The notion of corporate governance must be revised to protect us from short-term shareholder interests and ensure we make the long-term investments vital to our future, argues Filip Gregor.
Filip Gregor is head of Responsible Companies at Frank Bold, a law firm with offices in the Czech Republic, Belgium and Poland.
Climate change and other systemic risks, such as growing inequality, are spurring the debate on the role of the financial sector in the economy. The High-Level Expert Group on Sustainable Finance presented its interim recommendations last month on the subject of directing investments towards sustainable projects and transforming the financial system into a sustainable one.
The group, established by the European Commission, included in its interim report potentially far-reaching reforms to the governance of financial institutions and public corporations. It is a now-or-never moment to tackle the short-termism that is deeply entrenched in the functioning of capital markets, but will the EU muster the strength to break away from the orthodoxies that have dominated this area for so long?
Corporate governance defines how corporations are structured and managed, by whom and for what purpose. As corporations form the fabric of contemporary economies, corporate governance systems are central to the way economies function and are of paramount importance in addressing the complex challenges we face today.
From the 1970s onwards, mainstream corporate governance models have narrowed, pushing corporations to focus on maximising shareholder value. This has proven to be a self-defeating strategy as it has led to a myopic vision of the purpose of the corporation that focuses solely on increasing share prices at the expense of the corporation’s ability to properly consider risks, long-term development and the interests of society.
This model takes the focus away from investment in R&D and innovation, as well as from human and social capital. More broadly, it contributes to rising inequality within firms and society at large, and prevents companies from being socially responsible – at least genuinely so.
Besides the aforementioned, a recent study on the top performing FTSE 100 and ASX 100 listed companies showed how maximising shareholder value strategies actually harm shareholders’ interests. It revealed that a significant proportion of the wealth created for shareholders came from increasing the sustainability of those businesses rather than from short-term measures meant to boost the share price.
The Expert Group noted that one of the main reasons for this dysfunctionality is that “ the time horizon in finance is typically much shorter than the time horizon needed to address society’s pressing challenges; and the conception of risk in finance is typically much narrower than one that effectively captures economic, social and environmental sustainability ”.
The interim report also acknowledged that moving on from short-termism is not a simple task that can be solved with a single parameter. However, progress can be made through (a) continued emphasis by policy-makers on long-term finance; (b) a review of regulation and market practices to foster long-term decision-making; and (c) the protection of those who take long-term investment decisions in the face of short-term pressures from financial markets.
Amongst other recommendations, the Expert Group provided direction for several corporate governance reforms which will be further developed after receiving input from a public consultation (deadline 20 September).
Firstly, the report reflects the common misinterpretation of the fiduciary duty of institutional investors as a principle that focuses solely on the maximisation of short-term financial returns.
The term ‘fiduciary duty’ refers to an obligation based on trust to act in the best interest of another person. There are two separate forms of fiduciary duties that are relevant for improving corporate governance: (a) those of institutional investors and (b) those of corporate directors.
The Expert Group therefore recommends the formation of a single set of principles relating to fiduciary duty and the associated concepts of loyalty to beneficiary interests and prudence in handling money. These principles should integrate sustainability factors and assist in establishing them across the investment and lending chain.
Secondly, the Expert Group recommends defining European directors’ duties as well as developing a set of European corporate governance and stewardship principles that address long-term value creation and sustainability.
In this respect, it is important to note that the law recognises that directors’ duties are owed to the company as a separate legal entity rather than to the shareholders, a point confirmed by a recent study funded by the European Commission.
However, in practice, company directors are often expected to put shareholders’ interests first. This is a key opportunity to protect companies from the pressure to maximise short-term shareholder value and encourage a focus on sustainable long-term strategies.
Thirdly, in line with the previous two points, the Expert Group suggests strengthening the disclosure of material information relating to sustainability issues by both firms and financial institutions.
This can be achieved by harmonising metrics and converging financial and sustainability information, promoting the use of integrated reporting and developing associated accounting standards.
Financial institutions should then disclose how sustainability factors are taken into account when investing clients’ and beneficiaries’ money (for example, through mechanisms as seen in recent French legislation – Energy Transition Law, Article 173).
In recent years, there has been a growing movement towards responsible investing. This reallocation of capital to much needed transformational investments in sustainability is critical. The activism of responsible investors may also assist in improving the corporate approach in addressing some specific, well-defined social and environmental impacts.
However, any solution to short-termism must, in addition to expanding and broadening an investor’s horizon, recognise that companies need to be protected from the pressure to maximise short-term shareholder value.
This is only possible if the policy is built on the recognition that shareholders do not run or own companies. An over-reliance on their role increases the pressure on company managers to put the interests of shareholders first, and therefore sustainability, ESG and any other factors second — irrespective of their importance for the company’s longevity and success.
The Expert Group began mapping out how policy could align the interests of investors, companies and society. Delivering on its objectives will require courage and imagination to fundamentally rethink how capital markets and corporations interact.
Watch out for the final report in December.