Who’s afraid of the big, bad governance wolf?

Corporate governance has become an increasingly contradictory conversation. A year after the Hong Kong Stock Exchange finally bowed to pressure to allow dual class share structures in a bid to attract the tech giants it had in the past missed out on, ride-hailing firm Lyft was under pressure to abandon the proposed dual-class share structure it ultimately went public with. And even as the world’s largest institutional investors shine an ever-sharper spotlight on corporate governance and wider ESG issues, many IROs continue to report few questions along these lines in their investor meetings.

In fact, IR Magazine and Corprate Secretary research shows that for 33 percent of companies, governance is something that is only ‘sometimes’ discussed with investors, with ‘sometimes’ meaning quarterly. A larger proportion (39 percent) say governance issues ‘rarely’ come up – just once or twice a year.

Given the continued interest from investors and consumers in numerous firms that have faced governance issues, from the more commonplace board diversity questions to the global data scandals at Facebook, the numerous governance concerns at Uber – which remains so popular that more than 700,000 Londoners signed a petition to keep the company going when it lost its license to operate in 2017 – or the hype around Snap’s IPO despite it offering shares with no voting rights, it would be easy to assume that as long as the fundamentals remain attractive and a couple of fairly high profile heads roll if a situation goes seriously wrong, things can continue largely unchanged. So what’s behind the apparent mismatch?

The index effect

One reason companies might appear to go somewhat unpunished for governance scandals is the growth in index funds, says James McRitchie, governance advocate and founder of CorpGov.net. These index-matching or tracking mutual funds, first launched in 1975, last year accounted for an estimated $11.9 tn – or 17.5 percent – of the $67.9 tn in global equity market capitalization, according to research by BlackRock. 

‘Most investors are either indexed investors, and thus investing in the entire market or market segment, or they are modified index investors, overweighted or underweighted in some area they are paying more attention to,’ says McRitchie. ‘So they aren’t so focused on individual companies and their behavior.’ 

But he adds that ‘investors are starting to put more emphasis on ESG factors.’ In the index fund universe, this is evidenced by the increasing number of index funds with an ESG focus that have launched recently. And while companies like Lyft might still favor a dual-class approach, the Snap IPO did much to bring such voting structures into the public consciousness. In October this year, MSCI will launch a new set of indexes designed to give investors the choice to avoid companies based on voting rights. 

The impact on reputation 

But what happens when a problem arises? One IR professional with probably more experience than he’d like in ESG and governance scandals is Oliver Larkin, group head of IR at Volkswagen, which is now heading toward its fourth year discussing the outcome of not one but two diesel-emissions scandals to hit the company in 2015 and 2018. 

Media and analysts alike predicted the financial downfall of the firm after it first came to light that the car giant had been installing secret software to make car engines appear cleaner in tests than they were on the road. But consumers appeared largely unfazed and global sales actually continued to rise. 

Larkin explains that this was down to the widely varied impact of the scandal on the company’s different markets. Its China market, for example, where it sells no diesel cars, had been growing steadily and only saw its first fall in sales last year. But even within Europe, the impact varied. ‘Particularly outside of Germany and the UK, the reputation of Volkswagen wasn’t as impacted,’ Larkin explains. ‘The press was perhaps slightly more aggressive in Germany and the UK wasn’t so friendly. But in other markets – particularly in Eastern Europe – there didn’t seem to be much reaction. 

‘We did have a lot of issues in the US: we withdrew diesel completely from the market and, at that time, it accounted for about 25 percent of sales there. But the US is a relatively small market for Volkswagen so on a global scale that had a relatively small impact.’ 

When it came to investors, Larkin says the picture was equally varied. ‘There were some that were a little bit more opportunistic,’ he says. ‘Quite often in these situations share prices fall dramatically and then recover, so one or two investors doubled down and invested more at the very low price on the expectation that stock prices would ultimately bounce back – and I think that was quite an aggressive move. For other investors, particularly on the ESG side, Volkswagen became a no-go area and that still remains the case for some – perhaps more so in the Scandinavian markets than elsewhere.’

The stock also saw a shift toward greater hedge fund ownership, Larkin adds, as certain investors tried to predict the ebb and flow of the story. And while he notes that the 12-strong IR team has gone from spending around 80 percent of its time discussing the issue to around only 5 percent today, the twists continue, with the SEC in March accusing Volkswagen and its former CEO, Martin Winterkorn, of defrauding bond investors to the tune of $13 bn in March.

Even though sales remained strong, however, Larkin says ‘it’s common knowledge that our reputation has been damaged. And while the likelihood of people to buy Volkswagen remains good, it has probably been reduced from the higher levels it was at before.’

