What Does Corporate Governance Really Mean?

I have previously written about how words have become very powerful in the ESG debate, but are in danger of of being debased as a currency because of a lack of clarity. And because terms like "stewardship", "governance" and "custodians" are used interchangeably in marketing materials to promote funds and shares, we should be especially wary.

As I discovered when writing about stewardship, there is some overlap between concepts. UK government savings arm NS&I illustrates this in its promotional blurb for green bonds:

"Good stewardship contributes toward the building of sustainable economies by enabling more efficient capital allocation, fostering best practices in business management and corporate governance, and encouraging better risk management." (My italics). Stewardship also has its own code set by the Financial Reporting Council. That’s separate from the governance code.

Let's Start With Cadbury

Corporate governance has a long and well signposted history in the UK – as well as some regulatory heft in the form of codes and laws like the one above.

My first exposure to this came in the form of the Cadbury Report, which sat in printed form on my grandfather’s desk in 1992. Its full title was Financial Aspects of Corporate Governance and it was a defining moment for UK PLC.

Some of its principles are now enshrined as best practice. They include separating the role of chairman from that of chief executive, setting rules on the use of independent directors, and best practice on audit and pay policies. In turn they have influenced the development of "ground rules" in other nations.

30 years after the Cadbury Report, the UK enshrined its latest corporate governance code in 2018. Set out by the Financial Reporting Council (FRC), the code made clear that good governance should be outward-facing, and involve relationships between companies, shareholders and wider stakeholders (including the public and government). 

The code is also inward looking, and "promotes the importance of establishing a corporate culture aligned with the company purpose, business strategy, promotes integrity and values diversity". With this carrot comes a stick: all companies with a premium stock exchange listing are required to show in their accounts how they’ve applied the FRC’s code.

Crucially, companies are accountable to shareholders first, the FRC says, rather than regulators – another example of how governance has an external focus.

All that is aimed at ensuring UK investors get transparency and as much information as possible to help them make their decisions.

"Expectations around disclosure are comparatively high [and] while there is always room for improvement, there should be sufficient information out there for investors to make informed decisions," says Henry Hoffman, ESG research director, corporate governance, at Morningstar Sustainalytics.

Who Are You?

On the top the the numbers, investors are also increasingly keen to know who executives are and what they stand for – common questions are "how do you know they operate in your best interest?" and "who’s responsible, and are they fit to fulfil that role?" Sometimes data helps, but there’s no substitute for the face-to-face meetings conducted regularly by fund managers and rating agencies.

In this way, governance is more than just accounting. It encompasses corporate culture and how a company interacts with the wider world. Every week there are plenty of examples of UK companies treating customers poorly, and while bad communication can be a factor, the trail often leads from an unfortunate (and inexperienced) spokesperson on social media all the way up to board level. And it's the board that has a huge to-do list.

Sustainalytics breaks down corporate goverance into six pillars: board integrity and quality; board structure; remuneration; shareholder rights; financial reporting; and stakeholder governance. There’s a lot to analyse here, including proxy voting, pay policies, hiring and firing, filing accounts and ethics. Hoffman says investors large and small are especially keen to know about pay and how rewards targets are set. They want to know headline numbers but also how executives are incentivised and rewarded. Are targets too easy to meet? Gone are the days when executives could set their own pay without scrutiny.

Activists and AGMs

It's worth adding that companies whose shares underperform for reasonable periods often attract the attention of activist investors – for example GlaxoSmithKline – and they usually want board changes to affect a turnaround. When stocks struggle, executives often get the blame. CEOs, CFOs and chairpersons are in the spotlight for how the company is governed and the decisions they make, and it's often they who carry the can when it goes wrong.

AGM season is also a tesing period for executives in terms of corporate governance. Rules dictate they must put themselves up for re-election every year. And if they pass that hurdle, shareholders can and do vote against pay policies they think are excessive, poorly-communicated or opaque – or a mixture of all three. Fund managers, who own significant stakes in certain companies and logically have the biggest say, can make life difficult for boards by voting agaisnt pay plans and the re-election of executives.

Beyond evergreen grumbles about excessive pay, at its worst bad corporate governance can also act as an enabler of fraud. Poor oversight by boards, regulators, and investors (and even the media) allows bad actors to get away with financial crime. "If someone’s determined to commit fraud [...] while there are mechanisms and corporate structures that can lower the risk, there is always a risk," Hoffman says.

This comment piece reflects the opinions of the author and are not necessarily those of Morningstar