Resources on Corporate Governance and Social Enterprises

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Corporate governance is the system and structures of rules, practices and processes by which a company is directed and controlled, the goals and objectives of the company are established and the performance of the company is tracked. Traditionally, corporate governance has focused on the owners of the corporation that have supplied the financial capital necessary for the business to operate (i.e., the shareholders), regulation of the duties and responsibilities of the persons that the owners have selected as their agent to deploy their financial capital and generate a reasonable return on their investment (i.e., the directors and the members of the executive team); the control environment, which includes accounting procedures, internal controls and external audits used to track the operational activities of the company selected by the directors as the best means for delivering the anticipated return on investment to the shareholders; and transparency and disclosure, which are needed in order for the shareholders to fully understand how their financial capital has been used and to ensure that their agents, the directors and members of the executive team, have not abused their positions.

As time has gone by, corporate governance has emerged from what often seemed to be an esoteric collection of laws, regulations and contracts to recognition of its role as a primary driver of competitive advantage and profitability and a means for making and executing strategic decisions and ensuring that companies achieve their goals. Writing in 2008, Jamali et al. summed up the importance of corporate governance as follows:

“The importance of [corporate governance] lies in its quest at crafting/continuously refining the laws, regulations, and contracts that govern companies’ operations, and ensuring that shareholder rights are safeguarded, stakeholder and manager interests are reconciled, and that a transparent environment is maintained wherein each party is able to assume its responsibilities and contribute to the corporation’s growth and value creation. Governance thus sets the tone for the organization, defining how power is exerted and how decisions are reached.”[1]

In 2010, the International Finance Corporation (“IFC”) described corporate governance as referring “to the structures and processes for the direction and control of companies” and limited the coverage of corporate governance to the areas mentioned above (i.e., shareholders, directors, controls, transparency and disclosure). Notably, the IFC made it clear that it did not consider corporate governance to include, although the IFC said it might reinforce, corporate social responsibility (“CSR”) and corporate citizenship; socially responsible investing and other elements of what had become to be referred to as “corporate sustainability” such as political governance, business ethics, anti-corruption and anti-money laundering.[2] However, since that time, as the world worked its way through a global financial crisis that called into question the norms of corporate governance that had been in place since the 1970s and serious questions arose regarding the environmental and societal impacts of the decisions of shareholders and directors, there has been a clear shift in perceptions regarding the relationship between corporate governance and sustainability. In its guidance to corporate directors for 2018, one of the world’s most prestigious legal advisors to boards on transactions and governance issues nicely described the changing landscape as follows:

“First, while corporate governance continues to be focused on the relationship between boards and shareholders, there has been a shift toward a more expansive view that is prompting questions about the broader role and purpose of corporations. Most of the governance reforms of the past few decades targeted the ways in which boards are structured and held accountable to the interests of shareholders, with debates often boiling down to trade-offs between a board-centric versus a more shareholder-centric framework and what will best create shareholder value. Recently, efforts to invigorate a more long-term perspective among both corporations and their investors have been laying the ground work for a shift from these process-oriented debates to elemental questions about the basic purpose of corporations and how their success should be measured and defined. In particular, sustainability has become a major, mainstream governance topic that encompasses a wide range of issues such as climate change and other environmental risks, systemic financial stability, labor standards, and consumer and product safety. Relatedly, an expanded notion of stakeholder interests that includes employees, customers, communities, and the economy and society as a whole has been a developing theme in policymaking and academic spheres as well as with investors.”[3]

Setting the strategy for the corporation obviously requires consensus on the purpose of the firm, the goals and objectives of the firm’s activities and the parties who are to be the primary beneficiaries of the firm’s performance. Traditionally, directors were seen as the agents of the persons and parties that provided the capital necessary for the corporation to operate—the shareholders—and corporate governance was depicted as the framework for allocating power between the directors and the shareholders and holding the directors accountable for the stewardship of the capital provided by investors. While economists and corporate governance scholars from other disciplines recognized that the governance framework involved a variety of tools and mechanisms such as contracts, organizational designs and legislation, the primary question was how to use these tools and mechanisms in the best way to motivate and guarantee that the managers of the corporation would deliver a competitive rate of return.[4]

