CORPORATE GOVERNANCE ANDACCOUNTABILITY

Stephen Ong, BSc(Hons) Econs (LSE), MBA International Business(Bradford)

Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen University

MBA1034 GOVERNANCE, LAW & ETHICS

• Discussion: Governance & Accountability

1

• Corporate Social Responsibility & Accounting2

• Case Discussion: McDonald’s

• Video : Supersize Me3

Today’s Overview

1. Open Discussion

• Niamh M. Brennan, Jill Solomon, (2008),"Corporate governance, accountability and mechanisms of accountability: an overview", Accounting, Auditing & Accountability Journal, Vol. 21 No. 7 pp. 885 – 906

2. Corporate Social Responsibility & Social Accountability

• Reassess the impact of corporate activities on the environment and society at large

• Cases of environmental accidents, product failures, etc. impact on the firm’s value and its market share.

• Review types of corporate policies of stakeholder management and pay off, including policies that destroy rather than create firm value.

• Review the increasing importance of indices of corporate social responsibility as well as socially responsible investment.

Learning Outcomes• By the end of this lecture, you should be able to:

1. Critically review the studies that investigate the impact of corporate social responsibility (CSR) on firm value and vice-versa

2. Describe some of the CSR indices that are available from commercial providers and evaluate their usefulness

3. Discuss the definitions of CSR and socially responsible investment (SRI) and how these may change with an investor’s set of values

4. Assess the evidence on whether investors pay a price for SRI.

Overview

• Introduction• The trust gap• What is corporate social responsibility?• Compliance with the law• Market and government failures and stakeholders• Broader conceptions of social responsibility• Corporate social responsibility and corporate social

performance• A framework for corporate social performance• Corporate governance

Introduction

Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?

Edward, First Baron Thurlow 1731-1806Lord Chancellor during King George III’s reign.

Introduction (Continued)

• Craig Carter, Rahul Kale and Curtis Grimm define corporate social responsibility as follows– “[Corporate] social responsibility deals with the

managerial consideration of non-market forces or social aspects of corporate activity outside of a market or regulatory framework and includes consideration of

issues such as employee welfare, community programs, charitable donations, and environmental protection.”

• While CSR may be in the interest of the targeted recipients, it is less clear a priori whether it is in the interest of the company’s shareholders.

• At worst, CSR may just be a reflection of the principal–agent problem.

• Let’s attempt to answer the question whether CSR is in the interest of the shareholders.

Introduction (Continued)

• Many firms go beyond what is required by their market and nonmarket environments–Some explicitly attempt to serve

directly the needs of their stakeholders or, more broadly, of society

Introduction (Continued)

Integrated Strategy Framework

The Trust Gap

• In interacting with the public or with stakeholders, it is useful to begin with caution• The lack of trust in global

companies stands in stark contrast to the trust in NGOs

Milton Friedman’s Profit Maximization• “To conduct the business in accordance

with [owners’] desires, which generally will be to make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom”

Friedman’s Conception of a Corporation

Compliance with the Law

• A fundamental component of responsible management–In recent years the number

and size of corporate scandals and incidents of wrongdoing have been alarming

Market and Government Failures and Stakeholders• The market perspective of Friedman leaves

unresolved a number of issues about the role of business in society– Market imperfections can cause a divergence

between private and social costs– The reliance on private ownership and markets to

generate well-being is justified by utilitarianism– Just as markets can be imperfect, so too can

government

– The agency problem - Market capitalism coexists with managerial capitalism

Broader Conceptions of Social Responsibility• The Business Roundtable was

founded to:–Examine public issues that affect

the economy and develop positions which seek to reflect sound economic and social principles

The Business Roundtable View of a Corporation

Corporate Social Responsibility and Corporate Social Performance• CSR focuses on the responsibility of

a firm for social performance• Arises from a combination of:–An ethical failure that establishes

a moral duty–The assignment of that duty to the

firm

A Framework for Understanding Corporate Social Performance• Corporate social performance (CSP)

refers to social activities that satisfy two conditions–Social activities extend beyond the

requirements of the law and regulations–Social activities involve the private

provision of public goods or private redistribution

Motivations for CSP

• Moral• Managerial perquisites • Social pressure• Strategic (CSR) motivation

Corporate Social Performance and Business Sense

Rewards

• Consumer rewards• Employee rewards• Investor rewards• Government rewards

Corporate Governance

• Social accountability–Continues to be an issue for firms

that adopt social responsibilities

The Duties of Boards of Directors• According to the Business Roundtable:– Select, regularly evaluate and, if necessary, replace the chief

executive officer, determine management compensation, and review succession planning

– Review and, where appropriate, approve the major strategies and financial and other objectives, and plans of the corporation

– Advise management on significant issues facing the corporation– Oversee processes for evaluating the adequacy of internal

controls, risk management, financial reporting and compliance, and satisfy itself as to the adequacy of such processes

– Nominate directors and ensure that the structure and practices of the board provide for sound corporate governance

Sarbanes-Oxley

• The act is called the Public Company Accounting Reform and Investor Protection Act

• Requires:–Companies to identify an independent

“financial expert” on its board audit committee– The CEO and CFO to certify the firm’s financial

statements

Say-on-Pay

• A provision in the Dodd–Frank financial reform act of 2010• Required corporations to conduct a

nonbinding shareholder vote on executive compensation at least once every 3 years

The Market for Control•Disciplines management and

directors to serve shareholder interests through mergers, acquisitions, hostile takeovers, proxy contests, and depressed market valuations

CSR and Financial Performance

• Can the lack of corporate social responsibility or bad stakeholder management can cost a company dearly and may even be exploited by the company’s competitors?• Case : Perrier and Benzene

Perrier and Benzene• Benzene is a chemical which occurs naturally in

crude oil– In laboratory tests on animals, it has

been found to cause cancer– It is also believed to cause cancer in humans.

