STANFORD INSTITUTIONAL INVESTORS’ FORUM

Wednesday, June 12, 2019 Lane/Lyons/Lodato Room, Arrillaga Alumni Center Stanford, California

STANFORD INSTITUTIONAL INVESTORS’ FORUM

June 12, 2019

Lane/Lyons/Lodato Room Arrillaga Alumni Center, Stanford University 326 Galvez Street, Stanford, CA 94305

AGENDA

7:45 a.m. BREAKFAST and REGISTRATION

8:00 a.m. WELCOME FROM CO-DIRECTORS and PARTICIPANT INTRODUCTIONS

Joseph A. Grundfest, William A. Franke Professor of Law and Business and Senior Faculty, Rock Center for Corporate Governance, Stanford University; Board Member, KKR; Co-Director, SIIF

Amanda K. Packel, Managing Director, Rock Center for Corporate Governance; Co-Director, SIIF

8:15 a.m. ESG Measurement and ESG-Specific Funds: Does Any of This Make Sense?

Lydia I. Beebe (moderator), Principal, LIBB Advisors; Board Member, Aemetis Inc. and Kansas City Southern Colleen Honigsberg, Assistant Professor of Law, Stanford Law School Samantha Ross, Former Chief of Staff, Public Company Accounting Oversight Board Michelle Edkins, Global Head of Investment Stewardship, BlackRock

9:15 a.m. Human Capital Management and the Future of Work

Joseph A. Grundfest (moderator) James Andrus, Investment Manager, CalPERS Peggy Foran, Chief Governance Officer, SVP, and Corporate Secretary, Prudential Financial; Board Member, Occidental Petroleum Nicole Isaac, Senior Director, North American Policy, LinkedIn

10:15 a.m. Break

10:35 a.m. Activism by Employees as Shareholders

Mike Callahan, Professor of the Practice of Law and Executive Director of the Rock Center for Corporate Governance, Stanford University

11:35 a.m. Lunch

12:15 p.m. Proxy Season Review and Update on Potential Reform of Proxy Advisors and the Proxy Process

Anne Sheehan, Member, SEC Investor Advisory Committee; Board Member, L Brands; Advisor, PJT Camberview; Former Director of Corporate Governance, CalSTRS

1:00 p.m. Research, Regulatory, and Litigation Updates – Expanded 10b-5 Liability, The Future of Federal Forum Provisions, and More Insider Trading Litigation

Joseph A. Grundfest

1:45 p.m. Adjournment

The dinner on June 11, 2019 will be at the Stanford Park Hotel, 100 El Camino Real, Menlo Park, CA 94025, with cocktails at 6:15pm and dinner at 7pm. Our featured guest speaker will be Jennifer Eberhardt, Professor of Psychology at Stanford University, who will discuss her new book Biased: Uncovering the Hidden Prejudice That Shapes What We See, Think, and Do, as well as some new research on bias in investing.

STANFORD INSTITUTIONAL INVESTORS’ FORUM

June 12, 2019

Lane/Lyons/Lodato Room Arrillaga Alumni Center, Stanford University 326 Galvez Street, Stanford, CA 94305

MATERIALS SUMMARY

ESG Measurement • ESG activities – David F. Larcker and Brian Tayan, Stanford Graduate School of Business Corporate Governance Research Initiative. Research Spotlight.

• Making sense of the current ESG landscape – Peter Atkins, Marc Gerber, and Richard Grossman, Skadden, Arps, Slate, Meagher & Flom LLP. Harvard Law School Forum on Corporate Governance and Financial Regulation – October 18, 2018.

• Exploring ESG: a practitioner’s perspective – BlackRock Viewpoint – June, 2016.

• The ESG data challenge – Rakhi Kumar and Ali Weiner, State Street Global Advisors – March, 2019.

• The business case for ESG – Brandon Boze, Margarita Krivitski, David F. Larcker, Brian Tayan, and Eva Zlotnicka. Stanford Closer Look Series – May 23, 2019.

Human Capital and the Future of Work • Where does human resources sit at the strategy table? – Courtney Hamilton, David F. Larcker, Stephen A. Miles, and Brian Tayan. Stanford Closer Look Series – February 15, 2019.

• A deeper dive into talent management: the new board imperative – PwC Governance Insights Center – May, 2019.

• Human capital management coalition petition to U.S. Securities and Exchange Commission – Meredith Miller, Human Capital Management Coalition – July 6, 2017.

• BlackRock investment stewardship’s approach to engagement on human capital management – Michelle Edkins, BlackRock Investment Stewardship. Harvard Law School Forum on Corporate Governance and Financial Regulation – March 28, 2018.

• AI, automation, and the future of work: ten things to solve for – McKinsey Global Institute – June, 2018.

Employee Activism • Employees rising: seizing the opportunity in employee activism – Weber Shandwick and KRC Research.

• Employee activism: a powerful, yet untapped, driver of climate action – Dominic Hofstetter. Medium.com – April 23, 2019.

Proxy Season Review and Hot Topics • 2018 mini-season wrap-up and 2019 trends – ProxyPulse, a Broadrige + PwC initiative – 2019.

• What investors are expecting from the 2019 proxy season – Jamie Smith, EY – February 12, 2019.

• 2019 proxy season preview – Shirley Westcott, Alliance Advisors. Harvard Law School Forum on Corporate Governance and Financial Regulation – April 15, 2019.

• Coalition of publicly traded companies’ letter to U.S. Securities and Exchange Commission Chairman Jay Clayton – Nasdaq, Inc. – February 4, 2019.

• Keynote remarks: ICI mutual funds and investment management conference – Elad L. Roisman, U.S. Securities and Exchange Commission – March 18, 2019.

Litigation, Research & Regulatory Updates • Securities class action settlements – Laarni T. Bulan, Ellen M. Ryan, Laura E. Simmons, Cornerstone Research. 2018 Review and Analysis – 2019.

• Lorenzo v. Securities and Exchange Commission – Supreme Court of the United States – October, 2018.

• ‘Lorenzo’: what happens next and what to do about it? – Howard Fischer, Moses & Singer. New York Law Journal – April 30, 2019.

• Matthew Sciabacucchi v. Matthew B. Salzberg – in the Court of Chancery of the State of Delaware – December 19, 2018.

• Mathew Martoma v. United States of America – Supreme Court of the United States – May 14, 2019. ESG ACTIVITIES RESEARCH SPOTLIGHT

David F. Larcker and Brian Tayan Corporate Governance Research Initiative Stanford Graduate School of Business KEY CONCEPTS

Environmental, social, and governance (ESG) activities involves activities or investment that companies make to address environmental or social issues that impact the firm from a total stakeholder perspective. – ESG is alternatively referred to as corporate social responsibility (CSR) or socially responsible investing (SRI).

• Potential benefits. – Considers the interests of all stakeholders, not just shareholders. – Can decrease risk by internalizing costs that might damage the firm or its constituents over the long-term.

• Potential costs. – Can reduce value if it requires substantial investment.

Research shows that ESG is modestly associated with higher firm performance. ESG AND FIRM VALUE

• Dowell, Hart, and Yeung (2000) study the relation between corporate commitment to environmental standards and firm value.

• Sample: 89 S&P 500 firms, 1994-1997. Environmental data from IRRC.

• Categorize companies according to whether they adhere to 1. local environmental standards, 2. U.S. standards, or 3. internal standards that are more stringent than any national standard.

• Find that companies that adopt stringent internal standards have higher value (Tobin’s Q) than companies that adopt local or U.S. standards.

• Conclusion: companies committed to the environment perform better.

“This paper refutes the idea that adoption of global environmental standards by [multinational corporations] constitutes a liability that depresses market value.” ESG AND FIRM VALUE

• Lins, Servaes, and Tamayo (2017) study the performance of companies with high CSR scores during the financial crisis.

• Sample: 1,673 nonfinancial firms, 2005-2013. CSR data from MSCI.

• Find that during the crisis, high-CSR firms experienced higher returns, profitability, growth, and sales per employee than low-CSR firms.

• Find no significant associations during the periods before and after the crisis.

• Conclusion: companies committed to CSR have lower risk.

“Trust between a firm and both its stakeholders and investors, built through investments in social capital, pays off when the overall level of trust in corporations and markets suffers a negative shock.” ESG AND FIRM VALUE

• Manchiraju and Rajgopal (2017) study the relation between CSR and firm value in the context of a law that required minimum CSR spending.

• Sample: 2,120 Indian companies, 2009-2013. – Indian Companies Act 2013 required companies meeting certain thresholds for net worth, sales, and profit to spend at least 2% of average profits on CSR activities.

• Find that companies affected by the law declined by a market-adjusted 4.1% over the 4 years between introduction of the bill and final passage.

• Interpret results as evidence that firms choose optimal levels of CSR spending and that mandatory spending beyond this is value decreasing.

• Conclusion: forced CSR spending decreases firm value.

“Mandatory CSR activities can impose social burdens on business activities at the expense of shareholders.” ESG AND FIRM VALUE: ACQUISITIONS

• Deng, Kang, and Low (2013) study the relation between CSR and firm value by examining stock price returns around acquisition announcements.

• Sample: 1,556 successful mergers, 801 firms, 1992-2007. CSR data from KLD.

• Find modest evidence that companies with high CSR scores exhibit: – Higher returns around the announcement (3-day period, but not 5- or 10-day). – Higher long-term operating performance (operating cash flow, 2 years post-merger). – Difference in returns is driven by the fact that firms with low CSR perform below average; high CSR firms do not perform above average.

• Conclusion: companies committed to social goals might perform better.

“Firms that integrate various stakeholders’ interests … ultimately increase shareholder wealth and corporate value.” ESG AND FIRM VALUE: ACQUISITIONS

• Atkas, de Bodt, and Cousin (2011) also study the relation between SRI and firm value by examining merger-announcement and post-merger performance.

• Sample: 106 mergers, 1997-2007. SRI data from Innovest.

• Find that companies that acquire targets with high SRI scores: – Have higher announcement returns (3-day period). – Exhibit an increase in their own SRI score following the announcement (measurement term not specified).

• Conclusion: ESG increases firm value.

“Our results support the idea that the acquirer learns from the target’s SRI practices and experiences, and socially responsible investing pays for acquiring shareholders.” ESG AND FIRM VALUE: ACTIVIST ENGAGEMENTS

• Dimson, Karakaş, and Li (2015) study the impact of activist engagements on firm performance.

• Sample: 2,152 ESG activist engagement, 1999-2009. Proprietary dataset. – Subdivided: 900 governance-related, 1,252 ES-related engagements.

• Find that successful ES-related engagements are associated with: – Positive abnormal returns (7.2% over 18 months). – Improved accounting performance (ROA).

• Conclusion: ESG increases firm value.

“Consistent with arguments that ESG activities attract socially conscious customers and investors, we find that, after successful engagements, particularly for those on ES issues, engaged companies experience improvements in their operating performance, profitability, efficiency, shareholding, and governance.” ESG AND FIRM VALUE: EVENT RETURNS

• Krüger (2015) examines how shareholders respond to CSR-related events.

• Sample: 2,115 events, 745 companies, 2001-2007. Event data from KLD. – “Events” consist of instances where KLD makes positive or negative note of a social, environmental, or product-related occurrence at the company.

• Find that shareholders: – React negatively to negative events (0.9% over 11-day period). (breakdown: no reaction to events related to diversity or human rights; negative reaction to those related to environment, product, community, or employees.) – Have no reaction to positive events.

• Conclusion: some CSR-related events can impact firm value.

“A negative reaction with respect to negative events is consistent with the view that a substantial cost is associated with corporate social irresponsibility.” ESG, FIRM VALUE, AND AGENCY PROBLEMS

• Ferrell, Liang, and Renneboog (2016) study the relations between CSR, agency problems, and firm value.

• Sample: 2,500 global companies, 1999-2011. CSR data from MSCI and Vigeo.

• Find that firms with: – Low agency problems have higher CSR ratings. – Low agency problems and high CSR ratings also have higher value (Tobin’s Q).

• Conclusion: companies committed to CSR do not have higher agency problems.

“Corporate social responsibility … can be consistent with a core value of capitalism, generating more returns to investors, through enhancing firm value and shareholder wealth.” ESG AND FIRM VALUE

• Margolis, Elfenbein, and Walsh (2011) conduct a meta-analysis of the research on CSR and firm performance.

• Sample: 251 studies, 1972-2007.

• Find: – Small positive relation between CSR and firm performance. – Over time, the positive relation declines (i.e., it is more prominent in early studies than later studies).

• Conclusion: CSR might increase value; it does not decrease value.

“After thirty-five years of research, the preponderance of evidence indicates a mildly positive relationship between corporate social performance and corporate financial performance. The overall average effect … across all studies is statistically significant, but, on an absolute basis, it is small.” ESG MUTUAL FUND PERFORMANCE

• Geczy, Stambaugh, and Levin (2005) study the investment returns generated by mutual funds dedicated to socially responsible investing (SRI).

• Sample: 49 SRI funds out of 894 total funds, 1963-2001.

• Find that: – SRI mutual funds have higher annual fees (1.36%) than non-SRI funds (1.10%). – SRI mutual funds have lower performance (0.3% per month). – Shareholders do not receive diversification benefits.

• Conclusion: SRI investments underperform peers. ESG MUTUAL FUND PERFORMANCE

• Renneboog, Ter Horst, and Zhang (2008) also study the performance of SRI mutual funds.

• Sample: 440 SRI mutual funds out of 16,036 funds, 17 countries. 1991-2003.

• Find that: – SRI mutual funds underperform their benchmarks by 2.2% to 6.5% annually. – Risk-adjusted returns in many countries are not significantly different from comparable funds.

• Conclusion: SRI mutual funds might underperform peers.

“It seems that investors pay a price for ethics.” ESG MUTUAL FUND PERFORMANCE

• El Ghoul and Karoui (2017) also study the performance of CSR mutual funds.

• Sample: 2,168 U.S. mutual funds, 2003-2011. CSR data from KLD. – Rather than compare SRI-funds with unconstrained funds, the authors use the CSR ratings of the companies in the portfolio to derive a CSR score for the fund. – CSR is graded on a spectrum, not a binary metric.

• Find that funds with high CSR scores perform worse than those with low scores.

• Conclusion: CSR investments underperform non-CSR investments.

“Our empirical results reveal that the CSR score of the portfolio is negatively related to risk-adjusted performance. … Furthermore, we find that the CSR score negatively predicts future fund performance.” ESG: EQUITY AND CREDIT PERFORMANCE

• Gerard (2018) conducts a literature review of the research on ESG, including equity and fixed income performance.

• Sample: 55 studies, 2000-2018.

• Finds that: – High ESG scores are related to higher profitability and stock value (Tobin’s Q). – Relation between ESG scores and fixed income price and risk is mixed. – Positive performance differentials recorded in the 1990s decreased in the early 2000s and disappeared in the 2010s.

• Conclusion: companies committed to ESG perform better and have lower risk but their actions are largely priced into securities markets. CONCLUSION

• The research generally shows that companies committed to environmental and social goals have better performance and lower risk.

• The relations in most studies are modest.

• Research generally suffers from a problem of causality: does a commitment to environmental or social goals make companies more profitable, or are more profitable companies able to spend more on these activities?

• Socially responsible investing is associated with lower risk-adjusted returns; any corporate benefit to ESG is priced in the market.

• It is not clear that the metrics that third-party firms develop to measure companies on ESG dimensions are accurate or reliable. BIBLIOGRAPHY

Glen Dowell, Stuart Hart, and Bernard Young. Do Corporate Global Environmental Standards Create or Destroy Market Value? Do Corporate Global Environmental Standards Create or Destroy Market Value? 2000. Management Science.

Karl V. Lins, Henri Servaes, and Ane Tamayo. Social Capital, Trust, and Firm Performance: The Value of Corporate Social Responsibility During the Financial Crisis. 2017. Journal of Finance.

Hariom Manchiraju and Shiram Rajgopal. Does Corporate Social Responsibility (CSR) Create Shareholder Value? Evidence from the Indian Companies Act 2013. 2017. Journal of Accounting Research.

Xin Deng, Jun-koo Kang, and Buen Sin Low. Corporate Social Responsibility and Stakeholder Value Maximization: Evidence from Mergers. 2013. Journal of Financial Economics.

Nihat Atkas, Eric de Bodt, and Jean-Gabriel Cousin. Do Financial Markets Care about SRI? Evidence from Mergers and Acquisitions. 2011. Journal of Banking & Finance.

Elroy Dimson, Oğuzhan Karakaş, and Xi Li. Active Ownership. 2015. Review of Financial Studies

Philipp Krüger. Corporate Goodness and Shareholder Wealth. 2015. Journal of Financial Economics.

Allen Ferrell, Hao Liang, and Luc Renneboog. Socially Responsible Firms. 2016. Journal of Financial Economics.

Joshua D. Margolis, Hillary Anger Elfenbein, and James P. Walsh. Does It Pay to Be Good… and Does It Matter? A Meta-Analysis of the Relationship Between Corporate Social and Financial Performance. 2011. Social Science Research Network. BIBLIOGRAPHY

Christophe C. Geczy, Robert F. Stambaugh, and David Levin. Investing in Socially Responsible Mutual Funds. 2005.

Luc Renneboog, Jenke Ter Horst, and Chendi Zhang. The Price of Ethics and Stakeholder Governance: The Performance of Socially Responsible Mutual Funds. 2008. Journal of Corporate Finance.

Sadok El Ghoul and Aymen Karoui. Does Corporate Social Responsibility Affect Mutual Fund Performance and Flows? Journal of Banking & Finance.

Bruno Gerard. ESG and Socially Responsible Investment: A Critical Review. 2018. Social Science Research Network.

Posted by Peter Atkins, Marc Gerber and Richard Grossman, Skadden, Arps, Slate, Meagher & Flom LLP, on Thursday, October 18, 2018

Editor’s note: Peter Atkins, Marc Gerber and Richard Grossman are partners at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden memorandum by Mr. Atkins, Mr. Gerber, and Mr. Grossman. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here) and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

The question whether a public for-profit company can “do good” and make money at the same time has never been more relevant. Public companies are being bombarded with messages, requests and demands around “ESG”—environmental, social and governance—matters. These come from shareholders, asset managers, special interest groups, activist investors, private equity funds, ESG rating firms, trade groups, politicians, regulators, academics and others. They take a variety of forms, including shareholder proposals, surveys and questionnaires, letter writing campaigns, proxy voting policies, investor stewardship reports, speeches, white papers, academic studies, and legislation. Topics covered (putting aside the “G”—the governance issues with which boards are likely to be familiar) are numerous and varied, including sustainability, climate change, water management, human capital management, gender pay equity, board and workforce diversity, supply chain management, political and lobbying expenditures, the opioid crisis, and gun control. Boards of directors and management of public companies need to understand the increasing importance of this ESG landscape in which the company and investors are operating, including the growing prominence of ESG investing, the company’s environmental and social (E&S) profile and vulnerabilities, and the path forward for the company as it deals with particular E&S issues.

This post briefly summarizes some of the key trends of the rapidly evolving E&S landscape of which directors and company management should be aware. In addition, it highlights a corporate law framework that has particular relevance for directors of companies incorporated in states such as Delaware that follow a shareholder primacy model—that shareholder welfare is the sole goal of directors, and that other interests may be taken into account only to further that goal.

ESG Investment. Recent reports place the level of ESG-focused investment at approximately $20 trillion of assets under management. New ESG funds and ETFs are being launched on a regular basis and with increasing frequency, and studies show that millennials have a greater interest in socially responsible investing. Within this umbrella, ESG investing can take various forms, for example making investments in companies viewed as positively addressing environmental or social issues, choosing to exclude companies in certain industry sectors viewed as problematic from an ESG perspective, or integrating ESG data into an assessment of risk- adjusted returns in order to make investment decisions.

1 The demand for ESG investment approaches has spurred a number of traditional investors, activist funds and private equity funds to enter this space. For example, in January 2018, ValueAct Capital launched its Spring Fund to invest in companies addressing environmental and societal problems and capture the excess returns it believes will be generated thereby. Another activist investor, Jana Partners, is reported to have hired staff for a new socially responsible fund to be named Jana Impact Capital. Also, recent reports indicate that private equity firm TPG is raising $3 billion for its second social impact fund, after previously raising a $2 billion fund focused on investments with positive social and environmental impacts.

ESG Ratings. An inevitable corollary of the increase in ESG-focused investment is the demand by those investors for ESG data and the corresponding and exponential growth in the number of entrants into the business of collecting, aggregating, synthesizing and ranking that data. The challenge is that each ESG ratings provider has its own methodology, and a company may receive widely divergent ratings from different organizations. Moreover, the ESG rating agencies may use different combinations of data sources other than company disclosures, including press reports, litigation filings, internet postings and other third-party sources, even though the company may not agree with the veracity or accuracy of those data sources.

It is possible that, over time, some ratings methodologies may prevail over others and the field will narrow to two or three dominant raters, as is the case in the governance space with ISS and Glass Lewis. And ISS and Glass Lewis are attempting to protect their turf by also including E&S ratings in their reports. In February 2018, ISS announced the launch of its E&S QualityScore, which seeks to analyze company disclosure across more than 380 factors organized into four environmental pillars and four social pillars. ISS includes those scores in its annual meeting voting recommendations report, and in May 2018 expanded its E&S coverage to 4,700 companies. Recently, Glass Lewis announced that guidance on material ESG topics from the Sustainability Accounting Standards Board would be integrated into its proxy research reports and vote management application.

ESG Activism. On January 6, 2018, activist Jana Partners and the California State Teachers’ Retirement System (CalSTRS) published an open letter to Apple Inc. The letter expressed their view that Apple needed to offer parents more tools to protect children and to ensure that young customers use Apple products in an appropriate manner. Citing various studies regarding potential negative consequences of children’s use of smart phones, the letter linked the issue to Apple’s long-term value and called on Apple to take various steps to address the issue. Days later, Apple announced that it would introduce new features and tools to assist parents in combating children’s overuse of smart phones. It remains to be seen whether other traditional activist investors, seeking to attract ESG-focused capital, launch similar ESG-themed campaigns.

ESG activism can also take the form of industry-wide or issue-specific campaigns. For example, a coalition of 30 treasurers, asset managers, and faith-based, public and labor funds formed Investors for Opioid Accountability and filed shareholder proposals on board oversight of business risks related to opioids at 10 companies involved in the manufacturing or distribution of opioids. Recently, another group of investors launched a resource to evaluate and act on water risks in investment portfolios, including tips on engaging with companies and on water-related shareholder proposals.

2 ESG Shareholder Proposals. According to ISS data, for 2017 and year-to-date 2018, proposals relating to E&S now make up a majority of all shareholder proposals submitted to US companies, at 53.4 percent and 54.4 percent, respectively. ISS reports that the median vote results year-to- date are at a record high of 23.4 percent, but it is noteworthy that median results for some topics are significantly higher—41.4 percent for sustainability reporting and 36.4 percent for workforce diversity. In a turning point, in 2017, climate change proposals relating to two degree Celsius scenarios received majority support for the first time, at three different companies. Other 2017 majority-supported E&S proposals related to sustainability reporting and board diversity. This year appears to have set a new record, with 10 E&S proposals receiving majority support year-to- date: two on climate change, two on sustainability reporting, three on other environmental topics, one on governance measures related to managing the opioid crisis risk and two calling on gun manufacturers to produce reports on gun safety measures.

Perhaps in recognition of these increasing levels of support, 2018 has been noteworthy for the increased withdrawal rate, with almost half of all E&S proposals submitted being withdrawn. Based on various reports and anecdotal evidence, it is likely that a large portion of the withdrawals were the result of company engagement with proponents and reaching satisfactory agreement for the company to take some action or make some additional disclosure.

Company Actions. In the financial activist space, the advice that has crystallized over the past few years is to look at your company the way an activist and/or a long-term shareholder would; anticipate and analyze the potential criticisms and be ready to respond; engage with institutional investors to learn their views and establish the board’s and management’s credibility with them; and communicate the company’s business strategy, and the board’s role in overseeing the development and execution of that strategy, clearly and coherently, to build support before an activist shows up.

It turns out that there are many parallels in the ESG space and, as described above, the lines between financial activists and ESG activists may continue to blur. As a result, a company’s ESG vulnerability and profile may need to be given appropriate attention alongside traditional valuation and operational metrics.

Shareholder Primacy as a Guidepost. ESG should not be perceived as divorced from traditional economic metrics. At least for companies incorporated in states such as Delaware, that are subject to a fiduciary model of shareholder primacy—where the ultimate priority is the preservation and enhancement of shareholder welfare—boards should consider whether there is a nexus (and, if so, how strong) between specific ESG issues and the pursuit of shareholder welfare. The starting point involves consideration of ESG in light of the company’s business strategy, which is the driver of shareholder value, the dominant component of shareholder welfare. Questions may include: Will addressing ESG topics allow the company to satisfy growing consumer trends and increase sales? Will addressing other ESG factors position the company to have a better workforce and decrease worker attrition and the related costs?

Even in those cases where a particular ESG matter does not fit directly within a company’s business strategy, a company may need to consider whether inaction or a failure to be responsive to an issue presents risks to a company. These might include negative perceptions by consumers, regulators, employees or the public that could lead to a boycott of the company’s

3 products, regulatory intervention, active employee protest or morale decline, negative publicity, or other forms of harm to the company’s ability to compete and produce shareholder value.

The rise in ESG investing presents new risks and perhaps opportunities. ESG investors’ dissatisfaction with a company’s ESG policies (or lack thereof) or responsiveness may have significant adverse effects. In particular, this could include loss of interest in the company as an investment or, perhaps, initiation of a public campaign, submission of shareholder proposals, or an election contest or a “vote no” campaign focused on changing the company’s ESG position. On the positive side, understanding and anticipating ESG issues that may be promoted by investors might attract positive interest in the company and support from such investors.

These and many other potential questions are strategic decisions—like any other business strategy decisions—and as such are subject to board oversight. And once the board and management determine how, if at all, ESG factors align with that business strategy or are otherwise appropriate topics for action to preserve or enhance shareholder welfare, the board needs to determine the level of corporate investment appropriate in light of the expected returns (or losses avoided), how to measure success and how to incentivize management accordingly. Shareholder engagement then presents a forum to understand the concerns of investors and how they view the company, as well as to explain ESG in the context of that business strategy and the board’s oversight role. It then becomes critical for the company to communicate, whether in annual reports, proxy statements, sustainability or corporate social responsibility reports, or other public statements, its approach to ESG matters as part of its overall business strategy.

Over the years there has been a debate, which continues loudly today, about whether directors can or should consider the interests of non-shareholder constituencies. The Chief Justice of the Delaware Supreme Court, Leo E. Strine, Jr., has made clear where Delaware law stands on the subject:

“[A] clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare.”1

ESG issues can be presented as having, and often do have, an “other, non-shareholder constituency” character. However, the context today is quite different than during the 1980s, which witnessed the rise of corporate constituency statutes that have been adopted by more than 30 states. That difference is manifested by the concentration of U.S. public company ownership in a relatively few institutional asset managers, the active and growing support from those entities (and from other equity owners) for environmental and social responsibility by public for-profit companies, and the heightened level of consciousness in the media, academia and general population regarding the demand for ESG responsibility by public for-profit companies.

To borrow a phrase from then-Justice Andrew Moore of the Delaware Supreme Court, in his 1985 Revlon decision, directors would appear to have wide latitude—and responsibility—for dealing with ESG issues to the extent they represent matters “rationally related [to] benefits

1 Leo E. Strine, Jr., “The Dangers of Denial: The Need for a Clear-Eyed Understanding of the Power and Accountability Structure Established by the Delaware General Corporation Law,” 50 Wake Forest Law Review 761,771 (2015).

4 accruing to the stockholders.” That said, it is incumbent on directors to do their homework and apply appropriate processes to establish informed decision-making regarding that key determination—which also will enable them to defend challenges to spending shareholder money on “causes” that not all shareholders may support and to demonstrate to the “new” shareholder constituency, ESG investors, the attention paid to the subject at the board level.

Beyond that, of course, are a myriad of other important and potentially difficult decisions that may be required. These may include: Whether, when, to whom and how to engage in outreach regarding ESG issues. Choosing among ESG matters. Deciding how, how much and when to spend company resources to support selected ESG matters. How and when to communicate choices made and actions taken.

In the end, although more consequential than ever, these are board decisions just like others, requiring the exercise of business judgment in the best interests of the company and its shareholders.

5 EXPLORING ESG: A Practitioner’s Perspective JUNE 2016

Introduction Investors consider a variety of factors when determining the long-term value of a company. Public records such as annual reports and earnings statements have served as the traditional source of this information, helping investors discern the effects of macroeconomic and company-specific issues on valuations. However, with the amount of and access to information expanding significantly in recent years, more and more investors have new types of data to glean investment Barbara Novick Deborah Winshel insights. Vice Chairman Global Head of BlackRock Impact Environmental, social, and governance (ESG) factors are one such type of information gaining in prominence and consideration among mainstream investors globally. ESG data spans a range of issues, including measures of company carbon emissions, labor and human rights policies, and corporate governance structures. Policy makers, asset owners1, and the public at large are focused on ESG factors as a means to promote sustainable business practices and products. Investment professionals increasingly see its potential links to company operational strength, efficiency, and management of long-term financial risks.2 Michelle Edkins Kevin G. Chavers Nonetheless, there is still much ambiguity as to what exactly is meant by ESG, and Global Head of Government Relations Investment Stewardship & Public Policy how investors can gather relevant ESG data and apply this information in the investment process.

This ViewPoint sets out BlackRock’s views on ESG issues from the. perspective of a fiduciary investor acting on behalf of asset owners, in this particular instance focusing specifically on corporate equities and debt. We define three areas in which investment managers integrate ESG factors, and our views on how ESG factors contribute to long-term value. We move to describe the current landscape of ESG disclosure initiatives across organizations and regulatory bodies. As a Zachary Oleksiuk John McKinley result of the challenges associated with assembling and evaluating ESG Investment Stewardship BlackRock Impact information, we conclude with our recommendations for policy makers to promote the standardization of ESG metrics and disclosure requirements.

SUMMARY OF POLICY RECOMMENDATIONS Policy makers should focus on establishing a framework that enables stakeholders and market participants to develop detailed ESG standards and best-practice guidelines. 1. Encourage standardized ESG disclosure within a consistent global reporting framework, similar to international accounting standards, by: a. Recognizing the importance of identifying and managing ESG risks and opportunities as a component of investment analysis. b. Understanding the distinction between social, mission or “values” driven goals and investment (“value”) goals. c. Promoting clear and consistent definitions of ESG and developing a common lexicon. d. Providing guidance that recognizes the need to tailor reporting to industries. 2. Establish safe harbor provisions that ensure companies who initiate ESG factor reporting do not face retrospective litigation. 3. Ensure regulation is designed and implemented to achieve policy objectives, rather than result in unnecessary disclosure. 4. Review, understand, and remove barriers to ESG factor integration and reporting by investors and companies. 5. Clarify how ESG considerations are part of investors’ and companies’ fiduciary duties. 6. Require investors to report whether they integrate ESG factors in their investment analysis and, if so, their approach to integrating them as well as stewardship activities.

The opinions expressed are as of June 2016 and may change as subsequent conditions vary. The ESG Lexicon Exhibit 1). Investment managers can apply ESG screens, or remove a particular ESG factor from a The term ESG has become a catchall phrase that often portfolio at a client’s request. This can include screening means different things to different stakeholders. This has out companies that have significant labor law violations, created the need to better define what is meant by ESG with for example. Another common approach to incorporate respect to investing. Broadly speaking, ESG refers to the ESG into sustainable investment product is to maximize integration of environmental, social, and governance factors exposure to highly-rated ESG companies, which can be in the investment process. Today, investors can integrate done through a broad or narrow approach. A broad ESG factors in three primary ways: (1) traditional investing, approach would attempt to maximize a fund’s average (2) sustainable investing, and (3) investment stewardship: ESG score while maintaining characteristics of a 1. ESG integration in traditional investing is the inclusion of traditional market-cap weighted benchmark, while a environmental, social, and governance factors into narrow approach may focus specifically on companies financial analysis to evaluate risks and opportunities. The that have low carbon emissions. intended purpose is not to apply social values to 3. Investment stewardship, or corporate governance, is investment decisions, but to consider whether ESG engagement with companies to protect and enhance factors contribute to or detract from the value of a given the value of clients’ assets. Through dialogue and investment opportunity.3 An example of integration entails proxy voting, investors engage with business leaders a fundamental active equity portfolio manager evaluating to build a mutual understanding of the material risks various ESG risks of their portfolio, such as the risk of facing companies and the expectations of regulatory action due to a company’s environmental track management to mitigate these risks. Hence, record, to inform their investment views and positioning. identifying and managing relevant ESG risks are an 2. Sustainable investing refers to the explicit incorporation important component of the engagement process and of ESG objectives into investment products and to encouraging sustainable financial performance over strategies. The spectrum of sustainable investment the long-term.4 strategies has evolved over several decades and can be defined by three core segments, which reflect the wide BLACKROCK INVESTMENT STEWARDSHIP, ESG range of investors’ objectives from removing specific AND LONG-TERM PERSPECTIVE sectors to targeting positive social and environmental As a fiduciary to our clients, BlackRock has a outcomes. ESG factors can inform the construction of responsibility to protect and enhance the value of assets sustainable investing product in a number of ways (see entrusted to us. The Investment Stewardship team contributes to this by engaging in thousands of conversations with companies each year on factors that EXHIBIT 1: ESG FACTORS IN SUSTAINABLE are relevant to long-term economic performance. INVESTMENT PRODUCT CONSTRUCTION Environmental, social, and governance issues are Description Example integral to our investment stewardship activities, as the majority of our clients are saving for long-term goals. It is Exclusionary Removing specific Religious institution over the long-term that ESG factors – ranging from Screens companies or excludes tobacco, industries not aligned weapons, alcohol and climate change to diversity to board effectiveness – have with investors’ values gambling across its real and quantifiable financial impacts. Our risk analysis or mission portfolio extends across all sectors and geographies, helping us identify companies lagging behind peers on ESG issues. ESG Evaluating companies Pension fund We seek to engage companies on these issues on behalf Investments along ESG measures optimizes for high of our investors, irrespective of whether a holding is held and weighting ESG exposure while portfolios to increase minimizing tracking in an active or a passive portfolio. exposure to best-in- error to a standard Engagement allows us to both share our philosophy and class companies benchmark approach to investment stewardship and understand how a company’s governance and management structures Targeting specific High-net worth Impact support operational excellence. As a long-term investor, Investments social or investor seeks to environmental reduce carbon we are patient with companies, giving them time to outcomes alongside emissions through change on their own terms, but also persistent to ensure financial returns investment in they adopt sound practices that in our view support long- renewable power fund term value creation.

[ 2 ] Our View of ESG Factors When determining the long-term value of a company’s But relevance is key. Recent work suggests that firms with security, an enterprising investment analyst will often ask: good ratings on material sustainability issues significantly what factors will differentiate this company’s performance outperform firms with poor ratings on these issues.8 In from its peers? How does the company earn the trust and contrast, firms with good ratings on immaterial sustainability support of customers, employees, regulators, and other issues do not significantly outperform firms with poor ratings stakeholders? Does the company ensure efficient production on the same issues. Thus, there are no standard ESG factors processes that minimize or optimize the use of scarce (and that apply universally across companies, just as there are no expensive) natural resources? How do management and the universal non-ESG management factors that indicate board maintain credibility with investors to ensure reliable and potential performance – ESG factors need to be considered affordable capital? for their relevance to specific industries and companies.

While ESG information alone will not answer these questions, it can be meaningfully accretive to fundamental financial and INTEGRATING CARBON RISK FACTORS investment analysis. How a company manages the Amongst the array of ESG issues, climate change has environmental (E) and social (S) aspects of its business – emerged as a mainstream investment consideration. those that are relevant to performance and value creation – is Following the COP21 Paris climate conference, more and a signal of how well the company is run and its long-term more investors are integrating carbon emissions data financial sustainability. Corporate governance (G) – including across their traditional investing, sustainable investing, board composition and its role in shaping and overseeing and investment stewardship functions. This year, 10% of strategy – is another signal of the quality of leadership and the world’s 500 biggest investors reported measuring the management. Examining ESG factors can therefore support carbon footprint of their portfolios in an effort to manage and enhance traditional financial analysis. risk, up from 7% in 2015. Over the same period, dedicated low carbon investments by this group grew The best companies strategically manage all aspects of the 63% to $138B, and investors voting in favor of at least business and ensure that their investors, as well as other one shareholder resolution on climate change grew to constituents of the company, have enough information to 12%, up from 7% the year prior.9 understand the drivers of, and risks to, sustainable financial performance. For example, a beverage company might Integration of emissions data reflects the growing desire manage, measure, and report on its access to clean water – to better understand and manage climate-related risks. an input to production as well as a social and environmental Although increasing in popularity, investor challenges factor. Companies that manage relevant ESG issues well remain, as the ability to assess relevant carbon risk tend to quickly adapt to changing environmental and social factors is dependent on forecasting the risks imposed by trends, use resources efficiently, have engaged (and, new climate-related policies and the availability and therefore, productive) employees, and can face lower risks of quality of data. A number of industry bodies have regulatory fines or reputational damage. emerged to measure and collect material climate information, but large gaps remain. In the following In fact, an analysis of more than 160 academic studies section we examine the current state of carbon, in demonstrates that companies with high ratings on ESG addition to broad ESG data disclosure and collection. factors have a lower cost of capital,5 while separate research finds that greater transparency of public companies in disclosing non‐financial (ESG) data results in lower volatility.6 Hence, investment managers that have examined and integrated this information into their processes have benefited. 2014 Research in the Journal of Investing points to advantages of ESG integration in the investment process, finding that active managers can utilize the association between corporate ESG ratings and stock return, volatility and risk, to enhance their stock-picking and portfolio construction ability. 7

[ 3 ] Exhibit 2: HISTORY OF ESG INTEGRATION AND INVESTMENT

Source: “Ethical Screening in Modern Financial Markets” Michael Knoll, UN PRI https://www.unpri.org/, Global Sustainable Investment Alliance 2014 Review, United States Department of Labor https://www.dol.gov/ebsa/, COP21 UNEP http://www.cop21paris.org, California Department of Insurance http://www.insurance.ca.gov/.

The Current State of ESG Disclosure Principles for Responsible Investment (PRI): an investor- sponsored initiative in partnership with UNEP Finance After decades of increasing interest in ESG from various Initiative10 and UN Global Compact.11 Sets forth six voluntary stakeholders (see Exhibit 2), a critical mass of data and and aspirational investment principles that offer possible practitioner experience are emerging. The landscape has actions for incorporating ESG issues into investment practice. shifted such that some companies are now explicitly Launched in 2006.12 identifying, managing, and reporting on ESG issues, with various market participants collecting and disseminating the CDP (formerly the Carbon Disclosure Project): an NGO data. The practitioner-led efforts to establish ESG reporting that collects company-reported climate change, water, and frameworks and analytical guidance are becoming more forest-risk data. Works with global institutional investors refined given years of collective, practical experience within holding $95 trillion in assets, thousands of companies, and the market. Third party investment research providers are local and national governments to address related risks and expanding their offerings to include ESG alongside more opportunities.13 traditional investment analysis – all with a view towards economic materiality. Global Reporting Initiative (GRI): an international independent organization that helps businesses, Despite progress, these efforts are working against long- governments, and other organizations understand and established corporate disclosure practices. Companies do not communicate the impact of business on critical sustainability typically talk in terms of “ESG;” they have their own issues such as climate change, human rights, corruption and terminology. Corporate social responsibility (CSR), corporate many others.14 The GRI in 2013 released its fourth generation citizenship, and sustainability are a few commonly used of reporting guidelines (G4), listing over 400 indicators on terms in the corporate world. Companies face a distinct corporate sustainability performance.15 The GRI serves a challenge in that different issues will be important to different broad range of stakeholders and includes factors that go stakeholders. In our experience, current corporate beyond investment-related issues. sustainability reporting often includes disclosure about factors that, while honorable, are less relevant to investment decision International Integrated Reporting Council (IIRC): a global making (e.g., corporate philanthropy). As a result, current coalition of regulators, investors, companies, standard setters, reporting practices may make it difficult to identify investment the accounting profession, and NGOs. The coalition is decision-useful data (e.g., water usage and risks in the promoting communication about value creation as the next 16 aforementioned beverage company example). step in the evolution of corporate reporting.

To facilitate the consistent disclosure and integration of Global Impact Investing Rating System (GIIRS): a project material ESG factors by companies and asset managers, a of the non-profit B Lab, assesses the social and number of organizations have emerged. Below we provide a environmental impact of companies and funds. Each brief summary of select major ESG standards initiatives: company receives an overall score and two ratings; one for its impact models and one for its operations (ESG standards).17

[ 4 ] Sustainable Stock Exchanges (SSE): a peer-to-peer In addition to industry bodies, market data providers have learning platform for exploring how exchanges, in entered the space, seeing a competitive opportunity to develop collaboration with investors, regulators, and companies, can ESG assessments of companies and investment funds. MSCI enhance corporate transparency – and ultimately ESG Research22 and Sustainalytics are two of the more performance – on ESG issues and encourage sustainable prominent providers of ESG performance evaluation. This year, investment. The SSE is organized by the UN Conference on both MSCI ESG and Morningstar, in partnership with Trade and Development (UNCTAD), the UN Global Compact, Sustainalytics, published ESG and sustainability scores on over the UN Environment Program Finance Initiative (UNEP FI), 20,000 mutual funds and ETFs. In addition to differences in data and the Principles for Responsible Investment.18 coverage (e.g., by asset class and market capitalization), they and other sources of company ESG ratings measure different Ceres: a non-profit organization advocating for sustainability leadership, comprising a network of investors, companies, aspects of company sustainability, including through sometimes and public interest groups. Seeks to accelerate and expand conflicting evaluation methodologies and data inputs. Just as the the adoption of sustainable business practices and solutions range of investment research philosophies demonstrates there is to build a healthy global economy.19 no single way to predict company financial performance, no single approach to evaluate the ESG performance of companies Financial Stability Board (FSB): comprised of G20 members or funds has emerged. and chaired by Mark Carney, has established an industry-led Task Force, chaired by Michael Bloomberg, to report by the From a public policy perspective, there has been increased focus end of 2016 disclosure standards for companies on climate- encouraging the integration of ESG factors as a core part of related issues. This is to enable investors and policy makers investment processes. While ESG is clearly not new to the public to better incorporate this into their long-term decision- policy arena, we have observed a new impetus to establish making.20 market-level policies that advance ESG practices, even at the Sustainability Accounting Standards Board (SASB): an regional and global level. The list of global initiatives set forth independent non-profit whose mission is to develop and below and detailed in the Appendix highlights a number of the disseminate sustainability accounting standards that help US separate initiatives in place to address a breadth of ESG-related public corporations disclose material, decision-useful investment issues. information to investors. Standard setting occurs through One catalytic public policy initiative was the build up to, and evidence-based research and broad, balanced stakeholder output of, the Paris Climate Conference (Conference of Parties 21 participation. 21 or COP21), held in December 2015. The goal of this meeting was to reduce greenhouse gas emissions in order to limit global SUSTAINABILITY ACCOUNTING STANDARDS temperature increases. The resultant COP21 Agreement23, BOARD (SASB) signed by over 170 nations, sets a goal of limiting average global The SASB in the US is a preeminent example of an temperature rise to 2 degrees C above pre-industrial levels while industry body seeking standardized ESG disclosures that pursuing efforts to limit the increase to 1.5 degrees C. Achieving are relevant to business performance. SASB is an this requires national emissions reductions of increasing independent non-profit whose mission is to develop and stringency and the monitoring and reporting of progress. Focus disseminate sustainability accounting standards that help now turns to government plans to meet their respective goals, public corporations disclose material, decision-useful and the implications for carbon intensive industries. International information to investors. That mission is accomplished organizations – namely the G20 and OECD – are examining the through a rigorous process that includes evidence-based role ESG factors will play in financing broader climate change research and broad, balanced stakeholder participation. objectives. The OECD is looking specifically at investment  Through 2016, SASB is developing sustainability governance, and whether existing fiduciary standards sufficiently accounting standards for more than 80 industries in 10 incorporate climate-related risks. sectors.  SASB standards are designed for the disclosure of INVESTOR STATEMENT ON CLIMATE CHANGE material sustainability information in mandatory SEC BlackRock signed the 2014 Global Investor Statement on filings, such as the Form 10-K and 20-F. Climate Change. We believe that the emphasis on having a  SASB is an ANSI accredited standards developer. long-term, predictable policy framework is important to long-  SASB is not affiliated with FASB, GASB, IASB or any term investors seeking to incorporate environmental other accounting standards boards. considerations in their analysis and decision-making. A more certain policy framework and long-term approach from See Exhibit 3 for the SASB Materiality Map, an interactive governments is necessary for well-informed capital allocation tool that identifies and compares likely material decisions to be taken by investors and companies. sustainability issues across different industries and sectors.

[ 5 ] EXHIBIT 3: SASB MATERIALITY MAP Identifies and compares likely material sustainability issues across different industries and sectors Renewable Renewable - Health Care Financials andTechnology Communications Non Resources Transportation Services Resource Transformation Consumption Renewable & Resources Energy Alternative Infrastructure

Environment GHG emissions Air quality Energy management Fuel management Water and wastewater management Waste and hazardous materials management Biodiversity impacts Social Capital Human rights and community relations Access and affordability Customer welfare Data security and customer privacy Fair disclosure and labeling Fair marketing and advertising Human Capital Labor relations Fair labor practices Employee health, safety and wellbeing Diversity and inclusion Compensation and benefits Recruitment, development and retention Business Model and Innovation Lifecycle impacts of products and services Environmental, social impacts on assets & operations Product packaging Product quality and safety Leadership and Governance Systemic risk management Accident and safety management Business ethics and transparency of payments Competitive behavior Regulatory capture and political influence Materials sourcing Supply chain management

Sector Level Map Key Issue is likely to be material for more than 50% of industries in sector Issue is likely to be material for less than 50% of industries in sector Issue is not likely to be material for any of the industries in sector

[ 6 ] EXHIBIT 4: GLOBAL INITIATIVES COVERING ELEMENTS OF ESG INVESTING AS OF MAY 2016

ORGANIZATION INITIATIVE

UN Principles for Responsible Investment (UNPRI)

United Nations UN Environment Programme (UNEP)

UN Green Climate Fund

G20 Green Finance Study Group G20 Global Infrastructure Hub

High-Level Principles on Long-Term Investment OECD Work stream on Governance and Fiduciary Duty

Financial Stability Board (FSB) Task Force on Climate-Related Financial Risks

EU Energy Union

EU Capital Markets Union

European Find for Strategic Investments (EFSI) European Union EU Non-Financial Reporting Directive

ESG and Fiduciary Duty initiatives

Product disclosure initiatives

Vandebroucke Law (2003) Belgium Laws against financing of landmines and cluster munitions (2007)

Denmark Amendment to the Danish Financial Statements Act

Grenelle Law II, Articles 224 and 225 France Energy Transition for Green Growth Law, Article 173

The Renewable Energy Act Germany Amendment in regulations concerning pensions funds

Mandatory disclosure of ESG for pension funds Italy New measure on pension funds’ investment policy

Netherlands Green Investment Directive

Norway Norwegian Act on Annual Accounting

Sustainable Economy Law – Mandatory disclosure of ESG Spain Law modernising Spain’s Social Security System

Mandatory Disclosure of ESG for pension funds Sweden Public Pension Funds Act

United Kingdom Amendments to 1995 Pensions Act: Pension disclosure regulation

Hong Kong Social Innovation and Entrepreneurship Development Fund (SIE Fund)

Indian Ministry of Corporate Affairs’ new Corporate and Social Responsibility policy under the India Companies Act 2013

Japan Principles for Financial Action for the 21st Century

Philippines National Renewable Energy Program 2011-2013

Vietnam Climate Investment Funds’ Clean Technology Fund

Thailand Feed-in premium program

[ 7 ] Looking regionally, Europe could be a bellwether for Current Challenges legislative action. On the company side, the EU’s Non- Despite the myriad of standards and initiatives, more work Financial Reporting Directive provides a legislative framework needs to be done. The variety of market data providers’ to require public companies to disclose a range of methodology and the lack of ESG disclosure standards information, including ESG factors. As part of the contribute to corporate complaints of survey fatigue and to implementation process, the European Commission has investor challenges identifying the most material ESG issues. sought the views of investors on what types of ESG As an investor, we value the efforts to date to disclose and information they find important to investment decisions. On aggregate ESG data. However, we caution that the the investor side, the EU Shareholder Rights Directive, information is still in an early stage with discrepancies in currently under consideration, would mandate institutional quality and coverage, and the variety of providers may create investors to disclose more information on their investment more confusion than clarity. Three key challenges of the stewardship and engagement policies, with some focus on current state of ESG disclosure include: ESG factors. 1. Reliance on self-reported data to questionnaires and Policy makers in other regions are similarly active on ESG. industry bodies As of January 1, 2016, in Canada, the amended Ontario Company disclosed information is sparse and disparate Pension & Benefit Act requires certain pension plans to across industries and regions. The reliance on self- disclose whether ESG factors are incorporated in pension reported data to private aggregators allows companies to funds’ investment policies and procedures. In the United disclose favorable data or opt out completely. States, publicly traded companies are required, as of 2010, to Furthermore, there is no accountability or overarching disclose material business risks that climate change governing body ensuring accuracy of reported information. developments may have on their business. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires 2. Inconsistent collection, management, and distribution US companies also disclose information regarding mine of ESG data safety and conflict minerals in supply chains. Finally, the ESG data is collected, managed, and dispersed by Department of Labor in the US issued 2015 guidance stating, multiple data providers and is not easily accessible to all in part, that pension fund fiduciaries can consider ESG investors in a standard form. This creates a challenge for factors in their investment decisions, acknowledging that investment professionals attempting to systematically ESG factors may have a direct relationship to the financial compare companies across industries and regions, either value of an investment.24 in real time or over historical time periods.

Stock exchanges are often in a unique position at the 3. Disparate approaches to measure and report ESG intersection of public and private ownership to collaborate information to investors with their global peers to establish consistent guidance and Due to different methodologies and disclosures, index structures across markets. Several have adopted listing rules providers and asset managers report ESG considerations on ESG or sustainability reporting. In South Africa, the inconsistently, creating challenges for investors seeking to Johannesburg Stock Exchange requires companies to compare ESG investment strategies, objectives and comply with the principles of the King Code on Corporate outcomes consistently. Governance, including, as of 2010, a recommendation that companies integrate their approach to and reporting on risks Policy Recommendations and Conclusion and opportunities across financial and sustainability There is a need for comprehensive, standardized, and considerations.25 Similar to the Brazilian BM&FBOVESPA comparable data to accurately measure how companies are exchange, the Australian Securities Exchange recommends, managing relevant ESG issues. We note that although setting as of 2014, listed entities to disclose any material exposure to international reporting standards can be a generations-long economic, environmental and social sustainability risks and, if process, the results can be meaningful and lasting for the it does, how it manages or intends to manage those risks.26 investment industry. For example, efforts to drive The Hong Kong Stock Exchange requires companies to convergence of international accounting standards that first report on ESG issues on a comply or explain basis.27 The arose in the late 1950s involved numerous standard-setting stock exchanges in Singapore and Malaysia28 have indicated bodies that continue to this day.31 However, now, if an their intention to use listing requirements to improve investor wants to compare the financial performance of, for sustainability reporting.29 The World Federation of example, the telecom companies in Singapore, the US and Exchanges30 could play a role in coordinating peer Spain, they can rely on a set of those widely understood exchanges to follow suit in order to avoid a patchwork of 100 international accounting standards. This is not the case if they different ESG reporting regimes. want to compare the carbon dependency, employee turnover levels, or the number of independent directors of those companies. Accordingly, it is necessary to coordinate and consolidate a standardized ESG factor reporting framework.

[ 8 ] We see the potential over time for convergence towards a 2. Establish safe harbor provisions that ensure that more holistic, integrated approach to managing, reporting, companies which initiate ESG factor reporting do not face and analyzing business performance. Although some retrospective litigation, as the underlying ESG factors that companies now issue a separate sustainability report, we may be material to the investment decision or relevant to believe that ESG issues of relevance to business business performance can be evolving quickly; performance should be integrated into fundamental 3. Monitor to ensure that, where regulation is in place, it is company communications, publication and disclosures. In addition, some companies may find it useful to prepare designed and implemented to achieve the actual sustainability reports addressing values-oriented prescribed policy objectives, and does not require or stakeholders or employees wishing to understand their contribute to unnecessary disclosures or other compliance company’s citizenship, however, that should not be confused activities that do not add value to investment practitioners’ with reporting on ESG issues of relevance to business abilities to use ESG information; performance. 4. Review, understand, and remove barriers to ESG factor Policy makers should focus on establishing a framework that integration and reporting by investors and companies, enables practitioners to develop detailed standards and best such as conflicting ESG frameworks, ambiguous or practice guidelines.32 As noted, considerable data is now competing definitions of materiality and fiduciary duty, lack available and progress continues to evolve at a rapid pace in of widely available globally standardized ESG data, and response to market forces. Consistent, comparable, high public policies that may not achieve prescribed policy quality data and information are key to ensure sound objectives; decision-making by investors, companies, regulators, and 5. Clarify how ESG considerations are part of investors’ and policy makers. To that end, we recommend that policy companies’ fiduciary duties; and, makers: 6. Require investors to report whether they integrate ESG 1. Encourage standard ESG factor disclosure by companies factors in their investment analysis, and if so, their within a consistent global reporting framework (e.g. approach to integrating ESG factors in their investment comparable to international accounting standards). ESG processes and stewardship activities, including an reporting should be relevant to operational and financial explanation of specific policies, implementation guidance, performance and their management to achieve long-term and the resources deployed. Investors should also report financial sustainability. Policy makers can encourage this the outcomes from engagements undertaken to protect by: and enhance long-term financial returns. a. Recognizing the importance of identifying and We anticipate that there will be consolidation amongst the managing ESG risks and opportunities as a practitioner-led policy initiatives in the near term. Policy component of investment analysis, and understanding makers and regulators can play a supportive, galvanizing, and how practitioners use ESG data; potentially convening role. Given the increasing global b. Understanding the distinction between purely social, significance of ESG amongst relevant stakeholders and the mission or “values” driven goals and investment long-term nature of the investments necessary by companies (“value”) goals; – in innovation, reporting systems and, in some cases, c. Promoting clear and consistent definitions of ESG, physical assets – policy makers and regulators can play a understanding the distinction between these factors vital role in establishing a long-term, standardized, focused, driving long-term financial performance of companies and predictable policy framework to encourage informed from a values-driven approach taken by investors or capital allocation decisions. companies;33 d. Providing guidance that recognizes the need to tailor reporting across diverse industries, because relevant ESG factors can vary primarily by industry, and also by geography, and even by specific company;

[ 9 ] APPENDIX A: LIST OF GLOBAL POLICY INITIATIVES

YEAR OF INITIATION ORGANIZATION INITIATIVE ACTION PLAN / PROGRESS

United Nations UN Principles for Voluntary initiative (currently with 1300+ signatories w ~$60tn in 2005 Responsible assets) to adhere to 6 principles to incorporate ESG issues into *March 2016 Investment investment practices. consultation on (UNPRI) additional accountability provisions

UN Environment UNEP Sustainable Energy Finance Initiative (SEFI) is a platform Programme to bring financiers and developers together to facilitate financing 2008 (UNEP) of renewable energy and energy efficiency investments.

UN Green Climate Fund’s goal is to raise $100 billion annually by 2020 from both Fund global public and private sectors (so far, only $10 billion pledged 2010 from developed nations) to help mitigate the effects of climate change in developing countries.

G20 G20 Green Co-Chaired by Bank of England (BoE) and People’s Bank of Initial Report due by G20 Finance Study China (PBoC), with secretariat support from UNEP. Tasked Finance Ministers’ meeting Group with identifying institutional and market barriers to green July 2016 finance, developing best practice to mobilize green investment.

Global Global Infrastructure Hub works to better connect public and Infrastructure Hub private sectors to increase the flow of funding to infrastructure 2014 projects.

OECD High-Level High-level principles to help governments facilitate and promote Principles on long-term investment by institutional investors. 2014 Long-Term Investment

Work stream on OECD currently conducting research on investment governance Governance and and responsible investing. End result will be a report on Fiduciary Duty whether current fiduciary standards amongst institutional Timeframe unclear investors are adequate with regard to ESG analysis and climate change risks.

Financial Stability Task Force on Chaired by Michael Bloomberg – TF will develop voluntary Final Report due by end of Board (FSB) Climate-Related climate-related financial risk disclosures for use by companies to Chinese G20 Presidency Financial Risks allow market participants and policymakers to better understand (end 2016) an manage climate-related risks.

European Union EU Energy Union Strategic initiative to create a single EU energy market – at the Framework in place by same time incorporating climate goals and financing low-carbon 2019 for Single EU technology. Energy Market Reduction of energy usage by 27% by 2030 40% reduction of greenhouse gas emissions by 2030

EU Capital Promoting increased markets-based finance. specific work on Framework in place by Markets Union Green investment (e.g., green bonds), infrastructure investment 2019

European Find for €315 billion (public sector guarantees and private co- Strategic investment). Fund aimed at financing strategic infrastructure 2015 Investments projects in EU (strong focus on sustainable energy (EFSI) infrastructure)

EU Non-Financial Legislation requiring disclosure of a range of ESG-related Reporting information by listed companies and other designated entities Applies as of Jan 2017 Directive with 500+ employees.

ESG and Promoting ESG factors as part of investor fiduciary Currently under Fiduciary Duty responsibility and encouraging more disclosure of ESG consultation: Guidelines initiatives information by companies. End result will feed into Guidelines due by end 2016 supporting the Non-Financial Reporting Directive.

Product disclosure Various financial product (esp. funds) disclosure rules (UCITS initiatives and PRIPs KIIDs) include provisions on disclosure of ESG Various policy.

[ 10 ] APPENDIX A: LIST OF GLOBAL POLICY INITIATIVES (cont’d)

PROGRESS / YEAR OF ORGANIZATION INITIATIVE ACTION PLAN INITIATION

Belgium Vandebroucke Mandatory disclosure of pensions funds in their annual Law (2003) reports to which degree SEE criteria and considered in the 2003 investment strategy.

Laws against Exclusion of investments in landmines and cluster munitions. financing of landmines and 2007 cluster munitions (2007)

Denmark Amendment to Mandatory ESG disclosure for companies and investors. the Danish Information must include: Mandatory reporting on human rights Financial and/or climate change for organizations with policies 2012 Statements Act referencing one or both of those issues. Applies to both institutional investors and corporates.

France Grenelle Law II, Public disclosure of open-ended investment companies and Articles 224 and investment management companies (fund managers) how they 2010 / 12 225 integrate ESG objectives in their investment decisions, first on their websites, then in their annual reports.

Energy Transition Disclosure of how a wide range of investors integrate ESG for Green Growth issues into their investment policies and risk management (e.g. 2016 Law, Article 173 climate change-related risks), also incl. carbon reporting.

Germany The Renewable Tax advantages to closed-end funds to invest in wind-energy. 2010 / 12 Energy Act

Amendment in Information of pension funds to clients how ESG issues are regulations considered in the use of deposited funds when signing the 2001 concerning contract, and in annual report. pensions funds

Italy Mandatory Mandatory disclosure for pension funds of nonfinancial factors disclosure of whether and to what extent ESG influencing the investment 2011 ESG for pension decisions and the exercise of their voting rights in their funds communication and in their annual reports.

New measure on Mandatory communication (if any) ethical, environmental and pension fund’s social criteria are in the statement of investment principles. 2012 investment policy

Netherlands Green Tax reduction for green investments, such as wind and solar Investment energy or organic farming. 1995 Directive

Norway Norwegian Act on Annual reporting on business integration of corporate social Annual responsibility, including human rights, workers’ rights and Accounting social issues, the environment and measures against corruption. The report must contain information on policies, principles, procedures and company standards. Companies 2013 that do not have policies must disclose this fact. The company’s auditor must assess the accuracy and consistency of the reporting. Companies that report within UN Global Compact or GRI are exempt.

Spain Sustainable Mandatory reporting for pension funds on an annual basis Economy Law – whether or not they use ESG criteria in their investment Mandatory approach. 2011 disclosure of ESG

Law modernising Mandatory reporting for occupational pension funds in their Spain’s Social annual reports on investment criteria in regard to SRI as well as 2013 Security System how they implement, manage and monitor ESG issues.

[ 11 ] APPENDIX A: LIST OF GLOBAL POLICY INITIATIVES (cont’d)

PROGRESS / YEAR OF ORGANIZATION INITIATIVE ACTION PLAN INITIATION

Sweden Mandatory Mandatory reporting requirements for private and public pension Disclosure of funds in the annual business plan how environmental and ethical ESG for pension considerations are taken into account in investment activities and 2000 funds the impacts of these activities for the funds performance and management.

Public Pension The seven AP funds must take environmental and ethical Funds Act considerations into account without relinquishing the overall goal 2002 of a high return on capital.

United Kingdom Amendments to Pension funds are required to disclose in the Statement of 1995 Pensions Investment Principles (SIP) the extent (if at all) to which social, Act: Pension environmental and ethical considerations are taken into account 1999 disclosure in the selection, retention and realization of investment. regulation

Hong Kong Social Innovation Aimed at helping to overcome some obstacles in ESG and investing in the region, such as the absence of a platform for Entrepreneurship investor-project matchmaking, limited information sharing and 2012 Development cross-sector learning, as well as incoherent policies and Fund (SIE Fund) guidelines. ESG Reporting Guidelines have been published by the HK Stock Exchange as well.

India Indian Ministry of Authorities in India have deployed multiple policy tools—such Corporate Affairs’ as Renewable Purchase Obligations and Renewable Energy new Corporate Certificates—to close the demand gap by encouraging and Social investment into renewable energy growth. 2013 Responsibility policy under the Companies Act 2013

Japan Principles for 192 signatory financial institutions as of the end of October Financial Action 2014 have joined for the aim of the principles to steer society 2014 for the 21st toward sustainability by changing the flow of money to those Century activities which correspond to such sustainability goals.

Philippines National The Government of the Philippines, following on the Renewable Renewable Energy Act of 2008, set ambitious targets in the 2011-2013 Energy Program National Renewable Energy Program 2011-2013 to triple the 2011-2013 country’s current renewable capacity by 2030.

Vietnam Climate The government, in coordination with the Asian Development Investment Bank, has developed a plan for low-carbon investments in the Funds’ Clean power, transport and industrial sectors, funded by the Climate Technology Fund Investment Funds’ Clean Technology Fund.

Thailand Feed-in premium Thailand has more than doubled its installed clean energy program capacity with the help of the feed-in premium program 2010 introduced in 2010.

As of May 2016.

