Sustainable Corporate Governance (part I)

Abstract: The text explores the interplay between corporate sustainability, shareholder interests, and stakeholder value. It begins by addressing the evolving role of company law in shaping social policy. Ambiguities within the Environmental, Social, and Governance (ESG) framework are examined, along with concerns about greenwashing and dilution of content. The debate between shareholder value and stakeholder interests is traced historically, from Friedman's doctrine to the United Nations' Sustainable Development Goals. Additionally, it discusses empirical findings on the relationship between profitability and sustainability, highlighting market dynamics. Finally, it underscores the need for a nuanced understanding of corporate governance that balances divergent interests while advancing the common good.

Keywords: Environmental, social and governance (ESG); shareholder value; stakeholder value; corporate purpose.

1. General remarks: ESG and its backlash

PLMJ's Forum on Sustainable Corporate Governance endeavours to cultivate discourse and varied viewpoints on corporate sustainability, acting as a conduit between academia and practical application. This collaborative effort to generate and advocate for knowledge regarding corporate sustainability is crucial, given the ambiguity surrounding how commercial entities can effectively pursue sustainability without compromising the financial interests of the company and its shareholders.

The undeniable negative externalities stemming from corporate activities are compounded by the limited liability structure, which absolves shareholders of a significant portion of the costs imposed on third parties.¹ As highlighted by Fleischer and Hülse², in a dynamic global landscape, company law transcends its traditional role as merely an organizational framework, evolving into a potent instrument for social policy. Company law provisions are increasingly aligned with broader political objectives, notably evident in the realm of sustainability and climate policy.³ This recognition arises from the realization that the ambitious targets outlined in agreements such as the Paris Agreement on climate change and the UN's 2030 Agenda for Sustainable Development necessitate substantial support from the financial sector. Consequently, the European Commission has been formulating strategies to redirect capital flows toward a more sustainable trajectory. Recent European-level initiatives have prompted market participants, spanning from corporations to investors, to reassess their stance on Environmental, Social, and Governance (ESG) standards. Sustainability is no longer solely perceived as a financial or business risk, as encapsulated by an "outside-in" perspective focusing solely on its impact on financial performance. Rather, it encompasses an "inside-out" outlook, considering how companies influence their stakeholders,⁴ aligning with the concept of double materiality.

From a private law perspective, sustainability is viewed through the lens of the ‘Environmental, Social and Governance’ dimensions, reflected in the acronym ESG, without prejudice to the criticisms of this tripartite approach.

The flexibility resulting from the vagueness inherent in the term ESG can also be construed as ambiguity, leading certain companies to engage in greenwashing, particularly concerning their environmental policies. The broad spectrum of issues encompassed within the ESG framework poses a risk of diluting its substantive content, fostering confusion, and even engendering conflicts among the diverse elements underpinning Environmental, Social, and Governance (ESG). Integrating factors revolving around risk, opportunity, and ethics within a single conceptual framework presents inherent challenges. Consequently, there is a growing consensus that the concept warrants reform. Larry Fink, a prominent advocate of responsible capitalism, has publicly expressed regret over his prior use of the term ESG. However, this acknowledgment does not signify a shift in investment strategy but rather a semantic adjustment. Fink contends that terms like decarbonization, governance, or social issues might be more apt. Nonetheless, transitioning away from the term ESG does not signify a diminished focus on sustainability; rather, it denotes a transition from general discourse to a more substantive and targeted discussion on specific issues. This evolution reflects the maturation of knowledge and discourse surrounding sustainability, signaling progress towards its refinement. The adoption of more precise terminology not only enhances legal discourse but also aligns with the increasingly specific regulatory framework pursued by the European legislative agenda.

From the specific perspective of Company Law, the crux of the debate is whether shareholders' duties should be aimed at maximizing shareholder value or whether, on the contrary, they can or should consider the interests of other stakeholders.

2. The debate around shareholder value and stakeholder value

Colin Mayer⁵ traces the origins of the idea of shareholder primacy to Adam Smith's thesis that individuals are guided by an invisible hand to further the interests of society and that individual owners are entitled to the profits of their property. The idea of ‘corporate ownership’ or ‘ownership organised on a corporate basis’ has been developed in various countries. In Portugal, this analysis has essentially been carried out in the context of the squeeze out⁶ and in Germany the debate has gained new momentum with the discussion on the need for a resolution by the general meeting and the existence of a redemption right for shareholders in the event of delisting.⁷ In any case, the protection of private property is not a sufficient reason to justify maximising shareholder value at all costs, not least because corporate property will always be subject to the pressures that may arise from the balancing of other principles of equal dignity. That is why I don't think that corporate ownership confers a right to demand that directors maximise shareholder value, but only a right to oppose illegitimate situations of exclusion.