While primacy of shareholder interests was the dominant theme of corporate governance, at least in the US, for decades, there is no doubt that one of the most dynamic and important debates in the corporate governance arena, as well as in other areas of society, is the purpose of the firm. Williams described this debate as follows[5]:

“Is it ‘simply’ to produce products and services that create economic rents to be distributed to rights’ holders according to pre-existing contractual, statutory and (possibly) normative obligations? (Given that close to 70% of new companies ultimately fail, that task cannot be taken as too simple.) Or does the firm also have a social obligation to minimize harm to people and the natural environment in its pursuits of profits, or even a positive duty to promote social welfare beyond its creation of economic rents? In corporate governance and law, this debate tracks the competition between a shareholder versus stakeholder view of directors’ and officers’ fiduciary obligations.”

For a long time, the most influential voice among academics with respect to the role and primary objective of corporations was Milton Friedman, the Nobel Prize-winning economist who famously declared that the exclusive goal of corporate activities was to maximize value for the owners of the corporation (i.e., the shareholders). As history shows, this view was seized upon by investors and CEOs who often used aggressive tactics to drive up share prices and create large, yet often dysfunctional, conglomerates. Friedman and others who shared his view maintained that companies did make a positive social contribution by running a profitable business, employing people, paying taxes and distributing some part of their net profits to shareholders.[6] Another argument often made for the shareholder primacy approach to corporate governance was that requiring management to invest time and effort in devising ways to create additional social benefits beyond the honest pursuit of profits within the boundaries of the law would dilute management’s focus, undermine economic performance, and thereby ultimately undermine social welfare.[7] Other supporters of the shareholder-oriented perspective cautioned that corporate responsibility was too much responsibility to impose on directors and pursuing social policy goals was a task best left to the state and not to businesses, which should not get themselves involved with political matters. Another stated concern about expanding the directors’ power beyond shareholder interests is that it would undermine director accountability by allowing them to act in their own self-interest while claiming to act in other constituents’ interests.[8]

Eventually, other members of the academic community, as well as regulators, politicians, activists and even some of the investors that had grown wealthy during the stock market turbulence over the three decades starting with the 1980s, began to question the primacy of shareholder value and called for rethinking the role of the corporation in society and its duties to their owners and other parties impacted by their operational activities and strategic decisions. Among other things, this meant challenging the long-accepted assumption that the principal participants in the corporate governance framework were the shareholders, management and board of directors. For example, Sir Adrian Cadbury, Chair of the UK Commission on Corporate Governance, famously offered the following description of corporate governance and the governance framework in the Commission’s 1992 Report on the Financial Aspects of Corporate Governance:

“Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society.”

Cadbury’s formulation of corporate governance brought an array of other participants, referred to as “stakeholders”, into the conversation: employees, suppliers, partners, customers, creditors, auditors, government agencies, the press and the general community. As described by Goergen and Renneboog: “[a] corporate governance system is the combination of mechanisms which ensure that the management (the agent) runs the firm for the benefit of one or several stakeholders (principals). Such stakeholders may cover shareholders, creditors, suppliers, clients, employees and other parties with whom the firm conducts its business.”[9] The principles of corporate governance of the Organisation for Economic Cooperation and Development clearly state that the corporate governance framework should recognize the rights of stakeholders (i.e., employees, customers, partners and the local community) as established by law and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. For further discussion, see Purpose of the Firm: The Shareholder-Stakeholder Debate and Descriptions of Corporate Sustainability.

