and links between pay and performance. Concerns over remuneration also seeped into the re-election of directors, with chairs of Remuneration Committees in the firing line, while time commitments and board diversity resulted in a number of  resolutions being opposed by at least 20% of voting shareholders. As the scope of investor voting and review widens, expectations have also been raised on company practice across a range of E, S and G issues. During 2022, there was a 63% increase in the number of shareholder proposals globally, pointing to the role of shareholder proposals in raising different issues to the board agenda. While far less common in the UK & Ireland, five shareholder proposals made it to the ballot in the UK on environmental and social issues, up from three in 2021.

Expectations for 2023

As the obligation on investors to be seen as active stewards of their capital grows, so too does the importance of shareholder engagement; and clear and meaningful reporting. For decades companies have placed significant emphasis on communicating financial performance through the investor relations process. A growing number of investors now see governance and ESG related engagement as no different.

Engagement affords companies the opportunity to better understand shareholder expectations and allows shareholders to build a better understanding of specific company context – that context may be misconstrued among some stakeholders in the investment community and it is incumbent on the board to ensure that investors understand the rationale and context for its decision making.

Formal reporting is, naturally, the single biggest opportunity for companies to provide a detailed overview of all key actions, initiatives, and efforts in one place. While proxy advisors and investors will have established internal guidelines on key issues, annual reporting and engagement are the ways to help shape investor perspectives.

We recognise the perception among companies that proxy advisors engage in a ‘box tick’ exercise built around their annual guidelines with limited regard for reported context.

However, our view is that companies can use reporting and engagement to meaningfully set out the background and context to decisions. Ultimately, we believe disclosure is your friend and that providing investors with enhanced disclosure does drive better voting outcomes.

In thinking about reporting and engagement for the months ahead, we set out a number of key issues to consider as companies finalise materials and plans ahead of the 2023 AGM season.

1. Executive Remuneration

While there has been evidence of increasing integration of ESG factors into engagement and voting strategies, shareholders continue to use remuneration as a litmus test for board accountability. In the UK (and by extension Ireland), proxy advisor and investor voting guidelines on remuneration are heavily impacted by the Investment Association’s (IA) Principles of Remuneration. The updates to their principles for 2023 reflect the macroeconomic backdrop for wider society, which is increasingly relevant for companies determining bonuses for 2022; or any increase in pay potential as they propose a new remuneration policy for the next three years. In certain areas, detailed below, the expectations set out by the IA have been accompanied by specific updates from larger investors.

Bonuses and salary increases in the context of the cost-of-living crisis. In light of rising inflation, the cost-of-living crisis and a general level of uncertainty in the macroeconomic environment, the IA has asked companies to “sensitively” balance the need to continue to incentivise executive performance with the experience of shareholders, employees, and stakeholders most impacted by wider market turbulence, a similar lens to considering the impact on stakeholders during the Covid-19 pandemic. In line with this guidance, the CEO of Aviva Investors has written to the boards of the companies in which they invest, stating:  “It would be inappropriate for highly paid Executives to be fully insulated from the impacts of inflation. We expect any increases to executive base salaries to be below the average for the wider workforce.” In its UK Principles of Executive Pay, Legal and General Investment Management (‘LGIM’) has urged Remuneration Committees to “exercise caution if they plan to use the average workforce salary increase rate when setting executive salaries”, while also considering the impact of salary increases on total pay, where variable remuneration tends to be awarded as a percentage of base salary.

Along with demonstrating restraint in executive pay, institutional investors have set an expectation that companies provide detail and, where possible, examples on the specific action taken to support employees during this economic downturn. The Church Investors Group, and CCLA Investment Management, with the support of 17 long-term institutional investors, including Aviva Investors, LGIM and Cardano, issued a joint statement to set their expectations on the efforts by UK companies to protect lower paid employees during the UK cost-of-living crisis. These include decisions such as uplifting pay and one-off cost of living support, while also considering meeting Living Wage rates, and working in good faith to achieve agreements on pay claims with unions and other employee groups. Understanding the specificities of each business, investors concluded the letter by highlighting the importance of engaging on these issues to gain a better understanding of companies’ decision-making “as investors we are committed to engaging, both individually and collectively, companies in our portfolios on this issue and reflecting on it in our voting policies as we head into the 2023 proxy season”.

ISS has also modified its guidelines to say that companies should keep “Directors’ annual salary increases low and ideally lower proportionally than general increases across the broader workforce is considered to be good practice”.