Rather than focusing on shareholder ownership, proponents of shareholder value theories argue that this focus is necessary because shareholders are the ultimate risk bearers. This idea is reflected in all insolvency laws in that shareholders are the last to be satisfied, after all creditors.⁸ Another common argument is that shareholders are the principals of directors, who are their agents, which means that directors cannot pursue the full range of stakeholder interests.

It should be noted that, contrary to what is sometimes stated in the literature, increasing shareholder value does not necessarily mean seeking short-term profits. In fact, the value of a company corresponds to the ‘expected cash flows it can generate over time, discounted back at a ‘risk-adjusted’ discount rate’.⁹ None of the vectors of this concept refers to the idea of short-term value creation. On the contrary, a company may trade off lower profits in the short term for higher profits and cash flows in the future. None of the four drivers of company value – the growth lever, the profitability lever, the investment efficiency lever, and the risk lever – point in this direction. Creating shareholder value is therefore not necessarily about the pursuit of short-term profits.

Differently, stakeholder theory argues that companies should seek to consider the interests of all their stakeholders. These are seen as an end in themselves, not just as a means to an end.¹⁰ The most commonly used definition of stakeholder is provided by Freeman, who defines stakeholders as ‘any group or individual who can affect or is affected by the achievement of the organisation's objectives’,¹¹ which can include employees, customers, suppliers, local communities, and shareholders. Board members are bound by a ‘know your stakeholder rule’ because ‘the selection of relevant stakeholders is closely related to the purpose of each company’.¹²

If directors are to be loyal to various stakeholders, then stakeholder capitalism implies, at the very least, recognizing that directors are fiduciaries of the shareholders and not their agents. The difference is stark. Fiduciaries must decide independently on behalf of the beneficiary, whereas an agent must abide by the instructions of their principal. ‘An agent is an order taker, whereas a fiduciary is expected to make discretionary decisions’.¹³

In May 2017, a very interesting article by Joseph Bower and Lynn Pain was published in the Harvard Business Review. The article is entitled ‘The error at the heart of corporate leadership’ and it shows the fallacies of the economic theories that justify shareholder-centric corporate governance, short-termism and activist attacks on corporations.¹⁴ Bower and Pain challenge the idea of maximizing shareholder value by challenging its roots – the agency theory. ‘At the theory's core is the assertion that shareholders own the corporation and, by virtue of their status as owners, have ultimate authority over its business and may legitimately demand that its activities be conducted in accordance with their wishes’.¹⁵ Consequently, directors are mere agents to shareholders interests and only have ‘delegated decision-making authority’. The Authors challenge this idea, by emphasizing that shareholders do not own companies, they are only beneficiaries of the corporation's activities. This can be illustrated by the anonymity afforded to the shares' beneficial owners which mitigates shareholders’ relationship to the company (there is a phenomenon of separation of ownership from ownership, arising from the rise of institutional investors such as investment funds); the high turnover in shares, which means that asset managers make decisions driven by short term expectations. Although it is true that shareholders may vote on general meetings, they can exercise their voting rights in whatever way they deem appropriate. Additionally, the fact that exit strategies are easier than the ‘voice’ ones and the existence of empty voting scenarios also confirm that shareholders are physically and psychologically distant from the activities of the companies they invest in.

This confirms that directors should be seen as fiduciaries with the power to assess whether corporate decisions should take sustainability factors into account.

Stakeholderism has been implemented in several US states, that have been constituency states since the 1980s. In other words, they are states that explicitly reject shareholder value and extend the list of stakeholders to whom the board is accountable beyond the company and its shareholders. For example, Pennsylvania statutes empower directors to consider all relevant interests and to override shareholder interests in the event of a conflict.¹⁶ However, the fact that this rule is often interpreted in the light of shareholder value principles makes its actual impact on the position of stakeholders questionable.¹⁷

When we discuss the need to protect the company's stakeholders, we are essentially talking about non-contractual stakeholders. In fact, stakeholders who have a contractual relationship with the company can adequately protect their interests through the contract,¹⁸ and even if they don't, the company will always be bound by fiduciary duties of protection stemming from the law and, more specifically, from good faith, which aim to guarantee the integrity of the contractual relationship, but also of the business partner.¹⁹

Despite varying power dynamics between companies and their contractual partners, in certain instances, the influence of these partners can be significant enough to qualify them as controlling creditors or even de facto directors. Consequently, stakeholders lacking a contractual relationship with the company are often most in need of protection, though contractual stakeholders like employees may also be vulnerable.

