Integrating ESG into Corporate Governance

Introduction

While management is responsible for making day-to-day decisions for a company, the Board of Directors is responsible for overseeing the company as a whole and ensuring that the interests of the shareholders are protected. This crucial task can be accomplished through the use of board committees, a code of ethics, and corporate governance guidelines. In this article, we will explore how these tools work together to assist the Board in fulfilling its duties, as well as the Board's role in overseeing environmental, social, and governance (ESG) issues.

Committee Oversight

Board committees play a crucial role in overseeing important topics and risks within a company. However, since they manage critical aspects of the organization, it's essential to ensure that committees are ethical and accountable in carrying out their responsibilities. Although measuring ethics and accountability can be challenging, certain organizations such as Both the NASDAQ and the New York Stock Exchange (NYSE) strive to provide some level of assurance in this area.

The NASDAQ and the New York Stock Exchange (NYSE) both mandate that participating companies adhere to several governance standards. Since most public companies trade on these markets, these standards represent well-established and reasonable practices for disclosing governance in a business. For instance, in its "Preamble to the Corporate Governance Requirements," the NASDAQ outlines the following broad factors that must be included in governance disclosures:

Companies applying to list and listed on Nasdaq must meet the qualitative requirements outlined in this Rule 5600 Series. These requirements include rules relating to a Company's board of directors, including audit committees and Independent Director oversight of executive compensation and the director nomination process; code of conduct; shareholder meetings, including proxy solicitation and quorum; review of related party transactions; and shareholder approval, including voting rights.

The NASDAQ and NYSE's governance standards give special attention to three committees: the audit committee, the compensation committee, and the nominating/corporate governance committee.

All three committees are required to be composed of independent directors as per the governance standards of NASDAQ and NYSE. To gain a better understanding of independence in this context, you may refer to the Requirements for Public Company Boards or Regulation S-K.

Audit Committee

Considered the most critical committee, the audit committee is subject to specific requirements. It must comprise of at least three members, and as per 17 CFR § 240.10A-3, these members must be on the board of directors of the listed issuer and meet the independence criteria. To be considered independent, the member cannot:

(A) Accept directly or indirectly any consulting, advisory, or other compensatory fee from the issuer or any subsidiary thereof, provided that, unless the rules of the national securities exchange or national securities association provide otherwise, compensatory fees do not include the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the listed issuer (provided that such compensation is not contingent in any way on continued service); or

(B) Be an affiliated person of the issuer or any subsidiary thereof.

To comply with Section 407 of the Sarbanes-Oxley Act (SOX), at least one member of the audit committee must be considered a financial expert. Additionally, the SEC's Regulation S-K mandates the disclosure of whether the committee has a financial expert in annual reports. The term "financially literate" is defined as someone who possesses:

An understanding of generally accepted accounting principles and financial statements;
Experience applying such generally accepted accounting principles in connection with the accounting for estimates, accruals, and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant's financial statements;
Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements;
Experience with internal controls and procedures for financial reporting; and
An understanding of audit committee functions.

If a committee member serves on more than three audit committees simultaneously, the Board is required to evaluate the member's capacity to serve effectively on the committee and disclose its determination in either the annual proxy statement or the annual report on Form 10-K.

Under SOX Section 202, the audit committee is responsible for collaborating with an independent auditor, supervising the internal audit department, and approving all audit services. Additionally, the committee must have a written charter, which will be discussed in more detail later.

Compensation Committee

The compensation committee must be comprised of at least two independent members. The meaning of "independent" in this context is defined in Rule 5605(a)(2). If the committee intends to "receive advice from a compensation consultant, legal counsel, or other adviser," it must consider the following six factors:

the provision of other services to the Company by the person that employs the compensation consultant, legal counsel or other adviser;
the amount of fees received from the Company by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser;
the policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest;
any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee;
any stock of the Company owned by the compensation consultant, legal counsel or other adviser; and
any business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an Executive Officer of the Company.

These factors will help ensure that any outside advisers are independent of the company. The SEC’s Regulation S-K requires a disclosure in the annual proxy statement regarding the nature of conflicts of interest and how they are being addressed. The committee must also have a written charter.

Nominating or Corporate Governance Committee

There is no mandated number of members for the nominating or corporate governance committee. However, the nominations committee should consist of independent directors. If the committee has at least three members, it is permissible for one director to not meet the definition of independence as per Rule 5605(a)(2) and not currently be an executive officer or employee or a family member of one, if it is deemed to be in the company's and shareholders' best interests. Please refer to this website for information on disclosure requirements. Furthermore, it is important for the committee to have a written charter.

