An investment’s environmental and social impacts are among the most prominent issues that responsible investors consider when looking to invest in a company. But any responsible investing analysis would be incomplete if it did not incorporate a meaningful and in-depth review of a company’s corporate governance.
In many ways, effective corporate governance is a vital foundation for a company’s positive environmental and social track record. Any policy or program aimed at some level of environmental or social performance can quickly lose focus and momentum, or worse, simply serve an empty marketing or public relations end if directors and company executives do not inherently appreciate the value of building a business on a sustainable footing.
More fundamentally, though, effective corporate governance simply makes good business sense. Several studies have found that companies with reliable accounting policies and procedures, transparent reporting and disclosures, and directors and management open to shareholder engagement are more likely to produce long-term value than companies lacking in one, or all, of these essential characteristics.
Companies that incorporate strong environmental, social and governance (ESG) practices also outperform. In 2015, the Smith School of Enterprise and the Environment at the University of Oxford released an analysis of more than 200 academic studies and sources on sustainability. It found that the vast majority of the research indicated that solid ESG practices led to firms having better operational performance, positively influenced their stock price performance and contributed to lower cost of capital. A Harvard Business School paper released last year also found that management that paid attention to material sustainability risks outperformed their conventional competitors by a significant percentage of between 3% and 7.5%.
Corporate governance issues aren’t sexy. They don’t draw the same level of interest among investors and are perhaps the least understood, given the inherent complexities around effective corporate oversight, reliable accounting practices and how to compensate executive leadership appropriately. But the impact of poor governance can be long-lasting and can affect a company’s reputation, share price — even threaten its survival.
For example, there was no shortage of significant corporate scandals last year. Toshiba Corp.’s admission that it overstated its earnings by $2 billion during the past seven years led to the resignation of its CEO and uncovered a corporate culture in which “management decisions could not be challenged,” according to an independent investigation. Volkswagen AG’s emission scandal, which has led to a 50% drop in the company’s share price and could cost the company at least $18 billion, also led to the resignations of its chairman and CEO. And Laval, Que.-based Valeant Pharmaceuticals International Inc.’s accounting scandal has cost the company more than $16 billion in market value and led to the installation of a new CEO and board of directors. All of these instances could have been avoided if appropriate corporate governance existed throughout each of these organizations.
Fortunately, investors today have access to tools to help them take action on any early warning signs of trouble. Global ESG research firms MSCI, Sustainalytics and Vigeo-Eiris all flagged serious corporate governance concerns at Volkswagen long before the emissions scandal made headlines around the world.
In our increasingly competitive corporate landscape, the risk of poor corporate governance remains fairly high. In Japan, a report by Teikoku Databank Ltd. found that the number of Japanese companies declaring bankruptcy due to accounting fraud or wrongdoing has tripled between 2009 and 2015. And according to a report by Cornerstone Research, the number of class-action lawsuits filed in the U.S. resulting from accounting allegations rose for a third consecutive year in 2015.
Clearly, more work needs to be done in jurisdictions around the world to ensure that company executives and directors are working in the best interests of shareholders and stakeholders. That’s where responsible asset managers and investment firms can play an active role. By engaging with corporate leaders, they can be at the forefront calling for greater accountability and transparency, increasing board diversity and establishing more equitable executive compensation. All of these areas are opportunities to strengthen corporate governance that will ultimately help secure the long-term value of a company for all its stakeholders.