The ongoing debate over whether directors' duties prioritize shareholder value or allow for consideration of other interests remains one of the most enduring classic modern debates.

The debate is classic in two distinct senses. Historically, it pertains to whether companies should serve public interests, a question recognized since the 19th century.²⁰ However, it was later acknowledged that pursuing general public interests is the domain of other fields of law, such as antitrust law, securities regulation, or environmental law, not companies themselves.²¹ Additionally, the debate is classic in that it resurrects longstanding structural and dogmatic arguments. Despite diverse angles of inquiry,²² fundamental questions persist regarding the role and functions of companies and the scope of company law. Central inquiries include the role of companies in promoting the common good, the purpose of companies,²³ and for whom companies are managed.²⁴

In this debate, conservative positions on the role of corporations in promoting the common good have emerged, which view the scope and functions of company law with caution and reservation.²⁵ For these authors, the positions that recognise the role of the company in promoting the common good are populist or, in Friedman's eloquent words of 1970, ‘unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades’. Friedman accuses the discourses on corporate social responsibility of being analytically loose and lacking in rigour.²⁶ On the other side of the spectrum, other authors point out that stakeholder capitalism is not a political vision, but it is still capitalism: ‘In today's globally interconnected world, a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders’.²⁷

In fact, the debate is never about the merits of ESG objectives, but rather about whether company law is the right channel through which to achieve them,²⁸ or whether this protection should be provided by other areas of law, such as environmental law, human rights law, antitrust or financial regulation.

In fact, it can be said that the primary function of company law is to define a corporate form and to contain the conflicts between participants, and that the overall objective is to serve the interests of society as a whole. This idea translates into promoting the aggregate welfare of all those affected by a company’s activities, from shareholders to third parties, such as local communities and beneficiaries of the natural environment.²⁹ Several authors, such as Armour, Hansmann, Kraakman and Pargendler,³⁰ argue that the best way to promote overall social welfare is to ensure that firms serve the best interests of their shareholders or, more specifically, maximise the current market price of the firm’s shares.

The best way to deal with the negative externalities of corporate activity would be through regulatory constraints imposed by other areas of the law. It has been said that ‘the use of legal rules and standards – the constraints strategy – to promote interests extraneous to the corporate form is, almost by definition, not corporate law, but the application to corporations – as legal persons – of norms from other fields of law’.³¹ At the same time, it has been said that legal strategies to maximize the value of the company are the lion's share of corporate law.³² However, when it is said today that companies should be managed to maximize shareholder value, it does not mean that companies should maximise pecuniary profit regardless of the means used.³³

Nevertheless, I think it's important to move towards the idea that company law can be steered by underlying values, such as sustainability. This is the direction in which the legal framework at the EU level has developed, which today has a legal framework designed to make companies feel strongly obliged to behave responsibly.³⁴ These measures are based on a set of disclosure requirements related to sustainability, demonstrating that transparency remains the cornerstone of financial regulation. However, behind traditional disclosure regimes, such as market abuse regulation or prospectus regulation was the idea that the price of a given financial instrument in the market reflects all the information made public at a given moment. Simply put, this is the conclusion of the Efficient Market Hypothesis, which, despite the obstacles posed by behavioural economics, continues to guide capital market disclosure requirements. On the contrary, I believe that behind the European regulation requiring the disclosure of sustainability information lies the aim of nudging companies to behave more responsibly.³⁵ We are witnessing a development in corporate law that is oriented towards the common good. The pursuit of shareholder value is not the most appropriate way of advancing overall social welfare. This means that, without neglecting financial sustainability, companies should seek to identify the stakeholders affected by their activities and take their interests into account in management decisions. In many cases, it will be advisable for companies to change their governance structure in order to address these issues more effectively.

The claim that this orientation is no longer company law presupposes a watertight and pre-defined conception of the content of company law, which does not recognise its permeability to other values and interests. The assumption that the interests of those affected are necessarily external to company law presupposes a fundamental value judgement and a fixed and definitive conception of what this area of law is. Company law is ultimately an applied civil law, permeable to the culture and need for protection of the various stakeholders. The permeability of civil law is well illustrated by the identification and densification of duties of good faith in German-influenced legal systems. Duties of good faith allow legal duties to be discovered where they were previously thought to be non-existent, thus achieving the perfection of the system. The underlying materiality takes precedence over the formal reality, making the law fairer and better able to regulate relations in society.