[ 12 ] Notes

1. When we refer to asset owners, we mean the people and institutions whose capital is invested in global markets - including individual savers and households, as well as the institutions, like pension funds or insurance companies, who invest on their behalf. In this paper, we refer to the asset owner as ‘investors’ more broadly, and ‘our clients’ more specifically. Each type of asset owner has different needs, objectives and considerations that affect their investment objectives and considerations (and, if they delegate to asset managers, the mandates or funds in which they invest). See BlackRock, ViewPoint, Who Owns the Assets? (May 2014), available at http://www.blackrock.com/corporate/en-us/literature/whitepaper/viewpoint-who-owns-the-assets-may-2014.pdf. 2. 73% of global investors surveyed by the CFA Institute in 2015 indicated they take ESG issues into account in their investment analysis and decisions. Matt Orsagh, CFA Institute, CFA Institute Survey: How Do ESG Issues Factor into Investment Decisions? (Aug. 17, 2015), available at https://blogs.cfainstitute.org/marketintegrity/2015/08/17/cfa-institute-survey-how-do-esg-issues-factor-into-investment- decisions/. 3. It is important to note that ESG issues may often intersect with or be inseparable from deeply held personal or societal beliefs. As a fiduciary asset manager, BlackRock does not express value judgments or political views, but rather incorporates clients’ stated investment objectives and constraints into portfolios. Sometimes, this means our clients explicitly identify sustainability objectives. 4. BlackRock and Ceres, 21st Century Engagement: Investor Strategies for Incorporating ESG Considerations into Corporate Interactions (2015), available at http://www.blackrock.com/corporate/en-us/literature/publication/blk-ceres-engagementguide2015.pdf. 5. DB Climate Change Advisors, Deutsche Bank Group, Sustainable Investing: Establishing Long-Term Value and Performance (Jun. 2012), available at https://www.db.com/cr/en/docs/Sustainable_Investing_2012.pdf. 6. Teresa Czerwińska and Piotr Kaźmierkiewicz, ESG Rating in Investment Risk Analysis of Companies Listed on the Public Market in Poland, ECONOMIC NOTES, Vol. 44, Issue 2, at 211-248 (Jul. 2015), available at http://dx.doi.org/10.1111/ecno.12031. 7. Indrani De and Michelle Clayman, The Benefits of Socially Responsible Investing: An Active Manager's Perspective, Journal of Investing (Jul. 9, 2014), available at http://ssrn.com/abstract=2464204. 8. Mozaffar Khan, George Serafeim, and Aaron Yoon, Corporate Sustainability: First Evidence on Materiality, The Accounting Review (Mar. 9, 2015), available at http://ssrn.com/abstract=2575912. 9. Asset Owners Disclosure Project, “World’s Biggest Investors Step Up Action to Protect Millions of Pension for Climate Risk” (May 2016), available at http://aodproject.net/worlds-biggest-investors-step-up-action-to-protect-millions-of-pensions-from-climate-risk/. 10. UNEP Finance Initiative is a global partnership between UNEP and the financial sector. Over 200 institutions, including banks, insurers and fund managers, work with UNEP to understand the impacts of environmental and social considerations on financial performance. UNEP Finance Initiative, http://www.unepfi.org/. 11. UN Global Compact is a voluntary initiative based on CEO commitments to implement universal sustainability principles and to take steps to support UN goals, with over 8,000 signatories in almost 170 countries. See United Nations Global Compact, https://www.unglobalcompact.org/. 12. BlackRock has been a signatory to the PRI since 2008. Being a signatory has not changed BlackRock’s approach, as we have long been a strong proponent of active stewardship, including considering ESG factors as they pertain to long-term economic value creation. See Principles for Responsible Investment, available at https://www.unpri.org/. 13. About CDP, CDP, https://www.cdp.net/en-US/Pages/About-Us.aspx. 14. About GRI, Global Reporting Initiative, https://www.globalreporting.org/Information/about-gri/Pages/default.aspx. 15. Financial Services Council and Australian Council of Superannuation Investors, ESG Reporting Guide for Australian Companies (2015), http://www.fsc.org.au/downloads/file/PublicationsFile/2016_0302_ESGReportingGuideFinal2015.pdf. 16. The IIRC, Integrated Reporting, http://integratedreporting.org/the-iirc-2/. 17. B Analytics, Global Impact Investing Rating System (GIIRS) Company Ratings, http://b-analytics.net/products/giirs-ratings/company- ratings-methodology. 18. About the Sustainable Stock Exchanges (SSE) initiative, Sustainable Stock Exchanges Initiative, http://www.sseinitiative.org/about/. 19. Who we are, Ceres, http://www.ceres.org/about-us/who-we-are. 20. BlackRock is a member of the FSB Climate Task Force. 21. Sustainability Accounting Standards Board (SASB), http://www.sasb.org/. 22. BlackRock is a subscriber to MSCI ESG Research. 23. UN Climate Change Paris Agreement, available at http://newsroom.unfccc.int/paris-agreement/; United Nations Framework Convention on Climate Change, available at http://unfccc.int/resource/docs/2015/cop21/eng/10.pdf. 24. Department of Labor, Employee Benefits Security Administration, 80 Fed. Reg. 65135 (Oct. 26, 2015), available at https://www.gpo.gov/fdsys/pkg/FR-2015-10-26/pdf/2015-27146.pdf. 25. Regulator, Influencer, Advocate, Johannesburg Stock Exchange, https://www.jse.co.za/about/sustainability/regulator-influencer-advocate. 26. The World Federation of Exchanges Sustainability Working Group, Exchanges and ESG Initiatives (2015), and ASX Corporate Governance Council, Corporate Governance Principles and Recommendations (2014), available at http://www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf. 27. News Release, Hong Kong Exchanges and Clearing, Exchange to Strengthen ESG Guide in its Listing Rules (Dec. 21, 2015), available at https://www.hkex.com.hk/eng/newsconsul/hkexnews/2015/151221news.htm. 28. BlackRock, Comment Letter, Consultation Paper 1/2015: Proposed Amendments to the Listing Requirements Relating to Sustainability Statement in Annual Reports and the Sustainability Reporting Guide (Aug. 24, 2015), available at http://www.blackrock.com/corporate/en- us/literature/publication/sustainability-listing-requirments-bursa-malaysia-082415.pdf. 29. Christine Chow, Hong Kong Joins Push for Sustainable Stock Exchanges, South China Morning Post (Sep. 18, 2015), available at http://www.scmp.com/business/markets/article/1859225/hong-kong-joins-push-sustainable-stock-exchanges. 30. World Federation of Exchanges represents 64 regulated exchanges across the world, and acts on behalf of a total of 99 organizations including affiliate members and clearinghouses. WFE Mission & Vision, World Federation of Exchanges, http://www.world- exchanges.org/home/index.php/about/wfe-mission-vision.

[ 13 ] Notes (cont’d) 31. Comparability in International Accounting Standards – A Brief History, Financial Accounting Standards Board, http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156304264. 32. See, e.g., International Capital Market Association, The Green Bond Principles, 2015: Voluntary Process Guidelines for Issuing Green Bonds (Mar. 27, 2015). http://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/GBP_2015_27-March.pdf. 33. B Corps, for example, are for-profit companies certified by the nonprofit B Lab to meet rigorous standards of social and environmental performance, accountability, and transparency. There are more than 1,600 Certified B Corps from 42 countries and over 120 industries. What are B Corps? B Corporations, available at http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/green-bonds/green- bond-principles/.

This publication represents the views of BlackRock and is intended for educational purposes to discuss topics related to public policy matters and issues helpful in understanding the policy and regulatory environment. The information in this publication should not be construed as research or relied upon in making investment decisions with respect to a specific company or security or be used as legal advice. It should not be construed as research.

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GOV-0093 Article ESG The ESG Data Challenge March 2019

• Quality data about companies’ Environmental, Social and Governance (ESG) practices is critical for effective investment analysis.

• The lack of standardization and transparency in ESG reporting and scoring presents major challenges for investors.

• Third-party ESG data providers play an important role, but there are limitations with this data — especially in terms of differing methodologies that lead to variance in scores — which asset owners should understand.

• Moreover, there is a lack of market infrastructure to give companies insights into how they are evaluated with respect to ESG scoring.

• To improve the quality of the ESG data we use to make investment decisions for our clients, State Street has built a scoring system that uses data from multiple best-in-class providers, leverages Sustainability Accounting Standards Board’s (SASB) transparent materiality framework and incorporates our stewardship insights.

• We outline the considerations that asset owners should incorporate into their evaluation of ESG data providers.

Headwinds to ESG Quality data is the lifeblood of investment analysis. While “quality” can be defined in several Data Quality ways, most investors agree that consistency and comparability in the availability of data across companies are essential elements of an effective data set.

Unfortunately, the current landscape provides headwinds to achieving those elements of quality when it comes to data about a company’s ESG practices. Governments around the world don’t require companies to report on most ESG data. Companies are left to determine for themselves which ESG factors are material to their business performance and what information to disclose to investors.

Asset owners and their investment managers seek solutions to the challenges posed by a lack of consistent, comparable, and material information. Investors increasingly view material ESG factors as being critical drivers of a company’s ability to generate sustainable long-term performance. In turn, ESG data has increasing importance for investors’ ability to allocate capital most effectively. ESG Data Providers ESG data providers play an important role in the investment process by gathering and assessing — Contributions and information about companies’ ESG practices and then scoring those companies accordingly. The Considerations development of these ratings systems has helped to nurture the growth of ESG investing by giving asset owners and managers an alternative to conducting such extensive diligence themselves.

As of 2016, there were more than 125 ESG data providers, according to The Global Initiative for Sustainability Ratings. These include well-known providers with global coverage such as Bloomberg, FTSE, MSCI, Sustainalytics, Thomson Reuters, and Vigeo EIRIS, as well as specialized data providers such as S&P’s Trucost (providing carbon and “brown revenue” data), GRESB (sustainability performance in real estate) and ISS (corporate governance, climate, and responsible investing solutions).

Despite the valuable contributions these data providers have made in advancing ESG investing globally, it’s important for asset owners and managers to understand the inherent limitations of this data, as well as the challenges of relying on any one provider.

Differences in Data Lack of standardization and transparency in providers’ data collection and scoring Collection and methodologies pose key challenges for investors. Methodologies ESG data providers generally develop their own sourcing, research, and scoring methodologies. As a result, the rating for a single company can vary widely across different providers. We recently conducted research to quantify the degree to which this lack of standardization leads to variance among the ESG scores used by investors. (See “A Blueprint for Integrating ESG Into Equity Portfolios ,” by Bender, Bridges, et al.)1

As part of an 18-month due diligence process in which we looked at more than 30 data providers, we examined the cross-sectional correlations for four leading data providers’ ESG scores, using the MSCI World Index as the coverage universe. MSCI and Sustainalytics are two of the most widely used ESG data providers. But, as shown in Figure 1, our research determined a correlation of only 0.53 among their scores, meaning that their ratings of companies are only consistent for about half of the coverage universe.

Figure 1 Sustainalytics MSCI RobecoSAM Bloomberg ESG ESG Scores are Different Sustainalytics 1 0.53 0.76 0.66 Across Providers (Cross Sectional Correlation MSCI 1 0.48 0.47 for Constituents of the MSCI RobecoSAM 1 0.68 World Index, June 30, 2017) Bloomberg ESG 1

These differing methodologies have implications for investors. In choosing a particular provider, investors are, in effect, aligning themselves with that company's ESG investment philosophy in terms of data acquisition, materiality, and aggregation and weighting.

This choice is complicated by the lack of transparency into those methodologies. Most data providers treat their methodologies as proprietary information. By relying on an ESG data provider’s score, asset owners are taking on the perspectives of that provider without a full understanding of how the provider arrived at those conclusions.

The ESG Data Challenge 2 Assessing the Differences Given the lack of consistency among ESG scores, it’s helpful to understand the factors that are leading to this variance. In our research, three primary points of difference among the methodologies and approaches used by ESG data providers were identified:

Materiality. A critical part of any ESG scoring is determining which factors are material to a company’s financial performance; the importance of materiality has been supported by academic research.2 As part of the proprietary nature of their solutions, ESG data providers typically make their own determinations on materiality issues — and don’t provide full transparency into how these determinations are made. These differences in how materiality is defined and unveiled add to the difficulty asset owners and managers face in selecting an ESG data provider.

Data Acquisition and Estimation. We found discernable differences in how ESG data providers source and acquire raw data. In addition to using traditional sourcing techniques to gather data that is disclosed by the company or is otherwise publicly available, ESG data providers use statistical models to create estimates for unreported data. These models are based on averages and trends from what the data provider views as similar companies and industry benchmarks. This is an example of how investors are incorporating judgement calls by the data provider into their investment processes.

Aggregation and Weighting. Each ESG data provider has developed a method to aggregate and weight particular ESG factors for its summary scores. Again, these are proprietary judgments made by each provider.

Case Study: MSCI versus Examining the different methodologies used by two of the leading ESG data providers Sustainalytics highlights the challenge investors face when selecting a provider. Both MSCI and Sustainalytics are widely used across the asset management industry, and each of them offers global ESG product suites — including ESG ratings and climate-focused products. But, as Figure 2 illustrates, there are distinct differences in the way the two companies collect and analyze ESG data.

Figure 2 MSCI Sustainalytics Comparison of MSCI Materiality Proprietary Definition of Materiality International Financial Reporting Standards and Sustainalytics (IFRS) Definition of Materiality Approaches to ESG Normalization Key Issue Weighted Average by Global Industry Key Issue Weighted Average by 42 Peer Scores Classification System Sub-Industry Groups Weighting Key Issue Weights (proprietary model) Key Issue Weights (proprietary model) Aggregation 37 Metrics 60–80 Metrics

The ESG Data Challenge 3 ESG Scoring at State At State Street, we believe that ESG factors are directly linked to a company’s ability to generate Street: Our Goals and sustainable long term performance. As fiduciaries, we have a duty to rigorously analyze all Approach financial and nonfinancial factors that can affect a company’s performance, and we believe that ESG factors can be used to mitigate risk and identify potential alpha signals.

To address the gaps in the current market infrastructure, we are building our own scoring system, known as R-Factor. This scoring system will address the data challenges that we’ve articulated above.

Our approach to ESG data and scoring is guided by three goals: • Bring greater transparency to materiality considerations that drive ESG scores • Develop ESG scores that are based on frameworks supported by a large number of investors • Promote market infrastructure that both integrates stewardship into ESG scoring and incentivizes greater corporate disclosure of investor-relevant ESG information

We invite you to contact your State Street Relationship Manager to learn more about R-Factor and our broader ESG capabilities.

State Street Understanding & Comparing Harnessing ESG as an Alpha Source in Active Global Advisors ESG Terminology Quantitative Equity ESG Resources A practical framework for identifying the ESG Insights into leveraging ESG factors to increase long-term strategy that is right for you. portfolio returns.

Next Generation ESG for Better Alpha A tailored approach to ESG metrics for active equity strategies.

Authors Rakhi Kumar, CA Ali Weiner Head of ESG Investments and ESG Investment Strategy Asset Stewardship

Endnotes 1 Bender, Bridges, et al. “A Blueprint for Integrating ESG into 2 Mozaffar Khan, George Serafeim, and Aaron Yoon, Equity Portfolios.” Journal of Investment Management Corporate Sustainability: First Evidence on Materiality Volume 16 No. 1, 2018. (November 9, 2016).

The ESG Data Challenge 4 ssga.com T: +971 (0)4-4372800. France: State Street nancial Conduct Authority (FCA ), with a capital Eidgenössische Finanzmarktaufsicht (“FINMA”). Global Advisors Ireland Limited, Paris branch is of GBP 62,350,000, and whose registered office Registered with the Register of Commerce Zu- State Street Global Advisors a branch of State Street Global Advisors Ireland is at 20 Churchill Place, London E14 5HJ. State rich CHE-105.078.458. T: +41 (0)44 245 70 00. Worldwide Entities Limited, registered in Ireland with company Street Global Advisors Limited, Milan Branch F: +41 (0)44 245 70 16. United Kingdom: State number 145221, authorised and regulated by (Sede Secondaria di Milano), is registered in Italy Street Global Advisors Limited. 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SSGA Netherlands is and financial advisor. ised and regulated by the Financial Conduct Au- ed, 68/F, Two International Finance Centre, 8 Fi- a branch office of State Street Global Advisors thority in the United Kingdom. Canada: State nance Street, Central, Hong Kong. T: +852 2103 Limited. State Street Global Advisors Limited All information has been obtained from sources Street Global Advisors, Ltd., 770 Sherbrooke 0288. F: +852 2103 0200. Ireland: State Street is authorised and regulated by the Financial believed to be reliable, but its accuracy is not Street West, Suite 1200 Montreal, Quebec, H3A Global Advisors Ireland Limited is regulated by Conduct Authority in the United Kingdom. guaranteed. There is no representation or 1G1, T: +514 282 2400 and 30 Adelaide Street the Central Bank of Ireland. Registered office Singapore: State Street Global Advisors warranty as to the current accuracy, reliability East Suite 500, Toronto, Ontario M5C 3G6. 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The ESG Data Challenge 5 Stanford Closer LOOK series

the business case for esg

By Brandon Boze, Margarita Krivitski, David F. Larcker, brian tayan, and Eva Zlotnicka May 23, 2019

introduction ignore or underestimate long-term environmental or social costs Recently there has been increased debate among corporate in the pursuit of near-term profits.4 managers, boards of directors, and institutional investors around Boards can improve their analysis of ESG risks and how best to incorporate ESG (environmental, social, governance) opportunities at a practical level by considering how long-term factors into strategic and investment decision-making processes. investors integrate ESG factors into their decision-making Central to this discussion is the premise that both companies process. To do so, we examine a framework informed by the and investors have become too short-term oriented in their experience of ValueAct Capital. ValueAct is a long-term investor investment horizon, leading to decisions that increase near-term that aims to work constructively with portfolio company reported profits at the expense of the long-term sustainability of management teams and boards in a variety of ways, including at those profits. The costs of those decisions are assumed to manifest times having a ValueAct representative serve on the board. themselves as externalities, borne by members of the workforce or society at large.1 Broad Integration of ESG Factors Prominent investors such as Larry Fink at BlackRock adopt In many ways, a focus on the durability of earnings and downside this viewpoint: risk inherently incorporates many concepts commonly associated To prosper over time, every company must not only deliver financial with ESG. To that end, ValueAct has also adopted an approach to performance, but also show how it makes a positive contribution to evaluate ESG-related factors as part of its decision-making process society. Companies must benefit all of their stakeholders, including and has deepened engagement with its portfolio companies shareholders, employees, customers, and the communities in which around these issues. It does so because analysis of ESG factors can: they operate. Without a sense of purpose, no company, either • Provide an effective risk-management framework public or private, can achieve its full potential. It will ultimately • Provide a new lens for strategy development and growth lose the license to operate from key stakeholders. It will succumb opportunities to short-term pressures to distribute earnings, and, in the process, • Address the demands of stakeholders such as customers, sacrifice investments in employee development, innovation, and employees, and investors capital expenditures that are necessary for long-term growth.2

Similarly, Martin Lipton of law firm Wachtell, Lipton, Rosen As such, ValueAct generally incorporates ESG factors into its & Katz has urged corporate clients to adopt what he calls “The process by identifying relevant stakeholders and factors, isolating New Paradigm,” a more stakeholder-centric orientation that and evaluating potential risks, and supporting companies as they emphasizes a long-term investment horizon: invest in their businesses to increase returns. In essence, the New Paradigm recalibrates the relationship between public corporations and their major institutional investors and Identifying Relevant Factors conceives of corporate governance as a collaboration among The first step is to map the ecosystem of stakeholders associated corporations, shareholders, and other stakeholders working with the company and analyze their interests (i.e., their incentives, together to achieve long-term value and resist short-termism.3 values, viewpoints, etc.). These stakeholders typically include Evaluating claims such as these on a national or macro-level customers, suppliers, employees, regulators, the general public would require an accurate measurement of the time horizons (including environmental impact), shareholders, and competitors. of business managers today and the degree to which, if any, they Once this ecosystem is mapped, it is easier to understand which

Stanford Closer LOOK series 1 The Business Case for ESG

ESG factors are most relevant to a particular company. Certain costs. In the private student loan ecosystem, investments behind factors, such as governance and human capital, might be applicable improving student outcomes can significantly reduce default broadly while others, such as environmental footprint, might be risk while also improving the brand in the eyes of customers, more limited. employees, and regulators. These positive effects can build on As an example of this process, ValueAct created an ecosystem one another and create a powerful flywheel effect. To identify map as part of its diligence of the private student loan industry, and capitalize on opportunities such as these, senior business including the leading provider Sallie Mae (see Exhibit 1). The leadership must consider material ESG factors as core inputs into map identifies students and their parents, colleges and their their strategy development. financial aid officers, government regulators, U.S. taxpayers, and shareholders as key stakeholders and summarizes the goals of Beyond ESG: Investing Behind Business Models and Transitions Integral to Solving Global Problems each. Integration of ESG-related factors is broadly applicable across all Isolating and Evaluating Potential Risks companies. In ValueAct’s experience, there is also an opportunity Once the relevant factors have been identified, one can evaluate for institutional investors to identify and invest behind companies and quantify (to the extent possible) the company’s position where sustainability is at the center of the investment thesis, or and associated risk in each area. The active engagement of an whose business models are core to the ultimate solution for specific investor with a significant stake and long-term perspective can environmental and social problems (increasingly referred to as elevate a company’s discussion of risk at the C-suite and board “impact investing”). These global problems can include carbon level, encourage corporate investment to mitigate risk if needed emissions, waste recovery, access to education, affordability of (even at the expense of near-term profit), and provide support for healthcare, and biodiversity loss, to name a few. the management team as it justifies its decisions to the broader Below we explore two of those problems—carbon emissions investment community. and access to education—and provide an example of companies In the example of the student loan industry above, the federal that are transitioning their business models to address these government is an important focal point given its dual role as problems. lender and policy maker. This suggests several questions: Carbon Emissions • Can private student loans provide better value to students than Electricity production accounts for over a quarter (27.5 percent) federal programs? 5 • How might policy changes impact the competitive dynamic of greenhouse gas emissions in the United States. Approximately between private and federal programs? 64 percent of electricity production comes from fossil fuels such • What impact do various sources of student loans have on both as coal and natural gas, 19 percent from nuclear, and 17 percent school and student outcomes? from renewables such as wind and solar.6 Renewables have steadily gained share as they have become more cost competitive In attempting to answer these questions from an investor’s with fossil fuels in certain geographies. Increased investment can perspective, ValueAct was better able to evaluate how private accelerate this transition and pull forward the benefits from a student loan providers could play a positive role in any higher climate change perspective. education policy focused on access, quality, and affordability, and Global power company AES has a 38-year history of owning therefore serve as an important part of the long-term solution to and operating contracted generating capacity to utilities around fund higher education. the world. By early 2018, AES was addressing the environmental cost of its reliance on coal as an energy source and was in the Investing to Increase Returns process of repositioning its portfolio to renewable sources. The Beyond risk reduction, ESG factor analysis can lead to the company subsequently made a series of changes to accelerate the identification of investments or activities by the company that transition of its business model. In early 2018, AES announced increase long-term returns. For example, a company’s investment a broad reorganization, including asset divestitures primarily in a more sustainable supply chain can deepen relationships with related to coal plants. The company also committed to a target of customers (thereby promoting volume growth and premium decreasing reliance on coal from 41 percent of supply in 2015 to pricing), attract talent to the organization, and perhaps reduce 29 percent by 2020.7 It publicly set a carbon intensity reduction

Stanford Closer LOOK series 2 The Business Case for ESG

target of 70 percent by 2030.8 Through joint ventures with Siemens Strayer Education), one of the largest for-profit education and others, it built capacity for energy storage and development companies in the United States whose history dates back to of renewables. In November 2018, the company voluntarily 1892, operating margins, which exceeded 35 percent prior to the released a Climate Scenario Report, claiming to be the first U.S. change, fell into the teens. The company’s stock price declined publicly listed energy-related business to do so in accordance with from a high of $254 in April 2010 to a low of $34 in December guidelines set by the Task Force for Climate-related Financial 2013 (see Exhibit 3). Disclosures (TCFD). The company also modified its mission Since mid-2015, Strategic Education made a series of statement to emphasize its commitment to transformation to: changes to reposition itself for durable growth, based on a “Improve lives by accelerating a safer and greener energy future.” business model that contributes to positive societal change. The These actions appear to have had a number of ripple effects. company reduced tuition rates to increase affordability.10 It made According to AES, the updated mission statement galvanized the investment in machine learning and artificial intelligence to lower company’s culture, helping it to attract talent, increase workforce its costs and improve student outcomes, passing on the savings productivity, and further innovation. The company also received as lower tuition.11 It also increased its efforts to measure student recognition from external parties for its reporting efforts.9 outcomes and take the learnings to foster continuous innovation Shareholders who had pressured the company to conduct a in the education experience. Recently, it merged with Capella climate-change risk assessment voluntarily withdrew their proxy University—an online graduate school education company—to resolution, and according to AES, some foreign and domestic build scale and further its competency-based learning. Strategic investors, who previously would not invest in AES because of Education has also expanded non-degree educational offerings its exposure to coal, made new investments. During this time of for employed workforce members, with corporate partnerships investment in a less carbon intensive business, the company’s representing approximately a quarter of enrollment and growing.12 price-to-earnings multiple expanded from approximately 9x in Subsequently, student experience and retention improved, January 2018 to 14x by March 2019, and its stock price outpaced leading to higher unit economics. Operating margins and profits industry indexes (see Exhibit 2). increased. In 2018 alone, enrollment at Strayer University increased by 8 percent to nearly 48,000 students while the continuation Access to Education rate and number of students completing the requirements for Higher education is a critical determinant of future wages, with graduation also rose.13 Importantly, the company has positioned college graduates earnings approximately 80 percent more itself as a contributor to positive social outcomes by improving per year than those with only a high school degree. The cost of education and training for students and adults at lower cost. college education, however, has been rising significantly for many years, and student loans become the fastest-growing Incorporating Stakeholder Concerns category of consumer debt, rising to $1.6 trillion by the end of The examples of AES and Strategic Education illustrate how some 2018. Addressing the problems of access and affordability while companies can benefit from a foundational shift in their business maintaining quality offers substantial potential benefits for U.S. model to explicitly address stakeholder concerns, leading to more citizens and the economy. sustainable long-term economics. In some cases, it requires that The for-profit education industry has long had the potential management and the board be amenable to collaborating with to provide this solution by offering a less expensive educational stakeholders to determine how to achieve those changes or with experience focused on occupational training. By and large, a significant shareholder to champion this decision among the however, the industry had not achieved this objective. By the broader shareholder base. Ultimately, certain incumbents whose early 2010s, poor student outcomes and high student loan default industry faces significant environmental or social challenges can rates led to regulatory scrutiny. The federal government began to create value and generate returns by more centrally focusing on enforce punitive performance requirements and cut off funding addressing those challenges. to those institutions whose graduates could not find well-paying jobs. These actions led to the collapse of several companies in Why This Matters the industry, such as ITT Educational and Corinthian Colleges. 1. The examples included in this Closer Look involve companies Meanwhile, the survivors experienced precipitous declines in that appear to have a long-term investment horizon and are revenue and profits. In the case of Strategic Education (formerly willing to bear the cost of an up-front investment in order to

Stanford Closer LOOK series 3 The Business Case for ESG

statistically significant, but on an absolute basis it is small.” For a review increase long-term value. How prevalent are companies with a of the research literature, including these papers, see David F. Larcker long-term perspective? How many companies miss long-term and Brian Tayan, “Environmental, Social, and Governance Activities: opportunities because they are excessively focused on short- Research Spotlight,” Stanford Quick Guide Series (March 2019), available at: https://www.gsb.stanford.edu/faculty-research/ term profits? If many, what does this say about the quality of publications/environmental-social-governance-activities. corporate governance and board oversight in companies today? 5 It is the second-largest source after transportation (29 percent). See U.S. 2. This Closer Look offers two case studies of companies Environmental Protection Agency (2019), Inventory of U.S. Greenhouse transitioning “beyond ESG” to solve global problems. Both are Gas Emissions and Sinks: 1990-2017. 6 U.S. Energy Information Administration (EIA), “U.S. Electricity traditional businesses whose executives and board members Generation by Source, Amount, and Share of Total in 2018,” accessed recast their business models to try to solve environmental and/ April 2019. or social problems and improve long-term profit opportunities. 7 AES, Fourth Quarter & Full Year 2017 Financial Review (February 2018). How widespread are such opportunities? Can every company 8 Base year 2016. AES, Climate Scenario Report (November 2018). achieve such a transition and do so profitably? If not, what 9 Ceres press release, “New Disclosure Report from Major Global Power factors determine whether a company has such an opportunity? Company Highlights Shift Toward New Low-Carbon Investments,” 3. The approach described in this Closer Look suggests that (November 13, 2018). 10 Jeff Clabaugh, “Strayer Cuts Tuition by as much as 40 percent,” opportunities exist for investors to earn competitive risk- Washington Business Journal (November 22, 2013). adjusted returns with a favorable ESG focus. How large is this 11 Ari Chanen, “Using Artificial Intelligence and Machine Learning to opportunity? How does this compare to the total universe of Improve Student Success,” posted on LinkedIn (January 2, 2018). 12 “4Q18 Strategic Education Inc Earnings Call,” CQ FD Disclosure (March publicly traded companies?  1, 2019). 13 Strategic Education, 2018 Annual Report. 1 An externality is the cost of a commercial activity that is not incorporated in the cost of goods or services provided and is borne by third parties. Brandon Boze is Partner of ValueAct Capital. Margarita Krivitski is 2 BlackRock, “Larry Fink’s 2018 Letter to CEOs: A Sense of Purpose,” available at: https://www.blackrock.com/corporate/ Vice President of ValueAct Capital. David Larcker is Director of the investor-relations/2018-larry-fink-ceo-letter. Corporate Governance Research Initiative at the Stanford Graduate 3 Implicit in this argument is the practical consideration that by embracing School of Business and senior faculty member at the Rock Center for broad stakeholder objectives corporations can forestall costs, such as Corporate Governance at Stanford University. Brian Tayan is a those due to regulations that politicians will impose on them to satisfy the researcher at the Stanford Graduate School of Business. Eva Zlotnicka demands of their constituents. See Martin Lipton, Steven A. Rosenblum, is Vice President of ValueAct Capital. Larcker and Tayan are coauthors Sabastian V. Niles, Sara J. Lewis, and Kisho Watanabe, in collaboration of the books Corporate Governance Matters and A Real Look at with Michael Drexler, “The New Paradigm: A Roadmap for an Implicit Real World Corporate Governance. The authors would like to Corporate Governance Partnership Between Corporations and thank Michelle E. Gutman and Edward M. Watts for research assistance Investors to Achieve Sustainable Long-Term Investment and Growth,” with these materials. World Economic Forum (September 2016). 4 For example, it would require an accurate measure of the extent to The Stanford Closer Look Series is dedicated to the memory of our which short-termism is actually prevalent in corporate decision making colleague Nicholas Donatiello. today, the time horizon of institutional investors (perhaps as a proxy the stock market) and the impact this has on corporate decision making, the extent to which corporate managers take into account (or ignore) the This material is presented for informational or educational purposes needs of employee and non-employee stakeholders, the cost (or benefit) only and should not be considered a recommendation of any particular of including stakeholder considerations in decision making, and the security, strategy or investment product, or as investing advice of reduction in financial returns (if any) that investment professionals are any kind. This material is not presented or provided in a fiduciary willing to accept in pursuit of ESG objectives. Some research finds that capacity, may not be relied upon for or in connection with the making of companies that embrace ESG principles perform better, although the investment decisions, and does not constitute a solicitation of an offer to results are mixed. Lins, Servaes, and Tamayo (2017) find that during the financial crisis, high-ESG firms experienced greater returns, profitability, buy or sell securities. The content contained herein is not intended to be growth, and sales per employee relative to low-ESG firms. Deng, Kang, and should not be construed as legal or tax advice and/or a legal opinion. and Low (2013) look at value creation from mergers, showing that high- Always consult a financial, tax, and/or legal professional regarding your ESG acquiring firms experience significantly more positive returns from specific situation. Funds managed by ValueAct Capital Management, acquisitions than low-ESG firms. Ferrell, Liang, and Renneboog (2016) L.P. (“ValueAct Capital”) are or were invested in companies referenced in provide evidence that well-governed firms that suffer less from agency this material. Past performance is not indicative of future results. concerns engage more in ESG activities, and that a positive relation exists between ESG and firm value. However, Margolis, Elfenbein, This material contains opinions of the authors but not necessarily those and Walsh (2011) find, in a meta-analysis of 251 studies from 1972 to of ValueAct Capital or its affiliates. The opinions contained herein 2007, that the “overall average effect [of ESG…] across all studies is are subject to change without notice. Forward-looking statements,

Stanford Closer LOOK series 4 The Business Case for ESG

estimates, and certain information contained herein are based upon non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. The authors of this paper have not sought or obtained consent from any third party to use any statements or information, which are described in this paper as having been obtained or derived from statements made or published by third parties. Any such statements or information should not be viewed as indicating the support of such third party for the views expressed in the white papers. No warranty is made that data or information, whether derived or obtained from filings made with the Securities and Exchange Commission or from any third party, are accurate.

The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. It is published by the Corporate Governance Research Initiative at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http:/www.gsb.stanford.edu/cgri-research.

Copyright © 2019 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

Stanford Closer LOOK series 5 The Business Case for ESG

Exhibit 1 — private student loan ecosystem

Source: ValueAct Capital.

Stanford Closer LOOK series 6 The Business Case for ESG

Exhibit 2 — AES Stock Price and Milestones

6

5 3

1

4

2

1. AES announces investments in energy storage. 2. ValueAct announces investment in AES; joins the board of directors. 3. AES announces cost reduction efforts; carbon intensity reduction target of 50% by 2030. 4. AES commits to adopting recommendations of Task Force on Climate-Related Financial Disclosure. 5. Shareholders voluntarily withdraw resolution requiring climate-risk assessment. 6. AES changes mission statement. 7. AES increases carbon intensity reduction target to 50% by 2022 and 70% by 2030.

Note: The price of VPU is indexed to September 1, 2017. P/E refers to NTM (next 12 months) price-to-earnings ratio.

Source: CapitalIQ.

Stanford Closer LOOK series 7 The Business Case for ESG

Exhibit 3 — Strategic Education Stock Price vs. Selected Competitors

Source: Center for Research in Security Prices (CRSP) and Yahoo! Finance.

Stanford Closer LOOK series 8 Stanford Closer LOOK series

Where Does Human Resources Sit at the Strategy Table?

By courtney Hamilton, David F. Larcker, Stephen A. Miles, and Brian Tayan february 15, 2019

introduction Rock Center for Corporate Governance at Stanford University Two decades ago McKinsey advanced the idea that large U.S. finds that talent development and workplace issues play avery companies are engaged in “war for talent” and that to remain insignificant part in the performance evaluation and bonus competitive they need to make a strategic effort to attract, retain, calculations for CEOs, suggesting that boards do not place the and develop the highest-performing executives.1 Since that time, same weight on human capital as they do on other strategic and some companies have pursued this objective by elevating the financial objectives.8 importance of the human resources department and broadening its responsibilities beyond workforce administration to include Strategic Human Resources strategic talent and organizational issues.2 To understand the contribution of the human resources Studies have examined whether human resource (HR) department to company strategy, we surveyed 85 CEOs and chief departments have succeeded in this transition. For the most human resources officers (CHRO) at Fortune 1000 companies.9 part, the results are negative, suggesting that significant gaps Unlike prior research, we find significant positive assessments of remain between the potential and actual contribution of HR to the role that human resources departments and CHROs play in corporate outcomes. For example, research by The Conference strategic planning, workforce development, and company culture. Board and McKinsey finds that “business unit leaders view HR Of note, we find no discernable difference in the perception that as lagging in strategic performance relative to transactional CEOs and CHROs have in the value of HR to the organization’s duties,” such as payroll, benefits, and recordkeeping.3 A 2016 success, which are equally positive. study by Development Dimensions International finds that Ninety-six percent of respondents strongly agree or agree human resources leaders score below their peers on a variety of that the human resources department is vitally important to the dimensions, including business savvy, financial acumen, and global strategic success of their company (see Exhibit 1). Respondents acumen.4 KPMG finds that only a third (35 percent) of executives believe that HR plays a lead role in actively managing company believes that HR excels in contributing to the company’s people culture and values (4.6 on a scale of 1 to 5, with 5 indicating “to strategy; only 17 percent believe HR demonstrates the value it a great extent” and 1 indicating “not at all”). They give a similar provides to the business; and only 15 percent see HR as able to assessment (4.6) of the extent to which HR is highly attuned provide insightful and predictive workforce analytics.5 A piece to employee sentiment, including workplace satisfaction and in Harvard Business Review claims that “CEOs worldwide … rank negative chatter. To a lesser degree, they believe that HR directly HR as only the eighth or ninth most important function in a contributes to the financial performance of the company (4.0). company.”6 CEOs and CHROs share a positive assessment of the important This assessment is reflected in compensation figures. role that the chief human resources officer plays in the senior According to Equilar, chief human resource officers are paid management and strategic planning of the organization. Ninety- significantly below their peers in the C-suite, earning on average four percent of respondents say that the CHRO meets very a third less in total compensation than chief marketing officers frequently or frequently one-on-one or in small groups with the and general counsel, and half the amounts paid to chief financial CEO. Ninety-one percent of respondents say that the CHRO very officers.7 frequently or frequently discusses strategic, long-range personnel The problem, if it exists, might originate at the top of issues with the CEO. CEOs and CHROs widely believe that the organizations. A 2013 survey by The Miles Group and the CEO relies on the CHRO as a confidant or sounding board to

Stanford Closer LOOK series 1 Strategic Human Resources

discuss strategic, cultural, or organizational issues (4.4 on a scale minority assign their companies ratings of 3 (15 percent) and 2 (5 of 1 to 5). percent). These numbers suggest that while respondents might be One issue where we found significant disagreement between highly favorable of the contribution that the CHRO makes to the the CEO and CHRO is over the role that the human resources organization and its strategic management, the contribution that department plays in senior-level discussions about company this individual makes might not cascade down through the HR culture: 71 percent of CHROs claim that they lead the discussion department as a whole. on culture, whereas only 36 percent of CEOs believe that the Overall, these survey results are surprising in their optimism, CHRO leads the discussion. Instead, CEOs say that the chief particularly in contrast to the studies cited in the introduction. human resources officer contributes to the discussion but does While those studies rely on the opinions of a broad set of senior not lead it. executives, the survey results here exclusively reflect those of Respondents state that the chief human resources officer the CEO and CHRO, suggesting a potentially wide disconnect plays an important role in communicating management’s human between the viewpoints of those expected to lead human capital capital issues to the board of directors. Eighty-seven percent management efforts and the rest of the company. say that the CHRO presents succession planning issues to the This raises the question of how (and whether) the leaders of board, 80 percent say the CHRO presents on the company’s a company—CEO, the senior management team, and the board talent development efforts, and 78 percent say this executive of directors—validate the quality and effectiveness of its human presents on the company’s compensation and benefits programs. capital strategy. Other human capital issues presented to the board include talent In a general sense, approving HR strategy is analogous to recruitment (60 percent), workplace programs (54 percent), approving corporate strategy, including the establishment of internal workplace issues (35 percent), and workplace policies (29 overall objectives for the organization, identifying the steps percent). That said, the CHRO rarely participates in a company’s necessary to achieving those objectives, establishing targets and analyst or investor day conferences: only 3 percent of companies metrics to track progress, and developing the supporting budget. with an analyst or investor day invite the CHRO to present. The CEO and CHRO cannot drive HR strategy alone; each leader Sixty percent of companies in our sample have a formal talent- throughout the organization must be aligned and accountable for development program for senior executives. Among those, the prioritizing and delivering against the HR strategy (as they would CHRO plays a prominent role in the program, with 84 percent corporate strategy). To further reinforce the concept that human of respondents saying that the CHRO leads this program, 9 capital is central to the success of corporate strategy, specific percent saying that the CHRO participates in but does not lead targets should be included in compensation contracts and bonus the program, and 7 percent saying that the CHRO plays no role in targets. the management of the program. Furthermore, the board of directors plays an important role CEOs and CHROs report a variety of challenges around in assessing the acceptability of the human capital strategy. This talent development and recruitment at their companies. The includes not only advising senior management in HR strategy most prominent of these are an insufficient leadership pipeline development but also challenging the CEO and CHRO to (24 percent), difficulty in finding talent (20 percent), and too defend situations where their assessment differs from those of much competition for talent (17 percent). Difficulty in developing division heads and the broad base of employees. To facilitate the talent (11 percent), lack of leadership attention to talent issues discussion, the board should request that management develop (10 percent), lack of resources for development and recruitment reliable metrics and demonstrate the success or potential areas (6 percent), and difficulty in retaining talent (2 percent) are also to improve its efforts through data pulled from human resource referenced. management systems (HRMS). CEOs and CHROs are confident in the contribution that the For HR strategy to succeed, it needs to be treated more like human resources department makes to the strategic success of corporate strategy, as opposed to an addendum to the board book. their companies; however, there is some indication of room for improvement. Only 18 percent rate their company a 5 on a scale Why This Matters of 1 to 5 when asked to what extent their HR department does 1. Two decades after McKinsey coined the term “war for talent,” an outstanding job contributing to the strategic success of the there is relatively little evidence that companies have made organization. Sixty percent rate the company a 4, and a sizeable tangible progress developing and implementing strategies

Stanford Closer LOOK series 2 Strategic Human Resources

the Business Landscape,” (2016). See also: Ernst & Young, “The Call for to compete for human talent. Broadly speaking, have HR a More Strategic HR: How Its Leaders Are Stepping up to the Plate,” departments grown beyond their historical role of workplace Harvard Business Review (April 24, 2016). 5 administrators and compliance specialists to contribute in the HR received the highest marks among these executives for its ability to “manage costs.” See KPMG, “Rethinking Human Resources in a vital area of human capital development? Changing World,” (2016). 2. The survey data summarized in this Closer Look indicates that 6 The viewpoint that human resource officers might not hold the same both CEOs and CHROs are highly positive of the contribution standing within organizations as other senior executives is suggested in that the human resources department makes to the strategic a recent Wall Street Journal article about Goldman Sachs, which explains that in order to reduce the size of the company’s management committee, success of the company. However, a variety of observers “executives from nonrevenue divisions such as human resources and claim just the opposite. What role does HR actually play in legal might be shifted to a broader, less-powerful operating committee.” the development of corporate strategy? Do they have an equal See Liz Hoffman, “Goldman Sets a New Path—David M. Solomon, Tapped as Next CEO, Will Push for Fresh Sources of Growth,” The Wall voice in this process, or are they junior members of the senior Street Journal (July 18, 2018). See also Ram, Charan, Dominic Barton, management team? How directly important is HR to the and Dennis Carey, “People Before Strategy: A New Role for the CHRO,” financial performance of the company? Harvard Business Review (July-August 2015). 7 3. If human resources is vitally important to the strategic success See Equilar, “View from the Top: Executive Pay Beyond the CEO and CFO,” C-Suite (Winter 2018); Equilar, “CFO Pay Has Remained of an organization, it should be a key area of interest not only Stagnant Since 2013,” (October 9, 2018); and Equilar, “Human Resources for management but also for the board of directors. Do boards Executive Pay Trends,” (November 13, 2018). see human resources and human capital as critical to corporate 8 Stanford Graduate School of Business, the Rock Center for Corporate performance? If so, what questions do they ask to ascertain Governance, The Miles Group, “2013 CEO Performance Evaluation Survey,” (2013). whether management has the right human capital strategy? 9 Proprietary survey of 85 chief executive officers and chief human How does the process for developing an HR strategy differ resource officers at Fortune 1000 companies, conducted by The from that of developing a corporate strategy? Miles Group and Rock Center for Corporate Governance at Stanford University in summer and fall of 2018. Breakdown of respondents: 33 4. Companies are increasingly sophisticated in capturing CEOs, 48 CHROs, and 4 undisclosed. For convenience, we refer to the information on human capital. How adept are they at using this most senior human resource executive at a company as its chief human data? What data do they review to monitor company progress? resource officer, even if this executive has a different title (such as VP, Do they ask the management team to mine data from the SVP, EVP, or chief people person) or more than one title. company’s internal systems to gain insight into what programs and strategies work effectively and why? Are predictive analytic Courtney Hamilton is Managing Director, The Miles Group. David approaches used by top companies to explore these questions? Larcker is Director of the Corporate Governance Research Initiative at 5. What type of human capital information should the company the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. disclose to shareholders and stakeholders? Many voluntary Stephen Miles is Chief Executive Officer, The Miles Group. Brian reports now consist of standard items like voluntary and Tayan is a researcher with Stanford’s Corporate Governance Research involuntary turnover rates, hours of training, expenditures Initiative. Larcker and Tayan are coauthors of the books Corporate on human resource programs, and pay differential across Governance Matters and A Real Look at Real World Corporate employee gender. How informative are these data about the Governance. The authors would like to thank Michelle E. Gutman for quality of the human resources effort?  research assistance with these materials. The Stanford Closer Look Series is dedicated to the memory of our 1 Elizabeth G. Chambers, Mark Foulon, Helen Handfield-Jones, Steven M. colleague Nicholas Donatiello. Hankin, and Edward G. Michaels III, “The War for Talent,” The McKinsey Quarterly (1998). 2 Prominent institutional investors, such as BlackRock, are also becoming The Stanford Closer Look Series is a collection of short case studies that more vocal in prompting their portfolio companies to pay more explore topics, issues, and controversies in corporate governance and attention to workforce needs. See BlackRock, “Larry Fink’s 2019 Letter leadership. It is published by the Corporate Governance Research Initiative to CEOs: Profit and Purpose,” available at:https://www.blackrock.com/ at the Stanford Graduate School of Business and the Rock Center for corporate/investor-relations/larry-fink-ceo-letter. Corporate Governance at Stanford University. For more information, visit: 3 The Conference Board and McKinsey & Company, “The State of Human http:/www.gsb.stanford.edu/cgri-research. Capital 2012: False Summit,” (2012). 4 Development Dimensions International (DDI), “High Resolution Copyright © 2019 by the Board of Trustees of the Leland Stanford Junior Leadership: A Synthesis of 15,000 Assessments into How Leaders Shape University. All rights reserved.

Stanford Closer LOOK series 3 Strategic Human Resources

Exhibit 1 — Survey Data on Strategic Level of Human Resources

What prior executive-level experience, if any, does the chief human resources officer have working in a function outside of human resources? (select all that apply)

None 49%

Operations 22%

Divisional head 11%

Technology 8%

Legal 8%

Sales 5%

Marketing 5%

Accounting or finance 4%

R&D 2%

Other 15%

To what extent do you agree that the human resources department is vitally important to the strategic success of your company?

2% 1% 0%

8% Strongly agree

Agree

Neither agree nor disagree

Disagree

Strongly disagree

88%

Stanford Closer LOOK series 4 Strategic Human Resources

Exhibit 1 — continued

To what extent does the human resources department directly contribute to the financial performance of your company?

To a great extent - 5 25%

4 54%

3 13%

2 5%

Not at all - 1 2%

To what extent does the human resources department play a lead role in actively managing the company’s culture and values?

To a great extent - 5 66%

4 28%

3 5%

2 1%

Not at all - 1 0%

Stanford Closer LOOK series 5 Strategic Human Resources

Exhibit 1 — continued

To what extent is the human resources department highly attuned to employee sentiment, including workplace satisfaction and negative chatter?

To a great extent - 5 66%

4 28%

3 5%

2 0%

Not at all - 1 1%

How frequently does the chief human resources officer meet one-on-one or in small groups with the CEO of your company?

2% 4% 0%

Very frequently

19% Frequently

Occasionally

Rarely

Never 75%

Stanford Closer LOOK series 6 Strategic Human Resources

Exhibit 1 — continued

How frequently does the chief human resources officer discuss strategic, long-range personnel issues with the CEO?

2% 0%

7% Very frequently

Frequently

47% Occasionally

Rarely 44% Never

To what extent does the CEO rely on the human resources officer as a confidant or sounding board to discuss strategic, cultural, or organizational issues?

To a great extent - 5 62%

4 26%

3 6%

2 5%

Not at all - 1 1%

Stanford Closer LOOK series 7 Strategic Human Resources

Exhibit 1 — continued

What role does the chief human resources officer play in senior-level discussions about company culture?

71% Leads discussions 36%

29% Contributes heavily to discussions 52%

Contributes somewhat to 0% discussions 9%

Does not participate in discussions. 0% Executes policies. 3%

HRO Respondents CEO Respondents

What information does the chief human resources officer present to the board of directors? (select all that apply)

Does not present 4%

Succession planning 87%

Talent development 80%

Compensation and benefits 78%

Talent recruitment 60%

Workplace programs 54%

Internal workplace issues 35%

Workplace policies 29%

Other 25%

Stanford Closer LOOK series 8 Strategic Human Resources

Exhibit 1 — continued

Does your company have a formal talent development program for senior-level executives? [If yes] Does the chief human resources officer manage this program?

No 7%

Yes, participates in the management of 9% this program Yes, leads the management of this 84% program

What is the single greatest challenge around talent recruitment and development that your company faces?

None 1%

Insufficient leadership pipeline 24%

Difficulty in finding talent 20%

Too much competition for talent 17%

Difficulty in developing talent 11%

Lack of leadership attention to talent issues 10%

Lack of sufficient resources for development 4%

Lack of sufficient resources for recruitment 2%

Difficulty in retaining talent 2%

Other 18%

Stanford Closer LOOK series 9 Strategic Human Resources

Exhibit 1 — continued

What high-level functional skills are most important to your organization’s strategic success over the next five years? (select all that apply)

Talent recruitment & development 84% Strategic planning 69% Talent strategy 60% Data analytics 55% Engineering or technology expertise 51% Financial acumen 47% Product management 41% Sales leadership 40% Research and development 38% Corporate development expertise 35% Product marketing 33% Investor relations 31% Regulatory or legal expertise 28% Employee or labor relations expertise 16% Other 16%

What high-level leadership skills are most important to your organization’s strategic success over the next five years? (select all that apply)

Ability to inspire & motivate 80% Drives for results 79% Ability to drive innovation and disruption 68% Change management expertise 62% Growth expertise 58% Setting the right tone at the top 51% Comfort challenging others or the status quo 49% Ability to inclusively lead diverse teams 46% Ability to lead geographically dispersed teams 44% Team-building 42% Digital literacy 42% Global focus 40% Matrix leadership or leading without authority 38% Cultural awareness 34% Stakeholder management 27% Negotiation 15% Other 7%

Stanford Closer LOOK series 10 Strategic Human Resources

Exhibit 1 — continued

What percent of your senior management team was promoted to their current positions from within the company (as opposed to recruited from outside your company)?

15% More than 75% 28% Between 50% and 75% 16% Between 25% and 50%

Less than 25%

40%

To what extent do you believe that the human resources department does an outstanding job supporting the strategic goals of your company?

To a great extent - 5 18%

4 60%

3 15%

2 5%

Not at all - 1 0%

Source: Proprietary survey of 85 chief executive officers and chief human resource officers at Fortune 1000 companies, conducted by The Miles Group and Rock Center for Corporate Governance at Stanford University in summer and fall of 2018.

Stanford Closer LOOK series 11 Governance Insights Center

A deeper dive into talent management: the new board imperative

As business transformation continues to drive demand for new skills, directors need to ensure companies have the right talent to execute corporate strategies.

May 2019

Corporate directors have traditionally focused their talent management efforts on the C-suite, leaving oversight of the broader workforce to senior executives. But talent shortages, pressure from investors, and the astonishing pace of business and digital change have made it critical for boards to provide greater oversight of talent management at multiple levels of the organization.

pwc.com/us/governanceinsightscenter Governance Insights Center

Rethinking talent

Providing oversight of a company’s top talent has long been a core responsibility of corporate boards. They play a critical role in the hiring and firing of the CEO, evaluate the performance of top executives, develop leadership succession plans and ensure their companies have a robust pipeline of talent to execute company strategy.

Traditionally, directors have focused their talent management efforts on the C-suite, leaving oversight of the broader workforce to senior executives. But many boards have come to understand that a strategy is only as good as a company’s ability to execute it. And strong execution requires talented people at all levels of the organization— particularly when most companies are reinventing themselves to contend with disruption and technological advancements.

These days, the ability to attract, develop and retain the best talent has become a critical business differentiator. not having a comprehensive plan for Yet it is a challenge. In a recent survey, acquiring and developing these workers CEOs cited the low availability of key can hurt a company’s ability to grow and skills as one of the top three threats innovate. As a result, boards must play a to business in 2019.1 As widespread larger role in ensuring their organizations transformation continues to drive have the talent they need to execute demand for workers with new skills, new strategies.

2 | A deeper dive into talent management: the new board imperative Governance Insights Center

Rising investor pressure

Institutional investors have also begun paying closer attention to talent management. They realize that even a great company strategy can’t go far without the right people to execute it. And so they are urging boards to become more involved in workforce planning and development.

In January 2019, State Street Global Advisors sent a letter to the lead directors of S&P 500 and FTSE- 350 companies calling for greater board oversight of culture and talent- related issues. The letter emphasized the connection of these issues to long-term corporate performance.2 BlackRock has also identified human capital management as one of its key engagement priorities, pressing companies to invest in diversity efforts and upskill employees to succeed in increasingly automated work environments.

At the request of the Human Capital Management Coalition (HCMC), a group of 26 institutional investors with aggregate assets of over $3 trillion, the SEC is considering requiring public companies to disclose more information about their human capital management policies and practices.3 Companies now only have to report

3 | A deeper dive into talent management: the new board imperative Governance Insights Center

their employee headcounts. While some companies already disclose metrics like their employee retention rates as a Needs improvement measurement of their performance, the Directors say management HCMC is pushing for required disclosure needs to do a better job of: of detailed human capital metrics, such as workforce demographics, skills and Developing diverse executive talent capabilities, health and safety, and compensation and incentives.

Amid this rising investor and stakeholder Recruiting a diverse workforce pressure, directors are taking a hard look at talent management at their companies. And they see room for improvement. Nearly half of the directors Recognizing and addressing in PwC’s 2018 Annual Corporate gender pay disparity Directors Survey say their companies are doing a “poor” or only “fair” job of developing a diverse pool of executive talent. And roughly one-third say they Source: PwC, 2018 Annual Corporate Directors Survey, are missing the mark on recruiting October 2018. a diverse workforce and addressing gender-related pay differences.4 These are important issues given the research showing that diversity in the workforce leads to greater innovation, better decision making and stronger company performance.5

4 | A deeper dive into talent management: the new board imperative Governance Insights Center

Three steps to broader board oversight

Taking on a more substantive talent They can do this by requiring top management oversight role isn’t easy. executives to: It requires boards to strike a balance between acting strategically to ensure • Achieve strategic talent the strength of the company without management objectives stepping into the role of management. • Uphold healthy and ethical corporate To maintain a healthy balance, here’s values to set the right tone at the top what directors should focus on at three levels of an organization: • Model desired workplace behaviors • Create a diverse and inclusive culture 1. The C-suite. Directors are responsible for selecting and monitoring the performance of the 2. Up-and-comers. Boards need to CEO. As part of that responsibility, ensure the company has a strong the board needs to hold the CEO and talent pipeline for all C-suite functions. other C-level executives accountable They can do this by using a “C-Suite for company performance on talent Readiness Chart” (refer to chart on pg. management. This has become even 6) that identifies senior executives who more important as CEO tenure has could assume those positions now, as fallen to a median of five years, down well as in one to five years in the future. from six years in 2013.6 As tenures In the meantime, they should take get shorter, CEOs are under more steps to get to know and assess the pressure to deliver short-term results. capabilities of these high performers by: Tackling longer-term initiatives such as upskilling the workforce and increasing • Having them present to the board diversity become even more challenging. on major initiatives So, boards must demand that talent • Assigning them to work on special development remains a top board projects management priority despite the pressure to meet shorter-term • Inviting them to board dinners and performance targets. other social events

5 | A deeper dive into talent management: the new board imperative Governance Insights Center

3. Middle management. Getting to know • Reviewing metrics that indicate middle managers is particularly difficult whether the culture aligns with for board members. At this level, the company strategy board can provide oversight by gaining • Asking how management plans an understanding of the organization’s to address current and future skills talent philosophy, culture and talent gaps created by the adoption of needs for the future. This includes: artificial intelligence, machine learning, big data, advanced analytics, • Reviewing talent retention strategies and cloud technology and automation compensation programs to ensure they address issues like gender equity and diversity and inclusion

Sample C-Suite readiness chart

Chief Financial Officer

[name] [name] [name] [name] [name] SVP, Accounting VP, FP & A VP, Treasury VP, Investor Relations VP, Tax

Ready Now

Fran Smith External Hire Barbara Boulder Re-Organize Evan Jones Brian Bowman Tom Holder Glenn Martinez

Ready 1-3 Years

Ed North Kwame Gold Tim Bridges Fran Smith Tim Anderson

Ready 3-5 Years

Rich O’Hara Rebecca Chamberlain David Braun Mike Devlin Dorothy Hertzel

Source: National Association of Corporate Directors, Talent Development: A Boardroom Imperative, October 2013.

6 | A deeper dive into talent management: the new board imperative Governance Insights Center

Board oversight in action

Board efforts to ensure a company’s talent 2. First-hand information. Aside from management efforts align with corporate data, directors benefit from exposure strategy are best supported by three tools: to employees from as many levels of the organization as possible. Paying 1. Data. In today’s data-driven world, attention to employee sentiment and understanding and monitoring key metrics behaviors can identify areas of strength can help board members spot warning or concern. This can be done by: signs and make better informed decisions. A review of talent management-related • Getting a sense of the tone at the key performance indicators (KPIs) can top through observation and the use identify red flags and opportunities for of quantitative metrics improvement. Helpful data points include: • Observing interactions between management team members during • High turnover and high-performer board presentations to identify potentially departure rates unhealthy dynamics, such as top executives seeming wary of being candid • Unfavorable exit interviews (particularly those of high-performing employees) • Interacting with employees below the C-suite during social events, site visits • Positions that remain unfilled for and board programs long periods • Using the company’s products • Succession plan success (number and services to interact with frontline of times a plan has been established, employees and get a sense of its but management ultimately hires customer service style someone else) • Reviewing employee engagement • Low employee engagement scores surveys and requesting reports and • Lack of progress on diversity presentations on corporate culture and inclusion efforts

• Whistleblower complaints and lawsuits involving HR issues such as harassment and discrimination

7 | A deeper dive into talent management: the new board imperative Governance Insights Center

3. Accountability. Focus from the with human resources experience, board can ensure that developing and broader talent management skills can managing talent is one of a company’s be beneficial. Boards can prioritize top priorities. Directors should consider recruiting directors who have managed five actions as they broaden their roles entire divisions or regions to get to provide greater oversight: those with greater talent management experience into their boardrooms. It’s also helpful to highlight this expertise • Assign talent management responsibility among current directors in the company’s to either the full board or a dedicated proxy statement. Keep in mind that the committee so everyone understands “leadership skills” of current and former their roles and responsibilities. Talent CEOs can also be characterized as oversight is typically considered a full- talent development experience, which board responsibility with committees would clarify for investors the extent to overseeing the talent aspects associated which the board has this expertise. with their areas of oversight.7 However, some boards assign responsibility to a designated committee. For example, • Elevate the chief human resources officer 20% of public companies have expanded (CHRO) to a more strategic role and ask the purview of their compensation for regular updates. Many companies committees to include leadership and have elevated their human capital talent management.8 leaders, giving them greater responsibility for overseeing talent development and • Incorporate talent into strategy culture efforts. As a member of the discussions. When assessing the C-suite, the CHRO should have a regular viability of strategic initiatives, directors spot on the board’s agenda. Some sometimes focus on the financial boards have their CHRO present a talent implications of these decisions without review to the entire board once a year, discussing whether the company has with updates as needed. the right people to execute them. One way directors can ensure that • Make talent management a KPI for talent receives greater consideration executive compensation. Establishing in strategy discussions is to request specific people-development metrics and that management include a “talent goals in areas like diversity and inclusion, component” in every new initiative they as well as retention targets for new present to the board. hires and high-potential performers, can encourage leaders to place greater focus • Make talent management experience on talent issues. This requires having a key selection criteria for new board incentive plans with non-financial goals for members and highlight existing capability. the CEO and top executives rather than Although not every board needs a director solely a focus on financial performance.

8 | A deeper dive into talent management: the new board imperative Governance Insights Center

Building talent for tomorrow PwC perspective: communicating the board’s talent management approach in the proxy statement The shortage of skilled labor, the astonishing pace of business Investors are increasingly interested and digital change, and demands in how boards approach oversight from investors are just a few reasons of talent. As part of providing greater why boards need to shoulder greater transparency to investors, companies oversight responsibility for talent should consider the benefits of management. While day-to-day disclosing the following information in development responsibilities should their annual proxy statements: remain with management, directors need to ensure their company’s • How the board approaches its oversight of talent management approach to talent supports the company’s long-term objectives. • How often the board discusses talent management issues When boards and management teams prioritize investing time and • How often these discussions resources in human capital development include updates on the company’s throughout the organization, they are diversity and inclusion efforts more likely to win the talent wars while • How the board plans for becoming more agile, innovative succession beyond the CEO and productive.

9 | A deeper dive into talent management: the new board imperative Governance Insights Center

Appendix 1: Talent questions for directors to ask

Overall strategy Diversity and inclusion

1. Do we have a workforce plan that 9. How are we investing in recruiting, forecasts our talent needs now and developing and promoting a three to five years in the future? diverse workforce? 2. What’s our strategy for acquiring or 10. What are the results of those efforts? developing that talent? 11. If we don’t have a diverse workforce, 3. What are the challenges to executing have we conducted a root-cause on our people strategy? analysis to determine why, and decided how we will address 4. Are we adequately investing in skill the problem? development, reskilling, upskilling, job redesign and alternate workforce 12. Should we consider adopting the models to address rapid technology Rooney Rule of interviewing at least advancements? one minority candidate for certain management positions? 5. Does senior leadership recognize the strategic importance of human capital? Board composition

6. Does our CHRO have the right level 13. Does the board have sufficient talent of visibility in the boardroom? management experience? And to what extent have we prioritized Succession planning this experience when recruiting new directors? 7. How good are we at succession planning and following through on 14. In proxy disclosures, are we fully what we’ve decided? articulating the extent of talent management experience on 8. Are the executives two to three the board? levels below the C-suite getting the experience and training they need to 15. How should we assign responsibility drive strategy—even completely for talent oversight on the board? new strategies?

