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Taking the long-term view 2019 Directors’ Alert

Global Center for Corporate Governance 1 Introduction

3 13 25 33 Industry Shareholder engagement Environmental, social, Tax 4.0 and activism and governance (ESG) strategy

External perspectives 8 20 30 Elizabeth Corley Mellody Hobson Laura Cha

41 Conclusion

Global Center for Corporate Governance

02 Introduction | 2019 Directors’ Alert Introduction

Unflattering fluorescent lighting, yes. Tasteful, soft-cornered will affect organizations not only in the near term but well sconces, yes. There’s even the occasional chandelier, down the road. dripping with leaded teardrop-shaped crystals. We’ve all seen lots of boardrooms, but never one with a crystal ball Not all taxes are financial in nature, as the long-term costs hanging from the ceiling. It’s just as well, because it’s rare of environmental, social, and governance (ESG) impacts to see boards look very far into the future, despite the become clearer. Strategies and decisions implemented mantras and slogans declaring a corporate passion for long- years ago can result in ESG surprises that may have term success. This is odd, because directors are, above all, been avoided had a long-term view been taken. Those stewards of long-term value. They are uniquely positioned unexpected consequences can generate reputational, to consider the far-reaching impact of strategies and reporting, legal, financial, and other risks that the board decisions, yet many boards and executive teams are needs to oversee. Societies, governments, consumers, tempted to focus on the short term. The pace of change, workforces, and investors are becoming more attuned disruptive forces, and the demands of quarterly reporting to and demanding of organizations’ approaches to ESG all truncate time horizons in the boardroom with or without issues. The board has a strong role to play and a duty to a crystal ball. assist management in crafting actionable and sustainable responses and maintaining the operational discipline to see This state of affairs is concerning, because an organization’s them through. success depends on decisions and actions that occurred not yesterday, but well in the past. Today’s advantages Investors’ time horizons vary, but those who hold shares and challenges can be traced back to strategies, over long periods tend to be more vocal and visible to the initiatives, resource allocations, hires, and relationships organization and also deeply concerned with long-term that were developed—or not developed—some time value. There are, of course, investors with other priorities. ago. By the same token, decisions made today will shape Corporate leaders must understand and engage effectively the organization of the future. The board has a duty to with all shareholders and the larger investor community, encourage management to plan for the longer term. particularly in an environment of intensifying shareholder activism and rising interest in corporate governance. This is The 2019 edition of Directors’ Alert identifies board an area that requires greater involvement of management responsibilities and focus areas that benefit from the and, in many cases, the board. It is certainly one in which application of a long-term lens. The fourth industrial the board, as the representative of the shareholders, must revolution, often referred to as Industry 4.0, is driven by stay abreast of trends and developments. new technologies and relentless digitalization. It will require boards and management teams to plan for the long term As the ultimate stewards of the organization’s long-term and do so in new ways. The novelty and speed of Industry value, the board must look beyond the immediate future 4.0 may appear to demand snap judgments and rapid and guide management to do the same. The board should responses. That very urgency requires the board and also urge management to take steps now to address management to grasp the long-term implications of this conditions, risks, and opportunities that are likely to emerge massive shift. in the years ahead. The more intense the executive team’s focus is on the short term, the more important it is for One question is how value will be created in a more the board to direct attention to the long-term impact of digitalized world. Consider that governments and management’s strategies, decisions, and initiatives. businesses have been working within tax frameworks established about 100 years ago, which are clearly not Nothing less than the long-term value, and perhaps even designed for a digitalized world. Unsurprisingly, the matter survival, of the organization is at stake. has caught the attention of tax authorities and should be found on board and management agendas, as well. There Dan Konigsburg Michael Rossen are implications for areas as diverse as strategies, business Senior Managing Director, Managing Director, models, investments, talent management, corporate Deloitte Global Center for Deloitte Global Center for structure, and reporting, and changes we are seeing now Corporate Governance Corporate Governance

1 2 Industry 4.0 | 2019 Directors’ Alert

Long-term value creation Understanding the fourth industrial revolution

The first industrial revolution dates to the 18th The transformative power of Industry 4.0 century, when the steam engine and other To grow and prosper in the Industry 4.0 machinery radically changed the production and environment, organizations must embrace th th movement of goods. In the late 19 and early 20 digitalization and harness gains in computing centuries, electricity and assembly lines gave rise power. Digitalization creates visibility into to mass production and the second industrial processes, allows real-time communication, and revolution. The third arguably began in the mid- opens up new analytical capabilities. Tremendous Amberjit Endow 20th century, when mainframe computers enabled computing power is now available to any Lead Partner, the automation of processes and the creation of organization through the cloud. For example, Analytics and Cognitive – Robotics, networks, including the Internet. software as a service (SaaS) makes software Cognitive Automation, Enterprise Agility deployment far more rapid and economical, while Deloitte Australia Views differ on the start of the fourth industrial platform as a service (PaaS) simplifies complex revolution—Industry 4.0 for short—but all processes. The economics of cloud computing agree it is being driven by digital and cognitive enable Industry 4.0 for almost any organization. technologies: advanced analytics, scanning and sensing, artificial intelligence, machine learning, The introduction of machine learning technologies the Internet of Things, and combinations of typically requires a learning phase followed by those technologies and physical processes and a phase in which that learning is applied. The objects. The marriage of the digital and the learning phase requires computing power at physical is bringing us driverless vehicles, drone a scale most organizations cannot financially delivery, wearable technology, and robotic teams justify. That learning phase “trains” the system of homebuilders. These applications create to recognize and make decisions on the basis exponentially greater value for far less effort, and of characteristics in documents, transactions, they are already familiar in many industries. photos, videos, objects on a conveyor belt, or other content. It may require hundreds Although business leaders need to distinguish of thousands or millions of instances for the between the hype and the real opportunities technology to learn what it must recognize surrounding these technologies, it is as big a and then do, and the cloud makes that kind of mistake to dismiss them as it is to mindlessly computing power available at a reasonable cost. embrace them. This is particularly true as it applies to the board’s role as steward of the Once the machine has learned, costs decrease organization’s purpose and long-term shareholder dramatically in the second phase, when it applies value and its obligation to oversee risks. Industry what it has learned to documents, transactions, 4.0 is certain to change organizations’ long- objects, and so forth. The cloud, which can enable term value, just as earlier industrial revolutions these technologies as SaaS or PaaS, democratizes did. Organizations are presented with many cognitive technologies and is accelerating opportunities to profit even as competitors their adoption. seek to change not only the playing field, but the game itself. The risks that accompany these Cognitive technologies improve process technologies differ from IT and other familiar risks. performance exponentially, which is the usual Both boards and management teams have work to motivation for adoption. First, the process of do to ready their organizations for Industry 4.0. moving and inventorying materials, detecting product defects, monitoring predictive

3 2019 Directors’ Alert | Industry 4.0

maintenance, or approving loan apart from the main meeting agenda. How the C-suite sees Industry 4.0 applications becomes more efficient. This topic warrants a proper place on To assess business and government readiness Then the process becomes more that agenda to incorporate it into the for Industry 4.0, a 2017 Deloitte global survey effective because the technology corporate strategy and investment polled 1,600 C-level executives from 19 countries can do more. It can improve the choices for the organization, both who represent companies with at least $1 billion quality of the materials being moved in capability development and in annual sales.1 The survey focused primarily by monitoring and preventing reinventing processes and ways of on social impact, strategy, talent and workforce, breakage and rot. It can pinpoint working. It’s not enough for the board and technology concerns. product defects that were previously to be aware of uses of robotic process undetectable. It can monitor more automation (RPA) or experiments in Findings include the following: parts of a machine for predictive blockchain in the organization or at •• Social impact: 87 percent of the executives maintenance and approve peer companies. The board needs surveyed believe Industry 4.0 will lead to more applications based on a broader set of to cultivate a clear understanding social and economic equality and stability, documentation and external data. of the opportunities and risks with two out of three saying businesses will Industry 4.0 poses. have much more influence than governments Gains in efficiency and effectiveness in shaping this future. However, less than a have always been a goal in business, A number of directors have found quarter believe their own organizations hold and although these improvements five broad practices useful for guiding significant influence over societal factors like are part of Industry 4.0, they are not conversations and framing actions education, sustainability, and social mobility. its essence. The essence of Industry related to Industry 4.0: •• Strategy: Only one-third of executives are 4.0 is transformation, not only of •• Preparing the board itself: Some highly confident they can act as stewards processes but of business models, boards are more prepared than for their organizations during this time. Only organizations, entire industries, and others to discuss Industry 4.0 with 14 percent are highly confident that their work itself. Industries previously management. Digital technology organizations are ready to fully harness thought to be immune to disruption organizations, such as Internet- the changes associated with Industry 4.0. because they center on physical based businesses or cloud service Most senior executives continue to focus products and services, such as the providers, generally have board on traditional operations as opposed to retail, taxi, hotel, and travel industries, members from the digital world who opportunities to create new value. have been disrupted and transformed view cognitive technologies as not by digitalization. Others that were only an enabler of processes, but as •• Talent and the workforce: Only a quarter already digitized or content-driven, a source of potential transformation. of executives are highly confident they have such as banking, trading, television, Other boards are populated by the right workforce with the right skills for the publishing, and advertising, have people with deep subject-matter future. However, talent and HR are considered been totally transformed, primarily by and industry expertise but a more a relatively low priority (17 percent), the Internet. limited view of technology. Given despite 86 percent of executives saying that no organization in any industry they’re doing all they can to create a better- Industry 4.0 should stand among is immune to disruption—and that prepared workforce. the key pillars of any organization’s many could derive benefits—the •• Technology: Executives say their technology strategy for the short- and long-term board must take explicit steps investments are strongly oriented toward future. The options for executive to prepare itself to understand supporting new business models that will teams and boards now come down to the opportunities and risks that have an impact on their organizations over disrupt or be disrupted, transform or come with Industry 4.0. Across the next five years, but few say they have a be transformed. For many, it’s still a the globe, progressive boards are strong business case for investing in advanced choice at this point, so now is the time looking to enrich their work with technology. The hindrances they most often to act. technology-centric advice and cite are lack of internal alignment (43 percent), thought leadership. Be it through A board’s-eye view of Industry 4.0 lack of collaboration with external partners CTOs, CIOs, cognitive/AI evangelists, (38 percent), and a focus on the short term Many boards and executive teams are or a strong connection with the (37 percent). discussing Industry 4.0, but typically

4 Industry 4.0 | 2019 Directors’ Alert

start-up community, these organizations •• Elevating the risk conversation: and address the opportunities and risks are incorporating a significant voice Management must address traditional without a having a crystal ball to see how in the boardroom on the adoption of risks involving cognitive technologies, and the business will look in five or 10 years. Industry 4.0. the board must gain assurance that those risks have been addressed. But other •• Readying the organization: The These can be daunting and dangerous risks also abound, and they go beyond the board can also prompt management to waters to navigate. One way the board can usual playbook. There’s the risk of being consider the opportunities of Industry keep a firm hand on the tiller is by keeping disrupted, choosing the wrong technology 4.0, starting with increased efficiency management focused on the fundamental or timing, or missing transformative and effectiveness. Complacency and purpose and mission of the business. This opportunities. Managing the risks of short-termism are the enemies here. Even is not to say that the purpose can never Industry 4.0 requires an understanding an industry leader with a large market change. It may change along a continuum, of the business, its processes, and how share, a high degree of customer loyalty, as when an oil and gas company recognizes cognitive technologies behave. For and updated technology could, in as little that alternate sources of power should example, as a machine “learns,” it could as a year or two, face a new competitor be part of its long-term strategy. A new acquire biases from the humans around it that is using cognitive computing to purpose may break with the continuum; and start to discriminate against classes or redefine core products or services or for example, a bank may decide to move ethnicities of people in a process designed facilitate production and delivery. Perhaps from taking deposits and making loans to to approve loans, triage customer service more likely, a competitor could achieve becoming a payments-driven retailer, or a cases, or deal with suppliers. Change can economies that deliver similar results Silicon Valley tech company may decide to lead to unanticipated consequences and at deep cost savings, thus generating enter banking. risks. In addition to introducing new risks, a stronger value proposition. Seeking Industry 4.0 elevates the level of risk, gains and anticipating disruption can be Boards and senior executives must keep which means the risk conversation must especially difficult for leaders of highly their purpose and mission firmly in view also be elevated. Boards need to oversee successful organizations, where legacy and make explicit, periodic decisions to risks related to Industry 4.0 and learn thinking is often self-reinforcing. either maintain or alter them in response to from management how those risks are Industry 4.0. •• Gaining access to needed talent: being mitigated. Industry 4.0 will transform workforces at What the board can do right now •• Choosing the right strategy: Traditional both macro and micro levels. Consider long-term strategy is typically geared To chart a course between unalloyed the implications of not just replacing but toward linear “big bang” projects, such as enthusiasm and unreasonable fear over upskilling or reskilling a quarter, a third, or major IT installations, R&D efforts, and Industry 4.0 and to help management do half of your workforce. The needed skills market initiatives with multiyear horizons the same, your board might consider the may be in short supply and not all of them and large budgets. These won’t disappear, following: can be acquired through technical training. but they may become less critical to •• Get and stay up to speed. Unless you Managers must become comfortable with success, and a big-bang mindset may not have a genuine interest in their workings, experimental methods and with teams serve the organization well in the long do not worry about gaining a deep that could respond poorly to command- term. Worldwide, leadership teams are understanding of how machine learning, and-control supervision. Personnel will increasingly adopting strategic agility as AI, RPA, blockchain, and other cognitive need to work in short, iterative sprints and their goal. This blends with an iterative, technologies operate. Instead, ask: What be able to thrive in diverse ecosystems. experimental approach to evolving the can and can’t this technology do in an Those ecosystems combine physical organization as the marketplace evolves. organizational setting? How does it treat or design, data science, scanning and If you believe these technologies will change inputs and outputs in a process? sensing, cognitive computing, predictive impact your business, your long-term How do the people involved in the process modeling, and machine learning, as well as strategy should be to prepare leaders experience it and its results? What sort of core functional and industrial knowledge. and ready the organization to adopt and gains are achievable? Success, even close to the front lines, scale these technologies. The best goal will demand a roster of skills that no one Separate hype from reality by learning now may be to learn how adoption is likely person can master, requiring workers to where the technology is in terms of to occur in your industry and business, adapt to highly diverse teams. development, adoption, deployment, and how to respond to it, and how to identify

