No man is an Iland, intire of itselfe; every man
is a peece of the Continent, a part of the maine;
if a Clod bee washed away by the Sea, Europe
is the lesse, as well as if a Promontorie were, as
well as if a Manor of thy friends or of thine
owne were; any mans death diminishes me,
because I am involved in Mankinde;
And therefore never send to know for whom
the bell tolls; It tolls for thee.
John Donne, “No Man is an Island”, written in 1624
Companies do not exist in isolation: they use resources from the commons, employ labour and attract customers from towns and cities, and are required to operate under the laws of the land. They influence the lives of far more people than shareholders alone, but unfortunately plenty of businesses act to the detriment of many – including, in the long run, themselves and their investors. To help ensure that companies exert a positive impact on the world, including the bottom line, we believe that investors need to do more than assess environmental, social and governance (ESG) risks. They must engage.
To understand the need for engagement and the imperative for businesses to act responsibly, some historical context is useful. For most of the 20th century in the West, governments oversaw national economies. In the US, Theodore Roosevelt reined in the robber barons before his distant cousin Franklin occupied the commanding heights of the nation and mobilised resources to counter the Great Depression and then to fight World War Two.
But this economic playbook had a weak chapter on the globalisation of finance. In the 1970s, the burgeoning Eurodollar market enabled US banks to trade instruments without answering to the rules of their home market, and the Nixon Shock initiated the current era of fiat money and floating exchange rates. Add high inflation and industrial strikes, and it became apparent that the model was outdated. Thus in the latter half of 1970s, with the growth of the post-war decades petering out, people sought an answer to the uncertainty.
In response, Margaret Thatcher and Ronald Reagan captured the zeitgeist, and Western economic orthodoxy consequently took a dramatic turn. Their conservative message invoked Adam Smith’s invisible hand to push aside policies of income redistribution and promised upward mobility through hard work in a market economy. The Civil Rights Movement and rise of counterculture throughout the 1960s and into the early 1970s, epitomised by anti-Vietnam War protests and social and psychoactive experimentation, took a back seat. Spurred on by low interest rates and the rhetoric of a dynamic, deregulated economy in which the market would allocate capital more efficiently than the government ever could, more people pursued wealth.
While Thatcher and Reagan were the political advocates of this change, its ideological proponents were two radical thinkers, economist Milton Friedman and philosopher Ayn Rand, who respectively championed a government retreat from business affairs and prized the individual pursuit of satisfaction above all else. Given the expense of regulation, the new light-touch politics coming into play was a relief for businesses. But Friedman was just getting started.
The social responsibility of business
In 1970, the New York Times Magazine published Milton Friedman’s essay, “The Social Responsibility of Business is to Increase its Profits”. In it, the Nobel Prize-winning economist challenged a major US car manufacturer to neglect its “social responsibilities” – which were, specifically, to build safer and more fuel-efficient cars – and focus on maximising returns to shareholders by continuing to produce unreliable gas-guzzlers. He effectively said: ignore the environment, ignore safety and just go and make money.
Instead of becoming more profitable, as Friedman expected, the auto company alienated baby-boomers seeking safer and more environmentally friendly vehicles. This growing part of the market turned to Japanese car makers – companies which understood that protecting the lives of road users and environmental preservation are ultimately connected to the bottom line.
Japanese companies have not been the only ones to dismiss Friedman’s definition of responsibility as bunk. Closer to home, the former CEO and Chairman of an international US conglomerate called it “the dumbest idea in the world”. The founder and CEO of a large Chinese e-commerce business says that “customers are number one, employees are number two and shareholders are number three”. And the CEO of a leading US technology firm says the company’s ultimate aim is “to leave the world a better place than we found it”. Even Paul Tudor Jones, the Connecticut-based hedge fund manager, believes that Friedman’s logic is flawed. “Shareholders have benefited at the expense of labour and that has had a huge social impact on this country,” he says, speaking of the growing wealth disparity in the US.
If these leading capitalists understand that businesses should have a higher aim than to turn a profit – and if they are big enough, improve the world at large – isn’t a redefinition of the social responsibility of business long overdue?
