Corporate Governance: An expert insight and explanation
Updated: Aug 21
Corporate Governance and Corporate Social Responsibility (CSR) are at the core of business management and regulation, but it can be hard to understand these concepts, relevant regulation and trends. The following piece has been written with the help of Professor Andrew Johnston who is currently a professor at the University of Sheffield, having studied law as an undergraduate at Cambridge, and completed his PhD at the European University Institute in Florence. He has previously worked for Herbert Smith Freehills and lectured at the Universities of Queensland and Cambridge. Throughout, Andrew offers his insight, experience and top tips, whilst I'll unpack potentially unfamiliar terms or concepts and point you to further resources. Hopefully this is a welcome reminder of the amazing resources you have at your disposal whilst at university - your lecturers and professors! - and an encouragement to you to research and increasingly ask them questions.
Topic 1: Corporate Governance
What does corporate governance mean?
Corporate governance relates to how companies are directed and controlled, as the Cadbury Report taught us. But it also relates to the impact of outside forces on corporate decision-making, and how the costs and benefits of corporate activity are distributed. So, it builds on company law, but is also much wider than company law, because it encompasses market forces, social norms, soft law, social movements and so many other things.
Andrew refers to the Cadbury Report which is the first in a series of reports commissioned by the UK government looking into corporate governance. The Report defines corporate governance as: ‘the system by which companies are directed and controlled.’ This involves decision-making by management (i.e. directors of companies), shareholders (those who own shares in companies) and external pressures which may include stakeholder interests (stakeholders are those parties which have a vested interest in the company, or suffer negative consequences as a result of management failing to consider them in decision-making, for example, employees, the environment, social justice, equality and diversity…).
Why are shareholders so central to the corporate governance model in the UK and is this the case in other countries?
Some background to this question… If you aren’t aware, the UK system of corporate governance is driven in the direction of maximising shareholder value. The UK model subscribes to ‘shareholder primacy,’ enshrined in s172 Companies Act 2006. The Act states that directors run companies, balancing an array of interests (e.g. environmental effects, employee interests etc.) for the interests of shareholders. So, when crunch time comes and directors have to choose between maximising the value in a company and investing in employment, reducing their negative environmental effects or social justice… management take decisions on what benefits shareholders. This means that share value maximisation (simply an increase in the value of shares) almost always wins out, since it’s the most obvious common denominator among diverse shareholders.
So, back to the question… why is this the case?
In my research I have tried to trace the evolution of shareholder primacy corporate governance in the UK. I believe company law itself is fairly agnostic about the priority to be given to shareholder interests, but I think there has always been a political belief that shareholders are somehow more important than other groups, and at times there has been a strong assumption that corporate managers could not be trusted to do the right thing. So, shareholder value emerged partly by historical accident, partly because of the influence of the powerful and partly because people didn’t ask enough questions about what the role of companies in society should be.
I think the UK led the way in terms of shareholder primacy, and still does, although in some respects, the US corporate governance system is more shareholder-centric. Other countries around the world have copied aspects of the UK’s system, partly to try to attract investment, partly because of the influence of powerful groups. The EU, for a long time, copied measures from the UK, whether the Takeover Code, or more recently, the Shareholder Rights Directive, which is very closely modelled on the UK’s Stewardship Code. It remains to see whether, if Brexit happens, the EU is still so keen on following the UK’s lead.
What characterised shareholder behaviour in the UK? Are we seeing any changes in behaviour?
I think there is a lot more emphasis on shareholder stewardship/activism than previously (although the Bank of England has been pushing for institutional investors to take a more active approach since at least the 1970s). The interesting thing is that policy makers are assuming that institutional investors will take an interest in long-term matters, in sustainability, but that share registers are dominated by overseas investors. And the long-term investors based in the UK are increasingly investing in ‘alternative investments’ such as hedge funds and private equity, both of which are often considered to be quite short-termist in outlook. At the same time, there is massive growth in passive investment funds such as Exchange Traded Funds, and there is not a great deal of clarity about whether these funds are equipped (or have any incentive) to take an active approach to corporate governance.
