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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, April 24, 2013 posting

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday April 24, 2013 at 9:27 am

Editor’s Note: The following post comes to us from Deborah Gilshan, Corporate Governance Counsel at RPMI Railpen Investments, and Catherine Jackson, Corporate Governance Advisor at PGGM Investments.

We are witnessing a change in sentiment about independent director involvement in engagement meetings with shareholders. These interactions help to:

» Establish respect and understanding;

» Create a culture of no surprises; and

» Assess the quality and independence of directors by permitting shareholders the opportunity to learn how key board functions are managed and overseen.

To facilitate these interactions, we call on the independent directors of U.S. companies to develop suitable strategies that address their responsibility to communicate with shareholders.

Companies with significant governance concerns are increasingly recognizing the value of their independent directors engaging with shareholders. We are encouraged that some independent directors are actively seeking input from their shareholders to pre-emptively manage situations, while others are interested in understanding shareholder views on certain matters. However, such practices are by no means universal, with communication often occurring unilaterally through press statements and proxy disclosures rather than in face-to-face exchanges with shareholders. We advocate for independent director meetings with shareholders to become a routine part of a board’s approach to outreach with its shareholders, rather than only in exceptional circumstances or in times of crisis.

The time is now to communicate the information that we, as shareholders, seek from directors, and to recognize the benefits that such direct communication brings to both parties. The responsibility to ensure proper oversight by independent directors, and for shareholders to understand that oversight, requires appropriate resources to support these activities and an integrated approach in which governance matters are addressed as routinely as financial and operating results.

Why is dialogue between shareholders and independent directors necessary?

Effective boards are comprised of highly skilled and motivated directors who collectively safeguard the interests of shareholders and other stakeholders. Whilst proxy statements and other disclosures are helpful, they typically do not reflect the careful deliberations that boards undertake, and which long-term engaged shareholders want to understand.

Establish respect and understanding:

One major benefit to direct dialogue between shareholders and independent directors is that it increases understanding between both parties. Mutual trust, respect and understanding can be the foundation of robust discussions. Once established, this understanding can lead to shareholders being willing to more easily accept outcomes that, in the short term, depart from good governance practices because they understand the long term aims of the board. A constructive relationship between shareholders and companies will be mutually beneficial in both less demanding times and in challenging times.

Understandably companies do not want to hear from shareholders only in times of distress. However equally, shareholders do not wish to be contacted by directors only when the company is in crisis and needs shareholder support.

Create a culture of no surprises:

Effective engagement practices build goodwill and can eliminate the risk that surprises between shareholders, companies and their boards will occur. Engagement gives both parties the opportunity to give, and receive, timely and relevant information. For boards, this could pertain to changes contemplated with regards to compensation or board processes. Shareholders engage across many sectors and markets, and are therefore in possession of information that independent directors should avail themselves of.

For shareholders, it is important to understand the companies in which they are invested. This understanding extends beyond relying on the relationships between financial analysts or portfolio managers and company management. Shareholders need to understand how companies are governed and how boards see and fulfil their responsibilities.

In our experience, meetings with independent directors are often illuminating on situations that have appeared to be contrary to our interests as shareholders. Upon understanding the board’s deliberations, it has, at times, become apparent that shareholders’ interests are being well served and that support for the board is warranted. In such cases, it is not in the board’s interest to remain silent on significant governance matters and for them to assume that the proxy circular provides sufficient explanation.

Assess the quality and independence of directors:

Shareholders seek assurance that the independent directors understand their role in overseeing management. Anecdotal evidence on how this takes place provides useful insights into boardroom dynamics and helps to test the character of independent directors as shareholder representatives. Engagement between directors and shareholders is the only way in which this assessment can take place and is integral in ensuring that shareholders make informed vote decisions concerning director elections. In situations where independence is a concern, it is the duty of shareholders to engage with the independent directors and verify the effectiveness of their oversight. This is most obvious where the Chairman of the board and the Chief Executive Officer positions are shared by the same individual.

What is being discussed?

There are certain conversations which are appropriate to have with independent directors, such as with regards to compensation, strategy, risk, and succession planning. Equally, there are certain conversations that are better suited to have with management, such as those concerning operating results or the impact of an investment or divestment. An active dialogue with both management and director representatives is an important part of shareholder engagement and outreach practices, and it is based on the premise that no one else can better represent the decisions that have been made than the individual(s) who made them.

Below we list some examples of the types of conversations our funds are having with independent directors.