10 | A deeper dive into talent management: the new board imperative Governance Insights Center

Appendix 1: Appendix 2: Talent questions for directors to ask What directors need to know about the future of work

Advancements in high speed mobile ever for getting work done, companies internet and artificial intelligence, along with need to project how their talent needs widespread adoption of big data analytics will change over time and develop action and cloud technology are forecast to drive plans to address them. business growth from 2018 to 2022.10 As a result, more than half of all employees 2. Continuous learning. People are the across all industries will require significant main success factor in digital, business reskilling. With board input, companies will model and supply chain transformation need to make major investment decisions projects. Many organizations are about talent in two areas: deciding whether to acquire the new skills these projects require, or invest 1. Workforce strategy and planning. in workforce reskilling. How companies As technology advancement continues approach the potential for widespread to accelerate, companies are getting unemployment in sectors susceptible to the chance to completely rethink what automation could have a major impact their workforce will look like. The focus on their ability to attract and retain talent. is shifting from the jobs to the skills they Those that opt to retrain workers to meet require to execute their strategies. Which the demands of their evolving business functions will they automate? Which models can’t just focus on teaching ones will they augment? Which functions digital skills. They must also create an can be performed by contingent environment of continuous learning that workers? Which ones will require full- cultivates soft skills such as creativity, time employees? With more options than problem solving and empathy.

How companies will address shifting skills needs by 2022

84% Hire new permanent staff with skills relevant to new technologies 81% Look to automate the work 72% Retrain existing employees 65% Expect existing employees to pick up skills on the job 64% Outsource some business functions to external contractors 61% Hire new temporary staff with skills relevant to new technologies 54% Hire freelancers with skills relevant to new technologies 46% Strategic redundancies of staff who lack the skills to use new technologies

Likely Equally likely Unlikely Source:11 | A deeper World Economic dive into Forum, talent The management: Future of Jobs theReport new 2018 board, September imperative 2018. Governance Insights Center

Endnotes

1. PwC, 22nd Annual Global CEO Survey: CEOs’ curbed confidence spells caution, 2019. 2. State Street Global Advisors letter, January 15, 2019. 3. U.S. Securities and Exchange Commission, “Remarks for Telephone Call with SEC Investor Advisory Committee Members,” by J. Clayton. February 6, 2019. 4. PwC, 2018 Annual Corporate Directors Survey, October 2018. 5. McKinsey & Company, Delivering through diversity, January 2018. 6. Equilar, “CEO Tenure Drops to Just Five Years,” January 2018. 7. National Association of Corporate Directors, Talent Development: A Boardroom Imperative, October 2013. 8. Pearl Meyer, “The Board’s Role in Talent and Corporate Culture,” by J. Koors. February 2017. 9. U.S. Securities and Exchange Commission, “Remarks for Telephone Call with SEC Investor Advisory Committee Members,” February 2019. 10. World Economic Forum, The Future of Jobs Report 2018, September 2018.

12 | A deeper dive into talent management: the new board imperative Contacts

Paula Loop Leader PwC’s Governance Insights Center [email protected]

Paul DeNicola Principal PwC’s Governance Insights Center [email protected]

Julia Lamm Director People and Organisation Practice - PwC [email protected]

Marketing:

Christine Carey Marketing Manager PwC’s Governance Insights Center [email protected]

pwc.com

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

© 2019 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. 564498-2019 fo.

July 6, 2017

William Hinman Director, Division of Corporate Finance Brent J. Fields, Secretary Securities and Exchange Commission 100 F Street, N.E. Washington, DC 20549

Dear Mr. Hinman:

The Human Capital Management Coalition (the “HCM Coalition”) respectfully submits this petition for rulemaking pursuant to Rule 192(a) of the Commission’s Rules of Practice.1 As representatives of the HCM Coalition, a group of institutional investors with $2.8 trillion in assets, we request that the Commission adopt new rules, or amend existing rules, to require issuers to disclose information about their human capital management policies, practices and performance.

There is broad consensus that human capital management is important to the bottom line, and a large body of empirical work has shown that skillful management of human capital is associated with better corporate performance, including better risk mitigation. We view effective human capital management as essential to long-term value creation and therefore material to evaluating a company’s prospects.

Requiring disclosure regarding human capital management would fulfill the Commission’s core mission of investor protection; satisfy Congressional mandates to promote efficiency, competition and capital formation; and serve the public interest, for the following reasons:

• Given the key role of human capital, investors under current Commission disclosure requirements cannot adequately assess a company’s business, risks and prospects, for investment, engagement or voting purposes, without information about how it is managing its human capital. • Greater transparency would allow investors to more efficiently direct capital to its highest value use, thus lowering the cost of capital for well- managed companies.

1 Rules of Practice and Rules on Fair Fund and Disgorgement Plans, section 192(a) (Sept. 2016)(available at https://www.sec.gov/about/rules-of-practice- 2016.pdf). 2

• Consistent mandatory disclosure standards would obviate the need for issuers to respond to a multitude of investor requests for human capital- related information; make that information easier for all investors to collect and analyze; and level the playing field for investors that are not large enough to demand or otherwise access individualized disclosure. • There is broad consensus that long-term investing strategies are needed to stabilize and improve our markets and to effect the efficient allocation of capital. Human capital management metrics are precisely the type of information that enables investors to take the long view.

In the last section of this petition, we suggest key categories of information that we believe are fundamental to furthering investors’ understanding of how well a company is managing its human capital. These categories include: workforce demographics; workforce stability; workforce composition; workforce skills and capabilities; workforce culture and empowerment; workforce health and safety; workforce productivity; human rights; and workforce compensation and incentives.

The HCM Coalition is a collaborative effort among a global group of institutional investors to further elevate human capital management as a critical component in company performance and in the creation of long-term shareholder value. More information on the HCM Coalition and its members is available here. In the main body of this letter, we provide detailed evidence that supports our belief that human capital is a company’s most valuable asset and that stewarding human capital with that in mind will help to preserve and add value.

Human Capital and Value Creation

Over the past several decades, the importance of human capital to corporate value creation has surged. There is broad agreement that human capital encompasses the knowledge, motivation, skills and experience of a company’s workforce, as well as its alignment with the company’s mission and values.2

2 See, e.g., Gary Becker, The Age of Human Capital, at 3 (2002) (“Human capital refers to the knowledge, information, ideas, skills, and health of individuals.”); National Association of Pension Funds, “Where is the Workforce in Corporate Reporting,” at 8 (June 2015) 3

As the global economy has become more knowledge- intensive and competitive, companies are under increasing pressure to adapt to new technologies and differentiate themselves.3 Human capital is responsible for innovation, as well as effectively managing and carrying out companies’ day to day work—whether that is shelving goods at a store, caring for hospital patients, repairing equipment or investing assets to provide retirement benefits for its employees.

Human capital is thus key to getting and maintaining competitive advantage. Former Secretary of Labor Robert Reich asserted, “The only unique assets that a business has for gaining competitive advantage over its rivals are the skills and dedication of its employees.”4 One influential finance scholar has characterized human capital as firms’ “most valuable asset.”5

Companies and their leaders recognize the paramount importance of human capital. Global CEOs surveyed by PricewaterhouseCoopers in 2015 identified “availability of key skills” as the second most worrying risk, ahead of geopolitical uncertainty, tax burden and shift in consumer spending and behaviors.6 Kevin Ryan, founder and CEO of Gilt Group, put it this way:

Of all the duties facing a CEO, obsessing over talent provides the biggest return. Making sure that the

(http://www.plsa.co.uk/PolicyandResearch/DocumentLibrary/0439-Where-is- the-workforce-in-corporate-reporting-An-NAPF-discussion-paper.aspx). 3 E.g., Bo Hansson, “Employers’ Perspectives on the Roles of Human Capital Development and Management in Creating Value,” at 7, Apr. 2006 ("As economies continue to become more global and technological change continues to favour the highly educated and skilled, the already-significant role of human capital is likely to increase.”) (http://files.eric.ed.gov/fulltext/ED530787.pdf) 4 https://blogs.oracle.com/oraclehcm/create-great-employee-experiences; see also Michael Adelowotan, "The Significance of Human Capital Disclosures in Corporate Annual Reports of Top South African Listed Companies: Evidence From the Financial Directors and Managers”, Afr. J. Bus. Mgmt., Vol. 7(34), 3248-58 (2013), at 3249 (“Human capital is an asset that can provide a source of sustained competitive advantage because they are often difficult to imitate [citation omitted].”) (http://academicjournals.org/journal/AJBM/article-full-text- pdf/61F9D6E20836). 5 Luigi Zingales, “In Search of New Foundations,” The Journal of Finance, Vol. LV, No. 4, 1623-1653 (Aug. 2000), at 1642-43 (faculty.chicagobooth.edu/luigi.zingales/papers/research/search.pdf). 6 PricewaterhouseCoopers, “18th Annual Global CEO Survey,” at 9 (2015) (http://www.pwc.com/gx/en/ceo-survey/2015/assets/pwc-18th-annual-global- ceo-survey-jan-2015.pdf). 4

environment is good, that people are learning, and that they know we’re investing in them every day—I’m constantly thinking about that, yet I still don’t feel I’m doing enough. If CEOs did absolutely nothing but act as chief talent officers, I believe, there’s a reasonable chance their companies would perform better.7

Materiality of Human Capital Management

The importance of human capital is supported by decades of research. A large body of empirical work has shown that thoughtful management of human capital is associated with better corporate performance, including risk mitigation.

Research has shown that differences in human capital management performance can form the basis for successful investment strategies. Studies by Laurie Bassi, former director of research at the American Society for Training and Development, show that stock selection using training and other human capital management practices can produce superior investment outcomes. Two portfolios of large- capitalization companies launched in 2001 and 2003 using criteria related to training and employee development outperformed the S&P 500 on an annualized basis by 3.1% and 4.4%, respectively, through May 25, 2010.8 Four other portfolios launched in 2008, selected using a wider variety of HCM factors including commitment to talent management also outperformed the S&P 500 through May 25, 2010 on an annualized basis to varying degrees, from .1% to 11.9%.9

Similarly, investing in companies identified as desirable workplaces can generate superior returns. A study by Wharton’s Alex Edmans found that investing in a value- weighted portfolio of companies in the Fortune 100 America’s Best Companies to Work For from 1984 through 2009 generated excess risk-adjusted returns of 3.5% per year.10

7 Kevin Ryan, “Gilt Group’s CEO on Building a Team of A Players,” Harvard Business Review, Jan.-Feb. 2012 (available at https://hbr.org/2012/01/gilt-groupes-ceo-on-building-a-team-of-a-players). 8 Laurie Bassi & Dan McMurrer, “Human Capital Management Predicts Stock Prices,” at 1 (June 2010) (http://mcbassi.com/wp/resources/documents/HCMPredictsStockPrices.pdf) (hereinafter, “Bassi & McMurrer Stock Prices”). 9 Bassi & McMurrer Stock Prices, at 1. 10 Alex Edmans, “Does the Stock Market Fully Value Intangibles,” Journal of Financial Economics, Vol. 101, 621-640 (2011), at 621 (http://faculty.london.edu/aedmans/Rowe.pdf). 5

A recent report by the Harvard Law School Pensions and Capital Stewardship Program reviewed 92 studies that measured performance using metrics of value to investors, such as total shareholder return, return on assets, return on capital, profitability and Tobin’s Q.11 The Harvard Report found that in a majority of studies human capital management policies were associated with better financial performance.12

Many academic studies have concluded that combinations or bundles of policies and practices affect firm performance, and significant attention has been paid to the impact of a “high-performance” or “high commitment” workplace. Although there is no single definition, these are policies and practices designed to reduce turnover, encourage greater employee commitment and motivation and enhance employee skills.

For example, Mark Huselid analyzed a group of high performance workplace practices and determined that such practices are associated with lower turnover as well as better productivity and firm financial performance. Specifically, the study found that certain combinations of high-performance workplace practices were associated with statistically significant increases in productivity, Tobin’s Q and gross rate of return on capital. 13 Similarly, Huselid and Barry Becker found that high performance workplace practices have a statistically significant positive effect on firm performance.14 More recent scholarship has found that specialized high- performance workplace practices enhanced performance in

11 Aaron Bernstein and Larry Beeferman, “The Materiality of Human Capital to Corporate Financial Performance,” Pensions and Capital Stewardship Project, Labor and Worklife Program, Harvard Law School, Apr. 2015. (http://law.harvard.edu/programs/lwp/pensions/publications/FINAL%20Hu man%20capital%20Materiality%20April%2023%202015.pdf). 12 Bernstein & Beeferman, at 12. 13 Mark Huselid, “The Impact of Human Resource Management Practices on Turnover, Productivity, and Corporate Financial Performance,” Academy of Management Journal, at 645-47 (1995), at 658-659 (http://www.markhuselid.com/pdfs/articles/1995_AMJ_HPWS_Paper.pdf). 14 Mark Huselid & Brian Becker, “The Strategic Impact of High Performance Work Systems,” at 2 (Aug. 25, 1995) (http://www.bhbassociates.com/docs/articles/1995_Strategic_Impact_of_HR. pdf); see also Brian Becker & Barry Gerhart, "The Impact of Human Resource Management on Organizational Performance: Progress and Prospects,” Academy of Management Journal Vol. 39, No. 4, at 797 (1996) ("In sum, at multiple levels of analysis there is consistent empirical support for the hypothesis that HR can make a meaningful difference to a firm's bottom line.”) (amj.aom.org/content/39/4/779.short?rss+1&ssource=mfr). 6 interdependent work settings by supporting the relationships among roles needed to carry out tasks effectively.15

There is evidence that training can positively affect corporate performance. The Harvard Report reviewed 36 studies, of which 22 found that training was “associated only with superior investment outcomes.”16 Other overviews of studies have found ample evidence that the provision of training or higher training expenditures is linked to better performance on intermediate measures, such as productivity and customer satisfaction, as well as financial performance.17 Some of the studies reviewed measured performance in years subsequent to the years in which training was measured, to address the question of causation.

Research by Zeynep Ton, an expert on operations management, suggests one avenue by which training may improve performance in retail. Ton’s research has found that high-performing retailers use cross-training to provide flexibility and address variability in demand—thus better satisfying customers--without resorting to practices like last- minute (“just-in-time”) scheduling and extremely short shifts that lead to higher turnover and lower motivation.18

Ton’s research also showed that cutting labor hours, a common strategy among retailers looking to control expenses, often backfires in the form of reduced profitability. Ton obtained store-level data for over 250 Borders bookstores from 1999 through 2002 and analyzed their spending on labor; she found that increasing labor spending resulted in higher profit margins or, put another way, that increased labor costs

15 Jody Hoffer Gittell et al., “A Relational Model of How High-Performance Work Systems Work,” Organizational Science, Vol. 21, No. 2 (Mar.-Apr. 2010) (http://www.jstor.org/stable/27765979?seq=1#page_scan_tab_contents). 16 Bernstein & Beeferman, at 10. 17 Hansson, at 19-23 ("In one of the few U.S.-based studies that analyzed actual training expenditures, a recent analysis of financial institutions conducted for the American Bankers Association (2004) found that those financial institutions with higher-than-average training expenditures per employee subsequently had better outcomes than other institutions on five key financial measures examined: return on assets, return on equity, net income per employee, total assets per employee, and stock return.”); Laurie Bassi et al., “Profiting From Learning Firm-Level Effects of Training Investments and Market Implications, Singapore Management Review, Vol. 24, No. 3, 61-76 (2002), at 63 (http://home.uchicago.edu/ludwigj/papers/BassiEtal-Singapore-2002.pdf). The author of the first overview noted that few training studies had been done on U.S. companies due to data constraints. 18 Zeynep Ton, The Good Jobs Strategy, 138-148 (2014). 7 generated sales increases large enough to raise overall profitability.19 Understaffing led to “phantom stockouts,” where a product is in the store but cannot be located for the customer, bungled promotions, theft and spoilage.20 Similar conclusions were reached in a study by Vidya Mani and two colleagues, who found systematic understaffing during peak hours at 41 retail stores and estimated that appropriate staffing would improve profitability by 5.74%.21 Managing human capital by treating it solely as an expense to be minimized, then, can depress performance in retail.

Employee engagement, which many employers measure, has also been found to have a positive association with firm performance. Definitions of employee engagement vary, but it is generally agreed to include the strength of an employee’s commitment to the employer and the employee’s willingness to expend effort in his or her role.22

The reciprocal nature of employee engagement—its dependence on employer as well as employee commitment— differentiates it from employee satisfaction. Consultant Aon Hewitt has emphasized the need for senior leaders to create a “culture of engagement.”23 As one author put it, “The degree to which employee engagement technology translates into a happier, more productive workforce, however, may depend on company culture and management’s willingness to examine and act on its own shortcomings.”24

An analysis of 50 global firms by Towers Watson determined that the average one-year operating margins of companies with low engagement scores trailed those at companies with high “sustainable engagement” scores by 17

19 Ton, at 38-40. 20 Ton, at 40. 21 Vidya Mani et al., “Estimating the Impact of Understaffing on Sales and Profitability in Retail Stores,” Production and Operations Management, Vol. 24, No. 2, 201-218 (2015) (http://public.kenan- flagler.unc.edu/faculty/kesavans/understaffing.pdf). 22 Dinah Wisenberg Brin, “Technology for Employee Engagement on the Rise,” Society for Human Resource Management (Feb. 9, 2016) (https://www.shrm.org/ResourcesAndTools/hr- topics/technology/Pages/Technology-for-Employee-Engagement- Rising.aspx). 23 Aon Hewitt, “2015 Trends in Global Employee Engagement,” at 4 (2015) (http://www.aon.com/attachments/human-capital-consulting/2015-Trends- in-Global-Employee-Engagement-Report.pdf). 24 Gemma Richardson-Smith and Walter Bappert, “Employee Engagement: A Review of Current Thinking,” Institute for Employment Studies, at 14 (2009); Brin. 8 percentage points.25 A 2002 meta-analysis found that higher employee engagement is associated with higher customer satisfaction and loyalty, productivity and profitability, as well as lower turnover.26 Aon Hewitt estimates that a 5% increase in employee engagement leads to a 3% increase in revenue growth the following year.27

A case study by the Human Capital Management Institute (HCMI) found that Jet Blue locations and flights with a higher average “net promoter score”—a measure of how likely an employee is to recommend Jet Blue as an employer (often used in lieu of employee engagement measures)—had higher customer satisfaction and revenue. The HCMI estimated that a 5% increase in net promoter score was associated with a 1% increase in revenue.28

Further, board and workplace diversity has been linked to financial performance. A growing body of empirical research indicates a significant positive relationship between firm value and the percentage of women and minorities on boards. A 2012 Credit Suisse Research Institute evaluated the performance of 2,360 companies globally over six years and found that companies with one or more women on boards delivered higher average returns on equity, lower leverage, better average growth and higher price/book value multiples.29 A 2015 McKinsey study of 366 companies found that corporate leadership in the top quartile for racial and ethnic diversity were 35 percent more likely to have financial returns above their national industry median.30

Human capital management matters not only when it confers competitive advantage and improves firm performance. Material risks related to human capital management can

25 Tony Schwartz, “New Research: How Employee Engagement Hits the Bottom Line,” Harvard Business Review, Nov. 8, 2012 (https://hbr.org/2012/11/creating-sustainable-employee.html). 26 James K. Harter et al., “Business-Unit-Level Relationship Between Employee Satisfaction, Employee Engagement, and Business Outcomes: A Meta-Analysis,” Journal of Applied Psychology Vol. 87, No. 2, 268-79 (2002) (www.factorhappiness.at/downloads/quellen/S17_Harter.pdf). 27 Aon Hewitt, at 1. 28 http://www.hcminst.com/casestudy/jetblues-profit-to-engagement- linkage-case-study/. 29 Credit Suisse, “Does Gender Diversity Improve Performance?” Jul. 31, 2012 (https://www.credit-suisse.com/us/en/about-us/research/research- institute/news-and-videos/articles/news-and-expertise/2012/07/en/does- gender-diversity-improve-performance.html) 30 Vivian Hunt, Dennis Layton & Sara Prince, “Diversity Matters,” McKinsey & Company, Feb. 2, 2015 (http://www.diversitas.co.nz/Portals/25/Docs/Diversity%20Matters.pdf) 9 create substantial risks for companies and investors, damaging corporate reputation, generating legal liabilities and undermining relationships with key stakeholders.

Human capital-related risks are not limited to a company’s direct employees. Major shifts in the organization of work over the past several decades, including the rise of outsourcing, subcontracting, franchising and complex global supply chains, have multiplied those risks. When a company’s products or services are made or provided by its employees, that company has control over the work and, as a general matter, liability for legal violations related to it. As employment relationships are increasingly supplanted by contractual ones, there is a growing concern that the incentives of the company’s contracting partners are not necessarily aligned with those of the company. This misalignment may lead to financial and reputational damage.31

It is not unusual for there to be multiple layers of contractors and subcontractors whose employees produce goods or provide services for a firm and who may be spread out across multiple countries or geographic regions. Generally, the further down the chain one goes, the greater the incentives are to cut corners through nonpayment of owed wages, safety shortcuts and other violations.32 A company’s ability to control how work is performed on its behalf depends on clear performance standards and robust monitoring, enforcement and coordination mechanisms; falling short on any of these can have serious consequences. For example, investigators have concluded that BP’s 2010 Deepwater Horizon explosion and oil spill, which killed 11 workers, cost shareholders billions and released nearly five million barrels of oil into the Gulf of Mexico,33 resulted from, among other things, the lack of hazard assessment coordination between BP and the contractor actually operating the drilling rig.34

31 See, e.g., David Linich, “The Path to Supply Chain Transparency: A Practical Guide to Defining, Understanding, and Building Supply Chain Transparency in a Global Economy,” at 2 (2014) (“The dispersed nature of today’s supply chains creates increasing levels of risk for multinational businesses, making transparency both critical and complex.”) (dupress.deloitte.com/content/dam/dup-us-en/articles/supply-chain- transparency/DUP785_ThePathtoSupplyChainTransparency.pdf) 32 David Weil, “How to Make Employment Fair in the Age of Contracting and Temp Work,” Harvard Business Review, Mar. 24, 2017. 33 Campbell Robertson & Clifford Krauss, “Gulf Spill is the Largest of its Kind, Scientists Say,” The New York Times, Aug. 2, 2010 (http://www.nytimes.com/2010/08/03/us/03spill.html). 34 See U.S. Chemical Safety Board, “CSB Investigation: At the Time of 2010 Blowout, Transocean, BP, Industry Associations, and Government Offshore 10

Candy maker The Hershey Company (Hershey) was blindsided in 2011 when a subcontractor of a subcontractor of Hershey’s packing facility contractor used an educational travel program to bring foreign students to the U.S. to pack and move heavy boxes. Eventually, the students staged a public walkout to protest working conditions, the deduction of fees and inflated rent from their paychecks and the fact that they were required to continue working at the facility in order to maintain their educational travel visas.35 Hershey, its packing facility contractor Exel, and Exel’s staffing subcontractor SHS all claimed not to know about the students’ plight, since the student workers were provided by yet another subcontractor, raising questions about the adequacy of the firms’ oversight of their staffing providers.36

Evolving norms are calling for more due diligence and transparency on human capital risks in the supply chain. A 2010 Harvard Business Review article noted, “Consumers, governments, and companies are demanding details about the systems and sources that deliver the goods.”37 Regulators have responded by instituting measures that encourage attention to these risks. In the United Kingdom (U.K.), the Modern Slavery Act requires larger businesses to prepare a “slavery and human trafficking statement” for each fiscal year, confirming that the firm has taken steps to ensure that slavery and human trafficking is not taking place in any of its supply chains and in any part of its own business. The firm can, alternatively, state that it has taken no such steps.38 In California, the Transparency in Supply Chains Act requires that large companies doing business in California disclose their “efforts to eradicate slavery and human trafficking from [their] direct supply chain for tangible goods offered for sale,”

Regulators Had Not Effectively Learned Critical Lessons From 2005 BP Refinery Explosion in Implementing Safety Performance Indicators,” July 24, 2012 (http://www.csb.gov/csb-investigation-at-the-time-of-2010-gulf- blowout-transocean-bp-industry-associations-and-government-offshore- regulators-had-not-effectively-learned-critical-lessons-from-2005-bp- refinery-explosion-in-implementing-safety-performance-indicators/). 35 Julia Preston, “Foreign Students in Work Visa Program Stage Walkout at Plant,” The New York Times, Aug, 17, 2011 (http://www.nytimes.com/2011/08/18/us/18immig.html). 36 Dave Jamieson, “Student Guestworkers at Hershey Plant Allege Exploitative Conditions,” The Huffington Post, Aug. 17, 2011 (http://www.huffingtonpost.com/2011/08/17/student-guestworkers-at- hershey-plant_n_930014.html). 37 Steve New, “The Transparent Supply Chain,” Harvard Business Review, Oct. 2010 (https://hbr.org/2010/10/the-transparent-supply-chain). 38 See http://www.legislation.gov.uk/ukpga/2015/30/section/54/enacted. 11 including certification, audits, verification, internal accountability and training.39

Current Lack of Comparable Data on Human Capital

Despite the importance of human capital management to company performance, human capital is nearly invisible in the Commission’s disclosure rules. Regulation S-K, which sets forth disclosures required in registration statements and various reports under the integrated disclosure system, contains one item related to human capital: Item 101(c)(xiii), in the “Narrative Description of Business” section, mandates disclosure of the “number of persons employed by the registrant.”40

Companies often make mention of human capital-related risk factors in periodic filings with the Commission; these disclosures, however, tend to be boilerplate, designed to limit liability rather than convey meaningful information about human capital management practices. A study by the Sustainability Accounting Standards Board (SASB) found that more than 40% of all 10-K disclosures on sustainability topics were boilerplate and that lack of standardization limited the utility of the 15% of disclosures that used metrics.41 Boilerplate disclosures are not only unhelpful to investors; there is some evidence that vague risk factor disclosures are construed negatively by the market, leading to higher costs of capital.42

Surveys conducted by environmental, social and governance (ESG) data providers do not solve these problems. Many companies are overwhelmed with disclosure requests and limit their responsiveness, often to the largest investors.43 Even if an investor or data provider asks for uniform

39 Kamala Harris, The California Transparency in Supply Chains Act: A Resource Guide, at I (2015) (oag.ca.gov/sites/all/files/agweb/pdfs/sb657/resource-guide.pdf). 40 https://www.law.cornell.edu/cfr/text/17/229.101. 41 Comment of the Sustainability Accounting Standards Board on “Concept Release: Business and Financial Disclosure Required by Regulation S-K,” dated July 1, 2016 (https://www.sec.gov/comments/s7-06-16/s70616-25.pdf) (hereinafter, “S-K Concept Release”). 42 Ole-Kristian Hope et al., “The Benefits of Specific Risk-Factor Disclosures,” at 11 (Feb. 26, 2016) (“greater specificity in risk factor disclosure reduces the variance uncertainty premium and thus the expected cost of capital”) (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2457045). 43 E.g., Mike Hower, “Could Sustainability ‘Survey Fatigue’ Launch a $1 Billion Industry?” Greenbiz, Apr. 2, 2015 (https://www.greenbiz.com/article/gisr-program-cuts-core-esg-research-and- ratings). 12 information from all companies it surveys, responses may be incomplete, may not adhere to the requested format and may calculate metrics differently, making it difficult to compare companies across industries and markets.

Some companies do not respond to reasonable requests for information at all, leaving investors few options for recourse. Filing shareholder proposals is one strategy used by investors to encourage companies to report on various risks not captured fully by existing disclosure requirements, but rules limiting the topic and scope of these proposals effectively preclude investors from obtaining comprehensive human capital-related information in this way. For example, a shareholder may request information about human rights risks in the supply chain but proposals addressing other human capital matters, such wages and benefits, are barred, with few exceptions, by the “ordinary business” exclusion in the shareholder proposal rule.44 Recent efforts to place tighter restrictions on shareholder proposals, such as legislation that would dramatically increase the ownership threshold investors must meet to file a proposal, may effectively eliminate this strategy.45

Data acquired by searching websites have similar shortcomings. Some investors have turned to online social media sources such as Glassdoor, a jobs and recruiting site with a database of millions of employee reviews of companies as well as salary information.46 Reviewers can describe pros and cons of a company, indicate whether they approve of its CEO and critique their employee benefits. Users can also provide information about interviews at companies. Glassdoor data thus have the potential to shed light on companies’ human capital management. Glassdoor reviews are anonymous, though, and thus vulnerable to manipulation by companies seeking to project a positive image. Even assuming all reviews are penned by actual current or former employees, Glassdoor is subject to the same bias as other review sites:

44 E.g., Best Buy Co., Inc. (Mar. 8, 2016) (allowing exclusion on ordinary business grounds of proposal regarding minimum wage, reasoning it dealt with “general compensation matters”); Pilgrim’s Pride Corp. (Feb. 25, 2016) (permitting exclusion on ordinary business grounds of proposal requesting report on certain occupational safety and health matters). 45 See http://www.cii.org/files/issues_and_advocacy/correspondence/2017/Apr%202 4%20Letter%20Committee%20on%20Financial%20Services_FINAL.pdf. 46 E.g., Laurie Bassi, “Should You Be Worried About Your Company’s Glassdoor Scores?” Blog Post, Feb. 11, 2016 (http://mcbassi.com/2016/02/11/should-you-be-worried-about-your- companys-glassdoor-scores/). 13 unhappy employees will be more motivated to share their views than happy ones.

Disclosure Requirements Evolve in Response to Investor Needs

In sum, investors do not currently have the ability to obtain comparable human capital data from U.S. issuers. But the Commission’s rules are not static; it has broad authority conferred in the Securities Act and Exchange Act to “promulgate rules for registrant disclosure as necessary or appropriate in the public interest or for the protection of investors.”47

Evolving investor needs have led to updates in disclosure requirements. For example, the corporate governance disclosure items, including director qualifications and executive compensation, have been revised to accommodate investors’ increased interest in board accountability and desire for more granular disclosure around executive compensation packages.48 Similarly, the Commission has expanded the events triggering an obligation to disclose on Form 8-K (Current Report) and reduced the number of days registrants have to make those disclosures to keep pace with changing investor expectations.49

The Commission has recognized that current requirements governing periodic reporting about companies’ businesses and risks are likely outdated. Last year the Commission solicited comments from investors on a wide variety of potential changes to both the substance and format of disclosures as part of its Disclosure Effectiveness initiative.50 Commissioner Kara Stein noted last year:

47 See Securities Act Release No. 10064, “Business and Financial Disclosure Required by Regulation S-K,” at 21-22 & n.50 (Apr. 13, 2016) (available at https://www.sec.gov/rules/concept/2016/33-10064.pdf). 48 See, e.g., “Report on Review of Disclosure Requirements in Regulation S- K,” at 53 (Dec. 2013) (https://www.sec.gov/news/studies/2013/reg-sk- disclosure-requirements-review.pdf); Straka, at 806. 49 See Securities Act Release No. 8400, “Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date” (Mar. 16, 2004) (adopting release) (available at https://www.sec.gov/rules/final/33-8400.htm) and Securities Act Release No, 8106, “Additional Form 8-K Disclosure Requirements and Acceleration of Filing Date” (June 19, 2002) (proposing release) (stating that “investors and the securities markets today demand and expect more ‘real-time’ access to a greater range of reliable information concerning important corporate events that affect publicly traded securities”) (available at https://www.sec.gov/rules/proposed/33-8106.htm).

50 See Securities Act Release No. 10064, supra. 14

What investors want changes. Materiality evolves. It changes as society changes, and it also changes with the availability of new and better data. To achieve effective disclosure, we must understand what is important to today’s investors.51

As discussed below, investors have significant appetite for disclosures regarding human capital management and would use such information to inform their investment and voting decisions in a number of different ways.

Investor Demand for Human Capital Data

A wide range of investors have shown interest in obtaining information that will enable them to analyze the effectiveness of companies’ human capital management practices. Investor appetite for human capital disclosure should be understood within the larger context of concern over short-termism. In a widely publicized letter to CEOs at S&P 500 companies, BlackRock chief Larry Fink advocated “resistance to the powerful forces of short-termism” and investment in long-term growth. To that end, he urged CEOs to develop a strategic framework for long-term value creation and disclose more about their vision and plans for the future, including how they are “developing [their] talent.”52

Asset manager UBS has tied underinvestment in the workforce to short-termism: “A key reason behind the outperformance of the best places to work seems to lie in the short-/long-term conundrum created by human capital investments – often essential to long-term profit generation, but likely to hurt performance in the short term.”53 As long- term investors, we need to understand the drivers of sustainable value creation and address barriers to efficient capital allocation.

Investor participation in several major initiatives evidences support for human capital disclosure.54 The U.N.-

51 Speech of Commissioner Kara M. Stein, “Disclosure in the Digital Age: Time for a New Revolution,” May 6, 2016 (available at https://www.sec.gov/news/speech/speech-stein-05062016.html). 52 Matt Turner, “Here is the Letter the World’s Largest Investor, BlackRock CEO Larry Fink, Just Sent to CEOs Everywhere,” Business Insider, Feb. 2, 2016 (http://www.businessinsider.com/blackrock-ceo-larry-fink-letter-to-sp- 500-ceos-2016-2). 53 UBS Investment Research, “Corporate Culture: Relevant to Investors?” at 1, Aug. 19, 2013 (http://faculty.london.edu/aedmans/Rowe%20UBS3.pdf). 54 In the interest of brevity, we do not discuss all investor initiatives related to human capital disclosure. A matrix prepared by the Human Capital 15 supported Principles for Responsible Investment (“PRI”) has 1500 signatories with $62 trillion in assets under management who agree to incorporate ESG issues into investment decision making and seek those disclosures from companies in which they invest.55 The PRI’s Employee Relations Group coordinated an investor campaign from 2013-2015 that aimed to enhance human capital management and reporting at 27 global retailers. The group’s steering committee identified core metrics most strongly correlated with firm performance based on empirical research—employee turnover, absences, training and engagement. Subsequently, 24 PRI signatories engaged with the companies. According to the group’s report, the company engagement brought about some improvements, but left “much scope” for further work.56

Investors have also backed the work of SASB to establish sustainability accounting standards, including standards for human capital reporting. SASB explains its mission as follows:

A new, standardized language is needed to articulate the material, non-financial risks and opportunities facing companies today. These non-financial risks and opportunities that affect corporations’ ability to create long-term value are characterized as “sustainability” issues. Sustainability issues vary by industry because they are closely aligned with business models, the way companies compete, their use of resources, and their impact on society.57

SASB has identified one or more human capital issues as “material” for accounting purposes for at least some industries in each of its 10 sectors.58 It has characterized human capital as a “cross-cutting” issue.59

Management Institute, reproduced in a publication by the UK’s Pensions and Lifetime Savings Association, identifies additional efforts. Pension and Lifetime Savings Association, “Understanding the Worth of the Workforce: A Stewardship Toolkit for Pension Funds” (July 2016), at 9 (http://www.plsa.co.uk/PolicyandResearch/DocumentLibrary/~/media/Policy/ Documents/0591-Understanding-the-worth-of-the-workforce-a-stewardship- toolkit-for-pension-funds.pdf). 55 https://www.unpri.org/about. 56 PRI, “An Investor Guide to Engaging Retailers on Employee Relations,” at 4-5 (2015) (https://www.unglobalcompact.org/library/4071) 57 http://www.sasb.org/sasb/vision-mission/ 58 http://www.sasb.org/materiality/sasb-materiality-map/ 59 www.sasb.org/blog-moving-from-provisional-to-codified-an-update-on- the-consultation-period. 16

SASB’s board of directors includes numerous investor representatives.60 As well, representatives of many large asset managers and owners, including CalPERS, CalSTRS, PGGM, Vanguard, Goldman Sachs, State Street Global Advisors and BlackRock, serve on SASB’s investor advisory group.61

The integrated reporting movement also recognizes the importance of human capital disclosure to investors. The push for integrated reporting--providing information on all factors that create value, not just traditional measures of financial and physical capital, in one report—is spearheaded by the International Integrated Reporting Council (IIRC). The IIRC is a “global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs”62 whose board63 and council64 include institutional investor representatives.

The IIRC’s objective is to use integrated reporting—to embed “integrated thinking” within “mainstream business practice in the public and private sectors.”65 The IIRC defines integrated thinking as “the active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects.”66 The benefits the IIRC suggests for integrated reporting include better decision making by providers of financial capital.67

Human capital, defined as “[p]eople’s competencies, capabilities and experience, and their motivations to innovate,” is one of the six capitals on which disclosure should be made in an integrated report.68 Information about human capital, the IIRC says, needs to be treated with “similar rigour and accountability as is afforded to financial capital.”69

60 http://www.sasb.org/sasb/board-directors/ 61 http://using.sasb.org/investor-advisory-group/ 62 http://integratedreporting.org/the-iirc-2/ 63 http://integratedreporting.org/the-iirc-2/structure-of-the-iirc/the-iirc- board/ 64 http://integratedreporting.org/the-iirc-2/structure-of-the-iirc/council/ 65 The International Framework, at 2 (2013) (http://integratedreporting.org/wp-content/uploads/2015/03/13-12-08-THE- INTERNATIONAL-IR-FRAMEWORK-2-1.pdf) 66 The Integrated Framework, at 2. 67 The Integrated Framework, at 2. 68 The Integrated Framework, at 4, 12. 69 IIRC, “Creating Value: The Value of Human Capital Reporting,” at 4 (2015) (http://integratedreporting.org/wp- content/uploads/2015/12/CreatingValueHumanCapitalReporting_IIRC06_16 .pdf). 17

The Global Reporting Initiative (“GRI”) also illustrates investors’ desire for standardized information about sustainability issues, including human capital. The GRI describes its mission as “help[ing] businesses, governments and other organizations understand and communicate the impact of business on critical sustainability issues such as climate change, human rights, corruption and many others.”70

To that end, the GRI Global Sustainability Standards Board sets reporting standards,71 which include standards on training, labor/management relations, diversity, freedom of association and collective bargaining and several other subjects relevant to human capital.72 Shareholders sometimes refer to the GRI’s framework in shareholder proposals asking companies to issue a sustainability report.73 In 41 countries, almost 80% of the largest 100 companies issuing sustainability reports use the GRI’s guidelines.74

The international human resources and financial community are also currently pursuing the development of human capital disclosure standards. A committee of global experts, working under the International Organization of Standardization’s (ISO) directives for standards development are writing a standard called “Guidelines -Human Capital Reporting for Internal and External Stakeholders.” Since November 2015, this working group has aimed “to establish a common global understanding on human capital reporting” to allow stakeholders more easily to “access and derive an understanding of an organization’s human capital and its present and future performance.”75

The Global Unions Committee on Workers’ Capital (“CWC”) recently endorsed the Guidelines on Workers’ Rights

70 https://www.globalreporting.org/information/about- gri/Pages/default.aspx. 71 https://www.globalreporting.org/information/about-gri/governance- bodies/Global-Sustainability-Standard-Board/Pages/default.aspx. 72 https://www.globalreporting.org/standards/gri-standards-download- center/. 73 E.g., http://www.asyousow.org/wp-content/uploads/2013/09/2010-apple- reso.pdf. 74 https://www.globalreporting.org/information/news-and-press- center/Pages/GRI-is-the-global-standard-as-sustainability-reporting-goes- mainstream-says-KPMG-survey.aspx. 75 “Q&A: Professor Stefanie Becker Says Human Capital and Engagement are Worldwide Issues,” undated (available at http://enterpriseengagement.org/newswire/content/8475926/qa-professor- stefanie-becker-says-human-capital-and-engagement-are-worldwide- issues/). 18 and Labour Standards, which recommends, among other things, disclosure of human capital metrics to improve asset owners’ understanding of “company commitments to worker well-being.” These metrics include data on workforce composition, including workers employed by staffing agencies, franchisees and subcontractors; turnover relative to industry; human rights due diligence; leading worker health and safety indicators; and access to training. The CWC is an international labor union network that promotes dialogue and action on the stewardship of workers’ retirement savings and works to educate fund trustees on responsible investment.76

The Pensions and Lifetime Savings Association (the “PLSA”) recently sent letters to the chair of each company whose stock is a constituent of the FTSE 350 index of large- and mid-capitalization U.K. companies, asking for disclosure of the number of full- and part-time employees, as well as employee turnover. The PLSA’s chief executive Joanne Segars explained, “It's essential that pension funds know more about how the companies, in which they invest, manage and engage their employees. We know that engaged workers make for stronger companies and stronger companies make for better investment returns - creating an economy that works for everyone.”77

Investor Uses for Human Capital Disclosures

Investors are interested in using human capital disclosure for different purposes, depending on their investment strategy. Many investors favor more robust human capital disclosures to permit them to identify and invest in companies that manage their human capital most effectively; for these investors, human capital management is an input for fundamental analysis alongside more traditional inputs like product quality, technological innovation and distribution channels.

Comment letters submitted in response to the Commission’s Disclosure Effectiveness Concept Release reflect investors’ interest in human capital disclosure. The CFA Institute, an association of investment professionals, stated in its comment letter that investors “want disclosures that help them understand how changes in the business and competitive

76 http://www.workerscapital.org/priorities/. 77 http://www.professionalpensions.com/professional- pensions/news/2476649/plsa-urges-ftse-350-leaders-to-share-more-data- about-workforce. 19 environment, the economy, management, and business drivers will affect company performance . . . . [R]egistrants should provide disclosures on the different types of resources that help them generate revenues, cash and profit . . .[including] human resources.” More specifically, the CFA Institute urged the Commission to require more granular disclosure about the types of employees a company employs, to allow investors “to determine whether a company’s current employees matches the mix of employees that is optimal.”78

Similarly, Cornerstone Capital, an advisory firm with institutional investor clients, opined that “human capital is a key intangible factor for all companies,” and advocated that companies be required to report their total payroll cost, turnover and diversity data.”79 RPMI Railpen, which invests the 21 billion pounds sterling of assets in the U.K. Railways Pension Scheme, commented that employee engagement and turnover data were highly informative.80

Some investors also view human capital management as an integral part of corporate culture, which investors have regarded as an important indicator of performance but have struggled to define and measure. For example, financial advisor and asset manager UBS has stated that “[c]orporate culture is an important, difficult and likely under-analyzed topic” in which employee engagement and satisfaction play an important role. According to UBS, evaluating culture presents “analytical challenges” due to the paucity of data. Conceding the limitations of the sources, UBS analysts compiled an employee satisfaction index from data on career websites such as Glassdoor, then analyzed employee comments and developed investment themes to identify suitable companies for investment.81 Similarly, according to the National Association of Pension Funds, for long-term investors such as pension funds, information about the workforce is “crucial to understanding a company’s culture.”82

In addition to viewing human capital management as a criterion for identifying desirable companies in which to invest,

78 Comment of CFA Institute on S-K Concept Release, dated Oct. 6, 2016, at 2-4 (https://www.sec.gov/comments/s7-06-16/s70616-375.pdf). 79 Comment of Cornerstone Capital Group on S-K Concept Release, dated July 21, 2016, at 5 (https://www.sec.gov/comments/s7-06-16/s70616- 308.pdf). 80 Comment of Railpen Investments on S-K Concept Release, dated July 21, 2016, at 2-3 (https://www.sec.gov/comments/s7-06-16/s70616-200.pdf). 81 UBS, at 4. 82 National Association of Pension Funds, at 13. 20 investors also want data that will help them avoid material risks created by poor workplace practices and to inform engagements.

The role of disclosure in addressing these risks is underscored by the U.N. Guiding Principles on Business and Human Rights, which charge companies with respecting human rights throughout their operations.83 The Guiding Principles state that business is responsible for respecting, among other things, the International Labor Organization’s Declaration on Fundamental Principles and Rights at Work-- including freedom of association and freedom for discrimination, forced labor and child labor.84 The Guiding Principles favor disclosure of human rights risks; they direct governments to “[e]ncourage, and where appropriate require, business enterprises to communicate how they address their human rights impacts.”85

Investor interest in information about human capital- related risks is evident from the substantial number of shareholder proposals filed on the limited number of human capital-related topics that are permissible under the shareholder proposal rule, such as human rights risk in the supply chain, workforce diversity and pay equity. According to data from the Sustainable Investments Institute, in 2016 shareholders submitted 96 proposals on “social” subjects, a large proportion of which sought human capital-related disclosure or policy changes. Settlements were reached on some proposals after the company agreed to take action on the proposal.86

BlackRock’s Corporate Governance and Responsible Investment team has intensified its attention to human capital issues, spurred by the belief that human capital can be a source of both competitive strength and risk. BlackRock highlights this commitment in a presentation to a local municipal authority discussing —a four year engagement it undertook with a UK public transport company over employee health and safety and freedom of association, which BlackRock

83 United Nations Office of the High Commissioner on Human Rights, “U.N. Guiding Principles on Business and Human Rights,” at 13 (2011) (http://www.ohchr.org/Documents/Publications/GuidingPrinciplesBusinessH R_EN.pdf). 84 U.N. Guiding Principles, at 13. 85 U.N. Guiding Principles, at 4. 86 See, e.g., As You Sow & Sustainable Investments Institute, “Proxy Preview 2016,” at 36-43 (describing settlements) (http://www.proxypreview.org/proxy-preview-2016/). 21 believed posed reputational and financial risks.87 During the engagement, the company improved its disclosure, reduced employee injuries and accidents and appointed a new executive director with human capital experience. BlackRock predicted that such engagements will become more common, as “companies will become increasingly active in discussing human capital with their investors.”88 For 2017-2018, BlackRock has identified human capital management as an engagement priority.89

Many commenters on the Commission’s Disclosure Effectiveness Concept Release stated that improved human capital disclosure would allow them to avoid investing in companies with high levels of human capital-related risk or to engage risky companies in which they had already invested to advocate improved practices. The following statement in the comment by the Presbyterian Church U.S.A. is an example:

Information about the human rights risks present in a company’s operations and supply chain, as well as the management of those risks, is relevant information for an investor in assessing a company’s performance and management approach in both the short‐ and long‐ term. Poor management of human rights risks can lead to significant reputational, regulatory, and litigation risk for a company and can have a material impact on financial performance.90

Several commenters also pointed to legal liabilities for discrimination and pay inequity, health and safety violations and labor disruptions as material risks related to human capital management practices.91

87 BlackRock presentation to the London Borough of Lewisham, at 8 (February 19, 2015) (http://councilmeetings.lewisham.gov.uk/documents/s33886/BlackRock%20A nnual%20Presentation%2019-02-15.pdf) 88 “BlackRock Corporate Governance and Responsible Investment Report: Europe, the Middle East and Africa,” at 10 (June 30, 2015) (https://www.blackrock.com/corporate/en-il/literature/fact-sheet/blk-qtrly- commentary-2015-q2-emea.pdf). 89 See www.blackrock.com/corporate/en-us/about-us/investment- stewardship/engagement-priorities. 90 Comment of Presbyterian Church U.S.A. on S-K Concept Release, dated July 21, 2016, at 7 (https://www.sec.gov/comments/s7-06-16/s70616- 290.pdf). 91 See Comment of AFSCME on S-K Concept Release, dated July 21, 2016, at 5 (https://www.sec.gov/comments/s7-06-16/s70616-269.pdf); Comment of Christian Brothers Investment Service on S-K Concept Release, dated July 21, 2016, at 18; Comment of Rockefeller & Co. on S-K Concept Release, dated July 21, 2016, at 2-3. 22

Human capital disclosures can also, to some investors’ thinking, shed light on the quality of upper management and the board’s stewardship of the company; that, in turn, can be relevant to proxy voting decisions. Although proxy voting guidelines generally explicitly mention human capital issues only as they relate to votes on shareholder proposals addressing human capital-related risks, investors and proxy advisors take into account such factors when deciding whether to vote for director nominees.92 In its announcement that human capital management would be a 2017-2018 engagement priority, BlackRock stated that such engagement “also provides a lens into the company’s culture, long-term operational risk management practices and, more broadly, the quality of the board’s oversight.”93

Human capital disclosures may also signal broader challenges facing a company. Coalition member Sycomore Asset Management noted in 2013 an increase in fatal accidents at a French portfolio company reported pursuant to French disclosure requirements. Upon following up with a former safety manager, Sycomore learned that deep budget cuts had led to increased pressure on workers and decided to sell its stake. Shortly thereafter, the share price began to decline, and it remains far below 2013 levels today.94

Investors may also use human capital disclosures for “screening” purposes. They may wish to include in a fund or portfolio only companies with exemplary human capital management practices, or to exclude companies whose practices are viewed as problematic. Human capital disclosures could also enable investors to identify industries or geographic regions to screen in or out. The sustainable, responsible and impact (SRI) investing sector95 has grown tremendously: According to The Forum for Sustainable and Responsible Investment, one out of every six dollars under professional

92 See e.g., Goldman Sachs Asset Management, Global Proxy Voting Policy, Procedures and Guidelines, at 6 (may vote against or withhold support from nominees for “Material failures of governance, stewardship, or fiduciary responsibilities at the company”) (https://www.gsam.com/content/dam/gsam/pdfs/us/en/miscellaneous/voting_ proxy_policy.pdf?sa=n&rd=n). 93 See www.blackrock.com/corporate/en-us/about-us/investment- stewardship/engagement-priorities. 94 Email from Claire Bataillie, SRI Analyst, Sycomore Asset Management on Mar. 24, 2017. 95 It is worth noting that responsible investment is not limited to screening, but also includes engagement, which benefits from robust human capital information. 23 management in the U.S. at the end of 2013 was invested using SRI strategies.96 SRI investors applying screens to U.S. companies must rely on voluntary disclosures, with their flaws of incompleteness and inconsistency, and the information researchers can hand-collect from sources like court dockets, news accounts and databases of Occupational Safety and Health Administration violations.97

Human capital management disclosures could also be used by investment managers to create indexes and investable products. Investment managers are using those types of human capital data that are currently available for that purpose. For example, State Street Global Advisors has created a Gender Diversity Index made up of large capitalization U.S. companies with the highest levels of senior leadership gender diversity in their sectors.98 State Street considers the proportion of women on the board, whether a company has a female CEO and the number of women among senior leadership.99 The JPX (Japan Stock Exchange)/S&P CAPEX and Human Capital Index chooses companies using data from RobecoSAM on capital expenditures and human capital, including labor rights, employee development, employee turnover and talent attraction/retention.100

Finally, robust human capital disclosures would benefit investors that are “universal owners” by supporting long-term investment strategies, thereby stabilizing our markets, and encouraging employers to invest in their workforces. Universal owners are investors with such widely diversified portfolios that they “effectively own the economy as a whole.”101 As a result, universal owners, including many HCM Coalition members, have “an economic interest in the overall

96 http://www.ussif.org/sribasics. 97 By contrast, in France, where human capital disclosure requirements are more extensive, socially responsible investment firm Sycomore Investments has launched a fund called “Happy@Work”, which uses performance indicators on quality of work life, motivation and empowerment. (http://en.sycomore-am.com/files/P/R/572265a0- PR_Launch_Sycomore_Happy_Work_July2015.pdf) 98 https://www.ssga.com/investment-topics/general-investing/2016/she- gender-diversity-index-introduction.pdf. 99 Julie Segal, “SHE: The ETF That Trades on Female Empowerment,” Institutional Investor, May 12, 2016 (available at http://www.institutionalinvestor.com/inside-edge/3554005/she-the-etf-that- trades-on-female-empowerment.html). 100 http://www.indexologyblog.com/2016/11/03/sustainability-why-does-the- social-category-matter/ 101 Hawley & Williams, at 286. 24 performance of the financial markets and broader economy” in which they invest.102

Human capital disclosure would strengthen both our financial markets and the U.S. economy. More transparency about human capital management would improve investors’ decision making and lead to more efficient capital allocation.103 And greater transparency, at least in financial reporting, has been found to be economically beneficial.104

As well, disclosure could promote a longer-term orientation. At present, a variety of factors, including short- term earnings pressures,105 accounting policies106 and compensation structures, create incentives for corporate managers to produce short-term results, which may lead to underinvestment in the workforce, though lack of data impedes

102 Office of the New York City Comptroller, Corporate Governance Principles and Proxy Voting Guidelines, at 7 (Apr. 2016) (http://comptroller.nyc.gov/wp- content/uploads/documents/Corporate_Governance_Principles_and_Proxy_V oting_Guidelines.pdf). 103 See, e.g., Mary E. Barth & Katherine Schipper, “Financial Reporting Transparency,” J. Acctg., Auditing & Fin., Vol. 23, Issue 2, Apr. 2008, at 174 (greater transparency can lower the cost of capital, provided the information “reduces nondiversifiable risk that arises from information asymmetry among investors or increases the average precision of investors’ assessments of the firm’s future cash flows”); see also Securities Act Release No. 10064, supra (“Lowering information asymmetries between managers of companies and investors may enhance capital formation and the allocative efficiency of the capital markets.”). 104 See Barth & Schipper, at 174, 179 (“Research also suggests that financial reporting transparency is associated with positive macroeconomic effects.”) 105 See Dominic Barton & Mark Wiseman, “Focusing Capital on the Long Term,” Harvard Business Review, Jan-Feb. 2014 (citing 2013 study by McKinsey and the Canada Pension Plan Investment Board of 1,000 board members and C-suite executives; 63% reported increasing pressure over the previous five years to generate short-term returns and 79% reported feeling especially pressured to demonstrate strong financial performance over a two-year or shorter period). 106 For example, under Generally Accepted Accounting Principles, research and development (R&D) costs must be expensed in the period when they are made. There is evidence that this immediate impact on earnings leads to manipulation of investment to meet earnings targets. See Stephen J. Terry, “The Macro Impact of Short-Termism,” at 8-10 (2015) (economics.yale.edu/sites/default/files/terry_macrows_mifet_latest_draft.pd_ .pdf) (firms that narrowly meet earnings targets lower their investment in R&D and intangibles, “consistent with systematic manipulation of long- term investment to meet analyst forecasts of earnings,” leading to misallocation of R&D across firms). 25 efforts to quantify the extent of underinvestment.107 The influence of financial markets often encourages companies to shift from direct employment to contractual arrangements such as outsourcing, subcontracting and franchising as a way to lower labor costs. Human capital disclosure, which would inform investors about the long-term risks associated with cost-cutting measures, could help counter those forces and promote a longer-term approach for both companies and investors. More stable capital markets and investment in the workforce would in turn benefit the broader public interest, as well as diversified investors.

Principles for Crafting Human Capital Disclosure Requirements

Having established the ways in which human capital disclosure requirements would advance the Commission’s mission, we now describe how we believe the Commission should proceed in this area. We have not included in this petition the text of disclosure requirements we believe the Commission should adopt. Instead, we urge the Commission to solicit input from all affected constituencies, with an emphasis on the needs of investors, to identify the matters on which disclosure would be most useful. The Commission has undertaken similar efforts when formulating rule proposals in other complex areas such as executive compensation.

A number of frameworks, including the Integrated Reporting Framework, SASB’s standards, the Global Reporting Initiative, the CWC Guidelines and the U.N. Guiding Principles on Business and Human Rights, recommend disclosure requirements and can provide a starting point for this process. Some companies, as well, have made high-quality disclosures in particular areas of human capital. For example,108 Diesel & Motor Engineering plc, breaks down its workforce by position, gender and age, and discloses turnover, employee satisfaction scores and average training hours per employee.109 Unilever reports on turnover, training—including

107 Angela Hanks et al., “Workers or Waste?” Center for American Progress, at 5-12 (June 2016) (https://cdn.americanprogress.org/wp- content/uploads/2016/06/03042031/HumanCapital.pdf). 108 These examples are not intended to illustrate comprehensive disclosure on all human capital-related topics but rather to show various approaches the Commission might consider on particular matters. 109 See dimolanka.com/annualreport2014/human-capital.html. 26 within the supply chain, “where the bulk of [our] people work”—accident rates and gender equality.110

Below we set forth our views on some of the larger questions that the Commission will likely need to consider.

First, it may be argued that no human capital management practice or data point is applicable to all issuers, regardless of size, maturity and industry, and that the Commission should therefore not impose any across-the-board disclosure requirements. Although we agree that it may be appropriate to tailor some disclosure requirements more precisely, there is broad agreement that certain categories of information are fundamental to human capital analysis, and some disclosures from each category, whether quantitative or qualitative (or both), should be required (examples, which are not intended to be exhaustive, are in parentheses after each category):

1. Workforce demographics (number of full-time and part-time workers, number of contingent workers, policies on and use of subcontracting and outsourcing) 2. Workforce stability (turnover (voluntary and involuntary), internal hire rate) 3. Workforce composition (diversity,111 pay equity policies/audits/ratios) 4. Workforce skills and capabilities (training, alignment with business strategy, skills gaps) 5. Workforce culture and empowerment (employee engagement, union representation, work-life initiatives) 6. Workforce health and safety (work-related injuries and fatalities, lost day rate) 7. Workforce productivity (return on cost of workforce, profit/revenue per full-time employee) 8. Human rights commitments and their implementation (principles used to evaluate risk, constituency consultation processes, supplier due diligence) 9. Workforce compensation and incentives (bonus metrics used for employees below the named

110 See www.unilever.com/images/annual_report_and_accounts_ar15_tcm244- 478426_en.pdf. 111 The regulation could provide a limited exception for disclosure of workforce composition outside the United States, to the extent that local laws may restrict such disclosure. 27

executive officer level, measures to counterbalance risks created by incentives)

Both specific, rules-based disclosures, such as the amount spent on employee training in the past year, and more open-ended principles-based disclosures like how training expenditures are aligned with a changing business strategy, would provide investors with valuable information about human capital management. The Commission will need to find the appropriate balance between these two approaches when crafting disclosure requirements.

Line-item disclosures are easier to extract through an automated process leveraging keywords or tags because every issuer makes the same disclosure in the same place in a filing using a consistent format. As a result, line-item disclosures are less expensive to collect and thus more accessible to a range of investors. Line-item disclosures can be entered into a database or spreadsheet and thus lend themselves to comparison and analysis. An investor could, for example, examine training expenditures for a particular industry and identify typical industry practice and outliers for further research. Line-item disclosures can be easily analyzed over time, to identify trends.

Investors value consistency and comparability highly. The CFA Institute argued in favor of uniformity and specificity in its comment on the Commission’s Disclosure Effectiveness Concept Release:

In general, principles-based requirements will have one, some, or all of three primary outcomes. First, issuers will withhold disclosure based on an internal determination that the information is immaterial. Second, issuers will group information in a manner that obfuscates negative performance or conditions. And third, different issuers will apply the “principles” differently, thus making the information incomparable across different issuers. For data-driven disclosures, therefore, we believe the Commission needs to provide prescriptive rules as to what must be reported, the manner in which it is reported, and the assumptions behind the reporting. As noted above, without such prescription, investors may not receive materially important information, may not be aware of material information, and/or they would not be able to compare disclosures across companies or across industries.112

112 Comment of CFA Institute on S-K Concept Release, at 5. 28

Narrative reporting, by contrast, allows companies to provide a fuller picture and can give investors information they need to put quantitative disclosures into context. An investment researcher interviewed for an IIRC publication put it this way:

In this area there is always going to be a role for more narrative reporting. It is useful to know the staff turnover figure, but you want to know why it is at that level, what the baseline for that industry is. If there has been a move up or down, why that has occurred, has there been a business restructuring or has it been that the staff have become more dissatisfied over the past year?113

In many cases, quantitative and qualitative disclosures will complement each other. Investors have found that to be the case with the Commission’s executive compensation disclosures: Quantitative (and easily retrievable) data allows investors to identify companies where pay practices might be problematic, and the Compensation Discussion and Analysis narrative disclosure supplies important context and explanation for the reported data.

Finally, disclosure requirements should encompass the entire workforce, regardless of location, to provide investors with the most complete picture of an issuer’s human capital management practices. Global coverage is especially important for disclosures regarding human rights, given the increased human rights risks of operating in countries with weaker protections for workers. Including non-U.S. workers would also be consistent with the CEO to average worker pay ratio disclosure requirements taking effect for 2017;114 indeed, the same systems companies will rely on to comply with the CEO to average worker pay ratio disclosure mandate would facilitate data collection and calculation of metrics related to human capital management.

The Commission will need to consider the extent to which disclosure should be made about workers making a company’s products or providing its services pursuant to contractual arrangements between the company and a contractor, franchisee or supplier. In light of the proliferation

113 IIRC, Creating Value, at 24. 114 Securities Act Release No. 9877, “Pay Ratio Disclosure” (Aug. 5, 2015) (https://www.sec.gov/rules/final/2015/33-9877.pdf). 29 of such arrangements, disclosure about the mechanisms used to monitor and enforce performance, and mitigate risks associated with the loss of direct control, would likely be useful for investors.

We appreciate the opportunity to express our views to the Commission. If the Commission or Staff have any questions about this Petition, or if we can provide any additional information, please contact Meredith Miller, Chief Corporate Governance Officer for the UAW Retiree Medical Benefits Trust, at [email protected].

Respectfully submitted,

The Human Capital Management Coalition

On behalf of the Human Capital Management Coalition:

Sincerely,

Meredith Miller, Chief Corporate Governance Officer UAW Retiree Medical Benefits Trusts 734-929-5789 [email protected]

Harvard Law School Forum on Corporate Governance and Financial Regulation

BlackRock Investment Stewardship’s Approach to Engagement on Human Capital Management

Posted by Michelle Edkins, BlackRock Investment Stewardship, on Wednesday, March 28, 2018

Tags: BlackRock, Board oversight, Boards of Directors, Corporate culture, Diversity, Engagement, Fiduciary duties, Human capital, Institutional Investors, Management, Shareholder value, Stakeholders, Stewardship, Transparency

More from: Michelle Edkins, BlackRock

Editor's Note: Michelle Edkins is the Managing Director and Global Head of BlackRock Investment Stewardship. This post is based on a publication prepared by BlackRock Investment Stewardship.

BlackRock has an industry leading global investment stewardship program that promotes corporate governance best practices at the companies in which we invest. This program is part of the investment function at BlackRock, fulfilling our fiduciary duty to protect and enhance the value of our clients’ assets.

As Larry Fink recently wrote in his 2018 annual letter to CEOs:

Companies must ask themselves: What role do we play in the community? Are we working to create a diverse workforce? Are we adapting to technological change? Are we providing the retraining and opportunities that our employees and our business will need to adjust to an increasingly automated world?

For several years, the BlackRock Investment Stewardship (BIS) team has been engaging companies on the topic of human capital which we also identify as one of our 2018 engagement priorities. [1] The BIS team has been in discussions with companies about their management of employees as an investment issue.

This post sets out in some detail our thinking on human capital management (HCM) and explains how we approach engagement on the topic. Why Human Capital Management is an Investment Issue

Most companies BlackRock invests in on behalf of clients have, to varying degrees, articulated in their public disclosures that they are operating in a talent constrained environment, or put differently, are in a war for talent. It is therefore important to investors that companies explain as part of their corporate strategy how they establish themselves as the employer of choice for the workers on whom they depend. A company’s approach to HCM—employee development, diversity and a commitment to equal employment opportunity, health and safety, labor relations, and supply chain labor standards, amongst other things—will vary across sectors but is a factor in business continuity and success. In light of evolving market trends like shortages of skilled labor, uneven wage growth, and technology that is transforming the labor market, many companies and investors consider robust HCM a competitive advantage.