According to Rahim, there is an evolving interplay between corporate governance and CSR, both of which hold economic and legal features that may be altered through socio-economic processes in which competition within the product market is the most powerful force.[10] There are many definitions of CSR; however, one of the best is one of the earliest, namely Davis’ definition in the 1970s of CSR as “the firm’s considerations of, and response to, issues beyond the . . . economic, technical, and legal requirements of the firm to accomplish social benefits along with the traditional economic gains which the firm seeks”.[11] Rahim observed that the convergence of CSR and corporate governance has been slowly but surely evolving over a number of decades beginning with “the sophistication of consumers in the 1960s, the environmental movement of the 1970s and the increasing interest in the social impacts of business in the 1990s”.[12] While these changes and movements did not always trigger specific CSR initiatives, they did set the stage along with “the global social urge to include the previously excluded social costs of production and the hidden costs incurred by the environment as a result of business activities with the corporate balance sheet; the lack of confidence in the institutions of the market economy; and the demand for ensuring sustainable development”.[13] For further discussion, see Relationship between Corporate Governance and CSR.

The drive toward, and pace of, convergence of CSR and corporate governance has turned on a variety of key factors. Strandberg found that drivers of CSR at the values level included improvements in information technology and a surge of globalization that has resulted in greater interconnection between stakeholders and companies, recognition of the role that CSR and taking a values-based approach to governance and decision making on improving motivation and productivity among employees, the desire of companies to protect their reputation and build trust in an era of corporate scandals; the need to take steps to ensure that the benefits of globalization are shared more broadly and the ascendency of new types of corporate leaders dedicated to advancing CSR competencies in their organizations and linking CSR issues with mainstream business issues. At the risk level, the main drivers of CSR have been the recognition of investors that CSR can and does have a positive impact on the financial and overall performance of their portfolio companies and the growing attention that directors have paid to social and environmental responsibility which developing their governance frameworks. In addition, governments have become more involved with regulating activities in CSR areas such as the environment, labor relations and reporting, which means that companies have had to expand the scope of their compliance operations.[14] For further discussion, see Convergence of CSR and Corporate Governance.

Rahim observed that the potential convergence of CSR and corporate governance has affected the modes of corporate regulation and that “hierarchical command-and-control” regulation dictated by the state is being replaced by a mixture of public and private, state and market, traditional and self-regulation institutions that are based on collaboration among the state, business corporations, and NGOs.[15] In fact, Rahim argued that the impact of the convergence of CSR and corporate governance has mostly been reflected by the development of self-regulatory regimes in the business environment which have included both attempts by organized groups to regulate the behavior of its members and efforts by individual companies to exercise control over themselves to maintain the stability of their function and achieve certain organizational goals.[16] While self-regulation can be mandated or coerced by the state, most of the self-regulatory initiatives to date relating to CSR have been voluntary systems initiated and operated by corporations, often acting collectively with input from stakeholders. All of this seems to be consistent with the erosion of the authority and power of the nation-state that has occurred due to globalization and the accompanying rise of the influence of non-state actors and transnational bodies in constructing regulatory schemes and devices for businesses.[17] For further discussion, see Impact of Convergence on Corporate Regulation.

Businesses’ contribution to sustainability has become an important issue for the major institutional investors and asset managers and the marketplace is seeing an increase in smaller, more specialized investment funds that are primarily oriented toward providing capital to companies that excel in their environmental, social and governance (“ESG”) practices and which focus on ESG-oriented activities such as climate change and impact investing. The goal of investors is to encourage their portfolio companies to contribute to the successful pursuit of environmental and social outcomes which continuing to provide investors with a suitable financial return. A number of factors have contributed to the surge in the interest of investors in corporate sustainability and the ESG practices of their portfolio companies[18]:

Recognition in the financial community that ESG factors play a material role in determining risk and return;
Understanding and acceptance that incorporating ESG factors is part of investors’ fiduciary duty to their clients and beneficiaries;
Concern about the impact of short-termism on company performance, investment returns and market behavior;
Increased legal requirements protecting the long-term interests of beneficiaries and the wider financial system;
Pressure from competitors seeking to differentiate themselves by offering responsible investment services as a competitive advantage;
Increasing activism of beneficiaries who are demanding transparency about where and how their money is being invested; and
Concern regarding value-destroying reputational risk associated with environmental and social issues such as climate change, pollution, working conditions, employee diversity, corruption and aggressive tax strategies in a world of globalization and social media.

