Governance research round-up

Our latest review considers the fallout from cutting CEO pay, key ESG risks, market challenges in using ESG data, and why some directors are more vigilant on executive teams than others.

Dangers of cutting CEO pay

Better alignment between executive pay and performance has been one of the great governance debates and challenges of our times. The market has pressured boards to cut CEO pay after periods of poor performance, but there has been little analysis of the consequences.

It is assumed the pay cuts act as a disciplining mechanism on the CEO and encourage her or him to drive stronger firm performance in coming periods. Some academic research has found firm performance does improve after CEO pay cuts.

United States and Indian researchers have examined if cutting the pay of an incumbent CEO has consequences. They wanted to know if the pay cut was accompanied by stronger firm performance in coming periods, or if CEOs attempted to boost reported profits in the short run at the expense of long-term shareholder value.

Authors Gerald Lobo, Hariom Manchiraju and Sri S. Sridharan wrote: “CEOs have incentives to engage in earnings management after a pay cut because such activities can lead to faster improvement in reported performance and, hence, to speedier restoration of their pay to prior levels.”

Their paper, Accounting and Economic Consequences of CEO Pay Cuts, to be published in the Journal of Accounting and Public Policy, studied 1,496 instances of CEO pay cuts from 1994-2013. A pay cut was classified as a 25 per cent drop in a bonus or stock-related pay in a year.

The analysis revealed a significant increase in the magnitude of abnormal accruals and abnormal discretionary expenses after the CEO pay cut. “The firms with a CEO pay cut would have reported much lower profits in the year following the pay cut had they not engaged in these earnings-management activities,” the authors wrote.

In other words, CEOs who experience a significant pay cut, in aggregate, use more devices to boost profits the following year, presumably to restore their lost bonus or stock-related pay. The improvement in firm performance after the CEO pay cut may be illusory.

The authors wrote: “The pressure to achieve a quick turnaround and to restore compensation and reputation in the labour market to pre-pay-cut levels may lead CEOs to engage in both real earnings management and accruals management. Hence, our findings suggest caution before considering CEO pay cuts as a strategy to induce greater CEO effort, as it can have unintended consequences in the absence of strong monitoring mechanisms.”

The takeout for boards is to dig even deeper into reported firm performance after a CEO pay cut – and understand if a turnaround is because of better CEO performance or more aggressive earnings management designed to restore the CEO’s bonus quickly.

Lobo, G et.al., ‘Accounting and Economic Consequences of CEO Pay Cuts,” Journal of Accounting and Public Policy, March 2018.

Top global ESG risks to consider

As market interest in Environmental, Social and Governance issues grows, boards will need to spend more time on anticipating shifts in the ESG landscape. With a good understanding of current and emerging ESG trends, boards can use this data as a risk-mitigation tool.

ESG and corporate governance researcher Sustainalytics last month nominated 10 top ESG risks for 2018 that could have significant impact on shareholder value. “While the risks are not new, we expect many to reach a tipping point in the year ahead,” says Sustainalytics.

The research house groups the 10 risks into four themes. The first is water management; Sustainalytics is convinced the market is underestimating the financial risks posed by water scarcity. The second theme, unsurprisingly, is climate change.

The third overarching ESG theme is consumer protection. Sustainalytics believes we are on the verge of a “‘much larger conversation about data security in the digital age”. The fourth theme is the growing importance of stakeholder governance.

Sustainalytics’ top 10 ESG issues are:

Theme: Water security

• Issue 1: Water-driven community opposition is a growing threat to copper mining.
• Issue 2: Recent multi-million-dollar lawsuits highlight the increasing financial risk of hazardous releases from chemical firms.

Theme: Climate Change

• Issue 3: Rising energy demand and supply challenges in Taiwan may constrain the productivity of chip manufacturers.
• Issue 4: The great low-carbon transition is likely to significantly affect the profitability of oil and gas firms.
• Issue 5: The intensifying physical impacts of climate change pose major risks to the global real-estate industry.

Theme: Consumer protection

• Issue 6: There is a growing risk that the world's tech giants may need to be broken up.
• Issue 7: Health concerns over sugar consumption are leading beverage companies to reconsider their business models.
• Issue 8: New regulatory requirements are triggering new conversations about data security.

Theme: Stakeholder Governance

• Issue 9: Clothing and apparel companies are shifting production to Africa, which could heighten supply-chain risk.
• Issue 10: Governments are cracking down on bribery and corruption in the aerospace and defence industries, while key agencies are stepping up enforcement.

Sustainalytics, “10 for 2018: ESG Risks on the Horizon,” February 2018.

ESG data skill key barrier

With more than 1,600 investors, representing US$62 trillion in assets, signed up to the United Nations Principles for Responsible Investment, interest in ESG is growing rapidly. But several barriers to using Environmental, Social and Governance data in investing remain.

That is the view of a new study by State Street Corporation and its Centre for Applied Research. State Street conducted a global survey in late 2016 of 582 institutional investors that have implemented ESG strategies or plan. The results were published in the latest issue of the Journal of Applied Corporate Finance.

Investors surveyed said they benefit from incorporating ESG data into their investment filters. About 62 per cent said it ‘fostered a long-term mindset’ and 42 per cent said it ‘cultivated better investment practices’. Only 18 per cent said their interest in ESG was regulatory driven and 10 per cent mentioned peer pressure as a driver.

