Ethical issues in corporate governance are primarily the responsibility of

The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.

The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship.

Corporate governance is therefore about what the board of a company does and how it sets the values of the company, and it is to be distinguished from the day to day operational management of the company by full-time executives.

In the UK for listed companies corporate governance it is part of the legal system as the latest  UK Corporate Governance Code applies to accounting periods beginning on or after 1 January 2019 and,, applies to all companies with a premium listing of equity shares regardless of whether they are incorporated in the UK or elsewhere.

But good governance can have wider impacts to the non listed sector because it is fundamentally about improving transparency and accountability within existing systems. One of the interesting developments in the last few years has been the way in which the ‘corporate’ governance label has been used to describe governance and accountability issues beyond the corporate sector. This can be confusing and misleading as UK Corporate Governance has been built and developed to deal with the governance of listed company entities and not designed to cover all organisational types that may have different accountability structures.

The balance of pursuing market opportunities while maintaining accountability and ethical integrity has proved a defining challenge for business enterprise since the arrival of the joint- stock company in the early years of industrialism. The accountability and responsibility of business enterprise is constantly subject to question. The manifest failures of corporate governance and business ethics in the global financial crisis has increased the urgency of the search for a better ethical framework and governance for business. A substantial increase in the range, significance and impact of corporate social and environmental initiatives in recent years suggests the growing materiality of a more ethically-informed approach. However challenging the prospects, there are growing indications of large corporations taking their social and environmental responsibilities more seriously, and of these issues becoming more critical in the business agenda.

Introduction

Since the origin of commerce, the ethical basis of business has been in question. In the ancient Greek civilisation Aristotle could readily distinguish between the basic trade required for an economy to function, and trade for profit which could descend into unproductive usury (Solomon 1992, 321). Most major world religions cast a sceptical eye on business, including Christianity, Islam and Confucianism. Shakespeare immortalised the potential venality of business in The Merchant of Venice, “All that glisters is not gold.” Frentrop (2003) graphically records how greed, speculation, deceit and frequent bankruptcy punctuated the fortunes of the earliest of the great trading companies, beginning with the Dutch East India Company. Adam Smith in 1776 in The Wealth of Nations made a withering comment on company management that would echo through the ages: “Being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partner frequently watch over their own … Negligence and profusion, therefore, must always prevail more or less in the management of the affairs of a joint-stock company” (Smith 1976, 264–265).

As technological change advanced with the industrial revolution, there occurred a wider diffusion of ownership of many large companies as no individual, family or group of managers could provide sufficient capital to sustain growth. Berle and Means chronicled the profound implications of this separation of ownership and control: “the dissolution of the old atom of ownership into its component parts, control and beneficial ownership” (1933, 8). Berle and Means expressed hope that with this different concept of a corporation there might develop a much wider accountability to the community, recognising the significance of the diffusion of ownership and the concentration of control in the modern corporation: “The economic power in the hands of the few persons who control a giant corporation is a tremendous force which can harm or benefit a multitude of individuals, affect whole districts, shift the currents of trade, bring ruin to one community and prosperity to another (Berle and Means 1933, 46).

However any hope of a wider sense of fiduciary duty in corporations was eroded away in the later decades of the twentieth century in the Anglo- American world, as capital markets became more aggressive and unstable, and executive compensation was propelled upwards by stock options. A succession of cycles of booming economies, followed by market collapse and recession, culminated in 2007–2008 in the first global financial crisis, which was also a crisis in governance and regulation. The most severe financial disaster since the Great Depression of the 1930s exposed the dangers of unregulated markets, nominal corporate governance, and neglected risk management. What also appeared in stark relief were an economic system and corporations and managers singularly lacking in any moral compass.

It has been argued that the dominant logic in this era, in both finance and law of agency theory, had reduced managers to mere agents of shareholder principles. Agency theory asserts that shareholder value is the ultimate corporate objective which managers are incentivised and impelled to pursue: “The crisis has shown that managers are often incapable of resisting pressure from shareholders. In their management decisions, the short-term market value counts more than the long-term health of the firm” (Segrestin and Hatchuel 2011, 484; Jordi 2010). Agency theory has become “a cornerstone of … corporate governance” (Lan and Heracleous 2010, 294). As governments, regulators, and financial institutions examined what had gone wrong during the crisis, a new sense of the importance of robust regulation, alert corporate governance, and stronger ethical guidelines became widespread. In effect what is now emerging is an integration of corporate governance, corporate social responsibility and corporate sustainability which potentially offers a new framework for ethical business.