The potential benefits to institutional investors have been highlighted by the Conference Board, which has argued that CSR enhances market and accounting performance, lowers the cost of capital, improves business reputation, and fosters new revenue growth when it is channeled toward product innovation.[19] Similarly, the Chairman and CEO of BlackRock, Inc., the largest asset manager in the world, wrote in his 2016 Annual Letter to the CEOs of BlackRock’s portfolio companies that “[o]ver the long-term, environmental, social and governance (ESG) issues—ranging from climate change to diversity to board effectiveness—have real and quantifiable financial impacts”.[20] While many investors argue that focusing on corporate sustainability is necessary in order for companies to identify and mitigate the risks to current operations due to climate change, shortages of natural resources and ignoring basic human rights issues, investors also believe that developing and implementing innovating solutions to environmental problems, improving workplace conditions and forging strong relationships with local communities will lead to better economic performance for the business. For further discussion, see Investor Interest in CSR and Sustainability and Investors Beginning to Prefer Companies that Pursue Long-Termism.

Harper Ho suggested that investor activism around ESG issues and investors’ growing demand for investment-grade ESG information has important implications for how directors should approach corporate governance, investor engagement, compliance and disclosure practices.[21] First of all, the broadened scope of risks that directors must consider in light of ESG activism means that boards must have new capacities to support oversight of ESG risk. Second, investors want their companies to integrate ESG performance metrics and long-term benchmarks into executive compensation. Third, directors should ensure that investor engagement encourages dialogue and learning and confirm that senior management and investor relations personnel are aware of the increasing overlap between corporate governance and environmental and social concerns. Finally, directors need to improve the quality and formatting of their sustainability-related reporting and ensure that ESG materiality is being considered as part of their company’s financial reporting process. According to Harper Ho, companies that can improve their practices in these areas are likely to see improved financial and operational performance, improved focus on long-term risk and return, better access to “patient capital” (i.e., investors that are less fixated on quarterly earnings and more supportive of R&D and other investments in the company’s future) and be able to identify and exploit new sources of value for the company and keep ahead of emerging risks and opportunities.[22] For further discussion, see Changing Expectations for Board Oversight of Sustainability.

Notes

[1] D. Jamali, A. Safieddine and M. Rabbath, “Corporate Governance and Corporate Social Responsibility Synergies and Interrelationship”, Corporate Governance, 16(5) (2008), 443, 444 (citing J. Page, Corporate Governance and Value Creation (University of Sherbrooke, Research Foundation of CFA Institute, 2005)).

[2] International Finance Corporation, Corporate Governance: List of Key Corporate Governance Terms (2010), 4.

[3] M. Lipton, S. Rosenblum, K. Cain, S. Niles, V. Chanani and K. Iannone, “Some Thoughts for Boards of Directors in 2018” (Wachtell, Lipton, Rosen & Katz, November 30, 2017), 1, accessible at http://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.25823.17.pdf.

[4] H. Mathiesen, Managerial Ownership and Finance Performance (Dissertation presented at Copenhagen Business School, 2002).

[5] C. Williams, “Corporate Social Responsibility and Corporate Governance” in J. Gordon and G. Ringe (Eds.), Oxford Handbook of Corporate Law and Governance (Oxford: Oxford University Press, 2016), 34, available at http://digitalcommons.osgoode.yorku.ca/scholarly_works/1784.

[6] Id. at 35.

