bcu msc cg week 7 csr 220712

ASPECTS OF CONTROL : CORPORATE SOCIAL

REPORTING

MSC ACCOUNTANCY & FINANCE :CORPORATE GOVERNANCE

& OPERATIONS RISK ANALYSIS AND CONTROL

Stephen Ong BSc(Hons) Econs (LSE),

MBA International Business(Bradford)

Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen University

• Discussion : Global Corporate Social Performance

1

• Corporate Social Responsibility, Environmental, Sustainability & Ethical Issues

• Employee Issues2

• Case Presentation: Premier Oil3

Today’s Overview

Casestudy 3 : Premier Oil1. Read and prepare the Casestudy on

Premier Oil (Monks & Minow (2011)) for discussion next class. Identify the corporate governance issues faced.

2. You are required to:

– Analyse the scenario’s in the case study and plot the resulting risk analysis on an appropriate risk map.

– Map out the stakeholder power/interest issues, and propose the appropriate corporate actions.

Risk Map Action

High

Medium

Low

Low Medium High

SIGNIFICANCE

PROBABILITY

Requires close monitoring

Manage and monitor Significant focus and action

Accept but monitorManagement effort

worthwhile Manage and monitor

Accept risksAccept but

periodically reviewAccept but monitor

Stakeholder mapping: the power/interest matrix

Figure 4.4 Stakeholder mapping: the power/interest matrixSource: Adapted from A. Mendelow, Proceedings of the Second International Conference on Information Systems, Cambridge, MA, 1986

1. Open Discussion

• Foo Nin Ho, Wang Hui-Ming Deanna and Vitell, Scott J.(2012) A Global Analysis of Corporate Social Performance: The Effects of Cultural and Geographic Environments, Journal of Business Ethics, 2012:107: pp.423–433

2.1 CORPORATE SOCIAL RESPONSIBILITY,

ENVIRONMENTAL, SUSTAINABILITY

& ETHICAL ISSUES

The Role of Institutional Investors in Corporate Governance • What is the role of institutional investors in

corporate governance, mainly from a UK perspective

Learning Outcomes

• By the end of this lecture, you should be able to:• highlight the important monitoring role that

institutional investors play in UK corporate governance

• discuss the complex web of ownership that arises from institutional investment

• consider ways in which institutional investors are becoming more active in corporate governance

• Appreciate the importance of the Walker Review and the Stewardship Code

Institutional Investors and Corporate GovernanceAgrawal and Knoeber (1996) emphasized:

" . . . concentrated shareholding by institutions . . .

can increase managerial monitoring and so improve firm performance"

The Transformation of UK Institutional Ownership Berle and Means (1932)• Described share ownership as ‘dispersed’

in US (UK)• NOWConcentrated in investment institutions:• pension funds• life insurance companies• unit trusts• investment trusts

Ownership of UK listed companies1963• 54% individual shareholders1992• 51.9%insurance companies and pension funds• 8.5% unit and investment trusts• 20% individual shareholders• 12.8%overseas investors1998• 60% institutional investorsNOW• Over 70% institutional investors

A Complex Web of Ownership

• Institutional investors are not shareholders• They are intermediaries

Directors of investee company

Pension Fund Trustees

Investment Consultants

Brokers

Fund Managers

Pension Fund Beneficiaries

Sources of Conflict in Pension Fund Investment

Conflict arises due to frictions between parties• Produces frictional transaction

costs• Shareholders' views not heard by

companies• Breakdown in trust between

companies and their shareholders

The Growth of Institutional Investor Activism "Given the weight of their votes, the way in which institutional shareholders use their power to influence the standards of corporate governance is of fundamental importance. Their readiness to do this turns on the degree to which they see it as their responsibility as owners, and in the interest of those whose money they are investing, to bring about changes in companies when necessary, rather than selling their shares”

The Cadbury Report, 1992

Cadbury Report suggested institutional investors should :• encourage regular one-to-one meetings

with directors of their investee companies (‘engagement and dialogue’)

• make positive use of their voting rights• pay attention to the composition of the

board of directors in their investee companies

Institutional Investor Voting

• Stapledon (1995)–Until 1990s level of

voting fairly low• Mallin (1999)– Significant increase in

recent years• Hampel Report–Overall voting levels

remain at about 40%

Engagement & Dialogue• Combined Code :• Institutional shareholders should be ready, where

practicable, to enter into a dialogue with companies based on the mutual understanding of objectives.

• Higgs Report• Institutional investors should enter into a dialogue

with companies based on the mutual understanding of objectives

• Senior Independent Director (SID)• Should represent investors' interests on the board

Failure of Engagement in theFinancial Crisis

• Institutional investors have been partly blamed for the financial crisis

• Paul Myners targeted them as a scape goat in speeches• Financial Times (2009) suggested engagement failed to

avert the financial crisis, even though they were aware of the problems

• IMA was questioned by the Treasury Select Committee in January 2009

• IMA stated that investors lost confidence in the banking sector and sold shares in 2005

• Where investors engaged with banks it did not work

• Despite 55 meetings between one bank and shareholders before nationalization, the crisis could not be averted

• Engagement with banks before crisis did not change behaviour of directors/banks

• IMA has concerns that institutional investors do not have enough information or influence to be able to influence board behaviour

Failure of Engagement in theFinancial Crisis …

The Walker Review

• Many codes of corporate governance best practice have been reactionary

• In the wake of the financial crisis, the Walker Review has examined the causes of the crisis

• Specifically, the review made recommendation for institutional investors

Walker stated:• The limited institutional

efforts at engagement with several UK banks had little impact in restraining management before the crisis phase

• Levels of voting against bank resolutions rarely exceeded 10 per cent

Walker recommended

• Board evaluation should provide an indication of the nature and extent of communication with major shareholders

Walker recommended:• The FRC’s remit should be extended to include

establishing Principles of best practice in stewardship by institutional investors and fund managers.

