Excellence. Responsibility. Innovation.
Principles, September 2016
Hermes EOS
Corporate Governance
Principles
United States of America
For professional investors only
www.hermes-investment.com
Principles, August 2016
Introduction
Hermes EOS believes, as a representative of responsible long-term
shareholders, that company management and boards of directors
should align themselves to the interests of our clients. All parties should
seek to improve the performance of the company sustainably over the
long term to increase its value to its long-term owners, while respecting
other stakeholders. We therefore strive to foster a collaborative and
constructive dialogue with the companies in which our clients own
shares to satisfy ourselves that this is happening, and, if necessary,
we ask for effective change.
Shareholder activity and the 2010 Dodd-Frank Act have helped to
secure significant additional rights to enable shareholders to hold
boards of directors to account. We support these developments as
we firmly believe that the additional shareholder rights can serve
to enhance the dialogue between companies and shareholders.
Paradoxically, the enhanced dialogue will generally result in it being
unnecessary for these newly afforded shareholder rights to be exercised.
In 2015, the proxy access genie came out of the bottle. This
fundamental right of shareholders to nominate directors for election
to the board is enjoyed in nearly all other developed markets, in a less
restrictive form than the suggested – and later stayed – rule by the US
Securities and Exchange Commission (SEC). [See later section on proxy
access] We believe that the existence of the right will encourage boards
to demonstrate better their accountability to shareholders. We are
delighted by the continuing extension of this right across the largest US
companies during 2016.
In July 2016, the Commonsense Principles of Corporate Governance
were published by the CEOs of one large Canadian pension fund
and some of the largest US companies, including asset managers.
Their publication is a signifier of how far corporate governance has
evolved in the US during the past few years and we therefore welcome
them. We also look forward to their further evolution, just as our
principles have evolved over time. Our principles go further than the
Commonsense Principles in a number of areas and we look forward
to continued healthy debate on governance matters with company
directors and management on the many areas on which we would like
to see progress beyond what is already often in place.
It is in this spirit that we republish our principles with a few updates
this year.
Overarching principle
Importance of board and shareholder
engagement
Dialogue between boards and serious, committed long-term
shareholders on strategy, finance, corporate governance and risk
management – including the management of risks and opportunities
stemming from environmental and social issues – is essential. Through
this exchange of views, shareholders can better comprehend, and, if
necessary, attempt to influence the boards of companies in which they
are invested, developing relationships of trust based on an improved
mutual understanding. Our experience has shown that constructive
engagement between shareholders and directors in these areas can
lead to improvements in the performance and value of companies,
as well as help to prevent value destruction. Independent chairs,
lead independent directors and other non-executive directors, in
particular board committee chairs, should make themselves available
2
for meetings and teleconferences with owners of the company as
an essential part of their responsibilities as shareholders-elected
representatives. Developing relationships of trust with long-term
shareholders can be invaluable to boards. We therefore expect boards
to welcome more and better quality engagement between long-term
investors and directors and for independent directors to participate
in engagement.
Other principles
Companies are all different, with unique business models,
circumstances and boards. However, there are common governance
issues in the US that we focus on:
Proxy access
Shareholders in other jurisdictions may nominate director candidates
on management’s slate. In the US, however, this has historically not
been the case. This situation continues to be a contributing factor to
the often transactional and defensive nature of corporate governance
and board-shareholder dialogue in the US and can lead to costly,
distracting and divisive proxy contests.
We encourage companies to voluntarily implement the necessary
by-laws and governance changes to enact the right of shareholder
access to the proxy. We believe that shareholders owning 3% of the
outstanding shares for at least three years should be able to nominate
up to 25% of the board, as originally mandated by the SEC. This high
threshold presents a significant hurdle to shareholders to nominate
candidates to the board. Any candidate also needs to be elected by all
shareholders, meaning that frivolous candidates or candidates standing
on a single issue are unlikely to receive sufficient nominations, let
alone be elected. We therefore do not expect to see boards seeking to
implement higher ownership requirements or to reduce the number
of candidates able to be nominated below those levels originally
envisaged by the SEC. In the absence of the board implementing proxy
access provisions which we can support, we will support shareholder
proposals seeking the right in line with the stayed SEC rule.
