Corporate governance is about controlling and directing the company. The starting point is the objective of the company. In the shareholder model, the ultimate control is with shareholders, who usually aim to maximise company profits and thus put financial value as the company objective. In contrast, the stakeholder model includes other stakeholders, notably employees and customers, alongside shareholders. The integrated model expands the company objective to integrated value, which combines financial, social, and environmental value. This includes not just current stakeholders and shareholders, but also future stakeholders, by representing the environment and people not yet born.
The conflict of interest between managers and shareholders has been at the heart of corporate governance research for decades. However, this debate changes if one broadens the objective of the firm to integrated value. How does one balance the interests of the various stakeholders? What information is used for this balancing? What ownership structures and governance mechanisms are most effective in balancing these interests? How can management be held accountable to stakeholders? The answers lie in the concept of integrated value as introduced in Chap. 1. It provides guidance on the required information; the alignment of interests; accountability; and decision-making, which involves dealing with trade-offs between the interests of various stakeholders.
Overview
Corporate governance is about controlling and directing the company. The starting point is the objective of the company, a central theme in this corporate finance book. In the shareholder model, the ultimate control is with shareholders, although several mechanisms may limit the power of shareholders in practice. Shareholders aim to maximise company profits and thus put financial value as the company objective. In contrast, the stakeholder model includes other stakeholders, notably employees, alongside shareholders. Depending on its particular version, it may or may not include other important stakeholders, such as customers, suppliers, and local communities in which companies operate. The stakeholder model focuses on financial and social value as the company objective. Finally, the integrated model takes future stakeholders into account, by representing the environment and people not yet born. The integrated model expands the company objective to integrated value, which combines financial, social, and environmental value.
The emergence of the integrated model changes the discussion in corporate governance. Thus far the discussion has focused mainly on the question ‘Is management acting in the interests of shareholders and other stakeholders of the company?’ This question arises from the separation of ownership and management in the publicly listed company. The conflict of interest between managers and shareholders has been at the heart of corporate governance research for decades. To some extent, it has been challenged by stakeholder theory. However, the corporate governance debate should be broadened to include other stakeholders, the environment, and future stakeholders.
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In corporate governance, there are two related problems: (1) asymmetric information between insiders and outsiders and (2) agency problems between management (agents) and stakeholders (principals). As corporate ownership varies around the world, corporate governance challenges differ. Nevertheless, corporate scandals occur in all corporate governance regimes.
The balancing of the interests of various stakeholders is central to corporate governance. But what information is used for this balancing: is it financial information only? Or is social and environmental information included as well? What ownership structures and governance mechanisms are most effective in balancing these interests? How can management be held accountable? The answers lie in the concept of integrated value as introduced in Chap. 1. It is instrumental in providing the required information and aligning the interests of financial, social, and environmental stakeholders in ex-ante decision-making and ex-post accountability. Integrated value can also provide guidance on dealing with trade-offs between the interests of various stakeholders. In contrast, the shareholder model gives priority to financial value, as most shareholders are financially driven. The stakeholder model lacks good measures of comparison and tends to focus on specific stakeholders while neglecting others.
Learning Objectives
After you have studied this chapter, you should be able to:
Explain the role of corporate governance in steering companies’ behaviours
Analyse the influence of asymmetric information and agency problems
Distinguish and analyse the main corporate governance models
Explain how the interests of various stakeholders can be balanced
Describe differences in ownership structures across the world
3.1 Current Corporate Governance Models
Disconnects between the owners or shareholders of a company, its managers, and the society in which the company operates can and do happen. Hence, the importance of corporate governance, which refers to the mechanisms, relations, and processes by which a company is controlled and directed. It involves balancing the many interests of a company’s stakeholders. Modern insights from corporate governance go beyond financial factors. At the core of corporate governance, there are two problems (see Fig. 3.1).
2 inward opposite arrows are labeled corporate management or agents, and shareholders and stakeholders or principles. It includes 2 texts. 1, information asymmetry between principals and agents. 2, agency problem in which agents not acting in the interest of the principals.
Fig. 3.1
The two main corporate governance problems
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The first is asymmetric information about a company between the insiders of the company (corporate management) and the outsiders (stakeholders). The second is the agency problem whereby the agents (corporate management) may not act in the interest of the principals (stakeholders). These two problems aggravate each other: the information asymmetry makes it harder to ascertain to what extent the agent works for the principals, while the agency problem gives incentives to the agents to worsen information asymmetry. This section reviews the current shareholder model and stakeholder models. Section 3.2 introduces the integrated model of corporate governance.
3.1.1 The Shareholder Model
As corporate ownership varies around the world, so do corporate governance challenges. Anglo countries (a group of English-speaking countries made up of the United Kingdom, Australia, the USA, Canada, and New Zealand) typically have companies with dispersed shareholders, and active trading in stock markets. La Porta et al. (1999) indicate that common law countries such as the UK, USA, Australia, and Canada fit this picture. In this setting, classical agency theory focuses on conflicts of interest between owners (i.e., shareholders) as principals and managers as agents (Jensen & Meckling, 1976). Does the manager put in enough effort? Does he or she act in the interest of the shareholder? Solutions are found in the control and incentivisation of managers. Examples are contracts for a limited term (typically 4 years) and performance-related pay (see Sect. 3.4). A strong element of the shareholder model is the accountability of management and the scope for correction, such as the removal of management or takeover of the company in case of underperformance (see Chap. 18).
However, these solutions can create new problems, because managers might become incentivised to focus on short-term profits only. Shareholder value is a long-term concept, because it incorporates all future cash flows. But there is evidence of managers focusing on short-term earnings targets (Graham et al., 2005). Furthermore, managers with short-term incentives, such as stock and options packages, cut investment to meet short-term earnings targets (Edmans et al., 2017). Short-termism can result in massive losses for both shareholders and stakeholders. Box 3.1 provides an example.