• The Code on the Responsibilities of Institutional Investors, prepared by the ISC should become the Stewardship Code.

• Should have equivalent status to Combined Code

Walker recommended:• Fund managers should signify on their

websites whether they commit to the Stewardship Code

• Important for ACCOUNTABILITY!.

Walker recommended:• Institutional investors and fund

managers should actively seek opportunities for collective engagement• Voting powers should be exercised• Voting records should be disclosed• Voting policies should be described

on websites

Walker identified barriers to engagement• Effective dialogue

requires large senior resource commitment on the part of fund managers

• free-rider benefit that may be generated for those who do not contribute to the engagement process

Barriers to engagement• Resistance of some major boards to

engage in effective dialogue • When chairmen engage with major

shareholders there is often a disappointing response

• Boards dissatisfied with level and quality of shareholder representation in meetings

• Hubris/complacency at board level

The Stewardship Code• Principle 1: Institutional investors

should publicly disclose their policy on how they will discharge their stewardship responsibilities

• Principle 2: Institutional investors should have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed.

The Stewardship Code …• Principle 3: Institutional investors

should monitor their investee companies• Principle 4: Institutional investors

should establish clear guidelines on–when and how they will escalate their

activities as a method of protecting–and enhancing shareholder value

Code cont.• Principle 5: Institutional investors should

be willing to act collectively with other investors where appropriate

• Principle 6: Institutional investors should have a clear policy on voting and disclosure of voting activity

• Principle 7: Institutional investors should report periodically on their stewardship and voting activities

The Stewardship Code …

Overall Walker Conclusion• “There is a need for better engagement between fund

managers acting on behalf of their clients as beneficial owners, and the boards of investee companies.

• Experience in the recent crisis phase has forcefully illustrated that while shareholders enjoy limited liability in respect of their investee companies, in the case of major banks the taxpayer has been obliged to assume effectively unlimited liability.

• This further underlines the importance of discharge of the responsibility of shareholders as owners, which has been inadequately acknowledged in the past…

• there should be clear disclosure of the fund manager’s business model, so that the beneficial shareholder is able to make an informed choice when placing a fund management mandate”.

FINANCIAL REPORTING COUNCIL JANUARY 2010• CONSULTATION ON A STEWARDSHIP

CODE FOR INSTITUTIONAL INVESTORS

Rationale• FRC’s December 2009 review

Combined Code found significant concerns about the quantity and effectiveness of engagement between institutional investors and boards of listed companies• Conclusions of the Walker Report

Consultation asks for views on:• What are the responsibilities for engagement of

institutional shareholders to the beneficial owners whose interests they represent?

• Does the ISC Code cover all the relevant responsibilities?

• What are the responsibilities for engagement of institutional shareholders to the UK listed companies in which they invest?

• Does the ISC Code cover all the relevant responsibilities?

And …

• Are the respective responsibilities of the different parts of the investment chain sufficiently clear and appropriate?

• Does the Code strike the right balance between the need to avoid over-specification that might discourage the application of the Code and the need for it to be effective with an appropriate degree of transparency?

• Are there any parts of the ISC Code where further guidance is needed, or where the existing guidance should be amended?

Summary

• Not only companies have to be accountable• Shareholders,

especially institutional investors, need to be responsible by being ACTIVE owners

Environmental, Social & Governance• To consider the important role that

institutional investors are playing in broadening the corporate governance agenda and in driving corporate social responsibility, by increasingly taking account of environmental, social and governance (ESG) factors in their investment decisions

Learning Outcomes• After this lecture, you should be able to: 1. highlight the importance of corporate social

responsibility and greater accountability to a broad range of stakeholders;

2. consider the growth of socially responsible investment in the UK and elsewhere, highlighting the ways in which socially responsible investment has moved from a marginal to a mainstream area of institutional investment;

3. discuss the potential implications of the socially responsible investment movement for companies, their stakeholders and ultimately for society

4. evaluate new evidence on the integration of environmental, social and governance factors into institutional investment

Introduction• Corporate governance is the system of checks and

balances, both internal and external to companies, which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their business activity

• Therefore, sustainability reporting, social and environmental reporting and socially responsible investment all contribute to 'good' corporate governance

• They represent mechanisms which help companies to discharge a broad accountability and to behave in a socially responsible manner

Reporting for whom?

• Companies are producing sustainability reports, social and environmental reports, corporate social responsibility reports etc.

• BUT to what extent is this being driven by the

institutional investment community?