One of the overriding themes to wrap your head around is the contrast of short- and long-term goals in corporate governance. Financial reporting happens so regularly in modern markets that management are encouraged to increase share value in incredibly short periods of time, rather than invest in long-term sustainable growth. Corporate governance regulation in recent years has tried to reverse a trend towards short-termism and instil more sustainable development in companies (for example, through the Stewardship Code).
‘Institutional investors’ for anyone who doesn’t know are the big players in investments – large investment funds such as pension funds and the investment branches of commercial banks.
Foreign investment is the final aspect highlighted above which may need some clarification. The Stewardship Code, mentioned above, applies only to English companies, and so foreign investment funds will not be caught by its regulations.
A brief note on the Stewardship Code
To understand what the Stewardship code tries to do, we have to first understand how investment chains work, and how long they are. Have a look at the diagram below which demonstrates that individuals (like you and I) place our money in investment funds (including pension funds) which give that money to managers, who use agents to pump that money into other funds, or companies. Stewardship tries to ensure that each link of this chain has due regard for the interests of those higher in the chain, since each party higher in the chain is supposed to act in the interests of the party/parties directly below it in the chain.
Source: FCA/FRC ‘Building a regulatory framework for effective stewardship’ (January 2019) Discussion Paper, 17
How does UK shareholder behaviour compare to behaviour in other jurisdictions?
UK shareholders are more dispersed than in many other countries, so there is rarely a dominant shareholder. This means that UK shareholders rely more heavily on market mechanisms such as takeovers and other issues such as pay as a means of disciplining and incentivising management, although shareholder activism is on the rise. In contrast, in countries (and companies) where there is a dominant shareholder, there may be more concern about the behaviour of that blockholder and the possibility that they may be taking advantage of their position in order to extract private benefits of control. In this situation, of course, company law comes back to the centre of the picture.
What does Andrew mean when he says that shareholders can rely on takeovers as a mechanism to discipline and incentivise management? In short, if a company underperforms, share prices will begin to drop, as the market loses confidence in the company and regards it to be of lower worth than higher-performing competitors. If share prices continue to fall, shareholders may be approached by a party seeking to take over the company, which is likely lead to the removal and replacement of its directors. Therefore, the directors always have a vested interest in ensuring the company does well and that share prices continue to increase in value, and shareholders are content.
Topic 2: Corporate Social Responsibility (CSR)
What are some of the current issues to be aware of in terms of corporate governance?
I think we are seeing more and more attention being given to how corporate governance can contribute to greater sustainability, including but not limited to climate change. The European Commission’s Sustainable Finance Action Plan hints at large scale changes to corporate governance in order to ensure that companies take part in the essential transition to sustainability. At the same time, there is growing recognition that Corporate Social Responsibility, essentially voluntary action on the part of companies, is inadequate to address growing social and systemic problems resulting from the current system.
When we think of shareholder-centric approaches which have a short-term focus, that seems liable to generate what you’ve labelled as ‘negative externalities’ rather than promote ‘CSR.’ Can you explain these terms please?
Corporate Social Responsibility (CSR) used to be defined as voluntary action to make the world a better place, but in recent years, there has been greater emphasis on the impact of corporate activities on various ‘affected groups.’ This is a welcome development because it insists that CSR should focus on addressing and mitigating the effects that companies have on their environment. Where it falls short relates to how far companies should go. CSR has tended to be unobjectionable because it does not require companies to sacrifice profits in order to address their social costs (or ‘internalise their externalities’ as economists put it). They only need to address an impact where there is a ‘business case’ for doing so, that is, it can be done profitably. This leaves many impacts unaddressed, and leaves systemic problems such as climate change as ‘someone else’s problem’.
OK, pause there. ‘Negative externalities’ I think sounds like my motivation for going to the gym! But, it’s an idea I’ve bought into – beyond my minimal gym attendance! Andrew has written much about this which you can read, but for now, hopefully you can see the distinction between companies which simply ‘do good’ and those which ‘internalise their negative externalities.’ What do I mean?! Let’s take the example of a fuel company which drills for, and sells, oil. A ‘do good’ approach to corporate social responsibility would be simply to donate a lot of money to good causes – charities which protect children and the environment, further education across the globe and reduce poverty. This is undoubtedly good. The ‘internalising negative externalities’ approach forces companies to look at the negative impacts they have as a result of operating their business. In the case of the oil company, think of oil spills and increased CO2 emissions. To internalise these means to pump money into clearing up our oceans, to donate to those communities and habitats which are affected by oil spills, to increase research and development into renewable fuels and to reduce carbon footprints, through both the creation of greener fuel, and investing in schemes such as carbon capture and reforestation to reduce the amount of damage caused by fossil fuels.