• Perrier was the number one mineral water, charging premium prices based on its reputation of the “champagne of bottled water”.

• In early February 1990, traces of benzene were found in Perrier bottles in North Carolina, USA.

Perrier and Benzene (Continued)• Perrier initially wanted to hush up the incident,

shifting from explanation to explanation and delaying any action.

• It finally recalled 160 million bottles worldwide at a cost of £150m.

• By 1995, its market share in the USA had dropped by half.

• Its market share in the UK fell from 60% to 9%.

CSR and Financial Performance (Continued)• Early studies have found mixed evidence on the link

between financial performance and CSR– Stanley Vance finds a negative link, suggesting that CSR is

a net cost to the firm– Jean McGuire et al., and Richard Wokutch and Barbara

Spencer find a positive link– Gordon Alexander and Rogene Buchholz find no

relationship between the two.

• However, apart from McGuire et al., none of the above studies raises the issue as to the direction of causality between the two.

• Sandra Waddock and Samuel Graves acknowledge this issue–Higher levels of CSR may cause

higher levels of financial performance and vice-versa–Better performing firms have more

funds to spend on CSR.

CSR and Financial Performance (Continued)

• A reason why the direction of causality flows from financial performance to CSR is given by Jensen’s free cash flow problem– Managers who have access to significant free cash

flow may divert some of this to social causes.

• The reason why the direction of causality should flow from CSR to financial performance is that CSR is part of good management and part of having good relationships with the firm’s stakeholders.

CSR and Financial Performance (Continued)

• Waddock and Graves’s measure of CSR is based on the Kinder, Lydenberg and Domini (KLD) index which rates US firms according to several aspects of CSR (e.g. community relations and workforce relations.

CSR and Financial Performance (Continued)

• They first regress the level of CSR for each firm in 1990 on the financial performance for the previous year

– They find that there is a positive link for each of their three measures of performance (ROA, ROE and return on sales)

– This suggests that the free cash flow hypothesis is valid in the context of CSR.

• They also regress financial performance for 1991 on CSR for 1990

– They find a positive link for ROA and return on sales

– This gives support to the hypothesis of good management.

CSR and Financial Performance (Continued)

• Hence, Waddock and Graves find that the direction of causality between CSR

and performance flows both ways– Firms with better past performance have

more funds to spend on CSR– Firms with higher levels of CSR perform

better.

CSR and Financial Performance (Continued)

• Amy Hillman and Gerald Keim develop a model of CSR and financial performance.

• They argue that there are two components of CSR1. One component relates to improving the firm’s relationships

with its primary stakeholdersThey call this stakeholder management (SM)

SM has a positive impact on firm performance2. The other component relates to social issues that do not

improve the relationships of the firm with its primary stakeholdersThey call this social issue participation (SIP)

This component reduces financial performance.

CSR and Financial Performance (Continued)

• Hillman and Keim’s SM and SIP are equivalent to Waddock and Graves’s good management and free cash flow hypotheses.

• They find that financial performance depends positively on SM and negatively on SIP.

• However, they do not find that the levels of SM and SIP depend on financial performance.

CSR and Financial Performance (Continued)

• To summarise, recent empirical research suggests that it is important to distinguish between the two types of CSR–CSR that targets a company’s direct

stakeholders, such as its customers and employees, has a positive effect on profitability–CSR that targets wider social

issues has a negative effect.

CSR and Financial Performance (Continued)

CSR Indices• CSR indices (e.g., FTSE Kinder, Lydenberg and Domini

(KLD) 400 Social Index) tend to be based on – Exclusionary screens– Strengths along the lines of a series of attributes.

• Exclusionary screens consist of excluding firms from the index with significant involvement in e.g.– alcohol,– gambling,– tobacco,– fire arms, and – military weapons.

CSR Indices (Continued)

• Attributes include e.g.–Community relations• Support for education, social housing, …

–Diversity• The firm has policies in place to promote

women and minorities, …– Employee relations• Relationships with trade unions, employee

profit sharing schemes, …

–Environment• Policies aiming to reduce or prevent

pollution, carbon neutrality, recycling, …–Product• Quality, innovation, product safety,

antitrust, policies enabling socially disadvantaged groups to benefit from the firm’s products and services, …

–Corporate governance

CSR Indices (Continued)

• There are now indices which cater for investors concerned about e.g.–Catholic values (KLD)–Sustainability (KLD)–Islamic values (Dow Jones).

