Geopolitics Reasserts Itself as a Key Risk for Fortune 500 Committee Chairs

With Russia’s invasion of Ukraine, Ukraine’s unexpected resistance, Russia and China’s growing alliance, China’s desire to bring Taiwan back into its fold, and ongoing COVID-19–related lockdowns in China, geopolitics is affecting companies in ways they’ve never had to pay attention to before. In the spring of 2022, NACD, with Heidrick & Struggles, PwC, and Sidley Austin, brought together risk committee and nominating and governance committee chairs from Fortune 500 companies to hear how they can put these events into context and to discuss potential risks associated with these events and ways they can help their organizations mitigate the perils.

It’s a New World Order

The world is now in an era of hardening blocs, with Russia and China partnering, North Atlantic Treaty Organization (NATO) nations in another bloc, and the Global South caught in the middle, Michèle Flournoy, cofounder and managing partner at WestExec Advisors, told the group. This new world order is forcing change for companies both in the United States and abroad. The results are uncertain and how this plays out will take time, she said, so boards need to pay attention to the associated implications and risks since these will have a tangible effect on day-to-day operations.

What Are the Risks Related to Evolving Geopolitics?

We know that Russia’s economy is suffering from the sanctions that have been imposed. The longer they hold, the more isolated Russia will become. NATO’s presence—especially in countries bordering Russia—will strengthen, giving it a new sense of power. China’s economy is also slowing due to lockdowns from its zero-COVID policy. These factors, coupled with the aforementioned uncertainty, present challenges for companies that invest and do business in Russia and China and countries allied within this emerging bloc.

Risks boards should be aware of related to Russia’s invasion of Ukraine include:

Escalation. This conflict is far from over, according to Flournoy. Two scenarios concern her:

Nuclear war: If Ukraine succeeds, will Vladimir Putin escalate with chemical or nuclear weapons? If the latter happens, the risk becomes more about world order and nuclear peace.Miscalculation and escalation: Air policing by NATO countries opens the risk of all-out war. So do Russian missiles accidentally hitting supply convoys on NATO soil. The risk of a military escalation, while perhaps small, is very real.

Cyber risk. While Russia has already hit Ukraine with cyberattacks, the United States and European Union remain largely untouched. However, as the war continues, expect this to change. Putin will likely target critical infrastructure, financial institutions, the electrical grid, and government functions, among other systems.

Sanctions. More stringent sanctions will affect the energy market, leading to potential energy shortages in Europe and price increases everywhere.

Industry shutdowns in Ukraine. Factories and farming remain at a standstill, which will have ripple effects on commodities markets and supply chains, as well as contribute to rising inflation.

Reputational risk. Companies that haven’t pulled operations from Russia are increasingly being called out and shamed on social media. This can negatively affect business and corporate or brand reputation, as recent examples have shown.

The risks boards should be aware of regarding China include:

Supply chain resilience. Lockdowns resulting from China’s zero-COVID policy have negatively affected supply chains as factories and shipping ports shut down for weeks or months at a time. Supply chains in the technology industry are especially sensitive since semiconductors and devices such as computers are manufactured there.

Reputational risk over views on Taiwan. Companies that invest in both China and Taiwan face a tricky situation. The day-to-day operations of an organization is less of a concern. The bigger concern is leadership in China increasingly demanding that companies doing business there demonstrate loyalty to China. This creates a difficult choice—does your organization view Taiwan as an independent state or as part of China? Boards need to discuss how to address this with their organizations.

How Can Organizations Mitigate the Risks?

While boards can’t stop the risks, they can make sure their organizations are prepared to address them. For example, organizations should consider how they would approach a crisis resulting from these emerging global issues. Participants at the spring meeting talked about conducting tabletop exercises to work through different scenarios.

Some risks regarding geopolitical issues aren’t new, such as cyberattacks; however, others are uncharted territory. Here’s how to approach these newer ones:

Reputation. If you’re still operating in Russia, consider leaving. “The [war in Ukraine] is likely to be a long affair,” Flournoy said. The longer companies stay in Russia, the harder it will be to leave and the public perception of failing to act will stick with these companies. For companies doing business in China, the reputation challenge is a little different. Maintaining a positive reputation with the Chinese government is critical while also communicating to Western stakeholders the company’s beliefs about Taiwan’s independence. This is a difficult balancing act, but critical at this point in time.

Reshoring. The United States can’t rely on one region for manufacturing. This means moving operations back to the United States or to other Asian nations, Mexico, or Canada, depending on the area or sector. It also does not mean that companies should pull operations out of China entirely. “I think we’ll see the US government defining key tech areas where we have to reshore that are central to economic and national security imperatives,” Flournoy said. This has already started with the CHIPS for America Act, enacted in 2021 to bring semiconductor manufacturing back home. Companies with a large presence in China will have to take stock of their supply chains and map out the risks on an ongoing basis.

Congress and the executive administration have no new clear guidelines on China, so Flournoy advised that organizations and their boards monitor closely for guidance. “Make sure someone on the team is watching like a hawk,” she said. The same advice applies to Russia; since we don’t know how Putin will escalate the war or how sanctions could affect Russia internally at a grassroots level, companies need to keep Russia on their radar screens.

Risks from North Korea and Iran Are a Distant Possibility

While risks related to North Korea and Iran are less imminent, directors and their organizations should still keep an eye on them. North Korea has intercontinental ballistic missile capabilities and will continue to test these. Iran has enough materials to make nuclear weapons. It also funds terrorism in the region.