• If investment institutions are not interested in this information, it is unlikely that companies will be genuinely interested in producing it

Institutional Investors• Institutional investors own

almost 80% of shares in UK listed companies

• The current value of assets managed by the global institutional investment

community is in excess of 42 trillion dollars

• US and UK pension fund

investments total 7.4 trillion dollars

Ethical & Environmental investment• Decisions made by these

investors have a considerable impact on the environmental and on society as a whole

“. . . what we need is a means by which we can wield our influence over businesses to

act responsibly . . . Ethical and environmental investment is that means. “ (Hancock, 1999, p. 8)

ESG & SRI• We explore the extent to which the

institutional investment community in the UK, and elsewhere, are becoming increasingly interested in environmental, social and governance information

• We consider how socially responsible investment (SRI) has moved very quickly from the periphery to the mainstream of institutional investment

Impact• In 2004 the UK Government endorsed the important

role institutional investors have to play in integrating corporate social responsibility into business by their recognition of the impacts of social and environmental factors on long-term business performance

• Socially irresponsible behaviour is strongly related to bad financial performance and even corporate failure– Exxon Valdez–Brent Spar–Nike–Huntingdon Life Sciences

USA ViewCalPERS (California Public

Employees’ Retirement System) stated that:

“ . . . equity in corporations with poor social and ethical records could

represent an excessive fiduciary risk because such firms court boycotts, lawsuits, or labor activity. “

SRIFriends Provident chose SRI: “Good corporate practice on

human rights, child labour and environmental pollution is good for society, but it’s also good for shareholders. As a large investor, it is right that we use our influence with companies to encourage responsible business practices while serving the financial interests of our customers.”

Terminology and definitions

• From ethical investment to SRI• Socially responsible investment

combines investors’ financial objectives with their commitment to social concerns such as justice, economic development, peace or a healthy environment.

Issues of traditional importance to the ethical investorAlcohol Military/ MOD

contracts Poor workplace conditions

Animal testing

Arms exports to oppressive regimes

Third World concerns

Gambling Nuclear power Tobacco Greenhouse gases

Ozone depletion Water pollution

Health and safety breaches

Pesticides Tropical hardwoods

Human rights abuses

Pornography and adult films

Genetically modified food

Intensive farming

Road use/ construction

Gene patenting

Ethical Profile

• How to achieve consensus?

• Individuals have different ethical profiles

• Ask pension fund members for example

• Ethical relativism

From SEE/SRI to ESG• Early SRI (2000+)• Institutional investors interested in

social, ethical and environmental (SEE) factors

NOW• Environmental, social and governance

(ESG) factors• Shows SEE issues now central to

governance issues

Mercer Investment Consulting (2006) Issues Associated with ESG Investment

Climate change

Environmental management

Sustainability

Corporate conventions

Globalization Terrorism

Corporate governance

Health issues in emerging markets

Water

Employee relations

Human rights

Relevant ESG• Mercer Investment Consulting

(2006) found that globalization and corporate governance were the ESG factors viewed as most relevant to mainstream institutional investment analysis

• BUT they also found that a high proportion of fund managers expect clean water, climate change and environmental management to have a material impact on investment performance over the next five years

Universal Ownership• Emerging concept of 'universal

ownership' has encouraged the integration of ESG issues into mainstream institutional investment

• Universal owners:– "large investors who hold a wide

range of investments in different listed companies as well as other assets and therefore tied to the performance of markets of whole economies, rather than to the performance of individual assets"

• They are therefore forced to be concerned about long-term economic prosperity, and must consider ESG issues

Statistics on Growth of SRI and ESG• In the UK £4 billion was

invested in ‘ethical’ funds in August 2001

• SRI now an overarching investment criterion for ALL investment institutions

• 77% of the British public would like their pension funds to be invested in a socially responsible way, provided this did not harm financial returns

• 80% of pension scheme members require their schemes to operate an socially responsible investment policy

ESG next 10 years• Mercer Investment Consulting

surveyed 195 fund managers around the world

• 70% of fund managers believe that the integration of environmental, social and ethical factors into investment analysis will become mainstream in investment management within the next three to ten years

• 60% of fund managers consider that screening for social, ethical and environmental factors will be mainstream within the next three to ten years

ESG Analysis• Mercer Investment (2006)

canvassed 157 international institutional investors

• Confirmed that socially responsible investment is continuing to expand at a global level

• 38% of fund managers surveyed anticipated increased client demand for the integration of ESG analysis in mainstream institutional investment over the next three years.

Socially responsible investment strategies • Screening • Best in sector - engagement and

dialogue

The financial performance of socially responsible investment funds

John Maynard Keynes (1936):

“There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable . . . “

Essential question:• Is it possible to be ethical and still to

make a profit?• Few people are prepared to accept a

lower return to investment from investing in a socially responsible manner

SRI & Profits• Solomon and Solomon (2002) found

strong evidence of a growing perception among the institutional investment community that SRI enhances financial returns in the long term

• Drexhage (1998) considered that investors and fund managers believe it is possible to make a difference while making a profit.