We do not expect boards to implement by-law provisions that make
the ability to use the right of proxy access even more difficult or
cumbersome. Furthermore, we do not want to see restrictions on
shareholders aggregating holdings, on share retention requirements
after any election, on share lending or on director nominees’
compensation (provided it is fully disclosed). We also do not expect
to see onerous restrictions on previously nominated candidates – that
failed to win a majority of votes cast – to prevent them from being
nominated again. While boards should protect companies from
the use of proxy access to gain creeping control, different groups of
shareholders should have the right to nominate director candidates
without restriction.
In practice, we do not expect proxy access to be used often but
we believe that its mere existence will help to make boards more
accountable and more responsive to dialogue with their longterm owners.
Board independence, diversity and other
attributes
Boards of directors should comprise a substantial majority of
independent directors with an appropriate balance of relevant
experience and expertise. These directors should have the ability to
represent the best interests of all shareholders, with a focus on the
Hermes EOS
long term. They should provide support and, when necessary, robust
challenge to management and oversight of the company’s strategy and
risk management.
As part of their oversight function, we expect directors to become
highly knowledgeable about the company’s strategy and most
important risks. Directors must satisfy themselves that the executive
team is managing such risks well. We believe the board’s oversight of
risk is crucial in defining a company’s risk appetite, encouraging the
right level and type of risk and in discouraging undue risk-taking. This
is particularly important when considering long-term factors, such as
reputation and licence to operate. Boards should provide meaningful
reporting about their risk oversight. This should include how the board
and its relevant committees ensure a good quality internal and external
audit programme that can provide reassurance to investors about the
financial statements and internal controls and describe how the board
oversees risk identification and management.
When considering the independence of individual directors, particularly
those who sit on mandated board committees, companies should go
beyond the definitions of independence, according to the rules set by
the NASDAQ and NYSE stock exchanges. An independent director:
„„
will have no direct or indirect material relationship with the
company, other directors or its executives (including interlocking
board memberships, including those of not-for-profits)
„„
will not be a representative of a significant shareholder and
„„
will not have sat on the board for such a time, particularly with other
directors, as to compromise his or her independence of mind and
ability to hold management to account on behalf of shareholders.
We do not have strict rules for retirement as a result of age or
maximum tenure and we believe that detailed knowledge and
experience of a company can be helpful. However, we are concerned
that boards with a significant cadre of long-serving directors, including
those with service at related companies or other links to each other,
indicate a danger of over-familiarity and insufficient challenge. We
expect a board to explain cogently the reasons for the continuing
appointment of those directors and how such apparent lack of
independence is managed and mitigated. Where we see ostensibly
overlong tenure and no obvious programme to renew the board
with suitably qualified directors, we may recommend voting against
some directors, including potentially the chair of the nomination and
governance committee.
Boards of directors ought to have robust succession plans in place that
provide for refreshment of its members while managing any unhelpful
disruption to the board’s work. These succession plans should be
accompanied by thorough disclosures articulating how skill sets and
experience are matched to specific roles within the board and its future
strategic needs. We expect the board to report on how the attributes,
including the characters, of directors and the board as a whole are
assessed. When planning for succession or refreshment, a board
should be mindful of the strategy, the diverse nature of the company’s
activities, future plans, employees, customers, other stakeholders and
board dynamics and should therefore consider the gender, background,
ethnicity, nationality, experience and age as well as the skill sets and
other characteristics of possible candidates relevant to the specific
company board. We believe that most boards lack sufficient diversity
to reflect the markets and communities in which they operate and they
should address this by acknowledging the issue and taking positive
action to resolve it.
Combined chair/CEO roles
A significant and growing number of US companies have an
independent chair and a separate CEO. We encourage this structure as
it is likely to be more effective at most companies than a combination
of the roles. We believe the chair should manage the board and the
CEO should manage the business. Combining the roles can confuse
these responsibilities and overly concentrate power in one person,
creating not only problems with oversight, but also with accountability.