Research has consistently shown the importance of human capital to company performance. Companies included in Fortune magazine’s “100 Best Companies to Work For” lists earned, over the long-term, excess risk-adjusted returns of 3.5%. [2] Another report surveyed a multitude of studies on human capital and found that there is a positive correlation between human resource initiatives and investment outcomes such as total shareholder return, return on assets, return on earnings, return on investment and return on capital employed. [3] A survey concluded that companies that had a workforce that was not engaged had an average one-year operating margin below 10%; however, those that consistently promoted workers’ well-being had an average one-year operating margin of 27%. BlackRock’s Engagement On Human Capital Management

HCM is both a board and a management issue. We would expect a company’s board to be deeply engaged in the oversight of a company’s strategy and the defining of a company’s purpose—to help ensure the effective strategic implementation of HCM throughout their organization. Companies that can better articulate their purpose are more likely to build strong relationships with their employees (and customers), and have a clear sense of their strategic objectives. These are essential components of long-term growth. Employees who do not feel valued by their organization are generally less productive or more likely to leave. Product quality and reputation can suffer when employees are not fully engaged and supportive of the company, its business and goals. When present, these dynamics make it much more difficult for a company to meet its strategic objectives. For management, it is an issue that is central to their everyday duties. We also expect that boards, acting as fiduciaries on behalf of investors and as those who help set the tone at the top, to be focused on the opportunities and risks associated with HCM.

The BIS team is aware that disclosure of information on HCM is still evolving and that the way HCM risks manifest themselves may vary by industry and market. We are members of the Investor Advisory Group of the Sustainability Accounting Standards Board (SASB), which provides industry-specific HCM metrics. We encourage companies to aim over time to go beyond commentaries and provide more transparency on their practices. Investors recognize that most companies are already in possession of HCM data on their workforce, but are cautious of disclosing this information. We believe that both qualitative and quantifiable indicators can help effectively distinguish companies that are managing this important driver of value in their business.

Our engagements seek to be constructive, aiming to build mutual understanding while asking probing questions. Where we believe a company’s practices fall short relative to market or peer practice, we will share our insights and perspectives.

When engaging boards on HCM we are likely to discuss:

Oversight of policies meant to protect employees (e.g., whistleblowing, codes of conduct, EEO policies) and the level of reporting the board receives from management to assess their implementation Process to oversee that the many components of a company’s HCM strategy align themselves to create a healthy culture and prevent unwanted behaviors Reporting to the board on the integration of HCM risks into risk management processes Current board and employee composition as it relates to diversity Consideration of linking HCM performance to executive compensation to promote board accountability Board member visits to establishments or factories to independently assess the culture and operations of the company

When engaging management teams, the topics we may cover include:

Policies to encourage employee engagement outcomes and key drivers (e.g., wellness programs, support of employee networks, training and development programs, and stock participation programs) Process for ensuring employee health and safety and complying with occupational health and safety policies Voluntary and involuntary turnover on various dimensions (e.g., seniority of roles, tenure, gender, and ethnicity) Statistics on gender and other diversity characteristics as well as promotion rates for and compensation gaps across different employee demographics Programs to engage organized labor and their representatives, where relevant Systems to oversee matters related to the supply chain (including contingent workers, contractors and subcontractors) Endnotes

1 BIS’ 2017-2018 engagement priorities are publicly available on our website at https://www.blackrock.com/corporate/en-gb/about-us/investment-stewardship/voting-guidelines-reports-position- papers#2017-2018-priorities (go back)

2 Edmans, Alex. “Does the Stock Market Fully Value Intangibles,” Journal of Financial Economics 101 (2011): 621-640. (go back)

3 Bernstein, Aaron and Larry Beeferman, “The Materiality of Human Capital to Corporate Financial Performance,” Pensions and Capital Stewardship Project, Labor and Worklife Program, Harvard Law School, April 2015 (go back)

Both comments and trackbacks are currently closed. AI, AUTOMATION, AND THE FUTURE OF WORK: TEN THINGS TO SOLVE FOR

BRIEFING NOTE PREPARED FOR THE TECH4GOOD SUMMIT, ORGANIZED BY THE FRENCH PRESIDENCY JUNE 2018

Automation and artificial intelligence (AI) are 1. Accelerating progress in AI and transforming businesses and will contribute to automation is creating opportunities for economic growth via contributions to productivity. businesses, the economy, and society They will also help address “moonshot” societal Automation and AI are not new, but recent challenges in areas from health to climate change. technological progress is pushing the frontier of At the same time, these technologies will transform what machines can do. Our research suggests the nature of work and the workplace itself—which that society needs these improvements to provide is the focus of this briefing note. Machines will value for businesses, contribute to economic be able to carry out more of the tasks done by growth, and make once unimaginable progress humans, complement the work that humans do, on some of our most difficult societal challenges.1 and even perform some tasks that go beyond what In summary: humans can do. As a result, some occupations Rapid technological progress will decline, others will grow, and many more will Beyond traditional industrial automation and change. While we believe there will be enough advanced robots, new generations of more work to go around (barring extreme scenarios), capable autonomous systems are appearing in society will need to grapple with significant environments ranging from autonomous vehicles workforce transitions and dislocation. Workers on roads to automated check-outs in grocery will need to acquire new skills and adapt to the stores.2 Much of this progress has been driven increasingly capable machines alongside them by improvements in systems and components, in the workplace. They may have to move from including mechanics, sensors, and software. declining occupations to growing and, in some AI has made especially large strides in recent cases, new occupations. This briefing note, which years, as machine-learning algorithms have draws on the latest research from the McKinsey become more sophisticated and made use of Global Institute, examines both the promise huge increases in computing power and of the and the challenge of automation and AI in the exponential growth in data available to train workplace and outlines some of the critical issues algorithms. Spectacular breakthroughs are that policy makers, companies, and individuals will making headlines, many involving beyond-human need to solve for. capabilities in computer vision, natural language Challenges remain before these technologies processing, and complex games such as Go. can live up to their potential for the good of the economy and society Potential to transform businesses and AI and automation still face challenges. The contribute to economic growth limitations are partly technical, such as the need for These technologies are already generating value massive training data and difficulties “generalizing” in various products and services, and companies algorithms across use cases. Recent innovations across sectors use them in an array of processes are just starting to address these issues. Other to personalize product recommendations, find challenges are in the use of AI techniques. For anomalies in production, identify fraudulent example, explaining decisions made by machine transactions, and more. The latest generation of learning algorithms is technically challenging, AI advances, including techniques that address which particularly matters for use cases involving classification, estimation, and clustering problems, financial lending or legal applications. Potential promises significantly more value still. An analysis bias in the training data and algorithms, as well as we conducted of several hundred AI use cases data privacy, malicious use, and security are all found that the most advanced deep learning issues that must addressed.8 Europe is leading techniques deploying artificial neural networks with the new General Data Protection Regulation, could account for as much as $3.5 trillion to which codifies more rights for users over data $5.8 trillion in annual value, or 40 percent of the collection and usage. A different sort of challenge value created by all analytics techniques.3 concerns the ability of organizations to adopt Deployment of AI and automation technologies these technologies, where people, data availability, can do much to lift the global economy and technology, and process readiness often make increase global prosperity, at a time when aging it difficult. Adoption is already uneven across and falling birth rates are acting as a drag on sectors and countries. The finance, automotive, growth. Labor productivity growth, a key driver of and telecommunications sectors lead AI adoption. economic growth, has slowed in many economies, Among countries, US investment in AI ranked first dropping to an average of 0.5 percent in 2010–14 at $15 billion to $23 billion in 2016, followed by from 2.4 percent a decade earlier in the United Asia’s investments of $8 billion to $12 billion, with States and major European economies, in the Europe lagging at $3 billion to $4 billion.9 aftermath of the 2008 financial crisis after a 2. How AI and automation will affect work previous productivity boom had waned. AI and Even as AI and automation bring benefits to automation have the potential to reverse that business and society, we will need to prepare for decline: productivity growth could potentially major disruptions to work. reach 2 percent annually over the next decade, with 60 percent of this increase from digital About half of the activities (not jobs) carried out opportunities.4 by workers could be automated Our analysis of more than 2000 work activities Potential to help tackle several societal across more than 800 occupations shows that “moonshot” challenges certain categories of activities are more easily AI is also being used in areas ranging from material automatable than others. They include physical science to medical research and climate science. activities in highly predictable and structured Application of the technologies in these and other environments, as well as data collection and data disciplines could help tackle societal “moonshot” processing. These account for roughly half of the challenges.5 For example, researchers at Geisinger activities that people do across all sectors. The have developed an algorithm that could reduce least susceptible categories include managing diagnostic times for intracranial hemorrhaging others, providing expertise, and interfacing by up to 96 percent.6 Researchers at George with stakeholders. Washington University, meanwhile, are using machine learning to more accurately weight the climate models used by the Intergovernmental Panel on Climate Change.7

2 McKinsey Global Institute AI, automation, and the future of work:Ten things to solve for Nearly all occupations will be affected by including rising incomes, increased spending automation, but only about 5 percent of on healthcare, and continuing or stepped- occupations could be fully automated by up investment in infrastructure, energy, and currently demonstrated technologies. Many more technology development and deployment. These occupations have portions of their constituent scenarios showed a range of additional labor activities that are automatable: we find that about demand of between 21 percent to 33 percent of 30 percent of the activities in 60 percent of all the global workforce (555 million and 890 million occupations could be automated. This means that jobs) to 2030, more than offsetting the numbers most workers—from welders to mortgage brokers of jobs lost. Some of the largest gains will be to CEOs—will work alongside rapidly evolving in emerging economies such as India, where machines. The nature of these occupations will the working-age population is already growing likely change as a result. rapidly.11

Jobs lost: Some occupations will see significant Additional economic growth, including from declines by 2030 business dynamism and rising productivity Automation will displace some workers. We growth, will also continue to create jobs. Many have found that around 15 percent of the global other new occupations that we cannot currently workforce, or about 400 million workers, could be imagine will also emerge and may account for as displaced by automation in the period 2016–30. much as 10 percent of jobs created by 2030, if This reflects our mid-point scenario in projecting history is a guide. Moreover, technology itself has the pace and scope of adoption. Under the fastest historically been a net job creator. For example, scenario we have modeled, that figure rises to the introduction of the personal computer in the 30 percent, or 800 million workers. In our slowest 1970s and 1980s created millions of jobs not just adoption scenario, only about 10 million people for semiconductor makers, but also for software would be displaced, close to zero percent of the and app developers of all types, customer service global workforce.10 representatives, and information analysts.

The wide range underscores the multiple factors Jobs changed: More jobs than those lost that will impact the pace and scope of AI and or gained will be changed as machines automation adoption. Technical feasibility of complement human labor in the workplace automation is only the first influencing factor. Partial automation will become more prevalent as Other factors include the cost of deployment; machines complement human labor. For example, labor-market dynamics, including labor supply AI algorithms that can read diagnostic scans with a quantity, quality, and the associated wages; the high degree of accuracy will help doctors diagnose benefits beyond labor substitution that contribute patient cases and identify suitable treatment. In to business cases for adoption; and, finally, social other fields, jobs with repetitive tasks could shift norms and acceptance. Adoption will continue toward a model of managing and troubleshooting to vary significantly across countries and sectors automated systems. At retailer Amazon, because of differences in the above factors, employees who previously lifted and stacked especially labor-market dynamics: in advanced objects are becoming robot operators, monitoring economies with relatively high wage levels, such as the automated arms and resolving issues such as France, Japan, and the United States, automation an interruption in the flow of objects.12 could displace 20 to 25 percent of the workforce 3. Key workforce transitions and challenges by 2030, in a midpoint adoption scenario, more While we expect there will be enough work to than double the rate in India. ensure full employment in 2030 based on most of Jobs gained: In the same period, jobs will also our scenarios, the transitions that will accompany be created automation and AI adoption will be significant. The Even as workers are displaced, there will be mix of occupations will change, as will skill and growth in demand for work and consequently educational requirements. Work will need to be jobs. We developed scenarios for labor demand to redesigned to ensure that humans work alongside 2030 from several catalysts of demand for work, machines most effectively.

McKinsey Global Institute AI, automation, and the future of work:Ten things to solve for 3 Digital platforms, the gig economy, and the changes workforce skills, such platforms are rise of tech-enabled independent work becoming part of an essential suite of HR recruiting The rise of digital talent platforms, the gig tools. To harness them, companies will need to economy, and tech-enabled independent work are take a more strategic look at their talent needs, and also affecting the future of work. They are already adapt their human resources function to align it having a transformative effect on some sectors, more clearly with the CEO agenda.2 and they have the potential to help address some Digital platforms can also give a boost to of the labor markets’ challenges in matching independent work. MGI research finds that 20 to jobs to workers and in signaling information to 30 percent of the working age population in the prospective employers. At the same time, they United States and the European Union is engaged challenge some entrenched ways of working and, in independent work, with 70 percent of those in some countries, the workings of social systems. doing so out of preference. While only about Digital talent platforms create transparency and 15 percent of independent work is conducted efficiency in labor markets. Surveys by LinkedIn on digital platforms now, that proportion is find that workers using digital platforms are eight growing rapidly. Independent workers span all times more likely to be at the same company demographic groups: about half of senior earners after two years and 11 percent more satisfied have participated in independent work, and youth than in their previous jobs. By improving worker make up about a quarter of the independent satisfaction across the economy, these platforms workforce.3 While those who pursue independent can drive productivity. About 40 percent of work (digitally enabled or not) out of preference respondents to the surveys said digital platforms are generally satisfied, those who pursue it out of helped them secure a job they would not have necessity are unsatisfied with the income variability otherwise found. By drawing more people into and the lack of benefits typically associated with more formal employment, these platforms can traditional work. Policy makers and innovators will raise labor-force participation. MGI estimates that need to grapple with solutions to these challenges. these effects together could contribute $2.7 trillion to global GDP annually by 2025.1 As automation 2 Ram Charan, Dominic Barton, and Dennis Carey, Talent wins; The new playbook for putting people first, Harvard Business Review Press, 2018. 1 A labor market that works: Connecting talent with 3 Independent work: Choice, necessity, and the gig opportunity in the digital age, June 2015. economy, October 2016.

Workers will need different skills to thrive in the Many workers will likely need to workplace of the future change occupations Automation will accelerate the shift in required Our research suggests that, in a mid-point workforce skills we have seen over the past scenario, around 3 percent of the global workforce 15 years. Demand for advanced technological will need to change occupational categories by skills such as programming will grow rapidly. 2030, though scenarios range from about 0 to Social, emotional, and higher cognitive skills, 14 percent. Some of these shifts will happen such as creativity, critical thinking, and complex within companies and sectors, but many will information processing, will also see growing occur across sectors and even geographies. demand. Basic digital skills demand has been Occupations made up of physical activities increasing and that trend will continue and in highly structured environments or in data accelerate. Demand for physical and manual processing or collection will see declines. Growing skills will decline, but will remain the single largest occupations will include those with difficult to category of workforce skills in 2030 in many automate activities such as managers, and those countries.13 This will put additional pressure on the in unpredictable physical environments such already existing workforce skills challenge, as well as plumbers. Other occupations that will see as the need for new credentialing systems. While increasing demand for work include teachers, some innovative solutions are emerging, solutions nursing aides, and tech and other professionals. that can match the scale of the challenge will be needed.

4 McKinsey Global Institute AI, automation, and the future of work:Ten things to solve for Workplaces and workflows will change as more remained stagnant for about half a century despite people work alongside machines rising productivity—a phenomenon known as As intelligent machines and software are integrated “Engels’ Pause,” after the German philosopher more deeply into the workplace, workflows and who identified it. workspaces will continue to evolve to enable 4. Ten things to solve for humans and machines to work together. As In the search for appropriate measures and self-checkout machines are introduced in stores, policies to address these challenges, we should for example, cashiers can become checkout not seek to roll back or slow diffusion of the assistance helpers, who can help answer technologies. Companies and governments questions or troubleshoot the machines. More should harness automation and AI to benefit from system-level solutions will prompt rethinking of the enhanced performance and productivity the entire workflow and workspace. Warehouse contributions as well as the societal benefits. design may change significantly as some These technologies will create the economic portions are designed to accommodate primarily surpluses that will help societies manage robots and others to facilitate safe human- workforce transitions. Rather, the focus should be machine interaction. on ways to ensure that the workforce transitions Automation will likely put pressure on average are as smooth as possible. This is likely to require wages in advanced economies more actionable and scalable solutions in several The occupational mix shifts will likely put pressure key areas: on wages. Many of the current middle-wage ƒƒ Ensuring robust economic and productivity jobs in advanced economies are dominated growth. Strong growth is not the magic answer by highly automatable activities, such as in for all the challenges posed by automation, manufacturing or in accounting, which are likely but it is a pre-requisite for job growth and to decline. High-wage jobs will grow significantly, increasing prosperity. Productivity growth is a especially for high-skill medical and tech or other key contributor to economic growth. Therefore, professionals, but a large portion of jobs expected unlocking investment and demand, as well to be created, including teachers and nursing as embracing automation for its productivity aides, typically have lower wage structures. The contributions, is critical. risk is that automation could exacerbate wage polarization, income inequality, and the lack of ƒƒ Fostering business dynamism. income advancement that has characterized the Entrepreneurship and more rapid new business past decade across advanced economies, stoking formation will not only boost productivity, but social, and political tensions.14 also drive job creation. A vibrant environment for small businesses as well as a competitive In the face of these looming challenges, environment for large business fosters business workforce challenges already exist dynamism and, with it, job growth. Accelerating Most countries already face the challenge of the rate of new business formation and the adequately educating and training their workforces growth and competitiveness of businesses, to meet the current requirements of employers. large and small, will require simpler and evolved Across the OECD, spending on worker education regulations, tax and other incentives. and training has been declining over the last two decades. Spending on worker transition ƒƒ Evolving education systems and learning and dislocation assistance has also continued for a changed workplace. Policy makers to shrink as a percentage of GDP. One lesson of working with education providers (traditional the past decade is that while globalization may and non-traditional) and employers themselves have benefited economic growth and people as could do more to improve basic STEM skills consumers, the wage and dislocation effects through the school systems and improved on workers were not adequately addressed. on-the-job training. A new emphasis is needed Most analyses, including our own, suggest that on creativity, critical and systems thinking, and the scale of these issues is likely to grow in the adaptive and life-long learning. There will need coming decades. We have also seen in the past to be solutions at scale. that large-scale workforce transitions can have a ƒƒ Investing in human capital. Reversing the lasting effect on wages; during the 19th century trend of low, and in some countries, declining Industrial Revolution, wages in the United Kingdom public investment in worker training is critical.15

McKinsey Global Institute AI, automation, and the future of work:Ten things to solve for 5 Through tax benefits and other incentives, safety nets are available, and should be policy makers can encourage companies to adopted and adapted, while new approaches invest in human capital, including job creation, should be considered and tested. learning and capability building, and wage ƒƒ Investing in drivers of demand for work. growth, similar to incentives for the private Governments will need to consider stepping up sector to invest in other types of capital, investments that are beneficial in their own right including R&D. and will also contribute to demand for work ƒƒ Improving labor market dynamism. (e.g. infrastructure, climate change adaptation). Information signals that enable matching of These types of jobs, from construction to workers to work, credentialing, could all work rewiring buildings and installing solar panels, better in most economies. Digital platforms are often middle-wage jobs, those most can also help match people with jobs and affected by automation. restore vibrancy to the labor market. When ƒƒ Embracing AI and automation safely. Even more people change jobs, even within a as we capture the productivity benefits of company, evidence suggests that wages these rapidly evolving technologies, we need rise.16 As more varieties of work and income- to actively guard against the risks and mitigate earning opportunities emerge, including the gig any dangers. The use of data must always take economy, we will need to solve for issues such into account concerns, including data security, as portability of benefits, worker classification, privacy, malicious use, and potential issues of and wage variability.17 bias, issues that policy makers, tech and other ƒƒ Redesigning work. Workflow design and firms, and individuals will need to find effective workspace design will need to adapt to a ways to address. new era in which people work more closely ••• with machines. This is both an opportunity and a challenge, in terms of creating a safe There is work for everyone today and there will and productive environment. Organizations be work for everyone tomorrow, even in a future are changing too, as work becomes more with automation. Yet that work will be different, collaborative and companies seek to become requiring new skills, and a far greater adaptability increasingly agile and non-hierarchical. of the workforce than we have seen. Training and retraining both midcareer workers and new ƒƒ Rethinking incomes. If automation (full or generations for the coming challenges will be an partial) does result in a significant reduction imperative. Government, private sector leaders, in employment and/or greater pressure on and innovators all need to work together to better wages, some ideas such as conditional coordinate public and private initiatives, including transfers, support for mobility, universal basic creating the right incentives to invest more in income, and adapted social safety nets could human capital. The future with automation and be considered and tested. The key will be to AI will be challenging, but a much richer one if find solutions that are economically viable we harness the technologies with aplomb—and and incorporate the multiple roles that work mitigate the negative effects. plays for workers, including providing not only income, but also meaning, purpose, This briefing note was written by James Manyika, and dignity. chairman and director of the McKinsey Global Institute and a senior partner at McKinsey & ƒƒ Rethinking transition support and safety Company, based in San Francisco; and Kevin nets for workers affected. As work evolves Sneader, McKinsey & Company’s global managing at higher rates of change between sectors, partner-elect, based in Hong Kong. locations, activities, and skill requirements, many workers will need assistance adjusting. McKinsey Global Institute research reports are Many best practice approaches to transition available on www.mckinsey.com/mgi.

6 McKinsey Global Institute AI, automation, and the future of work:Ten things to solve for Further reading Endnotes 1 David Autor, “Why are there still so many jobs? Recent MGI reports on automation and the future of work, including A future that works: Automation, employment, The history and future of workplace automation,” and productivity, January 2017 and Jobs lost, jobs Journal of Economic Perspectives, Summer 2015. gained: Workforce transitions in a time of automation, December 2017. David Autor and Anna Salomons, “Does 2 Disruptive technologies: Advances that will transform life, productivity growth threaten employment?” business, and the global economy, May 2013. working paper prepared for ECB Forum on Central 3 Notes from the AI frontier: Insights from hundreds of use Banking, June 2017. cases, April 2018. 4 Solving the productivity puzzle: The role of demand and the Erik Brynjolffson and Andrew McAfee, The second promise of digitization, February 2018. machine age: Work, progress, and prosperity in a 5 Nicola Nosengo, “Can artificial intelligence create the next time of brilliant technologies, WW Norton, 2014. wonder material?” Nature, May 4, 2016. Jason Furman “Should we be reassured if 6 Mohammad R. Arbabshirani et al., “Advanced machine learning in action: identification of intracranial hemorrhage automation in the future looks like automation in the on computed tomography scans of the head with clinical past?” in NBER book The Economics of Artificial workflow integration,” npj Digital Medicine, volume 1, article Intelligence: An Agenda, Ajay K. Agrawal, Joshua 9, April 2018. Gans, and Avi Goldfarb, ed., NBER, forthcoming. 7 Nicola Jones, “How machine learning could help to improve climate forecasts,” Nature, August 23, 2017. Terry Gregory, Anna Salomons, and Ulrich 8 Michael Chui, James Manyika, and Mehdi Miremadi, “What Zierhahn, Racing with or against the machine? AI can and can’t do (yet) for your business,” McKinsey Evidence from Europe, Centre for European Quarterly, January 2018. Economic Research, discussion paper 16-053, 9 Artificial intelligence: The next digital frontier? June 2017. July 2016. 10 Jobs lost, jobs gained: Workforce transitions in a time of automation, December 2017. William R. Kerr, Allison Ciechanover, and Jeff 11 Ibid. Huizinga, Managing the future of work, Harvard 12 Nick Wingfield, “As Amazon pushes forward with robots, Business School, May 2018. workers find new roles,” The New York Times, September 10, 2017. Ljubice Nedelkoska and Glenda Quintini, 13 Skill shift: automation and the future of the workforce, Automation, skills use and training, OECD social, May 2018. employment and migration working papers, 14 Poorer than their parents? Flat or falling incomes in number 202, March 2018. advanced economies, July 2016. 15 Public spending on labour markets, OECD. 16 A labor market that works: Connecting talent with opportunity in the digital age, June 2015. 17 Independent work: Choice, necessity, and the gig economy, October 2016.

McKinsey Global Institute | Copyright © McKinsey & Company 2018 www.mckinsey.com/mgi @McKinsey_MGI McKinseyGlobalInstitute Employees Rising: Seizing the Opportunity in Employee Activism 01

INTRODUCTION Social activists. Environmental activists. Consumer activists. Activist shareholders. Today, there is no shortage of activists affecting business operations in some way. These stand-up-for-what-is-right campaigners may either be an employer’s best advocates or its worst opponents. In either case, they are change agents.

What about employee activists? Are employee activists the next wave that leaders need to be ready for? Who is asking this question? “In today’s environment where there is an alarming lack of trust in all institutions, Management, human resources and communications departments employees are increasingly the key of Fortune 500 companies are rightfully laser-focused on employee prism for brand credibility and trust. satisfaction and engagement. In fact, global research conducted by Engaging them can provide companies Weber Shandwick and Spencer Stuart among chief communications the best way to humanize and unify officers found that employee satisfaction as a critical metric of their enterprise voice — a strategic communications effectiveness rose dramatically during a five-year imperative in today’s environment.” span (from 61% in 2007 to 79% in 2012). Micho Spring Chair, Global Corporate Practice Weber Shandwick strongly believes that employee engagement is Weber Shandwick central to company success and is the underlying foundation for high-performing companies. Yet we also believe that to prepare for the future workforce, employers will need to build upon engagement and acknowledge and embrace employee activism. Employee activists are different — they make their engagement visible, defend their employers from criticism and act as active advocates, online and off. Many employee activists already exist today. Sometimes their activism is stimulated by the employer, but, more often than not, it rises organically out of self-motivation and determination. Employers can’t afford to miss the open window of opportunity to lean in and capitalize on this movement that will only increase in the years ahead.

In Employees Rising: Seizing the Opportunity in Employee Activism, Weber Shandwick explores the employee activist movement to help our clients and other organizations understand what it takes to catch the rising tide of employee activism.

Employees Rising: Seizing the Opportunity in Employee Activism Page 2 02 HOW WE DID THE RESEARCH Weber Shandwick, in partnership with KRC Research, conducted a global online survey of 2,300 employees. Respondents were between the ages of 18 and 65, worked 30 hours per week or more and were employed by an organization with over 500 employees.

Survey respondents represented 15 markets.

Europe United Kingdom France Germany Italy

North America Asia Pacific

United States Australia Canada China Hong Kong India Indonesia Japan Latin America Singapore South Korea Brazil

Our survey included a mix of attitudinal and behavioral by presenting lists of behaviors that respondents selected, questions. Employee attitudes were measured on 5-point and segmentation modeling identified distinct groups scales. Conclusions are based on the top scale point of “5” of employees based on these self-reported actions. The to capture the highest level of intensity of feelings toward specific actions and process of classifying employees is and perceptions about employers. Activism was measured discussed in greater detail later in this report.

Employees Rising: Seizing the Opportunity in Employee Activism Page 3 03 UNREST IN THE WORKFORCE Before we delve into the new wave of employee activism, it is important to understand the challenges facing employees today.

Employees are in a state of upheaval. More than eight in 10 (84%) have experienced some kind undergoing a major event at work, such as a mass lay-off, of employer change in the past few years — most typically a merger or acquisition and/or crisis. That is a lot of flux for the leadership change (45%). More than four in 10 (42%) report workforce to handle.

% of employees experienced the following events at their current employers in the past few years

45% 33% % 84 (net) 30% ANY CHANGE EVENT 27%

22% 22% % 18% 42 (net) TOP-TIER 17% CHANGE EVENT

12%

Employees are on the defense. Employers probably don’t know it, but many employees are newspaper. These “first responders” are even more prevalent in out there now defending the reputations of their organiza- organizations that experienced a top-tier change event (59%), tions. Nearly six in 10 (56%) respondents surveyed have indicating that employees are rising up to support organiza- either defended their employer to family and friends or in a tions in time of need. It may also indicate that employees are more public venue — such as on a website, blog, or in a strongly identifying with their employers.

Employees of a Fortune 500 agribusiness started their own blog in reaction to criticism about their company. They debuted the blog by saying, “If anyone should speak to [our company’s] vision of the world, it’s those of us who come to work here every day and collectively make this company what it is…We’re hoping this blog will offer a more personal view of our company.”

Employees Rising: Seizing the Opportunity in Employee Activism Page 4 03 UNREST IN THE WORKFORCE

Employers are not effectively communicating to employees. “Listening and responding are leadership The research revealed that only four in 10 employees can skills critical to driving employee engagement. confidently describe to others what their employer does Ultimately, companies that work hard at or what its goals are (42% and 37%, respectively). Fewer communicating and listening — from the mailroom than three in 10 report that they are being communicated to the boardroom — are the ones that win in the with, listened to and kept in the loop. Fewer than one in five workplace and marketplace.”

(17%) highly rate communications from senior management. Andy Polansky As expected, immediate supervisors are rated as better CEO, Weber Shandwick communicators than senior leadership but still not as highly as might be assumed.

Employers are not effectively communicating to employees Total % (rated 5 on 5-point scale)

% employees completely I know enough to explain to others what my employer does 42 agree with the following I understand my employer’s goals 37 statements My manager / supervisor frequently communicates with me 29 My employer listens and responds well to customers 28 My manager / supervisor listens and responds well to me 26 My employer surveys employees every 1-2 years on how well it communicates with employees 26 My employer does a good job of keeping me informed 25 My employer communicates frequently with employees 24

% employees highly rate Top leader 17 communications from... Senior leadership just below top leader 17 Department head 25 Immediate manager/ supervisor 31

These weak ratings are not a byproduct of too few communications — employees report that they receive, “An engaged employee is a worker who cares on average, 4.4 different types of communications from about the future and success of his company their employers. The general lack of effective employer-to- and therefore is actively involved in what is employee communications is surprising considering how going on, making a positive contribution.” technology has accelerated the proliferation of collaboration — Italian employee and communications tools available to most workforces.

Employees Rising: Seizing the Opportunity in Employee Activism Page 5 03 UNREST IN THE WORKFORCE

Only three in 10 employees are deeply engaged with their employers. Our analysis identified approximately one in five How could employers reasonably expect more engagement employees (21%) who feel strongly that they are when the workforce is in upheaval and employees do not putting more effort than is required into their job feel informed or listened to? This 3-in-10 engagement yet do not feel strongly that they are being valued level the survey uncovered is comprised of nine factors, the by their employer. This perceptual gap between highest rated of which is “I put a great deal of effort into my giving and receiving on the job is a recipe for job, doing more than is required” (38%) on down to “I feel a resentment that impairs engagement. strong connection to my employer” (23%).

Employee engagement benchmarks (% employees rated 5 on 5-point agreement scale)

Overall % of employees who 30% are deeply engaged (average)

38% 35% 33% 33% 30% 28% 26% 24% 23%

I put a great deal I care a great I care a great I am enthusiastic I am proud to I would I am very I feel valued I feel a strong of effort into my deal about my deal about my about the work work for my recommend my satisfied with as an employee connection to my job, doing more employer’s employer’s I do employer employer to others my job employer than is required success reputation as a place to work

While deep engagement — on the whole — is weak, the highly disengaged and, sadly, show it. That is why we believe results show that the workforce is in fact multi-dimensional. that employers should take these findings seriously and look As will be seen later in this report, some employee segments more deeply into their workforce to identify and cultivate are highly engaged and go to great lengths to show it. Some groups of employees that can serve as activists for their are engaged and need assistance to show it. And some are brands and reputations.

“Someone who is fully involved in and enthusiastic about their work, and will act in a way that furthers their organization’s interest is what engagement means to me.” — Canadian employee

Employees Rising: Seizing the Opportunity in Employee Activism Page 6 04 THE BIG BANG: SOCIAL MEDIA’S IGNITION OF EMPLOYEE ACTIVISM As business leaders know, the impact of social media on an employer’s reputation is now an everyday reality.

What some employers don’t realize is how critical social How leaders are using digital communications and modeling media is to employee engagement and how it fuels employee that use internally is the next frontier for organizational change. activism. Employees have multiple social platforms on which they can air their likes and dislikes of their jobs, bosses and According to LinkedIn research, 61% of LinkedIn organizations. While many employers are fearful that their members who follow your organization are willing to be employees will destroy their reputations with one easy click your brand ambassadors and share your Employee Value of a social media “share” button, the fact is that we now live in Proposition with their networks. an always-connected-online world that is not going to reverse course.

Here are some eye-opening statistics from our research about employees:

88% use at least one social media site for personal use 50% post messages, pictures or videos in social media about employer often or from time-to-time 39% have shared praise or positive comments online about employer 33% post messages, pictures or videos about employer in social media often or from time-to-time without any encouragement from employer 16% have shared criticism or negative comments online about employer 14% have posted something about employer in social media that they wish they hadn’t

Employees are sharing socially. For many, the divide between to embrace social media as an employee activist enabler, work and personal lives barely exists. For employers, the all employers need to be prepared to rally their employee opportunity and challenge is to embrace this new reality and activists and strive to have their supporters outnumber understand what drives employees to be positive activists. their detractors. While it is not feasible for every company or every sector

Employees Rising: Seizing the Opportunity in Employee Activism Page 7 05

THE EMPLOYEE ACTIVIST IS NOW AMONGST US Using segmentation modeling, all respondents were sorted by their reported actions toward their employers — both supporting and detracting actions — to develop deeper, more descriptive and more targetable profiles of the workforce.

Employees were asked if they had ever done any of the following:

1. Worn clothing or other accessories outside of work 8. Defended employer to family and friends with employer’s name or symbol 9. Defended employer where others could see or read it 2. Done volunteer work for a cause employer supports 10. Discouraged others from considering employer as a 3. Recommended employer to others as a place to work place to work 4. Encouraged others to buy company’s products 11. Discouraged others from buying company’s products or services or services 5. Voted for employer in a poll or contest 12. Made negative comments about employer where 6. Made positive comments about employer where others could see or read them others could see or read them 13. Made negative comments about employer to friends 7. Made positive comments about employer to or family friends or family

This analysis uncovered a sizeable segment of employees — 21%, employee activists — who are all taking positive actions (#1-#9 above) and nearly no negative actions. For a workforce of 5,000, this means that approximately 1,000 employees are enthusiastically letting others know 21% they stand behind their employer.

“As employee activists gain numbers and strength, organizations need to be prepared to facilitate the activism of these employees. Internal communications needs to move beyond being company news briefs and alerts to being more content-rich. Company storytelling is not just for external media anymore, it’s a way of ensuring that employees are informed and have something meaningful to say about their employers.”

Kate Bullinger Co-Lead, Global Employee Engagement & Change Management Weber Shandwick

Employees Rising: Seizing the Opportunity in Employee Activism Page 8 06

WHAT DRIVES EMPLOYEE ACTIVISM? Our survey also asked respondents to rate their employers on a series of nearly 30 attitudinal statements covering a wide range of organizational qualities from leadership to internal communications to HR (Human Resources) to CSR (Corporate Social Responsibility). Regression analysis determined how much each statement was correlated with the propensity for engagement and activism.

Significantly, we learned that leadership is most important By modeling responsiveness, leaders show employees that for influencing employee activism, but not to the exclusion they value their ideas and intangibles such as reputation of other organizational activities and characteristics. What and culture. Internal communications, fair treatment this means is that leadership plays a critical role in driving of all employees regardless of race, gender, age, sexual employee support, from making the company an employer orientation or cultural differences, and community of choice to building a reputation of trustworthiness and responsibility are also not to be overlooked in terms of demonstrating that it listens and responds to employees. deepening employee activism.

Employee Activism Driver Top Components of Activism Score* Activism (individual score in parentheses) Impact Score

• Employer values employee ideas and opinions (82) • Leadership makes it a good place to work (80) Leadership • Employer has a very good reputation (78) 75 • Leadership is trustworthy (78) • Leadership listens and responds well to employees (76)

Internal • Employer does a good job of keeping employees informed (81) 70 Communications • Employer communicates frequently with employees (77)

• Employees have many opportunities to grow and learn (83) HR/Employee • Employer provides training and resources needed to do the 70 Development job well (77)

Corporate Social • Employees are treated fairly regardless of their differences (69) Responsibility • Employer plays an active role in the community (68) 67 (CSR) • Employer works to protect and improve the environment (68)

*These are the top drivers of activism out of 29 items presented to respondents. The Activism Impact Score is the average of all the components in a set of multiple statements about each driver. Only the components that scored above the driver’s average are listed in this table. For each driver, there are many other components, with lower scores, that comprise the average score.

In comparing employee perceptions about each of these activists and fully maximize the activism of current activists. drivers in our survey, we find that employers severely We address these issues later in the report as we identify underperform. That means that employers have a lot of work triggers of employee activism based on targeted employee to do to improve perceptions if they are to develop additional activist segments.

Employees Rising: Seizing the Opportunity in Employee Activism Page 9 06 WHAT DRIVES EMPLOYEE ACTIVISM

Although social media is not included in the driver analysis, its force can’t be ignored. Our survey found that one-third of “An engaged employee is an active member of employers — 33% — encourage their employees to use social the workforce that is part of the team. Knows media to share news and information about the organization. the business and the values and spreads a This sounds risky, but this social encouragement has an positive message. On the look-out for new outsized impact on employer advocacy among employees. and innovative ways to do business.” For example, employees with socially-encouraging employers — Australian employee are significantly more likely to help boost sales than employees whose employers aren’t socially encouraging (72% vs. 48%, respectively).

Actions employees have ever taken for current employer (% employees who have taken these actions)

72% 68% 63% 60% 55% 54% 52%

54% 48% 44%

32% 28% 30% 24% 22%

Encouraged others Recommended Made positive comments Defended employer Done volunteer Defended employer Voted for employer to buy company’s employer to others about employer where to family and friends work for a cause where others could in a poll or contest products or services as a place to work others could see employer supports see or read it or read them

Employer encourages employee use of social media to share news and information about employer* Employer DOES NOT encourage

*All actions are significantly higher than those whose employers don’t encourage brand socialization

“Our research proves that leadership has a catalytic impact on employee engagement and willingness to be an ardent employer supporter. In the absence of trust in leadership, and credible and relevant communications from leadership, organizations run the risk of having more detractors than activists.”

Renee Austin Co-Lead, Global Employee Engagement & Change Management Weber Shandwick

Employees Rising: Seizing the Opportunity in Employee Activism Page 10 06 WHAT DRIVES EMPLOYEE ACTIVISM

How do these employers encourage their employees to be social stewards?

At a very basic level, they provide the tools and content to enable sharing, but a wide variety of tactics requiring modest investment are also used.

Provide readily accessible tools for employees to use in social media (55%)

Provide messages about the employer for employees to use in social media (50%)

Provide easy-to-understand guidelines to employees for using social media (42%)

How does your employer Ask employees to stay alert to social media postings about encourage employees to use the employer (39%) social media to share news Provide training for how to use social media properly and information about your (37%) work or your employer? Provide access to social media at work (35%)

Provide updates about changes in social media so that employees can stay current on the latest tools and uses (35%)

Provide employees with one or more social media accounts to use (13%)

VoiceStorm by Dynamic Signal is a social advocacy platform that gives employees access to sharable messages and content in a convenient and brand-safe environment through a social media hub. Employees are encouraged to engage with this platform by earning points that they can redeem for rewards and employers are reassured that the content meets corporate compliancy guidelines.

Zappos encourages employees to include company information and opinions on their Facebook, Twitter and personal blogs in addition to their LinkedIn profile. The company even has a Twitter aggregate of all employee twitter feeds. This serves as an excellent word-of-mouth platform for marketing as well as recruitment.

Employees Rising: Seizing the Opportunity in Employee Activism Page 11 07

THE WORKFORCE ACTIVISM SPECTRUM Our segmentation model identified six distinct segments of employees, including the 21% segment noted earlier who we call ProActivists because of their high engagement and activist profile.

InActives ProActivists Report little or no employer The embodiment of employee support or detraction behaviors. activism. Conduct the most Almost as unengaged as Detractors. positive actions with nearly no Are the least likely to put a great negative actions. Have the highest deal of effort into their jobs and level of employer engagement. few can explain to others what Highly social. their employer does. Little motivates them to do a good 22% 21% job, even pay increases. PreActivists All take positive actions but not nearly as many Detractors positive actions as ProActivists. Engage All take negative actions 13% in more negative actions against their employer. than ProActivists. Actions Are the least engaged 26% are not as social as those of and are the most distrustful ProActivists. Have an average of leadership. Not social so 11% level of engagement. damage is contained offline. 7%

ReActivists HyperActives Mostly take positive The wildcard of employee activism. actions but also have a high Have the most potential to both help propensity for detraction. and damage employer’s reputation. Have an average level of Half of them have posted something engagement. Are critical online about their employer that they of workplace conditions. regret. Are the most engaged next Highly social. to ProActivists. Two-thirds have a job that entails social media so are highly social.

Employees Rising: Seizing the Opportunity in Employee Activism Page 12 07 THE WORKFORCE ACTIVISM SPECTRUM

With the exception of Japan, each of the 15 markets in our study has each of these segments (Japan has no HyperActives and few ProActivists). However, some segments are concentrated more heavily in certain markets.

PreActivists HyperActives Detractors ProActivists HyperActives ReActivists InActives

ProActivists ProActivists PreActivists ProActivists PreActivists Detractors HyperActives ReActivists

Employees Rising: Seizing the Opportunity in Employee Activism Page 13 08

GET TO KNOW THY SEGMENTS The six employee segments show considerable variation in demographics, employer engagement, job description, employer profile and social media confidence.

The chart below points out each segment’s distinctive traits relative to the average employee in our study. It is worth noting that no segment is “all of anything.” These traits are directional skews, not absolutes.

InActives ProActivists Highest employer engagement level Low employer engagement level Millennial Least likely to be executive/managerial University-educated Least likely to have experienced any kind of change event Executive/managerial Least likely to have a personal social media account Use social media for work Least likely to use social media for work Unmotivated to perform well for work, even by pay increases

Detractors Lowest employer engagement level PreActivists Most likely to be female Average employer engagement level Least likely to be Millennial Younger Boomers Least likely to be university-educated Least likely to use social media Most likely to have physical/manual job for work Longest tenured Most likely to work for domestic operation Most likely to have experienced top-tier change event HyperActives Least likely to use social media for work High employer engagement level Highly distrustful of employer leadership Most likely to be male Most likely to be Millennial ReActivists Most likely to be university-educated Most likely to have an executive/managerial Average employer engagement level Experienced top-tier change event or artistic/creative job Millennial Often post online about work Work the most hours University-educated Regret posting something about work Most use social media for work Executive/managerial Critical of employer’s reputation, Most likely to regret posting something diversity practices, training/ Work the fewest hours online about work resources, workplace safety and code Use social media for work of conduct Work for a multinational Most likely to work for a B2C Most likely to work for a B2B Care more about recognition from top leadership than pay increases

Employees Rising: Seizing the Opportunity in Employee Activism Page 14 08 GET TO KNOW THY SEGMENTS

ProActivists are the employees every leader or manager wants on his or her team because their actions are entirely positive and influential. They “Millennials work more closely are an organization’s brand and reputation champions. They are the most together, leverage right- and highly engaged segment, with 49% reporting deep engagement, compared left-brain skills, ask the right to the average 30% for employees overall. questions, learn faster and take risks previous generations Compared to the average employee in our study, ProActivists are more likely to resisted. They truly want to be Millennials (18-36 years old) and university-educated. However, this is not change the world and use to suggest they are strictly highly educated Milliennials — 22% do not have a technology to do so.” university degree and 39% are GenX or older. They are the most likely of any group Mike Marasco to be executives or managers, but not all are (43% vs. global average of 30%). They Leader of Northwestern University’s NUvention program, The New York are the most likely segment to have multiple social media accounts for personal Times, November 9, 2013 use and are more likely than employees overall to use social media as part of their jobs (these are not, however, all digital or IT jobs; they may be using social media for competitive intelligence, marketing, etc.). Nearly half (46%) report that they often post about work or their employer on social media.

After a major automobile manufacturer’s reputation for quality took a serious hit because of widespread recalls, the company launched an ad campaign featuring its employees discussing how they personally ensure every vehicle is built to the highest caliber. In describing the campaign, one executive said, “[Our employees’] incredible passion, commitment to quality, safety for our customers is what has built our reputation. We want to show this human face. The real, authentic [company].”

PreActivists have high potential to become ProActivists; impeding

their activism is a relatively low level of social media usage, but A Global Fortune 500 bank they are engaged (34%) and predominately positive action-takers experienced reputational offline. As the largest segment representing more than one- damage because of a sensitive quarter of employees (26%), they are worth investing resources in. employee lay-off in which the CEO was criticized in the media. Compared to the average employee in our study, PreActivists are slightly more Coming to the bank’s defense: likely to be Younger Boomers (49-58 years old) and are less likely to have a employees who wanted to know university degree. While they are just as likely to have a personal social media how they could help. account as employees overall, they are less likely to use social media for their job, which is probably one reason their activism is kept to a close circle of friends and family.

CMO Employee

What can I do to help?

Employees Rising: Seizing the Opportunity in Employee Activism Page 15 08 GET TO KNOW THY SEGMENTS

HyperActives are taking positive actions HyperActives are the most likely of the segments to be men, but their adverse actions are likely Millennials and university graduates and to have an executive/ negating their positives. Because their managerial or artistic/creative job. They put in the most negative behaviors don’t reflect their hours at work of any segment. They are very social media high engagement level (44%), they can savvy, as 63% of them use social media as part of their jobs. alternatively be thought of as “wildcards.” Interestingly, they are more motivated than any other segment by top leadership recognition. Because leadership recognition is slightly more inspiring to them than pay increases, they may be the “ladder climbers” of the employee universe.

LinkedIn research shows that engaged “employer promoters” have 40% MORE internal company connections than extreme detractors.

ReActivists are also behaving both positively smaller companies (between 500 and 1,000 employees). and negatively, but can be very critical of internal They are more likely than average to work for an employer actions by their employers and voice those that has recently endured a top-tier change event, such as criticisms publicly. ReActivists’ engagement level extensive lay-offs, a merger/acquisition or a crisis/disaster. falls slightly below average (26%). They are also more likely than average to have a job that entails using social media, although not to the same extent Compared to the average employee, ReActivists are more as HyperActives, and half of them often post about work or likely to be Millennials. Of all our segments, they work their employer on social media. the fewest hours per week and are employed by relatively

In October 2013, a woman named Marina Shifrin posted a video of herself on YouTube explaining why she was quitting her job while dancing around her Taiwanese office during the middle of the night. Within weeks of its release, the video had more than 16 million views and she appeared on major entertainment broadcast shows.

Marina is an example of a ReActivist.

Employees Rising: Seizing the Opportunity in Employee Activism Page 16 08 GET TO KNOW THY SEGMENTS

Detractors’ engagement level seems almost InActives, a large segment of more than one beyond repair (12%). They are not candidates in five (22%) employees, exhibit minimal to be employee activists, so employers need positive or negative behaviors. They are highly to defuse their criticism and lessen their unengaged, with an average engagement potential reputational harm. level of just 16%, and little motivates them to do a good job — pay increases top their list but that Compared to the average employee, Detractors skew is cited by only 43% of them. We do not recommend female, older than 36 and not university-educated. They that employers invest in an employee activism program are the most likely group to have a physical/manual job, for this segment. The focus for InActives should be on are the longest tenured and are less likely than the average building engagement instead. employee to work at headquarters. They are also the most likely to work for an employer that has recently undergone Compared to the average employee, InActives are more a major change event, likely contributing to an exceptionally likely to be over 36 years of age and are the least likely to high lack of leadership trust. While they are just as likely as be executive/managerial. They are also the least likely to the average employee to use social media in their personal report that their employer recently experienced a change lives, they are less likely to have multiple accounts or to use event and to be on social media. social media as part of their job.

“A worker who is engaged is a person who truly cares about the organization for which he/she works, a person who does more than ‘show up’ for work, a person who gives his/her ‘all’ on the job.”

— U.S. employee

Employees Rising: Seizing the Opportunity in Employee Activism Page 17 09

THE PLAYBOOK FOR ACTIVATING EMPLOYEES

In addition to the diverse profiles just discussed, the segments also differ in their perceptions of the activism “An engaged employee is one who is very much drivers. This requires employers to “flip different switches” devoted to his work and other aspects of the on various aspects of leadership, internal communications, company, be it events, volunteer work or human resources and corporate social responsibility in promotion of certain sales.” order to effectively drive activism or reduce detraction. — Singapore employee Here are four strategies for activating employees:

1. Accelerate the activism of ProActivists. Ignite the activism of PreActivists and HyperActives

2. Negate the negatives for ReActivists and Detractors

3. Communicate in ways that matter

4. Customize strategies and tactics for each segment

Employees Rising: Seizing the Opportunity in Employee Activism Page 18 09 THE PLAYBOOK FOR ACTIVATING EMPLOYEES

1. Accelerate the activism of ProActivists. Ignite the activism of PreActivists and HyperActives

Perceptions of top drivers of activism (% employees rated 5 on 5-point agreement scale)

ProActivists PreActivists HyperActives

Leadership Internal Human Resources/ Corporate social communications Policies responsibility 60%

50%

40%

30%

20%

10%

0%

Leadership is trustworthy

Employer has a very good reputation

Leadership makes it a good place to work

Employer values employee ideas and opinions Employer plays an active role in the community

Leadership listens and responds wellEmployer to employees communicates frequently with employees Employees have many opportunities to grow and learn Employer works to protect and improve the environment Employer does a good job of keeping employees informed Employer provides training and resources needed to do job Employees are treated fairly regardless of their differences ProActivists PreActivists HyperActives

Every one of the top drivers of activism is rated highly highly on keeping employees informed (45%), so internal by ProActivists (hence, their activism!). To sustain communications is a must-have for turning their activism on. their ProActivist status, this segment needs continual reinforcement of what they perceive as their employers’ PreActivists are less social media savvy, and therefore best traits, leading with their employer’s reputation (48%) presumably less social media confident, than ProActivists and fair treatment of all employees regardless of race, and HyperActives. More than one-third of them say they gender, age, sexual orientation or cultural differences would be more inclined to use social media to share news (48%). PreActivists need more convincing to spur their and information about their work or employer if they were activism but fair treatment of all employees is most given easy-to-understand guidelines (34%), access to social meaningful to them (43%). HyperActives also rate the top media at work (32%) or the right tools (31%). Employers drivers highly but they need additional reinforcement of should take note — these provisions are fairly basic and these perceptions so that their positive actions overcome would help turn many PreActivists into ProActivists. their negative inclinations. They rate their employers most

Employees Rising: Seizing the Opportunity in Employee Activism Page 19 09 THE PLAYBOOK FOR ACTIVATING EMPLOYEES

2. Negate the negatives for ReActivists and Detractors

Perceptions of top drivers of activism (% employees rated 5 on 5-point agreement scale)

ReActivists Detractors

Leadership Internal Human Resources/ Corporate social communications Policies responsibility 60%

50%

40%

30%

20%

10%

0%

Leadership is trustworthy

Employer has a very good reputation

Leadership makes it a good place to work

Employer values employee ideas and opinions Employer plays an active role in the community

Leadership listens and responds wellEmployer to employees communicates frequently with employees Employees have many opportunities to grow and learn Employer works to protect and improve the environment Employer does a good job of keeping employees informed Employer provides training and resources needed to do job Employees are treated fairly regardless of their differences ReActivists Detractors

ReActivists are more critical than the average employee rated very poorly by Detractors. Their weakest perception of their employers’ reputations, provision of training and is trust in leadership — only 6% of them rate leadership resources, and climate of diversity and inclusion. These as trustworthy — but taken altogether, none of the drivers perceptions need to be improved to mobilize their activism are perceived positively. Employers should focus first on or at least take the edge off of their negativity. Although leadership issues since leadership is the most important not a driver of activism, ReActivists also rate their employer driver of activism to begin building trust and reputation. more harshly on safe working conditions than the average employee (27% vs. 34%). Perhaps employers should try competing for some of the Best Places to Work lists and “A professional who is dedicated, interested and improving their workplace benefits to counter their negative always looking to give their best for the workplace perceptions. With more than one-quarter (27%) of company is engaged with their employer.” ReActivists often posting something negative online about — Brazilian employee their employer, their criticisms need to be addressed. Not surprisingly, every one of the top drivers of activism is

Employees Rising: Seizing the Opportunity in Employee Activism Page 20 09 THE PLAYBOOK FOR ACTIVATING EMPLOYEES

3. Communicate in ways that matter

Employees, regardless of their segment, would like their communications method, but perhaps employees like the employers to communicate with them more frequently control that comes with deciding when to open and respond through written means (73%). Work email is the driving to email, or perhaps it is what they know best and can’t force behind written communications (48%). It is surprising imagine anything being easier or more efficient. in this high-tech digital world that email is the default

Communications employees would like to receive more often

100%

80%

60%

40%

20%

0 ProActivists PreActivists HyperActives ReActivists Detractors InActives

Written Digital/Online Face-to-Face Telecommunications

“There’s no doubt organizations have begun to realize significant value from largely external uses of social. Yet internal applications have barely begun to tap their full potential, even though about two-thirds of social’s estimated economic value stems from improved collaboration and communication within enterprises. Although more than 80 percent of executives say their companies deploy social technologies, few have figured out how to use them in ways that could have a large-scale, replicable, and measurable impact at an enterprise level. “

“Building the Social Enterprise,” McKinsey Quarterly, November 2013

Beyond email, segments diverge on other forms of employer to ProActivists, PreActivists and Detractors than to other communications they would like more often. Digital/Online, segments. Surprisingly, InActives are no less amenable to driven by intranets and social media, is in greater demand by any form of communications than other segments. This the most social media savvy — ProActivists, HyperActives may be a sign that there is some hope of engaging this very and ReActivists. In-person meetings are more important passive group.

Employees Rising: Seizing the Opportunity in Employee Activism Page 21

Page 19 09 THE PLAYBOOK FOR ACTIVATING EMPLOYEES

4. Customize strategies and tactics for each segment

Given the diverse nature of the workforce segments, it is considering launching an employee activist program to clear that mobilizing employee activists cannot be a “one- transform their organization, accelerate change or size-fits-all” approach. Based on our survey analysis, here drive performance: are our recommendations, by segment, for an employer

The employee activism tip sheet

Segment Strategy Tactics

• Maintain their high engagement level Leverage and empower • Continually reinforce their perceptions of top activism drivers their activism • Provide socially sharable content that showcases the drivers they rate highest • Improve leadership drivers, especially responsiveness to employees ProActivists

• Continually reinforce their perceptions of top activism drivers Ignite their activism: • Improve leadership drivers, especially responsiveness to employees Upgrade to ProActivists • Provide a social activism platform: social media guidelines, training and access PreActivists

• Feed their need to share with positive messages and make those messages socially sharable Handle with care: • Make handy and reinforce social media guidelines Upgrade to ProActivists • Continually reinforce their perceptions of top activism drivers • Communicate with them frequently HyperActives • Have senior management acknowledge their contributions

• Improve perceptions of all top drivers • Do a better job disseminating information about employer values and goals Attend to internal • Focus internal communications messages on internal issues, such as employee training and matters diversity ReActivists • Provide social media tools, guidelines, work access and sharable messages

• Fix negative leadership trust perceptions • Implement a change management program even if it is after the fact • Ensure social media guidelines are in place and well-understood. Even though this segment is Brace for and defuse not highly social, most have a personal social media account Ensure online monitoring tools are in place to flag behavior that is in violationof organization’s Detractors • social policies

• Implement a localized engagement program with direct supervisors identifying InActives and Focus on engagement, enacting an engagement plan not activism • Review Weber Shandwick UK’s Science of Ingagement study which provides guidance on build- ing engagement InActives

“An engaged employee is one who is involved in his work, satisfied with what he is doing and contributes positively in the organization.” — Indian employee

Employees Rising: Seizing the Opportunity in Employee Activism Page 22 10 IN CLOSING

Weber Shandwick’s Employees Rising: Seizing the Opportunity in Employee Activism was designed to help organizations recognize and understand that employee activism is a movement coming their way.

It needs to be accepted and proactively managed. Just focusing on employee ambassadors or champions is not enough anymore “Weber Shandwick’s new study demonstrates how in an always-on and super-enabled environment. Employers will organizations need to think ahead as to what is increasingly need a band of employees who can take action by next. Our research uncovered an emerging trend of spreading the right messages for them, helping them recruit vital importance for employers looking to mobilize the best of the best or defending their position when they support as they exit difficult times and transform are under scrutiny. Organizations need to move quickly since their organizations to be successful in a fast- employees are already taking matters into their own hands and, approaching future.” left unattended for too long, will define their employers’ brands Leslie Gaines-Ross and reputations on their own. Social media enhances this risk, Chief Reputation Strategist but also the opportunities. Weber Shandwick

To ensure they define brand and reputation in the most authentic light and win support during the tough times as well as the easier ones, employers need to provide a culture of trust that is rooted at the leadership level. Employers need to communicate with employees in ways that are relevant to them, with messages tailored for a variety of worker segments.

Employees will continue to rise to new heights of influence. This influence needs to be tapped into so that employers can maximize the opportunity of this exciting and transformative movement.

Employees Rising: Seizing the Opportunity in Employee Activism Page 23 For more information about Employees Rising: Seizing the Opportunity in Employee Activism, or Weber Shandwick’s Employee Engagement & Change Management services, please contact:

Jack Leslie Kate Bullinger Chairman Co-Lead, Global Employee Weber Shandwick Engagement & Change Management [email protected] Weber Shandwick [email protected] Andy Polansky CEO Colin Byrne Weber Shandwick Chief Executive Officer, UK & Europe [email protected] Weber Shandwick [email protected] Gail Heimann President and Chief Strategy Officer Jim Donaldson Weber Shandwick Executive Vice President, Corporate [email protected] Communications EMEA Weber Shandwick Cathy Calhoun [email protected] Chief Client Officer Weber Shandwick Tim Sutton [email protected] Chairman, Asia Pacific Weber Shandwick Sara Gavin [email protected] President, North America Weber Shandwick Tyler Kim [email protected] Head of Corporate & Crisis, Asia Pacific /WeberShandwick Weber Shandwick Micho Spring [email protected] Chair, Global Corporate Practice @WeberShandwick Weber Shandwick Zé Schiavoni [email protected] CEO, S2Publicom Weber Shandwick /WeberShandwick Paul Jensen [email protected] President, North American Corporate Practice /Company/Weber-Shandwick Weber Shandwick Bradley Honan [email protected] CEO KRC Research /WeberShandwickGlobal Leslie Gaines-Ross [email protected] Chief Reputation Strategist Weber Shandwick +WeberShandwick [email protected] You can also visit: www.webershandwick.com Renee Austin Co-Lead, Global Employee Engagement & Change Management Weber Shandwick [email protected]

Employees Rising: Seizing the Opportunity in Employee Activism Page 24 5/28/2019 Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

Dominic Hofstetter Follow Apr 23 · 6 min read

Amazon CEO Je Bezos (left) is one of a handful of corporate executives who could set the world on a course to avoid the most perilous eects of global warming. (Photo by Grant Miller for the GWB Presidential Center)

10 April 2019, the initiative Amazon Employees for Climate On Justice submitted an open letter to Amazon’s CEO Jeff Bezos, demanding that the tech giant take greater action on climate change. “We have the resources and scale to spark the world’s imagination and redefine what is possible and necessary to address the climate crisis”, the letter states. So far, it has been signed by more than 6’700 employees.

What seems like a small symbolic gesture might well mark a turning point in our effort to stem global warming. Employee activism holds enormous potential to set the world on the right course for safeguarding human civilization as we know it. To unlock its power, we need to spark a new social movement.

...

https://medium.com/in-search-of-leverage/employee-activism-a-powerful-yet-untapped-driver-of-climate-action-bdfdf5dc6eea 1/7 5/28/2019 Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

he world has been grappling with climate change for more than 40 T years. As of this writing, we are still not on track to avoid the most perilous effects of a warming planet. Our continued inability to make significant progress is mainly a result of political inaction. The failure of our political system is so severe that the British journalist George Monbiot recently argued that the only thing that could still prevent an ecological apocalypse was mass civil disobedience.

Policy is critical because it sets the goals, defines the rules, and distributes the power in our society. Regrettably, anti-climate lobbying groups excel at influencing the legislative process in almost all of the world’s political arenas. Not only do they outspend and outsmart climate advocates. They also monopolize narratives around job creation and economic growth — arguments that are often the decisive factors in shaping legislation.

Herein lies the tragedy. The argument that environmental regulation kills jobs is not supported by research. In fact, economists predict that unchecked climate change will have devastating effects on the world’s economy. A recent study in Nature estimates that the difference in economic cost between 1.5 and 2 degrees of global warming could be as much as $20 trillion, or 26% of world GDP. So all companies — except those in the business of selling carbon — should have an incentive to lobby for decisive climate action.

Indeed, a growing number of multinationals appear to be serious about reducing their carbon footprints, including Unilever, DSM, Coca-Cola, Apple, Microsoft, Novartis, IKEA, and Google — and countless other large corporations that have publicly spoken out for more stringent climate action.

But why don’t these companies use their power to influence climate policy?

...

he answer lies in an unwritten rule of corporate lobbying: T companies only intervene in legislative processes related to their core business. Food companies care are about packaging rules, technology companies about labor regulation, and retailers about trade law. Lobbying agendas are driven primarily by rational monetary

https://medium.com/in-search-of-leverage/employee-activism-a-powerful-yet-untapped-driver-of-climate-action-bdfdf5dc6eea 2/7 5/28/2019 Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

interests. If a piece of legislation doesn’t have a significant impact on a company’s bottom line, its regulatory affairs team will not engage.

Climate change is too diffuse an issue to directly relate to anyone’s core business, with the exception of those industries relying on fossil fuels. Moreover, the impacts of global warming materialize over a time horizon that is too long to be relevant to a company’s financial performance. So even those corporations most committed to curbing global warming don’t lobby for stringent climate legislation.

“Washington’s dirty secret is that even the American companies that are really good on sustainability put net zero effort into lobbying Congress on climate change.”, wrote U.S. Senator Sheldon Whitehouse in 2016. “Mars is going fully carbon neutral. No lobbying. Walmart is spending tens of millions of dollars to become sustainable. No lobbying. Apple and Google and Facebook are forward-looking, cutting-edge companies of the future, and they lead in sustainability. No lobbying.”, he added in a Harvard Business Review article.

So how do we encourage companies to start lobbying for more decisive climate policy?

...

orporate lobbying agendas are often set directly by the CEO. C Therefore, the key to mobilizing companies for climate action is to make the CEO care. Three groups of people are best positioned to do that: owners, customers, and employees.