Existing academic empirical research has produced mixed results• Luther et al. (1992) found half of the trusts

studied outperformed the market and half underperformed

• Mallin et al. (1995) found that both socially responsible and non-socially responsible trusts seemed to underperform the market

• Gregory et al. (1997) showed that both socially responsible and non-socially responsible trusts underperformed the market but that underperformance was worse for socially responsible trusts

SRI Index• Development of SRI benchmark indices

is clarifying this issue• Williams (1999) predicted growth in

SRI performance benchmarks which should

“. . . explode the myth that green and ethical investors have to accept that their investment performance will be disappointing. “

Cobb, Collison, Power and Stevenson (2005)• Examined the financial performance of the

FTSE4Good, and concluded that• Investors are unlikely to be worse off by

restricting their investment universe, and may well be better off

• Their interviews and questionnaires suggested that inclusion in the FTSE4Good indices was contributing

significantly to stakeholder relations, as well as to internal processes such as reporting and management systems on social and environmental issues

The drivers of SRISolomon et al. (2002) Questionnaire surveyInternal drivers:- fund managers- clients of the institutional investors- trusteesExternal drivers:- lobby groups- Government- society’s interest in CSR- NAPF, ABI, etc

Rank I believe that the development of SRI policy by pension funds is motivated by

Mean

1 The impact of environmental and social lobby groups

Agreement

2 A general increase in interest in social responsibility in society in general

Some agreement

3 Political parties competing for power

Some agreement

4 Companies seeking to improve their reputation and corporate identity

Some agreement

5 The actions of the NAPF Weak agreement

6 European Union legislation Disagreement 7 The social dimension of

European Union membership Disagreement

8 The growing interest of pension fund trustees in SRI issues

Disagreement

9 The growing interest of pension fund managers

Disagreement

10 A demand from active pension fund members

Disagreement

11 A demand from retired pension fund members

Disagreement

12 The religious beliefs of the general public

Strong disagreement

A growing demand for social, ethical and environmental disclosure• ABI guidelines on SEE disclosure (2001)• They would like company boards to state in their annual

reports whether or not they: – take regular account of the significance of SEE matters to the

business of the company;– have identified and assessed the significant risks to the

company’s short and long-term value arising from SEE matters, as well as the opportunities to enhance value that may arise from an appropriate response;

– have received adequate information to make this assessment and that account is taken of SEE matters in the training of directors;

– have ensured that the company has in place effective systems for managing significant risks, which where relevant incorporate performance management systems and appropriate remuneration incentives.

ABI Guidelines 2007• Modification of 2001 Guidelines• In 2007 the ABI published a set of guidelines on

responsible investment disclosure (ABI, 2007)• These guidelines represent a modification of those

launched in 2001. One of the main reasons for their updating was the progress in narrative reporting since 2001, including the EU Accounts Modernisation Directive (resulting as we saw earlier in the Business Review) and the new UK Companies Act. Although the new guidelines are similar they emphasise certain aspects of narrative reporting which institutional risks in order to decide what information should be included in the annual report.

Investors are especially interested in reporting which:• addresses ESG risks, within the company's

entire framework of risk management and disclosures

• adopts a forward-looking approach to ESG risks• addresses board action in managing ESG risksIt is also notable that the ABI have changed their

terminology from SEE (in 2001) to ESG (in 2007)

The Guidelines also contain an appendix which lists a series of questions for companies to interrogate themselves in relation to ESG

Lack of Disclosure• Friedman and Miles (2001) found the City of

London was taking SEE issues far more seriously

• Interviews by Solomon with institutional investors found they are dissatisfied with the level of social and environmental reporting

• Public disclosure is inadequate and therefore private disclosure channels are developing

Private social & environmental reporting• Sparkes (2002) highlighted the growth in SEE

engagement as a main indicator that socially responsible investment is moving away from the margin and into mainstream investment

• Solomon and Solomon (2006) found from interviews that engagement in this area has become formalized

• It is evolving into a two-way process, with companies asking institutional fund managers questions as well as questions being directed toward companies by shareholders

ESG & Shareholders• Freshfields Bruckhaus Deringer (2005)

concluded that shareholder engagement on ESG issues would be considered prudent from a legal perspective, as long as it is properly motivated, transparent, informed and objective

“… targeted and constructive engagement would be acceptable (and in some cases mandatory) where it is aimed at improving the financial performance of an investment over the relevant time horizon, for example by encouraging better environmental accountability or more forward-thinking management”

Private Social and Environmental Reporting: Mythisizing or Demythologising Reality?

• Solomon and Darby (2005) explored whether the dialogue between companies and their institutional investors breaking down barriers and misconceptions about social and environmental risks and impacts by business

OR• was it simply helping companies to create

a green myth about their attitudes to the environment and society?

Green Myth• Interviews showed that both

that companies and investors were creating and disseminating a 'green' myth, which suggested to society that both companies and investors were proactively working toward improvements in social and environmental management

Pension fund trustees and socially responsible investmentPension fund investment is complicated• Pension fund members• Investment analysts• Fund managers• TRUSTEES• Consultants

Do trustees have a responsibility to adopt an SRI policy for their pension funds?

Trustee Fiduciary DutyTrustees are concerned about breaching their

fiduciary duties• Under the rubric of ‘fiduciary duty’ much is

justified. The unexceptionable fiduciary requirement that trustees may consider ‘solely’ the interests of beneficiaries is adduced to justify non-involvement in ‘social’ or ‘political’ investments. Activism is dismissed as being unrelated to adding long-term value to the trust portfolio.

Cowan v Scargill legal case spread fear in the hearts of trustees on SRI

Interest of BeneficiariesJudge Sir Robert Megarry concluded‘. . . It is the duty of trustees, in the

interest of beneficiaries, to take advantage of the full range of investments authorised by the terms of the trust, instead of resolving to narrow that range.’

