The end of short-termism?  Launch of the EU impact assessment on sustainable governance

Will the EU’s latest initiative to improve the EU regulatory framework on company law and corporate governance lead to legislation by the European Commission?  Will it impact the future responsibility and liability of the director?  The outcome is not known, but at the very least it has caused consternation in the European corporate governance communities.

Since 2015, the EC has been heavily focused on sustainability issues, culminating in particular with the launch of the EU Green Deal in early 2020 and in July 2020, the “EC CG Impact Assessment” on sustainable corporate governance.  The EC CG Impact Assessment with its aim of ensuring long term sustainable corporate behaviour is one of the most far reaching initiatives launched by the EC.  The initiative sets out a roadmap ranging from guidance (soft law) to proposed legislation (hard law) to ensure that strategic EU focus areas related to sustainability are embedded into corporate governance frameworks. It addresses the duties of the Director in relation to the oversight of strategy, execution of governance, and balancing of stakeholder needs.

To share thoughts on the initiative and these questions , ILA board member Monique Bachner was joined by Leena Linnainmaa, Secretary General of the Directors' Institute Finland, and Karen Wauters, Chair of the ILA Board Organisation and Effectiveness Committee for the  ILA Coffee Chat on 21 October 2020  “Considering Directors' Duties & Sustainable Corporate Governance”.

Skewed report, Biased assumptions?

The EC CG Impact Assessment was heavily based on a related “Study of directors’ duties and sustainable corporate governance“ conducted by EY for the EC* (the “EY Report”), which as Monique stated was characterised as “notorious and controversial.”  

Leena highlighted several criticisms regarding the methodology and the data used.  A key piece of evidence was a survey of industry players; however, this had garnered relatively few replies.  Leena noted the preamble and the framing of the questions, which already assumed short-termism and profit maximisation had put many off responding. “Under these conditions, how many companies and directors would be willing to spend time answering more than 100 questions in the survey?” she asked. 

Another concern was the assertion in the EY Report that a company’s duty of care is only towards the shareholders (so-called “shareholder supremacy”) which seemed to assume the EU situation is the same as certain other parts of the world, such as the USA.  In fact, in several EU countries, company laws have specifically been updated over the last decades to directly embed stakeholder capitalism and ensure a better balance of longer-term societal interests with the interests of shareholders.  

In addition the data related mainly to listed entities and certain types of financial investors, however the majority of companies are in fact small or medium sized, and owned by strategic or long term owners such as founders and their families, foundations, and even longer-term financial investors.

Outdated impression of Boards – and of companies?

Whilst the aims of embedding more sustainability and long-term thinking into corporate governance processes and Boards was welcomed, it was regretted that it appeared to come from the assumption that all Boards are only focused on short termism and profit maximisation at the expense of longer-term objectives, and that since the 2008 financial crisis that company owners have been too passive.  The panel agreed that this interpretation does not appear to take into account the evolution across the EU since 2008 of Directors and Boards, as well as the company law and the societal values, including to embed principles of stakeholder capitalism and longer term societal interests with the financial interests of current shareholders.

ESG is no longer fringe.   Times are changing – and so is the role of the Board   

Boards across the EU are already focusing more and more on ESG issues.  Whilst there are still large differences, it is undeniably a topic which is already at the top of governance agendas.   

Market pressures are visibly driving a move toward sustainability. “Sustainability has become a mainstream strategic question for companies, and even more over the last year with the marked increase in focus on the social aspects as a result of CÒVID-19,” said Leena. “As investors have started to push this change, the move to greater sustainability will happen more rapidly.”  Whilst some data challenges remain, these should be transitional.

Of Shareholders and Stakeholders: what is the road to long term value creation?

In Luxembourg, the company law simply states that the Board should act in the “best corporate interests of the corporation” and Directors must act as “bon père de famille”.  The law does not go into whether that means longer term or shorter term, nor which stakeholders should be prioritised, however this has usually been interpreted as requiring a balance and to be looked at through the lens of the longer-term interests of the entity; as would be the case of any “bon père de famille”.