Shareholders and consumers have an impressive track record in influencing corporate behavior around a broad range of environmental concerns. In contrast, employee activism is a relatively recent phenomenon. It has started to make headlines in mainstream media at numerous occasions over the past couple of years, most notably when Google employees successfully mobilized against the company’s handling of sexual harassment, its involvement in a defense project involving drone footage analysis, and more recently over its appointment of an ethics committee on artificial intelligence. Facebook, Salesforce, Uber, and Microsoft have also faced backlash from their employees over ethically questionable business conduct.

https://medium.com/in-search-of-leverage/employee-activism-a-powerful-yet-untapped-driver-of-climate-action-bdfdf5dc6eea 3/7 5/28/2019 Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

Employee activism in action: Google employees at the company’s Sunnyvale campus walk-out on 1 November 2018 to protest the company’s handling of sexual harassment allegations. (Source: Wikipedia)

The increasing popularity of employee activism is driven by a growing collective conscience amongst workers. A 2017 study on corporate activism and employee engagement inside Fortune 100 companies showed that 45% of respondents care about a company’s actions on societal issues. In a world where dozens of companies are now bigger than entire countries, employees have the potential to wield power of geopolitical scale.

...

harness that power, we need to spark a social movement around To employee activism. As with all social movements, the first step is to raise people’s consciousness. “At its core, consciousness translates into awareness, both internal awareness of self and external awareness of context”, argues David A. Snow, a professor of sociology at the University of California and an authority in the field of social movements.

With climate change featuring more prominently in the news, general awareness of its existence and threat is at an all-time peak. However, we do need to heighten the public’s consciousness in understanding what Snow calls the locus of blame — the causal link between a company’s action and the climate injustice it creates. Here, organizations like InfluenceMap — which analyzes corporate lobbying practices related to climate change — and the Carbon Disclosure Project — which collects company-level emissions data and maintains a database with the world’s major climate offenders— can provide information that is critical for employees to understand what role their companies play in driving climate change.

https://medium.com/in-search-of-leverage/employee-activism-a-powerful-yet-untapped-driver-of-climate-action-bdfdf5dc6eea 4/7 5/28/2019 Employee Activism: A Powerful, Yet Untapped, Driver of Climate Action

Consciousness can then give rise to conscience — the value-laden component of awareness. Views about what’s morally proper and timely are important motivational factors in social movements, according to Snow. To develop such opinions, employees must first recognize their power to influence their firm’s business policies and then move from a self-identity of bystander to one of activist. Learning about successful activism campaigns can help with both.

Any new corporate conscience will have to oust current corporate norms, especially those emerging from the shareholder value paradigm. The idea that the firm exists to serve its owners is so entrenched that employee activists will inevitably be forced to fight an uphill battle.

Here is where civil society actors such as NGOs could make a difference by lending structural support to initiatives of employee activism. They could provide best practice examples around a range of topics, including how to use online petition platforms, leverage the benefits of peer-to-peer support groups, facilitate conversations about values with co-workers, and establish a line of communications between concerned employees and senior management. They could also provide legal advice and representation for activists, the need for which was made clear by Google’s repressive reaction to the November 2018 employee walk-out. In situations where employer repercussion might be severe, they could even play the role of voice aggregator, engaging with senior executives on behalf of employees and thus providing the first line of defense against individual punishment.

...

2019 is the year of unprecedented public support for climate legislation. The world seems to be far closer to serious climate action than at any point since the turn of the millennium. According to Senator Sheldon Whitehouse, the only thing that’s missing is “for the good guys in the corporate sector to start showing up.” Nobody is better positioned to make CEOs care than employees.

https://medium.com/in-search-of-leverage/employee-activism-a-powerful-yet-untapped-driver-of-climate-action-bdfdf5dc6eea 5/7 2018 This edition of ProxyPulseTM provides insights into the corporate governance trends to look for in the 2019 proxy Mini-Season season. It also looks back on shareholder voting at 1,024 meetings held during the “mini-season” between July 1 and Wrap-Up and December 31, 2018. What’s diff erent about the mini-season? Fewer companies hold meetings during the mini-season, 2019 Trends and those that do tend to be smaller. Twenty percent of all public company annual meetings took place from July 1 to December 31, 2018.

ProxyPulse™ data is based on Broadridge’s processing of shares held in street name. What to look for in 2019.

Investors continue to focus on long-term growth, highlighting the impact of culture, purpose and stewardship on a company’s long-term strategy and success.

BlackRock CEO Larry Fink’s 2019 annual letter to portfolio company CEOs highlighted the link between profi t and purpose noting that companies can realize long-term benefi ts by fulfi lling their duties to the communities in which they operate.

State Street Global Advisors (“State Street”) President and CEO Cyrus Taraporevala’s 2019 letter to portfolio company boards announced the investment fi rm’s 2019 stewardship focus on corporate culture.

“Unnerved by fundamental economic changes and the failure of government to provide lasting solutions, society is increasingly looking to companies, both public and private, to address pressing social and economic issues.”

— LARRY FINK, CEO OF BLACKROCK

Environmental and social topics continue to be front and center in the conversation as they comprised the largest segment of shareholder proposals in the 2018 calendar year. Early indications are that this trend is continuing in 2019.

PAGE 2 Legislators, investors and proxy advisors are weighing in on gender diversity.

On September 30, 2018, Governor Jerry Brown signed into law California Senate Bill 826 aimed at boosting female representation on company boards headquartered in the state of California. A similar bill was introduced in New Jersey in late November 2018.

In September 2018, State Street announced that in 2020 it would start voting against the entire nominating and governance committee (not just the chair) at companies without at least one woman on their board.1 BlackRock “encourages” boards to have at least two female directors2 and Vanguard is broadly supportive of initiatives to increase gender diversity in the boardroom.3

1 State Street Global Advisors, “State Street Starting in 2019, proxy advisory fi rm Glass Lewis will generally Global Advisors Reports Fearless Girl’s Impact: More than 300 Companies Have Added Female recommend voting against nominating committee chairs on boards Directors,” September 27, 2018. 4 2 BlackRock, Proxy voting guidelines for U.S. without a single female director. In some cases, the recommendation securities, January 2019. 3 Vanguard, “Advocating for the long term,” may extend to other members of the committee as well. Institutional April 24, 2018. Shareholder Services (ISS) will recommend voting against nominating 4 Glass Lewis, 2019 Proxy Paper Guidelines (United States), 2018. committee chairs on boards of Russell 3000 or S&P 1500 companies 5 Institutional Shareholder Services, United 5 States Proxy Voting Guidelines, December 2018. with no female directors in the 2020 proxy season.

PAGE 3 Share 1 Ownership

Year over year (2018 vs. 2017 mini-seasons), there was no A look back change in the percentage of shares owned by institutional and retail shareholders. on shareholder OWNERSHIP COMPOSITION ownership BREAKDOWN BY SHARES and voting 65% INSTITUTIONAL in the 2018 35% mini-season. RETAIL

PAGE 4 SHAREHOLDER PARTICIPATION PERCENTAGE OF SHARES BY SEGMENT

86% 2 84%

Shareholder Voting 27% 29%

Retail voting participation was up slightly over the same period in 2017. This was 2017 MINI-SEASON 2018 MINI-SEASON largely due to higher levels of solicitations at a few large shareholder meetings. INSTITUTIONAL RETAIL

Director Elections*

On average, retail shareholders cast 90% of their voted shares in favor of directors, down from 92% in the prior year. In contrast, institutional shareholders cast 87% of their voted shares in favor of directors, up slightly from 86% in 2017. Overall, 3 directors were supported by 89% of the voted shares, down 1% from 90% in 2017. A total of 3,637 directors stood for election this past season. 143 of them failed to receive majority support and 428 directors failed to attain at least 70% support, a threshold monitored by some proxy advisors.

DIRECTOR ELECTIONS DIRECTORS AT A GLANCE

AVERAGE SUPPORT 2018 MINI-SEASON

100% 92% 90% 90% TOTAL NUMBER 3,637 UP FOR ELECTION 86% 87% 80% FAILED TO ATTAIN 428 70% SUPPORT 0% 2017 MINI-SEASON 2018 MINI-SEASON FAILED TO ATTAIN 143 MAJORITY SUPPORT INSTITUTIONAL RETAIL

PAGE 5 Say-on-Pay* On average, retail shareholders cast 82% of their voted shares in favor of say-on-pay proposals, down from 83% the prior year. By comparison, institutional shareholders cast 85% of their voted shares in favor, down from 86% in 2017. Overall support averaged 4 83% versus 85% in the prior year. A total of 392 say-on-pay proposals were put to a vote; 36 failed to receive majority support and 79 failed to attain at least 70% support.

SAY-ON-PAY PROPOSALS PROPOSALS AT A GLANCE

AVERAGE SUPPORT 2018 MINI-SEASON

86% 85% TOTAL NUMBER 392 PUT TO A VOTE FAILED TO ATTAIN 83% 82% 79 70% SUPPORT FAILED TO ATTAIN 36 MAJORITY SUPPORT 2017 MINI-SEASON 2018 MINI-SEASON

INSTITUTIONAL RETAIL

SHAREHOLDER PROPOSALS FAVORABILITY (% OF VOTED SHARES)

46% 43% 5 40% 36% Shareholder * 25% Proposals 22% Overall support for shareholder proposals rose to 43%, on average, from 36% during the same 2017 MINI-SEASON 2018 MINI-SEASON period in the prior year. Retail support increased to 25% from 22% in the same period last year INSTITUTIONAL and institutional support increased to 46% this OVERALL season from 40% in the prior year. RETAIL

PAGE 6 CONTACTS Broadridge Financial Solutions:

Chuck Callan Senior Vice President Regulatory Aff airs +1 845 398 0550 [email protected]

Mike Donowitz Vice President Regulatory Aff airs +1 631 559 2486 [email protected]

PwC’s Governance Insights Center:

Paula Loop Leader Governance Insights Center +1 646 471 1881 About ProxyPulse™ [email protected] Paul DeNicola ProxyPulse is based in part on analysis of company Form 8-K fi lings from Principal EDGAR and Broadridge’s processing of shares held in street name, which Governance Insights Center accounts for over 80% of all shares outstanding of US publicly-listed +1 646 471 8897 companies. Shareholder voting trends during the proxy season represent [email protected] a snapshot in time and may not be predictive of full-year results. Catie Hall Broadridge Financial Solutions is the leading third-party processor of Director shareholder communications and proxy voting. Governance Insights Center +1 973 236 5718 PwC’s Governance Insights Center is a group within PwC whose [email protected] mission is to provide insights to directors and investors to help them

INSTITUTIONAL better understand governance topics and trends. OVERALL * In the past we reported voting outcomes by aggregating all votes cast across all meetings. In limited instances, reported outcomes could be impacted somewhat by a few companies with unusually large numbers of shares or heavy solicitations. In this report, each proposal is equally weighted, regardless of each issuer’s total shares outstanding.

PAGE 7 ProxyPulse™

PRIVACY The data provided in these reports is anonymous, aggregated data, which is a result of the data processing involved in the voting process. As a result of the automated processing used to quantify and report on proxy voting, data is aggregated and disassociated from individual companies, financial intermediaries and shareholders. We do not provide any data without sufficient voting volume to eliminate association with the voting party. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. PricewaterhouseCoopers LLP did not examine, compile or perform any procedures with respect to the ProxyPulse report, and, accordingly, PricewaterhouseCoopers LLP does not express an opinion or any other form of assurance with respect thereto. © 2019 Broadridge Investor Communication Solutions, Inc. All rights reserved. © 2019 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. What investors are expecting from the 2019 proxy season

By Jamie Smith

18 minute read 12 Feb 2019

Top investors look to boards to focus on social impact oversee emerging risk. nstitutional investors tell us they want boards to help set the tone at the top for diversity and culture and better Iarticulate how the company is investing in talent and transformation. They want to understand how companies are integrating business-relevant environmental and social considerations into a sustainable strategy that creates long- term value for a wide range of stakeholders. And they want to know how the board is overseeing emerging threats and opportunities amid continued market volatility and evolving risks.

Many investors are also further integrating environmental, social and governance (ESG) considerations into their stewardship programs and broader approach. For example, some asset managers are doing more to embed such factors into their investment processes and offering new ESG products and solutions; and asset owners are asking more questions around how their current and potential external managers are approaching ESG matters.

The 2019 proxy season preview

This is the eighth year the EY Center for Board Matters has engaged with governance specialists from the investor community to learn about their priorities for the coming year. This report brings together investor input and draws on our tracking of governance trends across more than 3,000 US listed companies.

These are some of the themes emerging from conversations with more than 60 institutional investors representing over US$32 trillion in assets under management, including asset managers (42% of participants), public funds (22%), labor funds (13%), socially responsible (13%) and faith-based investors (8%), as well as investor associations and advisors (3%). The themes focus on:

1. The top three areas investors want boards to focus on in 2019

2. Opportunities for enhancing communications around long-term strategy

3. Key factors investors use to assess board oversight of risk

4. Tips for more effective engagement 5. Shareholder proposal trends

Top three areas where investors want boards to focus in 2019

1. Board diversity — investors push for diverse directors as focus on board composition continues

Just over half (53%) of the investors we spoke with emphasized that board diversity, primarily inclusive of gender, race and ethnicity, should be a top board focus in 2019, up from one-third three years ago. An additional 19% cited diversity as part of a broader set of board composition considerations, including skill set, refreshment and assessment approaches.

Many investors said they want to see boards recognize and truly embrace the value of diversity to decision-making and performance, including by fostering an inclusive board culture as well as embedding diversity considerations into recruitment and assessment policies. They further shared that the dynamics of engagement conversations on diversity can reveal whether boards are “checking the box” or genuinely upholding diversity as a value. Many investors also noted the value of board diversity in setting a tone at the top that reflects a dynamic and inclusive view of talent. Relatedly, more investors are also expanding their focus to senior executives. Fourteen percent of investors explicitly raised both board and executive diversity as an important focus for boards, up from 4% three years ago. Some characterized a lack of diversity among directors and executive leadership as a human capital risk, particularly given today’s war on talent and the spotlight on corporate culture.

The push for diversity is occurring against a backdrop of slow-moving change in the boardroom. From 2017 to 2018, the percentage of women-held S&P 1500 directorships inched up two percentage points from 19% to 21%. That is double the annual one-percentage-point rate of increase we have observed since 2013.

Assessing racial and ethnic board diversity continues to be challenging for investors given the lack of disclosure. Thirty percent of investors who want boards to focus on diversity told us they are asking companies for better disclosure of director demographics. However, some directors may not want to self-identify for personal reasons.

Key board takeaway

Consider whether the board’s diversity and related communications (e.g., proxy disclosures regarding board composition and the role of diversity in board recruitment and assessment) set the appropriate tone at the top for the value the company places on diversity.

2. Company-relevant environmental and social issues, particularly climate risk

Around half (49%) of investors said a top board focus should be business-relevant environmental and social factors. That is, those that are most likely to impact the company’s strategy, risk profile and brand, such as water management for food and beverage companies; access and affordability for health care companies; and plastic pollution for consumer goods companies. Generally, these investors want to understand how boards and management are connecting these kinds of environmental and social issues to their long-term success and embedding related considerations into their risk management and strategy setting. And they want to see this integration consistently communicated in company disclosures on strategy and risk.

Most of these investors — more than a third (38%) of investors overall — are specifically focused on climate change, which is up from 15% three years ago. Notably, the types of investors citing climate risk were evenly divided among mainstream asset managers, public funds, and faith-based and socially responsible investors, reinforcing the increasingly broad spectrum of investors focused on this issue.

The direct relevance of climate risk is different for each company, and most investors focused on climate are engaging heavy greenhouse gas (GHG) emitters, such as those in the industrial or energy sectors. Regarding these companies, investors raised the need for concrete and significant GHG reduction goals and climate scenario planning that tests the resilience of company strategy against a 2 degree Celsius or lower scenario — both core elements of the Financial Stability Board’s Task Force on Climate related Financial Disclosures’ (TCFD) recommendations. Thirty-eight percent of investors citing climate change raised that they are actively asking companies to take these steps.

Another key theme arising from the conversation on climate risk was the need for enhanced reporting. Close to half (46%) of the investors citing climate risk raised the TCFD as a reporting framework they support. These investors noted the importance of such reporting for companies’ strategic planning and risk management, and many noted that they are part of the Climate Action 100+, an investor-led initiative that promotes voluntary disclosure in line with the TCFD’s recommendations.

As for expectations around board governance of environmental and social factors, including climate risk, investor expectations may vary based on company specific circumstances. Nonetheless, most investors told us they recognize effective oversight can come in different forms, such as charging a dedicated board committee or one of the key committees with related oversight, recruiting directors with business-relevant sustainability expertise, talking to external independent specialists, or setting a clear and ongoing agenda for the board to discuss sustainability impacts.

Key board takeaway

Challenge whether the company’s risk management processes, capital allocation decisions and strategic planning integrate business-relevant environmental and social considerations, and whether the company’s reporting process consistently demonstrates this integration. Consider the extent to which key stakeholders support external frameworks, such as the TCFD and the Sustainability Accounting Standards Board (SASB), and how company disclosures align with these frameworks.

3. Human capital management – investors seek to understand how boards are governing talent and culture

More than a third (39%) of investors told us human capital management and corporate culture should be a top board focus, up from just 6% three years ago. While some are focused on particular issues (e.g., workforce diversity, pay equity), most are taking a broad view of the topic. Several investors shared that recent business, technology and societal trends have played a role in them paying closer attention to human capital and culture, including a more discerning and empowered consumer base, radical shifts in the workforce and the growing importance of talent to an organization’s intangible value in today’s digital economy.

At a high level these investors want to understand the role of human capital management in the company’s long-term strategy and how the company is evolving, investing in and developing its talent to further innovate and meet future needs, particularly in industries or geographies where talent scarcities are on the horizon, such as technology and financial services. They also want to understand how companies are addressing, including how boards are assessing, potential cultural and workforce issues to support long-term strategy and enhance and protect the company’s reputation, brand value and ability to attract the best talent.

Twenty percent of the investors citing human capital management seek increased disclosure around related topics, and some view the pay ratio as an opportunity for companies to provide deeper context around their investments in human capital. Most told us that, at least for now, they are prioritizing dialogue over disclosure. Some even indicated that this kind of information need not be for public consumption, and that they are seeking assurance that boards are actively engaged in reviewing related metrics. Overall, there was consensus that investors would like to better understand how boards are engaged and exercising oversight in this space.

Key board takeaway

Assess how the board is governing around talent and culture, including how well the board understands the current culture, and whether the human capital metrics the board is reviewing and the quality and frequency of management reporting to the board are sufficient for robust oversight.

Opportunities for enhancing communications around long-term strategy

We asked investors if they think most companies are doing a good job of balancing their investments for the short- and long-term. Nearly all qualified their responses, stressing that it is highly dependent on the company and acknowledging the market pressures that encourage short-termism. A quarter declined to answer, with most explaining that this is an evaluation they leave to their investment professionals and a few stating that this is a debate they avoid. But most revealing to us was this: nearly 20% said it is hard to answer the question because of the current lack of disclosure around long-term strategy.

Some of these investors applauded particular companies for doing a great job in communicating their long-term approach but noted that many companies maintain a heavy emphasis on the short-term, including businesses with what appeared to them to be unacknowledged and unmitigated long-term risks. Notably, some said that when there is external pressure, such as an activist waging a proxy contest, companies are very articulate about their long-term strategy, but there is opportunity to better tell this story as part of their regular communications.

Investors generally want to understand how companies are anticipating and responding to external market developments and industry trends. They would like to see that a company’s identification of key risks and strategic opportunities includes environmental and social factors that impact the company’s business sustainability, and they want to see consistent messaging across various communications (e.g., the 10-K, the sustainability report and investor presentations). They also want a clear picture of how short-term goals and executive pay tie into and support long-term strategy.

To assess whether companies are effectively balancing the short- and long-term, investors told us they are looking at:

The company’s story. Is the company consistently communicating a strategy around long-term growth? Is there a strong articulation of the company’s purpose and how the company is managing its business to create long-term value?

Executive compensation. Does the pay program promote longer-term focus or does it primarily emphasize a one-year time frame? Are companies rewarding innovation, investment in the company, and progress tied to environmental or social goals?

Capital allocation/stock buybacks. How is the company investing in services, products, retraining or innovation that could build long-term value? And how do recent stock buybacks reflect the best use of cash?

Environmental and social metrics. Is the company investing energy, focus and disclosures around long- term sustainability goals? Does company strategy address business-specific opportunities and risks on environmental and social matters?

Risk disclosures. Does there appear to be an underappreciation of significant risks, such as environmental risks, cybersecurity or broader technology challenges?

Sell-side research. Is the company articulating business planning for the long-term?

Key board takeaway

Assess opportunities for enhancing communication of long-term strategy, and how near-term goals and pay incentives support that strategy.

Five factors investors use to assess board oversight of risk

We asked investors if they are raising particular risk issues (e.g., cybersecurity, talent/human capital management, climate, geopolitical) in company engagements and how they are assessing board oversight of those risks. Most said they don’t want to be prescriptive regarding board oversight; they want to see evidence that the board is engaged and to understand related oversight structures and procedures. Some of the key factors they raised included:

1. Management reporting to the board. Investors are interested in how management is reporting to the board on key risk issues at a high level and may raise related questions in engagement discussions, e.g., who from management is reporting, how often and what kind of information is discussed.

2. Committee oversight. Investors generally want to see that a board committee has responsibility over and is engaged on key risks, or that there are procedures in place to maintain sufficient attention to the issue by the full board. 3. Director qualifications and use of outside specialists. Investors generally want the board to include relevant expertise tied to key risks the company is facing. They also want assurances that the board is accessing outside specialists as needed to stay current on external developments and challenge internal bias, as appropriate.

4. Directors’ ability to speak to risks disclosed in the 10-K. Several investors said they expect board members to be able to speak fluently on how they are overseeing key risks identified in the annual report and may raise related questions in engagement conversations.

5. Explanation of differences between company’s disclosed risks and external frameworks/research. Several investors said they often compare a company’s disclosed risks to other benchmarks (e.g., industry research, ESG ratings reports, the SASB framework) and may raise questions about perceived gaps or areas of misalignment.

Tips for more effective engagement

We asked investors what they wish were different about their engagements with companies. Close to a third (30%) said that overall engagement has improved significantly, with most citing increased director involvement and a more respectful approach as important developments. Still, 91% cited opportunities for continuing to improve the process. Here are some tips based on what we heard:

Avoid engaging for engaging’s sake — engage as needed outside of proxy season and avoid discussing proxy advisory firm views. Investors said companies come across as tone deaf when they reach out in the spring (when investors are voting thousands of company ballots) or with no clear agenda, and when they focus on the views of proxy advisory firms that investors do not rely on for voting guidance.

Have a mutually agreed-upon agenda and the right people on the call. Having an agenda that benefits both parties provides for a richer conversation and allows both sides to prepare accordingly. Having the relevant decision-makers and subject matter specialists involved — including directors as appropriate — can make conversation more productive and efficient. Some investors noted that when boards rely solely on sustainability officers to discuss environmental and social issues, that may reinforce concerns that these issues are isolated from board discussions on strategy and risk. Similarly, when a compensation committee defers to management or the compensation consultant, this may raise questions about the extent to which the committee owns the pay philosophy and decision-making. Overall, many expressed frustration at IR playing a lead role in engagement, given the perceived lack of familiarity on company-specific governance and sustainability topics and focus on “canned” messaging.

Make the discussion more investor specific. The more the company understands the investor’s approach and position on governance issues, the more focused the engagement. While many investors post their proxy voting guidelines and stewardship reports on their websites (and some send letters to portfolio companies identifying engagement priorities), many said they do not expect companies to do in-depth research before a meeting, but at least expect the company to understand whether they are talking to an active or passive manager, or an asset manager or owner. Further, several investors said they wish companies would review notes from previous conversations with them to help move the dialogue forward. Finally, recognize that some investors view the shareholder proposal process as an important part of investor/company engagement.

Be forthcoming about challenges and controversies, as well as changes made in response to feedback. Several investors noted frustration around companies not directly raising challenges or controversies. They said that, when coupled with “all is well” type messaging, the communication raises concern that companies are obfuscating, which makes investors skeptical about what the company does share, and results in a missed opportunity for relationship-building. Conversely, companies that directly raise the challenges they face and discuss plans to address them build trust. Further, companies that reach out to share recent or potential changes made in response to feedback reinforce the value of engagement and relationship- building efforts.

One shortcut to understanding widely held investor expectations is the Investor Stewardship Group’s (ISG) framework of corporate governance principles, which reflects the common corporate governance standards of ISG members, which include some of the largest US-based institutional investors and global asset managers.

Shareholder proposal trends

Shareholder proposal submissions in 2018 were down 20% from five years ago based on our tracking of proposals submitted at Russell 3000 companies. Over the same time period, the portion of proposals that were withdrawn (in most cases because the proponents and the companies reached agreement) held steady at around one-third of all submissions. Notably, average support for proposals that went to a vote on environmental sustainability topics (e.g., asking companies to report on sustainability, climate risk, energy efficiency, greenhouse gas emissions) grew from 22% to 31%.

More changes to the shareholder proposal landscape may be ahead. Following a November 2018 U.S. Securities and Exchange Commission roundtable, Chairman Jay Clayton identified improving the proxy process as a key 2019 initiative for the Commission, specifically including examination of the share ownership and voting thresholds that determine whether shareholder proposals can be submitted and resubmitted. To set the context for proxy season 2019, here are the top shareholder proposal topics by average vote support in 2018, a year in which a total of 281 companies had shareholder proposals voted.

Top 20 shareholder proposal topics in 2018, based on average support received*

Average support Maximum support

Eliminate classified board 87% 96%

Adopt majority vote to elect directors 78% 98%

Eliminate supermajority vote 64% 87%

Allow shareholders to act by written consent 43% 86%

Report on sustainability 41% 80%

Allow shareholders to call special meeting 40% 94%

Address corporate EEO/diversity 39% 48%

Review/report on health care/medicine 32% 62%

Address political spending 32% 47%

Enhance pay­for­performance alignment 32% 48%

Address greenhouse gas emissions 32% 57%

Appoint independent board chair 32% 58%

Adopt/amend proxy access 32% 85%

Eliminate dual­class common stock 30% 41% Limit post­employment executive pay 30% 43%

Address food/consumer products 28% 43%

Address lobbying activities 26% 41%

Address alternative, renewable energy 23% 46%

Address internet/data security risks 20% 36%

Address board diversity 18% 33%

**Where at least five proposals were voted. Accordingly, certain topics that received strong, and even majority support, in 2018 are not included (e.g., proposals to address climate risk averaged 42% support last year, but only four came to vote while 17 were withdrawn).

The ES of ESG is growing in prominence, and many investors want to understand how companies are embedding relevant considerations in their long-term strategy. Many investors also want boards to set the tone at the top for diversity and do a better job of articulating oversight of long-term strategy, including how the company is investing in and developing talent, living its values and navigating external risks.

While these high-level insights come from a broad range of investors, boards must remember that institutional investor views can vary significantly.

Questions for the board to consider

Does the board’s makeup and culture reflect the company’s broader commitment to diversity and inclusion? And how is the board challenging itself to find diverse director candidates and communicating those efforts to investors?

Do the company’s various reporting channels (e.g., proxy statement, annual report, sustainability report, quarterly reports and earnings calls) tell a consistent story about long-term strategy and related risks, including business-relevant environmental and social factors? Is it clear how the executive pay program and short-term performance goals support that strategy?

How is the company investing in and developing its talent as the business evolves? What is the company doing to provide for its talent needs in 3—5 years? Does the board understand how the company’s culture aligns with the company’s purpose, values and strategy, along with any particular cultural strengths or opportunities for improvement?

Is the board able to articulate how it oversees the key risk factors disclosed by the company in its annual report? And has the company considered how its disclosed risks align to those of peers and external frameworks such as SASB or the TCFD?

Are there opportunities to make the company’s shareholder engagement program more targeted and outcome- driven?

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Summary

Institutional investors expect boards to be focused on board composition, climate risk and talent management. They also want effective communication and and engagement with boards.

About this article Jamie Smith

EY Americas Center for Board Matters Investor Outreach and Corporate Upvote 12 Governance Specialist

Trusted resource on corporate governance and institutional investor trends. Researcher and analyst. Lifelong learner. Mother and nature enthusiast.

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. Harvard Law School Forum on Corporate Governance and Financial Regulation

2019 Proxy Season Preview

Posted by Shirley Westcott, Alliance Advisors, on Monday, April 15, 2019

Tags: Board composition, Climate change, Diversity, Environmental disclosure, ESG, Proxy season, Proxy voting, Shareholder proposals, Shareholder voting, Sustainability

More from: Shirley Westcott, Alliance Advisors

Editor's Note: Shirley Westcott is a Senior Vice President at Alliance Advisors LLC. This post is based on an Alliance Advisors publication by Ms. Westcott. Related research from the Program on Corporate Governance includes Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

With the 2019 proxy season now underway, several trends are emerging in shareholder campaigns:

Environmental and social (E&S) topics will once again dominate the shareholder proposal landscape. For a third consecutive year, E&S issues account for a majority of all shareholder proposals filed, outpacing those related to governance and compensation. Topping the list of submissions are political spending resolutions, which proponents have ramped up in advance of the 2020 elections (see Table 1).

Withdrawals could approach last year’s record. In 2018, nearly half of E&S resolutions were withdrawn as a result of productive engagements, a trend that is likely to continue. Companies are showing more willingness to reach agreements with proponents due to shifts in investor voting, particularly among some of the largest institutional investors, notably BlackRock, Vanguard Group and Fidelity Investments. According to a recent Institutional Shareholder Services (ISS) study, more shareholders are supporting E&S proposals rather than casting abstention votes, which declined from 16% of votes cast in 2010 to 3% in 2018. This in turn translated into a record 12 majority votes on E&S resolutions in 2018, while another 20 received support in the 40% range.

The six-week federal government shutdown in January also spurred a number of withdrawals due to delays in the SEC’s processing of no-action requests. At least 17 companies withdrew their petitions after the government reopened as a result of reaching settlements with proponents.

New players are joining the E&S mix. The growing momentum of E&S campaigns is attracting new proponents. Now that many large-cap companies have shareholder-friendly governance provisions, corporate gadflies John Chevedden, James McRitchie, Myra Young and the Steiner family (the “Chevedden group”) are broadening their focus in 2019 to E&S proposals, particularly political spending where they account for one-third of all submissions. Although they are still advocating for independent board chairs, simple majority voting and written consent, they have downplayed their calls for amending proxy access bylaws and easing eligibility requirements for shareholders to call special meetings.

Employee activism is also on the rise. Silicon Valley workers are leveraging their stock compensation to agitate for change at their employers via proxy proposals. After staging a massive walkout last fall over their company’s handling of sexual harassment claims, Google employees have once again teamed up with Zevin Asset Management on a proposal to link executive compensation to diversity and inclusion goals. Similarly, over a dozen Amazon.com employees have filed a resolution asking the company to release a comprehensive plan to address climate change. Amazon.com holds the distinction this year of receiving the most shareholder resolutions—14 in all.

No-action challenges are usurping a number of new and recurring campaigns. Shareholder proponents and issuers continue to grapple with SEC interpretive guidance issued in 2017 and 2018 (Staff Legal Bulletins (SLB) 14I and 14J), which deal with ordinary business and economic relevance exclusions. Although these clarifications did not substantially impact the outcome of no-action requests in 2018, climate-related proposals were disproportionately affected.

Climate resolutions remain in the crosshairs of ordinary business challenges following a 2018 staff decision that a resolution at EOG Resources to set company-wide, quantitative, time-bound targets for reducing greenhouse gas (GHG) emissions constituted micromanagement of the company. This reversal of longstanding precedent has resulted in the omission of five proposals this year to align carbon emissions with the goals of the 2015 Paris Climate Agreement to maintain global warming at well below 2° C. Five similar no-action requests are pending.

Several other staff reversals have occurred this year on compensation topics, based on the micromanagement considerations of SLB 14J. These include proposals to exclude legal and compliance costs from executive pay (AbbVie and Johnson & Johnson) and on revolving door payments (JPMorgan Chase), which were disqualified as ordinary business in past years because they dealt with senior executive compensation.

First-time shareholder initiatives drawn from news headlines—the explosion of stock buybacks, illegal immigrant detention and fair employment practices—are also being squeezed out by ordinary business exclusions. As a result, some of this year’s social justice topics are unlikely to generate the level of investor and media attention that occurred last year with resolutions on opioid abuse and gun violence.

A more detailed look at some of the season’s key shareholder campaigns follows below. Governance Special Meetings

Last year, the most prominent governance initiative—with 84 proposals filed and 65 voted on—called on companies to adopt or reduce the ownership thresholds required for shareholders to call special meetings to

10% or 15%. Notably, seven companies were able to omit the resolutions under the conflicting proposal exclusion by substituting a management resolution to ratify their existing provisions. Although all of these passed, issuers may be reluctant pursue this course of action going forward now that ISS and Glass Lewis have adopted policies to oppose governance committee chairs at companies that engage in this practice.

So far, only two firms are taking this approach this year. At Franklin Resources’ February meeting, shareholders backed a management ratification proposal by 88.2% and supported the governance committee chair by 83%, notwithstanding negative proxy advisor recommendations. United Technologies also sought a Rule 14a-8(i)(9) exclusion in favor of ratification of the 15% special meeting threshold it adopted last fall (reduced from 25%). Ironically, the shareholder request (20%) would now result in an increase in the special meeting threshold. While that alone may have alleviated any proxy advisor backlash, the proposal was ultimately omitted because the sponsor failed to present a similar proposal at the 2018 annual meeting.

The proponents—the Chevedden group—have backed off from unleashing another deluge of special meeting resolutions this year, including refiling at the seven “offending companies” that knocked out their proposals last year. Instead, they are proposing other measures at those firms, such as an independent board chair, written consent, simple majority voting and more lenient proxy access provisions. Proxy Access

As in 2018, the volume of proxy access proposals is trending down due to corporate adoptions. To date, about 579 companies have implemented access rights—including 70% of the S&P 500 and 18.6% of the Russell 3000—and over 80% of their bylaws adhere to a 3/3/20/20 structure, typically with a two-director minimum.

Proxy access “fix-it” proposals—sponsored by the Chevedden group—are also receding after averaging only 28% support in 2017 and 2018. Most of those sought a package of enhancements to existing access bylaws or the expansion of group aggregations to 40, 50 or an unlimited number of shareholders. This year, the proponents have toned down their requests to a single, often minor revision, such as adding a two-director minimum to the board seat cap (Apple) or eliminating the vote requirement for renomination of access candidates (AMN Healthcare Services, Bank of America, JPMorgan Chase, Newell Brands, Spirit AeroSystems). So far, even their minimalist approach is not gaining traction. The vote at Apple was 29.5%, suggesting that the proposed change was immaterial to most shareholders.

This season also marks the second attempt to use proxy access after GAMCO’s aborted effort two years ago at National Fuel Gas. A Schedule 14N was filed in December at Joint by Steven Colmar, a co-founder and former director of the company, who left the board in 2017 over disagreements about the company’s strategic direction. His nominee, Glenn Krevlin, is the founder of hedge fund Glennhill Capital. Stock Buybacks

Shareholder activists are reviving proposals related to stock buybacks in the wake of the 2017 Tax Cuts and Jobs Act, which contributed to a record $1 trillion in corporate share repurchases in 2018, according to TrimTabs Investment Research. Critics argue that the tax savings have primarily benefited corporate executives and shareholders rather than being used for job-creating investments, thereby exacerbating wealth inequality.

Several variations of shareholder proposals are being submitted this season, largely by the Chevedden group. The first, which was omitted as ordinary business, would have required shareholder approval of any open-market share repurchase programs or stock buybacks adopted by the board. Another version asks American Express and Boeing to exclude the impact of share repurchases from the financial metrics used for determining senior executive pay. Similar resolutions have typically garnered only single-digit support in the past. The proponents are also referencing stock buybacks in some of their independent chair and simple majority vote proposals as an argument for better board oversight.

Oxfam America has submitted a new resolution, which is pending at Merck, that addresses concerns over executives profiting from buybacks by cashing their equity compensation during the stock price pop that often follows a buyback announcement. In line with recommendations by SEC Commissioner Robert Jackson, the proposal urges the compensation committee to adopt a policy to approve sales of shares acquired through equity compensation programs. If approval is granted, the committee should disclose to shareholders why the sale is in the company’s long-term best interest.

Senate lawmakers are also considering legislation to discourage corporate stock buybacks. Tammy Baldwin (D-Wisc.) recently reintroduced the 2018 Reward Work Act, which would ban open-market stock repurchases altogether. In a similar vein, Chuck Schumer (D-N.Y.) and Bernie Sanders (I-Vt.) plan to offer a bill that would precondition share repurchases on a company’s commitment to invest in workers and communities through better pay and benefits. A less drastic approach, proposed by Marco Rubio (R-Fla.), would eliminate the preferential tax treatment of share repurchases by taxing them as dividends rather than as capital gains.

Investors, for their part, remain largely supportive of stock repurchase plans. Consistent with past surveys, 43% of institutional investors polled by Corbin Advisors in 2018 believed that buybacks were the best use of a company’s cash, second only to M&A, which was preferred by 49% of investors. The Council of Institutional Investors (CII) further cautioned that restricting buybacks would interfere with corporations’ decisions about how best to allocate their capital. Instead, CII calls for better disclosure of buyback rationales and links to pay. E&S Diversity & Inclusion

Board Diversity Issuers can expect a greater degree of negative reaction to all-male boards as Glass Lewis’s new board gender diversity policy comes online this season. Glass Lewis will begin recommending against the nominating committee chairs of Russell 3000 firms with no female directors unless they disclose a timetable for addressing the lack of gender diversity on the board or specific restrictions in place regarding the board’s composition. ISS has adopted a similar policy for Russell 3000 and S&P 1500 firms, which goes into effect in 2020. The proxy advisor policies follow suit with the positions adopted by some major Institutional investors. Since the launch of its “Fearless Girl” campaign in 2017, State Street Global Advisors (SSGA) has been voting against nominating chairs if there are no female directors on the board. Beginning in 2020, SSGA will expand its dissenting votes to the entire nominating committee. BlackRock also plans to oppose nominating committee members at companies that do not have at least two women on the board and have not set a timeframe for improvement.

California-headquartered companies are additionally facing a newly enacted law (Senate Bill No. 826) that mandates gender quotas in the boardroom: at least one female director by the end of 2019 and two to three female directors, depending on board size, by the end of 2021. Based on data from Board Governance Research, some 184 California- based companies would need to add a woman to the board this year to comply with the law, while a total of 1,060 firms would need to appoint female board members to meet the 2021 deadline. New Jersey legislators proposed a nearly identical law last November (NJ Assembly No. 4726), which could impact as many as 42% of New Jersey-based firms, according to estimates by 2020 Women on Boards.

Issuers may also need to review their board diversity disclosures in light of two Regulation S-K Compliance and Disclosure Interpretations (C&DIs) issued by the SEC in February. To the extent that the board or nominating committee, as well as the company’s diversity policies, take into account self-identified personal attributes (race, gender, ethnicity, religion, nationality, disability, sexual orientation or cultural background) the staff expects Item 401 and Item 407 discussions to identify those characteristics and how they were considered, assuming the directors and nominees consent to having the information publicized.

Federal lawmakers are similarly promoting more transparency around diversity rather than outright quotas. House and Senate Democrats have introduced companion bills (“Improving Corporate Governance through Diversity Act of 2019”) which would require public companies to disclose in their proxy statements data on the racial, ethnic and gender composition, as well as veteran status, of both their board members and executive officers based on voluntary self- identification. It would also require disclosure of any board policy, plan or strategy to promote racial, ethnic and gender diversity. The bills have been endorsed by CII and the U.S. Chamber of Commerce.

For their part, shareholder activists on both the left and right continue to advocate for the inclusion of diversity characteristics in a director skills and qualifications matrix. As part of its Boardroom Accountability Project 2.0, the New York City Comptroller has filed eight resolutions seeking a board diversity matrix, including a resubmission at Exxon Mobil, which received 16.5% in 2018.

Meanwhile, to counter liberal bias in boardrooms, the National Center for Public Policy Research (NCPPR) is proposing an alternative matrix that reflects “true board diversity”—namely, each nominee’s skills, experience and ideological perspectives. To date, votes are in line with last year, receiving 1.7% support at both Apple and Starbucks. NCPPR has also reportedly withdrawn a number of its resolutions in exchange for the companies adopting some form of the request. Executive Diversity This year, diversity campaigns are increasingly expanding to the C-Suite, where female and minority representation has remained relatively flat. Trillium Asset Management has submitted proposals at five companies to report on the diversity of their executive leadership team and their plans to make it more diverse in terms of race, gender and ethnicity.

In line with this, recent studies by Calvert Impact Capital and ISS suggest that investors’ focus on gender diversity at the board level is misdirected. According to the research, the number of women in senior management positions—those reporting directly to the CEO—has a much greater impact on company performance than the number of female directors or the gender of the company founder or CEO. Workplace Diversity Trillium and As You Sow are also continuing their bottom-up approach to diversity by asking for workplace diversity reports (EEO-1 data), which break down a company’s workforce by race, gender and broad job category. 2017 was a breakout year for this campaign when filings nearly tripled in volume from the prior year, and one proposal (at Palo Alto Networks) received majority support. This year, the number of submissions has fallen dramatically—to eight from 23 in 2018—but the scope of the requests has expanded in some cases. At Fastenal, for example, the proponents are calling for a more robust report based on the Sustainability Accounting Standard Board’s (SASB) industry-specific, material risk metrics. This would include gender data for global operations and EEO-1 racial/ethnic data for U.S. operations, disaggregated into management (executive and mid-level officials) and non-management employees.

Investor demands for EEO-1 reports are likely to accelerate after a federal court recently lifted a stay on a 2016 Equal Employment Opportunity Commission (EEOC) requirement to include pay data. Companies with more than 100 employees will be required to report the gender, racial and ethnic makeup of workers in each EEO-1 job category within 12 pay ranges, along with the total hours worked. The measure was frozen in 2017 after the Office of Management and Budget (OMB) concluded that it was overly burdensome for employers, but labor and women’s rights groups successfully sued to have it reinstated. The EEOC and OMB have until April 3 to advise employers on how and when to submit their 2018 EEO-1 data. Given the unexpected court ruling—and the possibility that the OMB will appeal it—the May 31 reporting deadline is likely to be extended. Gender Pay Equity Proposals addressing gender pay disparities are making a comeback this season after highly successful campaigns in recent years. Since 2016, the primary sponsor Arjuna Capital has prodded 22 companies in the technology, consumer and financial services sectors to share their “pay equity” (“equal pay for equal work”) data and take steps to close any gaps.

This year, Arjuna is shifting its campaign to request global median gender pay gap disclosures from a dozen financial and technology firms. Median pay gaps measure the median pay of all men versus the median pay of all women in a company’s workforce, irrespective of position. Unlike equal pay data, these disclosures shed light on the “leadership gap,” namely, the extent that women are underrepresented in the top-ranking, highest-paying jobs. The initiative is in keeping with a new mandate in the U.K. requiring companies with over 250 employees to report their mean and median gender pay gaps.

Among the targeted firms, Citigroup became the first U.S. company to report median pay gap data for women and minorities, resulting in a withdrawal of Arjuna’s resolution. Based on its analysis, Citigroup plans to increase representation at the Assistant Vice President through Managing Director levels to at least 40% for women globally and 8% for black employees in the U.S. by the end of 2021. Corporate Culture and Human Capital Management The #MeToo movement and high-profile corporate scandals has sharpened investor attention to risks related to corporate culture and human capital management (HCM) that can negatively impact long-term performance. According to Morrow Sodali’s 2019 survey of 46 global institutional investors, 83% want more detailed information on HCM and 67% want a better understanding of how the board overseas corporate culture and the tone at the top. Similarly, a survey of 60 institutional investors conducted by the EY Center for Board Matters found that 39% believe HCM and corporate culture should be a top board focus, up from 6% three years ago. Twenty percent of these investors want more transparency around HCM-related topics, such as pay ratios, though most are prioritizing dialogue over disclosure.

In line with this, BlackRock has designated HCM as one of its 2019 engagement priorities, while SSGA has created a framework to assist boards and managements in aligning their corporate culture with their long-term strategies. Similarly, a coalition of California pension funds has developed a set of principles to manage and mitigate HCM-related risks, including company policies on sexual harassment, diversity throughout the organization, restrictive labor practices, and workers’ rights.

HCM is additionally factoring into proxy proposals this year, though many are getting withdrawn for technical reasons or omitted as ordinary business. The New York City Pension Funds (NYC Funds) and Change-to-Win (CtW) Investment Group filed resolutions at seven companies to adopt a policy not to engage in any “inequitable employment practices” that keep workplace misconduct in the shadows. These include mandatory arbitration of employment-related claims, non- compete agreements, no-poach agreements and involuntary non-disclosure agreements. Other union- sponsored proposals deal with how companies’ mandatory arbitration policies are impacting employees and sexual harassment claims and with formalizing the board’s oversight responsibility for managing and mitigating risks related to sexual harassment.

Following last fall’s global walkout of 20,000 Google employees over exit payments made to executives accused of sexual misconduct, CtW is presenting one of their demands in a first-time proxy proposal. It is asking parent company Alphabet to appoint an employee representative to the board by 2020 to help mitigate risks related to human capital and corporate culture and prevent the reputational damage caused by employee protests. Although the proposal will face certain defeat because of the founders’ superior voting rights, the concept of worker representation on corporate boards is featuring in legislation proposed by Senate and House Democrats and the platforms of several 2020 presidential contenders. Human Rights

Immigrant Detention In response to the Trump administration’s zero-tolerance policy on illegal immigration, faith-based investors and the Service Employees International Union (SEIU) are engaging and submitting proposals at companies in the private prison, technology, and defense sectors deemed at risk for human rights violations as a result of their contracts with Immigration and Customs Enforcement, Customs and Border Protection and other federal agencies.

Specifically, they are asking e-commerce firms, such as Amazon.com, to stop selling facial recognition technology to government agencies unless the board determines, using independent evidence, that it does not cause or contribute to violations of privacy, civil liberties and human rights. Similar risk assessments are being sought from government contractors, such as Northrop Grumman, which is developing biometric identification systems for the Department of Homeland Security. The proponents contend that these technologies facilitate immigrant surveillance and racial profiling.

Shareholder groups are also facing off with CoreCivic and GEO Group, the largest operators of private prisons and illegal immigrant detention centers. Religious orders want more details on the treatment of people held at their facilities and how respect for inmate and detainee human rights is incorporated into senior executive pay arrangements. Alex Friedman of the Human Rights Defense Center—a longstanding agitator for inmate rights—has proposed that the companies refrain from housing unaccompanied minors or illegal adults who have been separated from their children. The Friedman resolutions were successfully challenged as ordinary business.

Activists have made headway with banks that lend to CoreCivic and GEO Group, withdrawing all four of their proposals. Among the targeted firms was JPMorgan Chase, which is ending its financing of private prison operators, and Wells Fargo, which is reducing its exposure to this sector. Health­Related

Opioid Crisis The Investors for Opioid Accountability (IOA)—a coalition of over 50 institutional investors—is continuing its highly successful campaign against opioid abuse with drug manufacturers, distributors and retailers. Over the past year, the IOA has reached agreements with a dozen companies on governance measures to more effectively monitor and manage financial and reputational risks related to the opioid crisis. These include producing a board risk report, separating the chair and CEO positions, adopting a misconduct-based clawback policy, enhancing lobbying/political spending disclosure, and not adjusting executive compensation performance metrics to exclude legal costs. In addition, three resolutions on board risk reporting received majority support at Assertio Therapeutics, Rite Aid and, most recently, Walgreens Boots Alliance.

Nine opioid-related resolutions are currently pending for 2019 annual meetings, including three calling for risk management reports and the remainder for governance reforms. Given the strong investor and proxy advisor support for this initiative, some of these could ultimately be settled. Drug Pricing For a fifth year, faith-based investors are revisiting the issue of high prescription drug costs at major pharmaceutical companies. To avoid the ordinary business exclusions that have occurred in the past, the proponents are asking nine companies for compensation committee risk reports to show the extent that their drug pricing strategies are tied into senior executive compensation. Last year, these proposals averaged 23.3% support and were backed by ISS, but opposed by Glass Lewis.

Other proposal variations may not make it to ballots due to negotiated withdrawals. These include a new resolution to formalize board oversight of prescription drug pricing in a new or existing board committee and to add drug pricing risk expertise to the director qualifications matrix. Environmental­Related

Climate Change Risks related to climate change will be a top priority for investors this year, both in their discussions with issuers and in proxy proposals. Morrow Sodali’s recent survey of 46 global investors found that 85% considered climate change their most important engagement topic, up from 31% last year.

According to ISS, companies will face a record 75 or more climate-related resolutions this year. Yet despite the onslaught, some of the largest index investors (BlackRock, Vanguard and Fidelity) have historically backed only a small fraction of the proposals.

BlackRock, in particular, has been called out by a dozen environmental groups and social investment funds for its voting practices and “poor contribution to environmental goals.”

This year’s climate campaigns are going beyond stress-testing business plans and are asking carbon-intensive companies to establish hard targets for reducing their emissions. The Church of England, New York State Common Retirement Funds (NYSCRF) and other filers have submitted a first-time proposal, which is pending at Exxon Mobil, to set and disclose short-, medium- and long-term targets for cutting GHG emissions—for both its own operations and the products it sells—that are aligned with the goals of the Paris climate agreement.

This follows after rival Royal Dutch Shell relented to investor pressure last fall and announced that it would introduce three- and five-year carbon reduction targets that would include customers’ use of its fuels (Scope 3 emissions) and tie- ins to executive pay. BP and Chevron have similarly pledged to link employee bonuses to GHG reduction targets.

Aside from aggressive carbon reduction demands, one proponent (the NYC Funds) went to so far as to sue aerospace parts manufacturer TransDigm Group in federal district court for trying to omit their resolution to adopt goals for managing GHG emissions. The plaintiffs sought both declaratory and injunctive relief, claiming that exclusion of the proposal would cause them “irreparable injury.” Rather than fight the matter, TransDigm withdrew its no-action request and let the proposal go to a vote, which registered 34.9% support. However, the incident has raised concerns that the NYC Funds— or other proponents—will pursue judicial intervention to keep resolutions on the ballot.

Separately, the New York City Comptroller and a coalition of 19 public pension systems, social investment funds and faith- based investors have launched an ambitious campaign to eliminate carbon pollution from the country’s 20 largest electric power utilities, which account for nearly half of the sector’s emissions. In recent letters, they asked the utilities to commit to achieving net-zero carbon emissions by 2050, with near-term benchmarks in 2025 and 2030, and to adopt policies to ensure that their executive compensation and political activities are aligned with that goal. Of the companies targeted, only one (Xcel Energy) has committed to the net-zero-by-2050 objective. If the others fail to make this commitment by their 2020 annual meetings, the coalition will recommend that asset owners and managers vote against the board chair and/or lead director. Plastic Pollution For 2019, As You Sow and a coalition of 40 international investors—the Plastic Solutions Investor Alliance—are stepping up their efforts to combat plastic waste and marine pollution. In their first vote of the season, a repeat proposal at Starbucks to boost plastic recycling and transition to sustainable packaging won 44.5% support, a record high on this topic. Similar resolutions are pending at three other consumer goods companies.

This year, the proponents are broadening their campaign to include petrochemical companies (Chevron, DowDupont, Exxon Mobil and Phillips 66) to annually report on plastic pellet spills and cleanup measures during the resin production process and actions taken to prevent future contamination. Studies estimate that plastic pellets (“nurdles”) are the second largest direct source of microplastic pollution in the ocean by weight. So far, one resolution has been withdrawn at Exxon Mobil after the company agreed to the reporting.

Aside from proxy proposals, Walden Asset Management and the Sierra Club have written letters to a dozen companies to drop their support of the Plastics Industry Association (PLASTICS), which has lobbied for statewide preemption of local ordinances that ban or tax plastic bags. One recipient (Becton, Dickinson) decided to withdraw its association membership, while privately-held SC Johnson will ensure that its dues do not go towards funding plastic bag lobbying. Conclusion

This year’s annual meetings will give issuers additional insight into two key matters which will help frame post-season engagements and shape next year’s shareholder campaigns: the extent that investor views are shifting on E&S issues and how the SEC is applying new guidance on Rule 14a-8(i)(7) and 14a-8(i)(5) exclusions. As the season progresses, Alliance Advisors will keep issuers apprised of these and other key developments as they arise.

Table 1:

2019 2018 Proposal Proposal (as of March 31) (full year)

Political spending 56 Special meetings 84

Independent chairman 46 Independent chairman 58

Supermajority voting 35 Proxy access 55

Grassroots lobbying 35 Grassroots lobbying 51

Written consent 33 Written consent 45

Gender pay equity 28 GHG emissions reduction 31

Proxy access 21 Sustainability report 31

Board diversity—liberal Board diversity—liberal 21 30 version version

Sustainability report 21 Political spending 27

GHG emissions reduction 19 Gender pay equity 27

Link pay to social issues 19 Supermajority voting 26

Source: SEC filings, proponent websites and media reports.

The complete publication, including footnotes, is available here.

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February 4, 2019

The Honorable Jay Clayton Chairman U.S. Securities and Exchange Commission 100 F Street, NE Washington, DC 20549

Dear Chairman Clayton:

We, the undersigned publicly traded companies, want to thank you for conducting the Roundtable on the Proxy Process on November 15, 2018. The U.S. proxy process is critical to public company governance, and we appreciate the Commission’s recognition that areas within the process need to be reformed.

These issues have real effects on the economy, job creation and global competitiveness. As many have communicated to the SEC in the past several years, these issues are part of a poorly-calibrated regulatory ecosystem that is producing fewer IPOs and driving many companies out of the public markets.

The proxy process is a key opportunity for companies to communicate with shareholders. A transparent, accurate and verifiable proxy system that is oriented toward long-term value creation is vital to constructive shareholder engagement and the successful operation of public companies. The Commission emphasized this point in the 2010 Concept Release on the U.S. Proxy System, which noted: “With 600 billion shares voted every year at more than 13,000 shareholder meetings, shareholders should be served by a well-functioning proxy system that promotes efficient and accurate voting.”

The November 15th Roundtable provided for open discussion on several issues where reform is necessary for a more useful and efficient proxy system. As publicly traded companies, we urge the SEC to address the following critical items:

Proxy Advisory Firms: The SEC must take strong action to regulate proxy advisory firms to address three critical frustrations with their current operations:

 Conflicts of Interest: The SEC should adopt strong protections for both companies and users of proxy advisory services to ensure that conflicts of interest are eliminated where possible, minimized and/or mitigated where appropriate, and transparent to the users and subjects of reports. Conflicts should be disclosed on the front page of proxy advisor reports on companies so that investors make fully informed voting decisions.

 Accuracy: The SEC should require transparent processes and practices that allow ALL public companies, regardless of their market capitalization, to engage with proxy advisory firms on matters of mistakes, misstatements of fact and other significant disputes so that timely resolution of those disputes and corrections to the record can be made to minimize the negative impacts that such mistakes can have on the subject company’s proxy voting outreach and its shareholders. Such policies and procedures are absolutely critical to any reforms considered by the SEC. Given the impact of the proxy advisory firms’ decision-making and recommendations on the capital markets, and the large percentage of institutional voting that follows their recommendations, the ability to identify and correct errors is crucial for accuracy and accountability.

 Transparency of proxy voting standards: Proxy advisors currently play a critical role in the development of de facto market rules through their policies and recommendations. The SEC should require public transparency, including a formal public comment period, when a proxy advisory firm intends to change its voting policies from one proxy season to the next and ensure that companies have the ability to determine, on their own, whether they can satisfy those policies. Proxy advisory firms should not be allowed to significantly affect voting recommendations using opaque rules, which require paid services to interpret. Moreover, in the absence of transparent policies, neither the proxy advisory firms’ clients, nor the companies they report on, can determine whether a policy is applied correctly or if a recommendation is based on factual errors.

Shareholder Proposals: The SEC should modernize the shareholder proposal process so that it reflects more reasonable standards for submission and resubmission of shareholder proposals and is oriented toward creating long-term value for all shareholders. Reasonable standards for resubmissions were previously proposed by the SEC in 1997, which would have required 6 percent support for the first resubmission, 15 percent for the second, and 30 percent for the third.

Shareholder Communications: The SEC should focus on streamlining shareholder communications to enable companies to directly and cost-effectively communicate with their shareholders. The Commission should repeal the distinction between objecting and non-objecting beneficial owners (OBOs and NOBOs), which inhibits the ability of companies to communicate with the majority of investors who are not registered shareholders.

Proxy Process: The SEC needs to update the proxy voting process to make voting more transparent and verifiable and to increase retail investor participation.

Maintaining a viable public company model is of the upmost importance for companies that need capital, but also for Main Street investors and the overall economy. Addressing these critical proxy process issues will make our capital markets stronger and improve the experience for public companies and benefit their long-term investors.

Sincerely,

Nasdaq, Inc. Abraxas Petroleum Corporation Achieve Life Sciences, Inc. Aclaris Therapeutics, Inc. Acorda Therapeutics, Inc. Adial Pharmaceuticals, Inc. Advanced Emissions Solutions, Inc. Advanced Energy Industries, Inc. Aemetis, Inc. AgroFresh Solutions, Inc. Air T, Inc. Allegiant Travel Company AMAG Pharmaceuticals, Inc. Ambac Financial Group, Inc. 2

Ambarella, Inc. American Outdoor Brands Corporation ANGI Homeservices Inc. Apogee Enterprises, Inc. Apollo Endosurgery, Inc. Approach Resources Inc. Aquinox Pharmaceuticals, Inc. ArcBest Corporation Arch Capital Group Ltd. Aridis Pharmaceuticals, Inc. Artesian Resources Corporation Arthur J. Gallagher & Company Ascena Retail Group, Inc. Aspen Technology, Inc. Assembly Biosciences, Inc. Atara Biotherapeutics Inc. Athersys, Inc. Atomera Incorporated Attis Industries, Inc. Automatic Data Processing, Inc. (ADP) Avadel Pharmaceuticals Plc Avid Bioservices, Inc. Axon Enterprise, Inc. Axonics Modulation Technologies, Inc. Balchem Corporation Biogen Inc. BIO-key International, Inc. BioMarin Pharmaceutical Inc. Boingo Wireless, Inc. Box Boxlight Corporation Brainstorm Cell Therapeutics Inc. Brightcove Inc. Bryn Mawr Bank Corporation CaCanterbury Park Holding Corp Cadiz Inc. Caladrius Biosciences, Inc. Calithera Biosciences, Inc. Cardtronics plc Career Education Corporation Carrizo Oil & Gas, Inc. Casella Waste Systems, Inc. Century Communities Charles & Colvard, Ltd. Chart Industries, Inc. Chefs' Warehouse, Inc. Chevron Corp. ChromaDex Corporation 3

Ciena Corporation Cimpress N.V. Cincinnati Financial Corporation City Holding Company Clean Energy Fuels Corp. Cloud Peak Energy, Inc. Colliers International Group Inc. Colony Bankcorp, Inc. CommVault Systems, Inc. Computer Programs and Systems, Inc. (CPSI) Conformis, Inc. CONMED Corporation Core-Mark Holding Company, Inc. Core-Mark Holding Company, Inc. Coupa Software, Inc. Covenant Transportation Group, Inc. Cowen Inc. Criteo Crocs, Inc. Crown Crafts, Inc. CSW Industrials, Inc. CTI Industries Corporation CUI Global, Inc. CytomX Therapeutics, Inc. Dael Victoria Reyes Trust Data I/O Corporation Denny's Corporation Destination XL Group, Inc. DiaMedica Therapeutics Inc. Diodes Incorporated Dixie Group, Inc. Dollar Tree, Inc. Domo, Inc. Dynamic Signal E.W. Scripps Company Eagle Bancorp Montana, Inc. Eagle Bancorp, Inc. Ecolab Inc. EdtechX Holdings Acquisition Corp Encana Corporation Endo International Plc ENGlobal Corporation Ensign Group, Inc. Esperion Therapeutics, Inc. Esquire Financial Holdings, Inc. Euronet Worldwide, Inc. EZCORP, Inc. Finjan Holdings, Inc. 4

First Mid-Illinois Bancshares, Inc. First Solar, Inc. FirstCash, Inc. Five Star Senior Living Inc. Flexion Therapeutics, Inc. Flushing Financial Corporation FMC Corporation FNCB Bancorp, Inc. Franklin Templeton Fuel Tech, Inc. Full House Resorts, Inc. Funko, Inc. Gaia, Inc. Gaming and Leisure Properties, Inc. Genius Brands International, Inc. Genocea Biosciences, Inc. Geospace Technologies Corporation Gilead Sciences, Inc. Glacier Bancorp, Inc. Global Blood Therapeutics, Inc. Goosehead Insurance, Inc. Government Properties Income Trust Green Plains Inc. Grindrod Shipping Holdings Ltd. Hallador Energy Company Hamilton Bancorp, Inc. Healthcare Services Group, Inc. Hennessy Advisors, Inc. Hercules Capital, Inc. Heritage Financial Corporation Home Federal Savings Bank HomeStreet, Inc. Hooker Furniture Corporation Hospitality Properties Trust Howard Bancorp, Inc. IAC ICU Medical, Inc. ImmunoGen, Inc. Incyte Corporation Independent Bank Group, Inc. Industrial Logistics Properties Trust Innospec Inc. Inogen, Inc. Inseego Corp. Insteel Industries, Inc. Internap Corporation International Bancshares Corporation Investors Bancorp, Inc. 5

Investors Title Company Itron, Inc. IZEA Worldwide, Inc. Jack Henry & Associates, Inc. Jack in the Box Inc. Kforce Inc. Kindred Biosciences, Inc. Kinsale Capital Group, Inc. Kirby Corporation Kirkland’s, Inc. Lake City Bank Lamar Advertising Company Landmark Bancorp, Inc. Lazydays Holdings, Inc. LCNB Corp. Liberty Global, Inc. Lifetime Brands, Inc. Lifeway Foods, Inc. Live Ventures Incorporated Lumentum Holdings, Inc. Madrigal Pharmaceuticals, Inc. Magyar Bancorp, Inc. Manhattan Associates, Inc. Marathon Petroleum Corp. Marin Software, Inc. Marrone Bio Innovations, Inc. Marvell Semiconductor Masimo Corporation Maxim Integrated Products, Inc. Medical Transcription Billing Corp. (MTBC) Melrose Bancorp Inc. Meta Financial Group, Inc. Micron Technology, Inc. Middlefield Banc Corp. MidWestOne Financial Group, Inc. Misonix, Inc. MKS Instruments, Inc. Monmouth Real Estate Investment Corporation Monolithic Power Systems, Inc. MyoKardia, Inc. MYOS RENS Technology Inc. NantKwest, Inc. Nature’s Sunshine Products, Inc. NetScout Systems, Inc. NI Holdings, Inc. Novan, Inc. NutriSystem, Inc. Obalon Therapeutics, Inc. 6

Old Line Bancshares, Inc. Old National Bancorp OneSpan Inc. OptiNose, Inc. Oracle Organovo Holdings, Inc. Orthofix Medical, Inc. Otter Tail Corporation Overstock.com, Inc. Oxbridge Re Holdings Limited Pacific Premier Bancorp, Inc. Pacira Pharmaceuticals, Inc. PayPal Holdings Inc. Penn National Gaming, Inc. People’s Utah Bancorp Perma-Pipe International Holdings Inc. Plexus Corp. Pluralsight, Inc. Pool Corporation Power Integrations Inc. PRA Group Inc. Premier, Inc. PriceSmart, Inc. Principal Financial Group, Inc. Principia Biopharma, Inc. Profire Energy, Inc. Progress Software Corporation Proofpoint, Inc. Prothena Corp. Plc QIWI plc QuinStreet, Inc. Rambus Inc. Real Goods Solar, Inc. Red Rock Resorts, Inc. Rimini Street, Inc. Riverview Community Bank Rocky Mountain Chocolate Factory, Inc. Royal Gold, Inc. Ryanair Ryder System, Inc. S&T Bancorp, Inc. Salisbury Bancorp, Inc. Seagate Technology PLC Select Income REIT Senior Housing Properties Trust Shore Bancshares, Inc. SI-BONE, Inc. Sierra Oncology, Inc. 7

Signature Bank Simmons First National Corporation SINA Corp. SINTX Technologies, Inc. Spectrum Pharmaceuticals, Inc. Splunk Inc. Spok Holdings, Inc. SSR Mining Inc. STAAR Surgical Company Star Bulk Carriers Corp. Stein Mart, Inc. Steven Madden, Ltd. StoneCastle Financial Corp. Strategic Education, Inc. Streamline Health Solutions, Inc. Sunesis Pharmaceuticals, Inc. Sunrun Inc. SurveyMonkey Sutro Biopharma, Inc. Sykes Enterprises, Incorporated Symantec Corporation Synaptics Incorporated Tactile Systems Technology, Inc. Tech Data Corporation TechNet Teligent, Inc. Tenable Holdings, Inc. Tenax Therapeutics, Inc. Teradyne, Inc. Territorial Bancorp Inc. The Bancorp, Inc. The Boeing Company The Eastern Company The First of Long Island Corporation The Michaels Company, Inc. The RMR Group Inc. The Travelers Companies, Inc. Tilray, Inc. Tractor Supply Company Transcat, Inc. TravelCenters of America LLC Tremont Mortgage Trust TTM Technologies, Inc. Union Bankshares Corporation United Insurance Holdings Corp. Urban Outfitters, Inc. U.S. Chamber of Commerce Utah Medical Products, Inc. 8

Verisk Analytics Inc. Viking Therapeutics, Inc. W. R. Berkley Corporation Walgreens Boots Alliance, Inc. Washington Federal, Inc. Weibo Corp. Werner Enterprises, Inc. Westfield Bank Willamette Valley Vineyards, Inc. Willis Towers Watson Public Limited Company Windstream Holdings, Inc. WVS Financial Corp. Wynn Resorts, Limited Yum! Brands, Inc. Zafgen, Inc. Zagg Inc. Zebra Technologies Corporation Zions Bancorporation Zynerba Pharmaceuticals Inc.