Profit Maximisation?• Freshfields Bruckhaus Deringer (2005) considers that

the Cowan v Scargill case has had a misguided impact on trustee behaviour

“… Cowan v Scargill cannot be relied upon to support the single-minded pursuit of profit maximization, or indeed any general rule governing investment decision-making … Megarry's decision has been distorted by commentators over time to support the view that it is unlawful for pension fund trustees to do anything but seek to maximize profits for their beneficiaries… Read carefully, his decision stands for an uncontroversial position that trustees must act for the proper purpose of the trust, and not for extraneous purposes.

Or not only profit max?• Megarry, revisited his own

judgement in 1989• He said his decision did

not support the view that the fiduciary duties of pension fund trustees were only consistent with profit maximisation

Two instances where ESG considerations MUST be included in fiduciary responsibility:• consensus among the fund beneficiaries

that ESG factors should be taken into account

• if ESG considerations are reasonably expected to have a material impact on the financial performance of the investment

Cowan vs ScargillFreshfields Bruckhaus Deringer (2005) gave powerful

reasons why Cowan v Scargill case does not support sole pursuit of financial return maximisation:

• case focused on a narrow issue• Scargill represented himself• Technical legal points were not made - Scargill was not

a lawyer• no proper discussion of the case• trustees involved had an ulterior motive for their

actions, supporting the failing coal industry.• Scargill was thought not to have acted with integrity.• The investment plan concerned had nothing in common

with a modern ESG strategy

Trustees & SRI• Since July 2000 all UK pension fund trustees have had

to disclose the extent to which (if at all) they practise SRI

• This requirement [the new SRI disclosure requirement] has had a significant and wide-ranging impact on the investment community. The majority of trustees have incorporated reference to social, ethical and environmental (SEE) issues in their annual statements in 2001.

• Most of them have delegated responsibility for implementing this to fund managers which has added significantly to the growing Socially Responsible Investment (socially responsible investment) movement.

UK Pension Fund Trustees and Climate Change• “Financial Services

Accountability:How Are Pension Fund Trustees Dealing with Climate Change?”

• Research supported by ACCA / ESRC / UKSIF / PMI / NAPF

• Preliminary Findings• Report

Climate Change Predictions• The Intergovernmental Panel on

Climate Change (IPCC) state by end of 21st century global temperatures will rise by 1.5 to 5.8 degrees centigrade resulting in:– thawing of permafrost– declines in biodiversity– rising sea levels– extreme weather patterns– flooding, droughts and storms– direct, unpredictable and

possibly devastating consequences on human civilisation

Stern Review (2006): Insurance Companies and Climate Change"The insurance sector will face both

higher risks and broader opportunities, but will require much greater access to long-term capital funding to be able to underwrite the increased risks and costs of extreme weather events" (Stern, 2006, p.304).

Pension Funds and Climate Change

"Considering that both the physical and mitigation-related policy impacts of climate change will influence the ability for companies to create and maintain wealth for shareholders … pension trustees will want to ensure that these risks … are being addressed in relation to the funds in their care" (IPCC, 2005).

Climate ChangeRisk• Innovest Strategic Value

Advisors have estimated that up to 5.1% (and perhaps more) of market capitalisation may be at risk from climate change

• Climate change has been identified as a central issue for institutional investment strategy (Mercer Investment Consulting, 2006).

The Global Growth of SRI• Socially responsible investment

in the USA • USA is a strong advocate of SRI• More than $2 trillion (about

13%) of all US investment follows SRI criteria

• Freshfields Bruckhaus Detinger (2005) explain that given the US legal framework, ESG considerations may be incorporated into investment strategy, provided that they are pursued for genuine reasons and that they do not compromise the return to investment

Socially responsible investment in Canada• Jantzi Social Index• Freshfields Bruckhaus Deringer (2005) • No legislation encouraging trustees to take ESG issues

into account• BUT some pension funds have included these issues

within the context of profit maximization• Ontario Municipal Employees Retirement System

(OMERS)• Ontario Teachers' Pension Plan Board• The state of Manitoba has amended pension fund law

to specify that pursuit of ESG factors in investment strategy does not represent a breach of fiduciary duty

Socially responsible investment in Australia

• Traditionally, Australian fund managers have considered that SRI is incompatible with fiduciary duty

• Freshfields Bruckhaus Deringer (2005) indicated that Australia has been slower than the US in integrating ESG issues

• Factors which have hindered SRI:– confusion over what

constitutes ESG factors– a perception that SRI leads to

underperformance– confusion as to whether ESG

investment is consistent with fiduciary duty

– lack of demand from fund beneficiaries.

Socially responsible investment in continental Europe • European Commission

has endorsed SRI as an important instrument for encouraging corporate social responsibility

• European Social Investment Forum (Eurosif) has helped to promote SRI

Socially responsible investment in Japan • Solomon et al. showed SRI has grown

recently in Japan• Japan is a civil law country• Law does not depend on cases• Trust law in Japan stipulates that

trustees have a 'duty of loyalty' to carry out their responsibilities in good faith on behalf of their beneficiaries and to avoid conflicts of interest

• No current legislation encouraging ESG issues to be integrated into institutional investment

• Legal framework is an obstacle to SRI in Japan

• Freshfields Bruckhaus Deringer (2005) concludes that ESG in Japan is in its very early stages

2.2 EMPLOYEE ISSUES

Employee Rights & Corporate Governance Systems

• Employees are a key corporate stakeholder.