We are now in a unique period of geopolitics in which companies are affected in a multitude of new ways. From disruptions of supply chains to the risk of a new world war, directors will need to get up to speed quickly on the evolving geopolitical landscape and the strategic, financial, operational, and human risks and opportunities to their firms.

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Board Diversity Action Expands to Courtrooms, Regulators, and Investors

In the year since my colleague Fabrice Houdart wrote that LGBTQ+ inclusion in the boardroom is simply good governance, the board diversity landscape has heated up, become more complex, and provided glimpses into what the future may hold in this interesting area of corporate governance. Below are a few key themes that I expect will characterize the board diversity landscape.

When attention is focused board diversity can increase quickly, but the gains may be narrow. Much of the action on corporate board diversity over the past few years has been catalyzed by legislative action (notably in California, where two laws aimed at board diversity were struck down this spring, but not before leaving their mark) and the national reckoning on racial justice, both serving as wake-up calls for many corporations.

The impact of California’s landmark 2018 legislation requiring gender diversity on the boards of public companies headquartered in the state has been stunning. In 2018, nearly one-third of public company boards in California were composed of all men. According to the most recent report from the California Partners Project, today fewer than 2 percent are. In addition, women hold 32 percent of public company board seats in California, double the number of seats held in 2018. In 2022, two-thirds of California public companies have three or more women directors—six times as many as in 2018. However, progress has been uneven. For example, although California’s population is nearly 20 percent Latino, a recent report by the Latino Corporate Directors Association found that between the September 30, 2020 enactment of California’s AB 979 legislation, the second board diversity law, and the end of 2021, the share of California public company board seats held by Latinos grew by only one percentage point, to 3 percent of California’s public company board seats.

Across the United States, a similar story has emerged regarding racial diversity. According to research by Heidrick and Struggles, the share of new Fortune 500 board appointees that were Black or African American jumped to 28 percent in 2020 (26 percent in 2021), after nearly a decade in which only 8 to 10 percent of new appointees were Black. This newfound focus was surprisingly narrow, however. Appointments of Black women directors lag those of Black men directors significantly, and there was little impact on the appointment of other racial, ethnic, and underrepresented demographic groups. Asian, Latino, and LGBTQ+ directors remain heavily underrepresented on large company boards.

For candidates bringing diversity of sexual orientation and gender identity, progress has also been notable, but slow. Out Leadership’s Visibility Counts 2022 report found that 41 Fortune 1000 companies include “LGBTQ+” in their definitions of diversity when considering board candidates, including prominent companies such as 3M Co., Caesars Entertainment, Cisco Systems, The Clorox Co., Starbucks Corp., and Ulta Beauty. But across more than 3,300 Nasdaq-listed companies, just 2.4 percent include “LGBTQ+” in their definitions of candidate diversity.

In 2021, more out LGBTQ+ executives were appointed to the boards of global Fortune 500 companies than in any prior year—a grand total of three, to the boards of 3M, BlackRock, and Randstad. The year also saw slow growth in the number of board seats at large corporations occupied by openly LGBTQ+ people, to a total of just 26 seats held among 5,670 Fortune 500 board seats. Interestingly, half of the 18 openly LGBTQ+ Fortune 500 board members are women and one-third are Black or Latino.

One encouraging note: in 2021, 43 percent of directors appointed to the boards of Fortune 500 companies were first-time directors at a public company, the highest percentage since at least 2015, according to research by Heidrick and Struggles. These first-time directors bring a high level of diverse demographic and professional backgrounds, accelerating the diversification of corporate boardrooms. And for the first time since at least 2015, the average age of Fortune 500 directors (currently 63.7 years old) did not increase, as more younger directors were added.

The focus on board diversity has been expanding among stock exchanges and regulators around the world, but progress is uneven. Following an outcry after the New York Stock Exchange (NYSE) launched its NYSE Board Advisory Council to oversee its Initiative to Advance Board Diversity without a single openly LGBTQ+ member, the NYSE later added Dow CEO James Fitterling. But unlike its counterparts at Nasdaq, the NYSE has no board diversity reporting requirements for its listed companies.

In April 2022, the UK’s Financial Conduct Authority finalized new rules intended to boost board diversity for its listed companies. The rules require companies to report information and disclose how they are doing against targets on the representation of women (at least 40 percent of the board) and ethnic minorities (at least one non-white board member) beginning this year but are silent with regard to directors with diverse sexual orientations or gender identities.

And in Canada, the Capital Markets Modernization Taskforce has recommended that Ontario securities legislation be amended to require that publicly listed issuers in Canada adopt written director nomination policies, set board and executive management diversity targets, and provide data regarding the representation of those who self-identify as women, BIPOC [Black, Indigenous, and People of Color], persons with disabilities, and LGBTQ+.

Legal battles have slowed legislative actions, but battles are ongoing. Following passage of California’s SB 826 in 2018 (which required minimum levels of representation of women on the boards of publicly traded companies) and California’s AB 979 in 2020 (with similar rules for underrepresented racial and LGBTQ+ minorities) the predictable backlash of litigation emerged. Two rulings have handed first-round victories to opponents of board diversity.