State Street found that misconceptions about ESG – principally, that investors must sacrifice returns when incorporating this data – are fading.

The paper said: “It is still not uncommon for investors to belive that ESG investing requires sacrificing returns, violates fidicuary duty and is inconsistent with investors’ short time frames for outperformance. But these views are less prevalent than they used to be, in part because most academic studies find that ESG investing can produce at least competitive returns.”

But significant barriers to the adoption of ESG investing remain. A lack of standards for measuring ESG performance was the biggest barrier, said 60 per cent of respondents. Lack of ESG performance data reported by companies was cited by 53 per cent of investors.

The problem it seems, is not interest in ESG or the effectiveness of such data in investment decisions. It a lack of confidence in the quality and quantity of ESG data and problems in comparing it across companies and sectors, to gauge performance.

Eccles, G. et.al, “How to Integrate ESG into Investment Decision Making: Results of a Global Survey of Institutional Investors,” Journal of Applied Corporate Finance, February 2018.

Vigilance dilemma for independent directors

Agency theory is clear on the role of independent directors: their job is to monitor the behaviour of insiders and protect shareholder interests. But can vigilant monitoring of an executive team affect a director’s corporate reputation and future job prospects?

Few governance questions are more challenging or complex. An independent director who is concerned about his or her corporate reputation might, in theory, be more vigilant on insiders. Another director who wants to secure extra board roles could be less vigilant.

There is incentive for directors who want to build a board portfolio to be less vigilant on management. Academic research shows directors whose personal reputation is marred by negative firm outcomes have trouble finding future board seats.

Chinese and United States researchers have examined board-monitoring behaviour in a recent paper published in the prestigious Strategic Management Journal. The authors hypothesise that the vigilance with which independent directors monitor insiders is affected by directors’ concerns with their reputation or their prospects in the labour market.

The authors wrote: “When their actions are disclosed to the public, directors concerned more with their public reputations become more vigilant, whereas those concerned with their prospects for additional board seats become more passive in monitoring corporate insiders.”

Thus, directors face a dilemma in insider monitoring. “Independent directors looking to keep their options open in the director labour market … must engage in enough monitoring to ensure that the firm’s reputation – and, by extension, their own reputation – does not suffer. But (they must) also refrain from monitoring that is too vigilant, lest powerful insiders and their other firms view them as unsympathetic,” the authors wrote.

Differences in how directors monitor organisation insiders are not well known because such actions are rarely disclosed publicly. It is unclear if one director is more vigilant on the executive team than another, and why.

The authors argue that greater disclosure of the boardroom decision-making processes, advocated by some regulatory authorities overseas, could encourage directors who are worried about their career prospects to be even more passive on insider monitoring. Being publicly seen to “rock the boat” for an executive team could make it harder to get future board roles.

The authors make an interesting contribution to governance literature. In a small governance community such as Australia, it’s worth studying the career trajectory of directors who adopt more vigilant monitoring of insiders and publicly disclose their actions.

Li, W et.al., ‘Under the Microscope: An experimental look at board transparency and director monitoring behaviour,” Strategic Management Journal, April 2018.

Sustainability low on investors’ radar

Sustainability has become one the great governance buzzwords of this century. Directors are expected to govern “sustainable” companies and there is a perception that higher sustainability is accompanied by higher firm performance. But does sustainability pay?

United States researchers have studied whether investors value sustainability by analysing the market’s reaction to whether a company is included, excluded or retained in the Dow Jones Sustainability Index (DJSI) World from 1999 to 2015. The DJSI was the world’s first global sustainability index and is seen as the leading investment benchmark in this area.

The DJSI methodology ensures that firms that make the index are in the top 10 per cent of corporate social responsibility (CSR) leaders in their field. It’s believed that joining the DJSI highlights a firm’s sustainability credentials to the market

With an increasing pool of global capital earmarked for firms with high Environmental, Social and Governance (ESG) performance, inclusion in the DSJI should, in theory, boost demand for the firm’s stock from institutional investors, driving higher returns.

The study, published in the Journal of Strategic Management, found that DSJI inclusions or exclusions have only limited effect and that investors care little about such events.

If anything, there is a slightly negative market reaction when companies are included in the DJSI. “Investors appear to punish firms that are added to or continue in the index, suggesting these events might be a sign of excessive investment in sustainability initiatives and, possibly, divergence of capital from more profitable projects,” the authors wrote.

It’s possible that being included in or excluded from the DJSI is not sufficient to warrant a market response: the firm’s ESG credentials might already be factored into the stock. Or that the market reaction tends to strengthen over time, the longer the firm is included in the DJSI.

Either way, the study shows that being highlighted as a sustainability exemplar, through inclusion in sustainability indices, does little for a firm’s share price. Cynics could argue that for all the talk about sustainability, it has little influence on shareholder returns.

Many studies have found different results, but the correlation between sustainability and firm performance is arguably still uncertain and may be affected by data and study-design limitations.

Hawn, O., et.al., “Do Investors Actually Value Sustainability? New evidence from investor reactions to the Dow Jones Sustainability Index”, Strategic Management Journal, April 2018.