5 2019 Directors’ Alert | Industry 4.0

successful application. Having a direct monitoring the external environment. •• Continually clarify your purpose and line of sight and sponsorship from the Discourage management from dismissing mission. Industry 4.0 will likely take board on a number of these incubations new technologies and new competitors the form of incremental improvements is common among organizations that are as immature, marginal, or unthreatening, to processes, particularly when driven approaching this challenge head-on. because that is how almost all threats to by cost and quality. When exponential established industries appear initially. changes occur, even positive ones, the •• Start or change the conversation. fundamentals of an industry can change. Industry 4.0 and specific cognitive •• Encourage investment and Pioneering management consultant technologies should be found on the experimentation. Organizations Peter Drucker famously noted that board agenda. Briefings from the should be investing to migrate repetitive railroad executives believed they were technology owners within the organization processes that demand human in the railroad business rather than the should focus on how the technology will intelligence to technologies such as transportation business and were thus be used by the business and its related RPA and machine learning. Depending blindsided by the airlines. How leaders impact, rather than on the technology on the industry sector, licensing or define the organization’s purpose will itself. External experts can help frame acquiring technologies could accelerate determine its approach to cognitive the possibilities. Draw management’s progress toward a target-state business technologies. Gains in efficiency and attention to cognitive technologies’ or operating model. Moreover, cloud effectiveness achieved by one industry short- and long-term implications for the computing can make cognitive capabilities participant are soon replicated by organization and ask questions to gauge available at a fraction of the cost of others, but organizations that undergo management’s interest and intentions. internal development or outright transformation find themselves altering When management pursues gains in acquisition. Ascertain whether high-cost, the definition and experience of value. efficiency and effectiveness, raise the big-bang investments are necessary when Clarifying an organization’s purpose and possibility of more transformative change. a lower-cost, iterative approach may be mission can take a leadership team into It’s natural for management teams and possible. The audit committee may want to deep philosophical waters, but they are boards to see cost reduction as the major encourage internal audit to adopt RPA and waters the board should be willing to enter benefit of cognitive technologies, but advanced analytics in its assurance work and help management navigate. Useful transformative change can provide even and to foster the adoption of technology ideas and insights can also be gained by more value or, in the hands of competitors, in second-line assurance functions such as discussing the purpose and mission with pose threats to value. operational risk management. key investors. •• Gauge the risks. Understand both •• Monitor culture and talent issues. traditional risks and the new ones posed Organizational culture is a deeply Although long-term strategy may seem by Industry 4.0. Traditional operating, embedded, long-term characteristic that an oxymoron in our current environment, financial, and reputational risks may be cannot be changed overnight. Board decisions made in the year ahead regarding amplified. For example, if a bot operating members should ask themselves: Does Industry 4.0 will affect the organization’s for a few hours can do the work of 10 our culture position people to exploit the value proposition, technological capabilities, people working for a week, that bot opportunities and address the threats workforce, culture, and operational agility may have the potential to promulgate posed by Industry 4.0? It is critical to going forward. Management should make an error at a similarly exponential rate. work with management to frame the thoughtful decisions on when to be an New risks may be existential, such culture that the organization will need innovator or early adopter of cognitive as threats to the organization’s value to maintain its reputation and ability to technologies in light of company-specific proposition and business model. It is the attract and retain talent in an Industry circumstances, available resources, and responsibility of the board to ascertain 4.0 environment. If the organization will stakeholders’ needs and expectations. whether these types of risks are being need new types of talent, now is the time identified, assessed, monitored, and to develop the culture that will attract and managed. Ask whether the organization support those professionals. has a formal program and platform for

6 Industry 4.0 | 2019 Directors’ Alert

Questions for directors to ask

••What do we know—and not know—about ••What developments have Industry 4.0 Industry 4.0, both in general and as it prompted among our competitors and applies to our industry and organization? peers? How are new market entrants What internal and external expertise can or organizations on the periphery of we access to learn more? our industry using them? How are our customers and suppliers using them? ••Which cognitive technologies have we deployed in the organization? Where ••How should our organization pace itself have we deployed them? What have been on this journey? Where do we want to be the results? Are we seeing incremental innovators or early adopters? Would a or exponential gains in efficiency strategy of later adoption better serve our and effectiveness? organization and its stakeholders?

••How prepared is our organization to begin ••How is the board planning, testing, and or move to the next stage with cognitive refining its journey to Industry 4.0? How technologies? What assumptions underlie are we measuring and enhancing the the decisions management has made (or board’s collective capability to understand not made) about these technologies? Have the organization’s range of options related we assessed the adaptability and maturity to Industry 4.0? of our organization in navigating this ••How can the board best support complex transition? management in preparing the ••What risks do cognitive technologies and organization’s workforce for Industry 4.0? Industry 4.0 pose to the organization? What people and skills will be needed? What are the operational, financial, cyber, What changes will the organization need reputational, and other known risks? to make in its hiring, training, retention, What are the larger risks to our value and workplace policies to win the war proposition, business model, and strategy? for talent?

7 2019 Directors’ Alert | A conversation with Elizabeth Corley

A conversation with Elizabeth Corley

Elizabeth Corley serves on three How can boards plan for the long term? which should go beyond normal “IT company boards as a non-executive Most boards realize that successful risks.” Another level of focus is talent, director: Pearson plc, BAE Systems strategy stems from their ability to think plc, and Morgan Stanley Inc. an area where some organizations have long term while acting on the basis of that been slow to appreciate the strategic Elizabeth was CEO of Allianz Global thinking in the shorter term. Boards need relevance. You need the right people to Investors, initially for Europe then to work with management to shift their exploit opportunities of Industry 4.0, and globally, from 2005 to 2016 and thinking from planning at the present and continues to act as a senior advisor they’re probably not always the people to the firm. She was previously at beyond to starting instead with a vision who assumed senior positions in the past Merrill Lynch Investment Managers of a longer-term future and then defining decade. Many companies get Industry and Coopers & Lybrand. near-term actions that will make that 4.0 in theory but have not developed future a reality. She is a member of the CFA Future the mindsets and mechanisms to act on of Finance Council Advisory Council its implementation. and the AQR Institute of Asset Thinking long term can be difficult in an Management at the London Business environment where analysts fixate on How can boards ensure management School. She is chair of an industry quarterly reporting. The availability and Taskforce for the UK government on has the right leaders during these times social impact investing. velocity of data, along with shrinking of change? attention spans, reinforce short-term Boards are thinking harder about what’s Additionally, she is a member of expectations. However, boards know they needed in leadership: performance or the 300 Club and the Committee must balance short-term performance of 200, as well as being a trustee of potential? I’ve seen a shift in mindset from the British Museum. She is also a against longer-term considerations, and sourcing people who were very results- published author and a Fellow of the that investors expect leaders to deliver oriented to those also focused on the Royal Society of Arts. current value while innovating for the future. This goes back to balancing short future. All of this means that anything term and long term, and it involves culture. done slow, late, or wrong in short-term A purely short-term-oriented culture will execution has a much higher opportunity work against a company unless, of course, cost than it would five or 10 years ago. it is facing pressing operating or financial That’s because driving current efficiencies problems that must be immediately creates the space needed to shape long- addressed. Companies that are doing term value. well can and should develop long-term thinking as part of their cultures. They Are boards thinking about Industry 4.0? can seek or develop talent for the Boards are thinking about Industry 4.0 future, instill continuous learning, and on multiple levels. One level is defense of develop resilience. Industry 4.0 reduces the business model, of operating systems, the amount of control organizations data, and of sustaining a social license have and leadership will have to make to operate. Another level is being on the the necessary adjustments. Those offensive—using insights, innovation, and that understand this are engaging with technology to reshape the organization stakeholders in new ways and adapting to and the market. Boards should be updated change quickly. Those struggling with this regularly on cyber risks and cyber issues, change are usually trying to maintain their but many are not receiving useful insights, former control.

8 A conversation with Elizabeth Corley | 2019 Directors’ Alert

Are boards engaging with investors What ESG topics are being added to the to understand their views for long- board’s agenda? term success? Governance has certainly risen on the agenda. In It depends on where the company is in its the United Kingdom, it’s been driven by revisions relationship with investors, but yes, boards to the Corporate Governance Code, and in the generally appear to be increasing their European Union by increasing expectations engagement with investors. I am seeing regarding board accountability. I recently saw both passive and active investors asking for a presentation on factors correlated with long- engagement outside of the quarterly or half- term share price volatility and performance yearly reporting cycle. A board I sit on hosted in the United States, Europe, and Japan. a “governance day” where the chairman, CEO, Governance was the only factor associated and committee chairs invited investors to with lower volatility and/or higher performance talk about governance, and it was very well across all geographies. The presentation attended. There was no talk of earnings or suggested that the better the quality of the performance. The meeting focused only on governance, the lower the volatility and the governance, culture, and how the company better the share price performance over the is run. I am also seeing more sophisticated long term. questioning from investors and proxy voting agencies about boards and their competencies Which governance concerns are under the and dynamics. Investors will ask a chair about most scrutiny? governance and oversight, particularly in fast- Key things stakeholders look for include a well- evolving industries. articulated strategy; governance processes; high-caliber people; solid succession plans; In periods of rapid change, investors face more appropriate, diverse board composition and uncertainty in securities pricing and the role committee structures; and independent thinking of specific securities in their portfolios. That and judgment from non-executive directors. increases the need for management to present Beyond those themes, things can become more a clear and cogent narrative, often across a specific depending on geography. For example, diverse investor base. Doing that is now a there is now guidance in the United Kingdom hallmark of successful investor engagement. that if you are going to chair an important Another one is having a good understanding committee you should have been on the board of the investor base and sharing that for at least a year. understanding with the board. The boards I sit on receive current, relevant information on the buy-side and sell-side views of the organization.

9 2019 Directors’ Alert | A conversation with Elizabeth Corley

Most boards realize that successful strategy stems from their ability to think long term while acting on the basis of that thinking in the shorter term.