Objectivism: losing hearts and minds
US President Donald Trump is not known for being a great reader, which may help explain why he considers Ayn Rand to be his favourite writer. Rand’s philosophy has significantly influenced American society in recent decades by shaping the thoughts of prominent Conservatives, Freedom Caucusers and assorted Libertarians. In a 1991 opinion poll by the United States Library of Congress, her major work – Atlas Shrugged, the 1957 fiction novel depicting a dystopian US in which private businesses struggle under burdensome laws and regulations – was cited as the most influential book after the Bible. It should not come as a surprise that Trump has prestigious company: Reagan, ex-Federal Reserve Chairman Alan Greenspan, and Senator Paul Ryan are among many other Republican politicians who have shown public admiration for Rand’s arguments1.
Her philosophy, at its core, is simple: we should be selfish in order to pursue our own happiness. Called Objectivism, it argues that personal contentment is the moral purpose of life, productive achievement is the noblest activity and that an individual’s sense of reason is the only absolute2. There is no place for social mores, altruism, empathy or compassion: by caring for others, we neglect our own happiness and become "sacrificial animals". We should be driven by the primary virtue of selfishness, because nothing is more important than our own happiness3.
Sadly, Rand practiced what she preached. She was described by those close to her as haughty, narcissistic, devoid of empathy and, ironically, unhappy. These relationships were defined by animosity and vindictiveness. She despised the vast majority of human beings, calling them “mediocre, stupid, and irrational”, and saw personal gain as the primary motivation for any relationship. So she argues in The Virtue of Selfishness:
“The principle of trade is the only rational ethical principle for all human relationships […] Love, friendship, respect and admiration are the payment given in exchange for the personal, selfish pleasure which one man derives from the virtues of another man's character.”4
Objectivism laid the foundation for the doctrine, not widely adopted today, that governments should not ask people to take an interest in the welfare of the poor, sick and elderly – let alone use taxpayer money to support them. Sure, people can help the needy if it creates personal satisfaction, but they should know that charitable giving or wealth redistribution is purely optional rather than a social duty.
It follows that Objectivism has been key in justifying the individualism (and narcissism) that has spread in the US since the Reagan Era. European philosophers, and the majority of their US peers, have largely dismissed Rand as, at best, a minor philosopher and an individual who lacked empathy. Yet it would be a mistake to underestimate the influence she continues to exert on many sectors of life, politics and business in the US – and by extension, the West. Like a physician fighting a virus that has unexpectedly transformed into a disease, society needs to find a cure. Investors can play a role in this.
As investors, how can we play a part?
To confront the crises of our time – inequality, conflict and the exploitation of people and the environment, among many other injustices – we need to be considerate of others and not act purely for personal gain. In a previous issue of Gemologist, we argued that the act of investing for a financial return cannot – and should not – be separated from the environmental and social impacts of allocating capital to a company or asset5. Indeed, financial gain and sustainability are connected: there is a wealth of evidence demonstrating that long-term investment in companies with positive ESG practices results in stronger performance6. So in our view the rationale for being unselfish in an investment sense is logical: stronger holistic returns benefit the investor and the innocent bystander, too.
Figure 1. EM v DM: Rule of law
We all know that sustainability, as a global movement, is gaining momentum. In September 2015, 193 countries adopted a set of United Nations-sponsored goals to end poverty, protect the planet, and ensure prosperity for all. For these objectives, the UN Sustainable Development Goals (SDGs), to be achieved, governments, citizens, companies and their investors need to act.
Figure 2. EM v DM: Regulatory quality
Emerging market (EM) companies are typically perceived as laggards in sustainable practices, with corporate interest in ESG considerations generally lower than in developed markets (DMs). This is true at the institutional as well as the corporate level; the World Bank views emerging market corporate governance as substantially weaker than that of the developed world (see figures 1-3).
Figure 3. EM v DM: Controlling corruption
Source: World Bank as at 22 September 2017.
The stronger governance among DM companies may simply be due to the fact that information about their ESG characteristics is more easily accessible than in EMs, where coverage is patchy. Indeed, we know first-hand of many positive ESG stories among EM companies that much of the investment world underestimates or is not aware of (though also some that are not so positive).
