The European Commission (DG Just) has invited feedback on its current Sustainable Corporate Governance Initiative, which is based on the EY Study on directors’ duties and sustainable corporate governance. In so doing, the Commission has kickstarted an academic discussion on the role of the board in furthering sustainability issues. This blogpost summarises the authors’ submission to the European Commission’s Initiative.
We generally support the Commission’s objective to focus on long-term value creation and the alignment of corporate with societal objectives: there is strong empirical evidence that the integration of material sustainability factors in decision-making correlates positively with financial performance (eg, Friede, Busch and Bassen 2015; Grewal, Hauptmann and Serafeim 2020; Orlitzky, Schmidt and Rynes 2003; Revelli and Viviani 2015). However, the Initiative suffers from a number of shortcomings.
First, the EY study on which the Initiative is based does not take the basic academic norms of empirical research into account. It randomly collects empirical findings without filtering by qualitative criteria. This is especially regrettable because such an approach undermines the generally positive approach of DG Just towards strengthening the integration of material sustainability factors at the board level.
Further, we strongly disagree with the assumption that shareholder value (SHV) creation is a short-term phenomenon. The SHV model is based on the present value of future cash flows. Generally, this long-term model reflects the future risk and opportunities to generating returns. Therefore, it is still widely used to illustrate the influence of environmental, social and governance factors on companies’ risk-adjusted performance. This does not mean that we fail to recognise that the short-term behaviour of investors impacts on corporate behaviour. Short-term investors can have a positive effect on firm valuation (Doering et al 2020) when the threat of exit (selling the shares) is high due to high stock market liquidity. This will discipline management to increase the value of the company. However, it may also reduce R&D expenditure (Aghion, van Reenen and Zingales 2013), which has a negative long-term effect. By contrast, Kim, Park and Song (2019) show that long-term investors can increase investment in innovation through their monitoring. Therefore, short-term investors can be an additional important corporate governance mechanism in combination with long-term investors and their incentive to exert influence on firm management through engagement.
Regulatory proposals: disclosure and board structure
While we see merit in the regulation of disclosure obligations, the configuration of the board is less clear in its impact on sustainability. We also emphasise the need to take investor demand into account, as we see a growing trend of engagement on ESG issues on the part of asset managers and asset owners. Because engagement activities usually address the board directly or indirectly (via AGM or proxy voting), the results of this shareholder engagement can also be seen as a proxy for improving sustainability at the board level. There is empirical evidence of a positive effect of board member engagement on CSR performance. Barko, Cremer and Renneboog (2018) show that companies improve their ESG rating during the engagement process. Flammer (2015) and Hoepner et al (2020) also document the success of engagement activities. In that sense, we conclude that the integration of sustainability at the board level is a prerequisite for better CSR performance. Given this mixed evidence, however, it remains unclear how CSR performance can be improved by integrating relevant expertise at the board level. It should be the obligation of the regulator to internalise external costs if the overall benefits of externalisation for society are lower than its cost. For instance, it may be necessary to enhance the responsibility of the board to achieve the net zero CO2 objective by 2050.
Legal design challenges
There are different ways to improve companies’ long-term sustainability performance. The Initiative suggests four corporate governance mechanisms:
- Companies’ obligation to address their adverse sustainability impact
- Directors’ duty to take into account stakeholders’ interests which are relevant for the long-term sustainability of the firm or which are among those affected by it
- Mechanisms accompanying these duties, including possible remediation where necessary
- Additional corporate governance arrangements (eg directors’ remuneration etc)
First, it is paramount to ensure that new measures in this context be considered in the context of the legal framework in which they operate. Directors’ duties, for example, are notoriously vague and, given the low levels of litigation in Europe, rarely enforced (see, eg, Armour, Black, Cheffins and Nolan 2009). This is owed to the virtual absence of class actions and, in most Member States, the prohibition on contingency fees.
The Initiative leaves open to what extent any action should be laid down in legislation and which issues should be specified in complementary guidance. Against the backdrop of current developments during the COVID-19 crisis, global investors are increasingly promoting sustainability goals and campaigning for ESG objectives, with stewardship best practices worldwide encouraging this trend (Ringe, 2020). Further, central banks are also proposing steering towards green securities and supporting a sustainable finance strategy (ECB 2020).
Such market demand appears to be the ideal channel for furthering the broader objectives of the Initiative. It is submitted that any legal change should be carefully adjusted to these relatively recent trends and should be facilitative rather than restrictive. Sensible regulatory intervention may, for example, contribute to market standardisation and thereby support investor demand, rather than prescribing to firms and investors what the standards ought to be. Regulation could also play a role in facilitating greater investor engagement. Moreover, innovative and ideally dynamic tools of regulation are usually more flexible than traditional 'hardcore' legislation and can also be revised and updated with greater ease in the future—an additional benefit in this fast-moving field.
This Initiative would benefit from a more rigorous and academic fundament. Much of the Commission’s Initiative seems to be motivated by a political ambition rather than the promotion of an optimal corporate environment for European firms.
To avoid any misunderstanding: We generally support the proposal of integrating sustainability at the board level to improve sustainability performance and to contribute to the 2050 net zero objective. However, the Commission needs to go further in its analysis of individual steps. In particular, we recommend evaluating the effects and parameters of the different elements of the Initiative by a multidisciplinary high-level or technical expert group. For example, this would apply to the different corporate governance mechanisms based on empirical academic research and practitioner experience, and to broaden the analysis to include enforcement aspects. Based on this a careful and updated analysis should be performed of different regulatory instruments in light of recent market developments, in particular the consequence of the Covid-19 pandemic. Flexible and dynamic elements of regulation should be preferred.
To conclude, sustainable corporate governance will certainly have a strong influence on corporate decision making. We welcome the Commission’s ambition but question many elements of its approach.
Alexander Bassen is a Professor of Capital Markets and Management at the University of Hamburg, School of Business, Economics and Social Sciences.
Kerstin Lopatta is a Professor of Financial Accounting, Auditing and Sustainability at the University of Hamburg, School of Business, Economics and Social Sciences.
Wolf-Georg Ringe is a Professor of Law & Finance and the Director of the Institute of Law & Economics at the University of Hamburg, Faculty of Law, and a Visiting Professor at the University of Oxford.
This post is part of the new OBLB series: ‘European Commission Initiative on Directors' Duties and Sustainable Corporate Governance’.