10 A conversation with Elizabeth Corley | 2019 Directors’ Alert

What about the environmental and Has the board’s oversight of tax What else should be boards be focused social components of ESG? changed, and is it being considered a on for the long term? The environmental component is long-term matter? Each of these issues can impact becoming more central, partly because Yes, both at the full board and audit reputation. You’ll find brand, reputation, of policy developments, but also because committee level. Where tax optimization and customer experience in highly sustainability impacts the supply chain. used to be the highest priority, now there’s sensitive parts of the company’s In addition, investors are focused on a balancing focus on tax equality. In the risk register. When that’s the case, identifying external factors that may not United Kingdom and Europe, there’s an management must mitigate those risks. be reflected in current share prices and/ expectation to report on the fairness of The board and/or the risk committee or business performance. Many leaders the tax strategy, not only on optimization. should be having conversations related are rethinking the impact of climate Shareholders are sensitive to an to these matters with management change, weather-related events, and organization’s reputational risk associated and monitoring related views across natural disasters on just-in-time (JIT) with underpayment of tax. Executives and constituencies. Some boards have globalized supply chains, as well as the boards are engaged in a more balanced established ESG committees, or impact of political actions such as Brexit. discussion about paying taxes fairly. This responsibility and reputation committees, Management and boards have gone is driven partly by consumer reactions brand committees, or stakeholder from being able to rely on a relatively to organizations using sophisticated, but committees, to monitor these issues. Of benign, continually globalizing world with perfectly legal, tax optimization structures course, some companies have decided predictable outcomes to realizing that JIT but also by government intervention. that it’s not one of their priorities, but may not embody the resilient supply chain they are living with a higher appetite for of the future. That’s a big shift. A couple of years ago, one of the boards reputational risk. I sit on decided to produce a separate In the social area, leaders are thinking report on tax. This helped us to have about employment and purchasing a transparent conversation with any practices, inclusion and diversity, and stakeholders interested in the subject. long-term value creation for customers. It doesn’t only explain the effective tax They are also acutely aware of the ability rate; it also shows where we pay taxes of consumers to gather information from and what we pay. In Europe, I’ve also social media and for organizations to seen reports on the amount of payments be targeted for attention or action. As a associated with wider stakeholders, such result, organizations are assessing their as employees and specific communities, approaches to culture, risk management, and on local tax, national tax, and so on. and controls in their supply chains. Years There is clearly a much more thoughtful ago, it was assumed that many issues approach to tax management. would be outsourced. So, particularly at large organizations with significant brand equity, leaders realize they cannot assume they outsource responsibility when they outsource an activity.

11 12 Shareholder engagement and activism | 2019 Directors’ Alert

Investor engagement and activist shareholder strategies What the board needs to know and do for the long term

It’s not your imagination: shareholders and specifically, the board’s oversight role. Dodd- activists have asserted themselves more in recent Frank instituted a say-on-pay shareholder vote, years. For better or worse, activists are more and although it is not binding on companies, it numerous and more diverse than they were in the has emboldened investors and amplified their past, both in their agendas and their methods. voice. This is particularly true when it comes to This reinforces the need for management, with executive compensation, which investors often the board’s oversight and guidance, to engage view as an indicator of potential governance with shareholders proactively, to be prepared for weaknesses elsewhere in the organization. Digital Chris Ruggeri friendly or confrontational activists, and to have a technologies have transferred a measure of National Managing Principal, long-term plan for shareholder engagement. It’s organizations’ control of information to investors. Risk Intelligence also essential for the board to consciously craft its Today, investors and other stakeholders can Deloitte Transactions and Business Analytics LLP (US) role in this tricky area, where it is expected to both communicate with millions of people at the click represent shareholders and advise management. of a mouse rather than waiting for reports to be delivered by mail or other pre-digital methods. Shareholder activism has always existed, but its goals and tactics have changed over time. In Diminishing trust in institutions and publicly held the 1980s, corporate control was the chief goal, corporations, the abundance of cheap debt, and takeovers, poison pills, and greenmail were and the market environment following the Great common tactics. Corporate raiders wanted to Recession have also prompted shareholders to acquire businesses or take controlling positions exert more influence on management and the with the aim of reshaping or dismantling those board. Activist investment funds have proliferated, businesses. Today’s shareholder activism is both feeding and feeding off these trends and different. The goals are more often to unleash raising significant capital that they must invest or create value without a change in control, in ways that generate returns. They typically and to do so by leveraging a small ownership wrangle with organizations over issues such as percentage—generally three to five percent. capital structure, shareholder value, management Some investors have exerted significant influence, competence, board composition, asset sales, and usually in conjunction with other investors major business issues or decisions. and often by stating their view of a company’s prospects and making recommendations without These recent trends suggest that management undue publicity. Others have chosen to be more should proactively engage with investors and confrontational and public in their demands. be prepared for activists with strong points of view. The board needs to oversee and advise Regulatory and technological changes also management regarding these efforts and the have disrupted the traditional balance of power risks and opportunities that investor engagement between management and shareholders. and shareholder activism present in the short Regulatory measures, such as the Dodd-Frank and long term. In some recent cases of investor Act in the United States, have heightened public engagement and activism, the board can become awareness of corporate governance and, more directly involved. In fact, in recent years, some

13 2019 Directors’ Alert | Shareholder engagement and activism

board members together with management A given company’s activists and broader No company is immune have proactively sought out investors—and shareholders are not homogeneous. have opened up a direct line of engagement. When the current wave of activism began, A Deloitte survey2 of CFOs of US Initiatives like these highlight just how many corporate leaders and observers public companies conducted in 2015 prevalent this issue is becoming for boards characterized all activists as seeking identified the following trends. Our of directors. short-term monetary gains in ostentatious experience indicates these trends ways. In truth, many have been discreet, still hold true, and in some cases, Understanding today’s activism constructive, and respectful in making they have intensified. Trends in shareholder activism tend to their cases to companies. They often have •• Just under three-quarters of begin in the United States and then extend longer-term concerns and limit their efforts US public companies surveyed elsewhere. There are structural reasons why to conversations with management and experienced shareholder activism, activism is relatively less common in Europe; suggestions for boosting performance or most often in the form of direct for example, majority control by families and eliminating underperforming assets. Others communication to management or other organizations makes it more difficult. have been quite aggressive, leveraging the the board. In Asia, state-owned, listed companies media to dramatic effect with the goal of are resistant to activism. Culture also altering the structure of the board, replacing •• About 30 percent experienced influences where activism takes root. Some senior executives, divesting specific indirect communication in the highly regulated sectors such as financial subsidiaries, changing ESG policies, or press or social media. services, media, defense manufacturers, transforming operations. •• About half made at least one and utilities tend to have some natural major business change because insulation against shareholder actions, but The companies most attractive to activists of shareholder activism; the most that does not render them immune. Virtually tend to be those with strong cash flows, low common were share repurchases, any public company can be subject to dividend payout ratios, conservative balance management or board changes, shareholder activism. sheets, recent underperformance, or divestitures, and performance assets ripe for selling or spinning off. Other improvement initiatives. Activism most often comes down to targets are those companies operating differing views on how capital should be in industries marked by shifting market Because shareholder activism shows allocated. There is an ongoing discussion forces and changing business models. The no sign of abating, companies may in the marketplace about the short- versus board should be acutely aware of all these need to review their approach to long-term orientations of activists, but the conditions and actively discussing them with investor engagement and arrive at fact is that different activists simply hold management regardless of activist activity. response protocol to implement different views. Activism merely sharpens the focus on such when an activist emerges on issues, and it might intensify the need to the scene. Many institutional investors, particularly address them. pension funds and insurance companies that seek to match assets with liabilities over Efforts to address shareholder activism the long term, want to invest in companies are most productive when they are viewed with well-established strategies and an and conducted in the context of a robust established record of performance. Senior investor engagement program, usually found leaders of some prominent investment within the company’s investor relations funds also have expressed a strong desire department. Strong investor engagement for their portfolio companies to take a enables management to understand the long-term view, but not all investors in company’s shareholder constituencies and a company will share those goals and their goals, monitor changes in the makeup interests. Different investor classes will of the shareholder base, communicate have different investment goals, time short- and long-term strategies effectively, horizons, and priorities, which can create and cultivate both reliable supporters and conflicting objectives and opinions among trusted critics in that base. shareholders and complexity for the organization’s senior leaders. 14 Shareholder engagement and activism | 2019 Directors’ Alert

As part of its oversight and governance overseeing management and actually shareholders. Management should update responsibilities, the board should ensure managing the organization, especially if the board regularly on the composition of that management has established an there are no protocols in place for the the shareholder base and how satisfied investor engagement program and has board’s involvement. they are with the information they’re taken steps to prepare a response to either receiving on the company’s capital structure, friendly or confrontational activists when A company’s investor relations function performance, and other factors that could needed. The board must also coordinate exists to inform, to answer questions, drive questions and activism. its thinking and approach to activism with and to explain the organization’s strategy, management and the investor relations markets, and performance to shareholders Additionally, the board should be open to team. It is critical to create and enhance and the investment community. This not only listening to shareholders, but also a robust capital allocation methodology should not be a perfunctory exercise in to collecting input from them, for example that is communicated externally in an information distribution, but a means by attending investor conferences to appropriate manner. of deploying an ongoing narrative and observe the proceedings and hear what’s for meeting shareholders’ and investors’ on investors’ minds. These efforts could Establishing the board’s role genuine need for information. It should also extend to more direct interaction with There is some diversity of opinion regarding also seek to create a feedback loop with specific investors. But, despite a recent the board’s role vis-à-vis interactions shareholders and the market. Investor increase in board members engaging with shareholders, weighted toward the relations involves sending messages to the with investors directly, board-shareholder board leaving management responsible marketplace, but also gauging how investors interactions are generally limited as long as for engaging with shareholders. However, are receiving those messages. Do investors the company is performing well and there some maintain that the board has a see the information as transparent and are no concerns or crises. The primary responsibility to engage with shareholders complete enough? Do they understand points of contact for investors should as their representative. In practice, we are management’s short-term and long-term generally be investor relations personnel seeing more board engagement today than strategies and risks to those strategies? and management. in the past, but senior executives and the Are they confident in the leadership team? board need to establish clear guidelines Do they hold misperceptions about the If a decision is made to have a board regarding how and when the board engages company or stock? A successful investor member engage with a shareholder, he or with shareholders. relations function monitors the marketplace she should be an independent director. and shareholder sentiment to obtain the After all, if a shareholder approaches the A company’s investor relations group is answers to these questions. board, it will often be due to dissatisfaction the main channel for communicating with with the organization’s performance shareholders, and that function reports In the survey cited previously, we asked how or its handling of an issue. To add to management, and often to the CFO. companies are changing their approach to objectivity to the discussion and insulate Encouraging shareholders to approach investor relations in response to activism. management, this discussion should be the chair or board members directly could About half said they had changed very with an independent director rather than an call into question the value of the investor little, with most citing existing programs executive director. relations function, and perhaps of the that were working well. The half that had management team. If shareholders bring a made substantial changes most often Effective investor engagement provides concern to the board’s attention, it may be cited increased monitoring of activist visibility into the strategy, operations, appropriate, in some cases, for the board to activity, enhanced planning in response performance, and finances of the company, engage with those shareholders in concert to activists’ concerns, and more proactive as well as realistic expectations. It’s a matter with the investor relations group. Having the communication with investors.3 of describing an investment opportunity chair engage with shareholders is a common in ways that enable investors to decide practice in a limited number of countries, The board should be aware of the with confidence whether it meets their including the United Kingdom, Australia, shareholder base and its needs; the objectives. A company cannot be all things and South Africa. However, direct chair investment community’s perception of the to all investors. By providing the clearest or board engagement with shareholders organization, including its management possible portrayal of the organization and in the normal course of business team and performance; and the working to deliver optimal long-term value to could risk blurring the lines between organization’s vulnerability to activist shareholders, management and the board

