thebigpicture Weekly Review

Week commencing 13 February 2006

Evolution of CSR

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The Role of Directors: Going Beyond Shareholders

A parliamentary committee is currently enquiring into whether Australian laws should be changed to require greater corporate social responsibility. Recommended changes could affect company performance and investment returns should company directors be required to take greater account of non-financial matters in making business decisions. However, the committee might baulk at anything very radical.

A Parliamentary Enquiry
On 23 June 2005, Senator Grant Chapman, the Chairman of the Australian Parliamentary Joint Committee on Corporations and Financial Services, announced that his committee would inquire into corporate responsibility and triple bottom line reporting. The committee adopted seven terms of reference.

The enquiry covers listed and unlisted companies as well as not for profit companies. However, it is clear from the tenor of the hearings that listed companies are a primary target of its attentions.

The original reporting date of 29 November 2005 has been extended to 31 March 2006. After receiving 127 separate written submissions, the Committee took public evidence in Sydney for one day in November 2005. The chairman has indicated that further public hearings will be held in 2006 in Melbourne, Canberra and again in Sydney.

There are 10 committee members of whom five are senators and five are members of the House of Representatives. Five members are nominated by the Government whips, four by the Opposition and one is chosen from among independent or minority party members. The current chairman of the committee is a Government senator from South Australia.

After the committee tables its report, the government is required to react to the findings by way of a statement to the parliament within three months. The government has no obligation to accept or act on any of the recommendations of the Committee.

Whether a report precipitates any action often depends on the standing of the people conducting the inquiry and their capacity to work behind the scenes to effect policy changes. Whether or not the government of the day accepts the recommendations of a committee, its deliberations can help to form the views of legislators informally and affect how other legislation is framed.

The Evolution of Social Responsibility Reporting more...
The relationships between companies and society have been changing constantly since the inception of public companies and been the subject of public debate from their earliest days. Moves toward corporate social reporting picked up pace during the 1990s and, again, during the 2000s in the aftermath of several spectacular corporate failures.

There are now several methodologies from which companies can choose in reporting their triple bottom lines or assessing corporate social responsibility. However, there are no legal standards. The Global Reporting Initiative offers one of the most commonly used methodologies where triple bottom line reporting has been adopted.

From a capital market perspective, the committee needs to make judgements about three important issues:

the extent to which companies should adopt more non financial criteria in making decisions:

the methodology they should adopt in reporting their activities; and,

the sanctions to be applied to directors in gaining compliance.

What Does CSR Mean?
In addressing these three issues, one of the first challenges for the committee has been to identify what constitutes corporate social responsibility. There are three broad types of corporate social behaviour described by the literature and the different guidelines which have been promulgated:

action by companies to make a positive (or minimize an adverse) impact on their communities;

commitments by companies to standards of conduct in dealing with different stakeholders such as employees, suppliers, customers and governments; and,

programmes at an international level aimed at supporting development and distributing benefits equitably across countries and individuals.

The initial focus of the committee’s attention seems to have been on minimizing the number of HIH, Enron and James Hardie examples where, by general agreement, corporate behaviour has been inappropriate. These are the examples the committee members have cited most often in taking evidence.

Unfortunately, there has probably been too little analysis of why the events which overtook these companies occurred. In reality, the source of their problems was probably not a preoccupation with the interests of shareholders at the expense of other stakeholders.

More generally, the assumption that too much consideration is being given to the interests of shareholders by companies has been taken for granted perhaps erroneously when one views the poor historical returns on funds employed by Australian companies.

Judging from the discussion at the public hearing conducted by the committee, its members still appear to be grappling with what constitutes corporate social responsibility outside those examples of egregiously bad behaviour which in any event borders on the illegal.

A More Analytical Approach
A more analytical view of corporate social responsibility suggests that it becomes an issue under two circumstances when there are potential conflicts between society and the activities of a company.

Private costs v public costs
The first is where there is a divergence between private costs and social costs. The classic example is in the event of environmental pollution from manufacturing or mineral processing.

When that happens, the sum of the externally and internally borne costs of production exceed the internal costs alone. The company becomes more profitable to the extent it can transfer the burden of its production from its own shareholders to the broader community.

Where private costs coincide with social costs and benefits there is no conflict and, in the words of Charles E. Wilson, President of General Motors in 1952, “What is good for General Motors is good for America”. There would be, under these circumstances, little pressure on companies to measure the external impact of their activities. An IT service provider might today typify a company least likely to be imposing costs which are not recognised by traditional reporting.