What about the ‘business case for CSR’ referred to above? This was a once-popular rhetoric which stated that there was a profit-driven rationale behind these ‘do good’ investments – i.e. that charity is a great form of self-promotion and publicity, which adds value to companies. It is not widely regarded as persuasive.
What pressures and regulations are there on companies to reduce their negative externalities and promote CSR?
As I said above, there is a growing agenda that insists on linking corporate governance and sustainability, and we seem to be moving beyond voluntary forms of CSR towards various types of procedural regulation, whether a requirement to disclose and implement a sustainability strategy or some kind of expansion of the scope and enforcement of directors’ duties, or even changes to corporate boards so that they include representatives of stakeholder groups. Even the UK Corporate Governance Code now recognises the importance of companies engaging with their stakeholders, although its employee participation recommendations are weak.
Are these pressures coming from states or from shareholders?
I think these pressures are coming from a variety of sources, from progressive governments, from the European Union, from responsible shareholders, from civil society, from professionals and from academics.
Are measures effective in reducing negative externalities and what more needs to be done if not?
I think things are currently going in the right direction, although if/when the UK leaves the EU, there is potential for the UK to backtrack on what the EU is doing and attempt to create a race to the bottom. At the same time, we are running out of time to address climate change, so it is vitally important that the Sustainable Finance Action Plan is implemented as quickly as possible, and that further actions are taken. Two projects I contribute to (the SMART project at the University of Oslo, and the Purpose of the Corporation/Modern Corporation projects) are working very hard to develop workable recommendations to build on this momentum.
Topic 3: An insight into academia and top tips for students
Your research seems like a happy medium between corporate practice and research, can you explain a little bit about what you do and your specialist area of research?
As an academic we have a balance between teaching and research, and these two aspects of our role should inform each other. I teach company law and corporate governance, and I also research those subjects and publish on them. So this should mean that my teaching includes up to date critical thinking about these topics and the way they are developing. At the same time, the questions my students ask me often fuel further research. That is because research is essentially attempting to answer difficult questions, whether that is ‘why is the law like this?’ or ‘couldn’t we do this differently?’
Could you share a little about your experience in academia as opposed to legal practice? How does practising law compare to looking at them from an academic perspective?
Working as an academic, we are expected to have ‘real world’ impact and I really enjoy working with NGOs such as Frank Bold and the GOODCORP network at the European Trade Union Institute. But we have freedom to follow where our research takes us, and, whilst we might collaborate with civil society organisations, they are not our clients. So there is scope to look at the bigger picture, something that perhaps gets lost a little when you are working to tight deadlines and detailed technical advice for clients.
What are the key skills required for a career in legal practice and academia, and what are the different demands of each?
Both require top notch legal skills. Studying law at university provided a foundation of skills that I used both in practice and academia. It also enables you to provide a first diagnosis of a particular problem, knowing which areas of law are likely to be triggered and to provide any possible solution. Both require an ability to balance a variety of different demands on your time, and both increasingly require entrepreneurialism and networking, whether to bring in clients or students, or to find other opportunities. Legal practice probably creates more short-term pressure than academia, and academic performance is probably assessed over longer time frames, but the pressure is still there. If papers are not written, presented and published, then your career will not advance.
Last question, what are your top tips for:
1. Students preparing for a career in corporate law?
Study hard at university, obviously, and make sure your grades are as good as you can make them. Choose ‘hard’ corporate and commercial law modules, especially those that involve research. Read widely, including the Financial Times and blogs such as MainlyMacro. Speak to students who have successfully navigated interview processes. Consider studying abroad if you can in order to learn about foreign legal systems and to gain life experience. Be prepared to work very long hours.
2. Students thinking about a career in academia?
Much the same as for a career in corporate law. Academia is not a picnic and universities can be ruthless places. But academia gives you freedom to follow your interests across disciplines and across jurisdictions, to make networks of contacts around the world. So, I recommend it, but then I would, wouldn’t I?