Risks of weak corporate governance

In the current dynamic realm of corporate governance, the risks posed by weak governance are profound and multifaceted and can impact organizations in many ways.

One of the key risks of weak governance is financial mismanagement. Poor governance practices can have severe financial consequences, such as inaccurate financial reporting, mismanagement of funds, or insufficient internal controls over financial processes. These issues can result in financial losses, a decline in shareholder value, heightened scrutiny from investors and regulators, and—in the worst case—insolvency of a company.

Moreover, the lack of robust governance opens the door to an increased fraud risk. Without stringent controls and oversight mechanisms in place, individuals may exploit vulnerabilities within the organization, siphoning funds and damaging the company’s financial integrity.

Ultimately, failure of corporate governance—at least from a past perspective—was mainly associated with a company’s financial failure.

However, over the years, additional risks outside the financial mismanagement and asset misappropriation realm emerged, such as potential conflicts of interest. This can occur when board members or management executives have personal or financial interests that conflict with the company’s and its stakeholders’ interests. This leads to decisions that prioritize the interests of a few individuals over the interests of many—which is not only ethically questionable but also impacts an organization’s relationships with these internal and external stakeholders.

Furthermore, regulatory noncompliance emerges as a significant concern in the absence of effective governance. Failure to adhere to legal standards invites punitive measures and fines but also tarnishes the company’s reputation, impacting investor trust and market standing.

And lately, questionable emerging business practices—such as the alleged over-issuance of nature-based carbon credits by a leading global company—have demonstrated public concerns around “greenwashing” (deceptively claiming products or services to be environmentally friendly) are real. Even if critics claim that overly focusing on greenwashing concerns may discourage companies from making real progress in the area of sustainability, greenwashing needs to be taken seriously.^[1]

In the face of these financial or reputational risks, cultivating a culture of accountability and transparency becomes paramount. By implementing strong governance frameworks, companies can mitigate vulnerabilities and fortify their resilience in an increasingly complex business and regulatory environment. And this is where boards play a significant role.

Corporate governance as key to sustainable business

It is one of the board of directors’ key responsibilities as the governing body of a corporation to oversee risk management and compliance systems. In the context of ESG, boards play a vital role in addressing the question, “How do we, as a company, address relevant risks, capture pertinent opportunities, and handle compliance matters that arise from the environment and society, including from policymakers and regulators?” Furthermore, “What oversight framework enables communication and collaboration between the company’s board, management, and risk and compliance functions in a way that helps establish clear responsibilities, accountability, and transparency when it comes to monitoring and attaining responsible and sustainable business making?”

More than 50 years ago, the discussion around corporate governance focused mainly on mechanisms of direction and control. More recently, corporate governance has evolved at a fast pace to include additional dimensions such as decision-making capacities, responsibilities, and organizational structures, as well as fairness and transparency in working and communicating with shareholders and other stakeholders. ESG has become one of the guiding principles for good corporate governance.^[2]

Oversight guidelines on corporate sustainability-related matters have recently been incorporated in the Principles of Corporate Governance issued by the G20 and the Organisation for Economic Co-operation and Development (OECD).^[3] Given the pivotal role corporations play in the transition to a low-carbon economy, in human rights and community relations, diversity and inclusion, and in managing their supply chain; in other sustainability matters, the OECD’s new set of principles provides recommendations on corporate disclosures; the dialogue between the company, its shareholders, and other stakeholders; and the board’s role in addressing ESG.^[4] This is also in response to certain regulatory developments, such as in the U.S.—with the Securities and Exchange Commission’s rule on climate-related disclosures—or the EU.

While certain countries like China only very recently announced guidelines to ESG reporting and sustainability-related disclosures for listed companies, the EU had implemented binding sustainability reporting rules for such companies already in 2014. Its 2022 Corporate Sustainability Reporting Directive (CSRD) extended the scope of initial regulations, now impacting a far broader range of businesses. The very first EU-based companies and undertakings subject to CSRD will have to report for their financial year 2024 according to European Sustainability Reporting Standards (ESRS).

