by Theodore Roosevelt Malloch
Elon Musk recently tweeted that environmental-social-governance investing “is a scam,” after Tesla got removed from a major ESG index for a lack of disclosure around key environmental and social issues and allegations of racism on the factory floor.
ESG investing is a form of so-called sustainable investing that considers environmental, social, and governance factors to judge an investment’s financial returns and its overall impact.
An investment’s ESG score measures the sustainability of an investment in those specific categories. Upward of $6 trillion is now invested in funds deemed to have good ESG scores.
Some of the challenges are as follows: Not all ESG factors are easily quantifiable, and such factors may not directly translate into earnings growth or enhanced performance for the firm.
Current corporate sustainability disclosures are heavily skewed toward process and procedures, as opposed to actual performance.
ESG is indeed part of a scam based on the flawed World Economic Forum stakeholder theory where shareholders get shafted. It is pink socialism trying to force itself into the capitalist and corporate game. It should be called out for what it is.
As businesses everywhere have long known, however, that does not mean companies can ignore that customers come first, employees matter, governance is an expectation, and environmental damages are costly. (Some of us have written about this and provided important case studies for decades. See my book and PBS special, Doing Virtuous Business.)
In the last few decades, a plethora of laws, rules, and cases have made companies and other entities and their senior executives more accountable for the manner in which they manage their organizations. The spread of higher standards for corporate governance can be seen worldwide, from the passage of new securities laws in the United States stemming from the financial crisis, to promulgation of the Cadbury and like reports in the United Kingdom. Likewise, in the nonprofit and governmental sectors, concerns with the Red Cross’s handling of the 9/11 funds, the government’s handling of the relief efforts after Hurricanes Katrina and Rita, and the United Nation’s handling of the notorious Oil for Food Program in Iraq highlight the ubiquity of concerns for governance and transparency and their impact on all sectors.
Although the leading-edge developments in governance and transparency are taking place primarily in the corporate sector, the issues are equally important for government and for nonprofits. Global competition for investment funds means that every enterprise will be under increased scrutiny for performance at all levels, from governance to service.
Hence, it is important to place the issues of governance and transparency into the broader, corporate context and the global competition for funds.
More Rules, Less Liberty
The governance and function of companies in the future will be shaped increasingly by pressures and developments from around the world. Like their for-profit counterparts, nonprofits also will be affected by global dynamics that shape governance, social responsibilities, and ground rules for global investment, whether for profit or for human development. This will help to explain the underlying reasons for rethinking governance on a wider basis given the extent of global trade and capital markets.
Higher standards for governance and increasing rules bring increasing responsibility and liability. They also implicate liberty. In the United States, shareholders file approximately half of suits against corporate boards, and shareholders’ claims cost many millions in settlement or judgment. Numerous cases have been filed overseas, including, as examples, the Barings cases in the United Kingdom and the A.W.A. case in Australia. The U.S. based scandals of Enron, Adelphia, and WorldCom, Lehman, and Madoff, among others, have brought governance and transparency to the forefront of public awareness.
A disturbing number of corporate entities have been the subject of embarrassing and problematic failures, fraud, ethical lapses, and outright scandals in the past several years. Everything from financial irregularities to burnouts by chief executive officers; self-enrichment by trustees to misallocation of donated funds; excessive compensation arrangements to fraud have been the ruin of many organizations. So many companies seem to have lost their way and been beset by loss of reputation, budget deficits or irrelevancy of mission, that it is impossible even to keep track. Scores of others have thrived, have never been in better shape, and are ever stronger. Why do some companies have success and others such difficulty? While leadership is crucial, the key reason boils down to good governance.
What Is Good Governance?
As a result of the process of “globalization,” recent trends including an increased emphasis on shareholder value, a growing perception of the need for independent directors and committees, and the need for better disclosure of relevant financial information have spread around the globe. Some recent developments that have added impetus to the corporate governance movement, include: globalization itself, since action at a distance requires a high level of reliability and transparency; increasing competition for investment funding for all sectors, which increases requirements for performance and assessment; and improved standards of productivity and service in lead organizations, which significantly raises the bar of expectation for all nonprofits, government services, and businesses.
For the private business sector, other contributing factors include a significant increase in mergers, acquisitions, and takeovers around the world; increased aggressiveness by institutional shareholders; the spread of American-style stock options; a reduction in cross-shareholdings and the influence of banks; the growth of venture capital markets; and the issuance by the OECD of its “Principles of Corporate Governance.”
The enactment of the Financial Accounting Standards Board Interpretations rules for nonprofits and Sarbanes-Oxley and Frank-Dodd legislation in the United States and its ramifications on company practice in a host of governance and transparency areas is changing core practices of capitalism and finance, not only in America but also around the world, given the integration of capital markets. Increasingly, boards and CEOs are also adapting to the new cry for corporate responsibility. Those who take a lead in setting high standards for themselves are gaining respect and value for their enterprises and organizations.
What is corporate governance supposed to achieve? The corporation, for profit or nonprofit, is a separate legal entity with a pool of assets that do not belong to any particular constituents. These assets are not the property of those making the decisions. Corporate decisions regarding the use of such assets must be placed in a larger context.
