Corporate Governance and Esg

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Overview: ESG (of which Corporate Governance is one factor) are increasingly becoming an important component in investment analysis.  This can be seen in the explosive growth in assets over a relatively short period of time.  It has been estimated that investments grew 76% in the two years ended 2014.

Poor governance has resulted in several high-profile accounting scandals (i.e.-Enron) and bankruptcies, while environmental and social issues within companies have erased billions of dollars in value (i.e.-Nike Sweat Shop issues, BP oil spill).

Data tends to support that ESG, as a factor in investment selection, has shown better company performance as well as equity performance.

Though ESG investing is seen as focusing on values based investing, it not only plays a role in supporting various causes, but more importantly helps to manage risk, without sacrificing return.

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• Let’s start with Corporate Governance, which is defined as a system of internal controls and procedures through which individual companies are managed.
• Within an organization, it defines the rights, roles, and duties of management, the board members, and shareowners.  It really is a framework.
• It varies by jurisdiction and aims to minimize and manage conflicts of interest between those within the company and shareholders or stakeholders.
• Shareholders are an incredibly important stakeholder as they provide capital to the company.  But they are not the only individuals who are interested in the company.
• A broader theory of corporate governance, seeks to manage conflicts with all stakeholders.  We’ll focus on this view as it covers shareholders as well.

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• Stakeholders are any group that “has an interest” in the company.  This is extremely broad, but some of the most significant stakeholders are listed here.
• Each group has a particular interest:

• Shareholders-contribute capital and seek to grow profitability and maximize value of the company.  They are the owners and elect the BOD.
• Creditors-have little influence on the operations of the company.  Seek stability to receive their interest and principle.
• Employees-want the company to succeed, receive their salary and other compensation and seek job security.
• BOD-acts on behalf of the shareholders, overseeing the operations of the company while providing strategic direction.
• Customers-want a good product at a reasonable price that is safe.
• Suppliers-want to be paid for their services and products they provide.
• Governments/Regulators-wish to protect the economy and general public, and receive taxes from the company.

• Not-for-profits have stakeholders as well, though they are a bit different than for-profits and include volunteers, donors, patrons, trustees and others.  They seek to serve the intended cause of the organization.

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• Various relationships exist with stakeholder groups which can create conflicts.
• Shareholders can have conflicts with employees, as there is a principal/agent relationship. The principal hires an agent and imbedded in the relationship are characteristics involving trust, loyalty and other obligations. The employee knows more than the shareholder, and while the employee seeks to retain their job and earn as much money as possible, this can clearly conflict with creating value for the shareholder.
• Controlling shareholders and minority shareholders can conflict when there are differences in the actions to be taken in regards to voting on takeovers, board of directors or other items. With dual class structures, the owners hold voting shares while other investors have no voting rights.  
• Manager and Board relationships can have conflicts when limited information is shared with the BOD.  This can lead to decisions that are not in the best interest of the company, but may lead to situations that benefit the employee (i.e.-job security, promotion, bonus, etc.).
• Shareholders seek value in the growth of the company, and must take risks.  However, creditors seek to have their principal and interest repaid.  Reducing risk is a benefit to a creditor, which causes a conflict within this relationship.
• Other conflicts can occur between various groups.  For instance, the company will want to spend as little as possible on a product, but that may increase the risk of using the product.  A conflict between the consumer and the shareholder would then exist.

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• Conflicts will arise, and require prioritization as well as dealing with them in a methodical and logical manner.
• The most effective practice to address conflicts is through

• Effective Communication and
• Active Management

• A framework is constructed that lays out the “rules” for dealing with and interacting with stakeholders to resolve conflicts.  These include

• The Legal infrastructure which shows the ease/availability of legal recourse.
• The Contractual infrastructure that gives the secured rights of both parties as seen in the contracts they have executed.
• The Organizational structure is the manner by which the company is governed, internal systems and practices as to how the company is organized.
• The Governmental infrastructure will outline the regulations that are imposed on the company.

• With the framework constructed, conflicts can be addressed within the boundaries of each.