In the SB 826 case, the court issued a verdict in favor of the plaintiffs after a trial, finding that the state had failed to prove that the legislation was sufficiently “necessary” or “narrowly tailored” to survive the strict scrutiny standard under the Equal Protection Clause of California’s constitution. California’s secretary of state has announced an intention to appeal the ruling.

In the AB 979 case, the court granted a motion for summary judgment in favor of the plaintiffs, similarly finding that the legislation violated the Equal Protection Clause of California’s constitution. The state has not indicated whether it will appeal this ruling.

Litigation is also pending against the US Securities and Exchange Commission’s approval of Nasdaq’s board diversity reporting rules, which incorporate a “comply or explain” board diversity mandate for most listed companies, along with a requirement to disclose diversity statistics regarding board demographics.

Meanwhile, the Improving Corporate Governance Through Diversity Act of 2021 (H.R. 1277) was introduced in the US House of Representatives in February 2021, but it is unclear whether the bill will see further action in this Congress.

Board diversity initiatives are themselves diverse. Finally, the most interesting theme in recent board diversity efforts may be the wide range of initiatives and stakeholders who are involved. The 2022 proxy season has already seen new voting guidelines from major institutional investors, the growing influence of (and backlash to) environmental, social, and governance-focused investing, diversity-focused action from employee groups, and new appetite from executive recruiters to identify and engage diverse candidates. Focus on these topics will continue.

Matthew Fust serves as a board member for several publicly traded and venture-backed biopharmaceutical companies and is a corporate finance and strategy advisor in the life sciences industry. He was named to NACD’s 2022 Directorship 100. Matthew is an advocate for corporate board diversity, with a focus on LGBTQ+ inclusion, and is senior advisor to Out Leadership’s OutQUORUM corporate board diversity initiative.

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US Public Company D&O Insurance Market Sees Pricing Relief, Strong Competition

For the first time in four years, it is likely that an increasing number of public companies will, on average, experience a year-over-year decrease in their US directors’ and officers’ liability (D&O) insurance premiums in the second half of 2022. Material premium increases have become increasingly rare, and there is a dramatic return to competition in the marketplace as insurers look for new sources of revenue.

Despite a return to competition, the underwriting community remains focused on several risk areas including legal and regulatory trends; activist investors; environmental, social, and governance (ESG) issues; and other challenges that could lead to litigation. Companies should optimize opportunities, but also remain vigilant in their renewal preparations, and work with their brokers to carry out comprehensive reviews of policies and obtain the broadest coverage possible.

Pricing for Public Company D&O Insurance Continues to Ease

In the first quarter of 2022, the average public company experienced a premium increase of 2.7 percent for its total program, the seventh consecutive quarter in which pricing increases trended downward. In both March and April, Marsh McLennan clients saw this trend continue, on average, at renewal. Such favorable pricing may not, however, be available to companies that face open claims, sizeable stock drops, earnings challenges, or other legal matters.

Pricing changes are being driven by a dramatic upswing in an already established trend of increased competition among legacy insurers and new market entrants. The sharp decrease in companies going public—a notable source of new business revenue for insurers—is pushing many to seek revenue in the form of new premium dollars elsewhere. Given the ever-expanding risk landscape for public company directors, companies should be selective in choosing their carrier partners and should pay extra attention to even small nuances in coverage differences between insurers.

Global Events Continue to Raise Underwriting Concerns

Insurers continue to raise concerns about the broader economic environment and how companies plan to confront various risks. These challenges, including stock market volatility, supply chain issues, inflation, and heightened cyber threats, have caused some companies to miss earnings guidance or expectations, leading to shareholder lawsuits accusing them of inadequate risk disclosures.

Companies, therefore, must demonstrate to insurers that they are well positioned to address these issues and have adequately described these risks to investors. Despite the improving pricing environment, the threat for securities claims and derivative actions remains high, and there continue to be sizeable settlements in various cases.

Shareholder Litigation Threat Remains Elevated

Shareholders continue to bring securities fraud claims against public companies and boards, with 95 federal securities class actions filed through June 9. In all of 2021, there were 211 such actions, down from 319 in 2020. While the total number of these claims trended down over the last two years, they remain elevated compared to historic levels.

Event-driven litigation, in particular, continues to result from various adverse company events involving employee discrimination or harassment claims, cyber breaches and privacy matters, environmental disasters, and regulatory investigations, among others.

Shareholder derivative actions continue to settle for large amounts, though numbers have dropped from the record-breaking years of 2019 and 2020. Shareholders are raising claims alleging oversight failures on behalf of board members, with oversight shortcomings typically involving a purported failure of company boards to set up an adequate reporting system for mission critical risks. Or, where such a reporting system is constructed, shareholders may claim that the board ignored so-called red flags. We have seen these types of cases following cyber events, food safety outbreaks, opioid matters, false claims act violations, and #MeToo movement-related claims, among others.

Developments on the Regulatory Front

The US Securities and Exchange Commission’s (SEC) focus is on ESG issues, cybersecurity disclosures, executive compensation, insider trading, and special purpose acquisition companies. The SEC’s formation of an ESG Task Force has already resulted in some companies facing regulatory scrutiny over alleged inadequate ESG disclosures.

Additionally, earlier this year, the SEC proposed new disclosure rules that are presently the subject of public comment and debate. The proposed rules on cybersecurity disclosures require a more robust reporting of the board’s focus and credentials on cyber matters and on reporting material incidents to shareholders. The proposed rules on environmental matters would require companies to disclose a broad range of data on emissions and climate impacts, as well as offer detailed information about the broader effects and opportunities presented by the global transition toward renewable energy and carbon neutrality.