As an investment team, we analyse ESG risk as part of our fundamental research of companies, but we do not stop there. We leverage the expertise of the engagement specialists within Hermes EOS, which is one of the largest corporate stewardship teams in the world and has $403.5bn in assets under advice7. The team engages with companies – including holdings in our portfolio – that have both the willingness and potential to improve their ESG policies and practices. Our investment in a large Chinese dairy company, which has doubled in value since the company dramatically improved its food-safety checks and processes, is proof of the benefit of engagement. The academic evidence is also supportive, with a joint study between London Business School, Boston University and Temple University finding that engagements typically lead to a 1.8% additional return in the subsequent year, with successful engagements generating 4.4% more in cumulative returns8 (see figure 4).
Figure 4. Corporate engagement: evidence of its effectiveness
Source: “Active ownership” by Dimson, E., Karakas, O., and Li, X. Published in 2013 by London Business School, Boston College and Temple University.
Engagement case studies
Engagement is a feature of our investment strategy: Hermes EOS, Hermes’ engagement arm, often in tandem with the emerging markets investment team, is in continual dialogue with targeted companies in our portfolio on strategic and ESG considerations. Here we discuss several recent engagements and our role in contributing to the first-ever stewardship code in a major EM:
Mexican banking: Seeking above-board governance
Hermes opposed the re-election of the Chairman of a Mexican bank we hold at its 2016 AGM. Our reason was the potential conflict of interest arising from his family’s major shareholding in a competing bank run by one of his close relatives.
Afterwards, the bank failed to convince us (among other shareholders) that the safeguards it had put in place were adequate to mitigate the risk of it acquiring the competitor at a valuation that would harm the interests of minority shareholders. The only evidence that the management team produced was a copy of the company’s code of conduct, signed by the Chairman. We made it clear that this was insufficient and started engaging to obtain a clear, formal and robust policy to manage this potential conflict of interest.
The Chairman was nevertheless re-elected in 2016, but perhaps felt the embarrassment of receiving 75% of votes in favour compared to the approval given to other board nominees, who garnered more than 95%. The bank did take the concern felt by us and other investors on board, however, and subsequently took action to mitigate this governance risk.
Figure 5. Mexican bank holding: Stock price, January 2016 – September 2017
Source: Bloomberg as at 30 September 2017.
The company embedded a risk control designed to prevent acquisitions of large assets that were seen by shareholders to be against their interests. Indeed, the lender called an extraordinary general meeting of shareholders to propose that any acquisition amounting to more than 5% of its assets be referred to a shareholder meeting. Thus, any acquisition worth more than $3.5bn would need to be referred to a shareholder meeting. The previous level of 20% meant that acquisitions of $14bn could proceed without recourse to shareholders.
Until a large slide in the share price of the acquisition target in October 2017, the new level put any purchase of the bank without shareholder consent out of reach, thus preventing the Chairman from selling his stake in the target to the one he oversaw. Although we did not suggest this specific solution, we judged it to be an effective risk control that was aligned with the aim of our engagement, and voted in favour of it.
In a call with the bank’s head of investor relations in April 2017, we expressed our support for the corporate governance improvements described above, and we were further encouraged by the restructuring of the board nomination committee, which is now majority independent. We voted in favour of the re-election of the Chairman at the April 2017 AGM.
In October, the bank announced that it would acquire the target for a sum that was substantially than the $3.5bn threshold requiring a shareholder meeting on the purchase. Nevertheless, the deal is subject to shareholder and regulatory approval.
Russian banking: Throwing light on black money and environmental risk
Given the frequency of bribery, corruption and money laundering in Russia, we made sure we addressed these risks in detail during our engagement with one of the country’s major lenders, which began in 2016. The bank recently published a comprehensive anti-corruption policy, and we have seen the steps it is taking to deliver on this while identifying room for improvement.
In our discussions, the lender described the preventative measures being taken: investment in systems to monitor and intercept suspicious transactions; extensive anti-corruption training for all employees; embedding performance indicators linked to conduct; and promoting a whistle-blower hotline.