[7] Id. at 35 (citing H. Hansmann and R. Kraakman, “The End of History for Corporate Law”, Georgetown Law Journal, 89 (2001), 439, 442-443).

[8] Id. at 36-37 (citing D. Engel, “An Approach to Corporate Social Responsibility”, Stanford Law Review, 32 (1979), 1; D. Fischel, “The Corporate Governance Movement”, Vanderbilt Law Review, 35 (1982), 1259; and S. Bainbridge, “Corporate Social Responsibility in the Night-Watchman State”, Colorado Law Review Sidebar, 115 (2015), 39, 49).

[9] M. Goergen and L. Renneboog, “Contractual Corporate Governance”, Journal of Corporate Finance, 14(3) (June 2008), 166.

[10] M. Rahim, Legal Regulation of Corporate Social Responsibility: A Meta-Regulation Approach of Law for Raising CSR in a Weak Economy (Berlin: Springer, 2013), 13, 21 (citing L. Mitchell, “The Board as a Path toward Corporate Social Responsibility” in D. McBarnet, A. Voiculescu and T. Campbell, The New Corporate Accountability: Corporate Social Responsibility and the Law (2007), 279). See also M. Rahim, “Corporate Governance as Social Responsibility: A Meta-regulation Approach to Incorporate CSR in Corporate Governance” in S. Boubaker and D. Nguyen (Eds.), Board of Directors and Corporate Social Responsibility (London: Palgrave Macmillan, 2012).

[11] K. Davis, “The Case For and Against Business Assumption of Social Responsibilities”, American Management Journal, 16 (1973), 312.

[12] M. Rahim, Legal Regulation of Corporate Social Responsibility: A Meta-Regulation Approach of Law for Raising CSR in a Weak Economy (Berlin: Springer, 2013), 13, 22 (citing A. Bagi, M. Krabalo and L. Narani, “An Overview of Corporate Social Responsibility in Croatia” (2004); and T. Pinckston and A. Carroll, “A Retrospective Examination of CSR Orientations: Have They Changed?”, Journal of Business Ethics, 15(2) (1996), 199). See also N. Kakabadse, C. Rozuel and L. Lee-Davies, “Corporate Social Responsibility and Stakeholder Approach: A Conceptual Review”, International Journal of Business Governance and Ethics, 1(4) (2005), 277, 279 (identifying ‘consumerism’ and ‘corporate scandals’ as the most important drivers underpinning the growth in interest and acceptance of CSR).

[13] M. Rahim, Legal Regulation of Corporate Social Responsibility: A Meta-Regulation Approach of Law for Raising CSR in a Weak Economy (Berlin: Springer, 2013), 13, 22.

[14] Id. at 8-9.

[15] M. Rahim, Legal Regulation of Corporate Social Responsibility: A Meta-Regulation Approach of Law for Raising CSR in a Weak Economy (Berlin: Springer, 2013), 13, 23 (citing A. Gill, “Corporate Governance as Social Responsibility: A Research Agenda” (2008), 464).

[16] Id.

[17] Id. at 27 (citing J. Cioffi, “Governing Globalisation? The State, Law, and Structural Change in Corporate Governance”, Journal of Law and Society, 27(4) (2000), 572).

[18] https://www.unpri.org/about/what-is-responsible-investment

[19] M. Tonello, Corporate Investment in ESG Practices (The Conference Board, Inc.: August 5, 2015).

[20] Annual Letter from Larry Fink, Chairman and CEO, BlackRock, to CEOs (February 1, 2016), available at blackrock.com.

[21] V. Harper Ho, Director Notes: Sustainability in the Mainstream–Why Investors Care and What It Means for Corporate Boards (The Conference Board, November 2017), 13-14, electronic copy available at: https://ssrn.com/abstract=3080033 (based on information available at UNPRI, Signatories, https://www.unpri.org/signatory-directory/).

[22] Id. at 15.