Companies Should Focus on Structuring Optimal D&O Programs

While the risk landscape presents numerous challenges, the improved public company D&O market conditions should afford organizations and their brokers greater leverage in negotiating insurance policy terms and conditions. Many insurers are choosing to introduce new policy forms as competition heats up and are more receptive to bespoke coverage solutions and enhancements.

Buying the appropriate amount of coverage is critical, and companies should use data analytics and personalized damages modeling, along with peer benchmarking, to assess what is right for them. Brokers can provide an understanding of settlement size trends to help companies select the amount of coverage that is suitable.

Financial strain is placing some companies under the heightened threat of shareholder derivative actions; individual directors and board members should ensure that adequate Side A insurance coverage is available to protect their personal assets when a company is prohibited or financially prevented from indemnifying those individuals against claims.

As the claims environment and regulatory activity continue to evolve, the D&O marketplace will also shift. It is therefore important for companies to be informed on trends that can impact their risk profile and D&O programs.

Matthew McLellan is the US D&O product leader for Marsh’s Financial and Professional Liability Practice.

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Get Into the Quantum Game: Use Cases Are Emerging

Just over a year ago, I posted a blog focused on why the board should care about quantum computing. Since then, use cases for quantum computing continue to emerge.

One of the most misleading phrases found in articles about quantum computing goes something like this: “When quantum computers are available….” It turns out that quantum machines are not only available now but also powerful enough to tackle practical problems. In fact, they already do certain things better than classical computing, with some trade-offs.

Why Is It Time to Get Into the Game?

Quantum machines may not be able to crack encryption yet, but they’re already showing advantages in specific use cases. Some end-user companies are claiming “customer advantage” with quantum computing—meaning they’ve considered several leading options and found that a quantum approach provides some advantage, considering such aspects as price and speed.

Quantum computing has the potential to revolutionize all types of optimization and machine learning problems. Getting started now positions companies to be counted among market leaders. Think back to the first companies that took full advantage of the Internet. There is only one: Amazon.com.

We don’t know exactly when true quantum advantage (satisfying the scientific community that a quantum computer can best a classical computer at a task, considering all relevant factors such as speed and accuracy) will be reached; however, some use cases in optimization could get there within a year. The key point is that when the advantage is achieved by one or more industry players and new use cases fundamentally disrupt manufacturing, logistics, and finance, companies that are not quantum-ready won’t be able to simply flip a switch and get in the quantum computing game. Bottom line, this journey is about readiness, for quantum computing can disrupt and destroy. Laggards will pay a price.

Beginning the Quantum Journey

To begin the journey to quantum readiness, companies need to task quantum technology champions with selecting areas of the business that this new technology may revolutionize. Design thinking exercises help stakeholders recognize the possibilities by brainstorming the types of problems currently being solved with technology and ascertaining whether to attempt use cases involving quantum algorithmic approaches that add more variables and constraints that haven’t been considered before.

Implementing quantum use cases can’t happen in a vacuum. Governance structure and support are needed. The right people from executive management, business, and technology leadership should be involved. This team needs to consider the applicability and potential benefits and risks of quantum computing and the appropriate investment level for the business.

Next comes a resource plan. There is a serious skills shortage in quantum technology software development. Companies will have to train people, find talent and resources, and develop processes to support this radical shift in computing looming on the horizon. Leadership can consider hiring college graduates with relevant coursework as trainable developers. Bring in outside consultants with the right skills to help get initial proof-of-concept use cases off the ground and provide some hands-on knowledge transfer for staff.

Recognize that failure is a necessary part of the discipline. Not every use case will work out at first and lead to a solution, and some will only provide learning experiences.

Compelling Use Cases are Demonstrating Value

One of the most promising use cases gains its edge from a rapidly maturing technology. Optimization problems are performed on quantum annealers, which map variables to thousands of qubits in a way that can be thought of as a field of peaks and valleys. The computer finds the lowest energy state to give the best possible answer.

One way to visualize this process is to imagine searching for the lowest valley on a continent. With a traditional approach, you would have to drive up and down all over the terrain to measure and find the answer. Thanks to quantum tunneling, the annealer can quickly identify the answer by moving through all the hills without a slow road-trip approach. These “peaks and valleys” can be applied to things such as asset portfolios to solve for optimal returns. Specific constraints can be assigned, such as how long to hold an asset and the minimal gain before selling.

Hybrid annealers allow a classical computer to parse out those parts of the problem best handled by annealing. The hybrid annealer then stitches the answer together to quickly provide the best results. This capability has already outperformed traditional computers in speed at portfolio optimization, and it’s expected to be a likely first example of true quantum advantage.

It is already showing some advantage in solving the classical traveling salesman problem, where a mythical salesperson has to visit every city in a country using the shortest routes without ever passing through a city twice. An actual situation that the annealer addressed involved a vehicle routing problem that added real-world constraints such as downed power lines and other hazards to make the problem more complex. One run had the quantum approach providing a route with 20 kilometers of driving to make deliveries. The classical solution needed 27 kilometers of driving. An edge such as this would multiply quickly when dealing with thousands of kilometers or miles daily. Many use cases are easily adaptable in this fashion, such as to certain pricing decisions for hospitality and airlines. This is but one example. There are other types of quantum computers that address other kinds of use cases.