The ESRS includes provisions not only on general, environmental, and social sustainability reporting requirements but also on governance. ESRS 2 General Disclosures include governance disclosures related to:^[5]

• Roles and responsibilities;

• Expert functions on which governing bodies rely in carrying out their oversight;

• Internal communication and monitoring activities;

• How ESG-related topics are considered in a company’s overall strategy;

• Sustainability-related performance measures in incentive schemes;

• The company’s due diligence; and

• Risk management for and internal controls over sustainability reporting, among others.

Additionally, the more specific ESRS governance standard G1 Business Conduct requires disclosures on corporate culture, management of supplier relationships, avoidance of corruption and anti-bribery, the protection of whistleblowers, and political lobbying.^[6]

Noncompliance with CSRD rules may not only impact a company itself—resulting in investigations, lawsuits, or fines—but can also have criminal consequences for directors of companies that fail to comply. For example, in France, noncompliance can result in fines of up to €75,000 and imprisonment of up to five years.^[7] Boards have their “skin in the game” and thus have a very personal interest in complying with the EU’s sustainability reporting standards if their companies are subject to it.

However, corporate governance that truly enables sustainability and enduring business success goes beyond “just complying with the rules” to avoid legal consequences and reputational damages that may arise from ESG issues.

Not surprisingly, corporate culture is the foundation of good governance. A company’s culture can offer competitive advantages and be a decisive element for organizational transformations.^[8] And a culture genuinely committed to sustainability can help a board play its crucial part in ESG oversight due to the significant leverage the cultural aspect has on a company’s sustainability agenda. However, boards are not in a position to directly influence a company’s culture, and besides appropriately selecting the executive management team, its measures are limited.^[9] Hence, boards having allies within the organization becomes critical to creating a culture committed to sustainability.

Beyond the cultural aspect, boards should consider further aspects of ESG governance. The practices of responsible business conduct defined in ESRS G1 discussed earlier—management of supplier relationships, avoidance of corruption and anti-bribery, and protection of whistleblowers—are vital.

But leading boards go further. They establish clear roles and responsibilities for sustainability-related matters within their body (e.g., through committee structures). Furthermore, they ensure a board composition with individuals with appropriate leadership backgrounds and skills who can offer a variety of perspectives in board and committee discussions. Ultimately, a board’s composition should be commensurate with the complexities of a company’s business.

Also, leading boards more specifically consider the following key aspects and questions to do the best practices of good sustainability compliance systems justice (some of these can be found in the ESRS 2 discussed above):

• Risk assessment: What potential nonfinancial risks may significantly impact a company’s sustainable business (e.g., new clients, new third-party suppliers, or new services)? What increased risks for fraudulent reporting exist (e.g., in greenhouse gas emissions accounting or relation to the impact from nature-based carbon capture measures), which may unjustifiably reduce a company’s cost of capital and/or result in an overstated market value of the company (e.g., due to greenwashed products)? And what risks may arise from a company’s business practices, setup, and organizational structure (e.g., entities in low-tax jurisdictions) that may cause reputational damage?

• Organizational rules and delegation authorities: Do organizational rules appropriately reflect nonfinancial matters, including appropriate delegation of authorities to management regarding such matters? Do these rules cover reporting requirements from management to the board, and do they allow for timely communication with the board on significant ESG matters?

• Management compensation and incentives: How do management remuneration systems balance the pressure for short-term results versus achieving long-term sustainability targets? Do compensation schemes include clawback clauses to incentivize compliance?

• Internal controls: How mature are systems and controls over nonfinancial performance measurement and reporting (e.g., manually compiled data in Excel versus automated enterprise resource planning solutions)? How do systems and controls support segregation of duties and help safeguard the authenticity, accuracy, and integrity of nonfinancial data? Also, have weaknesses, deficiencies, and control gaps related to nonfinancial data and reporting been identified, and how have they been addressed?

• Regulatory requirements: Does the company understand relevant changes in ESG-related rules and regulations? How are these identified, and does identification of changes happen in a timely manner? And what changes to procedures and policies, internal guidelines, processes, and controls are necessary to implement new rules and regulations?

• Communication and reporting: Do a company’s external communication and reporting accurately convey its culture, moral compass, and how to do business? Does it adequately describe a company’s approach to risk-taking and mitigation, and does it give the reader an appropriate picture of risk and compliance systems in place, as well as their effectiveness?