Windfall Gains. Typically, LTIP performance periods in the UK & Ireland run for three years, and Remuneration Committees have been asked to exercise restraint in reviewing vesting outcomes for awards made during 2020. For many companies, these awards were granted at a time when share prices were, according to the IA, “artificially depressed”, against the backdrop of the emerging pandemic. The IA asks Remuneration Committees to explain to shareholders how they have considered the impact of any potential windfall gains when determining vesting outcomes and either (i) why any reduction is appropriate, or (ii) why the Committee has decided not to adjust for windfall gains. With equities now (generally) up when compared to most of 2020, investors are likely to scrutinise the monetary value of vesting levels detailed in remuneration reports over the coming months.

Pension Contributions. Pension contributions have been a recurring issue for the past number of years. With all FTSE 100 companies and all but four companies in the FTSE 250 companies having aligned – or shared plans to align – their pension contributions with that of the wider workforce, companies deviating from this practice are likely to face opposition.

ESG metrics in executive remuneration. While there has been growth in the use of ESG metrics in variable remuneration generally, certain investors have voiced their expectation that all executive remuneration structures include ESG targets and measures. Other investors only consider it necessary where the ESG metrics are material, are clearly linked to business strategy and can be effectively measured and disclosed. As of H2 2022, 90% of FTSE 100 and 70% of FTSE 250 companies have now incorporated ESG measures in their remuneration plans. In Ireland, based on FTI’s review of the remuneration reports of the largest 20 companies on Euronext Dublin, 65% have linked ESG metrics bonus awards.

In reporting, and throughout the pre-AGM engagement process, companies should explain the rationale for selection and weightings of metrics – ESG or not; the effectiveness of performance measurement; and, how the delivery against selected measures drives improved ESG performance and positive impact for wider stakeholders.

2. ESG Reporting

The transition of ESG factors from investor preference to regulatory requirements and stakeholder demands poses a challenge for companies, particularly in relation to integrating sustainability risk and opportunity into governance architecture, risk management frameworks and reporting structures.

TCFD reporting is now mandatory. In 2021, the FCA introduced the requirement for premium and standard listed UK companies to include a statement in their annual report setting out whether their disclosures meet the recommendations of the Taskforce on Climate-Related Financial Disclosures (“TCFD”). With many companies now preparing their second or third reporting cycle in line against the TCFD’s recommendations, there are growing expectations on the standard of reporting from investors and other stakeholders. The FRC expects companies to build on the findings from its thematic review of TCFD disclosures and climate reporting, and has committed to publishing a follow-up report focused on metrics and targets for four key industries at the end of 2023. This is part of its work with the Transition Plan Taskforce (TPT), launched by HM Treasury in April 2022, to “develop a common framework for developing and reporting climate transition plans”. As these standards for reporting increase over 2023 and beyond, laggards will likely begin to face increased pressure, including from major institutional investors such as Blackrock, who will hold companies to account through engagement and, ultimately, negative voting.

Shareholder proposals and say on climate. While shareholder proposals tend to be more frequent in the US than in the UK & Ireland, there were five such proposals that went to vote during the 2022 AGM season in the UK (compared to three in 2021). Three were related to environmental considerations, each relating to setting targets in line with the Paris Climate Agreement. The other two proposals were focused on social considerations with one relating to a Living Wage. While none of the proposals received majority support, it is worth noting that the Living Wage proposal was filed by Share Action with the support of leading investors such as Legal and General Investment Management and Fidelity international, potentially indicating greater use of proposals as a tool to pressurise boards among more ‘mainstream’ investors. While this is a small sample size, the proposals are symptomatic of wider pressure from investors on companies on a broader range of issues.

3. Diversity & Inclusion

While board gender diversity has been part of institutional investors’ agendas for a number of years, growing momentum in the last two years has resulted in more than half of FTSE 350 companies exceeding the 33% diversity target set by the Hampton-Alexander review in 2016. Initiated by the review, investors have tightened their own voting policies on board diversity, with increasing examples of dissent registered against the chair of the board or the Nomination Committee where there is less than 33% gender diversity.

