In 1991, publisher Robert Maxwell drowned, apparently having fallen from his yacht off the Canary Islands. In the chaotic aftermath, his business interests collapsed, and subsequent investigations found that he had transferred several hundred million pounds from the Mirror Group Pension Fund, without authorisation, to try to keep his businesses afloat.
This was the most recent of a series of financial scandals in the late 1980s which had led to the City of London deciding to put in place a formal set of guidelines regarding financial disclosure by listed companies to allay the growing mistrust between investing institutions and the managements of large, quoted companies. A committee was set up chaired by Adrian Cadbury to report on the financial aspects of corporate governance, and the committee reported its findings and recommendations at the end of 1992.
Essentially, the report put forward a Code of Best Practice for listed companies, whose principles were based on openness, integrity and accountability to their shareholders. There was a section on how boards should be constituted, the qualities and experience required of directors, the role of audit and audit committees, nomination and remuneration committees and the importance of internal control, and financial reporting. The Code itself comprised four sections and nineteen subsections, covering just over three pages of the A5 sized booklet, and this being the UK, the introduction of the new Code was voluntary, with the requirement to adopt or explain why not.
In the USA, huge financial scandals in the early 2000s at Enron in 2001 and WorldCom in 2002 contributed to the introduction of the Sarbanes-Oxley Act in 2002 and later, after the even bigger impact of the collapse of Lehman Bros and Washington Mutual in 2008, to the Dodd-Frank Act of 2010. Being the USA, these had the full force of the law behind them and were intended to cause boards to take their responsibilities for the honesty and integrity of their companies more seriously, by targeting directors personally for failures in management.
Did this sort things out? In 2016, Warren Buffett of Berkshire Hathaway and Jamie Dimon of J P Morgan found it necessary to hold discussions with the bosses of asset managers Black Rock, Vanguard, Fidelity & Capital Group to work on a statement of best practice covering the relations between big investors and the companies they held stakes in. Part of what drove this dialogue was concern on the part of corporate management about the focus of financial markets on short term gains at the expense of long-term goals, and on the part of investors about disagreements over such procedural matters as not splitting the roles of CEO and Chairman (an issue about which Jamie Dimon had strong views). So despite the introduction of major new laws, the worries continued regarding governance.
As we have written before, and most recently in relation to the impact of the UK’s introduction of Wates Principles for large unlisted companies (April 2022), the result of the past thirty years of development in corporate governance regulation in the UK and Europe has been a colossal increase in legal rules, regulations and guidelines. Essentially these volumes of controls have targeted board practice for companies and investing institutions and detailed rules regarding disclosure.
What they haven’t done is focus on the true purpose of corporate governance and a system to ensure that good governance is indeed implemented, monitored and maintained. Hence all this mass of new regulation has, inevitably, failed to prevent subsequent financial scandals, a recent large example in the UK being the collapse of Carillion in 2018, and in the USA, the fraudulent creation of savings and checking accounts at Wells Fargo emerging in late 2016.
The paragraphs above related to the Governance element in ESG. The Environment and Social elements have gathered force more recently and have become included in company law and regulation in various forms in many countries.
In autumn 2017, we published an article arguing that ESG was now becoming mainstream, having been accepted by the huge passive investing institutions. So, their acceptance that good ESG performance produced superior performance was likely to become self-reinforcing, and hence self-fulfilling, in terms of company valuation. And this was what companies ought to be taking seriously now.
In autumn 2019, in the light of research by MSCI as discussed in a series of presentations by MSCI analysts, we reviewed the way ESG was coming to be regarded, and how likely this was to affect the attitudes of investors, and hence lead to the increased incorporation of ESG principles into boardroom policies.
The research presented by the MSCI speakers covered, broadly: the problems created by the proliferation of indestructible plastic waste, the need for much increased innovation in the field of antibiotics to address the dangers of growing anti-biotic resistance, difficulties in recruitment of vital skills due to poor treatment of employees, benefits and disadvantages of different levels of ownership control, and the potentially catastrophic impact of climate change on certain real estate values.
