14 Mar 2022

The “G” in ESG

’’Good corporate governance, it’s about being proper and prosper.”

Toba Beta

Environmental, social and governance (ESG) factors are increasingly being used by investors looking to assess the sustainability and risk profile of companies. Governments worldwide are taking part in this ESG focus, with new legislation being introduced to build the foundations and provide a legal basis to ESG. We have already written about the importance of ESG when assessing the market performance of a company which is supported by a growing number of research and data analyses. In previous articles, we have covered the “E” and “S”, with the letter “G” in ESG” remaining to be addressed.

The “G” refers to the company’s governance and has to do with a company’s management, organization, and decision-making processes, with transparency being the keyword.  Within this article, we focus on the management-equity holders’ relation, excluding the employees since they were covered in our “S” edition.

The appearance of private limited and joint-stock companies enabled the separation of ownership and management, creating a gap between these two groups that is becoming ever larger over time, especially within large multinational companies. The shareholders keep their eyes peeled for the performance charts and profit margins. To instigate managers to focus on the profit,, equity holders pegged managers’ compensation to financial performance. This resulted in a situation where managers gained dominant power in the company and equity holders lost the capability to track and control the managers’ behavior, only to become dumbfounded when the managers’ compensation packages are revealed or when suspicious transactions suddenly resurface.

This is where the “G” enters the scene to analyze how transparent, balanced, and compliant a management board is. The “G” follows the management board and measures, inter alia, board structure, how diverse it is or how effective it is, what the managers’ compensation is, codes of conduct if there are any reporting mechanisms in place and how strict they are, if there are risk exposure assessments and what the applicable standards are, what the tax policy is, and if there are any anti-bribery codes or rules.

Why would any investor care about the board being diverse for instance? Well, apart from the equal opportunity principle, which is nice, a diverse board also creates other corporate benefits – different perspectives help make better decisions, minority representation may enable a wider market presence, plus research suggests that female managers tend to be more risk-averse whereas male managers are more risk-prone and together they make a balanced board with just the right dosage of risk. Diversity and representation within the company’s management yields more thought out and advanced business decisions, which is why some companies adopt board diversity policies, such as British American Tobacco, Nordea, or Arçelik.

Hot topics under the “G” include management compensation as well as tax policies. Golden parachutes are a niche subject in the corporate world with some exceptional stories. Some CEOs managed to negotiate such golden parachutes that their companies could not afford to lay them off. This is a stalemate position where a company cannot discharge a CEO whose bad decisions and mismanagement brought the company to the edge of bankruptcy. This is why the compensation policy is very important because it can show what motivates a manager’s behavior and if the manager holds an excessively strong grip over the company.

Tax is another hot topic, especially when it comes to multinational companies. This is also a slippery slope since much fuss was recently made regarding the taxation of the rich. Investors do prefer to reduce their tax costs, but any form of tax evasion can come back to haunt them with interest. Literally. One of the most famous cases in this topic is Apple vs. Commission on €13 billion Irish tax fee (plus interest) that ended in Apple’s favor. Tech companies are already notorious for their taste for Double Irish with a Dutch Sandwich but Apple still wants the public to think that Apple does not want to avoid paying taxes and understands their social role.

As in other areas, ESG wants companies to apply higher standards than the ones stipulated by the law.  This is why the companies adopt different policies of corporate governance to display their “G” standards.

In terms of the law, here is a quick overview of “G’s” legal background in the European Union and Serbia.

The “G” in the EU

Like all the aspects of ESG the main regulation for corporate governance is the Non-Financial Reporting Directive (“NFRD”) which introduced the ESG reporting rules. The reporting from the NFRD is so far obligatory only for the big companies, however, more companies are including the ESG aspects into their reports to attract investors.

Moreover, the EU company law rules also cover corporate governance reporting. The most important directives are Directive 2007/36/EC  setting out certain rights for shareholders in listed companies, which was amended by Directive (EU) 2017/828 aiming to encourage more long-term engagement of shareholders. Furthermore, the 2018 Commission Implementing Regulation (EU) 2018/1212 lays down minimum requirements regarding shareholder identification, the transmission of information and the facilitation of the exercise of shareholders’ rights.

 The “G” in Serbia

The main sources of corporate governance in Serbia are the Companies Act and the Capital Markets Act.  Corporate governance rules are usually collected and systematized in an internal corporate governance code. Some of the examples of governance codes in Serbia are the ones offered by the Belgrade Stock Exchange and the Chamber of Commerce and Industry of Serbia.

An interesting novelty in Serbian corporate law are the rules on directors’ compensation which were created to introduce more transparency in this matter. These novelties were specially directed to the public joint-stock companies which now need to have a compensation policy and to report on compensations. The compensation report must be publicly available for at least ten years. This is just another example of the importance of transparent directors’ compensation for sustainable corporate governance.

A white-collar world gave us many fascinating stories, we cannot but admire the ingenuity of entrepreneurs and CEOs, but we also cannot forget that their decisions crashed many dreams, drove many people homeless, and finally left many pockets empty.

 

 

 

Nemanja Sladaković, Milica Novaković, Teodora Ristić