Sustainability in Corporate Law

Stavros Gadinis is professor of law and Amelia Miazad is founding Director and Senior Research Fellow of the Business in Society Institute at Berkeley Law School. This post is based on their recent paperRelated research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

Over a quarter of total assets under management is now invested in socially responsible companies. This marks an astounding repudiation of Wall Street’s get-rich-fast mentality, as well as a direct challenge to corporate law’s reigning mantra of profit maximization. Yet, this new direction has gained followers not only among progressive academics and policy makers, but also among conservative corporate law scions and financial industry leaders. It has particularly benefited from the support of large asset managers like Blackrock, State Street, and Vanguard. And, if one is to judge by the 181 CEO signatures on the Business Roundtable’s recent Statement of Purpose Letter, companies may be listening. How can we understand the business world’s recent focus on stakeholders and environmental and social issues? And how can we reconcile it with shareholder primacy, the reigning mantra in corporate law?

Current literature has yet to provide an overarching explanation for this phenomenon. Some argue that ESG can generate higher profits, for example because some consumers pay a premium for sustainable products. But many important ESG initiatives do not fit well with the “doing well by doing good” framework because they come with significant short-term costs. Many claim that ESG helps companies become more profitable in the long term, without specifying any tangible mechanism for doing so or any time horizon in which they expect to see profits. Still others argue that ESG governance improvements reduce the likelihood of managerial abuses that plague other companies, even though many ESG initiatives have little to do with governance.

We propose an alternative explanation for the rise of ESG, arguing that companies see ESG not as a discrete set of issues, but as a process that helps them mitigate risk. In our conversations with corporate executives, in-house counsel, and investors, we found that the common characteristic of ESG initiatives, from the environment to diversity, and from privacy to human rights, is consultation with a wide variety of stakeholders on the ground. This extensive information-gathering effort, we argue, provides managers and directors with insights they would have difficulty accessing otherwise, because it portrays company operations from a perspective they lack. Companies invite NGOs, governmental bodies, local authorities, citizens’ groups, and of course their own employees, to provide input on the impact of their operation to their lives or to their constituents’ lives. In addition, companies track their constituents’ reactions with their own efforts, by monitoring developments in local communities and keeping a pulse on social media. The information collected through this process helps companies better predict negative consequences of their operations, aspects that they have overlooked, or dangerous incidents that betray larger underlying problems. By bringing all sides around the negotiating table, ESG can help broker solutions and establish trust. Based on this informational advantage, companies can better decide what steps would avoid a future crisis that would be detrimental for their shareholders.

To illustrate our argument, we compare ESG with compliance, the primary governance mechanism sanctioned by corporate law to protect against legal risk. Compliance and ESG often seek to protect shared or similar values, but their approach is drastically different. While compliance is tethered to statutory and regulatory definitions of misconduct and liability, ESG focuses on actual or potential harm on the ground, even if not currently punishable by law. Thus, it has a broader scope that can encompass emerging problems where the law is still developing. Moreover, compliance puts employees and managers on the spot and threatens sanctions, often leading them to conceal evidence or turn a blind eye. Instead, sustainability offers a new, optimistic vision of the future without lingering on the past, encouraging everyone to enter afresh into new commitments, sidestepping agency conflicts that have hampered compliance. Moreover, ESG initiatives, though often costly, manifest the company’s credible commitment to stakeholders’ concern which help establish trust that can come in handy if risks materialize.

In the paper, we document the many ways in which companies have actively sought to reorient their corporate governance in order to reward ESG initiatives by management. These reforms include incorporating ESG metrics in their compensation, creating specialized board committees, and recruiting directors with ESG expertise. Companies should be free to determine their preferred way of operationalizing their ESG commitments, we believe, but they should make their choices after having considered relevant information. We argue that the information companies receive through stakeholder engagement is so critical for their business that, if boards make no effort to understand their impact on stakeholders, they are exposing their shareholders to increased risks. If that failure is due to bad faith, it should be treated as a violation of the board’s fiduciary duties. To clear the bad faith hurdle, boards should ensure that the company has a well-established ESG function.

Our proposal comes at a time when corporate vilification is in vogue. Elizabeth Warren and Donald Trump agree on very little, but they both attack corporations often and this message is resonating with voters on both sides of the political spectrum. It is tempting to cast corporations as the villains locked in a perennial game of cat and mouse with legislatures, regulators, and law enforcement authorities. In this scenario, corporations are constantly seeking to evade current laws, exploit unregulated terrains for their own benefit, or force unequal bargains to struggling communities and disadvantaged groups. While this portrayal may still be accurate for many corporations, our research shows that a good number of companies are moving away from it because management, directors, and shareholders are realizing that it does not make business sense. Instead, ESG envisages corporations not simply as an efficient production mechanism, but as a mini-social laboratory where relationships between stakeholders are constantly evolving in the face of newly mounting challenges. From an aggregate social perspective, these laboratories are essential because they allow all interested parties to come together, put their cards on the table and negotiate openly. Through this process, corporations can turn stakeholders’ input into valuable information that can protect both themselves and their constituents from harm. Corporate misconduct happens in companies that are insular.

The complete paper is available for download here.

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