Box 3.1: Short-Termism at Boeing
As highlighted in this example from aircraft manufacturer Boeing, short-termism can result in massive losses for shareholders and stakeholders. Boeing hid significant instrument and flight-control risks in its 737 MAX aircraft from airlines. This resulted in two crashes in 2018 and 2019, in which 346 people died. A CNN article1 argued that Boeing’s 737 Max debacle could be the most expensive corporate blunder ever: ‘Boeing has detailed about $20 billion in direct costs from the grounding: $8.6 billion in compensation to customers for having their planes grounded, $5 billion for unusual costs of production, and $6.3 billion for increased costs of the 737 MAX program’.
The article then went on to say that the indirect costs of cancelled orders could be double that number, resulting in total costs of well over $60 billion. A Los Angeles Times article2 argued that Boeing had sacrificed quality on the altar of shareholder value: ‘Chief Executive Dennis Muilenburg testified before Congress. He was awful. He kept saying that safety was part of Boeing’s DNA, yet the evidence that angry legislators confronted him with—internal emails, for the most part—suggested just the opposite: that safety was no longer high on Boeing’s list of priorities. What was ascendant was maximising shareholder value, with catastrophic consequences’.
Controlling Shareholders and the Risk of Tunnelling
In contrast to the common law countries, mainland Europe and Asia have more companies with controlling shareholders. This brings more direct relations with management and potentially, better monitoring. However, these companies may still disadvantage minority shareholders (and other stakeholders). A case in point is the illegal business practice of tunnelling, whereby a controlling shareholder directs company assets to themself for personal gain (e.g., to other parts of their business group) at the expense of minority shareholders (Bae et al., 2002; Bebchuk & Weisbach, 2010). Strong shareholder protection measures are, then, a solution to protect minority shareholders. The controlling shareholder, often the family or the state, can directly appoint the manager (La Porta et al., 1999). In these civil law countries, the market for corporate control is less active, and management is held less accountable and more entrenched than in common law countries. As a result, intervention in underperforming companies can be delayed—or not happen at all.
3.1.2 The Stakeholder Model
Civil codes typically embrace the interest of a broad set of stakeholders, notably employees (Freeman, 1984). As explained in Chap. 1, the stakeholder model argues that managers should balance the interests of all stakeholders, which include financial agents (shareholders and debt holders) as well as social agents (employees, consumers, suppliers). The corporate law of stakeholder-oriented countries tends to specify that boards should act in the interest of the company and its stakeholders. Some countries, such as Germany, even enshrine the rights of employees in legislation. In the so-called system of codetermination, both shareholders and employees can appoint representatives to a company’s board. This may still result in poor outcomes, with shareholder and employee interests being maximised at the expense of other stakeholders. For example, in the Dieselgate scandal at Volkswagen, the shareholders pushed for profits (F), the local government pushed for jobs (S), and the E suffered as engineers gamed engine software to artificially meet emissions standards (see Box 3.2 below).
Liang and Renneboog (2017) find that cross-country variation in companies’ sustainability efforts is partly explained by legal origin. Legal origin refers to the distinction between common law (created by judges and written opinions) and civil law (rooted in Roman law, with core principles coded into a referable system), which are alternative systems of social control of economic life. Environmental, social, and governance (ESG) scores tend to be higher in civil law countries than in common law countries, reflecting social preferences for good corporate behaviour and a stakeholder orientation. Such social preferences are embedded in rule-based mechanisms that restrict firm behaviour ex ante. These mechanisms are more prevalent in civil law countries. In contrast, ex-post judicial settlement mechanisms are more important in common law countries. The English common law tradition emphasises shareholder primacy and a private market-oriented strategy of social control; and perhaps because of this emphasis, it is also less stakeholder-oriented (Liang & Renneboog, 2017).
Corporate Governance Codes
As legislation lacks flexibility, best practices in corporate governance are typically enshrined in corporate governance codes, which can be updated more frequently. Leading countries have a corporate governance committee or council with members drawn from industry, investors, trade unions, and academia. Corporate governance codes have started to address the narrow shareholder perspective and short-termism in financial markets. Interesting examples are the Dutch and UK corporate governance codes, which include long-term value creation for a company’s various stakeholders as a corporate objective.
3.1.3 Governance and Company Value
Good governance contributes to the value of the company. Well-run companies are better able to realise their long-term (or integrated) value potential by making better decisions, including investment decisions. In contrast, bad governance depresses company value and can lead to corporate defaults (see Box 3.2). The higher valuation of well-run companies is a combination of expanding business (integrated value creation) and reducing risk (lower cost of capital). The strength of corporate governance varies across countries. First, the ownership structure varies across the world, as set out in Sect. 3.3. Next, there is a strong correlation between company-level governance and the broad institutional setting of a country. Leakage of capital from companies, which is accommodated by weak country-level institutions, is detrimental to building sustainable business (Khan, 2019).
No corporate governance model is immune to corporate scandals, which can and do happen in all major regions. Well-known examples are Enron in the USA, Volkswagen in Europe, and Olympus in Japan (see Box 3.2). These corporate scandals reveal classical agency problems in companies, whereby management has several ways to boost profits and hide problems. The aim of corporate governance is to mitigate these agency problems.
Box 3.2: Corporate Scandals Across the World
Enron
The collapse of Enron in 2001, at the time the largest corporate bankruptcy in American history, involved the use of accounting loopholes, special purpose entities, and poor financial reporting. In that way, management (i.e., the CEO and the CFO) of the energy company was able to hide billions of dollars in debt from failed deals and projects. These practices inflated Enron’s accounts and performance. The bankruptcy of Enron also led to the closure of its accountant, Arthur Andersen.