Distributional inequity
The second source of conflict between society and a company is when perceptions of unfairness arise. Resource usage might be efficient in the sense that the company meets both private costs and public costs of production but distributional outcomes are not considered equitable by the broader community.

Some companies headquartered in developed countries have employed low income workers overseas in conditions not generally acceptable in their home countries. This has led to an outcry by labour unions as well as others approaching the issue from more of a moral standpoint. However, their concerns about exploitation run up against evidence that even apparently relatively low wages might be helping to raise standards higher than they would otherwise be.

Another related example is where products being made in poorer overseas countries are sold at huge premiums to the amounts being paid to the overseas workers. Concerns over equity can arise domestically, too, when executives receive large payments while workers are sacked or lose their employment entitlements.

Do Companies Necessarily Lose?
There are those who say that companies should be obliged to act responsibly (i.e. rectify these conflicts) no matter what the effect on their traditionally measured financial performance.

There are others who argue that embracing social responsibility delivers benefits which show up even in traditional measurement standards. The submission by Westpac Banking Corporation to the committee argued strongly that its commitment to corporate social responsibility had enhanced its profitability so that, ultimately, there was no conflict.

The Benefits
There are seven benefits for companies cited by proponents of corporate social responsibility standards.

By being more aware of its environmental impact, a company is likely to become a more efficient user of raw materials.

Governments and regulators are likely to look more favourably on companies with a strong reputation for corporate social behaviour when it seeks regulatory approvals or has other official dealings.

A corporate responsibility framework helps to identify non cash costs and benefits, even when they are wholly internal, which might not otherwise be recognised in decision making and which can improve resource allocation and business profitability.

Reducing conflicts with external interest groups can avert prolonged campaigns which might detrimentally affect earnings and provide competitors a chance to take market share.

Consumers might be more likely to choose the products of companies with a positive rating for social responsibility.

Research suggests that employees having pride in their employer adds motivation and boosts productivity making the firm more profitable and more likely to attract skilled workers ahead of other potential employers.

The cost of capital might be reduced for a socially responsible company since there are growing numbers of fund managers committing investment funds based on assessments of social responsibility.

The Problems

Critics of corporate social responsibility requirements usually focus on why it is not appropriate for companies to be made responsible for implementing or making judgements about social policy.

Any funds for social obligations will be drawn from other potential beneficiaries including shareholders, employees or more efficient capital or production processes.

There is a risk that decisions about non financial activities are taken without those responsible being required to make a similar sacrifice for the social good.

Other people (namely, investors) have decided to allocate resources in a certain way by funding a company. Their decisions are being second guessed by company executives when the latter choose a different allocation of resources which favours social objectives.

Democratic processes allow the community to express its views about how funds should be allocated and who should undertake such spending. When companies become engaged in social expenditure, these democratic processes are eroded.

There is a risk of mismanagement when executives are asked to take on more responsibilities. They might lack adequate training. Pursuing non financial goals might also be used as an excuse entrenching poor financial performance.

The added responsibilities will make it harder for the company to recruit the necessary people or might require the payment of significantly higher incomes to attract individuals with the right mix of skills.

The Role of Directors
The roles and responsibilities of directors are under consideration by the committee. Currently, directors have a duty to act in the interests of the corporation. This duty has usually been interpreted in a financial context and expressed as an obligation to pursue the interests of shareholders above those of any other stakeholders.

The Australian Securities and Investments Commission has advised the committee that “Australian corporations laws …. do not prevent corporate officers from taking into account the interests of stakeholders other than shareholders…. provided that there is some benefit to the company from doing so.” Moreover, there is a range of legislation which requires directors to take account of the interests of non shareholder stakeholders even when that is at the expense of shareholders.

Reasons Not to Change
Those opposed to making any changes to the obligations faced by directors cite:

the difficulty in defining precisely which interest groups directors should take into account;

confusion over the priority to be accorded to different interest groups;

the potential to aggravate a shortage of directors by making them more reluctant to join boards;

the potential for directors’ fees to be forced higher;

the need to change the composition of Boards by recruiting directors with broader interests;

the possibility that directors will become more risk averse and less inclined to commit to investment;

the possibility that directors will become less willing to invest in Australia;

the need to decouple salaries from profitability and other financial measures if corporate objectives have to be changed; and,

the possibility that investment returns will suffer.

Alternative Approaches
There are six alternative models for modifying the way in which directors conduct the affairs of companies to be found in the literature and in the evidence brought before the enquiry.

