Over the past few years, responsible investing – summed up by the acronym ESG, referring to a focus on environmental, social and governance factors – has taken the world by storm. Of these three factors, the last has been around the longest and is the least likely to set pulses racing. That may help explain why some so-called ESG ratings have wildly missed the mark, and some ESG investing has gone awry. Maybe old and boring isn’t so bad after all.
As noted by James Grant, a financial writer and founder of Grant’s Interest Rate Observer who’s been around for long enough to know, “Progress is cumulative in science and engineering, but cyclical in finance.” As night follows day, so speculative boom follows collapse in uninterrupted rhythm as successive generations experience collective amnesia. Things like due diligence, robust governance and sound regulation are seen as obsolete barriers to progress.
We can see this dynamic playing out forcefully in the crypto world. Following the invasion of Ukraine, the CEO of Binance, the world’s biggest cryptocurrency exchange, Changpeng Zhao was asked on Radio 4’s Today programme whether it had any Russian customers. He replied “I don’t know”. The recent sudden collapse of another giant cryptocurrency exchange, FTX, raises even more profound questions. FTX’s shoddy governance (a generous description in this case) managed to escape the notice of those who should have been paying much closer attention until the business was forced to file for bankruptcy protection after acknowledging it didn’t have sufficient reserves to meet withdrawal demands from customers scrambling to get their money out of its FTT tokens. Most of the crypto exchanges, including Binance and FTX aren’t publicly traded companies. But FTX did attract the interest of several big and powerful venture capital and investment firms. Some accept that their investments in FTX are now worthless.
Many investors prioritising ESG have long had concerns about crypto’s environmental impact because the methods of facilitating crypto transactions and creating new crypto coins (a process known as ‘mining’) are hugely energy-intensive. FTX sought to address such concerns by announcing several lofty environmental goals. These included a commitment that its business would quickly become carbon neutral as well as pledges to fund research into ways to solve the climate crisis. But these didn’t count for much given the huge flaws in its corporate culture – checks, balances and transparency were all glaringly absent.
Consider the judgement of John Ray III, appointed as CEO for FTX in its bankruptcy – a man whose CV includes similar roles in some of the biggest bankruptcies in modern times: “Never before in my career have I seen such a complete failure of corporate controls.” Yet according to the Wall Street Journal, despite having only three corporate directors – founder Sam Bankman-Fried, another FTX executive and an outside attorney – ESG ratings company Truvalue Labs gave FTX a higher score on “leadership and governance” than Exxon Mobil.
FTX’s appetite for the tech-era mantra “move fast and break things”, first coined by Facebook founder Mark Zuckerberg, clearly went way beyond what may originally have been intended. Its implosion serves as a very salutary reminder of how disastrous it can be to turn a blind eye to bad G, no matter how good the E and S may seem (which in hindsight also appear to have been heavily overegged at FTX).
Encouraging good behaviour
The role of good governance in capitalism is vital: it’s the foundation on which responsible investment thrives or fails. It may not be a page turner, but the fifth edition of Corporate Governance by Monks and Minow (the authoritative text book on the key concepts of governance and the minutiae of prevailing regulation) is foundational to our analytical framework. Our stewardship analysts can’t do their painstaking work scrutinising corporate governance without it.
Good governance solves a crucial issue – what social scientists would call an agency problem: how do you get someone to act in your best interests when they control an asset that you own? After all, that’s what investment entails – putting your capital into the hands of a company management, over whom you have influence but no control, and whose interests may differ from yours.
Imagine I give you a crisp £20 note, ask you to buy us lunch and say you can keep the change. What’s stopping you from getting the cheapest deal possible from the discount aisle and pocketing the difference? Our interests aren’t aligned. To get them aligned, we must forge a mutually beneficial relationship that involves clear accountability. The process of aligning our interests can be both costly and time consuming, but it’s vital.
Of course, good governance is not a magic bullet – a vaccine against corporate failure in ESG matters. A myriad of factors can combine to produce a serious controversy. But this much is clear: it didn’t matter how ambitious FTX’s plans for carbon neutrality were, because its corporate culture was deeply flawed and its controls were almost non-existent.
That’s why it’s so important to investigate governance and culture as well as social and environmental policies. And also why we believe that third-party ratings should be only a starting point. It may be old and worn and will never make the best-seller list, but our copy of Monks and Minow has proved its worth many, many times over.
Andrew Pitt is head of charities at Rathbones
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