The bank has carried out money-laundering checks for some time, but lacked a centralised approach, which we have encouraged it to implement in order to limit human error and ensure consistency across all branches. The company implemented this suggestion, creating a new central compliance centre based in St Petersburg, operating on a unified IT system focused on detecting suspicious transactions. This replaced a number of legacy systems, which as a group lacked cohesion, but there is still plenty of work to be done.
To us, it seemed that the company’s internally run whistle-blower line could be improved – a view reinforced by the fact that it had not received many calls thus far. Our work with other businesses has shown that for these channels to be most effective, they should be operated by a specialist third party. The bank recognised the limitations of the internal model and promised to consider outsourcing the function when it next comes under review.
Figure 6. Russian bank holding: Stock price, January 2016 – September 2017
Source: Bloomberg as at 30 September 2017.
The credit underwriting process was another key area of our engagement. The bank had not committed to the Equator Principles – a framework enabling financial institutions to manage environmental and social risks – nor did it have a clear policy to mitigate the impacts of the projects that it financed, including coal mines and oil fields. Since the bank funds many domestic mining and drilling projects, which can have high environmental and social impact, this was a concern.
We met with the institution’s Senior Independent Director, who confirmed that although the bank’s loan officers are instructed to consider the environment when assessing a business-loan application, there is no company-wide policy, set of detailed guidelines or reporting methodology for modelling environmental and social risk that they could follow. Given that inconsistent ESG risk assessments in underwriting could not only lead to controversies but also result in regulatory fines and damage the bank’s reputation, this has become an area of emphasis for the engagement.
Progress is being made. We have not yet seen a draft policy but are encouraged by some positive developments, such as:
The engagement continues. Our overall view is that the bank’s steps to prevent money laundering and, in time, reduce environmental and social risk in the projects that it finances, are taking the bank in the right direction.
Chinese e-commerce: Vetting vendors, fighting fakes
We are enthusiastic about the growth potential of one of our Chinese technology holdings, and are impressed by its new ventures and outstanding ability to capture and process data9. However the scale and complexity of its business means that it must work hard to remain vigilant of ESG risks, which has been a focus of our engagement with the company.
Last June, we informed the company’s Senior Vice President that a non-government organisation (NGO) had reported on the death of a 14-year-old labourer at a vendor on one of the business’s platforms. The NGO stated that the vendor had been an approved supplier for the e-commerce business since 2012, and accused our holding of paying little attention to the human rights of factory workers and for not applying workplace health and safety standards, focusing instead on product quality.
We encouraged the e-commerce business to respond openly. Within a week it investigated the matter, issued a public response condemning child labour and worker abuse in general. It committed to collaborate further with stakeholders – including international auditing bodies and Chinese government and law enforcement authorities – to combat the problem.
In addition to workers’ wellbeing, the company also has a responsibility to protect consumers. For a number of years consumers (and the market) have been concerned about its quality control and stewardship of customers’ purchasing rights, as some Chinese buyers have been wrong-footed by merchants of counterfeit products operating on its platforms.
The company’s problems are not unique: about 23% of consumers across the globe have unknowingly bought a counterfeit product online10. We initiated our engagement programme in Q4 2014, with the aim of helping the company to protect not only consumers but also its brand and future cash flows.
The company’s monitoring of vendors has steadily improved as it seeks to further protect customers and strengthen its business. In doing so, it recognises that proactively working with brands to promote and assess the integrity of vendors is a vital step, and in the past year has taken significant strides towards protecting both customers and the intellectual property of brands. This is definitely in the company’s interests, given that 75% of the world's most valuable consumer brands – spanning technology, entertainment and household-goods businesses – are now available on the company's platforms.11
Using an online ‘takedown tool’, it now helps to defend brands by monitoring its sales platforms for counterfeit products by initially screening merchandise and then carrying out test purchases to check if the products marketed to the public are authentic. The programme is both efficient and effective: from June 2016 to the end of August 2017, 97% of all takedown requests made during business days were handled within 24 hours, of which 83% resulted in takedowns. And this response rate is complemented by the company's efforts to shut down counterfeiters before they reach customers' screens. From September 2016 to August 2017, the company removed 28-times more listings proactively than in response to requests from rights holders. And almost all of those takedowns – 98% – were removed before a single sale.