Board gender diversity. In early 2022, the FCA introduced – on a comply or explain basis – a 40% board gender diversity requirement for premium and standard listed companies in the UK, as well as the requirement that there is one director from an ethnic minority on the board. At least one of the senior board positions (Chair, Chief Executive Officer (CEO), Senior Independent Director (SID) or Chief Financial Officer (CFO) should be a woman. According to the FRC 2022 review, it notes that while the majority of companies have met or are on track to meet board level diversity targets, this progress “has yet to translate into senior roles, for example, CEO and CFO roles where progress appears slow”. Both proxy advisors have incorporated these expectations into their guidelines.

Similarly, the European Parliament formally adopted new legislation that sets the requirement for 40% gender diversity among non-executive directors on European boards by 2026, and 33% diversity among all directors. It also sets the expectation that these appointments are to be made based on a clear and transparent board appointment process, that is based on merit and enhanced by gender diversity.

Ethnic Diversity. A recent FRC report on ethnic diversity states that, while “there are still significant challenges to be addressed, the need for change has been taken seriously across the spectrum, including senior managers, Executive leaders, Board Chairs and executive search consultants”. At the board level, the findings of the report note the limited level of reporting on ethnic diversity, with the recruitment of individuals from minority ethnic backgrounds the only initiative disclosed in reporting. With no clear detail on companies’ plans to improve the ethnic diversity of their boards, the FRC has recommended that FTSE 350 companies analyse the data on the diversity and demographic makeup of their board and ensure (and detail) how their succession planning and talent mapping efforts take into consideration the board’s diversity targets.

Diversity  policies should clearly identify who the policy is aimed at, the link between company strategy and diversity, and the targets and strategy to achieve them provides important and necessary clarity to the market. As companies approach their AGMs, there is merit in engaging with shareholders on progress towards these targets, particularly in the instances where diversity targets have not yet been achieved and why, to ensure investors have the full picture and context before making their vote deliberations.

4. Board Composition and Effectiveness

In addition to diversity considerations, institutional investors and proxy advisors continue to focus on the potential overcommitment of directors, and the Nomination Committee’s role in succession planning – issues which are viewed as central to (or could have a significant impact on) board effectiveness.

In light of the increasing responsibilities and expectations from boards, the number of director positions held by board members has been subject to growing scrutiny from shareholders over the past decade. During Covid-19, boards saw an increase in the number of meetings and calls throughout the Covid-19 pandemic, to support leadership in navigating that crisis. While the impacts of the pandemic have subsided, the workload for boards had already increased due to the complexity of modern business and stakeholder expectations, particularly as companies are faced with an inflationary economic environment, and a cost-of-living crisis that has affected the workforce.

As an example, in BlackRock’s 2023 proxy voting guidelines, the institution states it may vote against a director who sits on more than four public company boards (down from five) or is a non-executive board chair on one public company boards and as a non-executive director on more than two other public company boards. ISS has a limit of five mandates, where a non-executive directorship counts as one mandate, a non-executive chair position counts as two, and a position as executive director is counted as three. Glass Lewis’ position is that individuals should not take on more than five non-executive director roles or, in the event of being an executive director at a public company, should limit their external non-executive director positions to one.

Succession Planning. In its 2022 review, the FRC noted that Provision 19 (chair tenure) is among the provisions with the highest rate of non-compliance. In line with this, in its 2022 UK Proxy Season Briefing, Glass Lewis identified “poor Chair succession planning” as the third most common reason for recommendations against directors. With the provision on chair succession also linked to spurring greater divrersity at the head of the board, it is likely to remain a focus area for 2023 and an issue for companies to consider in reporting and pre-AGM investor engagement.

Summary

While the corporate governance landscape continues to evolve, issues such as executive remuneration and board composition and effectiveness continue to remain priorities for investors. The current macroeconomic context, characterised by an inflationary environment and cost-of-living crisis, is expected to significantly impact institutional investor action this year, across all aspects of an organisation’s corporate governance structures. Additionally, ensuring that boards have the appropriate diversity of background, skills, experiences and gender to promote effective oversight of businesses has never been as important in the eyes of investors. As with material financial issues, expectations for clear and meaningful reporting on climate and wider sustainability risks have become more evident, with a growing number of investors and associated groups encouraging reporting in line with the TCFD framework.

Operating in such a nuanced environment, subject to different market pressures and responding to a variety of stakeholders, the value of open engagement and clear reporting is at its highest. As companies approach the 2023 AGM season, it is important to evaluate the above priorities as a means of supporting direct engagement and avoiding criticism, all of which can lead to more favourable outcomes at AGMs in 2023.