Implications for Boards

Forward-thinking boards should see that their companies start planning sooner rather than later for quantum computing to avoid facing resource challenges that could leave them missing the near-term benefits and necessary long-term protections of this emerging area of computing. Understanding the opportunity and issues with quantum computing and preparing to seize and address them when the inevitable inflection point arrives could yield dramatic business advantage and disruption. Early movers across the globe may end up as top players in gaining quantum supremacy.

Questions for directors might include the following:

Have we conducted a quantum-readiness assessment?Are any of our competitors focusing on how to harness quantum computing? Should we sit and watch them and other industry developments, or should we appoint an executive sponsor, designate a quantum champion, and get into the game?Are there business challenges we are unable to solve today that quantum computing will be well suited to solve? If we don’t know, should we find out?Is there effective governance over where and how we invest in quantum computing?

Boards that can answer these questions put their companies in a better position to consider quantum computing and maximize its opportunity.

Jim DeLoach is a managing director of Protiviti. DeLoach is the author of several books and a frequent contributor to NACD BoardTalk.

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With Volatility and Rising Interest Rates, Will Some Performance-Based Equity Awards Be Worth the Greater Cost?

The price of the most common performance-based equity award is increasing for US-listed companies. Approximately half of companies that use performance-based equity awards have some portion tied to relative total shareholder return (rTSR). Typical designs are earned based on company shareholder return (stock price growth plus reinvested dividends), often over a three-year performance period. The target award level generally is earned for performance at or around median, and the number of shares ultimately earned can be above or below target for performance above or below median.

The appropriateness of rTSR as a performance measure is a topic for another discussion. Instead, this post is about how the current inflationary environment, US monetary policy, and market volatility are converging in a manner that impacts the Monte-Carlo and Black-Scholes models, or those that are most often used to calculate the accounting cost of a rTSR award. We observe that these forces are converging in a way that will increase these awards’ theoretical value (i.e., the grant date fair value or GDFV), perhaps materially. This matters because the GDFV is the compensation that is disclosed in the Summary Compensation Table of proxy statements and what is incurred over the performance period as stock-based compensation on the income statement. It’s a function of accounting rules and not a shift in companies or grant participants perceiving a higher likelihood of a payout.

To fully understand this, it is important to recognize some of the high-level key relationships that drive the theoretical value of these awards. For equity awards valued with Monte-Carlo and Black-Scholes accounting models, the GDFV (1) rises as interest rates rise, (2) rises as volatility rises, and (3) is fully recognized regardless of the performance achieved.

This matters because that GDFV is the compensation that is disclosed in the Summary Compensation Table of proxy statements and what is incurred over the performance period as stock-based compensation on the income statement. It’s a function of accounting rules and not a shift in companies or grant participants perceiving a higher likelihood of a payout.

The math implies that the award is worth more when the markets are volatile and interest rates are higher and accounting rules require the cost to be treated like an option (i.e., the cost is established today and not adjusted up or down based on the actual performance achievement at the end of the period). This is in contrast to internal or financial performance conditions, such as earnings or return measures, in which the cost can be reversed if the performance goals are ultimately not met.

How big might this problem be? Our client experience and experimentation with the model tells us that the cost of an award made today might be 10 to 30 percent higher than the same award made one year ago. Additionally, there will be extreme outliers in certain niche situations—think a more than 40 percent increase in accounting value per unit. While technically correct, these changes in value do not translate to a more valuable, or certain, award in the real world. Implications include the following:

The “real” probability that the award will finish “in the money” is basically the same across industry-specific comparator groups because all companies being compared are subject to the same macro forces.Stock-based compensation expense goes up. It is often explained away as a non-cash cost that is backed out by shareholders, but it is arguable whether or not analysts and investors will be more forgiving of this expense in the future as the cost of equity increases alongside debt rates.Reported compensation in the proxy goes up. For an executive who earns 70 percent of their total pay in equity, and 50 percent of that is in rTSR awards, a 20 percent increase in rTSR cost will increase pay by 7 percent without any other change. Proxy advisors and many large shareholders prefer this rTSR design. Presumably, they account for this accounting-driven force in their analyses of pay levels, but it is entirely subject to their perspective of “appropriateness.”The potential range of share prices at the end of the performance period is wider. Volatility means higher highs and lower lows. For rTSR plans, which measure returns from point to point, the program becomes riskier, also with higher highs and lower lows. The value of performance-based equity can already be a risky proposition for recipients, and more risk (and the underlying formulas to illustrate “value”) makes the award feel like a day at the casino.

So, what should compensation committees and management do? The answer is always about preparation and discussion, but here are two considerations:

Address award valuation and award design at the same meeting. Do not wait until design is approved. Have any valuation inputs changed? What would sample disclosure look like for last year’s awards under the new inputs? What is the impact on budgeted stock-based compensation expense? Does a different valuation change opinions about the appropriateness of the award?Consider performance-based long-term awards that are less dependent on “theoretical value” accounting calculations. If the objective is simply to manage reported compensation and income statement cost, performance awards whose cost does not vary with macro assumptions may generate outcomes that are more aligned with actual performance and company fundamentals over time. These metrics may also be more navigable during periods of heightened market volatility, given the point-in-time risk associated with three-year market measurement periods.

Todd Sirras is a managing director at Semler Brossy and Austin Vanbastelaer is a senior consultant at Semler Brossy.