This newly-emerging ethical framework for business provides a stronger base for the exercise of moral values and ethical reasoning. “People in business are ultimately responsible as individuals, but they are responsible as individuals in a corporate setting where their responsibilities are at least in part defined by their roles and duties in the company … businesses in turn are defined by their role(s) and responsibilities in the larger community …” (Solomon 1992, 320). This suggests an ethical alignment of individuals, corporations, and the economic system, which is captured in the definition of corporate governance offered by Cadbury, and adopted by the World Bank:

Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society.

This definition highlights the importance of corporate governance in providing the incentives and performance measures to achieve business success, and secondly in providing the accountability and transparency to ensure the equitable distribution of the resulting wealth. Finally the significance of corporate governance in enhancing the stability and equity of society recognises a more positive and proactive role for business. Rather than corporate governance and regulation being inherently restrictive, they can be a means of enabling corporations to achieve the highest goals of corporate achievement. Equally a more positive approach to business ethics can be imagined (Solomon 1992, 330):

Business ethics is too often conceived as a set of impositions and constraints, obstacles to business behavior rather than the motivating force of that behavior … properly understood, ethics does not and should not consist of a set of prohibitive principles or rules, and it is the virtue of an ethics of virtue to be rather an intrinsic part and the driving force of a successful life well lived. Its motivation need not depend on elaborate soul-searching and deliberation but in the best companies moves along with the easy flow of interpersonal relations and a mutual sense of mission and accomplishment.

Historical development of corporate governance and accountability

The balance of pursuing market opportunities while maintaining accountability has proved a defining challenge for business enterprise since the arrival of the joint-stock company in the early years of industrialism. The accountability and responsibility of business enterprise was constantly subject to question, and historically failed this test—often in the view of the public. Maurice Clark deplored how business “inherited an economics of irresponsibility” from the laissez-faire beliefs and practices of early industrialism (1916). He argued that business transactions do not occur in isolation, but have wider social and economic consequences which need to be considered, impacting directly on employment, health and the environment. He insisted that legal regulation may be required to ensure protection from abuses, but that this could never replace a general sense of responsibility in business that goes beyond the letter of the law, preventing competitive forces from leading to a race to the bottom. Hence the periodic outbreak of destructive competition needed to be restrained in Clark’s view by “an economics of responsibility, developed and embodied in our working business ethics” (1916).

The debate concerning the true extent of the accountability and responsibility of business enterprise has continued to the present day, punctuated by occasional public outrage at business transgressions, and calls for greater recognition of the social obligations of business. At the height of the economic depression in the United States in 1932, Dodd made a dramatic plea in the pages of the Harvard Law Review: “There is in fact a growing feeling not only that business has responsibilities to the community but that our corporate managers who control business should voluntarily and without waiting for legal compulsion manage it in such a way as to fulfill these responsibilities.” This resonated with Berle and Means’ insistence that large corporations “serve not alone the owners or the control, but all society.” Though Berle subsequently commenced a prolonged debate with Dodd on the subject of For Whom Are Corporate Managers Trustees, he (Berle) (1955) later conceded to Dodd’s argument that management powers were held in trust for the entire community (Wedderburn 1985, 6).

Such forthright views did not remain at the level of academic speculation, but often were translated into legal, policy and business interpretations and practice. For example in Teck Corp Ltd v. Millar, the Supreme Court of British Columbia, while retaining the identification of company interests with those of shareholders, nonetheless was prepared to grant directors a licence under their fiduciary duties to take into account wider stakeholder interests (Teck Corp Ltd v. Millar 1973, 313–314):

The classical theory is that the directors’ duty is to the company. The company’s shareholders are the company … and therefore no interests outside those of the shareholders can legitimately be considered by the directors. But even accepting that, what comes within the definition of the interests of the shareholders? By what standards are the shareholders’ interests to be measured? A classical theory that once was unchallengeable must yield to the facts of modern life. In fact, of course, it has. If today the directors of a company were to consider the interests of its employees no one would argue that in doing so they were not acting bona fide in the interests of the company itself. Similarly, if the directors were to consider the consequences to the community of any policy that the company intended to pursue, and were deflected in their commitment to that policy as a result, it could not be said that they had not considered bona fide the interests of the shareholders.

