As shareholder primacy gets dethroned, will executives lose focus?
Posted on by Cornis
Wouldn’t it be wonderful if we lived in a world where everything is not presented in simplistic polar oppositions? For example assuming that not prioritising shareholders implies prioritising the whole world, that all shareholders are the same and opposed to the sustainability world, that assessing financial impacts implies excluding sustainability impacts, and that the enterprise communicates through either a financial report or a sustainability report.
A decision last month by The Business Roundtable of the USA was followed by the usual array of responses reflecting extreme opposites. It among others illustrated the ongoing relevance of the AA1000 standard for stakeholder engagement, including its guidance on prioritising stakeholders. Consider the critical response by the American Council of Institutional Investors, who argued that the decision to drop the doctrine of shareholder primacy would lead to "accountability to no one". It also criticised the listing by the Roundtable of five stakeholder groups, listing shareholders last and on top of it describing them not as "owners" but simply as "providers of capital".
The statement by The Business Roundtable on the purpose of the corporation acknowledged that the duty of management and directors is not foremost to maximise shareholder value. The leadership needs to exercise accountability towards not only shareholders but all stakeholders. The almost 200 CEOs of the largest US corporations stated that business decision-making today should be guided by the undertaking to deliver value to all stakeholders.
Some praised the statement. It puts to end the doctrine of shareholder primacy as originated in the US since the 1930s and driven by the likes of Milton Friedman. It was never written into law, but found its way into common law through a series of court decisions. Today the view is, as The Wall Street Journal put it: “Move over shareholders. Top CEOs say companies have obligations to society”. From those who have worked in the environmental, social and governance (ESG) field since decades, there was also scepticism. Some saw it as another public relations statement in an Anglo-Saxon debate. Some noted that this is nothing radically new and that the five commitments in the Roundtable statement reflects corporate social responsibility as seen back in the 1990s.
In South Africa, a country that has been a central reference in the corporate social responsibility movement since the 1980s, the commitment to a stakeholder-inclusive approach is nothing new. This was among others reflected in the take-up by South African business of non-financial reporting and experimentation with integrated reporting over recent years. The approach is also engrained in the King Code that has steered corporate governance since the arrival of democracy in 1994. Making the case for a stakeholder-inclusive approach, the King Code puts all stakeholder types on an equal footing and notes that directors owe their duties to the company. Duty to the company is enshrined in the Companies Act. The company is represented by several interests, including those of diverse stakeholders.
The move away from prioritising shareholders and their returns was frowned upon by commentators on the Squawk Box programme of CNBC television in the US. Running a profitable business is an essential component of contributing to the welfare of society. Former Nasdaq CEO Robert Greifeld sought to put Milton Friedman in perspective, noting he said “you have to maximise profit within the confines of the law and the moral ethos of the time”. The debate illustrated the common error of framing the issue in terms of two simplistic opposites, i.e. making profit (thinking of shareholder return) versus doing the right ESG thing (thinking good of society), or the sequence within which these have to be done.
Who is that shareholder that the agent is accountable to? As the recent Steinhoff accounting scandal in South Africa and Germany illustrated, there are various layers of accountability at stake. It involves owners who may be pension-holding citizens, their institutional investor funds, the asset managers responsible for investment decisions, as well as a corporate governance structure that may involve a two-tier board structure as is practiced in for example Germany and The Netherlands. It can be argued that democratic or societal interest is represented in various ways, including the presence of independent or non-executive directors on either a unitary or two-tier board.
A separate issue is that of “profit maximisation”. Profit is probably the most abused term in debates on business performance. Any financial analyst knows that profit is only one of various key indicators. In the 1980s the father of shareholder value underlined that cash flows, and their sustainability in the longer term, is more important than profit. Alfred Rappaport insisted on the need to focus on longer-term value creation. He was highly critical of short-termism.