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Governing to Make ESG Disclosures Fun and Profitable

The proposed US Securities Exchange Commission (SEC) rules requiring climate change disclosures are more than a costly but poorly conceived attempt at getting useful, standardized information to shareholders. They are likely just the beginning of an effort to standardize reporting on all environmental, social, and governance (ESG) activities—a goal that may end up being a boon for lawyers and consultants, while providing little meaningful, actionable information to investors.

Rules like these will also have the unintended consequence of raising the profile of ESG raters, all of which use different, often questionable, and sometimes meaningless criteria, and will draw a straight line of accountability to the board of directors. Some investors and other stakeholders may see everything as proof of greenwashing and greenwashing as securities fraud. As Jean Case, CEO of the Case Impact Network and board chair at the National Geographic Society, said, “At the end of the day, boards have to be held accountable in this space.”

As insurers of ESG and reputation risk, we’ve seen boards blindsided by tactical distractions to the type of major strategic reputational issues that In re Caremark International Inc. delineates as their purview. ESG disclosures could become the next distracting frontier. Rather than viewing these rules as merely a costly new burden, boards should view them as an opportunity. They can take this moment to create a more expansive framework for ESG governance that will yield two precious benefits: improve the quality of the board work experience and demonstrably boost enterprise value.

Data the SEC is requesting on climate oversight is granular. According to governance experts, the SEC is asking the board to describe the process by which it provides oversight over climate risks and how these risks are integrated into the enterprise risk management system. No one doubts boards have the intellectual firepower to focus on these granular details. But that’s not what boards were designed to do.

Since Marchand v. Barnhill’s update to Caremark, a board’s role has been strategic oversight of a firm’s finances, compliance, and mission-critical operations. Failure to appreciate and oversee what is mission critical or material is the new issue tripping boards up today, and where boards must avoid tactical distractions.

We described in an NACD BoardTalk blog earlier this year that six of 18 Caremark claims raised in the Delaware Court of Chancery survived motions to dismiss—an approximately 33 percent success rate over the past two years. Of the six that survived, only one was linked to alleged environmental oversight failure. Others were associated with issues such as financial and compliance control failures, or with core reputation issues including safety and innovation.

Other ESG issues have been raised in court, however, including oversight failures in the context of social misrepresentations. Shareholders sued Wells Fargo & Co., for example, for a stock price drop following an ethics scandal arguing they were misled by the CEO’s public statements about ethics, greater accountability, and transparency within the company. Signet Jewelers settled their shareholder case over sexual harassment in the face of an explicit code of conduct promising no harassment. The price tag: $240 million.

Here’s the opportunity: Let’s assume that a board wishes to raise the strategic focus of its oversight, protect the assets of the firm, meet the expectations set by Caremark post-Marchand, and comply with the new climate disclosures without overreaching into executive tasks.

First, the board would leave the minutiae to management and have them wrap compliance work into an integrated enterprise reputation risk management activity. For most firms with a silo-busting operational or enterprise risk management apparatus that has a core intelligence-gathering capability, this would simply entail an overlay of a behavioral economics-inspired reputation risk management framework. We highlighted additional details in Directorship in 2019.

As is likely the case now, the board would be connected to that process through a firm’s risk leadership (CEO, chief legal officer, or chief risk officer). Its role would be to look beyond compliance to understand the expectations of employees, vendors, creditors, activists, regulators, and various other stakeholders. Through this apparatus, a board would gain visibility into those issues beyond climate that represent potential mission-critical risks. Climate risks would be among them, but only part of the picture.

We shared late last year in Directorship a few vignettes of companies that earned reputation premiums through superior ESG and reputation risk governance. Looking at a larger population, we recently reported that companies with ESG and reputational risk protection strategies have seen their stock prices rise 5 percent above the market within two weeks of a reputational challenge. Firms that validated and disclosed those strategies publicly before an event have seen their stock prices rise nearly 10 percent in the same time frame. We also found that stock prices of firms that managed, validated, and publicized ESG and reputation risk management strategies on average gained 9.3 percent over the subsequent seven months after a reputation-threatening event.

More than merely public relations, the evidence shows that the market rewarded firms that had implemented authenticated oversight of operational controls over the mission-critical process that underpinned a firm’s reputation. In addition, the firms that earned equity rewards were usually among the first in their peer group to make public their processes for managing mission-critical risks. Firms in which such risk management processes were assumed by shareholders to be in place gained 4.3 percent on average.

To adapt a Warren Buffet aphorism, firms shown to be swimming without out shorts as the tide receded were punished by equity investors. Companies that failed to institute, validate, and communicate risk management strategies lost 13.2 percent of their stock value over those seven-month periods, and they underperformed their peers by an average of 23.3 percent.

Compliance is necessary and expensive, with the usual return on investment being zero. Board directors are more likely to derive more personal satisfaction; earn stronger marks from asset managers, proxy advisors, investors, and other stakeholders; and realize a corporate equity boost by governing above ESG disclosure minutiae. Think of it as strategic reputation risk oversight for fun and profit.

Nir Kossovsky is CEO of Steel City Re, which mitigates the hazards of reputation risk with parametric reputation insurances, ESG insurances, and risk management advisory services. Denise Williamee is Steel City Re’s vice president of corporate services, where she heads client relations and education for reputation leadership teams.