We urge companies that continue to have a combined chair/CEO to
consider appointing an independent chair to improve the effectiveness
of board debate and its accountability to shareholders. While we
recognise that it may appear to be difficult to make changes in this
respect, our expectation is that no later than upon CEO succession,
the roles be split and an independent chair be appointed to the board,
for approval by shareholders at the subsequent AGM. We particularly
emphasise that succession is harder to manage, and therefore riskier,
when the roles of the CEO and chair are combined.
Hermes EOS, on a case-by-case basis, may support boards where one
individual holds both roles providing a permanent lead independent
director is appointed and that person not only has the right character
and skills for the role but has clearly defined powers, including a
significant role in establishing board meeting schedules and agendas,
in board and CEO evaluation and succession planning and the right to
meet shareholders. This helps to ensure that the independent directors
can act effectively as a body to advise and to oversee management.
We expect the board to explain how it has decided on the leadership
structure of the company, the timing of it and the factors it will take
into account at its next review.
The lead independent director’s powers ought to include:
„„
the ability to call a special meeting of the board of directors or the
independent directors at any time, at any place and for any purpose,
including the removal of the chair/CEO from one or both positions
„„
consulting with the chair of the board, CEO and committee chairs
on the topics and schedules of the meetings of the board and
committees and approve such schedules to assure that there is
sufficient time for discussion of all agenda items
„„
presiding over meetings when the CEO is conflicted or absent
„„
guiding full board consideration of CEO, board and committee
appointment, evaluation and succession
„„
meeting one-to-one with the CEO after every regularly scheduled
board meeting
„„
guiding the annual self-assessment of the full board
„„
engaging with long-term shareholders at their request
„„
a letter or statement from the lead independent director in the proxy
describing how the board has operated during the year
The company should state that the powers and role of the lead
independent director are equivalent to that of an independent chair
and why the person holding the position is the best candidate for
the role.
From time to time, we request meetings with company chairs or lead
independent directors. Meeting shareholders is a key part of the roles
of these individuals. Where this access is unreasonably denied, we find
it difficult to support the re-election of those board members.
www.hermes-investment.com | 3
Principles, August 2016
Executive compensation
Executive compensation continues to be an area of concern for Hermes
EOS. While requirements for additional disclosure have led, over recent
years, to improved transparency regarding the link between pay and
performance, experience shows that, in many cases, compensation
still fails to align the interests of executives with those of long-term
shareholders. In particular, it often fails to safeguard against excessive risktaking or tail risk or be sufficiently reflective of long-term performance.
We do not consider stock price appreciation on its own to be an
appropriate performance metric. We expect long-term compensation
plans to employ specific metrics, with rigorous targets that do not
reward average performance. The chosen targets should be closely
linked to a company’s long-term strategy. This nexus should be clearly
explained in the compensation discussion and analysis within the proxy
document. Most variable compensation should be explicitly linked to
these performance targets and not simply vest over time.
Our interest is not limited to executive level compensation. In
particular, at organisations where staff pay makes up a high portion of
the overall costs, we have concerns that levels of pay and performance
criteria may create perverse and short-term incentives for employees.
We therefore encourage companies to improve their disclosure on
how incentives for individuals with the ability to materially affect the
performance of the business are linked to the interests of long-term
shareholders, including the effective management of risk.
Compensation schemes almost invariably reward executives with
equity. The intention behind such schemes is to incentivise above
average performance and to align the interests of management with
those of the company’s owners. Too many schemes have rewarded too
much equity without sufficient performance or long-term ownership
criteria. Performance conditions should only reward above average
performance and the ownership of shares awarded should be long-term
in nature, otherwise alignment with owners is not achieved.
Share buybacks
We are concerned about the hidden cost of compensation through the
dilution of outside shareholders and managing this dilution by share
buybacks, often at too high prices. Moreover, metrics such as return
on equity and earnings per share can be flattered or even managed by
share buybacks.