Volkswagen
In 2015, the US Environmental Protection Agency found that many VW cars sold in America had a ‘defeat device’ (software) in diesel engines which could detect that the engines were being tested, changing the performance accordingly to improve results. Volkswagen engineers installed the software as they were under pressure from the company’s major push to sell diesel cars in the US, backed by a huge marketing campaign proclaiming its cars’ low emissions. Volkswagen admitted cheating emissions tests in the USA and paid billions in damages. As a response, there was a major overhaul of VW’s management board in Germany.
Olympus
In October 2011, Michael Woodford was suddenly ousted as chief executive of optical equipment manufacturer Olympus, launching a scandal. Woodford’s ‘sin’ was that he exposed ‘one of the biggest and longest-running loss-hiding arrangements in Japanese corporate history’. Irregular payments for acquisitions resulted in very significant asset impairment charges in the company’s accounts. The corruption scandal involved concealment of more than 117.7 billion yen ($1.5 billion) of investment losses and other dubious fees, as well as suspicion of covert payments to criminal organisations. By 2012, the scandal had wiped out 75–80% of the company’s stock market valuation and had led to the resignation of much of the board.
3.2 The Integrated Model of Corporate Governance
To update the stakeholder model, the integrated model of corporate governance introduces integrated value, which combines financial, social, and environmental value, as a central company objective. The company then optimises the interests of both current and future stakeholders. Table 3.1 compares the three main models, which are explained in Chap. 1. The differences between the models follow from their different objectives. In the shareholder model, the company is supposed to be run in the interests of the shareholders, thus to maximise financial value. The other models hold that managers should act in the interests of the stakeholders, including shareholders, and expand the company objective to stakeholder value and integrated value, respectively.
Table 3.1
Comparing corporate governance models
Dimension
Shareholder model
Stakeholder model
Integrated model
Objective
Shareholder value
Stakeholder value
Integrated value
Optimisation
FV
STV = FV + SV
IV = FV + SV + EV
Stakeholders
Shareholders
Current stakeholders
Current and future stakeholders
Assumptions
• Shareholders, as residual claimants, ‘own’ the company and deserve control
• Serving the interests of other stakeholders is instrumental to shareholder value
• Managers act in the interest of the company on behalf of financial and social stakeholders
• Managers act in the interest of the company on behalf of financial, social, and environmental stakeholders
Implications
• Shareholder value provides clear guidance for decision-making and accountability
• Social and environmental value considerations come second, if considered at all
• Multiple objectives suggest unclear guidance and require balancing rules for decision-making and accountability
• Financial and social value considerations incorporated
• Environmental value considerations come second, if considered at all
• Multiple objectives suggest unclear guidance and require balancing rules for decision-making and accountability
• Financial, social, and environmental value considerations incorporated
Note: FV, financial value; SV, social value; EV, environmental value; STV, stakeholder value; IV, integrated value
The strength of the shareholder model lies in its single measure of success (shareholder value), which improves the simplicity of decision-making and accountability—but at the cost of ignoring social and environmental objectives. Chapter 2 shows how companies can create integrated value by combining economic (shareholder) and societal (other stakeholders) value. While the stakeholder and integrated models include these interests, the multiple objectives provide unclear guidance for decision-making and accountability (Tirole, 2001). The solution is to develop rules for balancing the interests of the various stakeholders. The balancing of interests for integrated value creation can be done qualitatively and quantitatively.
3.2.1 How Can Interests Be Balanced?
Mayer (2018, 2022) argues that directors should act according to the company’s purpose: the reasons why the company was created, why it exists, and what it is there to do. These reasons should be the guiding star of the board, and not the rigid rules of shareholder rights or primacy that trump other interests. It is in light of the company’s purpose, and its associated values, that the board’s actions and performance should be judged. Directors have the right to act with judgement—business judgement—and they should exercise that judgement in a form that they believe is appropriate to the circumstances. By making corporate values explicit, management becomes accountable to deliver on corporate purpose. Mayer (2022) encourages a multiplicity of purposes across companies, and competition in models to deliver them, to stimulate innovation. This also means that companies should report on their performance in achieving their purpose. For example, if a company’s purpose is to improve people’s health, the company should collect data on the health improvements it achieves and report on it (see Chap. 17).
A different approach is taken by Edmans (2020). He develops principles of multiplication, comparative advantage, and materiality, which do not rely on calculations. Edmans (2020, p.61) stresses that ‘value is only created when an enterprise uses resources to deliver more value than they could do elsewhere—the social benefits exceed the social opportunity costs’. The three interrelated principles should guide a manager’s judgement to deliver value in complex situations with multiple stakeholders. The principle of multiplication ensures that the social benefits exceed private costs, which is an easy hurdle to pass. The principle of comparative advantage requires the company to deliver more value with an activity than other companies would. Finally, the principle of materiality asks whether the stakeholders that benefit from the company’s activity are material to the company. The combined application of these principles makes it likely that the activity creates profits by creating value for society. However, this does not necessarily mean that negative impacts are avoided.
The common element of these qualitative approaches is that a company should—in accordance with its purpose—deliver value to its main stakeholders. Both Mayer (2018) and Edmans (2020) argue that it is not only difficult or impossible to forecast the monetary effect on each stakeholder, but also difficult to weight the different stakeholders. Therefore, you cannot measure overall societal value. This leaves the problem of holding management accountable to its multiple stakeholders (Bebchuk & Tallarita, 2021; Tirole, 2001).