Whether the same can or should happen in company law is a complex question that needs to be properly considered. We should not start from an abstract legal construction regarding the purpose and functions of company law to conclude that it is not the appropriate vehicle for protecting interests outside the company.

The need to revisit these fundamentals must be considered. The law is a living entity, ready to provide answers to the problems of legal relevance that arise.

Opponents of prioritizing stakeholder value argue that board members lack the necessary skills and experience to address social problems effectively. Furthermore, since board members are not democratically elected, proponents assert that it is not their role to tackle such issues.³⁶ Rather, they advocate for the protection of third-party interests through the adoption of laws and public policies aimed at safeguarding stakeholder groups. Examples include worker protection laws, consumer protection legislation, and carbon taxes, which proponents argue provide more robust protection for stakeholder interests.³⁷

3. From the Friedman doctrine to the United Nations' Sustainable Development Goals

To illustrate the problem at hand, studies on corporate sustainability and corporate purpose typically draw on Friedman's doctrine as a starting point. Although this doctrine has been cited more than one can keep track of, and ‘most of the ESG literature starts with an almost perfunctory dismissal’³⁸ of this thesis, it is still a good place to start. Friedman questions the role and purpose of corporations, their relationship with shareholders and other stakeholders. According to Friedman: ‘There is one and only social responsibility of business - to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud’.³⁹

Contrary to some impressions, Friedman does not argue that a company should always maximise profits and cannot pursue other goals.⁴⁰ Friedman merely explains that a company’s directors are employees or agents of the company's owners (the shareholders). ‘Social responsibilities’ lay with individuals acting as principals, not agents. Therefore, directors have a direct responsibility to their employers to run the company in accordance with their wishes. Even though the general desire of shareholders is to ensure the profitability of the company within the applicable legal and ethical framework, it is possible that shareholders may have a different objective. There is no such thing as corporate social responsibility. Friedman illustrates his thesis by saying that if a company director had a social responsibility, this would mean, for example, that he should refrain from raising the price of a product in order to contribute to the social objective of preventing inflation. But in that case, he would be spending someone else's money for a general social good, which means he would be levying taxes and deciding how to spend the tax revenue. These are government functions.

To the argument that the problems are too urgent to wait for the course of political processes to work themselves out, Friedman replies that those who hold this view ‘are seeking to attain by undemocratic procedures what they cannot attain by democratic procedures’.⁴¹ Once again, responsibility for the common good lies with democratically elected public bodies.

This view has been echoed by several authors who consider that asking companies to be ‘society's conscience is not only unfair, but it tilts the playing field in favour of the least socially conscious investors and companies’.⁴²

Notwithstanding the conservative - one could say sceptical - views about the company's role in promoting social welfare, the 2030 Agenda for Sustainable Development,⁴³ adopted by all United Nations Member States in 2015, seems to point to a different path. The Agenda establishes 17 Sustainable Development Goals (‘SDG’), which define global sustainable development priorities and aspirations for 2030 and call for global action among governments, civil society, the United Nations systems, and the private sector. The Agenda expressly acknowledges that ‘private business activity, investment and innovation are major drivers of productivity, inclusive economic growth and job creation. [...]’ and as such the United Nations ‘call on all businesses to apply their creativity and innovation to solving sustainable development challenges’.⁴⁴ According to the United Nations, the relevance of the private sector is undisputable, although little is said about how the SDGs should be pursued or how the interests of shareholders are articulated with those of other stakeholders. However, when analysing the SDG Compass – the guide for business action on the SDGs⁴⁵ the perspective adopted is less ambitious than that which would appear to result from the Agenda. According to the Compass, if corporations align themselves with the SDGs, the benefits of this exercise will be felt in terms of (i) identifying future business opportunities; (ii) enhancing the value of corporate sustainability; (iii) strengthening stakeholder relations and keeping pace with policy developments; (iv) stabilising societies and markets; and, finally, (v) using a common language and shared purpose. The language used by the SDG Compass, as well as the rationale presented for encouraging the alignment of companies with sustainability, are deeply committed to the idea that this alignment is ultimately a way of maximising shareholder value.

