Ethical Investing: Corporate Governance
Corporate governance looks at how companies manage themselves and their relationships with shareholders and stakeholders. Ethical investors want to make sure that corporations are being honest and transparent, and that management isn't looking out for its own interests to the detriment of others.
Investors who want help analyzing a company's governance can turn to a number of resources:
- Standard & Poor's GAMMA score (GAMMA stands for governance, accountability, management, metrics and analysis) evaluates the governance of companies in emerging markets, according to shareholder influence, shareholder rights, transparency and board effectiveness.
- Institutional Shareholder Services (ISS) has an executive compensation database, and its Governance Risk Indicators measure companies' governance performance on audit, board, compensation/remuneration and shareholder rights issues.
- The Investor Responsibility Research Center Institute funds corporate governance research, and makes it widely available to the public. For example, it published a report in July 2010 called "Compensation Peer Groups at Companies with High Pay" that examined a number of S&P 500 companies whose executive compensation was out of line with the executives' performance, and the compensation provided by similar companies.
- Governance Metrics International (GMI) develops risk ratings and research related to companies' environmental, social, governance and accounting practices. It examines all the companies in the MCSI world index, the DJ STOXX 600 and the S&P 1500, and updates its data monthly.
- Glass, Lewis & Co. helps investors evaluate the risk of investing in a company as it pertains to governance, business, legal, political and accounting issues. It also provides proxy research and voting recommendations.
Let's examine the major corporate governance issues that concern ethical investors.
Many corporate governance issues have to do with accounting. Is the company honest and accurate in its accounting methods and disclosures? Has the company faced any regulatory sanctions, and if so, has it corrected the problems that got it into trouble?
No investor wants to hold shares of a company that commits accounting fraud, or is sloppy in its accounting practices. According to ISS, investors should be concerned if an auditor issues an adverse opinion, if the company has to restate its financials or if the company has been subject to enforcement action. Investors should also look out for the financial expertise of the audit committee and for weaknesses in internal controls. (Learn more in 8 Ways Companies Cook The Books.)
Investors are part-owners and have a financial stake in how well the company performs - perhaps not as large of a stake as the company's employees and managers, but an important stake nonetheless. Therefore, they should care how the companies they invest in treat their shareholders.
Some companies issue different classes of stock that have different voting rights, and investors in the lesser classes have fewer voting rights. In other companies, one share equals one vote. Other voting issues include whether all common shareholders have a say in the election of all board members; how the board handles popular shareholder resolutions; whether shareholders have a say in approving or denying proposed mergers, acquisitions and restructurings and whether the company has a poison pill policy. Investors want to see policies in their favor - for example, being able to vote on a proposed stock incentive plan, since too many stock options create the potential for significant share dilution.
Shareholders may want to see executive pay tied to stock performance. If the stock performs well, executives earn more; if it doesn't, they earn less. However, even if executive pay is not formally linked to performance, an underperforming CEO can be ousted in a takeover.
Some ethical investors want to limit CEO pay, to a multiple of what the company's lower-paid workers earn, but such limitations on pay may not be in the company's best interest. CEOs who are highly paid are more likely to remain with a company, and as long as they are performing well, stability can be good for the stock. Under the Dodd-Frank Act, companies must allow shareholders a nonbinding vote on executive compensation packages, and publish the results in their regulatory filings. (Learn more in Evaluating Executive Compensation.)
Conflicts Of Interest
It matters who sits on the board of directors, how they manage their responsibilities and what other associations they have. Board members should attend at least 75% of meetings. If they sit on more than one board, they should have enough time to meet all of their obligations, and their positions should not create conflicts of interest. Ethical investors may prefer that a high percentage of the board's directors be independent; if they are not executives or otherwise affiliated with the company, they may be better able to guide the company toward choices that are best for shareholders. A CEO who is also chairman of the board creates a conflict of interest.
When it comes to regulations like Sarbanes-Oxley and the plethora of other Securities and Exchange Commission rules that affect companies, how does the company you want to invest in measure up? Regulatory non-compliance might pay off in the short term, but in the long run, it's likely to be detected and penalized.
Sometimes companies make contributions to political candidates with the implicit understanding or expectation that if that person is elected, the company will receive some sort of special treatment from the government. Other times, companies make political contributions in an attempt to dissuade politicians from passing new regulations that would threaten their businesses. Ethical investors may not want to be affiliated with a company that engages in crony capitalism.
A company that engages in illegal behavior puts all of its shareholders and stakeholders at risk. Types of illegal behavior that companies might engage in are insider trading, kickbacks and bribery. Sometimes it can be difficult to evaluate how problematic these practices are, because practices that are highly frowned upon in the United States, like bribery, may be essential to conducting business in foreign countries.
Governance as a Practical Matter
Corporate governance, like other matters in ethical investing, is not just a feel-good issue. It's a significant factor in determining the company's bottom line and its long-term viability.
In the next section, we'll look at how investors can take action to get publicly traded companies to change their behavior. (To learn more, see Evaluating The Board Of Directors.)
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