Companies need to disclose clearly the effect of share buybacks on
their compensation plans and how the results of their plans would
differ before taking buybacks into account.
Compensation principles
We are increasingly concerned that executive compensation structures
globally are not fit for purpose, neither serving long-term investors nor,
in many cases, aligning properly with the core long-term objectives
of companies. Therefore we continue to hold many discussions across
the world on reforming pay with compensation committee members,
executives, human resource professionals, compensation consultants
and other investors. We believe that the principles that we developed
with a number of pension funds to provide high-level guidance to
companies about our expectations of their pay structures and practices
should be taken into account by all compensation committees which
need to explain how they fulfil each principle disclosed within the proxy
statement. The Remuneration Principles for Building and Reinforcing
Business Success are:
4
1. Compensation committees should expect executive management
to make a material long-term investment in shares of the businesses
they manage.
2.Pay should be aligned to long-term success and the desired
corporate culture throughout the organisation.
3.Pay schemes should be clear, understandable for both investors and
executives, and ensure that executive rewards reflect long-term
returns to shareholders.
4.Compensation committees should use the discretion afforded them
by shareholders to ensure that awards properly reflect business
performance.
5.Companies and investors should have regular discussions on strategy
and long-term performance.
The full version of the compensation principles along with a number
of other policy documents on compensation and other topics can be
found on our website, www.hermes-investment.com/stewardship.
Compensation, human capital management and
culture
Boards need to ensure that they oversee effectively human capital
management policies and practices at companies to ensure that
management is instilling and embedding the desired culture across the
whole organisation and into its value chain. We are increasingly of the
view that compensation plays little positive role in embedding cultural
norms and expectations. Indeed misaligned compensation within
companies and within the investment chain is largely responsible for
the short-termism that afflicts publicly traded companies. Moreover,
the perception is that executive compensation is not only higher but
is subject to different rules from how pay is structured elsewhere in
companies. These two factors are increasingly damaging to businesses’
licence to operate and their long-term performance. We expect
compensation committees and boards to consider these two factors
in their decision-making and for CEOs and senior management to be
mindful of them when considering their own pay and those of others
within the organisation.
Advisory vote on compensation
The compensation committee should be directly accountable through
an advisory vote on compensation. This vote should lead to improved
dialogue between compensation committees and investors. Companies
that consult shareholders on pay practices on a regular basis are, in
our view, better able to reflect their owners’ views on compensation.
We expect clear disclosure on how a company’s compensation policy
and practice meet the compensation principles we have outlined
above. Where companies decline to address shareholder concerns
following a significant level of shareholder opposition, we may be
forced to register concerns about pay by voting against compensation
committee members.
Environmental and social risk
management
Companies should manage effectively environmental and social factors
that are relevant to their business, with a view to enhancing their
sustainability. They also ought to regularly disclose to shareholders how
they identify and manage these material risks and provide evidence
that the processes to do so are effective. Furthermore, companies
should clearly define board and senior management responsibilities
for environmental and social issues. Directors of companies should
Hermes EOS
be accountable to shareholders for the management of material
environmental and social risks, as over the long term these will affect
value and the ability of companies to do business.
Therefore, we will seek to enter dialogue should we judge the
management of, or reporting on, environmental and social issues to
be insufficient. Climate change and human rights risk management
in particular are of increasing importance to our clients.
Climate change
Uncontrollable climate change is a systemic risk to the value of
our clients’ portfolios because of its economic and geopolitical
consequences. We therefore support the ambition of the 2015 Paris
agreement of 195 countries to limit climate change to below 2°C.
This historic commitment was helped by the intervention of companies
globally which publicly encouraged political action in the run-up to
and during the UN climate change conference.
Because of the systemic risk to the global economy, we encourage all
companies publicly to support the ambition of the Paris agreement
and to have this commitment embedded as a central tenet of their
public policy and sustainability activity. To support this, boards
should ensure that they have climate change on their board meeting
schedules at least annually and that they expose themselves and senior
management to experts who can challenge them on the strategic risks
and opportunities that climate change represents.