Other Committee

Apart from the three commonly established committees, the U.S. Spencer Stuart Board Index survey of S&P 500 companies in 2021 found that 13% of surveyed companies had a science and technology committee, 11% had an environment, health and safety committee, and 7% had a public policy, social, and corporate responsibility committee. However, the board may decide against forming a new committee for a given area and instead opt to add directors to an existing committee to address any expertise gaps. For instance, if the members of the board of a healthcare company feel a lack of necessary expertise in the healthcare industry, they may add a director with experience in that industry to the audit committee or compensation committee.

The Committee Charter

The aforementioned requirements ensure that committees are fulfilling their intended objectives. One of the best and most common means of ensuring accountability for committees, as mandated for each of the aforementioned committees, is through the committee charter.

A committee charter is a written document that outlines the responsibilities and purpose of a specific committee. Typically, the charter starts by defining the committee's scope and objectives, followed by a list of its duties and responsibilities. Most charters mandate an annual assessment of the committee's performance. The charter also commonly specifies member qualifications, appointment and removal procedures, committee structure and operations, and reporting to the board.

NASDAQ requires committee charters to be easily accessible on a company's website, with the webpage referenced in the proxy statement or the annual report on Form 10-K. Similarly, the SEC's Regulation S-K mandates comparable requirements with less stringent criteria. It is recommended that the charter is reviewed and evaluated for sufficiency every year.

Committee charters play a crucial role in promoting purposeful work and self-governance within committees by documenting the necessary conditions. To view examples of committee charters, please refer to JPMorgan Chase & Co.'s charter here and SandRidge Energy's charter here.

Code of Ethics

Implementing a code of ethics is another effective means of promoting strong governance. A code of ethics, also referred to as a code of conduct, comprises a set of values and principles that guide the behavior and decision-making of those responsible for governance in an organization. At present, the code of ethics applies specifically to the company's senior financial officers, such as the CEO, CFO, and others involved in financial reporting. In practice, many organizations have chosen to extend the code of ethics to cover management-level roles and even all employees.

Below is the SEC's five-point definition of a code of ethics from SOX 406. This definition is purposely broad to enable companies to report on ethical disclosures they deem necessary. A company must, at a minimum, report the five principles, and it is encouraged to include additional principles in its code of ethics. The SEC defines the code of ethics as written standards that are reasonably designed to deter wrongdoing and to promote:

Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships. This first principle is the foundation to a company’s code of ethics. A company’s code of ethics must promote honest and ethical conduct. If it does not, the company’s governance is not reliable. One way companies implement this guidance is by providing a process for informing an appropriate person of any material transaction or relationship that reasonably could be expected to give rise to a conflict of interest.
Full, fair, accurate, timely, and understandable disclosure in reports and documents that a registrant files with, or submits to, the Commission and in other public communications made by the registrant. A company should not put principles into its code of conduct if it is not actively following them. A company’s code of conduct should be free of grammatical errors and be written in a manner that individuals covered in the code understand their duties and responsibilities. This should also allow outside shareholders to easily identify the duties and responsibilities of covered individuals.
Compliance with applicable governmental laws, rules, and regulations. A company’s code of ethics must include principles regarding compliance with governmental laws. Applicable laws include but are not limited to privacy laws, trading laws, and independence laws. The code of ethics must encourage covered members to follow all relevant laws given the company’s industry and location.
The prompt internal reporting of violations of the code of ethics to an appropriate person or persons identified in the code of ethics. This does not mean a company must report to the public anytime a covered individual violates the code of ethics (although a company could report violations if it so chooses). The code should contain directions for individuals not only on how to properly report violations of the code but also to whom specific violations should be reported to. Some companies such as Tesla and Hormel Foods Corp. have a hotline where covered members can call to report violations of the code anonymously.
Accountability for adherence to the code of ethics. A company should report how it keeps individuals accountable. To enforce accountability, a company might state in its code of ethics that individuals covered within the code are subject to peer-evaluation tests; those who receive an insufficient score will receive reduced salary compensations.

A company's code of ethics must be publicly available either in its 10-K, on its website, or in a copy provided to any person upon request. Additionally, companies must disclose any changes to their code of ethics and any waivers of the code that are granted to executive officers or directors. Exemptions to a portion of the code of ethics must be approved by either the Board or a board committee. Although SOX does not require a code of ethics, both the NYSE and NASDAQ require listed companies to have a code of ethics. As a result, most public companies have a code of ethics.

Walmart's Code of Conduct And Hormel's Code of Ethical Business Conduct

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A code of ethics is integral to the ethical governance practices of a company. In light of the recent focus on ESG-related disclosures, evidence of honest corporate governance has become even more important. By establishing clear principles and values, companies can ensure that their financial reporting is transparent and accurate, and that their managers and employees act with integrity and in accordance with the law. This, in turn, can help to promote public trust in companies and enhance their overall reputation.

