Good governance pays - and for a reason.

Firms with ineffective or bad governance have suffered in the past, leading to failures that have had a cascading impact on stakeholders and the markets at large. That’s why investors are increasingly basing their investment decisions on ‘good governance’ practices among investee companies.

Regulators, too, are becoming increasingly stringent and proactive about governance. This is evident from the integration of good governance into the European Union’s (EU) Sustainable Finance Disclosure Regulation (SFDR), which mandates comprehensive and uniform disclosures from financial market participants (FMPs)¹ .

The SFDR lays down the ground rules for FMPs to justify the sustainability claims of their financial products. Level I of the SFDR provides the foundations of classifying ‘sustainable investments’ based on their level of sustainability (Article 6, 8 and 9), while Level II establishes stricter interpretations of this tag.

According to Article 2 (17) of the SFDR, for an investment to qualify as sustainable (either under Article 8 or 9 classification), it must fulfill the following three criteria:

• Be invested in an economic activity that contributes to an environmental or social objective
• Not significantly harm the objective
• Ensure that the investee companies practice good governance

Apart from incorporating sustainability risks and principal adverse impact, good governance plays a critical role in defining sustainable-investment products within the SFDR framework.

However, lack of clear definitions and non-availability of quality environmental, social and governance (ESG) data are making it challenging for private markets to evaluate good governance practices among portfolio companies. 

Need for good governance

The absence of a robust governance structure can make it challenging for companies to deploy a sustainability strategy across their business or enhance external-stakeholder relationships.

The concept of good governance is, therefore, a core requirement of sustainable investment. Fund managers are required to validate good governance practices in their portfolio companies, thereby protecting their reputation while attracting investors.

Good governance criteria

The SFDR bases its good governance criteria around sound management structure, employee relations, remuneration of staff, and tax compliance. However, it does not establish the minimum requirements to assess what qualifies as good governance. In the absence of specific guidance, FMPs have the added responsibility to scope out this assessment.

An FMP can consider the below listed indicators, reflecting established industry standards:

Pathway to good governance analysis

CRISIL Global Research and Risk Solutions (GR&RS) assists asset managers and investment firms in analysing the good governance practices of their portfolio companies to ensure compliance with the requirements under Articles 8 and 9.

Leveraging our experience, we have identified the approaches/areas for efficient analysis of the four topics of good governance:

In addition to publicly available research, the following documents can be leveraged to assess good governance:

• Governance documents
• Audit reports
• Tax filings
• Legal due-diligence documents
  

The above information is widely available for public entities. However, disclosing appropriate information under the SFDR is tricky in private markets because of inaccessible, inaccurate or inconsistent data in terms of quality and/or structure. Getting the above-mentioned critical information is vital for an efficient assessment of good governance.

Tackling data unavailability

Asset managers are advised to source as much information as possible from the investees to bridge this data gap.

The company under assessment can provide most of the policies and guidelines. Hence, asset managers often request portfolio companies for access to important documents, such as incorporation reports, corporate governance documents, Board meeting memos, articles of association, financial reports, and bylaw documents.

In case the information is not available for a portfolio company, which is backed by a larger entity that discloses this data, the asset manager can apply the parent’s policies. However, a disclaimer that the policies and governance practices apply for all its subsidiaries, including the portfolio company, is required. In the absence of such a disclaimer, those documents cannot be used.

Additionally, we apply geography-specific laws or regulations for portfolio companies with minimal public information - i.e., to evaluate potential investments from a compensation perspective, one can consider the compensation and labour laws applicable in the jurisdiction. For example, we apply the Dutch incorporation rules² for companies incorporated in the Netherlands. Additionally, we look at industry trends and draw information from the company’s peers that are either public companies or provide information publicly.

Checking for controversies

Checks regarding any public controversies help assess good governance practices among companies. We consider controversies that have: (i) proper evidence/rationale; (ii) been quoted by credible sources; or (iii) been raised by the government agencies (such as the US Food and Drug Administration (FDA) in the US, the Medicines and Healthcare products Regulatory Agency (MHRA) in UK, etc. Mere unsupported allegations are not considered. In addition, we utilize specialized sources for checks regarding controversies.

As a part of the checks, we look for controversies (litigation, penalties or violations) around the following:

• Board structure / members / policy compliance
• Employee pay or compensation
• Workforce health and safety and work environment
• Employee relations, including trade union strikes
• Discrimination, harassment and other business ethics-related lawsuits
• Human rights violation
• Tax filing, tax frauds and compliance

Further, technology can be leveraged for good governance analysis. To this end, ethical web-scraping enables sourcing press releases or articles, if available, and disclosing litigations or lawsuits relevant to the portfolio companies.

Conclusion

Asset managers/investing firms are required to conduct analysis on good governance, followed up with frequent monitoring to ensure compliance among portfolio companies. This would allow asset managers to make informed decisions, meet regulatory requirements and avoid legal consequences.

However, unavailability or limited availability of data in the public domain remains a challenge. Investment firms could engage with portfolio companies and promote the disclosure of their ESG metrics and practices, including governance aspects. These initiatives will allow them to efficiently monitor the compliance among portfolio companies with good governance practices. This would be a win-win for both asset managers/investment firms and the portfolio companies in the form of trust and compliant investments.

¹ Financial market participants/FMPs: Asset managers, insurance undertakings, pension providers and investment firms
² Business.gov.nl