FTX and Carillion – what went wrong and why governance matters

Environmental, Social and Governance (ESG) integration is gaining popularity as an investment analysis tool, but the E side of the equation tends to get the most attention. Although climate change and biodiversity represent huge risks for industries across the board, they’re impossible to mitigate without good corporate governance. Likewise with social issues.

Governance is the lynchpin in being a good corporate citizen. All businesses have a range of stakeholders, from employees and business partners to shareholders, customers, the local community, and financial lenders. Governance involves making decisions in a way that serves these groups equally.

It’s hard to truly put into words how fundamental corporate governance is for a business and ultimately investors. Perhaps the best way to see the benefits is to look at what can happen when governance fails.

The demise of FTX

The most recent example comes from the world of cryptocurrency. FTX was one of the world’s largest crypto exchanges, allowing customers to trade digital currencies.

At the beginning of November, leaked documents showed some shady links between the finances of FTX and a hedge fund run by the same man, Mr Bankman-Fried. What came after was nothing short of a run on the bank.

Withdrawals to the note of $6bn were placed by customers in the coming days, and it soon became apparent that FTX didn’t have enough liquidity to honour them.

Without delving too deep into the technical details of how this happened, this was essentially a case of customer funds being misused. A lack of proper governance allowed this practice to go on behind the scenes, until it was too late.

It’s now going through bankruptcy proceedings after seeing what the man in charge of sorting out the mess describes as “a complete failure of corporate control.”

The impact for users of the platform looks pretty dire. The wind-up process is ongoing, but it looks like hundreds of thousands of customers are in jeopardy.

The collapse of Carillion

FTX is an example of a private company clearly failing to have proper governance in place. But it’s not just private companies that can fall foul of poor governance. Public markets, which should have better regulation in place, have seen their fair share of scandals.

Perhaps the most famous UK example of recent years came in 2017/18. Carillion was the second largest construction company in the UK, before a roller-coaster of events led to a bankruptcy filing.

If we head back to the start of 2017, Carillion had just reported a strong set of results, declared its largest ever dividend and handed out generous bonuses to executives. Just four months later, profit warnings began and the downward spiral took hold.

So how does a booming business turn to dust over the course of a year or so?

It later transpired that Carillion was using a very aggressive form of accounting. Financial accounting typically relies on a host of estimates and it’s possible for businesses to manipulate estimates to portray a better picture than reality.

It’s unethical, in some cases illegal, and when these so called ‘aggressive accounting’ techniques stack up, fundamental issues can go under the radar until they boil over.

The UK government has pledged to introduce a new audit regulator, to help minimise the risk of Carillion-like events happening again. But ultimately, it’s almost impossible to completely remove the risk of aggressive accounting.

What can investors watch for?

Good governance looks different depending on a company’s size, location and industry. But there are several overarching things to keep an eye on.

Board composition is one quick and easy way to get a snapshot of how a company is run. Diverse views among board members are essential to making good business decisions. Company boards that are stacked with current and former executives can be a red flag. Instead, a mix of backgrounds from varying relevant industries is preferable because it lends itself to more effective decision making. The size of the board should also align with the size of the company.

A big part of governance is disclosure. Companies with transparent operations can be held accountable to their stakeholders. While there are legal requirements for listed companies’ financial disclosures, ESG-related disclosures are a little murkier. However, with lots of investors now considering ESG factors in their analysis, most companies have added some type of ESG disclosure to their results. Reporting on ESG issues is a good sign that the company’s willing to be transparent with its progress.

Executive compensation can be a sticky subject. However, the most important factor to consider is whether compensation is tied to the company’s core strategy. An oil and gas company might have pledged to ramp up renewable energy generation over the next ten years for example. However, if it pays its CEO based on share price movement alone, it suggests that the goal isn’t a key part of the strategy. Executive renumeration should be aligned with what’s important to the long-term future of the company and all stakeholders involved.

Share structure is another element of corporate governance that’s important to understand. Typically, investors hold shares which give them the power to cast a vote on things like executive compensation and board appointments. However, there are other setups that leave investors powerless over the company’s decision making. A share structure that gives the executives the lion’s share of voting power can be a red flag.

There’s no one-size-fits-all approach to governance. But evaluating whether the corporate structure is adequate is arguably the most important element of ESG investing.

Companies can have all the ESG credentials in the world, but a governance failure can completely sink the ship. Plus, good governance is needed to support the initiatives of the other two. If you want more information on how ESG integration can help in your investment analysis, visit our Responsible Investment hub.

This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice. All investments can rise as well as fall in value, so you could get back less than you invest.

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