Essentially, the speakers made the case that the constituent elements of ESG, particularly the environment, would become increasingly serious factors in guiding investment decisions.
Regarding environment, as an example, a speaker from Japan forecast that a combination of declining demand for non-bio-degradable plastics, regulatory pressure to withdraw such materials, and push-back from appalled customers and others, would collectively become a very serious threat to the producers of these plastics.
In the US, companies exposed to risk as a result of the focus on plastic packaging, were the ones in the fields of diversified chemicals and commodity chemicals. Conversely, companies with existing bio-degradable products, or with such products in development, and also companies providing recycling, would all have a future, and possibly a promising one.
The result was that companies in these sectors were effectively being named and shamed. MSCI would be looking for evidence that companies at risk had acknowledged their failings in this key environmental area and that their governance policies reflected the vital need to innovate to replace the environmentally unfriendly products.
A second example was climate change strategy and its potential impact on real estate, and the related risks. MSCI’s presenter described the detailed research they had carried out in various parts of the world to assess what were the major challenges to property in those locations, measured even down to the equivalent of postal code, and to what extent were measures being taken to protect against the dangers. To this end, they assessed the potential for storm and flood damage at one extreme and drought and water shortage at the other. Some situations were well protected for the foreseeable future, others were substantially unprotected.
The research endeavoured to assess the forward-looking probability of extreme events, the locations likely to be affected, and the financial impact of the resulting damage. The key implication was the probable influence on future insurance costs for those in the areas likely to be affected, risks which were not perceived as being priced into current insurance contracts.
Whether company boards were comprised of climate change believers or deniers, the way their insurers looked on their companies in future would clearly be dictated by research coming out of bodies like MSCI. And beyond the insurers, the same research would influence current and potential investors and financial backers of those companies.
By extension, as we have subsequently seen, companies working in those industries seen as contributing to global warming, such as coal mining, oil and gas, and transportation, would be increasingly avoided by environment-conscious investors.
Regarding social matters, and employee working conditions in particular, a speaker from China described how China’s transition from an economy based on manufacturing, mining, construction and farming to one increasingly driven by financial services, technology and health and social services, required different skills.
However, the tradition was still one of working 9.00am to 9.00pm, six days per week, hence involving excessive overtime. These intensive working conditions were coming to be regarded by an increasingly educated younger generation, with exposure to the world outside China, as unacceptable. This was coupled with internet-based communication leading to company reputations regarding employment conditions becoming widely known, and the result was that highly skilled people were avoiding such companies, or even emigrating to more congenial countries.
Hence, poor employment practices were depriving companies of the skilled workers necessary for their competitive development, and employee engagement was seen to lag that of their western peers.
Although this analysis was of the Chinese economy, there are parallels in the developed world, as evidenced by the success of Glassdoor, where employees can enhance or damage the reputation of their former employers, by posting their experiences.
Regarding ownership control as an aspect of governance, there has been increasing debate in recent years about the benefits and disadvantages of different forms and levels of control of listed companies. For instance, the failure of the WeWork planned IPO led directly to the diminution of the voting rights of the founder, Adam Neuman, and his removal as CEO.
MSCI’s analysis showed which countries made most use of control-enhancing mechanisms, and, perhaps most interestingly, presented a chart for China illustrating how certain companies with significant enhanced voting control were also those with significant skill shortages.
More generally, most of the speakers drew a link between the Environmental and Social dangers by which global companies were threatened, either as offenders or victims, and the actions which they were perceived to be taking, through refraining from harmful activities, or innovating to find solutions. Hence they found themselves looking at the Governance and corporate behaviour of the affected companies, since sustainability in the face of the various threats identified, and hence investability, would depend on their governance.
It would seem that this kind of analysis of governance structures will increasingly be deployed to judge the susceptibility of listed companies to policy mistakes, and influence investment decisions accordingly.
What has changed in regard to ESG and corporate behaviour in the past few years?