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• There are various mechanisms that are used to manage stakeholder relationships which fit into effective communication and active management.
• General Meetings are the most widely adopted practice to mitigate agency problems.  Information concerning the audited financial statements are presented and shareholders have the right to participate in and vote their shares. The meetings allow for better monitoring through a direct exchange of information.
• The Board of Directors is a link between management and shareholders, and monitors activities while assisting in strategy.
• The Audit Function helps to assure the reliability of financial statements, but also reviews and analyzes the systems and controls within the company.  The external auditors perform and independent review which are elected by shareholders.
• Reporting Transparency reduces information asymmetry, which helps to reduce conflicts.  Required company filings, social media as well as other procedures require disclosure such as related party transactions.
• Policies on Related Parties generally require the disclosure of actual/potential or direct/indirect conflicts.  These policies are to ensure the fair handling of the situation as not to advance the interests of related parties at the expense of the company or shareholders.
• Remuneration Policies are to align pay with shareholder interests, help to ensure that long-term strategies are met, increasing shareholder value.
• Say on pay helps to decrease conflicts by giving shareholders insights into the company’s remuneration policies, as well as a say about those policies.  Some systems require that shareholder desires are mandated to be implemented and others are not as it varies by country.
• Contractual agreements with Creditors clearly outline the obligations of each party, helping to reduce conflicts.  The legal document is called the indenture and has covenants and collaterals that help to ensure repayment.
• Contractual agreements with Customers and Suppliers do the same as those with creditors.
• Laws and Regulations help to protect the public, and form the basis of operations and interactions between the company and the public.

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• The Board of Directors is an important portion of corporate governance as it acts on behalf of the shareholders.  
• The board will monitor management, as they are not involved in the day-to-day management.  They will set milestones, based on the strategy of the company, which they help to construct and implement.
• The board is comprised of a number of individuals, depending on the size, structure and complexity of the company.  
• Diversity of experience gives the board strength.  Some key areas of expertise should include:

• Strategy
• Finance
• Audit
• Risk Management
• Human Resources

• A trend is to split the CEO and chairperson role which is called “CEO duality” as it is conflicting to have the CEO, for all intensive purposes report to him/herself.
• Staggered boards will break the board into several groups, which would require separate elections to replace the entire board (3 groups would require 3 elections).  This limits the ability to effect major change of control quickly.
• The board will establish committees to help with the oversight of key functions, including:

• Audit
• Governance
• Remuneration
• Nomination
• Risk
• Investment

• The audit committee is the most common committee and it helps to ensure the reliability of information in the financial statements, as well as the control systems within the company.  This committee reviews IT, evaluates policies/procedures, supervises the internal audit group, appoints/evaluates findings of external auditors and performs necessary processes/procedures.
• The governance committee will monitor the adoption of solid governance practices. It will determine if implementation is occurring and review policies and standards are in compliance with laws/regulations.
• The remuneration committee will develop and propose policies for approval. They will also set performance criteria, establishing HR policy and oversee the implementation of various employee benefits.
• The nomination committee creates policies and procedures for nominating new board members and executive management.  It will recruit new board members and review the skills, expertise and experience of existing members.
• The risk committee is primarily responsible for monitoring the appropriate level of risk within the company, by identifying, assessing and mitigating risk throughout the company.
• The investment committee is responsible for strategy and will be involved in large investments, while establishing, reviewing and updating investment policies. They will conclude on expansions, acquisitions and major disposals.

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• There are various market and non-market factors that can affect stakeholder relationships and corporate governance. Candidates should be aware of what they are, and how it effects those relationships.
• Market factors consist of:

• Shareholder Engagement – is the interaction with shareholders, meant to increase transparency and information, which ultimately increases management support.
• Shareholder Activism – is intended to create a change within the company with the ultimate goal of increasing shareholder value.  This can include lawsuits, raising awareness, or a proxy battle.
• Competition and Takeover – is generally initiated when the company is viewed as underperforming.  This leads to a desire to take over the company through a proxy contest (shareholders are persuaded to vote in a certain manner), a tender offer (shareholders are persuaded to sell their shares) or a hostile takeover (buying the company without consent of management). 

• Non-market factors include:

• The Legal Environment – offers different protections around the world for different stakeholders.  Shareholders have different rights as compared to creditors.
• Media – can raise awareness on various issues. Social media has become one aspect that has given power to level the playing field between company and stakeholder.
• Corporate Governance Industry – has arisen from the demand for information.  The industry is concentrated and therefore exerts a significant amount of influence, that require corporations to pay attention to their ratings and thus change their behavior.