The intention was never to “maximise profit” at any cost. Yet as industrial disasters and accounting scandals have shown, many executives and managers have fallen into the trap of maximisation, growth at any cost and short-term targets. Here also lies an onus on those defining public morals, guarding accounting norms and shaping laws to keep abreast of an evolving global sustainability agenda. This includes standards setters, market regulators and those leading government, sharing a public duty to ensure proper standards, regulations and laws are effectively enforced. What society found acceptable twenty years ago may be unacceptable today.
We will not secure sustainability by simply saying all stakeholders are relevant, and shareholders are not the top priority. Stating all stakeholders are relevant implies the ability of decision-makers to prioritise different stakeholder groups and exchange information in a manner that speaks to the needs of different user groups. If the new doctrine is to be that of Capital Providers, Employees, Customers, Suppliers and Community or CPECSC primacy, then we need to take a closer look at the information needs and level of understanding of each of these groups, ones that are interested and affected in different ways. It also requires us to improve the education of our board members and investors, enabling them to ask the right questions.
The principle of stakeholder responsiveness (AA1000) also requires a new look at how corporate reporting meets the information needs of different stakeholder groups. The annual report was historically seen as the primary vehicle through which management and directors report to their principles. In our digital age, large and complex corporations have the ability to disclose their performance and value creation story in different ways, through different vehicles. Consider the annual report (AR) as a compliance document that speaks to regulators, the integrated report (IR) as a forward-looking communication that speaks to investors and employees, and sustainability reporting (SR) as a communication that goes into the details required by for example consumer groups and community organisations. And of course these different communications need to be aligned and not contradict one another. As the CEO of the Global Reporting Initiative (GRI) commented: “corporate (and investor) interests are served when companies consider, and meet, the needs of all stakeholders”.
The IR Framework of the International Integrated Reporting Council (IIRC) defines the target audience of the IR as “the providers of financial capital”. The South African IRC gives this a broader interpretation, encouraging reporting that engages all stakeholders. Experience to date shows the risk of reports that lack focus (in terms of target audience) and continue to display a fragmented approach. Integrated reporting needs to go beyond simply presenting financial and non-financial capitals side-by-side. If CPECSC primacy is to respect the interconnection between different capitals, then the integrated report has to show the ability to translate ESG performance into financial performance. Doing this with a longer-term and future stakeholder perspective is critical in maintaining the focus of executives and their ability to effectively engage the responsible investor.
Corporate Governance in Integrated Reporting: Do we have a power failure?
Posted on by admin
Corporate governance was again frontpage news in November 2018 as Carlos Ghosn, head of the Renault-Nissan-Mitsubishi Motors auto alliance was arrested by Japanese authorities on suspicion of underreporting his income by half over the last five years. It highlights ongoing corporate governance challenges among corporations in Japan, including lack of independent oversight for executive pay. The Nissan case illustrates failure of corporate safeguards and internal control, at a company that lacked committees for audit, nominations and remuneration.
In another country where Integrated Reporting <IR> is also well established, the South African government is struggling to clean up corporate governance at state-owned enterprises. In November the Finance Minister suggested that the highly indebted South African Airways should be shut down. Governance at the company has progressively failed amidst alleged corruption during years of the Zuma presidency. The same scenario is evident at the power utility Eskom, which Government is seeking to revive with a new Board and reforms to control state-guaranteed debts of over US$ 30bn.
Failure in governance as illustrated by these cases raises questions about the impact of transparency and disclosure to combat fraud and improve the quality of governance. In both Japan and South Africa, new corporate governance codes explicitly promote principles such as ethical leadership, transparency and independence. The first principle of the King IV Code of 2016 is that “the governing body should lead ethically and effectively”. This includes transparency and the view that “sunlight is the best disinfectant”, as famously stated by US Supreme Court Justice Louis Brandeis in 1914. But how and where best to disclose information on corporate governance, in a manner that avoids the “mindless compliance” often attacked by IIRC Chair Mervyn King?