We acknowledge that climate change is even more important for some
companies, However, it is relevant to all business and we therefore
expect to see companies thoroughly prepare for a low-carbon economy
and to mitigate the likely risks of climate change in their business model
and operations, as well as seek opportunities from this transition. With
this long-term perspective in mind, we expect companies to voluntarily
embrace public policy initiatives required to make the transition.
Human rights
Licences to operate are increasingly affected by the reputation of
companies, including their performance on human rights. We support
the UN Guiding Principles on Business and Human Rights and the UN
Global Compact. We expect companies to use the reporting framework
for the Guiding Principles to disclose how they manage human rights
issues that are salient to their business.
Corporate political and charitable contributions
and lobbying
In addition, we encourage companies to provide good quality disclosure
on their approach to other major public policy issues that affect the
company. This should include details of their political and lobbying
contributions and activities as part of their mainstream reporting.
The reputational risks associated with such practices call for investors
to scrutinise this expenditure of financial and other resources better
to assess their material impact. We expect web-based reporting
that is easy to find and navigate and provides aggregate totals of
political and lobbying donations, with click-through access to more
granular legally mandated reporting. Reports should provide details
on expenses destined to influence legislation, elections and campaigns
supporting (or opposing) candidates for public office. We also expect
companies to describe why such activity is in the best interests of
their owners and how it is appropriate use of shareholders’ funds and
other resources. Moreover, we expect the disclosure to outline how
the governance regarding such expenditure is managed. It should
describe how the authorisation process for donations works, taking
account of the benefits and costs, including reputational risk, as well
as monetary amounts. The disclosure should outline what factors are
considered and how they are assessed in making the decision. If there
is a tiered approval process, this should be explained in full. It should
also demonstrate how decisions are monitored by management and
ultimately the board and what happens if the board disagrees with
decisions made under the policy.
We also expect disclosure on how companies manage their
relationships with trade associations and other lobbying organisations.
While we understand that companies and industry and other
membership organisations do not always agree on policy and other
matters, companies need to ensure that they have robust methods of
assessing the cost and benefit of memberships and have processes in
place for influencing the policy decision-making of such organisations.
These should be disclosed. Fundamentally, we need to be reassured
that the expenditures and activities within lobbying organisations are
aligned with the long-term interests of our clients and the stated public
policy positions of the companies of which they are part-owners. We
therefore expect companies to describe their governance approach to
lobbying activity in similar detail to that of their political activity.
Where the disclosure and governance of these issues appears to
be lacking, we are likely to vote in favour of shareholder proposals
concerned with these activities.
Above all, political and lobbying activity should be linked to the
company’s purpose and strategic objectives. The same applies to
charitable activities and donations. The company should similarly
scrutinise its charitable activities and donations and be particularly
mindful that any contributions to charities associated with directors
or their families should be justified through this lens.
Majority voting
It is our belief that electing directors is a fundamental shareholder
right. We prefer to have the opportunity to vote either for or against
directors, instead of going through the more cumbersome process
whereby the shareholder right to determine who is elected to the
board is passed to the other directors under director resignation
policies. We are pleased that a significant and growing number of US
companies have adopted some form of majority voting, thus increasing
accountability to their owners. We believe that voluntary uptake of
such best practice is preferable to further regulation. Hermes EOS urges
companies to adopt a full majority vote standard, with exceptions
limited to narrowly defined legal and regulatory requirements, such as
the need for financial expertise on a board. Where a director does not
receive majority support and is exceptionally asked to remain on the
board, the company should publicly commit to expediting a search for
a replacement director and for the director to resign as soon as possible
following the new appointment.
Multiple-class share structure
Multiple-class share structures disenfranchise minority shareholders
and often increase the power of one shareholder for a disproportionate
financial stake. We encourage issuers with multiple-class share
structures to adopt the concept of one-share one-vote and we will only
support initial public offerings of companies with single class structures
that provide a level playing field for investors.
