The Tricky Challenge of Measuring Governance
Environmental, social, and governance investing goes by the acronym ESG. But people often forget about the “G,” while calling for more climate disclosures and diversity metrics. But governance—the mechanisms that align management with shareholders’ interests and good old honest business—is every bit as important.
But how and what is being measured in corporate governance is quickly changing. Differing ideas about a company’s fiduciary duty, either to shareholders or general stakeholders, have split businesses and investors. Some companies that strictly believe management exists to maximize shareholder value incorporate their businesses in the state of Delaware, which has one of the strictest legal precedents in the US favoring corporations’ shareholders.
But the 2019 Business Roundtable promoted the idea that companies have a fiduciary duty to stakeholders, a larger group beyond their shareholders. For example, British asset manager Schroders said it was evaluating more than 1,300 companies based on how they manage across stakeholders, including employees, customers, suppliers, regulators, and communities. How do investors navigate that?
“What’s your investment horizon is the question,” said Brett Miller, head of data solutions at ISS. (Parent Institutional Shareholder Services also owns Chief Investment Officer magazine.)
“Over the short term, I think you can maximize profits by treating some of your materials stakeholders poorly for the benefit of another,” said Sarah Bratton, the North American head of sustainability at Schroders. “But over the long term, I don’t believe that that is a sustainable business strategy.”
The Building Blocks
Still, historically speaking, there are some factors that define corporate governance, such as whether there is an audit committee, board structure, compensation, and shareholder rights, all important metrics by which to measure a company. An uproar over failed governance at German payments processor Wirecard surfaced in June when about €2 billion ($2.35 billion) disappeared from its accounts. Its chief executive was sent to prison and is accused of inflating revenue. Its auditor, EY, is under investigation.
With those historical factors in mind, here are four ways to measure governance:
Audit and Risk Oversight: Companies may be leery about harsh shareholder scrutiny, but they need to file disclosures in a timely manner. For example, Wirecard did not even have an audit committee until 2019, when publications such as the Financial Times put pressure on the company for allegations of false accounting. By then, it was too late for the company. These filings are crucial to shareholders who need proper information to understand their companies.
Board Structure: Good board members play a large role in fostering shareholder trust that the fiduciary responsibilities of the company are being fulfilled. This quality is measured quite simply. In board elections, a director who gets less than 90% of shareholder votes is in the bottom quartile, while a director that gets just 80% support is an outlier, according to Miller. “What that’s saying is that 20% of your friends don’t like you,” he said.
“It’s not like these elections are contested most of the time. Fifty-six companies in the Russell 3000 currently have directors on their board who received less than 50% support the last time they were up for election, and while failing does not necessarily have immediate consequences, they still matter,” Miller said. “What those director elections are really saying is how much trust do investors have in the board.”
Compensation: Of all the factors, how boards construct executive payment packages is critical to understand what the board’s strategic priorities are for management. “It’s the one real window that we get into the board,” Miller said. Shareholders should eyeball how management is working to boost returns, or focus on operational metrics, or, increasingly, ESG metrics.
How large should an executive pay package be? It will always depend on the company’s specific situation, Miller said. Troubled firms will want to shift their focus to short-term incentives. Absent such disturbances, companies want to align executive pay packages with the long-term goals and interests of the shareholders, Miller observed.
Shareholder Rights: The ability to vote is especially important as the investment world shifts more and more toward passive strategies. Shareholders who invest in exchange-traded funds (ETFs) may find themselves more insulated from adverse impacts to any one company, but they may find it more difficult to pull dollars from companies they don’t feel aligned with.
Trouble is, there are fewer public companies nowadays. In other parts of the world, like Europe, a number of large companies are controlled by wealthy families. So disappointed investors, who want to be in a certain industry, say, have fewer options than was the case a decade or two ago.
“If you are a minority shareholder and your company’s controlled, you want to make sure that you have an alignment of interests. Because if you don’t, you run a risk. With the minority, we just have a lot less information, you have very little control, and even through the votes you may not have the ability to alter anything,” said Sudhir Roc-Sennett, head of ESG at Vontobel Quality Growth, a boutique owned by Vontobel Asset Management.
Diversity, and Health and Safety
But, increasingly, investors are changing what they look for in governance, especially with the rise of environmental and social considerations. More companies are going to adopt diversity incentives for their executives, said Miller, such as establishing hiring targets for underrepresented groups to ensure they are creating a diverse and inclusive workplace.
Diversity incentives would also require more company disclosures on racial demographics across their company, a metric that many firms are more reluctant to share than they would be with gender metrics. “That’s why we’ve made so much more progress on the gender side is because we have the data,” Schroders’ Bratton said.
And, with the pandemic, the governance imperative will expand to ensuring employees are not exposed to pathogens. Given the uncertain duration of the coronavirus, board members will be expected to oversee workplace safety metrics. True, companies that are in more dangerous sectors such as mining (cave-ins) and utilities (fires) have always put a premium on workplace safety. With the coronavirus, though, the duty to protect workers is wider spread, covering such seemingly safe places as financial services.
Overall, one aspect of the “G” part of ESG should be paramount: ensuring that a company has another quality beginning with that letter. Namely, good.
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