Accountability and liability – striking the right balance

Accountability and liability were flagged as the big issues with some of the suggestions of the initiative.  In particular, proposed regulations which tend towards strict liability.  In its current consultation there are risks of placing ultimate responsibility for all corporate actions on the Directors – potentially leading to unlimited and unquantifiable Director liability.  Legal certainty is always important, resulting in a risk the initiative could end up hindering not only the stated sustainability objectives of the  EC but also those related to the capital markets as Boards may become overly risk averse, impacting EU investment and growth.  

Traditionally corporate governance has largely been addressed via soft law initiatives such as Codes, and given the numerous EU legislation already in place or being implemented, it appears that the legislative approach of the EC CG Impact Assessment is perhaps premature by not allowing time for the current changes to be implemented and assessed.

The panel assessed alternative governance aspects such as the use of “Sustainability Committees” which could be useful for increasing focus on frameworks and engagement.  Like all other important topics, however, sustainability and ESG initiatives must be fully integrated in the strategy and operations and separating it out might undermine efforts to embed it across all aspects of an organisation.  

Stakeholder Committees containing key stakeholders could also be interesting, however can quickly become a distraction as stakeholders have their own and divergent objectives.  The key is to focus on the outcome: ensuring adequate engagement with key stakeholders, which is already being addressed via the Shareholder Rights Directives, and adequate stakeholder disclosures on ESG matters, which are currently being addressed via the EU’s Taxonomy Regulation.

Compensation was also raised. Aspects of compensation can often be skewed to the short-term and have unintended consequences especially where variable pay is used.  Questions of excessive compensation and perverse incentives are, however, usually more related to the executives, who may also be Board members and not the non-executive Board members, which leads one to question whether there is a confusion between Board and Executive functions and practices. Recent revisions to the Shareholders’ Rights Directive on “Say on Pay” should lead to further evolution embedding transparency and fairness on remuneration.

Investors are also key to promoting a long-term sustainable culture

It was noted that the EU is already acting to move investors away from short-termism, however not all will be solved via legislation.  A shift in culture is required, and investors and their expectations are equally key to the shift towards sustainable corporate strategy.

In terms of EU legislation, existing legislation already deals with items such as stakeholder information rights and transparency, including rights at annual shareholder meetings, non-financial disclosures, and reasonable and proportionate due diligence requirements.  And the front-runners have done all of this well before any legislation requiring the same.  The EU Taxonomy Regulation impacting financial actors from 2021 will also lead to increased due diligence on sustainability and ESG measures.

Director Institutes are already addressing sustainability issues for Boards

It is important for Directors and their associations to promote the existing work on responsible business conduct and how stakeholder and long-term interests are being considered.   More work is required to communicate these focal activities.

“Directors should be very active, raising awareness, because we have not been sufficiently able to tell the wider public how much companies are actually changing to become more sustainable,” Leena said. Karen agreed, but noted that this is sometimes a complex message to communicate. “Transparency is key,” although political decision makers have to understand that “it can be difficult to find the appropriate way of measuring sustainability and demonstrating the impact of sustainable action in the short term.”

Karen noted that the ILA Code of conduct underlines that the primary  ‘directors should always act in the best corporate interests of the entity” words which ILA has supported through providing directors with the necessary tools via training and awareness-raising campaigns on everything from new laws and regulations, to digitalisation, diversity and soft skills. ILA has  also launched many ESG forums; ranging from regular topical discussions on the EU taxonomy and implementation across the financial sector, to regular online sustainable strategy talks and interviews, to an ESG training programme introducing sustainability tools and related frameworks, to the launch of a multi-module “21st Century Board Leadership Masterclass” where ESG is heavily embedded across the programme.

Action required:   EC Public consultation is now open, and runs until 8 January 2021

The public consultation with its associated questionnaire is now live. “The outcome of this review process will be action,” Leena warned. “It may be recommendations from the Commission accompanied by campaigning. Or they may suggest to member states to pass national legislation, or there could be a directive.”   Companies could be required to have a sustainability strategy, regarding climate change, social questions and more.  Legislations could extend to linking remuneration to sustainability criteria. 

Sustainable development is a worthy cause and needs to evolve - however care must be taken that heavy-handed legislation does not stifle its evolution. It is thus important for Director communities to use the consultation period to participate and advocate a balanced approach. 

ILA will continue this discussion and invites members to reach out to Karen Wauters to provide input or join the dedicated working group who are focusing on this consultation.