In the United States and in Europe, the consensus tends to focus on the principal-agent problem and to assume that directors should serve shareholder interests, or in the case of nonprofits, abide by the donor’s intent, while producing outcomes for those served. But in some other countries, broader social interests are often recognized, and given globalization, these other issues are beginning to have an impact in the United States.
We can assume that widely spread ownership means weak monitoring. The mobility of capital in for-profits, however, protects minority shareholders by enabling them to divest easily. This is not the case to the same extent everywhere in Europe or Asia. In other countries, organizations traditionally have had large shareholders actively involved in monitoring so that shareholder protection seems less urgent. While U.S. investors want convergence based on the U.S. system, they have tended not to recognize that other countries are still concerned with social control. Yet these countries want access to U.S. capital. This tension may not be easy to resolve, yet within it lies the key to differing paths of management.
Convergence over governance has been occurring in function, but not necessarily in form. Many recent studies show that convergence will occur on the U.S.-U.K. pattern. There are significant differences in legal systems, ownership patterns and social/political systems. But there appears to be some convergence of functions—e.g., in transparency, oversight and an objective audit process. Increasingly, the focus is on substance, not form—specifically, protection of investors, donors, or taxpayers within the context of local traditions. U.S. institutions will continue to play a dominant role in shaping governance standards.
Accountability and risk management are part of the reason governance has become such a concern. For corporations, several factors raise the requirements for accountability and management of risk. First, foreign direct investment is now much more volatile, and directors must become more aware of ways to minimize the associated risks. Second, corporations throughout the world rely increasingly on global equity financing, rather than on bank loans and retained earnings. Third, corporations are increasingly subject to pressures from institutional investors
In the private sector, the market for corporate control—including mergers, proxy contests and takeovers—has substantially strengthened the board of directors as an institution, as well as the corporate governance system. The development of laws and standards in connection with the unsolicited tender offer has been the most influential factor in this process, because the threat of an unsolicited tender offer keeps boards focused on shareholder value, the role of independent directors and the role of institutional investors. The judgment of directors is protected by the business judgment rule.
A tender offer, however, changes the rules because directors have potential conflicts. Different U.S. states have different approaches to this problem. Pennsylvania law, for instance, protects the board at all costs, but this approach may actually weaken the board in relation to management since management, in effect, can ignore shareholder value. A number of corporations have opted out of the Pennsylvania law. Delaware, which is the most important corporate state, has a different approach. Under Unocal and subsequent cases, Delaware courts have developed a structure of rules for takeovers midway between the business judgment rule and the “entire fairness” test, which traditionally applied when the board was conflicted.
The intermediate standard of review is a “reasonably related” or proportionality test: Is there a threat here to corporate policy and is the response reasonable? Independent directors must play the key role. Were they informed? Did they have independent advisors? Were they independent of management?
This standard of review underscores the role of the board over management. Other cases such as Time-Warner indicate that the board can pursue a strategy not favored by a majority of the shareholders. Similar types of conflicts are present in mergers. For example, once the company is for sale, the directors must seek the highest price reasonably available. It should be emphasized that there is continuing and intense competition in the market for corporate control, which puts major responsibilities on the board.
Coming to Terms
Governance issues before investing are clear. Good governance is becoming a significant factor today in making investment decisions. Except in highly publicized cases of dysfunctional boards or fraud, corporate governance practices now receive scrutiny and not only after prolonged evidence of bad performance. In fact, there is a debate over the economic value of corporate governance. If society wants companies to have good corporate governance, it has to agree on what information is really needed. Measuring good performance means, among other things, doing a CEO performance review, the board’s evaluation of its own performance, and an outside check-up by an independent party.
There are significant differences between the U.S. and the European liability systems. It appears that the continental model is moving at least to some extent in the direction of the Anglo-Saxon model. One question is whether the legal liability system will also evolve in a similar direction. It would be logical to argue that there will be some such evolution, on the basis that, if continental shareholders are demanding new rights, they will also demand new remedies. In the United States, aggrieved shareholders may file class and derivative actions against directors alleging fraud and mismanagement.
The class action is for the most part a uniquely American institution. Prevention of executive misconduct in Europe is accomplished principally by government regulation and criminal sanctions. There are two features that make class actions much more likely to be brought in the United States than in other countries. The first is the widespread practice of bringing such cases on a “contingency” basis. The second is the fact that the plaintiff’s attorney, if he wins the case or achieves a settlement, is entitled to an award of counsel fees based on a substantial percentage of the amount of the recovery. In general, the culture in European countries, including the U.K., is much less oriented toward litigation.
ESG is an ideological weapon of the woke Left now infecting the financial markets but that does not mean companies should stop trying to be more virtuous in the original, and real sense of that term. Rather than engaging in unreflective signaling or superficial ESG scoring, companies should ask themselves what good governance really means. In the end such companies are more profitable!
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Theodore Roosevelt Malloch, scholar-diplomat-strategist, is CEO of the thought leadership firm The Roosevelt Group. He is the author of 18 books, including The Plot to Destroy Trump and, with Felipe J. Cuello, Trump’s World: GEO DEUS. He appears regularly in the media, as a keynote speaker, and on television around the world.
Photo “World Economic Forum Annual Meeting” by World Economic Forum. CC BY-NC-SA 2.0.