Directors are already concerned with more than just financial issues and are continually reconciling the interests of different stakeholder groups. Moreover, they are doing a good job and should be left to carry on. The status quo should prevail.

Many of the high profile corporate failures motivating the politicians arose because directors were insufficiently focussed on what was good for shareholders (not too focussed on them). Offering directors more distractions is inviting more disasters not preventing them so that they should be encouraged to concentrate on financial decision making.

Governments wanting to change behaviour affecting social or environmental outcomes should change the laws that apply to all legal persons, corporations or individuals not just place the burden on directors. Directors would then have firm guideposts against which to judge what they should do.

The relevant laws should be changed to explicitly allow directors to take account of non financial concerns, only if they choose to do so, without leaving them open to legal challenge by shareholders who felt they were affected adversely.

Incentives and rewards should be put in place to encourage a change in behaviour. Companies conforming to certain standards could receive government purchasing preferences or tax credits.

Directors should not have discretion as to whether they take account of social issues or not. Without compulsion, nothing would be done.

These models range from the status quo to a highly interventionist change to the role of directors. Members of the Committee will be required to make a judgement about these various models and opt for one of them.

Potential Committee Recommendations
Further hearings are likely to highlight the views of committee members more clearly as they gain a more thorough understanding of the issues. Many of their public comments suggest an initial disposition for change. However, as a review of the options shows, the choices are so wide they might prove too daunting for the committee which could simply seek to explore the possibilities without making a strong recommendation.

However, the composition of the committee makes a split recommendation possible with non government members of the committee seeking a more radical change and government members opting for a more voluntary code closer to the status quo.

In any event, ASIC itself appears to have very limited enthusiasm for an approach which admits other stakeholders into decision making processes. To that extent, any contrary recommendations by the committee might flounder when they reach the government.

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Weekly Chart Spot

UK manufacturing profitability (measured as a return on funds employed) has been declining for eight years from the peak levels reached in the late 1990s. A relatively unattractive return of under 7% is well below the more stable return available from investing in service industries.

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The Historical Evolution of Corporate Social Responsibility