• We review how various theories on corporate governance assess the impact on firm value of improvements in workers’ rights.

• We also review the level of investments in employee training, the strength of employee representation and voice across corporate governance systems and possible breaches of trust by management of implicit contracts they have with their employees via takeovers.

Learning Outcomes• By the end of this lecture, you should be able to:

1. Contrast the views of the law and finance literature and the varieties of capitalism (VOC) literature on how improvements of workers’ conditions impact on firm performance and investor rights

2. Compare the comparative advantages and disadvantages of economies based on networks and strong employee voice with those of economies based on flexible and highly liquid markets

3. Assess how investment in human capital varies across corporate governance systems

4. Evaluate the degree of employee voice and representation across corporate governance systems and their impact on firm performance and efficiency

5. Critically review the literature on employee ownership6. Appraise the existing evidence on breaches of trust of implicit

contracts.

Introduction• The focus so far has been on

the providers of finance, i.e. shareholders and debtholders.

• However, corporations also deal with other important stakeholders such as employees.

• The strength of

employee rights in a country is intrinsically linked to the generally accepted objective of the firm in that country.

Figure 1 – Dividend cuts or employee lay-offs

Notes: The number of firms surveyed is 68 for France, 105 for Germany, 68 for Japan, 75 for the UK and 83 for the USA.Source: Yoshimori, M. (1995), “Whose Company is It? The Concept of the Corporation in Japan and the West”, Long Range Planning 28, p.35.

Introduction (Continued)• The law and finance literature assumes that

the relationship between shareholders and

employees is a zero-sum game.• The rights of one party can only be improved

by weakening the rights of the other one.• We revisit the taxonomies of corporate

governance, but also review the literature on– employee ownership,– employee board representation, and – breaches of trust of implicit employment

contracts.

The Law and Finance Literature• Most of this literature is based on the premise

that institutions act as constrainers or facilitators on rational, profit-maximising individuals.

• The focus of this literature is on property rights, i.e. investor protection, as well as its enforcement.

• According to this literature, the level of investor protection dictates the size of a country’s capital market and, in turn, its economic growth and development.

The Law and Finance Literature …• Mark Roe’s theory on the political

determinants of corporate governance is the only theory from this literature that does not advocate the superiority of corporate governance systems that provide strong investor rights.

• Nevertheless, Roe still assumes that strong investor rights cannot be combined with strong employee protection.

• Roe argues that different countries have different ways of ensuring social peace.

• The social democracies of Continental Europe maintain social peace via strong workers rights.

• The USA focus on investor rights.

The Law and Finance Literature …

• Marco Pagano and Paolo Volpin concentrate on electoral systems.

• They distinguish between proportional systems and majoritarian system.

• They argue that politicians focus on homogenous social groups such as workers and managers in proportional systems and hence focus on improving employee rights.

• In majoritarian systems, the focus is on the rights of investors who inhabit the pivotal voting district.


• Pagano and Volpin also assume zero-sum game between investor protection and employee rights.

• La Porta et al. argue that weak law, in particular weak investor rights, make it easier for corporate stakeholders, such as managers and employees, to expropriate the shareholders.

• Improving the rights of workers can only be done

at the expense of the owners.


• La Porta et al. and Juan Botero go one step further.

• They study the regulation of labour markets in 85 countries.

• Their results suggest that countries with more strongly regulated labour markets have– higher unemployment rates, especially for younger

workers, and– lower participation rates.

• They find that politics matters, but that legal families are better at explaining the degree of regulation.


The Varieties of Capitalism Literature

• The law and finance literature attributes a central role to law, government and electoral systems and is firmly grounded in path dependence.

• In contrast, the VOC literature allows for institutions to co-evolve over time and to adjust to the changing and evolving environment.

• Importantly, the VOC literature is based on the concept of complementarities whereby the co-existence of two institutions increases the efficiency or productivity of one or both of them.

The Varieties of Capitalism Literature …

• It also focuses on relationships, i.e. it is embedded in patterns of expectations and activities that reflect not just norms and rules, but also attitudes and values.

• In contrast, the law and finance literature is much more mechanistic and also more fatalistic given its strong emphasis on path dependence and history.

• Peter Hall and David Soskice have proposed two broad varieties of capitalism, i.e.– liberal market economies (LMEs), and– coordinated market economies (CMEs).

• The main difference between the two varieties is the way they tackle economic coordination problems.

• LMEs resolve economic coordination problems via

markets.• Hence, markets – including

capital and labour markets – are highly developed and liquid and regulation is kept to a minimum.

• Firms invest in generic assets than can be easily sold off.

The Varieties of Capitalism Literature…

• Given the flexible labour markets, downsizing of the workforce in economic downturns is common practice.

• However, they also enable workers to switch between firms or even industries.

• Firms are unwilling to invest heavily in training given the risk that competitors may free-ride on their efforts.


• CMEs rely on complex networks to address economic coordination problems.

• The role and size of markets will be limited and heavy regulation will prevent their development.

• Firms invest in specific, less generic assets given the lack of liquid markets.

• The heavily regulated labour market makes it difficult for firms to reduce their workforce.

• Employees will also find it more difficult “shop around” for a better job.


• Firms are willing to provide industry-specific training and any attempts by competitors to free-ride will be kept to a minimum by powerful employer associations.