3.2.2 Integrated Measure
To address the accountability challenge, an integrated measure that captures overall societal value is needed. Chapter 6 develops an integrated value measure that balances financial, social, and environmental value. This is done by expressing social and environmental value in monetary terms and attaching different parameters to each type of value, depending on a company’s purpose. The basic model for integrated value (see Eq. (1.4) in Chap. 1) is as follows:
$$ IV= FV+b\cdot SV+c\cdot EV $$
(3.1)
where FV, SV, and EV represent financial, social, and environmental value (see Chap. 6 on the methods to measure social and environmental value). The parameters b and c are the weightings for the social and environmental value dimensions.
These decision rules allow for a structured balancing of stakeholder interests. The company board can set the parameters (b and c) of the decision rules in advance and in dialogue with the company’s main stakeholders (Schoenmaker et al., 2023). As a result, management has clear guidance for selecting investment projects and can be held accountable by its main stakeholders on the delivery of integrated value (IV) against these rules. Chapter 6 explains the working and application of the integrated value measure in more detail. Appropriate measurement and reporting on integrated value (see Chap. 17) also help to reduce asymmetric information between management and stakeholders.
A key issue in the design of decision rules is the weighting across the value dimensions. While shareholder-driven companies only value the financial dimension (b = c = 0), companies that pursue integrated value creation also give a positive weight to the social and environmental dimensions (b = c ≫ 0). But by how much? The current regime is characterised by a very small weighting of social and environmental value, in the order of magnitude of b = c = 0.1. This is quite close to the shareholder model.
What weights should a responsible company pursuing integrated value choose? There are two reasons to take social and environmental value into account. The first reason is normative: companies may want to behave responsibly (b = c = 1) to keep their license to operate, as explained in the Introduction of this book. The second reason is that companies may want to improve their competitive position by including social and environmental value in their business model ahead of the expected internalisation of negative impacts. The transition dynamics towards sustainable products and services can go fast, as explained in Chap. 2. Early adopters can build a competitive advantage.
The model allows companies to choose their degree of sustainability from intermediate (b = c = 0.5) and equal weights (b = c = 1)3 to purposeful (higher weights for the social and environmental dimensions than for the financial dimension; b = c > 1). The majority of responsible companies may apply intermediate or equal weights, depending on the expected speed of internalisation. An example of a company that appears to be applying intermediate weights of approximately one half is the Dutch-Swiss nutrition company DSM-Firmenich. Through a combination of strategic acquisitions and internal restructuring, DSM has been transforming itself from a chemical company to a nutrition company anticipating the transition to healthy food (see Box 18.4 in Chap. 18 on the DSM transformation).
A minority of purposeful companies are leaders in the shift to operating within social and planetary boundaries by shaking up industries and supply chains. Those that are able to scale up their comparative advantage are the ultimate frontrunners that accelerate the transition to a sustainable economy (Edmans, 2020). An example of such a frontrunner is Patagonia, the outdoor clothing company, which sets very rigorous standards for sustainable clothing. Chapter 11 highlights the sustainability challenges for the fast-fashion industry.
Interestingly, Patagonia’s founder announced in 2022 that he was giving away the company to protect its purpose. This is how he put it in an open letter4: ‘Instead of “going public”, you could say we’re “going purpose”. Instead of extracting value from nature and transforming it into wealth for investors, we’ll use the wealth Patagonia creates to protect the source of all wealth. Here’s how it works: 100% of the company’s voting stock transfers to the Patagonia Purpose Trust, created to protect the company’s values; and 100% of the nonvoting stock had been given to the Holdfast Collective, a non-profit dedicated to fighting the environmental crisis and defending nature. The funding will come from Patagonia: Each year, the money we make after reinvesting in the business will be distributed as a dividend to help fight the [environmental] crisis’.
3.3 Ownership and Integrated Value Creation
3.3.1 The Public Company
From the onset of the Industrial Revolution, the public company emerged as the main corporate vehicle in the United Kingdom and the USA. It enabled external financing on stock markets for the large investments needed to build industrial factories and infrastructure. For example, in the USA in the nineteenth century, the largest stock-listed companies were railroad companies. These Anglo countries typically have widely held firms, with dispersed shareholders and active share trading in stock markets. Figure 3.2 indicates that the United Kingdom, the USA, Australia, Canada, and Ireland fit this picture (first panel). The shareholder model is the leading model in these common law countries.
3 Bar graphs for widely held, family-held, and state-held percentage values of 27 countries have a decreasing trend, fluctuating trend, and fluctuating trend, respectively.
Fig. 3.2
Corporate ownership around the world. Note: The figures classify countries according to corporate ownership. They present means for each variable, using 10% as the criterion for control, for a sample of the 20 largest firms in 27 countries. Source: Adapted from La Porta et al. (1999)
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In contrast, Continental Europe, Asia, and Latin America have more firms with controlling shareholders in the form of a family or a state (second and third panel). External finance is then raised predominantly through bank loans instead of shares. These countries typically adopt the stakeholder model. Figure 3.2 shows that family or state ownership is common in Switzerland, Germany, France, the Netherlands, Italy, Spain, South Korea, Hong Kong, Singapore, Argentina, and Mexico.
The public company is an important corporate vehicle, but there are alternative solutions for the organisational form of companies. An important question is to what extent these alternative forms of organisation can be scaled up.
3.3.2 Alternative Company Forms
Private Companies: Held by Families, Foundations, and Private Equity
The first alternative to the publicly listed and widely held company is the private company. As public companies have difficulties resolving agency problems between investors and managers, private companies financed by debt and private equity are gaining in importance (Kahle & Stulz, 2017). The private equity holder is directly involved with management and can intervene directly with the company (see Chap. 10). Private equity adopts absolute performance measurement, which is generally better aligned with company interests than the relative view of institutional investors on publicly listed companies (see Box 3.3). The private equity model can be scaled up, as institutional investors are an important source of capital for private equity. However, there are capacity limits in terms of the skills required and costs made.