15 2019 Directors’ Alert | Shareholder engagement and activism

position themselves for favorable interactions gauging the long-term impact of management with investors. decisions on the organization’s performance and value and the effects on investors, That said, some investors will have activist employees, and environments in which the agendas from the outset, and others may develop organization operates. The board needs clear activist tendencies if it’s in their interest and, lines of sight into decision-making processes, usually, in the interest of the company. The board reliable assurance regarding the risks implicit has a duty to see that the company is prepared for in management’s assumptions and decisions, activists and responds to them effectively. and the willingness and ability to challenge management when needed. Actions to consider in light of activism •• Monitor the company’s shareholders and Shareholder activism should encourage boards their goals. Through surveys, discussions to step up their investor engagement oversight with management, and external perspectives, efforts, recognizing that different boards and the board should monitor the makeup of different directors will take different approaches. the shareholder base and understand the For example, some obtain updates from their reasons for its composition. For example, investor relations teams at every board meeting, industry factors may influence the diversity while others do so once a year. In some cases, of shareholder institutions and objectives. directors even meet directly with investors. Yet Although it is outside the board’s control, the very few omit shareholder engagement from the makeup of the shareholder base will reflect board agenda, and those that do act at their peril. investors’ views of the organization and management’s strategy and performance, and When authorizing corporate actions, the board the board must be aware of those views. The should consider the views and priorities of key board should also be cognizant of issues such shareholders and shareholder segments. For as a misalignment between compensation example, if the company is going to undertake a and performance, large and long-standing share repurchase program in lieu of reinvesting cash holdings, and activists targeting that capital in the company, the board should peer organizations. consider the potential effects of that decision on shareholders. Decisions that involve either raising •• Ensure that the company’s investor relations or allocating capital always warrant close scrutiny team performs well. The investor relations and an understanding of shareholders’ views function should articulate a fact-based and expectations. investment proposition that makes a clear case for why management’s strategy and decisions In that context, the board should also: are better than alternatives. The function should stay in front of developments that could prompt •• Exercise strong risk oversight and activist activity, such as industry reversals, poor organizational governance. The boards of performance, or negative media coverage. It most public companies have gone well beyond should also respond quickly to shareholder simply approving management decisions. They demands for information and cultivate good seek to truly understand and provide advice relationships with major shareholders, who can on strategies, business models, and major be invaluable in mounting an activist defense. investments and initiatives. True understanding An adequate staff of well-qualified people requires sound governance of the processes should work closely with the CEO and the CFO by which decisions are made and initiatives to communicate a compelling value proposition are undertaken. Sound governance involves

16 Shareholder engagement and activism | 2019 Directors’ Alert

and strategy. Boards also need to receive to keep employees informed and focused in periodic reports from the investor relations situations where activists go public. Failing to group; some receive them at every meeting communicate internally will only foster rumors and others only annually. Regular updates and distraction. Consider including financial, are imperative. legal, public relations, and accounting advisers in the response team. Also designate specific •• Request an activist vulnerability assessment. members of the board, such as the chair of the Companies should periodically commission an compensation, governance, and other relevant activist vulnerability assessment, which takes committees to be involved in specific issues and an objective, outside-in look at the company. It communications. Shareholder communications is difficult for management or the board to be should be structured to make higher levels of objective in this sense, given that they formulate executives available if an issue escalates. and approve the strategy and are responsible for performance. These assessments consider factors such as market capitalization relative Ongoing monitoring, proactive engagement, and to the sum of the company’s parts, financial deep preparedness will generally head off most performance versus that of peers, and the serious problems and enable a swift and effective stock’s trading range relative to that of similar response to those that do arise. companies. It identifies underperforming lines Engage and embrace of business as well as nonoperating assets, such as real estate, that could be monetized. The Shareholder activism has advantages as well as composition, skills, tenure, and performance drawbacks. On the down side, confrontational of the board is also considered. This kind activists can launch highly public campaigns that of assessment not only helps the company can distract management and cost millions. They prepare for an activist event, but also identifies can also disrupt customer and supplier relations, opportunities to lower the organization’s create openings for competitors, generate vulnerability to such an event. uncertainty, and discourage potential employees. On a more optimistic note, many companies •• Review management’s activist-campaign have benefited from activists who have directed response plan. As with any event that has the management’s attention to opportunities to potential to influence a company’s reputation, accelerate growth, improve the bottom line, management should be prepared to respond to monetize assets, or return capital to investors. an activist campaign. The plan should include The management team and the board must be protocols for responding to friendly activists prepared for either constructive or aggressive and those taking a confrontational approach. activism both in the immediate future and for the The plan should identify the members of long term. the response team and their responsibilities and provide guidelines on who should be informed (including the board), when they should be informed, and who formulates and delivers which types of responses. The first rule of activist response is to never ignore or stonewall, either of which can elicit frustration and aggressiveness. Management needs to prepare an internal communications program

17 2019 Directors’ Alert | Shareholder engagement and activism

How strategy can halt the excesses of activism

No industry or public company is immune •• Ensuring that management has a winning to shareholder activism. Some activists are strategy. Under every circumstance, the Jonathan Goodman constructive, others confrontational. board should confirm that management has Global Managing Partner, Monitor Deloitte and a winning, executable strategy in place and Vice Chairman of Deloitte Canada Activist shareholders often wish to exploit a at work today. This is not a call for the board company’s real or perceived vulnerabilities. Their to take responsibility for strategy, but for scrutiny can include a company’s performance the board to apply tough standards when and prospects, portfolio composition, capital weighing, vetting, and ultimately endorsing allocation, and governance. In fact, activism, when management’s strategy. combined with today’s dynamic, disruption-filled •• Viewing a company’s strategy through an environment, can bring about greater scrutiny activist lens. Periodically, the board should than ever before. instigate a stress test of the company’s positions, prospects, and strategy through While some shareholder activists are the lens of an activist investor. The intent is to unconstructive, there are cases where senior challenge the direction of the company and the executives and boards should view shareholder assumptions that underpin that direction. Do activism not just as a challenge to overcome, but the assumptions hold up in the face of reality? as an opportunity for growth and value creation. Are there choices or moves that an independent That opportunity is best met with what has always and dispassionate actor might suggest that been the bulwark of a company’s survival and merit consideration? What would an informed future: a clear strategy. and aggressive activist investor say about the company? No matter how large and complex or small and focused a company is, every company has a •• Encouraging engagement rooted in strategy. strategy. But simply having a strategy is not If faced with activist pressure, the board should enough to defend against activism. Rather it’s encourage constructive and proportionate management’s ability to convincingly articulate engagement. Such engagement is likely to be and execute a coherent and compelling strategy more compelling if it is coupled with a well-told that helps manage activist challenges successfully. and well-executed strategy.

•• Leveraging real or potential threats of The company’s strategy should address where activism. Ultimately, the board should consider and how it intends to win and create value over activist pressure as a potential opportunity. the long term given its aspirations and the realities By listening and reflecting on signals from the of how markets, customers, competitors, and marketplace, savvy boards can take advantage advantages are changing. A good strategy reflects of possibilities for value creation and defend genuine choices and a continually improving value against the excesses of short-termism. equation for the company’s customers.

Far from being a supporting player in activist In this context, the board of directors has confrontations, strategy should occupy a central important responsibilities relating to activism and role for those management teams and boards strategy. Some of these include: hoping to see the benefits that can result from productive activism.

18 Shareholder engagement and activism | 2019 Directors’ Alert

Questions for directors to ask

••What is our approach to investor Are we aligned with the expectations of relations? Do we have a shareholder our primary shareholders? How do we engagement plan? How proactive or reconcile expectations among our various reactive is our company when it comes shareholder segments? to shareholder engagement? ••How comfortable are we, as a board, ••Who is involved in our shareholder with our understanding of management’s engagement program and who is strategic and investment decisions? How responsible for which activities? What are do we maintain sufficient visibility into their qualifications, competencies, and the processes by which those decisions capabilities? How are we measuring the are made? How well are we governing the program’s performance and success? How process by which management formulates is the board involved? strategy and makes decisions?

••What is the detailed composition of ••How prepared is our leadership team for our shareholder base? What are the shareholder activism? What has been motivations and goals of various segments our experience? What have we done of our shareholder base? How do we know? right? What could we have done better? How can we improve our current level ••How, and how often, do we assess the of preparedness? perception investors have of us, our management team, and our company?

19 2019 Directors’ Alert | A conversation with Mellody Hobson

A conversation with Mellody Hobson

Mellody Hobson is the president How do boards distinguish between adjusted. Warren Buffett once said that of Ariel Investments, and serves as long-term and short-term thinking? champions adapt, and you have to adapt, chair of the Board of Trustees of Ariel It’s hard to generalize. At Ariel—we call Investment Trust. often due to short-term issues. You have ourselves “the patient investors” and have to walk some fine lines. Mellody also serves as vice chair of a turtle as our logo. We believe that the the board of Starbucks Corporation, long term is the foundation of how we How do you, as a board member, walk and as a director of JPMorgan think about investing in public companies. Chase. She is the former board those lines? chair of DreamWorks Animation. To me, the long term is about strategy I often ask myself, “If we were a privately Furthermore, she is a board member and driving long-term shareholder held company, what would we do?” It’s of the Rockefeller Foundation, value and growth, while the short term a way of setting aside forces that might George Lucas Education Foundation, is more about tactics. Your long-term and Lucas Museum of Narrative Art. lead you away from the best decision if strategy and growth help determine your those influences were not present, which As a Chicago-native, Mellody is short-term tactics, and your short-term they wouldn’t be if you were a private involved in numerous organizations tactics support your long-term strategy company. If there’s a difference between that focus on improving the city. and growth. She serves as chair of After School the decision you would make as a private Matters, and as a board member of company versus a public company, ask The Chicago Public Education Fund. How are directors applying a long-term yourself why that is. You can isolate forces In 2017, Mellody became the first lens in the boardroom? that might lead you down a short-term African-American woman to become As investors, we are not about investing chair of the Economic Club of Chicago rather than long-term path. That question in its 90-year history. She is a regular for the next quarter or even the next year’s helps me anchor my thinking. contributor for CBS News, provides earnings. We consider the underlying weekly money tips on the Tom Joyner value of businesses over time, and I bring How are boards thinking about Morning Show, and authors a column that perspective with me into boardrooms. for Black Enterprise Magazine. In 2015, technology-driven disruption? Time Magazine named Mellody as one I believe many board members share That’s a big topic that dominates a lot of of the 100 Most Influential People in that view of long-term value creation. boardroom conversations, and it’s an the World. The challenge is dealing with the day- important one. If a board is not having to-day real world of Wall Street, the that conversation, it would be problematic. media, and various constituents. While Everyone is trying to see into the future a board has to consider constituents’ to understand what will help and hurt issues and concerns, I believe the job of the company in terms of technology, and a board member is to drive long-term this goes across industries. We see those shareholder value. conversations across all organizations from small and mid-cap domestic How can boards avoid being overly companies to global organizations. short-term focused? A good board avoids getting caught up in the day-to-day noise, because that’s what most of it is. A good board stays focused on a clear goal that is supported by a strategy and a plan. A plan that can be

20 A conversation with Mellody Hobson | 2019 Directors’ Alert

Are boards recruiting more directors with So, I have not been in a situation in which tech and IT experience to their ranks? random investors call to speak with me, nor Board members with digital expertise are in high would I make myself available in that way. demand. When people tell us they are looking There are times, at Ariel, where we will ask to for board members, they often want people have access to a chair, but we do that through with digital backgrounds. A few years ago, it the company in which we’ve invested. I think a was more about financial expertise, especially company should always have a very unified and 10 to 15 years ago, after Sarbanes-Oxley and thoughtful message for investors. the financial crisis. These director qualifications often come in waves, but currently the demand What can a board do to understand the for digital expertise is strong. makeup of the shareholder base in terms of their short- versus long-term orientation? How can boards be proactive in anticipating That depends on the company, and different these changes? boards do it differently. You’ll typically have Good boards try to see around corners. That’s investor relations reports that portray your part of their job. That doesn’t mean they can be top investors, the conversations the company sure of the answer, but they try to anticipate. is having with them, and the key issues they’re Good boards are proactive. raising. Because I am in the investment business, I have a good sense of the firms that Should board members speak directly are out there and their reputation, and I see with investors? the difference between growth-oriented and I think it’s a bad idea to have board members value-oriented investors. So, I probably have a talking one-off with investors. Investor relations different lens when viewing top investors than should serve as a strong voice for the company, most directors. In a well-run company with an and obviously the executive team deals engaged board, you have a very good sense of directly with investors. There are situations the shareholder base and their concerns. where an investor might ask to meet with a lead director or chair if the chair and CEO are I also read the Wall Street research on our separate. I had that experience when I was companies, those we invest in, and those where chair of DreamWorks. But that does not occur I am on the board. That allows me to see on a on the fly—it is typically done with thought regular basis what analysts are saying about our and intention. companies, and we review that information in the boardroom.

21 2019 Directors’ Alert | A conversation with Mellody Hobson

Good boards think long term about every issue and decision they face.

