FTX collapse shows importance of good governance

It might be the boring or forgotten part of ESG but governance is the foundation on which responsible investment thrives or fails

Whatever you think about the alleged “backlash” against ESG that characterised 2022, there’s no denying the speed at which ESG as a concept has inserted itself into the mainstream of the investment world. Of these three factors, the last, governance, has been around the longest and is the least apt to set your pulse racing. But maybe boring isn’t so bad after all.

As noted by James Grant, a financial writer and founder of Grant’s Interest Rate Observer, “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 either quaint and obsolete, in the more charitable view of their detractors, or an obstacle to progress to be run over roughshod.  

We can see this being played in the crypto world. ESG investors have always had a lot of questions about cryptocurrencies and their aggregated environmental impact, but the concerns go far deeper. Following the invasion of Ukraine, Binance CEO Changpeng Zhao was asked on Radio 4’s Today programme whether the cryptocurrency exchange had any Russian customers, to which he replied, “I don’t know”.

The sudden collapse of FTX, the once-leading cryptocurrency exchange, is another recent example of poor governance (a generous description in this case) to escape the notice of those who should have been paying much closer attention.

Consider the words 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.”  

And 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 a notorious ESG laggard.

The application of the tech-era mantra of “move fast and break things”, first coined by Facebook founder Mark Zuckerberg, clearly went way beyond what was originally intended. Will investors now see more clearly how disastrous it can be to turn a blind eye to bad G, no matter how good the E and S?

An unlikely candidate

In the rush to adopt ESG and integrate it into the investment process, the ‘G’ has been relegated from its formerly leading position in stewardship dialogue. Environmental and social issues grab wider headlines – but at its heart, 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 are controlling an asset you own?

That’s what investment is – putting your capital in the hands of company management, over whom you have influence but no control, and whose interests may differ from yours. But how do you ensure the people looking after your property have interests aligned with yours?

The role of good governance in capitalism is vital: it’s the foundation on which responsible investment thrives or fails. An unlikely candidate plays an important role in our analytical framework and training for analysts, the fifth edition of Corporate Governance by Monks and Minow. This 498-page epic covers everything from lofty topics like why companies exist to the minutiae of corporate governance expectations in Azerbaijan.

Listen to ESG Clarity US’s podcast interview with Nell Minnow here.

Encouraging good behaviour

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 make them align, we must have an ongoing relationship and there needs to be accountability. In other words, aligning our interests is costly and time consuming, but necessary.

This is not to say that good governance is a vaccine against ESG failure. But it didn’t matter how ambitious FTX’s plans for carbon neutrality were, because the corporate culture was deeply flawed and controls were almost non-existent.

Before the Christmas holidays many people have their cars serviced before long journeys to visit family. The goal might be lofty – visiting family or reaching net zero – but that doesn’t matter if your brake pads are worn and there’s no oil in the engine. It’s the boring stuff that will see you reach your goals. Even the best thought through corporate ESG policy means little if directors aren’t incentivised to deliver it.

That’s why the ESG industry should take greater care to investigate governance and culture as well as social and environmental policies.

It may be old and worn, and it will never make the best-seller list, but our copy of Monks and Minnow has proved its worth many, many times over.