Making Corporate Social Responsibility Pay

Dorothy S. Lund is Assistant Professor of Law at the University of Southern California Gould School of Law. This post is based on her recent paper. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Robert H. Sitkoff (discussed on the Forum here); and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

The world is clamoring for corporations to serve society. With the recognition that adequate externality regulation is unlikely to manifest, scholars, politicians, major shareholders, and other corporate stakeholders have joined in urging companies to practice corporate citizenship. But this advocacy is unlikely to alter corporate decisionmaking to the desired extent. In particular, proponents of stakeholder governance ask fiduciaries to operate against a deeply-ingrained incentive structure that pushes them to maximize shareholder wealth as a first priority.

Is there any way to encourage companies to benefit the broader public in a world that remains tethered to wealth maximization? In the past few years, there has been ample financial innovation in this space. Today, investors can fund green bonds or impact bonds, to take two examples. But these instruments merely support profit-maximizing corporate projects that align with investors’ prosocial goals; they do not encourage corporations to make profit-sacrificing prosocial decisions.

In my article, Making Corporate Social Responsibility Pay, I describe a novel instrument that could, under certain circumstances, encourage corporations to prioritize stakeholder goals. More specifically, I describe a “corporate social responsibility bond” that could be used to offset costs associated with prosocial corporate decision-making. The intuition behind this instrument is as follows: if it is welfare-maximizing for individuals to see corporations make profit sacrificing choices, there should be a possible Coasian bargain between those individuals and the corporation. In such situations, an issuer (likely a non-profit, to increase the likelihood that the contribution would be tax deductible) could create a bond to finance a predetermined prosocial corporate action, thereby turning stakeholders into creditors with governance rights. Any individual for whom the choice is welfare-maximizing could participate; their loan would be forgiven if the decision was made, and if not, they would get their money back plus interest.

Consider the following stylized example of how a corporate social responsibility bond could be used. Suppose a coal-fired power company could install scrubbers that would reduce air pollution, increasing the life expectancy of employees and people who live near the company’s factories. But installing scrubbers would cost the company $150 million. As a result, the power company is unlikely to install the scrubbers without regulation, which, as a result of industry lobbying, is not expected to arise. Of course, pressure from environmental advocates, consumers, employees, and even shareholders might lead negative to repercussions for the company that fails to install scrubbers, but unless those costs exceed $150 million, the company will not install them. And this reality holds regardless of the company’s legal objective, and regardless of the extent of fiduciary discretion: even with broader leeway, management is unlikely to voluntarily sacrifice $150 million, which will subject them to negative reputational and financial repercussions, as well as a threat of ouster.

The calculus for the company changes, however, if it has the opportunity to receive bond proceeds to offset the cost of installing the scrubbers. Any individual who would like to see the company make the change could contribute; the most likely source of assets, however, would be a foundation or family office seeking an opportunity to make a tangible and measurable impact on social welfare. Socially responsible mutual funds might also contribute—indeed, a socially responsible index fund might promise that, instead of buying and selling shares of companies based on investor ideology (which research has shown to be generally ineffective in altering corporate behavior), the fund’s higher fees would support worthy corporate social responsibility bonds.

In this example, the bond would be the only way to encourage the company to install the scrubbers. In addition, by converting outsiders into creditors, the bond might alter other facets of corporate decisionmaking. Perhaps, for example, the bondholders would secure information rights or the right to monitor operations until the decision is made. And in addition to altering practices at the targeted company, the bond could have beneficial secondary effects on the market. For one, by advertising that it has installed scrubbers, the company could cause consumers to focus on industry rivals that have not followed suit, increasing the costs of non-compliance with the developing norm. Second, by inducing the company to install scrubbers, the bond would discourage it from lobbying against regulation that would impose the same requirement on rivals. Indeed, the power company might now lobby in favor of more stringent regulation (my article discusses additional examples in which these secondary effects are more pronounced).

As this example reveals, the social responsibility bond resembles a private Pigouvian subsidy that could be used to alter corporate decisionmaking by changing the set of decisions that are wealth-maximizing. At its best use, a bond could transform industries, ease the prospect of regulation, help prosocial individuals overcome coordination costs, and halt harmful corporate activities. These bonds would do this without any change in the law or corporate governance. Indeed, one of the advantages of the bond is that it works within the wealth-maximization framework, and therefore, does not risk eroding managerial accountability and other inefficiencies associated with a stakeholder governance model.

But the devil is in the details. Indeed, corporate social responsibility bonds are fraught with complications that could render them not useful or even harmful under certain circumstances. For example, the bonds could be impossible to price because of information asymmetries, lead to moral hazard for companies, and could result in harmful distributive consequences. In addition, companies might not be receptive to accepting funds when doing so will focus attention on their harmful practices (I address these and other potential pitfalls in the article). Therefore, corporate social responsibility bonds should not be seen as a cure for every instance of corporate irresponsibility, but a complement to action taken on other grounds—by consumers, employees, shareholders, and regulators.

More broadly, the observation that the individuals with the strongest interest in seeing corporations pursue corporate social responsibility goals are not always the shareholders has consequences for corporate law and corporate governance. In particular, it cautions that we should recognize the limits of shareholder activism to achieve socially optimal levels of corporate responsibility. The more difficult question is whether and how to reorient our corporate law system away from shareholders and toward other constituencies. As that project forges on, my article introduces a tool that could allow corporate outsiders to influence corporate behavior without any delay—one decision at a time.

The complete paper is available for download here.

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