In 2016, the UN’s Principles for Responsible Investment (PRI) celebrated its tenth anniversary and stated that “responsible investors” would incorporate ESG issues into investment analysis, decision making, ownership policies and practices and seek ESG disclosures from entities in which they invest. But what exactly do the different groups of investors (to say nothing of the investees) understand by ESG? In an article we wrote on ESG and brand value (October 2017), we listed overlapping, but differing definitions by the PRI, rating agency MSCI, the FT Russell Index and Investopedia.
However, whatever the definition, the growing belief in the phenomenon of global warming and the resulting impact of climate change has been a major driver in the adoption of an ESG approach to investing. By 2019, MSCI had ESG as the fastest growing part of its operations and its founder declared that his aim was for MSCI to be the biggest provider of ESG tools, even to the extent of being its defining service.
By 2021 Morningstar was talking about investment in ESG funds as amounting to $2.7tn. So a huge weight of money was lurching around on inconsistent metrics with an uncertain impact on board decisions.
During this time, S&P Dow Jones Indices produced an ESG version of its S&P 500 index. It stripped out some stocks like tobacco and armaments which fell outside normal ESG criteria, then applied a series of filters that excluded more, and created a composite score for the remainder, based on data from an ESG specialist. These scores could then be the basis of index fund investing, taking ESG into account.
However, by 2022 it became the subject of criticism because the new (ish) index was excluding Tesla, arguably a significant contributor to reducing global warming with its electric cars, but including ExxonMobil, a major producer of carbon-based fuels. The personal choices of the MSCI analysts which defined the selection criteria (based presumably on the somewhat erratic board practice of Elon Musk and his company compared with that of the more orthodox Exxon) led to this conclusion which frankly seems daft.
Around this time, a German asset manager, which had sold its shares in Vale after the waste dam collapse in Brazil which killed over two hundred people, came out against greenwashing in German industry. So the question was starting to be raised: what exactly is ESG, and how can we be sure that companies are genuinely pursuing “green” policies?
The EU’s Sustainable Finance Disclosure Regulations SFDR came into force in April 2022 to encourage investment in sustainable industries – but really is just another set of industry guidelines and an influence on investment decisions on the part of investing institutions, intended to make greenwashing more difficult. And promptly in May 2022, Deutsche Bank was raided by the authorities regarding greenwashing allegations by a whistle-blower in one of its subsidiaries, leading to the resignation of the CEO concerned.
So in the past ten years or so, we have a huge switch by passive investing institutions into so-called ESG stocks, with no agreed definition of what ESG actually means, and most recently, following the impact of the Russian invasion of the Ukraine, a reconsideration of defence companies as being “good” for contributing to peace and security and gas companies as “good(ish)” for bridging the gap in supplies of energy until the sunlit uplands of truly green energy and national energy sufficiency are reached.
Holistic Corporate Governance
Here we need to revisit, briefly, what we mean by Corporate Governance.
The origin of the word governance goes back to Ancient Greece, where the word kubernaein means to steer, in relation to a ship. Since then to “govern” has been applied to the control of peoples and latterly companies.
However, if we consider the original meaning, we can perhaps imagine the voyage of a Greek sea-going merchant, hiring a vessel for a commercial purpose, and five elements required for a successful enterprise on the part of the merchant “governing” the voyage:
- honesty on the part of the merchant hiring the vessel, so the hired vessel was used for the purpose declared to the owner
- a clear idea why the voyage was being undertaken, and where the vessel was heading
- a reliable plan for the voyage with trustworthy maps
- a boat that was ship-shape and seaworthy, with a competent captain and crew, and adequate provisions
- a contract agreed with the owner of the vessel entailing keeping the owner informed about progress and accounting for the condition of the vessel on its safe return.
The parallels with the conditions for a successful business enterprise today are clear, and the requirements of the Board exercising “governance”, namely:
- an honest or ethical business culture and morality of organisational behaviour
- a clear goal, and purpose, taking account of the interests of, and agreed by, all the key stakeholders
- a practical strategic plan to achieve the business’s goal, recognising the market opportunities and pressures, and the strengths and weaknesses of the resources available
- an organisation that is appropriately structured and adequately resourced, in terms of people, skills, processes, assets and finance, to deliver the chosen strategy
- trustworthy and reliable reporting systems to provide accountability and transparency to the stakeholders who have an interest in the business.
