Enhancing shareholder value with social responsibility

The ability of corporations to operate efficiently and add value for investors is under threat from new laws being considered by governments to make corporations socially responsible. Unless directors introduce a new reporting architecture described below to simplify and enhance their role, they are likely to be burdened with additional duties, reporting, and compliance obligations.

Excessive regulation is strangling capitalism as described by P.D. and E.P. Jonson 11 years ago in their article “Financial regulation and moral suasion” on the Henry Thornton website July 1, 1994.

They identified the problems of relying on black letter and as an alternative recommended the use of moral persuasion, information, and incentives. Following this approach this article suggests governments’ exempt corporations from many of the detailed prescriptive and intrusive one size fits all provisions in corporate law and regulations on condition that they introduce creditable self-enforcing provisions in their corporate constitutions.

The UK Government has proposed that directors’ duties take into account the interests of employees, customers, suppliers, community, the environment and standards of behaviour (UK Department of Trade and Industry (DTI) White Paper, March 2005, on Company Law Reform, Section 3.3, p. 20 and Section B(3) p 90) (pdf file 1.2MB). In an attempt to justify additional duties and to deflect concern the government described this as “Enlightened Shareholder Value”.

In Australia, the Federal Government and the Parliament have set up separate inquiries to consider corporate responsibility. This was in response to public outrage over inadequate compensation provided by a company responsible for manufacturing asbestos that had caused many deaths with more expected.

However, corporations could enhance both shareholder value and social responsibility if they took the initiative to change the processes by which they reported. If governments and their regulators endorsed the corporate reporting architecture described below, significant simplification could be achieved in company law, regulations and codes to reduce compliance costs for companies and risks for directors. It would allow directors and shareholders to become more reliably informed to enhance shareholder value and at the same time protect the interests of stakeholders while reducing the volume of information disclosed publicly.

The reason these apparently contradictory objectives can be achieved is because much of the information corporations are required to report is provided on a contingency basis and so rarely used. For example, some disclosure is mandated on the belief that “sunlight” prevents or “disinfects” undesirable behaviour. Other disclosures are required on the expectation that the information may be contentious for some companies at some times. Increasingly, process information is being required to be disclosed in an attempt to reveal the integrity of decision making and of reports. Examples are information on the formation, charter, membership and activities of board committees established to manage conflicts of interest such as those involved in compliance, auditing, director nomination and remuneration.

Substantial reduction in disclosure could be achieved for most companies, for most of the time, if information was only made public on a need-to-know basis and or there were people who had the will and ability to act on the information without disclosure. At present much disclosed information is not used and or there are not people with the interest or ability to use it. In any event, what is disclosed may be subject to spin, even if it has been audited.

A fundamental problem with the current reporting architecture is that it depends upon directors reporting on themselves.

This state of affairs cannot make sense to ordinary folk who elect our law makers. It shows how law makers have allowed common sense to be overruled by the vested interest of the accounting profession who obtain much of its income from servicing corporate interests.

The obsession by accountants to establish standards of reporting and auditing reinforces a belief that the integrity of the reporting architecture is sound when it is fundamentally conflicted with directors reporting on their own actions. The vested interests of WHO is doing the reporting are much more important in determining the integrity of information than establishing standards. In any event, standards are based on the unrealistic assumption that “one size fits all”.

The reason why corporate laws, regulations and codes have become so complex, prescriptive and intrusive is that they are attempting to compensate for, and patch up, the fundamental problem of directors reporting on themselves. The manifold conflicts of directors are identified in the author’s paper presented to The First European Conference on Corporate Governance in 2000. Much simplification could be achieved by removing this intrinsic flaw in the architecture of corporate reporting. Instead of relying on directors and the law to specify what should be reported, a new architecture is required that allows representatives of shareholders to undertake this task.

The shareholder representatives would also control the external auditor as proposed by the National Association of Pensions Funds to the UK Government in December 2004 and subsequent meeting with UK Minister on December 13, 2004. To provide creditable basis for both shareholders and directors to evaluate management separate advisory councils are required for representing the various stakeholder constituencies nominated by the UK Government for furthering “Enlightened Shareholder Value”.

The ability of non-executive directors (NEDs) to obtain feedback and feed forward information from representatives of customers, employees, suppliers and the host community would provide a rich alternative source of information about the business and its management independent of management. Without such sources of information, NEDs are forced to rely on information provided by management to jeopardise and or frustrate the basic reason for directors being appointed to direct and control management.

Without an inclusive and systematic process for obtaining intelligence independently of management to evaluate the scope and integrity of management activities and their reports, NEDs do not have a believable basis to convince shareholders and stakeholders that they are carrying out their role as required by the law with “due care and diligence”.

The formation of separate advisor stakeholder councils to provide independent but expert and informed intelligence for directors creates a basis for directors to:

1. creditably perform their duties with due diligence and vigilance;
2. enhance shareholder value; and
3. take into account the interest of customers, suppliers, employees and the community.

Separate councils are required to focus on the specific concerns of each class of stakeholder and to allow information to be kept confidential from other stakeholders. Stakeholders commonly donate resources to obtain representation when organising action against corporations so no payments would be needed to involve them when they have the incentive of protecting and furthering their commercial relationships.

Customers, employees and suppliers are strategic stakeholders because no company can exist or operate without them. They must therefore be considered an essential component of the “company as a whole” to whom directors owe their common law duty. On this reasoning there is no need to change the law to increase the duties of directors to achieve “enlightened shareholder value” as the statutory law already allows directors to use their powers for “a proper purpose”.

Because the survival and success of corporations is dependent upon strategic stakeholders it is very much in the interest of shareholders to have them recognised and bonded to the corporation independently of the directors. The protect and promote the interest of stakeholders, and the independence of their advise for the directors, the processes of establishing stakeholder councils would best be established through enabling provisions in the corporate constitution. Likewise the processes for establishing a shareholder committee established to mediate director conflicts of interest and the extent of discretionary public disclosure would also need to be set out in the corporate constitution or its by-laws.

In these ways corporations could enhance their ability to protect and further shareholder value as well as their social responsibilities while reducing the extent of their discretionary disclosure. The government and its regulators could then in turn relax a number of mandatory disclosure and auditing requirements for corporations who adopted constitutions that introduced shareholders and stakeholders as co-regulators. Provided directors resolved any problems raised in private discussions with representatives of shareholders and stakeholders the need for public disclosure on many matters could be avoided. After all the purpose of having corporate law, regulators, standards and codes are to protect shareholders and stakeholders. The objective should be to protect and nurture their interests so disclosure is not required.

As shown by a number of experiments and case studies such as “Why Good Accountants Do Bad Audits”, the most effective and compelling way to change the behavior of people is to change the institutional context in which they operate be they Nazis in Germany, US interrogators in Baghdad, or directors and auditors in any location. So instead of changing directors’ duties, the government should change the institutional architecture of corporate disclosure so this is managed by the users of the information and those that can act upon it rather than by those responsible for any unsatisfactory performance.

It is not rocket science as they say. The establishment of stakeholder councils and shareholder committees provide a way to change the institutional context of corporate reporting. They do so in way that richly increases the information available to NEDs while substantially reducing their need for public disclosure while greatly increasing the scope of public reporting to enhance the social accountability of corporations.