Given this variety of considerations and their interdependencies, monitoring the effectiveness of ESG-related compliance systems becomes pivotal. Questions like, “Do the measures in place achieve what they are intended to do (e.g., do compliance declarations make managers ‘stop, think, and ask’ if a company is acting in line with the standards set by the board)?” or “How many of the employees ‘at risk’ of manipulating nonfinancial data received adequate training?” need to be answered. It is here where compliance professionals can play an important role in supporting boards with sustainability-related governance aspects.

How you can support boards in good governance

Boards remain responsible for a company’s overall governance, including governance over ESG matters. However, boards need allies within the organization to shape a company’s culture and support them with overall ESG governance efforts.

Compliance professionals are best positioned to be the board’s ally and one of the key expert functions to support in carrying out oversight. They have deep expertise in regulatory matters and their application, as well as strong analytical and problem-solving skills and sense of culture and ethics.

So, what can they concretely do?

• Assessing a company’s culture: Professionals may feed boards the results of ethics surveys, findings from investigations in relation to cultural dilemmas faced by employees, and best practice examples seen in the field (e.g., what are people within the organization proud of). This will help boards understand how engrained the concept of sustainability is in an organization and the current cultural challenges, and it will provide input for directional feedback to management.

• Provide regulatory insights: Compliance experts may share their knowledge of ESG-related regulations and changes in an increasingly complex environment, helping boards stay compliant and up to date (e.g., through periodic regulatory update training sessions, such as on the EU Artificial Intelligence Act).

• Increase stakeholder engagement: Compliance can foster a dialogue with different stakeholders, enabling them to share their perspectives on ESG strategies and enhancing the organization’s reputation—ultimately increasing stakeholder engagement and strengthening the social dimension of ESG. This can be done by compliance sharing stories about addressing issues and how these were overcome.

• Manage risk: Compliance professionals help conduct thorough risk assessments and guide boards to effectively identify and manage ESG-related risks. This includes collecting inputs from relevant internal and external stakeholders (e.g., third-party vendors and service providers), and reviewing ESG-related matters raised through a company’s whistleblowing reporting lines. Moreover, financial and nonfinancial key performance indicators need to be considered in assessing risk—specifically, with a focus on ESG-related metrics, which are subject to increased evolution these days.

• Monitoring and reporting: Compliance professionals can also help track ESG performance and, with the accumulated knowledge, facilitate transparent reporting for informed decision-making. The compliance function may also provide valuable input when it comes to a company’s annual reporting (e.g., when assessing the clarity of tax transparency reporting for local jurisdictions and communities).

• Compliance system effectiveness measures: Lastly, compliance teams need to discuss goals with boards or the respective committees to determine an effective compliance function and how its impact can be measured. Is an effective compliance function one where detailed policies are followed to the letter or where decisions are made based on guiding principles by responsible business leaders? The latter will likely be more reasonable while also being more challenging to measure.

Ideally, compliance specialists have direct access to the board or the relevant committee (e.g., risk or audit committee) as they support these aspects of good corporate governance. This ensures open, transparent lines of communication and ultimately allows a company’s compliance function to unlock its full value on a company’s sustainability journey.

Conclusion

As society and politics continue to evolve in relation to ESG, it is becoming increasingly crucial for corporates to recognize and act on the critical role of the “G.” Corporate governance is foundational to responsible and sustainable business making. Hence, risks and opportunities associated with governance are expected to continue to grow in the future—with forward-looking boards and compliance functions acting in favor of good corporate governance.

Takeaways

• Environmental, social, and governance (ESG) matters have seen growing interest, even from shareholders. So far, the discussion has mostly centered around the environmental and social aspects.

• A weak governance structure exposes a company to a variety of risks, including financial mismanagement, conflicts of interest, regulatory noncompliance, and greenwashing, among others.

• The board of directors plays a pivotal role in risk and compliance oversight. The board is responsible for setting the direction for and overseeing sustainable business.

• Good ESG governance considers aspects beyond regulations, including a company’s culture, risk assessment, management incentive systems, internal controls, and communication and reporting.

• Boards need strong allies to support ESG oversight and compliance professionals are best positioned to help in areas relevant to good governance.