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• When corporate governance is poor or weak, it can effect the performance of the company.  The various areas that can be effected are:

• Weak Control System – which leads to poor financial information.  This can affect obtaining financing, as well as producing poor information internally.
• Ineffective Decision Making – can further exacerbate information asymmetry due to poor monitoring which ultimately leads to poor decision making.
• Legal, Regulatory and Reputational Risks – can occur when the proper control environment is not in place to maintain compliance thereby opening the company up to legal and regulatory risks, which would ultimately effect the reputation of the company.
• Default and Bankruptcy Risks – become a real concern as poor decisions can easily lead to poor financial results, increasing default and bankruptcy risks.

• When corporate governance is effective, it benefits the company in several ways, including the following:

• Operational Efficiency – is experienced when the organizational structure and reporting lines are clear.  
• Improved Control – will help to minimize various risks including regulatory, legal and financial, which ultimately reduces costs.
• Better Operating and Financial Performance – will be realized as better information is collected leading to better decision making.
• Lower Default Risk and Cost of Debt – is a by-product of having a strong governance structure as business and investment risk is reduced.

• Recognizing the benefits and drawbacks of an effective/ineffective corporate governance structure will aid in the evaluation of a company’s financial potential.  Therefore, it’s important to know what to look for when evaluating the corporate governance and stakeholder management of a company.

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• What are the factors that are relevant to the analysis of corporate governance and stakeholder management? These would include:

• Economic Ownership and Voting Control helps to understand how decisions are made by shareholders.  Generally, it is one vote per share, but different structures have split voting classes. It’s important to be careful and understand the differences.
• Representation on the Board of Directors is important to understand whether they have the right skills and background to effectively lead the company in the correct direction for the future.
• Remuneration and Company Performance seeks to incentivize management to act in the best interest of long-term growth.  Some important items to evaluate include:

• Are equity incentives aligned with shareholders?
• Are the hurdles inadequate, and show little variation over several years?
• Are there excessive payouts when compared to companies with comparable results?
• Is there strategic alignment with remuneration?
• Are the plans aligned with the company’s life cycle changes (startup, mature, etc)?

• Investors in the Company form a crucial part of understanding how voting may be influenced.  If a concentrated holding has control, this can dictate how decisions will lean or be influenced.  
• Strength of Shareholder’s Rights helps to explain the framework of the rights of shareholders and any obstacles for making changes within the company, or structurally with bylaws.
• Managing Long-Term Risks is important, because when it is poor, it can have an enormous impact on share value.  Witnessing a pattern of fines, accidents and regulatory issues can be a cause for concern.

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• ESG is the combination of environmental, social and corporate governance.  Integrating ESG considerations into the investment process has been shown to provide beneficial results. It is recommended that these factors be “integrated” into the investment process.

• Environmental factors include pollution prevention, natural resource management, water conservation, adherence to environmental safety and regulatory standards.
• Social factors pertain to human rights and welfare concerns in the workplace as well as product development and community impact.
• Governance includes all the systems and controls that determine how the company is managed, as discussed in the prior slides

• Some owners embrace the concept of being a universal owner, whereby the investor takes a long-term view with a diversified global portfolio that is linked to economic growth while being exposed to costs resulting from environmental damage.
• ESG Implementation includes various philosophies, including

• Negative Screening which excludes certain sectors as defined by the investor.  These can include traditional screening, such as weapons, alcohol and gambling.
• Positive Screening/Best-in-Class are used to find companies that have favorable ESG initiatives, philosophies or a history of positive outcomes.  Best-in-Class will use a rating system to determine the best actors within a group and choose those for investing.
• Thematic investing chooses a single theme, such as climate change or energy efficiency.

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• Conclusion:  ESG considerations have increased in their prominence over the past several years.  More and more empirical data supports utilizing ESG criteria as a means to increase returns.  
• This is due to several tangible and intangible factors which have become easier to evaluate as more data is readily available in regards to each of these characteristics.  A governance industry, as well as social and environmental tracking help to identify those acting in both a responsible and careless manner.
• ESG origins can be traced back several hundred years to a religious source.  However, it continues to change as demographics, natural resources and global trends have raised the awareness of the public on various issues.  
• Having an understanding of these factors, though not always quantifiable are important to understand, particularly from a risk perspective.