Wedderburn (1985, 12) documents an equivalent deep-seated and practical commitment of corporate responsibility to a wide constituency in the post-war beliefs of leaders of the British business community. A lively debate continues world-wide concerning the scope of directors’ duties. In Australia, the Corporations Act Section 181 obliges directors and other corporate officers to exercise their powers and discharge their duties:

• in good faith and in the best interests of the corporation;
• for a proper purpose.

Under common law directors are obliged to act in the interests of “the company as a whole.” Traditionally this phrase has been interpreted to mean the financial well-being of the shareholders as a general body (though directors are obliged to consider the financial interests of creditors when the firm is insolvent or near-insolvent). A recent generation of financial economists helped to translate this broad shareholder primacy principle into a narrow pursuit of shareholder value. This restrictive definition of shareholder value has often been associated with short-termism and a neglect of wider corporate responsibilities in the interests of immediate profit maximisation. Concerns have arisen that directors who do wish to take account of other stakeholder interests may be exposed. However there is a wider interpretation of shareholder value which suggests that only when all of the other constituent relationships of the corporation—with customers, employees, suppliers, distributors and the wider community—are fully recognised and developed, can long-term shareholder value be released.

In 2007–2008 the first global financial crisis exposed the dangers of unregulated markets, nominal corporate governance, and neglected risk management

Traditionally, commercial law in many European countries has supported a sense of the wider social and environmental obligations of companies, which continues despite a recent enthusiasm for the principle of shareholder value as some large European companies for the first time seek the support of international investors. The United Kingdom has stood apart from Europe as an influential exponent of the Anglo-American market-based approach to corporate governance. However, in an effort to jettison the company-law rhetoric instituted in the 19th century, and to make the law more accessible, a Company Law Review (CLR) steering group was established. The ensuing consultative document Modern Company Law for a Competitive Economy: Developing the Framework (2000) proposed for the first time that there should be a statutory statement of directors’ duties (in the past the core components of those duties was found in case law), and made a significant step in the direction of endorsing fuller corporate social and environmental reporting (CLR 2000, 180–181):

Current accounting and reporting fail to provide adequate transparency of qualitative and forward-looking information which is of vital importance in assessing performance and potential for shareholders, investors, creditors and others. This is particularly so in the modern environment of technical change, and with the growing importance of “soft,” or intangible assets, brands, know-how and business relationships. The full annual report must be effective in covering these, both as a stewardship report and as a medium of communication to wider markets and the public … we believe the time has come to require larger companies to provide an operating and financial review, which will cover the qualitative, or “soft,” or intangible, and forward-looking information which the modern market and modern business decision-making require, converting the practice of the best-run companies into a requirement for all.

These issues were extensively considered in the United Kingdom for several years in the deliberations of the Modern Company Law Review. Two approaches were considered:

• a pluralist approach under which directors’ duties would be reformulated to permit directors to further the interests of other stakeholders even if they were to the detriment of shareholders;
• an enlightened shareholder-value approach allowing directors greater flexibility to take into account longer-term considerations and interests of various stakeholders in advancing shareholder value.

In considering these approaches, the essential questions of what is the corporation, and what interests it should represent are exposed to light, as Davies eloquently argues (2005, 4):

The crucial question is what the statutory statement says about the interests which the directors should promote when exercising their discretionary powers. The common law mantra that the duties of directors are owed to the company has long obscured the answer to this question. Although that is a statement of the utmost importance when it comes to the enforcement of duties and their associated remedies, it tells one nothing about the answer to our question, whose interests should the directors promote? This is because the company, as an artificial person, can have no interests separate from the interests of those who are associated with it, whether as shareholders, creditors, employers, suppliers, customers or in some other way. So, the crucial question is, when we refer to the company, to the interests of which of those sets of natural persons are we referring?

