Corporations have a responsibility to the communities in which they operate. Here we take a closer look corporate governance.
Corporate governance describes the rules and procedures that determine how a corporation interacts with the world around it. As there is more established guidance around corporate governance, ESG-focused, investment research often looks more closely at environmental and social considerations. Yet Governance is arguably the most important factor for responsible investors to be aware of.
There are plenty of reasons for that. Put simply, corporate governance:
- determines how companies are managed, defines who has power and accountability for business decisions and clarifies the company’s objectives.
- covers a broad range of corporate decisions including management structures, capital allocation, as well as policies, standards, information disclosure, auditing, and compliance procedures.
- sets the direction for the company and ensures that a culture of ethics and compliance permeates throughout the entire organization, backed by a robust set of policies, procedures and checks.
- establishes how a business will approach common stakeholder concerns such as sustainability and equity.
For investors evaluating opportunities based on ESG metrics, companies that ensure a high level of transparency and accountability through strong corporate governance guidelines have the potential to outperform. Solid, well-planned governance, for example, generally supports a business’s financial needs, ensuring access to capital when needed. It also encourages new investment, boosts growth and attracts high-quality employees.
On the risk side of the equation, lax or opaque governance can result in poor company performance and heightened regulatory and/or reputational risks. Poor accounting standards, for instance, can result in regulatory consequences and heavy fines. Reputational damage is another risk: companies that do business in countries with oppressive regimes may be viewed negatively by customers and suppliers, losing potential business opportunities as a result.
Often, the value of good governance can be overlooked until a crisis occurs. Companies with robust oversight and reporting structures, that are clear in their values and purpose, often have the capacity to react quickly to changing or volatile business conditions, avoid risks and take advantage of developing opportunities more effectively than their competitors.
The key areas of social risk and opportunity for investors tend to fall into a few broad categories:
Board diversity, accountability and independence
A company’s board of directors has the ultimate responsibility to set policies, priorities and procedures for the organization. For example, most boards appoint corporate officers and make important decisions on issues that define the company’s financial conditions, such as executive compensation, its share capital structure and dividend policy.
Because of its pivotal influence on the strategic operations of an organization, responsible investors have been calling for greater diversity – in terms of age, gender, ethnicity, experience, and skills – on boards of directors and in the executive ranks of companies for several years. There is a growing acceptance that a wider range of backgrounds, beliefs and outlooks in the directors’ seats sets the foundation for a high-performing organization, while limiting the risks that may arise as a result of groupthink or tunnel vision. For example, recent research indicates that S&P 500 listed companies with more multi-diverse boards experienced less revenue loss than those without through the global pandemic in 2020.
Executive compensation
Executive pay packages in many industries have mushroomed in recent years, highlighting the growing relative disparity between the generous income offered to a company’s senior leaders and the wages afforded to average workers. Shareholders are increasingly concerned about the perceived unfairness of this growing income gap and are asking companies to both justify the outsized compensation offers and to use more perspective when calculating compensation, both across industries and within their own organizations.
Here again, responsible investors have pushed for and achieved change. Securities regulators in several jurisdictions including the U.S., U.K., Australia, Norway, and Denmark now require public companies to allow shareholder votes on executive pay – and “say on pay” votes have become increasingly common even where shareholder input is not a regulatory requirement. Elsewhere, given that it can be a challenge to limit executive pay packages for competitive reasons, more companies are linking ESG metrics to their compensation structures as an incentive for senior leaders to prioritize sustainable goals and practices.
Corporate purpose and values
Stakeholders increasingly expect companies to make positive contributions to the communities in which they operate. Business codes of conduct and ethics that target issues such as bribery and corruption, for example, can help to build trust among employees, customers and suppliers, and that trust can support shareholder value over the long term. A strong sense of purpose, meanwhile, usually means that companies are well positioned to adapt to changing business conditions or unexpected events.
By contrast, poor corporate leadership and values make lead a company to be involved in legally or ethically questionable practices. Inadequately addressing long-term risks to the environment such as climate change, for example, can result in heavy clean-up costs or fines and reputational damage. A good example is Volkswagen Group, which was found in 2015 to have programmed many of its diesel cars to cheat emissions tests. The scandal cost the company billions of dollars in recalls, fines and legal costs, and its stock price initially dropped by about 45%, although it has since regained much of its value.
What it means for investors
In a time of rising economic, social, and environmental risks, businesses are being held to a higher standard. As recently as a decade or so ago, it was commonly believed that the highest priority for publicly traded companies was to make profits to support their shareholders. But this shareholder-centric model is being increasingly challenged not only by responsible investors, but also by stakeholders including governments, employees, suppliers, and community groups. As a result, research now indicates that companies that broaden their perspective to consider these stakeholders as part of their strategy are better positioned to deliver long-term value for shareholders.
Responsible investment strategies hold companies to account from a corporate governance perspective, engaging in dialogue on building a strong, ethical business culture, improving board effectiveness, curbing excessive executive compensation schemes, and creating a purpose-driven strategy. Responsible investors can use their proxy votes to send clear messages on ESG-related issues and interact regularly with regulators to enhance governance practices and push for changes that prioritize stakeholder concerns. It’s an approach that is rooted in the belief that when companies prioritize good governance, good results will follow.