22 A conversation with Mellody Hobson | 2019 Directors’ Alert

How do boards respond to analysts’ reports, Are organizations rising to this challenge? whether positive or negative? The conversation is growing because investors, I actually don’t react. I am focused on the especially institutional investors, are asking long term and on strategy. Sometimes the about it. Ten years ago, you would occasionally points being articulated can be noise or do not hear these questions. The questions are now reflect the current situation. When I read those being frequently asked, but the “answers” aren’t reports I tend to look at the themes or at areas easy to categorize. You can’t put these issues where we are not communicating as well as we into boxes because there’s a highly qualitative should. I also get a sense of our competitors aspect to them. I would say the assessment part from reports that compare companies. It is is where we have a ways to go. simply information I want to know, and I want to understand what is being said. I think the Has taxation gotten more on the board idea of reacting to it would be missing the point, agenda over the past few years? because I am focused on the long term. Tax is a big part of a board’s agenda. The reasons include sweeping tax changes in the What major ESG areas should boards be United States over the past 18 months or so, focusing on? and charges companies had to take to repatriate Ariel has expertise in ESG and we’ve been assets. As companies became more global they involved in ESG-related issues for much of realized they had cash in various jurisdictions; our history. I think the evolving themes are they needed to decide how to use it, and where obviously around climate and climate impact, to invest it, in a tax-efficient manner. Companies as well as governance. We’re also seeing moving their headquarters to favorable tax institutional investors increasingly concerned jurisdictions has also become a concern. These about governance-related issues like gender conversations have been driven by changes in and ethnic diversity on the board, as well as the tax policy and increased globalization. environmental impact of business. What else should directors keep in mind over However, measurement and standardization the long term? are very challenging issues. There’s a real lack Good boards think long term about every issue of standards, which leads to a great deal of and decision they face. interpretation and many differences that make this area challenging for investors.

23 24 Environmental, social, and governance (ESG) | 2019 Directors’ Alert

The board and ESG Going long on the future of the enterprise

Discussions of environmental, social, and The evolving ESG landscape: Trends governance (ESG) matters have taken hold in and practices mainstream media, government bodies, coffee ESG matters are finding their way onto shops, the food industry, clothing manufacturers, boardroom agendas more frequently. As the and boardrooms. With such high stakes, this is an scope of these and the debate surrounding them area that organizations, and their boards, cannot continue to expand, so do the board’s oversight afford to get wrong. responsibilities. The following are among the key ESG-related trends: Olivier Jan As overseers of risk and stewards of long-term •• Impacts are increasing and increasingly Sustainability leader enterprise value, board members have a vital Deloitte Global important. Business activities have both oversight role in assessing the organization’s positive and negative impacts on society. environmental and social impacts. They are also Negative impacts include their contribution to responsible for understanding the potential climate change and weather-related events, air impact and related risks of ESG issues on the and water pollution, ecosystem degradation, organization’s operating model. In light of these mistreatment of animals, human rights abuses factors and stakeholder concerns, organizations in supply chains, and potentially unsafe practices are reimagining and enhancing their ESG and products. Many believe that most negative positions. This is happening more in some impacts related to human activities, such as regions (e.g., Europe) than in others, and it is climate change and biodiversity losses, are more prevalent in certain sectors (e.g., consumer worsening. Among the most favorable trends products, heavy industry). Shifting political winds is a decline in world poverty; global GDP has also can affect these efforts. Since ESG issues risen steadily in the past two decades. Business began to move into the mainstream, the trend has also been credited with innovations, job has generally been for organizations to pursue creation, philanthropy, and other contributions. sustainable practices for the long term. Some organizations have actively embraced and promoted “green” goals and aim to boost It can be challenging for boards to connect global the “triple bottom line,” which considers people, issues, such as climate change, water scarcity, or planet, and profits. human rights, to the organization’s operations, strategy, and risk profile. But given that ESG •• Transparency is the new normal. Trends concerns both influence and are influenced by in ESG reporting indicate a steady move operations, finance, risk, compliance, legal, human toward greater transparency. Standard- resources, and other considerations, leadership setting organizations, including a number of teams have ample opportunity to leverage ESG stock exchanges, have called for enhanced for the long-term good of the organization, its ESG disclosures. Civil organizations and the stakeholders, and society. It’s an endeavor both media regularly track and report on ongoing management and the board need to undertake performance and specific events in terms of for the general betterment of those inside and industrial accidents, environmental degradation, outside the enterprise. and impact on human populations. Social media

25 2019 Directors’ Alert | Environmental, social, and governance (ESG)

has also become a force for ongoing Pacific garbage patch and the subsequent and Asia. Under Directive 2014/95/EU, as transparency, and consumers increasingly media reporting. Not all ESG risks are of 2018, about 6,000 EU companies must want to understand what is behind the long term. Depending on the business disclose their policies on environmental product they see on a shelf. model, material and labor sources, protection, treatment of employees, evolving regulations, and stakeholder respect for human rights, anti-corruption •• Reputation is an indispensable asset. behavior, ESG matters can also present and bribery, and board diversity. Lower As trust in institutions and the power of near-term threats to an organization’s and more variable regulatory demands in traditional advertising have diminished, supply chain, reputation, and shareholder North America tend to generate practices organizations have come to realize value. Consider the potential impact of driven by stakeholder expectations and that reputation constitutes a strategic child or forced labor in the supply chain, individual companies’ initiatives, with some asset and can be directly and indirectly carcinogenic ingredients or conflict organizations and jurisdictions pursuing influenced by ESG practices. Although minerals in products, or major class-action aggressive programs. California will, as of reputation is often viewed mainly as suits launched over executive decisions 2020, ask the two largest US pension funds an issue for business-to-consumer or behavior. Given the potential impact to consider disclosing material climate- companies in developed countries, many on near- and long-term shareholder related risks if it is in the shareholders’ business-to-business companies in all value, leaders must gauge the full range best interests.4 ESG practices are also markets are affected by greater risks and of factors that generate ESG risks and reaching new regions; for example, many heightened transparency requirements develop ways to address them. Southeast Asian companies have boosted across the supply chain. In response, ESG efforts to bolster their reputations and many companies are now prioritizing It can be useful to think of ESG risks in their ability to do business in countries with ESG factors internally and among their terms of the organization’s social license to stronger policies. vendors. These organizations realize operate. Unlike a legal license to operate, that a significant ESG event anywhere the social license to operate is granted, in Investors look to ESG in the extended enterprise can damage part, by customers through their purchasing The ESG concerns of specific investors their reputation. decisions. If your ESG reputation is tarnished vary, as does their view of organizational •• The workforce cares. Employees want or people associate your enterprise with responses, but all need information to help to be proud of where they work and global warming, water pollution, resource them make investment decisions. They want want its purpose, mission, and culture abuse, child labor, or poor working insight into management’s posture on ESG to reflect, or at least not oppose, their conditions, your business may suffer either topics and the associated issues and risks, values. This is especially true of younger a gradual or rapid decline in demand. Many as well as plans and responses. For example, professionals. Corporate value statements consumers seek out companies known for institutional investors have become highly and management’s cultural messaging sustainable practices and are willing to pay concerned with climate change, and may mean little to these workers in the a premium for sustainably produced food many are voting their proxies, engaging face of negative ESG impacts, which can and clothing or space in a LEED-certified management, and seeking clarity on compromise an organization’s ability to building. Such consumers often represent management’s and the board’s positions in attract talent. A favorable ESG profile and a substantial, loyal, and affluent minority. this and other areas. Engagement can help an absence of negatives can be an asset, Equally important, sustainable products companies better understand which ESG particularly in areas where talent is scarce are being brought to market at costs topics their shareholders see as priorities. and competition is strong. increasingly comparable to those of more traditional versions, a trend that we expect Investors realize that ESG activities can have •• Business value is at risk. ESG issues can to continue. negative or positive financial consequences take a long time to erupt into risk events. and they want to anticipate and account for While many environmental risks, such Regulators tend to follow the public’s the operational, regulatory, and reputational as climate change and water scarcity, concerns on ESG matters, although they impacts of ESG issues. They see the link have been anticipated for a long time, also develop their own views. In general, the between ESG and the value of the business, others emerge rapidly. A recent example European Union has been the global leader but they cannot forecast value and factor in includes the plastic backlash that began a in ESG policies, followed by North America related risks without better ESG information. year ago, soon after the discovery of the

26 Environmental, social, and governance (ESG) | 2019 Directors’ Alert

It is in the organization’s interest to provide robust ESG disclosures. First, these disclosures give investors Sources of guidelines information they want and need; when it is lacking, they may Boards, CFOs, and audit committees should be aware of think the worst or simply invest elsewhere. Second, public organizations and initiatives that promulgate ESG reporting disclosure allows businesses to demonstrate progress guidelines. Some of these include: and benchmark their own practices and reporting. Finally, public disclosures put management in control of the ESG •• The Global Reporting Initiative is a network-based organization narrative. When investors do not receive ESG data directly committed to improving sustainability reporting; its from the company, they will turn to other sources for that participants include business, social, labor, and professional information or an approximation of it. It’s highly preferable organizations. GRI’s Sustainability Reporting Guidelines for the organization to provide accurate data and develop are widely used by large companies and set forth reporting the narrative context for its ESG practices to communicate principles, standard disclosures, indicator protocols, and the right message. economic, environmental, and social performance measures. The latest release stresses “material aspects” to help Unfortunately, even those companies that are working to organizations identify issues significant to stakeholders.5 enhance their disclosures often produce results that lack •• The International Integrated Reporting Council promotes the relevance, transparency, and comparability that would periodic, holistic reporting about value creation. The IIRC really benefit stakeholders. Some have still not identified helps organizations consider how environmental strategy, the most material ESG issues for their businesses. Most governance, and performance can create value in the short, communicate aggregate information rather than reporting medium, and long term. The IIRC also strives for a reporting on specific geographies and lines of business; this high-level environment that promotes understanding of strategy, drives aggregation is of little help in comparing companies with performance internally, and attracts investment.6 different geographical footprints and different degrees of value chain integration. Investors would need further •• The Sustainability Accounting Standards Board sets sustainability investigation and analysis to make those comparisons when accounting standards for publicly listed companies in the they are even possible. While the trend has clearly been in United States for use in disclosing material sustainability issues the direction of increasing ESG disclosure, there’s room for to investors and the public. It is developing standards for more improvement on detail, transparency, and comparability. than 80 industries in 10 sectors by researching material issues, convening industry working groups to establish accounting Some financial institutions now consider ESG factors in metrics, and providing education on how to recognize and their lending and investing decisions, with others moving account for material nonfinancial issues.7 quickly in this direction. Although these institutions might •• The World Federation of Exchanges, a global industry association not have considered corporate customers’ ESG profiles for exchanges and clearinghouses, published principles in the past, they now realize that ESG risks could affect in 2018 to integrate a long-term perspective into financial those customers’ future financial performance. They are markets to reduce socioeconomic and physical risks. While scrutinizing these issues more closely when considering member exchanges are not required to adopt additional rules which companies and projects they will finance, particularly or recommendations on ESG disclosures, 39 of the WFE’s 79 in light of climate-related issues, although concerns extend members have issued such guidance, and the new principles to other areas. This trend is strongest in Europe, where were greeted as a milestone by the United Nations Sustainable sustainability performance can influence what corporate Stock Exchanges initiative.8 customers will pay for a loan, which would not have happened years ago.