The business is also collaborating with other companies to fight fakes. After suing two merchants for selling false designer watches on its platforms, it launched an anti-counterfeiting alliance with international brands across the technology, fashion, jewellery and food industries. The initiative aims to stop the production and sales of bogus goods by enabling members to formally share data and analysis to curb the production and sales of counterfeit products. We have encouraged the company to invite more brands to join.
Figure 7. Chinese e-commerce holding: Stock price, September 2014 – September 2017
Source: Bloomberg as at 30 September 2017.
In our engagement, we discussed its efforts to combat counterfeiters. We learned that the business now has an unconditional, seven-day refund policy and a dedicated fund to reimburse customers who have been burned by fakes; and guilty merchants are subject to a penalty-point system that can ultimately see them blacklisted from the company’s platforms. In the course of our engagement, we discussed technology that can identify counterfeit goods that, having been spotted on one retailer’s portal, are relisted by another.
The company’s big-data analytics capability, based at its headquarters, is also being used to catch counterfeiters. The company can trace funds through its global payment network which helps to pinpoint illegal business activities. The company has helped authorities in China and overseas stop cross-border criminal operations, with 1,009 arrests being made from the 1,573 leads it has provided to the police. It has also established a scheme to educate small businesses about developing their own brands and businesses. Further measures to prevent luxury-item rip-offs entering the market have been introduced: sellers are required to show proof that their goods are authentic, such as an invoice or letter of authorisation from the brand.
In our engagement, we discussed the alleged attempted hacking of 20m customer accounts on the company’s online marketplace, as reported in the media12. Data security is a global issue, and we sought insight into the robustness of the company’s security systems. We were reassured that company’s data analysts have developed a methodology for spotting the accounts of potential hackers and freezing them. Aware that strong cyber security is critical to the company’s success, we encourage the company to keep striving to improve its protection of consumers.
Another dimension of our engagement is the company’s corporate governance, and shareholder democracy in particular. We have asked the company to discuss, with shareholders, how the current governance structure can be improved and what potential changes could be made in the future to meet investors' expectations of best-practice governance.
Engaging on public policy: Stewardship in Brazil
Many ESG concerns are not company specific thus need to be addressed through engagement with policymakers and industry bodies. This is particularly true in EMs, where corporate disclosure, pollution, workers’ safety and other standards are often behind those in the West. Our role as active owners is to help close this gap.
Hermes is a key player in ESG-focused public-policy initiatives worldwide, and a member of various stakeholder and investor groups aiming to improve corporate standards at domestic and international levels. Hermes has played a fundamental role in developing policies supporting responsible investment, such as the UN Principles for Responsible Development and stewardship codes in the UK, Japan, Malaysia and, most recently Brazil.
In 2016 the Brazilian Stewardship Code was created by a working group of members of the Association of Capital Market Investors (AMEC), of which Hermes was the only non-Brazilian member. The process included the benchmarking of stewardship codes, interviews with the International Corporate Governance Network (ICGN), the Financial Reporting Council, local and international asset managers and owners, as well as a public consultation. We expect that the new code will be instrumental in developing a stewardship culture in Brazil, especially as a number of major local asset managers attended the launch. The aim is to help investors better accomplish their fiduciary duty by undertaking to:
Zupta: State capture in South Africa
Can excess of greed hurt society as a whole, or, as Gordon Gecko proclaimed, is greed “good”? The Zupta scandal in South Africa provides a salutary lesson.
As investors in South African companies, we have been closely monitoring developments surrounding the Gupta family, which is accused of exploiting its friendship with President Jacob Zuma to win state business contracts and manipulate political appointments. The allegations, which Zuma and the Guptas deny, are at the epicentre of the saga known locally as ‘state capture’. It is the biggest political scandal to hit South Africa since apartheid.
The accusations of state capture levelled at the Guptas are encapsulated in two recent high-profile cases: the role of a UK public relations firm in inflaming racial tensions purely to divert media and public attention from their role in the Zuma government and the failure of the South Africa division of a professional services audit firm to accurately audit the Guptas’ business activities during a 15-year relationship.
From January 2016 to April 2017, the UK public relations firm was paid £100,000 each month, plus costs, to distract attention from the deepening scandal with a public-relations campaign focused on white economic superiority in South Africa.