Box 3.3: Relative Versus Absolute Performance Measurement
Investors in publicly listed companies typically focus on the relative performance of companies, as their own performance as investors is judged relative to the market index (see Chap. 12). They are thus less interested in the specifics of individual companies, which they label ‘portfolio’ companies, as long as the performance is in line with the market.
In contrast, private equity investors are interested in the absolute performance of their companies. In fact, they can hardly judge relative performance since they have difficulty comparing the performance of their company with that of other companies, as there are no stock prices available. Private equity investors perform fundamental analysis based on a company’s cash flows, return on invested capital, EBIT margins, and growth prospects. All these metrics are used to arrive at an assessment of the intrinsic value of a company (De Jong et al., 2017).
Other sources of private equity with concentrated ownership are families and foundations. Industrial foundations are often created by the founder or their family, who typically wants to continue the family business. Members of the founding family remain active on the boards of many industrial foundations (Thomsen et al., 2018). Box 3.4 shows the example of the IKEA foundation. Thomsen et al. (2018) show that foundations are patient and committed shareholders, enhancing the longevity of companies. While the tension between shareholders and other stakeholders is still present in privately owned companies, some families or foundations are adopting integrated (or long-term) value creation as an investment goal (De Jong et al., 2017). Family firms excel at smoothing out industry shocks and manage to honour implicit labour contracts. This allows family firms to pay lower wages (Sraer & Thesmar, 2007).
Box 3.4: IKEA Foundation
IKEA is a well-known company that designs and sells ready-to-assemble furniture, kitchen appliances, and home accessories. Founded in Sweden in 1943 by the 17-year-old Ingvar Kamprad, IKEA has become one of the world’s largest furniture retailers.
The founder created two foundations that own the IKEA group, INGKA foundation and Interogo foundation. In 2013, Ingvar Kamprad stepped down and appointed his youngest son Mathias Kamprad as chairman. Mathias and his two older brothers, who also have leadership roles at IKEA, work on the corporation’s overall vision and long-term strategy.
The Cooperation
A second organisational form is the cooperation. A cooperation or cooperative is created by groups of people, such as customers or suppliers, working together for common or mutual benefit instead of profit. The interests of the major stakeholders (i.e. customers or suppliers) are then aligned with the company in the cooperation model. A major drawback, however, is that a cooperation cannot raise equity beyond its members. The lack of access to external equity can become a constraint on expansion when the cooperation grows large or makes a loss (eroding equity). Moreover, cooperatives do not always incorporate the interests of stakeholders beyond their membership. Cooperatives go back to the nineteenth century (see Box 3.5).
Box 3.5: Credit Cooperatives
The credit cooperative was an answer to the problems farmers had in obtaining credit from regular banks during the agricultural depression in Germany in the 1850s. Raiffeisen created a firm jointly owned by German farmers: the credit cooperative. It was based on democratic governance by members, long-term horizon and relationships, locality, and combination of economic and social goals (Groeneveld, 2020).
The Raiffeisen cooperative model is still present today, for example in the Dutch Rabobank, the Austrian Raiffeisen Zentralbank, and the German Raiffeissen cooperatives.
B Corporation
A third organisational form is the B corporation, which is a company that is certified as meeting certain social and environmental standards (Kim et al., 2016). The B corporation certification is provided on a private basis to for-profit companies by B Lab, a global non-profit organisation. To be granted certification, and to preserve it, companies must receive a minimum score for ‘social and environmental performance’. Public transparency and accountability for balancing profit and purpose are other requirements. However, the B corporation has no legal status, unlike the benefit corporation, which is a legal form conferred by State Law in the USA. Figure 3.3 shows the exponential rise of certified B corps. The number of B corps rose from 43 in 2008 to 4413 in 2021, spanning 77 countries.
A bar graph estimates the number of certified B corporations from 2008 to 2021. The highest bar has a value of 4400 in 2021. The value is estimated.
Fig. 3.3
Number of certified B corporations. Source: Adapted from B Lab
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The B corporation highlights the tension between the shareholder and the integrated model, described in Sect. 3.2. Danone, a global food company and one of the larger B corps, is an example where tensions came to the surface (see Box 3.6).
Box 3.6: Danone as B Corp
Danone is a global food company headquartered in France. It is an industry leader in implementing sustainable agricultural practices. While Danone aims for 100% B corp certification, several divisions of Danone have already acquired B corp certification.
B corps are accountable for balancing profit and purpose, which in this book we call integrated performance (financial, social, and environmental). In early 2021, activist investors started to pressure Danone on its poor financial performance and asked for the dismissal of its CEO, Emmanuel Faber, who championed Danone as B corp. Ideally, the CEO would have been held accountable for Danone’s integrated performance by its stakeholders. However, the shareholders called the shots and fired the CEO because of poor financial performance.
Of course, companies need to meet financial, social, and environmental performance standards. However, accountability should be based on a holistic view of the three dimensions. In practice, this means that the board needs to ensure that profit (financial performance) and purpose (social and environmental performance) are well balanced. A prolonged shortfall on either side creates pressure.
Social Enterprise
A fourth organisational form is the social enterprise or foundation with a social or environmental objective (e.g., a hospital promoting health care). These social enterprises or foundations are non-profit, but to continue their operations they need to obtain sufficient funding, which may involve pressure from funders. Societal impact comes first at these organisations, reflected in a higher parameter value for b and/or c in Eq. (3.1). To prevent governance problems, these parameters are best set explicitly by management in discussion with its stakeholders.