1770s	Early in the life of the joint stock company, Adam Smith famously described how business decisions are made: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” The potential for management distraction was also identified by him: “….negligence and profusion …must always prevail, more or less, in the management of the affairs of a joint stock company”. (Wealth of Nations)
1813	As it sought approval to continue trading In India, the English East India Company became embroiled in one of the earliest examples of a debate about corporate social responsibility. The British parliament considered whether the company should use its commercial access to actively promote Christianity in India. William Wilberforce argued that missionary access to India was “the greatest of all causes” and James Mill referred to Hinduism as “the most enormous and tormenting superstition that ever harassed and degraded any portion of mankind” as they sought to have renewal of trading rights made conditional on these views being accepted.
1919	The Michigan Supreme Court, in deciding whether Henry Ford could go against the wishes of his minority shareholders and retain earnings to fund a broader commitment to boost employment, sided with the minority shareholders when it declared in Dodge v. Ford Motor Co that: “A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end. The discretion of directors… does not extend to a change in the end…or to the nondistribution of profits among stockholders in order to devote them to other purposes”.
1920s	Companies began to regard employee quality as having an impact on their business performance and so started to spend more on training and other benefits. More employees began rising to senior positions once occupied by family members or associates of business owners.
1932	Adolf Berle and Gardner Means in The Modern Corporation and Private Property observed that corporations had ceased to be controlled by their owners and that a new class of professional managers had emerged to take their place. Their analysis showed that in 1929 44% of the largest nonfinancial corporations in the USA were controlled by managers.
1956	Harvard academics Francis X Sutton, Seymour E Harriss, Carl Kaysen and James Tobin redefine the approach of corporate decision makers in The American Business Creed: “…corporation managers generally claim that they have four broad responsibilities: to consumers, to employees, to stockholders, and to the general public….each group is on an equal footing; the function of management is to secure justice for all and unconditional maxima for none. Stockholders have no special priority; they are entitled to a fair return on their investment, but profits above a “fair” level are an economic sin.”
1963	Thirty years on, a study by Robert J. Larner duplicated the earlier work by Berle and Means and discovered that 84.5% of companies had fallen under the control of their managers.
1960s & 1970s	In the high water mark for corporate social activity, 48 US states passed laws allowing companies to give funds to charities without having to amend their company charters.
1970s	The environmental movement highlighted the damage that had been caused in the previous 100 years in the USA by mining and industrial processing companies. Policy initiatives forced companies to recognise the external costs of their activities and, for the first time, foot the bill for remedial action.
1970s/80s	Slower economic growth in the aftermath of the oil price shocks changed the demands of shareholders. The performance of conglomerates such as ITT whose growth slowed were scrutinised more closely.
1976	Guidelines for multinational enterprises from the Organization for Economic Co-operation and Development (OECD) outline a non-binding code of corporate behaviour for multinational enterprises.
1977	The Global Sullivan Principles of Social Responsibility were originated by Reverend Leon Sullivan, a Baptist minister in the USA, initially to end discrimination against black workers in South Africa. The principles were formalised in 1999 for companies wherever they operate.
Early 1980s	n Institutional investors now accounted for nearly half the shares owned by listed US companies. As they grew in size, they acquired more economic power but it became harder for them to sell shares if they disliked business behaviour so became more likely to try to change the way business was conducted. n The availability of debt funding in a high inflation environment made hostile acquisitions attractive where predators could see more value than incumbent management was able to extract. No target appeared too big. Institutions and brokers encouraged the principal players. n Attitudes toward employees began to change as investors sought new ways to extract value. Reducing numbers employed directly and cutting costs through outsourcing became commonplace.
1991	The World Business Council for Sustainable Development was formed to promote sustainable development, the role of eco-efficiency, innovation and corporate social responsibility through an international membership.
1990s	n Formal shareholder value models were adopted more widely as managers sought to pre-empt hostile takeovers. The company share price became the dominant goal with senior executive remuneration increasingly tied to it. n Institutions began insisting that corporations belonged to shareholders and boards were their custodians. Boards were separated from management with fewer executives being appointed. n Boards increasingly rejected insiders for the most senior executive positions. Falling CEO tenure created additional incentives for quick action, including buying and selling assets, to boost share prices. Managers specialising in radical corporate makeovers gained prominence.
1997	The Global Reporting Initiative was launched as an independent institution to develop and disseminate globally applicable sustainability reporting guidelines for voluntary use by organizations reporting on the economic, environmental and social dimensions of their activities.
July 2000	The UN Global Compact was launched setting out ten principles of ethical conduct for global business covering human rights, corruption, labour standards and environment.
2000	The UN General Assembly adopted a resolution urging member countries to work together to develop a Universal Code of Conduct for Transnational Corporations. Added to the Global Compact were "respect for the sovereignty of the host nations" and "respect for the cultural values of the host nations."
November 2002	The Australian government published “An Australian Guide to Indicators and Methodologies for Public Environmental Reporting” as a first step toward encouraging companies to adopt triple bottom line reporting.
2000-2005	Following several high profile company failures in Australia and the USA, governments began to assert their rights to regulate companies more vigorously when even shareholders are not protected.

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Enquiry Terms of Reference

The Joint Committee on Corporations and Financial Services of the Australian parliament is undertaking an enquiry into corporate responsibility and triple bottom line reporting. The terms of reference of the enquiry are as follows.

The extent to which organizational decision-makers have an existing regard for the interests of stakeholders other than shareholders, and the broader community.
The extent to which organizational decision-makers should have regard for the interests of stakeholders other than shareholders, and the broader community.
The extent to which the current legal framework governing directors’ duties encourages or discourages them from having regard for the interests of stakeholders other than shareholders, and the broader community.
Whether revisions to the legal framework, particularly to the Corporations Act, are required to enable or encourage incorporated entities or directors to have regard for the interests of stakeholders other than shareholders, and the broader community. In considering this matter, the Committee will also have regard to obligations that exist in laws other than the Corporations Act.
Any alternative mechanisms, including voluntary measures that may enhance consideration of stakeholder interests by incorporated entities and/or their directors.
The appropriateness of reporting requirements associated with these issues.
Whether regulatory, legislative or other policy approaches in other countries could be adopted or adapted for Australia.

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thebigpicture is published by thebigpicture Economics (ABN 71 040 787 936). The author, John A Robertson, while working in Australia, London and New York, has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy.

As Chief Economist and a director of a leading Australian investment bank as well as a top-rated institutional equity analyst, he has marketed investment advice in all the major international financial centres. As a professional economist, he was also a senior member of John Howard's personal staff when the current Prime Minister was Commonwealth Treasurer.

His work as a senior corporate finance executive in several public companies in the mining, consumer goods and IT industries complements a unique perspective in analyzing Australian companies and the environment in which they operate.

John Robertson provides investment advisory services to wealth managers including advice on asset allocation methodologies, portfolio construction and client communication programmes. He also advises companies on their capital market communications and financial strategies.

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