• One of the limitations of the dichotomous approach of the VOC literature is that, apart from the role of markets, it ignores other institutional differences between systems.

• However, there are more complex taxonomies in the VOC literature.


• For example, Richard Whitley distinguishes between six different types of capitalism– “compartmentalized” (LMEs),– “collaborative” (Western

European type CMEs),– “industrial districts” (used to

explain regional synergies in Italy),

– and three others which largely describe business systems found in the Far East.


• Two of the shortcomings of Whitley’s approach is that – it ignores the peculiarities of Mediterranean

capitalism, and – it does not distinguish between “Rhineland” and

Scandinavian economies despite the marked differences in job protection, wage bargaining and financial systems.

• In contrast to Whitley’s a priori approach, Bruno Amable’s taxonomy is systematically grounded on comparative empirical, rather than sometimes anecdotal case study, evidence.


• Amable proposes five different types of capitalist systems which do a better job in terms of taking into account differences across Europe– “Asian capitalism” (e.g. Japan)– “market-based economies” (or LMEs)– “social democratic economies” (Scandinavia),– “Continental European capitalism” (France,

Germany, Benelux), and – “south European capitalism” (Italy, Greece, etc.)

CM

Es


• Indeed, within the broader group of the CMEs, there are significant differences between Scandinavia and many Rhineland economies.

• Germany, Austria, Switzerland and Sweden can be characterised as high job-security CMEs.

• Denmark and Norway operate so called flexicurity policies, which combine job market flexibility with some degree of job security.


• Flexicurity policies reduce job security, but they also give a greater role to government in the development of skills and unemployment benefits are better than in LMEs.

• South European capitalism has features of both LMEs and Continental European capitalism– Similar to LMEs, its firms compete on price– In common with Continental Europe, its firms have

concentrated control– While job security is high in large firms, it is less so in

small firms and the enforcement of labour law is weak.


• France and Italy share many features of CMES such as – the relatively small size of

their stock markets, and– the high job security.

• However, France has moved closer Anglo-Saxon type capital markets in recent years.

• Similarly, Italy is a capitalist system with ambiguous characteristics.


• There are also marked differences in terms of training and education between the varieties of capitalism.

• The flexibility of labour markets reduces the provision of vocational training by employers in LMEs to a minimum.

• In the UK, the government has focused on the provision of good quality tertiary, vocational training.

• This ensure cheap, short-term labour for firms.• It also enables employees to use their generic skills

in various jobs and to switch jobs quickly.

The Varieties of Capitalism Literature…

• This also facilitates the distribution of ideas and knowledge to a greater extent than would otherwise be the case under high competition.

• The USA is often characterised by the dualistic nature of employment and work practices.

• At one extreme, there is mass production of standardised products and basic services requiring cheap, unskilled workers.

• At the other extreme, there is a highly-skilled labour force working in highly innovative industries.


• The high job-security CMEs of e.g. Austria, Germany and Sweden rely heavily on employees with firm-specific skills and strong vocational training.

• Good job tenure provides employees with the right incentives to acquire firm-specific skills.

• A highly developed state welfare system operates as a safety net to support workers made redundant in an economic downturn.


• In contrast, firms in LMEs will focus on basic induction training, but have relatively high spends on training given the high employee turnover.


Employee Stock Ownership• There are two contrasting arguments about the

consequences of employee equity ownership.• Peter Drucker and Masahiko Aoki support the view

that employee stock ownership should be encouraged as it aligns the interests of the workers with those of the shareholders.

• This will not only improve corporate performance, but also increase the monitoring of the management.

• Employee-shareholders have both the incentives and

inside information to monitor the managers.

Employee Stock Ownership (Continued)• Conversely, Michael Jensen and William

Meckling argue that employee equity ownership entrenches employees.

• This will not only make it more difficult to remove employees, but it will also push employees to increase their wages beyond current market rates.

• Hence, employee ownership will reduce rather than increase corporate performance.

• Both of the above arguments assume that employee stock ownership comes hand in hand with employee voting power.

• However, this is not necessarily the case as executives frequently exercise the votes from the employee shares.

Employee Stock Ownership (Continued)

• The empirical evidence as to the effect of employee ownership on firm performance is as yet inconclusive.

• Event studies on the adoption of US employee stock option plans (ESOPs) either find a positive market reaction or an insignificant reaction.

• The lack of conclusive results may be due to the fact that– ESOPs generate tax benefits to the firm,– they may also be used to fend off a hostile bidder

and/or increase shareholder returns in a takeover contest.


• Hence, a priori it is not clear what the stock market reaction to ESOPs should be.

• However, Joseph Blasi et al. argue that it is important to consider the whole set of a company’s employment practices when assessing the effects of employee ownership.

• They find that employee ownership lowers employee turnover and increases the willingness to work hard when combined with low supervision, high-performance policies and fixed pay at or above market rates.


Employee Board Representation• Countries that have a legal requirement of

employee representation on the board of directly include Austria, Denmark, Finland, Germany, Luxembourg and Sweden.

• Board representation of employees in Norway exists in a significant percentage of private-sector firms.

• In France and the Netherlands, employee representatives have a consultative capacity.

Employee Board Representation (Continued)• The German Co-determination system is the

most generous one as it grants employee representatives 50% of the supervisory board seats in firms with more than 2,000 workers.