Governmental Organisation
A fifth organisational form is a governmental organisation with a public objective. This ranges from a full governmental organisation to a (majority) state-owned company or a private company with government intervention (by means of strict regulations or Pigouvian taxes; see Chap. 2). The advantage of governmental organisations is that they are run for the public good. However, the challenge is to operate efficiently in the public domain, as the profit motive is missing. Moreover, governmental organisations are dependent on the public budget for expansion, which may lead to underinvestment when public finances are tight. Box 3.7 discusses the importance of state-owned companies in China.
Box 3.7: State-Owned Enterprises in China
State-owned enterprises (SOEs) play an important role in the Chinese economy. While SOEs have lower economic performance (due to low production efficiency), they also have advantages (Lin et al., 2020):
1.
Government interventions in the market can benefit the economy by maximising resource mobility to capital-intensive industries, which are essential for the economy
2.
SOEs are a second-best way to maintain social stability by offering employment during economic recessions
3.
The government can use SOEs to maintain control over key elements of society: the ‘commanding heights’ of state control
The Chinese government can thus implement social and environmental policies in a more direct way through its SOEs. SOEs have two sets of agency problems. The first is between the controlling shareholder (the state) who has 100% of the voting rights and the minority shareholders (see Sect. 3.1). The second is between the controlling shareholder (the state) and the managers.
On the financing side, the Chinese banking sector is also controlled by the government. SOEs can therefore obtain long-term loans with low creditworthiness requirements, resulting in a large number of non-performing loans (Lin et al., 2020). Chinese SOEs are thus less constrained by the public budget than government organisations in other countries, but there is also an elevated risk of creating zombie companies. A zombie company is an uncompetitive company that needs a bailout to operate successfully, or an indebted company that is only able to repay interest on its debt.
3.3.3 Role of Institutional Investors
Institutional investors are (large) financial institutions that manage investments (equities, bonds, and alternative assets) for clients and beneficiaries. Traditional institutional investors include investment funds, pension funds, and insurance companies. Alternative institutional investors include sovereign wealth funds, hedge funds, and private equity. As professional parties, institutional investors have the means and knowledge to engage with companies. They play an increasingly important role in the investment landscape. Figure 3.4 shows that the size of traditional institutional investors has increased—from 67% of GDP in 1990 to 230% of GDP in 2016. Institutional investment is expected to rise further due to ageing, reduction of social security, and increased wealth (Darvas & Schoenmaker, 2018).
A line graph plots the rise of institutional investors as a percentage of G D P from 1990 to 2016. The approximated values are as follows. (1990, 70), (1995, 100), (2000, 160), (2010, 175), and (2016, 225).
Fig. 3.4
Rise of institutional investors (assets as a % of GDP). Note: Assets of institutional investors (pension funds, insurers, and investment funds) of 15 large EU countries, Switzerland and the USA as % of GDP. Source: Authors’ calculations based on ECB (2017) and OECD (2017)
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Institutional investors have become important players in the stock market. Table 3.2 shows that their share of equity holdings has increased to approximately 65% across developed countries. Traditional institutional investors (investment funds, pension funds, and insurers) own 58% of equity holdings, and alternative institutional investors (sovereign wealth funds and hedge funds) own another 7%. Institutional investors are thus the dominant shareholders of publicly listed companies.
Table 3.2
Share of institutional investors in equity (2016)
Type of institutional investor
Amount
(in US$ trillion)
Share in equity markets (%)
Investment funds
24.0
41.1
Investment funds (excl. pension funds/insurers)
11.2
19.1
Pension funds and insurance companies
22.9
39.1
Traditional institutional investors
34.1
58.2
Sovereign wealth funds
3.3
5.6
Hedge funds
0.9
1.6
Alternative institutional investors
4.2
7.2
Total institutional investors
38.3
65.4
Note: Pension funds and insurers invest directly in equity and indirectly via investment funds. This indirect investment is deducted from the equity managed by investment funds to avoid double counting. As only data for institutional investors in developed countries are available, the share is calculated as a percentage of developed equity markets
Source: Authors’ calculations based on OECD (2017) and SIFMA (2017)
This means they can potentially wield a lot of power. How can investors exert influence on the companies in which they invest? Institutional investors have two choices for action if they are disappointed with an investee company:
(i)
Voice (or direct intervention): they can engage with management to try to institute change and vote on shareholder resolutions at the annual general meeting or
(ii)
Exit (or divestment): they can leave the company by selling shares, or threaten to leave
The drawback of exit/divestment is that the impact may be limited as another investor simply buys the shares without questioning management, and nothing may change. Engagement refers to investors’ dialogue with investee companies on a broad range of ESG issues. Of course, the question then arises of how effective this engagement is.
Moreover, there are concerns that both voice and exit are limited by the rise of passive investments. These are investments in which institutional investors delegate much of their influence to a small number of index providers (Petry et al., 2021) and index funds (Fichtner et al., 2017) which have few incentives to exercise their voice and exit activities. Large investment funds, such as BlackRock and Fidelity, offer index funds (also called exchange-traded funds) that passively invest in the market index (see Box 12.3 in Chap. 12).
There is however a countermovement, with some pension funds building more concentrated portfolios based on active management and engagement with investee companies (Schoenmaker & Schramade, 2019). Institutional investors can increase their impact by forming coalitions to foster joint engagement. Dimson et al. (2021) provide evidence that collaboration among activist investors is instrumental in increasing the success rate of social and environmental engagements.
Emerging evidence indicates that large institutional investors, in particular pension funds, drive the social and environmental performance of companies (Dyck et al., 2019). These institutions are motivated by both financial and social returns. In contrast, hedge funds hold smaller shares (only 1.6% of aggregate equity in Table 3.2) but are very active shareholders, and more financially driven. Hedge fund campaigns are associated with three broad sets of outcomes for targeted companies: (a) an immediate but short-lived increase in market value and profitability; (b) decreases in the number of employees, operating expenses, R&D spending, and capital expenditures; and (c) the suppression of corporate social performance (DesJardine & Durand, 2020).