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How to Build Organizational Resilience With a New Work Operating System

The pandemic didn’t invent workforce issues related to accelerated digitalization, flexible working, reskilling, and upskilling or diversity, equity, and inclusion, but it certainly exacerbated and hastened them. The combination of these issues has created two significant risks for companies. First, the world of work that organizations have invested in is no longer fit for purpose. Digitalization and the democratization of work require fundamentally different ways of connecting talent to work. The use of work options such as automation and gig workers presents both opportunities and risks. Second, the established, functional response to work and workforce issues is no longer fit for purpose. Today’s hiring policies, compensation administration, and workforce planning, to name a few, are all responding to new challenges with old solutions. So, is it any surprise that we see companies of all sizes and sectors struggling with talent management while responding to the opportunities presented by digitalization?

If the ways we design work and our organizations are no longer creating value, then it’s time to rethink both and introduce new ways of functioning—a new work operating system. In a new work operating system, organizations can apply four principles to create the internal changes needed to meet the external moment, whether it’s today’s pandemic, supply chain, and inflation issues, or unknown future disruptions.

Start With the Work, Not the Job

Organizations are holding themselves back by continuing to define work as “jobs” and workers as “job-holding employees.” In a new work operating system, current and future work is deconstructed into skills and capabilities required to perform the given tasks. Freeing work from the “job” is an act of agility. By doing so, organizations can more clearly isolate the best option for performing a given body of work, whether that may be through an employee, artificial intelligence (AI), or a gig worker.

Fuse Humans and Automation

From corporate leaders to employees, most people tend to see a binary narrative between automation and jobs. And while this may be true in some circumstances, an “either/or” mind-set artificially limits organizational opportunity. By deconstructing jobs, leaders more clearly see where a particular type of automation (robotic process automation, machine learning, collaborative robotics, etc.) can substitute for human work, augment workers’ skills, or transform human work. In fact, one-third of executives say that the impact of automation on jobs will deliver the biggest return on investment in the next two years, according to Mercer’s 2022 Global Talent Trends report.

Envision the Full Array of Human Work Engagements

The pandemic plunged the world into alternate work arrangements as remote work became dominant for numerous workers. This experience has elevated the desire among many, but especially women and minority populations, to demand continued flexibility going forward. In the new work operating system, managers think beyond organizing work in fixed jobs. Instead, they consider various ways in which talent can engage with work. Internal and external talent marketplaces, which match workers with available opportunities, potential roles, and training based on their skills, interests, and preferences, have grown in popularity, for example. Marketplaces allow for the rapid deployment of employees or gig workers to where their skills are most needed. They also provide a framework for borrowing talent from other departments or companies. Strikingly, 40 percent of executives say they used AI-driven tools to uncover skill insights and power their internal talent marketplaces last year. An additional 48 percent plan to invest in such technologies this year, according to Mercer’s report.

Flow Talent to Work

Limiting human work to performing specific roles people are hired for has far too high of a frictional cost for our rapidly evolving world. Future-fit organizations eliminate that cost by increasingly flowing talent to work. Specifically, future-fit companies will embrace three models of connecting talent to work: fixed, flex, and flow. Fixed roles will continue to be used in situations where a convenient volume of work or compliance requirements necessitate a more traditional job. Flex roles involve talent in a traditional job, but with the flexibility to express their skills or acquire new skills in another function. Flow roles, meanwhile, will be unbounded from jobs completely and seamlessly connect talent with projects and assignments by matching skills to specific tasks.

These four principles can generate unparalleled organizational resilience and agility. Importantly, reaping these benefits does not require an immediate, complete organizational overhaul. Instead, most companies can likely identify one to two areas where prototyping the new work operating system can offer immediate benefits. Perhaps there are areas where the work is changing so quickly that traditional job descriptions and training cannot keep up. Or, perhaps automation presents some new opportunities. Maybe there are areas where full-time workers for some positions are hard to find, and new work arrangements are being considered to fill the gaps. However a new work operating system gets piloted, it can coexist with more traditional systems while building an organization’s ability to adapt and transcend the more conventional and limiting concept of “work with jobs.”

The rapidly changing nature of work requires a new work operating system. To successfully implement it, boards of directors will need to fully understand and stay on top of the shifting profile of risks associated with new ways of working. For even as resilience and agility are optimized, continued success rests on the understanding that we all live in a state of perpetual obsolescence.

Ravin Jesuthasan is the global leader of transformation services at Mercer.

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Private Equity Firms See Opportunity in Upheaval and ESG in 2022

Private equity deal value in 2021 dwarfed that of 2020, nearly doubling to $1 trillion from $565 billion in 2020. Experts suggest that the elevated deal value is the result of so-called “dry powder” in the hands of private equity firms. In other words, private equity firms that held back on deal-making in 2020 due to pandemic uncertainty or for other reasons made up for lost time last year.

Some experts also speculate that the pace of private equity deals in 2021, up 35 percent from 2020, was driven in part by the looming specter of proposed Biden administration changes to capital gains and corporate taxes.

With a record-breaking year in the books and the high deal-making levels expected to continue, private companies looking to either sell to or compete against private equity firms should pay close attention to their next moves.

Areas for Opportunistic Investment

Dry powder is a double-edged sword. While it is partly responsible for the enormous surge in deal value over the past year, dry powder also leads to greater competition and higher prices of entry into investments. In fact, 35 percent of global private equity executives surveyed by Dechert and Mergermarket said the quantity of dry powder combined with the ability to put capital to work would be a top-two challenge for the private equity industry in the months ahead.

