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Governance Roundup

January 26, 2016

2016 forecast: Even more governance focus on and by institutional investors.

Dina Medland writes in Forbes:1

Better corporate governance across the globe is likely to be in strong focus in 2016. Not only are investors increasing their scrutiny of boardrooms, but they are under pressure themselves....

Institutional investors, reeling from a spate of corporate scandals, are more aware than ever before of their stewardship responsibilities amid the globalization of company investor bases.

Medland cites a new report from Russell Reynolds Associates that found:

The Petrobras scandal in Brazil, Satyam and more recent incidents in India, Toshiba in Japan, and perhaps Volkswagen in Germany will have a substantial impact on corporate governance in those countries as legislators, regulators, and institutional shareholders demand more tools to promote accountability and transparency from companies and their boards of directors.

The report’s findings and predictions for investor priorities include more focus on board effectiveness and the contributions and abilities of individual directors and a “trust but verify” emphasis on governance codes, transparency and ESG measures.

Eugene McErlean argues in the Irish Examiner that government intervention is needed to strengthen corporate governance.2

McErlean was Allied Irish Banks' ("AIB") former group internal auditor who warned in 2001 about a major overcharging problem at the bank.  Now recognized as a whistleblower, he is expected to receive a formal apology from the authorities who did not listen to his concerns.  He is raising concerns now about the rising level of corporate failures and abuses that are considered almost routine:

The current system of self-regulated corporate governance does not appear to be working and does not appear to be capable of reforming itself.

Assurances that lessons have been learned and that it won’t happen again appear hollow when confronted with the evidence. We have become accustomed to corporate bad behaviour and inured to the absence of accountability.

Perhaps most concerning of all, we appear to have accepted that the extreme has become routine.

The obvious conclusion must be that self-regulation and voluntary codes of practice have run their course and that it is time for governments to step in and referee the match.

Barclays fined by FINRA for mutual fund switching.3

Barclays Capital, Inc. has been ordered by the Financial Industry Regulatory Authority (“FINRA”) to pay more than $10 million in restitution, including interest, to affected customers for mutual fund-related “suitability violations,” and was also censured and fined $3.75 million.  The bank failed to act on automated alerts warning it of “potentially unsuitable transactions”; failed to review some transactions for suitability; and did not send letters to customers regarding the transaction costs.  Barclays also failed to offer eligible customers “breakpoint discounts” – discounted fees on larger investments.

JP Morgan was fined $307 million for steering clients to its own funds.4

Violations include moving client funds to in-house funds that provide no additional benefit to the client but direct all of the management fees to JP Morgan. This is exactly the kind of failure of fiduciary duty that is at the heart of the current industry-led efforts to allow fund managers to benefit from their own fees regardless of client interest.

Political contribution disclosure suffers a setback in the United States.6

The hard-fought budget bill passed by the U.S. Congress just before the end of the year had a provision that specifically prohibits the SEC from enacting regulations requiring public companies to disclose their political contributions, despite the fact that a petition for this rulemaking received 1.2 million comments with record-breaking support.  Democratic Senators have urged the SEC to move forward anyway. In an op-ed, the professors who originally petitioned for the rule argue that thwarting it through the budget process is wrong on substance and process:7

The rider included in the omnibus budget bill reflects opponents’ interest in avoiding a debate on the merits of disclosure to investors....

The rider also undermines the standing of the S.E.C. It reflects a judgment that the commission and its staff, which have served the investing public well for generations, cannot be trusted to reach an appropriate decision about whether and how to develop rules in this area. Legislators should not tie the hands of independent and expert regulators and prevent them from doing their job.

And the rider undermines the critical premises on which the Supreme Court has relied in its Citizens United decision. In this consequential decision, the court reasoned that “the procedures of corporate democracy” would ensure that political spending by public companies does not depart from shareholder interests. Without disclosure to investors, however, such procedures cannot be expected to limit or prevent such departures.

