Corporate Governance Issues - Essay Example

Corporate Governance Issues (2) Part On Socially Responsible Investment This is a critical discussion of the following ment attributed to Sir Adrian Cadbury in the context of socially responsible investment (SRI): “The continued existence of companies is based on an implied agreement between business and society”. A discussion of this statement hinges on a clear understanding of business and society, why they exist, what they are and should do. A society is a group of people who get together and share a common goal, whilst a business is an artificial (something created or put together, as opposed to a natural, or existing in nature, society) form of social organisation that fulfils three main goals: it keeps the person who created it busy, it provides the same person some income, and it provides society with a product or service that meets a need. Thus, society and business co-exist in the same place, benefiting from each other through wealth transfer or the satisfaction of a need, and as long as business meets this need and serves its purposes for both society and the owner of the business, then it continues to be an ongoing and sustainable concern as the income generated allows the business to stay in existence. However, once any of these purposes is not met, either the business ceases to exist or a new business with a different set of purposes is created. In recent years, society and business have come into escalating conflict, as businesses focus on the generation of profit at all cost to the detriment of society. Thus, business has destroyed environments, abused its workers, and even sold products that killed or injured its customers. Other businesses have abused their economic power to subdue nations, twisted the arms of their governments, and caused severe harm to other sovereign nations, their people, and their environments. As the phenomenon of globalisation spread in the last decade, the extent of the conflict between business and society escalated. Now, not only are businesses supposed to earn profits and meet the needs of its consuming society. It also has to stand by the quality of its products, ensure that its working conditions are human, and that all of its activities are sustainable, i.e., do not cause permanent damage to the welfare of future generations. Negligence on any of these points would open the company to damaging lawsuits, as shown by recent experiences with costly litigation on the effects of asbestos, tobacco, and faulty pharmaceuticals. These developments were a consequence of the abuses resulting from the growing social power of businesses. Much has changed since almost half a century ago, when Friedman (1962) wrote: “There is one social responsibility of business…to use its resources and engage in activities designed to increase profits so long as it stays within the rules … and engages in open and free competition without deception or fraud.” Friedman’s mode of thinking inspired businesses to shift production to low labour cost countries where poor working conditions and employment abuses were not illegal, and where they can operate factories that damaged the environment and depleted natural resources. This was in sharp contrast with what was proposed by Dodd (1932), one of the earliest to write on the conduct of business. He stated that managerial power remains illegitimate in the sense that managers are not subject to the owners who are supposed to be their principals, but this is less of a problem if corporate managers purport to be managing in the “public” interest. Therefore, managers should seek not merely to promote the shareholders’ interest in profits but should manage with a view to the public welfare. In the wake of intensified global competition, corporate scandals and economic crises, and the growing social activism of the 1970s, several business thinkers began thinking of how managers can meet the social challenges that it faced. One of the most radical viewpoints was proposed by Freeman (1984), who pioneered the now-famous stakeholder theory. He defined (p. 48) stakeholders as “groups and individuals who can affect the organisation” and that “managerial behaviour must respond to those groups and individuals.” Freeman proposed that a business must go beyond the profit motive and consider the effects the business will have on others outside of it, especially on society. Towards the end of the century, several academics engaged the subject and concluded that business has to be more socially responsible because businesses, being a part of human society, must be subjected to the same demands made of the humans who created those businesses and who manage them, namely accountability and sense of responsibility for their actions, modes of ethical behaviour, and the search for a noble purpose for existence. Kay (1997) differentiated between the stakeholder and shareholder views of the purpose of a business and emphasised the difference between an organisation’s characteristic – behaviour that is developed and valued for its own sake – and policy – behaviour that is adopted for the time being because of its hoped for consequences. He then concluded that the greater capacity of the stakeholding business to make commitments in implicit contracts with all stakeholders may prepare it to perform better for all, including the shareholders. Elkington (1998) radically promoted this line of thinking and formulated the so-called Triple Bottom Line (TBL or 3BL) accounting that called for businesses to report not only on its financial performance, but also its environmental and social performance. Prominent corporations like Royal Dutch Shell, BP, and Body Shop, continue using this format (even if it did not prevent Shell from falsely declaring its oil reserves in 2004). Sen (1999) argued that business and good behaviour (ethics) need not be exclusive and that a closer contract between the two can substantively enrich and benefit both, and that businesses, and the humans who manage them, need not operate purely out of self-interest to maximise value. Over the past decades, terms such as corporate social responsibility (CSR), sustainable development, socially responsible investments (SRI), business ethics, social entrepreneurship, and corporate philanthropy, amongst several others, have been used to make businesses accountable to society for its actions. Mallin (2004, 81-82) defined SRI as the consideration, in addition to financial performance, of the ethical, social, and environmental performance of companies selected for investment. She proposed three basic strategies for SRI: engagement, where investors demand that a company improves its ethical, social, and environmental policies and practices; preference, where investments are selected on the basis of specific guidelines that meet the SRI policies of the investors; and screening, where the fund managers are directed to invest only in those companies that meet approved SRI criteria. It is mostly the large and powerful institutional investors such as pension funds and insurance companies that have the clout to carry out SRI, but individuals and small investors can also do so by grouping together as minority shareholders and using any or all of the tools of corporate governance such as one-on-one meetings with directors of companies or institutional investors, voting, use of focus lists, or use of publicly-known rating instruments in order to influence business behaviour. It is developments like these that illustrate Cadbury’s statement that companies can continue to exist only if society allows them, which it would do provided businesses go beyond their profits-seeking motive and take the good of all stakeholders into account. As Abdelal (2005, 2) argued in commenting about the relationship between business and society: “What societies want depends on who they think they are…” Part 2: Institutional Investors – Crusading Knights or Thorns in the Side? “Power” is the ability to compel another to do something that s/he would otherwise not do (Dahl, 1957; Lukes, 1974). Amongst the two holders of power in secular society – elected public officials and business executives – several have shown that businessmen and top executives have the greater power as they can twist government to cut or raise taxes, veto or approve laws, amass great wealth with the excuse of maximising shareholder value, and even fool the shareholders or owners of the business that they were hired to manage. Barnet et al. (1975) described how power is exercised by multinational enterprises, a few hundred of which that are bigger and more powerful than most nations have come to dominate the world economy. Using their business and shareholder resources, these firms exercise power by compelling individuals, nations, and governments, their own and that of nations where they operate, to comply with their interests. Gilpin (1975) showed how business and politics mix in a modus vivendi where business executives, political leaders, and the social elite shape economic and political systems to protect and reflect their selfish interests. Jensen and Murphy (1976) in their landmark study on Agency Theory show that aligning the interests of hired managers and owners has a cost (called agency cost) which diminishes shareholder value. Micklethwait and Wooldridge (2000), Sobel (2000), Stiglitz (2002), and Sachs (2005) cited countless examples of managers who rape nations, hold governments hostage, and take advantage of information asymmetries (in other words, managers know more about the business) to dupe their owners-shareholders. One way this was systematically done was shown by Bebchuk and Fried (2004) who documented several incidents of directors awarding themselves and the executives who hired them with pay and perks that would have shamed the most opulent monarchs of the world. Obviously, with so much power in their hands that was growing through the years, and which an increasing number of managers were wantonly abusing for their own benefit, it was only a matter of time before shareholders and owners rose up in arms to defend what is rightfully theirs: the wealth that were the fruit of their hard-earned investments. So complacent did managers and directors become – though they were merely hired hands already adequately compensated by their owners – that they fell prey to hubris. Aside from rewarding themselves with outsized compensation packages, some boards even resorted to ultra-liberal financial and accounting engineering to justify their compensation packages, which were mostly in the form of stock options that were tied to the performance of the stock. By manipulating stock prices to secure the highest possible gain, many crossed the line. Of course, when government regulators found out, it was the shareholders who were left holding an empty bag. This was the experience not only of recent corporate scandals and blow-ups in America but of similar events in other parts of the world in the last two decades. The wave of corporate governance reforms, corporate social responsibility, socially responsible investing, pay for performance, codes and laws in the E.U., the U.S., and other parts of the world (notably Japan and, now, in China) resulted from the rise of a powerful group of owners-shareholders: the institutional investor. These institutional investors are so-called because they represent institutions with huge amounts of investment funds. These institutions – insurance companies, pension funds, mutual funds, and hedge funds to name a few – have cornered a majority of the world’s total invested funds. Mallin (2004, Table 6.1, p. 64) summarised the growth in institutional investments in the U.K. from 46% in 