Nonetheless, Rafael Pastor, an advisor to the private equity firm Partners Group, and a director of multiple private companies, including KinderCare Education and Rosetta Books, predicts that private equity firms will take advantage of opportunistic investments in three areas this year: credit, real estate, and infrastructure. Pastor said in a conversation with NACD that private credit and real estate are well positioned now as interest rates rise—and even more private equity real-estate investment will happen as inflation continues to soar because real estate is traditionally viewed as a solid hedge against inflation. Meanwhile, last year’s $1.2 trillion Infrastructure Investment and Jobs Act will likely push many private equity firms to invest in infrastructure across the country, according to Pastor.

In addition, a third of respondents to Dechert’s survey named region-specific factors, including macroeconomic and geopolitical issues, as a top-two challenge for the industry. Indeed, private equity firms are pivoting to invest where they see opportunity in the wake of the pandemic, the war in Ukraine, US-China tensions, and other geopolitical uncertainty.

“Historically, uncertainty and even instability always create opportunity,” Pastor said. “Private equity firms are really good at spotting those opportunities.”

Military spending and energy (both traditional carbon-based fuel and alternative energy) will be two hot spots for private equity firms in this regard, Pastor said. In addition, life science and pharmaceutical companies will get even more private equity attention post-COVID.

“You have to remember that private equity firms don’t just jump into an opportunity because it pops up,” Pastor said. “They tend to track different sectors and different companies for up to a year or two and see how they’re doing so that they can identify companies that are targets for them when the opportunity arises. They don’t just show up in the eleventh hour—they’ve been there all day.”

A Greater Focus on ESG

Although private equity portfolio companies are not subject to as much US Securities and Exchange Commission scrutiny as public companies are, private equity firms are also increasingly paying attention to environmental, social, and governance (ESG) matters. How could they not, when major institutional investors such as BlackRock and State Street have pushed businesses to focus on ESG over the past few years?

A significant portion of private equity firms’ investment in portfolio companies comes from pension and union funds, and these funds want the companies they invest in to be doing the right thing for their stakeholders. In fact, 96 percent of North American respondents to the Dechert survey said that they expect an increase in limited-partner or third-party private equity fund investor scrutiny of ESG issues and reporting in deals over the next three years.

Twenty-nine percent of all respondents ranked climate change as their most important ESG consideration when making investment decisions, followed by sustainability at 14 percent, which aligns with regulatory initiatives’ focus on environmental issues and the fact that these issues are more easily measurable than social and governance matters. Privacy and data security received the largest share of responses (69 percent) for general ESG considerations that may not be the most important but are still top of mind. All in all, 76 percent of North American respondents said their firms were considering raising an ESG-focused fund over the coming year.

ESG won’t just be a consideration in the decision-making process. While 76 percent of all respondents said ESG’s importance at the time of investment would generally increase over the next three years, 72 percent said ESG would become increasingly important at exit and 70 percent said ESG would become increasingly important during the lifespan of the investment—with 46 percent of respondents saying that there would be a significant increase in its importance during this period.

Private equity firms are among the largest employers in the United States when you add up all the people they employ through their portfolio businesses. With this in mind, Ownership Works offers a recent example of private equity firms’ ESG consciousness. The nonprofit launched in early April, backed by a coalition of more than 60 investors, banks, and pension funds; that included 19 private equity firms, such as Apollo Global Management, KKR & Co., and Warburg Pincus.

In partnership with the founding firms, the nonprofit aims to help companies develop and implement employee ownership programs. The founding private equity partners have committed to supporting and implementing shared ownership models within their portfolio companies, demonstrating that they indeed intend to elevate their focus on ESG issues during the lifespan of their investments.

What This Means for Boards

For private equity-backed portfolio company boards, Pastor sees the following types of directors as vital in the months ahead:

Vertically Aligned Directors: If a private equity firm plans to invest in infrastructure, for instance, it will want to have portfolio-company board members who have a background in infrastructure.Functional Members: For example, when a private equity firm is looking to take its portfolio company public, it will keep an eye out for someone with expertise in digital marketing or finance. If the company is focused on diversity, equity, and inclusion, it will want a board member with a human resources background.Generalists: While less dominant than in the past, this type of director still has the attention of private equity firms looking for “horizontal experience,” as Pastor calls it—experience running a company as a CEO or on the board of a complex organization where they had to handle instability, inflation, and other environmental pressures.

In this environment of high valuations and increasing competition among private funds, potential sellers and their boards would be wise to consider all of these trends in seeking out any offers. Beyond those companies looking to sell, however, private companies and their boards should be aware of how private equity firms influence the competitive landscape.

Private equity firms bring to their portfolio companies sound governance processes, operational expertise, strategy oversight, and technology investment. Broadridge Financial Solutions predicts, for example, that private equity firms will increasingly deploy distributed ledger technology, artificial intelligence, and robotic process automation in deal-making, reporting, and recordkeeping to create cutting-edge efficiencies.

To compete, non-private equity–backed companies should seek to elevate their oversight and other business practices, particularly if they exist in the sectors noted above, such as real estate, infrastructure, or energy—especially when it comes to ESG.

Mandy Wright is senior editor of Directorship magazine and NACD BoardTalk.

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