The Ford Foundation shifts to “impact investing.” 8

Ford Foundation President Darren Walker has announced several important changes, including integration of investment and program goals:

Reflecting common practice at most large legacy foundations, the Ford Foundation has maintained the position that our policy is to maximize endowment returns, except in our screening out certain industries. This position, that we maximize returns, has been a source of questioning, discontent, and frustration among those we support, as well as among staff at Ford.

…I no longer find it defensible to say that our investment strategy is only to maximize the value of our endowment—just as it’s no longer defensible for a corporation to say its only responsibility is to maximize shareholder value. There is growing evidence that it is possible to find impact investing opportunities that deliver financial and social, double bottom-line returns.

In light of new regulations from the Obama administration, which encourage mission-related investment, now is an opportune time for foundation boards to confront the endowment question.

FASB tries to cut back on “material” information.9

Gretchen Morgenson reports in The New York Times:

The proposal10 would effectively change the definition of materiality, a mainstay of corporate financial disclosure that determines what a company must tell investors about its operations and results.

On its surface, that sounds tame enough. But bear with me: If you own stock in corporate America in any form, you need to understand what FASB is thinking of doing.

For decades information was deemed material if it could influence decisions made by users of financial statements, a.k.a. current and prospective shareholders or lenders.

But now, accounting standard-setters have proposed a new meaning for material information, one that some investors say will give far more discretion to companies in deciding what to disclose in their financial statements. The trouble with more discretion, the critics say, is that it usually means less information.

The comment period has ended, but objections filed so far will likely mean that FASB will hold a hearing on the proposed revisions before making a final decision.

CalPERS is calling on boards to find younger and more diverse directors.

Comstock’s reports:11

The $294 billion California Public Employees’ Retirement System is taking aim at older, white men on corporate boards with a proposed policy aimed at adding more women, minorities and gays to key positions at the largest U.S. companies. . . .

“We’ve got board stagnation,” said Anne Simpson, director of corporate governance at Sacramento-based Calpers. “We’re not going to create an opportunity for new members for diversity to progress unless there’s some space.”

SEC approves shareholder proposals on climate change.

U.S. investor efforts to push companies to act on climate change have been strengthened by a Securities and Exchange Commission ruling that Franklin Resources, which manages the Franklin Templeton family of mutual funds, will be required to include a shareholder resolution on its 2016 ballot focusing on its poor voting record on climate change proposals. The resolution was filed by Zevin Asset Management, an independent, socially responsible investment management firm, to highlight the contradiction between Franklin’s voting practices and its policy positions regarding climate change. A similar proposal has also been filed by Zevin at T. Rowe Price. Research conducted by Fund Votes, on behalf of Ceres, shows that Franklin Templeton mutual funds’ voting record on climate change issues is near the bottom of the pack among mutual funds.  Franklin’s voting record is all the more striking given that Franklin Templeton Investments has been a signatory to the United Nations Principles for Responsible Investment since 2013.

Will Japan’s new corporate governance reforms work?

Columbia Business School professor Bruce Greenwald is skeptical that structural reforms can surmount cultural and systemic forces in Japan.  He writes in East Asia Forum:12

As part of Abenomics' third arrow of structural reform, Japan recently adopted a new corporate governance code. The new code focuses on making Japanese corporations more transparent, more responsive to shareholders — including minority shareholders — and subject to more effective oversight by boards of directors, especially outside directors. It seeks to make boards of directors not only more active and independent, but more diverse. In most respects the code moves Japan toward Western, especially US corporate governance practices. . . .

. . . Corporate cultures completely dominate corporate behaviour in the United States. Formal governance rules have an effect that is an order of magnitude smaller. This shows up most obviously in differences in performance across US corporate managements.

Despite the widespread adoption of 'shareholder friendly' governance principles, many US managements perform poorly. They fail to manage costs efficiently and seek to grow in areas where they enjoy no competitive advantages (or worse, suffer from significant disadvantages) with disastrous consequences for returns on investment. They have self-indulgent capital structures (low debt and lots of cash accumulated at the expense of shareholder distributions) and pay limited attention to effective succession planning. And they hire and fire workers promiscuously in response to short term fluctuations in market conditions (a costly practice for workers and shareholders) and pay themselves generously without regard to their performance.