The revelations had wider implications on the ESG front, too. Volkswagen is a founding member of the UN Global Compact – established in 1999 to encourage businesses to adopt sustainable and socially responsible policies, and to report on the implementation of those policies.

‘As a consequence of the diesel scandal we suspended our membership of the UN Global Compact, and we haven’t rejoined yet,’ says Larkin. ‘For some investors, the fact that we are not a signed-up a member of the UN Global Compact actually makes it very difficult to invest in Volkswagen today.’ At the same time, Volkswagen was also the only automotive company included on the FTSE4Good Index. ‘Not surprisingly, that’s something we were kicked out of as a consequence,’ adds Larkin.

While he believes index inclusion can protect a company from the full impact of an ESG issue, he believes ‘index funds don’t necessarily slavishly mirror the index. Our experience is that the larger index funds also have ESG departments and, perhaps not so much with the number of shares they’re holding, but in terms of voting at AGMs, will use ESG criteria in determining how they vote.’

A longer version of the interview with Oliver Larkin of Volkswagen can be found here.

Advocacy, engagement and voting

That’s certainly the approach taken at Vanguard, one of the world’s largest asset managers, with $5 tn in assets. ‘Most of those investments are in index funds, which are very long term in nature,’ explains Adrienne Monley, Vanguard’s European head of investment stewardship. ‘And I say that because an index fund is going to own stock as long as it’s tracked in an index. We’ll own great companies, and we’ll own not-so-great companies, but we’ve committed to our clients to efficiently track the indices they want to invest in.’

What this ultimately means is that Vanguard won’t sell a company it’s invested in. Monley notes that in the past, some companies felt this meant they didn’t need to engage – but that’s a view she sees less often these days. And even though the asset manager might not sell, it does engage heavily with companies and will ultimately use its voting power against a firm if necessary.

The fact that Vanguard is so largely focused on index funds ‘gives us a really special investment stewardship responsibility,’ says Monley. And she adds that this stewardship program has three areas of focus: advocacy, by which she means ‘engagement with public policy-makers [and] standard-setters’, engagement on ‘issues we think can have a bearing on long-term value for our clients’ and Vanguard’s voting guidelines – also designed to drive long-term value.

Within that three-pronged approach, Vanguard focuses on four key areas of corporate governance: the board, oversight of strategy for risk issues at a company, long-term-oriented executive remuneration and governance structures.

Highlighting just how much the focus on governance and other material, non-financial risks has grown, Monley points out that when she joined Vanguard’s stewardship team in the US in 2015, it was made up of ‘around a dozen people’. In the last three years, that has expanded three-fold, with a growing focus on Europe despite the fact that Vanguard’s equity assets are around 75 percent US-invested.

When it comes to engaging around ESG issues, Monley observes that ‘no matter how we get to the engagement, our process [from then on] is consistent: we talk to companies about our priorities, we educate them about those four governance principles and we ask them to explain their approach to corporate governance and material risks.’

But what about companies facing a contentious issue or governance scandal? While not a common problem, Monley says ‘each year there tend to be a few situations that require a slightly different approach. We think it’s helpful for companies to hear Vanguard’s informed point of view, as they contemplate the next steps in addressing a complex issue. Also, we know that in a complex situation, we probably have more to learn, where information can get lost in media or industry swirl. Our approach is designed to cut through the noise by having direct discussions with a company and focusing on our long-term investment priorities.’

Vanguard’s large stewardship team means it has the luxury of taking a case-by-case approach when something contentious does come up, while the very long-term nature of its investments means conversations are ongoing and can happen over a long period. ‘We know we’re going to own these stocks as long as they’re listed in an index, which means we have the benefit of time and we can be patient,’ says Monley. ‘But we’re not infinitely patient.’

Punishing bad behavior

The spotlight is certainly shining on ESG and the increasing number of ESG-focused index funds means companies that stray too far from best practice are more likely to fall out of the index and, consequently, any tracking funds.

But what McRitchie says is needed in addition to the engagement and voting action he advocates – especially if companies are to be seen to be adequately punished by the market – is a change in the way firms are dealt with when they break the rules.

‘The penalties for bad behavior are not yet so severe as to really change behavior,’ he explains. ‘Witness the lack of prosecution of bankers and mortgage brokers that led to the great recession. Tobacco purveyors aren’t forced to pick up the medical bills of cancer victims. Oil companies aren’t paying for their contribution to climate change. Companies can still externalize costs and get away with it.’

A longer version of the interview with Oliver Larkin of Volkswagen can be found here. A longer version of the interview with Adrienne Monley can be found in the summer 2019 issues of Corporate Secretary and IR Magazine.

This article was published in the summer 2019 issue of IR Magazine