27 2019 Directors’ Alert | Environmental, social, and governance (ESG)

Guiding the enterprise toward greater stakeholders—particularly investors, be aligned on which facets of ESG are sustainability for the long term customers, employees, regulators, most important to the organization and Most leadership teams already see the and business partners—and how they adopt a method of reporting on related need to identify and manage ESG impacts view the organization’s performance. activities, risks, and opportunities. The and risks. Boards have the responsibility This information can be gathered and organization should articulate clear and to influence management to enhance the monitored through periodic surveys of measurable goals on ESG issues so it can organization’s approach to ESG. This is not specific stakeholder groups or across all gauge progress over time. Gathering ESG just about public relations and branding, stakeholder segments. It’s best to have data and developing an ESG reporting although those are valid considerations, nor a formal process of ongoing stakeholder infrastructure now helps position the is it merely a matter of ethical practices and engagement at the management level, organization for a future in which the having a positive organizational impact. It and in some cases to involve the board. demand for this information will likely is also a question of business performance For example, some companies develop increase. Management should make ESG and long-term value. Almost by definition, a committee of representatives of key disclosure a priority, update disclosure sustainable practices aim to ensure that the stakeholder communities to discuss practices based on changing standards organization creates and maintains value ESG matters. Others will consult “critical and organizational practices, and maintain over the long term. friends” on sensitive ESG topics. Many also control of the organization’s ESG narrative. monitor their reputation in traditional and •• Establish specific ESG roles and The business case for ESG generally social media and work to address ESG responsibilities. Once an organization begins with operational efficiency and concerns raised there. has identified and assessed specific risk reduction as primary goals and then •• Insist on high-quality internal ESG impacts, risks, and opportunities extends to longer-term operational and ESG reporting. The board needs to and the data gathering, measurement, organizational resiliency and sustainability. understand management’s approach to and reporting mechanisms are in place, ESG and its performance against relevant management and the board are better To head the organization toward an metrics. Energy use is an excellent starting positioned to set and pursue near- and increasingly robust approach to ESG, point for many large organizations; other long-term goals. Many large organizations the board might also consider the metrics may involve water use, especially have appointed a chief sustainability following practices: in areas where it is scarce; critical metals; officer, while others have given the CEO •• Request a formal ESG assessment. chemicals, plastics, and other materials; or other C-suite executives explicit ESG Senior executives and the board should be labor practices; climate and other responsibilities. From a board perspective, aware of all potential impacts, risks, and environmental impacts; and extended ESG is most often overseen at the full opportunities posed to the business by enterprise practices. Coverage should board level or by the board’s strategy ESG concerns and be clearly informed of extend to foreign, as well as domestic, or risk committee. The audit committee those that are most material for the future operations. ESG events should be should also initiate or strongly support of the organization. An ESG inventory and reported to the board in keeping with the efforts to provide high-quality ESG formal risk assessment should extend organization’s established risk-reporting assurance to the board, or to the primarily beyond the organization and its internal procedures regarding type and magnitude. responsible board committee. operations, and it may be appropriate Developing a reporting protocol can be to engage external stakeholders. The challenging, because this goes beyond Arguments boards make to encourage assessment should cover the complete financial and standard operating reporting. management’s ESG efforts typically involve supply chain, the extended enterprise, and Either the board or specific directors business disruption, regulatory compliance, strategic considerations such as resource should engage with management and and reputational risks. These arguments accessibility, usage, and sustainability; external experts regularly to understand are compelling in the absence of strong talent recruitment, engagement, and the interplay between ESG and the regulatory imperatives or in the presence of retention; financial performance and risk; organization’s operational and financial weak ones. and reputational impacts. The assessment performance, goals, risks, and reputation. should not only identify and rate all The board should also work with the CFO In keeping with recent trends, ESG risks, but also consider how those risks and other senior leaders to obtain data regulation is expected to continue to interrelate at the enterprise level. that is relevant and comparable from strengthen, as is the interest that investors, period to period. customers, supply chain partners, civil •• Urge management to engage with organizations, and the media have in ESG stakeholders. Management must •• Encourage more proactive disclosures policies that have a positive impact on the understand the ESG priorities of key and goal setting. Management should communities they touch. 28 Environmental, social, and governance (ESG) | 2019 Directors’ Alert

Questions for directors to ask

••Which ESG issues most concern our ••What is the best way for us, as a board, stakeholders? What steps is management to increase our internal and external taking to understand and monitor engagement on ESG? How often should stakeholders’ concerns? we discuss ESG among ourselves and with management? How can we make those ••How is management integrating ESG discussions more robust and productive? considerations into the business strategy? Which ESG risks and opportunities have ••How are we keeping pace with investors’ been identified in both the near and long expectations regarding ESG disclosures term and how is management addressing and reporting? How do we compare with and periodically assessing them? our peers in this regard? What is the best course for our organization to pursue ••What process does management have for when it comes to disclosure? identifying ESG risks and opportunities? What process is in place to integrate ESG considerations into strategic planning and decision making?

••How satisfied are we with the ESG information we’re receiving? What information should we be receiving that we are not? What type of assurance would improve our line of sight into our organization’s ESG practices?

29 2019 Directors’ Alert | A conversation with Laura Cha

A conversation with Laura Cha

Laura Cha is a member of the What is your view on short-termism Diversity will help, because having various Executive Council of the Government versus long-termism at the board level? perspectives will enrich the discussion and of Hong Kong, chair of Hong I would say that short-term and long-term debate. It’s almost a given these days that Kong Exchanges and Clearing Ltd and a member of the Financial thinking are interrelated, and you cannot you need diverse viewpoints, which makes Leaders Forum. really separate them. The short term the composition of a board so important. actually constitutes the first stage or the But being prepared goes beyond the Laura is also the non-executive first few stages of your long-term strategy. diversity characteristics of gender and deputy chair of The Hongkong and Shanghai Banking Corporation, The long-term view is critically important age. Being prepared is more about having an independent non-executive because that forms the backdrop of every a board that is well educated on the director of HSBC Holdings plc and company’s strategy: its direction and potential issues and impacts. The London Metal Exchange, and where it wants to be in the future. serves as a non-executive director at Unilever plc. How can boards plan for the long term However, if you set too long of a time during an uncertain and volatile period? Furthermore, Laura is a senior horizon, it can become unrealistic. These It depends. For example, early in 2018 the international advisor to Foundation days, short term should cover one to situation on the Korean peninsula made Assets Management Sweden AB, a member of Sotheby’s International three years whereas long term would headlines. In this case, a consumer goods Advisory Board, vice chair of the be closer to five years. A decade or two company likely had a different response International Advisory Council of ago, medium term would have been five than a financial institution. If a consumer the China Securities Regulatory years and 10 years would have been long goods company had a large market in Commission, and a director of the World Federation of Exchanges. term. With technology and the whole South Korea, they had to consider the world changing so rapidly, organizations impact on its markets and customers. Laura became the first and only can develop core long-term principles Meanwhile, a goal for a financial institution person outside Mainland China to- and values while adapting a shorter-term might be to reconsider its risks in Asia. At date to join the Central Government of the People’s Republic of China strategy. Of course, time horizons will the time, it all seemed very real, yet a few at the vice-ministerial rank when differ by industry. months later the risk seemed to have been she was appointed as vice chair of defused. So, whether a board should take the China Securities Regulatory Are boards ready for Industry 4.0? action depends on the situation, the issue, Commission in January 2001. She served in that position until It is hard to gauge readiness because it and the organization’s industry. September 2004. She also worked differs by industry, but boards must be for the Securities and Futures prepared. Being prepared means that you At the securities exchange, we understand Commission in Hong Kong from have thought through the issues and the that market volatility and various crises 1991 to 2000, becoming its deputy chair in 1998. She was also chair of organization is prepared to adapt. Given will come and go, and that there is little The Financial Services Development the prevalence of technology disruption, we or our board can do about that. On the Council of Hong Kong from January boards need continuous education in other hand, systemic preparedness will 2013 to July 2018. this area and need to stay abreast of ensure that our systems and operations the impacts, risks, and opportunities are resilient and are able to handle that technological changes pose to their unexpected situations and volatility. respective industries. That is what we strive for, whether the situation is geopolitical or something How does boardroom diversity impact else. Each issue should be considered and its preparedness for the long term? addressed individually. Preparedness means knowledge of the current issues and their potential impacts.

30 A conversation with Laura Cha | 2019 Directors’ Alert

The long-term view is critically important because that forms the backdrop of every company’s strategy: its direction and where it wants to be in the future.

What type of strategic plan do you What long-term concerns tend to be on Mainland China is considering communicate to your investors? the minds of institutional investors? adopting mandatory ESG rules. How Our next three-year strategic plan will be ESG is high on their agenda, and I’ve seen will other countries, more specifically launched in the first quarter of this year. this building up for a few years now. It’s Hong Kong, respond? Many organizations have useful ways of definitely driven by the buy side. There are Yes, they are ahead of Hong Kong in communicating their plans to investors, many ways in which an organization can that area. We are looking into their with investor relations generally playing an define responsible corporate citizenship. proposals and into ways to expand on our important role in that. I have seen some sovereign funds that requirements in this area. have said they will no longer invest in fossil Do boards often hear from investors on fuel industries or in the tobacco industry. What are the long-term focus areas for their short- and long-term views? That emanates from ESG concerns. Hong Kong company boards? In Hong Kong, the situation is slightly Corporate social responsibility will Board diversity is an important issue—it different from other markets as there are remain high on the board’s agenda, with has been for some time—and progress a lot of small investors and a significant the environment being an increasingly made has been slow. If you look at gender amount of retail participation in the important element of ESG. diversity on Hang Seng Index company stock market. One can expect to hear boards in particular, the proportion of many viewpoints from various investors, What would you say are the most women serving on boards has risen from but most of our institutional and retail important long-term aspects of ESG for around 10 percent to 11 or 12 percent in investors fall broadly into two groups. One Hong Kong-based companies? recent years. This is an area that needs group mainly wants to know that there’s Again, it depends on the industry, but improvement relative to other markets. a sound dividend policy with dividends I would say that the social component Beyond diversity, there are other focus declared every year. The other group is not is one that most Hong Kong companies areas. For us, our long-term relationship focused on dividends and may not want are embracing. This tends to cut across with the Mainland Chinese markets is dividends declared. This group appears to all industries and can take the shape of quite important. Meanwhile, technology be focused more on the long term. These caring for the community. As a securities is of course an overriding issue for all investors realize that the organization exchange, we work to promote financial exchanges and for all companies. probably has a long-term strategy that will literacy. Governance is also a very enable it to declare a dividend further into important aspect of ESG. the future.

31 S S S

32 Tax strategy | 2019 Directors’ Alert

Tax strategy for the long term Is your company getting it right?

Once considered just another part—and cost—of What’s driving change? doing business, tax has become a high-priority The impetus for many recent changes can be agenda item for both the C-suite and the board. traced back to the 2008 global financial crisis, Even amid decreasing corporate income tax rates which forced a number of countries to introduce in the United States, the sheer number and range significant budget-cutting measures. At the same of changes in government tax policies warrant time, there was a growing perception that MNCs close attention, certainly for senior leaders of were using tax planning to erode the corporate multinational corporations (MNCs) and for most tax base because international tax law had not Albert Baker enterprises doing business internationally. kept pace with the increasingly globalized and Tax Policy leader digitalized economy. The G20/Organisation for Deloitte Global Concerns now extend well beyond achieving Economic Cooperation and Development (OECD)’s 9 financial targets to include managing reputational Base Erosion and Profit Shifting (BEPS) project risk, weathering increased scrutiny from media set out to address these concerns by increasing and activist organizations, and addressing the transparency and curtailing international tax impact of tax on everything from business planning. This led to unprecedented legislative tax models to investor communications. Stakeholder changes around the world, a number of which are interest in tax matters has also increased. Given outlined on page 35. this heightened profile, organizations should be consciously shaping their tax strategies and Technology stands among the primary drivers involving senior executives, the board, and more of change in tax policy, as it does in many facets specifically, the audit committee in the process, of business. Tax practices within and between along with the finance and tax functions. countries were developed when Industry 4.0, artificial intelligence, cryptocurrencies, blockchain, The pace of change in government tax policies data analytics, and robotics were barely adds complexity to this inherently technical imaginable. Rapid adoption has left governments area. Those policies remain a work in progress playing catch-up even as those technologies and as tax authorities grapple with the effects of the practices they enable continue to evolve. digitalization, new business models, new methods of accessing talent, and globalization. When Consider the challenge that the digitalization you consider that today’s tax codes rest on of business poses with respect to tax matters. frameworks formulated more than 100 years ago, Taxation, historically and of necessity, seeks out the magnitude of the changes and their potential and draws from value; that is, global transfer to have a long-term impact become clear. pricing systems generally aim to tax value where it is physically generated. Therefore, business

33 2019 Directors’ Alert | Tax strategy

models that generate value from data prompt questions: Does the Agreement on how value that should be taxed reside in the data itself? In the processes that analyze or otherwise add value to the data? In selling the data? In the technologies that house and manipulate the data? And where, digitally developed value exactly, are each of these processes, activities, or technologies and digital transactions physically located? The OECD has been seeking consensus on these fundamental questions of how value should be defined and taxed. Unfortunately, should be taxed has agreement on how digitally developed value and digital transactions should be taxed has proven elusive. No fewer than four views of the proven elusive. matter have emerged: Some countries believe that current tax law can address digital matters. Others believe that specific legislative changes are needed to address them. Still others believe that the issue extends beyond digital considerations and that a broader revision of tax laws is needed. And a fourth group has yet to decide which approach is best.

As the OECD continues its work in this area, the importance of reaching a global consensus cannot be overstated. Each country taking unilateral action could result in chaotic complexity, double taxation, and impaired cross-border trade and growth. As of this writing, the OECD was contemplating three approaches:

•• A “digital permanent establishment” with allocations of profits made to jurisdictions based on criteria such as number of users in the member country

•• A return to jurisdictions-based approaches, taking into account the value of marketing intangibles

•• A minimum tax approach, along the lines of the US Global Intangible Low Taxed Income (GILTI) regime, coupled with a secondary approach applicable to companies parented in jurisdictions without a corporate income tax or that do not adopt the minimum tax.

