Jon Lukomnik is one of the pioneers of modern corporate governance. He co-founded the International Corporate Governance Network (ICGN) and GovernanceMetrics International (now part of MSCI), and served as interim chair of the Council of Institutional Investors’ executive committee. He serves as executive director of the IRRC Institute, whose research has been widely praised for objectively examining fundamental corporate governance and capital market issues. He is also the managing partner of Sinclair Capital LLC, a strategic consultancy to asset owners and the asset management industry. His new book, “What They Do With Your Money: How the Financial System Fails Us and How To Fix It” will be published in May.
Christopher P. Skroupa: What are the current hot topics trending for the 2016 proxy season?
Jon Lukomnik: I would say the number one trend right now is board accountability. What is so pivotal here is how rapidly the world has changed. Two years ago virtually no company had proxy access, now more than 200 companies give shareowners a voice during board elections. New York City’s pension funds have driven this change, it has become standard on the S&P 500 and throughout the capitalization chain. Proponents who put in proxy proposals have informed me that there has been a shift in terms of activity in this proxy season. At this time last year they were strategizing with other proponents as to how to maximize votes. This year, they’re spending more time having rational, reasonable conversations with issuers about the technical details in regard to what type of proxy access the issuer will adopt.
Skroupa: Have there been any emerging risks throughout proxy season in regard to proxy access and board accountability?
Lukomnik: On proxy access it’s not a risk, but there has been a coalescing around—what in the trade is called “three and three”—in which shareholders who have owned 3% of the company for three years may use proxy access. For example, Vanguard has changed its proxy voting process, and their mutual funds will now genuinely back proxy access at 3% ownership when they used to be at 5%. It is important to understand proxy access as part of board accountability. Investment managers, such as T. Rowe Price, are addressing this change. That firm just changed its policies to vote against some directors at dual class companies, such as Viacom and 21st Century Fox, where insiders exercise control that is disproportionate to their capital at risk. Notice I mention Vanguard and T. Rowe when analyzing new efforts at accountability and not long-time leaders like CalSTRS or Boston Common. The nature of traditional, mainstream institutional investors caring, in regard to board accountability, is a trending topic. Who knows? That pattern may extend to emerging risks such as climate change. Investor proposals focus on risk management, then the traditional mainstream investors weigh vulnerabilities and board ability to address these issues. These issues eventually percolate and become mainstream.
Skroupa: How does shareholder engagement impact proxy results?
Lukomnik: I think that you have to look at the history of the modern corporate governance movement. We tend to conflate proxy voting and proxy resolutions with engagement. The difference is that proxy voting and resolutions are quite visible, whereas private engagement is hidden. In the 1980s, there was an unequal power issue. There was no majority voting, you didn’t have proxy access—institutions were only in their infancy. There wasn’t even confidential voting. Public campaigns were the most common way to influence corporate behavior. It was almost reform by embarrassment. One classic example was when Bob Monks, one of the forefathers of the modern corporate governance movement, ran a short slate at Sears—still an American Icon at that point, much less so now. Monks ran an ad in the Wall Street Journal, outlining the board of directors with the question, “Sears’ Board of Director’s underperforming assets?” It grabbed their attention in a way that couldn’t be attained by just picking up the phone and calling. It was a little bit like trying to reform corporate problems through public shaming. Over the last 25 years, particularly in the last five years, there has been say on pay voting and proxy access and a trend towards quiet engagement. I admit there are still institutions that will file a proxy proposal, however the percentages have reversed. The vast majority of institutions prefer to quietly engage with companies. It allows nuance, subtlety and trust-building. Engagement is at an all-time high. Proxy voting has become the public tip of a mostly private iceberg of engagement that quietly takes place all year round. Even going back to 2014, roughly 4/5th of investors initiated engagement. By contrast, in 2011 almost half of investors never initiated in engagement. That shows how rapidly things change. Today, institutional investors are engaging. If you think about it, if someone has invested millions in your shares; they should want to talk to you. This relationship is two sided. Discussion initiated from the issuer is also beneficial. There is a system that involves more than just short-term market moving information. Shareholders are interested in your long-term planning. Questions need to be addressed such as: What succession plan is in place, what is the effect of climate change on your insurance company and how are you approaching supply chain issues? Real long-term discussions are taking place behind the scenes, between companies and their institutional owners.
Skroupa: Why has it taken so long for environmental and social issues to be considered mainstream risk/opportunities?
Lukomnik: There is a wonderful link between Renaissance Florence, the 1950s and the capital markets of today. Our accounting system, double book entry accounting, was invented by a person that few have heard of, but he’s a fascinating historical character. Luca Bartolomeo Pacioli was a Franciscan friar who taught mathematics and perspective. One of his best students was Leonardo Da Vinci. Pacioli was best known for his book entitled Everything About Arithmetics, Geometry and Proportion. For a sense of history, his book was printed on the Gutenberg Press. Pacioli outlined the “proto-accounting system” for merchants to account for the operations of bridge construction in Venice. It became the forerunner of our accounting system. This accounts for how we keep track of internal company functions. However, as you might imagine, defining intangible assets, risks, system shocks and the like wasn’t on the mind of a fishmonger on the Arno at the time. Now flash forward about 400 years, we have people like Harry Markowitz, who created modern portfolio theory. Modern portfolio theory is the dominant way in which people invest, but it deals with securities, not with companies. Securities are devised based on the balance sheets and earnings statements very similar to those that Pacioli invented. Those financial statements however, are transactional and post hoc. Inputs get captured after transactions happen, yet markets and discounting mechanism look into the future. Pacioli’s financial statements have little ability to quantify contingent risks to companies. An example of existential shock is when Eastman Kodak went bankrupt due to digitization. There are also environmental risks to consider. Alternatives to inefficient energy creation methods have caused coal to be rerated by the markets. Instead of King Coal it has become Pauper Coal due to this realization. At some point, we all realized that business today is related to the systems of the world—economic, social, environmental—but our financial statements and modern portfolio theory don’t adequately consider those systemic effects. The result has been a market opportunity for ratings agencies, whether it’s MSCI or Sustainalytics or others, to establish statistical measures of these risks. Transformative entities such as CDP, the Global Reporting Institute (GRI) and materiality standards from Sustainability Accounting Standards Board (SASB) produce information in quantifiable terms that investors can use to measure these risks. The CFA institute and Investor Responsibility Research Center Institute (IRRCi) reported that today, 73% of CFAs take environmental, social, and corporate governance issues into account. Some 64% consider governance issues, 50% consider environmental issues, and 49% consider social issues. People intuitively understand that these components matter. Change has become more obvious, things like global warming are more noticeable. Hidden incentives such as executive compensation have become more transparent due to increased disclosure. Specialty consulting firms now provide that information in a usable format for investors. The next challenge is for someone like a 21st century Pacioli to come along: We have a copious amount of data, and it’s not yet standardized.
Skroupa: What is the current state of environmental, social and governance integration into investing?
Lukomnik: You had “SRI 1.0” which was exclusionary. They didn’t want to invest in “sin stocks.” Then we had “Impact Investing 1.0.” People have become more nuanced. There are still exclusionary screens and “best-in-breed” screens where the object is to find the most environmentally conscious company and sector or the manufacturing company with the most sustainable supply chain. But the latest is quantitative analysis that tries to target certain risk exposures while holding other factors constant. For example, the New York State Common Retirement Fund has invested $2 billion into a Low Carbon Equity Index Fund. There are now several brands of Low Carbon Index Funds attracting billions of dollars. This strategy minimizes tracking error against a traditional index and also mitigates the system environmental or social risks.