CSR Indices (Continued)

Conclusions

• The link between CSR and firm performance.• The performance of SRI funds.• How do you define SRI?

CASE DISCUSSION : MCDONALD’S

Case - Nonmarket Environment of McDonald’s

• Obesity - Economists studied the increase in the body mass index and concluded that it was due to several factors:– Increase in calorie intake– Decrease in strenuousness of work– Decrease in cost of food due to

technological change leading people to eat more

1-49

Case - Nonmarket Environment of McDonald’s• Meal and Menu Nutrition Information - Public

attention to the obesity issue led to the introduction of the Menu Education and Labeling Act (MEAL) in the House and the Senate

• Healthy Lifestyles - As a result of the concern about obesity, McDonald’s suspended its promotion of supersize meals

1-50

Case - Nonmarket Environment of McDonald’s

• Children’s Advertising– McDonald’s promoted its trademark golden

arches on Barbie dolls and backpacks– Some schools had McDonald’s days for lunch– Used plastic toys for promotion

1-51

Cases - Nonmarket Environment of McDonald’s

• Acrylamide – Activists argued that the concentrations of acrylamide exceeded the EPA and WHO standards for water specifically in french fries from McDonald’s

• Mad Cow Disease - McDonald’s had dealt with the issue of mad cow disease in a number of other countries and had used that experience to prepare for such an event in the United States

1-52

Cases - Nonmarket Environment of McDonald’s

• Antibiotics and Growth Hormones - McDonald’s, the environmental group Environmental Defense, and Elanco Animal Health joined together to create the Antibiotics Coalition

• Animal Welfare - McDonald’s adopted new standards for its beef suppliers, including minimum space standards for cattle in feedlots

• The Environment - McDonald’s established an environmental policy pertaining to natural resources, rain forests, sustainability, and waste management 1-53

Further Reading• Solomon, Jill (2010) Corporate Governance and

Accountability 3rd Edition, Wiley, UK. Ch.9-11• Goergen, Marc (2012) International Corporate

Governance, Pearson. Ch.8• Gary, Owen & Adams (1996) Ch.2-4 • CIMA - Performance Strategy: Study Text (2012)

BPP Learning Media Ltd. Part B : 4• Baron, David P.(2013) Business and its

environment, 7th Edition, Pearson

Additional Readings (1)• Mallin, C. A., Saadouni, B. and Briston, R. J. (1995) ‘The financial

performance of ethical investment funds’, Journal of Business Finance and Accounting, 22, 483–96.

• Gregory, A., Matatko, J. and Luther, R. (1997) ‘Ethical unit trust financial performance: small company effects and fund size effects’, Journal of Business Finance and Accounting, 24(5), June, 705–725.

• Drexhage, G. (1998) ‘There’s money in ethics’, Global Investor, 109, 56.• Williams, S. (1999) ‘UK ethical investment: A coming of age’, Journal of

Investing, summer, 58–75.• Hancock, J. (1999) Making Gains with Values: The Ethical Investor,

Financial Times/Prentice Hall, London.• Friedman, A. L. and Miles, S. (2001) ‘Socially responsible investment and

corporate social and environmental reporting in the UK: An exploratory study’, British Accounting Review, 33, 523–548.

• Sparkes, R. (2002) Socially Responsible Investment: A Global Revolution, John Wiley & Sons, Chichester, UK.

• Solomon, J. F., Solomon, A. and Norton, S. D. (2002) ‘Socially responsible investment in the UK: Drivers and current issues’, Journal of General Management, November 2001.

Additional Readings (2)• Mercer Investment Consulting (2005) SRI: What Do Investment

Managers Think? 12st March, Mercer Human Resource Consulting LLC and Investment Consulting Inc., New York, USA.

• Cobb, G., Collison, D., Power, D. and L. Stevenson (2005) FTSE4Good: Perceptions and Performance, ACCA Research Report No.88, Certified Accountants Educational Trust, London, UK.

• Freshfields Bruckhaus Deringer (2005) A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, UNEP Finance Initiative, produced for the Asset Management Working Group of the UNEP Finance Initiative, October.

• Solomon, J. F. and L. Darby (2005) "Is Private Social, Ethical and Environmental Disclosure Mythicizing or Demythologizing Reality?", Accounting Forum, Vol.29, pp.27-47.

• Mercer Investment Consulting (2006) 2006 Fearless Forecast: What Do Investment Managers Think About Responsible Investment? March, Mercer Human Resource Consulting LLC and Investment Consulting Inc., New York, USA.

• Solomon, J. F. and A. Solomon (2006) "Private Social, Ethical and Environmental Disclosure", Accounting, Auditing and Accountability Journal.

• Solomon J. F. (2008) Preliminary Report on Pension Fund Trustees and Climate Change, ACCA (on blackboard).

NEXT Ideas for Discussion

• Carcello, Joseph V., Hermanson, Dana R. & Ye, Zhongxia (Shelly) (2011) Corporate Governance Research in Accounting and Auditing: Insights, Practice Implications, and Future Research Directions, Auditing30. 3 (Aug 2011): 1-31.

QUESTIONS?