As a member of the Corporate Law Review Steering Group, Davies goes on to defend the enlightened shareholder-value view suggesting that the pluralist approach produces a formula which is unenforceable, and paradoxically gives management more freedom of action than they previously enjoyed. An Australian legal expert, Redmond, endorses this critique of widening the scope of directors’ duties too greatly (Redmond 2005, 27):

The pluralist or multifiduciary model rests on a social, not a property, view of the corporation. It identifies the corporate purpose with maximizing total constituency utility. This is an indeterminate outcome measure which poses particular difficulties in translation into a legally enforceable duty. The indeterminacy of the criteria for decision and performance measurement also points to a probable loss of accountability for directors since it offers broad scope to justify most decisions. It is difficult to resist the conclusion of the British review that either it confers a broad unpoliceable policy discretion on managers themselves or just gives a broad jurisdiction to the courts. The model needs either practical rehabilitation or a superior performance metric. It is not clear where either might be found.

In the resulting British Company Law Reform Bill (2005) the enlightened shareholder-value view has prevailed in clause 156, which defines the essential directoral duty as:

Duty to promote the success of the company

1. A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.
2. Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, his duty is to act in the way he considers, in good faith, would be most likely to achieve those purposes.
3. In fulfilling the duty imposed by this section a director must (so far as reasonably practicable) have regard to:
   1. the likely consequences of any decision in the long term,
   2. the interests of the company’s employees,
   3. the need to foster the company’s business relationships with suppliers, customers and others,
   4. the impact of the company’s operations on the community and the environment,
   5. the desirability of the company maintaining a reputation for high standards of business conduct, and
   6. the need to act fairly as between members of the company.
4. The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

This clause replaces the discretion of directors to have regard for stakeholder interests with a duty for directors to do this (Davies 2005, 5):

As far as directors’ duties are concerned, this is the heart of the enlightened shareholder-value approach. The aim is to make it clear that although shareholder interests are predominant (promotion of the success of the company for the benefit of its members), the promotion of shareholder interests does not require riding roughshod over the interests of other groups upon whose activities the business of the company is dependent for its success. In fact, the promotion of the interests of the shareholders will normally require the interests of other groups of people to be fostered. The interests of non-shareholder groups thus need to be considered by the directors, but, of course, in this shareholder-centred approach, only to the extent that the protection of those other interests promotes the interests of the shareholders. The statutory formulation can be said to express the insight that the shareholders are not likely to do well out of a company whose workforce is constantly on strike, whose customers don’t like its products and whose suppliers would rather deal with its competitors.

In this way the Company Law Reform Bill treads a fine legal line between a sense of “enlightened shareholder value” which is becoming best practice in many leading companies, and more radical claims for company law to adopt a more “pluralist” sense of the ultimate objectives of the enterprise and the interests to be served. The reform manages this balancing act by suggesting that the pluralist objectives of maximizing company performance to the benefit of all stakeholders can best be served by professional directors pursuing commercial opportunities within a framework of standards and accountability:

The overall objective should be pluralist in the sense that companies should be run in a way which maximizes overall competitiveness and wealth and welfare for all. But the means which company law deploys for achieving this objective must be to take account of the realities and dynamics which operate in practice in the running of a commercial enterprise. It should not be done at the expense of turning company directors from business decision-makers into moral, political or economic arbiters, but by harnessing focused, comprehensive, competitive decision-making within robust, objective professional standards and flexible, but pertinent accountability (CLR 2000, 14).

The reform supports the ultimate power of shareholders to appoint or dismiss directors for whatever reasons they choose, and to intervene in management to the extent the constitution permits, and confesses: “There is clearly an inconsistency between leaving these powers of shareholders intact and enabling or requiring directors to have regard to wider interests … the effect will be to make smaller transactions within the powers of directors subject to the broad pluralist approach, but larger ones which are for shareholders subject only to the minimal constraints which apply to them” (CLR 2000, 26).

It is likely that the modern company law proposals will over time facilitate the wider and more conscious adoption by British companies of social and environmental commitments, and the willingness to report fully on them. In time it is possible that such social and environmental commitments will become part of widespread company and management best practice, in the way that the commitment to quality in the production of goods and services has become universal. Moreover, just as the United Kingdom in the publication of the Cadbury code of corporate governance ultimately influenced a considerable number of other countries to adopt a similar code, it is possible that other countries, particularly that share a common law tradition with the United Kingdom, will begin to review their company law with similar objectives in mind.