Corporate Governance Guidelines

Companies are required to adopt corporate governance guidelines, which provide a broad framework to assist the Board in overseeing the operations of the company. The guidelines should address specific items as recommended by the Exchanges, including:

The role of the Board
Director qualification standards
Board leadership structure
Director responsibilities
Director access to management and, as necessary, independent advisers
Director compensation
Director continuing education and orientation
Management succession

Most information in the corporate governance guidelines addresses these eight points, though more items may be included in practice. The following paragraph explains the director qualification standards and director responsibilities points further.

The director qualification standards include independence, diversity, memberships on other boards and changes in principal responsibilities, and retirement policy. The director responsibilities include selecting the CEO, approving corporate strategy, monitoring the implementation of strategic plans, reviewing and approving financial reporting and disclosures, and overseeing the approach to ESG in alignment with the company’s business strategy.

Companies are required to make the corporate governance guidelines document available on their website, and include a statement in their proxy statement or annual report (Form 10-K) indicating that the guidelines are accessible online, along with a link to the document. Below are examples from two companies that illustrate different approaches to structuring their corporate governance guidelines.

Alcoa's Corporate Governance Guidelines

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Forbes' Corporate Governance Guidelines

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Because these guidelines are not rigid in nature or all encompassing, every company will differ in what they include. The overall purpose of the corporate governance guidelines is to give the Board a framework to organize and accomplish its many responsibilities.

Board Oversight of ESG

In addition to the corporate governance requirements that boards must comply with, overseeing ESG issues is becoming increasingly important. As ESG becomes more prevalent in financial reporting and possibly a standardized part of governance, the board's responsibilities regarding environmental, social, and governance matters will continue to grow. The SEC climate proposal released in March 2022 is evidence of this, as it includes a list of proposed required disclosures regarding the board's oversight of ESG issues. If the SEC climate proposal is passed as currently written, companies would be required to disclose the following:

The board members or board committees, if any, who are responsible for the oversight of climate-related risks. Governance of climate-related risks could fall under an existing committee, such as the audit committee or risk committee, or a company could create a separate committee specifically dedicated to climate-related risks.
The board members who have expertise in climate-related risks, if any, and a description of that member's experience in such detail as necessary to fully describe the nature of their expertise.
A description of the process and the frequency by which the Board or a board committee discusses climate-related risks, including how the Board remains informed about the risks and how frequently they consider these risks.
A discussion about whether and how the Board or a board committee considers climate-related risks as part of its business strategy, risk management and financial oversight.
A discussion on whether and how the Board sets climate-related targets and how it oversees progress against those targets, including the establishment of any interim goals.

Although not currently required, boards should examine their current engagement in discussions related to ESG risks and objectives. If the SEC proposal is approved, these disclosures would not only incentivize but also hold boards accountable for their participation in environmental, social, and governance matters.

One of the key implications of the SEC proposal is that the board must inquire with management about how their teams are incorporating environmental, social, and governance strategies into the company's overall strategies, risk management processes, and financial oversight. ESG goals and overall corporate strategy can no longer exist independently of one another and instead must support each other. The board is also responsible for monitoring progress towards ESG objectives, ensuring that the company is taking appropriate actions to achieve them.

After establishing the company's ESG (Environmental, Social, and Governance) strategy, the board must determine whether to delegate oversight responsibilities to a board committee. One option is to assign ownership to an existing committee, such as the risk or sustainability committee. Another option is to create a new committee, such as an ESG or climate risk committee, solely dedicated to ESG oversight. Currently, as ESG reporting increases, many companies do not have specialized ESG committees. However, some companies have taken the initiative to create these committees. Here are two examples that demonstrate the options available for delegating ownership of ESG responsibilities.

Board Oversight Of ESG: BlackRock Inc.

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Creation of ESG Committee

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Delegation To Existing Committees

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As the demand for thorough ESG knowledge increases, boards can ensure that committee chairs and members receive proper training on specific areas of ESG. To upskill the committees on ESG, boards can consult with outside experts and receive briefings and specific training on ESG. Alternatively, directors can enroll in intensive programs focused on specific areas of ESG or educational institutes that offer certified diplomas and courses in governance. Global educational institutions like the Corporate Governance Institute provides its members with exclusive ESG content and training, a network of directors and business leaders, and the necessary tools and resources for a successful governance career.

To remain compliant with new ESG regulations, boards will need to stay up to date on the SEC climate proposal and the disclosures required if it is passed. As regulations continue to evolve, it is possible that requirements regarding ESG Committees will be introduced. However, for now, boards should prioritize ensuring that ESG risks are properly considered and managed.

Conclusion

Governance is a broad topic that encompasses many functions within a company. To organize, execute, and disclose their main responsibilities, boards of directors use various tools such as committees, a code of ethics, and corporate governance guidelines. With ESG issues becoming a heavily emphasized part of a company's overall strategy, boards face increasing responsibilities. As such, it is crucial for boards to integrate these growing responsibilities with their existing ones to fulfill their responsibility of overseeing a company and looking out for the shareholders' interests.