9

Speech

Keynote Remarks: ICI Mutual Funds and Investment Management Conference

Commissioner Elad L. Roisman

San Diego, CA

March 18, 2019

I. Introduction

Thank you, Susan [Olson], for the kind introduction. I am excited to join you here and deliver my first formal speech as a Commissioner. It has been a little over six months since I started in my new role at the Securities and Exchange Commission (“SEC”), and I can still say that it’s a very surreal feeling. Not a day goes by when I do not think about how incredible an honor it is to serve the investing public. My path to this job has not been linear. But my experiences along the way—working in private practice as an attorney, at the parent public company of a large stock exchange, in the role of counsel to an SEC Commissioner, and on the staff of the Banking Committee in the U.S. Senate—have given me a broad view of the markets that the SEC regulates and a deep commitment to the agency’s mission. I mean this, truly: it is a privilege to be serving in my role.

Today, I will talk about the proxy process. But, before I segue into any substance, this is a good time for me to provide my first standard disclaimer: My views and remarks are my own, and do not necessarily represent those of the SEC or other Commissioners.

Last year, Chairman Jay Clayton announced that the Commission would review the existing SEC rules that govern the proxy system.[1] The staff held a roundtable that raised many issues in this area and invited public comment prior to and following the event.[2] Recently, the Chairman asked me to take the lead on the Commission’s efforts to consider improvements to the proxy process. I gladly accepted and feel honored to have this opportunity.[3]

During my time at a law firm and as an in-house counsel at an exchange, as well as at the SEC and in Congress, I was able to interact with managers, directors, and shareholders of U.S. public companies. One of my most interesting professional experiences was working with the Corporate Secretary of my former employer, a job that involved preparing materials for board meetings and taking minutes. In these meetings, I saw, first-hand, how seriously directors took their jobs: challenging management, scrutinizing the business’s trajectory, and striving to act in ways that serve the interests of the company’s shareholders. I also worked on drafting the company’s proxy statement and annual report, as well as organizing and running the annual shareholder meeting. My interactions with management, directors, law firms, printers, proxy solicitors, proxy advisory firms, transfer agents, shareholders (including funds), and shareholder proponents still are fresh in my mind. These experiences led me to take great interest in the proxy process and recognize its fundamental importance to our capital markets. They are premised on the notion that shareholders demand economic value from the companies they own and vote in ways that can influence their corporate management to deliver that value. This shareholder-company dynamic drives productivity in our economy and helps investors grow their wealth.

I remember thinking every April, as the annual meeting approached: is this the best system we have for the world’s best capital markets? (I also remember thinking “Who is Evelyn Y. Davis?” “Why am I responsible for escorting her to the meeting?” and “What does it mean to be ‘the Queen of the Corporate Jungle?’”[4]) I thought some aspects of proxy season worked well and noticed others that did not. But after each meeting, I breathed a sigh of relief that nine or ten months stood between me and the next proxy season, and I’d start working on other matters.

Today, I am happy to bring all my experiences to my current role, where I am fortunate to engage with others who have equally passionate views on the proxy voting ecosystem.

II. Proxy Voting

This brings me to the here and now: I am excited to talk to this group, in particular, about proxy voting because you, in this room, represent some of the most influential shareholders in our economy today: the funds you manage. Long gone are the days when retail shareholders directly held the majority of shares in U.S. public companies. Today, over 100 million individuals, representing nearly 45% of U.S. households, own open-end funds. [5] And, in today’s market, funds own 1/3 of the shares of U.S.-issued equities outstanding.[6] Of course, that makes the task of voting proxies—as ICI put it in its comment letter last year—“no small job.”[7] In the 2017 proxy season, the average mutual fund voted on 1,504 separate proxy proposals.[8] It is an understatement to say that your voting has a direct impact on the economic returns of countless investors.

Today, I hope to follow up on a number of questions I posed at the November roundtable[9]:

How are fund boards and advisers fulfilling their fiduciary duty in the context of proxy voting? How are they relying on proxy advisory firms? Should the SEC take any actions to alter the current state of affairs?

Since the roundtable, my staff and I have spent countless hours reviewing the roundtable transcript and comment letters submitted to the file, reading additional literature on the topic, and combing through a broad sampling of relevant disclosures (on Forms N-1A, N-PX, and ADV) and fund stewardship documents. We have also met with many participants from across the capital markets to discuss their views in greater detail.

As with many things in life, the more I learn, the more knowledge I wish I had. So, I would like to take this opportunity to share my current thoughts and pose some questions on which I hope you will engage with me further.

To give you a preview, I have noticed certain asset management practices with respect to proxy voting that have raised questions. In particular, why some advisers 1) aim to vote every proxy for every company in every fund’s portfolio; 2) centralize proxy voting functions within a complex and vote uniformly across funds in the complex; and 3) rely on third-party proxy advisory firms to assist with devising and implementing voting policies. These are not necessarily inherently problematic practices, but without further insight into the thinking behind them, I can see ways in which they might not align with the best interests of individual funds.

I recognize that there is great variety in the asset management industry; there are large fund complexes, as well as smaller and medium-sized fund groups that each have differing objectives and investments. I hope my remarks today will inspire further comments and engagement on these practices from many different types of advisers, but particularly the smaller managers to understand where they face greater obstacles for compliance. I would also be interested in feedback on how Commission action could provide clarity on or recalibrate how our current proxy voting system can best (or better) serve investors. III. Existing SEC Rules and Guidance

The SEC’s current rules governing fund advisers’ roles in voting proxies focus on principles and disclosure. Most relevant here, in 2003, the Commission adopted the explicit requirement that each investment adviser adopt and implement policies and procedures that are reasonably designed to ensure that advisers vote clients’ proxies in the clients’ best interests.[10] Over a decade later, the Commission’s staff in the Divisions of Investment Management and Corporation Finance published additional guidance in a Staff Legal Bulletin.[11] This Q&A stated that advisory clients (such as fund boards) could limit how often advisers vote proxies if the costs of voting on certain types of proposals or issuers do not serve a client’s best interest.[12]

The Commission’s principles-based and disclosure-based approach to regulating in this area has left a lot of flexibility for fund advisers, relying on their fiduciary duty to fill in the gaps. We all know that funds invest other people’s money. While a large asset manager might exercise a high level of influence in our capital markets, its power emanates from this agency role. More than merely an agent, a fund adviser is a fiduciary, having the obligation not to place its own interests ahead of its clients’ interests.[13] This applies in the proxy voting context: when advisers vote proxies for the funds they manage, they must do so in a way that serves the best interests of each fund.[14]

IV. Certain Asset Management Practices

This leads me to the critical question: What is in the best interest of a fund in the context of proxy voting? [15] I have thought about this a lot and continue to seek further insight on the question, as I believe its answer should form the basis of any Commission action in this area. As I have studied this issue, I have observed certain practices that I would like to understand better, in terms of how advisers believe they serve each fund under their purview.

A. To Vote or Not To Vote? For example, it appears to be the default position of many advisers that they vote every proxy, for every company, in every fund’s portfolio. This is interesting since, in any given proxy season, a fund’s shares could be voted on issues as far-ranging as independent auditor ratification to corporate political spending, for the largest and smallest of the fund’s holdings. Since a fund adviser derives its authority to vote from its position as the fund’s agent, I would think that the nature and scope of the fund’s investment objective would logically influence whether, when, and how the adviser votes the fund’s shares. Do advisers believe that voting on all of these issues is material to a fund’s investment objective and benefits the fund?[16]

There is also the consideration of cost. The Commission acknowledged in the Proxy Voting Rule Release (and so did the SEC staff in SLB 20) that voting proxies has associated costs.[17] Obviously, these include the adviser’s time and cost of performing research. Opportunity cost may also be significant, such as foregone income from shares on loan that have to be recalled to be voted or shares that are restricted from being lent out for this same reason. I imagine these costs could add up quickly, considering the differing matters of the many companies whose proxies fund advisers are often asked to vote.[18]

I would like to hear input on whether it would be helpful for the Commission to provide further guidance in this area. There appears to be some understandable confusion about what our rules require with respect to whether an adviser must vote. SLB 20 included Question 2, which asks “Is an investment adviser required to vote every proxy?” I can’t help but notice that the 342-word answer did not contain either the word “yes” or “no.” I believe the answer should be, in some cases, NO.[19] I would be interested in perspectives on what considerations could factor into an adviser’s analysis. Some that spring to my mind are: 1) Is a company a material part of the fund’s portfolio?; 2) Is the outcome of the vote material to the fund’s investment objective?; 3) What is the opportunity cost to the fund of voting proxies for this company?; and 4) Would the potential benefits of voting justify the costs? B. Discerning Differences between Funds Next, it seems that some asset managers have moved toward centralizing proxy voting (and “stewardship”) functions within the fund complex, moving these roles farther away from portfolio management. Additionally, it appears that some asset managers aim to vote uniformly across funds. I would like to better understand how such practices account for differences between funds.

Funds themselves are distinct entities. They may be part of the same complex and managed by the same adviser, and even have some common investment objectives, time horizons, and portfolio holdings. But it seems to me that distinct funds could have different interests in proxy voting that could lead them rationally to desire different outcomes from the same company’s proxy contest, transformative transaction, or contested shareholder proposal.

One example is a merger, where the deal appears better for one company (say, the target) than the other (here, the acquirer, who may be taking on a struggling business and large debt obligations).[20] Let’s say an adviser manages two funds, one with a long position in the target that would benefit from the merger, and another, heavily invested in the acquirer, that could lose value. Shouldn’t the adviser vote both funds’ shares differently, one in favor of the transaction, and the other against? More broadly, it seems that conflicts could exist between funds with different investment objectives. Consider the preferences of a portfolio manager at a growth fund, which targets companies with high growth prospects, and an income/dividend fund, which seeks to generate an income stream for shareholders in the form of dividends or interest payments. If there is a proxy contest led by an investor to increase dividend payments, shouldn’t these funds vote differently? It would seem to me that voting these funds’ shares the same way could risk subsidizing one fund’s votes with votes of another.[21]

I am interested in exploring how advisers handle these types of conflicting interests. How have advisers remained cognizant of distinctions between funds when designing processes for centralizing voting and stewardship roles? Have advisers found voting policies that are flexible enough to apply to all funds, yet account for differences between them—in other words, can one size fit all?

V. The Role of Proxy Advisory Firms

Next, it has been widely recognized that many asset managers have come to rely on third party proxy advisory firms in several aspects of the proxy voting process. Let me say up front: I recognize that proxy advisory firms provide services that their clients greatly value. For that reason, I do not believe we should impose additional regulations upon them without thorough consideration. But, I believe it is incumbent upon their clients (i.e. asset managers) to use their services responsibly.[22] And, I am interested to hear how asset managers have gotten comfortable that they are doing that.

A. Voting Guidelines For example, I have seen many Forms ADV, in which asset managers disclose that they have adopted the proxy voting policies developed by proxy advisory firms. Yet, after reading through some proxy advisory firms’ voting guidelines myself, I noticed several things that would give me pause before adopting them wholesale. These include instances in which various guidelines appear either to undermine existing legal rights or to set benchmarks unrelated to legal requirements and company-specific attributes.[23]

How do asset managers come to understand what they are signing on to when adopting these guidelines or become comfortable that such guidelines best serve their clients? Also, to what extent are advisers customizing the guidelines before adopting them for their clients?

B. Robo-Voting or Pre-Populating? Regardless of which voting policies and procedures an asset manager decides to adopt, there is the matter of implementing them when voting. I have seen some evidence indicating that asset managers may be relying heavily on proxy advisory firms in this area.[24] Some have characterized this as “robo-voting,” suggesting that proxy advisory firms are going too far in acting on behalf of their clients. Others argue that proxy advisory firms merely pre-populate votes in electronic proxy cards to make the process less burdensome. I would be interested to hear directly from asset managers about how they are utilizing proxy advisory firms to cast votes. For example, how much upfront instruction does an asset manager provide to a proxy advisory firm about how to pre-populate an electronic proxy card? How much discretion does this leave to a proxy advisor? To what extent do advisers review and sometimes override the pre-populated suggestions of the proxy advisory firms before submitting their votes to be counted?

C. Accuracy and Completeness As I consider how asset managers may be relying on proxy advisors, I remain cognizant of recurring concerns with aspects of how these firms operate. Many have criticized proxy advisors’ processes for developing recommendations as being prone to errors and suppressing viewpoints from the companies they research.[25] I am primarily concerned about factual errors, rather than disagreements about the interpretation of those facts or unpopular recommendations resulting from accurate factual inputs. It is commonly known that proxy advisory firms do not allow most issuers an opportunity to review or correct errors in their reports in advance of sending the reports to clients, something that companies understandably find frustrating.[26] When an asset manager discovers that a proxy advisory firm has made some material error in its recommendation or underlying research, how do asset managers reassess how they are using the proxy advisory firm? I am also interested in hearing how advisers receive or account for input from issuers before voting proxies (including issuers’ reactions to what they might characterize as proxy advisory firms’ analytical errors). Should the Commission explore ways of making it easier for advisers to get this information in a timely manner?

D. Conflicts of Interest Another important concern with proxy advisory firms relates to their potential conflicts of interest, an issue that goes to the efficacy of the information and services they provide. These conflicts may emanate from proxy advisory firms’ organizational and ownership structure, affiliates, lines of business, clientele (including preferential treatment or disproportionate influence of certain clients), and other business relationships.[27] For example, it is well-known that certain proxy advisory firms consult for public issuers on corporate governance matters. When corporate governance matters of the proxy advisory firms’ corporate customers are put forward for a vote, is it likely that the proxy advisors would recommend against their own consulting services?[28]

It appears that proxy advisory firms have varying approaches to disclosing and otherwise mitigating these conflicts. I would be interested to hear how asset managers are diligencing proxy advisory firms’ conflicts and becoming comfortable with their methodologies before utilizing their proxy recommendations and products. Additionally, since these conflicts affect company-specific recommendations, it would be important to know—at the time an asset manager reviews the proxy advisory firm’s recommendations on each company’s proxy—whether the proxy advisory firm has a conflict with respect to that company or a shareholder proponent. I understand that some proxy advisory firms offer a way for their clients to have this information presented, along with their recommendations for each meeting, in the clients’ electronic portals. Do asset managers find that useful? Are there better ways to have this information presented or otherwise made more transparent? What ongoing monitoring or conflict review are asset managers conducting?

E. Where Should the Commission Go From Here? As the primary consumers of proxy advisory services, asset managers are in a unique position to provide input on these types of questions. From this input, I hope to understand whether industry demand could produce better results from proxy advisory firms or whether the Commission should consider other ways.

The Commission, undeniably, played a role in the evolution of proxy voting today, including the growth of proxy advisory firms. In 2004, the SEC staff gave investment advisers a green light to rely almost wholesale on proxy advisory firms, when it advised one firm that “the recommendations of a third party who is in fact independent of an investment adviser may cleanse the vote of the adviser’s conflict [of interest].”[29] That same year, the staff also blessed a key conflict of interest endemic to many proxy advisory firms’ business models when it affirmed that selling corporate governance consulting services to companies “generally would not affect the [proxy advisory firm’s] independence.” [30]

I commend [the Division of Investment Management’s] Director Dalia Blass for withdrawing these staff letters.[31] I do not believe that the SEC staff should unilaterally alter the intent of Commission rules by approving, across-the- board, practices that could be construed as outsourcing fiduciary duty or ignoring major conflicts of interest.

In light of this history and the questions I posed earlier, I believe it is a good time for the Commission to consider whether guidance would be helpful to asset managers as they consider how to utilize the services of proxy advisory firms. Relatedly, since proxy advisory firms rely on the proxy solicitation exemptions available under certain Exchange Act rules,[32] it may be appropriate for the Commission to reassess whether their current practices fit within the intended scope and purpose of these exemptions.

VI. Other Proxy-Related Reforms

I am also interested in other areas of the proxy process that are less directly related to asset managers, but which are worth noting here.

I have been focusing extensively on what the Commission can do to improve the “plumbing” that underlies our proxy voting system. The November roundtable shed light on how complex, inefficient, and, at times, unreliable this infrastructure is. I believe the Commission needs to consider not only “quick-fixes” that could marginally improve some aspects of how the system works, but also comprehensive solutions based on modern technology. For example, I think it is incumbent on all of us to find a way to achieve end-to-end voting confirmation. I am interested in hearing, from all those involved, about short-term and long-term ways to accomplish this and other improvements. For all of these suggestions, I particularly hope to hear feedback about what private ordering could accomplish versus what Commission action might be needed (either to remove barriers to private action or solve collective action issues among private actors).

Another aspect of proxy voting that I am interested in is thresholds for submission and resubmission of shareholder proposals. It is important to achieve a balance here so that we allow for robust shareholder engagement without providing a mechanism for certain shareholders with idiosyncratic views to use the shareholder proposal system in a way that does not benefit the interests of the majority of long-term shareholders. In that spirit, reviewing whether the current monetary threshold and holding period for submissions strikes this balance, or whether other alternatives could better do so, may be appropriate. Relatedly, I am interested in perspectives on whether raising or modifying resubmission thresholds would preserve management’s time, and shareholders’ money, from being spent considering the same proposals repeatedly, after they have been rejected by the majority of shareholders.

Another area where more discussion would be helpful is “proposal by proxy.” I am aware that the Division of Corporation Finance stated in 2017 that it is of the view that a shareholder’s submission by proxy is consistent with Rule 14a-8.[33] But, I would like to further understand how it is in the long-term interest of shareholders to allow this practice, when the proponent either is not a shareholder or cannot qualify to bring the proposal on his or her own.

VII. Conclusion

Let me conclude this round of 20+ questions with a sincere word of thanks to all of you who have already taken the time to meet with me or submit letters to the comment file. This includes, of course, ICI who thoughtfully and extensively provided comments to the Commission on many of these issues.[34] I view it as a positive sign that proxy issues are receiving so much attention inside and outside the Commission—this is a testament to their fundamental importance to our capital markets. I look forward to engaging further with all interested stakeholders who would like to share their points of view. My door is open, and I hope you come and visit. [1] See Chairman Jay Clayton, “Statement Announcing SEC Staff Roundtable on the Proxy Process” (July 30, 2018), https://www.sec.gov/news/public-statement/statement-announcing-sec-staff-roundtable-proxy-process.

[2] See the Commission’s “Spotlight on Proxy Process,” https://www.sec.gov/proxy-roundtable-2018, for information about the November 15, 2018 staff roundtable and a link to comments submitted before and after this event.

[3] See Chairman Jay Clayton, “Remarks for Telephone Call with SEC Investor Advisory Committee Members” (Feb. 6, 2019), https://www.sec.gov/news/public-statement/clayton-remarks-investor-advisory-committee-call- 020619; Commissioner Elad L. Roisman, “Brief Statement on Proxy Voting Process: Call with the SEC Investor Advisory Committee” (Feb. 6, 2019), https://www.sec.gov/news/public-statement/statement-roisman-020619.

[4] See “Evelyn Y. Davis, Shareholder Scourge of C.E.O.s, Dies at 89” by Emily Flitter of the New York Times (Nov. 7, 2018).

[5] See2018 Investment Company Fact Book (58th ed. 2018), https://www.ici.org/pdf/2018_factbook.pdf (“ICI Fact Book”), Figure 7.2.

[6] ICI Fact Book, at 39.

[7] Letter from Paul Schott Stevens, President and CEO of the Investment Company Institute, Re: Roundtable on the Proxy Process (File No. 4-725) (Nov. 14, 2018), https://www.sec.gov/comments/4-725/4725-4702049- 176465.pdf (“ICI Letter”).

[8] ICI Viewpoints, “Funds and Proxy Voting: The Mix of Proposals Matter” (Nov. 5, 2018), at 2.

[9] Commissioner Elad L. Roisman, “Statement at Proxy Process Roundtable” (Nov. 15, 2018), https://www.sec.gov/news/public-statement/statement-roisman-111518.

[10] These policies and procedures must address conflicts of interest that may arise between the adviser’s interests and those of its clients. The rules also require the adviser to describe to clients its voting policies and procedures and disclose to clients how they can obtain information about how the adviser actually voted the proxies. See Rule 206(4)-6 of the Investment Advisers Act of 1940 (“Advisers Act”), 17 C.F.R. 275.206(4)-6 (the “Proxy Voting Rule”); and “Proxy Voting by Investment Advisers,” Release No. IA-2106 (Jan. 31, 2003) (the “Proxy Voting Rule Release”). At the same time, the Commission adopted explicit requirements that each fund must disclose in its registration statement the policies and procedures that it uses to determine how to vote proxies relating to portfolio securities and publish the fund’s voting record annually on Form N-PX. See Rule 30b1-4 of the Investment Company Act of 1940 (“Investment Company Act”), 17 C.F.R. 270.30b1-4; Amendments to Form N-1A, Prescribed under the Investment Company Act, 17 C.F.R 274.128; “Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies,” Release No. IC-25922 (Jan. 31, 2003). Assuming a fund board adopts the investment adviser’s policies and procedures, rather than designing and adopting its own distinct policies and procedures for the fund, the voting policy would be part of the compliance program and subject to approval and review under Investment Company Act Rule 38a-1.

[11] See Staff Legal Bulletin No. 20 (IM/CF) “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms” (Jun. 30, 2014) (“SLB 20”), https://www.sec.gov/interps/legal/cfslb20.htm.

[12] See SLB 20, Answer to Question 2.

[13] SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963).

[14] See Proxy Voting Rule Release (“[A]n adviser is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting.”). An investment adviser’s fiduciary duty under the Adviser’s Act comprises a duty of care and a duty of loyalty. This combination of care and loyalty obligations has been characterized as requiring the investment adviser to act in the “best interest” of its client at all times. See Amendments to Form ADV, Release No. IA-3060 (July 28, 2010). [15] I think it is important to note here that the interests of a fund cannot be fully gleaned by looking only at its underlying shareholders. Unlike corporate directors, who owe fiduciary duties to a company’s shareholders, a fund adviser owes its fiduciary duties to each of its clients—the funds—not to the individual underlying shareholders of each fund. I believe this distinction is important because some have proposed that the SEC require advisers to conduct pass-through voting, in which they collect proxy votes from a fund’s underlying shareholders before they submit the fund’s votes. While this type of proposal has some democratic appeal, I do not see how it squares in every case with the legal requirement that the adviser look out for a fund as its own entity. In certain situations, underlying shareholders’ interests may differ from—and potentially conflict with—the fund’s interests. In these cases, the fund adviser must serve the best interests of the fund, even if it means going against the desires of certain underlying investors. It is possible that some asset managers currently use pass-through voting or similar types of voting methodologies. If so, it seems prudent for those asset managers to have analyzed how it is in the best interest of each particular fund as its own entity.

[16] What if an issue up for vote is not related to a fund’s investment objective? For example, an adviser to a plain vanilla index-tracking fund may be asked to vote fund shares on proxies related to sustainability. If the fund does not market itself as an “ESG” fund, disclosing these particular objectives in its regulatory filings, investors may not have reason to think this fund would vote on such issues.

[17] See Proxy Voting Rule Release (“We do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations. There may even be times when refraining from voting a proxy is in the client’s best interest, such as when the adviser determines that the cost of voting the proxy exceeds the expected benefit to the client.”); see also SLB 20, Answer to Question 2.

[18] See the ICI Letter, in note 7 above.

[19] I understand that there may be requirements, outside the federal securities laws, which could obligate certain advisers to vote their clients’ shares (e.g., ERISA). My views here are solely limited to an adviser’s requirements under the Advisers Act and the Investment Company Act.

[20] For a thorough discussion of potential conflicts between the interests of different types of funds when voting, see Sean J. Griffith & Dorothy S. Lund, “Conflicted Mutual Fund Voting in Corporate Law” (working paper, forthcoming in the Boston University Law Review).

[21] With respect to conflicting interests of different funds and advisory clients, the Commission has brought at least one enforcement action against an adviser for using funds’ proxy votes to benefit (and attract business from) other clients and failing to disclose its conflict of interest to investors. See In the Matter of Intech Investment Management, LLC and David E. Hurley, Rel. No. 2872 (May 7, 2009), https://www.sec.gov/news/press/2009/2009- 105.htm.

[22] See, e.g., SLB 20, Answer to Question 3 (“When considering whether to retain or continue retaining any particular proxy advisory firm to provide proxy voting recommendations, the staff believes that an investment adviser should ascertain, among other things, whether the proxy advisory firm has the capacity and competency to adequately analyze proxy issues.”)

[23] For example, Glass Lewis’s 2019 Proxy Paper Guidelines state that they will make note of instances where a public company has successfully petitioned the SEC to exclude shareholder proposals and potentially recommend against members of the company’s governance committee. See, e.g., Glass Lewis’s 2019 Proxy Paper Guidelines, at 29. It troubles me that the exercise of legal rights and responsibilities under the SEC’s rules would be held against a company or its directors. In an example of seemingly arbitrary guidelines, Institutional Shareholder Services, Inc.’s (“ISS”) recently updated “QualityScore” evaluates the diversity of companies’ boards of directors and considers “how many women are named executive officers [(“NEOs”)] at the company?” It states that “[c]ompanies without any women as NEOs will lose credit, and credit will be capped for companies having more than two.” See ISS QualityScore: Overview and Updates (Dec. 19, 2018), at 41, https://www.issgovernance.com/file/products/qualityscore-techdoc.pdf. For funds with objectives to improve diversity in leadership, how could this seemingly arbitrary cap possibly further this goal? [24] For example, one recent comment letter noted a research paper that found, in the 2016 and 2017 proxy season, 20% of shareholders’ votes were cast within three days after one proxy advisory firm issued its recommendations. See Letter from Timothy M. Doyle, Vice President of Policy and General Counsel, American Council for Capital Formation Re: File Number 4-725; SEC Staff Roundtable on the Proxy Process (Nov. 14, 2018), https://www.sec.gov/comments/4-725/4725-4649199-176473.pdf.

[25] Nasdaq recently sent a letter to the Commission, signed by 319 public issuers, representing almost $2 trillion in market capitalization across 13 industries (in addition to organizations such as TechNet and the U.S. Chamber of Commerce), outlining several concerns about proxy advisory firms’ process of resolving misstatements of fact in their reports, among other things. The letter is available on the Commission’s website: https://www.sec.gov/comments/4-725/4725-4872519-177389.pdf.

[26] ISS’s website states that only issuers in the S&P 500 are allowed one day to review reports before they are issued to clients.

[27] See Independent Directors Counsel and ICI, “Report on Funds’ Use of Proxy Advisory Firms” (Jan. 2015), at 14.

[28] In similar contexts, we have seen such conflicts prohibited. Consider the auditor independence rules that strictly forbid an auditor from telling an audit client how to account for a matter and then providing an audit opinion to investors with respect to that exact same matter. See Rule 2-0l(b) & (c)(4) of Regulation S-X. The temptation for one side of the house to rubber-stamp the advice provided by the other side of the house is simply too great.

[29] See Institutional Shareholder Services, Inc., No-Action Letter (Sept. 15, 2004), withdrawn Sept. 13, 2018, https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters.

[30] See Egan-Jones, Inc., No-Action Letter (May 27, 2004), withdrawn Sept. 13, 2018, https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters.

[31] See the SEC’s Division of Investment Management, “Statement Regarding Staff Proxy Advisory Letters”) (Sept. 13, 2018), https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters.

[32] See Securities and Exchange Act of 1934 (“Exchange Act”), Rules 14a-2(b)(1) and 14a-2(b)(3).

[33] See Staff Legal Bulletin No. 14I (CF) “Shareholder Proposals” (Nov. 1, 2017), https://www.sec.gov/interps/legal/cfslb14i.htm.

[34] See ICI Letter referenced above in note 7; see also Letter from Paul Schott Stevens, President and CEO of the Investment Company Institute, Re: Roundtable on the Proxy Process (File No. 4-725) (March 15, 2019). (Slip Opinion) OCTOBER TERM, 2018 1

Syllabus

NOTE: Where it is feasible, a syllabus (headnote) will be released, as is being done in connection with this case, at the time the opinion is issued. The syllabus constitutes no part of the opinion of the Court but has been prepared by the Reporter of Decisions for the convenience of the reader. See United States v. Detroit Timber & Lumber Co., 200 U. S. 321, 337. SUPREME COURT OF THE UNITED STATES

Syllabus

LORENZO v. SECURITIES AND EXCHANGE COMMISSION

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT

No. 17–1077. Argued December 3, 2018—Decided March 27, 2019 Securities and Exchange Commission Rule 10b–5 makes it unlawful to (a) “employ any device, scheme, or artifice to defraud,” (b) “make any untrue statement of a material fact,” or (c) “engage in any act, prac- tice, or course of business” that “operates . . . as a fraud or deceit” in connection with the purchase or sale of securities. In Janus Capital Group, Inc. v. First Derivative Traders, 564 U. S. 135, this Court held that to be a “maker” of a statement under subsection (b) of that Rule, one must have “ultimate authority over the statement, including its content and whether and how to communicate it.” Id., at 142 (em- phasis added). On the facts of Janus, this meant that an investment adviser who had merely “participat[ed] in the drafting of a false statement” “made” by another could not be held liable in a private ac- tion under subsection (b). Id., at 145. Petitioner Francis Lorenzo, while the director of investment bank- ing at an SEC-registered brokerage firm, sent two e-mails to prospec- tive investors. The content of those e-mails, which Lorenzo’s boss supplied, described a potential investment in a company with “con- firmed assets” of $10 million. In fact, Lorenzo knew that the compa- ny had recently disclosed that its total assets were worth less than $400,000. In 2015, the Commission found that Lorenzo had violated Rule 10b–5, §10(b) of the Exchange Act, and §17(a)(1) of the Securities Act by sending false and misleading statements to investors with intent to defraud. On appeal, the District of Columbia Circuit held that Lo- renzo could not be held liable as a “maker” under subsection (b) of the Rule in light of Janus, but sustained the Commission’s finding with respect to subsections (a) and (c) of the Rule, as well as §10(b) and

2 LORENZO v. SEC

Syllabus

§17(a)(1). Held: Dissemination of false or misleading statements with intent to defraud can fall within the scope of Rules 10b–5(a) and (c), as well as the relevant statutory provisions, even if the disseminator did not “make” the statements and consequently falls outside Rule 10b–5(b). Pp. 5–13. (a) It would seem obvious that the words in these provisions are, as ordinarily used, sufficiently broad to include within their scope the dissemination of false or misleading information with the intent to defraud. By sending e-mails he understood to contain material un- truths, Lorenzo “employ[ed]” a “device,” “scheme,” and “artifice to de- fraud” within the meaning of subsection (a) of the Rule, §10(b), and §17(a)(1). By the same conduct, he “engage[d] in a[n] act, practice, or course of business” that “operate[d] . . . as a fraud or deceit” under subsection (c) of the Rule. As Lorenzo does not challenge the appeals court’s scienter finding, it is undisputed that he sent the e-mails with “intent to deceive, manipulate, or defraud” the recipients. Aaron v. SEC, 446 U. S. 680, 686, and n. 5. Resort to the expansive dictionary definitions of “device,” “scheme,” and “artifice” in Rule 10b–5(a) and §17(a)(1), and of “act” and “practice” in Rule 10b–5(c), only strength- ens this conclusion. Under the circumstances, it is difficult to see how Lorenzo’s actions could escape the reach of these provisions. Pp. 5–7. (b) Lorenzo counters that the only way to be liable for false state- ments is through those provisions of the securities laws—like Rule 10b–5(b)—that refer specifically to false statements. Holding to the contrary, he and the dissent say, would render subsection (b) “super- fluous.” The premise of this argument is that each subsection gov- erns different, mutually exclusive, spheres of conduct. But this Court and the Commission have long recognized considerable overlap among the subsections of the Rule and related provisions of the secu- rities laws. And the idea that each subsection governs a separate type of conduct is difficult to reconcile with the Rule’s language, since at least some conduct that amounts to “employ[ing]” a “device, scheme, or artifice to defraud” under subsection (a) also amounts to “engag[ing] in a[n] act . . . which operates . . . as a fraud” under sub- section (c). This Court’s conviction is strengthened by the fact that the plainly fraudulent behavior confronted here might otherwise fall outside the Rule’s scope. Using false representations to induce the purchase of securities would seem a paradigmatic example of securi- ties fraud. Pp. 7–9. (c) Lorenzo and the dissent make a few other important arguments. The dissent contends that applying Rules 10b–5(a) and (c) to conduct like Lorenzo’s would render Janus “a dead letter.” Post, at 9. But

Cite as: 587 U. S. ____ (2019) 3

Syllabus

Janus concerned subsection (b), and it said nothing about the Rule’s application to the dissemination of false or misleading information. Thus, Janus would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information— provided, of course, that the individual is not involved in some other form of fraud. Lorenzo also claims that imposing primary liability upon his conduct would erase or at least weaken the distinction be- tween primary and secondary liability under the statute’s “aiding and abetting” provision. See 15 U. S. C. §78t(e). But the line the Court adopts today is clear: Those who disseminate false statements with intent to defraud are primarily liable under Rules 10b–5(a) and (c), §10(b), and §17(a)(1), even if they are secondarily liable under Rule 10b–5(b). As for Lorenzo’s suggestion that those like him ought to be held secondarily liable, this offer will, too often, prove illusory. Where a “maker” of a false statement does not violate subsection (b) of the Rule (perhaps because he lacked the necessary intent), a dis- seminator of those statements, even one knowingly engaged in an egregious fraud, could not be held to have violated the “aiding and abetting” statute. And if, as Lorenzo claims, the disseminator has not primarily violated other parts of Rule 10b–5, then such a fraud, whatever its intent or consequences, might escape liability altogeth- er. That anomalous result is not what Congress intended. Pp. 9–13. 872 F. 3d 578, affirmed.

BREYER, J., delivered the opinion of the Court, in which ROBERTS, C. J., and GINSBURG, ALITO, SOTOMAYOR, and KAGAN, JJ., joined. THOM- AS, J., filed a dissenting opinion, in which GORSUCH, J., joined. KAV- ANAUGH, J., took no part in the consideration or decision of the case.

Cite as: 587 U. S. ____ (2019) 1

Opinion of the Court

NOTICE: This opinion is subject to formal revision before publication in the preliminary print of the United States Reports. Readers are requested to notify the Reporter of Decisions, Supreme Court of the United States, Wash- ington, D. C. 20543, of any typographical or other formal errors, in order that corrections may be made before the preliminary print goes to press. SUPREME COURT OF THE UNITED STATES ______No. 17–1077 ______FRANCIS V. LORENZO, PETITIONER v. SECURITIES AND EXCHANGE COMMISSION

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT [March 27, 2019]

JUSTICE BREYER delivered the opinion of the Court. Securities and Exchange Commission Rule 10b–5 makes it unlawful: “(a) To employ any device, scheme, or artifice to defraud, “(b) To make any untrue statement of a material fact . . . , or “(c) To engage in any act, practice, or course of busi- ness which operates or would operate as a fraud or deceit . . . in connection with the purchase or sale of any security.” 17 CFR §240.10b–5 (2018). In Janus Capital Group, Inc. v. First Derivative Traders, 564 U. S. 135 (2011), we examined the second of these provisions, Rule 10b–5(b), which forbids the “mak[ing]” of “any untrue statement of a material fact.” We held that the “maker of a statement is the person or entity with ultimate authority over the statement, including its con- tent and whether and how to communicate it.” Id., at 142 (emphasis added). We said that “[w]ithout control, a person or entity can merely suggest what to say, not 2 LORENZO v. SEC

Opinion of the Court ‘make’ a statement in its own right.” Ibid. And we illus- trated our holding with an analogy: “[W]hen a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it. And it is the speaker who takes credit—or blame—for what is ultimately said.” Id., at 143. On the facts of Janus, this meant that an invest- ment adviser who had merely “participat[ed] in the draft- ing of a false statement” “made” by another could not be held liable in a private action under subsection (b) of Rule 10b–5. Id., at 145. In this case, we consider whether those who do not “make” statements (as Janus defined “make”), but who disseminate false or misleading statements to potential investors with the intent to defraud, can be found to have violated the other parts of Rule 10b–5, subsections (a) and (c), as well as related provisions of the securities laws, §10(b) of the Securities Exchange Act of 1934, 48 Stat. 891, as amended, 15 U. S. C. §78j(b), and §17(a)(1) of the Securities Act of 1933, 48 Stat. 84–85, as amended, 15 U. S. C. §77q(a)(1). We believe that they can. I A For our purposes, the relevant facts are not in dispute. Francis Lorenzo, the petitioner, was the director of in- vestment banking at Charles Vista, LLC, a registered broker-dealer in Staten Island, New York. Lorenzo’s only investment banking client at the time was Waste2Energy Holdings, Inc., a company developing technology to con- vert “solid waste” into “clean renewable energy.” In a June 2009 public filing, Waste2Energy stated that its total assets were worth about $14 million. This figure included intangible assets, namely, intellectual property, valued at more than $10 million. Lorenzo was skeptical of this valuation, later testifying that the intangibles were a “dead asset” because the technology “didn’t really work.” Cite as: 587 U. S. ____ (2019) 3

Opinion of the Court During the summer and early fall of 2009, Waste2Energy hired Lorenzo’s firm, Charles Vista, to sell to investors $15 million worth of debentures, a form of “debt secured only by the debtor’s earning power, not by a lien on any specific asset,” Black’s Law Dictionary 486 (10th ed. 2014). In early October 2009, Waste2Energy publicly disclosed, and Lorenzo was told, that its intellectual property was worthless, that it had “ ‘ “[w]rit[ten] off . . . all [of its] in- tangible assets,” ’ ” and that its total assets (as of March 31, 2009) amounted to $370,552. Shortly thereafter, on October 14, 2009, Lorenzo sent two e-mails to prospective investors describing the deben- ture offering. According to later testimony by Lorenzo, he sent the e-mails at the direction of his boss, who supplied the content and “approved” the messages. The e-mails described the investment in Waste2Energy as having “3 layers of protection,” including $10 million in “confirmed assets.” The e-mails nowhere revealed the fact that Waste2Energy had publicly stated that its assets were in fact worth less than $400,000. Lorenzo signed the e-mails with his own name, he identified himself as “Vice President—Investment Banking,” and he invited the recipients to “call with any questions.” B In 2013, the Securities and Exchange Commission instituted proceedings against Lorenzo (along with his boss and Charles Vista). The Commission charged that Lorenzo had violated Rule 10b–5, §10(b) of the Exchange Act, and §17(a)(1) of the Securities Act. Ultimately, the Commission found that Lorenzo had run afoul of these provisions by sending false and misleading statements to investors with intent to defraud. As a sanction, it fined Lorenzo $15,000, ordered him to cease and desist from violating the securities laws, and barred him from working 4 LORENZO v. SEC

Opinion of the Court in the securities industry for life. Lorenzo appealed, arguing primarily that in sending the e-mails he lacked the intent required to establish a viola- tion of Rule 10b–5, §10(b), and §17(a)(1), which we have characterized as “ ‘a mental state embracing intent to deceive, manipulate, or defraud.’ ” Aaron v. SEC, 446 U. S. 680, 686, and n. 5 (1980). With one judge dissenting, the Court of Appeals panel rejected Lorenzo’s lack-of- intent argument. 872 F. 3d 578, 583 (CADC 2017). Lo- renzo does not challenge the panel’s scienter finding. Reply Brief 17. Lorenzo also argued that, in light of Janus, he could not be held liable under subsection (b) of Rule 10b–5. 872 F. 3d, at 586–587. The panel agreed. Because his boss “asked Lorenzo to send the emails, supplied the central content, and approved the messages for distribution,” id., at 588, it was the boss that had “ultimate authority” over the content of the statement “and whether and how to communicate it,” Janus, 563 U. S., at 142. (We took this case on the assumption that Lorenzo was not a “maker” under subsection (b) of Rule 10b–5, and do not revisit the court’s decision on this point.) The Court of Appeals nonetheless sustained (with one judge dissenting) the Commission’s finding that, by know- ingly disseminating false information to prospective inves- tors, Lorenzo had violated other parts of Rule 10b–5, subsections (a) and (c), as well as §10(b) and §17(a)(1). Lorenzo then filed a petition for certiorari in this Court. We granted review to resolve disagreement about whether someone who is not a “maker” of a misstatement under Janus can nevertheless be found to have violated the other subsections of Rule 10b–5 and related provisions of the securities laws, when the only conduct involved concerns a misstatement. Compare e.g., 872 F. 3d 578, with WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F. 3d 1039, 1057–1058 (CA9 2011). Cite as: 587 U. S. ____ (2019) 5

Opinion of the Court II A At the outset, we review the relevant provisions of Rule 10b–5 and of the statutes. See Appendix, infra. As we have said, subsection (a) of the Rule makes it unlawful to “employ any device, scheme, or artifice to defraud.” Sub- section (b) makes it unlawful to “make any untrue state- ment of a material fact.” And subsection (c) makes it unlawful to “engage in any act, practice, or course of busi- ness” that “operates . . . as a fraud or deceit.” See 17 CFR §240.10b–5. There are also two statutes at issue. Section 10(b) makes it unlawful to “use or employ . . . any manipulative or deceptive device or contrivance” in contravention of Commission rules and regulations. 15 U. S. C. §78j(b). By its authority under that section, the Commission promul- gated Rule 10b–5. The second statutory provision is §17(a), which, like Rule 10b–5, is organized into three subsections. 15 U. S. C. §77q(a). Here, however, we con- sider only the first subsection, §17(a)(1), for this is the only subsection that the Commission charged Lorenzo with violating. Like Rule 10b–5(a), (a)(1) makes it unlaw- ful to “employ any device, scheme, or artifice to defraud.” B After examining the relevant language, precedent, and purpose, we conclude that (assuming other here-irrelevant legal requirements are met) dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule 10b–5, as well as the relevant statutory provisions. In our view, that is so even if the disseminator did not “make” the statements and consequently falls outside subsection (b) of the Rule. It would seem obvious that the words in these provisions are, as ordinarily used, sufficiently broad to include within 6 LORENZO v. SEC

Opinion of the Court their scope the dissemination of false or misleading infor- mation with the intent to defraud. By sending emails he understood to contain material untruths, Lorenzo “em- ploy[ed]” a “device,” “scheme,” and “artifice to defraud” within the meaning of subsection (a) of the Rule, §10(b), and §17(a)(1). By the same conduct, he “engage[d] in a[n] act, practice, or course of business” that “operate[d] . . . as a fraud or deceit” under subsection (c) of the Rule. Recall that Lorenzo does not challenge the appeals court’s scien- ter finding, so we take for granted that he sent the emails with “intent to deceive, manipulate, or defraud” the recipi- ents. Aaron, 446 U. S., at 686, n. 5. Under the circum- stances, it is difficult to see how his actions could escape the reach of those provisions. Resort to dictionary definitions only strengthens this conclusion. A “ ‘device,’ ” we have observed, is simply

“ ‘[t]hat which is devised, or formed by design’ ”; a

“ ‘scheme’ ” is a “ ‘project,’ ” “ ‘plan[,] or program of some- thing to be done’ ”; and an “ ‘artifice’ ” is “ ‘an artful strata- gem or trick.’ ” Id., at 696, n. 13 (quoting Webster’s Inter- national Dictionary 713, 2234, 157 (2d ed. 1934) (Webster’s Second)). By these lights, dissemination of false or misleading material is easily an “artful stratagem” or a “plan,” “devised” to defraud an investor under subsec- tion (a). See Rule 10b–5(a) (making it unlawful to “employ any device, scheme, or artifice to defraud”); §17(a)(1) (same). The words “act” and “practice” in subsection (c) are similarly expansive. Webster’s Second 25 (defining “act” as “a doing” or a “thing done”); id., at 1937 (defining “practice” as an “action” or “deed”); see Rule 10b–5(c) (making it unlawful to “engage in a[n] act, practice, or course of business” that “operates . . . as a fraud or deceit”). These provisions capture a wide range of conduct. Applying them may present difficult problems of scope in borderline cases. Purpose, precedent, and circumstance Cite as: 587 U. S. ____ (2019) 7

Opinion of the Court could lead to narrowing their reach in other contexts. But we see nothing borderline about this case, where the relevant conduct (as found by the Commission) consists of disseminating false or misleading information to prospec- tive investors with the intent to defraud. And while one can readily imagine other actors tangentially involved in dissemination—say, a mailroom clerk—for whom liability would typically be inappropriate, the petitioner in this case sent false statements directly to investors, invited them to follow up with questions, and did so in his capacity as vice president of an investment banking company. C Lorenzo argues that, despite the natural meaning of these provisions, they should not reach his conduct. This is so, he says, because the only way to be liable for false statements is through those provisions that refer specifi- cally to false statements. Other provisions, he says, con- cern “scheme liability claims” and are violated only when conduct other than misstatements is involved. Brief for Petitioner 4–6, 28–30. Thus, only those who “make” un- true statements under subsection (b) can violate Rule 10b– 5 in connection with statements. (Similarly, §17(a)(2) would be the sole route for finding liability for statements under §17(a).) Holding to the contrary, he and the dissent insist, would render subsection (b) of Rule 10b–5 “super- fluous.” See post, at 6–7 (opinion of THOMAS, J.). The premise of this argument is that each of these provisions should be read as governing different, mutually exclusive, spheres of conduct. But this Court and the Commission have long recognized considerable overlap among the subsections of the Rule and related provisions of the securities laws. See Herman & MacLean v. Huddle- ston, 459 U. S. 375, 383 (1983) (“[I]t is hardly a novel proposition that” different portions of the securities laws “prohibit some of the same conduct” (internal quotation 8 LORENZO v. SEC

Opinion of the Court marks omitted)). As we have explained, these laws marked the “first experiment in federal regulation of the securities industry.” SEC v. Capital Gains Research Bureau, Inc., 375 U. S. 180, 198 (1963). It is “understand- able, therefore,” that “in declaring certain practices unlaw- ful,” it was thought prudent “to include both a general proscription against fraudulent and deceptive practices and, out of an abundance of caution, a specific proscription against nondisclosure” even though “a specific proscription against nondisclosure” might in other circumstances be deemed “surplusage.” Id., at 198–199. “Each succeeding prohibition” was thus “meant to cover additional kinds of illegalities—not to narrow the reach of the prior sections.” United States v. Naftalin, 441 U. S. 768, 774 (1979). We have found “ ‘no warrant for narrowing alternative provi- sions . . . adopted with the purpose of affording added safeguards.’ ” Ibid. (quoting United States v. Gilliland, 312 U. S. 86, 93 (1941)); see Affiliated Ute Citizens of Utah v. United States, 406 U. S. 128, 152–153 (1972) (While “the second subparagraph of [Rule 10b–5] specifies the making of an untrue statement . . . [t]he first and third subpara- graphs are not so restricted”). And since its earliest days, the Commission has not viewed these provisions as mutu- ally exclusive. See, e.g., In re R. D. Bayly & Co., 19 S. E. C. 773 (1945) (finding violations of what would become Rules 10b–5(b) and (c) based on the same misrepresentations and omissions); In re Arthur Hays & Co., 5 S. E. C. 271 (1939) (finding violations of both §§17(a)(2) and (a)(3) based on false representations in stock sales). The idea that each subsection of Rule 10b–5 governs a separate type of conduct is also difficult to reconcile with the language of subsections (a) and (c). It should go with- out saying that at least some conduct amounts to “em- ploy[ing]” a “device, scheme, or artifice to defraud” under subsection (a) as well as “engag[ing] in a[n] act . . . which operates . . . as a fraud” under subsection (c). In Affiliated Cite as: 587 U. S. ____ (2019) 9

Opinion of the Court Ute, for instance, we described the “defendants’ activities” as falling “within the very language of one or the other of those subparagraphs, a ‘course of business’ or a ‘device, scheme, or artifice’ that operated as a fraud.” 406 U. S., at 153. (The dissent, for its part, offers no account of how the superfluity problems that motivate its interpretation can be avoided where subsections (a) and (c) are concerned.) Coupled with the Rule’s expansive language, which readily embraces the conduct before us, this considerable overlap suggests we should not hesitate to hold that Lo- renzo’s conduct ran afoul of subsections (a) and (c), as well as the related statutory provisions. Our conviction is strengthened by the fact that we here confront behavior that, though plainly fraudulent, might otherwise fall outside the scope of the Rule. Lorenzo’s view that subsec- tion (b), the making-false-statements provision, exclusively regulates conduct involving false or misleading statements would mean those who disseminate false statements with the intent to cheat investors might escape liability under the Rule altogether. But using false representations to induce the purchase of securities would seem a paradig- matic example of securities fraud. We do not know why Congress or the Commission would have wanted to disarm enforcement in this way. And we cannot easily reconcile Lorenzo’s approach with the basic purpose behind these laws: “to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.” Capital Gains, 375 U. S., at 186. See also, e.g., SEC v. W. J. Howey Co., 328 U. S. 293, 299 (1946) (the securities laws were designed “to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”). III Lorenzo and the dissent make a few other important 10 LORENZO v. SEC

Opinion of the Court arguments. They contend that applying subsections (a) or (c) of Rule 10b–5 to conduct like his would render our decision in Janus (which we described at the outset, su- pra, at 1–2) “a dead letter,” post, at 9. But we do not see how that is so. In Janus, we considered the language in subsection (b), which prohibits the “mak[ing]” of “any untrue statement of a material fact.” See 564 U. S., at 141–143. We held that the “maker” of a “statement” is the “person or entity with ultimate authority over the state- ment.” Id., at 142. And we found that subsection (b) did not (under the circumstances) cover an investment adviser who helped draft misstatements issued by a different entity that controlled the statements’ content. Id., at 146– 148. We said nothing about the Rule’s application to the dissemination of false or misleading information. And we can assume that Janus would remain relevant (and pre- clude liability) where an individual neither makes nor disseminates false information—provided, of course, that the individual is not involved in some other form of fraud. Next, Lorenzo points to the statute’s “aiding and abet- ting” provision. 15 U. S. C. §78t(e). This provision, en- forceable only by the Commission (and not by private parties), makes it unlawful to “knowingly or recklessly . . . provid[e] substantial assistance to another person” who violates the Rule. Ibid.; see Janus, 564 U. S., at 143 (cit- ing Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164 (1994)). Lorenzo claims that imposing primary liability upon his conduct would erase or at least weaken what is otherwise a clear distinc- tion between primary and secondary (i.e., aiding and abetting) liability. He emphasizes that, under today’s holding, a disseminator might be a primary offender with respect to subsection (a) of Rule 10b–5 (by employing a “scheme” to “defraud”) and also secondarily liable as an aider and abettor with respect to subsection (b) (by provid- ing substantial assistance to one who “makes” a false Cite as: 587 U. S. ____ (2019) 11

Opinion of the Court statement). And he refers to two cases that, in his view, argue in favor of circumscribing primary liability. See Central Bank, 511 U. S., at 164; Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U. S. 148 (2008). We do not believe, however, that our decision creates a serious anomaly or otherwise weakens the distinction between primary and secondary liability. For one thing, it is hardly unusual for the same conduct to be a primary violation with respect to one offense and aiding and abet- ting with respect to another. John, for example, might sell Bill an unregistered firearm in order to help Bill rob a bank, under circumstances that make him primarily li- able for the gun sale and secondarily liable for the bank robbery. For another, the cases to which Lorenzo refers do not help his cause. Take Central Bank, where we held that Rule 10b–5’s private right of action does not permit suits against secondary violators. 511 U. S., at 177. The hold- ing of Central Bank, we have said, suggests the need for a “clean line” between conduct that constitutes a primary violation of Rule 10b–5 and conduct that amounts to a secondary violation. Janus, 564 U. S., at 143, and n. 6. Thus, in Janus, we sought an interpretation of “make” that could neatly divide primary violators and actors too far removed from the ultimate decision to communicate a statement. Ibid. (citing Central Bank, 511 U. S. 164). The line we adopt today is just as administrable: Those who disseminate false statements with intent to defraud are primarily liable under Rules 10b–5(a) and (c), §10(b), and §17(a)(1), even if they are secondarily liable under Rule 10b–5(b). Lorenzo suggests that classifying dissemination as a primary violation would inappropriately subject peripheral players in fraud (including him, naturally) to substantial liability. We suspect the investors who re- ceived Lorenzo’s e-mails would not view the deception so 12 LORENZO v. SEC

Opinion of the Court favorably. And as Central Bank itself made clear, even a bit participant in the securities markets “may be liable as a primary violator under [Rule] 10b–5” so long as “all of the requirements for primary liability . . . are met.” Id., at 191. Lorenzo’s reliance on Stoneridge is even further afield. There, we held that private plaintiffs could not bring suit against certain securities defendants based on undisclosed deceptions upon which the plaintiffs could not have relied. 552 U. S., at 159. But the Commission, unlike private parties, need not show reliance in its enforcement actions. And even supposing reliance were relevant here, Lorenzo’s conduct involved the direct transmission of false statements to prospective investors intended to induce reliance—far from the kind of concealed fraud at issue in Stoneridge. As for Lorenzo’s suggestion that those like him ought to be held secondarily liable, this offer will, far too often, prove illusory. In instances where a “maker” of a false statement does not violate subsection (b) of the Rule (per- haps because he lacked the necessary intent), a dissemina- tor of those statements, even one knowingly engaged in an egregious fraud, could not be held to have violated the “aiding and abetting” statute. That is because the statute insists that there be a primary violator to whom the sec- ondary violator provided “substantial assistance.” 15 U. S. C. §78t(e). And the latter can be “deemed to be in violation” of the provision only “to the same extent as the person to whom such assistance is provided.” Ibid. In other words, if Acme Corp. could not be held liable under subsection (b) for a statement it made, then a knowing disseminator of those statements could not be held liable for aiding and abetting Acme under subsection (b). And if, as Lorenzo claims, the disseminator has not primarily violated other parts of Rule 10b–5, then such a fraud, whatever its intent or consequences, might escape liability Cite as: 587 U. S. ____ (2019) 13

Opinion of the Court altogether. That is not what Congress intended. Rather, Congress intended to root out all manner of fraud in the securities industry. And it gave to the Commission the tools to accomplish that job. * * * For these reasons, the judgment of the Court of Appeals is affirmed. So ordered.

JUSTICE KAVANAUGH took no part in the consideration or decision of this case.

14 LORENZO v. SEC

AppendixOpinion to opinion of the ofCourt the Court APPENDIX

17 CFR §240.10b–5

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, “(a) To employ any device, scheme, or artifice to defraud, “(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in or- der to make the statements made, in the light of the circumstances under which they were made, not mis- leading, or “(c) To engage in any act, practice, or course of busi- ness which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.”

15 U. S. C. §78j

“It shall be unlawful for any person, directly or in- directly, by the use of any means or instrumentality of in- terstate commerce or of the mails, or of any facility of any national securities exchange—

* * *

“(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities ex- change or any security not so registered, or any securities- based swap agreement[,] any manipulative or decep- tive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as Cite as: 587 U. S. ____ (2019) 15

AppendixOpinion to opinion of the ofCourt the Court necessary or appropriate in the public interest or for the protection of investors.”

15 U. S. C. §77q

“(a) Use of interstate commerce for purpose of fraud or deceit

“It shall be unlawful for any person in the offer or sale of any securities (including security-based swaps) or any security-based swap agreement . . . by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly— “(1) to employ any device, scheme, or artifice to de- fraud, or “(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or “(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.”