The latter two approaches would apply to all businesses and not just those operating in the digital economy.

34 Tax strategy | 2019 Directors’ Alert

Unprecedented change in taxation

The OECD’s BEPS project has introduced a number of actions The following specific developments have occurred beyond the guided by the principles of coherence, substance, and BEPS project: transparency. Initiated by the G20 in 2012 and now expanded to •• EU Anti-Tax Avoidance Directives 1 (effective in 2019) and 2 124 countries, the BEPS project stemmed from perceptions by (effective in 2020–2022) implementing certain measures some that many MNCs were not paying their “fair” share of tax described above and further measures, including a General and were engaging in legal tax arbitrage. Anti-Abuse Rule; a tax intermediaries directive to increase reporting requirements as of July 2020, with some retroactive Some of the actions now being implemented include: application; and European Parliament TAX3 Committee work •• Global Country by Country Reporting, which calls for detailed related to financial crimes, tax evasion, and tax avoidance.11 reporting of corporate taxpayers’ foreign operations to be •• A 2018 EU proposal (not yet adopted) to tax digital companies shared with tax authorities around the world, thus increasing using a temporary measure pending global consensus in this transparency. Generally, 2018 is the first year for tax authorities area: a 3 percent tax on specified sources of gross income. to exchange information. •• US tax reform in 2018 reduced the federal corporate rate from •• Global transfer pricing guidelines with more detailed global 35 to 21 percent and introduced exemptions for dividends from and country reporting and a focus on allocating income to foreign subsidiaries and other measures, including: those countries where activities are performed and economic substance10 is present. Generally, 2017 was the first year of ––A Global Intangible Low-taxed Income regime that taxes reporting, but the new guidelines have been applied by many earnings above certain thresholds in foreign subsidiaries on countries to open cases dating from 2015. an accrual basis at an effective rate of 10.5 percent for 2018 •• A multilateral treaty instrument, signed by 84 countries as through 2025 and 13.13 percent thereafter of November 2018, to swiftly implement the BEPS-related ––A Foreign-Derived Intangible Income regime that taxes changes into existing treaties and prevent using treaties for foreign income above certain thresholds at 13.13 percent for tax avoidance. This initiative is expected to impact over 2,000 2018 through 2025 and 16.41 percent thereafter12 bilateral tax treaties starting in 2019. ––A base erosion and anti-abuse minimum tax, which offsets •• Automatic global sharing of local-country tax rulings among the benefit of certain payments to foreign-related parties and tax administrations, applicable from 2016 and in the European ensures that the US payer is subject to at least a 10 percent Union from 2017. liability (5 percent for 2018 under certain transitional rules) •• A harmonized global approach to patent box incentive regimes, on taxable income, computed without regard to the related- generally applicable in 2016 through 2021. party payments.

•• Eliminating mismatches in country tax laws applicable to •• Inspired by the 2010 US FATCA, the Common Reporting taxation of cross-border hybrid instruments and entities; Standard (CRS)/Automatic Exchange of Information calls for countries are implementing anti-hybrid rules into local financial institutions to automatically advise a customer’s legislation with various effective dates from 2017. country of residence of any accounts opened; 49 countries adopted the CRS in 2017, another 52 in 2018, and seven more •• Restricting the deductibility of corporate interest expense are slated to do so in 2019–2020.13 starting in 2019 in the European Union, 2018 in the United States, and 2017 in the United Kingdom.

•• Greater domestic taxation of offshore income, known as controlled foreign corporation income, effective on various dates and in 2019 in the European Union.

35 2019 Directors’ Alert | Tax strategy

The US Supreme Court case of Wayfair perspective, so it’s useful for them to share versus South Dakota epitomizes the rapid those perspectives with government in change in the tax arena and its impact on the early stages of policy development business models. In this case, the Supreme and thereafter. Court determined that simply selling into a state may constitute nexus in the state for Active engagement with tax policy makers a company and thus create a tax obligation by executives and board members can also Deloitte conducted its fifth annual to that state. This decision has prompted help gauge where tax policy may be headed. BEPS survey in 2018 to gauge MNCs’ many organizations to revisit their taxation The board should confirm that management views of the evolving tax landscape.14 practices in individual states. In the past, is actively assessing potential legislative Key findings of this survey of 447 they may not have had sales tax or other developments at the regional, national, and participants from 39 countries tax obligations in a state where they did not provincial or state levels and considering include the following: maintain a physical presence. alternative responses. Inputs to scenario planning should take into account potential •• 86 percent agree or strongly The BEPS project has focused on increasing changes to tax laws and their likely impacts. agree that tax structures are now transparency and curtailing international under greater scrutiny by tax tax planning. The work regarding the digital Deloitte research suggests that changes administrators than a year ago. economy is focused on reaching agreement in tax policy are having a significant effect •• 49 percent agree or strongly agree among countries on the allocation of on organizations (see sidebar). As in any that country tax authorities are taxing rights. Consensus continues to be situation characterized by rapid change, becoming increasingly aggressive a challenge across the European Union competing interests, and unsettled rules, in tax examinations. and globally; some countries have already uncertainty prevails. And uncertainty introduced unilateral measures to tax the means risk. •• 91 percent believe that additional digital economy and more intend to do so, transfer pricing reporting potentially leading to double taxation. Tax-driven risks requirements resulting from BEPS Risks resulting from the foregoing will substantially increase their While some base-broadening initiatives developments can be broadly characterized corporate tax compliance burden. will result in an increase in tax liabilities, as financial risk, disclosure risk, and •• 48 percent are concerned about governments are striving to attract reputational risk. the lack of domestic guidance on and retain investment and create jobs BEPS-related legislative changes, through reductions in corporate tax rates, Financial risk arises when tax authorities and only 21 percent expect accelerated depreciation allowances, and could prevail in challenging an organization’s consistency in interpretations of other incentives. The average corporate tax position, with potential impacts on cash new transfer pricing guidelines by rate in OECD countries fell from 32.5 percent flow, earnings, and other accounts. If a tax authorities in various countries. in 2000 to 23.9 percent in 2018.15 material transaction is challenged and the company’s position is not sustained, These responses highlight the need Changes in tax policy present opportunities financial consequences ensue. for organizations to take a strategic, for corporate leaders, including the board, multidisciplinary approach to to take a more proactive approach to tax Disclosure risks may arise around how changes resulting from tax-related policy discussions. Policy makers generally clearly the sustainability of the organization’s government initiatives. In the past, seek business leaders’ input and certainly tax policy or effective tax rate is conveyed this might not have required the consider it. They realize that organizations and uncertainties related to tax assets attention of senior management and understand their businesses and the and liabilities. the commitment of organizational operational and financial impacts that resources, but the new environment changes in tax policy can have on individual Tax-related reputational risk varies in now requires both to support long- companies and entire industries. Business its forms and across organizations. For term success. leaders are positioned to help policy makers example, the media or activist groups may visualize what would and would not work portray a company as underpaying taxes, from a practical business and industry not paying its fair share, paying lower rates

36 Tax strategy | 2019 Directors’ Alert

than private individuals or smaller businesses, or will generally not be the key determinant in the avoiding taxes. business decision.

Management should conduct assessments of The board should also consider the following tax-driven risk and associated risk-return tradeoffs specific issues that can be influenced by and establish explicit tolerances. Senior executives tax matters: and the board should discuss these risks and •• Business strategies and models: Although tradeoffs and approve the related risk tolerances. business strategies and models should not These practices are occurring more frequently be determined solely by tax policy, changes to given that these issues often impact the broader the tax strategy should be considered. This is organization and thus fall within the board’s risk particularly true of marginal projects or those oversight responsibilities. in which depreciation or the deductibility of expenses are affected. However, because taxes Beyond enterprise-specific risks, there are follow business models, it is important to analyze macro-level risks if tax authorities fail to develop tax-related risks and opportunities. More change a coordinated approach in this new environment. can be expected as legislation and litigation There’s significant risk of highly uncoordinated, occur in countries and as disputes between unilateral action being taken around the world, countries are settled. Changes in trade policy, which could lead to multiple levels of taxation including increased customs duties, can also without offsetting relief. That would almost have a dramatic impact on global supply chains. certainly have a negative effect on specific businesses as well as the global economy. •• Systems and technology: The board should confirm that management has prepared the As part of its risk oversight responsibilities, the organization’s accounting and financial systems board must understand these tax-related risks to accommodate changes in tax reporting, and confirm that management has recognized and payments, data collection and analysis, and addressed them. The board’s involvement with other needs emanating from changes to tax strategy also extends beyond that, particularly jurisdictional tax policies and the organization’s regarding longer-term considerations. tax strategy. Management should prepare the organization to address future tax changes, Overseeing tax strategy, policy, and risks which can be expected in response to ongoing Given digitalization and the increasing role of digitalization and political pressure. technology in the future of business, tax matters •• Reputational considerations: Tax strategy will extend well beyond near-term financial, should be considered by management and the reporting, and reputational impacts. The board board in the context of overall reputational should ascertain that management has prepared risk management. Senior management the organization not only for immediate tax and the board need to understand the changes but also for its intermediate- and long- potential reputation risks associated with term impacts. Many boards include this language the organization’s tax strategy. Although in their audit committee charter. an organization’s tax function should play a significant role in informing the board, Tax considerations are rarely the sole factor in reputational risk should be assessed through an a strategic business decision. Yet they should organization-wide lens. be factored into decisions involving technology platforms, the control environment, compliance •• Talent models: Issues involving employment systems, and assurance activities, as well as those taxes, employee income taxes, and taxes on involving new business and talent models, new independent contractors may arise, particularly markets, and all third-party relationships. These as the gig economy, crowdsourcing, and talent areas present both opportunities and risks to be mobility continue to increase—the notion of analyzed from a tax perspective, even though tax taxing robots has even been proposed. As

37 2019 Directors’ Alert | Tax strategy

tax laws change, more robust support from and their impact. This information should be the human resources and tax functions may compiled and delivered to the board so it can be needed to handle the complexities of familiarize itself with the organization’s tax audits employment taxes and, in cases of foreign and the outcomes of any tax litigation. Historical employees or locations, home-country/ matters can be conveyed to new board members host-country income tax issues. Given in their orientation materials. the widespread use of alternative staffing models, management should closely monitor As a practical matter, many boards rely on the employee classification criteria, such as varying audit committee to keep them informed about the definitions of independent contractors and part- organization’s tax positions and developments. time employees. However, if the board perceives little change in the reporting methodology and disclosures related •• Reporting and disclosures: The increasing to tax, it may be time to raise the matter with emphasis on transparency should prompt the the audit committee or for the audit committee board to work with management to assess to do so with the tax, finance, and internal voluntary disclosures regarding tax strategy with audit functions. Few large organizations remain an eye toward investors and other interested untouched by the ongoing upheaval in tax policies. parties. For example, management might discuss the organization’s structure and its tax In this rapidly changing and highly technical implications or the board’s role in contributing area, tax expertise in the boardroom will vary to the government’s tax policy and any related significantly or, in some cases, may be lacking. consultations. The company might disclose all External expertise in the form of written briefings taxes it pays beyond income tax to give the or live presentations on tax changes and their public a clearer picture of its total contribution potential impact can be highly valuable to both the to the governments and societies of the audit committee and the full board. The full board countries where it operates. Management’s goal should now consider discussing tax regularly to should be a sustainable tax strategy supported keep abreast of legislative developments and the by technology, compliance, reporting, and organization’s responses. assurance systems that can accommodate numerous changes in reasonable time frames As in many areas that were once seen as at reasonable costs. In terms of reporting relatively static, tax strategy and the related and disclosures, boards should encourage technology, administrative, and risk management management to position the organization infrastructure must now be reviewed more to proactively respond rather than to react frequently, in greater detail, and at higher levels to change. of the organization than in the past. Considering the long-term impact that tax strategies and The board needs a clear line of sight into tax policies can have on an organization, proactive developments and management’s responses. This engagement by the board is clearly warranted. includes understanding the organization’s tax history, including the changes to past practices

38 Tax strategy | 2019 Directors’ Alert

Questions for directors to ask

••How is our organization’s tax strategy ••How can we keep abreast of changes in aligned with our business strategy? Where the government’s tax policy and their do they fail to align? How can management potential short- and long-term impact on better integrate the two, particularly in our organization and its operational and terms of long-term tax strategy? financial performance?

••What financial, reporting, and reputational ••How is management preparing our risks does management associate with organization to address the operational our tax strategies? What has management and financial impacts of proposed changes done to evaluate and address these risks to government tax policy? What has been and any associated tradeoffs in the short done so far? What remains to be done? and long term?

