Issue Brief: Corporate Governance and Business Ethics
Sound corporate governance and ethical business practices are critical to a company’s long-term success. Corporate governance refers to how a company is structured—including its by-laws, code of ethics, and board of directors—as well as the incentives and culture established at the top. Business ethics refers to the morality and integrity of how a company conducts its operations around the world, including its policies for suppliers and vendors. A well-governed company has strong, transparent policies in both areas—with accountability and rigorous board oversight—and operates in the best interests of its shareholders, employees, customers, community, and the environment. Over the past decade, we have witnessed numerous corporate governance and ethics scandals, from accounting irregularities, to rogue stock traders costing investors billions of dollars, to allegations of bribery and illicit corporate payments to foreign governments. But the most devastating example of all was the lack of adequate governance and oversight by many financial organizations—including rating agencies and regulators—that led to the 2008 financial crisis. Clearly, a company’s governance and ethical business practices affect not only its reputation, brand, employees, and bottom line; they can impact an entire industry, as well as investors, governments, and consumers.
A View From the Top
Calvert monitors numerous aspects of corporate governance and business ethics, which typically are rooted in policies and practices that flow from the top of the organization down. Areas we focus on include board independence and diversity, executive compensation, public disclosure of corporate policies and procedures, shareholder accountability, and attention to stakeholder concerns. Calvert looks for corporate structures and transparency that create and reinforce accountability, such as:
- Independent, diverse boards of directors
- Measurement and full disclosure of financial, environmental, and social performance
- Policies and procedures that allow shareholders to express their concerns and preferences, and
- Compensation plans that align the interests of management and investors
In the area of ethics, Calvert reviews a company’s code of conduct as well as any public record of complaints of bribery and kickbacks, money laundering, securities fraud, and insider trading. When problems are found—as happens occasionally at even the best companies, especially those with significant foreign operations and suppliers—we review how quickly and effectively the company rectified the situation.
Prioritizing ESG Considerations
In our view, board-level oversight of environmental, social, and governance (ESG) considerations is critical to establishing a strong, responsible corporate culture. In fact, companies are already doing this to varying degrees. A recent Calvert study of the companies in the Standard & Poor’s 100 Index revealed that 65% had a specific board committee assigned to evaluate some aspect of corporate responsibility or ESG factors.2 Integrating sustainability performance metrics into areas such as executive compensation plans and employee and supplier codes of conduct sends a clear signal that the company is assessing and managing the risks and opportunities of these so-called “extra-financial” issues.
Tell-Tale Signs of Good Governance
These four areas are especially important in assessing governance and business ethics practices:
Sustainability Reporting. The regularity and degree of transparency in a company’s sustainability reports is a key barometer of its governance standards. As they say, “What isn’t measured isn’t managed.” Therefore, annually published reports, with audited and independently verified data, is considered a corporate governance best practice.
Momentum is growing for companies to follow the Global Reporting Initiative (GRI) guidelines—the most widely used, standardized sustainability reporting framework in the world. The guidelines were created by an international, independent group of businesses, investment firms, and non-governmental agencies, in which Calvert participated. The GRI seeks to make sustainability reporting as common—and as comprehensive—as financial reporting. Calvert gives high marks to companies that use the GRI sustainability reporting guidelines.
Board Diversity. For years, Calvert has regarded board diversity as a critical governance goal. A company’s board membership should broadly reflect its customer base and employees. The array of viewpoints, skills, background, and experience provided by boards whose members have diverse backgrounds gives the company a broader foundation to draw upon for strategic decision-making—especially in today’s highly competitive, global marketplace. Unfortunately, while progress has been made over the years, women still hold just 18% of corporate board of director seats, yet comprise nearly 50% of the workforce.2
We believe that to be marketplace leaders, companies must actively seek women and minority candidates for their boardrooms. In fact, a McKinsey & Company study found that companies with the highest share of women on executive committees outperformed those with all-male executive committees, earning a 41% higher return on equity and 56% better operating results.3
Executive Compensation. Since the onset of the financial crisis, reports of multi-million dollar compensation and severance packages received for executives of companies that have suffered losses, foreclosed on homeowners, or laid off employees have sparked a public outcry. Doling out excessive payments to executives at the expense of other employees is in direct contrast to shareholders’ interests and often increases employee turnover.
We also have found that excessive executive compensation during a period of lackluster business performance may be an early indication of bigger trouble at a company. Poorly designed compensation programs that encourage executives to manage for short-term performance—at the expense of long-term profitability—are another concern, potentially compromising the governance goals of a corporation.
We strongly believe it is in the best interests of a firm to align senior manage-ment’s risks and rewards with those of employees, shareholders, and the long-term performance of the corporation. “Pay-for-performance” compensation plans, for example, typically link executive compensation to clearly defined and rigorous criteria.
Uncovering Governance Problems
Calvert uses a number of public sources to analyze a company’s corporate governance and business ethics, including: company websites, annual reports, SEC filings, sustainability reports, and direct feedback from companies. We also tap reliable third-party sources, such as Diversity Inc., the Human Rights Campaign Foundation’s Corporate Equality Index, the SEC Edgar database, and media reports. For example, in 2006 and 2007, Calvert identified numerous reports of massive back-dating of stock options to “juice” executive compensation—a clearly fraudulent action. We uncover this type of breach through SEC and Justice Department investigation reports, shareholder lawsuits, and corporate disclosures about earnings restatements, internal board investigations, or Sarbanes-Oxley violations. Needless to say, robust governance structures, fair and transparent compensation programs, and rigorous codes of conduct are no guarantee of ethical behavior. However, they—along with internal controls, a system for accountability, and a strong culture of ethics—can help the company quickly discover and manage any ethics issues. The lack of strong governance and inappropriate incentives can make conditions ripe for unethical and even illegal behavior—causing significant harm to the business and shareholders.
Driving Progress in Corporate Governance
As customers and investors have raised their expectations for companies to operate sustainably, the United States has toughened its regulation of corporate governance issues. In 2002, the Sarbanes-Oxley Act set today’s standards for U.S. public company boards, management, and public accounting firms in an effort to restore public confidence in corporate America. More recently, in the wake of the global financial crisis, Calvert joined forces with other investors to advocate for the Dodd-Frank Wall Street Reform and Consumer Protection Act, specifically those provisions on executive compensation, golden parachutes, shareholder “say on pay,” and “claw-back” policies to recover pay from employees whose actions created substantial financial or legal repercussions. The Act was passed in 2011.
Calvert sees a direct connection between comprehensive and enforceable regulations and ethical corporate behavior. Over the last decade, we believe companies have made progress in the corporate governance arena in response to both public and private pressures and increased regulatory oversight. Ultimately, reinforcing this link will promote more sustainable long-term performance for companies and their shareholders.
1. Calvert and The Corporate Library, Board Oversight of Environmental and Social Issues: An Analysis of Current North American Practice, 2010.
2. Calvert, Examining the Cracks in the Ceiling: A Survey of Corporate Diversity Practices of the S&P 100, October 2010.
3. McKinsey & Co., Women Matter 3, September 2009.
SRI criteria will vary from fund to fund. Please see a fund's prospectus for details.