15 U. S. C. §78t

“(e) Prosecution of persons who aid and abet violations

“For purposes of any action brought by the Commission . . . , any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed in violation of such provision to the same extent as the person to whom such assistance is provided. Cite as: 587 U. S. ____ (2019) 1

THOMAS, J., dissenting SUPREME COURT OF THE UNITED STATES ______No. 17–1077 ______FRANCIS V. LORENZO, PETITIONER v. SECURITIES AND EXCHANGE COMMISSION

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT [March 27, 2019]

JUSTICE THOMAS, with whom JUSTICE GORSUCH joins, dissenting. In Janus Capital Group, Inc. v. First Derivative Traders, 564 U. S. 135 (2011), we drew a clear line between primary and secondary liability in fraudulent-misstatement cases: A person does not “make” a fraudulent misstatement within the meaning of Securities and Exchange Commis- sion (SEC) Rule 10b–5(b)—and thus is not primarily liable for the statement—if the person lacks “ultimate authority over the statement.” Id., at 142. Such a person could, however, be liable as an aider and abettor under principles of secondary liability. Today, the Court eviscerates this distinction by holding that a person who has not “made” a fraudulent misstate- ment can nevertheless be primarily liable for it. Because the majority misconstrues the securities laws and flouts our precedent in a way that is likely to have far-reaching consequences, I respectfully dissent. I To appreciate the sweeping nature of the Court’s hold- ing, it is helpful to begin with the facts of this case. On October 14, 2009, the owner of the firm at which petitioner Frank Lorenzo worked instructed him to send e-mails to two clients regarding a debenture offering. The owner 2 LORENZO v. SEC

THOMAS, J., dissenting explained that he wanted the e-mails to come from the firm’s investment-banking division, which Lorenzo di- rected. Lorenzo promptly addressed an e-mail to each client, “cut and pasted” the contents of each e-mail—which he received from the owner—into the body, and “sent [them] out.” App. 321. It is undisputed that Lorenzo did not draft the e-mails’ contents, though he knew that they contained false or misleading statements regarding the debenture offering. Both e-mails stated that they were sent “[a]t the request of ” the owner of the firm. Id., at 403, 405. No other allegedly fraudulent conduct is at issue. In 2013, the SEC brought enforcement proceedings against the owner of the firm, the firm itself, and Lorenzo. Even though Lorenzo sent the e-mails at the owner’s request, the SEC did not charge Lorenzo with aiding and abetting fraud committed by the owner. See 15 U. S. C. §§ 77o(b), 78o(b)(4)(E), 78t(e). Instead, the SEC charged Lorenzo as a primary violator of multiple securities laws,1 including Rule 10b–5(b), which prohibits “mak[ing] any untrue statement of a material fact . . . in connection with the purchase or sale of any security.” 17 CFR §240.10b– 5(b) (2018); see Ernst & Ernst v. Hochfelder, 425 U. S. 185, 212–214 (1976) (construing Rule 10b–5(b) to require scien- ter). The SEC ultimately concluded that, by “knowingly sen[ding] materially misleading language from his own email account to prospective investors,” App. to Pet. for Cert. 77, Lorenzo violated Rule 10b–5(b) and several other antifraud provisions of the securities laws. The SEC “barred [him] from serving in the securities industry” for life. Id., at 91. The Court of Appeals unanimously rejected the SEC’s determination that Lorenzo violated Rule 10b–5(b). Ap-

—————— 1 For ease of reference, I use “securities laws” to refer to both statutes and SEC regulations. Cite as: 587 U. S. ____ (2019) 3

THOMAS, J., dissenting plying Janus, the court held that Lorenzo did not “make” the false statements at issue because he merely “transmit- ted statements devised by [his boss] at [his boss’] direc- tion.” 872 F. 3d 578, 587 (CADC 2017). The SEC has not challenged that aspect of the decision below. The panel majority nevertheless upheld the SEC’s deci- sion holding Lorenzo primarily liable for the same false statements under other provisions of the securities laws— specifically, §10(b) of the Securities Exchange Act of 1934 (1934 Act), Rules 10b–5(a) and (c), and §17(a)(1) of the Securities Act of 1933 (1933 Act). Unlike Rule 10b–5(b), none of these provisions pertains specifically to fraudulent misstatements. II Even though Lorenzo undisputedly did not “make” the false statements at issue in this case under Rule 10b–5(b), the Court follows the SEC in holding him primarily liable for those statements under other provisions of the securi- ties laws. As construed by the Court, each of these more general laws completely subsumes Rule 10b–5(b) and §17(a)(2) of the 1933 Act in cases involving fraudulent misstatements, even though these provisions specifically govern false statements. The majority’s interpretation of these provisions cannot be reconciled with their text or our precedents. Thus, I am once again compelled to “disa- gre[e] with the SEC’s broad view” of the securities laws. Janus, supra, at 145, n. 8. A I begin with the text. The Court of Appeals held that Lorenzo violated §10(b) of the 1934 Act and Rules 10b–5(a) and (c). In relevant part, §10(b) makes it unlawful for a person, in connection with the purchase or sale of a security, “[t]o use or employ . . . any manipulative or deceptive device or contrivance” in contravention of an SEC rule. 15 4 LORENZO v. SEC

THOMAS, J., dissenting U. S. C. §78j(b). Rule 10b–5 was promulgated under this statutory authority. That Rule makes it unlawful, in connection with the purchase or sale of any security, “(a) To employ any device, scheme, or artifice to defraud, “(b) To make any untrue statement of a material fact . . . , or “(c) To engage in any act, practice, or course of busi- ness which operates or would operate as a fraud or deceit . . . .” 17 CFR §240.10b–5. The Court of Appeals also held that Lorenzo violated §17(a)(1) of the 1933 Act. Similar to Rule 10b–5, §17(a) of the Act provides that it is unlawful, in connection with the offer or sale of a security, “(1) to employ any device, scheme, or artifice to de- fraud, or “(2) to obtain money or property by means of any untrue statement of a material fact . . . ; or “(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.” 15 U. S. C. §77q(a)(1). We can quickly dispose of Rule 10b–5(a) and §17(a)(1). The act of knowingly disseminating a false statement at the behest of its maker, without more, does not amount to “employ[ing] any device, scheme, or artifice to defraud” within the meaning of those provisions. As the contempo- raneous dictionary definitions cited by the majority make clear, each of these words requires some form of planning, designing, devising, or strategizing. See ante, at 6. We have previously observed that “the terms ‘device,’ ‘scheme,’ and ‘artifice’ all connote knowing or intentional practices.” Aaron v. SEC, 446 U. S. 680, 696 (1980) (emphasis added). In other words, they encompass “fraudulent scheme[s],” Cite as: 587 U. S. ____ (2019) 5

THOMAS, J., dissenting such as a “ ‘short selling’ scheme,” a wash sale, a matched order, price rigging, or similar conduct. United States v. Naftalin, 441 U. S. 768, 770, 778 (1979) (applying §17(a)(1)); see Santa Fe Industries, Inc. v. Green, 430 U. S. 462, 473 (1977) (interpreting the term “manipulative” in §10(b)). Here, it is undisputed that Lorenzo did not engage in any conduct involving planning, scheming, designing, or strategizing, as Rule 10b–5(a) and §17(a)(1) require for a primary violation. He sent two e-mails drafted by a supe- rior, to recipients specified by the superior, pursuant to instructions given by the superior, without collaborating on the substance of the e-mails or otherwise playing an independent role in perpetrating a fraud. That Lorenzo knew the messages contained falsities does not change the essentially administrative nature of his conduct here; he might have assisted in a scheme, but he did not himself plan, scheme, design, or strategize. In my view, the plain text of Rule 10b–5(a) and §17(a)(1) thus does not encom- pass Lorenzo’s conduct as a matter of primary liability. The remaining provision, Rule 10b–5(c), seems broader at first blush. But the scope of this conduct-based provision—and, for that matter, Rule 10b–5(a) and §17(a)(1)—must be understood in light of its codification alongside a prohibition specifically addressing primary liability for false statements. Rule 10b–5(b) imposes primary liability on the “make[r]” of a fraudulent mis- statement. 17 CFR §240.10b–5(b); see Janus, 564 U. S., at 141–142. And §17(a)(2) imposes primary liability on a person who “obtain[s] money or property by means of ” a false statement. 15 U. S. C. §77q(a)(2). The conduct- based provisions of Rules 10b–5(a) and (c) and §17(a)(1) must be interpreted in view of the specificity of these false-statement provisions, and therefore cannot be con- strued to encompass primary liability solely for false statements. This view is consistent with our previous 6 LORENZO v. SEC

THOMAS, J., dissenting recognition that “each subparagraph of §17(a) ‘proscribes a distinct category of misconduct’ ” and “ ‘is meant to cover additional kinds of illegalities.’ ” Aaron, supra, at 697 (quoting Naftalin, supra, at 774; emphasis added). The majority disregards these express limitations. Under the Court’s rule, a person who has not “made” a fraudulent misstatement within the meaning of Rule 10b– 5(b) nevertheless could be held primarily liable for facili- tating that same statement; the SEC or plaintiff need only relabel the person’s involvement as an “act,” “device,” “scheme,” or “artifice” that violates Rule 10b–5(a) or (c). And a person could be held liable for a fraudulent mis- statement under §17(a)(1) even if the person did not ob- tain money or property by means of the statement. In short, Rule 10b–5(b) and §17(a)(2) are rendered entirely superfluous in fraud cases under the majority’s reading.2

This approach is in tension with “ ‘the cardinal rule that, if possible, effect shall be given to every clause and part of a statute.’ ” RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U. S. 639, 645 (2012) (quoting D. Ginsberg & Sons, Inc. v. Popkin, 285 U. S. 204, 208 (1932)). I would therefore apply the “old and familiar rule ” that “the specific governs the general.” RadLAX, supra, at 645–646 (inter- nal quotation marks omitted); see A. Scalia & B. Garner, Reading Law 51 (2012) (canon equally applicable to stat- utes and regulations). This canon of construction applies not only to resolve “contradiction[s]” between general and specific provisions, but also to avoid “the superfluity of a specific provision that is swallowed by the general one.” RadLAX, 566 U. S., at 645. Here, liability for false state- —————— 2 I recognize that §17(a)(1) could be deemed narrower than §17(a)(2) in the sense that it requires scienter, whereas §17(a)(2) does not. Aaron v. SEC, 446 U. S. 680, 697 (1980). But scienter is not disputed in this case, and the specific terms of §17(a)(2) are otherwise completely subsumed within the more general terms of §17(a)(1), as interpreted by the majority. Cite as: 587 U. S. ____ (2019) 7

THOMAS, J., dissenting ments is “ ‘specifically dealt with’ ” in Rule 10b–5(b) and §17(a)(2). Id., at 646 (quoting D. Ginsberg & Sons, supra, at 208). But Rule 10b–5 and §17(a) also contain general prohibitions that, “ ‘in [their] most comprehensive sense, would include what is embraced in’ ” the more specific provisions. 566 U. S., at 646. I would hold that the provi- sions specifically addressing false statements “ ‘must be operative’ ” as to false-statement cases, and that the more general provisions should be read to apply “ ‘only [to] such cases within [their] general language as are not within the’ ” purview of the specific provisions on false state- ments. Ibid. Adopting this approach to the statutory text would align with our previous admonitions that the securities laws should not be “[v]iewed in isolation” and stretched to their limits. Hochfelder, 425 U. S., at 212. In Hochfelder, for example, we concluded that the key words of §10(b) em- ployed the “terminology of intentional wrongdoing” and thus “strongly suggest[ed]” that it “proscribe[s] knowing or intentional misconduct,” even though the statute did not expressly state as much. Id., at 197, 214. We took a similar approach to §17(a)(1) of the 1933 Act. Aaron, 446 U. S., at 695–697. We have also limited the terms of Rule 10b–5 by recognizing that it was adopted pursuant to §10(b) and thus “encompasses only conduct already pro- hibited by §10(b).” Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U. S. 148, 157 (2008); see Hochfelder, supra, at 212–214. Contrary to the suggestion of the majority, this ap- proach does not necessarily require treating each provi- sion of Rule 10b–5 or §17(a) as “governing different, mu- tually exclusive, spheres of conduct.” Ante, at 7. Nor does it prevent the securities laws from mutually reinforcing one another or overlapping to some extent. Ante, at 7–8. It simply contemplates giving full effect to the specific prohibitions on false statements in Rule 10b–5(b) and 8 LORENZO v. SEC

THOMAS, J., dissenting §17(a)(2) instead of rendering them superfluous. The majority worries that this approach would allow people who disseminate false statements with the intent to defraud to escape liability under Rule 10b–5. Ante, at 9. That is not so. If a person’s only role is transmitting fraudulent misstatements at the behest of the statements’ maker, the person’s conduct would be appropriately as- sessed as a matter of secondary liability pursuant to pro- visions like 15 U. S. C. §§77o(b), 78t(e), and 78o(b)(4)(E). And if a person engages in other acts prohibited by the Rule, such as developing and employing a fraudulent scheme, the person would be primarily liable for that conduct. The majority suggests that secondary liability may often prove illusory. It hypothesizes, for example, a situation in which the “maker” of a false statement does not know that it was false and thus does not violate Rule 10b–5(b), but the disseminator knows that the statement is false. Un- der that scenario, the majority fears that the person dis- seminating the statements could be “engaged in an egre- gious fraud,” yet would not be liable as an aider and abettor for lack of a primary violator. Ante, at 12. This concern is misplaced. As an initial matter, I note that §17(a)(2) does not require scienter, so the maker of the statement may still be liable under that provision. Aaron, supra, at 695–697. Moreover, an ongoing, “egregious” fraud is likely to independently constitute a primary violation of the conduct-based securities laws, wholly apart from the laws prohibiting fraudulent misstatements. Here, by contrast, we are concerned with the dissemina- tion of two misstatements at the request of their maker. This type of conduct is appropriately assessed under prin- ciples of secondary liability. B The majority’s approach contradicts our precedent in Cite as: 587 U. S. ____ (2019) 9

THOMAS, J., dissenting two distinct ways. First, the majority’s opinion renders Janus a dead let- ter. In Janus, we held that liability under Rule 10b–5(b) was limited to the “make[r]” of the statement and that “[o]ne who prepares or publishes a statement on behalf of another is not its maker” within the meaning of Rule 10b– 5(b). 564 U. S., at 142 (emphasis added). It is undisputed here that Lorenzo was not the maker of the fraudulent misstatements. The majority nevertheless finds primary liability under different provisions of Rule 10b–5, without any real effort to reconcile its decision with Janus. Al- though it “assume[s] that Janus would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information,” in the next breath the majority states that this would be true only if “the indi- vidual is not involved in some other form of fraud.” Ante, at 10. Given that, under the majority’s rule, administra- tive acts undertaken in connection with a fraudulent misstatement qualify as “other form[s] of fraud,” the ma- jority’s supposed preservation of Janus is illusory. Second, the majority fails to maintain a clear line between primary and secondary liability in fraudulent- misstatement cases. Maintaining this distinction is im- portant because, as the majority notes, there is no private right of action against mere aiders and abettors. Ante, at 10; see Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164, 191 (1994). Here, however, the majority does precisely what we declined to do in Janus: impose broad liability for fraudulent mis- statements in a way that makes the category of aiders and abettors in these cases “almost nonexistent.” 564 U. S., at 143. If Lorenzo’s conduct here qualifies for primary liabil- ity under §10(b) and Rule 10b–5(a) or (c), then virtually any person who assists with the making of a fraudulent misstatement will be primarily liable and thereby subject not only to SEC enforcement, but private lawsuits. 10 LORENZO v. SEC

THOMAS, J., dissenting The Court correctly notes that it is not uncommon for the same conduct to be a primary violation with respect to one offense and aiding and abetting with respect to another—as, for example, when someone illegally sells a gun to help another person rob a bank. Ante, at 11. But this case does not involve two distinct crimes. The majority has interpreted certain provisions of an offense so broadly as to render superfluous the more stringent, on-point requirements of a narrower provision of the same offense. Criminal laws regularly and permissibly overlap with each other in a way that allows the same conduct to constitute different crimes with different punishments. That differs significantly from interpreting provisions in a law to com- pletely eliminate specific limitations in a neighboring provision of that very same law. The majority’s overreading of Rules 10b–5(a) and (c) and §17(a)(1) is especially problematic because the heartland of these provisions is conduct-based fraud—“employ[ing] [a] device, scheme, or artifice to defraud” or “engag[ing] in any act, practice, or course of business”—not mere misstatements. 15 U. S. C. §77q(a)(1); 17 CFR §§240.10b–5(a), (c). The Court attempts to cabin the implications of its holding by highlighting several facts that supposedly would distinguish this case from a case involving a secre- tary or other person “tangentially involved in dissemi- nat[ing]” fraudulent misstatements. Ante, at 7. None of these distinctions withstands scrutiny. The fact that Lorenzo “sent false statements directly to investors” in e-mails that “invited [investors] to follow up with ques- tions,” ibid., puts him in precisely the same position as a secretary asked to send an identical message from her e- mail account. And under the unduly capacious interpreta- tion that the majority gives to the securities laws, I do not see why it would matter whether the sender is the “vice president of an investment banking company” or a secre- tary, ibid.—if the sender knowingly sent false statements, Cite as: 587 U. S. ____ (2019) 11

THOMAS, J., dissenting the sender apparently would be primarily liable. To be sure, I agree with the majority that liability would be “inappropriate” for a secretary put in a situation similar to Lorenzo’s. Ibid. But I can discern no legal principle in the majority opinion that would preclude the secretary from being pursued for primary violations of the securities laws. * * * Instead of blurring the distinction between primary and secondary liability, I would hold that Lorenzo’s conduct did not amount to a primary violation of the securities laws and reverse the judgment of the Court of Appeals. Accordingly, I respectfully dissent. 5/14/2019 ‘Lorenzo’: What Happens Next and What To Do About It? | New York Law Journal

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Page printed from: https://www.law.com/newyorklawjournal/2019/04/30/lorenzo-what-happens-next-and-what-to-do- about-it/ ‘Lorenzo’: What Happens Next and What To Do About It?

By expanding the scope of liability for those who are involved in disseminating misrepresentations even if they are not the authors or originators of them, 'Lorenzo' conceivably could have a vast impact on both SEC enforcement, as well as private lawsuits.

By Howard Fischer | April 30, 2019

Several years ago, in the landmark case of Janus Capital Group v. First Derivative Traders, 564 U.S. 135 (2011), the Supreme Court held only the author of a misstatement, its maker, could be held liable under Securities and Exchange Commission Rule 10b-5(b), promulgated under Section 10(b) of the Exchange Act of 1934. In the intervening years, many courts accepted that the statutory anti- fraud provisions of Section 10(b) of the Exchange Act of 1934 and Rule 10b-5 thereunder encompassed two dierent kinds of misconduct. Rule 10b-5(b) addressed

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misstatements and omissions while subsections (a) and (c) addressed fraud by conduct —e.g., wash sales, painting the tape, various forms of manipulative trading, and so on, that did not have a misstatement component.

It became accepted that a scheme claim could not be asserted if the basis was a misstatement or omission. Indeed, just last month, in SEC v. Rio Tinto PLC, 2019 U.S. Dist. LEXIS 43986, *51-52 (March 18, 2019), the U.S. District Court for the Southern District of New York ruled that “in order to state a claim based on scheme liability, the SEC must allege conduct beyond misrepresentations and omissions.” See also Alpha Capital Anstalt v. Schwell Wimpfheimer & Assocs., 2018 U.S. Dist. LEXIS 54594, * 34 (S.D.N.Y. March 30, 2018) (“subsections (a) and (c) may not be sued as a ‘back door into liability for those who help others make a false statement or omission … ‘”); SEC v. Wey, 246 F. Supp. 3d 894, 917-18 (S.D.N.Y. 2017) (listing cases holding that scheme liability hinges on the performance of an inherently deceptive act or conduct distinct from alleged misrepresentations or omissions); SEC v. China Northeast Petroleum Holdings Ltd., 27 F. Supp. 3d 379, 391-92 (S.D.N.Y. 2014) (scheme liability requires conduct beyond misrepresentations or omissions); In re Smith Barney Transfer Agent Litig., 884 F. Supp. 2d 152, 161 (S.D.N.Y. 2012) (“[T]he three subsections of Rule 10b-5 are distinct, and courts must scrutinize pleadings to ensure that misrepresentation or omission claims do not proceed under the scheme liability rubric.”). At the SEC, it was widely accepted that one did not assert scheme liability claims under Rule 10b-5(a) and (c) based on misstatements or omissions, and that such theories were unlikely to be approved by senior management.

This well-accepted distinction between misstatement fraud and manipulative and deceptive conduct was sharply eroded, if not erased, on March 27, 2019, by the Supreme Court’s decision in the case of Lorenzo v. Securities and Exchange Commission, 139 S. Ct. 1094 (2019), by a 6-2 vote (Justice Brett Kavanaugh did not participate). Lorenzo addressed the question of whether or not a non-author— someone who merely disseminated the fraudulent statements made by another— could be held liable under subsections (a) and (c) of Rule 10b-5.

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The relevant facts are as follows. Francis Lorenzo was the director of investment banking at a registered broker-dealer. One of his clients—in fact, his only client—was a company that purported to have technology that would convert waste to clean renewable energy. Lorenzo’s rm had been hired to sell $15 million in debentures to investors. Although he knew that its total assets were comparatively negligible, Lorenzo sent to investors, at the direction of his boss, two emails describing the oering. Lorenzo’s emails, which he signed with his own name, identifying himself as “Vice- President—Investment Banking,” inated the company’s assets from less than $400,000 to at least $10 million, and invited the recipients to call him with any questions.

Surprising many who expected a contrary result, the Supreme Court held in Lorenzo that, even if disseminating the statements of another would not establish liability under subsection 10b-5(b), it would count as a “device, scheme or artice to defraud” under 10b-5(a) (and under Section 17(a)(1) of the Securities Act as well) in addition to as engaging in “an act, practice or course of business” that operates “as a fraud or deceit” under Rule 10b-5(c).

By expanding the scope of liability for those who are involved in disseminating misrepresentations even if they are not the authors or originators of them, Lorenzo conceivably could have a vast impact on both SEC enforcement, as well as private lawsuits. Indeed, soon after the opinion came out various SEC enforcement sta, giddy with a decision they see gifting them with an expansive writ, were widely reported to have stated at the annual “SEC Speaks” CLE program that the Division of Enforcement anticipates the opinion will be applied “broadly”—for example, not only to people who distribute a false statement but those that direct others to draft or distribute false statements.

Private plaintis have also been given extra ammunition. As Justice Clarence Thomas pointed out in the dissent, the fear that Lorenzo’s wrongful conduct lacked an enforcement remedy was misplaced, since his conduct could also have been charged as aiding and abetting another’s fraud. This avenue would not, however, be available to

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a private plainti, as there is no private right of action for aiding and abetting a securities fraud. By eectively converting such a claim to a direct claim, Lorenzo added a powerful arrow to the quiver of the plaintis’ bar.

However, the oodgates might not be propped open as widely as some fear. A practitioner has several avenues available for keeping her client out of trouble, some based on a strict reading of the Lorenzo decision, others on the pragmatic realities of the SEC enforcement regime.

The rst line of defense is to distinguish one’s client’s conduct from that of Mr. Lorenzo, and to limit Lorenzo’s scope to its specic facts. Arguably, the Supreme Court recognized that Lorenzo might be construed as overly expansive, and cautioned against such a reading, specically excluding “actors tangentially involved in dissemination— say, a mailroom clerk—for whom liability would typically be inappropriate.” Nor is there much support in the text of the decision for expanding Lorenzo beyond dissemination, as SEC enforcement sta seems to think. In fact, in every single instance in which the decision refers to misconduct at issue, it is either some version of the word “disseminate” (15 times) or its synonym “send” (four times). As the Court explicitly noted, it only intended to make liable “those who disseminate false statements with the intent to cheat investors.” Moreover, the opinion notes that the preclusion of Janus would still apply “where an individual neither makes nor disseminates false information —provided, of course, that the individual is not involved in some other form of fraud.”

It is also important to point out that although he might not have been the “maker” of the misstatements, Mr. Lorenzo’s conduct eectively “vouched” for them. He held himself out to investors as someone in a position of authority, using his title in his emails to them. He invited the recipients to contact him if they had any questions, “and did so in his capacity as vice president of an investment banking company” further adding to his implied authority and bolstering the idea that he was the person with knowledge. He had direct contact with investors. Moreover, Mr. Lorenzo knew the statements were false, and intended to defraud investors.

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Thus, a persuasive argument can likely be made that the Supreme Court meant to inculpate only the most egregious of oenders, and to limit the scope of the decision to those who knowingly disseminate false information directly to investors with the intent to defraud. (Of course, these arguments can be made whether the adversary is the SEC or a private plainti).

Furthermore, there are practical considerations that might limit a radical expansion of SEC enforcement activity. First, the SEC lacks the resources and sta to investigate and prosecute every instance of securities fraud (and that was true before Lorenzo) and has to make pragmatic assessments of which conduct to prosecute. Defense counsel should communicate to sta that their client’s conduct is not of a sucient severity to warrant the expenditure of scarce enforcement resources, especially if there are risks that it falls outside the narrow area of “dissemination” targeted by the Lorenzo decision.

Second, regardless of what some senior sta at the Division of Enforcement might believe about the breadth of the Lorenzo decision, the fact remains that it is not the enforcement sta that makes the nal decision as to whether or not to bring charges. That decision is left to the full Commission, after consultations with the various divisions. A sizable portion of the current Commission is skeptical about expansive claims of liability. Reference to that skepticism in pre-charge negotiations with the sta might be a useful method for whittling down charges.

Given the limiting language of the Lorenzo decision, the resource limitations at the SEC, and the currently conservative Commission, a practitioner has signicant room to argue against wide theories of liability and for a more limited reading of the decision. The next few years should see some fascinating judicial decisions determining which side of the argument prevails.

Howard Fischer is a partner at Moses & Singer and a former senior trial counsel at the New York Regional Oce of the Securities & Exchange Commission.

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IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE

MATTHEW SCIABACUCCHI, on behalf of ) himself and all others similarly situated, ) ) Plaintiff, ) ) v. ) C.A. No. 2017-0931-JTL ) MATTHEW B. SALZBERG, JULIE M.B. ) BRADLEY, TRACY BRITT COOL, ) KENNETH A. FOX, ROBERT P. GOODMAN, ) GARY R. HIRSHBERG, BRIAN P. KELLEY, ) KATRINA LAKE, STEVEN ANDERSON, J. ) WILLIAM GURLEY, MARKA HANSEN, ) SHARON MCCOLLAM, ANTHONY WOOD, ) RAVI AHUJA, SHAWN CAROLAN, ) JEFFREY HASTINGS, ALAN HENDRICKS, ) NEIL HUNT, DANIEL LEFF, and RAY ) ROTHROCK, ) ) Defendants, ) ) and ) ) BLUE APRON HOLDINGS, INC., STITCH ) FIX, INC., and ROKU, INC., ) ) Nominal Defendants. )

MEMORANDUM OPINION

Date Submitted: September 27, 2018 Date Decided: December 19, 2018

Kurt M. Heyman, Melissa N. Donimirski, HEYMAN ENERIO GATTUSO & HIRZEL LLP, Wilmington, Delaware; Jason M. Leviton, Joel A. Fleming, BLOCK & LEVITON LLP, Boston, Massachusetts; Counsel for Plaintiff.

William B. Chandler III, Randy J. Holland, Bradley D. Sorrels, Lindsay Kwoka Faccenda, WILSON SONSINI GOODRICH & ROSATI, P.C., Wilmington, Delaware; Boris Feldman, David J. Berger, WILSON SONSINI GOODRICH & ROSATI, P.C., Palo Alto, California; Counsel for Defendants Katrina Lake, Steven Anderson, J. William Gurley, Marka Hansen, Sharon McCollam, Anthony Wood, Ravi Ahuja, Shawn Carolan, Jeffrey Hastings, Alan Hendricks, Neil Hunt, Daniel Leff, Ray Rothrock, and Nominal Defendants Stitch Fix, Inc. and Roku, Inc.

Catherine G. Dearlove, Sarah T. Andrade, RICHARDS, LAYTON & FINGER, P.A., Wilmington, Delaware; Michael G. Bongiorno, WILMER CUTLER PICKERING HALE AND DORR LLP, New York, New York; Timothy J. Perla, WILMER CUTLER PICKERING HALE AND DORR LLP, Boston, Massachusetts; Counsel for Defendants Matthew B. Salzberg, Julie M.B. Bradley, Tracy Britt Cool, Kenneth A. Fox, Robert P. Goodman, Gary R. Hirshberg, and Brian P. Kelley, and Nominal Defendant Blue Apron Holdings, Inc.

LASTER, V.C.

The Securities Act of 1933 (the “1933 Act”) bars any person from offering or selling securities except pursuant to a registration statement approved by the Securities and

Exchange Commission (the “SEC”) or in compliance with an exemption. The 1933 Act grants private rights of action to purchasers of securities so they can enforce its registration and disclosure requirements.

When Congress enacted the 1933 Act, it gave state and federal courts concurrent jurisdiction over claims by private plaintiffs and barred defendants from removing actions filed in state court to federal court. In 1998, Congress amended the 1933 Act in a manner that cast doubt on this jurisdictional allocation. In 2018, the Supreme Court of the United

States held that state courts continue to have concurrent jurisdiction over claims by private plaintiffs and that defendants cannot remove actions filed in state court to federal court.1

Before their initial public offerings, the three nominal defendants adopted provisions in their certificates of incorporation that require any claim under the 1933 Act to be filed in federal court (the “Federal Forum Provisions”). Contrary to the federal regime, the provisions preclude a plaintiff from asserting a 1933 Act claim in state court.

This decision concludes that the Federal Forum Provisions are ineffective. In

Boilermakers,2 Chief Justice Strine held while serving on this court that a Delaware corporation can adopt a forum-selection bylaw for internal-affairs claims. In reaching this

1 Cyan, Inc. v. Beaver Cty. Empls. Ret. Fund, 138 S. Ct. 1061 (2018).

2 Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) (Strine, C.).

conclusion, he reasoned that Section 109(b) of the Delaware General Corporation Law (the

“DGCL”), which specifies what subjects bylaws can address, authorizes the bylaws to regulate “internal affairs claims brought by stockholders qua stockholders.”3 But he stressed that Section 109(b) does not authorize a Delaware corporation to regulate external relationships. The Boilermakers decision noted that a bylaw cannot dictate the forum for tort or contract claims against the company, even if the plaintiff happens to be a stockholder.4

Section 102(b)(1) of the DGCL specifies what charter provisions can address. Its scope parallels Section 109(b), so the reasoning in Boilermakers applies to charter-based provisions.

The Boilermakers distinction between internal and external claims answers whether a forum-selection provision can govern claims under the 1933 Act. It cannot, because a

1933 Act claim is external to the corporation. Federal law creates the claim, defines the elements of the claim, and specifies who can be a plaintiff or defendant. The 1933 Act establishes a statutory regime that applies when a particular type of property—securities— is offered for sale in particular scenarios that the federal government has chosen to regulate.

The cause of action belongs to a purchaser of a security, and it arises out of an offer or sale.

The defined term “security” encompasses a wide range of financial products. Shares of

3 Id. at 952.

4 Id.

2 stock are just one of many types of securities, and shares in a Delaware corporation are just one subtype. A claim under the 1933 Act does not turn on the rights, powers, or preferences of the shares, language in the corporation’s charter or bylaws, a provision in the DGCL, or the equitable relationships that flow from the internal structure of the corporation. Under

Boilermakers, a 1933 Act claim is distinct from “internal affairs claims brought by stockholders qua stockholders.”5

This result derives from first principles. The certificate of incorporation differs from an ordinary contract, in which private parties execute a private agreement in their personal capacities to allocate their rights and obligations. When accepted by the Delaware

Secretary of State, the filing of a certificate of incorporation effectuates the sovereign act of creating a “body corporate”—a legally separate entity. The State of Delaware is an ever- present party to the resulting corporate contract, and the terms of the corporate contract incorporate the provisions of the DGCL. Various sections of the DGCL specify what the contract must contain, may contain, and cannot contain. The DGCL also constrains how the contract can be amended.

As the sovereign that created the entity, Delaware can use its corporate law to regulate the corporation’s internal affairs. For example, Delaware corporate law can specify the rights, powers, and privileges of a share of stock, determine who holds a corporate office, and adjudicate the fiduciary relationships that exist within the corporate

5 Id.

3 form. When doing so, Delaware deploys the corporate law to determine the parameters of the property rights that the state has chosen to create.

But Delaware’s authority as the creator of the corporation does not extend to its creation’s external relationships, particularly when the laws of other sovereigns govern those relationships. Other states exercise territorial jurisdiction over a Delaware corporation’s external interactions. A Delaware corporation that operates in other states must abide by the labor, environmental, health and welfare, and securities law regimes (to name a few) that apply in those jurisdictions. When litigation arises out of those relationships, the DGCL cannot provide the necessary authority to regulate the claims.

This limitation applies even when the party asserting the claim happens to be a stockholder. Envision a customer who happens to own stock and who wishes to assert a product liability claim against the corporation. Even though the corporation’s relationships with its customers are part of its business and affairs, and even though the customer- stockholder plaintiff would own stock, the shares are incidental to the operative legal relationship. Only a state exercising its territorial authority can regulate the product liability claim. Because the claim exists outside of the corporate contract, it is beyond the power of state corporate law to regulate.

This limitation applies even when shares of a Delaware corporation comprise the property that is the subject of the external claim. If a third party engages in the tort of conversion by stealing a stock certificate, the shares constitute the stolen property. The claim for conversion is not an attribute of the shares, nor does it arise out of the corporate contract. The fact that the stolen property consists of shares is incidental to the claim. The

4 legal relationship does not change if the corporation itself takes the shares. The conversion claim is still not an attribute of the shares, and it still does not arise out of the corporate contract. The same is true when a plaintiff asserts a claim for fraud involving shares. The speaker may have made fraudulent statements about the shares, or which relate to the shares, but the claim for fraud is not an attribute of the shares and does not arise out of the corporate contract.

Whether a purchaser of securities may have bought shares in a Delaware corporation is incidental to a claim under the 1933 Act. That happenstance does not provide a sufficient legal connection to enable the constitutive documents of a Delaware corporation to regulate the resulting lawsuit. The claim does not arise out of the corporate contract and does not implicate the internal affairs of the corporation. To the contrary, assuming the securities in question are shares, the claim arises from the investor’s purchase of the shares. At the time the predicate act occurs, the purchaser is not yet a stockholder and lacks any relationship with the corporation that is grounded in corporate law.

The constitutive documents of a Delaware corporation cannot bind a plaintiff to a particular forum when the claim does not involve rights or relationships that were established by or under Delaware’s corporate law. In this case, the Federal Forum

Provisions attempt to accomplish that feat. They are therefore ineffective and invalid.

I. FACTUAL BACKGROUND The facts are drawn from the materials presented in support of the cross-motions for summary judgment. The operative facts are undisputed.

5

A. The Federal Backdrop The question of Delaware law presented by this case emerges from a backdrop of federal law. A basic understanding of the 1933 Act provides essential context.

The 1933 Act After the Crash of 1929, in the midst of the Great Depression, Congress enacted the

1933 Act “to promote honest practices in the securities markets.”6 The 1933 Act requires a company offering securities to the public “to make full and fair disclosure of relevant information” by filing a registration statement with the SEC.7

Congress created private rights of action for investors and provided that the causes of action could be asserted in state or federal court.8 “More unusually, Congress also barred the removal of such actions from state to federal court. So if a plaintiff chose to bring a

1933 Act suit in state court, the defendant could not change the forum.”9

Section 11 of the 1933 Act “allows purchasers of a registered security to sue certain

6 Cyan, 138 S. Ct. at 1066. See generally Fed. Hous. Fin. Agency v. Nomura Hldg. Am., Inc., 873 F.3d 85, 96 (2d Cir. 2017) (“In the wake of the Great Depression, Congress took measures to protect the U.S. economy from suffering another catastrophic collapse. Congress’s first step in that endeavor was the Securities Act of 1933. The Act’s chief innovation was to replace the traditional buyer-beware or caveat emptor rule of contract with an affirmative duty on sellers to disclose all material information fully and fairly prior to public offerings of securities. That change marked a paradigm shift in the securities markets.” (citation omitted)).

7 See Cyan, 138 S. Ct. at 1066 (internal quotation marks omitted).

8 Id.

9 Id. (citation omitted).

6 enumerated parties in a registered offering when false or misleading information is included in a registration statement.”10 Its purpose is to “assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering.”11 “If a plaintiff purchased a security issued pursuant to a registration statement, he need only show a material misstatement or omission to establish his prima facie case. Liability against the issuer of a security is virtually absolute, even for innocent misstatements.”12 “[E]very person who signed the registration statement” may be liable,13 though defendants other than the issuer may avoid liability by proving a due diligence defense.14

10 Herman & MacLean v. Huddleston, 459 U.S. 375, 381 (1983); see 15 U.S.C. § 77k(a) (providing for liability where “any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading”); Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 135 S. Ct. 1318, 1323 (2015) (“Section 11 . . . creates two ways to hold issuers liable for the contents of a registration statement—one focusing on what the statement says and the other on what it leaves out.”).

11 Huddleston, 459 U.S. at 381–82 (footnote omitted); see Omnicare, 135 S. Ct. at 1331 (explaining that Section 11 “establish[es] a strict liability offense promoting ‘full and fair disclosure’ of material information”).

12 Huddleston, 459 U.S. at 381 (footnote omitted).

13 15 U.S.C. § 77k(a)(1).

14 See Huddleston, 459 U.S. at 382; 15 U.S.C. § 77k(b) (setting forth due diligence and other defenses); see also Donna M. Nagy et al., Securities Litigation and Enforcement: Cases and Materials 262 (2003) (“[U]nless the issuer proves that the plaintiff knew of the misstatement or omission at issue at the time of purchasing the security or unless the statute of limitations has run, the issuer has no defenses. . . . Defendants other than the issuer . . . . can avoid liability by establishing that they acted diligently in investigating the facts set forth in the registration statement. Such defendants may also avoid liability based on the 7

If a person offers securities without complying with the registration requirements of the 1933 Act, Section 12(a)(1) provides relief.15 Section 12(a)(2) of the 1933 Act provides an additional cause of action when a prospectus contains material misstatements or omissions.16

The PLSRA and SLUSA In 1995, Congress passed the Private Securities Litigation Reform Act (the

“PLSRA”) to address “perceived abuses of the class-action vehicle in litigation involving

plaintiff’s knowledge of the misstatement or omission, the statute of limitations, or negative causation.” (citations omitted)).

15 15 U.S.C. § 77l(a)(1) (providing for liability for “[a]ny person who . . . offers or sells a security in violation of” Section 5 of the 1933 Act); see Zacharias v. SEC, 569 F.3d 458, 464 (D.C. Cir. 2009) (“Sections 5(a) and (c) of the Securities Act prohibit the ‘sale’ and ‘offer for sale’ of any securities unless a registration statement is in effect or there is an applicable exemption from registration.”). See generally Pinter v. Dahl, 486 U.S. 622, 638 (1988) (“The primary purpose of the Securities Act is to protect investors by requiring publication of material information thought necessary to allow them to make informed investment decisions concerning public offerings of securities in interstate commerce. The registration requirements are the heart of the Act, and § 12(1) imposes strict liability for violating those requirements. Liability under § 12(1) is a particularly important enforcement tool, because in many instances a private suit is the only effective means of detecting and deterring a seller’s wrongful failure to register securities before offering them for sale.” (citations and footnote omitted)).

16 15 U.S.C. § 77l(a)(2) (providing for liability for “[a]ny person who . . . offers or sells a security . . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading”); see Gustafson v. Alloyd Co., 513 U.S. 561, 571 (1995) (“Section 11 provides for liability on account of false registration statements; § 12(2) for liability based on misstatements in prospectuses.”).

8 nationally traded securities.”17 According to the congressional findings, “nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests, and ‘manipulation by class action lawyers of the clients whom they purportedly represent’ had become rampant in recent years.”18 The PSLRA imposed various procedural requirements for cases filed in federal court, including an automatic stay of discovery pending a decision on a motion to dismiss.19

The PSLRA “had an unintended consequence: It prompted at least some members of the plaintiffs’ bar to avoid the federal forum altogether.”20 “Rather than face the obstacles set in their path by the [PSLRA], plaintiffs and their representatives began bringing class actions under state law, often in state court.”21

In 1998, Congress adopted the Securities Litigation Uniform Standards Act

(“SLUSA”) to prevent plaintiffs from circumventing the PSLRA by filing state law claims

17 Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 81 (2006).

18 Id.

19 15 U.S.C. § 77z–1; see Cyan, 138 S. Ct. at 1066–67.

20 Dabit, 547 U.S. at 82.

21 Id.; see In re Lord Abbett Mutual Funds Fee Litig., 553 F.3d 248, 250 (3d Cir. 2009) (“In reaction to the rigors of the PSLRA, plaintiffs began filing cases in state courts under less strict state securities laws.”); see also Dabit, 547 U.S. at 82 (“The evidence presented to Congress during a 1997 hearing to evaluate the effects of the [PSLRA] suggested that this phenomenon was a novel one; state-court litigation of class actions involving nationally traded securities had previously been rare.”).

9 in state court.22 SLUSA’s core provision states:

No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging—

(1) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or

(2) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.23

This decision refers to this provision as the “Federal Jurisdiction Statute.”

The Federal Jurisdiction Statute forces plaintiffs to sue in federal court if they wish to pursue class-wide relief involving publicly traded securities on a fraud-based theory, regardless of whether the cause of action invokes federal or state law.24 To make sure that plaintiffs cannot bypass the Federal Jurisdiction Statute by ignoring it and filing in state

22 See Dabit, 547 U.S. at 82; Madden v. Cowen & Co., 576 F.3d 957, 963–64 (9th Cir. 2009); Sofonia v. Principal Life Ins. Co., 465 F.3d 873, 876 (8th Cir. 2006).

23 15 U.S.C. § 77p(b); see also Dabit, 547 U.S. at 83–84 (discussing provision in the Securities Exchange Act of 1934 that is analogous to the Federal Jurisdiction Statute).

24 See 15 U.S.C. § 77p(f)(2)(A) (defining “covered class action”); Cyan, 138 S. Ct. at 1067 (explaining that the Federal Jurisdiction Statute “completely disallows (in both state and federal courts) sizable class actions that are founded on state law and allege dishonest practices respecting a nationally traded security’s purchase or sale”). SLUSA recognized two exceptions known colloquially as the “Delaware carve-outs.” Malone v. Brincat, 722 A.2d 5, 13 (Del. 1998). First, SLUSA permits an “exclusively derivative action” to be maintained in state court. 15 U.S.C. § 77p(f)(2)(B). Second, SLUSA authorizes class actions “based upon the statutory or common law of the State in which the issuer is incorporated” to be maintained in state court. 15 U.S.C. § 77p(d)(1)(A). These exceptions preserved the ability of state courts to continue hearing internal-affairs claims. See Malone, 722 A.2d at 13 n.42.

10 court, SLUSA permits the removal of certain class actions to federal court.25

SLUSA also modified the jurisdictional provision in the 1933 Act.26 Before SLUSA, the 1933 Act provided that state and federal courts had concurrent jurisdiction over claims arising under the act.27 SLUSA modified the statutory provision to say that concurrent jurisdiction existed “except as provided in [SLUSA].28 Likewise, before SLUSA, the 1933

Act provided that claims brought in state court that asserted violations of the 1933 Act were not removable.29 Congress amended this provision to preserve the prohibition on removal

“[e]xcept as provided in [SLUSA].”30

A Federal Split Spurs Corporations To Impose Their Preference For A Federal Forum.

The federal courts split on how to interpret SLUSA’s changes.31 Some held that

25 15 U.S.C. § 77p(c); see Cyan, 138 S. Ct. at 1067.

26 Cyan, 138 S. Ct. at 1067–68.

27 Id. at 1068.

28 15 U.S.C. § 77v(a) (“The district courts of the United States . . . shall have jurisdiction . . . concurrent with State . . . courts, except as provided in [SLUSA] with respect to covered class actions, of all suits in equity and actions at law brought to enforce any liability or duty created by this subchapter.”).

29 Cyan, 138 S. Ct. at 1068.

30 15 U.S.C. § 77v(a) (“Except as provided in [SLUSA], no case arising under this subchapter and brought in any State court of competent jurisdiction shall be removed to any court of the United States.”).

31 Cyan, 138 S. Ct. at 1068–69 & n.1; see Unschuld v. Tri-S Sec. Corp., 2007 WL 2729011, at *1 (N.D. Ga. Sept. 14, 2007) (“[B]ecause the specific removal provision and the general provision governing concurrent jurisdiction [over] federal securities [cases] are fraught with confusion, . . . . district courts are split, with some finding removal of such 11

SLUSA only permitted the removal of covered class actions that raised state law claims, while others held that claims under the 1933 Act could now be removed to federal court.32

Corporations and their advisors preferred federal court.33 In an effort to lock in their preferred forum despite the split in authority on removal, corporations began adopting forum-selection provisions that identified the federal courts as the exclusive forum for 1933

Act claims.34

B. The Initial Public Offerings On June 1, 2017, nominal defendant Blue Apron Holdings, Inc. filed a registration statement with the SEC for its shares of common stock and launched an initial public offering. Blue Apron is a Delaware corporation. Before filing its registration statement,

Blue Apron adopted a charter-based Federal Forum Provision.

On September 1, 2017, nominal defendant Roku, Inc. filed a registration statement with the SEC for its shares of common stock and launched an initial public offering. Roku is a Delaware corporation. Before filing its registration statement, Roku adopted a charter-

federal claims from state court to be proper and with others finding that these federal claims must be remanded to state court.”).

32 Compare, e.g., Fortunato v. Akebia Therapeutics, Inc., 183 F. Supp. 3d 326 (D. Mass. 2016) (granting motion to remand), with Brody v. Homestore, Inc., 240 F. Supp. 2d 1122 (C.D. Cal. 2003) (denying motion to remand). See generally Niitsoo v. Alpha Nat. Res., 902 F. Supp. 2d 797, 800–807 (S.D.W. Va. 2012) (pre-Cyan discussion of multiple ways to interpret SLUSA’s jurisdictional and removal provisions).

33 See Donimirski Aff., Ex. A at 3 (presentation summarizing perceived advantages for defendants of litigating in federal court and concerns raised by litigating in state court).

34 See id. at 2; see also id. at 10–11.

12 based Federal Forum Provision.

On October 19, 2017, Stitch Fix, Inc. filed a registration statement with the SEC for its shares of common stock and launched an initial public offering. Stitch Fix is a Delaware corporation. Before filing its registration statement, Stitch Fix adopted a charter-based

Federal Forum Provision.

Roku and Stitch Fix adopted substantively identical provisions:

Unless the Company consents in writing to the selection of an alternative forum, the federal district courts of the United States of America shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act of 1933. Any person or entity purchasing or otherwise acquiring any interest in any security of the Corporation shall be deemed to have notice of and consented to [this provision].35

Blue Apron hedged a bit. Its provision states that “the federal district courts of the United

States of America shall, to the fullest extent permitted by law, be the sole and exclusive forum for the resolution of any complaint asserting a cause of action arising under the

Securities Act of 1933.”36 Except for this phrase, its provision tracked the other two.

C. This Litigation Plaintiff Matthew Sciabacucchi bought shares of common stock under each nominal defendant’s registration statement, either in the initial public offering or shortly thereafter.

He therefore could sue under Section 11 of the 1933 Act to address any material

35 Compl. ¶¶ 15–16.

36 Id. ¶ 14 (emphasis added).

13 misstatements or omissions in the registration statements.37 He likewise could sue under

Section 12(a)(1) to enforce the 1933 Act’s registration requirements.38 He potentially could sue under Section 12(a)(2) over a material misstatement or omission in a prospectus.39

On December 29, 2017, Sciabacucchi filed this action. His complaint named as defendants twenty individuals who signed the registration statements for Blue Apron,

Stitch Fix, and Roku and who have served as their directors since they went public. His complaint sought a declaratory judgment that the Federal Forum Provisions are invalid.

D. The Supreme Court of the United States Interprets SLUSA. On March 20, 2018, the Supreme Court of the United States resolved the split in

37 See DeMaria v. Andersen, 318 F.3d 170, 176 (2d. Cir. 2003) (“[W]here there has been only one stock offering, any person who acquires the security may sue under § 11, ‘regardless of whether he bought in the initial offering, a week later, or a month after that.’” (quoting Hertzberg v. Dignity P’rs, Inc., 191 F.3d 1076, 1080 (9th Cir. 1999)).

38 See Pinter, 486 U.S. at 642 (“[T]he language of § 12(1) contemplates a buyer- seller relationship not unlike traditional contractual privity. Thus, it is settled that § 12(1) imposes liability on the owner who passed title, or other interest in the security, to the buyer for value.”).

39 “There is no clear appellate authority as to whether aftermarket purchasers may have § 12(a)(2) standing.” In re Wash. Mut., Inc. Sec., Deriv. & ERISA Litig., 694 F. Supp. 2d 1192, 1225 (W.D. Wash. 2009). Compare In re Wells Fargo Mortgage-Backed Certificates Litig., 712 F. Supp. 2d 958, 966 (N.D. Cal. 2010) (“Unlike Section 11, which permits an action by a plaintiff who has purchased a security that is merely ‘traceable to’ the challenged misstatement or omission, Section 12(a)(2) requires a plaintiff to plead and prove that it purchased a security directly from the issuer as part of the initial offering, rather than in the secondary market.”), with Feiner v. SS & C Techs., Inc., 47 F. Supp. 2d 250, 253 (D. Conn. 1999) (“This court now holds that § 12(a)(2) extends to aftermarket trading of a publicly offered security, so long as that aftermarket trading occurs ‘by means of a prospectus or oral communication.’” (quoting 15 U.S.C. § 77l(a)(2)). See generally Primo v. Pac. Biosciences of Cal., Inc., 940 F. Supp. 2d 1105, 1124 (N.D. Cal. 2013) (describing split in authority).

14 federal authority over SLUSA’s implications for the jurisdictional and removal provisions in the 1933 Act. The justices held that class actions filed in state court which asserted violations of the 1933 Act could not be removed to federal court.40 After the decision, under the federal regime, a plaintiff wishing to sue under the 1933 Act could maintain an action in either state or federal court.

II. LEGAL ANALYSIS The parties have filed cross motions for summary judgment. Summary judgment may be granted if the moving party demonstrates that there is “no genuine issue as to any material fact” and that it is “entitled to a judgment as a matter of law.”41 A facial challenge to the Federal Forum Provisions presents a question of law suitable for disposition on a motion for summary judgment.42

A. Existing Law Indicates That The Federal Forum Provisions Are Ineffective. The practice of including forum-selection provisions in the constitutive documents of a corporation is a relatively recent development.43 The arc of the law in this area provides

40 Cyan, 138 S. Ct. at 1069.

41 Ct. Ch. R. 56(c).

42 See ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 557 (Del. 2014) (addressing certified question regarding facial validity of fee-shifting bylaw as a matter of law); Solak v. Sarowitz, 153 A.3d 729, 740 (Del. Ch. 2016) (deciding facial challenge to fee-shifting bylaw as a matter of law in context of a Rule 12(b)(6) motion to dismiss); Boilermakers, 73 A.3d at 938–39 (addressing facial validity of forum-selection bylaw as a matter of law in ruling on Rule 12(c) motion for judgment on the pleadings).

43 See, e.g., Helen Hershkoff & Marcel Kahan, Forum-Selection Provisions in Corporate “Contracts”, 93 Wash. L. Rev. 265, 267 (2018) (describing the “emergent practice” of “including a clause in a corporation’s charter or bylaws that specifies and so 15 insight into the permissible scope of forum-selection provisions. The authorities indicate that the Federal Forum Provisions cannot accomplish what they attempt to achieve.

The Origins Of The Corporate Forum-Selection Phenomenon The impetus for corporate forum-selection provisions came from an epidemic of stockholder litigation, in which competing plaintiffs filed a bevy of lawsuits, often in different multiple jurisdictions, before settling for non-monetary relief and an award of attorneys’ fees.44 These frequently meritless cases imposed costs on corporations and society without concomitant benefit. Courts had to expend resources coordinating the actions and processing non-substantive settlements.45

limits where lawsuits may be filed”); George S. Geis, Ex-Ante Corporate Governance, 41 J. Corp. L. 609, 611 (2016) (“Long neglected, bylaws are gaining new attention as a vehicle for expanding, constraining, or channeling power in the corporate ecosystem.”); Verity Winship, Shareholder Litigation by Contract, 96 B.U. L. Rev. 486, 487 (2016) [hereinafter Shareholder Litigation] (tracing development of “corporate contract procedure,” including forum-selection provisions).

44 See, e.g., Verity Winship, Contracting Around Securities Litigation: Some Thoughts on the Scope of Litigation Bylaws, 68 SMU L. Rev. 913, 914 (2015) [hereinafter Contracting] (describing “[a] particular litigation pattern [that] triggered the development of these clauses”). See generally Edward B. Micheletti & Jenness E. Parker, Multi- Jurisdictional Litigation: Who Caused This Problem, and Can It Be Fixed?, 37 Del. J. Corp. L. 1, 6–14 (2016).

45 See generally In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 891–99 (Del. Ch. 2016); Jill E. Fisch, Sean J. Griffith & Steven Davidoff Solomon, Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform, 93 Tex. L. Rev. 557, 557–72 (2015); Browning Jeffries, The Plaintiffs’ Lawyer’s Transaction Tax: The New Cost of Doing Business in Public Company Deals, 11 Berkeley Bus. L.J. 55, 66–91 (2014); Sean J. Griffith & Alexandra D. Lahav, The Market for Preclusion in Merger Litigation, 66 Vand. L. Rev. 1053, 1060–73 (2013).

16

In Revlon,46 I replaced class counsel for failing to provide adequate representation when agreeing to a non-substantive settlement. When discussing the policy rationale for this outcome, I posited that “[a]ll else equal, the threat of replacement should cause representative counsel to invest more significantly in individual cases, which in turn should lead representative counsel to analyze cases to identify actions whose potential merit justifies the investment.”47 But I recognized that if Delaware sought to regulate abusive litigation, then plaintiffs’ counsel might “accelerate their efforts to populate their portfolios by filing in other jurisdictions.”48 As a possible response, I suggested: “If they do, and if boards of directors and stockholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.”49

46 In re Revlon, Inc. S’holders Litig., 990 A.2d 940 (Del. Ch. 2010).

47 Id. at 960.

48 Id. (citing Anywhere But Chancery: Ted Mirvis Sounds an Alarm and Suggests Some Solutions, M&A J. May 2007, at 17, 17).

49 Id. (citing 8 Del. C. § 102(b)(1)). I focused on charter-based provisions because I harbored concern about Sections 102(a)(4) and 151(a) of the DGCL, which generally require that any qualifications, limitations, or restrictions on the rights, powers, and preferences of shares appear in the certificate of incorporation. See 8 Del. C. §§ 102(a)(4), 151(a). Stockholders possess three fundamental rights: to vote, sell, and sue. Strougo v. Hollander, 111 A.3d 590, 595 n.21 (Del. Ch. 2015). It seemed arguable that a forum- selection provision constituted a limitation or restriction on the right to sue that needed to appear in the charter. Although Section 109(b) of the DGCL permits bylaws “relating to” a wide range of subjects, including “the rights or powers of [the] stockholders,” that section recognizes that a bylaw cannot be “inconsistent with law or with the certificate of incorporation . . . .” 8 Del. C. § 109(b). “For purposes of evaluating the statutory validity of a bylaw, therefore, it is not enough to measure it only against the ‘relating to’ language 17

Because the Revlon case did not involve a forum-selection provision, I observed that “[t]he issues implicated by an exclusive forum selection provision must await resolution in an appropriate case.”50 It was nevertheless my expectation that a forum- selection provision implemented through the corporation’s constitutive documents only would extend to “intra-entity disputes.”51

The Revlon dictum appears to have stirred practitioners and their clients to adopt

of Section 109(b). It is also necessary to consider what other sections of the DGCL say about the matter.” Sinchareonkul v. Fahnemann, 2015 WL 292314, at *7 (Del. Ch. Jan. 22, 2015). To avoid hazarding a view on the viability of a bylaw-based forum-selection provision, I only referred to charter provisions, where these statutory issues did not arise.

Arguments about the locus of forum-selection provisions evolved in a different direction. Rather than considering Sections 102(a)(4) and 151, the arguments prioritized the different approvals required for implementation or removal. Subsequent Court of Chancery decisions held that a bylaw-based forum-selection provision represented a statutorily valid exercise of authority under Section 109(b). See City of Providence v. First Citizen BancShares, Inc., 99 A.3d 229, 233–34 (Del. Ch. 2014); Boilermakers, 73 A.3d at 951–56. Although these holdings did not address Sections 102(a)(4) or 151, the Boilermakers decision cited the distinction between bylaws that validly establish procedural requirements and those that invalidly attempt to impose substantive limitations. 73 A.3d at 951–52 (citing CA, Inc. v. AFSCME Empls. Pension Plan, 953 A.2d 227, 236– 37 (Del. 2008)). In my view, the same distinction would apply for purposes of Sections 102(a)(4) and 151. Under these provisions, a substantive limitation must appear in the charter; a procedural regulation can appear in the bylaws. See CA, 953 A.2d at 235 (describing bylaws as “procedural” and “process-oriented”).

The General Assembly has now authorized both charter-based and bylaw-based forum-selection provisions, rendering moot any concern about Sections 102(a)(4) or 151 for these clauses. See 8 Del. C. § 115. The implications of Sections 102(a)(4) and 151 remain salient for other types of provisions. See Geis, supra, at 640–42.

50 Revlon, 990 A.2d at 960 n.8.

51 See id. at 960.

18 forum-selection provisions.52 Before Revlon, forum-selection provisions appeared in the charters or bylaws of sixteen publicly traded companies.53 A year later, approximately 195 public companies had either adopted forum-selection provisions or proposed them.54 By

August 2014, 746 publicly traded corporations had adopted them.55

Boilermakers In 2013, while serving as Chancellor, Chief Justice Strine issued the seminal decision on the validity of forum-selection provisions in the corporate contract. FedEx

Corporation and Chevron Corporation had both adopted forum-selection bylaws. In

Boilermakers, stockholders challenged these provisions, asserting that the corporations lacked authority to adopt them under Section 109(b) of the DGCL.

The FedEx bylaw stated:

Unless the Corporation consents in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and

52 See, e.g., Winship, Contracting, at 915 (positing that corporations and their advisors responded to the Revlon dictum); Joseph A. Grundfest, The History and Evolution of Intra-Corporate Forum Selection Clauses: An Empirical Analysis, 37 Del. J. Corp. L. 333, 339 (2012) (“During the fifteen months between Revlon’s issuance on March 16, 2010, and the June 30, 2011 cut-off date for this Article’s data analysis, the population of publicly traded entities with intra-corporate forum selection clauses in their organic documents more than octupled, increasing from 16 to 133.”).

53 Grundfest, supra, at 336.

54 Dominick T. Gattuso & Meghan A. Adams, Delaware Insider: Forum Selection Provisions in Corporate Charters and Bylaws: Validity vs. Enforceability, Bus. L. Today, Dec. 2013, at 1, 1.

55 See Matthew D. Cain, Jill E. Fisch, Steven Davidoff Solomon & Randall S. Thomas, The Shifting Tides of Merger Litigation, 71 Vand. L. Rev. 603, 618 (2018).

19

exclusive forum for

(i) any derivative action or proceeding brought on behalf of the Corporation,

(ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of the Corporation to the Corporation or the Corporation’s stockholders,

(iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, or

(iv) any action asserting a claim governed by the internal affairs doctrine.

Any person or entity purchasing or otherwise acquiring any interest in shares of capital stock of the Corporation shall be deemed to have notice of any consented to the provisions of this [bylaw].56

Chevron’s bylaw originally tracked FedEx’s, but in response to the lawsuit, Chevron’s board amended it in two ways. First, the amended bylaw permitted suits to be filed in any state or federal court in Delaware having jurisdiction over the subject matter and the parties.

Second, the amended bylaw would not apply unless the court in Delaware could exercise personal jurisdiction over all indispensable parties to the action.57

The defendants argued that the provisions covered four types of suits:

 Derivative suits. The issue of whether a derivative plaintiff is qualified to sue on behalf of the corporation and whether that derivative plaintiff has or is excused from making demand on the board is a matter of corporate governance, because it goes to the very nature of who may speak for the corporation.

 Fiduciary duty suits. The law of fiduciary duties regulates the

56 Boilermakers, 73 A.3d at 942 (alteration in original) (formatting added).

57 Id.

20

relationships between directors, officers, the corporation, and its stockholders.

 D.G.C.L. suits. The Delaware General Corporation Law provides the underpinning framework for all Delaware corporations. That statute goes to the core of how such corporations are governed.

 Internal affairs suits. As the U.S. Supreme Court has explained, “internal affairs,” in the context of corporate law, are those “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.”58

Although the defendants reserved the “internal affairs” label for the fourth category, all four types involved the internal affairs of a Delaware corporation. Chief Justice Strine described the categories as “all relating to internal corporate governance[.]”59

Because the forum-selection provisions appeared in the bylaws, Chief Justice Strine examined their facial validity under Section 109(b). At the time, this statutory provision stated: “The bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.”60

58 Id. at 943 (quoting Defs.’ Opening Br. 30–31 (quoting Edgar v. MITE Corp., 457 U.S. 624, 645 (1982))).

59 Id. at 942; accord id. at 943 (observing that the defendants’ description of the forum-selection bylaws was “consistent with what the plain language of the bylaws suggests” and that the bylaws were intended only to regulate “where internal governance suits may be brought”).

60 8 Del. C. § 109(b). As discussed later, the General Assembly amended Section 109(b) in 2015 to add a second sentence: “The bylaws may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the 21

Chief Justice Strine had no difficulty holding that the forum-selection bylaws fell within the scope of Section 109(b) because, as he repeatedly noted, they addressed internal- affairs claims:

As a matter of easy linguistics, the forum selection bylaws address the “rights” of the stockholders, because they regulate where stockholders can exercise their right to bring certain internal affairs claims against the corporation and its directors and officers. They also plainly relate to the conduct of the corporation by channeling internal affairs cases into the courts of the state of incorporation, providing for the opportunity to have internal affairs cases resolved authoritatively by our Supreme Court if any party wishes to take an appeal. That is, because the forum selection bylaws address internal affairs claims, the subject matter of the actions the bylaws govern relates quintessentially to “the corporation’s business, the conduct of its affairs, and the rights of its stockholders [qua stockholders].”61

Notably, Chief Justice Strine did not stop with the statutory language—“rights of its stockholders”—but emphasized that the forum-selection bylaws governed the rights of

“stockholders qua stockholders.”

Consistent with this point of emphasis, Chief Justice Strine provided two examples of the causes of action that a bylaw could not regulate:

By contrast, the bylaws would be regulating external matters if the board adopted a bylaw that purported to bind a plaintiff, even a stockholder plaintiff, who sought to bring a tort claim against the company based on a personal injury she suffered that occurred on the company’s premises or a contract claim based on a commercial contract with the corporation.62

corporation or any other party in connection with an internal corporate claim, as defined in § 115 of this title.”

61 Boilermakers, 73 A.3d at 950–51 (alteration in original) (footnotes omitted) (quoting 8 Del. C. § 109(b)).

62 Id. at 952.

22

Leaving no doubt that a bylaw could not regulate cases of this type, Chief Justice Strine stated: “The reason why those kinds of bylaws would be beyond the statutory language of

8 Del. C. § 109(b) is obvious: the bylaws would not deal with the rights and powers of the plaintiff-stockholder as a stockholder.”63 Later in the opinion, Chief Justice Strine emphasized that the bylaws did not purport “in any way to foreclose a plaintiff from exercising any statutory right of action created by the federal government.”64

Boilermakers thus validated the ability of a corporation to adopt a forum-selection provision for internal-affairs claims. The phrase “internal affairs” appears four times in the opening paragraph, and the decision as a whole deployed either those words or an equivalent concept (such as “internal governance”) over forty times. The decision also drew a line at internal-affairs claims. When describing cases where it would be “obvious” that a forum-selection provision would not apply, the decision cited causes of action that did not involve internal affairs, such as tort or contract claims that did not depend on the stockholder’s rights qua stockholder.

ATP After Boilermakers, commentators debated whether charter and bylaw provisions could regulate other aspects of stockholder litigation.65 In ATP, the Delaware Supreme

63 Id.

64 Id. at 962.

65 See, e.g., Alison Frankel, Wake Up, Shareholders! Your Right to Sue Corporations May Be in Danger, Reuters, June 25, 2013, https://www.reuters.com/article/ us-column-frankel-shareholders-idUSBRE95O1HO20130625 (positing that “[a] company 23

Court moved beyond forum selection by upholding the validity of a fee-shifting provision in the bylaws of a non-stock corporation that applied to “intra-corporate litigation.”66

The ATP decision addressed four questions of law that the United States District

Court for the District of Delaware had certified to the Delaware Supreme Court.67 The underlying suit involved a membership corporation that operated a men’s tennis league

(the “League”). The League’s members included entities that owned and operated tournaments. Two members sued the League after the board of directors made changes to the tour schedule.68 The plaintiffs asserted federal antitrust claims and state law claims for breach of fiduciary duty, tortious interference with contract, and conversion.69 The district court granted the League’s motion for judgment as a matter of law on the state law claims, and a jury found in the League’s favor on the antitrust claims.70

could evade the SEC’s IPO strictures by imposing mandatory shareholder arbitration through a bylaw amendment rather than in a charter, pointing to [the] language [in Boilermakers] on shareholders’ implicit contractual consent. Then, when shareholders claimed their statutory rights were cut off because they couldn’t vindicate securities fraud or breach-of-duty claims through individual arbitration, the corporation could point to [American Express Co. v. Italian Colors Restaurant, 570 U.S. 228 (2013)] and say, ‘Tough luck.’”).

66 See ATP, 91 A.3d at 555. Later, the Delaware Supreme Court observed that “[a] bylaw that allocates risk among parties in intra-corporate litigation” would satisfy the requirements of Section 109(b). Id. at 558.

67 Id. at 557.

68 Id. at 556.

69 See Winship, Shareholder Litigation, at 508 (describing complaint).

70 See id. (describing trial court outcome).

24

Having prevailed on all counts, the League moved to recover $17,865,504.51 in expenses.71 As the sole basis for its recovery, the League relied on the following bylaw:

In the event that (i) any Claiming Party initiates or asserts any Claim . . . against the League or any member or owners (including any Claim purportedly filed on behalf of the League or any member), and (ii) the Claiming Party . . . does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the League and any such member or Owners for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) . . . that the parties may incur in connection with such Claim.72

The district court denied the application, observing that the League had cited “no case in which a court held that a board-adopted corporate bylaw can form the basis for the recovery of attorney’s fees from members who sue the corporation, much less in actions where the bylaws are not directly in the dispute.”73 The district court also noted that the bylaw had been “adopted only after the plaintiff became a member of the corporation”74 and “less than five months before the complaint in this case was filed,” at a time when the League’s board was discussing the events giving rise to the litigation.75 In the dispositive portion of its analysis, the court reasoned that “allowing antitrust defendants to collect attorneys’ fees

71 Deutscher Tennis Bund v. ATP Tour, Inc., 2009 WL 3367041, at *1 (D. Del. Oct. 19, 2009), vacated, 480 Fed. App’x 124 (3d Cir. 2012).