• Employee representation on the board potentially has a dual informational role1. It provides valuable information to the managers

about work practices, work experiences and workers’ attitudes towards particular policies enabling them to run the firm more efficiently

2. It enables employees to gather information that is valuable to them, such as information on profitability, which may be used to extract above market-rate salaries from the firm.

• Hence, a priori it is not clear what the effect of employee board representation on performance and productivity will be.

• The existing empirical evidence is as yet somewhat inconclusive.

Employee Board Representation (Continued)

• However overall, the evidence suggests that– employee representatives that work for the work

increase firm profitability via information sharing with the management;

– this positive effect is particularly strong in industries where information sharing and coordination are important;

– there is no such effect for employee representatives from trade unions.

Employee Board Representation (Continued)

Breaches of Trust and Employee Expropriation• Andrei Shleifer and Laurence Summers argue

that changes in ownership, in particular takeovers, may result in breaches of trust.

• These breaches of trust consist of the new management breaking implicit contracts that the old management had with the workforce.

• For example, the old management may have promised lifetime employment in return for workers investing in skills valuable to the firm.

Breaches of Trust and Employee Expropriation (Continued)

• The new management may be tempted to break this promise by firing workers close to retirement age that are perceived to be less productive.

• However, the existing empirical research provides little support for the Shleifer and Summers hypothesis for friendly and hostile takeovers as well as management buy-outs.

• Nevertheless, there is evidence emerging from private equity acquisitions of reductions in employment that cannot be explained by an equivalent increase in productivity and profitability.

Breaches of Trust and Employee Expropriation (Continued)

Conclusions• The contrasting views of the law and finance

literature and literature on improving workers’ rights.

• The limits of the dichotomous version of the VOC literature.

• The effect of employee ownership on firm performance.

• The impact of employee board representation on firm value.

• Breaches of trust and employee expropriation.

Next Casestudy 4 : Arthur Andersen1. Read and prepare the Casestudy on Arthur Andersen

(Monks & Minow (2011)) for discussion next class. Identify the corporate governance issues faced.

2. You are required to:

– Analyse the scenario’s in the case study and plot the resulting risk analysis on an appropriate risk map.

– Map out the stakeholder power/interest issues, and propose the appropriate corporate actions.

Core Readings• Solomon, Jill (2010) Corporate Governance and

Accountability 3rd Edition, Wiley, UK. Ch.9-10• Goergen, Marc (2012) International Corporate

Governance, Pearson. Ch.8 & 10• Monks & Minow (2011) Ch.2 & 3• Gary, Owen & Adams (1996) Ch.5-10• CIMA - Performance Strategy: Study Text (2013) BPP

Learning Media Ltd. Part B : 5-6

Additional Readings• Mallin, C. A., Saadouni, B. and Briston, R. J. (1995) ‘The financial performance of ethical investment

funds’, Journal of Business Finance and Accounting, 22, 483–96.• Gregory, A., Matatko, J. and Luther, R. (1997) ‘Ethical unit trust financial performance: small company

effects and fund size effects’, Journal of Business Finance and Accounting, 24(5), June, 705–725.• Drexhage, G. (1998) ‘There’s money in ethics’, Global Investor, 109, 56.• Williams, S. (1999) ‘UK ethical investment: A coming of age’, Journal of Investing, summer, 58–75.• Hancock, J. (1999) Making Gains with Values: The Ethical Investor, Financial Times/Prentice Hall,

London.• Friedman, A. L. and Miles, S. (2001) ‘Socially responsible investment and corporate social and

environmental reporting in the UK: An exploratory study’, British Accounting Review, 33, 523–548.• Sparkes, R. (2002) Socially Responsible Investment: A Global Revolution, John Wiley & Sons, Chichester,

UK.• Solomon, J. F., Solomon, A. and Norton, S. D. (2002) ‘Socially responsible investment in the UK: Drivers

and current issues’, Journal of General Management, November 2001.• Mercer Investment Consulting (2005) SRI: What Do Investment Managers Think? 12st March, Mercer

Human Resource Consulting LLC and Investment Consulting Inc., New York, USA.• Cobb, G., Collison, D., Power, D. and L. Stevenson (2005) FTSE4Good: Perceptions and Performance,

ACCA Research Report No.88, Certified Accountants Educational Trust, London, UK.• Freshfields Bruckhaus Deringer (2005) A Legal Framework for the Integration of Environmental, Social

and Governance Issues into Institutional Investment, UNEP Finance Initiative, produced for the Asset Management Working Group of the UNEP Finance Initiative, October.

• Solomon, J. F. and L. Darby (2005) "Is Private Social, Ethical and Environmental Disclosure Mythicizing or Demythologizing Reality?", Accounting Forum, Vol.29, pp.27-47.

• Mercer Investment Consulting (2006) 2006 Fearless Forecast: What Do Investment Managers Think About Responsible Investment? March, Mercer Human Resource Consulting LLC and Investment Consulting Inc., New York, USA.

• Solomon, J. F. and A. Solomon (2006) "Private Social, Ethical and Environmental Disclosure", Accounting, Auditing and Accountability Journal.

• Solomon J. F. (2008) Preliminary Report on Pension Fund Trustees and Climate Change, ACCA .

Next Week’s Ideas for Discussion• Abernethya, Margaret A. , Bouwensb, Jan

and Laurence van Lent (2010) Leadership and control system design, Management Accounting Research No.21: pp. 2–16

QUESTIONS?