Governance is without a doubt the least glamorous of the three pillars of ESG. Nobody gets excited when they hear about audit committees and internal control frameworks. However, its lack of popular appeal does not mean it should be ignored. In fact, quite the opposite is true; many research studies have concluded that strong scores on governance factors are highly correlated with company performance and investor returns. The recent collapse of Wirecard is a perfect example of why it is so important for investors to keep a close eye on them.
It is rare for accounting scandals to hit the front pages of newspapers. It has after all been almost twenty years since the fraud at Enron was discovered. But when a company admits that 1.9 billion Euros of cash on their balance sheet has disappeared you can expect to read about it widely in the media. The revelations about the fraudulent activity sent the shares into free fall. Having closed at €104.5 on June 17th, the share price of Wirecard plummeted to less than €1.3 less than 10 days later. Shareholders of the company lost over 98% of their investment in this short time period. For those that remain fixed to the notion that ESG integration is not part of an asset manager’s fiduciary duty, this avoidable loss of wealth should be yet another example of how an ESG lens can protect investors.
The trigger for the drop was the announcement on June 18th that the release of their 2019 financial statements would be delayed. It was at this point that KPMG, their recently hired forensic auditor, said that the €1.9bn of cash was unaccounted for. A day later, Markus Braun resigned from his position as CEO and was then arrested later that week. The company admitted that the cash probably never existed and filed for insolvency, as they had no means to pay the €3.7bn that they had borrowed from creditors.
It was a wild week for a company that had grown from an obscure small German technology firm into one of the largest payment providers on the planet. But after the shocking news was unveiled, there were many questions that were still left unanswered. How was the fraud allowed to continue for so long and to grow so large? Where were the auditors and the regulators – the supposed watchdogs of the financial system? These questions become more pressing when you learn that concerns had been first raised about the company over a decade ago and that there had been many, many warning signs in the interim.
The auditors and regulators are certainly at fault to some degree. But it is important to start by questioning the governance structure at the company itself. It is the duty of the board of directors to oversee management and to act in the interests of shareholders in providing this oversight. It is obvious that Wirecard had extremely poor governance practices in place. With the lack of board oversight, celebrity CEO Braun was allowed to use his power to continue his practices unchecked. He had overseen the company through years of success and growth and consequently no one was willing to stand up to him.
Investors in the company should have demanded certain changes were made. In Germany, firms have a dual-board board structure. This means there is a management board, made up of company executives, and a supervisory board which is filled with independent directors. The supervisory board is meant to oversee management and make sure there is sufficient oversight over accounting and internal controls. And any scrutiny of Wirecard’s board structure would have raised serious red flags – they only had 6 members on the supervisory board (the German average is closer to 14) and these members simply did not have the required expertise to be monitoring a business as complex as Wirecard. Perhaps the biggest warning sign should have been that there was no audit committee for a significant period of time.
The failures of Wirecard’s auditor EY also cannot be understated. While it is not an auditor’s responsibility to catch every instance of fraud, it is their responsibility to confirm that material sums of cash listed on the balance sheet do exist. Wirecard claimed that €1.9 billion was held in two banks in the Philippines, the banks have since said that they have never dealt with the company. Unsurprisingly, EY faces lawsuits from both shareholders and creditors who argue that they were negligent in signing off the audit every year for the past decade. EY’s response was that the company had pulled off an “an elaborate and sophisticated fraud” and wanted recognition for their role in the uncovering of it.
The actions of the German regulator, BaFin, should also be examined carefully. When questions were first raised about the company’s finances in 2008, they ignored them. As Wirecard grew into Asian and Middle Eastern markets, journalists and analysts continued to scrutinise the company and questioned the huge levels of revenue that were reportedly being earned in these jurisdictions. In early 2019, BaFin opened up an investigation into journalists at the Financial Times for potentially colluding with short sellers. It says a lot about the financial system as a whole that rather than focusing their efforts on investigating the company itself, the regulator showed more concern to protect the large technology firm by targeting journalists. In July this year, in the wake of the Wirecard scandal, the European Commission launched an assessment into the supervisory response of BaFin which is due to be completed by October.
The Wirecard story is relevant for ESG investors for several reasons. First, it underscores the value that investors can get from integrating ESG factors into their analysis. ESG ratings agencies such as MSCI had red flagged Wirecard prior to their insolvency for their lack of industry expertise on the board and poor quality risk management. Investors who had studied the company’s poor ESG ratings would have avoided or sold their shares in Wirecard, thus protecting themselves from the negative price performance.
The second lesson is a reminder to take notices of the governance practices in a company. While environmental and social factors are discussed the most thoroughly in the world of sustainable investment, there is a great deal of value in examining the quality of a company’s governance. It has been almost twenty years since the Enron fraud scandal shocked the world, and perhaps investors have become complacent about the potential for large scale accounting fraud at modern companies. Hopefully, the Wirecard scandal will serve as a reminder that this is not the case, and that good governance is essential for ensuring a company is not at risk of bad actors manipulating markets.