72 Id.

73 Id. at *3.

74 Id.

75 Id. at *4 n.4.

25 in this case would be contrary both to longstanding Third Circuit precedent and to the policies underlying the federal antitrust laws.”76

On appeal, in a per curiam ruling, the United States Court of Appeals for the Third

Circuit reversed. The Court of Appeals held that the district court should have determined whether the fee-shifting bylaw was enforceable under Delaware law before considering whether it was preempted by the antitrust laws.77 The Court of Appeals expressed “doubts that Delaware courts would conclude that Article 23.3 imposes a legally enforceable burden on [the plaintiffs].”78

After the remand, the district court certified four questions to the Delaware

Supreme Court:

1. May the Board of a Delaware non-stock corporation lawfully adopt a bylaw (i) that applies in the event that a member brings a claim against another member, a member sues the corporation, or the corporation sues a member (ii) pursuant to which the claimant is obligated to pay for “all fees, costs, and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses)” of the party against which the claim is made in the event that the claimant “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought”?

76 See id. at *3 (citing Byram Concretetanks, Inc. v. Warren Concrete Prods. Co., 374 F.2d 649, 651 (3d Cir. 1967)).

77 Deutscher Tennis Bund v. ATP Tour, Inc., 480 Fed. App’x 124, 127 (3d Cir. 2012) (“Because a determination that Article 23.3 is invalid under Delaware law would allow us (and the District Court) to avoid the constitutional question of preemption, it is an independent state law ground. Consequently, the by-law validity issue needs to be addressed, and a finding of validity must be made, before the constitutional issue of preemption can be considered.”).

78 Id.

26

2. May such a bylaw be lawfully enforced against a member that obtains no relief at all on its claims against the corporation, even if the bylaw might be unenforceable in a different situation where the member obtains some relief?

3. Is such a bylaw rendered unenforceable as a matter of law if one or more Board members subjectively intended the adoption of the bylaw to deter legal challenges by members to other potential corporate action then under consideration?

4. Is such a bylaw enforceable against a member if it was adopted after the member had joined the corporation, but where the member had agreed to be bound by the corporation’s rules “that may be adopted and/or amended from time to time” by the corporation’s Board, and where the member was a member at the time that it commenced the lawsuit against the corporation?79

The Delaware Supreme Court answered the first, second, and fourth question in the affirmative, but held that it could not answer the third question as a matter of law.

When addressing the first question, the Delaware Supreme Court held that the bylaw fell within the scope of Section 109(b) of the DGCL. As the high court explained, “[a] bylaw that allocates risk among parties in intra-corporate litigation would . . . appear to satisfy the DGCL’s requirement that bylaws must ‘relat[e] to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.’”80 The court therefore concluded that the fee-shifting bylaw was a facially valid exercise of corporate authority.

For present purposes, the Delaware Supreme Court’s repeated references to “intra-

79 ATP, 91 A.3d at 557.

80 Id. at 558 (quoting 8 Del. C. § 109(b)).

27 corporate litigation” are important.81 Although the plaintiffs in the underlying action also asserted claims for antitrust violations, tortious interference, and conversion, the Delaware

Supreme Court interpreted the certified question as only asking about the validity of the bylaw for purposes of “intra-corporate litigation.”82 The Delaware Supreme Court then held that the bylaw was facially valid because it “allocate[d] risk among parties in intra- corporate litigation . . . .”83 The Delaware Supreme Court did not suggest that that the corporate contract can be used to regulate other types of claims.

The 2015 Amendments In 2015, the Corporation Law Council of the Delaware State Bar Association recommended that the General Assembly enact legislation that addressed both forum- selection provisions and fee-shifting provisions.84 The General Assembly responded by

81 See id. at 555, 557–558.

82 Id. at 557 (“The first certified question asks whether the board of a Delaware non- stock corporation may lawfully adopt a bylaw that shifts all litigation expenses to a plaintiff in intra-corporate litigation who ‘does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.’” (footnotes omitted)).

83 Id. at 558; see Henry duPont Ridgely, The Emerging Role of Bylaws in Corporate Governance, 68 SMU L. Rev. 317, 325 (2015) (describing the ATP ruling as addressing a bylaw involving “an intra-corporate suit”); Ann M. Lipton, Manufactured Consent: The Problem of Arbitration Clauses in Corporate Charters and Bylaws, 104 Geo. L.J. 583, 599 (2016) (“ATP Tour likewise limited its discussion of fee-shifting bylaws only to claims concerning intra-corporate litigation (an oddity to be sure, because the bylaw at issue purported to extend to any claim brought by a member, and the case was certified to the Delaware Supreme Court out of concern for the bylaw’s application to the antitrust laws).” (footnotes omitted)).

84 See Corporation Law Council, Explanation of Council Legislative Proposal (2015) [hereinafter Explanation of Council], available at Dkt. 26, Tab 7.

28 adding Section 115 to the DGCL and amending Sections 102 and 109.85

The new Section 115 addressed the ability of Delaware corporations to adopt forum-selection provisions in their charters and bylaws. It states:

The certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State, and no provision of the certificate of incorporation or the bylaws may prohibit bringing such claims in the courts of this State.

“Internal corporate claims” means claims, including claims in the right of the corporation, (i) that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.86

The General Assembly thus addressed only “internal corporate claims,” defined to encompass claims covered by the internal-affairs doctrine.87

Through the adoption of Section 115, the General Assembly codified the ruling in

Boilermakers.88 When describing the intent of that provision before recommending it to the General Assembly, the Corporation Law Council stated that “[t]he proposed legislation

85 See Del. S.B. 75 syn., 148th Gen. Assem. (2015).

86 8 Del. C. § 115 (formatting added).

87 See generally Lawrence A. Hamermesh & Norman M. Monhait, Fee-Shifting Bylaw: A Study in Federalism, Institute of Delaware Corporate and Business Law (June 29, 2015) (“By its terms, the legislation only applies to bylaws that provide for fee-shifting in connection with ‘internal corporate claims.’”), http://blogs.law.widener.edu/delcorp/201 5/06/29/fee-shifting-bylaws-a-study-in-federalism/.

88 Solak, 153 A.3d at 732 (“In 2015, Section 115 was added to the [DGCL], codifying this Court’s decision in Boilermakers . . . .”).

29 would give statutory force to the Boilermakers decision.”89 The synopsis of the bill expanded on this statement:

New Section 115 confirms, as held in [Boilermakers], that the certificate of incorporation and bylaws of the corporation may effectively specify, consistent with applicable jurisdictional requirements, that claims arising under the DGCL, including claims of breach of fiduciary duty by current or former directors or officers or controlling stockholders of the corporation, or persons who aid and abet such a breach, must be brought only in the courts (including the federal court) in this State.90

As the parties recognize, Section 115 does not say explicitly that the charter or bylaws cannot include forum-selection provisions addressing other types of claims. The omission comports with the precedent leading up to Section 115, which recognized that the charter and bylaws can only address internal-affairs claims. Two past presidents and leading members of the Corporation Law Council have said as much. Responding to a debate about whether Section 115 permits Delaware corporations to adopt charter or bylaw provisions that would regulate securities law claims, they agreed that a securities law claim is not an “internal corporate claim” within the meaning of the amendments.91 But they regarded that fact as beside the point, because the corporate charter and bylaws could not be used to regulate external claims.92 They explained that in light of these views, the

89 Explanation of Council, supra, at 9.

90 Del. S.B. 75 syn., 148th Gen. Assem. (2015).

91 See generally Hamermesh & Monhait, supra.

92 See id. (“[S]ections 102(b)(1) and 109(b) cannot be read, despite their breadth and the presumptive validity of provisions adopted pursuant to them, to authorize provisions regulating litigation under the federal securities laws.”); id. (“[T]he subject matter scope of Sections 102(b)(1) and 109(b) is broad. But it is not limitless . . . . And in our view, it does 30

Council “saw no reason for a statutory amendment that purported to reach beyond the confines of internal governance litigation . . . .”93

In addition to enacting Section 115 to codify Boilermakers, the General Assembly amended Sections 102 and 109 to “limit ATP to its facts . . . .”94 Together, the amended sections ban fee-shifting provisions from both the charter and the bylaws. To address charter-based provisions, the General Assembly adopted a new Section 102(f), which states: “The certificate of incorporation may not contain any provision that would impose liability on a stockholder for attorneys’ fees or expenses of the corporation, or any other party in connection with an internal corporate claim, as defined in § 115 of this title.”95 To address bylaw-based provisions, the General Assembly added a sentence to Section 109(b), which states: “The bylaws may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim, as defined in § 115 of this title.”

The amendments to Sections 102 and 109 reinforce the conclusion that the

not extend so far as to permit the charter or the bylaws to create a power to bind stockholders in regard to fee-shifting in, or the venue for, federal securities class actions.”).

93 Id.

94 See Solak, 153 A.3d at 734 (“Within one year of the ATP decision, the Corporation Law Council of the Delaware State Bar Association proposed legislation to ‘limit ATP to its facts’ and prevent the boards of Delaware stock corporations from adopting fee-shifting bylaws.” (quoting Explanation of Council, supra, at 12)); see also Explanation of Council, supra, at 4–6, 9 (explaining Corporation Law Council’s rationale for proposing ban on fee- shifting provisions).

95 8 Del. C. § 102(f).

31

Corporation Law Council and the General Assembly only believed that the charter and bylaws could regulate internal corporate claims. Their overarching policy goal was to ban fee-shifting provisions from the corporate contract.96 If they thought that the charter or bylaws could regulate other types of claims, then the prohibitions would have swept more broadly. The drafters would not have taken the half measure of banning fee-shifting provisions for a subset of claims, thereby permitting experimentation in other areas.

Implications For This Case The development of the law governing forum-selection provisions indicates that the nominal defendants cannot use the Federal Forum Provisions to specify a forum for 1933

Act claims.

First, the reasoning in Boilermakers applies equally to a charter-based provision.

The language of Section 102(b)(1) states:

In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters:

(1) Any provision for the management of the business and for the conduct of the affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, or the governing body, members, or any class or group of members of a nonstock corporation; if such provisions are not contrary to the laws of this State. Any provision which is required or permitted by any section of this chapter to be stated in the bylaws may instead be stated in the certificate of incorporation . . . .97

96 See Solak, 153 A.3d at 741–42.

97 8 Del. C. § 102(b)(1).

32

As leading commentators have observed, “[t]he language of Section 109(b) dealing with the subject matter of bylaws parallels in large measure the language of Section 102(b)(1) dealing with what may be included in a certificate of incorporation.”98 Stitch Fix and Roku agree that “[a]lthough there are subtle differences between the language of Sections

102(b)(1) and 109(b), the provisions are generally viewed as covering the same broad subject matter.”99

To reiterate, the authorizing language of Section 109(b) states that “[t]he bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to [1] the business of the corporation, [2] the conduct of its affairs, and [3] its rights or powers or [4] the rights or powers of its stockholders, directors, officers or employees.”100 Although its phrasing differs slightly, Section 102(b)(1) permits the certificate of incorporation to address the same subjects:

[1 & 2] [T]he management of the business and for the conduct of the affairs of the corporation, and [3 & 4] any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders . . . if such provisions are not contrary to the laws of this State.101

98 1 David A. Drexler et al., Delaware Corporation Law and Practice § 9.03, at 9- 5 to -6 (2018) (footnote omitted); see Strougo, 111 A.3d at 599 n.42 (interpreting Section 109(b) but noting that “[a]n equivalent limitation would apply to charter provisions” because of the comparable scope of Sections 109(b) and 102(b)(1)).

99 Dkt. 18, at 20 n.14.

100 8 Del. C. § 109(b).

101 8 Del. C. § 102(b)(1).

33

If anything, Section 109(b) is slightly broader, because it includes “employees,” whom

Section 102(b)(1) does not mention.

The parallelism between Sections 109(b) and 102(b)(1) means that Chief Justice

Strine’s distinction in Boilermakers between internal and external claims applies equally to charter-based provisions. Such a provision cannot “bind a plaintiff, even a stockholder plaintiff, who sought to bring a tort claim against the company based on a personal injury she suffered that occurred on the company’s premises or a contract claim based on a commercial contract with the corporation.”102 A charter-based forum-selection provision cannot govern these claims because the provision would not be addressing “the rights and powers of the plaintiff-stockholder as a stockholder.”103

This reasoning applies fully to claims under the 1933 Act, which assert specialized and wholly statutory causes of action:

Although limited in scope, Section 11 [of the 1933 Act] places a relatively minimal burden on a plaintiff. In contrast, Section 10(b) [of the Securities and Exchange Act of 1934] is a “catchall” antifraud provision, but it requires a plaintiff to carry a heavier burden to establish a cause of action. While a Section 11 action must be brought by a purchaser of a registered security, must be based on misstatements or omissions in a registration statement, and can only be brought against certain parties, a Section 10(b) action can be brought by a purchaser or seller of “any security” against “any person” who has used “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security. However, [unlike with a

102 See Boilermakers, 73 A.3d at 952.

103 See id.

34

Section 11 claim,] a Section 10(b) plaintiff . . . . must prove that the defendant acted with scienter . . . .104

A plaintiff asserting a violation of the 1933 Act need only contend either that (i) the registration statement or prospectus contained a material misstatement or omission

(Sections 11 & 12(a)(2))105 or (ii) the issuer “wrongful[ly] fail[ed] to register securities before offering them for sale” (Section 12(a)(1)).106 The distinct nature of a claim based on a defective registration statement demonstrates its external status.

The identity of the possible defendants for a 1933 Act claim further demonstrates that the claim is not internal to the corporation. Under Section 11 of the 1933 Act, a plaintiff may sue:

 “every person who signed the registration statement”;

 “every person who was a director of (or person performing similar functions) or partner of the issuer at the time of the filing of the part of the registration statement with respect to which his liability is asserted”;

 “every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner”;

 “every accountant, engineer, appraiser, or any person whose profession gives authority to a statement made by him, who has with his consent been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report which is used in connection with the registration statement, with respect to the statement in such registration

104 Huddleston, 459 U.S. at 382 (citation and footnote omitted).

105 See Gustafson, 513 U.S. at 571.

106 See Pinter, 486 U.S. at 638.

35

statement, report, or valuation, which purports to have been prepared or certified by him”; and

 “every underwriter with respect to such security.”107

Director status is not required. Officer status is not required. An internal role with the corporation is not required.

The definition of a “security” underscores the absence of any meaningful connection between a 1933 Act claim and stockholder status. A share of stock can be a “security,” but the 1933 Act defines that term far more broadly:

The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.108

Depending on how one counts the cross-referenced categories, this definition could identify as few as fifty or as many as 369 different types of securities. Shares are just one of these many types of securities, and shares of a Delaware corporation are only one subset of that one type. There is no necessary connection between a 1933 Act claim and the shares

107 15 U.S.C. § 77k(a).

108 15 U.S.C. § 77b(a)(1).

36 of a Delaware corporation.

Finally, even when the investor does purchase a share of stock (as opposed to a different kind of security), the predicate act is the purchase.109 The cause of action does not arise out of or relate to the ownership of the share, but rather from the purchase of the share.

At the moment the predicate act of purchasing occurs, the purchaser is not yet a stockholder and does not yet have any relationship with the corporation that is governed by Delaware corporate law. Nor must the purchaser continue to own the security to be able to assert a claim under the 1933 Act: the plaintiff can sue even if it subsequently sells and is no longer a stockholder.110

For purposes of the analysis in Boilermakers, a 1933 Act claim resembles a tort or contract claim brought by a third-party plaintiff who was not a stockholder at the time the claim arose. At best for the defendants, a 1933 Act claim resembles a tort or contract claim brought by a plaintiff who happens also to be a stockholder, but under circumstances where stockholder status is incidental to the claim. A 1933 Act claim is an external claim that falls

109 See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 752 (1975) (“[T]he 1934 Act . . . is general in scope but chiefly concerned with the regulation of post- distribution trading on the Nation’s stock exchanges and securities trading markets. The 1933 Act is a far narrower statute chiefly concerned with disclosure and fraud in connection with offerings of securities—primarily . . . initial distributions of newly issued stock from corporate issuers.”).

110 See 15 U.S.C. § 77k(e) (“The suit authorized under [Section 11] may be to recover such damages as shall represent the difference between the amount paid for the security (not exceeding the price at which the security was offered to the public) and (1) the value thereof as of the time such suit was brought, or (2) the price at which such security shall have been disposed of in the market before suit . . . .” (emphasis added)).

37 outside the scope of the corporate contract.

Under existing Delaware authority, a Delaware corporation does not have the power to adopt in its charter or bylaws a forum-selection provision that governs external claims.

The Federal Forum Provisions purport to regulate the forum in which parties external to the corporation (purchasers of securities) can sue under a body of law external to the corporate contract (the 1933 Act). They cannot accomplish that feat, rendering the provisions ineffective.

B. First Principles Indicate That The Federal Forum Provisions Are Ineffective. As discussed in the preceding section, the seminal Boilermakers decision and other extant authorities indicate that a Delaware corporation cannot use its charter or bylaws to regulate the forum in which parties bring external claims, such as federal securities law claims. The defendants argue that these authorities are distinguishable because they do not speak to the Federal Forum Provisions, which present an issue of first impression. The same result derives from first principles.

The defendants ask the court to start with the plain language of Section 102(b)(1), and they argue that its phrasing is broad enough to encompass a Federal Forum Provision.

But reasoning from first principles requires more fundamental starting points: the concept of the corporation and the nature of its constitutive documents.

For purposes of Delaware law, a corporation is a legal entity—a “body corporate”—

38 created through the sovereign power of the state.111 Although the promulgation of general incorporation statutes like the DGCL has reduced the visibility of the state’s role by eliminating the need for special legislation, the issuance of a corporate charter remains a sovereign act.112 When an incorporator files a certificate of incorporation that complies with the requirements of the DGCL, the acceptance of the filing by the Delaware Secretary of State gives rise to an artificial entity having attributes that only the state can bestow, such as separate legal existence,113 presumptively perpetual life,114 and limited liability for its investors.115

111 8 Del. C. § 106 (“Upon the filing with the Secretary of State of the certificate of incorporation, executed and acknowledged in accordance with § 103 of this title, the incorporator or incorporators who signed the certificate, and such incorporator’s or incorporators’ successors and assigns, shall, from the date of such filing, be and constitute a body corporate . . . .”).

112 See Del. Const. art. IX, § 1 (“No corporation shall hereafter be created, amended, renewed or revived by special act, but only by or under general law, nor shall any existing corporate charter be amended, renewed or revived by special act, but only by or under general law; but the foregoing provisions shall not apply to municipal corporations, banks or corporations for charitable, penal, reformatory, or educational purposes, sustained in whole or in part by the State. . . .”).

113 8 Del. C. § 106.

114 8 Del. C. § 102(b)(5) (authorizing the certificate of incorporation to contain “[a] provision limiting the duration of the corporation’s existence to a specified date; otherwise, the corporation shall have perpetual existence”); 8 Del. C. § 122(1) (“Every corporation created under this chapter shall have power to: (1) Have perpetual succession by its corporate name, unless a limited period of duration is stated in its certificate of incorporation . . . .”).

115 8 Del. C. § 102(b)(6) (authorizing a provision in the certificate of incorporation to “impos[e] personal liability for the debts of the corporation on its stockholders . . .; otherwise, the stockholders of a corporation shall not be personally liable for the payment of the corporation’s debts except as they may be liable by reason of their own conduct or 39

By virtue of Delaware’s exercise of its sovereign authority, a Delaware corporation comes into existence and gains the power to act in the world. The DGCL defines what powers the corporation can exercise, identifying both general116 and specific powers117 that a Delaware corporation possesses. A Delaware corporation only can wield the powers that the DGCL provides.118 When a corporation purports to take an action that it lacks the capacity or power to accomplish, that action is ultra vires and void.119

acts”); 8 Del. C. § 162(a) (authorizing liability of stockholder or subscriber only when consideration for shares of corporation has not been paid in full and the assets of the corporation are insufficient to satisfy its creditors; limiting liability to “the amount of the unpaid balance of the consideration for which such shares were issued”).

116 See 8 Del. C. § 121.

117 See 8 Del. C. §§ 122–123.

118 Lawson v. Household Fin. Corp., 152 A. 723, 726 (Del. 1930); accord Trustees of Dartmouth College v. Woodward, 17 U.S. 518, 636 (1819) (“[A corporation] possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence.”).

119 See Carsanaro v. Bloodhound Techs., Inc., 65 A.3d 618, 648–54 (Del. Ch. 2013) (discussing the largely outdated concept of “capacity or power” and its relationship to the ultra vires doctrine), abrogated on other grounds by El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248, 1264 (Del. 2016) (rejecting Carsanaro’s analysis of post- merger derivative standing). The ultra vires doctrine is largely a relic of the past because the DGCL retains only three limitations on corporate capacity or power. See 1 R. Franklin Balotti & Jesse A. Finkelstein, The Delaware Law of Corporations and Business Organizations §§ 2.4–2.6 (3d ed. 1997 & Supp. 2013). First, with specified exceptions, no corporation formed under the DGCL after April 18, 1945, may confer academic or honorary degrees. 8 Del. C. § 125. Second, no corporation formed under the DGCL can exercise banking power. 8 Del. C. § 126(a). Third, a Delaware corporation that is designated as a private foundation under the Internal Revenue Code must comply with certain tax provisions, unless its charter provides that the restriction is inapplicable. 8 Del. C. § 127. A corporation nevertheless retains the ability to impose limitations on (and create uncertainty about) its capacity or power by including provisions in its charter that forbid it 40

The contract that gives rise to the artificial entity and confers these powers is not an ordinary private contract among private actors.120 The certificate of incorporation is a multi-party contract that includes the State of Delaware.121 Unlike an ordinary contract, a certificate of incorporation always incorporates by reference the limitations imposed by the

DGCL.122 Unlike an ordinary contract, a certificate of incorporation can only be amended

from entering into particular lines of business or engaging in particular acts. See Balotti & Finkelstein, supra, § 2.1.

120 See Hershkoff & Kahan, supra, at 277–85. As mentioned in the introduction, this decision uses the term “ordinary contract” to refer to a purely private contract between purely private parties, in which the signatories allocate their rights and obligations. Such a contract is governed by the principles set out in the Restatement (Second) of Contracts, including requirements for contract formation that include an offer, acceptance, consideration, and a meeting of the minds on material terms. See Lipton, supra, at 586 n.14 (using this definition).

121 STARR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991) (“[A] corporate charter is both a contract between the State and the corporation, and the corporation and its shareholders.”); Lawson, 152 A. at 727 (“[T]he charter of a corporation is a contract both between the corporation and the state and the corporation and its stockholders. It is not necessary to cite authorities to support this proposition.”); see Hershkoff & Kahan, supra, at 277 (“A corporation’s charter and bylaws, however, are no ordinary contracts. They are instead a hybrid between an ordinary contract and state law— they are highly regulated constitutive documents that order collective decision-making.”).

122 8 Del. C. § 121(b) (“Every corporation shall be governed by the provisions and be subject to the restricts and liabilities contained in this chapter.”); 8 Del. C. § 394 (“This chapter and all amendments thereof shall be a part of the charter or certificate of incorporation of every corporation except so far as the same are inapplicable and inappropriate to the objects of the corporation.”); see STARR Surgical, 588 A.2d at 1136 (“[I]t is a basic concept that the General Corporation Law is a part of the certificate of incorporation of every Delaware company.”); Fed. United Corp. v. Havender, 11 A.2d 331, 333 (Del. 1940) (“It is elementary that [the Delaware General Corporation Law’s] provisions are written into every corporate charter.”).

41 in compliance with the DGCL.123 Unlike an ordinary contract, a certificate of incorporation may only contain provisions authorized by the DGCL.124 Although courts enforce both types of contracts, they deploy different principles, with courts enforcing the relationships created by the corporate contract using an overlay of fiduciary duty.125

Because the state of incorporation creates the corporation, the state has the power through its corporation law to regulate the corporation’s internal affairs.126 For example, the certificate of incorporation can specify the rights, powers, and privileges of shares of stock, thereby specifying contractual rights that accompany those shares.127 It can specify

123 See 8 Del. C. §§ 241–242.

124 See Berlin v. Emerald P’rs, 552 A.2d 482, 488 (Del. 1988) (“In examining the provisions of a certificate of incorporation, courts apply the rules of contract interpretation. . . . Nevertheless, the contract rights of the stockholders of the corporation are also subject to the provisions of the Delaware General Corporation Law.”); see also Boilermakers, 73 A.3d at 940 (“[O]ur Supreme Court has long noted that bylaws, together with the certificate of incorporation and the broader DGCL, form part of a flexible contract between corporations and stockholders . . . .”); In re Activision Blizzard, Inc. S’holder Litig., 124 A.3d 1025, 1050 & n.11 (Del. Ch. 2015) (collecting authorities).

125 See, e.g., Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 370 (Del. 2006) (explaining that directors owe duties of care and loyalty and that the duty of loyalty includes “a requirement to act in good faith”); Mills Acq. Co. v. Macmillan, Inc., 559 A.2d 1261, 1280 (Del. 1989) (“[D]irectors owe fiduciary duties of care and loyalty to the corporation and its shareholders.”); Polk v. Good, 507 A.2d 531, 536 (Del. 1986) (“In performing their duties the directors owe fundamental fiduciary duties of loyalty and care to the corporation and its shareholders.”).

126 See generally Jack B. Jacobs, The Reach of State Corporation Law Beyond State Borders: Reflections Upon Federalism, 84 N.Y.U. L. Rev. 1149 (2009).

127 8 Del. C. §§ 102(a)(4), 151(a).

42 the composition and structure of the board of directors128 and what powers the board can exercise.129 When taking these actions, Delaware deploys the corporate law to determine the parameters of the property rights that the state has chosen to establish.

The power of the state of incorporation to address these matters manifests itself through the internal-affairs doctrine. No matter where the corporation conducts its operations or locates its headquarters, the law of the state of incorporation governs the entity’s internal affairs.130 The corporation’s contacts with the forum state do not affect the choice-of-law analysis because the questions are internal to the corporation.131

128 See 8 Del. C. § 141(b), (d) & (f).

129 See 8 Del. C. § 141(a) (“The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.”).

130 McDermott Inc. v. Lewis, 531 A.2d 206, 215 (Del. 1987) (“The internal affairs doctrine requires that the law of the state of incorporation should determine issues relating to internal corporate affairs.”); accord Sagarra Inversiones, S.L. v. Cementos Portland Valderrivas, S.A., 34 A.3d 1074, 1081 (Del. 2011) (“The term ‘internal affairs’ encompasses ‘those matters that pertain to the relationships among or between the corporation and its officers, directors, and shareholders.’ The [internal affairs] doctrine requires that the law of the state (or, in this case, the sovereign nation) of incorporation must govern those relationships.” (footnote omitted)); VantagePoint Venture P’rs 1996 v. Examen, Inc., 871 A.2d 1108, 1116 (Del. 2005) (“[W]e hold Delaware’s well-established choice of law rules and the federal constitution mandated that Examen’s internals, and in particular, VantagePoint’s voting rights, be adjudicated exclusively in accordance with the law of its state of incorporation, in this case, the law of Delaware.” (footnotes omitted)).

131 McDermott, 531 A.2d at 214–15 (“Corporations and individuals alike enter into contracts, commit torts, and deal in personal and real property. Choice of law decisions 43

But the state of incorporation cannot use corporate law to regulate the corporation’s external relationships. Jurisdictions invariably enact laws addressing unfair competition, employment relationships, health and welfare standards, and numerous other issues that affect a corporation’s business. When states regulate these activities, they exercise authority over actors and activities within their territorial jurisdictions (or which have a sufficient nexus with their territorial jurisdictions).132 State “blue sky” statutes, for example, extend only to securities that are offered for sale or purchased within the state.133

relating to such corporate activities are usually determined after consideration of the facts of each transaction. . . . The internal affairs doctrine has no applicability to these situations. Rather, this doctrine governs the choice of law determinations involving matters peculiar to corporations, that is, those activities concerning the relationships inter se of the corporation, its directors, officers and shareholders.”).

132 See Singer v. Magnavox Co., 380 A.2d 969, 981 (Del. 1977) (discussing the “presumption that a law is not intended to apply outside the territorial jurisdiction of the State in which it is enacted”), overruled on other grounds by Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983); Ward v. CareFusion Solutions, LLC, 2018 WL 1320225, at *2–3 (Del. Super. Mar. 13, 2018) (interpreting California Labor Code as only applying within California); Marshall v. Priceline.com Inc., 2006 WL 3175318, at *2 (Del. Super. Oct. 31, 2006) (holding that Delaware Consumer Fraud Act does not have extraterritorial effect); Carter v. Dep’t of Public Safety, 290 A.2d 652, 655 (Del. Super. 1972) (declining to interpret Delaware statute requiring the forwarding of convictions to the Delaware Division of Motor Vehicles as having extraterritorial effect).

133 See Singer, 380 A.2d at 981–82 (holding that the Delaware Securities Act is a commercial statute that applies to certain purchases or sales of securities with a “sufficient nexus” with Delaware, and that the statute did not apply simply because the issuer was a Delaware corporation, nor because the vote on the merger that resulted in the issuance took place in Delaware); FdG Logistics LLC v. A&R Logistics Hldgs., 131 A.3d 842, 846 (Del. 2016) (rejecting interpretation of choice-of-law clause that “would lead to the bizarre result of converting a blue-sky statute that the Legislature intended to regulate intrastate securities transactions into one that would regulate interstate securities transactions”); Lipton, supra, at 598 (“Unlike corporate governance (and to the extent not preempted by 44

When determining what law governs state securities law claims, state courts apply territorial principles; they “do not look to the terms of the corporate charter of the law of the state of incorporation . . . .”134

Without more, the corporate contract does not enable Delaware to regulate the activities of parties that are beyond its territorial jurisdiction. Delaware can regulate the internal affairs of its corporate creations, regardless of their location, but only their internal affairs. While serving on this court, Chief Justice Strine articulated the resulting distinction between what Delaware can regulate using its corporate law and what it cannot:

Delaware’s corporation law is not what, in a European context, might be called a broad-based company law. Aspects of company law like competition law, labor law, trade, and requirements for the filing of regular disclosures to public investors, are not part of Delaware’s corporation law. . . . Delaware corporation law governs only the internal affairs of the corporation. In that sense, our law is a specialized form of contract law that governs the relationship between corporate managers—the directors and officers—of corporations, and the stockholders.135

Put self-referentially, the corporate contract can only regulate claims involving the corporate contract. It cannot regulate external activities, nor the behavior of parties in other capacities.

In light of these principles, “there is no reason to believe that corporate governance

federal law), states regulate the offers, sales, and purchases of securities on a territorial basis.”).

134 Lipton, supra, at 598; accord Singer, 380 A.2d at 981–82.

135 Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 674 (2005).

45 documents, regulated by the law of the state of incorporation, can dictate mechanisms for bringing claims that do not concern corporate internal affairs, such as claims alleging fraud in connection with a securities sale.”136 The state cannot assert authority over other types of claims based on the corporate contract, because the claims do not arise out of internal corporate relationships, and the fact of incorporation is not a sufficient nexus to support applying the chartering state’s law to external claims.137

These first principles establish the framework within which Section 102 of the

DGCL operates. Titled “Contents of certificate of incorporation,” it specifies information that the charter must contain and identifies provisions that the charter may contain.138

Section 102(a) identifies the mandatory information.139 Section 102(b) identifies the optional provisions.140 Perhaps the most well-known option is Section 102(b)(7), which

136 Lipton, supra, at 598.

137 See Singer, 380 A.2d at 981–82 (holding that fact of Delaware incorporation was not a sufficient nexus to warrant application of Delaware Securities Act to issuance of shares in connection with merger); Marshall, 2006 WL 3175318, at *2 (“[W]hile incorporation may be enough to allow Delaware law to apply to a dispute, it is not enough to allow the [Delaware Consumer Fraud Act] to apply to fraudulent transactions which did not occur in Delaware.”).

138 8 Del. C. § 102.

139 8 Del. C. § 102(a) (“The certificate of incorporation shall set forth . . . .”).

140 See 8 Del. C. § 102(b) (“In addition to the matters required to be set forth in the certificate of information by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters . . . .”); 1 Drexler, supra, § 6.02, at 6- 8 (“While Section 102(a) lists the matters which must be covered in the certificate of a Delaware corporation, Section 102(b) identifies certain optional provisions which may be included in the certificate.”); accord 1 Balotti & Finkelstein, supra, § 1.3, at 1-5 n.18 (“[Sections] 102(a) and (b) provide an outline of the provisions that must be included in 46 permits a corporation to exculpate directors from liability for breach of the fiduciary duty of care.141

Section 102(b)(1) provides general authority for the charter to contain non- mandatory provisions.142 Leading Delaware commentators describe it as “an all-purpose provision which grants authority for a broad variety of charter provisions dealing with corporate management and the relations of stockholders inter sese.”143 Notably, they regard it as dealing with the internal affairs of the corporation. They do not mention Section

102(b)(1) authorizing the certificate of incorporation to regulate the rights that external

every charter, Section 102(a), and a listing of the subjects that may be included in the charter, Section 102(b).”).

141 See 8 Del. C. § 102(b)(7) (permitting exculpation from liability except for (i) any breach of the director's duty of loyalty; (ii) an act or omission not in good faith or involving intentional misconduct or a knowing violation of law; (iii) an unlawful dividend or stock repurchase under Section 174; and (iv) any transaction from which the director derived an improper personal benefit); Stone, 911 A.2d at 367 (explaining that a Section 102(b)(7) provision “can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty” (footnote omitted)); 1 Drexler, supra, § 6.02[7], at 6-18 (“The totality of these limitations or exemptions . . . is to eliminate . . . director liability only for ‘duty of care’ violations.”). The presence of an exculpatory provision does not eliminate the underlying duty of care or the potential for fiduciaries to breach that duty. See Malpiede v. Townson, 780 A.2d 1075, 1095 n.68 (Del. 2001); In re Walt Disney Co. Deriv. Litig., 907 A.2d 693, 752 (Del. Ch. 2005), aff’d, 906 A.2d 27 (Del. 2006). Consequently, “[t]he duty of care continues to have vitality in remedial contexts as opposed to actions for personal monetary damages against directors as individuals.” E. Norman Veasey et al., Delaware Supports Directors With a Three–Legged Stool of Limited Liability, Indemnification, and Insurance, 42 Bus. Law. 399, 403 (1987).

142 8 Del. C. § 102(b)(1).

143 1 Drexler, supra, § 6.02[1], at 6-8.

47 actors might have against the corporation.

In an effort to expand the reach of the DGCL and the scope of Section 102(b)(1), the defendants cite cases that discuss Delaware’s support for private ordering, but each of these cases focuses on the internal affairs of Delaware corporations, not external issues.144

Consistent with the scope of what Delaware can regulate through the DGCL, Section

102(b)(1) only provides authority for the charter to govern internal claims.

As discussed at length in the previous section, a federal claim under the 1933 Act is a clear example of an external claim. The plaintiff is a purchaser of securities, and the source of the cause of action is the sale of a security that violates the federal regulatory regime. The defendants need not be directors or officers of the corporation; they can be anyone that the 1933 Act identifies as a viable defendant. The fact that the plaintiff might

144 See Jones Apparel Gp. v. Maxwell Shoe Co., 883 A.2d 837, 845 (Del. Ch. 2004) (Strine, V.C.) (“As Professor Folk noted in his comments on the 1969 amendments to the DGCL, and particularly on the enabling feature of § 141(a), ‘the Delaware corporation enjoys the broadest grant of power in the English-speaking world to establish the most appropriate internal organization and structure for the enterprise.’” (emphasis added)); Sagusa, Inc. v. Magellan Petroleum Corp., 1993 WL 512487, at *2 (Del. Ch. Dec. 1, 1993) (“[T]he public policy applicable to Delaware’s corporation law is expressed in 8 Del. C. § 102(b)(1), which authorizes companies to include in their charters any corporate governance provisions that do not violate Delaware law.” (emphasis added)); Frankel v. Donovan, 120 A.2d 311, 316 (Del. Ch. 1956) (“Charter provisions which facilitate corporate action and to which a stockholder assents by becoming a stockholder are normally upheld by the court unless they contravene a principle implicit in statutory or settled decisional law governing corporate management.” (emphasis added) (citations omitted)); see also Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 118 (Del. 1952) (upholding validity of charter provision permitting interested directors to be counted for quorum purposes because it “relat[ed] to the powers of the directors in conducting the corporate business” (emphasis added)).

48 have purchased shares in a Delaware corporation is incidental to the claim; shares are but one type of security covered by the 1933 Act. Even if the purchase did involve shares, the event giving rise to the claim takes place just before the plaintiff becomes a stockholder, before the corporate contract applies. Nor is continuing stockholder status necessary to assert a 1933 Act claim: the plaintiff can sue even if it sells and is no longer a stockholder.

The federal claim does not invoke the stockholder’s legal or equitable rights under the state law corporate contract.

Despite this array of distinctions, the defendants have argued that issuing securities and defending against securities lawsuits involve the business and affairs of the corporation. That is true, but it does not follow that these matters involve the internal affairs of the corporation. Many aspects of the corporation’s business and affairs involve external relationships. The certificate of incorporation and Delaware law cannot regulate those external relationships.

The defendants have also argued that a claim under the 1933 Act involves internal corporate relationships because a Section 11 claim seeks to hold corporate officials accountable for the content of registration statements. That is also true, but the claim remains external to the corporate contract.

Reasoning from first principles generates the same result as applying Boilermakers.

The nominal defendants lack authority to use their certificates of incorporation to regulate claims under the 1933 Act. The Federal Forum Provisions are ineffective and invalid.

C. Other Arguments The plaintiff argues alternatively that the Federal Forum Provisions are invalid

49 because they “transgress . . . a public policy settled by the common law or implicit in the

General Corporation Law itself.”145 He observes that the Federal Forum Provisions take

Delaware out of its traditional lane of corporate governance and into the federal lane of securities regulation.146 The extent of the infringement in this case might not seem significant (excluding one of two forums that federal law permits), but the implications would be vast (asserting that state corporate law could be used to regulate federal claims).

The Federal Forum Provisions would thus violate Delaware public policy and be invalid.

There are also grounds to believe that because the Federal Forum Provisions conflict with the forum alternatives that the 1933 Act permits, the provisions could be preempted.147

145 Sterling, 93 A.2d at 118; see Jones Apparel, 883 A.2d at 848 (“[T]he court must determine, based on a careful, context-specific review in keeping with Sterling, whether a particular certificate provision contravenes Delaware public policy, i.e., our law, whether it be in the form of statutory or common law.”).

146 See, e.g., Myron T. Steele, Sarbanes-Oxley: The Delaware Perspective, 52 N.Y.L. Sch. L. Rev. 503, 506–07 (2008) (“[T]he focus of the federal lane has always been, and should always be, market fraud and disclosure. On the other hand, monitoring the structure of internal corporate governance is the focus of the state lane.”).

147 See Hamermesh & Monhait, supra (“[A] state authorization of charter and bylaw provisions purporting to control fee-shifting and venue in federal securities class action is likely to be held pre-empted, regardless of their validity or effect under state law.”); cf. John C. Coffee, Jr., “Loser Pays”: The Latest Installment in the Battle-Scarred, Cliff- Hanging Survival of the Rule 10b-5 Class Action, 68 SMU L. Rev. 689, 696–701 (2015) (discussing preemption doctrines in the context of conflict between fee-shifting bylaws and provisions of the federal securities laws); William K. Sjostrom, Jr., The Intersection of Fee- Shifting Bylaws and Securities Fraud Litigation, 93 Wash. U. L. Rev. 379, 405–14 (2015) (same).

50

This decision has not reached these additional arguments.

D. Blue Apron’s Ripeness Argument Blue Apron (but not Stitch Fix or Roku) argues that its Federal Forum Provision is unripe for challenge. This is an interesting position, because multiple actions under the

1933 Act are pending against defendants affiliated with Blue Apron, including an action filed in state court that is stayed.148 Even without the existence of these actions, the challenge to the Federal Forum Provision is ripe.

Section 111(a)(1) of the DGCL confers jurisdiction on the Court of Chancery to

“determine the validity of the provisions of . . . [t]he certificate of incorporation . . . of a corporation . . . .”149 Delaware’s declaratory judgment statute permits a court “to declare rights, status and other legal relations whether or not further relief is or could be claimed.”150 The dispute must present an “actual controversy,” which includes the requirement that it “be ripe for judicial determination.”151

Courts decline to render hypothetical opinions, that is, dependent on supposition, for two basic reasons. First, judicial resources are limited and must not be squandered on disagreements that have no significant current impact and may never ripen into legal action [appropriate for judicial resolution]. Second, to the extent that the judicial branch contributes to law creation in our legal system, it legitimately does so interstitially and because it is required to do so by reason of specific facts that necessitate a judicial

148 See Dkt. 32, Ex. B (stipulation staying New York state court action pending resolution of motion to dismiss or settlement in the federal action).

149 8 Del. C. § 111(a)(1).

150 10 Del. C. § 6501.

151 Rollins Int’l, Inc. v. Int’l Hydronics Corp., 303 A.2d 660, 662–63 (Del. 1973).

51

judgment.152

Determining whether a case is ripe requires “a common sense assessment[.]”153 “The reasons for not rendering a hypothetical opinion must be weighed against the benefits to be derived from the rendering of a declaratory judgment. This weighing process requires the exercise of judicial discretion which should turn importantly upon a practical evaluation of the circumstances of the case.”154 “Generally, a dispute will be deemed ripe if litigation sooner or later appears to be unavoidable and where the material facts are static.”155

“Facial challenges to the legality of provisions in corporate instruments are regularly resolved by this Court.”156 The ripeness doctrine permits a court to postpone review until the disputed issue “arises in some more concrete and final form,”157 but there is no point in doing so here. A facial challenge presents a pure question of law.158 The material facts are

152 Stroud v. Milliken Enters., 552 A.2d 476, 480 (Del. 1989) (alteration in original) (internal quotation marks omitted).

153 XL Specialty Ins. Co. v. WMI Liquidating Tr., 93 A.3d 1208, 1217 (Del. 2014).

154 Stroud, 552 A.2d at 480 (internal quotation marks omitted).

155 XL Specialty, 93 A.3d at 1217 (internal quotation marks omitted).

156 Lions Gate Entm’t Corp. v. Image Entm’t Inc., 2006 WL 1668051, at *6 (Del. Ch. June 5, 2006); accord Solak, 153 A.3d at 737.

157 Stroud, 552 A.2d at 480 (quoting Continental Air Lines, Inc. v. C.A.B., 522 F.2d 107, 124–25 (D.C. Cir. 1974)); see XL Specialty, 93 A.3d at 1217–18 (“[A] dispute will be deemed not ripe where the claim is based on ‘uncertain and contingent events that may not occur,’ or where ‘future events may obviate the need’ for judicial intervention.” (footnote omitted)).

158 Solak, 153 A.3d at 740.

52 static, and litigation over the validity of the Federal Forum Provisions appears likely.159 It would add nothing to the record to wait to see if Blue Apron relies on its Federal Forum

Provision to move to dismiss a 1933 Act claim.

The current dispute is also ripe because the Federal Forum Provisions “have a substantial deterrent effect.”160 The Federal Forum Provisions should cause a plaintiff to think twice before filing a 1933 Act claim in state court, facing a motion to dismiss on jurisdictional grounds, and incurring the costs and delay that a plaintiff who filed in federal court would not have to bear. Few stockholders would pursue that course. Instead, plaintiffs will abide by its requirements, enabling the provision to evade review.161

Declining to review the Federal Forum Provisions could also encourage other corporations to adopt similar provisions to take advantage of their deterrent effect. As in other cases involving facial challenges, deciding “the basic legal questions presented” will provide “efficiency benefits to not only the defendants and their stockholders, but to other corporations and their investors.”162

Under a common sense assessment, the challenge to Blue Apron’s provision is ripe.

159 See Dkt. 41, at 5–6 (plaintiff’s counsel commenting that Blue Apron defendants can be expected to move to dismiss the state court action on forum selection grounds once stay is lifted).

160 Id. at 737.

161 See id.; Strougo, 111 A.3d at 595 & n.19.

162 Solak, 153 A.3d at 738 (quoting Boilermakers, 73 A.3d at 938).

53

E. Blue Apron’s Savings Clause Argument Blue Apron argues that its Federal Forum Provision should be upheld because it

“will never operate contrary to Delaware law.”163 According to Blue Apron, its provision achieves this ideal state by requiring claims under the 1933 Act to be brought in federal court only “to the fullest extent permitted by law[.]”

Blue Apron’s savings clause argument fails because there is no context in which

Blue Apron’s Federal Forum Provision could operate validly.164 “For a savings clause to negate a facial challenge . . ., there logically must be something left in the challenged provision for the savings clause to save.”165 Under the reasoning set forth in this decision, the corporate contract cannot be used to regulate federal securities claims under the 1933

Act. As a result, there is no possibility that Blue Apron’s Federal Forum Provision could comply with Delaware law. The savings clause does not save it.

III. CONCLUSION Judgment is entered for the plaintiff. The defendants’ motions for summary judgment are denied.

163 Dkt. 19, ¶ 3.

164 See Solak, 153 A.3d at 743 (rejecting similar argument based on savings clause because “the Fee-Shifting Bylaw is wholly invalid”).

165 Id.

54

NO. 18-972

In the Supreme Court of the United States ______

MATHEW MARTOMA, Petitioner, v.

UNITED STATES OF AMERICA, Respondent. ______On Petition for Writ of Certiorari to the United States Court of Appeals for the Second Circuit ______

REPLY BRIEF FOR PETITIONER ______

ALEXANDRA A.E. SHAPIRO PAUL D. CLEMENT ERIC S. OLNEY Counsel of Record SHAPIRO ARATO ERIN E. MURPHY BACH LLP C. HARKER RHODES IV 500 Fifth Avenue KIRKLAND & ELLIS LLP 40th Floor 1301 Pennsylvania Ave., NW New York, NY 10110 Washington, DC 20004 (202) 389-5000 [email protected]

Counsel for Petitioner

May 14, 2019 TABLE OF CONTENTS TABLE OF AUTHORITIES ...... ii REPLY BRIEF ...... 1 I. The Decision Below Radically Departs From This Court’s Precedents And The Many Decisions Faithfully Following Them ...... 2 II. The Question Presented Is Exceptionally Important ...... 6 III. This Case Is An Excellent Vehicle For Resolving The Critically Important Question Presented ...... 7 CONCLUSION ...... 13 ii

TABLE OF AUTHORITIES Cases Dirks v. SEC, 463 U.S. 646 (1983) ...... passim Salman v. United States, 137 S. Ct. 420 (2016) ...... 1, 3, 4 United States v. Bray, 853 F.3d 18 (1st Cir. 2017) ...... 5 United States v. Newman, 773 F.3d 438 (2d Cir. 2014) ...... 11, 12 Other Authorities Petition, United States v. Newman, No. 15-137 (filed July 30, 2015) ...... 6 SEC Br., SEC v. Waldman, No. 17-cv-2088 (S.D.N.Y. filed Feb. 19, 2019) ...... 8 Tr. of Oral Argument, Salman v. United States, No. 15-628 (U.S. argued Oct. 5, 2016) ...... 4 U.S. Mem., Marshall v. United States, No. 17-cv-2951 (S.D.N.Y. filed July 26, 2018) ...... 8 REPLY BRIEF The government’s brief in opposition is remarkable for what it does not say. The government does not even try to put forward any substantive defense of the Second Circuit’s paradoxical holding that an intention to give a benefit to the tippee somehow equates to the receipt of a personal benefit by the tipper. Nor does it try to explain how that holding could be reconciled with Dirks v. SEC, 463 U.S. 646 (1983), or with this Court’s decision not to adopt an equivalent test in Salman v. United States, 137 S. Ct. 420 (2016). The government says equally little about the substantial importance of the question presented. It does not dispute that the decision below has the practical effect of revising federal insider-trading law nationwide, as every insider-trading prosecution can be (and now will be) brought in the Second Circuit. Nor does it address the significant threat— highlighted by amici—that the Second Circuit’s judicial expansion of the quasi-common-law crime of insider trading poses to the financial markets and to individual liberty. Instead, the government proceeds as if the decision below were an unpublished opinion focused only on the sufficiency of the evidence of financial benefit to the tipper from consulting arrangements. But that is not the case the government argued or the opinion the Second Circuit wrote—and with good reason, as the tipper’s own testimony disclaimed that theory. The Second Circuit’s purported alternative holding cannot be reconciled with the government’s trial strategy or divorced from the court’s extreme 2 dilution of the personal benefit standard. And there is simply no denying that the Second Circuit consciously adopted a test for “personal benefit” to the tipper that requires nothing more than an intent to benefit someone else (i.e., the tippee). Indeed, the notion that this is just a run-of-the-mill quid pro quo case is belied by the months that the panel spent waiting for Salman, holding reargument after Salman, and then writing and revising its opinion to embrace a sweeping new personal benefit test. Nor is there any denying that the panel majority’s new test will now govern every prosecution in the Second Circuit, which is to say virtually every insider-trading case in the country. The Second Circuit’s test not only is inconsistent with Dirks but is essentially no test at all, as it captures everything but inadvertent disclosures (and thus suggests that Dirks itself was wrongly decided). The government has been trying, heretofore unsuccessfully, to get such a non-test for decades. Now that it has gotten its wish, it should not be allowed to shirk the responsibility of defending that sweeping ruling, especially when the personal benefit test is all that stands between lawful activity that is essential to the proper functioning of the market and activity that the government deems felonious. The issues here are too important to accept the government’s effort to have its Dirks-defying standard and evade plenary review too. I. The Decision Below Radically Departs From This Court’s Precedents And The Many Decisions Faithfully Following Them. The core holding of Dirks is straightforward: To determine whether a tipper has disclosed information 3 in violation of a fiduciary duty, and thus whether trading on that information is criminal, “the test is whether the [tipper] personally will benefit, directly or indirectly, from his disclosure.” Dirks, 463 U.S. at 662; see Salman, 137 S. Ct. at 427 (reaffirming Dirks). The divided decision below turns that test on its head. Instead of asking whether the tipper will receive a benefit, it holds that the test is whether the tipper intended to confer one on the tippee. Pet.App.21. That radical holding is wrong three times over: It focuses on the wrong thing (intent to benefit another versus actual receipt of a personal benefit); divorces the federal crime of insider trading from its longstanding theoretical basis; and severs the already-tenuous connection between that quasi-common-law crime and the generic statute on which it purports to be based. See Pet.19-28; NACDL Br.2-3, 8-10. Remarkably, the government makes no attempt to reconcile the Second Circuit’s novel intention-to- benefit standard with Dirks (which found the statute inapplicable to a tip intended to benefit the tippee)— or even to defend that standard on its merits. The government recognizes that the critical question under Dirks is whether the tipper “personally will benefit” from his disclosure, not whether he intends to confer a benefit on someone else. Opp.15 (quoting Dirks, 463 U.S. at 662). And it refrains from embracing the majority’s strained suggestion that when Dirks described the kind of “relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient,” 463 U.S. at 664, it meant to adopt the nonsensical proposition that an intent to confer a benefit on someone else constitutes a 4

“standalone personal benefit” to the tipper, Pet.App.16. See Pet.25-26; Professors Br.5-7. Faced with a misguided holding that all but eliminates the personal benefit requirement while making a hash out of Dirks, the government responds with deafening silence. The government has equally little to say about the striking fact that the decision below adopts the same basic test the government urged on this Court unsuccessfully three years ago in Salman. See Pet.11- 12, 23-25. There, the government argued criminal liability should attach “whenever the tipper discloses confidential trading information for a noncorporate purpose,” regardless of whether that purpose involved any benefit to the tipper. Salman, 137 S. Ct. at 426. Indeed, the government specifically asserted that it should be able to obtain a conviction by showing that the tipper was trying to obtain a benefit “either for himself or somebody else.” Tr. of Oral Argument 25, Salman, No. 15-628 (U.S. argued Oct. 5, 2016) (emphasis added). But as several members of this Court suggested at oral argument, that benefit-to- anyone approach cannot be reconciled with the line drawn in Dirks and consistently followed ever since. Id. at 28-29, 42, 46; see Pet.24. Unsurprisingly, this Court pointedly avoided espousing the government’s approach, choosing instead to “adhere to Dirks.” Salman, 137 S. Ct. at 427. The decision below ignores that lesson. Instead of following Dirks, it judicially enlarges the crime of insider trading to cover any case in which the tipper intended to benefit a third party, which is at least as expansive as the no-legitimate-government-purpose 5 standard rejected in Salman. Pet.24-25; see Pet.App.27 (holding that jury “can often infer that a corporate insider receives a personal benefit” when he discloses inside information “without a corporate purpose”); Professors Br.7-8; NACDL Br.9-10. Indeed, the government does not dispute that if mere intent to benefit the tippee sufficed, then Dirks itself should have come out the other way. Pet.26-27. As Judge Pooler thus pointedly noted in dissent, the majority’s approach not only allows the government to “convict based on circular reasoning,” but “flirts with the possibility that the personal benefit test that goes back to Dirks may no longer be good law.” Pet.App.47. The majority’s approach also conflicts with numerous cases that have followed Dirks and refused to treat a disclosure intended to benefit the tippee as a personal benefit to the tipper unless the two were relatives or friends. See Pet.22; Professors Br.8-10.1 The Second Circuit’s stark departure from the settled jurisprudence of this Court and other circuits readily warrants review.

1 The government’s feeble attempts to distinguish these cases fall flat. It especially misreads United States v. Bray, 853 F.3d 18 (1st Cir. 2017). Bray does not hold that a personal benefit to the tipper can be inferred from a mere “intention to benefit the [tippee].” Contra Opp.20. On the contrary, Bray follows Dirks, holding that a benefit to the tipper can be inferred when the “relationship between the tipper and the recipient” suffices to infer a benefit the tipper. 853 F.3d at 26 (emphasis added). That is why Bray specifically analyzed whether the tipper and tippee had a “close relationship.” Id. at 26-27. 6

II. The Question Presented Is Exceptionally Important. The government not only makes no attempt to defend the core holding of the decision below, but also makes no attempt to deny the exceptional importance of the question presented. As the circuit that includes the nation’s financial capital (and the world’s largest securities market), the Second Circuit’s decisions govern all of the countless professional traders that work in New York and all of the countless trades that pass through the city every day, effectively “defin[ing] the scope of criminal liability for market participants nationwide.” NACDL Br.3; see Pet.28; Petition at 32- 34, United States v. Newman, No. 15-137 (filed July 30, 2015). And because the decision below all but eliminates one of the key elements of the crime, the federal government will have every incentive to bring any insider-trading prosecution with an arguable nexus to New York (which is to say virtually all of them) in the Second Circuit. Pet.28-29; Professors Br.17. In short, it is no exaggeration to say that two judges on a divided panel have essentially rewritten the law of insider trading nationwide. That radical revision will impose substantial costs on the nation’s financial markets and on individual liberty. Professional traders play a critical role in the securities markets by ferreting out and trading on information that is better than that reflected in prevailing market prices—a process that is “necessary to the preservation of a healthy market.” Dirks, 463 U.S. at 658. But under the decision below, anyone who trades on such information risks federal prison if the information is traced back to an insider who intended 7 to benefit some outsider. Pet.29-30; Professors Br.15- 16. The government offers no response or reassurance, presumably because some federal prosecutors have long sought a prohibition on trading while in possession of inside information. But Congress has never authorized that regime. Indeed, in reading the government’s brief it is easy to forget that this entire insider-trading edifice is built upon the generic prohibitions in §10(b) and Rule 10(b)(5). By eviscerating the personal benefit test, the decision below severs one of the few remaining links between the government’s insider-trading prosecutions and the statute that purports to justify them. Moreover, the Second Circuit’s ever-shifting personal benefit law raises serious due process and fair notice concerns, and provides a powerful reminder of why this Court abolished common-law crimes. Pet.30-31; Professors Br.11-15; NACDL Br.7-8. Those concerns—and the government’s marked silence in response to them— confirm the need for this Court’s intervention. III. This Case Is An Excellent Vehicle For Resolving The Critically Important Question Presented. Unable to defend the decision below on the merits or deny its importance, the government concentrates its efforts on obscuring the court’s holding and conjuring up illusory vehicle concerns. Those efforts are unavailing. The Second Circuit issued a sweeping precedential decision for a reason, and the government’s efforts to convert that ruling into a narrow case-specific ruling are not accurate. Nor have they stopped the government from invoking the ruling 8 as a circuit precedent that eliminates the personal benefit test as a meaningful element of insider trading.2 1. The government attempts to portray the decision below as a routine application of plain-error principles. It claims there was no plain error here because the jury instructions were not obviously incorrect and a properly instructed jury would have convicted based on purportedly “compelling evidence of a quid pro quo relationship.” Opp.17. Neither contention withstands scrutiny. As for the first, the government never explains exactly which aspects of the instructions it thinks were erroneous or correct, but rather suggests that they “closely tracked the language of Dirks.” Opp.15. In fact, they deviated from Dirks in two critical respects. Dirks allows an inference of personal benefit only when there is a “relationship between the [tipper] and the [tippee] that suggests … an intention to benefit the [tippee],” such as the tippee’s relationship with a “trading relative or friend.” 463 U.S. at 664 (emphasis added). The instructions here, by contrast, allowed the jury to convict by finding that Gilman shared inside information to “confer[] a benefit on Mr. Martoma,” or to give him “a gift with the goal of maintaining or developing a personal friendship or a useful networking contact.” Pet.App.8 (emphasis added).

2 See U.S. Mem.4, Marshall v. United States, No. 17-cv-2951 (S.D.N.Y. filed July 26, 2018), Dkt.39; SEC Br.27, SEC v. Waldman, No. 17-cv-2088 (S.D.N.Y. filed Feb. 19, 2019), Dkt.106. 9

Those instructions are plainly incorrect under Dirks, which requires a genuine benefit to the tipper. Indeed, the majority deemed them (mostly) correct only because of its profoundly mistaken view that the “tipper personally benefits by giving inside information” to the tippee, Pet.App.78 (emphasis added)—a proposition that the government never advanced in any of its ever-shifting efforts to procure and then defend the conviction in this case. As for its contention that any error was harmless, the government emphasizes the majority’s cavalier claim—sharply disputed by the dissent, see Pet.App.46—that the government produced such “compelling evidence” of a quid pro quo relationship between Gilman and Martoma that a properly instructed jury necessarily would have found that Gilman disclosed inside information in exchange for some actual or expected financial benefit. Pet.App.25- 26; see Opp.16-17. But Gilman disclaimed that theory at trial, testifying that he neither wanted nor received any financial benefit for the inside information that drove the charged trades. Pet.9, 32; see Pet.App.46; C.A.App.179. To be sure, the government could have persisted in a financial benefit theory despite that testimony, but doing so would have come at the cost of directly undermining the credibility of its star witness. Understandably, the government instead shifted horses and emphasized its alternative “friendship” theory to the jury. See Pet.32; C.A.App.158. The government cannot be faulted for that tactical choice, which was permitted by pre- Newman circuit law, but neither can it avoid review of the decision below by reviving a theory it walked away 10 from and could not have emphasized without undermining the credibility of its key witness.3 The government’s harmless error theory is further belied by the history of this case. If the evidence that Gilman received a financial benefit for disclosing the critical efficacy data—despite his contrary testimony—really was so compelling that no rational jury could reject it, then the decision below should have been a summary order affirming the conviction on that narrow ground, not a wide-ranging precedential opinion that redefines the crime of insider trading. There likewise would have been no need for the Second Circuit to wait several months for this Court to provide guidance on non-financial benefit cases in Salman, then hold reargument after Salman, and ultimately spend nine months revising the initial panel decision to alter its test for non- financial personal benefits. The claim that this was a straightforward case about a financial quid pro quo all along blinks reality. Ultimately, moreover, the government’s harmless error argument boils down to the untenable proposition that no rational jury could decline to convict when “inside information is revealed within a paid consulting relationship.” Pet.App.46. Once again, the government provides no comfort that this is not the inevitable consequence of the decision below, or that the decision will not produce an enormous

3 The government’s references to Dr. Ross are a red herring. As the Second Circuit recognized, “it was Dr. Gilman, not Dr. Ross, who gave Martoma the final efficacy data” that was the purported basis of the charged trades, so any benefit to Dr. Ross is irrelevant. Pet.App.10 n.3. 11 chilling effect on legitimate activity that is vital to the markets. In an area that demands bright-line rules promulgated by politically accountable actors, the regulated community is left with ambiguous judge- made rules that skew the playing field toward prosecutors and against values like fair notice. 2. Instead of confronting the question presented, the government argues that the petition is about something completely different: whether the decision below “adhered to the prior panel opinion in Newman.” Opp.18-19; see United States v. Newman, 773 F.3d 438 (2d Cir. 2014). That is both incorrect and disingenuous. As the petition makes clear from the outset and throughout, the question presented is whether the government “must demonstrate that the tipper received a personal benefit in exchange for providing insider information, as required by Dirks, or whether it suffices for the government to show that the tipper intended to confer a benefit on the tippee.” Pet.i. That is a question about whether the test that the Second Circuit adopted in this case is correct, not about whether the majority “adhered to the prior panel opinion in Newman.” Opp.19. To be sure, the majority decidedly did not adhere to Newman and its “meaningfully close personal relationship” test. Pet.21-22. But that is relevant not to suggest that petitioner mistakenly filed his en banc papers in this Court, but because Newman, unlike the decision below, adopted a test consistent with Dirks. In other words, the distance between the decision below and Newman is important not for its own sake, but as a yardstick for the conflict between the decision below and Dirks (not to mention decisions from other 12 courts adhering to Dirks). As Newman and those decisions correctly recognized, Dirks’ gift-giving analogy applies only when the tipper and tippee have the kind of “meaningfully close personal relationship,” Newman, 773 F.3d at 452, in which “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.” Dirks, 463 U.S. at 664. Here, the Second Circuit not only allowed the government to invoke a gift-giving theory without abiding by that limit, but concluded that an intent to “gift” inside information to anyone—even “a perfect stranger,” Pet.App.18—constitutes a “standalone personal benefit” to the tipper, Pet.App.16. In doing so, the majority expanded the federal crime of insider trading far beyond the bounds set by Dirks, with grave consequences for the financial markets and for individual liberty. This Court should not allow that profoundly misguided decision to become the de facto law of the land. 13

CONCLUSION This Court should grant the petition. Respectfully submitted,

ALEXANDRA A.E. SHAPIRO PAUL D. CLEMENT ERIC S. OLNEY Counsel of Record SHAPIRO ARATO ERIN E. MURPHY BACH LLP C. HARKER RHODES IV 500 Fifth Avenue KIRKLAND & ELLIS LLP 40th Floor 1301 Pennsylvania Ave., NW New York, NY 10110 Washington, DC 20004 (202) 389-5000 [email protected] Counsel for Petitioner May 14, 2019