1961 to 86% in 2002. This represented a sea change in the way corporate governance is conducted. The simple reason is that, in the past, when millions of individuals had their investments in companies, the balance of power was obviously on the side of the managers of the business who, aside from information asymmetries, were able to exploit one of the most basic rules of acquiring and keeping power: divide and conquer. It was almost impossible for the self-interests of millions to be united and act as one, so managers almost always got their way, unless an outspoken shareholder activist manages to unite the multitude as to form a token majority. But normally, stockholders meetings were social events where shareholders were fed to listen and rubber stamp the proposals of managers. Managerial power grew until hubris led managers to abuse that power. This is why institutional investors, who made their presence felt only in the last two decades, were a welcome sight to other shareholders because their size and power held tremendous promise for corporate change. At last, the balance of power would be set right, and the abuses of managers and the business corporations they run would be checked. Using the governance tools available – voting power, clout, ability to influence public opinion, ability to call for meetings with corporate directors and executives, use of focus lists and ratings – these institutional investors were like knights in shining armour who have come to the rescue, at least in theory. In practice, however, institutional investors can also be ‘thorns in the side’ of directors and individual shareholders. There exists the possibility that small shareholders abandon their duties of ownership when they see institutional investors engaging in shareholder activism. Monks and Minow (1991) were amongst the well-known shareholder activists who claimed that institutional investors could increase firm value and shape corporate policies for the better. However, Lipton and Rosenblum (1991) and Wohlstetter (1993) claim that institutional investors merely distract the board and management from performing their duties, impairing firm management and degrading firm performance because they (institutions) neither have the skills nor the experience to make better decisions and they also tend to focus myopically on short-term goals that do not maximise share value. Some even seek to alter firm investment policies to pursue politically-motivated or social objectives (Romano, 1993), whilst others fall victim to the same abuse of power they want to control by gaining benefits for their investments to the determinant of the company and other small investors (Murphy and Van Nuys, 1994; Carleton, Nelson and Weisbach, 1998). Karpoff (2001) resolved the conundrum by conducting thorough research on each of these claims and concluded that institutional investors can prompt small changes in target firms’ governance structures but have negligible impacts on share values, earnings, and operations. What his study showed is that what really affects company performance is not the shareholder activism of institutional investors per se but the way the managers react to shareholder pressures and whether management is competent enough to do their work well. This is perhaps closer to what happens in real life: our parents may bawl us out to clean up our room before we are allowed to attend the party, but in the end it is only the occupant who can decide whether to really clean it up or to suffer the consequences of disordered actions. Reference List Abdelal, R. (2005). National purpose in the world economy: Post-Soviet states in comparative perspective (Cornell Studies in Political Economy). Ithaca: Cornell University Press. Barnet, R. J. and Muller, R.E. (1975). Global reach: The power of multinational corporations. London: Jonathan Cape. Bebchuk, L. and Fried, J. (2004). Pay without performance: The unfulfilled promise of executive compensation. Cambridge, MA: Harvard University Press. Bergsten, C. F., Horst, T. and Moran, T.H. (1978). American multinationals and American interests. Washington: Brookings. Carleton, W.T., Nelson, J. M. and Weisbach, M. S. (1998). The influence of institutions on corporate governance through private negotiations: Evidence from TIAA-CREF. Journal of Finance, 53, 1335-1362. Dahl, R. A. (1957). The concept of power. Behavioral Science, 2, 201-15. Gilpin, R. (1975). U.S. power and the multinational corporation: The political economy of foreign direct investment. New York: Basic Books. Karpoff, J. M. (2001). The impact of shareholder activism on target companies: A survey of empirical findings. August 18, 2001. Available at SSRN: Lipton, M. and Rosenblum, S.A. (1991). A new system of corporate governance: The quinquennial election of directors. University of Chicago Law Review, 58, 187-253. Lukes, S. (1974). Power: A radical view. London: Macmillan. Mallin, C. A, (2004). Corporate governance. Oxford: Oxford University Press. Micklethwait, J. and Wooldridge, A. (2000). A future perfect: The challenge and hidden promise of globalization. New York: Crown. Monks, R. A.G. and Minow, N. (1991). Power and accountability. Dunmore, PA: HarperCollins. Murphy, K. and Van Nuys, K. (1994). State pension funds and shareholder inactivism. Harvard Business School Working Paper. Romano, R. (1993). Public pension fund activism in corporate governance reconsidered. Columbia Law Review, 93, 795-853. Sachs, J. D. (2005). End of poverty: Economic possibilities for our time. New York: Penguin. Sobel, R. (2000). The pursuit of wealth: The incredible story of money throughout the ages. New York: McGraw-Hill. Stiglitz, J. E. (2002). Globalization and its discontents. London: Allen Lane. Wohlstetter, C. (1993). Pension fund socialism: Can bureaucrats run the blue chips? Harvard Business Review, 71 (Jan-Feb), 78-90. Read More