At its core, the idea behind the Compass is that doing well goes hand in hand with being good, which translates into the business case for sustainability, metaphorically presented as a virtuous cycle.⁴⁶ This is also the assumption behind most legal studies on corporate sustainability and behind the well-known Letters to CEOs that Larry Fink, CEO of Blackrock, publishes every year. In 2020, Larry Fink stated that ‘each company's prospects for growth are inextricable from its ability to operate sustainably and serve its full set of stakeholders’ and, furthermore, that a ‘company cannot achieve long-term profits without embracing purpose and considering the needs of a broad range of stakeholders [...] Ultimately, purpose is the engine of long-term profitability’.⁴⁷

It is true that some studies show a positive relationship between the social responsibility of a company and its market valuation.⁴⁸ Moreover, other studies indicate that employee satisfaction can increase shareholder return.⁴⁹ However, the defense of a model of stakeholderism entails acknowledging that this relationship is not always established. In fact, not all empirical studies support these conclusions. We must also consider that some authors argue that evidence that socially responsible firms have lower discount rates and investors have lower expected returns is stronger than the evidence that socially responsible firms deliver higher profits or growth. For example, Fama and French build a model to determine how disagreement and tastes for assets as consumption goods can affect asset prices,⁵⁰ which, when applied to the question under analysis, determines that if investors have a preference for highly rated ESG stocks, then those stocks offer lower average excess returns.⁵¹ On the other hand, the so-called sin stocks – shares in companies involved in the marketing of alcohol, tobacco and gambling – are associated with higher expected returns to compensate for the reputational cost associated with holding them.⁵² Cornell and Damodoran⁵³ document that the alignment between profit and sustainability may exist in cases where the company is (i) smaller, rather than larger, (ii) a niche business, with a more socially conscious customer base, (iii) privately held or a public company closely held by its founders, which mitigates the compromises the company must make in order to please the shareholders. However, with scaling up, the company will be faced with the dilemma: continue to grow or curb that growth to the extent necessary to ensure that it remains good. To acertain extent, this dilemma has been played out by Larry Fink, a great advocate of responsible capitalism. Faced with rising energy prices, BlackRock announced that it was likely to vote against shareholder's resolutions pursuing a ban on new oil and gas production. In fact, responsible investors, who underweight oil and gas investments, have underperformed conventional funds. Ultimately, when sustainability and profits are not aligned, many ESG-friendly investors seem to question their strategy, precisely because the most sustainable path is not always the most profitable.

On the other hand, there is stronger scientific support for the view that irresponsible companies are punished by investors and markets. Consider the striking example of the pharmaceutical company Valeant, which bought drugs under patent protection and then raised prices, generating considerable profits. The fact that this business strategy was legal did not prevent the market from reacting to Valeant's clear ethical and moral violation, which resulted in the company’s bad reputation, the need to replace directors, change the business model and even change its name. This is a clear example of the fact that the market does not tolerate all behaviour, i.e. that the market ends up punishing bad companies.

In other words, it is not possible to discover a direct economic incentive for companies to adopt sustainable behaviour, but only a disincentive to adopt reprehensible behaviour, based on fear of the market's reaction.

Moreover, the possibility of assessing the relationship between social responsibility and corporate profitability is hampered by the fact that there is no consensus on what behaviour should be considered good. Although the transparency measures introduced at the European level are intended to ensure uniformity and control in what is disclosed to investors, the lack of universal metrics and standards makes it very difficult to analyse and compare information.⁵⁴

Any discussion on the relationship between corporate governance and sustainability must therefore start from the premise that there is no definitive empirical evidence on the relationship between profit and sustainability⁵⁵ and, at least in some cases, the interests of shareholders and other stakeholders clearly diverge. This is the only way to have a serious debate and address the issue effectively. Attempting to cloak sustainability in the guise of the pursuit of profit is a ploy that does little to advance the dogmatic development of the issue. The path to a stakeholder-friendly governance model requires the assumption and acceptance that not all decisions that put the interests of stakeholders first are beneficial to shareholders.

4. Concluding remarks

The shift in company law towards sustainability implies a change in corporate culture, which must include a change in the way we view the role of shareholders as owners of the company. The way in which company law moves towards financial sustainability that does not profit from the loss of others will differ from country to country and from era to era. It has been emphasised that corporate law reflects political and efficiency effects along the way. One of the fundamental differences that needs to be taken into account is the ownership structure of firms, as this influences the operation of different legal strategies and affects the interest group dynamics that drive changes in corporate law. Therefore, any specific strategy adopted by a company must take into account its specific environment, in terms of the economic sector in which it operates, the nature of the market and the shareholder structure.

What this reorientation entails will be the subject of my subsequent article in this Forum.