In its latest assessment of what material topics the 60 Industry Leaders of the Dow Jones Sustainability Index (DJSI) most report on, Materialitytracker noted a significant trend in how and where corporate governance is reported on. An automated analysis was done by Datamaran of latest annual reports published up to October 2018 by 48 of the Industry Leaders. Using natural language processing (NLP) in scanning the sustainability reports (SRs), integrated reports (IRs) and financial reports (FRs) of the companies involved, the Artificial Intelligence technology found (as in the past) that Governance is a thematic area most covered in FRs.
While business ethics and corruption are among a top 10 issues most emphasised in SRs and IRs, the Datamaran screening found that the 15 IRs published to date this year by DJSI Industry Leaders do not devote significant attention to governance. This is rather addressed in FRs. The top 10 most emphasised topics in FRs include the governance-related topics of employee compensation and benefits (#1), anti-corruption and bribery (#2), business ethics (#3), executive compensation (#8) and board compensation (#9).
Considering that governance is one of the key content elements of the <IR> Framework, it is surprising that sustainability leaders do not devote more attention to governance in their <IR>s. While governance as a compliance theme is traditionally dealt with in FRs as statutory reports, one would expect the more strategic content of <IR>s to clearly address the role of governance as part of integration in reporting, processes and thinking. This is all the more important considering recent findings by the South African IRC (2017) on weaknesses in reporting on governance. A clear weakness was found to be lack of explanation of how governance structure, processes and practices contribute to the value creation process.
Consultations on the IIRC <IR> Framework in 2017 showed limited uptake of the required responsibility statement by “those charged with governance”. This raises the challenge of ethical and effective leadership. Effective disclosure on corporate governance in <IR>s deserves closer examination. As Judge Brandeis added many years ago, “electric light (is) the most efficient policeman”. While some powerful corporations struggle to keep the lights on, we are best advised to pay closer attention.
Climate-related financial disclosures: Task Force seeks to nudge-rock the system
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On 29 June 2017 the FSB Taskforce on Climate-related Financial Disclosures (FSB-TCFD) published its final Recommendations, on the eve of the 2017 G20 Summit in Germany. The recommendations build on climate-related guidance from various voluntary initiatives and standards developed since the 2000s. The Recommendations are voluntary, yet have been defined in a standardised and conservative way so as to be easily taken up by regulators for introduction at national level.
Since its establishment in late 2015 the FSB Task Force would have hoped the G20 would eventually endorse its Recommendations in mid-2017, yet by the time of finalising the Recommendations a welcoming statement from the G20 was questionable due to expected opposition from the US Government under a Trump Administration. It was probably preempting this that BoE Governer Mark Carney claimed (see Environmental Finance) that the Recommendations will gain traction even if they are not officially backed by the G20. The final Recommendations received early statements of support from over 100 businesses globally, the World Business Council for Sustainable Development (WBCSD) as well as investors with some US$ 25 trillion in assets under management (AuM).
One of the five themes of clarification and changes made to the final Recommendations based on public consultation feedback (since December 2016) has been that of materiality and disclosure location. It is important to note that these are Recommendations for climate-related "Financial" disclosures. This has two important consequences.
- The Recommendations ask for the disclosures to be included in annual financial reporting or financial filings. The disclosures involved should reflect correct pricing of climate-related risks, avoiding destabilizing effects on capital markets as the financial impacts of climate change progressively become more clear.
- The Recommendations employ an interpretation of "materiality" that is focused on "financial materiality" or significance in terms of likely financial consequences. For this reason, the Recommendations provide guidance (for example on metrics and KPIs) related to certain financial categories. Reflecting core Elements of financial statements, these categories are Revenues, Expenditures, Assets & Liabilities as well as Capital & Financing.
The Recommendations include special focus on Financial Institutions and Non-Financial Sectors, in the case of the latter especially those sectors "potentially most affected by climate change". The non-financial sectors given special attention are the following four heavy industry groups: energy, transportation, materials and buildings, as well as agriculture, food and forest products. These imply what researchers have often identified as the most impactful and resource intensive industries or value chains out there, i.e. fossil-based energy industries, metals and car manufacturing, building and construction, as well as agrifood and forest products. For the four industry groups, its clarifications also encourage large companies (ones with annual revenue over 1 billion US$ equivalent) to consider disclosing information related to strategy, metrics and targets "in other official company reports when the information is not deemed (financially - ed ) material and not included in financial filings". The 1 billion US$ threshold captures over 90% of scope 1 and 2 emissions of the four industry groups involved (about 2250 companies).