According to the thousands of emails disclosed as part of the Guptaleaks revelations, Duduzane Zuma, the President’s son and a business contact of the Guptas, said the theme of the campaign should be “economic emancipation or whatever” 13. Hired by Oakbay Investments, the Guptas’ investment holding company, Bell Pottinger targeted wealthy white South African individuals and corporations while undermining or misleading journalists who were sceptical of the campaign. As it gathered steam, President Zuma claimed that the interests inherent in “white monopoly capital” rather than his alleged misconduct were driving calls for his resignation, and he promised to dismantle white ownership of land and business. The incendiary slogan – a distortion of the economic concept of monopoly capital rather than a statement of fact – inflamed racial tensions, jeopardising the lives of many South Africans.
At the outset, Duduzane Zuma asked the UK firm to create a “narrative that grabs the attention of the grassroots population, who must identify with it, connect with it and feel united by it”. Yet the campaign caused social strife and sent Bell Pottinger into administration. And for what cause? To chase profit by protecting the Zuptas.
Auditor capers in South Africa
The auditor of Gupta-linked businesses for 15 years until March 2016, ended the relationship as the state capture scandal intensified.
Like the UK public relations firm, the company’s audit division sought to undermine critics of Zuma and the Guptas. In 2015, it wrote a report for the South African Revenue Service (SARS) falsely accusing the then Finance Minister, Pravin Gordhan, of establishing a spying unit to investigate political leaders and taxpayers when he headed the unit in 2007. Gordhan had accused state-owned companies of being corrupt and was ultimately fired by Zuma this year, despite having been found not guilty.
he website Guptaleaks reveals some significant oversights by the company. It shows that the company’s office did not raise the alarm when one of the Gupta’s businesses booked $2.2m spent on attending a wedding as a business expense. Four of the company’s partners attended the party, which one of the executives described as the “event of a millennium”. In response, the company has denied that it “was involved in, or condoned, any alleged money laundering activities” connected to Gupta-owned companies, or that it facilitated tax evasion.
The company has admitted, however, that its work “fell well short of the quality expected”, and in September eight of the company’s executives – including Partner and Head of Audit– were dismissed. The company stated that there were “certain red flags that came to their attention regarding the integrity and ethics of the Guptas that were not appropriately considered and addressed at that time. Had one or more of those red flags been heeded, the company would have stopped working for the Guptas earlier.”
The company has since retracted the SARS report that implicated Gordhan, saying that the outcome was not the “intended interpretation” of the report, and said that it would pay the $3m earned from auditing Gupta-owned companies since 2002 to anti-corruption charities. It also has committed to repaying the $1.7m earned from producing it.
Fallout and next steps for investors
The world no longer needs to worry about the UK public relations firm and the company’s unit has admitted fault – but the story is far from over. Advocacy groups have urged clients of the company to end contracts with the firm, and other companies have already culled contracts.
Although the company is a private company, but many of its clients are not. This means investors can indirectly exert pressure for positive change. Through existing engagements, we have discussed the implications of the scandal with the boards of 20 companies that use the firm as an auditor and understand that the boards of many companies are assessing whether it is a suitable services provider.
In a scandal-hit country with a leader who has 783 counts of graft, fraud and money laundering against him, everybody – particularly investors – has a role in fighting the extreme selfishness manifesting as excessive greed and corruption at the very top of the establishment.
Getting engaged: It takes commitment
Advocating for the protection of minority shareholder rights, promoting the importance of ESG risks in extractive-industry projects, helping to prevent money laundering and advising on best-practice whistle-blowing procedures, encouraging stronger consumer protection, helping to develop a stewardship code in a major EM and scrutinising the shameful and avoidable errors by a country division of a global auditing firm: these case studies provide an insight into the intensive work involved in engaging companies and policymakers.
They also clearly demonstrate the rewards. By improving their business practices and governance, these engagements are likely to make Russian banking, Chinese e-commerce and Mexican banking stronger long-term investments, and conversations with the auditor are likely to increase oversight at the national level. This performance should and can be generated not by exploiting the environment, workers or customers, but by seeking a sustainable and mutually beneficial way of doing business.