Moral liability occurs when corporations violate stakeholder expectations of ethical behaviour in ways that put business value at risk

One reason why the agenda of corporate responsibility is increasingly irresistible is that while legal liability of corporations is deepening, what has been described as an emerging and hardening moral liability is exerting increasing influence. In this respect the legislative process lags behind what society thinks, values and respects. Moral liability occurs when corporations violate stakeholder expectations of ethical behaviour in ways that put business value at risk. There is an increasing convergence between these two forms of liability, as corporations come under scrutiny both by the law and—often more immediately and pointedly—by public opinion (SustainAbility 2004, 5).

Corporate social responsibility

The narrow focus of corporate governance exclusively upon the internal control of the firm and simply complying with regulation is no longer tenable. In the past this has allowed corporations to act in extremely irresponsible ways by externalising social and environmental costs. Corporate objectives described as “wealth generating” too frequently have resulted in the loss of well-being to communities and the ecology. But increasingly in the future the license to operate will not be given so readily to corporations and other entities. A license to operate will depend on maintaining the highest standards of integrity and practice in corporate behavior. Corporate governance essentially will involve sustained and responsible monitoring of not just the financial health of the company, but the social and environmental impact of the company.

A substantial increase in the range, significance and impact of corporate social and environmental initiatives in recent years suggests the growing materiality of sustainability. Once regarded as a concern of a few philanthropic individuals and companies, corporate social and environmental responsibility appears to be becoming established in many corporations as a critical element of strategic direction, and one of the main drivers of business development, as well as an essential component of risk management. Corporate social and environmental responsibility (CSR) seems to be rapidly moving from the margins to the mainstream of corporate activity, with greater recognition of a direct and inescapable relationship between corporate governance, corporate responsibility, and sustainable development.

The burgeoning importance of this newly revived movement is demonstrated by the current frequency and scale of activity at every level (Calder and Culverwell 2005, 43). Among international organizations the United Nations is coordinating a public-private partnership between UNEP and 170 banks, insurers and asset managers world-wide including Deutsche Bank, Dresdner Kleinwort Wasserstein, Goldman Sachs, HSBC and UBS to explore the financial materiality of environmental, social and governance (ESG) issues to securities valuation (UNEP 2004). Early in 2005 the UN convened a group of 20 of the world’s largest institutional investors to negotiate a set of Principles for Responsible Investment, and published a Working Capital report in early 2006 as a guide to the investment community on how to incorporate environmental, social and governance issues into their investment decision-making and ownership processes. This builds on the work of the UN Global Compact with more than 1,500 corporate signatories, which is working with the world’s leading stock exchanges and the World Federation of Exchanges to advance the principles of corporate responsibility in capital markets and with public corporations (UN 2000).

In 2005 institutional investors representing US$21 trillion in assets came together for the third Carbon Disclosure Project meeting, collectively requesting the world’s largest corporations to disclose information on greenhouse-gas emissions and their approach to the management of carbon risks (UNEP FI 2005). Finally, 36 of the world’s largest banks, representing more than 80% of the global project finance market, have adopted the Equator Principles, a set of voluntary principles outlining environmental, social and human rights disciplines associated with project finance above US$50 million (Freshfields Bruckhaus Deringer 2005). The principles originally were developed by the International Finance Corporation (IFC), the private sector investment arm of the World Bank. The OECD also is active in the promotion of CSR in its guidelines for the operations of multinational corporations; and the European Union is actively encouraging CSR as the business contribution to sustainable development (OECD 2000; European Commission 2003, 2004). At the national level a growing number of governments in Europe, and across the globe, have identified strongly with the call for corporate social and environmental responsibility, even with the evident difficulties in applying the Kyoto Protocol and creating an effective international climate-policy regime.

At the corporate level the World Business Council for Sustainable Development. 2011. Global Corporate Citizenship Initiative: Redefining the Future of Growth: The New Sustainability Champions. Geneva: International Labour Office.

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