3.4 Corporate Governance Mechanisms
Section 3.2 has set out how the integrated model can broaden corporate governance to various stakeholders, and how the board can apply an integrated value measure to quantify and balance the underlying financial, social, and environmental value creation for these stakeholders. The next question is what mechanisms can be designed to make the integrated model operational: how to include the interests of the various stakeholders in board decision-making? This section reviews the mechanisms to include the interests of the various stakeholders on the board. These mechanisms can be enshrined in company law or in board mechanisms at the company level.
3.4.1 Role of Company Law
The European Union is most advanced in including the interests of the social and environmental stakeholders in legislation. Figure 3.5 illustrates the EU’s sustainable finance strategy5 with four key components.
A block diagram. The blocks are labeled as follows. 1, strengthening sustainability disclosure. 2, the taxonomy of green investments. 3, clarifying investors' duties regarding sustainability. 4, fostering sustainability corporate governance.
Fig. 3.5
EU sustainable finance strategy
×
Sustainability Disclosure
The starting point of the European legal framework is to create a consistent and coherent flow of sustainability information throughout the financial value chain. The first two components cover this information flow. The Corporate Sustainability Reporting Directive (CSRD, effective from January 2025) requires large companies to systematically disclose information in the way they manage social and environmental challenges, including negative impacts and double materiality (see Chap. 2). This helps investors, consumers, and other stakeholders evaluate the sustainability performance of companies, and it encourages these companies to develop a responsible approach to business.
Taxonomy
The investment side is covered by the EU taxonomy of green investment. This classification system establishes a list of environmentally sustainable economic activities. The taxonomy requires companies to disclose certain indicators about the extent to which their activities are environmentally sustainable, according to the taxonomy. By providing appropriate definitions to companies and investors on which economic activities can be considered environmentally sustainable, the taxonomy (1) creates security for investors, (2) protects private investors from greenwashing, and (3) helps companies to plan the transition. This will eventually help in the scale-up of sustainable investment. As of early 2023, the European Union is planning to expand the taxonomy in several ways: (1) to cover grey and brown investments that are detrimental to sustainability and (2) to include S(ocial) in addition to E(cological) activities. In this way, the EU would reward investors that transform brown or grey companies into green ones, such as done by the Follow This initiative, for example (see Box 3.8).
Box 3.8: Follow This and Oil Companies
Follow This is a non-governmental organisation (NGO) pressuring the oil industry. Marc van Baal, the founder, realised that to change the oil industry, he would have to become a shareholder. He bought the minimum amount of shares to file resolutions in the five major oil companies in Europe and the USA. He submitted resolutions asking the oil majors to align their emission targets with the Paris climate agreement. The management teams appealed to shareholders to vote against these resolutions.
The next step was to convince other (large) shareholders to vote in favour of the resolutions. Starting with 3% voting for it and another 3% withholding from voting at Shell’s annual general meeting in 2016, Follow This obtained 30% voting for its resolution in 2021. The voting patterns for the other oil majors are similar. The boards of the oil majors have now started to talk to Follow This and feel the pressure to speed up the transition to renewable energy in order to meet the Paris targets.
Investor Duties
With respect to investors’ duties, the European legal framework requires institutional investors to integrate sustainability considerations into their investment decision-making process. This supports the integrated model of corporate governance from the investor side.
Corporate Governance
Finally, the European sustainable corporate governance initiative aims to encourage businesses to consider environmental, social, human, and economic impacts in their business decisions and to focus on long-term sustainable value creation rather than short-term financial value.
3.4.2 Board Mechanisms at the Company Level
There are several mechanisms to include the interests of the various stakeholders in board decision-making. Figure 3.6 provides an overview.
A block diagram. The blocks are labeled as follows. 1, formal stakeholder models. 2, board mandates for sustainability. 3, board composition and expertise. 4, stakeholder council. 5, incentive mechanisms.
Fig. 3.6
Board mechanisms to foster stakeholder interests
×
Formal Stakeholder Models
Formal stakeholder models, such as codetermination (under which employees and possibly other groups elect directors along with shareholders), typically focus on the particular interests of the involved stakeholder groups rather than the general interest of the company. Moreover, the scope and number of stakeholders evolve over time, while formal mechanisms are static.
Board Mandates
A more flexible mechanism is formulating formal board mandates for sustainability at the company level. These formal board mandates can be incorporated into the company’s charter or bylaws (Ramani & Ward, 2019). Such mandates make sustainability an explicit board priority and facilitate board sustainability oversight. To make it work, boards must disclose whether they discuss sustainability with management during board meetings. Boards can then work with management to identify specific social and environmental priorities for the company, include them in the company’s strategy, and assess their impact on the company’s integrated value.
Board Composition and Expertise
Another mechanism is the composition of a board and the expertise of its members. Coffee (2020) argues for broadly representative and diverse boards that are sensitive to the company’s impact on society. Such broad and diverse boards are diverse not only in terms of gender, ethnicity, and age but also expertise. Without directors who have the proper sustainability expertise, boards do not possess the collective skillset and background to examine the impacts of complex social and environmental issues on corporate strategy. However, international evidence shows that less than 5% of executive and non-executive role specifications require sustainability experience or a sustainability mindset (Reus, 2018; Sørensen & Handcock, 2020). This seems to be a missed opportunity for companies in their pursuit of broader stakeholder interests.