Shareholders’ right to call special meetings
In other jurisdictions, including Canada and the UK, shareholders
representing 5% of the outstanding issue are often entitled to call
a special meeting. This is an appropriate threshold that strikes the
right balance between ensuring that such meetings are not called
www.hermes-investment.com | 5
Principles, August 2016
capriciously while still being practicable for shareholders to exercise.
We accept that this right is significantly restricted in the US at the
moment and are therefore prepared to accept 10% as an appropriate
level in the interim. As we do so, we emphasise that shareholders who
successfully request special meetings still need to obtain the requisite
majority to effect change and that in jurisdictions with the right to call
meetings with 5% of the shares, such meetings are convened extremely
rarely. However, providing such a right to shareholders at a reasonable
level demonstrates that the board is committed to open and trusting
shareholder relations.
Shareholder proposals
We encourage boards to engage with serious, committed long-term
shareholders, including Hermes EOS on behalf of our clients. Where
boards interact in an active and engaged way with shareholders on
issues that affect the long-term value of companies, we will see less
need to file or support shareholder resolutions.
We vote on a pragmatic basis, reviewing each proposal in its companyspecific context and considering the extent to which the issue in
question has been managed, usually, in the case of larger businesses,
following dialogue with the company on the issues arising from the
proposal. In our experience, shareholder proposals can be a natural
starting point or a catalyst for related dialogue with issuers and we
thus avail ourselves of these opportunities, where appropriate, whether
or not we vote in favour of the resolution itself.
We expect boards to address the issues raised by shareholder proposals
which receive significant support or where they are material to the
company. In addition, we view any failure to implement a shareholder
proposal that has received majority support as a clear indication
of a board of directors not fulfilling its obligations to the owners
of the company.
6
Excellence. Responsibility. Innovation.
Hermes Investment Management
Why Hermes EOS?
Hermes Investment Management is focused on delivering superior,
sustainable, risk-adjusted returns – responsibly.
Hermes EOS enables institutional shareholders around the world to
meet their fiduciary responsibilities and become active owners of public
companies. Hermes EOS is based on the premise that companies with
informed and involved shareholders are more likely to achieve superior
long-term performance than those without.
Hermes aims to deliver long-term outperformance through active
management. Our investment professionals manage equity, fixed
income, real estate and alternative portfolios on behalf of a global
clientele of institutions and wholesale investors. We are also one of
the market leaders in responsible investment advisory services.
Our investment solutions include:
Private markets
International real estate, UK commercial real estate, UK private rental
sector real estate, infrastructure and private equity
High active share equities
Asia, global emerging markets, Europe, US, global, and small and
mid cap
Credit
Absolute return, global high yield, multi strategy, real estate debt
and direct lending
Multi asset
Multi asset inflation
Responsible Investment Services
Corporate engagement, intelligent voting and public policy
engagement
Offices
London | New York | Singapore
Contact information
Hermes EOS
Tim Goodman
+44 (0)20 7680 2276
[email protected]
Business Development
United Kingdom
+44 (0)20 7680 2121
Africa
+44 (0)20 7680 2205
Asia Pacific
+65 6850 0670
Australia
+44 (0)20 7680 2121
Canada
+44 (0)20 7680 2205
Europe
+44 (0)20 7680 2121
Middle East
+44 (0)20 7680 2205
United States
+44 (0)20 7680 2205
Enquiries [email protected]
Disclaimer
This communication is directed at professional recipients only.
The activities referred to in this document are not regulated activities under the Financial Services and Markets Act. This document is for information purposes only. It pays no regard to
any specific investment objectives, financial situation or particular needs of any specific recipient. No action should be taken or omitted to be taken in reliance upon information in this
document. Any opinions expressed may change.
This document may include a list of Hermes Equity Ownership Services Limited (“HEOS”) clients. Please note that inclusion on this list should not be construed as an endorsement of HEOS’
services. HEOS has its registered office at Lloyds Chambers, 1 Portsoken Street, London, E1 8HZ.
CM155421/T4635 Global 08/16
www.hermes-investment.com