Investors should worry if company directors don't understand conduct
In recent years, there seems to have been an almost constant stream of news, hearings, and testimony about company scandals relating to executive and directors' poor governance and conduct. A few prominent examples spring to mind - AMP, Westpac, and Rio Tinto, among others.
One of the most recent examples is the inquiry into conduct at Crown Resorts, by the NSW Independent Liquor and Gaming Authority (ILGA), following years of media reports.
The investigation is centred on whether Crown has facilitated money laundering "by organised criminal syndicates working through junket operators to infiltrate its casinos in Melbourne and Perth", and the actions of the Crown officials that have testified in the inquiry have highlighted further conduct gaps.
Crown Resorts director and ex-AFL boss Andrew Demetriou was pulled up by counsel for reading written notes when giving evidence on alleged money laundering. He admitted to reading a definition of conduct downloaded from the internet.
It's a given that a corporate director like Demetriou should understand what conduct is, but for the rest of us who may not be up to date, conduct is the ways in which organisations, management or employees behave at work.
By extension, conduct risk is the risk of inappropriate, unethical or unlawful behaviour, whether deliberate or inadvertent, caused by gaps in company practices, frameworks or education programs.
But does conduct and governance impact on shareholder returns beyond damage to reputation, and the risk of regulatory action, fines, and potential criminal liabilities in the cases mentioned earlier?
Clearly, the way a company is run and how it conducts itself does have bearing on its ability to generate long-term capital. It makes sense then that, increasingly, listed companies are obtaining value from their intangible assets, which include company and brand reputation, goodwill, intellectual property, rather than tangible assets.
There's also this concept called 'social license to operate', which has come to the forefront in the wake of Rio Tinto's disastrous actions in destroying a sacred site in Juukan Gorge.
Social license to operate means a company is doing its business with permission from communities, and it's increasingly being considered an intangible asset.
A 2018 report by Regnan estimated that book value of ASX-listed companies represents only around half of market value, with the other half representing intangible assets.
The value of intangible assets has grown as manufacturing and resource sectors decline, and companies that create value from brand, reputation and human capital experience increased growth.
Take the example of Juukan Gorge. Since the 46,000-year-old sacred site was destroyed in a blast in May, Rio Tinto chief executive Jean-Sebastien Jacques and two other senior executives have resigned. Investors have divested from Rio, driving share price down, which could lead to greater costs for the company in accessing capital in future.
There is a risk of future litigation. And other mining companies have come under scrutiny for their processes around blasting in culturally sensitive areas - BHP has announced changes to how it engages with the traditional owners of land, meaning they have had to invest in processes relating to social license to operate.
The good news is that companies that manage their conduct and culture well seem to have better financial performance. The Regnan report also analysed ASX200 companies against their scores on environmental, social and governance (ESG) actions in December 2007 and December 2016. It found that when companies better managed the risks that impact intangible value, they experienced better performance.
The report in fact found that companies that manage conduct culture well under Regnan's scoring system "significantly outperform" companies with low scores, while companies with low scores underperform the ASX2000 benchmark.
So how can you assess if companies are performing well or not? One option is to seek out super fund options or investment products that have ESG screens - most ESG options will include criteria on governance and performance, and will either talk directly to companies about their concerns on conduct and culture or will exclude poorly performing companies altogether from the portfolio.