Stakeholder Council
To foster accountability, a company can establish a stakeholder council comprised of the relevant stakeholders. The board would discuss, at least once a year, the sustainability performance of the company. The board can also consult the stakeholder council on important decisions with societal impact. To promote transparency, the stakeholder council reports annually about its activities and advice in the company’s integrated annual report. A challenge is to include not only current stakeholders but also future stakeholders. An interesting mechanism, developed in Japanese local politics, is future design (Saijo, 2020). Future design aims to solve the dilemma between current stakeholders, who bear the cost of long-term investment, and future stakeholders, who reap the benefits (see Box 3.9).
Box 3.9: Future Design
The idea of future design is simple. If there is no one to protect the interests of future generations, then designate people to take on the role of future generations and have them stand in for future generations. This is the same reasoning as in role-playing scenarios used frequently in, for example, war games. Saijo (2020) calls the people who are to take on the role of future generations the ‘imaginary future generation’ or ‘imaginary future persons’. It is found that the people who become members of an ‘imaginary future generation’ truly change their lines of thought and points of view, becoming clearly aware of the interests of future generations. As a result, they actually think and act in the interest of future generations. One or more persons with such a designated role can be added to the stakeholder council.
Incentive Mechanisms
Finally, incentive mechanisms play a role. While variable executive pay is related mainly to financial performance, companies are starting to include sustainability targets in executive remuneration. Using an international sample of ISS Executive Compensation Analytics, Ormazabal et al. (2023) show that the adoption of sustainability metrics in executive compensation contracts is rising rapidly, from 1% in 2011 to 38% in 2021. However, Table 3.3 indicates that the distribution is uneven. While 45.3% of European companies include sustainability targets in executive contracts, only 16.5% of US companies do so. One could of course question the ambition levels of these targets. However, it is encouraging that the authors also find that the adoption of sustainability variables in managerial performance is accompanied by improvements in sustainability performance and meaningful changes in the compensation of executives. Linking executive compensation to sustainability goals helps boards make management accountable for sustainability performance (Ramani & Ward, 2019). Another incentive mechanism is deferral of variable compensation by up to 3, 5, or 7 years, for example. Such deferral helps to align executives’ interests with the long-term interests of their company. The deferral of bonuses means they can be forfeit if evidence emerges of unexpectedly poor financial, social, or environmental performance by the executive, their team, or the company overall.
Table 3.3
Geographical distribution of adoption of sustainability targets in executive pay
Country
# of companies in empirical study
# of companies with sustainability target
% of companies with sustainability target
Europe
1408
638
45.3%
USA
2243
370
16.5%
Total
3651
1008
27.6%
Note: The empirical study covers executive contracts of companies during the period from 2011 to 2020
Source: Ormazabal et al. (2023) based on ISS Executive Compensation Analytics
3.5 Conclusions
Corporate governance is about controlling and directing the company. In the shareholder model, the ultimate control is with shareholders, who are financially driven. The company objective in the shareholder model is financial value maximisation. The stakeholder model includes other stakeholders, such as employees, customers, and suppliers, alongside the shareholders. The stakeholder model thus adds social stakeholders and focuses on financial and social value as company objective. The integrated model also covers future stakeholders, representing the environment. It expands the company objective to integrated value, which combines financial, social, and environmental value.
The balancing of the interests of various stakeholders is central to corporate governance. Timely and reliable information on financial, social, and environmental factors is important to assess the status of the various interests. The concept of integrated value, introduced in Chap. 1, is instrumental in providing information and aligning interests in ex-ante decision-making and ex-post accountability. Integrated value can also provide guidance on dealing with trade-offs between the interests of various stakeholders.
Ownership structures are also relevant. While family- or foundation-owned companies typically have a long-term orientation, publicly listed companies have to serve a wide (and sometimes demanding) group of shareholders. Another important feature is the expertise of boards. Do board members have the expertise and mindset to apply integrated decision-making across the financial, social, and environmental value dimensions?
Key Concepts Used in This Chapter
Agency theory looks at conflicts of interest between people with different interests in the same assets. An important conflict is that between the principals (shareholders and other stakeholders) and the agents (managers) of companies
Asymmetric information refers to the difference in information about a company between its insiders (executive management) and its outsiders (shareholders and other stakeholders)
Corporate governance refers to the mechanisms, relations, and processes by which a company is controlled and directed. It involves balancing the many interests of the stakeholders of a company
Engagement refers to investors’ dialogue with investee companies on a broad range of environmental, social, and corporate governance (ESG) issues
Fiduciary duty sets out the responsibilities that financial institutions owe to their beneficiaries and clients. The expectation is to be loyal to beneficiary interests, prudent in handling money with care, and transparent in dealing with conflicts
Institutional investors are (large) financial institutions that manage investments (equities, bonds, and alternative assets) for clients and beneficiaries. Traditional investors include investment funds, pension funds, and insurance companies. Alternative institutional investors include sovereign wealth funds, hedge funds, and private equity
Integrated model means that a company should balance or optimise the interests of its current and future stakeholders: customers, employees, suppliers, shareholders, creditors, the community, and the environment
Integrated value is obtained by combining the financial, social, and environmental values in an integrated way (with regard for the interconnections)
Integrated value creation refers to the objective of companies that optimise financial, social, and environmental value in the long run
Responsible company manages and balances profit (financial value) and impact (social and environmental value)
Shareholder model means that the ultimate measure of a company’s success is the extent to which it enriches its shareholders
Short-termism refers to the myopic behaviour of executives, focusing on the short term
Stakeholder model means that a company should balance or optimise the interests of all its stakeholders: customers, employees, suppliers, shareholders, creditors, and the community
Tunnelling is a practice whereby a controlling shareholder directs company assets to himself for personal gain (e.g., to other parts of his business group) at the expense of the minority shareholders
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We only need two parameters to design relative weights for all three value dimensions in Eq. (3.1), because the effective weight for FV is 1. Equal weights means then a weight of 1 for all three value dimensions.
