In this post we discuss
- Disclosure regulation
- Compliance culture
- Risk and reputation management
- Conflicts of interest
- Organisational requirements
There have been many studies showing that good corporate governance leads to higher profitability. Companies looking for investment are needing to show good governance practices in order to be classified as a “sustainable investment’ as well as being aware that in March this year the EU’s Sustainability-Related Disclosure Regulation will be in place. It is clear that ESG matters are growing in importance as a compliance issue for financial institutions.
The Disclosure regulation seeks to harmonise existing provisions on disclosures to investors in relation to sustainability by imposing requirements on financial market participants (e.g. AIFMs and UCITS management companies and investment firms carrying out portfolio management) and financial advisers in relation to financial products. Firms will have to make disclosures on their integration of ESG risks and consider the adverse impacts on their investment processes and remuneration policies. Firms will also be required to disclose ESG factors and impacts on their products. This regulation is an amendment to MiFID II, which the FCA will seek to implement by way of changes to the Conduct of Business rules (COBS).
Overall, it sets out to achieve more transparency on how financial market participants and advisers consider sustainability risks in their investment decisions and insurance, pension or investment advice.
Above all else directors should be mindful of good corporate governance strategies
Businesses seeking to improve their corporate governance need to maintain a strong compliance function, or second line of defence which:
- Has appropriate oversight of business lines;
- Ensures the company adheres to legal and regulatory obligations;
- Has clear lines of reporting to the board of directors; and
- Is able to manage the demands of external and internal stakeholders;
In establishing and maintaining an adequate compliance function compliance officers need to ensure that legal requirements are met as a priority as well as enhancing or introducing additional systems and controls.
A number of studies have shown that by increasing diversity and representation on company boards there have been benefits to businesses in terms of improving governance and profitability.
Corporates are facing greater pressure from shareholders and external stakeholders to increase gender and ethnic diversity at board level. There are an increasing number of major investment companies warning that they will vote against boards who do not actively promote diversification within their organisation. In August 2020 State Street issued an open letter requiring companies in their portfolio to describe goals related to racial and ethnic representation at board level.
In 2018 the U.K. Corporate Governance Code was expanded to include guidance on gender, social and ethnic diversity in UK boardrooms. Whilst its requirements are not compulsory, it is generally considered to be best practice for companies to comply rather than to have to publicly explain any non-compliance. Amongst other requirements companies should include a section in their annual reports describing its policy on diversity and its progress towards meeting future goals. It is important that companies ensure their diversity initiatives can be shown to be an inclusive decision-making process.
Risk and reputation management
In the past we have promoted the view that good corporate governance is essential for control of legal, regulatory and reputational risks to businesses.
In November 2020, the FCA published a report on disclosures relating to corporate governance. Within this report it highlighted the need for non-executive directors to provide constructive challenge to the board. Additionally, last year the Financial Reporting Council (FRC) conducted a review of corporate governance reporting observing that boilerplate reporting on principal decisions was still common. It suggests companies explain the contribution of each principal decision to its long-term success and carefully document challenges made by independent non-executives to show how these challenges have helped the company. Corporate governance strategies can be improved by ensuring that there is effective oversight and meaningful challenges to business decisions, including, but not limited to:
- Legal and regulatory standards;
- Assessments of environmental impact;
- Reputational risk;
- Internal policies; and
- ESG factors.
These will provide help to the business, given the potential damage adverse media attention on poor decisions can have.
In order to substantively improve corporate governance practice and risk frameworks, businesses should ensure that they have clearly documented reporting lines, which are understood by all employees in the company. Committee structures should be proportional to the size of the business and board directors should be mindful of creating committees that do not have clear delegation of responsibility and accountability.
The focus on strengthening whistleblowing systems and controls for regulated entities, has increased in recent years, as demonstrated by the FCA’s expectation that firms appoint a non-executive director as a whistleblowing champion. Failure to have appropriate whistleblowing systems and controls may result in greater scrutiny by the FCA, financial penalties, public censure and sanctions against the senior managers.
Whistleblowers are protected under the UK Employment Rights Act 1996 with financial consequences for breaching these. Organisations should ensure that they implement and maintain both strong whistleblowing controls and employee and management training on the whistleblowing procedures.
Conflicts of interest
Firms should review their conflicts of interest policy to ensure that they consider ESG factors. Where firms provide investment advice or portfolio management services, they should ensure that the inclusion of ESG factors considered in the advisory or portfolio management process does not lead to misselling practices or the misrepresentation of products or strategies as fulfilling ESG preferences where they do not.
Under ESMA’s proposed ESG reforms, firms that are subject to the organisational requirements set out in Article 16 of MiFID II will need to take ESG considerations into account when complying with organisational requirements including:
- Establishing decision-making procedures and documented reporting lines;
- Ensuring that personnel comply with decisions and procedures at all levels of the firm; and
- Employing personnel with the skills, knowledge and expertise necessary for the discharge of their responsibilities.
In conclusion, companies should be considering enhancing their existing corporate governance procedures to ensure a greater focus on compliance, diversity, risk management, whistleblowing and stakeholder engagement. In addition, firms need to ensure that there is a sufficient understanding and knowledge base amongst its staff of the firm’s ESG policy, and potentially of ESG considerations where these are key to the firm’s trading or investment strategy.
If you need any help and advice with ESG or any compliance, regulatory and risk management issue please get in contact with Dan, Simon or one of the team.