••What tax-related expertise is available on the audit committee and board? How can we augment resources in areas where we may be lacking sufficient or specific expertise?

39 40 Conclusion | 2019 Directors’ Alert Conclusion

Act now for long-term results As stewards of long-term enterprise value and Every board member, and especially every board ambassadors of the organization to the larger chair, is facing a clear question: How should society, boards and their chairs are responsible I exercise leadership in this disruptive and for resisting short-term forces and keeping the unpredictable environment? focus on the long-term good of the organization and its stakeholders. We’ve discussed four areas A shift toward long-termism, as opposed to that organizations and their boards should pay the short-termism that has often dominated close attention to in 2019: Industry 4.0; investor David Cruickshank corporate thinking and behavior, is one answer. engagement and activism; ESG policies; and tax Deloitte Global Chairman Virtually every decision involving the board holds strategy. Boards might emphasize a broader shift long-term implications. But routine matters toward a more long-term focus by examining the and urgent distractions continually focus long-term aspects of every area of responsibility, board members’ attention on the short term— every major decision and investment, and all short-term earnings, near-term performance, critical policies. immediate impacts, and unfolding crises—often pushing long-term concerns to the end of The business environment is in constant flux— the agenda. that’s undeniable. Boards not only need to change the way they approach these challenges, but Paradoxically, a tight focus on the short term also to look inward. What skills and attributes can prompt leaders to dismiss new strategies, do directors and the board chair need today technologies, and methods as fads or as lacking to exercise leadership, good governance, and value when they actually represent the future. oversight? What will they need in five years? In 10? Short-term thinking can lead to inertia and In 20? What constitutes the board of the future undermine growth and performance. Why and what qualifications will be needed to chair develop a product that may be superseded in six that board? months? Why invest in employees who may leave next year? Why build capabilities when they can Recent research16 suggests that boards can be so perishable? prepare for the future by:

In the face of such doubts, current demands and •• Developing greater agility and responsiveness an emphasis on speed can blind management and adapting quickly to changes in the to long-term strategic and operational competitive landscape and the larger considerations. Similarly, investors’ demands socioeconomic and political environment for near-term returns can prompt efforts to •• Taking the lead in articulating the broader generate quarterly earnings while neglecting or purpose, role, and impact of the business even undermining the drivers of long-term value. relative to established structures, norms, Government actions can elicit knee-jerk reactions and values rather than considered responses. A short-term focus can result in diminished social responsibility, •• Embracing diversity of thought, including degradation of resources, and failure to upgrade disruption in the business and the boardroom, technology, plants and equipment. while bringing relevant perspectives and expertise into decision making

41 2019 Directors’ Alert | Conclusion

Every board member, and especially every board chair, is facing a clear question: How should I exercise leadership in this disruptive and unpredictable environment?

42 Conclusion | 2019 Directors’ Alert

•• Engaging in continuous education to stay •• Humility and the ability to create space abreast of new developments in technology, for reflection, partner with the executive innovation, strategy, risk oversight, and team, and make challenges constructively other areas and privately without stifling leadership’s creativity and drive •• Demonstrating added value to senior management and other stakeholders •• An appropriate understanding of the and making contributions to the wider business and competitive landscape, along organizational ecosystem with needed technical knowledge of the business and its evolving environment. •• Engaging in independent evaluations to improve the performance of boards and Like the organization of the future, boards individual directors. of the future will be shaped by decisions and actions undertaken in the present. Boards Strong leadership by the board chair will have the opportunity and the responsibility be needed. The same research identified to see that current activities lead to long-term the following skills, characteristics, and betterment. In a very real sense, long-termism success factors as being vital for the chair of begins with the board and the board chair. the future: While business will become increasingly •• Strong emotional intelligence and dominated by technology, artificial influencing skills and the ability to listen intelligence, and robots in the decades ahead, carefully, work with groups of diverse it will be the human decisions that will shape individuals, and manage increasingly the future. complex and vocal stakeholders

•• Agile and curious mindsets with a propensity to scan the horizon for developments and monitor for possible disruptors

43 Contacts

Global Costa Rica Korea Dan Konigsburg William Carvajal Jun Cheol Kim [email protected] [email protected] [email protected]

Michael Rossen Mauricio Solano Malaysia [email protected] [email protected] Cheryl Khor [email protected] North America Curaçao Canada Roy Jansen New Zealand Jonathan Goodman [email protected] Andrew Burgess [email protected] [email protected] Mexico Jacklyn Mercer Daniel Aguinaga Peter Gulliver [email protected] [email protected] [email protected]

United States Trinidad and Tobago Philippines Maureen Bujno Rikhi Rampersad Wilfredo Baltazar [email protected] [email protected] [email protected]

Deborah DeHaas Asia Pacific Singapore [email protected] Australia David Chew Paul Rehder [email protected] Tonie Leatherberry [email protected] [email protected] Taiwan China Mike Chang Debbie McCormack David Lung [email protected] [email protected] [email protected] Thailand Latin and South America Hong Kong Subhasakdi Krishnamra Argentina Hugh Gozzard [email protected] Maria Mercedes Domenech [email protected] [email protected] Vietnam Eric Tong Ivan Pham Brazil [email protected] [email protected] Camila Araujo [email protected] India Europe, Middle East Abhay Gupte and Africa Chile [email protected] Austria Fernando Gaziano Perales Guido Eperjesi [email protected] Sachin Paranjape [email protected] [email protected] Arturo Platt Belgium [email protected] Indonesia Rik Neckebroeck Antonius Augusta [email protected] Colombia and Peru [email protected] Maria Cristina Pineros CIS [email protected] Japan Natalya Kaprizina Masahiko Kitazume [email protected] [email protected] Croatia Masahiko Sugiyama Vedrana Jelusic [email protected] [email protected]

44 Cyprus Kenya Portugal Panicos Papamichael Julie Nyangaya João Gomes Ferreira [email protected] [email protected] [email protected]

Czech Republic Lithuania Romania Jan Spacil Saulius Bakas Andrei Burz-Pinzaru [email protected] [email protected] [email protected]

Denmark Luxembourg South Africa Martin Faarborg Laurent Berliner Johan Erasmus [email protected] [email protected] [email protected]

Finland Justin Griffiths Nina le Riche Merja Itaniemi [email protected] [email protected] [email protected] Malta Spain France Malcolm Booker Xavier Angrill Carol Lambert [email protected] [email protected] [email protected] Middle East Sweden Germany Hani Khoury Bjorn Mikkelsen Claus Buhleier [email protected] [email protected] [email protected] Hossam Samy Switzerland Ghana [email protected] Fabien Bryois Joe Ohemeng [email protected] [email protected] Netherlands Wim Eysink Lisa Watson Greece [email protected] [email protected] Alithia Diakatos [email protected] Arjan ten Cate Turkey [email protected] Itir Sogancilar George Trivizas [email protected] [email protected] Caroline Zegers [email protected] United Kingdom Hungary Tracy Gordon Gabor Molnar Nigeria [email protected] [email protected] Tony Olukoju [email protected] William Touche Ireland [email protected] Colm McDonnell Norway [email protected] Kine Kjaernet [email protected] Israel Irena Ben-Yakar Poland [email protected] Halina Franczak [email protected] Italy Ciro di Carluccio Dorota Snarska-Kuman [email protected] [email protected]

45 Resources

Want to dig deeper? We’ve selected the following Deloitte publications to help you plan for the long term.

Long-term value creation: Understanding the fourth industrial revolution Canada’s AI imperative: From predictions to prosperity (Deloitte Canada) Digital disruption: Meet the Fourth Industrial Revolution head-on (Deloitte Canada) Germany’s Digital Hubs: Geography of the Tech Talents (Deloitte Germany) Industrie 4.0 Studie 2019: Wie meistern CXOs den Wandel? (Deloitte Germany - in German) Deloitte Review: Navigating the future of work: Can we point business, workers, and social institutions in the same direction? (Deloitte Global) Embracing digital risk in the age of Industry 4.0 (Deloitte Global/Forbes) How leaders are navigating the Fourth Industrial Revolution: Our latest survey of Industry 4.0 readiness (Deloitte Global) The evolution of work: New realities facing today’s leaders (Deloitte Global) The Fourth Industrial Revolution is here—are you ready? (Deloitte Global) The Fourth Revolution is now: are you ready? Future of operations (Deloitte Global) The robots are waiting: Are you ready to reap the benefits? (Deloitte UK) On the board’s agenda | US: Industry 4.0 (Deloitte US) On the board’s agenda | US: Not if, but how: Evaluating the soundness of your digital transformation strategy (Deloitte US)

Investor engagement and activist shareholder strategies What the board needs to know and do for the long term Be your own activist: Developing an activist mindset (Deloitte UK) Hearing the stakeholder voice: Effective stakeholder engagement for better decision making (Deloitte UK) CFO Insights: Activist shareholders: How will you respond? (Deloitte US)

The board and ESG Going long on the future of the enterprise 2030 Purpose: Good business and a better future: Connecting sustainable development with enduring commercial success (Deloitte Global) On the board’s agenda: Sustainability and the board: What do directors need to know in 2018? (Deloitte Global) On the board’s agenda | US: The board’s role in corporate social purpose (Deloitte US)

46 Tax strategy for the long term: Is your organization getting it right? Canadian Tax Alert: US tax reform – Financial reporting considerations (Deloitte Canada) Canadian Tax Alert: US tax reform – Impact on M&A and the private equity industry (Deloitte Canada) Verrechnungspreise – linke Tasche, rechte Tasche?: Miteinander verbundene Unternehmen müssen strenge Regeln beachten, wenn sie interne Dienstleistungen oder Lieferungen verrechnen (Deloitte Germay – in German) 2018 BEPS global survey (Deloitte Global) Tax governance in the world of Industry 4.0: Adapting global tax regulation for connected enterprises (Deloitte Global) The global tax reset: Summary results of the 2018 annual multinational survey (Deloitte Global) Reshaping the code: Understanding the new tax reform law (Deloitte US)

Further reading Directors’ playbook: The future of work (Deloitte Australia) Chair of the future: Supporting the next generation of business leaders (Deloitte UK) Governance in focus: On the board agenda: The 2019 reporting season (Deloitte UK)

47 Endnotes

1 The Fourth Industrial Revolution is here—Are you ready? Deloitte, 2017

2 CFO Insights – Activist shareholders: How will you respond? Deloitte, 2015

3 Ibid.

4 Senate Bill No. 964: An act to add and repeal Section 7510.5 of the Government Code, relating to public retirement systems, September 2018

5 www.globalreporting.org

6 www.integratedreporting.org

7 www.sasb.org

8 www.world-exchanges.org

9 Base Erosion and Profit Shifting, Organisation for Economic Cooperation and Development

10 Additional Guidance Under the Codified Economic Substance Doctrine and Related Penalties (Notice 2014-58), Internal Revenue Service

11 TAX3: Financial Crimes, Tax Evasion and Tax Avoidance, European Parliament Committees

12 US Tax Reform: Foreign-Derived Intangible Income (FDII): Uncover the potential impact of this new deduction, Deloitte, 2018

13 AEOI: Status of Commitments, Global Forum on Transparency and Exchange of Information for Tax Purposes, Organisation for Economic Cooperation and Development, November 2018

14 The Global Tax Reset: Summary results of the 2018 annual multinational survey, Deloitte, 2018

15 Tax Policy Reforms 2018: OECD and Selected Partner Economies, Organisation for Economic Cooperation and Development, 2018

16 Chair of the Future: Supporting the next generation of business leaders, Deloitte UK, 2018

48 Acknowledgements The Deloitte Global Center for Corporate Governance would like to thank all the professionals who assisted with drafting, editing, designing, and reviewing this alert, including: Anchal Aggarwal (United States), Peter DeMoss (United States), Tom Gorman (Content Publishing Services), Riya Ghosal (United States), Tracy Tahara (Canada), Nancy Wareham (United States), Sarah Wowchuk (Canada) 49 About Deloitte’s Global Center for Corporate Governance Deloitte’s Global Center for Corporate Governance brings together the knowledge and experience of Deloitte member firms around the world in the critical area of corporate governance. Its mission is to promote dialogue among Deloitte practitioners, corporations and their boards of directors, investors, the accounting profession, academia, and government. Since 2009, the Global Center has launched over 65 centers of corporate governance in Asia, Europe, Africa, and the Americas.

Find us online at www.global.corpgov.deloitte.com.

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