The final Recommendations specified that those related to Strategy and Metrics & Targets are subject to materiality assessment. The implication is that the other two levels of Recommendations, those related to Governance and Risk Management are not subject to a materiality assessment since it is assumed that the climate theme is by definition material for disclosure (confirming due process) in these two areas. With its focus on financial materiality, the TCFD also clarified that "disclosures related to Governance and Risk Management recommendations shall be included in annual financial filings, independent of an assessment of materiality" (emphasis added - ed). It is therefore assumed that all sectors need to have Board oversight and defined management roles as well as processes for integrated risk management in place addressing climate change. In the domain of Strategy and Metrics & Targets, materiality assessments will determine the focus and level of detail of such elements.
Relations with other standards and Integrated Reporting <IR>
In its comments on the earlier draft Recommendations, The CFA Institute encouraged the TCFD to pursue alignment with other major initiatives, refering in particular to the US-based Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC). The CFA Institute is naturally concerned about possible confusion among issuers and investors, and wishes to counter duplication and non-comparable reporting. It encouraged the TCFD to pursue the goal of a mandatory standard in the longer term.
Considering the TCFD's focus on annual financial reporting, it may be asked where does this leave Integrated Reporting <IR> as per the IIRC's Framework, one that seeks precisely to speak to the providers of financial capital. On closer examination it is evident that the TCFD's Recommendations and the IIRC's <IR> Framework speak the same language. The two frameworks have the same spirit and intent, and the disclosure content recommended by the TCFD can feed into mainstream annual financial reporting as well as <IR>. This was evident from a panel discussion I joined in March 2017 with Axa Insurance and Total S.A. at the ProDurable Conference in Paris.
On Strategy, the TCFD's guidance on Recommended Disclosure (b) on the impact of climate risks and opportunities, states that: "Organisations' disclosures should reflect a holistic picture of the interdependencies among the factors that affect their ability to create value over time". This reflects exactly the approach of the <IR> Framework, with its emphasis on integrated thinking, interconnections between different types of capitals involved and the ability to create value in the longer term. Highlighting the value of scenario planning is the way in which the TCFD underlines the need for a forward-looking, longer-term focus. In its comments, The CFA especially hoped that the TCFD guidance would help companies to be more specific in breaking down climate impacts in terms of the short, medium and long term, considering different maturity periods of climate risks and describing the risk management horizons they work with.
Both the TCFD and <IR> frameworks are aware of the potential shortcomings of only focusing on quantitative information, and the need for qualitative information including description of the context within which the performance of an enterprise needs to be assessed. The structure of the TCFD Recommendations around four thematic areas, starting with Governance and Strategy before looking at Risk Management, Metrics and Targets reflects the need for putting performance metrics in appropriate context, including broader organisational, market and socio-economic context. The Recommendations recognise the need to understand the "governance and risk management context in which financial results are achieved", mindful of how global financial crisis showed the need for greater transparency on governance structures, strategies and risk management practises.
Risks, opportunities and business model resilience
While the TCFD Recommendations address both risks and opportunities, inevitably its entry point and greater interest is risk. The whole creation of the Financial Stability Board (FSB) comes against the background of global financial crisis of the late 2000s and the attempt to effectively address systemic risk. When one looks at the mandate of the TCFD and its Recommendations, this special interest in systemic risk, consistent categorization of climate risks and the appropriate pricing of such risks is evident.