Conversations with the Independent Chairman or the Lead Independent Director:

Discussions with the Independent Chairman or Lead Independent Director center around their relationship with the Chief Executive Officer, or, if the roles are combined, the Chairman and Chief Executive Officer, as well as board dynamics more broadly. They also include matters pertaining to oversight of the company’s strategy. Shareholders want to know whether the board can hold the Chief Executive Officer to account and effectively oversee the strategy and its implementation. If there is an effective counterbalance between the functions of the board and management, a healthy debate should exist in the boardroom. This is underpinned by appropriate dynamics and healthy tensions between independent directors and the Chief Executive Officer.

Conversations with the Chair of Compensation Committee:

Shareholders are keen to evaluate how the Compensation Committee understands its role and that there is sufficient independent and robust oversight over processes and decision making. Compensation is of great importance to shareholders and is viewed as an outcome of a board process. As an extension of this, specific pay outcomes can provide a view on the true independence of the board. If there are unintended outcomes of pay plans, shareholders need to be confident that the Compensation Committee will make the appropriate decisions that are in the long term interests of shareholders. Equally, shareholders may consider it appropriate to support directors in their decision-making when they are assured that a robust debate has taken place. Failed pay votes do not meet the needs of shareholders or companies, and it is in the interests of all parties that such situations be avoided.

Conversations with the Chair of the Nominations and Corporate Governance Committee:

It is important to be aware of the processes that boards undertake around succession planning of management and independent directors. Rigorous processes allow directors to build long term plans for succession planning and talent development, such that leadership transition risk is mitigated and succession plans are executed in a cost effective manner. Understanding other board processes, such as board performance evaluation, gives shareholders assurance that the board has appropriate mechanisms in place to manage problematic situations should they arise. It is unlikely that a board will not experience any challenges of this nature, and it is the stronger board that deals with, and learns from, these challenges.

The benefits: more effective boards and more informed shareholders

A major benefit to both shareholders and independent directors is the opportunity for an exchange of dialogue that is unfiltered. Boards must be cognisant of shareholder sentiment about various issues, including expectations on governance structures and procedures. Equally, shareholders must be aware of the nuanced processes that underpin the decisions reached by boards, as well as having a perspective on the tenor of discussions at board level.

Engagement is a two way process and pro-active companies reach out to shareholders in addition to shareholders reaching out to companies. Voting, in itself, can be a blunt instrument and engagement is critical to enhance the voting process, to make it more meaningful and representative of the views of shareholders.

In the UK, with the publication of the review of equity markets from Professor John Kay, and the implementation of the Financial Reporting Council’s Stewardship Code for investors, there is an emphasis on ‘voice over exit’ for shareholders, which leads to an expectation and a responsibility that they engage with the companies they own. Similarly in the Netherlands, the Dutch Corporate Governance Code contains provisions that explicitly require shareholders to engage with companies in order to understand any deviations from the Dutch Corporate Governance Code and certainly in advance of submitting shareholder proposals. The experience in our home markets informs the work of our funds in other markets, both in terms of shareholder responsibilities, and in the implementation of engagement strategies.

Ultimately, engagement between shareholders and independent directors increases the responsibilities on both parties. Directors are accountable to shareholders as their representatives in the boardroom, and dialogue between both parties is part of that framework of accountability. Engagement with shareholders should be embraced by independent directors as an opportunity to demonstrate their effectiveness and to create long term relationships with shareholders based on mutual respect and understanding.

Next steps for boards new to engaging with shareholders

Despite the positive changes, there are still many boards that have policies whereby the responsibility of shareholder communication is delegated to management. There are also boards that do not have such policies, but do not believe it is their responsibility to engage with shareholders and as such, do not respond to shareholder communication.

Our view is that such policies and practices are an abdication of the responsibilities of independent directors. It is no longer acceptable for board directors not to be accountable to shareholders and to be perceived as hiding behind policies of delegation, while expecting to be re-elected year after year. Instead, boards should show initiative with regard to their shareholder engagement practices.

We ask that boards develop a thoughtful strategy which outlines who their independent spokespeople are, and how they will undertake engaging with shareholders. Given the various issues that shareholders wish to discuss, it may make sense to share the responsibility of communication amongst committee chairpersons. We observe that, where boards have policies to communicate with shareholders, the responsibility most typically rests with the independent Chairman or the Lead Independent Director. We would contend that the chairs of each committee should consider engaging with shareholders as part of their responsibilities, especially given that they have the necessary subject matter expertise. It may be that the independent Chairman or Lead Independent Director accompanies their fellow board members to these meetings but that is for boards to decide.

We wish to stress the importance of the board having a voice of its own and speaking on matters pertaining to the governance of the company and related board decisions. This is paramount if there is to be meaningful dialogue with shareholders.

We call on the independent directors of U.S. companies to develop strategies that address their responsibility to engage with shareholders.


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