US corporate managements are able to achieve this by observing the letter, but not the spirit of corporate governance rules.

* * *

On the positive side, this means that the strong Japanese emphasis on social cohesion and discomfort with extreme individual distinctions means that the effect on differences in compensation and employment security within firms will also be minimal. On the negative side, hopes of significantly enhanced management performance and innovation are likely to be disappointed.

What is the Alpha of ESG?

Mackenzie Weinger asks for the FT’s Alphaville blog whether there is Alpha in the ESG (environmental/social/governance indicators):13

Barclays analysts have come away with what they’ve dubbed a “surprising conclusion” in a recent report assessing the US corporate bond market in light of ESG ratings.

* * *

“We find evidence that a high ESG rating has been a source of modest incremental return in corporate bond portfolios. This is a surprising conclusion given that ESG investing is typically seen as a constraint on bond portfolio construction and so could be expected to have a cost. Also, the fact that bonds with high ESG scores tend to trade at slightly lower than-average spreads has not translated into a return penalty in the period under consideration.

While ESG as a whole has benefited investors, individual Environment, Social and Governance attributes have all helped improve performance from 2007 to 2015. Governance appears to have been the largest contributor, while the effects of Environmental and Social scores have been weaker.” (Emphasis added by FT.)

* * *

ESG isn’t meant to just be about feel good, seemingly ethical investments, according to its backers, although the lens does attract investors who want to make a “positive impact” as MSCI’s Laura Nishikawa, head of fixed income ESG research, told FT Alphaville last week…. ESG is meant to be good risk management, Nishikawa says: “It’s not a magic fairy dust you can sprinkle on your portfolio. But it might tell you where some outliers are on your portfolio.”

Similarly, Martin Gilbert, chief executive of Aberdeen Asset Management, writes in City A.M. that governance is a key indicator of risk:14  “[A]mong 300 global financial decision-makers, governance was found to be an integral factor when selecting and analysing investments. Almost 90 per cent of respondents considered effective governance to be a critical driver of investment performance.”  He notes that “[g]ood governance involves a qualitative, rather than mechanical, evaluation of corporate practices and of the people carrying them forward. It evaluates complex issues as broad as the quality of management to effective risk management." 

1     http://www.forbes.com/sites/dinamedland/2016/01/02/institutional-investors-in-2016-seek-to-trust-but-verify-on-governance/

2     http://www.irishexaminer.com/business/corporate-governance-codes-are-not-working-361517.html

3    http://www.streetinsider.com/Corporate+News/

4      http://www.nytimes.com/2015/12/19/business/dealbook/jpmorgan-to-pay-307-million-for-steering-clients-to-own-funds.html?_r=1

5     http://socialinvesting.about.com/od/Sustainable-Investing/fl/BlackRock-Fidelity-and-Vanguard-Exposed-on-Climate-Change.htm

6    http://www.uspirg.org/news/usp/94-lawmakers-urge-sec-pursue-rules-strengthening-political-spending-disclosure

7   http://www.nytimes.com/2015/12/22/business/dealbook/hindering-the-sec-from-shining-a-light-on-political-spending.html?_r=2

8    http://us10.campaign-archive1.com/?u=3f89269c6132144b6f1c5ce78&id=4fe9d631dc

9    http://www.nytimes.com/2016/01/03/business/fasb-proposes-to-curb-what-companies-must-disclose.html

10  http://www.fasb.org/jsp/FASB/Document_C/DocumentPage&cid=1176166402203

11  http://www.comstocksmag.com/bloomberg/calpers-pushes-boards-clear-room-young-and-ethnic

12   http://www.eastasiaforum.org/2015/11/29/will-japans-corporate-governance-reform-work/

13   http://ftalphaville.ft.com/2015/11/26/2145911/nothing-but-a-g-thang/

14   http://www.cityam.com/229383/why-good-governance-now-key-investment-differentiator

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