The <IR> Framework lends itself to a balanced focus on both risks and opportunities, in particular a proper reflection on opportunities. At the heart of the <IR> Framework is the business model. The main TCFD Recommendations do not refer to business model (only to strategy and value chain). Its technical "Supplement on Scenario Analysis" recognises as part of the scenario analysis process the consideration of responses that include changes to the business model, as well as changes to portfolio mix and investments in capabilities and technologies. The <IR> Framework on the other hand centrally expects an organisation to describe its business model. The description of a business model starts by describing how your enterprise will help its customer to solve a certain problem that she or he has. That description of the solution offered through a defined value proposition and business model means that the whole reflection kicks off with opportunity in mind.
A further note on difference yet complementary between the TCFD Recommendations and <IR> Framework can be added with respect to intangible assets. The TCFD expects enterprises to consider their assumptions underlying cash flow analysis used to assess asset impairments. It refers to goodwill, intangibles, and fixed assets. Inevitably the Recommendations show greater interest in tangible assets and physical risk. Here again the <IR> Framework is highly important in enabling more nuanced discussion of intangible assets across all industrial sectors. An important driver behind the birth of the <IR> Framework was the desire to better define and assess intangible assets, including reasons for the difference between book value and market value. With its recommendations to employ the six capitals model, the IIRC enables a more targeted coverage of intangible assets.
In its tracking of key material topics by the DJSI industry leaders since three years, the online site Materialitytracker has found repeatedly that the two top issues they report on are climate / energy and people / talent management. With its reference to for example Intellectual Capital, Human Capital, Social and Relationship Capital, the <IR> Framework provides an excellent tool for addressing the intangible assets implied by these key material topics. This is of special interest to service industry sectors such as ICT, one reason the ICT sector has shown such interest in taking up the use of the <IR> Framework. It would be interesting to see how the heavier industries focused on by the TCFD report in future on the possible impact of climate risks on their intangible assets, including their reputation. It is often in these areas where accounting is more of an art than an exact science, and where the strategy bullet bites the hardest.
Stewardship of directors, management as well as investors
Finally, a note on decision-usefulness of information and accountability or stewardship. In recent years discussion in the accounting community of the purpose of and a Conceptual Framework for Financial Reporting (IASB) has highlighted the need to focus not only on decision-usefulness (enabling investors to assess prospects for future cash flows) but also accountability (the accountability of directors for the broader performance of the enterprise ). The combination of decision-usefulness and accountability implies consideration of time frame (past, current, future events), scope of accountability (more holistic approach) as well as target vis-a-vis whom directors or management is accountable (the enterprise as legal person, key stakeholders including shareholders as owners).
The TCFD Recommendations focus mainly on decision-usefulness of information (with investors, lenders and insurance underwriters in mind). The final Recommendations include 11 references to decision-usefulness and mentions it upfront as one of the four Key Features of the Recommendations. It includes no reference to accountability or stewardship. The objective of accountability or stewardship features much more prominent in the <IR> Framework. One of the key aims of <IR>, as stated in the <IR> Framework, is to enhance "accountability and stewardship" for a broad base of capitals. In this respect <IR> opens the way for a more two-way dialogue between enterprise (listed or unlisted) and its key stakeholders, targeting notably the providers of financial capital.
In its earlier comments on the draft Recommendations, the Network for Sustainable Financial Markets (NSFM of professionals and academics) urged the TCFD to emphasize also stewardship responsibilities on the part of investors. It argued that the investor fiduciary duty of impartiality also requires a balance (impartiality) in meeting current and future wealth generation needs. The NSFM further asked for an emphasis on longer-term strategic planning disclosures. In addition to describing scenario analysis, listed companies should disclose their longest planning horisons. The Network has in mind strategic plans with 10-20 year time frames, considering Future Growth Value in the face of climate change. It cites the example of Toyota that recently released a 35-year strategic plan.
Despite various requests for specification on time frames, the TCFD finally left this decision to reporting entities, arguing that it is dependent on the life of the assets of a company involved, the profile of the climate-related risks it faces, as well as the sectors and geographies in which it operates. It acknowledges that this may well go far beyond financial planning of up to 2 years or capital planning of up to 5 years. Consider that in many sectors large companies routinely work with time frames of several decades in capital expenditure planning and investment decision-making.