Evolving ESG Regulations: Board Diversity and Executive Compensation
It wasn’t long ago that the environmental aspect of Environmental, Social, and Governance (ESG) corporate issues was top of mind in the C-suite – climate-related matters in particular. The SEC proposed the Enhancement and Standardization of Climate-Related Disclosures for Investors rule on March 21, 2022, which was a topic of much consternation and debate. But while the business community held its collective breath and waited for a final climate-related disclosure rule, two governance-related issues began to gain prominence – corporate board diversity and executive compensation. The SEC ultimately issued its final climate-related disclosure rule on March 6, 2024, only to stay the rule a month later. In the meantime, corporate board diversity and executive compensation continued to build momentum, bolstered by regulatory rulemaking and the influence of proxy advisory firms.
Board Diversity: Pressure from All Directions
Although corporate perspectives on DEI policies have evolved over the past four years, leading up to the Supreme Court’s ruling against affirmative action on June 29, 2023, most companies continue to uphold one of the DEI policies’ key principles: corporate board diversity. This stance aligns with the regulatory agenda of the SEC, the priorities of the two main U.S. stock exchanges, and the positions of prominent proxy advisory firms, all of which are actively promoting diverse representation at the top levels of companies.
The SEC’s Division of Corporation Finance is in the early agenda stage of considering a rule proposal on registrant diversity disclosures for board members and nominees. Though this agenda item still has miles to go and many hurdles to clear before being finalized as a rule, “The Division is considering recommending that the Commission propose rule amendments to enhance registrant disclosures about the diversity of board members and nominees.”
At the stock exchanges, Nasdaq’s board diversity rule requires each company traded on its exchange, with certain exemptions, to publicly disclose board-level diversity statistics each year using a standardized template and to have (or to explain why it does not have) diverse directors.
The New York Stock Exchange (NYSE), which does not require board diversity reporting, takes a different approach to its support of diverse board profiles. While acknowledging its importance, the exchange so far has eschewed rulemaking in favor of its NYSE Board Advisory Council, which it set up in 2019 to connect diverse board candidates with NYSE-listed companies seeking new diverse board members.
While the SEC and major exchanges hold substantial regulatory authority, proxy advisory firms arguably exert even more influence in corporate America. Regarding corporate board diversity, they push their agenda by advising shareholders to vote against nominating committee chairs if boards don’t meet their minimum criteria for gender diversity and racial/ethnic diversity. Glass Lewis outlines this in its 2024 U.S. Benchmark Policy Guidelines, noting:
“We consider the nominating and governance committee to be responsible for ensuring sufficient board diversity, or for publicly communicating its rationale or a plan for increasing diversity. As such, we will generally recommend voting against the chair of the nominating committee of a board that is not at least 30 percent gender diverse, or all members of the nominating committee of a board with no gender diverse directors, at companies within the Russell 3000 index.” It also writes, “We will generally recommend against the chair of the nominating committee of a board with fewer than one director from an underrepresented community on the board at companies within the Russell 1000 index.”
ISS, another major proxy advisory firm, states in its 2024 U.S. Voting Guidelines its recommendation, regarding gender diversity, to “[g]enerally vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) at companies where there are no women on the company’s board.” Additionally, for Russell 3000 or S&P 1500 companies, its recommendation is to “generally vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) where the board has no apparent racially or ethnically diverse members.”
Executive Compensation: Closing the Loopholes
The focus on executive compensation is not new, but the way it’s policed by regulatory authorities continues to evolve as rapidly as companies and their executives devise new compensation structures. The SEC’s fixation on executive compensation is stronger than ever, as illustrated by its adoption of two key final rules – the Pay Versus Performance rule and the Listing Standards for Recovery of Erroneously Awarded Compensation rule.
Adopted on August 25, 2022, the Pay Versus Performance rule provides enhanced transparency in executive compensation disclosures by public companies. The rule includes requirements for registrants to disclose, in their proxy or information statements (in which disclosure of executive compensation is required), the relationship between executive compensation actually paid and financial performance.
In his statement on the rule’s adoption, SEC Commissioner Gary Gensler highlighted its potential to promote shareholder insight into corporate governance practices. “Today’s rule makes it easier for shareholders to assess a public company’s decision-making with respect to its executive compensation policies,” Gensler explained, emphasizing that the new disclosures grant a company the flexibility “to describe the performance measures it deems most important when determining what it pays executives.” Gensler added that the enhanced disclosure structure would provide investors with “consistent, comparable, and decision-useful information,” facilitating more informed assessments of executive compensation policies.
In addition, on October 26, 2022, the SEC adopted the Listing Standards for Recovery of Erroneously Awarded Compensation rule (the clawback rules), also dealing with matters relating to executive compensation. The clawback rules include, among other things, requirements for national securities exchanges to establish listing standards requiring listed companies to implement a compensation recovery policy (often called a clawback policy) and provide certain related disclosures. In implementing the SEC’s rule, the NYSE and Nasdaq proposed clawback listing standards that were approved by the SEC in June 2023.
Conclusion
The evolving focus on governance within ESG underscores the growing responsibility for companies to meet high standards of transparency and accountability. The SEC’s new rules regarding executive compensation and Nasdaq’s new board diversity rule impose a substantial regulatory burden on public companies. These mandates demand strict compliance that threatens to strain resources as companies navigate them.
Ultimately, this intensified environment, created by both regulators and proxy advisors that exert substantial influence, demands that companies adapt quickly, balancing shareholder expectations with a more transparent governance model. In short, compliance professionals should be prepared for a bumpy ride.
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