This is how we define the holistic requirements of good corporate governance – what we call the Five Golden Rules of good corporate governance – and this is what a Board needs to demonstrate to provide reliable long-term success for a business.
More narrowly, since the production of Sir Adrian Cadbury’s seminal Report in 1992, most people turn to the definition by his Committee, which was:
“Corporate Governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.”
Just over a decade later, in 2004, the OECD defined corporate governance as:
“Procedures and processes according to which an organisation is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation – such as the board, managers, shareholders and other stakeholders – and lays down the rules and procedures for decision making.”
In that period, we can see the emphasis broadening from the company to shareholder relationship of Cadbury to the more inclusive OECD definition which mentioned other stakeholders. Two years later, the UK Companies Act of 2006 addressed the general duties of directors in broader terms still, talking about promoting the success of the company for the benefit of a wide range of stakeholders.
However, the setting of ever-expanding rules and guidelines by regulatory authorities has led to a huge compliance industry, and our contention is that all the compliance in the world will be largely wasted if any or all of the five key elements of holistic corporate governance listed above are not implemented.
Impact of current developments in ESG on Corporate Governance
The reader will note that our holistic definition of good corporate governance includes the elements of ESG. But the reader will also note that a focus on ESG as an over-riding set of rules misses the point that good corporate governance is about achieving the Goal of the business.
A board should be focusing on the delivery of its own company goal, not some over-arching global purpose. To be required to prioritise ESG rather than simply to give the elements appropriate importance is to put at risk the future of the business.
As an example, to illustrate the potential conflicts between ESG and a company’s future, in 2020, the Norwegian Sovereign Wealth Fund sold out of Glencore over its involvement in coal use. In June 2022 Glencore reported that coal was one of its biggest sources of earnings and its plan was to run down the coal division over the next 30 years. The Company’s well-being differed from the goal of one of its owners. Where does its future lie in balancing conflicting goals – it is the role of the board to decide policy for success, not to be diverted by current fashions adopted by politicians or investing institutions. To be clear, this is not to say that investors should retain shareholdings in companies which pursue policies which the investor doesn’t agree with, but to emphasise that the board has to decide what is best for the company’s future security and prosperity.
Looking at issues from the point of view that the board’s fiduciary duty is to look after the company’s long-term future raises some interesting issues in relation to ESG. To take a couple of examples:
The recent furore over P&O breaking the current law by sacking large numbers of staff with financial compensation, but lack of due notice, in order to recruit a cheaper workforce, was done supposedly to safeguard the company’s future. Clearly, the Social part of the ESG guidelines was broken in most peoples’ understanding, but as corporate governance guru Prof. Bob Garratt observed in a letter to the Financial Times, was the action to save the company perhaps just what the Companies Act required of the board?
A different example is the Japanese brewer Kirin, which exited Myanmar days after the military takeover in early 2021. But the company had been in a JV with a company controlled by the army for several years previously. Should it have seen this coming, in its own best interests, never mind suddenly jumping on the ESG wagon. Here, a greater attention to the Social element of ESG by the board would surely have directed greater attention to country risk prior to the military coup.
Putting ESG into perspective
The role of the board in securing the future of the business, while staying within the rules, is what good corporate governance is all about. This clear responsibility is often obscured in cases where conflicts arise between shareholder rights and what’s best for the company, as, for instance, when activist hedge funds push companies into share buybacks and bigger dividends at the expense of investing in the future and innovation. Similarly, in takeovers, particularly by Private Equity, when the investment community (and analysts) say the directors have a fiduciary duty to accept the highest bid, regardless. Not true: their primary fiduciary duty is the company and its long-term future.
In summary, the focus these days on issues such as climate and health is fine but these are only some of the factors to be considered in determining whether a company’s Goal is still appropriate and feasible, or needs to be modified due to changes in external circumstances. ESG is not an end in itself.